Not Broken, Just Bent?

By: Michael Ashton | Thu, Aug 29, 2013
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Equity market bulls are a tenacious bunch. In August, with increasing tensions in the Middle East - Egypt and, this time, Syria - along with uncertainty over the future course of monetary policy and steadily rising interest rates, the S&P 500 has lost all of 2.8% after hitting a new all-time high early in the month. Investors who focus purely on the price charts and on the behavior of the indices should be delighted in how stocks have performed with this bad news and fairly weak earnings.

Of course, it should be noted that stocks have still not reached the 2007 highs, much less the 2000 highs, in real terms (see chart, source Bloomberg: this is just the S&P 500 divided by the CPI index). This isn't to belittle the rally, which has roughly doubled the value of equity investments, in real terms, since the bottom. But it should remind us that this is not a secular bull market, yet, even though we have reached new nominal highs.

As we step away from the pure equity focus, though, the picture grows progressively uglier. After a period of stability in late June through early August, interest rates have begun to rise again. The 10-year note is at 2.76% (but last week approached 2.90%). The 10-year TIPS is at 0.65% after challenging 0.80%. The further selloff makes the consolidation in July look like just a pause in the middle of an otherwise-steady uptrend in yields. We were at 1.60% as recently as May! This selloff has been unusual, but then we all know that it's because yields shouldn't have been that low in the first place. Some of this selloff is merely returning from a ridiculously expensive position. (With all that being said, I must admit that after this kind of selloff, I would want to be taking a shot from the long side as we move into September).

Commodities are higher, with the DJ-UBS index comfortably above the 100-day moving average for the first time this year (see chart, source Bloomberg). And this isn't merely a reflection of energy prices moving higher, because spot crude oil at $108.80 is actually back within the range it has held since early July: $104-$109. Over the last month, grains are 4% higher, livestock 2.5% higher, precious metals 10% higher, industrial metals 5% higher. So this movement in commodities has been fairly broad-based (the softs are down), even with the dollar treading water over that period.

So, while stocks are merely bent, not broken, at this stage, I'd prefer to own bonds - even nominal bonds - to them at these levels, and of course I still like commodities. I do think there is a halfway decent chance that the stock market could transition from bent to broken in the next month.

Both commodities and inflation-linked bonds did poorly today, though, at least partly because an article in the Wall Street Journal today (by Jon Hilsenrath) suggested that Yellen is "playing down her chances of getting the job," and that therefore Summers is the front-runner.

It is probably safe to say that Summers is less-dovish than is Yellen, although we don't know much about his monetary policy views since he seems to have few of them. We do know that he sees "few harmful side effects" from QE, which should be automatically disqualifying (almost as automatically disqualifying as being a super-intelligent academic economist should be). With either of these candidates - and it seems as if these really are the only two, since no one else has been mooted in the press - we are going to get a very dovish central banker by almost any historical standard. Central bankers have known for decades about the perils of quantitative easing...that's why they didn't do it in the recession of the early 1980s, or the recession of the early 1990s, or the recession of the early 2000s. Each of those recessions was plenty deep enough to warrant quantitative easing if there are few harmful side effects. But we know there are harmful side effects. So if Summers thinks there aren't any, this just means that he is very current with the "new" wave of monetary thinking and too dismissive of the old, time-tested views (which is, after all, one of the weaknesses you can expect from a 'brilliant academic' who has already proven himself unable to manage one institution filled with other brilliant academics).

Now, I find it personally distressing that the market is so concerned with who the Fed Chairman will be. It shouldn't matter that much, and here is something to reflect on: it wouldn't matter so much if monetary policy were as straightforward and as much of a science as central bankers are trying to convince us that it is. The fact that the market thinks it matters (as do I) is all the evidence you need that it does matter, and that central banking is more art than science. And you can guess what I think about most modern art too, by the way.

In the context of the fact that the Fed itself appears to be pretty much broken, not bent, I guess I take solace in another thought: given the quantity of "excess reserves" in the system, the Fed can't do much, positive or negative, for a while. The die has been cast, and it won't really matter who takes the Chairman's crown from Bernanke unless that person has a brilliant way to hit the delete key and make those reserves vanish. Otherwise, those reserves are going to press on the transactional money supply, and continue to push inflation higher over the medium term.

 


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Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA
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Michael Ashton

Michael Ashton is Managing Principal at Enduring Investments LLC, a specialty consulting and investment management boutique that offers focused inflation-market expertise. He may be contacted through that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist, and salesman during a 20-year Wall Street career that included tours of duty at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation derivatives markets and is widely viewed as a premier subject matter expert on inflation products and inflation trading. While at Barclays, he traded the first interbank U.S. CPI swaps. He was primarily responsible for the creation of the CPI Futures contract that the Chicago Mercantile Exchange listed in February 2004 and was the lead market maker for that contract. Mr. Ashton has written extensively about the use of inflation-indexed products for hedging real exposures, including papers and book chapters on "Inflation and Commodities," "The Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven Investment For Individuals." He frequently speaks in front of professional and retail audiences, both large and small. He runs the Inflation-Indexed Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes for client distribution and more recently for wider public dissemination. Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University in 1990 and was awarded his CFA charter in 2001.

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