Japan's 2Q Fiscal Stimulus Actually Increases the Odds of Recession

It is a widely accepted view that Japan's economy will contract in Q2 and today's data almost ensures that. This is due to the sequential fall in consumer spending as a result of demand being brought forward into Q1 to avoid higher consumption taxes. Indeed, data released today show that personal income and consumption expenditure in April fell by the most since the natural disaster in 2011 (1st chart).

The government, in a valiant effort to offset the decline in household consumption, has decided to bring forward 40% of the planned 2014 fiscal stimulus (about 1.1% of GDP in total) into Q2, which will boost GDP by about 44bps (1.76% annualized). Even still, this amount of fiscal stimulus will not be enough to avoid Q2 GDP from contracting as GDP is expected to fall by 2.5%. What it does instead is actually raise the probability that Q3 GDP also contracts due to the likely sequential slowing in government spending. If the Japanese government took a kitchen sink approach (and they likely would have been given a free pass because of the tax hike) they could have allowed Q2 GDP to fall sharply by postponing any fiscal stimulus until Q3, thereby increasing the odds of a strong sequential rebound in Q3. But this is not the tack they chose and so getting a technical recession (two sequential quarters of GDP decline) is a higher probability event.

In the second and third charts below we can see the Japanese fiscal stimulus at work as planned public construction spending in April rose by the largest YoY percent on record.

Checking In With The Citi Surprise Index - US Improving, Eurozone Deteriorating, China Still In The Basement

Economic data has generally been improving in the 2nd quarter according to the Citi Economic Surprise Index. There are, however, some notable exceptions.

The United States briefly broke above the zero line earlier this week before falling back a few points.


This has helped the Developed Market series to rebound to the highest levels in about three months.


However, the Eurozone and Asia-Pacific regions are still exhibiting weakness. In fact the Eurozone has been a steady decline since the end of January





The Emerging Markets are still stuck in negative territory (albeit with small bounce) while Latin America and CEEMEA (Central Europe, Eastern Europe, Middle East & Africa) have enjoyed an improving economic environment in 2014 in contrast to 2013.







China is certainly holding the Emerging Market index down. There has been some improvement but overall the Chinese economic statistics are still vastly underwhelming.

Information Contained In The Relative Performance of Utilities

We came across an interesting essay today highlighting the informational usefulness of moves in the utility sector.  The link to the entire report is here.


The authors argue that movements in the utility sector contain important information with respect to the broader stock market.  In the chart below, we have tried to capture the essence of the theme by comparing the relative performance of the S&P 500 Utility sector to the S&P 500 itself.  Over the last five years, there has been 89% correlation between the relative performance of the Utility sector and the S&P 500.



This relationship takes on added significance when we consider that the Utility sector has been the best performing sector in the MSCI World index year-to-date.

Gold and the Yield Curve Are Confirming Each Other

A few months ago in a post titled, "How Bullish is a Bull Flattener?" we took a look at how bull flattening of the yield curve (when the long end falls faster than the shorter end) has tended to impact various assets. We concluded that bull flattenings generally coincide with weakness in growth and inflation sensitive assets like commodities, EM stocks and gold and are usually positive for the USD.

Given the weakness we've seen in gold over the last few days (it has fallen almost $50 in recent days) we wanted to provide an update to our chart showing the spread between 30Y-10Y US Treasury Bonds and gold. It appears that the long end of the yield curve and gold are still joined at the hip, meaning that a continuation of the flattening would be bearish gold and a steepening would be bullish gold. It goes without saying that a downside breakdown of either one of these series would call into question the growth and inflation outlook in the US and elsewhere.

Four Simple Charts To Explain The Move In Bonds This Year

As an old friend used to say, "Price changes create their own news flow."  This is a good way to think about all the "stories" that have surfaced lately explaining the unexpected plunge in bond yields this year.

In our mind, there are four really simple charts that explain the movement in long bonds this year.  First, commercial traders--the so-called smart money--are holding a large long position in 10 year US Treasuries/ In the chart below, it is easy to see the huge shift in bond positioning by commercial traders in the last 18 months.  In the fall of 2012, they were short almost 200,000 contracts, and now they are long just over 250,000.

Second, the taper is still the elephant in the room.  In the chart below, we model the Fed's tapering scenario, looking at the three month rate of change in Fed total assets.  By March of 2015, if the Fed maintains its $10/meeting taper schedule, the three month accumulation in assets will total zero.  We plot 10 year US Treasury bonds alongside this taper temple to highlight not only the close relationship between rates and Fed asset purchases, but also to illustrate the glide-path to lower rates the taper template suggests.

Third, while expectations for the Fed to complete the taper remain on schedule, expectations surrounding the vigor of their expected rate raising campaign have softened.  The chart below compares the 10 year US Treasury bond to December 2016 Fed Funds futures.  In April, before the recent slide in rates began, expectations embedded in the Fed Funds futures suggested market expectations of 2% fed funds rates by the end of 2016.  The recent rally in this contract, from 98 to 98.5, now suggests that investors are expecting 1.5% fed funds rates at the end of 2016. 

Fourth, interest rates historically have a decent relationship with lumber prices.  The logic is easy: lumber is a proxy for the strength of housing; housing is proxy for the strength of the economy; so weakening lumber prices suggest a weakening economy and opens the door to lower rates.  For the last year, lumber and rates have been joined a the hip.  The breakdown in rates has occurred simultaneous to the breakdown in lumber.

Beating a Dead Horse on Weak Market Breadth

We admit that our weekly review of market breadth, in which we observe the continuing deterioration in all types of indicators that monitor the internal behavior of the world stock market, is becoming a bit repetitive. But as stock indices this week make new all-time highs we couldn't help but show, again, a cross section of charts indicating weakening internal dynamics of the stock market. As usual, our analysis covers the MSCI World Index, which represents 90% of the global investible market cap.

We'll start with the familiar chart showing the percent of stocks making new 200-day highs. Nearly every time the World Index has made a new cycle high since late 2013, fewer and fewer individual stocks have made a new 200-day high, with the current breakout being no exception.



Even though the World Index is sitting at an all-time high, the average stock is 8% away from it's 200-day high. Since the middle of 2013, each new high in the World Index has been met with the average stock trading further away from its 200-day high.



Our accumulation/distribution indicator has diverged from stocks since the end of last year.



A one year cumulative total of weekly advancing stocks minus weekly declining stocks has diverged from stocks since the end of last year.



Even though we are at new highs, our brute indicator that measures the percent of stocks with positive price momentum keeps heading lower.



The percent of companies that have outperformed the MSCI World Index over the last 200-days is still near a two year low.



The total number of negative outside reversal days over the last quarter (days in which both the intraday high is higher than the previous day's intraday high and the close is lower than the previous day's intraday low) is still elevated.



The number of weak market closes is on the rise and continues to diverge from stocks.

Pending Home Sales Can't Blame The Weather For The Latest Miss

Pending home sales rose by only 0.4% in April vs estimates of a 1% month-over-month gain. Pending home sales are down over 9% year-over-year. If you are living in the West or the Northeast than that decline looks great compared to fall they are experiencing in those regions. The West is down 15% year-over-year and the Northeast is down 12% year-over-year. The silver lining is that pending home sales is suggesting a gain over the coming months for existing home sales perhaps back to the 5 million annualized level. Perhaps if we continue to get a decline in bond yields like we did yesterday (the 10-year is down another 3 bps so far today) then lower mortgage rates will incentive more buyers back into the market.

Bond Yields Approaching 1-Year Lows

The US 10-year bond has dropped by 8 bps today and has slammed through what was looking like support around the 2.50% level. If it closes at current levels than this will be the lowest close since 6/20/13.





The 30-10 spread has widened by 7 bps during May, however, it is still down YTD. Same goes for 30-10 breakeven inflation spread. The front end of the yield curve (10-2 spread) has been narrowing all year as well and not just in the US.





A falling 10-year yield hasn't been the greatest sign for forward P/E ratios. However, since the end of 2011 this relationship has broken down somewhat.

A Deeper look at Corporate CapEx and Stock Buybacks

Yesterday we analyzed here aggregate capital spending on tangibles for non-financial constituent companies in the MSCI World Index (90% of global investible market cap). We found that CapEx as a % of sales has been extremely steady over the last nine years, fluctuating in a 0.9% range. In 2013 CapEx as a % of sales, at 7.9%, registered the second highest reading over the 9 year period.

Today we thought we'd follow up that quick analysis with a deeper look at corporate use of cash flow from a variety of angles (by region, cap size, with financials, ex financials). We find that no matter how we slice and dice the data we get the same result. The total USD amount of CapEx spending as a percent of either sales or operating cash flow is currently average to above average compared to the last 9 years.

Another point on stock buybacks is the following: yes, some companies have been buying back stock. However, this is primarily a US phenomenon and the allocation of operating cash flow to buying back stock (including for the US) is well below where it was at the end of the last cycle (perhaps not the best comparison, but it is what it is). It does appear that, to a large extent, share buybacks are being financed with debt issuance, but again, not to the same degree, in aggregate, as in 2006-2008. When we break down non-financial North American stocks into two groups (the vary largest 46 and the smallest 530), we find pretty clear evidence that the financing of stock buybacks with debt is concentrated in the smaller subset of companies. The largest 46 companies have bought back a cumulative $473bn in stock from 2011-2013 and issued a cumulative $100bn in new debt. The smallest 530 companies have bought back a cumulative $433bn in stock from 2011-2013 and issued a cumulative $454bn in new debt. Needless to say, we are sure there are more productive uses of cash flow than buying back one's stock, especially at the expense of one's balance sheet.

All companies in the MSCI World Index:

  

MSCI World ex financials:

 

MSCI North America:

 

North America ex financials:

 

MSCI Europe:

 

MSCI Europe ex financials:

 

MSCI Pacific:

MSCI Pacific ex financials:

  

Just the largest 200 companies in the MSCI World Index by market cap (50% of the MSCI World Index):

 

Smallest 1411 companies in the MSCI World Index:

MSCI North America largest 46 companies ex financials:

MSCI North America smallest 530 companies ex financials:

Where Art Thou Volatility?

Over the past 31 days, volatility in the MSCI World, as measured by the standard deviation of the daily percent change in the index, has fallen to levels last seen in November 2006. The 252-day moving average (one year's worth of trading days) has fallen to levels last seen in August 2007. It goes without saying that this market is about as dull as it gets.



The story holds when we look at the regional indices as well. The 252-day moving average for the MSCI North America is at similar levels last seen from 2004-2007. Volatility in Europe as has fallen quite dramatically over the past two years and in Asia-Paciic while volatility is at a higher level on an absolute basis, it has fallen there as well.