It’s a bull market

The US economy continues to show signs of a robust expansion. Net capital formation is rising (as a percentage of GDP) as it is wont to do during a boom. In layman’s terms net capital formation is the net growth in physical assets used in the production of goods and services, after allowing for depreciation.

Net Capital Formation

The Wicksell spread has turned positive. When return on investment (we use nominal GDP growth as a surrogate) exceeds the cost of capital (reflected by low investment grade Baa bond yields) that encourages new investment and economic expansion as in the 1960 – 1980 period on the chart below.

Wicksell Spread

Real bond yields, reflected below by Baa yields minus core CPI (blue line) on the chart below, are also near record lows. Low real returns on bonds support high stock earnings multiples.

Real Bond Yields

Fed Chairman Powell summed up the situation in a speech on Tuesday this week:

…Many of us have been looking back recently on the decade that has passed since the depths of the financial crisis. In light of that experience, I am glad to be able to stand here and say that the economy is strong, unemployment is near 50-year lows, and inflation is roughly at our 2 percent objective. The baseline outlook of forecasters inside and outside the Fed is for more of the same.

This historically rare pairing of steady, low inflation and very low unemployment is testament to the fact that we remain in extraordinary times. Our ongoing policy of gradual interest rate normalization reflects our efforts to balance the inevitable risks that come with extraordinary times, so as to extend the current expansion, while maintaining maximum employment and low and stable inflation.

The biggest risk is that investors get carried away and drive earnings multiples sky high, but gradual rate increases from the Fed and the threat of tariff wars appear to be keeping animal spirits in check.

ACCC bells the cat on electricity | Graham Young

While on the fringe of our normal investment sphere, this article by Graham Young on energy costs, published today in Online Opinion, poses some serious questions for the Australian economy.

In an inversion of the social hierarchy of Yes Minister, it would appear that Australia has at least one courageous public servant – ACCC Chair Rod Sims.

When it comes to energy generation Sims has shown remarkable fortitude and has belled the cat a number of times, including calling-out the price gouging of the Queensland government through their publicly-owned electricity utilities.

His latest act of heroism is the ACCC Electricity supply and prices inquiry final report which is a tacit acknowledgement that current strategies for CO2 abatement will not work at an affordable price.

It is the best analysis of the energy market that we have, and must lead to a rethink of the role of the AEMO, AER and AEMC. These bodies have comprehensively failed and pushed Australian power prices up to unsustainable levels.

The report also calls into question the NEG, proposing a role for the federal government to provide stability through the provision of stable baseload power generation.

The role of the Chief Scientist, Mr Finkel, must also be under review as it shows how ineffective his Review into the Future Security of the National Electricity Market was.

It also means that the states should wind-down their subsidy schemes for wind and solar and hand control of these matters to the Commonwealth government. With a national electricity network the decisions in one state impact on the prices paid by consumers in all states.

Many on the left, including the Opposition, are pointing to market failure as a problem, but what the ACCC reveals is the real problem is regulator failure.

In an ideal world the ACCC proposal for the federal government to underwrite the construction of new baseload power is suboptimal, but a regrettable necessity in the current situation. It is likely to be less costly than building Snowy 2.0 to deal with the vagaries of increased penetration of wind and solar.

Another implication of the report is that Australia, and the world, also needs to adopt a new approach to CO2 abatement: intermittent energy will not power the world, even with storage.

Not only has the current approach led to unsustainably high power prices, but CO2 world emissions are still growing, and after an approximate 10% decrease since 2005, so too are Australia’s.

It’s likely that any decrease in Australian emissions is due to higher power prices creating a degree of de-industrialisation. But as we consume at ever increasing levels, the amount of CO2 embedded in our economic production and consumption is probably higher than it was in 2005.

All that has happened is there has been a flight of production from Australia to countries with lower electricity prices, and higher CO2 emissions.

The world has been running a number of real world experiments on renewable energy over the last 13 years since the Kyoto Climate Agreement came into effect. Those experiments prove conclusively that with present technologies renewables are not viable, even if the politicians of Germany and California, to mention two, haven’t worked it out yet.

Everywhere that penetration of renewables has exceeded 25% or so, prices have increased. This is because, while the collection of energy is relatively cheap, with the raw materials of wind and sunlight being provided free by nature, the systems components are phenomenally expensive, requiring investment in networks, standby power generation and storage, at the same time pushing the price of baseload power higher.

The only form of renewables that provide reliable power at reasonable prices are hydro schemes, and some of them run out of water at times as well.

The definitive proof of this failure is that, if it were possible to power an economy using renewables only, and if they were, as Mark Butler claimed yesterday, cheaper than alternatives, then the Communist People’s Republic of China, a brownfields site for industrialisation, would take this opportunity to provide all future power through renewable energy.

Instead of that, our chief strategic rival is building nuclear reactors (17 under construction and a total of 100 operational by 2030), and coal-fired power stations (299 units under construction in China today, according to the Australian Parliamentary Library).

They are then using that power to manufacture and then dump photovoltaic cells on the Western World which we are then using to deindustrialise, giving them a further industrial and strategic advantage.

If Butler is right they wouldn’t waste their time building a “more expensive” system with baseload power generators which they will then have to decommission, and retrofit the system for “cheaper” renewables – it just wouldn’t make sense.

The ACCC report gives us a chance to take account of these realities and recalibrate our approach to the Paris Accord.

In the first place we need to get a real feel for the CO2 intensity of world economies, and that can’t be measured just on domestic emissions, when much of our consumption is imported. We need to measure the CO2 actually embedded in our consumption.

This will provide a better discipline and put an end to the Ponzi scheme where we shuffle our emissions off somewhere else without actually changing much more than place of production.

Then we need to accept the reality that Bronze Age technologies like wind, and novelties like solar, cannot provide reliable grid-scale power, and increase actual electricity costs and that the only technology that has a chance of solving the energy trilemma (cost, reliability and emissions) is nuclear. So if we are serious about emissions we need to be serious about nuclear.

Given the issues with nuclear a sensible use of the resources being poured into “clean” energy should be redirected to researching nuclear power and handling spent nuclear fuel.

Australia is already a leader in one of these areas, having developed Synrock for safe storage of spent nuclear fuel in 1978.

An alternative to storage is reprocessing. As a country which already mines uranium and turns it into yellow cake we have advantages there as well.

While developing a nuclear program we need holding and bridging strategies to limit emissions. Efficiency is probably the lowest cost strategy, and an increased use of gas, which emits half as much CO2 as coal, another.

Finally we need to understand that storage will never be suitable for a large scale grid without repealing the Second Law of Thermodynamics – that’s the one that put paid to perpetual motion machines.

Battery enthusiasts draw comparisons between computers and batteries and predict that, just as computers have dived in cost and soared in computing power, the same will happen to batteries and power output.

But computers have done this by miniaturising and using less power to do the same work. Batteries are all about producing energy, and only so much efficiency can be wrung out of this process.

A more realistic model for how much increased efficiency is available is the motor vehicle. While it is true to say that the modern car is a significant refinement on the Model T, that refinement is nothing like the one that occurred between a pioneering computer like ENIAC, and the laptop on which I am typing this article.

The only step change in energy production comparable to that in computing is contained in the equation e=mc2, where Einstein showed that changing a small amount of mass into energy released huge amounts of energy.

Which brings us back to nuclear.

While the ACCC report doesn’t mention nuclear, it does open up the conversation. Politicians need to grab the opportunity. Otherwise they face a grinding political death between the stones of increasing electricity costs and decreasing reliability, all while CO2 emissions continue to rise.

This article was first published in The Spectator. Republished under a Creative Commons License.

Graham Young is chief editor and the publisher of On Line Opinion. He is executive director of the Australian Institute for Progress, an Australian think tank based in Brisbane, and the publisher of On Line Opinion.

12 Charts on the Australian economy

Australian GDP grew at a robust 3.1% for the year ended 31 March 2018 but a look at the broader economy shows little to cheer about.

Wages growth is slowing, with the Wage Price Index falling sharply.

Australia: Wage Price Index Growth

Falling growth in disposable income is holding back consumption (e.g. retail spending) and increasing pressure on savings.

Australia: Consumption and Savings

Housing prices are high despite the recent slow-down, while households remain heavily indebted, with household debt at record levels relative to disposable income.

Australia: Housing Prices and Household Debt

Housing price growth slowed to near zero and we are likely to soon see house prices shrinking.

Australia: Housing Prices

Broad money growth is falling sharply, reflecting tighter financial conditions, while credit growth is also slowing.

Australia: Broad Money and Credit Growth

Mining profits are up, while non-mining corporation profits (excluding banks and the financial sector) have recovered to about 12% of GDP.

Australia: Corporate Profits

But business investment remains weak, which is likely to impact on future growth in both profits and wages.

Australia: Investment

Exports are strong, especially in the Resources sector. Manufacturing is the only flat spot.

Australia: Exports

Iron ore export tonnage continues to grow, while demand for coal has leveled off in recent years.

Australia: Bulk Commodity Exports

Our dependence on China as an export market also continues to grow.

Australia: Exports by Country

Corporate bond spreads — the risk premium over the equivalent Treasury rate charged to non-financial corporate borrowers — remain low, reflecting low financial risk.

Australia: Non-financial Bond Spreads

Bank capital ratios are rising but don’t be fooled by the risk-weighted percentages. Un-weighted Common Equity Tier 1 leverage ratios are closer to 5% for the four major banks. Common Equity excludes bank hybrids which should not be considered as capital. Conversion of hybrids to common equity was avoided in the recent Italian banking crisis, largely because of the threat this action posed to stability of the entire financial system.

Australia: Bank Capital Ratios

Low capital ratios mean that banks are more likely to act as “an accelerant rather than a shock-absorber” in times of crisis (2014 Murray Inquiry). Professor Anat Admati from Stanford University and Neel Kashkari, President of the Minneapolis Fed are both campaigning for higher bank capital ratios, at 4 to 5 times existing levels, to ensure stability of the financial system. This is unlikely to succeed, considering the political power of the bank sector, unless the tide goes out again and reveals who is swimming naked.

The housing boom has run its course and consumption is slowing. The banks don’t have much in reserve if the housing market crashes — not yet a major risk but one we should not ignore. Exports are keeping us afloat because we hitched our wagon to China. But that comes at a price as Australians are only just beginning to discover. If Chinese exports fail, Australia will need to spend big on infrastructure. And infrastructure that will generate not just short-term jobs but long-term growth.

Is GDP doomed to low growth?

GDP failed to rebound after the 2008 Financial Crisis, sinking into a period of stubborn low growth. Economic commentators have advanced many explanations for the causes, while the consensus seems to be that this is the new normal, with the global economy destined to decades of poor growth.

Real GDP Growth

This is a classic case of recency bias. Where observers attach the most value to recent observations and assume that the current state of affairs will continue for the foreseeable future. The inverse of the Dow 100,000 projections during the Dotcom bubble.

Real GDP for Q1 2018 recorded 2.9% growth over the last 4 quarters. Not exactly shooting the lights out, but is the recent up-trend likely to continue?

Real GDP Growth and estimate based on Private Sector Employment and Average Weekly Hours Worked

Neils Jensen from Absolute Return Partners does a good job of summarizing the arguments for low growth in his latest newsletter:

The bear story

Putting my (very) long-term bearishness on fossil fuels aside for a moment, there is also a bear story with the potential to unfold in the short to medium-term, but that bear story is a very different one. It is a story about GDP growth likely to suffer as a consequence of the oil industry’s insatiable appetite for working capital, which is presumably a function of the low hanging fruit having been picked already.

In the US today, the oil industry ties up 31 times more capital per barrel of oil produced than it did in 1980, when we came out of the second oil crisis. ….Such a hefty capital requirement is a significant tax on economic growth. Think of it the following way. Capital is a major driver of productivity growth, which again is a key driver of economic growth. Capital tied up by the oil industry cannot be used to enhance productivity elsewhere, i.e. overall productivity growth suffers as more and more capital is ‘confiscated’ by the oil industry.

I am tempted to remind you (yet again!) of one of the most important equations in the world of economics:

∆GDP = ∆Workforce + ∆Productivity

We already know that the workforce will decline in many countries in the years to come; hence productivity growth is the only solution to a world drowning in debt, if that debt is to be serviced. Why? Because we need economic growth to be able to service all that debt.

Now, if productivity growth is going to suffer for years to come, all this fancy new stuff that we all count on to save our bacon (advanced robotics, artificial intelligence, etc.) may never be fully taken advantage of, because the money needed to make it happen won’t be there. It is not a given but certainly a risk that shouldn’t be ignored.

….For that reason, we need to retire fossil fuels as quickly as possible. Ageing of society (older workers are less productive than their younger peers) and a global economy drowning in debt (servicing all that debt is immensely expensive, leaving less capital for productivity enhancing purposes) are widely perceived to be the two most important reasons why productivity growth is so pedestrian at present.

I am not about to tell you that those two reasons are not important. They certainly are. However, the adverse impact the oil industry is having on overall productivity should not be underestimated.

I tend to take a simpler view, where I equate changes in GDP to changes in hours worked and in capital investment:

∆GDP = ∆Workforce + ∆Capital

Workers work harder if they are motivated or if there is a more efficient organizational structure, but these are a secondary influence on productivity when compared to capital investment.

The chart below compares net capital formation by the corporate sector (over GDP) to real GDP growth. It is evident that GDP growth rises and falls in line with net capital formation (or investment as it is loosely termed) by corporations.

Net Capital Formation by the corporate sector/GDP compared to Real GDP Growth

A quick primer (with help from Wikipedia):

  • Capital Formation measures net additions to the capital stock of a country.
  • Capital refers to physical (or tangible) assets and includes plant and equipment, computer software, inventories and real estate. Any non-financial asset used in the production of goods or services.
  • Capital does not include financial assets such as bonds and stocks.
  • Net Capital Formation makes allowance for depreciation of the existing capital stock due to wear and tear, obsolescence, etc.

Net Capital Formation peaked at around 5.0% from the mid-1960s to the mid-1980s, made a brief recovery to 4.0% during the Dotcom bubble and has since struggled to make the bar at 3.0%. Rather like me doing chin-ups.

Net Capital Formation Declining in the Corporate Sector

There are a number of factors contributing to this.

Intangible Assets

Capital formation only measures tangible assets. The last two decades have seen a massive surge in investment in intangible assets. Look no further than the big five on the Nasdaq:

Stock Symbol Price ($) Book Value ($) Times Book Value
Amazon AMZN 1582.26 64.85 24.40
Microsoft MSFT 95.00 10.32 9.21
Facebook FB 173.86 26.83 6.48
Apple AAPL 169.10 27.60 6.12
Alphabet GOOGL 1040.75 235.46 4.42

Currency Manipulation

Capital formation first fell off the cliff in the 1980s. This coincides with the growth of currency manipulation by Japan, purchasing excessive US foreign reserves to suppress the Yen and establish a trade advantage over US manufacturers. China joined the party in the late 1990s, exceeding Japan’s current account surplus by 2006. Currency suppression creates another incentive for corporations to offshore or outsource manufacturing to Asia.

China & Japan Current Account Surpluses

Tax on Offshore Profits

Many large corporations took advantage of low tax rates in offshore havens such as Ireland, avoiding US taxes while the funds were held offshore. This created an incentive for large corporations to invest retained earnings offshore rather than in the USA.

The net effect has been that retained earnings are invested elsewhere, while new capital formation in the USA is almost entirely funded by debt.

Net Capital Formation by the corporate sector/GDP compared to Corporate Debt Growth/GDP

Donald Trump’s tax deal will make a dent in this but will not undo past damage. The horse has already bolted.

Offshore Manufacturing

Apart from tax incentives, lower labor costs (enhanced by currency manipulation) led large corporations to set up or outsource manufacturing to Asia and other developing countries. In effect, offshoring capital formation and — more importantly — GDP growth to foreign destinations.

Offshoring Jobs

Along with manufacturing plants, blue-collar jobs also moved offshore. While this may improve the company bottom-line for a few years, the long-term, macro effects are devastating.

Think of it this way. If you build a manufacturing plant offshore rather than in the USA you may save millions of dollars a year in labor costs. Great for the bottom line and executive bonuses. But one man’s wage is another man/woman’s income (when he/she spends it). So, from a macro perspective, the US loses GDP equal to the entire factory wages bill plus the wage component of any input costs. A far larger figure than the company’s savings. As more companies offshore jobs, sales growth in the USA is affected. In the end this is likely to more than offset the savings that justified the offshore move in the first place.

Stock Buybacks

Stock buybacks accelerate EPS (earnings per share) growth and are great for boosting stock prices and executive bonuses. But they create the illusion of growth while GDP stands still. There is no new capital formation.

Can GDP Growth Recover?

Yes. Restore capital formation and GDP growth will recover.

How to do this:

Trump has already made an important move, revising tax laws to encourage corporations to repatriate offshore funds.

But more needs to be done to create a level playing field.

Stop currency manipulation and theft of technology by developing countries, especially China. Trump has also signaled his intention to tackle this thorny issue.

Repatriating offshore manufacturing and jobs is a much more difficult task. You can’t just pack a factory in a box and ship it home. There is also the matter of lost skills in the local workforce. But manufacturing jobs are being lost globally at an alarming rate to new technology. In the long-term, offshore manufacturing plants will be made obsolete and replaced by new automated, high-tech manufacturing facilities. Incentives need to be created to encourage new capital formation, especially high-tech manufacturing, at home.

Stock buybacks, I suspect, will always be around. But remove the incentive to boost stock prices by targeting the structure of executive bonuses. It would be difficult to isolate benefits from stock buybacks and tax them directly. But removing tax on dividends — in my opinion far simpler and more effective than the dividend imputation system in Australia — would remove the incentive for stock buybacks and make it difficult for management to justify this action to investors.

We already seem to be moving in the right direction. The last two points are relatively easy when compared to the first two. If Donald Trump manages to pull them (the first two) off, he will already move sharply upward in my estimation.

Judge a tree by the fruit it bears.

~ Matthew 7:15–20

The Fed and Alice in Wonderland

In Lewis Carroll’s Alice in Wonderland a young Alice experiences a series of bizarre adventures after falling down a rabbit hole. The new Fed Chairman Jerome Powell will similarly have to lead global financial markets through a series of bizarre, unprecedented experiences.

Down the Rabbit Hole

In 2008, after the collapse of Lehman Bros, financial markets were in complete disarray and in danger of imploding. The Fed, under chairman Ben Bernanke, embarked on an unprecedented (and unproven) rescue attempt — now known as quantitative easing or QE for short — injecting more than $3.5 trillion into the financial system through purchase of long-term Treasuries and mortgage-backed securities (MBS).

Fed Total Assets

The Fed aimed to drive long-term interest rates down in the belief that this would encourage private sector borrowing and investment and revive the economy. Their efforts failed. Private sector borrowing did not revive. Most of the money injected ended up, unused by the private sector, as $2.5 trillion of excess commercial bank reserves on deposit at the Fed.

Fed Excess Reserves

Richard Koo pointed out that the private sector will under normal cirumstances respond to lower interest rates with increased borrowing but during a financial crisis, when their balance sheets have been destroyed and their liabilities exceed their assets, their sole focus is to restore their balance sheet, using surplus cash flow to pay down debt. The only way to prevent a collapse is for the government to step in and plug the gap, borrowing surplus capital and investing this in infrastructure.

One Pill Makes you Larger

Fortunately Bernanke got the message.

US and Euro Area Public Debt to GDP

… and spread the word.

Japan Public Debt to GDP

And One Pill Makes you Small

Unfortunately, other central banks also followed the Fed’s earlier lead, injecting vast sums into the financial system through quantitative easing (QE).

ECB and BOJ Total Assets

Driving long-term yields to levels even Lewis Carroll would have struggled to imagine.

10-Year Treasury Yields

The Pool of Tears

Then in 2014, another twist in the tale. Long-term yields continued to fall in Europe and Japan, while US rates stabilised as Fed eased off on QE. A large differential appeared between US and European/Japanese rates (observable since 2014 on the above chart), causing a flood of money into the US, in pursuit of higher yields.

….. with an unwanted side-effect. The Dollar strengthened. Capital inflows caused the trade-weighted value of the US Dollar to spike upwards beween 2014 and 2016, damaging US export industries and local manufacturers facing competition from foreign imports.

US Trade-Weighted Dollar Index

The Mad Hatter’s Tea Party

A jobless recovery in manufacturing and low wage growth in turn led to the election of Donald Trump in 2016 promising increased protectionism against global competition.

US Manufacturing Jobs

Then in 2017, to the consternation of many, despite rising interest rates the US Dollar began to fall.

US TW Dollar Index in 2017

Learned analysis followed, ascribing the weakening Dollar to rising commodity prices and a recovery in emerging markets. But something doesn’t quite add up.

International bond investors are a pretty smart bunch. When they look at US bond markets, what do they see? The new Fed Chairman has inherited a massive headache.

Donald Trump is determined to stimulate job growth through tax cuts and infrastructure spending. This will certainly create jobs. But when you stimulate an economy that is already at full employment you get inflation.

Who Stole the Tarts?

Jerome Powell is sitting on a powder keg. More than $2 trillion of excess reserves that commercial banks can withdraw without notice. Demand for bank credit is expected to rise as result of the Trump stimulus. Commercial banks, not known for their restraint, can make like Donkey Kong with their excess reserves provided by the Bernanke Fed.

Under Janet Yellen the Fed mapped out a program to withdraw excess reserves from the market by selling down Treasuries and MBS at the rate of $100 billion in 2018 and $200 billion each year thereafter. But at that rate it will take 10 years to remove the excess.

Bond markets are worried about what will happen to inflation in the mean time.

Off With His Head

The new Fed Chair has made all the right noises about being hawkish on inflation. But can he walk the talk? Especially with his $2 trillion headache.

….and the Red Queen, easily recognizable from Lewis Carroll’s tale, tweeting “off with his head” if a hawkish Fed threatens to spoil the party.

One pill makes you larger
And one pill makes you small
And the ones that mother gives you
Don’t do anything at all
Go ask Alice
When she’s ten feet tall

….When the men on the chessboard
Get up and tell you where to go
And you’ve just had some kind of mushroom
And your mind is moving low….

When logic and proportion
Have fallen sloppy dead
And the White Knight is talking backwards
And the Red Queen’s off with her head
Remember what the dormouse said
Feed your head
Feed your head

~ White Rabbit by Grace Slick from Jefferson Airplane (1967)

Australia: Housing, Incomes & Growth

A quick snapshot of the Australian economy from the latest RBA chart pack.

Disposable income growth has declined to almost zero and consumption is likely to follow. Else Savings will be depleted.

Disposable Income & Consumption

Residential building approvals are slowing, most noticeably in apartments, reflecting an oversupply.

Residential Building Approvals

Housing loan approvals for owner-occupiers are rising, fueled no doubt by State first home-buyer incentives. States do not want the party, especially the flow from stamp duties, to end. But loan approvals for investors are topping after an APRA crackdown on investor mortgages, especially interest-only loans.

Housing loan approvals

The ratio of household debt to disposable income is precarious, and growing worse with each passing year.

Household debt to disposable income

House price growth continues at close to 10% a year, fueled by rising debt. When we refer to the “housing bubble” it is really a debt bubble driving housing prices. If debt growth slows so will housing prices.

House price growth

Declining business investment, as a percentage of GDP, warns of slowing economic growth in the years ahead. It is difficult, if not impossible, to achieve productivity growth without continuous new investment and technology improvement.

Business investment

Yet declining corporate bond spreads show no sign of increased lending risk.

Corporate bond spreads

Declining disposable income and consumption growth mean that voters are unlikely to be happy come next election. With each party trying to ride the populist wave, responsible economic management has taken a back seat. Throw in a housing bubble and declining business investment and the glass looks more than half-empty.

Every great cause begins as a movement, becomes a business, and eventually degenerates into a racket.

~ Eric Hoffer

US Retail & Light Vehicle Sales slow

Retail sales growth (excluding motor vehicles and parts) slowed to 2.4% over the 12 months to June 2017.

Retail Sales ex Motor Vehicles & Parts

Source: St Louis Fed & US Bureau of the Census

Seasonally adjusted light vehicle sales are also slowing.

Light Vehicle Sales

Source: St Louis Fed & BEA

Seasonally adjusted private housing starts and new building permits are starting to lose momentum.

Housing Starts & Permits

Source: St Louis Fed & US Bureau of the Census

The good news is that Manufacturer’s Durable Goods Orders (seasonally adjusted and ex Defense & Aircraft) are recovering.

Manufacturing Durable Goods Orders ex Defense & Aircraft

Source: St Louis Fed & US Bureau of the Census

Cement and concrete production continues to trend upwards.

Cement & Concrete Production

Source: US Fed

And estimated weekly hours worked (total nonfarm payroll * average weekly hours) is growing steadily.

Estimated Weekly Hours Worked

Source: St Louis Fed & BLS

All of which suggest that business confidence is growing and consumer confidence is likely to follow. Bellwether transport stock Fedex advanced to 220, signaling rising economic activity in the broader economy.

Fedex

Target: 180 + ( 180 – 120 ) = 240

The S&P 500 broke resistance at 2450, making a new high. Narrow consolidations and shallow corrections all signal investor confidence typical of the latter stages of a bull market. The immediate target is 2500* but further gains are likely.

S&P 500

Target: 2400 + ( 2400 – 2300 ) = 2500

The stock market remains an exceptionally efficient mechanism for the transfer of wealth from the impatient to the patient.

~ Warren Buffett

Investment the key to growth

Elliot Clarke at Westpac recently highlighted the importance of investment in sustaining economic growth:

The importance of sustained investment in an economy cannot be understated. Done well, investment in real capacity begets greater production volume and employment as well as a productivity dividend. Its absence in recent years is a key factor behind sustained soft wage inflation and the US economy’s inability to consistently grow at an above-trend pace despite the economy being at full-employment and household balance sheets having more than fully recovered post GFC.

The graph below highlights declining US investment in new equipment post GFC.

S&P 500

source: Westpac

There are three factors that may influence this:

  1. Accelerated tax depreciation allowances after the GFC encouraged companies to bring forward capital spending in order to stimulate the recovery. But the 2010 to 2012 surge is followed by a later trough when the intended capital expenditure was originally planned to have taken place.
  2. Low growth in personal consumption, especially of non-durable goods and of services, would discourage further capital investment.

US Net Debt & Equity Issuance

  1. The level of stock buybacks increased as companies sought alternative measures to sustain earnings (per share) growth. The graph below shows debt issuance has soared while net equity issuance remains consistently negative.

US Net Debt & Equity Issuance

source: Westpac

Net capital formation (the increase in physical assets owned by nonfinancial corporations) declined between 2015 and 2017. While this is partly attributable to the falling oil price curtailing investment in the Energy sector, continuation of the decline would spell long-term trouble for the economy.

US Net Capital Formation

The cycle becomes self-reinforcing. Low growth in personal consumption leads to low levels of capital investment ….which in turn leads to low employment growth…..leading to further low growth in personal consumption.

Major infrastructure investment is needed to break the cycle. In effect you need to “prime the pump” in order to create a new virtuous cycle, with higher investment leading to higher growth.

It is obviously important that infrastructure investment target productive assets, that generate income, else taxpayers are left with increased debt and no income to service it. Or assets that can be sold to repay the debt. But the importance of infrastructure investment should be evident to both sides of politics and any attempt to obstruct or delay this would be putting political ahead of national interests.

Australia

Australia is in a worse position, with a dramatic fall in investment following the mining boom.

Australia: Business Investment

source: RBA

If we examine the components of business investment, it is not just Engineering that has fallen. Investment in Machinery & Equipment has been declining for the last decade. And now Building Investment is also starting to slow.

Australia: Components of Business Investment

source: RBA

You’ve got to prime the pump…. You’ve got to put something in before you can get anything out.

~ Zig Ziglar

Federal budget 2017: The next boom is under way – before another bust

From Michael Pascoe:

A Caterpillar and Komatsu cavalry is arriving just in time to save the next two federal budgets from the effects of slowing residential building approvals, solving one of Treasurer Scott Morrison’s fiscal dilemmas. National spending on transport infrastructure is in the process of soaring 73 per cent from last financial year to 2018-19, according to industry research company Macromonitor.

Spending on road and rail hit a cyclical low of about $19 billion in 2015-16. In constant dollars, the cycle is expected to peak at $33 billion in 2018-19. That spending would more than cover a 10 per cent decline from last year’s $63 billion worth of new residential building….

Increased infrastructure spending is welcome but former RBA governor’s comments on setting up a proper process of infrastructure planning and selection [see link below] highlight the negative boom-bust mentality of government focused on the election cycle.

Source: Federal budget 2017: The next boom is under way – before another bust