Back in June in our conversation "Agree to Disagree", we indicated that until US Treasury Yields rose significantly in response to stronger growth and a healthier global economy, a secular bull market is not in the cards if history is any guide, although lower yields are indeed giving arguably more incentive to shift from bonds to stocks:
"When looking at the growing divergence between US stocks and US Bond yields, and softening US economic data, one can wonder our long US investors can "agree" to "disagree".
In our previous conversation we argued that the latest round of QE policy followed by the Fed would be hindered by US Corporate Borrowing given the already very low levels of funding which might overwhelm any growth in bond demand. Once again it seems to us that the latest policy enacted by the Fed looks farfetched and is that of engineering yet again another attempt in "wealth effect" in order to trigger shareholder spending as indicated by Bloomberg:
Yes, September's reading from the Conference Board, for the sentiment index was indeed at 87.4, more than any other time since January 2008, exceeding by 17.1 points the estimate. But, consumer "fear" might derail this plan and magnify the US fiscal cliff woes as indicated by Bloomberg:
Consumer purchases, which account for about 70 percent of the economy, also grew 1.7 percent, the weakest in a year. Spending has cooled as the labor market struggles to improve. Employers added 96,000 workers to payrolls in August, less than economists projected, after July’s 141,000 gain, Labor Department figures showed Sept. 7." - source Bloomberg.
As far as we have seen as of lately, considerable data improvement has been priced in current stock prices, leading us to feel rather "uneasy" in this sea of "easiness". "Fundamentals" wise, economic support is indeed lacking for additional US stock gains as reflected by Bloomberg so "Mind the Gap":
Not only does the projected earnings have been rising but an upcoming earnings recession may soon put some additional pressure on US stocks as we moved towards the third quarter earnings season, hence our title give projected earnings as reflected in current stock prices look to us increasingly indicating "The World of Yesterday" and not 'The World of Tomorrow", sticking with our deflationary stance.
On top of that the large Capital Good Orders drop at the end of August which have declined in four of the past five months is as well an early warning signal about future shipment growth turning negative in the near future:
While orders for durable goods slumped 13%, the most since January 2009, consumer confidence in the US climbed for a fifth straight week to -39.6 from -40.8. The "somewhat" improving housing market is indeed supporting the markets but as far as Europe is concerned Europe Economic confidence is in the doldrums, and dropped from 86.1 in August to 85 in September. Record unemployment and a deepening slump with euro-area contracting 0.2% in the second quarter are putting a strain on consumer confidence.
Following up on our previous conversation dealing with "Zemblanity" and why these Central Banks operations will eventually fail, we would like at this juncture to remind ourselves of what we wrote back in May 2010 in our conversation "The inflation debate or why you can have inflation in a deflationary environment":
The initial MV = PT Fisher equation means that a rise in ‘M’ leads in reality to a fall in ‘V’ leaving no net benefit.
MV = PT where:
M is the amount of money in circulation
V is the velocity of circulation of that money
P is the average price level and
T is the number of transactions taking place
"We are currently in a deflationary environment which poses no short term threat of massive inflation, but creates a risk of high inflation, if there is no debt restructuring at some point, as well as some profound structural reforms in public finances in the very near future, which will push us towards a double dip recession. It is unavoidable."
As a reminder:
"In Fisher's formulation of debt deflation, when the debt bubble bursts the following sequence of events occurs:
Assuming, accordingly, that, at some point of time, a state of over-indebtedness exists, this will tend to lead to liquidation, through the alarm either of debtors or creditors or both. Then we may deduce the following chain of consequences in nine links:
1.Debt liquidation leads to distress selling and to
2.Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes
3.A fall in the level of prices, in other words, a swelling of the dollar. Assuming, as above stated, that this fall of prices is not interfered with by reflation or otherwise, there must be
4.A still greater fall in the net worths of business, precipitating bankruptcies and
5.A like fall in profits, which in a "capitalistic," that is, a private-profit society, leads the concerns which are running at a loss to make
6.A reduction in output, in trade and in employment of labor. These losses, bankruptcies and unemployment, lead to
7.pessimism and loss of confidence, which in turn lead to
8.Hoarding and slowing down still more the velocity of circulation.
The above eight changes cause
9.Complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rates and a rise in the real, or commodity, rates of interest." - (Fisher 1933)
We wrote at the time:
"Therefore a perceived inflation can happen in a deflationary environment, it can co-exist."
In the post "Low rates environment and the risk of evergreening à la Japanese", we described the following:
"Companies "are hoarding and in fact not hiring. The paradox of thrift versus the paradox of debt. Companies hoarding cash and households paying down their debt, typical of a deflationary environment and the fear of uncertainty. Households are busy rebuilding their balance sheets and companies have been busy defending their balance sheet."
We concluded our December 2010 conversation making the following important point:
"It is therefore critical to avoid evergreening à la Japanese, the sooner the restructuring of debt, the better and the faster the economic recovery."
To illustrate the above important point, we think the convergence between Iceland's 5 year CDS and Ireland is a compelling display of the impact an accelerated restructuring can have on economic recovery. We have discussed at length this important point back in our conversation in March entitled "Equities, there's life (and value) after default"): "By preventing default, creative destruction cannot happen in true Schumpeter fashion"- source Bloomberg:
Iceland - The Great Debt Escape" - August 2011). - "He who rejects restructuring is the architect of default." - Macronomics.
We agree with the recent comments from Exane BNP Paribas from their QE3 FAQ from the 21st of September:
"The effective impact of QE3 may be less elevated than suggested by econometric models, for two reasons. First, interest rates and mortgage rates have already reached record lows, without triggering much additional business investment. In other words, investment has been much less sensitive to interest rates than in the past and it is uncertain whether a further decrease in yields can change this situation. Second, the mortgage market remains impaired, as close to 50% of households with a mortgage cannot refinance or get a loan at the record low market rates due to their lack of equity."
We think Dr Bernanke is indeed going "all in", expecting the "bluff" will be enough to raise expectations and therefore boost the economy and changing expectations.
There would be an easier way to boost the prospect for a return of economic growth and it would mean improving service for struggling homeowners given US banks have been failing to adhere to at least two sets of servicing guidelines since 2010. The Home Affordable Modification Program, that required speedy response from banks has repeatedly been ignored. As indicated by Bloomberg in their article - "Banks That Flunked Servicing Tests Face Watchdog" by Hugh Son from the 25th of September:
"One in five U.S. residential units are underwater, or tied to loans that are bigger than the value of the home, according to CoreLogic Inc., a Santa Ana, California-based mortgage data firm. Of those 10.8 million properties, 15 percent have fallen behind on payments."
We believe accelerating the restructuring process and the deleveraging of US households would be far greatly effective in helping out the US economy in the on-going deleveraging process otherwise the US risk facing "evergreening" à la Japanese as indicated above and might never move back towards "The World of Yesterday".
From the same Bloomberg article:
"The five biggest servicers have given about $10.6 billion in relief through June, mostly in the form of short sales in which a delinquent borrower’s home is sold for less than the amount owed, Smith said last month in a report. That results in fewer credits because servicers get less than 50 cents on the dollar for short sales. They are expected to ramp up loan modifications in the coming months."
Moving on to credit, we believe credit is becoming incredibly expensive and crowded akin to a potential "Bull Trap" as indicated by CreditSights in their latest Euro Issuance Performance review from the 26th of September:
"With two days left before the end of September, fixed rate-euro denominated issuance has already easily exceeded all previous September issuance volumes with 52 billion Euro of investment grade and high yield deals brought to market.
Those deals have broadly performed well, especially those from the stressed-eurozone countries.
But outperformance remains reliant on improvement in the sovereign situation. And so while stressed-country new issues offers attractive yields and compelling new issue premiums, they could prove a trap for investors when volatility returns and liquidity disappears."
We already discussed at length the risks of dwindling liquidity in credit markets. Back in our July conversation "Hooke's law" we argued:
"Given the "Yield Famine" we are witnessing, we believe our credit "spring-loaded bar mousetrap" has indeed been set and defaults will spike at some point, courtesy of zero interest rates. (The first spring-loaded mouse trap was invented by William C. Hooker of Abingdon Illinois, who received US patent 528671 for his design in 1894)."
In our last conversation we also indicated the following worrying trend:
"This latest credit market "euphoria" has been marked by the significant return of Covenant lite issuance. Back in May 2012, we specifically discussed this return in our conversation "The return of Cov-Lite loans and all that Jazz..."."
Our concerns have been duly validated by the following information relating to the covenant quality of new deals from the following Bloomberg article - "Bond Sales Approach $1 Trillion in Third Quarter: Credit Markets" - 27th of September:
"Bond investors are also accepting looser terms from speculative-grade companies. A Moody’s measure of weakness in bondholder protections included in U.S. junk-rated debt increased to 3.94 in September, the worst since November. The gauge, known as a covenant-quality score, compares with 3.71 in August and a 2012 average of 3.72 through last week, according to Moody’s. “In environments where there is a lot of demand, investors will have less say in the covenant package,” said Matthew Musicaro, an associate analyst at Moody’s. “Either you invest in the deal or you don’t.” Moody’s reviewed covenants on 41 bonds sold through Sept. 21 and focused on covenants including those that restrict the use of cash, investments in risky assets and leverage. The deals are rated on a scale of one to five, with five representing the weakest covenants."
Mouse trap, or Bull Trap, it is indeed definitely loaded...