How to take the pulse of America’s economy and markets

Although they have yet to get back to their January (and all-time) highs, America’s trio of leading stock indices, the Dow Jones Industrials, the S&P 500 and the NASDAQ Composite are all back in positive territory after a rapid rebound from early February’s sell-off.

This contrasts with the UK, where the FTSE 100, FTSE 250 or FTSE All-Share are down for the year, although the impact of the weaker dollar (and stronger pound) will have an influence on returns.

Such apparent resilience also puts the February stumble in some context and it seems likely that the slide felt so powerful as it came so quickly and did so after a lengthy period of unusual calm.

This still leaves advisers and clients wondering how best to take the pulse of America’s financial markets and economy and this column can offer two quick, short-hand suggestions. They are

  • The Chicago Fed National Financial Conditions Index
  • The St. Louis Fed Financial Stress Index

Both are easy to follow, for free, via FRED, the St. Louis Federal Reserve’s database.

Both suggest that financial conditions in the US will have to worsen before the going gets really tough for stocks, although with the Federal Reserve seemingly intent on raising interest rates further this cannot be ruled out, based on past trends.

Although history is by no means guaranteed to repeat itself, the National Financial Conditions index and Financial Stress indices have tended to reach levels which have coincided with stock market downturns when the Federal Reserve Funds rate has exceeded 5% in nominal terms.

At 1.5%, we are still a long way from that threshold (and real, inflation adjusted interest rates remain negative). But with the US so much more indebted than in the past, it seems logical to assume that it may take a lesser sequence of interest rate rises this time to make financial conditions in America sufficiently uncomfortable that asset prices start to take the hint.

Sweet home Chicago

The Chicago Fed’s National Financial Conditions Index is constructed in a way to give it an average value of zero and a standard deviation of one over a sample period extending back to 1971.

The index contains no less than 105 separate indicators which cover nine specific areas of data, ranging from business credit, to shadow banking, bond and derivative and stock markets and the banking system.

Positive values have been historically associated with tighter-than-average financial conditions.

As the latest weekly score of -0.82 and the latest monthly reading of -0.86 suggest we are still seeing very loose monetary conditions, as confirmed by a Fed Funds rate of just 1.5% and the Federal Reserve’s bloated balance sheet, which stands at $4.4 trillion compared to barely $900 billion a decade ago, thanks to Quantitative Easing and asset-buying programmes.

The good news is that a score of 0.00 on the National Financial Conditions index tends to signal more difficult times ahead for US stocks, in the form of the S&P 500.

Financial Conditions are nowhere near as tight as they were at previous peaks in the S&P 500 ...

Source: Chicago Fed; FRED - St. Louis Federal Reserve database; Thomson Reuters Datastream

Moreover, that reading of zero has only tended to come when the Fed Funds rate reaches something like 5% (on a nominal basis) and we are nowhere near that mark either.

... and US interest rates are well below the threshold which has tended to sufficiently tighten conditions to the detriment of stocks

Source: Chicago Fed; FRED - St. Louis Federal Reserve database; Thomson Reuters Datastream

The bad news is it took only a small tightening of conditions, from -0.89 last November to -0.82, to put stocks (and bonds) into a funk, let alone those brave souls who had sold volatility short and were promptly carried out as the VIX index surged from barely 9 to 50 in less than a month.

It only took a small tightening in financial conditions to prompt a market wobble

Source: Chicago Fed; FRED - St. Louis Federal Reserve database; Thomson Reuters Datastream

Gateway to the West

The St. Louis Federal Reserve’s Financial Stress index monitors 18 different variables, ranging from the Fed Funds rate to a range of US Government and corporate bonds yields, credit spreads, the VIX and the performance of the equity S&P 500 Financials index.

As with the Chicago indicator, the St. Louis gauge suggests that conditions are becoming less accommodative, even if they are far from tight.

The latest weekly reading was -1.06 and the latest monthly score was -1.47. Neither of these readings is close to the score of 1.00 which has tended to warn of trouble ahead for securities valuations.

The St. Louis Fed Financial Stress index sits way below the 1.00 level which has historically signalled trouble for US stocks ...

Source: FRED - St. Louis Federal Reserve database; Thomson Reuters Datastream

And thankfully, US interest rates are nowhere close to the 5%-plus level which has tended to drag the St. Louis Fed Financial Stress index toward that killer 1.0 level.

... and US interest rates are below the 5% nominal mark which has tended to take the financial stress to dangerous levels ...

Source: FRED - St. Louis Federal Reserve database; Thomson Reuters Datastream

However, only a relatively minor run of five interest rate hikes, from 0.25% to 1.50%, and a smidgeon of Quantitative Tightening have prompted an increase in the Financial Stress index. And that shift in the index has coincided with the February stock and bond market stumble, as well as a huge surge in the VIX, or fear, index, as volatility made its presence felt once more.

... but only a minor increase in the index has seen US stocks wobble ...

Source: FRED - St. Louis Federal Reserve database; Thomson Reuters Datastream

... and volatility surge

Source: FRED - St. Louis Federal Reserve database; Thomson Reuters Datastream

Conclusion

This all suggests that the US economy – and therefore potential US asset valuations – are more sensitive to even minor shifts on US monetary policy than previously.

This makes sense, given that the US has more debt now than ever before, so any small upward move in interest rates will quickly add to interest bills.

US debt levels continue to rise inexorably

Source: FRED, St. Louis Federal Reserve database, Federal Reserve G.19 Consumer Credit report, Federal Reserve of New York. *Excludes pension obligations and Medicare. **2017 full-year data not yet available

The St. Louis Financial Stress index and the Chicago Financial Conditions index have both worsened. Further deterioration seems likely if the US Federal Reserve sticks to its plan of three more rate rises of 0.25% apiece, to 2.25%, by year end and continues to withdraw QE.

None of this suggests US stocks are about to hit a wall, as history suggests conditions need to get much tighter yet. But the direction of travel in financial conditions seems clear for now and while winter is not here, it may be drawing closer and advisers and clients may like to think about how they could wrap up and stay warm when they need to. One way to start the process is with an evaluation of portfolios’ risk profiles and whether they are appropriate for clients’ needs, time horizons and target returns.

AJ Bell Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.

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