Stocks On 'Collision Course With Disaster,' Face 40% Drop

The stock market is on "a collision course with disaster," according to Scott Minerd, managing partner and global chief investment officer (CIO) at Guggenheim Partners, writing in a note to clients quoted by CNBC. "Ultimately, when the chickens come home to roost and we have a recession, we're going to see a lot of pressure on equities especially as defaults rise, and I think once we reach a peak that we'll probably see a 40 percent retracement in equities," he stated in an interview with CNBC, adding, "Defaults are going to be concentrated in corporate America, where in the past downturn they were basically focused in areas of consumer activity."

The S&P 500 Index (SPX) closed at 2,662.84 on April 5. A drop of 40% would slice 1,065 points off the widely-followed market barometer, sending it below a value of 1,600. That level was last seen almost five years ago, on June 26, 2013. 

Minerd made his comments as JPMorgan Chase International Chair Jacob Frenkel warned that a trade war is the biggest threat to the global economy today.

The Debt Bomb

Corporate debt is at a record high $8.83 trillion, CNBC indicates, and Minerd said that corporate defaults are bound to rise once short-term interest rates hit 3%. A fundamental problem, he noted, is that "Monetary policy and fiscal policy are both heading in directions that are contradictory to each other." Specifically, stimulative fiscal policies, most notably the tax cut passed in December, have been enacted at a time when the U.S. is "running out of workers," he said.The main result is increased wages and prices, he noted. Meanwhile, the Federal Reserve is committed to controlling inflation mainly through hiking interest rates.

 By contrast, economic analyst and consultant Stephanie Pomboy sees massive consumer debt - as opposed to corporate debt - as the main threat to the economy and the stock market right now. (For more, see also: What Will Trigger the Next Stock Market Crash.)

Cash Flow Boost: 'One Shot Deal'

Regarding the increase in corporate free cash flow (FCF) created by the tax cuts, Minerd said the positive impact will be short-lived. He told CNBC that it's "a one shot deal" and that a rise in interest rates to 3% will quickly absorb it all. Moreover, he indicated that there will be "no cash windfall" in the end because corporations are not using the extra cash flow to pay down debt. He cited a recent survey indicating that corporations plan to use their improved free cash flow mainly to repurchase shares (40% of respondents), fund mergers and acquisitions (40%), increase employee compensation (10%), and increase dividends (10%).

Real Estate Value Plunge

Minerd expects a recession to commence either in late 2019 or in the first quarter of 2020 as the fiscal stimulus from the tax cut dissipates in 2019. The recession's first effect, he told CNBC, will be waves of layoffs. The second effect, in his opinion, will be a steep decline in commercial real estate values. He sees severe overbuilding in many areas of the country, particularly in multi-family housing.

On the bright side, he told CNBC that, compared to a decade ago, "financial institutions are a lot sounder." Also, he finds that "homes are more affordable than 20 years ago." However, former FDIC head Sheila Bair thinks that the recent loosening of bank capital requirements is ill-advised, and that debt is at dangerously high levels among households, businesses, and governments alike. (For more, see also: 4 Early Warning Signs Of The Next Financial Crisis.)

Psychological Impact of Market Plunge

Daniel Pinto, co-president and co-chief operating officer (COO) of JPMorgan Chase & Co. (JPM) issued his own warning about a 40% stock market nosedive a month ago. Pullbacks of similar magnitude have been typical over the long course of history for bear markets. However, the psychological impact today may be much greater than in the past, given the large number of new investors who have known only uninterrupted gains. (For more, see also: Stock Investors Should Brace for 40% Plunge: JPMorgan.)

'Greatest Danger'

Commenting on the growing trade tensions between the U.S. and China, Jacob Frenkel, chair of JPMorgan Chase International, told CNBC: "I think it's the greatest danger today to the world economy." Looking back on economic history, Frankel alluded to the Smoot-Hawley Tariff Act that played a role in worsening, if not causing, the Great Depression of the 1930s:  "I think we all should remember the disaster of 1931--always good intentions, to protect American jobs, and the result was a catalyst to the Great Depression. We should avoid it all costs."

He added: "A world that is so interdependent, so interconnected, cannot afford shooting each other. The world in which the rules of the game are an eye for an eye is a world in which there are many blind people." Nobel Laureate economist Robert Shiller has raised similar concerns, warning that a trade war would create economic "chaos," disrupting business processes and planning based on global supply chains, among other negative effects. (For more, see also: Why a Trade War Risks Economic 'Chaos': Shiller.)