To my clients:
It was an up week for North American stock markets with the Canadian TSX up 1.8%; the U.S. Dow Jones Index up 1.9%; and the U.S. S&P 500 up 2.1%.
Items on the agenda for this week: 1) the “big three” economic releases; and 2) more thoughts on the recent yield curve inversion and how it has/will impact portfolio positioning. This second topic is particularly important, and I’d encourage clients to read this portion of today’s update.
- It’s the first week of a new month, and the big three economic reports were released:
first up on Monday came the ISM Manufacturing Index, and at 55.3 it beat expectations of 54.5 and was higher than the prior month’s reading of 54.2. Remember, anything above 50 indicates growth, and anything above 55 is reasonably healthy (anything above 60 is exceptional, and also unsustainable for long periods). In other words, manufacturing activity looks to be stabilizing and possibly improving from its recent slowing trend.
- next came the ISM Non-Manufacturing (Services) Index on Wednesday. At 56.1, services missed expectation for a reading of 58.1 and were below the prior month’s reading of 59.7. As seen in the data, services notably slowed, and should be watched for a continuation of this trend in the months ahead. But, as above, a 56.1 reading – on its own – is reasonably healthy.
- lastly, today saw the release of the U.S. Employment Report which came in at 196,000 new jobs created for the month of March – beating expectations for a 175,000 new jobs and vastly improving upon the prior month’s 33,000 reading (itself revised up from an initial reading of 20,000). This release seems to support the view that last month’s starkly lower employment gains may indeed have been a blip in the data. Today’s number also returns the U.S. to the long established trend of +/- 200,000 jobs per month that has prevailed through much of this 10-year economic expansion.
The big three indicators cited above point to continued economic expansion.
The preceding said, two weeks ago the U.S. (and Canada) saw its yield curve invert for the first time in more than a decade. Yield curve inversions are particularly ominous signals that have a very strong track record of preceding recession by about 9 to 36 months. Clients well know that “recession” is the boogey man I/we are particularly keen on avoiding. By way of “avoiding” recession, I mean to reduce equity (i.e. stock) exposure for clients meaningfully if recession appears imminent. On the day of the inversion (March 22nd), I reduced equity exposure for most clients by roughly 5%. This is NOT the degree of equity reduction I envision if recession seems imminent. The reduction I envision would be many magnitudes greater. So, the question begging to be asked is why did I not reduce equity weightings more meaningfully? There are probably three parts to the answer.
First, the cited inversion was very short lived and exceedingly shallow. The difference between the higher three month interest rate and the lower 10-year rate never registered much more than a couple 100ths of a percent. Also, the 3 month to 10-year inversion did nor persist for very long, with the 10-year rate moving back above the 3-month rate by about 1/10th of a percent earlier this week. To be sure, other parts of the yield curve remain inverted (i.e. 2-year rates remain very slightly above 5-year rates), and the overall curve remains very flat and is flashing a decisive yellow. But it would be a step too far to characterize the curve as flashing “red” at this juncture. To be sure, the internally published RBC “Recession Watch Dashboard” which I review every morning NEVER did characterize the yield curve as flashing a “red” signal. To do so would likely have required the yield curve inversion to steepen (i.e. short term rates moving more substantially higher than long-term rates) and sustain (certainly persisting longer than just one week).
Second, the inversion was not supported by any of the other major indicators we track. Perhaps most notable of these other indicators is weekly jobless claims. While the week to week change in claims is not considered a “major” economic release, the fact is that a sustained and decisive move higher in jobless claims is perhaps one of the very best recession indicators RBC has identified. Simply put, a change in trend in jobless claims whereby weekly claims begin to trend higher on a sustained basis over the course of a couple of months (or more) has clearly been shown to precede recessions (with the occasional false signal here and there). Currently, jobless claims continue to plumb multi-generational lows in absolute terms, and all-time lows in population-adjusted terms. To wit, yesterday’s weekly jobless claims of 202,000 are the second lowest reading seen since the 1960’s.
And third, the Federal Reserve might possibly have engineered an economic soft-landing (the “unicorn” I cited two weeks ago). I am fully aware that by even suggesting this possibility, I am, in essence, suggesting that “this time is different”, which is a very fraught assertion to make with respect to anything economic or market related. Many a strategist and economist has proverbially died upon the blade of such a claim. But, it remains the case that the U.S. Federal Reserve has made a very abrupt and dramatic pivot with respect to its future interest rate expectations and, further, that current Chairman Jerome Powell has been much more vocal about promoting the “economic growth” mandate of the Fed as opposed to the more traditional “stable inflation” mandate pursued by his predecessors. In fact, Powell has suggested the Fed would allow inflation to exceed its target for a period of time in order to promote said economic growth.
Perhaps, a “bonus” fourth reason might be a looming trade agreement between the U.S. and China (which is looking ever more likely although I did not have time to discuss this week).
All in all, despite the brief yield curve inversion, recession risks remain low in my and RBC’s opinion. We continue to forecast economic growth, and stock markets should directionally follow this growth trajectory. That said, I am fully comfortable having reduced equity exposure by ~ 5% two weeks ago, and an additional ~ 5% last October. I would characterize these modest reductions as prudent given economic developments. However, it is important to emphasize that all discretionary portfolios continue to have equity weightings above the long-term target specified in the Investment Policy Statements. It’s simply the case that the degree to which equities are above the long-term target has now been reduced.
That’s it for this week. All the best,
Nick Scholte, CIM, FCSI
Vice-President & Portfolio Manager
RBC Dominion Securities Inc. │ Tel: 604.257.7569 │ Fax: 604.235.9950
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