Stocks resumed their developing downtrend last week with the S&P 500 falling a bit over 3.5%. That wasn’t bad compared to emerging market equities, down nearly 5% on the week or the darling NASDAQ stocks, down over 4%. Bonds finally found a bid as the economic data was nearly uniformly miserable, culminating with a less than expected retail sales report that merely confirmed what Macy`s Inc (N:M), Nordstrom (N:JWN), Penney’s and so many other retailers have been reporting, namely that the US consumer doesn’t seem to be in a shopping mood. That was also confirmed by the release of inventory figures that showed levels relative to sales that are higher now than at the beginning of the last recession.
That the consumer appears to be slowing down should not in any way be a surprise. We’ve been watching a steady decline on the investment side of the economy for over a year now, something commonly dismissed as “just energy”, but which is looking more and more like the normal sequence of events leading to a growth slowdown or recession. It is always investment that leads us into and out of recession; consumption is the laggard. The slowdown that knocked Macy’s, Nordstrom and Penney down over 15% on the week is merely confirmation of what the data has been telling us for over a year – the US economy is slowing down. Will it turn into recession? I don’t know and neither does anyone else but with earnings falling again this quarter it might not matter that much for stock investors.
It isn’t just publicly traded stocks that are starting to get marked down either. Last week brought reports that Fidelity had marked down a lengthy list of private company investments including a Snapchat haircut of a mere 25%. Blackrock (N:BLK) recently wrote down their investment in Dropbox, another press darling, and Square announced plans to go public at a valuation well south of their last private round. There are also early signs that the London property market may be finally cooling – although any drop so far is modest at best – and I’ve heard anecdotal evidence of some slowing in NYC and Miami. In credit markets, banks are having trouble unloading some of the M&A loans on their books and the junk bond market is in a persistent downtrend.
I find it hard to believe that anyone is surprised by the markdowns on some of these private companies. Silicon Valley is as good at creating hype as it is technology and this cycle is no different than past periods of exuberance. Is or was it a bubble? I don’t know and I hate that term anyway and what difference does it make what you call it? My two cents is that while the companies involved in the most recent version of the high tech lottery may have been of a slightly higher quality than the previous iteration at the end of the last century, the attitudes, crazy spending and lack of discipline were about the same. As were the stock prices although they were a bit less obvious this time since many of the companies remained private. These markdowns are but a small step toward rationality and unlikely to be the last.
I don’t think it is coincidence that we see these markdowns and a general pullback in risk taking at the same time we see dysfunction in other markets. There are numerous signs of reduced dollar liquidity in the dark corners of the global markets, something our Jeffrey Snider has been writing about for over a year now. Swap spreads have recently turned negative, something only previously seen during the depths of the financial crisis and considered impossible until recently outside that level of crisis. If you are interested this post by Jeff offers one explanation for the freeze up in this derivative market. Suffice it to say that more stringent regulatory capital requirements and extreme monetary policy is a volatile mix with unintended consequences.
The lack of liquidity affects a wide variety of markets from repos to credit default swaps to the plain vanilla corporate bond market. The big moves we’ve been seeing in markets, starting with the unheard of move in the Treasury market in October of 2014 and continuing through the Swiss Franc earlier this year and then the stock market mini-crash in August are all symptoms of a lack of liquidity. Volatility is the inverse of liquidity – when you have one you don’t have the other. Whether it is the end of QE or too much QE or new regulations or the trend toward more protectionist trade policies or currency manipulation or increased capital controls or a combination of all the above or something I haven’t thought of, I can’t say. But bouts of volatility, a lack of sufficient liquidity, are becoming more frequent and hard to ignore.
What is a bit unnerving is that we’ve seen these episodes of reduced liquidity – higher volatility – even while global monetary policy is perceived to be ultra-easy and getting easier. The ECB and PBOC are easing and the BOJ won’t hesitate to do more if they feel they need to push the yen lower. Almost every move by a central bank this year was to ease. Only the Fed stands ready – so they say – to tighten policy although it seems the closer they get to a hike the further away they are. Mere anticipation of the hike so far has been sufficient to create conditions which prevent its implementation. Which is exactly what I expect to happen by the time the December meeting comes around by the way.
It should not be forgotten that the Fed and the rest of the world’s central banks really don’t know how their future moves will affect markets or economies. In fact, there isn’t even any agreement yet about what their past moves have accomplished. Heck, economists are still arguing about the Great Depression, not sure what caused or ended it. We are in uncharted territory when it comes to monetary policy. Economists can’t predict the consequences of US QE by looking at Japan’s experience because the Yen isn’t the global reserve currency. Mario Draghi doesn’t know what the unintended consequences of ECB QE will be or even if the intended ones are reasonable. He doesn’t have a proven model he can consult.
With the world’s central banks flying blind I don’t think it should be surprising that we’re seeing increased volatility. Anticipation of the Fed’s tightening is being transmitted around the world, markets pricing in the Fed’s expectations – until they change again and markets have to price the new mood into asset prices. The global economy is still weakening and earnings are falling. Financial conditions are tightening. Risk taking is being reined in. The war with ISIS is taking a dangerous and frightening new turn. And we’ve got a Presidential election next year with nary a sane, trustworthy candidate in sight. The wonder is that markets, in the face of all that, haven’t come completely unglued. Maybe this little pullback in risk taking is nothing more than a pause on the way to irrational exuberance, a blowing off of the froth that lets us fill our risk mug to the brim. Or maybe the sobering has already begun. If it is the latter, we are probably going to need a hangover cure.