Macro changes occur at a glacial speed but these are typically the most important metrics to track. This is separating the signal (macro shifts, leading data points, etc.) from the noise (CNBC).
Warning Signals from the Yield Curve
One of the most basic yet crucial metrics is the yield curve, which has certainly received a lot of buzz lately as it continues to flatten. The yield curve simply compares the yield of shorter dated bonds to longer dated bonds, and plots a line to connect them. Almost everyone focuses on the 2 year-10 year Treasury bond curve as THE key curve to track. Over the last 50 years or so, an inversion (2 year yield trading higher than the 10 year yield) has been a very reliable indicator that trouble is near.
I’ve always wondered why the government bond curve was the yield curve of choice for the markets since it’s the corporate sector that drives the economy so I typically watch corporate curves and spreads as well. Then Charles Gave, of Gavekal Research, penned a wonderful article a couple of weeks ago discussing this same thing. Charles is a very experienced market veteran and I make sure to get my hands on everything he produces. In his piece, he discusses how he has adjusted his framework over the years and, given the distorted nature of government bond markets these days, now prefers to focus on the corporate yield curve using the bank prime rate as the short rate and Moody’s Baa corporate yield as the long rate. I’ve looked into it and this is one of the best corporate curve indicators I’ve seen, and is something I will certainly be incorporating in my toolbox of analysis. You can read about it here.
The basic premise is that long-term corporate bonds typically track nominal economic growth so it can be used as a proxy for return on investment for companies. When short-term rates are below this, companies will borrow (at the low rate) to invest and earn the higher return. This spurs economic growth. Conversely, when short rates rise to a level that is higher than a return you can expect to earn, companies look to pay down debt instead of making new investments. This leads to a contraction in spending and the money supply, potential layoffs, falling prices, etc., which is basically a recession. It’s the same way I help clients decide what to do with extra money when comparing potential investment returns vs using the money to pay down existing debts.
The corporate curve has been flat for the last 6 months and as of last month’s print, the prime rate is now higher than the Baa market rate again – meaning the curve is inverted. If this does not reverse, things will almost certainly slow down in the months ahead. This could catch a lot of people offsides as most are still focusing on the Treasury yield curve which remains upward sloping. Historically, this corporate curve inversion has preceded either a recession here in the US or issues in emerging markets (like the Mexican Tequila Crisis of ’94 and Asian Financial Crisis of ’98). It’s the shortage of cheap funding that reveals the weak hands.
Corporate Yield Curve (shaded areas indicate recession).
This lines up with what I’ve been seeing all year: Volatility in the stock market has picked up, a weaker dollar (now starting to reverse), supply constraints and rising energy prices are leading to higher inflation readings, and most importantly, leading economic indicators are turning down (especially in China, which pretty much determines the direction of the global economy these days). All of these are typical late cycle signals. I’ve been putting on some option hedges over the past couple of weeks as I’m still expecting this weakness to lead to a shaky summer for stocks.
A Global Slowdown ‘Made in China?’
A quick side note on China: 2021 is the 100 year anniversary of the founding of the Chinese Communist Party (CCP). To put it nicely, China has a tightly controlled economy. The government basically decides whether to goose up or slow down the economy, and typically does so for political reasons. Going into elections and major celebrations, they want the economy and markets running red hot, which means they typically look to cool them down a couple years beforehand. This lines up well with what I’m seeing in the Chinese data turning lower and will affect things like emerging markets, industrial production, trade, and industrial commodity prices. This weakness should last for the next year at least and then start to bottom out sometime in mid or late 2019 to eventually pick up speed in 2020.
My hope is that the Chinese yuan, emerging market stocks and certain (industrial) commodities all move lower over the next year. I would view this as a major buying opportunity if it plays out as I’m expecting. For example, long-term I’m very bullish on copper but short-term we could absolutely see prices come off 15% or 20% if China continues to manufacture a slowdown and the US dollar continues to strengthen. That would create what is probably the best buying opportunity in copper for the next decade. I like copper long-term because electric vehicles, smart homes and smart appliances all require anywhere from 50% to 200% more copper than the “traditional” versions, but that’s for another post.
The Inflation/Disinflation Debate Rages on
Another major macro theme to follow is whether we’re shifting from 35+ years of disinflation to a new regime of structurally rising inflation. It feels like this debate has been ongoing since 2010 and it’s vitally important to get this right because it’s a completely different makeup of what you want to own in a portfolio. During times of disinflation, the tailwind of falling rates benefits both bonds and long-dated assets like real estate and growth stocks. During periods of rising inflation, one wants to own things like value stocks, commodities and cash, while long-term bonds denominated in the currency that’s falling get annihilated in real terms.
There are very smart people on both sides of this debate. The common argument for the deflation camp is high debt levels and poor demographics will keep prices compressed, both of which I agree with. The common argument for the inflation side is usually something along the lines of trillions of dollars of QE will eventually make it’s way into the system, weakening fiat currencies and leading to inflation. My view is that it’s still undetermined and there’s no need to go all in one way or the other (yet). The inflationistas are pointing to rising inflation and bond yields to declare victory, but in my opinion, this is not yet any different from past late cycle (cyclical) behavior. This is basically how the cycle works: supply constraints lead to higher inflation, long yields start to rise, the Fed raises short-term rates (usually too late and too far), inverts the curve and chokes off economic activity.
I can say with absolute certainty that the US dollar will be devalued in the years ahead, which is simply inflation, so I’ve already started shifting away from bonds and into other income producing assets which hold up better in the long run, like REITs. But I also think we’re likely to see one last deflationary shock hit the global economy before we go down the path of direct currency devaluations. This would mean another push lower in yields and short rates.
Regardless, I’m going to let the markets tell me which side is winning. The metric I’m using to track this dynamic is the ratio of gold to long-term Treasury bonds. If we’re shifting to a higher inflation regime, we will see gold outperform treasuries by quite a bit. If we’re in store for another disinflationary wave, then the opposite will happen and the ratio will drop. I believe this will be one of the most important metrics to watch moving forward to determine portfolio positioning.
Gold/Treasury Bond Ratio
Thanks for following!
-Nick