The “Everything Bubble” – What is It? When Will it Burst? Or is this Fake News?
“It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us, we were all going direct to Heaven, we were all going direct the other way—in short, the period was so far like the present period, that some of its noisiest authorities insisted on its being received, for good or for evil, in the superlative degree of comparison only.” – Charles Dickens (from A Tale of Two Cities)
Is the Next Great Recession at Our Doorstep?
If you’ve opened the pages of the New York Times, the Financial Times, Forbes, or Bloomberg lately, you’ve probably seen articles guessing at the timing of the next market collapse. One thing is for sure. It is only a matter of time.
Nouriel Roubini, an economist at the Stern School of Business at New York University known for forecasting the bursting of the housing bubble before the Great Recession, just wrote. “Economic growth in the Eurozone, the United Kingdom, Japan, and a number of fragile emerging markets is slowing. And while the U.S. and Chinese economies are still expanding, the former is being driven by unsustainable fiscal stimulus.”
The imminent recession is being called the “Everything Bubble” for a number of reasons. During the last two major recessions, the proportion by which household wealth (measured in asset values of real estate, stocks, etc.) exceeded nominal GDP were about 400% (2001 Recession) and 475% (2008 Great Recession) as compared with well over 500% today. It was also spurred primarily by overinflated housing prices, rather than more broad-based price-to-value imbalances.
Asset values are artificially inflated by at least as much as was the case in 2008 and the average household is saddled with quite a bit more debt. Thus, by every marker, from drops in real asset values, to unemployment, to length of recession – all else being equal – the upcoming recession would be expected to be much more severe. It will dramatically affect all asset classes. It is an “Everything Bubble.”
An Alternative, But Perhaps Even More Terrifying Viewpoint
Dalio said, “I think it will be more severe in terms of the social, political problems. And I think it will be more difficult to handle ... It won’t be the same in the terms of the big-bang debt crisis. It’ll be a slower growing, more constricting sort of debt crisis that I think will have bigger social implications and bigger international implications.”
Dalio explains that all of the growth in the economy since 2008 has been in the top 1% and has exclusively been confined to increases in the values of financial assets. Those with financial assets got wealthier on paper. Those that didn’t have financial assets got poorer—in reality. But, there has been no real economic improvement. While his lone ray of sunshine is a short reprieve from recession, he is not so rosy on what the outlook is once the coming recession inevitably hits. He even warns of the serious possibility that the U.S. will lose its reserve currency status.
Dalio thinks that we are not likely to experience a huge level of default rates all at once, because the proportion of debt service on any one asset class versus gross incomes is not as lopsided as it was with mortgages in 2008. Instead, there will be a domino effect where defaults slowly increase across all asset classes for a prolonged period of time.
Dalio notes that we have only one tool left to use that would have any impact on a recession from a monetary policy perspective. We cannot lower interest rates. Quantitative easing will not work, because we have maxed out the potential utility of that tool. Thus, fiscal policy won’t save the date like it did in the past. The only remaining tool the Federal Reserve has left is to sell a lot of Treasury bonds internationally and continue to print money to stimulate an increase in asset values and incomes. This will cause the $21 Trillion deficit to grow and grow and grow.
Unfunded pension liabilities and healthcare costs will cause a geometric increase in the national debt on their won, which exacerbated by printing money, will act in concert to threaten our reserve currency status in the near term. The dollar will continue to depreciate in value, making us increasingly less competitive globally over time, which will have political implications and decrease our bargaining leverage incrementally with respect to international trade. Dalio sees the U.S. currency weakening by around 30%, causing a “dollar crisis” which may be the trailing fallout from the next recession, which is hard to come back from given the “Graying of America.”
So, Dalio is most worried about broad political unrest and social upheaval, domestically and abroad, leading to increased political polarization and changed political policies that will slowly result in a decentralization of wealth. Dalio is not worried because this is an inherently bad thing, but because the process of political flux creates a dangerous social powder keg that can explode if not handled properly. Looking back to a similar period of ’35 to ’39, Dalio sees a multi-year period of decline, with a negative risk return scenario for stocks and other financial assets, with double-digit drops for a number of years into the future. He does not think that stocks are going to torpedo 50% as in ’35 to ’39 or to even drop as rapidly as in 2008, but the drops will be substantial and prolonged.
Dalio’s biggest concern is the socio-economic tensions and conflicts that will be spurred by the coming recession and he is advocating for an “Emergency Economic Powers Act” which would give the government (President & Speaker of the House) the ability to bypass the normal legislative process when it comes to economic or military measures – since legislative gridlock is a natural result of political polarization and social unrest, and could make reacting to a recession more difficult.
If you find Dalio’s views interesting, he also has a good YouTube overview that gives a basic but comprehensive overview of how the economy works and what leads to these boom and bust cycles in the first place. https://www.youtube.com/watch?v=PHe0bXAIuk0
Indicators that the “Everything Bubble” Will Burst and Recession is Near
In a Forbes article by Jesse Colombo that takes a deep dive into the numerical data, he points out that the gap between household wealth and the underlying economy cannot stray very far from a 4:1 ratio before a recession comes along to reset overpriced financial and real asset values. The market is smart and it will not overpay for consumption indefinitely. And, the greater household wealth figures stray, and the more concentrated that wealth is in the hands of a few, the greater the ensuing recession will be. Asset values simply have farther to go down to reset to their intrinsic values.
The 2001 Dot.com bubble burst when the household wealth reached 429% of GDP, the more recent 2008 housing bubble burst when household wealth reached 473% of GDP, and at present we have reached a record with household wealth exceeding 505% of GDP.
The “wealth effect” is a scenario where wealthy Americans who work or own their own business lack the “income” to pay their bills from earnings, due to flat incomes and rising household costs, but have “fake wealth” in the form of equity in overpriced real estate or in the form of stocks that are valued 300% greater than they were in 2012, despite having the same fundamentals. This “fake wealth” promotes spending on consumer items, but ultimately does not reflect true buying power, and is neither sustainable nor helpful to increasing GDP and driving inflation.
That 5:1 ratio we have now is more like a 10:1 ratio when you consider that GDP growth has been anemic and the cost of a basket of household goods has gone up dramatically during a time where interest rates were held near zero and inflationary rates did not exceed 2% for even a few months in succession—household deficits are a function of structural problems around items like health insurance, student debt, and childcare expenses—only wage growth and inflation will reduce the impact of these fixed costs.
Everything comes down to household income and consumption of goods and services bought and sold in the marketplace. Unlike past bubbles where the average household had a measure of discretionary spending or savings with which to rebound and some access to credit, household budgets are far tighter and the availability of credit is much scarcer than in prior recessions. Businesses have not been able to raise prices, which in turn has led to stagnant wages, which in turn has led to lower household incomes, which creates higher debt-to-income ratios, which limits consumption on goods and services, which prevents real GDP growth. Thus, until operating businesses experience growth and consumers get raises, most households will continue experiencing their own “household micro-deficit” that constrains GDP growth. To make a buck, you need a consumer who has that buck to pay.
Moreover, a smaller and smaller number of Americans even have $1,000 of savings with which to weather an economic storm. In fact, in a 2017 GoBankingRates Survey, 57% of Americans have less than $1,000 of savings. 75% of Americans have less than $10,000 saved, far less than the minimum suggested 6-months of income that should always be on hand for job loss or emergencies. These results are on an upswing, but almost all of the improvement in savings is in adults 65 years of age or older. Few individuals under 60 have any savings whatsoever.
The net effect of a recession where households are already tapped is that there will be a much higher rate of defaults on a broader range of items. It won’t just be mortgages that aren’t being paid. It will be credit cards, student loans, health insurance, tuition and a series of other items. The coming recession will affect every sector of the economy. Thus, the upcoming recession is being called the “Everything Bubble.”
2nd Longest Expansion of Record – It Can’t Go On Forever Folks!
We are in the midst of the second longest expansion in U.S. history, and the absolute weakest recovery we’ve ever experienced. In an unsettling trend, expansions have been less robust with each boom and bust cycle, in part, due to our extreme reliance on monetary policy as a crutch.
Why has the economy been getting progressively weaker over time since the 1970s? That is a more complex question, subject to debate and interpretation, but a look at inflation rates shows that between 2015-2018 inflation rates have only reached levels of 1-2%, far below the levels of 10%+ experienced in the expansions of the ‘70s and ‘80s and levels of 5%+ in the expansions of the ‘80s and ‘90s.
Between 1991 and 2001, the economy expanded for 120 straight months with average annualized GDP growth of 3.6%. This was (and still is) the longest expansion in U.S. history. After a mild recession in 1990-1991, home prices started to increase rapidly around 1995. Debt levels and a runaway stock market road the bullish trend through 1999, when the Fed attempted to avoid the upcoming crash with fiscal policy. Nonetheless, the Dot.com bubble eventually burst in 2001.
As of today, the economy has been expanding for 108 straight months, albeit at the weakest level in modern history, an anemic and somewhat pathetic annualized GDP growth of 2.2%. Quantitative easing, stimulus, and seven-years of near zero interest rates propped up the economy, allowing some increased economic growth. But, government and individual debt levels and structural instability have worsened, rather than improved.
Historically, we experience a recession approximately every 6-8 years and its impacts last for about 2-3 years afterward, before expansion takes hold.
We are long overdue. And, a year from now, we will have set a new record, if we skirt recession that long.
The Republicans Would Have Us Believe the Economy is Roaring – What Gives?
2nd Quarter GDP numbers posted an annualized U.S. growth rate of 4.1%. Predicted economic growth this quarter is probably at an annualized rate of 5%. Unemployment (below 4%) is at the lowest rate in 18 years. Surely, good days are ahead?
Not quite. We may be headed into a major recession, potentially of an order of magnitude far greater than what the U.S. economy experienced in the Great Recession of 2008. In fact, while the bears are certain that a huge recession is knocking on our door any day, and while recent economic numbers have been good overall, with history as our guide, we are almost certain to experience a historic collapse sometime in the next two years. Let me explain.
It is distinctly possible that all of the positive economic markers noted above are nothing more than a short-term result of the shot-in-the-arm the economy got from the Trump tax cuts (equivalent to a $1.5 trillion infusion into the economy). These short-term increases in spending are not necessarily sustainable as they do not take into effect the historic economic instability created over the last decade due to irresponsible fiscal policy, runaway government spending and an impending “stagflation collision” between stagnant wages and ever-increasing nondiscretionary household costs (i.e., housing, childcare, healthcare, student loans, and consumer debt).
The Fed cannot lower interest rates below zero. No amount of interest rate manipulation, quantitative easing, and devaluation of the currency will insulate the economy from natural peaks and troughs forever. There is a simple problem that economists don’t define with a catch-phrase, but which expresses the real root problem which all of these economic indicators are only a symptom of – when households have more nondiscretionary costs to pay for (that are net drags on consumer spending and small business growth) than income to pay those bills with, the only possibility is deflation – falling prices.
And since every subsidy and every sector of the economy is counting on indefinite price increases to remain stable, deflation sinks the economy into a dangerous downward spiral of GDP decline, high unemployment, and tightening credit markets. But, as with the Hindu god Shiva, “the destroyer,” whose silver lining is that Shiva’s devastation clears the way for rebirth and restoration, this destructive cycle, left unchecked, eventually spurs tremendous innovation and creates the foundation for future growth.
A bubble forms and eventually becomes unstable when indefinite price increases cannot be sustained because inflation (even at anemic levels) outpaces purchasing power. Pop!
What goes up must go down.
Case-Shiller 20-City Composite Index Shows Dip in Housing Prices
Home prices have been steadily rising, but have started to drop gradually since May. In June, according to the S&P Core Logic Case-Shiller Indices prices were up 6.2% nationally year-over-year, down from 6.4% in May.
"Even as home prices keep climbing, we are seeing signs that growth is easing in the housing market," said David Blitzer, managing director and chairman of the index committee at S&P Dow Jones Indices, in a release. "Sales of both new and existing homes are roughly flat over the last six months amidst news stories of an increase in the number of homes for sale in some markets."
With more homes on the market and greater supply than demand, price increases are weakening.
With average mortgage rates rising to an average of 4.5% for 30-year mortgages, borrowers are getting more price-sensitive over time and are more hesitant to make such a profound buying commitment in uncertain economic times. Fewer and fewer home buyers are taking the leap into the deep end of the pool, and banks are relying on re-finances with many of the subprime characteristics experienced in 2008 to boost their numbers, which, as history has shown, is a slippery slope.
Updated Case-Shiller numbers suggest that home prices in New York are down about 1%. New York tends to be a leading indicator of national trends. The majority of U.S. cities in the index have also substantially exceeded the prior 2008 housing bubble highs, with no structural economic improvement in real purchasing power having taken place during the recovery, which is a sign that markets are reaching a ceiling and that real estate values are potentially seriously overinflated. The New York market, which is less inflated than other newer markets, is only up 25% from recessionary lows, making this market an outlier that has recovered less than national averages, due in part to the disproportionately high cost of living in the New York metropolitan area.
During the Great Recession, housing prices nationally dropped about 40%. Housing prices today are about 10% greater than they were when we reached pre-recession highs in 2007, and the overall economy, structurally speaking, measured by discretionary household income (real purchasing power), is not nearly as strong.
Thus, if the upcoming recession were roughly equal to what happened in 2008, and not worse, housing prices would be expected to fall by 50% over the course of the next 4 years. Housing prices reached a floor in the Great Recession in around 2012 before rebounding, and very slowly at that. The silver lining is that housing prices would be expected to eventually climb back to present levels and possibly exceed them, but the yo-yo of peaks and troughs is an unsettling and destabilizing pattern that makes long-term planning incredibly difficult and leaves many homeowners without a cushion when “life happens.” Recessions tend to adversely affect household income at the same time that real asset values plummet, leaving debt-ridden households facing an economic adversary that gives no quarter.
Flattening Yield Curve A Troubling Sign
The gap between two-year and ten-year United States Treasury bonds is roughly .34 percentage points. What does this mean? A “flattening” yield curve where long-term interest rates narrow and approach the level of short-term interest rates is a signal of imminent danger. Like chest pains that precede a heart attack or labor pains that precede childbirth, a flattening yield curve indicates that the economy is retracting and that credit markets do not believe that the economy will support higher interest rates in the next few years than are in place now. In other words, we are in for a recession, and soon. You know how the hit Shakira song goes… “Markets Don’t Lie.”
The last time a “flattened” yield curve approached the .34 percentage point level was in the fall of 2007, a few months before the failure of Lehman Brothers. Once the yield curve reached this level, it rapidly fell below zero in November of 2007, signaling a recession had arrived. An inverted yield curve like the one we have today is such a reliable indicator of an imminent recession, that it has preceded and accurately predicted every prior recession in the past 60 years.
Trade Wars: The Showdown at the O.K. Corral
Much could be said of the potential budding U.S. vs. China trade war. But, from an economic standpoint, this showdown is a lot like the famous Showdown at the O.K. Corral depicted in the movie “Tombstone.” Perhaps the outlaws will lay down their arms, but if they don’t, we may be in for a shoot-out. And, given our nearness to an eventual recession, a trade war could be the straw that breaks the camel’s back.
The famous standoff between lawmen Doc Holliday and Wyatt Earp on one side and a cadre of outlaws on the other side was one of the bloodiest gun fights in the history of the Old West. And it might have been avoided. The overzealous lawmen drew a line in the sand and made some unequivocal threats if the outlaws didn’t turn over their weapons. Stoically unmoved, the outlaws refused to comply, setting the stage for a massacre.
Moments before the first shots were fired, the scene was eerily calm. A mere 30 seconds later close to a hundred shots had been fired, everyone was bloody, nearly half of the men had lost their lives, and none escaped unscathed. That incident is a flashbulb moment, oft replayed in our history, where hard lines and stubborn rigidity can spillover into a morbid calamity if no one blinks. Good negotiating strategy—maybe; but, only if you can absorb the cost of not making a deal, and handle the fallout of a blown negotiation.
The O.K. Corral in this case is international trade. The four lawmen are the U.S. and the six outlaws
are China. In the famous historical shoot out, the outlaws got the worst of it, and certainly paid dearly for their provocation and lawlessness (i.e., threatened U.S. tariffs), but Doc Holliday and Wyatt Earp lost some of their own and faced murder charges. In the end, they lost their positions and were lucky to leave Tombstone with their lives, as they left town in disgrace.
The U.S. might give as good as it gets, or even gain the upper hand by following through with tariffs on steel and aluminum and might even inflict some heavy casualties if the U.S. imposes the threatened 25% tariff on imports. However, China is one of our most important trading partners, and engaging them in an economic confrontation is the kind of zero-sum game we want to avoid.
The Chinese, dealing with their own economic woes, if subject to unbending force, might refuse to lay down their weapons and strike back instead, as outlaws are prone to do. In that case, the U.S. might steep itself in a costly confrontation, threatening it’s entrenched economic supremacy, just as the U.S. economy sputters to a grinding halt, precipitating a worldwide recession that could have been muted or avoided for a bit longer. There is, after all, such a thing as a “lose-lose.”
Economic cycles are predictable. For every expansion, there is a recession. We have been in one of the longest expansions in U.S. history. At some point, perhaps very soon, there will be a recession. Commentators warn it could be coming any time. So, it behooves everyone to pay attention to the warning signs, take action to avert the negative consequences of a coming recession, and to make solid plans to weather the storm.
If you have questions about how to plan for an upcoming recession please give us a call at (201) 529-8024 or e-mail me at [email protected]
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