Watching the markets over the last weeks is like watching the seven stages of grief – shock, denial, anger, bargaining, depression, testing and, finally, acceptance. We in our opinion clearly have not reached that last stage yet. This isn’t really about coronavirus – that was in our opinion simply a trigger for a correction we at Calvin•Farel have long expected.
The US is in the longest economic recovery cycle on record, with mounds of global debt, falling credit quality, and decades of low interest rates driving asset prices to in our opinion unsustainable levels. The reluctance of investors, politicians and central bankers to accept that is not just an example of the natural human tendency to put off pain. Rather it is something scarier and more factual. The truth is that the US economy is now dependent on asset bubbles for survival.
About two-thirds of the US economy is consumer spending. But people’s spending patterns are not based only on their income. Our personal consumption is also linked to our expectation of wealth held in assets like stocks and bonds. What’s stunning to us is how utterly dependent American fortunes have become on the inflation of those asset prices. Net capital gains plus taxable distributions from individual retirement accounts are equal to 200% of year on year growth in US personal consumption expenditure.
That does not necessarily mean that people are pulling money out of their retirement accounts to buy hand – sanitizer, bottled water and face masks. But it does mean that US gross domestic product “cannot mathematically” rise if asset prices are falling.
No wonder the US Federal Reserve cut rates by 50 basis points last month. The move came with a predictable risk of spooking the market – and it did so. The S&P 500 fell nearly 3% that day and almost 10% on a single day just a few days later. But the fundamental risk of inaction was deemed greater. Central bankers are clever people! They know that they cannot fix pandemics or political dysfunction with monetary stimulus. But in the US more than anywhere else, they have found themselves in and in our opinion unenviable position: managing an economy that has, over the last several decades, particularly since 2008, depended on low interest rates to push up asset prices. That in turn has made it less obvious to consumers (and voters) that the average real weekly earnings for the bottom 80% are at about the level they were in 1974, and that the things that make people middle class – healthcare, education and housing have become unaffordable.
Seen in this light, President Donald Trump’s disingenuous attempts to equate the fortunes of Wall Street with those of the country at large make a kind of grim sense. The value of the S&P 500 is less a gauge of the broad health of US corporations or consumers than it is of the wealth of a few tech firms and value of the 2017 tax cuts. The latter accounted for two-thirds of the aggregate rise in corporate profits between 2012 and today.
But share price increases represent a disproportionate amount of the income tax paid by the top 5% of earners, who pay 60% of income tax receipts. Given the importance of asset price increases in both tax receipts and GDP growth, it’s hard for us at Calvin•Farel to imagine a world in which the Fed won’t keep cutting rates indefinitely. Live by the market, die by the market.
It did not have to be this way, and this situation did not develop overnight. The US built an economy that is dangerously dependent on the whims of Wall Street little by little, since the 1970s onwards. It is the result of policy changes driven by both Democrats and Republicans and it currently looks like that part of that action can be now heard as an echo.
At some point the music stops playing for investors. Last month steep drop in the oil price sent traders across equities, credit and emerging markets rushing for the pause button.
The initial shock was the coronavirus outbreak’s impact on the global economy. Then came the blow of an oil price war. Next is escalating financial contagion. Markets are in our opinion likely to burn until the fuel of high debt levels and aggressive risk taking is extinguished. Investors are seeking at least some protection in “long bonds” as their portfolios suffer a hit across equities. Many portfolios were already nursing losses from big falls over the past weeks. And while an oil price war raises the pressure on energy shares and debt, it also reinforces demand for the safety of long-dated government bonds. The fall in the US’s 30-year Treasury yield – from 1.7 to just 0.7% in the past weeks – suggests investors do not believe central banks can prevent the world from sinking into deflation.
Big market shake – outs can escalate over weeks as risk managers subject portfolios and trading desks to tighter limits. There is in our opinion the prospect of increased margin calls on traders to increase collateral on their positions. In turn, that is likely to compel the sale of shares that have performed strongly until last month. A more troubling sign for markets would be asset managers “gating” their funds, or preventing investors from selling their holdings.
Many seasoned investors will note that markets ultimately bounce back from bouts of turmoil. Buying the dip has worked no matter how tough times have looked. The scale of recent equity declines up to 10% in one day not seen since 1987 is a necessary development before markets eventually stabilize and recover. One small consolation is that the combination of ultra-low interest rates and oil prices – along with governments boosting their spending – should start to lift the global economy in the next few months.
The catalyst for a market turn in our opinion are more likely to be some combination of peak infection rates, underweight positioning and very cheap markets.
On those metrics, financial markets face in our opinion quite a wait before the music starts playing again. During this period we will take a deeper focus on crypto assets.