The Right is turning “nationalist,” the Left is turning “socialist,” and the US is foisting a trade war on the world which no one wants. Does that sound like the 1930s to you? Because it sounds like the 1930s to me.
- A very unfunny joke I’ve been telling for three years now. No one has laughed yet.
The Tails Are Fat
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When statisticians say that a probability distribution has “fat tails,” in plain English that means the things we usually think are very unlikely are now more likely than we think. What is the probability of another Great Depression? Very low, yes, but is it 0.001%, 0.1% or 1%. It makes a difference.
We live in a time of fat tails:
- Global economies are careening towards recession, with the US a weak but notable exception.
- The current cycle is very long in the tooth.
- Stock prices are historically high relative to GDP and corporate profits.
- The globalized nature of capital is under attack.
- Central banks have lost control in two important ways.
- The uncertainty of global oil/gas infrastructure has risen with the Saudi drone attack.
- There is an unusual amount of political turmoil right now.
- Foremost among these political risks, the US faces a long and protracted political stalemate around impeachment and the 2020 election.
I’ve been droning on about this for about a year now, but now it seems like it is all coming to a head. In the interval:
Meh. A lot of up and down, but mostly sideways. The best bet in this period has been US Treasuries, anywhere in the 2-10 year maturities, which are on an historic run.
We are right on the knife’s edge.
Global Economies Are Careening Towards Recession
Beginning with the advanced economies aggregates:
In this chart, and the ones to come, we are looking at the 2nd derivative — the rate of change of the rate of change. This shows us whether economies are accelerating (positive number) or decelerating (negative number).
So we can see that the overall picture is gloomy. OECD economies are decelerating by about 40% YoY in the last three quarters.
The US is the all-star in this and is still decelerating fast.
Bad news all around here. The UK is actually recovering a bit from their Brexit slump, which came earlier for them than the others. But still decelerating.
The developing world giants, China and India:
Bad news here too, but China is holding up better.
Finally, our Asian allies, Japan and South Korea:
So we see a lot of negative numbers everywhere, meaning economies are all decelerating. Holding it all together is the US. Switching to YoY growth rates (1st derivative):
Though hardly outstanding at 2.3% YoY, US GDP growth is keeping the rest of the world from collapsing for now. The growth is largely on the back of the US consumer, and continued wholesale inventory buildup. If the Atlanta Fed’s GDPNow estimate is to be believed, the current quarter will show consumers slowing their roll, amid continued inventory buildup.
So we’re going to stipulate that the rest of the world is doing poorly, and focus mostly on the US. That is the first element to the backdrop — global weakness, with US consumers and wholesalers holding it all together for now.
Yes, Economic Cycles Die of “Old Age”
It depends on what you mean by “old age.” What I mean is that, like the human body, unpredictable shocks of varying size are happening to the economy all the time. Earlier in the cycle when we are still below full employment and the economy is growing rapidly, it can absorb these shocks, even big ones like the 2015 oil shock.
But as the cycle ages, bubbles have been forming, sometimes without anyone knowing, and so sources of weakness multiply, like in an aging body. Recessions have two causes: the underlying weaknesses, and the proximate shock that tips it over.
Let’s look at a few recent shocks, going backwards. Beginning with the oil shock of 2014-2016. First this happened:
Then this happened:
The economy was strong enough, growing at over 3% coming into this, to absorb the sectoral shock and get back up, especially after the Fed remained accommodative.
Before that, the underlying weakness was an oversupply of housing in places people didn’t want to live:
Residential investment was growing in the 8-11% YoY range in the early 2000s, and then collapsed a full 2 years before the recession began. That was the underlying bubble, but the proximate shock was when everyone realized that the AAA securitized mortgage debt they held was actually a lot of subprime junk, unpriceable in any reasonable time frame, and effectively worth zero at mark-to-market.
The economy was growing at around 2.2% when this started happening, and could not absorb the giant shock to the financial system.
Before that, there was DotCom 1.0, where public markets raced to fund big money-losing growth companies. From my review of the We S-1 filing:
Of the 304 IPOs in 1999, 245 of them had zero or negative profit margins; the median profit margin was -67%. It sounds bad, and it was, and it included some of the more fantastic blowouts of the dot-com era like WebVan (-8895% margin at IPO). The number of search engines, ISPs, and companies out to “disrupt” an existing industry that are no longer with us is pretty staggering.
I was going to count up how many companies that IPOed in 1999 are still with the living, and in what capacity, but I only made it through the first 20. None of them had gotten past 2006, most of them out of business in 2001. Sorry, it was too depressing to watch all that capital be set on fire, so I gave up. I’m only human.
In 2000, the stock market was the bubble, with investors turning on profitless growth in March 2000. Q3 and Q4 1999 profits were abysmal, with bad guidance for Q1 2000, and by the end of the reporting period, everyone reevaluated what they owned; that was the proximate shock.
The market crashed an economy that was already slowing a bit; the reverse wealth effect sent consumption crashing down beginning the next month in April 2000.
The recession didn’t begin until the following March and 9/11 sealed the deal. But this shock took down the economy, because growth had already slowed a bit towards the end of 1999, and could not handle the huge hit to consumption.
But just a few years before that in 1998, a smaller shock, the Asian Crisis, only shaved a little off of robust 5% YoY real GDP growth.
I could keep going, but the point is this: shocks are happening all the time, but it’s the incoming condition of the economy, and the size of the shock that determine the outcome. This entire current recovery has been tepid, with flirtations with high real GDP growth in 2014-2015 and 2018. Right now we are not in a healthy condition to absorb a shock, even a medium-sized one.
So that’s the second part of the backdrop to all the rest: we are not in a good position to absorb a big shock.
Central Banks Have Lost Control
The third part of the backdrop is that we’ve relied on central banks to soften the blow of these shocks for many decades now, but they are much less able to solve our current dilemmas than previous ones.
In the first place, central bankers cannot find the neutral rate, the rate at which full employment meets 2% inflation. They can achieve neither without driving rates even lower, which will likely be counterproductive anyway as the Japanese and German examples show us.
Overnight rates in the US topped out at 2.4% this cycle. Germany and Japan, economies numbers 3 and 4 on the global list, barely scraped off the floor the entire cycle and have negative nominal rates to almost no effect since 2016.
Let’s zoom that out so you can see how historically low this is:
Typically, the personal savings rate and interest rates (represented by the 10-year Treasury yield here) are highly correlated, as we see in this chart from 1990-2008. This makes sense — higher interest rates encourage people to save more. But the relationship has become unglued in the current cycle, and we are at personal savings rates not seen since the early 1990s when rates were much higher.
Widening out to all private savings as a percentage of GDP, we see it came down with rates through 2000, stayed pretty level in the last cycle, and is way up in this cycle:
The blue line is the ratio of personal savings to personal consumption
This held through 2008, but again we see the relationship shattered in the current cycle. We are back up to early 1990s levels, when rates were much higher.
The net effect is that even as rates decline, there is not enough demand to warrant investment for all that savings — the Paradox of Thrift.
So even though rates continue to decline in the long term, they are still not low enough to entice more consumption and investment. They must go lower, but as the example of Japan and Germany show us, this does not help.
Why this is happening is a much longer story, but the 3-way Catch-22 for central banks:
- The real neutral rate is near or below zero.
- Near the lower bound, rate cuts are ineffective or even, in some circumstances, counterproductive. Cutting to zero or negative does not solve the problem.
- These low interest rates also introduce bubbles into the economy, which makes the problem worse. When a debt-fueled bubble bursts, individuals and companies get their balance sheets in order and increase savings. While this makes sense at the micro level, on the macro level there is not enough investment for all the increased savings, because aggregate demand is low from too much saving.
The choice for policymakers becomes either slow growth, or short bursts of growth fueled by asset bubbles that burst spectacularly, and drag us down to a lower plateau.
The other manner of loss of control is in the overnight repo markets, as I discussed last week. It remains to be seen whether this is just a hiccup or a more systemic issue, but the troubling part is that it was a perfect storm everyone saw coming, yet the boat still got swamped. Since the repo flare up ended:
As you can see, it has not been entirely smooth sailing, with the overnight rate popping up to 2.35%, dragging Fed Funds back up to 1.90%, above 1.85% where I think they would prefer it. In any event, on most nights there’s been adequate reserves, but not September 29-30 for the end of quarter. Like the first repo spike, everyone knew this was coming, so it gives more credence to the position that this is a more systemic issue.
But central bank loss of control is frightening because of this:
The NBER’s monthly recession indicator goes back to December 1854. There are 4 distinct periods here:
- 1854-1913: The Free Banking Era. No central bank.
- 1914-1951: Fed Mark I. The Fed is established and takes a limited, mostly hands-off approach. During WWII, the Treasury took over Fed operations through 1951.
- 1952-1977: Fed Mark II. The Fed regains independence from Treasury and takes a more active, but still limited role in the economy. That ends with the 1977 Federal Reserve Act modifications.
- 1978-Current: Fed Mark III. The most active the Fed had been in this history.
Before Fed interventions, almost half of months were recessionary. Increasing intensity of Fed intervention has led to the current period, when only 11% of months are recessionary.
So we have come to rely heavily on central banks to ease cycles, step in so panics don’t become recessions, and make recessions shorter when they do come. But that only works if the Fed has a broad toolkit to work with, the primary tool being interest rates. Near zero, rates become ineffective.
Japan has not had overnight rates above 0.5% since October 1995, but they have been in and out of recession repeatedly since then:
Even with zero and negative rates, the Japanese cannot stem the tide. Germany is experiencing that now, and the US is likely there soon.
So the fat tail here is that central banks will not be able to save us the way they have since 1951. It multiplies all the other risks.
The Stock Valuations Are High
Relative to GDP, stock valuations are at an all-time high, eclipsing even 2000:
The Globalized Nature of Capital Is Under Attack
Since that March 2018 tweet:
Global trade is cratering. And the US:
Total trade is about flat in the past year, and the deficit is skyrocketing. (Not) coincidentally, this also happened:
This is not going well. From my most recent trade war article:
Everyone is focused on the first-order effect of tariffs: 10% of $300 billion is $30 billion. That doesn’t sound like much in a $20 trillion GDP economy. But that’s also 2.8% of all the nominal GDP growth in 2018, so in the first place, it’s not nothing.
But the second-order effects are more scary, and harder to predict or quantify. The global supply chain is a symphony of just-in-time delivery that has created massive efficiencies over the past 25 years, expressed in 25 years of goods price declines here in the US. But Tariff Man has brought an airhorn to the concert hall. It’s not just the dollars; it’s the uncertainty, the investments not made, the increased friction in the entire system, and, yes, the fear. The effect on behavior, beliefs, norms and relationships is much more damaging than $30 billion.
And if we get into a full-blown currency war, it will most certainly spiral out of control. Does it look like anyone is in control now?
The Chinese were already looking for a future where they were not as dependent on the US consumer as they are. They just may get their wish much earlier and more rapidly than they would have liked. On their side, the consumer will feel the brunt of this.
For the US, this will be a massive restructuring of the goods economy that has built up over 25 years, and there’s really no telling where that ends up.
China will continue to try and limit the damage to their economy without giving up anything big. The currently discussed agricultural buy is a mere pittance compared to what US farmers have lost on all this, and at deflated prices as well. This is the kind of thing we can expect from the Chinese side. They will give Trump small, relatively costless “wins” that Trump can tweet about, without ever getting to any real concessions on their part.
With Trump, the self-proclaimed “Tariff Man,” who knows? We have already seen him capitulate and declare victory with Canada and Mexico, but he has been less easy on Europe and China. But now he faces reelection and impeachment. We may have just scratched the surface of the chaos his presidency has brought to the global supply chain.
Even worse news is the rumors of possible capital controls on US investments. I don’t want to get to deep here, because we only know that there has been policy discussions on it. Goldman estimates that US investors have $785 billion in exposure to Chinese securities via direct ownership of Chinese-listed stocks, Honk Kong-listed stocks, and US-listed stocks. Putting it all together, that’s 7% of all Chinese market cap that would be on the selling block. This will dwarf the effects of tariffs, but let’s not get ahead of ourselves just yet.
But most importantly, I still don’t know what a deal looks like that is acceptable to both sides. Do you?
Uncertainty in Oil/Gas
Since the drone attacks.
Leaving aside the possibility of a larger Shia-Sunni war centered around the Persian Gulf, my greatest fear is how incredibly simple this attack was, and how difficult it would be to defend against future attacks, even in the US.
If you wanted to go top-shelf, you can get a top-end cinematographer’s drone for about $20,000. It can carry up to 20 pounds (9.1 kg) of explosives instead of a digital film camera, stays in the air for 45 minutes, and is very accurate for an experienced operator. It flies well under radar. It is small enough to be launched from any boat with a decent sized deck, effectively making it an aircraft carrier, or any concealed land.
Does that scare the crap out of you? How do you defend the sprawling US gulf coast complex, or the Midland complex or Cushing, Oklahoma. How do you defend this sprawl?
Another drone attack, anywhere in the world that is part of the global supply chain, will send prices skyrocketing. The probability of frequent supply disruptions just went from very close to zero to something more than that.
Political Turmoil is Rocking Many Important Countries
US: Let’s begin with the US, because how can we not. The American President is at the beginning of both the 2020 election season, and his own personal hell of impeachment. Never the most stable of forces, it is about to get really weird.
Donald, you know, is great at the one-liners. But he's a chaos candidate. And he'd be a chaos president.
Jeb Bush, December 2015
I have two degrees in political science, and there is no way in hell I’m going to try and predict anything that happens next, except that Jeb was right, and it’s about to get more chaotic. Just in the past 72 hours Trump has tweeted about arresting a member of Congress for treason, threatening witnesses, and [checks Twitter], um, civil war.
It will only get crazier.
The uncertainty surrounding trade has already done this to investment:
We are about to walk through a portal of strange, and if you think markets have been whipsawed by the President’s Twitter feed up until now, what’s coming will make that pale in comparison.
Bill Clinton came into impeachment hearings with a roaring economy, but Richard Nixon not so. This is how the economy and market reacted to that:
The economy was already beginning to falter, and the drag of Congressional hearings, Nixon’s singular focus on it, and the drip-drip of daily bombshells eventually brought it and the market down. The uncertainty surrounding the President killed investment:
Investment began slowing the same quarter Congressional hearings did. Uncertainty will reign at least through the end of this year, and likely all the way through the 2020 election. The worst part is that it may solve nothing, the way the last election in the UK solved nothing.
Which brings me to Brexit. Since the Brexit vote in June 2016, UK GDP growth has decelerated by 27%, and the pound has lost 15% against the dollar:
The last election solved nothing. Like with the US-China trade war, I still don’t know what a deal looks like that is acceptable to both a majority of Commons, and the EU. The EU has no incentive to make this easy, and give anyone else any ideas. They have every incentive to make life without the EU look bleak, and it has been not hard to pull that off.
But this is a broader issue. The current 73-year absence of war on the continent is the historical exception. Western Europe hung together during this time under the threat of Soviet invasion, US leadership of the north Atlantic alliance, and growing economic interdependence. The Soviet threat is long gone, the US President is now showing disdain for NATO, and interdependence is fraying. At times, it seemed like Frau Merkel was the only one holding it together, and she is soon to exit the stage.
Both far right and left wing parties are rising in prominence, pitching nationalist xenophobic policies and finding receptive audiences. Why?
Brexit and Trump both eeked out narrow victories because the gains from globalization have been huge, but very unequally distributed. In the early 19th century, David Ricardo’s basic observation was that the gains from free trade are so great, that the winners can afford to pay off the losers, and everyone will be at least as well off as they were beforehand. We did great on the “gains from free trade” part, but failed miserably on “winners paying off the losers”.
Over time, this cut out the middle. Low productivity jobs that could be off-shored to developing economies left. High-productivity jobs became concentrated in a few industries in a few metropolitan areas. On the other end, in large geographic areas what was left was low-productivity service sector jobs that could not be off-shored, or labor that was already cheap enough that it didn’t make sense to off-shore. This left a lot of people in a lot of places susceptible to nationalist, anti-globalist calls from both left and right. A deep recession will make that worse.
China is also not without internal turmoil. Hong Kong is on a razor’s edge, with protests shutting it down repeatedly for months now. The Lady Liberty of Hong Kong wears a gas mask. This is a huge story that has gone ignored amongst the daily US soap opera, but this has the potential to mushroom into a Tiananmen event. They also have the added pressure of slowing growth both from the trade war, and long-term secular trends in their economy.
The possibility of a broader Sunni-Shia war has been growing with the US abandoning the 2015 nuclear accord, a newly assertive Iran in the Gulf, and Saudi Arabia fighting proxy wars against Iranian allies on the Arabian Peninsula. The US outsourcing its Gulf policy to Saudi Arabia has not been helpful, and has inflamed a dangerous situation.
This has been brewing for 16 years, 40 years, 70 years, or 1300 years depending on how you look at it. With the recent tanker seizures, oil field attacks, and lack of US leadership, it’s easy to see this escalating. US troops are back on the Arabian Peninsula, protecting Aramco fields for the first time in 16 years.
If you recall, US troops in the Kingdom was the initial complaint that began Al Qaeda. Fun times.
I Am a Fat Bear
The first week of October is Fat Bear Week in Katmai National Park in Alaska. The bears have spent the summer fattening up on salmon so they can survive the long hibernation ahead of them. I crawled into my cave about a year ago, and have been at around 75% cash and Treasuries, give-or-take, for about a year of sideways in the stock market.
I had been writing that we had one more irrational bull push to 3200-ish in the S&P in September, but events — Saudi Arabia, repo and impeachment — overtook that. Still, things could calm down long enough to get there, but either way I believe we are at the end of this very, very long bull market. Since March 9, 2009:
- Apple (AAPL): I never sell, just buy more when it goes down. It’s worked so far. This is the biggest chunk.
- The second biggest is Mastec (MTZ). You can read why here. Between Apple and Mastec, that’s about two-thirds of invested funds.
- Brookfield Property (BPY). Nothing sexy here. Just a fabulously run REIT.
- PolarityTE (PTE). High risk/reward biotech. Mostly in January 2021 calls.
- Symantec (SYMC). Just here for the $12 special dividend.
- Amarin (AMRN). Took a small taste when bad news punched it down to 13.60 overnight. Will likely sell after FDA AdCom.
- Invesco Water Resources Portfolio ETF (PHO). I have a long rant about water. Some other time.
That’s it. The rest is at 2.3% money market, 1.9% in a savings account, or various Treasuries I purchased last autumn.
Holly is my spirit animal.
And now we wait. I still think there’s a chance for a last run here, but it is slimmer after September’s barrage of news. Either way, I want no part of it. I have enough salmon for now.
The good news is that eventually winter ends, and the river swells with salmon again. Everyone can be a genius. This is what happened in the year after the last market bottom:
If you can’t make money in that, you should just give it up. That’s when you should extend your risk. Not now.
Good hunting in Q4!
Disclosure: I am/we are long MTZ, AAPL, AMRN, SYMC, PHO, BPY, PTE. 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.