By Danielle DiMartino Booth
“Yes, I have tricks in my pocket, I have things up my sleeve. But I am the opposite of a stage magician. He gives you the illusion that has the appearance of truth. I give you truth in the pleasant disguise of illusion.”
The next time you happen to find yourself at 111 West 44th Street in New York’s theater district, make it a point to gaze up at the haunting image of the illuminated sign for The Glass Menagerie, the play that launched the career of America’s greatest playwright. Maybe you too will recall the unsettling opening lines written in 1944 by Tennessee Williams, spoken by his protagonist, Tom Wingfield. Tom’s words promised to deliver the sort of truths few of us covet, though the play’s entertainment value has clearly withstood the test of time.
If you’re of the rip-the-Band-aid-off philosophy on facing life’s unpleasant realities, pivot on your heel and look across the street, to 110 West 44th Street. Your eyes will be immediately drawn to the less mesmerizing, but equally inescapable, signage gracing the edifice of that building, the U.S. debt clock, that live, unrelenting tally that is marching towards $20 trillion, be we all damned.
One must wonder if Broadway’s denizens see the theater in having these two facades stare one another down, as if taunting the other to wax more fatalistic.
This week, Federal Reserve policymakers will release a policy statement that paints an illusion of prosperity in cold monetarist verbiage that feigns the appearance of truth. The doves’ message will be uncharacteristically hawkish. They will flap their wings about accelerating underlying growth and inflation. They will allude to the time being upon us to normalize interest rates, to come in from a long, brutal winter of artifice.
The truth, you ask? Unconventional monetary policy in the form of zero interest rates and quantitative easing braced an economy that has been and remains fragile. And yet, as evidenced by the most recent bout of euphoria, animal spirits are out in full force.
There are other calendar years ending in the number ‘7’ associated with rampant speculation in asset markets and a strong Fed. Only one of the two proved to be a buying opportunity. The other stands as testament to one of the greatest monetary policy blunders in history.
As was the case in 1936, monetary policy had been manipulated to serve political needs. It’s noteworthy that the form assumed differed from that of recent years: it was huge gold inflows that were being monetized back then, but similarly, interest rates had been held closer to the zero lower bound for a protracted period.
In another parallel, measured goods inflation was conspicuous in its inability to achieve liftoff while that of asset prices was off the charts. (Has it really been 80 years of repeating the same mistake in gauging aggregate price behavior?) Then and now, investors exiled to a yield dessert justified their irrational approach to investing by rhetorically asking, “What’s the alternative?”
Commodities and stocks were the primary target of speculators in the recovery that took hold in 1933. Today, commercial real estate (CRE) and bonds have taken center stage while that of stocks is running a close third depending on your preferred valuation metric.
The latest Moody’s/RCA CPPI aggregate price index for CRE is remarkable. Prices through November, the latest on offer, are up nine percent over the past year. But they are perched 23 percent above their pre-crisis peak, which represents a vertigo-inducing 159 percent recovery of prices’ peak-to-trough losses. Morgan Stanley’s Richard Hill and Jerry Chen helpfully provide perspective on this figure: residential real estate, by comparison, has recovered a mere 80 percent of its losses. As for what’s driving the CRE train, office and industrial properties have taken the lead while, no shock here, retail property prices have begun to decline.
As was the case throughout the housing mania, loose underwriting standards can be credited with initially pushing prices upwards. Add to this lender behavior. Smaller banks, in particular, have aggressively reduced fees to garner market share, raising the ire of Fed regulators alarmed at the growing concentration of banks’ exposure to CRE loans. At last check, banks accounted for nearly half of CRE lending activity, up from 35 percent a few years ago. The good news, unless you’re a seller, is that lending standards have tightened for five consecutive quarters. In response, transaction volumes fell 21 percent in the final three months of last year. Hill and Chen observed that the sales slide, “was unusually high for a period that is typically very active.”
The prima facie evidence on extreme bond market valuation is equally compelling. Rather than delve into specifics on sovereign, corporate and emerging market bonds, we’ll let Deutsche Bank’s math speak for itself. It took a mere eight weeks through early January for the global bond market to rack up $3 trillion in losses. The swiftness of the move placed in stark perspective how hyper-sensitive bonds had become to interest rate moves. Investors should consider themselves warned.
As for stocks, the broadest valuation measure compares the market capitalization of all stocks to gross domestic product. Anything north of 100 percent denotes overvaluation making today’s reading of 127 percent disconcerting. That said, it has been higher – the ratio peaked at 154 percent in 1999 and was 130 percent in late 2015. It was, though, appreciably lower shortly before the stock market tanked. Just before the 2008 crisis, the ratio was at ‘only’ 108 percent. So make your own determination on this count. Does a relatively lower nosebleed valuation give you great comfort?
Looked at from a holistic perspective, the VIX, or so-called fear index, which reflects investors’ comfort level with stocks, flirted with single-digit territory last week. Though it did not break through 10 on the downside, which would have matched its 2007 low, the 10-handle is associated with plenty of daunting history.
“When the VIX is low and yields are falling, stocks do very well,” wrote Citigroup’s Brent Donnelly in a recent report. “When the VIX is low and yields are rising, stocks do poorly.”
That’s intuitive enough. Donnelly then goes on to compare the move in the benchmark 10-year Treasury to moves in stocks over the next 120 days. The sample set he used incorporates instances in which the VIX was less than 11 since 1990. A second step entailed comparing these occurrences to their corresponding three-month moves in the 10-year. Donnelly found that the largest three-month rise had been one standard deviation (you recall the term from Statistics 101, as in the distance from the center point on the bell curve). That is, until today.
“The craziest thing is this: Currently, the three-month rise in 10-year yields is more than 2.5 standard deviations. So based purely on this analysis, the 120-day outlook for U.S. equities is very poor.” The strength of the relationship between yields and future returns suggests stocks will fall by about seven percent over the next three months.
Like it or not, risky assets certainly appear to be sticking to the post-election, honeymoon-is-over script.
The burning question will quickly become one of, how will the Fed react? In its past life, stocks wouldn’t have to give back even 10 percent to trigger the next iteration of quantitative easing riding to the rescue. Listen to the doves’ tough talk today, though, and they sound as if they’re finally comfortable leaving risky assets to their own devices. Politics anyone?
The problem is that perhaps too much like the breakable menagerie of glass animals on display in Tennessee Williams’ play, borrowers of all stripes have amassed a veritable collection of debts throughout the market acts playing out since the Fed first lowered interest rates to the zero bound.
In an economy contingent upon conspicuous consumption, it won’t take much for the Fed to bring on a recession. The recent downtick in the personal saving rate is no cause for alarm on its own. Combine it with the steady increase in credit card spending – inflation-adjusted credit card spending has outpaced that of income growth for over a year now — and you quickly understand just how dependent continued gains in consumption are on interest rates not rising.
It’s been a mighty long time, eight years to be exact, since paper gains eviscerated the net worth of U.S. retirement savings in its various 401k, IRA and pension forms. Factor in the demographic backdrop, however, and know it won’t take long for investors to tune in to just how precious their non-yielding cash has become.
Perhaps the best news is that all heretical arguments in favor of the abolishment of cash necessarily go by the wayside during times of tightening financial conditions. After all, economic theory advocates the destruction of cash for the purpose of forcing hoarded money back into the economy. Even the illusionists at the Fed, hellbent as they are in their insistence that the economy is overheating, cannot square that circle.