These 5 Major Economic Threats Could Be Hazardous for Investor Portfolios if Ignored
The Great Stock Market Crash 2017. That could be an alternate headline should recession strike. It almost seems unbelievable that stock markets keep rallying under such awful conditions. But suspension of reality can happen much longer than anyone anticipates. It’s happening today, but not necessarily tomorrow. At this point in the cycle, the next dip could be the one that doesn’t come back. I’ll talk about five major economic threats which might be the rolling pebble that starts the mudslide.
One economic threat definition can vary from the next. But I’ll focus on threats large enough to potentially trigger recession. Because when you boil it down, without sufficient growth in the system, it all implodes. As long as people and corporations are borrowing enough money, the economy can stay afloat, and stock markets can maintain their low-volume levitation on drip share buyback purchasing. The problem is, credit expansion isn’t sustainable. When you force-feed too much of it into the system, the blowback always gets more extreme on the other side.
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Eventually, consumers pare back durables purchasing financed by credit. In turn, this hurts the corporate bottom line and stalls out business expansion and stock buybacks. It takes awhile, but the whole edifice comes crumbling down in smoking ruins. All that’s left is to pick out the dead bodies.
Of course, this is a simplified explanation of how recessions happen. But regardless of how, overall effects remain the same: overvalued stocks get pummeled during these periods. It’s no different now than it was in 2001, 1990, or 1929. Some investors get brainwashed into thinking this time is different. But it never is. It’s simply normalcy bias beating you over the head into submission. These times are anything but normal. They’re just made to look that way via a credit bubble that has long since lost any logical founding.
But are equity markets close to finding religion? We think so. We believe recession will arrive and throw the market into disarray. The real question on our minds is, will government intervention be able to stop it? Can the Federal Reserve quell the torrent of credit contraction, overinvestment and misallocation in the system so pervasive today? And if so, where does this demand for credit growth come from? More zero percent interest rates? Helicopter money? Do they reverse course on their scheduled bond offerings and become buyers again? So many questions remain unanswered.
In the famous words of Shakespeare: “Something wicked this way comes.” It perfectly describes the U.S. economic outlook 2017, now that the Hail Mary “Trumponomics” looked to provide is dead.
Here Are the Biggest Economic Threats to U.S. Economy as We Head into Summer 2017
The list of major economic threats to the economy is expansive. I could talk about nosebleed CAPE ratios and subpar retail sales, but those don’t really matter. These metrics have been way out of line for years, yet the market grinds higher.
This is really about the hammer catalyst which provides the “a-ha!” moment for the hungry bear to wake from hibernation. It’s the proverbial watershed “moment” where humans, stat arbitrageurs, quant programs, fundamental investors (collectively a.k.a. “the market”) stop buying the dips. For this to happen, a major catalyst must crystallize the fact that recession is inevitable. This economic expansion will be the second-longest on record, so it’s primed for a knockout blow.
Without further ado, here are five major economic threats to our U.S. GDP forecast 2017 poised to unravel it all.
#5 Chinese Credit Bubble
If you haven’t heard, China is currently embroiled in a credit bubble of epic proportions. Total credit to its non-government sector has increased by almost 100% of GDP since 2008, and it’s still building infamous “ghost cities” throughout the country. In fact, it’s so big, it puts the late 1980’s Japanese property bubble and U.S. Housing Bubble 2017 (or 2008 for that matter) to absolute shame. This is quite the feat considering Japan’s Imperial Palace was once worth more than the entire state of California. Yes, really! (Source: “China is far away, but its bursting bubble will hit close to home,” The Hill, May 9, 2017.)
More Americans might shrug this off as being irrelevant in the greater scheme. But it matters—a lot. Here’s why.
Total U.S. GDP is currently around $17.95 trillion annually. Total China/U.S. trade was around $462.8 billion in 2016, or about 2.58% of total GDP. If China is forced into a sharp credit contraction or level-off, U.S. exporters won’t be faring so well. If Chinese exports slowed down, say, 20%, then domestic GDP could be cut by half a percentage point. That doesn’t sound like much, but when you’re growing at stall speed rates, that’s a big slice of the pie.
This also doesn’t account for the negative impact a Chinese slowdown will have on exports to other Asian partners. If they in turn slow down, U.S. exports or raw goods and finished products will follow. The U.S. trade deficit with China would also likely increase, and that’s something President Donald Trump is focused on addressing. Who knows what diplomatic spats this could lead to, as import tariffs and the “currency manipulator” tag has already been threatened.
#4 The Fed Got It Wrong…Again
There was a time when the Federal Reserve hiked rates to tame inflation or an overheating economy. This is not one of those times.
With personal consumption, GDP growth, and inflation rates struggling to push past two percent, some are worried that the Fed is tightening at the wrong time. Since the economy is more dependent on low-interest credit than ever before, higher rates could lead to a disproportionate amount of delinquencies. Demand for consumer durables will fall. Even with historically low rates, consumer spending has lagged. If they go higher, the price-sensitive consumer will fold.
Some would argue that after eight years of emergency-level rates, they had to “normalize” eventually. Fair enough. But there’s simply no room for consumers to take on higher debt loads right now, let alone in a rising rate environment. If the Fed is wrong about this, it could end up being the great financial miscalculation of our time.
#3 Algorithmic Trading Takeover
Algorithmic trading programs were originally devised to parse large institutional block orders into little bits, allowing for orderly selling of large positions. It makes much more sense selling 100 or 500 lots a thousand times than to dump a large order on the market and cratering the price. We all understand that.
The natural extension of this technology was to execute orders based on defined strategies. When multiple inputs hit certain levels, the algo program would buy or sell the market. Other strategies would do things like buy one asset and sell another correlated one when spreads became too out-of-whack (arbitrage). Hundreds of different strategies based on anything you can imagine have come into fruition over the last dozen years. The market has simply evolved, just like everything in life.
The problem is, we may be reaching a critical threshold where sophisticated programs—many using artificial intelligence—are so dominant that the market no longer makes sense. They may be playing by a different set of rules that don’t define stock market value by the same things that are important to humans. Considering they account for 60% of all market activity, that’s a huge problem.
Why? Because these programs are unregulated and have taken on a life of their own. No one really knows the rules by which they are bound. They’re not operating on “normal” human-based logic. This sends false signals to investors who purchase stocks with overinflated prices to chase yield. This elevates the risk of large flash crashes, or huge air pockets in the markets once enough programs “decide” the market is overvalued. We’ve seen this several times before. But with the pervasive overvaluation in today’s market, the circuit breakers designed to protect investors from large drops may prove ineffective.
#2 Testy U.S. Political Climate
America’s political climate is more divided than ever—that much is clear. This is a trend we’ve witnessed over the past several years, back when George W. Bush took office. This isn’t news.
But why it matters more today is because it threatens the “Trump Trade” narrative. That is, the huge unrelenting move higher in equities following Trump’s November 2016 election win. The market found new reasons to push valuations higher based on the future repatriation of corporate tax dollars, corporate tax cuts, and reshoring of jobs (wage growth). But it’s not quite working out that way.
It started with the Congressional non-vote to repeal “Obamacare,” which would have saved $1.0 trillion and allocated to future tax cuts. It was obvious from that point on that everything on Trump’s legislative agenda would be stonewalled—and it has. All the goodies the market expected to come this way to juice valuations look very remote.
If Trump’s legislative business agenda doesn’t gain traction soon, the market will discount appropriately.
#1 Commercial and Industrial (C&I) Loan Growth
It’s accurately predicted the last eight recessions going back to 1960, and it’s signaling again. Anytime C&I loan growth flatlines or goes negative, the market goes into recession. that’s what’s happening today.
But there’s more.
Going back the last three recessions, peak-to-trough credit growth has increased, and so too has the severity of each subsequent recession. The 1990 recession, where peak-to-trough C&I loan growth dropped 9.02%, was shallow and over quickly. In 2000, C&I loan growth over doubled, but it took the Fed 11 rate declines to stabilize demand for credit, thus ending the cycle. In 2008, C&I growth dropped an additional 20%, and this time it took $2.0 trillion, emergency fed Funds rate lasting for eight years, and growth has still been subpar.
The credit bubble has been blown up even more since then (on the consumer side also). This means peak-to-trough C&I growth will likely fall more than in 2008, suggesting the next recession will be even larger than the last. America is not equipped to deal with yet another round of quantitative easing and stimulus programs, with ballooning deficits that have not been brought under control in this business cycle.
Ultimately, job cuts, crashing U.S. auto sales, the U.S. housing bubble 2017 and a rising national debt will result. There’s no other way around it, unless some sort of economic Hail Mary comes our way.
Stranger things have happened, but we think the likely result is deeply underperforming stock markets and bond yields that test their established lows. The government will intervene with a huge stimulus package when things get bad enough, but how markets react this time around will be interesting to witness. Rates are already ultra-low, and the U.S. has long since been intervening with direct asset purchases to prop up markets.
Can stock market crisis be averted? Possibly. But hope is not an effective investing strategy.
