Turmoil In The Repo Market – A Safer Market Commentary

Fed policymakers have been thrown another unexpected curveball as cash available to banks for their short-term funding needs (the overnight Repo market) all but dried up on Monday and Tuesday. That forced the New York Fed to make an emergency injection of more than $50B, its first since the financial crisis, to bring down key short-term rates that had spiked to as high as 10%. Fed traders will be back this morning and Friday morning to restore calm by offering another $75B of cash to the market.

However, the reality is, no one is absolutely sure why it’s happening.

Stay tuned; we’ll be following this closely.

Fed Rate Cut This Week

Wednesday’s Federal Reserve action disappointed those who wanted a larger rate cut, but bond expert Mark Grant says almost everyone, including the Fed, is missing the real point. The European Central Bank and Bank of Japan are aggressively trying to support their economies, creating collateral damage to the US dollar and US economy, while the Fed is not responding.

Key Points

• The Fed doesn’t seem to recognize that US rates, while low, are much higher than European and Japanese rates and the effect this has on our economy.
• However, they are still fostering a “borrower’s paradise.” Grant thinks both individuals and corporations should take advantage.
• Investors (lenders) are in the opposite position, suffering from low yields and unable to generate cash flow. This affects banks, pension funds, insurers, retirees, and others.
• While the Fed fritters, the ECB is taking action, handing free money to banks and buying bonds with a restarted quantitative easing program.
• Fed officials seem to no recognize this at all. They nod to “global events” but are not protecting American interests.

Bottom Line: Grant has said elsewhere the Fed should cut rates to just above zero and stop there. That doesn’t seem to be the strategy they have chosen – or if it is, they’re in no hurry to get that low. US growth will be difficult so long as interest rate differentials keep strengthening the dollar. Only the Fed can change that, and it seems uninterested in doing so.

China

Why You Should Read: This is one of the more bearish outlooks we have seen lately and (unfortunately) make some excellent points, particularly on China. Crescar says recession fears becoming self-fulfilling late in an expansion when people finally start acting like on is imminent. That seems to describe where we are right now.

Key Points

• Macro indicators have been turning down all year, in a pattern not seen since 2015 when several emerging markets went into recession and Chinese stocks crashed.
• Today’s economic outlook is much worse than it was in late 2015, with China facing much bigger recessionary pressures.
• Asset bubbles, particularly US stocks, are also much bigger today. The Wilshire 5000 is now at its most expensive point ever relative to the US economy.
• Crescat believes the present downturn will likely continue to a hard landing, and it is too late for the Fed to keep the expansion going.
• Recessions are “necessary, normal, and inevitable.” Interventions to postpone them create malinvestment and bigger bubbles, making the downturn even more violent.
• The Chinese economy is in the early stages of a debt and currency crisis. Its debt levels are overwhelming, and a significant currency devaluation is likely.

Bottom Line: Crescat concludes, “just as asset prices rise in a positive feedback loop of easy credit, investor speculative behavior, consumer and business spending, so they decline in the opposite self-reinforcing fashion.”

US Recession?

Recessions become self-fulfilling prophesies late in an economic expansion at a point when people finally start believing and acting like one is imminent. It is particularly true when asset bubbles are present. A huge spike in concerns about the economy as measured by Google Trends analysis of the search word “recession” was not a contrary indicator at all at the very beginning of 2008.

US And Global Macro Indicators

Beware the narrative that the US economy is still strong when it is being spun by conflicted central bankers, politicians, and investment professionals. The truth is that the macro indicators have been turning down materially all year as we can see by the year-over-year change in the Atlanta Fed’s GDP Now macro model.

In the history of the Wilshire 5000, the total US stock market index, stocks recently reached their most expensive ever relative to the underlying economy, higher than the peak of the tech bubble in 2000.

Per the Bank of International Settlements (BIS), China’s total international bank claims have just contracted for the first time in three years reflecting an early warning sign of financial stress. These claims, valued at $920 billion, comprise cross-border transactions in any currency plus local claims of foreign affiliates denominated in six non-local currencies. Chinese banking activity similarly faltered during the emerging market crisis in 2015 and the global financial crisis.

The median Chinese stock had fallen close to 40% during the 4th quarter of 2018. Since then, the PBOC has attempted to revive its economy through aggressive monetary policies that continue to put downward pressure on its currency to depreciate against the dollar. The Chinese central bank targeted specific forms of liquidity injection, one of them being through its state-owned commercial banks. Their quarterly rate of change in total assets just surged as much as it did times prior to and during the global financial crisis.

Ray Dalio Recap

Last week, I showed you Ray Dalio’s latest Three Big Issues article. To recap, Ray says we are now in a world where:

• Central banks have limited ability to stimulate growth as we approach the end of a long-term debt cycle.
• Wealth and political polarity are producing internal conflict between the rich and poor as well as between capitalists and socialists.
• There is also external conflict between a rising power (China) and the existing world leader (the USA).

The world last saw this combination in the 1930s, which is not comforting, to say the least. But, as I said, we can get through this together if we approach it wisely. That’s a big “if,” given the ways some investors behave at cyclical peaks, but people will do what they do. We can only control our own actions, and today I want to talk about some we can take.

Another Reason Why Buy And Hold Will Not Work From Today’s Market Valuation

As investors, we have to make assumptions about the future. We know they will likely prove wrong, but something has to guide our asset allocation decisions.

Many long-term investors assume stocks will give them 6–8% real annual returns if they simply buy and hold long enough. Pension fund trustees hire consultants to reassure them of this “fact,” along with similar interest rate and bond forecasts, and then make investment and benefit decisions.

Those reassurances are increasingly hollow, thanks to both low rates and inflated stock valuations, yet people running massive piles of money behave as if they are unquestionably correct.

You can, however, find more realistic forecasts from reliable, conflict-free sources. One of my favorites is Grantham Mayo Van Otterloo, or GMO. Here are their latest 7-year asset class forecasts, as of July 31, 2019.

These are bleak numbers if you hope to earn any positive return at all, much less 6% or more. If GMO is right, the only answer is a large allocation to emerging markets, which, because they are emerging, are also riskier. The more typical 60/40 domestic stock/bond portfolio is a certain loss, according to GMO.  (Note these are all “real” returns, which means the amount by which they exceed the inflation rate).

Others like Research Affiliates (Rob Arnott), Crestmont Research (Ed Easterling), or John Hussman (Hussman Funds) have similar forecasts. They differ in their methodologies, but the basic direction is the same. The point is that returns in the next 7 or 10 years will not look anything like the past.

Remember, though, this forecast is what GMO expects if you buy and hold those asset classes for the next seven years. We are free to move between asset classes and use other asset classes, too, which is exactly what I think we should do to do well in the next seven years.

Many financial advisors, apparently unaware the event horizon is near, continue to recommend old solutions like the “60/40” portfolio. That strategy does have a compelling history. Those who adopted and actually stuck with it (which is very hard) had several good decades. That doesn’t guarantee them several more, though. I believe times have changed.

But, those decades basically started in the late 40s and went up until 2000. After 2000, the stock market (the S&P 500) has basically doubled, mostly in the last few years, which is less than a 4% return. When (not if) we have a recession and the stock market drops 40% or more, index investors will have spent 20 years with a less than 1% compound annual return. A 50% drop, which could certainly happen in a recession, would wipe out all their gains, even without inflation.

And, yes, there have been historical periods where stock market returns have been negative for 20 years. 1930s anyone? Yes, it is an uncomfortable parallel.

The “logic” of 60/40 is that it gives you diversification. The bonds should perform well when the stocks run into difficulty and vice versa. You might even get lucky and have both components rise together. But, you can also be unlucky and see them both fall, an outcome I think increasingly likely.

More Information On The Inverted Yield Curve

While the 10-year Treasury rate did pop up last week, it did little to reverse the majority of “inversions” which currently exist on the yield curve. While we did hit the 90% mark on August 28th, the spike in rates only reversed 2 of the 10 indicators we track.

Nor did it reverse the most important inversion, which is the 10-year yield relative to the Federal Reserve rate.

However, it isn’t the “inversion” you worry about. 

Take a look at both charts carefully above. It is when these curves “un-invert,” which becomes the important recessionary indicator. When the curves reverse, the Fed is aggressively cutting rates, the short-end of the yield curve is falling faster than the long-end as money seeks the safety of “cash,” and a recession is emerging.

There are certainly plenty of warning signs the economy is slowing down.

S&P Profit Margins

Although S&P 500 profit margins are near record highs, there can be a lag between a fall in economy-wide profit margins and profit margins for the S&P 500. This chart suggests that we may be in one of those lag periods right now.

Market Data

• The jump in crude oil on Monday was one of the most shocking in 30 years.
• The S&P’s energy component didn’t quite pop enough above its 200-day average, which would end one of the longest downtrends since 1926.
• Broadening rally. The percentage of stocks on the NYSE above their 200-day averages hit a 1-year high.
• Big money gets bullish. The latest survey from Bank of America Merrill Lynch that polls large money managers with nearly $700 billion under management showed a large jump in optimism over the past month.
• Momentum renewal. Several major indexes, both domestic and overseas, are seeing renewed momentum in the breadth of rising vs falling stocks.
• Volume flow. The improved breadth can also be seen in the NYSE Up Volume Ratio, where the 15-day average has cycled from below 40% to above 63%.
• Every period of GDP expansion since 1950—with a few exceptions—has been weaker than the prior one. Since around 1980, the expansions have also been lasting longer. The current expansion is now the longest of the entire period—and the weakest.
• GDP is a statistic with all the usual statistical flaws, and today’s economy is quite different from that of the 1960s. But, the data suggest that expecting sustained 3% to 4% real GDP growth may be overly optimistic.
• After last week’s huge drop in momentum stocks, and shift toward value from growth, those shares fell a bit more and have since rebounded. The two-sided volatility is notable and is something that preceded the last two recessions.
• The McClellan Oscillator on the Japanese Nikkei 225 has neared a 17-year high. According to the Backtest Engine, it has crossed above 135 only twice before, in March 2009 and November 2014.
• While SPY made another all-time intraday high on Thursday, the number of S&P 500 component New Highs continued to contract from the level they had reached earlier this month. This kind of activity should be taken as a warning flag, increasing our expectation of a price top. Also interesting is that the New High complex for this month is considerably smaller than the New High complex of June and July, showing us how dramatically participation has waned.