Market Recap

Posted on May 22, 2015 by Gemmer Asset

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It was a generally a positive week for the domestic equity markets. The S&P advanced a modest +0.2% while small-cap equities were up +0.7%. But the U.S. markets look pretty boring compared to the overseas markets for a change. Germany jumped +3.2% in local terms while France was up +3.0% and Japan +2.7%. The European markets were helped by two key items, both related to the European Central Bank (more detail below). Japan was boosted by a decent GDP number and signs that the Bank of Japan had no intention to change currency policy. However, returns for U.S. investors were diminished by currency moves. The euro lost -3.9% for the week while the yen was off -1.9%.


Bond yields ticked higher again this week with the yield on the 10-year Treasury closing at 2.22%. Intermediate-term government bonds lost -0.5% while high-yield bonds were down -0.2%. More on the global fixed income markets below.


Madness in China


From an equity perspective the real fun and games is taking place in China. The local A-share market (stocks traded on the mainland – chart below) notched up an impressive +9.3% weekly gain while the H-share market (Chinese stocks traded in Hong Kong) was up +1.5%.




Equities in China are still being boosted by hopes of further policy easing. The authorities there are sending strong signals of more interest rate cuts to come as well as further debt support for the provinces. But the Chinese market has to be one of the most speculative around. Just this week two companies saw massive declines after – well – nobody is quite sure. There are hints of insider dealing and possible fraud. Hanergy Thin Film Solar group saws its shares fall 50% on Wednesday alone before being halted. The majority holder of the firm, Li Hejun, saw his worth reduced by roughly $15 billion in minutes and he stands accused of actually shorting his own shares. This fiasco came after Goldin’s shares plummeted on Friday.
Of course Hanergy was up something like 500% before the fall, with a huge increase in margin debt clearly playing a role. The chart below from Macquarie shows the rapid increase in margin debt as a percent of shares traded on the local exchanges. Crazy.




The Fed is Waiting Like Everyone Else


The Fed was vocal this week with two main events. First, the minutes from their last meeting were released and they basically pointed to no hike at the June meeting. Key points include:


– No hike in June. Many members were quoted as wanting to wait for more information before hiking rates.


– Officials generally see the bout of slow growth in the U.S. as temporary.


– However, they are puzzled why consumer spending remains so soft given the fall in oil. To quote from the minutes:


“Some participants expressed particular concern about this prospect, as their expectations of a moderate expansion of economic activity in the medium term, combined with further improvements in labor market conditions, rested largely on a scenario in which consumer spending grows robustly despite softness in other components of aggregate demand.”


Nothing too surprising here. Janet Yellen also gave a speech on Friday.


1. Yellen said that liftoff of the funds rate “will be appropriate at some point this year” if the economy continues to improve in line with her expectations. She also reiterated that “continued improvement in labor market conditions” and reasonable confidence that inflation will move back to 2% over the medium term are requirements for liftoff, but that this does not imply waiting until employment and inflation are already back at the FOMC’s objectives.


2. Yellen downplayed the weak economic data received in recent months. In particular, she described the soft Q1 GDP print as “largely the result of a variety of transitory factors” such as severe weather and the West Coast port strikes.


3. Returning to a theme from her March 27 speech, Yellen noted that three major economic headwinds–deleveraging, drag from fiscal policy, and a weak global economy–have diminished but not “fully abated.” As a result, Yellen said, the FOMC should “proceed cautiously” with respect to the pace of normalizing monetary policy.


Again, nothing really new. Some thought today’s inflation report might spark a bit more of a hawkish tone. The core CPI increased +0.3% in April, the largest gain since January 2013 and 0.1% higher than expected. But if you look at the inflation chart below, the Fed’s favored measure, the core PCE (the green line), still remains well below 2%, and most estimates for the full year see it trending around current levels.




Mohamed El-Erian, former CEO at PIMCO summed out the outlook nicely:

“All this is consistent with:


• An economy that will cyclically recover but, unfortunately, will remain demand/supply impaired for the economic liftoff that it is capable of, especially under a more comprehensive policy response that unleashes more fully the private sector’s potential;


• That there will be nothing automatic or traditional about the upcoming interest rate cycle – it will involve a very shallow path, meeting-by-meeting assessments, a lower terminal point and, probably, stop-go dynamics; and, thus


• This cycle will end up being the “loosest tightening” in the modern history of central banking.”


The Deflation Scare Comes to an End?


While the Fed may be moving at a snail’s pace, the global bond market is going through its periodic bout of crazy. Yields in the U.S. have moved noticeably higher the last few months, as you can see below. Importantly, yields have increased despite pretty downbeat economic data.




This is also the case in Europe.  The yield on the 5-year German bond has shot higher the last few weeks.  And while today’s yield of roughly +0.1% rate isn’t much to write home about, it is quite a turnaround from -0.2% back in April.




There is no-end of explanations for rising yields in the face of still sluggish growth. The explanation in the FT is about as good as it gets:


“What explains the recent “bund tantrum”? Its causes can be traced back to the summer of 2014, when oil prices suddenly collapsed. With headline inflation rates plummeting, fears of “bad deflation” spread like wildfire, especially in the eurozone. Eventually, the ECB adopted a major regime change, culminating in the announcement of a €1tn programme of sovereign bond purchases on January 22nd.


The initial response of financial markets to these events seemed well justified. Led by the eurozone, government bond yields trended sharply downwards, and the euro and dollar exchange rates adjusted appropriately. By the end of January, markets had adjusted to ECB quantitative easing very much in line with the playbook established in previous QE episodes in the US, UK and Japan.


After that, however, the bond and currency markets went much further than they had done in those earlier examples of QE…The term premium on bonds – ie the difference between the long bond yield and the expected cumulative short term interest rate over the same period – was abnormally low.


With speculative positions in eurozone fixed income and the euro reaching unprecedented sizes, the markets were ripe for a sharp reversal. It came when an easing in Chinese monetary policy triggered a recovery in oil and commodity prices. Markets realised that the deflation threat had ended in most advanced economies.”


And this idea of rising inflation expectations (off a very low base) is borne out in the data. The chart below shows expected future inflation rates (red line) versus the German 10-year bond yield. Inflation expectations have clearly increased with the rally in oil, and yields have followed expectations higher.




But we shouldn’t get too carried away.   The fall in yields the last few quarters is simply staggering.  You can see that above with the 10-year yield falling from 1.5% to almost zero.   It really stands out in the chart below where you can see that 5-year yields have fallen all the way from 5% back in 2000 to today’s 0.2%.  The recent blip higher hardly stands out.




And we probably shouldn’t pile into to the short bond positions just yet, particularly in Europe. The ECB isn’t likely to stand by and let higher yields undermine the recovery there. This week the ECB surprised most people by pledging to increase its monetary stimulus over the next few weeks. Benoît Cœuré, a member of the ECB’s top ranking executive board, said in London on Monday evening that eurozone central bankers would front-load some of their purchases of sovereign debt in May and June to deal with an expected shortage of liquidity in July and August. This came on the same day that head of France’s central bank Christian Noyer said:


“The Eurosystem is ready to go further if necessary to deliver on its mandate of maintaining inflation close to but below 2%.”


The ECB is certainly going to continue to keep pushing on the accelerator until they get the result they want. If it works inflation moves modestly higher and bond yields probably drift up. If it doesn’t, it won’t take long for the deflation worries to return.


Another Type of Crazy!!


The fun and games with Chinese equities is all well and good, but how about something a little closer to home, namely San Francisco real estate. The Chronicle had a great article this week and how crazy the market there is becoming.


“When 3658-3660 18th Street came to market in April, we knew that buyers would overlook the bright green carpeting, the funky paint colors and the complete gut job needed in the kitchens and bathrooms. We figured they’d be willing to overlook these defects due to the duplex’s prime location at 18th and Dolores and its low asking price of $1.099 million.


However, given that the nearly 2,800-square-foot 1908 building requires a top-to-bottom remodel (even the listing materials say “bring your contractors and your vision”), it’s still a little surprising that the fixer got just over 100% more than its asking price: $2.35 million.



Yes, that picture on the right is the kitchen. I don’t think the saying cheap at twice the price applies here. Not even sure it’s cheap at half the price.


Have a good weekend.


Charles Email Sig




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