October 8, 2019
Over the past 3, 12 and 18 months there has been a wide dispersion in the returns of various asset classes. US equites remain range-bound while ex-US, stocks continue to ebb. Risk-off assets like bonds and gold have done very well over the past year, while stocks vacillate. Interest rates continue to fall, and inflation expectations are subdued. Earnings growth for the third quarter are expected to be negative year over year, and likely zero growth for full year 2019. US economic data continues to be weak while Eurozone and Asia may be entering a recession. Below are the approximate returns over the 3-month, 12-month and 18-month time frames.
3 mos. 12 mos. 18 mos.
S&P500 1.7% 4.25% 13.5%
Russell 2000 (US small cap) -2.4% -8.9% .5%
Euro Stoxx 600 .8% -.5% -2.4%
Emerging stocks -4.2% -2% -14%
Gold 4% 23.1% 10.4%
Long-bond price (TLT) 8.1% 25.2% 21.8%
Aggregate Bond Index 2.3% 7.5% 9.6%
Economic data in the US continues to roll over. The chart below shows the top three inputs into the LEI (Leading Economic Indicator) as published by the Conference Board. Data continued to slow and is now in contraction in some areas like manufacturing. Payroll growth has declined significantly during 2019. These data points must reverse very soon otherwise we will undercut the 2015 slowdown and increase chances of a recession in the coming months.
We’ve been seeing risk-off assets outperform substantially in recent quarters under the pressure of slowing global economic data and lack of growth in earnings. More recently there are been reports of large-scale rotation from growth stocks (like Consumer Discretionary sector; XLY) to more value-oriented stocks (like Consumer Staples; XLP). Value has begun to outperform growth. While not completely uncommon, it is uncommon to see this while Consumer Confidence is very high. Recently I came across the chart below from Sentimenttrader.com which shows how rare this is.
Discretionary items are what people buy with ‘extra’ money, while Staples are what people need for everyday life. Defensive areas usually outperform only when consumers and investors are less confidence about the future. Only just after the market peak in 1969 (far left side) and the 2000 peak (center) confidence was high (survey results) while defensives were beginning to outperform cyclical stocks. If this rotation continues it may portend tough times for the general stock market.
Why might consumers be confident while investors are buying more defensive stocks over more cyclical stocks is a difficult question. Sentiment is often a lagging indicator. People feel good and optimistic after good things happen. The long string of employment growth and a long bull market has buoyed sentiment, perhaps so much that any contrary information is being discounted. A poor job report or two may change this outlook. But again, we are faced with an imminent need for very good economic data points to counteract current downtrends.
Credit Expansion (aka QE/liquidity/debt)
These two charts show how China’s credit impulse (QE/liquidity/Reserve Rate reductions etc.) have a lagged impact on US manufacturing. Coming out of the 2009 recession, China had the spigot wide open and we can see US PMI hit a high mark in early 2011. The Impulse was removed during 2010 which resulted in a decline in US PMI. The renewed impulses in mid-2012 and late 2015 helped create the rise in US PMI in 2013 and 2016. There is about a 6-9 month lag between an expansion in credit and its impact on the real economy.
Today we are seeing the impact of a lack of significant credit expansion which should continue Global economies appear to be completely reliant upon increasingly larger credit impulses to maintain growth. China has eased during calendar year 2019, but not as much in the past. Hopefully we will soon see better US PMI numbers to avoid outright recession in the very near term.
Update on the Yield Curve
We’re not hearing much on the Yield Curve lately. It remains inverted with the 10-year Treasury yield being lower than the 90-day T-bill rate. The 90-day bill and Fed Funds rate (set by the Federal Reserve) follow each other hand in glove. We can see market rates, the 10-year Treasury yield began to decline in earnest about a year ago. We can also see how the 90-day rate moved lower prior to the Fed lowering rates. It is clear that the Fed follows the market.
Current market expectations are that the Fed will lower its rate again in October by another 25 bps (.25%). I have showed in previous writings how the last two recessions began (the official dating) as the yield curve regained normalcy with the 10-year yield rising above the 90-day/Fed Funds rate by .33%.
If the Fed Funds rate decreases by .25%, from 1.75% to 1.5%, and the 10-year yield remains constant at 1.56%, the yield curve will un-invert and become positive. Further decreases will cause the spread to go above .33%. In 2007 the Fed lowered its rate enough (following the 90-day T-Bill) to get below the 10-year yield, resteepening/normalizing the curve again. This occurred August-October 2007, and the official dating (which was given to us November 28, 2008(!) that it started December 2007. Waiting for economic data regarding a recession, before reallocating one’s investments will always result in very poor returns
Adam Waszkowski, CFA
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