Approaching a Turning Point

The bulls point to rising rates as a sign of economic strength and a reason to own stocks. Of course, this ignores the fact that the beginning of tightening cycles tends to mark the end of multiple expansion, which of course, has driven almost all of the gains in domestic equity markets this year. Furthermore, while the world is focused on the level of rates, few have considered the implications of the speed of the advance. Guggenheim’s Scott Minerd hits the nail on the head in a brief note today:

There have only been 16 occasions during the past half century when interest rates rose more than 20 percent over 200 days. On a percentage basis, the recent rise in rates has been the most violent on record and we are continuing to see evidence of the negative effects of this in the real economy. In particular, lower activity in the housing market and the reduction in residential construction have caused a drop in disposable income. 

Aggregate income growth has slowed over the past four months, and the resulting downturn in consumption caused a poorer-than-expected back to school season for nearly all major retailers. On top of that, the September 6 employment report, which saw only 169,000 new jobs created and included significant downward revisions for the previous two months, was in all shapes and forms a disappointment. This will create further problems for generating the type of wages and household income necessary to support consumption. 

The signals in the real economy suggest that yields may already be somewhat stretched . . . Equities also look stretched at current levels, and divergences are exacerbating, meaning we could be facing a pull-back. The situation in the stock market right now brings to mind the words of Baron Rothschild who said the secret to his great wealth was that he sold early. 

Our friend, Michael Gayed, recently shared similar concerns in a brief note to investors:

The stock market has completely ignored how fast rates have risen in 2013 thus far, just like how markets ignored yields spiking before the 1987 Crash. The below chart provided by GaveKal Data provides a nice visual history of spiking rates. Yes – the speed of the bond market sell off today is very much like 1987. No – it is not bullish. 

Unusual Spikes in Rates

Some have argued that “this time it’s different” because of the level we are coming off of. It should come as no surprise that yields are spiking given how “artificially low” they have been for the past several years. Maybe that is true, but I would argue that the yield spike in isolation is not the only similarity to 1987. The chart below, provided by Bank Credit Analyst, shows the total return price ratio of stocks relative to bonds. Note the first circle is 1987, the second the technology bubble, the third the 2007-2008 financial crisis, and the fourth where we are today. 

Ratio of Stocks to Bonds

What caused the Crash of 1987 was not portfolio insurance – it was a massive disconnect between bonds and stocks, whereby bonds fell aggressively (yields spiked) against the backdrop of a runaway Dow Jones Industrial Average that ignored the deflationary shock of spiking yields. The massive outperformance of stocks to bonds was resolved on the Crash as stocks collapsed and bonds were bid higher, taking the ratio back to trend. Note that the 1987 arrow I put in was copied and pasted to the far right. The speed of outperformance now is nearly the same against the backdrop of what may be a down trending resistance line in the relationship of stocks to bonds. Spiking yields on their own have throughout history been a significant negative to the economy, and the speed of the relative outperformance of stocks to bonds is precisely like 1987.

If the Fed does not calm the bond market down, traders likely will do the work for them, sending stocks down substantially harder than a normal correction and in turn cause a flight to safety trade back into duration which is precisely what happened during the 1987 Crash. For U.S. markets, the next 30 days may serve as a reminder that what is at stake here is far more than execution risk over the question of how smoothly the Fed can pull its foot off the gas pedal. What is at stake is if the last great bubble, the idea that central banks alone can solve all problems, is about to burst because the solution has now become the problem.

In short, the spike in rates has the potential to cause serious problems for risk assets and with domestic equities near all-time highs, there is plenty room for prices to catch down to fundamentals.  Even still, there are larger issues brewing abroad.  Ambrose Evans-Pritchard summed up the situation succinctly in the UK Telegraph last week.  A few excerpts follow below:

The Fed has a duty of care to emerging markets, since its own hands are hardly clean. Zero rates and quantitative easing were the cause of dollar liquidity flooding these countries. It was the biggest reason why net capitals flows into emerging markets doubled from $4 trillion to $8 trillion after 2008, much of it wasted in a late cycle blow-off.

Yes, China, Brazil, India and others handled the liquidity bath badly. They ramped up credit without generating much worthwhile growth. The diminishing returns have shrunk to almost nothing.

As Matt King from Citigroup says in a pithy note, tourists have discovered that “reality is less good than the brochure” in emerging markets and now they are pining for home. “Don’t all come home at once. The exits are small,” he warned.

One cannot blame the US for the failings of these countries, yet Ben Bernanke and his successor will still have to live with the consequences. Globalisation has entrapped the Fed. Like it or not, the Fed is the world’s monetary superpower. 

If the Fed really thinks that the rest of the world will have to “adjust to us” as it insists on draining global liquidity come what may, it may have a very rude surprise, yet again. This has the makings of a grave policy error: a repeat of the dramatic events in the autumn of 1998 at best; a full-blown debacle and a slide into a second leg of the Long Slump at worst.

We are told that emerging markets are more resilient than in past crises because they have $9 trillion of reserves. But any use of that treasure to defend the exchange rate entails monetary tightening, and therefore inflicts a contractionary shock on countries already in trouble.

We are in entirely uncharted waters. Emerging markets were less than 15% of global GDP in the early 1980s, when tightening by the Volcker Fed brought Latin America crashing down. That was an ugly episode for Western banks, but easily contained. China was then in autarky, shut off from the world. The Soviet Union and its satellites formed a closed system.

The picture was already very different by the mid-1990s, when ex-Communists had joined the party. By then emerging markets had grown to a third of global GDP, big enough to rock the boat, as Fed chair Alan Greenspan discovered after Russia’s default in August 1998.

Bottom Line: We would argue that the risks today are far higher than in the past, as global imbalances are far greater than they were, while the magnitude of leverage in the system is measured on a totally different scale.  With 50% of the global economy now dependent upon emerging markets, tightening too quickly would be a VERY expensive mistake for the Fed.  The good news is that imbalances create opportunities and this time will be no different.  We plan to offer up our thoughts on how and where this shakes out in the next Broyhill Letter.