An Update on Recession Watch (w/ Nick Reece)
NICK REECE: Well, I'm Nick Reece from Merk Investments, senior analyst and portfolio manager. I've been there since 2012. Before that, I was working in Hong Kong for a US corporate law firm, post-2008 Global Financial Crisis. I was working for a hedge fund out there and then had an interim period and a stint working for a law firm there while I was working through my CFA exams, and then moved to San Francisco to join Axle and for the past 3 years, I've been working here in New York City. Over the past couple of years at Merk, I've been publishing on a regular basis, both business cycle reports and US equity market reports. That's evolved out of the internal research meeting process that we have at Merk, very heavy on data and on charts. One of the things that I noticed over the years of following sell side analysts and the FinTwit community and any usual sources that are out there is that you'd see these really interesting charts and frameworks come up but they might be cherry picked or it might just be a confirmation bias thing where they're trying to present a certain view. Those charts were, I thought interesting and worthwhile and so over the years, what I've done is develop a chart library within Bloomberg where I'll try to recreate the chart that I see, number one, to confirm that that's really what the data is saying, and then maybe change the time horizon to make sure that that time period isn't just selected to paint a certain picture. Then at this point, I've got thousands of charts in that chart library, and I go through them on a weekly basis. Then for the published reports, I select what I think are the most relevant charts and then stick to a consistent set of charts that I look at and analyze so that there is an intellectual consistency to it. It's the same data with the same frameworks, month in, month out and then go through those chart by chart, analyze them positives, negatives, and then come up with an overall assessment both for a short term outlook and a longer term outlook. This is an extremely challenging environment to analyze in terms of the business cycle. In my view, there's a lot of mixed data. I'd say that recession risk is real, it's elevated, it has not yet become my best case scenario but I've estimated it to be between 30% and 45% chance of going into recession over the next six months. Keep in mind that the NBER that does the official recordkeeping for recessions doesn't announce the recession the month that it starts, it's not a real time announcement. It might take several months or a year later, and then they'll look back and say, "Oh, the recession started in December of 2007," as was the case last time. The idea is to have some real time indicators to gauge whether we're likely heading into recession. I'd say the recession risk is as high as it's been, certainly in the last couple of years, I'd say even for this entire expansion and one of the key reasons for that is that we've finally gotten yield curve inversion. Now, it's been on the 10-year versus the 3-month, but pretty classic inversion pretty similar to what we see historically, we did not have inversion on the 2s 10s or the three stands. In other words, looking at the 10-year yield versus the 2-year yield or 3-year yield, and I think that there are some important potential reasons for that and implications for it. One thing is that the way that the curve inverted was actually with yields both on the short end and the long end coming down. It wasn't the classic situation where you really had the Fed fighting inflation and hiking above where the 10-year yield is and that's why I think we never saw the 2-year versus the 10-year invert or the 3-year versus the 10-year invert, but we did get it on the 10-year, three-month. In my opinion, just looking at the historical data and historical pattern, that needs to be respected, that needs to be taken seriously. We do have the steepness now taking place, the un-inversion, and some people are interpreting that as a positive but it's not entirely clear, at least not yet, in my view, because we do historically see the steepness, the un-inversion happening really leading up to the recessions. Now, typically that's happening because the Fed is cutting rates aggressively, which they have done, at least to some extent, they've cut three times. In those situations where you've got the steepening going into recession, you still usually have the 10-year yield coming down. Right now, what we've seen is short and rates have stabilized and the 10-year has actually started to move up a little bit. To me, gauging whether this un-inversion, the steepening that's taking place right now is actually a positive sign for the economy, it's going to be really important to watch what happens with the US 10-year yield. That keeps moving higher, if it moves above two and we see that not just in the US, but in Germany as well, I think that is a positive sign that growth prospects are genuinely improving. The inversion that we've seen so far could be somewhat like the 1998 inversion where it's a late cycle inversion, but it's not the end of the cycle. Then we get-- maybe the Fed stabilizes on pause for a while, maybe they hike again before the end of the cycle. Something to really keep an eye on here, I think, is the US 10-year yield with respect to that inversion being a genuine indicator. One of the indicators that I haven't seen anybody else specifically look at is the New York Fed puts out the quarterly household debt survey. The focus is always on the dollar value of household debt. I think that that is not that relevant. It's, I think, taking things out of context. The more important data point there is the percentage of household debt that's delinquent. That's been continuing to go down with the exception of earlier this week, or maybe it was late last week, we did see a notable uptick there. That's something to really keep an eye on but up until my latest report, that had been giving pretty much an all clear signal that US household delinquency rates were reaching cycle lows, and that survey data only goes back to the very early 2000s or the late '90s. You do see this moving average crossover, if you want to look at it in that framework, which I do in my report, you see that going into the early 2000s recession, you see that again, going into the late 2007 recession. It actually is a pretty good leading indicator because that crossover actually happened well in advance of the beginning of the recession. We have seen a notable uptick there. Not yet crossover in terms of the moving averages that I look at which is looking at the three quarter versus the sixth quarter, but it's I would say at this point, it's a neutral to negative and that had been in the positive camp before this latest data point. In terms of other classic business cycle indicators that aren't quite flagging recession risk, at least not eminently are the LEIs. We just got the new LEI data this month. Year over year, we're still slightly positive. Certainly, the trend has decelerated and if that continues, we will go negative in the coming months, but the LEIs year over year is still positive. That's been a really good indicator historically that we haven't had recessions if on a year over year basis, that is still positive. That's still one that hasn't crossed over yet into the negative. The labor market, I know a lot of people say that the labor market is a lagging indicator, but there are a couple of frameworks that I think you can use that are helpful for gauging where we are with the labor market. The initial claims, for example, we're seeing some weakness in that trend but still not seeing a recession warning out of the initial claims. This is one of good luck's favorites but the US U3 unemployment rate versus its 12 month moving average, we still haven't crossed over there. If you look at the backdrop for that unemployment rate, we actually see the participation rate making new multi-year highs which is generally a positive for the economy. A couple of data points that I look at with regards to labor market slack, that are also in the report is the number of people that are on the disability roles. I don't see a lot of focus on that so I think that's something that might be something that I focus on more than others. We see that continuing to come down. I think a lot of people went on to disability, not necessarily for physical disability reasons during the Great Recession, and are now coming back into the labor force as labor market improves, and as the demand for workers improves. Coming back to the point about yield curve inversion, the fact that we did not see the 2s, 10s invert, I think part of the reason is because we haven't had that classic overshoot of inflation that we get late cycle. That's one reason to have a little bit of pause about whether we're really going to into a recession here is that you typically see at the end of the cycle, inflation overshoots the Fed's target so it's running well above 2%. You see the Fed coming in to tighten, they interact the yield curve, and then you roll over into recession. Oftentimes, I think historically, the dynamic there is that why do you get that inflation buildup because you've run out of slack in the economy. Whether that's capacity utilization, factories are running at full capacity, and there's pressure there, or whether it's labor inputs, you've run out of slack in the labor market. There are some signs on both of those fronts that we have not exhausted the available slack. That, to me, at least implies that this cycle can continue for a while longer. It's a very mixed picture. I think the number of positives that you can hang on to on this checklist of where we are in whether we're headed into a recession and what that risk is, is diminishing, because now you've had for the first time in the cycle, yield curve inversion so you've checked that box. LEIs are not negative yet year over year, but they might be within the next few months. We've got the manufacturing PMIs below 50 which is a good leading indicator, services have remained above 50 and we'll see how that develops. Labor market still looks okay to me. I think it still looks relatively strong. If you look at the output gap, we are arguably above our potential GDP, which is typically a late cycle indicator. That can persist for a number of years so it's not a great short term timing indicator, but it does indicate that we are probably more towards the end of this cycle than the beginning, which shouldn't be a surprise given that we're 10- years into it, even though I agree with the statement that's often made that expansions don't die of old age. We can't just say it's 10-years old, and therefore, it's time to have a recession but certainly, I would say we are late cycle. The high yield spread, we're not seeing really any signs of stress in the credit markets. As I said, the household seems to be pretty strong. We've seen a lot of deleveraging of households in this cycle. There are number of indicators that I think still point to the idea of this expansion potentially continuing for a while longer, I think it'll be key to watch what happens with the 10-year yield and if we see a turnaround in US and global manufacturing, where we've had really, I think we've clearly observed the brunt of this recent slowdown in that sector and in those areas. If we continue to see some further improvement with the manufacturing PMIs in the US and in Germany and some of the other big international economies, that would be further indication that we might weather this soft patch, and that it might be like that 1998 period where you get a few rate cuts. The Fed supports things, you weather the soft patch and the expansion continues. It's often said, and I would agree, that the equity market and the economy are different things, and maybe that's best observed in looking historically at the fact that you can have bear markets outside of recessions and you can also have recessions that don't coincide with bear markets. What we can know historically is that by far the worst bear markets do coincide with recession. The most recent one, which is probably weighs heavily on people's minds, the 2008 bear market and recession and the early 2000s, ahead of recession, we had a big bear market then as well. Then the biggest one of all, 1929 and the Great Depression. It's important to note that there is a relationship, but it's not a perfect one for one. Moving over to the US equity market analysis, I've remained generally positive on the equity market. For me, my unit of analysis is the S&P 500 and basically remaining positive has been calling for the market to continue to make new all-time highs, which we did again recently. The business cycle analysis does make this a little bit challenging because as I noted, the recession risk in my view is elevated, but it's not clear that we're rolling over into imminent recession. We have a number of other indicators that we can look at to gauge where we are with respect to the equity market. There, in a similar way that I'm trying to look at a checklist of indicators for the business cycle, there's a checklist of indicators for the equity market. I'm asking the question, if we make new all-time highs, does this look like it's historically consistent with previous major market tops? There's a range of both fundamental and technical indicators to review when trying to answer that question. One of the things that's kept me positive over the past couple of years on the equity market is that the breadth has actually looked pretty healthy. The way that I look at breadth and I look at a range of indicators, and I know that they're even more than that people look at and some of them are showing a couple signs of concern even recently, but let me talk about two or three that I think are relevant. Every time that bull market makes a new all-time high, I look at the percent of member companies that are above their respective 200-day moving averages. Right now, we're still at a pretty healthy level at 75%. What you can see over time, as the bull market ages, is that that percentage goes down as the index keeps making new all-time highs. The number of-- or the percentage of stocks that are above their 200-day moving averages is coming down and down. There's a critical threshold level that I have that's a classic, at least in my interpretation of the historical data, a level that's a warning level where I would say there's a real risk, at least just judging by that indicator that we're at a major market top and that's below 65% for at a new all-time high in the S&P 500. We're below 65% in terms of the participation as measured by member companies being above their 200-day moving averages, that would be cause for concern. The other two indicators when the index makes a new high is to say is the equally weighted S&P 500 also making a new high because that takes out the effect of market cap and that has been confirming these new highs by also making new highs. The other one is the cumulative advance decline line. If that's making you all-time highs in lockstep with the market, that's a generally healthy sign. If you start to get a divergence where the market is making new highs, but the advanced decline line is not, that's a concern that you have potentially a major market tops. Those are a few of the market breadth indicators that I look at with respect to that question. Earnings are definitely a factor and there are a number of different ways to look at to look at earnings. The chart that I use is actually relatively straightforward but it does an okay job historically, which is to say is earnings per share on the S&P 500 above its 12 month moving average or not, if it dips below, that's signaling an earnings recession. You can have earnings recessions in the midst of an ongoing bull market and we did in 2015-2016, have a pretty pronounced earnings recession. That was weathering and the bull market continued, that right now is neutral, the negative I would say. We did just finish up, we're at the end of Q3 earnings. Apples to Apples on aggregate earnings were basically down year over year 1%. That is a little bit of a concern, certainly probably a neutral to negative there, although, perhaps more importantly on what's happening with forward guidance. It's a little bit of a mixed picture. Earnings, I'd say in terms of fundamentals, neutral to negative. The other thing to keep in mind with fundamentals, I suppose, is what can happen with the multiple. Oftentimes people like to break down equity market performance in terms of earnings growth, and then multiple expansion or contraction. In my view, the multiple can fluctuate far more than what people think so a lot of times, you'll hear forecasts are subdued because of maybe the fact that earnings can only grow a certain amount but I think the market can actually fluctuate far more than that just based on multiple expansion or contraction. We do have yields at pretty low levels, which would all else being equal, warrant higher valuations. Just a few weeks ago, we had the dividend yield on the S&P 500 at 2% and the 30-year US Treasury yield below 2%. If you're asking yourself the question, what would I rather own for the next 30 years? Is it a US Treasury bond that's going to pay me 2% nominally per year guaranteed? Or should I take the risk and the volatility of owning the basket of S&P 500 companies that's probably going to have a dividend that grows over time, and that's going to deliver some capital gains as well? I think the valuation question is to put in the context of the available alternatives that are out there, and this relates to that ongoing discussion of TINA, there is no alternative, and I realized that people can make a lot of money in bonds with yield fluctuations over six months or a year or shorter timeframes, but if you're looking at it from the standpoint of a buy and hold investor, I still think there's a strong case to be long equities. Some of the historical classic valuation indicators do look like this as an overvalued market. That indicator that you're referring to is what I referred to as the Z1 indicator, which looks at allocation to equities versus bonds and rattle and it does correlate pretty well with the forward 10-year returns. Right now, if history is any guide, it's suggesting a low single digits returns on the S&P that's excluding dividends reinvested but as we were just discussing, maybe that's not so bad when you're only getting maybe 2% on treasuries. It's possible that this low interest rate environment is moving the benchmark for what should be considered overvalued or undervalued. I'm not going to go that far. I think that it's warranted to be concerned about these valuation levels and to respect the historical analysis. That does indicate that maybe we're at some stretched valuations here and take that into account. Valuations aren't a great timing indicator and so in my reports, I have a short term time outlook, which is within the next six months, and then a longer term outlook. My longer term outlook is neutral to negative because I do think that we are again, going to have a bear market but really, I think you could have another two years of economic expansion and two more years in a bull market that maybe you're 30% or 40% higher on the S&P. I know that sounds crazy, but historically, it's not that unusual. If you're going to have a bear market that's maybe 30% to 50%, but it's only going to start 30% or 40% higher than current levels, I think it's just you have to be careful about when you really want to get defensive and how much you want to try to time things. I think there's also an argument to be made that central banks are now really supportive of equities here as well, arguably, many have made this point, QE and in general, balance sheet expansion of central banks has been a driver for this bull market over the past 10-years. Whether or not it's called QE or not in the US, I don't think is really that important. The point is that the balance sheet is expanding. The Fed does grow its balance sheet in normal times, if you look at the pre-QE era, the pre-Global Financial Crisis era, and so it's getting back to that dynamic of growing its balance sheet. If you chart the cumulative balance sheet assets of the Fed and the ECB and the Bank of Japan, it does look like it has a pretty strong relationship to what's happening in both US and global equity markets. I think that that makes sense and what we saw last year with the peak in equities in October, early October of 2018, that actually coincided with the peak in the cumulative G3 central bank balance sheet assets and now, what we've had happen is the-- because at the time, the Fed was doing the quantitative tightening, the ECB was tapering and then ending QE at the end of last year. Now, what we have is we have the Fed has wrapped up quantitative tightening, they're expanding the balance sheet again, ECB has now reintroduced QE. That overall total, and by the way, Japan never left QE, so the overall total balance sheet is now moving higher again and making new all-time highs, which is consistent with the equity market making new all-time highs. That's something to keep track of that a lot of people say, well, central banks are distorting markets. I just think you have to put it into your analysis. It's just part of the dynamics that move markets so it has to be part of the analysis that goes on when you think about what's happening in this case with the equity market. One of the things that I think is a little bit near term concerning is we've seen sentiment get pretty optimistic now with this breakout. Looking back at the history, we're actually not that inconsistent with where sentiment was when we had the breakouts coming out of the 2015-2016 market consolidation and the 2011-2012 market consolidation. We broke out of those and had about a 46% advance over about a 2-year period coming out of that 2011-2012 consolidation, about a 35% advance coming out of the 2015-2016 consolidation. Pull back any day any week, of course, is possible. Advances won't be in a straight line, but I think that least short term sentiments probably a little bit overdone here. The other thing that coming back to the point about whether this looks consistent with a major market top is to keep in mind what's happening with, I guess, it's related to sentiment, but I look at in terms of the uncertainty index are the headlines, positive or negative, is basically what that's looking at and the headlines have been really negative. A lot of fear has been out there. There's been a lot of fear in the headlines about trade war and about Brexit and about Hong Kong and all these potentially concerning geopolitical issues. When you have that, it's typically not at a major market top. A major market top uncertainty is very low. As the expression goes, if you wait for an all clear signal, you'll buy at the top, you actually need that fear to be out there. You want that uncertainty there in order for the market to continue to go higher. Because the market needs that wall of worry to be able to climb. What would be concerning is if we had no fear out there, the uncertainty index is very low, sentiment is measured in the way I look at it by the AAII survey of bulls and bears, if that's at extreme readings, and you have breadth deteriorating, then I think you've got the right recipe for potentially a major market top, but this market can likely continue to push higher. In my checklist summary, there are four indicators that I look at that my frameworks are contrary. One that's an obvious one is sentiment. If everybody's bullish, that's actually a time to be potentially cautious. There, I look at the AAII bulls to bears, and that's been a pretty good indicator to use. Another one that I use is margin debt. I know a lot of people focus on the dollar value of margin debt. I think that's a little bit misleading. It needs to be put into more context, if you actually measure market debt relative to the size of the market, we're not at extreme readings, it does not look like a euphoric buildup of margin debt or leveraged long positions in the equity market. It's not so much a positive as it is the absence of a negative in looking at that one. Then I have a framework for looking at correlation and volatility. The basic framework, which again is confirming, is that when volatility is really high, and that's measured as the realized volatility trailing over the past year. When correlations are really high, that's actually a time to be potentially bullish on the outlook, because the way that people look at their portfolio risk is with trailing portfolio standard deviation and the inputs are volatility, the volatility of the components and the correlation between those components. Your portfolio is going to look extremely risky when correlations are high and when volatility is high. That also means that there's a lot of room for both to decline. That's what we've seen in this bull market that nine correlations were extremely high and volatility was extremely high and they've been able to fall for these past 10-years. Now, right now, they're in the middle of the long term range so the interpretation is neutral. It's probably most relevant to look at that when we're at extremes, either extreme lows or extreme highs, but that's another contrarian framework. Then the third one is the uncertainty index, which I just talked about a little bit and that's basically trying to measure the wall of worry, is there still a wall of worry here left to decline? If there's not, that's a concern, but if there is still a lot of fear out there, that's actually indicating that this market can potentially continue to climb the wall of worry. Those are the four contrarian frameworks that I use. Wrapping up in summary, both the business cycle analysis and the equity market analysis, starting with the business cycle, as I've said in my reports, this is an extremely challenging environment to analyze with a lot of mixed signals. Each data point matters. I think, tonight, we've got preliminary PMI figures coming out. That's going to each data point that comes in is going to continue to be relevant and potentially move those odds of recession. It's the odds of a recession, in my opinion, are elevated and real, even though they're not yet my best case scenario, which does to some extent, complicate the equity market analysis. Looking at some of the sentiment indicators longer term where we're coming from with this choppy sideways period that we had for 21 months from the beginning of 2018 up until the recent breakout where the market went nowhere with a lot of drawdowns and a lot of volatility, a lot of fear in this market, I think that still says to me that this market can push higher. If we do see recovery in the US and global manufacturing sector, which we very well might see, then I think you could see this market really continued to move higher. That's something that I'm keeping in the back of my mind, but I think every data point takes on, I'd say renewed importance here, just given where we are potentially in the business cycle.