Our base case scenario remains unchanged. We think that the post Global Financial Crisis economic recovery is now in the late cycle stage. The US is the most mature, and naturally the Federal Reserve is at the forefront of the monetary policy tightening cycle. Chart 1 below (courtesy of Bank of America Merrill Lynch) illustrates that ultimately the Federal Reserve tightens policy too far. Not only do Fed tightening cycles end up with some sort of financial event, the majority of cycles have ended with a US recession. Basically, the Fed always ends up making a policy error.
Chart 1 – Fed tightening cycles
There is a pervasive feeling amongst market participants that the Fed will simply not let anything bad happen this cycle. This may well be true, and certainly when the Fed backed away from rate rises for most of 2016 (and every other Central Bank went all in), it was difficult to argue against this view. Furthermore, with financial conditions remaining at or near record easy levels despite the Fed following through this year on its normalisation plans, some are arguing for a version of “this time is different”; the Fed can tighten just enough, but not too much.
We also know that Jerome Powell will take over from Janet Yellen in February, and there are now a number of stories that he wants to make some changes, with talk that a higher inflation target may be adopted. Who knows what the future holds, but the Fed is an institution that changes only slowly, and with Powell being on the inside already, we suspect that there will not be too many major policy changes early in his tenure; that is, rates will rise gradually and the balance sheet will reduce as previously outlined.
Indeed, there is every reason to believe that policy continues as previously outlined. Not only is unemployment (currently 4.1%) at or below target, but inflation is set to rise over the next year or so. Chart 2 (courtesy of Deutsche Bank) shows four leading indicators of US inflation all heading higher over the next year or so. Not shown is any wage growth indicator, but they too are pointing towards higher inflation.
So, with the dual mandates both met, the Fed will surely continue to both raise rates and reduce its balance sheet unless a financial event begins to materialise. But with inflation likely above 2% next year, any halt to the tightening cycle with have to come with an admission that they are letting the economy run a little hot. And although this is entirely feasible, it may look a little odd to the guys on Main Street that the Fed is seemingly setting policy on movements in financial markets rather than the real economy.
Chart 2 – Inflation set to move higher in next year or so
The period since early 2016 has been simply incredible in terms of amount of policy stimulus from global central banks. The recovery post the sell off into January 2016 has been nothing short of remarkable, investors have piled into risky assets and are now pretty much the most bullish on record. Not only can we point to extremely expensive market valuations, but we can illustrate growing evidence that capital has already been mis allocated. All of this is also consistent with a late stage economic and financial cycle.
We need to keep in mind that global QE will be approximately zero by Q4 2018, and US rates will be higher. The question is, will this matter? Will markets react negatively with the flow of QE stopping, or will they remain elevated with the stock remaining at a very high level? Will US debtors be able to cope with higher interest rates, and if not, will they be able to limp on in zombie like fashion, or will defaults rise?
With the benefit of hindsight, it is easy to point out that Japanese and European QE exceeded their respective domestic supply of new Government bonds, and as such, there was a spillover into other assets. Perhaps it should have been obvious where this new liquidity would end up but not to us at the time, but with so much extra liquidity and negative rates in both Europe and Japan, it would appear that virtually every asset on the planet has benefitted.
As of January, the major change in policy is the ECB halving its QE programme to EUR30 billion per month. That amount still exceeds net new Government bond supply from the EU, and so perhaps the spillovers will continue in the first three quarters of next year. But at the risk of pointing out the obvious, we have the following situation from Q4 2018 onwards;
US; Rising interest rates and the Fed’s balance sheet falling by $50 billion per month
Europe; Deposit rate at minus -0.40% but no more QE
Japan; Deposit rate at minus -0.10% and QE of about JPY80 billion per month, dependent on their yield curve control policy
We cannot know if Japanese QE can lift all asset prices globally nor whether negative rates in Europe and Japan are enough to float global assets without any net new global QE. With the US Dollar still the global reserve currency, we suspect that higher US rates and quantitative tightening will have an impact on US assets, and if they do that should spill over into global assets. Looking at non earnings based valuation measures, near record tight credit spreads and near record investor complacency, it does not feel like many risks are priced in; in fact, it feels like everyone expects the party to carry on forever.
However, there is something that is puzzling a number of commentators including ourselves. The US yield curve continues to flatten relentlessly, as seen in chart 3 below. We have to say that this is beginning to look like a very typical cycle, with the Fed raising rates which helps lift short end 2 year yields, but longer dated 10 year yields remaining fairly stable. The question perhaps is whether bond investors are beginning to sniff out a policy error, or whether longer dated US yields are being suppressed by European and Japanese investors chasing yield; and if so, we could see US yields rise as ECB QE halves in January and ends in September next year.
Chart 3 – The US yield curve
Our base case scenario at the moment is that this is simply a good old fashioned cycle, and that if the Fed raises rates again next month, and again in March and June next year, then there is a good chance that the US yield curve will be close to inverting. Frankly, the US yield curve remains one of the single best indicators of recessions. Chart 4 shows the US yield curve (advanced by 12 months) alongside Real US GDP (year on year % change). Recession areas are highlighted, and as the yield curve inverts, we need to be on the look out for a recession within a year or so.
Chart 4 – US Real GDP and the 10s2s yield curve
We have shown in recent weeks how both consumers and companies are leveraged like never before. To be clear, yes, the situation is nuanced. There is a small handful of companies that are extremely cash rich, but there are a large number of companies with a huge debt pile that is going to be much more onerous to serve as interest rates rise. Also, the wealthy are in rude health after a huge increase in asset prices, but many households have very low savings and record levels of consumer debt (as distinct from mortgage debt) is becoming harder to service. Our main point here is that the vast majority of households and businesses are extremely interest rate sensitive.
Of course, the bulls will point out that the tax package will boost growth and income and so what’s to worry about. Independent analysts are assessing the tax proposals, and it appears that any benefit for the majority of households is limited in both extent and duration. But what is striking is the continuing insistence of policymakers that the corporate tax cuts will unleash a wave of growth. Our best guess is it won’t. Companies will simply not take their tax savings and make large capital investments. It is highly likely they will simply return the cash to shareholders via share buybacks.
Indeed, this became evident to one of Trump’s economic advisors this week. At a conference, an audience of CEOs was asked to raise their hands if they were going to use the tax savings for investment purposes, and Gary Cohn even had to ask “why aren’t the other hands up?” We attach a link to a Zero Hedge article that contains a link to this short video clip. Therefore, we should expect a surge in share buybacks because of the tax plan but not a surge in capital investment and economic growth. Furthermore, we should expect trillions of Dollars to be added to the national debt over time.
So in short, our base case remains that the Fed, having embarked on rate rises nearly two years ago, and now also reducing its balance sheet, will ultimately keep going until something breaks, either domestically or overseas or both, and either in the financial markets or the real economy or both. They are heading towards another policy error.
This is happening at a time when non-financial debt levels in the US, and in a number of other countries, are at record levels, financial market valuations have hardly ever been more expensive, and a large slug of capital has probably already been mis-allocated. It is entirely possible that a tax induced share buyback frenzy boosts US stocks in the short term, and that there is just enough juice from global QE in the next few quarters to help bond markets.
However, we see the whole leveraged edifice built in recent years on the back of extraordinary central bank policies as extremely fragile. The recent wobble in credit markets seems to have stabilised by the end of last week, but we are not convinced that this calm will last forever. As we have said before, long term returns from all assets will be well below average in the years ahead. The timing of the next bear market remains impossible to predict ahead of time, but as central banks normalise policy, the risks appear to be mounting.