From an economic perspective, the last decade was remarkable. Unemployment declined steadily, inflation, which can heat up during the late stages of an economic recovery, remained muted and interest rates low. Investors also had a good 10 years. Between the end of 2009 and 2019, stocks in the S&P 500 returned just over 250% and they did this with remarkably little volatility. Yes, there were six 10% “corrections” but for the first time on record, the decade ended without a classic “bear market” decline of 20% or more.
The global economy today also seems to be humming along just fine. But there is growing evidence that, under the surface, all is not so calm. Consider the banking sector. Traditionally, banks needing to bridge unexpected cash flow shortfalls borrow overnight from the Federal Reserve’s discount window. But over the last six months, banks have turned to hoarding cash rather than borrow when needed. The resulting lack of liquidity in the financial system caused interest rates in the lending “repo market” to spike last September (see chart below). Economic concerns and new post-financial crisis regulations appear to be at the root of banks’ unwillingness to borrow. The good news is that bank balance sheets are stronger today. But it also appears that this key mechanism designed to buffer shocks to the financial system is not working as intended. To reduce financial market volatility, the Federal Reserve is pumping money into the overnight lending markets. These efforts will likely continue until some measure of confidence is restored in this corner of the financial markets.
If the big money center U.S. banks are pulling in their horns, it appears that many corporate executives are as well. Fears of slowing global growth have caused many U.S. firms to slash spending on everything from vehicles to computers. From an economic perspective, trends in capital spending are especially important as these investments drive long-term productivity gains and ultimately, GDP growth. Over the last two quarters, companies have also reduced spending on stock repurchases, another big use of corporate cash. Corporate decision makers will need renewed confidence in their supply chains and future profits before opening up the purse strings again.
Finally, last year’s heady gains should have left investors in love with stocks but instead they are selling them them at a record pace. From the beginning of last year through early December, investors pulled a total of $135.5 billion from U.S. stock-focused mutual funds. Most of the proceeds found their way into more conservative bond and money market funds. The reasons for investor caution are not hard to find – – trade war tensions, political uncertainty and the record length of the current bull market come to mind. But there is also some good news in this collective run to safety. Bull markets typically end when even the most skeptical investor has thrown in the towel and bought stocks. Today, the American Association of Individual Investors finds that only 36% of polled investors are bullish – a level well below the 50% peak reached in early 2018. Clearly, many investors are waiting for the next shoe to drop. While this is an uncomfortable place to inhabit, it also suggests that we may not be quite as close to a market top as feared. There are fundamental issues facing the market today but investor euphoria is not one of them.