Fully 1.4% of the 2.0% average annual real GDP growth observed since the beginning of 2010 has been driven by growth in civilian employment. As slack labor capacity has slowly been reduced, the unemployment rate has dropped from 10% to just 4.4%. That jig is up.
While there are bright spots, without major reforms the economy will drift lower, toward stall speed. Any outside shock – and several may be in the offing – could push us into recession.
Performance in the bond market in the first half of 2017 was characterized by a lack of inflation, optimism about economic growth reflected in both equity markets and credit spreads and a seemingly insatiable demand for yield.
Understanding the interplay between credit and finance is critical to recognizing the signs of economic distress. Yet this was precisely the failure that plagued economic analysis leading up to the financial crisis. Let’s take a look at the recent history of credit, finance and the underlying nature of market stability.
We are at the far edge of a monumental mesa here, but speculators are ignoring the cliff, assuming that they are on a permanently high plateau. The unfortunate aspect of these mesas and valleys is that they encourage backward-looking investors to believe that projected returns based on “old valuation measures” are no longer relevant, precisely when valuations are most informative about future returns.
The first half of 2017 is shaping up to be unequivocally brutal for value-oriented rebalancing strategies. Wired to avoid pain, we humans know it’s very tempting to ask whether a model or philosophy is broken, especially the moment it dashes expectations.
Put simply, with market internals unfavorable and interest rates off the zero bound, the two main supports that made the half-cycle since 2009 “different” have already been kicked away.
When a person or an organization fails – and of course we all do – the best response is to show some humility, identify the problem, and modify the strategy. The Fed is doing the opposite.
MSCI has announced that China A-shares will be included in its emerging-market (EM) index next year, as we anticipated. Now, global equity investors need to consider how to access the vast universe of stocks traded onshore in China.
The Fed does not have to make guesses about exactly what is required to normalize its balance sheet, except to the extent that it ignores a century of evidence.