Still Drifting
Sentinel Asset Management
By Christian Thwaites
July 16, 2012
We are in earnings season. This is a welcome relief from the macro and political world that has dominated markets and sentiment for several weeks. Earnings allow us to look at what companies are seeing and how they're reacting. We know they're operating in world of miserable nominal GDP growth so we will look at margins, sales, pricing power, management and cash positions. But first, why so listless and skittish?
Start first with the central banks: The ECB lowered rates but would not extend the LTROs. These may not have helped Spanish banks but at least would have signaled willingness to extend the period of easing. This was a mistake. The ECB acknowledged that inflation is well under control, heading towards less than 2%. They then threw responsibility for mending banking, fiscal and budgetary problems firmly at governments. And in doing so abrogated their obligations to manage demand. Yes, the wording of the mandate is "price stability" but price is simply a function of demand and every signal screams low and slowing demand.
Both the BIS and ECB (and indeed the Fed, but we'll get to that in a moment) talked about raising pressure on governments to delever and make structural adjustments. This is way outside their purview. At a time when there is a palpable and ongoing output gap, an imprecise term for sure but evidenced by unemployment and deviation from trend growth, CBs should be raising inflation expectations and holding to policies until those goals are met. Some claim CBs are out of ammunition. Not so. Almost everyone believes that CBs can create inflation. If one believes that, one must believe they can raise demand. It's a sequitur. And how can they raise demand? More purchase of debt securities, without the claw back of a collateral repo, and more toleration of price increases in excess of 2% that has become the standard, "well it feels about right," target.
So what happened as the ECB stepped back? 1) The € lost nearly 4% against the dollar and the yen, 2) French and German bills went negative, 3) 10-year Bunds rose 5%, 4) Euro stocks fell around 3% bringing the YTD decline to nearly 15%, and 5) adjacent currencies like the Danish kroner saw bonds fall into negative yields all the way out to four years. Low rates are not enough to change risk-aversion and we expect almost every economic report to dim in coming months. Meanwhile capital flight remains a problem. Around €150bn of capital fled Spanish banks last quarter, a sure sign that attempts to contain the crisis lack bite.
What next at the Fed? The minutes mention the words "employment" and "labor" 85 times. They mention "price" and "inflation" 155 times. Which tells you a lot about a) what they're more comfortable trying to manage and b) priorities. We had two Fed presidents press this point, with Jeffrey Lacker at Richmond and James Bullard at St. Louis stating that employment was "close to maximum right now" and "the output gap is not as large as commonly believed." We certainly believe that unemployment is overwhelmingly cyclical. It's tempting to think that unemployed construction workers can not be retrained into industries where there's demand and that therefore the natural rate of unemployment must rise. But there's precious little substance. This chart shows total private sector employment against three sample industries: construction, transport and finance (it wouldn't matter which you chose). If there were structural unemployment, then one would see big variations in a) the rates of decline or b) wages. But there isn't. Misery likes company and few parts of the economy were immune.
Source: Federal Reserve Bank of St. Louis, Economic Research
Also the JOLTS report this week showed much the same. The blue line shows job openings, on an inverse scale so down means more jobs, against unemployment. If structural employment were in play, we would see the opening line fall much more quickly than unemployment. There's also little evidence that firms are finding it hard to fill vacant positions. Even in the NFIB, which historically finds it hard to compete for employees, only 15% of employers are unable to fill open positions. Pre-crisis it was more like 25%.
Source: Federal Reserve Bank of St. Louis, Economic Research
Neither of the employment/output views are in the ascendant. And thankfully so because if they were, we would be raising rates and exiting asset purchases and this is not an economy that can carry its own momentum. But they do show the struggle of balancing demand, inflation expectations and employment with zero-based rates.
The Fed lowered all economic forecasts: lower growth, PCE and core inflation and higher unemployment. The bar for more policy action was set at "if the economic recovery were to lose momentum...or if inflation [were] below...objectives." They got both in the last few weeks perhaps most dramatically with the PPI, here shown jogging along way below long term averages.
Source: Federal Reserve Bank of St. Louis, Economic Research
So that increases the likelihood that we may get another version of QE and the timing sometime between the next meeting in early August and the Jackson Hole meeting at the end. Watch for more hints of this in coming weeks.
The markets seem to be previewing some action. We had an extraordinary $21bn auction of 10-year notes at a record low of 1.45% with strong bid-to-cover and non-dealer demand. This chart shows the 10-year TIPS at record lows. This says simply that the government can borrow at negative 0.6% for the next eight years and so the inflation risk is minimal and that nominal rates will remain stuck. For most of the last 20 years the TIPS rate has been closer to 2%.
Source: Federal Reserve Bank of St. Louis, Economic Research
Other Economic Stats: The trade deficit for May declined by $2bn, mostly because of lower crude and petroleum product. They represent 18% of all imports and were at their lowest level since February last year. But while exports are still strong, it is likely that slowdowns in China and Europe will dampen growth in coming months and provide little contribution to 2Q GDP. Consumer credit appears to be on the mend and almost back to where it was in early 2008. But no, this is not a resurgence in consumer confidence. Quite the reverse because nearly all the growth is due to student loans. The government now owns 18% of all credit. And that's because jobs are scarce, conventional loans hard to come by and demand flat. And it's also, make no mistake, consumption brought forward which means that a whole generation of students is going to be very reluctant to form households.
Source: Federal Reserve Bank of St. Louis, Economic Research
Bottom Line: Bonds this week rallied with a mid week bounce to 1.45%. We think that's mainly foreign buying and, specifically, the Swiss National Bank which is defending its €1.20 peg against the CHF. The more they sell CHF to maintain the peg, the more they accumulate euros, some of which are swapped into dollars and GTs. Which all makes sense if you're a central bank with a limited appetite for your main trading partner's currency. The story in equities is watch and buy. The dividend story remains a main driver. S&P dividends have doubled since 2002, during which time the market has done nothing.
Sources: The Economist, Blogs, Free Exchange; European Central Bank; FT Alphaville; Peterson Institute for International Economics; Capital Economics; High Frequency Economics; Bloomberg; Federal Reserve Bank of Richmond; Federal Reserve Board; Federal Reserve Bank of St. Louis; ISI; US Census Bureau; US Bureau or Economic Analysis; National Federation of Independent Business; Sentinel Asset Management, Inc.
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