Loan Growth Signals Possible Recession

The latest news regarding the healthcare vote is it will happen on Friday. That could either mean enough votes have been gathered for it to pass or it could mean President Trump is frustrated with the process and wants to get it over with even if it could fail to get a majority. I don’t see how one day would make a difference in the vote especially without any additional changes to the bill. President Trump says he’s done with negotiating; this could be bad news for the stock market if the vote fails Friday. This bull market has dealt with political uncertainty well; I guess I shouldn’t be surprised with its ability to hold up well during the current circumstances.

There is a good reason stocks go down when there’s political uncertainty. Businesses slow their initiatives during politically uncertain times because they want to wait for clarity on what the rules will be. For example, if Obamacare is costing an employer more money to hire workers, the employer will wait for the healthcare reform to pass before making his/her next hiring decision. If you don’t know your costs, it’s best to be cautious. You don’t want to be in a situation where you hired workers because you thought your healthcare costs would fall, but due to the government’s ineptitude, nothing is reformed. The business owner who takes too many risks like that isn’t a business owner for long. Policy uncertainty is a tax on the economy.

As you can see from the chart on the right, policy uncertainty is inversely correlated with C&I lending. I have not read through the white paper on how the policy uncertainty index was created. Without knowing the specifics, I can say that this index is an inexact science as measuring exactly how uncertain an election or policy is, is subjective. The index is GDP weighted which means the American 2016 election had a high impact on it. Even though I’m making the point that policy uncertainty will negatively impact bank lending, this is not the only factor in play. If the U.S. presidential election was another year, I think the economy would have slowed anyway. There has also been some benefit from the hope small business owners are expressing which stemmed from Trump’s election, even if it may be a mistaken outlook.

As you can see from the chart on the left, total credit creation is weakening. Using the traditional viewpoint on economics that I use to color my thinking, productivity, population growth, and credit growth are the only possible catalysts for economic growth. Some may argue that creative monetary policy actions can boost the economy, but I have yet to see the positive effects of QE other than inflating asset prices. The defenders of QE claim it wasn’t a failure because the doomsday scenario of hyper-inflation didn’t take place. That prediction came from the misunderstanding of Fed policy. If the Fed did the helicopter money policy it discussed, inflation would occur, but the low velocity of money prevented QE-driven inflation. The concept that because QE didn’t cause hyper-inflation, it means it was a successful policy sets an awfully low bar for success.

The future of lending growth looks weaker than its currently at. As you can see from the chart below, reported loan demand leads C&I loan growth. Reported loan demand has hit negative growth for the first time since the financial crisis which signals recession risk is high.

I often discuss the global asset purchases by central banks as a reason for the overvaluation of stocks. The chart below shows the size of central banks’ balance sheets in relation to the size of their respective country’s economy. Even though the ECB’s line is much lower than the others, it still has the most importance because Europe is the largest economy in the world. Although the Fed’s balance sheet has stopped growing, the Swiss central bank can act as a proxy for the Fed if it purchases the same assets. In fact, the Swiss central bank’s asset purchases are more aggressive than what the Fed was purchasing. The Fed was only buying treasuries and mortgage bonds; the Swiss central bank is buying American equities like Apple, Google, and Amazon.

I often discuss the high valuation of the American stock market because that’s what most readers are probably researching. However, the hope/central bank driven bull market has also led to European equities reaching historically high valuations. As you can see from the chart below, the median EV/EBITDA ratio in Europe was only higher in the late-1990s. The chart is nearly identical for American equities. When central banks cause almost all financial assets to be expensive, it puts investors in a tough situation.

Much is discussed about the economic inequality among individuals, but less of a fuss is made about the inequality between big and small firms. The median ROE for smaller companies is barely above the trough of the financial crisis. Therefore, some the of the valuation metrics for the Russell 2000 are at record highs. You can look at this chart in two ways. One way is that Trump’s deregulation efforts will help the smaller companies which means you should avoid the larger firms due to rising competition. The other way is that you should avoid small caps because they’re overvalued. I think both subsets need to be avoided. It makes it tough to find diamonds in the rough when the ROE for small caps is so low.


Politics will drive the market in the near-future. I don’t know what the outcome of the House vote on healthcare will be. What I do know is lending has dried up which means economic stress is coming. American stocks and European stocks are both extremely overvalued on an EV/EBITDA ratio. Small caps are especially vulnerable to a crash after they were the top performers in the Trump rally. Some of the valuation metrics for the Russell 2000 are so out of whack it makes you wonder if your Bloomberg terminal is using the wrong inputs.

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