Some Pictorial Quickies
Welcome to idea purge day with some Pictorial Quickies. I hope you find a nugget or two interesting.
We’ll let the charts do most of the talking today. When you have multiple files open on your computer and your mind is flying across various concepts, sometimes it’s good to purge some of these thoughts. So, welcome to purge day with some Pictorial Quickies. I hope you find a nugget or two interesting.
1. Which Federal Reserve does not act like the others?
Just yesterday Chairman Powell provided an update suggesting recent stronger than expected inflation reports in the first quarter introduced new uncertainty about when and whether the Federal Reserve would be able to lower interest rates yet this year. Surprise, the Fed is still on hold.
As highlighted in Chart 1, despite a peak in the annual consumer price inflation rate almost two years ago, this Fed has been slower to ease interest rates compared to any other inflationary peak in post-war history. And, by a wide margin. Of the 13 inflationary peaks isolated (based on the 13 Fed funds hiking cycles since 1952), excluding the last two which have been under the leadership of Chairman Powell, on average, previous Federal Reserves eased the Funds rate for the first time five months “before” the inflation rate peaked. The Powell Fed waited 12 months past the inflation peak until it eased in 2019 and has gone without easing for 22 months since inflation peaked in 2022.
Amazingly, during each of the 1970s inflationary spikes and even during the early Paul Volcker era from 1979 to 1983, the Fed chose to initiate easing either commensurate with or mostly before the inflation rate peaked. It's okay to have an unconventional policy and for the Powell Fed to follow its own path, but this is getting a bit silly with the Fed still debating whether to ease off some after inflation peaked almost 2 years ago! Like on Sesame Street, can you tell “which Federal Reserve does not act like the others”?
2. How are Cyclical and Defensive Stocks Responding to Good Economic News?
Charts 2 and 3 compare the relative total returns of the S&P 500 cyclical sectors and defensive sectors to a daily economic news sentiment index. This news sentiment Index is a high frequency measure of economic sentiment based on lexical analysis of economics-related news articles. The newspapers utilized to construct the index cover all major regions of the country, including some with extensive national coverage.
The relative return performances (relative to the overall S&P 500 Index) of both cyclical sectors and defensive sectors are significantly impacted by “good news” (or worsening news) on the economy. But, as expected, in inverse fashion. The relative total return of cyclical stocks (chart 2) is positively impacted by economic news and the relative return of defensive sectors (chart 3) is inversely related to economic news. That is, in chart 2, for defensive stocks, the economic news sentiment index is shown on an “inverted right-side” scale.
Because of their respective opposing relationships to economic news, cyclical and defensive stocks tend to perform opposite one another. Typically, when cyclicals outpace, defensives underperform and vice versa. Interestingly, however, since mid-2023, this has not been the case. As economic sentiment has improved, although defensive stocks have persistently underperformed, in uncharacteristic fashion cyclical stocks have also lagged.
What does this suggest? Could “both” cyclicals and defensives do better for a period. Defensives have been pounded into a sustained underperformance by persistently good economic news. But cyclicals also are weak performers despite good economic news. Why? I think rising bond yields and a tightening Fed have kept cyclical stocks from prospering during good economic times. Should economic growth weaken some in the coming months, however, defensive stocks should start to outpace and I expect that cyclicals may also do better once bond yields and the Fed are forced to lower interest rates. Could investors soon get a rare chance to outpace simultaneously with both cyclicals and defensives?
3. Health Care is struggling with weak Drug prices?
The S&P 500 healthcare sector, like other defensive sectors, is probably being pressured by better economic growth and overheat concerns. However, as shown in chart 4, the fundamental problem hanging over this industry is weak product pricing. Drug prices have been under intense public scrutiny, and since at least 2018, the price of prescription drugs (a proxy for general healthcare pricing) has been weakening relative to the overall consumer price index.
For much of the last 35 years, healthcare stocks were a chronic outperformer primarily because they could implement premium pricing for their products and services. Since 2018, however, pricing has trailed the overall CPI and these stocks have likewise trailed the overall stock market. While the healthcare industry is certainly diversified and has segments which are prospering, before investors overweight this sector significantly, it needs to regain some business pricing power.
4. Has China become the new Japan?
China is the Pandemic’s biggest economic loser. The pandemic reminded companies worldwide that they needed to diversify supply chains, which for most companies meant reducing exposure to China. China also is suffering from its past one-baby policy which has resulted in one of the worst demographic profiles in the world. Tough to growth without an ample labor supply. In addition, as the U.S. has experienced in the past, China is in the early stages of dealing with the aftermath of an out-of-control debt cycle during the last couple decades. Debt overhang issues are likely to plague (perhaps poetic justice?) this economy for years. Finally, China is simply a bad economic partner. Do companies really want to get into bed with someone who can mandate what they can or can’t do and who may steal their proprietary innovations?
These issues make me to wonder if China has become the new Japan. As chart 5 highlights, after dominating the world economically during the 1980s, Japan found itself overextended and busted. And it remained busted for a long time! During the 1990s and into the 2000s, Japan’s stock market performance was so bad for so long that investors around the globe simply quit investing there. The vast majority of international investment allocations were made to global mutual funds “EX-Japan”. From an investment standpoint, Japan essentially boomed, busted, and was then ignored.
Is this the same path China is now on? China’s stock market dominated (chart 6) the Emerging Marketplace for years leading up to the pandemic. But their bust since 2020 is causing more and more investors to limit EM allocations to funds or ETFs which are “EX-China”. Although the “Bust” in China may finally be nearing its end, the worst part may still yet be coming. Ask Japan, is China ready for its stock market to be “ignored”?
5. US Dollar strength pressuring both Smalls & Cyclicals?
Small cap stocks and cyclical sectors have been underperforming for some time because they are facing an array of pressures. Continued Fed tightening, rising bond yields, chronic worries about an imminent recession, and their respective persistent underperformances have kept many investors away from these stocks. Charts 7 and 8 highlight yet another hurdle these stocks are struggling with – strength in the U.S. dollar.
Obviously, for these stocks to finally become sustained market leaders, interest rates need to be cut. If interest rates decline, bond yields will follow, and the dollar will ease. Should interest rates be cut before a recession occurs, recession fears should also fade. However, even if a recession does occur, given how poorly and for how long these stocks have already underperformed, I think rate cuts – with or without a recession – may still result in “both” smalls and cyclicals simultaneously outpacing.
As shown in charts 7 and 8, the relative price of these stocks is already lower than they were at the bottom of the 1990 recession, not far from their relative lows in 2000, at or below their lows in the 2008 crisis, and beneath their respective pandemic relative price lows. They appear washed out whether a recession is coming or not. And so many things turn supportive once the Fed finally does begin to lower rates – bond yields decline, recession fears subside, and the U.S. dollar eases. For hardy investors who can outwait the Fed, smalls and cyclicals may offer substantial stock market leadership in the coming year.
6. A Positive Pandemic Fallout – Business Formations!
There are not many silver linings from the pandemic. However, as illustrated in chart 9, the Covid experience seems to have convinced many to stop working for the Man and create your own business!
Applications for new businesses are still running nearly double what they were prior to the crisis. This probably pays substantial dividends for U.S. economic health and vitality in the coming years. Indeed, it celebrates a central tenant behind the success of U.S. capitalism -- taking a risk to fill an unmet consumer need or desire. Go innovative spirit! Go American Capitalism!
7. Consumer Discretionary stocks driven by mortgage yield spreads?
Discretionary stock performance (chart 10) tends to be highly correlated with mortgage yield spreads. At least 2000, when mortgage spreads have widened, signaling rising debt stress for homeowners, discretionary stocks have underperformed. Most recently, mortgage spreads began widening in mid-2021 and discretionary stocks have mostly been underperforming since.
The bad news is mortgage spreads are currently at levels which in the past have indicated a recession (e.g., 2000, 2008, 2020). The economy does not appear to be headed to a recession anytime soon, but who knows? The good news is mortgage spreads have been tightening again throughout this year. If this trend continues, as they have in the past when spreads tighten, consumer discretionary stocks may regain some leadership?
8. No wonder the US has not had a serious endogenous inflation problem since the 1970s!
As shown in chart 11, after WWII until 1980, the proportion of real GDP comprised by business investment spending was less than 6%. With so little supply-side investment, it is no wonder why the U.S. suffered a major secular inflationary problem during the 1960s-70s. Demand was stimulated endlessly while supply spending was only marginal.
Since 1980, however, there has been a steady surge in supply-side spending relative to the overall economy. Indeed, business investment spending has risen to just shy of 15%, nearly 2.5 times its average between 1947 to 1979. It certainly is no coincidence that since 1980 the U.S. has experienced an amazing era of steady and game-changing innovations.
For me, this chart simply makes clear that inflation risk today is not nearly as high as many (including the Fed) seem to fear. Outside of an endogenous viral pandemic in 2020 which created a once in a lifetime temporary supply shortage, the U.S. has not been able to produce any significant inflation problem. Robust supply-side spending and frequent deflationary innovations have simply make it too difficult for inflation to emerge or sustain. And the best news? Business investment spending relative to overall real GDP still appears to be trending higher!
9. Can the U.S. Financial Industry survive when nobody borrows anymore?
The answer is of course, yes. The financial industry does much more than just lend money. But, as illustrated in chart 12, watershed changes in the cultural debt preferences of private sector players since the Great Financial crisis of 2008-09 has likely forever altered business in the financial sector.
Since at least 1990, the relative total return performance of the S&P Financial sector has been tied closely to the debt service ratio of the household sector. As households and businesses added leverage indiscriminately and without concern from 1990 to 2008, the financial sector boomed! Since 2008, though, debt usage – primarily among households -- has been declining, and financial stocks have suffered accordingly. The financial industry faces adjustment to a barrage of developments. Debt preferences are much lower, paper money is going away, crypto remains an unknown, and technologic innovations make it increasingly unnecessary to go to a bank.
Creative destruction is often good for future results and it probably will be eventually for the financial industry. But investors need to ask themselves whether the financial industry has yet ascended to the creative phase or are they still grappling with the destruction era?
10. Labor supply still has some elasticity if we quit paying so much to remain unemployed?
The official unemployment rate is below 4% and many, including the Fed, worry the jobs market is becoming strained which could escalate wage pressures. As suggested in chart 13 however, this may, at least in part, be a self-inflicted problem.
Since 2000, the U.S. labor force participation rate has been steadily declining as government transfer payments relative to disposable personal income have risen. The participation rate has fallen from a peak in the early-1990s of 67.3% to its current level of 62.7%. At the same time, the level of transfers to disposable income has increased from about 14% to 21%. Coincidence? Doubtful. Essentially this chart indicates the U.S. has been paying people too long and too much to stay out of the workforce.
If the Federal government really wants to help the Fed in its fight against inflation, it should help boost the labor force by lowering transfer payments. Imagine how much more capacity the economy would have to grow, in a non-inflationary manner, if transfer payments were reduced from 21% to 19% encouraging a rise in the participation rate toward 64%.
Thanks for taking a Peek! Jimp
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Thanks for the kind words, Kevin. Yes, I think the biggest difference is that the chart I showed was "real" investment compared to "real" GDP. And, as you say, investment also included intellectual property spend and info spend. Because New Era spend is deflationary, it tends to have an outsized impact in real terms. The data came from the BEA site, and they don't publish the real spending data beyond the last few years so one has to use the "quantity indexes" to construct it back to 1947. I hope this helps and again thanks for reading and reaching out.
https://substack.com/profile/2298707-kevin-cousins/note/c-54208451
Link to the chart in notes