InnOvation Capital & Management, LLC
IntelDigest
LAW – POLICY – FINANCE – MARKETS
INFORMATION FOR THE ENTERPRISE AND INVESTOR
MAY 30, 2018
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We have begun to take a Look Ahead at the Economy-To-Come in recent issues of IntelDigest … planning for the transition from Bull to Bear.
We expect high volatility in the markets as we go into August and September, so we want to prune the most volatile stocks from portfolios before August … trying to sell into strength by mid-Summer.
And, we fully expect that the Economy will fall into recession by some time next year, and perhaps result in an extended period of stagnation in the equities markets lasting for at least a few years. Perhaps, stagnation will roll into a return of the Stagflation of the 1970s … especially if political pressure is applied.
Stagflation
Looking back to 1972 … Richard Nixon was President, ramping up his campaign for re-election that year. Part of his strategy was keeping the Economy running well through Election Day, so he put significant pressure on Federal Reserve Chairman Arthur Burns to keep interest rates low.
Despite the danger of runaway inflation from such a policy, Burns acquiesced to the President’s “request.”
The inflation resulting from this action and other “easy money” policies of the Federal Reserve came to the fore in the mid-‘70s. Inflation spiked over 12%. Interest Rates were catapulted to unheard-of levels (do you remember mortgage rates of 15-16%?). From 1977 through 1981, the U.S. Dollar lost half of its value.
What are the chances that history repeats itself in the next couple of years, as Donald Trump ramps up his own bid for re-election?
Danger signs of just such an occurrence were revealed in a recent Politico interview. Kevin Warsh … a former governor of the Federal Reserve and a candidate for Chairman before Jerome (Jay) Powell was chosen … spoke on the Politico Money Podcast about a meeting with Donald Trump last year in the Oval Office.
“If you think it was a subject upon which he delicately danced around, then you’d be mistaken. It was certainly top of mind to the president,” Warsh said about Trump’s questioning on interest-rate policy. “The president has a view about asset prices and stock markets. He has a view based on his long history in his prior life as a developer and real estate mogul of the role of interest rates.”
Warsh added that he did not have the impression that Trump viewed the central bank as an independent organization meant to make decisions in the best long-term interests of the economy rather than at the bidding of the White House or any other political institution. “In some sense, the broader notion of an independent agency, that’s probably not an obvious feature to the president,” he said.
Asked if the president appeared to understand the historical importance of the Fed’s independence from partisan political pressure, Warsh said: “This might be a good time for a no comment.”
The interviewer, Ben White of Politico, summarized the discussion:
“The fear is that Trump pressures [Fed Chairman] Jay Powell to keep rates low even if it means higher inflation … We are now entering a new age of explicit political pressure on the Fed to keep interest rates low.”
There is no urgency regarding Interest Rates at the moment, as the Economy has been going through a period of expansion and Markets have been strong. The stated policy of The Fed is to increase short-term rates gradually, from the current level of 1.75% to 3.25% by early 2020.
A likely scenario is that the next Recession will be upon us before The Fed reaches that target. When the Recession hits, stock prices of many companies will slide, and could see their values cut in half.
At that point, political pressure from the White House to cut interest rates will be overwhelming. The combination of: (1) tight labor markets, (2) federal government deficits of A Trillion Dollars per year, (3) the still-bloated balance sheet of The Federal Reserve, and (4) Interest Rate Cuts … would likely bring on 1970s-style Stagflation.
The Unraveling
We have written about the coming Unraveling of the Bull Market, and some of the causes. One viewpoint on the Markets is that we are turning a corner on Valuations.
Up to this point … and for the last two years … we have been writing that we were unconcerned that stock prices were soaring. Even with stocks at historically nose-bleed levels, we did not see them as overvalued, primarily because Interest Rates were at abnormally-low levels.
However, we are turning the corner … costs are rising, interest rates are increasing (gradually), and economic growth/expansion will not support further acceleration of stock values. Here are a few areas where corporate profits will be pressured over the next couple of years, which will act to deflate the valuation balloon:
* Commodity Prices Rising … grain and feedstocks, lumber, steel, and many other commodities
* Labor Costs Growing
* Trucking/Transportation Costs Exploding … on all goods
* Strengthening U.S. Dollar … weighs on U.S. trade, especially on the exports of multinational corporations
* Interest Costs Climbing … The Fed raising short-term rates and reducing its balance sheet … The European Central Bank will soon follow as it tapers its own quantitative easing program
* Energy Costs Making New Highs … rising oil prices are a tax on consumption
* Regulatory Threats on Technology/Social Media … Alphabet/Google, Facebook, Twitter, and other companies in this space have to hire thousands of compliance personnel to monitor and supervise the dissemination of personal data, putting a drag on profits
Reversion to Mean
Rising costs have been evident in the 1Q earnings reports of most companies, but have been masked by the new federal cuts on corporate tax rates. Count on future corporate profits and stock valuations being hampered by rising costs.
David Rosenberg, chief economist and strategist at the Gluskin Sheff firm, concludes that valuations have topped out. He points to admissions by the Federal Reserve Bank of San Francisco that “Current valuation ratios for households and businesses are high relative to historical benchmarks … We find that the current price-to-earnings ratio predicts approximately zero growth in real equity prices over the next 10 years.”