We think most observers’ senses have been dulled by a continuation of weak growth for so many years. Many have become numb to just how poorly the economy is really doing. Plus, the media has done its best to paint a rosy picture and confuse the truth. After all, we have endured the worst recovery in decades, but you would often never know it listening to the press or talking to some of your friends and neighbors.
We think that because of endless propaganda, even many astute investors repeat mantras that make no sense like “the economy is strong, just look at job growth.” However, that statement fails to consider that a large percentage of the jobs created in this cycle were low quality and part-time and that the labor force participation rate remains at multi-decade lows. Factor in those realities and it makes sense that GDP growth has been weak and wages stagnant. Talking heads could have easily closed this loop if they had wanted to do so.
Our point here is that the media has become a powerful force in creating a narrative that changed perceptions of some smart people to a degree we have not seen in prior cycles. We also suspect that the media will no longer be talking about how great things are because of its obvious contempt for Trump. We also bet his approval ratings will not get the supportive statistical tweaking of the last eight years. We think that will be an important factor for business and market confidence and presents a hurdle that might be tough to overcome, especially when it is obviously not hard to find nagging problems like that of weak consumer spending.
Consumers were mostly scrooges all year in a lot of categories. The media stayed away from the crisis brewing in retailing for months and predicted a robust Christmas shopping season. The pundits were very wrong. In fact, the most recent same-store sales numbers from many retailers and restaurants during the important fourth quarter are the worst we have seen in a long time. Somewhat surprisingly, these poor numbers came about even as consumers borrowed quite heavily. We could very easily see this story morphing into a “consumers lack confidence in Trump” narrative, but only time will tell and there is plenty of other potential fodder.
Auto sales did end the year at a high level, but discounting was said to be heavy and, of course, money is cheap courtesy of still extremely friendly lenders and generous lease terms. The glut of cars coming off lease over the next few years and the deterioration in credit measures for subprime auto loans could prove painful for the sector. Perhaps this will be another story looking for a scapegoat in the White House this year.
Luxury apartment construction has been booming for a few years, but now rents are under pressure as supply of new buildings is starting to overwhelm demand. Also, the big jump in the production of commercial jets appears to have peaked for the cycle after years of strong growth.
Much of the industrial economy was quasi-recessionary for most of the year, if you listen to the managements of numerous industry participants and look at soft industrial production numbers. Capital equipment demand was generally quite soft. That was not just a crude oil production issue. Rail traffic was down 5% in 2016. That is a big deal and not something you expect to see outside of a recession.
Residential construction did have a good year, but the recent spike in rates is already biting if you look at bank earnings reports. The single-family housing industry has yet to recapture the magical tone of 2006 as overall home ownership rates are being held back by prices that are too high relative to incomes. We are also seeing too much reckless lending in FHA arena. Yes, it seems that so many bright spots are at least partially driven by such a credit-creation gimmick.
Speaking of nothing being fixed, Europe is obviously still working through its debt issues and EU membership worries after Brexit. We are particularly focused on the massive quantity of bad loans at Italian banks and increasing credit concerns in Portugal. Elections this year in a number of countries will lead to volatility as nationalism and populism continue to gain ground.
The ECB plans to reduce the pace of QE as the year progresses and that could mark a significant inflection point. Importantly, an enormous amount of credit risk in Europe may be housed at their central banks, but it has not disappeared. Ultimately, Germany remains the key credit backstop for all of Europe and the problem is just too big for it to swallow. The euro will fail at some point. The cause and timing are unknown, but a euro breakup is the only answer.
Not surprisingly, China spent yet another year failing to figure out how to reduce the pace of GDP growth fueled by reckless debt creation without completely collapsing its economy. It remains the largest bubble in history and a crisis in-waiting just needing a catalyst. We ultimately expect a currency devaluation there that should have profound deflationary ramifications.
Japan remains mired in its multi-decade debt hangover in spite of massive QE efforts in recent years. While it appears to be running out of last ditch efforts to maintain order, markets are less focused on troubles there for now. Regardless, its government debt-to-GDP ratio is now more than an astounding 250% and getting worse as it runs a budget deficit of 5% of GDP. Longer term, it is likely that the BOJ may be forced to write down the value of its massive government debt position in order to reset the system there. Yes, that will be a big deal, but ignored for now like all the other big issues.
The emerging markets face a dollar scarcity crisis that will not go away if our Fed moves to raise rates this year. We think the consensus view of three additional hikes in fed funds is a stretch given the still soft pace of growth in the U.S. and the global risks mentioned above. Global trade has been quite soft for months. Many of these issues are exacerbated by higher U.S. rates and a stronger greenback.
Whether one looks at positions in futures markets or the giant flows into ETFs, it is clear that investors are making a big bet that the good times for stocks will continue even as the median equity trades at its highest valuation ever. Many long-short hedge fund managers are giving up on shorting stocks based on the equity exposure data we have seen. That should also awaken the contrarian in everyone. Make no mistake; equities are at bubble levels like 1929, 2000, and 2007.
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.