The Federal Reserve today announced its decision to proceed with a December rate hike of the federal funds rate. This is the fourth rate hike in 2018 and the ninth since the Fed started raising rates in 2015, each time with an increase of a quarter-percentage point (0.25%).
These rate hikes have reversed what was effectively a zero-rate policy after the Great Financial Crisis of 2008-09. The latest rate increase is under scrutiny because it comes at a time when all market indexes are in correction territory. Corrections are defined as market declines of 10%, but less than the 20% declines associated with bear markets. It is rare for the Fed to raise rates when markets are this beaten down — and, indeed, it has not done so since 1994. Also, consider that the S&P 500 being down over the last three, six and twelve months is a backdrop that has accompanied just two of 76 rate increases since 1980 (source: Bloomberg).
Along with this latest rate increase, the Fed adjusted its forecast for rate hikes in 2019 from three to two. However, the Fed’s more dovish messaging did not dissuade markets from reacting negatively. Today’s market action suggests market participants view this move as an error in policy.
Our positioning in our last post, End of Year 2018 – Maneuvering Delicately (Nov. 30), was that “while fundamentals are still relatively sound, and recessionary headwinds are currently not an issue, geopolitical risks remain, and volatility will be with investors for the foreseeable future. For the time being, our portfolios will remain positioned for economic growth until recession rumblings are detected.” As of today, Dec. 19, a short 13 trading sessions later, the markets have declined approximately 10%, and are down even more from their Q3 highs. While we pride ourselves on investing based on what the data are telling us and not being driven by our emotions, this quarter has been challenging.
The following tables show relevant economic and market indicators that historically have preceded recessions once they reach certain inflection points and highlight some of our current thinking about whether recession rumblings have been detected.
- Leading Economic Indicators (“LEI”) is currently at 5.9, a level not historically associated with recession.
- Unemployment claims typically have increased by more than 21% from their bottom entering a recession.
- Consumer Confidence is currently 135.7, a level not historically associated with recession.
- New Homes sales have fallen by an average 32% from their peak entering a recession.
- Temporary employment has fallen by an average of 3.8% from its peak entering a recession.
- Tonnage hauled by trucking has fallen by an average of 10.6% from its peak entering a recession.
Four of the six indicators have started gravitating towards a recession, but taken together, these indicators do not suggest a recession is imminent. However, when the indicators make a move away from their peak (for example, LEI) or bottom (think unemployment claims), we must start to consider the possibility that recession is closer than we would otherwise believe.
- Inversions along the Treasury Yield Curve have shown up in the shorter-end of the curve (the spread between 2/3-year and 5-year has inverted). Typically, the spreads between wider maturities (for example, 2-year and 10-year spread) are of more concern regarding future economic contractions. To date, none of these have inverted, although most have flattened significantly.
- The stock market peaks on average seven months before the start of a recession — although this can vary significantly. Historically, those peaks in the S&P 500 have been preceded by at least two of the other indicators. Right now, only one — housing starts — has preceded this peak.
Other items to note
The market is beginning to display signs of selling exhaustion:
· The percentage of stocks trading above their 200-day moving average is now about 16%, a level that has been associated with market bottoms since 1994, with only the 2008 GFC and Eurozone crisis of 2011 being lower.
Potential positives that could provide a catalyst:
· Some resolution to trade tensions with China.
· Fed Governors start to provide dovish messaging to offset the initial interpretation of the hawkish move today.
As we go to rebalance portfolios for 2019, two drivers that we use are valuation and recessionary signals. Based on valuation, equity markets are still a bit expensive relative to fixed income, and they dictate a greater allocation to bonds. Based on recessionary signals, (the signals are still in the distance, but they are starting to appear), once triggered, a substantial move to bonds would occur.
As always, we welcome further discussion. Please do not hesitate to contact us.
- Fed Rate Hikes Are Extremely Rare When Stocks Are This Beat Up
- Powell Enters Era of Rate-Hike Caution as Growth Headwinds Mount