No Need for Predictions

Investors are pricing in the pricking of the asset bubbles without selling equities. Bulls believe stocks will continue to rise even if interest rates increase even though they supported their claims for high equity valuations by saying interest rates are low. At all market peaks market consensus is wrong, but the current situation is much more egregious than prior cycles. In this cycle investors believe the Fed will start raising rates at the end of the business cycle, but the growth will continue indefinitely anyway. They expect a continuation of growth which would lead this to be one of the longest expansions since 1921.

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So far I’ve been too early in my projection of a recession as the economy has stalled out, but there hasn’t been a crash in the market or sharp declines in key indicators such as the ISM and consumer confidence. The chart below shows Morgan Stanley’s U.S. business cycle indicator. It is forecasting a recession in the next few months if you extend the line lower like what has occurred in previous cycles. This cycle clearly never hit its full stride as President Obama was the only president to never have a year of 3% GDP growth. Bulls argue the weakness in the recovery means it will last longer than usual, but it is already 3 years longer than the average. While Trump’s de-regulation and tax cuts can help long-run growth, there is no avoiding the business cycle.

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One of the most important aspects which is being overlooked by the media and investors is the timing of the Trump stimulus plan. The Fed is already raising rates in December in anticipation of the Trump growth, but the legislative process will not be quick. It’s quite something to see investors taking a politician at his word instead of thinking critically and assessing risk. While the GOP is pretending to be unified after Trump’s victory, there will be some infighting before anything gets done.

The difference between the two budgets shown below is startling. Trump’s plan has the Debt to GDP reaching 105% in 2026 and the House Republican’s budget is expecting Debt to GDP of 57%. The GOP is trying to save face by reaching out to Trump. It also wants to get as many appointments as possible. However, once Trump becomes president these differences will have to be hashed out. Trump’s deficit is actually greater than Hillary’s. If Trump’s budget doesn’t have support by either party, how will it get passed? This means the market and the Fed are overestimating the size of Trump’s stimulus and the speed at which it will be passed.

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The House  has tried to push forward with deficit reductions since the Tea Party wave election in 2010, but it hasn’t been able to get much done besides the sequester. Now a Republican is President, so they should be more emboldened to get their budget cuts passed. Democrats have often questioned the GOP’s viewpoint that tax cuts reduce the deficit. That’s a debatable topic, but no one can debate that Trump’s plan to not cut entitlements will raise the debt to unsustainable levels. I am not sure what will happen when the basic arithmetic catches up to his bluster. Will he ignore the deficit or will he cut entitlements? There isn’t as much ‘waste, fraud, and abuse” that Trump says there is. That was a cop out on the campaign trail; let’s see how he governs.

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It remains to be seen what occurs in the next few quarters, but currently the market is very optimistic about Fed rate hikes. The market tended to ignore the Fed’s bluster this year, at the start, when there were calls for 4 hikes in 2016. Now the market is acquiescing to the Fed’s dot plot more than in the past. Currently there is a 23.9% chance that the Fed’s target rate is 100-125 basis points by November 2017. 100-125 basis points is the current forward guidance by the Fed. While, this is evidence of skepticism by the market, if you add up chances for rates being at or above 75-100 basis, you get 72.8%. The market is pricing in 1 rate hike in 2017 after the 1 rate hike in December. I think this is way too optimistic given the timing of the business cycle shown above.

The optimism about Trump’s policies is bluster, but this optimism will be more of a disappointment if we get the sort of hawkishness the market is currently pricing in. The chances of the Fed achieving its dot plot target is almost impossible. The Fed has constantly revised its growth estimates lower. Trump criticized this on the campaign trail and his advisor’s criticized this in the stimulus plan they drew up. He will be eating crow as they do the same thing during his first year.

Conclusion

            Sometimes investing is complicated and sometimes it is very easy. When investors start believing in statistically improbable and even statically impossible things, investing gets easy because your predictions don’t even have to predict anything. I acknowledge that timing economic cycles is difficult. However, noticing that the gaping hole between Trump’s budget and the House’s budget will cause one side to give in which will have consequences, isn’t even a prediction; it is an arithmetic fact. If the Fed relies on optimism surrounding Trump’s plans which don’t add up, it is going to raise interest rates into a slowdown and pop the asset bubbles it created.

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1 Comment

  • Martin

    November 29, 2016

    Trump says he will change the tax code so as to encourage the "repatriation" of $2 Trillion which will help growth. Also, he suggests an energy boom will also encourage growth. These apparently are "wild cards" in the mix. Is the business cycle downturn that certain?