Many know of my years in the investment business and some have asked what I think of the recent goings on in the stock market. Considering the importance of the topic to many readers, I thought I would spend the next few posts on the markets. This opening edition will give a broad overview and a summation of the current market environment, and will be needed to appreciate the additional posts in the series. Let’s begin.
The market crash of 2007 through 2009 was the worst broad market decline since the Great Depression. Most global equity indices fell by greater than 50% during the year and half decline. But from its low in March 2009, when it hit 700, the S&P 500 has shot up to a high of 2,100, reached in mid-2015. The rise produced broad market returns of 200% during the six-year rally or annual returns in excess of 20%.
To combat the downward spiral of deflation caused by recession, the Federal Reserve has made significant monetary policy accommodations. Not only have short-term interest rates been lowered to nothing, there have also been three bouts of quantitative easing (QE) as marked on the chart below. QE was halted in November 2014 and the market has had difficulty reaching new highs since.
During QE, the Fed was the biggest buyer, and many times purchased more than 50% of the most liquid treasury securities offered in the market. It did this with money that it created and is similar to the old practice where countries would print money in times of economic stress. Now it owns more than 25% of the publicly-held float. With that much price-insensitive buying power that was in the market, the Fed’s actions were assured to push prices up and beyond their fair values. This had to lead to an even greater appreciation of all other riskier assets. It’ is easy to see why most asset prices have moved sideways or have fallen during the last year with the halt of the Fed’s purchases.
QE undoubtedly pushed almost all assets in the domestic economy above their fair values. Maybe it could be argued that assets were considered fairly valued when QE was underway. But it’s over now and a major determinant of risk pricing has been changed. This cannot help but cause revaluation of all financial asset prices. Just as QE influenced the market to the upside, its termination is bound to create downside pressure.
When QE was pulled, the thinking was that the economy had responded sufficiently to the fiscal and monetary deluge and is now able to stand on its own. But certainly factored into the decision to terminate were the sheer size QE had grown, its continued effectiveness, and its potential for longer-term, adverse consequences. QE had to stop and whether it can be reinstituted in the face of an upcoming global slowdown is a matter of great debate.
U.S. Treasury Debt
The Fed’s monetary policies and natural market forces caused 10-year U.S. Treasury yields to fall from a high of approximately 5% in mid-2007 to a low of 2% in 2009. After many moves back and forth in the 2% – 3% range (mostly based on trading around the Fed’s QE announcements) and six years later, the 10-year yield is still hovering around 2%.
Of course, when yields fall, bond prices rise and it becomes confusing to figure out how much money was actually made. So, put another way, the U.S. Treasury’s 30-year bond gained more than 60% during the past six years for a total return of more than 10% per year, an impressive feat for holding a “default free” asset.
The amount of U.S. government debt now outstanding is $18 trillion or 100% of GDP. At the beginning of the recession, the amount outstanding was $9 trillion or 65% of GDP. The only time when the government debt was this large relative to GDP was during World War II when the war needed financing. The size of the debt was then subsequently resolved by the massive productivity and wealth creation that resulted during and after the war.
And the potential interest on the debt could be staggering. In 2007, the Treasury incurred interest expense at 5% or $430 billion. Last year the number was about $400 billion but interest rates were much lower at 2.2%. If Treasury interest rates rise by 1%, the interest costs will increase by $200 billion or 1% of GDP. There is no way to dismiss the potential drag not only to the government’s deficit but also to the whole economy, if rates rise.
As for the housing market, the effects of the crash caused the national median home sales price to fall more than 30% from its pre-recession highs. In some states, the losses were significantly greater. But now, the nation’s median home sales price is back up to its previous high of $220,000.
American households today own $23 trillion of real estate. While the value of real estate has significantly fluctuated over the last decade, outstanding mortgages have not. After all the controversy over mortgages, this fact is surprising. From 2007 to now, there has been a small reduction, but this lessening has been more than offset by a greater corresponding increase in consumer credit. Total household debt has not changed much from its $10 trillion balance since before the crash. Also, restructuring the mortgage market has supposedly led to the weeding out of “weaker hands” from residential real estate ownership. But these “weaker hands” are now paying monthly costs of their residences in the form of rent and credit card payments rather than with mortgage payments. Because of higher credit card interest and higher rent, the total monthly expense for the less well-off is actually greater than before – a further hindrance to the economic inequality dilemma now facing the country.
As globalization and changeover to a more serviced-based economy took hold of the U.S. economy in the 1990s, capital investment trended downward. During the Great Recession, it further retreated by over 30%. So far, it has retraced three-quarters of the more recent loss. But most domestic companies still are not investing in their businesses much above the level required to replace depreciated assets. Companies continue to hoard huge cash balances, mostly in overseas accounts, free from U.S. corporate income taxes. Money that has been spent has gone to mergers of existing companies, dividends and share buybacks, and sizeable executive compensation packages rationalized from the stock market’s incredible performance.
Capital investment’s one shimmering light has been the spending on U.S. oil production. Over a trillion dollars have been invested in domestic oil and gas production since 2009. The industry has accounted for more well-paying new jobs than any other. The capital investment and oil revenues earned since the recession have contributed a quarter of the country’s economic growth. But with the massive decline in oil prices – now greater than a 60% drop – domestic oil production has slowed and the investment in oil could turn out to be a double-edged sword.
Investment in oil production has huge upfront costs which encourage further production when prices drop. As output rises, revenue from increased volume covers the initial fixed costs plus marginally increasing costs. The break-even cost per barrel falls with more barrels produced. Thus it becomes a game of cornering market share. All oil producing countries know this and the incentives to produce more oil add even greater pressure to oil’s downward price. If oil prices continue to be depressed, as is likely with the current supply glut, larger deflationary forces will persist. As a result and sooner or later, companies will default or go out business. Jobs gained will become jobs lost.
The American Consumer
Population growth has also aided in the absolute recovery of the country’s GDP. Since 2009 America’s GDP growth has averaged 2% – 3%, while its population growth has averaged 1%. The American population has risen by 18 million to 322 million in 2015. That’s an increase in five million households with that many more people to feed, clothes to wear, and services to provide. The population increase has more than sopped up the excess housing problem that existed at the depths of the recession.
The most interesting take away about population and the economy is that while total GDP has increased by 20% since 2009, the real, after-inflation GDP per capita – or real GDP per person – has remained at the same level that it was ten years ago. Inflation and the population increase in the denominator have made GDP recovery and growth meaningless for most Americans. Even then, GDP per capita does not tell the whole story on how the average American is weathering the economic storm. Many economic statistics are now showing that more and more Americans are actually worse off than before the crash.
All told, household net worth has gone from $67 trillion before the crash to $85 trillion now. The ride has been rocky. At the low in 2009, net worth had fallen 20%. In 2012, it finally made it back to pre-recession highs. In 2013 and 2014, following the effects of the Fed’s final QE #3 and the skyrocketing of U.S. oil production, household net worth rose to new highs.
The chart of household net worth, if presented, would look almost identical to the path of the stock market chart above. It cannot be denied that its increase is mostly from the rise in price of financial assets. But like GDP, the increase in household net worth is misleading. The richest 20% of Americans now own more than 85% of all net worth. And since before the recession, the median net worth has actually fallen, another confirmation of the condition that most American households (and most consumers) are worse off.
Briefly touched on above, oil is one of the biggest wild cards now being played in the global economy. Over the last three decades, technological advances for getting oil from harder to reach places have been a game changer for the world’s energy status quo. The world’s known energy reserves have almost doubled and the old-guard oil producing countries of the Middle East continue to lose market share, revenues and relevance. Along with the push for carbon energy alternatives, the increase in oil reserves and production were bound to cause the price of oil to drop precipitously. And that drop is sending significant economic, not to mention geopolitical, reverberations throughout the global economy and society.
The Global Slowdown
The performance of the U.S. stock market since the recession could lead to the belief that all is well, but certainly it’s not. During the entire period of the global economic recovery, institutions such as the IMF and the World Bank have continually revised growth estimates downward. For all the fiscal and monetary accommodations, the global recovery has been anemic and has taken longer than expected. Aggregate demand for goods and services has not recuperated to pre-recession levels, especially in the more consumer-oriented and wealthier economies. Trade with the less developed, export producing countries has slowed significantly. The world’s production chain and labor markets have been upended. And new structural barriers, such as nationalistic protectionism and global credit restrictions, have made recovery that much more difficult.
Added to the lackluster recovery is the fact that for any period of advance, even if muted, there is the cyclical nature to growth. It never extends in a constantly upward slope. At some point, a pullback in the economy is destined. The recovery has been underway for almost seven years, one of the longest periods of expansion in U.S. history. It is safe to say, the global economic recovery is tired.
The economies of Europe and Japan wobble in and out of contraction, China, Russia, India, Brazil are now suffering considerable economic disruptions. And “no man is an island” is the best way to characterize the potential for spillover to the U.S.
As you have probably surmised, the ending of QE is not the only headwind now facing the stock market. The global economic slowdown, oil, the housing, interest and currency markets, aggregate demand weakness, structural impediments and geopolitical volatility – all are coming home to roost and have their impacts on U.S. share prices.
Was the recent downturn in the stock market to be expected? Of course. How much more can it go down? This and more will be discussed in the next edition.
Christopher Petitt is the author of the book, The Crucible of Global War: And the Sequence that is Leading Back to It. It is available for sale at Amazon.com, Barnesandnoble.com and for order at bookstores everywhere.