Looking Beyond Circular Feedback Loops In The Market

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Includes: EPS, IVV, PPLC, RSP, RWL, RYARX, SDS, SFLA, SH, SPLX, SPUU, SPXL, SPXS, SPXU, SPY, SSO, UPRO, VFINX, VOO
by: Gene Balas, CFA

Summary

Oil markets and financial markets have coupled; falling oil prices worry investors, who send stock prices falling and yield spreads rising (or the opposite, when oil prices rise instead).

This leads to circular logic of oil traders seeing signs of trouble in the financial markets; meanwhile, stock and bond traders see problem signs in the energy markets.

This circular feedback loop can distort the true indicators of the economy; some are problematic, leading to recession concerns - but many metrics are actually quite favorable.

In algebra class, you may remember that an equation of simply x = x cannot be solved, because any number can be substituted for "x" and the equation would still hold true (You'll get a "circular reference" warning if you try this in Excel). Financial markets, however, might not always remember that relationship, and variables feed into each other in what can be vicious cycles. For example, consider how tightly linked the equity markets, interest rates, and corporate bond yield spreads are to oil and commodity prices. As the price of the latter falls (or rises), each of those other, preceding variables is simultaneously affected, and often in ways that signal heightened economic uncertainty.

Falling oil prices must signal some slowdown in economic growth, right? With that as their mindset, investors who believe oil prices are the signal to watch then send stock markets falling, bond yield spreads rising, and Treasury yields drifting lower. Many oil traders may then view these latter financial indicators as possible harbingers of deteriorating economic output, which sends oil prices lower still - regardless of the fact that many data indicate oil prices are falling because of excessive supply, not inadequate demand. And the cycle continues anew - or it reverses direction for exactly the same reasons, driving prices higher instead of lower if oil rises instead of falls, etc. As such, it makes discerning the economic reality viewed through the financial indicator kaleidoscope difficult at best.

You can certainly find enough evidence of soft economic conditions, of course. I've written about precisely these issues recently in a piece that we'll build on here. We would be remiss to simply dismiss the concerns raised in the prior piece; they are hardly irrelevant - though there may be good explanations for why those data might be soft. However, what we can do is differentiate manufacturing - at about a tenth of the U.S. economy, in data from the Bureau of Economic Analysis - from the far-larger services sector, which constitutes much of the remainder of the private economy.

Let's first compare the health of the manufacturing sector with that of the services sector. For the first example, we'll turn to the Empire State Manufacturing Index from the New York Fed, which shows a clear contraction in the manufacturing sector, in a measure where any reading below zero indicates contraction. Then, for the service sector, consider a survey of companies in the non-manufacturing sector. Each month, the Institute for Supply Management surveys a number of these businesses to garner a sense of economic momentum, where anything below "50" indicates the sector is contracting. Here, we see that the service economy is growing at a fairly decent pace, as seen in the nearby graph.

Empire State General Business Conditions Index (New York Fed)

Institute for Supply Management Services Sector Purchasing Managers It really is a tale of two economies. As explained in the earlier piece, manufacturing has suffered because of two main issues: a cutback in the energy sector; and excessive inventories, accumulated for a variety of reasons. However, what worries some investors is that weakness in manufacturing could spill over into the rest of the economy, especially pertinent since manufacturing has been a good leading indicator at times in the past.

However, there are more factors at play in the economy. Manufacturing has been relegated to a rather small role in the economy, although there are a number of feedback loops. For example, specific cities may be hard hit, and of course, manufacturers hire accountants, lawyers, ad agencies and all sorts of other companies in the services sector. A cutback in manufacturing could spread to the rest of the economy.

For that to happen conclusively, though, you might need a few more conditions present. One of them is deteriorating consumer and business confidence, for example. And right now, consumer sentiment as reported by the University of Michigan is buoyed by low gas prices and real (i.e., net of inflation) wages that are growing, slowly but at least surely. If concerns about energy companies placing fewer orders to their manufacturing suppliers are percolating through the minds of business executives, it isn't filtering down to consumers. Indeed, consumers are as optimistic now as they were at almost any point during the expansion preceding the financial crisis. Moreover, the stock market volatility hasn't seemed to reach (yet) a level of concern that might cause consumers to cut back their spending. Meanwhile, job growth has been robust, in data from the Bureau of Labor Statistics, driving the unemployment rate down and consumer confidence up.

Consumer Sentiment (University of Michigan)

Besides consumer and business confidence, the financial markets are another channel that can transmit stress from one sector to another. Here, we can turn to the Chicago Fed National Financial Conditions Index (NFCI). It measures risk, liquidity, and leverage in money markets and debt and equity markets as well as in the traditional and "shadow" banking systems. Positive values of the NFCI indicate financial conditions that are tighter than average while negative values indicate financial conditions that are looser than average. Here, we see that conditions are still quite accommodative - and are thus supportive of growth. You may observe that this measure had spiked during some recent recessions.

Chicago Fed National Financial Conditions Index

So, are we saying that we won't have a recession? Well, no, we can't say that, because there's always some chance. The data do indicate there may be an excellent chance we could have a slowdown, but the economy is notoriously difficult to forecast. But what we can say is that one must look carefully at the right data to avoid endless, circular feedback loops in one set of data that can distract or detract from what a broader array of data might indicate. Here, we've provided two data points to counter the series of negatives we presented in our prior piece, after having offered in that article an explanation of why metrics mean what they measure - and oftentimes, not much more than that.

Disclosures

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