The global trade system may be stumbling toward collapse. The stock market, though, appears remarkably unconcerned.
During the first half of the year, North American stocks managed to shrug off trade-war rumblings and tirades from U.S. President Donald Trump. In Canada, the S&P/TSX composite finished June at essentially the same level it started the year. In the United States, the S&P 500 advanced modestly, gaining 6.2 per cent in Canadian dollar terms.
The question for the second half is whether stocks can continue to remain impervious to the new reality of rising tariffs. The answer hinges on whether economics, history or politics will dominate investors’ minds.
If it’s economics, stocks should continue along their placid course. Following huge tax cuts unleashed by Congress late last year, the U.S. is booming. Unemployment has fallen to its lowest level since 2000. Corporate profits are on a tear. While you can disagree with the rationale for the tax cuts, and worry about the deficits they will leave behind, there’s no reason to think the market-boosting impact of all that stimulus will suddenly fade between now and Christmas.
On the other hand, people who know their history should be cautious. Wall Street has advanced for more than nine years without suffering a 20-per-cent drop, the usual definition of a bear market. This extended period of investor bliss is on track to become the longest bull market in U.S. history on Aug. 21, according to Howard Silverblatt of S&P Dow Jones Indices.
You have to wonder how much longer this geriatric bull can run. Politics could be the blow that finally brings it to a halt.
Mr. Trump’s ferocious defence of his highly personal “America First” interpretation of macroeconomics has already soured relations between the U.S. and its major allies as well as China. Further escalation of the current conflict, especially a showdown between Washington and Beijing, could send stock prices tumbling worldwide.
Investors should remain on high alert. To help, we’ve assembled a six-pack of key indicators that can help guide you through the current chaos – or at least gain a bit more insight into some of the forces at play.
The long and short of it
Only bond geeks normally pay much attention to the yield curve, a measure of the difference between short-term and long-term borrowing costs. But this obscure yardstick has emerged from the shadows in recent months – and for good reason. Over the past half-century in the United States, it has provided remarkably accurate warnings of trouble ahead.
The danger comes when the yield curve inverts its normal shape. It almost always costs more to borrow money for 10 years than it does for two years. But on the rare occasions when two-year rates on U.S. Treasury bonds move higher than the equivalent 10-year rates, a recession typically follows within six months to two years.
Why is an inverted yield curve so ominous? In part, it’s because it suggests financial institutions will have to pay more in interest on short-term deposits than they can make by lending the money for longer periods. That has a chilling effect on lending and on business in general.
The yield curve is still not inverted, but the gap between short-term and long-term rates has narrowed to its tightest level since 2007, just before the financial crisis. At a mere 33 basis points – there are 100 basis points in one percentage point – the yield curve is essentially flat.
If the U.S. Federal Reserve continues to hike short-term rates, and long-term rates remain at historically low levels, the yield curve will invert. If that happens, brace yourself for a stampede of investors out of the market.
Good news in stores
Not everyone finds the yield curve all that persuasive, especially right now. Skeptics argue that massive bond buying by the Fed and other central banks has artificially depressed long-term rates.
If you’re seeking further clues to what lies ahead, a look at consumer spending can provide some help. Most of the time, sales at U.S. stores and restaurants grow in real, or after-inflation, terms. When year-over-year growth stops and real sales shrink, a recession is often starting.
To be sure, this isn’t an infallible indicator. There are occasions when growth touches zero or falls below that line without a recession beginning. But the combination of two signals – a recently inverted yield curve and anemic retail sales growth – usually indicates a serious downturn is brewing.
Right now, real retail sales growth tells a positive tale. In the most recent report, for May, U.S. retail and food-services sales expanded at a 3.1-per-cent annual clip. At least by this measure, there is little need to worry about a recession any time soon.
Safe as houses
Of course, not all potential problems emanate from the United States. In Canada, one big question is what home prices will do next. Stagnating or falling house prices would hurt a large swath of the economy, from mortgage lenders to construction workers to real-estate agents.
The Teranet-National Bank National Composite House Price Index offers a convenient way to track what’s happening across Canada. After advancing without a break since the financial crisis, the index has struggled to make new gains since last August. However, in May, the benchmark advanced 1 per cent from the previous month.
For now, that suggests trade fears and new mortgage rules are having only a limited effect on this key sector of the Canadian economy. That sanguine view gibes with a recent report from Moody’s Analytics, which predicts minor falls in Toronto and Vancouver home prices, but argues an extended national decline is unlikely.
However, if the Teranet index starts sliding again, and keeps sliding for more than a few months, all bets are off. Investors could well take that as a cue to start selling Canadian stocks.
The question that hangs over markets everywhere is whether global commerce is heading for a big freeze. Three indicators can help you monitor whether the current head-butting on tariffs is merely an annoyance or something more ominous.
For starters, there’s the CSI 300 Index, which tracks the top 300 stocks on the Shanghai and Shenzhen exchanges. It’s a notoriously volatile benchmark, but it offers a useful window on the state of mind of Chinese investors and what they foresee for the trade showdown between Washington and Beijing. The index has been sliding since late January as the rhetoric grows increasingly fierce.
On the other side of the world, the S&P SmallCap 600 Index offers a complementary viewpoint. This benchmark of smaller U.S. companies has soared over the past year as investors have reacted to trade concerns by flocking to businesses that are less exposed to international markets. The index has declined in recent days, suggesting that some people, at least, may be growing more optimistic about the outcome of trade talks.
Finally, there’s the yield on the 10-year Italian government bond. It’s a good indicator of the state of euro zone tensions, with a higher yield indicating elevated stress. The yield soared in May, shooting from below 1.8 per cent to almost 3.2 per cent, as worries grew over Italy’s new populist government. It has since subsided to about 2.7 per cent, but any new surge would signal a fresh worry for investors.
WHERE TO FIND IT
You can track the current state of the yield curve by going to FRED, the economic data site maintained by the Federal Reserve Bank of St. Louis (fred.stlouisfed.org). Search for “10-year minus two-year” and you’ll see the current difference between the two yields.
FRED will also give you the latest on U.S. retail sales. Search for “advance real retail and food services sales,” then use the edit button to display the number as a percentage change from a year ago.
The Teranet house price index can be found at housepriceindex.ca. Turn to Google for the stock market indexes and Italian bond yield.