In the midst of a nine-year economic expansion, popular market sentiment is confident, while medium-term uncertainty on financial obligations loom. Additionally, long term dollar hegemony looks increasingly uncertain with rising sovereign competition in economic growth and credit worthiness.
“The narrative that stocks are overvalued comes from the [robust] price action in 2017 and tinged by the justified cynicism following The Great Financial Crisis (GFC),” New College alumni Matthias Murray (‘11), told the Tangent in an email interview. Murray said that U.S. dollar depreciation last year increased the dollar value of stocks.
“Banks with a large deposit base will benefit from rising interest rates as they will be more profitable in this environment,” Murray said. “As the Federal Reserve raises short term borrowing rates, acquiring new money for loans becomes more expensive for banks, but the resultant increase in rates on consumer loans is greater. The widening of this spread in rates results in higher profit margins on loan making activity, as long as rates are not extreme and economic activity progresses somewhat normally otherwise.”
Murray also noted that investment banks, whose earnings have suffered for years on the lower volatility, will, too, see increased profits as the monetary authority tightens credit. Markets have already responded with volatility to the Fed’s policy in recent weeks.
“Anybody paying attention to the Chicago Board Options Exchange Volatility Index (VIX) will know we had our black swan event in early February–Feb. 5, 2018,” Murray said. “Traders who bet against low short-term volatility were wiped out as markets went from months of sub-one percent moves in the market to daily moves of one to three percent in either direction.” But Murray still holds that interest rates have a ways to go–upward–before markets react significantly.
Trump’s trade wars
“Though the President makes a lot of noise about the North American Free Trade Agreement (NAFTA), Mexico and Canada–and I am certain some change will happen with NAFTA–China is a more primary focus,” New College alum and fund manager Henry Smyth (‘81) told the Tangent in an interview.
“The 1997 asian debt crisis was a wake up call for China–in an unfavorable financial and economic position under dollar-western hegemony,” Smyth said. He pointed out that now eastern countries have gone on the economic offense–the $5 trillion One Belt One Road project on the Eurasian landmass as the prime example.
However, Smyth notes that with the unpredictability of the new administration, it is hard to predict where policy will end up. There are contextual inconsistencies with Trump’s plans.
“The President conflates trade and Chinese steel importation with national security,” Smyth said. “In reality, there are many other rare-earth elements that we need for the security of our national industries, which are too found in China.” Likewise, professor and author Michael Hudson pointed out in an interview on Keiser Report on Mar. 13, that tariffs have traditionally been used successfully by well-developed countries which import cheap raw material and export high-taxed processed goods. Trump’s steel tariffs do the exact opposite and parallel the U.S. deindustrialization trend of the past 40 years which his–and Pres. Reagan’s– “MAGA” campaign slogan rhetorically combated to draw large support bases.
The ETF effect and ignored counterparty risk
“Exchange-Traded Funds (ETFs) are tradable securities that track whole indexes. They tend to drag worse performing stocks up in a popular index and pull higher performers down due to the overall valuation metrics of the index funds reflecting the a weighted average of holdings,” Murray said. “There is technologically-based risk, where the drop of one company could drop unrelated and unhurt companies. This would be exacerbated by algorithmic trading methods–resulting in flash crashes.
“The London Inter-bank Offered Rate-Overnight Indexed Swap (Libor-OIS) rate spread signals counterparty risk–the risk of both sides of a financial transaction not living up to their obligations–throughout international credit markets,” Smyth said.
“A rising Libor-OIS spread tells us that the Fed wants to raise interests rates based on growing inflationary expectations, and that credit risk–thus counterparty risk–is growing in the markets too. The GFC’s cause is an example of ignored counterparty risk, wherein credit default swaps (CDS) went bad between Wall Street and international banks,” Smyth explained. “The complexity in credit markets matters as well.”
Whereas the 1987 crash was merely a stock sell off in one day, the GFC was initiated by parties’ failure to satisfy financial obligations in an interconnected network, causing insolvency in financial institutions, nonfinancial corporations and even sovereign nations on an international scale.
“Janet Yellen said that reducing the Fed’s balance sheet–original stimulus for post-GFC economic growth–will be like watching paint dry, but history has shown these things do not work like that,” Smyth said. “The past has shown that credit will expand in every space available to it. It will seek to expand even in spaces that are even denied to it. Across time and space, there is a tendency for leverage to expand. But once it cannot anymore, the expansion will not plateau, it will collapse.”
“The question to ask if we think equity markets are currently overvalued, is how these price levels sustain themselves regardless of what we think,” New College alum and author of interfluidity.com, Steve Waldman (‘88) told the Tangent over the phone. “Once upon a time the stock market was a competition between stock pickers with a common understanding that if you choose wrong, you lose.
“Now we tell the public, especially younger investors, to put all their money in consolidated stock indexes–treating them as pseudo-long-term savings accounts,” Waldman continued, implying this development rendered the stock market less sensitive to traditional, fundamental valuations and potentially more prone to bubbles and crashes.
“The Fed is of two minds. It doesn’t want to be perceived as creating a safety net for equity investors, but it always acts sharply in times of crisis and always justifies their actions as saving the economy,” Waldman said. “In the last decades, our political system has been more aggressively pro-stock market.”
“The Fed wants to pretend it has options, but now by virtue of QE, it has now tied its fate with the fixed-income market in the U.S.,” Smyth said in agreement with Waldman. “It will continue to reduce its balance sheet until the credit markets capitulate, and this event could originate anywhere, most likely where we are not expecting.
“One of the fastest growing areas in the credit markets is student loan debt. Securitized student loan debt is in every bond portfolio of every bond fund because of the implicit [insurance] guarantee by the government,” Smyth continued. Current student debt is at $1.5 trillion according to 2017 data from Federal Reserve Economic Data (FRED), which is on par with the similarly large junk-bond credit market. He noted that “monetary authorities will not give the warning. If they do, they will be blamed for it–the last thing they want–and it is true for other central banks too.”
“I went through the Latin American sovereign debt crisis of the 1980s and 1990s,” Smyth said. “I saw first hand how this operates, the various attempts to resolve it and the attempts to lay the blame on the sovereign borrowers. But no party was innocent, and that is as true then as it is true now. The difference is that back in that day, if you had worries about Latin American sovereign debt, you could always go to the safety of the U.S. dollar, the Swiss Franc, the Deutsche Mark–then ultimately the Euro.” Now, there is so much leverage embedded in these so called safe havens, that option is now constricted if not eliminated.
“Over the last few Democratic and Republican administrations, our leaders have made long-term decisions that have put your generation at considerable risk,” Smyth said to students in particular. The U.S. public debt is currently at $20 trillion and growing, according to usdebtclock.org, and there are $49 trillion in unfunded liabilities for government social insurance programs like Social Security and Medicare, according to the 2017 Financial Report of the United States Government.
Our country has complimentary issues, like rampant inequality–predominantly owed to capital income gains–income made from owning and investing large capital wealth for investment. Waldman pointed out that the millennial generation is even more economically bifurcated than generations before, and–like always–financial markets are the conduit for this trend. He portends that unless market and government leaders make more gradual adjustments to our current concentrated market and distributional structure, eventually a swift re-organization of politics and the economy may take place.
Information gathered by Keiser Report, Federal Reserve Economic Data (FRED), usdebtclock.org, Bloomberg and 2016 Financial Report of the United States Government