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 with 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 economy did slip late last year.  We have placed vertical lines at certain points when the indicator fell below zero.  Although it works fairly well as a signal that equities are turning lower, there is a lag.  In other words, by the time this indicator suggests the economy is in trouble, the recession is likely near or 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 weakened but is not yet at a point where an investor 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 so, and the economic data begins to improve, then we should see equities turn higher in the coming months.

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by Asset Allocation Committee

The pullback in equities in Q4 coincided with a sharp drop in long-duration Treasury yields.  However, the recovery seen in early 2019 has not led to a rise in yields.

This chart shows the S&P 500 (left axis) and the 10-year T-note yield (right axis).  Note that yields and the equity markets tended to rise together in the first three quarters of 2018.  More importantly, they tracked each other in the fourth quarter; as equity values fell, yields also declined.  However, as equities have recovered since late December, yields have not rebounded into the range where they were when the S&P was around 2700.

In part, yields are currently running below fair value.

This chart shows our bond model; the core variables are fed funds and the 15-year average of CPI.[1]  In addition to these variables, we add the JPY/USD exchange rate, crude oil prices, German 10-year sovereign yields and the Federal deficit/GDP ratio.  The market would not be “rich” in this model until yields approach 2.17% but they are modestly below fair value after being above fair value for most of last year.

There are thee variables that account for the decline in the 10-year T-note yield, fed funds, German sovereign 10-year yields and oil prices.  In October, the 10-year T-note yield was running around 3.15%.  That level had discounted oil prices at $60 per barrel, German yields at 20 bps and a terminal fed funds rate of 3.25%.  The decline in the fed funds estimate to 2.50% accounted for 30 bps in the decline in yield, while the remaining 3 bps to fair value came from the decline in oil prices to $55 per barrel and German 10-year sovereign yield declines to 14 bps.

The “undershoot” to 2.70, below the fair value of 2.87%, could be achieved with a fed funds of 2.12%.  Given that the actual target is the mid-point between the upper and lower bound of the fed funds target (the announced rate is actually the upper bound), this would imply a rate cut.  Or, a decline in inflation expectations to 1.8% from 2.1% could also account for the undershoot, assuming no change in fed funds.

We suspect the primary reason for the slide is that inflation expectations have probably fallen.  This is because there isn’t much in the data to support the FOMC cutting rates.

This chart compares the fed funds target to the implied three-month LIBOR rate from the two-year deferred Eurodollar futures contract.  History shows that policymakers tend to stop raising rates when the spread between these two rates invert.  As the spread line shows, the spread is near inversion which is consistent with a policy pause but would not be consistent with rate declines.  Policy cuts would be in order if the implied yield were to fall further, but that evidence doesn’t exist for now.

If inflation expectations are leading to the undershoot, then stronger economic growth could trigger a rise in inflation fears.   We would not be surprised to see a modest rise in yields in the coming weeks, but a rise beyond 3.00% on the 10-year T-note yield would likely require a return to policy tightening by the FOMC.  We would not expect such a shift until later this year, if then.

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[1] Which is a proxy for inflation expectations.

by Asset Allocation Committee

Gold is considered by some to be a commodity, but we treat it as a non-liability-backed currency.  In other words, gold isn’t created because someone makes a loan.  Instead, it is created by mining.  In addition, most commodities are consumed but much of the gold refined through the ages still exists.  In other words, gold may be “lost” but it is rarely consumed.  Even in jewelry, it can return to its bullion state with modest effort.

Instead, gold provides one of the three functions of money.  It is rarely used as a medium of exchange and we don’t price things in ounces of gold, so it isn’t a numeraire.  But, it does act as a store of value.  Thus, gold demand tends to rise during periods of monetary instability.  Monetary instability is partially described as rapid increases in the money supply, currency depreciation and negative real interest rates.  When any of these three events occur, they tend to be supportive for gold prices.  In other words, gold prices tend to react to excessive money growth, dollar weakness and falling real short-term interest rates.

Our gold model uses the central bank balance sheets of the Federal Reserve and the European Central Bank, the two most frequently used currencies for foreign reserves.  We also add the EUR/USD exchange rate as a proxy for the dollar and the real two-year T-note yield.

The model’s current fair value is $1,414, suggesting the current price is undervalued.  We have seen the fair value decline recently.  This is due to the explanatory variables adjusting in a bearish fashion; the Fed’s balance sheet is contracting, short-term real interest rates have increased and the dollar has strengthened.  However, even taking these issues into account, gold prices still appear cheap.  If our expectations of dollar weakness this year come to pass, the fair value for gold will likely rise.  However, given the level of undervaluation, gold should have further upside potential in the coming months.

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by Asset Allocation Committee

In our analysis, both small caps and mid-caps are undervalued relative to their large cap cousins.

These charts compare mid-caps and small caps to large cap stocks.  We log-transform the data and use a time trend to scale the transformed indices as well.  The lower line on both charts indicate that small caps and especially mid-caps are deeply underperforming large caps.

Why is this occurring?  One clue is the relative underperformance in the last recession.  Smaller capitalization stocks tend to be more sensitive to the economic cycle.  Thus, monetary policy tightening can raise fears of recession and encourage investors to move to larger companies that would better withstand economic weakness.  Note that both of the smaller capitalization indices underperformed large caps during the slowdown in late 2015 into 2016.  However, when recession was avoided, both recovered strongly.  In addition, both the smaller capitalization groups are mildly inversely correlated to the broad P/E multiple; using the CAPE, a rising multiple tends to benefit large cap stocks more than the smaller caps, although the impact is rather modest.  Since the CAPE has been contracting, this factor should contribute to our expected smaller capitalization rebound.

Thus, given the deep level of undervaluation relative to large caps, we tend to favor both small and mid-caps.  This position assumes that a recession will be avoided over the next year to 18 months.  However, if the economy stumbles into recession, large caps will likely continue to outperform their smaller capitalization brethren.

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by Asset Allocation Committee

One of the important unknown factors for 2019 is whether slowing global growth will have a negative impact on the U.S. economy.  Or, put another way, can the world lead the U.S. into recession?  For the most part, history suggests the answer is no—the U.S. can bring down the world but the world can’t bring down the U.S.

The upper two lines show the yearly change in U.S. GDP and World ex-U.S. GDP.  The lower line shows the difference.  World and U.S. GDP are positively correlated at the 70% level, suggesting they are sensitive to each other.  Since the U.S. provides the reserve currency it would make sense that a stronger U.S. economy would also support imports from abroad which would foster foreign economic growth.  However, the U.S. doesn’t export as much relative to its size as other nations do, so it follows that stronger U.S. growth would support higher world growth but better growth in the rest of the world wouldn’t necessarily lead to better American growth.

A couple of examples show this pattern.  In the late 1990s, world GDP growth fell sharply while the U.S. was unaffected.  The Asian Economic Crisis and the Russian debt default did not derail the U.S. economy.  In 2005, the U.S. economy began to slump due to the deflating housing bubble.  World growth did hold up into 2008 but eventually succumbed to follow the U.S. into recession.

At the same time, this analysis doesn’t mean policymakers should ignore the world.  In theory, the Federal Reserve’s mandate is full employment and low inflation.  Since these goals can be mutually exclusive at times, the Fed has tended to leave both specifically undefined.  That has changed; the Fed now has a semiformal[1] 2% core PCE goal, which means the full employment goal is even more amorphous.  When asked about the world, Fed officials are usually circumspect but do say they will address the issue if overseas events affect the U.S. economy.  The above research suggests this comment is something of a “fudge”; the world rarely affects the U.S. directly.  But, there are times when the Fed does appear to move policy in light of world events.

A couple of events are notable, where the Fed appeared to have adjusted policy due to global events.  In the early 1980s, the Fed was still managing interest rates by focusing on the money supply.  However, the high level of interest rates led Mexico to default and caused cascading debt crises throughout the region.  The Volcker and Greenspan Feds reacted by cutting interest rates from 11% to 6% and the spread between U.S. and global growth narrowed.  The Greenspan Fed eventually cut rates during the Asian Economic Crisis and the Russian debt default in the late 1990s, although the Long-Term Capital Management debacle contributed to that move.  We also note that the Fed continued to reduce rates into 2004 even though the recession had ended; while weak global growth may have contributed, as we discussed two weeks ago, high equity market volatility probably contributed as well.

If the FOMC is looking for an excuse to ease policy, it could certainly use concerns about global growth affecting the U.S. economy as a reason.  Although we doubt that the weak global economy will bring down American growth, concerns about it could allow the Fed to lower rates and maintain credibility.  So far, we have not seen any indication that this factor is affecting policy, but it would not be a stretch to see the reason pop up in comments and statements from the U.S. central bank to at least justify a sustained pause in rate hikes.

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[1] It’s semiformal because Congress hasn’t given the Fed an exact mandate.