Financial markets are currently, according to my judgment, committing three important mistakes. These three mistakes imply that asset prices currently are – again, according to my judgment – also mistaken. Some asset classes are rather expensive, whereas other asset classes seem to offer better opportunities. The three mistakes that I want to highlight this week, are leading to (a) too high stock market prices, (b) too low gold prices, and (c) too high debt levels.
“Mr Market” was the way by which Warren Buffett’s mentor, the belated Benjamin Graham (author of The Intelligent Investor), tried to personify capital markets. As Buffett remarks, we should see the market as a helpful fellow who constantly throws price quotations at our heads. Every day, “Mr Market” stops by to give you a price quotation, against which you can either acquire an interest in a business or against which Mr Market is willing to acquire your interest. Curiously, this poor fellow suffers from irreparable psychological troubles and inexplicable mood swings: on some days, Mr Market feels euphoric and tends to look exclusively at the bright side of things and, as a result, is only willing to give up his interest in a business when the price offered is high enough.
On other days, however, Mr Market is sad and depressed, and his market outlook becomes rather pessimistic. On his bad days, Mr Market arrives at your doorstep with extremely depressed prices. Fortunately, Mr Market has the habit of not taking things too personal. Even when on some days you completely ignore him, he happily stops by the next day to throw new price quotations at you.
In short, Mr Market is far from perfect: on both extremes, he sometimes gets too caught up in his own emotions. And that is precisely the reason why an attentive investor (for example, Warren Buffett) can profit from Mr Market’s emotional rollercoaster.
So, why is Mr Market wrong this time around?
Ben Bernanke mentioned Trump’s tax reduction last week, but even Bernanke does not seem to grasp the implications of Trump’s tax reform. According to the former Chairman of the Federal Reserve, Trump is making a big mistake by introducing this fiscal “economic stimulus” at precisely the wrong moment (at a time when the economy appears to show signs of economic strength). However, what both Trump and Bernanke fail to understand, is that Trump’s tax reduction is anything but a “stimulus”.
Because besides a lowering of the corporate tax rate, Trump’s tax reform consists of a variety of other fiscal adjustments. Left or right, the new tax reform discourages capital formation and investment, whereas capital consumption is actually encouraged. Trump tax reform is, contrary to what many think, harmful for medium-term economic growth.
Better yet, the initial growth estimate of US GDP for the first quarter of 2018 came in at a meager 2.3% year-on-year. This was substantially less than the fourth quarter of 2017, beforethe tax reform was introduced, when growth came in at 2.9% year-on-year.
Of course, the first quarter in general has been the worst quarter of the year in earlier years, but still, the numbers do not seem to point at the economic miracle that some might have been expecting. Moreover, the forecasts for the second quarter, at least the forecast by the GDP Nowcast model of the Federal Reserve of New York, does not indicate much of an improvement: FRNY’s forecast for the second quarter points at 3.2% year-on-year growth, but mostly due to an increase in consumption rather than an increase in investment.
One of Goldman Sachs’s chief economists came to a similar conclusion: economic growth seems to have “peaked,” at least according to the investment bank.
The second mistake has to do with a possible escalation of the impending international trade war. As the very same Goldman Sachs economist – Jan Hatzius – remarked on CNBC, the consequences of the first round of import tariffs are rather small. “At most, a tenth of a percent of GDP growth,” says the Goldman Sachs economics department. And this all the while Trump’s tax reform, of course, is able to raise GDP growth by multiple percentage points, at least according to the world’s optimists. After all, Trump promised to grow the US economy by at least4%.
But nothing could be further from the truth. Not only will a trade war cost the American consumer and industry billions of dollars, it will also severely weaken the Chinese economy, a major trading partner of the US who is, of course, the focal point of the trade conflict (Trump argues that China does not play by the rules). Yet, the Chinese economy appears fragile. A trade war, therefore, could have tragic consequences: a snowball effect and a wave of bankruptcies in a China in which too many companies currently have too high and unserviceable debt levels. These fragile Chinese businesses will fall like dominoes as soon as part of their revenue streams are blocked by trade sanctions and import tariffs. Such second-order effects are often not accounted for in the economic models estimating the consequences of a trade war.
Curiously, last week the 10-year US Treasury came very close to that “magical” 3% barrier. Nevertheless, some sort of flash crash occurred in US Treasury markets. As a result, the 10-year interest rate fell from 3% back, within no-time, to 2.92%, an abrupt movement that usually does not occur on a regular day in bond markets.
In other words, the yield curve continues to flatten and long-term interest rates are notrising, contrary to what analysts have been saying for years. Better put, the idea that Trump’s magical fiscal stimulus will lead to a miraculous burst of economic growth and will therefore result in higher demand for long-term credit and, consequently, in higher long-term interest rates, is a thesis that – unfortunately – is completely false.
What was even more surprising, was the fact that for the first time since the recession of 2007 the interest rate spread between the 10-year US Treasury rate and the 3-month government rate was less than a single percentage point. This becomes even more surprising when we take into account that the historical median of this spread is precisely 1% (one percentage point). This specific yield curve spread (10-year minus 3-month rate) dropped below 1% to 0.95%, a major red flag for the US economy and a sign that a recession is gradually nearing.
When we add up all the mistakes committed by “Mr Market”, then there is only one conclusion possible: gold prices are too low, stock prices are too high and debt levels are excessive.