By Brian G. Long, Ph.D, C.P.M.
It may sound silly, but when I was four years old, I remember being terrorized by familiar song entitled “Rock-a-Bye Baby,” largely because of the punchline going “…when the bow breaks, the cradle will fall, and down will come baby, cradle and all.” This was a clear case of child abuse by current definitions.
In today’s economic terms, it’s not branches breaking but “bubbles” breaking that we fear. From economic history, we remember that the first bubble to break in 1929 was the stock market. However, the collapse of the stock market by itself would not have yielded much more than a 1930 recession. Hence, it was the multitude of mini-bubbles breaking at the same time that drove the unemployment rate to about 25% about three years later. Where were the other bubbles? MANY. For one thing, the auto industry embarked upon a huge capacity build-up in 1928, and the bubble broke in 1930. For a second mini-bubble, the appliance industry had also built up excess capacity in the late 1920’s, exacerbating the layoffs. And of course, we all heard of the (literally) thousand of banks, small and large, that collapsed obliterating the savings for some unsuspecting people. Because of the infamous Hawley-Smoot tariffs, the ensuing trade war resulted in exports falling about 50%. Housing was another overbuilt mini-bubble that piled on to the collapse. In short, almost every major segment of the economy had over-expanded and created numerous mini-bubbles by 1929, and the infamous stock market crash triggered the mini-bubbles to break, one by one.
Where are we Today? A few economic headwinds are now upon us. The world economy is slowing, dampening the entire world economy. Some countries like Italy are still in financial trouble, risking contagion for the European economy. It is noteworthy that many recessions in recent history were proceeded by rapidly rising interest rates, and the Fed still plans to raise interest rates, albeit at a slower pace. Of course, there is still the unresolved trade war with China, which could easily create significant problems for both economies if a resolution is not reached soon. As always, a major terrorist act could completely and severely upset economic tranquility.
Positive Factors. The good news is that the 2017 tax cuts are still the wind at our back, although the major surge is now behind us. The theory behind the tax cuts stems from “supply side” economics, which suggests that reduction in taxes should MORE THAN pay for themselves because of the economic stimulus generated by business expansion and more personal spending. And they may. However, I will stick with my previous estimate that it will take numerous quarters of GDP growth at 4% or higher to cover the cost of the lost revenue.
Bubbles Breaking. Most everyone agrees that mortgage crisis was the big bubble that exploded and spawned the Great Recession. For the 2000 recession, it was the dot-com bust. In the 1970s it was the oil crisis. In the 1950s, it was the accumulation of inventories. Fortunately, I do not currently see any kind of a big bubble that is simmering and about to explode. I do, however, see plenty of mini-bubbles starting to form or break. Here are a few that are already causing trouble:
Stock Market. By historical standards, the market is about 30%-40% ahead of where it should be based on current earnings. With the euphoria of the tax cuts, the market has surged in anticipation of future earnings that may or may not materialize. The market has been on a “sugar high” for the past two years, and now needs to see signs of sound business investments to maintain the current market values. If the market continues to fall, we can say that this mini-bubble has broken.
Oil Prices. In early 2016, WTI crude oil prices fell to $35 per barrel. Prices have edged higher ever since, partially driven by the strength of the world economy. Slowly, drilling for new wells began to pick up as the apparent oil recession receded. However, with the world economy now starting to slow just about the time new supply has been coming on line. This may be another mini-bubble that is already breaking.
Housing Prices. The shortage of housing has run up prices for both new and used homes in many markets, which has resulted in too many high-priced homes available for sale in SOME areas of the country. For some of these markets, prices are starting to fall. Building material prices are also falling in response to declining sales. Hence, the collapse of housing speculation in a few areas of the country form another mini-bubble starting to break.
All three of these factors point toward a 2019 slow-down, not a recession. Furthermore, none of the aforementioned economic components has collapsed. In fact, the declines so far have been fairly orderly. However, there are some additional of mini-bubbles that are starting to form and may cause trouble in the future:
Auto Sales. I never believed that the auto boom could go on as long as it did. For the Great Recession, the beginning of the recovery began on the day that the “cash for clunkers” program opened on July 1, 2009. Although the sales for autos and light trucks has apparently topped out, 2009 to 2016 was an unprecedented boom time for the auto industry. Altogether too much of the boom was fueled by low interest rates, large rebates, and a return to subprime auto loans. Hence, a renewed tightening of credit, higher interest rates, and a reduction in the rebates could spook the auto market. On top of all of this is the fact that cars and truck simply last much longer than the used to, and trading for a new vehicle can be put off for months or even years when economic conditions turn negative. So far, although the market is saturated, the decline in auto sales has been orderly because the economy is still strong. But this is a bubble that could easily break if economic conditions worsen.
Subprime Loans. Many credit card companies were burned in the Great Recession, and tightened requirements for issuing new cards considerably. However, some banks are now enticed to issue riskier cards in order to get higher returns. In the housing market, the same is true. The spectacular rise in home values in some regions of the country may be another sub-prime bubble. Some lenders with short memories are again getting carried away with high interest “home equity” loans. However, it is highly unlikely that we will ever end up with the massive subprime mortgage collapse like we experienced ten years ago.
Low Quality Bonds. Corporate bond interest rates have been historically low, which has encouraged more borrowing. That’s supposed to be good. However, a huge portion of the corporate bonds issued in the past 10 years have been BBB rated, i.e., one notch above junk status. The money has seldom been used for expansion, but most often to pay off old bonds which carried higher interest rates. What’s worse, some of the money was simply used to buy back company stock. In twenty years when many of these bonds come due, these companies will find servicing their debt far more expensive. Short term, it will make the financial status of many firms look MUCH less attractive.
Credit Default Swaps. A credit default swap can best be described as an insurance policy against a given bond defaulting. Needless to say, the premium on a CDS for a AAA bond would be very low, but a similar guarantee for a BBB bond would be much higher. The CDS market grew out of the 1990’s, and has never been fully tested. Hence, more than one financial guru has questioned the actuarial soundness of the current default swaps. Unlike fire insurance or car insurance, as much as 30% of the CDS claims could all come due at once, and the few billions of reserves would simply not enough to cover the claims. With more than a trillion dollars at stake, this could create another panic inside the financial system similar to the sub-prime loan collapse ten years ago.
Home Equity Loans. One of the major bubbles to break in the Great Recession was the excess issuance of home equity loans, often based on the assumption that home values ONLY go up in value, never down. When home values fell in almost every market of the country, the collateral was not there to cover the mortgages, much less the home equity loans. Today, with housing prices skyrocketing in some markets, banks with short memories are again issuing altogether too many shaky home equity loans wherein higher interest rate can be charged.
Student Loans. As we have now heard from many sources, the fastest growing batch of shaky loans comes from the sector called student loans. Unlike housing loans which are based on the collateral value of the home or auto loans that are based on the wholesale value of the car, student loans tend to be open-ended. The current default rate is excessively high, and many of the defaulters never finish the academic program they started. Furthermore, students who can’t find jobs upon graduation are encouraged to seek masters’ degrees, for which they also can’t find jobs. High student loan debt is one of the reasons young people find it difficult to afford starter homes. Somewhere, somehow, the regulators are going to be forced to put a lid on the expansion of these kinds of loans with no collateral.
Raw Material Inventories. Fifteen years ago, JIT was a corporate religion. Firms prided themselves on reducing their inventories to nearly nothing, and believed that proper planning and supply chain management reduced the need for inventory of just about any commodity. But in today’s world, the big-ticket inventories have started to creep back up. Two reason: Money is still cheap, and inventory investment is not much of a drag on earnings like it was in the past. Second, some firms, like Honda, got burned badly when natural disasters shut down some of their JIT suppliers. Historically, the problem with accumulating large manufacturing inventories is that the bubble will someday break, firms will stop ordering, and the bloated inventories will meet most production requirements for several months. These pulls billions of dollars out of the economy overnight, and as it washes back through the supply chain, the reduced activity causes or accelerates the recession. Granted, manufacturing inventories are not super-high right now, but the are much higher than they were ten years ago.
Supply Side Incentives. If history is a precedent (and it isn’t always), the 2017 tax cuts should have followed the pattern of the Reagan tax cuts and propel us forward for another 2-3 years. The stock market boomed last December after the cuts were implemented, and SOME business did expand like the “supply side” advocates promised. However, putting more cash in the hands of the corporate planners has so far not resulted in a major boom in business expansion. It HAS resulted in a significant surge in the purchase of capital equipment, but even this “sugar high” may have run its course. Why is the 2017 tax cut not yielding the promised three years of growth? The reason is simple. With interest rates already at historically lows, money for expansion has already been readily available for the past ten years or so. Yes, SOME businesses have expanded, hired more people, and stoked the supply chain… but not nearly as many as we had hoped.
Conclusion. An unfortunate feature of the capitalistic free market system is the business cycle. As previously noted, a recession is usually triggered by the collapse of some form of a major speculative bubble, followed by the collapse of numerous mini-bubbles. The longer the supply chain, the greater the impact. Some of these mini-bubble are very small, such as the retailer that opens one too many new branches or the metal stamping company that installs one too many new presses. However, the collective collapse we call a recession.
For 2019, here are the things to watch. First, keep an eye on the industries with the long supply chains. One job at GM supports about 10 additional jobs in the automotive supply chain. One job in construction supports a supply chain of about 6 additional jobs. One job in the office furniture business supports another 7 jobs in the supply chain. Look around Grand Rapids and you see some of these other 7 jobs supported by the primary office furniture firms.
Three possible scenarios going forward:
First Possibility: I may be overly pessimistic about the future impact of the 2017 cuts, and there may be more gains to come. Some of the new equipment ordered after the tax cuts took effect has not yet been installed, so the economic benefit is still not showing up in the economic numbers. Hence, the economic benefits of the 2017 tax cuts may still be enough to more than offset the weaknesses in other sectors of the economy and yield GDP growth in the 3% to 4% range.
Second Possibility: One of the aforementioned mini-bubbles could turn out to be a maxi-bubble, and usher in a new recession. In another context, all of the mini-bubbles could start breaking at once. The simultaneous collapse of all of these supply chains would spell the beginning of a late-2019 recession.
Third (and most likely) Possibility for 2019: A few of the bubble will continue to break, and the world economy will still continue at the present slow pace. The pace for the U.S. economy could return to the same pattern of slow growth we have seen for the past ten years or so, waiting for another major bubble to break. However, the business cycle has not been repealed, and sometime in 2020, 2021, or even as late as 2012, a major bubble will break along with numerous mini-bubble. That will be the beginning of our next recession.