posted on 19 March 2017
by Lance Roberts, Clarity Financial
On Wednesday, as the Fed hiked rates for the second time in the last three months, and a third time since December of 2015, the Atlanta Federal Reserve released their latest GDP NowCast which reduced estimates for first quarter growth to just 0.9% from nearly 3% in January.
Interestingly, following the Fed’s announcement of a rate increase, stocks, bonds and gold all surged.
The reason I say “interestingly," is that higher interest rates increase borrowing costs which slow economic growth and quells inflationary pressures. Therefore, since the primary argument to support the second highest valuation levels in history is an economic and earnings recovery story, higher rates slow both of those supports.
Of course, the wisdom of hiking interest rates, thereby removing monetary accommodation, at the lowest average level of economic growth on record is also questionable.
Furthermore, there is also some doubt as to the veracity of the following justification from Ms. Yellen regarding the policy change:
First, I guess we have to quantify what we mean by the “economy is doing well." In 2016, the economy grew at 1.60% which is well below the expected average of 2.0%. But more importantly, take a look at the chart below of annual “real" economic growth rates.
There are three things of importance to note:
At a 1.6% growth rate, there is very little wiggle room between Fed rate hikes and a negative growth rate in the economy. The chart below adds the Fed Funds (effective rate) to the chart above.
Two important points:
The table and chart below show the historical time frames for the economy to fall into recession following the start of a rate hiking campaign. At 1.6%, historically, the economy has found a “crisis" withing 1-3 quarters.
So, as to Ms. Yellen’s second point of a resiliency to shocks, there is actually no historical evidence of that being the case. The only question is what “shock" eventually ignites the “gasoline" of excessive complacency, exuberance and leverage into a “panic fueled" explosion of liquidation.
Unfortunately, I do not know the answer to the “what" or the “when" of when such will occur. I am certain that it “will."
But, if you need more evidence, here is this tidbit from Nautilus Research’s Tom Leveroni:
So…let’s add this all up.
The bullish trend is intact which keeps portfolios on the long-side of the ledger for now. However, such does not mean one should become complacent and ignore the rising number of warning signs.
Valuations are stretched by most measures. While valuations are not reliable “timing" indicators, they are useful in predicting forward rates of returns.
Leverage is extended. Margin debt, or the dollar volume of stocks bought with borrowed money, surged just before the US election to a record high.
Retail investors are suddenly rushing to buy. Following eight years of net outflows, they poured nearly $80 billion into mutual funds and exchange-traded funds in the post-election rally. This year, however, corporate insiders have been selling at the fastest pace in nearly 30 years.
The technicals are showing vulnerability. From Monday through Thursday last week, the number of stocks making 52-week lows surpassed new highs. It was the longest streak since November 4 and was a sign of a toppy market, Rosenberg said. Also, the S&P 500 has traded as much as 10% above its 200-day moving average.
Investors are complacent, and it seems like the calm before the storm. The Chicago Board Options Exchange volatility index, or VIX, remains unusually low. The S&P 500 has not swung 1% intraday for almost 60 days, the longest streak in at least 35 years.
The Fed is raising rates. The rise in short-term yields could invert the yield curve before the Fed Funds rate is at 3%. An inverted curve - which reflects investors’ expectations for slower future growth - is seen as a precursor of recession.
Inflation is picking up. The core personal consumption expenditures index is at a 30-month high. Though it is likely not sustainable, it is a “classic late-game signpost."
The gap between economic growth and sentiment is large. The pace of policy change in Washington could disappoint investors.
Households have over-ownership. Their exposure to the stock market is 42% above the norm.
Credit markets are frothy. The compensation investors demand for choosing risky US high-yield bonds over risk-free assets - the risk premium - is widening.
Like gasoline, all of these warnings are “inert" and, other than smelling really bad, are harmless.
Well, that is until your cousin “Randy" shows up and decides to have a quick smoke.
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