By Joseph Y. Calhoun
Markets stabilized some last week, stocks large, small, emerging and foreign finding a bid. Short covering for sure, but maybe some real buying too; there are a lot more cheap stocks around right now than there has been in quite a while. Value players are starting to pick around in the debris of the materials sector. Energy companies have found eager buyers for secondary stock offerings, a sign perhaps that a durable bottom hasn't been found - yet. You'll even find some steel, aluminum and iron ore companies among the big winners last week. It's almost like everything is back to normal, the angst and panic of the beginning of the year rapidly fading in the rear view mirror. I think it would be a mistake to assume that the all clear has been sounded.
The economic data last week continued the pattern that has held over the last year. Weak manufacturing data alongside other data that isn't nearly as disturbing. The Empire State and Philly Fed surveys are still in contraction, while the housing starts and permits continue to look fairly healthy. Or do they? Housing has been an important prop to the economy the last year so any slowing there is significant. And indeed, the year-over-year rate of change is slowing, starts up just 1.8% from last year. Permits have done better, up 13.5% year over year but that is down from nearly 30% in the middle of last year - and permits can be canceled. Jobless claims continue to impress, near cycle lows. Despite the claims performance, though, the leading indicators were down for the second straight month.
The question has been and remains whether the economy can avoid recession with the manufacturing/goods side of the economy already there. Frankly, I think it is a dumb question and I can give you an answer right now - no. It never has before and it won't this time either. The list of indicators that are at levels or rates of change that are usually associated with recession is getting very long. The global economy is already in recession and its effects are being felt in the US right now. S&P recently reported that 394 companies in the US cut their dividends last year, a 38% increase from 2014. The last year with a higher number was 2009 in the aftermath of the Great Recession. In fact, last year was 23% higher than 2008. And no it wasn't all energy companies but one could say that the vast majority were companies hurt by a rising dollar. Curiously, the last time the dollar rose so rapidly was… 2008. And things haven't improved in the New Year, with a cumulative 40 cuts already. Dividend cuts of that magnitude happen in or around recession.
Or we could look at trade which is really what will drive the inflection point to which the title refers. Both imports and exports are down more than 5% year over year. You won't find numbers like those in the available historical data outside of recession. And it isn't just the US; global trade peaked in the 3rd quarter of 2014, with all the major economic areas of the world suffering to some degree from China and Japan to Europe and the US. Emerging markets like Brazil that are dependent on commodity exports are in deep recession, a victim of the global slowdown and a strong dollar. You can call it what you want, but if global trade is shrinking, we've got a serious problem with the global economy.
The inflection point I want to talk about is the one that is coming with global monetary policy, the global currency war, political populism and the backlash against globalization, all of which are interrelated, reinforcing and reflected in those trade numbers above. The popular notion of foreigners stealing American jobs has become so pervasive and potent that Donald Trump could accuse the Chinese of devaluing their currency even when it wasn't true and get applause on the campaign trail. That is a dangerous path we take at the risk of repeating the global economy of the 1930s. Just as in the '30s, the xenophobia, the isolationist, nationalist urge is not confined to the US. Europe's debate on immigration may be more divisive than our own. The Fed may be intent on not repeating the monetary mistakes of the Depression era, but the politicians have made no such promises. And if outright protectionist, nativist policies can't be enacted - yet - the world's central banks have a substitute policy in the form of negative interest rates. The Fed may not make the same mistakes, but they can surely come up with some new ones.
I wrote last week that investors should prepare for a weak dollar world, but it would have been more accurate to urge investors to prepare for a weak fiat currency world. It is said - correctly - that if all countries try to devalue, none will gain an advantage (I don't buy the original premise but that is another argument). That won't keep them from trying but it is surely true that any advantage gained will cue a rapid response. While the US gets most of the blame for setting this currency war in motion with its early versions of QE, I think the real culprit is Japan. With Abenomics, they were the first to acknowledge, with barely a wink and a nod, that they were pursuing a cheaper currency, an overt devaluation of the Yen. The results were mixed economically but not from the viewpoint of corporate profits and stock market gains.
The "success" of the Japanese experiment with devaluation led directly to the European version, which like most things in Europe is a bit more sedate, sclerotic and confused by bureaucracy. And is it coincidence that the Singapore dollar, the Korean Won, the Malaysian Ringitt, the Taiwan dollar, the Thai Baht, the Indian Rupee and almost any other Asian currency you care to name all followed the Yen lower against the US dollar? There were other factors involved obviously but one shouldn't over think this; these countries certainly didn't oppose a cheaper currency in light of the BOJ's actions.
And then in August of last year came the earthquake. China managed to freak out the entire global market by letting the Yuan move too much in one day. It wasn't a big move - about 3% - but it sent a shot across the bow of all those countries who thought they could gain an advantage on China through the currency markets. Now the Yuan is down about 5% since just before that August surprise. It is moving slowly I think because the Chinese are trying to give their companies a chance to refinance their dollar debts into Yuan, but the direction is obvious and relentless. It seems likely that there will be some Chinese dollar debtors sacrificed along the way, but the Chinese have officially entered the currency war - after Trump accused them of having already done so. Did Presidential campaign rhetoric play any role in their decision? Maybe not, but if you are going to be accused regardless of the facts, there isn't much downside to going ahead with what you're being accused of.
So, now the whole world is in a game with no winners but no way to get out of the game. The only country sitting out right now is the US, but the evidence is that doing so has pushed down corporate profits and put the US economy on the edge - or past the edge - of recession. I expect that to change this year as the Fed is forced to back off and rejoin the currency fray. In fact, I think the market is telling you that right now. Bond yields are trading at levels that reflect the existing recessionary conditions and the increasing likelihood of the Fed reversing course. It might not be a reversal of rates, but the market is expecting some kind of action by the Fed that will weaken the dollar. Real yields are falling and gold prices are rising, a cause and effect of a weak dollar. If the market is right - and I think it is - then all the major currency areas will soon be fully engaged in policies intended to weaken their currencies. Which means that none of them will succeed in relation to other fiat currencies.
Until now, more easing by the Fed would be seen as a green light to buy stocks. But if every country is running policy just to keep their currency even with their trade competitors - everyone becomes a competitor in a world of shrinking trade - then there is no advantage gained and no reason to expect corporate profits to respond and, therefore, no reason to buy stocks. So what happens when every country is running an ultra-loose monetary policy to match the ultra-loose monetary policy of its export competitors? What happens if currencies can't devalue against each other?
We are near an inflection point with regard to globalization and monetary policy. The desire to gain a competitive trade advantage through currency devaluation will persist but its effectiveness - or more accurately its perceived effectiveness - will not. From here on, assuming all countries continue to rely on monetary policy as their primary economic growth policy - and that seems a good bet for now - excessively loose monetary policy will have a more traditional impact. It will be felt in gold, other commodities and real assets as the opportunity cost of holding them drops to nil. Or in countries with negative rates offers a pick-up in yield over government bonds.
This shift in the impact of monetary policy will also have political implications. It will reinforce the appeal of the populists. If the inflation the Fed and other central banks have worked so hard to achieve does indeed become reality, it will hurt the poor and middle classes the most. The Fed can call inflation ex-food and energy core if they want but those are the most important items - core one might call them - for the poor and middle class and they will be looking for relief. As someone put it to a Fed official a few years back, I can't eat my iPad. We're already seeing the beginnings of the response in the steady increase in minimum wages across the country. Don't think the politicians won't go for price controls next if prices really start to accelerate. Add in anti-trade and anti-immigrant policies and you have a recipe for about as toxic an economic stew as one can imagine. I hope it doesn't come to that but voters are angry and voting with their hearts not their minds. The inflection point is near.
A history note: The original Democratic populists - there have always been populists on both sides of the aisle but they are most often associated with Democrats - were led by William Jennings Bryan, three time nominee for President, never a winner. The populists favored a return to a bi-metallic system of gold and silver backing the dollar. Having been on a pure gold standard, adding silver back into the mix - which was abundant due to recent discoveries - was essentially a devaluation of the dollar, at least at the ratios favored by Bryan. Interestingly - or not - they also favored free trade. In other words, they favored policies remarkably similar to what countries are attempting today. He wanted the US to devalue the dollar while the rest of the world stayed on the gold standard. And he wanted trade to be as free as possible to take advantage of the weak dollar. The Republicans, by the way, were the party of the gold standard and high tariffs.