Fed downgrades view of US economy, markets fall

The Federal Reserve downgraded its view of the US labour market and economy on Wednesday after a report earlier in the day showed that the economy grew at an annual rate of just 0.2 percent in the first quarter, suggesting that the central bank may have to wait until at least the third quarter to begin raising interest rates.

Bloomberg reports that crowded trades were hit on Wednesday.

The year’s most-popular market bets got hammered on Wednesday, showing just how risky it is to follow the crowd.

The dollar, which has rallied more than 15 percent during the past 12 months, extended its longest losing streak since August 2013. The euro, which has lost about 19 percent in the period, soared. Oil gained, European stocks tanked, and U.S. Treasures slumped without any obvious reason.

Another Bloomberg report said that 55 billion euros were wiped off the value of eurozone government bonds on Wednesday.

The first Bloomberg report added:

This may give a glimmer of how painful it’ll be for all those investors who piled into now-crowded trades to all pile out when there’s a real catalyst.

Stocks hit records despite absence of funds inflows

Stocks have been having a good run again recently.

The Standard & Poor's 500 rose 1.8 percent last week to close at a new high. The Nasdaq Composite jumped 3.3 percent to wipe out its losses since the dot-com bubble and hit a record high.

Riskier stocks have also done well. Small stocks have significantly outperformed the S&P 500, as have emerging market stocks.

However, strategists at Bank of America Merrill Lynch sounded a note of caution last week.

They said in a note on Thursday that even as US stock markets have been making record highs, investors have been pulling money out of US stock funds.

“Correction risks will grow in [the] absence of fresh inflows in coming weeks,” wrote the strategists.

Bonds overvalued but remain in demand

CNBC reported that bonds are not well-liked by fund managers.

A survey by Bank of America-Merrill Lynch found that a net 54 percent of fund managers remain underweight in bonds in April. A net 84 percent said bonds are overvalued, the highest in the survey's history.

And yet, demand for bonds is expected to remain firm. JPMorgan has estimated that demand is likely to outstrip supply globally by around $450 billion this year on a notional basis, widening from $384 billion last year, with retail investors expected to be major contributors.

Richard Jerram, chief economist at Bank of Singapore, said that "there is still globally a search for yield taking place".

In addition, JPMorgan noted that equities have rallied even more than bonds in recent years, leaving retail investors "more overweight equities vs. bonds even as they bought more bond than equity funds over the same period".

Should governments borrow more?

Brad DeLong of the University of California at Berkeley suggested at the International Monetary Fund’s “Rethinking Macro” conference last week that rich countries should borrow more.

From the WSJ blog:

The interest rate that rich countries with super-safe debt ... pay is astonishingly low... In the U.S., the Treasury yield has gone from roughly equal to growth in nominal GDP in 2005 to 3 percentage points lower today.

By Mr. DeLong’s reckoning, this means those countries are borrowing too little... Mr. DeLong asks, “Isn’t the point of the market economy to make things that are valuable?” Since the debt of rich countries is “very cheap to make… shouldn’t we be making more of it?”

However, DeLong's suggestion could be problematic if future GDP growth turns out lower than currently projected.

Paulo Mauro, formerly of the IMF and now at the Peterson Institute for International Economics, raised this issue in a blog post.

For example, a country projecting a stable government debt ratio of 100 percent of GDP over the next decade or two would experience an increase in that ratio to 140 percent in 10 years if growth turns out to be 1 percentage point lower than assumed. As deficits rise, the ratio would balloon to more than 200 percent after 20 years.

In this regard, it is probably useful to remember that apart from the US, many of the economies with very low interest rates, for examples Japan and Germany, are rapidly ageing societies, and thus have little capacity for rapid economic growth. Japan in particular has already spent much of the past few decades in virtual stagnation.

Yen resilience unlikely to last

Sober Look noted that despite the large quantitative easing being implemented by the Bank of Japan, the yen has remained steady against the US dollar so far in 2015 and has even risen against a trade-weighted yen index.

Part of the reason for this is that recent US economic data have been weaker than expected.

Indeed, Bloomberg noted that its economic surprise index for the US has fallen to the lowest level since the financial crisis.

Nevertheless, Sober Look thinks that the yen is unlikely to maintain its resilience for long.

In the long run however, further yen weakness seems inevitable. The reason has to do with the sheer relative size of Japan's quantitative easing... Furthermore, given the scope and size of this program, it is unclear if the Bank of Japan can ever effectively exit it without a massive disruption to the nation's economy...

Many tech stocks look like value stocks

Bloomberg reports today that the rally in technology stocks this year has extended the Nasdaq 100's gains since 2009 to 317 percent and brought it within 8 percent of its record high set in 2000.

In addition, it has pushed the price-earnings multiple for the Nasdaq 100 to 22.9, above the average valuation of 19.2 over the last five years but below the mean level of 23.5 since the start of 2005. The index is also trading at 2.9 times annual sales compared with 2.5 over the last decade.

Among the well-known tech stocks, Microsoft is trading at a multiple of 15.8 times earnings, near the average since 2005, but Facebook and Regeneron Pharmaceuticals Inc. are trading above 70. Still, Facebook is much cheaper than it has been over the last three years, when the price-earnings ratio averaged more than 300.

Google Inc. trades at 26.3 time earnings, close to the Nasdaq 100 multiple but down from a 10-year average of 34.8.

Indeed, Bloomberg notes that when compared to the height of the tech bubble in 2000, tech stocks are now much cheaper.

Declines in the biggest U.S. tech stocks and expansion in their profits have done much to close the valuation gap from 2000. How overvalued where they then? Based on prices at the Nasdaq peak and analyst forecasts for 2015, Microsoft was trading at a 15-year forward price-earnings ratio of 72, Cisco Systems Inc. at 41, Intel at 49 and Oracle Corp. at 45.

“I wouldn’t call technology stock valuations stretched,” Jason Benowitz, a New York-based senior portfolio manager who helps oversee $4.5 billion at Roosevelt Investment Group Inc., said by phone. “Many tech companies are considered value stocks.”

Chinese economy slows

China’s economy is slowing.

Data on Wednesday showed that China’s real gross domestic product rose 7 percent in the first quarter from a year earlier, the weakest pace since the last quarter of 2009.

The slowdown extended right into the end of the quarter. Industrial production rose 5.6 percent in March from a year earlier, the smallest increase since November 2008.

My previous post notwithstanding, the latest data adds to concerns that China's stock market is getting overextended.

Just as well then that it has just become easier for investors to bet against Chinese stocks.

Futures on the small-cap CSI 500 Index started trading on Thursday. This comes five years after China introduced futures on the large-cap CSI 300 Index.

Chinese stocks rebounded on Thursday. The Shanghai Composite Index jumped 2.7 percent to a seven-year high after having fallen 1.2 percent on Wednesday.

Is China's stock market in a bubble?

Many analysts think that China's stock market is in a bubble. For example, Ron Insana at CNBC wrote:

Everyone, these days, is looking for a bubble here in the U.S. But it may be more wise to look overseas — to China.

Whether it's Shanghai, Shenzhen, or Hong Kong, Chinese stocks are shooting up like bottle rockets, lifted, in large part, by individual investors. Not to condescend to "mom and pop" anywhere in the world, but they are often the last ones to arrive at a party, and the first to be carried out the door.

See also my earlier post on the surging margin debt and the impact of high-school dropouts on the Chinese stock market.

However, the Economist blog is not so sure the surge in Chinese stocks is a bubble.

... Valuations for smaller companies are increasingly irrational but the market as a whole is less frothy. The Shanghai index, which includes China’s biggest companies from banks to oil majors, is trading at a forward PE of about 15, in line with its ten-year average. From this perspective, the rally looks more like a “mean-reversion trade” than something wildly unsustainable, says Francis Cheung of CLSA, a broker...

And Jonathan Shapiro at the Sydney Morning Herald cited London-based macro-consultant James Aitken's interview with The Australian Financial Review in saying that a "put" had effectively been placed under the market by Chinese policymakers who were keen to inject liquidity into the system to help it transition through a weak patch.

For now it seems momentum, the weight of money, the will of policymakers is behind China's sharemarket rally. And if it keeps going, it's a matter of time that more international funds feel compelled to enter the hottest stock market around.

Will S&P 500 earnings really decline?

Analysts expect S&P 500 earnings to decline 5 percent in the first quarter compared to the same quarter last year.

Brian Belski, chief investment strategist at BMO Capital Markets, thinks the forecast is "bunk". He told CNBC that US companies are under-promising earnings so that they can over-deliver.

On the whole, Belski is bullish on stocks, thinking that we are six years into a 20-year bull market.

In contrast, Ashwani Kaul, CEO of Kaul Advisory Group, sees S&P 500 earnings falling 4.6 percent. The silver lining, however, is that earnings are expected to grow 5 percent excluding energy and materials and that overall earnings should turn back up after one or two quarters.

In any case, a period of earnings declines can still turn out to be positive for stocks.

Does Fed tightening hurt stocks?

With the Federal Reserve expected by many analysts to tighten monetary policy some time this year, investors have become concerned about the stock market as tighter monetary conditions are considered bad for stocks.

However, John Buckingham at The Prudent Speculator thinks that there is little reason for concern, at least at the start of monetary tightening.

Based on S&P 500 data since 1945, Buckingham showed that in the six months before the start of tightening, the S&P 500 rose an average 9.8 percent. In the six months after the start of tightening, the S&P 500 on average still rose, albeit by a smaller 6.7 percent.

So, based on historical data, Fed tightening, by itself, does not necessarily hurt stocks much.

Decline in earnings may be positive for stocks

An earnings recession may actually be bullish for stocks.

This is according to an article by Mark Hulbert at MarketWatch.

According to Hulbert, analysts’ consensus estimate for US first-quarter corporate earnings are for them to decline by 4.6 percent from a year earlier. Second-quarter earning are expected to decline 1.9 percent from a year earlier.

However, Hulbert says that, based on data from Ned Davis Research, over the last eight decades, the S&P 500 has performed best during quarters in which quarterly earnings are between 20 percent lower and 5 percent higher than they were a year earlier.

In fact, S&P 500 returns tend to be greater when earnings are weaker.

The exception to this pattern is when the year-over-year decline in earnings is 20 percent or more, which tend to produce the worst S&P 500 performances.

Ageing South Korea and Japan have trouble boosting consumption

Bloomberg reports today that South Korea cannot get the elderly to spend their savings.

South Koreans are getting older and spending less, making it more difficult for the central bank to stoke spending and price gains to keep the nation's tiger economy powering along...

"Changes in South Korea's demographics are the key reason why rate cuts aren't boosting consumption,'' said Kim Seong Tae, a Sejong-based research fellow for Korea Development Institute. "If you think you're going to live longer and are unsure of what's going to happen in the future, there's little incentive to spend more and save less, despite the low rates."

In my opinion, the issue should not be how to get Koreans to spend more but whether they should be spending more in the first place, considering the need to accumulate savings before their retirement.

Monetary stimulus properly has little role to play in an economic slowdown that is driven by ageing demographics, as Japan is finding out. From CNBC:

Rising prices are forcing Japanese pensioners to reduce spending, undercutting Prime Minister Shinzo Abe's plan to boost economic growth and pay down the hefty public debt burden in one of the world's fastest aging nations.

"There is no solution to the structural problem: the government is running a huge budget deficit, but the only way to coax the elderly into spending more is by increasing public spending on them," said Dai-ichi Life Research Institute (DLRI) chief economist Hideo Kumano...

"The average Japanese is suffering because of a weaker yen," said Keio Business School associate professor Seki Obata, but "pensioners are suffering the most from the rising prices because there is no prospects of their incomes rising."

Indeed, Japan is already drawing down its savings. From the New York Times:

The country’s savings rate, long one of the highest in the world, is now below zero. In short, Japan’s citizens are spending more than they earn...

The national household savings rate slipped to minus 1.3 percent in the last fiscal year, according to a government report issued in December. The situation adds an extra layer of complexity to the task facing Mr. Abe...

Naohiko Baba, the chief Japan economist at Goldman Sachs, worries what will happen if both households and companies turn their backs on saving. At the equivalent of two and a half years of economic output, Japan’s debt load is the heaviest in the world...

Mr. Baba calculates that Japan could run short of the savings it needs to fund the debt locally by about 2020. After that, it would need to turn to foreign investors — a potentially destabilizing shift.

“Once we have to rely on foreign investors to finance the debt,” he said, “that could be the beginning of a disaster for Japan.”

Slowing job growth shows impact of stronger dollar

US nonfarm payrolls rose by a disappointing 126,000 in March, the smallest monthly increase since December 2013. Bloomberg thinks that the slower employment growth is the result of the appreciation of the US dollar.

The March jobs report showed tell-tale signs that the factory sector is struggling and the broader economy is feeling the impact. Private sector job growth slowed to the weakest pace since December of 2013, as manufacturing employment fell into contraction. While some economists will be quick to attribute this to port disruptions and weather, it is the view of Bloomberg Economics that this is the broader impact from a stronger dollar hurting the export sector as well as domestic industry.

The report is likely to trigger a re-assessment of the timing of interest rate hikes. Indeed, after the employment report, the rate for fed funds futures for December fell four basis points to 0.34 percent on Friday. S&P 500 futures fell 1 percent.

Asian stock markets show signs of bubbles

Asian stock markets are showing signs of bubbles.

In China, Bloomberg reports that margin debt has surged.

The outstanding balance of margin debt on the Shanghai Stock Exchange surpassed the trillion-yuan mark for the first time on Wednesday, a nearly fourfold jump from just 12 months ago. The city’s benchmark index has surged 86 percent during that time, more than any of the world’s major stock gauges...

The outstanding balance of the margin debt on China’s smaller exchange in Shenzhen was 493.8 billion yuan on March 31. That puts the combined figure for China’s two main bourses at the equivalent of about $241 billion...

For BNP Paribas SA economist Richard Iley, the surge in Chinese margin purchases is among signs of a bubble fueled by individual investors...

“Leverage cannot rise forever,” Iley wrote in a report last month. “The more the stock of margin debt climbs, the greater the risk of a disorderly unwinding of leveraged positions once net redemptions begin to accelerate.”

Another Bloomberg report said that China’s stock market rally is being fueled by high-school dropouts.

New data from the China Household Finance Survey, a large-scale survey of household income and assets headed by Professor Li Gan of Southwestern University of Finance and Economics ... finds that the biggest new investors in China’s equity markets have below a high school education and relatively low levels of asset ownership.

Meanwhile, in Japan, Bloomberg reports that this year’s Japanese stock rally has a surprise leader: pharmaceutical companies.

Drugmakers soared 22 percent, the most among the 33 industry groups on the benchmark Topix index, compared with a 10 percent gain for the Topix itself. The Topix Pharmaceutical Index climbed to its highest on record on March 24, and earnings multiples are about twice the market average. The Topix has beaten pharmaceutical shares in 12 of the past 17 years it rose.

“Valuations are ridiculous, and foreign investors are scratching their heads,” said Richard Whittall, a fund manager at Alltus Capital (U.K.) in Singapore who’s watched Japanese stocks for 25 years.