Caution

Caution

4th Quarter 2018 Review

Download the PDF to view the GMO White Paper insert.

The title of the 3rd Quarter Review & Outlook was “Aggressive or Defensive”.  In our 4th Quarter Market Update, we followed up by saying, “There is no reason to panic at this point.  Corrections are normal in bull markets.  That said, there are a lot of clouds forming that can affect stock and bond prices.”  As we know the clouds got darker in the 4th quarter and became a storm.

After the S&P 500 peaked in early October at 2,926, it began to fall when Federal Reserve Chairman Powell said that the Fed has a way to go in raising the Fed Funds rate to a neutral rate.  He implied that 3.0% would be neutral.  If this happened at that time, the yield curve would have inverted.  The fear of this happening started a selloff in the stock market.  Fed presidents immediately started walking back Powell’s comment.  The market settled down until the third week when interest rates spiked, sending the 10-year Treasury to about 3.25%.  The stock market was down significantly that week and volatility was up.  In November and December the stock market continued to fall overall.  In early January 2019, the market began to rebound as Powell implied that the Fed may pause in raising rates.

The following commentary is from the Hoisington Investment Management Company “Quarterly Review and Outlook Fourth Quarter 2018”:

The Federal Reserve [Fed] has raised the Fed funds rate nine times (or about 2.25%) since December 2015 which contributed to the shrinkage in the key monetary indicators.  It is now evident that the Fed actions have spread through the financial sector into the broader economy as inflation wanes and the growth rate in the interest-sensitive bellwether sectors such as housing, autos and capital spending is either slowing or declining.

Pricing Power

One of the most consistently reliable indicators of the vibrancy of an economy is pricing power.  If business conditions are robust, firms will take advantage of their good fortune and raise prices.  If product demand is poor, or overproduction is evident, firms will pull the only lever in their command which is to lower prices. Based on such diverse items as transportation, apparel and commodities, price weakness was widespread in the fourth quarter, suggesting final demand is weak relative to productive capacity.

In the fourth quarter, the GDP price deflator is estimated to have eased to the slowest rise since the second quarter of 2017, on par with the headline CPI.  For 2018, the CPI increased 1.9%, slower than the 2.1% rise in 2017.  In the 12 months ending in November, the headline personal consumption expenditures (PCE) deflator rose less than the Fed’s 2% inflation target. Measured by the annualized rate of change, the core PCE deflator has only been above the Fed’s target for one month since March 2012.  When firms cut prices, they will, at least temporarily, boost demand. But if the dynamic of monetary, fiscal, demographic, indebtedness, and foreign factors are not supportive, lower prices will not be a pathway to a buoyant economy.

The loss of pricing power evident late in 2018 takes on much greater significance since historically prices have been very sticky and largely unresponsive to slowdowns in demand during aging expansions.  This pattern is one of the reasons that inflation is a lagging indicator.  A fall in inflation does not normally occur until the economy is in an actual recession, which was not the case last year.  As such, the inflation drop is a notable development that suggests final demand is weaker than volumetric measures imply. 

Economic Sectors

As 2018 ended, several high-multiplier sectors appear to have either passed their cyclical peaks or rapidly approached them. Exports, vehicle sales, and home sales exhibited characteristics of sectors in recession.  Capital equipment and oil and gas drilling have also lost considerable momentum and, while remaining positive, their leading indicators are deteriorating.

Housing and Autos.  Home and vehicle sales peaked over a year ago and have declined irregularly since then.  New and existing home sales have fallen 23% and 7% from their recent peaks, respectively.  Homebuilders have expressed concerns over the considerable weakness, while the layoffs announced by auto manufacturers are tacit confirmation of faltering sales.

Capital Equipment.  Prior to the fourth quarter, the trend in real producer-durable equipment expenditures was discouraging, with the 3.4% annual rate of increase in the third quarter well below those of 4.6%, 8.5% and 9.9% in the prior three quarters, respectively. Core capital goods orders fell in the three months ending in November and anecdotal evidence from diffusion indices derived from business surveys indicate new orders were much weaker in December than for many months prior.  This slow rate of gain was a precursor of the stagnation in the fourth quarter.  That such a considerable shift has occurred makes an important statement in view of the major corporate tax cut in 2018 and the ability of firms to repatriate overseas funds at low tax rates.  These fiscal actions were widely anticipated to lead to a capital spending boom, which has failed to materialize.  The prospects for capital equipment are bleaker since much manufacturing output is directed to international markets where conditions eroded even further towards the end of 2018.  Firms operating commodity businesses are likely to cut back in view of much lower selling prices of their products. 

A large segment of capital expenditures are the oil and gas related companies.  Oil prices in the fourth quarter registered one of the largest three-month declines on record, dropping well below the year’s earlier levels, indicating that drilling activity is poised to move considerably lower.  U.S. economic growth is now positively correlated with oil prices.  Any boost in consumer spending resulting from a decline in oil prices is far outweighed by the loss in domestic, corporate and household income caused by the oil-price slump.  This collinearity was not always the case, but the relationship has changed dramatically as domestic production of oil and related products surged since 2010.  Late in 2018, total supplied petroleum products (an approximation of the amount consumed) were 21 million barrels per day (mbpd), including oil and related products.  Imports amounted to about 1.8 mbpd, meaning that domestic sources provided 89% of oil consumed domestically, which would approximate the percentage of each dollar’s worth of petroleum spending that went to domestic sources.  As recently as mid-2010, this amount was 48% and in earlier periods, the domestic content of petroleum usage was even lower.  Thus, while consumers may benefit from lower oil prices, the aggregate U.S. economy does not as Gross Domestic Income falls.

Consumer

The January 1, 2018 tax reduction boosted consumer cash flows and continues to buoy real consumer spending which constitutes the largest subset [68%] of the economy.  However, the personal saving rate (PSR) indicates this boost to the economy has been largely, if not entirely, exhausted.  In the final two months of 2017, the PSR was 6.2%.  Reflecting a $40 billion dollar drop in personal taxes, the PSR jumped to an average of 7.2% in the first two months of 2018 before ending at 6% in November 2018, slightly less than before the tax cut.  November’s PSR was near the lowest levels since the expansion began in mid-2009 and was well below the 7% average of the more than nine-year span.

Monetary Restraint

Going forward, the economy will face past and continuing restraint of monetary actions.  First, the flatter yield curve means that financial entities that borrow short and lend long will find their activities less profitable and will slow activity or increase risk premiums, and thus credit will become more expensive or less readily available.  Second, world dollar liquidity [WDL] continues to decline.  Third, the velocity of money, following a mild four-quarter advance, fell in the fourth quarter, possibly restarting its multi-year downtrend.  Fourth, monetary restraint in the form of Fed balance sheet reduction will tighten financial conditions.

Quantitative Tightening [QT3]

By the end of January 2019, the Fed balance sheet and excess reserves [ER] of the depository institutions will decline another $50 billion as a result of QT3 with similar reductions scheduled for each of the remaining 11 months of the year.  ER dropped from a peak of $2.7 trillion in August of 2014 to a recent level of $1.5 trillion.  Since balance sheet normalization cut ER by $400 billion dollars, the remaining $800 billion dollar decrease in ER may be attributable directly and indirectly to the increases in the policy rate.  If QT3 is sustained, by the end of this year, ER will fall to $0.9 trillion, assuming float, currency and other technical factors are neutralized.

Return to the Zero Bound

In view of the increasingly restrictive monetary conditions, a change in Federal Reserve policy is in the offing.  The historical record indicates even a quasi-recession would necessitate a significant decrease in the Federal funds rate.  However, the Fed will not be able to deliver the same rate cut as historically has been the case since the Funds rate would be truncated by the zero bound.  Even a quasi-recession would lead to such diminished inflation that the U.S. economy could face zero inflation or outright deflation.  Zero inflation would imply that some sectors would be in deflation and that the real burden of the debt levels would become onerous enough to eventually turn a slowdown into a more persistent and/or deeper economic funk.  

We looked at three time periods when sufficient economic difficulties arose that a major Fed response was required although a full-fledged recession did not materialize: 1966-67, 1984-86, and 1995-99.  All three cases have important similarities.  Each period was preceded by a monetary deceleration and included a notable bankruptcy, in order: Westec (also known as Western Equities), Continental National Bank of Illinois and Long-Term Capital Management.  There are four key differences this time compared to past episodes which cast doubt on the Fed’s current capability to turn the economy around with already current low interest rates.  First, money velocity was much higher in all cases and was not in a secular downturn as presently.  Second, indebtedness was far less.  Third, demographics were robust and in stark contrast to the population growth that was only 0.6% in 2018 and an eighty-one year low.  Fourth, foreign business conditions were far superior to the synchronized slowdown currently apparent.

On average, during those episodes, the Federal Funds rate and the U.S. inflation rate, decreased by 300 basis points and 1.3 percentage points, respectively.  Interest rates and inflation were much more elevated during these previous episodes.  However, as noted, our current lower rate and inflation circumstances are due to lower velocity of money, higher debt, and poor demographics.  Therefore, a larger percentage decline in inflation and interest rates can be expected.  Even a mild recession in 2019 would put the Fed in an untenable situation.

It is conceivable that the Fed, constrained by the zero-bound interest rates and in attempting to raise economic activity, could engage in another untested experiment with unforeseen consequences to boost debt levels.  If that occurs, the U.S. debt overhang would worsen and the country would follow a path pursued by other heavily indebted countries such as Japan, Europe and China.  The risk is rising that the U.S. will not only return to zero short rates but, as they have in Japan, might remain there for several years. 

In the 3rd Quarter Review & Outlook we pointed out that on November 7, 2018 the trailing Price/Earnings Ratio (P/E Ratio) of the S&P 500 was 21.76x, the Dow 21.51x and the Nasdaq 22.87x.  The historic coverage is 14.5x.  We stated that the stock market was overvalued compared to historic norms and one of the reasons was that interest rates were so low that investors had nowhere else to invest.  We then saw the drop in prices in the fourth quarter.  The P/E Ratio of the S&P 500 dropped to 19.60x.  As of January 18, 2019 it is 20.03x.  Still overpriced.  Earnings growth compared to 2018 will be down significantly from the effects of the tax cut, which ended at the end of 2018.  Revenue growth is also predicted to fall.  Profit margins are predicted to fall.

FactSet publishes its predictions based on what Wall Street anlaysts are estimating for earnings growth in 2019.  You will see in the below table what they were saying at the end of the 3rd quarter and what they are saying now:

Quarter Original Earnings Estimate Current Revenue Estimate Original Revenue Growth Current Revenue Growth
1st Qtr
6.00%
1.30%
6.60%
6.20%
2nd Qtr
6.50%
2.60%
5.19%
5.30%
3rd Qtr
N/A
3.40%
N/A
5.10%
4th Qtr
N/A
11.40%
N/A
6.40%
FY 2019
9.40%
6.50%
5.40%
5.30%

Market Bubble Bursting?

The money manager GMO (Grantham, Mayo and Otterloo) has issued a white paper entitled “Is the U.S. Stock Market Bubble Bursting?  A New Model Suggests ‘Yes’” that describes the potential for the bursting of the stock market bubble they say has developed.  The Key Points listed in the white paper:

  • A new model suggests that from early 2017 through much of 2018, the U.S. stock market was a bubble.
  • Driven by negative changes in sentiment, the bubble started to deflate in the fourth quarter of 2018, in spite of strong fundamentals.
  • Our advice, consistent with our portfolio positions established in Q1 2018 – as usual, we were early – is to own as little U.S. equity as your career risk allows.

We have attached the white paper for your reading pleasure.

Conclusion

As a result of all of the above information, Monroe Vos recommended in the fourth quarter that our clients reduce their equity exposure to 40% of their portfolio.  By moving 20% of the portfolio from stocks to bonds, we were not timing the market but reducing our clients’ risk (volatility) in their portfolio.  We have done this on two other occasions.  First was in 2000, prior to the bursting of the “Tech Bubble”, and second in 2008 during the “Financial Crisis”.  We also reduced stocks a second time in 2008 to 25% of the portfolio.  We are concerned about the still overvalued stock market, the slowing global economy and its effect on corporate earnings, the Fed’s ability to jump start the economy if what Hoisington says is correct, and the effects of negative sentiment on the stock market should GMO be right.  We consider an allocation of 40% stocks and 60% bonds/alternatives to be a neutral allocation.

We look forward to discussing all of these points with you at our next meeting.

Jamison Monroe
Chairman & CEO
Director of Consulting

Released: January 24th, 2019 04:30 PM

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