Crude Behavior

Crude behavior.  Markets took traders on a wild ride yesterday as a market on edge before a Fed decision was hit with multiple rounds of information.  Equities opened with a positive rush in response to better than expected housing numbers, an apparent easing of the White House stance on a government shutdown, and some more progress on trade discussions with China.  The positive sentiment was welcomed by traders in the midst of the worst December for stocks since 1980.  But investors remain skittish, with many of the larger would-be backstop buyers already checked out for the year.  Later in the session all eyes turned to crude oil prices which were pummeled as investors reacted to large inventory pileups in the US.  Crude has had a tough time recovering from its recent fall despite efforts from OPEC and Russia to cut production in an effort to stabilize the commodity.  West Texas Intermediate Crude made some new annual lows after posting a close below $50 on Monday.  Lower crude prices are a double edged sword as cheap oil is technically good for economic growth but simultaneously bad for the energy sector that depends on it to thrive.  Crude’s chart shows its slip from highs to lows in just 3 month’s (see chart 11 in my attached daily chartbook).  WTI will get resistance from its new Fibonacci line at 46.15 and 45 below.  Though stocks closed well off their daily highs, they managed a mixed close with the S&P 500 squeaking out a +0.01% gain, the Dow Jones Industrial Index closing up +0.4%, the Russell 2000 slipping -0.07%, and the NASDAQ 100 trading up by +0.67%.  All of the major indices remain risk off.  Bonds rallied in yesterday’s session as 10 year yields closed below a 2.85% Fibonacci support line and right around support at 2.81%, which has held since the summer.  The bid on bonds continues as investors flock to treasuries as a safe haven and traders ponder the possibility of an economic slowdown in the near term.  With the flattening of the yield curve, some small signs of a slowdown, and an expected deceleration of earnings, a growing number of economists and investors are beginning to ponder an economic recession.  Because today is geek-out Wednesday I would like to answer the questions of what is a recession and why everyone seems to be talking about it lately.

First let’s define what a recession actually is.  Economies grow and recede in a cyclical manner. When an economy is growing it is called an economic expansion and when an economy shrinks it is referred to as a recession.  Economic growth is typically measured by examining the change in Gross Domestic Product (GDP).  GDP is a measure of all goods and services in the United States.  It is classically comprised of all consumer expenditures, government expenditures, investments, and net exports (referred to as the expenditure methodology).  By adding all goods and services in these four aggregates, we can determine the total value of an economy.  Consumer expenditures, which is the money spent by you and me on goods and services represents the largest part of GDP, some 68%, which is why there is so much focus on Personal Consumption and Expenditures (PCE) by the Fed and most economists.  Government comprises roughly 17% of GDP expenditures.  It is important to note that figure because the Government can theoretically increase that number at will by borrowing and spending money.  They actually do just that through fiscal policy in order to stimulate the economy.  So now that we know how to measure the economy we can see that in good times consumers spend more and more on goods and services.  Are you spending more on holiday gifts this year than you did a few years back?  Are you paying more to have your lawn cut?  If so, and you probably are, then you are contributing to the growth of the economy.  Another GDP component is investments, which represents investments and capital expenditures by corporations.  This aggregate represents around 18% of GDP and is controlled by businesses.  Assuming that companies act rationally, they will invest more during good times which also contributes to GDP growth.  In a simplified view consumers and companies spend more and more when times are good thus expanding GDP (AKA economic growth).  Getting back to how much you pay for your lawn service.  If your landscaper continues to charge more and more every year, there comes a point where you simply won’t pay or can’t afford to continue the service.  In this case inflation has gotten the best of you and the system of growth breaks down.  This oversimplified example can be applied to all aspects of consumer spending, which is why price inflation is such a closely monitored figure.  In the investment aggregate, corporations will begin to cut back on capital investments if they believe that business will slow down.  Slowdowns in business occur when consumers slow down and stop spending on goods and services.  With those two groups representing roughly 85% of the economy, their spending habits have a significant impact on GDP.  Other factors which affect consumer and business expenditures include costs of borrowing.  Consumers can afford to make bigger purchases when interest rates are lower (think mortgage payments and credit cards).  Corporations, likewise can afford large capital expenditures when they are able to finance projects at lower costs (think corporate bonds).  A low rate environment, such as we have experienced for the past ten years combined with positive sentiment have contributed to one of the longest expansions in US history.

Now let’s define recession.  Recession is technically defined as two consecutive periods of negative GDP growth.  There are other ways to determine recession, but this is the most widely accepted method.  Since World War II, the US has experienced 11 recessions, and by observing the attached chart (GDP.pdf), you will see that they typically follow long periods of expansion and that their duration is relatively small.  On the chart, areas shaded in red are recessions.  As mentioned before, recessions happen when consumers and companies slow down and stop spending.  You can also see that prices and inflation are important factors in determining spending.  When prices go up faster than income, consumers and companies borrow money to make more purchase thus expanding the cycle of growth.  At some point consumers can no longer afford to increase expenditures and the system breaks down.  If GDP shrinks in two consecutive quarters as a result of this breakdown, we get a classic recession. This is where the Federal Reserve and monetary policy comes in.  Recessions cannot be avoided, however their impacts and durations can be to some extent.  The Fed can control the cost of borrowing by raising and lowering key lending rates.  In an expansion, if prices start to go up as a result of fast paced growth, the Fed will slowly increase the cost of borrowing in order to keep the economy from overheating.  Once again back to your lawn, no matter how high or low interest rates are the cost of service will eventually be too much to continue, clearly requiring a reset.  So recession is unavoidable, but a vigilant Fed can lessen the blow.  Once the economy enters recession, prices tend to normalize due to decrease in demand.  The lawn cutter finally gets a reality check and lowers fees.  At that point the Fed needs to restart the growth process and they accomplish this by lowering the cost of borrowing.  Once consumer confidence returns and purchases slowly resume, corporate spending begins to pick up and the economy begins a new cycle of expansion.  Seems like the lawn service got the worst of it but unfortunately it doesn’t end there.  In recessions, companies cut their costs not only by slowing capital expenditures but also by reducing labor costs (AKA layoffs).  As labor cost for companies is one of the simplest expenses to control, they typically cut back on labor first.  Unemployed consumers certainly cut back on expenditures thus accentuating the economic pullback.  That is why economists and the Fed also monitor employment health so closely.  What about the stock markets?  As you might suspect stocks perform poorly in recessions as revenue shrinks as a result of layoffs and lack of consumer confidence.  Lower revenues usually lead to lower stock prices.  The good news is that stocks are cyclical as well, so if you are a long term investor a recession will be a bump in the road, and while it may be scary and uncomfortable, long term investors have always persevered.  To illustrate this, I have attached a long term S&P500 chart (SP500.pdf) which also plots recessions.  On this chart you will note that the index falls through a recession but ultimately recovers eventually returning to growth.  While I don’t want to get too much into it because I covered it in last week’s geek-out Wednesday (https://www.siebertnet.com/blog/index.php/2018/12/12/up-down-all-around/), the flattening yield curve has been at the center of many discussions lately.  An inverted yield curve has preceded every recession in the past 60 years leaving many wondering what 2019 will bring.  The yield curve however has not yet inverted and even if it did, it is difficult to predict how far after the inversion a recession might actually occur.  By now it should be clear why the stock market is so volatile and why the Federal Reserve interest rate policy, inflation, and the employment situation are all so closely watched.

The Federal Reserve will be up at bat today as they announce their policy decision at 2:00 PM Eastern.  The announcement will be followed by a statement and Q&A session with Chairman Jerome Powell.  Though rates are largely expected to be hiked today, the odds have gone down in the past few weeks as stock markets have receded.  That said, a hike is already baked into the market so if rates are held steady, a positive response is likely.  More important than the hike itself will be Powell’s commentary and the Dot Plot.  Analysts will be looking for signs that the Fed is projecting less hikes in the year ahead.  Of course, the Chairman’s words will be overanalyzed looking for clues either way.  All of this means more volatility.  This morning, we will get some more home numbers in the wake of yesterday’s positive surprises.  Existing home sales are expected to have slipped by -0.4% month over month after growing by +1.4% last month.  While surprises in home sales can certainly impact trade today, the show stopper will come with the Fed later in the session.  Please call me if you have any questions.

daily chartbook 2018-12-19

GDP

SP500