September’s Start Gives Investors Whiplash

September’s Start Gives Investors Whiplash

The markets closed last week in a bullish mood on the news that (stop me if you’ve heard this one before) the US and China will be back at the negotiating table in October. You don’t say! Oh but this time we have schedules and a list of attendees so it is totally different.

h/t @StockCats

The past three days of bullishness have been in sharp contrast to the chaos of August during which global stock markets lost around $3 trillion in market cap thanks to the ongoing trade wars and more data pointing to global slowing. As of Friday’s close, over the past year, the S&P 500 is up 3.7%, the Nasdaq 2.5%, Dow Jones Industrial Average up 3.4%, the NYSE Composite Index up 0.17% and the Russell 2000 is down -12.1%. During August 2,930 acted as a resistance level for the S&P 500 multiple times, but the index managed to break through that level last week, which is typically a bullish signal.

As the markets have taken an immediate about-face on the reignited hopes for progress in the trade wars, we’ve seen a profound flip-flop in equity performance which gave many a portfolio whiplash.

  • Those stocks with the lowest P/E ratios that were pummeled in August are up an average of 5.3% since last Tuesday’s close.
  • The stocks that held up best in August are barely breakeven over the final three trading days last week while those that were soundly beaten down in August are up the most so far in September.
  • Stocks with the most international revenue exposure are materially outperforming those with primarily domestic revenue exposure.

While corporate buybacks have been a major source of support for share prices in recent years, corporate insiders have been big sellers in 2019 selling an average of $600 million worth of stock every trading day in August, per TrimTabs Investment Research. Insider selling has totaled over $10 billion in five out of the first eight months of 2019. The only other time we’ve seen so much insider selling was in 2006 and 2007.

Bonds

August saw an additional $3 trillion of bonds drop into negative territory. We are now up to $17 trillion in negative-yielding bonds globally, with $1 trillion of that corporate bonds – talk about weak growth expectations! We also saw the yield on the 30-year Treasury bond drop below the dividend yield for the S&P 500 recently. The last time that happened was in 2008.

The yield on the 10-year Treasury dipped below the 2-year multiple times during the trading day in August but closed for the first time inverted on August 26th. August 27th the spread between the 10-year Treasury yield and the 2-year rate fell to negative 5 basis points, its lowest level since 2007. Overall the yield on the 10-year Treasury note fell 52 basis points during the month of August – that’s a big deal. The last time we saw a fall of that magnitude in such a short period of time was in 2011 when fears of a double-dip recession were on the table. Currently, the real yield on US 10-year is sitting in negative territory which says a lot about the bond market’s expectations for growth in the coming years. Keep that in mind as you look at the PE multiple for the S&P 500 after having two consecutive quarters of contracting EPS.

A growing number of countries have their 10-year dropping into negative territory:

  • Switzerland first in January 2015
  • Japan in February 2016
  • Germany and Netherlands in the Summer of 2016
  • Finland and Denmark in the Fall of 2016
  • Ireland, Latvia, Slovakia, Belgium, Sweden, Austria, France all negative

The US is now the only nation in the developed world with any sovereign rate above 2% (h/t @Charlie Bilello). My bets are that we are the outlier that won’t stay an outlier indefinitely.

Recently the Italian 10-year bond dropped to new all-time lows as Cinque Stelle (5 Star) movement managed to team up with the center-left Democratic Party of former Prime Minister Matteo Renzi. Don’t expect this new odd-couple coalition to last long as these two parties have basically nothing in common save for their loathing of Matteo Salvini and the League, but for now, the markets have been pacified. These two parties detest one another and were trading insults via Twitter up until about a month ago. This marriage of convenience is unlikely to last long.

The European Central Bank meets on September 12th, giving them one week head start versus the Federal Reserve’s Open Market Committee meeting, which is September 17th & 18th, kicking off the next round of the central bank race to the bottom. The ECB needs to pull out some serious moves to prop up Eurozone banks, which are near all-time lows relative to the broader market. We’ll next hear from the eternally-pushing-on-a-string Bank of Japan on September 19th.

Currency

Dollar Strength continues to be a problem across the globe. The US Trade Weighted Broad Dollar Index recently reached new all-time highs, something I have warned about in prior Context & Perspective pieces as being highly likely. It’s happened and this is big – really big when you consider the sheer volume of dollar-denominated debt coming due in the next few years and that this recent move is likely setting the stage for significant further moves to the upside.

In the context of the ongoing trade war with China, the renminbi dropped 3.7% against the dollar in August, putting it on track for the biggest monthly drop in more than a quarter of a century as Beijing is likely hunkering down for a protracted trade war with the US, despite what the sporadically hopefully headlines may say.

Make no mistake, this is about a lot more than just terms of trade. This is about China reestablishing itself as a major player on the world stage if not the dominant one. For much of the past two millennia, China and India together accounted for at least half of global GDP. The past few centuries of western dominance have been a historical aberration.

As the uncertainty around Brexit continues to worsen (more on this later), the British pound last week dropped to its lowest level against the dollar in 35 years, apart from a brief plunge in 2016 likely for technical reasons.

Domestic Economy

The US economy continues to flash warning signs, but there remain some areas of strength.

The Good:

  • Consumer Spending rose +0.4% month-over-month in July, beating expectations for an increase of +0.3%.
  • Average hourly earnings for August increased by 0.4% month-over-month and 3.2% year-over-year, each beat expectations by 0.1%.
  • ADP private nonfarm payrolls increased by 195,000 in August versus expectations for 148,000.
  • Unemployment rates for black and Hispanic workers hit record lows.
  • The prime-age (25-54) employment-population ratio hit a new high for this business cycle, still below the peak of both the prior and 1990s expansion peaks, but still an improvement.
  • While employment growth is slowing, jobs continue to grow faster than the population.
  • Despite the weakest ISM Manufacturing report in years, the ISM Non-Manufacturing report painted a much rosier picture of at least the service sector. While expectations were for an increase to 54.0 from 53.7 in July, the actual reading came in well above at 56.4. In contrast to the ISM Manufacturing report, New Orders were much stronger than the prior month and only slightly below the year-ago level.
  • The Citi Economic Surprise Index (CESI) has continued to recover, moving above zero (meaning more surprises to the upside than down) for the first time in 140 days after having been in negative territory for a record 357 days.

The Bad:

  • Nonfarm payrolls increased by only 130,000 versus consensus estimates for 163,000 and only 96,000 of those jobs came from the private sector – the slowest pace since February. Both July and June job figures have been revised lower, which is basically what we have been seeing in 2019. A long string of revisions to the downside means there is a material shift in the labor market. Total nonfarm payroll employment increased by 130,000 in August.
  • Job growth has averaged 158,000 per month in 2019, below the average monthly gain of 223,000 in 2018.
  • University of Michigan Consumer Confidence survey total contradicted the Conference Board’s findings with its main index falling the most since 2012 in August, dropping to the lowest level since President Trump took office. Concerns over tariffs were spontaneously mentioned by 1/3 of the respondents. The most concerning data from the survey where Household Expectations for personal finances one year from now experienced the biggest one month drop since 1978, falling 14 points.
  • Consumer spending doesn’t look so great when you look at the drop in the Personal Savings rate from 8.0% in June to 7.7% in July, which means that 75% of the increase in spending was at the cost of savings. Net income only rose 0.1% in nominal terms in July versus expectations for a 0.3% increase – not at all consistent with the narrative of a strong labor market.
  • The Chicago Fed’s Midwest state economy survey found that the number of firms cutting jobs rose to 21% in August from just 6% in July while those hiring dropped to 25% from 36%.
  • The Quinnipiac University poll found that for the first time since President Trump took office, more Americans believe the economy is getting worse (37%) than believe it is improving (31%).
  • Camper van sales dropped 23% year-over-year in July. This has historically been a pretty accurate leading indicator of future consumer spending.
  • The Duncan Leading Indicator (by Wallace Duncan of the Dallas Fed in 1977) has turned negative year-over-year for the first time since 2010. A Morgan Stanley study found that when this indicator has turned negative, a recession began on average four quarters later, with only one false positive out of seven going back to the late 1960s.
  • While expectations were for the ISM Manufacturing Index to increase from 51.2 to 51.3 in August, the reading came in at 49.1 (below 50 indicates contraction), the fifth consecutive monthly decline in the index and the first time the index has dropped into contraction in three years. Even worse, the only sub-index not in contraction was supplier deliveries. New Orders (the most forward-looking of all sub-indices) hasn’t been this weak since April 2009.
  • Durable Goods New Orders and Sales are improving but remain in contraction territory while Inventories are rising at around a 5% annual pace – that’s a problem.
  • US Producer Prices experienced their first decline in 18 months.
  • The Atlanta Fed’s GDPNow estimate for the third quarter has fallen to 1.5%.

The Ugly:

  • US Freight rates have fallen 20% from the June 2018 high. Even more dire warning comes from freight orders, which dropped 69% in June from June 2018.

Europe

That nation that has been the region’s strongest economy is struggling as the fallout from the US-China trade war expands around the world.

  • The German unemployment rate rose for the fourth consecutive month.
  • German retail sales took a bigger battering than expected in July, falling 2.2% from June to reveal the biggest drop this year in the latest indication that Europe’s largest economy may well slide into recession. Since February, monthly retail sales figures have either declined or been flat, with the exception of the 3% gain in June.
  • A recent survey revealed that employers are posting fewer jobs, intensifying fears that the downturn in the country’s manufacturing industry has spread into the wider economy.
  • Manufacturing orders came in weaker than expected, declining -5.6% versus expectations for -4.2%.
  • Construction activity has contracted at the fastest rate since June 2014.
  • Germany’s export-dependent economy shrank 0.1% in the second quarter while the central bank warned this month that a recession is likely.

The rest of Europe continues to weaken.

  • Italian industrial orders fell -0.9% in June, making for a -4.8% year-over-year contraction
  • French consumer spending is up all of +0.1% year-over-year.
  • Spain’s flash CPI has fallen from 0.5% year-over-year in July to 0.3% in August year-over-year.
  • Switzerland’s year-over-year-GDP growth has fallen to 0.2% versus expectations for 0.9% – treading water here.
  • Brexit has turned into an utter mess as Prime Minister Boris Johnson has lost his majority in Parliament. Novels could and likely will be written on this mind-boggling drama in what was once one of the most stable democracies in the world. Rather than put you through that, as they say, a picture is worth a thousand words.

The challenge for anyone negotiating terms for Brexit with the Eurozone basically comes down to this.

Talk about a Sisyphean effort

Understanding this impossible reality, here is what to expect in the coming weeks.

For those who may not be convinced that this is a material problem, this is an estimate of the impact of a hard Brexit on the Eurozone alone.

Bottom Line

Around 70% of the world’s major economies have their Purchasing Managers Index in contraction territory (below 50) – that is a lot of slowing going on. Much of the world is drowning in debt with excess productive capacity – a highly deflationary combination.

We are witnessing a major turning point in the global economy and geopolitical landscape. The past 60 post-WWII years have primarily consisted of US economic and military dominance, increasing levels of globalization and relatively low levels of geopolitical tension.

Today we are seeing a shift away from an optimistic world of highly interconnected global supply chains towards one driven by xenophobia and nationalism. We are seeing rising economic and political tensions between not only traditional rivals but also between long-term allies. In the coming decades, the US economy will no longer be the singular global economic and military powerhouse, which will have a material impact on the world’s geopolitical balance of power.

The big question facing investors is whether the US and much of the rest of the world are heading into a recession. Many leading indicators that have proven themselves reliable in the past indicate that this is highly likely but today really is different.

Never before in modern history have we had these levels and types of central bank influence. Never before have we had such a long expansion period. Never before have we had this much debt, particularly at the corporate level. Never before have we had such profound demographic headwinds. On top of all that, we have a directional shift away from globalization that is forcibly dismantling international supply chains that were decades in the making with no clarity on future trade rules.

Will central bankers be able to engineer a way to extend this expansion? No one who is intellectually honest can answer that question with a high level of confidence as we are in completely uncharted territory. This means investors need to be agile and put on portfolio protection while it remains relatively cheap thanks to historically low volatility levels.

I’ll leave you with a more upbeat note, my favorite headline of the week.

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.