Rate hikes ≠ The Apocalypse

Preface: Explaining our market timing models
We maintain several market timing models, each with differing time horizons. The “Ultimate Market Timing Model” is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.

The Trend Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. This model has a shorter time horizon and tends to turn over about 4-6 times a year. In essence, it seeks to answer the question, “Is the trend in the global economy expansion (bullish) or contraction (bearish)?”

My inner trader uses the trading component of the Trend Model to look for changes in the direction of the main Trend Model signal. A bullish Trend Model signal that gets less bullish is a trading “sell” signal. Conversely, a bearish Trend Model signal that gets less bearish is a trading “buy” signal. The history of actual out-of-sample (not backtested) signals of the trading model are shown by the arrows in the chart below. Past trading of the trading model has shown turnover rates of about 200% per month.


The latest signals of each model are as follows:

  • Ultimate market timing model: Buy equities
  • Trend Model signal: Risk-on
  • Trading model: Bearish

Update schedule: I generally update model readings on my site on weekends and tweet mid-week observations at @humblestudent. Subscribers will also receive email notices of any changes in my trading portfolio.

Pundits vs. the bond market

As expected, the FOMC delivered a rate hike last week, From the bond market`s perspective, you would have thought that the Fed cut rates. The stock market rallied, and bond yields fell.


From the viewpoint of some of the pundits, I thought that the Apocalypse was at hand. David Rosenberg warned that “There have been 13 Fed rate hike cycles in the post-WWII era, and 10 landed the economy in recession”.

Not to be outdone, Bill Gross said that “Our highly levered financial system is like a truckload of nitro-glycerin on a bumpy road”.

What’s going on? Who is right, the bond market, or the pundits?

The bear case

Let’s start with the risks. Focusing strictly on the US, Ned Davis Research studied past tightening cycles and categories them as either fast or slow. They found that the current rate hike cycle is most like the ones that began in 1946 and 1963 (highlighted in yellow).


If history is any guide, then expect the forward one year equity performance to be about -10%.


David Rosenberg identified 10 key risks to the stock market in a note published Friday:

  • Valuations are stretched
  • Leverage is extended
  • Retail investors are suddenly rushing to buy
  • The technicals are showing vulnerability
  • Investors are complacent
  • The Fed is raising rates
  • Inflation is picking up
  • The gap between economic growth and sentiment is large
  • Households have over-ownership of stocks
  • Credit markets are frothy

Bill Gross also elaborated on the risks facing the global financial system in a recent CNBC interview. It’s not just about the Fed, but the global reflationary trend and the dampening effects of the re-synchronization of monetary policy:

Monetary policy in both Europe and Japan is causing international investors to buy U.S. Treasurys, he explained.

The European Central Bank is currently buying 80 billion euros ($85.7 billion) a month in bonds and Japan’s 10-year is pinned at zero to 10 basis points, said Gross, who runs the Janus Global Unconstrained Bond Fund.

“Once [ECB President Mario] Draghi begins to taper, that probably won’t happen for a few months, but once he begins to taper and reduce that $80 billion a month, once that zero to 10 basis point cap is eliminated in Japan, then hell could break loose in terms of the bond market on a global basis,” he told “Power Lunch.”

Reuters reported that China has already followed suit by raising rates in the wake of the FOMC decision. I wrote before that we are already seeing upside inflation surprises all around the world (see 3 steps and a stumble: The bull and bear cases).


This chart (via Credit Suisse) shows the scale of monetary accommodation around the world. It is only a matter of time before other central banks ease off their extremely easy monetary policies.

Global central bank balance sheets


In light of the medium term upward pressure on interest rates, Ned Davis Research expressed concern about what that would do to debt service ratios as rates rise.


I did some back of the envelope calculations, using this chart from the JP Morgan Asset Management’s excellent quarterly review. Currently, household balance sheets are in good shape, with debt service ratios and net worth in healthy positions. But if we were to assume that everyone pays a floating rate debt at the prime rate and disposable income remains unchanged, then a 75bp increase in rates in 2017 would raise debt service costs by 28%. Household debt service ratios would surge to levels last seen just before the Great Financial Crisis, and the household sector would be very stressed. The caveat to this analysis is not everyone has floating rate debt, and most pay a rate higher than prime, so the percentage increase would be lower. Therefore the 28% rise in interest expense should be regarded as a worst case analysis. The actual figure would probably fall somewhere within the box shown in the figure below.


So far, this is a “this will not end well” investment story, with no immediate bearish trigger. Investors should relax. This is not Zero Hedge. Rate hikes are not the Apocalypse. Don’t panic, and watch the data.

Here is what I am watching.

Rising consumer stress

The biggest risk to the stock market is a Fed policy mistake that tightens monetary policy in the face of economic weakness. Such an error would push the economy into recession. Despite Janet Yellen’s assertion that the economy is doing fine, there are some signs of incipient weakness on the consumer front. Wages are starting to lag behind inflation (yes, I know the chart shows headline CPI, but households have to eat, drive, and heat their homes).


When the consumer stops making progress on real wage gains, they have a number of coping mechanisms in order to keep the party going. One simple way is to save less. As the chart below shows, the real savings rate is retreating, but not to danger levels. This metric has fallen to zero just before the last few recessions but remains positive today.


New Deal democrat observed that households are tapping home equity as another way of coping with the lack of progress in real wages. When consumers run out of ways to cope with falling real incomes, a recession develops. For now, real retail sales has been holding up well. This indicator has turned down ahead of past recessions – so the party is still going.


As well, consumer confidence remains upbeat. These readings reflect greater confidence and a willingness to spend. Households want to party, despite signs of rising stress on their finances.


Another way of thinking about how consumers cope with financial stress was addressed by the New York Fed’s Liberty Street Economics blog, which asked the question: When debts compete, which wins? As the chart below shows, households stopped paying mortgages (gold line) in the wake of the Great Financial Crisis as real estate prices tanked and strategic mortgage defaults mounted. More recently, they’ve been lowering the priority on their car loans (blue line) in favor of mortgages. As long as the housing market holds up, it is difficult to envisage a scenario of sufficient consumer stress consistent with a recession.


That’s why housing is such an important cyclical sector of the economy. A slowdown in housing has accompanied every past recession. So far, housing starts remain robust, though mortgage rates have ticked up (red line, inverted scale on right). In effect, the housing party is still going.


Since stressed households appear to be giving a lower priority to car loans, then vehicle sales will be a key cyclical indicator. The progress of vehicle sales is an emerging dark cloud on the horizon, as they seem to have peaked and may be in the process of rolling over. I do not regard this development as a definitive signal of weakness and it would only be a very early warning sign.


Another key indicator to watch is the growth in money supply, which is especially important when the Fed is committed to a tightening cycle. M2 growth was part of the group of leading indicators, but got dropped because it wasn’t as predictive as expected. Nevertheless, real M1 growth has dipped below zero and real M2 growth has dipped below 2.5% before past recessions. While these indicators are slowing, they are not flashing danger signals yet. Something to keep an eye on.


Don’t fight the tape

For the time being, the stock market is enjoying the reflation party. The message of powerful momentum from the market is, “Don’t fight the tape.” Global stock markets have been on a tear. Recently, the Dow Jones Global Index has made a new high, with European indices rallying to new recovery highs.


Over in Asia, the Chinese market and the markets of China’s major Asian trading partners are all looking very healthy. Of particular interest is the cyclically sensitive South Korean market, which shrugged off the impeachment of its president and rallied to a new high.


Another cyclically sensitive indicator, the industrial metals, fell below its 50 dma, but eventually rallied to hold above that key support.


The fundamental driver of stock prices, namely earnings, are still going strong. The latest update from Factset shows that forward 12-month EPS is still rising. These readings are also consistent with the observations by Brian Gilmartin, who also sees a pattern of rising EPS estimates. The party is still going, according to Wall Street.


All of these readings are consistent with New Deal democrat’s latest observations of strength in coincident and short leading indicators, but long leading indicator are starting to roll over from positive to neutral territory. There is no need to panic and sound a recessionary alarm (yet).

Peak reflation growth?

Even though there has been a surge in reflationary growth around the world, the magazine cover of The Economist which accompanies this story about a synchronized global recovery, provides a sobering contrarian magazine cover warning.


The bulls should relax. Some time ago, The Economist highlighted a study by Citigroup analysts showing that Economist covers were ineffective as contrarian indicators after six months, but works well on a one-year horizon:

Interestingly, their analysis finds that after 180 days only about 53.3% of Economist covers are contrarian; little better than tossing a coin. After 360 days, the signal is a lot more reliable—68.2% are contrarian. Buying the asset if the cover is very bearish results in an 18% return over the following year; shorting the asset when the cover is bullish generates a return of 7.5%.

In other words, the reflation growth party is still going for the next six months.


The week ahead: The start of a correction?

In the near term, there are a number of ominous signs of equity weakness ahead. I pointed out on Friday that a number of broad based indices have violated their uptrends, which suggests a period of either sideways consolidation or correction.


In addition, Rocky White at Schaeffer’s Research noted that the DJ Transports had significantly underperformed the DJ Industrials in the last three months.


While this is not technically a Dow Theory sell signal, past episodes have led to market weakness.


The Fear and Greed Index has plunged below the neutral 50 level, which is usually an indication that it will move to a “fearful” oversold reading. Such readings generally only occur during corrections.


Lastly, Tim Duy observed that there are a total of 11 Fed speakers next week. As the market has already interpreted the rate hike as a dovish hike, it’s difficult to see how much more dovish the Fed could get. They have already committed to a tightening cycle and penciled in three rate hikes for 2017. Equity risk is therefore tilted to the downside.

My inner investor remains bullishly positioned. He thinks that the highs for this bull cycle have not been achieved yet. My inner trader re-entered his short positions on Friday (see Sell St. Patrick’s Day?).

Disclosure: Long SPXU, TZA

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