- Super Tuesday's premature excitement commenced via an emergency Fed rate cut due to coronavirus fears, failing to assuage investors' worries.
- As additional measures of drastic monetary policy are taken to combat supply shocks, data suggests the public is likely to restrict movement and in turn, precipitate a slump in demand.
- Consequently, this may roll over into transports and could present a good opportunity to sell the iShares Transportation Average ETF.
The Federal Reserve just put the pedal to the metal via an emergency rate cut. Yields on the benchmark 10-year Treasury note fell below 1% for the first time ever. Other financial markets such as industrials recently made history as well. Investors continue to reassess risks as stability is nowhere to be seen.
On February 27, the Dow Jones Industrial Average (NYSEARCA:DIA), an index that tracks 30 large publicly-owned companies trading on the NYSE and the NASDAQ, succumbed to its largest one-day drop in history per points basis - a decline of 1190.95. The next Monday on March 2, the index realized the largest one-day gain in the same terms - an increase of 1,293.96 points. The next day, with the advent of the Fed's emergency rate cut, the index had stumbled once again - nearly 800 points. So long as the Fed continues spooking the market, I expect this type of behavior to continue in the near-term pari passu.
As such, actual volatility was and will continue to be ripe for the picking due to implied volatility expansions amidst the increasing uncertainty - I forecasted such two weeks ago, explaining the high likelihood for a dead-cat bounce in both the Shenzhen and Shanghai Composites as well as the high probability that this would precede similar declines in U.S. indices. Moreover, I elaborated as to how certain knock-on effects would transfer into a spike in the VIX and in turn, an attractive risk-to-reward opportunity for VXX (BATS:VXX). The timing was very much luck, as much as I want to say it was purely the analysis.
Although it may be too late to take advantage of the 80%+ price appreciation in the above-mentioned VXX call, going bearish with transports through the iShares Transportation Average ETF (BATS:IYT) seems like an ideal trade for the upcoming weeks, albeit with more of a probability of profit with less reward than the VXX call. Just as the broader market indices rolled over from China into the United States causing a spike in the VIX, a supply-cum-demand shortage from China and abroad may roll over to declines in domestic transports.
Throughout this thesis - which opens with a broad analysis of historical monetary policy and explains its interconnectedness to yield curves - I will detail the spillover effects that Fed policy may have on both production (supply) and consumption (demand) within a historical framework of the business cycle. Later, the bearish thesis is encapsulated with a more granular approach per leading and lagging indicators such as PMI and the price action of IYT's constituents, respectively. The totality serves as an explanation as to why declines in the transport sector may be unavoidable.
The Fed's Drastic Measures: Too Little Too Late
As Harvard economist Ken Rogoff eloquently describes in his book This Time Is Different: Eight Centuries of Financial Folly, the experts who clamor about how old rules no longer apply to current circumstances and explain how recent events bear little resemblance to past disasters - they are the individuals who are consistently proven wrong. At present, a case study is in the making that could further solidify Rogoff's views regarding the psychological aspects of financial history.
The Fed's abrupt measures may be too little, too late. The central bank has historically realized a negligible impact regarding near-term support for the market after enacting similar emergency measures that were taken this past week. Those opining to buy the dip and suggesting we are in recovery mode would be wise to analyze the data more closely.
As the Dow closed nearly 800 points lower after the surprise half-point rate cut, the economic outlook remains bleak - at least for the near term. Although emergency open market operations are bona fide attempts to quell impending stagnation and slowing growth, these measures seem to have little to no meaningful impact as time passes. Moreover, these emergency cuts have only occurred during severe shocks to the system and the psychological effects thereafter have not been positive for Mr. Market. For reference, recent emergency rate cuts by the Fed and the resulting percentage change in the S&P 500 (NYSEARCA:SPY) are detailed in the following table:
In the table, every emergency rate cut resulted in positive gains during the following month - with the exception of the Lehman Brothers collapse during the onset of the 2008 Global Financial Crisis. Moreover, these cuts have led to an average increase of 2.85% in the S&P 500. However more importantly, after a three-month, six-month, and one-year period the index continually slowed to an average increase of 1.42%, - 1.47%, and -8.87%, respectively.
During each of the times in which the Fed and the Bank of Canada simultaneously cut rates - bubbles have burst and financial panics have ensued. This occurred during the tech bubble and Lehman Brothers debacle in 2001 and 2008, respectively. It transpired one other time - earlier last week.
Since 1998, five of the last seven instances of emergency rate cuts have resulted in the Dow Jones Industrial Average declining the following year. It is highly probable the U.S. economy is close to a similar inflection point. The recent yield curve activity solidifies this notion.
According to a June 1996 study by the Federal Reserve Bank of New York,
The yield curve — specifically, the spread between the interest rates on the 10-year Treasury note and the 3-month Treasury bill — is a valuable forecasting tool. It is simple to use and significantly outperforms other financial and macroeconomic indicators in predicting recessions two to six quarters ahead.
Likewise, the Federal Reserve Bank of Cleveland proclaimed in a similar study,
The slope of the yield curve — the difference between the yields on short-term and long-term maturity bonds — has achieved some notoriety as a simple forecaster of economic growth. The rule of thumb is that an inverted yield curve (short rates above long rates) indicates a recession in about a year, and yield curve inversions have preceded each of the last seven recessions. One of the recessions predicted by the yield curve was the most recent one.
The chart below exhibits this spread alongside YoY GDP since the last recession.
Based on the last seven recessions mentioned in the Federal Reserve Bank of Cleveland's study, these downturns have occurred roughly within a year's time. The most recent inversion leaves two more months until a year has passed. Below is a bulleted list detailing the economic calamities that followed once these interest rate inversions were realized:
- The Iran/Energy Crisis Recession: (July 1981 - November 1982)
- The Gulf War Recession: (July 1990 - March 1991)
- Long-Term Capital Management/Russian Ruble Crisis (August 1998)
- The 9/11 Recession: (March 2001 - November 2001)
- The 2007-08 Financial Crisis: (2007-2009)
- Coronavirus Supply-Cum-Demand Recession: (To be determined?)
The inversions that occurred around the tech bubble and the financial crisis of 2008 are easily recognizable in the chart below. The latest inversion occurring at the tail end of 2019 is just as glaring. Looking at the most recent three-month and 10-year yield curve inversion should give one pause if they remain full of optimism. After all, there have only been two false positives when these two debt instruments have inverted - an inversion in late 1966 and a very flat curve in late 1998 during the Russian ruble crisis.
Taking all of this into consideration, let's remember that the U.S. economy is also in the midst of the longest expansion without undergoing a recession in the country's history. The Fed generally does not enact or even consider multiple rate cuts during expansions. It wouldn't be crazy to suggest stagflation is a possibility. This is due to expectations of rising inflation, increased unemployment, and declining demand for goods and services as the business cycle turns over. Below are the probabilities for future rate cuts according to the CME FedWatch Tool as of March 4, 2020.
In summary, monetary policy isn’t a very useful tool to fight the current economic problems stemming from the coronavirus epidemic nor is lowering rates to fix supply-chain problems faced by companies reliant on Chinese goods. These measures are never ahead of the curve and seldom improve the underlying issues at play. More important, the current economy is in the midst of a problem larger than the aforementioned issues - one of a systemic declining business cycle. Signs can already be seen in the movement of goods, discussed in the next section.
Lower Production Begets Lower Transport Activity
The advent of this virus, regardless of whether it is being blown out of proportion, has ultimately had a disastrous impact on the global economy. As it spread out from Wuhan, production figures in China have seen record lows. There is good reason to believe similar stagnation and declining activity will occur in the United States and elsewhere.
This notion is derived from recent prints in PMI data alongside supplemental information coming from trucking, railroad, and marine industry activity. International financial organizations are also becoming more vocal with time. The IMF managing director proclaimed that global output gains will be its weakest since 2008-2009. Furthermore, it's the biggest setback for the travel industry since the 9/11 terrorist attacks. A couple of data points to to give one a frame of reference:
- China's Caixin services PMI tumbled to 26.5 in February, the lowest on record, slipping into contractionary territory for the first time since the survey started.
- Hong Kong's IHS Markit PMI realized the steepest downturn since at least 1998 when the survey began. The previous record low at 38.1 was posted during the 2003 SARS epidemic.
- U.S. ISM imports fall to the lowest levels seen since the 2008 Global Financial Crisis.
- Heavy Truck Sales in the United States seem to have peaked with 6M actual change declining to levels not seen outside of a recession since 1967.
- The Association of American Railroads reports that total U.S. carload traffic for the first two months of 2020 was 2,092,817 carloads, down 6.5%.
China's Caixin Manufacturing PMI fell to a survey low as seen in the left chart below. Output, new orders, and employment dropped at survey-record rates. You can read the IHS Markit report here. Additionally, Caixin is reporting that "local companies and officials are fraudulently boosting electricity consumption and other metrics in order to meet tough new back-to-work targets as the spread of Covid-19 in China wanes." Unfortunately, this is not a new or innovative tactic and is hardly an unbelievable exposé, as unethical Chinese firms have methodically done this for quite some time in order to juice growth statistics and satisfy local government officials.
The IHS Markit Hong Kong PMI sank to its lowest in survey history as seen in the right chart below. The full report can be read here. It printed 33.1 in February, down from 46.8 in January, signaling the steepest deterioration in private sector conditions since the survey started in 1998. The latest data are now broadly indicative of GDP contracting at an annual rate of nearly 5.0%, suggesting that Hong Kong is heading into a steeper recession.
Although this investment thesis partly expounds upon spillover effects derived from supply chain conundrums, declining demand from manufacturer imports has already been in place for some time pre-Coronavirus - and the U.S. already looks to be in dire straits. The ISM Imports Index has fallen to the lowest level since 2008. This index registered 42.6% in February, which is a decrease of 8.7 percentage points compared to 51.3% reported for the month of January.
From the official ISM report:
Imports returned to contraction territory, with the index recording its weakest performance since May 2009, when it recorded 38.5 %. Respondents noted the combined effects of the Lunar New Year as well as the coronavirus. Lower imports will continue as the effects of the virus are better understood.
The decline in these imports will certainly have knock-on effects in the transport markets. The U.S. Heavy Truck Sales actual change of 6 million just declined to new cycle lows. Current levels have never been seen outside of a recession since 1967. Taking a bird's eye view over a longer time frame, these sales seem to have peaked and are in the process of reverting downward, as they have always done since records were stored.
The Association of American Railroads, an industry trade group representing the major freight railroads of North America, just released its February report on March 4. To be frank, 2020 is off to an underwhelming start and unquantifiable uncertainty. AAR Senior Vice President John Gray stated:
There’s a huge amount of uncertainty regarding the coronavirus situation, but to date, the impact on U.S. rail traffic appears limited. That could change if, for example, sharp declines projected by U.S. ports occur in the weeks ahead.
Total U.S. carload traffic for the first two months of 2020 was 2,092,817 carloads, down 6.5%, or 146,168 carloads, from the same period last year. Intermodal units accounted for 2,242,763 units, down 7%, or 167,978 containers and trailers, from last year. Total combined U.S. traffic for the first nine weeks of 2020 was 4,335,580 carloads and intermodal units, a decrease of 6.8% compared to last year.
Supply chain disruptions related directly or indirectly to the coronavirus may have played some unquantifiable role in the decline in U.S. intermodal volumes in February, but intermodal has been falling for more than a year. The headwinds facing railroads that pre-date the virus include lingering trade impacts and economic uncertainty; severe winter weather in parts of the country; blockades in Canada that shut down rail traffic there and impacted domestic traffic too.
It seems that Mr. Gray's worries pertaining to ports are coming to fruition.
According to the American Association of Port Authorities, U.S. ports are expected to handle approximately 20% less cargo this quarter. This is in large part due to fewer shipments from China. "Due to the coronavirus outbreak, cargo volumes at many U.S. ports during the first quarter of 2020 may be down by 20% or more compared to 2019." A recent Wall Street Journal article explains that maritime operators are facing their biggest challenge since the 2009 financial crisis.
Alphaliner, the worldwide reference base for liner shipping, reported last week, "over the past three weeks, some 30% to 60% of weekly outbound capacity has been withdrawn from the Asia-Europe and Transpacific trade, as well as from intra-regional routes". Even more shocking, a record 2 million containers of shipping capacity has been idled. That amounts to more than the 1.6 million TEUs sidelined after South Korea’s Hanjin Shipping Co. collapsed in 2016 or the 1.5 million TEUs of capacity idled in 2009 at the height of the financial crisis.
More specifically, volumes from China sank in February as factory shutdowns crippled industrial production. Operators canceled 60 transpacific sailings to Long Beach and Los Angeles, CA. In total, more than 110 had been canceled that were scheduled to arrive in North America in that same month. On average, there are 200 sailings of container ships that transit across the Pacific each month. About 95% of the world’s manufactured goods are transported in shipping containers.
This accumulation of data regarding the declines in industrial production, truck, rail, and marine data gives reason to be cautiously pessimistic for the broader transport sector.
IYT Composition and Trade Setup
The iShares Transportation Average ETF seeks to track the investment results of an index composed of U.S. equities in the transportation sector. More specifically, its benchmark is the Dow Jones Transportation Average Index (DJT). As the broader industries were analyzed in the above sections, a closer look into the companies which comprise this ETF will be analyzed in hereafter.
This ETF's targeted access to domestic transportation stocks with exposure to rail, air, and trucking companies make the U.S.-domiciled BlackRock fund exposed to all of the aforementioned mediums of travel. The fund comprises 25 holdings and is categorized by weight in descending order below:
Norfolk Southern Corporation (NSC) is the largest component in IYT with a weighting of 11.70%. Many classify this stock as one with an economic moat, which is understandable given the abundant traffic it handles to power utilities alongside its oligopolistic business model. CSX Corp. (CSX) operates on the East Coast alongside NSC, which itself comprises 4.53% of IYT. Union Pacific Corporation (UNP) and Burlington Northern Santa Fe Corporation both operate on the West Coast with Union Pacific comprising 10.29% of the holding - the second-highest weighting. Kansas City Southern (KSU), the third-highest-weighted company in the ETF, is mainly operational in the Midwest. YTD, only KSU, is treading in positive territory - barely. I expect this rail company to turn negative alongside its peers in the not too distant future.
Airline companies, both freight and passenger, have a combined 40% exposure to the fund. The airline components alongside the YTD performances are charted directly above. Due to the contagion of the virus and recent announcements of venues and conferences shutting, I believe the damage done in the foreseeable future is self-explanatory.
Depressed bookings for all of these companies are now forecasted to extend into peak summer. CEO Oscar Munoz and President Scott Kirby of United Airlines (UAL) recently told staff the company will cut domestic capacity by 10% in April from its previous plan and international flying by 20%. These cuts could extend into May.
Regarding the trade, the setup for IYT has a 1:2 risk-to-reward ratio. It would be prudent to wait until the price action on IYT confirms a break to the downside below the ascending channel near the current price level. This trendline of support has been in place since the first round of quantitative easing back in November 2008. Breaking through this barrier will give investors the confidence they need to put on a short. The take-profit price is $125 and if declines do not come to fruition as planned, a prudent stop loss at $180 seems reasonable given the current environment.
Emergency monetary policy is a lagging indicator of the current economic environment. More often than not, these measures came before very slow growth periods and outright recessionary stages of the business cycle. Furthermore, they have done little to boost stocks in our current stage of the debt cycle. Yield curve inversions are a vital indicator of secular declines as well. We are currently at the inflection points of both the aforementioned.
As industrial capacity and production slow, transports may be negatively impacted across all subsectors. These subsectors include air, rail, marine, and land. Although most supply chain disruptions are unquantifiable at the moment due to recent shocks still making the trek across the Pacific, a typhoon of data will be unleashed soon. These figures will most likely be extremely unappealing for investors and as a result, many may head for the doors and sell in order to favor safer assets such as utilities, gold, et cetera.
Fleeing investors who once saw transports as stable stocks that had great business models with economic moats may not see these companies in the same light during the upcoming weeks. In turn, the constituents making up IYT may decline and retrace back to the .50 Fibonacci level seen in 2016. The world is on the precipice of a downturn as many indicators suggest and as Rogoff would most likely opine, the four most dangerous words in the English language are "this time is different".
This article was written by
Analyst’s Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in IYT over 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.
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