The release of the Producer Price Index this morning gives the Fed the green light to lower interest rates yet again and more aggressively if it needs to. The PPI declined 0.3% from the prior month and is now up just 1.4% over the last 12 months – extending to 9 months the length of time it has remained under 2%. 2% is the target inflation within the Fed's mandate and it relates to Personal Consumption Expenditures, not PPI or CPI, but the fact inflation is still benign is an important consideration for markets looking to the Fed to give it a boost while the outlook looks a bit cloudy.
Source: Bureau of Labor Statistics
One of the first indications of inflation is wages. As they start increasing, the higher costs lead to tighter profit margins, which leads to cost cutting measures, often in the form of layoffs. The labor market is arguably still very strong with the unemployment rate reaching its lowest level since 1969, but with hiring slowing, the forecast for the next 3-4 quarters should call for a rising unemployment rate.
Historically when unemployment is low, wages tend to start climbing, which is a harbinger of higher inflation. But so far the inability of the Fed to reach it’s target inflation rate of 2% has been both a source of concern and frustration. The natural rate of unemployment – the rate of unemployment which will always be present even in a healthy economy - has steadily decreased, indicating the lower levels of unemployment can persist for much longer than it has historically before inflation kicks in. Today's PPI release confirms that this might be the case.
What's confusing is that the workers are getting paid more yet the percentage of auto loans going into default is rising. If consumers are getting paid more why are they falling behind on their car loans and is that a potential signal that something is amiss? Auto loans are at a higher level than they were before the last recession, primarily because of the rising costs of automobiles, and the effects of higher tariffs might cause prices to increase even further.
The delinquency rate has risen but isn't yet at a level that is worrisome, but the last two times the indirect auto loan delinquency rate increased, it was followed by a recession about two years later. That seems like an eternity from now but certainly something to keep an eye on.
Auto loan delinquencies have been grinding higher in recent years ( see definition of indirect loans).
What's worrisome about some of these tangential data points despite a strong labor market is that there is a massive reliance on the US consumer for global growth. And it's not just the US economy but the global economy, that gets affected by US consumption. Despite the growth of other economies like China, for example, the old adage that when the US consumer sneezes, the world catches a cold, is still very true.
The US consumer alone makes up 17% of world GDP, which is more than the entire GDP of China, to put that in perspective. It's part of the negotiating leverage that Trump has with China, and as last quarter's GDP data showed, consumption was almost entirely responsible for US GDP growth. It usually makes up around 70% of US GDP but last quarter, it contributed more than 100% of GDP growth. (government spending was only slightly positive, and net exports and investment were net detractors)
If the consumer pulls back spending, it could get ugly.
Too Much Defense?
I have been a big proponent of defensive strategies entering a phase of the business cycle that usually brings higher volatility and sharp pullbacks. Last week's start to the month of October was a good example of that – and we had clients calling asking whether it was time to sell some equities. But at some point, too much defense can be a bad thing, especially if everyone else is piling in as well.
So far in Q3 2019, there has been a higher inflow into Low Vol ETFs than we have had in the last 3 years. Real Estate and Consumer Staples have also led the way from a Sector rotation perspective – two defensive sectors – although investors haven't been all in on defense, as shown by the strong interest in Technology as well.
At some point, inflows drive outperformance of defensive versus cyclical sectors but at extreme levels, performance tends to reverse. I'm still suggesting investors should be more cautious about this market, but I'm also wary of a shift towards cyclicals. Conservative investors should be more concerned with protecting their portfolios, however, than missing out on the next upturn. So timing should be based on your tolerance for risk and your overall investment objective. If you can't afford to lose, stay defensive for longer.
Lack of Optimism could be a self-fulfilling prophecy
Consumer confidence, small business optimism, and CEO confidence are all still relatively high but are in a downward trend. Sometimes, how these three constituents 'feel' and 'think' starts the market moving in that direction.
A drop in consumer confidence could lead to a pullback in spending, whereas declining small business and CEO optimism could lead to a decrease in investment and hiring. Either can be a catalyst for the market to turn.
The NFIB Small Business Optimism Index is down again this month to just above 100. That is still a solid reading, but some of the underlying components for forward looking plans look dire.
The biggest decrease was a 4% suggesting now is a good time to expand, and those with plans to increase employment dropped 3% to 17% - perhaps a leading indicator of a further slowdown in hiring.
The Vistage CEO Confidence Index has historically been a leading indicator of GDP growth as well. The downward trend in the index suggests GDP could be close to zero in coming quarters. The decline in the index isn’t too surprising, considering some CEOs may be in a wait and see mode to see how trade issues are resolved or even to find out who the Democratic candidate will be for the 2020 Presidential election.
The index is now at an 8-year low and some of the underlying details don't give me confidence that GDP growth will get any help from business investment in the near-term – once again relying on the consumer to keep the economy afloat.
The S&P 500 (SPY) is still flirting near all-time highs and the last time I checked it was just 2.5% from it's highest level ever. It has now reached near peak levels twice and both times it has pulled back. It recently crossed back down past the 50 and 100 day averages and is still showing a bearish trend towards the 200-day average at 2845, a level it has touched on three occasions in the last 2 months before recovering. If it breaks through support at that level, I can see the market declining to 2750 – a 5.5% decline – which isn't terrible, but a sell off beyond that level has a lot more to fall.
It’s nice when the preponderance of evidence suggests a consistent trend, but lately, economic indicators have diverged in different directions making it difficult to draw any conclusions with any level of confidence. The heightened sensitivity of markets caused by the trade war hasn’t provided any clarity or consistency either. And when bad news is good news and good news is bad news, the result is unpredictability. All I’m saying with all of this is be careful and be prudent.
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Disclosure: I am/we are long SPY. 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.
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