It's time again to discuss the economy. Most readers know by now that I do this based on a set of leading indicators that have proven to be able to predict business cycles. In this article, I will discuss what the current economic trend means and why the Fed will soon start to cut rates. All things considered, the conclusion of this article will contain the reasons why my current largest position is cash.
Back in 2018, I started to discuss the potential risks of a growth slowing trend which would hurt cyclical stocks, commodities, and benefit bonds. Back then, it felt like I was a bit early because growth was still at multi-year highs. Unfortunately, the call was right and peak growth quickly turned into growth slowing this year.
Below, you see the leading ISM manufacturing index and the average of my regional manufacturing indicator. An ISM value above 50 indicates growth. A value below 50 does the exact opposite. What we see is that growth had rapidly declined this year. The just-released ISM manufacturing index for the month of May came in at 52.1 which is 0.7 points lower compared to April. This is still 2.1 points above the neutral level, but that's not that important. What matters is the rate of change and the direction of the trend.
As long as the trend is down, investors will continue to price in slower growth. Declines below the 50 level will result in larger funds starting to go from flat to net-short. The graph below shows a comparison between the ratio between industrial stocks and the S&P 500 (orange line) and the ISM manufacturing index (black line). What we see is that traders started to go underweight industrial stocks as soon as growth peaked. That's where the risk/reward for a successful long position is hitting a low. This works also for other cyclical to 'less-cyclical' ratios like basic materials versus utilities or financials versus telecoms.
At this point, it's up to the direction of economic growth to determine whether it makes sense to start buying cyclical stocks again. Personally, I refrained from buying industrials and more basic materials based on the fact that the ISM index did not bottom as I discussed in my previous article.
And with that being said, I think it's a good idea to play it safe. Even though March data came in quite strong, I am waiting for further confirmation before I start to seriously increase my long exposure. For now, I am just happy that the growth slowing trend has taken a break.
Anyhow, what leading indicators tend to do if they are valid is predicting the direction of 'hard' economic indicators. In this case, I like to look at a few common indicators like industrial production, new orders, and retail sales. The graph below shows 2 of them. Both peaked shortly after the ISM manufacturing started to lose steam and are currently at new cycle lows. Well, retail sales growth is close, but industrial production has fallen further to a current growth rate of 0.89%. Retail sales growth is at 2.78%, but there is no denying that the consumer is increasingly starting to feel the pressure.
With all of that being said, one might wonder what we can expect from the Fed. First of all, it is incredibly hard to predict the exact moment the Fed is going to make a move. And to be honest, it's not really important to get the timing right. What matters is the outlook and the understanding of whether rates are too high or too low.
What we see below is the difference between the US 2-year government bond yield and the Federal Reserve fund rate. The 2-year bond is one of the best predictors of turns that indicate either a new hiking or easing cycle. What we see below is that the Fed should cut rates by almost 60 basis points which roughly indicates that we should expect up to 2 rate cuts this year.
The gold price absolutely loves this and is currently breaking out of a falling wedge. It totally makes sense as a lot of money is trapped in the dollar which seems to be peaking.
And just to make sure, the purpose of this article is not to get you to buy gold. What I want to make clear is that economic growth is continuing to decline. We are getting dangerously close to the neutral ISM 50 level after a steady downtrend since the 2018 growth peak. Simply put, this will increasingly put pressure on the Fed to cut rates. This could happen in the short term or towards the end of the year. Regardless when it will happen, I am sure it will happen.
At this point, I sticking to cash as my largest position. I am going to buy once we see that leading indicator starts to bottom. I expect this could happen in a scenario similar to 2016 when a weakening dollar pushed up commodities and cyclical assets. This could happen again as the dollar could easily start a longer term downtrend. However, I am not yet going all-in on commodities. It's best to keep cash to become bullish again with support from the economy. Even if this means I am missing the perfect entry, I am sure it won't keep me from being long during the largest part of the next rally. It's just unfortunate that I am not sure when leading indicators will bottom. The only thing I know for sure is that the bear case is playing out the way I expected. And it never hurts to stick to cash in such a situation.
Thank you very much for reading my article. Feel free to click on the "Like" button and don't forget to share your opinion in the comment section down below!
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.
Additional disclosure: This article serves the sole purpose of adding value to the research process. Always take care of your own risk management and asset allocation.