Wall Street’s post-election rally suggests that many investors currently have the wrong idea about Donald Trump. They have decided he is a new Ronald Reagan, with policies that will deliver a major bull market.
But those promoting this narrative have forgotten their history. Both men certainly share a link with the entertainment industry. But Reagan took office towards the end of one of the worst recessions in the 20th century. By contrast, Trump takes office at the end of an 8-year bull market.
Prof Robert Shiller’s CAPE Index (based on average inflation-adjusted earnings for the past 10 years), provides the best long-term view of the US stock market, going back over a century to 1881. As the chart shows:
Ronald Reagan took office in January 1980, when the CAPE Index was 9.4
It fell to 6.6 in July/August 1981 at the bottom of the recession, when the S&P 500 was just 109
At the end of Reagan’s Presidency it was still only at 14.7, and the S&P 500 was at just 277
Today, Donald Trump takes office with the CAPE ratio at 28.5 and the S&P at 2271, after an 8-year rally
Is it really credible as a Base Case that the rally could continue for another 8 years? After all, Trump himself claimed back in September that the US Federal Reserve was being “highly political” in refusing to raise interest rates:
“They’re keeping the rates down so that everything else doesn’t go down. We have a very false economy. At some point the rates are going to have to change. The only thing that is strong is the artificial stock market.”
Common sense would also tell us that Trump is about to make sweeping changes in economic and trade policy. He made his position very clear in October with his Gettysburg speech. And his Inauguration Speech on Friday explicitly broke with the key thrust of post-War American foreign policy:
“We assembled here today are issuing a new decree to be heard in every city in every foreign capital and in every hall of power. From this day forward, a new vision will govern our land. From this day forward, it’s going to be only America first, America first. Every decision on trade, on taxes, on immigration, on foreign affairs will be made to benefit American workers and American families.”
Change on this scale is never easy to achieve, and usually starts by creating major disruption. The expected benefits take much longer to appear. This, of course, is why “business as usual” is such a popular strategy. But it is clear that Trump is perfectly prepared to take this risk. As he said at the start of the speech:
“We will face challenges. We will confront hardships. But we will get the job done.”
Many companies and investors are still hoping nothing will change. But CEOs such as Andrew Liveris at Dow Chemical and Mark Fields at Ford have already realised we are entering a New Normal world:
Liveris told a Trump rally last month that jobs would be “repatriated” from outside the USA when Dow’s new R&D centre opened, adding as the Wall Street Journal reported “This decision is because of this man and these policies,” Mr. Liveris said from the stage of the 6,000-seat Deltaplex Arena here, adding, “I tingle with pride listening to you.”
Fields personally told Trump of their decision to cancel the Mexican plant and invest in Michigan, saying “Our view is that we see a more positive U.S. manufacturing business environment under President-elect Trump and the pro-growth policies and proposals that he’s talking about”.
The reversal of US trade policies will impact companies all around the world. The White House website has already confirmed the planned withdrawal from the TransPacific Partnership – and from NAFTA, if Mexico and Canada refuse to negotiate a new deal. China is certain to be targeted as well. Protectionism will start to replace globalisation.
This means that today’s global supply chains are set for major disruption. This will directly impact anyone currently selling to the US, and US companies currently selling overseas. It will also impact every supply chain that involves a final sale either to or from the US. The Great Reckoning for the policy failures since 2009 is now well underway:
The Dow Jones Industrial Average’s repeated failure to break the 20,000 level may well be a warning sign
Japan’s Nikkei Index was also poised to hit 40,000 when closing at 38,916 on 29 December 1989 – but never did
Sometimes, as US writer Mark Twain noted, “History doesn’t repeat itself, but it often rhymes”.
There was one bit of good news this week. For the first time since the financial crisis began, a Governor of the US Federal Reserve acknowledged that today’s demographic changes are having a major impact on the US economy. John Williams, of the San Francisco Fed, argued that:
“Shifting demographics….(mean that) interest rates are going to stay lower that we’ve come to expect in the past…In this new normal, recessions will tend to be longer and deeper, recoveries slower, and the risks of unacceptably low inflation and the ultimate loss of the nominal anchor will be higher…We’ve come to the point on the path where central banks must share responsibilities. There are limits to what monetary policy can and, indeed, should do. The burden must also fall on fiscal and other policies to do their part to help create conditions conducive to economic stability.”
Williams thus confirmed our conclusion from 5 years ago in chapter 2 of Boom, Gloom and the New Normal:
“The Boomers have moved on from being a high-spending generation. Instead, they are becoming a high-saving generation, as they need to save more to survive a longer retirement. And therefore the failure of the various government stimulus programmes since the crisis began should be no surprise. The concept of pent-up demand is now wishful thinking.
“The key issue is that we need a change in mindset. Those companies who continue to expect stimulus measures to deliver a return to the Golden Age are likely to be disappointed. Instead, the winners will focus on understanding how to profit from the demographic changes now underway, as we transition to the New Normal.”
It is good news that one leading central banker now accepts that stimulus policies cannot return the economy to SuperCycle levels. The chart above, showing the labour market participation rates for the US Wealth Creator 25 – 54, and New Old 55+, cohorts, highlights two core issues:
□ Fewer Wealth Creators are working today than in 2000, when the oldest BabyBoomer was about to become 55
□ The US has also done very badly at keeping the New Olders in the work force – their participation rate today at 40% is half that of the Wealth Creators, and is lower than in the pre-1965 era
It is really no surprise that the US economy is struggling, given these figures.
One of the key problems is that current US Social Security rules penalise people who want to work, but need to take their benefits early. This matters, as 10k Boomers are retiring every day until 2030. Only around 2% of these retirees can afford to wait until the age of 70 to take their benefits – even though this would increase their benefits by an astonishing 76% versus taking them at 62:
□ More than 1/3rd of all retirees rely on Social Security for 90% or more of their income, and 2/3rds rely on it for more than half of their income.
□ More than half of American households in the New Old 55+ cohort have nothing saved for retirement
□ A quarter of these households will also not receive any kind of company pension
Company pensions themselves are another issue that Congress needs to tackle urgently. As the second chart from Bloomberg notes
□ Pension plans in S&P 500 companies are currently in deficit by $500bn
□ Congress actually made the situation worse in 2012 by allowing companies to value their pension liabilities by using a “smoothed” discount rate based on average interest rates over the past 25 years
□ This makes no sense, in the light of John Williams’ conclusion that “interest rates are going to stay lower than we have come to expect in the past“.
□ The reason, of course, was that Congress wanted to join the Fed in supporting financial markets by prioritising share buybacks and boosting stock prices. Thus since 2012, many companies haven’t had to fund their pensions plans – and on average, those with large plans have been able to cut their contributions by half
THE NEW CONGRESS WILL HAVE TO FOCUS ON SUPPORTING RETIREMENT INCOME
So here’s the nub of the issue. The Fed, like other major central banks, is close to admitting that its monetary experiments have failed to produce the expected results. The next Administration will therefore be faced with a need to unwind many of the policies put in place since the financial crisis began 8 years ago.
3 key issues will therefore confront the next President. He or she:
□ Will have to design measures to support older Boomers to stay in the workforce
□ Must reverse the decline that has taken place in corporate funding for pensions
□ Must also tackle looming deficits in Social Security and Medicare, as benefits will otherwise be cut by 29% in 2030
It has always been obvious that the Fed could not possibly control the economic fortunes of 321m Americans. Common sense tells us that demographics, not monetary policy, drive demand. Unfortunately, vast amounts of time and money have been wasted as a result. The path back to fiscal sanity will be very hard indeed.
It may be an idea to keep your smartphone charged and within reach, if you are planning a trip to the beach this month. Certainly market behaviour since June has been more and more skittish. The experts, after all, were telling us that central banks were certain to do more major stimulus efforts to boost stock and commodity prices: they were also sure that the US economy was poised to do well.
Instead, we have had minimal stimulus from the European Central Bank (ECB) and Bank of Japan (BoJ), whilst the US Federal Reserve was clearly taken by surprise with Friday’s weak GDP news for Q2.
Now investors are beginning to worry that the central banks are out of stimulus ammunition, and have very little further room for manoeuvre. Japan has suddenly become the “weak link” in the chain:
Its interest rates have risen sharply since Friday when the BoJ disappointed markets with only minor policy moves
The benchmark 10-year bond is almost yielding a positive amount, after offering only negative yields since March
Some traders now even worry that the BoJ may have to raise interest rates to protect the banking sector
There was a similar state of confusion at the ECB last month, when markets were told to wait until after the holidays for any further stimulus.
So traders have gone on holiday leaving a vacuum behind them. And as we all know, “nature abhors a vacuum”. Oil prices are thus becoming a key indicator for the financial sector:
They are now down $11/bbl since their early June peak, a 21% fall
Their attempts to rally are being beaten back by news of ever-higher supply gluts in oil and products
And even though the US$ has weakened sharply over the past week, the hedge funds are not moving back into the market, as has always happened in recent years, when they believed that “weak dollar = higher oil prices”
So we could now be watching the second stage of the Great Unwinding in action. The first stage began nearly 2 years ago, when the dollar began to rise and oil prices to collapse. Now we may be seeing markets start to ignore the actions of central banks, and instead focus for the first time since 2008 on the fundamentals of supply and demand. If they do this, they may not like what they see:
Oil markets have record levels of inventory all around the world
Traders have become nervous about buying shares with borrowed money in the New York stock market
Developments in the European debt and refugee crises are also not encouraging
Plus there is increasing nervousness around the world over the outlook for the US Presidential election
As always, the IeC Boom/Gloom Index is highlighting the potential turning point. Although the S&P 500 has recently made a new all-time high, the Index did not confirm the higher numbers. Instead, it has retreated to just above the 4.0 level which has signalled pullbacks in the past.
If this proves accurate, and oil prices keep tumbling, then we may have a busy month ahead.
It is 7 years since global stock markets bottomed after the 2008 financial crash. But as my regular 6-monthly update on their performance shows, it has been a very mixed picture since then. The chart shows how prices have moved since their pre-2008 peak in the world’s 8 major markets, and in the US 30-year bond market:
- Pre-crash history showed markets moving steadily upwards over time, in line with their own circumstances
- But since 2008, only 3 markets have reached new post-crash highs, plus the US 30-year bond (blue column)
- The US S&P 500 is up 29%, Germany’s DAX is up 22% and India’s Sensex is up 18% (but are all lower than March 2015)
- The UK FTSE is down 9% and Japan’s Nikkei down 7%
- China’s Shanghai index is down 54%, Russia’s RTS is down 66% and Brazil’s Bovespa down 32%
- The only market that has consistently shown gains is the US 30-year bond, whose price is up 43%
This is not good news for those who believe that stock markets always rise over time. And it is a particularly weak performance, given that the major central banks have deliberately targeted stock markets in their stimulus programmes. As then US Federal Reserve Chairman Ben Bernanke wrote in November 2010:
“Higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”
Clearly, this theory has been proved to be incorrect, with global GDP falling a record amount in current dollars in 2015, according to IMF data. It was always hard to see why it should work, given that even in the US, just 40% of the population have $10k or more invested in the markets, according to latest Gallup data.
The performance of individual markets is also throwing up warning signals:
- Japan and the UK were positive a year ago, but have now retreated; half of Germany’s and India’s gains have also evaporated since March 2015: even the USA is lower than a year ago
- China, Russia and Brazil are very close to their lows in March 2009
- Only the US 30-year bond is still making new highs, and seems to have peaked at least for the moment
The bond’s performance is very revealing. Policymakers have done everything they could to ignite inflation, as this is critical for reducing the real value of all the debt they have created. Yet investors have effectively bet against their success, and have continued holding the 30-year bond, even though its yield was just 2.75% on Friday night.
The market’s performance confirms the Great Unwinding of policymaker stimulus is underway. It will likely prove an increasingly bumpy road, as the policy failures since 2009 become more widely recognised.
WEEKLY MARKET ROUND-UP
My weekly round-up of Benchmark prices since the Great Unwinding began is below, with ICIS pricing comments:
Brent crude oil, down 62%
Naphtha Europe, down 59%. “The naphtha arbitrage window from Europe to Asia remains closed, thus shutting out a key export outlet for Europe”
Benzene Europe, down 54%. “The sudden rise puzzled some players who continued to see largely unchanged fundamentals”
PTA China, down 41%. “Demand was stable, with regular enquiries for cargoes”
HDPE US export, down 36%. “Some market players reckoned that the price uptrend cannot be maintained in the long term as China’s economic performance has not improved substantially”
¥:$, down 11%
S&P 500 stock market index, up 3%
Central banks are in a losing battle, as they try to reverse the inevitable slowdown created by the arrival of the demographic cliff. Last year’s 5% fall in global GDP in current dollars tells its own story.
Common sense would tell them they can’t possibly win. After all, how do you persuade New Olders in the 55+ age group to spend more money – when they already own most of what they need, and their incomes are declining as they enter retirement?
- The New Olders will soon be 1 in 5 of the global population thanks to vastly increased life expectancy
- And there are relatively fewer of the high-spending Wealth Creators aged 25-54 due to collapsing fertility rates
But as I feared in my Budget Outlook for 2016-18, this won’t stop central bankers from trying. Last Friday, the Bank of Japan joined the European Central Bank in moving to negative interest rates – where you pay the bank to look after your money. This is likely to create further problems in high-yield and emerging market debt, to add to those already appearing, as investors rush into stupid high-risk investments in a desperate search for yield.
As Time magazine has reported, even the strongest and best-managed companies are now being impacted:
“As Moody’s recently warned, some of the world’s biggest firms, like Royal Dutch Shell, Total, and Chesapeake Energy, are among the 175 firms that are at risk of ratings downgrades thanks to plunges in commodity prices.”
Of course, the Japanese move produced the usual knee-jerk rally in financial markets, confirming once again that the biggest rallies always occur in bear markets. This time last year, the ‘SuperBowl Rally‘ saw oil prices rally from $45/bbl to $70/bbl, before they resumed their fall to today’s levels around $30/bbl.
But this only highlights the growing vulnerability of Western stock markets. The chart of the IeC Boom/Gloom Index shows sentiment is weakening and market volatility is increasing. This usually indicates a market is changing direction. And the Index itself is now firmly back in negative territory, confirming the downturn signalled last month.
As with subprime, the banks are blind to these developments. They are sure their economic models are just about to produce a sustained recovery, and so they see no need to consider other viewpoints. It could be a very bumpy ride.
WEEKLY MARKET ROUND-UP
My weekly round-up of Benchmark prices since the Great Unwinding began is below, with ICIS pricing comments:
Brent crude oil, down 68%
Naphtha Europe, down 63%. “Naphtha crack slips into negative territory – US gasoline inventories rise once again”
Benzene Europe, down 60%. “Prices in Europe have seem some roller coaster action over the past week.”
PTA China, down 47%. “Restocking of cargoes were just about finished, with most companies expected to stop business activities from next week due to the Lunar New Year holidays”
HDPE US export, down 42%. “Export prices remained steady”
¥:$, down 18%
S&P 500 stock market index, down 1%
Its not been a great start to the year for those who have trusted in conventional wisdom:
- Western stock markets have been reeling, with the US S&P 500 Index down sharply since Monday
- It has been the worst opening for world stock markets since 2008 – not a good year for investors
- China’s currency has been under major pressure: its stock market closed “limit down” on Monday and Thursday
- Oil prices have broken through the critical $36.20/bbl support level
This is the Great Unwinding of policymaker stimulus in action. As I highlighted last month, it is very likely that companies and investors will end up paying the price for policymakers’ refusal to accept the simple fact that ‘demographics is destiny’:
“What we know is that the first 3 phases of the Great Unwinding are now underway: the fall in the oil price, the rise of the US$, and the rise in US 10-year interest rates. Only the 4th is still to come – the bursting of the S&P 500 stock market bubble. And political risk is rising at the same time. It could be a difficult 2016.”
This month’s IeC Boom/Gloom sentiment Index highlights the change underway as the chart above confirms:
- The Index has fallen back to levels that suggest a major downturn is close
- In the past, this led to major new stimulus efforts from the major central banks
- They have poured in $tns at similar moments since 2009
- But with China now moving in its New Normal direction, it is hard to see how they could do this again
Instead, markets are starting to rediscover their true role of price discovery based on supply/demand fundamentals.
The major bubble today is clearly in Western stock markets, which have been convinced that central banks would never let prices fall. The charts above from Advisor Perspectives highlight the extreme level of over-valuation that have developed as a result for the S&P 500:
- The 10-year price/earnings ratio is at its 92nd percentile in terms of the historical context
- It was only higher ahead of the 1929, dot-com and subprime crashes
- Similarly, the amount of stock bought on margin is at all-time highs
- The amount of debt adjusted for inflation is higher than in 2000 or 2007
Further signs of likely problems are obvious in the popularity of the so-called FANG stocks (Facebook, Amazon, Netflix, Google/Alphabet). These were up around 60% in 2015 as a group, even though the wider market ended marginally lower.
Divergence between a small group of shares, and the wider market, is a very typical way for bubble markets to end.
And it is very significant that these 4 stocks have been so successful – investors have wanted to travel in hope, rather than analyse today’s reality. Thus they have preferred to follow the “greater fool theory” and chosen to invest in the belief that all 4 companies have developed fabulous new ways of making money for the future.
History therefore suggests that markets may have a very long way to fall, if central banks fail to rush to their rescue.