Debt By Country Relative To GDP - "Go Grab A Prozac" Before You View This Chart

“Don’t be afraid of change for it is the catalyst of opportunity.”
– Unknown

We want it short, we want it easy to understand and we want it right. Here’s my best guess:

U.S. stocks will remain in an uptrend fueled by a strong dollar
Tax cuts, infrastructure spending and $2 trillion in tax repatriation will drive capital flows to the U.S.
The European sovereign debt crisis will be the first major crack to crack. Unmanageable debt in Portugal, Italy, Greece and S Include France and Germany in their dysfunctional union. Confidence in government/political leadership is lost.
The European banks sit on the fault line. Watch the banks. Hope so… Not so sure.
The smart money races out of EU banks to U.S. dollars and U.S. assets.
In China, debt too is the major concern. Ghost cities lacking rental income will prove unable to support the structured debt that financed the construction. Defaults mount.
Drastic measures are put in place to prevent the flow out capital to the U.S.
Gates, tariffs, currency wars escalate – trade wars escalate.
Loss of confidence in government here, there and most everywhere.
Global and U.S. inflation become a major concern as global growth remains well below the average of the last six post-recession expansions (great chart below).
Stagflation returns. Low growth/high inflation. Interest rates move higher with the 10-year touching 3% this year and 6% within a few short years.
The great bond bull market is over. Bond investors lose money.

I hate making predictions. I got the tech wreak and sub-prime right, but was far too early on those predictions. Importantly, the above could most certainly be wrong. It’s a highly complex world. We can measure instability, we can score up risk but we can’t precisely know timing. Tech made no sense, sub-prime was easy to see. The clear risk to me today is in the bond market.

We can all see that interest rates at 5,000-year lows and negative rates in many places are unattractive. But it is curious as to why record amounts of hard earned investor capital chased into bonds last year. A secular bond market top? Likely, in my view.

We can understand human tendencies (e.g., herd mentality), we can measure market valuations, we can measure degrees of risk and we can identify trends. We can get pretty close on probable future 10-year returns but we can’t know what will happen this year, how it will happen (good or bad) or when it might happen.

I have some really great charts for you today. You are going to see charts on debt, recession probabilities and inflation risk.

Let’s first take a look at debt by country relative to GDP. Recall that debt north of 90% of GDP is identified by academics as the point in which growth becomes impacted. To give you a sense of just how deep a debt hole we are in, go grab a Prozac and then take a look at this next chart:

Source: Ned Davis Research (includes disclosure)

If 90% is the line in the sand, what do we do with 335.4%, or 577% or 469.5%? It’s pretty safe to say that debt is our greatest global issue. We must find a way to deleverage, restructure, and default. It is not sustainable and, as you’ll see next, the evidence visible.

In a picture, this next chart is the proof statement that debt has become a drag on growth.

Here’s how you read the chart:

The dotted red line shows the average of the last six post-World War II expansions.
The start date begins at the end of the last recession (vertical black line) in June 2009.
Comparisons are from prior recession end dates – right of vertical black line.
The solid blue line shows the path of the current expansion.
The 2001 expansion and the 1981 expansions are also plotted.
Simply look at the path of the dotted red line vs. the solid blue line.
In my view, debt is the drag on the economy.

Source: Ned Davis Research (includes disclosure)

Here’s my call: We are at the end of a long-term leveraging up cycle and the beginning of a long-term secular deleveraging cycle. I think that this is the most important global macro big picture issue for you and me to understand.

Stocks may continue to rally this year and I think they will; however, equities are expensively priced and the cyclical bull market is aged. A rally in stocks doesn’t mean we should avert our heads. A simple 10% correction takes the S&P 500 Index (stocks) annualized returns back to 0%. That’s in zero over the prior three years.

Just how aged is the current bull market? I found the following from John Hussman to be interesting in a piece called “The Economic Risk of Ignoring Arithmetic.”

The stock market bubble that ended with the September 1929 peak began in August 1921, running just a few days beyond 8 years in duration.

The bubble that ended with the March 2000 peak began in October 1990, running fully 9 years and 5 months in duration.

Those two episodes represent the longest bull markets in U.S. history.

The current half-cycle began at the March 2009 low, and has now run 7 years and 10 months in duration, making it the third-longest advance in history, placing it just 2 months short of the 1929 instance, but a full year and 7 months short of the 2000 instance.

Big picture? Got it… debt’s a drag. Big picture? Got it… the bull market’s overpriced and aged. Big picture? Got it… ultra-low yielding bonds and the size of debt outstanding makes the bond market the king of all bubbles.

And speaking of bonds and bond kings, let’s jump back into that prediction thing. Did you catch Bill Gross on Bloomberg’s Surveillance last Friday? The “bond king” said that 2.60% on the 10-year Treasury is “the most important level for the markets this year.” Maybe he’s right.

Some say the current bond king is Jeffrey Gundlach. Let’s call him King II. King II is saying that 3% is the problem threshold.

My friends at Ned Davis Research put out a nice piece this week saying 2.76% (red arrow next chart) is the most important level. The reason? That’s the point at which yields cross above the long-term dotted trend line.

Source: Ned Davis Research (includes disclosure)

Take a look at the chart again. Note the series of lower highs. For example, in late 1987 the yield peaked at 10.23%. It then made a series of lower highs with each lower high failing to move above the long-term trend line. Also note the series of lower lows with the lowest low touching 1.37% last June 2016. I think the line in the sand is 3.04% (circled in red on the chart). That point would confirm a break above the long-term down trend (dotted upper line).

My friend Lacy Hunt believes interest rates are ultimately headed lower. Call it 1% on the 10-year Treasury and something like 2% on the 30-year Treasury. He’s a smart player who’s been winning at the fixed income poker table for a very long time. So I take note. Lacy says growth and inflation will remain low. He says, “The secular downward trend in Treasury bond yields is still intact.” I share his quarterly letter with you below.

So back to this “prediction” thing with some thoughts about what you might do. Predictions often turn out to be wrong and most prognosticators will remind you past performance means nothing. We live in a complex world with many moving parts.

My best example of what’s wrong with predictions is this:

In December of 2014, 25 out of 26 economists thought that the yield on the 10-year Treasury Note would rise from 2.75% to 3.25%. The low estimate was 3% and the high was north of 3.50%. I too felt rates would rise. We were all wrong. The yield finished 2015 at 2.25%. It was an exceptionally strong year to be invested in Treasury bonds.

The best and brightest missed one of the single best performing years for the bond market! Despite my higher rate view, the Zweig Bond Model (trend based) said to stay invested in bonds. So I did.

Twenty-five of the twenty-six lost out. If you follow my “Trade Signals” blog, you’ll know we stayed invested in long-dated bond funds and ETFs. And that’s my point. Find a risk management process that works for you. When to shorten exposure (reduce risk) and when to put risk back on. With rates so low, my best two cents is to encourage you to diversify to several fixed income ETF trading strategies.

My belief is that most of what we need to know is imbedded in price. Let the “trend be your friend” as the saying goes. Some religiously stick to buy-and-hold. That’s ok over 30 years if you can do it. It’s not ok if you get run over by a 50% market correction if you are a pre-retiree or retired.

Your average client thinks you should know exactly what is going to happen and when. However, far too many expert predictions turn out to be wrong. What would have caused any of the 25 Wall Street economists to get back into longer-dated bonds in 2015?

What’s my point? Investing is a probability and risk management game. Complexity exists. As the great Paul Tudor Jones once said, “If trading is like chess, then macro is like three-dimensional chess.” View all predictions will both eyes open.

Keep a close eye on the broader markets trends (equities and fixed income). You’ll see in the “Trade Signals” post that the equity market trend remains strong and the fixed income market trend remains bearish. The high yield bond market remains in a buy signal.

The macro challenges remain. Debt tops the list. It is pretty clear that we are going to get change. Like it or not, we have a disrupting force who will take the oath of office next week.

“Don’t be afraid of change for it is the catalyst of opportunity.”

I’m not sure when the bull market peaks, but I do know that recessions are when all the bad stuff happens. We tend to get one or two recessions per decade. The last two were in 2001 and 2008/09. I keep front of mind Jones’ sage advice, “At the end of the day, the most important thing is how good you are at risk control.”

So grab a coffee and find your favorite chair. The balance of this week’s OMR is a quick read. You’ll find a few pretty cool “recession watch” charts below and an interesting chart that is currently signaling “high inflation risk.”

Rising interest rates may be the most important trend for us to keep our eye on. If you owe a lot of debt and your interest rate rises, so does your monthly payment. That’s not a good thing when collectively debt in the developed world is north of 300%. Change and opportunity. Complex indeed.

Also take a look at the latest “Trade Signals.” I tried to reorganize the flow so that it reads easier (dashboard of latest signals at the top). Let me know what you think.

I hope you find this week’s post helpful for you personally and for your work with your clients. It sure helps me to spend the time to put my thoughts to paper. Thank you for spending your time with me each week. Very much appreciated!

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Included in this week’s On My Radar:

My Favorite Recession Risk Probability Charts
Inflation Risk is High
Trade Signals – Rising Inflation, Low Probability of Global and U.S. Recession, Equity Cyclical Bull Trend Remains in Place

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