A play in which nothing happens three times

Samuel Beckett’s “Waiting for Godot” is a play in which nothing happens, twice, in the bon mot of the late Professor Vivian Mercier, a frequent guest in my childhood home. This week’s market has been a play in which nothing happened three times – that is, on Tuesday, Wednesday, and Thursday. With the major US indices down about 0.4% today, equities are unchanged on the week. Equities are sitting on a bubble.

The market waited for the Fed, which came and went without event, and it continues to wait for the US-China trade negotiations, in which nothing is likely to happen, either. Meanwhile, the trickle of economic data continues to suggest a contraction of world trade and capital investment counterbalanced by a modest expansion in services.

Earlier this week, exports were reported to have fallen year-on-year in Korea (-5.8%) and Japan (8.4%). Today the Markit Eurozone Purchasing Managers’ Index for manufacturing came in at 49.2 (below 50 is a contraction), vs a reading of 60 a year ago. The US manufacturing PMI printed at 53.7. In both cases the service sector looked somewhat better. The US also reported the third decline in capital goods orders in four months.

Of particular interest today was the decline in existing home sales, which came in well below expectations at a 4.94 million annual rate. That is one the forecasters should have seen coming. New home sales are extremely sensitive to mortgage rates, which tells us that every uptick in the cost of mortgage borrowing prices a significant proportion of prospective homebuyers out of the market.

In fact, the 30-year mortgage interest rate is a very good predictor of the level of home sales with a few months’ lags.

Except for the impact of the oil price, US yields are going nowhere. Since the last week in December, the
“real” (that is, inflation-indexed) component of the US 5-year Treasury yield has fallen by about 40 basis points while the inflation component has risen by about 30 basis points. The “real” component fell because the Federal Reserve backed away from plans to raise interest rates and the inflation component rose along with the price of oil and other commodities.

As I have shown in several past reports, all risk assets – oil, stocks, commodities and so on – traded in line with expectations about monetary policy during the last four months. The Fed’s lurch towards reflation brought down “real” yields and indirectly brought up the inflation component of yields.

The Powell Fed has taken a lot of flak for its about-face, including from this writer. But it’s important to point out that the Powell isn’t being a baby. The good news is that a shift towards easier money was, in fact, able to revive the price of oil and other commodities after their mid-2018 plunge. That hasn’t happened in Europe and Japan, where we do not observe the same recovery in the inflation component of government bond yields.

In the chart below, we see that the expected inflation rate in Germany is languishing around 0.9%, down from 1.2% in November. The price of oil has recovered, but not German inflation expectations. That a sign of weakness

The only not-so-terrible news is that the US economic juggernaut isn’t crashing. It’s merely decelerating to a crawl. Implied volatility on equity index options continues to decline across markets. I continue to believe that the environment is good for interesting-earning assets but unwholesome for equities in general.

German and Japanese bond yields have flat-lined. No amount of monetary stimulus appears to lift inflation expectations off the ground. That’s not surprising. Recessions are deflationary because businesses lose pricing power. Germany just skirted a recession by the thinnest margin of fourth-quarter growth, and Japan is in recession. That’s the consequence of a regime of uncertainty about global supply chains, which has frozen capital investment plans around the world and hurt the largest capital goods producers the most.