PCE Deflator points to equity market sell-off in 2014

16 Dec

The Personal Consumption Expenditure (PCE) Deflator is a United States-wide indicator of the average increase in prices for all domestic personal consumption. Along with the CPI, it is commonly used as a measure of inflation.

The PCE has very rarely dropped below 1.0%. Global macro-economic forces, however, are pushing the PCE down towards a very dangerous level. As countries battle to devalue their currencies they become more competitive as their goods are cheaper for foreign consumers to purchase. This cheapening of goods leads to downward pressure on the average price of goods.

The recent devaluation of the Yen has is a good example of how this is affecting prices in the US presently. The drop in the Yen has substantially increased the competitiveness of Japanese manufacturers in global trade. As Asian manufacturers struggle to retain market share they also drop the prices of their USD goods. This compounding effect raises serious issues for importing nations such as the United States as their manufacturers become less competitive and consumers become accustomed with the idea that goods will continue to cheapen, hence preferring to save for when they are cheaper than to invest and buy goods today.

The chart below shows that the PCE deflator (in blue) has been dropping consistently for the past 20 months. The yellow line shows the 5-year breakeven rate, a measure of the market’s future expectation of inflation, in this case in five years’ time. The breakeven rate shows that the FED has, so far, been very successful at buoying the market’s expectation of future inflation by promising to keep monetary policy very loose for a long time.

PCE Deflator

The issue, however, is that the enormous quantity of money printed by the FED is not making its way down to consumers. Instead, it has inflated equity markets and created the largest credit market bubble in history. At some stage the perception of the FED’s efficacy in easing will fade and inflationary expectations will fall to more realistic levels.

Equity markets on the edge of a precipice

This could cause a serious re-rating of equities as market participants set more realistic expectations of companies’ future earnings.

The chart below shows that inflationary expectations tend to move in sync with equity market movements.

Breakeven vs SPX

Unfortunately, as seen in the previous chart, inflationary expectations tend to follow the PCE deflator which is most certainly on a downward trajectory.

George Magnus, the well known economic consultant and former chief economist of UBS, recently wrote an interesting article in the Financial Times link highlighting the risks of ever richer equity markets fuelled by monetary easing in a world facing anaemic growth.

Investors should always expect return when taking risk. The current environment doesn’t offer a very rewarding environment for risk takers. Savy investors would be wise to take profits and watch the events unfold from the sidelines.

High Yield Bonds: The End Of a 25-Year Bull Market

13 Dec

High yield bonds are debt securities rated as below investment grade, i.e. BB or lower and therefore more likely to default than investment grade companies.
Issuers of high yield bonds may include start-ups, publicly listed or unlisted companies, highly leveraged firms that may be managed by private equity funds and capital intensive firms.

High yield bonds emerged in the 1980s as an attractive instrument to finance leveraged buyouts. Investor appetite increased over the period as interest rates fell as inflation was brought under control.

The market capitalisation of the high yield market is over $1.1 trillion, with 60% of issuers in the US. Most bonds are issued with an 8-10 year maturity with call dates attached, that allow the company to redeem the bonds earlier.

High yield at record exuberance

High yield bonds have experienced an unprecedented rally since their yields peaked at 23% in early 2009. Morte interestingly , however, is the extraordinary performance of high yield bond over a 25 year period:


While lower interest rates have substantially aided the reduction in absolute yields it is important to note that even on a spread basis high yield spreads are back to record levels, under 300bps.


One big mess

The outlook does not bode well for investors: High yield bonds have rallied substantially since 2009 and have become a mainstream asset class; yields are lowest on record and credit spreads are near all time lows; credit quality has deteriorated as highly leveraged issuers and private companies have come to market; average maturities are rising as companies take advantage of low long term rates and the potential upside has all but diminished as interest rates are unlikely to drop any further and spreads are unlikely to drop fall below current record levels.

As the 25 year high yield party comes to a close one thing is certain: investors stuck in the asset class will suffer substantial losses.

Watch out for this week’s minutes from the FOMC meeting

8 Jul

Since Bernanke’s suggestion that QE may be tapered sooner than markets expected, equities have fallen, bond yields have risen and many commodities, particularly metals, have fallen off a cliff.

What can we expect from the minutes?

The statement following the meeting on June 19th said: “Labor market conditions have shown further improvement in recent months, on balance, but the unemployment rate remains elevated. Household spending and business fixed investment advanced, and the housing sector has strengthened further, but fiscal policy is restraining economic growth. Partly reflecting transitory influences, inflation has been running below the Committee’s longer-run objective, but longer-term inflation expectations have remained stable.”

Markets read into this that the Fed was preparing to taper its QE program. The minutes might suggest markets were a little too eager to sell risk assets and that the committee may not be as confident about the recovery as it may have first appeared.

Last week’s statement by the new BOE Governor, Mark Carney, and Mario Draghi, the ECB’s president made clear that Central Bank policy will remain accomodative for a good while longer. The fact that both statements were made within two hours of each other provides clues that Central Banks believe co-ordinated action, with forward guidance, the first in the BoE’s history, is the most effective way to manage the market’s expectations.

If the minutes do indeeed suggest that tapering may not happen for a while longer, we could see another substantial rise in equity prices. Bond yields appear a little more resilient to recent policy statements which could suggest investors are beginning to hesitate to buy bonds on dips.

The outlook for bond returns has very likely now swung towards the bearish camp.



Can this market rally continue!?

20 May

With US markets up 17% and Japan up 47% year to date, can equity markets rise any higher?

The S&P 500’s Price to EBITDA has risen from 7.2 at the start of the year to 8.2 now, some 20% above its long term average. Technicals are looking very overbought, economic numbers are grim and commodity prices are pointing to lower demand.

Marc Faber, well known economist and investor said last week…” In the 40 years I’ve been working as an economist and investor, I have never seen such a disconnect between the asset market and the economic reality … Asset markets are in the sky and the economy of the ordinary people is in the dumps, where their real incomes adjusted for inflation are going down and asset markets are going up.”

Can equities really rise any higher? As Keynes famously declared ” the market can remain irrational far longer than you and I can remain solvent.” So yes, but perhaps not for much longer.

The bull case is that optimism can be self-fulfilling. The rise in optimism can get people to start spending and hiring. This in turn could lead to GDP recovery and upgrades in response to lower interest rates and credit spreads, optimism in the banking sector encouraging lending and greater levels of disposable income from lower oil and commodity prices.

But nothing goes up in a straight line and for every quarter of disappointing economic news the chances of a sustained rally become ever slimmer. With investor confidence near record highs and volatility at levels last seen in 2007 one must be very optimistic to remain invested in markets such as these.

Is the Topix just the Yen in disguise??

9 May

Investors love to find deep and academic excuses for the movements of markets, but sometimes things are so obvious they fail to be noticed.

The chart below shows the progression of the Japanese Yen and the Topix over the last year.

Yen and Topix

It is nothing short of remarkable how correlated the two are. One could argue that this makes perfect sense given that Japanese companies become more competitive as the Yen devalues. This is, of course, true, except that according to the World Bank exports of goods and services account for less than 15% of the Japanese economy compared to 50% in Germany. Like the US, where the figure is 14%, Japan relies far more on the domestic market and should therefore have less sensitivity to the weakness in the Yen than most other countries.

So why have Japanese equity markets been so correlated to the Yen?

The most likely answer is that it has been driven by foreign investors keen to profit from Japan’s new inflationary policy. The cheaper the Yen gets, the more USD-based investors can afford to buy Yen denominated equities.

The eventual outcome for Japanese equities could be astronomical. Domestic investors are still sitting on the sidelines, instead sitting on return-free risky government bonds. As inflation picks up, assets flowing out of bonds and into equities could be enormous. Great for equities but very damaging for bonds and the Japanese Government that will have to pay higher interest rates on its monstrous debt pile. This is clearly very bad for the Yen as panic ensues and investors seek safer havens. A currency collapse is, not only plausible, but now increasingly probable.

A long term buyer of Japanese equities could realistically make a significant return, potentially multiple times their initial investment. But only – and this is absolutely crucial – if the Yen exposure is completely hedged. The last thing you’d want is for your stocks to triple yet still lose as the Yen proves to be worthless.


Brace yourself. Equities are in for a rough ride

3 May

Valuations are stretched, corporate profit margins are at record highs (can they go any higher?) inflation is falling and commodity prices are pointing to a significant fall in demand.

How long before equities fall?

The Fed’s preferred measure of inflation, the personal consumption expenditure (PCE) deflator, has been declining consistently for a year sitting currently at 1.1%. As CPI usually tracks PCE it is likely that the index will fall towards the 1% mark raising questions from markets on whether the US could fall into a deflationary spiral. The QE impact on markets may finally be coming to an end.

Agricultural commodities, oil and metals, have all been trending lower pointing to weak support from the overall economy. Copper, which typically tracks the S&P very closely, has finally broken down, just as it did in 2007.

With corporate profit margins at record highs it is far more likely that they will revert to the longer term mean rather than continue to expand as is predicted by most Wall Street analysts. Once earnings disappoint a mass re-rating could add substantial pressure to equity prices.

When the penny will finally drop is anyone’s guess but given the odds are increasingly stacked against equity markets and valuations no longer offer easy pickings investors might want to reflect on their equity exposures. 

Will Japan experience hyperinflation?

18 Apr

The broad definition of hyperinflation is generally regarded as excessive price rises, usually over 50% a month. Such rises are hugely damaging to economies leading to a huge loss of productivity, severe economic depression and mass unemployment. Central bankers have fought for decades to take control of inflation and, in most cases, have done a very good job.

Now they are acting with complete disregard to monetary theory and ignoring all the valuable lessons of the past. Are we in for the hyperinflationary ride of our lives?

In early April Japan’s Central Bank announced its commitment to double the monetary base over the next two years from 29% to 55% of GDP (Y135tn to Y270tn) – an increase of a over 1% of GDP per month.

Should the newly created currency flow equally throughout the economy and if we assume that all else remains equal, the simple expectation would be that the purchasing power of the Yen should halve (i.e. that the average price of goods should double in Yen terms). This rather naïve analysis assumes the world is simple and equal. People adapt when things change leading to far graver consequences than our naïve analysis would assume.

Investors have picked up on the Bank of Japan’s aggressive stance and have reacted by pumping money into the Japanese stock market, while selling the Yen. The next leg usually involves large institutional investors which, move slower but control enormous assets, selling their bond holdings and using the proceeds to buy equities, both Japanese and overseas, and other real assets where they can protect their purchasing power. Pension funds (who invest over 85% in bonds) are next and finally, the man or woman on the street, who also control vast sums of savings, adapts to the realisation that their risk free assets are in fact return free risks.

This, again, is a very simplistic and perhaps a naïve assessment of possible events, bit given Japan’s immense debt load (total debt is 500% of GDP, gross government debt is 240% of GDP, net debt is 140%) Japan needs to maintain yields at very low levels so they can afford to pay the interest on their debt. A 1% rise in yields would soak up nearly 25% of tax revenues!

Eventually investors will realise that they are lending money for 0.5% a year to a government that is effectively insolvent. If they then begin to worry about inflation they will offload bonds en masse demanding the BoJ to purchase even more bonds to maintain yields at the depressed levels they are today. How do they do that? Print more! And so the self-fulfilling prophecy ensues.

So will Japan experience hyperinflation?

With each stage the crisis deepens and central bank control slips further away. A currency and bond market collapse may seem a slim possibility but the probability of such an event has increased dramatically. In such a case it is likely that Japan would experience bouts of hyperinflation.

Japanese investors who are worried about their savings would be wise to diversify out of Japanese bonds and into overseas bonds and, for the less risk averse, overseas equities, preferably of companies with strong balance sheets that generate strong free cash flow. And, of course, gold!

For those wishing to read further Gordon Long’s post is a fascinating read.


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