I am doing this in a guest post format, without blockquotes. You can download the entire article here as a Seven Steps and a Stumble PDF. I post major excerpts below, but not the entire article.
Suspended on the Brink
The MSCI All-Country World Equity Index has been stuck in a tight range since January of this year (Chart 1), but it now seems as if it is suspended on the brink of a sharp fall. With the Fed having already delivered seven rate hikes since January 2016, the central bank has become even more hawkish at a time of escalating trade tensions between the U.S. and its trading partners. The risk of policy overkill is escalating, and, as such we are downgrading global stocks and moving to overweight bonds versus equities.
I don’t expect a recession in the U.S. economy, but downward pressure on equities will likely be sustained unless or until the Fed backs away from its hawkish stance and/or the White House eases its harsh rhetoric. Both may happen in the third or fourth quarter when the U.S. economy softens, inflation calms down or the mid-term elections are over. Until then, bonds are a better bet than stocks.
U.S. Household Sector: Real Income vs Real Consumption
Chart 2 shows that Americans’ real disposable income growth is 2% and real private consumption is growing at a similar rate. With the savings rate having already fallen to 2.5%, which is close to a record low, it is almost impossible for consumers to double their real spending growth, unless they take on lots of leverage. Yet, consumer debt has been growing at a very subdued pace.
Despite this, Chairman Jerome Powell is more concerned about economic overheating and the strong labor market is emboldening policymakers to become more hawkish. I stick to the view that the U.S. economic growth will hit a “soft patch” in the months ahead.
The Treasury yield curve does not agree with Powell’s assessment and has flattened sharply since the Fed’s last decision.
Case for Soft Patch
Our Boom-Bust indicator for the U.S. economy is making a clear top, suggesting that the mini economic boom in the U.S. is cresting.
Although Trump’s tax cuts are stimulative, higher tariffs are anti-growth. These two policies are not only offsetting each other but are also creating enormous confusion for investors and businesses.
Dollar Inflation Expectations
Inflation will likely undershoot expectations in the third quarter, when the lagged impact of the strong dollar is felt (Chart 4).
Already, the U.S. monetary base is contracting (Chart 5) primarily due to higher rates and a shrinking Fed balance sheet. This usually heralds growth deceleration in the broad economy.
The bottom line is that Fed policy is always reactive, which by definition means that it is prone to policy mistakes. The Fed narrative seems to be that U.S. economic strength will be sustained, and inflation will creep higher. However, forward-looking indicators are telling a different story. This is not to mention that higher tariffs are higher taxes and therefore, anti-growth.
Profit Growth Decelerating
U.S. equity markets are facing several hurdles. First, forward earnings expectations are very optimistic, but underlying profit growth has already begun softening (Chart 6). What are the odds that U.S. corporations beat forward earnings projections, which currently stand at 22%?
It is possible, but not likely, especially if harsh rhetoric on trade turns into a tit-for-tat tariff war. Second, equity multiples will continue to be squeezed by rising interest-rate expectations — since the early 1970s P/E ratios for U.S. stocks have always come down whenever the Fed raised rates. This time should be no exception.
Finally, a rising interest rate cycle often leads to a period of rising price volatility (Chart 7). This is simply another way of saying that equities will face increasing vulnerability as rates move higher. Therefore, it is reasonable to expect Treasury bonds to outperform stocks as long as the Fed stays hawkish and Trump is willing to keep up brinkmanship with America’s trading partners.
Should the Fed indeed raise rates two more times this year, the Treasury bond market could rally sharply, taking yields down to 2.5% or even lower. The S&P 500 could fall hard. Two more rate hikes this year would constitute a policy overkill, in my view.
Trade Spat: Asymmetric Warfare
It looks as if President Trump is more interested in talking to his political base than having a cohesive strategy in dealing with trading partners. His approval rating has been rising and his base loves his approach on China and the EU. Therefore, Trump’s pressure tactics may not ease until the November elections are over.
…
Chen Zhao
Chief Global Strategist
Stumble? Then What?
There are three more charts and a lot more comentrary in the Alpine Macro PDF.
I do not agree with everything Alpine Macro came up with, but their analysis and charts are well presented and worth a closer look.
My strongest disagreement is on the likelihood of a recession.
At this point, I wonder why so many people think a recession will not happen. Heck, given that the Alpine Macro “Boom-Bust indicator for the U.S. economy is making a clear top“, I wonder why they don’t see it.
“Stumble” is a huge understatement. Complacency abounds, even in seemingly bearish presentations.
However, the Alpine Macro view on treasuries seems spot on. It looks like they are playing thing cautious without being willing to commit to stronger statements.
Mike “Mish” Shedlock
You cannot exactly roll back the hands of time and set up the same conditions. Demographics in 1992 were still favorable. Home prices were affordable. We had a dotcom bubble and a housing bubble that created lots of good-paying jobs. Now we have a demographic time bomb, a pension crisis, a debt bubble, etc.
Partly agree with this. But this wont work for long because eventually there will be too many holes to plug and negative interest rates are just a bandaid. Good assets will have to be sold to pay for the bad ones.
You dont understand the corporate bond market. Most cash that companies show on the balance sheet are actually loans that come due. The stuff that is high yield bonds is actually closer to junk. See John Mauldin’s recent letter on this. The economy is getting trapped by debt and leverage — the same things that caused the last two crises.
The debt overhang today is several orders of magnitude higher than it was in the 1990’s and will continue to grow. It is fundamentally required by the very nature of this credit-based monetary system, which is now in it’s twilight. With the rate of new debt creation far outstripping GDP growth, do not be surprised when we eventually see negative interest rates EVERYWHERE.
Personally, I think move it to 3 or 3.5 in one shot and be done with it. Corps and individuals deal with price shocks (likely bigger) on a regular basis from food and energy. Lets get back to a normalized cost of money.
While there is much talk about the impact of ZIRP and now the Fed raising rates there has been less and less “focus” on inflation or the effect of inflation is minimized…there is a reason the savings rate is so low at a time when real wages are not growing…most people cannot afford to save money. The inflationary impact of increasing premiums for Healthcare (where no one will ever reach their deductible), plus the cost of food and all other fixed expenses will prevent any average American from being able to save money…
I guess the fundamentalists will need to be clubbed over the head by the simultaneous ramp in stocks, interest rates, and the dollar to grasp they are not on a random walk through their daddy’s world. This guy exemplifies why so many are going to get crushed in the next vertical move up in stocks. He reminds me of the gloBull warming propagandist who desperately tries to link pollution to temperature change, all the while ignoring the earth’s long history and the biggest influence on temperatures – the sun. The fundamentalists ignore historic periods that don’t fit their ratios (or they don’t have the data) and conveniently forget what has the biggest influence on stock prices – global capital flows.
Global investment is over $80 trillion, dwarfing trade, stock buy backs, and everything else the “analysts” and pundits use to justify their position. Chen Zhao makes the same mistake as the majority, which is always wrong, he focuses on the US and ignores the world. No matter how bad the US looks, it is still better than the vast majority of the world, which also loaded up on US debt during the last 10 years. What happens to this debt as rates AND the dollar rise? Emerging markets are telling the story – the global economy always crashes from the periphery to the core.
How can bonds be the choice after interest rates have bottomed at their 5000-year low, and govt confidence is about to be pushed off the cliff? I’m not saying there won’t be a traditional knee jerk reaction into bonds during the next stock scare, but Mr. Zhao should not be participating in pushing the last bag holders over to the same side of the boat. Over the next couple of years, people will learn that assets back by nothing but promises from proven liars are not as safe as those backed by real property, plant, equipment, and intellectual property. BTW, the gloBull warming propagandists with a conscience will also be humiliated in the decades ahead as global temperatures slide into another mini ice age, which is going to have a much bigger impact on the economy and life on earth than Fed rate hikes.
“The bottom line is that Fed policy is always reactive, which by definition means that it is prone to policy mistakes. The Fed narrative seems to be that U.S. economic strength will be sustained, and inflation will creep higher.”
Is it just possible that the Fed simply wants to move away from ZIRP as much as possible and that it has realised that QE is a bottomless pit and a one way street and is just using any story that can enable it to move away from ZIRP and QE? In that case will the Fed’s future course of action be something other than this or just more of the same when economy and markets take a turn for the worse?