A Tale of Two Markets, Continued
Political dysfunction in the United States is at an all-time high.
Republicans and Democrats are fighting pitched battles on immigration, Obamacare, tax cuts, regulation, infrastructure and just about every other major policy issue you can name. These fights are bitter, involve a lot of name-calling and show no signs of abating soon.
The stakes could not be higher. These policy fights are a prelude to the congressional elections in November 2018 when the entire House of Representatives is up for grabs. Right now the Republicans are in control, but a loss of 24 seats will put the Democrats in charge and hand the gavel over to Nancy Pelosi as the speaker of the House.
Once that happens, the impeachment of Donald Trump will begin within a matter of weeks.
In this toxic environment, it seems that Republicans and Democrats cannot find common ground on anything. It turns out that’s wrong; they can agree on something. More spending!
The Republicans have thrown in the towel and given up any pretense of being fiscally conservative. Republicans have joined forces with Democrats to eliminate budget caps on defense and domestic spending.
Entitlements were already out of control because they’re on budget auto-pilot and don’t require new appropriations or votes. Now even the budget items that were subject to votes are out of control.
The bad old days of $1 trillion annual government deficits of the Obama administration (2010, 2011, 2012) are back under a Republican administration. Of course, none of this spending is paid for, because the recent tax cuts already increased the deficit before the new spending spree took effect. Many economists try to find a silver lining by saying spending will be stimulative for the economy.
This is part of the “tale of two markets” narrative I relayed last week.
The first narrative could be called “Happy Days are here Again!” It’s being offered by much of the mainstream.
It goes like this: We’ve just had three quarters of above trend growth at 3.1%, 3.2% and 2.6% versus 2.13% growth since the end of the last recession in June 2009. The Federal Reserve Bank of Atlanta GDP forecast for the first quarter of 2018 is a stunning 5.4% growth rate.
This kind of sustained above-trend growth will be nurtured further by the Trump tax cuts. With unemployment at a 17-year low of 4.1%, and high growth, inflation will return with a vengeance.
This prospect of inflation is causing real and nominal interest rates to rise.
That’s to be expected because rates typically do rise in a strong economy as companies and individuals compete for funds. The stock market may be correcting for the new higher rate environment, but that’s a one-time adjustment. Stocks will soon resume their historic rally that began in 2009.
In short, the Happy Days scenario expects stronger growth, an improved fiscal position due to higher tax collections, higher interest rates, and stronger stock prices over time.
Don’t believe it.
We’re past the point of no return. With a 105% debt-to-GDP ratio, heading toward 110%, the historical evidence is clear that bigger deficits do not produce real growth — they just produce higher interest rates, slower real growth and, ultimately, inflation.
The competing scenario, therefore, is far less optimistic than the Happy Days analysis. In this scenario, there is much less than meets the eye in recent data.
The most recent employment report was much touted because of the 2.9% year-over-year gain in average hourly earnings. That gain is a positive, but most analysts failed to note that the gain is nominal — not real. To get to real hourly earnings gains, you have to deduct 2% for consumer inflation.
That reduces the real gain to 0.9%, which is far less than the 3% real gains typically associated with a strong economy.
The employment report also showed that labor force participation was unchanged at 62.7%, an historically low rate. Average weekly earnings declined slightly, another bad sign for the typical worker.
It’s also important to note that the Atlanta Fed GDP report, while useful, typically overstates growth at the beginning of each quarter and then gradually declines over the course of the quarter. This is a quirk in how the report is calculated, but it does suggest caution in putting too much weight on the above-trend GDP growth suggested.
In fact, GDP growth for all of 2017 was just 2.3%, only slightly better than the 2.13% cumulative growth since 2009. And worse than the 2.9% growth rate in 2015 and the 2.6% rate in 2014.
In other words, the “Trump Boom” is nothing special; it’s actually just more of the same weak growth we’ve seen since 2009.
I’ve made the point that the catalyst for the stock market correction was much higher interest rates. But higher interest rates are not due to inflation. In fact, there is no inflation anywhere in sight. The jobs report on Friday, Feb. 2, was much weaker than was widely reported, as I just explained.
The reason for higher interest rates is the sudden fear of huge deficits arising from the Trump tax cuts, the congressional budget-busting deal and surging defaults on government-guaranteed student loans.
The deficit implications of this triple-whammy are so horrendous that gold is showing strength despite higher rates, on fears that huge deficits and credit downgrades will erode confidence in the U.S. dollar itself.
Higher deficits = higher interest rates = lost confidence in the dollar = plunging stock prices = higher gold prices. It’s all connected.
Where do we go from here?
There are plenty of asset managers and government officials warning that stock markets are riskier than they have been for a long time. But not all of their analyses are particularly persuasive; some are just fear-mongering or an effort to say “I told you so” if markets do crash.
Relatively few analysts can give you sound technical, historical or fundamental reasons for a potential stock market crash.
But one manager, Peter Toogood of Embark Group, has actually identified the Achilles’heel of this stock market and why a catastrophic crash could be in the cards.
Toogood says that because this bull market is almost nine years old (with a few corrections along the way), and because the economic expansion is just as old, pretty much every investor who wants to get into stocks is already in.
Put differently, there’s no money “on the sidelines” waiting to get back into the market as there was in 2009 and 2010. This means that if stocks hit an air pocket, there’s no liquidity pool of reserve buyers to cushion the fall.
That’s exactly what happened between Feb. 2 and Feb. 8 when stocks dropped over 2,500 Dow points, or 11%. Since then, stocks have recovered somewhat and market volatility has calmed down.
But Toogood’s fundamental point remains valid. Volatility and drawdowns are still in the cards, and when they hit you can expect stocks to drop even more dramatically in less time than they did in early February.
With a mild stock market recovery over the past week, this is a good time to lighten up on stocks at good levels and increase your allocation to cash. That way you can go shopping for bargains when the next air pocket hits stocks.