While most people are familiar with the story of Goldilocks and the Three Bears, they might not know the real story – where the bears ultimately punish her intransigence.
In economic parlance, a ‘Goldilocks Economy’ refers to a period of economic expansion where market conditions reach the right balance to prolong growth without downside risk. Like a children’s story, this interpretation of the current economy is pure fantasy. While the post-crisis global economy is currently undergoing one the longest periods of growth in history, the underlying fundamentals are less than solid. In fact, the world economy is on the brink.
The Writing on the Wall
While many people tend to dismiss Cassandra as hysterical and irrational, there is some value in taking a moment to look at the writing on the wall. As a footnote, Cassandra turned out to be correct.
What are the warning signs? These would include unemployment, debt levels, uneven consumer spending, asset bubbles, global trade, and finally geopolitical risk.
Here is the good news. U6 in the U.S, which measures total employment including marginally attached workers and those employed part time for economic reasons, is at its lowest point since November 2007.
But it’s known how that movie ended and every time since 1994 that the U6 rate has dipped below 8.9% a recession has followed. During the dot com bubble of the 1990’s, U6 remained below the 8.9% mark for 53 straight months. These were also the days when Robert Shiller coined the phrase of ‘irrational exuberance’.
Following the recession of the early-aughts, U6 once again fell below 8.9% and remained there for 29 of 30 consecutive months from June 2005 until the end of 2007. Fast forward to 2017 and this is not in a period where U6 has been below the 8.9% threshold for four consecutive months.
While one may conclude the current recovery could continue for another year or two, another, and equally plausible conclusion is that the economy is set to run out of steam. This bearish view is in some ways backed up by sluggish wage growth and labor force participation.
In fact, the cracks are starting to show as manufacturing employment remains below 2014 levels and retail employment – which has shown some modest growth over the summer – is extremely unstable.
‘Money makes the world go around’ or so the saying goes. However, the reality is that the modern economy is driven by debt.
In the U.S., the federal deficit is currently estimated to be more than $20trn. Add to this nearly $50trn – and this is being conservative – of pension fund and public sector liabilities and the total debt level in the U.S. is more than the combined asset value of the country – talk about a going out of business sale.
As bad as things are in the U.S., the run up in debt is even worse in other countries. Reports coming out of China indicate that off balance sheet lending is far higher than previously estimated.
Meanwhile, the dumpster fire that is China’s debt crisis continues to grow as bank and nonbank lenders continue to add fuel to the fire. The result is that total debt levels are quickly approaching 300% of GDP and this does not include social costs attributed to a rapidly ageing society.
One characteristic shared by the U.S. and China is that the central banks in both countries have been unable to curtail the run up in leverage. In light of this, many corporates are borrowing a play from Ford’s 2007 playbook and maxing out their leverage while the cost of money is still low.
This leads on to consumer spending. While economic growth in emerging markets has continued, the fact remains that the U.S. consumer remains the engine that drives the global economy.
However, one canary in the coal mine is vehicle sales which fell by more than 2% in the first half. To make matters worse many automakers have resorted to 0%t interest offerings and other gimmicks to coax buyers through the doors. Given the sluggishness, it should not come as a surprise that some automakers are already beginning to shelve expansion plans for the time being.
Peeling the numbers back, the Wall Street Journal Market Data Center indicates new car sales for the month of July continued to fall. Keep in mind the sluggishness in new car sales is happening even while official measures of inflation have remained persistently low.
One hallmark of the contemporary economy is the over reliance on bubbles to fuel growth. In the 1990’s it was the internet, in the aughts is was home prices in the U.S. and abroad. The result was a massive run up equities which ultimately valuations across the board.
In addition, to the run up in share prices, there has been the explosion of private equity activity and this is fueling an asset bubble of sorts as funds make riskier investments in the hopes of delivering alpha to their limited partners.
Back to the public markets, the forward P/E ratio of the S&P 500 points is roughly 24% lower than today’s close of 24.57. Granted, this does not prove that a correction in imminent but one has to ask what is driving stock prices higher?
One explanation if the rise of passive money, but a rapidly ageing society in many developed economies should herald a rush to safety – i.e. bonds, more on that in a moment.
Another explanation is the so-called ‘Trump Trade’ but following six months of ineffective government and no major legislative achievements this hypothesis is dubious. In fact, Mr. Trump’s meltdown during a press conference to discuss plans for infrastructure spending is highly likely to rattle markets over the next few days.
Group think is another explanation but this should be a clear sign to get out of the market. A perfect example of this is the VIX, as it took the threat of nuclear war last week to wake the risk index from its slumber.
While bonds appear to be impervious to the Fed’s intentions to increase rates, near zero rates in other advanced economies explain why bond yields in the U.S. have barely moved following three, 25bps rate increases since last year.
However, this might have the makings of a perfect storm as a correction in the equity markets could push even more money into bond markets. The result would be such a discount on risk to such a point yields on junk bonds might start to fall.
While the United Kingdom is finally starting to come to grips to the reality of Brexit, Europe looks to take a back seat to East Asia and the Gulf Coast over the next six-to-eight months. In the Gulf Coast region, the cold war between Qatar and Saudi Arabia could turn a messy part of the world into something which is broken beyond repair.
Yet, the real flash point is North Korea. Not only does the conflict pit the U.S. and its allies against China and Russia; but the unpredictability of Kim Jong Un and Donald Trump complicate matters.
War on the Korean peninsula would cause chaos around the world. Not only would it disrupt exports from Korea, northern China, and Japan but the prospect of long-range missiles and the active participation of the world’s largest military powers would grind most supply chains to a halt. Granted, this is an extreme view, but given the current trajectory, it is a scenario which is no longer improbable.
What Can You Do?
Dialling down the paranoia, a more prudent approach would be to conduct a thorough review of your portfolio to identify the triggers which would force a sudden shift in asset allocation.
From a corporate perspective, the best approach would be a combination of pursuing a wide-moat strategy in a select number of growth markets as well as leveraging technology to further strategic advantage. The combination would help insulate from the potential downside risks if the world economy were to fall off a cliff.