If you had known in October all that would transpire over the next 2 ½ months, how would you have positioned your portfolio? The conventional wisdom before the election was that a Biden win would be negative for stocks because he has promised to raise taxes and specifically corporate taxes. In 2016, conventional wisdom was that a Trump victory would be bad for stocks because of his protectionism. In both cases, conventional wisdom turned out to be nothing of the sort.
After the November election, attention shifted to the Senate, where control would be determined by two runoff elections in Georgia. The consensus view was that a divided government would be the best outcome, a Republican Senate to contain the worst impulses of a Biden administration. Now that piece of “wisdom” has also proven wrong.
Based on my highly scientific method of talking to a bunch of investors, my guess is that most of them would have expected these political events – not to mention the other events of the last two weeks – to produce, at a minimum, a stock market correction. It turns out that an accurate crystal ball isn’t much help after all. I’ve said it many times before, but it bears repeating: an investors’ task is not to predict the future but to properly analyze the present.
The S&P 500 is a mere 1.5% from its all-time high set just a few days ago. Bond yields have finally broken above 1%, unified government seen as likely to increase government spending, as if the next trillion will accomplish something the last several didn’t. Believing that government spending is the key to increased economic growth is the epitome of the triumph of hope over experience.
Nevertheless, it will be some time before this generation of investors figures that out, and in the meantime, bond yields rise because investors still have hope that this time is different. In this case, the hope is that this next tranche of COVID relief will get us past the virus so the real boom can start. The consensus narrative that has developed over the last few months is that once the virus is vanquished there will be a surge of activity as people get back to their old lives. That may or may not prove true but maybe more important for markets is that it will be months before we know.
In the meantime, there is the reality of a developing economic slowdown. The data has been somewhat mixed but the slowing is obvious in the employment data, incomes, retail sales, and even in a slight slowing in the housing market. Most markets, however, are not really reacting yet, investors seemingly still focused on that post-virus period and the expected demise of social distancing.
There is one glaring exception in markets that can’t be ignored. While the 10-year nominal Treasury yield has continued to rise, the same can’t be said for the 10-year TIPS yield. Most investors seem to be focusing on inflation expectations which have been rising, a positive sign in the minds of central bankers and others enthralled by the idea that economic growth causes inflation. But real rates are in fact falling, an indication that real growth expectations are as well. More inflation and less real growth does not sound like an outcome the stock market would like.
There are some trends that are losing momentum but that could just be a pause. The dollar, for instance, appears to have found at least a short-term bottom at an expected support point. Sentiment on the dollar is very negative at the moment; a falling dollar in 2021 is the consensus, the one thing on which everyone seems to agree. And while futures market positioning isn’t as extreme as it has been in the past, there is a definite preference to be on the short side of the dollar.
Bond yields are also stretched versus the trend and a pullback in nominal rates in the coming weeks would not be surprising. Whether it turns into more than that, I can’t say, but I would caution not to get too excited about a bond rally until you see the post-virus boom narrative start to fade (if it does). For now, I’d put any bond rally in the technical, countertrend category.
Another area that has probably moved too-far-too-fast is the commodity markets. Futures market positioning is overwhelmingly bullish on commodities and the reflation trade right now. Large speculators are sitting on record or near-record longs in everything from industrial metals to soybeans. A reversal would not be surprising in the least and with extreme positioning, it could be a swift adjustment.
There has been a pretty major change in the political landscape over the last two months and yet the market’s course has barely changed. If you needed more evidence that politics really shouldn’t be part of your investment plan the market action since the election should have provided all you need.
Can the markets also continue to look past the current economic slowdown? I don’t know but with another round of COVID relief in the pipeline, I wouldn’t bet against it just yet. Stay tuned.
We classify the investing environment by the trend of the dollar and the economy. The environment is still Growth Rising, Dollar Falling but both of these are a lot more tentative than they were a month ago. Growth is still positive but the rate of change continues to slow. The dollar is still in a downtrend but very short term measures of momentum have turned up.
Selected Economic Charts
Existing home sales fell in November. Some of that may be due to a lack of inventory which stands at an all-time low of just 2.2 months.
New home sales were down 11% in November but are up 20% year-over-year.
Personal Income fell last month for the second straight month. Incomes are still higher by 3.8% year-over-year, but that is well down from the 9% rate in July. These are also November numbers and December probably wasn’t better.
Retail sales also fell for the second straight month but are up nearly 3% year-over-year.
Nonfarm payrolls were down 140k in December, the first drop since April. The second or third or whatever number surge this is for the virus is having an impact.
10-Year Treasury Yield
The 10-Year Treasury yield is in an obvious uptrend, finally breaking through 1% that had acted as resistance for months. Bonds are a little oversold here though and a pullback in yields wouldn’t be surprising.
The 10-year TIPS yield touched -1.08% early in the new year, matching the August low. It has since recovered slightly to -0.94% but that is still not an encouraging sign for growth.
Rising nominal rates and falling real rates mean inflation expectations are rising, recently moving above 2%. Of course, these are inflation expectations that have been routinely disappointed in recent years, so I can’t say I’m particularly worried about it at this point.
2-Year Treasury Yields
The 2-year Treasury note yield is not budging. With Jerome Powell saying recently that they aren’t even thinking about tightening policy, this is unlikely to change. That, by the way, has nothing to do with whether it even matters whether the Fed stops QE or anything else. The only thing the Fed can really affect is the narrative but we live in an era where the only thing that really matters is the narrative. So, when – if – the time comes when they tell the market they are going to tighten policy, short rates will rise. But until then, forget it.
The yield curve continues to steadily steepen as the 10-year rate climbs. This is a reflection of the rise in inflation expectations. Does it have any real-world implications? The accepted wisdom is that it is positive for banks who borrow short and lend long. That assumes that banks care at all what the difference is between the 2-year and the 10-year Treasury yields. I can assure you, based on the rate Wells Fargo is paying on my savings account and charging me on my mortgage, that it makes no difference to them.
Credit spreads fell another 31 basis points since my last update in December. This isn’t far from the lows since the 2008 crisis so there is no concern in credit markets at the moment. I think the word we’re looking for here is “sanguine”.
The dollar index is still in a downtrend with 3, 6, 9, and 12-month rates of change negative.
However, shorter-term measures of momentum have turned up. How far it goes, I don’t know, but for now, it is just a rally in a downtrend.
Gold is not confirming the slowdown thesis. We would normally expect to see gold rising when real growth expectations are falling (real rates falling). It might take new lows in TIPS yields to see gold resume its uptrend. 3 and 6-month rates of change are now negative. Much more downside and we may have to call an end to gold’s uptrend.
Commodities have continued their rally, up over 5% since the beginning of the year. The GSCI is now up year-over-year as well, although just about 1%.
The GSCI also continues to outperform gold as nominal growth expectations rise.
Copper is still in an uptrend but short-term momentum has waned.
The copper to gold ratio continues to rise with nominal interest rates. There is still a gap between rates and this ratio that I expect to close at some point. Given the extreme bullish positioning of copper futures, the odds probably favor a fall in copper at some point.
Our investing environment hasn’t changed despite some big changes in the political landscape. We’ve had a complete change of control in DC and yet market participants remain focused like a laser on the end of the virus. That could change as we get a better idea of how economic policy might change once the new administration gets past dealing with the virus, but I would not expect any big changes until then. And based on recent events, even if we knew exactly what and how policy would change, I’m not sure we could predict the market reaction.
My advice about politics and investing is always the same. Don’t let the former dictate the latter. The market is bigger than almost anything the politicians can do in DC. The key word in that sentence is “almost” though so I’ll keep one eye on politics no matter how painful.