September 9, 2015


Last month, I discussed how risk was rising and that it was time to “fasten your seatbelts” for increased volatility.  That volatility arrived in August as the chart below of the S&P 500 illustrates.




Starting on August 19th, the S&P 500 dropped 11% in just four days and the Dow dropped over 2,000 points over the same four days.


So, the question on everyone’s mind now is whether or not the decline is over.  Let’s highlight a few dynamics in play to see what may be the likely answer.


First, let’s take a look at the economic fundamentals.  As we look around the globe, most economies are slowing down, if not already in recession.  China continues to slow rapidly, the European central bank just lowered their outlook for the Eurozone, Japan continues to be very weak, Canada just entered into a recession, most all of the commodity centric countries continue to slow such as Australia and Brazil and the rest of Asia is very weak as evidenced by the significant drop in exports from South Korea. 


In the midst of this, most of the economists here in the U.S. continue to believe that our economy will not be affected by the global weakness and were encouraged by the 3%+ reading of 2nd quarter GDP as well as the employment report last week.  Let’s take a look at global trade and then more squarely on the U.S. economy.




I highlighted a few thoughts early in the year by ECRI [Economic Cycle Research Institute] on global trade and they have recently published an update.  Below are their latest comments.


“After years of extraordinary policy stimulus around the globe – aimed at pulling demand forward from the future – world trade growth has collapsed even further (top line in chart) since we last highlighted it publicly.  Indeed, year-over-year (yoy) world export growth is now nearing zero.”




“This is happening even with everything ‘on sale’ as yoy export price growth has plunged deep into negative territory (bottom line).  After some four years of falling export prices, export price deflation had become almost as intense as in the depths of the Global Financial Crisis (GFC).”


“In essence, we have a shrinking trade pie.  Unable to generate adequate domestic growth, economies are trying to grab a larger share of that pie through competitive devaluation.  As we observed earlier, this amounts to war by other means, and all that’s happened recently is that it’s China’s turn to devalue. “


“As we’ve shown, global debt has grown to some $200 trillion, with debt-to-GDP ratios having risen in every major economy.  These debts can be repaid over time either by generating sufficient real growth to do so; or by inflating away the debts, so that they can be repaid in currency that is worth much less.”


“But, as ‘the yo-yo years’ make clear, real GDP growth has been stair-stepping down for decades in most advanced economies.  In conjunction with the yo-yo years, export prices are exhibiting increasingly severe deflationary patterns – in both advanced economies and emerging markets.”


“Under the circumstances, in the fullness of time, all the major economies are likely to face a day of reckoning.  Though this journey may well involve a rush to a succession of ‘safe’ assets en route to that destination, many economies are all effectively circling the drain.”


“The last time export price deflation was this intense, not only was Chinese GDP growth even weaker than it is today, but also every G7 economy was in recession.  It is ominous that the global trade pie is shrinking so rapidly today – with none of the G7 economies in recession – yet.”  [note: these comments were as of August 17, before some of the latest global economic news such as Canada entering a recession and China beginning to devalue their currency].




Next, let’s look at the latest leading economic indicator for the U.S. by ECRI [Weekly Leading Index Growth Rate].  This index tends to lead the economy by about three to six months.




The chart above shows their leading indicator dropping notably during the 4th quarter last year.  This decline gave an indication that economic growth would weaken.  First quarter GDP turned out to be only 0.6%.  Then, ECRI’s leading indicator turned back up sharply during the 1st quarter of this year.  Subsequently, 2nd quarter GDP rose to 3.7%.  Now, their indicator has turned back down and the decline is getting steeper.  If it continues to anticipate growth here in the U.S., we are likely to see weakening growth this quarter.  As the global economy has weakened, it looks to be spilling over onto our shores.




Now, let’s put the recent backdrop of economic indicators into a broader perspective with the help of Ray Dalio from Bridgewater.  He is one of the better macro thinkers and runs the largest hedge fund in the world.  Here are some of his comments from his latest investor letter.


“That's where we find ourselves now—i.e., interest rates around the world are at, or near 0%, spreads are relatively narrow (because asset prices have been pushed up) and debt levels are high.  As a result, the ability of central banks to ease is limited, at a time when the risks are more on the downside than the upside and most people have a dangerous long bias.  Said differently, the risks of the world being at or near the end of its long-term debt cycle are significant.”


“That is what we are most focused on.  We believe that is more important than the cyclical influences that the Fed is apparently paying more attention to.  While we don't know if we have just passed the key turning point, we think that it should now be apparent that the risks of deflationary contractions are increasing relative to the risks of inflationary expansion because of these secular forces.  These long-term debt cycle forces are clearly having big effects on China, oil producers, and emerging countries which are overly indebted in dollars and holding a huge amount of dollar assets—at the same time as the world is holding large leveraged long positions.”


“While, in our opinion, the Fed has over-emphasized the importance of the ‘cyclical’ (i.e., the short-term debt/business cycle) and underweighted the importance of the ‘secular’ (i.e., the long-term debt/supercycle), they will react to what happens.  Our risk is that they could be so committed to their highly advertised tightening path that it will be difficult for them to change to a significantly easier path if that should be required.  We believe that the next big Fed move will be to ease (Via QE) rather than to tighten."


He updated his thoughts a few days later by saying, “We don’t consider a 25-50 basis point tightening to be a big tightening.  While we might see a tiny tightening akin to what was experienced in 1936, we doubt that we will see anything much larger before we see a major easing via QE.”


I have also quoted Stanley Druckenmiller many times, as he has been probably the best investor of our time.  He has been pushing the Fed to get off the zero bound for a while and just recently came out and said they missed their opportunity and now they probably won’t raise rates until at least 2017.


As the markets move through these volatile days, it is easy to get caught up in the trees and lose sight of the forest.  Dalio and Druckenmiller are two of the best macro thinkers around and what they are implying by their comments is ominous to say the least. 


Dalio is anticipating that there is the possibility that the Fed may go ahead and increase rates in the upcoming meeting but will subsequently reverse course and start printing money again in a significant way.  I have said recently that either the Fed will not raise in this month or if they do, it will be later viewed as a policy mistake and I think Dalio is suggesting a similar scenario.  If they raise rates this month and then we get a weak GDP number for the 3rd quarter like ECRI is suggesting, the financial media will be squawking “policy mistake” by the Fed over and over. 


That is the near-term caution by Dalio, but his comments about nearing the end of the long-term debt cycle has much more implications for a meaningful shift in one of the more important secular trends regarding global debt.  I have addressed this many times before and will save additional comments for a later paper.  Nonetheless, Dalio’s comments are worthwhile to think through in the midst of increasingly short-term attention spans by investors. 


To be clear, I was never in favor of the Fed going to the zero bound in the first place, much less starting the printing press.  I have said many times that Bernanke led the world down this path and that the unintended consequences will be very significant.  While many still think he saved the financial system in 2008, I believe history will ultimately view his policy decisions as going down a path that led to much greater financial problems and to be the worst mistakes since the Fed was formed about 100 years ago.  In fact, I think his policy decisions will ultimately lead to the elimination of the Federal Reserve as we know it and that a much improved structure based more on market forces will hopefully emerge.  Remember, the current structure is a room full of academics who have mostly never operated in the private sector setting monetary policy based on their economic models, forecasts and theories.


Bottom line is that the Fed has dug themselves deep into a hole and Dalio as well as Druckenmiller anticipate that rather than starting to climb out, they are likely to get an even bigger shovel.  That also implies that there are very important developments to the global economy on the horizon.


To continue this discussion on the Fed, let’s take a look at some data relating to their two mandates; maximum employment and price stability [even though they have dramatically expanded their mandate over the last two decades to encompass much more than what is outlined in their charter].  First, let’s look more closely at the employment picture. 




The Fed and other economists have been pointing to the jobs numbers as one area of strength in the economy.  In addition to the factors such as the participation rate, part-time employment and other dynamics that are making the employment picture seem better than the real situation; there is another interesting development behind the numbers.  We can use data from ECRI again here to highlight this.


“The sustained decline in the official jobless rate – now approaching the Fed’s estimate of ‘full employment’ – is a misleading indicator of labor market slack.  Indeed, the stagnation in nominal wage growth is consistent with the weakness in the employment/population (E/P) ratio.  That said, even the E/P ratio may be overstating the health of the jobs market.”


“After dropping to three-decade lows in the wake of the Great Recession, the E/P ratio, has barely improved since the fall of 2013, reversing only about one-fifth of its decline from its pre-recession highs.  Furthermore – as a breakdown of the E/P ratio by education level shows –this modest improvement is illusory.”




“Since 2011, when the E/P ratio for those with less than a high school diploma bottomed, that metric has regained almost two-thirds of its recessionary losses (orange line in chart).  But the E/P ratio for high school or college graduates – i.e., eight out of nine American adults – has not recovered any of its recessionary losses, and stands about where it started, one, two and three years ago (purple line).”


“This data shows that the so-called jobs recovery has been spearheaded by cheap labor, with job gains going disproportionately to the least educated — and lowest-paid — workers.  This is scarcely a good basis for resilient consumer spending driven by ‘solid’ job growth that the consensus – including the Fed – is banking on.”




Now, the second part of their mandate is price stability.  Here is a chart of market-based expectations of inflation from Bloomberg.  This chart also lines up the inflation expectations according to the time intervals of their Quantitative Easing events [QE, or printing money].



You can see by this chart that the initial round of money printing had the most impact on inflation expectations and each subsequent round had less and less impact.  Since QE ended, inflation expectations have weakened further. 


Combine the thoughts of Dalio on the potential ending of the long-term debt super-cycle with the quality of the jobs market and declining inflation expectations, and you can start to see why he thinks the next major Fed policy will be another large round of printing more money.




Now, let’s shift gears to look at a newer form of margin that investors have pursued.  It is often called “non-purpose loans” which they get from their financial institutions.  Here is a summary from the Wall Street Journal.


“Loans backed by investment portfolios have become a booming business for Wall Street brokerages.  Now the bill is coming due—for both the banks and their clients.  Among the largest firms, Morgan Stanley had $25.3 billion in securities-based loans outstanding as of June 30, up 37% from a year earlier.  Bank of America, which owns brokerage firm Merrill Lynch, had $38.6 billion in such loans outstanding as of the end of June, up 14.2% from the same period last year.  And Wells Fargo & Co. said last month that its wealth unit saw average loans, including these loans and traditional margin loans, jump 16% to $59.3 billion from last year.”


“In a securities-based loan, the customer pledges all or part of a portfolio of stocks, bonds, mutual funds and/or other securities as collateral.  But unlike traditional margin loans, in which the client uses the credit to buy more securities, the borrowing is for other purchases such as real estate, a boat or education.  Securities-based loans surged in the years after the financial crisis as banks retreated from home-equity and other consumer loans.  Amid a year’s long bull market for stocks, the loans offered something for everyone in the equation: Clients kept their portfolios intact, financial advisers continued getting fees based on those assets and banks collected interest revenue from the loans.”


So, investors have now essentially used margin loans not only for buying more stocks but also to support their spending habits [i.e., buying real estate and boats].  Traditional margin debt is used to buy liquid securities so if margin calls come from declining security prices, either the investor or the financial institution can sell down their loan balance immediately because stocks can be sold daily.  Now, think through what happens when the loans are used to buy illiquid assets such as real estate and boats and a margin call comes in as a result from declining stock prices.  As the clients will struggle to get liquid on the assets purchased with the loans, there will be ever increasing pressure to liquidate much more from their stock portfolios.  This is just yet another example of the ongoing speculation due in large part to profligate monetary policies.




Let’s close for this month.  In August, the market broke down out of the tight range it had been in the whole year with a very sharp initial move lower.  We are now seeing a bounce off short-term oversold conditions.  The bounce may go a little further in price but it is likely to end relatively soon in time and roll back over and break below the lows in August.  The longer-term structural issues continue to build and we may be closer to an important inflection point if Dalio is correct.  For now, keep your seatbelts fastened as more turbulence is to come.



Joseph R. Gregory, Jr.





 Past results are not indicative of future results.  Joseph Gregory is President of Heritage Capital Partners, Inc., a registered investment advisor.  All materials presented herein are believed to be reliable but we cannot attest to its accuracy.  All material represents the opinions of Joseph Gregory.  Investment opinions or recommendations may change and readers are urged to check with their financial advisor before making any investment decisions.  Opinions expressed in these commentaries may change without prior notice.  Joseph Gregory and/or clients of Heritage Capital Partners, Inc. may or may not have investment positions that are in or aligned with any opinions mentioned in these commentaries.  There is risk of loss as well as opportunity for gain when investing in the financial markets.  Investment opinions or positions mentioned in these commentaries are not suitable for all readers and therefore, readers are urged once again to check with their financial advisors before making any investment decisions.