By Albert Lu
U.S. stocks jumped to record highs on Monday, with the Dow Jones Industrial Average surging more than 150 points. The S&P 500 and Nasdaq Composite followed suit, rising by 0.8% and 1.3%, respectively.
President Trump expressed satisfaction, while claiming credit via Twitter:
Another new Stock Market Record. Enjoy!
— Donald J. Trump (@realDonaldTrump) November 25, 2019
But Canadian resource investor Eric Sprott is skeptical.
“[There’s] plenty of signs that there’s weakening in the economy,” he told listeners of his Weekly Wrap Up podcast with co-host Craig Hemke.
“[Not] much to grab on to if you’re a bull because the earnings weren’t great. The outlook seemed to be weakening through time,” said Sprott in reference to declining U.S. GDP growth estimates and falling third-quarter sales figures from companies such as Nordstrom Inc. and Gap Inc.
Nevertheless, markets continued to edge forward on Tuesday, in part due to increasing optimism of a U.S.-China phase one trade deal. All three major stock indexes remain up for the year, with the Dow up 20% and the S&P 500 and Nasdaq gaining 25% and 30%, respectively.
NO SERIOUS IMMEDIATE THREATS
In its November Financial Stability Report, the Federal Reserve System’s Board of Governors concludes that there are no serious and immediate threats in the financial system. According to the report, despite declines in interest rates that pose headwinds to profitability, the banking sector is strong. Furthermore, according to the report, regulatory reforms enacted after the financial crisis have created a banking sector that is “well capitalized.”
Indeed, standard measures of bank solvency risk, such as tangible capital, continue to hold at levels far above required minimums.
But Bill Dudley warns otherwise.
In a recent Bloomberg Opinion piece, the former vice chairman of the Federal Reserve Open Market Committee argues there are two such risks and, in his assessment, both “seem likely to be realized in the years ahead.”
UNSUSTAINABLY LOW TREASURY YIELDS
In its report, the Fed acknowledged that asset prices, relative to cash flows, remain high in several markets, but added that when seen relative to historically low Treasury yields, valuations sit close to their historical norms.
True, perhaps, but far from comforting.
Imagine telling your doctor that elevated cholesterol levels, when examined relative to your excessive weight and proclivity for cigarette smoking and excess alcohol consumption, are actually within the norm?
The low Treasury yields are unhealthy and cannot last.
According to Dudley, “The potential for a significant rise in long-dated Treasury yields is high.”
He believes, for good reason, that the current combination of low short-term rates and compressed term premia — the long-run average spread between long-term Treasury yields and short-term rates — will not last much longer.
“Bond term premia are unusually low because investors are more worried about the risk of recession than the risk of higher inflation,” wrote Dudley.
But with each intervention, the Fed reduces the risk of recession at the cost of increasing inflation risk.
Furthermore, according to Dudley, government spending also poses a serious risk.
“[T]erm premia should also rise over time as chronic budget deficits require large increases in the supply of Treasury debt,” he explained.
Simply put, more supply translates to higher yields.
CORPORATE DEBT BUILDUP
In theory, years of low interest rates should result in increased balance sheet leverage and a corresponding buildup of corporate debt. Indeed, this has been the case.
In an environment where investor appetite for riskier corporate bonds remains strong, many corporate CEOs have been happy to meet the demand by leveraging to fund EPS (earnings per share)-boosting share buybacks. According to the Fed’s report, the business debt-to-GDP ratio has expanded significantly over the past several years and now sits near its historical high.
“This is all incredibly pleasant during a period of sustained economic expansion,” admits Dudley.
But what happens when the next recession inevitably arrives?
The concentration of debt in the BBB-rated sector (the lowest investment grade rating) poses a problem.
“When the next recession occurs, a significant portion of this debt will be downgraded to junk. Credit spreads for this debt will rise because of the deterioration in quality,” he explained.
To make matters worse, mandates restricting holdings to investment-grade debt will force some large investors to part with their newly demoted junk-rated bonds.
“This selling will push securities prices below their underlying value. Prices will have to become overly cheap to provide opportunistic buying,” concludes Dudley.
HIDDEN IN PLAIN SIGHT
Given our experience with the last financial crisis, it’s natural to focus on factors such as real estate prices, securitized products and financial sector liquidity when evaluating economic risks. Although these factors may be in play, the evolving history of boom-bust cycles suggests the next big downturn will be different from the last — different enough to catch many of us off-guard.
Is the real risk hidden in plain sight?
- Ten years of double-digit stock market growth fueled by low interest rates, quantitative easing, tax cuts and corporate buybacks
- Aggressive growth of corporate debt combined with declining credit quality
- Chronic government deficits putting upward pressure on interest rates resulting in the dangerous death spiral of higher debt-servicing costs, larger deficits and even higher interest rates
Whatever the cause, the next downturn is coming — and, according to Dudley, it will be “messier than anticipated.”
“So enjoy the next year or two. As long as inflation stays low, the Fed will remain friendly, but this is unlikely to last.”