A Growing Interest in Bonds
Will the volatility in fixed-income markets continue to lead the wide fluctuations in global equity and currency markets? After the dust settled last Friday, the 10-Year Treasury, which traded with a 1.80% yield in mid-April, reached 2.40% on Monday, only to fall back to a 2.15% yield by week’s end. The German 10-Year bund, which only a few weeks ago was yielding a barely positive 0.08%, saw yields rise above 0.75% before declining to 0.65% on Friday. This rise in the bund came as the ECB continues its aggressive bond purchases. The euro continues to rise against the dollar. Since its lows of 1.03 in early-April, the euro climbed to 1.14 by week’s end. US stocks reacted by falling over 1% early in the week, but by Friday the S&P 500 was up 0.31%, a new record high. The Dow and the NASDAQ finished up 0.45% and 0.89%, respectively, and remain in striking distance of record highs.
Explanations abound over these fluctuations, but the truth is elusive. One factor is that fixed-income markets are thin with trading volumes about half of the pre-2008 crisis levels. Government policy (Dodd-Frank) and the forced exit of proprietary trading desks at large brokerage firms and banks left dealer inventories at an estimated 10% of prior levels. Trading is now concentrated and without adequate dealer inventories, a repricing of bonds to more realistic levels results in wide spreads. In retrospect, European Bonds were irrationally priced as the Central Bank QE policy reduced the likelihood of deflation. For most of this year, momentum traders have moved between oil, the dollar, and bonds which seem to rise in lockstep. Oil prices, which reached $110 a barrel in mid-2014, fell to $42 at its lows in January. Until recently, there was an overwhelming consensus that the dollar would reach parody with the euro as the euro fell to 1.03 while at the same time oil reached its lows on its way to $30 a barrel. European Bond prices rose after the ECB buyback was announced and yields of most of most bonds under ten years were negative. Traders and hedge funds piled into long-term bonds as markets priced in permanent deflation in Europe and disinflation in the US. Participating traders believed fundamentals supported these moves. But markets reversed, and many of these hedge funds along with algorithmic traders, were caught on the wrong side of the trade. Last week the sudden turnaround reached the equities markets as stocks fluctuated widely in response to the bond selloff. In our opinion the sharp selloff in equities reflects a need for dollars to cover trading losses and margin calls.
The recent volatility distracts from the real problems for bond investors, fixed-income mutual funds. Year-to-date through May 3rd equity mutual fund outflows were $51 billion dollars, compared to a $1 billion inflow over the same period last year. Meanwhile, domestic fixed-income bond funds had $52 billion in net inflows year-to-date. More interesting is the net outflow from domestic equity funds has continued for 19 consecutive weeks, while US taxable bond funds have experienced 20 straight weeks of net inflows. Many of these retail investors switched out of equities during the latter stages of the stock market collapse in 2008-2009. Since that time taxable bonds have remained in a bull market. Unfortunately, this bull market is about to end, even if rates move up slowly. We do not expect any immediate flood of withdrawals from these funds until losses begin to accrue in the accounts and are mirrored in quarterly statements. Bond fund inflows remain strong, but it is important to watch for a slowdown in the net inflows. Remember, the job of the bond mutual fund manager is to manage along the yield curve, not to time the market.
As often stated on these pages the US economy is presently in no danger of a cyclical recession. Data for 1Q2015 are weak and the marginal growth of 0.2% in real GDP will be revised to a negative when the second estimate is released on May 29th. The most recent economic data show no marked pickup in activity thus far in 2Q2015. This is somewhat disconcerting as weather, particularly in the Northeast, is often the reason given for a weak 1Q2015. The long-awaited return of the consumer remains uncertain, as retail sales in April were much weaker than consensus. Last week the University of Michigan Consumer Sentiment Index fell much more than forecast. The decline was widespread, covering all demographics and regions. Noteworthy, for the first time in recent years, consumers lowered expectations for a faster recovery. According to the data source, consumer disenchantment witnessed in the 7.6% decline in the May Sentiment Index remains consistent with a 3% PCE. Our position has been that personal consumption expenditures (PCE) is far less important to overall economic growth (38%) than to real GDP final sales (68%). In addition, housing remains lackluster as the supply of affordable new homes is less than demand, resulting in higher prices. In a report today, the National Association of Home Builders claimed “Consumers are exhibiting caution, and want to be on a more stable financial footing before purchasing a home.” However, the average loan is $315,670 for a newly-built home as builders focus on higher-end buyers, not entry level.
The positives of the oil price decline has yet to work its way back into the economy. The negative effect on capital spending, employment, and earnings in the Energy sector far outweigh the benefits. According to economists there is little need to worry because there is a lead-time of 12-18 months for the full impact of increased consumer spending and business saving to be realized. Time is running out, crude oil is already 43% above its February lows and at the pump, gas prices have risen 37.3% to $2.80 per gallon, well-above their late-January lows. Retail gas prices are now back to levels last seen in November 2014. Any consumer savings on energy has been spent on increased costs for necessities, including the rising payment for Obamacare. With an economy expected to grow in the 2%-3% range for full-year 2015, the question is; where will the growth come from? Market strategists focus on increased employment and the eventual uptick of wages and salaries, but without pricing power, corporations are reluctant to raise wages. According to a study by the Chicago Fed, it will take an increase in employment of at least 800,000 to ignite wage push inflation. Even the much awaited income tax returns for 2014 are lower than normal and tax payments have risen above expected levels. A rise in the PCE above the average 2.5% is unlikely for some time and during this cycle may never reach the sustained 5.0% seen in previous recoveries.
Stocks are up, albeit at low single digit rates, despite the current economic slowdown, the consequences of a rising US dollar for US corporate growth and earnings, perceived risks related to Fed policy, and stretched stock market valuations and various geopolitical risks. The economy is growing slower than had been forecast a few months ago, but it is growing. The dollar has stabilized and oil prices are at a more sustainable level. Although impossible to model the ideal level for oil, the US dollar, and bond yields, all are moving closer to equilibrium. Oil normally sells at a price where the marginal producer can make a normal profit. According to “experts,” this is between $60 and $80 a barrel. A rising dollar attracts foreign funds offering positive currency translation and appreciation in underlying securities, US equities markets are the recipient of this shift in capital flows. Bonds reflect inflation expectations, which at current levels of 1.5% and offering a real return of 1%, make a 10-Year Treasury yield of 2.5%-3%. Signs of increasing growth should begin to appear as we move through the summer. Stability in energy, currency, and fixed-income markets will give the stock market the underpinning for further upside.
Markets remain vulnerable as investors and traders assess the effects of declining earnings amid fluctuating oil prices, a strong dollar, and below consensus economic data. In the short-term, there is potential for a definable correction which will offer a tactical buying opportunity. Once the Fed raises rates, stocks should perform well during a rate normalization process. Longer term we believe that moderate economic growth, accompanied by slow rising real interest rates and low inflation, will result in increased earnings and limited multiple expansion with continued upside for equities. Our investment policy remains optimistic on selective Large-Cap domestic corporate equities.