There has been much talk about the strength of the American labor market. And for a good reason. Most measures of worker health – U-2 unemployment rates, jobless claims, wage increases, year-over-year job growth, etc. – support the notion that US workers "win."
On the other hand, very few people have addressed the possibility that the data is weakening rather than strengthening. On the other hand. So much trust is given to the tax-incentive that few discuss the potential erosion of employment prospects.
For example, when the U-2 unemployment rate reached a business cycle low of 3.8% in May, the financial media cheered. When it rose to 4.0% in June, the media applauded even louder, suggesting that this was a sign that more people were returning to work.
There is of course another explanation. Perhaps 3.8% represented a low unemployment rate in business cycles. In fact, unemployment ratios tend to precede economic contractions and / or bear-bears by about a year.
The unemployment rate in the previous expansion was 4.4% (October 2006). The recession officially began in December 2007, while the bear market for equities began in October 2007.
Likewise, in April 2000, there was a U-2 low of 3.8%. Ironically, the bear population had already started in March 2000 and the recession was only a year away (March 2001).
Dive deeper into recent history and discover a myriad of intriguing observations. For example, strong slowdown in employment growth has been preceded by a recessionary environment. This happened in 2000. It also occurred in 2007 and led to financial collapse.
What is not necessarily mentioned is the timing of the abrupt slowdown in employment growth. For example, the reversal of the government bond yield curve in 2000 and again in 2006 appeared to produce dramatic declines in percentage gains year-on-year. Finally, employment growth has been negative alongside economic recessions. Job Growth and Return Curve Inversion ” data-width=”622″ data-height=”353″ data-og-image-twitter_small_card=”true” data-og-image-twitter_large_card=”true” data-og-image-twitter_image_post=”true” data-og-image-msn=”true” data-og-image-facebook=”true” data-og-image-google_news=”true” data-og-image-google_plus=”true” data-og-image-linkdin=”true”/>
Remember that since the 1960s, yield curve inversion has successfully anticipated all seven recessions that occurred. In other words, for whatever reason, when short-term interest rates have yielded more than longer-term interest rates, the economic contraction has followed within a relatively short period of time.
Is it possible that the Federal Reserve? which reduces market liquidity and increases short-term borrowing costs, will employers become more ruthless? Are companies hiring their recruitment plans? Maybe.
Evidently, Fed Chairman Powell seems determined to take a twofold tightening path. He will continue to increase overnight rates. And he will continue the reduction of balance sheet assets.
Theoretically, raising the overnight rate may not be so important if the maturities of longer-term debt rise in parallel. But they were not. Indeed, the ten-year yield has actually dropped 20 basis points since the Fed last raised its overnight money target to a range of 1.75% -2.00%. This has resulted in a pathetic difference between 10-year Treasury yields and 2-year Treasury yields at 0.28%.
Why is it important to note the fact that the flatness of the curve and the prospect of curve reversal are partly a function of falling yields on longer-dated bonds? For one, the economy should shoot at full speed. On the other hand, wage inflation should become higher. In addition, the tax reduction stimulus involves issuing more government debt, which increases supply. In addition, the quantitative easing of the Fed is also increasing in the longer-term maturities available, where the corresponding rates should rise. In other words, if everything is so great, why should not the curve become steeper instead of steeper?
Granted, when the gap between the 10-year and the 2-year-olds turns negative, a recession is not guaranteed. Seven of the last seven recessions? For sure. Nevertheless, it is possible that the eighth time has no meaning whatsoever.
It is also plausible that the yield curve inversion may have a much greater delay than the often quoted lead time of 12 months. Maybe it will be 24 months or 36 months. And if that's the case, stocks can have much more leeway.
On the other hand, even if recessions are not imminent, equities tend to worry about the future before it becomes apparent. And in some cases the devaluation of the asset price itself leads to self-fulfilling prophecies. In fact, the bursting of the tech bubble in March 2000 led to layoffs and the subsequent recession, not the other way round.
So for the investor, I am not sure how important the inversion of the yield curve is tends to be bad for stock values. All I know is that an additional investment risk in this case may not be optimal.
The broadest stock market indices may already respond to the apparent inevitability of yield curve inversion. Imagine an index that unites all NYSE Composite-traded stocks on the New York Stock Exchange. Not only has it been banded in since the correction in January, but its current performance is essentially 0%.
Ironically, the S & P 500 is currently up 4% and the index is moving at peak times from its all-time highs in January. The reason for its superior performance, however, is worrying for a variety of market watchers. Why so disturbing? The market-capitalization-weighted S & P 500 almost fully owed its gains in 2018 to the FANG-plus phenomenon.
Indeed, Facebook (NASDAQ: FB), Amazon (NASDAQ: AMZN), Netflix (NASDAQ: NFLX), Alphabet / Google (NASDAQ: GOOG), Apple (NASDAQ: GOOGL), and Apple (NASDAQ: AAPL) MSFT) accounts for 98% of the success of the S & P 500 this year. Without their presence, the S & P 500 would bet on 0% gains, much as the NYSE Composite now sits.
The good news? Most domestic indexers are quite heavily affected by FANG-plus in their portfolios. That is, they are currently outperforming technically shy active managers, value indices, and international stock enthusiasts.
The bad news? Most domestic indexers will falter with the "HANG-N-HOPE, FANG-plus" paradigm if things go wrong.
From my position, yield curve inversion is likely to be a pretty dramatic burden on job growth. Downward pressure on the stocks would follow. And excessive borrowing on FANG plus securities could lead to a wave of margin calls that force the liquidation of the most desirable stocks in the investment world.
Did you have a plan in 2000? Did you have a plan in 2008? Even if the catastrophe never comes to fruition, planning ahead for the possibility of extremely difficult results is financially wise.
Disclosure : Gary Gordon, MS, CFP is the President of Pacific Park Financial, Inc., A Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc. and / or its clients may hold positions in the above-mentioned ETFs, mutual funds and / or investments. The Commentary does not constitute individual investment advice. The opinions contained herein are not personal recommendations for the purchase, sale or holding of securities. Occasionally, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its affiliates for advertising on the ETF Expert website. ETF expert content is created independently of advertising relationships.