SERIOUS MONEY:INVESTORS' ON/OFF love affair with risk assets has characterised financial market behaviour all year, writes CHARLIE FELL
Indeed, infatuated portfolio managers have begun to court stocks once again, and stock prices have climbed almost 10 per cent from their lows in early-July, as impressive second-quarter earnings reports soothed equity investors’ double-dip fears.
Meanwhile, fixed-income investors are having none of it and continue to gravitate towards the relative safety of treasury securities; the strong demand has pushed 10-year yields down to just 2.75 per cent, under the rate that was registered when stock prices bottomed 17 months ago.
The signals emanating from each market stand in sharp contrast to one another, so which message should be believed?
Ten-year treasury yields have recorded a meaningful decline from their recent high of slightly more than 4 per cent in early April, when financial markets were presuming that the US economy would enjoy a typical “V-shaped” recovery. The macroeconomic data has consistently disappointed since that time, revealing that the fledgling recovery is anything but normal. The hard numbers for economic activity and employment creation have fallen short of expectations, while numerous surveys continue to be indicative of an economy that is mired in recession.
The pace of economic growth slowed to below 2.5 per cent in the second quarter, and the level of economic activity remains below the pre-recession peak. A typical postwar recovery expands at a more than 6 per cent annual rate one year into the recovery, and stands 8 per cent above the prior business peak 2½ years after the recession began.
Furthermore, the economy grew by less than half of 1 per cent if the contributions from inventory accumulation and government spending are excluded, and would have been close to zero but for the temporary boost to residential investment from the homebuyer tax that has since expired. The bottom-line is that the average 1.2 per cent growth in real final sales since the economy bottomed last summer confirms that this is the most tepid recovery in postwar history.
Labour market data paints a similar picture. July’s employment report revealed that 131,000 jobs were lost last month, more than double the consensus estimate. Additionally, the numbers for the prior two months were revised downwards by 97,000. A typical postwar recovery has not only recovered all jobs lost during the prior downturn at comparable points in the cycle, but has created an additional one million jobs 2½ years after the recession began.
The household survey, which tends to be a leading indicator of payroll data at turning points, showed that 159,000 positions were shed last month following contractions of 35,000 and 301,000 in May and June respectively. The unemployment rate remained unchanged at 9.5 per cent, but only because the labour participation rate dropped to its lowest level since 1984. Roughly 45 per cent of the unemployed are out of work for more than 27 weeks, a postwar record, while broader measures of joblessness reveal that 16.5 per cent of the workforce is currently unemployed. The evidence is clear; the labour market is not recovering but stagnating.
Surveys of consumer confidence and business optimism also side with pessimistic bond investors. The University of Michigan’s consumer sentiment index stood at 67.8 in July, as compared with an average of 74 during recessions and 91 in economic expansions. The Conference Board’s consumer confidence survey reads 50.4 for July, 20 points below the average for recessions. The National Federation of Independent Business’s survey of small-business optimism came in at 88.1 for July versus an average of 92 during recessions and 100 in expansions. The survey evidence is hardly indicative of a self-sustaining recovery.
The macroeconomic evidence clearly sides with the risk-averse bond investors, and not with the equity bulls. The diehard optimists can point to another exceptional earnings season, as more than half of the companies that have reported to date beat consensus expectations. Although corporate America’s performance has been nothing short of impressive, almost all of the three percentage point improvement in return on equity has been driven by margin improvement, with only a modest uptick in asset turnover. Trailing 12-month sales remain 14 per cent below their prior peak, an unprecedented postwar development, which helps explain why strong profits are not translating into significant job hiring or capital spending programmes. The record levels of cash sitting on corporate balance sheets is cited by many as a bullish development, but perhaps it reflects increased caution given limited growth opportunities.
Investors should note that the pessimistic signal emanating from the bond market is far more convincing than the perennial optimism espoused by the equity bulls. Furthermore, the historical record shows that bond yields lead stock markets and not the other way around. The recovery is extraordinarily fragile and the economy is just one recession away from deflation. Take note.
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