by Franklin J. Parker, CFA
The Summary
- The Bottom Line. Despite the Fed’s best efforts to slow it down, the US economy remains ok, though Q3 earnings in a couple of weeks will be an important data point. Bonds are starting to look like good investments again, so some of the recent selloff may be investors moving back down the risk spectrum and picking up some yield, a reversal of the trend we have seen over the last decade where cash has flowed into ever-riskier assets. Unless consumer and business spending slow, or corporate earnings deteriorate in a meaningful way, it is my view that there is a bottom in these markets somewhere near here.
- This week we see data on jobs for September and factory orders for July, both important. Despite the Fed’s efforts to slow it down, the job market remains very tight, which is fueling demand in the economy. We expect factory orders to shrink, and we expect an addition of about 250,000 jobs with an unemployment rate holding steady at 3.7%. Ironically, if this data comes in better than expected, it will push the Fed to be more aggressive in their rate hikes, so we are in a good-news-is-bad-news situation here.
- Last week’s data was a continuation of the trend. Consumer confidence surprised to the upside and weekly jobless claims were fewer than expected, while durable goods orders shrank. Consumer spending is a key variable to watch in the coming quarter.
The Details
Let’s talk about the constraints on central banks.
Over the past week or so, the UK has seen enormous moves in its bond market and currency market. At a time when the Bank of England (the UK’s central bank, also called the BOE) has said they want to stop printing money and buying government bonds, the new prime minister proposed a significant tax cut. Obviously, when a government has less revenue and more expenses, someone has to finance that deficit by lending them money.
Over the past decade or so, the Bank of England has been fine with creating money and lending it to the UK government. With that program coming to an end, it is investors who are left to lend their money to the UK government to cover deficits. However, unlike central banks, investors care about getting paid back.
With the rate on UK government debt suddenly out of the hands of the BOE and in the hands of investors, the gap between what investors demand to be paid and what the central bank demands to be paid became immediately and painfully obvious.
In the end, the BOE stepped into the market and said they would start buying bonds to stabilize the market, which can be read as “to keep borrowing rates for parliament at reasonable levels.”
This is a bit of a lesson for central banks, globally. There are very real constraints on what central banks can do (and I have talked about this before), not the least of which is political. If the pain becomes too great, central bank heads (who are themselves political appointees) will be replaced. I expect central bankers know this, and are doing what they can quickly before those constraints are reached and/or noticed.
This is a slightly different view than most of the marketplace which seems to believe that central banks can operate as unconstrained as they wish.
Chart of the Week
There is an interesting relationship between earnings yield on stocks (which is the inverse of the price-to-earnings ratio), and 10-year US Treasury yields. In essence, investors have a choice between getting yield through stocks or getting yields through bonds. When bond yields fall, earnings yields tend to fall, as well. This means that stock valuations get higher.
Now that bond yields are marching upward in a meaningful way, valuations are coming back down. After seeing the gap between the two widen to historically high levels, it is now moving to be more normalized. Moreover, there are times when earnings yields are lower than bond yields, but those tend to be outliers (1980s and 1990s, or in recessions), but it is possible if we see a return to a stagflationary environment.
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