We talked last week about the employment data. It was broadly thought to be disappointing. Even though the headline unemployment rate dropped to 4.7%, the job creation number was weak.
So stocks fell sharply following Friday’s numbers. The dollar fell. And Treasuries rose (yields lower). All of this immediately priced in a gloomier outlook and a Fed that would hold off on a June rate hike.
But remember we discussed how market professionals are trained to hyper-focus on the jobs numbers, even though the jobs numbers are far less important than they are in “normal” times. And with that, we said “it’s probably a good idea to use those moves as opportunities to enter at better levels (i.e. buy stocks, buy the dollar, sell Treasuries).”
That’s played out fairly well today, at least for stocks (the dollar is mixed, yields are quiet). Stocks have recovered and surpassed the pre-employment data levels of Friday morning. Small cap stocks are now trading to the highest levels of the year.
Remember, in the past two weeks we’ve talked about the similarities in stocks to 2010. Through the first half of this year, we’ve had the macro clouds of China and an oil price bust that shook market and economic confidence. Back in 2010, it was Greece and a massive oil spill in the Gulf of Mexico. When the macro clouds lifted in 2010, the Russell 2000 went on a tear from down 7% to finish up 27% for the year. This time around, the Russell has already bounced back from down 17% to up 4%. And technically, it looks like stocks could just be breaking out.
You can see the long term trend dating back to 2009 is still intact following the correction earlier this year. And the trendline that describes the correction has now broken.
As for broader stocks (the S&P 500), the chart looks intriguing too.
Similarly, the trend off of the bottom in the S&P 500 is clear, and a breakout toward new highs looks like it is upon us. New highs in stocks would get a LOT of money off of the sidelines.
With all of the above said, Yellen had a chance to respond to the Friday jobs number today, through a prepared speech for the World Affairs Council of Philadelphia. She downplayed the Friday numbers, highlighted the passing of global risks from earlier in the year, but she did note the Brexit risk (the coming UK vote on leaving/staying in the EU).
With that, perhaps they will use the market sentiment adjustment from the jobs data to their advantage, to justify passing on a June hike in favor of July.
That would give them a chance to see the outcome of the UK vote, and perhaps give them a chance to hike into positive momentum created by another round of stimulus from the BOJ (a possibility next week). Waiting another month is a low risk move. But again, we think the UK leaving the EU can’t happen/won’t happen – maybe down the road, but not now. Despite the popular polling reports, the experts are assigning a low probability. Plus, there has already been clear political messaging attempting to influence the outcome, and we expect that will increase dramatically as the vote approaches (June 23).
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Central bank posturing has put a bottom in oil and stocks in the past month. Rising stocks and oil, in this environment, have a way of restoring sentiment and the stability of global financial markets. Those efforts were underpinned by more aggressive stimulus from the European Central Bank last week.
And the Fed furthered that effort today.
Just three months ago, the Fed projected that they would hike rates an additional full percentage point this year. Today they backed off and cut that projection down to just 1/2 percent (50 basis points) by year end.
That’s a big shift. In the convoluted post-QE, post-ZIRP world, that’s almost like easing.
What’s happened in the interim? Janet Yellen was asked that today and said it was: Slowing growth in China … A negative fourth quarter GDP number in Japan … Europe has had weaker growth … and Emerging markets have been weighed down by declines in oil prices.
Aside from the negative GDP print in Japan, none of these were new developments (even Japan was no shocker). Meanwhile, during the period from the Fed’s December meeting to its meeting today, oil did a round trip from $37 to $26 and back to $37.
So what happened? It appears that the Fed completely underestimated the threat of weak oil prices to the global economy and financial system. We’ve talked extensively about the danger of persistently weak oil prices, which, at sub $30 was pushing the world very close to the edge of disaster. That threat became very clear in late January/early February, culminating when the one of the biggest oil and natural gas companies in the world, Chesapeake, was rumored to be pursuing the path of bankruptcy (which was of course denied by the company). It was that moment, it appears, that policymakers woke up to the risk that the oil bust could lead to another global financial crisis — with a cascade of defaults in the energy sector, leading to defaults in weak oil exporting countries, spilling over to banks and another financial crisis.
Today’s move by the Fed, while confusing at best, led to higher stocks and higher oil prices. The market has been pricing in a much more accommodative path for the Fed for the better part of the past three months, and today the Fed dialed down to those expectations (i.e. they have now followed the ECB’s bold easing with some easier policy/guidance of their own), which should provide more fuel for the stabilization of financial markets and recovery of key markets (i.e. the continued bottoming of key industrial commodities, more stable and rising stocks and aggressive recovery in oil).
Were they just that wrong, or are they doing their part in coordinating stimulus from last month’s G20 meeting?
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The Fed has manufactured a recovery by promoting stability. And they’ve relied on two key asset prices to do it: stocks and housing. Today we want to look at a few charts that show how important the stock and housing market recoveries have been.
While QE and the Fed’s ultra easy policy stance couldn’t directly create demand in a world of deleveraging, it did (and has) indirectly created demand by promoting stability, which restored confidence. Without the confidence that the world will be stable, people don’t spend, borrow, lend or hire, and the economy goes into a deflationary vortex.
But by promising that they stand ready to act against any futures shocks to the economy (and financial markets), investors feel comfortable investing again (stocks go higher). When stocks go higher and the environment proves stable, employers feel more confident to hire. This all fuels demand and recovery. And, of course, the Fed has pinned down mortgage rates at record lows, which promotes a housing recovery, and gives underwater homeowners (at one point, more than a quarter of all homeowners with mortgages) a since that paper losses will at some point be overcome, and that gives them the confidence to spend money again, rather sit on it.
Along the path of the economic recovery, the Fed (and other key central banks) has been very sensitive to declines in stocks. Why? Because declining stocks has the ability to undo what they’ve done. And if confidence breaks again, it will be far harder to restore it.
The first chart here is the S&P 500. Stocks bottomed in March of 2009, when the Fed announced a $1 trillion QE program.
Stocks surpassed the pre-crisis highs in 2013 after six years in the hole. But even after the dramatic rise you can see in the chart the damage from the crisis is far from restored. If we applied the long term annual rate of growth of the S&P 500 (8%) to the pre-crisis highs, the S&P 500 should be closer to 3,150 (over 60% higher).
How does housing look? Of course, bursting of the housing bubble was the pin that pricked the global credit bubble. Housing prices in the U.S. have been in recovery mode since 2012. Still, housing has a ways to go. This is a very important component for the Fed, for sustainable recovery.
While bloated government debt continues to be a big structural problem for the U.S and the rest of the world, growth goes a long way toward fixing that problem.
And growth, low interest rates, higher stocks and higher housing prices goes a long way toward restoring household net worth. As you can see in the chart below, we have well recovered and surpassed pre-crisis levels in household net worth…
Source: Billionaire’s Portfolio
What is the key long-term driver of economic growth overtime? Credit creation. In the next chart, you can see the sharp recovery in consumer credit since the depths of the economic crisis (in orange). This excludes mortgages. And you can see how closely GDP (economic output) tracks credit growth (the purple line).
Source: Reuters, Forbes Billionaire’s Portfolio
What about deleveraging? It took 10 years to build the global credit bubble that erupted in 2007. Based on historical credit bubbles, it typically takes about as long to de-lever. So 10-years of deleveraging would put us at year 2017. With that, it’s fair to think we could be very near the end of that period, where paying down debt has weighed on economic growth.
You can see in the chart below, the average annual growth rate of consumer credit over the past 55 years is 7.9%. And over the past five years, despite the deleveraging, consumer credit growth has been solid, just under the long term average. And importantly, FICO scores in the U.S. have reached an all-time high.
With the recent correction in stocks, there has been increased scrutiny on the economy. Some are predicting another recession ahead. Others are waving the red flag anywhere they find soft economic data. Consumption makes up more than 2/3 of the U.S. economy. And you can see from the charts above, the consumer is in a solid position. But stocks and housing remain key drivers of the recovery. The Fed is well aware of that. With that, don’t expect the Fed, in the current economic environment, to do anything to alter the health of the housing and stock markets.
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The Bank of Japan stepped in overnight and put a floor under stocks. Only 6 of 42 economists at Bloomberg thought they might do something.
We made the case over the past couple of days that they needed to. The opportunity was ripe, and we thought they would take advantage. They did.
Of course, that’s all the media is talking about today. The word “surprise” is in the headline of just about every major financial news publication on the planet with respect to this BOJ move (WSJ, Reuters, BBC, NYTimes … you name it).
Remember, we said earlier this week, the Fed was just a sideshow and the main event was in Japan. If you understand the big picture: 1) that central banks are still in control, 2) that the baton has been passed from the Fed to the BOJ and the ECB, and 3) that they (central banks) need stocks higher, then this move comes as no surprise.
Today we want talk a bit about what these central banks have done, what they are doing and why it works. We often hear the media, analysts, politicians, Fed-haters saying that QE hasn’t worked.
Okay, so QE hasn’t directly produced inflation and solved the world’s problems as the Fed might have expected when they launched it in late 2008. But it has produced a very important direct benefit and indirect benefit. The direct benefit: The Fed has been successful at driving mortgage rates lower, which has ultimately translated to rising house prices (along with a slew of other government subsidized programs). That has been good for the economy.
The indirect benefit: As Bernanke (the former Fed Chair) said explicitly, “QE tends to make stocks go up.” Stocks have gone up – a lot. That has been good for the economy.
But we need a lot more – they need a lot more. Here’s a little background on why…
The Fed has told us all along they want employment dramatically better, and inflation higher. They’ve gotten better employment. They haven’t gotten much inflation. Why? In normal economic downturns, making money easier to borrow tends to increase spending, which tends to increase demand and inflation. In a world that was nearly destroyed by overindebtedness, people (businesses, governments) are focused on reducing debt, not taking on more debt (regardless of how “easy” and cheap you make the money to access).
With that, their best hope to achieve those two targets (employment and inflation) has been through higher stocks and higher housing prices. Strength in these key assets has a way of improving confidence and improving paper wealth. Increasing wealth makes people more comfortable to spend. Better spending leads to hiring. A better job market can lead to inflationary pressures. That’s been the game plan for the Fed. And that’s the gameplan for Europe and Japan.
So how do they promote higher stock prices? They do it by promising investors that they will not let another shock event destabilize the world and global financial markets. They’ve promised that they will “stand ready to act” (the exact words uttered by the Fed, the ECB and the BOJ). So, they spent the better part of the past eight years promising to do “whatever it takes” (again exact words of the ECB and BOJ).
The biggest fear investors have is another “Lehman-like event” that can crash stocks, the job market and the economy. The thought of it makes people want to hold on tight to their money. But when the central banks promise to do anything and everything to prevent another shock, it creates stability and confidence to invest, to hire, to take some risk again. That’s good for stock prices.
Now, despite what we’ve just said, and despite the aggressive actions central banks have taken in past years (including the BOJ’s actions last night to push interest rates below zero) and their success in manufacturing confidence and recovery, when stocks fall, people are still quick to talk about recession and gloom and doom. On every dip in stocks since the culmination of the global financial crisis in 2007-2008, the comparisons have been made to that period.
First, they’re ignoring what the central banks have been telling us. “We’re here, ready to act.” Second, and again, things are very, very different than they were in 2007-2008. In that period, global credit was completely frozen. Banks were failing, and the entire financial system was on the precipice of failing. And at that point, it was unclear what could be done and what actions would be taken to try to avert disaster. That uncertainty, the thought of losing 100 years of economic and social progress across the globe, can easily send people scurrying for cash, pulling money from everywhere and protecting what they have. And that uncertainty can, understandably, result in stock prices getting cut in half – a stock market crash.
Now, what’s happening today? The financial system is healthy. Credit is flowing. Unemployment is very close to long-term historical norms. The U.S. economy is growing. The global economy is growing. The best predictor of recession historically is the yield curve. It shows virtually no chance of recession on the horizon. So the economic environment is very different. Still, the biggest difference between that period and today is this: We didn’t have any idea what could be done to avert the disaster OR how far central governments and central banks would go (and could go) to fight it. Now we know. It’s all-in, all or nothing. There is no ambiguity. With that, the central banks will not fail and cannot fail. And remember, they are working in coordination. No one wins if the world falls apart.
With all of this in mind, any decline in stocks, driven by fear and misinformation, offers a great buying opportunity, not an opportunity to run.
We’ll talk Monday about the very strong, and rational fundamental case for stocks to go much higher. On that note, today we’re wrapping up one of the worst January’s on record for stocks, which has given us a great opportunity to buy at a nice discount.
