As we sit here trying to navigate the markets and the news flow, we are seeing a number of inconsistencies crop up. With US equities continuing their march upwards, it would appear that these guys still subscribe to the reflation promised by the new administration. Frankly, we have our doubts that he will achieve anywhere near his 4% economic growth target. It would appear that our doubts are shared by some in the bond markets where price signals have flat-lined since late November/December. Currency traders seem as unconvinced as the fixed income boys. Here are some of the things we are looking at.
Let’s start with equities. In the US, the uninterrupted rise is beginning to look a little strange. The lack of variation in daily prices and the complete lack of any corrective price action of any significance is indicative of a large “sellers strike”. Even those who have bearish leanings are not selling now as the feeling grows that prices are simply not ready to go down. We are not sure how much truly discretionary money is actually buying into US equities at the moment; we suspect not very much. But clearly the short term trend is up, and at some level is indicative that equity investors subscribe to the economic reflation narrative.
As noted above, not all investors in the bond market would seem to agree. Chart 1 below compares the S&P 500 with the 5 year breakeven inflation rate implied by the bond market. Aside from a period post the Brexit vote when global bond investors incorrectly focused on deflation risks, the two do move together pretty well. However, if we squint hard enough, we can see that whilst the equity market continues to hit new all-time highs on a daily basis, the breakeven inflation rate has not made any progress for nearly a month.
Chart 1 – The S&P 500 with the US 5 year breakeven inflation rate
Are bond investors simply non-believers in the Trump reflation narrative? Hardly; yields remain quite a bit above levels from before the election. However, they seem to be very much in the wait and see camp. Chart 2 below shows the US yield curve (difference between 10 year and 2 year yields) and the 5 year 5 year forward inflation rate. As can be seen, although both spiked up on the news of the Trump election win, they have basically tracked sideways now for three months. At some point, these ranges will break. An upward move indicating more reflationary expectations, and a downside break indicating economic growth is missing in action.
Chart 2 – The US yield curve (10s less 2s) and 5yr5yr forward inflation rate
So what is it that bond investors are seeing to make them unsure? On the surface, economic data is beating expectations and inflation is nudging higher (we’ve discussed how inflation may peak around the end of Q1 before – a topic we will revisit soon). However, scratch below the surface, and the economic growth narrative is not so strong. There seems to be a bit of a divide between “soft” or survey economic data (both business and consumer surveys) which are on fire, and “hard” data which is more mixed – yes, some data like last week’s retail sales beat expectations, but other data like real wages and industrial production missed. Chart 3 below courtesy of Bill Hester shows the difference between the survey data and the hard economic data.
Chart 3 – Difference between “hard” and “survey” data
Perhaps bond investors are simply a glass half empty crowd and prefer to focus on real data whereas equity investors prefer to focus on the hope and hype. Trouble is there is no clear consensus on the exact nature of the current economic situation and even less certainty on how much impact new policies may have and when they will begin to have an impact.
A couple of hard data points that are garnering a little more attention in recent days, one of which is the amount of tax being paid. When the economy is performing well, more tax is collected, and so it should be worrisome that nearly eight years into the current economic expansion, taxes paid by both households and companies are basically not growing year on year. Now, maybe the data is being distorted by timing factors, for example, with “phenomenal” tax reform coming, perhaps there is a degree of delaying income and tax into a future period when tax rates will be lower? We will see, but this is a small warning sign that the economy may not be quite as strong as many think.
Of more immediate concern is the slowdown in bank lending growth. Chart 4 below shows the 6 month annualised change in Commercial and Industrial Bank lending. The economy is usually in recession when this measure of bank lending drops into negative territory. So although the slowdown is apparent, we have not dipped into negative territory. However, given the almost euphoric nature of current business surveys, we do find it off that this is not translating into faster loan growth.
Chart 4 – C&I Bank Lending 6 month annualised
Of course, there could be other factors involved, but slowing loan growth is simply not consistent with accelerating economic growth. This is a red flag that needs to be monitored closely. Furthermore, new data out of consumer lending shows a deterioration in those behind on payments for auto and credit card debt. This is not a healthy development.
We had an update on Fed thinking this week as Yellen gave her semi-annual testimony to policymakers. We also had a slew of other Fed governors speaking. And what did we learn? Not a huge amount of new stuff to be honest. Yes, the Fed thinks that they are very close to meeting their goals and as such will be removing accommodation. But we knew that. What is still not clear is how many rate rises and whether the Fed will be reducing its balance sheet at all this year. Whereas odds of a March rate rise immediately rose after Yellen spoke, by the end of the week, they had receded.
Chart 5 shows the market implied probability of a rate rise by the Fed at its March meeting. Typically, the Fed never raises rates unless this probability is above 50%. And with only just over three weeks until the meeting, the drop back below 35% indicates that the market is not ready for a rate rise. Will the Fed surprise? Well, we would argue that Yellen’s DNA is dovish and unless she is becoming more structurally hawkish in what is likely to be her final year as chair, then we expect no change next month. That said, clearly the probability is not zero, and if we are right that a rate rise is indicative of a structurally more hawkish Fed, then our concerns are that the Fed is tightening more aggressively at a time when the hard economic data is not as strong as they think it is – the perfect set up for a policy error (something we have discussed before).
Chart 5 – Market Implied Probability of a Fed rate rise in March
So where does all this leave our market views? We said a couple of weeks ago
“In the portfolios we manage, we are erring on the side of fading the Trump reflation trade. Our net exposure to the Dollar is close to zero, we are modestly long of US Government bonds and have bought some put options in US and European equities. Where we hold positions via options, we will be looking to add value by trading some of the associated hedge on those trades, and overall we are looking to manage risk to a low level until we see a degree of clarity returning.”
Clearly our equity options have not worked, but our losses here have been relatively small and we have made some money on our hedges. The same is true of our US bond positions. However, we don’t feel like we are either missing out or badly positioned at the current time. Overall, we continue to be somewhat under invested and risk is pretty low. We continue to view the reflation narrative with some suspicion and we need to see the details of Trump’s economic and tax plan before we can update our macro views. As for markets, the disconnect between the equity and bond markets grows by the day, and at some point, something has to give. Either bond yields rise to confirm the reflation narrative, or equities fall to reflect the current sluggish hard economic data.
Stewart Richardson
RMG Wealth Management
