Investors are Dumping Inflation Hedges
The noticeable shift in sentiment suggests the market may be approaching a breaking point where investors give up on the notion that the economic recovery is accelerating and/or that inflationary pressures are rising.
Since global financial stability slowing continues to improve (as confirmed by recent IMF statements), what we are talking here is not another look into the abyss, but a reality check, where “excessive” investor expectations for growth and inflation are again squeezed out of market prices. While “acute” global financial stability risks have been reduced, the Eurozone has an ongoing debt and credit problem that is suffocating economic growth and thus corporate and bank balance sheet repair in the region remains spotty and uneven, leaving a sword of economic and financial stability hanging over the region. The following are some yellow flags that markets (investors) are beginning to “smell” deflation.
Yellow Flag 1: Investors dumped their holdings of TIPs (Treasury Inflation-Protected Securities) last week following a weak auction of 5-year notes. Falling prices prompted a spike in yields on the TIPS, which ostensibly hedge against inflation. Traders observed that, “the rest of the TIPs market is having a mini implosion since the auction, as real yields on TIPs have jumped 8-10bps across the curve in what appears to be a ‘get me out’ trade. The spread between the yield on TIPS and the yield on plain vanilla Treasurys, or break-even rate, which dictates the rate of inflation necessary for TIPS to provide a better return, has been in free fall. Before the auction, the rate was at roughly 2.24%.
Yellow Flag 2: Commodity prices are selling off. While the financial media was focused on the first weakness then sharp selloff in gold, significant selling was also underway in other commodities more closely linked with the real economy. The CRB index has quickly sold off some 7.9% from a 2012 high and is still over 24% lower than its 2011 post-crisis high. Copper has recently sold off just under 14% and is 30% lower than its post-crisis high, while crude oil (Brent) has sold off over 11% and is also about 24% below its post-crisis high.
In the week ended April 9, investors unloaded the equivalent of about 20 million barrels of oil in U.S. petroleum contracts, according to the CFTC’s Commitments of Traders data. Bloomberg data indicate indicate hedge funds and other money managers cut their bullish bets on Brent to their lowest level in four months, while a separate survey by Bloomberg shows investors expecting US crude supplies to hit a 23-year high of over 390 mm/bbl.
Since bottoming in October 2012, inventory levels of copper have risen 190% in warehouses operated by the London Metals Exchange. That’s a huge and rapid increase, and it conveys a powerful message about the future for copper prices. We are seeing an even more rapid rise in inventory levels than when global demand collapsed in 2008, and it comes on just a small amount of drop in copper prices.
Yellow Flag 3: Great rotation not. Despite all the talk of the “great rotation” from bonds to stocks, global bond yields have taken another leg downward, with the German 10yr bund recently falling 50bps to 1.25%, the 10yr US treasury dropping 38bps to 1.68% and of course Japan’s 10yr dropping 39bps to historical lows at 0.45%. Even Spain’s 10yr bond yield continues to decline, by a large 238bps to 4.64% from July 2012 highs. Falling bond yields of course are another hint of shrinking growth expectations and/or shrinking inflation expectations.
Yellow Flag 4: Emerging markets have been underperforming by a widening margin since late 2012, ostensibly because of softening economic data, weakening commodity prices and slowing capital flows.
The Gold Crash Whodunit
The $20 billion gold futures sale and concentrated selling of gold futures on the US COMEX on Friday and Monday has gold bugs shouting “conspiracy” as they smelled manipulative selling by a large hedge fund, bullion bank or even the Fed, behind the crash. The CFTC is scrutinizing whether gold prices are being manipulated, although they public state that the drop doesn’t necessarily mean “anything nefarious”. The CFTC said in March that it is looking at issues including whether the setting of prices for gold—and the smaller silver market — is transparent and if it is fixed. Blackrock said it saw“no visible central bank activity” although the reported sale of (USD400 mm) gold by Cyprus was supposedly one trigger for the selloff.
Selling of paper gold ETFs backed by real gold probably accelerated the move. This is because GLD shares are dumped at a quicker pace than gold’s own selloff, creating an excess supply of GLD shares, forcing GLD administrators to buy up this excess supply, and raising cash to do this by selling gold bullion. According to Zeal LLC, the recent “correction” in GLD’s holdings forced it to dump a staggering 169.8 tons (5.5 million ounces) of gold bullion simply to keep GLD shares’ price tracking gold! There are only two gold-mining companies in the entire world (Barrick and Newmont) that produce that much gold in a whole year. The drop capped a trend of declining global gold investment (including bars, coins and ETPs), as the World Gold Council saw an 8.3% drop to 424.7 tons in 4th QTR 2012.
George Soros and Louis Moore Bacon reportedly cut their stakes in gold ETF products last quarter, for Soros by 55% as of December 2012. Once heavily long gold, hedge funds reportedly cut bets on a gold rally by 56% since the yellow metal reached a 13-month high last October. As hedge funds headed for the exits, the investment banks turned bearish. SocGendeclared the gold era was over and set an end 2013 target of USD1,375, near the time that Citigroup declared the end was nigh for global oil demand growth (on substitution natural gas for oil combined with increasing fuel economy).
Goldman set a year end target of USD1,450 and said it could go lower, then nailed the selloff with a “short gold” recommendation a week before gold really tanked. This selling came amidst a consensus among economists that economic growth would accelerate in the U.S. and China in the coming quarters, according to Bloomberg and other surveys.
Gold has Lost its Safe Haven Status?
Soros total the South China Morning Post, “Gold has disappointed the public”…”when the Euro was close to collapsing in the last year…gold was destroyed as a safe haven, proved to be unsafe…Gold is very volatile on a day-to-day basis with no trend on a longer-term basis.” While Soros was long gold big time until fairly recently, he called gold “the ultimate bubble” in February 2010, implying he would enjoy the momentum ride until the music stops.
It is puzzling that gold crashed just as the BoJ was unleashing its “shock and awe” monetary expansion that will double Japan’s monetary base from Y138tn or 29% of GDP at the end of 2012 to Y270tn or about 54% of GDP by the end of 2014. This compares to a US monetary base expansion of 6% GDP in mid-2008 to 19% of GDP by this March. The BoJ’s increase in balance sheet of Y5.2tn (US$54bn) per month in 2013 is the equivalent of annualised 13% of 2012 GDP, or roughly twice the Fed’s current balance sheet expansion, at annualized 6.5% of 2012 US GDP.
If the real reason for the gold crash ends up being “rogue” shorts by Goldman, Morgan Stanley or JPM, etc. traders swinging for the fences that eventually blows up in their face, we may have a more serious problem than realized.
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| Source: 4-Traders.com |
Is the Recovery Bull Market Already Long in the Tooth?
Looking at every bull market in the US since 1871, the historical “average” bull market lasted 50 months, with a media gain of 123.8%. The range since 1970 however has been substantial, from 32 to 153 months in duration, and gains ranging from 56.6% to over 516%. There is of course no way of knowing whether this bull market will be a short one or a long one, but coming out of the 1930s depression, there were no less than four bull markets ranging from 140% to 413% gains. For our money, this bull market is reaching a historical median milestone has no particular significance.
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| Hat Tip: Big Picture |
Economic Surprise Index Turns Negative
In addition to the disappearing inflation premium in TIPs, we believe the negative turn in Citigroup’s Economic Surprise Index is having an impact…i.e., investor expectations were overshooting what it now appears the recovery is able to deliver. This is a marked contrast from the June 2012 to November 2012 period, when investor expectations were low and the economic data was surprising on the upside despite investor concern about the Eurozone and the US budget impasse. Given that US sequestration has kicked in, know one should really be surprised that the US economic data is looking “squishy”.
The March US jobs report (which came in at just 88K) was an example of disappointing weakness, accompanied by some weak U.S. housing and retail data. Building permits have declined since January. Single family starts were down 4.8%. Homebuilder confidence, which climbed to its highest level (47) since 2006 in December, stalled in January 2013 after an eight-month rise and fell to 42 in April. Foreclosure starts have also begun to pick up again.
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| Source: Citigroup |
The IMF Lowers its (Too Optimistic) Global Growth Forecast
The IMF lowered its 2013 global growth forecast, to 3.3% from 3.5% and its 2014 forecast to 4.0% from 4.1%, reflecting,
a) Sharp fiscal spending cuts in the U.S. (sequestration, etc.) should shave about 0.3 percentage points from US GDP this year,
b) Struggling, recession-striken Europe, with economic contractions in France, Spain and Italy expected this year.
c) With the IMF was upbeat on China, mediocre growth here is sparking concerns that growth is slowing.
d) The good news was that the IMF raised its forecast for Japan, ostensibly on the BoJ’s aggressive new monetary stimulus.
To IMF cynics, these downward revisions haven’t gone far enough, particularly as regards expected inflation.
US Commerce Board Suggests US Economy Has “Lost Some Steam”
The economy “has lost some steam” and will grow slowly in the near term, the Conference Board said Thursday as it reported that its leading economic index ticked down in March. The LEI declined 0.1% last month, following three months of gains, and economists polled by MarketWatch had expected the index to rise 0.2% in March. In February, the LEI rose 0.5%. The largest negative contribution came from consumers’ expectations. Other negative contributions came from building permits, a manufacturing new-orders index, weekly manufacturing hours and weekly jobless claims.
Goldman Sachs’ Business Cycle Indicator Goes from Bad to Worse
The latest Goldman GLI (global leading indicator) shows that the situation has gone from bad to worse. Consumer confidence, global PMIs, and industrial metals have all worsened significantly, pushing the Global Leading Indicator momentum down. Goldman’s GLI also points to future deterioration in global industrial production.
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| Hat Tip: Zero Hedge |
The Spring Equities Swoon Revisited
The disconnect was that while the economic data flow was increasingly falling below expectations, bond yields were falling not rising, the TIPs inflation premium was shrinking, and commodities were selling off, the S&P 500 was blithely ignoring this in hitting a new rebound high.
Over the past several years, investors have repeated a pattern of beginning the year with optimistic U.S. growth/recovery expectations, only for these expectations to evaporate by mid-year as waning data suggest sluggish activity, which has contributed to a “sell in April-May” and go away pattern in stock prices as investors fretted about a) a possible end to QE, b) sputtering economic growth and c) ongoing Eurozone crisis.
Yet, in “selling in May and going away”, investors would have missed most of the next up-leg that took the S&P 500 to new recovery highs, with the entire move from the March 2009 low of 683.38 now representing a 132% gain over a period of just over four years. This time, the correction could be essentially the same, i.e., basically a reality check that does not seriously endanger the post great recession, QE fueled market recovery. While the apocalyptic bears are still out there, their hyperbole is somehow less believable than in 2011 or 2012.
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| Source: Yahoo.com, JapanInvestor |
Short-Term Breakdown in S&P 500
In addition to the yellow flags previously mentioned, cracks are forming in the S&P 500 rally itself.
The S&P 500 index is recently unable to close back above its 50-day moving average. This is the first close below this key price level in 2013 as high-beta Tech (AAPL) and Homebuilders underperformed notably. Stocks are below Cyprus levels and marginally above Italian election levels.
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| Hat Tip: Zero Hedge |
The Trend is Still Your Friend
The so-called momentum effect is one of the strongest and most pervasive phenomena of any market phenomenon studied. Researchers have verified its value with many different asset classes, as well as across groups of assets. The momentum effect works in terms of asset’s performance relative to its peers in predicting future relative performance, and momentum also works well on an absolute, or time series basis, where an asset’s own past return predicts its future performance. In absolute momentum, there is significant positive auto-covariance between an asset’s return next month and its past one-year excess return. Absolute momentum appears to be just as robust and universally applicable as crosssectional momentum. It performs well in extreme market environments, across multiple asset classes (commodities, equity indices, bond markets, currency pairs), and back in time to the turn of the century.
In short, the trend is your friend until, like was seen in gold, it is decisively broken.
Foreign Investors Pile Into Japan
Having ignited a virulent “short yen, long Nikkei trade”, Shinzo Abe and his BoJ buddies continue playing the market psychology game to the hilt, knowing that a change in consumer, corporate and investor sentiment can be just as good as “real” change through what George Soros termed reflexivity. Japanese policymakers know full well that public expectation of more deflation can become self-fulfilling, and they are actively trying to change the way ordinary Japanese think about prices, just as they have engineered a dramatic turnaround in foreign investor sentiment.
They see the fight against deflation not just as one that involves measures like quantitative easing, but also psychic warfare: Once Japan’s consumers and business leaders believe prices will start rising, there’s a better chance people will go out and spend, putting pressure on prices to go up.
Ryuzo Miyao, a member of the Bank of Japan’s policy board, has actually said that deflation will end in the current fiscal year (to March 2014). “The achievement of 1 percent inflation in fiscal 2014 has come into sight,” Miyao said. “The public’s inflation expectations will rise gradually, and in this situation the inflation rate is likely to rise above 1% during fiscal 2014.”
While Piling In, They Also Discuss Possible Loss of Control By the BoJ
For many years very underweight and generally very pessimistic about Japan, foreign investors have piled into Japanese equities since November of last year, and this buying accelerated to a record weekly figure last week, according to the Tokyo Stock Exchange. A new net buying record of JPY1.58 trillion was set in the second week of April, after the Bank of Japan unveiled new “shock and awe” quantitative and qualitative easing measures under newly installed Governor Haruhiko Kuroda. The new data put cumulative net purchasing by foreign investors since mid-November, when the decision to dissolve the lower house was made, at JPY8.15 trillion.
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Source: Nikkei Astra, Tokyo Stock Exchange, Japan Investor
JPY Billion |
At the same time, they continue to discuss the probability that the Bank of Japan (BoJ) would lose control of the printing press and how a rapidly declining yen could lead to a replay of the 1997 Asian currency debacle. Perma bear Albert Edwards points out that investors may have forgotten that yen weakness was one of the immediate causes of the 1997 Asian currency crisis and Asia’s subsequent economic collapse.
Japan Becomes Extremely Overbought
Regardless of whether the big Abenomics/BoJ bet eventually pans out, the following chart from Orcam Financial shows the Nikkei as the most overbought (i.e., above its 200-day MA) and Gold the most oversold, suggesting there is now ample room for a short-term mean reversion trade between the two (like short Nikkei, long gold), and this big contrarian call is exactly what CLSA strategist Chris Wood is now suggesting.
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| Hat Tip: Pragmatic Capitalism |
The call is predicated on the non-belief that the US economy is “normalizing” and US QE will come to an end earlier than what investors currently expect. Indeed, it counts on the conjecture that the BoJ’s bold move on QE is not the last by a long shot. For one, Mario Draghi at the the ECB would love to do more if he thought he could get it by Germany. Support for this view comes from three regional Fed bank presidents saying a further decline in US inflation below the Fed’s 2% target may signal a need for more accomodation, not a potential curtailing of easing discussed by other Fed officials.
Other brokers are beginning to suggest the Topix/Nikkei 225 is due for a 10% or so pause from the parabolic move upward since November of last year. In looking at individual stocks and sectors like Sumitomo Realty (8830.T) and the real estate sector as a whole, prices have already surged to Koizumi reform years peak levels, meaning a lot of the expected reflation for the foreseeable future is already priced in, given that Sumitomo Realty for example is already selling at a very rich P/E of 43X and a PBR of over 4X.
The Japan equity rally has been driven primarily by Nikkei 225 constituents, i.e., larger cap, more liquid names that foreign investors found the easiest to quickly raise their Japan exposure. However, the core 30, which includes more than its share of troubled electronic sector and other “dogs” continues to lag by a considerable margin.
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| Source: Nikkei Astra, Japan Investor |
The best year-to-date performers in the Nikkei 225 include many real estate companies, both first and second-tier, major retailers, second-tier financials, heavy industry stocks and even a couple of pharmaceutical companies.
Over the past month, however, buying has gone from “all in” to more specific sector and stock selection, amidst continued selling by domestic financial institutions who see this as an ideal time to unload unwanted strategic holdings. The biggest irony is that the electric power “zombies” are on the leader board. while the bank sector has taken a breather. The growing sector divergence is indicative of the emergence of quick sector rotation.
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| Source: Tokyo Stock Exchange, Japan Investor |
Japan investor tokyo takes 