World bond bloodbath

 Bonds are being heavily sold off.  (Reminder:  yields rise as prices fall)

It's because of :

• the Iran war, and its effect on oil prices and inflation.  
• ballooning US deficits
• concern that the Fed won't fight inflation
• Japan's economic unravelling
• stubborn inflation, not just in the US, but in Europe and elsewhere.
• the beginning of Central Bank tightening.
• strongly rising commodity prices — it's not just oil.

When bond yields rise, it's a signal of tightening credit.  The riskier the borrower, the bigger the rise in the interest rates they must pay to obtain credit. (That's why national government bond yields haven't risen by equal amounts over the last 2 years). At some point, the elastic snaps, and companies and possibly countries start going bankrupt.  Which leads, inevitably, to a recession.

The AI bubble is dependent on credit and circular financing.  When outside credit flows dry up, it will pop, taking down the economy and share markets with it.

Every previous oil crisis has been followed by a recession, and the bigger the relative increase in prices, the deeper the recession. 

152 years of S&P500 returns

 From Visual Capitalist

Observe how the returns are skewed to the right, i.e., are greater than zero.   And how big falls are not always immediately followed by big rallies--for example, 1931's -50% was followed in 1932 with -10%.  1933, however, was between plus 40 and plus 50%.   There were a couple of bear traps (false rallies) between 1929 and 1933.  And the level of the S&P500 didn't pass the 1929 peak until 1954.

US shares at 125 year valuations

 From BarChart

It's not just the BLS's data

In this piece, I discussed a few indicators of the US labour market from surveys not carried out by the BLS (Bureau of labour statistics).  I said I would combine them into a composite indicator.  This is a partial result.  I say partial, because I want to do a bit more research.

The labour indicator is a composite of the 'jobs plentiful' and 'jobs hard to get' (inverted), from the Conference Board's consumer confidence survey, and the National Federation of Independent Business's small business 'hiring intentions' and 'jobs hard to fill' questions.  I extreme-adjusted each series before combining it into the composite indicator.

There is an excellent long-term correlation between the indicator and the unemployment rate (plotted inverted in the charts.)   If anything, the chart suggests that my labour indicator sometimes leads by a few months, which means that it should start rising before the unemployment rate starts to fall, i.e., before the economy picks up.  Note how the gap has widened over the last year, which could point to bigger rises in unemployment than we have seen.

What does it look like over the last 3 years?  Notice how the unemployment rate fell (the line rises in the chart below, as the unemployment rate is plotted inversely) from the middle of last year, then started rising from January onwards, as the economy slowed.  At the same time, my labour indicator, rose, and then fell. 

The moral of the story is that the official BLS data are not obviously manipulated or incorrect, whatever Trump says.  They show much the same picture as the private sector survey data.

My forecast is that unemployment will continue to rise, because of the drag on incomes caused by the tariff hikes, uncertainty, and the loss of agricultural labour.   I may be wrong.  There are a couple of leading indicators (next post) which point towards an imminent rebound.  If that rebound happens, the Fed will definitely make no further cuts to the Fed Funds rate, because not only will inflation be rising, but the economy will be picking up again.  A further cut in the cash rate in those conditions  (forced perhaps by Trump) would be taken very badly indeed by the bond and currency markets.  Equities might love it, but expect big switches in sectoral performance.  And over all this lour the spectres of overvaluation, record stock concentration, and the AI bubble.

Many have accused me in the past of being too bearish, and perhaps I am.  But I have been known on previous occasions to (correctly) recommend buying shares with your ears pinned back.  This is not one of those occasions.

US stock valuations reach an all-time high

 From Jesse Felder

‘A combined measure of valuations for US stocks has just hit a new record high, pointing to poor long-term market returns.’ blinks.bloomberg.com/news/stories...

 

Why aren't markets freaking out?

 From Paul Krugman

For those of us who follow economic policy in general and the Federal Reserve in particular, the past week has been shocking and terrifying. Donald Trump’s ongoing attempts to bully the Fed into large interest rate cuts have escalated into an attempt to fire Lisa Cook, a member of the Fed’s Board of Governors, over unsubstantiated claims that she committed financial fraud while still a college professor. Indeed, Trump claims that he has already fired her, although he has no legal right to do so.

Whatever happens, Trump’s campaign to take over monetary policy has shifted from a public pressure to personal intimidation of Fed officials: the attack on Cook signals that Trump and his people will try to ruin the life of anyone who stands in his way. There is now a substantial chance that the Fed’s independence, its ability to manage the nation’s monetary policy on an objective, technocratic basis rather than as an instrument of the president’s political interests and personal whims, will soon be gone.

So why aren’t markets freaking out? Nations in which central banks lose their independence sooner or later suffer high inflation, especially when they are taken over by autocrats who buy into crackpot economic doctrines. And Trump, who has been demanding large rate cuts because, he claims, the economy is running hot — which almost every economist would say is a reason to raise rates, not cut them — certainly fits that pattern. Yet although there have been small tremors in the bond and currency markets, there have been no significant upheavals in financial markets that reflect the severity of the situation we are in. Throughout this episode, the stock market has remained fairly flat and bond yields haven’t spiked.

Why not? Do financial markets doubt that Trump will get his way? Or do they reject mainstream economics and the clear examples of countries like Turkey and Argentina?

Neither. My read of economic and financial history is that market pricing almost never takes into account the possibility of huge, disruptive events, even when the strong possibility of such events should be obvious. The usual pattern, instead, is one of market complacency until the last possible moment. That is, markets act as if everything is normal until it’s blindingly obvious that it isn’t.

The inimitable Nathan Tankus summarizes this by saying that the market is not, as stylized economic models would have us believe, a mechanism that pools the knowledge and informed judgment of millions of investors. It is, instead, a “conventional wisdom processor.” That is, it reflects views that seem safe to hold because many other people hold them — and the crowd only abandons those views when they become blatantly unsustainable.

John Maynard Keynes said something similar in Chapter 12 of his General Theory of Employment, Interest and Money. Market investors, he argued, pay little attention to the question of what assets are truly worth. Instead, they worry mostly about the market value of those assets a few months in the future. In a memorable albeit sexist passage (it was 1936), he declared that:

"Professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view … we devote our intelligences to anticipating what average opinion expects the average opinion to be."

So if the conventional wisdom is that economic conditions will remain more or less normal despite highly abnormal policy, markets will remain calm until the illusion of normality becomes unsustainable. At that point market prices may “change violently.” The current technical term for this phenomenon is a “Wile E. Coyote moment” — the moment when the cartoon character, having run several steps off the edge of a cliff, looks down and realizes that there’s nothing supporting him. Only then, according to the laws of cartoon physics, does he fall.

You might ask why smart investors with long time horizons don’t foresee Wile E. Coyote moments and get very rich in the process. Some do. But for reasons that would take another long post to explain — maybe a primer one of these days — there never seem to be enough such investors to shake market complacency, no matter how unwarranted. It’s one thing to short a stock, but to short the entire market is a completely different beast.

Can I document these assertions? Let’s look at a couple of relatively recent examples of market complacency and myopia in the midst of clear signals of an oncoming crisis.

First, the subprime crisis of the 2000s. By 2005, at the latest, there were very good reasons to suspect that we were in the midst of a major housing bubble. Here’s a graph of one measure of housing overvaluation, the ratio of home prices to average rents: 

When home prices are very high compared with average rents, that indicates the likelihood of a bubble because, ultimately, the value of the house lies in its use as a place to live.

The shaded area starting in late 2007 is the Great Recession [GFC]. Now, one could try to rationalize the extremely high prices of houses relative to rents in 2006. But an honest assessment would at least have reflected the serious possibility — not the certainty — that there was a bubble in house prices during this period. It would also reflect the possibility of a flood of mortgage defaults when the bubble popped.

Yet ABX indices, a measure of perceived default risk on securities backed by subprime mortgages, didn’t show any serious decline until well into 2007, when the housing bubble had already been deflating for more than a year

Source: Bank for International Settlements

Another example of market complacency is the euro area crisis that began in 2009. By the mid 2000s it was already obvious that huge sums of money were flowing into southern European nations like Spain, where they were being used largely to finance highly speculative real estate investment — very much like the US sub-prime bubble.

Even if it was unclear that the flood of money would abruptly end -- a nasty “sudden stop” – the possibility of such a stop should have been reflected in bond yields.

Yet the spread between interest rates on Spanish and German bonds — a measure of the risk markets perceived that Spain would experience a crisis — stayed very low until the crisis was already underway:

So if you want to know why markets aren’t reacting to the risk of very bad policy if Trump takes over the Fed, you should know that major market reactions to that kind of risk are rare. In fact, I can’t come up with a single example.

All of which says, in turn, that the absence of a strong reaction to Trump’s assault on the Fed isn’t a sign that everything is OK. We are, in fact, looking at a policy disaster in the making. But markets probably won’t react strongly until the disaster is already upon us.

I sold all my personal holdings in early May, going into 100% cash.  (In my notional portfolio, I also went into cash, but reinvested later.  The reality is that clients want to enjoy the last of the any rise in the markets, and get angry if you underperform the share market, even if you eventually are right.  Understandable, but it leads to exactly the kind of market actions Krugman deplores.)

When I was still managing portfolios professionally, I sold 50% of our portfolios in early 2008, just before the GFC hit.  Mortgage default rates were already high.  If there was a recession, unemployment would rise, and defaults would explode.   At the first payrolls report in January 2008, for December 2007, employment fell (ironically revised away later!).  I was on holiday, and so was our dealer.  I went back into the office, I called him in from his holiday too, and we sold all our liquid stocks.

The perilous situation now is made even riskier by the dominance of AI stocks in the US share market.  AI may eventually make money, but the situation smells just like the dot-com boom of the early 2000s, which I also sat out.  Some internet companies did go on to eventually make big profits (Amazon!) but the market halved between 2000 and 2002.  The market cap of the top ten companies as a percentage of the total market cap is now at a record high.   7 of those companies are AI-related.  When the AI bubble bursts, the market will collapse, just like it did after the dot-com boom.

Will that happen tomorrow?  Who knows?  But it will happen.  It's only a matter of time.

DISCLAIMER:  I might be wrong.  That has happened from time to time before.

Have we seen the bottom of the bear market?

 Short-term, Wall Street is now very overbought (lower chart).  Normally, that will be followed by a retreat.  Markets (and economies) tend to move in waves, with small waves and bigger waves and sometimes giant, decades-long waves.  But movements in the short waves can give us some guide to likely moves in the somewhat longer waves.  For example, if the share market goes sideways from here, momentum will decrease, and it will move from being overbought to oversold without falling.  Being oversold, the next likely move would be up.  So that's something to watch for.  We have seen one very tentative sign that we might be approaching a cyclical bottom:  the last oversold downward spike in momentum didn't go as low as the previous one, often a sign of an impending cyclical turn, i.e., the beginning of a new bull market.  However ....

[Continued below these charts .....]

The trouble is ..... the market isn't cheap.  Look at the chart below, showing the dividend yield for the S&P500 and the 10-year bond yield.  Before the Covid crash, the D/Y averaged 1.9%.  Let's regard this as "normal" for the sake of the argument (it isn't normal, but it'll do for now)  Then the Fed cut the Fed funds rate to zero, and embarked on a massive program of quantitative easing (QE)  After plunging, so that the D/Y rose to 2.6%, the combination of massive fiscal stimulus and zero interest rates drove the market back up from an index level of 2237 to a peak of 4793, and the DY down from 2.6% to 1.2%.  

So if we are returning to a pre-Covid "normal" state, the DY should be 1.9% instead of 1.6%, which means either dividends have to rise by 20%, or the market has to fall by that amount.   Yet dividends are unlikely to rise.  A recession (mild according to most analysts, but possibly severe, according to me) is on the way.  Moreover, during the bull market from the Covid crash lows, fiscal and monetary policy were hugely supportive.   But the opposite is true now.  The Fed might have slowed the rate of increase in the Fed Funds rate, but it hasn't stopped lifting rates.  And, despite claims of a spendthrift Democrat administration, fiscal policy is tightening.  And that's before we get to soaring inflation and oil prices.  Yes, they have prolly peaked for this cycle, but the Fed won't end its penchant for rising rates and tightening policy until they are certain inflation is heading towards their target.  Even rising unemployment and falling payrolls may not deter them -- and we're not seeing anything like that yet.  Payrolls are still rising by more than 200K per month.  It's a good idea not to bet against the Fed.

Where am I positioned?   I'm sitting on a lot of cash in my notional portfolio---which has however underperformed for the last few weeks!  But I've been wrong before.  And no doubt will be again.  I'd be much more convinced that we're beginning a new bull market if the DY was back at 2.5%, in other words, if we'd had the final capitulation plunge, the last panic-stricken sell-off before markets rally.  As we had during the Covid Crash.

The usual warnings apply:  I could be wrong; these opinions are free and, like most free things, worth what you paid for them; forecasting the future is difficult; past performance isn't necessarily correlated with future performance; your personal circumstance may differ (e.g., you might only care about long-term performance); the share mkt might be looking through the  recession to the airy uplands of recovery later in 2023 (seems a bit early to me, but ....) .  

So when will shares bottom?

Typically, stock markets often show a cyclical turning point when they decide that Central Banks are going to start cutting interest rates, or perhaps, going to stop raising them. Stock markets turn up before the economy turns up, and they turn down before the economy turns down.

Central bank discount rates (such as the Fed Funds rate, the Bank of England base rate, or the Reserve Bank of Australia cash rate) tend to lag behind the cycle.  The chart below shows the year-on-year change in GDP-weighted world average central bank rate, calculated for countries representing 83% of world GDP, compared with the GDP-weighted average PMI of the "Big 8" economies.  Observe how the average Central Bank discount rate goes on rising for a year after the PMI peaks.  So we might expect the world discount rate to start to peak about now, a year after the Big 8/world PMI peaked (June last year).  The problem is, the US only started raising the Fed Funds rate 3 months ago, and is nowhere near through a typical rate rise cycle.  And the European Central Bank hasn't even *started* raising its discount rate yet.  On top of which, inflation is at 40 years records, and so far, still rising.  

So the risk is that the world discount rate will keep on rising.  

In addition, the huge jump in commodity prices is setting up the world for a deep recession ― perhaps as deep as the one after the 1972 commodity price boom.  Probably as deep as the GFC (global financial crisis) in 2008.  In that crisis, even though discount rates were plummeting, the stock market didn't bottom until March 2009, when it started to appear plausible that economies would recover.   If we look at the 1974 and 2008 bear markets, which were associated with deep recessions, the share market continued to fall even though interest rates were being cut.  That could happen again.

Interesting times.

Europe also at 40 year inflation highs

Earlier, I did a blog post showing that US inflation is at 40-year highs.  This isn't just a US problem.  European inflation is also at 40-year highs.  And the ECB (European Central Bank) is likely to respond much as the Fed will, by raising interest rates sharply.  World growth is likely to slow fast.  It takes a year or longer for interest rates to affect economic growth, and even longer for them to reduce inflation.  Which means that the real impact of rising interest rates on economies won't be felt until next year.  However, the impact on share and bond markets, and indeed on most asset classes, is likely to be much more immediate.

Central banks might choose not to raise interest rates to the sorts of highs seen last time we had such high inflation (the Fedfunds rate briefly touched 19% in 1981!), because they may regard this rise in inflation as temporary.  But ― and this is vital  ― they will not stop raising rates just because the stock market falls. 

To slow inflation, the real interest rate will have to be positive, i.e., the nominal rate will have to be higher than inflation.  That means nominal discount rates would have to exceed 8%.  CBs might argue that if the rise in inflation is temporary, they can quickly reverse the interest rate increases.  But even a six month rise in rates to 8% will push economies into recession.  And stocks into bear markets.

Is the Fed behind the curve?

 An interesting chart from TopDownCharts

Based only on this chart we could make an assertion that the Fed has fallen behind the curve.  Against that there is the argument that other factors are important too, and not to mention the point that the Fed basically decided to position itself behind the curve to try and prevent the mistake of tightening too soon. With the composite measure of inflation expectations at 40-year highs it’s fair to suggest that the Fed may have some catching up to do as it kicks off the transition away from easing.

What the chart shows is that inflation expectations (their proprietary index, I assume) is now much higher than where the Fed Funds rate should be.  Note that it shows the change in Fed Funds, not the level.  Note also that the inflation expectations index is higher than it's been in nearly 40 years, as indeed inflation itself is.  In the past, the Fed has often quickly unwound tightening when there is a market tantrum.  But what this chart means is that may not happen this time.  Bad news for equities.  Luckily, fiscal policy under the Biden administration is still very expansive, so the impact on the economy may not be so severe.  I've been taking money off the table for a while and now sit on just 45% equities in my notional portfolio.

Boomtime

 As ever, this chart shows the extreme-adjusted versions of  IHS Markit's PMI (manufacturing) and the Institute For Supply Management's ISM manufacturing index.  Extreme-adjustment removes or attenuates extremes in the data (duh!) to give a clearer picture of underlying trends.  In addition, if we take the average of two independent (statistically) time series, this also gives us a smoother picture―that's the green line in the chart below, and it's the one to concentrate on.

This is the strongest cycle over the last decade.  A rebound from the covid crash, a fiscal sugar hit, and the record low Fed bank rate have all produced a massive stimulus.  Which makes it inevitable that the Fed will start tightening policy, moving the Fed Funds rate back to pre-crisis levels―2-ish per cent.  It's currently zero.   

Their moves are likely to be cautious and measured, but all the same, equities are vulnerable.

20 years of declining interest rates ending

 I've been dithering and delaying for months about some major software updates I needed to do, and as a result I haven't been doing much economic commentary.  I had to change a key program which is essential to easy manipulation of time series in Excel spreadsheets and since VBA (Visual Basic) is such a clumsy language, every time I considered doing it, I put it off to the next day.  Anyway, you'll be glad to hear, I'm sure, that I've finally done the update, and it seems to be working, so far.

Meanwhile, behind the scenes (as it were), I've been extending my interest rate times series backwards.  For over 20 years, I've been updating my spreadsheets with my own fair hand for most major world markets, but I decided I needed to add some smaller and developing economies to the data I monitor.  You can see the first result in the chart below.   It shows average central bank discount rates, weighted by PPP GDP for the world as a whole.  I had been using data for just 50% of the world (mostly developed countries), and the new time series I've added have increased this to 83%.  The biggest economy I added was China, but I also added Turkey, Indonesia, India, Russia, Taiwan and Korea and a couple of others.

The broader average is higher than the older one, reflecting higher inflation rates, but the cyclical movements are pretty similar.  Even though the USA, Europe and Japan haven't (yet) starting raising their discount rates, the world average has started to rise.  Interest rates were cut to emergency lows in response to the Covid Crash, and will now move back to pre-pandemic levels. 

The secular downtrend in interest rates has driven secular bull markets in shares and property, and I expect that a return to "normal" levels will puncture these bull markets.  We  may have already seen the beginnings of that inevitable downturn over the last few days.

I've started the same process that I've done with world discount rates with world bond yields.  I haven't yet got bond yields for all the countries I monitor going back 20 years, but I am gradually extending my time series backwards/  In the meantime, you can see how bond yields have trended sharply upwards in the last couple of weeks, moving to new post-pandemic highs.  Rising bond yields affect (reduce) property and share valuations, eventually.   Not good for these two asset classes.

I have a bad feeling about this

My US diffusion index measures the combined effect of over 50 different series.  It looks to see whether a component time series is up or down on 5 months ago.  If it is up, it "scores" 1, if it is flat, it scores 0.5, and if it is falling, it scores 0.  At 100, all measured series are rising (a boom) and 0 all measured series are falling (a bust).  It tends to lead the economy by a couple of months, and has a slightly better lead than the "official" leading index from The Conference Board.  The chart below shows the two, with the leading index (red) shown as a year-on-year percentage change plotted on the left-hand scale, and my diffusion index (blue) on the right hand scale.

The diffusion index has fallen sharply, but is showing a bit of a rebound, consistent with recent economic indicators.

However, my long-leading index suggests a sustained downturn in activity through the rest of this year and into 2020.  The long-lead index  looks as if it's bottoming, at higher levels than it has done in previous recessions, suggesting perhaps that this downturn will be moderate, though probably prolonged.

The GFC deep downturn in 2008/2009 was also preceded by a relatively moderate decline in the long-leading index, yet we experienced the worst recession since the Great Depression.  That happened because of the mortgage/housing/banking crisis.

Every cycle is similar, but different.   This cycle will be much deeper if there is an oil crisis and/or leveraged debt in the USA blows up.  There is also a budding crisis in car loans, with default rates rising sharply, even though unemployment is at 50 year lows.  Before the GFC, the sign that the impending downturn would be severe was default rates on mortgages despite low unemployment and strong growth.  If there are record problems when times are good, how big will the problems get when times are bad?

To quote Star Wars, I have a bad feeling about this.

Bear markets

They don't last a long time.  On the other hand, it can take a decade or more to get back to the previous high.

Source: Visual Capitalist

A blip?

Click chart to get it at full size

US markets fell a couple of percent last week.  In the context of the last 25 years, the fall is barely visible on the long-term chart (which is, as it should be, plotted on a log scale).  Yes, the market's had a good run, yes, it's much pricier than it was, and yes, there are question marks about emerging market growth.  On the other hand, DM (developed market) growth is accelerating, and DM central banks are very unlikely to raise interest rates for many many months.

If the blue line (the 150 day moving average) turns down, I shall be very concerned, because that would be one (strong) signal that a new bear market is emerging.