There is a significant risk of a major decline in equity prices and Treasury yields before long. Indeed, the process of decline in both may have already begun, especially for Treasury yields. The Treasury 10-year note yield, at 3.44%, though up in recent days ahead of next week's auctions of new Treasury debt, is still down from its highs of 4% earlier this year and 5% in 2007. And this 10-year yield is still twice the yield on 10-year Japanese bonds, which tend to lead US Treasury yields downwards, despite Japan's gross debt as a percentage of GDP at more 200% versus less than 100% for the US.
That prospect of lower Treasury yields and equity prices may seem out of step with the signs of a bottoming in the recession and advance indications of recovery. Moreover, the consensus view of economists is that the economic recovery will be sustained, producing a continued rise in equity prices and an extended rise in Treasury yields, as well as an early step-up in inflation.
However, I do not share those forecasts. Instead, in my view, there is a prospect of a renewed weakening in the economy after the various forms of economic stimulus run their course. That, in turn, will produce a disappointing corporate profit performance and renewed concerns over a continuation of deflation, already down more than 1.5% year-over-year for consumer prices. Together,those fears will likely lead to a significant anticipatory decline in both equity prices and Treasury yields. These views are not just mine alone. Though it does not alter the probability of the outcome, these views are shared by a few notable economists, as well as a consensus of major hedge fund managers. This is despite the the continued reltively low level of the Chicago Board of Options VIX, or volitility index, the so called equity market "fear index" which continues under 30,versus levels above 50 earlier this year and near 80 at its highs late last year. Why then the disparity in views? One contarian warning sign is that there has been a compete reversal in bullish and bearish sentiment. Over 50% of investors now have bullish views, up from near 20% at their lowslate last year, while only 20% of investors are now bearish, versus more than 50% with that view late last year. Sentiment follows the crowd and trend when it should be forewarned by it to consider the opposite.
Look at the seemingly moderate decline in nonfarm payrolls in the September employment report that led to a Friday rebound in equities and a selloff in Treasuries that pushed the 10-year yield to 3.44% from 3.35% the day before. And the futures market indicates that equities will extend their price advance on Tuesday, while the pressure of new Treasury supply next week may add to the backup in Treasury yields over coming days.
But, the reality is that markets completely misread the significance of the employment report. On balance, the September employment report was far more negative than positive, even with the relatively moderate 216,000 August decline in nonfarm payrolls, versus declines of 276,000 the month before,463,000 in June and 741,000 in January. Because the Bureau of Labor Statistics does not sample all new companies, it tries to compensate by artificially boosting the nonfarm payroll sample results each month even though in the midst of a recession there are generally layoffs not hiring at such unsampled firms. Without this fictional increase for August the actual decline in nonfarm payrolls would have been 118,000 larger or 334,000. But, even that larger nonfarm payroll decline almost certainly understates the actual August employment loss. That is because in the more reliable household survey, employment declined 392,000 in August, while unemployment rose 466,000. This was sufficient to push the August unemployment rate to 9.7% from 9.4% the month before. But, the still more realistic u-6 unemployment rate, which includes discouraged workers and those employed only part-time because they can not find full time employment, surged to 16.8% in August from 16.3% in July. That brings the number of Americans affected by some form of unemployment to more than 26 million. That horrendous number of desperate under-employed Americans is hardly the stuff of which a sustainable consumer-led economic recovery is made. When a sustainable economic recovery does eventually come, it is likely to prove essentially jobless. That is signaled by an even smaller percentage of unemployed on temporary layoff than in past recessions.
Though real GDP is likely to be up in the third quarter, perhaps by an annual rate of some 3%, the growth rate will likely weaken from there, and almost certainly by early next year as the impact of the stimulus recedes. Speculative inventory building will subside after restocking. The Baltic dry cargo index is already falling, down 44% in the past three months, indicating a drop in the demand for bulk shipping and a lessening in speculative commodity stockpiling. There will be a new wave of mortgage foreclosures pressuring home prices and sales lower again. Prime home mortgage loan borrowers, not just sub-prime borrowers, are increasingly delinquent. Such prime loan borrowers now account for more than half the mortgage delinquencies. It turns out that negative home equity is the major driving force prompting foreclosures. And nothing has changed that widespread realty that many homeowners, at least 22%, owe more on their mortgage than their home is worth. Commercial real estate is also in increasing distress as more and more of these properties are similarly worth less than their outstanding mortgage balance. Over 15% of offices are already vacant, with the prospect of more to come.Given these trends it is not surprising that banks are rapidly increasing their write-off of such mortgages in default. It follows that bank lending caution is also increasing, reducing credit availability to consumers and small-to-medium sized businesses. Consumers are increasing their savings rate at the expense of consumer spending. States and local governments are being forced to retrench as their tax revenues subside. Though some economic measures suggest recovery, underlying and long-range trends are still recessionary and deflationary.
The next economic report will be published in early October.
Philip Braverman, Chief Economist and CEO
Braverman Economic and Financial Consulting
One Hewitt Square #249
East Northport, NY 11731
My e-mail address follows: philipbraverman@Gmail.com
This and earlier reports can be accessed by going to internet explorer and typing the following:philipbraverman.blogspot.com
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