David Rosenberg, Chief Economist & Strategist of Rosenberg Research, worries that the surge in bond yields threatens the economic recovery. He warns of the consequences of today’s massive debt volumes and explains why he spots investment opportunities in the commodity sector and in Asia.
The temperature is rising. In the US, yields on long-term government bonds have jumped to the highest level since early 2020. Oil prices are rising, and copper is more expensive than it has been in almost ten years – clear signals that markets are bracing for a strong economic recovery.
«Not so fast,» says David Rosenberg. The internationally renowned economist and strategist from Toronto has no doubt that the pandemic will subside. But he also thinks that the post-opening growth spurt in the economy will soon lose steam and structural problems will resurface and reality sets in. «And then, we have to assess how these massive deficits and debts are going to be regressed,» he’s warning.
In this in-depth interview with The Market/NZZ which has been edited and condensed for clarity, the founder of Rosenberg Research explains why he sees attractive prospects for commodities such as oil, gas and copper despite subdued demand. He’s also bullish on US banks. Globally, he sees the best investment opportunities in Asia, where the economy is benefiting from China's robust growth.
Mr. Rosenberg, one year ago today, the global outbreak of the pandemic triggered the worst market crash since 1929. Since then, the S&P 500 has fully recovered and gained another 15%. What's your take on the current state of the financial markets against this background?
We are in another massive bubble. Not every single part of the market is in a bubble, but we have speculative frenzies in many pockets. There is not just this view that the central banks are always going to have your back and we have tremendous growth in money supply and liquidity, but there is also this extremely high level of confidence that life is going back to normal starting in the second half of this year. That’s really the primary driver of this tremendous confidence, whether you’re talking about corporate bonds, crypto currencies or the stock market.
To what extent is this optimism justified?
No question, we are going to get to the light at the end of the tunnel, but it’s going to take longer, and timing is extremely important in this regard. In the US, it looks like the vaccine rollout is winning and by a wide margin. But we also have to weigh in the fact that not every country in the world is going to come out of this at the same time. We are a globalized economy, and that’s going to be an impairment. Especially, with respect to the fact that Europe is so far behind which is going to have a big impact on foreign travel and on tourism. Keep in mind: Europe is every bit as large an economic unit in the world economy as the US.
However, the infection numbers are also declining in Europe.
I don’t believe life is going back to normal once we get to the end of the tunnel. There hasn’t been enough thought given on how behavior has been fundamentally altered from this past year of social distancing, travel restrictions and other curbs to movement, working from home. Sure, we are social animals; everybody is going to want to get out and go to bars and restaurants and go on a vacation. But we shouldn't base our economic forecast on the fact that we're going to have a couple of quarters of pent-up demand release in these cyclical services. That’s just temporary.
So what does the future look like in your opinion?
We are going through a secular change in behavior. Actually, we’re seeing it already. The market believes that the household sector has all this dry powder to spend. To that I’m saying: not so fast. If you go back to the Great Financial Crisis and look at the wealth shock the households in the United States endured, you can see a pattern that developed in the personal savings rate. This is crucial, because the savings rate is the most important behavior aggregate, the household decision on how much to spend and how much to save on every incremental dollar disposable.
What exactly do you mean by that?
Before the Financial Crisis, the trend average in the savings rate was 4%. In the following decade, the new equilibrium savings rate was 7%. In a $22 trillion economy, that’s a pretty big deal. It can make the difference between the economy growing in the low 2% range and in the high 2% range. So why is it that the last decade was one of the weakest economic cycles of all time despite all the stimulus? It's because there was, at the margin, a fundamental shift in behavior. Those scars never went fully away. From a human standpoint, this current health crisis is far bigger than the wealth shock from the Financial Crisis. It affects everybody to a varying degree. Based on our work, in the next decade the new equilibrium precautionary savings rate is going to be closer to 10% than 7% - and that’s going to be a deadweight drag on aggregate demand growth for a long period to come.
However, the Federal Reserve and the US government remain committed to massive stimulus measures.
The markets believe we’re going to have a post pandemic party that’s going to last to perpetuity. I’m saying, maybe it lasts for a few months and then reality will set in. And then, we have to assess how these massive deficits and debts are going to be regressed. At the peak of the last bubble in 2007, the level of global debt outstanding was $100 trillion. Here we are at the peak of the next bubble, 13 years later, and it’s over $200 trillion. It has more than doubled from bubble peak to bubble peak. This is a very unstable situation. That’s why we can’t have interest rates rise for any length of time or any meaningful degree. It’s because of the implications from a debt servicing standpoint, and the impact rising rates will have on economic growth, defaults and delinquencies and so forth.
The yield on ten-year Treasuries got another strong push last week, topping 1.3% for the first time since last March. At what level do rising bond yields become a problem?
Nobody is that smart to know when we get to a breaking point. But let me just tell you with a 100% certainty: We’re getting closer to that point, than we were five, ten or twenty years ago. These deficits and debts will get regressed one way or the other. I don’t see how we are going to grow out of them, we’ve already tried that. I also don’t see how we are going to manage to inflate our way out. People don’t realize that the causation runs the other way. They say: «We're just going to inflate our way out of this debt morass.» But the real problem is that the debt morass is what’s causing the credit multiplier to become impaired, and why we’re having this deflationary circumstance that was prevalent even before the pandemic.
Then again, there are many indications that inflation is picking up. In the USA, inflation expectations have risen to the highest level in more than five years.
Let me put it this way: The level of outstanding debt in the United States today at all levels of society, government, households, businesses, is just about $80 trillion. If the general level of interest rates goes up by 100 basis points and stays there, you’ve just pushed $800 billion or 4% of GDP into debt servicing. The US economy can’t really afford to have bond yields back up more than they already have.
Still, the US economy is expected to pick up steam this year. The Atlanta Fed's GDPNow indicator signals 9.5% growth for the first quarter.
If bond yields rise because economic growth is accelerating, that’s one thing. But it’s not clear to me that the economy is going to be on a self-sustaining upward trajectory. Right now, it’s just an assumption, and we already know that less than 30% of these stimulus checks are actually going into the real economy. All that is happening is that we are borrowing from future growth; that is the overriding story: Money spent on borrowed money from the government. So we are building up for a «fiscal cliff» of epic proportions in 2022, and very likely a renewed economic downturn. And this means that the backup in Treasury yields will ultimately be reversed and I would not be surprised if the lows get revisited.
What are your expectations in terms of central bank policy?
For at least the balance of this year, central banks are going to do what they have been doing: Ongoing asset purchases and zero percent interest rates. I don’t see that changing. Many economists think that the Fed is going to have to pull the plug earlier than expected. I’m not so sure about that. I wouldn't be surprised if the central banks are ultimately forced to do more easing as opposed to less. There is a risk that they will have to get even more creative in terms of their policies.
How should investors position themselves in this kind of market environment?
If I’m right and the market is way premature on its forecast, then there is a real opportunity here to go back to long-duration in the Treasury market. In fact, our proprietary bond duration model is flashing green right now after this latest move up in bond yields.
In other words, you recommend betting on long-term US government bonds and high-quality mortgage securities?
Absolutely. This move up in yields has been based on assumptions as opposed to reality. In terms of how you want to be invested, people think that they have to choose between value or growth. To me, it’s not value or growth, because you can actually own pieces of both. I don’t like the airline stocks. Neither do I like restaurant stocks, or theme parks, or hotels. If I want to play the recovery, I would rather do it in a diversified way than in buying single sector stocks. And, as a part of the value trade that is still relatively inexpensive, I would be buying the US banks.
But if yields fall again and the yield curve flattens, wouldn’t that weaken the banks' margins?
Don’t get me wrong. I’m not saying there is a zero percent chance of some sort of recovery and that we’re going back into a perfectly flat yield curve. We will have a recovery, but it’s not going to be as big as people think. And insofar as you have a recovery in our mindset, you want to have exposure to the banks because they are a prudent, diversified way of playing any sort of recovery. Banks are still trading inexpensively, they generate a cash flow stream, and they pay a solid dividend. Basically, all the things you don’t get with Bitcoin you will get with the banks.
Where do you see further opportunities for investments?
You want to be invested in sectors where there are shortages, and there are several commodities that fit that bill. For instance, the demand outlook for oil is still challenging, but the pandemic caused significant interruptions in the production and storage of oil. It resulted in a drastic cut-back in capital expenditures in the sector. Indeed, the International Energy Agency estimates that upstream oil and gas investments fell 28% globally in 2020. In comparison, during the severe oil market downturn in 2015 which decimated many producers in the US and Canada, these investments fell only 12%. That’s why I believe that energy stocks as well as the debt of energy companies is attractively priced right now. The Oil and gas sector was undervalued and under-owned even before the pandemic, but with collapse in global demand in 2020, it has been even more unloved.
Crude oil prices have seen impressive gains since last fall. However, many investors are convinced that the trend is favor of renewable energies and electric vehicles.
Sure, longer-term, there are significant headwinds from the shift towards renewables, but that's likely still years away. Bottom line: While the conventional energy space has been valued for extinction the future is one where petroleum products continue to play a major role. In the meantime, amid the current market backdrop where value and yield are scarce, the energy players offer low-cost access to an income stream in a sector where the bad news is likely already priced in.
How do you assess the prospects for commodities in general?
LNG and natural gas in particular have alluring characteristics, too. That’s why you want to have natural gas content and owners of pipelines in your portfolio. What’s more, if we get any sort of infrastructure package in the US, it’s going to have to include a revamp of the electricity grid. Within the commodity complex, there are other areas with clear supply and demand imbalances in favor of the price. Copper surely fits that bill. So you can have my cautious view on the economic outlook and still have a constructive assessment of the commodity landscape based on supply fundamentals.
Unlike oil and copper, gold is currently under pressure. Rightly so?
I own gold not to make a killing but as a ballast in the portfolio, a source of diversification and insurance policy against the gargantuan levels of outstanding liabilities. It’s a hedge against inflation, if we ever get it, and it’s also a hedge against deflation given these destabilizing financial imbalances we have. They’re not that apparent obviously when you look at the markets this year: The junkiest bonds have outperformed the most, and the junkiest stocks have outperformed the most. That’s how you know that we are in a speculative mania. So gold is an insurance policy against things going wrong, especially in a time when most asset markets are priced for perfection. You hope your house doesn't burn down, but you still have home insurance.
Where else do you spot opportunities?
If my thesis is correct that we’re heading into a future of an elevated precautionary household savings rate, then you want to focus on what people need, not what they want. That’s why I prefer consumer staples over consumer discretionary. More to the point, you want to own companies with an ability not just to deliver growth but also with utility like characteristics. Here, you can actually pick up some quality names in the technology sector. Microsoft is the poster child for that particular viewpoint. It’s a classic growth company that has been re-rated for having utility like characteristics.
What’s your advice for investors looking outside the US?
Asia is where the opportunities are. If you are scanning the world for growth investments with P/E multiples that at least approximately match the growth outlook, you’re better off in Asia than in the developed world. The Asian countries, by and large, have dealt with the pandemic much better than most other parts of the world. Leaving politics aside, you have to face the fact that China was practically the only country in the world whose economy did not contract in 2020. They’re poised for at least 8% growth this year, and a lot of the countries in Asia are feeding off the improvement in Chinese economic growth.
What does this mean for investors?
China is about the only country with the capacity to ease monetary policy in a traditional sense. They did not embark on quantitative easing; they didn’t blow their brains out on fiscal stimulus. So far, they’re actually successfully moving towards deleveraging they’re heavily indebted economy. In contrast, the Fed is perpetuating a situation of survival instead of creative destruction. As a result, 20% of the companies in the S&P 500 are technically zombies, meaning they don’t earn enough cash flow to cover interest expenses. So at the margin, we have a situation where capitalism in America is going on a long-term sabbatical, when at same time, this communist country called China is moving increasingly more towards capitalism.
However, the authoritarian regime in Beijing could take different measures than Western governments to contain the spread of the coronavirus.
That’s true, but the reality is that as strong as China was relative to the rest of the world before the pandemic, it’s that much stronger today. This is going to be a big headache for Joe Biden in terms of how to curb China’s accelerating economic dominance. The irony of ironies is that Donald Trump's first move as President was to walk away from the Trans-Pacific Partnership which actually would have helped to restrain China to some extent. Now, here we are after Donald Trump just left the White House, and China signs on to a trade deal with most of the rest of Asia that gives China more security of supply. So geopolitical complications aside, China’s growth outlook is very strong and that’s going to feed off into the rest of the region. That’s why one of my principal themes for the past several months has been «go east young man and young woman».
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