Double Shock

Double Shock

3/21/20

Investors looking to jump back in may be too early. The market went on sale this month, but only off of peak valuations. It is commensurate with the "value" most shoppers find at discount retailers and factory outlet malls. Inherent value is not equivalent to discounted prices.

And that is exactly what we are witnessing in the markets today. After a decade long post-2008 bull market driven by discounted rates, cheap money, a Fed put, and corporate buybacks, we are now seeing the deleveraging effect on the other side of the hill. It always falls off faster, quicker, and steeper than the climb up. And it will continue... in the short run. 

It will continue because the market is a function of 3 factors: (1) The supply of stock, (2) The demand for those shares, and (3) The economy. Global supply chains are frozen due to the Coronavirus, and the demand for non-essential products grinded to a halt. Companies across the globe are instituting their disaster plans. They are focused on preserving liquidity, not growing their companies. 

The supply of stock is not increasing as private companies are not even considering going public; but the supply of stock available for sale on the market is growing faster than the scary charts CNN is showing on the proliferation of the virus. This is partially driven by the near term outlook, a rush to liquidity over the uncertainty, fear from the prior banking crises, and forced selling from 401-Ks. Most Americans live paycheck to paycheck, so when their job prospects look grim, they must sell their equity portfolios regardless of valuations. 

True this is the environment Warren Buffet and other value investors love. True that valuations are certainly more reasonable today than at any time over the past few years. True that buyers today will perform well over the next decade if they buy and hold high quality shares. But the double supply and demand shock that is still in its infancy will prevail in the short term. 

A downside $150-$160/share EPS for the S&P 500 is reasonable given 1-2 quarters of material economic contraction. A downside multiple of 14x is possible. In 2008 it briefly dropped much lower, but interest rates are now at record lows, so spreads imply a more reasonable bear case S&P multiple. At 14x $150-$160, the downside for the S&P 500 in the double shock we are experiencing is 2,100-2,240. The S&P closed on Friday just over 2,300. We are getting close to attractive buying levels, but build your shopping list and wait a little longer. Do not be fooled by the intermittent pops from short term volatility.

     

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Now that you have a year's supply of toilet paper, get your equity shopping list prepared!

For over a year it felt like the market was focused on a single story, namely that low interest rates and pro-business fiscal policy would let the bull run for another decade undeterred. I had nothing to post!

Warren Buffet's hoarding of record amounts of liquid cash was questioned by market pundits, similar to that of every other economic peak. Predicting a recession triggered by a global pandemic was only predicted by a few (see Bill Gates TED speech). Nobody could accurately see the timing until the stories from Wuhan emerged, and many like Bridgewater's Dalio still refused to accept the inevitable spreading from forecasting models. Based on what we see in Italy and China, things could get worse but should still recover in 2020 if our political responses are effective. Trading based off healthcare related modeling could be difficult to those without industry experience, like most Wall Street investors. 

My prediction is that the wild volatility of -9% followed by +9% trading days will continue as the institutional capital and algos react to news and margin calls, but the trend will continue down. When looking at the massive uncertainty over how long this could impact the economy, even the most realistic bullish case implies a still frothy market. I understand that valuations warrant a strong PE multiple when interest rates dropped to record lows. But the EPS on the S&P 500 can drop a lot more when the global economy (Main Street) just ground to a halt. Goldman predicted a menial 5% EPS hit to 2020 S&P earnings. I was not buying it. Then they lowered it 5% again to $157/share. They estimate the S&P could drop to 2,450 before rising to 3,200 by year end. I am not going to discuss the upside target for now. It is realistic should everything work out. However, let's focus on actionable trading for the next 3-6 months. Where should you start allocating? Ignoring individual positions, a realistic downside multiple on a recessionary outlook with super low rates could be 15x trough earnings. 

Assuming a fairly drastic cut of 25% to total 2020 EPS versus original guidance of $174/share * 15x, the downside S&P target would be ~$2,000. At today's S&P we have 20% more downside to this very conservative case. We also have ~32% upside to Goldman's realistic year end target should we recover. Current positioning indicates investors should remain bullishly positioned, or even add to their original equity weightings, but recognize that we are not yet in an aggressively bullish trading environment.

We are starting to see some individual bargains too which can be picked up while recognizing the impact of extremely high correlations, indexing, and deleveraging when considering allocations. 

Get your equity shopping lists ready!



Dan Shainberg#DanShainberg#RecessionResister@DanShainberg

Markets are Adjusting

Daniel Shainberg
January 22, 2019

Stocks tank as economic jitters intensify. The S&P 500 shed 1.4% and the NASDAQ dropped 1.9% as the blame was placed on weak Chinese economic data, a lack of progress in negotiations for a U.S. / China tariff deal and further weakness in housing numbers, specifically new home sales.

Existing home sales in the U.S. tumbled to a 3-year low, baffling brokers who have yet to understand the correlation and impact of rising rates on home affordability. The National Association of Realtors said that existing home sales declined 6.4% to a seasonally adjusted annual rate of 4.99M units in December. Rising mortgage rates and tight inventory are not a healthy mix for sales volumes, and the continued federal government shutdown is not helping.

Today’s news though is reflective of the broader trend in the economy that investors have started to “price into” the equity markets. Namely, that the likelihood for a domestic recession after a decade long bull run is growing more intense, a message echoed by Bridgewater’s Ray Dalio. Dalio warned Tuesday that there is a “significant risk” of a recession by 2020. Once factoring in the potential for a reversal in the multi-decade trend of declining interest rates, the CAPE ratio on the S&P 500 suggests a multiple that needs to correct lower. As we have said before, if risk free rates are trending towards the 4% range, risk assets such as publicly traded equities need to adjust to factor in the required risk premium. Assuming 400bps of incremental return, an 8% implied earnings yield on $175 per share of S&P 500 earnings would put a median price target on the S&P 500 at about 2,200 for another 15% selloff, and that assumes no degradation in earnings quality.

Dan Shainberg

#DanShainberg

#RecessionResister
@DanShainberg

Even Greenspan is Warning the “Party is Over”

December 18, 2018
Daniel Shainberg

“It would be very surprising to see the market stabilize and take off again from here. What’ happening now is there is a pronounced rise in real long-term interest rates. If you look through history compared to the past 15-20 years that is the key factor that brings the stock market down. Long-term rates are going to rise. We’re moving towards stagflation. That is a toxic mix.”

When asked about leverage, he replied, “leverage is average. The leverage that occurs in the context of a toxic asset is a problem.”

The Fed is set to convene its interest-rate setting committee next Tuesday and Wednesday. Investors will closely parse their guidance on the potential for a 4th hike this year as well as any insights into 2019.


When Greenspan, who became famous (or some say infamous) for coining the term “the fed put,” comes clean with a bearish outlook, you know things are dicey! 

Dan Shainberg

#DanShainberg

#RecessionResister
@DanShainberg

Flashing Orange Signal

December 13, 2018
Daniel Shainberg

Flashing Orange Indicator

According to PIMCO, the economy is “flashing orange,” signaling a recession is near.

The economic cycle does not work that way. There are no hard cut signs that the economy or markets will turn. Volatility can be an initial sign of a turn. So can the yield curve inversion, or a spike in credit defaults, or a widening of the TED spread, or rising unemployment, higher rates, and the list goes on. These economic statistics are backwards looking. To get a sense of the future, once has to understand where we are in the business cycle, the source of recent macro data and a sense as to whether that source can continue feeding the trend. 

In 2008 the statistics all looked great. Home prices were rising, new home starts were improving, oil prices were rising from what most perceived as healthy demand and unemployment was low. But what we now know is that the cause of that boom was artificially low interest rate policies set in place by the Greenspan Fed after 9/11. All of the apparently positive market data and statistical reporting on the economy thereafter were simply a reflection of that unsustainable policy. Once rates spiked, the market turned south quickly and the data changed. There was no single truism or “smoking gun” data point that we could have tracked to flash a sign that the crash was starting. It just doesn’t work that way.

PIMCO stated that “the chance of a U.S. downturn of 30% in the next 12 months is at a 9 year high.” This is nonsense. Pimco economist Joachim Fels and Andrew Balls, global fixed-income chief investment officer, wrote in an outlook, “the models are flashing orange rather than red.” They certainly might prove to be right but where does this 30% likelihood come from? Past examples? There are no perfect correlations to this decade long bull run of multiple rounds of QE. Add in the rise of Asia and related tariff threats plus technological advances. There is just no way to create a statistical model that can accurately input all of these real world situations and model out some color threat. It’s almost as ridiculous as the government’s color based threat list implemented after 9/11. Even they scrapped the use of that type of indicator.

In an instant we could hear news of softening rhetoric with regards to Chinese U.S. relations like we saw with North Korea. We could have the Fed announce a pause in their rate hiking trend, a prognostication that many Fed watchers believe is likely. We could see the benefits of the recent decline in oil prices follow through to consumer spending, the most impactful segment of the U.S. economy.

While this newsletter is dedicated to our bearish outlook for the markets, we will call out headlines such as the one in today’s PIMCO report that is clouded with eccentricity and unsubstantiated fear-based marketing.

Dan Shainberg

#DanShainberg

#RecessionResister
@DanShainberg

Was that the Pinprick?

Daniel Shainberg
October 12, 2018

The art investor and collector community was stunned last week when immediately after Sotheby’s completed the auction of Banksy’s Balloon Girl the piece started self-destructing. Of course the notoriety of the surprise is believed to have actually increased the value of the piece! One might call it “art in motion.” 

Unlike Balloon Girl, the economic bubble will eventually pop, and it won’t increase the equity value of its stakeholders. 

  

The big debate currently roiling the financial news is whether or not the spike in volatility this week was the pinprick that will bust this cycle’s bubble or just standard volatility that re-entered the markets after a dull “low-vol” start to 2018.

• Peter Schiff: “The Recession is Coming”

• Howard Marks: “No Signs of an Imminent Correction or Crises”

• Ray Dalio: “War With China is Coming”

• Jeffrey Gundlach: “Something Bad Must be Happening”

• Larry Kudlow: “Normal Correction in a Bull Market”

• Scott Minderd: “More Inflation in the Pipeline”

• Mnuchin: “Yield Curve is Normalizing”

Everyone wants to predict where the market is going. It makes us sound smart. Of course nobody knows…. At least in the short term. 

The technical crash through the moving averages is not a good indicator for those bullishly exposed. The fact that the global markets have been rocked year-to-date while the U.S. was an outlier until this week likely as a hangover from the Trump tax cuts is not a good sign. The elevated level of volatility as measured by the VIX index is not a good sign. The likelihood that the move down is correlated to rising rates is not a good sign either.

As we noted in yesterday’s podcast, if the market is starting to reflect the anticipation of higher rates, then equities will demand a spread commensurate for its higher risk. And with the 10 year on a straight trajectory to 4% within the next 12-18 months, equities simply cannot trade at 20x earnings unless justified by material economic growth. And that just becomes a harder and harder sell when the economic growth we have been experiencing was largely due to one-time tax cuts, one-time global-trade wins upon the threat of tariffs and an end to the interest rate cycle. Nobody can predict daily moves or accurately predict where the market’s are heading next week. It’s just too tough. But when you consider all of the noted artificial stimulus that buoyed the market up, and the fact that they are all turning now, it just gets harder and harder to believe this bull cycle is just witnessing a bump in the road. And we haven’t even discussed margin debt!

Dallas Fed Chief Robert Kaplan recently addressed NYSE margin debt as it hit another record high. The reason this matters so much is that when markets tank, investors with margin exposure become forced-sellers. The lenders require them to liquidate their equity positions to repay their loans as their assets drop below minimum coverage ratios relative to their liabilities accounts. This has the effect of magnifying market selloffs. It becomes an excellent and ripe ground for value oriented investors, but only once the full brunt of the forced-selling waves is complete.

While we have listed true market indicators in this newsletter previously, NYSE margin debt reversals are excellent warning signs to the next bear market. Even FINRA warned in January that investors may be underestimating the risks. The chart below shows how the current market cycle could see a record forced-selling blowout as NYSE margin debt is ~50% greater than the peak of the 2008 market precipice. 

Dan Shainberg

#DanShainberg

#RecessionResister
@DanShainberg

Bloodbath Continues After Hours

With the ugliest day on Wall Street in a long time, the “bounce-back” may elude us tomorrow as the Dow is down another 1,000 points after hours. 

What’s going on? 

Well if you have been reading this newsletter then you would have already been informed of the macro themes that continue to present compelling and material downside risks to this market. The interesting thing about today’s selloff, and the continuation in the after-market, is that there was no significant single news event, no change in rates, no spike in oil, no new tariff news. 

It seems to simply be an unexpected pocket of air that hit the markets without any warning. The reassurances from the White House about the “strength of the economy” will prove meaningless to investors who have their own cash on the line. What equity investors finally picked up on was that the economic readings suggesting strong growth are driven by the low rate environment. And since rates have been spiking up quickly, the stock market as a forward indicator is incorporating its expectations for the future impact of these rate hikes. 

The market is not liking what it’s seeing! 

Nedbank's strategists Neels Heyneke and Mehul Daya explain why "we are approaching historical thresholds", where Fed tightening traditionally becomes the "straw that breaks the camel's back" for the equity markets and why "this time should be no different." 

According to Dennis Gartman, “the U.S. economy has close to a 100% change of entering a recession.” Gartman noted that the catalyst will almost certainly be the Fed.

As of now, he seems to be right. 

Dan Shainberg

#DanShainberg

#RecessionResister
@DanShainberg

The Yield Curve

What the bond markets are predicting is that the next recession is already set in place from a long period of inflation and the distortion of global interest rates for far too long. With a record deficit combined with rising rates the U.S. government will not have the same ammunition to attack the powerful forces of economics that struck in 2008. Economics will strike again. Bubbles can last longer than expected, but when debt is run-up, money is printed without concern for its effects and debt is assumed in excess, bubbles form. 

But they eventually pop.

Today we are living way beyond our means. The only way to determine the timing of the end is by researching prior cycles. Increasing rates are the first sign, but it does not necessarily act like a pinprick to an oxygen filled balloon. Since most reasonable analysts agree that our first premise is accurate, in that we have had years of excess artificially induced growth, let's focus on the very difficult to determine question of timing. The phrase "economic indicator" should be reserved for economists. We want to understand real stock market indicators. What are the signs that the stock market cycle is ready to turn from a bull into a bear? 

The Yield Curve

When the economy is healthy, longer dated bonds demand a premium return. Investors naturally demand more money to compensate the extra time, risk and inflationary impact involved in having their capital tied up for a longer period of time. The yield curve notes the difference between the 10-year and 2-year yield on U.S. government bonds. This has been a reliable accurate signal for a looming recession over history. Inverted yield-curves are when the yield on 2-year bonds exceeds that on 10-year bonds which is a counter-intuitive situation. Normally if an investor locks her capital up for a longer period of time, that should be compensated for with a higher yield. But when the short term yield is larger than long dated bonds, that suggests that the credit market is forecasting a "top" nearing. 

Recently the spread between the 10-year government bond and the 2-year bond has shrunk, suggesting traders are concerned about growth. Grey areas below are U.S. recessions, you can see that the yield spread has dipped below zero before each one. 

After careful analysis of this chart one can see that when the spread shrinks towards the horizontal black line where investors demand the same return for 2-year and 10-year government bonds, a recession follows, but not always immediately. In both 1984 and 1994 the recession hit a few years after the signal was triggered.

Every recession over the past 60 years was preceded by an inverted yield curve according to research from the San Francisco Fed. Inversions correctly signaled all nine recessions since 1955 and had only one false positive in the mid-1960s but that period witnessed a true economic slowdown even though it did not reach the status of an official recession. Keep an eye on the spread. The chart is updated and can be viewed here:

https://fred.stlouisfed.org/series/T10Y2Y

Dan Shainberg

#DanShainberg

#RecessionResister
@DanShainberg

China's Total Recall

Daniel Shainberg

September 23, 2018

Just as we were expecting the Trump pattern of "bluster" followed by a "dial-back," we get the exact opposite with an apparent "double-down." 

Sometimes things don't go as planned, and that is precisely what the market may be underestimating with regards to the China-U.S. trade dispute that now seems headed for a trade war or even worse.

China was set to send two delegations, but as of Saturday morning, according to the Washington Times, both delegations have been "recalled."

The talks have been in play for weeks, but China blamed President Donald Trump's new round of tariffs as "undermining efforts." The latest U.S. tariff salvo was in reaction to news that China was buying Russian weapons, notably the purchase of Russian fighter jets and surface-to-air missile (SAM) equipment. 

Foreign Ministry spokesman Geng Shuang said China "is strongly outraged by this unreasonable action by the U.S. We strongly urge the U.S. to immediately correct its mistakes and revoke the so-called sanctions. Otherwise, it must take all the consequences." The U.S. says China's purchase of the weapons from Russia violated a 2017 law, the Countering America's Adversaries Through Sanctions Act.

For now, Trump has an incentive to talk tough and support the farm-belt voters that China threatens with their agricultural counter tariffs. With the rise in nationalism globally, the tough talk of threats and warnings of "dangerous escalations" seem more and more likely to become a self fulfilling prophecy. Russia was always ruled by an iron fist. Recently Chinese leader Xi Jinping performed a surprise "power grab" condemned by the West as a step towards tyranny after scrapping the two-term limit that was designed to guard against Mao-style rule. 

The weekend headline of the latest ramp up in tariffs and threats is noteworthy after a bullish week in the equity markets and timely after Ray Dalio's recent warning that history suggests we could be entering a hot-war. Dalio likened the current wave of nationalism to the pre-war period stating "I think that the 1935-1940 period is most analogous to the current period and that it is worth reflecting on what happened then when thinking about US-Chinese relations now. To be clear, I’m not saying that we are on a path to a shooting war, but I am saying that we have to watch what path we are on, given these cause-effect relationships that history has taught us."

Dan Shainberg
#DanShainberg
#RecessionResister
@DanShainberg

Leveraged Loans are Booming

Daniel Shainberg
September 22, 2018

The "beginning of the end" is a decent way to sum up the economic outlook for the next few years. It's always a shot from the least expected corner of politics, society or the economy that breaks the back of the bull. 

In the prior two economic busts, for example, we had all the classic warnings signs: overheated sectors (technology, housing), excess leverage driven by low borrowing rates, classic cash flow based valuation methodologies thrown out for circus metrics, and Warren Buffet laughed at for being too "old school." 

Today we have the cryptocurrency fad, the cannabis boom, a decade of low rates, excess shadow lending, bursting sovereign debt levels across the Eurozone and of course the much discussed trade war with China which just seems to be snowballing into a real issue. Then there's the rising oil prices and 10 year yields breaking every technical signal. San Francisco is another bellwether indicator as the technology industry always seems to experience elevated cyclical correlation to the economy. The city by the bay is so advanced technologically that someone actually created an app to track human feces and syringes laying on the street. These are indicators and signs of the times. 

The next bust, like previous ones, will likely be triggered from where we least expect it. That's why the timing is so difficult to nail down. Peter Schiff, Nouriel Roubini and many other economists with fancy accents have been pointing out many of these indicators for a decade and the result was the biggest boom in equities during the tenure of their preaching. 

One of the biggest signs of a downturn that also serves as a catalyst is the leveraged loan markets. In our prior article "Watch Credit Markets Not Chinese Tariffs" we highlighted how the credit markets are a bigger risk than a trade war with China. Leveraged loans are one of the few markets that actually can predict timing as corporations may extend their balance sheets, but once the cycle stretches too far, the game is up, and they have to pay their interest due. It is at that point when covenants are breached, interest payments are missed or refinancing transactions fail, that investors fall over each other to bail. 

Today, exactly a decade from the 2008 financial crises, the leveraged loan market is back to a peak. 

Investors, starved for yield and petrified of duration risk, are once again chasing the allure of income that floats with Prime or LIBOR. As interest rates climb higher, leveraged loans offer commensurate yields to their investors. But there's a price and value to every investment asset, and after the recent boom in this market, the average leveraged loan is trading near par, a level that historically offered its investors less than a 3% total return in the following two years. 

The problem is that while loans are the "safest" financial security within the capital structure, defaults can occur and recovery rates may end up being significantly lower than prior cycles. Moody's predicts that U.S. 1st lien recoveries could fall to 61%, versus their 77% historical average, and second lien loans could see recoveries drop to 14% versus a 43% historical average. 

In the current environment, like prior market peaks, creditor friendly financial covenants are virtually non-existent. The U.S. market for leveraged loans is now in excess of $1 trillion. Pension funds have been plowing in, eager to take advantage of the limited interest rate risk offered by these floating instruments. 

The key driver for the leveraged loan market this year has been the Fed's increase in rates. With the fed set to increase rates again next week, the demand for this product will likely continue to grow in the short term. 

But once investors in these products recognize the default risk, recovery risk and limited remaining return opportunity, this market can reverse and take the equity markets with it.

Dan Shainberg
#DanShainberg
#RecessionResister
@DanShainberg

Watch Credit Markets not Chinese Tariffs

Dan Shainberg

September 17, 2018

Today's headlines of $200 billion in Chinese tariffs sent risk back into the markets. 

WSJ: "US and China Ramp Up Trade Threats"

Bloomberg: "China to Cancel Talks if Trump Moves With Tariffs"

Reuters: "China Paper Warns it Won't Play Defense"

ABC: "Trump Administration Unveils Fresh Round of China Tariffs"

Yahoo: "Stocks Wobble as Trade War Worries Deepen"

The expected market repercussions followed with the growth oriented tech sector hit hard and safe-haven assets like the U.S. dollar soaring as the 10-year Treasury yield hit 3% yet again. But these self inflicted risks can easily be reversed. Both sides are playing a game of chicken. The genie can always be put back in the hat. Once the risk/return equation changes for the parties involved, they can easily come to a negotiated settlement that calms the markets, at least according to game theory. This is all a distraction from the real risks in the global financial system ... Leverage.

Personal leverage and bank leverage are not nearly as risky as the last downturn. Most banks have seen an increase in regulatory oversight and tougher stress tests that ensure liquidity as we have somewhat learned our lesson at the financial level. The government itself has no true watchdog though and our Debt/GDP already surpassed the 100% threshold even without accounting for unfunded liabilities. 

Personal leverage has also been somewhat muted. But the corporate sector has seen a material increase in leverage and is the most vulnerable. The chart below from Morgan Stanley shows the Federal Reserve's calculations of debt at the corporate level in the U.S. as a % of GDP. The low rate environment and benign economic outlook has sent corporate officers seeking returns on equity the old fashioned way... by issuing debt to repurchase stock. 

As explained in a prior blog "The Next Recession" when a corporation issues debt to repurchase stock, they increase the Return on Equity (ROE) as the denominator usually shrinks by more than the decrease in the numerator. When interest rates are low a corporate CFO can issue debt with minimal earnings degradation. Net Income shrinks by the incremental minimal interest expense that itself is partially offset by tax benefits as interest expense is a tax deductible write-off. But the denominator decreases by more as the share count drop from the stock buyback. The effect is an immediate increase in ROE making the CFO look smart. The company can highlight their apparent growth even in the absence of true organic growth. The risk is if the trend lets you get carried away by keeping rates low for too long, and that seems to be what is happening based on the chart above. 

Debt funded stock buybacks are of course not the only culprit for the excess leverage. We also have increasing growth rates with the latest GDP print crossing 4%. That encourages more borrowing as corporate executives try to take advantage of the reported growth by issuing debt for acquisitions and capital expenditures. 

But if the economy turns south, if rate hikes force a change in our bullish perception, if Italy defaults or if some unexpected event strikes the economy as it usually does, the elevated leverage in the financial system will compound the downturn. And unlike the last decade's recession, we won't have the government's relatively clean balance sheet to provide any backstop this time. 

Dan Shainberg
#DanShainberg
#RecessionResister
@DanShainberg

Where Has All the Inflation Gone?

Dan Shainberg

September 12, 2018

The PPI is an economic indicator of the CPI. Also known as the Producer Price Index, the PPI measures the average change in prices received by domestic producers of goods and services. It differs from the CPI in that the measurement is from the perspective of the seller's prices versus the CPI which measures price changes from the purchaser's perspective.

Why is the PPI relevant? Because as a leading inflation indicator it may predict inflation trends which are strongly correlated to the outlook for interest rates. And the economy is highly correlated to the rate of change in actual interest rates and the pace of change in rates versus expectations. With a lack of inflation the Fed would not need to raise interest rates or raise them as quickly as expected. By keeping rates lower for longer, the economy is more likely to continue its record of strong growth. Investors can borrow at relatively cheap rates, consumers can pay for goods they otherwise would not be able to afford and business activity rolls on. Of course this all may be increasing the likelihood and severity of the next downturn, but it still allows investors and economists to glimps into the near term outlook for the economy and markets barring unexpected surprises.

Today the wholesale inflation report fell for first time in 18 months. The PPI dropped 0.1% in the August report. The drop was the first since February 2017. Over the past 18 months the Fed has clearly changed its posture to a more aggressive tightening stance to combat the early signs of inflation. The labor market is tight and wages are increasing. The central bank is still expected to raise rates again this month and once again prior to the end of the year.

But ultimately the future pace of rate hikes likely rests on expectations for inflation and this PPI data may provide a glimpse into that trend. Or it may not! It could easily just be a blip tied to the way the calculation is reported as many economists who analyze the index have pointed to its recent overweighting in the retail and transportation sectors which are more service oriented and carry lower margins. This could have the effect of nominally changing the output from the index while not really explaining anything materially important about true inflation in the economy.

Dan Shainberg
#DanShainberg
#RecessionResister
@DanShainberg

A Decade Since the Great Recession

Dan Shainberg

September 10, 2018

Everyone wants to know the future catalyst that will pop the current economic expansion. It could come from a political surprise, or an emerging markets crises, or an inflation scare. Or it could come from something totally unexpected, as it usually does. 

It is extremely difficult to read into current economic indicators to foresee the timing of such a reversal in the economy. The economic figures bounced all over CNBC and Wall Street trading floors are not only usually lagging indicators, but they also are the wrong metrics to look at. Metrics like unemployment trends, CPI and GDP are "income statement" data. They account for performance trends over a specific period of time. And that is precisely the problem when using these data points to try to attempt at forecasting the next recession.

The key to this economic expansion du jour is that the likely tailwind propelling the growth is the numerous rounds of quantitative easing ("QE"). Recent political and regulatory changes under the Trump administration may have inflated the outlook causing market multiples to rise. However, the true underlying economic expansion began with QE1 after the great recession of 2008. It is universally accepted that the catalyst for the upturn in the economy and markets was due to the monetary injections of QE and the resulting expansion of the Fed's balance sheet. We are now seeing some uncertainty as to whether or not they can change course to more of a tightening posture without blowing up the economy. The key is the balance sheet. Not the income statement. 

All debt cycles go through stages. We are at an interesting point in the economic cycle as the Fed already swung from a "loosening" to a "tightening." Getting the money supply balance right is paramount for maintaining a growing economy. Capitalist markets always have these cyclical trends. If one can understand the historical cyclical factors and reference the right balance sheet metrics of today's cycle, then it is possible to forecast the next downturn. 

The debt fueled economic downturns of emerging markets caused by inflation have almost always had a levered sovereign government that could not repay foreign denominated debt. Obviously the United States today is not comparable because our debts are denominated in our domestic currency and thus we can print our way out of the debt crises with a loose monetary policy.

In such cases where government's have the debt denominated in their local currency they can avoid catastrophe as long as they do not fail with central banking policies. If you narrow down the problem the U.S. faces, it is a simple leverage issue. We have way too much Debt relative to our GDP. 

The numerator is the debt and the denominator is the GDP. The debts are relatively fixed and unlikely to be the primary catalyst to improve the formula as there's way too much debt per person in the U.S. and even less when factoring in only taxpaying citizens. Reducing debt would help the financial formula although it could also cause more harm if it causes the economy to turn down which is essentially the denominator. 

Like corporations, the easiest way to delever is not through actually paying off the debt, it is through economic expansion. As an example, in California, owners of real estate have seen tremendous wealth generation from real estate ownership over the past decade. In almost all cases, this strong ROI investment was not caused from real estate owners actually paying off transaction related mortgage notes. It came from the value of the property itself appreciating.

Similarly, for the Debt/GDP formula to improve meaningfully, we have to get economic growth moving. The only true path to macroeconomic nirvana comes through a healthy approach to interest rates. If interest rates are tightened too quickly, the economy sputters and leverage increases due to the denominator declining. If interest rate policy is balanced well with inflation, then the GDP can continue to grow thus reducing leverage. But the beauty of keeping inflation and the economy in a healthy growth mode is that inflation also has the effect of reducing the debt in real terms. The U.S. national debt is not adjusted to inflation (CPI). 

If the government can keep inflation and GDP growing at a stable level then we can reduce our balance sheet problem over time to at least a manageable level that would allow for the typical inflationary responses to the next crises.

Dan Shainberg

#DanShainberg

#RecessionResister

@DanShainberg