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.

Consumer Confidence & LEI’s Flash Warning

Consumer Confidence & LEI’s Flash Warning

Consumer Confidence for September declined a bit more than expected, falling to 119.8 from 120.4, versus expectations for a decline to 120. While that doesn’t sound all that meaningful as it is still well above the long-term average of 93.9, we see something occurring beneath the headlines that warrants further attention and is particularly concerning – relative confidence levels by age group.

 

As one would expect, confidence among younger consumers is almost always better than amongst older consumers, (less time alive means less time for regrets and a perception of more time to accomplish one’s goals) which is why this month’s Consumer Confidence report is so remarkable. This month middle-aged consumers, those 35-54 years of age, have a higher level of confidence at 128.2 than younger consumers, those under 35 years of age, who have dropped to 120.9 from 126.6. This divergence is quite rare, but even more concerning is the magnitude of the reversal. Going all the way back to 1980, the negative 7.1 spread in confidence between those middle-aged and those in the younger cohort has never been greater. The low rates of household formation coupled with the well above average rates of college grads living with mom and dad put the Millenial generation deep in our Cash Strapped Consumer investing theme.

 

We also saw something with respect to confidence levels by income that could be a concern for the current administration. While confidence levels for consumers with incomes over $50,000 and those with incomes under $35,000 rose, confidence for consumers with incomes between $35,000 and $50,000 dropped to the lowest level since last October. Given that a large portion of President Trump’s base is in that cohort, don’t expect to see an improvement is his approval ratings anytime soon.

For investors, this means that President Trump may have an even more difficult time passing the legislation he promised on the campaign trail. Low approval ratings make it less appealing for legislators to reach across the aisle and increase the perceived potential risk versus reward for those in his own party to be staunch supporters of any Trump-led legislation. Repeal/replace of Obamacare and tax reform, let alone that much-promised infrastructure spending is more challenging when fewer and fewer support the current administration.

 

The Consumer Confidence report also revealed weaker plans to spend, with autos falling to a 14-month low and housing dropping to 6.9 from 7.3. On the other hand, the trend to remodel versus trade up continues as plans to buy a major appliance jumped to 54.0 from 50.5, the highest level since May 2009. This bodes well for shares of Home Depot (HD) and Lowe’s (LOW).

 

The Chicago Fed National Activity Index (CFNAI) gave us ample cause for concern as 50 of the 85 variables it measures across the national economy were in contraction mode for August with the 3-month moving average dropping to -0.04 in August from +0.15 in June. Personal Consumption & Housing was in the red at -0.06 and has now been negative for 123 consecutive months – more evidence of our Cash Strapped Consumer.

 

Finally, the ECRI leading index smoothed growth rate has fallen for seven consecutive weeks, stalling last week after having growth at nearly a 12% pace at the beginning of 2017. We haven’t seen growth this weak since March of 2016.

 

The bottom line is we see a continued disconnect between sentiment, the hard data and the market’s enthusiasm coupled with a profound “meh” when it comes to political and geopolitical risks. However, as we noted earlier, expensive stocks can get more expensive and the market isn’t giving us any signs of an imminent reversal, particularly as we see an increasing number of stocks moving above their 50-day moving averages.

Consumer Sentiment Closer to Economic Reality than Blankfein?

Consumer Sentiment Closer to Economic Reality than Blankfein?

The CEO and Chairman of Goldman Sachs (GS), Lloyd Blankfein, is arguably one hell of a sharp fellow, which leads us to believe there are reasons behind this that go beyond a straightforward assessment of the economy.

Perhaps consumers see something different than what we hear in the mainstream financial media. The University of Michigan’s Consumer Sentiment Index dropped to 94.5 in June, which was well below expectations for 97.1.

Let’s start with a look at the Citi Economic Surprise Index, better known at the “CESI,” which has hit a multi-year low.

While US stocks look to have decoupled recently from this measure.

But we’re sure that stock prices aren’t anything to worry about. 🙄

The Cyclically-Adjusted Shiller P/E ratio today sits at 29.95, just shy of the 32.54 peak from 1929. The fact that this metric has only been at these levels twice in history, just prior to the Stock Market Crash of 1929 and again before the bursting of the DotCom bubble, is likely immaterial – so say those who derive their paychecks from investors staying fully invested. 🙄🙄

One other thought for those so inclined, in 1929 the Fed rate was at 6 percent – that’s a lot more room to move than we have today.

As we head into the summer driving season, US crude oil stockpiles declined much less than expected while gasoline inventories have actually increased over the past two weeks versus expectations for a decline. Gasoline stockpiles are now above the 5-year average for this time of year as gasoline demand has unexpectedly fallen to well below last year’s level.

According to a recent Bloomberg study, back in March, 31 percent of economists were boosting their GDP forecasts. Today 27 percent are cutting them.

US CPI recently disappointed to the downside, coming in at 1.87 percent versus expectations for 2 percent. Core CPI came in at 1.73 percent versus expectations for 1.9 percent and the 3-month moving average of year-over-year change for Core CPI indicates that this key measure of inflation is rolling over to an impressive degree. This puts that Fed rate hike into a different light!


Used car and truck prices have rolled over hard and are continuing to drop significantly.

Housing has also rolled over, both for multi-family…

and single family…

 

According to the U.S. Commerce Department, housing starts declined 5.5 percent in May, after falling in April and March. Building permits fell 4.9 percent.

The cost of putting a roof over one’s head rolling over has rolled over as well.

The cost of medical care has also rolled over.

While retail sales growth is still pretty decent, it has been declining since early 2015.

Restaurants and bars are having a hell of a tough time, with their businesses experiencing a more severe decline, over the past two years.

Manufacturing inventories remain frustratingly elevated. That is basically capital sitting on the shelves, earning nothing and in many cases wasting away.

 

With elevated inventory levels, not a big surprise to see that U.S. factory output fell in May as manufacturing production dropped 0.4 percent, the second decline in the past three months. Overall factory output was lower in May than in February. Output fell across a wide range of industries, from motor vehicles and parts production to fabricated metal. Manufacturing capacity utilization fell 0.3 percent in May with overall industrial capacity utilization falling 0.1 percent. Where’s the accelerating growth?

There is some good news for a segment of the economy. Online sales continue to command a greater and greater portion of retail sales as our Connected Society intersects with the Cash Strapped Consumer where online shopping is not only fun from one’s couch, but it is a lot easier to compare prices and get the best deal for families concerned with watching their pennies in an economy with weak-to-no wage growth.

The bond market is not telling a tale of accelerating growth, with the 30-year Treasury yield now back where it was in November.

30 Year Treasury Rate Chart

While the 10-2 Year Treasury yield spread is back down to where it was in late 2007.

10-2 Year Treasury Yield Spread Chart

The 30-10 Year Treasury yield spread is also showing a flattening yield curve – more signs of an economy that is do anything but accelerating to the upside.

30-10 Year Treasury Yield Spread Chart

Finally, we have the Bloomberg Commodity Index heading back towards those lows from early 2016, not exactly an indicator of accelerating demand.


Here at Tematica, we are a fairly jovial bunch, with innately optimistic personalities, but we let the data first do the talking and that data is giving us a plethora of warning signs.

Turns out, we aren’t alone in our skepticism as the New York Federal Reserve now expects the economy to grow at an annualized rate of just 1.9 percent in the second quarter!