SIC Perspectives

It’s been a week and I’m starting to recover from my post-SIC high. It’s a weird feeling. I love SIC, yet processing it all takes time. Imagine one of those brain maps that shows the neurons opening new pathways. That’s what SIC does. It opens connections that I didn’t previously have.

Mapping these new connections takes time, so I’ll have more to share over the next few weeks. What I’m going to give you today is a rather short letter covering my overall impressions – my sense of feel of what I took away – and a few of the great lines that really impacted me.

The Basic Questions I Wanted Answered at SIC

This was my 15th Strategic Investment Conference. Each year I walk away wondering how we can make the next one better, and so for we seem to have been able to do that. We set an incredibly high bar this year, according to the feedback we’re getting.

In the early years of the conference, I simply tried to get the best speakers I could. My Rolodex was small and my budget was tight. For whatever reason, I have finally developed a large and diverse network of speakers to draw upon. And while there are a few speakers that I just have to invite back every year, I try to create a program that can speak to the economic and geopolitical moment we find ourselves in, every year.

As I was creating this conference there were five large questions that I was mulling over.

1. I see nothing on the immediate horizon that suggests a recession in 2018. I know a couple of people who have compiled recession indicators that are generally good for about nine months out, and right now a 2018 recession just doesn’t appear to be in the cards, even though the consensus is that the economy will slow (more on that below). But there is always another recession; and if it’s a recession in the US, that generally means it’s a global recession, and those are always market-moving events – and by market-moving I mean all markets everywhere. The current recovery is getting long in the tooth, but that doesn’t mean it can’t last a lot longer. Australia has gone (I think) 26 years without a recession. So I had some serious macro watchers among our speakers and panelists.

2. I am extremely concerned about the rising debt levels of the developed-world governments and China. Not to mention the swelling debts of individuals and corporations. I don’t see how this piling up of debt ends well – but then I don’t even see how it ends. Japan has monetized an extraordinary amount of its debt, and its currency has gotten stronger. That is not what we learned should happen in Macroeconomics 101. Monetizing the debt has always meant a deep, and often seriously destructive, devaluation of the currency.

What has changed? Is it demographics or is it something else? It’s a serious question, and until we have an answer for it we are liable to be stumbling around in the dark, making poor investment decisions. I wanted answers from our speakers.

3. We have to be able to put money to work if we want our portfolios to grow. And even though US stock market valuations are in nosebleed territory, the US market is not the only game in town. Where are people putting money? Where are the great opportunities? So I put some extremely successful investors who are more rifle-shot than macro types on the stage.

4. Longtime readers know that I have a fascination with the future and the direction of technology. I made sure a few of the presentations addressed those areas.

5. Finally, we are seeing a regime change in politics and indeed in the nature of the relationships of people to government. Possibly even more profoundly, it is beginning to look like we are changing the very nature of how we relate to each other as human beings. Compound this with the extraordinarily rapid technological change that is happening everywhere, and it feels as if our cultural foundations are shifting beneath us. I am going to devote at least one letter to a panel that I was able to pull together with Democratic pollster Pat Caddell; Neil Howe, who is the single best expert on generations and especially on Millennials; and Steve Moore, currently at the Heritage Foundation.

That panel was convened on Thursday evening, and we were supposed to close at 9 o’clock. As I began to announce that it was time for the last question, the crowd very aggressively let me know that under no circumstances was I allowed to close the panel! At 9:40, when I finally called an end, hardly anybody had left the room, and many of the attendees then rushed the stage to get answers directly from the speakers. We had clearly struck a nerve that was shaking the audience members to their very core. Honestly, you really want to see that video. I can tell you that I’m going to watch it several times. I’m not going to tell you that I liked what I heard or some of the conclusions we came to. Frankly, they worry the hell out of me. But as my dad used to say, you have to play the hand you’re dealt.

A General Consensus About a Potential Recession

When will the next recession start? I kept asking the speakers on-stage and off-stage plus a lot of the really smart people in the room that I know are extraordinarily well-versed in economics and economic cycles.

I always try to close the conference with a powerhouse panel, and I put the question to them. Their consensus and general consensus of the conference seemed to be 2019 or possibly as late as 2020. We have just stretched the rubber band too tightly, and it’s fraying. Consumer spending, the driver of the economy, is beginning to slow.
Consumers have accumulated about as much debt as they can tolerate. Savings are at a ridiculous low.

This is from Telmatica Research:

While Friday’s job report got the markets all excited, perhaps the reason that enthusiasm has cooled is folks are realizing that the 50k gain in retail jobs isn’t syncing up with the -4.4% SAAR decline in retail sales over the past three months. Then there is what we are hearing from the horses’ mouth. Walmart (NYSE:WMT) and Target (NYSE:TGT) both issued weak guidance, as did Kroger (NYSE:KR) which also suffered from shrinking margins. A tight and tightening job market is unlikely to help with that. Costco (NASDAQ:COST) missed on EPS, as did Dollar Tree (NASDAQ:DLTR), which also missed on EPS and gave weaker guidance. Big Lots (NYSE:BIG) saw a decline in same store sales. At the other end of the spectrum, the 70k gain in construction is in conflict with rising mortgage rates, traffic and declining pending home sales, while the 31k gain in manufacturing has to face a dollar that is no longer declining, high costs on tariff-related goods, and potentially some sort of trade war.

And do you think automobile manufacturers are going to be able to maintain their current high production levels in the face of literally tens of millions of high-quality leased cars coming off their leases in the next few years? Not to mention the hit they’ll take from steel tariffs?

I know that many readers support the steel tariffs, but there wasn’t much support in the crowd at the conference, especially from the large contingent of non-US attendees. One of my main concerns – and it’s one that I have expressed in this letter for 16 years – has been a move to protectionism and trade wars. That would be pretty much end economic progress as we know it and usher in a period not unlike the Great Depression. It would not be the end of technological progress, just global economic progress.

I’m going to spend a whole chapter in my book talking about how things are so much better than they were 20 years ago or 40 years ago or 60 years ago. The simple fact of the matter is that things are getting better almost every year on a wide variety of fronts, at least from a global perspective. I think people will be surprised at the data on how things are improving in the developed world on the matter of putting carbon into the air. Even China is trying to get into the cleanup act. Which I applaud, because I don’t want to see the air I breathe, and I don’t want anything in my water but scotch. I like to think of myself as a sane environmentalist.

But that does not mean things are getting better from individual perspectives in various parts of the country and the world and especially for particular groups within countries. More on that below.

Those of us of a certain age have lived through a half-dozen or more recessions. But it helps if you can have a little warning so that you can get ready, not just with your portfolios but with your business. Frankly, recessions can be quite useful for growing your portfolios and businesses if you prepare for them properly. But preparing for a recession that seemingly never materializes is also bad for business and portfolios. Timing is everything.

No one actually knows when a recession will start. People have opinions based on past performance and personal experience, and past performance is generally worthless in the world we inhabit today. One thing I do know is that the Atlanta Fed’s GDPNow metric, which tries to predict what GDP for the current quarter will turn out to be, has dropped precipitously in the last 45 days. Those of you who are interested in how they actually create their model can click on the link above.

Their Q1 GDP estimate has plunged from 5.4% growth to 1.8%. Even my great friend Steve Moore admits that we would have to have multiple years of 3%-plus growth in order to overcome the current deficits that we have racked up by working from a supply-side approach. We haven’t had 3%-plus growth year-over-year since the 90s.

Let me be blunt. We needed those corporate tax cuts in order not to make the biggest companies in our country more money but to help our middle-sized companies be more competitive globally. Frankly, I just don’t give a rip about how profitable Apple or Google are or how much tax savings they get. The FANGs just don’t create that many jobs in the grand scheme of things.

They represent a lot of jobs to be sure, but they don’t reach deep into Middle America. That’s what small businesses and startups do. But we are not seeing a monster increase in capital spending from these tax cuts, at least so far. Executives seem to be saying that they’re going to increase stock buybacks and dividends. And while I’m all for dividends, those typically don’t create jobs, and jobs are what we need.

I come away from this conference with my recession antenna up. Recessions don’t happen overnight. Things start slowing down and then they roll over. Some of the attendees think the next recession will not be all that bad, while others think it will be worse than the Great Recession.

I think the outcome depends on the timing of the next recession and the political reaction. More on that later, too.

The Return of Volatility

Maybe it’s because of the experience of the last month and because we tend to read the latest trend into our forecast, but there was a consensus at SIC that market volatility is going to resume its normal place in our lives. Five percent drawdowns are actually quite normal in any given year and sometimes occur several times in a year.

What is not normal is 15 months of less-than-2% drawdowns, which we just experienced. The volatility of February was not the odd thing; it was the preceding 15 months that was extraordinary. Have we seen a market peak, as my friend Doug Kass thinks? Maybe. I have no idea. That is why I have my personal portfolio and those of the clients who work with me structured to be in diversified trading strategies and not be actually long (or short) everything. And then we rifle-target specific investments that I think have long-term potential or can produce reasonable fixed-income returns.

The Rise of Global Debt

At SIC I did not gain any comfort on the problem of rising global debt. Everybody agrees it’s a problem, but there’s no consensus on what to do about it. A question I posed many times was, where we going to sell $2 trillion worth of US Treasuries in 2018? And it’s not just the on-budget deficit; it’s the off-budget deficit and the money that the Federal Reserve seems to indicate it is going to sell into the market. The world is buying less of our debt now, too.

Lacy Hunt says we will have to buy it. I told a joke that I will not repeat here, but the punchline is basically, what do you mean by “we.” And at what Price?

I get the concept of supply-side economics and tax cuts creating growth that will overcome the deficits. But those tax-cut precedents that are referred to, the ones during the Kennedy and Reagan years, were implemented in completely different economic environments. Number two, we don’t have a Clinton and a Gingrich who can sit across the table from each other and come up with a way to balance the budget. The budget deficit they were trying to balance out was considerably smaller than the one we have today, too. We are one recession away from $30 trillion in total debt, not including state and local debt. Altogether, that’s well over 160% debt-to-GDP. And as we will explore below, it can get worse.

Where to Put Money to Work Today

Our first panel of the conference comprised David Rosenberg, Louis Gave, and Grant Williams. When my publisher, Ed D’Agostino, walked out on the stage, he commented that some of the ladies in the back were calling this our “cute bears” panel. Before the panel kicked off, Louis stood up and said, “I just want everyone to know that I am not a bear,” and then, pointing to Grant Williams, “and he is not cute.”

They all had places where they felt you could put money to work today. I will point out that David Rosenberg has shifted from a full-throated bull to bearish. He was very pleased that Gluskin Sheff, the large money management firm he works for in Canada, has moved to 25% cash. I came away with the feeling that he would like to see that figure increased. But all of our “bears” had good ideas for putting money to work now.

I think my biggest surprise of the conference was that two of the speakers I invited, John Burbank of Passport Capital (who I had been trying to get to come for years) and Mark Yusko of Morgan Creek, both of whom I thought were in my macroeconomics contingent, have completely shifted their business plans in the last few months, moving away from trying to predict macro developments, which they believe are incredibly more difficult to plan for than in the past, to focusing on specific investments, setting up new funds and strategies.

Burbank had one of the great quotes of the conference: “Invest in things that have never happened before, hedge for regression to the mean, and plan for the unimaginable.” 

Mark Yusko essentially echoed that theme. I was surprised that they are both looking at how to get involved in the cryptocurrency world. We had a panel on cryptocurrencies that I found fascinating (I admit to being somewhat skeptical). I was entranced by the 28-year-old multibillionaire who has become the largest miner of Bitcoin and other cryptocurrencies in the world.

George Gilder is a longtime friend. I interviewed him for 30 minutes, and I have never seen him more animated on stage. He had graciously helped me prepare for the interview by giving me the latest version of the manuscript of his new book, called Life after Google, in which, while acknowledging the prowess of Google and Facebook and the other large tech companies, he talks about coming technological changes that will change everything – again.

George is not shy about predicting technological change. In 1990 he wrote the following amazingly prescient words. He had no idea I was going to display them on the screen. As I started to read them he stopped me, reminding me that he had given that speech before. He then stood before the audience and quoted those lines, and more, from memory.

Vividly described in the early 1990s was the coming dominance of the smart phone. “The most common personal computer of the next decade will be a digital cellular phone with an IP address.” As I declared in scores of speeches, “It will be as portable as your watch and as personal as your wallet; it will recognize speech and navigate streets; it will collect your mail, your news and your paycheck, connecting to thousands of databases of all kinds.” 

[Pregnant pause] “It just may not do Windows… but it will do doors – your front door and your car door and doors of perception.”

Remember, that was 1990. We were still using bricks for cell phones, if you could afford them, and they worked only in your neighborhood. So when George makes predictions about a coming regime change in the technological world, perhaps we should pay attention. Because that means there are going to be extraordinarily valuable new enterprises being built –and a number of the people on our stage agreed, naming names and companies.

But George’s vision all streams from his understanding of the importance of freedom in the markets and the ability of the entrepreneur to meet and create demand. That’s the driver of growth and profit. Here’s another prescient line from George’s book Knowledge and Power, which I think is one of the five most important books of the last 20 years:

The most important feature of an information economy, in which information is defined as surprise, is the overthrow, not the attainment, of equilibrium.

That is a devastating critique of current economic thinking and models, which are all built around some hypothetical equilibrium state that never in fact – as in never ever ever ever – actually exists. But given the impossibility of creating a model built around the complexities of entrepreneurship, economists have ignored what happens in the real world in preference for hypothesizing an equilibrium world that they might have some chance of controlling. Back to George:

…the great peril of establishment Republicans from the time of both Bushes through the presidential candidacy of John McCain. All cherish the illusion that leading Yale, Harvard, and Princeton economists possess vital wisdom about the economy. They generally don’t. Their preoccupation with static macroeconomic data blinds them to the actual life and dynamics of entrepreneurship. Their preoccupation with liabilities and debt blinds them to the impact of their policies on the value of economic assets.

Their GDP model, where everything is measured as a kind of spending – power rather than knowledge – pushes them to manipulative policies and redistribution inimical to business value and growth. Believing that a weaker dollar is just the thing to spur a sluggish economy, by hyping the spending category of “net exports,” they miss the consequent devaluation of all the assets of the country.

The Coming Political Storms

The final panel, with Pat Caddell, Neil Howe, and Steve Moore, was a revelation. I’m going to do a full letter on some of the conclusions they reached and on the conversations I have been having, based on what I learned from them.

Bottom line: If we have a recession between now and 2020, the chances of Trump’s being reelected are not good. Some of you that might consider that to be a good thing. But what is likely to ensue is a left-wing populist government that will enact tax increases. Ironically, since a pre-election recession will increase our deficits even more, you will see the Democrats running on a deficit-reduction platform. Only they will be planning to do it not by cutting spending, except possibly on defense, but by raising taxes.

Any tax increases sufficient to cut the deficit will throw the country into back-to-back recessions again, and we could easily be looking at $40 trillion in national debt by the mid to late 2020s. I don’t care how low interest rates are; we can’t pay off that kind of debt. Not in a world where technology is about to eat up 25 million jobs, just in the US alone. Can we monetize that debt? I don’t know. Japan seemingly can. Europe is on its way to doing so.

We’re entering a period of volatility and instability unlike anything any of us have experienced, except perhaps for the oldest of us. It will be worse than the 70s. And all of this is going to happen in the midst of massive technological change, with its resultant economic dislocations. Factor that into your business and investment models.

As I said, I have a lot to think about. I will be sharing those thoughts with you over the next few weeks. Stay tuned.

My marketing team has asked me to include a video of Robert Ross interviewing me at the very end of the conference. It’s a very short interview with my first out-of-the-box impressions. If the information from the conference is of interest to you – and it should be – you can get all the videos, the audio, and the transcripts from our speakers and panelists and access to literally multiple hundreds of slide presentations. Over 1,000 people have attended the conference in virtual format. (If you are a writer of some kind and don’t order the Virtual Pass just to get access to the slide presentations, you are not paying attention. Just one writer to another.)
They tell me the Virtual Pass promotion will stop soon and the price will go up, so do it now.

Play Video

It Takes a Team

We had at least a dozen staff working to put this conference on. I think I got more compliments on how smoothly the conference was going than I ever have. It does take quite a team. I’m extraordinarily proud of how well everything worked, from the registration booth to the backstage coordination. Everything went off like clockwork.

And speaking of the stage, I don’t know of an economic or investment conference anywhere that has a stage and the technology behind it that are up to our standards.
We’ve had the same team doing our conference for 12 years. If you walk back-stage you’ll find about a dozen people driving the technology from over two dozen laptops and very large TV screens. There was more technology than we used to put a man on the moon. Plus, this year we were live streaming; so, with almost 600 attendees and 700 people watching via the Live Stream, we were reaching more people than we ever have. Here’s a photo from the back of the packed room.

I want to thank our speakers. Almost to a man or woman, they cut their speaker fees for me. You don’t even want to know what my speaker budget is, even after they cut me some slack. Nobody pays to get on my stage. Most conferences have two or three headliners, and everybody else is paying. We make far less than most conferences because we don’t cut corners and we don’t sell speaker slots. But that is why SIC has nothing but A-list speakers.

Next year we will be back in Dallas, May 13-16. Book it in your calendar right now. I am committed to making it our best conference ever – even if I don’t quite know how I will do that. But you won’t want to miss it.

And finally, I want to thank the attendees. Well over half have been to multiple conferences and many have come back for five years or more. That is the highest compliment I can imagine. Thirty percent came from outside the country, with over 30 countries represented. Some of the Aussies have been coming for five years running – there were 33 of them this year.

And with that I will hit the send button. Have a great week. After I take a few days off, I am going to dive back into work and writing that book, which is the 1,200-pound gorilla on my back.

Your drinking through an information firehose analyst,

John Mauldin

The Blockchain Pipe Dream

Nouriel Roubini , Preston Byrne   
Digital security concept

NEW YORK – Predictions that Bitcoin and other cryptocurrencies will fail typically elicit a broader defense of the underlying blockchain technology. Yes, the argument goes, over half of all “initial coin offerings” to date have already failed, and most of the 1,500-plus cryptocurrencies also will fail, but “blockchain” will nonetheless revolutionize finance and human interactions generally.

In reality, blockchain is one of the most overhyped technologies ever. For starters, blockchains are less efficient than existing databases. When someone says they are running something “on a blockchain,” what they usually mean is that they are running one instance of a software application that is replicated across many other devices.

The required storage space and computational power is substantially greater, and the latency higher, than in the case of a centralized application. Blockchains that incorporate “proof-of-stake” or “zero-knowledge” technologies require that all transactions be verified cryptographically, which slows them down. Blockchains that use “proof-of-work,” as many popular cryptocurrencies do, raise yet another problem: they require a huge amount of raw energy to secure them. This explains why Bitcoin “mining” operations in Iceland are on track to consume more energy this year than all Icelandic households combined.

Blockchains can make sense in cases where the speed/verifiability tradeoff is actually worth it, but this is rarely how the technology is marketed. Blockchain investment propositions routinely make wild promises to overthrow entire industries, such as cloud computing, without acknowledging the technology’s obvious limitations.

Consider the many schemes that rest on the claim that blockchains are a distributed, universal “world computer.” That claim assumes that banks, which already use efficient systems to process millions of transactions per day, have reason to migrate to a markedly slower and less efficient single cryptocurrency. This contradicts everything we know about the financial industry’s use of software. Financial institutions, particularly those engaged in algorithmic trading, need fast and efficient transaction processing. For their purposes, a single globally distributed blockchain such as Ethereum would never be useful.

Another false assumption is that blockchain represents something akin to a new universal protocol, like TCP-IP or HTML were for the Internet. Such claims imply that this or that blockchain will serve as the basis for most of the world’s transactions and communications in the future. Again, this makes little sense when one considers how blockchains actually work. For one thing, blockchains themselves rely on protocols like TCP-IP, so it isn’t clear how they would ever serve as a replacement.

Furthermore, unlike base-level protocols, blockchains are “stateful,” meaning they store every valid communication that has ever been sent to them. As a result, well-designed blockchains need to consider the limitations of their users’ hardware and guard against spamming. This explains why Bitcoin Core, the Bitcoin software client, processes only 5-7 transactions per second, compared to Visa, which reliably processes 25,000 transactions per second.1

Just as we cannot record all of the world’s transactions in a single centralized database, nor shall we do so in a single distributed database. Indeed, the problem of “blockchain scaling” is still more or less unsolved, and is likely to remain so for a long time.

Although we can be fairly sure that blockchain will not unseat TCP-IP, a particular blockchain component – such as Tezos or Ethereum’s smart-contract languages – could eventually set a standard for specific applications, just as Enterprise Linux and Windows did for PC operating systems. But betting on a particular “coin,” as many investors currently are, is not the same thing as betting on adoption of a larger “protocol.” Given what we know about how open-source software is used, there is little reason to think that the value to enterprises of specific blockchain applications will capitalize directly into only one or a few coins.

A third false claim concerns the “trustless” utopia that blockchain will supposedly create by eliminating the need for financial or other reliable intermediaries. This is absurd for a simple reason: every financial contract in existence today can either be modified or deliberately breached by the participating parties. Automating away these possibilities with rigid “trustless” terms is commercially non-viable, not least because it would require all financial agreements to be cash collateralized at 100%, which is insane from a cost-of-capital perspective.

Moreover, it turns out that many likely appropriate applications of blockchain in finance – such as in securitization or supply-chain monitoring – will require intermediaries after all, because there will inevitably be circumstances where unforeseen contingencies arise, demanding the exercise of discretion. The most important thing blockchain will do in such a situation is ensure that all parties to a transaction are in agreement with one another about its status and their obligations.

It is high time to end the hype. Bitcoin is a slow, energy-inefficient dinosaur that will never be able to process transactions as quickly or inexpensively as an Excel spreadsheet. Ethereum’s plans for an insecure proof-of-stake authentication system will render it vulnerable to manipulation by influential insiders. And Ripple’s technology for cross-border interbank financial transfers will soon be left in the dust by SWIFT, a non-blockchain consortium that all of the world’s major financial institutions already use. Similarly, centralized e-payment systems with almost no transaction costs – Faster Payments, AliPay, WeChat Pay, Venmo, Paypal, Square – are already being used by billions of people around the world.

Today’s “coin mania” is not unlike the railway mania at the dawn of the industrial revolution in the mid-nineteenth century. On its own, blockchain is hardly revolutionary. In conjunction with the secure, remote automation of financial and machine processes, however, it can have potentially far-reaching implications.

Ultimately, blockchain’s uses will be limited to specific, well-defined, and complex applications that require transparency and tamper-resistance more than they require speed – for example, communication with self-driving cars or drones. As for most of the coins, they are little different from railway stocks in the 1840s, which went bust when that bubble – like most bubbles – burst.

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.

Preston Byrne is a Fellow of the Adam Smith Institute and Sole Member at Tomram Consulting.


Markets fret about America’s turn toward protectionism

A trade war would be certain to roil markets and disrupt central banks’ plans to reduce stimulus

IN THE run-up to the presidential election of 2016, investors were nervous about Donald Trump.

They liked his tax-cutting, anti-regulation promises, but fretted about his foreign and trade policies. Some dubbed the two agendas “Trump lite” and “Donnie Darko”.

Almost as soon as it became clear that Mr Trump would become president, the markets decided to believe in the optimistic version. His tweeting and decision-making may have been erratic, but investors seemed to forgive the president his peccadilloes as a wife might her errant husband: “He may not be faithful but he’s a good provider.”

Fears about trade conflict almost disappeared. In last month’s survey of global fund managers by Bank of America Merrill Lynch, just 5% regarded a trade war between America and China as the biggest risk facing the markets, compared with 45% who worried about a return of inflation or a crash in the bond markets.

The announcement of tariffs on steel and aluminium on March 1st thus came as a nasty shock, especially as it was followed by boasts about trade wars being “easy to win”. Furthermore, the news came just a few weeks after the stockmarket suffered a nasty wobble as investors worried that higher interest rates might pose a threat to global growth.

Analysts have started to calculate the market consequences if a trade dispute escalates. Erik Nielsen of UniCredit Bank thinks a trade war would reduce global economic growth by 0.5-1% a year and send the stockmarket into a “measurable correction”. This would in turn disrupt central banks’ plans to withdraw monetary stimulus, sending both bond and currency markets on a “rollercoaster ride” for several months. Alan Ruskin of Deutsche Bank thinks that the president’s protectionist rhetoric will be seen by many investors as a sign that America desires a weaker dollar, which is another way of trying to bring the trade deficit down.

Ben Inker of GMO, a fund-management group, says that the rise of economic nationalism has increased the likelihood of a trade war that would be in no one’s interests. It would cause investors to shorten their time horizons—a problem for shares, which depend for their value on an uncertain stream of future profits. “If one wanted to imagine a scenario in which valuations fall not merely to long-term historical averages but right through onto the other side, a global trade war is a strong candidate,” Mr Inker warns.

Clearly, not everyone feels the same way. There was a big fall in the American stockmarket when Mr Trump announced his intention to raise tariffs. But shares quickly bounced back before falling again when Gary Cohn, the president’s economic adviser and a fervent advocate of free trade, resigned. Adding to the uncertainty is the possibility that America will decide to take separate measures against China for intellectual-property theft.

At the time of writing there was still scope for Mr Trump to change his mind in the face of congressional opposition at home or the prospect of retaliation from abroad. And even if tariffs are imposed the dispute could soon subside, as it did when the Bush administration pushed through similar measures in 2002.

But the global economy is in unfamiliar territory. Because restrictions on trade have generally been easing since 1945, investors have no experience of a broad tariff dispute. The Smoot-Hawley Act, which pushed up tariff rates by an average of six percentage points, is regarded as having been an unhelpful act in the midst of the Depression. Congress passed it in June 1930 despite a statement opposing it signed by 1,028 economists published in the New York Times.

Although the big crash in the market came in October 1929, the S&P Composite index suffered a further decline of 10% in the month the act passed. (The tariffs were not the only thing driving the market down, of course; the American banking system was collapsing at the same time.)

Even if the world manages to avoid a full-blown trade war, the threat to global markets is clear.

Politicians are becoming more nativist, and as they do so, barriers to the free movement of capital, goods and services are likely to rise. Financial markets, with high equity valuations and low bond yields, are currently priced for perfection. But a protectionist world is far from perfect.

If the trend continues, markets are likely to become more risky. After all, when a politician says “America First”, or indeed “Ruritania First”, that suggests that the interests of foreign investors are being left far behind.

Hanging Curve

by: Eric Parnell, CFA

- Economic growth is accelerating, inflation is increasing, and bond yields are on the rise!

- What if something entirely different is actually unfolding?

- What does the hanging curve tell us about what we should reasonably expect going forward?

- This idea was discussed in more depth with members of my private investing community, The Universal
It is a message we keep hearing about in the mainstream financial media today. Bonds yields are on the rise. The optimists attribute the increase to a budding phase of accelerating economic growth and the higher inflation that comes with it. The more skeptical among us believe that an inevitable outbreak of higher inflation will induce the Fed to tighten more quickly than currently expected.
Despite their differing views, both leading narratives rely on the key underlying premise that inflation is going higher. But what about a third outcome? What if higher inflation never comes to pass? And what if this takes place at the same time that the economy sputters while the Fed is still raising rates?
What then?
Scoffs Of Derision
Dare raising the possibility of this third outcome in the mainstream financial media. I can hear now the haughty scoffs and see scornful glances of derision being cast upon the market heretic for even raising such a possibility. But here's the thing. Every single year since the calming of the financial crisis we have heard the same exact themes being uttered. Economic growth is accelerating! Higher inflation is right around the corner! Yet every single year to date through today, such an outcome has never come to pass. So forgive my cynicism, but given that this narrative has been largely wrong the last eight years and counting, why exactly is it absurd to think it might happen for a ninth time in a row? Just sayin'.
But 2018 is different! We are now in a phase of synchronized global economic growth. And we just had the passage of a massive tax cut program that is propelling corporate earnings projections to new all-time highs. It is only a matter of time now before corporations pass along this bounty to its workers in the form of higher wages that will result in too much money chasing too few goods. Hence, bond (BND) yields are set to go flying to the sky.
OK. Maybe. But how much has this recent perception of synchronized global growth been fueled by the fact that the European Central Bank and the Bank of Japan has been buying virtually every asset in sight at the same time that the People's Bank of China resumed expanding its balance sheet after a two-year hiatus? Adding more than $3 trillion to the collective global major central bank balance sheet can do wonders to foster the perception, and perhaps the illusion of synchronized global growth. And now all of this stimulus is in the process of being slowly drawn away.
As for the corporate tax cuts, the boost to the corporate earnings outlook has been impressive indeed. But will companies actually pass along these higher earnings to its employees not in the form of one-time bonuses but instead in repeatable wage and salary increases? Or will these higher earnings instead get channeled to shareholders in the form of increased buybacks and dividends? If history is any guide from more than a decade ago when corporations last received a major tax break to fill their coffers, we still have good reason to believe it may be more of the latter until proven otherwise when core inflation gauges remained relatively subdued as well.
Final mention: a global trade war is not good for synchronized global growth. Nor is it good for corporate earnings. We'll see how this all plays out.
So can I see the potential that the ninth time will finally be the charm in 2018 for the long anticipated breakout in economic growth and higher inflation? Absolutely. But given that such predictions have been flat wrong eight years prior, it is prudent to require more than just an easy narrative to conclude that such a sunny outcome is inevitable this time around.
Hanging Curve
It is in assessing the data to find confirmation of this higher economic growth, higher inflation, higher bond yield narrative where things start to break down.
To begin with, forecasted economic growth remains positive, but hardly robust or anything notably better than what we've already been experiencing in recent years. But it is possible that despite recent downward forecast revisions that these projections will prove gross underestimations.

What of the inflation data? The latest core consumer price index reading for January 2018 came in at 1.85% on a year-over-year percentage change basis, which is up from the 1.69% reading in August 2017. But this number is still much lower than the 2.25% reading from this same time a year ago. And at below 2%, it has not even risen yet to the Fed's target level much less climbed to anything that would be considered heralding a major inflation outbreak. But the CPI is a lagging indicator, so let's see what reading for February holds that comes out next Tuesday to see if we're getting any traction. If the latest reading on wages from Friday's employment report is any guide, next week's report may not be lighting any fires, but we'll see.
So what then do the leading indicators tell us? Bond (TLT) yields certainly have risen in recent months. Isn't this telling us that inflationary pressures are set to take hold? Let's take a closer look. And in order to do so, let's take a walk through recent history to put where bond yields are today into better context.
We will begin our journey back in time to February 2011. If ever there was a moment more than any other during the post-crisis period where the market was signaling to its investors that a phase of sustained economic growth and higher inflation was poised to break out, it was February 1, 2011. For it was on this date that the U.S. Treasury curve was at its steepest slope throughout the entirety of the post-crisis period to date. Why is this significant? Because a steep yield curve signals optimism among investors about the economic outlook due to the fact that they are requiring a more significant premium to tie up their capital in an increasingly longer duration bond instrument and forgoing the potential to participate in higher growth opportunities from the likes of equities while at the same time exposing themselves to the greater risk that inflation will erode the real value of the coupon payments they are set to receive in the future.
Thus, what has taken place in the seven years since has been a slow deterioration of the optimism implied during this still early phase of the post-crisis period. Put simply, the anticipated breakout in economic growth never really materialized. Neither did the sustainably higher inflation expected by so many despite the fact that central banks were relentlessly pumping monetary stimulus into the financial system (why higher inflation is going to break out now that central banks are moving to take this stimulus away today is a topic for another debate). This evolution over the next five years brought us to the following yield curve by contrast in August 2016.
While the short end of the curve remained effectively pinned to the floor, the long end of the curve had essentially collapsed. The fact that investors had become much more willing to accept a meaningfully smaller maturity risk premium for moving further out the yield curve suggested that investors had become vastly more skeptical about the prospects for economic growth and higher inflation going forward. This was confirmed by the fact that the five-year breakeven inflation rate, which indicates the rate of inflation investors are anticipating over the next five years, had fallen from as high as 2.64% in 2011 to as low as 1.21% in 2016, which of course is well below the Fed's target inflation rate of 2%.
Of course, much has changed in regard to the economic, corporate earnings, and inflation outlook since the summer of 2016. What then has the yield curve telling us about our prospects going forward?

The first major event was the 2016 U.S. election. Capital markets initially cheered the outcome, and the yield curve began notably steepening.
While the shift was nowhere close to the slope seen in February 2011, it was a strong push in the right direction for the economic and inflation outlook.
But then things stalled. Much of the legislative agenda that the market initially priced in to effectively take place on Inauguration Day ended up getting stuck in the mud. While regulations were relaxed across many segments of the economy, infrastructure was put on the back burner, the repeal and replacement of the Affordable Care Act was repeatedly delayed before finally fizzling out, and the fate of tax cuts much less tax reform was looking increasingly uncertain. And all of this was taking place at a time when the Fed had finally cast off its fear and started to move more assertively in raising interest rates, thus lifting short-term interest rates off of the floor. The result was a notable drop in optimism in the economic and inflation outlook as implied by the yield curve.
But then the legislative agenda finally started to turn. The notion of tax reform was quietly set aside as the focus turned to landing some measurable tax cuts. Leading among them were major corporate tax cuts including measures to encourage the repatriation of profits stashed overseas. After months of wrangling and debate, the Congress completed a tax cut package that was signed into law by the White House by late December 2017. While economic growth and corporate earnings projections were immediately revised higher, the yield curve remains notably subdued. If anything, it had notably flattened with the long end remaining effectively unchanged as the Fed continued to push forward in lifting the short end of the curve. In short, it was signaling even greater consternation about the outlook, not optimism, as the yield curve had reached its flattest levels to date in the post-crisis period.
Of course, the calendar flipped to 2018 and it seemed that the mood had suddenly changed.
Stocks (SPY) stormed out of the gates in the new calendar year to the upside. And they were followed higher by a surge in long-term rates. While certainly nothing close to the magnitude of what existed in February 2011, it was a notable move in its own right that exceeded the pace of implied further tightening by the Fed. All of this was supporting the more optimistic narrative for a few weeks in January, but then concerns supposedly suddenly erupted about the threat of higher inflation ruining the party, sending stocks careening to the downside with a notable spike in volatility in early February (never mind the fact that the inflation report came in hot a week after this quick and dirty stock market mess - let's stick with the narrative for now that this was an "inflation concern" induced issue and not something else entirely). Nonetheless, the yield curve was still moving, albeit marginally, in the right direction by early February.
But what have we seen since through today in mid March? The yield curve has been steadily flattening once again. In the process, it is quickly descending to the flattest post-crisis levels set at the very end of 2017 across the curve. Put simply, while the stock market has stabilized and the ability to melt higher no matter how bad the news on any given trading day has returned, the concerns implied by the flattening yield curve are persisting.
Putting this altogether we have the following three points of contrast from February 2011, August 2016, and today.
Put simply, the long end of the yield curve is much lower versus where it was seven years ago, and the short end of the yield curve is much higher today versus where it was as recently as 18 months ago in the summer of 2016. This has resulted in a yield curve that is about as flat as it has been throughout the post-crisis period despite all of the continued talk of economic growth optimism and higher inflation.
The Key Takeaways
What are the key takeaways from this walk through yield curve's past?
First, the yield curve implied optimism about the growth and inflation outcome is nothing like it was back in February 2011. Sustained economic growth and higher inflation didn't materialize then, and the current yield curve suggests we should maintain a healthy degree of skepticism that it is going to materialize going forward from today. For it is in fact telling an entirely different story about the future outlook. Sure, stock prices may rise in the meantime, but as evidenced over the past decade, higher stock prices are not economic growth and they are not higher inflation.
Second, not only has the yield curve flattened markedly since August 2016, but it has done so with an overall shift in the curve itself to a level that is several percentage points higher today versus where it was the summer before last. In short, the risk-free rate is much higher today than it was less than two years ago when stocks were surging their way back from their last near accident from the summer of 2015 through the winter of 2016. And the risk-free rate as implied by the shorter end of the yield curve is set to rise measurably still in the coming year with the Fed expected to raise interest rates by a quarter point as many as three times on average in 2018 with some estimates going as high as five hikes this year. As short-term rates continue higher, this will apply increased pressure on stock prices given their historically high valuations, as increasingly pressure gets applied to the equity risk premium required by investors to take on the added risk of owning stocks. Moreover, if the long end of the curve continues to move slowly in following the short end higher in the coming months as the Fed continues to raise, it only brings the specter of the next economic recession all the closer, an outcome of which is very much the opposite of economic growth and higher inflation.

Lastly, the movements in the yield curve particularly over the past year should highlight why investors much exercise caution and do their own homework before reacting too swiftly on any news about economic growth, higher inflation, higher interest rates and steepening/flattening yield curves.
If one were to listen only to the news, they might perceive that these indicators are flying all over the place. But the reality remains that while such moves may seem dramatic in the isolation of a handful of trading days, they have still been relatively minor in a broader historical context. Put more simply, avoid being reactive and maintain your discipline amid any seemingly major market moves at any given point in time.
The yield curve may ultimately find its mojo and start sustainably steepening as the elusive hopes and dreams of economic growth and higher inflation are finally realized. But to date, the latter remains unconfirmed while the former continues to foretell an entirely different tale as evidenced by the hanging curve.
Be careful out there in today's markets. And be prepared for the outcomes that the broader market may least expect.

Debt, Boom, Bust: How Borrowing Drives the Business Cycle

By Amir Sufi and Atif Mian

     Photo: Doug Chayka for Barron’s 

Every major financial crisis leaves a unique footprint. Just as banking crises throughout the 19th and 20th centuries revealed the importance of financial-sector liquidity and lenders of last resort, the Great Depression underscored the necessity of countercyclical fiscal and monetary policies. And, more recently, the 2008 financial crisis and subsequent Great Recession revealed the key drivers of credit-driven business cycles. 
Specifically, the Great Recession showed us we can predict a slowdown in economic activity by looking at rising household debt. In the U.S. and across many other countries, changes in household debt-to-GDP (gross domestic product) ratios between 2002 and 2007 correlate strongly with increases in unemployment from 2007 to 2010. For example, before the crash, household debt had increased enormously in Arizona and Nevada, as well as in Ireland and Spain; after the crash, all four locales had particularly severe recessions.

In fact, rising household debt was predictive of economic slumps long before the Great Recession. In his 1994 presidential address to the European Economic Association, Mervyn King, then the chief economist at the Bank of England, showed that countries with the largest increases in household debt-to-income ratios from 1984 to 1988 suffered the largest shortfalls in real (inflation adjusted) GDP growth from 1989 to 1992.
In our own work with Emil Verner of Princeton University, we have shown that U.S. states with larger household-debt increases from 1982 to 1989 had larger increases in unemployment and more severe declines in real GDP growth from 1989 to 1992. In another study with Verner, we examined data from 30 countries over the past 40 years, and showed that rising household debt-to-GDP ratios have resulted in slower GDP growth and higher unemployment. Recent research by the International Monetary Fund, which used an even larger sample, confirms this result.

The conclusion we draw from a large body of research into the links between household debt, the housing market, and business cycles is that expansions in credit supply, operating primarily through household demand, are an important driver of business cycles generally. We call this the credit-driven household demand channel. An expansion in the supply of credit occurs when lenders either increase the quantity of credit or decrease the interest rate on credit for reasons unrelated to borrowers’ income or productivity.

In a new study, we show the credit-driven household demand channel rests on three main conceptual pillars. First, credit-supply expansions, rather than technology or permanent income shocks, are the key drivers of economic activity. This is a controversial idea. Most models attribute macroeconomic fluctuations to factors such as productivity shocks. But we believe that the financial sector itself plays an underappreciated role through its willingness to lend. 
According to our second pillar, credit-supply expansions affect the real economy by boosting household demand, rather than the productive capacity of firms. Credit booms tend to be associated with rising inflation and increased employment in construction and retail, rather than in the tradable or export-oriented business sector. Over the past 40 years, credit-supply expansions appear largely to have financed household spending sprees, not productive investment by businesses.

OUR THIRD PILLAR explains why the contraction phase of the credit-driven business cycle is so severe. The main problem: The economy has a hard time “adjusting” to the precipitous drop in spending by indebted households when credit dries up, usually during banking crises. Even when short-term interest rates fall to zero, savers can’t spend enough to make up for the shortfall in aggregate demand. And employment can’t easily migrate from the nontradable to the tradable sector.

Our emphasis on both the expansionary and contractionary phases of the credit cycle accords with the perspective of earlier scholars. As the economists Charles P. Kindleberger and Hyman Minsky showed, financial crises and credit-supply contractions aren’t exogenous events hitting a stable economy. Rather, they should be viewed as at least partly the result of earlier economic excesses—namely, credit-supply expansions.

In short, credit-supply expansions often sow the seeds of their own destruction. To make sense of the bust, we must understand the boom, and particularly the behavioral biases and aggregate-demand externalities that play a critical role in boom-bust credit cycles.

But what sets off sudden credit-supply expansions in the first place? Based on our reading of historical episodes, a rapid influx of capital into the financial system often triggers an expansion in credit supply. This type of shock occurred most recently in tandem with rising income inequality in the U.S. and higher rates of saving in many emerging markets.

The credit-driven household demand channel could be helpful in answering longer-run questions, too. As the Federal Reserve Bank of San Francisco’s Òscar Jordà, Moritz Schularick, and Alan M. Taylor have shown, there has been a long-term secular increase in private—particularly household—credit-to-GDP ratios across advanced economies. This trend has been accompanied by a related decline in long-term real interest rates and increases in within-country inequality and across-country “savings gluts.” The question now is whether there is a connection between these longer-term trends and what we know about the frequency of business cycles. 

AMIR SUFI, professor of economics and public policy at the University of Chicago Booth School of Business, and ATIF MIAN, professor of economics, public policy, and finance at Princeton University, co-wrote House of Debt.