Running on Fumes

It’s hard to believe, but our current economic expansion is nearly 10 years old, and will soon become the longest economic expansion on record. However, it has also been the weakest of the 11 expansions that have taken place since 1949. Is this a coincidence?

As the chart below shows, beginning around 1982, we entered what some have called the “super cycle era.” Economic cycles earlier in history were much shorter, but over the last few decades they’ve increased dramatically in length.

U.S. Business Expansion Lengths

There are many purported claims as to what caused this shift, but one huge reason that cannot be ignored is the secular, multi-year decline in interest rates. As the chart below shows, the yield on the bellwether 10-year Treasury note has fallen from around 15% to 2%.

10-Year Treasury Rate

As you can imagine, that’s an awful lot of stimulus, not just for the U.S. economy, but for anyone around the world utilizing dollar-denominated debt.

It’s also a stimulus package that appears to be mostly used up. The term-premium on longer-dated bonds is now roughly nil, with these bonds barely providing enough yield to maintain purchasing power. Sure, it’s possible that interest rates could go lower still, but this is unlikely to have a dramatic impact as corporate debt levels are already quite elevated (chart below).

Nonfinancial corporate business debt

We’re also running big government deficits, so that source of “stimulus” seems to be largely tapped as well (chart below shows the current deficit as a percentage of GDP).

Federal Surplus or Deficit as a Percent of GDP

The end result is that we appear to be approaching the conclusion of our steroid cycle. It’s been a good run, but the fiscal and monetary policy levers that have achieved this growth are now getting rusty and starting to breaking down.

This has some interesting implications. As I’ve discussed many times, the natural boom and bust cycle of our economy is a function of overstimulation, followed by a period of contraction, as we oscillate above and below the economy’s long-term growth rate.

As we become increasingly unable to stimulate the economy above its long-term growth rate, the inevitable result is that booms will become much more moderate – as we’ve seen with this economic expansion ranking dead last in terms of growth since 1949.

And if it’s true that economic oscillations above the long-term growth rate are being dampened, then it’s quite possible that oscillations below that growth rate will also be dampened. This is not to say that we should let our fear of recessions subside, only that I do think there is indeed a relationship between the length of an expansion and its corresponding growth rate.

In theory, if we had never exceeded the long-term growth rate of the economy, we could have ended up like Australia, going some 27 years (or more) without a recession. So while it’s a bit frightening that we’re running out of ways to stimulate economic growth, the silver lining is that our boom and bust cycles may indeed be increasing in length and decreasing in amplitude.

That said, it’s inevitable that crafty politicians and economists will find a new lever, and that could come in the form of modern monetary theory (MMT). This radical economic theory is garnering more and more attention, and I will begrudgingly admit, there are some interesting facets to it. In a future article I’ll cover it in more detail, but for now, let’s get back to the markets.

The S&P 500 hit a new record yesterday (and again today), but as I’ve expressed in recent articles, I wouldn’t get carried away with the excitement. Beneath the surface, both U.S. and global economic conditions continue to deteriorate.

As the market breathed fresh, untouched air yesterday, the J.P. Morgan Global Manufacturing PMI posted its second back-to-back sub-50 reading for the first time since 2012.

JP Morgan Global Manufacturing PMI

The index came in at 49.4, which suggests that global manufacturing is actually beginning to contract. A look at the subindexes (shown below) does not present a very compelling picture, with most items other than input and output prices falling.

Global Manufacturing PMI Subindexes

A couple of weeks ago we also saw the IHS Markit U.S. Composite PMI (including both manufacturing and services) fall to a 40-month low of 50.6.

IHS Markit Composite PMI and U.S. GDP

Add in some of the things we discussed last week, including the flat-lining LEI, as well as the fact that corporate profit growth is now expected to be negative for the next two quarters (-2.6% in Q2 and -0.5% in Q3), and it makes you wonder just what exactly the market is rallying on.

Well, I’ll tell you … The market seems to be cheering the expected arrival of two developments: some type of resolution to the trade war, and more importantly, a cut in interest rates by the Federal Reserve.

Unfortunately, I have a feeling that both of these could turn out to be “buy the rumor, sell the news” types of events. Investors are certainly looking forward to a rate cut, but the obvious elephant in the room is that if a rate is warranted, and provided, it means the economy is under duress.

As for a resolution to the trade dispute, I think this saga is far from over. Even if we reach some type of tentative deal with China, that says nothing for all the other trade agreements that would remain up in the air.

So at this point, even though price action in the S&P is telling us to be bullish, I remain cautious. A troughing of economic data would help to improve my spirits, but at the moment it feels like there is a disconnect between stock prices and economic fundamentals.

Benjamin Graham, the father of value investing, famously said that, “In the short-run, the market is a voting machine, but in the long run, it is a weighing machine.” It seems to me that current market action is being driven by a vote of confidence on both the trade and monetary policy fronts, but that economic fundamentals (the weighing part of the equation) are not as robust as one might hope.

If that is indeed the case, then we should continue to remain somewhat conservative in terms of positioning. A core position in stocks is still warranted, but I would shy away from becoming overweight equities. I think trimming positions into this strength will end up being a wiser move than chasing the market at these levels.

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