SUMMARY
- The expectations of US GDP growth have slowed to 1.7 to 2.0% for the next 1 to 3 years.
- Market valuations are very high.
- There will likely be more volatility as Quantitative Easing (QE) unwinds.
- Inflation is a high medium-term risk due to high liquidity which will impact interest rates.
INTRODUCTION
The investment model that I created looks at the current investment climate, but not the longer term. The format of this article is changed as I summarize the changes since The Escape from Balance Sheet Recession and The QE Trap was written by Richard Koo in 2014 in the Listening to the Experts Section. I believe that we will feel repercussions of the financial crisis for many years. Mr. Koo describes that this is likely to be true because of the unwinding of Quantitative Easing (QE). Financial Sense posted a CNBC video of Mr. Koo in April 2014 in Koo Warns on Fed "QE Trap" and Inflation.
The NYFRB estimates that Q3 GDP growth will be 2.2% followed by 1.3% in Q4. The Atlanta Fed’s GDPNow estimates Q3 GDP to be 2.1%. The IMF World Economic Outlook estimates that Real GDP growth will be 1.58% in 2016 for the US with only a modest pickup in 2017 and no improvement in 2018 (See Jeffrey Snider, IMF Finally Kills The Recovery). The FOMC now estimates that Longer Run projections of real GDP are 1.7 to 2.0%. Of the 10 recessions that have occurred since 1948, only the 1980 recession had a lower average 4 quarter growth than 1.7% prior to the start of the recession. Throw in 5 quarters of corporate profit declines and the median Economic Forecasting Survey of economists estimating the probability of recession being 20% and you have a high potential for a recession starting in 2017. My estimate of a recession starting by the end of 2017 remains at 40%.
Last month I referenced Doug Short’s article (see Visualizing GDP: An Inside Look at the Q2 Advance Estimate) that describes the second quarter GDP which was impacted by strong personal consumption spending and weak private investment (inventories). Since then Lance Roberts wrote, “…the majority of American consumers have likely reached the limits of their ability to consume” (see 3 Things: The Economic Fabric and Rising Recession Risks). He also used different economic models to extrapolate data trends to determine an average starting date for a recession of October 2017 (see Suspended Animation).
John Mauldin makes the points in Start Moving Some Dirt that the next president will likely face a recession early on and unless monetary and fiscal policies change it will be fairly serious, and the fiscal deficit will likely swell to over $1.3 trillion. He points out that by 2019, entitlement spending and interest will be consuming all tax revenue excluding the impact of a recession, according to the Congressional Budget Office. He offers infrastructure spending and tax and regulatory reform suggestions as part of the solution.
REVIEW OF DATA
The following figure visualizes many of the main indicators that I use to create the Allocation Indicator. The predominant trends are flat or downward since mid-2014.
The next chart shows how the main indicators compare to the previous two recessions. Some deterioration (blue) can be seen.
INDICATOR HIGHLIGHTS
Below is my Household Indicator. It is a composite of year-over-year change in Household Net Worth and Net Worth to Disposable Income. Growth in net worth has slowed which ultimately should have a negative impact on future spending, known as the “wealth effect”.
The GDP Indicator is a composite of the gap in GDP versus Potential GDP and growth in Real GDP supplemented by the Atlanta Fed GDP Now. Below zero is a negative impact so current slow growth has a weak indicator value, currently at 22% out of 100%
The Leading Indicator shown below is a composite of State Leading Indicators, Chicago National Activity Index, Philadelphia Fed US Leading Indicator, and the Conference Board Leading Indicator. It is fairly neutral, but declining.
My Risk Indicator is a composite of Financial Conditions, ST Louis and Kansas City Financial Stress, Volatility and Economic Policy Uncertainty. Financial Risk has been decreasing since the earlier in the year.
The Corporate Indicator is a composite of 7 sub-indexes including Corporate Profits, Disposable Income and Business Sales. From Factset, “The second quarter marked the first time the index has recorded five consecutive quarters of year-over-year declines in earnings since Q3 2008 through Q3 2009.”
The Income Indicator is a composite of Real Personal Income Excluding Transfer Receipts, Compensation of Employees and Real Disposable Income. Slower growth in income is likely to impact future spending.
The Spending Indicator is a composite of Real Retail Sales, Real Personal Consumption Expenditures, and Chicago Fed National Activity Index: Personal Consumption. It also shows some weakness.
INVESTMENT MODEL
The Allocation Model is around 30% for stocks. It can be seen that the main composite index (dashed blue line) has stopped falling rapidly as it did prior to the last two recessions and in now moving sideways. The dark blue line is the stock market allocation index constrained by a minimum and maximum stock market allocation. I use the Investment Model as a Nowcast and not for forecasting, however the trends are shown to the end of the year. The trends are for a flat to slightly improving investment environment. With the unusual Presidential Election and aging business cycle, I will remain cautious through the end of the year.
VALIDATION
Real Personal Consumption Expenditures typically follows Real Personal Income. Recently, consumers have been borrowing to finance consumption which is typically not sustainable for long periods of time. Real Median Household Income has been rising toward that of the Tech Bubble era.
John Hussman makes a strong case in Sizing Up The Bubble that the markets are overvalued and debt defaults, insolvencies, and pension crises are unavoidable. He believes that an equity market correction of about 7% will sharply increase the probability estimate for a recession.
Commercial loan growth is slowing, borrowers are becoming more delinquent and banks are starting to tighten lending standards. The American Bankruptcy Institute reports that commercial bankruptcy filings through the first 9 months of 2016 are up 28% compared to 2015, while total filings fell 6%.
Investment is contracting.
Profits and business sales have been contracting.
LISTENING TO THE EXPERTS
Background
I just returned from a great vacation to the redwood forests in Northern California. I managed to find the time in the early hours of the morning to read The Escape from Balance Sheet Recession and The QE Trap by Richard Koo. Central to Mr. Koo’s book is that monetary policy and fiscal policy, in particular, prevented the Japanese downturn in the 1990s and the US downturn during the Great Recession from becoming as severe as the US during the Great Depression. Mr. Koo separates balance sheet recessions from run of the mill recessions in that in the former, the private sector is trying more to minimize debt as opposed to maximizing profits. The latest downturns were not as severe as the Great Depression, but remain at levels 10 years earlier as shown in the following chart.
Globally, government debt is currently at about 82% of GPD with 7 countries higher than 100%, while the median is about 50% of GDP (see Trading Economics). The average government deficit of the half of countries below the median debt/GDP ratio is 1.9% compared to 3.7% for the half with the highest debt to GDP ratio. As a generalization, it is the more developed countries that have higher debt/GDP ratios and higher budget deficits while the more export-oriented countries have lower debt and lower budget deficits.
Michael Pettis, author of The Great Rebalancing, describes in The Impact in China and Abroad of Slowing Growth the relationship of debt growth and GDP Growth. Because, in part, of the high debt levels of China, he expects China’s GDP growth to moderate to 3 to 4% or lower over the next decade or two.
In This Time Is Different, Reinhart and Rogoff describe the relationship between recessions and budget deficits as, “Declining revenues and higher expenditures, owing to a combination of bailout costs and higher transfer payments and debt servicing costs, lead to a rapid and market worsening in the fiscal balance.”
Gary Shilling listed causes of slow global growth in The Age of Deleveraging as:
- Increased savings rate at the expense of consumer spending
- Financial deleveraging
- Increased government regulation
- Low commodity prices
- More fiscal restraint in developed countries
- Rising protectionism
- Weak housing market due to inventories
- Deflation
- Contraction of state and local governments
More recently, Mr. Shilling said (see Financial Sense September 3, 2016, An In-Depth Discussion With Dr. Gary Shilling) that he has extended his original forecast that it will take another 6 or 8 years to work down the accumulation of debt from the 1980s and 1990s. He believes that fiscal stimulus could shorten this process.
The chart below shows that the Great Moderation (Greenspan Era 1987 to 2006) was in part due to high deficit spending (red, right axis) and an increase in credit (left axis). These, combined with other factors, helped create the Stock Market (Technology) bubble and subsequent lower interest rates helped create the Housing Bubble. There has been substantial deleveraging since the Great Recession, particularly in the financial industry and among households. This chart illustrates Mr. Koo’s point that in spite of very low interest rates, the private sector is paying down debt instead of investing. Helu Jianf and Juan Sanchez conclude in Household Financial Distress and Household Deleveraging that “a contraction in credit demand may have played a role in the deleveraging”, in addition to banks being unwilling lenders.
From the previous chart, nonfinancial corporate business continues to borrow. However, Buyback Quarterly by FactSet shows that about a half trillion dollars per year has been used to buy back shares. Gross Private Domestic Investment has been declining illustrating another of Mr. Koo’s points that even with low-cost money, managers “cannot find a good use for money that is essentially free.”
Corporate debt to net worth has been steady, although probably impacted by inflated market prices.
Quantitative Easing and Market Valuations
The effect of QE was to drive down interest rates pushing up the prices of alternative assets such as stocks. From StockCharts, we can see below that the price to earnings ratio of the S&P 500 has increased from 14 to 25 over the past 5 years, accounting for 79% of the gain.
At these high valuations, expected three-year stock market returns are negative (currently -17%) based on the past 20 years of historical relationships. Mr. Koo points out that the appropriate price for an asset is the discounted cash flow model, but corporate profits have been declining for five quarters now. He posed the question in 2014 whether the economy can keep up with the resulting gains in asset prices. The answer to Mr. Koo’s question, as discussed in the introduction, is that GDP growth will not keep up with current equity valuations.
Balance Sheet Recessions
Mr. Koo separates balance sheet recessions from run of the mill recessions in that in the former, the private sector is trying more to minimize debt as opposed to maximizing profits. Households have been increasing their savings even as Treasury yields fell (see chart below). Mr. Koo views the fiscal deficit as a means to return unborrowed savings to an economy’s income stream during times of deleveraging by the private sector. He views fiscal tightening during 1997 in Japan as similar to what was done in the US in 1933 which exasperated and extended the Depression.
Balance sheet recessions often take decades to recover from. The current budget deficit is less than 3% and not excessive by historical standards. He describes a trade-off in balance sheet recessions between higher debt/GDP ratios and severe recessions or depressions, both of which are a cost to future generations.
Mr. Koo describes the ending of balance sheet adjustments as, “… the money multiplier will turn positive once the private sector completes its balance sheet repairs and starts borrowing again. Once that happens, the whole situation is turned upside down as the central bank is forced to absorb all the liquidity it supplied just when the economy is starting to show signs of recovery.” According to this part of the definition, the balance sheet recession has not ended.
Balance Sheet Repairs and Deleveraging
Jeffrey Snider (More Balance Sheet Anecdotal Inferences) says that it is difficult to define loss of balance sheet capacity in the banking industry except indirectly from a comprehensive review of how the entire system is working. He describes money inflections starting in 2011 and now the rising dollar as causing banks to shrink balance sheets.
As evidence that balance sheets are being repaired, Nonperforming Loans and Credit Card Delinquencies have returned to low levels, although banks are beginning to tighten lending standards.
Japan as the Precedent
Mr. Koo makes several comparisons between the United States and Japan during its post-bubble phase including wage growth. As the following chart shows, the US is following 20 to 25 years behind Japan on trends of flattening industrial growth and slowing or declining population growth. Mr. Koo attributes more weight to repairing the balance sheet than to Japan’s declining population and the aging population reducing spending.
Michael Pettis wrote (see Financial Sense How Will Long-Term Deflation in China Impact the World?) where he describes that today’s environment of weak consumption, excess savings and excess capacity is far different than when Japan started its deflationary period when global growth was more robust. Two decades ago, developing country debt had been written down and debt levels were low, while this process of sovereign debt restructuring is yet to happen with currently high debt levels now. “When growth is most needed, when a country is suffering from excessively high levels of debt, it is hard to find many cases in which the aggressive implementation of reforms led to growth rates fast enough for the debtor to grow its way out of debt… When debt levels are perceived as excessive, there is downward pressure on growth… First, spending on both consumption and investment declines as households and businesses cut back on disbursements in order to repay debt (I think this is what Richard Koo refers to as ‘balance sheet recession’)”.
Population as a Contributor to Slowing Growth
The Washington Post reported (There’s a Devastatingly Simple Explanation for America's Economic Mess) research by Fed economists that most of the decline in growth can be attributed to aging Baby Boomers. I agree that as people age, they will tend to save more and pay down debt as opposed to investing, however there are many factors contributing to slow growth, more in lines with what Gary Shilling stated. I add that personal consumption expenditures have increased from 60% in the 1960s to about 69% now which has greatly fueled growth and has probably reached its limitations and the possibility exists to decline. The employment ratio peaked around 64% during the Tech Bubble and has since declined to about 59%. Trade, savings and consumption imbalances due to globalization have also contributed to instability and slower growth.
From the Population Division of the Department of Economic and Social Affairs of the United Nations Secretariat, we see that the “One Child” policy of China puts China 20 years behind Japan on the trend of declining working age population.
According to the World Bank, the trend in declining working age population is global and peaked in the late 1960s before starting a rapid decline in the 1980s.
Monetary Policy
Mr. Koo believes that Quantitative Easing only produced minimal results and for monetary policy to work effectively, there must be private borrowers. “While the current market has been described as a liquidity-driven market fueled by QE, the money supply—the money actually available for the private sector to spend or invest—has grown very slowly... Under ordinary circumstances, monetary accommodation expands the money supply throughout the economy, while during a balance sheet recession monetary accommodation only increases the funds entrusted to investment managers.”
It can be seen in the chart below that the monetary base and reserve balances have begun unwinding.
Quantitative Easing, among other factors, is starting to translate into increased money supply as shown below, but the impact on GDP is slow.
My Monetary Indicator follows and shows a long lead time has preceded recessions. It is a composite of M1, M2, Federal Funds rate, 1-Year Treasury Constant Maturity minus Federal Funds Rate and St. Louis Adjusted Monetary Base. It anticipates a negative impact when unwinding QE on equity prices.
Inflation
The book was copyrighted in 2015, and Mr. Koo describes a future time when the Fed desires to raise interest rates when balance sheets have been repaired, loan demand is picking up and inflation is becoming a concern. The following chart shows the probability of deflation, low, moderate, and high inflation along with my inflation indicator. The inflation indicator shows that moderate inflation is positive for investments.
Vikram Mansharamani describes, in a PBS Newshour, the lack of inflation across developed countries as “1) the slowdown in China, 2) a technology- and globalization-driven decline in manufacturing costs and 3) aging populations in the developed world.” Robert Harding attributes, in a Financial Times article, some of the lack of inflation to low commodity prices and the failure of monetary policies to increase inflation. Mr. Koo presents a case for the lack of borrowers because of deleveraging in spite of very low interest rates.
Below is a chart of the YOY change in the Personal Consumption Expenditures Price Index. Mr. Koo points out that below 1.0% inflation raises concerns over deflation, but with massive liquidity from QE he adds, “…if the Fed waits until the inflation rate reaches 2 percent or private loan demand recovers, it will be forced to hike short-term rates. When that happens, the yield curve will lose its anchor, and long-term rates could potentially see an explosive growth.”
Jeffrey Kleintop states (see Going Godzilla: What has the Bank of Japan Unleashed?) “In September 2016, with the monetary base at 405 trillion yen, the BOJ announced its intent to expand the monetary base until growth in core inflation 'overshoots' its 2% target.” The BOJ should heed the title of Mr. Koo’s section, “BOJ and Government Must Stress That Inflation Overshoot Will Not Be Tolerated”. Trading Economics is forecasting that inflation in Japan is estimated to remain negative through the end of 2016, but increasing to 1.7% by 2020. The BOJ Governor Haruhiko Kuroda recently noted that, “the Japanese economy’s moderate recovery means such action [additional easing] is not currently warranted.” He adds, “Based on Japan’s experience, the argument that a central bank can lift inflation expectations of various economic entities simply by raising its inflation target seems a little naive to me”.
Impact of Inflation on Asset Prices
Ed Easterling is the author of Probable Outcomes: Secular Stock Market Insights and Unexpected Returns: Understanding Secular Stock Market Cycles, which are both excellent books. Mr. Easterling just wrote Understanding Secular Stock Market Cycles which summarizes these topics as 1) Every measure of the market’s P/E is relatively high when compared to its appropriate historical average, 2) Investors can expect total returns from the stock market over the next 5-10 years to be 0% to 6%, 3) Earnings growth cannot outrun economic growth over the longer-term, and 4) high inflation or deflation drives P/E lower returns. Mr. Easterling’s research shows that high inflation will tend to drive the price to earnings multiple down which impacts stock market returns.
As inflation, measured by the year over year change in personal consumption expenditure prices, increases to the 2% target, interest rates may rise above 4%. The chart below covers from 1985 through 2016, when inflation was generally below 5%.
Side Effects of Quantitative Easing
In Mr. Koo’s words, “I have long described quantitative easing as a policy that is fun while going forward but absolutely terrifying coming back. The September 2013 drama over a Fed tapering marked the beginning of the trip back.”
Mr. Koo describes the unwinding of QE, “The problem will become much more pressing once the private sector completes its balance sheet repairs and business and households resume borrowing. That will necessitate monetary tightening, the third chapter in the QE saga… As soon as these political and distributional issues hit the front pages it would become clear to everyone that the excess reserves must be removed as quickly as possible, and the QE saga will enter its fourth and final chapter. The Fed should start mopping up excess reserves by selling long-term bonds with fast approaching maturity dates, which are effectively short-term bonds... The end of the fourth chapter is unlikely to come for many years…”
William White, Chairman of the Economic Development Review Committee, stated "I see a curve where the efficiency of monetary policy goes down with time, and the harmful side effects of policy go up with time," White said. "At some point, those two curves intersect, and the central banks are doing more harm than good. My feeling is this has been the case for quite some time" (see Financial Sense: Interview with OECD's William White on the Negative Side Effects of Ultra-Easy Money). Mr. White adds that he believes that with balance sheets as high as they are, it is uncertain that tightening monetary policy would result in orderly growth and inflation. He believes that there are many paths that will lead to financial instability and believes that governments may need to step in to help stimulate growth instead of monetary policy. Solutions are likely to take years. One of the negative impacts he mentions is the potential impact of continued slow growth or interest rate increases on inflated asset prices. He also cautions that central banks should not fall behind the curve on controlling inflation. Mr. White points out that debt to GDP is now 20% higher than in 2007 meaning that overall global debt has increased, not deleveraged.
As I was about to hit send on this article, I received an email by John Mauldin’s Thoughts From The Frontline about much of the content of this article so I could not resist getting another cup of coffee and reading it. “From the Fed’s perspective, super-low interest rates were economic stimulus. With borrowing costs so low, we were all supposed to race out and buy stuff… What was supposed to happen was a normal recovery. What we got was the weakest recovery on record. …we got stimulus for Wall Street in the form of QE, and it led to an inflation of asset prices…They have kept rates too low for too long.. In doing so they have financialized the economy and made it hypersensitive to interest rate moves… Low interest rates have traumatized US pension funds and basically made it impossible for funds to meet their investment targets.”
QE Trap
The “QE Trap” is where countries that used QE to lower long-term interest rates to help the economy recover start to unwind excess reserves. The cycle that Mr. Koo describes as the “QE Trap” is when the economy starts to recover, the central banks start to reduce excess reserves, pushing up long-term interest rates which hurts interest-sensitive sectors of the economy and slows down the recovery. Wash, rinse, repeat…
The chart below shows how 10-year Treasury rates have behaved with quantitative easing as represented by Monetary Base divided by Gross Domestic Product. The red dot represents where we were in the 2nd quarter. As the monetary base is reduced to normal levels (around 4% of GDP) the interest rate should approach 4%. The QE Trap, as described by Mr. Koo is related to the winding down of QE. The Monetary Base is now 7% lower than it was a year ago. If unwinding QE causes longer-term interest rates to rise, then interest rate sensitive industries such as housing and automobiles may be adversely impacted.
The Fed September Rate Projections are shown below. Combining the above chart and table below, it may take more than three years to unwind excess reserves.
As shown below, Real GDP growth has been declining since early 2015. Interest rates have been declining irregularly since early 2014. The estimates for Real GDP growth in the introduction suggest the economy will not be growing strongly for a few years. Interest rates are rising, perhaps in anticipation that the Fed will raise rates at the end of the year as GDP growth exists, unemployment is low, and inflation is above 1%. Reducing excess reserves held at the Fed or the realization that a recession is not imminent may also be pushing up interest rates.
Credit Growth
Consumer loans began growing again starting in 2013 and are now increasing at roughly 10% YOY. The blue line in the chart below shows that Household Debt as a percentage of GDP has fallen from 99% to 80% while the Federal Debt has increased from 64% to 104%. Deleveraging and lower interest rates have caused Household Service Payments to fall from 13% of Disposable Income to 10% with most of the reduction in mortgage payments.
Credit growth has been low as shown in the chart below, but without government deficit spending, GDP growth would probably have been negative. The CBO estimated “if the fiscal cliff of increased taxes and decreased spending occurred, real GDP growth in 2013 would have likely been reduced to -0.5% from 1.1%. This would mean a high probability of recession (a 1.3% GDP contraction) during the first half of the year, followed by 2.3% growth in the second half.” By avoiding the fiscal cliff, the CBO estimated that economic growth would be 1.7% in 2013, which is what it ended up being.
The chart below shows new one-family houses sold bottomed in 2011 and that house prices began increasing in 2012.
The next chart shows that households and nonprofit organizations were deleveraging mortgage debt from the financial crisis through 2014, but began borrowing again in 2015 as interest rates continued to fall. By 2015, with housing prices improving, sales increasing, and mortgage rates still low, households had repaired their balance sheets enough to have the confidence to begin borrowing again. The spike in mortgage rates in 2013 came after the announcement that the Fed would begin tapering Quantitative Easing.
Fiscal Spending
Mr. Koo says that much of Japan’s problems were self-inflicted by trying to balance the budget while still in a balance sheet recession. He shares my biggest concern about Japan: “Now the question is what to do about Japan’s massive public debt… Some are even afraid it is too late no matter what Japan does. That may be true if the menu of policy options is limited to tax hikes and spending cuts.”
Mohamed El-Erian appears to be in agreement with Mr. Koo in that, “Governments around the world need to step in with fiscal policies that promote growth because central banks will eventually have to take their feet off the monetary easing pedals… We could easily see a situation where low growth becomes recession. Artificial stability becomes instability..." He adds that investors should build up cash.
S&P Global published research that one private sector solution is to have a zero tax rate on repatriated earnings with a requirement to commit 15% to investments in infrastructure bonds. They add that both presidential candidates support addressing infrastructure problems. They cite findings that some of the largest companies have increased cash holdings overseas while having to borrow roughly the equivalent amount in the United States.
Current Trends
An article by Kathy Jones at Charles Schwab has the chart below and points out, “With nearly half of U.S. Treasuries held by foreign investors and the correlation among major international bond markets high, moves in one market can influence others. While still very low, bond yields in Japan and Germany have moved up from the most negative yields recently.”
This chart from Fidelity shows that for 2016, bonds have performed almost as well as stocks without the volatility. Bond returns were helped by falling interest rates and equities were helped by increasing valuations.
CONCLUSION
The time period between recessions has increased during the past 30 years compared to the previous 30 years. The past 30 years has seen the taming of inflation, a technology revolution, the collapse of the Soviet Union, aging of the Baby Boomers, more globalization, and credit-fueled growth. We are now having the hangover of excessive debt, moderately high budget deficits, high equity valuations, excessive liquidity and normalizing interest rates. I agree with Ed Easterling that we are in a secular bear market that began with the bursting of the Technology Bubble and won’t end for years to come (when valuations are low, and inflation is high or negative).
Reflecting on The Escape from Balance Sheet Recession and The QE Trap, borrowers are returning to the banks, balance sheets are being repaired, QE and reserve balances are being reduced.
Expectations of lower growth are being realized. Investors may be realizing that growth won’t support the 15% increase in valuations in equity 2016. The S&P500 has been declining since early September. Inflation is low and not climbing rapidly, whether measured by PCE or CPI. Kiplinger predicts that the Fed is likely to raise interest rates in December but after that interest rates are likely to stay low for some time to come which is consistent with the author’s view.
I have a low allocation to stocks and am overweight in cash so I see no reason to change my allocation. As a result of writing this paper, I will be monitoring indicators of the “Balance Sheet and QE Trap” such as money velocity, reserve balances, loans, inflation, and interest rates more closely.
As an aging Baby Boomer, I understand the Balance Sheet Recession and will continue to save more, pay down debt in spite of low interest rates, reduce consumption and work longer. Sorry if this causes frustration, Mr. Koo, but thanks for helping me understand and prepare for the potential QE Trap.
DISCLAIMER:
I am not an economist, investment advisor nor investment professional. This material is for informational purposes only and should not be construed as investment, legal or tax advice. Investors should do their own research or seek the advice of investment professionals.
