The Forest and the Trees

The adage “don’t miss the forest for the trees” came to mind last week as markets squirrelled around in response to random data points and ECB rumors that made the Real Housewives proud. Christoph Wieland, an eighteenth century German poet, gets credit for saying, “Too much light often blinds gentlemen… They cannot see the forest for the trees.”

 

The majority of investors focus their attention on market developments that paint the picture they want to see. They focus on the Gummi bear trees that grow alongside the chocolate milk river. This way of processing information makes it easy to lose site of the forest, and becomes extremely problematic when the forest is nowhere near Willy Wonka’s Chocolate Factory and is straight out of a Tim Burton film.

 

When investors focus on trees instead of forests, it provides opportunities to those of us who can keep the forest in focus. Investors are now locking on to any Gummi bear tree that makes the U.S. economy appear healthy, and they are missing the recessionary forest, which is providing us with a huge opportunity in three markets.

 

Can I get some service around here?

The ISM Service PMI had the largest one-month increase ever, allowing media types and bloggers to rave about the bounce-back of the U.S. economy. I’ve said it many times: one month means nothing in a data series. The most important developments in economic data occur at the margins. Well, the trend in the ISM service index has been downward since it peaked in July 2015.

 

I should also point out that the last two times this index had huge monthly gains in the midst of downtrends, in 1998 and 2007, the U.S. entered a recession shortly thereafter.

 

I’m not picking only on the ISM. Markit has its own service sector index, which peaked a full year before the ISM index and has been tumbling ever since.

 

But it’s not only the service trees decaying: all the other trees in the forest are withering, too.

 

Tim Couch

There are several data sets across the U.S. economy experiencing losing streaks that remind me of the Cleveland Browns’ streak of picking quarterbacks in the draft.

 

Industrial production has contracted for 12 straight months, which is the longest losing streak outside of a recession. Factory orders have declined for 22 consecutive months, which is the longest losing streak outside of a recession. Commercial and industrial loan standards have tightened for four consecutive quarters, which, you guessed it, has never happened outside of a U.S. recession.

 

Mark Twain said, “History may not repeat itself, but it rhymes.” Well, if that’s true, then recession is my obsession.

 

Labor Pains

Like with the one-off ISM number, everyone was giddy last week when the weekly unemployment claims hit a brand new 40-year low.

 

Now for everyone’s favorite trees, the monthly US labor reports. ADP employment numbers have been in a downtrend since peaking back in 2015, and last week hit a fresh four-year low. Growth in non-farm payrolls has declined 30% since peaking last year based on last week’s 1.9% growth rate, with no floor in sight.

 

Speaking of things that haven’t happened in 40 years, productivity growth just contracted for the third straight quarter! Why doesn’t anyone talk about that tree?

 

From a consumer perspective, it’s not only the decline in jobs and productivity that is troubling. The entire make-up of the U.S. consumer is heading in the wrong direction.

 

Income growth and consumption have been falling for the better part of a year, and we just saw the first annual increase in delinquency rates on consumer loans and credit cards since the Financial Crisis.

 

The deterioration in the profile of the U.S. consumer is a real problem, because the only thing keeping the U.S. GDP from officially signaling a recession, other than the Fed treating the GDP deflator like a Cracker Jack prize, is the U.S. consumer.

 

Everything Must Go

If you need more evidence that we may run into problems on the way to Grandma’s house, look at what’s been happening with U.S. growth forecasts.

 

Both the IMF and the Fed have been slashing forecasts for U.S. growth the way that a furniture store that has a “going out of business” sale every other weekend slashes prices.

 

The Fed’s 2016 U.S. GDP growth expectations started at a robust 3% back in 2014, declined every quarter since, and hit the Financial Crisis level of 1.5% most recently. The IMF slashed their own expectations from 2.2% just three months ago to last week’s guesstimate of 1.6%.

 

But it’s not only U.S. growth requiring a markdown.

 

Global GDP expectations for 2016 started at 3.5% last October, and guesstimates are now 20% lower at +2.9%. This is on top of the fact that expectations for global trade are getting slashed like they’re staying at Jason Voorhees’ summer camp.

 

Optimism isn’t just an overused tool for growth forecasts. For the last two years, the Fed has been overly optimistic about the number of rate hikes they expect, leading investors to embrace the power of positive thinking, too.

 

Power of Positivity

Rate hike odds for both November and December have been rising for weeks now and markets are wrong. Since 2013, the Fed has forecasted nine rate hikes, and they’ve hiked once. Coming into this year, they forecasted at least two more hikes, and we haven’t seen one.

 

Historically, once nine months have passed since the Fed’s first rate hike without any additional hikes, the probability of its next action being a rate increase is 0%.

 

I’ve been saying on record since December that the Fed wouldn’t raise rates this year, and would return to their easing ways by early 2017. I’m not a Fed whisperer, but contrary to the Fed, I am data dependent.

 

All year long, the health of the U.S. economy has been unable to absorb a rate hike, and it still can’t. The Fed won’t hike heading into an election, which leaves only December available, and there’s no way the economy will improve enough by then to absorb a rate shock.

 

Labor data will continue to worsen, and Yellen focuses on the labor market as her economic wind sock. Without a significant improvement in ADP and non-farm payrolls, there is no chance of a December hike. If I’m wrong and the Fed hikes, it means the U.S. recession will become official more quickly.

 

Bottom Line

Growth is declining, it hasn’t hit a floor yet, and one Gummi bear tree here or there does not change the make-up of the forest.

 

Our boy Christoph Wieland said “Too oft is transient pleasure the source of long woes.” Investors have been seeking transient pleasure by selling the very assets they need to own to profit during a U.S. recession.

 

Over the last two weeks, Treasuries, gold, and utilities have been crushed because investors are staring at trees and missing the forest. Yet the economic forest we are traversing is the same one that allowed Treasuries, gold, and utilities to more than double the S&P’s return this year.

 

That recessionary forest has only one possible Fed response, and it isn’t a rate hike. If you want to avoid long woes and maximize returns between now and the ball drop on New Year’s Eve, get LONG in the markets that have gotten you paid all year. Keep your eyes on the forest and save the Gummi bears for the movies.