Recap 2014-09-11: US yields, Buffet on Stock Market Valuation vs Bonds

Commentary:

US 5y yields have been in a rising triangle formation since mid 2013. Yesterday’s close was the highest since the one print a year ago, and today’s close seem destined to settle about multi-month resistance:

Most of the move has been driven by real yields – inflation breakevens have actually fallen 30bps from the June highs. The currency market has actually moved ahead of the rates market – the Dollar index notched up is fastest gain from early July to now since last summer, although how much of that was due to the ECB and oil prices is up for debate.

The charts certainly suggest an imminent breakout, but does the move in yields make fundamental sense? The data suggests yes, but perhaps it is a bit early. Economic surprises (white below) are at the strongest levels since early 2012, which is supportive. But a breakdown of the components shows that the strongest contributors are the survey components rather in the hard data. While the surveys are historically strong leading indicators for the data, the Fed has historically wanted to see the strength reflected in the hard data before moving.

And that segues to the crux of the issue – market expectations for the FOMC next Wed. Many participants have noted the possibility that the Fed removes the ‘considerable period’ language in the statement. Given that Yellen let slip in her first press conference as chair that ‘considerable period’ means around 6 months, such a change without further qualifiers would cause the market to price in a strong possibility of a hike by March of next year. But the price action suggests that despite the chatter, markets are actually fairly sanguine about such a shift, as the April 2015 Fed Funds future shows: (FOMC meets on 3/18/15 and 4/29/15) This suggest the possibility of an interesting, asymmetric bet.

Buffet on Market Valuation, via the Brooklyn Investor: (and why Buffet probably thinks that equity valuations should be notably higher than the historical average)

From the 1981 Berkshire Hathaway letter:

  • The economic case justifying equity investment is that, in aggregate, additional earnings above passive investment returns – interest on fixed-income securities – will be derived through the employment of managerial and entrepreneurial skills in conjunction with that equity capital.
  • Several decades back, a return on equity of as little as 10% enabled a corporation to be classified as a "good" business – i.e., one in which a dollar reinvested in the business logically could be expected to be valued by the market at more than one hundred cents. For, with long-term taxable bonds yielding 5% and long-term tax-exempt bonds 3%, a business operation that could utilize equity capital at 10% clearly was worth some premium to investors over the equity capital employed… Investment markets recognized this truth. During that earlier period, American business earned an average of 11% or so on equity capital employed and stocks, in aggregate, sold at valuations far above that equity capital (book value), averaging over 150 cents on the dollar.
  • That day is gone. But the lessons learned during its existence are difficult to discard. While investors and managers must place their feet in the future, their memories and nervous systems often remain plugged into the past. It is much easier for investors to utilize historic p/e ratios or for managers to utilize historic business valuation yardsticks than it is for either group to rethink their premises daily. When change is slow, constant rethinking is actually undesirable; it achieves little and slows response time. But when change is great, yesterday’s assumptions can be retained only at great cost. And the pace of economic change has become breathtaking.

Notable:

  • RBNZ kept policy rates unchanged but used aggressive language on the exchange rate:
  1. The exchange rate has yet to adjust materially to the lower commodity prices. Its current level remains unjustified and unsustainable. We expect a further significant depreciation, which should be reinforced as monetary policy in the US begins to normalise.
  2. In light of these uncertainties, and in order to better assess the moderating effects of the recent policy tightening and export price reductions, it is prudent to undertake a period of monitoring and assessment before considering further policy adjustment. Nevertheless, we expect some further policy tightening will be necessary to keep future average inflation near the 2 percent target

AU Employment jumped to +121k vs +15k expected, at 36 year high, driven by part time employment. This is obviously something of an outlier, but even after revisions, the results are likely to be stronger than consensus expectations.

France CPI declined to 0.5% YoY as exp vs 0.6% prev

US Jobless Claims rose to 315k vs 300k exp and 304k prev

China August CPI printed +2% y/y versus +2.2% expected, a four month low. PPI -1.2% y/y versus -1.1% expected. Vegetable and oil prices were some of the drivers.

Upcoming:

  • Thu: NZ PMI
  • Fri: Kuroda Speaks, US Retail Sales, U Michigan Confidence
  • Mon: China Retail Sales, IP, US Empire Manufacturing,
  • Tue: UK CPI, PPI, German ZEW, US PPI
  • Wed: BoE Minutes, UK Employment, US CPI, NAHB Housing Index, FOMC, NZ GDP
  • Thu: UK Retail Sales, US Jobless Claims, Housing Starts, Philly Fed
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4 thoughts on “Recap 2014-09-11: US yields, Buffet on Stock Market Valuation vs Bonds

  1. Hi GMT, thanks for this excellent post.
    1/ On the Fed I definitely agree with you. As I wrote before Jackson Hole, I think Yellen wants to inject uncertainty and risk premium into the yield curve. Despite all the uncertainty in her “if, maybe” speech, the market didn’t copy (except Robin Harding and Ian Sheperdson I must say). And finally last monday things starting to move when there were 4 articles saying that i/ after all the fall in labor participation was mostly structural, ii/ the market is consistently under estimating Fed’s projection, iii/ Tobias writing that QE for too long is threat to financial stability, and iv/ FT and WSJ together saying that the language will change. But as you say, I guess we have not seen the fullness of the move, given the excellent US data. I wouldn’t be surprised to see 10Y back at 3% for a start.
    2/ On Buffet, it makes me think of a Mc Culley piece recently (june?), saying that the last leg of the equity rally will happen once the Fed recognises that the potential rate of growth is now structurally lower, (see my point i/ above, they are apparently going there, contrary to what stan fisher suggested earlier), which in essence means that the 10Y now has to be strucutrally lower in the long term to discount equity valuations – in other words that the final neutral FF rate will be much lower than previously thought.
    3/ To finish a technical feedback. I can’t see your graphs too well, they are blurred. Wondering if you have changed the way / format you save them?
    Thanks for all your interesting food for thought…

  2. Hey macrottt, thanks for your comments!
    On your first point, I think the ECB may have had a role to play as well. I’m not sure about 3% 10’s though. Maybe late this cycle. But you’re certainly right that lots of articles have been pushing in the same direction recently.
    On your second point, I didn’t see that McCulley piece, but I’ll have to look for it. Arguably, the Fed is already starting to get it. Long term ‘neutral rate’ estimates in the SEP has fallen significantly since they were first published. In any case, I think most will agree that the equity risk premium remains massive

    I’m sorry to hear that you can’t see the graphs well – can you tell me a bit more about it? Which graphs and which browser are you using?

    Cheers

  3. 1/ Yes you’re right, I hadn’t thought about that… the ECB’s easing is also to be taken in account. As RBI’s Rajan said last week, the ECB stance is going to compensate a bit the Fed’s stance in terms of Global liquidity conditions and EM risks. I guess that stan fisher has emphasized those risks heavily at the Fed.

    2/ Here is the article… http://www.pimco.com/EN/Insights/Pages/Just-Give-Me-a-Framework.aspx
    Long and tough to read because it is full of macro theory reference as often with mc culley, but well worth it. Here the key conclusion “Thus, I don’t see current valuations for either bonds or stocks as “artificial.” They are not cheap, to be sure, because they have been discounting a lower equilibrium fed funds rate for quite some time. And, yes, there are some elements of froth in both markets, particularly in specific sectors. But on the whole, I have no problem with prevailing macro valuations of either asset class.
    And I think they could get richer still, especially for stocks, in the run-up to the day when the FOMC takes an “official” sharp whack to that 4% dot, which I expect will happen before the first policy rate hike. Ironically, that would probably be a good time to take tactical chips off the equity table, before the Taper Tantrum is reincarnated into the Hike Heebies. But I digress.”… It is the whole debate of output gap etc…

    3/ On graphs/images, I am using google chrome, on your FFJ5 chart for instance I can see the graph overall, but the definitin is pretty poor, for instance I can read the 99.8050 spot level in yellow but can’t read the text in the pink and blue box (right of the chart). Not sure what it is due to… The definition maybe. Anyway I can see enought of the chart so dont worry.

    Txs

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