The New Year has gotten off to a rocky start and I’m sure there are a number of market prognosticators out there wishing their trusty coin had come up heads rather than tails. That’s actually not fair. I’m sure a lot of thought went into those annual market outlook pieces. That they are no better than a coin flip is not the fault of the hard working market seers. When it comes to markets, figuring out the present is hard, predicting the future impossible. There are a few indicators we can use to guide us – credit spreads, the yield curve, momentum – but none of them are infallible. And there are no indicators that are consistently useful over a short time frame. And the plethora of recent articles telling us that what happens in the first five days of the year – or the first month – predicts the full year prove nothing more than the effectiveness of torture in the field of statistics.
Luckily, being an investor does not require one to be a soothsayer. Even the Superforecasters of Phillip Tetlock’s latest book aren’t able to tell the future. What they do and what all the great investors I’ve read about do is interpret the incoming information in a probabilistic way. The future is not set in stone, pre-determined and knowable given the proper insight. At least I don’t see it that way and if Tetlock’s work proves anything it is that good forecasting is more about perspiration than inspiration. Forecasts must be adjusted as new information is added to the mosaic of the markets.
There is, it seems to me, more than one potential outcome for the markets at any given time. How they proceed depends on many factors, most of which we cannot know in advance. How could we possibly know, for instance, what a central bank might do in response to a market or economic event when the members of the central bank probably don’t know themselves? Rather than try to predict outcomes, one is probably better served by considering the possibilities and the probabilities associated with them.
There exists now a bearish case, one that foresees a recession and bear market in stocks. Indeed, for some parts of the world – Brazil to mention just one – that is no longer a forecast but rather the present reality. For the US though, it is a forecast and one for which the probabilities are quite a bit higher now than they were a year ago or even six months ago. The bearish scenario takes into account an increasing number of negative economic trends that are consistent with economic contraction. There is not yet, however, a sufficient number of these negative microeconomic trends to say that the US economy is contracting as a whole.
These negative micro trends are most obvious in the industrial/manufacturing sector of the economy. The regional Fed surveys are almost universally negative and the last two ISM manufacturing surveys were less than the 50 level that divides expansion from contraction. Corporate profits are falling, a consequence mostly but not exclusively of a rising dollar and falling oil prices. Imports and exports are both falling, global trade now contracting. Inventories are rising relative to sales, either a reversal of a secular trend – which seems highly unlikely – or a harbinger of weak future production.
Capital goods spending is also a drag on growth, as oil producers retrench in the face of rapidly falling oil prices. Having made up a much larger portion of capital spending in recent years to fund the shale boom, the bust is having an outsized impact on the economy. In the past it has been high oil prices that stunted growth but this expansion has depended more than usual on oil production. It seems obvious now that dependence on demand side economic management through easy monetary policy and a weak dollar was a mistake. It is not coincidence that the end of the weak dollar period coincided with the end of the shale boom. Having been a large part of the economic expansion, shale is now a large part of the slowdown. Whether it turns into an outright economic contraction is something that only time and future policy will tell. On the international side, the capital that fled the weak dollar policies into the warm embrace of the emerging markets has reversed and with it the artificial, credit fueled expansion of their middle classes. The recent Chinese market turmoil is as much about this reduction in global liquidity as it is any fundamental change in the economy there.
This bearish scenario ends with a US recession and a bear market in stocks. Theoretically, it should also coincide with a bull market in longer dated Treasuries. The best portfolio hedge is probably still the one that has always worked best for diversified investors. The extent of this incipient bear market would likely be determined by the policy response but a run of the mill return to historic median valuations involves a drop of around 50%. A drop to past bear market extremes is a scenario most investors cannot imagine, on the order of 75%.
It is easy to believe that this story is playing out before our eyes as the trend of economic statistics continues to worsen and stocks fall by the day. But it is not a certainty and the probability of the US entering recession soon may actually still be quite low. Not even considering the bullish case yet and just to cite one reliable indicator, the yield curve is nowhere near the flat or inverted shape that has preceded almost every post war recession. The spread between the 10 year and 2 year Treasury yield is 1.19% a level for comparison purposes that is roughly equivalent to December 2004 or June 1994, two points in time that were far from recession.
Of course, bears will tell you there are problems with relying on the yield curve in an era of extremely low, Fed manipulated rates. How can the yield curve invert when the Fed is holding short term rates down? That’s probably a decent point but not one that is definitive. Economic growth and inflation are weak and short term interest rates would probably be quite low regardless of Fed policy. There are other indicators, however, that are more closely associated with recession. Credit spreads, for instance, have widened considerably over the last 18 months and are also one of the more reliable warning signs of impending recession.
The current Baa spread sits at 3.26%, a level well above the 2.52% that prevailed in December of 2007 right at the beginning of the last recession. It is also above the 3.04% in March of 2001. There is not, however, some level that makes recession a certainty – the 1990 recession started with this spread below 2%. We can and do look at other spreads such as the ML US High Yield Master OAS – the junk bond spread – but again there are no certainties. That spread today is 7.24% which is higher than December 2007 (5.92%) but lower than March 2001 (8.18%). All we can really say from this is that widening spreads tend to precede and coincide with recession and they are widening today. In other words, the probability of recession is likely rising.
What about the bullish case? It certainly exists and isn’t hard to imagine even if it seems unlikely as the S&P drops 5% in a week. The rising dollar that has been a bane to emerging markets is boon to the US. Capital that flows here, fleeing the turmoil of China or Brazil or Europe or the more chaotic Middle East has to be invested somewhere and somehow. It isn’t just sitting in a vault somewhere collecting dust. Of course, it may be that it is being invested in Treasuries but if so, then someone had to sell those Treasuries and they’ll have to reinvest their cash in something more productive. There’s a finite supply of Treasuries at any given moment – although our politicians seem to have no problem creating the need for more – and someone has to hold them. More capital and more investment ultimately leads to better economic performance, higher profits and higher stock prices.
The currency devaluations that are the flip side of the dollar rise have an impact too. Assets in emerging markets are cheap and will eventually attract investment. That will ultimately cap the rise in the dollar, relieving the global deflationary pressure that it has engendered. Countries that have devalued could also, at least theoretically, use their cheapened currencies to capture market share in trade.
The bullish case then involves a stabilization or maybe a pullback in the dollar which stabilizes commodity prices. Oil prices that stabilize or maybe move up into the $40s relieves the strain on the shale oil companies and the junk bond market. It also allows inflation to stop falling and the Fed to continue hiking interest rates slowly. The rise in rates raises income for savers and has a positive impact on spending. Emerging markets – and Australia and Canada – stabilize as commodity prices stop falling and reverse. In short, the global economy rebalances naturally and without any major further disruptions. US growth may slow more but not so much that it contracts outright, while emerging market economies improve at the margin and Europe’s cyclical rebound gains some steam.
We don’t know yet which scenario will prevail, bull or bear. The probability of a bear market outcome has certainly risen over the last year and that must be taken into account by investors. Asset allocation should reflect the rising probability of recession. Bond allocations should have eliminated exposure to junk already and replaced them with Treasuries or investment grade corporates. Equity allocations should have already been reduced or should be if they haven’t. The bullish case should be respected too, most easily by an allocation to international stocks although probably not emerging markets just yet.
Investing is not, contrary to what the pundits seem to imply, a matter of absolutes, all bull or all bear. Like most things in life it is about nuance and subtlety, acknowledging the potential for the bull and bear outcome. That might not be satisfying for those who want definitive answers but it is the best a rational, logical investor can do. Who wins the bull vs bear match this year? I don’t know yet but the bear certainly had the upper hand this week. Will it be a KO and full blown bear market? Or is the bull just stunned, destined to regain his senses and rally for the win? That’s yet to be determined but every investor has a ringside seat.
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