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John Hussman: Race to the Bottom

Injuring the real economy with paper wealth

July 11, 2016

On the basis of leading economic data we find most strongly correlated with actual subsequent economic performance, the underlying strength of the U.S. economy remains tepid at best.

Looking beyond the U.S., China’s trade minister over the weekend described the global economic situation, correctly, I think, as “complicated and grim.” The chart below presents our leading economic composite (measured in standard deviations from the mean) along with actual growth in U.S. nonfarm payrolls over the subsequent three-month period. Despite Friday’s strong payroll showing, the three-month rate of payroll growth in the U.S. remains on a slowing trajectory.

We’ve observed a very slight pickup in our leading measures since their trough early this year, but thus far the magnitude of that pickup is indistinguishable from short-term noise (we observed a similar pickup near the 2007 peak). Employment has held up somewhat better than expected in recent quarters, but the prospects for employment growth over the coming months point distinctly lower even with the slight uptick in leading measures. Given clear indications of fresh economic and banking tensions in Europe, Britain and China, it’s not at all clear that the U.S. has escaped the prospect of oncoming recession.

We’re certainly open to that possibility and are not tied to any particular economic forecast, but there is little indication from reliable data that economic prospects have materially improved. Those in search of rosier views can find that assurance in any random five-minute segment of financial television. Still, we’ve always insisted that views should be supported with evidence and that analysts should show their work. “Without data,” as W. Edwards Deming once observed, “you’re just another person with an opinion.”


Race to the bottom

Far from reflecting some renaissance of economic growth, the behavior of the financial markets last week suggests something very different. Specifically, accelerating global economic risks have actually created a short-term yield-seeking panic, which has infected the entire structure of global yields.

To understand what’s happening in the financial markets, it’s important to recognize the sequential nature of yield-seeking speculation. Consider a central bank launching a fresh round of quantitative easing. Initially, central banks focus on purchasing the highest-tier government securities (such as Treasury bonds in the case of the U.S. Federal Reserve). Central banks buy these interest-bearing securities and pay for them by creating “base money” – currency and bank reserves. That base money takes the place of interest-bearing securities in the hands of the public, and someone then has to hold that amount of zero-interest money at every moment in time until it is actually retired by the central bank.

Now, having traded their high-quality, interest-bearing securities to the central bank in return for zero-interest cash, a portion of those investors will simply hold the cash in the form of currency or bank deposits, but some investors will feel uncomfortable earning nothing on those holdings and will try to pass the hot potatoes on to someone else. To do so, these investors now have to buy some other security that is lower on the ladder of credit quality and more speculative. The sellers of those securities then get the zero-interest cash. Some of those sellers, unwilling to reach for yield in even more speculative securities, hold the cash, but some climb out to a further speculative limb. Ultimately, the process stops when yields on speculative securities have fallen low enough that investors are indifferent between holding zero-interest cash and holding low-yielding but more speculative securities. At that point, all of the new base money is passively held by somebody.

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