The Run Flat Economy Of 2016

by: Paul Ticu

Summary

Most developed countries have short term interest rates negative, while Japan recently embarked on a negative rate policy path.

The US cannot afford a diverging monetary policy, if most developed markets have negative rates.

Inflation expectations are worsening, while S&P earnings growth rate is virtually zero.

All else equal, 2016 will be a run flat year for risk assets, if not worse.

Run flat tires are great - theoretically; if the tire is punctured, the vehicle can still reach its destination. Yet, these have only 1% of market share (according to Wikipedia) as the price tag is steep, and the vehicle can drive only at low speeds (less than~ 50 miles/h) and for short distances (less than ~50 miles).

"Run flat" appears to be a fitting metaphor for brave new world QE-addicted developed economies. Developed markets wobble along with depressing growth and falling inflation, and blame emerging markets for all woes.

You can bet that if the market falls in any one day, the majority of reporters will blame EM and/or China. Super-pundits (X-Files crowd - because they want to believe) are recently discounting the latest 6.9% GDP growth number and envision a 3-4% growth. I haven't seen the details of the 3-4% calculation, and they haven't most likely either.

The icing on the cake in developed markets came recently from Japan, where the BoJ adopted a negative interest rate strategy outright. Three arrows with a twist?

In a recent lecture, Europe's Draghi concluded that there are forces in the global economy "conspiring to keep inflation down." Yes, these forces are due to systematic overproduction as the cost of capital fell drastically following monetary easing. He ends the lecture by saying that inaction cannot be justified - so, more intervention to be expected from the ECB as well?

Many developed markets have shorter term interest rates (arbitrarily picked 2-year maturity in the first chart) at zero or negative. The only two countries with - still - positive rates are the US and the UK, and the US is about to remain the only one. The BoE's Carney just recently decided to hold off on increasing rates and signaled that rates could stay low well into 2018, setting the stage for a potential cut.

Can the US afford to have positive rates, if most developed markets have negative rates?

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The second chart shows US inflation expectations (US 5y5y inflation swap forward), the U.S. dollar index, inverted, and WTI crude spot prices.

The co-movement is undeniable, and the market variables appear co-integrated: where crude and the (inverse) of the dollar goes, so does inflation lately. It goes beyond correlation, as there is a meaningful relationship.

Assuming subdued crude prices in 2016, and, despite a flat to weaker dollar (assuming a weaker dollar helps generate some inflation), inflation is not about to rip to the upside.

The point here is that the US will continue to experience very low inflation for a while (2016 and potentially 2017).

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The US manufacturing PMI has been on a declining trend last year and recently slipped below 50, indicating an increased risk of economic contraction.

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The co-movement of forward inflation expectations and US manufacturing activity is self-evident: you can't have one without the other.

All else equal, with a weakening manufacturing PMI, S&P 500 equity earnings could weaken as well, as the next chart shows. The relationship between earnings and PMI SHOULD be there - otherwise equity earnings are happening in the absence of manufacturing activity - which doesn't make sense (we're not there yet).

Yet this is exactly what happened pre-2008 when earnings continued to increase while manufacturing activity weakened (Greenspan monetary stimulus).

Once again, manufacturing activity is diverging from forward earnings - potentially indicative of a crisis brewing underneath the surface.

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The recent correction in the S&P 500 appears to be trying to close the gap between the PMI and S&P 500 forward P/E (note that while there was a gap in earnings pre-2008, there was no gap on the P/E side).

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Where forward earnings go, the stock market follows; if the earnings follow the PMI lower, the S&P 500 should do the same.

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The issue is the weak earnings growth rate, as the last chart shows. Absent earnings, a stock market is propelled by multiple expansion - which is just the resultant of price momentum and investor sentiment.

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With the momentum trade dead, for now, persistent low inflation in the near future, declining manufacturing activity, and a clear divergence between price performance and earnings growth, equities are at risk of having a flat 2016 - at best.

The negative rate environment in developed markets indicates extreme risk aversion as investors are paying governments to keep their money safe.

Investors will see that price paid (negative rates) as insurance premium, and, as long as it costs less than protection via options or something similar, they will take it. Remember that these are mostly institutional investors who benefited from 150% appreciation in the S&P 500 in markets since 2009. With that track record, they will protect their track record and hedge the downside.

In that instance, rates will go lower to a point where the negative rate paid in Treasuries is equal to hedging the downside away via options.

Assuming that volatility normalizes (range between 15%-30%), rates could go even lower, or finish 2016 around current levels.

Evidently another round of QE (or some other acronym) can change this pessimistic scenario, but it would only increase the asset price bubble.

So, at best, earnings in 2016 will try to catch up to price, or wobble along, in run flat mode (although the distance since 2008 has exceeded a prudent run flat mileage). Make your bets - or don't.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.