It’s Got Us Scratching Our Heads
BY: JIM McELROY, CFA
This was the comment made by one of our fixed income managers at a recent investment strategy meeting, and it accurately describes our bewilderment over the mixed signals we’re receiving from the marketplace. The cause for this specific itch was the simultaneous occurrence of an inverted yield curve and a shrinkage in the credit spread (the difference in interest rates between like-maturity government and corporate bonds). This isn’t supposed to happen.
An inverted yield curve (a higher rate for three month T-Bills than for ten year Treasury Bonds) forecasts and often causes economic weakness and recessions. A shrinkage in the credit spread normally indicates that investors are unconcerned about a recession-induced lowering of corporate bond quality and are more interested in the higher yields available in the less than perfect corporate sector. In short, the first is sending a “risk off” signal while the second is encouraging investors to take a “risk on” posture.
It is a “head scratcher”, but it’s not the only one. The entire investment marketplace appears to be operating in at least two divergent universes and neither seems to be communicating with the other.
The stock market, after having registered two corrections in 2018 — one in the winter and a second over the summer and fall — roared back in the first half of 2019, set two new records in May and June and so far is up 17%, recording the best first half return since 1997.
In the meantime the economy, while definitely not in a contraction mode, is showing some signs of fatigue in what is now tied for the longest expansion since WWII: the index of Leading Economic Indicators has been trending downward since its peak in mid-2014; consumer sentiment has slipped to its lowest level since September of 2017; the Conference Board’s CEO Outlook for future business conditions recently came in below 50 (above 50 suggests an expansion, below 50 suggests contraction); the Purchasing Managers’ Index, though still above 50, has been declining since the beginning of 2018; and Non-Farm Payrolls posted the lowest increase since 2010.
In the Wall Street universe, the stock market is forecasting robust growth and earnings, while in the universe on Main Street, the mood is less optimistic.
We prefer to resist characterizing this divergence as a struggle between fantasy and reality. It may only be the usual difference of opinion between optimists and pessimists, bulls and bears, or the greedy and the fearful.
For us, this sense of dislocation is reminiscent of other periods that were late in their cycles. We’ve already mentioned that the U.S. economy is now tied for a post-war record. The stock market also has some age on it: at about ten years, it’s the second longest bull market since 1928 (the longest was the twelve and one third years’ run from December 1987 to March 2000).
Everyone knows the good times can’t last forever, but few wish to invest, or disinvest, strictly based on extended age: the only difference between early or late and wrong is the spelling of the error.
As in so many other periods of past stock market and economic dissonance, the leading suspect is the Federal Reserve and its tinkering with interest rates.
When the news from the economy is good, the market expects that the Fed will raise short term interest rates in pursuit of its governmental obligation to keep inflation in check. One would expect this to be a good thing — the Fed raises interest rates gradually so that the economy doesn’t overheat and cause prices to rise faster than productivity — but the market often has little faith in the Fed’s ability to moderate growth without precipitating a recession: good news on the economy translates to an overly aggressive Fed, an end to the existing expansion and a plunging stock market.
Bad news — or suspicions of bad news — on the economy suggests to the market that the Fed will remember its other governmental obligation (to maintain full employment) and either will keep interest rates steady or will lower them. Obviously, the market likes this latter scenario: lower interest rates mean lower capitalization rates, higher stock and bond prices and accelerating economic activity. And what effect this may have on inflation is apparently a concern for another day; to be fair, however, with a current inflation rate below 2%, it’s hard to argue that an acceleration to hyperinflation is an imminent risk.
On the subject of bad news or suspicions of bad news, there is much outside the U.S. to give the Fed concern. In fact, with the exception of the U.S., most of the world economy is decelerating or already in recession mode.
The Trump administration’s campaign of brinksmanship on tariffs and trade seems, for the moment, well timed: tariffs hurt everyone, but for the U.S., currently the largest and strongest economy — and the one least dependent on foreign trade — a trade war would appear to have favorable consequences. Unfortunately, being least dependent on foreign trade does not mean invulnerable: unintended consequences and unrecognized trading interrelationships could have dire consequences for the U.S. This and the other signs of slowing growth mentioned above have caused the Fed to announce that they’re postponing any new rate hikes and could possibly reverse those already in place. This is the primary reason behind the 17% return for the first half of this year.
If the Fed does reduce short rates in the second half of this year — the futures’ market has the odds at 100% that the Fed will cut rates at their next meeting in July and at 22% that the cut will be by .50% — then there’s a good chance that that troublesome inverted yield curve will disappear. It’s not necessarily the case that this would also propel the stock market higher or that long term interest rates would increase to more attractive levels: the stock market has already factored in the cut while the current yield on the ten year U.S. Treasury bond (only a shade over 2%) reflects more dollar strength and lack of competition from negative yields overseas than from concern over the U.S. economy.
Having said this, however, we should also mention that it is long past the time for higher bond yields. Early in our careers, there was a time when the ten year bond sported double digit yields — as high as 15.22% in September of 1981 — and we have witnessed the long zig-zagged decline in yields from that period. It’s probably too early to claim that a floor in U.S. bond yields has been reached, but if the bull market in stocks is long in the tooth, then the secular bull market in bonds has lost its teeth and is also missing a lower jaw.
In this investment environment, with stocks hitting record levels and bond yield curves portending a recession, “head scratching” may well be a useful response. It certainly suggests that caution should be the emphasis among investors over the next six months.
Rebalancing portfolios to long term goals makes a lot of sense: equity positions in balanced portfolios are likely above desired levels following double digit stock returns in the first half of the year.
In the fixed income portion of balanced portfolios, we recommend keeping maturities in the higher grade, intermediate term range (ten years or shorter): more than ever, now is not the time to reach for somewhat higher yields in longer term and/or lower quality bonds.
And although overnight yields are strongly rumored to be headed lower, we think a little cash would not be unwise. No one can accurately forecast the timing of a stock market crash or a long overdue increase in bond yields: having a little extra cash in reserve can soften the blow and allow investors to take advantage of lower prices in the future.
