Unsurprisingly, the Fed finally got the message from the markets and pulled a hard 180 last month. In a very short six weeks, they went from “balance sheet runoff on autopilot and more rate increases to come in 2019” to “we’re pausing rate increases and we’ll be flexible with the balance sheet.” Risk assets have bounced strongly since the start of the year but we’re far from being out of the woods yet. In fact, I think the toughest hurdles are still to come later this spring.
After the Fed’s comments, yields across the board pushed lower (again) and now we’re even starting to see the yield curve slightly steepen as short-term yields are falling faster than long. This is usually one of the last signs that the economic cycle has rolled over so this will definitely be a key metric to watch. I personally believe the Fed’s rate hiking cycle is over and the next move will eventually be a cut. Italy is officially now in recession, Germany’s new orders and retail sales last week were the weakest since the 2011/12 euro crisis and before that 2008, and France is close behind with their turmoil. Much of this weakness stems from China which doesn’t look like it will be bottoming out until at least the second half of 2019. Plus, the Leading Index for the US is starting to slip. I just don’t think the US economy can remain strong with the rest of the world slowing so dramatically. It puts things at risk of another shock if there is a policy misstep.
The corporate curve is still inverted and getting worse with long yields dropping. At these yields, the Fed needs to cut 50 basis points (0.50%) or else policy remains restrictive.
Treasury bonds still look attractive to me as 10 year government bond yields throughout the world are all breaking lower. The global financial system is highly intertwined so we should see US yields pulled lower even if the US economy avoids a recession. Most other sovereign yields have dropped between 10 and 25 basis points over the last month, while the US is only down about 5 bps. It looks like we’ll have some catching up to do. India just cut short-rates too so it will be interesting to see if other central banks follow suit or if it was a one-off event.
US stocks have been sending mixed signals. The recent bounce has been very strong from a breadth perspective but as of right now, my take is that it’s just reversing the sharp drop in December, which was more of a liquidity event than anything else. The breadth readings during December’s drop were equally as robust but on the negative side (the worst breadth readings since the heart of 2008) so this bounce feels more like the reversal of those conditions than a new thrust higher. Accordingly, I’ve used the bounce to put on some stock market hedges via put options. This isn’t something I do often as it can be expensive but my systems are telling me it’s wise to have on right now. The last time we owned put options was late 2015.
Earnings actually have their toughest comparisons during Q1 which will be the reports coming out 3 months from now. I also think analysts are overestimating earnings for the S&P 500 by a good bit for 2019 and I would guess that the markets start pricing this in as the data weakens before before next quarter’s reports actually begin. But if the S&P 500 got down to around the 2100-2200 level, I will be buying things on my shopping list pretty aggressively.
With markets, it’s always about “what’s next?” We’ve used our fiscal bullet with the tax deal and with the Democrats taking back the House, I don’t expect anything big agreed on for the next 18 to 24 months. As for a China trade deal, I think an agreement would only be one in name alone with nothing substantial. This is a clash of two heavyweights that want different things and neither has a reason to back down (especially from a political standpoint).
On the monetary side, the Fed is basically out of bullets too, other than their attempts to jawbone the markets up each week, unless they go full reversal and reimplement QE – something that would be very tough to justify unless the markets forced their hand first. Either the market goes up, they continue tightening and eventually break the markets. Or the market goes down and they eventually reverse course. From a longer-term perspective, this is still an environment to fade whatever the market does (i.e. sell big rallies, buy big drops) with the caveat that the drops might be bigger and last longer if the cycle really does turn down.
So we largely have a slowing global economy with very little out there in terms of new stimulus until late 2019 at best. It all suggests it’s prudent to be more in “be careful” mode than “be aggressive” mode. It’s just a messy geopolitical environment right now.
Thanks for following!
-Nick