The late singer-songwriter Leonard Cohen once lyricized that “there is a crack in everything, that’s how the light gets in.” That’s sort of how we feel about financial markets right now. After a dismal stock-market performance in the fourth quarter of 2018, market participants were clearly panicked and seeing a “crack in everything.” However, we think that investors may see some light in 2019 as the U.S. economy avoids recession.
Importantly, while Citi’s economists believe that the U.S. economy will likely slow in 2019, perhaps to a pace of about 2% by year-end, they remain in the camp that sees this as a modest slowdown and not the start of a recession (defined as two consecutive quarters of negative growth).
There are obviously a lot of economic data points that one can point to, but we want to highlight three leading economic indicators that we think are important: the yield curve, jobless claims, and credit conditions for both commercial and industrial firms.
The yield curve suggests stocks have room to run
Let’s start with the yield curve, which represents the difference between short-dated bonds and long-dated bonds. As an example, a 10-year U.S. Treasury yield, is normally higher than a 2-year U.S. Treasury yield because investors are taking on more risk by holding a longer-term bond (as inflation can eat away at returns over time).
However, the yield curve occasionally inverts, meaning that the 2-year yield, is higher than the 10-year yield. This doesn’t happen often, but when it does, stocks tend to peak about 10 months later, with a recession following about six months after that. This is a very simple analysis, but this means that stocks generally tend to peak about half a year before a recession, not a year or two prior, as some are now suggesting.
Additionally, the yield curve is actually still in positive territory with a spread of about 19 basis points (or in plain English, the 10-year U.S. Treasury yield is about 0.2 percentage points higher than the 2-year U.S. Treasury yield). Given that the stock market tends to peak after inversion and not before, we think that the market can move higher from here. If we look at the last four yield curve inversions, the S&P 500 (.SPX), returned an average of 19.7% before reaching its peak.
Currently, Citi (C) is looking for the S&P 500 to reach about 2,850 by year-end, for an annual return of about 14%.
Jobless claims suggest the labor market is still healthy
We also mentioned jobless claims and bank lending conditions, so let’s discuss those. Jobless claims are one of the timeliest leading indicators of the economy because they’re released every Thursday. They’re also extremely accurate because people tend to go to the unemployment office to collect their unemployment checks when they’re out of work.
If the economy were entering a recession, we would be seeing a rise in jobless claims as employers start to lay off workers. We are not seeing that. In fact, jobless claims are near 50-year lows and just fell by 3,000 to 213,000.
If they were to start trending upwards on a sustainable basis, we would start to be concerned, but right now jobless claims levels are extremely low and stable.
Credit conditions for commercial and industrial firms point towards growth
While it often gets little attention, the Federal Reserve’s Senior Loan Officers’ Survey (SLOS) is one of the most useful forward-looking surveys for investors. With the banking system serving as the nervous system of the economy, healthy lending is key to economic growth. Remember what happened in 2008 when credit conditions froze up? We experienced one of the worst financial crises in U.S. history.
Fortunately, credit conditions for both commercial and industrial firms remain accommodative, with the banking community willing to extend funding to corporate borrowers. While one could argue that easy credit has led to a record level of debt for non-financial corporations and could eventually pose a problem were the economy to slow noticeably, for now it portends future economic growth with credit conditions for commercial and industrial firms leading real GDP by about nine months. Based on where credit conditions are right now, we should see decent economic growth well into 2019.
We acknowledge that risks to growth probably do lie to the downside. Particularly with the lengthy government shutdown, which by the White House’s own admission could subtract 0.1 percentage points off growth each week the government remains closed. However, most signs suggest that a U.S. recession is not yet in the offing, especially with a Federal Reserve that is increasingly looking more and more tentative about future rate hikes.
If one believes the old market adage that, “bull markets do not die of old age, the Fed murders them,” then one must also consider that, “a less aggressive Fed can breathe life back into an aging bull.”
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