Thin Ice

Thin ice.  Stocks were trounced yesterday as heightened recession fears crept into the markets with a yield curve inversion.  There was no good news to be found yesterday and risk investors headed for the exits.

 

MY TWO CENTS

 

1.  Which end is up?  As reported here yesterday morning, the spread between 2-year treasuries and 10-year treasuries turned negative for the first time since 2007, prior to the financial crisis.  When this occurs, it is referred to as a yield curve inversion and it usually happens prior to a recession.  It is actually considered one of the most accurate predictors of a recession, based on the past.  Some facts for some perspective: Fact A) Curve inversions don’t cause recessions!  A yield curve flattens because short maturity interest rates are largely controlled by monetary policy and longer maturity rates are controlled by speculation.  If the Fed holds interest rates steady and investors believe that the economy will be slowing down with low inflation, they will buy longer maturity treasuries.  The buying will push bond prices up and yield to maturities down.  Front end yields stay steady and longer yields go down which is, in essence, why the curve flattens.  When fears start to increase, the buying intensifies to the point of inverting the yield curve.  Fact B)  The spread between 3-month treasuries and 10-year treasuries has been inverted for some time and is actually the most accurate predictor of recession, based on the past.  The 2-year / 10-year curve finally inverted prior to yesterday’s open, but it was heading that way for the past several weeks, so it wasn’t really a surprise for bond traders.  Fact C)  You will notice that I keep using the statement: “based on the past”, that is because there is no real way of predicting when a recession will occur and while an inverted 3-month / 10-year yield curve lasting more than 3 months predated the past several recessions, times are different now.  Using the phrase “this time its different”, is usually a dangerous thing for investors, but I want to suggest to you that the current economic expansion was largely driven by unprecedented aggressive monetary stimulus by not only the US Fed, but also central banks around the world.  In the past, recessions usually occurred when central bankers slowed economies too aggressively or cataclysmic financial events occurred.  While it is clear that the US economy is showing some signs of fatigue and global economies are slowing (specifically, in the EU with Germany and Italy, The UK, and in China), central banks have been stepping up, and depending on how aggressive they are, they may be able to engineer soft landings.  So this time, it is a little different.  What is the take away?  The economy works in cycles and it can’t just keep going straight up, so recession is always inevitable, despite the shape of the yield curve.  What does it mean for investors?  Stock performance typically weakens during recessions but often perk up and rally once the recessions end.  Investors who have a longer term (>7 year horizon) should make sure that their portfolios are diversified.  Shorter term horizon investors need to diversify with an emphasis on safer instruments.  Investors who need to preserve capital and need access to principle over the next 2 years should minimize their exposure to riskier stocks and focus on very short maturity, high quality bonds and money market type instruments. This is a time for prudence, not panic.

 

2.  Can Cisco tell us something about things to come? Despite lots of signs of economic weakness around the globe, the US economy continues to chug along.  This is because corporate and consumer confidence continues to remain healthy.  Nearly 2/3 of the economy is driven by consumers, ~20% is driven by business spending, and the remainder is driven by government spending.  Consumers are fickle but as long as they continue to spend money, economies remain healthy and continue to grow.  Corporations are more strategic and less emotional spenders.  Departments full of analysts using spreadsheets are constantly polling customers and suppliers in order to properly forecast business success.  When analysts believe that sales are going to be soft in the future, they typically cut back on expenditures as part of their normal budgeting.  Seems straight forward, right?  There used to be a saying that oil is the oil of all industrybecause it actually was… back when the US was a manufacturing economy in which petroleum products of one type or another were needed in virtually all businesses.  Today, the saying should be something like Information Technology is the oil of all industry, because companies of all types rely on IT hardware to conduct business.  Last night WHILE YOU SLEPT, Cisco Systems, the bellwether networking equipment manufacturer, announced earnings, and while they beat some Wall Street estimates they lowered forward guidance for 4Q and expect 0% growth for 2020.  The reason cited?  “Deteriorating corporate IT spending”.

 

THE MARKETS

 

Stocks were in panic mode yesterday as traders responded to a yield curve inversion which only became scarier with bad economic numbers from overseas.  The S&P500 dropped by -2.93%, the Dow Jones Industrial Index fell by -3.05%, the Russell 2000 sold off by -2.85%, and the NASDAQ Composite Index traded off by -3.02%.  Bonds surged driving 10-year treasury yields down by -13 basis points to 2.57%.  The 2-year / 10-year yield curve closed the day just about flat 1/100 of a basis point (you read that right) despite trading in negative territory during the day.  Though things simmered down after the close, the Chinese Government stepped up trade rhetoric WHILE YOU SLEPT causing futures to give up early gains and are now pointing to a softer open.

 

WHAT’S NXT

 

– Philadelphia Fed Business Activity Index is expected to come in at 9.5, down from last month’s reading of 21.8.

– Retail Sales is expected to show a month over month growth of +0.3% compared to last month’s growth of +0.4%.

– Industrial Production is expected to come in at +0.1% month over month compared to last month’s 0% growth.

– The NAHB  Housing Market Index is expected to come in at 65, same as last month.

– Before the bell we will hear from Dillards, JC Penney, and Walmart, amongst others.  After the bell earnings include Applied Materials and Nvidia.

daily chartbook 2019-08-15