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 May data.

This chart shows the results of the indicator and the S&P 500 since 1995.  The updated chart shows that the economy did slip late last year but has recovered in 2019.  We have placed vertical lines at certain points when the indicator fell below zero.  It works fairly well as a signal that equities are turning lower, but there is a lag.  In other words, by the time this indicator suggests the economy is in trouble, the recession is likely near or already underway and the equity markets have already begun their decline.

To make the indicator more sensitive, we took the 18-month change and put the signal threshold at -1.0.  This provides an earlier bearish signal and also eliminates the false positives that the zero threshold generates.  Notwithstanding, we will pay close attention when the 18-month change approaches zero as it did in January.

What does the indicator say now?  The economy has decelerated but is not yet at a point where investors should become defensive.  Breaking below the red line would be our signal to expect a broader downturn.  Most likely, we are going through a period similar to what we experienced in 2016.  If this is the case, and the economic data begins to improve, then equities should remain supported into H2.

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by Asset Allocation Committee

Establishing when “the” yield curve inverts is a bit of guesswork as there are a plethora of permutations one can use to calculate the spread.  One yield curve we like is the same one the Conference Board uses in its index of Leading Economic Indicators, namely, the 10-year T-note less fed funds yield.  As we show below, this particular spread has inverted this month.  Because of the time it takes to fully accumulate all the data points in the leading indicators, the inverted yield curve won’t be in the index until August.  But, the inversion will start to act as a drag on the leading indicators and likely start signaling a slowdown in the economy.

Here is a chart of the 10-year/fed funds yield curve.

This spread didn’t become a reliable indicator of the economy until the 1960s.  It isn’t perfect; it has had two false positives (shown as a black lines on the above chart).  In the 1981-82 recession, the curve didn’t invert until the recession was underway.  We have shown the current inversion as a black line, but we will change this if, or when, the recession develops.

This table shows the time period from the inversion to recession.  Although there is variation, the average is 12 months.  Using the range, a recession would be due at the earliest in February 2020 or the latest at February 2021.

So, with inversion, what should investors do?

These two charts show equities (the S&P 500) and long-duration bonds (10-year T-notes total return index), indexed to the yield curve inversion (shown as a vertical line on the chart).  We looked at the data 12 months before the inversion and 24 months after the inversion, excluding the 1982 inversion since the recession was already underway.  We also calculated the average for the seven events.  These calculations show that the financial markets don’t always treat inversions as bearish.  Under low inflation conditions, long-duration interest rates tend to perform well.  Equities decline about 10% or less after inversion the majority of the time; however, in three cases, they actually continued to rise.  Furthermore, during the 2005 inversion, the real bear market didn’t start until two years after the yield curve turned negative.

There are two key issues for investors.  First, it is possible that the current inversion is a false positive.  If the FOMC moves quickly to cut the fed funds rate, the slope of the curve could return to positive so remaining fully invested is recommended.  Second, even if this inversion is a harbinger of recession, there were several events where equities performed quite well for some time after the inversion.  This is especially true when the inversion predated the recession by more than a year.  At the same time, investors are now on notice that if the Fed doesn’t react soon to unwind this inversion then the odds of recession are rising, thus it would be prudent to build a plan to become defensive.

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by Asset Allocation Committee

Monetary policymakers are facing divergent trends that complicate future policy actions.

Financial markets are signaling that the policy rate needs to be cut immediately.

The chart on the left shows the implied three-month LIBOR rate, two-years deferred, from the Eurodollar futures market.  Last October, the implied rate was around 3.30%; it has fallen sharply to 1.625%, a decline of nearly 70 bps.  The chart on the right compares that implied rate to the fed funds target.  History shows the Fed has tended to cut the target rate when the implied rate inverts relative to the policy rate (shown on the upper line).  The spread has widened considerably, meaning the Fed should be moving to cut rates soon.  This data would suggest the longer policymakers wait, the higher the probability of a recession.

Current economic conditions probably don’t warrant a rate reduction.

This chart shows the NY FRB recession indicator, which projects the odds of recession 12 months out and the Atlanta FRB GDP-based recession indicator.  In general, combining the two indicators reduces the chance of a false positive, namely, predicting a recession that doesn’t occur.  We use the 20% threshold as a warning sign; if both indicators are above 20% then a recession warning is warranted.  The only false positive that was triggered with the 20% threshold was in 1995 and that event was considered a rare “soft landing.”  As the first chart shows, in 1995, the Greenspan Fed did cut rates and this action probably extended the expansion.  The current reading of these two indicators suggests caution, but the economic data is not signaling that a downturn is imminent.  And, as a cautionary tale, we had a similar configuration in the data in 1997-98.  The Fed did ease in that event, in part driven by the LTCM Crisis, and that easing is often blamed for stoking the tech bubble in 1999.

Inflation remains controlled, but tariffs could affect prices.

This chart compares the ISM Manufacturing Index to core CPI.  The ISM index tends to lead inflation by two years.  Comparing core CPI to the ISM Manufacturing Index suggests that inflation might lift in the coming months but should not overshoot by a wide margin.  However, it is important to note that tariffs are a form of consumption tax.  While the incidence of the tax does not automatically fall to the consumer (the producer or importer could absorb the cost, cutting profit margins, or the dollar could appreciate and offset the tariff), there is the possibility of an unexpected rise in inflation.

These three issues will likely keep the FOMC on hold in the near term.  If that analysis is correct, the chances of recession will tend to rise in the coming months.

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by Asset Allocation Committee

There are three factors that tend to cause recessions—inventory misadjustments, policy errors and geopolitical events.  The first in the series has become less of a factor over time.  Inventory management has improved dramatically since the end of WWII, and excess inventory leading to falling output has become less of an issue.  Therefore, we tend to focus on the latter two factors.  Since fiscal policy changes tend to occur more slowly, monetary policy is where we spend most of our efforts.  With regard to geopolitical events, we write a weekly report on that issue.

Monetary policy is facing a serious signaling problem.   One of the signals we use for monetary policy is the implied LIBOR rate from the two-year deferred Eurodollar futures.  That rate is an indication of what the financial markets are thinking.  As we will show below, it has generally been a good indicator for when policy tightening should stop.  The implied LIBOR rate has declined significantly.

Since peaking at 3.30% last October, the rate has declined to 1.90%, a drop of 140 bps.

The lower lines show the implied LIBOR rate with the fed funds target.  Note that the FOMC has tended to stop raising rates when the spread inverts.  During the Greenspan years, easing tended to follow shortly after inversion.  The Bernanke Fed did stop raising rates after inversion but didn’t ease, which may have contributed to the severity of the 2007-09 recession.

To compare how the financial market signs compare to economic signals, we have overlaid the fed funds target/deferred LIBOR rate with two of the Mankiw Rule variations, one using core CPI and the unemployment rate and the other using core CPI and the employment/population ratio.  The Mankiw Rule is a simplified version of the Taylor Rule, which estimates the fed funds rate based upon core inflation and GDP relative to potential GDP.  Because potential GDP isn’t directly observable, Mankiw’s original research replaced GDP with the unemployment rate.  We have created our own variations as well (not shown).

The lower lines on the chart show the implied LIBOR rate, with the fed funds target and the two aforementioned estimated Mankiw Rule rates.  Aside from the Mankiw Rule variation using the unemployment rate, all other variations are suggesting the Fed should be cutting rates.  However, in each of the prior inversion events (shown by the vertical lines on the above chart), the estimates for the fed funds target from the Mankiw Rule variations were below the target rates.

This has been a consistent issue during this expansion; essentially, it has been difficult to determine the degree of slack in the economy.  Fortunately for policymakers, this problem of estimating slack has not been a serious issue until recently.  Given the current divergence in signals, the most likely outcome is for the FOMC to maintain a steady posture.  The lack of a clear signal between the financial markets and the interest rate markets increases the odds of a policy mistake.  Although the FOMC’s official stance is neutral, we suspect the next move will be to lower the policy rate.

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by Asset Allocation Committee

How important have mergers, buybacks, etc. been to equity market performance?  Several analysts have attempted to answer this question by focusing on buybacks alone.  However, there is a more straightforward method of looking at this question and including all the factors that affect the number of shares available—the index divisor.

This chart shows the divisor for the S&P 500.

The divisor adjusts the S&P for membership changes (either by mergers or index adjustment), new share issuance or repurchases, or special stock-related transactions.  So, it isn’t a pure look at buybacks but isolating buybacks alone may overstate the impact of the activity if new shares are being issued or it may ignore the impact of membership adjustments.  In general, a rising divisor tends to depress the index and vice versa.  In the most recent data, the divisor peaked in Q3 2011; the decline in the divisor is partly due to buybacks, but merger activity has affected it as well.

To calculate the impact of the divisor, we would use the following formula:

Divisor * S&P Index = S&P Market Capitalization

Rearranging terms leads to this formula:

S&P Index = S&P Market Capitalization/Divisor

And so, if we take the market capitalization and hold the divisor fixed at this peak in Q3 2011, we can estimate what the S&P 500 would have been without the decline in the divisor.

At the end of Q1, the S&P 500 was at 2824.44; if the divisor had held at its previous peak, it would have been 2593.63, or 8.2% lower.

The more important question is if or when the trend in the divisor might reverse.  In general, history suggests that elevated equity market values tend to trigger equity issuance.  However, that has not been the case since 2000.

This chart shows the divisor and the S&P 500 Index since 1964.  From that year to Q1 2000, the two series were positively correlated at the 69.5% level.  However, since then, the correlation between the two series has not only flipped to inverse but strengthened.  During this century, for the most part, the equity markets appear less critical to raising capital.  Overall, we expect the divisor to continue to decline as firms continue to shrink the number of shares available; if we are correct, the equity markets have a modest tailwind going forward.

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