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Kicking the Can...Towards a Downturn

The Federal Reserve decided to leave benchmark interest rates at 0 to 0.25%, where they have sat since December 2008.

They kicked the can down the road, hoping I can only assume that things will be better in December. I disagree.

I see an economy that just doesn’t support a big bull market and a bull market that is set up to become a victim of its own success.

The Fed said economic activity is expanding at a moderate pace, household spending and business fixed investment are rising moderately, housing is improving moderately – see the pattern? Things are ok.

Well, Yellen acknowledged that exports are ‘soft’ and inflation weak (though the reality of inflation is another whole debate, which I’ll touch in in a minute), but described the labour market are solid.

Yup. Things are good. Just not good enough to raise rates.

I agree. As I’ve pointed out in recent articles, the US economy is doing ok. Not great, but ok. OK does not support monetary tightening. On the contrary, OK still relies on supportive policies. Tightening now could easily have sparked a market correction and Yellen sure doesn’t want to get blamed for that.

The problem is that certain parts of the system are now addicted to cheap money…and the rest is struggling.

Ultra-low interest rates pushed money into stocks from savings accounts, with their negative real returns. The result has been a raging bull market for US equities.

Great…except that few people prosper when the stock market runs.

Half of Americans do not own any stocks at all. The average middle class family has $14,000 in stocks. The top 10% of Americans have investment portfolios of a quarter of a million dollars or more. That means the rally benefitted the rich 20 times more than the average middle class-er and infinitely more than the other half of the population.

I’ll get to what it means for everyone else in a moment. First: the upside of the hot market is a deep pool of investment dollars. Big US investors have done very well. Their accounts are brimming with money. That is the strongest reason I can find for a continued US bull market.

However, the economic crisis was not long ago. Many similarly flush investors lost big when the markets crashed in 2008 and they do not want to relive that experience. That is why caution is creeping back in to the market.

Cautious eyes see a stock market flirting overtly with overvaluation. The latest bit of evidence came from Deutsche Bank, which analyzed 15 major markets over the last 200 years. The conclusion? Global markets, stocks, bonds and housing, are at their “peak valuations relative to history”.

“Looking at three of the most important assets (bonds, equities and housing) across 15 DM countries, with data often stretching back two centuries, we are currently close to peak valuation levels relative to history. Indeed when aggregated, current levels are higher on average across the three asset classes than they were back in 2007/08 and certainly higher than in 2000. At the equity market peak back in the summer months of 2015 we were pretty much at the peak.”

-- Deutsche Bank strategists Jim Reid, Nick Burns and Seb Baker

So stocks are highly valued. That’s great: supportive policies restored the economy, right?! Wrong.

I have been describing the US economy as OK but not great, and today Janet Yellen agreed. A raging stock market does not a strong economy make.

Joe Average trying to make a living in America is still struggling, even more so now that high-paying oil and gas jobs are disappearing, and the stock market has not helped him one iota.

Some businesses have taken advantage of cheap money to truly grow, but in a moderate (to borrow the Fed’s favourite word) economy such moves may or may not have paid off.

Many more businesses borrowed cheap money to make their balance sheets look better, through share buybacks (on track for an all-time high this year) or the simple appearance of cash. These manoeuvres have not added to the US economic engine at all.

There is reason to believe that inflation is much higher than the niggling 1.8% officially suggested. Shadow stats pegs it at about 4%. The Chapwood Index, which tabulates costs of the top 500 items on which Americans spend their after-tax dollars in the 50 largest cities in the country, has inflation running at 9% year to date. In the country’s ten biggest cities it is averaging 14%.

That really matters. If rates remain low but inflation is high, the value of a paycheck declines. Lower incomes mean less buying. Less buying means a slower economy.

Even without inflation, wage gains have been so weak that disposable income is already down. That makes for the same setup.

Then there are low oil and gas prices. Strong energy prices created real economic growth in recent years; the energy sector had good cash flows to build infrastructure and hire employees into well-paying jobs. Now that is gone.

The US dollar is the cherry on top. The greenback did decline as soon as Yellen’s no-raise news broke, but as the cleanest shirt in the dirty laundry bag of world currencies I do not think it will fall very far.

That is problematic. The weight of the dollar is hurting multinational companies and I expect Q3 earnings will be disappointing. Q2 earnings already were and US markets rarely survive through two quarters of earnings decline without a serious correction.

It adds up to an economy that just doesn’t support a big bull market. And a bull market that is set up to become a victim of its own success.

With Yellen not raising rates, there is no event looming likely to kick off a correction or crash. But (1) corrections don’t need a specific kick off and (2) events are unpredictable.

It might happen quickly; it might happen slowly. There may yet be bounces. But however it happens, I don’t like the look of the next few months.

A downturn is not bad in and of itself. It’s horrible if you are unprepared, of course. But those who see it coming can set up for success on the flip side.

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Once again, it's great to hear your pearls of wisdom in the mining sector that translate into income and profits. Now that we are in the nascent stage of this commodities bull market, everything that the retail investor can learn in order to maximize profits is education today that will be worth a fortune tomorrow.

-NL (May 2021)

BTW - I really enjoy reading your newsletter - very comprehensive and you do an excellent job of integrating a macro perspective into your analysis.

-RC (August 2019)