In my previous newsletter excerpt that I posted here on Seeking Alpha last month, I discussed how U.S. recession risk was rising, but still by no means certain in the near term. This is another excerpt for October.
- The yield curve remains inverted (particularly, 10-year minus 3-month)
- The rate of U.S. and global GDP growth is slowing but still positive
- Construction spending has entered a mild contraction
- The manufacturing sector has entered a mild contraction
The year-over-year construction spending and industrial production dual chart gives a quick snapshot of what some of these cyclical “physical stuff” sectors are doing lately:
Chart Source: St. Louis Fed
Construction spending in the U.S. continues to be in a mild contraction for the first time since it went positive after the subprime mortgage crisis, while year-over-year growth in industrial production has touched zero for the first time since it had a big dip in 2016.
The economy is still being held up by consumer credit, consumer spending, and large government deficits acting as a stimulus. Services sectors like healthcare and education are still expansionary.
We have a few new data points since the previous newsletter. Manufacturing has continued to decline based on ISM manufacturing data (the worst reading in a decade), payroll growth is starting to noticeably slow down, and auto sales from many automakers are in a decline. ISM non-manufacturing data came in softer than expected, and the latest jobs report showed soft-but-stable results with low unemployment, but potentially setting up a bottom.
Heavy truck sales are down in the United States this past month, which is one of the metrics I watch, because it tends to be a leading recession indicator. Auto sales more broadly have been tough worldwide.
Manufacturing tends to be one of those all-or-nothing worldwide issues, because it’s so interconnected. One country can have a construction boom while another country has a construction contraction, because they are not very correlated and can thrive independently. With the global manufacturing industry, however, the supply chains are so interconnected and they often rise or fall somewhat in unison. A slowdown in a German auto plant means they buy fewer circuits from Taiwan, which means they buy fewer semiconductor components from Korea, which means they spend less on manufacturing automation equipment from the United States, which means they buy fewer cabling harnesses Mexico, and that butterfly effect cascades through the global supply chain and impacts a couple dozen countries.
During the past three weeks, the United Auto Workers union has been striking against General Motors. The last time they went on strike was late 2007, literally within days of the previous stock market top, and shortly before the 2008 recession. It’s an anecdotal contrarian indicator.
When the economy is weak, workers generally don’t feel confident to push for more, and feel content to have a job when many people do not. When times seem good, unemployment is low, and corporations are reporting strong profits and margins, workers often start to demand a piece of this success. In my previous newsletter, I pointed out that U.S. corporate profit margins are near a record peak, and that such a state has more downside risk than upside potential as we move forward.
Some companies preemptively handle this cycle better than others. In my recent e-book, StockDelver, I used the example of Nucor (NUE), which has historically maintained a strong reputation of being one of the better places to work for in the challenging steel industry. When times are tough, they slash executive pay and cut hours to employees, but try not to perform lay-offs. When times are good, they share profits with workers. This “we’re all in this together” culture has led to low employee turnover, high employee morale and experience levels, and high job satisfaction ratings. Nucor has a 4.0 rating on Glassdoor, for example, compared to a 2.9 rating for U.S. Steel (X), and Nucor's CEO approval is twice as high.
And, well, this:
Lately, a lot of big flashy IPOs have been crushed. In my April newsletter issue, I pointed out that the percentage of initial public offerings that are unprofitable rivals that of the 2000 dotcom bubble and that some of their valuations were out of hand, and listed that as one of my two key concerns for the month. I used Uber (UBER) and Lyft (LYFT) as examples, and they are down significantly since then.
Silicon Valley and the rest of the U.S. venture capital market, heavily financed by Japan’s SoftBank (OTCPK:SFTBY) (which also includes money from Saudi Arabia), has been in its own world in recent years where valuations don’t matter, companies don’t even need a clear outline towards profitability, and every type of business, whether it’s a fitness equipment maker (PTON) or a real estate company is re-branded as a social media tech startup.
The poster child for this era is turning out to be WeWork. For years, they expanded worldwide thanks to external investment, and became a highly-valued startup darling that provides co-working space, became valued privately at $47 billion, and were estimated by major investment banks to IPO with a valuation of over $60 billion. When they filed to do an IPO a few weeks ago, they faced widespread criticism as analysts dug into the details.
Despite being a real estate company at its core, WeWork’s paperwork was filled with phrases like “our mission is to elevate the world’s consciousness” and displayed an odd adoration of its CEO with 169 references to him in the filings. The business structure was shady, and there were multiple examples of potential conflicts of interest by the CEO. The company was burning through cash at an accelerating rate. Investors started to value the upcoming IPO as low as $10 billion, and sinking from there. The result was so bad that the CEO was ousted from the company and the IPO was cancelled.
Basically, once the company’s numbers and executive culture were displayed for the world to see, it crashed and burned. And without an injection of capital from the expected IPO, they are now likely turning to large-scale layoffs. That’s how fragile companies are when they rely on external funding with no clear path toward profitability.
Some of these failed IPOs are another log on the recession risk bonfire, because now bondholders are at risk, employees are at risk, investors are starting to tone down their enthusiasm, etc. With manufacturing down, construction down, and unicorn IPOs down, that leaves U.S. consumers holding up the U.S. economy like Atlas.
I wrote an article here on Seeking Alpha about why the U.S. consumer is more fragile than people realize. I recommend checking that out. The short version is that the U.S. consumer has record high consumer credit as a percentage of GDP, low median net worth, and problems underneath the headline low unemployment rate that labor participation metrics show more clearly. It’s a risky foundation to rely on. Atlas is getting tired.
For me, the most important metrics remaining to keep an eye on are initial jobless claims and consequentially the unemployment rate. If unemployment starts going up in the coming months, that’ll be one of the last warning signs for a likely recession rather than just a slowdown.
Here’s the unemployment rate (blue line), the Wilshire stock market index (red line), and recessions shaded in gray:
Chart Source: St. Louis Fed
The difference between economic slowdowns and recessions is partially one of magnitude, but particularly whether the more cyclical parts of the economy get deep enough to pull down the overall employment rate and create a vicious cycle where those unemployed people spend less, leading to more business declines and layoffs.
I’ve been mildly bearish on the U.S. stock market for a couple years now after being bullish for the better part of the past decade, and we’ve indeed had flat and choppy U.S. stock market performance for nearly two years, with better performance from defensive companies, bonds, and precious metals. I partially bought the stock market sell-off during the fourth quarter of 2018, and am looking to buy again on further weakness.
One of the most interesting charts I came across this month was from Pervalle Global. They mapped their proprietary measure of global liquidity (blue line) onto year-over-year S&P 500 returns (black line) with a 12-14 month lead time, and they see a substantial probability of a sharp-sell off into year’s end:
Chart Source: Teddy Vallee, Pervalle Global
The horizontal axis is for liquidity, so adding 12-14 months to that places a potential S&P 500 sell-off in this fourth quarter of 2019 followed by a potential rebound during the first half of 2020.
That doesn’t mean it will certainly play out like this. However, with dollar tightness across the world, some troublesome technical analysis indicators, and the possibility for weak third-quarter earnings reports later this month, I wouldn’t be surprised to see another sharp sell-off like we saw during the fourth quarter of 2018.
I have cash-equivalents on standby and would be ready to pounce on any equity sell-offs if they occur, especially for global opportunities but also within the U.S. stock market. We’ll see.
In particular, I’d like to add some exposure to the SPDR Small Cap Value ETF (SLYV), which is already down 17% from its 2018 highs (small caps in general never recovered to new highs in 2019 like the S&P 500 did). I added it to my "best ETFs to buy and hold" list this year. If I can start dollar-cost averaging into it when it’s down 25% or so from its highs, I’d be happy to.
Longtime readers know that I don’t go “all in” or “all out” of defensive or aggressive assets trying to time the market. Many people write to me saying they went all to cash at some point (many of them back during the slowdown in 2016) and are looking to get back in at some point.
For my low-turnover model portfolio, and for most people who are not active traders in general, I often recommend a “spectrum” approach where, at any given time, I am positioned somewhere on the spectrum between purely aggressive and purely defensive. Right now, I’m firmly on the defensive side, which means although I have substantial exposure to equities, I also have substantial cash-equivalents, precious metals, and so forth.
This spectrum approach of dialing portfolio risk up or down once in a while compared to your baseline allocation, according to market conditions, can work well for disciplined investors, whether you’re an individual stock investor or a relatively passive index investor.
Keep Your Eye on the Dollar
Whether you measure it with year-over-year GDP growth or PMI reports, this decade-long business expansion cycle has had three “mini-cycles” within it, where U.S. and global economic growth accelerated and decelerated, but remained in a generally expansionary manner with no employment declines. This chart visualizes the three mini-cycles rather well:
Chart Source: Trading Economics
The first slowdown since recovering from the recession in 2009 occurred in 2012, and the big event at the time was the European sovereign debt crisis.
After a period of growth, the global economy slowed again in 2015 when China started deleveraging its corporate debt bubble, commodity prices dropped, and so forth. China reversed course and stimulated into 2016, helping to give the world another bullish cycle, but is now deleveraging again. Tax cuts in the U.S. also helped push up U.S. equity prices throughout this cycle.
We’re now in the third slowdown, which is shaping up to be the deepest slowdown of the three and might be the one to become an outright recession. China really needs to deleverage its corporate sector, and the trade war is putting further pressure on them, so there are still no signs of a major stimulus from them.
U.S. Bank Liquidity
The biggest subject I’ve been monitoring during this month has been U.S. dollar liquidity, because one way or another this will likely have a significant impact on forward returns for multiple asset classes over time.
In particular, whether this period ends up being just another dip followed by a fourth growth cycle, or an outright recession, may depend in significant part on the strength of the dollar and the underlying liquidity for it.
Investors that have been watching the financial news may know that the overnight bank lending system in the U.S. suddenly broke down in mid-September. Cash was in short supply between banks, and the overnight lending rate spiked to levels not seen since 2008.
Chart Source: Trading Economics
The Federal Reserve has responded by injecting cash into the banking system in exchange for collateral every day for the past three weeks, with plans to continue doing so at least into November.
I wrote a few articles on this subject with The Most Crowded Trade being the most detailed piece.
During my previous newsletter, I discussed how U.S. federal deficits are large and accelerating at 5% of GDP per year, and are quite an outlier compared to many other countries at the current time. Evidence shows, as I described in the linked article above about the most crowded trade, that excessive issuance of U.S. T-bills has soaked up all of the available liquidity in the U.S. banking system until the banks ran into regulatory cash limits.
Large banks have run out of extra cash and are stuffed with record high levels of T-bills as a percentage of total assets, in other words.
Although I’ve been cautioning about the U.S. deficit at multiple points this year (which indeed is “different this time” in tangible ways), my base case was that it would start to matter in an acute sense during the next recession. The bank liquidity crunch last month suggests that the issue is occurring already, ahead of schedule.
The Federal Reserve now is in the position of supplying liquidity (essentially monetizing U.S. federal deficits), potentially for the foreseeable future, which I suggest will likely level off the current dollar strengthening cycle and eventually weaken it as we move into next year or so.
Why Dollar Strength Matters
Chart Source: St. Louis Fed
Dollar strength is a weird thing because causality goes both ways. Historically, investors flee to the dollar as a safe haven when global growth slows. On the other hand, a strong or weak dollar can accelerate or decelerate global growth rates, respectively.
This is partially because emerging markets (EEM) represent the majority of global growth in recent years, and many of them have high dollar-denominated external debt. Organizations that provide financing to emerging markets rarely do so in local currency of that nation, and instead prefer to do so in U.S. dollars.
Since emerging market corporations and governments make their income primarily in local currency, but a big portion of their liabilities are in dollars, it can cause significant problems and volatility for them. When the dollar strengthens relative to their local currency, it effectively increases their debts in local currency terms and forces deleveraging and slower growth. When the dollar weakens, it’s like a partial debt jubilee, allowing for faster re-investment and economic expansion.
This hits emerging markets the hardest, but then spills over into developed countries because many of them rely on selling products and services to emerging markets for a big portion of their growth. The S&P 500, for example, receives over 40% of its revenue from abroad. Some is from Europe and Japan, and some is from emerging markets. A strong dollar puts pressure on emerging market growth, but then also means that all of the foreign currencies that S&P 500 companies receive translate into fewer dollars.
Emerging markets, emphasizing China in particular, but also India and others, are representing a bigger and bigger share of the global economic pie over time. As the second largest economy in the world, the biggest importer of raw materials, and a major trading partner with many countries, whether China is stimulating or deleveraging its economy affects growth rates worldwide.
Chart Source: Visual Capitalist
My base case going forward is that, since total liquidity in the U.S. banking system has dried up and the Federal Reserve is forced to provide liquidity injections (and eventually a fourth round of quantitative easing), we’re likely to see the strong dollar level off and probably start to weaken over the next year.
This means that, as 2020 comes, or perhaps 2021 if the timing occurs more slowly than my base case, I believe that being globally diversified will be of significant importance, and I have a positive view towards select emerging markets after the sell-off that we might get later this year. I also continue to view precious metals as offering strong risk/reward potential.
Model Portfolio Update
I started a real-money model portfolio in September 2018 with $10k of new capital, and I put an additional $1k into it before each newsletter issue, totaling $19k so far.
Last month when I posted my newsletter excerpt here, I shared this portfolio and reviewed its returns for its first year of existence.
It’s by far my smallest account, but the goal is for the portfolio to be accessible and to show readers my best representation of where I think value is in the market. It’s a low-turnover multi-asset globally diversified portfolio.
After adding $1,000 in fresh capital in October, here’s the portfolio today:
Here is the full list of holdings within those various sections:
Changes since the previous issue:
- Added some extra money into defensive segments (cash, bonds, and precious metals).
- Replaced Aflac (AFL) with Johnson and Johnson (JNJ) in the dividend segment.
- Tweaked the weighting of the international equity segment a bit.
- Added Rio Tinto (RIO) and Total S.A. (TOT) to the commodity segment.
- Switched to the Aberdeen Physical Gold ETF (SGOL) instead of the iShares version (IAU).
Although nothing is for certain, market risks are elevated at the moment and could get rough during this quarter, so make sure you know what you own and that you're comfortable holding it through periods of volatility. Look for bargains and stick to your process.
Disclosure: I am/we are long JNJ, RIO, TOT, SGOL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am long all securities shown in the model portfolio.