Stocks, Bonds And Real Estate: High Probability Of A Wealth Effect Reversal
Gary Gordon | Apr 19, 2018 02:44PM ET
According to Michael Leibowitz of 720 Global, the cumulative amount of new debt issued by the U.S government surpassed the cumulative amount of U.S. gross domestic product (GDP) growth in each year since the financial crisis of 2008. In other words, GDP economic growth would have been negative in every year following the crisis were it not for massive federal deficits.
Unfortunately, it’s not just the past that we are talking about. The International Monetary Fund projects that the U.S. is the only advanced economy slated to increase its debt-to-GDP ratio over the next five years.
Why is this so disturbing? The higher that ratio climbs, the less willingness investors may have in buying our country’s debt without meaningfully higher interest rate adjustments.
Ironically enough, I received a great deal of flack for suggesting that powerhouses like China and Japan might decide to further slow the pace of their Treasury bond purchases. Naysayers exclaimed that export-dependent countries would never shoot themselves in their proverbial feet and that the U.S. wields far more leverage than its counterparts at the trade negotiation table.
However, Federal debt held by foreign investors has been slowing on a consistent basis since its most recent peak back in 2009. In other words, foreigners have been reducing their Treasury acquisitions for quite some time and they might be willing to do so at a slightly faster pace.
There’s more. Not only might foreign ownership continue to lessen, but the Federal Reserve is a net seller rather than a net buyer. They are reducing their balance sheet through a combination of selling securities and quantitative tightening (QT).
So far, the Fed has downshifted from $2.465 trillion to $2.415 trillion. Drop in the bucket? Sure. On the other hand, the process of balance sheet reduction is expected to accelerate markedly throughout 2018.
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In essence, the U.S. is dramatically increasing the supply of government debt at a time when 40% of current buyers exhibit less demand (e.g., Federal Reserve, foreign investors, etc.). What might one anticipate from an increase in supply and a reduction in demand? It could mean higher yields and higher associated borrowing costs to attract other buyers to step up.
Buyers might be particularly intrigued if the economy and/or the stock market falters. They might become downright enamored when real central bank rates turn positive.
Indeed, for nine years since the financial crisis, central banks have made it a “no-brainer” for households, corporations and governments to borrow on the ultra-cheap. However, with the 10-year U.S. Treasury trading 50 basis points above CPI inflation (2.4%), the borrowing cost dynamics have become less favorable than they used to be.
There’s another possibility that few are planning for. The Fed would be forced to raise its overnight lending rate at a much faster clip if CPI inflation suddenly spikes.
To be sure, the bond market does not seem particularly concerned about inflation getting out of control. Longer-term yields have remained somewhat contained, even as the Fed lifts shorter-term rates.
Yet the flattening of the yield curve presents other troubles. Consider the fact that a mere 45 basis points separate the 10-year Treasury bond yield from the 2-Year Treasury bond yield. If longer term yields stay relatively anchored, two more rate hikes could invert the yield curve by late September.
The circumstances would signify the likelihood of a recession occurring in the 2nd half of 2019. Meanwhile, forward-looking risk assets like stocks and higher-yielding bonds might depreciate in earnest six months beforehand.
Economic contraction concerns notwithstanding, financials (e.g., REITs, banks, insurers, etc.) could struggle mightily. After all, when you rely on shorter-term funding to finance longer-term lending, net interest margins erode alongside flatter yield curves. Inversion? Net interest margins may shrink to the point that companies begin to deleverage their books, leading to pricier and/or less accessible credit.
From my vantage point, central banks like the Fed have set the stage for a “reverse wealth effect.” What do I mean by that? Policymakers have erroneously claimed that the massive buildup in debt is not problematic because net worth has climbed alongside it. Sadly, the illusion of wealth becomes a perception of poverty when emergency level policies that led to asset price nirvana get replaced by attempts to normalize interest rates.
In a nut shell, higher borrowing costs and reduced access to credit will harm stock, bonds and real estate prices. Net worth will go down, but debt will not.
Now, the normalization/tightening efforts by the Federal Reserve and other central banks will not last particularly long. To deal with the unsustainable path of debt, they’ll go right back to emergency level efforts like zero percent rates (ZIRP), negative interest rates (NIRP) and quantitative easing (QE). Central banks will decide that they must recreate and reflate yet another credit bubble. And total debt levels? They’ll keep right on climbing into the cosmos.
In the simplest of terms, at least at the government level, it is no longer possible to pay debts back. This is especially noteworthy when we recognize that the public debt grows faster than our underlying economy.
More pressing, higher debt servicing brought about by Fed tightening is likely to strain the financial system, bankrupt “zombie corporations,” and bring about economic stagnation, if not outright contraction. All of these things are likely to send the wealth effect into reverse, where consumers lament a laceration to perceived purchasing power.
You may not feel as though now would be a good time to rebalance your portfolio. Stocks have done so much to increase your net worth, why would you want to sell those to buy low-yielding bonds? However, there’s already the risk that you have overstayed your welcome at the record asset price palace.
Needless to say, the last three recessions and accompanying stock market bears occurred when corporate-debt-to-GDP peaked. Is it really going to be different this time around?
Prevailing wisdom might tell you that the stock market correction of 10%-plus is close to being over. After all, the economy appears sound. Corporate tax cuts have bolstered earnings-per-share (EPS). And Amazon. (NASDAQ:AMZN) has more than 100 million Prime subscribers.
On the flip side, whereas Fed easing buffered the impact of bad news in the past nine years, (e.g., euro-zone debt crisis, China economic slowdown, fiscal cliff, partial U.S. government shutdown, oil collapse, earnings recession, Brexit, U.S. election fears, etc.), the central bank of the United States appears to be balking at its “third mandate” to protect asset prices. If this is indeed the case, and the pattern of “lower highs” persists, one would benefit from some risk reduction in his/her portfolio.
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