watch the replay below
Click here to access Senior Macro analyst Darius Dale's presentation.
The U.S. economy is undergoing a significant phase transition—understanding the market implications is critical.
We discussed this development during a free webcast with Merk Investments portfolio manager Nick Reece and Senior Macro analyst Darius Dale.
In case you missed it, this was the inaugural episode in our new webcast series, In the Trenches. Darius is the host and he’s opening up his rolodex, selecting the sharpest minds in finance to interview.
Below we’ve transcribed key excerpts from the discussion between Nick and Darius. Watch the entire discussion above.
* * * *
Darius Dale: Welcome everyone to the inaugural episode of In The Trenches. I’m Senior Macro analyst Darius Dale. I’m joined by portfolio manager Nick Reece of Merk Investments. Thank you for being here Nick.
Nicholas Reece: Thank you for having me.
Dale: What gets me out of bed each morning is my process and iterating and evolving to make it more resilient, more robust to deliver better solutions for your clients.
I think Nick does some of the best long-term cycle work. Many people think Macro investing is jumping from headline to headline. That’s Macro Tourism.
Guys like you and I are doing quite the opposite. We jump from time series to time series. Where are we in this time series? What’s the probable range to anticipate what that means for markets?
Reece: I agree. It’s all about the process – getting up each morning and looking at the income data. A lot of the work I do is trying to understand the likelihood that the U.S. economy will slip into imminent recession. So from there I’m trying to gauge the impact for markets – is this a major market top? Or is it likely that this market continues to make new all-time highs?
By far the biggest bear markets and the ones that take the longest to recover from are the ones that coincide with recessions. So I’m really looking for monitoring these two separate things and monitoring for when the economy and the market are becoming the same thing in a negative way. The idea being you really want to avoid these big bear markets during a recession.
Dale: One of the things I like that you do – that Hedgeye does as well – is separating Church and State from the perspective of what’s the economy doing and what’s the market doing in terms of that reflexive feedback loop? And certainly that reflexivity tends to correlate to 1 when you’re getting into the depths of recession.
So let’s get into it. You’ve prepared some slides.
Reece: Sure. I have two yield curves here. This is the 10-year versus the 3-month. We had an inversion last year, from May to October. That was the first time that we had yield curve inversion since the last recession. We’ve always had inversion prior to recession and we don’t have many false signals.
Now, the sample size is relatively small. We only have seven recessions in this time series. Now, typically when you get the inversion it’s 6 to 18 month lag before you go into recession. So was this a genuine signal? If you look at the 10-year versus the 3-year it’s telling a different story. We haven’t had inversion. So yield curve analysis suggests the outlook is neutral to negative.
The way that you typically see inversion is inflation picks up because capacity utilization is high, the Fed comes in to fight inflation and hikes rates. Continued rate hikes get priced into the curve. The two-year rises and you get inversion. In this case we got inversion with both moving lower.
Dale: That’s important. What a lot of investors think is that yield curve inversion means recession risk. What they forget is that the year leading up to many bull market peaks are among some of the best returns for bull markets. It’s typically characterized by double digit returns for factors like growth, high beta and momentum. That’s the key takeaway. Where are you in this cycle?
And if you look at growth we’ve been basically on the backside of the GDP sine curve since growth peaked in 3Q 2018. We know the path to a recession. At a certain point, growth is slowing, you hit stall speed, the labor market gets too tight, the Fed tightens too much and all the correlations go to 1 – firing starts to happen, there’s the depressing impact on corporate profits, consumer spending and business confidence. It’s about understanding the system has vulnerabilities and monitoring diligently for the trigger that would cause the system to break.
Reece: That leads to the analysis of the market itself. An expansion is a positive environment for equities. What I look for on the market side is every time the S&P 500 makes a new all-time high, I measure the breadth in a few different ways.
One of the ways is what percentage of member companies are above their respective 200-day moving averages. Historically, breadth is very strong in the early bull market. As the bull market ages that participation and breadth declines to a critical level. My critical level historically has been 63% participation. If you’re making new highs on the index but fewer than 63% of the component stocks are above their 200-day moving averages that’s a sign of a very old bull market that’s going to roll over.
As far as the breadth analysis goes, it’s historically very strong. Recently, new highs in January we got as high as 87% participation. That’s very inconsistent with a major market top.
Dale: A lot of the work I’ve been doing recently is excess liquidity. Excess liquidity is consensus nomenclature for the death of process. Investors say, “I’m just going to buy the SPY because of the Fed.” It’s not about excess liquidity. It’s about using the cycle to time big investing decisions. I say this all the time. Don’t be beta, beat beta.
If you look at this chart, you really only needed to make two material asset allocation decisions in the past 5 years. That’s the second half of 2016, when U.S. growth was bottoming out, and the second half of 2018, when U.S. growth slowed off its most recent peak.
Mid-November 2016 to the end of September 2018, when the U.S. economy bottomed, looking at Cyclicals that’s up 40% relative to something like Utilities at only up 20%. If you make that pivot on time and you’re long Utilities when growth slows again, you’re up 40% versus cyclicals only up 11%.
I don’t want to be beta. I want to make the most amount of money along the entire ride.
Dale: So, similar to you, the question any investor should be asking is, “Where are we at in the business cycle and where do we go from here?”
So let’s open it up to some Q&A. Starting with Michael, “This current market cycle has a strong ability to shake off any shock and headwind simply by using policy tools that have historically proven ineffective over the course of the full cycle. How do you reconcile that?”
Reece: If you’re looking at policy tools and a recession, Fed rate cuts aren’t going to prevent that.
Dale: They never have. Because the Fed can cut rates but it can’t cut labor. We go into recession on a market event that is perilously timed for when unit labor costs are destroying corporate profitability. You catalyze a sequence of firings that causes depressed consumer confidence, depressed consumer spending and it becomes very reflexive. The Fed can’t do anything about that.
Most people don’t realize that money supply growth is inversely correlated to GDP. Beta has done well for 10-year but I remind people that if you wanted to be beta in Europe and Japan you’ve done absolutely nothing. The Euro Stoxx 600 is only up 6% from where it was 20 years ago. The Nikkei is down -37% from where it was 30 years ago.