September 17, 2021
By Steve Blumenthal
“There are always those that thrive even in not so good economic times
and there are always those who don’t thrive even in excellent economic times.
Don’t worry, and let’s thrive.”
― Yours Truly
Last week, we looked at equity market valuations and coming returns. Essentially, we are looking at slightly negative returns over the coming one, three, five, seven, nine, and 11 years. Some expect better returns, some worse.
Vanguard’s 10-year return forecast predicts U.S. stocks will return 2.40% to 4.4%, and U.S. bonds will return 1.40% to 2.40%. Source.
GMO’s 7-Year Asset Class Real Return Forecast is more somber. Note that “real” refers to after-inflation returns. Compounding at -8.2% per year for seven years means your $100,000 is worth $54,941 in September 2028. Not a good outcome. And you can see returns are negative for all asset classes except for emerging market value stocks.
Almost all of the forecasts are based on cap-weighted indices like the S&P 500 Index. This doesn’t mean your personal portfolio will perform poorly. It depends on what you own. As stated in my opening quote, there are always investments that thrive and those that don’t thrive.
I have written that it will be inflation and rising rates that “trump the Fed’s hand.” Interest rates are low, and debt is high. It’s not just the governments that are piling on debt; corporations have taken advantage of low rates and issued new debt. Much of it used to buy back their own shares. Individual investors have used low rates to margin up their brokerage accounts. Debt can influence market prices and generally does so in a positive way when debt is increasing; however, risks mount when debt becomes too large. It’s the unwinding of all the financial leverage that causes markets to tumble. The trip wire in the system is inflation and higher interest rates.
From Vanguard: “There is a risk, however, that significantly more fiscal spending on the order of $2 trillion to $3 trillion—our ‘go big’ scenario in the chart below—could lead inflation to significantly overshoot the Fed’s target later this year and into 2022. Such a development could affect inflation psychology, in which higher expected inflation can lead to higher actual inflation.”
Higher interest rates are the probable trigger that causes the next great recession/secular bear market. Some investors will thrive; some won’t. The good news is, I believe we have time to prepare. Following is my 2021–2022 Investment Outlook Update. Not a guarantee of future performance. I could be wrong.
Over the last 200 years, the average yield on the U.S. long-term Treasury has averaged approximately 5%. There was one other period in time when the yield dropped below 2%. That was in the mid-1930s. That’s when the last long-term debt cycle peaked. Today, the 30-year U.S. Treasury yields 1.87%. The all-time record low was 1.18% on April 24, 2020. Low rates have been a bullish factor in driving equity market indices higher. I see one more run to lower rates tied to a 2022 slowing economy. I then see them going much higher. How far, don’t know. Inflation will lead to a loss of confidence in the Fed, then rates spike higher.
To be clear, timing is always an imperfect, if not impossible, task. But here goes: Over the near term, my best guess is that the U.S. and global equity markets peak when Congress increases the debt ceiling. A few fist fights remain on the path to the increase. Right now, the Republicans are telling the Democrats, “You have the tools to increase the debt ceiling without our support.” Meanwhile, the Democrats know this and are trying to shame Sen. Mitch McConnell. As of June 30, 2021, an additional $6.5 trillion had been borrowed, bringing the amount of outstanding debt subject to the statutory limit to $28.5 trillion. We reach the ceiling within weeks. One way or another, we’ll get more debt.
Some of the math hidden behind the scenes is the U.S. Treasury cash balance held at the Fed. That number has dropped from nearly $1.7 trillion to $208 billion. Think of it like your personal bank account. When you spend more your cash balance goes down. Your extra spending is someone else’s income, so you’re spending is boosting the economy. At some point, you spend less and save more to rebuild your bank account balance. When you save more and spend less, someone else has less income, and so on. Thus, the economy slows.
In the next chart, when the line goes up, more money is going into the Fed’s bank account and less is going into the system. There is a high correlation to Fed activity and the performance of the markets. Think of it as money that is or isn’t being injected into the system. The Fed is targeting holding $500 billion in cash reserves. At the same time, they are buying $120 billion worth of Treasury and mortgage bonds each month. I believe the debt ceiling will be raised and over the course of the 2020s will be raised again and again. Doubling and tripling down with the same tools with lessening effect. I believe Dr. Lacy Hunt has the best handle on the issue. You can find his latest quarterly letter here.
My best-guess timing conclusion is that the equity markets have already peaked or will peak when the debt ceiling is passed. However, I see this as a cyclical (short-term) potential peak and not the top of the secular (long-term) bull market. That to me will come 2023–25. Again, I could be wrong (data dependent, as they say, and we just can’t know all the future data).
Debt and Demographics
In an upcoming OMR, we’ll focus primarily on debt. I think we all know debt levels are off the charts. Many argue that low interest rates make it sustainable, to which I agree. The problem is when interest rates rise.
We are nearing the end of a long-term debt accumulation cycle. They’ve happened before, but few of us have ever lived through one, as the last one occurred in the mid-1930s. More debt equates to more risk to the system. It makes the system less stable and increases overall economic risk.
Money borrowed and spent today needs to be paid back tomorrow, and tomorrow is now today. If more and more of your income goes to service your debt, then you have less to spend on other things. That’s not good for the economy, as your spending is someone else’s income. Should interest rates rise, as I suspect they will over the coming few years, the squeeze to pocketbooks becomes even greater. That’s why I believe Dr. Lacy Hunt is right.
Demographics are not good. We are aged in the developed world. The percentage of people over the age of 65 is now growing faster than those aged 0–64. The corresponding spending habits, worker productivity, and societal dependency of that older population equate to a drag on growth.
Inflation / Deflation / Stagflation
This high debt/bad demographics/slow growth problem is being fought with unprecedented global central bank money creation and fiscal spending: short-term economic sugar highs with little long-term impact. In fact, more debt is even more detrimental to the stability of the system.
It’s been nearly 40 years since we’ve had an inflationary regime. The future I see is likely more stagflation––slow growth, rising inflation and rising interest rates. Record high valuations, high debt, high margin debt balances, and investors overweighted to equities means the system is ripe with risk.
Rising inflation and rising rates are kryptonite to Fed policy and investors’ confidence in that policy. I think this is a 2023–24 problem, though, not a today problem.
More on Timing
My best guess: we are heading into a period of very slow growth. China was the growth engine for the world. The largest real estate company in the world just went bust. China’s largest developer, Evergrande, is on the brink of default, and China is allowing it to fail. Xi is taking a hard line. Evergrande has debt due next week and can’t pay it. Recall all of the ghost cities? They remain ghost cities and the capital behind them is now facing defaults. Bluntly, China is facing a Lehman-like moment.
Further, China’s geopolitical relationship with the U.S. has changed. Tensions are high ranging from the SEC’s position on Chinese financial transparency to war games in the South China Sea. Hong Kong has bent the knee. Is Taiwan next? That’s a hard line in the sand for the U.S. and its allies.
2021–2022 Outlook Update
Pulling it all together, best guess, I believe the U.S. equity markets are heading into rough waters. A 10% to 20% decline into mid–2022 is probable. But I don’t see more than that to the downside, as faith in the Fed has yet to be broken. If I’m correct, the next round of QE and government handouts will be bigger than the last, and that should arrest the decline. We recover and have perhaps one more final-run at a bull-market secular high.
If I’m right, the coming economic slowdown will be more challenging than that last (even more debt than at the start of the last recession, along with the demographic headwinds). Recession is probable in 2023 or ’24. Then we get a big bear market correction of 50% or more.
As for interest rates, the 10-year yields 1.31% as of 9-16-21. I think we make one last push lower. I doubt we challenge the 2020 lows of 0.50%, but we likely decline below 1%. Then, lock in your 30-year mortgage rate. Post that, I believe rates rise towards 5% or more.
In the next recession, governments use the crisis to monetize the debt. We will reach a point where inflation gets out of control. People will lose confidence in the Fed. The jig will be up. Then the next major equity bear market will kick in. Call it sometime between 2023 and 2025. We then decide to live within our means, save more, and restructure our way out of the mess. The system resets and stock indices will offer good return potential again.
With all that said, you may want to jump off the ledge. I encourage you not to get stuck in the negative. From an investment perspective, there is opportunity. It just depends on where you point your needle. There are always those that thrive, even in not-so-good economic times, and those who don’t thrive even in excellent economic times. Let’s thrive in both.
Ideas – What You Can Do
Instead of bonds yielding 2% or less, consider well-collateralized and liquid short-term private credit yielding 7%. Certain special situations will yield even more. You’ll need access, but access exists. Trade bonds. Don’t buy and hold them. There is a solid opportunity for bond market capital gains in the economic story I just presented. There are some good inexpensive ETFs that give you upside market exposure with downside hedges built in. Consider trading strategies to replace traditional buy-and-hold bond exposure. Think about opportunities in disruptive/transformational business that have publically traded stocks. And if you are an accredited investor, there are select opportunities in private companies. My bullish, ever-optimistic, ever-forward mindset says, “Let’s thrive.”
The Trade Signals section is next. If you haven’t done so in the past, click through on the link. Scroll past the commentary down to the dashboard of indicators, and you’ll find explanations of how each indicator works. What I’m after is the overall weight of evidence. Does the technical picture support my fundamental view of a September/October market peak? The answer is not yet. The dashboard remains predominantly green.
Trade Signals – Keep Trading, Manage Risk
September 15, 2021
Posted each Wednesday, Trade Signals looks at several of my favorite equity market, investor sentiment, fixed income, economic, recession, and gold market indicators.
For new readers – Trade Signals is organized into three sections:
- Market Commentary
- Trade Signals — Dashboard of Indicators
- Charts with Explanations
Notable this week:
“Where you want to be is always in control, never wishing, always trading, and always first and foremost protecting your ass.
That’s why most people lose money as individual investors or traders because they’re not focusing on losing money. They need to focus on the money that they have at risk and how much capital is at risk in any single investment they have. If everyone spent 90 percent of their time on that, not 90 percent of the time on pie-in-the-sky ideas on how much money they’re going to make, then they will become incredibly successful investors.”
– Paul Tudor Jones,
Hedge fund manager, conservationist and philanthropist
No significant changes in the Trade Signals since last week’s post. Although September is historically volatile, equity market signals remain mostly green. Gold remains in a sell signal. The Zweig Bond Model remains bullish on high-grade corporate and long-term Treasury bonds.
Click HERE to read to the balance of Wednesday’s Trade Signals post.
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 – Country and Jazz, Daiquiris and Wine
“Just don’t give up trying to do what you really want to do.
Where there is love and inspiration, I don’t think you can go wrong.”
– Ella Fitzgerald
In late 1970s, Dad would pull his favorite Waylon & Willie record out of its sleeve, lift the needle on the record player and turn the stereo volume up high. He’d make frozen Strawberry Daiquiris and happy hour was on. At age 18, I sure loved those daiquiris, but can’t say I was much of a country music fan. That’s since changed. Pretty much every time I get on my Peloton bike, I pick a country music ride. I love country music, especially the cross over music. It never fails to power me through.
I came across the Ella Fitzgerald quote this week and thought about Dad. He was also big fan of jazz music. Dubbed “The First Lady of Song,” Ella was the most popular female jazz singer in the U.S. for more than a half a century. She won 13 Grammy awards and sold over 40 million albums. Some of her most famous songs were “Hallelujah,” “I Love Him,” “Taking A Chance On Love,” “Mack the Knife,” and “Over the Rainbow.”
This time of year is awesome. Comfortable temperatures with less humidity make dinners outside on the patio even more enjoyable, especially with a dry red wine in hand and music playing. Susan’s controls the music, flitting across genres and beats. The Sonos app makes it easy to find whatever she’s in the mood for. I might have to get my hands on the app and sneak in a little Ella Fitzgerald this weekend. I so love her positive way.
The great Ella Fitzgerald
Click on the picture of Ella, grab your favorite beverage, and turn the volume up high. Maybe a little Willie Nelson too.
Here’s a toast to doing what you love to do…
Have a great week!
All the best,
Stephen B. Blumenthal
Executive Chairman & CIO
CMG Capital Management Group, Inc.
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Stephen Blumenthal founded CMG Capital Management Group in 1992 and serves today as its Executive Chairman and CIO. Steve authors a free weekly e-letter entitled, “On My Radar.” Steve shares his views on macroeconomic research, valuations, portfolio construction, asset allocation and risk management.
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