For The Millionth Time, Markets Exaggerate

The S&P 500 fell more than 12% in a few weeks.The 10-year Treasury yield fell nearly 40 bp. There were cries that the sky was falling. A recession is imminent, we are warned by prognosticators. The Fed went ahead and raised interest rates on March 21, 2018, and the S&P 500 proceeded to gap lower the next day and continued to sell off the following day. Investors did not like the unanimous decision. Yet far from the apocalypse, the US economy was on the verge of a growth surge.

As the economy rounded out a 4.2% annualized pace of growth in Q2, the Federal Reserve hiked rates again in mid-June. The S&P 500 at the time was at the upper end of the range seen since the January-February slide (~2800), and again investors did not like the hike and took the S&P 500 down around 3.5% by the end of the month. 

The real Fed funds rate was below zero (until H2 18). The economy was growing above trend, the labor market was strong (no need to wade into the weeds to discuss the technicalities of the meaning of full employment), and inflation was near the Fed's target. On top of this, the federal government was providing a combination of tax cuts and spending increases that surpassed what was delivered during the Great Financial Crisis.  

After crying wolf of an impending recession, a year ago, market fundamentalists tell us, again a recession is looming, and the Fed made a policy mistake by hiking rates in December. Many who had been critical of the Fed expanding its balance sheet now want to it reconsider the pace of the unwind. 

The US cycle is getting old in the tooth.Weakness in housing, for example, is often associated with late business cycle activity. The 12-month moving average of non-farm payrolls typically peaks in the middle of a cycle, and it appears to have peaked in 2015. However, this does not mean a recession is imminent.

In fact, beginning with last week’s employment data and service PMI, we expect a string of more upbeat US economic data. The ongoing government shutdown will impact some releases, but the general picture in broad strokes we expect to emerge is something like this: October data was poor, but the economy picked up in November. The deterioration in the US trade balance partly reflected a boost in imports to beat tariffs, and the drag on GDP appears to be largely offset by an increase in inventories.The sharp drop in oil prices may push headline CPI below 2% in December, the core measure is expected to remain firm (2.2%). 

While the regional Fed manufacturing surveys were weaker in December, and the manufacturing ISM dropped by the most in a decade, two nuggets warn that the headline weakness is exaggerated.  First, the new export orders of the ISM rose in December, which is particularly notable given the slowdown among many US trading partners. After falling in October, new exports orders stabilized in November and turned higher in December. Second, manufacturing job growth in last year was the strongest in 20 years, and Q4 was the strongest, and December was best. 

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Read more by Marc on his site Marc to Market.

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