January 11, 2016


My last market commentary was titled, “Global Recession Risks Are Rising.”  This month, I want to highlight how probabilities have increased for a global recession based on the price action in various areas of the market.  I will also include a few new data points on the economic front.


First of all, the first week of the New Year was the worst first week for the stock market of any new year since 1930.  The S&P 500 is now down about 10% from its high last May.  However, the weakness in many areas of the market is much more significant than the broader averages.  We can look at some of these areas to see if they suggest what may be going on with the economy.


Base metals like aluminum, nickel, zinc and copper are core metals used in the economy.  The chart below shows an ETF which tracks a basket of these metal prices.




You can see how the prices of these economically sensitive metals have been declining sharply and the basket is down over 35% from its recent high.  Next, let’s take a look at the stock prices of a few transportation companies since those companies move the goods within the economy.  The first company shown below is Union Pacific.  This railroad company transports a wide variety of products.




The chart above shows how Union Pacific’s stock has dropped by almost 40% recently.  Next, let’s take a look at the largest North American trucking company; JB Hunt.




JB Hunt’s stock price has declined by about 26% recently.  From a global transportation perspective, Federal Express’ stock has declined by a little more than JB Hunt.  Next, let’s take a look at a stock which is directly affected by consumer credit and spending; Capital One.  It has over $300 billion in assets and is one of the largest credit card companies and has significant exposure to other consumer lending areas such as auto loans.




Capital One’s stock has declined by 29% recently.  Next, let’s look at an ETF for the retail sector to get a sense of consumer spending.  It is a very broad-based index of many types of retail companies.




The chart above shows how the retail sector has declined 20% lately.  Next, let’s look at what has been the two strongest segments of the economy; autos and housing.  The first company is AutoNation, which is the largest auto dealer in the country.




While it had been holding up in the midst of all the pundits celebrating the strong auto market, things changed this past week as their CEO said sales are slowing, promotions are rising, inventory is bloated and the environment has changed.  The stock is now down around 26% from its recent high.  Next, let’s look at the homebuilders as an indication of the housing market.  Here is an ETF of the largest homebuilders.




After the recent drop, it is down over 20%.  Let’s also take a look at the largest realty company in the U.S.; Realogy.




It has decline by over 30% from its recent high.  Now, let’s look at a few international stock markets.  First, here is the broader emerging markets index.




The emerging markets index has fallen by around 33% recently.  Let’s look at the EAFE index next [Europe, Australia, Far East].




This index has dropped by more than 21% lately.  Canada is next.




Canada’s major index has fallen by 31%.  Now Mexico. 




Mexico’s stock market has dropped by 24% lately.  I could show more, but you probably don’t want to see how bad it is in some of the economic disaster countries such as Brazil.  Remember, Brazil was one of the hottest areas to invest in not long ago as it represented the first letter of the BRIC’s acronym. 


Also, notice I did not include Japan which is still a significant part of the global economy.  Their market is starting to roll over as well, but things are so distorted from all of their monetary policies it is ridiculous.  Bloomberg noted in an article back in October that the Bank of Japan already owns more than half of their country’s market for ETFs.  That is like Janet Yellen and her crew buying up over half the stock index funds here in our country to support stock prices.


The charts above include base metals, railroads, truckers, consumer finance, retail, autos and housing.  Each are in technical bear markets already, which is a decline of 20% or more.  The significant market declines representing various segments of the economy further suggests that the ongoing slowdown is likely developing into the next recession.  The world economy has been slowing, reflected by the international charts above, and the weakness is increasingly coming onto our shores.  Don’t be fooled into believing the “decoupling” myth; that the U.S. economy can decouple from the rest of the world. 




Now, let’s look at trade as another indication of the economy here and around the world.  Here is a chart by ECRI [Economic Cycle Research Institute] showing both U.S. export volume growth and export prices. 




The chart above shows export volume growth and prices and they are on a trajectory similar to the last two recessions; in ’01 and ’08.  ECRI also notes that world export volume growth is at a 34-month low. 




Next, let’s look at business inventories in the economy relative to sales.  Here is a chart by ECRI illustrating this.




The chart above shows how the gap between inventories and sales is growing wider.  As a result, the inventory-to-sales ratio is at the highest level since June 2009.  This is going to add pressure for companies to cut production to get inventories back in line with slowing sales.  It is no wonder the ISM manufacturing index fell further into contraction territory for the second month in a row.  Raoul Pal, from The Global Macro Investor, recently commented that the current level of the ISM manufacturing index suggests that the probabilities of a recession are already at 65%.  Given the latest inventory-to-sales ratio, this ISM reading will likely continue to decline, raising the probability notably higher.


Before I close, let’s take a look at two more items; one is corporate balance sheets and the other is oil inventories.




Let’s look at a chart relating to debt on corporate balance sheets.



The chart above shows the growing leverage on investment grade company balance sheets in the first pane and the related interest coverage [ability for companies to service the debt] in the second pane.  You can see how the leverage is reaching new highs and notably above the level after the last recession in ‘08/’09.  Also, interest coverage is trending back down toward the levels seen after the last recession. 


It is worth noting that after a deep recession like the last one, it would not be unusual for leverage to rise and interest coverage to decline as a result of the sharp drop in economic activity.  That would be due to a deterioration on the asset side of the balance sheet and a decline in cash flows.   On the other hand, if you see this deterioration prior to a deep recession, that is indicative of more obligations on the liability side of the balance sheet and a related increase in servicing those debts from an interest coverage perspective.  A notable increase in leverage on corporate balance sheets and a decline in interest coverage prior to a recession will likely present greater challenges for CFO’s in the period ahead.


As I have discussed many times recently, corporate balance sheets have deteriorated and Goldman Sachs continues to raise red flags regarding this issue.  Excluding the finance sector, they are in worse shape to deal with a recession than they were at the peak in 2007.


Let’s look at this issue from another angle.  In a healthy economy, corporations issue debt to fund new projects.  As those new projects are developed, they generate future cash flows which then provide the means to service the debt that funded the projects.  In the past few years, corporations have found fewer and fewer new projects to fund, as evidenced by muted capital spending.  Instead, many have decided to use the cheap financing enabled by the Fed to issue debt and use the proceeds to buy back stock.  This helps to reduce the number of shares outstanding, and as a result they get a temporary boost to earnings per share.  However, as corporations have levered up their balance sheets, the stock they bought back does not generate any future cash flow to help service the additional debt.  And, they have been buying their stock at elevated valuations.  This focus on short-term stock performance will likely present longer-term challenges.




Next, let’s take a quick look at another topic; oil inventories.  So, in December, we saw a notable decline in oil inventories which has made some analysts more constructive.  The issue is that oil inventories tend to have their biggest monthly declines in December each year for different reasons such as taxes.  Here is a chart which shows average changes in oil inventories for each month of the year.



The chart above shows how oil inventories usually decline in December by the greatest amount in any month of the year but then build in the first five months of the following year.  Also, the recent inventory data for Cushing is showing that storage capacity is getting very full.  While rig counts continue to decline and production has declined some, production needs to be cut more to get the balance of supply and demand back in check.  If the global economy is slipping into a recession, demand is going to decline as well which puts more pressure back on additional production cuts to get supply into balance.  Just recently, credit default swaps are indicating more default risk to Saudi Arabia than Portugal.  As a result of the ongoing supply/demand dynamics and seasonal patterns, oil prices may flush lower in the period ahead and if so, related geo-political tensions will likely rise. 


WILL 2016 RHYME WITH 1937???


Let’s wrap up.  All of the stock charts that I showed above, which reflect various segments of our economy as well as the global economy, add to the evidence that the probabilities of a global recession continue to grow.  Looking at those charts make the declines in the S&P 500 seem very mild, even after the worst first week in a new year since 1930.  It is likely time for the major indices to play a little catch up.


One of the building concerns for the U.S. economy is the growing gap between inventories and sales.  Exports are not helping corporations either as global trade continues to weaken.  Finally, corporate balance sheets are not well prepared to deal with a recession as they have levered up in order to achieve short-term performance metrics through stock buybacks, partly due to pressure from their investors. 


The final point in the discussion above relating to oil prices is important since the general market has been tracking the direction of oil in recent weeks.  If oil prices break into the 20’s in the coming period, it will add further pressure to the overall market.


Now, consider the Fed and their recent decision to raise rates.  I said all last year that they will either not raise rates or if they do, it will subsequently be viewed as a policy mistake.  They should not have ever into entered this black hole of unconventional policies but Bernanke led the global central banks down this path and it is becoming increasingly difficult for them to get out of it.  You are going to hear more and more about the implications of a “policy mistake” similar to 1937 as this year progresses, especially if the global economy is entering a recession.  The Atlanta Fed GDPNow model, which incorporates the latest economic data is suggesting that 4th quarter GDP has decelerated down to 0.8% growth here in the U.S. 


We led the Europeans down the path of printing money and I think they are going to lead us and Canada down the path of negative rates.  Remember, this is about what the Fed will likely do and not about what they should do.  I think Janet Yellen and her team will likely realize that they raised rates just ahead of a recession and they will reverse course.  However, they will not stop at the zero bound this time but go negative and start printing again, as that is what the Europeans are doing as we speak.  Who knows, maybe both the Europeans and the U.S. will join Japan’s central bank and start buying stocks too.  If our stocks start dropping like they did in 2008, you can bet on it.  It’s as if one central banker comes up with an idea and all the others eventually follow.  Goldman Sachs notes that the Chinese government bought at least CNY1.8 trillion of equities in the second half of last year. 


The global central banks are pursuing unconventional policies into the abyss.  We will all be surprised just how far they go and it will continue until everyone realizes this grand experiment failed.  Remember, monetary policy is being set by just a roomful of academics.  In July of 2007, when many signs were flashing warning signals of the upcoming crisis, here was Bernanke’s and the Fed’s forecast: “Overall, the U.S. economy seems likely to expand at a moderate pace over the second half of 2007, with growth then strengthening a bit in 2008 to a rate close to the economy’s underlying trend.”  This is very similar to Janet Yellen’s and the Fed’s forecast now.



Joseph R. Gregory, Jr.





 Past results are not indicative of future results.  Joseph Gregory is President of Heritage Capital Partners, Inc., a registered investment advisor.  All materials presented herein are believed to be reliable but we cannot attest to its accuracy.  All material represents the opinions of Joseph Gregory.  Investment opinions or recommendations may change and readers are urged to check with their financial advisor before making any investment decisions.  Opinions expressed in these commentaries may change without prior notice.  Joseph Gregory and/or clients of Heritage Capital Partners, Inc. may or may not have investment positions that are in or aligned with any opinions mentioned in these commentaries.  There is risk of loss as well as opportunity for gain when investing in the financial markets.  Investment opinions or positions mentioned in these commentaries are not suitable for all readers and therefore, readers are urged once again to check with their financial advisors before making any investment decisions.