Economicus
Terra Incognita
By John Mauldin
“The
most reliable way to forecast the future is to try to understand the present.”
– John
Naisbitt
“We
really can’t forecast all that well, and yet we pretend that we can, but we
really can’t.”
– Alan
Greenspan
Welcome
to 2016. Tradition dictates that you spend the first few weeks or so reading
forecasts for the coming year. I can say with certainty that most of them will
be wrong. A smaller number may hit the target. Unfortunately, no one knows
which forecasts will fall into which category.
For
the last 16 years my first letter of the year has also been a forecast issue,
and I will continue to go with that tradition – but with one major caveat. I do
not base my forecasts on mathematical models or some finely honed methodology,
but on my sense of where the economic world stands today and where I think it
might likely be in the near future.
Actually,
I’m going to spend the first few pages demonstrating that the mathematical
models used to forecast GDP and all sorts of interesting economic events are
basically nonsense.
For
me, forecasting the year ahead is somewhat like being an explorer who comes to
the top of a high new mountain pass along with a group of his friends and looks
far out in the distance and sees another mountain pass, shrouded in clouds but
offering the promise that it’s possible to continue the journey. It is clear to
him that they should all forge ahead to find a way to that next mountain pass,
but between his location and his destination lie all manner of unknown
geographical features, not to mention the prospect of unfriendly natives who
may want to contest their passage.
So
today, as we crest the mountain pass of a new year, I will look off in the
distance and tell you what I see. Let me be clear, though, that I’m not coming
back from the future and telling you what it’s like; I am merely hoping to get
our general direction right. Some years the path ahead seems remarkably
straightforward and clear of obstructions. I can tell you right now that this
year the challenges seem particularly fog-shrouded. But what’s an explorer to
do but to press ahead?
Before
we begin, I want to suggest you mark out time in 2016 to attend my Strategic
Investment Conference. This year we’ve moved the event to Dallas. The dates are
May 24-27.
I’m
proud to say that SIC probably has more repeat attendees than any conference I
know. This fact speaks to the care with which my conference team organizes the
event and the quality of our speakers. A side effect is that the bar is raised
a little each year. Somehow I have to deliver a better-than-ever program year
after year – and somehow we’ve always done it.
My
goal in designing the agenda is to give you a mixture of old favorites as well
as new perspectives. Our confirmed speakers so far (in no particular order) are
George Friedman, Mark Yusko, Pippa Malmgren, Charles Gave, Lacy Hunt, Anatole
Kaletsky, David Rosenberg, David Zervos, Gary Shilling, Louis Gave, and Neil
Howe. We will be confirming several others within the next few weeks. You
probably know at least some of those names. If not, you should. Just this
initial group is quite a brain trust.
This
year I’ve juggled the schedule to give us more time for informal networking
opportunities. SIC attracts an impressive group of attendees, and every year I
hear from people who made invaluable business contacts at the conference. We
are going to be using an app for the conference that, among other cool options,
will help you network and find people whose ideas and information will enhance
your own life.
Note that this extra “networking” feature is completely
optional. (We are still accepting sponsors, too, if your company would like to
reach several hundred high-powered investors and money managers from around the
world.)
For
more information, you can visit
the SIC 2016 website. Register by Jan. 31 and you’ll save $500 off the
walk-up rate.
Two
notes before we start. At the beginning of the letter I am going to launch a
few nukes on the banality of making predictions based on models. That is at
least the first half of the letter. If you want only my musings on events to
look for in the coming year, skip down about halfway.
Second,
and VERY IMPORTANT. At least to me. This is the typically the most forwarded
letter of the year. If you are reading me for the first time, this letter is
free – you can subscribe at www.mauldineconomics.com
by simply entering your email address. And you can get free emails from a
brilliant group of writers and analysts who are far smarter than I am, if you
choose. The whole team at Mauldin Economics looks forward to serving you.
Now,
let’s jump in!
“What
will the stock market do this year?” It seems like a simple question. You might
wish for a simple answer to it, and think that people who watch stocks for a
living should know that answer. Not so. The evidence shows they are no more
accurate than anyone else is.
Morgan
Housel of The Motley Fool
skewered
Wall Street’s annual forecasting record in a story last February. He
measured the Street’s strategists against what he calls the Blind Forecaster.
This mythical person simply assumes the S&P 500 will rise 9% every year, in
line with its long-term average.
The
chart below show’s Wall Street’s consensus S&P 500 forecast versus the
actual performance of the S&P 500 for the years 2000–2014.
The
first thing I noticed is that the experts’ collective wisdom (the blue bars)
forecasted 15 consecutive positive years. The forecasts differ only in the
magnitude of each year’s expected gain.
As we
all know (some of us painfully so), such consistent gains didn’t happen. The
new century began with three consecutive losing years, then five winning years,
and then the 2008 catastrophic loss.
The
remarkable thing here is that forecasters seemed to pay zero attention to
recent experience. Upon finishing a bad year, they forecasted a recovery. Upon
finishing a good year, they forecasted more of the same. The only common
element is that they always thought the market would go up next year.
Housel
calculates that the strategists’ forecasts were off by an average 14.7
percentage points per year. His Blind Forecaster, who simply assumed 9% gains
every year, was off by an average 14.1 percentage points per year. Thus the
Blind Forecaster beat the experts even if you exclude 2008 as an unforeseeable
“black swan” year.
This
data raises plenty of questions, starting with, “Why do investors listen to
forecasters who are so consistently wrong?” I have a guess, but let’s first
look at Morgan Housel’s answer. (I should note that Morgan is my favorite
writer at The Fool.)
The
first question is easy. I think there’s a burning desire to think of finance as
a science like physics or engineering.
We
want to think it can be measured cleanly, with precision, in ways that make
sense. If you think finance is like physics, you assume there are smart people
out there who can read the data, crunch the numbers, and tell us exactly where
the S&P 500 will be on Dec. 31, just as a physicist can tell us exactly how
bright the moon will be on the last day of the year.
But
finance isn't like physics. Or, to borrow an analogy from investor Dean
Williams, it's not like classical physics, which analyzes the world in clean,
predictable, measurable ways. It's more like quantum physics, which tells us
that – at the particle level – the world works in messy, disorderly ways, and
you can't measure anything precisely because the act of measuring something
will affect the thing you're trying to measure (Heisenberg's uncertainty
principle). The belief that finance is something precise and measurable is why
we listen to strategists. And I don't think that will ever go away.
Finance
is much closer to something like sociology. It's barely a science, and driven
by irrational, uninformed, emotional, vengeful, gullible, and hormonal human
brains.
For
the most part, I agree with Morgan. Investors want to believe that certainty is
possible, that crunching the right numbers or listening to the right guru will
reveal what lies ahead.
The idea that markets are inherently messy and
disorderly frightens them. It’s much more comforting to think that someone out
there has a crystal ball that you just haven’t found yet.
I’ll
add a twist to Morgan’s answer. I think what many investors really want is a scapegoat.
The only
thing worse than being wrong is being wrong with no one to blame but yourself.
Forecasters keep their jobs despite their manifest cluelessness because they
are willing to be the fall guy. Present company excepted, of course.
There
used to be a saying among portfolio managers: “No one ever gets fired for
owning IBM.” It was the bluest blue chip, one that everyone agreed would always
bounce back from any weakness. If IBM made you have a bad year, the boss would
understand.
Wall
Street strategists serve a similar purpose. If, say, Goldman Sachs forecasts a
good year, and it turns out not so good, you will be well-armed for the
inevitable discussion with your spouse, investment committee, or board of
directors: “I was just following the experts.”
Compare
that to the alternative. How does that discussion turn out if you build your
own forecasting model and it delivers dismal results? The story probably
ends with you sleeping in the doghouse and/or polishing your resumé.
In the
short run, hiring a scapegoat, er, forecaster, seems the path of least
resistance.
That’s why so many people choose it. But in the long run, that path
leads you nowhere that you want to go. You will be in fine company as you
underperform, but underperform you will.
People
also look to forecasts that reward their confirmation
bias, reinforcing and validating their understandings of
markets and investment strategy. Sadly, I must confess that I much prefer to
hear a forecast or read analysis that confirms my own biases. Which is one
reason I make sure to read the analyses of those who don’t agree with me.
I
typically ignore – for good reason, as we will see below – forecasts based on
mathematical models. I much prefer the assessments of those who analyze the
future in terms of trends and general economic forces, giving us their own
sense of direction about the interplay of the complex drivers of the economy.
But that’s just me.
All
right, so if forecasting the stock market is harder than it looks, how about
forecasting the economy? Surely the Federal Reserve has a good handle on future
growth prospects.
If
that’s what you think, prepare to be disappointed.
We
can’t say the Fed doesn’t try. In 2007 the Federal Open Market Committee (FOMC)
started releasing GDP growth projections four times a year. They do this in the
same report where we see the much-discussed interest-rate “dot plots.” It is
called the “Summary of Economic Projections,” or SEP.
A 2015
study by Kevin J. Lansing and Benjamin Pyle of the San Francisco Federal
Reserve Bank found the FOMC
was persistently too optimistic about future US economic growth. They
concluded:
Over
the past seven years, many growth forecasts, including the SEP’s central
tendency midpoint, have been too optimistic. In particular, the SEP midpoint
forecast
(1)
did not anticipate the Great Recession that started in December 2007,
(2)
underestimated the severity of the downturn once it began, and
(3)
consistently overpredicted the speed of the recovery that started in June 2009.
So, it
isn’t just Wall Street that wears rose-colored glasses – they are fashionable
at the Fed, too. Lansing and Pyle provide helpful charts to illustrate the
FOMC’s overconfidence.
This first one covers the years 2008–2010.
The
colored lines show you how the forecast for each year evolved from the time the
FOMC members initially made it. Note how they stubbornly held to their 2008
positive growth forecast even as the financial crisis unfolded, then didn’t
revise their 2009 forecasts down until 2009 was underway – and then revised
them too low. However, they did make a pretty good initial guess for 2010, and
they stuck with it.
The
next chart shows FOMC forecasts for 2011–2013.
We see
a different picture in this chart. As of October 2009, FOMC members expected
2011 and 2012 would both bring 4% or better GDP growth. Neither year ended
anywhere near those targets. Their initial 2013 forecast was near 4% as well.
They reduced it as the expected recovery failed to materialize, but as in 2009,
they actually guessed too low.
One
problem here is that GDP
itself is a political construction. Forecasting the future is hard enough
when you actually understand what you are forecasting. What happens when the
yardstick itself keeps changing shape? You get meaningless forecasts. But this
doesn’t stop the Fed from trying.
If the
Fed can’t accurately forecast the economy, can anyone? Surely someone in the
federal government has better answers.
The
Congressional Budget Office issues forecasts much as the Federal Reserve does.
And like the Fed, the CBO grades itself. You can see for yourself in “CBO’s
Economic Forecasting Record: 2015 Update.”
Read that
document, and you will find the CBO readily admitting that its forecasts bear
little resemblance to reality. Their main defense, or maybe I should say
excuse, is that the executive branch and private forecasters are even worse.
I’m
not kidding. The CBO report includes the following chart. I removed other
categories they measure so we can look specifically at their GDP estimates. I
should also point out that they cooked the books a little by averaging two-year
forecasts to make themselves look better. But even so…
The
bars compare the degree of error in forecasts by the CBO, the Office of
Management and Budget (OMB), and the private Blue Chip economic forecast
consensus. A reading of zero would mean the average forecasts matched reality.
A negative number would mean they were too pessimistic. A positive number –
which is what we see for all three entities – means they were all overly
optimistic on GDP growth.
So,
what we see is that the OMB – whose director is a political appointee – was
more optimistic than the Blue Chip consensus, which in turn was more optimistic
than the CBO, which was more optimistic than reality.
It is
also worth noting how the CBO views the future. Their latest economic outlook
update, published last August, features this chart.
The
forecasts for GDP growth, unemployment, inflation, and interest rates all
flatline after 2016. As of now, the CBO’s official position is that the US
economy will remain stable with no recession until at least 2025.
If you
find this particular prognostication hard to believe, you aren’t the only one.
Nevertheless, this is what the government agency with the best forecasting
record says we should expect.
I’ll
go out on a limb here and say that the CBO is wrong. I am 100% certain we will have a recession before
2025. We can debate when it will start, what will cause it, and how long it
will last, but not whether it will happen.
I
wrote these next few paragraphs three years ago, but what I said then is
still true today.
In
November of 2008, as stock markets crashed around the world, the Queen of
England visited the London School of Economics to open the New Academic
Building. While she was there, she listened in on academic lectures. The Queen,
who studiously avoids controversy and almost never lets people know what she's
actually thinking, finally asked a simple question about the financial crisis: "How
come nobody could foresee it?" No one could answer her.
If
you've suspected all along that economists are useless at the job of
forecasting, you would be right. Dozens of studies show that economists are
completely incapable of forecasting recessions. But forget forecasting. What's
worse is that they fail miserably even at understanding where the economy is
today. In one of the broadest studies of whether economists can predict
recessions and financial crises, Prakash Loungani of the International Monetary
Fund wrote very starkly, "The record of failure to predict recessions is
virtually unblemished." He found this to be true not only for official
organizations like the IMF, the World Bank, and government agencies but for
private forecasters as well. They're all terrible. Loungani concluded that the
"inability to predict recessions is a ubiquitous feature of growth
forecasts."
Most economists were not even able to recognize recessions
once they had already started.
In
plain English, economists don't have a clue about the future.
If
you think the Fed or government agencies know what is going on with the
economy, you're mistaken. Government economists are about as useful as a screen
door on a submarine. Their mistakes and failures are so spectacular you couldn't
make them up if you tried. Yet now, in a post-crisis world, we trust the same
people to know where the economy is, where it is going, and how to manage
monetary policy.”
Central
banks tell us that they know when to raise or lower rates, when to resort to
quantitative easing, when to end the current policies of financial repression,
and when to shrink the bloated monetary base. However, given their record at
forecasting, how
will they know? The Federal Reserve not only failed to predict the recessions of
1990, 2001, and 2007; it also didn't even recognize them after they had already begun. Financial crises
frequently happen because central banks cut interest rates too late or hike
rates too soon.
The
central banks tell us their policies are data-dependent, but then they use that
data to create models that are patently wrong time and time again. Trusting
central bankers now, whether in the US, Europe, or elsewhere, is a dicey wager,
given their track record.
Unfortunately, the problem is not that economists are
simply bad at what they do; it's that they're really, really bad. They're so bad that their
performance can’t even be a matter of chance.
The
reason is that they base their models on flawed economic theories that can only
represent at most a pale shadow of the true economy. They assume they can use
what are called dynamic equilibrium models to describe and forecast the
economy. In order to create such models they have to make assumptions
– and when they do, they assume away the real world.
It is
not so much that the models I am criticizing are useless – they can offer
economic insights in limited ways – but they cannot be (successfully) used to
predict the economy or stock markets with anything close to certainty. They are
simply not complex enough – and they cannot be made complex enough – to
accurately describe the nonlinear natural system that is the economy.
Such
models can at best give you insights into certain conditions that are limited
by the assumptions you have to make in order to create the models. If you’re
using your models properly, you understand their deep limitations. I freely
admit to using models to gather as many insights as I can (especially about
relative valuations), but I certainly don’t rely on them to actually predict
the future. You should never use a model without understanding in a deep and
all-encompassing way that past
performance is not indicative of future results.
I’m
concerned that, in the coming years, looking at historical data for guidance
about the future will be more
misleading than simply guessing would be. The times aren’t just changing; the
very underlying economic conditions that produced past performance will no
longer pertain. We are truly on economicus
terra incognita. (Okay I made that one up, but you get the idea.)
If I
were a young and mathematically gifted economist, I think I would explore the
use of complexity theory to model the economy, based not on Keynesian nonsense
or the hubristic assumption that an economy can ever be in a state of
equilibrium (it can’t), but using Claude Shannon’s information theory instead
as a better way to demonstrate how economics works in the real world (an idea
brilliantly suggested by George Gilder in Knowledge
and Power).
So now
that we’ve established that forecasting is worthless, let me make a forecast.
When we next have a recession in the US, the Federal Reserve will give us QE 4.
They are going to base their monetary policy on the data they have at the time,
even though all their own research says that the last round of QE really didn’t
do anything.
They will once again push us into a world of financial repression
malinvestment because they will feel the need to “do something,” and about the
only thing they will be able to come up with is more quantitative easing. Which
will force the world into yet another mutually destructive round of competitive
currency devaluations. The image that springs to mind is that of a circular
firing squad, with the participants being the world’s major central banks, some
of which actually do have bazookas. As usual, the investors of the world will
be caught in no-man’s land. (I hear the old tune by Martha and the Va ndellas
starting to play in the back of my brain: “Nowhere to run to, baby, nowhere to
hide….)
There
is a significant part of me that now feels, or perhaps fears is the better
word, that the Fed will embark upon an experiment with negative interest rates
in the world’s reserve currency. One of the ideas that I want to explore at my
conference this year is what the consequences would be of negative interest
rates in the US and how we should deal with them. We will have a number of
European financial experts in attendance, and I will pose the question to them.
I am more interested in this prospect as a practical matter than as a
theoretical one. If you are managing a client’s money in anything that looks
like income ETFs or mutual funds, how would you deal with this? There are a
number of different types of funds that are actually required to hold their
excess assets and cash reserves in short-term Treasurys. Will regulators really
make funds hold reserves in assets that force clients into negative returns?
Seriously?
By
this point it should be clear that even the brightest economic and financial
minds struggle to make accurate forecasts. Should we ignore them all?
No. I
think the real problem is timing.
I
think it is possible to observe events and trends and then to make informed
projections about the future. A few people can even do it with reasonable
accuracy, at least in their own areas of expertise. The problem lies in
correlating what you know is coming with the particular calendar year in which
it will occur.
For
instance, note what I said above. I made a recession forecast within a 10-year
period. I feel very confident we will have a recession between 2016 and 2025. I
can’t tell you exactly what year it will occur, although I will expose the
extent of my hubris by actually trying to narrow that range down in just a few
paragraphs.
I can
readily forecast within a 10-year window because economic trends rarely change
overnight. The events that drive national and global economic cycles take time
to unfold. Even if we completely ignore present circumstances, we know it would
be unprecedented for the US economy to go 10 years without at least a mild
recession.
I’ll
readily admit that some people are pretty good at forecasting short-term market
movements. Most of them are professional traders. They’re also the first to
tell you that they don’t bet the house on their forecasts. They know how easy
it is to be wrong – and how costly.
My own
talents are at the other end of the scale. I can look out 5–10 years and tell
you in broad terms what I think will happen, but the next year is a crapshoot.
I make annual forecasts mainly because so many people want to know what I
think. If that’s you, please note that I reserve the right to change my mind
tomorrow.
So
with all that as prelude, let’s get on with my 2016 forecast. I talked about it
in a CNBC appearance last month. Click on the picture of the old guy for a
quick summary; then I’ll give you some additional detail.
I
don’t know exactly how this happened, but I have become widely known in
financial circles as “the Muddle-Through Guy.” I began using the term in 2002,
when I was forecasting that we would be lucky to do more than 2% for the entire
decade. It turns out I was an optimist – we did only 1.9%. Likewise, I think we
will be lucky to average 2% in the US in 2016.
In
general, recent data has been trending down (with the obvious exception of the
employment numbers). I am concerned that the US will be much closer to 1%
growth than 2% for 2016. I know plenty of folks who expect the US to go into
recession this year. They may be right, but if so that downturn will be due to
some kind of external shock. But at a 1% growth rate, which is close to
economic stall speed, it wouldn’t take much of an external shock. I can see
three real possibilities that we will need to keep an eye on.
- The
first is Europe. Longtime readers know that my base forecast is that the
euro survives, but only if the eurozone nations mutualize their national
debts. The euro is not an economic currency; it is a political currency.
And it will take the political solution of creating a fiscal union to
maintain it. Given the level of debt of most of the major members of the
eurozone, a fiscal union can occur only if every country – read Germany –
agrees to mutualize debts,.
Up
until recently I believed that you could get a majority of eurozone voters to
go along with the pro-euro elite politicians’ extraordinary intentions to
actually mutualize debts under the balance sheet of the European Central Bank
(or another organization that would be created in the midst of crisis).
I
now think that a political solution is at serious risk because of the
immigration crisis. You can almost feel whatever sense of political unity
existed in Europe disintegrating right in front of us. The recent tragic events
in France and Germany are exacerbating the problem. I think getting a majority
of voters to go along with the idea of giving up national sovereignty over
their own budgets (which is what a fiscal union and the mutualization of debt
would require) is becoming increasingly unlikely. As more and more people begin
to demand that their countries control their own borders, the entire Schengen
agreement is in jeopardy. And without that agreement, the next national debt
crisis (beyond that of Greece – Italy? France? Spain?) will call into question
the unity of Europe.
As
country after country in Europe begins to close its borders, the flow of
refugees will not slow but will actually increase. If you are in a failed state
in the Middle East or North Africa and you think the doors to Europe are
closing, you’re going to go now rather than wait. The refugees will find ways
into Europe through those countries that don’t have the resources to control
their borders (think Greece). Europe’s ad hoc approach to border control simply
won’t work. It will only serve to demonstrate the true impotence and
incompetence of Brussels and EU bureaucracy. And it will provide political
fodder to nationalist groups that are beginning to hold sway in a number of
major European countries.
No
matter what you think of economic austerity in Europe, that concept is going to
come increasingly under political fire and will be discarded. European borders
are becoming less transparent, and Europe is increasingly economically
vulnerable. A recession in Europe will cause a recession in a US economy stuck
at stall speed.
- I
am flying over China (from Hong Kong) as I write this paragraph. I have
just been a speaker at a conference sponsored by Bank of America Merrill
Lynch, with some 60 major investment representatives sitting around a
large table, for a very wide-open conversation. There were multiple
hundreds of billions of dollars of funds represented around that table.
Now perhaps it was influenced by two days of significant losses in the
Chinese stock market, but the overall mood was decidedly bearish. Only a
few people were actually talking hard landing, but the large majority of
Chinese growth projections were decidedly lower than government forecasts.
Further,
there seemed to be general agreement that the renminbi is headed down. I was
particularly impressed by the Merrill Lynch Chinese analyst from Shanghai who
pointed out that if the wealthiest 3% of Chinese moved just 7% of their money
offshore, we would be talking close to $1.5 trillion. Money is literally flying
out of China, in a variety of legal and questionable ways.
The
Chinese government has been manipulating its currency higher for many years.
That is now getting ready to change. Andy Xie, a well-regarded China analyst
who sat next to me during my presentation, would not rule out a 30–40%
devaluation over time. Admittedly, his is one of the more bearish forecasts, but
few in the room were arguing that the renminbi would get stronger. Andy in
particular was bearish about China over the next two years, though he remains
an undaunted China optimist over the longer term. He truly believes China will
rule the world within a few decades. In what was a very multicultural room (as
you would expect in Hong Kong trading and investment society), it was
interesting to watch the crowd’s reaction to Andy’s sentiments.
China’s
slowing down more than forecasts anticipate – or, God forbid, a hard landing –
would definitely deliver a shock to a still-weak US economy. We will have to
pay close attention to China this year.
- While
everybody thinks of the Middle East in terms of geopolitics and military
conflicts, the economic consequences of low oil prices will have far more
problematic effects on the stock markets of the world. We are talking
about sovereign wealth funds holding multiple trillions of dollars having
to liquidate a portion of their assets in order to maintain their
governments. These vehicles were created as the ultimate rainy day fund,
and it is raining hard right now. My personal view is that we will see oil
in the $20s before we see it back in the $50s. By a kind of perverse
logic, the cure for low prices is low prices. It won’t happen overnight,
but oil will reverse. In the meantime, low oil prices mean that sovereign
wealth funds have to liquidate.
But
let’s examine that concept for a moment. Many sovereign wealth funds are
invested in very long-term and illiquid projects. Rightly so – that is what you
should be doing with that sort of money. But that means when you have to
liquidate, you sell what you can, not what you want. And that means funds will
be selling liquid stocks and bonds. By the hundreds of billions of dollars’
worth. That is a lot of selling pressure, much of it in dollars and much of it
in the US.
Unfortunately,
this will happen just as more people realize the US stock market is priced for
a correction. The earnings expectations of many companies are far too
optimistic, and they are running out of financial engineering tools to hide it.
We have gone much too long without an extended correction. I believe we could
see a 15–20% downturn if key companies miss their forecasts.
While
multiple crises blanketing the entire Eurasian continent suggest that dollars
will be flowing into the United States, the sovereign wealth fund need for
liquidation will require the reverse. I defy anyone relying on anything other
than an educated guess to tell me which will be the greater force. (Do Japanese
pension funds continue to liquidate JGBs and buy US and European stocks? In
what size? Do they wait for the markets to settle out? Inquiring minds want to
know.)
Here
is the real question: Can the US have a recession without an inverted yield
curve? This is an ongoing debate I am having with several prominent economists.
I would say yes. Although we have not seen a recession without an inverted
yield curve since World War II, I think we are now in different times, with
different underlying conditions, as noted above.
Zervos and Rosenberg would
argue that the Fed will continue to raise rates until we get the potential for
an inverted yield curve, albeit at a lower rate than we have ever seen. I am
doubtful that the Fed will raise rates more than two or three times this year.
We are going to enter the next recessionary period with interest rates the
lowest they have ever been. I defy you to perform an historical analysis that
sheds light on future conditions under those circumstances. Which is why I’m
concerned about the Fed giving us negative interest rates.
I’m
actually far more concerned about a real bear market in stocks creating the
conditions for a recession. Any of the three potential shocks I listed above
could create a bear market and a US recession. Attention must be paid.
Jim
Grant, who spoke at the same private conference in Hong Kong that I did, said
he was worried that the US is already slipping into recession. I am certainly
not ready to agree with that analysis, but I am not confident enough to
disagree with my friend Doug Kass, who expects that the US will enter recession
before the end of the year.
My base case at the moment is that we will not, but
we will continually teeter on the brink. For all intents and purposes, the
result may feel like a recession. Which suggests to me that the data the Fed
looks at will keep them from raising rates the four times they currently
predict. I still think we will once again see 0% interest rates before we see
2% rates or maybe even 1% rates – depending (I say with a dollop of sarcasm) on
the data.
Looking
beyond China and Europe, Latin America is a wild card. The strain of lower
resource demand from China is beginning to show. Argentina has a new president,
and Brazil may get rid of its current administration. I think we will see some
dramatic swings in Latin American stock, bond, and currency valuations this
year. Venezuela is on the edge of collapse.
Pulling
all the evidence together into a strategy, my own plan is to avoid directional
market exposure as much as possible. We should see plenty of volatility, and
staying on the right side of it will be very difficult. I think certain
targeted technologies will do well – mainly those that enhance productivity.
Human workers will keep losing ground to artificial intelligence algorithms – a
phenomenon that will continue to spread both vertically and horizontally in
2016.
I
intend to direct more of my own assets into the private
credit opportunities I mentioned two weeks ago. Thank you, by the way, to
the many readers who wrote to me about the opportunities you’ve seen. A lot is
happening below the radar, with very promising results so far. I’ll share more
with you as the year unfolds and legal restrictions permit.
Bottom
line for 2016: Don’t tie your fortune to a rising market – and I mean any kind
of market anywhere on the globe. This is a time to think strategically, stay
hedged and diversified, and avoid big directional bets. I think active and
hedged management will be the place to be in the coming period. To quote the
motto of House Stark in Game
of Thrones, winter is coming.
In
summary, while I understand the argument that Zervos and Rosenberg make about
our not entering a recession until there is an inverted yield curve, I do not
believe it.
In the past it is been easy to predict a recession because every
recession since World War II was preceded by an inverted yield curve. With
short-term rates artificially low, we no longer have that indicator. The US
economy is close to stall speed, and a negative nudge could push us into
recession, inverted yield curve or not.
The
average stock market retreat in a recession is around 40%. If the Fed takes us
back to zero rates and, gods forbid, possibly even negative rates, I think we
will see the long bond at 2% and the 10-year below 1%. Think Japan. It’s
counterintuitive in the extreme, but the world is going to be turned upside
down. You are going to get a shot at the lowest mortgage rates of your life.
This year? Next year? If such intricate timing makes a difference to you, you
need to rethink your portfolio balance. Seriously.
Next
week I will look at the forecasts that others have made and comment on them.
Back from Hong Kong
I
normally put a personal note here, but the letter is already overly long, and I
need to hit the send button to get this to my intrepid editors, who will be
working on Sunday.
I want
to thank my hosts at Bank of America Merrill Lynch in Hong Kong for being most
gracious. I believe I learned a great deal more at their conference than
whatever small morsels of knowledge I dished out. The dinner conversations were
sparkling.
I’m looking forward to some biotech startup finding a fix for jet
lag, because I do enjoy getting outside the confines of my home and absorbing
the knowledge and wisdom of those from other backgrounds.
Even
with what is a rather sober forecast issue, I remain an unrepentant optimist
about the future. You have a great week and even better new year! I look
forward to exploring Economicus Terra Incognita together with you. It will be
an adventure!
Your
fellow explorer analyst,
John Mauldin
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