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An approaching financial crisis — reality or myth?

The data seen so far in Q2 are somewhat better than Q1, and Q1’s real GDP growth has been upgraded from a miserable 0.5 percent to a miserly 0.8 percent. The U.S. economy remains in first gear, mainly due to the oil patch and continued sluggish manufacturing activity. With such poor results from a record-breaking level of deficit spending for the last decade, it isn’t any wonder that the purveyors of doom and gloom in the financial media have reappeared. According to these doomsters, we should be afraid of the equity market’s future as another financial crisis is brewing and/or is imminent. Let’s examine this thesis.

The near-term

For the near term, it looks like the equity market is richly priced. Q1 earnings and top-line revenues have been stagnant. Simply based on this, there appears to be more downside risk than upside reward. But, don’t forget, the equity markets are forward-looking, not backward-looking. And if they smell increasing revenues and profits, as they have this past week, then that pretty much shuts down the idea of an imminent recession and bear market in equities.

Rising rates

Then there is the Fed. In every market where they have been deployed, there have been significant diminishing returns to the use of “unconventional” monetary policies, including quantitative easing and zero and negative interest rate policies. This includes Japan, where the unconventional policies have been most aggressive and where new stimulus attempts by the Bank of Japan have been met with negative market reactions in both equites and foreign exchange, just the opposite of BOJ expectations. Such diminishing returns from these unconventional policies have also been observed in Europe and are just being felt now in the U.S.

That interest rates must “normalize” sometime appears inevitable. After nearly eight years of zero rates, it is almost a certainty that negative equity market reactions will accompany additional upward rate moves. We saw this in the January/February market after the Fed’s December rate hike. So expect such a reaction when the Fed raises rates again, be it in June, July, or later this year. But such downward market moves don’t mean a recession is coming (it is a recession that usually causes the really nasty equity sell-offs). In fact, the Fed’s raising of rates has always been a signal that the economy is doing well. And without a recession, market dips are almost always a buying opportunity.

Longer-term

Are we growing another housing bubble? Is another banking/financial crisis brewing? What about all the debt buildup, both in the public and private sectors?

The biggest housing issue, rising prices, is the result of a lack of supply, not an overabundance of it like there was in ’06-’07. And, yes, there are markets like San Francisco and New York City where prices are frothy, but price adjustments in those markets, which appear to have already begun, will not cause a nationwide recession. Finally, unlike ’05-’08, mortgage lending standards remain quite tight; foreclosures aren’t going to be an issue. One of the few positives of the Dodd-Frank legislation was significantly increased bank capital; and the portfolios of U.S. banking institutions have easily weathered the depression in the oil patch these past 18 months. Another financial crisis like that of ’08-’09 is not brewing.

Debt buildup

The buildup of debt has been in the government sector, especially at the federal level, and in corporate America. Significantly, the U.S. consumers’ debt ratios have remained healthy.

Major governments that borrow in their own currencies can pay down their debt either by taxing their populations or by simply printing the money (inflation). They all choose the latter. Now, I am not making light of this, as inflation hurts everyone. But I am saying that because the dollar is the world’s reserve currency, U.S. capital and equity markets won’t tumble if we have some inflation, at least until it heats up so much that the economy has to endure a Paul Volcker moment. Such an event appears to be years away.

In the private sector, the top-line revenue of a company can grow via debt-financed merger/acquisition activity. But without investment in organic growth, the system, in aggregate, stagnates, leading to low levels of economic growth and sideways equity markets. While this is our current situation, it is illogical to conclude that a financial panic or a meltdown is imminent. Most of the newly issued corporate debt has fixed coupon rates and long-term maturities. So, as rates rise, corporate income statements won’t be negatively impacted.

Conclusions

  • Q2 looks to be better than Q1 from an economic growth perspective;
  • The equity markets remain richly priced (sell the rallies);
  • Any Fed move toward interest rate “normalization” is likely to cause a negative equity market reaction (buy the dips);
  • A bank and/or housing-induced financial crisis in the U.S. like that of ’08-’09 has very low odds;
  • Excessive Federal debt can be inflated away without a financial panic or a recession;
  • Consumer debt is not an issue as household debt ratios are quite healthy;
  • Long-term fixed rate corporate debt will not cause profit degradation or corporate financial strains as interest rates rise;
  • An imminent financial crisis = myth.

Robert Barone (Ph.D., Economics, Georgetown University), an adviser representative of Concert Wealth Management, is a Principal of Universal Value Advisors (UVA), Reno, NV, a business entity. Advisory services are offered through Concert Wealth Management, a Registered Investment Advisor. Robert is available to discuss client investment needs. All inquiries welcomed. Call him at (775) 284-7778.

Statistics and other information have been compiled from various sources. Universal Value Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information. A more detailed description of Concert Wealth Management, its management and practices is contained in its “Firm Brochure” (Form ADV, Part 2A) which may be obtained by contacting UVA at: 9222 Prototype Dr., Reno, NV 89521. Ph: (775) 284-7778.

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