Trade War Is The Biggest Tail Risk
Empire State Index Is Very Disappointing
The general business activity reported in the April Empire State Index was ok as it fell from 22.5 to 15.8. This missed expectations for 18.2. This decline signals the manufacturing index is weakening from the rapid growth pace seen in Q1. The new orders index was even weaker as it fell from 16.8 to 9. This is a far cry from the over 20 readings seen at the end of last year. Every single indicator was down except inventories and the average employee workweek. Increasing inventories when sales are declining is terrible. It’s interesting to see that the number of employees index fell from 9.4 to 6, but the workweek increased from 5.9 to 16.9 which is the biggest increase since at least early 2013.
The other notable change is the prices received and prices paid indexes fell slightly from their recent high. I think inflation is about to be generated by high oil prices which is an extremely late cycle indicator. Oil did well in 2007 and 2008 right before the last recession and even after it started as the price peaked at $147.30 in July 2008. That was clearly pure speculation as the demand for oil was weak in 2008. It’s tough to predict such a speculative bubble based on no fundamental backdrop. I will stick with the supply and demand fundamentals and say I can’t even see oil getting to $80 in 2018 because of the fracking supply that would quickly come on line if the price increases further.
I mentioned in the title that this report was very disappointing because the forward looking indicators crashed. This is a very negative signal for manufacturing in Q2. Since manufacturing was one of the strong spots in Q1, I’m not optimistic about the service sector. The list of charts below shows half of the forward looking part of the Empire State Index. It’s a perfect score of disastrous results as the expectations for business conditions in the next 6 months fell from a very optimistic 44.1 to a somewhat pessimistic 18.3 which is the lowest reading since early 2016. The expectation for new orders and shipments fell 24.5 and 24.8 points respectively. The expected spending on technology and the projection for capex fell 0.4 and 4.2 points respectively. There’s nothing positive about the forward looking segment of this report. This could be a one off signal, but it’s following the weakness in European manufacturing, so it should be accurate.
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Morgan Stanley Indicator Expects A Recession Soon
The chart below shows the Morgan Stanley developed market cycle indicator. It shows the current economy is still in the expansion phase, but it’s extended. The index has a 50% weight for America, a 35% weight for Europe, and a 15% weight for Japan. Given the multiple cyclical weak periods in this expansion, I’m surprised the indicator stayed in the expansion phase. Many indicators suggested the U.S. economy was in a recession in 2016. This isn’t complexly wrong because many emerging markets were in a recession in 2016. This indicator seems to peak right around where it is right now which is disconcerting. There were two false red flags in the 1990s, but I don’t expect another one in this cycle because the indicator is so high.
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Biggest Tail Risk
I love to review the fund mangers’ surveys because they have accuracy unlike the retail surveys which should be faded more often. The survey below asks fund mangers the biggest tail risk facing the market. The important point with this survey is to understand that if the risk doesn’t occur, it doesn’t mean the answer was wrong. Since there haven’t been major crashes in the past 3 years, it’s fine that most of these didn’t occur.
The two ways these surveys can be wrong is if some other tail risk occurs or if the risk occurs and it doesn’t send stocks down. The biggest wrong call in this list is the claim that the GOP winning the White House was a big tail risk. Clearly, since Trump was elected stocks have gone up. I’m not saying that was the cause of the rally, but it didn’t act as a tail risk. The most recent response has been that a trade war is a potential tail risk. This is the same as last month, but it got more attention. The trade war was considered a risk right after Donald Trump was elected in January 2017 which shows how the fund managers were early.
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Cov-lite Loans A Big Risk
If you were to ask me about the biggest tail risk in the economy was I would ask to specify what the timeframe was. In the next 12 months, the biggest tail risk is clearly that this current slowdown doesn’t see a recovery and instead leads to a global recession. The scariest black swan event would be if the cov-lite loans defaulted at a higher rate that loans with a similar rating in the next recession. The charts below show that the lending guidelines have prevented leverage from growing so borrowers want loans with fewer covenants. The cov-lite loans are 77% of the leverage loan market; over 90% of the 1st lien loans have 2 covenants or less. The 3 year spread between the cov-lite and cov-heavy loans is very narrow as you can see in the 4th chart.
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Conclusion
We continue to see slowing growth. Because it is a widely held belief that the economy is late in the cycle, further negative results could cause a selloff to breach the low end of the recent range. If it does break the range and it turns out that the economy fell into one of its brief slowdowns which have occurred in this cycle, there should be a sharp rally which takes the market to new highs. If there is another mini-slowdown in 2019 or 2020, it’s highly likely that will be the one which leads to a recession since the yield curve will have inverted beforehand.
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