Fed Trapped “Between the Devil and the Deep Blue Sea”
The Expert View
Featuring Julian Brigden
Published on: April 29th, 2019 • Duration: 30 minutes • Asset Class: Bonds/Rates/Credit • Topic: Inflation, US Dollar, Deflation, Housing Market, Fed, EquitiesJulian Brigden, co-founder and head of research at MI2 Partners, believes the U.S. economy is at a critical inflection point. In this episode, Brigden interrogates the economic expansion and asks the tough questions about the rally in stocks: Why have U.S. equities outperformed the rest of the world so late in the cycle? What are the key risks? And what will central banks do next? Filmed on April 19, 2019 in New York.
JULIAN BRIGDEN: This is another classic example of the sort of academically driven policies that we've seen come out of the halls of central banking, which are no longer really populated by central bankers, but by academics. The theory was fine, OK? The theory was kind of like how you launch an aircraft off an aircraft carrier. You jam the aircraft back at the back of a deck. You let it build up enough momentum and speed. And then eventually you let the elastic band go, and the thing soars off into the bright blue yonder. That's great on paper, but it comes, unfortunately, with some consequences.
Hello, everyone. My name is Julian Brigden. I'm the co-founder of MI2 Partners, and the co-producer, along with Raoul, of Macro Insiders. I'm here today, because I think we're at a really important inflection point in markets. I think the big debate now, at least in the equity market, and this opposition in the equity market, is that the central banks have once again pulled the rabbit out of the hat, and successfully reflated the bull market just like, in a way, that they did in early 2016.
I think that's possible. I'm not sure that we're quite there yet. I think some of the assumptions that are being made are a little pre-emptive. And so I think there are some still risks. I think ultimately I'm pretty certain where the trend is going. But I think it's important at this juncture to sort of take a step back, look at how we ended up here potentially, and what are those markers that you need to be watching.
How did we get to where we are now?
JULIAN BRIGDEN: I put some slides in the presentation. And the first one that I've stolen from the Fed is Janet Yellen's slide on optimal control from D-day of 2012-- so 6th of June. If you look at that slide, what you'll see is a sort of typical trajectory of where rates should have gone. And then you see a dotted green line that represents Janet Yellen's policy, which she referred to as optimal control.
This is another classic example of the sort of academically driven policies that we've seen come out of the halls of central banking, which are no longer really populated by central bankers, but by academics. And the theory was fine, OK? The theory was kind of like how you launch an aircraft off an aircraft carrier. You jam the aircraft back at the back of a deck, you let it build up enough momentum and speed, and then eventually you let the elastic band go, and the thing soars off into the bright blue yonder.
That's great on paper, but it comes, unfortunately, with some consequences. So if you look at the next slide, you'll see a slide that I actually stole from another Fed governor. And this is Bostic's chart, which he talked about last September. And in that classic sort of central bank understatement, he said, I've been thinking about the risks of running an economy too hot.
So what did he mean by too hot? What he means by is when you push unemployment well below NIRU, which is the Non-Inflationary Rate of Unemployment. And if you look at this slide, you'll see that traditionally that hasn't ended well. It's almost always ended up with a recession, very simply because you create one of two things.
The first thing that you create is you create inflationary pressures, which forces the Fed to use his parlance to be overly muscular. And the second thing it does is you create misallocation of resources in the process of holding those rates super low. And as you try and normalize, or if some exogenous event comes along, or shock comes along, the system tends to tip over. And the net result is, guess what, you end up in a recession.
Well, we've already run this economy objectively too hot, right? We've pushed unemployment right back down to levels that we haven't really seen since the mid-'60s. And you can see on this chart that while the Fed kept it going for a couple more years, it really didn't end well. It ended up with the massive recession we saw in the early '70s-- late '60s, early '70s.
So I think we're at a bit of an inflection point. That's where we are. The question is, can they keep it going?
So if we look at the two conditions that he set out for the necessity of recession-- have the Fed being too muscular, and/or do we have excesses in the economy. If you look at the next chart here, you'll see a chart of Fed funds. And what you see is there's a nice, downward sloping channel on Fed funds. And essentially we've come up, and we've hit the top of that channel.
Why is it downward sloping? Well, we keep accumulating more and more and more and more debt. So it takes a relatively lower level of rates to tip the whole system over. So, objectively on paper, we're already at a level which you could argue is too muscular.
The next chart I want to show you is excesses. And the two areas where I can see some clear excesses, the first one is in the financial markets. And this chart shows you a chart of the MSCI indexes for the US versus the rest of the world, ex the US. And what you can see is US equity outperformance, the like of which we have essentially never seen before-- we're at levels that surpass anything we've seen in the last 50 years on a relative basis.
And there's sort of a couple of observations. Firstly, you can see that since the presidential election, and the fiscal stimulus that we had, and the talk of deregulation, the US market has surged. So if we go back to that idea is, is this similar to 2016, the answer is it could be. But we're a lot more extreme in the cycle. Those valuations, and that extreme divergence are a lot more extreme than they were back then.
And the second thing is, it's very, very unusual to see financial markets really move this far, or US equities outperform to this extent, when the Fed's hiking. If you look at this chart, there's a little purple bar which shows the last time that we had US equities outperform as the Fed hikes. This is massive outperformance as the Fed is hiked.
So there really is, I think, arguably, real excesses in the US equity market. And particularly when we talk to MI2 clients, or Macro Insider clients, we've delved into some of those more internal metrics to look at how we would see those divergences.
What divergences are you seeing?
JULIAN BRIGDEN: When we look at some of those internal metrics, one of the ones I like to look at is look at some of the divergences we're seeing within the markets between growth and value stock sectors. We've had this big growth in the growth sectors, the names like sort of Amazons, the Ubers of the world, Netflix, [? Nvidia, ?] these very rapid-growth companies.
Now these companies, somewhat counter-intuitively, grow in low-growth environments, right? They grow because nothing else is growing. And they do that, because they can get hold of super cheap cash. And they take that super cheap cash, and they basically burn through it at a very rapid rate. We can see these companies losing billions of dollars a year. But they do it to generate revenue, and that's how stocks are valued.
We saw this actually, ironically, exactly back in the 2000 dot com period, where the same sort of companies were-- stock analysts would argue, you can't look at them from an earnings perspective. You have to look at them from a growth perspective, and a revenue growth perspective. And, of course, well, that didn't end up very well at all.
And actually, in fact, if you look at some of the ratios between growth and value, we've actually come right back to the tick to the same levels that we saw in March of 2000, and the summer of 2000. Of course, that didn't end up very well at all. So I think it's arguable that the Fed's policy, together with the fiscal stimulus of the Trump administration, has driven some of the internal metrics of the equity market back to dot com highs, which is not good.
But I think it goes beyond that. And I think that's where things get a little bit more problematic. Because if you think about the equity market, it's quite easy, potentially, for the Fed to do some QE. We could even have a trade deal with China, and maybe push those PEs a little bit higher, and those valuations a little bit higher.
When it moves into the real economy, and particularly to one segment, it's not really about price. It's really more about affordability. We've pushed up prices of a lot of products now to pre-GFC highs. And yet incomes have not grown accordingly. And even now, a relatively small increase in rates has destroyed affordability.
So if you look at this next slide, what you'll see is new home and existing home prices. And you can see that both of them are well above, in particular, a new home their GFC highs.
Now some note of caution. We don't build the same types of new homes now that we built heading into the GFC. There are no affordable two-bedroom apartments, as everyone certainly in this New York area knows; and probably pretty much around the country, every new two-bedroom apartment now is luxury with all the bells and whistles. And that makes it-- the median price-- a lot more expensive.
But the point is, affordability is poor. So yes, there are many of you perhaps who are watching here who want to move out of Mom's apartment or basement, but you can't afford to.
And so if you look at this next slide, what you'll see is a metric for existing home affordability. And when you take income into account, when you take deposits into account, and you stress it even with a small amount of rate hikes in absolute terms that we've seen, affordability just imploded at the end of last year. This is a lot tougher metric to solve.
Now we've seen some improvement as this graph has bounced in affordability, as rates have come down a little bit. But you're going to have to get rates a hell of a lot lower to get them close to where affordability was back in, say, 2015, or 2016.
How do you do that? Well, you could crash the equity market. Well, I suspect there wouldn't be that many people buying homes if you crashed the equity market. You could raise wages. I think that's ultimately where the policy makers want to go. But that has implications, too, potentially for inflation, and potentially for rates. So this affordability metric, which is a lot more extreme than it was in 2016-- houses were at their peak of affordability almost in 2016-- is another thing that makes me question this automatic assumption that it's game-on 2016 redux.
What's the end result of these divergences?
JULIAN BRIGDEN: So the end result-- I just want to show you one more slide on this-- is that if we look at our growth metrics, unlike 2016, where growth was basing at the beginning of the year-- so as Janet Yellen turned super dovish post the Chinese devaluation, the pseudo emerging market crisis that we had at the end of 2015, she turns dovish, and at the same time growth picks up. So you get that perfect combination to drive the reflation trade, the higher stocks, higher commodities, in that you had growth and valuations rising at the same time.
If you look at this slide here, which is a GDP model, one of the ones that we use, doesn't look to us that we're going to get that rebound in the growth story to back up current valuations. So I'm a little concerned that some things have run a little too far ahead of the curve, and a little too far of the story, in that presumption that we automatically have pulled off a repeat of 2016.
So if you look at a chart of equities-- and I've just thrown one in here-- you'll see that at least superficially it looks like we're game on. We've pulled it off. Everything's great. We used some internal metrics which, in the next few weeks, will signal either a failure or a renewed bull cycle, in which case you sort of get-- Larry thinks that-- chairman of BlackRock-- has been talking about the melt-up, right? And that's possible.
But I think the jury's essentially still out, because at this point this could be nothing more than arguably a bull trap rally. And if you remember late 2015, stocks start to come off as China devalues. We initially do get a bounce. We get a bounce that goes almost to the prior highs within techs, which is kind of exactly where we are. And then we fail again.
So I think in the next few weeks we're going to know. We're going to get more data, which is either going to confirm existing data that the recovery is real and it's broadening. A lot of that has to do with what's going on in Asia-- not so much in the States. I think really the problems are overseas a little bit. That will have had all the earnings numbers, and that will confirm things as well.
So I think superficially, yes. But there are a couple of things, if you look at some of the other markets, which aren't confirming it. So I've put a chart in here of forward swaps. So this is two 10s swaps pushed two years forward. So it actually moves faster than the metric that a lot of people look at, which is the three-month, 10-year curve as a metric for where we are in the cycle.
And what you can see is this thing based in September of last year. So just heading into the downturn in the equity market. And it got down to levels where it sort of hit in 2000, 2005, 2006. And it is following exactly the same path. It is beginning to steepen.
That's not a good sign. That is a sign that the bond market is starting to anticipate a recession. And in marked contrast to 2016, where front yields actually collapsed, what you'll notice is basically two-year yields have hardly moved. So we really haven't had that easing from the bond market.
The second thing is, I put a chart in here of the dollar. And this is the rate of change of the dollar. So it encapsulates both the acceleration or deceleration of the dollar. And essentially, from that rate of change, you can see the level-- did it move up or down? 2015 we see this very rapid up move in the dollar as the Fed had been launched, had ended QE. The dollar springs up. That it's a trade that Raoul and I have been particularly bullish on for the Macro Insider clients.
And this runs all the way into the beginning of 2016. You have this destructive rally by the reserve currency, which is hugely toxic for the rest of the world. China's devaluing. Emerging markets are getting thrown under a bus.
And then you get Janet Yellen coming out. And she stops hiking, ends all the talk of tightening on a dime. And immediately all that momentum of the dollar dissipates. And not only does the dollar stop accelerating, but it actually physically drops.
It hasn't physically dropped at all this time. And to me-- and maybe we'll see that-- something that we're going to be tracking very, very closely for our clients in the next few weeks-- that's essential to keep the game going. I mean, you cannot have sustainable reflation without a weaker dollar. I mean, the dollar is literally, as the reserve currency, the denominator of global risk assets around the world.
You can have an up move in oil a little bit. You can have an up move in some precious metals a little bit. We've just seen in the last week, though, that the failure of the dollar to continue to-- or to move at all-- is causing some problems for things like gold, right? We've come up to levels where we just can't push it any further without that additional stimulus from a weaker dollar. And the same is true of oil.
And even that renowned stock picker aficionado Jim Cramer has said this is a rally that's been driven by technology and energy. And I think if oil can't break higher, it's going to be difficult to sustain this equity rally. And the only way I can see that oil can break higher at this point is dollar weakness. So it's just a very different kind of macro scenario in terms of growth data.
And also, when you sort of lift the cover beyond, oh, look, equities are up, and you see some of these divergences, but they're just radically different. Gold has gone up. Well, where's silver and platinum, two metals which are arguably higher beta than gold?
Gold did about 30% in early 2016. Silver and platinum both did 50% or more. We haven't seen anywhere near that sort of performance. And so when I look at things, there were just holes. Now it could change. It's possible that we can keep this game going. But I think it's going to take something more.
How does reflation usually impact the dollar?
JULIAN BRIGDEN: If you look at it in broad terms over a historic basis, reflationary environments are broadly dollar negative, because other countries are doing better, and there are greater opportunities in emerging markets in particular. Commodities should do very well. And they are typically high beta plays. Within that, commodity miners should do even better. There's a whole strata of you can pick the more aggressive trade to do that.
You're just not