Milan Seminar: November 19 — With Anatole Kaletsky & Cedric Gemehl

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Goldilocks And The Ten Grizzly Bears

Records are made to be broken. So the fact that November will likely be  the 13th consecutive month of rising stock prices on Wall Street, breaking  previous record winning streaks that only lasted for 12 months (in 1935-36 and 1949-50), does not mean that December will be a month of losses. If anything, normal seasonality suggests that 2017 will be the first year in Wall Street history without a single down month. But this momentum cannot continue forever. Even if I turn out to be right in my expectation that the market trend will continue for years ahead (see This Is (Still) Not A Peak: It’s A Global Bull Market), the end of a record-breaking year is a good time to consider what events could prove me wrong.

The risks that worry most investors are the long-term structural financial flaws that were manifested in the 2008-09 crisis, that have not been repaired and may even have been aggravated by the subsequent response.

On May 20, 2013, one day before Ben Bernanke’s “taper tantrum” speech, I wrote an article called Goldilocks And The Ten Bears. In it I argued that the bull market on Wall Street was only just getting going and would not be reversed by unsustainable monetary policies, unreformed banking systems, supposedly profligate governments, high corporate leverage and weak productivity growth. Today, the S&P 500 is 60% higher than in May 2013 and my lack of concern about so-called “structural headwinds” seems to have been right. So, what should investors worry about today?

In my opinion, they should focus on cyclical, financial and policy risks which could transform market conditions in the next year or two. And just as in 2013 we should not get distracted by structural arguments about debt, public spending, central bank balance sheets and so on, which investors have been debating for decades, and which are, by definition, long-term issues unlikely to create sudden market reversals in a matter of months. Here, then, is a summary of what I now see as the biggest risks to the bull market—ten genuinely bearish events, that could threaten Goldilocks in the next year or two. In the coming months, I plan to focus in a lot more detail on some of these real cyclical grizzlies, as opposed to the fairly harmless structural teddy bears I considered back in 2013. 

To provide what I hope is a clearer analytical framework, my ten risks to the global economic expansion and equity bull market can be divided into three broad categories: (i) cyclical risks that tend to develop in the late phase of an economic cycle; (ii) financial risks created by the bull market itself (iii) policy risks caused by social, political or geopolitical events.

At present, none of these risks seems very likely to materialize and some are mutually exclusive (e.g. a Wicksellian recession and accelerating inflation). So trying to hedge against them is probably premature. But it is worth watching economic data, geopolitical developments and market behavior closely so as to be ready should the evidence change.

Category 1— The US cycle suffering diseases of old age

Cycles don’t just “die of old age”, but old age does make the cycle vulnerable to fatal diseases.

#1: Late-cycle slowdown

The Austrian approach to economic cycles often cited by Charles and Will predicts recession when business investment costs exceed what Knut Wicksell called the “natural” interest rate, which is roughly equal to the structural growth rate of nominal GDP. As a guide to this structural rate, Charles uses 10-year trailing GDP growth, currently 3.1%. With Baa corporate bond yields at 4.3%, a Wicksellian analysis suggests that the US could already be on the brink of recession.

But the focus on investment-led recessions seems to me implausible for two reasons: in modern post-industrial economies, business investment no longer plays the dominant role in driving cycles assumed by early 20th century economists. And even if the Wicksellian emphasis on investment cycles were still relevant, the US structural growth rate is probably much higher than 3%. At present the 10-year trailing growth rate includes the deepest recession and longest price deflation in post-war history. If instead of 3% we posit a structural growth rate of 4% or 5% (2-2.5% real growth plus 2-2.5% inflation), the Wicksellian argument for a late-cycle economic slowdown becomes unpersuasive, or at least very premature. 

#2: Accelerating inflation

The Federal Reserve uses a broadly Wicksellian approach, but arrives at a different conclusion that implies the opposite risk: economic growth and asset prices could soon be threatened by rising inflation. The Fed, like Charles, believes that US structural growth has slowed drastically and it estimates that the “neutral” level of Fed funds (which it calls R*) is 0.75% in real terms, or 2.75% in nominal terms allowing for the 2% inflation target. If the Fed now raises interest rates, as implied by its latest quarterly “dot plot”, this neutral rate will be reached in late 2019. The implication is that inflation is likely to accelerate in the meantime.

Moreover, if the Fed’s estimate of the US structural growth rate turns out to be too low, which seems quite likely—or if faster than expected growth is stimulated by fiscal easing—then inflation could accelerate after the “neutral” rate is reached in 2019. At some point, bond investors will respond to this threat and drive bond yields well above their 2014 highs. If 10-year yields break out of their 2012-17 range of 1.5-3% and rise into the 4-5% range, where they traded before the crisis, equities on P/E multiples of 25x to 30x (or earnings yields of 3.3-4%) could start to look  overvalued.

#3: Pre-emptive Fed tightening

This is the opposite risk to #2 above. The Fed could reassess its economic forecasts upwards and aim to “get ahead of the curve” of rising inflation. The market reaction to faster than expected tightening would almost certainly be negative initially for equities and other risk assets, but probably positive for bonds. A slightly more aggressive Fed—say, a tightening of 100bp next year instead of the 75bp suggested in the dot plot—would probably do no permanent damage to the bull market, since a somewhat tighter monetary policy would extend the prospect of moderate non-inflationary growth. If, however, the Fed funds rate was pushed above the presently projected R* level of 2.75% and if the Fed decided to do this in 2018, instead of waiting until 2020, the markets would be gripped by fears of a recession caused by over-tightening.

These fears might be unjustified, since the true level of neutral interest rates may turn out to be much higher than 2.75%. But nobody could be sure about this at the time. The obvious warning sign of a recession would be an inversion of the yield curve and this might well cause a panic among equity investors. If, on the other hand, bond yields rose moderately along with short rates, this would be a sign that financial conditions were moving back towards pre-crisis normality. The impact on equity markets would then depend on whether rising bond yields stabilized in the 3-4% range or whether yields kept moving up to the 4%+ level that would challenge equity multiples, as mentioned in #2 above.

My hunch is that a slightly more aggressive Fed tightening would ultimately help equity markets by preempting higher inflation and thereby stabilizing bond yields in the 3-4% range for several more years. But the first response to an acceleration of Fed tightening would almost certainly be negative—and this is probably the scenario most likely to cause a serious correction in equity prices next year.

Category 2 — Excessive asset appreciation sparks a crash

Investor complacency followed by irrational exuberance can drive up valuations so far that asset prices crash spontaneously even in economic conditions that seem benign. This kind of “Minsky moment” caused US recessions in 1929, 2000 and 2008.

#4: Excess valuations could lead to a stock market crash

At current valuations, the bond bubble would have to blow up first. The two most popular measures of “fundamental value”—Shiller’s CAPE (a “cyclically adjusted” concept that ignores the wildly varying length and depth of economic cycles, not to mention inflation and interest rates) and Tobin’s Q (a measure of book value that makes no allowance for brands, knowhow, network effects, intellectual property or monopoly power)—are both useless. For the past 30 years, both CAPE and Q have sent out near continuous “sell signals”, telling investors to sit out the two biggest bull markets of all time.

Does this mean that equity prices can rise forever, completely untethered from profits or the underlying value of corporate assets? The answer is obviously no. If US equities appreciated another 20-30%, a 1987-style crash would become quite plausible. Even then, such a crash would probably need a catalyst, most likely an unexpected tightening of monetary policy or an upward inflation blip. But as in 1987, the scale of the market crash could be out of all proportion to the minor event that happened to trigger it. 

#5: Technology stocks—from cyber-currency Ponzi schemes to unrealistic expectations about monopoly business models

While equities generally are not (yet) so over-valued as to threaten a spontaneous crash, there is cause for concern about the most important part of the US stock market: the technology sector. Cyber-currencies have arguably been a Ponzi scheme all along, but now it is clearer than ever that the “greater fool” theory is the force driving Bitcoin. What happens to Bitcoin may have no relevance to broader financial markets, but the mania in cyber-currencies does seem like a canary in the coalmine, pointing to speculative risks in the tech sector as a whole.

Valuations for mega-cap tech stocks like Apple, Google and Facebook, may appear reasonable, or even cheap, but only if their business models— now based on monopoly rent-extraction as much as on innovation—prove politically sustainable (see #9 below). Meanwhile, many unprofitable technology companies, like Netflix and Tesla in public markets, Uber and Airbnb in private markets, and hundreds of aspiring imitators supported by venture capital, are attracting wildly speculative valuations in the hope that they turn network effects and “first mover advantage” into the same kind of unassailable global monopolies enjoyed by Google or Facebook. These hopes are bound to be dashed in most cases—and a major disappointment of this kind could undermine tech valuations at any time, especially if the timing coincides with some kind of regulatory attack or market setback for the mega-cap tech stocks.  

Category 3 — Policy changes that sabotage the expansion

The first Iraq war prematurely ended the US cycle in 1990 and political crises aborted Europe’s economic recovery in 2010-13. Although the Brexit and Trump votes did not have the immediate economic impact widely expected, the jury is still out on the medium-term consequences of these events and other political shocks. Below are five political shocks that could reverse the bull market within the next year or two.

#6: Oil shock

Every US or global recession in the past 50 years has been preceded by a doubling or more of oil prices, but not every doubling of oil prices has been followed by recession. The average world oil price has more than doubled from a low of US$27/bbl in February 2016 to around US$60/bbl today. While US$60/bbl or even US$70 probably does not pose any serious risk to the world economy, if the oil price were to rise above US$70/bbl the resulting combination of inflationary price pressure and demand contraction could prove lethal to global financial conditions and economic growth. From 2011 to 2014, central banks treated high oil prices as a deflationary phenomenon and responded with monetary accommodation. But in today’s strong cyclical conditions, the Fed would almost certainly tighten more aggressively in response to energy inflation, and even the European Central Bank might reconsider its ultra-stimulative policy if oil boosted headline inflation towards 2%.

I still believe, as I have since 2014, that around US$50/bbl is a natural ceiling for oil prices, as this price offers US shale producers a strong incentive to boost output. But my view that shale oil will create a permanent ceiling for global oil prices is now being severely challenged by an apparent change in the time-horizons of Saudi, Russian and Iranian politics. If the new oil cartel tries to push Brent crude above the 2015 peak of US$68/bbl, momentum could take over and propel the oil price all the way to US$80/bbl or even beyond. In that case, a burst of inflation and/or monetary tightening could trigger a severe setback in all assets and quite possibly cause a US-led recession. This sequence of events is in my view still unlikely, for the reasons explained on Tuesday (see A Regime Change For Oil?), but it now presents the single biggest risk to the bull market.

#7: US fiscal stimulus

A big fiscal stimulus applied to an economy already nearing its capacity limits increases the risk of either an upside inflation surprise and/or an unanticipated monetary tightening.  This suggests a contrarian view of the tax cuts—successful passage of the tax bill would be a bearish event as it would make unexpected inflation or monetary tightening more likely; a failure to cut taxes would extend the US cycle and should therefore be treated as bullish. That said, the current US proposals are worth US$150bn annually, which is only about 0.8% of GDP.  And they are biased towards the top of US income distribution, which means they would only have a marginal Keynesian effect on aggregate demand. If, however, the tax cuts were redesigned to channel more income to middle-class and poor Americans, they could be far more expansionary—and that would make them more dangerous from an inflation and monetary policy standpoint.

#8: Protectionism

Last year, the Trump election and Brexit vote provoked big worries about protectionism and a reversal of globalization. These worries have been forgotten, mainly because Trump has not delivered on his protectionist rhetoric and Brexit did not turn out to be a leading indicator of broader European Union fragmentation. But these threats have not totally disappeared. The US has offered provocative demands in its renegotiation of the North American Free Trade Agreement which Canada and Mexico will almost certainly reject. A breakdown of NAFTA is thus conceivable next year, with devastating effects on all three North American economies. While this is not a high probability scenario, it is the kind of unanticipated policy shock that could trigger a US recession. The same could be true of a breakdown in the Brexit negotiations—again an unlikely event, but one that would devastate the UK economy and possibly turn the EU upswing into a premature recession, with consequences for the global economy.

#9: Technology regulation

While many investors remain preoccupied with the tug-of-war between financial regulation or deregulation, new regulation in the technology sector is now a much greater risk to stock markets than regulation of banks, insurance companies or energy businesses. The four dominant technology firms—Google, Apple, Facebook and Amazon—all derive their extraordinary profitability from global monopoly power. Much tougher anti-trust policy, tax enforcement and privacy regulation, especially in Europe, would transform the business models of these globally dominant companies and raise questions about the sustainability of their profits and therefore their apparently moderate earnings multiples. These are issues on which Louis has increasingly focused, and I plan to do more work next year on the links between technology network effects, monopoly rent extraction and government protection of intellectual property. What is clear is that tech equities as a whole would suffer in the event of a serious anti-trust challenge to Google, Facebook or Amazon similar to the EU case against Microsoft, or the US lawsuits against IBM and AT&T.

#10: Left-wing politics

The share of profits in national income is near all-time highs in the US and other advanced economies. If inequality widens much further, for either regressive tax reforms or rapidly rising profits, populist opposition to global trade and technological innovation will intensify and the next phase of populism could take a left-wing, rather than right-wing, guise, with demands for more state spending, redistributive taxes and higher minimum wages. Such a shift in politics would threaten profit margins and equity valuations, as they did in the late 1960s. Such risks may seem irrelevant until the 2020 US election and next European electoral cycle in 2021/22, but markets could be rattled in 2018 if—as is perfectly possible— a breakdown in the Brexit talks and snap election in Britain led to a Labour government led by Jeremy Corbyn, or if next November produced a Democratic wave in the US Congressional elections.

2 Comments

  • >Anonymous

    Anonymous

    30/11/17

    Curious as to why you did not mention geo political risk.

    Reply
    • Dear Sir,

      I think that, when we look at geopolitical risk today, these are the ones that stand out:

      a) Islamist terrorism: for me, this is the biggest risk as it has proven to be massively disruptive for countries like Britain, France and of course the US. All the manpower monopolized to fight this scourge (police everywhere, extra security at airports etc...) and the consequent loss of productivity (long lines to get to anywhere etc...) have had a genuine negative impact on our growth, and most Western Nations' budget deficits. Combine that with the consequent refugee crisis in Europe, and the long shadow of Islamist terrorism is proving to be both resilient and cumbersome. Having said, our economies have adjusted over the past decade to this scourge; and unless we see a new outrage (dirty nuclear bomb? chemical warfare?...) I think (hope?) it is hard to see this particular problem having a marked market impact? After all, the past decade has shown that most of these terrorist cells are made up of losers, who can definetly cause grief and pain, and can kill in a single attack a lot of people. But can they really do much more than that?

      b) Saudi-Iran war: this is the second risk that keep me up at night for the rhetoric in the Middle-East seems to be getting heated and it seems that single spark (say a terrorist event that killed some of the Saudi, or Iranian, leadership?) could set things on to a perilous course. And here, the risk on the markets would be fairly straightforward: just like the Kippur War triggered a tripling of oil prices, it is likely that a Saudi-Iran war would trigger a spike in the price of oil, with the consequences reviewed by Anatole in his piece.

      c) North korea: My colleague Yanmei Xie has published a number of pieces that detail why we do not expect the North Korean situation to slip into a hot war. Personally speaking, I wonder whether all the fuss that Donald Trump kicked off over North Korea was really a strategy to:

           1- Sell more US weapons to the Japanese and Korean armies (if so, mission accomplished)?

           2- Guilt/bully the Chinese into more trade and investment consequences (whether liberalization of auto sector, liberalization of financial industry etc...)?

      After all, since his return from Asia, Donald Trump has been much quieter about North Korea, in spite of renewed provocations by Pyongyang?

      d) China overplays its hands: As my colleague Tom Miller reviewed in his excellent book (China's Asian Dream), China is rapidly embracing its 'imperialist destiny' under Xi Jin Ping. But does that mean that China is thus slated to clash with the US? I don't think so, partly because China doesn't mind a 'three step forward, two step back' policy, which over time still makes progress but avoids direct confrontation with the US (a clear policy goal of the Chinese). But also because the US itself no longer wants the burden of running an empire. After all, both the candidacies of Barack Obama and Donald Trump were the more 'isolationist" platforms on offer to American voters (McCain and Romney were much bigger on international intervention than Obama, and Clinton was much more of a foreign policy hawk than Donald Trump). Clearly, American voters like the message of "America First"... On this, let me put it this way: we just had a massive spat between China and South Korea. And the US didn't really go out of their way to back South Korea. Now, the spat is over, with everyone making mild concessions and "saving face". Hereby proving that China can 'bully' a US ally with limited longer-term impact?

      So putting it all together, I struggle to see an immediate geopolitical shock that would destabilize markets, except for an Iran-Saudi war. But then, the consequences of that were covered by Anatole's section on the risk of a spike in oil prices. This is one of the many reasons why I today own some US, Canadian and Columbian energy names (one could also own Russian, Mexican etc...). As i see it, these names are a decent hedge against the biggest risk in the system today, namely a speike in energy prices.

      Best

      Louis

      Reply