19 November 2018

Checkpoint: 115 Months of recovery, where are we?

In February 2018 I noted that the recovery had reached 105 months (I must have been off in my count, as the WSJ today calls it 115 months so far, with the longest in US history being 120 months), and asked what could end the recovery. I listed nine possible scenarios that could crack investor confidence sufficiently to cause a sustained market downturn or crash. How have those nine held up over the past ten months, and has the level of risk increased or decreased?

If we should take any lesson from the passage of the past 10 months, it should be that we are closer to the storm, not that we have avoided it.

There has been, with the US mid-term elections, both a reduction in the level of risk and potentially, a major increased risk event. More about that below.

As a recap, the nine potential issues (one removed, one added) that could bring about an end to the US recovery include:

  1. Interest Rates;
  2. Inflation shock; 
  3. Budget deficits;
  4. External Shock;
  5. Housing market;
  6. Automotive Loans default rates; 
  7. Credit Card delinquency rates;
  8. Environmental event; 
  9. Mid-term elections

After years of single-direction trajectory for the markets, the February correction jolted people from their complacency, but concerns were short-lived as the markets recovered and eventually reached new highs in early October. Then there was the October market shock, and now it appears a post-election bump.

Being very clear, I still do not know if the top has been reached, or is there more headroom in this market. I have no idea. None. Also being clear, while the discussion focuses on the US markets, there is nothing in here that either does not have or is not impacted by events and economic situations in other countries.

If the markets continue their advances, how far can they go, and for how long? Is the US in the "demographic sweet spot" that I wrote about in August 2017? I asked if the fall in the US labour market participation rate had been strong enough to create sufficient pools of surplus labour to allow for multi-year growth as that surplus labour drip-feeds into the workforce. If it is, then there may actually be a few more years of growth in the economy and the markets. If not, then the third longest recovery in US history may come to a sudden end.

So having presented all the caveats that matter, the question remains; when will the recovery end, what factors could cause a market rout, and how close are we to that happening?

Interestingly, almost all of the nine catalysts has deteriorated over this year, increasing the chances of any one of these reaching a tipping point, and with contagion, bringing about a multiple Black Swan event stream.

In February I wrote “Most important, there is not one situation that will cause the coming crash, and all are interlinked and interdependent. Each can, and probably will, impact and potentially exacerbate another or multiple others.” That assessment remains true, and the deterioration of each potential catalyst since then has only increased the probability of such contagion.

Below I look again at each, with a potential update on the current situation.

1. Interest Rates: Fed rates hikes have continued through the year, and there is an expectation that there will be another rate hike in December 2018. I predicted that the Fed rate would continue to rise, and it has. More importantly, the 10-year Treasury, hovering then around 2.9% up from a low of 2.06% only six months previously, is now in the 3.2% range, and will go up further with additional rate hikes. Eventually, returns on “zero-risk” assets will move closer to the returns that can be expected (minus the desired margin for risk) from risk assets. When that happens, there may be a flight to Treasuries. There continues to be the additional risk of tipping point in consumer credit growth due to increases in interest rates. Interest rates remain a potential cause of a sudden drop in confidence.

2. Inflation shock: While the years of QE, QEII, Twist, Abenomics, and ECB purchases did not create the inflation shock that should be expected from too much cash chasing too few assets, there are signs of inflation beginning to creep in – in employment costs. Surplus labour is being consumed, and the dearth of skilled workers is beginning to be felt. While demographically the US may have a deep lake of workers waiting to return to work, the decade of reducing participation rate has stripped many of these workers of skills that are required in an economy that has changed so significantly in that decade.

3. Budget deficits: the official 2018 US federal budget deficit is $779 billion, and has jumped 17% since 2017. This, of course, is not the actual US federal budget deficit and total borrowing by the federal government, because it only includes “budget” items, and does not include a wide range of additional spending that has resulted in the US federal government actually borrowing $1250 billion. A Congressional Budget Office projection stating that servicing of the national debt will exceed 8% of the 2019 federal budget (from a current 6% of the federal budget)? As interest rates increase, so does the interest payment obligations of the US government. At some time, there will be a confidence shock related to the budget.

4. External Shock: In the past 10 months there are been plenty of External Shocks, and defying expectations, none seem to have actually impacted levels of confidence in the US economy (and it is the US economy and markets that will crash the rest of the world). Turkey has crashed, as has Argentina, and Venezuela continues to perform to form. Equally unsurprising, there has not been a war with North Korea (not that there ever was going to be a war with the Norks – and yes, The Donald was played like a cheap fiddle). 

Yet potential external shocks remain, and the most “predictable” today include the Italian budget, Brexit, and China. None is a war, but we shouldn’t discount the possibility, with Iran being vocally belligerent (with the threat to Oil supplies and price) after the imposition of the extremely harsh sanction by the US, and an accident could spike tensions in the South China Sea at any time. Extreme but highly unlikely events might include the fall of the current Crown Prince in Saudi Arabia and an associated short civil war.

5. Housing market: The US housing market is turning, even though it has had a very strange 6 months, with months of good starts, contacts and completions for both new and existing homes, and months of badness in the numbers. The latest information suggests that optimism is gone from the market. Optimism drives the market, as without consumer optimism major purchases, and a home is one of the largest purchases most people will ever make, will be postponed. 

6. Automotive Loans default rates: This is one area where the numbers appear to be improving, with auto loan default rates reducing marginally in the previous quarter. Current default rates are increasing, and the total outstanding loan period is also at a record high. In 2018 the most common car loan term was 72 months, and average new car loan monthly payments have reached a record high of $531/month. In addition, over 30% of used car trade-ins are under water. Combine the two, and the consumer is likely to become trapped in the vehicle they are in, and with that trap will come a reduction in car sales, and an expectation of future poor performance by the automotive section.

7. Credit Card delinquency rates: The American binge on consumer credit continues, and in fact never really stopped. Net savings rates are at historic lows of around 2% (average across the entire economy) while credit card debt continues to rise. This is unsustainable. However, so far delinquency rates are not rising, and remain cyclically low at around 2.47%, and in fact remain lower than before the GFC.  None the less, with consumers continuing to splurge on consumer debt, it is only a matter of time before delinquency rates start to climb again. 

8. Environmental event: In a strange twist, the hurricanes and fires that have caused so much damage and misery across the American south and west are now beginning to show up as increased economic activity. The latest retail and home improvement sales have shown a nice jump, probably due to rebuilding activity. Unfortunately, like wars, this is false economic growth, as the country and the people spending the money are paying to return to something less than their pre-event status.

9. And, the Mid-term results: And of course there is now the new situation that could result in longer term (18 months at best) stability, or could result in a US national trauma that spills over into markets and globally; the Mid-term results. It is a given that there will be investigations, indictments, and quite possibly an impeachment, or at least the start of an impeachment process. We will enjoy the drawn-out process of the President attempting to keep his tax returns secret, and fighting subpoenas all the way to the highest court, if he can.

We will also see any market setback being blamed on a Democratic House refusing to go along with his additional tax cuts. A government shutdown is also possible.

One thing is certain, legislative gridlock and a shutdown in the passage of meaningful legislation to help the economy.

Whatever the trigger, when the fall in the markets come, it will be steep and quick, followed by months if not quarters of a cyclical bear market. And while I am writing based on the US economy and markets, the same issues highlighted above are true for so many economies, and any individual large economy could provide the trigger for a global rout.

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