Numerical Microphobia

 

We have long suggested that the recent recovery was unlike any other and that interest rates would not need to rise very far before the US economy would slow. Unfortunately, we were right. There should now be very little debate that the US economy is indeed slowing. Two key indicators (shown below) which have led the economy and interest rates for decades are now clearly pointing in this direction. Taken together the case is very compelling.

 

That this is happening is hardly a cause for celebration. Indeed the current slowdown is alarming. Why? It is happening with US interest rates at 3%, European interest rates at 2%, and Japanese interest rates at zero. Not only are these nominal short term interest rates at remarkably low rates but real interest rates are close to zero!

 

We have never seen, in our living memory, this level of weakness in the developed countries of the world with nominal and real interest rates this low at the beginning of a downturn. 

 

The reason that we should be experiencing some “Numerical Microphobia” -   fear of low numbers for peak interest rates – is that there is now very little room for the central banks to cut interest rates. We cannot know whether the central banks have enough ammunition to stimulate demand to offset the next downturn.

 

There is still very little discussion about the possibility of a recession despite the strong evidence of a slowing economy. What is disturbing about this is the significant risk of deflation that this would entail if we start a recession from such low levels of interest rates. The bond markets have already been signaling this risk as we have discussed before. This means it is now time for everyone to carefully consider possible economic outcomes that they have never experienced in their lifetime.                           

 

Interest rates and the cycle

 

The chart below shows the interest rate cycle compared to the national ISM index. The recent ISM reading was 51.4 from 53.3, the lowest print since June 2003, and the orders/inventory ratio fell further, which suggests further weakness going forward.

 

 

 

 

This chart also shows us a great deal. It tells us that the Greenspan Fed has never raised interest rates with a reading below 50 on this index, and we could be there very soon. It also shows how far interest rates have moved in previous cycles. From 10% to 3% in the early 1990s, and from 6.5% to 1% in the early 2000s. Starting from around 3%, therefore, the room for maneuver is very limited.

 

No doubt the Fed are very aware of this, and while they wanted to raise interest rates as far as they could in the current cycle there is now a key danger that any further interest rate increases would simply reinforce the downturn. 

 

This risk is further demonstrated by the relationship between the Index of leading economic indicators (LEI) and changes in the Fed Funds rate. The chart below shows that whenever the LEI turns negative, and it already has, it is not too long before interest rates are falling.

 

 

 

It is remarkable that these time worn relationships between the LEI, and the ISM indices on the one hand and the outlook for the Fed Funds rate are currently being so widely ignored. Perhaps market participants are waiting for a clear change in Fed rhetoric. But looking at the data, what choice do they really have? This is especially the case now as the Fed’s overriding objective is to avoid deflation at all costs. With so little room to move they can hardly afford to be any more restrictive than they have been in the past. We are therefore close to a change in the direction of interest rates.

 

Equity investors should also take note that there is also a tight correlation between the ISM “Prices Paid” index and Global Corporate Earnings Growth (%) and the former has just fallen to a near zero rate of increase as shown in the chart below, so the chances are that earnings growth rates have much further to fall.

 

 

 

 

 

The “Y curve”

 

Most investors tend to believe that lower interest rates and bond yields are positive for equities. We spent some time examining this theory in Market Notes 20 and concluded that while most of the time there was a loose relationship, it was very far from being either accurate or reliable. Furthermore, we argued that at extreme interest rates levels (close to zero or well above 10%), that the theory was both  invalid and highly misleading.

 

So we would greatly caution equity investors from getting too bullish during the next downturn in short term interest rates, given how close we are likely to get to zero. Much will depend on how quickly and aggressively the Feds cut interest rates as well as the economic response.  We do not know what the likelihood of deflation is but it is now clearly a possibility that cannot be ignored.

 

The chart below shows the relationship between the CPI and the P/E ratio over the last 100 years. This clearly shows that if the CPI is below zero or above 10 then the equity market tends to trade at a lower than usual valuation. This is shown by the Y - curve relationship between the CPI and the P/E ratio, and the data in the  accompanying table.

 

 

 

 

 

Summary

 

Investors need to be very aware of the strong relationship between the ISM index and interest rates as well as the equally strong relationship between the LEI and interest rate changes. Both of these indicators suggest that we are very close to a reversal in the direction of interest rates from rising to falling.

 

This will be the lowest peak in interest rates for decades. It can only be alarming that this reversal should happen when interest rates are so low. The Fed’s room for cutting rates is minimal and without aggressive early action and an adequate economic response there is once again a significant, but hard to quantify, risk of deflation.

 

The outlook is most clear at this point for short term interest rates. Long term rates usually travel in the same direction as short term rates but tend to lag short term rates once they begin falling.

 

The outlook for equities is the least certain, but we should bear in mind that earnings are at a multi-decade peak in relation to GDP and as the chart above showed earnings growth is now set to fall rapidly. Furthermore, the Y-curve shows us that as we approach zero CPI it is far from clear that lower bond yields and interest rates are bullish for equities in general.

 

 Much will depend I believe on the Fed’s policy. The greatest risk would be for the Feds to continue to raise rates and create an overkill situation for the economy.  If the Fed quickly reverse to cutting interest rates, there is much more likely to be a soft landing and avoidance of deflation. Given what the charts above are telling us, and the signals from the bond market, how much of a choice do you believe the Fed really has?