«Bonds yielding north of 2% will be a good deal»
Ed Yardeni has more than forty years of experience in the global financial markets. The renowned investment strategist and President of Yardeni research is highly regarded for his profound analysis when it comes to stocks, bonds, commodities and currencies. On Wall Street well known as Dr. Ed, he remains bullish on equities and sees potential in growth stocks – despite the inverse US yield curve, where long-term market rates are lower than short-term rates. He does not share the concern about an immediate recession in the USA. In the long term, however, he expects a profound slowdown in growth. One of the reasons for this is demographics, which makes it more difficult to return to a normal monetary policy and will keep deflationary pressure intact.
Dr. Ed, after the temporary inversion of the treasury yield curve, investors worry about the economy. Is a recession imminent?
I don’t think so. Recessions are not caused by inverted yield curves. In the past they were caused by credit crunches, that were triggered by monetary tightening.
But the yield curve has had a good track record of calling recessions.
The yield curve anticipates monetary policy, which then in turn has an impact on the business cycle. So far, even though the yield curve is completely flat, we have yet to see signs of a credit crunch. The evidence doesn’t suggests that the yield curve is about to cause a recession or that it is accurately predicting a recession.
So the yield curve isn’t that good in predicting recessions?
The notion that the yield curve can cause a recession is related to the believe that when the yield curve inverts, banks stop lending, because their cost of money is higher than the return they can get on their loans. That’s not what happens at all. The net interest margin of banks has been positive since the mid-1980s, which is when the data started to be collected. The yield curve that’s relevant to to bank loan officers has not turned negative in the past. Even when the treasury yield curve had turned negative.
So what leads to a credit crunch?
The credit crunch is attributable to a flight to quality away from risky lending. First out of the riskiest of borrowers. And then it becomes even difficult for good credits to borrow and you get a recession. Currently there’s no sign of a credit crunch anywhere. Bank loans continue to rise, the credit markets remain wide open and there is still lots of issuance of corporate bonds.
But not everything is okay.
There are some signs of stress in the market for subprime auto loans. There are also concerns about student loans and they’ve been there for a while. It’s not to say that everything everywhere is wonderful. But the areas where we have stress are not big enough or really important enough to qualify as a credit crunch.
What about the increase in corporate debt?
I am not really seeing any problems so far in the corporate market. Credit quality spreads – the difference between investment grade and high yield – which widened late last year, have narrowed quite dramatically so far this year.
What does this mean for the for the stock market?
I remain bullish, because I don’t think we will have a recession this year or next year.
Do you see any triggers for the markets?
We are going to get a deal between the US and China, that could lead to a peace dividend in the short term and some growth pick up over six to twelve months. There could also be a pick up in productivity and more growth with still low inflation. In terms of the next twelve months I’m looking more for upside to downside surprises.
And after that?
I’m looking forward to the presidential election in November 2020. Usually politics don’t matter that much to the stock market, but I think this time they do. I don’t see a credit crunch causing a recession, or that inflation comes back and the Fed steps on the brakes. My concern would be if we have a radical change in Washington.
There has been a radical change in 2016.
Donald Trump has on balance been bullish for the market. He has been bullish with the tax cuts and deregulation, but also bearish with the trade war. So the radical change in 2016 was bullish. But if we have another radical change in November 2020, and we have a very left-leaning Democrat as president with enough votes in Congress to undo Trump’s policies, with an increase in corporate taxes and taxes on the rich as well as more regulation. That kind of radical change could very well cause a recession and a bear market.
A left-leaning Democrat might increase fiscal spending.
It is conceivable that we could have a leftist government, that will raise taxes on corporations and that the offset would be a tremendous increase in deficit financing for infrastructure and more welfare. But I think on balance the market would not read that scenario as bullishly.
That sounds like Modern Monetary Theory, where an increase in government spending is no problem, as long as inflation doesn’t pick up.
We have been doing Modern Monetary Theory for the last ten years. There is a huge increase in debt, we borrow in Dollars and the Federal Reserve has played along by making it cheap to borrow. But we haven’t had any inflation. Everything that MMT says we should be doing, we have been doing for the past ten years. So the question is why not do even more?
Does the increase in spending lead to more growth?
After a certain level government debt starts to weigh on the economy. At the same time governments are increasingly borrowing not to build things, but to provide social welfare support for ageing populations.
Why have interest rates not increased?
The supply and demand of the bond market have never been helpful in forecasting interest rates. It has always been about inflation and the Fed. It’s about the Fed’s monetary policy in reaction to the Feds perception of inflation and of the expectations of what inflation might do. That’s also my interpretation of the yield curve.
So there is no inflation in sight?
Inflation is dead. What killed it is the new abnormal and the four Ds. demography, debt, disruption and deflation. Demography is deflationary. Young families spend a lot more than older people. Debt at some point instead of stimulating weights on an economy. Disruption, stands for technological innovations. In a world where working-age employees are becoming scarce. There’s a lot of pressure to use technological innovation to supplement or to replace the workers who are available. Technologies are inherently deflationary, because it’s always responding to high prices with new innovations that are cheaper and better. The bond market is seeing structural issues which have been out there for a while but are becoming more of a problem. These issues are not gonna go away. If anything the deflationary pressure will intensify.
And why is there no deflation?
Because of the central banks. They are still under the illusion that if they just keep money ultra easy, that they can bring inflation back up to 2%. The Fed is close, it’s just about there but it took a long time to get there. Meanwhile the European Central Bank and the Bank of Japan, have clearly demonstrated that easy money may not have as much to do with inflation as expected. But if they hadn’t done it, we might have had outright deflation.
Did the central banks fail?
Central banks are trying to solve a problem, that they can’t solve. Central banks can’t do anything about the demography, the debt or about technological innovation. They are run by macroeconomists who were trained to believe that they are superheroes, with their tools and with their theories, that they can get the perfect balance of price stability and full employment. But the reality is, they have not succeeded in doing so.
Monetary policy is far away from being normal. What can central banks do once the economy faces a slowdown?
They can admit defeat and admit, that it is not their job to solve these problems, that monetary policy was not designed to solve. Or they could to what the Bank of Japan has been doing, which is buying everything, bonds as well as equities – monetize everything. That’s a version of MMT. We just allow the government to keep borrowing at zero or negative interest rates. I know this sounds a little bit like an exaggeration, but it seems to me we’re increasingly getting fiscal and monetary policies designed for managing the self extinction of the human race.
That sounds drastic.
It’s not a forecast. It’s a description of what is going on. Fertility rates have collapsed to below replacement in many places. Meanwhile we’re living longer and governments are under pressure to provide social welfare. But they don’t have the taxpayers to do it with taxes, so they have to borrow.
Are we ever going back to a normal monetary policy?
We have to get used to the abnormal monetary policy. It’s abnormal what we’re seeing with demography and with debt. Technological evolution used to be about brawn. Now it is about brain. But Japan has demonstrated, that we need all the technology we can get, to replace the offset of the shrinking workforce. Japan has a very low unemployment rate and it is one of the most technologically advanced societies. It demonstrates that technology is not going to lead to a mass unemployment.
What does this mean for investors?
It’s not the end of the world. It’s not a catastrophe. It means slower growth and it means that inflation is dead. It means for investors that bonds yielding north of 2% will be a good deal. It means that growth is scarce and you want to buy growth stocks, especially those that not only grow their earnings, but also pay some of that as dividends. Those are going to be increasingly scarce and they will have high valuation multiples. But growth should continue to outperform value.
Where do you currently find value?
Nothing is cheap at the moment. And the outlook for overall earnings growth this year and next is low to mid single. So nothing that is wildly exciting.
What do you expect from the Federal Reserve.
I’d like to see the federal funds rate move higher, so that we have more room to lower it next time we get into trouble. But we need to do it on a more gradual basis. 25 or 50 basis points a year for the next two to three years should be doable. But I don’t see any emergency that requires interest rates to be lowered right now.
Trump would disagree.
There’s always that kind of talk. but the Fed is still independent. I don’t see that they’ve done anything under Jerome Powell that is inconsistent with what the data suggested they should do.