Per Stirling Capital Outlook – November 2019
On November 13th of this year, Federal Reserve Chairman Jerome Powell stated, “I think the new normal is lower interest rates, lower inflation, probably lower growth, and you’re seeing that all over the world, not just in the United States.”
This is a remarkable statement on many levels, starting with the fact that it is unusual for a Fed Chairman to speak so clearly and in such long-term, secular terms, as such bold statements are perceived as inhibiting to their future monetary policy flexibility.
No one can debate the veracity of Powell’s comments from a backwards-looking perspective, with Japan and Europe experiencing negative interest rates, global inflation and inflationary expectations at undesirably low levels, economic growth in much of the world bordering on recession, and even the economic recovery in the U.S., while one of the longest in history, also being one of the slowest.
The question becomes whether or not these recent trends will, as Chairman Powell expects, not only continue into the future, but also become so embedded into expectations that they are simply accepted as the way that things are.
While this concern may, at first glance, appear to be nothing more than hyperbole and an unjustified extrapolation into the future of an extreme and even bizarre period in economic history, what Powell is describing is not very far removed from the economic experience of Japan over the last three decades.Moreover, the stage remains set for Powell to potentially be right, as we are in a world where both markets and economies are being driven by extraordinary and often external macro-economic factors like trade wars and tariffs, nationalism, economic isolationism, and heroic measures of monetary policy. Further supporting his perspective is the fact that the world’s central banks are already pushing their ability to stimulate the global economy to the absolute breaking point, where low interest rates are actually becoming an economic drag, particularly in Europe and Japan, where negative interest rates are simply making banks too financially weak to make loans into the economy.
This likely explains Fed Chair Powell’s November 13th warning to the Joint Economic Committee of Congress that “The federal budget is on an unsustainable path, with high and rising debt. Over time, this outlook could restrain fiscal policymakers’ willingness or ability to support economic activity during a downturn.” In other words, the Federal Reserve is almost out of ammunition and Congress may be too constrained by the huge deficits to introduce fiscal stimulus through tax cuts and spending increases.
In addition, if we are to take Powell at his word, the Fed is on indefinite hold in regard to interest rates, until either inflation exceeds 2.0% on a persistent and sustainable basis, in which case they could raise rates, or the economy changes in a way that is significantly outside of their current expectations, in which case they could move rates in either direction.
However, that is not to suggest that the Fed is on hold overall, as its desire to start “normalizing” monetary policy has been sabotaged by liquidity issues in the repo market, where banks go for overnight financing. This lack of liquidity was likely caused by over-regulation, and exposed by the Fed’s quantitative tightening program, when they drained liquidity out of the economy by shrinking the size of their balance sheet.The Fed has been forced to respond to this issue by reversing the factor (quantitative tightening) that exposed the problem in the first place, and has been injecting billions into the markets through the purchase of short-term Treasury bills.
Just since the repo market liquidity issues first appeared back in mid-September, the Fed has already reversed 40% of its previous quantitative tightening, and it is having a big impact on money supply, which has, over the past 12 weeks, been growing at a double-digit annualized rate.
While we doubt that this will make a huge difference to the economic outlook, as interest rates being too high seems to be the least of the economy’s troubles, history suggests that its impact on equity prices could be quite significant.You can see quite clearly the very tight correlation that has existed since the onset of quantitative easing between the size of combined balance sheet of the world’s central banks (blue line) and the combined value of the world stock markets (red line). We also suspect that it is anything but coincidence that the recent $286 billion expansion of the Fed’s balance sheet (which represents a 4.5% increase in the size of their balance sheet) coincided with a 4% increase in the S&P 500 Index.This global relationship between monetary liquidity and equity prices is further evidenced by both the very tight correlation between the size of the Federal Reserve’s balance sheet and the returns of the S&P 500 (top chart) on one hand, and the S&P 500 versus broad money supply (M2), which has been growing at an annualized rate of 10.5% over the past twelve weeks (second chart) on the other.Of note, the Federal Reserve has frequently stated that the recent expansion of their balance sheet should not be construed as a renewal of quantitative easing, and that it is purely a technical move designed to offset liquidity constraints in the repo market. Perhaps so.
However, these liquidity injections have served to both normalize the yield curve (i.e. return to a state where longer-term rates are higher than shorter-term rates) and have even helped to reduce the level of negative-yielding debt in the world. In short, despite the Fed’s protestations, this Fed response to the illiquidity in the repo market is quantitative easing in every sense of the term. Moreover, according to Gluskin Sheff, the amount of liquidity that the Fed has already injected to calm the repo market is equivalent to a de facto easing of 60 basis points (0.6%) just since September, which is almost as much as they lowered rates (0.75%) through a combination of their three actual cuts in the Federal Funds Rate. So much for the Fed’s ambitions of returning to a “normal” monetary policy.
At present, the futures markets are pricing in one more rate cut from the Federal Reserve within the next twelve months, which is slightly more dovish than is the recent guidance from the Federal Reserve itself.However, if you look at the most recent Federal Reserve “nowcasts”, which try to provide a snapshot of current economic conditions, they are showing a rather disturbing pace of economic slowing, which is much more pessimistic than are most current Wall Street estimates.
If the current slowing is indicative of a future trend, the Fed may soon find itself in need of abandoning it neutral policy on interest rates. Indeed, even more potentially concerning than the Fed’s nominal reading of current conditions is the rate of acceleration to the downside.The Atlanta Fed’s GDP Nowcast has lowered its estimate for current growth from 1.00% to only 0.30% in just the last week alone and, not to be outdone, the New York Fed made a similar adjustment over the past week to its Nowcast, with a decline from 0.73% to only 0.39% U.S. growth.If these readings are even close to being accurate, it suggests that the economy is growing at a much slower pace than what is being priced into either economic models or the capital markets.
Granted, it should not be much of a surprise if we were to see a renewed slowing in the economy, as the very fact that the yield curve has, until just recently, been inverted, with short-term rates being higher than longer-term rates. This condition, as we have discussed extensively in our past writings, has historically been a remarkably accurate predictor of economic recessions.
That said, there has been a lot of market and economic commentary recently that the normalization of the yield curve means that the economy is now out of the woods, and that a recession (or at least a substantial slowdown) has been delayed for the foreseeable future. However, while the past is not necessarily prelude, that is not the lesson that history teaches us.To start with, the historical correlation between an inverted yield curve (shown in red) and recessions (shown as grey bars) is one of the most easily discernable and historically most reliable of all economic indicators. Indeed, we suspect that its reliability is a result of the fact that an inverted yield curve is both a useful predictor of recessions and a logical cause for them, as they make it unprofitable for banks to lend.
As such, it certainly makes sense on the surface that the restoration of a normal yield curve, with longer-term rates moving higher than shorter-term rates, would indicate an improving outlook for the economy, as it improves the profitability of the banking system and suggests an economic rebound. We absolutely buy the first point, which is largely why the banking sector has gone from being a significant laggard to an equity market leader. However, we are less convinced of the latter.
In point of fact, the yield curve almost always normalizes between its period of inversion and the impending recession, and it does so for a very simple and explainable reason. As the risk of recession becomes evident, the Fed starts lowering short-term rates (orange line) in an attempt to forestall the slowdown, and this action causes short-term rates to fall relative to longer-term rates (blue line)thus normalizing the yield curve.
Further, this time, in addition to three cuts in the Fed Funds Rate, the Fed has reengaged in quantitative easing and is using the program to buy short-term debt, which further normalizes the curve. This is one difference between the current quantitative easing and its predecessors (QE1, QE2 & QE3), when the Fed concentrated its purchases on long-term debt.
In summary, while we are not suggesting that the recent normalization of the yield curve necessarily means that a recession is imminent, we do view as specious the idea of using it as evidence that the previously inverted yield curve’s warnings of a significant slowdown and/or recession have somehow been invalidated.
Ultimately, we believe that trade is still the single most important issue for the market and the economy, and this perspective was just echoed at the Chicago Mercantile Exchange’s Global Financial Leadership Conference, where 58% of attendees listed a trade agreement with China as the single biggest driver of the economy over the next twelve months and 39% listed the U.S./China Trade War as the single biggest risk to the economy over the same period.
We continue to believe that the new consumer tariffs currently scheduled for December 15th are of particular importance, as they will be the first tariffs directed at the domestic consumer, which has been driving the U.S. economy in the face of great pessimism among corporate executives and a corresponding decline in business spending. During the third quarter “CEO confidence plummeted to the lowest level since the Global Financial Crisis,” according to a recent study from Duke University that found a majority of CFOs expect the U.S. will be in a recession within the next year. Surveys show that much of this caution is trade and tariff-related.
The prediction markets are only assigning a 23% likelihood of Trump and Xi meeting in person this year, and many are viewing this as a proxy for the likelihood of a trade deal. If correct, this means that a trade deal will not be in place by the date of the December 15th tariff increases.Nonetheless, the markets seem to be pretty confident that the new tariffs will not go into effect, and that President Trump will end up delaying their implementation based on some claim of trade progress.
However, former White House chief economic advisor Gary Cohn noted on November 18th his opinion that President Trump will impose the Dec. 15 tariffs if the U.S. and China haven’t agreed to a trade deal. He noted in a CNBC interview, “I think he thinks that that’s a forcing function and if he keeps blinking, he loses credibility in the Chinese eyes.” That comment echoes the comments made by Treasury Secretary Steven Mnuchin on October 14th. Moreover, on November 19th, President Trump threatened to increase tariffs even beyond those already scheduled to go into effect on December 15th, if a deal was not made. Unfortunately, it remains the case that the least predictable market catalyst is also the most influential.
Of note, while it is hard to be anything other than skeptical in light of so many previous examples of “crying wolf”, there are new reports of China making some concessions in regards to intellectual property protection. If true, that would be significant progress.In addition to concerns about the potential impact of the December 15th tariffs, we worry about current equity valuations and excessively bullish sentiment. Indeed, with a forward P/E multiple of 17.6X earnings, the market is the most overvalued since January of 2018, which marked the highest relative strength reading (i.e. extreme bullish sentiment) ever, and led to a significant decline that took months to recover from. Furthermore, valuations are likely to be further exacerbated by what is expected to be two consecutive quarters of declining corporate earnings.
That said, there are a variety of reasons why the equity markets are likely to remain buoyant for at least the remainder of the year, unless trade tensions worsen and the December tariffs are implemented. To start with, with so many accrued capital gains in their portfolios, many investors may, for tax reasons, be hesitant to sell anything until after the turn of the year, which may keep selling pressure at bay.
We also would expect for the equity markets to be supported by performance-chasing and portfolio managers trying to catch up with their performance benchmarks after such a strong year. Further, the market’s recent unwillingness to decline on negative trade news has been nothing but impressive. There are even reasons to believe that 2020 might be another decent year for equity investors, including the fact that years with very strong returns tend to be followed by years with decent gains.
That said, next year is an election year, and the first half of election years tend to be rather weak due to all of the election-related uncertainty, only to rally in the second half of the year once investors think that they have figured out what the election results are likely to be (almost without regard what that outcome is). In the meantime, proponents of free-market capitalism are likely to be encouraged by the declining poll numbers (and prediction market odds) for Elizabeth Warren, and the addition of Michael Bloomberg into the race, which should help to pull Democrats towards the center. 2020 should be a very interesting year.