A bump for Donald Trump next year

From Tim Wallace at The Age:

Nine years on from the start of the financial crisis, the US recovery may be overheating, Legal & General Investment Management economist James Carrick has warned.

He has predicted a series of interest rate hikes will tip the US into a 2018 recession.”Every recession in the US has been caused by a tightening of credit conditions,” he said, noting inflation is on the rise and the US Federal Reserve is discussing plans for higher interest rates.

Officials at the Fed have only raised interest rates cautiously, because inflation has not taken off, so they do not believe the Fed needs to take the heat out of the economy.

But economists fear the strong dollar and low global commodity prices have restricted inflation and disguised domestic price rises. Underneath this, they fear the economy is already overheating.

As a result, they expect inflation to pick up sharply this year, forcing more rapid interest rate hikes.

That could cause a recession next year, they say. In their models, the signals are that this could take place in mid-2018.

I agree that most recessions are caused by tighter monetary policy from the Fed but the mid-2018 timing will depend on hourly earnings rates.

Hourly earnings are a good indicator of underlying inflationary pressure and a sharp rise is likely to attract a response from the Fed. The chart below shows how the Fed slams on the brakes whenever average hourly earning rates grow above 3.0 percent. Each surge in hourly earnings is matched by a dip in the currency growth rate as the Fed tightens the supply of money to slow the economy and reduce inflationary pressure.

Hourly Earnings Growth compared to Currency in Circulation

Two anomalies on the above chart warrant explanation. First, is the sharp upward spike in currency growth in 1999/2000 when the Fed reacted to the LTCM crisis with monetary stimulus despite high inflationary pressures. Second, is the sharp dip in 2010 when the Fed took its foot off the gas pedal too soon after the financial crisis of 2008/2009, mistaking it for a regular recession.

Hourly earnings growth has risen to 2.5 percent but the Fed is only likely to react with tighter monetary policy when earnings growth reaches 3.0 percent. Recent rate rises are more about normalizing interest rates and are no cause for alarm.

I am more concerned about the impact that rising employment costs will have on corporate earnings.

The chart below is one of my favorites and shows the relationship between employee compensation and corporate profits (after tax) as a percentage of net value added. Profit margins rise when employment costs fall, and fall when employment costs rise.

Profits After Tax v. Employment Costs as a Percentage of Value Added

Employee compensation is clearly rising and corporate profits falling as a percentage of net value added. If this trend continues in 2017 (last available data is Q3 2016) then corporate earnings are likely to come under pressure and stock prices fall.

Source: Warning of bump for Donald Trump next year with slide into recession

6 Replies to “A bump for Donald Trump next year”

  1. US recessions ??? … come-on now …. it’s far too infrequent and insignificant – in the normal scheme of things – to even entertain it as a reasonable probability.

    Put another way :
    1. Rationally the arranging of portfolios now – in anticipation of a recession – cannot be an effective ;
    2. Discussions now – in an attempt to put forward alternative theories – is equally uncalled for.

    I find that to not assume recessions so far in advance and therefore to not anticipate it by 18 months points to real related ‘wisdom’ – all associated else is superfluous.

    1. I agree it doesn’t help investors to anticipate recessions too far in advance. If the market rises another 5 or 10 percent, all else is forgotten. But it pays to be mindful of monetary conditions and I will do my best to keep reminding readers if and when monetary tightening is likely to occur.

  2. An alternative view from Elliot Clarke at Westpac (emphasis added):

    “While Q4 GDP and durable goods orders have signalled a return to positive growth for business investment, it remains historically weak. This must change if growth at or above trend is to be achieved.

    On that point however, there remains considerable doubt, with firms clearly still favouring efficiency over expansion.

    This mindset also plays through to employment and wages. Here we see firms reducing hours and benefits to reign in growth in the wage bill. As a consequence, household income growth is still being crimped.

    Because of these investment and consumer income trends, we believe the FOMC will be limited to two rate hikes in 2017 and another two in 2018. There is simply not enough momentum in the domestic economy to spark an inflation breakout.

    1. Inflation and the StockMarket – USA

      For the last ten years, there is – with the brief exception of nine months in 2008 – absolutely no correlation and no causal linkage between the two, as your graphs may show. That is, the CPI inflation goes from -2% to +4% in the two years to mid-2011 and the market climbs ; it goes down from +4% in 2011 to zero in 2015, and the market climbs ; it then goes from zero to +2% and the market climbs, also.

      Medium-term, interest rates will reform to be positive in real terms. However, real economic growth and CPI price rises will be the cause. So, shares and their valuations will be subject to / receive the same upward force; that is, it will not be negative for shares.

      So, neither real interest rate rises nor inflation will really significantly matter; it’s the relative valuation levels that share attain that is the most important – by far – consideration.

      1. Graham you are equating inflation with CPI which is not always a good reflection of underlying inflation.

        Even if we use hourly wage rate growth there is a lag effect. First, growth surges above 3 percent. Second, the Fed starts to tighten monetary policy. Third, the cumulative effect of progressive tightening causes the economy to slow and stocks to fall.

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