The new year has started like the old one ended; volatile and with confusion among punters and analysts with respect to the notional Narrative™. The volte-face in expectations for U.S. interest rates is a good example. In October, eurodollars were implying a Fed funds rate of just under 3.3% in December 2019 and 2020. At the beginning of the year, they had collapsed to 2.6% and 2.4%, respectively, effectively pricing in an imminent recession, and Fed rate cuts in 2020 to counteract that. Indeed, at some point, the Fed fund futures were even pricing cuts this year, a position that was stung badly on Friday by the hilariously bullish NFP report. Although neither the Fed nor markets know where the terminal/neutral rate—not to mention that this is a moving target—I reckon that the past six months have given us a decent clue. Anything close to 3.5% probably is too high, while sub-2.5% is too low, at least as long as the economy remains in a more-or-less stable expansion. Looking beyond the navel-gazing that is U.S. monetary policy, I am warming to the idea that (equity) markets will pivot towards cyclicals at some point this year, but we are not there yet. Over Christmas, I toyed with the idea that the next shoe to drop would be a downturn in the (hard) global economic data. The numbers have already deteriorated, but I reckon that they could slip further.
Read MoreIf you just want my views on the increasingly unruly price action in the equity market, scroll down to the bottom of this post, and you will find the link to the PDF. Now that I have your attention, though, allow me to wish you a Merry Christmas and a Happy New Year. Thanks for reading, and for the comments you throw my way on email, on Twitter or over at Seeking Alpha. I am very grateful for this interaction. This has been a good year for me in terms of keeping a steady output here, a tempo I hope to keep up next year. That said, I am, as ever, struggling with too many ideas and too little time. I wouldn’t want it any other way.
I managed to finish one short story in 2018—it will be published soon—which took much longer than it ought to. The main issue is that I have also been working on a novel, which I am now determined to finish before starting any new fiction-projects. I also hope to do more podcasts next year, about other topics than economics and finance, though I must confess that the state of debate about the issues that I want to discuss is in such a dire state that I don’t know where to begin. People don’t seem to be having proper conversations about important issues anymore, though some are if you care to go beyond the beaten track. Instead, they seem to be engaged in a race to the bottom of mutually assured destruction. In any case, this is a discussion for another day.
Read MoreI think that I am on record somewhere for saying that I would sell everything if the 2s5 inverted. Well, it just did—by a slender margin of 2bp—and for that reason alone, I should have a view. It isn’t easy, though, to add something that hasn’t already been added by the cacophony of comments on the back of recent gyrations in U.S. bonds. If a falling tree in an empty forest doesn’t make a sound, does a yield curve inversion matter if everyone has been talking about it for a year? As it happens, the tree does make a sound, and the yield curve inversion does matter, though not for the reason that you might think. Rick Reider, CIO of the investment manager Blackrock, is a smooth operator, and he delivers the goods in a few tweets. The significance of a yield curve inversion is not about its ability to predict a recession in the U.S., or elsewhere—more about that in a bit—but about the following three points. First, the Fed has some questions to answer; second, an inverted yield is as much a statement of markets’ perception of the Fed’s neutral/terminal rate as it is about its ability to forewarn about a recession, and third; bonds are finally offering a bit of protection for balanced portfolios. This week, I’ll go through each of these points in turn.
Read MoreI am short on time this weekend, so I am doubling down on the story I told last week, with two more charts and some additional comments. The first chart updates picture of the startling spread between price change in S&P 500 and its multiple. As of last week, the U.S. large cap equity index was down 0.2% on the year, but trailing earnings were rising just under 22%. The only way to square these two headlines is to note that the P/E multiple has crashed, from a high of nearly 23 in January to 18 today. The silver lining is easy to spot. The market is now about 20% cheaper than it was at the start of the year, a significant re-rating.
The flip side is that paying 18 times earnings for the S&P 500 is not egregiously cheap. If growth in earnings roll over, a further decline in multiples would, at best, lead to stagnation; at worst, it would drive prices much lower. That’s certainly a significant risk if you consider that this year’s impressive jump in earnings, at least in part, have been driven by tax cuts, which won’t be repeated next year. It gets even worse if we start to change the assumptions around share buybacks, another important support for earnings growth via its denominator-reducing effect on the share count in the EPS calculation.
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