The Magic 8-Ball Market

The Magic 8-Ball Market

Last week ended with equity markets taking another dive that accelerated into Friday’s close as the trade war with China intensified heading into its eighteenth month with China announcing that it will impose retaliatory tariffs on US goods. The S&P 500 closed down 2.5% for the third time this month. After the close President Trump launched a twitter storm to announce additional retaliatory tariffs in response to China’s. So that’s going well.

Investors face challenging times as the major market movers have simply been words (tweets) coming from politicians and bureaucrats, the prediction of which is akin to assessing the next missive from a Magic 8-Ball.

While many continue to talk about the ongoing bull market, the major US equity market indices have seen four consecutive weekly declines and are all in the red over the past year with the small cap Russell 2000 down well over 10%, sitting solidly in correction territory. On the other hand, this year has seen the strongest performance out of long-maturity Treasuries since at least 1987.


Source: Bespoke Investment Group

How many bull markets see the total return for the long bond outpace the S&P 500 by over 16%.

This comes at a time when the domestic economy is in it 121st month, the longest is post-war history, which means that many have not lived through a recession as an adult.


Yield Curve

As the adage goes, expansions don’t die of old age, but their footing becomes less sure over time and we are seeing signs of rockier terrain. One sign comes from the yield curve which has been flattening steadily since October 2018 with the spread between the 10-year and the 3-month falling from over 100 basis points to -39. The most widely watched part of the curve, between the 10-year and 2-year, has inverted four times in the past few weeks.


This 2-10 inversion is most closely watched as over the past 50 years it has preceded all seven recessions. Credit Suisse has found that on average a recession hit 22 months after the 2-10 inversion occurred.

The third of August’s four inversions came as Kansas City Federal Reserve President Esther George and Philadelphia Fed President Patrick Harker stated in a CNBC interview that they don’t see the case for additional interest rate cuts following the cut in July. Mr. Market was not looking to hear that.

This past week we also received the meeting minutes from the prior Fed meeting with led to July’s 25 basis point cut which gave the impression of a Fed far less inclined to cut than the market was expecting with most Fed participants seeing July’s cut as part of a recalibration but not part of a pre-set course for future cuts. Keep in mind that central bank rate cuts are a relative game and ECB officials have been signaling a high likelihood of significant accommodative measures at the September meeting, saying the ECB “will announce a package of stimulus measures at its next policy meeting in September that should overshoot investors’ expectations.”

Manufacturing

Another source of bumps on the economic road comes from the manufacturing sector, both domestic and international. A recent IHS Markit report found that the US manufacturing sector is in contraction for the first time in nearly a decade as the index fell from 50.4 in July to a 119-month low of 49.9 in August – readings below 50 indicate contraction.

According to the Institute for Supply Management, US manufacturing activity has slowed to a nearly three-year low in July. By August New Orders (a key leading indicator) had dropped by the most in 10 years with export sales falling to the lowest level since August 2009.

New business growth has slowed to its weakest rate in a decade, particularly across the service sector. Survey respondents mentioned headwinds from weak corporate spending based on slower growth expectations both domestically and internationally – likely caused by the ongoing trade war that got much, much worse this past week.

In a note to clients on August 11th, Goldman Sachs stated that fears of the US-China trade war leading to a recession are increasing and that the firm no longer expects a trade deal between the two before the 2020 US election. The firm also lowered its GDP forecast for the US in the fourth quarter by 20 basis points to 1.8%.

Global manufacturing has also been slowing, with just two of the G7 nations, Canada and France, currently showing expansion in the sector. In July, China’s industrial output growth slowed to the weakest level in 17 years.

Germany is seeing the most pronounced contraction with its manufacturing PMI dropping from 63.3 in December 2017 to 43.6 this month. German car production has fallen to the levels last seen during the financial crisis.

Overall, we see no sign of stabilization in global manufacturing as global trade volumes look to be rolling over, leaving the economy heavily dependent on growth in the Consumer and the Service sectors. Keep in mind that the last time global trade volumes rolled over like this was back in 2008.

The Consumer

The consumer is yet another source of bumps on the economic road. Ms. Pomboy’s tweet is perfect.

As for that debt, Citigroup recently reported that its credit-card delinquency rate had risen to 2.91% in July from 2.56% in June versus its three-month average of just 1.54%. With all the positive stock moves we’ve seen in retail, keep in mind that the story for many has been more about earnings than actual growth.

For example, Nordstrom (JWN) shares rose 21% after it delivered stronger-than-expected earnings, but that was off of weaker than expected revenue of $3.87 billion versus expectations for $3.93 billion. Nordstrom also slashed net sales guidance for the fiscal year as well as earnings guidance. Management forecast net sales for the year to decrease by about 2%. It previously estimated sales would be flat to 2% down. It also slightly lowered guidance on earnings per share to a range of $3.25 to $3.50, compared with the prior guidance of between $3.25 to $3.65. Did I mention shares rose 21%?

US Consumer sentiment fell to 92.1 in August, the lowest reading for 2019, versus expectations for 97 and down from 98.4 in July. If sentiment continues to degrade, how long will the consumer continue to load up credit cards in order to spend?

Debt

It isn’t just the consumer that is taking on more debt – yet more economic bumps. The federal government deficit rose by $183 billion to $867 billion during just the first 10 months of this fiscal year as spending grew at more than twice the rate of tax collections. The Congressional Budget Office expects the annual budget deficit to be more than 1 TRILLION dollars a year starting in 2022. Total public debt, which includes federal, state and local has reached a record 121% of GDP in 2019, up from 69% in 2000 and 43% in 1980.

Keep in mind that debt is pulling resources out of the private sector and at such high levels, fiscal stimulus becomes more challenging in times of economic weakness. The only time debt to GDP has been higher was after WWII, but back then we had relatively young population and a rapidly growing labor force compared to today.

I’ve mentioned before that I am concerned with the strengthening dollar. Dollar denominated on balance sheet debt is over $12 trillion with roughly an additional $14 trillion in off-balance sheet dollar denominated debt – that’s a huge short USD position. The recent resolution of the debt ceiling issue means that the US Treasury now needs to rapidly rebuild its cash position as I had been funding the government through its reserves. This means that we will see a drain on global liquidity from the issue of over $200 billion in Treasury bills.

I’ve also written many times in the past concerning the dangers that lie in the enormous levels of corporate debt with negative yielding corporate debt rising from just $20 billion in January to pass the $1 trillion mark recently – more bumps on the road.

Bottom Line

As I said at the start of this piece, this expansion is the longest in post-war history which doesn’t itself mean a recession is imminent, but it does mean that the economy is likely to be more vulnerable. Looking next at the economic indicators we see quite a few that also imply a recession is increasingly likely.

The President’s twitter storm in response to China’s tariffs and the continually rising geopolitical uncertainties that create a strong headwind to any expansions in the private sector only increase risks further. Perhaps by the time you read this piece some part of the rapid escalation of the trade war will have been reversed, as foreign policy has become increasingly volatile day-to-day, but either way, the view from here is getting ugly.

We Aren't Out of the Woods Yet

We Aren't Out of the Woods Yet

The growth of an economy is dependent primarily on just two factors, (1) the quantity and quality of the labor pool and (2) the amount of available investment capital. With the current unemployment rate, clearly the quantity of the labor pool is not a problem. The quality of that pool is a discussion for another time. So what about the amount of available investment capital? The talk in the investment world is about QE2, and unfortunately they aren’t referring to the Cunard ocean liner. QE2 refers to the second round of “Quantitative Easing” by the Federal Reserve, which is a politically savvy way of describing the Fed printing money. (Please see “U.S. Banking System” on this blog for more details.) At its November 3rd meeting, the Fed is expected to announce the launch of QE2. Expectations are for an initial level of $500 billion, with room for upward revisions. Last week Goldman Sachs opined that $4 trillion is quite possible, according to their analysis using the Taylor Rule, which is a measure of inflation, GDP and the impact of Fed rate cuts. This rule has been fairly spot on so far in tracking the Fed’s rate decisions so their analysis warrants attention.
When credit contracts, the economy is contracting, when credit expands, the economy is expanding. The Fed is hoping that by increasing banks’ ability to lend, it can jump start the economy. Mr. Bernanke is a bit like 49er and Charger fans in the 4th quarter. This time it will be different! Anyone who saw the 49er and Charger games on October 24th understands our pain. For credit to expand, borrowers need to want to borrow, and banks need to want to lend. According to an August 23, 2010 article in the Wall Street Journal, non-financial companies in the S&P 500 are sitting on a record $2 trillion in cash.  Doesn’t sound like the problem is that businesses are lacking the funds necessary to expand, now does it? So what about existing bank reserves? This chart, using data from the Federal Reserve, shows that bank reserves are at record highs, so that seems unlikely as well.

Both corporate and household lending rates are at historical lows. So the lack of borrowing can’t be because the interest rates are too high, yet the Fed is intent on lowering these already historically low rates. Be wary as history shows that excessively low interest rates inevitably lead to asset bubbles as those who have cash desperately seek some place to generate returns.

Household income is showing slight improvements, savings is trending up while spending is trending down. This doesn’t seem to indicate a desire by households to borrow. (The following chart is derived from Data from the U.S. Department of Commerce, Bureau of Labor Statistics)

What is QE2 likely to accomplish? The Fed will once again create money out of thin air and most likely use it to purchase Treasury bonds to send long-term interest rates even lower. If this works, bond yields should fall, the dollar will fall and stocks and commodities should rise. A good deal of this has already been “baked in” to the market, meaning since the markets are convinced Bernanke is going for round two, they’ve already adjusted as if it were a done deal. Shorting the dollar has become a favorite pastime of many market professionals, so we could even see a rally in the dollar if QE2 doesn’t come on as strong initially as some have predicted. In the short run, things could go in a variety of directions, all of which are becoming increasingly difficult to anticipate. In the long run, inflation and potentially high inflation is a real possibility with all this expansion of bank reserves. I recently attended a meeting of the Mont Pelerin Society, (an international organization composed of economists, Nobel Prize winners, philosophers, historians, and business leaders) in Sydney, Australia. A topic of discussion at this conference was the possible destructive consequence of the developed nations’ seeming race towards the bottom through currency debasement. The investing world is becoming a more challenging jungle to navigate as the actions of individuals in governments around the world have increasing impact on the global economy, rather than market fundamentals. This past weekend the finance ministers of the G20 countries met in Korea to discuss “re-balancing the world.” When 20 fallible human bureaucrats, with imperfect knowledge under great political pressure try to impact the world, it usually doesn’t turn out well. For investors a defensive position that does not rely on strong GDP growth or economic stability is in our opinion, a wise choice.

Now how about those banks that Bernanke wants to nudge along with increased reserves? This past week PIMCO, Black Rock, Freddie Mac, the New York Fed, and Neuberger Berman Europe, LTD., collectively sued Countrywide for not putting back bad mortgages to its parent, Bank of America. This is surely the first in a series of suits aimed at getting control of the mortgage-backed security portfolios. Then there is the testimony from Mr. Richard Bowen, former chief underwriter with CitiMortgage given in April to the Financial Crisis Inquiry Commission Hearing on Subprime Lending and Securitization and Government Sponsored Enterprises, (why are government activities always so wordy!?). He stated that, “In mid-2006 I discovered that over 60% of these mortgages purchased and sold were defective. Because Citi had given reps and warrants to the investors that the mortgages were not defective, the investors could force Citi to repurchase many billions of dollars of these defective assets….We continued to purchase and sell to investors even larger volumes of mortgages through 2007. And defective mortgages increased during 2007 to over 80% of production.” Does anyone really believe that Citibank was the only one up to this mischief, and we use the term mischief generously! We could see substantial level of lawsuits launched against these institutions, which would further serve to undermine an already weakened economy.

As for the banking sectors’ recent financial performance, there were mixed results with Bank of America posting a $7.3 billion loss in the third quarter and Goldman Sachs profit down 40% and Morgan Stanley’s profits fell 67%. Regional banks have shown some positive results, but smaller banks continue to close. There have been more than 300 bank failures since the recession began with 132 this year alone. There is considerable opportunity in the banking sector for mergers and acquisitions and all this tumult provides some opportunities, but again, defensive posturing is the name of the game for those investors who want to be successful in the long run.

Consumer confidence, which improved to August to 53.2, dropped to 48.5 in September. According to Lynn Franco, Directors of the Conference Board Consumer Research Center: “September’s pull-back in confidence was due to less favorable business and labor market conditions, coupled with a more pessimistic short-term outlook. Overall, consumers’ confidence in the state of the economy remains quite grim. And, with so few expecting conditions to improve in the near term, the pace of economic growth is not likely to pick up on the coming months.”

Is there any hope? I attended an investment conference in July where Niels Veldhuis of the Fraser Institute discussed the Canadian success story. Canada came through the recent financial crisis with no major bank failures, stronger GDP than the U.S. and the Canadian dollar is now selling at close to par against the USD. It has one of the lowest debt to GDP ratios among industrial nations and one of the fastest economic growth rates since adopting fiscal reforms in 1995. The Heritage Foundation/WSJ Economic Freedom Index ranks Canada No. 7, the U.S. is now at No. 11.

In 1995 Canada faced a crisis similar to the one facing the U.S. today with a downward spiraling currency, huge deficits, a tripling of the national debt since 1965, ballooning entitlements, government spending approaching 53% of GDP, and rampant inflation. The government cut spending by 10% over two years, laid off 60,000 federal workers over three years and eliminated the deficit in two years. For the next 11 years they ran a surplus, cut the national debt in half and reduced the size of government from 53% of GDP to today’s 39% all without raising taxes.

There is hope, but it will require discipline and an end to kick the can down the road solutions. We are positioning our clients to be able to take advantage of and be protected from the inevitable volatility as sovereign nations take actions that are impossible to predict in addressing their economic and financial problems. We are also cognizant of and prepared for impending inflation, that while unlikely in the short-term is highly likely in the longer-term and will be devastating for those who are not prepared.

KEY ECONOMIC METRICS

Gross Domestic Product (GDP): GDP dropped to 1.7% annualized rate in Q2 from 3.7% in Q1 and 5.0% in Q4 of 2009. GDP is expected to remain at 1.5% in Q3 and drop to 1.2% in Q4. Traditional buy-and-hold strategies struggle with such dismal growth prospects.

Unemployment continues to be the biggest economic concern and appears to be stagnating. The Bureau of Labor Statistics reported a rate of 9.6% in September with the number of unemployed persons at 14.8 million, essentially unchanged from August. There are currently 1.2 million discouraged workers, defined as persons not currently looking for work because they believe no jobs are available for them, which has increased by a staggering 503,000 over the past year.

Housing: Mortgage rates have dropped nearly 1% in the past year to a historic low of 4.42% for the 30-year, yet existing home sales dropped a record 27% (measured month-over-month) to an all time low, since data tracking began in 1999, of 3.83 million units at an annual rate. If record low rates cannot stimulating housing, pay attention!

Market Volume: CNBC recently reported that currently 90% of all trading volume in the markets is in 5% of the stocks. This means that a very small number of stocks are moving to manipulate the indices, which calls in question the meaning of the trends. In addition, the majority of the trading that is taking place is now generated by high-frequency computers and these programs can enter more orders in one second than a whole trading room of traders can enter in a month. Just one more reason to maintain a defensive portfolio.