Let the good times roll: the beginning of the end?
Stock market prices continued to grind higher as economic data releases surprised to the upside this week. Indeed, a host of indicators suggest to some that growth in the U.S. may in fact be improving after a softer showing in 2019 which has supported a rally in risk assets not just in the U.S. but globally this year. A key question for investors and savers now, however, is whether the good times are just getting started or the data mark the beginning of the end of good economic times.
We have argued that 2020 is likely to mark the beginning of the end for U.S. economic buoyancy and financial market resilience. Indeed, longer term indicators point to a rising risk of economic and market disappointment this year with recession related risks remaining elevated and not decreasing even as Fed policymakers would otherwise like people to believe.
What this means is that households should increasingly prepare for higher levels of economic and market volatility in 2020. This includes taking efforts to increase net positive cash flows, building up emergency reserves, rebalancing investment risk exposures and generating cash in investment portfolios to cover an extended period of retirement living expenses as market volatility increases.
Figure 1: Market momentum near 2-year high
Why so glum?
Key data releases hailed by the financial markets this week included seemingly robust retail sales and housing market data. The reports pointed to generally better than expected activity in December and capped a strong finish to an otherwise lackluster year for both sectors. Indeed, government data showed that December retail sales grew at its fastest year-over-year pace (+5.8%) since August 2018. This compares to a meager 1.6% rate in December 2018 and contrasts a period of general economic malaise in the fourth quarter of 2018.
Similarly, reports on building permits, housing starts, mortgage applications and builder confidence all trended higher in the month of December, pointing to a rebound in housing market activity. Building permits, for example, were up 11.4% year-over-year at the end of the fourth quarter of 2019 compared to a decline of -1.8% in 2018. What’s more, builder sentiment rose to its highest level in over 20 years as mortgage rates remained low all the while December UofM Michigan Consumer Sentiment rose to its highest level since May 2019. Taken together, these developments have given financial markets a reason to keep pushing higher this year.
To be sure, market participants have been heartened by the seemingly positive economic data and the S&P 500 is now up over 3% in January, making new all-time highs in 10 out of the first 12 trading days of the year. Year-to-date, riskier international equities are in some cases outpacing the U.S. with China up 5%, Mexico up 6% and Turkey up 7.3%. These developments come even after the threat of war between Iran and the U.S. and ongoing impeachment proceedings on Capitol Hill. So why are we so pessimistic on the market and economic outlook?
Figure 2: Stretched equity market valuations
No so fast…
While it is tempting to extrapolate positive near-term developments into the future, the truth is that cyclical factors that we track suggest that economic and market conditions may be more fragile than the recent historical data suggest. Take, for example, the latest labor market data. While December payrolls bested estimates, the trend in new job growth remains biased to the downside. This is evidenced in the latest nonfarm job openings data, an important leading indicator of labor market developments. To be sure, the rate of employers putting out ads to hire new workers declined -10.8% in November and is on track for their worst rolling 12-month pace of growth since 2017.
This is important because, if labor market conditions continue to deteriorate, and business sentiment weakens as our projections suggest, then growth in the U.S. economy is likely to remain weak in the first half of 2020. Such a development would put downward pressure on corporate revenues, leading to earnings disappointments in the year and giving market participants a reason to step back from their expensive positions in stocks. What’s more, a continued decline in labor market conditions, weaker economic sentiment and increased financial system instability could lead to a rising risk of a U.S. recession in 2020.
Figure 3: Labor market conditions waning
Juicing the markets
To be sure, equity prices have been on a tear since the Federal Reserve quietly restarted its asset purchase program, increasing the size of its balance sheet by 11% since August 2019 even as Chairman Powell asserts that the Fed has not restarted quantitative easing (QE). Better near-term economic data aside, this form of money printing has arguably boosted risk asset prices all the while corporate earnings growth has slowed and the economic outlook remains weak.
The effect of central bank supported rising prices and stagnant earnings growth has contributed to stretched valuations in the equity market. In other words, U.S. stocks, as measured by the S&P 500 are now more expensive than they have been in the past two years when measured by its trailing and forward-looking P/E ratio. And these stretched valuation measures have also been showing up in other parts of the equity market, particularly in the growth style of large, mid and small cap U.S. stocks as a whole.
Figure 4: Recession risks remain elevated
Preparing for economic and market uncertainties
The fact that risk asset prices continue to push higher even as geopolitical risks linger and economic fundamentals remain subdued has given us reason for pause. To be sure, we believe that the current rally in risk assets has more to do with the Fed’s unsustainable easy money policies which could set the stage for a pullback in prices this year. While central bank asset purchases have been supportive of lower borrowing rates and provided a near-term boost to housing market sentiment, we are hard pressed to find positive catalysts that would support a sharp economic rebound this year and hence underpin the financial market rally.
In fact, we believe that global easy money policies have contributed to systemic excesses, and are providing a lifeline to firms that otherwise should no longer be in business. History has shown that such excesses do not continue in perpetuity, and when combined with our latest business cycle work, suggest that risk of an economic downturn and heightened market volatility is likely to increase this year. Taken together, we believe that recent market exuberance could be marking the beginning of the end to this economic and market cycle.
With the economic outlook set to weaken this year and financial market volatility likely on the rise, we recommend households take some constructive steps to remain prepared for the unexpected. First, we recommend households take a step back and reevaluate the vision and purpose for their money as they look ahead into 2020 and beyond and determine whether their plans are in alignment with current economic and market conditions.
Next, we recommend preparing for rising uncertainties by increasing net cash flows by reducing discretionary spending and finding ways to refinance debts given today’s lower interest rate environment. We also suggest reevaluating big ticket spending decisions, topping off emergency savings and ensuring employer-matching contributions are maxed out. We believe that these steps will better prepare households for unexpected life events, particularly as labor market conditions show signs of weakening in the coming months.
For investors oriented towards asset growth, we recommend maintaining a diversified investment exposure and stepping back from riskier investments. Further, households would be best served by ensuring that aggregate portfolio holdings across all investment accounts are in alignment with their long-term goals. This includes rebalancing portfolios to target allocations and trimming winning positions to raise cash to keep as dry powder for when market volatility creates favorable buying opportunities.
Finally, for households taking distributions from investment, we recommend rebalancing accounts to long-term investment objectives and reduce unnecessary risk taking. Further, we recommend ensuring that cash positions are adequate to meet 6-12 months of living expenses. This is intended to avoid forced selling at depressed prices when market volatility increases.