December 8, 2015


Last month, I discussed how risk was rising instead of declining even though the markets had a nice bounce off the August lows.  Risk continues to rise as probabilities are increasing that this global slowdown may develop into a global recession.  As recession probabilities are rising, the Federal Reserve is on track to raise rates next week for the first time in over nine years.  As usual, they are focused on lagging indicators such as the recent employment report instead of leading indicators. 


I believe the Fed should not have gone down this path of zero rates and money printing but this is about dealing with what the Fed is likely to do instead of what they should do.  Also, I continue to think that either they will not raise rates next week or if they do, the market will view it as a policy mistake afterward and they will ultimately reverse course, as we are likely headed toward negative rates and more money printing sometime in the New Year.  Right now, it looks more like the second scenario and that they will raise rates.  We may hear a lot about the year 1937 next year from the pundits on CNBC.


First, let’s take a look at the average time between recessions in the chart below.




If you look at the chart above, draw a line across at the six year mark and you can see that it is about the average time.  The last recession ended in 2009 which happens to be a little over six years.  So, that suggests just from a time perspective that it would not be unusual to see another one in the near future.


If we just look at some of the latest data on the manufacturing sector and the service sector, we see growing weakness.  The ISM manufacturing index just reported a drop down to 48.6% with new orders and production contracting.  A 50% reading is the break line between growth and contraction.  It was a surprise to the market that it dropped that low from a reading of 50.1% the prior month.  The ISM services index also came in weaker than what was expected.  It was 55.9% which still indicates expansion but it dropped from 59.1% the prior month.  Usually the manufacturing sector leads the service sector regarding turning points in the economy.




Next, let’s look at the yield curve or the spread between two-year Treasury yields and ten-year Treasury yields.  Often the yield curve flattens or inverts as the economy slows or enters a recession.  Here is the latest view of this spread.




You can see that just in the last two months, the spread has taken a notable decline.  The short-term rates have been rising as investors believe the Fed is going to raise rates next week while the longer-term rates are not moving up as they typically reflect more of a view on the economy.




Last month, I showed how profit margins were rolling over from an all-time high.  In that chart it highlighted that the only time profit margins declined by 60 basis points or more without the economy either in or just prior to a recession was in 1985.  This occurred around all six recessions since the early 1970’s and now they have rolled over by more than the 60 basis points. 


Next, let’s look at a forecast by J.P. Morgan of corporate profits relative to GDP.  In the chart below, the blue line represents their forecast of corporate profits as a percent of GDP based on comparing wages in the U.S. to GDP.  The black line is actual corporate profits as a percent GDP. 




If you look at the chart above, the blue line [forecast line] tends to lead the black line [actual corporate profits/GDP] both on the way up and the way down.  You can see how both turned down ahead of the recession in ‘01/’02 and ‘07/’09.  Recently, the forecast line has turned down sharply and suggests that corporate profits will follow.  This would also indicate rising recession risk.


To illustrate in another view what is happening with corporate profits, here is chart which shows year-over-year profits for both large and small companies.




The chart above shows profits for the S&P 500 [large companies] in yellow and for the Russell 2000 [small companies] in blue.  If you look back to the recession beginning in ’01 and the one beginning in ’07, you see corporate profits decisively roll over into negative territory.  It is just the past two reporting periods where profits are rolling over into negative territory now.




I recently highlighted how Goldman Sachs has been discussing the deterioration in corporate balance sheets.  Let’s look at the two charts below to see an emerging trend.



In both charts above, the light blue line represents companies in the high yield space [ex. utilities/energy] which have higher credit risk.  The darker blue line reflects companies in the investment grade category with lower credit risk.  The first chart shows the median debt-to-EBITDA [cash flow].  It indicates how companies have been leveraging up relative to their available cash flow.  The second chart shows total EBITDA [cash flow] and you can see how it is rolling over.  Also, in the second chart, look how the investment grade companies’ cash flow turned down in the last recession during ‘08/’09 and we are currently seeing the largest drop since then.


I have discussed how capital spending has been very muted during this recovery and companies have been issuing debt to fund buybacks.  Let’s look at the chart below to illustrate this trend.




In the chart above, you can see how since the last recession, companies have been increasing their buybacks which is reflected in the green bars.  Also, the amount companies are reinvesting for growth is indicated by the black line.  This shows that companies are finding little opportunity for investing in future growth so they are buying back stock to inflate earnings per share.  This will likely become an issue as their debts are rising, cash flow rolling over and they have been buying back stock instead of investing in projects that generate future cash flow to service the rising debt.


Along these lines, let’s take a look at the corporate financing gap.  This measures the difference between cash flow coming in and the cash flow needed to support the outflow which is spent on dividends, buybacks and capital spending.  The chart below shows the financing gap with the black line and previous recessions in the shaded blue areas.




You can see in the chart above how the financing gap rolled over notably before the ‘01’02 recession and again before the last recession.  Now, once again, we see the corporate financing gap take a sharp decline recently and it suggests a rising risk of recession.




Next, let’s see what is happening with high yield bond spreads.  These reflect companies that have higher credit risk and they are helpful to watch since they typically come under pressure ahead of economic slowdowns or recessions.  As economic growth slows, the cash flows of companies also slow down or decline and those companies that have higher levels of debt face increasing challenges in servicing their debt.  As the market begins to price in increased default risk, yields on the bonds of those companies increase as investors require higher returns for buying or holding the bonds. 


High yield spreads often lead both the economy and stock prices.  So, here is a chart of high yield spreads compared to stock prices.  Since the energy sector is under unusual pressure now, this chart excludes the energy sector so it does not artificially skew what is going on in the overall high yield market.  In the chart, the high yield spread is inverted so when the blue line in the chart turns down, high yield spreads are rising.  Stock prices are indicated by the black line.




You can see in the chart above how there is a growing gap between stock prices and high yield spreads.  We saw a similar divergence early on before the recession that began in November of ’07 and the related decline in stocks.




Before I close, let’s look at one last interesting development with global foreign exchange reserves.  Foreign exchange reserves reflect the amount of reserve currencies [primarily the dollar] held by global central banks.  As capital flows freely into areas of growth around the world it usually is associated with expanding global GDP and rising global stock prices.  And, when capital flees prior growth areas and reverts back to safe havens like the U.S. it is often associated with slowing global economic growth and declining global stock prices.  Just this past month, China posted its third-largest decline on record in their foreign exchange reserves.  We are seeing this in many other emerging market countries. 


Now, let’s take a look at the chart below which shows global foreign exchange reserves with the dark blue line in both graphs.  In the first graph, the grey line is the year-over-year change in global stock prices and in the second graph, the grey line is the year-over-year change in global net GDP. 



In the chart above, you can see that the last time we saw a very sharp drop in global FX reserves in ’08, it was associated with a sharp drop both in stock prices and global GDP.  Now, if you look at the end of both charts, you see another sharp drop in global FX reserves.  The growing divergence in both charts highlights another sign of growing risk for both global stock prices and global GDP.




Let’s wrap up for this month.  Risk has been growing for stock prices as this year has progressed.  Now, we add in increasing risk that the global slowdown in economic growth may develop into the next global recession.  We haven’t had one in over six years so it would not be unusual from a time standpoint.  The various charts above as well as others I have shown recently view this risk from a variety of angles as we don’t want to rely on any one measure. 


What is especially interesting is that our central bank is highly likely to raise rates next week and they are basing their decisions on mostly lagging indicators such as the latest employment report.  If we look around the world at the other central banks, they continue to ease more.  The ECB just expanded their money printing by around six months so they are going to keep printing at least until March of 2017.  Draghi basically said QE is here to stay.  Not only did they expand the time of printing, but they also cut the deposit rate further into negative territory and said that they were going to widen the available securities they would buy with the printed money into regional and local government bonds. 


In addition to Europe, Canada’s central bank announced today that the effective lower bound for monetary policy in their country is -0.5%; that Canadian financial markets could function in a negative rate environment; and that they are ready to act.  It is a timely announcement as their economy looks to be headed into a recession.  By the way, remember, a few weeks ago both Yellen and Dudley [the two most influential members of our central bank] squarely put negative rates on the table for acceptable policy here in the U.S. as they have “studied” the effects in Europe and view that the benefits outweigh any side effects. 


The key North American central banks are signaling that negative rates may be crossing the ocean and coming onto our shores and Canada may be the first to strike.  As a side note, expect China to devalue their currency in the near-future as a monetary easing; David Tepper and other prominent macro investors expect up to a 30% devaluation.


Also, remember the discussion on the long-term and short-term debt cycles two months ago in my commentary.  The last peak in the short-term debt cycle was in 2007.  The average time to the next peak is around 7 to 8 years and it has been 8 years since the last peak.  If the short-term debt cycle reconnects with the long-term debt cycle on the way down amidst another global recession, significant turmoil in the financial markets will reappear. 


Back in late’07, central banks around the world had not printed any money except Japan and the Fed Funds rate was over 5%.  Essentially, the global central banks had lots of ammunition to fight a sharp global recession and stress in the financial system.  Now, we are sitting at the zero bound with over $12 trillion of money printed around the world by central banks and the efficacy of incremental monetary policy has been shown to have less of an impact. 


All of the extreme monetary policies have created significant asset price inflation which is disconnected to the reality of the underlying fundamentals.  A global recession and reconvergence of the debt cycles would act as a catalyst for prices to reconnect with fundamentals especially as the fundamentals deteriorate. 


I have highlighted the saying before, “It takes long for things to happen than you thought they would, but when they happen, they happen faster than you thought they could.”  Just think back to late 2007 and if I told you General Motors, Wachovia, AIG, Lehman Brothers, and other companies would either go bankrupt or would be bailed out by the government, you would have thought I had lost my mind.  At the time, these companies were showing little to no signs of stress at all and would have been in the investment grade category of companies.  Then, in less than a year it all happened.


We are living in a time where debt is saturated all over the globe and the long-term debt cycle has likely turned.  In a time of a deleveraging, things tend to happen that seem out of the realm of possibilities.  Just think of all the financial events, economic dynamics and extreme monetary policies since 2007.  Be mindful of the long-term macro picture and alert to the recent developments that are emerging as rising risks can be reflected in prices quicker than you think.



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.