Archive for October, 2013
The US shutdown is over. Japanese inflation for the year to September reached its highest level for nearly 5 years. And UK GDP data showed signs of a strengthening recovery. The S&P 500 has risen 4% since the beginning of the month, the FTSE 100 has done likewise and the Euro Stoxx 50 is up by a little more.
At the same time, the Norwegian sovereign wealth fund – the world’s largest with $810bn under management – announced that it is waiting for a correction before increasing its equity exposure. (See the widely-read Bloomberg story here.)
Developed-world equity markets have had a strong 2013, to the point where it is difficult to argue on some measures, such as p/e ratios, that they offer value. Are we entering the territory of over-exuberance?
As a starting point let’s have a look at what the CEO of that Norwegian fund actually said:
Our share in the stock market has been stable or falling even though markets are rising, and that means in practice that we’re not using inflows to buy stocks … In general, we see market corrections more as opportunities than as threats, so it’s not something that worries us. If they come, that’s just a positive sign for us as an investor.
According to the interview he did say the fund was “preparing for a correction”. But this is a fund whose rapid growth is underpinned by sizeable petrodollar inflows. They are not selling the market, and in the event of a correction – should it come – they intend to start buying again. In fact this sounds like the Norwegian central bank is offering the market a put!
In addition it is always worth looking at what reported earnings are doing. US news has been dominated by political and monetary goings-on, but the S&P is almost half way through the latest quarterly earnings season: 243 companies have reported an overall EPS increase of 8.4% on the previous year so far, significantly ahead of expectations. If that growth rate can be sustained as predicted the current price level would soon look much easier to bear.
Finally, the rally in risk pricing has not been universal. We took a look at India a few weeks back when the rupee was coming under heavy pressure for instance. Indeed, emerging market equity in general has underperformed its developed-world equivalent by a margin of 23% over the year to date. Selective exuberance may be irrational in some ways but it is not so terrifying as indiscriminate (and price insensitive) optimism.
The Norwegian view looks sensible: no panic, nor any excitement over the major markets at current valuation levels, and a preparedness to buy again should prices come down.
The markets which have performed the most strongly – as ever – may not be offering the most obvious opportunities. But the steady stream of positive data on earnings and economies is encouraging for their investors nonetheless.
Three months ago we had a look at US price behaviour, noting that inflation should be expected to rise as the labour market recovers and GDP growth returns to trend. This is not an expectation confined to America of course. And absent an unlikely-looking statistical surprise, data for Q3 will show that GDP grew across all of the major developed economies.
Should this be the case it will be the first time that the economies of the US, the eurozone, Japan and the UK have all grown for two consecutive quarters since Q3 2010. (The east Japan earthquake and renewed contraction in Europe saw to that.) This is good news, of course. But as the UK housing market, or the freight index we looked at a few weeks ago should be reminding us: stronger growth increases the risk of inflation.
Now inflation has not been a concern for the developed world lately. US CPI briefly pushed up to 4% in 2011 on the back of dollar weakness and rising oil prices, while the more persistent erosion of real wages in Britain over the same period saw the household sector back in recession. Since then, however, prices have been rising at much slower rates.
Looking back more broadly, price behaviour has not been a pressing issue for the past 20 or so years – other than in Japan, where deflation has notoriously been a symptom of persistent economic malaise. Returning to the US as an example, the average rate over that period was 2.4%, compared to 6.2% on average for the twenty years before that (1973-1993).
The longer term picture is interesting. Older City hands who worry more about inflation remember the 70s and 80s, and are as behaviourally anchored to their personal experience as are we all. Twenty years is a long time. Against this more recent background it becomes easy to understand why such worries do not seem to be widely shared.
Reasons for the relatively benign inflation of the last two decades are varied. The development of the online market place from the mid-1990s and the outsourcing of the production of goods to the developing world have been often and rightly cited as examples for some time. But there is another very important reason why inflation stayed broadly contained: monetary policy was used to contain it. In 1994-5 the Fed doubled its target rate from 3% to 6%; here in the UK the Chancellor, and then the Bank of England, raised rates from 5.25% in 1994 to a high of 7.5% in 1998. A few years later, as growth recovered from the TMT bust, the entire developed world tightened policy: from 2003 to 2006 the Bank of England, Fed, ECB, Bank of Canada and Reserve Bank of Australia all hiked rates and even Japan ended its zero interest rate policy. (Most dramatic was the move in the US, where the target rate rose from 1% to 5.25% over two years.)
Perhaps this makes an obvious point. While we can be forgiven for having got very used to low inflation, however, as investors we should not be forgiven if we forget what underpinned it. Important factors as they were, it wasn’t just a case of China and the internet. And if we think that even extremely significant technological advancement (such as horizontal fracking) can do the job of managing prices on its own we are kidding ourselves.
To reiterate one point from three months back, we do not seem to be in danger of an immediate inflationary spike. But the economic landscape has changed for the better this year. The natural direction for inflation in developed economies will not be down for much longer. Central banks should and must respond accordingly if seriously uncomfortable price behaviour is to remain a thing of the past.
The United States has been a source of much consternation this year. First of all the Federal Reserve accidentally triggered a mild panic over one of its least efficacious policy programmes. Then Congress deliberately threatened to push the nation towards default to force the government’s hand over legislation passed by itself in 2010. It is almost as if elected representatives in Washington have become so disappointed with the failure of their European counterparts to provoke another global financial meltdown that they have decided to do the job themselves. This is an unusual attitude to American exceptionalism. And it is hardly intuitive to wave the cudgel of a selective default on US debt while claiming to do so in an attempt to bring US debt under control.
However, what Warren Buffett has rightly called the “extreme idiocy” of the present position has not had that much of an effect. This seems incredible given what might technically be at stake. Already, 70% of intelligence staff have been placed on unpaid leave; just enough employees at the Department of Energy have been left in post to discharge their responsibilities to supervise the nation’s nuclear stockpile; diplomacy has already been affected, though troops are still to be paid (and the postal service remains in operation). And yet the S&P 500 is only 2% off its record high of a couple of weeks ago. The trade weighted dollar has tumbled all of 1% over the same period. Credit default swaps – which are priced specifically to insure against the risk of sovereign default – have admittedly ticked up a bit, but only to 42bp. That isn’t even the high for the year. According to Bloomberg the US still prices in this market as the sixth safest debtor in the world (between Britain and New Zealand).
Compare and contrast this picture with the down-to-the-wire debt ceiling negotiations of July and August 2011. Back then there was pandemonium. President Obama and Congress between them hammered out a complex package of fiscal arrangements and at the eleventh hour managed to avoid the shutdown we’re now seeing – and markets collapsed. The meltdown which accompanied the events of that summer was truly savage (see this blog’s coverage here and here).
Something has clearly changed.
As was apparent from the start in 2011, the real trigger for the crash was not the political turmoil: it was downward revisions to US GDP, raising fears of a double dip recession. This occurred against the background of looming default for Greece, revolution across the Arab world, the obliteration of part of Japan’s east coast – in short, a climate of absolute fear.
And let us not forget that at that time, the US federal budget deficit was running at 8% of GDP.
Today the situation is very different. Markets are behaving with relative equanimity because the infighting on Capitol Hill really isn’t as important as the economic fundamentals – unless Buffet’s point of extreme idiocy is breached, of course. Today, the federal deficit is 4%, and falling. US GDP growth has been increasing (and the last set of backdated revisions saw the numbers go up this time). Unemployment is 2% lower, bank balance sheets are cleaner, the housing market has picked up, manufacturing is stronger – and Europe, too, seems considerably further from the brink of catastrophe than it was two years ago.
A particularly gifted politician might be expected to assimilate all these things without even thinking, adapting instinctively to the changed national mood. It certainly appears that the President has done so. In 2011 he conceded ground to avoid a shutdown which was posing an additional threat to confidence. This time round there have been no concessions. In fact, Mr Obama has ruled out negotiating with his opponents at all until the government is reopened and the debt ceiling raised. “I’ll negotiate with you only after you give me what I want.” It’s an insouciant stance to say the least, and so far, the damp squib shutdown appears to justify it.
We ought not to be one-sided. The healthcare reform so vehemently opposed by many Republicans has been controversial from the start and unwieldy to implement. And without their intransigence back in 2011 that budget deficit would likely not have been repaired to the extent that it has. The US debt burden is huge, and such a position brings with it expense and vulnerability.
Nonetheless, the President is on the right side of the markets’ mood and the economic undercurrents this time – so long as he can avoid a sovereign default. At that point, CDS at 42bp would begin to look like something of a bargain …