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Scared straight

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The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Eaton Vance disclaims any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Eaton Vance are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Eaton Vance fund. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results.

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      By Bill Hackney, Atlanta Capital Management

      Atlanta - The whole thing started with an innocent and somewhat vague remark by our esteemed Federal Reserve Board Chairman Jay Powell. "We're a long way from neutral at this point. . . probably," he told PBS's Judy Woodruff in an interview on October 3, 2018. The next day US and global stock markets began to tumble. By Christmas Eve, the S&P 500® had declined a whopping 20% from its record close of 2930 on September 20 -- a bonafide bear market in a little over three months.

      What was so potent about Powell's words? He was implying interest rates were headed higher. . . a lot higher, implying monetary conditions were going to get a lot tighter.

      And what is the "neutral" rate of interest? Nobody knows precisely what level the neutral rate might be for any given economic situation. But in theory it's the federal funds interest rate (currently 2.25 to 2.50%) that is neither stimulating nor inhibiting to economic growth.

      In September, Powell spoke bullishly about the economy, stating "there's no reason to think this cycle can't continue for quite some time, effectively indefinitely." Also in September, the Fed implemented its eighth fed funds rate hike for this economic cycle and signaled another was to follow in December 2018 and perhaps three or four more in 2019.

      Many investors didn't share the Fed's optimism about the economic outlook. They worried about our economy's ability to withstand further rate hikes. There were growing signs of a sharp economic slowdown in China and Europe, which sooner or later could affect the US. The US inspired tariff wars had begun to slow international trade and were beginning to disrupt the supply chains of US companies and agricultural interests. Energy and other industrial commodity prices had begun to weaken. In fact, oil prices hit their 2018 peak of $76 per barrel on the day of Powell's PBS interview and declined 43% by Christmas Eve.

      In a nutshell, by the fall of 2018, a growing consensus of investors saw the neutral rate of interest much lower than the Fed did. Fearing the Fed might strangle the economy with tight money, investors began to dump stocks, commodities, junk bonds and riskier assets. They put the money into Treasuries and other high quality investments. The last three months of 2018 constituted a classic flight to safety in the financial markets.

      The key questions now for investors are: Is the lengthy US economic expansion on the eve of destruction and does the nasty market downturn of the past few months represent just the beginning phase of a more severe bear market in stocks?

      My short answer to both questions is no. But it is an answer given with only moderate conviction because it is premised on the so-called tariff wars not getting any worse. Worsening trade relations with China was a key worry in the market's meltdown in the fourth quarter. And recently, there are signs that the slowdown in global trade which logically follows a tariff war is affecting the US. On January 2 the closely watched ISM Purchasing Managers Index (PMI) was released. For December 2018 it posted its largest monthly decline since the Great Recession. See chart 1.

      Blog Image Hackney PMI Jan 23

      I believe the sudden weakening in US manufacturing gives the Trump administration powerful incentive to show progress on easing, if not resolving, many of problems between China and the US. Such progress will provide a welcome boost to world financial markets. If the US inspired tariff war worsens, however, it will act as a giant tax increase on global economic activity, killing growth and raising inflation -- the kind of public policy mistake that can end an economic cycle.

      Tariff wars aside, the current US economic cycle, which turns ten years old in June, is maturing. Labor markets are tightening and interest rates should eventually be pushed higher by accelerating wage inflation and increasing credit demands, particularly from federal government deficit financing. Higher inflation and interest rates can end a bull market in stocks and cause a recession, because monetary conditions become "too tight" and/or the burden of high interest rates crushes the players in the economy who have taken on too much debt relative to their ability to repay it. In my opinion, the US economy and its financial system have not yet reached these painful thresholds.

      So, in the short term, say the next six to twelve months, I am bullish on the stock market. I believe that a US recession in 2019 is unlikely. Given the skittishness of world financial markets, the weakening Chinese economy and renewed weakness in the US industrial sector, it seems to me that both President Trump and President Xi have a strong political interest in making some progress on the tariff issue.

      The violent correction/bear market in stocks during late 2018 remedied many of the market's valuation excesses, particularly among the high-flying FAANG stocks (Facebook, Amazon, Apple, Netflix and Google) which were providing lopsided market leadership for much of the two years leading up to the fourth quarter market debacle. Today the S&P 500® index at about 2580 sells at a quite reasonable and normal 16 times its 2018 earnings. Throughout much of 2018, the S&P 500® sold at a pricey 20 times trailing 12 month earnings.

      One key risk facing investors last year was that a synchronized global economic expansion might cause the US economy to overheat, leading to a spike in interest rates and inflation. Recent weakening in the global economy plus some lackluster data from the US industrial sector have dashed those fears. US Inflation seems stuck around 2% for both the headline and core (ex food and energy) readings. In fact, inflation pressures have moderated somewhat thanks to lower oil and food prices.

      Ten-year Treasury yields, which rose most of last year hitting 3.2% in October, fell sharply during the stock market plunge and settled at 2.7% by year-end. With both inflation and interest rates below normal by historical standards, what's not to like about a stock market selling at its historical normal of 16 times earnings. Given current valuations, it would be foolish in my view to abandon the stock market after a 20% decline, unless one were convinced that a recession was right around the corner.

      Let's take a look at the prospects for a recession in the next 12 months.

      Does the current shape of the Treasury yield curve tell us anything about the prospects for an upcoming recession? See chart 2. The yield curve is the relationship of interest rates to the maturity of fixed income instruments. A normal shape is for interest rates to increase as maturities increase. The curve should arc upward to the right like the top line on Chart 2. This makes intuitive sense since risks (inflation, recessions, bankruptcies, war) rise with the passage of time.

      Blog Image Hackney Curve Jan 23

      An abnormal shape is a straight or inverted yield curve, i.e., shorter term interest rates are the same as or higher than longer term rates. Why would anyone invest in a longer maturity bond when they could get the same or a higher yield on a shorter maturity? Because they fear deflation or recession. Thus they believe the yield on shorter instruments is likely to be temporary and will eventually decline as economic conditions worsen.

      An inverted Treasury yield curve has been a reliable leading indicator of recessions in the US. According to a study by the San Francisco Fed, an inverted curve, measured by yields on one-year bills exceeding ten-year notes, has successfully predicted every US recession since 1955.

      There's been only one false alarm, in the mid-1960s when the economy slowed but didn't enter recession. When the yield curve inverts, a recession generally follows within six to 24 months.

      Note from Chart 2 that the current Treasury yield curve at year end 2018 is virtually a straight line -- a flat curve in the vernacular of economists and investors. This is what has scared the markets -- a fear that the yield curve is on its way to inversion. As the Fed has hiked rates over the past few years, the Treasury yield curve has steadily flattened and by December 2018 lost all semblance of normalcy. At year end, the one-year yielded 2.60% and the ten-year 2.68%.

      What is the message of today's "almost flat, but not yet inverted" Treasury yield curve? I believe the message is that US economic growth will slow in 2019, but not enter recession. Real GDP growth, which should average 3% in 2018, will probably soften to 2% or lower this year due to a slowdown in the US industrial sector. It's important to remember that the US economy is heavily service-oriented, with industrial production representing only about 12% of GDP and 9% of total employment.

      While the US industrial sector will continue to be battered by an ongoing global slowdown, the US consumer sector, about two-thirds of GDP, remains on an improving trend. Job creation remains strong, wages are rising faster than inflation and consumer balance sheets are in much better shape today than they were in 2006-2007. All this suggests that US consumer spending should remain solid in 2019. The US banking system is also in much better financial condition today than it was prior to the last recession -- although a flat yield curve makes for a tough earnings environment for banks who essentially borrow short term funds, mostly deposits, to makes longer term loans and security purchases.

      S&P 500® earnings growth, which probably surged a tax-cut assisted 25% last year, will struggle to grow 6% in 2019. I see S&P 500® earnings per share moving from $160 last year to $170 in 2019 due to a combination of share repurchases, weak organic revenue growth and some inflation.

      While the sorry state of Washington politics seems to dampen enthusiasm for any forecast about America's future, other events bolster my confidence about the year ahead. As stock prices plunged in December, there was a huge surge in corporate insider purchases of stock -- the most since 2011 when the market experienced a temporary correction of 19%. Corporate share repurchases also surged in the past two months. So while many investors were apparently losing faith in Corporate America, corporate managers were not.

      The Chinese central bank has begun to aggressively ease monetary policy. Granted, their economy is in a lot worse shape than ours. But if you're worried that our monetary policy is too tight, perhaps you can take comfort that the world's second largest economy is aggressively easing their monetary policy. I do.

      Lastly, there's the loquacious Mr. Powell. The man has changed his tune. In recent days, he's no longer spooking the markets with hawkish rhetoric, but soothing frayed nerves with suggestions that the Fed may take a pause in its anticipated string of interest rate hikes. This is just the kind of news to set off a rally in stocks and it has. I'm not sure the stock market can exceed last September's record high in 2019, but I'm pretty sure that it can make up a lot of what it lost in last year's fourth quarter debacle.