We got more evidence last week that the economy is recovering from its winter hibernation. We also got evidence that it is doing no such thing. The good news came from the establishment survey on jobs Friday that showed a gain of 288,000 new jobs and upward revisions to previous months. The bad news came from the household survey which showed a whopping 806,000 people dropped out of the workforce, pushing the unemployment rate down to 6.3% for all the wrong reasons. It also showed no change in the workweek or weekly earnings. So which one should we believe?
The initial market reaction confirmed the establishment survey view of the world. Stocks and the US dollar rallied while bonds, especially ones of longer maturities, sold off. That is exactly what one would expect if expectations for future growth are rising. Unfortunately, the initial reaction proved only fleeting and by the end of the day stocks and the dollar were lower and long term bonds had resumed their previous trend (higher prices, lower yields). The movements in gold were similar with a sell off in the morning followed by a rally the rest of the day. None of those are signs of increased optimism.
Of course, one day of market action tells you exactly nothing and the most frequently offered explanation for Friday’s reversal was fear of weekend happenings in Ukraine so maybe it had nothing to do with the US economy. And the Dow Jones Industrial Average did manage to make a new high in the middle of last week so at least one market is still on the polar vortex recovery bandwagon. The rest of the markets are singing from a different hymnal though and contradictions abound right now. The long end of the bond market, confounding the consensus, has been rallying since the turn of the new year even as the Fed has reduced its purchases. Meanwhile, shorter maturities haven’t fared as well with the yield on the 5 year Treasury barely lower than the beginning of the year. In other words, the yield curve has flattened as the short end anticipates Fed tightening while the long end reckons the long term consequences for growth and inflation will not be good.
The US dollar index and the gold market are also acting as if future growth will be nothing to write home about. The dollar index is down on the year and on the verge of breaking support that has held since early 2012. Gold has seen a renewed bid this year and despite a correction in March is up about 8%. Technically, it appears to be setting up for another leg higher. In contrast to the weak growth expectations shown in the dollar and gold markets, the general commodity indexes are also moving higher, something one would not expect if growth is about to falter. On the other hand (how many hands does he have?) most of the gains in commodities this year have been in the agriculture sector and has more to do with supply/demand factors than economic growth. Also confounding is the rally in emerging market stocks since their bottom in February despite continued concern about China’s economic well being. That move seems to be confirmed though by the higher Aussie dollar and other commodity currencies although it is hard to figure how China can prosper right now if US and European growth remains weak.
As for actual US economic growth we did get an initial report on the 1st quarter last week and it wasn’t a pretty sight. GDP was up all of 0.1% in the quarter and while weather may have had an impact it is hard to say that is all that is going on with the US economy right now. Exports and imports were both down and investment also subtracted from growth. Residential investment detracted from growth for the second straight quarter and equipment and software added to the negative tone this quarter. That is not a trend that can persist long if the economy is to avoid recession. It is always investment that leads us into and out of recessions and real estate is often the canary in the coal mine. And the housing market looks increasingly like it is peaking for this cycle. Sales are down and inventories higher in most of the previously hot markets while construction spending growth has stalled. As for capital spending, companies still seem more interested in stock buybacks than equipment and software.
Another contradiction in markets right now – maybe the biggest of all – is the strength of the Euro and the peripheral bond markets. Even after defaulting a couple of years ago (I know, I know; technically it wasn’t a default) the Greek government is able to borrow at 6%. Italy with a debt to GDP figure well over 100% can borrow for ten years at 3%. That’s barely above the yield on the US 10 year and while we may not be a paragon of virtue when it comes to budgets, we do still have the ability to print all the dollars we need to pay off our bonds, something Italy gave up when it joined the Euro. I have said for some time that the Euro crisis would eventually prove to be a positive for these countries as they are forced into structural changes they wouldn’t attempt if they could just devalue their currencies. But those changes are not happening fast enough to justify bond yields at these levels. The contradiction between current bond prices and the prospects of getting paid back in full is extreme.
The Euro itself has been stronger than anyone – least of all Mario Draghi – expected. That is hard to square with the growth prospects on the continent outside – maybe – Germany. I think it is the shifting of global monetary policy that is the moving force in a lot of these markets. All the trades associated with US QE seem to be unwinding with the notable exception of large cap US stocks. As the dollar has weakened capital appears to be flowing back to emerging markets. That is being reinforced by the perception that the monetary tightening cycle in those countries is coming to an end as their currencies firm. The momentum stocks of the NASDAQ and the Russell 2000 have been hit hard this year although neither index has even hit the mandated 10% down that qualifies as a correction. The mortgage market has been throttled and some high profile IPOs have been postponed. And finally, as growth expectations generated by QE continue to be frustrated and the Fed stays the tapering course, bonds are rallying.
What conclusions can we draw from all these seemingly contradictory markets? The bond market, the dollar and gold are all saying that US growth prospects are worsening as QE winds down. The rise in commodities and emerging markets would seem to indicate that investors believe those markets can grow even as the US falters. I think that probably depends on the depth of any US slowdown but that appears to be the early line. As for Europe the most likely explanation is that those who rode the American QE bull believe they’ll be able to do the same in Europe. That assumes that Draghi succumbs to the lure of QE, something about which I’m far from convinced. He has accomplished more than the Fed by merely threatening to do something and I suspect he’ll keep doing that as long as it works.
Markets often give contradictory signals at turning points as investors probe markets and try to find the next asset to produce returns. Some of these nascent trends will prove durable and others will prove to be nothing more than noise. Can commodity markets continue to rally if US growth sags and the dollar falls? Will the Euro keep rallying despite Draghi’s desires to the contrary? Will the ECB finally do something other than talk? Will emerging markets be able to grow if the US economy is weak? Can China overcome its problems without US and European growth accelerating? Which market is right? US large cap stocks or long term Treasuries? We’ll find the answers to these questions in the coming months and I suspect investors in US stocks may not like the answers. Given a choice of trusting the Fed’s economic forecasting skills or the markets, I’ll take the markets every time.
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