When the most enthusiastic buyers of US Treasuries are Japanese housewives (to the tune of an astonishing $160bn in the last 3 months) and an unprecedented 20% of all Treasury trading is now accounted for by hedge funds, is the bond market an accident waiting to happen in the form of another 'flash crash' type event?  

It's been clear since mid May that the US economy has been losing momentum, and by mid June that growth forecasts were going to be scaled back sharply as reflected in tumbling bond yields.  I advised a couple of week's back stepping to the sidelines again as downside risks were growing given the disparity in equity versus bond market implied growth expectations. Despite so far robust growth in Emerging Asia and Latin America, global leading indicators are following US ones in turning down, notably in China and Brazil. While another economic crash landing remains unlikely given the inventory and corporate funding backdrop, there won't be much room for policy error wither politically or at the Fed in coming months.  

Soaring prices in the Chinese housing market have attracted global investor attention for their eerie parallel to excesses seen in the US, Spain and Ireland at the peak of their recent real estate bubbles (not least that of hedge fund bear Jim Chanos).  Price-to-rent ratios in the eight largest Chinese cities have increased by up to 70% since the beginning of 2007.  Sustained capital gains would be necessary to justify current valuations on a yield basis. Of course, millions of apartments simply lie empty, hoarded as a store of value when the only investment alternative for wealthy Chinese is the volatile and casino like Shanghai market. Price-to-income ratios are at the highest levels ever seen in Beijing, Shanghai and several other major cities, and housing costs have become a major source of popular discontent. The underlying driver isn't construction costs, but land values which have soared 8 fold in Beijing since early 2003, with half that rise occurring since 2008. Taking the broadest index of the 35 largest Chinese cities, prices have risen 35% in real (inflation adjusted) terms since early 2009 as the the vast credit stimulus applied via state banks has leaked into speculative activity.

Markets are currently obsessed with 'fat tail' risks i.e. extreme economic outcomes like deflation and hyperinflation, with PIMCO among others chasing the investment fashion du jour with a fund protecting investors from a 15% plus downside move. In fact, efforts to protect against another disaster, which helped drive up the relative costs of the most bearish credit derivatives to the highest in 2 years, look like an incipient bubble which is being taken full advantage of by Wall Street.  The Taleb 'Black Swan' hasn't just gone mainstream, but becomke a cliche, and that's a classic example of behavioural finance in action.  

It is often argued that the creation of large amounts of money by central banks in the wake of the global financial crisis will eventually drive further gains in the gold price, given its status as an inflation hedge (with the risk of hyperinflation as the end game for the credit bubble and bust we've seen and the ongoing explosion in sovereign debt). In particular, the US monetary base i.e. cash and commercial banks’ deposits at the central bank) has surged by around 140% since August 2008. However, this has not been matched in the broader monetary aggregates that, in economic theory at least, are what actually matter for inflation. The M2 measure of the US money supply has increased by just 10% over this period (and by only 1.8% in the 12 months to May, see chart below), while the M3 measure discontinued by the Fed has actually been shrinking. Historian Adam Fergusson's classic 'When Money Dies: The Nightmare of the Weimar Hyper-inflation' has just been republished. This definitive account of the collapse of the German currency and economy under the Weimar Republic in the 1920s was originally published in 1975 and having fallen out of print, second-hand editions were changing hands for several hundred dollars a piece (ironic, considering that the point of the book is to warn of the pernicious effects of inflation). Popular demand for a book of this nature reflects an ongoing shift in cultural mood post the 2008 crash and near collapse of the global banking system.  In the wake of WW1, the French attempted via the Treaty of Versailles to bleed German dry (an attempt that the ever wise Keynes warned would end in disaster) and 20 years later, after uncontrolled hyperinflation had ripped Germany's social fabric asunder, Nazi troops were goosestepping under the Arc de Triomphe. The scale of the destruction in paper money's value was such that a 1919 Mark would have bought 500,000,000,000 (yes, 11 zeros) 1924 Marks, reflected in those iconic photos of impoverished citizens pushing a wheelbarrow of cash to buy a loaf of bread, which Angela Merkel probably has on the wall of her office in the modern German Chancellery and is certainly seared in the collective national memory. The only parallel in more recent times is Zimbabwe, which was similarly impoverished by endless currency issuance (according to economist Steve Hanke, prices in Zimbabwe increased roughly 6,400% in just a single week between 7 November and 14 November 2008).

We learned this week that at least Australia and Canada know how to generate jobs, even if the US is struggling, with surprisingly strong employment growth in both countries (Canada's at almost four times expectations and Australia approaching effective full employment) and both currencies finding a bid again after selling off sharply since April on sliding commodity prices fuelled by global recovery fears. Meantime, Asian central banks showed confidence by hiking rates in Malaysia and Korea as a move toward normalizing policy, while the IMF went all in on its emerging economies bet for sustained growth. The Chinese economy is clearly slowing down from its first-quarter boom, with a broad-based decline in leading indicators that are consistent with continued expansion but a material reduction in the economy’s momentum. New export orders declined in June, as did the purchasing managers’ indices for sectors targeted by the government’s restrictive policies in real estate, steel, coal, and cement. The slowdown was signaled by the OECD’s composite leading indicator, which peaked in November 2009 and by April of this year had fallen back to the July 2009 level.

 As can be seen in the chart below, imports of iron ore and copper peaked back in March (and lower shipment volumes have driven the slump in the Baltic Dry shipping index, although container rates have held up so far).  China consumes up to 50% of the world’s steel, with some 60% of that steel used in construction & infrastructure as detailed in the second chart. Global lead indicators have peaked and are falling, and the market is now looking for a second derivative 'inflection point' i.e. indicators hinting that they might be close to bottoming in things like the Chinese PMI, US ISM & the OECD lead indicator. Some positive newsflow from Europe regarding credit and the banking system would certainly support a sustained pickup in risk appetite. The stress test to be announced in July could be a key catalyst as could some definitive newsflow on Spain's ongoing credit risk in particular.

Over the last decade to end May 2010, EM Government Bonds returned almost 12% on an annualized basis, EM equities and REITs just over 10%, TIPS returned almost 8%,  US bonds just over 6%, commodities 4%, cash just over 2% and US stocks...nothing. It was possible to own an asset mix that generated high single digit annual returns, so long as you avoided US (and other developed) stocks. Over the very long term the Equity Risk Premium, or the excess return over bonds you got paid for the additional risk, has been 2.5%. Robert Arnott in The Journal of Indexes highlights multiple 20, 30 and even 40 year periods where the average investor would have been better off in bonds i.e. the risk premium did not exist. So earning this mythical risk premium is largely a function of timing, and timing is a function of valuation.  The reality is that the risk premium exists over very, very, long periods of time. In 2000 we began what may be a 16-18 year secular bear/sideways market that followed an 18 year bull market from a historically unprecedented level of equity market overvaluation on normalized earnings numbers. Though timing the exact starting point and ending point of a secular market is next to impossible, it is possible to determine a range based on the duration of the present market movement and valuations. The charts below looks at annualized 10 year real returns subsequent to a range of market P/E multiples; it seems absurdly obvious but is often forgotten that equity returns depend above all else on starting valuation.

The biggest economic debate at the moment, which underpins very polarized opinions on deflation versus inflation and the risk of a recessionary 'double-dip', is whether it makes sense to cut fiscal deficits while the private sector is still shrinking its balance sheet. The purist followers of the Austrian school (known as 'liquidationists' in the 1930s Depression, such as Andrew Mellon, the then US Treasury Secretary) argue that we need to flush the system of the excess debt that has accumulated via aggressive restructuring and a return to financial discipline in both the public and private sectors, or risk the debasement of money. The alternative viewpoint, taken by the neo-Keynesians, whose poster child is Japanese economist Richard Koo, is that premature austerity will kill a fragile recovery in a 'balance sheet recession', and that encouraging nominal GDP growth via government spending is the best way to bring down debt ratios. Total US debt outstanding shrank in 2009  for the first year in the 58 years of data. The aggregate debt/GDP ratio at the end of 2009 had shrunk to 345%, having peaked at 359% in Q1 as households deleveraged in the wake of the housing collapse and soaring unemployment. The US financial sector has seen borrowing dropping from a peak of $2.6 trillion in the third quarter of 2007, to $2.2 trillion in Q2 2009. Household debt peaked in Q1 2009 at $13.9 trillion (97% of GDP); that ratio has since come down to sub 94%. The only sector where leverage has been increasing is government debt, both federal and state. 

After all the hype, the headline number for May non-farm payrolls was disappointing at 431k versus consensus expectations well above 500k, following a 290k in April, and a 208k gain in March. April's increase was unrevised and while March was reduced by 22,000. According to the BLS, Census hiring added 411k temporary jobs to the payroll gain so private nonfarm employment increased by a hugely disappointing 41k, or a fifth of April's gain.   This morning, the Spanish/German10-year government bond yield spread hit a lifetime high of 192 bps, higher than before the $1trn EU/IMF bailout plan. Meantime, Italian/German 10-year spreads over Bunds hit 168bps and even the French premium hit 39bps, the highest level in a year and Hungary has become the latest focus of bond investor's default fears. Fear and loathing is alive and well in the euro zone, not helped by stories of a major bank taking a huge derivatives loss. That's why a reassuring jobs report was particularly important this time, to give investors some comfort amid the endless uncertainty they have been bombarded with in recent weeks on the credit risk and geopolitical front.

On a y/y basis, payroll jobs came in at down 0.4% in May from minus 1.1% the prior month. The only positive news in the payroll survey was in earnings, the workweek, and production hours. Wage inflation picked up to  0.3% in May, following a 0.1% advance the month before. The average workweek for all workers edged up to 34.2 hours from 34.1 hours in April. Analysts had expected 34.1 hours. Production hours overall dvanced 0.3% in May after a 0.4% rise the month before. For manufacturing, the improvement was even more notable with a 1.1% jump after a 0.85% gain in April.  Aggregate earned personal income is still rising more than the headline number suggests and the gains in temporary workers and workweek points to future hiring while the aggregate hours jump for manufacturing suggests a robust increase in industrial production for the month. From the household survey, the unemployment rate slipped to 9.7% percent from 9.9% in April but only because 322k potential workers simply dropped out i.e. the participation rate dropped.