Technically Speaking For December 3: 2019 Looks Challenging
- There is good news on the trade war front.
- The Fed is becoming more dovish; the latest Markit PMI numbers were positive but weak.
- 2019 looks challenging for the markets.
There's good news on the trade war front. Canada, the U.S., and Mexico have signed the new tripartite agreement. The deal must now get through Congress, which, according to analysts, will be much more difficult with the Dems in charge. China and the U.S. have agreed to a three-month moratorium on additional trade sanctions while they attempt to negotiate a new relationship:
The United States and China called a truce in their trade war on Saturday after President Trump agreed to hold off on new tariffs and President Xi Jinping pledged to increase Chinese purchases of American products. The two also set the stage for more painstaking negotiations to resolve deeply rooted differences over trade.
I'm very skeptical that anything major can be accomplished in a mere three months. The Trump administration's complaints go right to the heart of the U.S.-Chinese relationship; it's difficult to see any major change occur in 90 days. Still, this news should please the markets.
The latest Fed Meeting Minutes show a more dovish tone [emphasis added].
However, a few participants, while viewing further gradual increases in the target range of the federal funds rate as likely to be appropriate, expressed uncertainty about the timing of such increases. A couple of participants noted that the federal funds rate might currently be near its neutral level and that further increases in the federal funds rate could unduly slow the expansion of economic activity and put downward pressure on inflation and inflation expectations.
Monetary policy was not on a preset course; if incoming information prompted meaningful reassessments of the economic outlook and attendant risks, either to the upside or the downside, their policy outlook would change. Various factors such as the recent tightening in financial conditions, risks in the global outlook, and some signs of slowing in interest-sensitive sectors of the economy on the one hand, and further indicators of tightness in labor markets and possible inflationary pressures, on the other hand, were noted in this context. Participants also commented on how the Committee's communications in its postmeeting statement might need to be revised at coming meetings, particularly the language referring to the Committee's expectations for "further gradual increases" in the target range for the federal funds rate. Many participants indicated that it might be appropriate at some upcoming meetings to begin to transition to statement language that placed greater emphasis on the evaluation of incoming data in assessing the economic and policy outlook; such a change would help to convey the Committee's flexible approach in responding to changing economic circumstances.
Several Fed Presidents have obviously taken note of slowing auto sales (punctuated by GM's recent plant closure announcement) and the weaker residential real estate market. And the labor market numbers clearly indicate we're closer to the end of the expansion than the beginning. We can expect this slowdown to continue, as it takes 6-12 months for changes in interest rates to move through the economy. As for interest rates, here's a chart from the Richmond Fed of one estimate of the neutral rate:
U.S. rates are currently higher than the median estimate.
The latest Markit PMI data continues to show a slowdown. On the good news front, no one is in a contraction. The bad news is there's weakness across the multiple fronts. In Japan, manufacturers are less upbeat due to weaker export orders from China and the EU. Companies are hoarding inputs in anticipation of further tariffs. China's headline PMI was barely positive, rising from 50.1 to 50.2. Export orders have declined for eight months and hiring has contracted for two. In the EU, Germany, Italy, and France are at multi-month lows. Export orders have declined for three-months while new orders overall are down for two. Germany -- the economic juggernaut of the region -- saw the sharpest new orders decline in 4 years.
Today, I want to summarize my thoughts about the next 6-12 months. I foresee a difficult overall environment, meaning the solid gains we've gotten used to over the last 4-5 years will give way to a far more defensive tone and orientation.
Let's begin with this old adage: don't fight the Fed, which I first learned in the book, Winning on Wall Street by Martin Zweig. When the Fed starts raising rates, it's time to start taking profits and moving money into more defensive issues. The Fed has been tightening for about three years:
While the increases started in early 2016, that does not mean traders should have started reorienting their portfolios in 1Q16. Rates were abnormally low as a result of the Global Financial Crisis; they were below the neutral rate for most of this time. It's only been over the last 6-9 months that the discount rate has approached the neutral rate, meaning this was when traders should have rebalanced their portfolios to a more defensive orientation. That they have done:
Over the last three months, staples, utilities, and healthcare are the top performing sectors. They are also the only sectors that have increased.
These three defensive sectors are also the top performing sectors over the last six months, handily outperforming far sexier groups like real estate and consumer discretionary. As I noted in this week's Sector ETF Week in Review, all three defensive sectors are technically in strong shape while also outperforming the SPY over the last 10 week period, which they have done for the last few months.
The broader averages are now is weaker shape:
Above is a chart of the SPYs' primary EMAs -- the 10 (in blue), the 20 (in red), the 50 (in green), and the 200 (in red). Let's start with the long-term trend: the 200-day EMA is now moving slightly lower, indicating the long-term trend has changed. The shorter EMAs appear to be coalescing around the 200-day EMA. Even if they move higher, it's going to take a fair amount of mathematical effort to meaningfully move the 200-day EMA back to a bullish orientation. For that to happen, we'll need another round of really strong fundamental news.
And that's where we run into the biggest problem: the 2019 economic backdrop will be more challenging. International activity is slowing. Germany and Japan contracted in 3Q18; China is slowing, as is the EU. The FT's global Nowcasts are pointing towards a slowdown. The above paragraph on the latest Markit PMI data (which is very good at predicting economic activity) points to a continued slowing in new orders (especially exports) and activity. Brexit remains an economic wild card that could potentially disrupt the UK, EU, and other regions. Global equity markets have priced this weakness into their respective share prices:Above are the yearly charts of the ETFs that track the major global equity indexes. All except the US started to weaken in the Spring as a result of the U.S.' Tariff war. U.S. indexes continued to rally thanks to tax cuts (which goosed earnings) and increased federal spending (which increased defense allocations). But the weight of global negativity eventually caught up with US markets over the last few months, sending them lower.
And that brings us to the final pieces of the U.S. puzzle: there are clearly growth headwinds . I first increased my recession probability percentage to 30% on September 20, when I noted [emphasis added]:
So -- what exactly does all this mean? As of now, four leading indicators -- global equity prices, the yield curve, commercial paper yields, and building permits -- are moving towards a recessionary signal. It's not so much the weight of one indicator but the totality of four of these data points showing a combined modest weakness. And there was nothing special about yesterday's building permits levels; it's simply that the indicator has been trending lower for the entire year that led me to conclude we should be thinking about a recession.
This does not mean that a recession is imminent. These indicators could always reverse, after all. It's simply that the probability of a recession in the next 18-24 months is now higher. I don't have a model that assigns specific percentages to the possibility. If I was going to use a number, I'd say that right now, we're looking at a 25-30% probability in the next 18-24 months.
The leading indicators continue to paint a modestly concerning picture as I noted in my latest Turning Points newsletter:
As regular readers know, I upped my recession probabilities to about 30% over the last few months, based on declining building permits, heightened corporate paper spreads, a tightening Fed, a flattening yield curve, and a declining equity market.
While the Fed is probably a bit more dovish now, deteriorating conditions in several credit market sectors keep my recession percentage at 30%
Some time ago, a commenter described these events as "cracks emerging on a windshield," which I think is an apt description. There are signs of weakness that are spreading. The real issue going forward is does the spread continue or will this trend reverse?
Finally, tax cuts goosed 2018 earnings reports. They won't be a factor in 2019; in fact, they'll be a headwind, making 1Q19 comparables that much less impressive than their year-prior numbers. And the sugar-high from federal spending increases will start to diminish next year:
Federal spending increases hit the economy in the second and third quarter of 2018. Expect that trend to diminish going forward.
Let's tie all this together. The weight of the global slowdown finally caught up with the U.S. averages a few months ago, sending the markets lower. Technically, the EMAs points toward a general weakening of share prices. Traders have reoriented portfolios to a more defensive position. Rate hikes are slowing interest rate sensitive economic sectors and the effects of tax cuts and increased federal spending are waning. All this adds up to a difficult 2019.
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