(Or to paraphrase Clint Eastwood’s Dirty Harry: “A government’s got to know its limitations”)
The past week has certainly accomplished what market pundits had long since called for: volatility.
Volatility that was generated by four straightforward catalysts:
The advent of wage growth
More US debt
Quantitative tightening
Fed tightening
While we can talk at length about valuation, it was really last Friday’s Non-Farm payroll number's wage data that provoked the market (especially Treasuries) into the epiphany that the Fed, and rates, were the biggest risks to the economy going forward.
We saw wage growth of 2.9% which we have not seen for some time!
However, now that these risks have been highlighted, I would prefer to focus our attention and discussion to what lay ahead. For the sake of some narcissistic vanity, I have included here the link to my CNBC broadcast during the market correction (Troise CNBC link here).
Whilst we can fear the Fed, I would prefer to believe that the Fed will ultimately manage the economy through this phase of growth. And, that is an important statement…this is growth we are managing now. The world’s economies are now growing in unison for the first time since the GFC. So the fear isn’t recessionary, but rather a worry about inflation.
In the midst of all of this, the US Administration threatens shutdown. In the midst of all of this, the US Administration (and the Tea Party) throw away any previous adherence/belief on deficit reduction. Instead, the US keeps adding to its debt load. (How has the USA done historically? Click here)
Begging the question…how does the US intend to pay for all of this? Or, another way to view the dilemma, who is going to lend the US the cash?
This question is worth focusing on further as it will define, and explain the stock market’s sentiment in the months and years ahead.
How much money are we talking about near term? The US Treasury is planning to borrow $955 billion in FY 2018. Who has the appetite to buy this?
It basically boils down to several possible market participants:
American savers
Institutional investors
Sovereigns (i.e. China, Japan, OPEC, etc.)
As we look at each, we can conclude that a debt shortfall at current rate interest rate levels is inevitable.
American savers have been virtually non-existent. We sacrificed a generation of senior citizens in the GFC to low yields to foster QE and the asset bubble. Now to hope that Americans will double down when they need a 34,000 DJIA level to retire is too optimistic. My view is that Americans will be reticent to fund the debt and will instead double down on other asset classes (#NoCoin)
Institutional investors, like US pension plans, have the same dilemma. Ideally, the yield curve would be positively sloped (the carry trade), but it isn’t there yet to the degree necessary today. In addition, given the extraordinary amount of pension shortfalls, most US pensions are facing the same dilemma that US savers are: they need the “8% equity return” of old.
Leaving us with sovereigns. This gets interesting when we compare this to US foreign policy, the US dollar, and the underlying dynamics of energy.
China is trying to diversify away from US dollars. Keep in mind, that due to the trade deficit, the US is paying them in dollars, and for the Chinese, the easiest asset to buy is US Treasuries. Even if they buy assets elsewhere, the dollars ultimately have to be used by someone. The Chinese don’t like this dependency on the US and as such have begun several initiatives to mitigate that risk. Their One Belt, One Road initiative portends their move away from US dollars.
To top it off, Asia has less of a need for the US consumer. In the past, exports to the US were a key driver. But now the Asian economies have far more autonomy than their Western counterparts seem to be acknowledging.
NOTE: In the next few weeks I will be sharing with you some data (and fantastic portfolio manager interviews!), where the smart money has now seen that the Asian consumer has finally arrived. Asia isn’t as export driven as before…which does not bode well for the US debt problem.
OPEC, another reliable buyer of US debt has its own issues. Not the least of which is US energy independence. To oversimplify it, if the US isn’t buying large amounts of oil with dollars, then OPEC has no rationale to buy the same amount of US Treasuries.
In fact, as we look at the holders of the US debt worldwide (link here), we can conclude that the US has to provide an “incentive” to buyers of its debt to make up for the shortfall.
How best to do that? Higher rates.
Who has realized this? The market(s). Hence the sell off and increase in volatility.
I am sorry that I do not have a more optimistic message, but this is the reality that we face in the markets today.
It has been over ten years since we have seen a market like this. Investors, traders and market participants have gotten used to low rates for far too long and many are ill-prepared with how best to deal with it.
In the weeks ahead I will spend more time on this, and will provide you a roadmap for navigating this market environment.
My Keynote in Sydney!
In late February 21-23, I will be speaking at RFI’s Mortgage Innovation Summit Event in Sydney. If you are in town, let me know and it would be good to get caught up then! The link to the event is here.