Who’s Right?
BY: JIM McELROY, CFA | jmcelroy@heritagetrust.com
Is the stock market, down 6.2% for all of 2018, telling us there will be a recession sometime in 2019? Most economists say “no”. They point to a low and still declining unemployment rate, modestly accelerating wage gains and strong consumer confidence as evidence that a recession is not in the near future. One of the most widely followed indicators of future economic activity — the non-profit Conference Board’s index of Leading Economic Indicators — is still forecasting solid GDP growth for 2019. This is even more noteworthy because the S&P 500 is one of the ten indicators it employs for its calculation. As for which source we should trust, the stock market or economists, history and experience teach us to be skeptical of both. Everyone knows the famous quip by Paul Samuelson, an economist, that the stock market has predicted nine of the last five recessions. To be fair, the S&P 500, currently down about 15% from its recent high (intraday on Christmas Eve, it actually dropped 19.8% before dramatically recovering), is not yet in a bear market (down 20% or more) and is therefore not yet predicting a recession in 2019. Our best guess is that there will be no recession in 2019. That would be good, because although the stock market has had many false positives, since at least 1929 there has never been a recession that wasn’t preceded or accompanied by a bear market in stocks.
At the end of the third quarter of this year, we allowed that we were closer to the end of the bull market in stocks than the beginning. Since then, we have witnessed a dramatic return of volatility and the onset of a sixth correction in the current bull market. Is this sixth correction in the second longest bull market in history more evidence of the bull’s eminent demise or is it a welcome pause that refreshes? As always, there are arguments for both sides.
One of the most troubling arguments for a bull demise comes from the fixed income markets. Like the stock market, the fixed income markets have their own predictor of economic malaise: the yield curve. In simple terms, the yield curve is a graphical chart showing maturities and yields to maturity for a series of fixed income securities (almost always those of the US Treasury); the maturity dates, in ascending order, make up the horizontal axis and the yields to maturity form the vertical axis. When this curve is positive — longer term maturities commanding higher yields than shorter term maturities — the bond market is said to be accommodative: lenders can borrow money in the short term and profitably lend it out for the long term, encouraging the assumption of risk and keeping the economy moving forward. But when the yield curve is negative (inverted), the reverse is true: lenders have no incentive to borrow money in the short term to make loans in the long term, thereby discouraging risk and causing the economy to contract. Currently, the yield curve is almost flat. The difference in yield between the two and ten year USTs is a mere 0.183%, while the difference between three month T-Bills and the ten year UST is only 0.31%. History and many fixed income market gurus warn that when the yield curve inverts, a recession is not far behind.
The driving force behind a potential inversion of the yield curve is not hard to find. The Federal Reserve for the past three years has been lifting short term rates with the goal of “normalizing” them following its heroic easing efforts during and following the financial crisis of 2008. From the end of 2015 until now, the Fed has lifted rates from an effective 0% to a current range between 2.25% – 2.5%. Of course, the Fed can only set rates in the short end; it has limited influence over long term rates. And the market, which sets long term rates, doesn’t fully believe that the Fed’s gradualist approach has been gradual enough. In addition, the Fed’s efforts to shrink its balance sheet by selling and allowing to mature bonds which it purchased during the financial crisis removes even more liquidity from the financial system. The market fears that the Fed’s too aggressive tightening will trigger another financial crisis/recession and consequently prefers to keep long term rates lower than one would expect seven years after the last recession.
Besides fear of the Fed, another factor that has kept U.S. long term rates low for the last seven years has been the absence of competition. As low as long term rates are in the U.S. — 2.68% for ten year US Treasury bonds — they’re still well over twice that of ten year government bonds in Europe and Japan. With foreign investors clamoring for relative yield and safety, there’s little pressure for U.S. long term rates to rise. It’s small wonder that the US Dollar has been the strongest of currencies among our trading partners.
Despite these market portents of economic dislocation in 2019, other reports from the actual economy and beyond remain mostly positive. Consumer confidence, though somewhat tempered by volatility in the stock market, remains very strong. Retail sales for the current Christmas season, according to preliminary data, look to be the strongest in six years. Declining oil and gasoline prices may have negative impacts on oil companies, but it’s good for inflation, which remains quiescent; for consumers, this is “found money”. The Fed, despite its professed disregard for market activity, has lowered its “neutral” Fed Funds target rate from 3% to 2.75% and has suggested that it may raise rates only twice in 2019.
But no recession does not necessarily mean that there will be no further corrections or a possible decline into bear territory. In fact, in December, the tech-heavy NASDAQ index breached the 20% threshold for a bear market. At approximately ten years, the S&P 500 is in its second longest bull market since 1926 (the longest lasted twelve and a half years). We should expect increased volatility as investors begin to doubt their good fortunes. Judging by the wild stock market gyrations in the closing days of 2018, we’re getting it. And while the U.S. economy continues to perform well, the same cannot be said for much of the rest of the world. Europe appears to be sliding back into recession territory and China, the second largest single economy, is also showing signs of a slowdown. And, of course, President Trump’s tariffs and on-again, off-again trade wars have not produced much confidence in foreign export-driven economies. Since something like 44% of S&P 500 revenues come from foreign sources, and somewhere between 60% and 70% of GDP comes from consumer spending, it’s not unusual for the stock market to slump while domestic GDP continues to grow. In such cases, the market eventually recognizes its mistake and moves to higher levels. As we noted above, there is no requirement that a recession follows a bear market. And, to be fair, there’s nothing magic about the convention that “down 20% or more” is a bear market and “down 10%, but less than 20%” is only a correction.
The year is ending with a lot of volatility, loss, and uncertainty. During the last week, the VIX index of volatility hit its highest level in over nine months. On Friday alone, the S&P 500 changed direction nineteen times and ended the day down only 0.12%. In December, the S&P 500 lost 8.43% — the worst month since February 2009 — leaving the totals for the quarter at minus 13.6% and for the year at minus 6.24%. The reasons behind such end of year turmoil is still a bit of a mystery, but it is likely due to a combination of several factors. On the political front, President Trump, just before Christmas, refused to sign a budget bill that did not finance his wall, thereby shutting down part of the government; for investors, this adds more uncertainty to an already uncertain future. In the markets, the holiday season may have thinned the number of active participants and left actual trading to computers, models, or passive investing formulas (already a surprising 85% of daily trading activity); such a condition can only encourage irrational and herd-like behavior. For whatever the reason, these last few days of 2018 have been very anxious ones for the stock market.
At such times, particularly when they occur at year end, one is tempted to express a pessimistic note for the coming year. But, there’s something positive about a market that flirts with disaster and somehow finds enough buyers to mount a comeback. And there’s little in the way of economic news to justify the market’s December swoon. If there’s no recession in 2019, then this late unpleasantness may be short lived.
For more information about the commentary found in this newsletter, please contact a member of Argent’s investment team:
- Erik Aagaard eaagaard@argenttrust.com
- Vaughn Antley vantley@argenttrust.com
- Marshall Bartlett mbartlett@argenttrust.com
- Kenny Brown kbrown@amerad.com
- Sam Boldrick sboldrick@argenttrust.com
- Hutch Bryan hbryan@argenttrust.com
- Drew Davis ddavis@argenttrust.com
- Richard Fox rfox@argenttrust.com
- Saiyida Gardezi sgardezi@heritagetrust.com
- Brandon Glenn bglenn@argenttrust.com
- Shannon Harrington sharrington@argenttrust.com
- Frank Hosse fhosse@argenttrust.com
- John McCollum jmccollum@heritagetrust.com
- Jim McElroy jmcelroy@heritagetrust.com
- Jed Miller jmiller@highlandcap.com
- Walter Park wpark@argenttrust.com
- Gary Pierce gpierce@amerad.com
- Robert Strauss rstrauss@heritagetrust.com
- David Thompson dthompson@highlandcap.com
- Oren Welborn owelborn@argenttrust.com
