This month marks the eighth anniversary of the Great Recession’s official end. When will the next downturn occur? Well, I believe that in a world of low volatility as a direct result of central-bank intervention, the U.S. economy will remain constrained from either recession or growth for as much as seven more years.
Should we enter a recession in the coming years, it’s likely that the market would shake it off with barely a murmur. After all, both stock and bond markets are trading these days as if sell-offs aren’t politically feasible, with any dips bought by global central banks or soothed by official jawboning.
It certainly feels like the politicians are wary of upsetting the wealth affect that a rising stock market generates. This is a sad commentary on where we are in the economic cycle.
While most market watchers would agree that stocks are overvalued and valuations are stratospheric in historic terms, there’s little conviction or appetite to short the broad market in any meaningful way. That’s because central banks are loaded up on sovereign debt issued by their own governments, making it against their interest to normalize rates higher. That would create losses to their own balance sheets — and possibly generate negative effects on their countries’ stock markets as well.
In fact, markets widely believe (as do I) that central banks are in a bind. With economies barely scraping by with positive growth, any rate hikes could have an adverse effect on markets and drive GDP gains from slightly positive to flat-out negative. That’d be untenable for most politicians, so it’s balance-sheet management rather than rate normalization that’s the name of the game these days.
Central banks can’t really shrink their balance sheets by direct reduction. Rather, they have to let sovereign bonds mature and roll off the balance sheet instead. This will take time — in the Federal Reserve’s case, I believe as much as seven more years to substantially reduce the balance sheet.
Personally, I expect the Fed to halt continued balance-sheet reinvestment towards 2017’s end. That will pave the path for mature U.S. Treasuries to roll off the balance sheet in a way that minimizes market disruptions. Only then do I expect volatility to pick up — and with it, markets’ ability to not only grow but also to swing away from their current neutral stance.
After all, stock and bond prices can only correspond to the underlying data in a free market, and we’re definitely not in a free market these days. Rather, we’re in a market that runs on inflows generated by central banks that buy dips in both equities and fixed income as a way to control interest rates, diversify assets and manage their countries’ supposedly free-floating currencies.
How to Play Today’s Conditions
Against this backdrop, I expect the U.S. dollar to continue to fall relative to the currencies of countries/regions that America has a current account deficit with, most notably Canada, Mexico, Japan and the eurozone. This has been my favored trade throughout 2017, and it continues to top my list of best trades to make.
I don’t expect stocks or Treasuries to see a dramatic sell-off in the near term, even though both are overvalued. Remember, taking a position to the downside on either asset class is taking a position against central banks. But at the same time, going long on equities or fixed income would be taking a position against heightening inflation and overvaluation.
In short, being long or short is tough. In challenging environment like this, I’d suggest a relative-value portfolio, where you’re directionally neutral but fundamentally sound.