On how weak growth begets low yields and on Spain over Germany

I want to revisit two themes from my ten surprises post for a mini-post follow up to the last newsletter. The first theme is Treasury strength due to US economic weakness and the second is Spain outperforming Germany economically. Both of these trends are holding but I have a few specific comments now eight months after the Surprises list.

Here’s how I put theme one on Treasury strength in February:

10-year US Treasury yields fall below 2.25%. This surprise falls directly out of the last one. If growth in the US is weak, then yields should fall. I keep hearing from various talking heads that they believe inflation is about to break out. And they then say that means interest rates will rise as traders front-run a Fed hike. OK. If that’s so, then inflation irresistible force meet poor wage growth immovable object. Inflation without wage growth doesn’t lead to higher rates at all; it leads to lower real wages which is a fancy way of saying there’s less money in people’s pockets to spend. If we do get this inflation that these talking heads expect, it would only create demand destruction that weakens the economy so much that inventories start to get purged. That’s negative for growth and therefore bullish for Treasurys. I’m looking at 2.25% as an aggressive target.

When I wrote this, Treasury’s were about 2.75%. So 2.25% was an aggressive target that I think is a big surprise to markets. We have basically hit that number with 10-year rates getting down to 2.28% earlier today. Now, the way I put it in February, even if we got inflation – which I didn’t expect – then it would create demand destruction in a world of poor wage growth. We did not get inflation. As I just reported, breakevens in the TIPS market are actually starting to plummet. And that says something big is happening.

There are two interpretations here. The bullish interpretation is that inflation is nowhere on the horizon because oil is oversupplied. This is essentially a tax cut for consumers that will translate into more economic growth with few negative side effects due to the already low inflation rate delaying Fed rate hikes. The second interpretation that I adhere to is that the TIPS market is telling us that inflation is falling because global demand is weak. And that means nominal GDP will fall. Thus, even if US growth is broadly positive, the data in Q4 are now less positive than they were in Q2 or early in Q3.

Time will tell which interpretation is right. But the first scenario means the present equities weakness will end up being just a mid-cycle pause while the second sees this cycle entering its decline.

Here’s how I put theme two on Spain over Germany:

Spanish GDP growth rebounds and outstrips German GDP growth. I can’t be completely downbeat here. So, in line with my more optimistic view, I am looking to Spain to re-assert its growth ’tiger’ role alongside Ireland. A number of things come into play here. First, everyone is extolling Germany for a job well done. And second, people are less optimistic on countries in the periphery. I think this is wrong-headed and believe that Spain has the best chance of showing why. The Germans are saying their economy will grow 1.8% in 2014. While the Spanish are saying 0.7% growth for their economy. The European Commission has bumped up its forecast to 1.0%. But it is still below estimates for Germany. Morgan Stanley has Germany at 1.4% growth for 2014. But it has Spain at 0.6% growth. Therefore I believe the market would be surprised by German weakness and Spanish strength.

First, Spain is allegedly going to raise its forecast. Second, German domestic numbers are weak. Foreign trade is driving growth. This is Germany’s Achilles heel, especially with emerging markets slowing, the US slowing, and the periphery still weak. Spain is benefitting from lower yields, which will pass through into credit growth at some point this year, increasing Spanish home prices. And rising bad debt will stabilize, further improving the situation. Bottom line: Spain has a basing effect to work from. Having been savaged by austerity, they will benefit from a low base and GDP growth will increase more than anticipated. That’s my call here.

This prediction was on the mark because trade has been Germany’s Achilles heel. But I would look at the data for 2014 as less bullish for Spain than I couched it in February. The story is more about Germany underperforming than Spain outperforming. And so, instead of writing Spain “will benefit from a low base and GDP growth will increase more than anticipated”, I would have to write “Germany will weaken so much more than anticipated due to weak export growth that Spanish growth will outstrip German growth.”

I would like to remain bullish on Spain but I am not convinced the macro environment warrants it any more. Increasingly, I am concerned with downside risk.