2018 Starts With Thunder, It May End In Lots Of Tears

by: Global Opportunities Analyst

Our current economic model is based on creating economic activity by pumping asset prices.

Asset prices have, one by one, and country by country, reached today's record levels when they all seem very expensive in historical context.

As the current economic cycle ages, it is rational and absolutely normal to expect a recession sooner rather than later.

When the next recession hits, central bankers will no longer be able to pump asset prices enough, and the reckoning will be very ugly.


Our current economic system is one that evolved from the Bretton Woods system, which was based on the gold standard. The gold standard was given up on June 5, 1933, by President FDR. The gold standard of Bretton Woods was abandoned by President Nixon in early 1970s, preventing a potential repeat of the 1930s depression, though causing double-digit inflation, which led to massive depletion of real asset values over the ensuing decade. Starting with the early 1980s, the Federal Reserve managed to gain control of inflation, and the stepstones of our current economic world were laid. The chart below shows how deflationary periods of the past have been replaced with continuous (with the exception of a very short episode in 2009) inflation in our modern fiat monetary system. Since the 1980s, we have had almost four decades of 1) benign inflation, 2) rising asset values, and 3) massive private debt accumulation.

During periods of the gold standard, things were far more different than we have had in recent decades. Business performance seemed to be more prone to gravity. Whenever there was too much aggregate debt and too much aggregate investment, production would rise, prices would fall, deflation would follow, and indebted businesses would get under pressure, in turn adversely affecting banks, and depressions of various severities would follow. Things seem to have changed quite dramatically since then - or perhaps they haven't, and we are just going to have similar experiences, but we are not just there yet. Fiat money may have simply helped delay the inevitable! True depressions do not happen very often. One happened in the 1870s, another in the 1930s, and one might say that a modern sort of fiat-currency-world mild depression occurred in the 1970s. But this is all speculation for now.


Let's look at how things seem to have changed since the 1980s. Since the early 1980s, both stocks and real estate started to appreciate while inflation started to fall steadily. Then, as the economy started weakening in the early 1990s, real estate did not do very well, but stocks continued to rise rapidly until the year 2000. The 1990s also saw the beginning of what was to become known as an asset class of its own; Emerging Markets (EM). EM also did very well until 1997, when it crashed and did not recover for several years. Developed market stocks reached their highest valuations ever in 2000, and after they started to falter, real estate took over and reached its highest valuation levels ever in 2006-2007 pretty much all around the world (with very few exceptions). Then, real estate crashed. After 2009, all these asset classes have started to rise in tandem - stocks, real estate, and EM have all risen sharply until now and have either surpassed their previous valuation records, or have come very close.

The inflation-adjusted chart below shows how real estate has done in the US. Real estate prices have outperformed inflation since the early 1980s, and the divergence has got bigger, and stayed so, more recently.

The chart below shows how the stock market, adjusted for inflation, has performed in the US, and as it can be seen, stocks have done extraordinarily well since the early 1980s.

The fact that both real estate and stocks have considerably outperformed inflation since the 1980s is a clear proof that wages have not managed to keep up with asset prices. This is a failure of policy, and an unintended consequence of the 'success' of the monetary system that has been applied for almost four decades. Although many cheer the fact that stocks are so high, and houses are so expensive, it is understandable that most of the electorate (who are fundamentally the ones to whom policy-makers are responsible) do not care much about them. Most of the electorate care most about their employment situation and their wages. Rising house prices are actually a bad omen for the younger generations who are either completely squeezed out of the market, or obliged to get too large loans in order to join the ownership bandwagon.

Central bankers have continuously applied a simple recipe; whenever the economy slows, they cut interest rates and pump money into the financial system (more recently in the form of Quantitative Easing, or practically printing new money). Falling asset prices during recessions erode bank balance sheets, consumer and business confidence, and of course, eventually wages and employment. We have had three major recessions in the past four decades, early 1990s, early 2000s, and late 2000s. Each time, the Fed cut interest rates by about 5% (chart below), and the last time, it also resorted to massive Quantitative Easing to also push longer term interest rates lower.

These measures helped maintain overall asset prices high, preventing deep recessions, and of course, possible depressions. And it appears that every time, it worked. Little by little, after three recessions in the US and one semi-depression in EM in the late 1990s, real estate is at near-record levels, EM debt is at absurd levels, corporate bonds are more expensive than ever on aggregate, and US stocks are more expensive (according to Shiller P/E) than they have ever been except for the year 2000 (chart below).

Current US economic growth, historically tepid, of 2.3% for 2017, was achieved in an unusually favorable monetary environment, with both stocks and housing at near-record levels at the same time. China was able to achieve its growth target for 2016 and 2017 pushing its housing market to stratospheric levels. According to a WSJ article, Chinese authorities have gone as far as buying huge numbers of excess housing inventories in order to prevent a crash. China's gross rental yields in all of its major urban areas have now fallen below 2% while 10-year government bonds yield around 4%. China's housing market has been absurdly expensive for years, but legitimate fears of a housing crash have repeatedly pushed the authorities to take measures - pumping more money. And the result has been the extreme valuations of today. These measures have led to the current situation in which housing has become vastly unaffordable for ordinary Chinese. The same is also true for the US and other countries where the desire to prevent deep recessions has pushed asset prices out of the reach of an ever larger number of wage-earners, widening the gap between the haves and the have-nots.

Practically speaking, our current economic model is based on achieving growth through maintaining, and often propping up, asset prices. High, or higher, asset prices do stimulate economic activity. High house prices help banks keep their loans in good shape, allowing them to lend. At the same time, high house prices attract developers and investors to pour money into building new projects, creating employment and improving wages. Falling house prices on the other hand would hurt bank balance sheets, consumer and business confidence, and would also dissuade investments from building projects, hurting both employment and wages. The same also applies for stocks. Falling stock markets are not good for consumer and business confidence and discourage businesses from investing, further hurting employment and wages. This is why authorities are scared about falling asset prices. Monetary easing of central bankers has repeatedly led to what has been called a bubble, one after another, but as monetary easing has continued unabated and has rather gained steam over the past four decades, we have reached a point in which all asset classes have become bubbly. Any period of economic growth has been, naturally, associated with asset price appreciations, but any decline in asset values has been followed by massive central bank easing, so that the repercussions would be contained. The result has been that asset prices on aggregate have kept on rising in the aftermath of each recession as the result of an easier monetary policy. And this has brought us to the current situation in which there seems to be a bubble in every asset class, from real estate to stocks, to EM and corporate debt.

The question is how far, and for how long, this model can go on! This is the $100 trillion question. How far can central bankers push asset prices higher in order to stimulate economic activity? Although wage earners have seen their incomes grow (chart below), almost continuously for the past decades, they have become less and less able to buy houses or save and invest, as asset prices have outdone them ever so precipitously over time.

This is also the reason why, despite having so many bubbly assets around, you don't see many people cheering and feeling excited about them (probably with the exception of the relatively small crypto bubble that is going on as well), simply because not many people are participating. Actually, not many can afford. Most people are in all kinds of debt, and their earnings have lagged behind asset prices. Then again, how far can this scheme continue to work? Is there a ceiling above which asset prices will not go? If asset prices reach a certain high ceiling, above which they can no longer go, our current economic model will collapse, and we can expect true economic hardship, and perhaps a depression. Although China, because of its non-democratic and authoritarian regime, can defy some economic and gravitational rules for longer (but not forever), that is not the case for America and most of the rest of the world. And I see one clear sign that the most important asset class, real estate, is already showing serious signs of fatigue, in the US, but more importantly, all around the world. For more than a year, major US urban areas like New York, San Francisco, Miami, and others, have started to see rents fall quite seriously. Some of the frothiest real estate markets (UK, Canada, Australia, Sweden etc.) in the world have already started seeing significant price declines. These real estate markets are suffering while the economy is doing very well. The real estate market has reached the top simply because of too much building. Too much supply of housing has already saturated the frothiest markets. The same situation can spread to other areas of the economy, and when the overall balance changes, or seems to offer clear indications of changing, markets can react and possibly react in a violent and panicky way, as they have done so many times in the past. There isn't any doubt about the fact that there will be a recession sooner or later, but the real problem is whether central bankers can pull the same trick yet again, and help, through more monetary easing, push asset prices even higher and create more economic activity! And the real problem there is that this time around, central bankers in developed markets are either completely (EU and Japan), or almost completely (US and some others) out of ammunition. Real estate seems to have peaked (and already started to show signs of decline) while central bank rates are just around 1% in the US and below zero in most other developed economies. Last recessions required interest rate cuts of about 5%. That weapon is no longer there this time around. Will Quantitative Easing suffice? Quantitative Easing doesn't do more than help push longer term interest rates lower. While short-term interest rates are around zero and cannot (in reality) be pushed much below zero, how will it help to lower longer term interest rates from 1% or 2% to, let's say, zero? That will not replace a 5% cut to short-term rates. And the fact of the matter is that shorter-term interest rates are much more important, especially in recessions, as struggling businesses, banks, and households, have relatively short-term concerns. In any case, one thing is clear, that the real ceiling for asset prices will likely prove to be the impotence of the central banks to pump them up further. We are probably quite close to witnessing how the next slowdown, and the monetary response to it, will unfold. But for now, markets are euphoric, especially about president Trump's tax reform, and expect exceptional returns for 2018 and beyond, or at least this is what the stock market is signalling. However, in the very likely case that the Fed does not manage to raise interest rates several percentage points before the next recession hits, things will get very ugly. For the market to be able to absorb such massive rate hikes, things need to change radically in the coming couple of years, to the better. Can the economy improve significantly, with unemployment already near record lows (chart below), and the current economic cycle already the third longest in history?


How can the Fed raise rates several percentage points while the real estate market is already showing clear signs of fatigue? That sounds crazy to me. It simply doesn't add up. But the stock market is euphoric, and for now, it is ignoring simple and obvious realities. US real estate is already on the verge of total oversupply, and US stocks are already very close to their record levels of the year 2000. How can they manage much higher interest rates? It is simple; they won't. The next recession will hit BEFORE interest rates will have managed to go much higher. It will be the moment of reckoning for decades of exuberance, or that's what I think, and fear. I wrote about this fear of mine also back in 2016, and my timing was of course terrible. I may be wrong again this time, but as the market has aged and asset prices have stretched MUCH further, it has become a lot likelier to get a recession soon. It is a great time to sell risk assets and sit on the sidelines to see how the whole thing unfolds.

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.