2015 has started with a bang, with the Dow trading in a roughly 700 point range through the first six trading days. The increase in volatility started in the 4th quarter and appears to have entered the new year with a new – higher – range. The source of the volatility appears to be angst about the health of the global economy, and while Wall Street – and a lot of investors – seem convinced that the US economy can decouple from the messes emerging around the world, there are reasons for concern right here in the US.
The US economy, despite the 3rd quarter GDP figures, is still weak, and looked at from a bit longer perspective, the growth path hasn’t changed much. We’ve been stuck in a 2% to 2.5% growth economy since 2010, and it hasn’t changed. It took that 5% surge in Q3 (that’s a quarter-to-quarter annualized change) just to get the year-over-year change to 2.6%.
The economic reports lately have been more of the same, with a slight bias to the downside. Other than the employment report – more on that later – most of the reports last week were weaker than expected, although many of them continue to show the same moderate growth of the last few years. Domestic auto sales came in less than expected and down from last month (and by the way, the number of people missing payments on their new wheels has been climbing lately) but are still at the high end of the historic range. Factory orders fell again and are now down year over year. The ISM services index was less than expected but still in growth territory at 56.2. Mortgage applications continued to fall, down over 9% on the week. The trade deficit fell but both exports and imports fell; part of the import drop is probably due to lower oil prices, but not all – and falling imports have in the past been associated with economic weakness, not strength. Jobless claims were slightly higher than expected, but still printing a robust sub-300k. Wholesale inventories rose and sales fell, leading to a rise in the stock/sales ratio to 1.21, up from 1.19 in September. That might bode well for Q4 GDP, but not for future production.
The employment report was somewhat stronger than expected at 252,000 (and with revisions up for previous months), but included some of the usual caveats that we’ve seen the last few years. Wages – hourly earnings – fell, and the workweek was unchanged; incomes are not improving much faster than inflation. The unemployment rate fell to 5.6%, but that was at least partially due to another drop in the participation rate down to levels last seen in the 1980s. Still, I guess the employment picture is improving if only modestly. I do wonder if the problems starting to emerge in the shale industry – after the big drop in oil prices – are having an effect on the wage numbers. The jobs produced in that sector have been high-paying ones, and with layoff announcements coming almost daily in the oil patch, it seems unlikely those laid off will be able to find similarly compensated employment.
Of course, the flow of economic data, as I said above, hasn’t changed much, and so one is reluctant to say that this recent data says anything particularly negative about the outlook for the economy. The fact is that the data has fluctuated around the slow growth path for a long time, and this data doesn’t change that. We have gone through similar periods of disappointing data over the last few years only to have the data turn higher and push stocks higher along with it. It seems that weak data doesn’t produce much in the way of downside in stocks while positive data has continued to push markets higher. The response to the incoming economic data has been asymmetric and positive for investors.
There does seem to be something a bit different about this latest rise in volatility though and some of the market based indicators we rely on are flashing warning signs we haven’t seen in some time. The most obvious reason for concern and one that many have commented on, is the drop in Treasury note and bond yields over the last year. 10 year Treasury yields fell below 2% again last week, reflecting an ongoing reduction in inflation expectations. That drop in inflation expectations over the last year has been driven by falling commodity prices, with crude oil only the latest to join in on the downside. The fact is, though, that falling inflation expectations themselves are not necessarily a cause for concern.
Of greater note has been the flattening of the yield curve, as long-term rates (20+ years) have fallen faster than intermediate-term rates (7-10 years). A flattening at the long end of the curve has, in the past, been a warning that the Fed has gone too far in hiking rates and that economic growth is in the back half of the economic cycle – not particularly comforting considering the Fed hasn’t even raised rates yet. Not necessarily a concern by itself, but certainly a warning about how aggressive one should be with one’s investments.
Of more importance is the relationship between TIPS and nominal bonds. The drop in nominal rates over the last year has not been matched by a drop in real rates. In fact, real rates – and real growth expectations – have been rising since early 2013. So the drop in inflation expectations – a drop in nominal growth expectations – has not been matched by a drop in real growth expectations. That is, until the last week or so, when TIPS yields finally fell along with nominal rates. That is another warning sign and certainly deserves our attention going forward.
Continuing with the bond market theme, another indication of stress that has only recently reared its ugly head is the behavior of credit spreads (the yield difference between corporate bonds and Treasuries). Spreads have been rising across the spectrum of credit, with the lowest rated bonds performing the worst. CCC bonds, the junkiest of junk, have seen spreads move from a low of 6.3% in June of last year to near 10% recently. BBB bonds, the low end of investment grade, have seen a similar percentage rise from 1.4% in July of last year to a recent 2%. Even AAA bond spreads have risen, although only from 0.5% to 0.65% recently.
Any one of these bond market indicators by themselves – flattening yield curve, falling TIPS yields, or widening credit spreads – might not mean much. But when they are all moving in the wrong direction simultaneously, it is a sign of stress, and in the past has been a time for a maximum defensive investment posture. We saw the same conditions in 1998, prior to the Asian crisis (we didn’t have TIPS back then, but you can derive the same real growth information through other markets), again in early 2000, and most prominently – and ominously – in mid-2007. That isn’t meant to scare you, just to point out that current conditions are not particularly favorable for risk-seeking investors.
Bond markets are not infallible; there’s an old Wall Street saying that the bond market has predicted 9 of the last 5 recessions. We have had these conditions before and not gone on to have a recession or bear market. The most recent example was from early 2011 to the fall of 2012, during the peak of the European crisis. I would point out, though, that that period did include a nearly 20% correction in stock prices.
Other indications of stress are also evident in currency markets. The rising dollar, as I’ve said many times in the past, is a good thing for the US economy in the long run – as long as it doesn’t go too far, like it did in the late '90s. But in a world where the dollar dominates, a rise in its value often leads to problems outside the US (see: every emerging-market crisis of the last 30 years). The build-up of dollar debt over the last few decades – and particularly since the early part of this century – means that a rising dollar is a problem for the rest of the world, as dollar debts become harder to service.
It is also interesting that the recent rise of the dollar against other currencies has not been accompanied by a fall in the dollar price of gold. That would seem to indicate that at least part of the bid for dollars recently is due to fear, and not just a reflection of a better US economy.
The most concerning of these indicators is the widening of credit spreads, which is a clear indication of stress in the credit markets. Although the movement in spreads to date is not very large, it is unclear whether historical precedent will guide us now. One of my main concerns of the last few years – outside of sentiment and valuation concerns – is that the US economy’s slow growth path gives us less room for error. A shock that would have a modest impact when growth is well over 3% might now be sufficient to push us into recession. How much of our recent tepid growth has come as a result of easy funding conditions in the junk area of the credit market? If we reduce funding for that segment of the economy, how much will it reduce growth? I don’t know the answer to that question, but my guess is that the contribution to growth from low-rated credit has been more significant in this cycle.
One last item to consider in the widening of credit spreads is the effect of the energy sector. There seems to be an impression that most of the recent widening in spreads is due to stress specifically in the energy/shale sector, and that is certainly true. Because of that, there is an emerging consensus that it doesn’t matter as much, since it is confined to that sector.
But that sounds way too close for comfort to what we heard about the subprime mortgage sector in 2007, if you ask me. With the emergence of ETFs and other indexed investment products over the last decade, a problem in one sector of the junk bond market is unlikely to be confined to that area. When someone sells a junk bond ETF, it isn’t just the energy portion that gets sold. Selling effects spreads across all sectors and, if anything, means that a rise in credit spreads will have a greater impact than in the past, when junk bonds were not traded as an asset class.
There are clear signs of stress in the market that are being expressed through an increase in volatility. I would expect the volatility to continue – and potentially worsen – until the current conditions are reversed. That could be soon, and this episode will mean nothing. Or the stress could continue to increase and push the US into recession. There is no way to know in advance which outcome is more likely, but a defensive investment stance is warranted until the markets reveal the answer.