Our Top Market Takeaways for the week ending November 1, 2019.

Markets in a minute

Putting it in perspective

Not many spooky feelings here! Heading into Friday, the S&P 500 had rallied +0.5% and notched not just one, but two record highs this week. How common are these record highs, you might ask? There have been 15 so far in 2019, which is pretty in line with an average of 18 for such new highs in calendar years going back to 1950. What’s to thank for the optimism?

Well, it’s been busy for investors, with trade headlines, another Federal Reserve rate cut, and new data on corporate earnings, growth and jobs. And overall, this news has been more positive than negative. A few highlights: Q3 earnings season continues to surprise to the upside: Of those companies that have reported, 61% have beat on sales and 80% have beat on earnings per share. The U.S. economy expanded more than expected in Q3 at +1.9%, buoyed by consumer spending, and the latest U.S. jobs report showed a still very robust labor market (adding 128,000 jobs in October versus expectations for 85,000). And while the latest manufacturing surveys suggested lackluster activity, at least they aren’t getting worse. To top it all off, the Fed’s third rate cut this year continued the central bank’s accommodative policy streak.

During busy weeks like this, it is easy to get caught up in the details. But at the end of the day, we have to put new information into perspective and consider one key question: Does it change our view of where we are in the cycle?

Spotlight

Where are we in the cycle?

This is a crucial question for investors to answer. Different assets tend to perform better at different points in the cycle, and, perhaps most notably, risk assets like stocks and high yield bonds tend to lose substantial value when “late cycle” becomes “end cycle.” We talk about “the cycle,” but there are really a few cycles that we need to consider. Specifically, while the most important is the economic cycle, the market cycle, and the monetary policy cycle are also crucial, and they all interact to influence one another.

 

Where are we in the economic cycle?

There are many convincing signs that we are late in the economic cycle, but let’s focus on the labor market and economy-wide corporate profits. On the former, the unemployment rate has been declining for 10 years, and hasn’t been this low since 1969. This is one indication that the economy is running up against a natural barrier to growth.

When there aren’t many workers left to hire, businesses have to compete for their services. The easiest way to do this is to raise wages. Other resources (such as raw materials, intermediate goods, and support services like consulting, advertising, or audit) also become more expensive as demand increases. These rising costs are in part absorbed by corporate profit margins. In the U.S., these have been steadily declining since 2015. Because the U.S. seems to be reaching some structural limits, and business are having to absorb higher costs, we are comfortable saying that we are “late” in the economic cycle.

The chart shows the corporate profit margin percentage from 1970 through 2018. It has been declining since 2015.

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Where are we in the market cycle?

Markets tend to have shorter-term cycles than the economy as a whole (there have been three distinct equity market cycles in this expansion alone). One reason why they happen frequently is that they are influenced just as much by, in the words of John Maynard Keynes, “spontaneous optimism” as they are by “fundamentals.”

Further, equity markets are more levered to manufacturing than the economy as a whole, and manufacturing activity tends to be more volatile than other segments (think about the consistency with which you pay your phone bill versus how often you buy a new washing machine). Because of this, manufacturing Purchasing Managers Indices are typically useful in measuring the market cycle. Over the last 20 months, PMIs have fallen and stock prices have flattened out. Recently, there have been some early signs of stabilization, but it seems too early to declare an imminent upswing. Overall, it seems like the market and manufacturing cycle is close to bottoming. 

The chart shows the year-over-year percent change in stock price returns and the Global Manufacturing PMI from 2003 through 2019. The graphic illustrates that the two tend to be correlated.

Where are we in the monetary policy cycle?

This week, the Federal Reserve lowered interest rates for the third time this year. In its statement, it hinted that it may be able to keep rates on hold (as long as economic data cooperates). This would be a welcome change, given the Fed has been very active. Consider that one year ago, the market expected the Fed to hike the fed funds rate to ~3% by the end of this year. Now the Fed has already cut rates by 25 basis points three times, and is expected to reduce rates by another 25 basis points by the middle of 2020. Said differently, the interest rate cutting cycle is either over or very close to being over.

The chart shows the federal funds rate from 2015 projected through 2021. It shows the difference in the expectations from 12 months ago versus the expectations today. Twelve months ago, the Fed was expected to hike rates, but instead, the Fed has already cut rates three times.
Now this is where things get complicated. These three cycles are inextricably linked. Typically in the late stages of economic cycles, businesses raise prices on their goods in order to defend their margins. This begets inflation, which central banks are tasked with controlling. Central banks raise interest rates in order to slow demand and stymie inflation. The risk is they go too far, make debt too expensive, and cause a recession. When this happens, market cycles take a turn for the worse. 

This isn’t a reason to take outsized risks, but it does argue for a modest overweight to stocks.

We got a taste of this dynamic late in 2018. The Fed hiked a bit too aggressively to get ahead of inflation, and markets sold off violently. If the Fed had kept hiking, it would have likely begun to inhibit new borrowing in the economy and ended the economic cycle. But because inflation never materialized as a credible threat, the Fed had the flexibility to reverse course. However, the Fed’s pivot didn’t reset the economic cycle to an earlier phase. That means it did not magically add more workers to the U.S. economy, or change the capacity constraints in any other way.

How long can the “late cycle” phase last?

We think it can continue to chug along until interest rates rise to threatening levels, or an exogenous shock changes its path. This could take quite some time, and it’s important because it means that markets can probably go through another cycle of their own. This isn’t a reason to take outsized risks, but it does argue for a modest overweight to stocks.

 

All market and economic data as of November 2019 and sourced from Bloomberg and FactSet unless otherwise stated.

We believe the information contained in this material to be reliable but do not warrant its accuracy or completeness. Opinions, estimates, and investment strategies and views expressed in this document constitute our judgment based on current market conditions and are subject to change without notice.

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