Undiscounted, Fed-Induced Slow Growth

Today the Fed chose to leave rates unchanged for now, but it did its usual hand-holding routine to assuage investors’ concerns by promising to be there for them if they were to even get so much as a tummy ache, sunburn, or a hangnail at the pool this summer.  The Fed knows there is no room to error on the side of being too tight because equity investors would rebel.  Though the reliance is repugnant, it has become quite clear again in recent months that global stock markets need what is termed monetary “stimulus” to keep from collapsing.  However, this “stimulus” is an economic depressant in so many ways.

Markets are in the process of slowly figuring out that the downside of overactive central bankers is that stocks and other risky assets have once again become divorced from economic reality.  This has not historically gone on forever.  Assets tend to revert back to GDP over time.

The bond market has become enormously concerned about growth prospects.  It seems to have a view that is more in line with a lot of bank stocks, some cyclicals, and other value stocks.  There is likely a message for the broader stock market in this, especially as most rallies are still being led by a narrow group of market favorites with fading growth profiles.  A large portion of stocks remain below key moving averages and small caps are lagging.

Numerous coincident and leading indicators suggest the cycle has peaked and meaningful softness is ahead.  A few pundits now think we are already in a recession, though the jury is still out on that.  Overseas the growth slowdown is more pronounced than in the U.S.  China is of particular concern to us. 

While central bankers think they are riding to the rescue, you can almost see the eyes rolling in recent weeks when the ECB and BOJ promised more of the same tired monetary policies that were once portrayed as the equivalent of monetary bazookas.  This bears watching because it could mark the onset of investors becoming entirely disenchanted with central bankers.     

The bond market is conveying the thought that current efforts to stoke animal spirits with monetary jawboning are falling far short of targets with the 10-year Treasury near a 2% yield from over 3% a few months ago.  Interest rates have broadly collapsed in recent weeks as a giant safe-haven bid has hit the Treasury market on recession fears.  Commodities generally remain depressed versus stocks. 

Some measures of global trade and industrial production are hitting the weakest levels of the last ten years.  Rail carloads in the U.S. have turned decidedly negative.  Job growth is weakening.  Homebuilding and auto sales still look to have peaked for the cycle.  Most retailers’ earnings reports for their most recent quarters were dismal.  It’s not just China tariffs that are at fault because the softness is too widespread across numerous sectors. 

It’s concerning to us how participants are willing to assign much of the blame for current economic weakness on trade issues without respecting cycle dynamics.  In the end, it may not matter, especially if Trump takes a hard line with China.  However, we do expect him to back off with a face-saving “deal” if U.S. stocks turn chaotic.

Based on history, the currently inverted Treasury curve usually means risk should be avoided.  The front end of the curve is pricing in a lot of Fed easing, so it will have a tough time getting ahead of investors’ expectations.  The 2-year is trading about 60 bps below fed funds.  That’s a problem. 

At 21 times trailing GAAP earnings for the S&P 500 are stock investors paying any attention to worries expressed in the bond market?  Based on how many cyclical stocks in sectors like auto parts, retailing, and energy are hitting the new 52-week low list the answer is yes to a degree.  Often the broader market follows suit when this happens.  We find it meaningful, but no one seems to talk much about the fact that many non-U.S. banks trade at depressed valuations below book values despite monetary policies that are supposed to boost lending and growth.  The ECB and BOJ have clearly hurt banks’ profitability with their extreme policies.  In the U.S., banks have sat out much of the rally in recent years as if investors worry about more extreme policies coming here.  We just don’t understand how central bankers can expect to stimulate growth when they are causing bank stocks so much pain. 

One untold story of this cycle is how value stocks have failed to rally with fervor in response to central bank policy.  It’s not told because it does not fit the omnipotent Fed narrative.  We think value stocks’ underperformance speaks to how central bank policies don’t drive the economy in a traditional way.  At the same time, we think it calls into question how much longer investors will react positively to monetary madness because the growth stocks that have been the leaders of this cycle have been stretched to historic levels versus value stocks while their business momentum is ebbing. 

The Fed’s problem is that over the last year it became too tight only relative to ten years of ludicrous policies that have left it with much less future flexibility. If you had a crystal ball and told investors in 2009 how poor economic growth would be for ten years given how recklessly and shamelessly central bankers were about to behave, most would not have believed you.  That has yet to be discounted by equity holders.  

The views expressed on this blog are the opinions of the authors. This information is not intended as investment advice or to recommend the purchase or sale of securities. More information on Strategic Balance, LLC may be obtained by contacting investor relations.