RECESSION FEARS
Recession fears have been tilting investor sentiment for the past two years making the longest bull market in history the least loved bull market in history. Leaders of the world’s central banks were meeting last week in Jackson Hole Wyoming to discuss monetary policy – possibly joint policy – that could ease recession tensions. The challenge as opined by Fed Chairman Jerome Powell, was and continues to be, attempting to advance policy without a playbook. There is simply no Fed action that can offset the damage caused by trade wars.
It doesn’t help when President Trump elevates tension with ill-timed Tweets…
As usual, the Fed did NOTHING! It is incredible that they can “speak” without knowing or asking what I am doing, which will be announced shortly. We have a very strong dollar and a very weak Fed. I will work “brilliantly” with both, and the U.S. will do great…
— Donald J. Trump (@realDonaldTrump) August 23, 2019
…My only question is, who is our bigger enemy, Jay Powell or Chairman Xi?
— Donald J. Trump (@realDonaldTrump) August 2
From my perspective it is much easier to share the Tweet because there is nothing one can add to separate the text of the message from his narcissistic tendencies.
To Chairman Powell’s credit, he acknowledged during his keynote address at Jackson Hole, that the shorter-term challenges facing the U.S. economy have gotten tougher since the July 31st Federal Open Market Committee (FOMC) decision to cut rates by 25 basis points.
“The three weeks since our July FOMC meeting have been eventful, beginning with the announcement of new tariffs on imports from China,” Powell said.
Powell listed several other headlines as contributing to a “complex, turbulent” picture: slowdown in Germany and China, and geopolitical events like the growing possibility of a hard Brexit and the escalating tensions in Hong Kong. He also mentioned that equity markets have been “volatile.”
Still, Powell believes the U.S. economy is performing well, citing consumer spending as the main driver. Although Powell said job creation has “slowed from last year’s pace,” inflation “seems to be moving up closer” to the Fed’s 2% target.
What we can glean from the Jackson Hole speech is the mixed signals coming from the US economy. In that light, it seems that future FOMC meetings will manage interest rates based on the incoming data. We look for a 25 basis-point cut in September and put the odds at 60-40 in favor of another quarter point cut at the December meeting.
Opening a new Playbook
We understand investor’s concern over a looming recession. Aside from Trump’s grandstanding and Powell’s commentary, there are disconcerting data points;
- We are witnessing the longest running bull market in history which implies that it is getting long in the tooth.
- The yield curve is at best flat and for periods has been inverted. The 10 year over two-year US Treasuries have inverted six times in the previous two weeks.
- Nearly 25% of the world’s high-quality debt is trading with negative yields.
- There are muted inflation expectations
- There is an unmistakable global slowdown because of Trump’s trade war with China and threats of additional trade skirmishes with the EU. Germany’s negative growth in the last quarter is concerning.
- As we near the October 31st deadline, a hard Brexit looks to be the most likely scenario.
It’s clear from the data points that here is abundant evidence underpinning a recession thesis. But our take is that a recession is not as likely as the evidence would suggest. To make the point we will tackle the data points in order of presentation.
Long in the tooth bull market
There is no debate that the current bull market is the longest in history. However, valuations have not risen in a straight line and have been supported by periodic pauses (corrections) along the way. The fallout in the fourth quarter of 2018 is a case in point as is the decline among tech names in the fourth quarter of 2017.
Further evidence can be found in the market’s performance since February 2018. A quick review of figure 1 we can see that the S&P 500 Depository Receipts (symbol SPY, the ETF that tracks the S&P 500 composite Index) which is the best proxy for the US market is trading at levels that were in place eighteen months ago.
Between February 2018 and today, we have witnessed sharp sell offs, and record all time highs but, what we have really seen, is a market stuck in an expanding trading range. Similar results can be found in the price weighted Dow Jones Industrial Average and the NASDAQ 100 Index. This price action substantiates an unresolved tug of war between bulls and bears. It also supports the correction analogy. Earnings rise, stocks prices fall leading to a contraction in price to earnings multiples.
In what has been the most unloved bull market in history we are bearing witness to equity indexes climbing the proverbial wall of worry. Even now, analysts are stoking the fear gauge pointing to heightened volatility, negative interest rates on a quarter of the world’s highest rated debt and the potential for an inverted yield curve in the US. Which, by the way, Trump also blames on FED Chairman Powell.
Listening to the talking heads on the financial networks leaves little doubt that volatility has returned. And while that is true to a point, recent readings on the CBOE Volatility Index (symbol VIX; the market’s proxy for risk) are nowhere near what I would consider indicative of red line risk. At the time of writing the VIX at 19.87 is not far from its’ 200-day moving average around 16.75. The VIX is well off recent highs of 26 in early August and 35 in December 2018 (see figure 2).
So why the disconnect with investor fear and volatility metrics? In our mind, the disconnect reflects misguided assumptions about risk. Investors perceive that the market has a put option paid for by the FED or manipulated through supportive Presidential Tweets. Which is to say the market variability is more noise than substance.
Noise tells us very little about value and even less about risk. What it does is cause investor sentiment to shift from bullish to bearish at the whim of short-term swings driven by obscure algorithms. None of which produces a positive outcome. Bottom line, the US market is not in a death spiral. To get to that point we need more than Tweets from a fractured President.
Inverted Yield Curve, Negative Interest Rates and Muted Inflation
In our mind, points 2, 3 and 4 above are inter-connected. An inverted yield curve has preceded seven of the last seven recessions. However, and we don’t get to say this often, “this time it’s different.”
We believe the inverted US Treasury yield curve is a direct result of negative yields on 25% of the world’s prime debt. We are witnessing a flight to quality from global institutional investors who are seeking yield from an issuer with the strongest currency. Buying debt with a positive yield effectively strengthens the currency which makes it more difficult to engage in a tariff driven trade war. Most likely why Trump is so adamant about getting the Fed to cut rates.
The negative interest rate story is something we have never seen before and why this environment is different. Our take is that negative interest rates are the market’s version of inflation. When you think about inflation in its purest form, it is the devaluation of paper currency. Normally we see currency devaluation in terms of purchasing power… goods and services become more expensive diminishing the buying power of paper currency. In that light, inflation remains below trend. But looking at inflation through a different lens… say, one that magnifies the impact of demographics, we uncover some interesting twists.
We know that millennials are the single largest cohort in terms of numbers. However, millennials are not the largest in terms of purchasing power. When you multiply the size of a cohort by the average net worth, baby boomers occupy top spot in terms of purchasing power. And this cohort has a very different agenda.
Baby boomers are not particularly interested in discretionary items and would rather spend disposable income on entertainment, restaurants, home renovations and travel. From an investment perspective, this group is keenly interested in yield. They have sizable net worth (average net worth of Canadian families over 65 is $845,600) and generally invest for income.
Now look at interest rates as another proxy for inflation. We suspect the surge in demand from yield hungry investors has depressed interest rates to the point where nominal returns on Canadian and US Treasuries guarantee a loss of purchasing power over time. The enormity of high-quality debt yielding less than zero sheds a light on how interest rates or lack thereof, have led to extreme devaluations of paper currency. Or in a word… inflation!
Impact of the Global Slowdown
There is little doubt that China’s economy is weakening, the European Union is teetering on recession and Japan can’t seem to gain momentum. Most worrisome within the EU is the slowdown in Germany which experienced negative growth in the last quarter and among analysts, there is concern that a second quarter of negative growth is in the offing. Two quarters of negative growth is the definition of a recession and Germany is the main pillar within the EU.
Slowing growth in China has more to do with tariffs than with a change in domestic policy. In many ways China and the US are similar in that they have a large consumer base with a growing middle class. China is well positioned domestically and has the fiscal tools to manage any downturn. In short, they can survive a protracted trade war which lest we forget, is being driven by a President intent on shooting himself in the foot.
We think the trade war is likely to continue for some time. We see little chance of a resolution prior to the next US election. After that, depending who wins the US Presidency and whether cooler heads prevail (unlikely with Trump unless Apple President Tim Cook can convince him to rethink his position), will dictate how long the trade war lasts.
What we do know is that the motives underpinning the trade war are fracturing. The original intent was to get China to change their approach to intellectual property rights. That may not be an insurmountable problem as China has developed a strong technology base and like the US, has a keen interest ensuring their intellectual property rights are protected. The two sides simply need to find a way to cool the rhetoric and set in motion a win-win solution.
Germany is a different animal. Germany is a manufacturing economy that depends on trade. But that is not necessarily the lynchpin that will lead to a US recession. The key is to understand that an economy based on manufacturing is volatile. When you restrict supply lines excess capacity gets wrung out of the system making a recession more likely. The same cannot be said about a service-based economy.
And there’s the rub. The US is a service economy – 70% of US GDP come from service industries – and efforts by President Trump to reignite the manufacturing sector have not fared well. And it won’t likely in the future, because the US has been moving away from manufacturing as their core driver of growth. Today, the US economy is propelled by technology (considered a service sector), entertainment, travel and restaurant sales.
On the positive side, a service-based economy is less volatile. Given the propensity of US consumers to spend and US demographics – wealthy baby boomers – it is less likely that the US economy will suffer a recession resulting from a global slowdown. Moreover, every previous US recession was the result of domestic dislocations. Never has a US recession been imported from global constraints and we do not think that will change in the current environment.
A Hard Brexit
The final component underlying recessionary fears is a hard Brexit. When you consider that Britain is the world’s fifth largest economy, it is hard to imagine that a hard exit from the EU will not have serious consequences for both sides.
However, we think the ensuing dislocations will be contained within Britain and the EU. We also think that the tentative hold Boris Johnson has in the British parliament, will cause him to return to the negotiating table. In time Britain and the EU will survive the divorce, and we think it unlikely the spillover effect will push the US into a recession. Since the US is our major trading partner, any muted impact should also insulate Canada from a worst-case scenario.
Summary
Our clients need to understand that the thesis presented in this commentary is not consistent with base case forecasts. That’s not a bad thing, but it is helpful to know where we stand relative to the market.
For the remainder of 2019 our best case for the S&P 500 Composite Index is that it remains within a trading range framed by 2800 to the downside and 3100 on the upside. We see trading ranges as corrections from a different perspective. The end goal is to reset the earnings yield for stocks (the reciprocal of the price to earnings ratio) relative to the yield on ten-year US Treasuries.
We could also accomplish a market reset if yields continue to decline (i.e. bond prices continue to rise). In that scenario, stocks could remain where they are and through osmosis, the earnings yield would normalize as Treasury yields decline.
Another point that was not mentioned is the impact the trade war is having on corporate investment. In a recent interview, James Bullard a voting member of the FOMC, talked about the slowdown in corporate investment. Executives have been telling him that they were reluctant to make major long-range investments when, at any moment, the business and logistical environment could change at the whim of the President. Moreover, explained Bullard, the FED has no tools that can offset the impact of a protracted trade war.
Corporate executives realize that, and we suspect traders will succumb to the same view, at some point. In the meantime, we think US corporations will funnel their excess capital away from infrastructure and into buybacks and dividend increases. This continued use of financial engineering will go a long way towards providing a foundation or floor to underpin market valuations. Something the Fed cannot provide if market sentiment is being goaded by toxic trade rhetoric.