September 19, 2014
By Steve Blumenthal
As the debt bubble steps forward, we search for signs of inflation and deflation. Some growth and inflation is apparent in the U.S. while it is deflation and recession pressures in Europe and Japan. Which way are interest rates headed? The year-to-date surprise is that they have declined.
I presented this morning at the Morningstar ETF Conference in Chicago. Leading my panel was David Sekera, head of fixed income research at Morningstar and Bob Smith from Sage Financial. We talked about the direction of rates and ideas around portfolio positioning. There were several other important issues noted in our discussion:
- The market making game has changed over the last few years. Large banks are no longer making markets in fixed income.
- This is largely attributed to increased regulation. There is very little capital allocated to the bond desks.
- Bond market liquidity will be challenged during the next disconnect.
- While the positives are transparent pricing and smaller spreads, one has to wonder who steps in during the next crisis
- We agreed that we expect a harder and faster disconnect when either interest rates spike and/or defaults surge.
All of this means that getting the rate direction correct is really important. Being nimble is important. Being ahead of the move quickly is mandatory. We shared the logical ideas around patiently positioning to shorter-term debt and considering some small exposure to emerging market debt. We suggested adding tactical bond strategies. The bottom line is that we investors must think differently about our bond exposure.
As for the direction of interest rates, I shared my two cents is low rates for the next few years with significantly higher rates in three to five years; but that’s a best guess. I think the Fed begins to raise rates next year and that they’ll move towards a 2% Fed Funds rate (currently zero) within two years. If inflation remains near 2% (a big if), then the 10-year Treasury should move to 3.5% or 4% if history is any guide. That means bonds lose 15% to 20%.
I added that the biggest risk I see is in the high yield bond market. Over owned as investors raced to chase yield. A $1 trillion market has grown to $2 trillion in just four years (it took over 30 years to reach a trillion). Nearly 75% of those bonds may default over the next five years (see Code Red In High Yields). Companies that should not find funding have found funding. Not everyone wins. The good news is that on the other side of this exists an outstanding opportunity but only for those who don’t get run over by the coming default wreck.
With the Fed updating its interest rate forecast this week (again tweaked higher) and the Pimco presentation on my mind, I share the following in this week’s On My Radar:
• Pimco’s Long-term and Short-term Outlooks (bullet point notes from the conference presentation)
• El-Erian – Bartiromo one-on-one with Mohamed El-Erian
• Value Line Median Appreciation Potential for the S&P 500 Index
• The Zweig Bond Model – Sell Signal switch to BIL
• Trade Signals – Too Few Bears – 09-17-2014
Pimco’s Long-term and Short-term Outlooks (bullet point notes from the conference)
Secular View (long-term):
• Private debt improving, government debt is not.
• Debt remains a large overhang.
• In developed economies – low inflation and they want more, but can’t get it.
• In emerging market economies – want less inflation and can’t get rid of it.
• EM can drive global growth – Pimco sees it as 50% of global GDP by 2016 (but EM is still dependent on the developed world.
• The eurozone economy should grow by about 1% in the next 12 months, continuing a painfully slow climb out of a double-dip recession.
• We expect Japan will grow by around 1% to 1.5% in the next 12 months and China’s growth is likely to slow to around 6.5%. The outcomes for other developing economies will be tied to what happens in China next year.
• Pimco’s economic forecast for the next 12 months calls for a continuation of a low amplitude, long frequency U.S. business cycle recovery, with growth between 2.5% and 3.0%.
• Demographics are a negative in the developed world as working age population will continue to decline up to 2029.
• A significant growth headwind. Older population spends less and earns less. Pimco expects 2% nominal GDP while Wall Street expects 3½% to 4% – expect Wall Streets estimates to be lowered.
Cyclical View (short-term 12 month view)
• Current GDP of 2 ¾% – a bit better than their prior estimate.
• Positive trends have emerged: Consumer confidence is up and they see diminishing policy uncertainty leading to stronger investor confidence.
• US household net worth is improving and higher than the 2007 high.
• US household debt service is now lower than it was in 1980. Better individual balance sheets – more money in the pockets.
• Housing affordability is good – a positive.
• Government spending is becoming less contractionary.
• Corporations yet to spend on capital expenditures have yet to materialize. Pimco is expecting this to pick up and continue to improve over the next two years.
• Central Bank policy to diverge:
• Fed – rising rates
• BoJ – flat
• Boe – rising rates
• ECB – flat and accommodative
Several additional notes:
• What happens when the Fed takes the punch bowl away? Exit the great experiment?
• Regulatory environment constraints: money market reform and Basel III – changes coming in the money markets – going to be gates put up upon exit, money market (MM) funds will move off the $1 peg value
• There are not enough assets available to put into MM funds compared to the large demand. MM portfolios have stepped into greater risks. It is a demand and supply mismatch. Risk up, liquidity down.
• In the past, banks were willing to take risks and make markets – that is now GONE (due to increased capital requirements – regulations)
• Banks are moving capital toward higher profit markets. No longer making markets. Market dynamics have changed. Few bids in times of crisis. Markets more apt to dislocate (this is something I discussed at length during my Morningstar presentation – especially as it relates to the HY bond market. Tread carefully!).
• Liquidity continues to decline.
Overall:
• 1¾% to 2% modest inflation expected
• 2 ¾% current GDP expectation, longer-term 2% nominal GDP for a number of years
• Fed begins to raise rates in mid-2015
The above are my conference notes but I do wish to share this from the bond king himself:
“This global monetary experiment may in the short/intermediate term calm markets, support asset prices and promote economic growth, although at lower than historical levels. Over the long term, however, economic growth depends on investment and a rejuvenation of capitalistic animal spirits – a condition which currently does not exist. Central bankers are hopeful that fiscal policy (which includes deficit spending and/or tax reform) may ultimately lead to higher investment, but to date there has been little progress, as seen in Chart 2. The U.S. and global economy ultimately cannot be safely delevered with artificially low interest rates, unless they lead to higher levels of productive investment.”
“For Wonks Only” Speed Read: “Cross your fingers, credit growth is a necessary but not sufficient condition for economic growth. Economic growth depends on the productive use of credit growth, something that is not occurring.”
Bill Gross, Pimco Investment Outlook Sept 2015 “For Quant Geeks Only”. Highlights are Bills. http://www.pimco.com/EN/Insights/Pages/For-Wonks-Only.aspx
El-Erian – Bartiromo one-on-one with Mohamed El-Erian
With little regard to the personal gruff between the two old friends, it seems only fitting to pair them together, at least on paper, this week. Following, I highlight a few of the questions and answers. Link to full piece below.
Q: Let me begin with the markets. Terrorism, beheadings, threats to oil facilities, the Ukraine. And yet stocks continue to soar despite all of this. Why?
A: First let me add to your “despite list” — despite the disappointing global economic environment and a less-than-comprehensive policy response. And don’t forget the notion that Brazil, Russia, India and China are not what they used to be. That means that the stabilizing wall on the global economy is not as good as it used to be. And yet the market is doing really well.
The first reason is the market is convinced central banks remain their best friends and that it is in the interest of central banks to boost financial prices and to repress volatility. And because of that, investors feel comfortable taking on a lot of risk.
The second reason is a lot of corporate cash is entering the market. It used to be held on balance sheets after the near-death experience of the global financial crisis. But recently we see a step-up in share buybacks, a step-up in dividends, and a boom in merger and acquisitions. So cash that was previously held on the balance sheet of companies is coming into the marketplace and is supporting it.
Q: What do you see as the biggest risks in the world today?
A: The first risk is that the major economies are not able to generate enough economic growth, and that matters for companies’ earnings. The U.S. is doing better, but still nowhere near liftoff. Europe is stagnating again. Japan has just re-recorded a significant decline in GDP. Even the emerging countries, which we once looked to be the local motivate of growth, are struggling.
The second is that the West has relied on a very unbalanced policy response. In particular, it has been the central banks that have been doing all the heavy lifting, not because they want to, but because they feel obliged to do so given the political dysfunction elsewhere that undermines a comprehensive policy response. There’s concern that the central banks are buying short-term economic calm at the cost of longer-term financial stability.
The third factor is a set of geopolitical tensions, which in the case of Russia could spill over in the economic field. If the West and Russia fail to deescalate the geopolitical tensions over Ukraine, we will get another round of sanctions and counter-sanctions. If Russia feels really hurt, it will likely counter by disrupting the flow of energy supplies to Eastern, Central and Western Europe, and that would definitely push Europe into recession. It’s a a 50-50 chance right now because of the role of non-state actors, in particular the separatists on the ground in Ukraine. It is not clear that Russia controls them completely.
Q: Meanwhile, the dollar has been soaring.
A: This is an issue that’s completely off the radar screen that should be of interest to all investors. I warned about this much earlier that at some point volatility will return to the currency markets. And it’s returning for three very valid reasons.
First, the U.S. is on a different economic track than Europe and Japan. The U.S. isn’t growing as much as we’d like it, but it’s growing and continues to heal. Japan and Europe are going the other way.
Second, policy is starting to diverge. The ECB is stepping harder on the stimulus accelerator while the Fed is slowly easing off the accelerator.
Third, the geopolitical tensions affect Europe a lot more than the U.S. So what we have seen is a major move in the dollar versus both the yen and the euro. This is key because it means the return of volatility in the foreign exchange market can undermine central banks’ effectiveness in limiting volatility elsewhere, which is one of their objectives.
Q: Meanwhile, we have not had a double-digit correction in the stock market in several years. Does this surprise and worry you?
A: I do worry that things are overvalued because there is now a significant wedge between financial asset prices, which are high, and fundamentals which remain sluggish. So I do worry. Do I understand why it has happened? Yes. Because the Federal Reserve has given comfort to a lot of investors. And secondly because so much cash is coming out of corporate balance sheets and being put back into the marketplace.
I remain a big El-Erian fan and always like to know what he is thinking. Here is a link to the full piece.
Value Line Median Appreciation Potential for the S&P 500 Index
The next chart gives a unique look at the correlation between the market and what Value Line analysts’ projected stock prices to be three to five years out. This chart looks out 5 ½ years and shifts the projection back to the present. Note the high historical correlation. In sum, it says choppy – correction – rally with ultimately little return over the next 5 ½ years.
The blue line is the S&P 500 Index total return 1986 to present. The red line is the Total Return Predicted Value looking forward about 5 ½ years. Data from Value Line. Source: NDR
The Zweig Bond Model – How It Works
I highlight the Zweig Bond Model each week in Trade Signals. Every Wednesday morning I go through a series of market indicators to get a feel for trend direction. This model is one of my favorites. Given today’s ultra low interest rates, it is important to stay in line with the major trend. I noted to the Morningstar audience today that this model is saying it is time to move from longer-term bond exposure to short-term bond exposure. We’ve seen similar indications from our fixed income relative strength-based models. No process is perfect (nor was the collection of Wall Street analysts’ guesses on rates last December). Personally, I prefer a defined process that can help me remove and later reestablish fixed income risk.
Given the recent sell signal (recommendation to move to BIL or some other shorter duration bond ETF), here is the updated chart and link to the process (you can follow and implement yourself).
Trade Signals – Too Few Bears – 09-17-2014
Too Few Bears: You have to go all the way back to October 1987 to find a period that matched today’s lack of bearishness. We are now at a 27 year sentiment extreme reflecting complete lack of downside concern on the part of investors.
So, what does this all mean in English? NDR took a look at pessimistic extremes going back to 1965.
S&P 500 Index returns 3, 6 and 9 months later were low and actually negative 12 months later. The message is to be wary of the crowd at points of optimistic extreme. Hedge that long-term equity exposure.
The trend evidence continues to remain positive for stocks but has turned negative for bonds. The market remains over believed, overbought and overvalued. Risk of a meaningful correction is high though stocks can continue to move higher.
Included in this week’s Trade Signals:
• Cyclical Equity Market Trend: Cyclical Bullish Trend for Stocks Remains Bullish (as measured by NDR’s Big Momentum indicator and separately by the 13/34-Week EMA S&P 500 Index Trend Chart)
• Weekly Investor Sentiment Indicator – NDR Crowd Sentiment Poll: Neutral (Bearish for the Market)
• Daily Trading Sentiment Composite: Neutral Reading (Bullish for the Market)
• The Zweig Bond Model: Cyclical Bullish Trend for Bonds (supporting bond investment exposure)
Click here for the weekly charts.
Conclusion
Too Many Hot Dogs – it was a real joy to share the stage with my co-panelist Bob Smith from Sage Advisors. A smart, fun and witty man, every time he spoke, a title for a future On My Radar jumped into my mind. We were talking about how ETFs and bank regulation has changed the trading landscape. Bob said we have to watch out for a “Kobayashi moment” and shared a story about Takeru Kobayashi the hot dog eating champion. Devouring all those hot dogs in such a short period of time. He asked, “What do you think happens when Kobayashi goes backstage?” That is what we are looking at when the next event hits. I think zero interest policy has pulled investors to the hot dog table and they have eaten far too many hot dogs.
I’m somewhere over Ohio and thankful for Wi-Fi (again). The past week was highly productive and informative. Morningstar has taken a lead role in researching the ETF Manager Solutions space. iShares, State Street, Invesco Powershares and Vanguard are supporting tactical strategists like never before. A lot more work lies ahead in setting a clear understanding of the diverse types of tactical strategies and there needs to be more work done around appropriate benchmarking, but progress is being made. It was a good week. Maybe five more pounds too good. Ugh.
Have a wonderful weekend and don’t eat too many hot dogs!
With warm regards,
Steve
Stephen B. Blumenthal
Founder & CEO
CMG Capital Management Group, Inc.
Philadelphia – King of Prussia, PA
steve@cmgwealth.com
610-989-9090 Phone
610-989-9092 Fax
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