Well, one thing we know about this recent surge in equity markets is that it has little do with anything real or fundamental.
The world economy is soft and getting softer. The global manufacturing purchasing managers’ index (PMI) is at a seven-year low, and its U.S. counterpart is at a three-year low, with backlogs and vendor performance extremely weak. And the World Bank just reduced its global gross domestic product (GDP) growth forecast for 2019 to 2.6 per cent from 2.9 per cent (the previous estimate was published in January), and sees only a feeble recovery in 2020 to 2.7 per cent.
Perhaps the most important data point this week, with due deference to the jobs report, was the number of times the Fed Beige Book used the word “uncertain” to describe the outlook – the most in six years. And in uncertain times, the private sector tends to boost its savings rates at the expense of spending growth, and those savings in turn gravitate to safe havens – one reason why bonds and gold have reasserted their traditional roles in uncertain times.
That said, in this delayed spring, May showers have turned into June flowers for equities. The market seems to be responding mostly to efforts by Mexico to appease the U.S. administration and prevent a costly chapter in this global trade war.
And, of course, this most recent “Powell Pivot II,” in which Federal Reserve chairman Jerome Powell gave a nod to the prospect of a policy easing. Market-based odds of a rate cut as early as July have shot up to even odds from just 20 per cent a month ago. This could certainly spark a brief and sharp rally, as we saw in early 2001 and again in the fall of 2007. But they don’t last long because of the reason the Fed is cutting rates to begin with: the recession – you know, the ones nobody ever seems to see even as they commence. Investors with long time horizons, but who still account for the cycle, know that you don’t go long on the first rate cut; you go long on the last one.
So what happened was a huge short squeeze in equities, with both large- and small-caps, as the stocks that had the highest short positions more than doubled the rest of the pack. The S&P 500 showed that the 200-day moving average proved to be resilient support yet again. But let’s face it – the April 30 peak of 2,945 seems light years away now and the index is actually right where it was all the way back on Jan. 17, 2018. This marks the 19th time that the S&P 500 has crossed above and below the 2,800 mark since first hitting that milestone 16 months ago. All that “long-only” equity investors have been left with for nearly a year and half is the dividend, heightened volatility and recurring anxiety attacks.
Keep in mind that we are coming off the worst May for the S&P 500 since 2010, and that ultimately compelled former Fed chair Ben Bernanke into rolling out QE2 (and then even more incursions and five more years of free money). This was, in fact, the second worst May since 1962! And we know, with all due deference to the technical rally in recent sessions, that June is one of the weakest months seasonally for the stock market. But we are coming off oversold levels, and it is not every day that we see the news telling us that ETFs saw assets slide US$20-billion last month. In fact, that is unprecedented. So as the shorts cover, average investors are appropriately de-risking. And it’s not as if bonds and gold haven’t been a good refuge of late.
With that in mind, I found it interesting this past week to see Bank of America chief executive Brian Moynihan issue a warning on the “carnage” that will ensue if the economy slumps (though he doesn’t expect the Fed to ease … come again?). To wit: “It’ll be ugly for those companies if the economy slows down and they can’t carry the debt and then restructure it, and then the usual carnage goes on … we should worry about that.”
Indeed, according to Moody’s, covenant protections for loan investors are about the weakest on record. That means borrowers can now easily move more collateral out of the reach of lenders, which means bigger losses in a downturn.
The key here is that it is the inevitable recession that impairs the cash flows needed to carry the excess debt, which ends up taking an economic recession into a financial recession with negative feedback loops right back into the economy. Remember, it was the recession that impaled the dot-com sector in 2001, not the other way around. The last recession started in December, 2007, and yet Bear Stearns went under three months later, and it was in September of 2008 that we had the likes of Merrill Lynch (sigh), Lehman and AIG go down for the count. I can go back to 1990-91, too – it was the recession that caused the commercial real estate crisis, which the Resolution Trust Corp. had to clean up, and the Fed had to slice the funds rate 700 basis points that cycle.
Keep in mind that all of these situations followed an asset bubble caused by excessive Fed easing cycles that shifted to a tightening phase. And typically the yield curve flattens or inverts, the economics community dreams up ways for why it’s no longer important, and the recession ensues with time lags that are long and variable.
Hold onto your hat.
David Rosenberg is chief economist with Gluskin Sheff + Associates Inc. and author of the daily economic newsletter Breakfast with Dave.