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Dusty recesses

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The Days Ahead: Fed minutes and lead up to Central Bankers’ Jackson Hole meeting

One-Minute Summary: Trade talks took a welcome break from the news last week as investors’ confidence in a settlement rose.

No, no, no. We'd like to write that one day and our guess is we probably will. But for now it's trade and economic policy on the fly. If there’s a grand strategic plan, please let us know.

Argentina kicked off the week with the crushing of the reformists and likely reelection of the disastrous Peronists. Emerging Markets bond funds were particularly hard hit.

We'd summarize the trade talks as the U.S. blinking. The good news is that the 25% tariff on the $300bn of consumer goods will take place in December, not September. Full list here. That was good news for the likes of Apple and chipmakers like Micron, Qualcomm and Roku and for the wider market. The tariffs are showing up in inflation. Prices for things like appliances, furniture, auto parts, flatware and lighting are up 4% more than the broader CPI. They're likely to continue to do so. Average tariffs with China have risen from 3% in 2017 to 21% by December 2019. It's going to show up in inflation, lower wages and  lower corporate margins.

There’s really no good news in the tariffs. Rolling them out slowly is better than all at once. But this issue will hang over markets for a while.

Market reaction was predictable. We had intraday swings of over 1% every day with a net loss of 0.9%. We're down 4% from the ding-dong highs in July but up 15% for the year. Bonds had another strong week with the 10-Year Treasury at 1.5% and the 30-Year Treasury below 2% for the first time since its launch in 1977. It’s been a good year for bond and particularly Treasury investors.

1. What's with the inverted yield curve?

We've talked a lot about the inverted yield curve over the last few months. A few years ago, curve inversion was the talk of the geeky corner of Fixed Income desks. Interesting in a technical way but not great predictors of wider events. Now it’s gone mainstream. In the last big yield curve inversion in 2006, when the inversion was nearly 100bps, the New York Times mentioned it a total of 20 times. Last week, the Treasury 2s/10s inverted briefly. It mentioned it 80 times.

The 2s/10s was almost the last one to invert. The more important 3m/10 year inverted back in March. So here’s an update of our thinking.

Do other countries have inverted yield curves?

Yes. Germany, Japan, France, U.K., Switzerland and Australia

Is the inverted curve a recession indicator for them? Are they in recession?

No and no.

Is the inverted curve a good recession indicator?

Erm…not really. The curve has inverted 7 out of the last 9 recessions. But its timing is lousy. It can be up to two years early, which is not helpful, and it gives false signals.

Does it cause recessions?

No. The fact that short-term rates are higher than long rates usually means the Fed is behind the market in rate expectations. Low confidence, inflation and, critically, unemployment cause recessions (that’s over simplifying, we know).

Could this time be different?

Yes. Rates were much higher in past cases. In the 1950s the 10-Year Treasury averaged 4.5%, in the 1970s 8% and 1980s 9%. Now Ten-Year rates are around 1.5%. The absolute level does matter. The Fed also all but ignored past inversions. They're paying attention to this one and likely to do something.

Are there better recession indicators?

Yes. Debt service, claims, employment, housing sales and starts, hours worked and consumer confidence.

Are they indicating a recession?


So what now?

We know the economy is slowing. Trade, manufacturing, housing, consumer confidence have all stopped rising but they're not falling much either. That doesn't mean “all clear” and data can deteriorate quickly. But we’re well positioned for the slowing growth.

2. “Is this the end of the bull market?”

Is what you would have heard tuning into, well anyone, last week. But wait, what bull market? Bull markets have exuberance, irrationality, quick wealth, swapping jobs to day trade. You know, moron stuff. But this bull market is a decidedly dull affair. Take a look at the following:  

That’s a nice chart, no? Up from 700 or so at the 2009 bottom and now 2850, or +256% growth. But a few points:

  • The market fell from 1600 in 2007, so the return from then is +41%

  • The snap back from the bottom to mid-2015 was +105%

  • Then the market went sideways for a year and rose +36% from mid-2016 to January 2018.

  • Since January 2018, the market has done precisely nothing (excluding around 4% in dividends)

And finally, the rolling 5-year return is a healthy 10% but the rolling 20-year return is 6% (see below)…respectable but not a bull market.

What we've really seen in stock since late 2016, is a one-off adjustment for lower tax rates. All things being equal, the S&P 500 corporate tax rate dropped from an effective 28% to 18%. Corporate taxes now bring in around $800bn compared to $1,600bn in 2016. Put the stock market multiple of 17x against that, net out dividends, and you're at around the increase in total stock market capitalization since then. So, it's a straight transfer of tax revenues to shareholders.

This is all to show that we’re not in a bull market and haven't been for nearly 20 years. What we've been in is an extended sideways market with some upward trends. Beating inflation, beating bonds, beating international. But also settling into flat trends for long periods. We're in one now.

We expect it to break upwards and there will be short-term corrections. But it’s not a bull market.

3. Is a rising stock market good for everyone?

No. The general opinion is that a strong stock market is one of those rising tides, all boats things. Everyone benefits. It all rests on the wealth effect theory. People feel wealthier because of strong house or stock prices. They feel more confident. They buy more stuff. The trouble is that the top 1% of earners own 38% of the stock market. And 50% of all families own less than $54,000 in stocks. That upper group, the 1%, have a “low propensity to spend”, which is another way of saying, they look at the stock market and say “meh…what’s for dinner?” They don't adjust their spending one iota.

Anyway, courtesy of an old friend of the firm, David Ader, here's an update on the number of hours the average guy needs to work to buy the S&P 500.

It’s bounced around for the last two years but remains high by past measures. So what? It simply says the average worker has to work a lot to keep up with stocks. And the wealth effect is irrelevant for most people.

Bottom Line: Stop-start and bluffs on trade. We used to think Presidents’ had little effect on markets…more just stay and keep out of the way. This is, well, different. Companies seem to be keeping a cool head but we’d stay defensive.

Please check out our 119 Years of the Dow chart  

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Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

All charts from Factset unless otherwise noted.

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