Quarterly Commentary: Welcome to the Late, Late CycleSubmitted by Integras Partners on April 27th, 2019
The first quarter rebound of the financial markets was nothing short of spectacular. After the S&P 500 Index® dropped nearly 17% in the fourth quarter, one would believe that only a miracle could bring it back to within just a few points of the all-time highs set last September.
Yet, a miracle is just what it received. The fourth quarter carnage resulted from the Federal Reserve’s desire to raise rates in the face of a global economy digesting a slowdown in China, trade disputes and Brexit uncertainty, just for starters. When financial markets began to melt down and several sections of the interest rate curve inverted the Fed “pivoted” by announcing it would pause raising interest rates and cease further reductions in its balance sheet. The effect was immediate, and markets responded.
The pattern of recent recoveries repeated with stocks that fared the worst during the sell off leading the advance – “the dash for trash”. While most of the recovery can be traced to oversold levels, it highlights a pattern that has repeated since beginning this economic expansion.
One of hallmarks of the strategy to recover from the Great Financial Crisis of 2007-2009 was to influence investor psychology, referred to as The Wealth Effect. Stimulating the markets with massive amounts of cash and very low interest rates encouraged borrowing and risk taking. Personal wealth and investor sentiment increase, people feel better and a virtuous cycle ensues. The Fed lowered interest rates, embarked on three rounds of Quantitative Easing, investors bought risk assets, household wealth is the highest in history and until early 2018, investor sentiment was at an all-time high. The strategy worked.
Throughout history, such easy money and high employment has almost always led to higher inflation. In December 2015, the Janet Yellen-led Fed preemptively increased interest rates .25% and telegraphed plans to embark on a series of increases in coming years. The strategy was to “normalize” interest rates to the level needed to control inflation at 2%– the “Neutral Rate” in economic parlance. Financial markets hated it, sending the S&P 500 down 10% in a month. In response, the Fed did what no other Fed in our history has done - it capitulated. It was a full year before they raised rates again; for fear of upsetting financial markets, unwinding the wealth effect and potentially putting an end to the expansion.
With this latest manifestation, the Fed continued raising rates in the face of muted inflation and a market telling it to stop. Had the “pivot” not occurred, we would likely be in recession by year-end. With the pivot, the Fed verified that forecasting inflation is difficult and protecting asset values is paramount. It appears the Fed is equally beholden to financial markets and policy to preserve the Wealth Effect.
We agree the Fed should be paying attention to what financial markets indicate as it hasn’t any better ability to forecast the trajectory of the economy than other financial institutions. However, should the Fed take future cues from financial markets, the risks of accumulating financial system excesses only increase. Wall Street is adept at squeezing the last drop of juice by encouraging investor enthusiasm, rendering the next recession just as painful as the others we all lived through. That said, due to its recent pivot it is quite possible this expansion may very well extend and temporarily overcome some of the quite dire signals below. Even if it risks creating further excess.
In our 4th Quarter Commentary we wrote that the risk of a market selloff could become a self-fulfilling prophecy by undermining investor sentiment and fostering an economic recession. Today, there are several signs that a recession is near, even without deteriorating sentiment.
Below are a few warning signs we haven’t seen for years. While none is a single foolproof indicator, together they become more ominous. Still, other more important shoes must fall for a recession to occur. (Below: years are along the bottom and the gray bars represent recessions.)
Before most recessions, a wide disparity between consumer expectations and present conditions has been a hallmark of the very late stages of an economic expansion (top chart).
While the absolute level measured isn’t as important, the difference, or “spread” (bottom chart) between the two is relevant.
Each time the spread exceeded 50, recessions weren’t far behind. (As of January 2019.)
You have likely heard of an “Inverted Yield Curve”. We discussed it most recently in our July 2018 commentary.
The chart below illustrates why we are quite concerned, as an inverted curve has presaged every recession over the past 50 years by 12-24 months. However, stock market returns are typically quite good from its inversion right up to the beginning of the recession.
Employment growth is a primary driver of economic expansion durability and strength. As jobs become more plentiful, employers compete for an increasingly smaller pool of workers, wages increase, and employees find it easier to change jobs for better pay and benefits. We are effectively out of workers with the unemployment rate below 4%. In fact, the US Job Openings Index declined by 500,000 jobs in February as small businesses simply withdrew posted job openings due to the inability to find workers. Each time the Jobs Hard to Get Index minus the Jobs Plentiful Index has reached the current levels, recession was near.
This is only a sampling of the data we review. Several other warning signs exist. Corporate profit margins are getting strained by higher wages plus increasing materials costs. Purchasing Managersand Industrial Production Indicesacross the globe are in decline. Leading Economic Indicatorsare still rising but decelerating. Nearly 200 companies are slated to go public this year – a clear sign that private equity is looking to cash-out now. There are others and they are all late cycle observations.
There is good news, too. Corporate credit - a telltale sign of deteriorating economic conditions - remains strong and defaults on lower-rated bonds remain near cycle lows.
- Household credit delinquencies remain at cycle lows.
- Economic conditions have eased considerably.
- China has used its own form of stimulus, boosting economic growth and benefiting the entire global economy.
- Corporate profits are likely to remain positive this quarter, after analysts slashed profit forecasts prior to the Fed pivot.
- Retail sales, which had slowed markedly in prior months, rebounded sharply in March, signifying the durability of the US consumer.
- Average hourly wage increases are above 3.5%, yet core inflation remains subdued near 2%.
- And the largest potential catalyst of all – a US/China trade agreement – is still possible. It could reignite investor sentiment, improve corporate outlooks, capital spending plans and earnings guidance.
Accordingly, we believe today’s conditions do not warrant being overly conservative and the best opportunities lie overseas, primarily in emerging markets. They will be the primary beneficiaries of a trade agreement as supply chains ramp back up.
While we are very watchful for further deterioration, there remains plenty of reason to be guardedly optimistic for the next year or so. Typically these late, late cycles produce outsized investment returns as those who dismiss accumulating evidence of impending recession fear missing out and pile into stocks. Still, the US market is relatively expensive at this point, earnings and operating margins have peaked and there is little worldwide economic momentum to push the needle much further. In this environment, volatility becomes elevated and selloffs could happen at any time. Should a US/China trade agreement prove to boost economic activity, inflation is likely to follow. The Fed would raise interest rates, recreating the 4th quarter experience all over again.
We consider the 4th quarter a dress rehearsal for what will one day come. None of us knows when, but the real thing will be worse. As data changes and the clouds darken, look for us to lighten up during rallies and move increasingly towards more conservative assets. We do not intend to wait for the music to stop before looking for a chair.
Our strategy is to participate and defend.