Second section of Vanity of Vanities, Market Shadows Newsletter (11/5)
In general, current economic indicators are strengthening, the latest job numbers have been better than expected and consumers are gaining confidence. But the coast is not clear. Ahead, there’s the (still) unsolved EU’s debt crisis, the US fiscal cliff, the slowdown in China, the demise of the US dollar, and a trajectory downward for which there is no real, politically acceptable solution.
The fiscal cliff - a conundrum that our government backed itself into - has been receiving attention because it begins in 2013. It comprises the end certain tax breaks and the introduction of new taxes:
- end to temporary payroll tax cuts (resulting in a 2% tax increase for workers) ($125M)
- end to certain tax breaks for businesses
- shifts in the alternative minimum tax that would take a larger bite
- end to Bush tax cuts from 2001-2003 ($280B), and
- the beginning of taxes related to President Obama’s health care law.
As certain tax breaks end, spending cuts agreed to as part of the debt ceiling deal of 2011 will begin to take effect. According to Barron’s, over 1,000 government programs – including the defense budget and Medicare – are in line for “deep, automatic cuts” ($98B).” It is estimated that the economic drag produced by the effects would be in the range of 3.5%. The debt ceiling is also coming into play again, as we are ‘only’ $133B away from that magical number where we hit it!
This is at a time when earnings are also disappointing, earnings surprises went negative last quarter.
Troubles in the EU remain in the background. Unemployment is stubbornly high at 11.6%, with the worst results coming out of the fearsome foursome: Spain (25%), Greece (20%), Portugal (16%) and Ireland (15%).
Source of Chart: the Economist (http://media.economist.com/sites/default/files/t2db.png?1336662456)
In spite of the headwinds, economists at RBS and HIS Global Insight argue that retail sales will be good this upcoming holiday season. “This week’s string of economic data showed modest signs of consumer strength, some obvious and some deeper within the numbers, which bodes well for the holiday shopping season. Consumer Confidence rose to 72.2 in October from 68.4 in September; the strongest level since February 2008. Looking beneath the headline, economists at RBS cited in a research note:
“‘The results confirmed the improvement suggested by other October measures of consumer confidence. Though the fiscal cliff appears to be weighing on business sentiment, households have thus far been more resilient…’
“Economist Chris Christopher of IHS Global Insight called the numbers a ‘positive signal for holiday sales.’ In a client note Christopher states: ‘The recent news on the consumer front has been favorable. The unemployment rate has fallen below 8.0%, personal income gains have been favorable, the housing marketing is looking brighter, pump prices started falling, and consumer mood is elevated. This is a good report. It serves as a positive signal that the holiday retail sales season is looking significantly brighter.’” (Retail Sales, Rising Confidence Bode Well for Holiday Shopping Season)
Will consumer confidence and buying plans change in the wake of Hurricane Sandy? Common sense (not solid numbers) dictates plans will change – spending will occur but the focus will shift. (See Event Horizons: Storm of the Century, Fibonacci Spirals and No Silver Lining.)
Mutual Fund Flows
Mutual funds have seen an outflow from their coffers over the entire year, with up to $100B being withdrawn and either spent paying bills, or moved into bond funds or savings accounts that earn nothing.
According to Investor’s Business Daily, in September, investors pulled $24.36 billion from stock funds despite a rising market! Bond funds, year to date, have taken in a $238.27 billion vs. $83.61 billion last year.
Nevertheless, investors are starved for yield, and the Federal Reserves’s QE is shifting the curve to riskier fixed income assets, which is driving down yields. Investors are soaking up bonds that pay small spreads over the artificially propped up Treasuries. (In last week’s Value in the Eye of the Storm, Paul Price argued that bonds are in bubble territory.)
According to Sober Look, “New issue investment grade corporate bond market continues to run hot… investors are chasing quality paper and willing to accept historically low rates… Current treasury yield investors are taking Caterpillar risk for 5 years to receive about 1.35% per year in total coupon. This is below some 5-year FDIC-guaranteed CDs (Barclays will pay 1.7% on a 5yr CD). CAT is a strong company, but most individual investors would generally prefer FDIC risk, particularly at a higher rate. The point is that 1.35% is just ridiculous.” (Investment grade spread touching multi-year support level as CAT issues 5y notes at T+60)
The chart below shows the spread between the corporate yields (higher risk) and those of the treasuries. On the y-axis is the percent spread between corporate (junk/risk) and treasury yields – i.e. the difference between yields on corporate bonds and yields on treasuries. During the 2008-09 recession, people were dumping corporate bonds – driving yields way up. The difference between the corporate bond yields and government bond yields spiked up. People were selling corporate bonds, and unwilling to accept the risk.
Now, the situation is different. Investors are dumping their money into bonds, and also chasing yield (they don’t earn anything in their savings and money market accounts). Investors are accepting more risk for a smaller difference between corporate yields and treasury yields. This is reflected in the chart below.