What's up Volatility? Markets are Dropping and the Fear Gauge is Up?

Dear Reader,

The Market.

• The 3-month yield (1.55) and the 10-year yield (1.51) inverted.
  • The Treasury yield curve inverted again, including the three-month/10-year relationship that has proved the most reliable recession indicator in the past 
• There has been a growing drumbeat that the Fed may raise rates in 2020 to keep the economy from overheating on too much debt. (Low-interest rates stimulate borrowing, and we've been doing a lot of borrowing at these levels).
• Look for Gold and Silver prices to continue to rise.
• Energy Outlook for 2020 predicts consumption growing more slowly than production.
• “Bad news is often shrugged off earlier in a market cycle but can more easily accentuate volatility in late cycles when valuations are stretched and leadership narrows.”
• E-commerce now accounts for 14% of U.S. retail sales.
• The latest monthly retail sales report from the U.S. Census Bureau recorded December sales (excluding gasoline, automobiles, and restaurants) of $384.6 billion. Compared with the prior year’s $ 360.5 billion, that’s a solid year-over-year gain of 6.7%.
• The forward 12-month price/earnings (P/E) ratio is at around 18.6, well above the market’s 5-year average of 16.7 and its 10-year average of 14.9.
• Throughout the first three quarters of 2019, the strength of the U.S. consumer helped propel economic activity forward, even as other areas including business fixed investment lagged.
• 4Q real GDP came in at 2.1% vs. 2% est. & 2.1% in 3Q; consumption down to 1.8% vs. 3.2% in 3Q; nonresidential business investment -1.5% vs. -2.3% in 3Q (3rd straight drop & longest slump since 2009); imports fell -8.7% vs. 1.8% in 3Q.
• WHO Director-General has declared the outbreak of novel coronavirus (2019-nCoV) a Public Health Emergency of International Concern. In China, more than 7700 cases have been confirmed, and 170 people have died. There are 82 additional cases confirmed in 18 countries. 
• A pickup in global growth will be due to the supportive stance of fiscal policy in major economies like China, Europe, and Japan. With fiscal and monetary policy now working in the same direction, the outlook of further expansion has improved. BUT, when the next recession occurs, policymakers have fewer tools to get out of it.

 
Helicopter Money. Helicopter money is an extreme, unconventional, and unorthodox practice of stimulating growth within the economy. It is comparable to Quantitative Easing, which involves increasing the money supply by purchasing debt from the market. Unlike, quantitative easing, helicopter money involves the central bank distributing printed money directly to the public. It is also referred to as a helicopter drop, as if the money were scattered from a helicopter. Consumers could do whatever they want with this money, but in theory, sustained helicopter "drops" would encourage spending and create demand, sparking growth. It is a permanent impact on society; once the money is out there, it cannot be taken back. Distributing money to the public comes with its own problems, such as inflation and currency weakening. Obviously, Jerome Powell is not going to charter a helicopter and toss money out of it (that seems like an Elon Musk type of thing). Rather, there are more tamed actions they can take to go about this. The Central Bank's spending on tax cuts and purchasing government bonds with the condition to distribute the interest directly to consumers rather than government spending are two possible ways of dropping money into the economy. 
 
The Feds. This week the Federal Open Market Committee held the first meeting of 2020. The Fed’s position has not changed much since they met in January, stating that the “labor market remains strong and that economic activity has been rising at a moderate rate”. The Fed did note that household spending has been constantly rising and business fixed investment and gross exports remain weak. In response to current economic conditions, the Fed Funds Rate was held steady at 1.75 percent, which is within their target of 1.50-1.75 percent. The rate is down from a year ago when the rate was 2.25%. Since mid-October, the Fed has been buying $60 billion a month of T-bills, and reserve levels have risen by more than $270 billion since then to roughly $1.67 trillion. At the meeting, Chairman Powell expressed his intention to reduce the market's reliance on the Fed. He outlined loose plans to reduce cash injections into the market by the second quarter. Some analysts have liked these cash injections to a new round of QE, but the debate on that continues. Powell intends to lower the Fed’s reserves from $1.67 trillion to around $1.55 trillion which is the level the reserves were at when the market first ran into liquidity problems. With the trillions in annualized balance sheet expansions from Central Banks around the world, stocks will have a difficult time selling off much and any correction may be limited. In other Fed news, Trump has formally nominated Judy Shelton and Christopher Waller to fill the remaining seats on the Fed’s board of governors. Shelton is known for criticizing the Fed, advocating for a return to the gold standard, and questioning the independence of the Fed itself. No doubt if she is confirmed we will see future changes in the Fed’s policies. 
 
Consumer Confidence. Consumer confidence measured through the Consumer Confidence Index (CCI) has recently reached a normalized high of 101.4 (meaning long term average is 100). This high hasn’t been seen since March of 2018. Although CCI has been reaching highs, business confidence (BCI) has been steadily decreasing, currently at 96.3 (normalized at long term average of 100). This rise in consumer confidence, not accounting for the Wuhan outbreak, is being brought on by an increasing job market, which is increasing optimism for consumers' futures wealth, fueling current consumption. This disconnect between CCI and BCI can be bridged by looking at the CEO confidence survey, which is at a level of 7 out of 10, which backs up the CCI report. This also brings into question what you believe powers GDP more, consumption or investment. With CCI backing up consumption, and BCI backing up investment. But what drives the market: consumers or businesses? Keynes’ Law says, “Demand creates Supply” and Say’s Law says, “Supply creates Demand”. I say businesses drive the economy; aggregate supply drives the economy while aggregate demand responds passively. Purchasing power grows out of production. The great producing countries are the great consuming countries. Consumer confidence is important, but the real factors to look at are business investment and business spending indicators. Once business slows down, consumer confidence and spending will slow.
 
VIX. Volatility is the statistical measure of the dispersion of returns for a given security.  The higher the volatility, the riskier the security is. The price of the security can move more dramatically in a short period of time. BETA is how you measure volatility. A beta approximates the overall volatility of a security’s returns against the returns of a relevant benchmark like the S&P 500. The beta of 1.1 has historically moved 110% for every 100% move in the benchmark. A beta of 1 indicates that the security's price moves with the market. A beta of less than 1 means that the security is theoretically less volatile than the market. Low volatility means small fluctuations and high volatility means large fluctuations. Generally speaking, when investing the more risk you take with your money the higher the return can be, so investments that often see low volatility are lower in risk and therefore offer less of a return. The two most common ways to measure volatility are the VIX and Average True Range (ATR for short). VIX is a popular measure of the stock market's expectation of volatility implied by S&P 500 index options. It uses the prices of options on the S&P 500 and then estimates how volatile those options will be between the current date and the option’s expiration date. The Volatility Index (VIX) is an index created by the Chicago Board Options Exchange. It shows the market’s expectation of 30-day volatility, constructed using the implied volatilities on S&P 500 index options; calculated from calls and puts. It uses the price of options on the S&P 500 and then estimates how volatile those options will be between the current date and the option’s expiration date. One of the biggest risks to an equity portfolio is a broad market decline. The VIX Index has had a historically strong inverse relationship with the S&P 500 Index. VIX below 12 is considered low, above 20 is considered high and in between, normal.
 
 
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Keep Climbing,


The Alchanati Campbell and Associates Team