We Have Seemingly Hit Some Turbulence
Before I begin, let me share with you something that I experienced on a recent trip back to Birmingham. Last Friday, on the 2nd of August, I was returning to Birmingham from having spent that week in my office in Lincoln, Nebraska. While sitting in the airport in Atlanta, I looked at the weather and noticed that we would likely be returning into the throes of some thunderstorm activity.
As we boarded the airplane, my seatmate appeared very nervous. He didn’t seem able to get settled, and was agitated. He played with every channel on the seatback display, and probably chewed four pieces of gum before the wheels left the tarmac.
As we drew nearer to Birmingham, and began to encounter the turbulence of the thunderstorm, he gripped the armrests as though they were a lifeboat. He had such a grip, I’ll bet he indelibly left his fingerprints on the armrests. He nervously glanced up at me at some point on the way home and apologized, saying that he was not a fan of flying.
I felt sorry for him, and almost offered him my napkin so that he could blot the sweat from his forehead. I enjoy flying, but I don’t know that I’ve ever met anyone who was truly a fan of turbulence. However, I understand the basic physics of flight. As long as we have forward motion, and there is lift under the wings, we will be fine.
Upon reaching Birmingham, I couldn’t help but appreciate the analogy between the behavior of my seatmate, and that which we are observing now with the behavior of market participants. We have seemingly hit some turbulence, and at least initially, the market’s reaction seems to be to grip the armrests and panic.
Is There An Impending Economic Recession?
You have all seen this image at some point during our routine quarterly meetings. Again, this image resonates with me because if I had to caption what I do on any given day, it’s being the metaphorical jet fighter pilot on vacation. So once again, we are compelled to analyze data in a stoic, and dispassionate manner to see if we can rationalize the recent behavior of the market. I believe there is an alternative explanation to what the markets may be pricing into themselves as certainty of an impending economic recession.
Over the 4 plus years since Covid worked its way across the globe, from an economic perspective it has been like walking through a fun house of mirrors at the circus. Hardly anything is as it seems. That’s why I have dedicated myself to intense research. I am not satisfied with the superficial, but rather pursue quantitative evidence with a spherical approach, with 360° of thought.
So, on to the data. It’s interesting that at the beginning of the year, market participants were clamoring for as many as three rate cuts over the course of 2024. It was just two months ago that the fixed income market was pricing into itself the thought of two rate hikes before the end of the year.
At a headline level, inflation just seemed stubbornly stuck at a 3 ½% level. The fear over the early summer was that the Federal Reserve would lose its patience, and offer a new series of excessive rate hikes in an effort to plunge through this 3½% barrier, to their target of a 2% rate of inflation. That thought stood in stark contrast to what the Federal Reserve was actually suggesting about their thought process, and what could the ahead in the future.
Here we are in August, and once again we are pricing in the thought of potentially having three rate cuts before the end of the year.
What a roller coaster. We go from expecting three rate cuts, to two rate hikes, and now we’re back to three rate cuts. In my opinion, that alone demonstrates the degree by which we remain with nervous lemming mentality in the market.
Sure enough, last week Chairman Powell suggested that easing would be in our future, and market participants seemingly discerned from the Fed speak between the lines, that such accommodation could begin as early as September.
That has seemingly kicked off a new wave of concern that we may be headed into a recession, and this sudden departure from previous guidance could be the Fed tipping its hand, and implying that it knows more about impending economic doom than we may realize.
Economic Slowdown During Summer Months
Again, back to images that you have all seen before during our meetings. When a herd of nervous lemmings decides to evacuate toward the nearest body of water, the most healthy course of action may be to at least outfit yourself with a life jacket. In my opinion, the data just does not justify the latest stampede.
I would remind everyone that in any given year, the economic data coming from the summer months is usually the slowest. We normally see a slowdown in hiring, and in production, and across other metrics as the vacation season reaches a peak, and for other seasonal reasons. Also remember that weather can have an impact in quarterly economic data. At the beginning of July, hurricane Beryl impacted nearly two thirds of the United States, as it swept into Texas and eventually made its way through the Midwest, and into the Northeast, bringing torrential rain.
Many economists have cited the economic impact that was felt by such a strong hurricane. To feign oblivion to this is just not rational.
In my opinion, there are many bullish indicators that would suggest that market participants should actually be responding in a different manner.
Last month, in July, the Federal Reserve Bank of Chicago released its financial conditions index. As you can see in the bottom chart, the financial conditions index continues to improve, and continues its upward movement from the bullish breakout indicated in November of last year. Markets as a result have seemingly paid attention to this metric as is evidenced by the top chart. Over the last 30 days, I have seen no evidence that the financial conditions index has retreated or deteriorated from this positive momentum.
Credit spreads between corporate high-yield issues and investment-grade issues remain very tight. This too is considered a bullish indicator. Normally, investors demand higher yields from companies offering lower credits of quality. In this environment, as late as June of this year, there was a very thin margin between yields of lower credit quality issues, and higher credit quality issues, implying that fixed income market participants saw little economic concern to warrant higher yields from lower credit quality issues. In my opinion, this can be construed as a positive referendum on economic conditions.
Indeed, the same can be said about credit spreads between corporate high-yield issues and theoretically riskless 10-year treasury issues. Again, for this chart, anything below the 2.00 mark is a bullish indicator, and clearly we remain below that mark.
Anecdotally, over the years we have always heard that the bond market rarely gets it wrong. For this reason, we seem to pay much attention to the inversion of the yield curve as it pertains to being a predictor of an impending recession. We have discussed this at length during our quarterly review meetings.
A brief primer on the inversion of the yield curve. This is the comparison of yields between two-year treasury issues and 10-year treasury issues. Remember, there is an inverse relationship between price and yield when it comes to bonds. The higher the price, the lower the yield. If you believe that a recession is on the horizon, then you are more inclined to sell two-year issues, resulting in lower prices, and higher yields. In such circumstances, issues of 10-year treasury debt are in greater demand, and therefore prices rise, and yields decline.
The result is a higher yield for the two-year issue, and a lower yield for the ten-year issue, thus giving you the inversion of the yield curve that we heard so much about.
Every recession that has ever been recorded was preceded by an inverted yield curve. This is why inversions get so much attention. Every time the yield curve has inverted however, we have not always had a recession. As a high-level rule of thumb, the longer the inversion, and the deeper the inversion, the worse the recession could possibly be.
At its deepest, the recent inversion of the yield curve stood at 108 basis points. As of Friday, the 2nd of August, the inversion stood at just under eight basis points.
In my opinion, this is a huge reversal, and you can see the degree by which it has occurred since the middle of June. There is only one way that the yield curve can reverse an inversion. There is more buying on the two-year issues, and more selling on the ten-year issues, thus leveling the yield curve inversion.
In my opinion, this is clearly a bullish indicator, and suggesting that there is increasingly less concern about the possibility of a recession in the near term. Otherwise, why would there be such discernible buying in the two-year issues?
Have we had weaker than expected employment data? Yes, we have. Is the ISM Manufacturing index once again below 50? Yes, it is. Are weekly jobless claims stubbornly above 200,000 again? Yes, they are. Each of these points of data can be explained by seasonal weakness coming during the slowest quarter of the year, while coupled with weather anomalies.
Might we truly be on the precipice of a long and deep recession? Clearly, I can’t guarantee that were not, but as far as the data is concerned, I see no evidence of that. To me, this is like hearing your local weather forecaster suggesting that you should break out the winter coats, because we could potentially have 6 inches of snow, on 5th of August, in Alabama.
I have 103 years-worth of data that suggests that markets average again of 15% over the 12 months following the first easing, from a cycle of restriction.
I have no idea if the Fed was merely hinting at the possibility of a rate cut in September. What I do know is that it hasn’t happened yet, so it remains in the windshield. Remember that the windshield is 35 times larger than the rearview mirror for reason. Where we are going is what is most important, and we haven’t received the first rate cut yet, and I can’t discount what 103 years-worth of previous anecdotal evidence tells us about what might happen next following that first rate cut.
Furthermore, going back to 1965, I know that markets have averaged impressive gains during environments when bond yields were falling. Again, as referenced by the yield curve, that seems to be happening now. Frankly, it has been happening since October 2023.
So why exactly are falling bond yields generally beneficial to the prices of equities? As interest rates and bond yields decline, the equity market looks to be an increasingly compelling place to seek growth and forward momentum.
Indeed, as late as July, there seem to be over $7 trillion that had been drawn to the sidelines as bond yields peaked. As referenced by the previous two graphics, those yields may be falling at the present time, and if history is any indicator, the market should become increasingly attractive at these valuations to the cash that has built on the sidelines during the Covid crisis, and the economic aftermath that followed.
When you couple this with other economic metrics, such as the University of Michigan’s consumer confidence survey, ISM manufacturing and services data, and industrial production, in my mind, a picture of economic summer begins to emerge.
Has consumer confidence risen this year? Yes, it has. Until just recently, the University of Michigan’s consumer sentiment survey stood at a level that we had not seen since prior to the Covid pandemic. This has translated into better-than-expected patterns of consumption behavior.
People who feel increasingly confident about their ability to consume, generally demonstrate increasingly better patterns of consumption. As data indicates over the first and second quarters of this year, that is happening.
It was just in mid-July, just three weeks ago, that the market was up 742 points on the day when we received this much better-than-expected indication of consumption patterns.
Why is this important, and why did the market respond so positively on 16th of July when we received this report? Because consumption is 70% of gross domestic product. To me, there seems to be a great disconnect between these most recent indications of consumption behavior, from just three weeks ago, and the current concern just three weeks later, that we may be on the precipice of a long and deep recession. Those two conclusions just don’t seem to exist in the same ZIP Code. I’m not sure how you can be wet and dry, at the same time.
So, again I appreciate your attention to this email today. I wanted to proactively get information into your hands, because I know the deep and red arrows on the television screen are causing concern. In my opinion we continue to emerge into a warmer, early economic summer period of time, from the economic winter through which we have been over the last four years. Remember, this will happen over the course of fits and starts. Nothing ever evolves in a straight line. Along the way, we will have the metaphorical blackberry economic winter, where we have a cold snap in the middle of emerging into a warmer season.
Lastly, please bear in mind that all of this is happening under the specter of an election year. The sensationalism and the hyperbole are palpable. I find it interesting that when potential voters are asked for their opinions regarding the economy, and inflation, they are returning much more dire answers when it comes to the candidate for whom they will cast a vote.
However, when the University of Michigan calls and asks, do you have a job, can you get a job, do you believe that the job that you have will pay a higher income over the next 12 months, do you have a greater capacity to purchase today than you did 12 months ago, and similar questions, we are getting much more positive answers.
Those positive answers are seemingly manifested much better-than-expected patterns of consumption to which I previously drew reference in this email. You absolutely must insulate yourself from the noise, and wade through the sensationalism and the hyperbole to get down to the data. Data is what it is. There is no distortion. You just have to approach the analysis of data with a stoic disposition, and without foregone conclusions. Then data can talk to you. When it does, you must then have the intestinal fortitude to listen, and do what it is telling you to do.
So, in conclusion, in my opinion I do not believe that we are on the precipice of a long and deep recession. I believe that the Federal Reserve has done exactly what they said they were going to do, since March 2022. This is particularly true since November 2022 when they adopted a more docile and data-driven approach to monetary policy.
I believe that the market is replete with attractive valuations, and now would be the time to critically evaluate the implementation of your financial plan with an eye toward where you will be one year from now, and five years from now, rather than five minutes from now. We must resist the temptation to join the stampede of lemmings. Rise above that, as we move from one economic season to the next.
Seth J. Edgil and David Guttery offer products and services using the following business names: Keystone Financial Group– insurance and financial services | Ameritas Investment Company, LLC (AIC), Member FINRA/SIPC – securities and investments | Ameritas Advisory Services, LLC (AAS) – investment advisory services. AIC and AAS are not affiliated with Keystone Financial Group. Information is gathered from sources believed to be reliable; however, their accuracy cannot be guaranteed. Data provided is for informational purposes only and should not be construed as a recommendation to purchase or sell any investment product.
