Leveling the Playing Field

October 5, 2015
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Whats the only thing better than a bye week for your dysfunctional team? Scheduling the only
team 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 wont rehash that entire
discussion. The results were well below expectations and weak across a variety of measures. In
other words, there really werent 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 yields
approached 2.00%. Stocks actually finished in the black for the day. The black! After a jobs
report 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 Fridays reversal to determine whether I believe we are
headed for a recession. The average expansion cycle is about 5 years and we are nearly 18
months beyond that point. Its 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% (or
lower) 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 red
flags 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 people
than me (a deep pool of people indeed) for their thoughts. And my all-time favorite is
TBTIHEK.

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 a
slowdown 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 the
Wachovia trading desk while I worked there. He went on to work at SAC hedge fund and now
runs 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 'international
developments' 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 full
employment 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 assets
languish 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 the
commodity 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 happenso in some ways the new
normal 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...clearly
as 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 somewhat
reassuring.
He also touched briefly on China. We think the slowdown in China presents a very real drag on
the US economy, but that the impact isnt so large as to single-handedly throw the US into a
recession. China has trillions of dollars in reserves and central bank ready to intervene and keep
GDP north of 4%. The news out of China isnt great, but Im not ready to concede its dire,
either.
As for commodities and my growing fear about the high yield market, his suggests that
commodities are experiencing a cooling off rather than a crash. And since commodities
comprise such a large percentage of the high yield market, he isnt ready to take the widening
spreads as a sign of overall panic.

Jobs
As weve said repeatedly this year, you can complain about the quality of jobs all you want
(service, part-time, etc), but the numbers clearly arent recessionary. So what to make of
Fridays disappointing headline and downward revisions? No rational player can argue the
results arent a sharp slowdown relative to the results over the rest of the year, but how
worrisome are they?

Over the last twenty years, weve had two real recessions. The graph above shows how NFP
typically behave during these downturns.
In the six months prior to the recession in 2001, the economy added an average of 119k jobs per
month, 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 per
month, also with two of those months showing a net loss.

Our conclusion NFP is a tricky predictor of a recession because it isnt until after the recession
begins that the economy consistently shows net losses of jobs. Fridays report, coupled with the
downward 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 if
they trend towards 100k.
In particular, a report with a net loss of jobs will really heighten our sensitivity. I cant imagine
its a coincidence that a third of the reports preceding a recession showed net losses of jobs, even
if the revised number a month later didnt. 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 plunge
following a weak showing in that data? Why are we at emergency levels of rates when we dont
appear to be in an emergency situation?
We expect Fed-speak in the coming weeks to reiterate that the October meeting is a live one, but
that is really just to prevent expectations from backsliding too far. If you didnt 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 some
ammunition in the event of an actual recession. Global headwinds and a distinct lack of inflation
give 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 communication
efforts by the Fed and straining credibility. First, it was the dual mandate of inflation and full
employment. Then market volatility was blamed for a pause. Now its international
developments. Whats next, the debt limit?
We expect the FOMC to really harp on two keys points in the weeks ahead.
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Firstly, they view the job market as a cumulative trend, not just a snapshot report. San
Francisco Fed President John Williams recently indicated that a gain of 100k/month
would be enough to justify a rate hike, so they are setting the stage for a lower bar. But
as we examined with the previous two recessions, that would actually be below the six
month rolling average during those windows.

Secondly, hiring has to slow down as we approach full employment. Nothing to be

worried about here ladies and gentlemen, just a normal cooling off as employment
markets reach capacity

These points seem reasonable and valid, particularly in a less jittery market. I just dont know
how much weight they carry in todays market.
Will the FOMC hike an October hike would hurt the Feds credibility so much that we just
dont see that happening. They simply dont have enough time since the dovish FOMC
statement 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 issue
anyway, 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
Fridays NFP miss isnt cause for panic, but it does raise our awareness. We dont believe it to
be part of a larger overall move towards a recession. As one client noted this week, everyone is
talking about a slowdown and risk management, which is a very good thing. He didnt (and I
agreed) 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 a
slowdown, its unlikely to sneak up on anyone else.
Heres our nagging concern: as we noted Friday, the Feds balance sheet has ballooned from $1T
to more than $4.5T, coupled nearly seven years of ZIRP and yet this is as good as it gets? How
fragile is the recovery within this framework? Are stocks up because of the Fed or underlying
fundamentals?
We are in the camp of TBTIHEK slow but steady growth is the base case, being mindful that a
slowdown in China/Europe/commodities is likely to be offset to some extent through foreign
central bank intervention (again). If that does not occur, todays loss of momentum could
become tomorrows recession.
For the time being, the heightened concerns probably means that markets react more strongly to
negative news than positive news, keeping a lid on yields.

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