As if waking up to an economic nightmare, investors see
headlines like these and many others flashing across their Bloomberg terminals:
Facebook says Oculus headphone production will be delayed due to virus
Apple extends country wide store closing for another week
Foxconn delays iPhone production
Qualcomm cuts production forecast due to virus uncertainty
Starbucks announces China store closures through Lunar New Year, uncertain when they may reopen
US Steel flashes a warning of a cut in demand
Nike shoe production halted
Under Armour missed on sales, and their outlook is weak. They partially blamed the Corona Virus outbreak.
IEA forecasts drop in oil demand this quarter- first time in a decade
never ending list of delays, disruptions, and cuts rolls on from retail to high
technology. Even services are impacted as flights and train trips are canceled
within and to and from China. While some
technology-based services are provided over the Internet service, restaurants,
training, and consulting, as examples, must be performed in person. Manufacturing operations require workers to be
at the factory to produce products. Thus, manufacturing is much more acutely
affected by quarantines, shutdowns, transportation disruption, and other government
It is as if an economic tsunami is rolling over the global economy. China’s economy was 18 % of world GDP in 2019. For most S & P 100 corporations, the Asian giant is their fastest growing market at 20 – 30 % per year. Even more critical, China has become the hub of world manufacturing after entering the World Trade Organization in 2000. Over the past two decades, U.S. corporations have relocated manufacturing to China to leverage an inexpensive labor force and modern business infrastructure.
Source: The Wall
Street Journal – 2/7/20
Prior to the epidemic,
world trade had begun to slow as a result of the China – U.S. trade war and
other tariffs. World trade for the first
time since the last recession has turned negative.
Analytics, The Wall Street Journal, The Daily Shot – 1/19/20
Based on severity
estimates, analysts have forecasted the impact on first-quarter China GDP
growth. In the chart below from Fitch Ratings, growth for first quarter drops
almost in half and for year growth drops to 5.2 % if containment is delayed:
Sources: The Wall
Street Journal, The Daily Shot – 2/6/20
When news of the
virus first was announced, the market sustained a quick modest decline. The
next day, investors were reassured by official news from China and the World
Health Organization that the virus could be contained. Market valuations
bounced on optimism that the world economy would see little to no damage in the
first quarter of 2020. Yet, there is growing
skepticism that the official tolls of the virus are short of reality. Doctors
report that at the epicenter of Wuhan that officials are grossly underestimating
the number of people infected and dead. The London School of Hygiene and
Tropical Medicine has an epidemic model indicating there will be at least
500,000 infections at the peak in a few weeks far greater than the present 45,000
The reaction, and not statements, of major governments to the epidemic hint that the insider information they have received is far worse and uncertain. U.S. global airlines have canceled flights to China until mid-March and 30 other carriers have suspended flights indefinitely – severely reducing business and tourist activities. The U.S. government has urged U.S. citizens to leave the country, flown embassy staff and families back to the U.S., and elevated the alert status of China to ‘Do Not Travel’ on par with Syria and North Korea. All of these actions have angered the Chinese government. While protecting U.S. citizens from the illness it adds stress to an already tense trade relationship. To reduce trade tension, China announced a relaxation of import tariffs on $75 billion of U.S. goods, reducing tariffs by 5 to 10 %. President Xi on a telephone call with President Trump committed to complete all purchases of U.S. goods on target by the end of the year while delaying shipments temporarily. It remains to be seen if uncontrolled events will drive a deeper trade wage between the U.S. and China.
chaos in the supply chain operations is creating great uncertainty. Workers are
being told to work from home and stay away from factories for at least for another
week beyond the Lunar New Year and now well into late-February. Foxconn and Tesla announced plant openings on
February 10th, yet ramping up output is still an issue. It will be a
challenge to staff factories as many workers are in quarantined cities and train
schedules have been curtailed or canceled.
Many factories are dependent on parts from other cities around the
country that may have more severe restrictions on transportation and/or workers
reporting to work. Thus, even when a plant is open, it is likely to be operating
at limited capacity.
On February 7th,
the Federal Reserve announced that while the trade war pause has improved the global
economy, it cautioned that the coronavirus posed a ‘new threat to the world
economy.’ The Fed is monitoring the
situation. The central bank of China infused CNY 2 trillion in the last four
weeks to provide fresh liquidity. The
liquidity will help financially stretched Chinese companies survive for a
while, but they are unlikely to be able to continue operations unless
production and sales return to pre epidemic levels quickly.
Will the Federal
Reserve really be able to buffer the supply chain disruption and sales declines
in the first quarter of 2020? The Fed already
seems overwhelmed, keeping a $1+ trillion yearly federal deficit under control
and providing billions in repo financing to banks and hedge funds causing soaring
prices in risk assets. While the Fed may
be able to assist U.S. corporations with liquidity through a tough stretch of
declining sales and supply chain disruptions, it cannot create sales or build
Prior to the
virus crisis, CEO Confidence was at a ten year low. Then, CEO confidence levels improved a little
with the Phase One trade deal driving brighter business prospects for the
coming year. Now, a possible black swan epidemic has entered the world economic
stage creating extreme levels of sales and operational uncertainty. Marc Benioff, CEO of Salesforce, expresses
the anxiety many CEOs feel about trade:
“Because that issue (trade) is on the table, then everybody has a question mark around in some part of their business,” he said. “I mean, we’re in this strange economic time, we all know that.”
Adding to the uncertainty
is a deteriorating political environment in China. During the first few weeks of December, local
Wuhan officials denounced a doctor that was calling for recognition of the new
virus. He later died of the disease, triggering a social media uproar over the
circumstances of his treatment. Many Chinese people have posted on social media
strident criticisms of the delayed government response. Academics have posted petitions for freedom
of speech, laying the blame on government censors for making the virus outbreak
worse. The wave of freedom calls is
rising as Hong Kong protester’s messages seem to be spreading to the mainland. The
calls for freedom of speech and democracy are posing a major challenge to
President Xi. Food prices skyrocketed by
20 % in January with pork prices rising 116 % adding to consumer concerns. Political
observers see this challenge to government policies on par with the Tiananmen
Square protests in 1989. The ensuing massacre of protestors is still in the
minds of many mainland people. As seems to be true of many of these events that
it is not the crisis itself, but the
reaction and ensuing waves of social disorder which drive a major economic
has forecast a slowdown in US GDP growth in the first quarter of 2020 to just
Economics, The Wall Street Journal, The Daily Shot – 2/6/20
Will U.S. GDP
growth really be shaved by just .4 %? If
we consider the compounding effect of the epidemic to disrupt both demand and
supply, the social chaos in China challenging government authority (i.e., Hong
Kong), and a lingering trade war – these factors all make a decline into a
recession a real and growing possibility.
We hope the epidemic can be contained quickly and lives saved with a
return to a more certain world economy.
Yet, 1930s historical records show rising world nationalism, trade wars,
and the fracturing of the world order does not bode well for a positive
outcome. Mohammed A. El-Arian. Chief Economic Advisor at Allianz in a recent Bloomberg
opinion warns of a U shaped recession or worse an L :
“I worry that many analysts do not fully appreciate the notable differences between financial and economic sudden stops. Rather than confidently declare a V, economic modelers need more time and evidence to assess the impact on the Chinese economy and the related spillovers – a consideration that is made even more important by two observations. First, the Chinese economy was already in an unusually fragile situation because of the impact of trade tensions with the U.S. Second, it has been navigating a tricky economic development transition that has snared many countries before China in the “middle income trap. All this suggests it is too early to treat the economic effects of the coronavirus on China and the global economy as easily containable, temporary and quickly reversible. Instead, analysts and modelers should respect the degree of uncertainty in play, including the inconvenient realization that the possibility of a U or, worse, an L for 2020 is still too high for comfort.”
Patrick Hill is the Editor of The Progressive
Ensign, https://theprogressiveensign.com/ writes
from the heart of Silicon Valley, leveraging 20 years of experience as an
executive at firms like HP, Genentech, Verigy, Informatica, and Okta to provide
investment and economic insights. Twitter: @PatrickHill1677.
Can Six Myths Keep The Market Going?
Piper Jaffray forecasts by year end 2020, the S&P 500 (SPX) will hit 3600, a 12.8 % increase. Of eighteen analysts interviewed by Marketwatch only three forecasters expect a decline for the SPX. Will the SPX reach 3600? The SPX has soared over 400 % from a low of 666 in 2009 to over 3200 at the close of 2019. Mapping the SPX ten year history onto a psychology market cycle map of growth and decline phases poses interesting questions. As the market has zoomed over 400% upwards over ten years, it is clearly in the Mania Phase. Yet, the US economy is growing at the slowest rate of any economic recovery since WWII at 2.2 % GDP per year, why the disconnect?
Patrick Hill – 12-31-19
reason for the disconnect is investment analysts and the media lead investors
to believe there is no downside risk. On New Year’s Eve, Goldman Sachs released
a prediction for 2020 claiming that the ‘tools of the Great Moderation’ (Fed
policy shift) begun 30 years ago low-interest rates, low volatility,
sustainable growth and muted inflation are still in place and were only
interrupted by the 2008 financial crisis. Plus we would add the Dotcom crash.
GS concluded that the economy ‘was nearly recession-proof.’
mainstream financial media also feed the Mania Phase with stories like Goldman
Sachs declaring the Great Moderation is working with our economy in a ‘new
paradigm’. We are to believe there will not be a recession because our
policymakers have the economy under control.
Really? With over $17 trillion of
negative debt worldwide to keep the world economy going, central banks have
succeeded in sustaining worldwide GDP at 1 – 2 % and falling as of late! For
the SPX market to not descend into the Blow Off phase, investors will need to continue to believe in six economic myths:
Phase of the Economic Cycle is Continuing
Will Bailout the Economy
The Fed Will
Keep the Economy Humming
If the Fed
Fails Then the Federal Government Will Provide Stimulus
The Trade War
Won’t Hurt Global Growth
and Markets Are Insulated from World Politics
Let’s look at each myth that is likely to affect portfolio and market performance in the next year. This analysis is based on research data of economic, social, government, business trends and observation of markets and the economy. If markets are to continue to climb, either policymakers must solve difficult issues or investors must continue to believe these myths are true. The first myth establishes a critical framework for viewing all economic activity. We are actually at the end of the growth phase of the economic cycle; here is why.
Myth 1. The Growth Phase of the Economic Cycle is Continuing
The Fed has reported that the economy is still in ‘mid-cycle’ phase. We differ with this position as several indicators show the economy is reaching the end of its growth cycle and ready to revert to the mean. As GDP is driven 70 % by consumers, let’s look at what is really happening to consumers. The ratio of current consumer conditions minus consumer expectations is at levels seen just before prior recessions not mid-stage growth economies.
Sources: The Conference Board, The
Wall Street Journal, The Daily Shot – 6/14/19
In the chart below, consumers are stretched as
loan default rates are rising despite a 50-year low unemployment rate. Rising
delinquencies tend to signal rising unemployment and economic decline is likely
in the near future.
Sources: Deutsche Bank, Bureau of
Labor Statistics, The Wall Street Journal, The Daily Shot – 6/4/19
Of major concern is that the manufacturing
sector is now in a recession based on five months of ISM reports below the 50 %
economic expansion benchmark. The overall contraction is validated as 70 % of
manufacturing sub-sectors are contracting as noted in the report below. While the US economy is primarily driven by
services, the manufacturing sector has a multiplier effect on productivity,
support services, and employment with high paying jobs. Note the contraction in
sub-sectors is reaching levels last seen before recessions.
Oxford Economics, The Wall Street Journal, The Daily Shot – 12-20-19
There are other indicators pointing to the end of the growth phase. For example, the inversion of the 2 – 10 yield curve last summer is now steepening – often seen before an economic slowdown. Another indicator is the number of firms with negative earnings launching IPOs in 2019 was at levels not seen since 2000. Finally, productivity and capital investments are at ten year lows.
Myth 2. Consumers Will Bailout the Economy
Market pundits have been quick to rely on the consumer to continue spending at growth sustaining rates. Yet, budgets for the middle class are squeezed as consumers cope with student loan debt payments, new car payments, health care bills, and credit card debt. The Bloomberg Personal Finance Index dropped significantly in October:
Source: Bloomberg, The Wall Street
Journal, The Daily Shot – 11/10/19
Car loans now span seven years on average
versus five years a few years ago. Further, the new loans ‘roll in’ debt from
previous car purchases due to negative equity in the owner’s trade-in vehicle. Vehicle price increases up to 10 % over the
last year for both cars and trucks add to the debt burden. Car debt is beginning to weigh on consumers
as delinquencies are climbing:
Sources: NY Federal Reserve, The
Wall Street Journal, The Daily Shot – 10/29/19
Today, credit card rates are running at a ten-year
peak of 17 – 22 % have seen no relief despite the Fed cutting rates. There is a record spread between the Federal
Funds rate and credit card rates as banks seek new revenue sources beyond
making loans. Many consumers are turning to credit cards to pay bills to
sustain their lifestyle as their wages are not keeping up with rising living
In addition, consumers are increasingly working
at more than one job to be sure they can pay their bills.
Sources: Deutsche Bank, Bureau of
Labor Statistics, The Wall Street Journal, The Daily Shot – 10/21/19
Workers need to take on multiple jobs in the
gig economy. McKinsey & Company estimates that 52
million people are gig workers or a third of the 156 million person workforce.
Contractors have no job security. Gig workers often receive hourly wages
with no health, retirement or other benefits. The lack of benefits
means they have limited or no financial safety net in the event of an economic
There are other key indicators of consumer financial distress, for example, consumer spending on a quarter over quarter basis has continued to decline, Bankrate reports that 50 % of workers received no raise in the last year. Real wages (taking into account inflation) for 80 % of all workers have been stagnant for the past twenty years. Uncertain economic forces are putting consumers in a financial bind, for more details, please see our post: Will the Consumer Bailout the Economy?
Myth 3. The Fed Will Keep the Economy Humming
The Fed has said it will do whatever necessary to keep the economy growing by keeping interest rates low and injecting liquidity into the financial system. However, a survey on Fed actions shows that 70 % of economists interviewed believe the Fed is running out of ammo to turnaround the economy.
Sources: The Wall Street Journal, The Daily
Shot – 12-30-19
We agree with their perspective that the Fed is entering an economic space where
no central bank has gone before. In
the past, the Fed lowered rates when an economic downturn was evident. Just
prior to earlier recession’s interest rates were at a higher starting level of
at least 4 – 5 %. Plus, today the Fed has
returned to pumping liquidity into the economy via its repo operation and QE as
Sources: The Federal Reserve of St. Louis, The
Wall Street Journal, The Daily Shot – 12/30/19
The International Bureau of Settlements (BIS)
disclosed in their analysis of recent Fed repo operations that funding
supported not only banks but hedge funds. A key concern is the nature of the
hedge fund bailout. How steep is the loss being mitigated? Is there a possibility
of contagion? Is more than one hedge fund involved? Should the Fed be bailing out hedge funds
that are overextended due to speculation? The
Fed is already using its tools at the height of the current economic growth
cycle. The Fed financial tools are too stretched to turnaround an economy in a recession
from multiple financial bubbles bursting.
The Fed continues to declare that inflation is
at 2.1 %, missing the reality of what
consumers are actually paying for goods and services. We find from industry research that finds inflation
is likely in the 6 – 10% range. Inflation should be defined as price increases of goods and
services that consumers buy, not inflation defined by a formula to suit
political needs. Using inflation lifestyle ‘cost of living’ data, which is not
transparent or available for audit does not meet the foundational data needs of
investors. Gordon Haskett Research Advisors conducted a study by
purchasing a basket of 76 typical items consumers frequently buy at Walmart and
Target. Their study showed that from June 2018 to June 2019, prices
increased by about 5.5%.
industry research supports inflation running at a much higher level than
government figures. On a city by city basis, Chapwood has developed an index
for 500 items in major metropolitan areas of the US. Chapwood reports the average national
inflation level to be about 10 %. Note
inflation is compounded; for example, in San Jose a five year average price
increase of 13% is for each year. An item costing $1.00 would cost $1.13 the
next year and then $1.28 the third year and so forth. It islikely workers caught
in a squeeze between stagnant wages and 10 % inflation will not be able to
continue to sustain present levels of economic growth.
inflation at 6 – 10 % has major policy, portfolio, and social
implications. For example, with the ten
year Treasury Bond at 1.90% and inflation at 6 %, we are actually living in a ’de facto negative interest’
economy of – 4.10 %. Higher inflation levels fit the financial
reality of what workers, portfolio managers, and retirees are facing in
managing their finances. Many
workers must take multiple jobs and develop a ‘side hustle’ to just keep up
with inflation much less get ahead. For portfolio managers, they must grow
their portfolio at much higher rates than was previously thought just to
maintain portfolio value. Finally, for
retirees on a fixed income portfolio it is imperative they have additional
growth income sources or part-time work to keep up with inflation eating away
at their portfolio. For more details on our analysis of a variety of inflation,
categories see our post: Is
Inflation Really Under Control?
One additional assumption about Fed
intervention repeated by many analysts is the Fed liquidity injections mean
that corporate sales and profits will bounce back. For some financially sensitive industries
this argument may be true. For other firms with excellent credit ratings, they
may be able to obtain low-interest loans to ride out falling sales. But, the reality is that corporations build and
sell products based on demand. If demand falls, low-interest loans will not
increase sales. Only new products, new
channels, reduced pricing, marketing and other initiatives will revive sales.
Myth 4. If the Fed Fails Then the Federal Government Will Provide Stimulus
European Central Bank leaders have called on European governments to provide economic stimulus for their markets. Picking up on this idea, analysts have proposed the US government move on infrastructure and other spending programs. However, tax cuts, low-interest rates, stock buybacks, and record corporate debt offerings have shifted a huge balance of world-wide wealth to the private sector. For 40 years, there has been a significant increase in private capital worldwide while public wealth has declined. In 2015, the value of net public wealth (or public capital) in the US was negative -17% of net national income, while the value of net private wealth (or private capital) was 500% of national income. In comparison to 1970, net public wealth amounted to 36% of national income, while net private wealth was at 326 %.
Source: World Inequality Lab, Thomas Piketty,
Gabriel Zucman et al. – 2018
Essentially, central banks, Wall Street, and governments have built monetary and economic systems that have increased private wealth at the expense of public wealth. The lack of public capital makes the creation of major levels of public goods and services nearly impossible. The US government is now running $1 trillion yearly deficits with public debt at record levels not seen since WWII and total debt to GDP at all-time highs. The development of public goods and services like basic research and development, education, infrastructure, and health services are necessary for an economic rebound. The economy will need a huge stimulus ‘lifting’ program and yet the capital necessary to do the job is in the private sector where private individuals make investment allocation decisions. Congress may pass an ‘infrastructure’ bill in 2020 but given the election, it is likely to be lightly funded to pass both houses of Congress and receive the president’s signature.
Myth 5. The Trade War Won’t Hurt Global Growth
By closing the Phase One trade deal, the market has been sighing with relief with observers declaring that trade will resume a growth track. Yet, the Phase One deal is not a long term fix. If anything, the actions on the part of both governments have been to dig in for the long term. The Chinese government has taken several key actions in parallel to the deal to move their agenda ahead.
China has quietly raised the exchange rate of
their currency to offset some of the impact of still in place tariffs on the
U.S. economy. The government made a
major move to block US and foreign companies from providing key technical
infrastructure. The technology ministry has told government agencies that all IT
hardware and software from foreign firms are to be replaced by Chinese systems within
three years. If the Chinese government decides to establish ‘China only’
network standards it may be difficult for US firms to even work with state-sponsored
companies or private businesses that must meet China’s only standards. Apple
and Microsoft would have to build two versions of their products. One version
for the Chinese economy and one for the world.
A critical change is taking place
in world trade which is the establishment of a two-block trading world. China is a key growth market at a 20 % – 30 %
increase in sales annually for US multinational companies. For these
corporations navigating the trade war will be problematic even with the Phase
One agreement. Our post characterizing
this major change in world trade can be found at: Navigating
a Two Block Trading World.
The U.S. has placed sanctions on Chinese
sponsored network provider Huawei, effectively limiting the network vendor from
US government and private networks. The
Phase One agreement includes the US canceling planned tariffs for December 15th
in 2019 and rolling back tariffs to 7.5 % on $120 billion of goods imposed on
September 1st of last year. Yet, tariffs of 25 % remain in place on
$250 billion of Chinese goods. The
Chinese have canceled retaliatory tariffs planned for December 15th
and plan to increase purchases of US goods and services by $200 billion over
two years. In addition, China will purchase US agriculture products at a $40
billion rate per year from a baseline of $24 billion in 2017. If the
Chinese follow through on their purchase commitments US companies should see
increased sales. However, history on
Chinese purchases shows they forecast large purchases but small purchases are
A major trade issue has been created when the
US decided not to appoint any new judges to the World Trade Organization court
for disputes. The court cannot hear or make decisions on any disputes any
longer; meaning countries will resort to free-for-all negotiations on trade
disputes. We expect as economies falter, nationalist policies on trade will gain
more popularity and world trade will continue to decline after a slight
blip up from the U.S.-China Phase One deal.
Sources: BCOT Research, The Wall Street
Journal, The Daily Shot – 12/16/19
Finally, prior to the trade war global trade
has been facing major headwinds. Since 2008, global firms have looked to open
more international markets to sell their goods, but have met sales resistance
causing revenue and profits to be flat or decline. We expect the flattening of global
sales to output to continue and eventually decline as overall world trade falls.
CEOs in a Conference Board survey rate trade as
a major concern as they look at a highly uncertain economic picture. Marc Benioff, CEO of Salesforce, described
his concerns at a company all hands meeting last November:
“Because that issue (trade) is on the table,
then everybody has a question mark around in some part of their business,” he
said. “I mean, we’re in this strange economic time, we all know that.”
Myth 6. The Economy and Markets Are Insulated from World Politics
Protests have broken out in Hong Kong, Iraq, Iran, Chile, and other world cities while stock markets continue their climb. Yet, when the U.S. killed a key Iranian general the overnight S &P futures market fell 41 pts before recovering and closing 23 pts lower. The VIX soared 22 % overnight before settling back to close for a 12 % increase at 14.02. The U.S. – Iran conflict does not seem to be under control with most Middle East analysts predicting a major retaliation by the Iranian government. The price of oil spiked 4 % before settling to a 3.57 % increase on fears the Iranians may attack oil tankers in the Gulf. An escalating conflict will drive oil prices higher, disturb supply chains and likely tip the world economy into a recession.
saw during the negotiations for the Phase One trade deal how rumors both in
China and the U.S. would send the S & P futures market up or down by 10 –
15 points depending upon whether the news was positive or negative. Algo
traders would drop 30k contracts in a matter of seconds to make huge moves in
SPX price, while the VIX was at 12.50, supposedly a calm market. The chart
below shows how positive and negative news whipsawed the market.
Liz Ann Sonders – Schwab – 12-7-19
news not only moves markets but the economy as well. When the president tweets a tariff threat,
consumers and industry move swiftly to buy those goods before their prices go
up. Businesses have to build the product
quickly, sell it and they are left with falling sales as future purchases are
pulled forward. Business to business
deals are caught up in this constant flip flop on trade policies as well. CEOs
must make investment decisions to build a plant in a particular country 1 – 3
years in advance. They must calculate their allocation plans based on
inadequate information and in a highly uncertain policy environment. Often, rather
than make an investment decision, executives will wait for the economic clouds
The current bull market run has set record highs continuously. Yet, as the saying goes: markets go up in stair steps and down in an elevator. As a selling panic sets in the market goes into a free fall. If an economic myth is revealed by market action, corporate results, economic reports or an event the loss of belief causes the market to fall much faster than a slow stair step up.
The prudent investor will recognize the end of
the business cycle is likely underway. It is time to prepare for an economic
slowdown and a resulting equity market reversion to the mean. A reversion to
the mean quite often requires that markets swing beyond the mean.
The wary investor will ask hard questions of
their financial advisor and review corporate reports with an eye on fundamentals.
Financial success is likely to result from good risk management and
implementation combined with agility to make mid-course corrections. Investors should test their assumptions based
on breaking trends that may impact portfolio performance. At the same time, constantly flipping
investments will lead to poor performance. Allocate funds to different
portfolio groups based on long, medium and short term goals to keep from being
emotionally swept up in temporary market swings. The key is to be prepared for
the unknown, or a black swan event. Expect
the unexpected and consider the advice of market legends like Bernard Baruch:
“Some people boast of selling at the top of
the market and buying at the bottom – I don’t believe this can be done. I had
bought when things seemed low enough and sold when they seemed high enough. In
that way, I have managed to avoid being swept along to those wild extremes
of market fluctuations which prove so disastrous.”
Patrick Hill is
the Editor of The Progressive Ensign, https://theprogressiveensign.com/
writes from the heart of Silicon Valley, leveraging 20 years of experience as
an executive at firms like HP, Genentech, Verigy, Informatica and Okta to
provide investment and economic insights. Twitter: @PatrickHill1677.
Is Inflation Really Under Control
analysts have been discussing the pros and cons of using negative interest
rates to keep the U.S. economy growing. Despite
this, Fed Chairman Jerome Powell has said that he does not anticipate the
Federal Reserve will implement a policy of negative interest rates as it may be
detrimental to the economy. One argument
against negative interest rates is that they would squeeze bank margins and
create more financial uncertainty. However, upon examining the actual rate of
inflation we are likely already in a ‘de facto’ negative interest
rate environment. Multiple inflation data sources show that actual inflation maybe
5%. With the ten year Treasury bond at 1.75%, there is an interest rate gap of – 3.25%. Let’s look at multiple inflation data
points to understand why there is such a divergence
between the Fed assumptions that inflation is under control versus the much
higher rate of price hikes consumers experience.
October, the Bureau of Labor Statistics (BLS) reported that the core consumer
price index (CPI) grew by 2.2% year over year.
The core CPI rate is the change in the price of goods and services minus
energy and food. Energy and food are not
included because they are commodities and trade with a high level of
volatility. However, the Median CPI
shows a ten year high at 2.96% and upward trend as we would expect, though it
starts at a lower level than other inflation indicators. The Median CPI
excludes items with small and large price changes.
Source: Gavekal Data/Macrobond, The Wall Street Journal, The Daily Shot – 11-29-19
key items that have small and large price changes is not what a consumer buying
experience is like. Consumers buy based
on immediate needs. When a consumer drives up to a gas pump, they buy at the
price listed on the pump that day. Consumers
buying groceries don’t wait for food commodity prices to go down; they have to pay the price when they need the
food. Recent consumer purchase research shows that prices of many goods and
services continue to increase at a rate much higher than 2.2%.
Haskett Research Advisors conducted a study by purchasing a basket of 76 typical
items consumers buy at Walmart and Target.
The study showed that from June 2018 to June 2019, prices increased
Gordon Haskett Research Advisors, Bloomberg – 8/10/19
and Target are good proxies for consumer buying experiences. Walmart is the
largest retailer in the U.S. with over 3,000 locations marketing to price-conscious
consumers. Target has 1,800 locations in the U.S. and is focused on a similar
consumer buyer profile, though a bit less price sensitive. Importantly, both
Walmart and Target have discount food sections in their stories.
has been rapidly increasing in cost as well.
Rental costs have soared in 2019 as the following chart shows a month
over month shift to .45%, which is an annualized rate of 5.4%.
Bureau of Labor Statistics, Nomura – 5/13/19
of other services like health care and education have increased dramatically as
well. Service sectors, which make up 70% of the U.S. economy, are where wages
are generally higher than in manufacturing sectors. Techniques to increase
service productivity have been slow to implement due to service complexity. Without
productivity gains, prices have continued to rise in most services sectors.
Deutsche Bank – 11/14/19
care costs have increased by 5.2% per year, and education costs have risen 6.8
% per year. Wages of non-supervisory and production workers have fallen behind
at 3.15 % increase per year. Note that the overall CPI rate significantly
underestimates the rate of costs in these basic consumer services, likely due
to underweighting of services in the cost of living calculation.
consumers, housing, utilities, health care, debt payments, clothing, and
transportation comprise their major expenses. Utility and clothing costs have
generally declined. While transportation, housing, and health care costs have
increased. The rate of new car annual inflation
was as low as 1 percent in 2018. Yet, according
to Kelly Blue Book, the market shift to SUVs, full-sized trucks, and increasing
Tesla sales have caused average U.S. yearly vehicle prices to zoom 4.2% in 2019.
The soaring price of vehicles has caused auto loans to be extended out to 7 or
8 years, in some cases beyond the useful life of the car.
are financing 25% of new car purchases with ‘negative equity deals’ where the
debt from a previous vehicle purchase is rolled into the new loan. The October consumer spending report shows
consumer spending up by .3% yet durable goods purchases falling by .7%
primarily due to a decline in vehicle purchases. A 4.2%
increase in vehicle prices year over year is unsustainable for most buyers and
indicates likely buyer price resistance resulting in falling sales.The October durables sales decline could have
been anticipated if inflation reporting was based on actual consumer purchasing
wars with China, Europe, and other countries are contributing to significant price
increases for consumer goods. Tariffs
have driven consumer prices higher for a variety of product groups, including:
appliances, furniture, bedding, floor coverings, auto parts, motorcycles, sports
vehicles, housekeeping supplies, and sewing equipment.
Department of Commerce, Goldman Sachs, The Wall Street Journal, The Daily Shot
chart above, prices increased by about 3.5% over 16 months before mid-May 2019.
As uncertainty in the trade wars grows and earlier cheaper supplies are sold, prices
will likely continue to rise. The President has announced new tariffs of 15% on
$160 billion of Chinese consumer goods for December 15th if a Phase
One deal is not signed. On December 2nd, he announced resuming
tariffs on steel and aluminum imports from Argentina and Brazil and 100 %
tariffs on $2.4 billion of French goods. The implementation of all these
tariffs on top of existing tariffs will only make consumer inflation worse. Tariffs are driving an underlying
inflationary trend that is being under-reported by government agencies.
Evidently, the prices for goods and
services that consumers experience are vastly different from what the federal
government reports and uses to establish cost of living increases for programs
like Social Security. So, why is there a disconnect between the government CPI rate
of 2.2% and consumer reality of inflation at approximately 5%? The raw data that the Bureau of Labor
Statistics (BLS) uses to calculate the CPI rate is not available to the
public. When a Forbes reporter asked the
BLS why the data was not available to the public the BLS response was companies
could ‘compare prices’. This assumption does not make sense as companies can compare
prices on the Internet, in stores, or find out from suppliers. The ‘basket of
consumer items’ approach was discontinued in the 1980s for a ‘cost of living’
index based on consumer buying behaviors. There was political pressure to keep
the inflation rate low. If real inflation figures were reported the government
would have to increase payments to Social Security beneficiaries, food stamp
recipients, military and Federal Civil Service retirees and survivors, and
children on school lunch programs. Over
the past 30 years the BLS has changed the
calculation at least 20 times, but due to data secrecy there is no way to audit
the results. The BLS tracks prices on 80,000 goods and services based on
consumer spending patterns, not price changes on goods and services per
se. For example, if consumers substitute
another item for a higher-priced one it is discontinued in the
Williams has calculated inflation rates based upon the pre-1980s basket
approach versus the cost of living formula used by BLS today. His findings show a dramatically higher rate
of inflation using the 1980s formula.
Government – 10/2019
using the earlier basket formula sets the present inflation rate at nearly
10%. Based on our research on various
price reporting services, we think the real consumer inflation rate is probably
about 5 to 6%.
of this gap between real inflation and reported inflation rates are profound
and far-reaching. Federal Reserve
complacency about a low inflation rate to justify a low Fed Funds rates is
called into question. In fact the
economic reality of today is we are living in a 3.25% ‘de facto’ negative interest rate environment where
the ten year Treasury bond rate is 1.75%, and inflation is 5%. The liquidity
pumping into the economy, based in part on low inflation, is overheating risk
assets while providing support for corporate executives to take on debt at decade
economic framework on erroneous inflation data versus the reality for consumers
and businesses lead to massive financial dislocations. This economic bubble is
unsustainable and will require a brutal recession to rebalance the
economy. As part of a possible soft
‘landing’ policy, the BLS could make price data available to all economists.
Full data access will provide an opportunity for objective comments and
feedback based on other consumer price research.
The Fed actually
focuses on the even lower Personal Consumption Expenditure rate of 1.6%
reported by the Bureau of Economic Analysis for October. The Fed prefers the
PCE rate because a consumer survey technique is used, while economists prefer
the CPI, which is more granular so it is easier to identify goods and services categories
that are driving inflation. Using
unrealistically low inflation assumptions leads to misguided policy decisions
and perpetuation of the myth that inflation is under control. Yet, in fact
inflation it is out of control due to extremely low Fed interest rates,
liquidity injections, and trade war tariffs.
Patrick Hill is the Editor of The Progressive Ensign, writes from the heart of Silicon Valley, leveraging 20 years of experience as an executive at firms like HP, Genentech, Verigy, Informatica and Okta to provide investment and economic insights. Twitter: @PatrickHill1677.
Trump recently nominated Judy Shelton to fill an open seat on the Federal
Reserve Board. She was recently quoted by the Washington Post as follows: “(I) would lower rates as fast, as efficiently,
and as expeditiously as possible.” From a political perspective there is no
doubting that Shelton is conservative.
Yellen, a Ph.D. economist from Brooklyn, New York, appointed by President
Barack Obama, was the most liberal Fed Chairman in the last thirty years.
appears to be polar opposite political views, Mrs. Shelton and Mrs. Yellen have
nearly identical approaches regarding their philosophy in prescribing monetary
policy. Simply put, they are uber-liberal when it comes to monetary policy,
making them consistent with past chairmen such as Ben Bernanke and Alan
Greenspan and current chairman Jay Powell.
In fact, it
was Fed Chairman Paul Volcker (1979 to 1987), a Democrat appointed by President
Jimmy Carter, who last demonstrated a conservative approach towards monetary
policy. During his term, Volcker defied presidential “advice” on multiple occasions
and raised interest rates aggressively to choke off inflation. In the short-term,
he harmed the markets and cooled economic activity. In the long run, his
actions arrested double-digit inflation that was crippling the nation and laid the
foundation for a 20-year economic expansion.
Today, there are no conservative monetary policy makers at the Fed. Since Volcker, the Fed has been run by self-described liberals and conservatives preaching easy money from the same pulpit. Their extraordinary policies of the last 20 years are based almost entirely on creating more debt to support the debt of yesteryear as well as economic and market activity today. These economic leaders show little to no regard for tomorrow and the consequences that arise from their policies. They are clearly focused on political expediency.
Different Roads but the Same Path
Sanders, Alexandria Ocasio-Cortez, Elizabeth Warren, and a host of others from
the left-wing of the Democrat party are pushing for more social spending. To
support their platform they promote an economic policy called Modern Monetary
Theory (MMT). Read HERE
for our thoughts on MMT.
In general, MMT
would authorize the Fed to print money to support government spending with the
intention of boosting economic activity. The idealized outcome of this scheme
is greater prosperity for all U.S. citizens. The critical part of MMT is that it
would enable the government to spend well beyond tax revenue yet not owe a
Trump blamed the Fed for employing conservative monetary policy and limiting
economic growth when he opined, “Frankly,
if we didn’t have somebody that would raise interest rates and do quantitative
tightening (Powell), we would have been at over 4 instead of a 3.1.”
President Trump took office, U.S government debt has risen by approximately $1
trillion per year. The remainder of the post-financial crisis period saw
increases in U.S. government debt outstanding of less than half that amount. Despite what appears to be polar opposite
views on just about everything, under both Republican and Democratic
leadership, Congress has not done anything to slow spending or even consider
the unsustainable fiscal path we are on. The last time the government ran
such exorbitant deficits while the economy was at full employment and growing
was during the Lyndon B. Johnson administration. The inflationary mess it
created were those that Fed Chairman Volcker was charged with cleaning up.
From the top down, the U.S.
government is and has been stacked with fiscal policymakers who, despite their
political leanings, are far too undisciplined on the fiscal front.
We frequently assume that a candidate of a certain political party has views corresponding with those traditionally associated with their party. However, in the realm of fiscal and monetary policy, any such distinctions have long since been abandoned.
the current stance of Democratic and Republican fiscal and monetary policy within
the TRUST framework. Government leaders are pushing for unprecedented doses of
economic stimulus. Their secondary goal
is to maximize growth via debt-driven spending. Such policies are fully
supported by the Fed who keeps interest rates well below what would be
considered normal. The primary goal of
these policies is to retain power.
To keep interest
rates lower than a healthy market would prescribe, the Fed prints money. When
policy consistently leans toward lower than normal rates, as has been the case,
the money supply rises. In the wake of the described Fed-Government partnership
lies a currency declining in value. As discussed in prior articles, inflation,
which damages the value of a currency, is always the result of monetary policy
If the value
of a currency rests on its limited supply, are we now entering a phase where
the value of the dollar will begin to get questioned? We don’t have a definitive answer but we know with 100% certainty that
the damage is already done and the damage proposed by both political parties
increases the odds that the almighty dollar will lose value, and with that,
TRUST will erode. Recall the graph of the dollar’s declining purchasing
power that we showed in Part 1.
Data Courtesy St. Louis Federal Reserve
If the value
of the dollar and other fiat currencies are under liberal monetary and fiscal
policy assault and at risk of losing the valued TRUST on which they are 100% dependent,
we must consider protective measures for our hard-earned wealth.
underlying appreciation of the TRUST supporting our dollars, the definition of
terms becomes critically important. What, precisely, is the difference between
currency and money?
defined as natural element number 79 on the periodic table, but what interests
us is not its definition but its use. Although gold is and has been used for
many things, its chief purpose throughout the 5,000-year history of
civilization has been as money.
to Congress on December 18, 1912, J.P. Morgan stated: “Money is gold, and nothing else.” Notably, what he intentionally
did not say was money is the
dollar or the pound sterling. What his statement reveals, which has long since
been forgotten, is that people are paid for their labor through a process that
is the backbone of our capitalist society. “Money,” properly defined, is a
store of labor and only gold is money.
In the same
way that cut glass or cubic zirconium may be made to look like diamonds and
offer the appearance of wealth, they are not diamonds and are not valued as
such. What we commonly confuse for money today – dollars, yen, euro, pounds –
are money-substitutes. Under an
evolution of legal tender laws since 1933, global fiat currencies have
displaced the use of gold as currency. Banker-generated
currencies like the dollar and euro are not based on expended labor; they are
based on credit. In other words, they do not rely on labor and time to
produce anything. Unlike the efforts required to mine gold from the ground,
currencies are nearly costless to produce and are purely backed by a promise to deliver value in exchange for
and workers are willing to accept paper currency in exchange for their goods
and services in part because they are required by law to do so. We must TRUST that we are being compensated in a
paper currency that will be equally TRUSTed by others, domestically, and
internationally. But, unlike money, credit includes the uncertainty of “value”
a bank liability which explains why failing banks with large loan losses are not
able to fully redeem the savings of those who have their currency deposited
there. Gold does not have that risk as there is no intermediary between it and
value (i.e., the U.S. government or the Japanese government). Gold is money and
harbors none of these risks, while currency is credit. Said again for emphasis, only gold is money, currency is credit.
There is a
reason gold has been the money of choice for the entirety of civilization. The
last 90 years is the exception and not the rule.
Despite their actions and words, the value of gold, and disTRUST of the dollar is not lost on Central Bankers. Since 2013, global central banks have bought $140 billion of gold and sold $130 billion of U.S. Treasury bonds. Might we say they are trading TRUST for surety?
To repeat, currency, whether
dollars, pounds, or wampum, are based on nothing more than TRUST. Gold and its
5000 year history as money represents a dependable store of labor and real
value; TRUST is not required to hold gold. No currency in the history of humankind,
the almighty U.S. dollar included, can boast of the same track record.
TRUST hinges on decision
makers who are people of character and integrity and willingness to do what is
best for the nation, not the few. Currently, both political parties are taking
actions that destroy TRUST to gain votes. While
political party narratives are worlds apart, their actions are similar.Deficits do matter because as they
accumulate, TRUST withers.
is not a call to action to trade all of your currency for gold, but we TRUST
this article provokes you to think more about what money is.
Federal Reserve Headlines – Fact or Fiction?
“When it becomes serious, you have to lie.” – Jean-Claude Juncker, former President of the Eurogroup of Eurozone finance ministers
On July 16, 2019, Chicago Federal Reserve President Charles Evans made a series of comments that were blasted across the financial news wires. In the headlines taken from his speech on the 16th and other statements over the past few weeks, Mr. Evans argues for the need to cut interest rates at the July 31st meeting and future meetings.
In this article, we look at his rationale and provide you with supporting graphs and comments that question his logic supporting the rate cuts. We pick on Charles Evans in this piece, but quite honestly, he is reiterating similar themes discussed by many other Fed members.
The issues raised here are important because the Fed continues to play an outsized role in influencing asset valuations that are historically high. As such, it is incumbent upon investors to understand when the Fed may be on the precipice of making a policy error. If asset prices rest on confidence in the Fed, what will happen when said confidence erodes?
The Fed’s Mandate
Before comparing reality with his recent headlines, it is important to clarify the Fed’s Congressional mandate as stated in the Federal Reserve Act. The entire Federal Reserve act can be found HERE. For this article, we focus on Section 2A- Monetary Policy Objectives as follows:
The stock market is at all-time highs, bond yields are well below “moderate,” unemployment stands at 50-year lows, and prices are stable. Based on the Fed’s objectives, there is certainly no reason to cut rates.
Evans Thoughts versus Reality
All of the headlines below in red are courtesy of Bloomberg News and the data is sourced from Bloomberg and the St. Louis Federal Reserve
There are a lot of risks out there, citing BREXIT
BREXIT, the UK withdrawal from the European Union (EU), passed in a public referendum over three years ago. Since then, lawmakers on both sides of the Channel have tried unsuccessfully to fulfill voters’ wishes. The exit was supposed to occur by March 29, 2019 but was extended to October 31, 2019. BREXIT is not a new risk. In fact, there was a high likelihood of a hard BREXIT in late March before the extension, and the Fed never mentioned it then as a reason to take action. Further, the Bank of England (BOE) and the European Central Bank (ECB), not the Fed, are the parties that should be first in line to mitigate any financial/monetary risks associated with Europe and any repercussions coming from BREXIT. At some point Fed action may be warranted if a hard BREXIT occurs and rattles global economies. However, acting in advance on what might or might not happen is not the Fed’s job.
There are other risks, such as the ongoing trade war with China, the coming debt cap, and Iran to name a few. We ask you though, has there ever been a period where numerous concerns and risks did not exist?
Fed should not generate excess stimulus
The first graph quantifies the level of Fed Funds and the amount of QE, allowing us to compare monetary stimulus over the last 40 years. Clearly, the last ten years, including the current period, is excessive and if anything means the Fed should be removing “excess stimulus.”
Other evidence also indicates that current monetary policy is excessive. For instance, the graph below, courtesy of Mr. Evans own Chicago Federal Reserve, shows that national financial conditions are near the easiest of any period in the last 50 years. Of the 2,531 weekly data points in the graph, only 60 weekly periods (2.3%) had easier financial conditions than today. Again, conditions are easy because monetary policy is very accommodative. Excess is an appropriate term to describe the state of monetary policy and it may actually be an understatement.
We need to do everything we can to get to 2% inflation
The Federal Reserve Act clearly says the Fed should promote stable prices. Stable prices do not axiomatically mean 2% inflation as they have interpreted it. The Act also makes no mention of persistent inflation that compounds over time.
The following graph shows the level of prices since the Revolutionary War. From 1775 to 1971 prices were relatively stable, except during times of war. Since 1971, when Nixon revoked the gold standard and allowed the Fed carte blanche to manipulate the money supply, higher annual prices have accumulated, resulting in massive price inflation.
The Fed’s 2% inflation target is a far cry from the price stability mandate to which they are supposed to adhere.
Says path of U.S. economy is toward trend growth
Mr. Evans uses language that suggests U.S. GDP has been running below trend but making progress toward trend growth. Based upon data supplied by the St. Louis Fed, real GDP has been running above trend for the last eight quarters as shown below.
Inflation situation alone calls for two 25 basis point cuts by year’s end
The following graphs show various measures of inflation and inflation expectations. It is hard to point to any recent inflation trends in these graphs that have meaningfully changed from the trends of the last few years. Given this broad set of data, why does the current inflation “situation” warrant even more aggressive monetary policy action?
Economic fundamentals are solid / U.S. economy is really quite solid
Mr. Evans is right. GDP was a little soft in the second quarter, but it was running above trend for the prior eight quarters. With Fed Funds still at dangerously low levels, the Fed’s balance sheet swollen beyond any historical precedent, and the economy “really quite solid,” his call for rate cuts does not reconcile with his own assessment of the economy.
Says he forecasts 50 basis points of accommodation to lift inflation
Using data going back to 1990, the graph below shows that there is no statistical relationship between the Fed’s (current) preferred measure of inflation (PCE) and the Fed Funds rate they manage. PCE measured a year forward to the current Fed Funds rate demonstrates even less of a relationship.
Based on data provided by the Fed, the idea that the Fed possess a magical joystick which enables them to control prices is fallacious. Evan’s statement lacks any statistical backing and is a complete guess at best. At worst, it is an intentional effort to influence public sentiment improperly.
The conclusions here suggest that Evans logic is flawed and misleading. Based on his arguments, the Fed has no basis to cut interest rates. Fed speakers that modify their language daily, as they have been doing over the prior month or two, to conjure support for rate cuts put their integrity and investor confidence in the Fed at risk.
The primary objective of Fed policy should be geared toward imperceptible adjustments to foster a well-functioning market-based economy. On the contrary, what we increasingly see is a market-economy increasingly jostled and cajoled by hair-on-fire day-traders posing as a monetary authority. By employing well publicized micro-management tactics, the Fed naturally increases the chances of a policy error. Indeed, the proper characterization of that risk is that the Fed increases the likelihood of further policy errors compounding the legacy issues already in play thanks to Powell’s predecessors.
Given the reliance of equity prices on the so-called “Fed Put” and the excessive valuations in many asset markets, we advise paying close attention as a policy error could quickly cause assets to re-price to properly reflect their inherent risks, and then some. Seldom do those adjustments stop at fair value.
In The Fed We Trust – Part 1
This article is the first part of a two-part article. Due to its length and importance, we split it to help readers’ better digest the information. The purpose of the article is to define money and currency and discuss their differences and risks. It is with this knowledge that we can better appreciate the path that massive deficits and monetary tomfoolery are putting us on and what we can do to protect ourselves.
How often do you think about what the dollar bills in your wallet or the pixel dollar signs in your bank account are? The correct definitions of currency and money are crucial to our understanding of an economy, investing and just as importantly, the social fabric of a nation. It’s time we tackle the differences between currency and money and within that conversation break the news to you that deficits do matter, TRUST me.
At a basic
level, currency can be anything that is broadly accepted
as a medium of exchange that comes in standardized units. In current times,
fiat currency is the currency of choice worldwide. Fiat currency is paper notes,
coins, and digital 0s and 1s that are governed
and regulated by central banks and/or
governments. Note, we did not use the word guaranteed to describe the role of
the central bank or government. The value and worth of a fiat currency rest solely on the TRUST of the receiver of the
currency that it will retain its value and the TRUST that others will accept it
in the future in exchange for goods and services.
Whether its yen,
euros, wampum, bitcoin, dollars or any other currency, as long as society is
accepting of such a unit of exchange, trade
will occur. When TRUST in the value of a currency wanes, commerce becomes
difficult, and the monetary and social
prosperity of a nation falters. The history books overflow with such examples.
Maslow and Currency
diving into the value of a currency, it is worth considering the role it plays
in society and how essential it is to our physical and mental well-being. This point
is rarely appreciated, especially by those that push policies that debase the
his famous pyramid to depict what he deemed the hierarchy of human needs. The
levels of his pyramid, shown below, represent the ordering of physiological and
psychological needs that help describe human motivations. When these needs are met, humans thrive.
up the pyramid by addressing their basic, lowest level needs. The core needs,
representing the base, are physiological needs including food, water, warmth
and rest. Once these basic needs are met,
one then seeks to attain security and safety. Without meeting these basic physiological
and safety needs, our psychological and
self-fulfillment needs, which are higher up the pyramid, are difficult to come
by. Further, as we see in some third-world countries, the social fabric of the
nation is torn to shreds when a large part of the population cannot satisfy their basic needs.
In modern society,
except for a few who live “off-the-grid,” fiat currency is the only means of
attaining these necessities. Possession of currency is a must if we are
to survive and thrive. Take a look back to the opening paragraphs and let’s
rephrase that last sentence: possession and
TRUST of currency is a must if we are to survive and thrive.
It is this
most foundational understanding of currency that keeps our economy humming, our
physical prosperity growing and our society stable. The TRUST backing the
dollar, euro, yen, etc. is essential to our financial, physical and
why we should not assume that TRUST is a permanent condition.
Deficits Don’t Matter…. or Do They?
the imperative connection between currency and TRUST and its linkage to trade
and commerce along with our physical and mental well-being,
we need to explore the current state of the United States government debt
burden, monetary policy, and the growing belief
that deficits don’t matter.
debt never matures, it is rolled over. Yes, a holder of a maturing Treasury bond
is paid in full at maturity, however, to secure the funds to pay that holder,
the government issues new debt by borrowing money from someone else. Over time, this scheme has allowed deficits to expand,
swelling the amount of debt outstanding. Think of this arrangement as taking
out a new credit card every month to pay off the old card.
below shows U.S. government debt as a percentage of GDP. Since 1967 government debt has grown annually 2% more than GDP.
Data Courtesy: St. Louis Federal
debt at a faster rate than economic growth (as shown above) is limited. To
extend the ability to do this requires declining interest rates, inflation and
a little bit of financial wizardry to make debt disappear. Fortunately, the
U.S. government has a partner in crime, the Federal Reserve.
As you read about
the Fed’s methods to help fund deficits, it is important to consider the
actions they routinely take are at the expense of the value of the currency. This warrants repeating since the value of the currency is what supports TRUST
in the currency and allows it to retain its
helps the government consistently run
deficits and increase their debt load in three
The Fed stokes moderate inflation.
The Fed manages interest rates lower
than they should be.
The Fed buys Treasury and mortgage securities
(open market operations/QE) and, as we are now witnessing, monetizes the debt.
Fed’s charter, Congress has mandated the Fed promote stable prices. To you and me, stable prices would likely mean no inflation or deflation. Regardless of what you and I think, the Fed interprets
the mandate as an annual 2% rate of inflation. Since the Fed was founded in 1913, the rate of inflation has
averaged 3.11% annually. That rate may seem
inconsequential, but it adds up. The
chart below illustrates how the low but consistent rate of inflation has
debased the purchasing power of the dollar.
Data Courtesy: St. Louis Federal
in 1913 can essentially be paid off with .03 cents today. Inflation has
certainly benefited debtors.
Interest Rate Management
better part of the last decade, the Fed
has imposed price controls that kept interest
rates below what should be considered normal. Normal, in a free market economy,
is an interest rate that compensates a lender for credit risk and inflation.
Since Treasury debt is considered “risk-free,” the predominant risk to Treasury
investors is earning less than the rate of inflation. As far as “risk-free”, read our article: The
Mind Blowing Concept of Risk-Free’ier.
If the yield
on the bond is less than inflation, as has recently been the case, the
purchasing power and wealth of the investor declines
in the future.
below highlights how U.S. Treasury real rates (yields less CPI) have trended
lower over the past forty years. In fact, over the last decade, negative real rates are the norm, not the exception. When investors are
not properly compensated by the U.S. Treasury, the onus of government
debt is partially being put upon
investors. We have the Fed to thank for their Fed Funds (FF) policy of negative
Data Courtesy: St. Louis Federal
Fed Balance Sheet
The Fed uses
its balance sheet to buy and sell U.S.
Treasury securities to manage the money supply and thus enforce their interest
rate stance. In 2008, their use of the balance sheet changed. From 2008 through
2013, the Fed purchased nearly $4 trillion of Treasury and mortgage-backed
securities in what is called Quantitative Easing (QE). By reducing the supply
of these securities, they freed up
liquidity to move to other assets within the capital markets. The action
propped up asset prices and helped keep interest
rates lower than they otherwise would have been.
Since 2018, they have reversed these actions by
reducing the size of their balance sheet in what is called Quantitative
Tightening (QT). This reversal of prior action essentially makes the benefits
of QE temporary. However, if they fail to reduce it back to levels that existed
before QE was initiated, then the Fed permanently monetized government
debt. In plain English, they printed money to extinguish debt.
As we write
this article, the Fed is in the process of ending QT. Based on the Fed schedule
as announced on March 20, 2019, the balance sheet will permanently end up $2.28
trillion larger than from when QE was initiated.
To put that in context, the balance will have grown 269% since 2008, as compared
to 48% economic growth.
Data Courtesy St. Louis Fed
the Fed employs to manage policy as described
above, all involve using their balance sheet to alter the money supply
and help the Treasury manage its deficits. We can argue the merits of such a policy, but we cannot argue a basic economics
law; when there is more of something, it is worth less. When something of value is created out of thin air, its
point is debt too onerous, deficits too large and the Fed too aggressive such that
TRUST is harmed? No one knows the answer
to that question, but given the
importance of TRUST in a fiat currency regime, it would be wise to avoid
actions that could raise doubt. Contrary to that guidance, current fiscal and
monetary policy throws all TRUST to the wind.
Prelude to Part 2
grow and government debt becomes more onerous, the amount of Fed intervention
must become greater. To combat this growing problem, both political
parties are downplaying deficits and pushing the Fed to do more. In part 2 we
will explore emerging fiscal mindsets and what they might portend. We will then
define money, and with this definition, show why the difference between
currency and money is so important.
Inflation: The Fed’s False Flag
“Don’t piss down my back and tell me it’s raining” –Clint Eastwood/The Outlaw Josey Wales
On April 30,
2019, one day before the Federal Reserve’s FOMC policy-setting meeting, the
Wall Street Journal published an article by Nick Timiraos and Paul Kiernan
Is Likely to Fuel Discussions as Fed Officials Meet. We quickly
recognized this article was not the thoughts of the curious authors but more
than likely indirect Fed messaging.
Similar to a
trial balloon, conveyances like the one linked above allow the Fed to gauge
market response to new ideas and prepare the markets and public for potential
changes in policy.
Based on numerous
articles published over the last two weeks, we are under growing suspicion that
the Fed wants us to believe we need more inflation. For their part, the Fed in
the May 1, 2019, FOMC policy statement changed language from the prior
statement to highlight that inflation is not running at their 2% target but it
is “running below” their goal.
Is declining inflation a legitimate concern or a false flag meant to provide cover to lower rates?
The WSJ article
published the day before the FOMC policy meeting has the Fed’s fingerprints all
over it. The gist of the article is that inflation is running below the two
percent goal and therefore needs to be addressed.
following quotes come from that article:
Lower inflation remains the fly in
Officials worry that the failure to
hit the inflation target could undermine its credibility over time, which could
cause consumers and businesses to expect lower inflation in the future, which
in turn could cause price pressures to weaken further.
If officials grew concerned that the
(inflation) shortfall was persistent, some could push for lowering rates.
Not to be
outdone, Neil Irwin of the New York Times, in discussing how the Fed might
fight the next recession, stated:
“In the near term, any changes are
likely to tilt policy in the direction of having lower interest rates for
longer periods, with the aim of getting inflation to more consistently
average 2 percent (it has been consistently below that level for
These and a
slew of comments from Fed officials, the media and market prognosticators lead
us to believe the Fed is now using a lack of inflation to justify lowering
quarter 2019 GDP was just reported at 3.2% and has grown in each of the last 12
quarters, an unprecedented string of consecutive increases in GDP growth. The
unemployment rate and jobless claims are at or near 50-year lows. Despite the
solid economic growth and strong labor market, the amount of monetary and
fiscal stimulus being employed is immense as we have documented on numerous
occasions. Fed Funds at 2.5%, while off of the zero bound, is still well below
rates of the prior 50 years. The Fed’s balance sheet, despite some run-off, is still
four times larger than where it stood pre-financial crisis.
Since the economy and labor markets are strong and monetary policy very easy, inflation appears to be the only factor that the Fed could use to justify adopting an easier policy stance.
The Smoking Gun
Before considering inflation data, it’s worth reviewing the Fed’s thoughts about inflation as it relates to monetary policy. On October 2, 2018, Chairman Powell stated the following:
From the standpoint of contingency
planning, our course is clear: Resolutely conduct policy consistent with the
FOMC’s symmetric 2 percent inflation objective, and stand ready to act with
authority if expectations drift materially
up or down.
Given the statement above, is
Inflation or inflation expectations materially changing?
Below are six
charts to help you decide if inflation or inflation expectations are moving materially lower. If not, is inflation the
Trojan horse that allows the Fed to lower rates despite any reasonable
rationale? All of the data for the graphs below are sourced from Bloomberg.
Fed’s Own Inflation Measures
two graphs are inflation indicators that the Fed created. They are designed to reduce
temporary blips in the prices of all goods and services within the CPI and GDP
reports. The Federal Reserve believes these measures present a more durable
reading that is not as subject to transitory forces as other inflation measures.
inflation “expectations drift(ed) materially up or down?”
Looking at the ebbs and flows of inflation and inflation expectations of the last three years, we see no consistent change in the trend. As for the dreaded fear of deflation, the United States has not experienced it since the Great Depression in the 1930’s. In our opinion, this recent talk about lower inflation is a sad case of the Fed manufacturing a story to justify easier monetary policy.
with a message for the Federal Reserve- If you want to lower rates then lower
rates, but please do not feign concern about inflation trends that are
non-existent as cover for such moves. You preach transparency, so be
Quick Take: Bulls Attempt A “Jailbreak”
Yesterday, I discussed the “compression” of the market being akin to a “coiled spring” that when released could lead to a fairly decent move in one direction or another. To wit:
“As you can see in the ‘reddish triangle,’ prices have been continually compressed into an ever smaller trading range. This ‘compression’ is akin to coiling a spring. The more tightly the spring is wound, the more energy it has when it is released.”
As shown, the bulls are “attempting a jailbreak” of the “compression” that has pressured markets over the last two months. While the breakout is certainly encouraging, there isn’t much room before it runs into a more formidable resistance of the 100-day moving average. Furthermore, with interest rates closing in on 3% again, which has previously been a stumbling point for stock prices, it is too soon to significantly increase equity risk in portfolios.
This is just one day.
As I stated previously, as a portfolio manager I am not too concerned with what happens during the middle of the trading week, but rather where the market closes on Friday. This reduces the potential for “head fakes” as we saw last week with the break of the of the 200-dma on Thursday which was quickly reversed on Friday. The weekly close was one of the two outcomes as noted in our previous Quick-Take:
“If the market closes ABOVE the 200-dma by the close of the market on Friday, we will simply be retesting support at the 200-dma for the fourth time. This will continue to keep the market trend intact and is bullish for stocks.”
This breakout will provide a reasonable short-term trading opportunity for portfolios as I still think the most probable paths for the market currently are the #3a or #3b pathways shown above.
If we get a confirmed break out of this “compression range” we have been in, we will likely add some equity risk exposure to portfolios from a “trading” perspective. That means each position will carry both a very tight “stop price” where it will be sold if we are wrong as well as a “profit taking” objective if we are right.
Longer-term investments are made when there is more clarity about future returns. Currently, clarity is lacking as there are numerous “taxes” currently weighing on the markets which will eventually have to be paid.
Rising oil and gasoline prices (Tax on consumers)
Fed bent on hiking rates and reducing their balance sheet. (Tax on the markets)
Potential trade wars (Tax on manufacturers)
Geopolitical tensions with North Korea, Russia, China and Iran(Tax on sentiment)
We continue to hold higher levels of cash, but have closed out most of our market hedges for now as we giving the markets a bit more room to operate.
With longer-term indicators at very high levels and turning lower, we remain cautious longer-term. However, in the short-term markets can “defy rationality” longer than anyone can imagine. But it is in that defiance that investors consistently make the mistake of thinking “this time is different.”
It’s not. Valuations matter and they matter a lot in the long-term. Valuations coupled with rising interest rates, inflationary pressures, and weak economic growth are a toxic brew to long-term returns. It is also why it is quite possible we have seen the peak of the market for this year.
I will update this “Quick Take” for the end of the week data in this coming weekend’s newsletter.(Subscribe at the website for email delivery on Saturday)
The Myth Of “Buy & Hold” – Why Starting Valuations Matter
If you repeat a myth often enough, it will eventually be believed to be the truth.
“Stop worrying about the market and just buy and hold stocks.”
Think about this for a moment. If it were true, then:
Why do major Wall Street firms have proprietary trading desks? (They aren’t buying and holding.)
Why are there professional hedge fund managers? (They aren’t buying and holding either)
Why is there volatility in the market? (If everyone just bought and held, prices would be stable.)
Why does Warren Buffett say “buy fear and sell greed?” (And why is he holding $115 billion in cash?)
Why are there financial channels like CNBC? (If everyone bought and held, there would be no viewers.)
Most importantly, why isn’t everyone wealthy from investing?
Because “buying and holding” stocks is a “myth.”
Wall Street is a business. A very big business which generates huge profits by creating products and selling it to their consumers – you. Just how big? Here are the sales and net income for some of the largest purveyors of investment products:
There is nothing wrong with this, of course. It is simply “the business.”
It is just important to understand exactly which side of the transaction everyone is on. When you sell your home, there is you, the buyer and Realtor. It is clearly understood that when the transaction is completed the Realtor is going to be paid a commission for their services.
In the financial world the relationship isn’t quite as clear. Wall Street needs its customers to “sell” product to, which makes it less profitable to tell “you” to “sell” when they need you to “buy the shares they are selling for the institutional clients.”
Don’t believe me? Here is a survey that was conducted on Wall Street firms previously.
“You” ranked “dead last” in importance.
Most importantly, as discussed previously, the math of “buy and hold” won’t get you to your financial goals either. (Yes, you will make money given a long enough time horizon, but you won’t reach your inflation-adjusted retirement goals.)
“But Lance, the market has historically returned 10% annually. Right?”
Correct. But again, it’s the math which is the problem.
Historically, going back to 1900, using Robert Shiller’s historical data, the market has averaged, more or less, 10% annually on a total return basis. Of that 10%, roughly 6% came from capital appreciation and 4% from dividends.
Average and Annual or two very different things. Investors may have AVERAGE 10% annually over the last 118 years, but there were many periods of low and negative returns along the way.
You won’t live 118 years unless you are a vampire.
The Entire Premise Is Flawed
If you really want to save and invest for retirement you need to understand how markets really work.
Markets are highly volatile over the long-term investment period. During any time horizon the biggest detractors from the achievement of financial goals come from five factors:
Lack of capital to invest.
Psychological and behavioral factors. (i.e. buy high/sell low)
Despite your best intentions to “buy and hold” over the long-term, the reality is that you will unlikely achieve those promised returns.
While the inability to participate in the financial markets is certainly a major issue, the biggest reason for underperformance by investors who do participate in the financial markets over time is psychology.
Behavioral biases that lead to poor investment decision-making is the single largest contributor to underperformance over time. Dalbar defined nine of the irrational investment behavior biases specifically:
Loss Aversion – The fear of loss leads to a withdrawal of capital at the worst possible time. Also known as “panic selling.”
Narrow Framing – Making decisions about on part of the portfolio without considering the effects on the total.
Anchoring – The process of remaining focused on what happened previously and not adapting to a changing market.
Mental Accounting – Separating performance of investments mentally to justify success and failure.
Lack of Diversification – Believing a portfolio is diversified when in fact it is a highly correlated pool of assets.
Herding– Following what everyone else is doing. Leads to “buy high/sell low.”
Regret – Not performing a necessary action due to the regret of a previous failure.
Media Response – The media has a bias to optimism to sell products from advertisers and attract view/readership.
Optimism – Overly optimistic assumptions tend to lead to rather dramatic reversions when met with reality.
These two behaviors tend to function together compounding the issues of investor mistakes over time. As markets are rising, individuals are lead to believe that the current price trend will continue to last for an indefinite period. The longer the rising trend last, the more ingrained the belief becomes until the last of “holdouts” finally “buys in” as the financial markets evolve into a “euphoric state.”
As the markets decline, there is a slow realization that “this decline” is something more than a “buy the dip” opportunity. As losses mount, anxiety increases until individuals seek to “avert further loss” by selling.
This is the basis of the “Buy High / Sell Low” syndrome that plagues investors over the long-term.
However, without understanding what drives market returns over the long term, you can’t understand the impact the market has on psychology and investor behavior.
Over any 30-year period the beginning valuation levels, the price you pay for your investments has a spectacular impact on future returns. I have highlighted return levels at 7-12x earnings and 18-22x earnings. We will use the average of 10x and 20x earnings for our savings analysis.
As you will notice, 30-year forward returns are significantly higher on average when investing at 10x earnings as opposed to 20x earnings or where we are currently near 25x.
For the purpose of this exercise, I went back through history and pulled the 4-periods where valuations were either above 20x earnings or below 10x earnings. I then ran a $1000 investment going forward for 30-years on a total-return, inflation-adjusted, basis.
At 10x earnings, the worst performing period started in 1918 and only saw $1000 grow to a bit more than $6000. The best performing period was not the screaming bull market that started in 1980 because the last 10-years of that particular cycle caught the “dot.com” crash. It was the post-WWII bull market than ran from 1942 through 1972 that was the winner. Of course, the crash of 1974, just two years later, extracted a good bit of those returns.
Conversely, at 20x earnings, the best performing period started in 1900 which caught the rise of the market to its peak in 1929. Unfortunately, the next 4-years wiped out roughly 85% of those gains. However, outside of that one period, all of the other periods fared worse than investing at lower valuations. (Note: 1993 is still currently running as its 30-year period will end in 2023.)
The point to be made here is simple and was precisely summed up by Warren Buffett:
“Price is what you pay. Value is what you get.”
This is shown in the chart below. I have averaged each of the 4-periods above into a single total return, inflation-adjusted, index, Clearly, investing at 10x earnings yields substantially better results.
So, with this understanding let me return once again to those that continue to insist the “buy and hold” is the only way to invest. The chart below shows $3000 invested annually into the S&P 500 inflation-adjusted, total return index at 10% compounded annually and both 10x and 20x valuation starting levels. I have also shown $3000 saved annually in a mattress.
The red line is 10% compounded annually. You won’t get that, but it is there so you can compare it to the real returns received over the 30-year investment horizon starting at 10x and 20x valuation levels. The shortfall between the promised 10% annual rates of return and actual returns are shown in the two shaded areas. In other words, if you are banking on some advisors promise of 10% annual returns for retirement, you aren’t going to make it.
I want you to take note of the following.
When investing your money at valuations above 20x earnings, it takes 22-years before it has grown more than money stuffed in a mattress.
Why 22 years?
Take a look at the chart below.
Historically, it has taken roughly 22-years to resolve a period of over-valuation. Given the last major over-valuation period started in 1999, history suggests another major market downturn will mean revert valuations by 2021.
The point here is obvious, but difficult to grasp from a mainstream media that is continually enticing young Millennial investors to mistakenly invest their savings into an overvalued market. Saving your money, and waiting for a valuation based opportunity to invest those savings in the market, is the best, safest way, to invest for your financial future.
Of course, Wall Street won’t like this much because they can’t charge you a fee if you are sitting on a mountain of cash awaiting the opportunity to “buy” their next misfortune.
But isn’t that what Baron Rothschild meant when quipped:
“Thetime to buy is when there’s blood in the streets.”
Quick Take: Market Breaks Important Support
I have often discussed that as a portfolio manager I am not too concerned with what happens during the middle of the trading week. The reason is daily price volatility can lead to many false indications about the direction of the market. These false indications are why so many investors suggest that technical analysis is nothing more than “voo doo.”
For me, price analysis is more about understanding the “trend” of the market and the path of least resistance for prices in the short and intermediate-term. This analysis allows for portfolio positioning to manage risk.
Over the last several weeks, I have been mapping out the ongoing correction in the market and have noted the important support that has been provided by the running 200-day moving average. The chart below is updated through this morning.
The break of the 200-dma today is not a good sign. Consolidation processes are much akin to the “coiling of a spring.” As prices become compressed, when those prices break out there is a “release of energy” from that compression which tends to lead to rather sharp moves in the direction of the breakout.
Importantly, the break of support today is NOT a signal to run out and sell everything. It is, however, a worrisome warning that should not be entirely dismissed.
As stated, nothing matters for me until we see where the market closes on Friday.
Here is what we are wanting to see:
If the market closes ABOVE the 200-dma by the close of the market on Friday, we will simply be retesting support at the 200-dma for the fourth time. This will continue to keep the market trend intact and is bullish for stocks.
If the market closes BELOW the 200-dma on Friday, the break of support will be confirmed, suggesting a downside failure of the consolidation pattern over the last couple of months. This break is bearish for the market and suggests higher levels of caution. Such will lead to two other options:
With the market oversold on a short-term basis, any rally that fails at the 200-dma will further confirm the downside break of the consolidation. This would suggest lower prices over the next month or so.
If the market recovers by early next week, above the 200-dma, positioning will remain on hold.
I am often asked why I don’t just take ONE position and make a call.
Because we can not predict the future. We can only react to it.
After having raised cash over the last couple of months on rallies, there isn’t much we need to do at the moment.
However, the weakness in the market, combined with longer-term sell signals as discussed on Tuesday, is suggesting the market has likely put in its top for the year.
We remain cautious and suggest the time to “buy” has not arrived yet.
Bull Markets Actually Do Die Of “Old Age”
David Ranson recently endeavored in a long research report to simply declare that “bull markets do not die of old age.”
“The life expectancy of bull markets can be inferred from history. Fourteen bull markets in U.S. stocks have come and gone since 1927, and their mean lifetime is 55 months. But this calculation can be taken further. From the age of one year to the age of eight years, there’s no overall tendency for life expectancy to decline as a market advance gets older. The present stock market advance, which began 105 months ago, is no more likely to end within the next twelve months than it was when it was only twelve months old. Bull markets do not die of old age.”
Think about this for a moment.
This is the equivalent of suggesting that since the average male dies at 88-years of age if he lives to be 100, he has no more chance of dying in the next 12-months than he did when he was 40-years old.
While a 100-year old male will likely expire within a relatively short time frame, it will not just “being old” that leads to death. It is the onset of some outside influence such as pneumonia, infection, organ failure, etc. that leads to the eventual death as the body is simply to weak to defend itself. While we attribute the death to “old age,” it was not just “old age” that killed the host.
This was a point that my friend David Rosenberg made in 2015 before the first rate hike:
“Equity bull markets never die simply of old age. They die of excessive Fed monetary restraint.”
First, averages and medians are great for general analysis but obfuscate the variables of individual cycles. To be sure the last three business cycles (80’s, 90’s and 2000) were extremely long and supported by a massive shift in a financial engineering and credit leveraging cycle. The post-Depression recovery and WWII drove the long economic expansion in the 40’s, and the “space race” supported the 60’s.
But each of those economic expansions did indeed come to an end. The table below shows each expansion with the subsequent decline in markets.
Think about it this way.
At 104 months of economic expansion in 1960, no one assumed the expansion would end at 105 months.
At 118 months no one assumed the end of the “dot.com mania” was coming in the next month.
In December of 2007, no one believed the worst recession since the “Great Depression” had already begun.
The problem for investors, and the suggestion that “bull markets don’t die of old-age,” is that economic data is always negatively revised in arrears. The chart below shows the recession pronouncements by the National Bureau Of Economic Research (NBER) and when they actually began.
The point here is simple, by the time the economic data is revised to reveal a recession, it will be far too late to do anything about it from an investment perspective. However, the financial market has tended to “sniff” out trouble
The Infections That Kill Old Bull Markets
Infection #1: Interest Rates
As noted by David Rosenberg, with the Fed continuing to hike rates in the U.S., tightening monetary conditions, the previous 3-year time horizon is now substantially shorter. More importantly, the “average” time frame between an initial rate hike and recession was based on economic growth rates which were substantially higher than they are currently.
Furthermore, as interest rates rise, so does the cost of capital. In a heavily leveraged economy, the change in interest expense has been a good predictor of economic weakness. As recently noted by Donald Swain, CFA:
“What if marginal interest expense pressures are the true recession signal (cause of economic weakness) and the yield curve is just a correlated input to that process? If so, for the first time, the Fed is hiking into what is already the most hostile refit period in 35-years.”
The point is that in the short-term the economy and the markets (due to momentum) can SEEM TO DEFY the laws of gravity as interest rates begin to rise. However, as rates continue to rise they ultimately act as a “brake” on economic activity. Think about the all of the areas that are NEGATIVELY impacted by rising interest rates:
Higher borrowing costs which lead to lower profit margins for corporations.
Stocks are cheap based on low-interest rates. When rates rise, markets become overvalued very quickly.
The economic recovery to date has been based on suppressing interest rates to spur growth.
Variable rate interest payments for consumers
Corporate share buyback plans, a major driver of asset prices, and dividend issuances have been done through the use of cheap debt.
Corporate capital expenditures are dependent on borrowing costs.
Infection #2: Spiking Input Costs
When rate hikes are combined with a surge in oil prices, which is a double whammy to consumers, there has been a negative outcome as noted by Peter Cook, CFA last week.
“A better record of predicting recessions is achieved when Fed has hiked rates by 2.00%-2.50%, AND oil prices have at least doubled. The price of money and energy are major financial inputs to financial planning, so when they simultaneously rise sharply, consumers and businesses are forced to retrench. Based on the Fed’s well-communicated strategy, it plans to raise rates another 0.75% during 2018 on top of the previous 1.50% over the past few years. If crude oil stays above $50-60, both conditions for a recession would be met in the second half of 2018.
Yet neither the Fed, or any high-profile economist, is predicting the beginning of a recession during 2019, let alone 2018. Answering the inflation/deflation question correctly is the most important issue of the day for investment portfolios. If recession/deflation arrives before growth/inflation, a major adjustment in expectations, and capital market prices, is coming within the next year.”
This shouldn’t be surprising.
In the past, when Americans wanted to expand their consumption beyond the constraint of incomes they turned to credit in order to leverage their consumptive purchasing power. Steadily declining interest rates, and lax lending standards, put excess credit in the hands of every American. Such is why, during the 80’s and 90’s, as the ease of credit permeated its way through the system, the standard of living seemingly rose in America even while economic growth slowed along with incomes.
“With a deficit between the current standard of living and what incomes, savings and debt increases can support, expectations of sustained rates of stronger economic growth, beyond population growth, becomes problematic.
For investors, that poses huge risks in the market.
While accounting gimmicks, wage suppression, tax cuts and stock buybacks may support prices in the short-term, in the long-term the market is a reflection of the strength of the economy. Since the economy is 70% driven by consumption, consumer indebtedness could become problematic.”
Infection #3 – Valuations
Lastly, it isn’t an economic recession that is truly problematic for investors.
If asset prices rose equally with increases in earnings, in other words the price-to-earnings ratio remained flat, then theoretically “bull markets” would last forever.
Unfortunately, since asset prices are a reflection of investor psychology, or “greed,” it is not surprising that economic recessions reveal the mispricing between the premium investors pay for a stream of earnings versus what they are really worth. As I noted just recently:
“Bull markets are born on pessimism, grow on skepticism, and die on euphoria.” -Sir John Templeton
Take a look at the chart below which is Robert Shiller’s monthly data back to 1871. The “yellow” triangles show periods of extreme undervaluation while the “red” triangles denote periods of excess valuation.
Not surprisingly, 1901, 1929, 1965, 1999, and 2007 were periods of extreme “euphoria” where “this time is different” was a commonly uttered phrase.
What the majority of mainstream analysis fails to address is the “full-cycle” of markets. While it may appear that “bull markets do not die of old age,” in reality, it is “old age that leaves the bull defenseless against infections.”
It is the impact of an exogenous event on an over-leveraged, extended and over-valued market that eventually leads to its death. Ignoring the “infections,” and opting for “hope,” has always led to emotionally driven mistakes which account for 50% of investor’s under-performance over a 20-year cycle.
With expectations rising the Fed will further tighten monetary policy, the vulnerabilities of an “aged bull market” will be an issue for investors in the future.
“In investing, the man who wins is the man who loses the least.”– Dick Russell
Analysts’ Estimates Go Parabolic – Is The Market Next?
At the end of February, I discussed the impact of the tax cut and reform legislation as it related to corporate profits.
“In October of 2017, the estimates for REPORTED earnings for Q4, 2017 and Q1, 2018 were $116.50 and $119.76. As of February 15th, the numbers are $106.84 and $112.61 or a difference of -$9.66 and -7.15 respectively.
First, while asset prices have surged to record highs, reported earnings estimates through Q3-2018 have already been ratcheted back to a level only slightly above where 2017 was expected to end in 2016. As shown by the red horizontal bars – estimates through Q3 are at the same level they were in January 2017. (Of course, “hope springs eternal that Q4 of this year will see one of the sharpest ramps in earnings in S&P history.)”
That was so yesterday.
Despite a recent surge in market volatility, combined with the drop in equity prices, analysts have “sharpened their pencils” and ratcheted UP their estimates for the end of 2018 and 2019. Earnings are NOW expected to grow at 26.7% annually over the next two years.
The chart below shows the changes a bit more clearly. It compares where estimates were on January 1st versus March and April. “Optimism” is, well, “exceedingly optimistic” for the end of 2019.
The surge in earnings estimates gives cover for Wall Street analysts to predict surging asset prices. Buy now before you miss out!
“While earnings season has only just gotten started (only 10% of the S&P 500 companies have reported so far), a whopping 84.6% have beaten their earnings estimates, and 78.8% have beaten their revenue estimates. Those are impressive stats. And this earnings season looks like it could be even better than the lofty expectations going into it. This sets the market up for all-time highs just ahead.”
Sure, that could well be the case as a momentum-driven market is a very tough thing to kill. Despite the recent “hiccup” over the last month or so, the market remains above it’s 200-day moving average and there are few signs of investor panic currently.
However, there are two major concerns with the current trajectory of earnings estimates.
The first is that Wall Street has historically over-estimated earnings by about 33% on average.
Yes, 84% of companies have beaten estimates so far, which is literally ALWAYS the case, because analysts are never held to their original estimates. If they were, 100% of companies would be missing estimates currently.
At the beginning of January, analysts overestimated earnings by more than $6/share, reported, versus where they are currently. It’s not surprising volatility has picked up as markets try to reconcile valuations to actual earnings.
Furthermore, the overestimation provides a significant amount of headroom for Wall Street to be disappointed in future, particularly once you factor in the impacts of higher interest rates and slower economic growth.
But economic growth is set to explode. Right?
Most likely not.
As I discussed last week, the short-term boost to economic growth in the U.S., driven by a wave of natural disasters, is now beginning to fade. However, the same is seen on a global scale as well. To wit:
“The international slowdown is becoming increasingly obvious from the widely followed economic indicators. The most popular U.S. measures seem to present more of a mixed bag. Yet, as we pointed out late last year, the bond market, following the U.S. Short Leading Index, started sniffing out the U.S. slowdown months ago.”
Furthermore, the economy is sensitive to changes in interest rates. This is particularly the case when the consumer, which comprises about 70% of the GDP calculation, is already heavily leveraged. Furthermore, with corporations more highly levered than at any other point n history, and dependent on bond issuance for dividend payments and share buybacks, higher interest rates will quickly stem that source of liquidity. Notice that each previous peak was lower.
With economic growth running at lower levels of annualized growth rates, the “bang point” for the Fed’s rate hiking campaign is likely substantially lower as well. History suggests this will likely be the case. At every point in history where the Fed has embarked upon a rate hiking campaign since 1980, the “crisis point” has come at steadily lower levels.
But even if we give Wall Street the benefit of the doubt, and assume their predictions will be correct for the first time in human history, stock prices have already priced in twice the rate of EPS growth.
There are few, if any, Wall Street analysts expecting a recession at any point in the future. Unfortunately, it is just a function of time until a recession occurs and earnings fall in tandem.
More importantly, the expectation for a profits-driven surge in asset prices fails to conflate with the reality that valuations have been the most important driver of higher stock prices throughout history. Currently, despite surging earnings expectations, market participants are already revaluing equity and high-yield investments.
In our opinion, the biggest mistake that Wall Street is potentially making in their estimates is the differential between “statutory” and “effective” rates. As we addressed previously:
“From 1947 to 1986 the statutory corporate tax rate was 49% and the effective tax rate averaged 36.4% for a difference of 12.6%. From 1987 to present, after the statutory tax rate was reduced to 39%, the effective rate has averaged 28.1%, 10.9% lower than the statutory rate.
In reality, a company that earned $5.00 pretax only paid $1.41 in taxes in 2017 on average, leaving an after-tax profit of $3.59, and not $3.25. Under the new tax law that after-tax profit would come in at the $3.95 as stated in the article and the gain would be 10%, or half, of the gain Wall Street expects.”
There is virtually no “bullish” argument that will currently withstand real scrutiny.
Yields are rising which deflates equity risk premium analysis,
Valuations are not cheap,
The Fed is extracting liquidity, along with other Central Banks slowing bond purchases, and;
Further increases in interest rates will only act as a further brake on economic growth.
However, because optimistic analysis supports our underlying psychological “greed”, all real scrutiny to the contrary tends to be dismissed. Unfortunately, it is this “willful blindness” that eventually leads to a dislocation in the markets.
Wall Street is notorious for missing the major turning of the markets and leaving investors scrambling for the exits.
This time will likely be no different.
Will tax reform accrue to the bottom lines of corporations? Most assuredly.
However, the bump in earnings growth will only last for one year. Then corporations will be back to year-over-year comparisons and will once again rely on cost-cutting, wage suppression, and stock buybacks to boost earnings to meet Wall Street’s expectations.
Are stocks ready to go parabolic?
Anything is possible, but the risk of disappointment is extremely high.
Tax Cuts & The Failure To Change The Economic Balance
As we approach “tax day” in the U.S., I wanted to take a moment to revisit the issue of taxes, who pays what, and why the “Tax Cut and Jobs Act” will likely have limited impact on economic growth.
This week, Laura Saunders penned for the WSJ an analysis of “who pays what” under the U.S. progressive tax system. The data she used was from the Tax Policy center which divided about 175 million American households into five income tiers of roughly 65 million people each. This article was widely discussed on radio shows across the country as “clear evidence” recent tax reform was having a “huge effect” on average households and a clear step in “Making America Great Again.”
The reality, however, is far different than the politically driven spin.
First, the data.
“The results show how steeply progressive the U.S. income tax remains. For 2018, households in the top 20% will have income of about $150,000 or more and 52% of total income, about the same as in 2017. But they will pay about 87% of income taxes, up from about 84% last year.”
See, the “rich” are clearly paying more.
Not really, percentages are very deceiving. If the total amount of revenue being collected is reduced, the purpose of a tax cut, the top 20% can pay LESS in actual dollars, but MORE in terms of percentage. For example:
Year 1: Top 20% pays $84 of $100 collected = 84%
Year 2: Top 20% pays $78 of $90 collected = 87%
This is how “less” equals “more.”
So, where is the “less?”
“By contrast, the lower 60% of households, who have income up to about $86,000, receive about 27% of income. As a group, this tier will pay no net federal income tax in 2018 vs. 2% of it last year.”
“Roughly one million households in the top 1% will pay for 43% of income tax, up from 38% in 2017. These filers earn above about $730,000.”
While the “percentage or share” of the total will rise for the top 5%, the total amount of taxes estimated to be collected will fall by more than $1 Trillion for 2018. As Roberton Williams, an income-tax specialist with the Tax Policy Center, noted while the share of taxes paid by the top 5% will rise, the people in the top 5% were the largest beneficiaries of the overhaul’s tax cut, both in dollars and percentages.
Not surprisingly, as I noted previously, income taxes for the bottom 2-tiers of income earners, or roughly 77-million households, will have a negative income tax rate. Why? Because, despite the fact they pay ZERO in income taxes, Congress has chosen to funnel benefits for lower earners through the income tax rather than other channels such as federal programs. Since the recent tax legislation nearly doubled the standard deduction and expanded tax credits, it further lowered the share of income tax for people in those tiers.
The 80/20 Rule
In order for tax cuts to truly be effective, given roughly 70% of the economy is driven by personal consumption, the amount of disposable incomes available to individuals must increase to expand consumption further.
Since more than 80% of income taxes are paid by the top 20%, the reality is tax cuts only have a limited impact on consumption for those individuals as they are already consuming at a level with which they are satisfied.
The real problem is the bottom 80% that pay 20% of the taxes. As I have detailed previously, the vast majority of Americans are living paycheck to paycheck. According to CNN, almost six out of every ten Americans do not have enough money saved to even cover a $500 emergency expense. That lack of savings can be directly attributed to the lack of income growth for those in the bottom 80% of income earners.
So, with 80% of Americans living paycheck-to-paycheck, the need to supplant debt to maintain the standard of living has led to interest payments consuming a bulk of actual disposable income. The chart below shows that beginning in 2000, debt exceeded personal consumption expenditures for the first time in history. Therefore, any tax relief will most likely evaporate into the maintaining the current cost of living and debt service which will have an extremely limited, if any, impact on fostering a higher level of consumption in the economy.
But again, there is a vast difference between the level of indebtedness (per household) for those in the bottom 80% versus those in the top 20%.
The rise in the cost of living has outpaced income growth over the past 14 years. While median household incomes may have grown over the last couple of years, expenses have outpaced that growth significantly. As Stephanie Pomboy recently stated:
” In January, the savings rate went from 2.5% to 3.2% in one month—a massive increase. People look at the headline for spending and acknowledge that it’s not fabulous, but they see it as a sustainable formula for growth that will generate the earnings necessary to validate asset price levels.”
Unfortunately, the headline spending numbers are actually far more disturbing once you dig into “where” consumers are spending their dollars. As Stephanie goes on to state:
“When you go through that kind of detail, you discover that they are buying more because they have to. They are spending more on food, energy, healthcare, housing, all the nondiscretionary stuff, and relying on credit and dis-saving [to pay for it]. Consumers have had to draw down whatever savings they amassed after the crisis and run up credit-card debt to keep up with the basic necessities of life.”
When a bulk of incomes are diverted to areas which must be purchased, there is very little of a “multiplier effect” through the economy and spending on discretionary products or services becomes restricted. This problem is magnified when the Fed hikes short-term interest rates, which increases debt payments, and an Administration engages in a “trade war” which increases prices of purchased goods.
Higher costs and stagnant wages are not a good economic mix.
The Corporate Tax Cut Sham
But this was never actually a “tax cut for the middle-class.”
The entire piece of legislation was a corporate lobby-group inspired “give away” disguised as a piece of tax reform legislation. A total sham.
Why do I say that? Simple.
If the Administration were truly interested in a tax cut for the middle class, every piece of the legislation would have been focused on the nearly 80% of Federal revenue collected from individual income and payroll taxes.
Instead, the bulk of the “tax reform” plan focused on the 8.8% of total Federal revenue collected from corporate taxes.
“But business owners and CEO’s will use their windfall to boost wages and increase productivity. Right?”
Corporations are thrilled with the bill because corporate tax cuts immediately drop to the bottom lines of the income statement. With revenue growth, as shown below, running at exceptionally weak levels, corporations continue to opt for share buybacks, wage suppression and accounting gimmicks to fuel bottom lines earnings per share. The requirement to meet Wall Street expectations to support share prices is more important to the “C-suite” executives than being benevolent to the working class.
“Not surprisingly, our guess that corporations would utilize the benefits of ‘tax cuts’ to boost bottom line earnings rather than increase wages has turned out to be true. As noted by Axios, in just the first two months of this year companies have already announced over $173 BILLION in stock buybacks. This is ‘financial engineering gone mad.’”
The historical evidence provides a very different story than the bill of goods being sold to citizens and investors. There is no historical evidence that cutting corporate tax rates increases economic growth. In fact, as recently noted by Michael Lebowitz, the opposite has been true with high correlation between lower tax rates and slower economic growth.
With the deficit set to exceed $1 Trillion next year, and every year afterward, the government must borrow money to fund the shortfall. This borrowing effectively crowds out investment that could have funded the real economy.
“Said differently, the money required to fund the government’s deficit cannot be invested in the pursuit of innovation, improving workers skills, or other investments that pay economic dividends in the future. As we have discussed on numerous occasions, productivity growth drives economic growth over the longer term. Therefore, a lack productivity growth slows economic growth and ultimately weighs on corporate earnings.
A second consideration is that the long-term trend lower in the effective corporate tax has also been funded in part with personal tax receipts. In 1947, total personal taxes receipts were about twice that of corporate tax receipts. Currently, they are about four times larger. The current tax reform bill continues this trend as individuals in aggregate will pay more in taxes.
As personal taxes increase, consumers who account for approximately 70% of economic activity, have less money to spend.”
This issue of whether tax cuts lead to economic growth was examined in a 2014 study by William Gale and Andrew Samwick:
“The argument that income tax cuts raise growth is repeated so often that it is sometimes taken as gospel. However, theory, evidence, and simulation studies tell a different and more complicated story. Tax cuts offer the potential to raise economic growth by improving incentives to work, save, and invest. But they also create income effects that reduce the need to engage in productive economic activity, and they may subsidize old capital, which provides windfall gains to asset holders that undermine incentives for new activity.
In addition, tax cuts as a stand-alone policy (that is, not accompanied by spending cuts) will typically raise the federal budget deficit. The increase in the deficit will reduce national saving — and with it, the capital stock owned by Americans and future national income — and raise interest rates, which will negatively affect investment.The net effect of the tax cuts on growth is thus theoretically uncertain and depends on both the structure of the tax cut itself and the timing and structure of its financing.”
Again, the timing is not advantageous, the economic dynamics and the structure of the tax cuts are not self-supporting. As Dr. Lacy Hunt recently noted in his quarterly outlook:
“Considering the current public and private debt overhang, tax reductions are not likely to be as successful as the much larger tax cuts were for Presidents Ronald Reagan and George W. Bush. Gross federal debt now stands at 105.5% of GDP, compared with 31.7% and 57.0%, respectively, when the 1981 and 2002 tax laws were implemented.
However, if the household and corporate tax reductions and infrastructure tax credits proposed are not financed by other budget offsets, history suggests they will be met with little or no success.”
Since the current Administration has chosen to do the exact opposite by massively increasing spending, having no budget offsets, or slowing the rate of growth of either deficits or debts, the success of tax reform to boost economic growth is highly suspect.
Policymakers had the opportunity to pass true, pro-growth, tax reform and show they were serious about our nations fiscal future, they instead opted to continue enriching the top 1% at the expense of empowering the middle class.
The outcome will be very disappointing.
The Great American Economic Growth Myth
Since the end of the financial crisis, economists, analysts, and the Federal Reserve have continued to predict a return to higher levels of economic growth. As I showed in my discussion of the Fed’s forecasts, these predictions have continued to fall short of reality.
“Besides being absolutely the worst economic forecasters on the planet, the Fed’s real problem is contained within the table and chart below. Despite the rhetoric of stronger employment and economic growth – plunging imports and exports, falling corporate profits, collapsing manufacturing and falling wages all suggest the economy is in no shape to withstand tighter monetary policy at this juncture.”
“Of course, if the Fed openly suggested a ‘recession’ could well be in the cards, the markets would sell off sharply, consumer confidence would drop and a recession would be pulled forward to the present. This is why “what the Fed says” is much less important than what they do.”
“I have been in this business for 30 years and have never seen a central bank chief slip the word “uncertainty” into the headline.
Not just that, but she invoked the term no fewer than 10 times to describe the domestic and global macro and market backdrop — this even as we pass seven years since the worst point of the Great Recession and seven years into the most radical easing of monetary policy in recorded history.
It begs the question: what has gone wrong?”
However, the issue is much greater than just what has gone wrong in recent months. Since 1999, the annual real economic growth rate has run at 1.86%, which is the lowest growth rate in history including the ‘Great Depression.’I have broken down economic growth into major cycles for clarity.
While economists, politicians, and analysts point to current data points and primarily coincident indicators to create a “bullish spin” for the investing public, the underlying deterioration in economic prosperity is a much more important long-term concern. The question that we should be asking is “why is this happening?”
From 1950-1980 nominal GDP grew at an annualized rate of 7.55%. This was accomplished with a total credit market debt to GDP ratio of less 150%. The CRITICAL factor to note is that economic growth was trending higher during this span going from roughly 5% to a peak of nearly 15%. There were a couple of reasons for this. First, lower levels of debt allowed for personal savings to remain robust which fueled productive investment in the economy. Secondly, the economy was focused primarily on production and manufacturing which has a high multiplier effect on the economy. This feat of growth also occurred in the face of steadily rising interest rates which peaked with economic expansion in 1980.
However, beginning in 1980 the shift of the economic makeup from a manufacturing and production based economy to a service and finance economy, where there is a low economic multiplier, is partially responsible for this transformation. The decline in economic output was further exacerbated by increased productivity through technological advances and outsourcing of manufacturing which plagued the economy with steadily decreasing wages. Unlike the steadily growing economic environment prior to 1980; the post-1980 economy has experienced a steady decline. Therefore, a statement that the economy has had an average growth of X% since 1980 is grossly misleading. The trend of the growth is far more important, and telling, than the average growth rate over time.
This decline in economic growth over the past 30 years has kept the average American struggling to maintain their standard of living. As their wages declined, they were forced to turn to credit to fill the gap in maintaining their current standard of living. This demand for credit became the new breeding ground for the financed based economy. Easier credit terms, lower interest rates, easier lending standards and less regulation fueled the continued consumption boom. By the end of 2007, the household debt outstanding had surged to 140% of GDP. It was only a function of time until the collapse in the “house built of credit cards” occurred.
This is why the economic prosperity of the last 30 years has been a fantasy. While America, at least on the surface, was the envy of the world for its apparent success and prosperity; the underlying cancer of debt expansion and declining wages was eating away at the core. The only way to maintain the “standard of living” that American’s were told they “deserved,” was to utilize ever-increasing levels of debt. The now deregulated financial institutions were only too happy to provide that “credit” as it was a financial windfall of mass proportions.
The massive indulgence in debt, what the Austrians refer to as a “credit induced boom,” has likely reached its inevitable conclusion. The unsustainable credit-sourced boom, which led to artificially stimulated borrowing, has continued to seek out ever diminishing investment opportunities. Ultimately these diminished investment opportunities repeatedly lead to widespread mal-investments. Not surprisingly, we clearly saw it play out “real-time” in everything from subprime mortgages to derivative instruments which were only for the purpose of milking the system of every potential penny regardless of the apparent underlying risk. We see it playing out again in the “chase for yield” in everything from junk bonds to equities. Not surprisingly, the end result will not be any different.
When credit creation can no longer be sustained, the process of clearing the excesses must be completed before the cycle can resume. It is only then, and must be allowed to happen, can resources be reallocated back towards more efficient uses. This is why all the efforts of Keynesian policies to stimulate growth in the economy have ultimately failed. Those fiscal and monetary policies, from TARP and QE to tax cuts, only delay the clearing process. Ultimately, that delay only potentially worsens the inevitable clearing process.
The clearing process is going to be very substantial. The economy currently requires nearly $3.00 of debt to create $1 of real (inflation adjusted) economic growth. A reversion to a structurally manageable level of debt* would require in excess of $35 Trillion in debt reduction. The economic drag from such a reduction would be dramatic while the clearing process occurs.
*Structural Debt Level – Estimated trend of debt growth in a normalized economic environment which would be supportive of economic growth levels of 150% of debt-to-GDP.
Rosenberg is right. It is likely that “something has gone wrong” for the Federal Reserve as the efficacy to pull-forward future consumption through monetary interventions has been reached. Despite ongoing hopes of “higher growth rates” in the future, it is likely that such will not be the case until the debt overhang is eventually cleared.
Does this mean that all is doomed? Of course, not. However, we will likely remain constrained in the current cycle of “spurt and sputter” growth cycle we have witnessed since 2009. Such will be marked by continued volatile equity market returns and a stagflationary environment as wages remain suppressed while costs of living rise. Ultimately, it is the process of clearing the excess debt levels that will allow personal savings rates to return to levels that can promote productive investment, production, and consumption.
The end game of three decades of excess is upon us, and we can’t deny the weight of the debt imbalances that are currently in play. The medicine that the current administration is prescribing is a treatment for the common cold; in this case a normal business cycle recession. The problem is that the patient is suffering from a “debt cancer,” and until the proper treatment is prescribed and implemented; the patient will most likely continue to suffer.
It’s been more than seven years since the financial crisis and Central Banks globally have kept their rates at record lows, and have even ventured into negative rate territory, to stave off the threat of a recessionary relapse and boost anemic economic growth. While such policies have failed to spark inflationary pressures or boost economic growth, the “illusion of permanent liquidity” has spurred investors to make risky bets and push up asset prices.
This “illusion” has not only been driving investors to make risky bets across the entire spectrum of asset classes; it has also led to the illusion of economic stability and growth. For example, in 2014, financial analysts started pushing the idea of a “new generational cycle” of growing earnings driven by a stronger economic growth that would last for another decade. Unfortunately, as we are now witnessing, such rosy projections have fallen far short of reality.
“As shown in the chart below, once again the Fed lowered expectations further for economic growth and reduced the number of rate hikes this year from 4 to 2. Yep, ‘accommodative policy’ is here to stay for a while longer which lifted stocks yesterday’s close.”
“Besides being absolutely the worst economic forecasters on the planet, the Fed’s real problem is contained within the table and chart above. Despite the rhetoric of stronger employment and economic growth – plunging imports and exports, falling corporate profits, collapsing manufacturing and falling wages all suggest the economy is in no shape to withstand tighter monetary policy at this juncture.”
While Central Banks globally are working to “repeal” the economic cycle, the continued deterioration in economic growth has become more prevalent as even ongoing accounting manipulations, share buybacks, and cost cutting are no longer boosting bottom-line earnings.
Of course, such an outlook was ALWAYS overly optimistic and fraught with peril as such an economic expansion would rival the longest previous period on record (119 Months) from March of 1991 through March of 2001 during the “technological revolution.”
Such a prolonged expansion will be quite a feat if it were to occur, particularly given an economy growing at half the rate it was during the 1990’s. Furthermore, given that a bulk of the economic expansion during the 1980-90’s was driven by an $11 Trillion dollar increase in consumer credit, there is little ability to repeat such a “tailwind” currently.
However, the idea of “permanent liquidity,” and the belief that economic growth can be sustained by monetary policy alone, despite slowing in China, Japan, and the Eurozone, has emboldened analysts to continue to expect a resurgence of profit growth in the months ahead. As I noted in this past weekend’s newsletter:
“However, leading economic indicators remain bearish, and the slide in the monetary base warns that the path of least resistance for GDP growth is lower. History shows that once GDP growth dips below the level of 10-year Treasury yields, a prolonged slump in stocks typically ensues.
This outlook contrasts starkly with current expectations. The Chart below shows that an aggressive recovery in S&P 500 earnings is expected this year.”
“Importantly, these expectations are not simply a reflection of hopes for a recovery in resource prices, but are broad-based across sectors. That is wildly optimistic, underscoring that disappointment will remain a key risk.”
It is unlikely given the current scenario of sub-par economic growth, excess labor slack globally and deflationary pressures rising, that such lofty expectations will be obtained. Importantly, it will be the consequences of such a failure that will be the most important as the longer the music plays the more deafening the silence will be that follows.
There is a rising realization by Central Banks these excess liquidity flows have failed to work as anticipated. The Bank of Japan’s foray into a “quantitative easing” program nearly 3x the size of that of the Federal Reserve’s last endeavor, or a relative basis, was met with nothing but an ongoing drop in economic growth. Domestically, the Federal Reserve’s program has boosted asset prices that has inflated the wealth of the top 10% but left the bottom 90% in arguably a worse financial position today than five years ago. (see “For 90% of Americans There Has Been No Recovery”)
But what ongoing liquidity interventions have accomplished, besides driving asset prices higher, is instilling a belief there is little risk in the markets as low interest rates will continue or only be gradually tightened.
However, it is a common mistake is to take unusually low volatility and risk spreads as a sign of low risk when, in fact, they are a sign of high risk-taking.
The ongoing mistake currently being made by the vast majority of Wall Street analysts is two-fold. The first is the assumption that the Federal Reserve can normalize interest rates given the underlying deterioration in global growth currently. The second is that increases in interest rates will have ZERO effect on future earnings or economic growth.
As I discussed repeatedly in the past, there has been no previous point in history where rising interest rates did not only slow the economy, but eventually led to an economic recession, market dislocation or both.
“While rising interest rates may not “initially” drag on asset prices, it is a far different story to suggest that they won’t. This is particularly the case when those rate increases are coming from a period of very low economic growth.
What the mainstream analysts fail to address is the ‘full-cycle’ effect from rate hikes. The chart and table below address this issue by showing the return to investors from the date of the first rate increase through the subsequent correction and/or recession.”
The “Illusion of Permanent Liquidity” has obfuscated the underlying inherent investment risk that investors are undertaking currently. The belief that Central Banks will always be able to jump in and avert a dislocation in financial or credit markets is likely deeply flawed.
The problem is these excessive liquidity flows have only impacted the economic surface by dragging forward future consumption. Eventually, the ability to fill the future economic void through monetary policies will fail as the efficacy of liquidity interventions fade. It is only then that investors will come to understand the gravity of the “risks” they have undertaken as the illusion of permanent liquidity fades.
Over the weekend, Donald Trump, in an interview with the Washington Post, stated that economic conditions are so perilous that the country is headed for a “very massive recession” and that “it’s a terrible time right now” to invest in the stock market.
Of course, such a distinctly gloomy view of the economy runs counter to the more mainstream consensus of economic outlooks as witnessed by some of the immediate rebuttals:
There are no signals of any “massive” recession ahead or a market crash and his talking like this is grotesque. https://t.co/bPaLZl5i5E
Ben is correct. There is CURRENTLY no evidence of a recession now, or even in the few months ahead. There never is.
A Funny Thing Happened On The Way To The Recession
The majority of the analysis of economic data is short-term focused with prognostications based on single data points. For example, let’s take a look at the data below of real economic growth rates:
January, 1980: 1.43%
July, 1981: 4.39%
July, 1990: 1.73%
March, 2001: 2.30%
December, 2007: 1.87%
Each of the dates above show the growth rate of the economy immediately prior to the onset of a recession.
You will remember that during the entirety of 2007, the majority of the media, analyst and economic community were proclaiming continued economic growth into the foreseeable future as there was “no sign of recession.”
I myself was rather brutally chastised in December of 2007 when I wrote that:
“We are now either in, or about to be in, the worst recession since the ‘Great Depression.'”
Of course, a full-year later, after the annual data revisions had been released by the Bureau of Economic Analysis was the recession officially revealed. Unfortunately, by then it was far too late to matter.
However, it is here the mainstream media should have learned their lesson.
The chart below shows the S&P 500 index with recessions and when the National Bureau of Economic Research dated the start of the recession.
There are three lessons that should be learned from this:
The economic “number” reported today will not be the same when it is revised in the future.
The trend and deviation of the data are far more important than the number itself.
“Record” highs and lowsare records for a reason as they denote historical turning points in the data.
For example, the level of jobless claims is one data series currently being touted as a clear example of why there is “no recession” in sight. As shown below, there is little argument that the data currently appears extremely “bullish” for the economy.
However, if we step back to a longer picture we find that such levels of jobless claims have historically noted the peak of economic growth and warned of a pending recession.
This makes complete sense as “jobless claims” fall to low levels when companies “hoard existing labor” to meet current levels of demand. In other words, companies reach a point of efficiency where they are no longer terminating individuals to align production to aggregate demand. Therefore, jobless claims naturally fall.
But there is more to this story.
Less Than Meets The Eye
The last two-quarters of economic growth have been less than exciting, to say the least. However, these rather dismal quarters of growth come at a time when oil prices and gasoline prices have plummeted AND amidst one of the warmest winters in 65-plus years.
Why is that important? Because falling oil and gas prices and warm weather are effective “tax credits” to consumers as they spend less on gasoline, heating oil and electricity. Combined, these “savings” account for more than $200 billion in additional spending power for the consumer. So, personal consumption expenditures should be rising, right?
What’s going on here? The chart below shows the relationship between real, inflation-adjusted, PCE, GDP, Wages and Employment. The correlation is no accident.
Economic cycles are only sustainable for as long as excesses are being built. The natural law of reversions, while they can be suspended by artificial interventions, can not be repealed.
More importantly, while there is currently “no sign of recession,” what is going on with the main driver of economic growth – the consumer?
The chart below shows the real problem. Since the financial crisis, the average American has not seen much of a recovery. Wages have remained stagnant, real employment has been subdued and the actual cost of living (when accounting for insurance, college, and taxes) has risen rather sharply. The net effect has been a struggle to maintain the current standard of living which can be seen by the surge in credit as a percentage of the economy.
To put this into perspective, we can look back throughout history and see that substantial increases in consumer debt to GDP have occurred coincident with recessionary drags in the economy. No sign of recession? Are you sure about that?
Importantly, the extremely warm winter weather is currently wrecking havoc with the seasonal adjustments being applied to the economic data. This makes every report from employment, retail sales, and manufacturing appear more robust than they would be otherwise. However, as the seasonal trends turn more normal we are likely going to see fairly negative adjustments in future revisions. This is a problem that the mainstream analysis continues to overlook currently, but will be used as an excuse when it reverses.
Here is my point. While Trump’s call of a “massive recession” may seem far-fetched based on today’s economic data points, no one was calling for a recession in early 2000 or 2007 either. By the time the data is adjusted, and the eventual recession is revealed, it won’t matter as the damage will have already been done.
As Howard Marks once quipped:
“Being right, but early in the call, is the same as being wrong.”
While being optimistic about the economy and the markets currently is far more entertaining than doom and gloom, it is the honest assessment of the data and the underlying trends that is useful in protecting one’s wealth longer term.
Is there a recession currently? No.
Will there be a recession in the not so distant future? Absolutely.
Trump’s call for a “massive recession” may very well turn out not to be true. However, whether it is a mild, or “massive,” recession will make little difference as the net destruction to personal wealth will be just as disastrous. That is the nature of recessions on the financial markets.
Of course, I am sure to be chastised for penning such thoughts just as I was in 2000 and again in 2007. That is the cost of heresy against the financial establishment, but well worth paying to keep my clients from being burned at the stake, not if, but when the next recession begins.
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