In this time of market exuberance and significant increases in almost every sentiment index, it is time to recognize that when reality returns, markets will correct. This coming year is going to begin with more uncertainty than is normally the case: The Trump fiscal agenda is huge, but so are the debt levels; and the Fed has begun a tightening cycle in earnest, with the economy still in first gear. Of the 13 interest tightening cycles in the post-WWII period, 10 have resulted in recessions. And since 1980, every Republican president has had a recession in the first two years of his administration. The economic cycle is in its eighth year, old by historic standards. I am not predicting a recession, just making sobering observations.
The financial markets appear too enthusiastic. The stock market itself is trading at nearly 19x forward and 21x training earnings — two standard deviations above the mean. Such events occur only 2.5 percent of the time. Shiller’s cyclically adjusted PE ratio (CAPE), at 27x, is higher than at any time except for the dot-com bubble. Furthermore, on net, forward earnings estimates are falling (except energy and financials). Even good economic news, if it isn’t good enough, will likely disappoint.
Forecast No. 1
The equity markets will have at least a 10 percent correction in the first half of 2017 and maybe even as much as 20 percent depending on the economic data. (Investors should take profits earlier and hold more cash than normal.)
Current data indicate the economy is not as strong as markets believe:
- November retail sales were barely positive, not a good sign for holiday spending.
- Industrial Production was down 0.4 percent in November, has been flat all year and is no higher than it was in March, 2014.
- Capacity Utilization in the industrial sector, at 75 percent, is probing recession territory.
- Auto sales fell in November after record discounts in October pulled sales forward; Currently, inventories of new autos on the lots of auto dealers represent 73 days of supply, a record for any November.
- Rising sub-prime auto delinquencies and rising loan delinquencies in general indicate consumers could be tapped out, especially with the heavy debt load they are carrying.
- October’s trade deficit was ugly, and that was pre-election. Postelection, the dollar has strengthened further. And, after the mid-December Fed rate hike, the value of the dollar now stands at a 14-year high. Going forward, the trade deficit is going to get worse, subtracting from GDP growth.
- Mortgage rates, priced off the 10 Year U.S. Treasury Note yield (T-Note yield), have risen 70 basis points (0.7 percentage points) from their lows last July, most of it in the postelection period. New applications for mortgages are in free fall.
Forecast No. 2
Q4’s GDP growth, once thought to be as high as 3.5 percent, will come in closer to 2 percent, and maybe even lower. The GDP growth rates for Q1 and Q2 will be anemic, much like what we experienced in the first half of 2016.
Interest rates have soared. The 10 Year T-Note yield hit 2.64 percent in mid-December, double its 1.32 percent level of last July, and up significantly in the postelection period. While the Fed’s December rate hike (0.25 percentage points) itself was expected and priced in, its forecast for three more hikes in 2017 was not, so the T-Note yield spiked yet higher. Problem is, while the Fed is now tightening, the other major central banks, in Europe and Japan, remain in easy money mode. This will keep upward pressure on the value of the dollar, further impacting the trade deficit. The strengthening dollar also raises concerns over capital outflows from China as their currency weakens. The best way to stem that outflow is to raise interest rates. But that will only exacerbate issues already apparent in China’s real estate sector and in their banking system where the Financial Times reports as many as 20 percent of their bank loans are nonperforming. Fears over a weakening Chinese economy can cause consternation in the financial markets, as it did last year.
Part of the reason for rising rates is markets believe Trump’s economic policies will actually be able to increase the rate of inflation. The reality is, Trump can do little about that:
- Demographics in the U.S. and in the world are deflationary.
- Trump’s pledge to reduce regulations on business is deflationary (cost reductions).
- Trump’s policies imply more oil and coal production; an increase in supply is deflationary.
- A stronger dollar means imports cost less — deflationary.
- And, despite a 4.6 percent unemployment rate (U3), a closer look reveals underlying softness. There are 12 million people working part-time but want full-time jobs, and then there are those not looking (so not counted in the labor force) but would take a job if offered. Apparently, the labor market still has slack — perhaps the reason why wage growth remains soft.
Forecast No. 3
A slower than expected economic growth rate and little evidence of rising inflation will exert downward pressure on interest rates. The 10 Year T-Note yield will once again approach 2 percent in 2017.
Legendary Wall Streeter, Bob Farrell, had a saying for various markets’ conditions. For this one, he said: “Rapidly rising markets can go further than you think — but they never correct by going sideways.”
