What a difference a few weeks make. At the end of January, financial markets were melting up, commentators were salivating over the US tax cuts within an environment of global synchronised economic growth. Investors of all stripes were throwing caution to the wind as measured by extreme confidence measures and huge inflows into investment funds. We noted at the time that the new participation by retail investors was typically something seen in very late stages of a bull market.
Aside from the price, what has changed at the end of February? News this week that Trump is set to impost Steel and Aluminum tariffs (25% and 10% respectively) is new and important news, but should hardly be surprising to many as this is a theme that he promised on both the campaign trail and after he entered office. We feel like we have covered some of the other big issues of the day (valuations, debt levels as interest rates rise, funding the ballooning federal deficit as the Fed reduces its balance sheet) widely in recent weeks and months and so we are concentrating heavily on price developments at the moment.
We believe that we are at an interesting juncture in a number of markets as it pertains to pure price analysis. With momentum being such a powerfully bullish force in the last two years, any sign that bullish momentum is dissipating and confidence levels are rolling over reinforces our belief that the majority of markets have entered a multi-month topping process. One chart that is intriguing us at the moment, and actually reflects something positive in the US, is that of the NFIB Small Business Index. In chart 1 below, we plot this index alongside US GDP.
One area that we think Trump has actually had some success is with rolling back some of the mountainous red tape that exists. This, as well as some euphoria surrounding the tax cut, and perhaps a good number of small business owners being Republican supporters, may well lie behind the huge positive swing in this sentiment index post the US election, and also the fact that it remains at an elevated level.
In the months ahead, we will be watching for whether the high level or business optimism will drag economic growth the a higher level, or will some sort of disappointment see optimism decline. Clearly, tariffs and a potential trade war could influence the outcome here. We will just have to wait and see.
Chart 1 – NFIB Small Business Index & US Gross Domestic product
Consumer sentiment is also riding high. Historically, a booming stock market and low unemployment will make consumers optimistic, and vice-versa. The relationships can be seen in chart 2 below. We would point out that periods of flat equity performance such as that seen in 2015 coincided with stable (as opposed to rising) consumer sentiment. If equity performance and unemployment were to plateau or even deteriorate, than we would expect the same from consumer sentiment.
Chart 2 – Consumer sentiment with S&P 500 and unemployment
What we are watching very closely is the performance of credit spreads. We know that aggregate corporate debt is at historically high levels, and outside of a handful of large technology companies, balance sheets are more stretched than at any time in history. So, with interest rates rising, and without a mini economic boom, there is a point where many companies will become stressed. Before that point is reached, credit spreads will widen.
In fact, it strikes us that not only are credit spreads extremely tight on an historical analysis, but they have been in a tight range for the last year or so. If they were to increase by 0.50% or so from here, then it would appear that momentum has turned and spreads were widening. If the historical relationship were to hold, then wider credit spreads would be coincident with a lower stock market, which could impact both consumer sentiment, and perhaps also be coincident with a rise in unemployment. It seems unlikely that the economy will deteriorate in the next couple of months, but as we head into the second half of this year, these indicators and relationships need to be watched closely.
Chart 3 – High yield credit spreads with S&P 500
As should be becoming obvious, these relationships are all a bit circular. So long as equity markets move higher, credit spreads lower and the economy chugs along, then businesses and consumers will remain confident. If something breaks, then both financial and economic risks rise, perhaps quite quickly, as demonstrated by the speed and extent of the February correction.
So, moving onto the equity markets themselves. The US is holding up better than other markets. We put this down to the continuing huge buy backs from companies, magnified to a degree by the tax plan. As can be seen in chart 4 below, the long term trend remains higher and price remains above the rising 40 week moving average. Yet, after rising swiftly from the February low, the market turned lower quite abruptly this past week. Our preferred path for the US market in the weeks ahead is that it will move lower to test the February low.
Chart 4 – Weekly S&P 500 chart with 40 week moving average
The picture is different in Europe. Chart 5 plots the Eurostoxx 600 index. The post 2016 bull market appears to have failed to even overcome the 2015 high, which is a disappointment to the bulls. Furthermore, price has already cut below the 40 week moving average which is now falling and the rally of the last three weeks failed at the falling 40 week moving average. The picture here looks more neutral to bearish than bullish, although perhaps the first level of highlighted support, around current levels, will hold. Otherwise, we look for a further decline of 5% or so to structural support in the 350 index area.
Chart 5 – Weekly Eurostoxx 600 index with 40 week moving average
Chart 6 shows the FTSE 100. Although the post 2016 bull market did carry the index to new multi-year highs, we speculated a few weeks ago that this could prove to be a false breakout. The action since has done nothing to disprove that thesis. The decline in recent weeks has broken below the 40 week moving average which itself is now falling. The rally of the last few weeks has failed at the underside of a previous uptrend line and the index is already testing structural support in the 7100 area. If this breaks, we may see a swift move to the 6500/6600 area.
Chart 6 – Weekly FTSE 100 index with 40 week moving average
The Japanese and emerging markets appear to be in a similar technical condition to the US, i.e. the long term trend remains up, but the post February rally appears to have failed and a retest of the recent low may well occur.
So, to try and wrap things up this week, the rally of the last few weeks appears to have failed this past week. European markets appear to be the weakest structurally, but that does not mean they will necessarily underperform in the future. What we think this shows is that European markets are the first to have entered the multi-month topping process we have been calling for. We think that other markets have either also entered the topping process, or may make more minor new highs in the months ahead before joining in the process.
Federal Reserve speakers, including new chair Powell, confirmed this past week that rates will rise gradually (which NY Fed Dudley says may mean 4 times) and the balance sheet will fall as previously outlined. Tighter polices should begin to impact on more vulnerable businesses very soon. Furthermore, even the Bank of japan may consider exit strategies in a year or so, and so it is clear that central bank support for markets is dissipating. We look for credit spreads to break first, followed by concrete signs of a topping process in equity markets which should be fairly coincident with a deterioration in both business and consumer sentiment.
But, won’t the tax cuts boost the economy and animal spirits? Won’t share buy backs boost the equity market? Won’t central banks step in at the first sign of trouble? Of course these things could happen, but they did not prevent a nasty little correction in February. We will write about this more in future weeks, but we have our doubts about how big a boost the economy will receive from tax cuts, which may well weigh on sentiment in the second half of the year. We do accept that corporate buy backs are a powerful force, and this dynamic is what gives us bullish hope here. As for the level of the central bank put strike price; well, it would appear to be below the February low, perhaps quite a bit below.
The news of US tariffs is clearly the new dynamic that investors are focusing on, and if trade wars do break out properly, then we suspect that our more bearish tendencies will move front and centre. However, if investors wait for the bad news to hit the tape, they will already be too late to protect their capital. We suspect that if we are correct in our topping thesis, then investors will get several bites at the cherry in the months ahead to reduce risk. However, the mind set has to change from buy the dip to sell the rally.
When looking at sentiment surveys and price developments in markets, it’s all about trying to gauge the fabled animal spirits. At the recent peaks in equity markets, the animal spirits have historically barely been stronger, and yet we then witnessed the first 10%+ correction in 2 ½ years. We think that the animal spirits are generally peaking, and that the economy will simply not accelerate to justify even more optimism. In fact, any escalation in tariff announcements will surely dent optimism.
All that said, optimism does not die overnight, especially when buy the dip has worked so well for so long. Consistent with a multi-month topping process in financial markets, we expect business and consumer sentiment to deteriorate in the months ahead. And as noted above, this is all too circular. Once the animal spirits start to deteriorate, unless central banks stop tightening or even loosen policy and poor economic policies get reversed, the downside potential may really open up.
Stewart Richardson
RMG Wealth Management
