Weekend Round-up: Sunday, September 12, 2010

Hello all

Not too much on the data front this weekend, though there were a couple of articles worth discussing.  Let’s start with this piece from the Financial Post titled: Equity rally suggests double-dip unlikely.  I’m afraid the ‘analysis’ is pretty incomplete.  It’s true that the stock markets in both the US and Canada are pricing in GDP growth in the 3% range, but the stock market’s not the only game in town.  At present, the stock market and the bond market are telling distinctly different stories.  We discussed the outlook conveyed by the bond market in our first primer on deflation.  To wit:

“The bond market certainly is banking on deflation (added:  and economic contraction by extension).  You may not know it, but the bond market is 14 times the size of the stock market and governed overwhelmingly by ‘sophisticated’ investors.  If inflation is a concern, bond investors demand more of a premium, as the money being repaid to them in the future is inflated money with each dollar buying less.  In a time of inflationary pressure, bond yields sky-rocket.  The opposite is true of deflation.  Times of deflation mean that money being returned in the future is MORE valuable, so less of a risk premium is demanded.”

The article notes that:

“There have been only two double-dip recessions in postwar history — in the early 1970s and early 1980s. In both cases, the world economy was hit by massive negative shocks: The 1973 oil crisis killed the feeble global economic recovery. In the early 1980s, then-Federal Reserve chairman Paul Volcker jacked up interest rates to 18% to fight runaway inflation. The draconian monetary tightening indeed reined in out-of-control inflation, but at a cost of a second dip in world economic activity. Obviously we are not looking at negative shocks of comparable strength and magnitude today.

I strongly disagree with that last statement.  The largest peace-time deficit spending is winding down, and I don’t buy for a second that half the stimulus is left to be spent, since the US is already discussing a second stimulus.  The withdrawal of this stimulus in the face of ongoing consumer deleveraging IS the negative shock (the highlighted article is a fantastic read, by the way).

The article is also not even internally consistent. First it notes that:

“…although the U.S. consumer spending recovery has slowed somewhat, the U.S. corporate sector is in excellent shape, with abundant cash, high profit margins and extremely low borrowing costs at its disposal.”

Then it follows that up with this…

“I have long argued the bond market has been discounting a too-pessimistic scenario, and as such the risk of bond yields moving up is high. If stocks continue to rise, downward pressure on government bond prices is likely to accumulate.”

So if the consumer isn’t going to consume, to whom will the corporations be selling their goods?  And if bond yields rise because they are discounting a ‘too-pessimistic scenario’, will that not further dampen the over-leveraged consumers and cut off access to the ‘extremely low borrowing costs’ the author notes?

Let’s spend a minute and talk about those US consumers.  I noted in a previous daily round-up that the ECRI WLI had turned decidedly negative and had reached a level that had preceded a recession in the US 100% of the time since the creation of the index.

Now we turn our attention to another interesting leading indicator, the CMI (Consumer Metrics Institute) Growth Index.  This index has been published since 2004 and is meant to be a measure of consumer spending and consumer intentions.  Given that more than 70% of GDP in the US has been driven by consumer spending, and given that those consumers are the ones we here in Canada need to sell our exports to, it is always worth monitoring the mindset of the American consumer.

From their own website:  “The Consumer Leading Indicators on our web site track consumer interest in major discretionary purchases. These typically include such items as automobiles, housing, vacations, durable household goods and investments. Not included would be expenditures that are more or less automatic, relatively minor and/or nondiscretionary, such as groceries, fuel or utilities.
We conduct samplings of consumer interest in making purchases within each of our defined
sectors on a daily basis. It is important to note both the immediacy of our results and their scope. We sample consumer activities across the entire U.S. economy, sampling millions of transactions covering all 50 states. Our data is collected daily, and is generally available in the form of updated indices within several days of the sampling period.”

Keep in mind that this index represents a leading indicator, meaning that it typically leads other measures such as GDP growth.  With that in mind, I will let this fascinating graph do the talking.  It shows the CMI Growth Index in red, GDP growth out of the US in green bars, and the S&P 500 (a broad stock index) in blue.  Thanks to Ilargi over at The Automatic Earth for creating it.  I should note that the GDP readings and CMI data have been overlayed, where typically there is a two quarter lag between them.

Interesting, no?

Finally, the article does not address one of the big semi-permanent secular shifts that is under way: The reallocation by millions of boomers out of stocks (in which they are terribly over-exposed) and into fixed income (in which they are equally under-exposed).  Take a look at the following graph which shows the money pouring out of stock mutual funds in the US.  According to ICI, there has been 18 consecutive weeks of domestic net outflows from US stock funds….a record.  Now anyone with a basic understanding of supply and demand would realize that as all of these people sell, there will be great downwards pressure on stocks (unless foreign domand surges at the same time, which I have seen no data to support).  Yet in anomalous behaviour, the market has actually moved sideways.

Now I can’t explain that at all, but I can tell you that this type of anomalous behaviour cannot last forever.  Although I have exposure to US and Canadian stocks, I’m not adding significantly to my position and it’s my belief that long bonds, strips, and high quality corporate bonds will be the far better performers in the economic slowdown to come.  I don’t buy for a second that stocks in Canada or the US have priced in any sort of double dip (which I see hitting Canada by Q3 2011) or even a significant slowing.  We’ll see.

The award for the must-read of the weekend goes to this beauty from the Globe:

“A cold dose of reality from a stimulus cynic”. Love it!

Cheers

Ben

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