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Samuel Johnson famously called second marriages, “the triumph of hope over experience.” I think this phrase is awfully fitting to investors’ relationship to risk assets over the past couple of decades. In the late-1990’s, they fell in love with the stock market. The aphrodisiac during this episode was more than just easy money to be made by day-trading. It was the prospect of a “new era” for both the economy and the financial markets. This love affair famously ended in bitter divorce after the Nasdaq destroyed all hope by declining 90% in value after the March, 2000 peak.
Only a few years later investors found a new love. Real estate became their next infatuation. This was something real, something tangible that they could actually get their hands on. The allure this time was that ‘real estate prices had never fallen year-over-year on a nationwide basis.’ It was a can’t lose proposition and they fell head over heels for it. Until, of course, the unthinkable happened, prices fell and the pain of this amorous disillusionment was even greater than the fallout after the prior tryst.
Once again, investors are ignoring these prior painful experiences and embracing a new hope once again. Only this time they are in love with them all. Corporate valuations, including both equity and debt, are equal to where they were at the peak of the dotcom bubble still investors have decided now is the time to pour record amounts of money into the stock market. Real estate prices are also right back to where they were at the height of the bubble. Altogether, household financial assets relative to incomes show that the current bubble is at least as large as either of the two that proceeded it. But you know what they say: “love is blind.”
Over the past couple of months we have seen this blind love for risk assets surge on the hope of an “economic miracle.” The miracle-worker in this case appears to be none other than Donald Trump. At least it was his election triumph that appears to be the catalyst for the outpouring of affection we have seen in the markets. More than just deregulation and fiscal stimulus, investors seem to be embracing a “new era” of radical innovation that will miraculously solve the structural impediments to growth that we now face.
Dr. John Hussman recently detailed these impediments explaining:
In practice, nearly all of the variation in GDP growth over time is explained by the sum of employment growth plus productivity growth… Given existing U.S. demographics, even if we assume an unemployment rate in 2024 of just 4%, civilian employment would reach 157.2 million jobs in 2024, resulting in an average annual growth rate for civilian employment of just 0.4% annually over the coming 8 years… Over the past decade, productivity growth has declined from a post-war average of 2% to a growth rate of just 1% annually, with growth of just 0.5% annually over the past 5 years… Combining the plausible ranges of employment and productivity growth in the coming years (but ignoring the possibility of outright recession), the bounds of average U.S. economic growth over the coming 8 years range between 0.7% annually to an extremely optimistic 3.2% annually, with a likely midpoint of less than 2% annually for real GDP. That figure aligns with the central tendency of long-run real GDP growth expectations from the Federal Reserve, which recently fell to 1.85% annually.
This is the simple math that investors now face. This math expressly prohibits the sort of miracle that investors now require to in order to fulfill their expectations for risk assets. Furthermore, this analysis ignores the possibility that Trump’s protectionist policies might actually be harmful to economic growth. Dr. Hussman also points out that much of the productivity gains we have witnessed in recent years are due to the offshoring of labor. To the degree that Trump follows through on his anti-offshoring rhetoric, productivity and thus economic activity will be constrained or even harmed.
At the same time, while focusing solely on the possible benefits of reflation, investors in risk assets seem to be ignoring the risks associated with even attempting to stoke it. There are signs around the world that, while economic activity remains subdued, inflation is rearing its ugly head. Like many new lovers, though, investors seem to be viewing it through rose-colored glasses today. Experience, however, tells us that inflation, especially that which comes without commensurate economic growth, is not something to celebrate. “Stagflation,” as it’s called, is one of the more insidious challenges for economies and markets to deal with.
To address the structural issues behind a reversal in the trend of disinflation we have witnessed over the past 35 years, some are obvious, some not so much. Most obvious is the prospect of looser fiscal policy. Trump has said he’s like to spend more, possibly on infrastructure projects like upgrading our airports and building a wall along the Mexico border. This could put pressure on both commodity prices and wages, especially when we find ourselves already at or very near full employment. Equally as obvious are the repercussions of tighter trade policy. Tariffs raise prices, plain and simple.
Less obvious are the trends in deglobalization and demographics. Because these are very long-term trends they sneak up when nobody’s paying any attention to them or worse, they have already dismissed them as meaningless. As I have written recently, it’s not difficult to argue that the single greatest force of disinflation we have seen over the past 35 years is the rise of globalization. Companies have greatly reduced their costs by producing overseas. To the extent that this long-term trend is now reversing, so too will its disinflationary impacts. Similarly, the baby boom generation represented a massive deflationary force on wages as job competition greatly increased as they entered the work force. As they now move into retirement competition for jobs is lessening, possibly putting pressure on wages.
We shouldn’t fail to note that all of this is occurring during the most unjustifiably dovish central bank policy era in history. The popular view, when the Fed began its quantitative easing, was that it would be inflationary. That proved to be true but not in the traditional sense. Inflation appeared in financial assets rather than in consumer prices. Seven years later this result has many believing that inflation is a thing of the past. However, if you combine loose monetary policy with a loosening of fiscal policy you start to put the printed money in the hands of ordinary people rather than just in the hands of financial institutions. It’s hard to see how this wouldn’t be inflationary in the traditional sense.
What’s more, the Fed, possibly due to psychological issues such as loss aversion along with a strong herding impulse, has kept monetary policy so loose for so long that a strong sense of inertia has taken hold at the institution. Even if inflation continues to rise the Fed will most likely continue to lean dovish. In fact, they have recently said as much. It was only a few months ago Janet Yellen was extolling the virtues of letting the economy “run hot.” But there’s another psychological force underlying this thinking, as well.
As William White, former Chief Economist as the BIS, recently noted they have simply gone too far to turn back now. A reversal in the epic dovishness we have seen over the better part of the prior decade would be a repudiation of everything they have done and said over that time. As human beings, and under the most powerful of microscopes, they are very unlikely to make this sort of admission and this sets up a very interesting dilemma. White explains:
Suppose a central bank is worried about rising inflation and decides to raise interest rates. But the government has a huge debt with a short maturity. By raising short term interest rates, the central bank raises the debt service burden for the government. At some point, people realise that the government can’t support the debt burden without going back to the central bank to print more money. This is a tipping point. And then you are in hyperinflation.
This is the real risk to reflation today. While many are waiting with bated breath for the Dow Jones Industrial Average to cross the 20,000 mark others have noted that a similar, though far more important numerical threshold is approaching. The national debt currently stands at $19.9 trillion (not including the massive unfunded liabilities of Medicare and Social Security). Even with today’s ultra-low interest rates, interest costs amount to 6% of the total budget and roughly half of the deficit. The plans of the Trump administration could quickly exacerbate these issues by increasing the debt burden through fiscal spending, widening the deficit via tax cuts and pushing interest rates higher by pursuing reflationary policies. At this point, the question of whether the government can support the debt burden without the Fed monetizing the debt could come to the forefront.
It seems the bond market has started to take notice. The recent selloff in bonds has been swift and steep even though we have only gotten a hint of inflation so far. In addition, many real treasury yields are still negative so bond prices still have plenty of room to fall even before inflation really begins to show itself. What could be more troublesome, though, is the fact that actors in the bond markets have seemingly followed the Minsky script to a tee. 35 years of rising bond prices and falling interest rates have inspired a degree of risk taking in these markets we have never seen before. The IMF recently noted that the increasing use of leverage and derivatives, along with a focus on greater duration, present unique risks to the financial markets today.
In our analysis we find that a portion of leveraged bond mutual funds exhibit both relatively high leverage and sensitivity to the returns of U.S. fixed-income benchmarks… This combination raises a risk that losses from highly leveraged derivatives could accelerate in a scenario where market volatility and U.S. bond yields suddenly rise. Investors in leveraged bond mutual funds, when faced with a rapid deterioration in the value of their investments, may rush to cash in, particularly if this results in greater than expected losses relative to benchmarks (and the historical performance of their investments). This could then reinforce a vicious cycle of fire sales by mutual fund managers, further investor losses and redemptions, and more volatility.
Structurally, then, the risks to bonds may be even greater than the fundamental risk of rising inflation. Together, they could present a “perfect storm” for the bond market, a storm that could present some very difficult challenges for the Fed dealing with a structurally restrained economy overburdened by a massive and growing debt load and an administration that has never shown any healthy fear of leverage.
These risks stand in stark contrast to the “economic miracle” the markets have now priced in. The time to buy risk assets like stocks and junk bonds is when they are pricing in total and utter despair. Any outcome that is not outright Armageddon then is cause for rising prices. On the other hand, when risk assets are pricing in economic miracles as they are today, any outcome that falls short of outright economic utopia is cause for falling prices. But if there’s one thing I’ve learned over the past couple of decades it’s that once investors have fallen in love with an asset bubble wild horses couldn’t drag them away from it, that is until they inevitably feel the pain of heartbreak once again.