There was a lot of action last week in markets, which is exactly what we expected.
But the most important and unexpected development last week could have the most significant ramifications. But before we get into that, lets discuss a couple of the other highlights from last week.
From a US perspective, the most important events last week were both the Fed minutes from the latest meeting and the first look at Q3 GDP.
The Fed minutes didn’t really surprise as most market participants had anticipated that the Fed would follow through and end QE3 officially and that the commentary would lean more hawkish than in the past. Both of these expectations were met.
The Fed ended QE3 citing solid job gains with lower unemployment, the fact that the underutilization of labor resources is gradually diminishing and the fact that the risk of below-target inflation has diminished somewhat since their last meeting. Some people were surprised that the Fed went through with ending QE3 at this particular meeting simply because of the recent volatility in markets. But for the moment, QE is dead and investors are expecting the first rate hike to occur in mid-2015.
The first iteration of Q3 GDP was released on Thursday and showed a 3.5% quarter-over-quarter growth rate and a 2.3% year-over-year gain. US equities and the US dollar all reacted positively to the news, rising 64 and 26 bps respectively.
Interestingly, US yields fell on the news, after gaining almost 2% the day before in reaction to the ending of QE. There are several reasons why US yields, used as a indicator of future US growth, fell in response to Q3 GDP and several other US data points that day.
Regular readers of TWR know exactly where I’m headed -- the margin.
First and foremost, let’s look at what’s occurring at the margin. The quarter of quarter growth rate of 3.5% was a decline from Q2’s 4.6% q-o-q growth rate. Q3’s year over year rate of 2.3% fell from the previous quarter’s 2.6%.
The US grew at a slower rate over both timeframes during Q3, which, at the margin, is a negative. In addition, if you drill down into the make-up of Q3 GDP, you start to see a real issue. Namely, the issue is that Q3 GDP was buoyed by government spending, specifically defense spending.
Government spending had its highest contribution rate to GDP since Q2 2009, and defense spending had its highest contribution rate since 2008. Juxtapose those numbers with the fact that personal consumption, a benchmark for US Consumer strength, declined from 2.5% in Q2 to 1.8% in Q3, and provided its lowest contribution rate since Q2 2012. So, without the government back stop who knows how badly the GDP print could have been.
I’m not one of these guys that is always looking for the bad part of every single economic report that comes out. I don’t get paid on fear and panic. But what I do look for is the sustainability of certain growth metrics.
US economic growth can’t be sustained if it relies on government spending, defense or not. Period.
The two other critical numbers that came out that day were consumer spending and personal income for September. Both numbers declined from August. Personal Income grew at a slower rate, and personal spending outright declined 0.2% month over month. This marks only the third month since the Fed started expanding its balance sheet that personal spending has declined. That’s pretty significant.
Couple that fact with the realization that 2 of those 3 month-over-month declines have occurred this year and you can start to understand why looking at the margin is so important.
It allows you to process information in a way that is outside the norm and can possibly give you an edge over other market participants. So, while the topline of most of the numbers looked fine, the activity at the margin was painting a different picture.
That said, keep in mind that most of the world’s money is both long-only and mandated to be near fully invested at all times. Which means that capital is always flowing to the highest expected return all of the time, irrespective of economic conditions.
The fact is that even though the US growth’s is slowing, the US still looks a hell of a lot better than the Eurozone, Japan or even China. This continued divergence will place a natural wind at the back of most US assets but certainly US equities and the US dollar.
Speaking of Japan and the US dollar, lets get to what might turn out to be the development from last week that might have the most significant impact on asset prices both in terms of duration and magnitude.
The Bank of Japan shocked the markets on Friday when it voted, by a narrow 5-4 margin, to raise its bond-buying program from JPY 70 trillion to 80 trillion and that it would be buying longer-dated debt. The BOJ also said it would triple its purchases of exchange-traded funds (ETFs) and real estate investment trusts (REITs).
Just as a side note, could you imagine if the Fed came out and said they were going to start buying ETFs and REITs to expand their balance sheet? The rationale behind this decision? To fight deflation.
Bank of Japan Governer Kuroda stated "We decided to expand the quantitative and qualitative easing to ensure the early achievement of our price target," reaffirming the BOJ's goal of pushing consumer price inflation to 2 percent next year. "Now is a critical moment for Japan to emerge from deflation.
Today's step shows our unwavering determination to end deflation." In addition to the BOJ announcing plans to accelerate asset purchases, Japan's $1.2T Government Pension Investment Fund announced that it would be raising its holdings of domestic and foreign equities to 25%, up from the current 12% level.
The news of the BOJ’s acion sent risk assets across the globe soaring. The news also crushed the Yen, which had its worst 1 day decline in over 4 years. In addition, to a record decline, the news also firmly pushed the Yen out of a 16 year downtrend that began in August 1998. In addition, to being a tailwind for the US dollar, a weaker Yen has several other significant ramifications on the global economy.
First, the Chinese economy will see a further rise in its already strong real exchange rate, especially if other Asian currencies are pulled down with Yen. This hurts the Chinese economy which, appears to be weakening again.
Second, a declining Yen could wreak havoc on the West as a wave of deflation flows westward from a rapidly devaluing East.
This monetary tightening through the strengthening of exchange rates could send US and Eurozone corporate profits into the toilet pushing their respective economies into recession. The probability of this occurring only rises given how outright bad economic growth has been in the Eurozone and the fact that the US has yet to hit a truly sustainable level of growth quarter in and quarter out.
The actions of both the Fed and the BOJ last week bring to the forefront a question that every person involved in capital markets needs to ask themselves.
All of the major central banks coordinated their monetary policy together in 2008 and 2009, in order to come out of the Financial Crisis. What happens to asset prices when those same central banks start to come off the dole at different times?