And look at how earnings season is now turning out. The good stuff got out of the way at the beginning — the industrials benefitted the most from the rebound in manufacturing, which seems to have peaked out early in the second quarter. The mini-inventory cycle that played a key role in the profits recovery, not to mention critical changes to how the banks could account for loan losses, looks to be over. But it did have an impact. Now we are getting the earnings of companies who rely on domestic demand, like the retailers, and let’s face it, things don’t look too good.
Secular growth dynamics in the B.R.I.C. countries — though India and China have recently put up some pretty soft numbers — were obviously not enough to prevent Cisco from missing and from guiding lower to boot. Ditto for J.C. Penney; the company just trimmed its 2010 earnings. Macy’s and Kohl’s expressed a good dose of caution over the outlook for consumer spending as we head into the back-to-school and then holiday shopping season. Others in the consumer space such as Coach, Kellogg, P&G and Unilever have all either issued disappointing results and/or guidance as well. Against this background, we are concerned over the amount of discounting that lies ahead seeing as how imports of consumer goods have been bulging in the past three months and is a key reason why the trade deficit has ballooned — see Shipping Surges at Ports in Los Angeles Area on page B6 of the weekend WSJ. The port activity in July was led by a “surge in Asian imports” (total inbound traffic was +21% YoY in L.A. was the highest growth rate since August 2008, and +33% in Long Beach was the best since October 2008 — and we know how that timing turned out to be).
Indeed, the markets are beginning to sniff something out and the smell isn’t so good. The equity market was so oversold going into last Friday’s action that a technical rally should have been baked in the cake. The fact that the major averages faltered in such a deeply oversold market is not good news for the bulls. The bond market is really telling the tale as the long Treasury has generated a total return of 17% so far this year while the S&P 500 has triggered a loss of 2%. In fact, the 10-year note yield closed the week at a new low of 2.67% — the lowest since March 20, 2009 when the stock market was still struggling around the 12-year lows at the time. The long bond yield is all the way down to 3.86%, the lowest it has been since April 27, 2009. The big bull flattener in bonds seems to be starting. No doubt there is always the risk of some countertrend reversal in yield activity after the monumental rally we have seen in the bond market, but the charts don’t lie and the case they present is one of a major downward trend in interest rates right out the curve.
Bonds do not generally outperform equities to such an extent without a pronounced slowing in economic activity or a recession coming down the pike. This was not well advertised but the yield on the 5-year TIPS swung into negative terrain last Wednesday (-2bps) in a clear sign that the bond market is pricing in a recession. Imagine where yields go to when deflation gets more appropriately discounted.
So far this meltdown in yields is only a “real economy” event, not a “price stability” or deflation event. The last time the yield on the 5-year TIPS was this low was back on March 10, 2008 when, amazingly, everyone was debating whether the economy was in a hard landing or a soft patch, and whether the near-20% selloff in the equity market at the time was a bear market or merely a correction. Well, history doesn’t lie and we all know that in the ensuing year — the year after the TIPS yield touched zero — the equity market was down 40%. Suffice it to say that few saw that coming, and by and large, the folks that didn’t see it coming are the same ones telling investors to hang onto their overweight equity positions today. Someone should really call the police.
It is only a commentary on the human condition and the innate need to be optimistic that the vast majority of economists, analysts, strategists and market commentators still seem to be acting like ostriches with their heads in the sand. Even the venerable Economist concludes that “on the current evidence don't expect America's recovery to grind to a halt” on page 12. Well, from our lens, there is fairly substantial evidence that the growth was cut at least in half in Q2 and there is negative momentum in real retail sales being “built” into the current quarter. But we have a fiduciary responsibility to our client base to be realistic at all moments of time, not optimistic, and if we are pessimistic then we can actually deploy strategies that will generate profitable results — certainly better than 0% yielding cash — via hedge funds that truly hedge, reliance in hybrid funds that carry a near-5% yield with low beta characteristics as well as classic credit strategies that take advantage of our bullish view regarding corporate balance sheets and default risks even as we lament what a recession does to the income statement — and hence to equity market valuation, which we intend to move back into at some point and at much better pricing points.
You may register free to read this complete letter at Gluskin Sheff.
Copyright (c) Gluskin Sheff
Comments are closed.