I haven’t posted anything in a while because every time I’m about to write an update, a new piece of pretty big news develops that potentially shifts the picture. So here’s a high level overview of my thoughts from the past month.
There’s a debate going on right now if the current slowdown will be a repeat of the 2015/16 slowdown which forced central banks around the world to inject the most stimulus on record and eventually led to a re-emergence of a new upswing. Or, with central banks running out of ammo and trying to pass the baton to fiscal spending, if this time we’ll actually see things slip into a recession. The stock market is very much buying into the “all-clear, growth upswing coming” camp, but with the Fed now implementing “not QE” and stocks mirroring their purchases on a weekly basis, it’s hard to know just yet. I, however, am still in the “recession risk is quite high” camp, as I will illustrate in this post.
US stocks continue to ignore the macro backdrop. The S&P 500 has held its momentum support trend line all year and November’s close broke back above the downtrend as well as the horizontal structure (see below, bottom left pane). From a technical perspective, this looks bullish unless we get a swift rejection and close back underneath – which is possible but a lower probability event right now. Last week’s pullback also perfectly tagged the prior price resistance line which is now holding as support (see below, right half).
S&P 500 – monthly & daily charts
US small caps also look like they want to make a run back up to last August’s highs after spending most of the year chopping around in what has emerged as a bull-flag pattern:
Russell 2000 – 5 year, weekly
And when looking underneath the hood, breadth has slowed a little, but I’m still not seeing the typical signs that would make me concerned yet.
Now for the macro concerns:
After a year of these trade war charades, President Trump is creating a real “boy who cried wolf” situation. He continues to play the markets like a fiddle because he knows algos respond instantly to every tweet or press release put out, but it’s really starting to feel like people are needing to see something substantive at this point. It’s bad when you’re watching Chinese press conferences to try to actually glean some real information about China’s position on the negotiations. I understand it may all be for leverage as a negotiating tactic, but it’s putting the markets in an unstable state by continuing to price in a “really great deal” if it never actually materializes. And buying an extra $30 billion of soybeans is not going to fix the underlying issues. Hopefully real progress can be made but my skepticism remains and my fear is that things have already taken too long and will negatively impact corporate spending plans for 2020.
But the real concern remains the money markets. This receives hardly any attention in the media because it’s not a sexy topic and not understood by most, but it is the #1 risk to be monitoring.
And it’s actually not stocks that I’m concerned about during the next economic downturn – it’s the bond market, and more specifically junk bonds and leveraged loans. The amount of outstanding junk rated debt has risen dramatically over the last decade as the need for yield continues to push money in their direction. At the same time, standard covenants (investor protections) have deteriorated to the point that they are almost non-existent. This will be where investors stand to lose the most – this cycle’s “sub-prime” blow up, if you will.
I was in the middle of writing a more detailed piece on this and then Larry McDonald put out a post that summarizes the issue way better than I could have. You can find it here. I highly recommend you read it for more details on this potential powder keg of a situation.
The Fed continues to ramp up their Repo operations and just approved $365 billion just to get through the end of the year. These are staggering numbers that suggest something serious is going on within the plumbing of the financial system. With bank balance sheets this constrained, it once again opens the markets up to another flash crash type of move as dealers aren’t carrying the inventory they used to and the liquidity is just not there to step in. We will likely continue to see the stock market cycle between periods of complete calm where we grind to new highs, followed by a sharp selloff that lasts a month or two. After an attempt to slowly unwind the Fed’s balance sheet, we should pass the old highs in January:
Fed’s Balance Sheet – new highs, here we come!
At this point, it appears like the Fed is doing everything they can to patch up any holes and essentially push things off until we can get past the election in Nov 2020 where fiscal spending can pick things up. I’ve been watching for clues the past 2 months as to whether or not they are actually able to achieve this because we’re at that “tipping point” of the cycle and today’s setup is quite different from ’15/16. If they are willing to continue with this “not QE” expansion of the balance sheet and pump trillions into the system, I suppose they theoretically can keep things afloat for another year. But the longer that policymakers continue to intervene in markets, the larger the imbalances they ultimately create.
Here are some of the key data points I’m watching:
The first thing to understand is that we are now in a post yield curve inversion world. I wrote a blog post last year saying that it’s not an inverted curve to worry about, but the steepening that follows the inversion. Well, the curve has been steepening the past 2 months. Recessions are never declared until 9-12 months after they have actually begun because the data is reported with such a lag and we need to see 2 consecutive quarters by the “official” definition but we are potentially at the start of the next recession right now so watching the leading data on unemployment and spending over the next quarter is key. Last Thursday’s big rise in initial unemployment claims and Friday’s weaker consumer spending report were not good signs. Also, most companies have already formulated their 2020 spending plans (which will be discussed during Q4 earning’s calls in mid/late January). My concern is that the unresolved trade issues pushed on for too long and without having any clarity to this point, plus the unknown of next year’s big election, companies may push off spending/projects another year and actually reduce headcount. We’ll find out soon. My last post highlighted these concerns as well.
10 yr – 3 mo Treasury Spread
10 yr – 2 yr Treasury Spread
CCC rated high yield spreads have been widening for over a year. These are the lowest rating you can receive so they’re basically the crappiest crap and are most sensitive to a slowing economy. You can see that spreads have been widening since the economic deceleration started in the summer of 2018.
CCC Spreads
Now if we compare CCC’s to BB’s (the best junk rating), we can see the gap has also been widening. This indicates that money is slowly leaving the lowest rating and will soon be following up the ladder. You can also see a widening between the two during the ’11/12 and ’15/16 slowdowns. The main difference between these periods and today is that we still had a positive Treasury and “corporate” yield curve back then, meaning policy was still supportive relative to growth expectations which is largely why the slowdown was contained to just manufacturing, transports and energy. The current slowdown is much broader and therefore should be taken more seriously.
CCC – BB Spreads
The Fed is still too tight with interest rates. Last fall they should have been cutting instead of raising rates twice, and they’re still about 0.75% behind, by my estimates based on the “corporate” spread (see below). If they want to successfully push off a potential recession until after next year’s election, they need to weaken the dollar ASAP and the best way to do that is to slash rates and indicate forward rates to remain lower too. By waiting, they actually increase the probability of things slipping into recession as policy remains too tight.
“Corporate” Spread
Lastly, there’s still no uptick in longer leading indicators, and after a small bounce in Q1 2020, leading indicators actually point lower again in Q2 in kind of a sideways stagnation. It’s like everything is on hold and waiting. This reinforces the need for the Fed to act right now or else the gravity can become too strong as we move into the spring if some sort of negative shock hits.
In summary, from a macro perspective, risks remain quite elevated and the jury is still out in terms of whether we see a successful reflation. I expect to have our answer by the end of Q1 2020 though and if this cycle does eventually begin to rollover we’ll likely see trouble emerge first in areas like junk bonds and leveraged bank loans before hitting stocks. These macro concerns are still the “what should” while the “what is” still aren’t showing any signs that the investment markets are worried just yet. So, for now, we continue to ride the wave until I see the technical signs of deterioration.
Thanks for following!
-Nick