The Pensford Letter - 10.5.15

8/20/2019 The Pensford Letter - 10.5.15

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Leveling the Playing Field October 5, 2015 ______________________________________________________________________________

What’s the only thing better than a bye week for your dysfunctional team? Scheduling the onlyteam in all of sports that are actually more dysfunctional than yours. Ladies and gentlemen –time to play the Washington Redskins!

We sent out an update Friday following the jobs report, so we won’t rehash that entirediscussion. The results were well below expectations and weak across a variety of measures. Inother words, there really weren’t any positive signals, even in the fine print.

The result in the market was an immediate drop in yields (T10 tested 1.90% briefly) and equities, just as we would have expected.

But then, something odd happened. Bonds reversed course and the T10 sold off until yieldsapproached 2.00%. Stocks actually finished in the black for the day. The black! After a jobsreport missed huge!

My knee jerk reaction was summarized thusly: negative report means more Fed accommodation,ZIRP, and stocks can only go up!

I spent the weekend digging deeper into Friday’s reversal to determine whether I believe we areheaded for a recession. The average expansion cycle is about 5 years and we are nearly 18months beyond that point. It’s a fair concern.

I think bond markets are very touchy right now. We have a heavy supply calendar coming up.That, coupled with a sell-off in equities this week could push the T10 back down to 1.90% (orlower) in the near term. We tested 1.90% in August during the mini-flash crash in equities.Labor markets were stronger then than today, but would this kind of move be enough to raise redflags about a genuine slowdown? Or is this just another blip as part of the new normal?

Longtime readers will know that when the going gets tough, I simply ask more intelligent peoplethan me (a deep pool of people indeed) for their thoughts. And my all-time favorite isTBTIHEK.

The Best Trader I Have Ever Known (TBTIKEK)

I emailed TBTIHEK and asked for his thoughts on the market and whether we are poised for aslowdown or if this is just a normal course of events. I also inquired about high yield (HY)market concerns. For those of you new to the Pensford Letter, TBTIHEK was the head of theWachovia trading desk while I worked there. He went on to work at SAC hedge fund and nowruns his own hedge fund. Here are his thoughts.



I think the Fed erred by not moving in September, and now are going to find it increasingly

difficult to move, as the new goalpost (at my count this is their 4th) of 'internationaldevelopments' is sufficiently vague to make it almost impossible to have been clarified by

October and Dec 16 is just not a good time to make your first move in so long.

The subsequent market reaction tells me that the market agrees...it no longer needs/wants zero

short term rates and the Fed's extreme caution in just moving off zero as we approach/are at fullemployment makes the market worried there is something deeper to be concerned about.

Having said that...the main street vs wall street is overextended, and I see wage growth and

domestic economy continuing to chug along while the broader equity markets/financial assetslanguish over the next 18 months.

I think the signal being sent by weak commodity prices is not as dire as the pessimists like to paint. China is slowing, this is undeniable, and has broad implications for the industrial

commodity complex...but did anyone freak out that global growth was over-heating during thecommodity supercycle of the past decade? Take a look at the parabolic commodity chart...it was

clearly unsustainable. There will be winners (the importers/developed markets) and losers(exporters/emerging markets) but I think the slowing growth signal that the overall weakness is

sending is wildly overstated.

Growth cannot be as strong as its been in the past cycles unless fiscal restraints globally are

lifted, and I don't see the political will there to make that happen…so in some ways the newnormal of lower growth, yet still growth not a global recession, is my base case.

HY spreads/CDS too dominated by energy for me to take a broader signal there either...clearlyas energy continues to decline/languish near the lows, junk will not perform well.

Our takeaway – the base case is lower, slow growth, but not a recession. That is somewhatreassuring.

He also touched briefly on China. We think the slowdown in China presents a very real drag onthe US economy, but that the impact isn’t so large as to single-handedly throw the US into arecession. China has trillions of dollars in reserves and central bank ready to intervene and keep

GDP north of 4%. The news out of China isn’t great, but I’m not ready to concede it’s dire,either.

As for commodities and my growing fear about the high yield market, his suggests thatcommodities are experiencing a cooling off rather than a crash. And since commoditiescomprise such a large percentage of the high yield market, he isn’t ready to take the wideningspreads as a sign of overall panic.



Jobs

As we’ve said repeatedly this year, you can complain about the quality of jobs all you want(service, part-time, etc), but the numbers clearly aren’t recessionary. So what to make of

Friday’s disappointing headline and downward revisions? No rational player can argue theresults aren’t a sharp slowdown relative to the results over the rest of the year, but howworrisome are they?

Over the last twenty years, we’ve had two real recessions. The graph above shows how NFPtypically behave during these downturns.

In the six months prior to the recession in 2001, the economy added an average of 119k jobs permonth, with two of those months showing a net loss.

In the six months prior to the recession in 2007, the economy added an average of 111k jobs permonth, also with two of those months showing a net loss.



Our conclusion – NFP is a tricky predictor of a recession because it isn’t until after the recession

begins that the economy consistently shows net losses of jobs. Friday’s report, coupled with thedownward revision from last month, is worrisome but not yet a warning shot about a recession.The economy has added 3mm jobs this year, definitely not recessionary.

We will be closely watching to see if the reports going forward level off around 150k/month or ifthey trend towards 100k.

In particular, a report with a net loss of jobs will really heighten our sensitivity. I can’t imagineit’s a coincidence that a third of the reports preceding a recession showed net losses of jobs, evenif the revised number a month later didn’t. Perhaps net losses will be the warning shot across the bow.

FOMC- What a Tangled Web We Weave

The Fed has made us slaves to data, so who is to blame when market expectations plungefollowing a weak showing in that data? Why are we at emergency levels of rates when we don’tappear to be in an emergency situation?

We expect Fed-speak in the coming weeks to reiterate that the October meeting is a live one, butthat is really just to prevent expectations from backsliding too far. If you didn’t hike when the

economy was adding 250k jobs per month, how do you justify doing so now?

The Fed has been talking about a hike for over a year now and has expended considerable effort

to manage expectations. They still want to hike, if for no other reason than to have someammunition in the event of an actual recession. Global headwinds and a distinct lack of inflationgive the doves all the cover fire they need to remain extremely accommodative.

The moving target of factors that influence a rate hike decision are muddying the communicationefforts by the Fed and straining credibility. First, it was the dual mandate of inflation and fullemployment. Then market volatility was blamed for a pause. Now its internationaldevelopments. What’s next, the debt limit?

We expect the FOMC to really harp on two keys points in the weeks ahead.

- Firstly, they view the job market as a cumulative trend, not just a snapshot report. SanFrancisco Fed President John Williams recently indicated that a gain of 100k/monthwould be enough to justify a rate hike, so they are setting the stage for a lower bar. Butas we examined with the previous two recessions, that would actually be below the sixmonth rolling average during those windows.



- Secondly, hiring has to slow down as we approach full employment. “Nothing to beworried about here ladies and gentlemen, just a normal cooling off as employmentmarkets reach capacity…”

These points seem reasonable and valid, particularly in a less jittery market. I just don’t knowhow much weight they carry in today’s market.

Will the FOMC hike – an October hike would hurt the Fed’s credibility so much that we justdon’t see that happening. They simply don’t have enough time since the dovish FOMCstatement nor the data to support such a move.

December hike – our biggest issue with a December move is that liquidity at year end is an issueanyway, why compound it? But we felt the same way about tapering and they moved forward,so what do we know?

Markets have all but eliminated a hike in December, but we believe there is still at least a 50% probability of a hike, likely driven by the job reports between now and then.

Conclusion

Friday’s NFP miss isn’t cause for panic, but it does raise our awareness. We don’t believe it to be part of a larger overall move towards a recession. As one client noted this week, everyone istalking about a slowdown and risk management, which is a very good thing. He didn’t (and Iagreed) recall anyone worried about a crash in the first half of 2007.

In other words, if a state school educated Army grunt in Charlotte, NC is talking about aslowdown, it’s unlikely to sneak up on anyone else.

Here’s our nagging concern: as we noted Friday, the Fed’s balance sheet has ballooned from $1Tto more than $4.5T, coupled nearly seven years of ZIRP and yet this is as good as it gets? Howfragile is the recovery within this framework? Are stocks up because of the Fed or underlyingfundamentals?

We are in the camp of TBTIHEK – slow but steady growth is the base case, being mindful that aslowdown in China/Europe/commodities is likely to be offset to some extent through foreigncentral bank intervention (again). If that does not occur, today’s loss of momentum could become tomorrow’s recession.

For the time being, the heightened concerns probably means that markets react more strongly tonegative news than positive news, keeping a lid on yields.



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The Pensford Letter - 10.5.15