While many in Congress claim to be frustrated no one yet has found a key to get President Trump and Speaker Pelosi to the negotiating table.
Evidently the pressure to date hasn’t been severe enough to either. That will likely change sooner rather than later. While the direct economic impact will be fairly modest, if the shutdown lasts a lot longer, everything from public stock and bond offerings, small business loans, drug approvals and permitting needed to open or expand businesses will be impacted in a significant way. If there is a glimmer of hope, pressure builds daily. Elected officials are never immune to constituent outrage. We are probably at the point where no one wins; there are only going to be losers. That ultimately threatens every incumbent and they know that. Financial markets haven’t shown any negative reaction yet. When they do, expect the shutdown to come to an end quickly.
On December 20, prominent hedge fund manager David Tepper told CNBC that the Federal Reserve had taken away the Fed put on the market. In English, he meant that the backstop of ultra-low interest rates was gone. The resultant tailwind was no more. While his point was spot on, his public statement to that effect was a bit late. From the moment Jerome Powell became Chairman of the Federal Reserve, he made it pretty clear that as long as economic growth was solid, he was planning to restore interest rates to a neutral state via steady quarterly increases in rates. There were four such increases last year. In early October and again in December, both times accompanying rate hikes, Mr. Powell hinted that it was possible the Fed could even raise rates a bit past neutral if it felt the need to keep a lid on inflation. Both times he said that, markets were spooked. The equity markets declined sharply in October after leading averages set record highs in September. A brief relief rally took place in November but markets soon headed lower again and accelerated after Mr. Powell’s remarks in December. The final straw was a 2%+ move lower in a holiday shortened session on Christmas Eve. After that, Mr. Powell adopted a more conciliatory tone. While he had mentioned all along that actions at each FOMC meeting would be dependent on the data and evidence of the moment, he began to emphasize that the Fed had reached the bottom end of the range of normal and no further increases were required at the moment. While the Fed still penciled in two more increases in 2019, he indicated that after four in 2018, it might be prudent to pause and see how the data flowed in, especially given the total absence of inflationary pressures to date and the reduction in inflation expectations through the fall. Stocks started to rally and have been on a steady upswing although the pace of improvement was certainly more moderate than the sickening declines of December. Today, markets are now back close to fair value based on historic norms. Traders should be at least aware that both the February and October declines came suddenly and both followed strong previous months.
In that regard, look at the market action this week of companies that have reported results so far. The banks have mostly all rallied on rather tepid results. In general, loan demand has been good but trading has been poor. Earnings generally matched or beat expectations but revenue performance was mixed. Bank stocks got creamed from September through December in expectations of slower growth, weak trading, and a flattening yield curve. While results weren’t great, they were better than feared. Thus, the pop this week. Note that even with the gains, most bank stocks are still 10-20% or more below their 52-week highs. It isn’t just the banks.
Which brings me to my last topic for the morning and week. Late cycle. The most common phrase I hear almost daily is that our economic is late cycle. What does late cycle mean? Let me take a stab. To do so, I will define the economy in four phase; early cycle, mature cycle, late cycle and recession. I don’t think I need to spend any time defining a recession. That’s when the economy declines for at least two quarters. We clearly aren’t there.
Early cycle, when the economy escapes from a recession (or depression) is characterized by tons of added liquidity by central banks, low interest rates meant to goose demand, and a catch-up period when consumers gain the wherewithal to buy what they forsook during the recession. It is also a period characterized by sharp jumps in productivity. Companies don’t add workers until they are sure the economy is on solid footing. Thus, existing workers work a bit harder until new workers are added. This phase generally lasts a relatively brief period of time, perhaps 1-2 years on average. If the recession was serious enough, it might last a bit longer.
The next phase, the mature cycle phase, is when everything is generally humming along in a balanced fashion. Growth fluctuates but not by a serious amount. It generally follows a path defined by labor force growth rates and sustainable gains in productivity. In this phase, government policy is generally neutral. Inflation is tame. While it isn’t trivial to keep everything in relative balance, during this phase, the tweaks needed by central banks are relatively modest. I suspect we are in this phase today. It took the Federal Reserve a bit longer than normal to allow interest rates to normalize but every recovery doesn’t follow a financial crisis as severe as 2008. Perhaps the penalty for the Fed being late and having to catch up was a modest market decline in 2018 and an economy that got a little bit ahead of itself at the same time. Easy money also allowed some degree of speculation to creep in late in 2017 as stocks move toward 20x forward earnings and the buzzword at every cocktail party was bitcoin.
But that euphoria burned itself out before it became supercharged. This was not the Internet bubble redux. Which leads me to the last phase, late cycle. In my head, late cycle is when serious imbalances start to appear. In the stock market, there is an IPO boom where half-baked ideas have to opportunity to go public. In housing, it is like 2005 when one out over every two homes sold was sold to a non-occupant. It’s the Internet bubble. In 2007, it was credit default derivatives and collateralized mortgage pools. In 1987, it was portfolio insurance.
We saw whiffs of this in 2017. The aforementioned bitcoin bubble was one piece of evidence. The emergence of dozens of so-called unicorns, private companies with valuations of tens of billions was another. Some of this crept into the stock market but the decline of 2018 snuffed it out. Some of the unicorns were exposed as unsuccessful businesses. A few turned out to be outright frauds. But there real good news is that a modest correction in valuation in 2018 coupled with a Federal Reserve that did its job means that we remain in the mature cycle of the economic expansion with no obvious end in sight. The Fed neither has to raise interest rates to squelch inflation nor step on the accelerator to stimulate growth. Washington doesn’t have to do anything. Maybe it is so dysfunctional that it can’t anyway!
None of this means that we are problem free. Debt levels of corporations below the Fortune 100 are worrisome. Our budget deficits keep rising. Together with rising mandated entitlements, that will lead to a serious problem before too long. Europe, gripped with Brexit, gilets jaune, and other populist movements, is struggle to stay out of recession. Chinese growth is slowing. But to me, late cycle is the end, the last step before recession. I don’t think we are there. Rather I think market forces and the Fed saved us from approaching that stage. Perhaps, as 2019 begins, markets are seeing what I am seeing and the fears that so dominated December rightfully have faded. We are back to fair value. It isn’t time to be complacent. But it isn’t time to panic either.
Today, Kevin Costner is 64. On this date, in 1882, A. A. Milne was born. In his honor, today is Winnie the Pooh Day.
James M. Meyer, CFA 610-260-2220
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