Author: Scott Brown, CFA, Founding Partner
The central bank crowd still does not completely understand the mess that it has made, but it’s figuring it out. The equity indices that hold sway over policy decisions don’t seem to reflect systemic dysfunction to these mostly uninformed observers of markets. They continue to wrongly pursue inflation targets they can never reach because it has provided an excuse to coddle stockholders with monetary largesse. Debt levels, technological advances, and demographics hold much more sway over pricing than central bankers will admit. Only economists like inflation anyway.
With tax cuts at their back, corporations will continue to buy back stock instead of pursuing growth strategies because they recognize that final demand for their products is not likely to take off. Why expand capacity in a big way? If anything, QE and zero-rate policies have been deflationary because they enabled zombie companies and less efficient producers to remain in business. Keynesian economic models are broken because they do not account for a system with excessive leverage like the current one.
Cycles can die by both fire (inflation) and ice (deflation) as we have written in prior letters. We think the mistake many investors are making is being strongly wedded to the notion that an inflationary scare is the only possible avenue to a recession or market disruption.
We would suggest that a deflationary bust is highly likely because of the enormous leverage that has been used to prop up asset prices to unsustainable levels. For instance, homes once again remain out of reach for many based on the failure of incomes to keep up with rising prices. Lack of affordability will hit home values at some point.
We think the inability of massive QE programs to lead to GDP growth rates near those of prior cycles points to an eventual deflationary outcome. Is inflation going to suddenly skyrocket with central banks reducing global liquidity now? We think that is unlikely. Early 2016 provided a glimpse into how quickly a deflationary mindset can take over and cause market disruption.
We’d like to be optimistic that the new Fed chair, Jerome Powell, is more likely than his predecessors to unshackle markets from Fed dominance, especially because Mr. Trump and Congress make for easy scapegoats if things go badly in that process. Both the President and the legislative branch have embraced deficit spending in a big way. It could prove quite easy to blame tax cuts and bigger deficits for anything that goes awry with quantitative tightening.
Because the stakes and downside risks are so high, Mr. Powell will likely feel compelled to fold like a lawn chair before it’s all said and done. It’s likely just a matter of time before he caves on hawkish policy because, as usual, the economy just does not fit the fanciful strong growth narrative being spun. We will change our minds in coming months if the evidence supports a position switch as tax cuts factor more fully into the equation.
As of now, GDP looks to be running at a weak 1.9% this quarter. Even with the stronger employment data for February that included a strangely large increase in retail jobs, payroll growth is still running below the pace of twelve months ago. Retail sales have now fallen for three straight months in spite of all that strong consumer punditry out there. Business loan growth seems to be running at a slow pace still. Measures of positive economic surprises have rolled over globally as new data comes in. Freight traffic does remain a source of strength and we will be keeping our eyes on that.
Delinquencies were already rising on household debt before the fourth quarter borrowing binge. It marked the fastest pace of credit growth since 2007. Small banks are at the center of a brewing consumer credit storm. Auto sales are slowing as subprime borrowing growth fades. Student loan credit metrics continue to be worrisome, but nobody seems to care. It was another big growth category of this cycle.
Trump’s tariff scheme may be a long overdue effort to correct failed trade policies that have shafted U.S. factory workers for decades, but near-term impacts are not favorable for growth and will raise prices. Like all things Trump, including White House staffing, the final version of these trade policy changes is indeed a wild card. That said, we can’t help but be happy about seeing members of the global elite being sent packing from 1600 Pennsylvania. Tariffs will give the Fed cover for any mishaps or changes of policy direction.
Another Chinese conglomerate, Anbang, has joined HNA in being forced to finally deal with years of reckless asset accumulation. It is facing an inevitable reckoning process and deleveraging as the government steps in to try to calm the storm. At the same time, with President Xi Jinping being given control of the nation for life recently, perhaps real reform involving needed debt restructuring can now take place in China. That would further slow growth there and globally, but it has to happen.
Despite the economic data proving somewhat disappointing for weeks as hurricane-related spending fades, it seems like practitioners and pundits are still busy one-upping each other about how high interest rates are going to go. The Fed is projected to both hike fed funds three or four times and shrinks its balance sheet by billions of dollars each month. We think an additional $2 trillion in net Treasury supply will have to be absorbed through next year if you combine Fed policy with budget deficits. That’s a big liquidity drain for markets to absorb.
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.