(I think I got the important people's names into a concise title.)
Around mid-year, after the Brexit vote sent interest rates down sharply, I turned pretty cautious on bonds for the first time since the 2013 Taper Tantrum. To express that, I wrote an article the title of which began with "A Top In Bonds?" I also took advantage of the Brexit-induced selloff and wrote some articles, including that one, that were favorable to cyclical stocks and for a while, a metal, palladium (NYSEARCA:PALL).
By August and again in September, after stocks had rebounded from their post-Brexit selloff, I laid out a more extensive argument: that it was now time to call the financial bubble what it was and just assume that it encompassed the three major asset classes I have been writing about since beginning to write on the Internet in late 2008. So I said in essence that collectively, gold/bonds/stocks were overpriced, and that cash was likely superior to some mix of them.
If I may pat myself on the back for good timing once in a while, the first article saying that was written on August 15 and concluded by saying, in part:
So my view is that of the 3 major markets I've been following since beginning to write on the Internet nearly 8 years ago, none are attractive right now except perhaps in the ultra-long view.
Just based on where my written enthusiasms have been over the past 8 years, that would roughly be 25% gold and 37.5% each stocks and bonds. As of August 15, these were the prices for each asset:
It's quite unusual to have all those major asset classes trade mostly sharply down over even a day or a week, but especially over a 3-month period.
What this action over a 3-month period suggests to me is that my thesis that there was too much panic out of cash, into any asset available, was well-thought out.
On the one hand, when coming from such an extreme, with both stocks and bonds at historic high valuations, and gold back as a momo play, this can just be the start. On the other hand, over a longer time period, there's something about cash that makes it not a true investment. One steadily has to pay what amounts to a fee to have funds fully liquid.
This article updates that call in view of the political changes since then, market action, and now near-certainty that the Fed will announce that it has resumed raising short-term interest rates on December 14.
Introduction to interest rates and the bond bull
Interest rates often whip around without meaning much fundamentally. Focusing for now on Treasuries, here's a chart of the yield on a 10 year T-bond posted November 7. That was two days before the bond market began its swoon following the election of Donald Trump. Look how much the yield has jumped just in 2 weeks, all the way to 2.34% from well below 2.00%:
This move has power and needs to be respected.
Two other points in this chart to note:
First - how the writer documents that with repeated rate spikes since 2013, inflation did not spike with it.
Second - nothing has happened yet, and neither any special strong economic data, nor booming signs of inflation, have occurred. In fact, if anything, matters have moved against inflation.
To put the above in perspective, just think if the following much longer-term view of Treasury rates were a stock or stock index. It would look as though the downtrend were still in force, just with a correction from the extreme lower bound of the channel, correct? From a bond manager:
You could continue this backward to about 1984 within about the same channel. So, has anything really changed? Or is it just anxiety over Trumponomics and the Fed?
The downward channel is still intact - and not even at the upper end of this channel (which can be drawn somewhat differently using somewhat different methods).
In addition to the downward channel in rates, Treasuries are 8 years into a new horizontal support area below 2.5% on the 10-year and in the low 3s or below on the 30-year. Based on the 35+ year history of the bond bull, soon it will be time to either descent to new lows or break precedent, which might presage, finally, a change to either flat rates or rising rates.
Does the Trump election change this trend?
Maybe, which I examine below. However, certain trends have been in train all year when a Clinton administration was generally assumed. I have been talking about late cycle stagflationary pressures presenting headwinds for both stocks and bonds most of this year. An exponent of this stagflationary view is ECRI, which is out with a blog post titled All of a Sudden, Inflation Fears Intensify, and which says in part:
...in March, ECRI cautioned that "underlying inflation pressures - though relatively restrained - have started perking up." At the time, "[w]ith U.S. economic growth sluggish and slowing, and inflation low but rising," we had warned of "stagflation lite," which is now a reality...
ECRI then goes on to list a number of fundamental economic negatives, which I rearrange into bullet points without changing the wording:
- yoy payroll job growth is down to a 32-month low
- yoy real personal income growth has fallen to a 33-month low
- yoy GDP growth - excluding the onetime Q3 pop in soybean exports - is at a 3¼-year low.
That's the "stag" part; the only evidence of inflation they bring to bear is that:
- yoy core PCE inflation is the highest it's been in a couple of years.
I think that focusing on "core" inflation raises the question of the strength of this argument from ECRI. What matters is overall price changes, including food and energy, not excluding those two necessities of life. And that broader metric is not to bad, at least not yet.
Atlanta Fed increases deflation probabilities, and the Chicago Fed remains sanguine about inflation
With all the worries, a la ECRI and Mr. Market, about inflation, it's interesting to see bond traders also show increased worry about deflation.
As of Nov. 17, their TIPS-derived probability of CPI deflation over the next 5 years has spiked to 10%. When it spiked to 10% in H1 2011, when inflation fears (and the reality) were everywhere, that presaged one of the great bond bull rallies ever - with a lot of deflationary pressure that continues to this day.
The Chicago Fed's National Activity Index 3-month moving average, as of September, had been below zero for perhaps a year already. This indicates an absence of significant inflation pressures.
Gold, other metals, oil and lumber point to possible deflation
Silver (NYSEARCA:SLV) has entered a bear market along with platinum (NYSEARCA:PPLT). Gold, less volatile than those, has been breaking down as well. One exchange-traded lumber contract has recently dropped almost 15% from its recent high, also a measure of disinflationary pressures.
Oil prices remain in their downtrend, and the Trump campaign promises a "drill baby drill" supply-side strategy that is outright deflationary for energy prices.
In that vein...
Chinese yuan is crashing, and the strong dollar restrains US inflation
The Trump campaign promised to label China as a currency manipulator (as if the EU or the US are not). We shall see about that. For now, what we can observe is increasing deflation about to be sent to us from China.
It's not only the yuan. The widely followed USDX, which is heavily weighted to the euro, has broken out to or near new cycle highs.
Of more commercial importance, the trade-weighted US dollar index has surged recently to near its January multi-year highs. All this reflects some combination of perceived US economic strength, ex-US economic weakness, and better real returns on financial assets in the US than ex-US. It would be unusual if these currency trends were occurring if the Fed in specific, and the US bond market in general, were far behind the inflation curve.
Services turned to deflation in the PPI
The Producer Price Index for October shows the reverse of what we have grown accustomed to:
PPI for final demand unchanged in October; goods advance 0.4%, services decrease 0.3%
Services down in price? Let's look at a detail or two:
A major factor in the October decrease in the index for final demand services was prices for securities brokerage, dealing, investment advice, and related services, which fell 5.7 percent. The indexes for food and alcohol retailing; fuels and lubricants retailing; apparel, jewelry, footwear, and accessories retailing; consumer loans (partial); and hospital outpatient care also moved lower.
Apparently, there were widespread deflationary pressures in the service economy in October - not something that has even been hinted at in the financial media. Is it likely that this will suddenly morph into a broad inflationary surge just because some additional planes and ships for the US military get ordered, a wall might get built, and some additional investment in "infrastructure" might occur - all spending being spread over many years? I'm a little dubious about that, in view of constraints posed by the budget (see below).
If this trend continues, could we again see outright PPI deflation as recent oil price declines hit the calculation?
Other data are relatively weak
The Empire State Fed, Philly Fed and K. C. Fed November manufacturing indices are sluggish, on average just a little above zero in November. That's not terrible, but following long weak spells, there's no sign of a significant snapback - tough there is on Wall Street.
Industrial production was reported by the Fed as down from one year ago, and is roughly equal to where it was at its peak before the Great Recession.
And Bloomberg News was pushing a downbeat theme for the global economy Thursday, with a detailed article titled Global Trade Is Slowing. A theme of this article is overcapacity - implying deflation is possible.
Nominal GDP has not turned the corner
I recently showed a different version of this metric, so I will just link to a multpl.com graph (with associated table) that shows nominal GDP in a secular downtrend since peaking above 14% in or around 1979. Current and recent readings are at or below those found in many prior recessions, with the June 30 reading only 2.5%.
In Japan, no matter how much monetary plus fiscal "stimulus" was employed, this downtrend went to zero GDP growth - and it was no disaster. It could happen here, as well, or something close to that. Once you're in a pleasant situation of, say, 1% real growth, 1/2% (say) population growth, and 1% deflation, you have zero nominal growth and slow but positive per capital GDP growth. Not wonderful, but if the country is already in the aggregate rich, not terrible. (Questions of income and wealth distribution are very relevant in the big picture, but are beyond the scope of this article.)
And there are no signs amongst consumer that GDP is turning the corner.
The New York Fed has just released a consumer expectations survey. In its summary, it reports general stability, but notes:
The most notable change in October was a month to month drop in expected household spending growth.
If inflation were beginning to roar, the trends would be up, not flat to down. That's what was going on in the '60s as inflation began rearing its head.
Numerous US as well as international facts on the ground raise the question of whether all the build-up for higher inflation, as with ECRI going on to say that "this inflation story is far from over," is overblown and may already be accounted for by the recent, sharp interest rate rise.
All the above represent just possibilities, set-ups. But I show it because the drumbeat from the financial media has turned to emphasizing inflation and a new economic boom.
Now it's time to take a look at the political changes. I'll begin with the Fed. Janet Yellen is now the only Democrat in the Federal government with a lot of power. She just may wield it, and America's savers would benefit.
Why the Fed may lean toward more tightness than expected
This could be an entire article, or series of articles. In addition to basic and changing economics, sometimes politics becomes the swing or surprise factor in decisions made in Washington.
Thus, perhaps this news item is relevant:
Since Obama took office, Republicans have captured control of 27 state legislative chambers Democrats held after the 2008 elections. The GOP now controls the most legislative seats it has held since the founding of the party (emphasis added).
Janet Yellen cannot be happy about this. Will she, within the Fed's dual mandate and her responsible nature, ditch the Fed's unofficial "third mandate" (stock prices) and now focus on undoing some of the inflation caused largely by the Fed since President Obama took office, which I call for want of a better term Obamanomics (and which she supported and has continued with her "easy money" policies as Fed Chair)?
I think it's a valid concern and one about which investors may have become complacent.
So both because the Fed has overdone it on the easing thing and with restoration of some balance between the parties in mind, Dr. Yellen may wish to ask the FOMC to tilt toward the side of higher short-term rates. Of course, she would do this within a reasonable view of the Fed's mandates. Paul Volcker did this to Ronald Reagan well into 1982. Even with the prolonged "great recession" of 1981-82, and with inflation plunging to about 3% from double digits, Volcker was said not to want to ease policy even with the recession well over a year long and fated to last about as long as last decade's Great Recession. Then a crisis in Mexico in August 1982 forced him to finally ease. The Volcker Fed had been so tight, with such very high real interest rates, for so long, with what had obviously become a manufactured prolongation of the recession, that when it eased sharply in mid-August 1982, the NYT announced the news in a banner front page headline. Page 1! This was not just business news. Every observer could see that the Fed removing its foot from the monetary brake was a very big deal. The stock market sprang to life from its famous 777 DJIA (NYSEARCA:DIA) bottom, and within months exceeded its all-time high above 1000. The trend toward higher combined stock and bond valuations was underway, and has, irregularly, continued into 2016, as I have previously documented.
What if the Fed now continues to tap the monetary brakes, and harder than anticipated? Will this be a signal to sell, in effect reversing the August 1982 Volcker effect and sending financial market valuations lower, not higher?
The times are different now, but my base case is for the Fed to get tougher than expected over the next year. I think it will tend that way for three reasons:
- most important, it has been behind the curve for too long; it's time to move
- this will force realism on Congress regarding the costs of deficit spending
- some amount of political considerations; Chair Yellen and the Democrats can argue for responsible, limited deficits.
The result could be a slower economy than expected, with repression of inflationary impulses. (And note that, as discussed below, other independent economists than ECRI are emphasizing economic stagnation.)
So, to the extent circumstances allow - and within the bounds of responsible Federal Reserve action - my base case is to "take the over" on Fed tightness versus inaction.
The other major figure, of course, is Donald Trump.
Trump's program may be disinflationary or deflationary on balance, given Fed tightening
Much of the Trump program involves supply-side thinking. Most easily understood is to unleash American energy reserves. But other aspects of his program are at least as important. Prime among them: deregulation. This is generally as deflationary as anything a government can do.
More broadly, if a Trump administration can get US jobs increasing at the (mercantilistic) expense of non-US jobs, it's an open question as to whether that would be inflationary or deflationary. Yes, if the extra US jobs come from simple protectionism, the effect would be inflationary. But I will bet it will not be so simple. For example, just the election of Mr. Trump has led to appreciation of the USD versus most other currencies, which is itself deflationary from a US perspective. The more a Trump administration may improve trade deals, the more it may be able to squeeze out of various trading partners, in essence getting other countries to export to the US for less in order to keep as much production in their countries as possible.
The economist Ed Yardeni presents a blog post with a detailed and slightly less optimistic view of Trumponomics with respect to inflation/deflation.
Now, if this were a 2009-type economy, and the US were coming out of a recessionary shock with the Fed inclined to ease and receiving infinite runway to print money - and with interest rates at panic lows - I would be looking to buy gold as I did between 2009-11. But with the Fed looking to be restrictive, then I do not expect the actualization of the Trump program to be very inflationary any time soon.
The deeper question is whether the US has gone too far down the road of very high Federal debt levels and Federal Reserve activism to escape the "Japanese" trap.
The reason this may be so is at least twofold:
- interest rate math on the deficit (discussed next)
- pledge from candidate Trump not to attack entitlements.
Budget math locks fiscal policy in if the market believes policies are inflationary
The Federal government may already have 'gone Japanese.' (A number of economists think it is insolvent.)
Higher interest rates on accelerated increases in government debt above current projections will force interest payments much higher. The cumulative budget deficit has gone from just below $10 B in FY 2008 to a projected $20+ B in FY 2017, per the Office of Management and Budget; see Table 7.1.
Yet interest payments on the debt are low, as shown in a government document:
Available Historical Data Fiscal Year End
Interest expense has stayed stable or declined since 2008. It has only doubled in 28 years as the cumulative deficit has gone up vastly more than 2X.
Projections for the deficit for the next few years are in the $400-500 B range. Note that these are the cash budget and do not include each year's unfunded commitments, which are much larger than the cash budget.
The average maturity of marketable Treasury debt was recently calculated to be just under 70 months. Per the GAO, as of September 2016, 58% of marketable Federal debt securities held by the public mature within 4 years (see link for chart; pdf page 20).
If the deficit explodes upward as Mr. Market is now thinking or fearing, the Fed is raising short-term rates, and inflationary pressures (mostly wages) are on the rise, then all of a sudden the cumulative deficit AND the interest rate on the accelerating total debt will begin to cause much higher interest costs at a time of diminished revenues. This would appear to be a major constraint on any legislation enacted next year.
Unless serious entitlement reform is enacted, the government is stuck. No major fiscal effort is possible under a conventional debt-based situation. It would be "stimulus" that will not stimulate.
A scenario that follows the path of least resistance both politically and economically is the Japanese and EU solution. That involves debt monetization with interest rates returning to their downward channel.
There are other possible alternatives, but the enormity of the entitlements tsunami makes them politically difficult to achieve.
Before summing up, I want to mention two independent economists who have recently proffered downbeat assessments of the upcoming economy. These fit in with ECRI's emphasis on a general downtrend in the US economy since QE3 ended two years ago, or more broadly since QE3's Taper began nearly three years ago. Again, I do this not because I have any special directional view of the performance of the economy, but because P/Es are elevated and cyclical stocks have been especially strong lately.
First up, the well-regarded Levy Forecast, which has had a strong record on interest rate calls, including fund management several years ago with a strong performance record.
Levy Forecast begins to turn bullish (again) on bonds
I wish I could just link to the site, but the information provided comes from downloaded position papers found at the Levy Forecast website. So here are some quotes from three successive communications that have been made public free of charge recently. From the oldest to the most recent:
Not a Bond Bubble, a Bubble Caused by Bonds (July 2016)
Assets are valued so highly and their valuations are so dependent on a collapsed discount factor that either a drop in earnings or a rise in interest rates (even with some earnings gain) could undermine asset prices.
This piece concludes by predicting that the next recession will take the 30-year bond below 1.5% and perhaps much lower. The same recession, they think (or, thought at the time, to be precise), will take the 10-year to below 0.5% and perhaps to zero or negative.
Next, from August:
Weaker Dollar Will Not Prevent Core Inflation from Falling over Next 12 Months
Import prices have stopped falling, but deflationary pressures still abound in the U.S. economy. The weakening of the dollar in the first half of 2016 is likely to have only a minor impact on core consumer prices over the next twelve months.
That piece ends by saying that they expect the US economy to weaken before any important steepening of inflationary trends occurs.
Then, from October:
Excluding Initial Claims, Most Indicators Suggest Softening Labor Market
A number of indicators, ranging from a flattening unemployment rate to stalled hiring rates, are consistent with slowing payroll gains and an approaching peak in wage growth.
They go on to say that they expect wage inflation to decelerate next year.
I think this commentary makes sense.
The latest JOLTS data comports with the above
The blue line shows flattening of hiring for many months. And the number of hires is at or below the 2001-2002 level - but there are many more people in the US now. So it's not really strong at all.
If the Fed is going to raise interest rates, the economy always slows as a result. With hiring rates already slow, the fuel for rising interest rates that the Fed is not manipulating - i.e. long-term rates - may be absent.
(The yellow line - help wanted - is high, but that could be almost irrelevant. Employers can put out electronic help wanted "signs" all they want. If they never hire, it means nothing.)
Paul Kasriel is downbeat, as well
The former chief economist of Northern Trust (NRTS) was one of the few mainstream economists to understand well before Lehman collapsed that a financial crisis was brewing. He has retired from NTRS and maintains a blog.
In his November 1 post, which I discussed in a recent article, he argues that the private banking sector is creating a healthy amount of credit, but the Fed has gotten restrictive, saying (his emphasis in bold print, not mine):
What's more, assuming that the October 2016 employment report, to be released Friday, November 4, is not a washout, the Fed is likely to formally tighten again at the conclusion of its December 13-14, 2016 FOMC meeting by announcing a 25 basis point increase in its target level for the federal funds rate. This will imply that the Fed will have to reduce the monetary base even more in order to push the federal funds rate up toward its new desired higher level. In turn, this will imply a further deceleration in the growth of thin-air credit from an already anemic current 52-week growth rate of 2.8%. Investors, get ready for slower U.S. economic growth in the first half of 2017. And Fed, get ready for a barrage of criticism from the administration of the next President, whoever it is.
After the election, he added a highly theoretical post, with this conclusion:
In sum, there may be rational reasons why the U.S. equity markets rallied in the wake of Donald Trump's presidential election victory. But an expectation of faster U.S. economic growth due to a more "stimulative" fiscal policy is not one of them unless the larger budget deficits are financed with thin-air credit. Fed Chairwoman Yellen, whether you know it or not, you are in the driver's (hot?) seat.
I had written the bulk of this article before I saw this recent post of his, and was glad this expert, who I respect greatly, sees it the way I do in this regard.
Conclusions - still cautious on duration, but changing asset prices change investing emphasis
Given all the above, I present these thoughts for your consideration:
Because equity and fixed income markets remain quite expensive based on historical norms, the basic fundamentals argue for shorter duration portfolios. Periods when the Fed is hawkish and investors are worried about inflation are ideal for investors to reset their equilibria to higher bond yields and lower P/Es.
The inflationistas have a point. However, with oil at $47, down 10% from its October highs, silver and platinum in a bear market and gold in a correction, lumber prices on the weak side; with the USD strong; and with the CFNAI's MA-3 showing no inflation pressure as of October's data (which goes through September, so it's mildly out of date), the argument that inflation is even reaching the Fed's 2% goal hardly appears rock solid.
Several independent analysts, ranging from ECRI which is predicting higher inflation and likely higher interest rates to the Levy Forecast, which is predicting lower interest rates; and Dr. Kasriel, are cautious on the real economy when inflation is stripped away. They are basically arguing with Mr. Market, who is keeping the SPY in an uptrend.
Given all the above, and many other possibilities, I submit that the situation is as murky as it was clear in August 1982 when the Fed eased that a great bull market was dawning.
However, the possibility that the Yellen Fed will finally tilt toward giving savers higher interest rates and raising interest rates in December and again in, perhaps, the second meeting of the year (mid-March), despite the strong dollar appears real to me. Adjusted for different economic times, that would tend to make her the equivalent of Paul Volcker to Donald Trump from the equity market's point of view.
How much could a 0.5% (50 basis points) rise in the Fed funds rates and therefore interest rates paid to savers affect the SPY? It could be substantial. When rates on money funds and plain vanilla demand deposits in banks were virtually zero, and the SPY returned to $100, the dividend yield on the SPY has been hanging around 2% for most of this bull market. (It was 2.02% as of the latest data from the SPDR website.)
Since the differential between cash returns and the SPY was 2%, then if by March, cash yields 1% or is anticipated to get to 1% soon with one more rate hike, then could the SPY trade to a 3% dividend yield? Yes, and that would represent a 1/3 price decline, offset by the amount of dividend increases that have occurred. On the longer end, I have noted that for much of the combined stock-bond bull market since, say, Q2 of 2011, the SPY and the 10-year T-note have taken turns yielding more than each other. Recently, with the 10-year only yielding 1.5% or even 1.75%, the SPY was yielding 2.1% or greater, and the risks were more on bond prices (higher yields). Now the 10-year is at 2.34%. If that yield edges up after two rates hikes by March to a mere 2.6%, and the SPY takes its turn yielding a little more than the 10-year, say 2.75%, that would translate to a 27% price decline, offset by dividend increases.
Even a very large 1/3 off price decline in the SPY would take its TTM P/E from today's 24X per S&P (see spreadsheet found in "Additional info") to 16X. Per Multpl.com, this is 1-2 points above the median and mean P/E of the '500' going back many years, so P/E compression is very possible from there.
In other words, faster nominal GDP growth, especially if caused more by inflation than by real growth, but even if caused by real growth, has an elevated chance of pushing P/Es down much faster than TTM earnings can possibly grow. And since many investors use P/E 10 (Shiller P/E) sorts of metrics, and those change very slowly, a mere one-year change in earnings can affect some ways to value equities only marginally. And we Gilead (NASDAQ:GILD) investors know how quickly rapid growth can be discounted by Mr. Market.
On the other hand, should Mr. Trump be greeted by the economic circumstance that has greeted every Republican president who has succeeded a Democrat going back to Warren Harding in 1921, namely a recession either ongoing or beginning soon after inauguration, all bets on stock prices would be suspended, as earnings might drop a significant amount.
So it continues to look to me that while both bonds and equities have price (valuation) risk of significance, if the Fed raises short term rates, there is the possibility that the Greenspan "conundrum" could be seen. That is, the long end of the yield curve might not react much, having increased its spread above short rates substantially recently. Thus, somewhat paradoxically, rising rates could, for a while, do more damage to stock prices than those of fixed income.
I would therefore answer the question posed in the title that, with appropriate modifications, yes, Janet Yellen could pull a Volcker and lead her Fed to tighten monetary conditions faster than the market anticipates, with adverse effects on the economy, stock prices, and (perhaps to a lesser extent, bond prices.) Though perhaps the effect on the economy, and on tax and spending policies in the next Congress and White House, might be salutary.
I am positioned accordingly, with less exposure to duration, especially very low interest rate vehicles with long duration, than I have had in some time - though I still have some.
In the next article, which stands on its own while serving as in effect a part 2 for this article, I wish to present some ideas about maximizing return versus risk characteristics in a portfolio under today's market and economic conditions.
Disclosure: I am/we are long TLT,HYG,GILD.
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.
Additional disclosure: Not investment advice. I am not an investment adviser.