Wall Street Says Weak Economic Growth Isn’t Just a Blip

by Daniel Putnam | May 7, 2014 8:45 am

Since the beginning of the year, the prevailing market narrative has been that the weak economic data of the first quarter was simply a result of the weather, and that the economy is set to re-accelerate now that the winter is finally past. There’s just one problem with this storyline:

Wall Street isn’t putting its money where its mouth is.

Given that the financial markets are a leading indicator of conditions, a short-term blip in economic growth shouldn’t have much of an impact on performance. Rather than reacting to the weaker data, investors would simply “look across the valley” to the anticipated spring rebound and second-half recovery.

Instead, the opposite is occurring. Many growth-sensitive market segments have in fact weakened considerably in the past month, indicating that forward-looking investors are indeed taking the threat of a slowdown seriously.

Consider these developments:

Treasury Bonds’ Persistent Rally

If the bond market is indeed the “smart money,” then Wall Street’s braintrust has a message for the rest of us: The economy is going nowhere fast. The 10-year note has fallen below 2.6% from its 3.03% level at year-end, while the 30-year has dropped all the way to 3.39% — its lowest level in nearly 11 months.

As a result, the spread between the 2- and 10-year notes has plunged from 2.68 percentage points at the beginning of the year to 2.18 at midday on May 6. Meanwhile, the 2- to 30-year spread has fallen from 3.61 to 2.98. This type of flattening is in no way consistent with an outlook for improving second-half growth — especially since it has occurred even as the Fed has aggressively tapered its quantitative easing program.


Weakness in the Consumer Discretionary Sector

This group was the big winner in 2013: The Consumer Discretionary SPDR (XLY[2]) surged nearly 43%, vastly outpacing the 32% gain of the S&P 500. So far this year, however, it’s a different story: XLY has lost 4.8%, trailing the 1.5% return of the SPDR S&P 500 ETF (SPY[3]) by 6 full percentage points. This indicates that the markets might be concerned that the first-quarter slowdown might have been caused by more than just inclement weather.


Small-Cap Downturn

The Russell 2000 Index roared to a gain of 38.8% in 2013. This outperformance was partially the result of hearty investor risk appetites, but it also reflected confidence in the strength of the domestic economy relative to the rest of the world. Now, small caps have lost their mojo and are trailing their large-cap counterparts by a wide margin. Year-to-date, the Russell 2000 has declined 4% and fallen well short of the 1.5% gain of the large-cap Russell 1000.


It’s true that this reversal reflects a pull-back in investors’ appetite for risk. At the same time, however, it also raises the question of whether Wall Street’s more cautious approach reflects rising concerns about the economic outlook.

A Double-Top in the Homebuilders?

Home construction is one of the key drivers of economic growth, so investors should be concerned by a potential double-top in iShares U.S. Home Construction ETF (ITB[6]), which failed in its effort to make a new high in late March and has since fallen 2.3%. The high-profile bond manager Jeffrey Gundlach agrees[7], telling CNBC yesterday, “I’m really kind of surprised by how copacetic people are about the homebuilders and housing markets. If you look at the data, in recent months it’s gotten really soft.”

This potential weak outlook for housing is supported by weakness in the prices of copper and lumber, both of which are down year to date.


Bottom Line

Alone, any of these shifts could be overlooked. But together, they indicate that Wall Street is paying little heed to the consensus expectations for a second-half revival in the U.S. economy.

The key question is whether this means anything for the broader equity market. After all, the rally of the past three years has occurred in the face of persistently slow economic growth.

This time around, however, there’s one key difference: Rather than adding liquidity to the markets, the Fed is pulling back via its tapering policy. Already, the Fed has reduced its bond-buying program from $85 billion to $45 billion, and it’s on track to wrap up QE entirely by autumn. While this by no means guarantees that the slow-growth environment will feed through into the markets, it certainly increases the odds.

A weaker-than-expected economy might not necessarily be a headwind for stock market returns, but investors need to take discussions about improving second-half growth with a grain of salt.

The stock-market cheerleaders still might see this positive story unfolding, but actual market performance simply doesn’t support it.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.

  1. [Image]: https://investorplace.com/wp-content/uploads/2014/05/tyx.gif
  2. XLY: http://studio-5.financialcontent.com/investplace/quote?Symbol=XLY
  3. SPY: http://studio-5.financialcontent.com/investplace/quote?Symbol=SPY
  4. [Image]: https://investorplace.com/wp-content/uploads/2014/05/xly.gif
  5. [Image]: https://investorplace.com/wp-content/uploads/2014/05/rut.gif
  6. ITB: http://studio-5.financialcontent.com/investplace/quote?Symbol=ITB
  7. high-profile bond manager Jeffrey Gundlach agrees: http://blogs.marketwatch.com/thetell/2014/05/05/jeffrey-gundlach-shorts-home-builders-as-young-buyers-shun-mortgages/
  8. [Image]: https://investorplace.com/wp-content/uploads/2014/05/itb.gif

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