Stock Prices & Economy Don’t Compute
Stock Prices - What Is Priced In?
The biggest question investors need to answer is “what is priced in?” The current market is particularly perplexing because of the extreme rally despite the global economic weakness. The S&P 500 has been above its 10 day moving average for 35 days. That's the longest streak in over 9 years. This is while global growth is slowing; Ned Davis Research states there’s about a 96% chance the global economy is in a recession. Investors need to figure out if the bear market in late 2018 was enough to price in this economic weakness.
Is the stock market 2 steps ahead of the economy as it prices in an economic recovery? Even though there have only been small green shoots? The more stocks rally, the more confident investors are saying they are in the economy. Personally, I see the U.S. economy improving modestly in Q2. Sentiment indicators have picked up because stocks have rallied, and the government shutdown ended. However, I don’t have much confidence in a strong economic rebound in the 2nd half of 2019. The ECRI leading index and the Conference Board leading indicators are showing growth will weaken further.
Normally, stocks reach a euphoric state at the end of the cycle. In this cycle, many people think that the euphoric peak was in January 2018. Now stocks are rallying in the face of a weak economy. This is partially because of the trade war ending and the Fed becoming dovish. Investors can’t see the S&P 500 breaking out to a new record high. At least not until the economy shows more improvement besides a few good sentiment indicators.
Stock Prices - Trailing S&P 500 Earnings Set To Fall
The chart below compares the global manufacturing PMI pushed ahead 9 months with the S&P 500’s trailing 12-month earnings. As you can see, the global manufacturing PMI fell to 50.7 in January. Based on the recent manufacturing weakness, I expect this to be below 50 in February. That indicates trailing S&P 500 earnings growth will fall. To be clear, everyone already knows earnings growth will be low in the first 3 quarters of 2019. That makes it confusing as to whether it’s priced in. Is the consensus priced in if the consensus is poor while risk assets explode higher? The chart shows trailing earnings growth isn’t perfectly correlated with the global PMI. However, it’s not a huge prediction to say earnings growth will fall in the next 3 quarters; it is the consensus as I mentioned.
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Stock Prices - 6 Month PMIs Have Cratered
It’s best to look at economic data in various ways. The US and European February PMIs were strong because of the service sector. The chart below shows the 6-month change in various country’s PMIs. Maybe this shows us the past which was reflected in the late 2018 decline. Maybe the recent economic improvement is part of a new trend. The rally this year certainly prices in the latter possibility. As you can see, only 5 countries saw their PMIs improve. And only 28 countries saw their PMIs fall in the past 6 months. Germany saw an 8.3 point decline. However, as I showed in a previous article, Germany’s Q4 GDP growth had underlying strength. It was hurt by a one-time inventory drawdown.
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Stock Prices - Potential Effect Of The Fed’s Balance Sheet Unwind
Personally, I think changes to the balance sheet aren’t nearly as important as changes to the Fed funds rate. However, I am always open to various perspectives which is why I show charts like the one below. As you can see, the shadow Fed funds rate was pushed lower by 490 basis points. Assuming every $100 billion in asset purchases by the Fed corresponds to a 14 basis point reduction in the rate. If you use the same assumption for QT, the $400 billion balance sheet unwind has raised the shadow rate. But only by 56 basis points. That’s a big increase relative to the total hikes this cycle which equal 225 basis points.
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Fed is pausing rate hikes. So any further unwind in the balance sheet which increases the shadow rate is very hawkish. As you can see from the chart below, the Fed has been very cautious this hike cycle. The Fed has been cautious with the balance sheet unwind too. It waited until October 2017 to start the unwind and it gradually increased the size.
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The timing of the end of the unwind is interesting. If the Fed thinks it will hike rates again this cycle after a pause, then it won’t stop the unwind this year. It can’t restart it easily. If Fed knows it won’t raise rates for the rest of the cycle, it’s inconsistent to unwind the balance sheet. I think the truth is somewhere in between those two. Fed doesn’t know if it is done hiking rates this cycle. All the Fed knows is what we know which is that it won’t hike rates at the next few meetings.
Stock Prices - Powell’s Statement
Fed chair Jerome Powell spoke on Tuesday. Ignore the stories about his opinion on the Modern Monetary Theory because there is no way the Fed will backstop individual fiscal programs like the Green New Deal. Quantitative Easing is nothing like running unlimited deficits; QE is an asset swap.
On the balance sheet, Powell stated, "I would note that we are prepared to adjust any of the details for completing balance sheet normalization in light of economic and financial developments. In the longer run, the size of the balance sheet will be determined by the demand for Federal Reserve liabilities such as currency and bank reserves." The key point is the timing of the ‘long run.’ When is there a perfect scenario where the economy is fine, and the Fed can react to the demand for Federal Reserve liabilities?
Finally, Powell stated, the Fed will end the balance sheet roll-off when bank reserves are at $1 trillion plus a buffer. Currently, bank reserves are at $1.6 trillion. That means the unwind will end sometime around the end of 2019.