Recently market participants began to breathe a sigh of relief that “the worst is over”. By many measures the official recession that began in February is largely over as states re-open.

The rebound in growth from low levels is surprising economists to the upside, as evidenced by record high economic surprise indexes:

Massive fiscal and monetary policy deployed in the first month of the crisis helped soften the blow and provide much needed liquidity to dislocating markets.

With the recovery underway it looks like the worst is over. However, I believe we are in the eye of the storm. The closest market and economic analog I can come up with is the 70’s when rising inflation, high unemployment, and wide market swings characterized strained economic conditions.

Here, fiscal and monetary policy had reached its limit while long term demographic and economic trends had also reached a breaking point. In a way, the conditions today largely mirror the 70’s, but at an extreme opposite.

For example:

Instead of chronic high inflation we have chronic low inflation.

Instead of record high interest rates we have record low interest rates.

Instead of record low equity market valuations, valuations are at record highs, indicating poor returns going forward.

Instead of extremely low public and private debt levels, debt has exploded and is historically high.

Labor’s share of GDP was also at highs and unions remained a key force in labor negotiations in the 70’s. Today those trends have completely reversed with labor's share of productivity at all time lows.

Globalization was limited and business regulation was high in the 70’s. While you could argue that regulation has begun to increase again from the deregulatory 80′s and 90′s, it’s apparent globalization has reached its limits, at least in the near term.

Demographics in the 70’s were unfavorable, but on the horizon was the first wave of Baby Boomers entering their 30’s and a surge of women entering the workforce. A similar dynamic exists today, with Millennials poised to expand the labor supply again as Boomers roll off.

This all points to a similar scenario today as experienced in the 70’s, when secular trends from the prior decades reached their extreme and a transition to new secular trends developed. This transition phase in the 70’s early 80’s saw the conventional wisdom and tools which worked in the prior decades fail. The result was economic and social uncertainty coupled with extreme market volatility.

I believe we are at another such transition phase, where the secular trends that started in the early 80’s are reversing. This transition phase will be marked by many of the same characteristics in the 70’s but at opposite extremes: low interest rates blowing out to the downside, dis-inflation and deflationary episodes, a final surge in debt levels, huge market swings, de-globalization, etc.

Once this transition is complete we will have another multi-decade secular growth period of self reinforcing trends upon which the new conventional wisdom is built. But until that transition completes, it will be a wild ride.

Inflation: 

2 Year US Treasury Yield:

Long term equity valuations:

Debt as a share of GDP:

Labor share of productivity:

Demographics:

So where does that leave the markets? Well, I believe the volatility that started in December 2018 was the first wave, the March 2020 bear market the second wave, and there should be a third wave to mark the final low. After that third wave, the markets should chop upward as uncertainty peaks and new secular trends begin.

This was a similar pattern in the 70’s. See below.

S&P 500 in the 70’s: Three distinct waves down and up, with a choppy uptrend after the final low. This time period was unusual with lower market lows, but also higher highs. Just as the markets made a new high, they plunged to a new low:

Today: A similar pattern of lower lows and higher highs; expanding volatility as policy responses push markets higher following sharp sell offs, only to crash again. This recent rebound should reach a new marginal high before crashing to a low below 2250.

As opposed to the 70’s it looks like these moves are playing out on a compressed time frame of a couple of years rather than a decade.

And like the 70’s, but for opposite reasons, I expected gold to perform well. Real interest rates will be low, not because of high inflation, but low positive inflation coupled with zero to negative rates. Bonds should blow off as the secular trend reaches a crescendo and investors pile in.

Equity valuations should reach more normal levels as the only place to be is bonds and gold. Equities will be viewed with complete disdain. Then will be the time to buy. 

We and our global market competitors are and have been experiencing a lack of aggregate demand for several decades. It is now only visibly coming to a head, as the magic elixir of leverage is drained and exhausted.

This potentially fatal disease of capitalism is a result of several long-term secular phenomena:

(1) Aging demographics, where boomers everywhere spend less, in contrast to their youth, as they approach retirement; babies, houses and second cars shift to the scrapbook of memories as opposed to future spending power.

(2) Globalization, where 2 billion new competitive workers from Asia and elsewhere take jobs and paychecks from complacent and ill-trained 40-somethings in developed markets.

(3) Technological innovation, where machines and robots displace human labor, resulting in corporate profits but declining wages.

It is not the debt, however, but the lack of global aggregate demand that is at the heart of the crisis. As the entire world strives to put its own people to work before other nations do, policymakers constructively lower interest rates and delay sovereign, corporate and household defaults to provide breathing room. Fiscally, however, an anti-Keynesian, budget-balancing immediacy imparts a constrictive noose around whatever demand remains alive and kicking.