Barron’s interviewed Stephanie Pomboy of Macro Mavens this week and she presented an especially bearish view on the US economy. She argues that as the Federal Reserve stops buying Treasuries the economy will falter and the Fed might even taper the taper. She thinks there is little upside to Treasury yields and believes that the 10 year will be trapped between 2 percent and 3 percent for a long time.
Pomboy: The No. 1 thing is that investors generally have underestimated the impact that QE [quantitative easing] has had on the economy and the degree to which it has supported growth. As a consequence, they have underestimated the cost the tapering [of monthly Treasury bond purchases by the Fed] would have, and that is starting to come into focus. People will realize that the economy really has not achieved any self-sustaining momentum and that it requires continued stimulus. I liken it to a car on a flat road that has no momentum. When you take your foot off the gas, the car just stops moving. That’s essentially what the Fed is doing.
Eventually, people will start to connect the dots and say, “Hey, wait a second. We had five years of unprecedented monetary and fiscal policy, and the Fed did succeed in reinflating asset prices. Household net worth increased $25 trillion from the lows of the financial crisis, and yet we haven’t generated a sustainable wealth effect.” Maybe this is a dark place to go, but where would we be if the Fed hadn’t succeeded in inflating household balance sheets to that degree? It is scary to imagine, because if you look at a chart of nominal consumer spending, which is 70% of GDP [gross domestic product], it has continued to decelerate, even in this period of unprecedented monetary accommodation and rampant financial-asset inflation.
“I liken the economy to a car on a flat road that has no momentum. When you take your foot off the gas, the car just stops moving. That’s essentially what the Fed is doing.” — Stephanie Pomboy Photo: Matt Furman for Barron’s
Where do the equity markets fit into your thesis?
What happens if stock prices just stop going up at this pace, much less go down? We don’t even have to talk about the latter scenario. But if stock prices just stop inflating at the rate they had been in the past couple of years, what are the odds that consumer spending grows any faster than it has? And yet, that’s the expectation—that the economy can withstand the taper, growth has its own momentum, spending is going to accelerate, and employment is going to accelerate.
What kind of U.S. economic growth do you expect?
I see growth generally doing what it has done, which is to continue to gradually slow. We’ve had a steady decline in nominal growth, basically since 2000. So I can see the U.S. economy continuing to grow at a slower pace. If GDP growth is currently 3.7%, I could see it slowing to 3% or 2%, with nominal Treasury yields coming down along with it. And over the longer term, there is no material upside risk to Treasury yields, contrary to the popular perception that rates are going to the moon.
Where is the yield on the 10-year Treasury, currently around 2.6%, heading?
I expect to see Treasury yields trading in a range from 2% to 3%, basically how it’s been for the past several years. You want to sell at 2% and buy at 3%. I wouldn’t be surprised to see rates fall below 2%, as investor perceptions about the economy meet with reality and they realize that the Fed still has a lot of work to do. In the past, the prospect of the Fed pausing the taper would have been a recipe for running to risk assets. But this time, there would be such disappointment that the economy really isn’t up to snuff. We will have had QE1, QE2, and QE3. So how many times is the Fed going to get it wrong before people start to say, “These guys don’t know any better than the rest of us what’s going on, and they certainly don’t have the solution because they’ve done QE three times and it hasn’t helped?”
Where does the housing market fit into all of this?
To me, that’s really the key piece, because the impact that QE had on real estate is arguably the most effective part of this whole policy. I share a lot of the cynicism about the effectiveness of QE and whether it just expanded the wedge between the haves and the have-nots. But it clearly helped generate this recovery in real estate prices, which did lift 5.5 million households out of negative equity. That had a legitimate cash-flow impact, as these people could either sell their homes and relocate to find a job or refinance their mortgage, because suddenly their homes weren’t underwater. So it had a legitimate, positive economic impact that you can quantify, to say nothing of the benefit to the financial sector. But all of that came to an end when [former Fed Chairman] Ben Bernanke just talked about the possibility of tapering last May. So a full year has gone by, and the housing market has yet to recover its footing from just the threat of tapering. Fixed-mortgage rates have come down a little bit on the back of this recent rally in U.S. Treasuries, but rates for 30-year fixed mortgages are up 70 basis points, or 0.70%, versus a year ago.
On top of that, home prices have gone up, putting affordability further and further out of reach for many people. So what we need to sustain housing from here, if anything, is lower rates, not a taper.
What else concerns you about economic growth?
One chart that really summarizes my entire view compares net worth with consumer spending. Of the $25 trillion expansion in household net worth since March 2009, $21 trillion was financial assets, and $3 trillion was real estate. So the $21 trillion helps a very small segment of the population, while the $3 trillion has a much broader impact. But it is a massively disproportionate benefit for the high end. Even though people in that group are the marginal drivers of the economy because they spend a lot more, overall consumer-spending growth has continued to slow. In the past 50 years, we have never seen household net worth increase this much without spending growth accelerating materially as well. This time, though, spending growth has decelerated, and each year it takes another step down. With asset prices still not girding spending, we need income gains. And unfortunately, employment isn’t ready to take the handoff. While the latest employment figures have fueled the hope that things are returning to normal, the numbers are skewed by people holding more than one job. Jobs have increased, but hours have not. This is reflected in the gap between the household survey—where they ask if you are employed—versus the payroll survey, which adds up each payroll.
What are some of your key concerns about consumers?
The increase in spending—punk as it is—is almost entirely due to higher prices—not higher demand or unit sales. Fully 90% of the increase in discretionary spending from the precrisis level is explained by inflation. In other words, people aren’t spending more because they want to. They are spending more because the price of all the stuff they buy has gone up—hardly a sign of consumer strength.
Haven’t you been too gloomy at times over the years?
At every turn, expectations for the economy have proved to be far too sanguine, and my seemingly pessimistic view has been vindicated. The Fed has repeatedly had to lower its assessments for growth, and renew QE. So my feeling is that I’ve nailed the economic forecast and that, as a consequence, I was right on interest rates. What I missed was the flight to risk against a backdrop of weakening growth, and I admittedly worshipped at the altar of the fundamentals. Liquidity can only take you so far, and at some point, the fundamentals win out, as they did ultimately in 2008. You could have asked me that question in 2006 or 2007, and I would have said, “Look at what all the economic data are telling you–people are defaulting on their mortgages, etc., and the hit is coming.” And, eventually, it did. At some point, the fundamentals will be undeniable, especially at a time when the Fed is taking away liquidity by tapering.
And the Fed can’t continue to taper Treasury purchases, considering that foreign purchases of Treasuries have collapsed in the past several years. We used to rely on foreign financiers to fund our borrowing, but those days are long gone. They are buying Treasuries at a rate not much above $100 billion a year, down from $800 billion 3½ years ago.
What’s the implication of this?
Foreigners are buying about $10 billion a month of Treasuries. This compares with deficit financing needs for the U.S. government of roughly $40 billion a month, based on this year’s deficit. So the Fed needs to pick up roughly $30 billion a month in slack. When the Fed slashed its buying to $25 billion, effective this month, it for the first time opened up a demand deficit for Treasuries. If they continue to taper, that gap will expand, and things could get bumpy in the Treasury market. Rates won’t go up five basis points before the Fed would start talking about more QE.
Who is going to buy a 10-year Treasury yielding 2% when inflation in the U.S. is 2%? No profit-oriented domestic investor is going to do that. We were able to rely on foreign central banks to buy our Treasuries, because they were trying to debase their currencies to manage their exports. But that’s not the case anymore. The upshot is that we are out of natural buyers of Treasuries, and that’s where the Fed has been so critical. So unbeknownst to many, the reason why Treasury yields are 2.6% is in part due to the economy, but it is largely due to the fact the Fed has just been sopping up all of the surplus supply that foreigners are leaving behind.
So, what kind of investing makes sense now?
Given my thesis that the Fed is going to have to taper the taper, so to speak, it will become clear that the economy can’t handle a reduction of stimulus. As a result, Treasuries should continue to rally, in part because buying long-dated Treasuries is the mechanism by which the Fed will continue the stimulus. Second, the dollar should take a hit. There is a feeling that the U.S. is the furthest along in the recovery as it unwinds its stimulus, while the central banks in Japan and Europe are just getting started.
OK, then what assets are attractive?
The easiest way to play the idea that the dollar is going to take a hit in terms of global psychology is being long gold. This brings me back to the trades that I have recommended throughout this entire postcrisis stretch: Be long Treasuries and gold, as the twin beneficiaries of continued monetary accommodation.
Could you summarize a few other investment themes?
In the U.S., the consumer discretionary sector is the most vulnerable, and those stocks have come under pressure recently, along with the retail stocks. I’d probably want to be overweight the large-cap multinational companies versus the small-caps, because when you have a slowdown in growth, you want to stay with the companies that have the economies of scale. And in this environment, it would be good to have access to global consumers, rather than having all your eggs in the U.S. consumer basket. Looking more globally, I really do think that Russia and China are interesting plays. Yes, growth has slowed in the emerging economies, but they are still expanding faster than all the developed economies are. They are unencumbered by debt, and they have a much better demographic situation than many of the developed countries do.