The thought of an economic crisis in 2015 is all too distant for too many. With the S&P 500 advancing 200% since its bottom in 2009, it’s worth taking some time to pause and reflect. As is often the case, the most devastating risks are those that we don’t see coming. Few recognized the dangerous consequences of the overvalued housing market or loose financial regulations before the recession hit. This time around, it wouldn’t be surprising if investors are blindsided again.
Interest Rates Hike to Trigger U.S. Economic Crisis in 2015?
Since the Great Recession, interest rates in the U.S. economy have been kept artificially low at almost zero, but they will inevitably rise. Please look at the chart below. It shows the federal funds rate—the interest rate set by the Federal Reserve—from 1999 to 2015.
Chart courtesy of www.StockCharts.com
If you have been following the Federal Reserve for some time, it is adamant that it will raise rates in 2015. I am asking: if the interest rates rise, will the U.S. economy be able to handle it? I think it will have trouble adjusting.
Higher rates will impact the already-struggling housing market—activity has not returned to normal since its crash. The latest reading of single-family housing starts sits at 32% of the value reached in 2006, meaning it has another 70% to go in order to recover! (Source: Economic Research, Federal Reserve Bank of St. Louis web site, last accessed March 25, 2015.)
If the Federal Reserve increases the federal funds rate, mortgage rates will jump higher. As a result, fewer Americans will be able to afford a mortgage, and it will eventually affect the housing market.
Mind you, the housing market is just one of the many places where higher interest rates will have an impact.
Labor Market Remains Fragile
Interest rates aren’t the only factor that keeps me concerned of a financial crisis in 2015; the U.S. labor market is something to be worried about as well. It hasn’t improved and until it does, an economic slump should not be ruled out.
Consider this: since 2008 the amount of labor force participation has been steadily declining. Fewer people are working or are looking to enter the workforce. Look at the chart below of the civilian labor force participation rate, which measures how many able Americans are actually working. It shows the number of Americans working continues to dwindle.
With this said, have you paid attention to the stock market valuations lately?
Absurd Stock Market Valuations and Investors’ Complacency
As I mentioned earlier, the S&P 500 has advanced an astonishing 200% since the bottom in 2009. Leading up to the meltdown in 2008, the S&P 500 had advanced 100% from its low in October of 2002. Clearly, this bull market has advanced significantly more than the previous run. Unprecedented accommodative measures from central banks and recovering corporate earnings have supported the market and made it the best investment alternative thus far.
Nevertheless, markets are looking frothy. One well-established measure of market valuation is the Shiller cyclically adjusted price-to-earnings ratio (CAPE), which takes into account earnings over many years to smooth out any short-term variations. (Source: Yale University Economics Department web site, last accessed March 26, 2015.) Averaging corporate results over several years and comparing that to the current market price levels completes the calculation. Higher readings signal that investors are willing to pay greater amounts for every one dollar of company earnings.
At the moment, the CAPE stands at 27X while the pre-financial crisis high was at 26.5X. The markets are in similar shape as they were just prior to the sell-off in 2008, suggesting a U.S. economic crisis this year is possible.
Data source: Yale University Economics Department web site, last accessed March 25, 2015.
What’s even worse is that not much attention is being paid to these valuations. Investors continue to bid prices higher and are way too optimistic. Remember: when everyone is on one side of the trade, you want to be careful.
What’s Ahead for the U.S. Economy?
As it stands, with the Federal Reserve almost ready to raise rates, economic data pointing to fragility, a labor market with fundamental problems, and the stock market valuation showing extreme optimism, to me, the risks are growing.
After the Great Recession, the U.S. government and the Federal Reserve were able to jump in and give a sense of security to the markets. Sadly, the U.S. government can’t afford to spend now like it did then, and if the Federal Reserve starts printing again, it will only be troublesome.
We may be at an inflection point, just like we were on October 9, 2007, when the S&P 500 peaked at 1,565 and began its descent. Going forward, caution may just be the best investment strategy for investors.