Welcome to the Rorschach Economy. Like the famous ink-blot test, today’s market is an ambiguous mass of squiggles that people can interpret in wildly different ways.
Pessimists can point to fading factory activity, negative bond yields and rising trade tensions as evidence that calamity lies ahead.
Optimists, meanwhile, can gesture at 50-year lows in Canadian and U.S. unemployment as proof that the world is unfolding as it should.
Differences in opinion are nothing new, but today’s divergence is striking, with bonds and stocks offering diametrically opposed takes on the state of the global economy.
Bond markets seem braced for terrible news. Maybe it is a recession immediately ahead. Or maybe it is slow growth for as far as the eye can see. But whatever the exact reason, bond buyers are in a hyper-cautious mood. In most countries, they’re willing to buy bonds that yield next to nothing or even less.
Stocks, on the other hand, are positively buoyant, with share prices in both Canada and the United States standing near record highs. This suggests most equity investors expect economic growth to remain at least somewhat robust.
The divergence between stocks and bonds may reflect the prevailing uncertainty about global politics, from a potential impeachment of Donald Trump to Hong Kong riots. But if the problem was solely politics, both bonds and stocks should reflect similar levels of caution. They’re not, which suggests that people are reading the current economic ink blots in very different ways. Here are some of the greatest areas of disagreement.
One of today’s biggest uncertainties is how much of an effect trade tensions will have on factories around the world. Canadian and U.S. factories have had a bumpy ride since the start of this year, while those in Germany and many other euro-zone countries are already in a deep downturn, according to purchasing managers indexes compiled by research firm IHS Markit.
The European slump reflects a broad global slowdown in auto sales. Auto demand is falling in 12 of the world’s 15 largest auto markets, “with sales plausibly on track to decline by more than 5 per cent this year,” according to Eric Lascelles, chief economist at RBC Global Asset Management. To put that into context, he adds, the global financial crisis of a decade ago saw a mere 3.6-per-cent drop.
However, optimists aren’t conceding a recession any time soon.
The recent readings on North American manufacturing are poor, but not horrendous. Consider, for instance, the ISM Manufacturing Index, which jolted markets earlier this month with an unexpectedly weak showing of 47.8. (Any number under 50 indicates contraction.)
The index, which tracks U.S. factories, “normally descends into the low 40s before an economy-wide recession occurs,” Mr. Lascelles says. The latest reading is only slightly worse than levels recorded in 2016 and 2012, neither of which led to an economy-wide recession.
One potential bright spot in North America would be a resolution of the strike among U.S. workers at General Motors Co. The strike, which began on Sept. 16, has crippled GM factories and battered suppliers.
Then there is the services sector, which accounts for a much larger portion of the economy than manufacturing. It may help offset the weakness in factories. The Global Services Business Activity Index compiled by IHS Markit fell to 51.6 in September, its weakest reading in more than three years. However, it remains at a level associated with economic expansion, not contraction.
Signs of a slowing global economy raise questions about lofty share prices in both Canada and the U.S. Are investors being too complacent, given the dimming outlook for growth?
Maybe so. One of the more reliable ways to measure the froth in stock markets is known as the cyclically adjusted price-to-earnings ratio, or CAPE.
It measures current share prices against their average earnings over the past decade. This long-term view of profits evens out blips in the business cycle. It shows just how richly valued the market is in terms of its ability to generate consistent earnings.
Right now, the CAPE ratio for the S&P 500 stands at 29, which is the highest level it has ever reached outside of the dot-com bubble or the run-up to the Great Depression. Compared with the 16.9 average that has prevailed since the 1870s, today’s CAPE reading looks positively slaphappy.
This is unquestionably disturbing. Still, it may not constitute reason to run for the hills.
Aswath Damodaran, a professor of finance at New York University and expert on stock valuation, argues that comparisons of share prices to earnings are misleading on their own. They have to be seen in context of what other investments have to offer. Bond yields today are some of the lowest in history. Compared with bonds’ miserly payouts, stocks don’t look like obvious losers.
Prof. Damodaran calculates what he calls the implied equity risk premium, a gauge of how much extra return investors are expecting to collect from stocks compared with Treasury bonds, based on the growth that analysts foresee in companies’ cash flow and earnings a share. You can think of the risk premium as the extra payoff the market is demanding for the extra risk that goes along with investing in stocks.
When investors are unduly optimistic, the equity risk premium shrinks because everyone wants to own shares at any price. When the mood is more cautious, the risk premium expands, because investors insist on a bigger cushion of safety.
Right now, the equity risk premium is higher than its historical average, suggesting that investors are being properly cautious, according to Prof. Damodaran. “Given Treasury rates, earnings and cash flows today, stock prices are not unduly high,” he says.
The bond market
Only bond geeks usually care about the yield curve, a gauge of how short-term bond yields compare with longer-term bond yields. In recent months, though, this obscure indicator has become a hot topic, because short-term yields have moved higher than their longer-term cousins – an inversion of the usual pattern. Similar inversions have nearly always preceded U.S. recessions in recent decades.
Should investors be alarmed by the inverted yield curve? Perhaps. But optimists can fire back with a slew of more positive indicators.
Consider the excess bond premium, an even more geekish financial gauge. It measures risk appetite in the corporate bond market. In contrast to the yield curve, the excess bond premium has been steadily falling in recent months, indicating a reduced level of anxiety. In September, it indicated a mere 8-per-cent chance of a recession in the year ahead.
Or look at the Sahm recession indicator, which uses changes in the unemployment rate to gauge the probability of a U.S. downturn. Based on September jobs data, it sees less than a 20 per cent of a recession over the next 12 months.
If nothing else, the flurry of conflicting indicators underlines the essential nature of the Rorschach Economy. This is a moment when uncertainty reigns and people can see what they want to see.
For investors, caution seems to be in order, but not panic. If you are comfortable with the overall level of risk in your portfolio, doing nothing is a fine notion. But if a downturn would put a serious dent in your retirement plans, now may be an excellent time to become more conservative.
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