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4-17-2013
Bubblelicious Markets
Spring brings to mind baseball cards and bubblegum –
at least for kids. While kids enjoy trading baseball cards,
some grown-ups are preoccupied with trading markets.
Certain markets have been particularly juicy due to what
we like to describe as a “liquidity bubble.” Central bank
securities purchases are responsible for this liquidity
bubble. The Bank of Japan (BoJ) recently joined
counterparts in the US, the euro zone and UK in making
the bubble even more enormous. The main beneficiary
of central bankers’ largesse has been equity markets. On
the heels of a 16% total return (income plus price change)
in 2012, the S&P 500 Index returned an additional 10.6%
in the March 2013 quarter, exceeding the prior record
high realized in 2007. Bond returns were fairly lackluster
during the first quarter with the Barclays Aggregate Bond
Index essentially flat from a total return standpoint.
However, following the BoJ’s decision to double the
amount of money in circulation, US, European and
emerging market sovereign debt yields dropped
dramatically. The liquidity bubble is being pumped with
air from more than the “Big 4” central banks noted above
(Federal Reserve, European Central Bank, Bank of
England, and Bank of Japan). In 2012, 28 of 50 key central
banks accelerated their easy money policies by lowering
rates a total of -4,274 basis points.
Central bank bond purchases force yields lower and
encourage investors to take more risk for a higher
yield/return. The liquidity bubble thus gives birth to a so
called reflation trade, which results in buying of riskier
assets such as equities, commodities, and emerging
market securities. The reflation trade has shown most
brightly on equities so far. Commodities, such as oil, gold
and copper, have actually suffered in recent weeks. Their
lack of performance can be attributable to specific
factors, including a strong dollar (oil and gold), excess
supply (copper), lack of physical demand (gold), global
growth concerns (oil and copper), competitive product
displacement (gas for oil), and lack of yield (all three).
Regarding yield, it is interesting to note that dividend
return is a very significant variable in the long-term total
return from equities. More recently, high dividend stocks
have outperformed the general market. This may simply
be due to the dividend return phenomenon or to
concerns regarding the growth outlook.
BubbleVicious Markets
So, how and when does this bubble turn vicious and go
splat in our faces? We see this as a longer-term risk, and
one that would be precipitated by either: (1) the liquidity
bubble contracting causing markets to normalize; and/or
(2) onset of an inflation spiral as liquidity impacts incomes
and demand. So, what are other, shorter-term risks? There
are four key risks in our opinion: (1) US sequestration; (2)
China’s economic transition; (3) the euro zone’s economic,
financial and political challenges; and (4) social unrest.
Sequestration became effective March 1, 2013, and
mandates automatic, across-the-board spending cuts for
federally funded programs totaling $1.2 trillion over 9
years (2013-2021). Mandated sequestration was the
“Draconian” alternative Congress thrust upon itself in the
absence of a budget deal. The amount of drag on the
economy in calendar year 2013 will be about $109 billion
or 1.3% of real GDP from an authorization standpoint (See
chart). Actual spending cuts are likely to be closer to $70
billion or 0.8% of real GDP. Excluding the sequestration
drag on growth, we estimate real GDP in a range of 0% -2.0% this year. So the cushion to avoid recession is rather
thin. The impact will be gradual as furloughs require 30
days notice and contract changes 60 days notice. Nonfarm
payroll growth could be reduced by 80,000 per month on
average starting in the spring. On balance, we believe
recession will be avoided, primarily reflecting gains in
nonresidential investment, housing and manufacturing
and a benign inflation environment.
China is gradually transitioning from an export/
infrastructure investment economy to a more consumer/
services-led economy. This is occurring while some key
export markets are contracting. China recently reported
first quarter GDP growth of 7.7% versus a consensus
estimate of 8.0%. The downside surprise rattled equity and
commodities markets. GDP growth below 7% is generally
considered a “hard landing” and not good for global
growth prospects. Our view of GDP prospects is based on
China’s Purchasing Managers Index (PMI) – Manufacturing,
export/import trends, and a proprietary Alternative GDP
Model (see chart). Bottom line, we continue to believe that
China will avoid a hard landing with growth in a 7.5%-8.0%
range. Export growth moderated in March, but imports
remained firm, suggesting manufacturing activity will be
moderate in coming months. The most optimistic indicator
is our Alternative GDP Model, which estimates growth
based on energy production, residential floor space and
iron ore prices. Due largely to outsized gains in residential
floor space, GDP growth could be at the upper end of our
range or higher.
Most countries are confronted with economic, financial
and political challenges; however, in the euro zone these
are supersized. In the absence of growth drivers and with
a hefty dose of austerity, consensus growth forecasts have
been moving toward our -1.0% to
-1.5% estimated range. While
ECB President Draghi’s pledge to
“do what it takes” and Outright
Monetary Purchases (OMT) have
quieted financial markets, Cyprus’
bank debacle indicates that
problems remain. Political differ-ences are exemplified by Italy’s
fractious parliament, which has yet
to elect a head of state.
Social unrest is the wild card that
can happen almost anywhere and
at anytime. The catalysts can vary between rising aspirations in developing economies (think
China) to falling expectations in developed economies
(think peripheral euro zone countries).
Capital Markets - Bubbling Up
In early January, we revised our 2013 equity market
expectation considerably higher, with an upside target of
1,645 for the S&P 500 Index. The revision was based
mainly on the liquidity bubble and the dividend return
variable. The S&P cleared the 2007 high of 1,565 and
reached a closing high of 1,593 on April 11, which is 3%
from our target. Given the aforementioned risks, the ride
will no doubt be bumpy. The market should find support
in the 1,500-1,540 range. In the short run, bond yields
could remain suppressed by the weight of the liquidity
bubble and tame inflation expectations. From a total
return perspective, however, equities are likely to
outperform bonds. While there have been no signs of a
“great rotation” out of bonds into equities yet, it is
apparent that investors are moving out of both cash and
select commodities and into equities and bonds.
Alan D Segars
Chief Investment Officer
Beacon Trust Company
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