(By Darrel Whitten) The
Credit Suisse Global Investment Returns Yearbook for
2012 has some interesting charts that show a) the decreasing impact of successive Fed easings on risk appetite, and b) the positive correlation between risk appetite and global industrial production (IP) momentum. Both are showing a secular low in risk appetite that appears to overshoot the actual deterioration in global IP. Are investors just being too pessimistic about the Euro crisis, China, the U.S. fiscal cliff etc., or has there been a semi-permanent downward shift in growth expectations, such as seen in Japan over the past 20 years?
First is the Credit Suisse Global Risk Appetite Index (GRAPI), which shows investor confidence at secular lows despite two QE's and a Twist program by the Fed, and despite the fact that other central banks like the ECB and the BOJ already have balance sheets swollen to historically massive levels from stimulus. QE 1 of course had the largest impact because it generated the largest YoY change in U.S. broad money supply. QE2's impact was much more subdued, and Operation Twist even more so, because of the impact on the change rate in the broad money supply. So unless the Fed is prepared to really goose the broad money supply (which we don't think they are), the expectation of "QE 3" could be than its actual implementation in terms of stimulating the stock market.
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| Source: Credit Suisse |
The next Credit Suisse chart shows that global risk appetite is associated with global industrial production momentum. While the recent bottom in global IP momentum was rather mild compared to the post 2008 financial crisis plunge, investors remain more bearish on global IP growth than they were in 2009, before they fully realized the long-term implications of the financial crisis and the limitations of monetary policy to counteract these forces. Are investors overly bearish on global growth? The chart below would seem to indicate so. But what if there has been a semi-permanent downward shift in growth expectations?
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| Source: Credit Suisse |
The SP500 has recently de-linked from falling treasury yields. In other words, it appears that bond yields are discounting weaker economic activity, balance sheet deleveraging and deflation, while stock prices are discounting recovery. If it were a real recovery, bond yields should also be moving higher on rising inflationary expectations, as was seen in th lead-up to the 2007 peak, and 2009~2010 recovery. Which is right? Treasury yields of course haven't been this low in half a century. In a previous post, we referred to a Hoisington Investment Management piece that looked at the movement of long-term interest rates after past major financial crises. The studies indicate that long-term bond yields were still depressed after such panics some two decades later, ostensibly caused by secular over-indebtedness and slowing economic activity, resulting in a) deflationary, not inflationary expectations and b) a secular downgrading of economic growth expectations, (our view) which in turn leads to a secular de-rating of equities. Our evidence is the move from 4% to sub-1% JGB yields and the 23-year bear market in the Nikkei 225.
The Credit Suisse historical data on asset returns during inflationary period versus deflationary periods shows that stocks have historically performed best during periods of low-to-mid-single digit inflation, while bonds of course generate the greatest returns during
deflation. Over the past 112 years measured, equities still won out, with a mean return of 5.4% versus a 1.7% return for bonds. But there has been very few instances of debt deflation, such as the first three years of the 1930s, when general prices declined over 20%, while stock prices tanked 60%~70%. Then, as now, deflation was (is) a symptom of the downturn, not the cause, which is balance sheet delveraging.
Sustained high rates of inflation and ever-growing debt are largely a 20th century phenomenon, as central banks and governments abandoned the gold standard and therefore any self-regulating restrictions on unmitigated credit growth. On the other hand, every country covered in the Credit Suisse Yearbook has experienced deflation in at least eight years, with Japan winning the prize for a 25-year bought of deflation. In July, government bond yields in the U.S., U.K. and Germany fell to record lows. Germany's two-year note yield fell below zero, U.S. five- year yields touched an all-time low of 0.54 percent, and U.K. two-year yields dropped to an unprecedented 0.05 percent. The lesson from Japan is that the downward trend in long-term bond yields can last a lot longer than investors can envision, as growth (= inflation) expectations are wrung out of market prices.