February 2, 2015
Market Action Suggests Abrupt Slowing in Global Economic Activity
The combination of widening credit spreads, deteriorating market internals, plunging commodity prices, and collapsing yields on Treasury debt continues to be most consistent with an abrupt slowing in global economic activity. Generally speaking, joint market action like this provides the earliest signal of potential economic strains, followed by the new orders and production components of regional purchasing managers indices and Fed surveys, followed by real sales, followed by real production, followed by real income, followed by new claims for unemployment, and confirmed much later by payroll employment. Stronger conclusions, particularly about the U.S. economy, will require more evidence, but from a global perspective, these pressures are already quite evident.
It’s striking how little economic thought seems to go into talking-head assessments of these developments. The plunge in Treasury yields, for example, is attributed to yield-seeking in response to expectations of European Q-ECB. But if investors still retained speculative yield-seeking preferences, we would observe that uniformly through similar yield-seeking in lower quality credit, as well as risk-seeking in equities without large internal divergences (factors that serve as the central distinction between overvalued markets that continue to advance, and overvalued markets that drop like a rock – see A Most Important Distinction). Instead, the broad retreat – though still early – from speculative assets toward havens considered free of default, essentially signals a shift toward risk aversion. Bad things tend to happen when compressed risk premiums meet increasing risk aversion. As I’ve frequently noted, risk premiums tend to normalize in spikes, so low and expanding risk premiums are the root of abrupt market losses.
While Wall Street talking heads seem unanimous in viewing the decline in oil prices as “stimulative” for the global economy, on the notion that it frees up spending money for other purposes, the problem is that the decline in oil prices is indicative of a retreat in global demand. That is, when prices fall, it makes a difference whether the decline is due to an expansion of supply (which lowers price but expands output), or a retreat in demand (which also lowers price but contracts output). If the demand curve shifts back, you don’t take the lower price that resulted from the reduction of demand, and then use it as an argument that demand is going to increase (and then use that as an argument that increased demand will raise the price, and then…) No. The decline in price is itself an equilibrium outcome of the decline in demand. At that point, you end the sentence.
Unfortunately for monetary authorities around the world, the same is true for interest rates here. Attempts to press interest rates to preposterously low levels aren’t stimulating demand for borrowing, because the global economy is already submerged in its own indebtedness. Yes, before investor preferences shifted toward risk aversion in about mid-2014, depressed yields on safer investment classes did create an opportunity for really junky issuers to issue debt to yield-seeking investors by offering a “pickup” above Treasury yields. We saw the same thing during the housing bubble, which allowed an enormous amount of malinvestment funded by yield-seeking. In the recent cycle, the malinvestment has primarily taken the form of leveraged loans (loans to already highly-indebted borrowers), and “covenant-lite” junk lending. The other primary form of malinvestment has been through corporate repurchases of equities that are strenuously overvalued on historically reliable measures, financed – make no mistake – through the issuance of new debt (see The Two Pillars of Full Cycle Investing for the data on this).
So what we’ve really got is a situation where interest rates are low because safer borrowers are swimming in debt, while credit spreads are widening because junkier borrowers are hugely sensitive to even a moderate slowing in global economic activity.
We generally agree with Charles Plosser, one of the more economically thoughtful minds at the Federal Reserve, who observed last week:
“The history is that monetary policy is not ultimately a very effective tool at solving real economic structural problems. It can try for a while but the problem then is that it’s only temporarily effective, and when you can’t do it anymore you get the explosion yesterday in the Swiss market. One of the things I’ve tried to argue is look, if we believe that monetary policy is doing what we say it’s doing and depressing real interest rates and goosing the economy, and we’re in some sense distorting what might be the normal market outcomes, at some point we’re going to have to stop doing it. At some point the pressure is going to be too great. The market forces are going to overwhelm us. We’re not going to be able to hold the line anymore. And then you get that rapid snapback in premiums as the market realizes that central banks can’t do this forever. And that’s going to cause volatility and disruption.”
That’s already an issue at present. If we were still in an environment where investors were risk-seeking (which we infer from the uniformity of market internals, credit spreads, and other risk-sensitive market action), overvalued markets might have a tendency to become more overvalued, regardless of how thin risk premiums might be. That, right there, is the essential lesson to be drawn from our own challenges in the recent half-cycle, at least until about June of last year when we viewed them as fully addressed (see A Better Lesson Than “This Time is Different” – probably the best reference on that awkward transition). But once internals and credit spreads deteriorate, as they have been doing in recent months, compressed risk-premiums have a tendency to normalize - not gently, but in spikes, which we observe in price action as air-pockets, free-falls, and crashes.
Where I think Plosser and I might disagree is that, in my view, the first step by the Federal Reserve should not be to raise interest rates – indeed, in the face of what we view as a clear deterioration in global economic prospects, I question that this would be particularly constructive – and would cast a great deal of blame toward the Fed if the weakness continues. Not to say that raising rates would have much actual effect on economic activity, as the only form of economic activity that has proved responsive to zero-interest rate policy are those activities where interest itself is the primary cost of doing business: financial speculation and leveraged carry trades. But hiking rates by paying interest on reserves, rather than by normalizing the monetary base, would have no promising effects. In my view, the primary response to a hike in the Fed Funds rate (achieved by raising the interest rate paid on reserves) would be to draw currency out of circulation and expand the already grotesque mountain of idle reserves in the banking system.
Rather, I think the Fed should – and should immediately – cease the reinvestment of principal as assets on the Fed’s balance sheet mature. There’s utterly no sense to these reinvestments, as 1) the balance sheet could contract by about $1.4 trillion without moving short-term interest rates from zero (see A Sensible Proposal and a New Adjective), and 2) at the present 10-year Treasury yield of 1.64% and interest on reserves of 0.25%, the breakeven curve on new bond purchases by the Fed – the future yields that would result in zero total returns, even after interest income – are just 1.81% on a 1-year horizon, 2.02% on a 2-year horizon, and 2.29% on a 3-year horizon. Future yields any higher than that will produce net losses to the Fed.
Now, my impression is that yields may move even lower over the next few quarters if the economy weakens, in which case we might even see a 1-handle on the 30-year bond and a 0-handle on the 10-year. But bonds are already priced at speculative levels in the sense that one must expect virtually no normalization of yields at all, for years to come, if one is to avoid net losses on purchases at these levels. As usual, our own approach leans toward seeking longer duration on upward spikes in yields, and avoiding long-duration exposures on overextended retreats in yield. In short, 10-year Treasury bonds are priced to be feeble long-term investments, as are nearly all other investment classes thanks to years of yield-seeking speculation. But the assets that will be hit first – and hit hardest in any normalization of yields or risk premiums – are likely to be junk, then equities, then seemingly credit-worthy corporates, with Treasury debt at the tail end of that normalization.
But – a Fed-chasing lemming might counter, in the belief that Federal Reserve intervention “works” regardless of investor risk preferences – if the economy softens, doesn’t that ensure that the Fed will come to the rescue by deferring any hike in interest rates? Won’t that in turn drive the financial markets higher?
There are two answers to that question. The first, as I noted in The Line Between Rational Speculation and Market Collapse, is a reminder that the Fed did not tighten in 1929, but instead began cutting interest rates on February 11, 1930 – nearly two and a half years before the market bottomed. The Fed cut rates on January 3, 2001 just as a two-year bear market collapse was starting, and kept cutting all the way down. The Fed cut the federal funds rate on September 18, 2007 – several weeks before the top of the market, and kept cutting all the way down.
As a result, the second answer to the question above is that it is the wrong question. Our attention should not be absorbed in speculation about what the Fed might or might not do, but should instead attend to measures of investor risk preferences such as market internals and credit spreads. In the event they improve – which we certainly don’t rule out but don’t particularly expect in the near term either – the immediacy of our concerns about downside risk will ease markedly. Depending on the status of other market conditions, we may even observe an opportunity to encourage an outlook more along the lines of “constructive with a safety net.” On the other hand, if we observe a material retreat in valuations followed by an improvement in market action, I expect we could encourage a clearly constructive or even aggressive stance toward the market. So we’ll take our evidence as it comes, with a continued focus on adhering to a historically informed, value-conscious, risk-managed discipline.
With respect to risk management, it’s helpful to recognize that it takes two back-to-back 33% losses to experience a 55% loss as the S&P 500 did in 2007-2009. Compounding has very interesting effects over the course of a market cycle. A 50% loss wipes out a 100% gain. A 20% gain in asset X during a 40% loss in asset Y leaves asset X at double the value of asset Y. Passive investment strategies invariably look desirable relative to risk-managed strategies at the peak of a market cycle, because risk-management looks like a mistake in hindsight. Over the course of the complete market cycle – of which we have now experienced an unfinished half – those relative comparisons typically look dramatically different.
With median valuations for the average stock higher now than in 2000 on the basis of price/revenue, price/earnings, and enterprise-value to EBITDA; with numerous historically reliable valuation measures more than double their pre-bubble historical norms; and with the S&P 500 now beyond the peak valuations of every market cycle on record (including 1929) except for the final quarters surrounding the 2000 bubble, understand that stocks are no longer an investment but a speculation. There are times that such speculation tends to work out – but those times require risk-seeking preferences among investors, which can be inferred from features of market action that are not in place at present. I expect that these distinctions will serve us greatly over the completion of the present cycle and in those to come.As for the completion of the present cycle, I’ll say this again – the 2000-2002 decline wiped out the entire total return of the S&P 500, in excess of Treasury bill returns – all the way back to May 1996. The 2007-2009 decline wiped out the entire total return of the S&P 500, in excess of Treasury bills – all the way back to June 1995. A shift back toward risk-seeking preferences among investors will not relieve the extreme overvaluation of the equity market, but it would defer our immediate concerns. We may observe constructive opportunities along the way, but we view it as inescapable that the completion of the current market cycle will end in tears for investors who don’t carefully align their investment exposures with their expected spending horizon (see the second half of Hard Won Lessons and the Bird in the Hand for a discussion of these considerations). For now, we maintain a sharply negative outlook toward equities.
The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse. Please see periodic remarks on the Fund Notes and Commentary page for discussion relating specifically to the Hussman Funds and the investment positions of the Funds.
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