For the first time in history, the yield on the 30-year U.S. Treasury bond has fallen below the real GDP growth rate. The closest these two have ever come in the past was October 1998 when the spread was down to only 0.09%. The median spread, going back to 1977 (earliest data available), has historically been 3.63% with the average 4.26%.
So what's going on here?
In a QE-flush world Treasury yields correlate more closely with rates across the pond in the primary eurozone economies than with domestic economic trends. U.S. Treasury yields, and all rates that flow from them, are the lucky beneficiaries of the economic malaise throughout Europe (July's retail sales volume fell 0.4% vs. expectations of flat), proof that silver linings do sometimes occur, particularly these days for borrowers. A great deal of attention will be paid to the ECB's comments on Thursday, with mounting pressure to announce something that will inject some serious caffeine into an economy that is looking more and more like Charlie Sheen around 10 a.m ... on any day, let alone any given Sunday. This could be an enormous boon to those at the Fed, as the removal of one central bank from the sovereign bond trough may elegantly coincide with the arrival of yet another. Even Japan is sampling the sovereign delicacies, slurping up nearly $37 billion in Treasuries in the past six months.
While the engine of U.S. economy is starting to get a nice V8 purr, around the globe economies are starting to sputter like my college Suzuki Samurai.
- The eurozone is perilously close to being back in a recession, with Italy already back in one.
- Japan is flailing after the crushing sales tax increase in April.
- Brazil is in contraction, with Q2 GDP dropping 0.6%.
- Argentina is in default, again.
- China is slowing, with rising fears over the magnitude of bad debt and even Hong Kong's GDP contracted last quarter.
- Russia is suffering notably under the economic sanctions imposed due to its dalliances with Ukraine.
So, these low rates, given the geopolitical climate, are likely to be around for a while, which may help spur some much-needed capital spending in the U.S. after seeing a painful 5.0% decline in productivity last quarter from the prior quarter at an annual rate. In our view, this raises the issue that perhaps the Fed may have sufficient ground cover to postpone its first rate hike into the second half of 2015. That could breathe some life into high dividend-yielding companies, like Digital Realty Trust (DLR), CenturyLink (CTL) or Physicians Realty Trust (DOC), that would have come under pressure in a raising rite environment.
Post-economic crisis companies were understandably obsessed with debt reduction and cash and hesitant to make new investments. The aftermath of the crisis first saw companies storing up record-high levels of cash in order to shore up their balance sheets, while earnings improvements were driven primarily by cost-cutting. That obviously can't couldn't continue indefinitely, so next these still-wary executives chose to use the cash they'd built up to strengthen EPS through share buybacks. But now, with productivity rates actually falling, companies will have to start investing in capital in order to prevent profit margin erosion. Recent data have shown this in fact is starting to happen.
Last week's GDP growth revision gave us an impressive line item concerning real nonresidential fixed investment, which grew by 8.4% vs. the initial estimate of 5.5%. This increase in spending was driven by structures spending, up 9.4%, and business equipment expenditures, up 10.7%. The Manufacturers Alliance for Productivity and Innovation (MAPI) recently released its quarterly economic forecast, which calls for further spending on nonresidential fixed investment over the coming 30 months. That was just part of the bullish outlook MAPI has on business investment.
Other key items from that prognostication include:
- Inflation-adjusted investment in equipment to grow 5.7% in 2014, 8.3% in 2015 and 7.2% in 2016.
- Inflation-adjusted expenditures for information processing equipment are anticipated to increase 4.0% in 2014 and by double digits in each of the next two years -- 11.9% in 2015 and 10.2% in 2016.
If MAPI's forecast is at a minimum directionally accurate, companies like Jacobs Engineering (JEC), Fluor (FLR), Chicago Bridge & Iron (CBI) and Granite Construction (GVA) should see a pickup, as should Cisco Systems (CSCO), Juniper Networks (JNPR) and WMware (VMW).
Now, while we continue to think that equities in the U.S. are still rather pricey, they are much like the U.S. economy as a whole, the one car that's still able to get into second gear after the demolition derby. As long as the world's major economies continue to struggle and central bankers succumb to pressures to use monetary policy to desperately spark growth, we will live in a world of financial repression in which investors are forced to take on extra risk to get any sort of reasonable return. That is a tailwind to equities and credit spreads have been crush, forcing otherwise conservative investors into assets they wouldn't normally consider. In addition, the apparent trend in capital expenditures is positive for both technology and industrials, making them relatively more attractive.
On a final note, those that heeded our suggestion on Aug. 6 that the state-owned Russian energy giant Gazprom (OGZPY) was worth considering are today enjoying gain of more than 9.5% in less than a month. We remain relatively bullish on the stock's upside potential vs. current downside risks.