Why Permabears' Predictions Might Come True In 2019

by: Crispus Nyaga

Summary

Interest rate hikes could lead to yield curve inversion.

Emerging Markets contagion coupled with low commodity prices and high crude prices.

Slowing corporate earnings and GDP growth to contribute to increased uncertainty.

US national debt has almost doubled.

Deregulation could lead to risk taking by big banks.

For almost 10 years, ‘permabears’ like The Heisenberg, Mohamed El Erian, and Nouriel Roubini have warned about the coming crash in the world’s stock market. Repeatedly, they have been proven wrong as the market has continued moving higher. In this article, I will explain why 2019 could be the year their bearish predictions come true.

The Federal Reserve

The Fed started normalizing in 2015. Since then, the gradual process of hiking interest rates has continued. This month, the Fed will oversee another rate hike and provide guidance about another hike in December.

At the Jackson Hole symposium, the Fed chair Jerome Powell indicated that the Fed will continue tightening if the economic data provides support. In the next three months, economic data will likely make the case for a rate hike.

The inflation rate has remained near the 2% target, the unemployment rate is at historic lows, the participation rate has increased, the jobless claims have tanked, manufacturing is coming back, corporate earnings are impressive, and the consumer confidence is at 18-year highs.

Therefore, based on Powell’s statement, there is a likelihood that the Fed will have another rate hike in December.

If the Fed continues the tightening pace in 2019, it could mean trouble for the stock markets. A survey by Reuters in June found that most economists expect the Fed to implement three more rate hikes in 2019. The Fed has however remain tight-lipped though the recent minutes show that the Fed is unlikely to implement more hikes in 2019. The minutes said:

“Participants noted that the federal funds rate was moving closer to the range of estimates of its neutral level.”

Recently, Atlanta Fed president, Raphael Bostic has sounded warning on the continuing pace of rate hikes. In a recent interview, he said that he would oppose any monetary policy that will likely lead to the inversion of the Fed curve.

As shown below, the yield curve is at the lowest level since 2007, before the crisis. Therefore, continuing the pace of rate increases will likely lead to a yield curve inversion, which will likely lead to a recession.

The chart below shows that most recessions tend to come during periods of tightening by the Fed.

If the crash happens, the Fed will not have enough tools to contain it for three reasons. First, US rates are expected to be lower than they were before the 2008/9 crisis. Analysts expect the lending rate to be between 3.0% and 3.25% at the end of 2019. This will be lower than the 5% rate before the crisis. It will therefore provide little room for the Fed to control the crisis. In addition, other central banks in the developed countries are less prepared.

The Bank of Japan has continued to retain negative interest rates and last week, Kuroda signalled that there will be no hike for an extended period. Before the crisis, Japan’s interest rates were 0.75%.

The ECB has signalled that it will have the first hike since the crisis in September next year. The officials have maintained that this rate will only happen if the data supports it. This is an indication that the bank could leave interest rates lower for longer.

The Bank of England raised rates in August and projected that more rate hikes could be coming. However, as the odds of a no-Brexit deal rise, the bank will likely be on the sidelines.

The Swiss National Bank has signalled that it is not interested in a rate hike any time soon. The officials believe that the franc is overvalued against the dollar. Similarly, the RBA and the RBNZ have signalled that they won’t hike any time soon.

Second, the US national debt has soared after the crisis. In 2009, the national debt was about $11 trillion. Today, it has risen to more than $21 trillion and the tax reform, and is projected to rise more because of the tax reform and the increase in government spending. Between the 2001 crisis, the national debt was at $5.9 trillion. Before the 2008 crisis, it had ballooned to $9.2 trillion. The chart below shows how recessions tend to happen during periods of accelerated debt growth.

Third, while the leading banks are better capitalized, the ongoing deregulation push by the Trump administration could lead to more risk taking by the banks. This could lead to more delinquencies of debt as was the case during the subprime mortgage crisis. After the crisis, the delinquency rate on consumer loans fell sharply. As this chart shows, the delinquencies have started to rise. In addition, a recent working paper by the IMF said:

“Financial booms, and risk-taking during these episodes, were often amplified by political regulatory stimuli, credit subsidies, and an increasing light-touch approach to financial supervision. The regulatory backlash that ensues from financial crises can only be understood in the context of the deep political ramifications of these crises. Post-crisis regulations do not always survive the following boom. The interplay between politics and financial policy over these cycles deserves further attention. History suggests that politics can be the undoing of macro-prudential regulations.”

Emerging Markets

In recent months, the problems in the Emerging Markets have raised concerns about contagion. These problems are likely to continue as crude oil prices rise and commodity prices fall.

Last week, Argentina was forced to ask for the release of the long-promised emergency funding from the IMF. Two weeks before, the Turkish Lira plunged as the central bank resisted rate increases. This week, the Indonesian central bank was forced to intervene after the currency fell to a 20-year low. In South Africa, low commodity prices and political tussles have made it difficult for the South African rand and the economy, which fell into a recession in the second quarter.

The same is the case with Brazil, and India. The chart below shows the YTD performance of key EM currencies.

Writing for Bloomberg, Marcus Ashworth said that the sell-off on the Emerging Markets seemed contagious. He said:

“This looks like contagion. One emerging country’s problems have become other emerging countries’ problems, and it’s hard to see how to break the cycle.”

As their currencies have weakened, the EM are faced with a big debt problem. After the financial crisis, the countries went on a borrowing spree – mostly in China. Most of the times, this borrowing happened in their local currencies. As the dollar strengthens, these countries might have a difficult time paying back. In fact, recently, Malaysia has rejected more money from China, while Sri Lanka was forced to surrender its Chinese-built port.

Source: FT

US Politics

US politics will likely get ugly in 2018. As president, Donald Trump has broken all the presidential norms. As he has done that, the republican establishment have been scared to abandon him. In November, things might change if the Democrats are able to take the senate and congress. Historically, statistics are in their favour because the presidential party tends to lose during the mid-terms.

If they retake the two houses, chances are that they will promptly move to impeach the president. Already, a key donor – Tom Steyer – has spent more than $10 million to campaign for his impeachment basing his argument on the emolument clauses. More than 60 democratic leaders have already signed up to impeach the president.

The calls to impeach him will increase if Robert Mueller releases a damning report that finds the president culpable of conspiring with a foreign country and obstructing justice. However, a full impeachment will be unlikely if republicans will not join them.

As leaders, democrats will likely oppose some of Trump’s deregulatory policies. They will also move to roll back the tax reform package.

Therefore, the progress made by the president in lowering taxes and deregulating the industry will be at risk if republicans don’t win in November.

Corporate Earnings

The bull run has been supported by strong corporate earnings. In the second quarter, the earnings rose by 16.1%. This was the highest level of growth in six years. These earnings were supported by an expanding economy, tax reform, and deregulations.

In the coming year, there is a likelihood that the earnings will slow down. A recent report by WSJ said that:

“Still, analysts see little sign of a letup in earnings momentum this year, though Wall Street projections for 2019 point toward a modest slowdown.”

In Washington, the Congressional Budget Office (CBO) found that the growth in the economy was likely to slow in 2019. The chairman of the CBO said:

“In 2019, the pace of GDP growth slows to 2.4 percent in the agency’s forecast, as growth in business investment and government purchases slows.”

Final Thoughts

A combination of rising interest rates, contagion in the emerging markets, political instability and the slowing US economy and corporate earnings will likely lead to the financial crisis, long predicted by permabears like Nouriel Roubini. An ideal way to anticipate this scenario is to reduce the sizes of winning investments, holding cash, and investing in balancing portfolio with long and short investments.

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.