Investing Environment Review and Outlook

Investing Environment Review and Outlook – Volume 27

This month there is much to discuss: equity sentiment extremes, a bond rating improvement, the yield curve inversion and the trade war. However, recent economic releases like the May ISM index confirm moderate to slow growth and no inflation pressure. A good environment for stocks. The equity rating remains a bullish 5. We are raising the bond rating to a 2 from a 1. Gold and commodity ratings remain at 4.

Equity Sentiment Extreme

After the 6% S&P 500 decline in May, equity sentiment shifted dramatically from a majority of groups that were optimistic (on May 7th) to 7 of 8 groups pessimistic on June 4th. This kind of sentiment move is meaningfully bullish if fundamental market conditions are positive as they are now. They are also normal pull backs following prior severe liquidations like we saw in December. These investor groups have likely cut their allocation to stocks, building up cash to drive the next rally.

Economic Outlook Weaker: Bond Rating +1 to 2

Our economic outlook weakened in May to 38 reading due to weaker commodities like copper, lower interest rates and lower stock prices. Following this signal, the ISM manufacturing report, the best coincident U.S. economic indicator, declined slightly to 51.2 in May, a level consistent with slow to moderate growth. In this environment, it is less likely long rates will rise and bond prices will decline. As a result, we are raising the long-term bond rating to a 2 from a 1 last month. If economic indicators remain weak, we will raise the rating further since it would increase the odds interest rates will continue their decline.
The 10-year yield is down 1.2% in just 6 months as trade war rhetoric focused attention on an old story, the slowing economy. There are now 3 cuts expected in 2019, an extreme view considering economic indicators like the ISM index and Consumer Confidence are not signaling a recession. If however, economic outlook and inflation indicators continue deteriorating, we will move the bond rating further.

Yield Curve Inversion

The 10-year yield declined 0.20% below the 3-month yield in May, a condition known as a yield curve inversion. It only happens 10% of the time because normally long term yields are higher than short term rates to compensate for the uncertainty. For stocks it becomes meaningful when the inversion is more severe. For instance, when the 10-year yield was more than 50 bps below the 3-month yield, the S&P 500 returned -11% since 1962. That compares to a +11% return when the curve was inverted but less than 50 bps as it is now. A bigger inversion signals the Fed is tight by holding short term rates too high relative to the 10-year yield, and a tight Fed is negative for stocks and the economy. For now though, it is not extreme, and 2% inflation means the Fed has room to ease as needed. In addition, our inflation outlook model is neutral, showing no pipeline pressure on inflation yet. In 3 of the 4 most recent cases, the yield curve inversion was followed by the Fed cutting rates.

Trade War Interest Fading

According to Google Trends, interest in the Trade War is fading, similar to prior spikes in April and July of last year. Political events like this are nearly impossible to use as investment data points because in a single Tweet they can and do change without warning. However, trade is clearly a key component of the world economy. According to the World Bank, world trade accounted for 58% of world GDP in 2017 up from 38% in 1990 and 26% in 1970. This implies a trade war could significantly cut growth, and there is evidence it is already affecting the economy. For instance, U.S. imports from China declined 18% Y/Y in March, down from 10% Y/Y growth last year and close to the 2008 decline. However, total imports to the U.S., a good coincident economic indicator, were ok at 0.2% Y/Y. As recently as 2016 total imports were worse, down 10% Y/Y. So far, trade declines are consistent with a mid-cycle slow down.

1906 Global Tariffs

For historical perspective, this chart shows that in 1906 tariffs over 20% (dark green) were the norm globally.

Despite the potential headwinds of a prolonged trade war with China and the inversion of the yield curve, conditions for equities remain bullish. We currently remain less optimistic on the prospect of long-term bonds with a 2 rating. If however economic indicators remain weak, we will raise our rating further since it would increase the odds interest rates will continue their decline.

 

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