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Macroeconomic Thoughts - April 2018

Macroeconomic Thoughts

The best laid plans of mice and men…

Approximately one year ago I sent a letter noting my intention to resume providing you with occasional macroeconomic updates. As you may have noticed, that had not happened as of the time of this letter. I have not forgotten. In the period following that letter, my partners and I have been wholly occupied with stewarding what has now grown to exceed $1.2 Billion of client assets entrusted to our care. We have dedicated ourselves to building our team, infrastructure, and systems necessary to make this stewardship successful.

Before I dive into the latest macroeconomic update, I want to pause to convey a heartfelt thank you from myself and my partners across our entire group of companies! It is our passion to empower people to be secure, free, and generous; it is your confidence in us that has provided the opportunity to do just that. We love getting to work on your behalf, and so deeply appreciate that you have chosen us to steward your wealth—that which ultimately enables you to be secure, free, and generous with others. We are deeply humbled by the depth of trust that this reflects, and we take this responsibility seriously in every aspect of what we do. Thank you!

Macroeconomic nerd heaven

We believe that it is essential for us to take time to consider the forest (macroeconomics) for the trees (investments) so that we do not miss major economic trends that could materially impact our investments. We have continued our commitment to actively studying shifts in macroeconomic conditions in order to guide and enhance our investing strategies. We are willing to invest in and recommend only those select few investments that are 1) well positioned against the macroeconomic backdrop, and 2) provide a significant value-added or opportunistic cushion so that we can achieve downside protection and upside potential that are not dependent on a thriving market. This approach seems like common sense to us, but we have learned that the prioritization of macroeconomic research and value-added strategies is rare.

I recently returned from my annual trek to the Strategic Investment Conference—an outstanding conference that features four densely-packed days of presentations and debates featuring some of the greatest economists, geopoliticists, financial historians, and investment managers of our day—many of whom accurately predicted the last Great Recession. It is one of the best conferences of its kind and serves as my annual retreat to gain macroeconomic insight and to consider how to navigate the upcoming financial, economic, demographic, technological, and geopolitical shifts that may impact our investing strategies and operations. After drinking from this fire hydrant of macroeconomic data and insightful analysis, I came back renewed, challenged, and extremely motivated to consolidate my thoughts and pass on what I learned to you. What follows are some of the biggest investing takeaways from that conference.

For those of you who do not have the time or desire to sift through all of the macroeconomic data, preferring to skip to the bottom line, I have included a “bottom line” section at the end just for you.

Volatility is back

We have seen increasing market volatility over the past couple months, which could be the canary in the coal mine warning us that the good times are behind us. In fact, the first quarter of this year has seen higher volatility spikes than the entire time since the Great Recession, setting aside the Flash Crash of 2016 (see chart below). Thus far, we have maintained significantly higher average volatility in the first quarter of 2018 than the highest point of volatility in all of 2017.

2018 has already brought us four of the 20 largest single-day point drops in the history of the S&P 500. Resurging volatility could result in disaster for investors who are banking on strategies that have been relying on the Fed-induced suppression of volatility over the past decade—and especially over the past 18 months. Since this volatility is piggy-backing on extremely high valuations in the equities markets (more on that later), it could lead to the realization of significant downside risk for stock and bond investors.

A line graph shows spikes at the Great Recession, Flash Crash of 2010, EU Debt Crisis, and Flash Crash of 2016
Source: S&P 500 Volatility Index (VIX) 2007–2018, Joshua Ungerecht, JRW Investments

Next recession to start in 2019?

The consensus of the economists at the conference was that we are headed toward the next recession, which is likely to begin sometime next year (2019). Several of the speakers voiced expectations of a stock market correction beginning this year, which would be reflecting that recession potential in advance.

Chief among the prognosticators was David Rosenberg (Chief Economist for Gluskin Sheff and formerly chief economist for Bank of America/Merrill Lynch) who was among those few economists who accurately forecasted the previous downturn in advance of the Great Recession. He became bullish in 2009 and remained bullish (and rightly so) through the end of 2017. However, as of 2018, he has now turned bearish and is expecting a recession to begin next year and anticipates a significant stock market correction later this year to reflect the rising risks of recession.

There Have Been 13 Fed Hiking Cycles, 10 Landed in Recession! (with accompanying chart)
Source: David Rosenberg, Gluskin Sheff

In Rosenberg’s view, a number of indicators demonstrate that we are nearing the end of our bull market phase, not least of which is the fact that the Fed has shifted from quantitative easing to quantitative tightening. When the Fed begins employing a tightening monetary policy we almost always end up in a recession, and when we don’t, we still undergo a significant correction. We are now over two years into this current tightening phase.

Rosenberg also notes a number of red flags that potentially signal the end of the market cycle. For example, many people have been heralding rising consumer sentiment as an indication that the economy is strong, but few remember that consumer sentiment is primarily driven by the “wealth effect” (people feeling richer and more confident when their stocks and asset values become inflated). The wealth effect tends to peak right before significant market corrections and recessions. This is depicted well in the chart below.

The same is true for unemployment. Politicians and pundits in the media are pointing at record-low unemployment as evidence that the economy is thriving. They forget that unemployment tends to be at its lowest directly prior to a recession.

Little (If Any) Slack Left in the Labor Force—United States: Unemployment Rate line graph

Valuations are dangerously high

I recommend that you have a seat (and maybe a stiff drink) before reading this next section. The charts that follow capture the sheer magnitude of the potential overvaluation currently embedded in the stock market.

The Enterprise Value-to-EBITDA Ratio has nearly exceeded the 2000 Dotcom Bubble.

More Signs of Excessive Valuations—United States: S&P 500 Enterprise Value to EBITDA Ratio line graph

The current Price-to-Sales Ratio exceeds its Dotcom peak.

Taking Out The DOTCOM Peak—United States: S&P 500 Prices to Sales Ratio line graph

The current Cyclically Adjusted Price-to-Earnings Ratiois exceeded only by peaks preceding the Great Depression and the Dotcom Bubble, and it dwarfs the peak that preceded the Great Recession (2006–2007).

Mark Yusko of Morgan Creek Capital Management pointed to many of the same levels of overvaluation and thought that the recent breakdown looked eerily similar to a popping bubble.


Source: Mark Yusko, Morgan Creek Capital Management

Taking a note from Doug Short, Grant Williams of Real Vision highlighted the Price-to-EBITDA Ratio among the S&P 500, showing that we are now well in excess of the Dotcom Bubble’s highs.

S&P500 Price-to-EBITDA: 1997-2018 line graph
Source: Grant Williams / Original Data: Doug Short

The picture is just as concerning whether we look at Price-to-Forward Earnings, Price-to-Book, Inflation-Adjusted, Denominated-in-Gold, Market Cap-to-GDP(Warren Buffet’s favorite), or other metrics. Don’t shoot the messenger, but no matter how you slice it, all the indicators seem to be warning us that we are at or above historic valuation highs that have been typically followed by significant market corrections or deep recessions.

But hey, this time could be different! Why not double down on risk and hope for the best! Only kidding—extreme caution is clearly warranted!

Removing the punch bowl

Another clear consensus at the conference was that the regime change at the Federal Reserve is far more significant than most people realize. Everyone in the financial world has been focused on the appointment of Powell to take Yellen’s place as the Fed Chair. What people are missing is that, given the annual rotation of voting governors on the board, the entire voting makeup of the board has turned over, flipping from primarily dovish (accommodative monetary policy, a.k.a. "spiking the punch bowl") to primarily hawkish (tightening monetary policy). Instead of spiking the punch bowl, the new board is taking it away, breaking up the party, and calling the police.

In Powell’s first FOMC meeting as the new Fed Chair, it became clear that he would continue the quantitative tightening and may exhibit even less sensitivity to its potential stock-related consequences than his predecessor. In addition to this shift in Fed policy, central banks around the world are shifting towards tightening instead of easing.

Quite simply, while the expansion of central banking balance sheets has been relatively ineffective in curing economic ailments (funny how more debt won’t solve over-indebtedness! Who knew?), it has produced sizable bubbles in almost every investment category, with the bubble in the stock market ranking among the largest. What happens when the easing policy that created these asset bubbles gets replaced by a tightening one? The result is captured perfectly in Grant Williams’ presentation on tightening central banking policies and the real-world effects that would likely follow. In his chart below, he overlays the Fed’s balance sheet and S&P 500 pricing over the past decade.

S&P500 vs Federal Reserve Balance Sheet (All Assets, $TLN): 2008-2018 line graph

Along with the Federal Reserve, the majority of the other central banks throughout the world are shifting from easing to tightening policies. Unless there is a significant worldwide reversal in central banking policy, it looks like the party may be coming to an end. Next comes the hangover.

S&P500 12-Month Return vs Total Fed Purchase 12-Month Change: 2012-2018 line graph
Source: Grant Williams, Real Vision

Interest rates and the velocity of money

Dr. Lacy Hunt is the chief economist and one of the primary investment managers for Hoisington Investment Management, one of the most profitable bond mutual funds over the past 5-, 10-, and 15-year timeframes. Dr. Hunt provided an exceptional presentation on the economic principles that are ultimately at work behind the velocity of money, inflation, and deflationary forces. His conclusion is that in the face of increasing over-indebtedness, we are going to persistently struggle to escape deflationary forces and will therefore continue to experience lower interest rates over the long term. He believes that the Federal Reserve is going to have to reverse its course on fighting inflation and will have to walk back the policy moves that have come as a result.

One of the biggest indicators that has convinced him that deflation is here to stay is the velocity of money. The velocity of money is the rate at which money is used and reused in a given period of time. Put simply, it is the number of times the same unit of money is used to effect a transaction in a given period of time. For example, if you spend $100 dollars at the clothing store, and they take that money and spend it on buying more inventory from their manufacturer, and the manufacturer spends that same money on upgrading machinery, etc., the same $100 has been used to effect $300 in transactions.

An increasing velocity of money is indicative of inflationary pressures prevailing, whereas a shrinking velocity of money is more indicative of deflationary pressures prevailing. As the next chart clearly indicates, the velocity of money continues to decelerate, and this trend has only worsened as the Federal Reserve has chosen to maintain course with quantitative tightening. Dr. Lacy Hunt believes that deflation will continue to be the rule rather than the exception in this current cycle. Therefore, he is expecting lower interest rates to be the dominant theme, with higher interest rates being merely transitory.

Velocity of Money 1900-2017; Equation of Exhcange: M*V = GDP annual
Source: Lacy Hunt, Hoisington Investment Management

Many of the speakers disagreed with Dr. Hunt on the direction of interest rates. I would say that a small majority of economists at the conference expect interest rates to rise. One of the most notable among the predictors of higher interest rates was Jeffrey Gundlach. Gundlach has been crowned the new “Bond King” and is the CEO of DoubleLine, with over $118 Billion in assets under management. He believes that the bull market may be over and that inflation will ultimately lead to higher rates. His chart below shows the 10-year treasury yield breaking a trend line that starts in the mid-2000s and approaching an important point of inflection near the previous highs.

U.S. 10-Year Treasury line graph
Source: Jeffrey Gundlach, DoubleLine Capital, Bloomberg

Grant Williams would also argue that we have likely broken the long-term trend and may be headed into a bond bear market (higher yields to come). With charts like the one below from Grant, it is hard to argue that we are not at least at a very important inflection point for the 10-year treasury yields.

U.S. 10-Year Yield: 1980-2018 line graph
Source: Grant Williams, Real Vision

David Rosenberg was more on the fence, certainly agreeing that we are indeed at an inflection point, but believing that the bond bull market (a.k.a. lower longer-term yields) would remain intact unless the 10-year broke above 3.5%. For most others, the line in the sand was the low-3% range. For my part, I tend to agree with David Rosenberg and am waiting for a more decisive break above the mid-3% range before anticipating the end of the 30-year bond bull market and significantly higher long-term yields.

On a relative basis, short-term rates have risen even more sharply than long-term rates over the last few months. This puts incredible pressure on businesses whose debt is based off of LIBOR and other shorter-term rates and benchmarks that have been previously hugging zero. We are now seeing interest rate levels in short-term bonds that have not been seen since the Great Recession.

U.S. 1-Year Treasury Yield line graph
Source: Grant Williams, Real Vision / Bloomberg

Financial suppression by central banks has created a world in which S&P 500 dividend yields have been comparable with, and even north of, the 10-year treasury yields and significantly higher than shorter-term instruments. What happens now that this has reversed for the first time in a decade? For many investors, getting a higher yield in short-term treasury bonds with less risk might take some of the wind out of the sails of the S&P 500.

US 2-Year Treasury Yield & 1-Year Treasury Yield vs S&P 500 Dividend Yield: 2013-2018 line graph
Source: Grant Williams, Real Vision / Bloomberg

Why does all of this matter?

Investors have been drinking from a heavily spiked punch bowl of extremely accommodative central banking policy and low interest rates for the past decade (since the start of the Great Recession). Trillions of dollars have been pumped into the global financial system, and this has created irrational valuations and asset bubbles across a number of asset classes. Every time the markets got even a whiff of sobriety, the central banks of the world would double down on spiking the punch bowl in order to forestall the consequences of excess valuations and an economy distorted by near-zero interest rate policies.

There is a new sheriff in town with Jay Powell taking over Yellen’s Fed Chair position. The Federal Reserve and the rest of the world’s central banks are now turning towards tighter monetary policy and starting to unwind trillions of dollars of assets off their balance sheet (i.e., selling into the market vs. providing support through buying). At the same time, both short- and longer-term interest rates have been headed higher. What happens when all of the cheap money that created massive asset bubbles over the past decade starts to unwind? What happens when the volatility that has been suppressed for the better part of a decade starts to rear its ugly head? What happens when greed turns to fear at valuations levels that are well in excess of what we used to refer to as historically insane? What happens when the financial hangover that we have been putting off for the past decade is finally realized (and now with $10+ trillion more in debt than when we entered the last Great Recession!)?

Is this time really going to be any different than the last?

My take

I do not believe that the market will be able to tolerate higher interest rates for very long. We are simply too overleveraged across consumer, corporate, state, and federal balance sheets. The debt service costs become crushing relatively quickly now that everyone has leveraged up their balance sheet to take advantage of cheap money. Therefore, I think that the longer-term odds favor the deflationary forces of over-indebtedness prevailing and would expect a significant drop in equity market values unless and until central banks reverse course and head back towards quantitative easing.

Even that last statement assumes that markets will respond favorably to quantitative easing, which I am not so sure is a safe assumption. At some point, if the markets ever realize that adding trillions of dollars of debt and quantitative easing actually bought us one of the worst decades of GDP growth in U.S. history, spiking the punch bowl in the future may not carry the same calming effect. Adding debt and printing money could actually trigger the exact opposite effect next time, as people continue to realize that A) there’s a problem that is big enough to require Fed intervention, and B) Fed intervention has not actually proven to be effective.

While we could see higher rates in the shorter term, I believe that the move would be transitory and that the impact of higher debt service costs would ultimately drive our economy back into recession, which would eventually be accompanied by lower interest rates. Lower interest rates in the longer term are especially probable in the face of the declining velocity of money and the weak GDP growth we are experiencing thus far this year—and this on the back of recently-passed tax cuts.

All of that being said, I would probably end up looking for a more-significant breakout above 3.5% on the 10-year bond yield before I would expect a secular bear market in bonds. As depicted in my chart below, my initial line in the sand would be 3.05% to start to suspect that this inflection point would be leaning towards a breakout in much-higher 10-year bond yields. While we remain below that level, I think that we have a decent shot to move back into at least the 2.5—2.6% range in yields on the 10-year before moving too much higher. Given the price action over the past couple of weeks, I have been expecting a decent move back down in 10-year bond yields since we neared but did not break above 3% just as market sentiment was peaking.


Source: Joshua Ungerecht, JRW Investments, CBOE, Trading View 10-Year Treasury Yields 1985-Present

I believe that the Fed’s ultimate reaction to recessionary pressures would be to lower shorter-term rates. Longer-term rates will ultimately reflect whether we are truly in a deflationary or inflationary market cycle and may already be signaling the former. If forced to choose, I would bet on the former over the latter over the next several years.

I recently wrote an article and was interviewed to provide my perspective on market cycles. In both cases I called attention to the fact that we are painfully overdue for a major correction and full-on recession. I will send more-detailed context in my next letter. I believe that stock market valuations have been stretched to an extreme and that the next recession could result in a lot more downside than people are expecting. Again, it is essential for investors to adopt an extremely cautious outlook and pay much more attention to downside risks vs. upside potential at this time.

The bottom line

  • Volatility has risen significantly in 2018, indicating a shifting market dynamic and increasing market risk.
  • A regime change at the Federal Reserve is likely to add more interest rate pressure than many realize. The punch bowl is being removed, and the results are not going to feel very good as we go from quantitative easing (the Fed injecting trillions of dollars’ worth of liquidity into the markets) to quantitative tightening (the Fed removing trillions of dollars’ worth of liquidity from the markets).
  • Key data indicators suggest that the next recession is likely to start sometime in 2019, and could even be moved up into 2018 as a result of trade wars, interest rate shock, or almost any other reason, given our tenuous economic condition.
  • Market valuations have reached extremes not seen since the periods directly prior to the Great Recession, Dotcom Bust, and Great Depression. Let that last sentence sink in for a moment.
  • Interest rates are at a crucial inflection point, poised either to go much higher and indicate the end of the 30-year bull market in bond prices, or to go much lower to indicate the nearness of the next recession and the resumption of lower interest rates. I am currently betting on the latter.

As was hopefully made clear throughout this letter, extreme caution is necessary at the current juncture. Only part with your cash for compelling investment opportunities, and embrace the fact that you will likely be building up a relatively significant cash position at this stage in the cycle.

Concluding thoughts

The conservatism permeating this letter is what guides us in every investment decision we make. The real estate market is not invulnerable to the excesses that have already impacted stock and bond market valuations. One of the reasons why we focus on real estate is that its relative lack of liquidity provides us with the opportunity to take advantage of idiosyncratic market dislocations that are undervalued due to seller or property misfortunes rather than market forces. In other words, the illiquidity of real estate creates market inefficiencies that we use to achieve a substantial discount, which can then serve as a cushion for our clients and us during the eventual market downturn. This cushion provides more significant income potential to withstand market cycles while simultaneously preserving upside potential for the future.

In the meantime, a rising tide lifts all boats—and hides more naked swimmers. Lower interest rates over the past decade caused an enormous rise in the economic tide. This has masked underperformance and rewarded riskier strategies. It has made it significantly harder to find good value at this stage of the cycle. This is why you have seen fewer and fewer investment recommendations from us over the past couple of years.

Many of you have articulated concerns to us regarding your growing cash position. We have sold a number of investments, returning your capital plus profits, and have not found enough new investments that meet our standards for you to be able to reinvest. Please take comfort in knowing that we are in the exact same position, as we deploy our own capital right alongside yours in every value-added investment opportunity we recommend. However, we are absolutely unwilling to relax our underwriting standards to chase higher valuations in the midst of unwarranted market euphoria. If and when we find compelling value-added opportunities, we will invest in them and also bring them to you. But until then, it is the perfect time to be building a significant cash position this late in the cycle. After all, you will want that cash to be able to go shopping with us after the next recession!

The tide will eventually go out, as it always does. And when it does, it will create significant distress for many on the one hand, and phenomenal investment opportunities for those whom are prepared, and we will be here to help you invest accordingly.

Please feel free to send me your macroeconomic or financial questions or thoughts. I will do my best to incorporate a response into a future letter.

Your macroeconomic nerd,

Joshua Ungerecht signature

Written By: Joshua Ungerecht
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