After seeing a decent decline in the market, the natural thought is to take advantage of the decline and allocate additional resources to equities. This strategy works well when the global economy is growing but when it begins to slow, this strategy should be avoided and is why I recommended decreasing exposure to US equities last month.
In this post I will discuss:
- An updated view of US demand overlaid with equities
- How US demand affects the profitability and performance of the S&P 500
- How US demand affects global trade and ex-US equities
In some areas of the market, we’ve already seen multiples decline significantly, giving off the elusion that equities are cheap. However, based upon my analysis, the market is seeing a slowdown develop, which is why “buying the dip” should be avoided at this time.
An Updated View of US Demand Overlaid with Equities
In July (https://wp.me/p9vaFZ-6N) I did a detailed breakdown of how I track US demand with various economic data points and confirming those data points with the relative performance of equities. Three months later, we see the rate of change has continued to decline.
Demand tends to be driven by a change in credit. Therefore, when we see commercial & industrial loans (corporate loans) and consumer credit card debt growth rate decreasing Y/Y, the probability of demand increasing from the current is slim. Additionally, it shouldn’t be a surprise that banks (large cap and regional) are underperforming the S&P when this occurs.
Commercial and Industrial Loans: Absolute (blue), Y/Y (red)
Consumer Loans- Credit Cards and Other Revolving Plans: Absolute (red), Y/Y (blue)
Banks Index vs S&P 500 (white), Regional Banks Index vs S&P 500 (yellow)
Next, we see that ISM New Orders continues to decline from the January 2018 peak along with the relative performance of the Machinery Industry. As seen in the last economic cycle, the relative performance of Machinery tends to be more driven by global growth instead of only US growth.
ISM New Orders
Machinery Index vs S&P 500
Turning to the volume of containers at the five major US ports, we see that they are barely above 0% growth on a 6 month average Y/Y through August. When looking at the container companies, they continue to move lower against the market.
CAI vs S&P 500 (white), TGH vs S&P 500 (yellow)
Turning to intermodal rail volume, it looks like we saw the peak in July. However, rail stocks continue to do well. Historically, rails are the last cyclical industry to outperform relative to the S&P.
Intermodal Rail Volume
Rail Industry vs S&P 500
With loan growth, new orders for manufacturing, and the transportation of goods all declining, we now turn to end demand.
With the 30 year fixed rate continuing to increase, we see New Home Sales and Existing Homes Sales disappoint on a 6 month average Y/Y. Therefore, seeing LEN and MHK underperform should be expected.
New Home Sales 6ma Y/Y (red), Existing Home Sales 6ma Y/Y (green), National 30 yr Fixed Rate (blue, inversed)
National 30yr Fixed Rate (white), LEN vs S&P 500 (yellow), MHK vs S&P 500 (red)
Auto Sales continue to see a slowing growth rate, which makes the Auto related stocks undesirable to own compared to the S&P 500.
US Auto Sales
Autos and Components Index vs S&P 500
Finally, when we look at Retail Sales ex Autos and Gasoline, we see that they might have peaked last month on a 6ma Y/Y. Until the 3ma Y/Y is less than the 6ma Y/Y, there is a possibility of it rebounding. Nonetheless, based upon the way the Specialty Retailers have recently performed vs the S&P 500, the market might be telling us that we’ve seen the peak.
Retail Sales ex Autos and Gasoline
Specialty Retailers vs S&P 500
To summarize, the probability that the demand of goods in the US has peaked continues to increase, which leads us to the next part in regards to how this affects the broad index.
How Demand Affects the Profitability and Performance of the S&P 500
In April (https://wp.me/p9vaFZ-4J) I showed how the market rewards equities based upon relative financial performance. When thinking about the S&P 500, you can go through the same process but on an absolute level.
Starting with Revenue Growth Y/Y, we see that it is still increasing but the pace of the increase is beginning to slow.
Surprisingly, when we look to profitability (i.e. Operating Margin), instead of seeing it expand with Revenue Growth, we actually see that it has stagnated since the 1H17. This is not something you would expect to see when all we hear is how strong the market is fundamentally.
S&P 500 Operating Margin (Semi-Annual Basis)
Digging into the drivers the same way you would analyze a company, we start with the leading indicators of inflation, which is going to impact the cost of goods sold (COGS). We know the leading indicators of inflation (PPI, Import & Export Prices, and ISM Prices Paid) started rising in early 2016. It wasn’t until they began to make five year highs in 2017 did we begin to hear companies discuss rising costs.
Two items to note. First, Core CPI (light blue) & Core PCE (dark blue) are lagged 18 months because they trail the leading indicators of inflation. Two, the leading indicators have recently begun to decline so there is the potential for this headwind to dissipate in the next few months.
Inflation Data: 3 month average, Y/Y
Next, we know that companies have increased Capital Expenditures substantially since 2010 and even more so since the tax cuts were past.
S&P 500 Capital Expenditures –Semiannual Basis
However, these newer projects have yet to increase in efficiency, as shown by the utilization rate in the US still being below where it was in 2014.
Finally, we know that the pace of hiring has increased, which has resulted in the initial jobless claims and continuous jobless claims reaching levels not seen since the late 1960s.
Going forward, we should expect revenue growth Y/Y to begin to decline from the 2Q18 levels as demand continues to slow. Therefore, management teams will need to determine how to reduce the pace of spending to help support profitability. If they can’t reduce the pace fast enough, that’s when they will start to make larger cuts to their expenses by reducing the labor force or delaying planned projects.
Regardless of how management teams decide to deal with a reduction in revenues, it seems that the market has already determined that we have reached peak profitability.
S&P 500: Price (white), Operating Margin (red)
How US Demand Affects Global Trade and ex-US Equities
Due to all of the political headlines and tweets, everyone is very aware that the US doesn’t make a majority of its goods and we import quite a bit from China.
Looking first at US imports from China, we see that it actually peaked in 1Q18. On a short term basis, we saw a rebound in the Y/Y data in 2Q18 but that is beginning to fade.
US Imports From China
In a normal situation, I would expect this decline to show up in China’s Industrial Production numbers. However, it’s been flat as a pancake for years, which goes with why I (and numerous others) don’t trust data that comes from the Chinese government.
However, this does show up in the trade data for China’s largest trading partners, such as Australia, South Korea, and Brazil.
When thinking about previous periods, like 2014-2015, we see that exports Y/Y peaked in 1H14 for these countries, which is when ISM New Orders peaked as well.
South Korea Exports
Additional, we see that Mexico saw somewhat similar data points as the other countries. Since 75% of Mexico’s exports come to the US, Mexico is more “in tuned” with the US economy so they tend to see turns in their export data at the same time end demand is declining.
When thinking about equities, we see a similar pattern as the export data on an absolute basis and relative to the US.
Emerging Markets (EEM): Absolute (white), Relative to S&P (yellow)
Developed Markets ex-US (EFA): Absolute (white), Relative to S&P (yellow)
South Korea (EWY): Absolute (white), Relative to S&P (yellow)
Mexico (EWW): Absolute (white), Relative to S&P (yellow)
Finally, with US demand slowing, China is going to have to decide if they want to do another massive stimulus program like they did in 2H15. Just a reminder, China’s M1 (12ma, Y/Y) tends to lead Global Manufacturing, ISM, and the trade data for Australia, Brazil and South Korea by about 6 months. Therefore, we have a long way to go before growth potentially returns that is being driven by Chinese demand.
As I’ve said numerous times, whether this is another mid-cycle slowdown or the beginning of a recession, the positioning will be the same. What is important to note is that we are still very early in this slowdown, since ISM tends to take about 18 months to go from peak to trough.
No changes in recommended asset allocation this month.
- Overweight (or long) the USD
- Underweight (or short) Emerging Market currencies
- Overweight (or long) long dated maturing US debt
- Underweight (or short) Emerging Market debt
- Neutral (or 50% exposure) S&P 500
- Underweight (or short) Emerging Markets
- Overweight (or long) US defensive sectors and industries
- Underweight (or short) US cyclical sectors and industries