Many market experts are calling for a market crash in 2017, including a bond market crash. They also did every year since 2012. I never did up to now, as I called steady growth and asset price inflation for 5 years. Unless a political shock comes in the USA such as an impeachment or a Euro shock such as Le Pen elected, I do not see a likely stock or bond market crash for 2017… but I DO see significant risk for 2018-2019. Read on for the full story.
Planets aligning and triggers
For a major crash to happen, you need specific “ingredients.” These “crash ingredients” are a magical combination of several (but not all) of the following:
Many analysts and commentators rightfully point to the high corporate and government debt levels, which makes them say that a crash is right around the corner. This makes them call a crash every year, and obviously one day they are right, as a crash eventually does happen… and clueless media then calls them the “guru that saw the crash coming.” But it is useless for practical purposes to have a crash called every year. What they are missing to call the market top and subsequent crash is a TRIGGER and a realistic scenario that becomes high-probability due to the combination of planets aligning and triggers.
Once all or several of the above ingredients are in place and “align”, the triggers for the start of a stock and/or bond market correction or crash are:
THE ingredient that typically causes interest rates to rise is inflation, especially when the labor market is booming and capacity utilization is high, because this causes wage inflation and prompts the central bank to tighten monetary policy, which then causes all market rates to rise. Yields that rise go in tandem with falling asset prices (just trust me if you don’t understand why) and when asset prices start to fall, everyone wants out so that they are among the first to sell (at still-high-prices-that-are-falling-fast), which triggers a rapid and self-reinforcing selloff.
When asset prices drop (stocks, bonds, CDOs, currencies, etc.), the market value of assets in the balance sheet of financial institutions drops, and this means the capital (value of assets minus value of liabilities) drops. This makes the institution worth less and face tightening credit conditions. In the worst cases, financial institutions have trouble in the debt rollover (borrowing again to pay maturing debt that you don’t have money to pay right now) and they sell assets to get the much-needed cash, which adds to the selloff. At this point, the central bank and/or the government are asked for “help” in the form of low-interest loans or other forms of help. You get the picture.
The US economy right now
Growth slowed in 2015-2016 but picked up in the second half of 2016, showing good momentum for 2017, although high inventories may cause some growth slowndown in early 2017. Unemployment is low and the employment rate is improving, although still low. The leading economic index is up, as well as consumer and business confidence. Industrial production just turned positive, after a full year of contraction. Financial conditions are very accommodative and are likely to remain that way for all of 2017. Low yield spreads suggest bullish sentiment and risk tolerance.
The USD is strong on a historical basis, but may have room to appreciate another 5%. Although historically high, household debt is much lower than it was in 2007. The high level in historical terms combined to household wage stagnation will be a drag on growth and profits going forward, unless exports increase significantly to pick up the slack.
Inflation in the USA and across the world is still low but picking up slightly – nothing to panic about but enough to keep an eye open on price pressures. Total US inflation stands at 2.1%, core inflation at 2.2%, and core PCE inflation at 1.6%, which is below the Fed’s target of 2%.
With the lagged effect of USD appreciation keeping inflation low and the remaining slack in the labor market, I see low chances of significant Fed rate hikes beyond 2 or perhaps 3 moves in 2017, with a probable dovish tone to avoid a bond market selloff (read on to understand).
A high inventory buildup at the end of 2016 suggests we may have a slowdown in 2017Q1 due to inventory adjustments, but this effect should dissipate in 2017Q2. All in all, I am prudently bullish for 2017, as I was for 2016, but I do see warning signs and a few serious elements of risk, especially for 2018. Read on.
Households are stuck with stagnating incomes but are not in severe trouble right now, because the stagnating real incomes did NOT cause a rise in debt as was the case between 2001 and 2008, with the housing bubble allowing rising debt without improving incomes. I do not think the “next crisis” will originate in the housing sector or from households.
The labor market is “OK” but not spectacular. The unemployment rate is indeed low, but the participation rate and the employment rate are both very low. This does NOT suggest a coming crash – to the contrary, it suggests stagnation and slack in the economy, with potentially 3 million idle “workers” not counted in the labor force. Along with real wage stagnation, this is what explains why the middle class is angry and asking for “change.”
Unemployment claims are very low, which is often a sign of a market peak. The Federal Reserve’s Labor Market Conditions Index has been negative in the last year and is close to flat now. The labor market may suggest a peak when you look at jobless claims or the unemployment rate, but I think there is still one year’s worth of “slack” before it is truly tight and causes significant inflationary pressure.
On the corporate side, retail sales are weak, which can be explained by stagnating wages and low employment-to-population ratio, but this is no cause for a crash, it is cause for eternal stagnation, especially when combined with a high debt-to-income ratio.
In the past 5 years, stock prices increased while profits flatlined completely, which means that the bull run on stocks was “artificially” maintained with stock buybacks – hardly “productive” use of capital for companies. This is because corporations retained profits and used highly available liquidity and super-low-interest-debt to buy their own stock back from the market, thus removing their own stock from circulation and making it scarce and expensive. This largely explains the huge corporate debt buildup of the last few years (as a percentage of income or of GDP), and it means the corporate sector is more exposed than ever to interest rate risk. This debt buildup is, in fact, “normal” because the falling interest rates naturally create an incentive for debt, but it does make the economy more fragile to inflation and interest rate shocks. The Trump corporate tax cuts will help improve profits in the coming year, so stock prices could remain high and even edge higher in the near term.
All in all, there does not seem to be enough pent up pressure in debt and inflation to present a context that is ripe for a serious market crash. But there are signs of a brewing storm that need to be kept in mind…
One can always build a doom scenario if one wants to find “potential causes for crises.” These doom scenarios are always “convincing” and well explained, but they often fail miserably, because they lack pragmatism and probabilities for triggers being hit, so the timing is way off.
During a “market selloff”, all funds convert to pure cash (bank deposits) or quasi money such as 3-month AAA government bonds. When this happens, mutual funds, pension funds, trust funds, banks, sovereign funds, individuals, foreign governments, bond and stock brokers and all other market participants sell their stocks, medium-and-long-term bonds, private sector assets, CDOs and MBSs, and other risky assets and “park’ all the proceeds in cash and AAA short term bonds.
We will discuss the likelihood of these triggers as well as their potential effect in a minute, but let’s start by listing just “a few” potential triggers for a selloff. All these and many more can cause market mood to shift from “all good” to “panic mode” quite rapidly:
The elements that make the US economy fragile to shocks are:
The likely scenario
There are unfortunately a growing number of likely triggers, especially with Trump in the White House due to his impulsive nature – regardless of what you think of him. The high corporate debt (including commercial real estate debt) along with high government debt and the record US debt towards the rest of the world all imply that any drop of demand for US assets can cause a small disruption that triggers a run for the exits and a bond and stock market crash. The context is almost ripe, but not quite…
If Trump starts to fight with Congress over many of his planned policies, it may be enough to start the selloff. This could happen, but it is below 50% probability for now in my opinion. Supposing the US political context remains under control (not a sure bet with such a rogue and emotional President) and that no major geopolitical standoffs arise, to me the 2 higher probability risks are 1) inflation and 2) Euro Area or EU shocks.
The likely scenario for me goes something like this:
The gradual Fed tightening will cause a USD appreciation. This will cause global capital to leave emerging economies (as happened in 2014-2015) to avoid currency risk and will put pressure on many currencies and USD-denominated debt loads in China and Latin America. This will not cause a global recession but will stress markets enough to make them jittery.
The increased market tension will then increase more if US inflation rises clearly above 3%, especially core PCE inflation… and this does not seem probable for 2017. Within this general picture, a shock from Europe would pose a significant blow to markets. If the Europe shock comes first, then inflation will not have time to boost interest rates and cause asset price deflation.
If nothing special happens in Europe, in the Middle East or in politics, US inflation will rise and cause the Fed to tighten, which brings me to THE subject: the bond market…
The bond market
Bond prices and bond yields go in opposite direction. When bond prices increase, yields and interest rates fall, and stock prices get a boost. When bond prices drop, yields and interest rates rise and stocks drop. Since 2008, the bond market was supported by strong demand from ALL major central banks, but notably the Fed, the ECB, the BOJ, and China. This demand was supported by printing money that was used to purchase massive amounts of bonds AND by the market, which “knew” that bond prices were supported by “the big players”, so the private market bought bonds as well, knowing that the price was supported by central bank money – a sure bet. The global central bank bond buying party will end in 2017. It is already over for the Fed, which has maintained total asset value roughly unchanged since 2014 and the BOJ signaled it will not add more buying, as did the ECB, which will stand aside as of April-May 2017.
The USA as a whole owes about 8 trillion to the rest of the world, or slightly less than 50% of GDP and on track to hit 50% soon… and foreign appetite for US assets turned negative since 2016. This means that bonds face a falling demand. As long as the Fed and other central banks were buying the bonds, prices held up, but now that inflation is trending slightly up, the bond buying party is approaching an end because money printing is over, and that means lower bond prices and increasing interest rates…
The final nail in the coffin
If inflation increases enough to cause central bank tightening, interest rates will start rising and bond prices will be looking down into the canyon that awaits them… and holders of bonds will not want to keep those bonds while prices drop, so the selloff will accelerate. If the Fed could print new money to buy the bonds to replace the falling bond demand, it would be OK, but faced with higher inflation, it would not be able to… and THAT would be the end of the party: a MASSIVE bond market selloff that converts to cash and AAA short term safe haven bonds, a major negative wealth effect shock that would ripple through the globe. Governments would have significantly less breathing room to intervene with “stimulus packages” and central banks would have to step in with fresh printing, if they choose to go that way.
To avoid the likely MAJOR recession (if not depression) that would follow, it is likely that governments and central banks would abandon their inflation targets to print and spend galore, so that the problem would be pushed further down the road. This would happen under considerable social upheaval and associated political tensions.
That is the likely scenario for me. It is NOT likely for 2017, in my humble opinion, but the odds will increase significantly in 2018. We may never get to reach this point, as all the other “triggers” may cause an advance selloff before we get there… The USA is living on borrowed time and money and households are stuck with stagnating wages and increasing financial pressure. The water is starting to boil, which is what I explain in my book. Like and share if you appreciate the insights. This was a bit long to write, but I feel the effort did deliver good insights for you – hope you agree!