Volatility continues. The market fell about 1.5% on Monday amid heightened trade fears and concerns about the growing demonstrations in Hong Kong. Then yesterday morning, President Trump said he would defer some tariffs on consumer goods imported from China to December 1 to avoid price increases before Christmas. Stocks regained Monday’s losses. This morning the 2-10-year Treasury yield curve inverted briefly and sellers returned. Futures point to losses at the open approaching 2%.
Volatility accompanies change. Change can be good or bad. At the moment, most of the visible change appears bad. German manufacturing is in recession and its exports are declining. China manufacturing activity is at its slowest pace in more than a decade. The trade/tariff war with the U.S. is squeezing growth. While Q2 growth was reported at 6.2%, no one believes it. As in the U.S., it is the consumer today that is keeping China out of recession. Over 30% of sovereign debt now sports negative yields. All the heavy lifting to try and support world economies is being borne by central banks. Thanks to Germany’s century long obsession with budgetary conservatism (it still feels the pain of massive devaluation after World War I, a century later) European nations watch as it slips back into recession.
Just under 50% of world growth comes from the U.S. and China. Both nations are still growing and, despite the warnings of an inverted yield curve, recession doesn’t seem imminent in either nation. China’s central bank has been aggressively easing monetary policy for over a year, but there are limits how far it can go. Debt levels are rising. Letting the yuan weaken risks a flight of money out of the country. Uncertainties surrounding Hong Kong add to that risk. While the media talks of Chinese army intervention and even President Trump tweets about it, the Chinese know full well the repercussions should armed intervention lead to significant casualties. It still may happen but it is a last resort, not something imminent. It would be unwise to overstate the severity of what is going on in Hong Kong. I don’t mean to ignore the risks but until events force a flow of money out of Hong Kong to other nations like Singapore, we should probably view what is happening in Hong Kong more like the Occupy Wall Street movement of a few years ago.
Putting Hong Kong aside, the real worries the market faces are threats of looming recession (the yield curve inversion is just one more signal) and the threat of deflation. Let’s look at them separately starting with the risk of recession.
Our manufacturing sector may already be in or very close to recession. About 25% of the S&P 500 companies are now estimated to have down earnings over the next 12 months, a combination of weakness in the manufacturing sector, and recessions or near-recessions overseas. Of course, that means ¾ of the companies are still projected to grow. Capital spending growth has slowed, mostly related to policy uncertainty, but it is still positive. Government spending is strong as are tax receipts. Government spending should grow about 4%. That leaves the consumer who remains quite healthy. He is earning more money, adjusted for inflation, he is saving more, and he is increasing spending at a 3%+ pace. Employment remains high and jobless claims are still near record lows. None of this suggests recession. However, while consumer confidence remains high, business confidence is fading fast. Part is the politics. Part is uncertainty overseas. Part is margin squeeze supported by higher taxes. The President may proclaim that China and Mexico are paying the tariffs, but we all know that they are borne by producers, importers, and retailers. Higher sales are not translating into higher margins. If employers get too fearful or see any actual sign of weakness, we may start to see a rise in unemployment claims. If I had to watch one economic indicator as a red flag warning sign of serious trouble ahead, I would watch unemployment claims. You don’t have to see a big increase to be worried. They tend to rise about 10% in the last months of economic growth and then spike during the actual recession, if one actually occurs. That means a 10% rise might be a false signal; that happens often without leading to recession. But this time around, given all the other negatively trending data including lower manufacturing output, weaker exports, the inverted yield curve, etc., I would be very cynical about a continued expansion if claims started to rise steadily.
I indicated earlier that central banks around the world are stepping up efforts to ease monetary conditions. But I should note that our Federal Reserve has made the least response in part because our economy to date has been growing at a very acceptable pace without any inflationary pressures. If the July rate cut put the Fed out in front, the reaction in the bond market would likely have been a steepening of the yield curve, not an inversion. I warned before the Fed meeting that we would have to watch the weeks that follow to determine whether the Fed’s moves were deemed to be sufficient or not. Markets have stated clearly that they were not. Of course, markets aren’t always right but neither is the Fed. In fact, if one looks back at almost every recession in the recent past, the Fed was always late to react. Markets are screaming for a 50-basis point rate cut at the September meeting. The Kansas City Fed holds is annual conclave that everyone watches at the end of August and we should expect strong signals that suggest what the Fed will do in September, if not sooner. Once again, market reaction to the Fed statements will tell if they are strong enough.
The other major fear overhanging markets is deflation. As I note continuously, the world is oversupplied. It is oversupplied because of the last recession and because there has been a surge of low cost manufacturing capacity in Asia, principally China. This appears everywhere. Commodity prices are in a downward trajectory with few exceptions. Since the threat of U.S. tariffs just a couple of weeks ago, iron ore prices in China have dropped by 20%. The last thing the world needs is more Chinese steel.
The June CPI came out this week and showed an annualized increase in prices, ex-food and energy, of 2.2%, a sign that inflation isn’t completely dead. But if you look within the components, the following have risen by less than 1% year-over-year or declined; transportation services, medical care commodities, generic drugs, cars, commodities other than food and energy, home utility costs, apparel, and food consumed at home. The only categories where prices rose by more than 2.2% were shelter, restaurants, and medical care services. Indeed, only labor is in short supply. Wages are rising faster than inflation. Thus, services with a high labor component are seeing a bit of inflation, but nothing else.
This all paints a somewhat ominous picture. Growth is slowing with parts of the world already in recession. Prices are rising at an ever slower pace and threaten to slip into deflation. What is needed, obviously, are stronger government actions to accelerate growth to stimulate confidence. Obviously, tariffs do just the opposite. I have no idea what enticed President Trump to delay some new Chinese tariffs until December. He had a pretty good idea when Christmas was when he suggested they would be instituted on September 1. Maybe it is simply the Trump method to set a stake in the ground and then pull back, a tactic we have seen often in the past year. What can boost the markets from here? Quite simply more aggressive Federal Reserve policy, fewer tariffs, or fiscal stimulus from around the world.
If recession does happen, and that remains a very big if, there are few signs that it should be a severe one for several reasons. Both banks and individuals are in fine shape. Low interest rates relieve many of possible surging debt service costs. Ultimately, a weak economy will bring proper reactions in the form of stimulative monetary and fiscal policy. Just to put an exclamation point on that statement, weekly mortgage application data released this morning shows a sequential 37% spike in applications to refinance, a jump to the highest level since July 2016. Even mortgage applications to buy are 12% above year ago levels. As rates keep falling, refi activity will only accelerate. This is exactly what low rates are intended to do. Homeowners that refi can spend the savings elsewhere, save it, or invest it in something like home improvement.
Thus, don’t label this economy dead quite yet. Just as markets overreacted to a modest delay in some tariffs yesterday, they are likely to overreact to a yield curve inversion today. The median time since World War II between the time of a yield curve inversion and the end of the bull market is about 11 months. And not every inversion signals a recession. Note that both the Fed and President Trump watch markets closely and both have tools to react.
But with that said, this is clearly evolving into a risk-off market. I think there is a much better chance that the next 10% move in the stock market is lower, not higher. For markets to move higher from here, bond yields have to stabilize and earnings expectations have to increase. With the bond market in a free fall that we haven’t seen for years, it is anyone’s guess where the bottom might be for the 10-year Treasury yield. Rationally, a yield of 1.6%, less than anyone’s reading of inflation, is too low. Money for 10 years, adjusted for inflation, shouldn’t be free. Negative yields overseas are equally irrational. A Danish bank reportedly is offering mortgages at a negative yield. Don’t ask me to explain the rationale. That is what happens when a market goes into freefall and emotion begins to trump rational behavior. None of this means, however, that yields can’t go still lower. More important for stocks, however, is whether 2020 expected earnings have any chance of achieving the 5% growth that constitutes today’s consensus forecast. Clearly, if the economy weakens further, not only will that forecast prove wrong, it could be wrong by a wide margin.
A decline of 10-20% isn’t fun. It may not even occur. But as we learned as recently as this past fall, such declines can be reversed quickly. Long term investors don’t need to change asset allocations but they should make sure that their equity positions are not higher than normal as a result of the 15-20% rise in the first seven months of this year. Just remember August-October is generally a very nervous time for equity investors while October-December is often a good time. Don’t overreact! But do pay attention and make appropriate changes as needed.
Today, Mila Kunis is 36. Halle Berry turns 53. Magic Johnson is 60. Steve Martin is 74.
James M. Meyer, CFA 610-260-2220