The recent turbulence in our global financial markets has analysts spooked and well before Halloween. October is typically a bad month for equities, if history has anything to say about it. The recent rocky spot in the markets, however, sent shivers down the spines of far too many edgy people, who are now having nightmares of carnage in the streets, namely Wall Street. As if timing is everything, JPMorgan Chase released a study that purports that a recession in the next year has a 28% probability of happening and a 60% chance within two years, 80% in three. Yes, recession fires have been ignited again, although most conservative models show nothing on the near-term horizon.
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A potential reversal in the Yield Curve had been the loudest topic on the financial beat for months, but its sizzle soon dissipated when yields for 10-Year Treasures leapt over 3%, a first in quite a while. The main point was that a yield curve reversal was our most reliable indicator for signaling an imminent recessionary trend, if only 12 to 18 months down the road, as verified by the chart presented below:
According to Bloomberg: “The J.P. Morgan model calculates outcomes based on the length of the economic expansion, the potential duration of the next recession, the degree of leverage, asset-price valuations and the level of deregulation and financial innovation before the crisis. Assuming an average-length recession, the model came up with the following peak-to-trough performance estimates for different asset classes in the next crisis:
- A U.S. stock slide of about 20%.
- A jump in U.S. corporate-bond yield premiums of about 1.15 percentage points.
- A 35% tumble in energy prices and 29% slump in base metals.
- A 2.79 percentage point widening in spreads on emerging-nation government debt.
- A 48% slide in emerging-market stocks, and a 14.4% drop in emerging currencies.”
First reviews of these alarms note them as “tame”, considering the prognostications of gloom and doom that have been heard from non-believers of the longevity possibilities of this Bull Market. During the last recession, the S&P 500 fell 54%. Much of the projected slide in emerging markets has already transpired, if that can be seen as some solace at this stage, but the depth and length of the oncoming recession is the worrisome issue that confronts the investment industry. Many well-respected insiders have warned that systematic trading will zap whatever liquidity is overflowing at the moment and central bankers will have no tools at their disposable to stem the tsunami’s flood waters.
The emerging market rout may have defused this scenario to a degree, but the authors of this study, based upon their analysis of past episodes, remarked that, “The longer a recession lasts, typically the bigger the hit to markets. The recession’s duration is a powerful drag on returns, which should dovetail with some readers’ concerns that policy makers lack the necessary monetary and fiscal space to extract economies from the next recession”. A massive boost in global liquidity was the answer ten years back, but cheap credit created a host of what many have called “Zombie Companies”, which will collapse the moment interest rates surge. Their jobs will collapse, as well.
Is it time to get really worried about the “Big Crunch” to come? Gold promoters have stoked their advertising budgets, pushing gold coins and ingots across the Internet and any televised network that will air their siren songs, a sure sign that they are licking their respective chops and salivating for a kill. Is the greatest Bull Market really coming to an end and soon? Are emerging markets still perched upon a precipice? Is a yield-curve reversal still in the cards? All queries are food for thought at this time in our journey, but as Yogi Berra said: “When you come to a fork in the road, take it!”
Does our record-breaking Bull Market still have more room to run?
Everyone loves a winner, but rarely can a winner avoid a losing streak, unless it can somehow retire from the pursuit of perfection. Financial markets do not have that option, but knowing what the triggers might be in order to forecast a sudden bout of back peddling can give one an advantage for when the sky actually falls. But where do we start? The global economy is now entwined like never before, and central bankers have restrained market forces for so long that an orderly unwinding may not happen.
One clever analyst recently suggested that the best way to find a clue was as follows: “One straightforward approach to is to follow the money, i.e. global capital flows: assets that attract positive global capital flows will continue rising if demand for the assets exceeds supply, and assets that are being liquidated as capital flees the asset class (i.e. negative capital flows) will decline in price.” He also noted that tracking global capital flows is not the easiest task in the world, primarily because these liquid assets flow through a host of “shadow” banks, corporations, and holding companies that are not subject to reporting rules, disclosures of ownership, or providing wonderful audit trails for tax collectors. In other words, employ your best guesstimates, when necessary.
This analyst, Charles Hugh Smith, chose to start with a report issued by a group that is very familiar with global capital flows, especially to safe havens and outside the purview of taxing authorities, i.e., Swiss bankers: “Despite the limitations of tracking global wealth, Credit Suisse Research Institute’s (CSRI) Global Wealth Report 2017 gives us some clues about where capital is flowing in and where it’s leaving for safer, higher-yield climes”. The initial premise or directive, if you will, is to note that global wealth is concentrated at the top, extremely concentrated, as this “pyramid” reveals:
The alarming figure of 8% of the world’s population controlling 85% of all global wealth is a signal that capital flows are not homogenously distributed. They are very concentrated, such that the $300 trillion or so of available securities around the world could turnover quite rapidly, as long as liquidity permitted, and we are not talking about popular fads, i.e., cryptocurrencies, which do not comprise one tenth of one percent of this total.
Since the financial meltdown of a decade back, smart money has been seeking yield across the planet. The rich got richer, and, as every forex trader knows, the most common vehicle used was the ubiquitous “carry trade”. Investors this time around, however, were clever enough to use other peoples’ money, so to speak. We know, for example, that much of the funny money used has come from the dramatic increase in global debt deployed since the millennium crossover – see chart below:
Credit Suisse believes these capital flows began reverting back to the U.S., as the greenback rebounded in 2015. For a carry trade to be effective, you must avoid leaving your funds where the local currency is depreciating. These flows, together with corporate stock buyback programs, created “a gargantuan inflation in assets, while real-economy wages and GDP have stagnated.” Can anyone spell “asset bubble”?
What are the folks at Credit Suisse telling us? Once you “follow the money”, you are left with the realization that most of it has parked itself in the United States, where interest rates are favorable, currency stability is not an issue, but the U.S. cannot “win” forever. The conclusion of the report is compelling: “Smart money is mobile, opaque and constantly on the move seeking safety, tax shelters, yield and capital gains. If mobile capital continues flowing into U.S. assets such that demand exceeds supply, the Bull Market will continue sloshing higher. Once supply exceeds demand and capital starts liquidating U.S. assets, the Bull Market will end, perhaps with a whimper (stagnation) or with a bang (crash). Capital flows will dictate the outcome.”
As for yield-curve reversals, is it still a possibility any time soon?
We started this article by noting the attention that had been given to yield curves and their propensity for predicting an oncoming recession. The curious thing, however, is that when long-term Treasuries suddenly surged a week or two ago, market mavens were not approving of that outcome either. The spread between 2 and 10-Year Treasuries expanded, thereby halting the infamous reversal from occurring, but champagne corks were not popping. The fear then, it seems, was that the Fed would overreact to an overheated economy, slam on the brakes, and deliver a recession right on cue.
What is going on in the minds of men? Do all roads point to recession? Another analyst, Kevin Karty, answered this question with a question of his own: “The key question is whether the yield curve is still a good predictor, and this question hinges on Goodhart’s Law, i.e., “When the measure becomes the target, it ceases to be a good measure”. Essentially, will all of the attention on the yield curve ruin its reliability?” He contends that, “Economists do not yet know exactly why the yield curve predicts recessions, though there are many theories.” In other words, the correlation of recessions with yield-curve inversions does not get to the actual causes, such that preventing the dreaded inversion will not necessarily prevent a recession from occurring.
The 80-year history of yield-curve inversions predicting recessions has never had to deal with a decade-long period of central bank manipulation. Raising its benchmark interest rate another 100 basis points in the coming year, along with unloading long-term securities on its balance sheet (the other Normalization program that no one talks about), could act as a catalyst for sending mortgage rates through the roof. The housing industry is already shivering due to tax changes and rising rates. Pouring gasoline on that fire may surely bring a recession, even if the yield curve never flattens. Mr. Karty cautions that, “Assuming the Fed goes through with its plans, we are highly likely to experience a good bit of excitement in the next few years. Indeed, the excitement seems to have already begun.”
Is this Bull Market about to end? Despite the recent 5% correction, various sentiment polls reflect more Bullish optimism, and Bears have yet to pierce a meaningful threshold of pessimism, even thought Emerging Markets are still at peril. The yield curve is steepening, a welcomed sign, but is that really a cause for celebration? Has the damage already been done? Are the consequences of central bank market manipulation across the globe finally at our door? The plot thickens – “Indeed, the excitement seems to have already begun.” Stay tuned! More drama to unfold, as the global ledger turns!