Summertime and the Livin’ is Easy? Three Takeaways from the Market Movements of Summer 2019
When George Gershwin penned Summertime and noted how the livin’ was easy, he was surely contemplating a capital market environment like the one we had in July. The MSCI All Country World Index rose 33 basis points, the Barclay’s Aggregate Fixed Income Index gained 22 basis points, the HFRI Fund of Fund Index tacked on 5 basis points…all perfectly suited for the lazy, hazy days of summer (yes, I’ve moved ahead a few decades to Nat King Cole, with an assist from Hans Carste).
Of course, true music aficionados know it’s actually the lazy, hazy, crazy days of summer and sure enough the crazy part kicked in when President Trump’s August 1 tweets revived the China trade war tensions, which Federal Reserve Chairman Powell proclaimed just a day earlier had settled down to a mere “simmer.”
I won’t rehash the assorted twists and turns of the trade saga over the past month but suffice it to say that the situation remains highly fluid. And yes, I was being a bit facetious by implying that July was non-eventful. Afterall, the continued evidence of slowing global economic growth was punctuated on July 31 by the Fed’s first rate cut since the depths of the financial crisis—amid a persistent decline in global interest rates. Still, the renewal of the trade tensions contributed to an unusually rocky month for equities in August, exacerbated by the historically ominous inversion of the 2/10-year yield curve.
If nothing else, August was a reminder that we are seemingly always just a tweet away from a new market narrative. Still, if one goes under the assumption that it is best to avoid dancing in the dark (I’ve now fast forwarded to the 1980’s—thanks Bruce), let’s briefly review three things that seem quite clear and that are largely tweet-proof:
1) Central banks still rule the roost. Most economists entered the year expecting inflation to accelerate in classic Phillips Curve style. They posited that neutral interest rates should be much higher—probably closer to 4%. As I have argued in previous posts, the consensus expectation of an inflation spike was highly off-base due to a combination of factors ranging from technology to demographics to debt.
Moreover, while trade uncertainty has clearly contributed to the recent economic slowdown, much of the domestic deceleration can be attributed to the more customary lagged effect of over 200 basis points in interest rate increases and $800 billion in quantitative tightening by the Fed over the prior two years. In that sense, the recent Fed cut (with another one-to-two cuts likely on the way before year-end) should begin to offset the impact of the trade uncertainty. As a reminder, knock-on effects notwithstanding, Chinese imports account for ~1% of US GDP. Furthermore, the US appears to be making reasonable progress on the trade front with Mexico, Canada, Japan, and, to some extent, Europe.
One point to keep in mind as we move forward was captured recently in a rather remarkable Bloomberg op-ed by Former Fed Governor Bill Dudley who called for the Fed to avoid monetary easing so as to make it harder for President Trump to sustain the trade war. While Dudley ultimately issued an apology after his piece was widely criticized by his fellow economists and central bankers, it’s a safe assumption that there are likely some on the Fed’s Open Market Committee who would prefer to see the president leave office after one term. That does not imply that they will willingly look to tank the economy to serve that purpose. But it will make for some treacherous political waters for Chairman Powell to navigate through next November.
2) Equities are likely not overpriced. Based on averages over the past 25 years, the current 12-month forward PE ratio of ~17x is pretty much spot on for the current low interest rate environment. Consistent with the 11-year bull market, the S&P 500’s trailing twelve-month earnings yield—the inverse of the customary PE ratio—has stayed above the US Corporate Investment Grade Yield to Worst. As noted in Athena Capital’s recent Interim Market Update, this has typically been a bullish indicator for equities. A key caveat, of course, is that both the earnings and interest rate outlook can change. On the former, 2Q19 earnings produced enough upside surprises to push out widespread calls for a 2015/2016-type earnings recession at least a bit longer.
Further, the steady drumbeat of negative economic headlines—one of the aforementioned knock-on effects of the China trade tensions—appears to be taking a toll on business capital spending, even if it hasn’t trickled down very much to consumer spending. In that sense, we’re hard pressed to see much, if any, near-term upside to the consensus 2020 S&P 500 earnings estimate of ~$176.
As for interest rates, the not-so-simple reality is that lower rates are a positive for stock multiples…until they aren’t. An attractive earnings yield likely won’t mean very much, at least in the near term, if super-low rates are interpreted as a clear sign of an impending recession—or if they are deemed to be a precursor to the kind of disinflationary quagmire that has afflicted Japan for the better part of the last 30 years.
3) Fixed income is very expensive. AQR’s Cliff Asness made this point quite clearly a couple of weeks ago in highlighting that both real 10-year bond yields and the slope of the yield curve (the 10-year minus the Treasury bill yield) are in the bottom 5% of observations since 1955. Put the two measures together and one gets a 64-year low, excluding two months in the late 1970’s. Momentum being momentum, the odds favor even more extreme readings in the next few weeks or months, but the probabilities tilt dramatically in the other direction over the next several years.