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Angels on the Head of a Pin

Wall Street is fervently trying to figure out the answer to one overarching question this summer: Are we heading into a recession?  Every day, dozens of learned analyses are published trying to prove that a recession is coming, or conversely, that we nothing to fear and that the economic expansion will continue.  It has been eleven years since the dark days of 2008’s recession, and the current expansion is now the longest on record. Each economic report seems to generate either euphoria or despair among investors, as investors grasp at any straws they can to help divine the answer to this important question.  Investor anxiety has been clearly evident in August stock market action, as daily up or down moves exceeding one percent have dominated the latter half of the month. While Wall Street analysts are parsing every data point and projecting their conclusions well into next year, we feel it is akin to arguing over how many angels fit on the head of a pin.  Holding out hope for continued expansion, they are wasting time arguing over minutiae, while more urgent warnings go unheeded.

It is not hard to see the reasons for investor’s angst, as a confluence of less-than-hopeful trends are now gaining steam.  The trade war with China has taken a significantly more serious turn this month, as negotiations broke down with vague prospects for their resumption.  When China raised tariffs on American goods, the Trump team immediately retaliated by announcing that tariffs would be raised further on Chinese goods. The two sides seem to moving farther apart on an agreement, rather than closer together.  Having been badly insulted, the Chinese are digging in, and not simply acquiescing to America’s demands like some sort of Asian lap dog. They may have simply decided to wait out the Trump administration, and see how the 2020 election turns out, in hopes of having a more amenable administration to deal with in the future.

The Chinese have a long-term vision of their preeminent role as a global superpower.  China has the longest continuous history of any country in the world—3,500 years of written history.  They are not going to let their vision of global dominance be derailed by trade tariffs. Moreover, president Xi Jinping is president for life, having abolished term limits in 2018.  Thus, he can afford to play the long game politically, a necessary facet to seeing their long-term plans come to fruition.

Wall Street, whose perspective is considerably shorter, is nervous as reports from the business community are increasingly dire.  With Europe slipping into negative growth, Chinese markets drying up, and a general sense that our trading partners are circling the wagons to protect their own constituents, great hope is being attached to the U.S. consumer to save the day.  So far, housing and consumer spending have held up, as American households have enjoyed low unemployment and some wage strength. This is reflected in recent consumer confidence surveys, which show the highest level in this measure since 1999.

While the consumer is holding up its end of the economy, other sectors are not faring as well.  Transportation, for example, is already in recession. The Cass Freight Index Report is available to the public, and provides monthly updates on truck, rail, and air shipping.  This is a good real-time indicator of one of the most basic economic indicators-transporting goods to their markets.  Their latest report shows the extent to which things are slowing, with the July decline making it eight months in a row of falling freight volumes.  The report does not mince words about the meaning of this trend: “With the -5.9% drop in July, following the -5.3% drop in June, and the -6.0% drop in May, we repeat our message from last two months: the shipments index has gone from “warning of a potential slowdown” to “signaling an economic contraction.

The regional Federal Reserve Bank activity surveys also show a marked softening in activity, with most of the indexes hugging the borderline between expansion and contraction.  The view from Richmond, Chicago, and Kansas City all convey the same message that business is slowing down. They, like many economic reports, are not bad enough to declare that the recession has arrived, but are identifying a major change in trend from growth to, at best, a stagnating state of affairs.

Perhaps the loudest alarm is coming from the bond market, where bond yields have collapsed this summer.  As of this writing, the 10-year Treasury Note yield is under 1.5%,and the 30-year T-Bond yields just under 2%.  This is not the behavior of a market expecting an economic boom. It is reflective of the low, and increasingly more pessimistic, outlook for financing needs and inflation.  With the pace of activity slowing, the need for borrowing is abating as companies restrict activities and conserve resources as they see demand drop. And the most precious resource in a slowing economy is cash.

With corporate debt to GDP ratios reaching new highs, it is no surprise that companies want to be careful.  A highly leveraged balance sheet combined with a drop in demand is a toxic combination. It is often high debt levels that become unsustainable that lead to bankruptcies, not so much a change in customer preferences or product obsolescence.  Given the new highs in corporate debt, it appears we are about to learn that lesson all over again.

While economists are debating how many recession indicators fit on the head of a pin, the bigger, ignored question is what severity of recession should we expect?  We believe the risks are significant because two traditional economic stabilizers will not be up to the task.

For nearly a hundred years, governments have tried to stave off the worst effects of recessions.  Indeed, mitigating the devastating effects of 19th century liquidity crunches was the primary impetus in forming the Federal Reserve in 1913.  Historically, interest rates would rise with inflation in boom times. The rise in rates would begin to make borrowing more expensive as the economy overheated, leading to a drop in demand for homes, cars, and other big-ticket items.  Unsold inventories would build up, and companies would cut back production and employment. The Fed, having raised rates, would have the capacity to lower them significantly, stimulating demand, and starting the cycle all over again.

But monetary policy today is in exactly the opposite position it should be for this stage of the business cycle.  Today, the Fed does not have much capacity to lower interest rates, which are near rock-bottom. This is despite the longest expansion on record.  The legacy of “quantitative easing” (QE) has cast a long shadow, keeping rates too low for too long. Companies, households and governments have borrowed mightily during the QE years.  Thus, if the Fed lowers rates, it may not provide the hoped-for stimulus, as we may have reached the limits of the willingness to borrow. The struggle to provide stimulus has pushed European interest rates into the absurd zone of negative yields.  Yet, that continent is seeing growth turn negative also. It shows that there is a limit to what monetary policy can do to forestall recessions.

Fiscal policy, or outright government spending, has also been a traditional tool to help dig out of the economic doldrums.  Spending on infrastructure and other public works projects has been a politically favorite way to put people to work (and enhance the odds of reelection).  Historically, budget deficits would shrink during expansions, and rise during recessions as deficit spending sought to stimulate demand.

Today, however, we face the exact opposite situation.  The budget deficit has expanded under Trump, and is projected to hit almost $1 trillion this year.  This makes it increasingly difficult to invoke fiscal policy when it is needed in the depths of a downturn.  Moreover, it will take direct expenditure on projects, rather than tax cuts, to have the most beneficial results from fiscal policy.  Unfortunately, our political leaders have other priorities, and will find, we fear, that they have left the remediation of America’s precarious finances until too late.

The risk of a recession occurring is that we lack the tools to fight it as we traditionally have.  Thus, the prospects for a deeper and longer recession than expected is very real. Both monetary and fiscal policies have evolved from being solutions to yesterday’s problems into problems themselves.  The repression of interest rates at artificially low levels and the yawning chasm that is the federal budget deficit will prove to be “demons of our own design.”

The relentless monetary stimulus of the last ten years has created a bubble-like environment for almost any asset class you can name.  Rather than argue over angels, we should be prepared for a recession to serve as the pin which deflates the bubble in which Wall Street currently exists, and naively views as the new normal.

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