Wall Street in Wonderland

Signs of economic slowdown are proliferating by the day.  Recent weeks have seen modest declines in housing starts, reports of softer sales of existing homes, a sudden reversal in industrial production (blamed on softer global growth and the ongoing trade war with China), flat readings in the Leading Economic Indicators, and a pullback in retail spending. This latter decline—perhaps the most worrisome in this group—reflected lower sales at home improvement stores, department stores, and Internet sales. This overall deceleration in business activity suggests that GDP growth, which was nearly 3% in 2018 and more than 2% in the first half of this year, will average 1.5%-2.0%, at best, over the next year or so.

Yet Wall Street continues to exhibit Alice in Wonderland behavior, seemingly impervious to multiplying warnings of a slowdown.  Investors have pushed the blue-chip indexes toward their highs, and in fact, the S&P 500 and NASDAQ 100 have made new highs as of this writing.  Far from being worried about the prospects of a slowdown, investors appear to be ignoring them and focusing instead on their financial drug of choice, money printing.

Yes, the Pandora’s Box of quantitative easing (QE) has been opened up again.  First, by the European Central Bank in response to ever-slowing European economic growth.  This region has been impacted by the never-ending ordeal of Britain’s exit from the European Union (EU), and the uncertainty of the fallout should Britain actually leave.  Moreover, the trade war has hit Europe hard with virtually every industry feeling the effects of diminished trade. In the U.S., the Federal Reserve has reinstated a form of QE focused on the money markets, in an effort to provide liquidity to the short-term lending market.  This was necessitated by a spike in interest rates in mid-September, reviving memories of the gridlock in 2008 that contributed to the cave-in of the residential mortgage market. While the Fed has declared this was not a revival of QE, the effects will probably be the same.

Those effects include pumping more cash into the financial system which, of course, provides the fuel to propel financial asset prices higher.  This offers a tidy resolution to the divergence between softening economic data and stock prices. With a new gusher of cash coming in, Wall Street puts that money to work, creating demand for stocks and pushing up prices, regardless of valuation or diminishing business fundamentals.  To the public, it all seems benign and Wall Street is in no hurry to dispel that notion as robust money flows into investments only help the bottom lines of brokerages, mutual funds, and advisors.

QE is also an attempt to encourage even more borrowing in the hopes that it will further stimulate economic demand.  But a look at the reasons for the Fed’s QE epiphany reveal some troubling trends. We are starting to see some of the least credit-worthy companies unable to get financing.  One area where this stress is evident is in the leveraged loan market. This is a market for lower quality companies to get debt financing. In good times, when cash flows are high, credit is generally available to these marginal companies.  Now, however, with an increasing number of companies voicing concerns about the trade war stalemate and its effects on the future, credit is starting to dry up for all but the most gilt-edged borrowers. These low quality companies, usually with debt-heavy balance sheets, must have ready access to loans as they continually borrow and refinance.  The underlying reasons for the Fed’s QE revival are what Wall Street should be focusing on, rather than the hope that QE blows the financial asset bubble even further out of proportion.

If this sounds vaguely familiar, it’s because it is a broadly similar replay of the sequence of events that led to the bear markets in 1999-2000 and 2008-09.  The actors will be different but the movie will be the same. If global economies continue to slow, we should expect the stress on heavily indebted companies to continue.  While central banks may be able to bend or delay the laws of economics, they can’t break them. This is the biggest risk investors face, and one which cannot be fixed with a tweet, a symbolic yet empty trade deal signing ceremony, or a 0.25% cut in short-term interest rates.  

Wall Street has taken heart this autumn from the surprising number of companies that have exceeded their earnings estimates, providing further rationale for bidding up stock prices.  Setting aside for a moment that securities analysts are very poor at producing accurate earnings estimates, the joy over a company beating estimates is not the same as earnings growth.  And earnings growth is slowing to near zero due to the confluence of macro factors we are all now familiar with. To underscore the Alice in Wonderland rules Wall Street is playing under, Albert Edwards of Société Générale published a chart showing how far the S&P 500 has diverged from earnings.

Ominously, the last time a divergence of this magnitude occurred was in 1999-2000, at the height of the internet bubble.  Like today, that too was a period of highly stretched valuations, an investor psychology that bought into the notion that the old rules didn’t apply, and that the internet had repealed the business cycle.  Substitute “Federal Reserve” for “internet” and you have a neat replay of the belief that an institution has the power to defer recession forever. Both periods were times of Wonderland-like rationalizations that asset prices had reached a permanently higher valuation plateau, only to be brought to earth when recession intervened.

Stock market indicators are still sending positive messages, reflecting that the desire to own stocks is strong.  Measures of breadth and momentum continue to be positive, and may have a new lease on life due to the Fed’s recent QE resumption.  However, many indicators have reached “overbought” levels, with measures of investor psychology having risen to overly bullish levels.  CNN’s Fear and Greed Index is a case in point, which is now at 76, or just inside the “Extreme Greed” boundary.

Treasury bonds continue to send a message diametrically opposite to that of stocks.  With yields in the 2-2.5% range, long-term bonds are conveying that inflation is not a problem and that strong growth is not expected.  This is echoed resoundingly overseas, where a staggering $15 trillion (not a typo) of worldwide debt trades with a negative yield. Most negative yielding debt is concentrated in Japan and Europe.  The prevalence of low and negative-yielding debt is a sign that we have likely reached the point of diminishing returns with central bank policy, and that even lower interest rates may not do much to spur economies.

The productivity of debt has declined significantly in the 21st century.  Between 2001 and 2007, global sovereign debt increased by over $14 trillion while global GDP grew by nearly $25 trillion.  But from 2008 to 2018, debt expanded by $27 trillion, and global GDP only grew by $22 trillion. Put another way, in the earlier period each dollar of debt produced $1.78 of GDP growth, but in the last decade, each dollar of debt only produced $0.81 of GDP growth.  And yet central banks are reverting to the same old playbook to keep the debt, that they were instrumental in creating, from being the catalyst that tips us into recession.

We are currently in some sort of twilight zone, where economic indicators are sending warning signals, but haven’t unequivocally turned negative.  Risky assets such as stocks have rallied this year, but so have “safe” assets such as Treasury bonds. Main Street investors can be forgiven if they are feeling confused by these conflicting signals.  The overarching question for them (and us) is how to position for the environment ahead.

The Fed of New York’s Recession Indicator has declined slightly this month, but remains at not only a high level, but at a level that has been consistent with predicting previous recessions.  This joins numerous other measures of the economy pointing to some sort of slowdown, so our operating assumption is that we will have to cope with a “recession-like” environment in the 12 months ahead.

Asset classes most at risk in this scenario are cyclical industries such as steel, raw materials producers (e.g. copper), autos, and the long-suffering retail sector.  High-yield bonds and the companies that rely on them will likely underperform, as credit availability continues to gravitate to the least risky borrowers. Foreign emerging markets will likely be poor performers, as they are getting a double-barreled hit from weak commodities prices and the effects of the trade war.

Probable winners in a recessionary world would have to include high-quality bonds such as Treasuries, despite their current low yields.  Extending that theme, income-producing securities will likely find favor over those whose sole source of return is the hope for price appreciation.  Thus, utilities, some real estate investment trusts, dividend-paying blue chips such as pharmaceuticals and consumer staples could find favor over today’s growth stock darlings.  

Alice, when in Wonderland, had trouble distinguishing between fantasy and reality.  Investors today should approach markets with a healthy dose of skepticism and common sense to avoid succumbing to a similar fate.

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