While President Trump, the newly dovish Jay Powell, and the mainstream media continue to sing praises about the U.S. economy, the data undoubtedly points to a U.S. economic slowdown. I see two major reasons for this:
1) Tightening of credit and liquidity through the Federal Funds rate and QT - Near zero interest rates were sure to create excesses that higher rates would illuminate. Weaknesses in housing, consumer loans, and the automobile sector are the natural side-effects of tightening credit. Unlike past cycles, we also have tightening liquidity through QT. QT constricts dollar liquidity, hurting countries with dollar-denominated debt. Because this is unprecedented monetary policy, the full effects of QT will not be understood until well into the future. However, taking $1 trillion out of the financial markets by the end of 2019 will likely have a deflationary effect.
2) Chinese weakness and trade wars - A "growth at all costs" economic policy in China led to a massive debt accumulation (from nearly zero to one-third of global corporate debt) and systemic overcapacity leading to ghost cities, zombie companies, and misallocation of resources. While it also led to the "Chinese miracle" of 6%+ growth since 1992, this growth could not last indefinitely. I expect that China will monetize its excess debt and grow (albeit at a slower pace) out of this malaise. However, economic weakness in China and EM in general leads to less global demand that hurts U.S. and European multinationals. Manufacturing data has also weakened with tariffs reducing the number of U.S. exports.
This article will highlight the weakening data and what it means for the future. I will end with a section on how I intend to play the next 12-24 months.
Rising rates crushed homebuilder stocks in 2018, with most plummeting over 20% for the year. Homebuilders have since undergone a relief rally in reaction to the Fed's dovishness and a potential halt to rate hikes altogether. However, the less reactive underlying data continues to soften.
15% of listings experienced a price cut in January of this year. As the charts below show, existing home sales are down 8.5% YoY. Home prices, as measured by the Housing Affordability Index, have been declining since July 2018. YoY housing inventories rose for the first time in five years. Such statistics are expected with mortgage rates hovering a whole percentage point higher than last year.
(Source: Trading Economics)
As weak manufacturing, consumption, and earnings estimates poured in, optimists clung to the fact that unemployment remained at record lows. Unemployment rose from 3.7% to 4.0% in January 2019. One reason may involve the rising labor force participation rate, which moved from 62.7% to 63.2%. However, with unemployment claims recently spiking by 6,000 in one week, the participation rate alone does not explain the uptick in unemployment.
3) Earnings estimates
The Q1 estimated earnings decline currently rests at -3.4%, with four of eleven sectors expected to report earnings gains and seven of eleven expected to report losses. The waning effects of the Trump tax cuts and the global slowdown contagion explain the decline in earnings estimates. If -3.4% is the actual decline for the quarter, it will mark the first YoY decline in earnings since Q2 2016. Thus far, four companies have reported positive earnings surprises. However, this may be a case of setting the bar too low than positive economic conditions.
Regardless, focusing on individual company positive earnings surprises is missing the forest through for trees in my opinion. A -3.4% earnings estimate signifies that a slowdown is the consensus. Despite weakness built into the Wall Street consensus, the S&P continues to rally, currently testing the important 2,800 resistance level.
4) GDP growth estimates
The Fed cut its U.S. GDP estimates for 2019 to 2.3%, down from its original estimate of 2.5%. This is a significant drop from 2018's GDP growth of nearly 3%. With a global economic slowdown, 2019 should not be "a rising tide lifts all boats" kind of environment. However, as the title suggests, the market may continue to rally despite a weakening economy. Investors should understand the divergence between market sentiment and economic reality, as well as the risks involved in buying in such an environment.
From November to December of 2018, the U.S. experienced the second largest one-month drop in Personal Consumption Expenditures since August 2009. I suspect a large part of this drop is the result of a negative wealth effect from the December market volatility event. Personal income also dropped for the first time since 2015.
Also in the realm of consumer spending, rising rates led to a sharp drop in auto loans and credit card debt. With consumption at 70% of GDP, weak consumption is a huge drag on the U.S. economy.
In January, U.S. industrial output fell by 0.6% versus the estimation of a 0.3% gain. Purchasing Managers' Indexes, both manufacturing and ISM, show a sharp decline following Q1 2018 and continue to fall. As previously mentioned, reduced international demand and export-inhibiting tariffs explain the slowdown in production.
(Source: Trading Economics)
Roadmap and Positioning
The market is at a critical juncture. A thorough break of the 2,800 handle on the S&P could mean off to the races for the S&P despite the global growth slowdown narrative. I recommended being underweight overvalued U.S. stocks and accumulating undervalued EM throughout 2018. The EM position fared very well in light of the Fed's dovish pivot which was bearish for the dollar. Meanwhile, I missed out on the face-ripping relief rally that undid the gains made from a short, overvalued U.S. position.
The economy is weakening and the market will follow suit. However, as the old adage goes, markets can remain irrational longer than you can remain solvent. Given recent news and market activity, here is what I believe is currently happening and how to play it. Again, preparedness trumps forecasting.
1) In an unwelcome marriage of politics and economic policy, Fed dovishness will keep markets propped up until the 2020 election. The dovish pivot one year before the election was no accident. I foresee sideways trading and still more volatility, but a hard landing U.S. recession delayed for another 1-2 years. I believed Powell would stick to his guns when he said tightening was on "autopilot," which would have cracked the market. However, his U-turn indicates that the Fed Put is still in place and the "third mandate" of keeping financial markets afloat is real. 2) President Trump will announce an end to the trade war before the 2020 election and markets will rally. If this happens, we will likely see new highs. 3) Economic reality will catch up to markets. According to Raoul Pal of Macro Insiders, the Fed cut rates going into the last fifteen recessions. Thirteen of those still experienced hard landings. While Fed policy may delay the day of reckoning, the narrative that lowering rates into a slowdown can overcome the business cycle is a false one, meaning this rally on dovishness is unwarranted.
I still recommend being fundamentally long EM, gold, and cash. In the next volatility event, I recommend being tactically long U.S. going into the 2020 election, while accumulating en masse only after a recession happens. Despite market valuations at nosebleed levels, I am willing to trade on the thesis that the dovish pivot is a political move to keep the market alive until the election season and a trade war conclusion.
Disclosure: I am/we are long EEM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.