Market volatility finally showed up in the popular indexes (DJIA, S&P 500, NASDAQ). These were down two weeks in a row as of November 17 on rising volume (never a good sign when markets are falling), and they are no higher than they were a month earlier (October 20). The VIX, a measure of market volatility, rose to 13.13 on November 15, from a near record low of 9.14 earlier in the month, a sign that “complacency” is finally on the wane. And, well it should be, as current data, on which the Fed will rely to raise rates at its December meeting (97% chance according to Wall Street), has been significantly skewed by rebuilding after the natural disasters in September and October. Then, markets rose again the Monday and Tuesday of Thanksgiving week.
Equities have Flatlined
Truth be known, individual investors with diversified portfolios have seen their assets flatline over the past three months, as most stocks in the popular indexes are trading below their peaks. The indexes, themselves, are weighted by market capitalization. Companies like Apple (3.99) and Microsoft (2.89) have more weight in the index than do companies like Best Buy (0.07), Hartford Insurance (0.09), American Airlines (0.09), CBS (0.09), or Foot Locker (0.02) (their weights in the index are the values shown in the parentheses). Using an equally weighted S&P 500 index where all the components count equally (i.e., price movements in Foot Locker count the same as price movements in Apple), the reason for the flatline becomes obvious. The equally weighted index closed on November 17 at the same level as on August 7. In other words, for most equities, three months of stagnation.
Another sign of rising volatility and of a tired market is investor reaction to companies that “beat” analyst expectations relative to those that “miss.” The positive response to a “beat” has been much more muted than the negative response to a “miss.” In some cases, even “beats” have been met with negative price action.
The Earnings Backdrop
A year ago, the consensus of analysts was that operating earnings for the S&P 500 would be nearly $133 for 2017 and $148 for 2018. There was some optimism in these numbers regarding how rapidly the new President would get his agenda through, especially regarding corporate taxation. Nonetheless, today, with just over a month to go to year’s end, 2017’s consensus is for just over $131 in earnings for 2017 and $145 for 2018. (There still may be some corporate tax relief in the 2018 view.) The point here is that the markets have actually risen into a falling profit forecast; resulting in an expansion in the PE ratio. Today investors are putting a higher value on each dollar of earnings than they were a year ago, so much so that the market PE ratio has risen to levels rarely seen in the past. When viewed from an historical perspective, the market’s PE ratio is now at levels achieved just prior to the oncoming recessions of 2001 and 2009.
Until Now!
The fact that the equity markets have not had a significant sell-off in more than a year has stymied most market commentators. My belief is that, until now, the ultra-accommodative monetary policies of the world’s central banks, along with the puny fixed income returns that have accompanied such policies, have driven yield starved investors into equities, as it isn’t hard to find dividend yields in multinational large cap securities that handily beat bond returns. The historically narrow yield spreads between corporate investment grade bonds and high yield (aka “junk”) bonds is also symptomatic of this movement.
I say until now for a reason: the ultra-accommodative policies of three of the four major world central banks appear to be coming to an end. We know that the Fed is committed to their pre-announced December rate hike, and the distorted consumption data from the natural disaster rebuild will be used as support for that move. In addition, the Fed began their Quantitative Tightening (QT) program in October, allowing assets in their bloated balance sheet to “run-off,” i.e., they won’t be replacing them as they mature. Since the U.S. budget is still significantly in deficit and the Treasury must constantly issue additional new debt, the debt maturing on the Fed’s balance sheet plus any new debt must now be placed into the market. This puts upward pressure on interest rates, especially in the short-end of the yield curve where the Treasury has chosen to operate. (The 2-year T-note, at a yield of nearly 1.80%, has doubled in yield over the past year and is higher now than at any time since the last recession.)
Tapering
To compound the rising yield issue, the European Central Bank (ECB) has announced a “tapering” of their Quantitative Easing (QE) program and will now purchase fewer bonds in the open market on a monthly basis than has been the case for the past couple of years. The Bank of England (BOE) has also joined the Fed in announcing that their next policy move would be to raise their base short-term rate. Only the Bank of Japan (BOJ) remains steadfast in its QE. Adding to all the uncertainty is the changing of the guard at the Fed (Jerome Powell replacing Janet Yellen in February) and at the ECB, where the “easy money” Italian (Draghi) is likely to be succeeded by a German. The market reads the latter as less accommodation, sooner. All of this means that, if interest rates do rise, the fixed income market will begin to siphon off the liquidity that is now chasing dividends in the equity market. That liquidity will also be lessened by the tighter central bank policies..
The Fed’s Fingerprints
The question arises as to why the Fed believes that they should be raising rates. One theory is that the Fed needs to move rates higher now so that, when the next recession comes, it has a tool to use from its traditional toolbox. The danger here is that if the Fed has misinterpreted the recent consumption growth in the economy as emanating from a healthy consumer rather than as temporary and due to the rebuild after several natural disasters, then raising rates and continuing with successively larger doses of QT, as is their plan, may just be the policy mistake that causes the next recession. Let’s face reality: every recession in the post-World War II period has had the Fed’s fingerprints all over it (accommodative too long followed by over-tightening).
Market’s don’t see Inflation
The Fed’s main influence on the yield curve is at the short-end, as it moves the overnight Fed Funds rate up or down and deals mainly in T-bills in its portfolio operations. Long-term interest rates are market driven and consist of two components: 1) a real rate of return; and 2) an inflation premium. As I have written in past blogs, inflation is just nowhere to be found. As the Fed raises short-term rates based on the fear of future inflation, if investors do not see the same inflation premium, then long-term rates won’t respond by moving upward, and the result may be the classic yield curve inversion that so often appears just prior to recessions.
Today, because the markets do not see a case for rising inflation, longer-term interest rates are “stubbornly” not rising. In the immediate post-election period, the 10-year T-note yield rose to 2.64% based on the Trump reflation narrative. But today, in the face of a near certain December rate hike and three to five more promised in 2018, along with the beginnings of a QT program that is scheduled to accelerate, the 10-year T-note yield can’t break above the 2.40% level. The reason: markets don’t see the inflation that the Fed fears. If this continues, the yield curve will invert within two to three rate hikes. A recession almost always ensues when the yield curve inverts.
Flawed Models
The Fed often relies on its data driven econometric models when viewing the short to medium-term economic landscape. Such models use historical data, so, the underlying assumption is that the economy will react to certain stimuli in the future much like it did in the past. As we are all well aware, rapid change has occurred in many aspects of life, shaped by AI, robotics, the shared economy, the level of debt, the rapidly changing retail and telecommunications landscape, and, of course, the most important aspect, aging demographics. The Fed’s models have predicted 2% and accelerating inflation (i.e., the Phillips Curve) for 65+ months, but, so far, inflation is nowhere to be found. It could be that model reliance on past data biases the output. Maybe a Powell led Fed will adapt to the new reality – only time will tell. If it doesn’t, and the Fed sticks to its same flawed narrative (that inflation is coming!), a 2018 recession is likely.
Robert Barone, Ph.D.