The Most Unloved Bull Market In History

Last week saw a further modestly positive upward movement in equities. The NASDAQ, German and Japanese markets did best, at least in local currency terms, possibly reflecting the thought that this economic recovery will be led by capital investment type companies rather than by consumers.

We have taken the view for some time that this recovery is likely to be a production-led recovery. In a production-led recovery consumption kicks in late in the cycle and the first part of the cycle is more about improving corporate profitability on the back of cost-cutting. Eventually, cash rich companies begin investing again. Still later, new jobs are added, leading to greater confidence and, finally, increased consumption. The US data suggests that the US is part way along this cycle.

Corporate cash levels are high, industrial production and orders are increasing, recent rises in shipping prices and port activity point to inventory restocking, and the unemployment rate has reached a plateau. Eventually, consumption should recover substantially and in some areas that process has already begun.

US retail sales rose 0.3% in February, which was more than expected. Ex autos, retail sales rose 0.8% after a more modest gain of 0.5% in January than previously estimated. Indeed, US household balance sheets are improving too. Household net wealth rose by +$700 billion to $54.2 trillion in the fourth quarter, according to the US Federal Reserve’s Flow of Funds report released on Thursday last week. This is smaller than the $2.7 trillion gain in the third quarter, but the direction is still upwards.

Since the bottom in January 2009, US households have added $5.7 trillion in wealth. The missing element in the recovery equation is consumer lending. The US Federal Reserve’s latest report on the state of US bank balance sheets showed that US consumer lending actually fell to a new 73 year low as a percentage of total assets. At the beginning of March, consumer loans made up just 6.88% of the assets of all US banks.

It is clear that banks are continuing to bolster their balance sheets and their primary fundraising vehicle has been new deposits rather than borrowing from banks or other financial counterparts. The current funding now suggests that Bank deposits currently make up 74% of all liabilities whilst borrowing accounts for 18%. A 56% gap between the two sources of funds is at a 5½ year high reflecting a move back to more traditional banking practices. Deposits have the advantage of being preferred by the ratings agencies and the regulatory authorities and banks are certainly keen to please both audiences at present.

An advantage of retail deposits is that the depositor is unlikely to be as credit aware as a professional counterpart. The drawback is that deposits often come at a higher price and so reduce margins. Indeed, in the current climate, banks have been able to raise the margin on such consumer lending thereby keeping a lid on consumer spending. The risk, of course, is that the growth of money supply, which is an important leading indicator, slows down. And monetary growth is currently very slow. The composite of money growth in the US, the Eurozone and Japan has slowed to a record low of just 1.7% year-on-year. This is not, if reliable, consistent with sustained economic recovery.

Meanwhile, the US Federal Reserve is gently laying the groundwork for a reduction in the excess cash in the US system. The overnight federal funds rates rose last week to the highest since September. Indeed, the cost to dealers to borrow and lend US securities for one day has more than doubled in the past months. Three-month Treasury bill rates rose last week to their highest since August.

In the three months before the US Federal Reserve started raising borrowing costs in June 2004, 10-year Treasury yields rose about 0.75 percentage points and bond prices fell. While higher rates mean increased borrowing costs, they show some confidence that the economic recovery is gaining traction.

The German Finance Minister Wolfgang Schauble provided a modest bombshell in his guest editorial in last Friday’s FT, titled Why Europe’s Monetary Union Faces its Biggest Crisis? Near the end of the piece, he aired the thought that the Germans were open to the idea of dismissing Greece from the EMU: “Should a Eurozone member ultimately find itself unable to consolidate its budgets or restore its competitiveness, this country should, as a last resort, exit the monetary union while being able to remain a member of the EU.”

However, this is probably a bluff, providing Schauble with some cover. The bulk of his article implied that Schauble is retreating from his earlier opposition to collective bailouts for any member facing fiscal problems. His most interesting statement was that: “We could build on experience gained from use of the EU’s facility for medium-term financial aid to non-Eurozone member states. In May 2009, funding from this source was topped up substantially on account of the considerable economic difficulties faced by some central and eastern European member states. This helped curb the consequences of a crisis.”

This, of course, would not require a treaty change, an institutional reform or any other complex negotiation. It could be done in one hour by the European Council, voting on a qualified majority basis. In fact, talks begin today in which EU ministers will discuss the issuance of Eurozone bonds to finance a Greek bailout. It would appear that the FT article was planted deliberately. We remain convinced that Greece will be sorted out but not until the April deadline.

We are in a bull market for equities, although as one commentator put it “From the very beginning we have called this the most “unloved” bull market in our memory. The wall of worry was extraordinarily steep, yet the market kept climbing. Over the past year, headline after headline warned of foreboding events or catastrophes that still lay ahead. And each time the market started to correct, the Bears would again proclaim ‘it’s over …. we’re going back down now’.” In the last year, there have been five corrections of between 5% and 10%, which is more than the first year of any Bull market since 1988 – the year following the 1987 crash. Then, as now, anxious investors were waiting for the other shoe to drop. It never did.

Rather more technically, Lowry’s point out that, as of 11th March, their buying power index was at a new rally high for the advance from the March 2009 market bottom. This new high suggests demand continues to expand, consistent with a healthy rally. Also, as of 11th March, the selling pressure index was at a new reaction low. Historically, a sustained rise of at least 2 to 3 months (and usually much more) in selling pressure has preceded every major market top. That is clearly not the case at the moment. Meanwhile, all the advance-decline lines that Lowry’s follows recorded new rally highs last week. These gains suggest that demand continues to be robust and broad based.