David Rosenberg Screenshot via Bloomberg TV RISKS ARE RISING RISKS ARE RISING ‎

In other words, the economy in “3D” (Debt, Deflation, and Demographics), and a return to SIRP (Safety and Income at a Reasonable Price) as the optimal investment strategy.

I may not see a recession around the corner (similar to Gene Epstein in this week’s Barron’s column), but I am not exactly whistling past the graveyard either.

The risks are not trivial and are on the rise, but even if a downturn is averted, we are likely to remain in a stuck-in-the-mud global economy, with no leadership, diminishing returns from monetary stimulus and still little in the way of a fiscal response.

Though some of this could change after the November U.S. election.

The growing macro risks have been reason enough for why we have trimmed our equity allocation within the recommended asset mix over the past year, while further de-risking by raising tactical cash at the portfolio level, reducing the overall beta, and focusing heavily on the running yield on a holistic basis.

The U.S. economy has been for some time the proverbial smartest kid in summer school. The best house in a bad neighborhood.

But that story has lost some of its allure of late. The data flow has been disappointing, to wit:

Industrial production is down in six of the past eight months and at a 2.1% annual rate; Core capital goods orders have declined in four of the past six months and at an 8.8% annualized pace over that time frame; Goods-producing employment has fallen for four months in a row, by a 1.2% annual rate; The softness has spilled into the consumer and services sectors, with confidence slipping in three of the past four months to the lowest level since last November; and The non-manufacturing ISM index, in a five month span, has gone from 58.3 to a two-year low of 52.9 in May in a pattern that is hauntingly reminiscent of late 2000 and early 2007.

Did I say I was worried? ‎

An oil refinery Neil Kremer

SLOW GROWTH, DEFLATIONARY THRUST ‎

‎The national income data that were released with the first quarter Fed flow-of-funds report were telling.

Nominal growth at an annual rate slowed to 1.7% from 2.5% in Q4 and Q3, and the nearby peak of 4.9% in last year’s second quarter.

The annual trend has softened from 4.3% YoY a year ago to 2.9% currently, and is actually running at the same pace or lower than five of the past six official recessions.

What else?

Well, personal savings on a flow-of-funds basis has jumped 13% over the past year and is on a clear uptrend.

On this basis, the savings rate is hovering near 10% — it wasn’t rare at all during the 2003-to-2007 bubble era to have seen the savings rate zero or negative as the boomers relied on asset inflation to do the savings for them.

Household debt growth slowed to a mere 2.7% annual rate in the first quarter of 2016 from 3.7% in Q4 — the 12% annual expansions in credit in 2004, 2005, and 2006 as the housing bubble formed are clearly a thing of the past.

Even with that debt containment, the ratio of household net worth-to-disposable income edged lower to 6.40x from 6.41x in Q4 of 2015 and down from 6.53x a year ago. In fact, this ratio is no higher now than it was a decade ago.

‎There are lags between changes in household net worth ratios and changes in consumer spending patterns — right now the big picture is one of near-stagnation in consumption growth.

Despite the best efforts from the world’s central banks to ignite a self-sustaining expansion, it is our contention that in this post-bubble, mean-reverting process, the ability for policymakers to recreate a credit cycle and trigger a wealth effect on spending is being thwarted by secular changes towards credit, savings, discretionary spending, and homeownership.

The first of the boomers are turning 70 this year while the median boomer is now 60-something, and at the margin they are being forced to plan for retirement by setting aside an ever-greater share of their paycheck as opposed to relying on the perceived level of their future net worth, which had become the norm in recent decades.

Retirement Michael Steele/Getty Images

The bottom line is that as everyone focuses on the inflationary aspects of worker shortages and the apparent tight labour market, the overriding story is that the constraint on growth from excessive leverage has still not been ‎resolved this cycle.

As the flow-of-funds data revealed, nonfinancial sector debt relative to GDP just hit a record high of 250% — at the peak of the last cycle, it sat at 240%.

With this debt albatross, market rate hiccups as we have seen periodically cannot be sustained. They get pushed back because even with ultra-low rates, the economy simply cannot withstand even small incremental debt service strains.

That is how fragile the economy is, and why the fundamental trend in bond yields is still down.

With a global output gap of around 2%, the world is saddled with roughly $1.5 trillion of excess capacity. In such an environment, the prospect of inflation becoming a problem for the bond market or the Fed is remote at best.

I can understand the temptation to look at the Fed’s balance sheet and growth in the money supply and come up with an inflation view. Yet, seven years after the initial round of QE, pricing power is anemic and consumer long-term inflation expectations are at record lows.

The expansion of the money supply has merely been a cushion against the years of balance sheet repair attempts in the household sector, which for a good chunk of this cycle involved asset liquidation, debt repayment, and rising savings rates.

In some respects, this process is still in its infancy stage because a chronic lack of income growth has frustrated the improvements.

On net, this is a highly deflationary development, and this is precisely what the bond market has been signaling for a very long time.

Put simply, unwinding the excesses from the epic 2003 to 2007 credit and real estate bubble has taken far longer than anyone had thought just a half-decade ago, and a key reason why the Fed has been so egregiously wrong with their GDP forecasting — they have been perennially and perpetually optimistic.

Meanwhile, the money supply has stayed glued to commercial bank balance sheets, partly due to reregulation and partly due to weak credit demands.

The turnover rate or velocity of money is critical to the inflation view, and there is no sign of a turnaround nor will there be until the next credit cycle begins.

Money printing Getty Images

While some at the Fed will likely continue to jawbone publicly, Janet Yellen full well knows that deflation, like runaway inflation, can be self-perpetuating insofar as consumers defer expenditures in expectation of further discounting and this delay itself reinforces the discounting trend by putting downward pressure on domestic demand.

Likewise, businesses faced with deflation to their top-lines are typically forced to cut costs to protect their profit margins and in so doing, trigger a nasty second-round income effect on their workers and suppliers, which also ends up exacerbating the trend towards lower pricing.

THE CHASE FOR YIELD CONTINUES UNABATED ‎

‎In the meantime, yield appetite seems insatiable. The thirst for income in a world where central banks have assured its scarcity is forcing investors into chasing yield ‎and moving down the quality curve.

Damn the torpedoes, full speed ahead!

In the equity market, the mantra is all about “TINA” (There Is No Alternative) now more than ever. Then again, we’ve only seen the S&P 500 make a dozen runs at the high over the past year, and each attempt failed.

All this reminds me of what Alan Greenspan said about this type of behavior more than a decade ago:

Thus, this vast increase in the market value of asset claims is in part the indirect result of investors accepting lower compensation for risk. Such an increase in market value is too often viewed by market participants as structural and permanent. To some extent, those higher values may be reflecting the increased flexibility and resilience of our economy. But what they perceive as newly abundant liquidity can readily disappear. Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher asset prices. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low risk premiums.

Alan Greenspan, August 25th, 2005.

A decline in perceived risk is often self-reinforcing in that it encourages presumptions of prolonged stability and thus a willingness to reach over an ever-more extended time period. But, because people are inherently risk averse, risk premiums cannot decline indefinitely. Whatever the reason‎ for narrowing credit spreads, and they differ from episode to episode, history caution’s that extended periods of low concern about credit risk have invariably been followed by reversal, with an attendant fall in the prices of risky assets. Such developments apparently reflect not only market dynamics but also the all-too-evident alternating and infectious bouts of human euphoria and distress and the instability they engender.

Alan Greenspan, September 27th, 2005.

Alan Greenspan REUTERS

Well, remember what happened next! The ensuing two years caught up to investors pretty quickly. ‎

It goes without saying that we should all heed the message from a zero percent interest rates. We are seeing in some cases negative interest rates right out to the 10-year part of the yield curve or even sub-zero as is the case in Japan and Germany, something we only really saw to this scale in the 1930s.

We never did have a garden-variety recession, so there really isn’t any reason why we should have ever expected there to be anything close to a normal recovery.

The problem with macroeconomic modeling is that the regressions are done using data within the time frame of post-WWII cycles.

What we had on our hands was an atypical balance sheet recession and not just within the confines of the financial sector, but ensnared the broad U.S. household sector, and ultimately the world economy.

For much of this so-called recovery, the lingering trauma for the marginal household balance sheet and the ensuing deleveraging process have poised serious limits on growth and impeded the central banks best efforts to reflate the economy.

BIZARRE RECESSION FOLLOWED BY EQUALLY BIZARRE RECOVERY ‎

‎In the post WWII era‎, ‎recessions of the past lasted around four quarters.

This last one lasted seven quarters, which is the longest in the post-WWII era.

‎The peak-to-trough decline in U.S. real GDP this cycle was -4.2%; the 10 previous recessions saw an average peak-to-trough decline of 1.9% (the median was -1.9% as well).

For nominal GDP, the last recession saw a peak-to-trough decline of 3.4%; only six of the previous 10 recessions actually saw a decline and for those that did, the average drop was 1.5%, while the median -1.3%.‎

And what about the recovery phase?

Well, it took 14 quarters to recapture the peak level of U.S. real GDP in this expansion; in the previous 10 cycles, the average was four quarters (median as well) with a range of two-seven.‎

It took 75 months for U.S. payroll employment to recapture its pre-recession peak in this current cycle. The average for the post-WWII period is 23 months (median 21 months) with a range of 9 months (in 1980) to 46 months (following the 2001 recession).‎

People seeking employment fill out applications at a job fair at the Matrix Center April 23, 2014 in Detroit, Michigan. Joshua Lott/Getty

‎Did I say nothing we have seen or are close to seeing is anything that could be classified as garden variety?

‎Past recessions we’re typically characterized by inventory cycles — 80% of the decline in GDP was typically due to the de-stocking in the manufacturing sector.

Traditional policy stimulus almost always works to absorb the excess by stimulating domestic demand.

Depressions, even ones that are kind and gentle (next to the 1990s) often are marked by balance sheet compression and deleveraging: debt elimination, asset liquidation, and rising savings rates become the norm.

Clearly when the economy has endured more than seven years of zero per cent Treasury bill rates, it has gone far beyond anything that can be described as typical.

Not just rate relief, but multiple liquidity backstops, earlier fiscal stimulus, rampant central bank balance sheet expansion, loan modifications and yet we still have subpar growth and a degree of excess capacity that is far from the norm this deep into the cycle.

All the expansion in the money supply has done to date is act as an antidote to years of shrinking money velocity (the turnover rate of money in the real economy).

The ignition gets started, but the motor doesn’t turn, as cash as a percentage of commercial bank assets remains in nosebleed territory (to the point where cash exceeds outstanding consumer credit on aggregate bank balance sheets). ‎

‎Simply put, an economic depression occurs only once it becomes painfully obvious that the markets and the economy are failing to respond to repeated rounds of policy stimulus.

The major issue is that the lingering impact of the acute stress to the household balance sheet has resulted in a secular rise in the personal savings rate and a commensurate shift in household budget priorities toward necessities and away from the most discretionary goods and services.

This really came through loud and clear when the bulk of the de facto tax cut from the plunge in gasoline prices from the Summer of 2014 through to early 2016 was saved and not spent.

So again, in a nutshell, it is crucial for investors to heed the message when risk-free rates melt away for a prolonged period of time as has been the case this cycle.

This happened in the 1930s in the U.S. and in the 1990s in Japan.

There are differences, to be sure, but it is the similarities that should not be dismissed. The message really is that we have a fundamentally weak economic outlook on our hands and major balance sheet imbalances have yet to be fully addressed.

The global nonfinancial debt-to-GDP ratio has actually risen to new record highs this cycle, and no major country has really managed to contain, let alone reverse, this upward trend.

A photo from the federal government's campaign to document the Great Depression. Wikimedia Commons

THE FRUGAL FUTURE IS NOW ‎

This debt overhang ‎remains a ball-and-chain on the economy.

The fact that the deleveraging cycle has been so slow to materialize means even more time needed before the next cycle of sustainable above-trend growth can take place.

It has to be emphasized that this 30-year secular credit expansion has come to an end, and the quicker that debt no longer acts as an albatross, the better.

This was a credit expansion that began with the repeal of The Glass-Steagall Act in the mid-1980s and went parabolic in 2001, with the proliferation of no-doc loans, low-doc loans, liar loans, subprime, zero per cent vendor financing! “Alt-A” and option “ARM” with negative amortization features.

We had, for decades, until the 1970s a household debt-to-income ratio of 60% and it was a stable ratio. By the late 1980s that ratio got to 80%, by the late 1990s it got to 90% and at the peak of the last bubble got as high as 130%.

It is now 102% and while all of the 2003 to 2007 insanity has been reversed, the ratio is still some 30 or 40 percentage points above what could be considered healthy. This persistently high level is exactly why interest rates cannot go up, at the expense of savers.

‎So this is a clear case of meet the new theme, same as the old theme.

That old theme, dusting off the books from my time at Mother Merrill some eight years ago, is The Frugal Future — except that it has become the “present”.

We are not bearing witness to any kind of normal post-recession expansion. The macro themes of the day are much more secular in nature. We truly are living through a period of time that historians will be discussing for decades to come, and all we are doing is rewriting chapters of this post-bubble-collapse story, still so fresh seven years after the worst point of the Great Recession.

The recessions prior to that in the post-WWII era were influenced by inflationary pressures, excessive manufacturing inventories, asset bubbles that needed popping (starting in the late 1980s) and aggressive Fed tightening.

For the most part, the traditional recessions we came to know and understand were short and mild affairs, tiny contractions in GDP that were cyclical in nature, could be easily combatted by monetary policy stimulus, and once the late-cycle imbalances were purged, it was time to get on to the next business expansion.

That was the thing — recessions were short and mild while expansions were long and strong (the 1970s being an exception). But this recession was different in that it has influenced people’s behavior to this very day.

We are witnessing epic changes in the ways in which people move around, decide when to get married or have kids, allocate their budgets, especially with respect to the discretionary component of the family budget and attitudes towards debt. ‎

The frugal future, courtesy of the lingering effects of the credit collapse and asset plunge on spending, saving and investing patterns, will also have the effects of an aging boomer population to consider.

The reality that cannot be dismissed is that 78 million Americans were born between 1946 and 1964 and this is the pig in a python that set the fashion for decades.

They ensured that every recession we became accustomed to was mild affairs, for the most part. The experience with real estate deflation and credit contraction in the early 1990s, while regional, was still rather mild in economic terms because the median age of the boomer crowd was close to 30 and so the bulk were still there buying cars, furniture and appliances.

The Tech crash in 2000 and 2001 was no walk in the park, but again, the median age of the boomer was young enough at around 40 years to still be in the game and participating (as in still young enough to trade up), so much so in fact that in that recession, consumer spending did not go down for one single quarter.

Things are rather different today.

The first of the boomers are turning 70; the median age is 60. They are well past their peak spending years, are downsizing, preparing for retirement, and are in savings mode. Whole short on savings, they are saturated when it comes to ownership of household durable goods. So for the first time in four decades, we cannot expect to see the demographic support to consumer spending from the baby boomers.

For the age groups that come up behind the boomers, the fact that so many older folks are working longer to sustain the cash flows to fund retirement lifestyles has impeded job growth for the 20 and 30 year olds who are saddled with a mountain of student loans because their parents were too financially constrained themselves.

Having been burned by two busted bubbles separated by seven years (Tech then Housing), which in turn has curtailed spending potential for these younger age categories.

You see, the Great Recession had a monumental impact and the effects linger on.

BACK TO SIRP! ‎

‎From an investment strategy stance, it is about getting back to SIRP (Safety and Income at a Reasonable Price). Stepping up in quality in terms of bond exposure. In the equity market, a pervasive focus on ‎dividend yield and dividend growth in areas of the market that do not have a great deal of cyclical sensitivity.

One final note. We have seen lately press articles showing how patterns of behavior are still changing fully seven years after the earthquake.

The aftershocks continue. This is why this recession was so much different than the others and what it shares in the 1930s which was not a sustained economic contraction as much as a complete change in behavior which affected a whole generation or more. To wit: