ADER UPS FORECAST; RECESSION TO DEPRESSION

September 21, 2018

(They say that a recession is when your neighbor loses their jog and a depression is when you lose yours. Well, guess what? Read on.)

It is with inevitable mixed emotions that I announce I’m on the road again meaning I’ve become one of those ‘contingent’ workers I’ve written about having lost my position at Informa. I don’t know what I’m going to do next, but plan to continue these Musings sporadically and investigate possibilities as they arise, and I uncover them.  

I’m open to ideas, but I do want to continue with my macro musings and ideally engage people more via discussion and presentations. As you may know from my TV appearances, I am a bit of a ham.

Anyway, reach out to me please so I can keep you on my distribution list and I could use a few “good luck” and “best wishes” to keep the ego intact.  I’ll have these systems for a while longer, but presumably under a different ID.  Try [email protected] in the near future. 

* Unemployment level adds one in September! *Nine reasons for bear steepening, eight say it’s temporary. * Federal Debt concerns attached to the eighth, -- supply side tax cuts won’t pay for deficit, -- nor will tariffs. * Compensation gains in all areas other than wages

At last it appears we have a bit of movement in Treasuries, which shouldn’t be either surprising or alarming. That is, it’s a range break opportunity and not a directional event. At least, I don’t think so. Let me give you some points.

First, in a very recent Musings I pointed out the seasonal bias in September for the curve to steepen and said I saw little risk in shorting 10s from that perspective. I realize this is not all about me, but nonetheless want to point out the general September behavior.

Second, I won’t be the first or last person to point out that the marginal bond buyer based on the tax-advantaged pension contribution program. I’ve cited a potential degree of evidence in the form of Treasury Stripping activity that fell $885 mn in August. That was the first month of negative stripping this year. This is, of course, more about a lack of buying than selling.

Third, though not a new story, there are the tariffs and their inflationary potential. Consider 10-yr TIPS at 92 bp, the most since 2011. BBG’s Tom Keene and Pimm Fox used the term ‘trade war’ on Tuesday. The concept of a trade war has been out there, and there’s not specific event to say now it’s really a war, but I concur with those two that things have heated up rather sharply; you don’t hear much about Trump’s tariffs being a negotiating tactic, art of the deal so to speak, any more. Rather, these come across as salvos with a response.

Fourth, there’s the Fed. I don’t mean in terms of hiking, which would tend to be long-end supportive, but rather the discussion in the market -- notably more so in the market than from Fed officials -- that there might be a pause coming as the Funds rate meets some undisclosed level of neutral or no longer accommodative. This doesn’t alter the fact that September’s a given and December highly likely, but I sense the market is wondering about the statement and press conference that might hint that a pause is at least possible.  That’s an excuse to unwind flatteners and only that.

Fifth, there’s the ECB and their QE conclusion leaving the market with more options than long Treasuries.

Sixth, go back 30-odd years and readers of mine will recall my favorite expression, “prices change more than facts” which I’m proud to say has been picked up by my former protégé and now BMO’s award-winning Ian Lyngen. He wrote that earlier in the week and he’s right. In the wake of a slower pace to CPI, softer pace to Retail Sales, big drop in Import Prices and, in the meantime, the enthused folks polled in the latest U Michigan Survey dropped their long-term inflation outlook to 2.4%. That was only surpassed with a one-off 2.3% print in its entire history. “What, me worry?” asked the sage. Take a look at gold or BEIRs; they’re not offering much to affirm the very recent price action in Treasuries. I think that’s relevant.

Seventh, and this is small potatoes, but if you look at the construct of sentiment, THE most liked rate instrument according to the Daily Sentiment figure, is US. Again, this is my favorite contrarian indicator and had gotten close to overly bullish levels by normal measures and certainly more bullish than TY or Euro$. I don’t want to make too much of that other than to connect it to an earlier view that ‘everyone’ was in a flattening trade and some of that’s coming off simply to ring the proverbial register.

Eighth, maybe 2s at 2.80% (note that’s not yet a technical breakout) carry ample allure for investors.

Ninth, if I’m making too light of the price action in a strategic sense, I think where I’ll be wrong is on the size of the deficit and handling all that supply in the coming days. History has shown that, at least initially, high deficits stall growth, don’t accompany inflation and aren’t a credit event until they are. I again urge you to look at the work of the folks at Hoisington Investment Management, where Van and Lacy Hunt have done wonderful work on that topic.

This is all my way of saying if it looks like a duck, walks like a duck, quacks like a duck, then it’s certainly not a bear (or a bull) market but more like a simple position unwind, which in this case is from a curve flattener.

CHARTS AND THEMATICS:  I know, I’ve talked about debt to the point of exhaustion, but I have to stick with it in light of a few bits in the news. First, Larry Kudlow trumpeted the supply-side idea that if you lower taxes, you’ll spur growth and that growth will pay for the deficits that come as a consequence. History and his own experience are not Kudlow’s side. Consider the Reagan tax cut in 1981 and the series of tax hikes that followed into the Clinton Administration.  

Kudlow in the same speech blamed the deficit on too much spending and put the onus on the entitlements of the obvious. He promised to consider, presumably, the entitlements beyond the ACA when he said, “As far as the larger entitlements, I think everybody’s going to look at that, probably next year.” Hmm, just the thing to get the AARP excited into a Presidential election year. Watch this space.

Surely, we all know what’s going to happen ultimately. Taxes will go up as they already have for those in high tax states who saw their state and local deductions cut, but that will spread out and just wait until the Democrats are back in control. And spending will come under some restraint, which I imagine will look a lot like means testing on Medicare, Social Security and a slower pace of annualized increases on that latter.  If you see another way out, please tell me, but don’t cite some fabricated GDP forecast to do so. Dust off Simpson-Bowles; what a great effort that was and it never even got a vote in Congress.

Why am I on this high horse? Because debt is gaining attention more and more, perhaps because the US starts a new fiscal year in October. Some argue that the rise in Treasury issuance will result in higher rates and so are bearish on bonds rather irrespective of an inflation angle. If you believe that idea, then you have to ponder the headwinds those higher rates will provide for the economy and risk assets (as debt does need to be refinanced). That seems a recipe for a very long period ahead of slow growth and low returns.

Here's some context lifted from a recent Barron’s piece, “It’s Not Too Late…Yet” telling us why we should worry about Federal debt levels and trajectories. The US’s level of outstanding debt has been rising faster than GDP for, well, ever with the exception of a few years in the late 90s. The CBO puts GDP growth at 1.7% in the next 10 years, but the deficit gaining 4.9% annualized. See a problem? Kudlow’s entitlement cuts won’t solve the problem unless all those under the umbrella of ‘welfare’ were entirely eliminated; all told that would be about $742 bn, says Barron’s.

Oh, that still leaves $2.1 trillion on mandatory programs like Social Security, Medicare, and government retirement programs. I ponder how politically acceptable cut or means testing to those would be. Still, it seems they have to come.  

The Barron’s piece closed with a note of almost optimism suggesting the correlation between high deficits and a crisis in countries with a similar profile (debt to GDP) to the US is ‘surprisingly’ rare. In other words, we’re not on the cusp of a sovereign debt crisis a la Greece. However, I would say the US is rather vastly more critical than any country on this matter.  We have to borrow more, our dollar impacts the world’s economy, as do our interest rates, and our level of debt faces a Congress and Administration that seem entirely unwilling to compromise for a sense of the greater good. I mean, if a GOP House, Senate and President couldn’t get this under control when the economy was doing so well without the benefit of the tax ‘reform’ that boosted the deficit I don’t see a way out of the problem, especially when the next recession hits.  

Oh, I think it’s worth mentioning since a reader asked if the tariffs would offset the corporate tax cuts and budget deficit in general. Treasury estimates about $40 bn in such duties this year and that’s bound to go up with new tariffs. A 25% tariff on, say, $200 bn of Chinese goods would be good for $50 bn a year and 25% tax on auto imports would raise $85.25 bn. Considering that we import $2.36 trillion or so of stuff, do the math; we’d need about a 40% tariff rate to pay for a $1 trillion budget deficit which doesn’t take into account how that might impact our export economy or how much domestic prices would rise as a consequence. Still, get back to the original point, which is that the deficit will have to be paid for, paid down, one way or another. Tariffs might do that, but are a tax by another name which means we the people will end up paying for it.

IN OTHER NEWS:  Others are taking note of the debt being the seed, perhaps now a sprout, for the coming crisis. There was a very comprehensive WSJ Opinion piece last weekend by Daniel Arbess titled “Get Ready for the Next Financial Crisis.” He goes over the debt side of the corporate world with a few kind words for Trump on easing regulations, lowering taxes and incentivizing firms for repatriating profits to invest here. (That’s hopeful thinking. Alas, the WSJ also reported that “Trump Promised a Rush of Repatriated Cash, But Company Responses Are Modest.” Commerce Department relays that $306 bn came back in Q1 of something like $2.7 trillion. The bulk of repatriated funds so far have been used for buybacks.)

But Arbess’ concern is about global debt which is up some 75% in the last decade. Corporate debt globally is up 78% of $66 trillion! A McKinsey report also notes that global non-financial borrowing stands at $11.7 trillion, 270% of the 2007 level, and warns that 40% of US companies are BBB. just one notch over junk. (https://goo.gl/VLngr7).  That study notes that between $1.6 trillion and $2.1 trillion of global corporate bonds mature in each of the next four years, presumably at a higher rate. “This is what zero interest rate quantitative easing have wrought -- more debt and lower credit quality,” writes Arbess. He concludes, “When credit turns, stocks have never been far behind.”

The WSJ relays on the front page that “Employers Choose Bonuses Over Raises,” pointing out that non-wage benefits are outpacing salaries. Since 2009, Bonuses and supplemental pay take 59% of that, but entering the equation are retirement benefits with 42.1%, paid leave with 29.2%, health care and insurance at 27.7% and the residual of 22.6% going to salaries. (It just hit me that the slow wage gain might impact the ability of a household to get a mortgage or other loan.)

This adds to the narrative of modest wage gains relative to the level of unemployment. Too, I don’t see that changing as the population broadly wants the non-wage components; baby boomers need time off for various reasons (seeing doctors, pacing themselves, elder care) while younger cohorts seem to value free time for its own sake.  

 NEAR-TERM MARKET THOUGHTS: When you find yourself quite suddenly unemployed it’s hard to offer much economic optimism other than it’s been fun while it lasted (and, indeed, it has). That said, all eyes (including my four) are on the Fed and whether they offer a ‘dovish’ hike or a ‘hawkish’ one. I suspect they’ll offer a bit of both depending on how you want to read the statement. That is, they are closer to neutral and another 50 bp this year -- which remains my expectation -- gets them that much closer at a time when inflation isn’t heating up too much even if expectations (TIPS BEIR) are.  

Such a view will keep the curve in flattening mode. As I overplayed in the opening gambit, I get reasons behind the most recent bear steepening and see it as technical and position-inspired.  The daily momentum measures are oversold and there is the potential for 10s to face a double top up near 3.12+%. I still would ‘like’ to see a rout to 3.25% or better as a buying opportunity. My best rationale for getting there is more technical damage combined an effort to front run the supply consideration (along with a diminished corporate pension demand).  

I would be careful about the latter. With the gain in equities despite all the negative potentials (EM, politics, some data) pensions are surely in better shape against their liabilities. As the 4th quarter rapidly approaches and yields and stocks gain, the prudent thing to do is make some asset shifts to lock in funding levels. The corporate pension contributions that perhaps helped long yields fall may be out of the way, but that also means the value of those pensions as increased accordingly. In other words, yes, there’s been some bond buying but also stock buying. Milliman’s Pension Funding Index was 93.3% in August and probably has risen a bit since. Keep an eye of asset allocations in Q4 especially if yields rise a tad further.

Note, I see a potential rising wedge reversal in the S&P against maybe momentum divergences. 10s and 30s have potential double top action in place so, at least, perhaps it’s a sideways move into the FOMC.

PS Thanks for reading me over these years and depending on access to systems etc may or may not be back next week.

David Ader, Chief Macro Strategist for Informa Financial Intelligence

Bringing 30 years of investment strategy experience to his role at Informa Financial Intelligence, David Ader has held senior positions at major investment banks and financial information firms as well as serving on investment policy committees and management teams. Most recently Partner, Head of Government Bond Strategy for CRT Capital, he headed the team voted #1 in U.S. Rates Strategy for 11 years and #1 in Technical Analysis for five years in Institutional Investor’s annual survey.