by Asset Allocation Committee

Equity markets have come under pressure this autumn.  The weakness has gained momentum in recent weeks.

This chart shows the yearly change in the S&P 500 Index on a monthly average basis.  We have added recession shading; in general, recessions tend to trigger bear market declines of 20% or more.  In fact, every decline of this magnitude has been associated with a downturn in the business cycle since the 1987 Crash.

There have been two sources of recent weakness.  The first is fear that the Federal Reserve will make a policy error and trigger a recession.  These fears are not unfounded.  Since the mid-1950s there have been 13 tightening cycles; only four have resulted in a “soft landing,” a cycle that didn’t trigger a recession.

This chart shows the path of fed funds since 1955, shortly after the central bank became independent of the Treasury.  We have placed arrows where tightening cycles didn’t bring a downturn.  As the chart shows, it’s rare for the Fed to avoid a downturn.  It should be noted that the second arrow coincided with the Nixon price and wage freeze; Chair Burns likely lowered fed funds in response to the price freeze.  Thus, we can make the case that there were only three soft landings that were independently engineered by the Fed.

The second concern is over trade policy.  The administration’s trade policy threatens to disrupt supply chains tied to China which could lead to shortage and higher prices for various goods.  The impact of this outcome is very difficult to estimate; we haven’t had an aggressive policy of trade impediments since the 1920s.  At the same time, it should be noted that trade frictions are partly a negotiating stance.  These issues can be adjusted given the economic and political climate.  Since next year is the last full year before elections, we would not be surprised to see some moderation of the Trump administration’s stance on trade policy.

If the FOMC does manage to bring a fifth soft landing and we see some moderation of trade policy, the equity market may be poised for a recovery.  Since the late 1990s, the ISM manufacturing index has been a reasonably good indicator of the S&P 500.

This chart compares the yearly change in the S&P 500 Index monthly average against the ISM Manufacturing Index.  The equity index, relative to the perspective of U.S. manufacturing purchasing managers, should be up 22.1% from last year; that would put the index at 3259.27.  Not only that, but the current reading is at levels consistent with recession.  This analysis suggests that if recession is avoided in 2019 then the equity market could be poised for a strong recovery.  Essentially, this model is saying there is a disconnect between the economy and equities.  These disconnects occur occasionally but the current one stands out as extreme.  Therefore, there may be more risk to reducing equity exposure in the current turmoil.

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by Asset Allocation Committee

The election of Donald Trump has been characterized as part of a populist uprising.  In the president’s inaugural address, he talked about the “forgotten” that would have a voice in his administration.  At the same time, we work under John Mitchell’s dictum of “watch what we do, not what we say.”[1]

In a recent Bloomberg podcast, Edward Alden, a journalist and fellow at the Council on Foreign Relations, was asked if the Trump administration favored business or labor.  He replied that they are trying to help both.[2]  We think Alden is correct in his assessment which is one of the reasons why analyzing the direction of policy with this administration is so difficult.  It appears that one of the goals of the president’s trade policy is to bring production back to the United States which would benefit labor.  At the same time, tax policy has generally favored capital.  But, the most underestimated benefit to capital may be deregulation.

George Washington University measures the pages of the Federal Register, which is the official journal of the federal government.  It publishes agency rules, proposed rules and public notices.  So, the number of pages in the register says something about the number of regulations.  The idea is that the more pages added to the register signals an increase in regulation.

The decline seen in the first full year of the Trump administration is remarkable.

The drop from 2016 to 2017 was 35.4%, which exceeds the 21.2% decline in 1981, Ronald Reagan’s first full year in office.  The only year that was larger was 1947, which saw a 39.6% slide.  That drop was likely due to postwar changes.

Another measure is called the “significant rule changes,”[3] a policy measure created during President Clinton’s first term.  The decline in 2017 was unprecedented.

Only 55 new rules were added in 2017.  That is clearly the fewest on record by multiples.

The drop in regulatory activity is partly why small business sentiment has been so strong.

The jump in small business sentiment mostly tracks the drop in regulation.  A persistent complaint from small business leaders during the Obama administration was the regulatory burden.  Not only did President Trump promise to reduce regulation, he actually accomplished it.

Tax changes and deregulation have been supportive factors for equities since the November 2016 presidential election.  However, as Edward Alden noted, the Trump administration has tried to placate both capital and labor.  Recent market action, with equities selling off despite a civil meeting between Presidents Trump and Xi and the yield curve flirting with inversion,[4] suggests that the financial markets are pressing President Trump to choose.  Will it be capital or labor that wins out in the end?  If capital is going to win, a lasting trade ceasefire needs to be declared.  If President Trump sticks with tariffs, and there are ample indications that he intends to for now, then the financial markets appear to be preparing for recession.  A recession in 2019 will jeopardize the president’s chances at reelection in 2020.  Our expectation is that, at some point, President Trump will “blink” and tone down the trade rhetoric.  But, that is an open question for now.

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[1] http://www.arlingtoncemetery.net/mitchell.htm

[2] https://www.bloomberg.com/news/audio/2018-11-27/surveillance-china-general-motors-with-cfr-s-alden-podcast Alden’s segment begins at 16:00 minutes and the response in question is at 18:40.

[3] https://www.reginfo.gov/public/jsp/Utilities/EO_12866.pdf and summarized https://www.epa.gov/laws-regulations/summary-executive-order-12866-regulatory-planning-and-review

[4] For an analysis of the impact of inversion, see our Asset Allocation Weekly (6/29/18).

by Asset Allocation Committee

As the FOMC raises rates, there are increasing concerns about the credit markets.  After a long period of low rates, credit spreads are starting to widen, raising fears of financial stress.  In this report, we will look at these concerns.

First, here is what we are seeing with credit spreads:

This chart looks at the spread between 10-year T-notes and similar term Baa corporates.  The average and standard deviation lines are calculated from 1921.  Currently, the spread is about average but it has been widening recently.

Second, here is the impact of monetary policy on credit spreads:

This chart examines credit spreads with periods of policy tightening.  Although policy tightening may bring conditions that trigger a widening of credit spreads, in reality, periods of tightening usually coincide with narrowing credit spreads.  This is because the FOMC usually raises rates in response to positive economic conditions, which, coincidentally, are also consistent with conditions that support firms’ ability to service debt.  Credit spreads tend to widen when the Fed is easing rates.

Third, the key trigger to widening credit spreads is economic conditions.

This chart shows the Chicago Federal Reserve Bank’s National Activity Index along with the T-note/Baa credit spread.  The national activity index uses 85 variables to track the economy; we smooth the raw data with a six-month moving average.  A reading of zero indicates an economy growing at trend.  Thus, a reading below zero suggests a weakening economy.  Note how credit spreads widen when the index dips below zero.  The two series are correlated at -71.9%.  A regression based on this relationship suggests that the recent widening of the T-note/Baa spread is mostly a rise toward fair value.

The regression suggests the spread had become too narrow given the performance of the economy.  The recent widening has mostly moved the spread back to fair value.  Although it is possible the spread could widen further, it would not be justified based on the performance of the economy.  For this reason, we still view credit risk as manageable.

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by Asset Allocation Committee

(NB: Due to the Thanksgiving holiday, the next report will be published on November 30.)

Last year, 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 October data.

This chart shows the results of the indicator and the S&P 500 since 1995.  The updated chart shows that the economy is doing quite well.  We have placed vertical lines at certain points when the indicator falls 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.

What does the indicator say now?  The economy is healthy and currently supportive for equity markets.  Thus, the recent weakness in equities is not due to the economy but other factors, including monetary and trade policy.  The good news is that if there is any reduction in concern over these issues then the economic data would likely support stronger equity prices.  The negative news is that there isn’t much evidence yet to expect a pause in Fed tightening or a systemic easing of trade tensions.  Thus, for the time being, equities will struggle to challenge recent highs.

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by Asset Allocation Committee

In light of rising interest rates, this week we will take a look at credit spreads.  But, before doing that, it makes sense to examine overall Treasury valuation.

This chart is our 10-year T-note model.  It incorporates fed funds, the Japanese yen exchange rate, German sovereign 10-year yields, oil prices, the fiscal deficit as a percentage of GDP and an inflation proxy.[1]

This model does suggest current 10-year yields are elevated, but not at extreme levels.  However, if we assume a terminal fed funds rate of 3.25%, assuming no change in the rest of the variables in the model, fair value for the 10-year rises to 3.27%, which is near current levels.  Thus, we can postulate that current yields have discounted about 100 bps of further tightening.  Another interesting note is that the most significant variables in the model are fed funds and the inflation proxy.  Just using these two variables in the model yields a fair value of 3.60%; if we assume another 100 bps of tightening, the terminal 10-year yield ends up at 4.10%.  Compared to the broader model, it is clear that overseas factors, especially German yields, are keeping U.S. yields from rising faster.  Overall, we don’t expect these foreign factors or oil prices to change in such a way as to support higher yields, so we don’t expect a rise in the 10-year yield to exceed 3.50% unless (a) inflation expectations become unanchored, or (b) the FOMC signals it will raise rates much more than expected.

Thus far, the impact on credit spreads from rising Treasury yields has been minor.  The chart below shows investment grade spreads.  Current investment grade spreads are holding near their long-term average.

High-yield spreads have nudged higher but remain tight, with spreads holding near the bottom of their historical ranges.

The lack of spread widening is consistent with the continued low level of stress in the financial system.

This chart shows fed funds with the Chicago FRB National Financial Conditions Index; the index rises when stress increases (or, put another way, when financial conditions deteriorate).  From 1973 (when the index data begins) until 1997, the two series were tightly correlated; if the FOMC raised rates, stress rose.  Stress was a “force multiplier” for monetary policy.  We believe increasing transparency has removed this “tool” from the Fed; now, financial participants can so easily project the path of policy that they don’t necessarily fear the rising rates.  And so, instead of seeing participants react to stress as policy tightens, we now have a situation where stress remains low only to soar.  Credit spreads are a key component of the aforementioned conditions index.  If spreads begin to widen, they could do so rapidly, leading to significant market disruptions.  For now, all is calm, but we continue to closely watch market conditions because when they begin to deteriorate they tend to so rapidly.  In asset allocation, we have tended to favor investment grade spread products but are less favorable toward high yield.  If conditions start to deteriorate, we will shift allocations toward Treasuries.

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[1] For an inflation proxy, we use the 15-year moving average of the yearly change in CPI.  This is based off research by Milton Friedman, who postulated that investors build their inflation expectations over a long time frame.