Posted on: Monday, January 4, 2016
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Difference between Past Fed Tightening and Now
Cycle of Deflation --Authored by Comstock Partners 

A reporter asked us about the prospects of the stock market if the Fed raises the Fed Funds rate, since at the time there was a strong possibility of a rise in the rate to around 25 basis points.  We explained that, in our opinion, the ending of the ZIRP (Zero Interest Rate Policy) and increase in Fed Funds will be a significant negative for the stock market.  The reporter asked why this is a negative since many times when the Fed raised rates in the past, the stock market also rose.  We explained that the difference between the Fed raising rates in the past and today is that raising rates now has a lot more to overcome than in the past. We then explained the difference.

Difference between Past Fed Tightening and Now

  1. ZIRP has been going on for the past 84 months (7 years) and will probably now end.  During the past 7 years with interest rates far below where they should have been, investments in risk assets are much higher now than they would have typically been.  Also, the Quantitative Easing (QE) 1, 2, and 3 has ended after years of the Fed starting and stopping major purchases of Treasury Bonds and Mortgage Backed Securities.  Whenever they stopped the purchases in the past the stock market declined. 
  2. This time the Fed is raising interest rates right into the face of a profits recession as well as a manufacturing recession (both down at least 2 quarters in a row).
  3. This time the Fed has grown its balance sheet since the “great recession” from about $800 bn. to over $4.5 tn.  This enormous amount of money has to eventually be wound down.  This injection of money printed by the Fed has not driven us into an inflationary environment because there is very little “Velocity” (or transactions) associated with the liquidity.  This is because of the “Liquidity Trap”.  A liquidity trap is caused when people hoard cash because they expect an adverse event such as deflation, insufficient aggregate demand, or war.  Common characteristics of a liquidity trap are interest rates that are close to zero and fluctuations in the money supply that fail to translate into fluctuations in price levels.  Japan went through this process (back and forth) for the past 26 years since the high debt they generated caused a deflationary environment.
  4. Our Government debt is not just the $18-$19 tn that all the Presidential candidates constantly talk about.  That amount is much lower than the actual government debt.  If you include the unfunded liabilities and entitlement promises the government debt skyrockets to over $100 tn.
  5. Global debt has grown by just about double the global GDP over the past 10 years and over indebtedness causes deflation.  In the U.S. the Fed made sure we had plenty of money over the past 7 years with QE and ZIRP. Easy money is the cause of indebtedness and as we said before, over-indebtedness is the cause of deflation.  We will attach the “Cycle of Deflation”, which we authored years ago, to explain exactly what takes place after excess debt drives weakness in pricing power.  The Bloomberg Commodity index is at its lowest level since 1999 and is not far from its lowest level since the start of the index in 1991. Virtually all commodities are “canaries in the coal mine” warning of a global recession.  These commodity price declines are all you need to see in order to put everyone on guard for a significant recession.  Don’t let anyone convince you that the reason for the declines are all related to over-supply.  OPEC as well as Russia and the U.S. are continuing to pump oil and Iran is trying desperately to get rid of the sanctions that are holding them back from selling more oil (they would love to add another 500,000 barrels of oil to the world’s supply).  Also, there are some crops that are plentiful, but the main reason for most of the commodity declines is a lack of “demand”!  It is the slowdown in demand that starts most commodity price declines, and they continue to decline as businesses refuse to close down plants, and mines that keep pumping out their commodities in the face of the slowing demand.  It is difficult to reduce the supply as the mining and oil companies do whatever they can to maintain or increase their market share.  The only way to stop the mines from producing commodities is for them to go bankrupt.  It is hard to imagine continuing to pump out commodities (like copper and iron ore), while at the same time there is a worldwide slowdown occurring. China is slowing at the same time it is having environmental problems, and Japan just emerged from a recession that saved them from going through 5 recessions in 5 years.  Brazil and Ireland are already in recessions.  Europe is also struggling, and if we do slip into a global recession the stock markets worldwide will be a disaster along with the commodities. 
  6. U.S. stock market valuations are also extended and if the employment rate stays low there will be wage pressures which probably will affect profit margins that are at extremely high levels now.  The market is trading around 17 – 18 times earnings and if profit margins come down it will also be very negative for the US stock market.  Also, Robert Shiller’s CAPE (Cyclically adjusted PE ratio—take the S&P 500 and divide by the average of 10 years of earnings) shows that US stocks are around 50% to 60% overvalued. 
  7. In the past when the Fed was raising interest rates corporations were making normal capital expenditures.  Presently most corporations have been replacing cap-ex by borrowing money to buy-back their own shares in order to increase their earnings per share (EPS) as well as increase the stock price.  The announced buybacks in 2015 reached close to $1.2 tn., which shattered the prior yearly record of $863 bn. in 2007. 
  8. Geopolitics—The US and even the rest of the globe will have potential terrorism problems for some time until we can contain or deal with ISIS.
  9. Because of the US dollar’s rise, and probably continued rise as rates move higher, it will be more difficult to compete with our trading partners.  Most of our trading partners are participating in a race to the bottom as they do whatever they can to lower their currency.  This is called a “Currency War”.  And even with the fanatical lowering of rates and currencies, Brazil, South Africa, Russia and other countries that are tied to commodities (which are in a deflationary downtrend) are still doing worse than us economically. Of course, if the spread of interest rates and their currencies continue it will not be good for the U.S. long-term.  The best signals to watch for will be the high yield spread widening, and a flattening yield curve that turns inverted.      

Will all of these Headwinds be the Catalyst for a U.S. Recession or even a Global Recession?

The most controversial question for 2016 and 2017 is whether the U.S. will collapse into a recession ….one that could wind up as a global recession?  In mid-year 2016 we will have 8 years of global expansion even though the expansion in the U.S. has been one of the weakest expansions on record.  Global recessions typically occur on the average of about 8 years.  This potential recession may not be due to the U.S. consumer because unemployment has improved and wages are finally starting to rise after 20 years of stagnation in real wages.  Oil and food prices declined significantly, but have been somewhat offset by health care costs and apartment rentals.  Also, the unemployment rate is partially distorted since the labor force participation is near a 40 year low.  Even though there could be a consumer produced U.S. or global recession, the greater risk is the American export sector, which has been a larger factor in the weak recovery due to the dollar’s rise and if the dollar, as well as rates, rise in 2016 watch out for a recession.  

Now that the Fed has started its tightening policy whereas almost all other parts of the world are now following the Fed’s easy money position, this will take the global economy into the awkward position of easing as the U.S. is tightening.  This will probably cause interest rates and the currencies of our trading partners to decline just as they are starting to rise in the U.S.  This will put pressure on the U.S. manufacturing sector and will probably drive the U.S. into a recession while our trading partners could prosper.  The manufacturing sector is important to the U.S. economy because it has provided many of the skilled jobs in the U.S.  This may seem fine for the global economy until the world’s largest economy pulls down the global economy as we did in 2007 and 2008 with the housing bubble bursting.  Keep in mind that the bubbles of the dot coms in the late 1990s, housing in 2007, and now central banks have had an enormous negative influence abroad.  We discussed this in many comments in 2006, 2007, and 2008 (just type “housing” in the archives of our comments to see how many times we warned our viewers about the housing bubble and you can do the same for the dot com bubble and central bank bubble).  It was the Fed that drove us into the housing bubble and it was also the Fed that was oblivious to the U.S. having the most expensive valuations in the world during the dot com bubble.  You would have to reach far and wide to find a market more expensive than the U.S. stock market (especially NASDAQ) in the late 1990s (maybe the tulip bulb mania of the 1600s). 

We believe strongly that the Fed will be to blame for the central bank bubble we find ourselves immersed in presently.  After all, it was the Fed (under Greenspan) that missed the dot com valuations, and it was the Fed that lowered rates to 1% in June of 2003 that brought on the housing bubble with virtually no discipline of the banks and other mortgage lenders.  When the credit markets and housing markets imploded in 2007-2008, driving the U.S. into the “great recession”, the Fed resorted to whatever it took to save our economy from collapsing into another depression.  As stated previously, the measures the Fed took in the “central bank bubble” and inspired other central bankers to follow our lead (like QE and dramatic increases in the balance sheet) could be worse than the dot com bubble and housing bubble combined.  When this breaks there will be no shortage of business school textbooks about the inter-relationships between these three bubbles.

Another reason we are skeptical about the U.S. economy avoiding a recession in 2016 is because of the breadth being as weak as it was in 2015.  The top 10 companies in the S&P 500 accounted for virtually all the gains, but were overwhelmed by the 490 stocks that accounted for the decline in the index.  This is also true about the number of stocks in the S&P 500 above the 10 day, 150 day and 200 day moving averages.  We are also very concerned about the unsustainable path of the entitlements in our country.  We have to elect the politicians who can get us on a sustainable path for the promises we made for the Affordable Care Act, Social Security, Medicare, and Medicaid by increasing the retirement age, means testing, and adjusting for inflation properly (for the ACA we need a program that doesn’t increase the premiums while making sure we increase the participants).   

In fact, we believe the Fed’s decisions over the past 20 years were instrumental in the dot com and housing bubbles.  In the Fed’s mind they have done everything possible (including increasing their balance sheet from $800 bn. to $4.5tn.) to resurrect the U.S. economy.  Instead, their legacy will be tarnished by the outrageous policies that were used over the past 8 years, and in our view, will not result in the salvaging of our economy, but rather what may become one of the greatest destructions of wealth in history.

We hope that we satisfied the reporter’s question about why the stock market may not do well this year.  Keep in mind, every time the Fed raised rates in the past, there was never a time that the financial environment was even close to being this difficult.  In fact, the only time we can remember the Fed raising rates while interest rates were very low like now, was in 1937, and that drove us into another recession on top of the great depression.    

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