A Bearish David Rosenberg Re-Emerges: “Fade This Rally” As “Trump Will Engineer A Return To Deflation”
While the majority of sellside analysts predict that the impact of Trump’s fiscal stimulus policies will be largely beneficial for US inflation and economic growth, if only in the short-term, with a knock on reverse effect following shortly after…
… one prominent strategist disagrees.
According to a recent report from Gluskin Sheff’s David Rosenberg, in which he lays out is “out-of-the-box” call for 2017, “Trump will accidentally engineer a return to the disinflation trade” in the coming year, well ahead of most expectations.
As a reminder, Rosenberg famously flipped his generally bearish opinion on the economy and assets several years ago, when he called for the advent of broad, wage-driven reflation, as a result urging to buy risk assets while shorting bonds. While he was right on the former, his call was offset by the relentless surge in global yields to all time lows as recently as this summer. And now, with consensus largely calling for a broad reflation, Rosenberg appears to have made a call against the prevailing consensus, and is once again shifting toward the deflationary camp.
Below he explains his reasons why (highlights ours).
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MY OUT OF-THE-BOX CALL FOR 2017: TRUMP ACCIDENTALLY ENGINEERS A RETURN TO THE DISINFLATION TRADE
Yes, I say this with the knowledge that 10-year TIPS inflation breakeven levels have surged to over 200 basis points.
Somehow, inflation expectations among households and even businesses have not exactly moved quite as quickly as what financial market participants have priced in.
At last count, the University of Michigan survey showed consumer inflation expectations, as short as one-year out to as long as 5-to-10 years, just 10 basis points above their all-time lows — and that includes a doubling in oil prices off their lows and a 20% bounce in base metal prices.
Not just that, but in the National Federation of Independent Business’ small business survey, the grand total of a 3% share stated inflation as their number-one concern.
Yet I did a BNN interview yesterday on the market outlook and the conclusion (not from me, mind you) was that 2017 was going to be defined by what inflation was going to do.
Well, beyond base effects caused by the dramatic plunge in oil prices at the start of the year and the more recent bounce towards year-end, I don’t see a whole lot of upside to inflation.
In fact, despite base effects taking the year-over-year trends higher near-term, I think we will close 2017 with consumer inflation, headline and core, below 1.5% (though both will peak in the opening months of the year at 2.6% and 2.3% respectively).
The question is what sort of growth we get, and as we saw with all the promises from “hope and change” in 2008, what you see isn’t always what you get.
What followed the 1980 election of Reagan (recession in the next 18 months), George H. W. Bush in 1988 (recession within two years), Clinton in 1992 (a near double-dip recession), George W. Bush in 2000 (recession within months) and Obama in 2008 (the worst recovery of all time) shows one thing and one thing only when it comes to elections (keeping in mind that it is completely normal to have a market bounce between election day and inauguration day).
There are strong grounds to fade this current rally, which has more to do with sentiment, market positioning and technicals than anything that can be construed as real or fundamental.
There is perception and then there is reality. Perception is unequivocally bullish. For example, the University of Michigan consumer sentiment index jumped to 98.0 in December from 93.8 in November and 87.2 in October — this was the best since January 2015 and second best of the cycle. But spending intentions on both autos and housing actually both fell a point. Go figure.
So people are basically saying I feel a lot better for whatever reason out of the election — maybe because the stock market is telling me to feel more bullish — but sorry, no, I’m not changing my spending plans because of it.
And look at the NFIB small business sentiment index. Similar story. The headline optimism index shot up to 98.4 in November from 94.9 (the consensus was 96.7), the highest level since December 2014. The monthly gain of 3.5 points also is the best run up since April 2009.
And yet, the index assessing whether these companies intend to boost their own capital spending in the next three to six months fell to a six-month low of 24 from 27. This is where surveys reveal how you feel and at the same time how little you’re going to react!
The markets are indeed forward-looking but this latest leg of the risk rally has a certain speculative feel to it.
Now, some full disclosure. I actually find it senseless to provide a forecast for the entire year ahead at this time.
We are not in normal, more stable time periods.
We have been in a heightened state of volatility and that will intensify in 2017 because of the political dynamics in the U.S. as well as in Europe.
We have a president who tweets the first thing that comes to his head, has appointed a cabinet filled with billionaires even though it was rural blue-collar voters that pushed him over the top, and every pro-growth promise was met with an anti-growth measure.
We go into the New Year with investor optimism and equity market valuations running at extremely high levels so initially the risk is that disappointment sets in, but that may not happen until we are well into 2017.
I will go on record to say that sentiment and market positioning are so radically negative on Treasuries that it wouldn’t take much to elicit a countertrend bond market rally. We are way oversold here.
The economy isn’t that strong and anyone who thinks one man can reverse on his own the structural forces that led to the multi-year disinflation trend — and I’m talking about excessive debt, globalization,
aging demographics and technology — needs to go back to economics school right away.
I think it is very dangerous to be basing investment decisions on expectations of government policy. What is done and when it is done is far too uncertain, and uncertainty is inherently difficult to price.
I look back to the Obama “hope and change” enthusiasm — also apparently following a failed presidency.
Barrack Obama said he would renegotiate NAFTA, that he would cut income taxes for low and middle income earners, that he would create five million green energy jobs, that he would sharply reduce the power of lobby groups in Washington, that he would embark in an $830 billion, 10-year infrastructure stimulus plan, and that he would not bail out Wall Street.
Well, none of this happened, right?
And yes, the stock market tripled, but that was almost exclusively due to TARP, ZIRP, and QE.
Obama did not fully live up to half his initial pledges, even with the Democrats taking the House and Senate in his first two years in office, not to mention the fact that he secured 53% of the vote and 365 electoral college votes in November 2008 (it is not lost on Senate Democrats that this was a far tighter race with no clear mandate outside of “making America great again” which is nothing more than apple pie rhetoric).
In fact, even the mighty Ronald Reagan, despite all the great things he did, fulfilled barely over 50% of his campaign promises. Looking at data compiled by FiveThirtyEight, U.S. presidents historically keep little better than 60% of their promises.
So as I said, it is too early to handicap what Trump will or will not do, especially since nothing “big” can really happen without 60 votes in the Senate (needed to circumvent any filibusters).
And yes, I am aware that Mr. Market is not exactly taking my advice, but it’s not the first time and I doubt will be the last.
Back to the coming year. Look for extreme volatility. That will breed recurring trading opportunities on both the long and short side, and across the asset classes.
This means holding a higher level of cash than is normal at all times for optionality purposes.
Be mindful of how quickly things are getting priced in and be willing to take profits on positions early — more than normal.
Pay more attention to market positioning, sentiment and valuations — moving against the herd mentality will be more important than is usually the case; trades are going to become very crowded as we saw repeatedly in 2016.
Which is why 2016 is so instructive in terms of making big bold predictions at the end of a given year, especially the one we are about to head into given the extremely wide range of outcomes.
We started off the year at 2.27% on the 10-year U.S. Treasury note yield; went down to 1.63% in February; up to 1.98% in March; then down to 1.37% in July; and closing the year near 2.5%.
We had a cumulative 397 basis points of declines on the rally days and 419 basis points of cumulative increases in yield on the selloff sessions.
Look for even wilder moves this year — a year that could well see a test of technical support at 3% before heading down to close the year at 2%.
At the end of 2015, the calls were for 3% yields on the 10-year T-note and then by the summer, there were many calls for 1%.
And look at the Fed: the consensus for 2016 was four rate hikes and instead we will see but one (today).
So again, why would anyone plan around some analyst’s year-ahead forecast? What happens when, even if proven right, all those forecasts come to fruition by the end of January?
The S&P 500 started the year at 2,044. As of June 28th, it was sitting at 2,036 and the legion of bulls looked foolish. Even by November 4th, just before the election, the S&P 500 was 2,085 or up marginally for the year. And here we are, with a Trump Rally taking the index to 2,256.
And if you were long the rate-defensives and out of the cyclicals, Energy and Financials in the opening months of the year, you were golden. But if you stayed in that position in the last four months, you look like a dope.
The up days saw a cumulative 13,288 rally points this year on the Dow; and the bear-days had a combined 10,917 down points. Expect even wider swings in the year ahead.
And look at the sector shifts: as of August, the two S&P 500 leaders were Utilities and Telecom as they had been with near consistency all year along until then. As of September, the worst was Financials and to the end of October, was still ranked 8th. To think by now it would be #2 for the year here in mid-December, let alone Energy as the top sector, at the start of the year, would have been unthinkable.
Look at what oil did: the WTI price started the year at $37 per barrel, then plunged to nearly $26 by February — and now closing the year above $50 on this OPEC/non-OPEC supply cut deal.
Commodities in general, started the year extremely weak and closed the year very strong (gold the opposite). Recall all the calls in the first quarter for WTI to retreat to $20 per barrel or lower.
The Canadian dollar had a similar wild year, starting 2016 at C$1.3840, then hitting C$1.46 in January, rallying to C$1.25 in April, to then sell off to C$1.35 in November and now closing the year with a bullish run back to C$1.31. At the early-year lows, there were calls for the loonie to break to C$1.60. Remember that.
I don’t really have much confidence in how much Donald Trump ends up getting accomplished. But I am respectful on what history has to say on the matter, and I sense that far too much reflationary optimism is priced in at the moment.
The CNN “fear and greed” index is now at 87%, up from 75% a week ago and 48% a month ago. Only two other times in the past three years has this index has this index been this high and both times proved to be a classic case of chasing nickels in front of a steamroller for those following the herd.
Look at the just released BAML global fund manager survey:
- Expectations of “above trend” growth and inflation have surged to five-year highs
- Global growth expectations are at a 19-month high (net 57% from 35% in November)
- Inflation expectations have only been as high as they are today just one other time in the past 20 years — a net 84% see inflation accelerating
- Global profit expectations are at six-year highs
- Only 6% of portfolio managers see lower bond yields in the coming year
- Cash ratios have dropped to 4.8% from 5.0% in November and 5.8% in October; only coming out of the 2001 recession did cash ratios come down this quickly (and then we had the double-dip in 2002)
- Net exposure to global banks soared to 31% from 25% in November, two standard deviations above normal levels
- Net percent of those who think the U.S. dollar is now a “crowded trade” is at the third highest level of the past decade
- Nothing has been done and yet — and yet a net 37% believe fiscal policy is too restrictive, down from 56% in November
- A net 58% of asset allocators are underweight bonds, up from 48% in November
- Allocation to equities rose to a net 31% from an 8% overweight position last month
- Net overweight in commodities rose to a five-year high this month
- Only a net 7% (record low) believe large-caps will outperform small caps, despite the move we already have seen
- Allocation to Emerging Market equities has fallen to seven-month lows; investors in the survey are underweight Eurozone equities for the first time in five months; U.S. overweight exposure up to a two-year high (15% from 4% in November); bullishness on Japanese equities has risen to a 10-month high (21% overweight form 5%)
- Relative Emerging Market versus Developed Market positioning is down to eight-month lows (now at –8.7 percentage points versus +1.7 in November)
- Net overweight positions in Industrials (2½-year high), Materials (two-year high), Energy (two-year high); Tech exposure down to 2½ year lows and Consumer Staples to 18-month lows
In addition to knowing how investors are positioned, and the BAML survey confirms the data from the Commodity Futures Trading Commission’s Commitment of Traders report, we also know that the surprise this year will be the opposite of what the surprise was last year which is that the Fed tightens more than what is currently being discounted.
Of course, Janet Yellen is likely a lame-duck Chairperson and she may well give Donald Trump exactly what he was clamouring for during the election campaign — higher rates.
As my good pal Peter Boockvar published, and this is a crude estimate but likely a good working assumption, America is so heavily indebted that every 100 basis points increase in market rates causes interest charges to soar $470 billion or 2.5% of GDP. It will be interesting to see how this plays out.
And we know that we are that much more late cycle than we were this time a year ago and that we are just six months away from this expansion celebrating its eighth birthday.
It is true that no cycle dies of old age, but they do die nonetheless, and usually at the hands of the Fed, who have engineered 10 recessions in the post-WWII era but only three “soft landings” and those soft landings (mid-1960s, mid-1980s and mid-1990s) occurred when the cycle was roughly three years old, not eight.
Most important is to look at what is priced in with price-to-earnings multiples of 20x on trailing and 18.5x on forward — multiples we have not seen in 15 years and two standard deviations above the norm.
Using ultra-low interest rates as rationale for multiples this high no longer make much sense. What has to happen for these multiples to make any sense is for earnings in the coming year to soar more than 30% — which means that Trump does all the good stuff, none of the bad stuff, interest expense does not rise that much and profit margins are not affected by rising wage growth and a stronger dollar.
If we get an earnings profile that is more befitting of a late-cycle backdrop, it is tough to get an estimate for the S&P 500 much above 1,950.
Again, that is an estimate, but assumes that Trump ends up getting the 60% of what presidents generally squeeze out of Congress — nobody ever got 100% but maybe this President will merely use the bully pulpit more aggressively. Then again, for someone who is resisting having to be briefed daily, the potential for a mistake or two can’t be underestimated either, though this is not on Mr. Market’s radar screen at the current time.
So if I have a year-ahead crystal ball (and I don’t), I will lean back on three of Bob Farrell’s 10 Market Rules to Remember:
- #2. Excesses in one direction will lead to an opposite excess in the other direction.
- #4. Exponentially rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways.
- #9. When all the experts and forecasts agree, something else is going to happen.
So I strongly think we will be seeing a ton of volatility in an even more politically charged year. I think that there is a risk as per #4 that we could well see an early-year meltup in bond yields and equity prices that will then leave us with a #2 situation where the excessive move up in long-dated rates and stock prices reverse course.
The market is not at all discounting any chance of there being a disappointment on growth — sort of like December 2015 but less extreme and look what happened when first quarter growth collapsed to a 0.8% annual rate.
If I do agree with the consensus it is that the bullish U.S. dollar trade is a bit of an overcrowded trade, and if that proves to be the case, then Emerging Market equities, which are so under-owned, could well be an upside surprise. I also agree with the consensus on Japan.
But there is too much emphasis on the U.S. market for my liking and it has become the most overvalued equity region.
If Angela Merkel can survive in Germany and anyone but Marine le Pen win in the French elections, we could see some positive political rerating in Europe; and there is always the chance that Brexit is delayed even further.
The fact that the far-right did not emerge victorious in Austria last week was a very positive signpost that we have seen a peak in this antiestablishment momentum that has swept much of the global political landscape over the past year.
Valuations in Europe are more compelling and like Japan, liquidity conditions remain flush and currencies are acting as a tailwind for earnings revision ratios, which have much greater upside now compared to the U.S.
The Financials were looking best when things were darkest but a lot of good news has been priced into this sector. The cyclicals for the most part now look overvalued and overdone, including Materials and Energy which have received a lift from supply adjustments but will need much better global demand growth to usher in a full-fledged bull phase.
The bond proxies which have been hard hit of late are now under-owned and will benefit from any unwinding in this bond market selloff, but we will soon have to see the run up in mortgage rates and auto financing rates dampen the credit-sensitive sectors of the economy before this happens — but to be successful in 2017, we will have to be willing to move against the herd and accept Bob’s rule #9.
That in turn means to own anything that can benefit if this rampant pro-growth/pro-inflation market psychology doesn’t take hold, which I expect to unfold.
Timing is never easy, but these markets are so manic today that we could well end up seeing this retracement taking place by the end of the first quarter. And who knows? By then when everyone has turned bearish and that CNN “fear and greed index” is back to 30%, I will be the one turning optimistic.
Every football game has four quarters. As the Giants/Cowboys game showed you on Monday night, how the game goes in the first quarter isn’t necessarily how it ends. So let’s take it one quarter at a time.
And my call for the coming quarter is to be cognizant that “something else is going to happen” with respect to what is currently being discounted by stocks, bonds and commodities.
While it is extremely difficult to predict what the markets are going to do when it comes to inflation expectations, or how the Fed responds, I do have as strong view that inflation very much is going to be the non-event it has for the past several decades.
Donald Trump has no influence on aging demographics. He can try to reverse globalization, but I think he will not be very successful. If he is successful on the deregulation front, that will reduce business costs and as such will be disinflationary.
His choice of energy secretary will be in favour of more drilling which means more supply and hence lower prices.
His labor secretary is in favour of abolishing minimum wages.
And of course, the strong dollar will continue to depress import costs as the November data just highlighted.
Even if Trump does engage in trade wars, the reality is that manufacturing employment was falling just about as fast in the 15 years after China joined World Trade Organization (WTO) as was the case the 15 years prior. And manufacturing productivity in the U.S. over the past 15 years at over a 3% annual rate is identical to what it was in the 15 years before China gained WTO membership.
We are just starting what is called the Fourth Revolution which is going to involve the advent and proliferation of industrial robot manufacturing and this promises to be intensely deflationary — but at least is a response to a shrinking workforce in the industrialized world (and now in China).
There truly is very little that Donald Trump will be able to do in the realm of technological advancement — these deflationary factors, like aging demographics, are unstoppable.
Trump’s pledges to roll back regulations and lower health care costs are just icing on the cake for the return to the disinflation view … which is what I think will win out in 2017 and beyond.
Be that as it may, while some planks of the Trump plan will likely be effective (such as deregulation and corporate tax cuts financed in part by induced repatriation of locked-up retained earnings abroad), one of the big surprises to the market will be how limited fiscal policy will be given a record debt ratio for a peace time economy. The bang for the buck from fiscal stimulus is much more powerful at low levels of government debt, which is why the FDR and Regan stimuli worked so well.
As Janet Yellen said recently, “With the debt-to-GDP ratio at around 77%, there’s not a lot of fiscal space, should a shock to the economy occur, an adverse shock, that did require fiscal stimulus.” So this may well be the year of the rooster in China, but as far as the U.S. is concerned it will be the year of Ricardian Equivalence where fiscal policy proves to be just about as tapped out as monetary policy has been at the zero-bound on interest rates.
Investing in an equity market that is priced for perfection will prove to be a very big challenge in 2017.
To reiterate, I believe that fading the inflation psychology and identifying equity sectors and areas of the capital market more generally that are not priced for excessive optimism and not currently experiencing a crowded trade, in other words moving against the herd mentality, will likely bear fruit in what is probably going to be an even more intense roller coaster ride than what we witnessed in 2016.
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Looking immediately ahead, Rosenberg expects a “big Q1 hit” to come from the following three sources:
Surging gasoline prices
The market may love higher oil prices, but consumers sure do not. The 52 cent per gallon jump at the pumps from the lows to $2.35 per gallon is akin to a $60 billion tax hike. Before Trump has done anything, taxes are going up!
Spiking mortgage rates
Housing has subtracted from GDP for two straight quarters now and this is about to get worse, with 30-year fixed mortgages rates up more than 70 basis points during this bond selloff to 4.11%.
The run up in the U.S. dollar
As we saw this time last year, the U.S. dollar does have an impact on exports and the trade deficit. And the move in the past couple of months is equivalent to 50 basis points of Fed rate hikes — on top of the one we got this week.
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Finally, a quick anecdote from Rosie:
On December 16, 2015, the Fed hiked rates a quarter point for the first time in nearly a decade. The S&P 500 actually rallied 30 points that day! And it went on to a high of 2,078 on December 29th. Classic case of whistling past the graveyard. By January 20, something quite unexpected happened. The S&P 500 closed at 1,859. That’s a heck of a correction, no?
The 10-year U.S. Treasury note yield had already risen around 30 basis points off the nearby lows and ticked up by two basis points on December 16. It then went on to rise further to 2.32% on December 29, not more than a couple of months after slipping to grip a “1-handle”.
Two weeks after the Fed hiked rates, the mantra was that bonds were for losers and the Fed was raising rates for the right reason (consensus views were for accelerating growth and higher inflation). And once again, by January 20, the 10-year T-note yield was back sitting pretty at 2%. Believe me, you could not have sold that story a year ago any more than you can today.
Oh yes. As for GDP growth, it came in below a 1% annual rate that opening quarter of the year (and it wasn’t just because of the weather!) There is one added snafu, which is that short-term corporate funding costs have hit their highest level in nearly eight years (three-month LIBOR rates now stand at 0.96% versus 0.61% a year ago. It is going to be imperative that nominal GDP quickens or else this incremental rise in funding costs will weigh on debt servicing capacity at the margin. The bottom line here is that even ahead of the Fed, financial conditions have tightened and could actually lead to a slower, not faster, global growth profile that the investment community has recently discounted.