Despite a significant stock market rally, this year has been beset by escalating recession fears. The list of worries include broad-based slowing in the global economic recovery (centered in the manufacturing sector), a never-ending trade war, persistent political and geo-political drama, a chronic decline in global bond yields, a surge in negative yielding bonds, an inversion in the U.S. yield curve, and an expansion that recently celebrated a birthday which makes it the oldest ever in U.S. history!
The underlying character of the financial markets is often a good indication of investor sentiment. It takes courage (or stupidity in retrospect?) to buy certain assets, while the purchase of other investments is driven mostly by fear. In this fashion, a good read on whether the stock market is being propelled by excessive hope or angst can be obtained by monitoring the character of its leadership.
The ISM manufacturing and services reports have significantly increased recession anxieties and have been wreaking havoc with the stock market over the last couple days. And, who knows, the real pain for equity investors may come tomorrow morning when the monthly payroll employment numbers are released?
Several factors helped the stock market resume a climb to marginal new highs this year. Valuations came down, inflation pressures moderated, yields collapsed, and policy officials became universally supportive. However, a key element remains elusive and, without it, a further significant advance in this bull market seems doubtful.
Lost in the roar surrounding the trade war, the inverted yield curve, an expanding wave of negative global bond yields, and persistent recession chatter, is a “silent U.S. productivity miracle!” Largely AWOL in this expansion until recently, and despite being barely acknowledged due to widespread recession fears, productivity has finally arrived, adding yet another wildcard to the remaining years of this economic recovery.
Investors have been playing defense in recent months, piling into bonds despite low yields, sleeping well at night with gold purchases, staying with the perceived safety of U.S. stocks, avoiding risky small cap companies, and buying traditional low-risk sectors including Utilities, Consumer Staples, and REITS.
Investors have long recognized that the stock market often does better in certain months compared to others. That is, stocks have a seasonality which can be exploited. The January Effect, the Santa Rally, “Sell in May and Go Away”; and, the carnage created by August, September, and October are appreciated and feared by “seasoned investors.”
Many increasingly fear the global economic recovery is in severe peril because overused economic policies have become futile. Bloated central bank balance sheets, large fiscal budgetary fiascos, and the unprecedented global phenomenon of widespread negative bond yields leaves an impression that economic help is spent!
The stock market is re-testing its August 5th collapse low, the U.S. 10-year bond yield is nearing its lows of this recovery, yet another yield curve inversion (tens vs. twos) was breached this week, silence from the Federal Reserve, negative yielding global debt now totaling more than $15 trillion, an escalating riot in Hong Kong, and trade-war negotiations hanging by a thread as ongoing communications are now only by phone! Whew, it’s tough being a bull. Maybe foolhardy?
Adding to current anxieties are the growing fears that businesses may be curtailing spending plans. Real nonresidential investment spending declined in the second quarter for the first time since early 2016. However, this decline was due entirely to ‘old-era investment spending’ while ‘new-era spending’ remains healthy.
This is why financial market prognostications are so difficult and why some believe fruitless! Currently, two recession indicators – both with equally impressive accurate historical prowess – are giving entirely contradictory signals? As shown by the accompanying charts, the yield curve has inverted while fiscal stimulus has been expanding. At least since 1965, this has ‘never’ happened.
Despite the current drama, the stock market will not likely be sustainably driven by the Federal Reserve, ongoing trade negotiations, or by presidential politics. Although these spectacles will continue to bounce the market around, ultimately, its direction will most likely be tied to corporate earnings.
Despite a widespread impression that business confidence is declining under the weight of ongoing global uncertainties, it was reported yesterday that, after being flat for almost a year, new orders for nondefense ex-air capital goods (core business capital goods spending) rose to a new recovery high in June.
Little is expected from the current earnings season. At best, corporate profits may eke out a small gain compared to last year’s second quarter. Moreover, with Trump’s trade war still threatening to worsen, the yield curve still inverted, and because the U.S. economy is now in the longest expansion in its history, many are understandably worried that earnings growth may remain challenging.
As shown in Chart 1, since 2015, the trade-weighted U.S. Dollar index has generally ranged between 90 and 100. Its recent stability, at a level much higher than it was during the first half of this economic recovery, has played an important role in shaping the economic and financial-market landscape.
There is still plenty to worry about. The never-ending trade war enters yet another round of negotiations, geopolitical risks simmer, many economic reports (both in the U.S. and around the globe) remain weak, the size of negative-yield debt is becoming nearly as large as U.S. GDP, the U.S. stock market continues to exhibit a worrisome “triple-top” pattern, small cap stocks continue to trail, the yield curve is still inverted and, because of a “strong” jobs report on Friday, there is now doubt about whether the Fed will cut interest rates later this month.
Like today, the Federal Reserve usually sucks all the oxygen out of the national economic-policy conversation. And, why not? It is comprised of a small elite group who hold conferences in exotic locations (Jackson Hole), have regular strategy meetings culminating in ‘must-see’ press conferences, make dot-plots sound interesting, and, between meetings, members regularly spout-off contradictory opinions.
This week the Federal Reserve delivered the requisite preamble signaling an inevitable cut in the Fed funds rate. Following that, the 10-year Treasury yield declined below 2%, financial markets now point to a 100% probability of a rate reduction, and the old adage ‘Don’t Fight the Fed’ has been ringing in investors’ ears.
A survey asking equity investors whether the stock market does best with a strong or weak U.S. dollar would likely yield a variety of contradicting opinions—and they would all be correct! Like many couples, the stock/dollar relationship is complicated. Sometimes they get along blissfully, other times they separate because they find they rarely agree and, often, they simply seem indifferent to each other. They are an odd couple!
Despite the current trade war with China, the U.S. economy has taken on an air of ‘Goldilocks’ since the December stock market swoon. Real economic growth has slowed, and both inflation and interest rates have moderated. The pace of growth is no longer too hot—as it was last year—nor has it yet become too cold—as most feared earlier this year.
After the December stock market swoon, amidst escalating recession fears, the Federal Reserve hit the pause button on interest rate hikes. Investors, though, had a déjà vu moment, sensing the 2018 experience as reminiscent of a few years earlier and, considering the aftermath of the prior occurrence turned out to be profitable, investors in 2019 opted to hit the replay button!
An aging economic expansion can be hazardous for investors. It tends to develop vulnerabilities (e.g., indebtedness, a lack of savings, over-indulgences, etc.) which threaten a premature ending. Often, old recoveries develop a capacity shortage leading to worsening inflation, interest rate pressures, and restrictive economic policies.
Investors have struggled this year with the relationship between stocks and bonds. The stock market seems very optimistic about the future, whereas bonds appear much more reserved, if not frightened, by the outlook. Should investors be concerned by the seeming contentiousness between stocks and bonds?
This morning’s U.S. GDP report should help calm fears about a pending recession and perhaps set the stage for a surprising acceleration in economic growth? Fears of recession have caused the Federal Reserve to pause its tightening campaign, slightly boost the pace of money supply growth, and significantly lower long-term yields. Improved monetary accommodation definitely raises future economic growth prospects.
Compared to post-war norms, the contemporary economic expansion has been odd in many ways. Persistent sub-par economic growth, a lack of normal lending and borrowing activities, declining labor-force participation rates, a stubbornly high underemployment rate, an inflation no-show, negative yields, and bizarre economic policies (e.g., TARP, cash for clunkers, stress tests, and quantitative easing).
U.S. profit margins have widened significantly in the last couple decades. Total U.S. corporate profits as a percent of GDP averaged only about 8% in the 20 years leading up to 2000, but has since risen by almost 30%, averaging 10.5%. Similarly, the overall profit margin among S&P 500 companies has increased steadily in this recovery to record highs!