Where Is The Ammo?

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Economies expand and contract as part of a natural economic cycle… growth, boom, slowdown, recession, recovery… repeat. The magnitude of the ups and downs changes, but not the cycle itself.

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Since, and including, the Great Depression of 1929, the U.S. has been through a total of 14 economic recessions – defined by the National Bureau of Economic Research (NBER) as “a significant decline in economic activity spread across the economy, lasting more than two quarters which is 6 months, normally visible in real gross domestic product (GDP), real income, employment, industrial production, and wholesale-retail sales”.

The average gap between these economic contractions has been just under five years. The U.S. emerged from the last recession in the quarter ending December 31, 2009 – which is nearly eight years ago.

The NBER subsequently determined that the U.S. “trough” (that is, the lowest point) in business activity occurred in June 2009. This marked the end of the “Great Recession” that began nearly a decade ago in December 2007, and at 18 months in duration. It was the longest recession since World War II.

The average “trough to trough” of U.S. economic cycles, dating all the way back to 1919, is a little over 5.3 years. If we look at the post-World War II era, it’s around 5.8 years.

As per the chart below, some of the more recent periods of economic expansion have been longer, leading to bigger gaps between economic troughs. But even if you take the average of the last seven cycles (i.e., starting in 1970), the average is still less than seven years between troughs.


And where are we now? Well we’re at over eight and a half years and counting since the last trough – a lot longer than the average.

Why does that matter?

At the risk of stating the obvious, economies evolve in cycles (hence, the “economic cycle” and the “business cycle”). If you want a better understanding of why this is the case, then I strongly recommend that you spend thirty minutes watching “How the Economic Machine Works”, by founder of hedge fund giant Bridgewater Associates Ray Dalio.

I’d go so far as to say it’s compulsory viewing for anyone with more than a passing interest in financial markets. I’ll tag back to Mr. Dalio a bit later.

When you look at the history of U.S. economic cycles, and where we are now, it’s hardly a contrarian observation to point out that we are closer to the start of the next U.S. recession, than we are to the depths of the last one.

Nobody knows for sure. But it feels a bit like nobody’s really paying much attention to this simple historical fact. Perhaps a large part of this is because it’s taken a full decade for U.S. median real (inflation adjusted) household income to surpass where it was back in 2007.

In other words, the average American family is likely still waiting for a recovery – not battening down the hatches and getting ready for the next downturn.

Where’s the ammo?

Central banks and politicians fight economic downturns using an array of tools. And their response is typically proportional to the severity of the recession.

In the Great Recession ending in 2009, we saw a global co-ordinated response unlike any other in history. Interest rates around the world plummeted. In the U.S., the Federal Reserve cut interest rates from over five percent, to zero in the course of just over a year.

Coupled with that, we saw an unprecedented surge of money printing as the Fed expanded its balance sheet (by creating money and buying assets) from a little over US$800 billion to over US$4.4 trillion today, along with a wholesale bailout of the banking system.

The problem is, that ammunition – the five percent of interest rate reduction and trillions of dollars of monetary stimulation – has been spent. It’s taken most of a decade for the Fed to inch interest rates back up to a little over one percent today. And the Fed have only just begun to start the process of unwinding its balance sheet (i.e., letting assets on its books mature and repay principal, and not repurchase more assets).

The Fed knows it’s running low on ammo…

Back in July, I talked about how John C. Williams, the president of the Federal Reserve Bank of San Francisco, had shared a very dim view of the capacity of the Fed to spur much if any more economic growth. He said:

“As a monetary policymaker, I wish I could tell you that it’s within the purview of central banks to solve all this, that the answer lies in raising or lowering interest rates.

Reality, unfortunately, dictates otherwise.

Our long-term challenges are going to require the sort of long-term investments that fiscal policymakers—and private investors—have within their own toolkits: investments in education, job training, infrastructure, research and development… all the things that propel an economy and prosperity over the longer term.”


An early-warning sign

We have a financial market that is stretched, from a valuation perspective, on all fronts.

The benchmark S&P 500 equity index trades at a forward price-earnings ratio of 19.4 times, above the roughly 18 times multiple we saw at the height of the Global Financial Crisis (GFC).

Ten-year treasuries yield 2.4 percent, just 0.2 percent above their five-year average.

Thirty-year yields at 2.85 percent have back from the three-plus percentage yields we saw in the first quarter of the year.

And what’s particularly of note is the persistent flattening of the U.S. treasury yield curve.

We measure the steepness of the yield curve by subtracting the 10-year (or 30-year) treasury yield from the 2-year (or 10-year) one.

Why is this important? Well, a steep yield curve (where longer-term rates are higher than shorter-term ones) represents a healthy economy. The spread between short and long-term rates represents higher inflation expectations in the future, which is why longer-term investors need a relatively higher return, to compensate them for inflation.

A steep curve also implies a path of rising interest rates, which are usually associated with a strengthening economy. As the economy starts to do well, central banks typically raise rates in response, raising the cost of borrowing and generally keeping economic growth positive but stable, reducing the risk of “overheating”.

A flat or flattening curve implies the opposite. Investors don’t see much more economic growth on the horizon or much in the way of interest rate increases that would accompany it. Likewise, they don’t see much inflation (itself a by-product of a healthily expanding economy).


As you can see above, the U.S. yield curve, on both the 30 minus 10 and 10 minus 2 parts of the curve, has been consistently flattening over the past five years.

What’s more, if you take a look back to the historical 10 minus 2 year spread, you can see that a flattening or inverted curve, where short-term rates are higher than long-term, is what we see in the lead-up to and during economic recessions.

We saw this in the lead-up to recessions in 2007, 2001, 1990 and 1980.


Is a downturn imminent?

No. But the clock is ticking…

What I’m trying to point out is that we’re nearing the end of this economic cycle. And we’re doing so at a stage where equity market valuations are near all-time highs, the bond market is telling us it’s bearish on the economy, and with rates so low already, and a swollen Fed balance sheet, policymakers simply don’t have a lot of ammunition to deal with anything more severe than a mild recession.

How do you protect yourself? Well, it’s not easy in this environment. But Ray Dalio, one of the all-time macro investing greats, has been saying to buy gold for a while now, recommending anywhere from five to 10 percent of your portfolio be in gold. We’ve recommended likewise on several occasions, either through physical holdings, or through an ETF like the SPDR Gold Shares ETF (New York Stock Exchange; ticker: GLD, Singapore Stock Exchange; ticker: O87 or Hong Kong Stock Exchange; ticker: 2840)

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