First a Quick Update
In our on-going attempt to move into the 21st century, we have launched two new ways to follow us on-line
We have developed a new blog page where we will periodically offer our thoughts on the markets, financial planning topics, and anything else that we feel is interesting and possibly amusing. You can find our blog at the link below.
We are also now on Twitter under the moniker @gemmerllc
It was another one of those weeks where the daily volatility got a lot of attention but we basically ended up flat. The S&P was unchanged on the week while the small-cap index dipped -0.4%. Despite the weak economic data out of Europe, equities in that region were up +0.1% while the developed markets in general added +0.4%. The one standout were the emerging markets where a large rally India helped push that index to a +3.2% weekly gain.
The action in fixed income was much more interesting. The yield on the 10-year pushed lower to 2.47% before closing out at 2.52%. Intermediate-term government bonds added +0.7% for the week while high-yield added +0.4%.
A Stealth Correction
The spread in performance between various indexes in the U.S. is pretty interesting. The S&P touched a new high this week of 1,902 before backing off. We closed the week only 1.3% below the all time high. However, other indexes have seen material corrections. As you can see below, the NASDAQ (equally weighted) is down roughly 9% while small-caps are down about 10% from the highs.
Another way to look at this is through market breadth. The chart below shows the S&P 500 in the top panel and the number of S&P groups either above or below their 40-week moving average in the lower panel.
This chart means fewer stocks are participating in the rally, and that mainly a few large-cap stocks have supported the index. As a matter of fact, the number of advancing sectors has reached a point where you might actually expect a rebound. This proved to be the case in 2011 and 2012 when this ratio reached similar lows. Regardless, it is worth noting that there has been some decent amount of pain in certain sectors of the market.
Our suspicion is that over the last few weeks we’ve seen a rolling correction in the U.S. markets. First biotech names sell off, then high valuation tech issues. Both pull down the pricey small-cap indexes. But little of the selling seems to do with deteriorating economic fundamentals. It is more a result of froth in certain segments of the market combined with reality falling short of lofty expectations.
Finally, if investors were truly worried about the U.S. economy yields on high-yield bonds would be increasing (prices falling). As you can see below, during the past four corrections in the S&P we’ve seen a significant increase in junk bond yields. This time junk bond yields have actually fallen.
We still consider the rolling correction of the last couple months to be just that, a correction. There is no knowing how long it will persist, but in the U.S. at least a generally supportive economic backdrop should ultimately be supportive.
The ECB is in a Corner
Europe may prove to be something different. Economic growth numbers came out this week and they generally fell short of expectations. For the area as a whole growth came in at +0.2% in the first quarter versus expectations of +0.4%. Growth in the fourth quarter of 2013 was also revised lower. Probably just as important as the overall growth number is the fact that growth remains unbalanced. Germany beat expectations but France was flat while Italy and Portugal actually saw their economies contract.
The poor growth numbers out of Europe plus recent low inflation data make it almost a foregone conclusion that the European Central Bank (ECB) takes action at their June meeting. This week the Wall Street Journal reported that the Bundesbank is ready to support additional monetary easing at the next meeting. This comes on the heels of last week’s comments by ECB president Mario Draghi. During his press conference he was surprisingly forthcoming about what was likely to happen at the next meeting, in June. To quote The Economist:
“The council was dissatisfied, he said, with unduly low inflation and was ‘comfortable’ with acting next time.
Mr Draghi referred in particular to the recent strength of the euro in contributing to the current spell of low inflation. Although the ECB does not directly target the exchange rate, his remarks suggest that the central bank is most likely to lower interest rates, which would help to combat the currency’s unwelcome appreciation. Such a step would also be consistent with its forward guidance, to keep policy rates at ‘present or lower levels for an extended period of time’.”
Central bankers in Europe certainly have a budding problem on their hands. Deflation risks are rising in the Eurozone and, critically, money growth is faltering, as you can see below. The suspicion is the ECB will be loath to allow outright monetary contraction in the months to come as it almost certainly will guarantee outright deflation.
To continue with the Economist:
“Whatever the council does plump for in June, why wait until then, especially since Mr Draghi revealed that its discussions today had in effect previewed next month’s? The main reason, it appears, is that the ECB will then have available its latest set of staff forecasts (produced each quarter). The previous ones in March, which showed inflation averaging 1% this year and rising to 1.3% in 2015, already appear out of date especially for 2014. On May 6th the OECD forecast inflation would be only 0.7% in 2014, rising to just 1.1% next year. It would be surprising if the staff forecasts were not also lowered, supplying the final piece of evidence needed for the ECB to turn words to deeds.”
The pressure is now on the ECB. If they don’t move in June the European equity and bond markets will almost certainly riot. Draghi has painted himself into something of a corner in that the markets might actually be expecting something big such as large scale asset purchases. It may be tough for Draghi to meet expectations this time around.
Bond Yields Break Down
The situation in Europe also partially explains the fall in bond yields this week. On the surface one might have expected yields to have increased this week. Weekly jobless claims fell to a new cyclical low while the U.S. inflation report was a touch higher than expected. The Consumer Price Index (CPI) rose +0.3% in April and is now up +3.2% on an annualized basis. Core inflation (excludes food and energy) is up +1.5% year-over-year as you can see below. This is a notable increase from the lows at the beginning of the year
Further, both the Philly and New York Fed Manufacturing surveys were in solid positive territory, counteracting the fall in industrial production in April.
However, yields broke out of their multi-month trading range to the low side this week, as you can see below.
What explains the fall? Feel free to add to the list, but points we’d offer are:
- While inflation has ticked up lately, we are very unlikely to see inflation approaching the Fed’s 2% target on core inflation anytime soon.
- The deflationary impulses out of Europe and China are significant. This means tradable goods prices are falling on a year-over-year basis.
- Bigger picture, the savings glut that has been with us for a number of years persists. And with most developed governments running lower fiscal deficits, much of this surplus is finding its way into government bonds in the large developed countries.
- Sentiment is very negative on government bonds. You could probably contend that everyone who wanted to sell their long-term bonds have sold.
- Finally, it is not necessarily a given that bond yields have to rise during an expansion. The chart from J.P. Morgan below shows that the cumulative change in bond yields from the last day of the recession until the last day of the expansion was actually negative (falling yields) in 1982, 1991, and 2001.
Two Upcoming Catalysts for Bonds and Equities
The bulls and the bears battled to a draw this week, at least in the equity markets. In our mind the next two major events that could decide the battle will be:
- What does the ECB do at their June 5th meeting? If they disappoint that could be the catalyst for the large-cap indexes to push towards a more significant correction while bond yields fall further. An aggressive ECB would be supportive of risk sentiment.
- The day after the ECB meeting we get the unemployment/payrolls report. Another strong report would bolster confidence in growth this quarter. A weak report will almost certainly be bullish for bonds.
The fall in bond yields this week is a sign of strong deflationary forces flowing through the markets (insert Star Wars joke here such as ‘the force is strong with this one’). We suspect the markets will grow increasingly fixated on the above two events as a sign of what this summer has in store.
Have a good weekend…Charles Blankley, CFA