Gartenhaus Blog

Capital Markets Not Buying What Talking Heads Are Selling

The last half of 2013 bubbled with talk about how much better the US economy was going to get in
2014.  Well…, It may be time to hit the reset.

Between bad weather, events in Crimea, as well as signs of a slowdown in China, just about every economist has lowered their forecast regarding Gross Domestic Product (GDP) growth expectations. Our read of economic commentary indicates first quarter GDP growth forecasts are now gravitating around 1.0% versus the previous consensus of 2.6% annualized growth rate (primarily due to an inventory drag).

The overarching point in the general forecast trend is that the economy didn't accelerate in the first quarter.  It decelerated.  Despite all of the claims that faster growth and better times lie ahead, the capital markets aren't behaving in a way that supports the view that escape velocity will soon be realized.

Treasury Market

The first stop is the Treasury market.  Specifically, we'll be looking at the benchmark 10-yr note which has traded so far this year  as if investors are fleeing the equity markets and moving into treasuries.
The 10-yr note has rallied while the Fed has been curtailing its asset purchases and talk of accelerating growth has increased.

Why that has been the case is open for interpretation.  Explanations range from geopolitical concerns to demographic factors to volatile stock trading to pension funds rotating into Treasuries in an effort to
protect the huge gains achieved in the stock market in 2013.  Whatever the case may be, the drop in yield
since the end of 2013 doesn't mesh with the idea that US economic growth will be above potential.

* S&P 500 Index is an unmanaged group of securities considered to be representative of the stock market in general.  You cannot directly invest in the index.

In the same vein, narrowing Treasury spreads aren't consistent with an economy expected to ramp
up.  Such a view should lead to curve steepening as longer duration securities show more sensitivity to higher rates that would accompany stronger growth.  What the flattening spreads between the 2-yr note and 10-yr note and the 5-yr note and 30-yr bond imply is that there is concern growth will be choked off  by policy miscues at the Fed or there simply won't be strong growth.

Stock Market

The next stop is the stock market, which has generated its share of excitement and heartburn thus far.  It has been likened to a roller-coaster ride and we would have to say that we agree with that metaphor.

The S&P 500 declined 3.6% in January, jumped 4.3% in February, increased 0.7% in March, and is down
0.5% so far in April as of this writing.  That leaves it up 0.8% year-to-date.

The peculiar thing when looking at the stock market is that it seems to be grappling with the cyclical recovery argument.  It hasn't given up on it, but it hasn't fully embraced it either. Below are sector market leaders. You will notice that the market has been a mix of cyclical and countercyclical sectors.

Source: FactSet

The significant out-performance of the utilities sector has been astounding.  It has been catalyzed by the cold weather, which has been a boon for utilities output, and the drop in long-term interest rates, which has been a boon for the high-yielding utilities stocks.

If market participants were truly convinced the US economy is on the cusp of a growth breakout, the utilities sector would most likely be at the bottom of the sector performance table.  Instead, we see the consumer discretionary sector there joined by the industrials and the financials, all of which have a strong cyclical orientation.

It could very well be a different performance picture by the end of the year.  The way things stand now, however, doesn't line up with an economy expected to hit escape velocity.

Currency Market

If we had a dollar for every time we have heard the US economy is showing the best growth prospects of the developed economies, we'd have a bunch of depreciated dollars.

All of those proclamations, however, haven't done much to boost the dollar.

The US Dollar Index has risen about 9% from its low in 2011, but two broader points stand out today: (1) the US Dollar Index is down 10% since the Fed expanded its Quantitative Easing (QE) initiative in 2009 and (2) it is down 5% since July 2013, which is about the time the talk of how much better the US economy will be in 2014 started to crank up.

The remarkable strength of the euro has been an important element in the US Dollar Index mix (the British pound hasn't been any slouch either).  We say remarkable because the eurozone economy isn't growing as fast as the US economy (which isn't growing fast) and the European Central Bank (ECB) is currently touting the prospect of launching a QE type plan in an effort to maintain price stability.

Not that long ago, ECB President Draghi said the central bank would do "whatever it takes" to defend the euro; now, it sounds like the ECB is going to do whatever it takes to weaken it.  Strange times.

The US Dollar Index, though, doesn't tell the most complete story about the dollar's standing since it measures the performance of the dollar against a basket of just six other currencies.  The better view, arguably, is the Federal Reserve's nominal broad effective exchange rate index.  It has held up a little better than the US Dollar Index since last July, but even so, it is pretty much flat since then.

Stronger economic growth, theoretically, should spark higher inflation and higher interest rates.  Those higher rates should be supportive for the dollar.  As of now, the dollar isn't showing any escape velocity either.

Commodity Market

When one thinks of economic growth, copper is one commodity that always jumps out as a leading indicator.  That's because copper is used extensively in industrial applications.  Consequently, it carries the moniker "Dr. Copper" because demand for the metal provides insight on the health of the economy -- not just the US economy but the global economy.

What can be gleaned from the chart below is that the global economy has some shaping up to do.  The red metal isn't acting well.  Actually, it has been trending lower since early 2011.

The peculiar thing today is that the downtrend is still intact even though the economies in the US, the eurozone, and Japan are improving.  China's economy is growing, too, but its growth rate has
slowed.  That slowdown has reportedly weighed heavily on demand for copper, creating an excess supply situation, along with collateral financing issues, that has weighed on prices.

The China slowdown concern has been at the heart of copper's difficulties since the start of the year.  It is peculiar, however, that growth expectations for the US economy -- the world's largest economy -- haven't provided much offsetting support (note the upward bias in prices in the latter half of 2013 when concerns about a China slowdown were alive and well and the US economy was being talked about as being poised for a banner year of growth in 2014).

Another peculiar happening in the commodities market has been the roll in lumber futures since the end of 2013.

In discussing US recovery prospects, residential construction is never left out.  Lumber is obviously a key production component there.  Futures prices for lumber, though, aren't exactly painting a picture of strong demand.  They are down 9.8% year-to-date, trailing only copper prices (-10.6%) as the worst-performing commodity.

This is an interesting trend because the continued softness in lumber prices doesn't fit the consensus
view that weather was the sole reason for the first quarter slowdown.  If that was indeed thought to be the case, futures prices should be reflecting the pent-up demand.  What they seem to be reflecting today

**Chicago Mercantile Exchange per board foot of lumber

What It All Means

The ultimate question in looking at the peculiar performance of the capital markets is this:  what does it all mean?
It is certainly perplexing because it doesn't fit very well with the economic acceleration argument. Treasuries are strong; the countercyclical utilities sector is outperforming the broader stock market by a
significant margin; the dollar is soft; and both copper and lumber prices are trending lower.

The message of the markets is always changing, but what those performances suggest today is that the smart money has grown less comfortable buying what a whole lot of talking heads are still selling.

In our opinion, the best play for the majority of investors is a defensive approach coupled with a cautious offensive maneuvering strategy. Hedge all bets, but always let patience guide you while keeping emotions at bay.

Source:

www.briefing.com/investor/our-view