How Long Can Global Equities Continue to Ignore
Deteriorating Economic Fundamentals?
By Victor Sperandeo with the Curmudgeon
Global Central Banks have totally dominated the financial markets since the great recession supposedly ended in mid-2009. Despite world economic growth being the lowest since WW II, there's been incredible strength in global equity markets. How can that be? Answer: Central Bank manipulation (QE, QE on steroids, ZIRP, etc.) and "talking the talk" (e.g. ECB's Draghi doing "whatever it takes"). There may also have been clandestine buying of stock index futures, as many pundits have speculated.
Although we have pointed out many of the problems financial markets have faced, risk has been ignored by "investors," money managers, and other market participants. For them, the Fed has been the only game in town.
[Those that are not "buy and hold" or dedicated "long only" investors and appreciate risk, have paid an opportunity price for holding large cash positions or hedging their long stock positions. They were decimated if they went net short.]
Global economic growth forecasts continue to be ratcheted downward with little or no effect on risk appetites. We have grudgingly referred to that as "the new normal" in previous Curmudgeon posts.
The latest BIS quarterly review, titled Buoyant Yet Fragile clearly makes that point. It states: "Markets remain buoyant despite mid-October's spike in the volatility of most asset classes. This sharp retreat in risk appetite reflected growing uncertainty about the global economic outlook and monetary policy stance, as well as increased geopolitical tensions. As selling pressure increased, market liquidity temporarily dried up, amplifying market movements."
Can the equity markets continue to rise? If the Fed (and other Central Banks) could continue to ease, the answer would be yes. But with short rates at virtually zero in Japan, the UK, the EU, and the U.S., the answer is probably no.
Bond yields were expected to rise sharply this year on the expectation of stronger economic growth and credit demand. The U.S. 10 year note yield closed 2013 at 3.03% and was predicted to be ~4% or higher at this time in 2014. Surprise! It's now at 2.08%, despite the Fed ending QE (at least for now).
Other nation's 10 year yields are also incredibly low: Japan 0.395%, UK 1.804%, German Bund 0.625%. Can long rates really go down much further -to any significant extent that has meaning - to stimulate non-inflationary economic growth and stop an eventual decline or crash in global equities?
As we've repeatedly pointed out, the issue is not lower interest rates, but rather ineffective fiscal policy and the lack of structural reforms.
In a NY Times op ed titled Why Japanese Voters Feel Hopeless, R. Taggart Murphy notes that Japanese Prime Minister Shinzo Abe's third arrow of structural reforms has not been executed. With the Liberal Democratic Party in power in 56 of the last 60 years, Japan's voters are whipped. Their mindset is "Shikata ga nai" or "it can't be helped" i.e. hopelessness and despair.
[News flash: on December 14, 2014, the Japanese people voted to reaffirm Mr. Abe for another term in office.]
This same "hopelessness" is currently demonstrated in the U.S. by the House's passage of the $1.1 Trillion spending bill. They accepted "tax extenders" to special interests, e.g. ~$95 million to thoroughbred horse owners, ~$15 million to NASCAR owners, and over $430 million to Hollywood to help those "poor producers" make movies. Politically, this spending plan is the creation of House leader John Boehner, with the blessing of his "good friend" President Barrack Obama, who lobbied for it. While John Boehner would be a very good bartender and been great as George Wendt's character in "Cheers," but leader of the House of Representatives?
If the American people don't get to keep more of their own money to spend and save, what will change? A horse owner getting a few more thoroughbreds, courtesy of the U.S. taxpayers? Does anyone seriously believe that would boost U.S. GDP growth?
Meanwhile in France, the economic minister Emmanuel Macron has warned that "France would turn into Cuba, without the sunshine, if government doesn't change its tax-spend-regulate ways." Fat chance of that happening as the French unions are already protesting and striking down Mr. Macron's new proposals.
The problem for governments is that once you give a benefit to someone, it is virtually impossible to change it without causing a crisis. Then crises are used to legislate more controls and powers for the political/power class as an excuse to "fix" the problem(s). Therefore, overall economic activity declines.
Moreover, the markets are clearly at the mercy of the Fed (and other central banks), as changing the fundamentals of what's wrong is very difficult to do. However, fundamentals do count today, at least in my humble opinion. Let's look at U.S. company earnings and P/E ratios.
According to the latest issue of Barron's, the S&P 500 trailing earnings per share is $103.11 and it's P/E ratio is at 19.42 times trailing earnings. Next year's earnings are projected to be ~$120 by conservative analysts, $113 by "pessimists," and $122-132 by very bullish analysts (I wonder what they're drinking?).
Note: Barron's survey of strategists see mean S&P 500 earnings per share rising by 7.5% to $127 in 2015, from an expected $118 this year. The consensus S&P 500 earnings estimate for next year is $128.80, according to Yardeni Research.
However, all of the above earnings estimates were made before the recent crash in crude oil prices to below $80 per barrel!
But with oil down 47%, and the energy sector weighted at 9.6% of the S&P 500, one can estimate next year's earnings could be $108! That implies the S&P would trade at 1920 - not 2002.33 (Friday's close)! However, all these estimated valuation metrics are not static and many more events will take place that will adjust forward earnings and the psychological P/E value.
The Austrian School of Economics (of which I am a strong proponent) maintains that all "value is subjective." Therefore, valuations can change rapidly as they are not objective.
As the Fed can't lower short term rates (which have been zero for six years), any economic threatening event that requires a monetary rescue, necessitates yet even more "unconventional means." Writing in Foreign Affairs magazine, two professors suggest the Fed should give paper money directly to the people. A revealing interview on this topic with Mark Blyth, Professor of International Political Economy at Brown University, is in this video.
John Dorn of the Cato Institute doesn't share that view. From an Investors Business Daily article, titled Federal Reserve Bank Policy Can't Heal Economic Malaise:
"The Fed has increased its balance sheet from less than $800 billion before the crisis to more than $4.5 trillion, and has dramatically increased the monetary base in the process. Member banks are now holding nearly $3 trillion of excess reserves at the Fed due, in part, to payment of interest on those reserves since October 2008, and also because of regulations and policy uncertainty. Those funds are not being lent out, and thus not entering the income stream. Thus, even though the Fed has been creating massive amounts of new base money, the growth rates of the monetary aggregates have not been inflationary."
Dorn continues, "It is a myth to think that monetary authorities by a stroke of a keyboard can create economic prosperity or that monetary policy can be fine-tuned with every twist and turn of the real economy. Fed policy seems largely designed to prop up financial asset prices and to encourage risk-taking with the hope that newly acquired financial wealth will stimulate spending and ignite real economic growth rather than inflation." Such a "trickle down" effect has been discredited many times, but the Fed persists.
Of course, the U.S. government is very powerful, and has kept the game going, but our government is not omnipotent. The question is how much longer can the system be pushed forward without coming apart?
Congress and the Fed really don't objectively judge their own success or failure. There is nothing factual about what they do. Only the spin is changed for the asset bubbles they create. They don't envision the game of musical chairs that inevitably ends in a crash and even if that occurs, they believe they can escape blame.
Our government officials think they're just ordinary people doing their job and don't have to be held accountable or even responsible for their shortcomings. That mentally can be compared to gangster John Dillinger’s girlfriend Mary Kinder who said: "Johnnie's just an ordinary fellow. Of course, he goes out and holds up banks and things (i.e. kills innocent people for money), but he's really just like any other fellow, aside from that."
Is it different this time? We shall see as the saga continues.....
Curmudgeon's Comment: Fallout from Oil Price Crash and True State of the U.S. Economy
“The relentless decline in oil prices continues to unsettle risk sentiment,” said analysts at Barclays. That's no surprise to us! In a recent Curmudgeon post titled Oil Price Crash is a Double-Edged Sword we pointed out there were negative effects of the oil price decline and identified the winners and losers. For sure, oil exporting nations like Russia are being hurt. The Russian ruble was down another 1.8% to a record low of Rbs 57.44 per dollar, despite the country’s central bank raising interest rates by a full 1% to 10.5% in an attempt to protect the currency.
There are other negative effects on the global economy and markets: sharply reduced energy Exploration and Production (E&P) capex, repricing of credit with wider spreads for energy related companies, and a sharp drop in the flow of petrodollars into global financial markets.
The steep decline in crude price raises fears that small exploration and production companies could go out of business if the prices fall too low. That, in turn, could cause turmoil among those who are lending to them such as junk-bond institutional purchasers and smaller banks. That phenomenon spread to the entire high yield market last week.
Investors sold U.S. junk bonds en masse as the sell-off which started in low-rated energy debt spread to the broad corporate high yield bond market amid fears of a spike in default rates. The sharp drop in energy bond prices pushed average yields on broad junk debt to near 7% for the first time since June 2013, according to Barclay’s indices. The jump in yields comes as redemptions from mutual funds and ETFs buying the securities more than doubled in the past week, to $1.9bn, according to Lipper.
Energy companies sold $50 billion in junk bonds through October 2014 - 14% of all junk bonds issued! But junk-rated energy companies trying to raise new money to service old debt or to fund costly fracking or off-shore drilling operations are now finding resistance from would be buyers. That's likely to continue unless the oil price rallies sharply.
Regarding petrodollar flows, a December 4th front page FT article notes that "big oil producers have pumped the windfall they enjoyed from soaring oil prices over the last decade into a huge range of global assets, from U.S. Treasuries and high-grade corporate bonds to equities and real estate. The flow of petrodollars into the global financial system boosted liquidity, spurred asset prices and helped to keep borrowing costs down. But the ~47% fall in Brent crude since mid-June will reverse this trend, as the shrinkage of the oil producers’ cash pile removes a pillar of support for global markets."
BNP estimates that if oil production remains at its current level and oil prices stay at about $70 a barrel for the next year, OPEC nations will receive $316bn less in oil export revenues than if oil prices were at their three-year average of $105. With oil prices below $60 per barrel oil export revenue is set to fall by ~$400bn. All that implies that the financial market's petrodollar prop won't be around in 2015.
Finally, we quote from a recent update of the highly
economist John Williams (both Victor and I subscribe):
"The Panic of 2008 continues; it never went away. To prevent systemic collapse at the time, governments and central banks took stop-gap, not corrective actions. They only pushed otherwise unresolvable issues into the future, and that future rapidly is closing in again on the system. The U.S. economy never recovered; it remains severely, structurally impaired and is turning down again. The U.S. banking system remains impaired and will face an intensifying crisis with the deteriorating economy. The federal government has no viable approach for addressing its long-term solvency issues, and the rest of the world has lost confidence in, and patience with, U.S. actions or lack of same."
That quote brilliantly sums up the current U.S. economic environment in our view. John believes the reason the economy has never recovered is that inflation is understated by ~2% per year from 2008. Therefore, real GDP is really flat since then! For sure, we don't think the U.S. is the pillar of economic strength that many analysts perceive. Maybe the best of a case of rotten apples, but not much more.
Till next time......
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Curmudgeon is a retired investment professional. He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996. He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.
Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies and government policies. Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.
Copyright © 2014 by The Curmudgeon and Marc Sexton. All rights reserved.
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