“The only thing we have to fear is fear itself.”
Franklin Delano Roosevelt
FDR’s first inauguration speech gave us the iconic quote above. Delivered in the midst of the Great Depression (1932), he was referring to fear about the economy, but as all experienced investors know, the thought can just as easily be applied to financial markets. Whether it’s an economic or market collapse, there is a truism inherent in the statement. Panic is a necessary condition for such events. However, it is not sufficient. Busts do not happen without booms, and market crashes only come after periods of extreme optimism.
In that vein, the nasty equity market correction we have experienced in the last week should not have come as a surprise. Over the last year, the S & P 500 has barely had more than a 3% correction, with market volatility setting record lows. By any technical measure, the market was severely overbought. A simple check of the daily “Relative Strength Index” (RSI), which is a common “oscillator” type technical indicator, shows the extreme optimism. The RSI runs between 0 and 100, with readings above 70 considered overbought, and below 30 being oversold. The daily RSI for the S & P 500 (SPX) was above 70 for almost all of January, and reached 87 on January 26th, which is the highest level since 1971!
Bullish momentum such as this can lead to quick and scary corrections when they break. The rapidity and severity of this correction (the SPX is down around -10% in 2 weeks) has led to worries that something worse could be in store. As long as fundamentals are solid, and a recession isn’t set to occur for the next year, a -10% to -15% is usually as bad as it gets. Both global and U.S. growth are the best we have seen in several years, which is supporting a general consensus that this is no more than a “healthy correction”. That is likely an accurate depiction, but it is always worth asking the question of how, or why, the downturn may be than just a technical correction.
The Ebbing of Global Liquidity
Most market commentary is focusing on the long duration of this business cycle, and the abnormal level of interest rates. As everyone knows, we have had almost a decade of record low interest rates. Exiting from these extraordinary monetary provisions is bound to cause anxiety in markets, as there is no historical precedent to provide insight. To some extent, every business cycle suffers from uncertainty as the labor market tightens, inflation picks up, and the central bank is forced to raise rates.
The one thing missing from most market analysis has been an acknowledgement of the continued central bank liquidity that has been persistent over the last three years. The Federal Reserve has been raising rates (at a glacial pace), but that has more than been offset by Europe, Japan and China. Europe and Japan unleashed extraordinary measures at the beginning of 2015, with China stepping up in early 2016, as global growth began to falter (see Manna From Heaven ). I continue to believe that the “coordinated global growth” that many have been touting to support a bullish thesis is, to a great extent, a function of coordinated QE. If that is the case, removal of that liquidity would be problematic. In that last decade, we have had no significant removal of global liquidity without economic growth weakening to worrying levels.
Detox is Painful
Chart 1 shows U.S. 5 year Treasury Inflation Protected Notes (TIPs) as a proxy for 5 year real interest rates. Since inflation actually benefits debtors, tracking real rates gives a better view of how much rising interest rates are actually curbing liquidity. As can be seen, real 5 year interest rates have remained below zero for most of this cycle. The few times it has risen above zero for any length of time, economic weakness followed. Certainly, this time may be different. It is possible enough economic momentum has been created that will allow real rates to rise above the levels that derailed growth previously in this cycle (around +50 basis points for the 5 year).
5 Year Real Interest Rates
It is also important to note the trend in real interest rates for the last 20 years. During the late 1990s, the economy was able to weather 4% real 5 year rates. In the mid-2000s, that level was around 2.5%. Since the crisis, negative rates have been needed to keep the economy above water. There may be several reasons for this, but the most relevant issue is the record level of debt. Chart 2 shows the ratio of total nonfinancial debt to GDP for the United States going back to 1947. In effect, the chart shows that the ratio of all U.S. nonfinancial debt has roughly doubled since the 1950s to approximately 2.5 times GDP. Simplistically, that would imply the amount of GDP required to service debt has almost doubled in the last 60 years.
However, the actual amount of debt service versus GDP depends on the level of interest rates, the distribution of debt among economic sectors, the distribution in terms of risk, and risk premiums. As a general rule, corporate debt is considered most beneficial to an economy, because investments are geared toward generating long-term profits and growth. On the other hand, household debt, which is used for consumption, is a more dangerous, because its generation provides no means for its repayment. Government debt is often considered “risk free” (at least for developed countries), due to the ability of the federal government to tax (and yes, print money!) in order to ensure repayment. However, government debt shares some of the characteristics of household debt in that it is not necessarily efficient, or self-sustaining.
Chart 3 shows U.S. debt to GDP ratios broken down by the major sectors (corporate, household, federal). For greater clarity, Chart 3 only goes back to 1980, which was a watershed period for interest rates and debt generation. The Federal Reserve Chairman in the early 1980s, Paul Volker, “broke the back” of inflation by hiking short-term rates to double-digit levels, and convincingly tightening monetary policy. Yields on 10 year U.S. Treasuries reached almost 16% in 1980, before embarking on an epic bond bull market that saw yields go to 1.32% in 2016.
The descent of interest rates set off an equally epic trend in debt accumulation, with the most dramatic expansion of debt occurring in the household sector. The origin of the mortgage bubble can be seen clearly in the move of household debt as a percentage of GDP from 67% in 2000 to a high of 97% in 2008 (red line). As the crisis developed, mortgage defaults drove a cycle of debt deflation in the household sector that was almost completely offset by expansion of debt by the federal government (green line). While many have criticized the record peacetime expansion of government debt, it is the primary reason we avoided another Great Depression. That is, along with the unprecedented purchasing of government debt by the Federal Reserve known as quantitative easing (QE).
The upshot of this exercise is that household debt, while much lower than pre-crisis levels, is only back to where it was in 2002, which was a record at the time. Chart 4 shows the U.S. Household Debt Service Ratio. It is the percentage of household disposable income which must be used to pay interest on debt. As optimistic analysts have highlighted, the ratio is close to a record low. However, it should be recognized that this low level is very much a function of record low interest rates. Any substantial pick up in rates will lead to a rise in household debt service.
Furthermore, the debt service ratio does not measure the credit quality of loans being made. It is well-known now that the mortgage crisis was worsened by a tendency to lower credit standards in order to keep loan growth going. With the homeownership rate at 64.2%, below its long-term average 66.5%, mortgage debt is unlikely to be an issue this cycle. However, areas such as subprime auto loans (see New U.S. Subprime Boom ) and student loan debt (see Student Loans “Eerily Reminiscent” of Subprime Mortgages ) have been flagged as potential problem areas in the future. While default rates are rising in these areas, most do not believe they portend the systemic level danger of subprime mortgages circa 2008. That is a reasonable assessment, but I believe caution is still warranted. There may not be a systemic crisis on the horizon, but that does not mean a reduction in liquidity (higher rates) will be a smooth ride for this economy.
A Shot Across the Bow
Ultimately, it could be argued that recent market volatility is nothing more than a technical correction. Markets as overbought as U.S. equities were coming into February do not need a fundamental catalyst to trigger a correction. Most analysts and strategists are touting strong economic fundamentals, and good corporate earnings as reasons to ignore the recent selloff, and stay the course. Yet, a small minority has been warning of a 1987 style crash for some time, and not surprisingly, those warnings have become more strident with the recent selloff. Before investors dismiss such warnings, they should be aware that the 1987 crashed occurred amidst considerably stronger economic fundamentals than what we have now. The danger, as some have been noting, is in a collection of portfolio strategies (e.g. volatility targeting, risk parity) that could lead to self-reinforcing selling in a downturn (see “The Coming Crash Will Be Like 1987…But Worse” ). Personally, I prefer to avoid hyperbole, but it would be foolish to not factor in such circumstances.
As I write, the market is bouncing hard off the lows of last week. Having touched the 200 day moving average, which usually provides support in a bull market, the S & P 500 has ripped higher in the past few days. In all likelihood, the market will consolidate here over the next few weeks, and fear will subside. But interest rates have barely moved to what should be considered restrictive levels. With 10 year treasury yields at only 2.85%, we just witnessed some vicious volatility. Businesses are warning of inflationary pressures rising. Average hourly earnings just registered a 2.9% YoY rise, the highest of the cycle. With inflation finally starting to rear its ugly head, the one thing that has kept this cycle going (i.e. endless central bank liquidity) is now in danger of disappearing. So far, global central banks continue to be very accommodative. That is unlikely to continue. When liquidity really starts to get drained is when investors should start to get seriously cautious. The warning shot has been fired.