U.S. Growth Slowdown Ahead: The Dog that Didn't Bark

-- This is a guest post by Jay Pelosky, Principal, J2Z Advisory, LLC --  When one considers Q1 2011 results: broad commodities up 12%, led by oil up 24%, S&P stocks up 6% in its best Q1 since 1998, USD down 4%, one asset class stands out and that is bonds - bonds were roughly flat across both the corporate and government space in Q1, even in the face of sharply rising commodity prices and inflation fears.

The old adage states that one should pay attention to the dog that didn’t bark. So why didn’t the bond dog bark? Well, it could be because of Fed buying under QE2 or perhaps because of a safe haven bid in the midst of the Arab Spring and Japan’s calamities. Or it could be something else.

That something else I believe is the bond market sniffing out the sharp slowdown in US growth that looms ahead. Why a slowdown? Well, first and foremost because we are entering into an unprecedented economic experiment: the dual and simultaneous withdrawal of fiscal and monetary support on both sides of the Atlantic. In effect, we are making a bet that the US economy (and the EU economy as well) is self sustaining without government support as deficit reduction rules the political roost and the Fed ends QE2 on schedule in June. We make this bet without any proof that it’s the right bet to make and without any safety net in place should it prove wrong. Any QE3 will face huge political opposition and require a very weak economic environment to force the political wing into reversing course; this is especially true given that 2012 is an election year.

It seems clear that Q1 2011 GDP growth in the US will be weak; recall that Q1 was supposed to be the strongest quarter of the year aided by the payroll tax cut and building off of 3%+ GDP growth in Q4 2010. Well, most forecasters today are calling for Q1 GDP to come in around 1.5-2.0%, down from prior estimates of 4% on average. Yet, many economists maintain 2H 2011 growth estimates of 3% or better. It is hard to see what the growth drivers will be for such rosy estimates: fiscal spending at all levels is being cut, the Fed is preparing to go on hold, consumer sentiment is lousy, real wages are falling, gas prices are rising, home prices remain in the basement, and business investment is tailing off.  Yes, manufacturing is doing well and exports too; with many emerging economies allowing their currencies to appreciate in an effort to slow inflation, US exports should continue to do well but that accounts for only 12-13% of the economy.

A weak Q1 GDP report seems priced into financial assets at this point. The US stock market has been marking time since it hit post-crash highs in February while the yield on the 10 year UST bond has rallied some 50 basis points since its high in yields, also in February. The Treasury markets’ response to last Friday’s CPI report (it rallied) followed by Monday’s surprise further fall in yields in the face of Standard and Poor’s cut in the long-term outlook for US government debt tells us something. It tells us that the inflation bogeyman is the wrong thing to focus on for both US policy makers and investors alike. Inflation is an emerging economy threat – in the US by contrast, rising commodity prices dampen demand and growth. $4 gas is bullish for bonds, not bearish. With Spanish government 10 year yields hitting decade highs and Finland serving political notice that further bailouts, even for Portugal, are not a given, I expect Europe to face a long, hot summer of discontent; the safe haven bid for UST is unlikely to disappear over the course of this year.

What are the implications for US financial asset prices if we face a growth slowdown as opposed to an inflationary outbreak? I expect a grinding, range bound US equity market for the near term, perhaps extending into 2012. Upside is limited to perhaps the 1400 level on the S&P, roughly 7% from current levels while downside risk extends to the 1180-1200 level or a 10% decline. US equities remain the best way to participate in the globalization of demand but current risk reward is not very appealing. Professional investors dislike a grinding market because they can get chopped up in such an environment; one could see a gradual evacuation from equities, notwithstanding the underlying supports of valuation, rising dividends, stock buybacks and M&A activity. Such an evacuation might set up the next big buy opportunity in stocks.

Investors have to wonder what sectors will lead the market higher? In the first quarter, energy was the bell cow, representing 60% of the S&P advance; recently however XLE, the energy sector ETF, has not moved up in line with the rising oil price, suggesting some uncertainty there. Financials represent 15% or so of the S&P but have reacted very poorly to Q1 earnings results and do not appear ready to lead. Technology stocks could lead but there too, the sector has performed poorly of late, perhaps due to Japan’s influence on the tech supply chain. In fact, the sectors that are working seem to be more defensive in nature such as healthcare, telecom or consumer staples; defensive sectors rarely lead the overall market higher.

What about fixed income? I think bonds could do well on a relative basis versus stocks thru year-end. Bonds offer decent yields, especially at the longer end of the UST curve. The end of QE2 is likely to be USD supportive; contrary to perceived wisdom that may well draw in some foreign buyers who want to see the dollar bottom before committing capital to the US. In addition, fiscal tightening is bond bullish, inflation risks have been greatly overstated and will fade with growth weakening and best of all, virtually no one likes bonds with gurus such as Pimco’s Bill Gross publicly stating their disdain. It would not be a surprise to see the 10-year UST bond yield break below 3% from 3.40% currently.  Corporate bonds are also appealing as they provide exposure to the best positioned of the three main economic actors: the consumer, the government and business. High yield remains attractive for the coupon if not the capital gain potential. USD denominated EM bonds could also do well, offering as they do the best sovereign balance sheets at a significant yield premium over UST.