Recession fears dominated the month of May, sending stocks reeling and bond yields lower. In June, however, the mood changed 180 degrees, with the stock markets making a nearly vertical recovery of May’s losses. What was the impetus for this change of heart? It was the soothing words from the leaders of both the European Central Bank (ECB) and the U.S. Federal Reserve that indicated more monetary stimulus may be forthcoming.
Belief in the power of central banks has now reached cult proportions. The last ten years have conditioned investors to buy into the omnipotence of the Fed, and its ability to keep the bull market rolling. The past decade of extraordinary liquidity provision on the part of central banks almost certainly staved off a near-depression economic outcome in 2008, but its long-lived tenure has now turned what was extraordinary into an established monetary policy from which central bankers can’t figure out how to extricate themselves. It has been in place for so long that investors have come to accept it as the norm, and can hardly imagine a world without interest rate manipulation. They have “drunk the Kool-Aid” of recent monetary policy and believe, just like followers of charismatic cults, that their leaders are infallible.
This was clearly on display in June. Despite multiplying reports of economic slowdowns both here and abroad, the mere hint of an easing in monetary policy sent shares leaping. The belief in the rehabilitative powers of the central bank are not being questioned, and it is as if Wall Street has abandoned all pretense of security analysis, as long as they can find succor in lower interest rates. To underscore the current cult-like behavior of investors, the words “hope” and “save” seem to dominate the financial press. Investors “hope” that the Fed will acquiesce to Wall street temper tantrums and lower rates, and have an unshakeable belief that that is all it will take to “save” the ten-year-old bull market. Thus, we have lapsed into the part of the stock market cycle that is dominated more by hope than reality, and investors should be even more vigilant as a result.
The slowdown is real, and it is becoming more widespread, so investor anxiety is not without merit. The expanding trade war and tariff retaliation is having a negative effect on trade and demand. Tariff announcements initially resulted in a surge in imports to the U.S. as businesses placed massive orders to get ahead of the time when tariffs would be invoked. This brought demand forward into 2018, and we are now seeing a fall-off in demand as orders dry up. Technology companies such as Intel, Apple, and Samsung have all warned that business is slowing, and that the second half of 2019 will see a significant retrenchment in sales. The Federal Reserve regional business indexes are starting to show signs of weakness, with the Empire State (N.Y.) Manufacturing Survey showing its biggest monthly decline on record, followed closely by the Philadelphia regional index. Finally, transportation measures have turned negative, implying that the need for shipping goods to market is slowing.
The Cass Freight Index Report is available to the public, and provides monthly updates on truck, rail, and air shipping. This is a good real-time indicator of one of the most basic economic indicators-transporting goods to their markets. Their latest reading shows the extent to which things are slowing, with the May reading down 6% (year-over-year), and has now declined six months in a row. This has prompted their editors to be very blunt in their assessment of conditions, saying “With the -6.0% drop in May, we see the shipments index as going from ‘warning of a potential slowdown’ to ‘signaling an economic contraction.’ The weakness in spot market pricing for many transportation services, especially trucking, is consistent with the negative Cass Shipments Index and, along with airfreight and railroad volume data, strengthens our concerns about the economy and the risk of ongoing trade policy disputes. Weakness in commodity prices and the decline in interest rates have joined the chorus of signals calling for an economic contraction.”
This, of course, puts the Fed in a bind, as other economic indicators are still robust. Unemployment is at a generational low of 3.6%, the latest estimate for first quarter GDP growth is 3.1%, and consumer confidence, while slipping, is still high. Thus, the Fed must grapple with the notion that if they cut rates, they would be adding stimulus without clear-cut recessionary signals. Moreover, if the Fed cut rates now they would be seen as caving into Wall Street’s demands for more monetary Kool-Aid, as the effects of previously low interest rates, and the short-term boost from 2017’s tax act, begin to fade.
All this begs the question of whether additional stimulus would do much good at this point in the cycle: signs of slowdown are multiplying, but have not become recessionary yet. The strongest economic growth occurs after periods of profound decline, either a recession, natural disaster, or even war. During these periods a great deal of excess capacity develops in the economy, in the form of industrial slack, unemployed people eager to get jobs, and a willingness to borrow in order to build or speculate. It is very difficult to permanently increase growth from near-peak conditions.
There is also the question of how much stimulus the Fed can add, given that U.S. interest rates are still very low, and rates in Europe still sport negative yields out to ten-year maturities. Prospective rate cuts would be minimal, and may not provide much stimulus in any case.
Why? First of all, the marginal decline in rates from any cut may not provide an incentive to borrow or refinance. Lowering rates from 2.25% to 2% is not the same as a move from 6% to 4%, and so the expected boost in today’s low-rate world will probably be muted at best. Secondly, households, governments, and especially corporations have become bloated with debt over the last ten years, with many debt ratios now exceeding the high water marks of 2007-08. Is it reasonable to expect that a small decrease in rates will lead to some sort of borrowing spree? We don’t think it will, as the highly leveraged state of today’s economic players argues that there is very little incentive to add even more debt to already debt-heavy balance sheets. With economic indicators turning down in a more convincing way, companies will be wary of overleveraging themselves further.
Any discussion of today’s financial environment must include a few words about bonds and gold. The Fed’s reassurances have piqued risk appetites for stock investors, sending the major indexes close to new highs. But at the same time, bond yields collapsed in June, sending a more dire message. Falling bond yields imply economic sluggishness and the low inflation that comes with it. It is the polar opposite of the message from the stock market. The 10-year Treasury Note plunged to a yield slightly less than 2% in late June, while the 30-year T-Bond yield fell to 2.5%, both of which are the lowest yields in more than two years.
This is hardly reflective of strong growth expectations to come. So which market is correct? An old Wall Street saying is that the stock market has a high school diploma, while the bond market has a Ph.D. in economics. In other words, the bond markets reflects much more of the fundamental economic reality than stocks, which can be influenced by many factors, both fundamental and speculative. We believe bond investors have taken the signs of slowing growth to heart, and have lowered their expectations for GDP and inflation. Moreover, there has been a major reallocation into fixed-income for yields to have fallen so much, underscoring the idea that many investors share the recessionary view and have sought the safe haven of bonds.
Gold has also spurted higher, and reached six-year highs in the last month, to $1400/ounce. The legacy of gold as an inflation hedge stems from its performance during the bad old days of the 1970s, when U.S. inflation reached double digits prior to peaking in the early 1980s. We believe gold today is not so much an inflation hedge as it is an uncertainty hedge. And there is plenty of that to go around. With the struggle for global economic supremacy between China and the U.S. now fully out in the open, it is no surprise that investors are looking to diversify their assets away from paper assets and into tangible assets. The trade conflict between the two global superpowers is symptomatic of a larger secular battle. While all eyes are focused on whether Trump and China’s Xi can hammer out a trade agreement at the G-20 meeting on June 28-29, this titanic clash may play out over the next ten to fifteen years. Given that, financial assets could very well become victims of uncertainty, brinksmanship, and confidence busting trade retaliation. It comes as little surprise that gold has suddenly regained its luster in the current environment.
Long economic expansions like the 1960s, the 1990s, and today create complacency and overconfidence. It’s been so long since the last recession that the prevailing belief is that nothing can go wrong, and it seems there is no catalyst to cause another recession. The Federal Reserve has everything under control, or so say the cultists drunk on the Kool-Aid of the last decade’s extraordinary monetary manipulation.
But remember, this sense of complacency was also present in early 2000 when, despite twelve discount rate cuts, the economy dropped into recession in 2001, and the stock market bear market persisted into late 2002—after the Nasdaq index lost 77% of its value. Complacency was also widespread in 2007, and the Fed started cutting rates even before the market peaked. Notwithstanding another 12 rate cuts (from 6% to less than 1%!), they could not forestall the bear market and recession of 2008-09.
As investors, we should not place too much confidence in the Federal Reserve’s ability to avoid a recession if the warning flags are triggered, or continue to deteriorate. We should believe what we see, and avoid succumbing to the “cognitive dissonance” for which Wall Street is so famous. This is a highly-leveraged, mature bull market and we are in the late stages of the economic cycle. The fact that consumer confidence is near the highest level of the last 50 years-matched only by the late 1960s and late 1990s-is confirmation of that. Extraordinarily high confidence can leave a lot of room for disappointment. Investors should wean themselves off the belief that the Fed can always save the day, and approach today’s markets with their eyes wide open.