Stocks posted solid gains on Friday for the second day in a row as the brief 2-10-year Treasury yield inversion that lasted only a couple of hours faded and yields posted tentative gains along the curve. Over the weekend, China preannounced a new lending structure that is a de facto cut in rates. That has pushed Chinese stocks higher and set up an opening rally around the world.
As noted last week, the move toward lower rates had begun to turn parabolic and was taking place at an unsustainable pace. Over the past few sessions, and continuing this morning, rates have started to bounce back. Whether, this is a short-term counter trend or a start of a V-shaped recovery is uncertain but bears close watching. Anyone who follows my two-day rule will be less bearish this morning. The rational support for that rule implies that a strong rally lasting more than a day is more than short covering by traders. It appears equity markets will open strong today. A key is whether the morning gains can be sustained.
Normally, I don’t pay much attention to day-to-day movements but when volatility accelerates without a lot of net movement in prices, there is an obvious message. Usually, it involves a crosscurrent of factors. Over the past few weeks, the most obvious change has been the aforementioned sharp move down in interest rates all along the curve. That started August 1 when President Trump announced an escalation of trade tariffs against China starting September 1. While he moderated what he planned to introduce since, the escalation of tariff increases continues a pattern started last February. Whether all due to the tariffs or not, worldwide growth has slowed from a peak of well over 3% in the second quarter of 2018. Since almost 50% of worldwide growth comes from China and the U.S., the linkage between tariffs, reduced trade, and slower growth seems pretty direct and obvious. The tariffs might not be the only factor slowing growth worldwide, but it appears to be the dominant force.
As a result, excluding the impact last year of the Trump corporate tax cuts, profits have been flat for the past year and are expected to remain so at least through the current quarter. While analysts predict a reacceleration starting in the fourth quarter, those forecasts came out before the September 1 tariffs were announced. Mr. Trump continues to threaten more tariffs both against China and Europe. Threats alone may affect capital investment decisions, but it is the actual implementation that affects growth. Given the election in the U.S. next year, one can only speculate on the future direction of tariffs. Logic might suggest less pressure over the next 12 months than over the past 12 months. Clearly, the President is concerned about rising talk of recession precipitated by the momentary inversion of the yield curve. Yesterday, he sent his economics spokespeople out onto the Sunday news talk shows to support the notion that our economy is strong and to poo-poo any notion of a possible recession before the election.
In their favor, consumers continue to spend, not only here but around the globe. To the extent that there are recessionary winds in the air, they all center on manufacturing. With hindsight, inventories were too high at the end of 2018 and it takes time to work those down. Doing so precipitates a manufacturing slowdown. The imminent Brexit event has served to increase the stock piling of inventories. Assuming Brexit happens one way or the other this fall, that situation will self-correct rather quickly.
While data last week showing sharp gains in retail sales support the White House theory that all is well, a coincident survey that showed a sharp slide in consumer confidence in July bears watching. If consumers show any reticence to spend in the coming months, that could harden the notion that a global growth slowdown continues. Even assuming the consumer continues to spend, any reacceleration of growth will require some turn around in the manufacturing, capital spending, and commodities sectors. At the moment, there are virtually no signs of any imminent turn.
Trying to pull this all together, the notion of lower rates as a result of a weakening economy makes some sense. But the idea of a recession with consumer spending continuing anywhere near the recent pace makes very little sense. Moreover, rates everywhere are unnaturally low. Short rates, usually dictated by central bank policy will remain near zero in parts of the world and very low in others. Banks that can lower rates are doing so to try and stimulate growth. But it is the mid-long end of the curve that defies rational explanation. In trading terms, negative rates can be explained. There are enough traders and speculators who believe rates are going even lower (and prices higher) to justify such moves. However, while they can be justified, that doesn’t mean they can be rationalized. Why anyone would want to buy a bond whose interest rate is so low that it can’t cover inflation over its lifetime makes very little sense. The extreme negative rates make even less sense. Germany issues long bonds as zero coupon bonds. It may issue a long bond, therefore, at a price of over 105 euros and pay the bond off at maturity at 100. It may be a great deal for the German government, but only a fool would lend money for 10 years at 105 hoping to get 100 back in a decade. The only way that works is if speculators are willing to bet on even lower rates ahead. They too will be fools if they hang on too long, but they could win their gamble over the coming weeks or months.
Thus, as I noted last week, the bond market is being irrational, a true sign of a bubble. Maybe the market last week set a bottom and has begun to unwind. It’s too soon to make that judgment, but events of 2012 and 2016 when our 10-year bonds yielded under 1.40% at the extreme suggest that if last week wasn’t the bottom for rates, we probably aren’t far away.
What does this all mean for stocks? In the short run, a rebound in rates will stop the rush of fast money into bonds and out of all other asset classes. That would be a positive for equities as we have seen over the past few trading sessions. Note, however, that if the market opens where futures imply, all that will have happened is that we will open about where we were 10-days ago. Stocks have spent several years trading primarily between 15 and 17 times forward earnings. Right now, they are close to 17 times. Thus, there is a valuation lid to the upside unless (1) earnings begin to reaccelerate, or (2) there is a true reduction in inflation expectations. Note that inflation data last week and over the past few months points to a slight acceleration in the pace of inflation. And, as noted earlier, earnings expectations are coming in a bit. Stocks could test the outer limits of their recent trading band and retest recent highs. A lot may depend on the market’s reaction to Fed Chairman Jerome Powell’s speech on Friday. Note that the July 25-basis point cut happened the day before Trump announced another layer of Chinese tariffs. The September FOMC meeting will happen a couple of weeks after those tariffs are implemented. Trump’s anti-Fed rants are unlikely to move policy. Look for hints Friday supporting another 25-basis point cut in September and possibly a third later this year.
I would use any reasonable rally back toward old highs as an opportunity to rebalance, and an opportunity to shift from weak to strong within your portfolio. Looking ahead, I don’t want to be forced to guess how political decisions, e.g. tariffs, will impact the companies I am invested in if I can find solid growing companies that are less impacted by tariffs. With the S&P 500 still providing dividend yields in excess of the 10-year Treasury, I would emphasize companies with dividends of 2% or more that grow their payouts persistently in good times or bad.
Today, Matthew Perry is 50. Bill Clinton turns 73.
James M. Meyer, CFA 610-260-2220