Time to Put on the Green Eye Shades

By Aline Wealth Management on March 28, 2019

And not because its spring (and just past St Patrick’s Day). The term “green-eye shades” refers to the more studious members of the capital markets—those who scour over accounting reports and “worse case scenarios,” namely the cadre of analysts in the bond market.  Unlike their equity brethren, this lot is much less likely to be swayed by the daily noise of markets—they take a longer-term view, one much more focused on macroeconomics. Therefore, bond market investors are more likely to see the turning points of the economy than equity investors (who are more likely to get caught up in the momentum of the day). That is why the action of the bond market is so important for investors. It often serves as a clue to the economic conditions going forward.

One of the bond market’s favorite recession warning indicators is the inverted yield spread. This occurs when short term interest rates go above the 10-year Treasury bond yield—hence “inverting” the curve. In this environment bond investors are saying to the Fed—“You tightened too much—the economy is slowing too much”—and by buying bonds in the open market they have “forced” yields lower than the short end yields (which are controlled by monetary policy and the Fed). In June 2018, the St Louis Fed stated that the yield curve is one of the few “reliable predictors of a business recession” and showed the lag from inversion to recession to be 10 months.  By the way, historically the yield curve inversion indicator has an 85% success rate (though inverting for a few days, even weeks, may not be statistically significant).

But, you may say, the Fed (and many economists that work for Wall Street firms) are saying that we are not in nor heading to a recession.  Okay, I hear that also but, speaking of the Fed—as the following table (from our friends at Gluskin Sheff) indicates—the Fed does not have the best record of calling for recessions—in fact, it is downright awful.

Furthermore, as we learn from Gluskin Sheff, “the NY Fed recession risk model, even with the ebullience in credit and equity markets, pegged the R-word odds at 24.6% in February, up from 23.6% in January 9% a year ago and 4% 2 years ago. And it is at the same level it was in July 2008 when the consensus call was that the economy was in a soft landing.”

So what are the economic tea-leaves telling us as of late? New homes sales, after peaking in November were lower by nearly 15% in January. Orders for durable goods (x-transportation), a measure of investment spending, fell 0.2% earlier this year. US manufacturing output fell in February for the 2^nd consecutive month. The core inflation reading rose by just 2.1% over the last year despite many pundits views for higher inflation. Globally it is even worse—with German PMI data cratering last month to 44.7 vs an expectation of 48 (a sustained reading below 50 means that the economy is contracting). Despite somewhat dire economic data the ECB—the erstwhile champion of low (even negative!) rates stated that they are done—will no longer do anything to boost economic growth. Italy is already in a recession and the UK is playing with Brexit fire. Then there are increasing signs of a slowdown in China—leaders there lowered their economic growth expectations for 2019 to a range of 6-6.5%, from 6.8% in 2018 (which was the slowest in 28 years).

A cauldron of slower growth expectations but what has the stock market done since late last year?  Sharpley higher—a big bounce of the Christmas Eve lows. Now doesn’t that seem like a little bit of a disconnect? Clearly, the optimism that the stock investors have shown YTD is not shared globally nor by US bond investors (and typically, when it comes to pivot points in the economy, the green-eye shade guys have it hands down).

Add to this the fact that we have enjoyed a wonderful market period for nearly 10 years—imbibing heavy from the trough of low-interest rates and several rounds of quantitative easing (QE) on a global scale—an experiment whose unintended consequences may not have, yet, shown themselves.  Structural excesses may be present especially given the huge amount of corporate leverage during the cycle. To wit:

• The chart below shows current corporate leverage levels and their relationship to economic recessions.
• Since 2007, high yield debt has ballooned near 120%
• Over the last 5 years, the amount of debt issued (>$6 Trillion) for investment-grade borrowers (with little protection in the form of covenants for investors) represents 60% more than what was issued in the 5 years prior to the GFC.

Now onto stocks.  At this point in time, 105 companies in the S&P index have issued EPS guidance for Q1 2019. Of these 105 companies, 77 have issued negative EPS guidance and 28 have issued positive EPS guidance. The percentage of companies issuing negative EPS guidance is 73% (77 out of 105), which is above the five-year average of 70%. So, as the quarter unfolds we will be looking for signs of a slowdown in earnings. We do find a relatively undervalued opportunity in global value stocks.  See the charts below for more data on this topic and stay tuned-in to our blog as we will be watching this area carefully going forward.