Recession: Are We There Yet?

By John Mauldin


An old joke says economists predicted 15 of the last 10 recessions. In other words, they’re frequently wrong and often too pessimistic.

I think it’s not so simple. Every recession prediction is eventually correct; some just get the timing wrong. That’s because, so long as we have a business cycle, a recession is always coming. The only question is when it will strike.

There’s also some dispute about what, exactly, counts as “recession.” The usual definition is two consecutive quarters of falling real GDP. But as I’ve written, GDP itself is a nebulous statistic with substantial margin of error. We can never be quite sure.

My own outlook has been consistent: The current growth phase is getting old and will end as they all do, but we probably have another year or so. That is about as far out as my data reads can actually give us any statistical confidence. Macro events like Federal Reserve error, trade war, ugly Brexit, and others could hasten the decline. But as of now, the US and the developed world seem likely to sustain at least mild growth through 2019.

That doesn’t mean we rest easy. It means we have time to prepare for the worse conditions that we know are coming. How much time? That will be today’s topic as we review some recent analysis.

Now let’s review the recession forecast.

Dramatic Weakening

Recession antennae everywhere popped up on February 14 when the Commerce Department reported retail sales fell 1.2% in December. It was the worst month-over-month decline since 2009.

Chart: Bloomberg

Now, there are reasons to doubt this report’s significance. It came out four weeks later than scheduled due to the government shutdown, and thus is more subject to revision than normal. It also conflicts with private-sector data like Redbook, which climbed sharply in December. And even if the data is right, this is only one month and one month doesn’t make a trend.

Nevertheless, retails sales are an important input to recession models like the Atlanta Fed’s GDPNow. That model’s estimate for Q4 2018 instantly plunged from 2.7% just two weeks earlier to 1.5%. Ugh.

That will be a dramatic weakening if the final Q4 GDP report confirms it, but I doubt it will. I think this report is a glitch and will fade away as other data supersedes it. But even if it’s right, 1.5% GDP growth isn’t a recession. It would mean 2018 was an okay though not spectacular year, and a recession call by definition is at least six months away (since it takes two negative GDP quarters to mark one).

This illustrates an important point: The recession outlook is a moving target. It changes as we get new data. Forecasts should change with it, and I don’t blame anyone who lets new information change their mind. It might make me trust them even more.
Missing Inversion

I trust Dave Rosenberg of Gluskin Sheff—enough to make him a perpetual SIC speaker and he has been my “leadoff hitter” on the first morning for at least 10 years—but at the moment we disagree.

Dave is screaming recession every chance he gets, which for him is every business day in his Breakfast with Dave letters. But he is not a perma-bear by any means. He’s been bullish at the right times in the past, so I pay attention even if I’m not convinced. I should note he turned uber-bullish nine or 10 years ago, announcing his new forecast at my conference. It was way outside the consensus at the time, but Dave has never cared much about being part of the consensus.

Dave summarized his argument in a letter last month (Over My Shoulder members can read it here), weeks before the retail sales report knocked the legs out of more bullish outlooks. If that data holds up, he’s going to look more prescient than most.

His key points make a great launching pad for discussion about the probabilities of recession. This letter will be more like a back-and-forth between Rosie and I when we are together. I hope you enjoy our conversation. My comments are in brackets. His points are in italics.

His key points:

  •  We are now in month #115 of the current expansion, double the post-WW2 norm and five months from becoming the longest ever.

[I guess I just shrug my shoulders and ask, “so what?” We have maybe a dozen data points of recoveries after recession. Maybe when we have 100 we can start talking about statistical probability. There is no statistical reason this recovery couldn’t last a lot longer. Ask Australia. Maybe 10 cycles from now we’ll have another lengthy recovery and start talking about this period as the longest recovery ever.]

  • The yield curve doesn’t have to completely invert for a recession call. It barely did so the last two times.

[Agreed. This table from Michael Lebowitz at Real Investment Advice measures the size of the last five 2Y/10Y yield curve inversions. You see they’ve been getting progressively smaller. If that trend were to continue, we might not even need a yield curve inversion to signal recession.

Much of the curve is already inverted at the short end. Here are the rates from last Tuesday.

  • 1-month: 2.41%

  • 3-month: 2.45%

  • 6-month: 2.51%

  • 1-year: 2.54%

  • 2-year: 2.50%

  • 3-year: 2.47%

  • 5-year: 2.47%

  • 7-year: 2.55%

  • 10-year: 2.65%

Notice the one-year to five-year is inverted by seven basis points. Likewise, the seven-year is only one basis point away from inverting against the one-year note. The short end of the curve is unusually flat and some points are inverted.

About five years ago, maybe more, I was at speaking at a conference where David Rosenberg and David Zervos (of Jefferies) were on a panel aggressively arguing that the yield curve would have to actually invert before another recession. Remember, this was when the Federal Reserve was holding rates at zero, seemingly forever. I aggressively questioned them later as to how the yield curve could invert? I maintained that we could have a recession without a full inversion. They both thought that eventually the Fed would raise rates, the yield curve would invert, and we would have a recession.

Times change and the facts change, too. But I think David is right now. We don’t have to have a full 2Y/10Y inversion to signal a recession. It may happen, but then again that inversion is typically a year in advance.]

  • Stocks appear to have peaked last fall. Average lead time from market peak to business cycle peak is seven months.

[Maybe. Then again, a solution to the China trade war and a solution to Brexit coming at roughly the same time could cause a market melt-up and new highs. On the other hand, Doug Kass thinks the market is getting ready to roll over and is increasing his short exposure.]

  • Fed policy changes are coming too late. It already overtightened, as it did so often in the past. Rosenberg thinks “neutral” Fed Funds rate is no more than 1.75%, so the last two hikes were missteps.

[Again, maybe. I agree the neutral rate is historically low but it may be somewhere close to where we are today. This is something we will only know for sure in hindsight. If 50 basis points is the difference between slow growth and recession, then this economy is extraordinarily weak and is likely to enter recession anyway.]

  • Recessions historically begin when the unemployment rate climbs 0.4 percentage points above its cycle low, which this time seems to have been 3.7%. So 4.1% unemployment, when it happens, should ring an alarm bell.

[Completely agree. I’ve actually used charts in the past connecting small increases in unemployment with the onset of recessions.]

  • The recession will probably be mild but there is no correlation between a recession’s severity and how far equity markets decline. [Agreed.]

  • This time, the bubble is on corporate balance sheets as firms borrowed money at historically low rates. Instead of productive use, much of the borrowing went to share buybacks. This did nothing to cover future debt-servicing costs.

[This is something I’ve been writing about at length. I think corporate and high-yield debt and leveraged loans will end up being the next recession’s subprime mortgage loans, triggering a liquidity crisis which could be quite severe.]

  • While many focus on high yield, the leveraged loan market is in a bubble of its own. A key risk for this year is a debt refinancing “tsunami” as trillions in debt has to be rolled over at higher rates.

[No argument here. That “tsunami” could actually cause a recession.]

  • Share buybacks and capital spending will be curtailed as cash flow falls while wages and debt servicing costs rise.
  • A 35% decline in stocks would be typical for this kind of recession, though Rosenberg thinks some non-cyclical and defensive names could outperform.

To zero in further, I think the main question is whether the Fed stayed hawkish too long, as Dave thinks, or is loosening up in time to keep the economy growing. We don’t know yet. For that matter, we don’t know if they are turning dovish. We only know they’re talking about ending the rate hikes and/or ending the balance sheet reductions. The FOMC meets again March 19–20 so whatever they do then should tell us more. And if the economy perks up? The Fed can talk about more tightening later in the year.

No Credit Stress

Canaccord Genuity analysts Tony Dwyer and Michael Welch differ from Rosenberg, and outlined their own case in a February 13 Macro strategy note titled “Still no recession in sight.”

Dwyer and Welch concede all the big question marks: slowing growth, Brexit, trade war, and so on. Their conclusion is these will make the Fed even more dovish than it would otherwise have been. They think the Fed can do this because four factors will forestall recession. Quoting from their note:

  • NFIB Small Biz Optimism Index cycle peaks offer long runway. Clearly, survey-based indicators have seen sharp declines from their respective August 2018 peak, which makes sense given the Q4/18 market crash and early-year US government shutdown. The good news is the cycle peak in the NFIB Small Business Optimism Indices historically leads recession by a median 41 months. It is even longer if you use the last three credit-driven cycles.

  • Credit Stress Indicators never even budged as market swooned. It is hard to have a credit crisis when there aren’t any signs of credit stress. Again, we turn to the Chicago Fed’s National Financial Conditions Subindices that measure 105 indicators of credit stress in banking, shadow banking, and the financial markets. These subindices barely moved, suggesting a fear-based market event rather than a sign of a coming credit crisis-driven recession (Figure 3).

Source: Canaccord Genuity

If Rosie is right and the Fed has already tightened too much, we should see it in credit conditions. We don’t, at least not yet. Credit is still available to businesses that need it, although at higher rates in some cases. That’s not all bad; it might mean fewer “zombie” companies haunting the economy. The question is whether their demise will cause other damage. We shall see.

Not Going Global

So far we’ve talked about the US economy, but no country is an island anymore. All are exposed, more or less, to the greater world economy. So let’s look overseas.

In Italy the recession argument is over because they are officially in one. That got lost in other news but it really is happening. The Italian economy shrank 0.2% in the fourth quarter, following -0.1% growth in Q3. That is about as mild as a recession can be, but it counts. Germany may not be far behind. Europe’s largest economy contracted -0.2% in last year’s third quarter. Reports suggest the fourth quarter was no better and possibly worse.

Meanwhile in Asia, China is not in recession and nowhere near one, if we believe government data. Much depends on how (or if) the country resolves trade disputes with the US. As of now, a comprehensive agreement still looks elusive but Trump appears willing to extend the March 1 deadline for another tariff hike. The uncertainty isn’t good, but it’s better than a major trade war.

Looking internally at China, we all want to know how long Beijing can sustain such amazing growth rates. Gavekal’s Chen Long wrote in a report this week that China’s credit cycle appears to be turning back up after a few rough months. He sees solid bank lending and a recovery in the “shadow” banking sector contributing to overall credit growth. This typically leads economic growth by 6–9 months, suggesting the Chinese economy could be back on firmer ground by this fall.

Again, all this is subject to macro risks. All bets are off if China weakens too much or the UK makes a hard Brexit. As of now, however, nothing is exploding in a way that would set off a worldwide recession. That suggests 2019 may not be a great year in the markets, but it won’t be a terrible year, either. Things could certainly be worse.
Dallas, Athens, and Houston

Shane and I fly to Dallas tomorrow to begin moving our furniture to either Puerto Rico or a new, smaller apartment that will be our Texas base. The sale of my other apartment should close next Friday.

Monday night I will be in Athens, Texas for an Ashford, Inc. board meeting, then Wednesday morning I fly to Houston to meet with SMH and then on Thursday with the RISE economic council at Rice University. Then back to Dallas to help Shane move us and back on a plane the next day to return to Puerto Rico.

I’m going to hit the send button as thinking about Pat Caddell doesn’t have me in the mood to tell any personal stories. So let me wish you a great week, as we all need to spend more time with our friends and family, appreciating what we have.

Your going to miss Pat Caddell analyst,

John Mauldin
Chairman, Mauldin Economics

China’s Modernization Plan: The Blueprint and the Backlash

By Phillip Orchard


In 2015, Beijing released a series of ambitious industrial plans, the most prominent of which was called “Made in China 2025.” The blueprint itself is fairly anodyne; it lays out lofty goals that aim to refocus China’s economy away from labor-intensive manufacturing and toward high-tech and service industries. To try to blunt Western criticism, Beijing has effectively disowned the document itself, but its principal policies remain and are now the center of U.S. complaints about state-backed efforts to swipe Western tech and distort markets in China’s favor. The unspoken U.S. concern is what it would mean for the balance of power should the plan succeed.

For China, however, success is the only option. The low-cost manufacturing model that fueled its extraordinary economic rise has effectively run its course. The debt-fueled investment binge Beijing has relied on to stave off a socioeconomic crisis since the 2008 meltdown has peppered the Chinese system with financial landmines. It’s facing a demographic crisis and an ongoing trade war with the U.S. Thus, China is grappling simultaneously with an immediate risk of cataclysmic financial crisis and a longer-term risk of falling into the middle-income trap, where developing economies stagnate as the advantages of low production costs evaporate. At the same time, global manufacturing is undergoing a high-tech revolution, opening up opportunities for Beijing but also exposing China’s weaknesses.

In response, the Communist Party of China is relying on what it trusts most, its own power, to fundamentally transform the economy from the top down. In practice, this means shoveling money into state-owned firms and state-controlled universities and research centers in service of research and development priorities laid out by the State Council. China is applying economic statecraft to access markets and resources abroad and allegedly using commercial espionage and cyber-theft to help firms make up ground.

China is in a high-stakes ultramarathon to avoid the approaching crisis and running at a sprinters’ pace. But, increasingly, it’s fueling a backlash from foreign competitors that would prefer to see China remain on the sidelines. This Deep Dive takes a fresh look at Chinese industrial policy as defined by Made in China 2025 – its key components, its importance to Beijing, and its supposed threats to Western interests. It also explains why China won’t cave on the plan’s core philosophy. Ultimately, then, this report is about what the U.S. and China are going to be fighting about for years to come.
The Components
Made in China 2025 is the first of three 10-year plans aimed at guiding China’s transition to a high-value manufacturing economy by 2049, the all-important 100th anniversary of the founding of the People’s Republic of China (and the target date for completion of the ambitious Chinese military modernization program). By 2025, according to Chinese Minister of Industry and Information Technology Miao Wei, “China will basically realize industrialization nearly equal to the manufacturing abilities of Germany and Japan at their early stages of industrialization.” That China sees its manufacturing sector as effectively mirroring that of 1960s-era Japan says quite a bit about just how far it has to climb on the value ladder – and should belie narratives that China is already a manufacturing superpower.

In reality, China has long struggled with the stuff that fully modernized economies like the U.S., Japan and Germany have mastered, particularly development of core technologies and native innovation. China has been able to get by thanks to its large population and technology imports by foreign firms. But rising wages at home and rising competition from low-wage neighbors are squeezing profits in labor-intensive sectors. Moreover, Western anxieties about China’s growth in military power and market-distorting trade practices are increasingly threatening its access to core technologies in higher-end industries. Even before the Trump administration began tightening restrictions on Chinese firms, for example, Beijing was complaining that Western limitations on potentially “dual-use” civilian-military technologies, such as satellite tech, made it unreasonably difficult for Chinese companies to move into the high-tech civilian industries of the future. It can’t afford to stand pat.

Made in China admits as much, describing the task at hand thusly: “China’s manufacturing sector is large but not strong, with obvious gaps in innovation capacity, efficiency of resource utilization, quality of industrial infrastructure and degree of digitization. The task of upgrading and accelerating technological development is urgent.” The plan divides China’s shortcomings into four categories: innovation, quality efficiency, smart manufacturing and green development. Its overriding vision can be boiled down to a three-step process: indigenize R&D into core technologies and intellectual property; substitute Chinese tech for foreign tech at home; and make Chinese tech dominant overseas.
Notably, Made in China also identifies 10 sectors, which are outlined below, where the bulk of this effort will take place. On average, Beijing wants 70 percent of basic core components in these sectors to be sourced from domestic suppliers by 2025. Already, according to the Rhodium Group, these sectors account for some 40 percent of China’s entire industrial value-added manufacturing. When looked at as a whole, some common themes emerge. One is that China is prioritizing sectors where it has a latent comparative advantage – that is, where its labor force, existing industrial footprint and massive consumer base stand to help domestic firms play catch up – but where hefty up-front investment is needed (and generally unavailable through private capital markets). Third, each of these sectors has enormous market growth opportunities overseas. Finally, each is needed to address a core domestic vulnerability and/or serve as a strategic tool abroad.
New Information Technology

China is going big on next-level information technologies, from integrated circuits to big data to high-performance computing. For the next decade, the most prominent part of this push will be the development and export of fifth-generation mobile communication technologies (5G), which will open a new universe of consumer and industrial applications for technologies such as artificial intelligence and the so-called “internet of things.” This is one area where China is positioned for some success, as Chinese firms like Huawei are already dominant players in global markets and can reap major “first-mover” advantages, from market share to influence of global standards to application innovation. Such firms, however, are still heavily dependent on Western IP and component parts, particularly microchips – as demonstrated by the brief U.S. decision to cut off U.S. equipment to China’s ZTE, which very well could have killed the company. Its long-term success here will depend largely on advances in semiconductor development.

But 5G could also have profound geopolitical implications. The technology itself will have wide-ranging military and logistics applications, as well as new vulnerabilities to things like cyberespionage. If the U.S. and its allies are unwilling to expose critical logistical networks and sensitive military or intel-sharing operations to Chinese snooping in countries whose communication infrastructures contain certain Chinese technologies, it could very substantially limit U.S. defense partnerships in strategically important states.

Numerical Control Tools and Robotics

China’s most valuable asset has been its low-cost labor force. But Chinese firms can’t move up the manufacturing value chain if they’re making everything by hand. High-end products like cars and electronics require high-end industrial robotics, and Chinese progress has been mixed here. In 2017, for example, China had 138,000 industrial robots installed – three times the number of any other country and an increase of more than 120,000 over a decade earlier, according to the International Federation of Robotics. But the bulk were owned by foreign firms. Moreover, this amounted to just 68 robots per 10,000 industrial workers. The United States, by comparison, had 189 per 10,000 workers and the global leader, South Korea, had 631. Sophisticated robots also require sophisticated software, another point of Chinese dependence on foreign IP, and artificial intelligence applications. This push will become increasingly important as the effects of China’s looming demographic challenges become clear and as the productivity gains that have come with rapid urbanization run dry. To stay competitive, China will need to do more with fewer workers.

Aerospace and Aeronautics
Aerospace and aeronautics are apex industries. Given the immense investment and sophistication of the technology, expertise and accompanying logistical and regulatory structures required of the sector – and given that anything less than a near-flawless performance rating will keep a company grounded – if a country can compete there, it can compete just about anywhere. And given the increasing importance of aerospace to various military, communications and other applications, the sector is becoming essential to China’s wide-ranging ambitions in a range of fields.

With China set to be the world’s largest air passenger market within the next four years – and with global passenger traffic expected to double by 2036, according the International Air Transport Association – Beijing has been trying to compete with Boeing and Airbus since at least 2008. The state-backed Commercial Aircraft Corporation of China, or Comac, began production of the C919, a single-aisle commercial airliner akin to Boeing’s 737, in late 2011, but the project has been bedeviled by setbacks and delays, and Comac is still fully reliant on foreign suppliers of engines, avionics software and navigation systems. Made in China calls for Chinese commercial aircraft to supply 10 percent of the domestic market and 20 percent of the international market by 2025. It also calls for giant leaps forward in the space race, carrier rockets, satellite applications and deep space exploration – primarily using Chinese-made equipment. In a notable breakthrough, China’s homegrown satellite navigation system, Beidou, announced the launch of its global service in December. The firm, which began as a military project, has already shipped tens of millions of systems.
Ocean Engineering Equipment and High-End Vessels

More than ever in its history, China is a maritime nation. Shipping is indispensable to its economy, and the boundless long-term growth in global demand for maritime trade heralds ample opportunities for Chinese firms. A massive shipbuilding footprint would also help China produce naval and coast guard vessels in wartime. As a result, Made in China calls for the country’s shipbuilding industry to supply at least half of global demand for high-tech ship design and manufacturing equipment. The plan also emphasizes underwater production systems and deep-sea exploration and resource exploitation – which have obvious implications for Chinese energy needs and the competition for resources in the hotly contested waters off Chinese shores, but also for Chinese advances in submarine warfare. There’s a reason regional countries scream bloody murder whenever Chinese research vessels show up in their waters.

High-End Rail Transportation Equipment

China’s build-out of high-speed rail networks at home has been nothing short of extraordinary. This year alone, it’s expected to build 4,200 miles (6,800 kilometers) worth of new domestic railway lines. Increasingly, China is also looking to export its rail technologies – and for good reason. According to the Asian Development Bank, the region needs an estimated $26 trillion in new infrastructure over the next decade to sustain economic growth. Rail is an obvious area where China can help make up the shortfall, and one that pairs naturally with the goals of its Belt and Road Initiative. China has been able to pair its diplomatic muscle with subsidies and manufacturing cost advantages to land major contracts across Southeast Asia, the Middle East and Africa. But Chinese rail firms lack the stellar safety reputation of their Japanese and European counterparts, and repeatedly undercutting the competition is expensive, so Beijing is keen to see its firms become more competitive on the technological and performance fronts.

Energy-Saving and New Energy Vehicles

This is another area where China is responding to both domestic and global needs. China, of course, is home to the world’s largest car market – General Motors sold more than 1 million more cars in China in 2017 than in the U.S. – and perhaps the world’s worst pollution. By supporting development of electric vehicles, Beijing is hoping to meet its burgeoning transportation needs while also making a dent in its smog problem, which President Xi Jinping has characterized as a national emergency. Accordingly, Beijing wants electric vehicles to make up some 40 percent of domestic car sales by 2025 (compared to just 2.7 percent in 2017). And it wants at least half of these new EVs to be Chinese. Ultimately, this is really about battery development. Innovation in battery technology would have wide-ranging implications in other fields as well as geopolitical ramifications, as proliferation of EVs will increase demand for minerals such as cobalt that are concentrated in a handful of states such as the Democratic Republic of Congo.

Power Generation

Chinese electricity generation capacity has more than quadrupled since 2000, and there’s little reason to think this growth will slow down anytime soon. Beijing is keen to meet this need as cleanly as possible – and with as much domestic content as possible. Accordingly, Made in China calls for 80 percent of components in large-scale thermal, hydro and nuclear power equipment to be sourced domestically by 2025. Power generation is another key area where China can play an instrumental role in the modernization of less-developed but strategically important states. Its signature BRI project in Pakistan, the China-Pakistan Economic Corridor, for example, is focused overwhelmingly on power generation and transmission.

Agricultural Machinery

China has a lot of mouths to feed. But for the past two decades, it’s been encouraging rapid urbanization to boost productivity and consumption and meet the needs of its labor-intensive industries. To fill the labor gap and sustain production with fewer workers, China is pushing to bring the agriculture sector up to the standards of advanced economies. The trade war, meanwhile, has made clear the extent of Chinese dependency on U.S. agricultural exports. Made in China calls for 70 percent of critical parts and at least 60 percent of high-end agriculture machines to be built domestically by 2025.

New and Advanced Materials

This encompasses a vast range of goods – from advanced composites to special function metals to “strategic frontier materials” such as superconductors, nanomaterials, biomaterials and graphene. These are the lighter, stronger and more sophisticated building blocks that everything from advanced circuits to rocket ships to submarines and fighter jets will be made from, and China is anxious about being dependent on foreign suppliers for any of them. Notably, this is one area where Beijing is pushing Chinese civil industry and the military to work together – a comparative advantage to the U.S. and its allies, given Beijing’s greater capacity to harness civil society capacity for strategic aims.

Biopharmaceuticals and High-Performance Medical Equipment

The global population is getting older, and China is getting older fast. For Beijing, this poses a major budgetary problem, as well as a social stability problem. Over the past 20 years, Chinese health spending has increased by an average of more than 11.5 percent annually, well above gross domestic product growth. Continued periodic protests by army veterans upset about not receiving pension and health benefits are one example of the potential disruption. Beijing is, therefore, prioritizing development of the pharmaceuticals sector, particularly biotechnology, which has been growing since 2008 and now stands at 30 percent of global pharma product sales. Beijing wants biotech to account for upwards of 4 percent of China’s GDP by 2020. Technologies like gene editing will be valuable in the agriculture sector, as well.
The Critics
Although some of these goals seem unrealistic and overly ambitious, the U.S. is taking them very seriously. Made in China is cited heavily in the White House’s Section 301 report, which lays out much of the U.S. rationale for the trade war. Each of the 10 industries has been targeted by U.S. tariffs, which have had some effect. According to official figures, production of industrial robots has declined by more than 12 percent year on year in December, growth in the new energy car industry has slowed to roughly 15 percent from 24 percent in November and integrated circuit production has been reduced by 2.1 percent. By comparison, many of the export industries on which China (and U.S. consumers) is currently dependent, such as consumer electronics, have largely been spared from tariffs.

The issue, according to the U.S., isn’t the specific plan. After all, Made in China is not all that different in principle from Germany’s 2011 “Industry 4.0” plan, which inspired parts of the Chinese plan, or the Obama administration’s “Advanced Manufacturing Partnership,” which sought to foster collaboration among the private sector, universities and the government in emerging technologies. (In terms of funding and scope, however, both the U.S. and German plans pale in comparison to China’s.) In the short-term, at least, China’s pursuit of a modernized manufacturing sector will provide extensive opportunities for foreign firms and require heavy foreign investment.

Furthermore, much of the project appears aspirational, at best. China has been trying and failing to foster native innovation and core technology development since long before 2015, with only scant success in reducing dependence on foreign tech and IP. Its state-led system is well-suited for compelling system-wide collaboration, filling in investment shortfalls, tailoring infrastructure development around the needs of key industries, and freeing companies from weighting decisions around quarterly earnings reports. Between 2000 and 2014, for example, Chinese state R&D expenditures increased nearly 850 percent, compared to around 30 percent for the U.S., and China is now second only to the U.S. in annual outlays here. (As a share of GDP, though, China still lags behind South Korea, Japan, Germany and the United States.) In the telecommunications, shipbuilding and robotics sectors, in particular, Beijing’s support for “national champions” is already seeing some success. And in 2017, China surpassed the U.S. as the leading source of funding in artificial intelligence technologies.

But China’s centrally planned system is ill-suited for this game in other ways. Its tight grip on funding channels leads to clumsy allocation of capital, as illustrated by the credit crunch currently suffocating the Chinese private sector. Its mixing of domestic political and commercial aims warps incentives, forces firms to carry bloat and stifles appetite for risk-taking. Companies won’t invest in R&D if they think the fruits of their labor will inevitably get gobbled up with impunity by a competitor owned by the nephew of a local party boss. Its mixing of geopolitical and commercial aims, meanwhile, exposes companies to international backlash. And firms in sectors where China simply has little experience, such as industrial software development, likely have too much ground to make up to expect to be competitive anytime soon, and are unlikely to receive much support from the state since it will need to continue to woo foreign competition to meet the domestic market’s needs.

So why do the U.S. and its allies see Made in China as such a threat? And is there room for negotiation? For the most part, the West has focused its criticism on the means with which China is pursuing the aims outlined in the plan rather than the aims themselves. This includes more nefarious tools such as commercial espionage and forced technology transfers. Beijing will not admit that the state sanctions such activities, but it evidently has some degree of control over them. Cyberattacks, for example, dropped dramatically for two years after Xi and Obama reached a deal in 2015, before increasing again as trade tensions have intensified, according to U.S. cybersecurity firm FireEye. And China has been slowly lifting foreign ownership caps, ostensibly making it easier for foreign firms to avoid joint ventures in which tech is expected to be handed over in exchange for access to the Chinese consumer market. So there’s some room for concessions, even if informal ones. Whether it sticks to any such pledges if and when Chinese firms fall short of indigenization targets is another matter.

The other point of contention is China’s state-led system itself. Despite some language pledging to give markets a more decisive role in resource allocation, Made in China broadly heralds a deepening of the state’s role in the economy. And it’s explicit about its import substitution aims, its intent to use state-funded acquisitions as a tool to access Western technology, and its plan to use state funding and preferential access to credit to tilt the balance in Chinese firms’ favor. In other words, Made in China merely magnifies existing concerns about Chinese distortion of global markets.
The Bigger Picture
China, naturally, sees the dispute from the opposite angle – that it is effectively following the development path already taken by U.S. allies, and thus that the West is playing a zero-sum game to keep China down. Beijing also doesn’t see much of a choice in the matter. To abandon the plan’s central philosophy and tools would be to abandon the CPC’s fundamental model of governance – and thus threaten its grip on power. U.S. pressure won’t change this; rather, it only underscores China’s sense that it needs to develop its own technological expertise. To concede wholly would be to leave itself exposed to U.S. pressure in the future on any number of issues.

Beijing’s suspicions are not entirely groundless, even if few Western officials are admitting as much. So long as China remained dependent on Western markets and technology, and a valuable part of supply chains for Western firms, there were mutual incentives to get along. What happens if and when these go away? If China were to succeed in avoiding the middle-income trap – not to mention avoiding an outright socio-economic crisis in the next few years – it would wield enormous power. Newfound wealth will inevitably translate into military power and new resources with which to pull neighboring countries firmly into China’s orbit.

Whether or not the West should be able to find a way to peacefully coexist with a powerful China, history and the nature of geopolitics tell us that established powers rarely cede their dominance to upstarts without a fight. And even if Beijing is merely doing what it thinks it must to avoid economic calamity, its regime type, military trajectory, and recent track record of weaponizing aid and investment for strategic purposes will be the unspoken context hanging over narrower U.S. complaints. The U.S.-China rivalry will continue whatever happens in trade negotiations in the coming months.

A Mixed Economic Bag in 2019

Since the global synchronized growth of 2017, economic conditions have been gradually weakening and will produce an across-the-board deceleration in the months ahead. Beyond that, the prospect for markets and national economies will depend on a broad range of factors, some of which do not bode well.

Nouriel Roubini

NEW YORK – After the synchronized global economic expansion of 2017 came the asynchronous growth of 2018, when most countries other than the United States started to experience slowdowns. Worries about US inflation, the US Federal Reserve’s policy trajectory, ongoing trade wars, Italian budget and debt woes, China’s slowdown, and emerging-market fragilities led to a sharp fall in global equity markets toward the end of the year.

The good news at the start of 2019 is that the risk of an outright global recession is low. The bad news is that we are heading into a year of synchronized global deceleration; growth will fall toward – and, in some cases, below – potential in most regions.

To be sure, the year started with a rally in risky assets (US and global equities) after the bloodbath of the last quarter of 2018, when worries about Fed interest-rate hikes and about Chinese and US growth tanked many markets. Since then, the Fed has pivoted toward renewed dovishness, the US has maintained solid growth, and China’s macroeconomic easing has shown some promise of containing the slowdown there.

Whether these relatively positive conditions last will depend on many factors. The first thing to consider is the Fed. Markets are now pricing in the Fed’s monetary-policy pause for the entire year, but the US labor market remains robust. Were wages to accelerate and produce even moderate inflation above 2%, fears of at least two more rate hikes this year would return, possibly shocking markets and leading to a tightening of financial conditions. That, in turn, will revive concerns about US growth.

Second, as the slowdown in China continues, the government’s current mix of modest monetary, credit, and fiscal stimulus could prove inadequate, given the lack of private-sector confidence and high levels of overcapacity and leverage. If worries about a Chinese slowdown resurface, markets could be severely affected. On the other hand, a stabilization of growth would duly renew market confidence.

A related factor is trade. While an escalation of the Sino-American conflict would hamper global growth, a continuation of the current truce via a deal on trade would reassure markets, even as the two countries’ geopolitical and technology rivalry continues to build over time.

Fourth, the eurozone is slowing down, and it remains to be seen whether it is heading toward lower potential growth or something worse. The outcome will be determined both by national-level variables – such as political developments in France, Italy, and Germany – and broader regional and global factors.

Obviously, a “hard” Brexit would negatively affect business and investor confidence in the United Kingdom and the European Union alike. US President Donald Trump extending his trade war to the European automotive sector would severely undercut growth across the EU, not just in Germany. Finally, much will depend on how Euroskeptic parties fare in the European Parliament elections this May. And that, in turn, will add to the uncertainties surrounding European Central Bank President Mario Draghi’s successor and the future of eurozone monetary policy.

Fifth, America’s dysfunctional domestic politics could add to uncertainties globally. The recent government shutdown suggests that every upcoming negotiation over the budget and the debt ceiling will turn into a partisan war of attrition. An expected report from the special counsel, Robert Mueller, may or may not lead to impeachment proceedings against Trump. And by the end of the year, the fiscal stimulus from the Republican tax cuts will become a fiscal drag, possibly weakening growth.

Sixth, equity markets in the US and elsewhere are still overvalued, even after the recent correction. As wage costs rise, weaker US earnings and profit margins in the coming months could be an unwelcome surprise. With highly indebted firms facing the possibility of rising short- and long-term borrowing costs, and with many tech stocks in need of further corrections, the danger of another risk-off episode and market correction can’t be ruled out.

Seventh, oil prices may be driven down by a coming supply glut, owing to shale production in the US, a potential regime change in Venezuela (leading to expectations of greater production over time), and failures by OPEC countries to cooperate with one another to constrain output. While low oil prices are good for consumers, they tend to weaken US stocks and markets in oil-exporting economies, raising concerns about corporate defaults in the energy and related sectors (as happened in early 2016).

Finally, the outlook for many emerging-market economies will depend on the aforementioned global uncertainties. The chief risks include slowdowns in the US or China, higher US inflation and a subsequent tightening by the Fed, trade wars, a stronger dollar, and falling oil and commodity prices.

Though there is a cloud over the global economy, the silver lining is that it has made the major central banks more dovish, starting with the Fed and the People’s Bank of China, and quickly followed by the European Central Bank, the Bank of England, the Bank of Japan, and others. Still, the fact that most central banks are in a highly accommodative position means that there is little room for additional monetary easing. And even if fiscal policy wasn’t constrained in most regions of the world, stimulus tends to come only after a growth stall is already underway, and usually with a significant lag.

There may be enough positive factors to make this a relatively decent, if mediocre, year for the global economy. But if some of the negative scenarios outlined above materialize, the synchronized slowdown of 2019 could lead to a global growth stall and sharp market downturn in 2020.

Nouriel Roubini, a professor at NYU’s Stern School of Business and CEO of Roubini Macro Associates, was Senior Economist for International Affairs in the White House's Council of Economic Advisers during the Clinton Administration. He has worked for the International Monetary Fund, the US Federal Reserve, and the World Bank.

Buffett, Shiller, Bogle & Tobin: Valuations, Forward Returns & Winning The Long-Game

Written by Lance Roberts

What a difference just a couple of months can make.

Since the financial crisis, there has been much commentary written about the low forward returns on stocks over the subsequent 10-year period from high valuation levels. The chart below shows the forward 10-year returns from previously valuation levels.

However, just a couple of months later, those forward returns have exploded higher.

What changed?

Nothing really. It is simply the function to the massive decline in 2008 being removed from the 10-year average.

However, while the forward returns have spiked in recent months, this has been due to a market that has been fueled higher by massive amounts of global monetary stimulus rather than a reversion in valuations that fostered an organic growth in returns.

Just recently, Brian Livingston, via MarketWatch, wrote an article on the subject of valuation measures and forward returns.
“Stephen Jones, a financial and economic analyst who works in New York City, tracks the formulas that several market wizards have disclosed. He recently updated his numbers through Dec. 31, 2018, and shared them with me. Buffett, Shiller, and the other boldface names had nothing to do with Jones’s calculations. He crunched the financial celebrities’ formulas himself, based on their public statements.”

“The graph above doesn’t show the S&P 500’s price levels. Instead, it reveals how well the projection methods estimated the market’s 10-year rate of return in the past. The round markers on the right are the forecasts for the 10 years that lie ahead of us. All of the numbers for the S&P 500 include dividends but exclude the consumer-price index’s inflationary effect on stock prices.”
  • Shiller’s P/E10 predicts a +2.6% annualized real total return.
  • Buffett’s MV/GDP says -2.0%.
  • Tobin’s “q” ratio indicates -0.5%.
  • Jones’s Composite says -4.1%.
(Jones uses Buffett’s formula but adjusts for demographic changes.) 

Here is the important point:
“The predictions might seem far apart, but they aren’t. The forecasts are all much lower than the S&P 500’s annualized real total return of about 6% from 1964 through 2018.”
While these are not guarantees, and should never be used to try and “time the market,” they are historically strong predictors of future returns.

As Jones notes:
“The market’s return over the past 10 years,” Jones explains, “has outperformed all major forecasts from 10 years prior by more than any other 10-year period.”

Of course, as noted above, this is due to the unprecedented stimulation that the Federal Reserve pumped into the economy.

However, markets have a strong tendency to revert to their average performance over time, which is not nearly as much fun as it sounds.

But Jones isn’t the only one who has warned about the risks of high-valuations. The late Jack Bogle, founder of Vanguard stated:
“The valuations of stocks are, by my standards, rather high, but my standards, however, are high. 
When considering stock valuations, Bogle’s method differs from Wall Street’s. For his price-to-earnings multiple, Bogle uses the past 12 months of reported earnings by corporations, GAAP earnings, which include ‘all of the bad stuff,’ to get a multiple of about 25 or 26 times earnings. 
‘Wall Street will have none of that. They look ahead to the earnings for the next 12 months and we don’t really know what they are so it’s a little gamble.’ 
He also noted that Wall Street analysts look at operating earnings, ‘earnings without all that bad stuff,’ and come up with a price-to-earnings multiple of something in the range of 17 or 18. 
‘If you believe the way we look at it, much more realistically I think, the P/E is relatively high,’ 
‘I believe strongly that [investors] should be realizing valuations are fairly full, and if they are nervous they could easily sell off a portion of their stocks.'”

This, of course, from the father of “buy and hold” investing with whom millions of Americans have pumped roughly $4.7 Trillion into a whole smörgåsbord of indexed based ETF’s provided by Vanguard to meet investor appetites.

Richard Thaler, the famous University of Chicago professor who won the Nobel Prize in economics also stated:
“We seem to be living in the riskiest moment of our lives, and yet the stock market seems to be napping. I admit to not understanding it. 
I don’t know about you, but I’m nervous, and it seems like when investors are nervous, they’re prone to being spooked. Nothing seems to spook the market.”

As noted, the flood of liquidity, and accommodative actions, from global Central Banks, has lulled investors into a state of complacency rarely seen historically. However, while market analysts continue to come up with a variety of rationalizations to justify high valuations, none of them hold up under real scrutiny. The problem is the Central Bank interventions boost asset prices in the short-term, in the long-term, there is an inherently negative impact on economic growth. As such, it leads to the repetitive cycle of monetary policy.
  1. Using monetary policy to drag forward future consumption leaves a larger void in the future that must be continually refilled.
  2. Monetary policy does not create self-sustaining economic growth and therefore requires ever larger amounts of monetary policy to maintain the same level of activity.
  3. The filling of the “gap” between fundamentals and reality leads to consumer contraction and ultimately a recession as economic activity recedes.
  4. Job losses rise, wealth effect diminishes and real wealth is destroyed. 
  5. Middle class shrinks further.
  6. Central banks act to provide more liquidity to offset recessionary drag and restart economic growth by dragging forward future consumption. 
  7. Wash, Rinse, Repeat.

If you don’t believe me, here is the evidence.

The stock market has returned more than 80% since 2007 peak, which is more than two-times the growth in corporate sales and three-times more than GDP.

It is critical to remember the stock market is NOT the economy. The stock market should be reflective of underlying economic growth which drives actual revenue growth. Furthermore, GDP growth and stock returns are not highly correlated. In fact, some analysis suggests that they are negatively correlated and perhaps fairly strongly so (-0.40).

However, in the meantime, the promise of a continued bull market is very enticing as the “fear of missing out” overrides the “fear of loss.”

Valuations Are Expensive

This brings us back to Jack Bogle and the importance of valuations which are often dismissed in the short-term because there is not an immediate impact on price returns. Valuations, by their very nature, are HORRIBLE predictors of 12-month returns should not be used in any strategy that has such a focus. However, in the longer term, valuations are strong predictors of expected returns.

I have adjusted Bogle’s measure of valuations to a 24-month, versus 12-month, measure to smooth out the enormous spike in valuations due to the earnings collapse in 2008. The end valuation result is the same but peaks, and troughs, in valuations are more clearly shown.

While the current 2-year average P/E is at 23x earnings, it was over 26x just a couple of months ago.

The decline has been due to a drop in the “P” but the “E” is about to drop as well which will keep valuations elevated. Nevertheless, Bogle is correct that valuations have reached expensive levels.

More importantly, outside of the peak in 1999, stocks are as highly valued today than at previous market peaks in history. 

Bogle’s view is also confirmed by other measures as well. The chart below shows Dr. Robert Shiller’s cyclically adjusted P/E ratio combined with Tobin’s Q-ratio. Again, valuations only appear cheap when compared to the peak in 2000. Outside of that exception, the financial markets remain expensive.

I have also previously modified Shiller’s CAPE to make it more sensitive to current market dynamics.
“The need to smooth earnings volatility is necessary to get a better understanding of what the underlying trend of valuations actually is. For investor’s, periods of ‘valuation expansion’ are where the bulk of the gains in the financial markets have been made over the last 116 years. History shows, that during periods of ‘valuation compression’ returns are more muted and volatile. 
Therefore, in order to compensate for the potential ‘duration mismatch’ of a faster moving market environment, I recalculated the CAPE ratio using a 5-year average as shown in the chart below.”

To get a better understanding of where valuations are currently relative to past history, we can look at the deviation between current valuation levels and the long-term average going back to 1900.

With a 54.52% deviation from the long-term mean, a reversion will be quite damaging to investors when it occurs. As you will notice, reversions have NEVER resulted in a “sideways” consolidation but rather more serious declines. These rapid “maulings” of investors is why declines are aptly named “bear markets.” 

Lastly, even Warren Buffett’s favorite valuation measure is screaming valuation issues. The following measure is the price of the Wilshire 5000 market capitalization level divided by GDP.

Again, as noted above, asset prices should be reflective of underlying economic growth rather than the “irrational exuberance” of investors.

Note that 10-year forward earnings peak at the trough of the previous bear market. Like today, forward earnings are peaking due to the removal of the 2008 financial crisis. From this point forward, forward returns will begin to fall sharply.

Maybe Not Today

Jones, Bogle, Buffett, Shiller, and Tobin are right about valuations.

Maybe not today.

Next month.

Or even next year.

But as Vitaliy Katsenelson previously penned:
“Our goal is to win a war, and to do that we may need to lose a few battles in the interim. 
Yes, we want to make money, but it is even more important not to lose it. If the market continues to mount even higher, we will likely lag behind. The stocks we own will become fully valued, and we’ll sell them. If our cash balances continue to rise, then they will. We are not going to sacrifice our standards and thus let our portfolio be a byproduct of forced or irrational decisions. 
We are willing to lose a few battles, but those losses will be necessary to win the war. Timing the market is an impossible endeavor. We don’t know anyone who has done it successfully on a consistent and repeated basis. In the short run, stock market movements are completely random – as random as you’re trying to guess the next card at the blackjack table.”
With that point, I clearly agree.
But, if you can’t use these predictions to time the market, what good are they? As Brian concluded in his article:
“For long-term investors, the likelihood that the market is overpriced and will eventually pull back to a lower valuation should flash a bright yellow “caution” light. A disappointing decade is not the time to gamble your money on a 100% stock portfolio. Diversifying into other types of assets can prevent any one index – such as the S&P 500 – from dragging down your performance. 
“You are the captain of your own destiny, but you don’t have to go down with the ship when the S&P 500 hits the inevitable rocks. Diversify now.”