The Fed: Trapped.
Fed officials regularly say that their monetary policy is “data dependent.” Yesterday, Fed Chair Janet Yellen acknowledged that the Fed is also market dependent. In her congressional testimony, she said, “Financial conditions in the United States have recently become less supportive of growth, with declines in broad measures of equity prices, higher borrowing rates for riskier borrowers, and a further appreciation of the dollar.” She said that the Fed remains on course to raise interest rates gradually, but implied that the pace would be even more gradual given the turmoil in financial markets.
After acknowledging that financial conditions have tightened recently, she still claimed that even after last year’s rate hike, “the stance of monetary policy remains accommodative.” She obviously doesn’t see the connection between the Fed’s “dot plot” and the tripling of the high-yield corporate yield spread since mid-2014, the 22% jump in the dollar over this same period, the plunge in commodity prices, and this year’s global stock market rout.
The Catch 22 is that if financial conditions improve, Fed officials will start preparing the markets for another rate hike only to be stymied by yet another tightening tantrum in the financial markets.
Strategy: Contrary to Popular Opinion.
In my latest conversations with accounts, I’ve detected that all would like to believe that the current selloff is yet another panic attack that soon will be followed by a relief rally. This has been the modus operandi of the current bull market. However, most agree that this correction is more serious than the previous ones, and worry that stocks may be heading into a bear market. They fear that the global economy is falling into a recession that will drag the US down as well. They believe that central banks have run out of tools to avoid this scenario. They doubt that negative interest rates will work, and might actually make things worse.
Many were traumatized by the financial crisis of 2008 and are waiting for the other shoe to drop. They fear that something is bound to blow up in the credit markets, the way Lehman did, leading to a global financial contagion. Of course, their fears are being heightened by the awful performance of the World Financials MSCI stock price index (in dollars), which is down 15.7% ytd. The forward P/E of this index has dropped from last year’s high of 13.0 to 10.5 at the end of January, and that’s before the rout of the past few days.
No wonder that the Bull/Bear Ratio compiled by Investors Intelligence plunged to 0.63 this week, the lowest reading since the week of March 10, 2009, when it was 0.56, as Debbie reports below. The percentage of bears rose to 39.2%, the highest since October 2011. In the past, readings below 1.00 often set the stage for rallies.
This contrarian buy signal took awhile to work as stock prices plunged during the 2008 financial crisis. I suppose that could happen again if the other shoe drops again this time. Or it could take some time to work, until investors are convinced that the other shoe won’t drop this time. Perhaps we also need to see more bearishness in S&P 500 VIX. It’s been just under 30.0 lately. In recent years, readings of 40.0 have tended to be associated with major market bottoms.
We’ve been discussing and analyzing the other shoes that might drop since the start of the year when we titled our 1/4 Morning Briefing “The Panics of 2016.”
For now, while we are on this subject, consider the following:
(1) No US recession in latest numbers.
The Citigroup Economic Surprise Index was -52.6 on February 9. That’s unsettling, but it has been even more negative since the start of the current economic expansion without signaling a recession. Its current weakness is actually somewhat surprising given that the Atlanta Fed’s GDPNow tracker is forecasting Q1 GDP to grow at a 2.5% clip, up from 0.7% in early January.
Monday’s JOLTS report for December was chock full of good news about the labor market. The number of Americans who voluntarily quit their jobs climbed to a post-recession high, suggesting that workers are confident about their employment prospects despite financial-market turmoil and a slowdown overseas. Job openings are at the second-highest reading in the history of the series going back to 2000; July 2015’s was the highest. Total hires jumped to 5.4 million, the best pace since November 2006.
By industry, there were big jumps in the job openings rates in manufacturing and construction. Remaining high are comparable measures for professional and business services, leisure and hospitality, and education and health services.
(2) Happy people in China.
Fears of a hard landing in China may also be exaggerated. At least that’s the gist of a 2/9 WSJ article titled “What Slowdown? Chinese Consumer Confidence Still Strong.” Nielsen’s latest quarterly global survey on consumer confidence found that retail sales continue to be quite strong, while consumer confidence in China remains stable and high.
The article states, “China’s services industry is growing at a clip that helps offset the deterioration in the manufacturing, construction, and housing sectors. Many economists contend that while fears of the Chinese economy stalling are legitimate, they also may be overblown.” We agree. By the way, Nielsen says that 86% of Chinese consumers surveyed report having used digital payment systems for online purchases over the last six months.
(3) Known unknowns. Of course, the worst fear out there is that the global financial system is on the verge of another Trauma of 2008. Even worse is the widespread perception that the difference this time is that the central banks don’t have any ammo left to fight off a global financial contagion and to avert a global recession, or worse. As documented in the movie “The Big Short,” only a handful of savvy hedge fund traders understood that the housing market was a house of cards that was built on a foundation of subprime credit and its derivatives.
This time, the epicenters of the next credit contagion might be in the global oil industry or among dollar borrowers in emerging markets. While much of the dodgy credit might have been borrowed in the capital markets, some of it was probably extended by banks. The former can contain financial contagions better than the latter, in our opinion. The problem is that like the subprime mortgage problem there are lots of known unknowns about the risks in the credit markets.
The results have been that liquidity has dried up in the junk bond market and capital is flowing out of emerging economies. The yield spread between corporate junk bonds and 10-year Treasuries soared to 814bps on Tuesday, almost tripling from 2014’s low.
The 2/9 Bloomberg reported that “European banks face potential loan losses from energy firms of $27 billion, or about 6 percent of their pretax profit over three years, according to analysts at Bank of America Corp.” That’s actually a relatively small number that isn’t much of a threat to the capitalization of the banking system or its ability to provide credit to the economy. A bigger problem for the banks themselves is that the yield curve has flattened out as the US 10-year bond yield has declined by 63bps to 1.68% yesterday. In the Eurozone and Japan, the banks are facing negative interest rates.
No wonder that so many investors are waiting for the other shoe to drop. What will it take for them to regain their confidence in the stock market? It may take time, assuming of course that no shoes drop. That’s why we expect that this will remain a choppy year for the stock market. The bull market may resume next year, again assuming that no shoes drop.
(4) Talking ourselves into trouble.
The risk is that we talk ourselves into a recession. The 2/7 WSJ included an article titled “Big Companies Pull Back After Rough Quarter.” It noted, “After a tough end to 2015, big companies are starting the new year with a tight rein on capital spending, and in some cases layoffs, as they seek to cope with sluggish industrial demand and uncertainties about the continued resilience of the American consumer.” The strong dollar and weaker global economic activity clearly hit their revenues and earnings.
Indeed, S&P 500 forward revenues has been flat over the past year through the end of January, though is still near 2014’s record high (Fig. 12). However, the revenues of the S&P 400 and S&P 600 are both at record highs, in part because they aren’t as exposed to the dollar and overseas sales. That’s relatively good news for the economy, since it is small and medium-sized firms that tend to do most of the hiring. But if the tsunami of pessimism remains unabated, the risk is that even those firms will hunker down.
Meanwhile, Joe and I are lowering our outlook for S&P 500 earnings for this year and next again. The same headwinds as in 2015 are still blowing, including depressed commodity prices and the strong dollar. In addition, the flattening yield curve is flattening the earnings of the Financials.
So for 2016, we are cutting our estimate to $119 from $122, which reduces the growth rate to 0.6% from 3.4%. Our 2017 estimate is now $126, down from $128, representing a 6% growth rate. We are sticking with our S&P 500 target of 2000 for the end of this year, but lowering our target for next year from 2300 to 2200.
Dr. Ed Yardeni
is the President of Yardeni Research, Inc., a provider of independent global investment strategy research. To read more of his blogs, CLICK HERE NOW.
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