An expert from our 2019 Investor Letter II
Pessimism is in vogue. Everyone seems to be positioned “cautiously”—including, up to this point, yours truly. The end of 2018 reignited lingering fears of economic panic. A rush to treasuries and defensive stocks ensued, driving their returns higher. This created a feedback loop which has pushed still more into treasuries and defensives leading returns higher, at least for a period.
I am a bit surprised at how much bearishness I see out there. Recession expectations have made the rounds. I’ve begun seeing comparisons to 2008 and even 1929. Bad recessions do not come when everyone expects one. In fact, prudence and caution, which is what occurs when people expect a recession, actually work to avoid the downturn. It is difficult to get a persistently worsening economy when people are prepared for such an event. It is when people are overextended and ill-prepared for worsening economic conditions, thinking good times will go on forever, that deep recessions are more likely.
There is a lot of leverage in the system but comparisons to 1929 are tenuous. The market structure was quite different back then. Insider trading and stock manipulation were both legal in the 1920’s. Margin requirements were 10%. Roughly 1/3rd of all brokerage accounts were buying on 10/1 margin—they would invest $1,000 and buy $10,000 worth of stock. Equity was wiped out with just a 10% decline in stock prices. On top of this, levered mutual funds were introduced in the late-1920’s (dubbed “investment trusts”) further compounding the problem. Then tax rates were raised in the early 30’s.
Today we see problems in corporate and sovereign leverage as opposed to the type of structural issues created by margin debt combined with speculation. Coming full circle, there are pockets of highly levered equity—specifically SoftBank’s $100b Vision Fund—which have already begun causing pain. Right now, that pain is contained to the worst offenders.
Household and mortgage debt service as a percent of disposable income are at historical lows. Domestic state and local government debt levels and financial sector debt are also at reasonable levels.[i] The concerns lie with non-financial corporate debt which has returned to the highs of the previous crisis.
There is some talk about weak manufacturing data. Manufacturing makes up a fairly small percent of U.S. GDP, declining from around 3.6% (new orders) and 5.5% (inventories) of GDP in the mid-90s to 2.3% (new orders) and 3.2% (inventories) today.[ii] It will still have knock-on effects but manufacturing alone will not drive the U.S. into recession.