June 2, 2017
By Steve Blumenthal
“The initial conditions or the starting point conditions, mean to me that a small degree of
monetary restraint has a very quick and strong impact on economic activity.”
– Lacy H. Hunt, Ph.D., Hoisington Investment Management
2017 Strategic Investment Conference
Lacy stepped center stage. His presence demanded attention. An economist. A seasoned money manager. He has skin in the game and owns one of the best long-term investment track records in mutual fund history. Lacy argued that recession is nearing and interest rates are headed even lower. There is opportunity for profit should interest rates move lower (bond prices higher) and there is that near -40% average loss that has stung equity investors in past recessions. Today, I share my high level notes from Lacy’s presentation along with supporting charts. I try my best to be concise and to the point. Lacy began,
Economics is a science. Not precise like chemistry and physics. We have the capabilities of testing hypotheses to determine if propositions are valid. Being a science, the advances in technology changes our understanding over time. In fact, most of the macroeconomic propositions I was taught when I was a graduate student in the 1960s have been completely overturned. It is important to embrace the technological change that has taken place.
For example, in 1776, the founder of modern economics, Adam Smith, said price equals labor cost… nothing more nothing less. It took 120 years for Alfred Marshall to demonstrate that price is determined by the intersection of demand and supply.
In keeping with that spirit, here is my hypothesis. The monetary restraint already in place is a more potent force than any fiscal actions that can be taken if they are funded by new debt.”
What Lacy is saying is that the starting point conditions (where we are today) of ultra-low interest rates, a $4.5 billion Fed balance sheet and 372% debt-to-GDP, means that a small degree of monetary restraint (Fed raising interest rates and exiting Quantitative Easing (QE)) has a very quick impact on economic activity.
The Fed has now raised rates three times and another hike is probable in June. We are living through an unprecedented economic experiment. Japan is 11 years ahead of the U.S. and the U.S. is a handful of years ahead of the European Union. Either central bankers have gone completely mad or they’ll someday be hailed as geniuses. I find myself in the “mad” camp and I hope I’m wrong.
You and I have a front row seat. We get to watch the experiment play out. Beautiful or ugly? Many moving parts. We just don’t yet know.
In the very near term, we’ll get to see if Lacy’s hypothesis proves correct. Personally, I think he is right.
At the start of each new month, I typically share with you the most current valuation metrics and data that indicates what probable forward returns are likely to be. Valuations remain at the second most overvalued level in history and forward 7- and 10-year annualized returns are in the 0% to 4% range before inflation. Talk about lousy “starting point conditions.” Let’s take a pass on the valuation charts this week.
When you click through below you’ll find my detailed notes from Dr. Hunt’s presentation, along with select slides. For example, there have been 11 recessions since 1945. Without exception, a Fed tightening cycle preceded every single recession. The Fed has increased rates three times since December 2015. Number four is probable this month.
Lacy says the Fed is doing the wrong thing at the wrong time. I hope you enjoy the notes. It’s time to play defense. Grab that coffee and find your favorite chair – let’s jump in.
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Included in this week’s On My Radar:
- Lacy H. Hunt, Ph.D. – Will Monetary Restraint Overcome the Administration’s Proposed Economic Initiatives?
- Trade Signals — S&P 500 Up 8.7% YTD; Trend Evidence Remains Bullish
- Personal Note
Lacy H. Hunt, Ph.D. – Will Monetary Restraint Overcome the Administration’s Proposed Economic Initiatives?
Notes in bullet point format along with selected charts:
Chart 1 – The Federal Funds Rate (historical facts around tightening cycles)
- What you see here (Chart 1) is that there have been 11 recessions since 1945 (11 vertical gray shaded lines).
- Without exception, every single recession since 1945 was preceded by a monetary tightening cycle before the recession (also note the total number of rate hikes).
- There were a total of 14 tightening cycles since 1945. There were only three instances when a tightening cycle occurred and there was no recession: November 1968 (when the economy was in its 69th month of expansion); August 1984 (when the Fed reversed course and lowered rates in the 21st month of that expansion cycle that started in 1982) and the Fed reversed course in the 50th month of the expansion cycle that started in 1991.
- We are now in the 94th month of the current expansion and that means a great deal.
- Even though it is the worse expansion on record, it is a long expansion. And in long expansions, pent-up demand is exhausted.
- Pent-up demand is one of the most critical concepts in economics. And we see the telltale signs everywhere:
- Heavy price cuts on new automobiles
- Fall in used car prices
- Building overhang in the apartment sector
- A beginning decline in those rents
- More significant drops in the rents of retail properties
- Signs of excess capacity in the manufacturing sector
- And here is the point:
- Late stage tightenings have never avoided a recession because the economy is so frail once the pent-up demand is exhausted.
Chart 2 – A look at 1915 to 1945
- We can go back from 1945 to 1915 and see, too, that in every single case when the Fed tightened, the economy collapsed and a recession occurred.
- Lacy points to the Great Depression era as a parallel to today, noting the mistake that was made in late 1936 when the Fed tightened seven times. He believes they are making the same mistake today (supported by evidence he presented that follows in my notes below).
Chart 3 – A Look at Initial Conditions
- Why is the current Federal Reserve tightening special? This is not ordinary run-of-the-mill.
- The first initial condition is that top-line growth is decelerating sharply (red dot in chart). Notice it was already decelerating when the Fed first tightened in December 2015. Notice that top-line growth was weaker than at the trough of the recession in 2001 and also in 1991.
- The Federal Reserve is hitting the brakes with weakening indications in our very best economic indicator.
- Hunt’s view is that nominal growth is coming down to 2%.
- When nominal growth is coming down, it is not credible to believe that corporations and households are doing better.
- Yes, 500 elite stocks are having an improvement in earnings, but all that serves to demonstrate is that the other 15,500 corporations are experiencing terrible results.
- And if income growth is indeed holding up, it is not occurring in a broad-based manner. In other words, income growth is going to an elite group of households just as the corporate profits are being allocated to an elite group.
Chart 4 – Monetary Base
- Note in the next chart that the monetary base is below zero for the first time since the Korean War in the late 1940s
- Note also the wild swings since the great recession (2008 to present)
Chart 5 – Bank Loans plus Non-financial Commercial Paper
- Note the dramatic decline in bank lending – in this chart note how bank loans peaked and rolled over since the Fed first tightened in December 2015.
- As soon as they raised rates, note the immediate peak in the upward momentum in lending.
- Also, at the time of the December 2015 rate hike, the year-over-year change in the rate of growth was already cut in half from its 2007 peak.
- Loan decline is not just in one category. It’s in commercial industrial loans, it’s in consumer loans, it’s in all types of loans.
- Bank lending is slowing. When you raise the price of a good, the quantity in demand falls.
- Federal Reserve policy is biting and already biting substantially. We peaked and hit the top of the Bank Loan Cycle.
Chart 6 – Velocity of Money 1900 – 2017
- At the same time the Fed is tightening, the velocity of money is declining substantially (next chart).
- At the lowest level since 1949.
- In the current environment, money supply is decelerating and the velocity of money is continuing to set new lows.
- In Hunt’s view: we will not see the secular low in interest rates until the velocity of money reaches its secular trough and that, my friends, is not going to happen soon.
Debt Hurts GDP
Chart 7 – GDP Per Dollar of Debt
- $1 more in debt only generated 39 cents in GDP. That is the worst on record (red dot).
- In other words, we are taking on debt but each dollar is benefiting the economy less and less.
- If you look at total debt, a slightly broader figure, we are only generating 27 cents for each new dollar of debt.
- Here’s the problem: Debt is increasingly less productive, which means as long as that continues to happen the velocity of money will continue to fall.
- Small increments in monetary policy (raising rates) will quickly speed through the economy cutting into economic growth.
There is great evidence to believe that the velocity of money will continue to decline further.
Chart 8 – M2 Velocity: Four Major Economies
- Our total debt-to-GDP is 372% and our velocity is down to 1.43 and declining.
- Europe is more indebted at 467% debt-to-GDP and their velocity is down to 1.1.
- Japan is even more indebted at 578% debt-to-GDP and their velocity is down to 0.58.
- Regardless as to whether we have any new fiscal initiatives, federal debt is going to rise very substantially. From 107% today to over 125% in the next 20 years. Maybe sooner, maybe longer depending on fiscal initiatives.
- And that debt is going to be used for daily living needs. The least productive debt of all.
- In other words, our failure to pursue an appropriate fiscal policy means that monetary policy is incapacitated. The Fed is also responsible because they allowed a substantial buildup in private debt.
Chart 9 – Nonfarm Business Sector: Productivity
- When the productivity of the debt declines, there are two things that should jump out and tell a consistent story.
- The velocity of money should fall (as seen in charts above), but so, too, should the change in productivity.
- Notice we are at the lowest level since 1954 (seven year % change quarter over quarter).
- Taking on additional debt does not make us stronger. We may get a transitory blip uptick in productivity, but the blip quickly wears out and then we have the burden to pay back the interest and principal on the debt.
Chart 10 – Very Adverse Demographics – U.S. Fertility Rate
- We have a baby bust. Lowest since 1909. Babies are very stimulative to economic activity.
- We also have a household formation bust (middle-upper right). 0.8% since 2000 vs. long-term average of 1.5% since 1960. Another poor “initial condition.”
- The demographics have turned on us.
Chart 11 – Personal Income
- Another problem for the U.S. economy is that the Fed is also tightening into a secularly (long-term) period of poor economic growth. Not just the cyclical (short-term) conditions but the secular growth is also poor.
- Above is the 10-year moving average of Real Disposable Personal Income per Capita. So every point on the graph plots the 10-year average growth in Personal Income.
- Notice in the chart above, the long-term average growth rate in personal income is 2.1% (middle line). We are growing at less than half that average at 1% over the last six years.
- Studies tell us that when economies become extremely over-indebted, you lose about one-third of your growth rate against trend.
- In other words, if you historically grow your economy at 3% per year, you should drop to 2%.
- But the longer your over-indebtedness persists, the effect on economic activity is not linear. In other words, that rate of loss in growth becomes even greater the longer over-indebtedness persists.
Chart 12 – Real Average Household Income
- A vital development is the above data.
- Note the growth in average income broken into quintiles. Quintile 1 = top earners, Quintile 5 = lowest earners.
- Red dots represent the peaks.
- In the three lowest quintiles, the income growth is negative.
- And the second quintile is hardly growing, meaning all of the growth is in the top quintile.
- Without income growth in the broad number of our people, it’s confirmation that the surge in apartment construction, new homes, automobiles and some of the other big tickets, had to be financed by debt. Consumptive debt.
- There are benefits that accrue but they do not generate the income streams to repay the principal and interest.
Lacy believes that the current administration’s fiscal plans will provide just a transitory blip to the economy due to the fact that we are already so deeply in debt. Today’s economy is not Ronald Reagan’s economy. Then the Gross Federal Debt-to-GDP ratio was 30% vs. 107% today.
Chart 13 – Gross Federal Debt as a Percentage of GDP
We have deteriorating demographics on top of this.
In the last five years, Federal Debt-to-GDP has exceeded 100% each year.
Chart 14 – Japan: Gross Domestic Product
Basically, we are pursuing the same policy that Japan is following.
- There have been nearly a dozen tax cuts, Japan has the most modern infrastructure in the world, they’ve repaved the entire country, have built bridges that are essentially not useful.
- The multiplier data shows the results of all this is not stimulative. If we pursue the same policy, the results will be the same.
- People say Japan has worse demographics than we do. Next chart…
Chart 15 – Population Growth: U.S. and Japan
And they do have worse demographics. The point Hunt makes in this next chart is that our demographics are not so good either. Another confirmation we are following the Japanese playbook.
Chart 16 – Business Debt (critical for a number of reasons)
- Lacy believes that the leveraging of the corporate balance sheet has been basically to support the stock market and not for long-term business purposes.
- Corporations are borrowing to buy their own stock.
- They are engaged in financial engineering by issuing debt and buying back their shares. Shares of others. Increasing their dividends.
- But it does not increase the growth potential of the U.S. economy.
- The Fed is largely responsible for this for when they undertook QE, it was designed to give the stock market a boost. Idea was to create a wealth effect that would then trigger spending and faster economic growth.
- The notion of a wealth effect is no more than a hypothetical theory. If this occurred, we would not see the severe deterioration in secular growth that’s taking place.
- The net result is that the Fed signaled to corporate managers that your financial interests are protected by us.
- The Fed has encouraged the mal-use of our debt. And the numbers since 2015 show this.
- From 2015-2016, debt rose $717 billion. Investments in plant, equipment and inventories fell by $21.2 billion.
- No benefit to the standard of living. None whatsoever.
As for the Trump policy to give a tax break to repatriate the more than $2 trillion in offshore cash, he believes corporations will do more of the same – buy back their stock. [SBB here: Certainly bullish for U.S. equities.]
Why? We are not running at optimal capacity in our plants. Next chart.
Chart 17 – Capacity Utilization
- Note the average industry capacity utilization since 1967 is 80.4%. We have too much excess capacity.
- We are running at well below average. There is not enough demand to require an increase in outputs. There is more capacity available to produce. Money is not going to go to expand plant, equipment and inventories.
- Lacy notes that the 2014 uptick is from autos. That’s peaked. You take out autos and the manufacturing sector is basically stagnant.
Chart 18 – Corporate Tax Receipts
- A very telling chart… the above IRS tax collections from the corporate sector.
- It is a very good cyclical economic indicator.
- Note the decline in year-over-year tax receipts. Corporate tax collections are down y-o-y by about 10%. Below 0% far right of chart.
- Most corporations are experiencing a deterioration in earnings.
- This indicator has turned down prior to all of the post war recessions! (emphasis mine)
Individual income tax receipts over the last 12 months is unchanged. Lacy added, you might ask, “How can that be with employment up so much?” We are only adding low paying jobs and lopping off high paying jobs.
In conclusion, some thoughts on the 100 years of the Federal Reserve. “What I can tell you is that the record is incredibly clear. The Fed has left an indelible mark. Their record indicates that they have consistently tightened by too much and for too long. In other words, the Fed’s heavy hand is clear in every one of the recessions we have had in the last 100 years. Since 1915, we’ve had 18 recessions. Each one of them except one was preceded by a Fed tightening.”
We are forewarned. If you’ve been reading Lacy’s quarterly letter, like me, for many years, the conclusion Lacy reaches remains consistent. He expects a recession in the near future and rates to interest rates to head lower. The Fed is making a mistake. The secular low in interest rates is not yet in.
That concludes my notes. I realize it is a lot to take in. The overall problem we must solve is the massive amount of over-indebtedness in the U.S. and in the balance of the developed world. Play more defense than offense. Keep a clear eye on the recession indicators (I’ll share them again soon – no current sign of recession).
I remain in Ray Dalio’s Near Term Looks Good, Long Term Looks Scary camp.
I’d like to conclude this notes section with the interview Dr. Hunt did post his 2017 SIC presentation. It was sent to me as a courtesy to be able to share with you.
Steve Cucchiaro interviewed Lacy at the end of the presentation (hoping to get you the full youtube replay soon) and asks Lacy a great question, “What is the risk to your view?” Essentially, where might he be wrong in his view? The answer is outstanding. Lacy says that the biggest risk would be a complete restructuring of fiscal policy and a period in which we begin to live within our means. Another risk would be to have some highly significant technological advance that would allow us to pay off the excessive indebtedness in a way that enables us to avoid the contractionary effects. I don’t know what that would be. It has happened historically. Those are the two most likely to occur.
And so we pray for that. A “Great Reset” indeed.
Trade Signals — S&P 500 Up 8.7% YTD; Trend Evidence Remains Bullish
S&P 500 Index — 2,413 (5-31-2017)
Notable this week: Despite all of the negative chatter about the Fed, including mine, the Ned Davis Research (NDR) “Don’t Fight the Tape or the Fed” indicator continues to suggest a bullish environment for stocks. The NDR CMG U.S. Large Cap Long/Flat Index remains bullish and there remains more buyers than sellers as measured by the Volume Demand vs. Volume Supply indicator. As for bonds, the Zweig Bond Model remains in a buy signal, our High Yield trend model is bullish and our Tactical Fixed Income Strategy remains invested in HY and muni bonds.
The short-term gold trend indicator remains in a buy signal, suggesting some portfolio exposure to gold. Investor sentiment is Extremely Optimistic, which is S/T bearish for equities but, while that suggests caution, the major cyclical trend for equities remains bullish. Inflationary pressures are neither high nor low.
Click here for the charts and explanations.
I found it helpful to review the audio and slide deck. A bit like studying for an exam. Watch, listen, stop, rewind, play… and put the important points to paper. It sure helps me to better learn and do my best to digest potential impact and opportunity. To that end, if you’d like to sign up to receive the audio files and replays, Mauldin Economics has made them available for a fee. You can learn more here. (Please know I am not compensated in any way.)
Next week in Part 3, I will share with you my summary notes from both David Rosenberg, Mark Yusko and Raoul Paul presentations.
I was interviewed by Shaun Wurzbach from S&P Dow Jones Indices a few weeks ago. The discussion was on Trend Following. Let me know what you think. Click on the photo to watch the short interview.
Speaking of studying for an exam, Brianna has been in all week taking and reviewing test after test. Tomorrow she sits for the CFA Level 1 exam. Only 40% of the participants pass. My money is on Brie as is my heart. Send her some positive energy if you have a minute. An intense time. I’m proud she’s done the work and is taking the risk.
The weather looks great and some golf is in my immediate future. Everyone is home, cookouts are planned and much on the to-do list to get done. Wishing you and your family a fun filled weekend. Do something fun for yourself!
I hope you find On My Radar helpful for you and your work with your clients. And please feel free to reach out to me if you have any questions.
All the very best!
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With kind regards,
Stephen B. Blumenthal
Executive Chairman & CIO
CMG Capital Management Group, Inc.
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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From an investment management perspective, I’ve followed, managed and written about trend following and investor sentiment for many years. I find that reviewing various sentiment, trend and other historically valuable rules-based indicators each week helps me to stay balanced and disciplined in allocating to the various risk sets that are included within a broadly diversified total portfolio solution.
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