Do Stocks Perform Better When Consumption Growth is Booming or in the Doldrums?

Consumption growth matters a great deal in the developed world.  It’s about 2/3rd of US GDP.  So you would think there would be a pretty clear linkage between higher consumer growth rates, faster earnings growth and superior stock performance.   Think again.

In fact, it’s quite the opposite.

When you look at periods when annual retail sales growth was in the top decile and bottom decile over the last 10 years, and then measure subsequent stock returns, the bottom decile wins quite handily.  The chart below shows an 18 developed country average since 1960 of stock index returns after annual retail sales growth was in the bottom or top decile over the prior decade.

We have some sample size here too.  Between the 18 countries, there were 570 months when annual retail sales was in the top decile and 856 months when it was in the bottom decile.  To prevent one country dominating, I simply took an equal average across all countries.

What the chart shows is not a subtle difference.  When retail sales growth is in the bottom decile, you make, on average, just short of 25% over the next 2 years.  Buy when its in the top decile, and you make a mere 1.43% over the next 24 months.

 

Why?

I don’t know but there are two probable explanations, both of which may be at play.  Weaker growth leads to lower interest rates which begets borrowing and expansion.  Higher growth leads to higher rates and things slow down.  Markets are also discounting mechanisms and people aren’t real good at imagining a world different than the world they currently inhabit.  So when consumption is weak, people and markets are overly pessimistic.  Similarly, “happy days are here again” consumption is probably the period the market has become overly optimistic in its future pricing.

At present, only one country, France, sits in the top decile of 10 year retail sales growth.  No one, unsurprisingly, is currently in the bottom decile.

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What Happens Economically and Financially When The Short-end of the Yield Curve Inverts?

There are multiple ways of measuring the yield curve, but for the purposes of this post, we will be focusing on the short-end only, meaning the difference between the 2-year note yield and 3 month T-Bill rate.  In a normal market, interest rates at two years trade above those at 3 months, because there is greater risk in lending for a longer period of time.  Occasionally, however, short rates rise above long rates.  In the US, this inversion has happened 15 times since 1960.  In a fuller global set of developed markets that excludes the US, this inversion has happened 409 times since 1960. Yield curve inversion is traditionally seen as a negative, either a sign that banks will refuse to lend at rates below deposit rates, or that monetary policy is too tight.  What we see when we look at the data is that while inversion of the short-end of the yield curve is bad economically across almost all countries, and also bad for US financial markets, the results for financial markets outside the US are actually (and surprisingly) positive.

To measure economic impact, we will look at two simple metrics: industrial production and retail sales growth.  In each chart you will see what has happened in the two years following each yield curve inversion, on average.

The first chart shows what has happened to industrial production both in the US and the rest of the developed world over the last six decades after 3-month rates rise above 2-year yields (having been below the prior month).  In the US, the results are bad for the next two years (with growth only beginning to come out of its decline after 21 months).  We see a pretty similar story outside the United States, though because this is a much larger average of countries and outcomes, the results are more muted.  After a yield curve inversion, most developed countries’ industrial production declines about 1% and remains depressed for about 18 month before beginning to rise again.  There are a few exceptions, notably the English speaking countries.  Australia, Canada, New Zealand, the UK and Singapore show little to no decline in industrial production.

(Data Sources: Federal Reserve, US Census Bureau, as well as other Central Bank, Ministries of Finance & National Statistical Offices for non-US countries)

The next chart shows what happens to retail sales.  Unlike industrial production, which can frequently actually contract, retail sales almost always grow, so to adjust for this, the chart shows how much retail sales are weaker than the long-term growth rate in each country.   Whether it’s in the US or the rest of the developed world, yield curve inversion at the short end of the curve leads to below trend consumer spending.   Only one country is an exception to this: Italy.  Don’t ask, I don’t know why.

With all that horrible economic news a yield curve inversion should be bullish for longer maturity (10+ year) bonds, since there is almost no inflation threat on the horizon.  Turns out that this logic does indeed hold, except in the US.  As you can see in the next chart, in the first 9-10 months after the US yield curve flips, longer bonds actually decline.  By contrast, in the rest of the developed world, inversion is universally positive for bond prices.  After one year, every non-US developed country’s average bond market is higher than when the inversion happened.

Finally, let’s consider the impact on stocks.  Looking at the last chart, one can see that yield curve inversion is pretty terrible for US equities, which decline, on average, about 14%.  By contrast and somewhat surprisingly, most other developed countries actually experience stock appreciation after an inversion, though there is some variation, unlike in bonds.  After one year, Italy, Hong Kong, the Netherlands, Denmark all show lower stock prices, but after 24 months all markets, except the US were higher on average.

To tie up, yield curve inversion at the short end of the curve is almost always followed by economic weakness.  Whether it is a driver or simply coincidental is a question I cannot answer.  What is clear is that economic contraction following an inversion is a pretty universal phenomenon in developed countries.

What the inversion means for financial markets shows a bit more variation.  In the US, the results are bad whether you are in stocks or bonds, though it’s a lot worse in stocks.  Other developed countries universally experience bond rallies, probably as a result of weak economic news.  In general, global developed stocks also rally eventually following an inversion as well, perhaps because their longer term rates are moving lower.  Put another way, the decline in US stocks and bonds following a yield curve inversion at the short end of the term structure appears to make the US the exception to the more universal rule.

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What have 1% annual gains in interest rates meant for long bonds?

Last week we looked back through US and several developed countries financial history to see what effect of a 1% annual gain in short term interest rates had upon subsequent equity returns. The results showed that US equities have a fairly negative outlook over the next 4-6 months from an interest rate history perspective. This week we are going to be applying the same test to see the effect on long bond returns. Unfortunately, the news is also bearish for expected long bond returns for the next 4-6 months.

As noted last week, 3-month T-Bills have experienced annual changes of 1% or greater 21 times since 1960, while 2-year notes have seen 28 such increases. The first chart below shows what has happened to US long bond returns (meaning Treasuries of around 20 year maturities) over the next year. Like stocks, negative returns seem to bottom around 4-6 months out, with losses of 1.5% to 2% being highly probable if the past is any guide. Though 1 year later, the pain is over and you are back to flat. Whether US bond investors should expect this bond bounce back to repeat itself this time remains a question mark for me, however. Keep in mind that interest rates and bond yields have been in secular decline since their peak in the early 1980s, and there are a lot of tells of future inflation looming on the horizon at present.

Extending the same analysis more globally to 8 developing major countries, we can see a similar pattern, though with more sample size. Internationally, 3-month T-Bills have shown annual changes of 1% or greater 114 times since 1960, while 2-year notes have experienced 121 increases. Like in the US, the long bond’s maximum losses happen about 5-6 months out, but it’s worth pointing out that the loss is a much more modest 25-50 basis point decline. And also like the US, returns 1 year later are flat and even up.

We will conclude the same way we did last week, by pointing out that while the US and Canada have recently experienced 1% annual increases in short-term rates, the rest of developed world has not. So investing in other developing bond markets outside North America remains a very attractive relative value proposition for the next 4-6 months.

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