Caught in the middle of what we can only describe as a “popular delusion” that the economy is robust because the national “mood ring” is the closing price of the DJIA, many investors are willing to take enormous risks without much math or many facts to substantiate their positive views. At the same time, somebody might want to tell the Fed and the vast majority of pundits that the economy is not performing well based on the distress in the retail sector and the latest GDP estimates.
Wednesday’s hike in rates by the FOMC was a policy mistake from a pure economic perspective with first quarter growth near only 1% according to the Atlanta Fed. One brave reporter actually pointed out that the bulk of the data did not support the move to an incredulous Yellen who responded with the usual lack of clarity we expect from economists. Last year ended on a weak note too.
Tighter policy is necessary to contain the bubble the central bankers have created. Having stuck to emergency measures for too long, the Fed is caught offside once again. The flatness of the treasury curve still paints a much less giddy picture than equities and now commodities are rolling over as well.
It seems all the “smart money” remains long stocks, the dollar, and crude, while also short Treasury bonds. One has to wonder how they can all be right, especially as the incoming data is not consistent with the strong-growth themes expressed by those almost universally held positions. Our contrarian nature might put us on the other side of these trades anyway, but valuations clearly make the same argument.
According to the popular narrative, after the giant rally in equities under the prior administration in which GDP growth consistently ran at about half of prior cycles and earnings remained lackluster, now we are supposed to believe that the latest spike since the election must be an indication that good times are right around the corner under the new President. We still suspect equity market participants are not factoring in the difficulty of legislative implementation of the complete Trump agenda and that stock valuations are already the bubbliest ever.
After years of discussing the trouble in retail in these posts, that particular bubble in the U.S. is finally bursting. Square footage per capita grew for decades until it hit about 5 times levels seen in Europe and Japan. The continuing carnage in the traditional retail sector is being portrayed as simply an online sales migration issue with everyone trying to blame Amazon. We think the problem is too big and the crisis phase has been hit too suddenly for that to be the key factor. Restaurants are going through a somewhat milder version of this drama, so it’s a consumer spending issue plain and simple.
We have never seen such complete and utter lack of pricing power, same-store sales volumes, and foot traffic outside of a recession. A massive number of stores are being closed and vacancy signs are in abundance as bankruptcies mount. The effects of the lack of real income growth for most consumers for years and enormous overbuilding of shopping capacity have finally tipped the scales as the current cycle ages. Malls are at the center of the storm and internet sales have been a drag there for years, but the same issues are affecting strip shopping centers where even grocers are feeling the pinch.
While skeptical, we hold out hope that new policies out of D.C. can turn the economic tide. That will not be easy at this point in the cycle as bank lending has already begun to slow. The auto cycle is peaking with discounting on a rampage and sales plateauing. Home ownership affordability is reaching concerning levels as non-traditional buyers like “flippers” and investors account for an alarming one-third of purchasers. There is now a glut of condos and apartments in many cities in addition to death spiral going on in retail space.
Crude oil inventories remain extremely elevated as increased production in the U.S. continues to offset any OPEC supply-cut optimism. A renewed collapse in crude would put pressure on credit markets and earnings. Finally, GDP growth remains well below 2% based on the latest data and that does not match the surveys and other soft data that is paraded as proof positive of good economic times. Confidence surveys often peak late in cycles anyway.
If we had not witnessed other “popular delusions” before in both 2000 and 2007, we might be a bit more surprised by the current environment and the ubiquitous derision of active value investing and hedged strategies. When it comes to markets, Charles Mackay was right when he said investors “go mad in herds, while they only recover their senses slowly, and one by one.” We will maintain our current low exposure to the madness and remain reliant on math. We suspect that tightening monetary policy will have quite a pronounced negative effect on risk assets sooner than the overly optimistic crowd might think.
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.