Home on the Range

Home on the Range
Monday, September 12, 2016
See the pdf and the collection of the individual charts linked below.(1) Back in the range. (2) Bond King’s big moment. (3) Is the US “shovel ready” for helicopter money? (4) Deutsche strategists are depressed. (5) Dudley believes that 150,000 jobs per month is good enough. (6) Rosengren has a vote and is ready for a rate hike. (7) ECB and BOJ disappoint and confuse bond bulls. (8) Lots of weak inflation and economic indicators for data-dependent central banks. (9) Getting harder to find bonds. (10) ECB and BOJ official rates likely to stay negative for a while. (11) S&P 1500 forward revenues and earnings climb to record highs. (12) “Sully” (+ + +).

Bonds: Still Range-Bound? The 10-year US Treasury bond yield is up from its recent record low of 1.37% on July 8 to 1.67% on Friday (Fig. 1). Since the start of this year, Debbie and I have been forecasting that this yield will range between 1.50% and 2.00%. So we were somewhat surprised when it fell below the bottom of our range earlier this year. We are not surprised that it is back within the range. Last year, the bond yield was also mostly range-bound, between 2.00% and 2.50%. The recent backup in yields reflects mounting Fed chatter about a rate hike at the September 20-21 meeting of the FOMC.

In addition, there has been some disappointment that the ECB and BOJ, at their latest policy meetings, didn’t expand and extend their QE programs nor did they lower their official rates further into negative territory. Yet their current bond-buying programs are running into a shortage of supply. Furthermore, the inflation and economic indicators that the major central banks monitor remain mostly weak. On the other hand, influential bond strategists once again are calling the end of the 36-year bull market in bonds. Let’s review all the latest developments just to make sure we aren’t missing something:

(1) Bond King turns bearish. “This is a big, big moment,” Jeffrey Gundlach said during a webcast Thursday. “Interest rates have bottomed. They may not rise in the near term as I’ve talked about for years. But I think it’s the beginning of something and you’re supposed to be defensive.” Gundlach is the chief investment officer of DoubleLine Capital and one of America’s Bond Kings. So what he says matters and can move markets. In his opinion, fixed-income investors should prepare for rising interest rates and higher inflation. He likes cash.

Gundlach predicts that Donald Trump will beat Hillary Clinton. In any event, he figures that fiscal spending on infrastructure will rise significantly under whomever is the next President. That will boost the economy, inflation, and the supply of bonds.

In my opinion, the US economy–which wasn’t “shovel ready” for Obama’s infrastructure spending plans during 2009 and 2010–is less so now. Besides, any bonds issued by the government to pay for infrastructure spending will probably be financed with “helicopter money” from the Fed. In other words, the Fed will start another QE bond-buying program to pay for the infrastructure with more “Fed dough.”

A 9/9 Bloomberg article was titled “Deutsche Bank: Bond Investors Are About to Get Crushed as a New Global Cycle Kicks Off.” According to the article, the bank’s strategy team, led by Jim Reid, is warning: “Weak growth, higher inflation, and stagnant productivity in developed countries will roil bond investors in the decades to come, as the benign global forces that have buoyed returns on financial assets for the past 35 years stage a sharp reversal. That’s the big-picture call from Deutsche Bank AG analysts who predict an oncoming lurch towards trade and financial protectionism–combined with aging populations and weak worker output–will intensify financial repression as a new multi-decade-long economic cycle kicks off this year.” That’s grim. I wonder if the bank’s poor performance lately is starting to affect the mood of the employees.

(2) Fed doves turning more hawkish. The Fed’s doves seem to be turning more hawkish. However, while Fed Chair Janet Yellen may remain the lonesome dove, she does rule the coop (or is it the cuckoos’ nest?). August’s weaker-than-expected payroll employment gain of 151,000 should have jarred some of the doves. However, FRB-NY President William Dudley, who has always been Yellen’s wingman in the past, said in a 7/31 speech: “For example, over the past three months, payroll gains have averaged about 150,000 per month, as compared to an average of more than 200,000 per month over the course of 2015 and the first quarter of this year. But even 150,000 job gains per month would be consistent with gradually using up any remaining slack present in the U.S. labor market.”

On Friday, in prepared remarks to the South Shore Chamber of Commerce in Quincy, Massachusetts, FRB-Boston President Eric Rosengren, a historically dovish Fed policymaker, said, “A reasonable case can be made for continuing to pursue a gradual normalization of monetary policy.” He added that “risks to the forecast are becoming increasingly two-sided.” That means that while a slowdown overseas remains a concern, the US economy has proven resilient and could even overheat if Fed policy remains unchanged for too much longer, in his opinion. Rosengren is an FOMC voter this year.

(3) ECB and BOJ disappoint. Last Thursday, after the latest meeting of the ECB’s Governing Council, President Mario Draghi downplayed the need for more stimulus. He said that the central bank had not discussed extending the life of its bond-buying program at its meeting. Apparently, that surprised bond traders who expected more from last week’s meeting. He might also have confused them when he said that the ECB has a “full mandate” to redesign its QE program, if needed.

BOJ Governor Haruhiko Kuroda also created some confusion last Monday when he said that the BOJ is conducting a review of its policies that should be completed by the September 20-21 meeting of its policy committee. He said that it won’t result in any reduction in monetary stimulus, as is “being called for by some market participants.” Yet he also said he understands that negative interest rates have hurt banks and pension funds.

In Japan, the 10-year benchmark climbed to -0.02%, rebounding from the record low of -0.30% set in July (Fig. 2). German 10-year government bond yields rose into slightly positive territory on Friday for the first time since Britain’s June vote to leave the European Union. It had been as low as -0.19% on July 8.

(4) Inflation rates remain subdued near zero. Meanwhile, there continues to be significant undershooting of actual inflation rates and the 2% inflation target of the BOJ, ECB, and Fed for their favored measures. Japan’s core CPI excluding food, the BOJ’s main inflation gauge, fell 0.5% y/y during July (Fig. 3). The y/y advance in the Eurozone’s headline CPI rate for August, the ECB’s primary measure, was barely visible at just 0.2%, according to the flash estimate (Fig. 4). And the core rate–excluding energy, food, alcohol, and tobacco–came in slightly higher at just 0.8%. In the US, the core personal consumption expenditures deflator, excluding food and energy, was up 1.6% y/y for July (Fig. 5). Average hourly earnings rose just 2.4% y/y during August.

(5) Economic indicators mostly lackluster. The latest manufacturing indicators are weak in Germany, Japan, and the US. German factory production fell 2.2% m/m during July, and 1.5% y/y (Fig. 6). Japan’s manufacturing production index edged up 0.1% during July, and fell 3.8% y/y. US manufacturing output is up only 0.2% y/y through July, and the M-PMI dropped unexpectedly from 52.6 during July to 49.4 during August (Fig. 7). Germany’s Ifo business confidence index fell for the second month from 108.7 during June to 106.2 last month (Fig. 8).

On the other hand, there was some good news out of China. The country’s PPI was down 0.8% y/y during August (Fig. 9). Why is that good news? It was the smallest such decline since April 2012, suggesting that the Chinese may finally be reducing some of the excess capacity in their manufacturing sector. China’s exports and imports data, which we track on a seasonally adjusted basis, both are showing uptrends since the start of the year through August, though they remain below their record highs of 2014 (Fig. 10).

(6) Running out of bonds. “When will the ECB run out of bonds to buy?” That was the headline of a 9/8 FT article. The ECB’s current QE program is set to terminate next year during March. However, the article notes, “Citi believes the squeeze is so severe that the ECB will run out of German paper to buy in November, although BofA thinks the programme can run unaltered until the end of the year.” Under the terms established by the ECB, the central bank can’t hold more than a third of any specific bond issue or more than a third of any one country’s debt. Furthermore, these holdings must be in line with the size of member states’ economies. So it must buy far more German bonds than other government paper. In other words, the ECB’s goal of buying €80 billion of bonds a month as planned–or extending QE–will soon hit a wall unless it relaxes rules about what it can buy.

The 9/9 WSJ included an article titled “Bank of Japan Risk: Running Out of Bonds to Buy.” The gist of the story: “Japan’s central bank is facing a new problem: It could be running out of government bonds to buy. The Bank of Japan is snapping up the equivalent of more than $750 billion worth of government debt a year in an effort to spur inflation and growth. At that rate, analysts say, banks could run out of government debt to sell within the next 18 months.”

The BOJ and the other major central banks have turned into the world’s largest hedge funds. The BOJ holds about a third of Japan’s outstanding government bonds. By the end of 2018, that could rise to two-thirds since it is buying roughly twice as much as the government is issuing. It is currently buying ¥80 trillion ($786.32 billion) worth of Japanese government bonds a year.

The BOJ is unlikely to follow the ECB’s move into corporate bonds because that market is relatively small in Japan, according to the WSJ article. The bank has been buying ETFs in addition to bonds. It now owns nearly 60% of assets in ETFs!

(7) Staying negative. On Friday, the German 10-year bond yield turned positive for the first time since June 23. The comparable Japanese bond yield was back up to zero for the first time since February 23. They both had turned negative earlier this year after the ECB lowered its official rate deeper into negative territory from -0.30% to -0.40% on March 10. The BOJ surprised the markets by turning its official rate negative for the first time from zero to -0.10% on January 29.

Nothing happened last week to suggest that either the ECB or the BOJ is about to turn its official rate back up above zero. It’s possible that the bond market was anticipating that they might go deeper into negative territory. However, the ECB’s Governing Council certainly didn’t confirm such a move after its latest meeting last week on Thursday.

The BOJ’s negative-rate policy has been widely criticized. In his speech last Monday, Gov. Haruhiko Kuroda for the first time discussed the costs of negative interest rates. He acknowledged that banks have complained that their profits have been squeezed at a time when loan demand is low. In addition, pension funds are having trouble meeting their long-term obligations to pay out savers.

S&P 500 Revenues: Unbound. Friday was a bad day for bonds and an ugly day for stocks. The S&P 500 plunged 2.5%, managing to find support at 2015’s highs (Fig. 11). The VIX rose from 12.5 on Thursday to a 10-week high of 17.5 on Friday (Fig. 12). The forward P/Es of the S&P 500/400/600 dropped sharply on Friday by 42/53/56bps to 16.5, 17.5, and 18.3 (Fig. 13).

Meanwhile, on Thursday, Joe and I learned that the forward revenues of these three stock indexes rose to new highs during the 9/1 week (Fig. 14). Last Monday, Joe reported that the forward earnings of the S&P 500/400/600 all rose to or were very close to new record highs during the 9/1 week (Fig. 15). Forward profit margins continue to firm this year after weakening a bit last year (Fig. 16).

The bottom line is that the top and bottom lines of the S&P 500 are looking very good according to the consensus of industry analysts. Of course, the business environment is extremely competitive in many industries. To remain competitive, many companies continue to cut costs and do the best they can to maintain their profit margins.

While nothing happened on Friday to change our views about the outlook for the economy and financial markets over the rest of this year and next year, a review of the S&P 500 sectors’ performance derby shows that it was a widespread rout led by the highest-dividend-yielding sectors (table): Utilities (-3.8%), Telecom Services (-3.4), Materials (-2.9), Consumer Staples (-2.8), Industrials (-2.8), Energy (-2.8), Consumer Discretionary (-2.5), S&P 500 (-2.5), IT (-2.3), Health Care (-2.0), and Financials (-1.9).

Movie. “Sully” (+ + +) (link) is a great true story about a truly great American hero. Its release during the 9/11 weekend is a wonderful reminder of the strength of the American character. America is among the few countries in the world that have always extolled and still extol the freedom of individuals to pursue their happiness, i.e., their personal goals. Yet at the same time, American individualism has always been mostly community minded, not self-centered and selfish. Sully landed his jet on the Hudson, saving the lives of 155 people. He made it very clear that his heroism had to be shared with all the passengers and emergency responders who facilitated the rescue that lasted only 24 minutes. It is truly an uplifting American story expertly directed by Clint Eastwood with a great performance by Tom Hanks.