Tag Archives: wealth gap

SOTM 2020: State Of The Markets

“I am thrilled to report to you tonight that our economy is the best it has ever been.” – President Trump, SOTU

In the President’s “State of the Union Address” on Tuesday, he used the podium to talk up the achievements in the economy and the markets.

  • Low unemployment rates
  • Tax cuts
  • Job creation
  • Economic growth, and, of course,
  • Record high stock markets.

While it certainly is a laundry list of items he can claim credit for, it is the claim of record-high stock prices that undermines the rest of the story.

Let me explain.

The stock market should be a reflection of actual economic growth. Since corporate earnings are derived primarily from consumptive spending, corporate investments, and imports and exports, actual economic activity should be reflected in the price investors are willing to pay for the earnings being generated.

For the majority of the 20th century, this was indeed the case as corporate earnings were reflective of economic activity. The chart below shows the annual change in reported earnings, nominal GDP, and the price of the S&P 500.

Not surprisingly, as the economy grew at 6.47% annually, earnings also grew at 6.68% annually as would be expected. Since investors are willing to a premium for earnings growth, the S&P 500 grew at 9% annually over that same period.

Importantly, note that long-term economic growth has averaged 6% annually. However, as shown in the lower panel, economic growth has been running below the long-term average since 2000, but has been substantially weaker since 2007, growing at just 2% annually.

The next chart shows this weaker growth more clearly. Since the financial crisis, economic growth has failed to recover back to its long-term exponential growth trend. However, reported earnings are exceedingly deviated from what actual underlying economic growth can generate. This is due to a decade of accounting gimmickry, share buybacks, wage suppression, low interest rates, and high corporate debt levels.

The next chart looks at the deviation by looking at the market itself versus long-term economic growth. The S&P 500 and GDP have been scaled to 100, and displayed on a log-scale for comparative purposes.

The current growth trend of the economy is running well below its long-term exponential trend, but the S&P 500 is currently at the most significant deviation from that growth on record. (It should be noted that while these deviations from economic growth can last for a long-time, the eventual mean reversion always occurs.)

The Spending Mirage

Take a look at the following chart.

While the President’s claims of an exceptionally strong economy rely heavily on historically low unemployment and jobless claims numbers, historically high levels of asset prices, and strong consumer spending trends, there is an underlying deterioration which goes unaddressed.

So, here’s your pop quiz?

If consumer spending is strong, AND unemployment is near the lowest levels on record, AND interest rates are low, AND job creation is high – then why is the economy only growing at 2%?

Furthermore, if the economy was doing as well as government statistics suggest, then why does the Federal Reserve need to continue providing the economy with “emergency measures,” cutting rates, and giving “verbal guidance,” to keep the markets from crashing?

The reality is that if it wasn’t for the Government running a massive trillion-dollar fiscal deficit, economic growth would actually be recessionary.

In GDP accounting, consumption is the largest component. Of course, since it is impossible to “consume oneself to prosperity,” the ability to consume more is the result of growing debt. Furthermore, economic growth is also impacted by Government spending, as government transfer payments, including Medicaid, Medicare, disability payments, and SNAP (previously called food stamps), all contribute to the calculation.

As shown below, between the Federal Reserve’s monetary infusions and the ballooning government deficit, the S&P 500 has continued to find support.

However, nothing is “produced” by those transfer payments. They are not even funded. As a result, national debt rises every year, and that debt adds to GDP.

Another way to look at this is through tax receipts as a percentage of GDP.  If the economy was indeed “the strongest ever,” then we should see an increase in wage growth commensurate with increased economic activity. As a result of higher wages, there should be an increase in the taxes collected by the Government from wages, consumption, imports, and exports.

See the problem here?

Clearly, this is not the case as tax receipts as a percentage of GDP peaked in 2012, and have now declined to levels which historically are more coincident with economic recessions, rather than expansions. Yet, currently, because of the artificial interventions, the stock market remains well detached from what economic data is actually saying.

Corporate Profits Tell The Real Story

When it comes to the state of the market, corporate profits are the best indicator of economic strength.

The detachment of the stock market from underlying profitability guarantees poor future outcomes for investors. But, as has always been the case, the markets can certainly seem to “remain irrational longer than logic would predict,” but it never lasts indefinitely.

Profit margins are probably the most mean-reverting series in finance, and if profit margins do not mean-revert, then something has gone badly wrong with capitalism. If high profits do not attract competition, there is something wrong with the system, and it is not functioning properly.” – Jeremy Grantham

As shown, when we look at inflation-adjusted profit margins as a percentage of inflation-adjusted GDP, we see a clear process of mean-reverting activity over time. Of course, those mean reverting events are always coupled with recessions, crises, or bear markets.

More importantly, corporate profit margins have physical constraints. Out of each dollar of revenue created, there are costs such as infrastructure, R&D, wages, etc. Currently, the biggest contributors to expanding profit margins has been the suppression of employment, wage growth, and artificially suppressed interest rates, which have significantly lowered borrowing costs. Should either of the issues change in the future, the impact to profit margins will likely be significant.

The chart below shows the ratio overlaid against the S&P 500 index.

I have highlighted peaks in the profits-to-GDP ratio with the green vertical bars. As you can see, peaks, and subsequent reversions, in the ratio have been a leading indicator of more severe corrections in the stock market over time. This should not be surprising as asset prices should eventually reflect the underlying reality of corporate profitability.

It is often suggested that, as mentioned above, low interest rates, accounting rule changes, and debt-funded buybacks have changed the game. While that statement is true, it is worth noting that each of those supports are artificial and finite.

Another way to look at the issue of profits as it relates to the market is shown below. When we measure the cumulative change in the S&P 500 index as compared to the level of profits, we find again that when investors pay more than $1 for a $1 worth of profits, there is an eventual mean reversion.

The correlation is clearer when looking at the market versus the ratio of corporate profits to GDP. (Again, since corporate profits are ultimately a function of economic growth, the correlation is not unexpected.) 

It seems to be a simple formula for investors that as long as the Fed remains active in supporting asset prices, the deviation between fundamentals and fantasy doesn’t matter. 

However, investors are paying more today than at any point in history for each $1 of profit, which history suggests will not end well.

While the media is quick to attribute the current economic strength, or weakness, to the person who occupies the White House, the reality is quite different.

The political risk for President Trump is taking too much credit for an economic cycle which was already well into recovery before he took office. Rather than touting the economic numbers and taking credit for liquidity-driven financial markets, he should be using that strength to begin the process of returning the country to a path of fiscal discipline rather than a “drunken binge” of government spending.

With the economy, and the financial markets, sporting the longest-duration in history, simple logic should suggest time is running out.

This isn’t doom and gloom, it is just a fact.

Politicians, over the last decade, failed to use $33 trillion in liquidity injections, near-zero interest rates, and surging asset prices to refinance the welfare system, balance the budget, and build surpluses for the next downturn.

Instead, they only made the deficits worse, and the U.S. economy will enter the next recession pushing a $2 Trillion deficit, $24 Trillion in debt, and a $6 Trillion pension gap, which will devastate many in their retirement years.

While Donald Trump talked about “Yellen’s big fat ugly bubble” before he took office, he has now pegged the success of his entire Presidency on the stock market.

It will likely be something he eventually regrets.

“Then said Jesus unto him, Put up again thy sword into his place: for all they that take the sword shall perish with the sword.” – Matthew 26, 26:52

Strongest Economy Ever? Americans Receive More In Benefits Than Pay In Taxes

At the beginning of August, I discussed the following tweet from the President:

“But if it is the ‘strongest economy ever,’ then why the need for aggressive rate cuts which are ’emergency measures’ to be utilized to offset recessionary conditions?”

The following chart should quickly put that claim to rest.

While the claims of an exceptionally strong economy rely heavily on historically low unemployment and jobless claims numbers, historically high levels of asset prices, and strong consumer spending trends, there is an underlying deterioration that goes unaddressed.

For example, while reported unemployment is hitting historically low levels, there is a swelling mass of uncounted individuals that have either given up looking for work or are working multiple part-time jobs. This is shown by those “not in labor force” as a percent of the working-age population, which has skyrocketed since the recession.

The employment to population ratio would not still be at levels from the 1980s.

If employment was indeed as strong as reported by government agencies, then social benefits would not be comprising a record high of 22% of real disposable incomes. Here is the breakdown:

  • 40 million Americans on food stamps
  • An estimated 50% of the 330 million Americans in this country get at least one federal benefit, according to the Census Bureau.
  • An estimated 63 million get Social Security; 59.9 million get Medicare; 75 million get Medicaid; 5 million get housing subsidies; and 4 million get Veterans’ benefits.

Those numbers continue to rise.

Without government largesse, many individuals would literally be living on the street. The chart above shows all the government “welfare” programs and current levels to date. While unemployment insurance has hit record lows following the financial crisis, social security, medicaid, veterans’ benefits, and other social benefits have continued to rise and have surged sharply over the last few months.

With 1/5 of incomes dependent on government transfers, it is not surprising that the economy continues to struggle as recycled tax dollars used for consumption purposes have virtually no impact on the overall economy.

In fact, in the ongoing saga of the demise of the American economy U.S. households are now getting more in cash handouts from the government than they are paying in taxes for the first time since the Great Depression. This, of course, at a time when the current administration is more enthralled with trying to find some universe where cutting taxes actually increases tax revenues as a percent of GDP rather than actually cutting spending.

In 2018, households received $2.2 trillion in some form of government transfer payments, which was more than the $1.7 trillion paid in personal income taxes.

“Yes, but wages are now the highest ever.”

Fair enough, but if that were truly the case, then why are transfer payments as a percent of disposable personal income still hanging near its highs from the “Great Recession?”

In the “strongest economy in history,” American’s should be earning a bulk of the income from their labor, rather than from Government handouts. This is why, despite tax cuts, tax revenue growth has waned as the economy has remained weak.

You simply can’t create economic growth by recycling tax dollars. 

In short, Americans have the government, not private enterprise, to thank for their wealth growth – but, of course, there are massive implications to this.

As I noted in our recent discussion on the fallacy of the “savings rate:”

“The ‘gap’ between the ‘standard of living’ and real disposable incomes is shown below. Beginning in 1990, incomes alone were no longer able to meet the standard of living so consumers turned to debt to fill the ‘gap.’ However, following the ‘financial crisis,’ even the combined levels of income and debt no longer fill the gap. Currently, there is almost a $2654 annual deficit that cannot be filled.”

That gap explains why consumer debt is at historic highs and growing each year.

Furthermore, if more households have the government to thank for their wealth, does that mean those households are more inclined to re-elect politicians who are pushing for more government handouts? 

The answers to that question is quite obvious if you look at the candidates currently running for President on the Democratic ticket.

The bottom line is that America can’t grow its way back to prosperity on the back of social assistance. The average American is fighting to make ends meet as their cost of living rises while wage growth largely remains stagnant.

This brings us to the hard truth.

The budget deficit is set to grow over the next few years as interest payments alone absorb a chuck of the tax revenue. This comes at a time when that same dollar of tax revenue only covers entitlement spending as 75 million baby boomers begin their migration into the social safety net.

The call by the American people at the last election was a mandate to reduce the size of government and spending, however, that has fallen on deaf ears and weak stomachs. The current electorate is log jammed by personal agendas as the White House elected to cut taxes, increase defense spending, and exacerbate the crony-capitalism which currently plagues the country.

By the way, the only other time government income support exceeded taxes paid was during the “Great Depression” from 1931 to 1936.

Strongest economy ever? Hardly.

But it could be.

Today, we have the ability to choose our battles, make tough choices, and restore the economic balance for future growth. However, 800-years of history tells us that we will fail to make those choices, and at some point, those choices will be forced upon us.

America’s Debt Burden Will Fuel The Next Crisis

Just recently, Rex Nutting penned an opinion piece for MarketWatch entitled “Consumer Debt Is Not A Ticking Time Bomb.” His primary point is that low per-capita debt ratios and debt-to-dpi ratios show the consumer is quite healthy and won’t be the primary subject of the next crisis. To wit:

“However, most Americans are better off now than they were 10-years ago, or even a few years ago. The finances of American households are strong. 

But, that’s not what a lot of people think. More than a decade after a massive credit orgy by households brought down the U.S. and global economies, lots of people are convinced that households are still borrowing so much money that it will inevitably crash the economy.

Those critics see a consumer debt bomb growing again. But they are wrong.”

I do agree with Rex on his point that the U.S. consumer won’t be the sole cause of the next crisis. It will be a combination of household and corporate debt combined with underfunded pensions, which will collide in the next crisis.

However, there is a household debt problem which is hidden by the way governmental statistics are calculated.

Indebted To The American Dream

The idea of “maintaining a certain standard of living” has become a foundation in our society today. Americans, in general, have come to believe they are “entitled” to a certain type of house, car, and general lifestyle which includes NOT just the basic necessities of living such as food, running water, and electricity, but also the latest mobile phone, computer, and high-speed internet connection. (Really, what would be the point of living if you didn’t have access to Facebook every two minutes?)

But, like most economic data, you have to dig behind the numbers to reveal the true story.

So let’s do that, shall we?

Every quarter the Federal Reserve Bank of New York releases its quarterly survey of the composition and balances of consumer debt. (Note that consumers are at record debt levels and roughly $1 Trillion more than in 2008.)

One of the more interesting points made to support the bullish narrative was that record levels of debt is irrelevant because of the rise in disposable personal incomes. The following chart was given as evidence to support that claim.

Looks pretty good, as long as you don’t scratch too deeply.

To begin with, the calculation of disposable personal income (which is income less taxes) is largely a guess, and very inaccurate, due to the variability of income taxes paid by households.

More importantly, the measure is heavily skewed by the top 20% of income earners, needless to say, the top 5%. As shown in the chart below, those in the top 20% have seen substantially larger median wage growth versus the bottom 80%.

(Note: all data used below is from the Census Bureau and the IRS.)

Furthermore, disposable and discretionary incomes are two very different animals.

Discretionary income is what is left of disposable incomes after you pay for all of the mandatory spending like rent, food, utilities, health care premiums, insurance, etc.

From this view, the “cost of living” has risen much more dramatically than incomes. According to Pew Research:

“In fact, despite some ups and downs over the past several decades, today’s real average wage (that is, the wage after accounting for inflation) has about the same purchasing power it did 40 years ago. And what wage gains there have been have mostly flowed to the highest-paid tier of workers.”

But the problem isn’t just the cost of living due to inflation, but the “real” cost of raising a family in the U.S. has grown incredibly more expensive with surging food, energy, health, and housing costs.

  • Researchers at Purdue University recently studied data culled from across the globe and found that in the U.S., $132,000 was found to be the optimal income for “feeling” happy for raising a family of four. 
  • Gallup also surveyed to find out what the “average” family required to support a family of four in the U.S. (Forget about being happy, we are talking about “just getting by.”) That number turned out to be $58.000.

So, while the “median” income has broken out to highs, the reality for the vast majority of Americans is there has been little improvement. Here are some stats from the survey data which was NOT reported:

  • $306,139 – the difference between the annual income for the Top 5% versus the Bottom 80%.
  • $148,504 – the difference between the annual income for the Top 5% and the Top 20%.
  • $157,635 – the difference between the annual income for the Top 20% and the Bottom 80%.

If you are in the Top 20% of income earners, congratulations.

If not, it is a bit of a different story.

Assuming a “family of four” needs an income of $58,000 a year to just “make it,” such becomes problematic for the bottom 80% of the population whose wage growth falls far short of what is required to support the standard of living, much less to obtain “happiness.” 

This is why the “gap” between the “standard of living” and real disposable incomes is more clearly shown below. Beginning in 1990, incomes alone were no longer able to meet the standard of living so consumers turned to debt to fill the “gap.” However, following the “financial crisis,” even the combined levels of income and debt no longer fill the gap. Currently, there is almost a $3200 annual deficit that cannot be filled.

Record levels of consumer debt is a problem. There is simply a limit to how much “debt” each household can carry even at historically low interest rates.

Data Skew

While Rex’s analysis is not incorrect, the data he is using in his assumptions is being skewed by the “wealth and income” gap in the top 20% of the population. This was a point put forth in a study from Chicago Booth Review:

“The data set reveals since 1980 a ‘sharp divergence in the growth experienced by the bottom 50 percent versus the rest of the economy,’ the researchers write. The average pretax income of the bottom 50 percent of US adults has stagnated since 1980, while the share of income of US adults in the bottom half of the distribution collapsed from 20 percent in 1980 to 12 percent in 2014. In a mirror-image move, the top 1 percent commanded 12 percent of income in 1980 but 20 percent in 2014. The top 1 percent of US adults now earns on average 81 times more than the bottom 50 percent of adults; in 1981, they earned 27 times what the lower half earned.

Given this information, it should not be surprising that personal consumption expenditures, which make up roughly 70% of the economic equation, have had to be supported by surging debt levels to offset the lack wage growth in the bottom 80% of the economy.

More importantly, despite economic reports of rising employment, low jobless claims, surging corporate profitability and continuing economic expansion, the percentage of government transfer payments (social benefits) as compared to disposable incomes have surged to the highest level on record.

This anomaly was also noted in the study:

“Government transfer payments have ‘offset only a small fraction of the increase in pre-tax inequality,’ Piketty, Saez, and Zucman conclude—and those payments fail to bridge the gap for the bottom 50 percent because they go mostly to the middle class and the elderly. Pretax income of the middle class (adults between the median and the 90th percentile) has grown 40 percent since 1980, ‘faster than what tax and survey data suggest, due in particular to the rise of tax-exempt fringe benefits,’ the researchers write. ‘For the working-age population, post-tax bottom 50 percent income has hardly increased at all since 1980.’”

Here is the point that Rex missed. There is a vast difference between the level of indebtedness (per household) for those in the bottom 80%, versus those in the top 20%. 

Of course, the only saving grace for many American households is that artificially low interest rates have reduced the average debt service levels. Unfortunately, those in the bottom 80% are still having a large chunk of their median disposable income eaten up by debt payments. This reduces discretionary spending capacity even further.

The problem is quite clear. With interest rates already at historic lows, the consumer already heavily leveraged, and wage growth stagnant, the capability to increase consumption to foster higher rates of economic growth is limited.

With respect to those who say “the debt doesn’t matter,” I respectfully argue that you looking at a very skewed view of the world driven by those at the top.

The Next Crisis Will Be The Last

For the Federal Reserve, the next “financial crisis” is already in the works. All it takes now is a significant decline in asset prices to spark a cascade of events that even monetary interventions may be unable to stem.

However, to Rex’s credit, households WILL NOT be the sole catalyst of the next crisis.

The real crisis comes when there is a “run on pensions.” With a large number of pensioners already eligible for their pension, the next decline in the markets will likely spur the “fear” that benefits will be lost entirely. The combined run on the system, which is grossly underfunded, at a time when asset prices are dropping  will cause a debacle of mass proportions. As noted above, it is going to require a massive government bailout to resolve it.

But, consumers will “contribute their fair share.” Consumers are once again heavily leveraged with sub-prime auto loans, mortgages, and student debt. When the recession hits, the reduction in employment will further damage what remains of personal savings and consumption ability. The downturn will increase the strain on an already burdened government welfare system as an insufficient number of individuals paying into the scheme is being absorbed by a swelling pool of aging baby-boomers now forced to draw on it. Yes, more Government funding will be required to solve that problem as well. 

As debts and deficits swell in coming years, the negative impact to economic growth will continue. At some point, there will be a realization of the real crisis. It isn’t a crash in the financial markets that is the real problem, but the ongoing structural shift in the economy that is depressing the living standards of the average American family. There has indeed been a redistribution of wealth in America since the turn of the century. Unfortunately, it has been in the wrong direction as the U.S. has created its own class of royalty and serfdom.

The good news is that it can all be solved by the issuance of more debt.

The bad news comes when there are no buyers willing to continue to fund fiscal irresponsibility.

The next “crisis,” will be the “great reset” which will also make it the “last crisis.”

Jerome Powell on 60 Minutes: Fact Check

On Sunday, March 11, 2019, Federal Reserve Chairman Jerome Powell was interviewed by Scott Pelley on 60 Minutes. We thought it would be helpful to cite a few sections of their conversation and provide you with prior articles in which we addressed the topics discussed.

We have been outspoken about the role of the Fed, their mission and policy actions over the last ten years. We are quick to point out flaws in Fed policy for a couple of reasons. First, is simply due to the enormous effect that Fed policy actions and words have on the markets. Second, many in the media seem to regurgitate the Fed’s actions and words without providing much context or critique of them. The combination of the Fed’s power over the market coupled with poor media analysis of their words and actions might expose investors to improper conclusions and therefore sub-optimal investment decision-making.

With that, we review various parts of the 60 Minutes interview and offer links to prior articles to help provide alternative views and insight as well as a more thorough context of Chairman Powell’s answers.  

Click the following links for the interview TRANSCRIPT and VIDEO.

Can the Fed Chairman be fired?

PELLEY: Do you listen to the president?

POWELL: I don’t comment on the president or any elected official.

PELLEY: Can the president fire you?

POWELL: Well, the law is clear that I have a four-year term. And I fully intend to serve it.

PELLEY: So no, in your view?

POWELL: No.

Our Take: Yes, the Federal Reserve Act which governs the Fed makes it clear that he can be fired “for cause.”- Chairman Powell You’re Fired

Does the Fed play a role in driving the growing income and wealth inequality gaps?

PELLEY: According to federal statistics, the upper half of the American people take home 90% of income, leaving about 10% for the lower half of Americans. Where are we headed in this country in terms of income disparity?

POWELL: Well, the Fed doesn’t have direct responsibility for these issues. But nonetheless, they’re important.

Our Take:  Inflation hurts the poor and benefits of the wealthy. The Fed has an inflation target and therefore takes direct policy action that fuels the wealth divide. – Two Percent for the One Percent

Will Chairman Powell know when a recession is upon us?

PELLEY: This is the longest expansion in American history. How long can it last?

POWELL: It will be the longest in a few months if it continues. I would just say there’s no reason why it can’t continue.

PELLEY: For years?

Our Take: In January of 2008 Chairman Bernanke said a recession was not in the cards. It turns out the official recession started a month earlier.– Recession Risks Are Likely Higher Than You Think

How healthy is the labor market?

POWELL: So, the U.S. economy right now is in a pretty good place. Unemployment is at a 50-year low.

Our Take: We continually hear about the strength of the labor market. While that may seem to be the case, wages and the labor participation rate paint a different picture. – Quick Take: Unemployment Anomaly (RIA Pro – Unlocked)

Do record high stock valuations represent healthy financial conditions?

PELLEY: We have seen big swings in the stock markets in the United States. And I wonder, do you think the markets today are overvalued?

POWELL: We don’t comment on the valuation of the stock market particularly. And we do though, we monitor financial conditions carefully. Our interest rate policy works through financial conditions. So we look at a very broad range of financial conditions. That includes interest rates, the level of the dollar, the availability of credit and also the stock market. So we look at a range of things. And I think we feel that conditions are generally healthy today.

Our Take: We beg to differ with over 100 years of history on our side. – Allocating on Blind Faith (RIA Pro – Unlocked)

Is the Fed Chairman aware of the burden of debt and its economic consequences?

PELLEY: But the overarching question is are we headed to a recession?

POWELL: The outlook for our economy, in my view, is a favorable one. It’s a positive one. I think growth this year will be slower than last year. Last year was the highest growth that we’ve experienced since the financial crisis, really in more than ten years. This year, I expect that growth will continue to be positive and continue to be at a healthy rate.

Our Take: The record amount of debt on an absolute basis and relative to economic activity is a burden on the economy. Expectations should be greatly tempered. – The Economic Consequences of Debt and Economic Theories – Debt Driven Realities

Does Chairman Powell bow at the altar of the President and Congress?

On December 17 & 18 of 2019 President Trump tweeted the following: 

“It is incredible that with a very strong dollar and virtually no inflation, the outside world blowing up around us, Paris is burning and China way down, the Fed is even considering yet another interest rate hike. Take the Victory!”

I hope the people over at the Fed will read today’s Wall Street Journal Editorial before they make yet another mistake. Also, don’t let the market become any more illiquid than it already is. Stop with the 50 B’s. Feel the market, don’t just go by meaningless numbers. Good luck!”

PELLEY: Your Fed is apolitical?

POWELL: Strictly non-political.

Considering the Fed made an abrupt U-Turn of policy following the Tweets above, a sharp market decline and very little change in the data to justify it, we think otherwise. – The Fed Doesn’t Target The Market

Summary

The Fed has a long history of talking out of both sides of their mouths. They make a habit of avoiding candor about policy uncertainties in what appears to be an effort to retain credibility and give an appearance of confidence. The Fed’s defense of their extraordinary actions over the past ten years and reluctance to normalize policy is awkward, to say the least and certainly not confidence inspiring. As evidenced by his responses to Scott Pelley on 60 Minutes, Jerome Powell is picking up where Bernanke and Yellen left off.

This article aims to contrast the inconsistencies of the most current words of the Fed Chairman with truths and reality. Thinking for oneself and taking nothing for granted remains the most powerful way to protect and compound wealth and avoid large losses.

QE – Then, Now, & Why It May Not Work

Since the beginning of the year, the market has rallied sharply. That rally has been fueled by commentary from both the Trump Administration and the Federal Reserve of the removal of obstacles which plagued stocks in 2018. The chart below is an abbreviated, and a bit sarcastic, version of events.

While the resolution of the trade war is certainly beneficial to the economy, as it removes an additional tax on consumers, the biggest support for the market has been the assumption the Fed will return to a much more accommodative stance.

As we summed up previously for our RIA PRO subscribers (try it FREE for 30-days)

  • The Fed will be “patient” with future rate hikes, meaning they are now likely on hold as opposed to their forecasts which still call for two to three more rate hikes in 2019 and more in 2020.
  • The pace of QT, or balance sheet reduction, will not be on “autopilot” but instead driven by the current economic situation and tone of the financial markets. It is expected the Fed will announce in March that QT will end and the balance sheet will stabilize at a much higher level.
  • QE is a tool that WILL BE employed when rate reductions are not enough to stimulate growth and calm jittery financial markets.

In mid-2018, the Federal Reserve was adamant a strong economy, and rising inflationary pressures, required tighter monetary conditions. At that time they were discussing additional rate hikes and a continued reduction of their $4 Trillion balance sheet.

All it took was a rough December, pressure from Wall Street’s member banks, and a disgruntled White House to completely flip their thinking.

The Fed isn’t alone.

China has launched its version of “Quantitative Easing” to help prop up its slowing economy.

Lastly, the ECB downgraded Eurozone growth, and as announced today, not only will they not raise rates in 2019, they also extended the TLTRO program, which is the Targeted Longer-Term Refinancing Operations scheme which gives cheap loans to struggling Eurozone banks, into 2021.

But there is nothing to worry about, right?

Think about this for a moment.

For a decade the global economy has been growing. Market participants are crowing about the massive surge in asset prices as clear evidence of the strength of the economy.

However, such hasn’t been the case. As I discussed previously for the Fed, China, and the ECB, are signaling their concerns about “economic reality,” which as the data through the end of December shows, the U.S. economy is beginning to slow.

“As shown, over the last six months, the decline in the LEI has been sharper than originally anticipated. Importantly, there is a strong historical correlation between the 6-month rate of change in the LEI and the EOCI index. As shown, the downturn in the LEI predicted the current economic weakness and suggests the data is likely to continue to weaken in the months ahead.”

More importantly, monetary policy never really impacted the economy as prolifically as was anticipated following the financial crisis. The two 4-panel charts below show the percentage change in the Fed’s balance sheet from 2009-present (309%) versus the total percentage change in various economic components. I have also included the amount of stimulus required to create those changes.

First, it is interesting to note that despite headlines of strong employment growth, the percentage of people considered “Not In Labor Force or NILF” has grown more than full-time employment. Of course, and not surprisingly, the biggest beneficiary of monetary policy was…corporate profits.

Secondly, where monetary policy did work was lifting asset prices as shown in the chart and table below.

The table above shows that QE1 came immediately following the financial crisis and had an effective ratio of about 1.6:1. In other words, it took a 1.6% increase in the balance sheet to create a 1% advance in the S&P 500. However, once market participants figured out the transmission system, QE2 and QE3 had an almost perfect 1:1 ratio of effectiveness. The ECB’s QE program, which was implemented in 2015 to support concerns of an unruly “Brexit,” had an effective ratio of 1.5:1.

Clearly, QE worked well in lifting asset prices, but not so much for the economy as shown above. In other words, QE was ultimately a massive “wealth transfer” from the middle class to the rich which has created one of the greatest wealth gaps in the history of the U.S., not to mention an asset bubble of historic proportions.

But Will It Work Next Time?

This is the single most important question for investors.

The current belief is that QE4 will be implemented at the first hint of a more protracted downturn in the market. However, as we noted above, QE will likely only be employed when rate reductions aren’t enough. Such was noted in 2016 by David Reifschneider, deputy director of the division of research and statistics for the Federal Reserve Board in Washington, D.C., released a staff working paper entitled “Gauging The Ability Of The FOMC To Respond To Future Recessions.” 

The conclusion was simply this:

“Simulations of the FRB/US model of a severe recession suggest that large-scale asset purchases and forward guidance about the future path of the federal funds rate should be able to provide enough additional accommodation to fully compensate for a more limited [ability] to cut short-term interest rates in most, but probably not all, circumstances.”

In other words, the Federal Reserve is rapidly becoming aware they have become caught in a liquidity trap keeping them unable to raise interest rates sufficiently to reload that particular policy tool. There are certainly growing indications, as discussed recently, the U.S. economy maybe be heading towards the next recession. 

Interestingly, David compared three policy approaches to offset the next recession.

  1. Fed funds goes into negative territory but there is no breakdown in the structure of economic relationships.
  2. Fed funds returns to zero and keeps it there long enough for unemployment to return to baseline.
  3. Fed funds returns to zero and the FOMC augments it with additional $2-4 Trillion of QE and forward guidance. 

In other words, the Fed is already factoring in a scenario in which a shock to the economy leads to additional QE of either $2 trillion, or in a worst case scenario, $4 trillion, effectively doubling the current size of the Fed’s balance sheet.

Here is what is interesting, as reported by Jennifer Ablan:

So, 2-years ago David lays out the plan and yesterday Williams reiterates that plan.

Does the Fed see a recession on the horizon? Is this the reason for the sudden change in views by Powell in recent weeks?

Maybe.

But there is a problem with the entire analysis. The effectiveness of QE, and zero interest rates, is based on the point at which you apply these measures. This was something I pointed out previously:

“In 2008, when the Fed launched into their “accommodative policy” emergency strategy to bail out the financial markets, the Fed’s balance sheet was only about $915 Billion. The Fed Funds rate was at 4.2%.

If the market fell into a recession tomorrow, the Fed would be starting with roughly a $4 Trillion balance sheet with interest rates 2% lower than they were in 2009. In other words, the ability of the Fed to ‘bail out’ the markets today, is much more limited than it was in 2008.”

But there is more to the story than just the Fed’s balance sheet and funds rate. The entire backdrop is completely reversed. The table below compares a variety of financial and economic factors from 2009 to present.

The critical point here is that QE and rate reductions have the MOST effect when the economy, markets, and investors have been “blown out,” deviations from the “norm” are negatively extended, confidence is hugely negative.

In other words, there is nowhere to go but up.

Such was the case in 2009. Even without Federal Reserve interventions, it is highly probable that the economy would have begun a recovery as the normal economic cycle took hold. No, the recovery would not have been as strong, and asset prices would be about half of where they are today, but an improvement would have happened nonetheless.

The extremely negative environment that existed, particularly in the asset markets, provided a fertile starting point for monetary interventions. Today, as shown in the table above, the economic and fundamental backdrop could not be more diametrically opposed.

This suggests that the Fed’s ability to stem the decline of the next recession, or offset a financial shock to the economy from falling asset prices, may be much more limited than the Fed, and most investors, currently believe.

The Fed’s hope has always been that at some point they would be able to wean the economy off of life support and it would operate under its own strength. This would allow the Fed to raise interest rates back to more normalized levels and provide a policy tool to offset the next recession. However, given the Fed has never been able to get rates higher than the last crisis, it has only led to bigger “booms and busts” in recent decades.

Summary

It has taken a massive amount of interventions by Central Banks to keep economies afloat globally over the last decade and there is rising evidence that growth is beginning to decelerate.

While another $2-4 Trillion in QE might indeed be successful in further inflating the third bubble in asset prices since the turn of the century, there is a finite ability to continue to pull forward future consumption to stimulate economic activity. In other words, there are only so many autos, houses, etc., which can be purchased within a given cycle. There is evidence the cycle peak has been reached.

If I am correct, and the effectiveness of rate reductions and QE are diminished due to the reasons detailed herein, the subsequent destruction to the “wealth effect” will be far larger than currently imagined. There is a limit to just how many bonds the Federal Reserve can buy and a deep recession will likely find the Fed powerless to offset much of the negative effects. 

If more “QE” works, great. But as investors, with our retirement savings at risk, what if it doesn’t.

The Fed Doesn’t Target The Market?

Earlier this month, I penned an article asking if we “really shouldn’t worry about the Fed’s balance sheet?” The question arose from a specific statement made by previous New York Federal Reserve President Bill Dudley:

“Financial types have long had a preoccupation: What will the Federal Reserve do with all the fixed income securities it purchased to help the U.S. economy recover from the last recession? The Fed’s efforts to shrink its holdings have been blamed for various ills, including December’s stock-market swoon. And any new nuance of policy — such as last week’s statement on “balance sheet normalization” — is seen as a really big deal.

I’m amazed and baffled by this. It gets much more attention than it deserves.”

As I noted, there is a specific reason why “financial types” have a preoccupation with the balance sheet.

The preoccupation came to light in 2010 when Ben Bernanke added the “third mandate” to the Fed – the creation of the “wealth effect.”

“This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate this additional action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”

– Ben Bernanke, Washington Post Op-Ed, November, 2010.

As he noted, the Fed specifically targeted asset prices to boost consumer confidence. Given that consumption makes up roughly 70% of economic growth in the U.S., it makes sense. So, not surprisingly, when the economy begins to show signs of deterioration, the Fed acts to offset that weakness.

This is why the slowdown in global growth became an important factor behind the central bank’s decision to put plans for interest rate increases on hold. That comment was made by Federal Reserve Vice Chairman Richard Clarida during a question-and-answer session last week.

“The reality is that the global economy is slowing. You’ve got negative growth in Italy, Germany may just grow…1% this year, [and] a slowdown in China. These are all things that we need to factor in. 

Slower global growth would crimp U.S. exports and could also negatively influence financial and asset markets, a primary transmission mechanism for monetary policy.”

As we noted previously in “Data or Markets,” the Fed is not truly just “data dependent.” They are, in many ways, co-dependent on each other. A strongly rising market allows the Fed to raise rates and reduce accommodative as higher asset prices support confidence. However, that “leeway” is quickly reduced when asset prices reverse. This has been the Fed cycle for the last 40-years.

The problem for the Fed is they have now become “liquidity trapped.”

What is that? Here is the definition:

“A liquidity trap is a situation described in Keynesian economics in which injections of cash into the private banking system by a central bank fail to lower interest rates and hence fail to stimulate economic growth. A liquidity trap is caused when people hoard cash because they expect an adverse event such as deflation, insufficient aggregate demand, or war. Signature characteristics of a liquidity trap are short-term interest rates that are near zero and fluctuations in the monetary base that fail to translate into fluctuations in general price levels.

The chart below shows the correlation between the decline of GDP and the Fed Funds rate.

There are two important things to notice from the chart above. The first is that prior to 1980, the trend of both economic growth and the Fed Funds rate were rising. Then, post-1980, as then Fed Chairman Paul Volker and President Ronald Reagan set out to break the back of inflation, each successive cycle of rate increases were started from a level lower than the previous cycle.

The difference between the two periods was the amount of debt in the system and the shift from an expansive production and manufacturing based economy to one driven primarily by services which have a substantially lower multiplier effect. Since 1980, it has required increasing levels of debt to manufacture $1 of GDP growth.

In every case, the rate cycle increase ALWAYS led to either a recession, bear market, crisis, or all three. Importantly, those events occurred not when the Fed STARTED hiking rates, but when they recognized that their tightening process was confronted by weakening economic growth. 

The Trap

The problem for the Fed is that while lower interest rates may help spur economic growth in the short-term, the growth has come from an increasing level of debt accumulation. Therefore, the economy cannot withstand a reversal of those rates. As shown above, each successive round of rate increases was never able to achieve a rate higher than the previous peak. For example, in 2007, the Fed Funds rate was roughly 5% when the Fed started lowering rates to combat the financial crisis. Today, if the Fed started lowering rates to combat economic weakness,  they would do so from less than half that previous rate.

As Richard Clarida noted in his speech, one of the potential risks to Central Banks globally is the lack of monetary policy firepower available. We previously pointed out that in 2009, the Fed went to work to rescue the economy with a $915 billion balance sheet and Fed Funds at 4.2%. Today, that balance sheet remains above $4 trillion and rates are at 2.5%.

It isn’t lost on the Fed that if a recession were to occur, their main lever for stimulating economic activity, interest rate reductions, will have little value. Given the amount of debt outstanding and the onerous burden of servicing it, the marginal benefit of lower rates will likely not be enough to lift the country out of a recession. In such a tough situation the next lever at their disposal is increasing their balance sheet and flooding the markets with liquidity via QE.

However, even that may not be enough as both Ben Bernanke and Janet Yellen have acknowledged that they were aware that each successive round of QE was somewhat less effective than the last. That certainly must be a concern for Powell if he is called upon to re-engage QE in a recession or another economic crisis.

For the Federal Reserve, they are now caught in the same “liquidity trap” that has been the history of Japan for the last three decades. One only needs to look at Japan for an understanding that QE, low-interest rate policies, and expansion of debt have done little economically. Take a look at the chart below which shows the expansion of the BOJ assets versus the growth of GDP and levels of interest rates.

Notice that since 1998, Japan has not achieved a 2% rate of economic growth. Even with interest rates still near zero, economic growth remains mired below one-percent, providing little evidence to support the idea that inflating asset prices by buying assets leads to stronger economic outcomes.

But yet, the current Administration believes our outcome will be different.

With the current economic recovery already pushing the long end of the economic cycle, the risk is rising that the next economic downturn is closer than not. The danger is that the Federal Reserve is now potentially trapped with an inability to use monetary policy tools to offset the next economic decline when it occurs.

This is the same problem that Japan has wrestled with for the last 30-years. While Japan has entered into an unprecedented stimulus program (on a relative basis twice as large as the U.S. on an economy 1/3 the size) there is no guarantee that such a program will result in the desired effect of pulling the Japanese economy out of its 30-year deflationary cycle. The problems that face Japan are similar to what we are currently witnessing in the U.S.:

  • A decline in savings rates to extremely low levels which depletes productive investments
  • An aging demographic that is top heavy and drawing on social benefits at an advancing rate.
  • A heavily indebted economy with debt/GDP ratios above 100%.
  • A decline in exports due to a weak global economic environment.
  • Slowing domestic economic growth rates.
  • An underemployed younger demographic.
  • An inelastic supply-demand curve
  • Weak industrial production
  • Dependence on productivity increases to offset reduced employment

The real concern for investors, and individuals, is the actual economy. We are likely experiencing more than just a ‘soft patch’ currently despite the mainstream analysts’ rhetoric to the contrary. There is clearly something amiss within the economic landscape and the ongoing decline of inflationary pressures longer term is likely telling us just that. The big question for the Fed is how to get out of the ‘liquidity trap’ they have gotten themselves into without cratering the economy, and the financial markets, in the process.

The One Thing

However, the one statement, which is arguably the most important for investors, is what Bill Dudley stated relative to the size of the balance sheet and it’s use a tool to stem the next decline.

“The balance sheet tool becomes relevant only if the economy falters badly and the Fed needs more ammunition.”

In other words, it will likely require a substantially larger correction than what we have just seen to bring “QE” back into the game. Unfortunately, as I laid out in “Why Another 50% Correction Is Possible,” the ingredients for a “mean-reverting” event are all in place.

“What causes the next correction is always unknown until after the fact. However, there are ample warnings that suggest the current cycle may be closer to its inevitable conclusion than many currently believe. There are many factors that can, and will, contribute to the eventual correction which will ‘feed’ on the unwinding of excessive exuberance, valuations, leverage, and deviations from long-term averages.

The biggest risk to investors currently is the magnitude of the next retracement. As shown below the range of potential reversions runs from 36% to more than 54%.”

“It’s happened twice before in the last 20 years and with less debt, less leverage, and better-funded pension plans.

More importantly, notice all three previous corrections, including the 2015-2016 correction which was stopped short by Central Banks, all started from deviations above the long-term exponential trend line. The current deviation above that long-term trend is the largest in history which suggests that a mean reversion will be large as well.

It is unlikely that a 50-61.8% correction would happen outside of the onset of a recession. But considering we are already pushing the longest economic growth cycle in modern American history, such a risk which should not be ignored.”

While Bill makes the point that “QE” is available as a tool, it won’t likely be used until AFTER the Fed lowers interest rates back to the zero-bound. Which means that by the time “QE” comes to the fore, the damage to investors will likely be much more severe than currently contemplated.

Yes, the Fed absolutely targets the financial markets with their policies. The only question will be what “rabbit” they pull out of their hat if it doesn’t work next time?

I am not sure even they know.

The Fed Conundrum – Data Or Markets?

Following the Fed’s last meeting, we published for our RIA PRO subscribers (use code PRO30 for a 30-day free trial) a simple question:

“What does the Fed know?”

Of course, this meeting followed the stock market plunge at the end of 2018 where their tone that turned from “hawkish” to “dovish” in the span of just a few weeks. Seemingly, despite the previous commentary about concerns over rising inflationary pressures, it was pressure from Wall Street and the White House that quickly “realigned” the Fed’s views.

  • The Fed will be “patient” with future rate hikes, meaning they are now likely on hold as opposed to their forecasts which still call for two to three more rate hikes this year.
  • The pace of QT or balance sheet reduction will not be on “autopilot” but instead driven by the current economic situation and tone of the financial markets.
  • QE is a tool that WILL BE employed when rate reductions are not enough to stimulate growth and calm jittery financial markets.

This change in stance, not surprisingly, buoyed the stock market as the proverbial “Fed Put” was back in place.

But the change view may have also just trapped the Fed in their own “data dependent” decision-making process.

The Fed Should Be Hiking Rates

As we noted in our RIA Pro article:

“During the press conference, the Chairman was asked what has transpired since the last meeting on December 19, 2019, to warrant such an abrupt change in policy given that he recently stated that policy was accommodative, and the economy did not require such policy anymore.

In response, Powell stated:

‘We think our policy stance is appropriate right now. We do. We also know that our policy rate is now in the range of the committee’s estimates of neutral.'”

Powell’s awkward response, and unsatisfactory rationale to a simple and obvious question, the question must be asked if it is possible that economic or credit risks are greater than currently believed which would account for the policy U-turn?

However, given that the Fed’s two primary mandates are supposed to be “full employment” and “price stability,” the conflict between managing inflation and supporting the markets is a conundrum.

For example, there is currently sufficient data which suggests “real inflationary pressures” are mounting in the economy. For example, with a 300,000 job print in January and rising wage pressures, the Fed should raise interest rates. The chart below of labor costs clearly show the problem business owners are facing.

As noted employment remains strong and data suggests there is upward pressure on companies to hire more workers.

That pressure to hire is coming from the reality there are currently more demands on labor than there are people to fill them.

Wage pressures are clearly rising in recent months putting additional upward pressures on pricing as companies pass on higher labor costs.

More importantly, inflationary pressures as measured by both PPI, CPI, and the Fed’s preferred measure of Core PCE, continue to rise as well.

The chart below is the spread between PPI and CPI, historically, when “producer price” inflation rises faster than consumer prices, it has impacted economic growth by suggesting that inflation can’t be passed on to consumers.

The composite inflation index is also screaming higher suggesting that if the Fed pauses they could potentially get well “behind the curve.” 

Even the Federal Reserve’s favorite measure of inflation, PCE, is also suggesting the Fed should be hiking rates rather than pausing.

All of this data clearly suggests that the Fed should be hiking rates currently, rather than pausing. 

The Conundrum

However, all of this data is also consistent with the end of an economic cycle rather than a continued expansion. As we quoted last week from John Mauldin:

I think because unemployment is lowest when the economy is in a mature growth cycle, and stock returns are in the process of flattening and rolling over. Sadly, that is where we seem to be right now. Unemployment is presently in the ‘low’ range which, in the past, often preceded a recession.

That loss of confidence is already beginning to show signs as noted recently by Zerohedge:

“American small-business owners are growing increasingly anxious about a looming economic slowdown.

After a report published last week by Vistage Worldwide suggested that small-business confidence had collapsed with the number of small business owners worried that the economy could worsen in 2019 numbering more than twice those who expected it to improve, the NFIB Small Business Optimism Index – a widely watched sentiment gauge – apparently confirmed that more business owners are growing fearful that economic conditions might begin to work against them in the coming months.”

Furthermore, most of these data points are at levels that typically precede economic slowdowns and recession, so hiking rates further from current levels could exacerbate the recessionary risk.

The problem the Fed faces currently, as we discussed previously, is that when the last recession started the Fed Funds rate was at 4.2% not 2.2% and the Fed balance sheet was $915 billion not $4+ trillion.

“If the market fell into a recession tomorrow, the Fed would be starting with roughly a $4 Trillion dollar balance sheet with interest rates 2% lower than they were in 2009. In other words, the ability of the Fed to ‘bail out’ the markets today, is much more limited than it was in 2008.”

But…what do you do?

The Trap

There are clearly rising inflationary pressures on the market, which are also beginning to impede economic growth. Those pressures, combined with a sharp decline in asset prices, spurred the Fed to react to political and market pressures.

The Fed is most likely aware that if a recession were to occur, their main lever for stimulating economic activity, interest rate reductions, will have little value. Given the amount of debt outstanding and the onerous burden of servicing it, the marginal benefit of lower rates will likely not provide enough benefits to lift the country out of a recession. In such a tough situation the next lever at their disposal is increasing their balance sheet and flooding the markets with liquidity via QE.

Sure, Powell might be taking a dovish tone to placate the markets, the President and his member banks and concurrently buying time to further normalize the balance sheet? But this approach is like pouring liquid out of your cup so you can add more when the time is right. You would do this because it is not clear just how much “the cup” will ultimately hold.

Bernanke and Yellen have both acknowledged that they were aware that each successive round of QE was somewhat less effective than prior rounds. That certainly must be a concern for Powell if he is called upon to re-engage QE in a recession or another economic crisis.

If this is the case, Powell will continue to publicly discuss minimizing reductions to the balance sheet and refrain from further rate hikes. Despite such dovish Fed-speak, he would continue to shrink the balance sheet at the current pace. This tactic may trick investors for a few months but at some point, the market will question his intentions and damage Fed credibility.

So, therein lies the trap. Do you hike rates and reduce the balance sheet anyway to be better prepared for the onset of the next recession, OR reverse policy to try to “kick the recession can” down the road a bit which leaves you under-prepared for the next crisis?

For the Fed, it is a choice between the lesser of two evils. The only question is did they make the right one?

While the Fed has a long history of using economic jargon and, quite frankly, non-truths to help promote their agenda, they also have a long history of making the wrong policy moves which spark either some sort of crisis, recession or both.

As Michael Lebowitz concluded for our RIA PRO subscribers last week:

“The market has largely recovered from the fourth quarter swoon, as such the Fed should be resting more comfortably. Economic data remains strong, and if anything it is slightly better than December when the Fed was ready to raise rates three times and put balance sheet reduction on “autopilot.”

Today the Fed has all but put the kibosh on further rate hikes and, per Mester’s comments, will end balance sheet reduction (QT) in the months ahead.

It is becoming more suspect that the Fed knows something the market does not.”

But, exactly what is it?

Recession Risks Are Likely Higher Than You Think

It is often said that one should never discuss religion or politics as you are going to wind up offending someone. In the financial world it is mentioning the “R” word.

The reason, of course, is that it is the onset of a recession that typically ends the “bull market” party. As the legendary Bob Farrell once stated:

“Bull markets are more fun than bear markets.”

Yet, recessions are part of a normal and healthy economy that purges the excesses built up during the first half of the cycle.

economic_cycle-2

Since “recessions” are painful, as investors, we would rather not think about the “good times” coming to an end. However, by ignoring the risk of a recession, investors have historically been repeatedly crushed by the inevitable completion of the full market and economic cycle.

But after more than a decade of an economic growth cycle, investors have become complacent in the idea that recessions may have been mostly mitigated by monetary policy.

While monetary policy can certainly extend cycles, they cannot be repealed.

Given that monetary policy has consistently inflated asset prices historically, the reversions of those excesses have been just as dramatic. The table below shows every economic recovery and recessionary cycle going back to 1873.

Importantly, note that the average recessionary drawdown historically is about 30%. While there were certainly some recessionary drawdowns which were very small, the majority of the reversions, particularly from more extreme overvaluation levels as we are currently experiencing, have not been kind to investors.

So, why bring this up?

“In the starkest warning yet about the upcoming global recession, which some believe will hit in late 2019 or 2020 at the latest, the IMF warned that the leaders of the world’s largest countries are ‘dangerously unprepared’ for the consequences of a serious global slowdown. The IMF’s chief concern: much of the ammunition to fight a slowdown has been exhausted and governments will find it hard to use fiscal or monetary measures to offset the next recession, while the system of cross-border support mechanisms — such as central bank swap lines — has been undermined.” – David Lipton, first deputy managing director of the IMF.

Despite recent comments that “recession risk” is non-existent, there are various indications which suggest that risk is much higher than currently appreciated.  The New York Federal Reserve recession indicator is now at the highest level since 2008.

Also, as noted by George Vrba recently, the unemployment rate may also be warning of a recession as well.

“For what is considered to be a lagging indicator of the economy, the unemployment rate provides surprisingly good signals for the beginning and end of recessions. This model, backtested to 1948, reliably provided recession signals.

The model, updated with the January 2019 rate of 4.0%, does not signal a recession. However, if the unemployment rate should rise to 4.1% in the coming months the model would then signal a recession.”

John Mauldin also recently noted the same:

“This next chart needs a little explaining. It comes from Ned Davis Research via my friend and business partner Steve Blumenthal. It turns out there is significant correlation between the unemployment rate and stock returns… but not the way you might expect.

Intuitively, you would think low unemployment means a strong economy and thus a strong stock market. The opposite is true, in fact. Going back to 1948, the US unemployment rate was below 4.3% for 20.5% of the time. In those years, the S&P 500 gained an annualized 1.7%.”

“Now, 1.7% is meager but still positive. It could be worse. But why is it not stronger? I think because unemployment is lowest when the economy is in a mature growth cycle, and stock returns are in the process of flattening and rolling over. Sadly, that is where we seem to be right now. Unemployment is presently in the ‘low’ range which, in the past, often preceded a recession.

The yield spread between the 10-year and the 2-year Treasury yields is also suggesting there is a rising risk of a recession in the economy.

As I noted previously:

“The yield curve is clearly sending a message that shouldn’t be ignored and it is a good bet that ‘risk-based’ investors will likely act sooner rather than later. Of course, it is simply the contraction in liquidity that causes the decline which will eventually exacerbate the economic contraction. Importantly, since recessions are only identified in hindsight when current data is negatively revised in the future, it won’t become ‘obvious’ the yield curve was sending the correct message until far too late to be useful.

While it is unwise to use the ‘yield curve’ as a ‘market timing’ tool, it is just as unwise to completely dismiss the message it is currently sending.”

We can also see the slowdown in economic activity more clearly we can look at our RIA Economic Output Composite Index (EOCI). (The index is comprised of the CFNAI, Chicago PMI, ISM Composite, All Fed Manufacturing Surveys, Markit Composite, PMI Composite, NFIB, and LEI)

As shown, over the last six months, the decline in the LEI has actually been sharper than originally anticipated. Importantly, there is a strong historical correlation between the 6-month rate of change in the LEI and the EOCI index. As shown, the downturn in the LEI predicted the current economic weakness and suggests the data is likely to continue to weaken in the months ahead.”

With the exception of the yield curve, which is “real time,” the rest of the data is based on economic data which has a multitude of problems.

There are many suggesting currently that based on current economic data, there is “no recession” in sight. This is based on looking at levels of economic data versus where “recessions” started in the past.

But therein lies the biggest flaw.

“The problem with making an assessment about the state of the economy today, based on current data points, is that these numbers are ‘best guesses’ about the economy currently. However, economic data is subject to substantive negative revisions in the future as actual data is collected and adjusted over the next 12-months and 3-years. Consider for a minute that in January 2008 Chairman Bernanke stated:

‘The Federal Reserve is not currently forecasting a recession.’

In hindsight, the NBER called an official recession that began in December of 2007.”

The issue with a statement of “there is no recession in sight,” is that it is based on the “best guesses” about the economy currently. However, economic data is subject to substantive negative revisions in the future as actual data is collected and adjusted over the next 12-months and 3-years. Consider for a minute that in January 2008 Chairman Bernanke stated:

“The Federal Reserve is not currently forecasting a recession.”

In hindsight, the NBER called an official recession that began in December of 2007.

But this is almost always the case. Take a look at the data below of real (inflation-adjusted)economic growth rates:

  • September 1957:     3.07%
  • May 1960:                 2.06%
  • January 1970:        0.32%
  • December 1973:     4.02%
  • January 1980:        1.42%
  • July 1981:                 4.33%
  • July 1990:                1.73%
  • March 2001:           2.31%
  • December 2007:    1.97%

Each of the dates above shows the growth rate of the economy immediately prior to the onset of a recession.  In 1957, 1973, 1981, 2001, 2007 there was “no sign of a recession.” 

The next month a recession started.

So, what about now?

“The recent decline from the peak in the market, is just that, a simple correction. With the economy growing at 3.0% on an inflation-adjusted basis, there is no recession in sight.” 

Is that really the case or is the market telling us something?

The chart below is the S&P 500 two data points noted.

The green dots are the peak of the market PRIOR to the onset of a recession. In 8 of 9 instances, the S&P 500 peaked and turned lower prior to the recognition of a recession. The yellow dots are the official recessions as dated by the National Bureau of Economic Research (NBER) and the dates at which those proclamations were made.

At the time, the decline from the peak was only considered a “correction” as economic growth was still strong.

In reality, however, the market was signaling a coming recession in the months ahead. The economic data just didn’t reflect it as of yet. (The only exception was 1980 where they coincided in the same month.) The chart below shows the date of the market peak and real GDP versus the start of the recession and GDP growth at that time.

The problem is in waiting for the data to catch up.

Today, we are once again seeing many of the same early warnings. If you have been paying attention to the trend of the economic data, the stock market, and the yield curve, the warnings are becoming more pronounced. In 2007, the market warned of a recession 14-months in advance of the recognition. 

So, therein lies THE question:

Is the market currently signaling a “recession warning?”

Everybody wants a specific answer. “Yes” or “No.

Unfortunately, making absolute predictions can be extremely costly when it comes to portfolio management.

There are three lessons to be learned from this analysis:

  1. The economic “number” reported today will not be the same when it is revised in the future.
  2. The trend and deviation of the data are far more important than the number itself.
  3. “Record” highs and lows are records for a reason as they denote historical turning points in the data.

As Doug Kass noted on Tuesday there are certainly plenty of risks to be aware of:

  1. Domestic economic growth weakens, Chinese growth fails to stabilize and Europe enters a recession
  2. U.S./China fail to agree on a trade deal
  3. Trump institutes an attack on European Union trade by raising auto tariffs
  4. U.S. Treasury yields fail to ratify an improvement in economic growth
  5. The market leadership of FANG and Apple (AAPL) subsidies
  6. Earnings decline in 2019 and valuations fail to expand
  7. The Mueller Report jeopardizes the president
  8. A hard and disruptive Brexit
  9. Crude oil supplies spike and oil prices collapse, taking down the high-yield market
  10. Draghi is replaced by a hawk

While the call of a “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.

Pay attention to the message markets are sending. It may just be saying something very important.

Dalio’s Fear Of The Next Downturn Is Likely Understated

“What scares me the most longer term is that we have limitations to monetary policy — which is our most valuable tool — at the same time we have greater political and social antagonism.” – Ray Dalio, Bridgewater Associates

Dalio made the remarks in a panel discussion at the World Economic Forum’s annual meeting in Davos on Tuesday where he reiterated that a limited monetary policy toolbox, rising populist pressures and other issues, including rising global trade tensions, are similar to the backdrop present in the latter part of the Great Depression in the late 1930s.

Before you dismiss Dalio’s view Bridgewater’s Pure Alpha Strategy Fund posted a gain of 14.6% in 2018, while the average hedge fund dropped 6.7% in 2018 and the S&P 500 lost 4.4%.

The comments come at a time when a brief market correction has turned monetary and fiscal policy concerns on a dime. As noted by Michael Lebowitz yesterday afternoon at RIA PRO

“In our opinion, the Fed’s new warm and cuddly tone is all about supporting the stock market. The market fell nearly 20% from record highs in the fourth quarter and fear set in. There is no doubt President Trump’s tweets along with strong advisement from the shareholders of the Fed, the large banks, certainly played an influential role in persuading Powell to pivot.

Speaking on CNBC shortly after the Powell press conference, James Grant stated the current situation well.

“Jerome Powell is a prisoner of the institutions and the history that he has inherited. Among this inheritance is a $4 trillion balance sheet under which the Fed has $39 billon of capital representing 100-to-1 leverage. That’s a symptom of the overstretched state of our debts and the dollar as an institution.”

As Mike correctly notes, all it took for Jerome Powell to completely abandon any facsimile of “independence” was a rough December, pressure from Wall Street’s member banks, and a disgruntled White House to completely flip their thinking.

In other words, the Federal Reserve is now the “market’s bitch.”

However, while the markets are celebrating the very clear confirmation that the “Fed Put” is alive and well, it should be remembered these “emergency measures” are coming at a time when we are told the economy is booming.

“We’re the hottest economy in the world. Trillions of dollars are flowing here and building new plants and equipment. Almost every other data point suggests, that the economy is very strong. We will beat 3% economic growth in the fourth quarter when the Commerce Department reopens. 

We are seeing very strong chain sales. We don’t get the retail sales report right now and we see very strong manufacturing production. And in particular, this is my favorite with our corporate tax cuts and deregulation, we’re seeing a seven-month run-up of the production of business equipment, which is, you know, one way of saying business investment, which is another way of saying the kind of competitive business boom we expected to happen is happening.” – Larry Kudlow, Jan 24, 2019.

Of course, the reality is that while he is certainly “spinning the yarn” for the media, the Fed is likely more concerned about “reality” which, as the data through the end of December shows, the U.S. economy is beginning to slow.

“As shown, over the last six months, the decline in the LEI has actually been sharper than originally anticipated. Importantly, there is a strong historical correlation between the 6-month rate of change in the LEI and the EOCI index. As shown, the downturn in the LEI predicted the current economic weakness and suggests the data is likely to continue to weaken in the months ahead.”

Limited Monetary Tool Box

As Dalio noted, one of the biggest issues facing global Central Banks is the ongoing effectiveness of “Quantitative Easing” programs. As previously discussed:

“Of course, after a decade of Central Bank interventions, it has become a commonly held belief the Fed will quickly jump in to forestall a market decline at every turn. While such may have indeed been the case previously, the problem for the Fed is their ability to ‘bail out’ markets in the event of a ‘credit-related’ crisis.”

“In 2008, when the Fed launched into their “accommodative policy” emergency strategy to bail out the financial markets, the Fed’s balance sheet was only about $915 Billion. The Fed Funds rate was at 4.2%.

If the market fell into a recession tomorrow, the Fed would be starting with roughly a $4 Trillion dollar balance sheet with interest rates 2% lower than they were in 2009. In other words, the ability of the Fed to ‘bail out’ the markets today, is much more limited than it was in 2008.”

But it isn’t just the issue of the Fed’s limited toolbox, but the combination of other issues, outside of those noted by Dalio, which have the ability to spur a much larger

The nonprofit National Institute on Retirement Security released a study in March stating that nearly 40 million working-age households (about 45 percent of the U.S. total) have no retirement savings at all. And those that do have retirement savings don’t have enough. As I discussed recently, the Federal Reserve’s 2016 Survey of consumer finances found that the mean holdings for the bottom 80% of families with holdings was only $199,750.

Such levels of financial “savings” are hardly sufficient to support individuals through retirement. This is particularly the case as life expectancy has grown, and healthcare costs skyrocket in the latter stages of life due historically high levels of obesity and poor physical health. The lack of financial stability will ultimately shift almost entirely onto the already grossly underfunded welfare system.

However, that is for those with financial assets heading into retirement. After two major bear markets since the turn of the century, weak employment and wage growth, and an inability to expand debt levels, the majority of American families are financially barren. Here are some recent statistics:

  1. 78 million Americans are participating in the “gig economy” because full-time jobs just don’t pay enough to make ends meet these days.
  2. In 2011, the average home price was 3.56 times the average yearly salary in the United States. But by the time 2017 was finished, the average home price was 4.73 times the average yearly salary in the United States.
  3. In 1980, the average American worker’s debt was 1.96 times larger than his or her monthly salary. Today, that number has ballooned to 5.00.
  4. In the United States today, 66 percent of all jobs pay less than 20 dollars an hour.
  5. 102 million working age Americans do not have a job right now.  That number is higher than it was at any point during the last recession.
  6. Earnings for low-skill jobs have stayed very flat for the last 40 years.
  7. Americans have been spending more money than they make for 28 months in a row.
  8. In the United States today, the average young adult with student loan debt has a negative net worth.
  9. At this point, the average American household is nearly $140,000 in debt.
  10. Poverty rates in U.S. suburbs “have increased by 50 percent since 1990”.
  11. Almost 51 million U.S. households “can’t afford basics like rent and food”.
  12. The bottom 40 percent of all U.S. households bring home just 11.4 percent of all income.
  13. According to the Federal Reserve, 4 out of 10 Americans do not have enough money to cover an unexpected $400 expense without borrowing the money or selling something they own. 
  14. 22 percent of all Americans cannot pay all of their bills in a typical month.
  15. Today, U.S. households are collectively 13.15 trillion dollars in debt.  That is a new all-time record.

Here is the problem with all of this.

Despite Central Bank’s best efforts globally to stoke economic growth by pushing asset prices higher, the effect is nearly entirely mitigated when only a very small percentage of the population actually benefit from rising asset prices. The problem for the Federal Reserve is in an economy that is roughly 70% based on consumption, when the vast majority of American’s are living paycheck-to-paycheck, the aggregate end demand is not sufficient to push economic growth higher.

While monetary policies increased the wealth of those that already have wealth, the Fed has been misguided in believing that the “trickle down” effect would be enough to stimulate the entire economy. It hasn’t. The sad reality is that these policies have only acted as a transfer of wealth from the middle class to the wealthy and created one of the largest “wealth gaps” in human history.

The real problem for the economy, wage growth and the future of the economy is clearly seen in the employment-to-population ratio of 16-54-year-olds. This is the group that SHOULD be working and saving for their retirement years.

The current economic expansion is already set to become the longest post-WWII expansion on record. Of course, that expansion was supported by repeated artificial interventions rather than stable organic economic growth. As noted, while the financial markets have soared higher in recent years, it has bypassed a large portion of Americans NOT because they were afraid to invest, but because they have NO CAPITAL to invest with.

To Dalio’s point, the real crisis will come during the next economic recession.

While the decline in asset prices, which are normally associated with recessions, will have the majority of its impact at the upper end of the income scale, it will be the job losses through the economy that will further damage and already ill-equipped population in their prime saving and retirement years.

Furthermore, the already grossly underfunded pension system will implode.

An April 2016 Moody’s analysis pegged the total 75-year unfunded liability for all state and local pension plans at $3.5 trillion. That’s the amount not covered by current fund assets, future expected contributions, and investment returns at assumed rates ranging from 3.7% to 4.1%. Another calculation from the American Enterprise Institute comes up with $5.2 trillion, presuming that long-term bond yields average 2.6%.

The massive amount of corporate debt, when it begins to default, will trigger further strains on the financial and credit systems of the economy.

Dalio’s View Is Likely Understated. 

The real crisis comes when there is a “run on pensions.” With a large number of pensioners already eligible for their pension, the next decline in the markets will likely spur the “fear” that benefits will be lost entirely. The combined run on the system, which is grossly underfunded, at a time when asset prices are dropping will cause a debacle of mass proportions. It will require a massive government bailout to resolve it.

But it doesn’t end there. Consumers are once again heavily leveraged with sub-prime auto loans, mortgages, and student debt. When the recession hits, the reduction in employment will further damage what remains of personal savings and consumption ability. The downturn will increase the strain on an already burdened government welfare system as an insufficient number of individuals paying into the scheme is being absorbed by a swelling pool of aging baby-boomers now forced to draw on it. Yes, more Government funding will be required to solve that problem as well. 

As debts and deficits swell in the coming years, the negative impact to economic growth will continue. At some point, there will be a realization of the real crisis. It isn’t a crash in the financial markets that is the real problem, but the ongoing structural shift in the economy that is depressing the living standards of the average American family. There has indeed been a redistribution of wealth in America since the turn of the century. Unfortunately, it has been in the wrong direction as the U.S. has created its own class of royalty and serfdom.

The issue for future politicians won’t be the “breadlines” of the 30’s, but rather the number of individuals collecting benefit checks and the dilemma of how to pay for it all.

The good news, if you want to call it that, is that the next “crisis,” will be the “great reset” which will also make it the “last crisis.”