For new readers, we have been talking about a concept I have dubbed “slow growth forever” on MarketWatch and here at Fundamental Trends. The very simple premise is that perpetually low economic growth relative to the post WWII to 2007 period is not just possible, but is truly unavoidable in coming decades due to massive accumulated global debt and the dramatic aging demographics faced by most of the world.
Because most people don’t understand or accept the notion that slow economic growth is a structural issue that cannot be “fixed” they seek to blame somebody. “Brexit” is a manifestation of the frustration over slow growth and the psychological impact of economic change. Those in the United Kingdom who voted to leave the European Union have now chosen who to assign blame to for their frustration and fear.
The Real Danger
In my MarketWatch articles about “slow growth forever,” I have fielded comments that clearly reach into anger over the idea that there isn’t much that can be done to stimulate the type of economic growth the world saw for three generations after WWII. The criticism is often borne of ideology or ignorance – sometimes those two overlap quite a bit. At least some trolls have been creative, my favorite line so far is, “forever is a mighty long time,” which I don’t think the critic knew was a line from a Prince anthem.
Since the “Reagan Revolution,” the world has devolved into a cult of growth that has done increasingly more dangerous things to goose economies and financial markets in order to create the illusion of economic benefit for all and enable a big financial skim by those with access.
For decades, governments have engaged in deficit spending with the idea that growth would take care of the bill later. There has also been a lot of politicians who figured they could just leave their mess for the next group to clean up with inflation and have taken their payoffs pensions into the night. Today, governments are between a rock and hard place as they are running into limits on their finances.
During those same decades, central banks abdicated their responsibility to regulate the financial systems and loosened up on monetary policy anytime there was a hint of recession. Their methods, borne of Keynesian ideals to smooth economic cycles, have ultimately defied global economic realities (i.e. aging demographics) and are now the fuel for financial and economic crisis.
While Keynes was mostly right about short-term cycles and the positive impacts that central banks and governments could have using monetary and fiscal policy, the last two generations of leadership have mistakenly applied approaches meant for short time periods to very long time periods. They have completely bastardized what Keynes’ “The General Theory of Employment, Interest and Money” discussed. About 3 years ago, the Fed and other central banks should have stopped enabling governments avoidance of making hard decisions. Now, we are in an even more dangerous position than a decade ago because of the “drugs” – easy money – that the central banks have fed their affiliated governments.
What’s worse, is that today, central banks are diving further into experimental monetary policy, from QE to ZIRP to now NIRP, and soon to outright “helicopter money” (just printing money and spreading it around). The further the central banks press the pedal down on aggressive monetary policy, the greater the gap that develops between the living standards of labor and investors. Labor, which represents far more people than investors, is starting to take it personally. The result is a new rise of emotional populism. This emotional wave, growing in size, has now led to Brexit, and to a lesser extent in America, the rise of socialist Bernie Sanders and whatever Donald Trump is (I really wish I knew).
The dramatic impacts of the emotional nature of surges in populism cannot be underestimated. We have seen populism run amok dozens, if not thousands, of times in the world. It was at the core of World War II. It has been at the core of most socialist revolutions. Let us not forget that socialism is the greatest theory and idea that doesn’t work (not even in Northern Europe, which without oil money, would have been broke long ago). And let us not deny that capitalism unfettered becomes wildly inefficient as power shifts to a very few who protect their positions via financial and political means, and cronies litter the landscape in order to partake in the financial skim.
Traveling the circular path between emotional socialist dogma and ideological greed fueled capitalism is a dangerous winding, no rail, high cliff road. We must break the historical cycle we continue to ride by slowing down, considering history, respecting our neighbors and correcting our path. If we don’t do that soon, I fear we are doomed to another major war. In a world that is so well armed, it might be our last.
Politics
While Brexit might in the long-term be beneficial to the U.K. it could just as easily be very damaging. A much smarter approach would have been to negotiate a slightly different deal with the European Union – which was in fact tried and failed. The failure to reach a compromise solution for U.K. membership to the EU was in my estimation due to an arrogant stubbornness based on a lack of clarity about the realities of the EU members and economy – I mention one guilty party below. The U.K.’s David Cameron, for his part, was a fool to call for a straight up or down referendum on membership in the EU. He should have offered a 3 choice advisory referendum that had full membership in the EU, a revised relationship with the EU and withdrawal from the EU as choices. Too late for that now (maybe).
For the rest of the world, the slow divorce of the U.K. and EU is going to lead to more turbulence. Even the most amicable divorce is not smooth. In this case, there are fools on both sides of the issue no doubt.
Boris Johnson, who has already made extreme statements about the type of EU affiliation that the U.K. should have and Nigel “Independence Day” Farage in the U.K. are two of the fools. They are both blow-hard extremists and should have no role in determining the path that a nearly evenly split United Kingdom should follow as they would undoubtedly pull too hard in the direction they support rather than finding a common sense solution (sound familiar America?). The U.K. would be well served to push that pair to the back of the room.
EU Commission President Jean Claude Juncker is another fool. He has said that “it’s not an amicable divorce, but was not exactly a tight affair anyway” making fairly clear his biases. He’s also called for the U.K. to make “haste” in exiting the EU which is the exact opposite approach that should occur. The EU should summarily fire Mr. Juncker.
What is coming out of Scotland is also worrisome. Scottish First Minister Nicola Sturgeon has made suggestions that Scotland could block a U.K. withdrawal from the EU and that Scotland should prepare for their own independence vote if not. Such a vote, if Scotland proceeds down that path, should come well after all other avenues are explored and exhausted. If an independence vote comes quickly, it is sure to be a reach of political opportunism and not necessarily in the people’s best interest.
Ireland has also brought up the idea of Irish reunification and leaving the U.K. in order to maintain their EU relationship. That is another extremely complex relationship that could throw a wrench in things.
Ultimately, what is needed, is slow, well thought out, unemotional approach to the U.K. and EU relationship. I am not sure that can be achieved with emotions and attitudes running hot. Cameron in his resignation speech, essentially created about a 3 or 4 month cooling off period. All parties, it appears, will need it.
So, for now, what is done is done. The U.K. is on the road to withdrawal from the EU and negotiations on that path will start soon enough. Expect a lot of twists and turns regardless of who is in charge. I believe that ultimately, the U.K. will have another referendum that presents new choices to their citizens. It will be a backdoor approach to avoiding withdrawal from the EU. It might not happen with the current makeup of the U.K. government however. I fully expect a backlash from the “stay” population.
Economics and Markets
What we must all realize is that the EU economy is second only to the United States economy globally, thus, it is no small affair what is going on there. Suggestions that the U.K. and EU relationship doesn’t matter to U.S. economic health is ignorant of global economic mechanisms. Not only will Brexit continue to affect Europe, but the potential spillover into a very connected financial world could be substantial. While I don’t see an economic collapse developing, I think there is no doubt that a “risk-off” attitude could permeate global financial markets.
For investors, it is not too late to accumulate the cash I have been recommending for over a year. I have shown charts that demonstrate that the bull market is on either its last or next to last leg. If you are managing your investments or retirement savings, you should consider the risk you are willing to take right now. If you don’t analyze your risk today, do not complain tomorrow if the markets take a third or half of your money, it will be your own fault, not somebody else’s. What is interesting as always is that we certainly could see the 40% to 60% drop in stock market values we all fear, but that would be a major overshoot as valuations don’t indicate we need that large of a correction. In that case, you’d want to be a buyer if you have cash, however, at this point in the cycle, any rallies should be sold into in my opinion.
Here are a few things to consider regarding the investment cycle:
- Monetary policy has become less effective. This is seen in the decreasing velocity of money. Monetary policy has not been able to change this trend. Declining velocity of money is a direct result of the demographics in the United States, i.e. the aging of the baby boomers. Just as the boomers drove velocity of money up for decades, they are now pulling it down. 2016 also represented the first year that boomers turned age 70 1/2 – which is the age they must take required minimum distributions from their retirement plans. Next year will be another wave of RMDs and in 2018 another, and so on. Until the millennial additions to the markets offset the boomer withdrawals, which is not likely until the next decade when millennials are earning more and mortality impacts the boomers more significantly, monetary velocity will remain low. The millennials have just started household formation, so we are not far from the velocity line flattening, however, we are not close to it rising much either. A low velocity of money is highly correlated to a slow growth economy.
- There was a direct relationship between the dramatic increase in the Federal Reserve’s total assets and the rise in the S&P 500. Since the flattening of additions to the Fed’s total assets via quantitative easing, the stock market has been range bound, failing to reach new highs on three occasions now. The reinvesting of Federal Reserve held debt as it matures into new debt, rather than retiring it, appears to have put a floor under the stock market. However, we should wonder how solid that floor is. There have been calls for more QE from those in finance, frankly, I think that is about as greedy as it gets. We are probably more healthy if the Fed does little to nothing for an extended period and we find both market and economic equilibrium, even if that is a bit lower. Remember, the name of the game is to maintain standard of living, not to inflate away standard of living, or at least that’s my thought on the matter – it certainly appears questionable what the Fed believes.
- Corporate earnings growth has flattened and threatens to fall based on the recent jobs, manufacturing and GDP reports. Observing the velocity of money, it will probably be a while before earnings growth rebounds. In periods where there is little to no earnings growth, usually price to earnings ratios contract – of course we have not seen periods when central banks were so willing to prop up markets before either. (Yardeni Research’s chart book is a must read every month.)
- It is easier to understand that earnings are threatened when looking at revenues. Small company revenues are holding up best, with larger companies being comparatively weakest- which is a shock to most investors. Midsize companies seem to be in danger as they will have a hard time competing with larger competitors going forward and consolidation might be difficult to achieve in a slow growth economy that has large company CEOs looking to tighten belts.
- Buybacks have been a core support from keeping earnings from falling further. There were record buybacks in the first quarter which very likely drove the rally from mid-February to the end of the quarter. Bloomberg reports that corporate buybacks are set to fall the most since 2009 in coming quarters. If buybacks do in fact decline from the record first quarter, earnings remain flat or fall, and acquisitions at a premium do not materialize, then stocks will remain under pressure regardless of Brexit. Indeed, the 50 week moving average has already moved over the 100 week moving average, which has generally signaled a stock market decline. See this chart regarding the SPDR S&P 500 ETF (SPY). Unless a dramatic reversal occurs and new highs are set and held on the weekly, it is likely we are in fact at the start of a summer correction for all the reasons I have listed in other posts.
So, as we observe, the stock U.S. stock market is already facing multiple pressures. Will Brexit be the straw that breaks its back and drives a larger correction, or will the camel keep struggling through the sand but not collapse? If central banks continue to do what they have been doing, it seems unlikely we see a crisis as they are quick to throw money on anything that’s on fire. It seems very likely we see a normal correction of 10% to 20% (I’d be willing to wager on a 19% correction as a side bet – I won’t tell you why other than to say visit 2011) and it’s certainly possible we see markets correct much more. My biggest fear is that if the central banks do have to act to thwart a financial collapse (I really hope it doesn’t come to that, but we are relying on questionable leaders at this point), I think that sets the table for future stagflation, but I will save that horror story for another time.
In the meantime, I will repeat what I have been saying for well over a year now, that I was recently agreed with by several very prominent investors: be careful, hold a lot of cash and wait for very well priced opportunities to invest most of your money. When those opportunities come, subscribers here have an action plan to buy from our list of ranked ETFs and our “Very Short List” of stocks (about 45 companies pass our screening process right now).
