Weak Economic Data Led to a Sharp Drop in Interest Rates, but Stocks were Flat Because Bad News is Good News — For Now
|The fourth quarter began on a volatile note when disappointing economic data led to a 4.5% drop in the S&P 500. Stocks declined on Tuesday because the ISM Manufacturing survey was significantly weaker than expected, and fell to its lowest level since June of 2009. On Thursday, the ISM Non-Manufacturing Index was also weaker than expected and showed a sharp drop from August. After an initial decline, stocks rallied on the bad news, because the odds of another Fed interest rate cut rose dramatically. According to the CME, the odds of a rate cut at the Fed’s October 30th meeting jumped to nearly 89% from 39.6% on September 30th. On Friday, the employment report for September was released, and while it was slightly weaker than expected, stocks rallied again on the belief that the economy was not imminently headed into recession but was soft enough to warrant another rate cut. |
Despite a very volatile week, the S&P 500 decreased by only 0.33%, while the tech-heavy Nasdaq 100 rallied by 0.94% and the small-cap Russell 2000 fell by 1.33%. International stocks were mixed, the MSCI EAFE Index (international ex-US and Canada) dropped by 2.18%, while the MSCI Emerging Markets rose by 0.81%.
In this “risk-off” environment, the safe havens performed well — gold rallied by 0.43%, and the U.S. Treasury long-bond (TLT) jumped by 2.46% this week. Despite aggression by Iran in the Middle East, an excess supply of oil drove crude prices down by 5.5% this week. Oil is currently 4% lower than it was before the attacks on the Saudi oil facility. While lower oil prices are always good for the economy, its weak performance given the escalation in geopolitical risk is surprising, and in our view, it is another indication that the global economy is weak.
This week’s disappointing economic data shows the negative impact that the trade war with China is having on the economy. Unfortunately, the impeachment of President Trump has increased the uncertainty of favorably resolving the trade dispute. We assume that the Chinese believe that the impeachment crisis has weakened the President, so they are likely to demand a limited deal or wait until the next election. Also, with problems at home, we expect that the President will remain resolute to avoid additional criticism and require a significant agreement that resolves forced technology transfers, IP theft, government subsidies, and eliminates China’s trade barriers.
This Thursday the trade talks resume in Washington. Hopefully, they are productive because, on October 15th, tariffs are scheduled to increase from 25% to 30% on $250 billion of Chinese goods.
In addition to complicating the trade negotiations, we are concerned that the impeachment crisis and the politically divided country could negatively impact consumer confidence. This week’s ISM report showed that while the manufacturing sector is contracting, the service side (i.e., consumer sector) of the economy (despite being weaker than expected) is still expanding. We are closely watching Consumer Sentiment, which after reaching a cyclical high in May has fallen sharply and could portend weakness in the consumer sector of the economy (see chart below).
|Finally, WeWork, the shared workspace company, which is one of the largest commercials real estate tenants in the U.S., officially canceled its IPO and decided to remain private. The IPO was pulled because investors balked at the significant corporate governance issues, the questionable business model, and the outrageous private market valuation. While private equity investors and management believed that WeWork was worth $47 billion, public stock market investors believed the unprofitable company was worth $10 billion or less. |
WeWork canceled the IPO, fired its founder and CEO and planned a massive restructuring, which will include many layoffs. WeWork controls nearly 6% of the NYC commercial real estate market and currently has more than $47 billion in lease obligations that are payable over the next fifteen years. Unfortunately, they only have leasehold commits of $4 billion with an average maturity of fifteen months.As of June 31st, WeWork had $2.5 billion in cash and a burn rate of $700mm per quarter. Since the new issue failed, management must cut its massive losses quickly, or WeWork will run out of money sometime in the first half of next year.
WeWork’s fall from a $47 billion private equity valuation to a company struggling to survive is an extreme example of shifts in investor psychology. Sanguine privates equity investors believed that the company and led by its messianic leader was a technology company that would change commercial real estate, so it deserved a valuation of more than ten times sales manlig-halsa.se. Now, after reviewing its business model and financials, many investors and Federal Reserve President Eric Rosengren are concerned that WeWork’s size and flawed business model could be a systematic risk to the economy in the next recession.
The current bull market is more than ten years old. Similar to the past two bull markets that peaked in 2000 and 2007, the current bull market was fueled by artificially low-interest rates and the Fed’s Quantitative Easing program that printed money to buy financial assets. Historically, the central bank’s easy money policies led to financial booms and busts, and typically, there are very high profile market events that mark the end of the bull market.
In hindsight, the AOL and Time Warner merger marked the end of the 2000 technology bubble, Sam Zell’s sale of his apartment REIT (Equity Office Properties) to Blackstone Group LP in 2007 marked the end of the housing bubble, and JPMorgan’s “take under” of Bear Sterns in 2008 marked the beginning of the financial crisis.
WeWork’s fall ends the era of the Unicorn, the mega-billion dollar companies that were given outrageous valuation because of their “blitzscaling” strategy that pursued market share and hyper revenue growth at the expense of profitability. Also, we believe that WeWork’s failure is consistent with our view that the business cycle peaked last year and we are in a bear market.
|Our View:The S&P 500 is within 3% of its all-time high, yet the business cycle is contracting, we are in a trade war with China, the President is being impeached, and geopolitical tension in the Middle East is elevated. Additionally, the yield curve is inverted (which has preceded every recession since WWII), there are problems in the overnight funding market, and there were several high profile IPO failures that demonstrate a shift in investor sentiment and risk tolerance. |
We believe that investors are complacent and overlooking significant risk because they think the trade war will end soon, and the Fed can lower rates to stimulate economic growth. As discussed previously, we believe that the trade war will not be fully resolved until after the election. Also, we believe that the Fed is behind the curve and doesn’t have enough monetary policy tools to stimulate the economy. Interestingly, the S&P 500 was up only 1.33% in the third quarter, despite two interest rate cuts by the Fed, and one cut and the start of another QE program from the ECB.
In our view, the market offers a poor risk-reward – since stocks are expensive, there is a little upside if everything goes right, but significant downside if a recession occurs. Historically, the S&P 500’s average decline during a recession is more than 30%, and stocks dropped by more than 50% during the last two recession.
Instead of watching the S&P 500, which is near an all-time high, and being driven by a few megcap stocks, we believe that investors should focus on the broad stock market (Russell 2000), which peaked in August of 2018, and the bond market, which historically has a better track record forecasting the economy.
|Our Tactical Allocation (six-month view) is negative. Stocks have dropped for three consecutive weeks, the sentiment is neutral, and market breadth is weak. The market is in a correction, and we will become more constructive, on a short-term basis, when the market is oversold, investors are pessimistic, and market breadth begins to improve. We expect a short-term bottom to coincide with the end of the stock market’s period of negative seasonality, which is typically near the end of this month. |
Our Strategic Allocation (six-year view) remains underweight equities, overweight bond duration, and gold. We continue to believe that the stock market offers a poor long-term risk-reward. The upside is limited due to overvaluation and weak earnings growth, while the odds of a recession and bear market are elevated. The yield curve, which inverted in May, continues to indicate that the Fed is still behind the curve. At the sector level, we remain overweight in the defensive, non-cyclical areas of the stock market, which is consistent with our view that the economy and inflation are slowing.