Summary
- A bit of panic is afflicting the markets Friday morning, catalyzed by the threat of tariffs on Mexican exports to the US.
- My general take is that a global recession has probably been underway since last year, and that the Fed has been too tight.
- Now that there is a panic into bonds, which I dived into last October as value plays, I am focusing on which stocks with strong fundamentals are good buys.
- Global recessions end, and most recessions are not "great".
- If the US economy avoids recession and merely slows, a newly-lowered interest rate structure might justify higher P/Es and a fresh bull market.
Why The Angst Is Overdone
There may be a middle ground between the position of a president who says how good tariffs are and the many critics who say they are bad news. Perhaps that middle ground runs something like this: yes, taxes are in theory bad, but so are governmental deficits. The deficit was worsened with the 2017 tax bill. If tariff income makes some of that back, and some of the tariff cost is paid by foreigners who have to sharpen their pencils on prices of their exports, I'm not in a panic about the tariffs. Plus, there are political reasons for the tariffs, and I'm happy to let Congress and the White House work policy out over time and stick to investing.
Despite widespread expectations of inflation from the China tariffs, inflation rates have been dropping lately, which I ascribe to the Federal Reserve over-tightening. Also note, while steel prices rose in 2017 on the tariffs, they are dropping sharply now, as they are wont to do over time.
Wearing my trading rather than long-term investing hat, if the media headlines of the day are that Tariff Man is threatening global recession, I'm tending to go in the other direction toward a middle ground, because as shown below, I think the world has likely already been in a recession since last year.
Though, note, I scaled completely out of Apple (AAPL) last year - my largest position for years - in good measure because of the China issue. So it's also necessary to be selective (I would not buy the Mexico markets right now).
There are other reasons to increasingly like the prospects for many/most US stocks; namely, that recessions end and valuations look good relative to where I speculate the Fed will be going sooner rather than later.
Sticking with the recession topic.
A Global Recession Has Probably Been Going On Since Last Year - And All Recessions End
I track this via the Ned Davis Research organization's model of global recession risk, as reported by CMG Wealth. According to CMG's archives, global recession risk was rising last September and was already probable in October. See first linked article for NDR's copyrighted long-term chart of OECD-defined global recessions (scroll down). If we're in one, this would be the third global recession per OECD since the Great Recession ended.
What this model suggests is that the Fed erred in its talk last summer of needing to go to a restrictive monetary policy rather than just a neutral one. It also is consistent with my view that its December interest rate hike was a policy error.
Recessions end as the imbalances that caused them resolve. Typically, given our Fed's policy, they also end with the Fed swinging to ease. A global recession beginning in October would be entering its ninth month, which is a common time for non-Great Recession stock markets to bottom.
So that's potentially bullish.
Specifically on the Fed ...
Why The Fed Could Soon Be Bullish For US Equities
Let's start with something very unusual so far into an economic expansion. From May 2, CFO.com:
U.S. Productivity Surges to 3.6% Gain in Q1
U.S. worker productivity rose at the fastest pace in more than four years in the first quarter, a possible sign that the economy can continue to grow without sparking inflation.
The Labor Department reported Thursday that nonfarm productivity, which measures hourly output per worker, increased at a 3.6% annualized rate in the last quarter...
... a gradual shift towards 1.5-2.0 percent seems plausible to us,” Blerina Uruci, an economist at Barclays in Washington, told Reuters.
According to the Labor Department, unit-labor costs declined 0.9% in the first quarter, bringing the gain over the past year to only 0.1%, the smallest increase since 2013.
If, say, 1.75% productivity gains meet up with declining crude oil prices, the Fed could declare victory over inflation without a US recession (here's hoping) and lower short term rates.
Thus we could see a very bullish rate curve, which could justify higher P/Es, and a growing economy could allow higher profits.
The Signals The Markets Are Sending On US Rates Are Bullish Once The Fed Gets With The Program
A top-down bullish point about the US is that we have almost the highest interest rates of all developed countries Bloomberg News tracks. Given low US inflation right now, that suggests confidence in real US growth versus the other regions.
The bottom-up approach shows a difference between the rate structure found before the 2001 and 2007-9 recessions. In 2000 and again in 2007, the Treasury yield curve was flat from T-bills out to 30 years (TLT), peaking around 6.5% in Y2K and 5.25% in 2007.
Rates are moving as I write this Friday morning, but as they stand now, the yield curve is normal and upsloping once the effects of the laggard - the Fed and its control of short-term rates - is eliminated. Namely, the longer-term Treasury rates are:
- 5 years = 1.95%
- 10 years = 2.15%
- 30 years = 2.59%.
Where the Fed has declining influence, we see declining rates:
- 3-month = 2.36%
- 1 year = 2.27%
- 2 years = 1.99%.
What all this says is that the markets are expecting the Fed to gradually lower rates so that, if an investor wants the same return from a 2-year note at 1.99% as from buying two 1-year T-bills, the 2nd one-year T-bill would yield a similar amount less than 1.99% as the 1st one-year T-bill yields more than it, i.e. 0.28% (28 basis points). So the market is implying that in one year, a 1-year T-bill will yield around 1.99% - 0.28%, or about 1.71%.
But because the difference between the 3-month and 1-year T-bill rates is negligible, the market is saying that the rate cuts will mostly come toward the end of the 1-year period, not immediately.
This is what the media means in practical terms when it says that the market is pricing in three 25 basis point rate cuts from the Fed.
However, I think the Fed could very well be getting ready to move much faster than the markets are implying. Per MarketWatch the Fed's Vice Chairman Richard Clarida said in a speech this week:
... the U.S. economy was "in a very good place" but [he] addressed what factors would alter the Fed's stance. "However, if the incoming data were to show a persistent shortfall in inflation below our 2% objective or were it to indicate that global economic and financial developments present a material downside risk to our baseline outlook, then these are developments that the Committee would take into account in assessing the appropriate stance for monetary policy," he said. Clarida said longer-term inflation expectations sit at the low end of a range consistent with its price-stability mandate.
I think we are more or less there with respect to both those reasons.
I think the Fed may surprise investors with a truly dovish pivot, perhaps at its next meeting.
Another potentially bullish factor is the USD's strength, i.e. playing for it to reverse course.
The Dollar Is Too Strong
Economically, what matters most regarding the USD's strength is its trade-weighted value, not the trading vehicle called the USDX.
The trade-weighted USD has soared to about 17-18 year highs, reflecting economic weakness abroad and Fed tightness.
This strong USD is harming US exports while contributing to what the Fed views as "too low" inflation.
Thus I think that the Fed must be hearing complaints about the dollar from more sources than just the administration.
Put it all together, and I think that one of these days, it's a reasonable bet that the Fed sets off a surprise rally in risk assets by announcing a more aggressive rate-cutting program than is being priced in. It might end up at the same approximate 70 basis points of cut that is being priced in, but from a market timing perspective, if it gets there quickly, stocks may take over a leadership role from bonds.
Concluding Thoughts - Fighting The Fear
Bonds have had a big move up in price (down in yield) in a short time. I have been heavily long them. Very long-term, I have a lower target than the current 2.6% on the 30-year Treasury. But under the thesis that the US economy is bending but not breaking, powered by productivity gains, I'm tilting more toward high-grade junk bonds (HYG) and corporates rather than Treasuries.
When to pull the trigger on more equities is an interesting question. Often the best strategy is to enjoy one's bonds but make sure there is free cash to jump on either a panic crash in stocks (SPY) or a news-based rally that the Fed is going to be the equity investor's friend again.
After all, a bullish set-up coming into view does not mean that it has arrived.
On a traditional basis, stock market valuations are not at all cheap. However, everything is relative. If a 20-year A+ rated corporate bond right now yields, say, 3.8%, and an owner of the SPY is receiving about a 5% earnings yield (20X P/E on GAAP historical earnings) right now, isn't it better to start with a 5% rate of return to the owner of a business and expect that to rise over time than stick with 3.8% every year for the next 20 years? Of course, that's theory, not a dividend return on stocks, and Japanese investors in 1989 are down on their investment over the past 30 years. There are no guarantees.
But I think the math favors the SPY.
Risk versus reward, panic versus euphoria, fear versus greed.
In a world where central bank money printing has distorted - perhaps permanently - fair values of both stocks and bonds, I try to think of earnings yields and economic cycles and sub-cycles as guides to trading around various core stock and bond positions.
Last October and November, I contributed a few risk-off, bond-friendly articles, citing economic risks.
Now that those risks are apparent to all, but neither ECRI nor the Conference Board are warning of a US recession, I am looking for the strongest names in US business right now, such as Microsoft (MSFT), and carefully increasing allocation to them as headlines turn scarier, using either cash reserves or profits from bond sales for the purchases. Because one never knows about either a 1987-style non-recessionary crash or an outright US recession, in today's scenario I stick with quality names that will "be there" after an untoward downside process that might occur runs its course.
High-quality bonds are the momentum play right now, and may have further to run as spring turns to summer. But I think that high-quality US stocks now have better value, with uncertain timing of when that potential greater value may be realized - and I also think that a turn to risk-on could come sooner than most are now appearing to think.
Thanks for reading, and good luck to all.
