November 27, 2018

For the past few weeks, I and an assortment of other market commentators have been carefully dissecting if and when the market will have effectively priced in the many negative scenarios that prompted what is now a two-month correction. The S&P has shed over 10% and the Nasdaq has fallen 14.6%. If it weren’t for the healthcare, utilities, consumer staples, and specialty REIT sectors, the declines would be considerably worse. For growth stock investors, the losses have been particularly painful.

Taking into account the market’s full-blown retest of the October lows, some of the headwinds that investors cited in late September have certainly abated. Rising inflation has tapered with the softening of home prices, the softening of many commodities, and the crushing sell-off in global crude prices. WTI crude closed at $50.42 per barrel – a 13-month low that kicked the stool out from under the oil sector despite the bullish trend in natural gas that has emerged in the past six weeks.

It seems logical that investors and the Fed can put the threat of meaningful inflation risk aside for now. But that is not quite how the bond market sees it. As of November 24, according to the CME FedWatch Tool, rate hike expectations have declined a bit, but are not nearly at a level that would suggest the Fed won’t go ahead and raise the fed funds rate a quarter point to 2.25%-2.50% on December 19.

The fed funds futures market still sees a strong chance (74.1%) that the FOMC will increase the fed funds target range in December, but the implied probability of another hike in March has decreased to 37.7% from last week’s 51.9%. So, unless economic data deteriorates further in the next two weeks, it appears as if the Fed will indeed raise rates and offer a wait-and-see dovish statement in their policy statement. That’s what the bond market is telegraphing and if the Fed elects not to raise rates, stocks will react in a bullish manner that could help repair a lot of damage.

We just don’t know if Fed Chairman Jerome Powell and the rest of the voting members of the Fed are as concerned with the market’s recent drop as the majority of those invested in it. Recent statements from Powell and other Fed officials haven’t given any clear indications that they are considering a pass on a rate hike in December. Regardless, hopes are rising that the Fed will eye the recent rally in bond prices and the steep fall in stock prices and take the “wait and see” path next month instead of next year.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

If recent economic data showing slower GDP growth on the horizon isn’t enough hard evidence for the Fed to stand down, then a quick view of what’s occurring in the corporate bond market would surely cause some thought-provoking debate. The spread on the Merrill Lynch Corporate “A” Rated Minus 10-year Treasury has widened by 20 basis points in the past three months while the spread on the Merrill Lynch High Yield Minus 10-year Treasury has ballooned by 60 basis points to its widest level in a year.

I wrote back in early October how well these spreads were holding up in light of external events outside the U.S. markets, which were wreaking havoc on foreign currencies and emerging market debt held by the likes of Italy’s largest banks. Well, that situation has changed, and not for the better. Both the U.S. investment grade and high-yield debt markets are sending a clear message that future higher interest rates will undermine the level of creditworthiness and strength of America’s corporate balance sheets.

What’s Up with Corporate Debt Spreads?

According to S&P Global, the debt load for America’s corporations is at a record $6.3 trillion. And while that number may sound alarming, corporations are sitting on over $2.1 trillion in cash to service that debt, not including future free cash flow. However, the majority of that $2.1 trillion is held by a few giant companies, while the riskiest borrowers are more leveraged than they were during the financial crisis, according to S&P’s analysis, which looked at 2017 year-end balance sheets for non-financial corporations. This could lead to trouble for the economy as interest rates rise. Here, too, the Fed should be on “spread watch,” so as not to exacerbate or put further stress on what is already a flexed corporate bond market.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

As to the issue of trade with China, I will refer readers of this column to my musings from last week when I addressed this topic in more depth. My gut call on this highly fluid issue is that President Trump and President Xi will come away from the G-20 meeting with a “new and promising framework” that will pave the way for a long-term relationship of mutually beneficial trade terms. Basically, China will continue to refuse to concede to U.S. demands on Intellectual Property (IP) theft, forced transfer of technology, foreign investment in Chinese companies, respecting international rights of way in the South China Sea, and cracking down on state-sponsored cyber warfare.

There simply isn’t enough time to do a high-level deal and the next round of 25% tariffs on another $250 billion of Chinese goods will very likely take effect on January 1. I believe this realization contributed greatly to last week’s sell-off. It seems that after the Republicans lost control of the House, Beijing has only stiffened their resolve to see if Trump will only be a one-term President.

And then there is the nagging problem of many hot spots within the emerging debt markets, with Italy holding a bad hand. Italian bonds have taken another turn lower as investors respond with deepening concern to the latest political developments. Although investors are demanding ever-higher yields on Italian bonds relative to German bunds – which is considered a reliable financial measure of Italy’s perceived political risk – they are well below the levels reached during the worst of the euro-zone sovereign debt crisis in 2011. However, the recent trend higher is disconcerting.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

The good news is that the stock market and its participants seemingly aren’t aware of these risks and neither is the Fed, I presume. Right now, the rule of “less is more” (i.e. rate hikes) makes considerably more sense. Well before the next FOMC meeting, the future of trade with China will be better defined and most S&P 500 companies will have reported third-quarter earnings and provided forward guidance.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

The five-year chart of the S&P 500 SPDR (SPY) shows that as of last Friday, the market is sitting at a key technical support level. The stock market traded well above its long-term trading range in early January this year, and then again in September. The ensuing correction has taken a toll across most sectors, but it hasn’t broken the primary long-term uptrend, at least for now. And if the Fed is correct in their 2019 GDP forecast, calling for 2.5% growth, then we should see a resumption of upside momentum before Christmas. That could bring the kind of relief that few gifts under the tree could surpass.

About The Author

Bryan Perry

Bryan Perry

Bryan Perry is a Senior Director with Navellier Private Client Group, advising and facilitating high net worth investors in the pursuit of their financial goals.

Bryan’s financial services career spanning the past three decades includes over 20 years of wealth management experience with Wall Street firms that include Bear Stearns, Lehman Brothers and Paine Webber, working with both retail and institutional clients. Bryan earned a B.A. in Political Science from Virginia Polytechnic Institute & State University and currently holds a Series 65 license.


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