U.S. markets have been on a tear for the majority of the last ten years. Reaching all-time high after all-time high, many are wondering if the winning streak will continue, while others are pointing to certain signs that may suggest caution. The majority of those who are optimistic about continued growth cite the Federal Reserve’s accommodative policy in regards to liquidity and interest rates, as well as low employment. Views are often mixed, however, when it comes to definitively choosing whether loose monetary policy is a net positive or negative, and some suggest that rock-bottom unemployment means the metric could see an uptick according to the fluctuations of the past. For those that have a less optimistic outlook – or more accurately, feel that caution may be warranted moving forward in the market – a few points are often referenced that may justify a closer look.
It’s no secret that the U.S. debt is also at an all-time high. Reaching a record $22 trillion, each time the government runs a deficit the federal debt becomes greater. 2019 saw the 12-month deficit reach over one trillion for two months in a row, with federal spending rising seven percent from the previous year. The increasing debt depends on buyers for that debt in order to finance it and keep it churning. Meanwhile, foreign buyers – the largest purchasers in the past – have been reducing their acquisitions as well as their holdings. The 2019 year-to-date selling of U.S. treasury bonds by other countries stood at almost a trillion in October, with the Chinese and Japanese – both big buyers of U.S. bonds earlier in the decade – as the largest liquidators of U.S. holdings. Because of weakening foreign demand, the federal deficit is being increasingly funded and held domestically. In addition, the debt has another caveat – interest rates. Low interest rates likewise disincentivize buyers to hold U.S. debt; meanwhile, higher interest rates make the already massive debt more expensive to issue. In a time of trying to exit the era of record-low interest rates following the Great Recession, the ballooning federal debt is just one other factor making normalization challenging.
Another sign of caution being highlighted is the sudden and now-regular injections of liquidity the Federal Reserve has been pumping into the market as of late. While the Fed argues that the operations are to simply “ensure that the supply of reserves remains ample,” for others the similarity to programs like quantitative easing is too distinct. Quantitative easing, or QE, was put in place after the financial crisis, and involved pouring billions of dollars a month into the market in an indirect effort to shore up the broader economy. First implemented in late 2008, QE1 was followed by QE2 alongside a rapidly rising stock market. When the Federal Reserve threatened to pull the plug in 2013, markets collectively threw what is now known as the “Taper Tantrum” in reaction to the thought of its easy money being pulled, prompting a large and sudden sell-off that was then conveniently followed by QE3. Finally, in 2018, the Federal Reserve began painstakingly shrinking its balance sheet in an effort to normalize monetary policy. But less than two years in, the Fed started buying assets again. Beginning in September of 2019 amidst sudden shakiness in the repo market (the overnight funding source for institutions), the Federal Reserve has been regularly injecting billions of dollars once again into markets. Rebuffing labels of “QE4,” the reasoning behind the sudden nightly liquidity support is still largely a mystery, with many speculative theories abounding.
Recession-watchers often track what is called the “yield curve.” Under normal market conditions, long-term treasury bonds carry a higher interest rate than short-term ones. This is because holding the bonds for longer naturally assumes more risk over time, and the yield curve basically depicts this trend of shorter-term bonds having lower rates, and longer-term bonds holding higher rates. Thus the “yield curve” generally curves upward. When the curve inverts, it means the opposite – short-term bonds are paying more than long-term, which usually signals something is awry. Suggesting that investors see higher levels of risk in the short term, the other reason market observers look for an inverted yield curve is because recessions are generally preceded by one. The previous three recessions were all preempted by an inverted curve – in 1990, 2001, and 2008. What’s odd about inverted curves, however, is that they often right themselves months before recession actually arrives. In every recession since 1990, yield-curve inversion occurred about eight to 13 months prior to the start of the downturn. 2019’s yield curve inverted first in March, and sustained its inversion from May through October. So while some cite the normalized curve as a sign that everything is back to rights, others aren’t so sure.
U.S. manufacturing has seen a slowing over the last six months. On a contraction streak according to Institute for Supply Management data, concerns are that a slowing manufacturing sector may create a drag on the rest of the U.S. economy. And while unwelcome manufacturing data doesn’t have to necessitate a continuance of the trend, a large part of the rest of the globe has been experiencing contraction for a while already. With pundits describing the Eurozone as “stalled” and “stagnant,” economies in India and other countries are also slowing. China, meanwhile, has recorded its lowest growth rate in 30 years as of 2019. In an increasingly globalized world, the health of trading partners matters more than ever. 43 percent of the revenues from S&P 500 companies come from overseas, creating the potential for current forecasts of significant yearly increases in corporate profits to be overly optimistic. Labeled a “synchronized slowdown” by the International Monetary Fund, the IMF downgraded growth in 2019 to just three percent – the lowest rate since the financial crisis.
Despite the signs that may be flashing caution, some market participants still see reasons to be optimistic due to the Federal Reserve’s new apparent willingness to support markets by what many deem as any means necessary. Barring any unexpected shocks, the adage of “markets can stay irrational longer than you can stay solvent” has even been replaced in some circles as “the Fed can print money longer than you can stay solvent,” suggesting a certain new immunity to organic fundamentals. Yet despite being in the midst of what is rather an unprecedented monetary experiment, a range of catalysts still ultimately determine market outcomes, and staying abreast of market conditions is vital for investors.