Frothy Bubbles Make Me Whine
These are not the tiny champagne bubbles Don Ho used to sing about, but those greenish-gray floats of foam that pile up against harbor docks where the churn of the waves meets the oil spittle of boat motors. They are the economic froth that has piled up around us and is now beginning to fizzle.
They are the bubbles of overbuilt retail space, heaps of junk bonds and layers of leveraged loans, rafts of student loans, bloated government spending. They’re the slop that formed from massive monetary expansion frothed up out of less than nothing — out of debt.
You’ve heard about all of them many times, but my concern in this article is that we are starting to hear tiny popping sounds, which leads me to the following scenario as a plausible path into recession this summer: (Not the only possible route, but one littered with likelihoods.)
How the bubbles start to pop
The market’s bump from the Trump Thump on Mexico is already proving to be short-lived as I said would be the case in the article I was writing earlier this week and published on Tuesday. The market is moving into waiting mode as the Fed’s next FOMC meeting where they have the opportunity to live up to the rate-cutting hopes they’ve raised comes next week. As it does, it is forming that topping pattern that keeps repeating at this level.
Barring some major unexpected news, the market is most likely to simmer along that ceiling for the remainder of this week and first half of next week to await the Fed’s decision. Because the market is levitating near its last peak again, the Fed will stand pat on rates. Fact is, the Fed has only gotten interest halfway back to normal and only taken its balance sheet halfway back to the new normal it had intended to maintain. That means the Fed is low on ammo to fire up the economy in the event of the next recession. Therefore, it has to be judicious in how it uses the small ammo store it has built back up.
For that reason, I think the Fed is more likely to disappoint the stock market at its meeting next week than help it out, given that stocks returned to rising this month. If the whining market was in the same state as last month, or if stocks should return to falling between now and next week, that would be a different situation. However, with the market now looking more stable and with some hope still hanging on for signs of a China deal at the G-20 summit, I think the Fed will feel it cannot risk wasting ammo until help is clearly merited.
We are currently seeing upward pressure on the Fed’s lowest, anchor rate (the Fed Funds Rate). The Fed seems to be barely managing to hold rates down at their present level. That creates another factor that could make it hard for the Fed to lower rates even if it wants to.
The market won’t like that, even though the Fed will soften the news with lots of cut-rate candied hopes for investors. That’s a second reason I think the Fed will not cut rates just yet. They got so much bounce off of their-end-of-May jawboning that I think they’ll go for more of the same. However, the market is hanging right below a tough ceiling that has endured for almost a year and a half, so disappointment from the Fed is likely to bounce it back down off that ceiling. (Whether it goes marginally above its previous peak as it did the last two times between now and next week is almost irrelevant. You’ll wind up considering such a brief move above its all-time high a test to push to new strata that failed. I don’t, however, think it will.)
Then China re-enters the news feed at the end of June and refuses to negotiate. The market won’t like that either, and there won’t be much the Fed can do about that for another few weeks (its July meeting). By the time of the Fed’s July meeting, US data will be coming in worse, but the 25% tariffs on all things Chinese won’t have hit the data stream yet nor any of China’s retaliatory measures (such as its recent reductions in rare-earth exports) nor will the collateral damage that falls from all of that. By the time the Fed acts, all of that will be in play, and no Fed action will be able to stop any of that anyway.
Under that worsening picture, the Fed will probably lower rates a notch in July because the stock market will be showing its wounds. That may arrest the stock market’s slide, but it won’t make a dent on the economic decline that is already happening (see below) and that will steepen significantly when the new tariffs and retaliation do start showing up in the stats. It might not even save the stock market because buybacks will be temporarily stopping at about that same time for the corporate reporting season, taking the only fuel that remains out of stocks for that period.
Summer trading is also slowing, leaving the market placid. Moreover, forward earnings forecasts will be generally more negative than they were last time. The market will also likely experience more negativity than it wants to hear from actual second-quarter earnings. (Though, by that time, expectations may have been lowered enough that the drop in earnings will be priced in. That’s still suppressive damage that just played out sooner. Better soon than swoon.)
I’m not saying all of that with the conviction of a prediction. My only prediction for summer is the start of a recession; but I see it as one likely way the coming recession will start to form; but it can open up in other areas first or in a different order.
These frothy bubbles are the kind you see at the end of an effluent pipe
While we won’t be singing about them, there are a few lighter bubbles. I think housing in the US may get a little summer reprieve because sales have been falling for a year now and prices in some places have started to follow. At the same time, interest rates have gone back down as the Fed backed off of tightening. So that may be a slight summer light spot. I never believed housing would lead the economic decline (and have said so here a number of times) but simply that it would be a contributing factor.
Another plus for housing and banks is that I don’t think there are as many ARMs because people, in a low-interest environment, smartly went for fixed-interest loans. So, at least, we don’t have as many of those time bombs. Housing’s second and bigger leg down will begin when the overall economy is clearly collapsing. The first leg was just to soften the economy up a bit.
But there is a lot of gunk in the pipe that will be oozing out in big glops this summer:
The US is entering a manufacturing recession, a retail recession, the knock-on-effect of so many store and mall closures, declining freight orders and declining transportation stocks (typically a bellwether for how the economy because “if transportation is moving, the economy is moving”), an automotive production and jobs recession, declining corporate earnings growth (from which the word “growth” may start to disappear in the reporting of this quarter, tax stimulus that is fading in effect and that didn’t accomplish much to begin with), an inverted yield curve, a housing decline, even as the Fed continues tightening through the summer (with a six-month lag for the full effect of Fed actions on the economy).
As part and parcel of all that, we’re experiencing declining US GDP growth, weak durable-goods orders, declining capital investments, falling prices of copper and lumber (leading economic indicators) and no supportive tailwinds of any kind anywhere. (You know, all the things I said would be eroding the economy this year in my first Premium Post of the year, “2019 Economic Headwinds Look Like Storm of the Century.”)
Elsewhere, rest of the world is already crashing. Manufacturing growth has gone negative in many parts of the world. UK manufacturing just fell almost 4% in one month, far more than the 1% drop that was expected and the biggest drop in seventeen years as UK auto manufacturers went ahead with planned shutdowns. The drop also came because earlier stockpiling for Brexit, which brought sales forward from the future, finally was felt as an impact. The future arrived. UK GDP receded for its second month in a row (down 0.4% in one month). Even with negative bund rates, Germany remains in decline, being particularly impacted by the global auto manufacturing slowdown, and Australia is deep in a retail recession with the general economy being at its weakest since 2009. The Reserve Bank of Australia has now cut interest rates to their lowest in the nation’s history, but the economy is still slip sliding away. Housing there is tanking.
The impact of far higher tariffs this summer piles on top of all that. Do you really think we are going to be able to just sweep all of that under the rug this summer and in the months to follow? The economy is running on fumes while the stock market is smoking hope, and the China trade deal is exacerbating all of that, though it is far from being the sole cause or even primary cause.
The bubbles are bursting or are about to burst all over
Meanwhile, the Shiller Price/Earnings ratio higher than it has been at any time other than the crash of ’29 and the dot-com bust (more of a market problem than an economic problem):
Ultimately, the stock market is a slave to the economy. The economy will school the market, not the other way around. So, reality is just going to keep pounding its way in relentlessly from this point forward because it is increasingly hard to see where the market is going to get any lift. Even an interest increase, incremental as it will be, isn’t going to go very far.
High household net worth is a good thing right? Well, not when it is built on correspondingly mountainous bubbles of debt: (Make that “balloons” in my parlance, as “bubbles” is starting to seem far too tiny.)
Long periods of low interest created the hot air those bubbles are made of, and we’ve just come out of the longest period of the lowest interest ever. As I explained in an earlier post, the Fed’s move from lowering interest to raising interest cocks the gun for shooting down the debt balloon, but it is almost always the first rate reduction subsequent to those increases that squeezes the trigger. So, the market may want rate reductions right now, and the Fed has indicated it will give them, but watch out when it happens because the Fed has a track record of popping bubbles by squeezing off its first rate decrease. I know that sounds odd, but that is how it has happened again and again.
Note in the graph below how recessions typically do not start while the Fed is raising rates but immediately after the first decrease following such a raise (usually after a short period where it held rates steady like the present):
Perhaps the first decrease trips the economic decline, or perhaps the Fed always waits to decrease until it knows economic decline is about to begin. Either way, if the Fed raises rates at its June or July meetings … my predicted summer start for a recession could be right on.
On 13 occasions the futures market expected a cut in the funds rate the day prior to a scheduled FOMC meeting. The Fed cut rates in all 13 instances. In other words, the Fed has always cut interest rates when the market priced a cut on the day prior to a FOMC meeting…. And while … futures prices currently imply an unchanged funds rate by the June 19th meeting, the market is pricing 20 bp of easing by the July 31st.”ZH
With the economy clearly fizzling away, the Fed has said it MIGHT cut rates if economic conditions warrant. What does that tell you about whether or not they will cut rates soon enough to avert a recession — something I think they have never managed to do, as they confess they are the culprits who cause recessions.
Recessions also usually start as soon as unemployment starts to rise. So, beware May’s surprisingly low new-jobs number. That can start the rise in unemployment if it proves to be more than a one-month blip. A decrease in the Fed’s target interest rate coupled with an uptick in unemployment is almost the perfect set of marks for the starting point of a recession.