“We are experiencing a bubble, not in stock prices but in bond prices – The real problem is when the bond-market bubble collapses, long-term interest rates will rise. We are moving into a different phase of the economy – to a stagflation not seen since the 1970s”. - Alan Greenspan - July 31, 2017
A bubble is a product of feedback from positive price changes that create a ‘new era’ ambiance in which people think increasingly that prices will go up forever… Today’s bond market…is just the opposite of a new-era ambiance. Instead, the demand for bonds is driven by an underlying angst about the slow recovery and pessimism of the future…that’s not a bubble.” Robert Shiller from his book Irrational Exuberance.
I believe Shiller's narrative applies equally to today’s bond market.
Greenspan’s comments have no meat attached - there is no empirical data to support his bond bubble or inflation calls, and it also appears he has forgotten the root causes of stagflation in the 1970s. It’s like arguing against a ghost. He now joins the ranks of Professor Jeremy Siegel, who in August of 2010 stated that bonds were in a bubble. Seven years later, the 10-year treasury remains approximately 60 basis points lower than when the good professor made his silly forecast. One has to wonder why Greenspan did not make his bubble call last year when the 10-year treasury spent most of the year well below 2.0%. The only thing different from an economic standpoint is that we’re a year later in the business cycle.
Chairman Greenspan has not lost his long-term memory. The Fed Model, which forms the base for his Bond Bubble forecast, has never received an official Fed blessing and is both controversial and inconsistent as a valuation tool. Ironically, it was introduced to the mainstream back in July 1997 by none other than Alan Greenspan at his Humphrey-Hawkins testimony to Congress. His views are underpinned by his belief in the efficacy of the Fed Model. The Model compares the earning yield on stocks (the inverse of the P/E) to the yield on a 10-year Treasury Bond. It too often is used as a marketing tool to convince equity investors that stocks are cheap in direct comparison to bonds. Critics suggest that the Fed Model is theoretically invalid and just does not work.
The term stagflation was coined by Iain Macleod, a Tory member of the British Parliament in 1965: "We now have the worst of both worlds - not just inflation on the one side or stagnation on the other, we have a sort of 'stagflation situation'." Stagflation is usually defined by high inflation, low economic growth, high unemployment, and unstable exchange rates. In the 1970s, the country was also dealing with rising oil prices and a declining equity market. It is the Catch 22 of economic conditions. Measures taken to reduce unemployment (monetary easing by the Fed) can fuel inflation with little reduction of unemployment. Conversely, attempts to control inflation (monetary tightening) can increase unemployment.
Fewer and fewer Americans remember our last period of stagflation, the late 1970s. The conditions broadly associated with stagflation are not apparent today. However, on the last day of July, former Chairman of the Fed Alan Greenspan suggested that stagflation is on the horizon and that bodes poorly for the American economy. Does his concern reflect economic reality, fantasy or something in between?
Let’s briefly look at postwar history to better understand the origins of the 1970s tug-of-war with stagflation. The late 1950s through the early 1970s saw solid growth in gross domestic product with acceptable inflation. Economic growth was enhanced by very stimulative monetary and fiscal policies in support of the Johnson administration's "guns and butter" programs. However, these excesses accelerated inflation, which was further exacerbated when the Organization of Petroleum Exporting Countries flexed its muscles in late 1973 and early 1974. The difficult period that followed in the mid 1970s is where Chairman Greenspan is suggesting the United States economy is headed. God help us if Greenspan turns out to be correct (which I seriously doubt), because as a country, we have had very limited exposure to stagflation, and to make things worse, most of our economic leaders were teenagers or about to finish their undergraduate studies at the time. Experience does count!
Our view is that the United States economy remains fragile with 2.0% GDP growth likely for the foreseeable future. We have argued in other articles that the Fed has made itself irrelevant - 10-year treasury rates are fractionally lower today after four rate increases going back to December of 2015.
We’re comfortable siding with the bond market’s reflective view of economic growth. Our assessment of the monetary aggregates, productivity data, and debt levels does nothing to improve our economic outlook. The bulls look to employment growth to suggest that everything is ok. We do not see employment growth as a leading indicator – in fact, we see the junction of 4.4% unemployment and GDP growth of 2.0% or less as a paradox and a major yellow warning light. We see the unemployment rate as close to its nadir with the strength of the data mostly behind us.
Recent economic data has been underwhelming, and we are in the very late stages of the business cycle. If confirmed, these views don’t bode well for those calling for a pick-up in growth or higher interest rates. In addition, inflation, the worst enemy of bonds, is virtually nonexistent, and future expectations are declining. I have said since January that I don’t expect fiscal support to come out of Washington in 2017. This remains my view today. Finally, equity valuations are at historic highs by almost any traditional measuring metric which leaves the door open to a price adjustment and a subsequent flight to quality. Of course, if events begin to unfold differently, I will adjust my views accordingly. In the interim, I believe the 30-year bull market in bonds is not complete and expect rates to move lower in an irregular pattern.
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.