Author: Scott Brown, CFA, Founding Partner
The last ten years have been a laboratory experiment wrought by PhD economists that were allowed to adopt an authoritarian approach to help the Establishment avoid properly dealing with major problems. In spite of all the efforts to stimulate growth, GDP has been running at half of what we got before the GR even as the annual federal deficit as a percentage of GDP went from 2% to 5%. In other words, take away massive government spending, and GDP growth would have been even worse.
Because the Fed is now stepping away from its QE shenanigans for a spell and shrinking its balance sheet, it’s important not to understate the risks this shift represents. Other central banks are reducing QE too. The Fed is a seller now. The private economy must now absorb Treasury debt as money is no longer being printed by the Fed to take down new issuance in the U.S.
M2 growth is slowing to levels that imply a very challenged economic environment as suggested by the declining Citi Economic Surprise Index. Repatriation of overseas cash back to the U.S. by multinationals as result of tax code changes seems to be negatively impacting global dollar funding rates, making those tax cuts less of a positive for growth. There is simply a global shortage of dollars that is a real problem for borrowers abroad.
We still expect the corporate bond market to be the center of future market turmoil. Debt outstanding has doubled in this cycle. Much of it was used to fund stock buybacks. Roughly $4 trillion of corporate debt will have to be refinanced in the next five years. We think ETF holders and other investors will be surprised at how little liquidity really exists in corporate bonds. The capacity of broker dealers to absorb any selling has been reduced by regulations after the GR. We know firsthand how quickly bids can disappear in the corporate bond market even before Wall Street market making was curtailed.
We’d really like to think that policy normalization will continue, but we are quite doubtful that a system as leveraged as the current one can sustain it. Cracks in credit markets are already emerging and enormously popular schemes of this cycle like volatility selling and cryptocurrencies have been exposed as bubbly endeavors. Even bureaucrats and regulators are starting to take notice of corporate credit issues, so you know it’s getting to be late in the cycle.
Global economies are at an epic crossroads. Will pols and PhD’s turn towards free market capitalism or remain wedded to central bank-led socialism and fiscal irresponsibility in coming years? When risks are assumed by central banks and the proper functioning of markets is purposely thwarted as has been the case for this entire cycle, free market capitalism simply does not exist. Creative destruction has been prevented as the global elite choose winners and losers.
The bureaucrats have crafted policies that further concentrated power in the executive suites of large companies that helped them maintain pricing power for their products and take advantage of slack in the labor force on the wage side. Millions of people simply disappeared from the labor force and have yet to return. That kept profit margins high.
With over 2/3 of the earnings growth in recent years coming from leveraged stock buybacks, investors have been persuaded to confuse real growth with manipulated growth. Now, cost pressures from rates, commodities, and wages are coming to the fore and impacting profit margins.
Handing over the keys to Corporate America with the notion that it would all work out in the end has been a crushing blow to the working class. The Trump tax cuts were mostly just another gift to corporations particularly when one realizes that prior corporate rates were not as punitive as they were purported to be when adjusted for VAT’s so common in Europe and elsewhere. Also, the cuts will not improve the fiscal situation. We love tax cuts. We loathe deficits.
To pretend that “the sky’s the limit” now economically speaking is simply a myth that we are encouraged to tell ourselves by those in charge and their minions in the media. The data does not really support that view. Turning a blind eye to how radically different the financial system has become is not the foundation for an investment process, it’s denial. In the next few years, those in charge are going to have to decide if they are willing to permit capitalism to thrive when enormous pressures for governments and central banks to continue to remain the dominant factor in the economy will likely reach extreme levels.
We think many investors have forgotten that the new normal is not very normal at all. If we are not careful, socialism will gain significant ground here. Younger generations in the U.S. do not despise socialism like most older folks do. Crony capitalism on the way up and shared risk when trouble like 2008 hits is not a recipe that will serve us well over the long run. As a result, pronounced voter dissatisfaction with the agendas of status quo seekers who remain in control of the events will continue to be a factor. Elections across the globe are making this abundantly clear.
The rise of populism, most recently in Italy, is a response to the PhD’s holding stock prices sacrosanct without regard to the health of the real economy. The cart was put before the horse. The Establishment will keep fighting, of course. Just look at the deep state’s efforts to use a cadre of lawyers and swamp creatures to undo the last Presidential election here.
The views expressed on this blog are the opinions of the authors. This information is not intended as investment advice or to recommend the purchase or sale of securities. More information on Strategic Balance, LLC may be obtained by contacting investor relations.