The fickle and herd-like nature of the financial markets is on clear display right now, as conversations about the yield curve again take center stage. Last week, the 10-year note yield momentarily dipped below that of the 2-year yield (it did not close below that mark) and this has set off a frenzy of commentary that in my opinion, is completely misplaced.
One line of thinking suggests that because the 10-year yield didn’t actually close below the 2-year, all is well. That is, since the inversion between 10’s and 2’s only occurred during the trading session, we have nothing to worry about – there wasn’t an “official” inversion of the curve.
Meanwhile, another camp of storytellers is now saying that because the 2-year yield did in fact dip below that of the 10-year (momentarily), the prospect of recession has risen dramatically.
Frankly, I think both of these lines of thought are BS, and here’s why. Regarding the first point above, financial markets are not precise instruments, they’re blunt. We have millions of investors around the world all manipulating prices in their own unique way, and so asking for precision in terms of price movements is a fool’s errand.
Even when we look at technical analysis, we allow for some variation around key technical levels or trendlines. We don’t track prices to the penny and suggest that because an index closed a penny above or below a certain mark, that the takeaways are vastly different.
In this case, just because the 10’s minus 2’s curve wasn’t inverted at exactly 4PM Eastern Time doesn’t mean that all is well and we can shrug off this development. Instead, the takeaway should be that “wow, we basically have an inverted yield curve, so heads up.”
Next, for some odd reason that I don’t completely understand, the general consensus is that “traders” pay attention to the 10’s minus 2’s curve, while academia pays more attention to the 10-year minus 3-month curve.
Why does this matter? Because as we discussed in a previous article on which yield curve spread is the most accurate – it’s NOT 10’s minus 2’s. The chart below, which looks at the historical accuracy of various yield curves, shows that 10’s minus 2’s is actually the 4th most accurate depiction of the yield curve.
And guess what – the other “more accurate” curves have already been inverted, have closed inverted, and have remained inverted for quite some time. So to now say that either a) recession risks are elevated because the 10-year yield dipped below that of the 2-year, or b) that recession risks are not elevated because the 10-year yield didn’t close below that of the 2-year, completely misses the point!
Vast portions of the yield curve have been inverted for quite some time, and so we need be operating with the acknowledgement that a yield curve recession warning has been issued. ‘Nuff said.
Moving on, I’d like to provide a brief update on earnings season before we examine the latest economic data and price action. I typically quote earnings data from FactSet, but their main author is out of the office (not sure why they don’t have the resources to have someone fill in) and so their earnings reports for last week and next week have been delayed. As a result, we’ll turn to Refinitiv data, which is now co-owned by Blackstone Group and Thomson Reuters.
With 463 S&P 500 companies having now reported Q2 results, earnings are expected to rise 2.9%, while revenues are expected to increase 4.7%. The forward P/E ratio, according to Refinitiv, stands at 16.5.
The main takeaways here include earnings growth for the quarter coming in positive (it was previously expected to be negative) and the fact that revenues are growing at a healthy clip. Revenue growth is often more telling about the current economic climate than earnings, since earnings can be manipulated via creative financial engineering and cost cutting.
So overall, profits seem to be doing okay, and more importantly, the drop in interest rates has made future profits more valuable in today’s dollars. As I’ve mentioned many times, the lower the cost of money, the higher valuation levels should be. That dynamic should act to support equity prices as long as economic fundamentals don’t deteriorate substantially.
Speaking of economic fundamentals, let’s take a look at some of the more important data points that came in over the past week. First, we got a look at retail sales, which came in well above expectations, rising 0.7% in July. On a year-over-year basis, retail sales are up 3.4%, suggesting U.S. consumers remain healthy.
However, the dichotomy between consumer health and manufacturing was on clear display as industrial production came in below expectations, falling 0.2% in July. On a year-over-year basis, industrial production is only up 0.5%.
Two other items worth pointing out are the stabilization in housing starts and building permits, and the continued strength in productivity. Below we can see that housing starts and building permits (two key leading indicators) are holding steady.
And in this next chart we can see that labor productivity in the second quarter rose at a 2.3% rate. This is the 3rd strongest rate of growth since the beginning of 2015, which is important because GDP growth is simply the sum of productivity growth and labor force growth. With very little labor force growth expected in coming years, we need productivity growth to carry the economy forward.
The last economic item worth mentioning is that jobless claims came in at a six-week high, but remain extremely low by historical standards. No reason for concern there yet.
Now let’s switch gears and examine a few key price charts. To begin, I want to highlight the interesting dynamic going on between the Industrials and Transports. Recall that from a Dow Theory perspective we’re currently in a bullish non-confirmation state, as new highs set by the Industrials in mid-July were not confirmed by the Transports.
Making matters more perplexing, last week the Transports momentarily dipped below their late-May lows. Had the Transports continued lower, they would have actually transitioned to a bearish trend, marked by lower-highs and lower-lows. That technically didn’t occur (I view the action as a test of support), but if it had, we would’ve had a bearish non-confirmation by the Transports, in addition to the bullish non-confirmation by the Industrials.
In other words, based on peak/trough analysis, the Industrials remain in an uptrend while the Transports are very close to being in an official downtrend. I don’t necessarily think this portends catastrophic consequences for the market, but it certainly bears watching and is indicative of the tremendous amount of uncertainty out there.
On a brighter note, gold has continued its steady climb in the face of geopolitical uncertainty, and has now reached a major level of resistance set back in 2011 – 2012. The current level of gold (just over $1500) represents a level that gold sold off to many times following its collapse from the 2011 all-time high.
My guess is that resistance here could cause prices to stagnate or fall as the metal digests its recent gains. This view is bolstered by the fact that gold has now become overbought on the upper RSI chart for the first time in eight years, and overbought levels have a history of preceding minor downturns in the metal (see vertical blue bars).
Another chart that is oddly showing promise is that of FXI – the iShares China Large-Cap ETF. As you can see below, China’s market remains in a downtrend but has bounced off longer-term support.
We know, as the old saying goes, that the best time to buy is when there’s “blood in the streets.” Thankfully, there has so far been little actual blood in the streets of China, and particularly Hong Kong, but it makes one wonder whether now could be a good time to play for a move higher. If you’re inclined to go that route, recognize that this is a speculative trade with tremendous headline risk, and set a stop just below the support levels shown above.
Finally, there are two other charts that I believe are worthy of your attention. The first one is oil, which remains in a medium-term downtrend. Oil is tracing out a descending triangle pattern, which is an indication that demand for the commodity is weakening (or supply is rising).
These are typically continuation patterns, confirmed by a break below the lower trendline (green line). I’m not convinced we’ll see prices head that low, but remember that a drop in overall oil prices is a boon to consumers, who generally remain healthy.
As you can see in this next chart, the entire commodity complex is in a similar pattern. This shouldn’t be all that surprising since oil tends to drive moves in the rest of the commodity complex.
One important thing to mention here is that during the last two yield curve inversions, which ultimately precipitated economic recessions, commodity prices were rising. This forced the Fed to raise short-term rates, which in turn both slowed the economy and inverted the yield curve. Oil was also rising in both instances, which put further pressure on consumers and business.
This time around, the yield curve actually became inverted because of long-rates falling (as opposed to short-rates rising). That, combined with the fact that the Fed is already in easing mode, and doesn’t have to worry about excessive inflation, suggests that things could be different this time. We must still remain on high alert, but at the moment there is no inflation out there that is forcing the Fed’s hand.
Overall, I think the big picture takeaway is that while business activity is being suppressed from trade uncertainty, the U.S. consumer (the primary engine of the economy) remains healthy. That consumer is currently benefiting from continued job growth, lower borrowing costs, lower fuel costs, and asset prices that remain elevated – which promotes continued spending.
As a result, I think economic growth will hold up in the near-term, and therefore maintaining core positions in equities remains appropriate. If you’re looking for an opportunity to put some capital back to work, I would probably wait for a deeper pullback, but as always, incremental buying/selling is the way to go.