Capital spending on the rise

Just released July 2018 manufacturers’ new orders for capital goods, excluding defense and aircraft, show that the recovery is gathering speed.

Manufacturers New Orders: Capital Goods excluding Defense & Aircraft

Any fears that easy money has undermined capital budgeting restraints — and that the economy is entering the final heady stages of a boom before the bust — can be dispelled by adjusting the above graph for inflation.

Manufacturers New Orders: Capital Goods excluding Defense & Aircraft adjusted for Inflation

Adjusting manufacturers orders by the GDP implicit price deflator shows that the recovery in capital spending has barely started and is a long way from the excesses preceding the Dotcom crash and the GFC.

Australia: Good news and bad news

First, the good news from the RBA chart pack.

Exports continue to climb, especially in the Resources sector. Manufacturing is the only flat spot.

Australia: Exports

Business investment remains weak and is likely to impact on long-term growth in both profits and wages.

Australia: Business Investment

The decline is particularly steep in the Manufacturing sector and not just in Mining.

Australia: Business Investment by Sector

But government investment in infrastructure has cushioned the blow.

Australia: Public Sector Investment

Profits in the non-financial sector remain low, apart from mining which has benefited from strong export demand.

Australia: Non-Financial Sector Profits

Job vacancies are rising which should be good news for wage rates. But this also means higher inflation and, down the line, higher interest rates.

Australia: Job Vacancies

The housing and financial sector is our Achilles heel, with household debt climbing a wall of worry.

Australia: Housing Prices and Household Debt

House prices are shrinking despite record low interest rates.

Australia: Housing Prices

Broad money and credit growth are slowing, warning of a contraction.

Australia: Broad Money and Credit Growth

Bank profits remain strong.

Australia: Bank Profits

But capital ratios are low, with the bulk of profits distributed to shareholders as dividends. The ratios below are calculated on risk-weighted assets. Raw leverage ratios are a lot weaker.

Australia: Bank Capital Ratios

One of the primary accelerants of the housing bubble and household debt has been $900 billion of offshore borrowings by domestic banks. The chickens are coming home to roost, with bank funding costs rising as the Fed hikes interest rates. In the last four months the 90-day bank bill swap rate (BBSW) jumped 34.5 basis points.

The banks face a tough choice: pass on higher interest rates to mortgage borrowers or accept narrower margins and a profit squeeze. With an estimated 30 percent of households already suffering from mortgage stress, any interest rate hikes will impact on both housing prices and delinquency rates.

I continue to avoid exposure to banks, particularly hybrids where many investors do not understand the risks.

I also remain cautious on mining because of a potential slow-down in China, with declining growth in investment and in retail sales.

China: Activity

Low inflation risk keeps yield curve safe

The Fed is advancing interest rates at a measured pace, with the objective of restoring balance in financial markets rather than to curbing inflationary pressures. Only if inflation spikes is the Fed likely to adopt a restrictive stance.

Elliot Clarke from Westpac sums up the FOMC (Fed Open Market Committee) view from their latest minutes:

Beginning with inflation, whereas the market has recently been concerned that inflation may be getting away from the FOMC (given annual CPI inflation at 2.5%yr and persistent strength in the oil price), the Committee is unperturbed.

Instead of the CPI, the FOMC’s benchmark remains PCE inflation, which is currently 2.0%yr on a headline basis and 1.9%yr for core…..

To see upside inflation risks build, a stronger wage inflation pulse is necessary. At present the employment cost index is only reporting “a gradual pickup in wage increases”, and the signal from other wage measures is “less clear”. Two other important considerations for the pass through of wages to activity and thus inflation is that real hourly earnings growth is currently flat and the savings rate near historic lows. The capacity of households to boost consumption and thus inflation is therefore very limited.

Hourly wage rates are growing at a gradual pace.

Hourly Wage Rate Growth

Personal savings are low.

Personal Savings

And credit growth is modest.

Credit Growth

So not much sign of inflationary pressure.

….Turning to financial conditions, as yet there is no concern of them becoming an impediment to growth or policy. The 10yr yield has moved back to the highs of 2013, but the US dollar has only partly retraced its 2017 depreciation. Further, asset markets remain near recent highs.

Equally significant however is the reference to being nearer neutral and a clear desire to keep the yield curve’s positive slope…..

We do not believe that the yield curve will invert in this instance, in part because higher deficits should see the term premium rise. However, the curve will remain comparatively flat versus history, restricting both the timing and the scale of further rate hikes. This is a key justification for both the market’s and our own view of only two further hikes in 2018 and two more in 2019 – a stark contrast to the FOMC’s seven hikes to end-2020.

Yield Differential

A negative yield curve — when 10-year minus 3-month Treasury yields falls below zero — would give a strong recession warning. But the yield curve is only likely to invert if the Fed steps up interest rate increases. With little sign of rising inflationary pressure at present, the prospect seems remote.

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)

Outlook for 2018

At this time of year we are usually inundated with projections for the year ahead, from predictions of imminent collapse to expectations of a record year.

We live in a world of uncertainty, where both extremes are possible, but neither is likely.

We are clearly in stage 3 (the final stage) of a bull market. Risk premiums are close to record lows. The yield spread between lowest investment-grade (Baa) bonds and equivalent risk-free Treasuries has crossed to below 2.0 percent, levels last seen prior to the 2008 global financial crisis. The VIX is also close to its record low, suggesting high levels of investor confidence.

Corporate Bond Spreads and VIX

Money supply continues to grow at close to 5.0 percent, reflecting an accommodative stance from the Fed. MZM, or Zero Maturity Money, is basically M1 plus travelers checks and money market funds.

Zero-Maturity Money

Inflationary forces remain subdued, with average hourly wage rates growing at below 2.5 percent per year. A rise above 3.0 percent, which would pressure the Fed to adopt a more restrictive monetary policy, does not appear imminent.

Average Hourly Wage Rates

Tax relief and higher commodity prices are likely to exert upward pressure on inflation in the year ahead. But the Fed’s stated intention of shrinking its balance sheet, with a reduction of $100 billion in the first 12 months, is likely to have an opposite, contractionary effect.

The Leading Index from the Philadelphia Fed gave a bit of a scare, dipping below 1.0 percent towards the end of last year. But data has since been revised and the index now reflects a far healthier outlook.

Philadelphia Fed Leading Index

A flattening yield curve has also been mooted as a potential threat, with a negative yield curve preceding every recession over the last 50 years.

Yield Differential 10-Year compared to 2-Year and 3-Month Treasuries

A yield differential, between 10-year and either 2-year or 3-month Treasuries, below zero would warn of a recession. When long-term yields fall below short-term yields financial markets stop working efficiently and bank lending tends to contract. Banks, who generally borrow at short-term rates and lend at long-term rates, find their margins are squeezed and become strongly risk-averse. Contracting lending slows the economy and normally leads to recession.

But we are some way from there. If we take the last cycle as an example, the yield curve started flattening in 2005 (when yield differentials fell below 1 percent) but a recession only occurred in 2008. The market could continue to thrive for several years before the impact of a negative yield curve is felt. To exit now would seem premature.

Fed flunks econ 101?

Caroline Baum’s opinion on the Fed’s approach to inflation:

For all the sturm und drang about the Fed debasing the dollar and sowing the seeds of the next great inflation, the public’s demand for money has increased. The increased desire to hold cash and checkable deposits has risen to meet the increased supply. Velocity, or the rate at which money turns over, has plummeted.

The Fed has two choices. It can adopt the Dr. Strangelove approach and learn to stop worrying and live with low inflation and low unemployment. Or it can do something about it, which runs counter to its stated intention to raise the funds rate and reduce the size of its balance sheet.

Option #1 involves learning to live with a low, stable inflation rate about 0.5 percentage point below the Fed’s explicit 2% target.

Not only has the Fed has achieved price stability in objective terms, but it has also fulfilled former Fed Chairman Alan Greenspan’s subjective definition of price stability: a rate of inflation low enough that it is not a factor in business or household decision-making.

Option #2 means taking some additional actions to increase the money supply by lowering interest rates or resuming bond purchases. The Fed is taking the opposite approach. It began its balance sheet normalization this month, allowing $10 billion of securities to mature each month and gradually increasing the amount every quarter. And it has guided markets to expect another 25-basis-point rate increase in December….

The Fed faces a delicate balancing act. Unemployment is low but capacity utilization is also low, indicating an absence of inflationary pressure.

Capacity Utilization

Janet Yellen understandably wants to normalize interest rates ahead of the next recession but she can afford to take her time. The economy is unlikely to tip into recession unless the Fed hikes rates too quickly, causing a monetary contraction.

I believe the Fed chair is relying on the outflow from more than $2 trillion of excess reserves held by banks on deposit with the Fed to offset the contractionary effect of any rate hikes.

Capacity Utilization

If pushed, the Fed could lower the interest rate paid on excess reserves in order to encourage banks to withdraw excess deposits. But so far this hasn’t been necessary. The attraction of higher interest rates in financial markets has been sufficient to encourage a steady outflow from excess reserves, keeping the monetary base (net of reserves) growing at a steady clip of close to 7.5% p.a. despite rate hikes so far.

Capacity Utilization

Makes you wonder why Donald Trump would even consider replacing the Fed chair when she is doing a great job of managing the recovery.

Source: Fed flunks econ 101: understanding inflation – MarketWatch

How long will the bull market last?

US markets are clearly in a bull phase, with the Dow, S&P 500 and Nasdaq making strong gains. A rising Freight Transport Index highlights the broad up-turn in economic activity.

Freight Transport Index

Low corporate bond spreads — lowest investment grade (Baa) minus 10-year Treasury yield — and VIX below 15 both reflect bull market conditions.

Bond Spreads

Real GDP is growing around a modest 2 percent a year. Low figures are likely to continue, with annual change in hours worked (total payroll * average weekly hours) falling to 1.2 percent in September.

Real GDP

Money supply (M1) growth recovered to a balmy 7 percent (p.a.) after a worrying dip below 5 in early 2016.

M1 Money Stock

The Fed may be reluctant to tighten monetary conditions but will be forced to act if inflation starts to accelerate. Annual growth in hourly wage rates turned above 2.5 percent in September, signaling underlying inflationary pressure.

Average Hourly Wage Rate - Annual Growth

Another dip in M1 below 5 percent growth would warn that monetary conditions are tightening. From there, it normally takes 12 months to impact on the broad market indices.

M1 Money Stock and Fed Funds Rate

At this stage it looks like another 2 years of sunshine before the storm. But one false tweet and we could face an early winter.