Portfolio Strategies

As Good as It Gets

Advocacy Investing® Portfolio Strategies, Issue 110
Wednesday, December 19, 2018 10:00 am
by Dr. Karim Pakravan

  • No changes in the second estimate of third quarter GDP growth
  • Data releases show a relatively strong start for fourth quarter GDP, but growth seems to have peaked
  • Oil market rout has led to a crash in oil prices
  • November payrolls come in below market expectations; labor earnings gains cool down
  • A more dovish Fed has cast doubts about the pace of monetary tightening
  • The yield curve is close to inverting as 10-year yields fall under 3%
  • The global economy showing signs of strain as major players see growth tapering
  • The U.S. economy remains the leader of the pack, but growth may have peaked
  • Trade tensions, rising domestic political risks and Middle East turmoil dominate global risk factors
  • Sharp equity markets corrections raise fears of a market rout—do markets know something we don’t?

Third quarter (Q318) GDP growth numbers (Second estimate) were unchanged at 3.5% (all numbers annualized). Final Sales to Domestic Purchasers (which exclude Exports and Inventory Changes) rose by 3.1%. Private Consumption Expenditures (PCE), Government, Business Inventory and Non-Residential Investment made positive contributions to growth, while Residential Investments and Net Exports provided a drag. However, the data showed a change in composition of growth from the first estimate. PCE and Non-Residential Investment growth were revised downward, while Business Inventory Investment was revised upward. At the same time, the drag from Net Exports and Residential Investment was reduced. Furthermore, the combined impact of Net Exports and Business Inventory Investment (the two items with the greatest swing between 2Q18 and 3Q18) was reduced from 0.5% to 0.36% of total growth.

Figure 1: Composition of Growth


Recent data releases show a relatively strong start for 4Q18. Industrial Production and Manufacturing increased be respectively 0.1% and 0.3% month-on month (m/m) in October. Durable Goods declined by 0.8% m/m—Durable Goods, ex-Transportation rose by 0.1% and Core Capital Goods were flat. Factory orders fell by 2.1% m/m in October. Mid-November surveys were mixed, with the Empire State index of manufacturing rising to 23.3 from 21.1 in the previous month, while the Philadelphia Fed measure fell from 22.2 to 12.9 over the same period. End-November surveys were stronger. The ISM-Manufacturing rose to 59.3 from 57.7 the previous month, the Markit PMI Manufacturing fell slightly from 55.7 to 55.3 over the same period, and the broader Chicago PMI surged in the month from 58.4 to 66.0. Services remained robust, with the ISM-NonManufacturing rising to 60.7 at the end of November from 60.3 the previous month, and the Markit PMI Services essentially flat at 54.8 over the period.

Figure 2: Business Conditions


Exports (Goods and Services) fell by 0.1% m/m in October, while Imports rose by 0.2%, leading to a widening of the trade deficit to $55.5 billion from $54.6 the previous month. The dollar Index (DXY) was basically unchanged in November—having gained almost 10% from its 2018 low in mid-February.

While consumer confidence slackened, household income and spending remained robust. Retail Sales rose by 0.8% (m/m) in October—and by 0.3% ex-Food and Energy. Personal Income and PCE increased by respectively 0.5% and 0.6% m/m. The Conference Board index of consumer confidence fell to 135.7 at the end of November from 137.5 at the end of the previous month, while the University of Michigan-Reuters measure declined from 98.3 to 97.5 over the same period.

Figure 3: Households


The housing market was mixed. Housing Starts and Existing Home Sales rose slightly in October, while New Home Sales declined. Construction Spending fell by 0.1% m/m in October, and the Case-Shiller 20-City index of housing prices rose by 5.3% year-on-year (y/y) in September.

Figure 4: Oil Prices Rout


Oil Markets Crash: The rout in oil markets continued in November, the markets’ worst month in 10 years. Oil prices fell, West Texas Intermediate (WTI) down by 23%—to their lowest level in 13 months—and lower by a third from their three year high in late-September. 

In the past few months, oil markets have moved from balanced to oversupply, which sent oil prices (Brent) crashing by one-third from a high of $86/barrel (bbl) at the beginning of October to under $60/bbl at the end of November. Oil prices are now deep in bear territory, with the current Brent price below its 50-, 100- and 200- days moving average. In the run-up to the imposition of U.S. sanctions on Iranian oil exports, the Trump administration stated that it wanted to drive Iran’s exports to zero. In response, OPEC, led by the Saudis, ramped up production by 1.5 million barrels per day (mbd) between its May 2018 low point and an October high of 33.3 mbd. Saudi Arabia contributed to half of that increase, bringing its output to 10.6 mbd in October, from a 2018 low of 9.86 mbd in March. Furthermore, while OPEC cut back its output slightly in November, Saudi Arabia continued to pump more oil, averaging 11.3 mbd in the month. Meanwhile, Iran’s oil output fell by 0.5 mbd, to 2.85 mbd. Furthermore, U.S. oil production continues to climb, reaching another record level of 11.475 mbd in September, a 21% y/y increase. We should also note that the U.S. became a net oil exporter at the end of November.

While a softening of demand (in particular from China) has been a factor in the price rout, geo-political issues have overcome market fundamentals in driving market supply/demand. These issues are as follows:

  • In response to concerns over soaring oil prices and pressures from key allies, the Trump administration extended 90-day waivers to eight countries who import Iranian oil, in effect allowing Iran to continue its oil exports, albeit at a reduced rate. This move, which caught other OPEC members by surprise, also infuriated the Saudis.
  • The killing of Adnan Khashoggi, a dissident Saudi journalist, created a deep wedge between the United States and Saudi Arabia. The U.S. intelligence agencies believe that the brutal killing of Khashoggi was most likely ordered by the Saudi Crown Prince, Mohammad ben Salman (aka MbS) himself. While President Trump has chosen to give MbS a pass, the issue is not going away, as Congress is taking an increasing hard line on MbS and U.S.-Saudi relations. In response, the Saudis have sharply increased oil production (call it the Khashoggi effect) in an apparent effort to mollify the United States.
  • Despite efforts by the Trump administration to bury the Khashoggi affair, we are likely to see a bi-partisan effort on Capitol Hill to impose severe sanctions. Such an outcome would change the Saudi equation on oil and probably lead to cutbacks in Saudi oil shipments, and ultimately higher prices.

Russia is also an important player. In the past two years, Russia (alongside 10 other non-OPEC oil producers) has coordinated output cuts with OPEC. In recent months, however, it also ramped up production, and has been hit by the fall in oil prices. Broadly speaking, Russia and the Saudis agree on a (Brent) price floor of $60/bbl, with the Saudis preferring $70-80 dollars. At the same time, OPEC is under pressure from the Trump administration to keep oil prices low.

At their December 6th meeting, OPEC ministers unexpectedly agreed to output cuts of 1.2 mbd. Major non-OPEC producers are also expected to follow suit in curtailing output, with Russia agreeing to a 0.40 mbd reduction. In response, oil prices recovered somewhat from their lows (of almost $50/bbl for WTI) to almost $54/bbl before falling back to around $51. The output cuts are expected to start next January. These moves should keep oil prices in the mid-50s in 1H19, but oil markets are expected to face weaker oil demand in 2019, reflecting slowing global growth, as well as rising U.S. production. At the same time, geopolitical factors are expected to continue to keep the markets on a knife edge. Two questions in this regard. First, will the U.S. renew the Iran oil export waivers, and second, how will stresses in U.S.-Saudi relations impact oil markets?

Figure 5: Payrolls


Payrolls Back to Trend? The November payrolls printed at 155,000 new jobs (161,000 for the private sector), significantly below both the October number and market expectations. The previous two months’ number was also revised downward by 12,000, which brought the three-month moving average down to 170,000—compared to an average of 211,000 for the first ten months of the year. While some of the slowdown can be attributed to the unseasonal cold weather, the trend reflects in part an economy getting off its super-charged mid-year performance. The Goods sector added 29,000 jobs (Mining, minus 3,000; Construction, 5,000; and Manufacturing, 27,000). Private Services generated 132,000 positions and Government employed 6,000 fewer people. Average weekly hours worked fell to 34.4 from 34.5 in the previous month, and average hourly earnings increased by a more modest 0.2% m/m (3.1% y/y). The separate Household Survey showed unemployment (U3) stable at 3.7%, and unemployment and underemployment (U6) up to 7.6% from 7.4% in October, its first increase in the past fourteen months. The Labor Participation rate remained constant at 62.9%. High frequency data showed an uptick in Initial Weekly Jobless Claims to 231,000 at the end of November (with the average for November at 227,000), up from a 211,000 average for the previous 16 weeks. While job gains continue to be solid, it is likely that the November slowdown reflects an economy that is returning to trend growth. Furthermore, labor earnings growth remains disappointingly slow.

Figure 6: Inflation Slackens


Inflation has continued to run out of steam after an earlier mini-surge. Headline inflation (CPI) ran at 2.5% y/y in October—Core inflation slowed to 2.1% y/y form 2.3% the previous month. The PCE Deflator Core (the Fed’s preferred measure) fell further below the Fed’s target inflation rate of 2%, slowing to 1.8% y/y in October from 1.9% the previous month.

A Change of Heart? The next Federal Open Market Committee (FOMC) meeting is set for December 18th-19th, and it is expected that the FOMC will raise the benchmark Fed Funds rate for the fourth time in 2018 to 2.50-2.75%. However, Fed Chair Jay Powell and other Fed officials have managed to create a degree of uncertainty about the future path of interest rates. Powell’s most recent dovish comments about the current interest rates being close to their neural level represents a departure for his previous stance about the need for several rate hikes. Moreover, Powell’s comments and statements by other Fed officials seem to indicate that the Fed is optimistic on the U.S. medium-term economic fundamentals. At the same time, the Fed officials have stressed that their decision-making is not dogmatic, but data driven, and will be based on a careful study of the major developments in both the U.S. and the global economy, as well as financial conditions. Inflation has softened and labor costs are contained, and the present Fed path of monetary tightening is consistent with trend growth. Finally, while we don’t believe that there will be a “Powell put,” the Fed is likely to look at conditions in the financial markets and react appropriately. All in all, with these points in mind, one more rate increase is highly likely in 2019, with up to three possible. The only wild card would be an equity market downward spiral, which could force the Fed to review its tightening path.

Bond yields have collapsed in recent weeks. The 10-year U.S bond yield fell from a high of 3.24% on November 8th to 2.98% on December 3rd, falling under 2.90% by the end of the first week of December. Furthermore, the yield curve is flattening further; the 2-10 year Treasury note spread was down to 0.001% (10 bp) at the beginning of December and is close to inverting. This inversion is one more sign of the growing economic pessimism surrounding concerns regarding 2019 (slowdown) and 2020 (possible recession).

Figure 7: Yield Curve Close to Inverting?


Global Economic Picture: There are clear signs that the global economy is slowing; Both Japan and Germany experienced an unexpected decline in output in 3Q18. The Markit Global Manufacturing fell to 52.0 at the end of November from 52.2 the previous month. The Chinese economy is slowing further—the Caixin PMI-Manufacturing dropped to almost 50 at the end of November, the level separating expansion from contraction.

Table 1: OECD Growth Forecasts


The Organization for Economic Cooperation and Development (OECD) has presented a somewhat mixed picture in its latest economic forecast. According to the OECD, global growth remains strong, but has peaked, and is expected to slow over the next two years. (Note that the OECD, like the IMF, rarely projects recessions, while many business economists expect a recession by 2020). Moreover, global economic prospects face escalating risks from tighter financial conditions, as well as worsening trade disputes between the United States and its main trading partners. Trade and investment have slowed, and higher U.S. interest rates and a strong dollar have accelerated capital outflows from emerging markets. Furthermore, a long period of low interest rates and sharply higher sovereign debt will constrain the margin to maneuver for governments in the event of a sharper deterioration of global economic conditions.

Peak Growth: The current economic cycle is eight months short of the post-war record. U.S. economy enters 4Q18 in a relatively strong position, outperforming the other major economies. But there are signs that growth has peaked. Household spending is robust, but business spending is flat. The housing market is in a relative slump, and the Fed tightening is beginning to have an impact on economic activity. Moreover, the benefits of the mid-2018 economic surge are not evenly distributed, with labor compensation growing modestly despite record low unemployment. From a purely national accounting point of view, the relative trends in volatile business inventories investment and net exports will continue to play an important role in the actual 4Q18 outcome. Overall, 4Q18 growth should be driven by PCE, with trade and inventory adjustments providing a drag, leading to an expected 2.0-2.5% growth. The economic picture for 1H19 is murkier. Firstly, the 2018 stimulus will have faded by 4Q18. Second, the impact of trade tensions and a slowing global economy will begin to affect the U.S. growth prospects. Third, the yield curve could invert, always a concerning signal. Finally, the turmoil in the equity markets could spill into the real economy. At best, we should return to trend growth of 2.0-2.5%, with significant downside risks.

Yield Curve Inversion and the Heisenberg Principle of Uncertainty

The Heisenberg uncertainty principle or indeterminacy principle, statement, articulated (1927) by the German physicist Werner Heisenberg, that the position and the velocity of an object cannot both be measured exactly, at the same time, even in theory.  The same applied to the yield curve inversion. While the yield curve inversion has generally preceded recessions, we cannot use it to predict the timing of such a recession. For example:

  • Yield curve inverted in March 1973; recession began 297 days later.
  • Yield curve inverted in August 1978; recession began 560 days later.
  • Yield curve inverted in September 1980; recession began 350 days later.
  • Yield curve inverted in February 1989; recession began 564 days later.
  • Yield curve inverted in August 2000; recession began 272 days later.
  • Yield curve inverted in December 2005; recession began 765 days later.


Main Risk Factors:

Trade: Trade wars seem to be on hold for the time being, with the signing of the USMCA trade deal (NAFTA-plus) and the recent Trump-Xi summit. However, the issues are far from being resolved.  First, Congress has to approve the USMCA trade deal against the likely opposition of House Democrats and hardline conservative Republicans. Second, the Trump-Xi summit only postponed for 90-days another round of tit-for-tat tariffs. The mixed signals coming from President Trump and the White House have only added to the confusion. While the U.S. and China might start negotiating in earnest, there is no guarantee of success.

Political Risks: Political risks are rising, with the Democrats taking over the House and the Mueller investigation apparently nearing its end. These developments are only going to add to the political and policy chaos that has characterized the current administration.

Europe: The Brexit debate is coming to a head in England, with Prime Minister Theresa May’s exit plan foundering. At the same time, the violent and widespread “Yellow Vests” protests in France have taken the French political establishment by surprise and threaten to undermine President Macron.

Middle East: The U.S. policy in the Middle East is in shambles. U.S.-Saudi relations are on a knife edge, and Congressional sanctions on Saud Arabia could cause a further estrangement between the two countries. Furthermore, the Saudi-UAE intervention in Yemen is becoming increasing problematic, driving a further wedge between the Saudi government and their Western allies. While U.S. sanctions on Iran do not seem to have the expected impact, Iran has gained from the U.S. Saudi tensions. Meanwhile, Qatar has distanced itself further from the Saudi-UAE axis by quitting OPEC. With pressures building, we can expect further turmoil in the region.

Figure 8: Bears Prevail


Whiplash: The equity markets suffered one of their worst months since the 2009 recession in November. The S&P500 lost over 10% between its all-time peak of 2,930 on September 20th and it’s one-year low of 2,632 on November 23rd—technically a correction. Currently, the market index is below its 50-days and 200-days moving averages, a clearly bearish signal. The markets recovered in the last two weeks of November in response to a dovish message by the Fed Chair Powell. The markets got another boost after the G-20 Trump-Xi summit, only to be reverse themselves when it became clear that talks of a U.S.-China trade breakthrough were greatly exaggerated—the S&P500 fell by 4.7% over a two-day period to 2,695 on December 6th. Since the market peak on September 20th, the cyclical sectors have all registered sharp losses, while most defensive sectors have shown gains. The November payrolls number provided some relief; nevertheless, the S&P500 lost 3% in the first week of December, and the bloodletting continued in the second week of the month.

Figure 9: S&P500 Sub Indices


While the focus has been on the short-term gyrations of the markets, it is important to look at the fundamentals. We are seeing a convergence of late-cycle forces amplified by political and geo-political risks. First, estimates of earnings growth for 2019 have been trimmed. Businesses are dealing with rising labor and materials costs, the latter inflated by the Trump tariffs on steel and aluminum. Second, falling oil prices will impact the energy sector’s profits. Third, the bond markets are sending negative signals on growth, while the Fed is still on course for at least two rate increases in the next few months. Fourth, the looming trade confrontation between the United States and China and the plethora of political risks across Europe and the Middle East have added to bearish market pressures. Finally, the darkening political picture in Washington promises a deepening of the prevailing policy chaos. As we get closer to a second market correction, the danger is that the market turmoil turns into a rout as bears prevail over the next few weeks. The real question is however, whether or not the markets know something we don’t.

November Data Releases

Send this page to a friend

Dr. Pakravan has been a senior economic strategist in global financial markets for 25 years.  Dr. Pakravan is a recognized specialist in leading-edge applied macroeconomic and financial research on currencies and emerging markets, country risk assessment and modeling in an enterprise-wide risk management context, as well as international financial architecture.   Dr. Pakravan has a Ph.D. in Economics, University of Chicago, a M.Sc. in Econometrics and Mathematical Economies, London School of Economics, and a B.A. in Mathematical Economics, University of Geneva. He is the author of numerous publications and is an Associate Professor of Finance at the Kellstadt Graduate School of Management at DePaul University.

The Advocacy Investing® Portfolio Strategies newsletter is a publication of Marc J. Lane Investment Management, Inc. We attempt to highlight and discuss areas of general interest that may be useful for anyone interested in the dynamics of our economy and our markets. Nothing contained in Advocacy Investing® Portfolio Strategies should be construed as investment advice or a market recommendation. Consultation with a financial professional is recommended before implementing any of the ideas discussed herein. Copyright © 2018 Marc J. Lane Investment Management, Inc.

Announcing Marc J. Lane's 35th Book:

The Mission-Driven Venture: Business Solutions to the World's Most Vexing Social Problems

More About The Book