I’ve been seeing warning signals since the spring that we’re in the later stages of this economic cycle so I wanted to post an update to illustrate. One thing to mention is that cycles tend to move very slowly which can be a double-edged sword. It’s nice because you can typically read the tea leaves with plenty of notice, but on the other hand, investment markets often look like they’re ignoring the deteriorating economic fundamentals because short-term liquidity can keep a trend going. This can be a challenge if it makes you second guess your analysis. For example, in the previous cycle housing prices peaked in most parts of the country in 2005 yet the stock market didn’t peak until late 2007. Believe it or not, the stock market is typically one of the last markets to react to problems.
Please note that I try to remain flexible with my analysis and portfolio positioning so don’t take these views as set in stone. This isn’t necessarily a prediction but just how I’m seeing things today. If things start to improve, so will my outlook for risk assets.
Curve Inversion & Borrowing Rates
I’ve mentioned a couple of times over the summer that the corporate yield curve is already inverted, and the longer it remains this way, the more an economic slowdown gets baked in the cake. We’re now 4 months running and it doesn’t look like corporate yields will be pressing higher quick enough to offset what looks like another 2 rate hikes by the Fed this year with the market pricing in a 97% probability of a hike next week and 82% probability of another hike in December.
Corporate Yield Curve
Short-term funding rates have been on a relentless climb higher since the start of 2017. This has a pretty strong tightening effect on the economy as it kills off any corporate projects that were on the fence.
90 Day Commercial Paper Rates
Higher rates have already started to apply pressure to both housing and autos, two of the biggest parts of the economy, not to mention consumer spending. The problem with a credit based system that encourages a continual increase in debt is that the debt needs to be serviced and at some point repaid. Total per capita interest payments have already exceeded the prior cycle peak but interest rates aren’t even half the level of the prior peak… Notice that interest payments continue to grow despite rates peaking out at a lower point each cycle.
Per Capita Interest Payments (blue) vs Short-Term Rates (red)
Lastly, implied volatility has been higher all year following the quick drop in late January, suggesting the regime in the markets has shifted.
Volatility Index (the VIX)
Triggers to Watch for
Most economic data points that the media talk about are backward looking and have little value – like the unemployment rate and GDP growth. It’s much more helpful to look at what are called leading indicators. These include things like Housing Permits, New Orders, Inventories, the Purchasing Manager’s Index, etc.
You can combine these into a Leading Index. Historically, this will start to deteriorate before a recession hits. I take a drop below 1% as a serious warning. July’s print came in at 1.17%, still above 1%, but dropping hard the past two months. I’ll be watching the August release closely.
Leading Index for the US
I’ve written previously about why yield curves are so important and how an inverted curve will all but guarantee a slowdown in economic activity. While the inverted curve is the warning signal, a steepening of the curve is the actual trigger signal to take action within your investment portfolio. The curve will generally start to steepen as short-term market rates start to move lower in anticipation that the Fed is done lifting interest rates and will need to start lowering them again. This is the bond market’s way of saying all is not well.
2-10 Yield Curve (green) vs S&P 500 Index (blue)
You’ll also see corporate bonds spreads start to widen ahead of weakness in the stock market. Spreads are off the lows but not yet indicating that it’s time to adjust. Although, I will say that Junk Bonds are priced to perfection and look like a train wreck waiting to happen.
Baa Spreads
High Yield Spreads
Net Effect
The tax changes have had a big impact in extending this economic cycle and the repatriation of cash held overseas has been a boon to buybacks, both leading to a continued outperformance of US stocks over the rest of the world. However, this type of divergence between the US and Emerging Market stocks is odd and usually doesn’t last. Either EM will see a strong bounce or the US will be playing catch up to the downside (or both).
US stocks (black) vs EM stocks (blue)
With the Fed now reducing its balance sheet and other central banks running at a slower pace, the total change in central bank balance sheets is set to turn negative for the first time since the cycle started. This reduced liquidity will most likely lead to higher volatility in investment markets.
Total Central Bank Balance Sheet Net Change
From a Growth perspective, I’ve been growing more cautious on US stocks and have begun to shift more toward emerging Asia. If the broader US stock market does roll over (I’m thinking 2019 is when things could start to get bumpy), a 20% drop is not out of the question but that would create a nice buying opportunity. I do not think we’ll see a 2008 style 40%+ drop. The market has been fragmented the past couple of years with larger sector rotations and this type of action typically keeps the market as a whole afloat. I’m certainly seeing pockets of extreme valuation and these areas would get hit the hardest, but I’m also seeing rather attractive opportunities in certain areas. To me, this is much more reminiscent of 2000 than 2007.
Despite this seemingly cautious post, I’m actually quite optimistic about 2020 through 2030. It’s just this transitional period over the next couple of years that looks shaky and may require a step toward preservation over risk taking. One of the most viewed posts of all time discussed my long-term view but that was written a few years ago so I think it’s time to update it and talk about the best long-term areas of opportunity I’m seeing and will be using any weakness in markets to add to.
Stay tuned and thanks for following!
-Nick