Looking again at the Fundamentals

 A month ago (has it really been that long) I took a look at the fundamental trend of the economy and therefore the market. At that time, the trend was positive. The expectation was that economic growth would slow this year, however, it was slowing from all-time high levels. That is no reason for concern.  The drivers of the economy were still in place but were slowly being removed in terms of liquidity and stimulus. Again, we know we are going to be slowing, but this is from very high levels. Finally, the relative valuation of risk assets was not too bad. As we have seen in other categories, there were reasons to be worried near-term, but not the fundamental strength of the economy. Remember, it is the economy that drives earnings and earnings drive stocks.

A month later, how are we feeling now? the market has been under siege for a month. The S&P 500 is one of the best leading indicators of the economy. It may seem a bit circular but call it the wealth effect or reflexivity. The performance of the market leads to companies and consumers feeling wealthier or poorer and we see this affect consumption behavior and therefore the economy. How do we try to think about where the market may go then? We need to look at indicators that don't just lead GDP, but lead the leading indicators. The market is having a growth scare. Is this just a mid-cycle slowdown or something more meaningful? Let's take a look at a few ideas and see if we can get a thought on that. This will help us determine how we want to manage through the volatility of this market. 

Monetary policy

A major driver of the economy is monetary policy which affects the economy with a lag. This year, there has been considerable focus on changes to Fed policy. However, in a world with global capital flows, what really matters is what all central banks are doing around the world. My good friends at Cornerstone Macro put together a measure of global short rates, which is a GDP weighted measure of monetary policy around the world. Believe it or not, while the Fed has only just started removing some liquidity, global central banks have been acting for a year. In fact, with the move by the Bank of England this week, there have been 106 different tightening moves by central banks in the last year. You can see from this chart, that global short rates have moved higher by 174 bp year over year. The second chart shows you the impact this does and should have on our expectations for global PMI going forward. Again, we know PMIs were slowing, but as the rate of change in global short rates accelerates, this move lower in PMI could also begin to accelerate. 

 

Housing 

One of the best anticipatory indicators of the economy is housing. Housing is the biggest single asset on most people's balance sheet. Decisions on housing are the most major decisions and are not taken lightly. In addition, housing has a tremendous multiplier because it employs so many people who themselves are then spending money. Finally, furnishing a home is another wave of spending, or not. Thus, housing leads the economy, into and out of any recession. Again, I am using a chart from Cornerstone and it shows how housing leads ISM New Orders, which lead ISM manufacturing. This is another indicator that is pointing toward some choppier waters ahead.

New Orders

So housing is suggesting we might well see falling new orders. If we look at the components of the ISM, the ratio of new orders to inventories has some leading properties with the ISM itself. It makes complete sense. As new business starts to fall and inventories build up, this is an early warning of trouble ahead. Similarly, when orders are moving so quickly that inventories are depleting, this is a positive sign. This ratio has been falling for many months and it has little to do with supply chain noise. A great deal of consumer demand occurred in late 2020 and early 2021. Consumers had money and spent it. They have the goods they need. This is showing up as a negative sign for the economy. 

 

Regional Fed surveys

Each of the regional Federal Reserve branches is tasked with assessing the economic developments in its area and reporting back to the FOMC. Many of these regional branches put their measure of the economy in their region out for the public. These measures have a good correlation with the ISM and SPX. I like to look at Chicago, NY, Philly, Richmond and Dallas. It has enough breadth of the economy and enough length in the data series. These measures are also pointing to some tougher times ahead. 

 

China

I am concerned about global markets and therefore do not want to be too US-centric in my focus. I need to look at China but one of the problems with assessing China is the lack of transparency and reliability in the data. However, former Premier Li Keqiang once discussed what he looked at to assess the economy. Whether he was trying to shed light on the matter or simply made a mistake by telling us, Bloomberg put together an index and now we too can use it to assess China. It is a simple but logical approach to analyzing the economy. It looks at bank lending, rail freight and electricity consumption. You can see how they each matter to the economy. China had a much better 2020 than the rest of the world but a rough 2021. Maybe some self-inflicted wounds there. Right now, the trend is not looking a heck of a lot better and so is yet another yellow flag. 

 

Equity Risk Premia 

You are probably saying to yourself 'isn't this already priced in?' You may be onto something. While I look at SPX P/E and EV/EBITDA in the Behavioral section, I do care about the relative valuation of the equity market vs. the bond market and the credit market in this section.  I use the P/E of the stock market and compare it to the P/E of the corporate bond market which is just the inverse of the corporate bond yield. I do the same for the Treasury market. You can see that we go through long periods of investor preference. In the 90s thru early 00s, equities were preferred and became quite overvalued, trading up to 12 multiple points higher than corporate bonds. From 2002 thru the financial crisis there was a lot more balance. Post the financial crisis, investors have consistently preferred getting beta exposure via corporate credit instead. With about $2 trillion in issuance the last 2 years, investors have gotten their fill as well. While there is some bad news on growth, some of this is already priced in because equities on a relative basis have lagged. Thus, we should keep our eyes on the credit market, which is more concerned with the return OF capital than the return ON capital. 

Fundamental Stock Indicator

Finally the last indicator I look at is the fundamental stock indicator, which looks at jobs, confidence and commodity prices. Much like the Li Keqiang Index, you can see why these measures should also be indicative of economic performance and therefore investor risk appetite. Much like the overall economy, it is pulling back from all-time highs. Not yet a red flag but certainly something that should give us some pause for now.

 

Pulling it all together, you can see that from an economic standpoint, we have a lot of yellow flags. As I said earlier, the consensus was that we would slow from these all-time high levels of economic growth, but that it might be a more gradual glide path. The indicators we are looking at are all pointing lower and are showing no signs yet of stabilizing. Thus, you can see why investors are nervous. Until there is some sign that the slowdown has slowed or stopped, one never knows how far it can go.  Equity returns are positive when the ISM is falling, however, they go quite negative when the ISM goes below 50. Where will it stop? It is too soon to tell and a lot of signs suggest caution. We are in a 'sell-the-rallies' market until we get more clarity on this trend. At least equities look to be a better value relative to corporate credit. Keep your eyes there. If it starts to wobble, it is time to get really nervous. 

Stay Vigilant