Over the last few months, I’ve become something of a news cycle cynic. As a journalist this sounds an almost heretical statement – it’s like a Bishop denying the existence of god. For journalists, surely, our whole reason for being is to report on the news. But the important distinction is that I am a financial journalist and many years of bitter experience – and half-assed editorials – has taught me that financial markets and macro news is a match made in hell. On paper big picture political changes obviously drive markets. Candidate Trump hoves into view and wins the election – markets panic. Brexit trundles into view. Head for the exits. Yet short-term reactions to these news developments rarely gives us a glimpse of the real long-term drivers behind the pricing of assets such as equities, bonds or gold. I’d argue that news flow is 99% just noise. Trump threatens a trade war. Short term day traders react, everyone else mostly yawns. Which is not to deny that a full-scale trade war wouldn’t be terrible for financial assets – it’s just that the news cycle itself tells you very little about what to worry about. As an aside Trump is also a master of controlling the news cycle, and so you should treat just about everything he says with a considerable amount of skepticism.
In fact, I’d go so far as to say that investors should probably completely ignore the news cycle unless we have a
- A proper war involving thousands dead – which would be a true calamity
- The rise of outright hard left or hard right political regimes – think Corbyn with a 50 seat majority and the House of Commons jam packed full of Momentum supporters or
- Massive tax rises or currency controls (usually proceeded by factor number 2)
Stock and bond markets are largely powered by brutally simple to understand drivers such as the current level of interest rates and inflation rates as well as the current state of the business cycle, which is in turn partly determined by those interest and inflation rates. So, it’s against this backdrop – and my general quest for news that really matters – that I suggest you visit a web page at the main economics monitoring organization in the US, the NBER. The relevant web page is at http://www.nber.org/cycles.html.
Given how dismal most economists are at explaining why ‘stuff’ happens, this web page is a model of brevity and analysis. It discusses the various business cycles in the US since 1854 – 33 in total. It looks at the average length of the contraction phase – 17.5 months over that full-time period – and the average duration of the expansion phase – 38.7 months. Crucially it also tells us that that average peak to peak of a business cycle is 56.4 months. If we narrow the time period down and look at the period since the end of the second world war, that peak to peak period increases to 68.5 months, while the average expansion period of 58 months. For the record, the last peak was in December 2007 and the current expansion phase started in June 2009. So, by whatever calculation or reference point you choose we are well over 100 months into the expansion phase or after the last peak.
In simple to understand language, we are very late in the business cycle. There have been other business cycles that have lasted between 100 and 127 months but there are only three in total. We are currently over 130 months from the last peak and 108 months from the last trough.
So, when you hear investors worry about Trump/North Korea/China/Eurozone travails/bird flu, rest assured that there’s a good chance that none of that matters in the slightest. What really matters is that we are due a recession in the US in the next 24 months.
That is just a plain, hard statistical probability.
Maybe we’ll defy the rules and somehow avoid the slowdown….but the odds are that we won’t.
Which means that we need to keep a very watchful eye on indicators that suggest we are top of the cycle (inflation) and at peak excess optimism (indicators of leverage). The good news here is that all sorts of people with the words macro and analyst in their job title watch this stuff relentlessly. The current consensus is that the US yield curve, profit margins (before tax) and employee compensation are now sending a clear message that the current cycle is ending. Analysts at French investment bank SocGen have also observed that the rotation from accommodative monetary policy to tightening should put some upward pressure on funding costs which is also pretty bad news for corporates.
As a result they now highlight two – yes just two – areas of concern.
1) US small caps appear at risk on several metrics, including record-high Net Debt to EBITDA,
2) eurozone peripheral countries (Spain and especially Italy) could be under pressure from rising interest rates as both countries have currently low interest coverage ratios (EBIT / Interest Expenses) amid historically low yields and spreads.
But for me the really concerning charts are below. They look at flows of money into and out of – bond funds, in Europe. Investors are pulling money out of bond funds at an alarming clip. What do these institutional investors know that the rest of us don’t?
The simple answer is that to a man and woman, they are obsessed with one key number – the yield on 10 year US Treasury bonds.
The next chart below shows this yield as a percentage over the last ten years. Notice how it’s heading towards 3%. By the time you read this, it’ll probably have breached that barrier. And for most bond investors, that is very BAD news. Traditionally rising yields – powered by expectations of increased interest rates – are an indicator of an imminent slow down. Crucially as bond yields rise, the price of bonds fall. Thus, investors seem to be getting out of bonds anticipating even bigger losses.
As these bond yields grind higher, all things being equal, we might expect more uncertainty in stock markets – higher yields imply that the risk-free rate from cash is becoming more attractive.
So, in very simple terms, for most of the history of Western Capitalism, a push above 3% is usually
- Bad news for investors in bonds
- An indicator that investors expect inflation to rise
- A signal that investors are worried about an imminent top of the cycle and subsequent slowdown and
- Ultimately bad news for equity investors as that slowdown gets baked into estimates for profits growth.
So, if you have to watch anything in the news – watch the 10-year bond yield rate. But as with all things financial this 3% barrier is ‘complicated’. US bond yields hitting 3% might not actually be the signal for doom and despair I have conjured above – or at least not according to Jonathan Golub, chief U.S. equity strategist at Credit Suisse. He thinks that the yield level to watch out for is actually 3.5% – or at least that’s what he told investors in a recent note to clients. “Everybody says that rising yields are bad, but if you put aside that preconception and look at the data, you see that it’s not the case…If rates rise from 3 percent, that’s a good thing.”
Golub’s analysed returns from the S&P 500 for a period starting in 2014 to the present and estimates projected US equity returns after focusing on rising interest days – at yields of below 2% the equity markets return 62%, at between 2 and 3% they return 36%, while between 3 and 4 there’s a small decline of just 3.6%.
The bad news though is that once we get to 4 to 5% bond yields, the S&P 500 could drop by as much as 40%. According to Golub what really matters is the trajectory of the yields after 3.5%. If rates stay unchanged at this level, the S&P 500 probably won’t react. The further away yields rise from the 3.5 percent threshold, the bigger problem it becomes. “If yields rise from 4 percent, that’s a problem,” he said. “If rates rise from 5 percent, that’s a bigger problem.”
So, the bottom line is terribly simple. Watch the 10 year US bond yield. Worry at 3%. Get concerned at 3.5%. Start to worry at 4%. And sell all your equities and risk assets once it hits 4.5% or 5%.