Authored by Nicholas Colas via DataTrekResearch.com,
Last week was a busy one, with US, European and Japanese central banks all meeting plus the announcement of tit-for-tat tariffs between the US and China capping things off on Friday. This week should be quieter, with not much in the way of US economic data. The only caveat: the US is not in the World Cup, which means American markets are not subject to the documented lower volumes that come when home teams play during market hours. Yes, this is a real thing…
The week ahead will therefore be one where investors consider the big picture, so today we have some data-driven takes on inflation, rates, trade, and a few other pressing issues. Let’s dig right in…
Inflation
That US inflation will remain near 2% forever is THE bedrock assumption in global financial asset prices right now. It keeps Treasury yields low even as the Fed unwinds its balance sheet. Low yields support US equity valuations, which in turn keeps the high yield/leveraged loan market running in high gear. Lastly, they support US consumer spending, which is the economic lynchpin of Asian and European exporting economies.
Markets currently agree that 2% is the right number. Here is the inflation expectations data from 5/10/30 Treasury break-evens (TIPS vs Treasuries):
- 5-year break-even rates have run from 1.6% expected inflation to 2.1% so far in 2018. The post-Great Recession highs were 2.5% in April 2011.
- 10-year expected inflation rates are now 2.1% as well, and started the year at 2.0%. Their post-recession highs were 2.6% (also in April 2011).
- 30-year expected inflation rates are now 2.2%, up from 2.0% at the start of 2018. The highs were 2.7% in April 2011.
What to make of this:
- Look at that 5-year data again. Seven years ago the expected inflation rate was 2.5%. That proved spectacularly wrong, with core inflation running well below 2% for most of the next half decade. Bottom line: breakeven inflation spreads are a function of market psychology, not better information about the future.
- The relationship between expected inflation and US equity returns is fuzzy, at best. Inflation expectations have breached 2.5% twice since 2010 – in 2011 and 2012-2013. In 2011, the S&P 500 only posted a 2.1% total return, but in 2012/2013 returns were 16%/32%.
Bottom line: US inflation expectations will likely rise further in 2018, but that alone is not enough to call the end of the equity bull market.
Fed Policy Mistake
There’s an old rubric that says, “The Fed ends every bull market”. We personally don’t put much credence in that; geopolitical events that spike oil prices have a much better track record as matador than the Fed ever will. Still, with the Fed’s decision to raise rates again this week, we hear some concern they are responding to the current tax-cut fueled growth environment rather than the sustainable (lower) trajectory of the US economy.
The shape of the US Treasury yield curve tells the story:
- When the yield on 10-Year Treasuries exceeds that of 2-Year notes, a recession comes along in 12-24 months. There’s plenty of good data to support this (see a link to a recent Fed paper below).
- Expectations of Fed policy drive 2-Year yields, while long-term inflation expectations/term premiums/investor risk appetites inform longer term rates. If short rates are higher than long term rates, that’s an implicit signal the Fed has gotten things wrong and is too aggressive.
- Current 2-10 spreads are 35 basis points, after starting 2018 at 54 basis points. They were 100 basis points in July 2017. The trend is clearly not the Fed’s friend here.
Bottom line: unlike the prior point on inflation expectations, we are actually concerned about the shape of the yield curve because market worries of a “Fed mistake” are gaining real traction. If the levels here were an equity price chart, you wouldn’t buy that stock; the yield curve seems destined to go to zero in the next 3-6 months. After that, the recession fuse is lit and stocks can still rise but they are living on borrowed time.
Trade Wars
We get questions along the lines of “Why isn’t all this trade chatter hurting equity prices?” Our answer: they are, just not US equity prices. The US economy is at the peak of a near term momentum cycle, and domestic stocks are responding to that. In the rest of the world, the story is different.
The year-to-date numbers for various local-currency equity returns:
- S&P 500: +4.0%
Which beats…
- Nikkei 225: +0.4%
- Shanghai: -8.6%
- Hong Kong: +1.3%
- South Korea KOSPI: -2.6%
- German DAX: +0.7%
- French CAC 40: +3.6%
- FTSE 100: -0.7%
Bottom line: if the US economy were as weak as Europe, or slowing like China’s, or as exposed to foreign trade as South Korea, it would be responding differently to trade war headlines. For the moment, the American economy is simply best-in-class. Should it slow in Q3 and Q4, trade war news will matter more.
Rates and the US Consumer
We had a long exchange with a good friend and ace researcher this weekend on the role higher interest rates may play on US consumers, with the transmission mechanism being credit card debt. Interest rates here are generally tied to prime, so as the Fed raises rates it makes this debt more expensive to carry. And since US consumers owe $984 billion in revolving credit (the Fed’s name for this, and they keep the records here) that could be a substantial problem.
Here’s the rest of the data, which tells a calmer story:
- Minimum monthly payments for credit cards typically run at 5% of total amount owed. Rates will rise, but that doesn’t mean consumers will have to pay the incremental cost all at once. Yes – their balances will increase slightly more quickly, however.
- Credit card delinquency rates are currently 28% better than the best levels of the last cycle (Q4 2005) at 2.54% versus 3.54%. That is a function of better bank risk management and indicates (hopefully) less exposure to marginal borrowers who might be unduly affected by higher rates.
- Credit card interest rates never got all that cheap in the first place. Fed data shows the 2013 troughs at 13% and current levels at 15.3%. Card customers never really benefited from extremely low Treasury rates in the first place.
The bottom line: there are some reasons to worry that higher rates will slow housing demand, but that only touches current home buyers and those with resetting mortgages. The most common form of household debt where rates can vary – credit cards – is less of a concern to us.
Summing up: we score this evaluation as 2:1 in favor of US stocks. Inflation expectations can creep higher without hitting equity values. Higher rates aren’t going to kill the marginal US consumer in one fell swoop. The one warning sign: the shape of the Treasury curve. Not an outright victory, but enough to keep the market narrative positive through the end of the quarter.
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