“The initial conditions or the starting point conditions, mean to me that a small degree of
monetary restraint has a very quick and strong impact on economic activity.”
– Lacy H. Hunt, Ph.D., Hoisington Investment Management
2017 Strategic Investment Conference
Lacy stepped center stage. His presence demanded attention. An economist. A seasoned money manager. He has skin in the game and owns one of the best long-term investment track records in mutual fund history. Lacy argued that recession is nearing and interest rates are headed even lower. There is opportunity for profit should interest rates move lower (bond prices higher) and there is that near -40% average loss that has stung equity investors in past recessions. Today, I share my high level notes from Lacy’s presentation along with supporting charts. I try my best to be concise and to the point. Lacy began,
Economics is a science. Not precise like chemistry and physics. We have the capabilities of testing hypotheses to determine if propositions are valid. Being a science, the advances in technology changes our understanding over time. In fact, most of the macroeconomic propositions I was taught when I was a graduate student in the 1960s have been completely overturned. It is important to embrace the technological change that has taken place.
For example, in 1776, the founder of modern economics, Adam Smith, said price equals labor cost… nothing more nothing less. It took 120 years for Alfred Marshall to demonstrate that price is determined by the intersection of demand and supply.
In keeping with that spirit, here is my hypothesis. The monetary restraint already in place is a more potent force than any fiscal actions that can be taken if they are funded by new debt.”
What Lacy is saying is that the starting point conditions (where we are today) of ultra-low interest rates, a $4.5 billion Fed balance sheet and 372% debt-to-GDP, means that a small degree of monetary restraint (Fed raising interest rates and exiting Quantitative Easing (QE)) has a very quick impact on economic activity.
The Fed has now raised rates three times and another hike is probable in June. We are living through an unprecedented economic experiment. Japan is 11 years ahead of the U.S. and the U.S. is a handful of years ahead of the European Union. Either central bankers have gone completely mad or they’ll someday be hailed as geniuses. I find myself in the “mad” camp and I hope I’m wrong.
You and I have a front row seat. We get to watch the experiment play out. Beautiful or ugly? Many moving parts. We just don’t yet know.
In the very near term, we’ll get to see if Lacy’s hypothesis proves correct. Personally, I think he is right.
At the start of each new month, I typically share with you the most current valuation metrics and data that indicates what probable forward returns are likely to be. Valuations remain at the second most overvalued level in history and forward 7- and 10-year annualized returns are in the 0% to 4% range before inflation. Talk about lousy “starting point conditions.” Let’s take a pass on the valuation charts this week.
When you click through below you’ll find my detailed notes from Dr. Hunt’s presentation, along with select slides. For example, there have been 11 recessions since 1945. Without exception, a Fed tightening cycle preceded every single recession. The Fed has increased rates three times since December 2015. Number four is probable this month.
Lacy says the Fed is doing the wrong thing at the wrong time. I hope you enjoy the notes. It’s time to play defense. Grab that coffee and find your favorite chair – let’s jump in.
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Included in this week’s On My Radar:
- Lacy H. Hunt, Ph.D. – Will Monetary Restraint Overcome the Administration’s Proposed Economic Initiatives?
- Trade Signals — S&P 500 Up 8.7% YTD; Trend Evidence Remains Bullish
- Personal Note
Lacy H. Hunt, Ph.D. – Will Monetary Restraint Overcome the Administration’s Proposed Economic Initiatives?
Notes in bullet point format along with selected charts:
Chart 1 – The Federal Funds Rate (historical facts around tightening cycles)
- What you see here (Chart 1) is that there have been 11 recessions since 1945 (11 vertical gray shaded lines).
- Without exception, every single recession since 1945 was preceded by a monetary tightening cycle before the recession (also note the total number of rate hikes).
- There were a total of 14 tightening cycles since 1945. There were only three instances when a tightening cycle occurred and there was no recession: November 1968 (when the economy was in its 69th month of expansion); August 1984 (when the Fed reversed course and lowered rates in the 21st month of that expansion cycle that started in 1982) and the Fed reversed course in the 50th month of the expansion cycle that started in 1991.
- We are now in the 94th month of the current expansion and that means a great deal.
- Even though it is the worse expansion on record, it is a long expansion. And in long expansions, pent-up demand is exhausted.
- Pent-up demand is one of the most critical concepts in economics. And we see the telltale signs everywhere:
- Heavy price cuts on new automobiles
- Fall in used car prices
- Building overhang in the apartment sector
- A beginning decline in those rents
- More significant drops in the rents of retail properties
- Signs of excess capacity in the manufacturing sector
- And here is the point:
- Late stage tightenings have never avoided a recession because the economy is so frail once the pent-up demand is exhausted.
Chart 2 – A look at 1915 to 1945
- We can go back from 1945 to 1915 and see, too, that in every single case when the Fed tightened, the economy collapsed and a recession occurred.
- Lacy points to the Great Depression era as a parallel to today, noting the mistake that was made in late 1936 when the Fed tightened seven times. He believes they are making the same mistake today (supported by evidence he presented that follows in my notes below).
Chart 3 – A Look at Initial Conditions
- Why is the current Federal Reserve tightening special? This is not ordinary run-of-the-mill.
- The first initial condition is that top-line growth is decelerating sharply (red dot in chart). Notice it was already decelerating when the Fed first tightened in December 2015. Notice that top-line growth was weaker than at the trough of the recession in 2001 and also in 1991.
- The Federal Reserve is hitting the brakes with indications in our very best economic indicator.
- Hunt’s view is that nominal growth is coming down to 2%.
- When nominal growth is coming down, it is not credible to believe that corporations and households are doing better.
- Yes, 500 elite stocks are having an improvement in earnings, but all that serves to demonstrate is that the