In the aftermath of the surprise election victory here in the U.S., there was a surprise wave of optimism that lifted equity markets higher and, for the most part, has continued unabated to this day with the broad market indices seemingly hitting new highs on a weekly basis. Prices are up and volatility is low but underneath this hope, there have been some signs of sputtering that have been recently corroborated with a rally in the bond market sending yields at the long end of the yield curve lower, flattening the yield curve. However, the biggest warning signs have come from economic data of the last three months (Chart I). As seen, the divergence is stark and a break of the usual correlation. Of course, this doesn’t mean a correction is imminent, but it at least warrants some caution as one must begin to question the underlying fundamentals supporting a stock market at such lofty levels.
Chart I: Citigroup U.S Economic Surprise Index versus the S&P 500 Source: Bloomberg/FT
While catching up on reading over the weekend, I came across the following chart (Chart II) which shows the U.S. Recession Probability as calculated by the Federal Reserve. The shaded areas represent recession while the red line shows the probability of recession. It is interesting to note that the probability of a recession typically only rises once the government data agency that dates recessions goes back and tells us we were in fact in a recession. I could make a joke about how useless this indicator has proven over the last five decades, but it does highlight a key point that by the time we usually begin to worry about a recession, it’s typically already too late and we are already in one.
Chart II: Smoothed U.S. Recession Probabilities Source: St Louis Federal Reserve
Instead of trying to swim with the sharks in the markets, I prefer to swim with the whales and when I see articles such as the recent Sprott Money blog alerting us that Warren Buffett has now raised over $100 Billion in cash for Berkshire Hathaway, it only reinforces my view to be cautious in this market.
It is true that I have been cautious for nearly a year here since the aftermath of Brexit, keeping a conservative asset allocation with equities underweight at 30-40%, bonds overweight at 40-50%, and cash at 20-30% depending on the client and their needs. Security selection has been key for the equity side and although we have underperformed the last 12 months, for the most part it is by 2-3% against benchmarks, which in this market I’m fine with. If we are up 7% while a 60/40 benchmark is up 10%, I am willing to forego that opportunity cost to stay cautious and limit risk and drawdown potential. Warning signs were there in 1999 as well as in 2006, and it often led to underperformance. Nevertheless, discipline is important and there are times to be concerned with return of capital over return on capital and I believe this to be one of those times where the return of money is paramount.
My biggest concern is that the Fed will continue to increase interest rates at the short end of the curve despite the recent weak economic data and only lead to further slowing in the economy. As the yield curve (long versus short rates) flattens and potentially inverts, bank lending, which is already turning negative year over year, could drop dramatically as it becomes less profitable to lend. As is often the case when credit contracts, the economy slows even further and that could be the final nail in the coffin that leads to recession and an equity pullback of some magnitude.
I continue to watch the slope of the yield curve closely as it will be the next market event I watch before becoming even more cautious and move into what I call ‘Turtle Mode’, especially if we get an inverted yield curve. The good news is that beginning next decade (probably around 2020), we have a potential demographic-driven boom with millennials under 30 becoming the biggest block of the population in the country which will provide a significant tailwind to housing and consumption (Chart III). The lower stock prices that could occur over the next 12-24 months will create bargains, which is why Buffett is hoarding cash and being patient rather than chasing a stock market that by all measures appears overvalued. Tops are a process and not usually a quick event and that’s why I think there will be a few catalysts like the Fed and the yield curve that will take a few quarters to play out to lead to the moment that ‘nobody will see coming’.
Chart III: U.S. Population by Age – 2016 Census Estimates Source: Calculated Risk
….by John Bliss, IFS Director of Research