“The U.S. economy continues to improve,” said Bryan Novak, senior managing director with Astor Investment Management, which manages $1.1 billion. “Anyone who has maintained that view has been rewarded over the past couple of years.” (READ MORE)
At Astor, we have an analogy we like to use from time to time to put into perspective our view of economic/political/fiscal, etc. events and how the market and economy may react to them. When a healthy person contracts pneumonia, they get sick no question, but through normal processes of the immune system, they resume normal functions in short order. A patient with an already compromised immune system that contracts pneumonia becomes very sick and takes an extended period to recover, and may even die. At Astor, our job is to diagnose the health of the economy.
Astor utilizes our long-tested proprietary analytic measurements to determine how healthy the patient is (patient being the economy). We measure what we consider to be the major vital signs of the macro economy and financial markets (employment, output, interest rates, market performance) and determine if the economy is healthy enough to support rigorous activity. Can we support higher risk asset prices from here or not, and to what degree of probability? Our background, experience and research have enabled us to position these figures in such a way as to provide a relevant perspective and practical framework for an investable and executable solution for client portfolios.
This isn’t a healthcare blog obviously, so what am I getting at? Follow this example with me if you will. In 2007, we started seeing signs of a declining economy, and by Q2 2008, we had reduced our exposure so significantly that we had a defensive position on the economy and the markets. The excessive borrowing and loose regulation and oversight of credit creation was like a virus already reproducing in the global economic system. The economy was already slowing down and most likely headed toward a recession. When the events of Sept/Oct 2008 happened with Lehman Brothers and the collapse of other financial institutions, this was the virus being acquired by the sick patient, and it almost died.
In 2010, the global economy was in initial recovery mode, still showing symptoms but in general feeling active. In April and May that year, we experienced two distinct shocks to the system – one in the form of a sovereign debt crisis in Europe and the other a flash crash in the U.S. financial markets. One technical and one economic, however both were issues. The point to note is that the economy was actually growing and recovering here in the U.S. during that period, and it was healthy enough to absorb these events. Now, this is not to say that the sovereign debt crisis did not have an economic impact globally, as it did. It speaks to the ability of economies to handle negative inputs when they are growing, or at least stable and not decelerating.
So what does this all mean for where we are today? We have clearly contracted a virus called “Washington-impasse”. We also have a cold called “sudden interest rate acceleration”. If that isn’t enough, we are still feeling the lingering effects of sequestration (oh, that’s still Washington, isn’t it?). The economy suffered some fits and starts this year, but as of the most recent data, we have seen readings from broad based economic measures such as ISM Manufacturing PMI, Chicago PMI, ISM Non-manufacturing that are at multi-year highs or top end of the range, as well as post- recession lows in jobless claims. Additionally, this time around, Chinese PMI/economic activity appears to be stabilizing and Western Europe has shown increasing evidence of emerging from its multi-year recession. These factors should all act as support beams from fiscal stress.
What’s occurring in Washington will create disruption in the markets, and frankly should more than it has. The markets have brushed off fiscal drags for the past two years, and now that a short-term compromise has occurred it has the opportunity to do the same. The ripple effects of the initial government shutdown are being felt in elevated claims numbers and corporations are adjusting guidance already for Q4 revenue. This will have an impact to Q4 GDP and the consumer, but the result may be transitory. The bottom line is if the economy is gaining steam despite the headwinds finally, and recent numbers have suggested as much, it will absorb these shocks. This does not mean volatility will not exist and markets can’t react adversely short term, but those are the unknowns and timing them is difficult. If there is truly more to this movie than a temporary, we’ll know. We measure this patient’s vital signs every week. If it shows up with a fever, we stand ready to help our clients minimize the effects.
Even though the U.S economic picture is viewed as modestly improving, we’ve experienced two straight quarters of GDP under 2% and Q2 looks to follow suit. Empirically, that just doesn’t happen in expansions, but it’s what we’ve lived for almost two years now. The minutes from the June FOMC meeting continued on the thesis of improving structural conditions in the domestic growth picture for the medium to longer term as well as diminishing downside risks, but they are concerned with declining inflation, the other FOMC mandate, although they do view this as predominantly transitory right now. June CPI showed a marginal tick up, but this has been a problem for some time (see WANTED: Growth and Inflation). As accommodative as monetary policy has been, it has been successful in lowering the risk premium, but not igniting growth.
Clearly fiscal policy HAS had an impact. Not sure how that is debatable. However, the market has been extremely resilient in the face of slack growth, a 120 basis point rally in 10 year rates, declining inflation and a degrading credit situation in the Emerging Markets (EM). Who would think with that backdrop the US domestic equity markets would be up over 18% for the year while the rest of the world (sans Japan) was sucking for wind? While the MSCI Developed market index is up around 7% this year, strip out Japan (+ 22% approx. YTD) and the returns are considerably less.
The EM internals have been very disconcerting. While US equity market volatility jumped in June to the highest levels since the eve of sequester, emerging market volatility surged to levels last seen during the sovereign debt crisis of September 2011. Much of this was attributed to recent concerns on slowing growth and credit issues in China as well as significant pressure on the core BRIC economies. To be sure that credit was the concern, from the year high in the JP Morgan Emerging market credit index on May 2nd, to the low on June 24th, the index lost just over 12.5%, almost 90% of what the MSCI Emerging Market equity Index lost over the same period. The default swap index on EM CDS investment grade bonds traded at 2011 levels in June, whereas the US CDS investment grade index was nowhere near these levels. These economies have had a very challenging time with slow growth and inflation globally resulting in weak demand for commodities. Unless something changes in that equation, the relative value trade remains undoubtedly in favor of U.S domestic equities over international.
In the face of the current growth environment, how are the markets going to continue to provide returns for investors commensurate with the risk? The IMF just lowered their forecast for global AND U.S. growth for this year. The Chinese government also said last week “growth as low as 6.5% may be tolerable in the future”. Investors have become increasingly anticipatory of a revitalization and return to trend growth and employment in Q4 and 2015, respectively. The Fed propagated this in the June minutes by communicating their view that structurally speaking, growth is improving, labor markets are solidifying and weak inflation will be transitory. Corporate balance sheets remain strong and efficient and inflation is low. The housing market has been strong, but with rates up 120 bps, mortgage aps are already dipping. The consumer has held up, and hourly earnings have started to move marginally higher. Retail sales figures for June weren’t pretty, but volatile markets tend to do that to people. Right now, in technical economic terms, we are fine. Growth at 2% can plug along, but only for so long. PIMCO coined the term “new normal” in 2009/10 and caught flack for it. Were they so wrong? It is absolutely critical the economy move up to meet the market this time. Catalysts remain elusive while the sources of drag persist. Fiscal policy has to become neutral, forget about accommodative, in order for the true economic engine, corporate America, to regain confidence. The back half of July carries some significant data points, with the usual suspects of regional/national output measures, culminating in Q2 GDP and the FOMC rate decision on 7/31. Usually I would not put stock in June/July numbers, but as starved for signs of life as we are and as focused on the Fed as we have become, it is what it is. Volatility is not out of the picture.
The first quarter of 2013 defied many prognostications as growth tracked faster than most had expected. We noted in our outlook report that the sanguine Q4 GDP number would most likely produce a bounce back effect as we transitioned from uncertainty to an “identifiable risk” environment. However, in the face of ongoing concerns and the prospects of national austerity measures, this year surged at a rate faster than many anticipated. National output measures and employment reports buoyed hopes of a strengthening economy. Although Q1 GDP posted at 2.5%, below revised estimates of 3%. We should not forget we were not even close to 2.5% as the year began.
As steady as the data was, the vast majority of reports after March 20th and into April began to express a different tone than the recent trend. ISM Manufacturing took a dive to 51 from a previous 55, followed by other regional output gauges with similar declines. The Chicago Purchasing Managers Index reported its first reading under 50 since late 2009. Non-farm payrolls for March played out the recent move higher in weekly jobless claims. The aggregated job adds, including previous month revisions, was in the 150k area. Job creation was consistent with totals over the past 6-9 months but not in the ballpark of expectations after February’s 236K report. Given the surrounding environment, it’s excusable to have held off on buying into this market given its recent history to disappoint at this time of the year.
In reality, the most rational way to view the current period is we are still in a low growth range and experiencing a temporary patch of weakness. We simply got a little excited in Q1.
With that being said, there are some dichotomies in the financial markets right now that may foreshadow deeper rooted issues. Around mid-February, when the financial markets experienced their first bout of volatility of 2013, a divergence among international and U.S. markets seemed to appear. As you can see in the chart below, international equities are well behind domestic equities this year with emerging markets actually down for the year. The renewed stress on the European financial system and a weak recovery has put pressure on those markets. Commodity prices have fallen, led by base metals, as concerns about China’s growth have risen. The above factors pressured commodity producing nations and hampered returns for emerging markets.
Everyone is focused on when the Fed will exit its QE program as the economy moves forward. Maybe Mr. Bernanke was placating us by alluding to the exit, knowing full well the economy is not ready. Either way, recent economic reports have us moderately concerned about growth again.
So the question is why are all of these economically sensitive commodities (gold, copper, oil) seeing price declines if the global economy is evolving into a self-sustained expansion? Are rates signaling something as seen by 10 Year yield staying pressed below 2%?? Against the back drop of surging stock prices, this is curious. Combined with the recent announcement from the Bank of Japan on their U.S. look-alike QE program and it makes the interest rate AND precious metals price movement even more surprising on the surface. Throw in the continued weakness in Europe and a considerably benign inflation picture and you have a recipe for continued stimuli, not less.
The currency base has increased substantially, specifically MZM, or Money with Zero Maturity. However, if you look at velocity of money chart (shown by M2), you can see the rate of decline has been consistent for almost 5 years now. We are not creating the Fed induced monetary bubble that many think.
Money is just not out there chasing goods, the definition of monetary inflation. Consumers have been deleveraging for the last five years, banks are not lending a great deal and corporations are still reluctant to release the purse strings on capital investments with their record levels of cash. Commodity prices have been fading all year, another indication of slack end demand. To be sure about this sentiment, we also looked at other price and demand related gauges for further indication. Recent trends in PPI, CPI and Import Prices have all moved to multi-year lows and in some case post-recession lows. The Personal Consumption and Expenditure Core and Deflator indexes reported at month end also posted their weakest year-over-year readings post-recession. Lower commodity prices/input costs are helping keep cost down for producers, but the aggregate demand curve is proving a bit inelastic in the current environment.
How to read this:
What we’ve learned in recent weeks is the Fed is most likely to maintain its programs to support the economy. Recent FOMC minutes detailed that the Fed is willing to move that lever wither way as needed. With the labor market recovery pausing last month, their peg to the UE rate seems to support continuation for now. Recent national output reports from ISM Manufacturing and Chicago PMI, which measured a sub-50 reading for the first time since 2009, are supporting this recent soft patch. While concern may be building over the eventual exit of QE, recent data had provided support for at least the maintenance of the program for the near term.
The domestic inflation readings are confounding Fed policy. There is one way to look at this. Supply is currently outstripping demand and global growth is below expectations. Import price, PCE deflator, CPI, et al, have all been declining. This movement supports the Fed and other central banks in their continued supportive monetary stances, but it means the excess liquidity is only solving one half of the equation. It is not sparking a demand recovery, yet.
Broad markets in the U.S. have posted strong gains to start 2013. While the U.S. has fiscal issues to navigate, the European environment is much more unpleasant. A great credit shock seems less likely now as preparation and awareness is the antidote for surprise, but the recovery appears arduous and uneven. Logistics in the U.S., while not ideal, are more manageable at this point and the corporate sector is in good shape. Thus far, Q1 top line revenue growth and guidance have disappointed on the balance: a potentially ominous sign.
The economy has impressed early this year with its “plow along, steady as she goes” pace. However, more recent data has been less encouraging. If the current shift turns out to be a new pattern, we would become concerned and reduce exposure.
The lack of inflationary pressures in the market and economy are of some concern as they could be signaling a weakening demand picture or even a worst case scenario of a deflationary spiral if growth cannot pick up. The first half of 2013 was supposed to be on the weaker side. The second half of this year was supposed to be where we got back on track for good, remember? We may have gotten further ahead of ourselves recently, with our perspective suffering by default. Remember we have some non-standard issues in type and magnitude we are still reconciling, and they may take time.
We are not of the camp that the trend is back down at this point, but the length and breadth of the soft patch is expanding. This deserves our attention and some thought to risk. Lastly, as stated in our outlook report, we do not expect this to be the year the bond bubble (if there is even a bubble) bursts. Rates appear to be a bit jumpy but range bound. The persistent strong demand for fixed income assets is keeping a lid on rates. The transparency of the Fed has created a great environment for our Active Income strategy, which is a component of most of our other portfolios as well.
– Bryan Novak