Recession – Yay or Nay (Quick Update)

MACRO UPDATE

It has been awhile since my last post due to intense preparations that I have put into my CFA examinations this coming June. I’m unabashed to admit that I will be aiming to score in the top 90% -tile on top of passing all levels on one sitting. Moreover, I was also catching up on my “Breaking Into Wall Street” financial modelling module as I seek to improve in properly analyzing individual companies to complement my already proficient skills in macro trading the top-down approach. Nonetheless, I do admit that my macro knowledge can be further improved as in the past few months I have added David F Swensen’s “Pioneering Portfolio Management”, Ed Yardeni’s “Predicting The Markets” and Robert T. McGee’s “Applied Financial Macroeconomics & Investment Strategy” to my reading repertoire.

I have not been trading actively in the last few months but have made some decent money selling calls and put spreads on the VIX, SPY, GLD, TLT while swing trading with outright far OTM calls on the SPY. Q1 2019 has seen a solid run in the US markets while witnessing a transformation of global central banks from a hawk to a dove as US treasury yields collapsed and this marks a significant turning point in the market. The reason is simple – as I have written in my older posts, the bond market leads the stock market and the stock market leads the economy. The latter is well-known but the former is not widely discussed in the media except for the yield curve. The treasury market has been range-bound since early 2018 but has been stubbornly rejecting sellers albeit the S&P500 churning higher since the December 2018 sell-off. As it recently broke higher, the yield curve inverted on the 3/6m – 10y but did not remain for long. It has to stay inverted for at least 2 weeks but the longer the better. Still, any knee jerk reactions due to this inversion is actually a good opportunity to add longs as depicted by the chart below.

The yield curve did not invert along the whole maturity – in fact, the 2-5 still remains inverted and has been so since end of December. The 3/6m to the 5y has been inverted since the 2nd week of March. Nonetheless, what matters the most is the 2-10 and the 2-30 or 3m-10y would be more reliable with the latter of 3/6m-10y only remain inverted for 10 days including the weekends.

Scary? Not quite. Let’s take an objective look at some key macros data:-

It is imperative that the inversion happens on a wider maturity gap for recessionary signals to be reliable as seen on the top graph. At the very least, the 2-10 has to be inverted as seen on the FFR – 10y Treasury yield spread. We are almost there but there will be a time lag before the market falters. There is more than enough time to gradually scale out of equity positions and move into Treasuries – especially on the shorter end of the curve.

The sector rotation model also advocates for a rally in gold which is on my radar seeing how the GLD ETF is currently testing the 121-122 level with the Fed being dovish, alongside a Nike logo-shaped flat yield curve, could see further downside pressure on the USD. Moreover, with the US aiming to reduce the trade deficit, they need a weaker dollar to accomplish this goal. Still, we should not discount the fact that the markets can remain volatile and move sideways despite no recessionary threat on the horizon – markets not going down does not mean that it has to go up.

 

As to corporate bonds, despite the fact that high yields tend to have equity-like characteristics, it differs in terms of quality. As such, with yield spreads near the bottom, I would stay away from high yielders for now, despite the fact that they may offer high yield to maturity papers, I would just simply rotate funds into companies with solid earnings, good balance sheet, lower leverage to capture the final hoorah before pulling out from risky assets. One divergence is that in the lower chart, the red line is making a higher low despite the fact that markets are currently near all time-highs. There is probably doubt in the market – which is rightfully so since current earnings trend to not entirely support new highs in the US markets. The macro narrative would have to improve to warrant any genuine confidence in the market trudging to historical highs. I will watch volumes like a hawk should the markets be continuously bullish. Volumes are a powerful tell-tale sign and should never be underestimated.

 

Overall, the financial conditions still remain dovish as in the top graph – with total leverage being relatively low compared with the past two market cycles. However in the chart below, domestic banks are tightening lending standards for both consumer and commercial parties despite a dovish stand from the Fed. If this trends higher, it will not bode well for the US economy and will cast suspicions if indeed the market is higher than where it is now. However, there is nothing deadly about the current trend in both the charts.

 

I recently saw an article about fund managers increasing their long exposure to crude and I could not help but think that the capacity utilization chart showing a new high in the current cycle is indeed pointing to a potential demand-pull inflation. However this is too early to be forward looking in this sense – capacity utilization has to be consistently high as in the last cycle to warrant any inflationary pressure in the US economy. From the cost-push inflation perspective in the lower graph, average hourly earnings has to hit 3.5 – 4% YoY before the threat of a full inversion of the yield curve becomes imminent. Average hourly earnings have exhibited a reliable pattern signalling market tops in the past – despite the adage of past performance does not guarantee future performance, I am not dismissing AHE as one of my mainstay indicators.

 

Overall, PMI numbers are expansionary although the short term trend as seen on the bars indicates slowdown. Industrial production, durable goods orders and factory orders remain uninspiring. This is definitely a slowdown in the US if you were to ask me.

 

EARNINGS COMMENTARY

Th estimated earnings decline for Q1 2019 is around -4% which will be the first since Q2 2016. Forward 12m P/E is estimated at 16.7 which is above both the 5y and 10y averages at 16.4 and 14.7 respectively. So far, 79 S&P500 companies have issued negative EPS guidance while only 28 have issued positive guidance. Industry analysts are expecting a 8% increase in the S&P500 over the next 12m but they have typically overestimated this figure, which are typical of analysts. This time around, they have made larger than average cuts of EPS estimates by around -7.3% from 31st Dec till 31st March which is larger than the 5y average and the 10y average at -3.2% and -3.7% respectively. Four sectors, led by Utilities and Healthcare are expected to report YoY earnings growth while seven sectors are expected to show declines with the biggest detractors being the typical late cycle heroes (Materials and Energy). If this is truly a late cycle market phenomenon, this is indeed truly unique as inflation is low, leverage is lower than average and there are no equity bubbles present. Is this just a short-term scare where the bull market does indeed have more (and longer) legs to run higher and be the longest ever in history of bull runs?

As mentioned in the previous posts, I will be watching the divergence between the forward 12m EPS and the S&P500. They should be trending in the same direction and I would place emphasis on the EPS trend – should it remain steady and the market falls, good time to add. However if the market treads higher despite weak EPS trend, you can never go wrong by taking profits and staying on the sidelines.

 

GLOBAL INDICES COMMENTARY

 

They say birds of the same feather flock together but I cannot say the same for Malaysia, my beloved country at -2.9% YTD with the weakest positive performers being Chile (+2%) and Indonesia (+4.5%). China flexes its muscles YTD with a 30+% gain albeit weaker fundamentals being overshadowed by liquidity-pumping into its economy an a very supportive government eager on reforms on top of a strengthening case of a trade deal with the US.

This week we will see trade numbers from the Asian giants alongside UK and global inflationary trends from US, Germany, and China. Central bank-speak will also dominate the headlines on Wednesday and Thursday from the ECB and FED respectively. Consumer sentiment in both Japan and US will also provide a hint as to how domestic conditions are affected by the current global narrative of a growth slowdown and trade dispute potentially getting out of hand, for example if the USMCA will be officially ratified and if Trump will take the fight to the Eurozone once China is taken care of.

 

Over and out,

Ramone Kok

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