The rally in US equities is starting to look a little old, at least on the basis of the relative performance of S&P 500 sectors. Since 28th February, the leading sectors have been energy, technology, consumer staples, healthcare and, to some extent, utilities. When the market makes new highs on rallying defensives and tech (which dances to its own tune to some extent), the new highs being made don’t seem especially convincing.
It seems to me that the market and I have increasingly divergent views on the prospects for the US economy. The market is focusing on improvement in the leading indicators, and residential investment in particular (and, also, the market itself). I am focusing on the drag from fiscal policy, which monetary policy will be in no position to offset, and the effect of a reduction in the government deficit on corporate profits. Why do I think that I have the right way of looking at it? On the economy, the point is arguable, but it does strike me that, whatever model of the economy you happen to use, the improvement in residential investment would be best seen as endogenous whereas the change in fiscal policy is clearly exogenous (driven, if you like, by false consciousness). On the outlook for corporate profits, however, I think I clearly have the better case: corporate profit growth and GDP growth are only weakly connected, so even if GDP growth does come in strongly, significantly higher corporate profits are not assured; and there is a good reason to think that corporate profits will at least be prevented from growing by fiscal deficit reduction.
Speaking of the US economy, interest in the sequester, as proxied by Google search volume, has been growing since late January. I will continue to keep an eye on this. Memes do ripple through the market and they do have an effect, and Google Trends seems a good way of tracking them. Here is a chart: http://bit.ly/YnHwW5.
Jeremy Stein, a relatively new Fed governor and distinguished professor, has been talking about how investors may be “reaching for yield”. He acknowledges that credit spreads are not at their pre-crisis lows, but points out that issuance of both corporate bonds and leveraged loans have reached new highs. He argues that high-yield bond issuance and the ratio of high-yield to total issuance are good indicators of future defaults (and therefore of future returns) — these series are relatively high. Most importantly, he favours the use of interest rates (rather than regulatory interventions as favoured by Greenspan and Bernanke) to control this kind of thing. If that view grows on the FOMC then interest rates could be raised earlier than anyone expects. This is a theme to watch.
There seems to be an awful lot going on today, so I will switch to some notes:
* North Korea claimed to have detonated a nuclear warhead (it is trying to make one that is small enough to put on a missile). The US geological survey and others detected a tremor that would be consistent with a nuclear blast: 4.9 in magnitude, with an epicentre near North Korea’s test site. South Korea estimated a 6-7 kt bomb (compared to 15 for the one dropped on Hiroshima). This was North Korea’s third nuclear test.
* Janet Yellen has said that the Fed could remain on hold even after its stated unemployment or inflation criteria are met. That is not a surprise, since the Fed language is that it will remain on hold “at least” until the criteria are met. But I see this as being about trying to convince the markets that the end of asset purchases, when it happens, should not be seen as a significant tightening. With even the Fed moving away from the portfolio-balance view (which I never thought very convincing), I am not sure that the markets will be convinced.
* Mr. Grillo is doing ever better in the Italian polls, but is still third. He has called for Italian sovereign debt to be renegotiated. The Five Star Movement is unlikely to be a partner in any coalition, but it could create problems for the other parties. On the other hand, if it is particularly successful, it could force them into a grand coalition (like the one whose breakup precipitated the election!). At present, Mr. Bersani may still garner enough support to govern alone or in coalition with Mr. Monti.
* The Netherlands nationalised SNS, a big bank, at the start of February. I hadn’t paid much attention to this, but Alphaville has a piece on it today. It seems the bank had done perfectly well in the European stress tests, and reported a tier 1 ratio of 13% (a legacy property portfolio against which no provisions had been taken was the cause of the nationalisation — it became obvious that it could not be sold, and bankruptcy was seen as inevitable). To me, this serves as a reminder to be sceptical of anyone who claims to “invest” in a bank. Bank shares are macro counters, not investments.
The situation is looking a little less cheerful for holders of Cyprus’s bonds. Earlier in the week there were reports that a restructuring was one of three options put to finance ministers by the European Commission, albeit one that was not recommended. More details of the Commission’s analysis appear to be emerging. The EUR 17bn bailout that Cyprus needs (including EUR 10bn for the banks) would mean a debt/GDP ratio of 145% in 2015; it has been suggested that finance ministers might aim to reduce this to 100% either by 2015 or by 2020. Either way, some kind of PSI or depositor write-down would be involved. Cyprus strongly rejects any hit to depositors, and I suppose that means the bonds are looking rather more vulnerable now than they were before.