Dr. Lacy Hunt, “Economic Theory Matters, Especially So Now”Steve Blumenthal
“There are two bubbles: We have a stock market bubble and we have a bond market bubble…
What’s behind the bubble? Well, the fact is that essentially we’re beginning to run an ever-larger government deficit.
As a share of GDP debt has been rising very significantly and we’re just not paying enough attention to that.”
– Alan Greenspan, Former Chair, Federal Reserve (January 31, 2018)
Before we get started, I’ve had a number of calls about the markets this week regarding the drop in equities. CNBC captured the risk in a piece today, “Global markets slump as trade-war tensions escalate.” On June 17, 1930, Congress passed the Smoot-Hawley Tariff Act. The act raised U.S. tariffs on over 20,000 imported goods. Although economists disagree by how much, the consensus view among economists and economic historians is that the passage of the Smoot-Hawley Tariff exacerbated the Great Depression.
My 2018 SIC presentation took a look at current high equity market valuations and what they tell us about coming returns. I showed a favorite chart of mine that also looks at the risk associated with market valuations. The conclusion is this, when valuations are high, history has shown us that forward returns will be low. History also shows us that when valuations are high, the risk and magnitude of decline is most. The President’s economic saber rattling may be the great negotiation tactic (The Art of the Deal) but, boy, are the risks high. He doesn’t have business people on the other side of the negotiation table, he has politicians. And most have very little business savvy.
Here is the link to my 21-minute presentation and Q&A (starts at around the 45 minute mark after Gabriela Santos’ presentation). Watch it on your iPhone while you take a short walk.
Last week, I shared with you my notes from David Rosenberg’s 2018 SIC presentation. This week let’s take a look at what the great Dr. Lacy Hunt had to say. His presentation was titled, “Economic Theory Matters, Especially So Now.” What I like about Lacy is that he is both an economist and money manager. It’s important to have skin in the game. His firm, Hoisington Investment Management Company, is the sub-advisor to the Wasatch-Hoisington U.S. Treasury Fund® (WHOSX).
Lacy continues to believe that interest rates will make a new low in terms of yields before the secular bull market cycle in bonds is done. In many ways, David and Lacy share similar views. If you missed last week’s OMR piece about Rosenberg, you can find it here. He was outstanding!
Next week, we’ll dive deep into Jeffrey Gundlach’s presentation, “Inflation is Inflationary.” While Rosenberg and Hunt see a short-term higher interest rate trend, they believe the longer-term secular downward trend in rates is not yet broken. Gundlach sees us at a tipping point where interest rates on the 10-year Treasury could quickly race to 4% or 5%. That’d be a tough pill for the equity markets to swallow and a painful experience for bond investors. He suggested the 35-year bull market in bonds has ended.
According to the International Institute of Finance, “Global debt rose to a record $233 trillion in the third quarter of 2017, more than $16 trillion higher from end-2016.” Concluding, “The debt pile could end up acting as a brake on central banks trying to raise interest rates, given worries about the debt servicing capacity of highly indebted firms and government.” (Source: Bloomberg.)
Who’s right? I find myself in Rosenberg and Hunt’s camp. I just don’t see how we speed through the massive debt headwind blowing in our face. Rising rates will cause borrowers to pay more. It will slow the economy and quickly kick the global indebted system right into recession. There have been 13 Fed interest raising cycles in the last 70 years and 10 of them landed us in recession. The other three were mild economic slowdowns, but we weren’t then in this much debt.
I’m keeping a close eye my favorite recession watch indicators and I’ll be sharing them with you from time to time. For now, the good news is there is no signs of recession in the next six to nine months. And frankly, it’s hard to bet against Lacy.
Let’s take a look at what Lacy had to say. You’ll find my notes and charts from Lacy’s presentation when you click through below.
But first, Mauldin shared his initial conference takeaways in his “Thoughts From the Frontline” letter last weekend. A show he orchestrated like a maestro. John wrote:
- I come away from this conference with my recession antenna up. Recessions don’t happen overnight. Things start slowing down and then they roll over. Some of the attendees think the next recession will not be all that bad, while others think it will be worse than the Great Recession.
- The outcome depends on the timing of the next recession and the political reaction.
On “The Return of Volatility”
- Maybe it’s because of the experience of the last month and because we tend to read the latest trend into our forecast, but there was a consensus at SIC that market volatility is going to resume its normal place in our lives. Five percent drawdowns are actually quite normal in any given year and sometimes occur several times in a year. What is not normal is 15 months of less than 2% drawdowns, which we just experienced.
- The volatility of February was not the odd thing; it was the preceding 15 months that was extraordinary.
- Have we seen a market peak, as my friend Doug Kass thinks? Maybe. I have no idea. That is why I have my personal portfolio and those of the clients who work with me structured to be in diversified trading strategies and not be actually long (or short) everything.
- And then we rifle-target specific investments that I think have long-term potential or can produce reasonable fixed-income returns.
On “The Rise of Global Debt”
- At SIC, I did not gain any comfort on the problem of rising global debt. Everybody agrees it’s a problem, but there’s no consensus on what to do about it.
- A question I posed many times was, where we going to sell $2 trillion worth of US Treasuries in 2018? And it’s not just the on-budget deficit; it’s the off-budget deficit and the money that the Federal Reserve seems to indicate it is going to sell into the market. The world is buying less of our debt now, too.
- Lacy Hunt says we will have to buy it. I told a joke that I will not repeat here, but the punchline is basically, what do you mean by “we.” And at what price?
- I get the concept of supply-side economics and tax cuts creating growth that will overcome the deficits. But those tax-cut precedents that are referred to, the ones during the Kennedy and Reagan years, were implemented in completely different economic environments. Number two, we don’t have a Clinton and a Gingrich who can sit across the table from each other and come up with a way to balance the budget. The budget deficit they were trying to balance out was considerably smaller than the one we have today, too. We are one recession away from $30 trillion in total debt, not including state and local debt. Altogether, that’s well over 160% debt-to-GDP. And as we will explore below, it can get worse.
And On “Where to Put Money to Work Today”
- Our first panel of the conference comprised David Rosenberg, Louis Gave, and Grant Williams. When my publisher, Ed D’Agostino, walked out on the stage, he commented that some of the ladies in the back were calling this our “cute bears” panel. Before the panel kicked off, Louis stood up and said, “I just want everyone to know that I am not a bear,” and then, pointing to Grant Williams, “and he is not cute.”
- They all had places where they felt you could put money to work today. I will point out that David Rosenberg has shifted from a full-throated bull to bearish. He was very pleased that Gluskin Sheff, the large money management firm he works for in Canada, has moved to 25% cash. I came away with the feeling that he would like to see that figure increased. But all of our “bears” had good ideas for putting money to work now.
- I think my biggest surprise of the conference was that two of the speakers I invited, John Burbank of Passport Capital (who I had been trying to get to come for years) and Mark Yusko of Morgan Creek, both of whom I thought were in my macroeconomics contingent, have completely shifted their business plans in the last few months, moving away from trying to predict macro developments, which they believe are incredibly more difficult to plan for than in the past, to focusing on specific investments, setting up new funds and strategies.
- Burbank had one of the great quotes of the conference: “Invest in things that have never happened before, hedge for regression to the mean, and plan for the unimaginable.”
- Mark Yusko essentially echoed that theme. I was surprised that they are both looking at how to get involved in the cryptocurrency world.”
I’m not sure how I’m going to keep the conference summary to just six parts but I’ll try my best. High level, concise and hopefully you find On My Radar valuable for you personally and for your work helping and coaching your clients. It sure helps me to clarify my thoughts so thanks for hanging in there with me each week.
Ok, grab a coffee and find your favorite chair. Lots of charts again today but it flows quickly.
Quick aside: If you are interested, we are hosting a free webinar on April 4, 2018 at 2 pm. Click on the photo below if you are interested in joining. Note, if you sign up you’ll also be able to get a link to the replay if you are unable to attend live.
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Included in this week’s On My Radar:
- Dr. Lacy Hunt — “Economic Theory Matters, Especially So Now”
- Trade Signals — Equity Market Maintains Course; Caution Urged Due to Likely Interest Rate Increase
- Personal Note — Believe in Yourself
Dr. Lacy Hunt — “Economic Theory Matters, Especially So Now”
Before we jump into Lacy’s comments, following is a quick summary from David Rosenberg’s presentation. I share it with you to simply compare David’s view to what Lacy believes sits ahead.
David sees short-term cyclical inflation pressures but believes the longer-term trend for deflation (aged demographics and debt dominant theme… and technology). So inflationary pressures lead to higher rates in the near term and that will kick us into the next recession. He sees recession in 2019. Adding, the Fed will have very little leeway in the next downturn.
- Have cash. Hedge funds should shine in this environment.
- But focus on taking the beta down, tuck in your risk.
- Focus on companies with earnings visibility, not variability, balance your quality imperative, and be mindful of your duration.
- And I would say near-term inflation protection for the time being, I would say for the next several months. I still like TIPS.
- And then maybe, in two years, we’ll be back here, and I’ll be very bullish and we’ll build up some great valuations and we’ll see what happens. Or not.
David’s concluding thoughts:
“Let’s finish off with this,” David said. “This is something we all need to be cognizant of, because we’re late-cycle. I think the recession is a year away, so I don’t think this game is going into extra innings. And we have to be mindful of the Fed.
I find it interesting from a human nature standpoint that when the Fed’s cutting rates, people say, “Don’t fight the Fed.” When the Fed’s raising rates, nobody says, “Don’t fight the Fed.”
But let’s just say this much: Historically, in a recession, the Fed cuts the funds rate by more than 400 basis points to fight the recession. Last cycle, they cut by 500. How are they going to do that this time? We’ve got to be thinking about this. We’ve got to stay ahead of the pack. They will not be able to cut the funds rate 400 basis points like they have in the past.
“We have just brought forward so much growth, we have brought forward so much policy accommodation on the fiscal and monetary side, we have left nothing… nothing left over.”
He believes there ultimately will be a debt jubilee. And it’s got historical connotations as well. This will happen in the next cycle, which we will basically have a situation where the Fed and the Treasury will do a swap. And then we’ll move on, reset the button, and we’ll be talking more about inflation than we are today. But that’s for another day.
“Economic Theory Matters, Especially So Now”
My high level notes in bullet point format follow:
- John Mauldin: “Rosie was my leadoff hitter and Lacy is here to bat cleanup. He and his team run the most successful mutual fund in the business over the last twenty-five years.”
- Lacy: “At least up to the end of last year.” Bonds don’t do well when interest rates rise and since his management team is still fully invested in 30-year Treasury bonds the last few months haven’t been good for the fund due to the rise in interest rates.
- One of the most important things about economics that I learned in my very first course is that it’s a science, not precise like physics and chemistry. It is nevertheless a social science, and as a consequence, we continually move forward with advances in technology, and understanding, and perceptions, and with the advance of our own creative thinking. In that concept, what I’m going to do today is I am going to apply some of the most important concepts in economics to answer the critical questions that the U.S. and the global economy is facing. I’m going to begin by using the law of diminishing returns.
- The law of diminishing returns basically states that as you increase a factor of production, whether it’s capital, natural resources or labor, there will initially be an increasing rate of gain in output, but as you continue to boost the level of a particular factor or production, then diminishing returns will set in. And if that factor continues to increase, the returns will turn flat and then eventually they will turn negative.
- The reason that I’m doing this is that in years gone by, I have presented a rather lengthy and elaborate description of why extreme over-indebtedness leads to economic decline but I finally found a way to identify this process by just one concept: diminishing returns.
Let’s look at the first chart and what I’ve presented here is global debt-to-GDP.
- In 2007, when Bear Stearns failed, global debt was 276% of GDP and the extreme over-indebtedness was in three areas: Japan primarily, and secondarily in Europe and the United States.
- Today, global debt is 51 percentage points higher relative to GDP, 327%, but there’s a way to turn the data around which captures the law of diminishing returns.
- In 2002, each dollar of new debt generated 41 cents of GDP and we’re now down to 31 cents.
- In other words, clearly, we’re getting a slower and slower return which means that we’re on our way to the time, and we don’t know the timing, of when the returns will be flat and they will then eventually turn negative.
- I believe that diminishing returns is clearly setting in with regard to the use of debt in China. Last year, Chinese debt rose approximately 102%.
- In other words, it doubled in one year. Over the last two years, the Chinese debt increased by 56%. That was the largest two-year rise and I think two years is more meaningful than one… the largest two-year rise in debt that’s ever occurred. GDP gained 6.9%.
- Look back at the two-year gain in 2009. They had a 47% increase in debt and the gain in GDP was 13.6%. The Chinese are absolutely right to be reducing their economic forecast because debt is becoming less productive and when economic growth slows, that means that generally speaking, the pressure of output will be toward a lower inflation, not a higher inflation.
- It is also a solid reason for the Chinese to be in the process of trying to reduce capacity so that they have some capability of increasing debt and getting at least some modest return if they need to do so in the future.
Lacy goes on to talk about the reduction in the Fed’s balance sheet and the impact each rate increase has on something called the money multiplier. He explains the inner workings of the Fed in a way that will totally wonk you out. So hold onto your wonk hat or close your eyes and skip down to the short conclusion of what Lacy sees ahead. First the wonk:
- The velocity of money can be estimated through econometric techniques but it’s not algebraically determined. There are four basic determinants. One is the ratio of excess reserves to total reserves. The next is Treasury deposits to total deposits. The next is the currency ratio, and then finally the time deposit to demand deposit ratio.
- Now, when the Fed greatly expanded their balance sheet, in QE1, 2 and 3, the money multiplier fell from basically nine to slightly below three. (SB here: Lacy is talking about the law of diminishing returns. The Fed got less and less bang for the buck.)
Wonk hat still on?
- As a result, the Federal Reserve did not really accelerate money supply growth except very transitorily. In other words, the actions of the bank and non-bank public resulted in a completely offsetting move and M2 growth was virtually unchanged which is an illustration of one of the most important concepts in monetary economics. The Federal Reserve does not have the capability to print money. They do not have the techniques to print money. They do not have the mechanisms to print money. They can raise the monetary base but there is no certainty that there will be a corresponding change in the money supply or bank credit. Notice that after the banks began the quantitative tightening in the fourth quarter of last year, the money multiplier after a brief rise is now turning down.
- This is happening principally because the main source of the contraction in the M2 which we’re going to see momentarily is occurring on demand deposits rather than time deposits. The banks have not been raising the time and savings deposits in line with the increase in the Federal funds rate which is making them extremely uncompetitive. The time in savings deposits have zero reserve requirements. The demand deposits have 10% reserve requirements and so when there is this shift taking place, it’s the equivalent of a reduction in the Fed’s balance sheet but the balance sheet does not change, and the multiplier falls.
- Let’s look now at:
- As a result of essentially six and a half tightenings using excess reserves as the concept, the rate of growth in the M2 money stock, whether measured on a one-year, three-year, three-month or six-month, basically peaked in the first and second quarters of 2016 and we’ve decelerated very, very sharply. Very, very sharply, that’s why I say it’s a collapse.
SB here again: Look, Lacy is brilliant but he eats algorithms for breakfast, lunch and dinner and I know it is going to twist your brain as much as it does mine (but boy, do I love how he gets me thinking), so let’s fast forward to the bottom line:
- The Fed is withdrawing much liquidity from the system, money supply is declining and the velocity of money is near a record low. Velocity means that if I buy bread from your store, you use that money to buy things you need and the person who received money used it to buy things. If it slows, there is less money moving through the system.
- You can see what it looks like in the next chart (data since 1900). Note the 1930s period and also note where V-of-M was at the end of 2017…1.43 and trending lower.
- Also note the diminishing impact of QE2, 3 etc. since 2010.
Lacy went on to argue that the fourth quarter bump up in GDP was a temporary result of the weather disasters we experienced last fall. New cars and materials to repair homes, etc. That makes sense and if you follow the Atlanta Fed’s GDP Now forecast, it has declined.
Look at the drop since late February (green line):
He went on to talk about the high levels of U.S. domestic debt relative to GDP as well as global debt relative to GDP. He talked about how all of the central bankers are looking to exit QE and raise interest rates at the same time. Concluding that there will be an immediate halt to growth and that the central bankers will be putting us back in recession in relatively short order.
We had the diminishing returns as we piled on more debt, the diminishing returns as the Fed and the global central bankers expanded quantitative easing and he believes the impact of pulling the punch bowl away from the party will be immediate and painful.
U.S. business debt is back to the record levels set in 2007. Here is a look at the diminishing returns of business debt:
Here is the rate of change in productivity (diminishing impact from excessive debt… note 2013 to 2017 far right hand side):
And here is growth in selected periods:
Bottom line: SB here – my conclusion: Debt is a mess. It is a drag on growth. The Fed is tightening. It will drive us into the next recession.
Lacy’s presentation was on the “law of diminishing returns.” His closing few comments follow:
- The business debt is going into financial activities. It’s not lifting the potential of the economy to grow longer term. The law of diminishing returns not only applies to the global economy, or to China, or to Japan, but it also applies to the U.S. business sector.
- There’s one final confirming point and that’s the Productivity Chart above. This is productivity on the entire U.S. economy. These are five-year bars. Since 1952 the average increase in productivity was 2.1%. The last five years, 0.9%. By the way, last year was 0.9%, too. Confirmation: law of diminishing returns.
- There you have it, ladies and gentlemen. That concludes my talk and I guess I’m going to take some questions now.
- John Mauldin entered the stage… Lacy, you’re going to take one question from Steve Cucchiaro who’s coming out. Steve was beating me up backstage saying I want to ask one question. Steve, we have very little time.
- Steve C: Lacy, very insightful as always. One question that’s on the minds of many, I’ll get right to it. It has to do with money velocity.
- Lacy: Say again?
- Steve C: It has to do with money velocity and that’s been a great explanation…
- Lacy: By the way, yesterday, Jeff Gundlach took a hit at me and you probably heard it, very sweet of him. He’s a good friend of mine, and I don’t really object, but I have worked on it quite a bit for a long time, but I’ll answer it.
- Steve C: It’s been a great explanation of why a big expansion of the monetary base has not resulted in the inflation that many people expected. Right now, it’s continuing. It has continued to decline substantially and it’s well below its median. What would happen if we had a situation where because of physical stimulus, because of a business-friendly environment, deregulation, we created the animal spirits that actually, for the first time in years, drove a meaningful rise in money velocity. Wouldn’t that change the outcome of some of your predictions?
- Lacy: Yes, it would. I said on numerous occasions that if the tax cut that was passed by Congress was revenue-neutral, then the velocity of money would rise. There is no question about it in my mind. The original idea, as I understood it to be, is that we were going to first of all try to stop the very large and growing deficits in the Affordable Care Act. Now, it’s a very sensitive topic, but I think it’s fair to say that we’re facing deficits of $200 to $300 billion there and they’re going to get larger, unfortunately. Now, let’s also say…
- Steve C: $200 to $300 billion?
- Lacy: Yes, $200 to $300 billion. We’re at one point.
- Steve C: Just from Affordable Care Act, right?
- Lacy: Just from the tax cuts.
- Steve C: Just from the Affordable Care Act alone.
- Lacy: Okay, so let’s say that we had reformed the Affordable Care Act and we had managed to save $150 billion. But we couldn’t reform the Affordable Care Act. We went ahead and we passed the tax cut and so instead of having a revenue-neutral, at least in terms of the deficit, we have a debt-financed deficit. Now, I had said that if the tax cut was revenue-neutral, this would benefit the economy because consumptive-based expenditures like the Affordable Care Act have a negative multiplier. A reduction in tax cuts, by themselves revenue-neutral, have a positive multiplier and a stronger multiplier than the expenditure multiplier and that would give the economy a lift.
- Lacy: I also believe, and the academic research shows this, that when you have revenue-neutral tax increases, you lower the cost of capital. The real cost of capital, which would have helped us to encourage more real investment in the economy and less financial investment. But that’s not what we’re dealing with. The opportunity to turn velocity around was in my view lost.
- John Mauldin: The person on the stage earlier who said that velocity money is beginning to turn back up, you’re not buying that?
- Lacy: I went through it in detail. Note, the increase in velocity in the fourth quarter was a one-off event due to the failure in which we account for the spending on natural disasters. The fourth quarter is a dramatic example of the broken glass fallacy which you’ve written about and other folks have written about.
- Steve C: Thank you Lacy.
- John Mauldin: Thank you, Steve. Great question, Steve. So many questions, so little time…
I share that dialogue because I just love how the presenters are pressed. A test of conviction so to say. I believe that the person on stage earlier was Jeffrey Gundlach that Mauldin was referring to. More on his presentation next week. I conclude by saying, it is just hard not to bet on Lacy. He understands the inner workings of the Fed like few others.
Finally, Lacy shared a chart that essentially disproves the “Phillips Curve.” It shows a near zero correlation to the Fed’s unemployment and inflation. The problem is that it is the holy grail of Fed indicators and they remain wed to it and it drives their decision-making. More on this in another letter. Kind of like driving blindfolded. What a mess!
We are going to soon see what the other side of the Fed’s great experiment will look like. I personally think Rosenberg is right… we will find ourselves cheering the “great debt restoration act” or something like that. Meaning we will invent a way to buy the debt, dig a giant hole in the backyard and make it disappear. If we can do that all at the same time with our friends from Europe, Japan and China, then we reset… then we get a bad period of inflation but we “reset” and step forward. My two cents… we’ll see.
Between then and now is another recession. Seek growth opportunities but do so in a way that can meaningfully protect your downside. The reset buying opportunity will be epic.
Trade Signals — Equity Market Maintains Course; Caution Urged Due to Likely Interest Rate Increase
S&P 500 Index — 2,714 (03-21-2018)
Notable this week:
No significant changes since the posting of last week’s Trade Signals. Equity signals remain bullish, while fixed income signals are bearish. Investor sentiment is currently neutral. Today we await the Fed’s decision on overnight interest rates. The vast majority of rate watchers expect a 25 basis point bump up in rates. Stay risk focused and alert. The market is aged and overvalued.
Long-time readers know that I am a big fan of Ned Davis Research. I’ve been a client for years and value their service. If you’re interested in learning more about NDR, please call John P. Kornack Jr., Institutional Sales Manager, at 617-279-4876. John’s email address is [email protected] I am not compensated in any way by NDR. I’m just a fan of their work.
Important note: Not a recommendation for you to buy or sell any security. For information purposes only. Please talk with your advisor about needs, goals, time horizon and risk tolerances.
Personal Note — Believe in Yourself
“Believe in yourself! Have faith in your abilities! Without a humble but reasonable confidence in your own powers you cannot be successful or happy.”
— Norman Vincent Peale
I received a text a few days ago from my son, Matt. I clicked through to an article in the Penn State Daily Collegian to find the above picture and a quote from the kid, “I thought I finished right outside of the bubble. I went back to watch the finals and heard my name being called so I had to sprint up the course totally out of breath,” Blumenthal said. “[USCSA] broadcasted it on their website so my dad watched finals from California. That was really cool.”
Matt’s home for the weekend and asleep as I write early this Friday morning. I’ll give him a great big hug when he wakes up. Brianna is home too and we’ll be celebrating Matt’s 20th birthday tonight. I’m finishing the letter early as I’m racing to catch an 11 am Amtrak train to New York for an afternoon interview. Then a quick train home.
Villanova University is just a few miles away and they are in the March Madness Sweet 16. They play West Virginia at 7:30 pm tonight. It looks like the cake is going to have to be at halftime. I’m really happy most everyone is home. We’ll have to FaceTime Susan’s oldest son, Tyler.
If you got hit by the Nor’easter, let’s hope it melts soon. Two big storms in the last few weeks and I’ve been out of town for both. Feeling somewhat guilty, I told Susan to load the to-do list. Unfortunately, bringing the backyard furniture out won’t make the list.
Wishing you much success and happiness!
Have a great weekend!
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With kind regards,
Stephen B. Blumenthal
Executive Chairman & CIO