The chart below shows that the consumer confidence has diverged from personal consumption. The consumer might be anticipating a tax cut. I am surprised at the resiliency of the sentiment indicators given the fact that there haven’t been any votes on tax cuts in Congress yet. Congress plans to raise the debt ceiling, cut taxes, and do healthcare reform all in September. That seems dubious since nothing was done in the spring or the summer. I think the debt ceiling will be raised sometime between late-September and early October, but the other issues will take more time. The problem for the GOP is that the longer it waits to reform healthcare, the less likely it will happen because cutting benefits before a midterm election in 2018 isn’t politically feasible. The personal consumption growth of about 2% isn’t that inspiring given the strong labor market. Like I said with other indicators which have shown signs of weakness, imagine how weak it will get when the labor market softens.
I have discussed that the ECB bond buying program has allowed zombie companies to stay alive because of low interest rates. It’s almost impossible to go bankrupt if you have an unlimited lifeline of capital at low interest rates. It’s like how Greece can’t go under despite its inability to narrow its deficit considerably. The chart below shows that not only have U.S. stocks started to garner interest from abroad in the past few months, but also bonds have been getting an international bid. The low corporate bond yields created by the ECB push demand into the U.S. which has higher yielding bonds. The ECB also buys some American bonds, but not enough to make a dent in the market. As you can see, foreign buying in U.S. corporate bonds has been positive since 2014. It took a dip in late 2016 before rebounding sharply in 2017. It’s possible that some foreign investors were wary of the political risk surrounding the presidential election.
The U.S. high yield spreads have reached pre-crisis lows. That makes sense if you look at the chart below which shows the low leveraged loan default rate. It’s a great recession indicator because it didn’t spike up that much during the 2016 earnings recession. This recovery has been weak which has caused most indicators to give false signals. That’s why I value the fact that this indicator hasn’t yet wrongly predicted a recession. The spike because of the TXU bankruptcy doesn’t count because it was clearly a one-off event.
You might be asking the obvious question which is why do I say the high yield bond market is massively overvalued if default rates are low. My answer has two parts. First, the high yield spread is the lowest this cycle, as you can see from the chart below, even though speculative grade default rates aren’t at the lows of the cycle. The second point is that getting almost no added returns for risky bonds isn’t that appealing since you always wonder when the next default cycle will occur. You only miss out on 200-300 basis points of holding returns if you go with investment grade bonds over junk bonds. If you’re trading bonds, then buying junk is the ultimate high risk, low reward game. Playing that game only makes sense when you have central banks on your side, but you don’t now that the ECB is about taper and the Fed is unwinding the balance sheet.
The chart below breaks down the junk default rates with and without the energy sector. I was misguided by the energy defaults in 2016 which led me to mistakenly think a recession was coming. The defaults in energy were much like the defaults in the 1980s which had nothing to do with the economy and everything to do with oil price volatility. It’s easy to see that a recession didn’t come now. The best signal that there wasn’t a recession was that the problems in the oil market were driven by excess supply, not decreases in demand.
The chart below is one of the more unique financial calculations I have ever seen. Usually simplicity is best, but sometimes complicated charts show us important factors. The chart shows the cumulative surprises for inflation, wage growth, and core inflation. The fact that all of them are negative shows that the economists are almost always too optimistic about inflation and wages. The key to focus on in this chart is the rate of change since it is cumulative. Lately there have been negative surprises in all three measures. This stems from the fact that the labor market is very strong, yet we aren’t seeing accelerated wage growth or much inflation. I heard one speculation on Twitter which was that the wage growth is high because we’re in a deflationary environment. It’s tough for me to fully grasp what the wage growth even is because on the one hand tax deposits are up 8% and the other hand consumer spending growth isn’t that great as you can see in the first chart. The money isn’t going to savings because the Q2 GDP report showed savings was down to 3.8%. It’s possible the money is going to service student loans, car loans, and credit card debt.
Conclusion
The clear danger we must be wary of is that when spreads widen, the weakest firms will fold quickly. It’s the ultimate example of the quote “when the tide goes in we see who is swimming naked.” The zombie firms who can’t make their interest payments are swimming naked. Those are the firms which will spur the next downturn in the labor market. Labor market weakness is the best way to conclude a recession is coming. You can certainly argue that the vacillations in consumer spending between 1% and 4% are noise considering that stocks are being driven higher by capital flows.
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