I continue to see classic signs of late cycle behavior. Late cycle doesn’t mean that it’s over today, and I still haven’t seen the deterioration in credit or stock markets to turn me bearish yet, but it does suggest caution and not being overexposed to risk.
Danielle DiMartino Booth, a former advisor within the Dallas branch of the Federal Reserve, wrote a great piece last week that was featured as a guest article on Evergreen Gavekal’s blog. She was pointing out the wide divergence right now in consumer confidence/expectations vs. CEO confidence and expectations. You can read the article here. Here’s a very compelling chart illustrating the gap:
Why this matters is because CEO’s make the spending, hiring and firing decisions within a company. Consumer confidence and consumer spending simply track the stock market and unemployment rate. This is why the unemployment rate and consumer spending are pretty useless data points for making investment decisions regarding stocks – they are extremely backward looking whereas the stock market discounts the future. Looking at the chart, one can easily see that CEO expectations drop before the consumer, creating a gap, before nearly every recession. Maybe this is why we’ve seen record CEO turnover this year… not exactly a sign of confidence.
Another classic late cycle phenomenon is rising wages as the available labor pool shrinks. This leads to margin compression within companies, leading to a drop in year-over-year earnings growth. Eventually companies cut back on spending and start to layoff employees, which leads to a drop in consumer spending, and a recession unfolds. Q4 earnings are likely to be down YoY, Capex is non-existent, so the next warning sign to watch out for is an uptick in unemployment claims.
Leading indicators still have GDP growth decelerating through mid 2020. We should see a bump in inflation for a few months so I’ve been adding some inflation plays (switching from Treasuries to TIPS, exposure to energy, etc.) but I’m not seeing anything yet that leads me to believe it’s more than a short-term bounce. I don’t think we see a structural change in inflation and inflation expectations until we get a change in fiscal policy, and that won’t happen until after the 2020 presidential election. But trust me, it’s coming.
Over the past 40 years, the US economy has become increasingly financialized. What this means is that asset prices essentially drive economic behavior, whereas it used to be the reverse. When asset prices (real estate, stocks, etc.) rise, you get a positive economic response (the wealth effect as Ben Bernanke liked to call it), and when they fall, businesses and consumers cut back. Over time, asset values and net worth have been rising relative to GDP and incomes. The Levy Forecasting Center put out a great paper on this recently highlighting this evolution and how it has put our economy in an increasingly fragile position. You can find the paper here. This is the result of monetary policy focusing on re-inflating asset values after each recession to try to jumpstart the economy and it continues to put policy makers in an even greater pickle. At this point in the cycle, a drop in asset markets where we see credit spreads widen and stocks slide, could be the trigger for CEO’s to begin the cost cutting process.
So what could trigger a selloff in asset markets? Liquidity, or a lack thereof. Liquidity is what drives markets and global liquidity continues to tighten. This brings me back to the Fed. Jay Powell has clearly stated during each press conference that it is the Fed’s goal to extend this cycle as long as possible, despite the unintended consequences and distortions it creates, which means they’re doing everything they can to keep liquidity flowing through the financial markets to keep them elevated. One slip up and the down cycle could begin.
You may have noticed a lot of headlines in the middle of Sept and early October about the Fed implementing a Repo facility for banks. This gets a little esoteric but please stay with me because it’s critical in understanding the whole picture.
Basically, the major banks were going through a liquidity crunch as the Treasury department has been issuing a lot of new T-bills since we continue to run a large deficit. Since we increased the debt ceiling again in July, there has been a flood of new debt issuance from the government. The major banks act as primary dealers which means, by law, they have to purchase new issuance and can then sell it into the markets to investors. By being forced to buy all of these new bills and notes, there is a shortage of reserves and banks stopped (or were unable to) lending to each other in the overnight money markets. A lot of this is caused by new regulations following the GFC but regardless, this tightness forced the Fed to open a Repo facility for banks needing cash. Repo is short for repurchase agreement where they temporarily buy bonds from the banks to give them cash, and then the banks later repurchase the bonds and return the cash (by cash I mean electronic, digital reserves). This allows banks to meet daily reserve requirements as a short-term patch.
Here’s the timeline of events from the Fed:
- Sept 17th: We’re doing temporary Repos today and tomorrow to calm money markets and provide liquidity
- Sept 19th: We’re extending Repos until Oct 10th and increasing the facility to $75 billion in overnight Repos, $30 billion of term (usually 14 days)
- Oct 4th: We’re extending Repos until Nov 4th.
- Oct 11th: We’re extending Repos until Jan 2020
- Oct 23rd: We’re increasing the facilities to $120 billion in overnight, $45 billion in term
- Oct 30th: Open Market Operations (i.e. buying T-bills) will continue into Q2 2020.
First, as you can see from the comical timeline above, there’s nothing temporary about this. This will become a permanent facility as they continually extend and increase it. Second, these Repo operations are expanding the Fed’s balance sheet again, which just increased back above $4 billion.
In an interview on Oct 7th, Powell made it very clear that “this is not QE,” with QE referring to their policy of balance sheet expansion aimed at easing financial conditions for years following the GFC. That specific comment starts at 3:26 into the video.
To this, I agree with him. It’s not Quantitative Easing, it’s Quantitative Neutral – meaning we’re at the point where increased government deficits are having a negative “crowding out” effect on the economy and the Fed needs to purchase this new T-bill issuance simply to keep things from contracting. Let the gravity of that sink in for a minute…
In simple terms, the Fed is essentially being forced to monetize government deficits. Monetize is a fancy word for “turn into money,” meaning the government’s spending is being financed through money printing. For more information on the crowding effect created by increased government deficits, check out this post from earlier this year.
This is why I have such a positive outlook on real assets, precious metals and gold specifically. In my view, gold is the perfect hedge to just about every major risk out there right now. If the Fed is set on trying to extend the cycle, then they will continue to do everything they can to keep asset markets elevated, which means asset markets will eventually force their hand (as they have been doing for most of this cycle) to go pedal to the metal on easing: rates back to 0% and restarting QE. If we’re running record deficits while we’re not even in a recession, what do you think the government will do if the markets and economy start to slip? And if markets can’t absorb the current amount of new issuance, how will the government increase spending? This is what I think is coming after the 2020 election. If Trump wins, it will be tax cuts and infrastructure spending, etc. If a democrat wins, it will be Green New Deals and Socialist style spending programs. Either way, government deficits are going up and the Fed will be forced to (continue to) finance it. I think the Fed’s balance will expand to $10 billion at a minimum. Welcome to the new normal.
I’m growing increasingly confident that gold (and precious metals, bitcoin, and other similar assets) will outperform every major asset class over the next 5 years – stocks, bonds, real estate, everything. The system will need to balance in one of two ways, either 1) the Fed goes bananas, gold rises dramatically while stocks simply hold their ground or go up a little (the ideal scenario for policy makers). This is basically the currency devaluation scenario, or 2) a debt-driven deflationary contraction takes hold as the cycle rolls over, like 2008, and stocks come down a good amount while gold either falls a lot less or maybe even goes up. My wager, given the past actions of policy makers, the amount of debt in the system and the reliance on asset values remaining elevated, is that we’re going to get scenario #1. But regardless, I think gold wins.
This environment of growth decelerating with inflation accelerating is actually when stocks have peaked, historically. So I’m not surprised that US stocks are at/near new highs. Like I mentioned above, I’m still not seeing any warning signs yet and late cycle conditions can persist for a while, but it is starting to “feel” like things are shifting underneath and the pressure is building.
Thanks for following and mind your risk!
-Nick