July 19th, 2012
Article of the Week from Investing Daily
by Elliott Gue, Investing Daily
As major structural headwinds combined with glimmers of hopeful news continue to whipsaw investors, the words “risk-on” and “risk-off” have entered the popular investment lexicon.
The term risk-on refers to a market where investors, particularly fast-moving institutional investors, are relatively bullish on the prospects for the economy and snap up all assets that benefit from economic growth including stocks, high-yield bonds, crude oil and industrial metals. In a risk-on world, investors tend to shun assets that are considered safe havens such as US and German government bonds and the US dollar.
Conversely, in a risk-off world, traders run away en masse from anything that would be hit hard by a cyclical economic slowdown including stocks and commodities. The best-performing assets in such an environment: US, German and other safe sovereign debt and the US dollar. The problem is that while most would describe the period from April to date as a risk-off environment, the US equity market hasn’t followed its assigned script.
The US 10-year Treasury bond yield currently stands at about 1.50 percent, down from a high of 2.39 percent in mid-March and 3.75 percent in early 2011. Treasury yields climbed in June from a 220-year low of 1.47 percent to a high of 1.69 percent, but they’ve since slumped and are approaching those lows again (see chart below).
Much the same is true of other global safe-haven bond markets. The Netherlands, one of the more fiscally sound EU countries, saw government bond yields hit their lowest levels since 1517, German bonds hit their lowest levels since records became available starting in 1807 and French bonds plummeted to the lowest yield since 1746, while short-term rates went negative. Investors piling into safe-haven bond markets, sending yields plummeting to all time lows is consistent with a risk-off market.
As we predicted in The Summit Surprise: No Sustainable Upside (July 2 issue), the agreement reached at the EU Leaders Summit in late June exerted only a marginal and temporary effect on borrowing costs for troubled EU nations. Italian and Spanish government bond yields have now reverted to the elevated levels last seen just prior to the Summit.
Crude oil prices are also reflecting investors’ cautious mood (see chart below). While the price of Brent crude oil has bounced from its June lows of under $90/bbl to over $100/bbl, oil is still down more than 20 percent from its early 2012 highs. At its June lows, oil had corrected by 32 percent in the space of less than three months, its fastest decline since the nadir of the financial crisis in the second half of 2008.
However, the S&P 500 currently sits at around 1,350, down a paltry 5 percent from its early 2012 lows. That’s despite the fact that when the S&P 500 hit those highs over 1,400, US jobs creation was still averaging over 200,000 new jobs per month compared to about 75,000 over the past quarter.
Moreover, in late March and early April, US economic data was still beating expectations and most analysts were projecting a pick-up in economic growth through year-end, from the first-quarter pace of 1.9 percent.
Now, the economic data has turned for the worse and the consensus is looking for US economic growth of 1.9 percent in the first quarter of 2013, unchanged from the first quarter of this year.
This schizophrenic market is unlikely to stand. Either the S&P 500 needs to trade significantly lower or high-quality sovereign bond yields and oil prices should be higher than is the case today.
As regular readers know, we’re still looking for stocks to undergo another bout of weakness before putting in a durable bottom later this summer. At a minimum, we expect the S&P 500 to re-test its June lows and quite possibly undercut those lows and sell-off to the 1,200 to 1,225 level, for a correction of 10 percent to 15 percent from its March/April highs.
The Three Triggers for a Decline
A sell-off in stocks would likely be catalyzed by any combination of these three factors:
First, the European economy slips into outright recession and sovereign bond yields for fiscally troubled EU nations such as Spain and Italy continue to hover at elevated and unsustainable levels.
Second, US economic data continues to disappoint and consensus expectations for economic growth in the second half of 2012 still haven’t fully priced in that weakness, leaving a good deal of room for further disappointment.
Third, a contentious US presidential election cycle exacerbates uncertainty surrounding the 2013 “fiscal cliff,” a barrage of tax hikes and spending cuts due to hit the US economy in early 2013.
It’s unlikely that all of the fiscal cliff would be allowed to go into effect next year, but if it does the US economy would almost certainly slump into a recession. An economy growing at less than a 2 percent annualized pace simply could not sustain the largest fiscal contraction since World War II without spiraling into a moderate to severe economic downturn. With Europe already in recession, that’s a bleak scenario for global growth.
At the same time, we see the downside in crude oil prices as limited from current levels. While there’s been considerable talk about a decline in global oil demand because of weak economic growth, oil prices have already slumped by enough to price in that risk. Moreover, with oil and retail gasoline prices falling just as the US enters the summer driving season, the outlook for US oil demand is actually improving, not getting worse.
Meanwhile, the source of most of the world’s oil demand remains China and other emerging markets. Chinese growth has slowed but most of that slowdown stems from the government’s efforts to rein in inflation and prevent a housing bubble. The Chinese government hiked interest rates and bank reserve requirements through much of 2010 and early 2011, to dampen an overheated real estate market.
However, China is now back to promoting growth and has sliced interest rates twice over the past month; signs are emerging that Chinese banking lending activity is picking up again. Growth in China has likely already hit its lows for the year.
Finally, it’s truly puzzling to read headlines about how the world is “awash” in excess oil supplies. The US is the only country outside OPEC that’s seen its oil output grow over the past year, thanks in large part to the increased exploitation of unconventional shale oil plays such as the Bakken Shale of North Dakota.
America’s resurgent production has led to bloated inventories of oil at the Cushing, Oklahoma oil terminal in the US. However, that’s about the only major oil trading hub in the world that has excess supplies.
It’s good news for the US that the nation’s oil production is rising but let’s put the increase into perspective. The US produces 6.2 million barrels of oil per day but consumes about 19 million bbl/day. US production has grown over the past two years by over 1 million bbl/day, the first meaningful uptick in US oil output since the early 1980s.
However, these numbers still leave the nation a long way from energy independence when it comes to crude oil. While oil production will continue to rise, the idea that growth in US production will be enough to totally cut the nation’s dependence on imports over the next 20 years is pure fantasy.
In June, OPEC oil supply increased by 2.25 million bbl/day from a year ago, led by the recovery in Libya’s oil output as the country emerges from last year’s civil war. Recent data suggest that Libyan production has approached its prewar level of 1.6 million bbl/day.
Saudi Arabia has also ramped up production, with output topping 10 million bbl/day in each of the past three months, up about 1.1 million bbl/day from a year ago. Some of this production increase reflects efforts to offset sanctions against Iran.
Iran has maintained its oil output thus far, but much of this production is destined for storage. At some point, available storage capacity will fill up, forcing the nation to cut production.
Saudi Arabia is unlikely to maintain current production if Brent crude oil were to decline to less than $90/bbl for an extended period. However, the Kingdom could cut output if Iranian oil production exceeds expectations.
OPEC’s spare productive capacity continues to hover around 3 million bbl/day, compared to about 4.4 million bbl/day in May 2011. Saudi Arabia accounts for about 1.9 million bbl/day of this spare capacity.
Global oil markets are still tight despite the recent price decline and crude prices appear to be near an important low. The announcement of a third round of Federal Reserve quantitative easing later this summer, as explained in The June Rally: Built on Weak Foundations (July 6 issue) will be another important upside catalyst. In the meantime, investors are wise to play it cool this summer and stay defensive.
About the Author
Elliott H. Gue is editor of Personal Finance, a one-stop source for market-beating investing advice, and a contributing editor to Investing Daily. Mr. Gue scours the world for the best investments – whether it be growth stocks, bonds, Master Limited Partnerships or commodities – to build and protect your wealth no matter what the “market” does. Mr. Gue delivers in-depth insight and analysis that cuts through the noise and hype to reveal the truth about the economy, the market and your investments.
He has worked and lived in Europe for five years, where he completed a Master’s degree in Finance from the University of London, the highest-rated program in that field in the U.K. He also received his Bachelor’s of Science in Economics and Management degree from the University of London, graduating among the top 3 percent of his class. Mr. Gue was the first American student to ever complete a full degree at that business school.