The U.S. economy heads into 2016 on a 7-year winning streak. Since the financial crisis and Great Recession ended in 2009, the economy has managed to post positive annual growth rates. Growth has been described by some economists as anemic, but it’s been enough to avert official recessions.
The economy inevitably moves in cycles. Not even the heavy-handed intervention of the Federal Reserve can mute economic cycles. Booms lead to busts, and busts lead to booms. At some point the economy’s recent slow but steady growth will give way to a downturn.
Historically, 7 years of expansion without a recession is longer than average. An eighth year would be exceptional. Not impossible, though, especially in an election year. Hillary Clinton will effectively be running as the incumbent. If Team Obama and Team Yellen can postpone a recession until after this coming November, they will.
“Mother of All Margin Calls” May Be Coming
In their 2016 global outlook, Citi strategists put the probability of a recession at 65%. They cite interest rate extremes and global deflationary pressures led by the slowdown in China, as reasons why the economy will likely underperform.
Former Reagan administration official David Stockman recently issued a dire forecast for the global economy: “China and the [emerging markets] economies are rolling over into a debilitating deflation, thereby catalyzing the mother of all margins calls,” he wrote. “There will be a global CapEx depression and its contractionary cascade will cause the entire global economy to shrink for the first time since the 1930s.”
Perhaps the coming recession will look more like a depression. It would be the consequence of what Stockman calls “the abysmal failure of the two-decade long global experiment in massive central bank money printing, and the unsustainable credit fueled economic boom it enabled.”
The Fed has amassed a $4.5 trillion balance sheet since 2008 through various asset purchase programs. There is little hope of the central bank unloading these positions. It has permanently injected itself into financial markets. It is both the lender of last resort and the manipulator of last resort. Everything from interest rates to stock market valuations to automotive sales are out of whack due to the Fed’s omnipresence.
Sub-prime Auto Loans Are Flashing Red
Thanks to the Fed’s bond buying and ultra-low ratepolicies, auto lending has flourished. Originations hit a 10-year high last year. The growth is led by a surge in sub-prime auto loans.
Loans to people with bad credit now represent 20% of the market. When sub-prime mortgage lending got out of hand a few years ago (thanks to Fed stimulus and encouragement), things ended badly for everyone involved. Similar consequences could await auto lenders and overstretched borrowers. That could cause car sales to head south, which could contribute to a recession.
Then there’s the $1.3 trillion government-blown bubble in student loan debt. Students who graduate into an economy that doesn’t offer them the jobs they are looking for will feel the pain. But taxpayers may ultimately be on the hook.
So far the Fed’s massive inflationary interventions in financial markets haven’t caused any dramatic increases in price levels in the real economy. In fact, inflation has been so low that deflation now looms as a possibility. Oil prices have collapsed, and so has the Baltic Dry Index.
The Baltic Dry Index measures global bulk shipping rates. As such, it serves as a bellwether indicator for international trade and underlying economic conditions in the world economy. In late November, this indicator hit an all-time low. In December, it fell even further. Global demand appears to be crashing. Could the stock market be far behind?
Think Counter-Cyclically, Fellow Contrarian
The worst place to invest at the onset of a recession is the stock market, broadly speaking. The Dow Jones Industrials isn’t the place to be.
That doesn’t mean all sectors in the market will inevitably follow the economy down. Some niche areas can move counter-cyclical. The gold mining sector is a prime example. It’s been absolutely crushed over the past four years. Although the magnitude of the move has been extraordinary, it’s quite normal for gold mining shares to move in the opposite direction of
the broader stock market.
When the broad market tanks, investors will seek safe havens. Among the perceived safe-havens are precious metals. Physical gold and silver carry less risk than the miners. But the miners have more upside potential, especially from their recent extremely depressed levels.
In addition to precious metals-related investments, think bonds and cash. Admittedly, they are likely to be bad long-term investments. But they will provide shelter during a bear market in equities. When the stock market looks attractive again, you can rotate funds back into it.
And if you are a very long-term investor, you can ride out whatever may come this year. Maybe we’ll miraculously avoid a recession. Maybe new rounds of Fed stimulus will drive the Dow to new records.
No one knows the future. That’s why it’s prudent to diversify.
A Model Safe Harbor Portfolio
Long-time readers of this newsletter will be familiar with the concept of a permanent safe-harbor portfolio. By setting one up for yourself, you can attain truly broad diversification. What conventional investment advisors consider to be adequate diversification is dangerously inadequate most of the time.
In order to survive and thrive during booms, inflationary times and deflationary times – and, yes, financial crises – you need more than just stocks and bonds in a brokerage account. You need hard assets (e.g., gold and silver coins) held outside the financial system.
You need foreign assets, including stocks and bonds denominated in foreign currencies. You also need emergency cash reserves.
All these considerations go into constructing Independent Living’s model Safe Harbor Portfolio. Here is the breakdown, by weighting:
• 35% Vanguard Total World Stock Index (VT)
• 25% Physical Precious Metals → 12.5% gold; 12.5% silver
• 20% iShares Lehman Aggregate Bond (AGG)
• 5% Vanguard Total International Bond (BNDX)
• 5% iShares Barclays TIPS (TIP)
• 5% SPDR Global Real Estate (RWO)
• 5% Treasury Bills or Cash Equivalents
You can apply this model as is or modify and customize it based on your own needs and expectations. You can devote 100% of your investments to a Safe Harbor Portfolio or reserve some of your investments for more targeted or aggressive strategies.
But regardless of how much you might believe in a particular stock, or a particular sector, or a market guru’s list of top speculations for 2016, don’t put all your eggs in one basket. When in doubt, diversify.