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Bonds markets
are telling investors that a prolonged period of low rates will be necessary to
dig out from the deepest recession in almost a century.
In the United
States short rates are effectively zero. The American 10 year bond closed at
3.32% on Friday, a minimal ask considering the record amounts of debt
issued and to be issued by the Federal
Government. Bond investors have not
demanded a premium return for taking on ever greater amounts of debt. The flood
tide of government debentures has not driven bond prices into the depths.
But equity prices are even more buoyant. They predict a strong, almost
immediate economic recovery. The MSCI world index of global equity prices is
nearly 24% higher this year, an amount equal to its first quarter drop. The
index at the epicenter of the financial crisis, the Dow, is 47.6% above its
March 9th low; though still 32% below its October 2007 record of 14,164.53.
Similar advances can be found in almost all the first world’s equity markets.
Emerging markets have performed even better, up more than 60% since the
beginning of the year; they are now more than 90% above the bottom. The Korean
Kopsi, the Indian Sensex 30 and Brazil’s Bovespa have become the new darlings of
active investment.
But which prediction will come true? The strong
economic growth anticipated by the equities leading to inflation, higher
interest rates and chastened fixed income investors? Or the weak and slow
recovery predicted by the bond market with consumers unwilling to spend, high
unemployment and moribund business investment?
But perhaps this is the wrong opposition? Is there
any factor that could be driving both stock and bond prices higher regardless of
economic circumstances? The answer is liquidity or cheap money; the emergency
creation of the world’s central bankers.
But before we examine the
effects of this tidal wave of cash, let’s see if last week’s American statistics support one
economic case or the other.
They do not. The most recent spending and
housing numbers are not indicative of a strong recovery or an economy slipping
back toward recession, (my assumption is that economic growth in the third
quarter will be positive).
Durable Goods Orders, items meant to last
several years, fell 2.4% in August much worse than the predicted 0.4% gain. It
was the weakest reading since January. The headline number includes sales from
the volatile commercial airplane sector and Boeing Company added 32 orders in
the month as opposed to the 44 in July. But the ex-transport number, that is
without airplane orders, was flat and well under the +1.0% predicted by
economists.
Outstanding consumer credit, reported prior to last week,
declined a record $21.6 billons in July. It was the tenth negative month in the
last twelve and the sixth in a row. Restrained consumer spending and a near
record low capacity utilization of 69.6% in August (the lowest was 68.3% in
July) will probably keep companies from investing in new plant and equipment,
hiring employees or returning some capacity to production in the fourth
quarter.
Auto makers may also have a difficult quarter with demand having
been drained forward by the government’s cash rebate program. Edmunds.com
reported sales forecasts running at a 9.3 million annual units in September.
For comparison in September 2008, in the middle of the financial meltdown, units
were running at 12.5 million per annum
Homes sales have improved but the
small increase in prices is not nearly enough to augment consumer spending.
With so much equity having been lost there is no equity to withdraw for
supplemental income. New homes sold in August at a 429,000 annual pace. That is
100,000 units better than the low in January of 329,9000 but it is far from
the 10 years average of 916,840 million units and light years from the peak of
the housing boom in July 2005 when 1,389,000 homes changed hands.
Existing home sales have jumped 13.6% from the January low of 4,490,000
to 5,100,000 in August. But as with new homes, this is below the 10 years
average of 5.78 million and you have to go back to January of 2001 to find such
a low number pre-crash.
With American unemployment and underemployment
rising, the housing market stagnant, and consumers engaged in serious
deleveraging, it is hard to see where the consumption will come from to support
a strong economic recovery. Some of the best equity performers are stocks with a
large percentage of their earning from overseas operations. These firms have a
double benefit, faster foreign GDP growth and the trading boost of a weaker
dollar when profits are repatriated.
The case for a strong economic
recovery is unproven. A substantial amount of third quarter economic activity
was due to various government stimuli--the now ended cash for clunkers rebate
and the $8,000 real estate purchase credit scheduled to expire at the end of
November. Inventory replacement also played a part and the natural bounce after
such a hard economic fall. But with the exception of the real estate credit
which may be extended these stimuli will not be repeated in the fourth quarter.
Sustained economic growth needs consumer participation which is simply not at
hand.
History is unfortunately a poor guide to our choice of economic futures as well. In general the
steeper the economic collapse the stronger the subsequent economic growth
spurt. But it is also well documented that recoveries from financial recessions
are slower, weaker and more prone to relapse than normal business cycle
recessions. And this has been the most serious financial recession since the
1930s.
But there is a more pertinent explanation for the rise in bond and stock prices since March
Stocks and bonds are
both having a grand liquidity rally. With interest rates exceptionally low and
the economy flooded with cash, there is no place to earn return. Money mangers
are judged by their monthly, quarterly and yearly returns. They have no choice
but to get on board the rallies. Their
economic view is irrelevant; it is unimportant whether fundamental
developments justify a rally. A manager’s
performance is judged against the market and the market is up
There is a
similar situation in the bond markets. If bond traders were disposed to take the
stock rally as an indicator then their response would likely be to sell bonds anticipating higher
rates in the near future. In normal times
prices in equities and bonds tend to move in opposite directions.
But the
normal progression of rising equities presaging a stronger economy, inflation,
lower bond prices and higher rates has been broken by the Fed insistence that
rates will stay low for a long time. To paraphrase Ulysses S. Grant, ‘bond
traders have been told so many times by Mr. Bernanke that rates will stay low,
that they have finally come to believe it’.
So in yet another unusual
fact in a year of oddities, both higher bond and equity prices can be right at
the same time. The economy will probably not recover quickly, but even if it
does, rates will stay low and bond prices high. |
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