Change Is In The Air
Populism is spreading like wildfire across the Western world and the economic landscape is shifting beneath our feet. In the U.S., populism took the form of an eccentric billionaire who has made people on both sides of the aisle reexamine the identity of the nation. His economic views are Protectionist and stray far from what the country has pursed since the 1970's.
There is no telling how his policies will play out in the long-run but they will surely present a lot of uncertainty in the short-run. A shift in executive control is often accompanied by a recession shortly after.
The EU is beginning to fracture under the weight of discontent as well. The U.K. has voted to leave the EU, Merkel's approval rating is plummeting in Germany, Italy's referendum vote has ousted Renzi as Prime Minister, and many other European political changes are afoot. It is a clear sign of the people giving the middle finger to the establishment. This will not only present an overabundance of political risk, it will raise the risk of a global banking crisis springing out of Italy and Deutsche Bank (NYSE:DB).
Italy's banks have a mountain of Non-Performing Loans and Deutsche Bank is struggling to pay penalties for pushing toxic mortgages on investors leading up to the 2008 crash.
To make matters worse, Wall Street banks have accumulated $2 trillion in European financial assets, according to the Office of Financial Research. If the European banking sector begins to stall, it would put serious stress on the U.S. and world economy as well.
Metrics Indicating Recession
The Unemployment Rate seems to be the most talked about economic metric in the mainstream media as the Obama administration tries to save face. It is, however, a very flawed metric. It doesn't account for the quality of jobs being created. For example, part-time and low-skill jobs hold the same weight as high-skill jobs. Also, the Unemployment Rate does not take into account the Labor Force Participation rate. More and more people are giving up looking for work altogether, which puts downward pressure on the Unemployment Rate.
As flawed as the official Unemployment Rate may be, the complete time-series can still shed some light on overall economic conditions. The unemployment rate is very cyclical by nature. It falls consistently during times of economic expansion and rises sharply during an economic downturn. Before it rises sharply, it undergoes a small period of stagnation when it reaches its bottom. We are in that stagnation period now and about to enter a recession within a year.
Yield spreads, specifically the spread between 10-year and 2-year Treasuries, are indicating a recession within a year as well. A bottoming of the yield spread is usually followed by a recession 6 to 12 months later. The spread bottomed in July of 2016, so we are about 6 months in already.
Even though the yield spread did not invert (go beneath the black line) like it did in the previous modern-day recessions, there is still a high probability of recession. Joseph Lavorgna, Chief U.S. Economist at Deutsche Bank, explains why this is the case:
Over the last two decades, the Japanese yield curve has flattened ahead of each of the last four recessions (1997 to 1999, 2000 to 2002, 2008 to 2009 and 2012). Yet in each case, it did not invert. Consequently, we believe there is a high probability that whenever the next U.S. recession occurs, the 10s-funds curve is likely to remain positive, and perhaps significantly so, at least compared to past business cycles.
To expand on Lavorgna's sentiment; the inversion will not occur this time because the Federal Reserve has pursued Zero Interest Rate Policy and pumped trillions of dollars into short-term bonds, which has kept short-term rates unusually low. Ten-year Treasuries could not fall low enough to go below 2-year Treasuries this time around.
Another group of metrics signaling a recession are stock market valuations. The recent Trump Rally has pushed valuations to an absurd level. John P. Hussman, of Hussman Funds, does some of the most comprehensive research on stock market valuations. His research focuses on metrics that have a strong correlation with subsequent market returns. In other words, Hussman's valuation metrics are good predictors of long-run stock market returns.
A high value means low long-run returns and vice versa. We currently have a bloated stock market that has only been surpassed in value by the speculative bubbles that came before the Great Depression in 1929 and the tech crash in 2000.
This year will be much more volatile than years in the recent past. There is much that we can't predict, and with the political and economic environment changing so rapidly, Black Swans are most likely lying in wait. Donald Trump and many other leaders around the Western world will take power as the economy begins to deteriorate. The identity of Western nations will be in constant flux as two very different ideological sides battle for cultural supremacy. Social unrest will heighten.
At some point during the year, we will see the unemployment rate begin to slip upward. Then it will explode upward. Bankruptcies will soar and consumer confidence will plummet. Trillions of dollars will be erased from the global economy. Before the recession officially takes hold, the S&P 500 (NYSEARCA:SPY), FTSE 100 (UKX), and many other world markets will begin to seismically shift. There will be major downward and upward shifts in the market, but the general trend after the first few months will be down. After that, the drops will become severe. If this were a normal recession, stocks would lose about 30% and the bear market would end about a year from when it started. Because of the rapidly changing world and the instability it presents, I believe this recession will be more severe than the average recession.
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.