Economy

Highlights The combination of slower global growth, trade protectionism, Italy's budget crisis, and rising Treasury yields have made U.S. equities increasingly vulnerable to a phase transition from euphoric optimism to a more sober appreciation of the risks facing the global economy. The good news is that the U.S. economy is still quite healthy and none of our recession indicators are flashing red. This suggests that the correction which began last week will be just that, a correction. The bad news is that corrections usually end when investors stop believing that they are witnessing a correction and start thinking that a bear market is afoot. Stock market sentiment is still fairly ebullient, which suggests that it will take more pain to put in a bottom. Investors should anticipate renewed weakness in risk assets over the coming days, but be prepared to increase exposure to global equities if they retreat 9% from current levels. Feature Global Equities: How Low Will They Go? I have been on the road meeting clients this week. Not surprisingly, much of the discussion has focused on what caused last week's stock market sell-off and whether the rebound earlier this week marked the end of the correction. At times like these, I am reminded of Robert Shiller's study of the 1987 stock market crash. Soon after the crash, Shiller sent questionnaires to investors soliciting their views on what caused stocks to swoon. Shiller's assessment downplayed the role of program trading, instead ascribing the crash to investor panic.1 Simply put, Shiller contended that investors were selling because other investors were selling. While I broadly agree with Shiller's conclusion, I think his argument can be enhanced by drawing on a ubiquitous concept in physics: the idea of "phase transitions." Phase Transitions In Financial Markets A phase transition occurs when a substance changes from a solid, liquid, or gas into a different state. For example, water remains a liquid until its temperature either falls below zero degrees Celsius, at which point it becomes a solid (ice), or rises above 100°C, where it turns into gas (steam). The relationship between water and temperature is highly nonlinear. To someone who can only visually observe the contents of a kettle, it is difficult to say if the temperature of the water is 20°C or 80°C. The same principle applies to markets. Sometimes, as economic and financial stresses build, nothing discernible happens until a phase transition is reached, at which point everything goes haywire. Importantly for investors, these phase transitions are surprisingly common and, at least with the benefit of hindsight, are often predictable. The Twilight Zone From Boom To Bust Consider the lead-up to five market crashes in the U.S. over the past 100 years: 1929: The conventional wisdom is that the stock market crash of October 1929 was the first hint that the economy was about to go into a tailspin. But, in fact, automobile, machinery, and steel production were already falling by the summer of 1929 (Chart 1). Automobile output had declined by a third by the time stocks reached their zenith. Investors simply ignored the fact that the economic thermostat was plunging towards zero in those late summer months, setting the stage for a phase transition from boom to bust. Chart 1The Economy Had Started To Deteriorate Before The 1929 Stock Market Crash 1987: It was not so much one single thing that caused the stock market crash on October 19, 1987, but a culmination of things that the market either ignored or downplayed in the months leading up to Black Monday. A rising U.S. trade deficit and a falling dollar raised concerns that the Fed would be forced to expedite the pace of rate hikes. The 10-year Treasury yield increased from 7.1% at the start of 1987 to almost 10% on the eve of the crash (Chart 2). The House of Representatives filed legislation that sought to eliminate the tax benefits of financial mergers. Against a backdrop of increasingly stretched valuations, these developments were enough to bring the temperature of the stock market below zero. Chart 2Treasury Yields Spiked In The Run-Up To The 1987 Crash 1998: Popular lore attributes the 22% plunge in the S&P 500 from July 20 to October 8 to the implosion of Long-Term Capital Management (LTCM), but in fact almost all of the decline in the index occurred before the problems at LTCM surfaced. It was more the steady drip of bad news over the course of 1998 - the spread of the EM crisis from Thailand to Indonesia, Malaysia, and South Korea; the collapse of Hong Kong-based Peregrine Investments Holdings, Asia's largest private investment bank at the time; growing fears that China would devalue its currency; and finally, the Russian sovereign debt default - which caused market sentiment among U.S. investors to turn from euphoric ambivalence to bearish panic (Chart 3). Chart 3Key Events During The Asian Crisis 2000: After cutting interest rates three times in the autumn of 1998, the Fed resumed hiking rates, ultimately bringing the fed funds rate to a cycle high of 6.5% in May 2000. The Fed's actions pushed monetary policy into restrictive territory, weakening the foundation on which the stock market boom had been built. A massive wave of equity issuance from initial and secondary public offerings only made matters worse. Net corporate equity issuance went from -$111 billion in 1998, to $6 billion in 1999, to $153 billion in Q1 of 2000 alone (Chart 4). With the market unable to absorb the increase in the supply of shares, prices began to tumble. Chart 4A Tidal Wave Of Equity Issuance Preceded The 2000 Crash 2008: The stock market crash in the autumn of 2008 did not come out of the blue. U.S. home prices peaked in April 2006 - twenty months before the recession officially began. Delinquency rates on both conventional and nonconventional mortgages had already more than doubled by late-2007 (Chart 5). By then, residential investment had already fallen by 2.5% of GDP from its high in December 2005. Investors may be forgiven for not appreciating the full extent of the mortgage problem. However, it should have been clear, even at the time, that nothing was going to fill the void in aggregate demand that the decline in housing-related spending had opened up. This made a recession highly likely. Chart 5The U.S. Housing Sector Weakened Sharply Prior To The 2008 Crash Corrections Vs. Bear Markets The five sell-offs discussed above share many similarities, along with a number of key differences. As far as the similarities are concerned, all five began when stocks were richly priced and macro fundamentals were starting to look increasingly shaky (Chart 6). Chart 6Bear Markets Tend To Occur When Earnings Disappoint The differences lie mainly in what happened to stocks after the dam burst. In 1987 and 1998, equities quickly bottomed; whereas the initial drop in stocks in 1929, 2000, and 2008 was followed by further declines, morphing into major bear markets. The evolution of the economy distinguishes the two sets of episodes. The 1929, 2000, and 2008 sell-offs foreshadowed significant declines in economic activity and corporate earnings. In contrast, neither the stock market crash in 1987 nor the one in 1998 presaged any imminent economic doom. The latter two episodes were among those "false positives" that had led Paul Samuelson to quip decades earlier that "the stock market had predicted nine out of the last five recessions."2 History suggests that recessions are more likely to occur when the economy is suffering from significant macroeconomic imbalances. Both the 1929 and 2008 crashes were preceded by large increases in leverage (Chart 7). This made the financial system highly vulnerable to economic shocks. History also suggests that recessions are more likely to occur when policymakers lack either the will or the tools to stimulate the economy. The Fed did little to arrest the myriad bank failures in the early 1930s. This negligence allowed the money supply to decline by one-third, which caused deflation to set in. Chart 7Large Increases In Leverage Occurred During The Lead-Up To The 1929 & 2008 Crashes Policymakers were more adept in combating the Great Recession, but were nevertheless constrained by a lack of regulatory authority to handle distressed nonbank financial institutions. The zero lower bound on short-term interest rates also limited the Fed's ability to cut rates by enough to revive growth, a pernicious constraint given Congress' unwillingness to enact a sufficiently large fiscal stimulus program. Both the 1987 and 1998 crashes had the potential to spawn recessions. Fortunately, policymakers were quick to put out the fire. The Federal Reserve eased short-term liquidity conditions by engaging in large-scale open market operations in the hours following the 1987 crash. The Fed also issued a statement affirming "its readiness to serve as a source of liquidity to support the economic and financial system."3 Likewise, the FOMC's decision to cut rates in the autumn of 1998 helped to temporarily weaken the dollar and give some breathing room to struggling emerging markets. The Fed was slower to cut rates after the stock market fell in March 2000, partly because the economy was more overheated by that point than it was in 1998. In addition, the bubble in stocks was much greater in 2000, as were the economic imbalances created by years of easy financing, chief of which was a massive overhang of capital spending in the tech sector (Chart 8). Chart 8The Dotcom Boom Created A Massive Overhang In Tech Sector Capex Lessons For Today Buying on the dips in the early stages of a bear market is usually a recipe for disaster. Investors who jumped back into the stock market in September 2008 were in for a rude awakening as stocks continued to plummet into October and November. It was only in March 2009, when the first green shoots appeared, that the stock market finally bottomed. In contrast, buying into a correction tends to be a profitable strategy, provided one does so when technical indicators are signaling that a capitulation point has been reached. This brings us to today. The combination of slower global growth, trade protectionism, Italy's budget crisis, and rising Treasury yields have made U.S. equities increasingly vulnerable to a phase transition from euphoric optimism to a more sober appreciation of the risks presently facing the global economy. The good news is that the U.S. economy is still quite healthy and none of our recession indicators are flashing red (Chart 9). As we discussed two weeks ago, aggregate demand continues to benefit from fiscal stimulus, strong credit growth, and a strengthening labor market.4 While bond yields have risen, they are still far from levels that will choke off growth. This suggests that the correction which began last week will be just that, a correction. Chart 9A U.S. Recession Is Not Imminent The bad news is that corrections usually end when investors stop believing that they are witnessing a correction and start thinking that a bear market is afoot. Stock market sentiment is still fairly ebullient, which suggests that it will take more pain to put in a bottom (Chart 10). This message is echoed by our forthcoming MacroQuant model, which is designed to gauge the "internal temperature" of the market. (Chart 11). It is currently pointing to downside risk for the S&P 500 over the next 30 days. Chart 10Stock Market Sentiment Is Still Fairly Elevated Chart 11MacroQuant* Recommends Continued Caution Towards Equities Even EM sentiment has yet to reach bombed-out levels. The latest BofA Merrill Lynch Global Fund Manager Survey showed that managers were slightly net overweight emerging market equities in October. This is a far cry from 2015, when a net 30% of managers were underweight EM stocks. Bottom Line: Investors should anticipate renewed weakness in risk assets over the coming days, but be prepared to increase exposure to global equities if they retreat 9% from current levels. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Robert J. Shiller, "Investor Behavior in the October 1987 Stock Market Crash: Survey Evidence," NBER Working Paper (2446), November 1987. 2 Paul Samuelson, "Science and Stocks," Newsweek, September 19, 1966 (p. 92). 3 Mark Carlson, "A Brief History of the 1987 Stock Market Crash with a Discussion of the Federal Reserve Response," Federal Reserve, 2006. 4 Please see Global Investment Strategy Weekly Report, "The Next U.S. Recession: Waiting For Godot?" dated October 5, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades