Research Note: Watching for Late Cycle Warning Signs

August 15, 2017 | Market Commentary

Our top down commentary over the past several quarters has consistently maintained the view that while the economy has moved later cycle, there are few observable extremes that suggest a major recession or bear market is imminent. This has been the correct interpretation to date, but the reality is that at some point the view must change or it will be wrong. The death of bull markets and economic expansions alike tend to be remembered as being brought on by a single obvious catalyst, such as the sub-prime housing boom of the 2000s or the tech bubble in the 1990s. The starting point for each bear market and recession seem clear in retrospect, but in real–time, the risks built up gradually until a tipping point was reached. Low volatility often encourages greater complacency, allowing risks to build out of the view of the market.

Concerns over complacency are especially relevant today as market volatility is near multi-decade lows. The VIX has seen 16 of its lowest 25 closes, dating back to 1990, occur in the last 3 months! The near record low volatility can also be seen in the chart below, which depicts the frequency of volatile market days since 1980. Low volatility periods can persist for extended periods of time; however, they have a tendency to allow excesses to build that must eventually be worked out of the system. The adjustment is rarely a pleasant process.

Our top down tools continue to indicate that a sustained bear market is not lurking right around the corner, but there are a number of developing risks that require vigilance in order to avoid being lulled into a false sense of complacency. The risks that we will explore in this research note include coordinated monetary tightening by the world’s central bankers, early signs of consumer financial health issues, and the potential for investor disappointment as economic activity has fallen short of elevated expectations.

The Global Financial Crisis ushered in an era of unprecedented monetary policy response as central bankers around the world ventured into the realm of negative discount rates and quantitative easing. The zero bound was broken by several policy rates and, at one point, even the 10 year German Bund sported a sub-zero yield! The past several years have seen global financial markets gradually step back from the abyss, to the point that policy normalization has begun in some regions and is at least the topic de jour in others. The U.S. Federal Reserve’s discount rate now stands at 1.25%, and domestic deposit rates have in many instances increased accordingly. Looking beyond the U.S. market, we have begun to see deposit rates move higher across markets. The chart below shows the twelve-month moving average of the percent of countries that have experienced a month-to-month increase in their deposit rate.

This proxy for monetary policy activity suggests that conditions are beginning to become less accommodative, if only slightly. If the largest of the world’s central banks contributed to the rally in asset prices around the globe, what might happen if conditions started to go in reverse too quickly? The answer is unknowable today, but it is a risk that warrants ongoing tracking.

The glut of global liquidity has served to bid up the price of financial assets the world over, and send income seeking investors far and wide in their quest for yield. While many investors have been appropriately chastened by the subprime mortgage debacle of the last decade, others seemingly have forgotten these painful lessons as witnessed by the surge in subprime auto lending in recent years (chart below).

The good news is that subprime auto loans are a fraction of what subprime housing debt was at its peak. Furthermore, while subprime mortgage debt was the feedstock for massive amounts of attempted structured finance alchemy (anyone remember CDO-squareds?), subprime auto debt is but a bit player in both the domestic and global credit markets. The troubling issue is that delinquencies are on the rise despite unemployment levels that rival some of the best economic expansions. This curious trend can also be seen in the upward trajectory of credit card delinquency rates (chart below).

To be clear, the economy is a long ways away from a repeat of the consumer debt fueled disaster that set off the Global Financial Crisis. Delinquency rates have only moved modestly higher in recent quarters, but this is an area that should be closely monitored after eight plus years of economic growth.

The final risk to be highlighted here is the recent trend in the “soft” versus “hard” data debate. Last November’s Republican sweep of the U.S. House of Representatives, Senate and Presidency led to a surge in confidence and optimism in numerous surveys (i.e. “soft” data). The subsequent months ushered in a debate as to whether or not these elevated expectations might be sufficient to stoke the so-called animal spirits of the economy, leading to stronger economic activity (i.e. “hard” data). Thus far, the soft data has proved to be a questionable arbiter as the actual economic data has not come along for the ride. Recent months have seen many of the surveys start to converge back towards the “hard” data, and the markets thus far have been unfazed by this progression. Indeed, U.S. large cap stocks have reached new all-time highs despite the Citi Economic Surprise Index plummeting on economic releases that failed to meet investor expectations (chart below).

It was little over a year ago when the market was seemingly convinced that disappointing economic releases were a signal of an imminent recession, and it was a question of not if but when the Fed would join a group of other central banks to adopt negative yields. Is it too fanciful to suggest that another period where the market treats bad news as such cannot occur today? We think not.

While these risks are not enough to warrant a deviation from our current outlook, they do reinforce the importance of active asset allocation and the need for proactive risk management as this bull market moves into its ninth year. The best time to own risky assets is when their upside/downside profile is overwhelmingly skewed toward the former. Such favorable conditions tend to emerge from bear markets where both valuations and expectations of future growth are slashed. In these instances, risky asset owners have the opportunity to benefit both from a favorable normalization of valuations as well as earnings growth. Today, it is very difficult to argue that equity investors are due any further multiple expansion, and while earnings are likely to grow as a whole, the rate of growth might be modest. All things considered, we believe that a modest underweight to equities is warranted to acknowledge the risks of investor complacency and elevated valuations. We continue to closely monitor our economic, valuation, and sentiment indicators for signs of this dynamic changing.

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