Q3 2019 Review: Growth Down Interventions Up.
I believe that on examining the post 2008 economic data, and comparing this recovery with past recoveries, the constant theme is Growth down interventions up.
In 2019 that experience accelerated to a new level.
The chart below shows that even as this year’s earnings expectations have remained flat to negative all year, the price/earnings ratio has risen around 18%. No earnings growth has not been a handicap to significant equity performance as intervention reaccelerated.
Even before the decline in growth in 2019 it has become clear that despite record efforts to stimulate growth since 2008, the current recovery has been the weakest recovery for the last 70 years.
The link above shows that job growth has also been the weakest in any recovery over the last 70 years.
None of the multiple stimulus measures attempted since 2008 have even produced much of a short term growth boost. As the chart below shows the GDP peaks in this recovery have also been the lowest in 70 years.
Growth Down. Interventions Up. This is now an 11 year problem, for the US and the world economy, which is now intensifying as the global cycle continues it’s two year downcycle and the US continues it’s one year downcycle.
How can policy makers respond and will they respond in time?
How should investors manage these uncertainties when prospective returns look so challenging?
The deeper story
I believe that since 2008, it is massive interventions that have dominated the economy and markets; not organic growth and not natural price discovery.
It is important to understand intervention because it seems that policy makers are now operating in an increasingly aggressive and unprecedented manner, with a new main objective of constantly inflating asset prices.
A good starting point is the most obvious intervention…Deficit spending for growth.
The chart below shows that global debt has almost doubled since 2008 to the highest peacetime level for well over a hundred years.
Rather than leading to higher interest rates, it seems this debt burden can only be financed at ever lower interest rates. Ever lower interest rates is the second major intervention. As debt continues to grow, economies are now trapped by this policy into very low interest rate levels.
This sets up unprecedented economic conditions all based on extending the theory that low interest rates and perpetual increases in debt provide widespread economic benefit at some point.
Policy makers continue to push the envelope to new extremes, and began experimenting even with negative interest rates.
The chart below shows that government bond yields above 4% have gradually disappeared, while negative yields have grown to more than 30%.
However, I believe there are growing problems with this policy.
More importantly, so does the BIS, which includes all the major central banks, in a new report.
The Banks don’t like negative interest rates
In September 2019 European banks rebelled against European Central Bank (ECB) about negative interest rate policy, and the ECB finally announced measures to relieve the situation. However, it is clear that there is significant division across the ECB board, not just about this but also central bank balance sheet intervention, or QE.
Central bank policy has rarely been this divided and uncertain as even the Federal Reserve’s meeting showed dissent in both directions.
Investors also have challenges
For investors, economically failing policy interventions can cause significant challenges.
Prospective returns on bonds have turned negative in many cases, if not in nominal terms, then very likely in real terms. Even in the US the 10 year Treasury has the lowest negative yield relative to Core CPI since the 1970s.
Interest rates can not go much lower. This challenges the banking system, makes bonds unattractive investments and debt outstanding is already at record levels. These elements of intervention are reaching levels of concern even with the enabling central bankers.
US equity returns have been boosted by debt, central bank balance sheets, and unprecedented amounts of corporate buybacks, which have already stretched corporate balance sheets to historical extremes.
The chart below shows that the stock market has significantly outperformed Real GDP. Stocks more closely match the growth of the Federal Reserve balance sheet, which has facilitated the explosive growth in federal debt.
As Lance Roberts points out, “the reality is that after 3-massive Federal Reserve driven “Quantitative Easing” programs, a maturity extension program, bailouts of TARP, TGLP, TGLF, etc., HAMP, HARP, direct bailouts of Bear Stearns, AIG, GM, bank supports, etc., all of which total more than $33 Trillion, the economy grew by just $3.87 Trillion. The ROI equates to $8.53 of interventions for every $1 of economic growth.”
Policy intervention clearly picked up yet again at the end of 2018, with the reversal in Federal Reserve interest rate policy, and statements from the Treasury Secretary at that time. However, despite the recovery in the US stock markets, policy reversals have not been able to stop the deterioration of growth in the US economy over the last year and job growth is following and confirming the ongoing downtrend.
This chart and cycle research below from ECRI, shows economic growth has been declining for a year, job growth has begun declining too and this down cycle is far from over.
Policy makers seem to have been surprised by the downturn over the last year, but are now gradually returning to their playbook. Interest rates have been cut twice, QT has been abandoned, and money supply and the Federal Reserve’s balance sheet have turned back up.
Buybacks have also been a major factor in the 10 year rally, indeed by far the largest source of US equity accumulation, as shown in the link below.
Over the last 18 months buybacks have accelerated, perhaps in an attempt by corporations to support their earnings per share as growth and profitability decline.
This is yet another layer of intervention, which has stretched corporate balance sheets to the highest ever levels of debt to GDP. The link above discusses this and whether corporations have much room left for further buybacks.
The chart below shows that record highs in corporate debt to GDP have historically coincided with recessions, and that the Trump “boom” only produced a lower high in GDP growth.
Buybacks are a major factor in distorting GAAP earnings and the deviation of S&P 500 GAAP Earnings to corporate profits is remarkably wide. Corporate profits are close to unchanged for the last 7 years, and yet GAAP earnings have exploded higher.
Intervention has so far been far more effective at supporting markets than economic growth. The chart above also shows again, that despite record “stimulus”, it has remained the weakest recovery over the last 70 years.
What can policy do?
In my opinion, Japan and Europe provide little hope that persisting and expanding current policies will be fruitful. It seems that no clear experiential evidence can be found, and this may be a source of the recent dissent at both the Federal Reserve and the European Central Bank in September.
Central banks are also buying record amounts of gold, which is also a sign of lack of confidence in their own policy system.
No question policy can return to debt, money supply, QE and even just buying assets relentlessly. However, in Japan, this has been the case for 30 years now without producing any durable recovery, and the Nikkei is still far below its highs 30 years ago!
Investors should consider carefully how confident they can be in the success of further rounds of interventions from what are already unprecedented levels, taking account of their success so far and the elevated levels of market prices.
I believe there is also a new challenge in liquidity management as the Federal Reserve has been forced in September into sizable daily repos. This has meant that the Fed balance sheet has begun to rise again.
The US debt explosion over the last decade means that refinancing just Treasuries, based on simple estimates, is now running at around $5 Trillion per year.
With the exception of the banking system, everyone else seems to have been pulling back from US bond purchases. Now the banks seem to be saying that they are choking on all this debt!
There may well be other reasons for this liquidity crisis, but most likely we have started the countdown to QE4 …
The scale and permanence of QE would have to be far greater than before. If not it may not have sufficient impact.
No doubt the Federal Reserve is thinking this over.
What can investors do?
Rethink bond allocations. At current levels the nominal and real yield may not provide a good return. TIPS may be a better option with positive real yields, inflation protection and lower price volatility.
Corporate credit has to be considered high risk in the medium term given the historical relationship shown below. Be aware that this is also a risk for US equities, as dividends are subordinate to debt payments. Credit analysis is likely key as well as skill in avoiding the next cycle downturn.
US Equities are heavily depend on the path of intervention and cycles and will also have to be watched carefully, and acted on with agility as discussed below. International equities could, in time, provide better options as their downturn is more mature and valuations provide greater upside potential. However, the international upturn has remained elusive.
Gold and Commodities need separate attention.
Commodities are simplest for now as without a rising inflation environment they are broadly an avoid allocation.
Gold is far more interesting, as record central bank buying and policy confusion clearly indicates deep policy problems. Together with declining and record low real yields they are in the sweet spot, and an ideal hedge if central bank policy is running out of effectiveness globally and confidence continues to decline.
Q3 2019 conformed well to our view 3 months ago that Quad 4 conditions of declining growth and inflation were most likely. Treasuries and gold performed well which aligns with historical correlations in Quad 4. However, it gets complicated from here.
Q4 2019 starts with a continuation of Quad 4. However, I believe the data will have to be watched carefully for a change of conditions deeper into the quarter.
It is important to stay with current data and not get too far ahead with forecasts. Research strongly suggests that market turns are coincident with the data and the strongest performance, in both directions comes at the data turns.