Introduction
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You’ve heard of the old adage, “Don’t fight the Fed.” The Federal Reserve is a powerful force and has great influence over the economy. The Fed influences the economy through the fed funds rate, money supply growth, and announcements of its intentions. The Fed is divided on whether rates will increase or decrease in 2020, but it clearly has a bias toward easing right now. Money supply is growing quicker than GDP. It normally pays to heed the direction of monetary policy.
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Money Supply is Expanding Faster than GDP, and It Leads the PMI
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Remember equation 1 from macro-economics 101? Growth in money supply is directly related to growth in inflation (prices) and real GDP. Money supply growth needs to find a home. When growth is higher than nominal GDP, this could lead to (1) accelerating inflation, (2) accelerating real GDP, and/or (3) lower velocity. At this stage of the economy, all three would be heralded by the market as an achievement.
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Higher real GDP would lead to higher earnings, which would be cheered by the market since growth has stalled the last two quarters. Higher inflation, as long as it is not too high (core CPI is rising 2.4% Y-Y, but overall CPI growth and the PCE deflator are still below the Fed’s 2% target), would be an accomplishment. If the money supply does not find its way to GDP, then this means velocity declines. Banks grow lending at a pace slower than money supply growth, which means there is more savings. More savings drives bond yields down, pushing people out the risk spectrum to more risky assets that continue to rise. Also, savings eventually finds its way to the equity market.
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Figure 1 shows that money supply is accelerating quicker than GDP, and this leads changes in the PMI. The PMI should be bottoming about now if the model is predictive. However, sometimes the lead is shorter, but it averages around 16 months. This chart shows that the Fed has significant control over the economy – “don’t fight the Fed.” The Fed wants to stimulate the economy and it normally gets its way.
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The PMI Level and Change in PMI Drive Market Returns
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The PMI measures whether the manufacturing economy is improving or deteriorating. A reading above 50 indicates growth, and normally below 42.9 is indicative of a recession. The August PMI was 49.1, so it is close to recession levels, and the survey for prices (46.0) and orders (47.2) were even weaker.
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Figures 2-4 show that the PMI is highly correlated with both bond and stock markets.
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Figure 2 illustrates that the 10-year Treasury rate declined significantly as the economy faltered as investors ran to the safety of US government bonds. Also, the declining long-term rate and inverted yield curve indicate that the market expects the Fed to lower the fed funds rate to stimulate the economy. Lower long-term interest rates suggest lower future inflation which may materialize during a recession.
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High yield corporate bonds returns have started to lag Treasury returns (figure 3). Corporate bonds start with a yield advantage, so underperformance suggests that credit spreads have widened to compensate for corporate bonds’ extra risk going into a slow down. Through September 17, the Bloomberg Barclays Corporate High Yield Index is up 6.8% over the last 260 trading days and the Bloomberg Barclays Treasury Index is up 9.5%.
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S&P 500 returns are also highly correlated with the change in the PMI (figure 4). While the S&P 500 has been resilient (staying near an all time high) in the face of a declining PMI, it has treaded water since essentially January 2018 when the economy was running hot (see Positioning the Cycle). Plus, the intra-market returns are skewed to risk-off as cyclical sectors have significantly underperformed defensive areas of the market (figure 5).
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Will the Fed Be Successful?
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Figure 1 shows that the Fed is working to stimulate the economy by ramping up monetary growth and it is essentially always successful. Plus, the Fed is normally raising rates when the yield curve inverts, but it is not this time so does this indicate it is being more accommodative than in the past? Clare Zempel, former chief investment strategist and economist at RW Baird and friend of University of Wisconsin-Milwaukee’s investment program, guest spoke to my students last week. He discussed the inverted yield curve and how since the 1950s every time the curve inverted the Fed was raising the fed funds rate – except this time.
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Two questions remain? Should the Fed stimulate the economy, and will it work this time?
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Let me answer the first question by asking you this. Does it make sense for the Fed to stimulate the economy by allowing people to lever up more (and bring forward consumption) late in a cycle when leverage is already high? It made sense when the economy was in the depths of the financial crisis to pull forward consumption by stimulating spending and borrowing. However, what about now? There are already bubble-like tendencies in corporate debt (it is high as a percent of GDP (figure 6)), and there is a large amount of debt just above junk that is coming due in more significant amounts over the next few years and it is less credit worthy than before (slide 35 of 4Q 2018 Update). Furthermore, the percent of money-losing companies has risen (35-40% of the R2000, up 10 percentage points – figure 2 of Attractive Cheap, Profitable, Small Companies), money is pouring into venture capital and private equity, there is a large number of money-losing IPOs, etc. Enabling borrowing now may just lead to a worse recession later as leverage continues to rise. Small firms (less than 500) employ about half of the country. What will occur in the next recession if they are downgraded to junk, institutions sell, there are no buyers (because of institutional investment policies, fear, and the Volker rule), and firms cannot get needed financing to repay debt when it is due? To survive, there could be a firing frenzy.
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The second question is on whether injecting liquidity will work during late cycle. Corporate debt/GDP is high (figure 6), so do firms really want to leverage up more? The consumer financial obligation ratio (FOR ratio) was 15.38% in 1Q 2019, down several percent from its pre-crisis highs (18.13% in 4Q 2007), so one could say consumers can still lever up, but what would happen if interest rates were normal and people lose their jobs? Would this ratio – for mandatory payments by consumers – be at a high? Are consumers really that much better off? Are they really willing to spend because of lower rates? On the other hand, the latest on housing starts and sales is positive perhaps in response to lower mortgage rates.
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Hours worked is slowing (margins are peaking so firms are cutting back) and employment growth is slowing (most people have a job and corporations may worry about margins deteriorating so they may slow the pace of hiring). Consumer confidence is very high and looks like it has peaked (figure 7), and S&P 500 returns are correlated with retail spending and the market has gone nowhere for nearly two years (figure 8). Wage growth continues to accelerate (figure 9), net worth is high, and the savings rate is high, so these factors are positives, but the other items mentioned earlier are a hinderance to consumers leveraging up.
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I will come back to my first question again. Do we really want people to lever up more at this point in the cycle? Borrowing just brings future consumption to today, and potentially lowers future growth. The economy was slow to grow after the financial crisis as banks and consumers delevered, as the financial crisis was caused by consumers and financial sectors having too much debt. Now, the government and corporate sectors are over-levered (see figures 16-23 of Positioning the Cycle). Do we really want all four sectors to have too much debt going into the next recession?
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Economic Model is Still in Nose-Dive
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The success of the Fed, and other central bankers who have also turned on the monetary spicket, are critical to stimulating the economy. The economic model tracks eighteen consumer, business, credit, and policy variables, and it is in a nose-dive (figure 10) and is highly correlated with GDP (figure 11).
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The models latest August 2019 reading was -0.23, which represents a Z-score of a composite score to a moving average. This is down from 1.12 in April 2018. It fell to -0.01 in June and has continued to plunge. Both spending (consumer and business) and financial factors (credit and policy) have contracted (figure 12). When the model contracts, stocks normally underperform bonds (figure 10).
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As the model crosses lower than about -0.50, it normally declines further until a recession materializes. There were three exceptions. In January 1987, the reading was -0.48, ahead of the infamous October 1987 plunge (the reading rose to 0.99 by October). In January 1996, the reading fell to -0.78 when real GDP growth slowed to about half its prior pace. Finally, the reading was -0.54 in November 2015, but for all practical purposes a recession ensued in the manufacturing sector at the time which was caused by the collapse in oil prices. In each of these months and periods around them, M2 growth accelerated past GDP growth or was on the rise, perhaps keeping the economy out of a recession. In January 1987 M2 growth grew 4.9% faster than GDP growth (by October 1987 it had slowed to -2.8% and perhaps led to the market crash), in January 1996 M2 growth was behind GDP growth by 0.2% but up from -0.6% and on its way to 1.0% by March, and in January 2016 M2 growth surpassed GDP growth by 3.8% (up from 0.9% in March 2015 and peaking at 4.7% in August 2016). Thus, the exceptions for the model contracting from about -0.50 to recession territory were due to actions by the Fed to stimulate the economy through money supply growth, much like today. However, those periods were also not late into an economic expansion, like today.
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Furthermore, the Fed’s success may be influenced by current geopolitical risks including the trade war (see Does the Trade War Matter? Can the US Win It?), Brexit, the slowdown in China, and the attack on Saudi oil facilities that took out about 5% of global oil capacity. China is stimulating its economy with both fiscal policy (e.g., it is running up the deficit/GDP by one to two extra percentage points this year) and monetary policy (e.g., it reduced the required reserve ratio, etc.). However, the spike of oil prices caused by the disruption in Saudi Arabia oil capacity is concerning. Several of the prior recessions occurred after a spike in oil prices (figure 13), possibly causing a ramp up in inflation which the Fed had to counteract to control. Figure 14 shows my inflation model which depicts the change in the CPI annual growth rate (effectively, the shaded area is acceleration or deceleration in CPI growth). The three components of the model include oil prices (positive relationship), real GDP growth (positive relationship), and the dollar (negative relationship). All three variables have been supportive of lower inflation which has allowed the Fed to be accommodative, but a revival in real GDP, a pop in oil prices, and a declining dollar (if world growth picks up) are all inflationary catalysts. If inflation spikes, then all bets are off for economic re-acceleration as then the Fed will need to switch to being restrictive.
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