A Fat Bear Floating On A Sea Of Liquidity: Q1 Review And Q2 Outlook

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Includes: AAPL, BK, C, FDX, FTAI, SPXU, UVXY
by: Trading Places Research
Summary

By historical measures, the stock market is overvalued.

This doesn't mean stocks cannot go even higher like they did in 1999.

We are already in a pretax earnings recession.

The market is being driven even less than usual by fundamentals, and more by sentiment. Increased central bank liquidity is not having its intended effect on investment.

I don’t believe the upside potential is justified by the risks.

Navel-gazing in a sea of liquidity. PixaBay.

A Quarter of Wrong

Well. That was something.

Chart Data by YCharts

But, more to the point, just last quarter:

Chart Data by YCharts

While not the Q1 rally we saw in Chinese equities, the Fed’s double-reversal and continued trade optimism drove US equities back to levels last seen in early October. Here’s how I framed 2019 on Christmas Eve, 2018:

  • By all historical measures, the stock market is overvalued.
  • This doesn't mean stocks cannot go even higher like they did in 1999.
  • But we are 10 years into this cycle, and the limits of the recent massive fiscal stimulus will become apparent in Q1 2019.
  • Even if revenues remain strong, earnings growth rates will slow, as the one-year effect of the corporate tax cuts disappear and headwinds appear.
  • I expect the year to close out strong, but bad news will be just around the corner.
  • The market is being driven even less than usual by fundamentals, and more by sentiment.
  • I don’t believe the upside potential is justified by the risks.

Well, that was a quarter of wrong. But I can pretty much copy and paste my bullets from three months ago, especially that one in bold. We are floating a sea of central bank liquidity that we can just as easily drown in, like Japan has for going on 25 years now. As I will discuss below in the positioning and performance section, I underperformed the S&P this quarter, but it doesn’t bother me that much, because I don’t believe the added return is worth the risk.

The Dangers of Watching the “Real” Economy

The US government, when not shut down, publishes a lot of data about the economy, most of which is ignored. If people pay it any mind, they read a headline about the headline number, and maybe a couple of bullet points on Seeking Alpha. But with the very important data sets like the quarterly GDP report, much of the interesting information is in the splits and supplementary tables.

So if you spend a lot of time pouring over these tables like I do, and you see rapid changes in them, like we’re seeing now, you can wind up far ahead of market sentiment. But that doesn’t change the fact: there are numerous signs of a slowing global and domestic economy.

At the same time, the data is backward-looking. Even preliminary numbers, which often come with large revisions, are a month or two stale by the time we get them. Solid numbers are generally a quarter old. So you can easily lose sight of current conditions.

The Market Is Historically Overvalued

Achtung! None of the measurements in this section are good indicators of short-term movements in the market, but are rather presented as evidence of the high valuation of the S&P 500. All the S&P data in this section come from Robert Schiller’s S&P 500 data set that goes back to the 19th Century, which is updated daily by the good folks at multpl.com. Also, I will be discussing median values a lot. Remember that medians are not a support level, but typically more of a look-out-below in a bear market.

By historical measures, the S&P 500 is overvalued. While not at the peaks of January 2018, we are still seeing levels that are very high, and not justified by either corporate earnings or GDP growth. (The time periods below are a little shifted, with the S&P and GDP March-March, while profits are for the calendar years.)

YoY

2-yr CAGR

3-yr CAGR

4-yr CAGR

5-yr CAGR

S&P 500 (Q1)

7.33%

12.52%

11.23%

8.20%

8.65%

Real GDP Growth (Q1)

2.94%

2.99%

2.49%

2.25%

2.56%

Before-Tax Corporate Profits Growth (Q4)

-0.17%

1.13%

0.68%

-0.95%

0.25%

After-Tax Corporate Profits Growth (Q4)

6.32%

5.87%

3.88%

1.21%

1.71%

multpl.com, BEA, Atlanta Fed

For Q1 GDP growth, I’ve used the Atlanta Fed GDPNow estimate of 2.1% annualized, which is now well above the Blue Chip consensus number of 1.4%. I’ve included before-tax profits to filter out the effects of the tax bill for an apple-to-apples comparison over time. Profits figures come from the last GDP report.

In any event, you can see that absent the 1-year effects of the tax bill on year-over-year comps, the S&P performance is far outstripping the real economy’s growth. Minus the tax bill, we are already in an earnings recession, and every day brings new downward guidance. I’ll get into the tax bill in more detail below.

For historical analysis, PE10, the inflation-adjusted 10-year rolling average PE developed by Robert Schiller, is a much better measure of market valuation than PE, that smooths out much of the noise in the straight PE number, and makes more sense when laid out over US recessions. PE is very volatile, and not very well correlated to the beginning of recessions. In fact, PE looks more like a trailing indicator of recession than a leading one. Honestly, I don’t find it very useful.

First, the historical chart for PE10:

The PE10 peaked in January at over 33 and then again at the end of the September rally. This is high by historical standards, eclipsing all but the dot-com bubble, which is literally off the chart. A return to the median historical PE10 of 15.68 in this window would drop the S&P to about 1450.

But as you can see, the last 2 cycles look very different from the previous once, with peaks only matched by 1929, and only one brief dip below the median. When I look at a chart where every cycle looks pretty similar until the last two, I start asking myself if there’s any merit to this-time-it’s-different. So let’s look at the data again, but this time beginning in the 1990s during the “Great Moderation” of low inflation and interest rates. Beginning at the PE10 low in October, 1990:

The median PE10 in this window is 25.5, which would be a drop in the S&P to about 2360.

One of the more obscure market valuations is the Buffet Indicator. In a 2001 interview with Fortune, Warren Buffett said:

...the market value of all publicly traded securities as a percentage of the country's business--that is, as a percentage of GNP. The ratio has certain limitations in telling you what you need to know. Still, it is probably the best single measure of where valuations stand at any given moment.

I’m going to modify this a bit and use the Wilshire 5000 to nominal GDP ratio. While there isn’t much back testing here, it looks like a nice leading indicator of recession.

As you can see, we’re up in No-Man’s-Land. A return to the median of 0.92 would drop the S&P to about 1875.

The Great Moderation

Back in the stone ages, the 1970s, a series of bad policy choices by Nixon, Ford and Carter, along with the oil shortages in the later half of the decade, caused core CPI inflation to spike to 13.6% by 1980. Interest rates rose to corresponding levels. In 1979, my parents bought their first house with a 17.5% mortgage. True story!

The first step to curing the stagflation of the 1970s, and likely the most important for getting the ball rolling, was Paul Volker pushing the Fed Funds rate up to 19% to break inflation. This caused a massive recession and much hardship, but it was entirely necessary. It’s just about the gutsiest thing a Fed Chair has ever done, and makes the current kerfuffle over Jerome Powell laughable.

For Reagan’s part, he whined a bit, but mostly refrained from commenting on Fed policy, and took his beating in the polls with a smile as unemployment spiked. Eventually, he re-nominated Volker in 1983. So, kudos to both men for pure political courage, the likes of which we rarely see anymore.

Secondly, anyone who has read my writing knows I am not a big fan of debt-funded tax cuts, but in 1981 this was the right policy. The top rate was 70%, which had all sorts of distortionary effects on behavior. Additionally, the short-term stimulative effect of the tax cut was needed to soften the blow of draconian Fed policy.

I’ll go into some detail why I find the supply-side story unconvincing, and I believe that the data unambiguously back me up. I believe that the best tax rates we’ve seen were in the 90s, when we saw the last vestige of rational fiscal policy with deficits at the beginning of the cycle and surpluses at the end. But the first two rounds of Reagan tax cuts, with subsequent adjustments by Bush I and Clinton were very important to this macro-trend.

FRED

Since the peaks in the 70s, inflation has remained tamed. At first, the policies of the Volker Fed broke the back of inflation and brought it back to more reasonable levels in the 3-5% range. But after the 90s recession, inflation began dropping into its current range of 1.5-2.5% without any significant Fed policy driving it. Since then, inflation has remained historically low, and the Fed has not had big inflationary cues to raise the Fed Funds rate. As investors became convinced that the new low-inflation regime was not going anywhere, long term rates, as represented by the 10-year Treasury, have been dropping steadily over this long period.

People spend a lot of time focusing on the Fed Funds rate, but long-term rates are much more important to the health of the economy, because this is the type of borrowing that actually funds investment. As you can see from the chart, these rates are largely out of the control of Fed policy.

My contention is that the end of the Soviet bloc and the continued expansion of free trade agreements led to an explosion of trade globally, but especially here in the US. Total US real trade (imports plus exports) as a percentage of GDP has risen from 12% in the 1980s to 32% in 2018.

FRED

Why is this important? It used to be an obvious point, but no longer is. Trade reduces prices and tames inflation. Here’s a comparison of the Consumer Price Index for the whole economy and the Import Price Index for just imports.

FRED

While the CPI is up about 170% in this period, the IPI is only up 60%. Imports are cheaper, or else they wouldn’t be imported. Look at the IPI in the 1990s. It barely budged. Without the growth of imports, inflation would have been much higher in this period.

This entire era of low inflation, low long-term interest rates, and resulting high stock valuations rests on the continued expansion of trade. I want to type this 100 times, but if you have any takeaways from this article, please let this be it.

My Preliminary Data Caveat

When a data set is revised, it generally means the preliminary numbers come with very high error intervals and often big revisions. I used to use the BLS jobs numbers as the example here (massive revisions are common in the series), but we have a new champion for Preliminary Data Series You Should Probably Just Ignore: home sales. Here, without apparent irony, is what is on the current table from the Census Bureau:

For those of you who slept through statistics (not blaming you), that means the MoM growth range is -9.5% to +19.3%, or anything in between. The northeast growth range is from -27.0% to +80.8%. Moreover, this is a 90% confidence interval rather than the more commonly used 95%, which means there is a 1 out of 10 chance that the true number lies outside this already massive error range. The most recent revision turned January from an awful month at -6.9% to a standout at +8.2% MoM — an upward revision of 15 percentage points of growth. This is what a useless data set looks like.

There are many things that cause revisions, and without being an economist at the Census Bureau, BLS or BEA, it’s impossible to know what they are — every reporting period is different and is filled with non-recurring items. But it’s always been my (mostly unsupported) theory that the size and direction of revisions tell you about trends at the end of the reporting period that didn’t show up in the first report. As such, I always pay a lot of attention to the size and direction of revisions as well as the current number, as I believe they give us a better idea about the following reporting period.

You have been warned.

Slowing

It is now beyond question that the global economy has been slowing since the 2018 Q2 peaks. This began hitting the US economy in Q3, but December was a really bad month, and the timing for that was terrible. January and February seem to have been a little better, but not in a huge way.

All of the “real” data in this section uses chained prices, rather than the more commonly reported CPI deflator. Unlike CPI, chained pricing uses a changing basket of goods that reflects current spending patterns, and is a far better way of deflating nominal values. The quarterly data in this section comes from GDP table 1.5.6, “Real Gross Domestic Product, Expanded Detail in Billions of Chained 2012 Dollars, Seasonally Adjusted at Annual Rates.” That’s a sexy title. Also, this is the final print from March, so the numbers are as accurate as they’re going to get.

To set the stage, the 2018 Q2 report was truly a blockbuster with the annualized headline number at 4.16%, the best since 2014 Q3. But the good news was not just in the headline, with great growth up and down the tables. The highlights:

  • Led by durable goods at 8.64%, personal consumption was up 3.80% annualized
  • Led by non-residential construction, IT and IP, fixed investment surged 6.38% annualized, even while non-farm inventories shrank. Had inventories remained flat, the headline GDP number would have been 4.83% annualized growth, not 4.16%.
  • Exports were up 9.27% annualized, while imports shrank marginally.

The good news was over quickly. The big story in Q3 GPD was that, despite the high headline number of 3.36%, 61% of that growth went into warehouses as companies built up inventories ahead of tariffs, expecting huge payoff in Q4 that did not come. The headline number without changes to non-farm inventories was 1.30%, not 3.36%. Growth rates in personal consumption and fixed investment shrank considerably, and export growth was actually negative in the quarter.

Q4 saw more disappointment, with a revised downward headline growth rate of 2.17%. The worst part? All of that went into inventories. It’s all just sitting in warehouses and car lots.

The news from the Q4 report splits:

  • Personal consumption growth is down to 1.7% annualized from 3.8% in Q2.
  • Durables shrank from 8.84% annualized growth in Q2 to 3.40% in Q4.
  • Non-durables growth also shrank considerably in Q4, after holding up well in Q3.
  • Ditto for household services.
  • Exports and fixed investment recovered a bit.
  • Residential construction was down 4.72% in 2018, while non-residential construction was up 4.90%.
  • While other investment categories have been up and down, investment in IP is very strong, up almost 11% in 2018.
  • Federal spending was up 2.73% in 2018, but it all went to the defense budget — up 5.05% while the non-defense budget was down -0.53%.

Stepping back, what I see is that the US consumer, the engine of global growth, is slowing down and inventories have built up as corporate buyers have overbought and manufacturers have overproduced. Figures in billions of 2012 chained dollars, seasonally adjusted, but not annualized.

Q2 GDP

Q4 GDP

H2 GDP Growth

H2 GDP % Growth

$4,627.9

$4,691.3

$63.4

1.37%

Q3 Inventory Growth

Q4 Inventory Growth

H2 Inventory Growth

% of H2 GDP Growth in Inventories

$23.9

$25.8

$49.7

78.32%

So on January 1, 78% of 2018 H2 real GDP growth was still sitting in warehouses and car lots. All of it has to be sold before adding a single dime to GDP. Let’s dig deeper and see what’s going on here.

The US Consumer

When everything else is going wrong, the whole would counts on the US consumer to save the day. But at least in December and January, it has not been happening. Let’s start by looking at income and what’s happening to it.

Employment has been very strong, though U-6 unemployment (red line) jumped 50 bps in January.

FRED

It is probably shutdown related, and the rate is now lower than December’s in the preliminary February and March numbers. I’ve included the spread between U-6 and U3 (green line), so you can see how the problem of marginally attached and involuntary part-time workers that plagued the early recovery has abated.

But my own favored measure of real-ish time unemployment, the 4-week moving average of continuing claims, has been moving in the wrong direction since November, though we have see a sharp reversal in the last 2 weeks.

The Labor Department’s employment numbers are based on survey data, which come with large error intervals in the preliminary numbers, and we often don’t have a good handle on a reporting period until it is 3 months stale.

On the other hand, unemployment claims are very hard data, as state governments are party to every single transaction. Revisions are very small, so we get a pretty reliable number that is only about 10 days stale when the report comes out weekly.

As you can see, beginning in the first week of November, we ended the 8-year downward trend, and continuing claims rose before, during and after the shutdown. The last 2 weeks saw a sharp reversal, so we have to see where that goes.

So even though recent trends may be going in the wrong direction, the employment situation is still very strong, and this translated into strong growth in disposable income and personal consumption almost to the end of 2018. The quarterly numbers, in annualized QoQ growth of chained 2012 dollars per capita:

17Q1

17Q2

17Q3

17Q4

18Q1

18Q2

18Q3

18Q4

Disposable Income

3.86%

1.60%

1.51%

1.61%

3.88%

1.17%

1.93%

3.61%

Personal Consumption

2.33%

2.49%

2.43%

3.65%

0.65%

3.72%

3.85%

2.52%

BEA, BEA

These are mostly very strong numbers. And despite a January blip due to a tough comp with big December bonuses, wage income growth has remained strong in January and February.

But for some reason personal consumption of goods collapsed in December and January, just as inventories were rising to new records. This was led by durables.

BEA

What this looks like to me is that everyone did their Christmas shopping on Black Friday and then just stopped. The annualized growth in the trailing 3-months, including the November surge, is -0.29%, with goods at -4.03% and durables at -10.73%. In the major categories, only food and services held up.

So where did the money go? The answer is savings, which surged in December and January.

BEA

Had consumers saved that income in December and January at the 2018 average rate of 6.5%, it would have added another $300 billion to PCE in those months.

Retail

Moving up the economic ladder from consumers to retail, we find that retail sales were very strong in October and November and then just fell off a cliff as consumers started saving in December. Let’s see if we can tease out where the weakness is.

First let’s look at the headline numbers excluding gas stations and groceries (chained 2012 dollars seasonally adjusted at monthly rates).

December

January

February

1-month growth

-1.56%

0.75%

-0.23%

2-month CGR

-0.64%

-0.41%

0.20%

3-month CGR

-0.25%

-0.18%

-0.47%

12-month CGR

-0.04%

0.12%

0.07%

Census Bureau

As you can see, all the gains in retail trade of the first 11 months of 2018 have been mostly wiped out by inflation and a new, perhaps temporary, preference for savings over consumption. The growth from January’s revised-up number was not enough to make up for the hole in demand, and retail is only up 0.07% YoY. The lowlights from December’s splits:

Line Item

Percent of December ex-food & gas decline

Non-store Retail

44.11%

General Merchandise

17.59%

Health Care

10.73%

Misc

10.03%

Sporting goods/hobby/music/books

6.13%

Clothing

5.40%

Total

93.99%

Census Bureau

These 6 categories were responsible for 94% of the 1.56% MoM decline in December retail. Since a large portion is the three general categories, it’s difficult to zero in on where exactly the weakness is. The only categories not to see declines were small bumps in autos and building materials.

After a pretty sizable upward revision, January saw an increase over December, but not nearly enough to make up for the decline in December as we can see in the 2 and 3-month windows. It is an overall healthier picture, with partial recoveries in the above 6 categories (still way down in the 2 and 3-month windows). But this was offset by a huge collapse in auto sales in January. Had autos remained flat, the headline ex-food/gas growth would have been up 1.25%, not 0.75%.

The “advance” (i.e., super unreliable) February retail report paints a picture of more woe for the general, clothing and miscellaneous categories. But the biggest contributor was building materials, a previous area of strength, down 4.47%. Had it remained flat, headline ex-food/gas would have been up 0.15%, not down 0.23%.

The good news in the report came in the form of a small rebound in autos and non-store, though both still well down in the 2, 3 and 4-month windows.

So putting it all together, it seems like consumers are holding off on large purchases of durables and saving that money instead. Let’s see what effect this has had on wholesale and retail inventories.

Inventories

First, looking at the 2018 quarterly numbers, we can see that wholesale and retail inventories rose about $42 billion 2012 chained dollars in the last 2 quarters, a 3% increase, likely hoping to get out in front of the end-of-the-year tariff increase that never came.

BEA

Unfortunately, the demand, especially in durables, has not been there. The entirety of the slack in wholesale and retail comes in wholesale durables and retail autos — $45 billion 2012 chained dollars — an 8.43% increase year-over-year.

BEA

Let’s look at the monthly wholesale numbers for some more detail here. We’re going to be looking at the inventory to sales ratios here, which is exactly what it sounds like. A rising ratio means inventories are outpacing sales, and prices and margins should decline in response. Also, vice versa.

The buildup began in July and has continued through January

Jul

Aug

Sep

Oct

Nov

Dec

Jan

6-month growth

Durables

1.58

1.58

1.60

1.63

1.66

1.68

1.69

6.96%

...Autos

1.53

1.57

1.62

1.68

1.67

1.72

1.70

11.11%

...Furniture

1.83

1.81

1.83

1.90

2.00

1.94

1.91

4.37%

...Household appliances

1.06

1.03

1.04

1.07

1.11

1.11

1.17

10.38%

...Hardware

2.01

2.09

2.06

2.12

2.14

2.24

2.24

11.44%

Clothing

2.15

2.12

2.20

2.29

2.24

2.30

2.35

9.30%

BEA

I’ve added clothing in there, since we saw the weakness in retail, and indeed inventories grow there too. But other than autos, the problem is still with wholesalers, not retailers or manufacturers. While non-auto retailers have seen weakness since December, and the preliminary January and February industrial output numbers for consumer durables are way off, they have managed their inventories much better.

Additionally, we are now beginning to see the effects in the employment numbers with the preliminary (i.e., super-unreliable) Labor Department employer survey for March, with lower numbers in durable manufacturing and autos particularly.

Prices

So what effect has this had on prices? In the broad consumer durables category, what we’re seeing is deflated prices, but they are deflating at a slower rate, which is counterintuitive.

A little historical context is needed here. Since the explosion of free trade in the 1990s, the consumer durables price index has been down every month but one. It is one of the great benefits of free trade, and NAFTA specifically, that we all pay much less for large, expensive items than we used to.

But since the year-over-year deflation rate bottomed at -3% in November, 2016, it has been rising pretty steadily. To be clear, prices on consumer durables are still deflating, just at a much slower rate, now -0.94% year-over-year in January. So even though we’re seeing reduced demand since December, it does not seem to have effected prices.

FRED

BEA also breaks out the auto price index in the quarterly numbers so they are a bit stale, but seasonally-adjusted prices for new autos, both cars and light trucks, were down in Q4.

So What’s The Big Deal?

When I explain this to people, I often get blank stares — $50 billion in extra inventories in a $20 trillion economy sounds like very little, and it is. But it also represents almost 80% of H2 2018 growth, and there is no guarantee that it will be sold, or sold at a profitable price, and warehousing is not free. In any event, drawing down inventories is going to pull significant amounts out of H1 2019 growth. Unless it just sits there, which is worse. These things have a way of spiraling.

Another take on the same data is that it is the result of a series of non-recurring events. BofAML expressed this view in a note before the weak advance February retail numbers came out.

There are several explanations for the recent weakness in spending – all of which imply a temporary lull. In December, the stock market stumbled, creating a negative wealth shock and hurting confidence. This was accompanied by the government shutdown, which weighed further on confidence. Then the polar vortex created weather distortions in January, further holding back spending. Most recently in February, delays in tax refunds have crimped spending. The Census Bureau data – which will be released on April 1st – are likely to show weak spending for February as well, although the data have been much more volatile of late and prior months could be revised.

This view posits a 2016-type scenario, which was specifically alluded to by Jerome Powell in his last speech. In this scenario, a combination of factors would lead to a temporary earnings recession, but the Fed would save the day by pivoting to a neutral stance. But this doesn’t take into account the role of the tax bill on the 2017 and 2018 recovery from the 2016 sectoral recession. With the deficit over a trillion dollars, this sort of fiscal stimulus will not be forthcoming again.

But disposable income remains strong, so the dip in consumption is unusual. To be clear, it is a good thing that US consumers are saving more, especially now at the end of the cycle, but the timing, coinciding with the buildup in inventories, is not good. However, prices appear to be holding, so it seems like wholesalers also think this is temporary. Our next big clue to how this is working out will be the preliminary Q1 GDP report at the end of April.

The Earnings Recession: You’re Soaking In It

Many economists and analysts have predicted an earnings recession in 2019, like the one in 2016. But 2018 was already an earnings recession for US corporations. It has been masked by the tax bill’s effect on the year-over-year comps of GAAP earnings, up 6.32% for the year, but before-tax profits were down -0.17% in 2018. The tax bill also had a partial accounting effect on 2017 taxes, with changes to deferred taxes and depreciation. Figures in billions of nominal dollars:

Before-Tax Profits

YoY Growth

After-Tax Profits

YoY Growth

Effective Tax Rate

2016

$2,129.71

-0.21%

$1,736.85

-0.01%

18.45%

2017

$2,181.87

2.45%

$1,831.17

5.43%

16.07%

2018

$2,178.19

-0.17%

$1,946.89

6.32%

10.62%

FRED

Since this is nominal dollars, you can lop another 1.5-2% off those YoY growth rates.

Now that the year-over-year effects of the tax bill on after-tax profits are gone in 2019, GAAP earnings will follow, and will likely be down for the year as global demand slows and the US seems to be following. Apple’s (AAPL) earnings call at the beginning of May will certainly wake up everyone to this fact, if their guidance and Fedex’ (FDX) haven’t already. I think the Q1 numbers we start getting in a few weeks are going to have a lot of surprises on the downside.

Liquidity: You’re Drowning In It

When I was positioning my accounts for Q1, the thing that I underestimated is how much the sea of liquidity we have been soaking in over the past decade has effected sentiment. The only news that seems to interest investors these days is central bank liquidity, and how much they can fill up on.

As is typical at the end of cycles, sentiment has become divorced from fundamentals. In the past, it has usually been investors chasing growth, like in 1999, or yield, like in 2006. Now everyone chases any signs of liquidity in the system, whether they understand what that means or not. Demand for US Treasuries remains very high despite all-time record supply, because many investors see an interest rate just above inflation as the best use of their capital. No amount of added liquidity is going to change that.

I will get into it in greater detail below when discussing how the tax bill worked out in 2018, but the surge in buybacks is clear evidence that companies don’t believe investing in new capacity with all this liquidity is a very good bet. They have generated record amounts of cash, and as we will see, are returning all of it to investors. Some companies are even taking out debt at historically low rates to do buybacks, essentially raiding their own balance sheets.

This is a version of the Liquidity Trap that Keynes originally described. In his telling, when interest rates hit the lower bound, investors prefer cash to bonds and stop buying, driving rates back up when the central bank is trying to keep them low.

In this version, let’s call it LT2.0, the system is awash with liquidity, but the growth in the system doesn’t seem as attractive as a 6-month bill at 2.45% yield, or a 3-year bond at 2.26%, or the 10-year Bund at -0.041%, or buying your own shares. So the central bank loses the ability to juice the real economy with cuts to the lower bound, and only inflates asset prices.

Japan is the prime example as it happened to them first, back in the mid-1990s when the rest of the world was booming.

FRED

Real GDP growth (blue line, right axis) was up and down a lot, but their 24-year real GDP CAGR is a meager 0.95%. This is a period where the overnight rate for the BOJ (red line, left axis) never got above 100 bps, the inflation rate (green line, left axis) was negative most years, and the 10-year government bond (purple line, left axis) eventually hit zero in 2016.

At the end of 2018:

  • GDP growth: 0.80%
  • Inflation: 0.02%
  • Overnight BOJ rate: 0.30%
  • 10-Year Government Bond: 0.065%

This can all be ours if we are not careful. The Fed pausing at 240 bps means we do not have very far to go to zero if we need to. In 2008, we came into that recession with about 500 bps to zero, already an historically low number for the end of a cycle, and that was clearly not enough. The ending of the balance sheet runoff is actually a backdoor QE4, as the Fed will have to purchase new Treasuries to replace expiring paper, further increasing demand for Treasuries and driving rates lower.

But back to where I started this section. Equity markets are obviously gaga over rate cuts, even though the experience of the past decades tells us that they have diminishing returns the closer you get to zero. The outsized performance in US equities in Q1 is unmoored from either the performance of the economy as a whole, or corporate profits in particular. Liquidity can only keep it afloat for so long until we all drown in it.

The Tax Bill A Year In

The 2017 GOP tax bill was designed to add $1.5 trillion to the debt, though I would argue the final number will be much larger due to the pass-through income loophole and Congress may make certain expiring cuts permanent.

Forgetting for a moment that this represents an unprecedented transfer payment from future generations to current shareholders, it is also an unprecedented experiment in fiscal stimulus at the end of what was already a long cycle. It's Bizarro Keynesian.

We now have a price tag on the corporate side of the bill so far through 2018’s end: $220 billion in new federal debt. In billions of nominal dollars:

After-Tax Corporate Profits

Effective Tax Rate

Corporate Tax Paid

Corporate Tax at 2016 Effective Rate

Difference

2016

$1,736.85

18.446%

$392.86

$392.86

$0.00

2017

$1,831.17

16.073%

$350.70

$402.48

$51.78

2018

$1,946.89

10.619%

$231.31

$401.80

$170.49

Total

$222.27

BEA

As I pointed out, there were changes that effected deferred taxes in 2017 taxes, reducing the effective rate by over 2% and then another 6% in 2018. I hope we get our money’s worth!

But, counter the supply-siders, companies will take this extra cash and plow it back into the business in the form of capital expenditure. This will lead to long-term growth in productivity, which will translate into both higher profits and wages, leading to higher demand, leading to more CapEx, etc. The budget deficit gets wiped out by growth, and everyone sings Kumbaya.

Let's look at this argument one step at a time

  1. Lower statutory corporate tax rates lead to higher profits
  2. Higher profits lead to higher capital expenditures
  3. Higher capital expenditures increases worker productivity
  4. Higher worker productivity leads to higher profits and wages
  5. Higher wages increases demand
  6. Higher profits and demand increases capital expenditures
  7. The growth from this virtuous cycle wipes out the deficit

We have already seen that corporate after-tax profits rose by over 6%, even though pre-tax profits were actually down. So cash flows to corporations rose in 2018, but did that lead to higher investment? The answer is, “a little”. The 10-year window, dotted line is the median:

FRED

Those are annual numbers, but I think we are about to see weakness creep back into investment numbers. Since July new capital goods ex-defense/aircraft orders are down at a compounded rate of -0.20% monthly, or -2.42% annualized. Those are based on seasonally adjusted nominal dollars, so you can take another 1.6% off the annual number.

We’re seeing a slight above-median bump in investment that is likely dissipating as I type this. But where did the profits go if not to an investment boom? For the S&P 500 companies in 2018, in billions of nominal dollars:

GAAP Earnings

Buybacks

Dividends

Combined Yield

Net Cash

Percent of total net income to shareholders

$1,266.20

$806.43

$456.30

5.25%

$3.46

99.73%

S&P

So, all of it went back to shareholders. As discussed above, increased fiscal and central bank liquidity are not having their intended effects on investment behavior.

To put this in context, all US companies spent an additional $251 billion in nominal dollars over 2017 on all fixed investment in all of 2018. Instead of adding to that, just the S&P 500 companies chose to return $1.26 trillion to shareholders, a $324 billion increase over 2017, the previous record year. This should tell you everything you need to know about how corporate leadership view organic earnings growth prospects.

Moreover, this is nothing new; it has been going on since 2014. In those five years, buybacks and dividends for the S&P 500 totaled 106% of GAAP earnings for a net cash flow of -$296 billion in nominal dollars. These 500 companies went into a combined $296 billion in new debt to fund this, instead of using those earnings and low interest rates to increase CapEx.

To be clear, I am not railing against buybacks. When cash flows justify it, returning cash to shareholders is a good thing. But, borrowing $296 billion to return to shareholders is merely raiding the balance sheet, and it is up the investors of those companies to reject this tactic. To date, they have not.

Did the slightly higher investment lead to higher productivity? Again, just a little.

FRED

Is this leading to personal income growth? Yet again, just a little.

FRED

We’ve already seen that personal consumption expenditures are declining off their Q2 peaks, so this small bump in personal income is not going into increased demand, and we are unlikely to start the virtuous cycle predicted by the supply-siders.

And the budget deficit? The budget deficit was $779 billion, but that’s masking another $476 billion in other off-budget federal borrowing, so the total federal debt ballooned by $1.25 trillion in 2018, $170 billion alone from the hole in corporate income taxes, or 14% of the total. Total debt is now over 107% of GDP, a new record, eclipsing the worst years of the recovery.

The really bad news is now the left has their own Magical Budgetary Thinking in the form of Modern Monetary Theory. May God have mercy on our souls.

Tax season is upon us and by June we will be able to issue a final report card on the individual side of the bill. If you want to know where that’s headed, Google “Kansas Experiment.” Fun Fact: Trump’s latest FOMC nominee, TV “Economist” Stephen Moore, was one of the architects of that disaster.

So the report card for the corporate side of the tax bill, a year in: D+. Ask your kids or grandkids if the $1.5 trillion they borrowed was worth it.

The Yield Curve And The Next Recession

Recessions are notoriously difficult to call at first, and usually we don’t know until a quarter or two after it’s already started. For example, in the last go around, then CNBC talking head and current White House Chief Economic Advisor, Larry Kudlow had this to say when we were already in recession in December, 2007:

There is no recession. Despite all the doom and gloom from the economic pessimistas, the resilient U.S economy continues moving ahead ‘quarter after quarter, year after year’ defying dire forecasts and delivering positive growth. In fact, we are about to enter the seventh consecutive year of the Bush boom…

There’s no recession coming. The pessimistas were wrong. It’s not going to happen. At a bare minimum, we are looking at Goldilocks 2.0. (And that’s a minimum). Goldilocks is alive and well. The Bush boom is alive and well. It’s finishing up its sixth consecutive year with more to come. Yes, it’s still the greatest story never told.

This is not to pick on Kudlow, because many, many smart people and computer models got this one wrong too. So, don’t trust anyone’s recession predictions, including mine. That being said, here we go.

I’ll have a lot more to say about this in my next yield curve update, but the yield curve has proven to be a pretty decent predictor of recession. To be clear, while it has a big effect on the financial sector, curve inversions are a symptom, not the cause of recessions. When investors think recession is coming, they believe the Fed will lower rates in the future, so long term rates drop, while short term rates hold up.

For example, the 2-10 spread:

FRED

The big caveat here is the extremely small sample size, but it does look good on a chart, no?

My own model currently predicts the 2-10 will invert on August 26, with recession to start anywhere from 6-months to 2-years after, so the earliest would be February 2020.

The NY Fed’s yield curve model uses the 3-month to 10-year spread over a normalized distribution to generate a probability of recession a year out. The historical chart:

NY Fed

As you can see at the end there, the probability has jumped, as the spread has plummeted since the beginning of November, inverting for 5 days at the end of March, though it has pulled back considerably in April. The Fed publishes the 1-month moving average, but I also keep track of the daily value, which peaked at 28.5% for March 27 2020, currently at 25.8% for April 5 2020. To put that in context, the back testing of the start dates of previous recessions:

  • 1960: 7.7%
  • 1970: 36.7%
  • 1973: 10.3%
  • 1980: 43.3%
  • 1990: 31.1%
  • 2001: 26.2%
  • 2008: 37.9%

So, getting close.

Performance and Positioning

At the beginning of December, I switched my positioning to watch-and-wait, which was about 30% long and 30% short for a net long exposure of zero. Over the last 4 months, this has changed a bit, mostly because I bought a lot of Fortress Transport (FTAI) at 8.3% yield right before it went ex-dividend and then sold it after. Right now I’m at about 20% long and 20% short, still at net zero.

I haven’t begun shorting individual stocks, but I am keeping a close eye on the large banks, and will probably begin shorting them soon. They are usually the leading edge of any sort of recession and the flattening of the yield curve will impact a large part of their business, which is borrowing short-term and lending long-term. I just bought a new car and was offered a 6-year loan at 2.65%, only 25 bps above Fed Funds, which is a very thin margin for the bank. Anyway, I’m keeping a close eye on BNY Mellon (BK) and Citibank (C).

So as a hedge I had been using SPXU, a triple-leveraged inverse S&P 500 ETF, but once the VIX index slipped below 13 a few weeks ago, I swapped that out for UVXY (UVXY), a VIX Index tracking ETF. I prefer the VIX hedge because when it’s this low there is much less downside risk than SPXU (SPXU). To be clear, with leveraged products like these, you do not need to fill up. For example, to hedge my current 20% long position, I only have 5-6% UVXY. Also, UVXY is a special case — never own it for more than 4 weeks.

In any event, performance lagged the S&P considerably this past quarter, but still up 7% compared to 13% for the index. A lot of that came in interest and dividends and short-term gains, so not particularly tax-friendly. In any event, I continue to believe that the risk in the system is not worth the potential gains from added long exposure to equities.

The S&P closed the quarter at 2834. If the market really rallies on the back of a trade deal with China, for example, to 3100, we’re still only talking about about 9% gain. Meanwhile, I see a lot of empty air underneath us. Remember, Wile E. Coyote stays aloft, until he looks down.

Outlook

In case you skipped the liquidity section, go back and read it. I’ll wait, but for the rest of you, here’s an adorable bear cub to look at…

PxHere

There is a tug-of-war happening right now. The fundamentals are souring everywhere you look at the beginning of 2019, yet equities surged globally in response to increased central bank liquidity, and what people believe that means. But as we saw up top, these valuations are not justified by the growth of the economy generally or corporate profits specifically.

The entire point of increased central bank liquidity is to reduce the cost of capital so that marginal or high risk/reward investments go from thumbs down to thumbs up. But that’s not what’s happening. Outside of IP investment, fixed investment growth and productivity growth have been moderate at best.

So where is all this capital going? First, to the tune of an additional $1.25 trillion in 2018, it is going to fund the federal debt at rates barely above inflation. That should tell you what investors think about other opportunities. Second, at least for the S&P 500 companies, the increased cash flows they are generating from all this liquidity is going back to shareholders. Some companies are even issuing debt to return cash to shareholders, raiding their own balance sheets, because long term rates are so low. Again, there doesn’t seem to be much interest in investing in new capacity. Finally, with the increased savings rate, consumers put an extra $300 billion in the bank during December and January compared what they would have at the old rate.

So right now we are floating on a sea of global central bank liquidity, but soon, like Japan, we may start drowning in it. Germany looks like they’re headed there:

FRED

At the end of 2018:

  • GDP growth: 1.45%
  • Inflation: 1.28%
  • Overnight rate: -0.36% (yes, negative since 2015)
  • 10-Year Government Bond: 0.40%

This can all be ours.

I Am (Still) A Fat Bear

Beadnose, 2018 Fat Bear Champion, and my spirit-animal. Katmai National Park

For several years now, the rangers at Katmai National Park in Alaska have promoted Fat Bear Week, the week before the bears go off to hibernate. They compare pictures of the bears from spring, when they first emerged from their hibernation, all skinny and ready to feast, with their current huge girth after a summer of salmon.

So I am still hibernating in my cave and here I remain until the glaciers begin to melt and the salmon swim upstream. All bear markets end, and when it does, I will emerge, ready to fatten up in the river.

Only Half-Joking

I will end on joke I have been telling since the triple-whammy to globalism of Brexit/Corbyn/Trump:

The right is turning nationalist, the left is turning socialist and the US is foisting a trade war on the rest of the world that no one wants. Does that sound like the 1930s to you? Because it sounds like the 1930s to me.

I’m only half-joking.

Thanks for reading. Comments? Questions? Insults? Have at it.

Disclosure: I am/we are long AAPL, UVXY. 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.