Executive Summary
- US stock and bond markets have been sending conflicting messages all year
- Last two market peaks coincided with changes in Fed policy projections
- Futures market pricing in rate cuts while Fed remains neutral, hinting Fed is misjudging outlook
- Inversion of yield curve increases odds of a Fed cut and raises recession risk
- Morgan Stanley sounding recessionary alarm, risks to market outlook
- IHS Markit Chief Economist echoes downbeat economic assessment
- With outlook darkening, a defensive stance is warranted
Last year’s fourth quarter bear market went into overdrive due to several miscalculations by the Federal Reserve led by Jerome Powell in which they underestimated the rapid decline in liquidity and the market’s ability to handle further planned tightening for 2019. More fuel was added to the fire by rising escalations between the US and China regarding trade policy between the world’s two largest economies.
After an official bear market in the S&P 500 of a greater than 20% decline from the highs, the Fed adjusted their stance to a more neutral, market-friendly posture with Powell’s early January speech where he communicated no more rate hikes and an end to the Fed’s balance sheet reduction program many have dubbed quantitative tightening (QT).
While incoming economic data in the first quarter was softer than the fourth quarter of last year, the economy still showed decent growth; the US and China were working closer to a trade agreement and the global economy was showing signs of stabilization. This provided ample fodder for a powerful market rally that took us and many by surprise, which we believe was largely due to stock buybacks as corporations took advantage of the market selloff.
We've explained how significant corporate buybacks have been to this bull market in past letters, but nothing illustrates it more than the figure below showing how S&P 500 buybacks have accounted for more than $4.5T in demand for stocks! In other words, for every $100 of inflows into equities since the bull market began, $98.9 comes from S&P 500 buybacks.
Part of our suspicion towards the first quarter market rally was in the conflicting messages from the stock and bond markets. Interest rates typically follow economic growth rates as higher economic growth is typically associated with higher levels of inflation which pressure interest rates higher. The stock market also typically follows economic growth rates as corporate earnings tend to move in sync with the economy. For this reason, the stock market and bond yields often move in the same direction.
From late 2017 through the third quarter of 2018, both the stock market and bond market were singing the same tune as stocks and long-term interest rates moved higher. Then, beginning in the fourth quarter of last year, both stocks and bond yield began to decline, particularly in December, but both were still moving in concert.
While stocks enjoyed a strong rally at the start of the year, the same can’t be said regarding interest rates. Through the first quarter and well into May, stocks rallied while bond yields continued to decline, which argues one of the markets likely has the wrong outlook as seen below.
While the peak in equities occurred right around the time that trade negotiations between the US and China broke down, bond yields here in the US have been trending south all year and we believe it has been due to the continued economic disappointment for the US economy. We believe that, while the breakdown in China and US trade talks is significant, there was another major factor at play regarding the peak in the stock market and further decline in bond yields that can be boiled down to a single word: “transitory.”
The Word Powell Wishes He Could Take Back
We have already written about Jerome Powell’s policy missteps in 2018 in a previous letter (click for link), what we want to highlight is our belief that Powell made yet another major miscalculation during the May 1st 2019 FOMC meeting which marked the peak in the stock market so far this year. When commenting on the current low levels of inflation, Powell’s response was that he felt there were “transitory” factors at play. From that comment to the recent low on Monday, the S&P 500 fell 7.6% and the Dow Jones Industrial Average fell more than 2000 points.
The market had been interpreting the consistently low levels of inflation as ammunition for the Fed to consider a rate cut later this year, particularly considering slowing economic growth in the US. However, Powell’s transitory comment likely led market participants to the same conclusion they reached in the fourth quarter of last year, that the Fed’s view of economic trends was well off the mark. The Fed being behind the curve as well as renewed trade tensions between the US and China are putting us nearly in the same position we were in back in the fourth quarter, which means that risks to the outlook have risen dramatically over the past month.
Our call since the middle of last year was that the US economy was going to enter an economic growth slowdown that would carry well into this year while the slowdown in the global economy was moving into its later stages. Looking at incoming data this year, solidified that view as US growth continued to cool while we were seeing signs of stabilization globally through the first quarter. We felt that the global economy would likely bottom in the second quarter and begin to modestly accelerate heading into the third with foreign equities and bonds providing more appeal than the US.
Now that we have had a market pullback, is it still appropriate to wade back into the stock market?
Markets Are Betting a Cut Is Coming
Powell’s communication to the markets in January that the Fed was done tightening placed both the markets and the Fed in the same camp. The FOMC puts out quarterly estimates for economic growth rates, interest rates, and inflation for the current and future years. When the Fed met in March they dropped their 2019 end of year target for the Federal Funds Rate to 2.375% from 2.875%, which they provided back in December 2018. Since the middle of April, the futures market’s estimate for the December 2019 Federal Funds Rate has been steadily declining and as of June 12th the market believes the Fed Funds Rate will fall to 1.75%, implying more than two quarter point rate cuts from current levels.
The picture turns even darker when we look at market expectations for 2020. The Fed’s estimate for 2019 is no rate hike or cut and they believe they will hike rates by a quarter point once for 2020. The futures market believes the Fed is way off course as the estimate for the Fed Funds rate by the end of 2020 is 1.43% as of June 12th of this year. This implies the market believes that not only will the Fed not raise rates next year but will instead cut rates by four quarter point declines!
The disconnect between the Fed and the market is now even larger than where it stood back in last December. We are in the same situation as we were late last year in which we not only have the US market and Federal Reserve playing chicken in terms of whose outlook will change, but we also have the US and China playing chicken again with the global economy hanging in the balance.
Regarding the US and Chinese trade war, a resolution anytime soon is not likely given the strong demands being made by the US. I would highly recommend readers listen to our recent interview with geopolitical expert Peter Zeihan where he discusses the move by the US to isolate the Chinese firm Huawei and why trade talks collapsed (see Peter Zeihan on Huawei, China Surveillance and Collapse in Trade Talks for audio).
In addition to the above, I would also recommend listening to the discussion we had with legendary fund manager Felix Zulauf in April just prior to the collapse in trade talks. Felix felt if their was a trade deal, a market rally would be short lived and that Trump would revive issues again to focus on technology and intellectual property theft by the Chinese (see Felix Zulauf on U.S.-China Trade Deal, Global Markets and Gold for audio).
We agree with both Peter and Felix that a resolution to the ongoing US-Chinese trade dispute is not coming anytime soon. We also believe that resolution on who will blink first in terms of interest rate projections—the market or the Fed—will also not be answered anytime soon which keeps market risk elevated. Our belief that the Fed will not be so easily moved towards a rate cut stems from public comments made by Fed members last month since the May 1st FOMC meeting as highlighted by Jim Bianco from Bianco Research. Jim looked at news articles regarding Fed member views and categorized them as either against, agnostic or open to a cut, or no official view. Looking at FOMC member positions, there are clearly more members not in favor of cutting rates than those open to a rate cut.
While the Fed feels no urgency to cut interest rates currently, the market sure does. The market is pricing in an 82.3% chance the Fed cuts at their July meeting and the odds jump north of 90% for the remainder of the Fed meetings this year.
The bond market is clearly urging for a cut as the decline in US Treasury (UST) yields the last week of May was truly breathtaking. On the long end, the 30-Yr UST yield decline was the largest weekly decline since 2016. The 10-Yr UST yield saw the largest decline since 2014 and on the shorter end the 2-Yr UST yield saw the largest decline since the 2009 Great Recession!
Fed Rate Cuts and Economic Slowdowns
The 2-Yr UST yield is seen as a forward-looking proxy for the Federal Funds Rate and is now more than half a percent below the Effective Federal Funds rate. The decline in the 2-Yr UST yield has been dramatic as it peaked last November just under 3% when it was roughly 0.75% above the Federal funds to its current level of 1.88% as of June 12th, now 0.62% below the Federal Funds upper bound of 2.5%.
To determine what level the 2-Yr UST yield has declined below the Fed Funds Rate (FFR) to prompt a Fed response, we looked back at every time the 2-Yr UST yield was at least a half percent below the FFR when the Fed was not currently cutting rates at the time and the US economy was not in a recession, conditions which apply to today. We looked at only the first date this occurred and ignored any subsequent signals that occurred over the following nine months. Since the end of the 1981-1982 recession, we found five occurrences similar to today and with every one of them the Fed slashed interest rates within one year.
The results of the study are provided below and, in terms of the Fed’s response, the outlier of the five events was in September 2006. When the 2-Yr yield fell more than half a percent below the FFR, the Fed’s first cut did not come for nearly a year later. If we ignore that event, the other four events saw the Fed cutting rates with a quicker response time of just under two months. Typically, the Fed cuts rates in response to a financial crisis and/or recession so we looked at whether the US economy was in recession within the following year and a half post the initial event and four out of five events landed in recession. The one exception was the Fed slashing rates in 1998 in response to the collapse of Long-Term Capital Management (LTCM).
The average warning time between the 2-Yr UST falling more than half a percent below the FFR and the onset of a recession was 9 months and ranged from four months as the shortest warning period to as long as 14 months. Using the shortest and longest lead times to recession means the US economy could be vulnerable to slipping into a recession as early as October of this year to as late as August of 2020.
Morgan Stanley Sounds The Recession Alarm
The investment and economic team at Morgan Stanley looked at the yield curve as measured by the difference between 10-Yr and 3-Month UST yields. They adjusted the three-month T-bill rate to account for the influence of changes in the Fed’s balance sheet with quantitative easing (QE) in which they expanded their balance sheet from 2008-2014 to when they began quantitative tightening (QT) by shrinking their balance sheet from 2017 to the present. Their adjustment shows the yield curve inverted not last month but back in December of last year. A recent Bloomberg article highlights their conclusions and includes their adjusted yield curve and argues the recent trade war is merely just a side show and only darkens the outlook rather than being the cause.
Morgan Stanley Says US Yield Curve Now Clearly Spells Downturn
Make no mistake, the Treasury yield curve really is flashing recession angst — and the trade war is merely a sideshow.
While a key slice of the curve has inverted this month for the first time since March, an “adjusted” curve that accounts for quantitative easing and tightening has been persistently inverted for the past six months, according to Morgan Stanley.
In fact, the bank’s metric inverted back in December, well before the most recent escalation of US-China trade tensions, and has maintained its shape ever since, strategists led by Mike Wilson point out.
That suggests investors who are looking to a trade resolution as a salve for the world’s economic woes may be pinning their hopes in the wrong place.
“Get ready for more potential growth disappointments even with a trade deal,” the strategists wrote in a May 28 report. They see a risk of the S&P 500 Index falling to 2,400 from around 2,800 thanks to the softening data…
“We think this means the US economic slowdown and rising recession risk is happening regardless of the trade outcome,” the strategists write…
“Recession or not, we believe US equity market volatility is likely to pick up significantly over the next 6 months.”
Since 1970, the 10-Yr and 3-Mo yield curve has inverted by at least a quarter percent prior to every recession. Going forward, it is important to continue to monitor the odds of a US recession as it will influence the market’s reaction to the first rate cut by the Fed. Historically, the market rallies post the first Fed rate cut and continues to do so as long as the onset of a recession is at least a year out. However, when a recession begins less than a year out from the Fed’s first cut the market’s initial rally quickly fades and serves as one last opportunity for investors to reduce risk before the recession and bear market in stocks begins.
Economic Data Shows Continued Cooling
Is does not look like recessionary risk for the US economy will recede anytime soon as recent economic data has not been encouraging. IHS Markit tracks activity for both the manufacturing and service sectors through their Purchasing Managers Index (PMI) surveys and comments from their Chief Economist regarding May data was not encouraging as highlighted below (emphasis added).
Output Growth Eases to Three-Year Low
Commenting on the PMI data, Chris Williamson, Chief Business Economist at IHS Markit said: “The final PMI data for May add to worrying signs about the health of the US economy. With the exception of February 2016, business reported the weakest expansion for five and a half years as a trade-led slowdown continued to widen from manufacturing to services.
"Inflows of new business showed the second-smallest rise seen this side of the global financial crisis as the steepest fall in demand for manufactured goods since 2009 was accompanied by a further marked slowdown in orders for services…”
"The slowdown has also seen inflationary pressures fade rapidly. Despite upward pressure on prices from tariffs, the rate of increase of average prices charged for goods and services barely rose in May, in marked contrast to the strong rises seen earlier in the year, as increasing numbers of companies competed on price amid weak demand.”
While the message of slowing economic growth clearly stands out, what also stood out to us was the message that companies are cutting prices due to weaker demand. This clearly spells margin troubles for US corporations and hints that we could see companies miss future earnings projections. Next quarterly earnings announcement season could prove quite difficult and means we likely have negative analyst revisions ahead. The current consensus earnings per share forecast for the S&P 500 for 2019 comes in at $166.74, which is 9% above 2018 earnings of $152.94 per share. Against the backdrop of an inverted yield curve, companies reporting margin pressure, and escalated trade tensions between the world’s two largest economies, 9% earnings growth for the S&P 500 is hard for us to fathom. Instead, we are likely to see analyst estimates come down dramatically just as they did in the fourth quarter of last year.
Summary
We believe the outlook for the US and global economy has shifted lower and so too the stock market’s upside potential. We believe we are in a high-risk period with three key areas that need to be resolved before the market is likely to find solid footing. They are:
- US and Chinese trade relations
- Market vs Fed interest rate expectations
- Analyst 2019 earnings estimates vs economic reality
Until these issues are resolved, risks remain skewed to the downside.
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