5-Minute Huddle: History Rhymes

November 4, 2019

By Justin Pawl, CFA, CAIA

  • Last Week Today – A summary of news impacting financial markets and the economy.
  • History Rhymes – Parallels between the 1990 and 2010 decades.
  • Pregnant Pause – The Fed signaled it’s on hold.
  • Employment Report – Big headline, but weak under the hood.
  • Bulls – A couple of indicators show the stock market has room to go.

Last Week Today. The European Union extended the Brexit deadline from October 31st to January 31st. | Economic data out of China showed continued slowing with the manufacturing PMI falling for the sixth consecutive month to 49.3 (near the 2015 low) and the service PMI falling -0.9 to 52.8 (2016 low). | The Federal Reserve cut interest rates but signaled it’s done for now (more on this below).

Financial Markets. Stocks pushed higher last week on positive U.S./China trade sentiment and corporate earnings coming in above already low expectations. The S&P 500 and Nasdaq closed at new highs, gaining 1.5% and 1.7%, respectively, and the Dow closed within a whisker (0.04%) of a new record. International stocks generally paced their U.S. counterparts. However, the major indices such as MSCI All Country World Index (ACWI) and MSCI Europe, Asia, and Far East (EAFE) indices remain well below new record levels. Through last week, 75% of S&P 500 companies had reported Q3 earnings, with 55% of firms beating consensus estimates and only 11% missing. Thus far, S&P 500 earnings per share are on pace to decline by approximately 1% year-over-year, which is better than the 3% decline that was expected coming into the Q3 earnings season. Interest rates rose on the week and, following the Fed’s rate cut, the yield curve shifted flatter as much of the inverted portion of the curve un-inverted. For a summary of weekly, month-to-date, and year-to-date financial market performance, click on the table below.

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History Rhymes. In the mid-1990s, the stock market set record after record during a decade-long bull market propelled by a strong economy. The Fed and Alan Greenspan made a couple of mid-cycle interest rate cuts when the economic data showed some cracks in the labor market. It was during that decade that President Bill Clinton was impeached by the House of Representatives on the grounds of perjury and obstruction of justice. Fast forward to this decade. Last week the Fed cut interest rates for the third time (something Fed Chairman Powell once referred to as a “mid-cycle adjustment”), and the House of Representatives voted for a formal impeachment inquiry of President Donald Trump. While the economy is not growing at the vigorous rate of the 1990s, we are in the midst of the longest U.S. economic expansion in history. Why do I point this out? Because clients have asked if financial markets will suffer if President Trump is impeached. My response is that there may be some short-term volatility around the hearings, or if there is an actual impeachment, but investors care more about future corporate earnings than anything else.

Pregnant Pause. The Fed cut rates for the third time on Wednesday to the surprise of…. well, no one. Yet, the Fed’s associated statement and Chair Powell’s press conference afterward implied that the Fed’s on hiatus for a while. Specifically, the Fed’s policy statement removed the phrase “…will act as appropriate to sustain the expansion.” The absence of that phrase was interpreted as hawkish by the market, which sold off modestly shortly after the Fed’s announcement.

During his post-announcement press conference, Fed Chair Powell confirmed the Fed’s reluctance to move further, setting a high bar for another cut. In response to a question asking what it would take for the Fed to cut rates again, Powell responded “So, you ask what it would take – you know – to move, and as I mentioned, we’re going to be watching all factors, and if developments emerge that cause a material reassessment of our outlook, we would respond accordingly. But that what it would take. A material reassessment of our outlook.”

The Fed Funds rate now stands at 1.75%, and as I related last week, with the neutral interest rate (the rate that is neither restrictive nor accommodative) at about 1%, the Fed’s action is not accommodative, just less restrictive. Please don’t take my word for it; the market is clearly expressing that monetary policy is too tight based on inflation-linked instruments. The blue line (representing medium-term inflation expectations) in the chart below shows inflation expectations for the next five years have not touched the Fed’s 2% target this year. These medium-term inflation expectations rose early in the year when the Fed indicated they would cut interest rates. But have fallen since, as the Fed has not acted aggressively enough to kick-start economic activity to a level where inflation is expected to rise to the Fed’s target. Longer-term inflation expectations (shown by the red line) are slightly higher, but following a similar downward trend characterized by lower highs and lower lows.

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I also related last week that during our quarterly Investment Committee meeting, we discussed that crucial leading indicators of an economic slowdown are beginning to flash increasingly yellow. This week brought more squishy economic data, with the possible exception of the employment report, which we’ll discuss below. Given this backdrop, our view is that the Big Brains at the Fed are taking an awfully big risk by stepping back now as the effects of their ill-fated December 2018 rate hike haven’t even worked their way through the economy yet.

Employment Report. The employment report was met with a giant sigh of relief as economic data leading up to this report was relatively weak. The Bureau of Labor Statistics reported total nonfarm payrolls increased by 128,000, well above expectations of around 80,000 new jobs. Interestingly, interest rates didn’t move much higher in anticipation of growing inflationary pressures despite the booming jobs number, as would be expected. Our sharp-eyed resident economist, Sean Foley, pointed out the following:

  • The outsized “birth/death” fudge factor used by the Department of Labor (DOL) to “estimate” jobs created by new business formations.  The DOL assumed that 274K jobs were created by new small business births in October.  Prior to this October, the 10-year average adjustment for October was 167K. So, the difference added 107K “jobs.”
  • The job mix was poor, with about 61K jobs added in leisure/bars of the 128K total.
  • Weak wage growth (as expected with a weak job mix).
  • A report that is not consistent with other fairly reliable data (both hard and soft).
  • Even with possibly inflated numbers, the employment growth trend is still slowing both on a 6MA basis and YOY.

So…. a great headline jobs number that is a lot weaker when you look under the hood.

 

Bulls. The economy and the stock market are different animals. Yes, recessions generally cause equity markets to fall, but not all recessions look like the Financial Crisis, where nearly every asset declined simultaneously. For what it’s worth, while we are concerned about the health of the economy, based on the economic data we are seeing, we don’t expect that the next recession will be anything more than a garden-variety contraction. What’s interesting is that even as interest rates have risen over the last couple of weeks and stocks have hit new highs, stocks don’t appear overvalued relative to interest rates. Indeed, the difference between the earnings yield on the S&P 500 (the inverse of the price/earnings multiple) and the 10-year U.S. Treasury yield is 3.8%. Compared to a long-term average of 3.5%, equity prices could move higher and remain fairly valued if interest rates stay at these levels or move lower. It’s also worth noting that the dividend yield on the S&P 500 (1.87%) is higher than the 1.73% yield on the 10-year Treasury bond, typically a bullish indicator for future equity returns.

 

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Sources: Computstat, I/B/E/S, Goldman Sachs Investment Research, and Covenant Investment Research.

 

Be well,

Justin