Written by Jim Welsh
Macro Factors Monthly Market Report 01 January 2019
Is a Recession Looming in 2019?
One of the most widely accepted axioms on Wall Street is that markets are a discounting mechanism. The implication is that markets possess a form of collective wisdom and those who listen to the message of the market are smart investors.
Please share this article – Go to very top of page, right hand side, for social media buttons.
Copper is reputed to have a Ph.D. in economics because of its ability to predict turning points in the global economy and is therefore referred to by some market strategists as Dr. Copper.
Many Investors consider the bond market as being more astute than stock market investors, so messages from the bond market are taken more seriously. The messages investors have been receiving from the markets has created a sense of imminent doom. Crude oil has tumbled more than 40% just since October 1 on concerns the global economy is decelerating much faster than expected. Ten-year and 30-year Treasury yields have shed almost 0.50% just since November 1, and the S&P 500 has dropped by almost 20% since peaking on October 3.
When the Federal Reserve decided to raise the federal funds rates by 0.25% on December 19 and indicated it might raise the funds rate twice more in 2019, it was simply too much for equity investors to bear. Jerome Powell and his less than merry fellow members of the FOMC were widely derided for not paying attention to what the markets were saying. On December 20 The Wall Street Journal editorial accused Powell and the Fed for being deaf:
“Mr. Powell and the staff may think they setting interest rates, but the markets are saying, sorry, we are. Markets also seem to be saying they’re not sure Mr. Powell and the Fed appreciates the economic risks ahead of tightening financial conditions.”
CNBC’s Jim ‘They know nothing’ Cramer accused Powell and the Fed of being reckless and more willing to sacrifice additional wage gains for the middle class for fighting a nonexistent threat from inflation. On financial news programs the potential that President Trump might sack Powell as the Chairman of the Federal Reserve was discussed seriously. Not quite high treason but close enough!
Financial conditions have tightened in 2018 according to the Goldman Sachs Financial Conditions Index (FCI). It is worth noting though that financial conditions were far tighter in early 2016 than now. Although economic growth slowed to 1.3% in the second quarter of 2016, GDP subsequently recovered and finished 2016 at 1.9% in Q4. The majority of the recent tightening is due to the decline in the S&P 500 so the FCI has likely risen further but remains comfortably below its level in 2016.
From a low of $1.93 in January 2016 Copper rose to $3.31 in June of 2018 before falling sharply to a low of $2.55 in August 2018. Since then Copper has been chopping sideways between $2.65 and $2.85. A 50% retracement of the $1.38 rally from the January 2016 low would target $2.62 while a 61.8% retracement would allow for a drop to $2.46. The 2018 decline has held near these retracement targets and importantly held above the trend line connecting the lows in December 2016 and May 2017. This indicates that the uptrend since the low in January 2016 is still intact. So far the trading action in Dr. Copper is not unusual and hardly symptomatic of a recession warning. As long as Copper doesn’t close below $2.48, a rally to $2.90 or higher seems more likely than more weakness.
The 40% decline in WTI crude oil is certainly stunning but a significant portion of the plunge may be due to positioning in the energy futures market and President Trump’s Iranian double cross on November 5. From a low of $42.04 in June 2017 WTI crude oil rallied almost uninterruptedly to July 2018 before experiencing a modest correction. This one way trade higher attracted a lot of speculative money that went long WTI oil through crude oil futures. In June 2017 Large Speculators and Managed Money were long 433,171 contracts. By early July 2018 this long position increased by more than 250% to 1,084,181 contracts. The logic for this trade was compelling. Global growth was healthy and synchronized, U.S. growth was very strong, and President Trump had promised to apply sanctions against Iran, which was expected to remove more than 1 million barrels of daily production from the global oil supply.
As WTI oil was peaking in early October, the ratio of long positions to short positions was 14 to 1. Talk about a crowded trade! WTI crude subsequently fell from $76.40 on October 3 to $64.33 on November 5 which was the lowest price since mid April. This meant that every position in crude oil futures established since mid April was losing money. This likely contributed to some of the price weakness prior to November 5.
President Trump had asked Saudi Arabia to increase their oil production so crude oil prices wouldn’t spike higher after sanctions against Iran went into effect on November 5. Saudi Arabia responded by increasing production which also contributed to the price decline from the October 3 high.
When President Trump decided on November 5 to exempt most countries from Iranian sanctions, he effectively pulled the rug out from underneath the oil market. This meant the global supply of oil would rise by 1 million barrels a day, rather than falling by that amount, as traders in crude oil futures had expected and positioned for. Within 3 weeks of Trumps decision WTI oil was trading near $50 a barrel.
The massive long crude oil position held by Large Speculators and Managed Money wasn’t the only crowded trade in energy futures. For most of the last 2 years natural gas prices traded in a range of $2.50 to $3.25 in large part because supply was plentiful. This stability led energy traders to establish a long crude oil position offset by a short position in Natural Gas futures. A perfect storm developed in early November as an unusually long cold spell hit the Northeast driving up demand for Natural Gas just as WTI Oil prices were collapsing. Traders short Natural Gas were forced to cover their short positions which drove the price from $3.20 on October 29 to high of $4.93 on November 14, an increase of 54% in less than 2 weeks!
The unwinding of the long oil/short natural gas aligns with the record 13 consecutive days of decline in oil prices in the first half of November. Since the short squeeze expended itself natural gas prices have plunged and are below their October level in six weeks. It should be noted that a number of hedge funds have closed due to losses incurred from the extraordinary volatility in crude oil and natural gas futures.
Understandably, strategists think the oil market is ‘telling’ them that the global economy is slowing more abruptly than they or anyone else realized. This view has gained some traction since the global economy has already been slowing since the spring with recent data suggesting the deceleration in growth may have accelerated. Global financial conditions have tightened but as in the U.S. remain well below the levels reached in early 2016. Central bank monetary policy has been a major tailwind for the global economy and global financial markets, as the European Central Bank (ECB), Bank of England (BOE), and Bank of Japan (BOJ) joined the Federal Reserve with large Quantitative Easing programs of their own.
Even as the Fed began trimming its balance sheet in October 2017, the combined balance sheets of the Fed, ECB, and BOJ continued to expand so that the 12 month moving average was still positive. In 2018 the rate of expansion slowed materially with the Total 12 month moving average turning negative in mid year. The majority of global equity markets reversed lower in the April 2018 as the central bank balance sheet tailwind became a headwind.
The withdrawal of the liquidity infusion by central banks has contributed to a rapid slowing the Global M1 money supply and global liquidity. This suggests the slowdown in global economic growth is likely to persist in early 2019. Global Dollar liquidity leads global equity markets by 8 months. It has had a correlation of 76% and suggests that global equity markets on balance are likely to remain under pressure in the first quarter of 2019.
(The axis’ on the estimate of global liquidity chart are incorrect. M1 Liquidity is on the right hand scale with the World Equity market on the left hand scale.) I discussed the global growth outlook in the August Macro Tides which was entitled “Synchronized Slowing Growth” a few months before the hand wringing began.
The progressive chilling effect on global trade from the escalation of tariffs by President Trump and China is clearly evident from the marked decline in Global Manufacturing PMI New Export Orders. Global trade follows changes in PMI New Export Orders with a lag of 3 months and suggests additional weakening in global trade is coming in early 2019.
The decline in oil prices will also weigh on manufacturing as oil companies slash their drilling activity in the U.S. The monthly manufacturing report from ISM will fall in coming months but it must be noted that the decline will be from a historically high level of 59.3. Equity investors are likely to respond negatively to the downward direction than the absolute level.
Receding central bank liquidity had a profoundly negative impact on international stock and bond prices, especially after the Dollar began to rally in April. According to Deutsche Bank 90% of all asset classes have posted a negative return in 2018 the highest percent since 1901! Although this chart is based on data through November 27, (Table thru 12/27) global equity markets have fallen further since that update. This is one year where portfolio diversification has done a better job of producing investment losses than lowering risk as the table below illustrates.
The European Central Bank (ECB) has successively lowered its GDP growth estimate for 2019 and now projects growth will be 1.7%. Although it may be stating the obvious, 1.7% GDP growth is nowhere near a recession even if it comes in a bit lower.
There are risks that could negatively impact EU growth in 2019. Britain has to resolve its Brexit issue and a hard exit would be disruptive. My guess is another vote is likely since British support for leaving the EU has been falling for months and is now below 50%. Italy appears to have placated EU officials by lowering its budget deficit from 2.4% to 2.06%. This short term solution does nothing to address the longer term problems Italy faces of weak economic growth, low productivity, and a smothering debt to GDP ratio of 137% second highest in the EU. France is experiencing a bout of unrest and Macron’s support may be lower than Trump’s which puts his plight into perspective. France’s budget deficit for 2019 is comfortably above EU limits but may get a pass since it’s the second largest economy in the EU and gets to play by a different set of rules than Italy.
China’s growth has been slowing for years and that trend will continue in 2019. In November Retail Sales fell to their lowest since 2003 while Industrial Production is down to levels last seen in 2008.
The People’s Bank of China has been easing monetary policy by lowering interest rates and the amount of reserves Chinese banks are required to hold. The yield on China’s 3-year sovereign bond has fallen by 2.0% and should lead to a pick-up in money supply growth in coming months. Economic growth is set to stabilize and firm as money supply growth finds its way into the economy in coming months. One long term risk to China’s economy from the trade and tariff dispute is companies moving production from China to other Asian countries. Wages have risen significantly in the past 15 years which has been important in creating a larger middle class in China.
The downside is that Chinese wages are now higher than in Viet Nam, Philippines, Indonesia, India, Malaysia, and Thailand. If companies perceive that the trade tariffs might become permanent, they will seriously consider the disruption of moving production out of China to avoid the tariffs and hassle. In its October 2018 World Economic Outlook the IMF estimates global GDP growth of 3.7% in 2019 which is 0.2% lower than its 2019 forecast in April. Clearly, the risk to their forecast is that growth will prove weaker than projected. If global growth falls to 3.5% it will be at the level in 2016. As I discussed in the May Macro Tides and months before global slowing appeared on the radar screen:
“Periods of slower growth during an expansion are not uncommon and in the past 22 years have occurred often without leading to a recession. This is the 13th time global growth has slowed since 1995 but a recession followed only three times. Since the current recovery began in June 2009 this is the sixth time the economy has down shifted.”
It is likely that investors are overreacting to the slowdown in global growth.
Emerging Market bonds and equities have fared poorly in 2018 registering double digit losses. Emerging market equities peaked in January and rolled over in March as the Dollar began its rally to my target of 95.00 from its low of 88.25 in February. The relative strength of Emerging Markets as measured by the ETF EEM has been improving significantly as the S&P 500 has plunged since its high on September 21. This suggests that once the decline in the S&P 500 is over and a rebound takes hold, EEM is likely to outperform.
According to the Bank of America Merrill Lynch Euphoria / Panic indicator, Emerging Markets have reached a Panic level that has often preceded rewarding periods of positive returns. In early October EEM was trading near $42.00 and I thought EEM would trade down to $38.00 as noted in the October Macro Tides:
“In coming months EEM has the potential to test $38.00 which suggests patience.”
EEM traded down to $37.57 on October 29. I think EEM is approaching a great buying opportunity and would recommend an overweight position i.e. 150% of the normal allocation to EEM. Buy 50% of a normal position if EEM trades under $38.00 and add another 50% if EEM trades under $37.57. Once it appears that the S&P 500 has bottomed, I will recommend a third 50% position.
In addition to the crowded trades in Oil, Natural Gas, and Treasury bond futures, the other crowded trade was in the FAAMNG stocks. In the September 10, 2018 Weekly Techncial Review I discussed how much money had flowed into technology stocks in general and how excessive the valuation of the FAAMNG stocks had become:
“A Money Flow analysis by Bank of America Merrill Lynch illustrates just how crowded and extreme the Technology trade has become since October last year compared to the prior 8 years. The recent peak in money flow into Technology is more than 4 times as large as the highs 7 in 2011 and 2014. Flows have begun to reverse and the recent price weakness is likely to spur more selling in the short term. The FAAMNG stocks (Facebook, Amazon, Apple, Microsoft, Neflix, Google) have a higher capitalization than the bottom 290 stocks in the S&P 500 and comprise 15.0% of the S&P 500.”
In the September 24 Weekly Technical Review I provided the following warning:
“The market continues to lose internal strength as measured by a number of momentum indicators. This suggests the market is now vulnerable to a sharp sell off if any reason to sell materializes.”
In the October 1 Weekly Technical Review I noted that the market’s internal strength was as weak as it was just before the sharp decline in the summer of 2015:
“The S&P 500 came within 0.2% of a new all-time high on October 1, but the percent of stocks making a new 52 week high during the past 21 days is comfortably below 0%. The last time the percent of stocks making a new 52 week high was below 0% with the S&P 500 within 2.5% of its high was in mid June 2015. The fact that this is occurring so close to the all time high is extraordinary.”
In the September 4 Weekly Technical Review and just 2 days after the Nasdaq 100 had made an all time high, I noted that cracks were beginning to form within FAAMNG which didn’t bode well for the technology sector:
“The six FAAMNG stocks represent 49.1% of the Nasdaq 100, so those stocks have almost as much of an impact as the other 94 stocks. Since late July Apple is up 15.7% while Amazon has gained 13.1%, which has enabled the Nasdaq 100 to overcome the weakness in Facebook and Google, and the volatility in Netflix. The strength in Apple and Amazon are masking the fracture that is developing within FAAMNG. If and when Apple and Amazon experience a bout of profit taking, the Nasdaq 100 won’t be saved by Facebook, Google, or Netflix. Of these six stocks only Apple and Microsoft have posted a new high since September 4. Today (September 4) Microsoft closed below a trend line from the late June low, and Apple will likely confirm a top if it closes below 215.”
Apple closed below $215.00 on November 2 and crashed to $147.00 on December 24.
The 15% weighting of the 6 FAAMNG stocks in the S&P 500 has played a role in dragging the S&P 500 lower but the overall valuation of the stock market indicated that the S&P 500 was vulnerable to a valuation adjustment. In recent months the total capitalization of U.S. equities as a percent of GDP reached the second highest level since 1950. As of September 30 the ratio was 151.3% well above every prior peak other than during the dot.com mania. The ratio of equity prices compared to GDP is Warren Buffett’s favorite valuation metric and has become known as the Buffett Indicator. (Chart courtesy of Doug Short Advisor Perspectives)
Since 1871 the S&P 500’s real (inflation-adjusted) monthly average of daily closes has produced a compounded 1.83% annual growth rate. During the past 147 years there have been extended periods when the S&P 500’s return has jumped well above its trend growth rate of 1.83% and fallen below this trend during extended bear markets. The best examples are the great bull market that began in 1982 and carried to the valuation extreme in 2000 and the 89% plunge associated with the Great Depression.
In 1932 the S&P 500 fell 67% below its trend growth rate, rose 133% above it in 2000, and in March 2009 was -19% below its trend. At the end of November 2018, the S&P 500 was 113% above its long term growth trend. This analysis is not to imply that the S&P 500 is on the cusp of a major decline that might compare to the 50% haircuts experienced in the 2000 – 2002 bear market and the financial crisis. This analysis does underscore why the S&P 500 could fall 20% even though a recession is certainly not likely in the first half of 2019.
The unwinding since early October of the crowded trades in crude oil, natural gas, Treasury bonds, and FAAMNG stocks in such a compressed time created a dominoe affect that generated margin calls and forced selling that spilled over from each market into assets in general. The convulsion of selling pressure says more about the technical nature of the unwinding of crowded trades than it does about the health of the global and U.S. economy.
Clearly global growth has been slowing since the spring of 2018 and U.S. growth will decellerate in 2019 and could be further buffeted by the trade and tariff negotiations with China. The risk of a recession has increased but remains less than 20% according to research by Piper Jaffrey based on the spread between the 2-year and 10-year Treasury bond. As this is being written on December 31, the 2-10 spread is 19 basis points (bp) which suggests the odds of a recession is less than 15.2%. It should be noted that since 1950 a recession has begun on average 19 months after the 2-10 spread becomes negative (inverted yield curve).
On CNBC the running debate is whether financial markets are signaling that a recession is coming or just a slowdown. An economist for one of the largest banks in the world made the following commnets which have been made by other economists and stragetists in recent weeks:
“Financial markets don’t reflect what’s going on now. They reflect what’s likely a year or two from now.”
If one really believed this statement they wouldn’t have to worry about the economy until September of 2019 or later since the S&P 500 made an all-time high on September 21, 2018!
The belief that markets discount the future is so universally accepted that the silliness of this statement and view is rarely questioned. It is also remarkable that as economists and strategists grope for an explanation for the S&P 500’s 20% tumble, I haven’t heard a single one mention the extreme positioning in oil, natural gas, Treasury bonds, and the FAAMNG stocks as a contributing cause. The slowng in the global economy provided the spark but the unwinding of extreme positioning and its spillover effect on pyschology was an eccelerant on the fire.
Economic data is likely to be mixed in the first quarter. The ISM manufacturing data is going to decline in response to the sharp decline in oil prices and continued reluctance by companies to increase business investment until the tariff and trade dispute with China is resolved. Companies boosted their inventories in the fourth quarter in order to beat the increase in tariffs on January 1. The accumulation of inventories will lift GDP in the fourth quarter but likely subtract from GDP in the first quarter as companies cut back on their inventory purchases. Consumers are likely to pay down in Q1 some of the credit card debt accumulated for their Merry Christmas and Holidays.
Wage growth should hold above 3.0% and grind higher so consumer spending is likely to remain above 2.0%, which will add about 1.5% to GDP growth. While the decline in oil prices will weigh on manufacturing, the 22% drop in gasoline prices represents a mini tax cut for consumers and could add 0.4% to consumer spending in the first half of 2019.
Historically, 68% of tax payers have not itemized their deductions when they filed their tax return. The significant increase in the standard deduction for all filers is likely to increase the percent of taxpayers who don’t itemize to 90%, according to the nonpartisan Tax Policy Center. This may result in a larger refund than expected and affect up to 130 million tax filings. If correct, the economy could get a lift in the second quarter as some of the larger refunds are spent.
For years first quarter GDP has been consistently the weakest quarter of the year. In mid 2018 the Bureau of Economic Analysis (BEA) concluded an extensive analysis to remove ‘residual seasonality’ from the data it produces and receives from outside agencies like the U.S Census Bureau and the U.S. Labor Department. As part of their review, the BEA seasonally adjusted some underlying data that hadn’t previously been touched, and conducted numerous tests on historical data. The BEA now believes the updated series do not show signs of residual seasonality in real GDP or its major components over the full time span (1947-2017) or the most recent 15 years (2003-2017).
Correcting residual seasonality doesn’t impact annual GDP growth, but it did rebalance the amount of quarterly growth within each year. Prior to this analysis first quarter GDP averaged 1.6% from 2012 through 2017. After the revisions, the BEA now reports that first quarter GDP growth actually averaged 2.1% during that period. The average for growth in the second quarter was also lifted from 2.6% to 2.7% through 2017. Since the elimination of residual seasonality doesn’t change annual GDP, the increase in growth for the first and second quarter was essentially taken from the third and fourth quarter in the prior estimates for growth.
The BEA now reports that third quarter GDP averaged 2.4% instead of 2.7% from 2012 through 2017, and fourth quarter growth was revised down to 1.7% from 1.9%. The revisions now make the fourth quarter the weakest quarter each year rather than the first quarter.
I’m not sure the BEA’s seasonality changes are widely known compared to how conditioned investors have become with the first quarter always being weak. This creates the potential that many investors may be surprised that first quarter GDP proves more resilient since Q1 will be boosted by 0.5% due to the BEA’s seasonal adjustment change. The BEA’s first estimate of Q1 GDP will be announced on April 26, although investors will monitor and scrutinize every data point and the Federal Reserve of Atlanta’s GDPNow report which is updated continuously throughout each quarter.
The tariff and trade negotiation with China remains the biggest unknown for 2019 and could either boost growth if resolved or tip the economy toward a recession if it becomes a trade war. However, based on what is known a recession in 2019 is not likely. If the unwinding of crowded trades has influenced those who believe markets are a discounting mechanism into expecting the economy to be weak, they may be surprised. Many now believe the Federal Reserve will not increase the funds rate twice in 2019 and one prominent strategist has said the Fed will be forced to cut rates in 2019.
If the economy is as resilient as I think and growth picks up by mid-year, the Fed may again be in focus by midyear. The reality is that the members FOMC don’t know whether they will raise rates in 2019 or how many times if they do. They do know they will respond to the data and not the dot plot.
Federal Reserve
The Federal Reserve has been roundly criticized for increasing the federal funds rate at its December 19 meeting and for publishing its dot plot which anticipates two more rate increases in 2019, even though GDP growth is slowing. It should be noted that the FOMC’s projection for GDP growth in 2019 was 2.4% at the March and June 2018 meetings and 2.5% in September. The projections for 2018 GDP were 2.7% in March, 2.8% in June, and 3.1% in September. At the December 19 meeting the FOMC lowered its estimate for 2018 to 3.0% and to 2.3% for 2019.
The changes in its GDP projections for 2018 and 2019 indicate that the FOMC has been responding to incoming data all along. This suggests that if economic data comes in weaker in 2019 than the FOMC expects the dot plot will not be adhered to. In 2016 the dot plot projected three increases in the funds rate but the FOMC only increased it once. The dot plot is a communication tool and not a policy tool. After the December 19 meeting investors concluded that the dot plot indicated the FOMC would increase the funds rate no matter what. This reveals a complete lack of understanding of how the FOMC has proceeded in recent years.
Prior to the December 19 meeting a growing number of investors were expecting (hoping) that the FOMC would increase the funds rate and then communicate that it was pausing for a period of time. This expectation shows a naïve view of how the FOMC operates. There was absolutely no way the FOMC would shift from communicating 3 hikes in 2019 to none. Instead the FOMC lowered its projection for GDP growth from 2.5% to 2.3% and reduced the expected number of increases from 3 to 2.
This is the FOMC’s way of telling investors that it recognizes and acknowledges that growth is slowing and will be responsive to incoming data. By communicating in this manner the FOMC retained its optionality. Just as they don’t want to be boxed in by the dot plot, they wouldn’t want to publically hit pause and then risk having to communicate the need to resume hikes if incoming data proved stronger than expected.
The FOMC has been increasing rates once a quarter since December 2017 which implies another hike in March 2019. Based on how the FOMC communicated its outlook for 2019, the odds of an increase in March are very low.
I think the FOMC is pausing for three reasons. They want to see how pronounced the slowing becomes and whether it proves temporary. The FOMC wants to know how the tariff and trade negotiations will impact growth after the March 2 deadline.
Finally, one of their primary goals has been to increase the funds rate to a neutral level so monetary policy is neither accommodative nor restrictive, and where growth and inflation are both at their natural rate on a stable basis. By raising the funds rate at the December meeting the FOMC knows it is close enough to neutral to pause since there is no qualitative way to precisely measure the neutral rate.
Prior to the December 19 meeting there was a vocal but minority chorus of those who thought it was inappropriate given the weakness in the U.S stock market for the FOMC to increase the funds rate. Historically, the real federal funds rate has been 2.0% above inflation. With inflation hovering near 2.20% and the federal funds rates at 2.20% prior to the December meeting, the real federal funds rate was 0%.
The U.S. economy is in the tenth year and second longest recovery since World War II. The unemployment rate is 3.7% a 49 year low and inflation is hovering at the Fed’s target of 2.0%. The Federal Reserve has achieved its mandate of maximum employment and stable prices.
The current rate of GDP growth is well above the Fed’s estimate of the economy’s long run potential growth rate of 1.8% and will remain above it even if GDP growth slows to 2.3% in 2019. Under the current circumstances the FOMC determined it was inappropriate for the real federal funds rate to be 0%.
In June 2017 Fed Chair Janet Yellen said the unwinding of the Fed’s balance sheet would be like “watching paint dry.” Prior to December 19, 2018 one could agree Yellen’s comment was accurate. Chairman Powell was strongly criticized for saying the shrinkage of the Fed’s balance sheet which began in October 2017 was on autopilot. Clearly, Powell and the other members of the FOMC have seen nothing to suggest the unwinding of the balance sheet was causing any economic or financial disruptions.
There have been estimates that suggest the balance sheet unwinding is comparable to additional increases in the federal funds rate. The logic is straightforward. Quantitative Easing (QE) added liquidity to the financial system and effectively lowered the federal funds rate below 0%. According to the Federal Reserve of Atlanta QE effectively lowered the Shadow Funds rate to minus -3.0%.
It follows then that Quantitative Tightening (QT) not only removes liquidity but also equates to a higher federal funds rate. There is no play book since the Federal Reserve had never used QE so the full affect of QT is not known. One thing is for certain. Given the attention QT has received since December 19, the FOMC will be reviewing the process and deliberating under what conditions its $50 billion a month QT should be modified. I doubt the FOMC will specifically say QT is being reviewed but Fed presidents and FOMC members may comment that every aspect of monetary policy is always viewed in the context of incoming economic data.
In all likelihood the FOMC will conclude that QT does represent a higher federal funds rate than the official policy rate and determine that the current federal funds rate is at the mythical neutral rate. If correct the FOMC has another reason to pause and not increase rates in March.
Finally, some strategists have proclaimed that the FOMC had to increase the funds rate at the December meeting to show their independence after so many Tweets from President Trump criticizing the Fed for prior increases. This criticism borders on silliness and demeans the integrity, dedication, and absolute resolve the members of the FOMC possess in trying to do the best they can in conducting monetary policy.
This does not mean they will get it right. But to suggest that the FOMC would change the path of policy in response to sophomoric tweets illustrates such a shallow level of critical thinking and understanding by anyone espousing such nonsense. These folks have a fondness for conspiracy theories and would be happy to share all of them to anyone dumb enough to listen.
U.S. Stocks
One of the factors that weighed on stock prices in the fourth quarter was companies lowering their earnings guidance for coming quarters. When fourth quarter earnings are announced the number of companies that lower their forward guidance will increase. This could prove a negative for the stock market after the second half of January as the number of earnings calls jumps.
If companies guide lower, Wall Street analysts will be forced to lower their earnings projections for 2019 which could put further downward pressure on P/E ratios. One of the big stories in 2018 was the decline in stock prices and the compression in the S&P 500’s P/E ratio, even though earnings were up 25% in 2018.
Rising wages could put more downward pressure on the S&P 500’s P/E ratio in 2019. Depending on the industry labor costs represent 30% or a bit less of manufactured goods to 50% of sales for service oriented firms. Average Hourly Earnings (AHE) climbed from less than 2.0% in early 2017 to 3.1% in recent months.
Historically, there has been a 2 year lag between changes in AHE and when they begin to 13 squeeze profit margins. This correlation suggests that the increase in wages since 2017 should begin to negatively impact profit margins in 2019 and 2020. (Please note that AHE have been inverted in the nearby chart so changes align with changes in profit margins.) It will interesting to see if companies mention that wage growth is squeezing margins during their earnings calls as 2019 unfolds.
Profit margins are also going to be pressured from higher interest expense as more than $1.2 trillion in corporate bonds are rolled over in 2019 and 2020 at higher interest rates. The Federal Reserve kept rates low for a long time and corporate debt as a percent of GDP is at a record high of 46%. A chunk of that debt was used to buy back stock in recent years.
S&P 500 companies expended $583.4 billion for stock buy backs through September 30 and at prices higher than where they are trading now. Now companies are going to have to pay the piper. The yield on the Bank of America/Merrill Lynch AA investment grade bond index has climbed from 2.06% in July 2016 to 3.54% on December 27, 2018.
In the December Macro Tides I expected the S&P 500 to be weak:
“There is a good chance the S&P 500 will trade below 2603 before the end of December. At some point in 2019 the S&P 500 has the potential to trade down to 2300 which is where the long term red trend line connecting the March 2009 low and February 2016 low resides.”
The S&P 500 was weaker than even I expected and dropped to 2347 on December 26 before rebounding. In the December 24 Weekly Technical Review I noted that two important indicators were signaling that a trading low was near and would be followed by a rally of 150 – 200 S&P 500 points:
“The TRIN readings and the Call/Put Ratio suggest the S&P 500 is in the zip code and close to finishing wave 3 soon. After wave 4 carries the S&P 500 up by 150 – 200 points, a decline to a lower low is likely to follow in wave 5.”
After bottoming at 2347 on December 26 the S&P 500 traded up to 2520 on December 28 a gain of 173 points.
I also discussed why it is likely that the S&P 500 will test and probably fall below 2347 in the first quarter:
“The 21 day Net percent of Advancing stocks minus Declining stocks closed at -29.1 on December 24 (below the orange horizontal line), one of the lowest readings since the 1987 crash, 1998 Long Term Capital Management selloff, September 2001 after 9/11, July 2002, financial crisis in 2008, and August 2011. In each case the S&P 500 experienced a rally and then a subsequent decline to a lower low that recorded a less oversold reading.”
The examples of 1987, 1998, and 2011 are noteworthy since they represent a decline of 20% or more in the S&P 500 even though the declines were not followed by a recession. The decline since October 3 has been sharp and condensed in time as the prior examples and the odds of a recession developing in 2019 is quite low.
Treasury Bond Yields
Treasury yields have fallen to the targets discussed in the Weekly Technical Review with the 10-year Treasury yield falling to under 2.74% and the 30-year dropping below 3.0%. Treasury yields may hold near these levels especially if the S&P 500 falls below 2347 in wave 5 early in 2019.
However, if the economy is not as weak as investors currently expect Treasury yields can begin to rise gradually after the stock market bottoms. If the economy picks up in the second quarter and core inflation grinds higher as I expect, Treasury yields are likely to test their highs of 3.248% on the 10-year and 3.455% for the 30-year Treasury bond.
Dollar
The Dollar is a crowded trade and sentiment is widely bullish which suggests the next bigger move is not up but down. My guess is that the Dollar can trade down to 94.00. If the Federal Reserve is on pause through at least the first quarter, the Dollar could be hit with some selling. Brexit remains a caveat since it could cause the Euro to weaken. The odds are increasing that Britain’s Parliament will approve another Brexit vote since polls show that less than 50% of Brits support leaving the EU. A decision to allow another vote would help the Euro rally and contribute to a decline in the Dollar.
Emerging Markets
Emerging Markets have the potential to perform well in 2019 after the S&P 500 bottoms and the Dollar corrects. Establish a 33% position in Emerging Markets ETF EEM if it trades below $38.00. Increase the position to 66% if EEM trades under $37.57 and to 100% if EEM trades down to $37.05.
Gold
Gold has been and still is expected to rally above $1300 in the first quarter of 2019.
Happy and Healthy New Year to you and your family, and the strength to deal with whatever challenges 2019 throws your way.
Today be Thankful for how rich you are. Your family is priceless, your time is gold, and your health is wealth.
.