Can You Hear The Economic Warning Bells Ringing?

May 14, 2018

Can You Hear The Economic Warning Bells Ringing?

A quick investment perspective on the current economic news will give us insight into what to do with our portfolio, what the best risk reward portfolio allocation is at this point in time, and what one can expect to happen.

I’ll look at U.S. economic data, emerging market yields, and touch on Italy which is becoming a bigger and bigger risk.



Economic Data – Strong, But Also Weak

The headline consumer price index came in at 2.5% which is good, but might lead to higher interest rates which is a dance that has to stop at some point.

Figure 1: Consumer price index. Source: FRED.

Higher oil prices lead the impact on prices, but they take time to really impact the economy which is something that could happen over the next year or two if oil prices persistently remain above $70 per barrel.

However, the market expected even higher inflation which then sent bond yields lower and stocks higher. Perhaps lower inflation is a sign of an economy slowing down.

Like it or not, higher interest rates heavily impact sales of goods where a lot of debt is used—like new vehicles sales—and we’re already seeing new vehicle prices declining. This means that automotive companies are lowering prices in order to get rid of the inventory.

Figure 2: Year-over-year change in U.S. new vehicle prices is already a negative 1.5%. Source: FRED.

Credit card debt has stopped climbing and for the first time in 5 years, we are seeing it decline slightly due to higher interest rates.

Figure 3: Credit card debt is declining as the variable rate approaches 15%. Source: FRED.



Higher interest rates will also impact companies and their profits. Few think about the refinancing companies will need to do in the next few years and what the impact will be on earnings.

Figure 4: Debt wall ahead of U.S. corporations. Source: Bloomberg.

This pile of debt is fine a long as the economy is expanding and there is confidence, but we all know the pile of risk this is creating as there will be a rush to liquidity at some point. The thing to keep in mind is that the risks are piling up.

Fortunately, all other metrics are still strong and unemployment indicators are extremely strong with the unemployment rate down to 3.9%.

However, the yield curve is getting flatter and flatter which is a signal that the party might be coming to an end as it’s impossible to constantly grow because it simply isn’t natural.

Figure 5: 10-Year Treasury minus 2-Year Treasury. Source: FRED.

Emerging Markets

Higher interest rates on the dollar, which is still the global currency, puts severe pressure on emerging markets which have most of their debt denominated in dollars which increases their yields and dampens their economies. In the last year, the Argentinian Peso has lost 50% of its value against the dollar and other currencies—like Brazil, Turkey, etc.—haven’t fared that well either.



Italy – More Risks Piling Up

I like to keep an eye on Italy because of the risks piling up there that might one day destabilize Europe and, consequently, the whole global economy, or at least destabilize the European currency which is also something to watch.

The Italian 5-star movement founded by comedians is in talks to form a government with the anti-immigrant party where some of the plans are a flat tax at 15 percent for people and businesses, a citizens’ income to poorer Italians, both of which are interesting things to try and do with debt being 130% of GDP.

From an investment perspective, this means that the risks are piling up, but all is under control as long as the ECB keeps buying those bonds and the system is full with liquidity. However, this will one day burst and the currency will be toasted. Long term investors should keep an eye on this.

Conclusion

The problem is that we are in a globally interconnected economy, so every bit all around the world matters. At this point in time, we are close to a tipping point as the risks are accumulating due to higher global interest rates and a high debt burden.

So, as portfolio exposure goes, I’ll reiterate my stance that it’s better to be defensive now that all others are greedy. I know stocks are up lately, but chasing 2% returns with such big risks in the late part of the economic cycle is crazy.



Search