“We are in the endgame of central planners’ attempts to keep the lid on the simmering stew of profound imbalances that characterize the status quo. Maintaining the Illusion of Stability Now Requires Ever Greater Extremes of central-planning policies.”
Charles Hugh Smith
While US equities (SPY) are still in a 6 year bull market, performance has stalled during 2015, but measured against long term Treasuries (TLT) , SPY has been unable to make new highs for the last 18 months, or since the beginning of 2014. The chart above shows this relationship is near a long term extreme level that has historically capped the outperformance of SPY relative to TLT.
It is clearly worth investigating the relationship between stocks and bonds much more deeply at this very significant level as this is one of the most important allocation decisions that investors make. What Charles Hugh Smith is suggesting is that efforts of central banks to boost stock prices may be reaching a point of diminishing returns, and this could be coinciding with some deeply misunderstood positive economic factors in the bond market, which has recently become oversold.
Crucial to this debate is that investors need to be aware that it has become close to irrefutable that central banks have now subordinated economic management to market management. It should be obvious by now, in the case of China and Japan, but investors should also be aware that the Federal Reserve has now also clearly crossed the line, as explained below. This has substantial implications for risk and allocation.
First I will examine the forces at play in SPY, focusing on the interplay between the Fed, the stock market and the growing disconnect with economic criteria. Then I will highlight the very compelling case still supporting the 35 year secular bull trend in TLT, drawing on research from an investment advisor with one of the best long term track records in bonds. Lastly, it is worth taking a look at some key economic data out this week showing that economic weakness has continued across a wide range of indicators, and is now far beyond what could be described as a “transient” winter dip.
Starting with equities, the central banks have become increasingly focused on directly intervening in “markets”, which now need quotation marks to express the point that current prices now represent some kind of central bank altered state. However, are the central bank efforts to hold the stock market higher beginning to fail? Do they even make any sense as a policy?
Not only have the central banks been unable to provide useful or credible forecasts for the last several years, but they have now also lost their long term policy credibility as was recently so clearly articulated by their own forum, the BIS, in it’s annual review. So this leaves them with their latest experiment, leaning ever more heavily on market intervention as a policy mission.
This changed policy emphasis is revealed by their intransigence on changing their policy guidance, which they say is “data dependent”. Clearly, though, it is not economic “data dependent”. The data has already changed over the last 6 months or so because they themselves have already slashed their own 2015 growth forecast by almost a full 1%. Their forecasts have now fallen below their own growth and inflation objectives, so there is clearly a strong case for some recognition of this and a change in policy outlook.
Nevertheless, there has still been no change in their policy at all. They have remained with guidance that they are still about to raise interest rates sometime this year. Even though the initial reason to raise rates is no longer present in their own downgraded forecasts!
This essentially confirms the trend in the Federal Reserve policy guidance in place for several years now. It has become increasingly obvious that the Fed’s main policy is to boost the stock market. Achieving their stated economic policy objectives clearly seems to have taken a back seat.
This new policy approach may well be counter-productive. It is possible that this new focus can be detrimental to reaching their economic goals. Continuing with their current guidance may or may not boost the stock market but it will keep the dollar stronger and raise bond yields, which is restrictive policy. This can only make it even less likely that they can meet their own stated inflation or growth objectives. So their intransigence serves no sensible economic purpose. It is currently even conflicting with their objectives. They have just trapped themselves in another circle of diminishing returns.
The reason there is no change in policy guidance must be because they still need to project the impression that the economy is still sufficiently strong to raise rates, in order to keep the stock market up! It may also be that it is no longer clear to them what policy they would need to introduce to ease policy. Interest rates are already at zero and the results from their last round of QE have been so disappointing.
If this is the case then the gap between markets and economic reality can become unusually stretched. As the data continues to diverge at an accelerating rate from justifying central bank engineered “markets”. Investment risks are accelerating. Market consensus based on central bank policy guidance is becoming dangerously blindsided.
Furthermore, market intervention may be reaching its limits, given how investment performance has stalled, and now US equities may in addition be facing strong competition from bonds.
Hoisington Investment management have an excellent track record in their Treasury fund and have consistently remained with the long term bond trend. Their recent investment review works through four important misconceptions about the bond market currently. This then leaves a much more constructive outlook for TLT.
“Presently, four misperceptions have pushed Treasury bond yields to levels that represent significant value for long-term investors. These are:
1. The recent downturn in economic activity will give way to improving conditions and even higher bond yields.
2. Intensifying cost pressures will lead to higher inflation/yields.
3. The inevitable normalization of the Federal Funds rate will work its way up along the yield curve causing long rates to rise.
4. The bond market is in a bubble, and like all manias, it will eventually burst.”
Finally, the data over the last week, has remained with the economic slowdown theme. All the data below was apparently insufficient to change Yellen’s testimony this week, which ran along the same lines as last week’s statement and broadly speaking her statements over the last several months.
Ask yourself an important question. If your forecasts for 2015 were already below stated objectives and you saw the four data points shown below, would you recommend raising rates?
On retail sales, “… when viewed through the lens of retail “control purchases,” is currently operating at levels that have only previously been witnessed during recessionary periods.”
Then there has been sustained weakness in industrial production, which is now only up 1.5% year on year.
Wholesale sales and inventories are also at levels more consistent with a recession, than an economy that needs a rate rise.
Finally, looking at imports and exports the article below concludes that “what is taking place is a total systemic downturn rather than discrete or piecemeal problems in isolation. As should be obvious by now, there has been nothing like this except for the Great Recession and the dot-com recession before it.”
All the indications are that the US economy is shifting into a Quad 4 economic backdrop with growth declining and inflation flat to down at very low levels. This is happening at a time when Bonds are at record value levels of relative to equities.