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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