After a torrid start to the year, global stock markets corrected this week. The immediate catalyst was rising bond yields around the world. For the week the S&P 500 dipped -3.9% while small-cap stocks were hit for -3.8%. The developed EAFE declined in line with the U.S. indexes while emerging equities fell -5.8%.
The Fed met this week and left the Fed Funds rate unchanged. However, this didn’t prevent longer-term bond yields from rising. The 10-year yield was up 19bps to 2.85%, as you can see below. 2-year yields barely budged.
The increase in yields wasn’t just confined to the U.S. As you can see from the table above, the German 10-year yield increased 14bps to 0.77%. For the week intermediate-term U.S. government bonds lost -1.5% while long-term bonds dipped -3.2%. High-yield was down -1.8% but bank loans were up +0.1%.
And then of course there is bitcoin. Another tough week for the cyptocurrencies with bitcoin losing another -20.9%, bringing the YTD loss to -37.6%. It is now down roughly 53% from the all-time high hit a few weeks ago. As it turns out, this correction is par for the course. As you can see below, in late 2014/early 2015 prices corrected over 80%. In 2011 the correction was over 90%. Now that would get your attention!!
Overdue for a Correction, but Earnings Backdrop is Solid
In some respects, the increase in rates is simply the excuse for some selling. After all, the markets are pretty extended on a number of measures. For example, the S&P 500 has entered the longest period since 1929 without a correction of more than 5%. As you can see below, it has been 402 days since the last 5% correction, the longest run since 1928.
The S&P hit an inter-day peak on January 26th. Since then it is down -3.9% through Friday’s close.
The earnings backdrop for the market remains positive. We are in the middle of earnings season and the results so far have been solid. 80% of companies that have reported have beaten earnings estimates, way above the long-term average of 69%. 82% have also beaten sales projections. As a result, earnings estimates for both 2018 and 2019 are being revised higher, as you can see below.
Rising Inflation Expectations Drive both the Fed and Yields
The economic underpinnings also remain solid. This is largely why rates are increasing, of course. Investors are ratcheting up their inflation expectations and driving bond yields higher as a result. The chart below shows investor inflation expectations (the so called 5-year 5-year forward rate). Expectations have increased noticeably in the last few weeks (from roughly 2% at the end of 2017 to 2.25% today).
But we shouldn’t get carried away. We are basically back where we were in late 2016 and early 2015. Hardy soaring inflation.
The latest trigger for the jump in both bond yields and inflation expectations was this Friday’s jobs report. The economy added 200K jobs in January while the previous two months were revised lower by 24K. The unemployment rate was stable at 4.1%. What got everyone excited was the payroll gain. Year-over-year earnings grew by 2.9%, the fastest pace since 2009, as you can see below.
This feeds into the long running theme that once unemployment hits a low level, wage growth starts to pick up as employers compete for a limited supply of workers. Typically, faster wage growth then feeds through into accelerating inflation at some point. Thus, higher bond yields.
The Fed basically acknowledged this at their meeting this week (Janet Yellen’s last). The post-meeting statement noted “solid” gains in employment, consumption, and investment. They also upgraded their inflation outlook from “expected to remain somewhat below 2 percent in the near term” to “expected to move up this year” – something viewed as a hawkish shift (I know, this is like reading tea leaves!!).
Tim Duy, one of the best Fed watchers out there, noted the following after the meeting:
“Bottom Line: The Fed is set to hike rates in March. I continue to believe that the hawkish tilt of the FOMC should entrench forecasts of three rate hikes in 2018 and that it is premature to conclude four or more. I don’t see reason yet to think the Fed is about to conclude they are behind the curve if they retain the current projected policy path.”
Three hikes this year would take the Fed Funds rate to between 2.00% and 2.25%.
What Should We Be Watching?
So how worried should we be about Fed policy, rising bond yields, and increasing inflation expectations? We would contend that we are still at the point where rising bond yields are reflective of a strengthening global economy. We are not to the point where they are constricting growth by any stretch. How will we know when rates have gone up too far and we are on the cusp of a recession/bear market?
There are a number of signs people look for. Rising credit spreads usually come before a recession (they didn’t increase much on Friday). The Leading Economic Indicator is usually also in a pronounced downtrend. Critically, unemployment is rising prior to a recession. As you can see below, there has never been a case where the 3-month moving average of the unemployment rate has risen by more than one-third of a percent with a recession ensuing.
We are clearly not at this point. The unemployment rate has been stable at 4.1% the last few reports.
There is another way to look at it. At least historically, whenever the unemployment rate has increased by an annualized rate of 5%, it was time to get extremely cautious (see the chart below).
What this means is a 4% unemployment rate increasing to 4.2% over 12 months (5% of 4% is 0.2%). We are nowhere near this point at the moment. Over the last twelve months the unemployment rate is down 13%. So, this indicator is not signaling a stock market peak – yet.
Yield Curve Measures
But what causes the unemployment rate to increase? Historically the Fed has engineered a rise in unemployment to slow an overheating economy. They typically do this by increasing rates. However, they often times raise rates too far and trigger a recession. How will we know they have gone too far? Probably when the yield curve inverts. As you can see below, the yield curve has inverted before every recession with one false positive in 1998 during the Asian Financial Crisis.
With the yield on the 10-year at 2.85% and the 3-month at 1.48%, we have a positive slopped curve of 1.37%. We are a long way from inversion. But it may occur over the coming quarters as the Fed continue to tighten. Something to watch.
But even this isn’t an immediate ‘get out of stocks’ signal. The lag between yield curve inversion and recession can be long. For example, the yield curve inverted in December of 2005, the market peaked in October 2007, and the recession didn’t start until December 2007.
Have a good weekend.
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