David Rosenberg, Chief Economist at Gluskin Sheff:
Many in the past have used an ISM clock (while on Wall Street, I did the same several years ago) but the problem is that the ISM is a perfect coincident indicator. It leads nothing. But the ECRI leading index does look ahead six months and is now pointing to GDP growth of little better than 1½% at an annual rate through the second half of the year, which is anaemic enough to regenerate …
• A new peak in the unemployment rate (jobless claims have stopped falling and at current levels are consistent with net job loss 75% of the time in the past);
• A new low in housing prices (according to the venerable Lex column (see page 16 of the May 22, 2010 FT) — for a true Bob Farrell-type mean reversion, U.S. home prices still have downside risk of up to 40%!);
• And new concerns over consumer credit quality (we say this as we see the S&P/Experian consumer credit default rate index hit a new high of 9.14% in April — the proportion of credit card debt going bad is rising sharply and this is not receiving the attention it should but is a yellow flag for consumer-oriented lenders and businesses).
This is not necessarily a double dip scenario as much as a growth relapse — as we saw in 2002, still not exactly an ideal atmosphere for taking on long risk positions.
The ECRI not only leads but is also more timely than the ISM since the data are released weekly and the index covers the whole economy, not just manufacturing.
We divided the ECRI into four different phases:
1. From the trough to zero (coming out of recession).
2. From zero to the peak (“sweet spot” of the cycle — from the end of the recession to the cycle peak in growth).
3. From the peak back to zero (past the peak in growth; economy slows but not back in recession).
4. Zero back to the negative trough (heading back into recession).
From late 2008 to the fall of 2009, we were in Phase 2. Since last October, we have been in Phase 3 and it looks like we could be here for a while.
In Phase 3, historically, the S&P 500 has provided tiny positive returns (average price appreciation of +1.3%). Tech, industrials and energy are the top performing cyclicals, along with health care and staples in the more defensive area.
This cyclical-defensive barbell works well — basic materials, consumer discretionary, financials and utilities tend to lag the most. In the credit market, this is a period to be focusing on reducing duration and scaling into quality: Baa spreads tighten, on average, by 11bps but widen in the high-yield space by an average of 13bps.
Nothing is to say that we will automatically revert to Phase 4 just because we are in Phase 3 right now, although we are only 5.1% away from zero, even with policy rates still close to 0%. Then again, this was a credit cycle, not a rates cycle. It was credit that created the 2003-07 boom, and it was credit that created the 2007-2008 bust. A 5.5% peak in the funds rate was hardly the culprit, and we know that it was not a 0% rate in late 2008 that triggered the 2009 renewal in economic activity and investor risk appetite but rather the Fed’s massive expansion of its balance sheet and the government’s willingness to push the fiscal deficit to record peace-time levels.
In this sense, any analysis that relies on the classic post-WWII recession-recovery experience — even this one — has to be viewed in the context of a secular credit contraction, which began two years ago.
In Phase 4, the S&P 500 on average declines 6.3% with eight of the 10 sectors declining — a barbell of being long energy on the cyclical side and consumer staples on the defensive side has worked well. Consumer cyclicals, technology, industrials and financials are crushed in this segment of the ECRI cycle; telecom, utilities and health care do not perform as well as staples but are areas where at least you don’t typically get beaten up (for relative-return folks).
The CRB is down an average of 3% but gold and oil tend to be supported by a weaker U.S. dollar. The yield on the 10-year note rallies an average of almost 40bps; as with equities, corporate bonds are hurt in this quadrant — Baa spreads widen about 60bps and high-yield by close to 100bps. We have to be mindful that this can very well be the next phase of the cycle even without the Fed raising rates.
The ECRI bottomed this cycle a good four months before the equity market did and for those folks that paid attention, like Jim Grant, kudos to them. Because from the trough to zero — Phase 1 — the equity market rallies on average by 12% with all 10 sectors in the green column, led by tech, consumer discretionary and basic materials. Energy, telecom and utilities tend to lag behind. Financials are basically market performers. The government bond market is still rallying in this segment and the curve is steepening — that along with a slight softening in the U.S. dollar provides a positive liquidity backdrop, which in turn is conducive to spread narrowing in the credit market (average tightening of around 40bps in investment-grade and 200bps in junk).
The market really takes off once the ECRI crosses above the zero line on the way to the peak, which is Phase 2 or the “sweet spot”. In this phase, risk-taking works best with the S&P 500 rising 22% through this interval and every sector is up double-digits in terms of average price gains. Financials, basic materials, industrials, technology, and consumer discretionary typically provide the greatest alpha in this most intensely pro-cyclical phase of the cycle — utilities and telecom lag the most as does energy within the economic-sensitive space (energy tends to be a stage 3 and 4 outperformer). Again, the credit market mirrors the positive backdrop in equities — Baa spreads come in by more than 30bps and by nearly 170bps in the high-yield space.