The first quarter of 2016 was a tale of two halves, both marked by extremes. One might imagine that the turnaround in market sentiment reflected a sea-change in thinking about the global economy, consumer demand and/or corporate earnings. Such thinking would be very old-fashioned! This latest market rally resulted from nothing other than central banks’ backing away from even the slightest suggestion of the merest hint of normalizing interest rates. Liquidity remains abundant, buoying financial asset prices.
However, our economic challenges are more structural than cyclical, and cannot easily be remedied by cheap money. On the contrary, ultra-low interest rates have made things considerably worse in the long run. They have encouraged excess borrowing by over-indebted households, who are already in a precarious financial position. They have incentivized corporations to leverage their balance sheets with unproductive stock buybacks. They have kept global excess capacity and zombie companies alive. Not least, “free” money has enabled governments to delay the inevitable day of reckoning for unsustainable social insurance programs.
The “long-term challenges” that experts have been warning about for decades are coming home to roost, amid widespread denial about the reality of our circumstances. Our biggest problem is not sluggish growth. It is politicians’—and that includes central banks'—unwillingness to face facts, and deal openly and productively with the reality of our economic circumstances: excess indebtedness and rising inequality.
Many households no longer have the capacity or willingness to borrow and spend. The median household income, adjusted for inflation, was the same in 2013 as it was in 1989—and 12% lower than it was in 2007. Median household net worth was just $81,000 in 2013. That’s 40% lower than in 2007, and is equivalent to just two years of average retirement spending. The “twin deficits” of retirement (insufficient private savings and unfunded Social Security commitments) amount to roughly $25 trillion. Where will the money be found to sustain people in retirement? Taxing the wealthy is a popular idea, but the retirement savings gap could exhaust the entire accumulated assets of the top 1%, who are believed to control 40% of household wealth. And that’s not counting the $48 trillion in unfunded promises of our Medicare system, or the vast array of under-funded corporate, state and local pension plans.
As retirement realities sink in, Americans have begun saving more, which is contributing to weaker consumer demand and, with it, stagnant corporate revenue. Profit margins are coming under significant pressure, notwithstanding companies’ attempt to disguise the weakness through debt buybacks and “adjustments” to operating earnings. Escalating dividend cuts speak to the deterioration in corporate cash flow, as do rising rates of credit default.
The largest equity market declines have, historically, occurred in a context of high valuations and rising recession risk—exactly the circumstances we find ourselves in now.