by Asset Allocation Committee

In 2017, we introduced an indicator of the basic health of the economy and added it to the many charts we monitor to gauge market conditions.  The indicator is constructed using commodity prices, initial claims and consumer confidence.  The thesis behind this indicator is that these three components should offer a simple and clear picture of the economy; in other words, rising initial claims coupled with falling commodity prices and consumer confidence is a warning that a downturn may be imminent.  The opposite condition should support further economic recovery.  In this report, we will update the indicator with January data.

This chart shows the results of the indicator and the S&P 500 since 1995.  The updated chart shows that the upward momentum in the economy has slowed but remains well above zero.  We have placed gray bars to indicate recessions.  The indicator was coincident with the 2001 recession but didn’t turn negative until June 2008, when the recession was well underway.  Unfortunately, in its raw form, it signals trouble when the equity markets are already well into their decline.

To make the indicator more sensitive, we took the 18-month change and put the signal threshold at minus 1.0.  This provides an earlier bearish signal and also eliminates the false positives that the zero threshold generates.  Nevertheless, the fact that this variation of the indicator is below zero raises caution.

What does the indicator say now?  The economy has been decelerating but conditions have improved over the past three months, lifting this indicator back to near-zero.  Thus, the improvement does suggest that investors should remain in equities based on the idea that economic conditions remain supportive.  In past updates, we have expressed caution that at least rebalancing of portfolios was in order.  This update would indicate that further defensive action should be put on hold for now.

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by Asset Allocation Committee

The data on U.S. residential real estate has been improving in recent months.  Housing tends to have an outsized effect on the economy.  Not only do housing purchases trigger follow-on buying of consumer durable goods (e.g., furniture and furnishings, etc.) but non-durables as well (e.g., basic household items).  A house is an asset and there is a wealth effect that affects future spending as well.  The direct impact on GDP is rather modest; the average contribution to GDP from residential real estate is only 0.08% per quarter.  However, there is evidence that a weak housing market has been a precursor to recession.

This chart shows the four-quarter rolling contribution to GDP from residential real estate.  We have applied a Hodrick-Prescott Filter to the data to establish the underlying trend.  Since 1980, with one exception, a negative reading on the trend has been a warning of eventual recession.  The only exception was the 2001 recession which was an unusually mild downturn.  In Q1 of last year, the trend indicator turned negative.  Although it can take a long time from signal to recession (it turned negative in Q1 2005, for example), it has been a reliable signal of economic weakness.  However, some housing indicators have shown notable improvement recently, which may lead to the trend rising later this year.  Here are a couple indicators we are watching.

Home ownership rates have been rising rapidly.

In 1995, the government began to aggressively support home ownership.  Credit restrictions were eased, and refinancing was encouraged.  The home ownership rate peaked at 69.3% of occupied homes in 2004.  The housing crisis led to a collapse in this metric, reaching a trough of 63.1% in 2015.  As the chart shows, the homeownership rate has been rising rapidly since, reaching a new cycle high of 64.9%.  The rise in home ownership rates has increased the most among households earning less than median family income.

Although there is a potential credit quality issue with less affluent home buyers, the rise should be supportive for economic growth.

The only “fly in the ointment” has been that home prices have been rising rapidly.  Although it hasn’t adversely affected affordability due to low mortgage rates, it will make the housing market increasingly sensitive to interest rates.

Ideally, rising prices for existing homes should spur new building.  Housing starts are beginning to accelerate, which is a good sign.  If housing continues to accelerate, our estimates for GDP this year may be overly conservative.

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by Asset Allocation Committee

The Commerce Department recently released its first iteration of Q4 GDP.  The overall growth rate, at 2.1%, was mostly on forecast but the composition of the growth showed some unexpected developments.  In this week’s report, we will examine the most interesting changes and what it may be telling us about future economic activity.

To analyze the data, we focus on a set of statistics called “contributions to GDP growth.”  These datapoints show how much various parts of GDP contributed to overall growth.  Here is a chart of the data.

The largest positive contributor to growth was net exports; although it is not unprecedented, outside of recessions, net exports are usually a drag on growth.  It is important to note that this data is looking at the rate of change of the change, so a smaller deficit will contribute positively to growth.

Net exports are the sum contribution of gross imports and exports.  Usually, during expansions, the contribution from gross imports is negative.  But, during recessions or when growth falters, imports fall and contribute positively to growth.

This chart shows the four-quarter moving average of the contribution of gross imports to GDP.  A positive contribution tends to be consistent with recession.  So, is that the case this time?

It might be, but there are two reasons why this event might be a false positive.  First, the trade wars have probably had some impact on reducing imports.  Since WWII, the general trend in tariffs has been downward.  The recent reversal in this trend is a new factor that may be shifting consumption to domestic goods and away from imports.  In some respects, this is the goal of the administration’s trade policy.  Second, there is evidence that U.S. firms accumulated inventories in the months prior to the Phase One trade deal with China.  This was likely done to buy goods that might be the target of future tariffs.  As a deal was made, it would make sense for firms to reduce inventories.  The act of selling down inventories would reduce imports.

We will be watching the gross import data with great interest this year to see if (a) we are seeing a structural change in the economy where imports decline, or (b) we are on the cusp of a recession.  For now, the most likely explanation is that the swing in gross imports was affected by trade policy uncertainty.  But, if other economic data begins to corroborate the recession signal from gross imports, we would recommend that investors reduce portfolio risk.

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by Asset Allocation Committee

Last week, we updated our thoughts about a melt-up in equity markets.  We observed that retail flows had diverged from equity market performance and noted that if sentiment shifts and retail investors come into equities, the market could rise rapidly to levels that may not be sustainable.  This week, we are dealing with the opposite problem—a potential “black swan” from the Wuhan virus and the subsequent decline in risk assets.

The Wuhan virus is a coronavirus that recently emerged in the Chinese city of Wuhan in the Hubei province.  It likely originated in wild animals and “jumped” the species barrier to become a human infection.  Since the virus is evolving rapidly, we won’t cover the details of the disease in this report.[1]  In this report, we will discuss how the virus could affect financial markets and how investors should handle it.

Pandemics[2] can have lasting and significant effects.  The Black Death, transmitted by a flea-borne bacterium, killed about 25% of the world’s population.  The subsequent population reduction led to a 3.5x jump in real wages in Britain from 1310 to 1450.[3]  However, modern medicine has tended to reduce the economic impact of pandemics.  The worst influenza pandemic, the Spanish Influenza of 1918, infected 500 million and killed up to 100 million globally.  The economic impact was notable but rather short; within a couple of years, the U.S. economy had recovered.

The Spanish Influenza is shown in yellow.  The pandemic did have an impact on output but was dwarfed by the post-WWI recession of 1921.

The current situation is being compared to the SARS epidemic of 2003, which mostly affected China.  Using data from Capital Economics,[4] the disease clearly had an adverse effect on the Chinese economy.

What did financial markets tell us about SARS?  This is a chart of the Hang Sang Index from November 2, 2002, to July 31, 2003.

If this event follows roughly the same pattern as SARS, then Chinese equities could see a 15% decline.  It should be noted that SARS was first detected in November 2002 but was not reported to the WHO until February.  Beijing is acting much faster this time around so the timing could be compressed.  It is also important to note that by June the Hang Seng had recovered most of its losses.  Such recoveries are typical from these events.

What should investors take from this analysis?  First, these sorts of events usually have a three- to five-month period during which they have a significant impact on financial markets.  There is always fear that this one will be different and it is possible that it will be.  But, more than likely, the Wuhan virus will peak in the next six weeks and the recovery will start.  Second, it’s important to note that the operative factor affecting financial markets from this virus is fear.  The CDC estimates that between 291k to 646k die each year from influenza.  If the world has 8k cases of the Wuhan virus and a 10% lethality rate (which would be roughly in line with SARS), then we are looking at about 800 fatalities worldwide, with the majority in China.  That is notable but far less than the number of likely fatalities from influenza this year.  Still, the element of the unknown will tend to lead markets to overshoot to the downside which may open opportunities for a recovery in the spring.

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[1] Interested readers can follow the evolving details in our Daily Comment.

[2] Pandemic is an epidemic with global proportions.

[3] Scheidel, W. (2017). The Great Leveler: Violence and the History of Inequality from the Stone Age to the Twenty-First Century. Princeton, NJ: Princeton University Press, p. 303.