Back In The Old Days, This Was Called Stagflation

via Great Speculations

This time, indeed, could be different. It certainly is in the realm of possibility, but, the odds are against it.

One doesn’t get up on a particular morning and find an entry in the calendar on our smartphone, like “Cinco de Mayo” or “Mother’s Day,” that says “Start Day: National Recession.” In fact, the National Bureau of Economic Research (NBER), the official recession dating organization, did not identify the Great Recession’s start date (Dec., ’07) until a year later (Dec., ’08). It took even longer to identify the end date (Jun. ’09). That official demarcation occurred in Sep. ’10, fifteen months after the Great Recession ended. But, the market certainly knew when the recession started and correctly anticipated its end.

From a Technical Perspective

On Oct. 12, ’07, the Dow Jones (DJIA) peaked at 14,093. Note that in Dec., ’07, the NBER’s official start date (not revealed to the public for another year), the DJIA averaged about 13,200 and was only about 6% off its peak. By Jan. 22, ’08, however, it had fallen to 11,971, a 15% decline. A month later, Feb. 27, ’08, it had recovered to 12,694, stemming the loss to 10%.

Compare that to today’s experience: the peak occurred on Jan. 26, ’18 at 26,617 followed by a 12% loss to 23,533 on Mar. 23 (two months later), and a recovery to 24,262 on May 4 (the latest data as of this writing), for a net loss of 9%.

What happened next in ’08 was the market’s realization that all was not well in the country’s financial sector, and by Oct. 27, ’08, the market had fallen to 8,176 (a loss from the peak of 42%). Note that the NBER had not yet told us that we were in recession. The market gyrated from there. It rose back to 9,625 on Nov. 4, ’08 (moderating the loss to 32% from the peak), and then finally collapsed to 6,547 on Mar. 9, ’09 (peak to trough loss of 54%). I am not saying that equity markets are going to sell off by 50%. But, the market’s behavior, since the peak, should make an investor nervous, at the least.

Another troubling technical indicator is the rapid rise in short-term interest rates. The two-year U.S. T-Note’s yield has risen by 125 basis points (1.25 percentage points) over the past seven months. Looking back at history, such a rapid rise was associated with a) the October, 1987 market meltdown; b) the S&L crisis; c) the dot.com collapse; and d) the 2007-9 housing crisis. Once again, something to be nervous about.

From a Macroeconomic Perspective

I can’t say when a recession might begin, or even if we will have one. We are now in the 109thmonth of the economic upcycle, the second longest in history. And, it has been the weakest recovery in the post-WWII period in terms of growth. Much of that is driven by demographics, and some by technology and attitudinal changes. The fact is, however, that the economy is fragile. And, I am not willing to bet that “this time is different.” Here is a list of macroeconomic items that concern me:

  • The economy decelerated markedly in Q1 and the handoff to Q2 was less than stellar. GDP growth in Q1 was 2.3%, down from 2.9% in Q4 and above 3% prior to that. Spending on big-ticket items was off at a 3% annual rate. Auto sales, in particular, softened in Q1 and that continued in April. Removing exports and the inventory build (which may have been unintentional), real final sales to domestic purchasers, a good measure of the health of the consumer, only rose 1.6%, the weakest in four years.
  • Of course, of significant concern is the rapid rise in the price at the pump, which has skyrocketed over the past two months. As of May 5, the AAA national average cost for regular was $2.814. A year ago, that price was $2.361. That’s a 19.2% increase, way higher than wage growth. With Saudi Arabia aiming for a per barrel price for crude of $80 (current price is $68/bbl.), it is quite likely that gasoline prices could rise another 17.5%. That would be $3.25/gallon. This more than eats up all the consumers’ tax cut savings.
  • Speaking of tax cuts, they were supposed to herald in large increases in capital spending (capex). But that didn’t happen. In March, capex contracted slightly (-0.4%). This series has decelerated significantly from a 13.8% year over year (YoY) peak in October, falling to 12.1%, 11.2%, 7.8%, 7.0%, and 1.4% in subsequent months. Construction spending, a closely watched indicator for capex, also slumped in March (-1.7% month over month (MoM)).
  • I have remarked in the past that there was an observable difference between the high levels of the sentiment indexes and the resulting real observable results. Now, the sentiment indexes are turning over. The ISM Manufacturing and Non-Manufacturing Indexes both fell by 2 points in April, the Manufacturing Index to 57.3 (from 59.3) and the Non-Manufacturing Index to 56.8 (from 58.8). These are diffusion indexes meaning that readings above 50 represent expansion. But the change is important, and, in these two cases, deceleration is evident. Don’t forget, these are sentiments or intentions, not actual economic activity.
  • Interest rates are rising; labor markets are tight. The U3 unemployment rate now sits at 3.9%, a level last seen in Dec., ’00. This makes it almost a certainty that the Fed will raise rates again in June, and, barring actual declines in economic activity, likely twice more after that by year’s end. The fact that most inflation measures are above 2% while Fed Funds are 1.5% indicates that real rates of interest are still negative, an unprecedented condition for this late in a business cycle.
  • Rising interest rates are also impacting the residential housing market. As rates rise, affordability falls. Mortgage applications and purchase contracts are down YoY, and refinancing, a key source of household liquidity, have fallen 15% over that period. Add to this the rising cost of new construction due to rising material costs (tariffs) and rising labor costs (shortages), and it is easy to worry about an oncoming housing slowdown.
  • All the recently taken surveys highlight rising costs for both materials and labor. Wage increases have accelerated over the last six months and even more so over the past three. Unfortunately, the Fed concentrates on the YoY changes. These have remained relatively subdued due to the telecom price wars of early and mid-2017. That makes it likely that the Fed will be playing catch-up as the inflationary pressures accelerate over the remainder of 2018.
  • Rising material and labor costs also mean a compression of corporate America’s profit margins. Next year’s Q1 won’t have the tax cut tailwind. Add to this the increased interest costs corporate America is going to have to bear, as 20% of corporate debt matures each year and must be refinanced. In addition, the dollar is now strengthening which means that it has become a headwind, whereas it was a tailwind for the last year.
  • We are already seeing increased demands for cash from the U.S. Treasury due to both the unprecedented fiscal deficit and the substantial shrinkage of the Fed’s holdings of such debt. This is sure to keep upward pressure on interest rates, at least through year’s end, barring, of course, outright contraction in the GDP measures.
  • Wall Street continues with the narrative that there is a continuing coordinated upswing in the world’s industrial and emerging economies. This is simply not true. While there are some economies still experiencing solid growth, many are not.
    • The Euro area is slowing perceptibly, especially Germany, France, and the U.K. (Italy, of course, is always on the brink). As a result, both the European Central Bank and the Bank of England have announced that they will not tighten further anytime soon. The natural result of this is a strengthening dollar as U.S. interest rates rise relative to those of Europe and the U.K. That means that U.S. multinational corporate sales in the Euro area and in the U.K. will fall in dollar terms as the translation from the Euro or Sterling to the dollar for financial reporting purposes is less favorable (i.e., it takes more of those currencies to translate into a dollar). China, too, looks less bullish than it did three months ago. There was a significant slowdown in industrial profit growth in March.
    • Emerging markets, of late, have also begun to become unhinged. S&P downgraded Turkey’s external debt to junk status. Argentina’s central bank has raised its overnight rate to 40% (you read that right!). Both currencies have had a 5% slide versus the dollar over the past month. According to Wall Street economist David Rosenberg, Turkey has $457 billion of external debt, of which $357 billion is denominated in dollars. Argentina’s $233 billion of external debt is nearly all denominated in dollars. Back in 1997, Thailand’s external debt was but $112 billion. Yet, that paltry sum touched off the Asian currency crisis which in turn lead to the Long-Term Capital Management (LTCM) bankruptcy. Remember how that riled the markets? Other EM’s worth with significant external debt and current account deficits include Brazil, Poland, South Africa, Columbia, Indonesia and the Philippines. Given their external funding needs, rising U.S. rates and a rising value of the dollar are sure to have a negative impact.
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In Summary

The U.S. economy is operating at or above its potential growth rate, a potential (2%) about half of what it was pre-recession. Inflationary pressures are appearing with the Fed, clearly behind the curve, now forced into tightening mode. Those rising rates will play havoc with corporate financials and have already negatively impacted the housing market. The tax cuts apparently did not spur capital spending, and the U.S. consumer is now exhibiting signs of fatigue. Rising gasoline prices are just starting to bite hard. A stronger dollar will negatively impact corporate profits going forward. The dollar’s strength is partly due to slowing growth rates in both the industrial and emerging market worlds. Back before political correctness, economists would label this “stagflation!!!”

Markets appear to have recognized that the paradigm has changed. Thus, the huge swing in market volatility since the end of January. It has become quite common for equities to bounce between significant gains and significant losses in a single session, something that only happened once in 2017. Going back to technical indicators, history tells us that when volatility rises like it has in 2018, 100% of the time, equities show weakness.

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