The first week in August has come and gone. Recent economic releases have been positive, even though jobs related data in the U.S. market fell below expectations. The general feeling is that forward momentum will continue, a perfect excuse for taking an extended holiday for the rest of this month, or is it? The stimulative benefit of Trump’s tax plan is at work, but former Federal Reserve chairman Ben Bernanke argued that, “It is going to hit the economy in a big way this year and the next year, and then in 2020, Wile E. Coyote is going to go off the cliff.” GULP! The “Recession Watch” is back on!
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Following Uncle Ben’s remarks in June, a subset of the analyst community has been scurrying about, searching for any possible signs that a business downturn is approaching, even if more than a year out. This group of negativity is quick to remind all of us that the law of gravity will prevail in the end. Our current Bull market just celebrated its ninth birthday, but all good things must come to an end eventually. The questions are always, “When?” and “What triggers will create the dreaded “Liquidity Crunch”?”
Is the current positive economic picture a flash in the pan or a long-term trend?
The vast majority of writers, bankers, economists, and analysts continue to say, although with a caveat or two, that the current recovery is strong, that its underpinnings are solid, and that, even though GDP growth rates remain at unremarkable levels, the forecast is for more of the same – gradual growth with no signs of an imminent downturn on any horizon. Trump’s tax plan, believe it or not, will stimulate something somewhere, if only the wealthy having to find a new place to stash their undeserved windfalls.
GDP growth for the last quarter topped 4%, a psychological barrier for sure, and the two previous quarters were also adjusted upward. For those naysayers out there, their position is that the effects of these monetary changes will be illusory, like snow in a hot desert, they will quickly disappear. Others disagree, as per this analyst: “Americans should be patient before deciding what effect President Donald Trump’s tax cuts have had on the economy. It takes a while for companies to make investment decisions, more time for those decisions to be implemented and even more time for the resulting changes in labor demand to bid up workers’ wages. It therefore takes months or even years before the full impact of the tax bill will be known.”
As for caveats, analysts focus on job and wage data. The latest release of Non-Farm Payroll net new jobs created is embodied in the diagram presented below:
The presumption is that the signing of the tax plan changes in February was enough to put a fire under the hiring engine, but has it also slowed down of late? The threat of tariffs has also put a fire under the import/export trade, as pipeline sales have been rushed to market, presumably before the impacts of new tariffs take effect. Yet, the general opinion is that momentum will carry on through the last half of the year, even though activity may begin to slow by the first half of 2019.
Inflation is also behaving as expected, to a degree, as depicted below:
The Fed has made it known in the past that they prefer the PCE Price Index to CPI, but whichever one you prefer, the proverbial target of 2% is ever present in both of the charts for the U.S. market. If the EU could ever perform to this standard, as espoused by Mario Draghi and the ECB, then the world economy would be a different place altogether. If inflation were to shoot northward, as many economists have lately been suggesting, then the Fed may have to push interest rates up the scale more quickly than their previous announcements.
What then is the problem? Looks like all engines are performing. Where is the fly in this ointment? The concern goes as follows: If the U.S. economy is at full employment per definition, then why do we not see labor demand pulling wages higher? Yes, wages have grown, but only along with inflation, not above it. There must still be slack in the system that is unaccounted for, but on a real, inflation-adjusted basis, wages have been flat for the workingman for two decades. Without raises in disposable income, our service-driven economies in the developed countries across the planet cannot get off the dime, unless debt is the vehicle that enables consumer spending.
Increases in productivity, however, have always led to increases in wages across the board. In this “New Normal”, the old rules do not seem to apply. Productivity gains have been stuck in a lower gear during this recovery, as shown below:
For economists that focus on long-term trends, the elephant in the room is what will be the next technology wave that will generate increases in productivity. Artificial Intelligence (AI) and Robotics have been proffered up as possible “saviors”, but there is not general enthusiasm or consensus surrounding either one of these two suggestions. Neither is all encompassing like the Internet or space-age electronics, the last two waves that are often cited in these types of discussions.
Having followed this logic flow, the general message is still not all gloom and doom. When the Great Recession hit, businesses naturally cut back on R&D and Capital Expenditures, leading to the reduced productivity changes over the past decade. Even though we may see new technology all about us, it is difficult to measure the rate at which it flows into each sector of the economy. Stimulating capital investment in developed countries may be a key objective, but, without improved returns on a domestic basis, new capital flows overseas to greener pastures.
Due to this positive capital flow to developing markets, many economists concede that this “lack-of-investment” trend is reversing, such that there may be hope down the road. Per one analyst: “Within most companies around the globe, in every single industry, technology investment is growing faster than revenues and, in many cases, faster than the GDP of any country. It is clear to all companies that technology is vital to the successful operations of companies and, mainly, to the global economy, but being able to manage technology spending properly within a few years ahead will require an increasingly sophisticated way of looking at the world and at a company’s performance.”
Under present conditions, is a Liquidity Crunch even a possibility?
Whenever assets cannot be easily bought and sold without wild fluctuations in price, then basic liquidity issues suddenly become top of mind. It has only been six months, since the mini-liquidity crunch that occurred in stock markets in February, but memories have been short in this regard. Not all analysts, however, have forgotten. Financial crises tend to follow a liquidity crunch, which may be caused by a dreaded “Black Swan” event or by specific known factors that suddenly reach a tipping point.
Black Swans, by definition, cannot be predicted, but quite a few analysts fear the possible consequences of major central banks withdrawing their various liquidity support programs over the years to come. The Fed, the ECB, the BOE, and the BOJ have flooded the market with liquidity via various quantitative easing and asset purchase initiatives. These actions were supposed to be temporary experiments to boost economic activity, but, after ten years, the tide is finally reversing. Unwinding QE and normalizing balance sheets will now be experiments in the other direction.
The Fed has started normalizing, and other central banks will soon follow suit. The impact is already being felt in emerging markets. Urjit Patel, the Reserve Bank of India Governor, noted recently that, “Dollar funding has evaporated, notably from sovereign debt markets. Emerging markets have witnessed a sharp reversal of foreign capital flows over the past six weeks, often exceeding $5 billion a week. As a result, emerging market bonds and currencies have fallen in value.” There are also signs in other areas where price volatility has accelerated, but alarm bells are not sounding. Caution is advised.
What might be the causes for our next recession?
Liquidity issues not withstanding, most investors are basking in the light of what some have said as, “To be clear, the economy is going gangbusters right now.” The worrisome part, however, is that gravity has to take over at some point. A liquidity event could always trigger a run for the exits, but the concern this time around is that things may be different. It may not be one single thing that knocks the Bull to its knees. It may actually be a series of causes that, when combined, could drag this current business cycle down the recessionary spiral. Current thinking is that three causal candidates stand out:
- The Fed’s Tightrope Conundrum: The Fed is caught between normalizing interest rates and balancing a growing economy. As tax benefits wane, the probability of raising rates too quickly while the economy is overheating is a distinct possibility. A “perfect path” for threading the needle exists, but, as one analyst put it, “It’s not one you’d want to be betting the farm on.”
- Corporate Debt Bubble Goes Pop: Low interest rates have allowed capital to flow into many economically unjustified sectors of global commerce. More debt has gone to riskier borrowers. If interest rates rise materially, defaults will be pronounced, but, hopefully, more isolated than in previous crises.
- Trade War Aftermath: The total trade tariffs proposed, even if exaggerated, are but a small percentage of global GDP. From that perspective, tariff repercussions may be slight, but they will be uneven, causing possible erosions in business confidence.
August is always a delightful time of year, when sandy beaches and the smell of sea air call your name. Financial markets are typically receptive to this venturesome way of thinking, making a decision to get away more probable than not. Is anything different this time around? Yes, investors will always find worrisome topics to worry about, as will the analysts that write copy for their proprietary newsletters, but things are different this time around. The global central banking “experiment” is beginning to unwind, and the consequences are uncertain, as to how it might unravel over time and as to where its negative impacts might be more severely felt.
More pronounced price volatility is a certainty. De-leveraging and de-risking strategies may be worth your consideration. New opportunities will present themselves, as well.
In any event, be cautious, and be prepared!