Two sides of economy - Recession or Growth

Bonds & stocks (so called risk assets) always have a interesting relationship. Even Benjamin Graham (Father of value investing) talked in great detail,  about the ratio of stocks to bonds in a successful portfolio. There is a inverse relation between bonds & risk assets, at least it used to be. Even many Quant funds, which balance there portfolio based on the bond or stock volatility, uses this inverse relationship. But now we are living in fascinating times, when stock loses the most when yield is tanking (of course besides the trade news).

This is because of the amount of debt already in the world.  To put that in perspective -

"World's debt exceeding 320%  of its economic output "
                                                                                 ----Barron's cover 8/10/2019     


Even with record amount of debt, economic outlook is weak. This is already seen by slumping bond yields. Around $ 15 trillion of government yield pay less than zero ! That means, lender has to pay to borrower. Danish Bank is offering negative mortgage bonds so they pay you for your home mortgage. Even on 30 year (German) / 50 year (Swiss) bonds are in negative territory.10 year US Treasury yields 1.74 % ( Down from 2.62% from Jan 2 2019). And they are on a downward path.

Usually that much negative sentiment is associated with a impending recession. Just before last recession, it was around 4.60s in 2017. Cutting interest rate is a important tool in central Bank toolkit to fight recession and revive growth. So they had ample room to cut. Now the 10-year in 1.70s % and recession haven't started yet. Pretty much all the Central Banks are cutting rate (more than expected in some case), reviving growth would be a tough job for them in case of a upcoming recession.

We are in historic bull market (10 year +) since last recession in 2007 (because of the subprime mortgage crisis). Growth was extremely slow and because of that,  Central Banks didn't raise rates for a long time. FED in US started raising just 3 years ago (they already cut 25 basis point last month, 25 basis cut is coming in next one/two month). Because of low interest policy, risk assets got inflated because there is no other alternative (TINA) for getting yield. Low yields also motivated companies to borrow (record levels) here in US & around the world. Majorly of that capital was/is being used for buybacks which in turn inflated equities.    

This all makes me wonder how bad would be the next recession and how Central Banks will fight it ?

Many economist are predicting a recession in end of 2020. Global growth is already weakening and with US-China trade issues,  growth will slow down more than expected. According to IMF -

"After strong growth in 2017 and early 2018, global economic activity slowed notably in the second half of last year, reflecting a confluence of factors affecting major economies. Global growth is now projected to slow from 3.6 percent in 2018 to 3.2 percent in 2019(0.1 lower from April 2019), before returning to 3.5 percent in 2020."         

In my opinion, all this means is we will be in low-interest environment for a very long time. That doesn't mean recession in 2020, recession can be in 2020 or not for many years.But one thing is for sure - when the next recession hits, it would be really difficult  to get out of it.

I believe the cause of next recession will be  "cooperation debt" especially -junk rated bonds. As long as the interest rates are down, it's fine to borrow more ( as long as you can pay off the interest with revenue, they are fine.  That's why debt to cash flow ratio is extremely useful). But once the rates go up, like in 2017 & 2018 (when FED was hiking),  its difficult to pay off the interest. Also there is another risk ( stronger dollar ) if you are a emerging country company who borrowed in dollar or your sales are in emerging market, it will cost you more to pay off debt or principal.
With so many countries issuing more government debt ( FED is issuing more to fund the last year tax cut), there is a risk of interest rate shooting up unless FED and other central bankers stepped in and start buying ( quantitative easing ) .In the last 10 year bonds auction -  There was not that much demand so yield shoot up almost 5-10 basis point.

But on the other hand there is a demand of existing government debt if there is a geopolitical tension or risk of recession as explained in my previous post - " bonds signal trouble ahead".

So if we are in a late cycle or there is a risk of global recession or trade risk , low yield debt will work and companies can borrow more to support buybacks or mergers.But what happens when these risk subsides - for example trade issues are resolved between China - US . Yield will come up since consumer is healthy and spending in US. And employment rate is at record low.And Low interest rates is a catalyst to growth as we know. 

All this will lead to a 2018 equity and volatility story and risk assets will be plummeted. If this turns into recession , this will be a deep one. 

This is just one side of story. The other side is Tech trends. With 5G & autonomous driving on the horizon, it's hard to ignore the transformation & growth, that they will bring. For example, 5G means more semiconductor content in many devices.  5G means new phones. Recently all major U.S carriers started offering 5g plans. It's very very limited and their are many bottlenecks. But things will get better with time.

Total sales of semiconductors reached $98.2 billion during the second quarter of 2019, although a small increase of 0.3 percent over the previous quarter, but 16.8 percent less than the second quarter of last year. 2017 & 2018 saw a huge increase the sales of semiconductor. Companies added more capacity for these transformation trends. According to Lam research, ( one of semiconductor equipment maker)

2019 WFE (wafer fabrication equipment ) expected to be down in mid to high teens % from 2018.      June quarter earnings

I think this is a result of already added capacity by its customers in 2017 & 2018.   New wave of jobs that we don't even imagine at this time ( my parents never imagine the job that I am doing now can exist ). But these changes occur eventually. For example even with a dot com bubble, we saw a recession in 2001/2002. The point is with a bad economy,  these tread will be delayed because companies won't be able to invest as much they should for these trends.

 I think recession depends upon how many lay-offs can the market consume.So if there is more bankruptcies ( more layoffs), it will hard for the job market to consume that. Ultimately this will turn into growth contraction -RECESSION. So at any cost FED and other central banks wants to avoid this contraction situation because even a mild one can turn into a ugly and deep recession. So it could be possible that FED will start cutting rates aggressively if we see a mild recession and since there is lackluster demand for treasury from international sources ( mainly china - they are buying gold), they might start buying bonds ( Quantitative easing). 

This is good news for bonds investors but then again economy is doing good and employment is at record low so this doesn't justify such low bond yields. That's why I said these are FASCINATING times...

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