Third Quarter 2019 Forecast and Opinion

The New York Federal Reserve now sees a risk of recession at 33% in the next twelve months. When this indicator rises above 30%, a recession typically follows, although sometimes with a delay of 12-24 months.

The global economy is slowing nearly everywhere, but the U.S. is perceived by many as being in great shape, particularly if measured by the stock market. However, signs of a slowdown are looming in housing, construction, automobiles, and the industrial sector, in the latter case due to trade tensions between the U.S. and China. Purchasing manager Indicators are slowing, both in services and manufacturing, and the rest of the world is cause for concern, with Chinese, South Korean, Japanese, and Europe all slowing. The industrial side of the U.S. economy may already be in recession. If the trade war continues, it will worsen. If it resolves, it may stabilize. Persistent uncertainty is weighing on business activity and pushing economic indicators lower. Meanwhile, stocks are climbing to record levels even as economic fears rise.

Today, the Federal Reserve cut interest rates by 25 basis points, which might be considered an “insurance” rate cut due to global slowing. Some are worried that in the face of an all-time high in the equity market the Fed is communicating a worrisome economic background. Two non-voting Federal Reserve members disagreed with the rate cut, citing that the economy does not need stimulus at the moment.

We might argue that this rate cut was anticipated and thus fully priced into the stock market.

Bonds have experienced dramatic net inflows, and there are signs of madness in the global bond markets. The very fact that a 100 year Argentine bond was successfully sold two years ago, and was even oversubscribed, was a sign of the desperation that investors have for yield in a no-yield world. (They now trade at around 70 cents on the dollar). A 100 year Austrian bond came to market in June with a 1.2% yield, while Spanish 50 year bonds have a 1.7% yield. A recent German 10 year bond came out with a negative yield. In real, inflation adjusted terms, all industrialized countries have negative yields out to ten years. In Switzerland all bonds, including the 30 year, have negative yields. What does this mean? That dis-inflation is a global problem. That there is some sort of trouble ahead, although it might be years before it manifests itself. How else to explain why an investor would accept a negative yield on a 30 year government bond?

There are three factors which make today’s stock and bond markets more difficult to read. The first is that the U.S. economy has been supported by ten years of “quantitative easing”, an experimental monetary policy tool championed by Ben Bernanke in 2009. The result of this policy was to inject some $4 trillion into the economy based on printed money. As this was without historical precedent, one becomes strained to make any historical comparisons to the past. The second is the percentage of total stock market volume driven by machines. On a normal day, around 80% of all stock volumes are driven by machine algorithms, and during major selloffs, this number can hit 90%. The third is the relationship between active investors and “passive” ETF’s is at a tipping point; last November 48% of all investments were “passive” and that number is expected to bypass 50% shortly.
All three of these factors can increase instability in the financial markets.
While most Wall Street analysts claim that the U.S. economy is in excellent shape, it’s always a good idea to be mindful of the risks, which are always present.

As much as 90% of the current rally can be attributed to “multiple expansion” rather than an increase in earnings. What this means is that the rally we have experienced is not based upon solid business fundamentals, but exuberant buying.
The rally has largely been driven for the past ten years by $4 trillion of balance sheet expansion by the Fed, a $4.2 trillion increase in corporate debt, and $4.7 trillion of corporate stock buybacks.

Stock buybacks have led to the lowest levels of actual shares trading in the market for over two decades.

Corporate profits haven’t really increased for some time. Since 2012, if we strip out the effect of the 2017 tax cuts, they are more or less flat, as indicated by the following chart by the Federal Reserve Bank of Saint Louis:


What has changed is the “s” in “eps”, or the amount of shares in “earnings per share”. Less shares means more earnings per share, which is the primary reason why eps has increased by 30% since 2012.

Wage inflation is also a risk to the stock market, because wage inflation is a risk to profit margins, which may drag on earnings growth, particularly in labor heavy industries such as hospital clinics, restaurants, hotels, autos, brick-and mortar retail, and construction. While inflation is at 1.9% at the moment in the U.S., it is only a matter of time before a 3.6% unemployment rate drives up wages.

And yet, stock market valuations are not anywhere near the scary levels they hit during the technology bubble, when interest rates were much higher and forward P/E levels of 27* could be compared to today’s at 17.2*. However, today’s market is trading near the average historical level for market peaks.

It is in the interest of both Xi and Trump to come to an agreement on trade. China is probably growing at only around 3% as opposed to its “official” figure of 6%. As for Trump, further tariffs would represent a direct tax on his own voting base, which would not be popular in upcoming elections.

Given recent events in the Persian Gulf, oil stocks are underpriced. They represent an excellent political risk hedge, and would perform quite well with a spike in oil prices. Contrary to what one might think, war is not historically a huge risk to stocks. In a 2017 Barron’s Magazine article, stocks rallied, on average, 4% in the month following the last seven U.S. led discrete military conflicts, and 6.7% in the three month period following them.

For the first half of the year, the S&P 500 was up 17.3%, the Dow rose 9.8%, and the Nasdaq rose 20.6%

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