The business cycle still exists no matter what the folks on TV or the politicians say. The major economic trends continue to weaken.
Yield Curve Inversion
Bond yields have fallen dramatically recently. The equity markets reflect nervousness. The yield curve is now inverted to the rates “administered” by the monetary authority. The Fed Funds rate is pegged near 2.4% versus the 10-year T-Note yield which stands near 2.1% as of this writing (and down 115 basis points since peaking in Q4 at 3.25%).
Yield curve inversion occurs because the short-term area of the curve is set by the fiat of the Fed. On the other hand, long-term rates are set by the free market. A yield curve “inversion” occurs because free market forces have a much different view of the future than do the bureaucrats at the Fed. Free market forces today are 99% sure that economic forces will cause the Fed to change policy before year’s end with at least one rate cut, and 65% sure that there will be two.
One can argue that the Fed employs more Ph.D. economists than any other institution in the world, but, that doesn’t make them right. In fact, we saw Fed Chair Powell “pivot” in January from his “we are far from neutral” rate position of December. I suspect he will soon walk back his “low inflation is ‘transitory’” remark, and we will see rate cuts much sooner than anyone thinks.
For the rate inversion issue, the choice really is: “Do you believe the free markets, or do you believe a committee?” The Fed’s track record at cycle turning points is extraordinarily poor. They normally over-tighten and then wait too long to reverse policy.
As an aside, economists at Morgan Stanley, after adjusting the yield curve for both Quantitative Easing (QE) and Quantitative tightening (QT), found that the yield curve has actually been inverted for the past six months. “We think this means the U.S. economic slowdown and rising recession risk is happening regardless of the trade outcome,” they wrote.
Since the S&P 500 peak in January, 2018, the return on U.S. 10-year T-Notes has outperformed the equity index by nearly 5 percentage points (500 basis points). Looking at the cyclically sensitive sectors, we find that Regional Banks, Transports, Retail, and Small Caps are in correction territory (down 10% or more), and that spreads between investment grade bond yields and high yield issues have widened considerably as investors run from risk.
Falling Oil Prices
Oil prices have been falling for the past month and a half. In mid-April, oil prices peaked at $66.14/bbl. As of this writing, they are $52.68. Considering that there are supply constraints (Iran, Libya, Venezuela, and Saudi Arabia’s imposed caps), the fall in the oil price says something about the state of demand. The only item holding inflation anywhere near 1.5% has been gasoline prices. Given the dramatic fall in oil prices, gasoline prices are about to reverse. Is anyone taking bets on the week in which Fed Chair Powell walks back his view that “low inflation is ‘transitory’?”
The Historic Expansion, a Realistic View
June 1 marked the 10th anniversary of the current business expansion. This expansion is now tied with the dot.com expansion of the ‘90s for the longest on record. But, this expansion has been different in that it displayed the slowest growth of all of the post-WWII cycles. In this one, too, the top echelons of society benefitted most. And, no wonder! Policy was aimed at supporting equities and keeping interest rates low. As a result, we had $4 trillion of Quantitative Easing, with about an equal amount of corporate debt expansion, much of which was used for corporate stock buy-backs, which, in turn, supported equity markets.
Corporate executives get paid when their stock options increase in value; so, rising stock values are more important to them than spending on capex (which ultimately results in organic growth). In the recent Q1 GDP revision, the most surprising data update was the fall in the capex number from +0.2% to -1.0%. This is not a good sign for future economic growth or productivity.
The Trade Deficit and Inventories
The April trade deficit was -$72.1 billion. Both exports (-4.2%) and imports (-2.7%) contracted. This is yet another sign of flagging demand, both from a worldwide perspective (exports) and a domestic one (imports). At the same time, inventories are up 7.4% on a year over year basis and inventories of durable goods are up 10.6%. I suspect we are going to see significant price cutting in the retail space and by the auto companies in the months immediately ahead.
Until this expansion, housing had always led the economy in the up cycle. Today’s housing market is stuck in a recession of its own. As cited above, the 10-year T-Note yield, which greatly influences mortgage rates, has fallen dramatically, and mortgage rates are down more than a quarter of a percent over the past month. But, home sales have continued to fall, and prices in the “hot” markets (Manhattan and San Francisco) are now falling. I wonder how low interest rates must go to get housing to respond.
With 97% of S&P 500 companies reporting, Q1 earnings are -0.4% compared to year earlier results. Current analyst forecasts for Q2 are -2.1%. That puts us in an earnings recession, albeit a mild one. Q3 estimates are for +0.3%, but estimates have been coming down. With earnings growth essentially flat to down, PE ratios should contract. Perhaps that is what we are seeing in the equities markets.
On top of all of the downbeat trends discussed above, incoming data continue to disappoint (China Manufacturing April PMI was 49.4, in contraction; German retail sales for April contracted -2.0% …). We are in an escalating trade war with China, and now the President has threatened Mexico with tariffs on all imports. We have political issues at home (will Mueller’s statement embolden the Democrats to move to “impeach?”), and flare-ups with Iran and N. Korea. Then, there is the Brexit issue along with populist results in EU elections (U.K., France). And Italy is outwardly flaunting EU budget rules. India seems to be the only area of economic stability. Downbeat economic indicators and political instability are not positive for equities. I suspect the 10-year T-Note will hit 2% sometime soon. It got near 1.3% earlier in this cycle.
Robert Barone, Ph.D. (Georgetown) Formerly: Prof of Finance, bank CEO, Chair of FHLBSF. Currently: Director CSAA Ins., Norcal AAA, Allied Mineral Products. Co-manager: FFIU (NYSE traded) bond fund.