Comstock Partners, Inc.July 06, 2017
A RECESSION COULD BE COMING
And Asset Bubbles Caused by Central Banks May Burst
The Wall Street Journal recently published an article by Greg Ip entitled “Why Soaring Assets and Low Unemployment Mean It’s Time to Start Worrying”. While Mr. Ip stops short of predicting a recession or its timing, he details a list of preconditions for recession, all which exist now. These include a labor market at full strength, frothy asset prices, tightening by central banks, and a pervasive sense of calm, as illustrated by the very low levels of the VIX Index.
At the same time, the Fed, led by Janet Yellen, continues the narrative that they will normalize interest rates while slowly reducing the Fed balance sheet. This follows what we believe was an insane monetary experiment beginning with the bursting of the “Housing Bubble” in 2008 and lasting until the present day. The Fed would have you believe that its policies, after helping the economy avoid an outright collapse, have helped the economy grow at a moderate rate with low inflation. In our view, the word moderate is a gross overstatement. We think the better description is “anemic”, because no recovery since the Great Depression has been as slow as this one, even though it’s the second longest in the country’s history.
As the situation now stands, the trailing 12 month (TTM) P/E ratio of the S&P 500 based on GAAP (Generally Accepted Accounting Principles) earnings stands at just over 24X, which is among the most expensive in history. A casual observer might think, therefore, that a TTM P/E of 24X means that the stock market is expecting growth to accelerate. After all, there is no shortage of television commentators and portfolio managers that think we are on the path to an accelerating economy. All one needs to do is tune into any of the financial news networks to confirm that observation.
We do not agree with that assessment, and to no surprise, neither does the bond market. One of the most telling indicators of what the bond market “sees” as prospects for economic growth is the spread between 10 year and 30 year US Government Bonds. The steeper the slope of the yield curve, the more the bond market sees growth, and vice versa. So for the month ending 6/30/17 the 10 year to 30 year spread closed at 53 basis points. To find a lower monthly close for that series, one has to go all the way back to December of 2008, just as the effects of the bursting of the “Housing Bubble” were hitting with full force. So while the stock market “sees” prospects for growth as strong, as evidenced by the 24X TTM P/E, the bond market is just the opposite. Not only is the yield curve relatively flat, but the absolute level of bond yields are also very low. It should be also noted that an inversion in the yield curve, should that occur, would be a clear alarm bell as it pertains to the possibility of a recession. In the past, on the 12 occasions when the yield curve has been this flat, according to Mr. Ip, it went on to invert on 10 of those occasions.
In our view, the Fed, European Central Bank (ECB) and Bank of Japan (BOJ) all recognize that the main result of the massive money printing, and the low to negative interest rates of the last several years have done little more than increase the value of financial assets rather than generating solid economic growth. We, and others, have said as much for quite some time now. We also believe the central banks are “between a rock and a hard place”. They realize the need to not burst the “bubble”, but on the other hand, they do not want to negatively affect the already anemic economic growth rates of their respective economies. So the Fed continues on the path to “normalization”, speaking of one more rate increase this year and three each in 2018 and 2019. We agree with the Fed Funds market, which is calling the Fed’s bluff. The futures market on Fed Funds is priced for one increase this year and only one each in the next two.
The Fed is, of course, fully aware of the fact that of the thirteen tightening cycles since the Great Depression, ten of those were followed by recession. So the odds are not good, as we see them. We think the bond market will prove to be right and the stock market will prove to be wrong. As we have written in the past, the economy is swimming against a stream of rising debt, unfunded federal, state and local liabilities, low productivity growth, and negative labor force demographics. At the same time, the booming stock market has been partially fueled both by stock buybacks (that strip equity from shareholders, as in the money stock options are exercised by corporate managements) and “yield chasing” by return starved investors around the world.
Whether the Fed tightens aggressively,or not, remains to be seen. But in our view the damage has already been done by its policies and those of the other major central banks. Years of artificially low interest rates have resulted in mal investment and asset bubbles. When the market does start down in earnest, our view is that the move will be large and rapid. We believe it will then take considerable time, as in years, for the stock market to get back to highs that were achieved courtesy of "The Central Bank Bubble".