The Case For The New Sector Paradigm

Authored By: Joe Hornyak | Publish Date: March 7, 2019

The markets are in the early stages of a new sector paradigm where they will be adapting to a new set of rules, says David Rosenberg, chief economist and strategist at Gluskin Sheff + Associates, However, most market participants are still playing by the old rules,. Speaking on ‘The Year Of The Pig (Lipstick Won’t Help)’ at an ‘Investing Experts Speaker Series at Rotman’ session, he said investors are unaware of this new paradigm because most are conditioned to hear only the short-term noise. “They’ve been conditioned to respond to the prior existing secondary condition,” he said.

So when he is asked by people what they should do, Rosenberg advises them to not be that person playing by the old rules. They have to play by the new rules because the markets are changing fast and in real time.

A mentor when he joined BMO Nesbitt back in the ’90s ‒ Don Cox ‒ said investors want to always be cognizant of how much of the news, good or bad, is priced in. His message was “beware of the front cover effect.” Perhaps the most famous of all time was in Business Week in 1979 which proclaimed ‘The Death of Equities’ on the precipice of one of the most powerful 20-year bull markets ever. “This is where you have to be a bit of a contrarian. Don taught me that you want to fade the page A one story because it is already priced in at that point. You want to buy the page B16 story on the way to page one” remembering when it gets on page A one, “the story is over.”

Tom Brady

He said he knows what history teaches and “you have to look at everything when you’re going to be a market practitioner. You have to have a broad base view and almost have to be like Tom Brady (an American football player) in some sense.” As a quarterback, he can read the entire football field when he goes to pass. Investors need to do the same.

In this new paradigm, there is so much valuable information that can be considered, he said. “Many say “it’s voodoo and it’s not. We have to take a look at everything like when I gave the Tom Brady analogy of being able to read the entire field. You have to look at technical. You have to look at valuation. I’m an economist, of course, so you have to take a look at the fundamentals and you have to take a look at market positioning. You have to take a look at sentiment, but you also have to know what’s dominating at any moment in time.”

Last year, 2018, was the year of the dog, he said, where everything went down reversing the year of the rooster in 2017 where everything went up. There were two peaks on the S&P 500 ‒ January 26 and September 20 ‒ in 2018. “History teaches me when you get a double peak sprinkled with intense volatility which is what we’re living through and have been living through since last January, the bear market actually started then. It marks a transition phase away from the previous bull market condition towards a bear market.”

And despite talk about the UK leaving the European Union (Brexit), the economic situation of Italy, and U.S. President Donald Trump and his trade wars with China, “the important thing that has happened is monetary policy,” he said.

Completely Lost

Interest rates are what is important because with stocks or bonds or real estate ‒ “anything that generates an earnings stream ‒ you have to know where interest rates are going or you’re going to be completely lost. As Albert Einstein famously said, the power of compound interest is the eighth wonder of the world,” said Rosenberg.

However, there was no alternative until rates went up enough. In fact, in the past year investors were actually paid to be cash as its yield started to exceed the yield that could be earned on the stock market. “That relationship for the first time in 10 years was altered and that’s the primary reason why the stock market has had so many jitters. It’s about interest rates. This, the interest rate cycle, leads everything,” he said.

The other situation is the U.S. Federal Reserve’s quantitative easing since the 2008/2009 financial crisis. Now, quantitative tightening is taking place with the Fed shrinking its balance sheet which has gone negative. The debate now is about what it is going to do with the balance sheet.

Combining the effects of the lower balance sheet and the nine Fed tightenings in the past couple years and the cumulative impact has been over 300 basis points of interest rate increases. “I would submit to you that that is a significant tightening in liquidity conditions,” he said. That become another element as investors survey the field. “I mentioned a lot of things earlier from sentiments to fundamentals. I didn’t mention liquidity, but I would say that is something that we also have to consider when we’re talking about where the equity market is going,” he said.

He described Jay Powell, chair of the U.S. Federal Reserve, as the most powerful person on the planet. “It’s not Xi (Jinping, president of China). It’s not Trump. It’s not Shinzo Abe (prime minister of Japan). It is Powell. He controls global liquidity and the Fed is still the most powerful financial institution on the planet,” he said.

Tightening Cycle

History shows again that when the fed works on a tightening cycle, given time the bubble created in the previous accommodative cycle gets exposed and then expunged. This has been the case since former Fed chair Alan Greenspan created asset cycles in 1987 and they’re getting more and more intense. As the creator of more of these bubbles than anyone else, Greenspan probably knows most about them and, Rosenberg said that Greenspan said a year ago there was a stock market and a bond market bubble.

In terms of the stock market, this was the third most expensive stock market of all time. While that condition is being corrected, it is by no means cheap. “The big bubble, this time in equities that Greenspan was talking about, was the growth stocks, what you call FAANG ‒ Facebook, Apple, Amazon, Netflix, and Google (now Alphabet) with Microsoft a late addition.” he said. Today, these are “the fang-less stocks.”

This time last year, they reached a 17 per cent peak in terms of market cap share and now it’s rolling over just as tech stocks did 20 years ago when the tech bubble burst. “You see what happened then and you see what’s going to happen now because we are heading into a value proposition out of a decade long growth proposition and the markets are telling you that.”

Another warning sign is that in each of the bull markets in the post-World War II experience, the average increase in the S&P 500 was 16.7 per cent, excluding the impact of bear markets.

So while this looks like a normal bull market, historically that 16.7 per cent is backed up by over seven per cent nominal GDP growth and almost four per cent real GDP growth. This time around, GDP growth was about half as strong as normal so “we had a normal stock market in the context of the weakest economic expansion of all time … we’ve never seen this before,” he said

If the stock markets had been constrained by what the economy had actually done, the S&P 500 would have peaked at 1,850, not 2,940 and that gap is all about the excess liquidity the Fed pumped into the system through artificially low interest rates and quantitative easing. “The gift from the fed was a stock market that delivered 1,100 points over and beyond what was justified and not sustainable.”

Borrow Money

When CEOs are incentivized to borrow money in the capital markets to buy back their stock, it’s not hard to generate earnings per share. This is yesterday’s story, he said, but it explains how the stock market got to where it was in the context of a weak economy. It was all about excess liquidity and Powell is starting to drain that away and while he is probably stopping for the time being, “I think it’s too late.”

The bond market bubble is not exactly what investors may think. The bond bubble Greenspan was talking about wasn’t a government bond bubble. That doesn’t exist because the capital is protected as the government will pay investors back. “They might try to technically default by creating inflation, but in today’s world of aging demographics and accelerating technology and excessive debt, it’s very hard to create inflation in this sort of environment.”

The bubble is on corporate balance sheets. The corporate debt-to-GDP ratio reached a record high just until last quarter and when this get to these highs, recessions are not far behind.

Overlaying mortgage debt-to-GDP looks similar to 10 years ago just before the sub-prime crisis which was a factor behind the global financial crisis. Then it was just a matter of time before mortgages and housing were going to burst.

Bubbles on corporate balance sheets mean in the investment grade universe there has never been a junkier corporate bond markets than today. “What’s interesting about this cycle is it is not just about the debt, it is about the quality of this debt,” he said. The last tranche in investment grade bonds before they are considered non-investment grade is triple B. When Triple Bs are pushed down to double B, insurance companies and pension funds that have quality mandates can’t hold that paper anymore. Currently, a third of triple Bs have balance sheets that should move them to double B although rating agencies only have five of these on credit watch for negative implications. “This means the cost of debt capital is going to skyrocket and there will be a general tightening of financial condition right through asset markets, including equities, and then into the economy,” said Rosenberg.

So what’s going to cause the next recession is corporate deleveraging. Receding cash flows are going to face a lot of competition from rising debt service costs at the expense of capital spending, stock buybacks, and dividend payouts.

That’s good news for corporate bonds, but it’s “not so good news” for GDP. “I’m not saying this is going to be like 2008/2009 ‒ no two recessions, no two markets, are ever the same. This has some hints to me of 2000/2001 which was a mild capital spending recession,” he said.

Dips In Equities

For investors, this means those who are going to buy the dips of the corporate bond market this coming year, should then buy the dips in equities because corporations will be forced to delever to strengthen their balance sheets.

“Getting into where we are in the cycle, who would have thought back in March of 2009 we’d be standing here talking about 116 months of uninterrupted economic expansion, the second longest on record, rivaling the era,” said Rosenberg. Data back to after the Civil War shows the average expansion is 40 months. Going back to World War II, the average expansion is 60 months “so we’re double that.

“Thankfully, expansions are long bull markets and bear markets are short and severe. Recessions don’t last more than a year, but they happen and I can’t believe the number of people that seem so scared to say we’re at the end of the cycle,” he said.

Another sign of the lateness of the cycle is the tight pool of available labour. Both Canada and the U.S. are running out of workers. Plus, the index that measures quality of labour, the number of people out there that have the qualifications, has never been as bad as it is today. “Up until Trump got elected, the U.S. small business sector was saying that their biggest impediment to growth was taxes which Trump looked after and regulation, which he looked after. Now, consistently, the biggest constraint is quality of labour which Trump’s policies are actually making matters worse because it’s not just the illegal immigration which is down, legal immigration is also now down,” The U.S. has “hit the wall on labour.”

Labour is one of the two determinants of productivity.

The other is capital and there is no increase in this and this is unlikely to change if companies starting directing money into delevering instead of capital investment.

Yield Curve

Another indicator of the late cycle is the yield curve. “The Reserve Bank of San Francisco last year put out a report that said the power of the term spread ‒ which is central bank lingo for the yield curve ‒ to predict economic slowdown appears intact and the bond markets are saying uncle to the Fed which means it has gone too far,” he said.

The unemployment rate is a lagging indicator and a great recession indicator. “People will say to me ‘Why do you call for a recession when unemployment is so low.’ It’s not about the level. In the markets, everything is at the margin, it’s the change. The unemployment rate indicates the recession has started,” said Rosenberg.

Again, historical probabilities have to be take into account. There have been 13 Fed rate hikes in the post-World War II era and 10 landed the economy in recession. The only three soft landings ‒ when the economy slowed, but didn’t contract ‒ were in the mid-’60s, the mid-’80s, and the mid-’90s. “What made those periods special was the Fed didn’t just talk about not raising rates anymore or not reducing its balance sheet, it cut rates and that’s what staved off the recessions.

“While nobody is calling for a recession,” he said, “I actually don’t want to live in the old paradigm. I want to stay ahead of the curve. I don’t frankly really care what other economists are saying, I do my own work. The other Rosie, Eric S. Rosengren, president and CEO of the Boston Fed, says the best empirical record of policymakers’ ability to engineer growth that nicely lands the economy with full employment without a morphing into a full blown recession is not comforting. What’s funny is hearing somebody telling the truth.”

So what if we get a recession.

“I think it’s perfectly normal ‒ cycling and then a rebirth and I don’t think it’s going to be a severe recession. My big concern, as I said, is what is it going to take to get us out of it. We don’t have the traditional monetary fiscal ammunition that we’ve had in the past,” he said.

Joe Hornyak is executive editor of Benefits and Pensions Monitor (

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