- Stocks are likely to maintain their longer-term upward trend until the end of the year, and possibly until the summer of 2019.
- The US Economy remains strong and it is likely that a path towards a trade agreement between China/US trade will surface on or around the G20 meeting on November 30th.
- However, monetary tightening and rising interest rates will eventually become a drag on corporate earnings, economic growth and credit expansion.
- This will likely lead to the end of the bull market that investors experienced over the last 9 years, with equities peaking sometime between early- to mid-2019.
Investor Challenge #1:
Rising Interest Rates, Fading Effects From Fiscal & Monetary Stimulus & Tax Cuts Will Cause Growth to Slow
The expansion of credit is a primary factor driving economic growth. As rates continue to rise, credit will begin to contract in 2019. The expected rate hikes would likely push the ten-year treasury rate above 4% by the end of 2019. A 4% rate on the ten-year treasury is simply too high for the US economy to withstand at the current and projected growth levels. Availability of credit will shrink, and growth will slow at an accelerated rate. Larger capital costs will be required to service debt payments, leading to fewer capital expenditures and R&D, further slowing growth. Some riskier borrowers will be unable to service and/or refinance their loans under slower growth and higher rates. This will lead these underperforming borrowers to default, which will cause a credit squeeze and high-yield spreads to widen. Further, future growth estimates will be revised lower, and earnings multiples will compress. A mild and brief recession will subsequently take hold, likely in 2020 – 2021. This will lead to further downside pressure on risk assets until valuations become cheap enough that the trend reverses, or until there is ample accommodation from the Fed and/or fiscal policy that allows credit to expand again and stocks to appreciate.
However, there is a possibility that the Fed will back off its hawkish stance early in 2019 to prevent the economy from deteriorating too fast. While the Fed is supposed to be “independent” from the White House, historically there is mixed evidence for this in my opinion. For example, in 2004, Allen Greenspan kept the Fed Funds rate artificially low at 1% for 12 months prior to the 2004 election, helping to boost stocks 40% from their bottom in 2002 and giving the economy extra stimulus. This certainly helped George Bush win his re-election and also led to the housing boom and bust that followed. Therefore, as we approach another presidential election, anything is possible. If the Fed dampens down its hawkish rhetoric indicating the likelihood of only one or two rate hikes in 2019 instead of 4, this would certainly postpone the expected market downturn in mid-2019 and the next recession until mid-to-late 2021. In summary, it is not a matter of if but when the markets and economy will turn. This will primarily depend on policy decisions rather than pure economic drivers.
FACTOR #1: GDP will slow
After posting stellar Q2 and Q3 growth rates, the Department of Commerce predicts GDP for 2018 on an annual basis will likely come in at 2.9%. A 2.9% growth rate, record unemployment, and tame inflation is all good news, it is unlikely to be sustainable.
A prospective infrastructure spending bill, now a possibility with the support of the Democrats in the House, may also help extend gains in equities, but eventually, fiscal stimulus and the benefits of corporate tax reform will fade. When analysts begin to price in this lackluster forward guidance, equities and corporate bonds will fall precipitously.
Below is the Federal Reserve’s estimate of annual GDP growth, falling to 2.5% in 2019 and to 2% in 2020.
Fed GDP guidance chart
Housing is Already Slowing
New One Family Houses Sold fell to 553,000 for the month of September 2018. With rates likely to continue higher and employment hitting a peak sometime in mid-2019, houses sold will likely either remain flat or possibly fall in 2019 – 2020. In the past downturn, New One Family Houses Sold started to fall approximately two years before the market peaked. While the timing is difficult, declining houses sold will only add to the headwinds of slowing economic growth.
Autos & Light Truck Sales Have Already Stalled
Autos & light truck sales have steadily risen from 2009, the bottom of the last market downturn, to 2015. However, since 2015, autos & light truck sales have failed to make new highs. This trend is likely to continue to remain flat and slowly decline, adding additional pressure to economic growth.
Corporate Capital Has Been Used for Buybacks Instead of Investment
Since 2009, corporations have been using their cash to buy back their own shares instead of investing that capital in job-producing projects, such as infrastructure, manufacturing plants, employee training, and R&D, among other areas.
While stock buybacks usually help elevate stock prices in the short-term, they don’t provide the ingredients needed for future economic expansion. This lack of capital spending will eventually add significant headwinds for economic growth in the years to come.
Rising Interest Rates
Accompanying slowing growth is rising rates. Let’s look at the factors that are contributing to a rising rate environment:
Factor #1: Federal Fund Rate
First, we have the Fed Funds rate, which has an aggressive schedule of rate hikes under the hawkish Fed chairman, Gerome Powell. Below are the current projections of the Federal Funds Rate. While the Fed is “data-dependent”, it is likely to be more aggressive in hiking rates in this cycle versus other cycles based on the current rhetoric from FOMC.
Currently, the Fed Funds Rate sits at 2.25% with an expected hike in December, taking the rate to 2.375 – 2.5%. At the end of 2019, current projections put the rate at 3.125%, with three to four additional rate hikes expected in 2019. However, if the economy and markets falter in 2019, it is likely the Fed will only hike two or three times.
Factor #2: Quantitative Tightening
On top of hiking rates, the Federal Reserve is also engaging in Quantitative Tightening, or “QT”, whereby they are selling $50 billion worth of treasuries each month on the open market. The additional supply of treasuries hitting the market will cause interest rates to rise, including government bonds, investment grade corporates and high yield. Selling bonds to reduce the Fed’s balance sheet instead of letting the bonds mature puts additional pressure on rates. Not only is the Fed selling treasuries, but China has been increasing their dispositions of treasuries over the last several months. This will likely continue as China needs to sell these treasuries to increase their US dollar cash reserves to assist and stabilizing the RMB exchange rate to prevent capital flight from China.
Factor #3: Elevated Risk Exposure While High Yield Spreads at Post-Crisis Low
As the economy continues to expand, value investments are becoming harder to find, yet the demand to place capital currently has existed for some time and remains intact at the moment. This has led excess capital to be precariously injected into higher-risk loans, as well as corporate bonds and equities. When the economy stalls, many of these higher-risk investments will begin to default, increasing the yield spread and putting further pressure on rates.
Factor #4: Wage Growth Pressure
The labor market is tightening, which is driving up wages and subsequently causing a slight increase in inflation. Wage growth will continue to push rates higher.
Factor #4: High Deficits & Total Debt to Get Worse
Finally, as deficits continue to soar, domestic and foreign buyers of US bonds will require higher interest rates to take on the burden of added risk of the bonds depreciating and the increasing debt levels.
While this entire process will take years to cycle through, we have already started to feel the negative effects of rising rates, which was partly the cause of the decline in stocks this past October. Unfortunately, the recent drop in equities in October will be minor compared to what will eventually unfold.
US Deficit Projected to Increase
Federal Debt Exceeds $20 Trillion and Accelerating
Debt to GDP Ratio Almost 100% Higher Than Just 10 years Ago and Rising
Factor #5: The Ten-Year Treasury Yield
The Ten-Year Treasury Yield successfully bounced back off its 30-year resistance level at 3.25% at the end of October. However, once this resistance is broken and the Ten-Year Treasury rate rises above the crucial 3.25% threshold, significant pressure will be put on the corporate credit markets, causing the credit cycle to reverse from expansion to contraction. This will likely cause the post-crisis bull market to finally come to an end. Hopefully, the rise in rates will be slow, which will allow equities to reach new highs before finally entering into a bear market. This transition will likely happen early- to mid-2019.
Factor #6: U.S & China Trade War Could Push Prices Higher
The U.S. and China are both playing hardball negotiating a potential trade agreement. As both parties have surmountable leverage and dependence on each other, both countries know that if a trade agreement on, it will turn into an utter disaster for everyone involved, including U.S, China, and the global economy.
I believe both parties will come together and make an initial trade agreement. However, even with a trade agreement, some tariffs may remain in place, which could push prices, causing inflation and also pushing rates higher.
Investor Challenge #2:
Rising Rates To Cause Earnings Multiples To Compress
The Cyclically Adjusted Price to Earnings Ratio, also known as CAPE or the Shiller PE Ratio, is a measurement conceived by Robert Shiller which adjusts past company earnings by inflation to present a snapshot of stock market affordability at a given point in time.
As rates rise, multiples on price to earnings ratios decrease and, vice versa, when rates decrease price to earnings multiples increase. For example, in 1982 when US government ten-year treasury peaked at 15%, the P/E ratio was 8. As rates declined over the last 30 years, the Ten-Year Treasury rate bottomed in July 2016 at 1.3% and the P/E ratio on the S&P was 15. In both instances, the subsequent years experienced consistent and strong gains, even though multiples from the initial starting point were drastically different.
Now, we sit at the point where rates are moving up after moving down for 30 years. This will compress the P/E ratios, inevitably leading to lower equity returns over the next decade. Simple estimates suggest a 10-year average return on equities to be around 4.5% – 6%, including, both dividends and capital appreciation.
Investor Challenge #4:
The Longer-term Risk of High Inflation
For years, investors expected inflation to pick up and even sky-rocket. However, that never transpired and inflationary pressures never showed up, at least not yet. People ask about the risk of inflation. Then, the question is, “What do you mean, too much or too little?” This is an unprecedented situation where growth, unemployment and consumer confidence should be pushing inflation much higher, yet, the evidence suggests otherwise. Why is this? Globalization, competition from globalization and innovation has kept prices and inflation at bay for some time. However, with trade war fears, unsustainable government debt levels and years of minimal capital and infrastructure expenditures, in time, say 5 – 15 years, inflation may once again get out of control as the government adds to the already gigantic debt levels to fund social programs and re-build the dilapidated infrastructure. This will lead to a severe stagflationary period as secular growth remains weak and interest rates and inflation soar.
The Strong US Dollar Won’t Last Forever
It is also worthwhile to note that once the Fed does stop rising rates, this will likely cause the US Dollar to fall and push interest rates even higher.
Sometime in late 2019 – 2020, the Fed will soon be forced to back off their hawkish stance of hiking rates and either stop raising rates or lower rates, if economic or market conditions deteriorate precipitously. Moreover, the US Dollar is also faced with soaring deficits and government and corporate debt, leading to a toxic mix of conditions to weaken the US Dollar.
Over the past decade, trillions of dollars were injected into the financial system causing asset inflation, propelling equities, bonds and real estate higher. After experiencing dramatic inflation in financial assets and exploding government and corporate debt, investors will likely be confronted with a challenging investment environment and increased volatility over the next decade. In addition, future returns from risk assets in the developed world are likely to be lower than in the past decade, projected at 4.5-6% total annual average return over the next ten years. With expected lower returns and heightened risk, investors must seek out strategies and investments that offer a better risk-adjusted return rather than depending on traditional buy-and-hope strategies and traditional asset allocation mixes.
Below is my base case scenario for equity market performance over the next 5+ years.
Here, we see the market reaching the previous high or making a slightly higher high in mid-2019, then breaking below its three-year resistance to hit its nine-year support level, which would be approximately a 30% decline. The magnitude of the rebound from here will depend on several factors. The fed will again provide accommodative policies, which will drive asset prices higher. But the real influencer will be if a pro-growth administration stays in the white house with Trump or another candidate in 2020, or if the administration switches to a left-wing candidate and Congress, implementing higher taxes and regulations. My base case suggests Trump will get re-elected. This is primarily attributed to the fact that the economy will still be relatively strong despite a reset in asset prices. Therefore, he will still garner enough support from his middle-class base to keep him in the White House. However, assuming Trump does get re-elected in 2020, a bleak horizon awaits upon his departure as the ammunition that has propped up the economy will likely fade. I see the markets still falling at least 35% and the economy will enter a moderate recession. If there is a 180-degree change from pro-growth policies and deregulation to a far-left administration that implements higher taxes and more regulations in 2024, markets will likely crash around 60%, where the Dow Jones hits the technical support at 12,500 and the economy will enter a severe recession.
After this re-set-in asset prices, valuations will be so depressed that markets will start to head back up again, but only after a brutal market correction that will cause millions of Americans to sell at the bottom or close to the bottom and wipe out most of their retirement savings. The danger of this is that it may cause a political uprising where disgruntled Americans leverage their political clout to re-distribute the high disparity in the wealth gap, likely putting a socialist-oriented candidate like Bernie Sanders in the White House. This would lead to extremely high tax rates, a massive increase in benefits and entitlements, nationalized medical care, high regulations and possibly universal income standard. Such a scenario would be extremely unfavorable for capital markets and commerce, causing the US Dollar to plummet and inflation to soar.
Either way, 2023 is likely to be a painful year for long-only investors. The only question is how far the market fall will and how quickly will the market recover.
While there will likely be wide deviations from this base-case scenario, as these are only my personal base-case assumptions that will be updated as time goes by, it is prudent for investors to acknowledge some of these possible risks to formulate their own personal investment strategy to preserve and protect their capital.
Some strategies that may be worth considering are implementing methods to protect downside risk, identifying unique individual equities and sub-sectors that are likely to experience accelerated growth despite the downturn in the overall economy, consider institutional alternative and private equity investments, floating-rate secured loans, short duration corporate and government bonds, preferred securities, certain asset classes within commercial real estate, emerging market opportunities, emerging market bonds, energy, long/short and hedged investment strategies.