Stuck In The Middle...It seems much more than clear that equity investors of the moment have more than warmly embraced the Goldilocks thesis regarding the domestic US economy. After all, what else could equities be discounting right here? You know the routine. Prescient Fed, a slowing in economic growth to be followed by reacceleration, falling inflationary pressures, continued meaningful expansion in corporate earnings, a soft landing for housing, and the thought that this perfect world will lead to valuation/stock price expansion. Don'tcha wish life could always be this way? We suggest that implicit in this assumption is a reacceleration in consumer borrowing and spending. At least so far, we have not yet seen the reacceleration in rate of change of household borrowing as per the consumer credit and HELOC numbers. Moreover, messages from the retail sales world post Black Friday have been mixed at best. We'll just have to see what happens ahead. But clearly also implicit in the Goldilocks assumption thesis is the thought that the US economy experiences nothing more than a "mid-cycle" slowdown in terms of official economic growth. Wonderful. In other words, no negative GDP quarters. As many a pundit has pointed to again and again as of late, the mid-cycle slowdown periods of the mid-1980's and mid-1990's were accompanied by relatively meaningful expansions in stock prices. So the conclusion is naturally drawn in our present experience that if we indeed achieve the fabled mid-cycle economic slowdown, which may in fact have already begun, just like in 1995 and 1985, we're in for a big equity rally. Simple enough? Let's have a look at some history.
Although the flow of logic above certainly appears appealing, it's missing one key fact. The mid-cycle economic slowdown periods of the mid-1980's and mid-1990's that gave us such wonderful equity performance were also quite importantly accompanied by more than meaningful declines in long term interest rates. In the following charts we are using the ten year US Treasury yield as a proxy for longer dated interest rates. And as always, declining long term rates are a very powerful equity market aphrodisiac. Have a look.
From mid-1984 through early 1986, we saw the ten year yield decline by close to 650 basis points. In turn, the S&P rallied over 65%. The decline in the ten year yield was close to a 46% decline. That's powerful stuff. On to the mid 1990's. Conceptually, it's pretty much the same story as appears clear below. From late 1994 through 1995, ten year Treasury yields dropped close to 240 basis points, or roughly 30%, while equities were up close to 45% over the same period.
Let's fast forward to the present. In the following chart we've combined the S&P and the ten year Treasury yield experience over what's close to the last three years. It's clear, and as you already know, the rally in the major equity indices since summer has, up to this point, been accompanied by declining ten year yields. We've shaved 75 basis points off the ten year yield, or an approximate 14.3% decline, since summer. In very rough terms, many equity indices have rallied by a similar amount. So, where to from here?
We suggest that rather than focusing on the lore of mid-cycle economic slowdowns theoretically being big positives for equities in the aggregate, we instead keep our eyes on the ten year UST yield. We suggest that's the bigger key for equities as opposed to achieving some type of recessionary near miss, so to speak. Referring back to the examples of the mid-1980's and mid-1990's, the average decline in ten year Treasury yields that sparked the fabled equity rallies of size was 38%. Of course we need to remember that this is based on a whopping statistical sample size of two. Nonetheless, we pose the question, if we are to achieve the fabled mid-cycle slowdown at present, accompanied by a further large move in equity prices upward, is the ten year Treasury yield about to drop to 3.25%, near the prior multi-decade lows? 3.25% from the summer yield highs of near 5.25% is a 38% decline, the average ten year UST decline in the prior two mid-cycle slowdown periods. It seems very hard to believe ten year yields would experience this type of plunge without either a mean recession to come or a cliff dive by the US dollar, or both. Simply put, in our book long bond yields are the ticket as to whether a meaningful equity rally lays ahead, not absolute quarterly GDP experience. History appears pretty darn clear on the concept, despite a lot of current mainstream focus on the economic "mid-cycle" slowdown thesis. Enough said?
Attack Of The Fifty Foot Woman...It's been a very good while since we've checked in on the goings on with the Japanese monetary base. Important why? Global liquidity, global liquidity and global liquidity. And did we forget to mention global liquidity? You'll remember that at a G7 meeting in April of this year, global central banking heavyweights joined hands and pointed their collective fingers at the Bank of Japan in response to $80 oil, quadrupling copper prices, and the levitating act of far too many commodities across the planet. As you know, when excess global liquidity is finding its way into equities and bonds, that's wealth creation. When residential housing prices are the manifestation of a runaway mortgage credit bubble, that's prosperity. But when commodity prices are levitating due to white-hot excess credit related economic expansion in far-flung locales such as China, well that's "unwanted inflation", right? So the Bank of Japan did what any self-respecting central bank would do (except for maybe one Central Bank we can think of) when called on the global carpet for "creating" too much liquidity, they stopped. And not only did they stop, they began an immediate program of erasing their quantitative easing (printing money) efforts of the last half decade by beginning to shrink the Japanese monetary base in very big and rapid fashion. The following is a quick update of a chart we have shown you in the past. It's the long-term history of the Japanese monetary base with the year over year rate of change overlaid on top.
To suggest that the year over year rate of change in the Japanese monetary base has plunged is an understatement. There's no precedent for this anywhere in the last three and one half decades at least. Tangentially, as we've mentioned when discussing this subject in prior missives, every single time the year over year rate of change in the Japanese monetary base has experienced a sudden decline of magnitude in the past, it has been right in front of all official US recessions since 1970. Every single one. Whether that's to come ahead is another story.
As you also know, this plunge in the Japanese monetary base since early this year was at least initially accompanied by what was literally the coordinated decline in global equity markets that began in May. In fact, many blamed the spark that led to the collective equity market declines directly on the magnitude of BOJ action in contracting the monetary base. Of course what is interesting is that while the Japanese monetary base continued its decline through recent months, equity markets globally bottomed in the summer and you know the story from there. The point being that despite a Yen carry trade that is clearly still in force, Japan was not a massive or proactive liquidity pump levitating global equity markets in the last few months. As you may know, August purchases of US financial assets by the foreign community was the largest on record. That was certainly a huge support to the summer rally beginnings in both bonds and stocks. (Last month we fully discussed this global capital recycling loop.) Secondly, for those of you that have been watching, the Fed/Treasury dynamic duo have certainly done their part to keep the liquidity party going in the months leading up to the US elections with temporary open market operations and coupon passes transpiring with more than a fair amount of frequency and magnitude. But the reason we bring all of this up is that shrinkage in the Japanese monetary base appears to be coming to an end, at least for now. The chart below speaks to the fact of short tem stabilization in the monetary base.
Is the BOJ done in terms of the bulk of removing their prior quantitative easing efforts of the last few years at least? It sure could be. We fully expect more interest rate increases to come from the fun folks at the BOJ, but they will be gradual, if not glacial. So as we watch this change in the rate of decline in the Japanese monetary base, we need to ask ourselves whether Japan will once again heat up as a global liquidity factory, so to speak? And if so, how can we benefit, if at all? First, we need to remember that the carry trade (borrowing at uber low interest rates in Japan, hedging currency cross rates, and investing elsewhere in much higher rate of return assets) has not stopped in the least. The fact that the Japanese yen has been declining steadily since really early summer is darn indicative of the fact that the carry trade has anything but dissipated in aggregate. Just a few weeks back, Japanese monetary authorities made some noise about the need to more strictly monitor carry trade activities looking ahead. Perhaps someday they will really mean it. But at this point we have to continue to take a "we'll believe it when we see it" attitude toward any BOJ effort to reign in the carry trade action given their historical implicit don't ask, don't tell policy. Moreover, it very well could be that the action of contracting the Japanese monetary base is at least temporarily over due to recent Japanese economic stats/indicators turning down a touch. In the last few weeks we've seen year over year rate of change declines in Japanese M2, vehicle sales, machinery orders, CPI (core - ex food and energy), the leading indicator, and now the second consecutive monthly decline in retail sales. With this has come the stabilization, at least for now, in the monetary base as BOJ authorities have clearly taken their collective foot off of the monetary brakes.
Again, why do we bring this up? At least in our minds, for a global financial marketplace, and economy for that matter, that has been relatively heavily dependent on excess liquidity availability, we need to continue to try to monitor all available sources of meaningful global liquidity generation. If the actions of the BOJ are not a critical part of this larger exercise, then we're missing something. As we've mentioned probably too many times now, pre-election liquidity "availability" has been a key characteristic of the US environment courtesy of the Fed/Treasury/Administration. And that excess availability, if you will, has found its expression in financial asset prices, completely bypassing residential real estate markets. The thought among certain segments of the investment community has been that as the election period passes, so too the need for the domestic monetary powers to be so "generous" in their temporary and open market operations activities. So far, we have not seen any diminution in Fed/Treasury temporary or permanent open market activities. Although the forward level and intensity of Fed/Treasury actions ahead remains to be seen, could the BOJ become an important source of forward short term global liquidity generation once again, at perhaps the exact time US authorities take a "time out"? For now, the stabilization in the Japanese monetary base says "watch me".
So just how will we know whether the BOJ monetary pump has again been turned back on to some degree? Maybe it's as simple as watching the Japanese stock market relative to major global equity indices. Let's have a quick look at some very simple observations. First, it's clearly the obvious anomaly that YTD, the Nikkei is the standout equity index that has literally gone nowhere. Outside of the obviously volatile Middle Eastern equity markets, there have been very, very few pockets of nominal global equity market weakness YTD. Here's just a little example of what we're talking about.
|Equity Market||YTD Price Performance Expressed In Dollars|
This list is very far from exhaustive, but you undoubtedly get the picture. In very simple terms, has the contraction in the Japanese monetary base hurt Japanese equity market performance YTD? If not this influence, then what? So as we look forward, can we make the case that price action and direction in the Nikkei should be reflective of greater BOJ monetary policy vis-a-vis liquidity availability? We certainly hope the answer is yes. The bottom line here is that if the price action in the Nikkei improves, we could very well be facing yet another global liquidity shot in the arm that would only enhance what the Fed/Treasury/Administration has already been providing. And given the slowing in the US housing market and economy of the moment (GDP), can we really expect US monetary authorities to restrict liquidity availability in any meaningful manner? Of course not.
A few quick charts we hope are helpful, if you don't mind. First, we hope monitoring the directional relationship between the S&P and the Nikkei will be telling. You can see that YTD, directional changes in prices have been pretty darn highly correlated. There's certainly been a bit of divergence recently that demands monitoring. And unlike many global equity indices, but much like the US Transports and Russell 2000, the Nikkei has as of yet not returned to its April 2006 highs. Although hopefully not reaching for a rationale, it tells us that the BOJ has stabilized the Japanese monetary base for now, but has not yet become meaningfully stimulative. If this divergence continues, the focus of how changes in liquidity will influence US equity markets should continue to be centered on Fed/Treasury action.
Alternatively, if the Nikkei rallies from here in trying to "catch up" to the upward movement in the SPX and other major global indices, then we need to at least question whether the BOJ monetary restriction efforts have come to a dramatic conclusion for now with some type of stimulation in process. In other words, could the BOJ be the next key provocateur in any type of liquidity driven upside for global equities and bonds? Although it might sound hard to believe, we need to "follow the money".
It just so happens that the Nikkei appears at a relatively critical technical juncture as we speak. You can clearly see the long term declining tops trend line we've drawn in the monthly chart below. Without sounding melodramatic, this is fifteen years worth of very key resistance. Do you think an upside breakout from here would catch the attention of chartists across the planet? That would be an understatement, if we're not incorrect. Secondly, since 1997, the 200 month moving average of the Nikkei has been key upside resistance for this headline equity average. We stand roughly within 600 points of this very significant demarcation line as we speak. Is the monthly RSI overbought? Sure it is. But excess liquidity can maintain such a circumstance for a longer period than most would suspect.
A quick look at the daily chart. The upside channel since the rally began in June of this year couldn't be more well defined. Meaningful support lies 500-600 points below. Not earth shattering downside by any means. And on the monthly chart above, key decade and one half long technical support lies near the June 2006 lows.
One last circumstance to monitor should be the health, or lack thereof, of Japanese small caps. A sector that historically has been very responsive to excess macro liquidity. In the following chart we're using the Japan Small Cap fund as a proxy for this sector. Based on weekly RSI and MACD, Japanese small caps appear oversold and potentially turning up. But what is also clear is that we appear to have a meaningful trend break. A trend dating back to early 2003. At least on the weekly chart, a back test has already occurred and failed for now. If Japanese small caps cannot mount a convincing move to the upside, the BOJ again becoming a meaningful liquidity generator will be in question.
So we hope the conclusion of this little exercise is relatively simple. If the Nikkei breaks out to new multi-year highs above the 17,500 level and Japanese small caps can rally from here, it's a good bet that happens in concert with stimulative BOJ actions. Actions that could have big meaning for more macro global liquidity sponsorship. Sponsorship we have to take into investment consideration regardless of short term fundamental "news". Alternatively, if the Nikkei were to break down from here, and especially below key support, we'd have to conclude that one big piece of what has been multi-year liquidity support to the global economy and financial markets has been removed for more than just a temporary pause. And that would put the spotlight directly on the Fed/Treasury/Administration liquidity support actions of the moment. Can the Fed/Treasury carry the liquidity generation ball single handedly without upsetting the dollar relative to it's global currency peers? That's the $64 question, now isn't it? Maybe in today's world, it's really the $370 trillion question (the notional value of global derivatives outstanding), give or take a few trillion here or there.