Stating the Obvious

Economic data and commentary this week confirming what we have suspected for months now: the entire developed world (well, perhaps excepting the perpetually pushing on a string Japanese) is beginning to feel the effects of austerity.

Fed outlook, European PMI numbers, US unemployment, UK retail sales…all seem to point to a weakening expansion. A quick, off-the-cuff analysis might be that the busted debt bubble was too much for all of the global stimulus to overcome. In a strange way, analysts with views as disparate as Roubini and Krugman arrive at the same place – the difference is that the latter thinks more stimulus can solve (or at least help) the problem, where the former thinks it’s pretty nearly hopeless.

At the very inception of this blog, we began with the premise that getting the macro outlook on inflation/deflation rightly sorted would be vital to investing success. As of this writing, the deflationary winds are blowing as hard as they have at any point since the recovery got underway. My outlook has occasionally been lampooned over at Seeking Alpha for being unwaveringly bullish on Treasury bonds (until this week). At this point, I suspect my error may have been not being bullish enough.

2 thoughts on “Stating the Obvious

  1. Hi Harry,

    This is a insightful overview of what has been happening with this economy and market. Thanks for this because I am learning how to read the economy, using it for trading purposes.

    Could you please explain your last paragraph? Are you expecting continued strength in the bond market? I am struggling to understand the bond market, especially as it relates to stocks. And could you please comment on Bill Gross’s position regarding bonds.



  2. Hello Shirley,

    The bond market is much more of a pure play on the macroeconomic outlook than the stock market (except for high yield corporate bonds). It basically discounts inflation and future interest rate expectations, which are not the same as but very closely follow macro growth expectations (there are times when the bond market gets dislocated and this relationship drifts apart, but we’ll ignore that for the moment).

    The falling bond yield over the course of this year was signaling lower growth expectations. Well, lo and behold, we are seeing it in the data. Going forward, austerity regimes from excessively indebted sovereigns at a time of underutilized industrial capacity and high unemployment are probably not a recipe for growth. Where is the aggregate demand to drive corporate profits going to come from?

    To answer your question, though it makes me uncomfortable, I am reluctantly expecting continued strength in bonds. While this does not necessarily equate to a negative outlook for stocks, it can in the present context. When then Fed Chairman Volcker broke the highly inflationary environment in the early 1980s, bonds went on a furious rally, and stocks rallied as well. At that time the macro picture was one of extremely high interest rates choking off access to capital. When rates came down, capital became more accessible, businesses invested, growth took off, and stocks boomed.

    The present environment is altogether different. Rates are very low, there is a huge amount of central bank supplied liquidity, but there is little demand for capital. Rather than wanting to borrow and invest and being unable due to the high cost of funds, many individuals and businesses are already overly indebted and often more interested in divesting. While I’m not outright bearish on stocks, the economic headwinds coming from a macro environment of long term low growth will make it difficult to succeed with 1980s-90s type growth strategies such as buying the indexes. I think good timing and good stock and sector selection will be rewarded. In other words, if we want to make money we will have to work for it.

    With regard to Bill Gross, I must admit to not having paid much attention beyond seeing the headlines that say he is negative on Treasuries. He probably has forgotten more about the bond market than I will ever know, so this may be presumptuous on my part, but I can’t agree with that view. There are two main risks to Treasuries: inflation (loss of purchasing power) risk and default risk. I don’t see a serious threat of the former, at least in the near term, for the reasons outlined above. The latter is simply ludicrous. If the US does default we will have much bigger problems, but I see that probability as so remote that it’s not worth planning for.


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