Crosscurrents are defined as “a turbulent stretch of water caused by multiple currents, or, a situation in which there are conflicting opinions”. Why is this word on my mind as I reflect on the past six months and consider what may lie ahead? One obvious reason is our current Federal Reserve Chair Jerome Powell has used the term quite frequently this year. Starting back in December, Mr. Powell noted “some crosscurrents have emerged in the economic growth outlook”, which I believe was the first time he used the word. Subsequently, he noted again the presence of “crosscurrents and conflicting signals” in several speeches throughout January, February and March. During a press conference on May 1, Mr. Powell said the uncertainties and crosscurrents had moderated somewhat. He soon changed his mind though during another press conference on June 19 when he back-pedaled noting the “crosscurrents have reemerged”. Most recently, in the monetary policy report to Congress on July 10, he used the word four times during his opening remarks and peppered it throughout his responses during the balance of his testimony. In short, everyone in financial markets is quite familiar with the term crosscurrents by now. The real question is whether they can make sense of all the conflicting indications and navigate forth through the turbulent stretch of water that has defined the recent past and appears to be getting even more dangerous in the months ahead.
MARKETS IN REVIEW
The longest equity bull market in history kept on running in the second quarter, albeit with more volatility and significantly less return than the first quarter. The first half of 2019 marked the best six-month start to a year in over two decades for the S&P 500 which returned 17.35%, although the second quarter’s 3.79% return pales in comparison to the 13.07% return achieved in the first quarter. In contrast to the first quarter which included a significant rebound in January with three months of positive returns, things started to look scary again in the second quarter as May produced a significant -6.58% decline. In the end, the quarter was saved by another rebound in June. I do like to point out that even though the market performed well in the first half, we ended June only +0.38% higher than where we were last September when the market hit its previous all-time high. Furthermore, while news reporters are all celebrating the new record highs and excellent first half of the year, we need to keep in mind that on December 24, the S&P 500 was down -19.71% from its high and we were only 0.29% away from an official bear market that would have ended the current bull market run.
Indices focused on stocks with strong value characteristics performed well throughout the first half, although not as well as the S&P 500. Large company value stocks, as represented by the Russell 1000 Value Total Return Index, gained 3.84% for the quarter. Small and mid-sized company (“SMID”) value stocks, as represented by the Russell 2000 Value Total Return Index, were also positive but did not perform as well producing only a 1.37% gain during the quarter. SMID value has recovered somewhat from its -25% selloff at the end of last year but remains in “correction territory” meaning that, unlike the S&P 500 mentioned above, it is still more than 10% below the all-time high it achieved last August.
Fixed income produced some nice gains as well so far this year with the Bloomberg Barclays U.S. Aggregate Index returning 2.94% in Q1 and 3.08% in Q2.
Power of Powell: The Fed is Driving the Rally
I started this review by talking about Federal Reserve Chair Jerome Powell’s recent use of the word crosscurrents. Before diving more deeply into those conflicting indications and turbulent waters we are seeing out there, it is worth noting just how much impact the Fed has imposed on markets this year.
Although all Fed members give frequent speeches, investors often listen most closely to the words of Mr. Powell to determine the likelihood of any material policy changes that may help or hurt the markets. There were two key moments in the first half of the year when Mr. Powell clearly helped change the direction of the market. First, on January 4 he said, “We’re always prepared to shift the stance of policy and to shift it significantly if necessary in order to promote our statutory goals of maximum employment and stable prices.” Second, on June 4 he said, “We are closely monitoring the implications of these developments for the U.S. economic outlook and, as always, we will act as appropriate to sustain the expansion.”
The chart below contains the S&P 500 price history between November of last year through June 2019. Highlighted in blue vertical lines on the chart are the two days when Mr. Powell made the market boosting remarks mentioned above. It becomes quite clear that, in both situations, his comments helped reverse a negative trend and send the market rallying higher.
Furthermore, the market’s reaction to his words on those two days alone contributed a significant amount of the first half’s gains. The S&P 500 rallied 84.05 points on January 4 and 58.82 points on June 4 for a total “Powell Boost” of 142.87 points. The index increased by a total of 434.91 points during the first six months of the year which means almost 33% of the gains occurred thanks to those two “Powell Boost” days without even considering the gains that followed as a result of his change in tone or reassurance of action.
Certainly, Mr. Powell’s words and Fed policy always have the power to change market direction and give investors hope that more economic growth still lies ahead. The question we need to ask ourselves is whether market increases this year are justified by a true continuation of quality fundamentals in a record-breaking economic expansion, or, whether the Fed is just doing everything they possibly can to use monetary policy to push the market higher. Do the U.S. and global economies still show consistent signs of strength and positive momentum, or are we actually seeing signs of economic deterioration or even asset bubbles which might lead us towards the next recession?
Canary in the Coal Mine
In the same way coal miners used canaries to determine if the environment was dangerous far before they could identify the presence of any toxic gas, investors must look for warning signs that might not be obvious but should be taken seriously. One such warning sign is whether the market still has an appetite for riskier assets, or, are investors starting to play it safe.
The Russell 1000 Index is widely regarded as a gauge of investor appetite for large-capitalization companies (“large-caps”), which are typically large international firms with more diversified revenue streams and are less sensitive to the overall business cycle and liquidity problems. In contrast, the Russell 2000 Index is a gauge of investor appetite for small-capitalization companies (“small-caps”), which typically have less diversified revenues and are more sensitive to the business cycle and liquidity problems.
The Russell 2000 hit its all-time record high on August 31, 2018. In the “Small-Cap Companies Underperforming Large-Caps” chart, I have indexed the daily price returns of both indices such that each starts at a value of 100 on that date. This form of comparison allows us to look at the returns on the same scale. One critical thing to note is the Russell 2000 dropped well below the Russell 1000 in December last year and was still down around 10% from its high at the end of June. The Russell 1000 recovered better in the first half of 2019 although it ended up only 1.14% higher than its August 31 level. However, a more ominous sign is the divergence between the two indices that occurred year to date as investors clearly favored safer large-cap companies versus riskier small-cap companies over the past six months.
As one analyst recently noted, “when the Russell 2000 is underperforming, it suggests investors are losing their appetite for risk, and the market is getting ripe for a selloff.” The analyst continued to explain that this divergence is even more interesting because it is coming at a time when “many feel the biggest headwind for the stock market and the economy is all the uncertainty surrounding the U.S.-China trade war, which should weigh on large-cap multinational companies more than small-cap companies that have more domestic exposure.”1 The point being, even though small-cap companies are probably getting some degree of a boost from their lack of exposure to trade concerns, they are still significantly underperforming large-caps. This suggests investors are really trying to avoid the inherent risk of smaller companies that suffer when an economic expansion is ending, and the toxic fumes of recession begin to waft through the air.
One of the primary crosscurrents in the markets this year is the uncertainty surrounding a U.S.-China trade war as well as trade conflicts with other areas of the world. We came into the first half feeling like things were going to work out. Talks and negotiations were progressing, and it appeared that a resolution was possible. This ended abruptly when the U.S. received a copy of the 150-page draft trade agreement back from the Chinese on May 3 with material edits to the document. Apparently, core demands from the U.S. were deleted. Commitments initially made regarding the theft of U.S. intellectual property and trade secrets, forced technology transfers, competition policy, access to financial services and currency manipulation were eliminated by China and this yearlong conflict suddenly escalated again.
On May 5 President Trump tweeted “For 10 months, China has been paying tariffs to the USA of 25% on 50 billion dollars of high tech, and 10% on 200 billion dollars of other goods … the 10% will go up to 25% on Friday [and] 325 billion of additional goods sent to us by China remain untaxed, but will be shortly, at a rate of 25%.” This weighed heavily on markets and we saw a significant decline throughout the month of May as investors considered the effect on domestic and global growth that trade uncertainties could have.
These trade risks were not limited to China. The U.S. raised the potential for tariffs on autos and other goods with the Eurozone and Japan. At the beginning of June, President Trump threatened Mexico with tariffs as well because of concerns regarding border security, immigration and NAFTA. The markets rejoiced when a deal was reached with Mexico, however, and President Trump agreed to indefinitely suspend the implementation of tariffs on that country’s goods.
With rare broad support from both political parties, Trump headed to the G20 meeting to meet with China’s President Xi at the end of June. Throughout most of the month, investors considered whether a trade deal would be reached at the meeting or, at a minimum, would there be some type of truce that would allow negotiations to start again. In the end, things cooled off a bit at the G20 meeting as both sides agreed to start working together once more, and markets celebrated briefly.
Looking forward, it seems that although many in the U.S. hope the trade uncertainties will go away soon, the Chinese appear to be digging in for a much longer confrontation. Trump recently said the U.S. “still has a long way to go” on trade talks with China, and once again threatened to impose tariffs on the remaining $325 billion of Chinese goods if the two sides cannot come to a deal. These trade uncertainties have evolved into a new type of “cold war” that is primarily focused on technology but will likely impact global growth and spending across many industries for the rest of this year and potentially for many years to come.
Signs of slowing domestic and global demand started to become more frequent in the first half of the year. The Institute for Supply Management (ISM) Manufacturing Index came in weaker than expected and declined to a 31-month low in May. This index is based on a survey of purchasing managers from more than 300 manufacturing firms and helps indicate the amount of demand and economic activity. Another similar indicator, the Markit U.S. Manufacturing Purchasing Managers Index, dropped to a level not seen since 2016. The MNI Chicago Business Barometer, yet another summary of current business activity considered to be a leading indicator of the U.S. economy, plunged from 54.2 to 49.7 (50 is the line of demarcation between economic growth and contraction). This too was the lowest reading since February 2016.
These manufacturing related indicators suggest a slowdown in growth due to tariff-related concerns and trade uncertainty, but there were other signs of trouble as well. The Markit U.S. Services Index also fell in May to its fourth weakest level since late 2009. During a speech in late June, Fed Chair Powell discussed the incoming data and acknowledged that investment by U.S. businesses, or capital expenditures, has appeared to slow since the beginning of the year. He explained the outlook for the U.S. economy is cloudier now due to questions about the strength of the global economy, the decrease in capital expenditures as well as business confidence in general.
As the first half of the year comes to an end, reports will now start coming in from companies that tell us how they performed in the second quarter. Typically, businesses always hope these earnings reports will be well received by the market which is accomplished by “beating expectations” of Wall Street analysts. At this point, it looks like businesses are very nervous about their ability to beat expectations however, and the potential for a brutal earnings season is another looming threat. Seventy-seven percent of companies that have issued earnings-per-share guidance ahead of publishing financial results have warned their upcoming numbers will fall short of Wall Street estimates. That is the second-worst quarter on record going back to 2006 according to FactSet.
According to other analysts, “The S&P 500 looks set to suffer its first earnings recession in three years … and early signs suggest the recession could continue into the third quarter.”2 As of July 12, the estimate was that the blended year-over-year growth estimate for earnings per share for the S&P 500 was negative at -3.34%, according to data provided by FactSet.
Although Mr. Powell and the Fed are now acknowledging the crosscurrents and hinting that they might impose the first U.S. interest rate reduction in a decade at the end of July, many of us are asking whether it will be too little … too late. Will a Fed interest rate cut cause businesses to suddenly increase their capital expenditures just because it’s slightly cheaper to borrow funds? Will the interest rate cut help increase their net income and prevent further earnings declines in the quarters ahead? I think not. Overall, companies already have plenty of cash and credit (more on that in a minute), but what they don’t have is global demand.
Recession Probability and an Update on the Yield Curve
As you might have read in our prior commentaries or heard in the news yourself, a yield curve inversion has historically been a good predictor for an economic recession. An inverted yield curve occurs when the yields on short-term fixed income securities are higher than the yields on long-term fixed income securities. This is not the normal situation because typically, investors will demand more return for a ten-year investment, for example, than the return they will demand for a three-month investment. However, when investors perceive that risk in the near future is relatively greater, they prefer to invest in long-term investments even though they will earn less return.
In the chart above, we have plotted the yield spread between the three-month U.S. Treasury Bill and the ten-year U.S. Treasury Note. Typically, the number is positive when 10-year yields are higher than 3-month yields. As you will see, the spread became negative in 2006/2007 and the dark gray bar on the chart indicates the “Great Recession” that followed. Here we are again as the same yield curve has not only inverted but has remained negative since May 22 of this year. That does not necessarily mean a recession is imminent, but, this inversion has preceded every recession over the past eighty years.
The New York Federal Reserve Bank even created a model based upon this yield curve inversion. The model attempts to determine the probability an economic recession will occur twelve months ahead. In the graph below, the gray bars indicate every recession since 1960 and the green line indicates the model probability that a recession will occur in twelve months. I note that the 30% probability barrier appears to be a good watermark historically and as you will see on the chart, the model has increased significantly over the past year and is now above that level with a reading of 32.9% as of July 5. Could the next recession be twelve months out? Maybe, but the chart also demonstrates a few situations where the probability crossed the 30% watermark after the recession was already underway.
Corporate Debt: Possible Asset Bubble?
With a record-breaking bull market and economic expansion, several pundits out there are saying this time will be different, there are no signs of any asset bubbles, and we should not expect a recession for years to come. Must we remind them about the definition of insanity as repeating the same actions over and over again with the expectation of different results? The Great Recession of 2008 – 2009 was primarily caused by the housing bubble in which lending standards became too loose as banks struggled to keep up with insatiable investor demand for yield. Back then, individuals with poor credit and no documented income were issued mortgages that exceeded the value of the property they were buying. Those mortgages were then packaged and sold to investors who were looking for high-yield assets in a relatively low-yield world.
Are we are seeing the same scenario play out in corporate borrowing, rather than individual borrowing, this time? Chair Powell said during a speech on May 20, “Many measures confirm that the business sector has significantly increased its borrowing as the economy has expanded over the past decade. Business debt relative to the size of the economy is at historic highs. Corporate debt relative to the book value of assets is at the upper end of its range over the past few decades. And investment-grade corporate debt has shifted closer to the edge of speculative grade.”
He continued to explain that not only is business debt at record levels and recently concentrated in the riskiest segments, but this highly leveraged business sector could amplify any economic downturn.
Another ominous sign occurred when, on May 30, the Financial Stability Oversight Council met secretly “in executive session” to discuss the recent surge in corporate borrowing and leveraged lending. Leveraged lending is another term for loans issued to companies with poor credit ratings. This type of borrowing hit a record amount of issuance in 2018 topping $125 billion, and the frenzy continued into the first half of this year. One analyst noted, “Increased [leveraged loan] demand will support issuance and refinancing activities” but that “highly-leveraged businesses could face severe financial stress in the next downturn.”
With historically low rates over the past decade, businesses have loaded up their balance sheets with debt. This certainly helped fuel the expansion, but we are once again seeing record amounts of borrowers with poor credit quality leveraging up as much as possible thanks to insatiable investor demand. Sounds familiar.
Is Your Portfolio Ready for Turbulent Waters?
Chair Powell definitely has one thing right: crosscurrents are everywhere. Large-cap stocks ended the first half of the year only +0.38% higher than last September and small-cap stocks remain in a correction. Equity investors are favoring less risky assets. We might be on the verge of a full-blown trade war that could last for many years to come. Both manufacturing and servicing industries are showing signs of severe stress. Businesses are preparing investors for the worst reporting season in a long time. The yield curve continues to predict a U.S. recession is on the horizon. Highly leveraged companies with poor credit continue to issue more debt. And a global economic slowdown is already well underway.
Some investors are justifiably nervous as “net outflows for 2019 from U.S. equity funds totaled $41 billion” as of June 28. Against this backdrop, the Fed is clearly doing anything it can to keep the party going. The problem is this time, they don’t have as much “dry ammo” as they had in previous cycles. The Fed Funds Rate was at 6% in 2001 and 5.25% in 2006 before the last two recessions, but today it sits at 2.5% with a 0.25% cut likely at the end of July. Furthermore, ongoing market momentum appears to be supported almost entirely by Fed activity, corporate buybacks and investor fear of missing out on any remaining upside, rather than fundamentals and growth.
We have entered another period where bad news is good news for the market. The market rallies on bad economic data because it solidifies the likelihood the Fed will start cutting rates. However, this underscores a disconnect between what is pushing the market higher and what should be pushing the market higher. With all of these crosscurrents, equity investors should be lowering their expectations for earnings and growth right now and identifying the best way to prepare their portfolio for the turbulent waters ahead.
Here at WBI, we have managed risk to capital for institutions and private investors for over 30 years. Our time-tested active portfolio management process has no mandate to be fully invested. For us, cash is a tactical weapon that can help protect investor capital during market corrections. We believe preserving capital to unleash the power of compounding is the most important element of a successful investment approach. WBI also uses its high-quality security selection process as another weapon in both our actively managed and passively managed strategies with the goal of participating in market rallies as much as possible when conditions are right. With all the crosscurrents in the market, we believe it is even more critical at this time to work with a manager that is specifically focused on protecting investor capital and navigating through the turbulent waters that lie ahead.
-Steven Van Solkema
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