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Wait and see but don't trade

The Days Ahead: Small business optimism indicator. Fed will be in slient mode.

 One-Minute Summary: We're writing this the day before the jobs number. This is typically a major data point for traders but we’re not traders and there’s probably no number that would lead us to change our outlook. Why? Well the estimate is for around 190,000 new jobs, compared to 250,000 last month but these numbers are subject to very big revisions…as much as 50,000 either way. We know the unemployment rate will remain around 3.7%. The only item that may move the market is if there’s a big jump in average hourly earnings. But, if you've been following us, you’ll know we think real wages are unlikely to move much.

The markets had a very busy week. Much of the trading action is prop desks, algos and macro funds closing trading positions towards year-end. It’s not a time to react to headlines. Any view one has is likely to be mown down by stop loss trading. In the last 10 days, we've seen five days where the intraday move was more than 1.5%, six consecutive days of rises and one where the days started very badly and closed up.

Or as Leon Cooperman said “[quant managers] have created a tremendous amount of volatility in the market, scared the public, [and] effectively raised the cost of capital to business”. Yep

Clients have been asking:

Is this the start of a bear market? No. Yes, to corrections and some big moves on stocks but no, to stocks being way overbought and in need of a wide spread sell-off.

Is it the start of a recession? No. The housing market is soft and some leading indicators like trade, oil, and chemical shipments are down. But they're not collapsing. Growth will slow but not stop.

Why is the Fed raising rates? Because of the unemployment numbers. Inflation and wage inflation are not a problem. But it seems likely the Fed will not raise as much as people thought. A few months ago, we said yes to a December hike and two to three in 2019. Right now, we think yes to December and one to two hikes in 2019. The futures market has only one hike priced in for 2019, but that's not hugely reliable.

How are Treasuries doing? Well, thank you for asking. The 10-Year Treasury yield fell from 3.05% to 2.85% last week. That would be a 2% price increase for a bond maturing in August 2028. We expected Treasuries to perform well in times of stress and they did.

 1.     The Yield curve inverted. Should I be worried? No. Let’s take a quick look at what we’re talking about. Here’s a graph of the yield curve today, a month ago, a year ago and the dark days of 2006.

A year ago we had a nice, normal-as-you’ll-ever-see yield curve. Short rates were around 1.25%, the 10-Year Treasury at 2.4% and the 30-Year at 2.8%. But then 1) the Fed committed to more rate increases in 2018 and 2) the government passed a late-cycle, fiscal stimulus package that dropped corporate and personal taxes. If you're a believer in the “tax cuts solves all problems” school, you would have expected 1) rapid growth in Q2 and 2) a bump in tax revenues as more people went back to work, earned and invested more.

But, ha, they only got the first.

And if you're a believer in “don't cut taxes at the back end of an economic cycle when the Fed is raising rates” school, then you weren’t surprised by what the market did next. The front end of the curve rose, because the Fed increased rates, but longer yields rose and then fell back. The market was basically saying, yes, the economy is growing for now, but it won't last and the Fed will have to ease in the next year or so. And that’s when the yield curve inverted (the “Now” line). Except it only inverted at the three and five year line (here). That's part of the yield curve. And only by 2bps. That’s why the “Now” line has a little kink in it at the 3 and 5 marker on the X-axis.

But suddenly we saw a lot of headlines about a how a yield curve is a recession indicator, so look out.  But, you need a lot more information to worry about imminent economic woes. See the top line, from September 2006? Now that’s an inverted curve. Every single rate was above the Federal Funds rate of 5.25%. Back then the Fed was busy raising rates but long-term rates refused to move. And that spelled big trouble.

We’re not there yet.

And how good is the yield curve inversion as a recession predictor? Not very. Here’s the data going back to the 1950s.

When that blue line falls below the zero it turns out a recession follows in as much as four years (the 1960s) to as little as one year (2007). And many times it throws off a false signal, as in 1995.

We'd take the yield curve as one measure but there are much better indicators of a weakening economy. Claims, auto sales, housing, industrial production and some Fed indexes have a much lower error rates. 

As for the bond market, we’re already positioned for lower growth by investing in the middle of the curve (so 7-10 years) and Floating Rate Notes.

So, when somebody says “Aha, the yield curve is inverting” you can say, up to a point.

 2.     The trade talks. That's all settled, right? No. Well, yes for about half a day when the talks seemed to bring about a delay in the tariffs and some commitments from China to buy more stuff. But take a look at the two statements from the White House, here, and the Chinese Foreign Ministry, here. Here’s a quick side by side:

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We could go on but were these guys even in the same room? The markets understand the issue of tariffs. It’s not so much that they're a tax on consumers (they are), or that the U.S. is a chronic low-saving, high-cost service producer (it is), so will always run a goods deficit (it does)…it’s that it creates a heck of a lot of uncertainty for companies in managing their costs and demand.

Right on time, the trade deficit announced on Thursday (last week was just goods…this one has services like air travel in it), ballooned out to a near record high. As one of our favorite commentators put it, “pumping up domestic demand with fiscal easing and picking fights with trade partners does that”.

Bottom Line. The market is over-playing the economic slowdown. We're still at 3% growth for the year but with some slowdown coming. Trade remains front and center. Expect more headlines about the yield curve but remember the news cycle is 24 hours and we’re investing for years.

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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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