Will the rational bubble become irrational?
In my last article, “Riding the Rational Bubble,” I shared that given the economic conditions we have experienced over the last six years, financial bubbles could be developing. Alan Greenspan said, “Long-term economic stability with low inflation will result in a bubble.” If he is right, get ready for a financial bubble, because that is exactly what we have seen over the past seven years.
Since 2010, the U.S. economy has been stable, with real GDP growing at an annual 2.2 percent average. Inflation during that period has been low, with the consumer price index growing at 1.7 percent on average over that same period. However, financial bubbles alone aren’t necessarily damaging to an economy. Take the stock market debacle of 1987—late in the year the market tumbled 24 percent in one day, but fundamentally the economy didn’t change. Financial bubbles with leverage, on the other hand, can be dangerous.
Since the Great Recession, the U.S. economy has been stimulated by aggressive monetary policy, with little impact on growing the economy, yet perhaps with significant impact on stabilizing the economy. With the new administration, we will experience a paradigm shift moving from aggressive monetary policy and weak fiscal policy to the opposite—aggressive fiscal policy and diminishing monetary policy stimulus. Could this exacerbate financial bubbles and change rational bubbles to irrational ones?
At present, we see three potential financial bubbles worth watching: 1) sovereign debt, 2) the stock market, and 3) interest rates. At this time we think interest rates could be the first irrational bubble, with sovereign debt following suit if not dealt with over the longer-term.
The U.S. national debt is $19.8 trillion or 105 percent of our GDP. On the surface that looks like a bubble that will end badly. However, $5.4 trillion, or 27 percent, of that debt is intragovernmental holdings. Therefore, if evaluating debt held by the public, debt to GDP is only 75 percent.
This model has been the recent strategy to combat slowing economic growth around the world. Japan’s debt to GDP stands at 229 percent. Again, on the surface it seems like a bubble, yet 40 percent of their debt is held by the Bank of Japan. What matters is who owns the debt.
Professors Carmen Reinhart and Kenneth Rogoff and economist Vincent Reinhart studied the debt- to-GDP ratios of advanced economies. Their conclusion was when countries have a debt to GDP ratio that exceeds 90 percent for at least five years, it has a negative effect on the economy. High levels of public debt are associated with lower growth. In total government debt, the U.S. passed the 90 percent debt- to-GDP ratio in 2010; but when we consider just the debt in the public’s hands, we still have a way to go.
The sovereign debt bubble has been developing over many years; I don’t think it will burst in the next few years, but do believe it will become more problematic. President Trump’s fiscal policy may deflate one bubble and exacerbate another. Lower taxes and regulation may jump-start corporate earnings and keep equity valuations in check. However, more than likely, it will increase the national debt. Sooner or later there may be a day of reckoning, but I have been in the investment business for 27 years, and over the years the common question has always been, “What about the debt?” In hindsight, perhaps the best response would have been, “So what about the debt?” The reality is that even though the economy grew and the debt levels increased, investors continued to make money.
The Stock Market
Since the beginning of 2009 to the end of 2016, the S&P 500 has moved up nicely—190 percent to be exact. But that alone doesn’t put it in bubble territory. When you analyze the valuation of the S&P 500, it is clearly not in bubble territory. In fact, I would argue that it is fairly valued. Today the market trades at 17.5 times forward earnings, far from the near 30 times earnings we saw in the tech bubble in the late 1990s.
Bubbles with debt are dangerous. Margin debt, or leverage in buying stocks, is now at previous peaks relative to GDP. If the market traded at a lofty valuation, along with this leverage, it would be a red flag, and an irrational bubble would be looming. That is not the case today as valuations remain rational.
Last year we were concerned with an earnings recession due to the contraction of oil prices and the U.S. dollar headwinds. In the first and second quarters of 2016, earnings contracted, putting the market’s valuation in question. However, earnings did rebound in the second half of the year, and we expect earnings growth for calendar year 2016 to be in the 2-4 percent range. This year, given the economy’s momentum, we anticipate corporate earnings to grow around 9 percent, not assuming any of President Trump’s growth initiatives. If President Trump is successful in implementing his proposed fiscal policy initiatives swiftly, the risk to our earnings forecast is to the upside. This should keep valuations in check and avoid an irrational bubble.
The U.S. bond market has been in a bull market for more than 35 years. In 1981, the yield on the 10-year Treasury was 15.8 percent. Over the next 35 years, interest rates came down to virtually zero. In August of 2016, the yield on the 10-year Treasury fell to 1.3 percent, partly due to loose monetary policy and quantitative easing. This has become an irrational bubble. Why have Fed Funds been at virtually zero with a stable economy growing at 2 percent? This is not solely a U.S. problem—global growth has slowed and the central bankers in Europe and Japan have pushed interest rates down to zero in an attempt to stimulate their economies, putting additional downward pressure on interest rates in the United States.
President Trump has suggested the economy will grow faster than 3 percent. We think 2.5-3 percent is more realistic. If the president’s forecast comes to fruition, inflation expectations will move higher, ending the longest bull market I have seen in my career. As long as we don’t experience a surprise inflation spike or runaway inflation, the Federal Open Market Committee will be able to manage this financial bubble deflation by moving short-term interest rates higher on a moderate glide path.
As economies and markets ebb and flow, financial bubbles come and go; they’re just part of the cycle. Many times it is difficult to identify bubbles until they pop. As a friend once told me, “All peaks aren’t bubbles, yet all bubbles have peaks.”
Conditions are conducive for financial bubbles to develop; we have to be mindful of that. Risk-based assets may perform well this year, and we remain cautiously optimistic. Yet, as always, we never lose sight of the risk that is present.
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