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The Calm Before The Storm?

Submitted by Joseph Y Calhoun via Alhambra Investment Partners,

Stocks rallied again last week, up a bit less than 1% as weak economic data pushed out – again – expectations for the first Fed rate hike to March of next year. I suspect this won’t be the last week that sees that time line extended although whether that translates to higher stock prices is more questionable. In looking through the data released last week one is hard pressed to find a report that was unambiguously positive outside of jobless claims which hit a low last seen in the early 1970s. The rest of the data ranged from uninspiring (retail sales) to awful (Empire State and Philly Fed surveys) to deflating (CPI and PPI) to blamed on exports (Industrial production) to recessionary (Inventory/sales ratio), to a bit surprising (JOLTS report which showed a drop in job openings).

The idea that an economy that performs so poorly that it keeps the Fed on the sidelines is good for stocks is one that can only be based on recent history, one that starts after the 2008 crisis. For if one looks even a bit further back it becomes pretty obvious that if the economy is headed for recession there isn’t an interest rate low enough to prevent it. The Fed was cutting rates furiously as we entered both of the last two recessions and the only thing that will prevent that from being true at the beginning of the next recession is that the Fed has wasted their chance to get off the zero bound. The fact that the market has now pushed the Fed’s first rate hike out to March of next year is not, contrary to recent market action, good news for investors.

At some point bad news will be bad news for stocks again but the rest of the markets are already reacting to the bad news as if it were exactly that. It is more than passing curious that while stocks took all that bad economic news as a reason to be bullish, other parts of the market were not as sanguine. Bonds rallied all week, Treasuries leading the pack with the 10 year Treasury at one point dipping below 2% again. The Fed may think rates need to be higher but the market disagrees vehemently. Bonds at the long end of the Treasury curve were up more than the S&P 500 –  in a good week for stocks – while high yield bonds managed only a token gain. Bond investors aren’t buying the stock rally, refusing to take on additional risk in the face of weak data.

Or it could be that bond investors are merely suffering from indigestion as corporate debt may have finally reached the saturation point. The spate of M&A deals announced early last week will all require major commitments from bond investors – and banks – and supply concerns may well keep a lid on corporate bond prices. The surge of deals is historically worrying too, coming near the end of bull runs in the past. The Dell/EMC deal in particular looks like a bit of a desperation move by Michael Dell as his debt laden company struggles, losing $768 million in the last year according to one source. This often happens near the end of a cycle when profit growth is hard to find, although the Dell deal may say more about the PC industry than the general economy. One wonders if Dell just needs EMC’s cash flow or really likes the company. Storage isn’t exactly a growth industry these days.

Meanwhile, corporate profit margins appear to have peaked and debt incurred for previous stock buybacks is starting to bite, two not entirely unrelated events. Interest expense is eating into profits at the same time revenue growth is harder and harder to come by. And after so many years of low rates, refinancing just doesn’t get companies the jolt to earnings it once did. Companies have spent the last 7 years cutting costs – through layoffs, reluctant hiring, more offshoring and by refinancing higher cost debt at today’s low rates. All of those trends appear to have run their course leaving company profit growth at the mercy of top line growth, something conspicuous only by its absence the last couple of years.

Another emerging trend that doesn’t bode well for those recent stock buyers is the recent rise in gold. Treasuries outperformed stocks last week but gold outperformed both by a pretty wide margin. Gold has outperformed stocks for the last six months now and long term momentum now favors gold over stocks, something that hasn’t been true since gold peaked back in 2011. The trend is certainly young and could yet reverse but it is one that should be watched very closely. Investors don’t generally favor gold over stocks when they are comfortable with the outlook for growth. It may be that gold is already starting to anticipate the next Fed move which I suspect, contrary to most expectations, to be some form of easing rather than a hiking of interest rates. In other words, gold is confirming the negative trend in the economic data.

The Fed has worked overtime since the 2008 crisis to produce a stability, a sense of normalcy in the economy and markets. The stability encouraged companies, credit worthy and some not so much, to go on a debt binge of epic proportions to fund mostly financial engineering projects – stock buybacks and takeovers – while ignoring investments in real, productivity enhancing projects. It also encouraged – forced according to many – investors to take on more risk than they probably should or even know. The Fed’s forced stability has produced an economy that struggles to grow at the new normal, secular stagnation rate of about 2% per year but also one more vulnerable to shocks. It is a stable equilibrium now but almost any minor shock could change that dynamic for the worse and quickly.

I have no idea what that shock – minor or major – might be that pushes the economy over the edge into contraction. I also have no idea when that might happen; it could be weeks, months or years but as we’re seven years into this expansion, it seems more likely it is one of the former than the latter. Widening credit spreads, Treasuries and gold outperforming stocks indicate that some parts of the market are already preparing for the storm. Stocks are about the only asset yet to batten down the hatches. If this is the calm before the storm, stock investors are about to get swept overboard.