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No Recession in Sight; Just Volatility, End of Cycle Worries

As June began, market volatility re-emerged with both the stock and bond markets fluctuating wildly on a daily basis. The good news is that it looks like U.S. manufacturing got a bit stronger entering Q2, as did consumer spending. So, Q2’s U.S. GDP will be stronger than Q1’s. The May employment report, too, was stronger than anticipated; more good U.S. news. Unfortunately, the rest of the world, especially Europe and Japan, appears to have hit a wall, and the U.S. economy is now the only major economic juggernaut.
Of late, I have remarked that the talking heads on business television (“bubblevision”) were misleading investors with their view that the equity markets would remain strong because of “synchronized” global growth. Despite the data that was already there for everyone to see (Japan: negative GDP growth in Q1; Europe: significant growth slowdown in Q1 to half of the Q4 pace; U.K., growth stagnation), it took the likes of Mohammed El-Erian, in a May 29th Tuesday morning interview on CNBC, and a meltdown in Italian politics, to convince investors that such “synchronized” growth was in the rear-view mirror.

Market Sell-Off, “Italian Style”
The initial market sell-off occurred on Tuesday, May 29th, the day after Memorial Day in the U.S. On Sunday, May 27th, Italy’s President, Sergio Mattarella, blocked the formation of a new government when he rejected 81-year old economist Paolo Savona, who was picked by the coalition of the 5-Star (left) and League (right) parties as their choice for Economic Minister, an especially important role given Italy’s precarious public finances and weak banking system. Savona is a “Eurosceptic.” That term pretty-well conveys what his policies would be toward the EU’s fiscal rules. Italy is the world’s 8th largest external debtor; it has $2.5 trillion of debt denominated in U.S. dollars. Its banks are also very weak with 11.1% of total loans categorized as non-performing. Contrast that with France (3.1%), the Netherlands (2.2%) and Germany (1.9%).
The potential of another Greek style debt default, but of much greater magnitude, this one “Italian Style,” rocked markets on Tuesday, May 29th in Europe and Asia. Then, when U.S. markets opened, there wasn’t a flight to quality, there was a stampede. The U.S. 10 year T-Note, whose price had risen quite rapidly over the week ended May 25th, as yields fell from just under 3.10% to 2.95%, duplicated that same feat within that Tuesday’s trading session, with yields closing under 2.80%.
The rest of the week was dominated by continued volatility with nerves being alternately frazzled and soothed, by trade tariffs, by Italy’s formation of a non-Eurosceptic government (with an Economy Minister (Giovanni Tria) with a more moderate view toward EU policies – which walked the U.S. 10 year T-Note yield back toward 2.95%), by a re-emergence of direct talks between the U.S. and N. Korea, and finally by a much stronger than anticipated U.S. jobs report.
Getting back to the synchronized global growth story, the currencies of the Emerging Market (EM) countries of Argentina, Turkey, and Indonesia, all countries with large dollar denominated debt, have been hard hit by the rising value of the U.S. dollar. The Italian caused flight to quality (to U.S. dollars) has only served to exacerbate this situation. Impacts were also felt by the Brazilian Real, the Russian Ruble, and the So. African Rand, currencies of countries with large external (U.S. dollar denominated) debt as the rising value of the dollar makes it harder for them to service that debt. In the extreme, rising rates can throw those countries’ economies into recession. At the very least, it will significantly slow their growth. Already we are seeing this in the downturn in the Baltic Dry Index (shipping).

The U.S., An Island of Growth
On the positive side, the May U.S. jobs report was much stronger than anticipated. This, along with stronger manufacturing data and a rise in consumer spending (at the expense of a falling savings rate), should underpin Q2’s GDP growth rate; now likely to be closer to 3% than to 2%, perhaps even above 3%.
The U.S. economy, itself, is in the late innings of the expansion phase of the business cycle. Like cycles playing out in the rest of the world, the U.S. cycle will eventually run its course. While recession worries have been pushed further into the future, they have, by no means, been eliminated. Here’s why:
• Housing has always been a key growth ingredient. But the housing data have stagnated. The latest is pending home sales which contracted in April. No doubt, supply constraints were a big contributor, but so was receding affordability due both to rising mortgage rates and rapidly escalating home prices. Then, in the last 4-week reporting period, mortgage applications simply collapsed (at a 55% annualized rate).

• As comforting as the May employment data was, a more circumspect view produces concerns. The U3 unemployment rate fell from 3.93% to 3.76% (reported in the media as a fall from 3.9% to 3.8%). The last time it was this low was December, 1969. When labor becomes this scarce, wages rise, cost-push inflation emerges, and the Fed raises rates to combat the emerging inflation. Because monetary policy impacts the economy differently each time it is tried (in economic parlance, “with a long and variable lag”), the Fed doesn’t really know when to start, when to stop, and how hard to apply the brakes. The result has been that in 10 of the last 13 tightening cycles, recessions have resulted.

• The Fed’s own estimate of the non-inflationary unemployment rate is 4.5%. The U.S. economy has been below this rate for more than a year, and, while we don’t have rapidly rising prices of goods (except gasoline), just yet, the rate of inflation in services (70% of consumption) now exceeds 3%.

• In addition, the labor market’s tightness is now translating into inflationary pressures.
o The “voluntary” quit rate rose to 13.8% in May from 12.7% in April. This is an 18-year high, and there is a high correlation between this measure and wage inflation six months hence.
o We are now seeing the beginnings of cost-push inflation. While the year over year (YoY) wage trend for nonsupervisory production workers (80% of the jobs) was 2.8% in May, the three- month pace comes in at a much hotter 3.6% annual rate.

• The Fed does not have much of a choice. Because their 2% inflation target was never adjusted downward during the deflationary post-recession period, they have now stayed too long in easy money mode. The Fed is behind the rate raising curve and will continue to raise short-term rates, perhaps at every meeting for the rest of ’18. Such rate increases ultimately impact economic growth, corporate profits, and stock values.

• The world’s other major central banks are nowhere near an actual tightening phase: Not the Bank of Japan (negative GDP growth in Q1); not the European Central Bank (Italy and slowing economic growth across the region); not the Bank of England (U.K. economy stagnating); and not the Peoples Bank of China (slowing growth and loan quality issues). EMs have their own issues with the strong dollar playing havoc with their currencies (Argentina, Turkey, Indonesia, Russia, Brazil, So. Africa) and, thus, the pace of their economic growth.

Inverting the Yield Curve
The money created by the easy money policies of the major world central banks will continue to find a home in the intermediate and long-term U.S. Treasury and corporate bond markets where rates and rating quality are higher, holding down U.S. intermediate and long-term interest rates. Meanwhile, the Fed’s need to tighten U.S. short-term rates to combat the emerging inflation will work to invert the yield curve, the Fed’s own best indicator of an oncoming recession. The strong dollar will continue to batter EM currencies, keeping the “synchronized” growth story at bay. The stronger dollar, too, will act as a headwind on multinational corporate profits (via currency translation). And, upward wage pressures end up either reducing margins or causing prices to rise and eliciting further Fed actions. None of this is positive for the stock or bond markets.

Conclusions
The U.S. economy is showing some resilience after a soft Q1. The rest of the world, however, is rapidly slowing. This, along with trade uncertainties and European drama will continue to keep market volatility high. Foreign central banks will continue with easy money policies while the U.S. Fed tightens into rising inflationary pressures, a prescription for yield inversion. Enjoy the party. Midnight approaches.

Robert Barone, Ph.D.
Robert Barone, Ph.D. is a Georgetown educated economist. He is a financial advisor at Fieldstone Financial. www.FieldstoneFinancial.com .
He is nationally known for his writings and Robert’s storied career includes his having served as a Professor of Finance, a community bank CEO and a Director and Chairman of the Federal Home Loan Bank of San Francisco. Robert is currently a Director of CSAA Insurance Company (a AAA company) where he chairs the Finance and Investment Committee. Robert leads the investment governance program at Fieldstone Financial, is the head of Fieldstone Research www.FieldstoneResearch.com, and is co-portfolio manager of the Fieldstone UVA Unconstrained Medium-Term Fixed Income ETF (FFIU).

Statistics and other information have been compiled from various sources. The facts and information are believed to be accurate and credible, but there is no guarantee as to the complete accuracy of this information.

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