David Rosenberg is chief economist with Gluskin Sheff + Associates Inc. and author of the daily economic newsletter Breakfast with Dave.
Now is not the time to panic or hyperventilate (as in, don’t behave like the U.S. President and lose your cool).
Wednesday’s 831-point slide, or 3.2 per cent, on the Dow didn’t even make it to the top-75 daily selloffs of the past six decades. This is hardly the first time we’ve seen a 3-per-cent plunge in the broader S&P 500, either− in fact, in this nine-plus-year cycle, this is the 20th time such a daily slide occurred and the market still managed to surge 312 per cent since March, 2009.
Go back to earlier this year when the S&P 500 dropped 10 per cent from late January to early April − again, fuelled by bond yields and some inflation pressure. The world didn’t exactly come to an end, although it ushered in a more selective and discerning market condition. This doesn’t mean I’ve turned bullish just yet − only that some perspective may be needed at this point. As we saw earlier this year, corrective phases can last a few months and require hefty doses of capitulation before they end.
Everybody says “what happened yesterday that caused such a meltdown?” Everybody is always searching for answers, and the reality is that when it comes to financial markets, there isn’t always rhyme or reason. People should just recognize that volatility is part and parcel of the landscape and that markets move in both directions.
When markets surge for no apparent reason, I don’t typically see anyone asking “why?” As Bob Farrell would have told you, “The markets make the news; the news does not make the markets.”
Here’s the reality: The stock market played some catchup to the treasury market and, in part, a reappraisal of Fed policy.
But the technical picture had already been eroding for some time. Long before Fed Chairman Jay Powell said anything, we had the likes of Walter Murphy, a legendary technical strategist and former Merrill colleague, saying that we “are at the top of the ninth with two outs” (how prescient!).
The lagging performance of the financials was a canary in the coal mine, especially since this is one group that should have been benefiting from rising rates. Banks are shedding assets, we have been discussing this at length, and several have announced layoffs among their credit loan office groups. Credit growth has been slowing. Households have never before been so exposed to equities in their overall asset mix, and as such have done the reasonable thing, which is to start taking some chips off the table.
Indeed, net flows into U.S. mutual funds and ETFs are down 46 per cent from a year ago (US$282-billion versus US$517-billion last year) through the first three quarters of the year. The Vanguard boom that helped create the fund-flow surge in equities is over − net inflows of $105-billion in the past two quarters are down nearly 40 per cent from where these flows were a year ago. Earnings estimates have stopped going up dramatically, and we are seeing a subtle change in corporate guidance to the downside. This is a brand spanking new development that has nothing to do with the Fed. And insider selling has really been picking up sharply. At the same time, we have gone into this correction with the same level of complacency we had last January − exceedingly low PM cash levels, huge net speculative long positions on the CBOT and sentiment surveys back to being off the charts bullish.
I have to say that Mr. Trump is doing more harm than good with his finger-pointing at the Fed and his inflammatory language. He came out and said “I really disagree with what the Fed is doing” and added, “I think the Fed has gone crazy.”
The problem is that Mr. Trump is not an expert on monetary policy, but Mr. Powell and his team are experts, and he would be well-advised to bite his lip for a change. After all, comments like these will not cause the Fed to budge. Mr. Powell is not some cabinet member who can be fired or replaced − he was chosen by the President because he is a Republican and a deregulator. Go back to the January confirmation hearing, and Mr. Powell made it very clear that he was going to “normalize” interest rates. If Mr. Trump wanted a “low rates person,” he should have just stuck with Janet Yellen − but the problem for him, in this ultra-partisan landscape, is that she is a Democrat (and was appointed by Obama … gasp!).
The stock market is still up 4 per cent for the year, is up 30 per cent since the November, 2016 election, and 312 per cent from the March, 2009 bottom. So just take a deep breath. This is how markets operate. I don’t recall president Ronald Reagan going ape about Alan Greenspan on Oct. 19, 1987, when the market collapsed 24 per cent, not 3 per cent. And a year later, the S&P 500 was back challenging the highs.
No doubt, Mr. Powell’s comments that the Fed is a long ways away from “neutral” was only stating the obvious. We already know that the Fed’s estimate of neutral is 3 per cent, and the policy rate is in a 2-2.25-per-cent range. So we are three to four hikes away.
And while the term “accommodative” was removed from the last FOMC press statement, Mr. Powell made it abundantly clear that policy was in fact exactly that ... accommodative. The ensuing comment that Mr. Powell made that the Fed may have to exceed neutral, again, is a complete no-brainer. The neutral or normal funds rate is the rate that exists when the economy is cruising along at full employment and price stability.
Well, the unemployment rate has actually been below the Fed’s 4.5-per-cent estimate of where it is at full employment for 18 months now and every inflation measure is at 2 per cent or higher (the central-bank definition of price stability). So the macro climate is definitely consistent with the funds rate moving above neutral. Only the uneducated and uninitiated don’t see this, not to mention that there has never been a Fed rate-hiking cycle that failed to see the policy move beyond neutral. Remember what Mark Twain said about history.
Now this view that inflation is not a problem is actually a bit of a joke and belies the data. Talk about a fake narrative.
This time last year, CPI inflation was 1.9 per cent. Today it is 2.3 per cent. This time last year, core CPI inflation was 1.7 per cent. Today it is 2.2 per cent. This time last year, the PCE deflator was running at 1.5 per cent year over year. Today it sits at 2.2 per cent. The core PCE deflator trend was 1.4 per cent a year ago and it is 2 per cent today.
So what am I missing? Is inflation, core and headline, moving up or down?
If the bond market saw deflation or renewed disinflation coming, then surely the safe-haven rally in treasuries would have been a lot more apparent in the past 24 hours. For all the bellyaching, all Mr. Powell has done is maintain the funds rate at, or below, ZERO in real terms. Oh my stars, what a tight monetary policy we have on our hands. And yes, the Fed is gradually shrinking the balance sheet but it is still hugely bloated to such an extent that even today, the balance sheet adjusted “shadow funds rate” resides in negative terrain at 2.4 per cent! This is what Mr. Trump is crying over.
I’ve said it before and I’ll say it again. Leadership means you accept the blame and share the credit. We have a U.S. President that takes all the credit when things are going well and plays the blame-game when they are not. Then again, he was deft in 2016 when it came to tapping anxiety, anger and fear among certain segments of the population. We know he is very good at deflection and pointing fingers at others. And if the economy does indeed begin to sputter, Mr. Trump already has his pinata and is setting this up very craftily.
As an aside, here is why the U.S. stock market is going down. It is playing catch-up (catch-down?) to the rest of the world. The problem in starting a trade war with China is that when the Chinese economy cools off, it is big enough to reverberate across the planet.
Surely if we learned anything from the past cycle, the past two cycles in fact, it is that there is no such thing as “decoupling” in such an intertwined global economy. In 2008, it was the rest of the world that caught the U.S. flu, and now it is the other way around. It’s just about the lags.
Now if the complaint from the White House is about this last leg of the bond yield runup, think of how the administration’s own actions are responsible for this. The fiscal deficit is spiralling. The Treasury has filled the gills at the auctions to such an extent that borrowing needs have ballooned about 70 per cent from a year ago, and we see from these tenders that there is insufficient demand to clear them at yesteryear’s yield levels. Investors can see the low bid-to-cover ratios and also see that China is fighting back in this trade war by reducing their exposure to treasuries − and guess what? So is Japan. And these are America’s two largest creditors (with holdings in excess of US$1-trillion).
We had been saying for some time that stimulating the economy at this stage of the cycle would certainly lift after-tax incomes for a while, but why on Earth would anyone believe that interest rates would stay static as a result? Are these people completely ignorant of Newton’s third law of motion?
The White House embarks on trade skirmishes that may well end up “bringing jobs home,” but disrupting global supply chains, my friends, is inflationary from a cost-push standpoint. We also have the most restrictive immigration policy in recent memory at a time when the pool of available labour has shrunk 10 per cent over the past year to the lowest level in twelve years, and when labour quality (or lack thereof) has emerged as the top constraint for the small-business sector. Indeed, to such a critical point that all of the U.S. job growth since May has been concentrated in the segment of the labour force that has either a high-school diploma or dropped out before their senior year. That cannot be good news for productivity growth, and, again, a development that will end up creating more, not less, inflation.
So fiscal policymakers in the United States decided to run the economy hot as it heads into the tenth year of the expansion with a lack of any spare capacity in the economy. This has helped produce an environment where real GDP growth on a year-over-year basis is 2.9 per cent and the real funds rate at or below 0 per cent. And an environment where the year-over-year trend in nominal GDP is 5.4 per cent compared with a nominal funds rate of 2-2.25 per cent. And so if you believe the President, the recent gyrations are all about the Fed. I have a name for this − “fake blame!”
I will finish off by saying that what goes around, comes around. The reality is that the stock market radically outpaced what the economy did this cycle − completely unprecedented. And this was because of the Fed’s policies of maintaining unnaturally low interest rates and the market incursions via relentless QE’s. We estimate that about a thousand rally points in the S&P 500 were due directly, and indirectly, to the Fed’s benevolence − so what is happening, which is actually a good thing, is that the central bank is gradually moving us all away from a liquidity cycle to a more fundamentally based cycle. And maybe some investors are seeing that the fundamentals, as they pertain to endless massive fiscal deficits, aren’t quite as bullish as they appear today in the form of transitory fiscal stimulus.
David Rosenberg