Cracks in the Wall

I wrote in December widespread market fear and pessimism in the US seemed like an overreaction based on fundamental data. To be clear, I don’t think US stocks are a good bargain, and I prefer emerging markets anyway.

But the YTD rally does support my view that the sell-off in Q4 was technical, and as investors pile back into the market, US stocks could very well make new highs. Ironically, this renewed enthusiasm for stocks could mark the beginning of the end.

I’ve consistently stressed the importance of emphasizing fundamental data rather than short-term market movements for long-term investing. While data held up well through last year, cracks in the wall are starting to show. I provide a few examples below.

Credit spreads, a reflection of financial market liquidity, have widened over the past year after staying tight for many years. There was an obvious spike in Q4, but even after reverting, spreads are finding support at wider levels versus one year ago. Figure 1 shows this for high-yield (option-adjusted), same is true for investment grade.

Figure 1

I’ve written frequently about the Treasury yield curve. This is one of the most reliable leading indicators and an inversion of the curve has preluded every US recession in modern history. The most widely followed curve segment (2 to 10 year) still has not inverted but is bouncing around basis points from doing so (Figure 2). And of course, less widely followed segments at the short-end have already inverted.

Figure 2

Employment, the most important driver of consumption and the economy, is strong without a doubt. But its momentum may be fading. After a long trend of decline in initial jobless claims, this leading indicator could be finally reversing the trend. If claims continue upwards, it’s likely they hit a bottom in Q3 2018 (Figure 3).

Figure 3

One other crack in the wall, admittedly a simple observation, is the recent emergence of the “Powell put.” The markets were anxious over Powell’s hawkish tone in 2018 and celebrated his “patient” position since January as dovish. However, that joy may be misplaced because Powell was tightening based on growth and is now pausing due to caution. The widespread positive reaction reeks of the consensus getting it wrong.

To clarify, my concerns are about the beginning of a deterioration process and not a specific turning point, I’m not calling a top here and now. We’ve heard warning shots and should watch closely for corresponding signs of weakness across leading indicators. And even then, the business cycle could still take months (even years) to ultimately turn.

The bottom line is I’m not calling for an imminent recession or crash in 2019, but the chances look higher now than they did last year. Just as Q4 was not the time to cash-out and expect market Armageddon, now is not the time to enthusiastically overweight stocks and expect a sustained rally. That’s especially true for US equities which I think are among the priciest and riskiest in the world right now.

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Victor K. Lai, CFA