Thursday, July 2, 2009

Market Update: Consolidation or Correction?

While risky asset markets are rather in a consolidation than correction mode, government bond yields have dropped markedly. Looking ahead, I maintain the government bond-bullish outlook which I adopted early June (see here: Have we seen the highs in UST and Bund yields?) as well as my defensive asset allocation (Asset allocation: defensive stance).
The underlying economic situation is improving only slowly and the output gap is increasing further, leading to an ongoing easing in inflationary pressures. Today's employment report confirmed this. While unemployment tends to lag the recovery, there are some forward looking elements within the report, such as temporary work and hours worked. Temporary workers are usually the first to be let go and the first to be hired. However, the number of temporary workers is still declining (-38k vs. May09) while average weekly hours declined slightly. I also look at what I call the index of aggregate weekly earnings. This is constructed by multiplying average weekly earnings with the index of aggregate weekly hours for the private sector (for more details see here: Consumer deleveraging spiral still getting worse). The chart shows the yoy change in this index. The sum of wages paid to private sector workers is declining at an unprecedented rate of 4.4% (after 3.8% in May) amid easing wage growth and sharply dropping aggregate hours worked.
Combined with the destruction in households' net worth, this is a strongly disinflationary development. Employment benefits and active fiscal easing by the federal government cushion the negative impact on households' income. However, the fiscal easing would need to increase further given the ongoing drop in income. Therefore, the outlook for consumption remains very bleak!
In the Eurozone, the situation remains even more fragile amid a less aggressive ECB than its US counterpart but a more substantial drop in growth across a host of Eurozone countries. Today's acknowledgement by the ECB that there might be more rate cuts if necessary is at least a positive sign and accepting the reality of falling inflation (and therefore potentially higher real yields) and further falls in domestic and external demand.
Overall, the outlook for nominal growth remains very subdued amid low/negative real growth and lower inflation. This will seriously constrain the ability of real assets to show positive returns! The risk remains that the current consolidation in commodities and equity markets (<=10% price fall) turns into a correction (>10% fall in prices). Government bonds on the other side should remain underpinned. Stay defensive in equities/commodities but stick to long duration positions in Bunds and USTs.

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