Sell in May and go away? Only if you were a bond investor. For equities, May was another reminder that, contrary to classical theory, prices are not independent. Yesterday’s price move does impact today’s. And the trend is your friend (until it ends of course). The S&P 500 rose 3.6% last week (and 5.3% in May), Russia rose 7.3% on the week and 30.6% on the month, China 1.4% and 6.3%, and Brazil 5.2% and 12.5%.

But last week the big stories were in other asset classes: plunging bond prices, rising inflation expectations (see MM’s story here), rising oil prices and volatile currencies. It was a big issuance week for the Treasury, so the nominal yield movement was not without motivation. But pundits jumped all over inflation expectations too.

It could be that the breakeven rate (see Chart 1 below) continues to increase beyond its historical average. But, thus far we are only seeing a normalisation of inflation expectations congruent with the recovery of broader money markets. This shift should not surprise since consensus economic forecasts never visited deflationary territory – the Fed made it amply clear that it would not allow deflation take hold.

US 10 Year Breakeven
Inflation Expectations, Normalising Or Soaring?

If the market process underway was really a surge inflation risk (following a period of deflationary expectation) then I would expect equities to suffer in the short-medium term. The fact that stocks haven’t fallen off a cliff this week supports the normalisation argument. For now, at least, equities are positive about future price levels. But, fundamentally, the normalisation of inflation expectations does not add value to equity markets, since no one was modelling zero or negative terminal value growth anyway.

Looking ahead, there is little sign that the mood of the optimists is breaking. Will they triumph again in June? For most of the data due out in June, I expect a continued improvement of the second derivative – numbers will get worse, but by a smaller degree. This is not really good news, but it might continue to support prices.

The markets could remain buoyant until either the expected recovery fails to start (in 2H09) or until it fails to prove sufficiently virulent (in 1H10). More likely, we will get some kind of correction sooner. What might cause this? Possible drivers include:

- An unexpected rebound of the rates of economic decline. (Something that would not surprise regular MM readers.);

- Acute dislocation of 20th century business structures (so far, for example, it is unclear how the world is going to reduce auto manufacturing capacity);

- Rising treasury yields and a negative reaction to fiscal expansion financing needs. (Although the market might take a look at this risk, the risks of treasuries not getting away are some what alleviated by the fact that the Fed is anyway going to have to increase QE to keep mortgage rates low.)

Many would add inflation, but I am not there yet. I agree of course that inflation will remain a monetary phenomenon, and I see capacity for dollar weakness causing some natural inflation, but I do not see it being sufficient to choke the economy. If anything, it is likely to help the US trade balance improve – one of the key restructuring changes that we need to see at this time.

Coming back to the more immediate future, the outlook is mixed. Developed world equities have cooled off recently. If treasuries continue their downward course, then there is a possibility that the momentum will turn. But we are not there yet, for now the upside potential is equally strong, if not so fundamentally justified.

Internationally, markets continue to rise on the decoupling trade. This trend has clearer momentum. It is being fed now by international long-only funds receiving new money and anxious not to under-perform. Fundamentally, the case is less clear – yes I believe emerging markets will lead us out of the global recession, but we are definitely not there yet. And a lot of tough structural adjustments have yet to come.

But, with such momentum underway there is a clear case not to get off the train until it stops. Yes you will lose something on the downside, but there’s no telling how much gain you will miss if you sell early.

The first week of the month is always a big one for data releases. Here are some of the key data points we are watching this week:

Monday
US – Motor Vehicle Sales (May), Personal Income & Spending (April), ISM Manufacturing (May), Construction Spending (April). Car sales are expected to stabilise at levels well below basic replacement volumes. Personal income and spending are key concerns as primary economic drivers. The data due today are likely to remain negative, although consensus outlooks are quite mixed – these data could move the market. ISM Manufacturing information is also gaining importance as economists look to other sectors in the face of a consumer slowdown, the data due today is expected in line with the previous month. It will matter if this number meets or exceeds expectation. Construction Spending numbers will reflect the extent to which the economy has yet to stabilise.
Europe – Manufacturing PMI (May). Moderate improvement expected, but short of the recovery that we still need in the global inventory cycle.

Tuesday
US – Pending Home Sales (April). While the flow of transactions matters, investors may care more about levels of foreclosed sales, and about how rising mortgage rates threaten future sales trends.

Wednesday
US – Factory Orders (April), ISM Non-Manufacturing (May). Both factory orders and ISM Non-Manufacturing data are expected to decline again this month, although not by much surprises will impact equities.
Europe – Services PMI (May), 1Q09 GDP, PPI (April). Look for deflating PPI, and continued declines in GDP and PMI. A bearish set up for Thursday’s ECB meeting then.

Thursday
US – Non-Farm Productivity (1Q09), Unit Labour Costs (1Q09). Both numbers remain in healthy positive territory, but by Thursday the market will be more concerned about Friday’s jobs data.
Europe, UK – Interest Rate Decisions. Rates of course won’t move, but expansion of QE is possible in both cases.

Friday
US – Non-Farm Payrolls, Unemployment (May), Consumer Credit (April). Ignore any suggestions that less new non-farm job losses represents progress. The market still expects half a million jobs to have gone in May. And unemployment is now likely to have passed the 9% level. Generally bearish data.