The US economy looks like it’s in pretty good shape. But a question from a reader prompted me to think about whether it’s about to crash. Some thoughts on the issues follow.
Following my article earlier in the week about how the wealthy invest, I received this message from a reader:
“Again I really enjoyed your email and the really great content. Question: my daughter is working high up in finance circles on Wall Street, New York and is certain that America is very close to a major crash.
What are your thoughts and opinions on this? Keep up the great informative work.
Kindest of regards,
Firstly, thanks to JE for his positive feedback and for sharing this insight. I’m always happy to hear from you, my readers.
Back in 2006, when I was still a bank insider at UBS, I had the same feeling as JE’s daughter. Everything felt really bubbly – across real estate, stocks (especially banking stocks), hedge and private equity funds, leveraged lending, commodities and all the rest of it.
In early 2007, HSBC was the first big bank to report major losses on US subprime mortgage lending. Shortly afterwards, I dumped every single one of my accumulated UBS stock and call options that I was allowed to sell. Since I had to get permission from my boss, it led to some awkward conversations about whether I was drinking enough of the corporate kool-aid.
A little later, by early 2008, I also got out of pretty much all other stock investments. That was just before everything went off a cliff (although the broader market actually peaked towards the end of 2007).
I’m no longer a bank insider. But I do spend more time thinking about investments these days, since I have more time (those frenetic 10-12 hour working days weren’t very conducive to thinking time).
So, could JE’s daughter be right? Is America “very close to a major crash”? What follows are some brief thoughts about some of the major issues.
The good news
First, the good news. Here are some economic snippets for the US:
- During 2018, GDP grew by 2.9%. For a developed country, that’s a very strong result.
- Total bank loans grew 4.4%, including 6.7% growth in commercial & industrial loans.
- Interest rates have normalised or, at least, are more normal than a few years ago. The Fed funds rate – used in interbank lending – is now 2.4%, compared with just 0.13% in November 2015.
- Unemployment is a low 4%, although up from 3.7% in November. Wages are growing above a 4% annual clip.
- Consumer price inflation (CPI) was just 1.6% in the year to January (although probably still understated in relation to the reality that most people experience).
- With a trailing price-to-earnings (P/E) ratio of 21, the S&P 500 is trading well above its median of 14.7 since 1871 (according to multpl.com). On the other hand, it’s well below the recent peak at the end of 2017, when it went above 24. US corporate tax cuts have boosted profits and helped to deflate earnings-based valuation ratios.
- There’s no longer a government bond bubble in the US. The yield on 10-year US treasury bonds bottomed out at 1.38% in July 2016. Now it’s back up to 2.65%. That’s still relatively low in relation to inflation, but no longer an outright bubble (unlike European and Japanese bonds).
- Lest we forget, the US dollar is still the world’s favourite reserve currency. Although the Congressional Budget Office expects a budget deficit of $897 billion this fiscal year, the dollar is unlikely to collapse anytime soon (although it may fall somewhat).
- US banks are much less leveraged than a decade ago, and do much less trading for their own account (proprietary trading). This makes them less at risk of insolvency. For example, to use JP Morgan Chase as an example (being huge in both the fields of commercial banking and investment banking), the ratio of tangible assets (excluding goodwill) to tangible equity was down from 19.4 at the end of 2007 to 12.2 at the end of 2017, a drop of 37%.
- US banks have much bigger liquid reserve assets, as a percentage of total assets, than before the GFC. This makes them much less likely to suffer a liquidity crisis (for example, having insufficient liquid funds to cover a bank run by depositors). Once again using JP Morgan Chase as an example, its cash plus deposits at central banks were just 3% of tangible assets at the end of 2007. By the end of 2017, this had jumped to 17%.
Some less good news
Now for some less good news:
- The Federal Reserve is busy with quantitative tightening (QT), by which it sells bonds that it previously bought under quantitative easing (QE), or simply allows them to mature. This drains bank deposits to the tune of $50 billion per month, or $600 billion per year. Not bad news in and of itself, since QE was abnormal behaviour. But, with a government that already needs to finance its budget deficit to the tune of $900 billion a year, that means there’s an extra annual supply of US bonds of around $1.5 trillion a year. Will there be enough buyers at current yields? Or will yields have to rise to increase investment demand?
- Margin debt, used for leveraged speculation on stocks, is at high levels. That said, it’s already down sharply from the early 2018 peak (see the red line in the following chart). High levels of margin debt increase the chance of a self-reinforcing crash in the stock market, since leveraged speculators can become forced sellers (as happened in 2008 / early 2009).
- There are clear signs of a venture capital bubble, especially in the tech sector, or companies that lead with their tech. For example, Lyft – a taxi company with an app – is set to be listed on the stock market for around $25 billion. That’s a huge valuation, given that it made revenues of $2.1 billion in 2018, and made a bottom-line loss of about $1 billion (and that there’s plenty of competition from the likes of Uber, Cabify and so on). VC investors in this kind of company had better hope they get out in time.
- The ratio of non-financial corporate (i.e. not banks and other financial companies) net debt to assets is hovering around levels not seen since 2000 (a bubble year, if ever there was one). Higher corporate leverage makes companies riskier, and exposed to paying higher rates when they refinance. See the blue line in the following chart.
- In particular, riskier leveraged lending it at record highs. Both the amounts of outstanding leveraged loans and “high yield” bonds (previously known as junk, before they were rebranded) are way above the levels of 2008. If the profits of all companies with debts get hit when rates rise, then the profits of highly-leveraged companies get decimated. Rising defaults are likely, sooner or later.
- Assets managed by hedge funds exceeded their 2007 peak in 2016, and were well above it in 2017 and 2018. Hedge funds are speculative outfits that charge fat fees for (mostly) unspectacular returns. They’re also usually leveraged, which can make them forced sellers when there’s a market “surprise” (meaning their risk models didn’t work).
Global hedge fund assets since 1997
- The (long-winded) S&P CoreLogic Case-Shiller 20-City Home Price index is above the peak reached during the 2006 bubble. This sounds ominous.
Case-Shiller 20-City Home Price index, since year 2000
- However, this is perhaps not as bad as it sounds. The ratio of home prices to median household incomes went above 5 during the 2006 bubble. It then fell to 3.5 by 2012, as the bubble burst. It’s now back up to around 4.4, which sounds high again. On the other hand, interest rates are still much lower. Many homeowners will have taken the opportunity to lock in ultra-low rates in recent years, often fixed for 20 or 30 years (something that’s fairly unique to the US mortgage market). This leaves mortgage interest costs much lower than in 2006, relative to incomes. It also means many homeowners have little or no exposure to rising mortgage rates for a very long time. (A far cry from the “exploding adjustable-rate mortgages” of the subprime lending crisis, which made mortgages unaffordable within a few years.)
Case-Shiller Home Price index / US median annual income
Since the 1940s
(Incidentally, note how the ratio of house prices to income is still below the levels of the late ‘40s and early ‘50s. Apparently, the “good old days” weren’t always quite so good.)
The overall picture in the US is mixed. Interest rates and the bond market are relatively normal. Banks are in much better financial shape than before the GFC. Housing looks quite expensive relative to incomes, but not in relation to mortgage financing costs. Stocks overall are still on the pricey side, but not as much as in late 2017. (For a selection of great stocks that are already priced highly attractively, see here.)
On the other hand, corporate debt is high, particularly at the riskier, leveraged end. There’s a huge supply of treasury bonds flooding into the market, from the budget deficit and Fed selling (QT). There’s still a bubble in much of tech, or in disrupter companies that use new tech to do old things (like booking taxis). Venture capitalists and other tech investors could be running out of time.
At this point, I’d like to encourage readers from the US to send in their personal experiences. Are house prices bubbly where you live? How do you see the job market? How’s your business doing? All comments and feedback would be welcome (as it always is).
In the meantime, back to the original question posed. Is the US “close to a major crash”? I think the jury’s out. There are clear pockets of risk, but it’s not across the board. Of course, only time will tell, and much could depend on policy moves (by the government or the Fed).
For now, my feeling is that even if there’s some kind of slowdown in the next year or two, we’re a long way from any repeat of the global financial crisis. That episode certainly was a major crash.
Stay tuned OfWealthers,