2017 Will be a “Reset” Year for Markets

2017 is shaping up to be a reset year in the economy and markets. Already we have seen a trillion dollars shaved from the bond market. I anticipate we will see more losses soon, including in the stock, real estate and commodities markets. We will also see what I have called a “skip-straight recession.”

Review Your Portfolio by Year-end

I recently wrote two articles about the “slow growth forever” global economy that have gotten a lot of traction on Seeking Alpha. I’ve also talked extensively about the subject on MarketWatch.com. The recent articles are listed here: 

Understanding the “Slow Growth Forver” Global Economy

Investing in the “Slow Growth Forever” Global Economy

Understanding the structural problems with the global economy, especially in the United States, China, Europe and Japan is vital to protecting your standard of living.

I warned about a financial crash in April of this year, anticipating it could happen anytime between H2 2016 and H2 2017. Here is the article: 

Stock Market Crash Alert – 1st from Fundamental Trends, My 1st since 2008!

Don’t be complacent after having given thanks. Take a look at your portfolio with somebody or get involved with a good investment letter service (I know of one). 2017 is going to be a rocky financial year. I’ve only said that about a year, two other times, in 1999 just before the 2000-2002 tech-wreck and in 2007 just before the financial crisis. 

I’ve been preparing people for 2017 for about a year now. We’re holding extra cash and have our “Very Short List” of stocks and our “ETFavorites” ready to buy when people start selling at overemotional panic prices. We’ve also adjusted our retirement plan holdings at work. 

You can ignore me, but do so at your own risk. 2017 is the year we get the next reset. 

What is Going to Change

Even before the Presidential election, we were starting to see signs that the “slow growth forever” economy just wasn’t going to take off. As I discussed in the two articles cited, a GDP growth rate of about 2-3% is the “new normal.” In order to have a period of growth higher than that, we would either need to come off of a recessionary trough or pull growth forward leaving a hole for later.

While a newly elected President Trump does have growth plans, there is little reason to believe that any will have an impact as soon as 2017 and maybe not even until the second half of 2018. It is just a fact of politics that the wheels turn slowly.

The reality of 2017 is that we are on the last fumes of the this economic expansion cycle. So, what should we expect?

Well, I don’t expect another financial collapse like so many pundits have been calling for since the last financial collapse. What I do expect is for what I have termed a “skip-straight recession.” What is that? Very simply, we will see continued slow economic expansion with a negative quarter mixed in. Nothing horrific, but a downturn nonetheless. 

Watching Unemployment

The main data point that people should watch in my opinion is unemployment. If it ticks up, that will be good for corporations briefly, but bad for the general economy, which becomes bad for corporations.

Here’s why unemployment is likely to tick up soon.

First, with the attainment of higher employment rates after an eight year slow grind back from the financial crisis, we can expect some people to get pulled back into the labor force. By expanding the workforce, the unemployment rate ticks up until those people have jobs.

The problem with an expanding labor force is that many people who are out of the labor force are not highly skilled. This presents a dilemma for employers looking for labor.

The result in the past year of tighter labor conditions has been wages starting to drift up for the first time in a long time. While that is good for employees, it keeps margins at corporations from expanding unless there is an increase in productivity. We have seen that productivity growth fall over the past year:

Correlation of productivity and jobs

(Source Bloomberg)


A question I have not seen asked is whether or not the drop in productivity could be due to employers training lower skilled labor? It would stand to reason that as some people came off the sideline, corporations chose to train, rather than pay higher wages to take the employees of other company’s who were demanding higher pay to switch. I do not have the definitive answer on this question.

The common wisdom for lower productivity is that technology and lack of business investment were causing the decline. I certainly believe those are factors, but likely a large contributing factor was the simple tightness of the labor force. 

The tightness in the labor force could be about to get less tight, presuming that millions of people do not get deported anytime soon. Many corporations are set to start doing some layoffs. Why? Because there has been a merger boom. 

In 2015 and 2016 we have seen mergers hit a cyclical peak. In the past that has usually led to a period of increasing layoffs while companies look for “efficiencies.”

If those who are laid off in 2017 quickly find work, then we could avoid a substantial reset to the economy. It usually doesn’t work that way and the uncertainties of President Trump adds, well, uncertainty. And, let’s be realistic, a lot of people who get laid off early in the year will be happy to not look for work until the end of summer. 

Watch layoffs and the unemployment rate closely. 

Don’t Fight the Fed

According to the CME FedWatch Tool, there is a 93% chance of a Fed funds rate hike in December. Frankly I think that’s light. Only an external event could stop a rate hike at this point in my opinion.

What isn’t priced in is a rate hike in the first quarter of 2017. I think that is naive on the part of the markets. If the short-term economic numbers stay firm enough, I think it is very likely that Janet Yellen gives President Trump just what he asked for in higher rates. 

If rates exceed expectations, then we know that markets usually react negatively. The expectations appear to be wrong to the low side for the first quarter. The expectations for faster growth however seem very priced into equities suddenly. What if rates are higher and growth is lower than expectations? 

One place I am avoiding with higher interest rates is the utility space. Even if rate increases by the Fed remain slow, I am bearish on utilities. An increase in the cost of capital due to higher interest rates is particularly tough on utilities. Most utilities face a period of extremely high capital expenditures due to aging power plants and a need to upgrade the grid. 

So, with higher interest rates available, utilities, which are known for their dividends, are less attractive. In addition, the weighted average PE ratio for the components of the SPDR Select Utility ETF (ETF) is 22. This is far above historical norms. Sell utilities. 

Donald Trump & China

While I really try to stay away from politics, it is clear that Donald Trump brings the unknown. So, while I like some of his ideas, others that he campaigned on sound too much like failures of the past. We will see what he actually proposes and can get passed. 

What I am most concerned about with President Trump is how he will deal with China. There are three items of interest to me that could all cause China to become very aggressive monetarily and on trade which would contribute to a full-blown recession in the United States.

The first item is whether President Trump will in fact label China as a currency manipulator on his first day in office. It would be a silly accusation as we manipulate our currency constantly. However, if he does, then batten down the hatches. He is initiating a trade war.

The problem with a trade war with China is that we can’t win. There is no scenario I can find that the U.S. and likely the world doesn’t suffer a recession if the U.S. and China butt-heads on trade.

I know the common wisdom is that China wouldn’t dare be more aggressive with America on trade. I think that is flat out stupid. Not only is China willing to stand up for itself, they are clearly willing to suffer the short-term loss to make their point. Are we willing to suffer for no likely long-term gain?

Other ways that we could see a trade war with China is if President Trump backs out of the Paris Climate deal that 196 nations have signed onto, including China. Upon his election, the Chinese immediately warned Trump not to back out of that deal. They are serious. 

A flat out challenge of trade terms by President Trump by imposing tariffs would also plunge the U.S. and China into a lose-lose trade war.

One thing that Americans need to get very clear on is that the United States is the biggest winner from global trade in the world. We are the world’s largest exporter despite being only 5% of the global population. [Our inequality problems are not due to global trade, our problems are from a small handful of people at the very top of the capital structure taking far too huge a share of America’s wealth by manipulating board rooms, taxes and laws.] 

If we get into a trade war with China, I have very simple advice: Sell everything except energy. If there is a trade war, which I have no way to handicap, then my “no financial collapse” scenario goes out the window. 

Demographics, Debt and Nationalists, OH MY!

In the “slow growth forever” articles, I summarize the problems of global aging demographics and debt.

In short, here is what we know. Japan and Europe are ancient. Both are also debt ridden. 

The idea that Japan, with limited resources and fewer working age people, can overcome their debt without massive inflation someday is a pipe-dream. I hope that there is a non-tragic solution for Japan, but I don’t see it without pre-preemptive bailout. I don’t see their end game until the early to mid-2020s however. 

Europe on the other hand is fraying now. Brexit already is happening. In a couple weeks Italy could take another step towards a major confrontation with Germany and the EU. That sentence should just scare you from the historical relevance.  

Here in America we have another year’s worth of Baby Boomers about to take Required Minimum Distributions (RMDs) from their retirement plans. Expect this to contribute to early year selling in the stock market. In fact, given that Millennial stock market contributions are years away from offsetting Boomer withdrawals, foriegn capital inflows have been running hot for a while now and buybacks are sagging back to normal, it is not hard to see a rough first quarter developing. There could in fact be a change to how seasonality works for the next several years.

It’s not just developed nations with demographic and debt issues, many of the emerging markets are in trouble too. South America in particular is at tremendous risk. Consider Venezuela’s struggles with low oil prices, a horrible political structure and questionable legal rights. Brazil is challenged as well. 

The problems of demographics and debt are manifesting in such a way to give rise to nationalist populists. While tinged with racism, the main problem of these rising nationalist populist movements is a complete ignorance of socioeconomic history and economic reality. 

The view that by turning inward, nations can solve problems that were caused by natural forces of demographics, irresponsible debt creation over the past 35 years and hoarding of power and wealth by the very few, is not only ignorant (worth repeating), but very dangerous. Rather than turning inward, populists ought to be looking upward, very upward, not at their small business neighbors, but in the corporate boardrooms and in government.

Earnings Will Disappoint Sometime in 2017

With wages rising and growth still slow, there is very little reason to believe that earnings will accelerate enough to justify the post-election rally.

In addition to rising labor costs, the strong dollar is having a significant impact on multi-national earnings. We have to remember that global sales account for about 40% of the earnings in among S&P 500 companies. That strength internationally trickles down to companies in America that act as suppliers and contract companies. 

With the rapid rise in the dollar the past few months, corporate earnings are in danger of major negative currency adjustments.

Too many people are pricing in a quick fix to growth issues that probably have no real fix. If interest rates expectations are wrong and rates rise faster than expected, and if economic growth numbers are too optimistic, then there is no way for the stock market to justify high valuations. 

The SPDR S&P 500 ETF (SPY) has a forward PE of 18.50 and a current PE a shade over 19. While not in bubble territory, those are historically high valuations and without growth will be very hard to maintain. I am a seller of the SPY at current prices. 

Three Scenarios

The first scenario I see for 2017 is that the stock market has a 20-30% correction and bonds continue to lose until the skip-straight recession hits. For investors, they could do nothing and ride through it as in this scenario, 2018-19 is probably pretty good. Tactical investors would be wise to raise cash before Christmas. I put this at about 60% probable.

The second scenario is a trade war with China or another external event causing a global recession. In this case, stock markets can lose over 50% again. A global recession would likely drag on over a year and we would have to be extremely cautious about reinvesting until real solutions are agreed upon. I put this at about 20% probable in the short-term. Trump might accelerate the inevitable global debt reckoning – weirdly, that might be good long-term, if we don’t kill each other that is.

The final scenario is that I’m wrong about my view of the world and everything is just fine. That doesn’t seem plausible given so many people think there are a lot of things wrong, even if we disagree on what’s wrong. But, when a lot people are on the same side of a boat, often they are wrong. If that’s the case, then maybe we just keep floating along with slow growth economic growth and rising stock and real estate markets. Of course, when everybody is on the same side of the boat, a lot of times almost everybody gets wet and some drown. 

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