Stocks fell once again following the path of interest rates downward as recession fears rose and policy confusion continued to increase. Energy, bank, industrials and consumer discretionary stocks were particularly weak. It was clearly a risk-off day for investors. This morning the trend continues as interest rates continue to fall, inversions widen, and stock futures are under renewed pressure.
There are many who continue to believe that there won’t be a recession any time soon. There is lots of data to support their views. Consumer spending is strong, leading economic indicators have started to tick up once again, and low rates are accelerating mortgage refinancing activity (as they should). Employment remains strong. Overnight data from China showed resilience supporting a forecast of continued solid growth there.
But there are disturbing signs as well. The yield curve has inverted, a telltale warning that recession may not be far off. Global growth is slowing, and has been slowing since President Trump started his tariff wars. In fact, since the first announcement of tariffs back in February 2018, the stock market has been flat and interest rates have fallen significantly around the globe.
One of the problems facing investors is that recessions tend to creep up on us. They don’t emit loud warning signs. Look at the chart below which documents weekly unemployment claims going back to the 1960s. The shaded vertical bars are recessions. Notice how claims always spike up during recession. That correlation should be obvious. When business slows, companies lay off employees. But what may not be obvious is that claims data gives very little warning before the recession hits. Claims may begin to creep up shortly before a recession begins but then suddenly rise in parabolic fashion as economic growth falls until the recession ends. Indeed, the end to layoffs is what almost always marks the end of recession. Look at the right side of every recession bar below and you will see that claims peak almost exactly coinciding with the end of a recession.
If you look to the right side of the chart, you see that claims have not hooked up yet; we still are in an all-clear zone. But if there is any one indicator worth watching to see whether recession is imminent, I would suggest this is the one. Even a 10% rise in weekly claims raises a yellow flag, if not a red one.
Obviously, I am not the only person watching this. The Federal Reserve does as well along with other key leading indicators. So far, most still say “no recession.” But many have begun to trend in the wrong direction. The average workweek, for instance, has been declining for three quarters. That is often a prelude to an acceleration in layoffs. The yield curve inversion everyone is talking about is another warning sign.
Clearly, the Fed has ammunition to counteract negative forces. It cut rates in July and will do so again in September and maybe October as well. It can resume buying bonds adding to money in circulation. However, given the subdued monetary velocity today and tepid loan demand, it is problematic how much stimulus renewed bond buying would achieve unless it is done in massive amounts. The Fed, always worried about inflation, needs to pay more attention to deflationary forces. Not only is the worldwide oversupply I talk about all the time a problem, tariffs add to the headwinds. Simply put, they are a tax and every economist knows that raising taxes when an economy begins to weaken is precisely the wrong step to take. Like everyone else, I understand that President Trump feels tariffs are the best way to force China to alter the way it trades with the rest of the world, but, in the interim, it is increasingly likely that tariffs could precipitate a slower economy, if not a recession.
Over the next three weeks, there are two binary events due to occur. The first is this weekend when the next round of tariffs on Chinese exports to the U.S. are due to take effect. It is certainly possible that Trump could delay or cancel the tariffs. Possible doesn’t mean probable; it means possible. But, simply said, if the tariffs go into effect, the economic headwinds will increase. In stock market terms, no tariffs or delayed tariffs would ignite a stock market rally. But if the tariffs do go into effect with no other trade related news, next week could start off ugly for stocks.
The second event is the mid-September FOMC meeting, a two-day affair scheduled to end September 18. It is highly likely the Fed will cut rates 25 basis points. That may not be enough to cause the end of the interest rate curve inversion. As the inversion steepens, there are increasing calls for a 50-basis point cut. Yet, there are some FOMC members who still don’t see the need for any cut at all given recent solid economic data and stable inflation.
Again, the FOMC meeting represents a binary event. No rate cut would send stocks down sharply. That is unlikely to happen. The impact of a 25-basis point cut would be dependent on how the Fed places the cut into context with future planned actions. But even if it says more cuts will come if needed, markets are likely, at this point in time, to react well to a cut of only 25-basis points. A 50-basis point cut, on the other hand, would be very well received and could stop the inversion from getting worse. Parts of the curve could even uninvert. However, a 50-basis point cut also could send a message that the Committee views the economy as weaker than current data suggests. The quandary the Fed has to wrestle with is whether what is good for markets in the short run is good for the economy in the long run.
With all this said, any investor knows that over the long run, stock prices are a function of earnings and interest rates. The latter is governed by inflation expectations. As interest rates have come down worldwide, so have inflation expectations. That can argue for a higher P/E ratio. Good for stocks. On the other hand, economic headwinds and tariffs in a world where few have pricing power suggest that earnings estimates are too high and have to come down. So, we are left with a ying and yang. Higher P/Es on one hand; lower earnings on the other. Current estimates for this year for the S&P 500 suggest earnings of about $165. Next year’s current estimates are in the $175-180 range, but I think $165-$175 is a better range, assuming no end to the tariff wars and no great escalation either. Even if the tariff picture clears, political uncertainty, which will rise if the 2020 election is a close one, will continue to limit capital spending growth. Government spending will increase. Overseas growth will be subdued. The key, once again, will be the consumer. If he hangs in and remains confident, earnings can meet or even exceed the upper end of my range. If, however, businesses start to layoff workers and the consumer retrenches, that is how you get to a recession and even $165 will be too high. If I use 17 times $175, I come close to 3000 as the top end of the range. There is no law restricting P/Es to 17 but that is the top end of the past 5-year range. To assume higher, one would have to ascribe some permanence to lower inflation expectations.
On the downside, 15 times $165 yields a number below 2500. Today, at 2870, we are closer to the top of the range than the bottom. That doesn’t mean stocks have to retreat to the lower end, although they might if tariffs escalate and the Fed disappoints. On the other hand, given Trump wants to get reelected, at some point over the next 12 months, he could signal a tariff détente in exchange for a deal that might be seen as a stepping stone to a larger deal down the road. In that case, 3000 would be an easy target.
As I said at the start, over the near term, the binary events of tariff escalation and the upcoming Fed meeting will drive stock prices. Recession risks are rising, but a recession certainly isn’t confirmed at this point in time. But given that stocks aren’t cheap here, a more defensive posture is called for.
Again, I remind all that stocks remain much more attractive than bonds as a long term investment. The S&P 500 this morning yields more than the 30-year Treasury. That might not matter today but it will matter a lot over time. Good companies that pay a solid dividend that can grow steadily over time may not outperform in an ebullient stock market environment, but they will provide a comfortable hiding place in this market environment.
Today, Jack Black is 50. Shania Twain turns 54.
James M. Meyer, CFA 610-260-2220