It seems incredible that the market would be touching all time highs after an extended period of inverted yield curves and falling leading indicators. Yet, that is exactly what happened in September 2007 before the financial crisis. Nobody expected a crisis and the mood at the time was very upbeat because the economy was doing well despite 5.5% interest rates. Does this setup sound familiar? | |
Market Update - October 2024 | |
- During September, consumer discretionary, utility and industrial stocks led the stock markets higher as investors reacted to the first Federal Reserve rate cut of this cycle. The 0.50% cut was more than many expected and encouraged those who believe there will be no recession or, at worst, a soft recession.
- Bonds rose slightly during the month as inflation readings continued to fall along with leading economic indicators. The big fear of the bond investors is that we are following the path of the 1970s with regards to government spending and inflation.
- Commodities showed mixed results. Natural gas and gold rose, while crude oil fell.
- China announced an enormous stimulus program targeting their stock market and consumer economy that resembles the 2008 stimulus implemented in the US. China's moribund stock market may have found a bottom.
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Table 1: Market performance estimate as of 9/30/2024 (LIMW) | |
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When I fly on commercial airliners, I wonder about whether the pilot was trained in the Navy or the Air Force. Have you ever noticed when the plane gets planted firmly on the runway? Or, on other occasions have you observed a nice, graceful feather-light landing? This traveling game is exactly what pundits play as they watch the Federal Reserve.
There is a lot of hope that the Fed is guiding the economy into a soft landing. That means different things to different people. In general, if the Fed is able to 1) normalize inflation, 2) avoid widespread unemployment, 3) keep earnings from falling and 4) lower interest rates all at the same time, they will be considered geniuses.
However, if a hard landing or recession is triggered several bad things will happen and they will have slash interest rates to start the stimulus cycle over again. Getting this timing right will be critical to many investors, ESPECIALLY if they are prone to panic. When the market falls, you KNOW you are supposed to buy, but many don’t. Sadly, they sell.
On an aircraft carrier, there is no such thing as a soft landing unless you are in a helicopter. All the fixed-wing pilots are trained to land on the same spot over and over again. That’s because they are trying to catch a wire with a tail-hook the size of a large broom. This habit of always landing on the same spot over and over again stays with many pilots, even when they are landing an airliner on a long runway. So, the next time you travel and the plane practically bounces down the runway, you can thank the US Navy for training that fine pilot. Watch the first four minutes of TOP GUN and you’ll see what I mean. (Here is a one-minute video comparison of Air Force and Navy landings.)
It is too early to tell how the next few years will play out. There is tremendous domestic and international political uncertainty along with the cross currents of an inflationary environment. We live in interesting times.
Picture credit: Tony Osborne, 2006. This may be an aircraft I flew in the fleet since this is my old squadron VS-24.
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The Fed rate cutting cycle has begun | |
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After teasing us at every meeting since December 2023, the Fed has finally initiated its first rate cut this cycle. This needs to be put into the "be careful what you wish for" bucket because Fed rate cuts are usually associated with economic and market problems.
The curious thing about all this is that the broad bond market is also on the move. Long-term interest rates are falling in the government, mortgage and corporate bond market. In isolation, this is stimulative because lower interest rates cut interest expense for borrowers. However, it can also signal a risk rotation from stocks into bonds as investors reduce risk and lock in higher yields. There is no sign of cash moving off the sidelines as money market accounts keep growing.
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Figure 1: Consumer Price Index, US 10 year Treasury yield, and Federal Funds rate (LIMW) | |
Figure 2: Corporate bond yields used in pension plan calculations are also falling (LIWM) | |
Hey! The Fed cut rates! Wait, why is the curve still inverted? | |
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The Fed cutting rates is not a straightforward stimulus story. Lower rates help reduce interest expense, yes, but if the yield curve is still inverted, banks and lenders are still not that motivated to lend. With short-term rates above long-term rates, the yield curve is still "inverted".
The Fed will have to cut rates down to 3.5% from 4.75% today just to get to neutral on this metric and the market doesn't expect that for about a year. Of course, as circumstances change, Fed policy and the bond market's reaction will get updated, but this is what we see today.
Remember, the inverted yield curve is a traditional recession leading indicator and it is still inverted. Because of higher than normal inflation, the Fed is reluctant to commit to rapid and deep rate cuts at this time.
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Figure 3: US Federal debt yields at various future maturities (Wolfstreet.com) | |
Some evidence for a hard landing | |
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We will be the first one to admit that our recession forecast has been too early. The power of stimulus spending from Washington has kept the economy chugging along at a nice pace despite the recession predictions from the inverted yield curve and leading economic indicators.
However, the cycle is turning in a very familiar direction. The decline of the US 2-year Treasury bond is considered a key leading indicator in its own right because it tends to lead the economy and Fed policy. Today, 2-year Treasury yields have fallen dramatically at the same time unemployment has begun to tick up.
What this means is that recession is probably here, but our other data points are not showing it, yet. Here are some interesting charts that show the 2-year Treasury yield's behavior around other major recessions.
Later this week we will get a pile of new economic data points. Watch for the monthly unemployment report Friday morning. It is too early to tell if we will experience a hard or soft landing.
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Figure 4: US 2-year and US 10-year Treasuries yields compared to unemployment and the yield curve inversion 1987-2024 (Henrik Zeberg Trading View) | |
Figure 5: 10-year/2-year Treasury spread (inverted) compared to the S&P 500 1987-2024 (LIWM). Note that the spread changes rapidly going into recession. | |
Signals from the US 2-year Treasury yield | |
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One other problem with US 2-year Treasury yields is that the differential to Federal Funds rate is very extended. This becomes a measure of how far behind the curve Fed's policy may be if the economy continues to deteriorate.
Here is a chart showing similar 2-year/Federal Funds differentials in 2008, 2001, 1989, 1980, 1975 and 1969. Do you recognize some of those dates from our past discussions? These years all coincided with major recessions.
Figure 6: 2-year Treasury/Federal Funds interest rate gap 1965-2024 (ASR)
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Lower interest rates have not stimulated the mortgage market | |
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It's hard to figure out what is really going on in residential real estate. Normally, lower interest rates would stimulate higher mortgage activity as borrowers move to lock in rates for a home. This is not what we see happening.
There are two issues here that we can't tease apart:
- EITHER, rates haven't fallen far enough for houses to be affordable. This implies prices or interest rates must fall further.
- OR, the inverted yield curve is still curtailing lending on the part of mortgage lenders.
Figure 7: Home buyer demand versus mortgage rates 2018-2024 (Re:venture)
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There is evidence that home prices are historically high even after adjusting for inflation. While the recent spike can be blamed on high immigration, home prices have been on a tear since the financial crisis in 2009. Zero interest rates and government stimulus have played a powerful role in re-inflating this critical household asset.
Figure 8: Real home price index (i.e. home prices adjusted for inflation) (Robert Shiller, re:venture)
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Additionally, residential mortgages are starting to go sour due to reduction of income, unemployment and excessive financial obligations. It is not clear if these are mortgages with more recent high interest rates or older low-rate mortgages.
The reason this is important is that many mortgages, both residential and commercial, are owned in portfolios that have leverage. This implies that if a residential default cycle is added to the existing commercial mortgage defaults, we may see some banks or investment funds deliver some very bad news.
There is great confidence that whoever gets in trouble will receive a Fed bailout of one type or another. Don't laugh; three banks were bailed out in early 2023. The Dodd-Frank Financial Reform bill was supposed to put a stop to bank bailouts in 2010. Under the current administration, the new policy seems to be "bail them out early and often!"
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Figure 7: Mortgages are starting to go sour (US Dept of HUD/FHA) | |
Leading indicators still point to trouble, but they've been wayyy early this cycle | |
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The Conference Board's Leading Economic Indicator has been indicating recession for a record 30 months now. There are 10 factors in this indicator, but 3 key components have been driving the negative results:
- Inverted yield curve (Federal Funds rate above 10-year Treasury yield)
- Consumer Expectations for Business Conditions
- ISM Index of New Orders
We expect this indicator to bottom as we work through the cycle.
Table 3: Consecutive months of LEI declining or negative (Jeff Weniger)
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One interesting way to modify the Conference Board indicators is to combine the Leading and Lagging Indicators to mark recessions. Remember, the reason we go through this exercise is that most of the corporate and government data is reported late, and we are looking for current market and survey data that helps us get a better view of what is actually happening.
You can see down below this combination of the Leading and Lagging Indicators has correctly pointed out several economic troughs since the late 1950s. Additionally, as we learned in 1981, there is no firm rule that says recessions must be "X" years apart. Each cycle is different.
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Figure 8: Analysis of Leading/Lagging Conference Board Indicators 1958-2024 (Jeff Weniger) | |
Consumer confidence as a leading indicator | |
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There is a fairly tight relationship between Consumer Confidence and corporate earnings over time. Even in recessions, when there is a disagreement between the two, Consumer Confidence usually leads us to where corporate earnings will go.
This is important because today's Consumer Confidence is pointing down, while analyst earnings estimates point up. Unless something dramatic occurs, this implies earnings estimates and stock prices may be heading down eventually.
Figure 9: Consumer Confidence versus S&P 500 earnings 1989, 1999 and 2018 (Trahan)
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Figure 10: Consumer Confidence versus S&P 500 1986-2024 (Trahan) | |
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If we were to put all the important recession leading indicators into one list, what it look like and how many items are checked off?
Here are some items that we positively check off:
- Yield Curve inverts (short-term rates > long-term rates)
- Leading Economic Indicators negative (30 months)
- Bank lending tightens
- Fed pauses rate increases
- Net savings depleted
- Credit card balances at highs
- Auto delinquencies increase
- Housing prices decrease
- Fed/State tax receipts turn negative
- ISM New Orders fall
- Inflation falls
- Unemployment increases
- Fed pivots and cuts interest rates
What hasn't happened, yet?
- Credit spreads widen (junk bonds fall)
- Quantiative tighening ends (Fed halts selling/redeeming bonds)
- Quantitative easing begins (Fed begins buying bonds)
All government policies have consequences, whether it be the zero interest rate policies of the 2010s, the pandemic stimulus programs of 2021, or the higher interest rates of 2022-2024. Each came with consequences and as we learn from history, "The deferral of consequences should not be confused with the absence of consequences."
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The stock market is optimistic while the bond market recovers | |
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The stock market hit new highs in September, but not because of earnings, economic growth or high consumer confidence. In fact, all of those factors were unchanged or weakening. Rather, it is the hope that the Fed will firmly support asset prices and re-stimulate at the first sign of economic trouble. The larger than expected Fed rate cut of 0.50% was considered a step in the right direction. Optimism and confidence are very high.
Figure 9: S&P 500 hits new all-time highs 2021-2024 (LIWM)
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The bond market bottom continues to build. Bond investors continue to be focused on lower inflation reading and reports of slower economic growth. From a fundamental perspective, the bond market is very attractive until the Fed restarts quantitative easing alongside Congressional fiscal stimulus. | |
Figure 10: Aggregate Bond portfolio ETF (SPDR, LIWM) | |
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It is our view that the economy is gradually falling into recession. Inflation is higher than desired, broad earnings are stagnant, and the labor market is weakening. The Fed is cutting rates because the economic weakness is now obvious.
The headline down below was published late last week and is an interesting reflection of how many stock investors feel today. So much money has been made on this bull run that it is almost unthinkable that the current rally would stop or that a recession would interrupt it.
It is possible that government stimulus policy has changed the dynamics of the US economy and that most of this excess money is being captured by large corporations that make up the stock indexes. It is also possible that this was a normal cyclical peak extended by pandemic stimulus and it is now entering its long overdue cyclical down leg.
Time will tell.
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Rob 281-402-8284
Chris 281-547-7542
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Christopher Lloyd, CFP ®
Vice President and Senior Wealth Planner
Lloyds Intrepid Wealth Management
1330 Lake Robbins Dr., Suite 560
The Woodlands, TX 77380
281-547-7542
Chris.Lloyd@lloydsintrepid.com
www.lloydsintrepid.com
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