This Might Be The Snowflake, But The Avalanche Already Was In Place
Summary
- The outbreak of the Coronavirus is a negative economic shock that has caused a plunge in interest rates and recessionary concerns.
- It's inaccurate to suggest that Coronavirus is the sole cause of the potential recession. Initial conditions in the US and global economy were fragile prior to the negative shock.
- Monetary policy has demonstrated a worrisome degree of inefficacy as aggressive balance sheet expansion has resulted in a lack of an increase in economic growth.
- The tax cut and increased deficit spending also has failed to generate sustained above-trend growth, proving the diminishing marginal product of debt.
- All signs point to a continuous grind toward the zero-lower-bound and trend economic growth converging near 1% rather than the already sub-par 2% growth we have grown accustomed to. Treasury bonds will continue to perform strongly.
- I do much more than just articles at EPB Macro Research: Members get access to model portfolios, regular updates, a chat room, and more. Get started today »
The Coronavirus outbreak is undoubtedly a negative "shock," and one that's rightfully causing recessionary concerns.
The economy is hit with shocks all the time. The snowflake and the avalanche analogy properly describes the relationship. The Coronavirus outbreak is a snowflake. A big snowflake. If the economy was stable and had healthy initial conditions, even a big snowflake won't cause an avalanche.
An economy that is highly indebted with weakening initial conditions is ripe for any snowflake to set off the avalanche.
Economic Cycle Research Co-Founder Lakshman Achuthan describes this process and how recessions occur.
"The received wisdom is mistaken about how recessions are made. They are not simply caused by shocks. They are caused by a window of vulnerability in the economic cycle where the cyclical drivers of the economy have weakened to the point where it’s susceptible to a negative shock. Within that window of vulnerability, virtually any reasonable shock becomes a recessionary shock. That’s how you get a recession."
– Lakshman Achuthan, Economic Cycle Research Institute
When constructing a portfolio, it's impossible to predict all the potential economic shocks that will occur in the coming years. The best course of action is to determine the level of recession risk or how easily a snowflake will create an avalanche.
A combination of secular economic conditions such as debt, monetary policy, fiscal policy, and demographics and cyclical conditions including the rate of growth and the direction of growth can provide an accurate assessment of the economy's vulnerability to a recession.
The Coronavirus outbreak is a negative shock that has the potential to create recessionary conditions. Should this be the case, the recession will be a result of both the snowflake, but also the pre-existing avalanche of secular and cyclical conditions.
Below I will outline the ineffectiveness of both monetary and fiscal policy and the deteriorating secular economic conditions leading to lower growth.
Excessive levels of public and private debt are primarily responsible for creating worsening economic conditions.
US Public and Private Debt As a Percent of GDP:
Source: Bloomberg, EPB Macro Research
Cyclically, the economy is not immediately vulnerable to a recession, but that probability is rising rapidly.
Prior to the virus outbreak, due to the risks associated with the secular and cyclical conditions, an overweight allocation to Treasury bonds, including ETF (NASDAQ:TLT), was a necessary step to protect again recessionary/deflationary fears.
TLT remains a critical part of my portfolio to hedge against a worsening of conditions which can assuredly devolve into a recession given the initial conditions, and the inefficacy of both monetary and fiscal policy.
Initial Conditions: Monetary Policy
As graphed above, public and private debt has surpassed 370% of GDP, a level that has been empirically proven to degrade economic conditions and the efficacy of monetary and fiscal policy.
An economy struggling under excessive debt also has been impacted by a significant increase in regulations post-2008.
Recently, monetary policy from the Federal Reserve has helped keep the banks stable after Quantitative Tightening "QT" drained far too many excess reserves from the banking system.
The Federal Reserve learned that "excess reserves" were really not "excess." Banks must keep a 10% reserve requirement on checking accounts and maintain 100% Liquidity Coverage Ratio, "LCR."
Excesses reserves were used to satisfy these regulatory requirements.
Cash At Banks Is Held As Excess Reserves:
Source: Bloomberg, EPB Macro Research
The Federal Reserve created an insufficiency of reserves and thus had to reverse course and through a combination of repo operations and purchasing T-bills, adding reserves back into the banking system to help satisfy new regulations.
The Federal Reserve expanded its balance sheet by nearly $400 billion and the rate of money growth started to increase.
True money supply or "TMS" excludes volatility categories and conforms more to the Austrian definition of the money supply.
As the Federal Reserve expanded its balance sheet, money supply growth started to increase.
US "True" Money Supply 24 Month Change, % From 3-Year Low:
Source: Bloomberg, EPB Macro Research
An increase of $400 billion in a matter of months was a substantial fire hose from the Federal Reserve, which emphasizes an inability for monetary policy to impact the real economy.
As shown below, an unprecedented increase in the Federal Reserve balance sheet has resulted in virtually no economic impact and no material increase in bank sector activity.
Federal Reserve Balance Sheet:
Source: Bloomberg, EPB Macro Research
Economist Lacy Hunt helps us understand why despite a massive increase in the Federal Reserve's balance sheet, and a corresponding increase in money growth, the recent actions by the FOMC have failed to start a "monetary process."
Without a monetary process, the risk of inflation is minimal and the larger risk is deflation from the excessive levels of debt, augmenting the case for long-term Treasury bonds in a portfolio.
The chart below shows the level of public and private debt to GDP (left) and the velocity of money (right) for major countries.
As economies become more indebted, the velocity of money declines.
Debt To GDP and Velocity of Money:
Source: Hoisington Management, Lacy Hunt
When the velocity of money declines, monetary policy does not flow into the real economy and instead gets "stuck" in the financial sector.
According to Hunt, a monetary process requires an increase in money supply, followed by a simultaneous increase in bank loans and liabilities with at least stable velocity.
These factors together would create the conditions necessary for an inflationary spiral and a negative environment for long-term bonds.
In the United States, the velocity of money is not stable and instead is declining nearly every quarter.
US Velocity of Money:
Source: Bloomberg, EPB Macro Research
Declining rates of velocity render monetary policy ineffective as increases in the monetary base never finds its way into the real economy.
Despite a $400 billion increase in the Federal Reserve's balance sheet, the two-year annualized rate of bank liabilities is flat and the rate of bank loan growth is declining.
US Bank Liabilities and Loans 24-Month Change (%):
Source: Bloomberg, EPB Macro Research
Falling velocity and declining rates of bank loan growth fail to suggest that a sufficient monetary process is underway.
When $400 billion of monetary stimulus fails to result in an inflationary spiral, the inefficacy of monetary policy is put on display.
The chart below shows the current policy rate for several countries, as well as the expected policy rate three months, six months, one year, two years and three years in the future.
After the most recent "surprise" rate cut from the FOMC, the market is suggesting the US will see the policy rate drop to just 0.50% in the next 12 months.
Market Implied Policy Rates:
Source: Bloomberg
Other than Japan, most major economies are not yet in recession. Still, the Eurozone, Switzerland, Denmark, Sweden, and Australia are all expected to lower interest rates deeper into negative territory in the next six months.
The rate of central bank easing including rate cuts and balance sheet expansion has only resulted in declining rates of bank loan growth, proving that monetary policy is not improving bank conditions.
As Hunt noted in a recent interview, massive monetary policy is not providing a boost anymore. All of these Fed actions have just allowed banks and the economy to run at a normal pace. There has not been an improvement in bank loans or economic growth, even before the virus outbreak.
Thus, monetary policy will not be able to generate a recovery in the real economy if the virus outbreak creates recessionary conditions.
Initial Conditions: Fiscal Policy
Debt-financed fiscal spending has also demonstrated no material impact.
The Federal debt is increasing near 6% year over year and nominal GDP growth is only increasing at roughly 4% year over year.
US Federal Debt Vs. Nominal GDP Growth, Year Over Year (%):
Source: Bloomberg, EPB Macro Research
Typically, over-indebted economies get a transitory boost from additional debt before becoming worse off from an increased debt load.
After the Trump tax cuts at the beginning of 2018 and two major increases in government spending, the BLS reported that employment growth increased from roughly 1.3% to 1.9% before falling to 1.4%.
This transitory boost is what we'd expect.
The results were worse, however. After the BLS updated the data series with a benchmark revision, the increase in employment growth was virtually wiped away.
Nonfarm Payrolls Growth, Revised and Unrevised:
Source: Bloomberg, EPB Macro Research
Fiscal policy and debt-financed spending have failed to generate an increase in employment growth nor an increase in GDP growth. The economy is simply becoming more indebted and taking on more debt just to stand still.
This raises the risk of deflation rather than inflation and thus, Treasury bonds (TLT) continue to generate massive returns as the bond market expects the Federal Reserve to return to the zero-bound.
Cyclical Indicators
Cyclically, this global shock hit the world economy at a time when world trade growth was at decade lows.
World trade growth was down 0.7% over the past two years, an indication of very fragile cyclical conditions.
World Trade Monitor, 24-Month Change:
Source: CPB World Trade Monitor, EPB Macro Research
The consumer is empirically weaker than the usual descriptions. Since 2011, the average rate of real consumption growth is roughly 2.50%. The current two-year annualized pace is roughly average at 2.58% but the six-month rate of consumption growth has trailed off to 2.3%.
If the virus outbreak causes consumption to pull-back, the consumer would fall substantially below trend.
US Real Consumption Growth:
Source: Bloomberg, EPB Macro Research
Secular economic conditions are challenging but cyclical conditions are also unfavorable and unlikely to have enough strength to withstand a serious shock.
Step Function Lower
The chart below from Hunt shows the amount of growth generated for each dollar of debt in 2007 and in 2019 as well as the percent change.
The effectiveness of debt, a proxy on productivity growth, is declining in all major countries with the largest percent declines occurring in the most highly indebted economies.
Diminishing Marginal Impact of Debt:
Source: Hoisington Management, Lacy Hunt
Trend economic growth is a function of productivity growth (proxied above) and population growth.
World population growth is expected to decline sharply across all major countries.
Population Growth:
Source: Hoisington Management, Lacy Hunt
US population growth is expected to follow most other nations but remains at stronger levels than Japan, Europe, and China.
Population Growth, 5-Year Annualized Rate (%):
Source: Bloomberg, EPB Macro Research
Economic growth around the world is faltering under reduced efficacy of debt and slower population growth. The effectiveness of monetary and fiscal policy have proven immaterial.
To further emphasize this point, we can look at the rate of corporate profit growth by decade.
Corporate profits are reported in the GDP report in the National Income and Product Account. This measure is far more reliable than the adjusted earnings reported by S&P 500 companies.
Pre-tax corporate profits also neutralize the impact of tax changes over time.
Pre-Tax Corporate Profit Growth From GDP Report: Growth By Decade
Source: Bloomberg, EPB Macro Research
The private sector and the ability to generate profits is deteriorating under weaker secular and cyclical conditions, challenging the economy's ability to withstand a shock.
Treasury Bonds As A Deflationary Hedge
Throughout this disorderly decline in the stock market, Treasury bonds, an often ridiculed investment, was the lone outperformer as even gold took a small decline. Gold (GLD), an overweight allocation in my portfolio, rallied strongly after the 50bps rate cut from the Federal Reserve.
Still, as recession fears flare due to the economy's inability to withstand a shock, Treasury bonds proved to be the most effective hedge with the 10-year yield crashing below 1.0%.
10-Year Treasury Rate:
Source: Bloomberg, EPB Macro Research
At EPB Macro Research, we have been adamant about an overweight exposure to Treasury bonds with an emphasis on short-term and intermediate-term Treasuries.
We also continue to hold an allocation to longer duration Treasury bonds (TLT) outlined by the track record of articles below.
TLT: Still A Part Of My Portfolio:
Source: Seeking Alpha
As the economy becomes more indebted and both monetary and fiscal policy fail to start a monetary or inflationary process, deflation starts to become the largest risk.
Treasury rates have collapsed, falling well below 1% on the 10-year yield as Treasury bond ETFs have soared.
Treasury bonds should be a part of your portfolio to protect against deflationary and recessionary fears.
Recession risk is rising rapidly as cyclical indicators turn sharply lower, credit spreads widen and the yield curve remains inverted, despite an emergency rate cut.
Coronavirus was impossible to forecast, but the secular and cyclical conditions were weak enough to warrant a portfolio allocation tilted toward deflationary risks.
The economy will slip into recession if job losses start, which for now is not yet the case.
In the most recent ISM Manufacturing PMI report, however, job losses were reported in the transportation sector.
ISM Manufacturing PMI Respondent Commentary:
Source: ISM
While Coronavirus might be the snowflake, it's not responsible for the avalanche that was already in place.
Treasury bonds remain an effective deflationary hedge as bond yields will continue to crash to new all-time lows as we return to the zero-lower-bound.
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This article was written by
Eric Basmajian is an economic cycle analyst and the Founder of EPB Macro Research, an economics-based research firm focusing on inflection points in economic growth and the impact on asset prices.
Prior to EPB Macro Research, Eric worked on the buy-side of the financial sector as an analyst at Panorama Partners, a quantitative hedge fund specializing in equity derivatives.
Eric holds a Bachelor’s degree in economics from New York University.
EPB Macro Research offers premium economic cycle research on Seeking Alpha.
Analyst’s Disclosure: I am/we are long TLT, GLD. 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.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
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Comments (65)
but it's like you are the Peter Lynch of bonds here.
- 2011: US debt downgrade + EU Debt Crisis;
- 2012: Fiscal Cliff Crisis + EU Recessions and Depressions;
- 2013: Government Shutdowns + Fed Tapering Crisis;
- 2014: Ukraine War + Global Ebola Pandemic Scenario;
- 2015: Earnings Recession + Global Commodity Crisis;
- 2016: EU Deflation Recessions + Trump Election;
- 2017: Nuclear War with N. Korea (/China);
- 2018: Trump Trade Wars + Fed QT;
- 2019: more Trump Trade Wars;
- 2020: Global Ebola Pandemic Scenario.Each of those financial/fiscal crises including system shocks caused by unpredictable black-swan events were predicted to be more than enough to knee-cap the US economy and result into major recession and catastrophic bear markets, specially during economic downturns that sometimes resulted into transient collapses of US GDP (/mostly during 1st quarters post 200/09 GFC).- always Different This Time: drive.google.com/...It is always different this time with no rhyme nor reason nor synergy among different types of exogenous crises and events. With no reliable pattern, practically impossible for even the brightest and most knowledgeable economists and financial analysts to succeed in correctly predicting the markets for decades and centuries, even if any of them can possibly live for centuries to acquire all the knowledge and correctly analyze all of them:- History Repeating Itself = nada, caput, none whatsoever.If financial/fiscal crises and black-swan events never repeated themselves, how is it possible for History to Repeat Itself?That's why the most knowledgeable and highly experienced (89 years old) Warren Buffett looked ever so STUPID each time CNBC asked him what's his future 'prediction' regarding say the EU debt crisis, the US debt crisis, the Fed QEs, the government deficits, the Ebola Pandemic Crisis, etc. etc.- FUD Investors Club: staticseekingalpha.a.ssl.fastly.net/...Tough Luck for those Who Got LEFT Behind.
What happens when you put 10 economists in a room? You'll get 11 different opinions.
