The credit cycle is now turning down
|Edward Harrison||Nov 23, 2018|
I am now stuffed with Turkey after days sitting around eating for the Thanksgiving holiday here in the US. Today is Black Friday, the biggest day of the year for retail sales. And so it makes sense to write this newsletter post today. I have had this post teed up since Monday. But I just wasn't able to get it out because of the Thanksgiving holiday here in the US. I also have a review of Jonathan Tepper's new book coming out next week called "The Myth of Capitalism". So look for that in the coming days.
Here's the deal: the turn in the credit cycle I have been predicting all year to come by 2019 is now happening. We saw the slowdown in auto sales first, and later in new home sales. But we are also seeing it in existing home sales, credit card debt and in subprime. I have been getting a slew of Black Friday promotions into my inbox. It definitely feels like an onslaught I haven't seen in recent years. It's almost as if it is a make or break for the retail sector. So, I suspect that, after today, we are going to see whether this incipient credit distress has impacted retail sales.
I'll have a post out on the data for the investor subscribers of Credit Writedowns Pro. But, the overall gist is that this is happening against a background of high corporate debt and loosened bond covenant standards, making corporate leverage the Achilles Heel in this US business cycle. And so the question now is how, when and how acutely does incipient credit distress get transmitted into the corporate structure. This credit distress transmission will be the defining economic event for the second half of Donald Trump's (first) term as US president.
The data show a clear deceleration of economic activity, both globally and, now, in the US as well. We have seen the market reaction, with October's equities volatility spilling over into November. Tech stocks have been particularly hard hit because their prices are predicated on high growth rates that translate into big operating leverage and large earnings multiples. The downside of this is a big potential fall in medium-term earnings prospects, hence the volatility.
As a bond guy, I tend to look to the bond world as a clearer signal of the macro implications. If you look at the Treasury curve, the price action is similar to what we saw in February and March, with a bull flattening occurring as short rates and long rates both go down. Long-dated bond rates have gone down even more, though, with the spread now 24 basis points between 2- and 10-year Treasuries. That's certainly good for mortgage rates. So, in that sense, one could be encouraged, particularly since we saw an economic uptick immediately after the early 2018 volatility.
But now, the Treasury curve action is also being joined by spreads widening between Treasuries and corporate bonds, particularly high yield. And that's a signal that distress is about to hit the vulnerable corporate bond market. And this is going to occur against a backdrop of slowing economic growth, making the most vulnerable credits susceptible to defaults. With WTI now trading at $51.08, look to the energy sector as one of those areas of greatest vulnerability.
So, at this juncture, the question is the Fed. The way to look at this is as the Fed raising rates under Yellen, followed by an acceleration under Powell, followed by a delayed economic impact. If we think of the delay as 6 to 12 months, then the economic impact we're seeing now from higher rates is the result of late Yellen hikes and early Powell hikes, with the impact of the last two rate hikes yet to be fully transmitted into the system.
With the Fed on course to hike next month and again in March, followed by twice more in 2019, we have a considerable amount of monetary policy still left to be transmitted into a weakening economy. I think we get at least two rate hikes here, one in December and another in 2019. So, even if the Fed pauses or pushes back its timetable, there is still more tightening left to work through the system.
Does the Fed see the danger here? And what impact does President Trump's constant sniping have on Fed policy? On the first question, I think the Fed does see the danger. The parsed language of recent Fed speeches, especially one by Richard Clarida last month, tells you that. But the Fed is still on track for December and at least one more hike in 2019, probably more unless the economy decelerates abruptly.
Richard Clarida October speech
Look at the bullish comments littered in Clarida's speech:
Household finances are robust: "Recently revised Commerce Department data now show that the aggregate household saving rate is running at 6.7 percent of disposable income. This revised estimate is nearly double the previous estimate. The higher level suggests that, in contrast to the previous economic expansion from 2001 to 2007, when households were borrowing to maintain consumption while income growth slowed, households today, at least in the aggregate, are well positioned to maintain or even increase consumption relative to gains in income. To me, at this stage in the business cycle, a historically high household saving rate is a tailwind for the economy, not a headwind. And, of course, recent reductions in personal income tax rates are also a tailwind for the economy."
Productivity growth looks better: "Over the past few years, we have seen some pickup in productivity growth, albeit from a very depressed pace. By contrast, at a comparable stage in both the 2001-07 and 1982-90 economic expansions, productivity growth (as measured by an eight-quarter moving average) was actually slowing relative to its contemporaneous peak-to-present pace."
The labor market is tight: "the labor market today is robust, and inflation is at or close to the Fed's 2 percent inflation goal. Thus, the economy is as near as it has been in a decade to meeting both of the Fed's dual-mandate objectives, which suggests to me that monetary policy at this stage of the economic expansion should be aimed at sustaining growth and employment at levels consistent with keeping inflation at or close to the 2 percent rate consistent with price stability. By contrast, until this year, the appropriate focus of policy had been to return employment and inflation to levels consistent with our dual-mandate objectives."
Rates are still too low: "even after our September decision, I believe U.S. monetary policy remains accommodative. The funds rate is just now‑‑for the first time in a decade‑‑above the Fed's inflation objective, but the inflation-adjusted real funds rate remains below the range of estimates for the longer-run neutral real rate"
Translation: More hikes are coming. Not only are rates still too low relative to what the Fed considers the best level for the longer term. But also the household sector is well-positioned to withstand rate hikes. And the job market today, in contrast to as recently as last year, is so good that we need to focus on tamping down on inflation, not in getting to full employment.
You add in Trump's pressure on the Fed and I think it adds an upward bias to policy rates because the Fed can't be seen caving to political pressure. That would reduce the Fed's credibility as an independent institution. And I don't believe Fed policy makers want to be seen caving to Trump.
So, forget about the Fed slamming on the brakes. It won't happen. And that means higher rates during a slowing economy. Likely, we will see distress in the credit markets before the Fed pauses. And even then, the transmission delay means more tightening will be in the pipeline.
The political reaction will be key then. I would argue that the working and middle classes are not seeing enough gains from Trump's economic policy changes to overcome the loss of suburban voters appalled by his nativist policy messaging. In a worsening economic environment, Trump's poll ratings threaten to dip into the 30s, putting re-election at risk as well as the Senate for 2020, since more Republican seats will be in play than in 2018.
In 2019, Republicans will become alarmed at their political prospects for 2020. The House is gone. More Republican seats will be in play for the Senate in 2020, making them vulnerable to significant losses. And many statehouses will be in play, setting up potential Democratic control for 2021 redistricting.
At the same time, Trump will face a reinvigorated House of Representatives investigating him at every turn, the revelation of the Mueller investigation's findings, and a declining economy. What will he do? What will his party do, with the 2020 election bearing down on them?
I think this is going to be a dramatic turn in the political economy, perhaps as dramatic as 2007 and 2008. Nothing is written in stone. So I am still soft-pedaling this outcome. But the mere fact that I am making comparisons to 2007 and 2008, when we saw a financial crisis, tells you that I believe the coming two years will be turbulent - nothing like the decade that preceded them.
Get your seatbelts on. We are in the final stretch of a great bull market. This expansion is going to end soon. And when it does, there will be fireworks.