Yield Curve Inversion In 3-4 Months
The ultimate signal for investors looking for the next recession is the yield curve. The chart below shows the difference between the 30 year yield and the 5 year yield. At the pace the yield curve is flattening, it will be inverted by August or September. To be clear, you can’t just extrapolate current moves onto future moves because that leads to crazy results. If you extrapolated the January increase onto the rest of the year, stocks would’ve been up over 65% which is almost impossible. The point of this chart is to show what the yield curve would do ‘all else being equal.’ If inflation and growth increases in Q2 like I expect, the 10 year yield and the 30 year yield can increase a bit. That would delay an inversion by a few months. There’s usually a lead time of 1 year before a recession occurs. I will undoubtedly get into the specifics of how long the lead time will be after an inversion occurs.
We’re certainly at a weird point in the cycle because nothing indicates a recession is coming in the next 18 months. The capex expansion by S&P 500 firms and the expected increase in GDP growth make it look like a new leg of the expansion is coming. Furthermore, the muted inflation rate and slow Fed hike cycle mean a recession won’t be catalyzed soon. In 2008, oil prices peaked at $147 making the current price jump to the $70 level seem inconsequential.
Leeding Index Is Improving
In keeping with my point that the economy is not looking like a recession is around the corner, the weekly leading index from the ECRI report shows growth will be ticking up as it is now at 4.5%. I’m looking for the spike in growth in January to eventually translate to an increase in GDP growth in the next few months. The latest improvement in this index signals the 2nd half of the year leading into the beginning of 2019 will have solid growth as well. It’s constructive to see the downtrend, which was emerging in the past couple months, has reversed.
Earnings In Q1 Were Great
I like utilizing The Earnings Scout Reports because they have more updated data than the weekly reports which come out of FactSet and S&P Dow Jones. As you can see from the first section, the EPS growth has fallen slightly to 24.9%. The average EPS surprise was an amazing 6.68% as 77% of firms beat estimates. You know it’s a great quarter when even the telecoms and utilities have double digit growth. Energy had 186% growth because of the easy comparisons and the improvement in oil prices. The increase in oil prices in the past few weeks and the 12.77% average surprise percentage has led to superior returns from the sector. The XLE ETF, which measures energy, is up 8.64% in the past month while the S&P 500 is only up 2.22%. The sector is completely done reporting.
The tech sector was the sector best as it had 30.82% growth with an 8.65% surprise rate as 95% of firms beat earnings growth estimates. The sector still has 19% of firms left to report. There are some claims that because technology production takes place out of America, the capex spent won’t benefit the American economy. I disagree with this perspective because cloud computing is moving back to America. Plus, the lower tax rate and repatriation tax holiday encourage capital to be spent in America. The financials had 27.27% growth which an average surprise of 6.38%. The major banks didn’t do well after their results. Owning the banks will be increasingly difficult as the yield curve flattens. The net interest margins are increasing, but this hike cycle is getting close to its end. The Fed may be forced to start cutting rates in 2019 or 2020. That will once again crimp net interest margins. If the long term trajectory is any signal for the future, net interest margins will fall below the previous cycle.
The consumer discretionary sector had 19.63% growth along with a 10.36% average surprise. This sector has been supported by Amazon and Netflix. The consumer staples sector had 12.94% growth, but investors weren’t impressed as the sector has underperformed this year. The sector is down 12.92% year to date. As you can see from the chart below, the ratio between the consumer staples index and the tech sector is at the lowest point since May 2001. It was even lower during the height of the tech bubble. Consumer staples stocks don’t like inflation and rising rates. Inflation increases costs and higher rates increases competition for dividend stocks. Obviously, inflation increases costs for all sectors, but the appeal of private label goods hurts when prices are being raised.
The sales growth rates are similarly impressive. The numbers are lower, but the results aren’t amplified by the tax cuts. Materials, energy, tech, and consumer discretionary all had double digit growth as the total growth was 9.36% with 455 of the S&P 500 firms reporting earnings. 9.4% sales growth is especially impressive when you see that the 3 year average sales growth is only 1.9%. The market had been riding high on record margins as sales growth was mediocre. The EPS surprise was one tenth higher last quarter, but the total growth is 8% higher thus far.
Conclusion
The current situation is ripe for stocks to do well as inflation has been modest, earnings growth has been strong, and economic growth should accelerate in the next quarter. I’m weary of the yield curve flattening, but that’s something that indicates a recession in 2020, so I wouldn’t sell stocks now because of that. I personally, have been burned trying to time the bottom in consumer staples stocks as their bear run has led to a 15.62% decline since January. It’s considered a good signal when the risk on sectors outperform consumer staples, but usually the sector isn’t declining during a bull run.
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