Category: Deficit Spending & Employment

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Employment lifts but S&P 500 tentative

Growth in total non-farm payrolls ticked up to 1.76% for the 12 months to April 2019, supporting Fed reluctance to cut interest rates.

Payroll Growth

The Philadelphia Fed Leading Index has been revised upwards, above a comfortable 1.0%.

Leading Index

Real GDP growth came in at a healthy 3.2% for the 12 months ended 31 March 2019 but growth in total hours worked sagged to 1.47%, suggesting that GDP growth is likely to slow.

Real GDP and Total Hours Worked

Growth in average hourly earnings came in at 3.23% (total private), suggesting that inflationary pressures remain under control. Little chance of a Fed rate hike either.

Average Hourly Earnings

The S&P 500 retracement respected support at 2900. Rising Money Flow indicates buying pressure but gains seem tentative.

S&P 500

US growth looks to continue but commodity prices warn that global growth is slowing.

Nymex crude penetrated its lower trend channel, warning of a correction. Despite the supply impact of increasing sanctions on Iran and Venezuela, and the threat of supply disruption in Libya.

Nymex Light Crude

A similar correction on DJ-UBS Commodities index reinforces that global demand is slowing.

DJ-UBS Commodities Index

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Australia’s irrelevant election

Satyajit Das spells out the challenges facing the Australian economy in the next decade:

The centerpiece of both major contenders’ campaigns are large tax cuts and significant government spending on infrastructure and welfare. Both parties pay lip service to sound public finance. But the sustainability of policies based on outbidding political opponents and financing permanent expenditure with impermanent revenues is questionable.

….This striking lack of control that Australia has over its economy is grounded in four factors.

….Sadly, no party’s manifesto addresses these fundamental challenges. Tax cuts will not reform a system which needs to be overhauled. Infrastructure spending provides a short-term increase in demand. Bad choice of projects and poor delivery, evidenced by the disappointing National Broadband Network which is over-budget and slow by the best international standards, may not enhance longer-term efficiency and productivity.

The narrowness of the economic base is ignored. No political party is willing to address over-investment in housing, the total value of which is around $6 trillion or around 4 times gross domestic product and constitutes a large proportion of household wealth. Encouraged by complex subsidies, capital is locked up in property, unavailable for more productive activities such as new industries. Leaders are reluctant to champion forceful structural reforms to improve education and skill levels as well as streamline regulation. Instead, all contenders seem happy to rely on windfalls to finance the nation’s living standards through ever shorter electoral cycles.

Worth reading the full article at Nikkei Asian Review

Hat tip to Macrobusiness.

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Nasdaq breaks resistance

Real GDP growth came in at a healthy 3.2% for the 12 months ended 31 March 2019. Growth in total hours worked is lagging below 2.0%, suggesting that further acceleration is unlikely.

Real GDP and Total Hours Worked

Growth in total non-farm payrolls continues at close to 2.0%, minimizing the chance of an interest rate cut by the Fed.

Payroll Growth

The S&P 500 is testing its previous high at 2940, while a rising Trend Index (13-week) indicates buying pressure.

S&P 500

The Nasdaq 100 broke resistance at 7700, signaling another advance. Expect retracement to test the new support level. The long-term target is 9000.

Nasdaq 100

A rapid advance would outstrip earnings growth, with high earnings multiples warning of elevated risk. The market is quite capable of continuing this behavior for an extended time but I urge readers to be cautious and look for rising sales and earnings to support the stock price.

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S&P 500: Expect slower earnings growth but no sign of recession

Credit growth in the US above 5% shows no signs of tighter credit conditions from an inverted yield curve. Growth in the broad money supply (MZM plus time deposits) has also not slowed, remaining close to 5%.

Credit Growth and Broad Money Supply

Growth in hours worked has slowed to 1.71%, suggesting that real GDP growth will dip below 2% in 2019 but remain positive.

Hours Worked and Real GDP growth

The Fed is unlikely to cut interest rates when average hourly earnings are growing at 3.2% (Total Private for the 12 months ended March 2019).

Average Hourly Wage Rate

The Leading Index from the Philadelphia Fed fell below 1%, giving an early warning that GDP growth will slow.

Philadelphia Fed Leading Index

A similar dip below 1% occurred ahead of the last three recessions. A second, stronger dip would warn of recession ahead.

Philadelphia Fed Leading Index

The S&P 500 is advancing to test resistance at 2950/3000, while the Volatility Index crossed below 1%, signaling that risk is no longer elevated.

Treasury Yields

Real GDP is likely to slow this year but remain positive. S&P 500 earnings growth is expected to slow and the index is likely to meet stubborn resistance at 2950/3000. The Fed is still a long way off cutting interest rates (a strong bear signal) and there is no sign of recession on the 2019 horizon. An extended top is the most likely outcome.

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China slowdown

Consumer durable sales are falling sharply:

And from Trivium China:

Premier Li Keqiang reiterated that big stimulus isn’t coming:

“An indiscriminate approach may work in the short run but may lead to future problems.”
“Thus, it’s not a viable option.”
“Our choice is to energize market players.”

….It’s a decidedly different tack than the credit-fueled stimulus of yesteryear, and the practical outcomes of this new policy response are two-fold:

  • Given that it’s a new strategy, the transmission channels from policy to actual economic growth support are not well understood.
  • The one thing we do know – this approach will take longer to impact the economy than the credit-driven responses of previous cycles.

The bottom line: It will take China’s deceleration longer to bottom out than markets and businesses currently expect.

China’s stated intention is to avoid big stimulus, so a policy reversal, if we see it, would signal that the slowdown is far worse than expected.

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Why the RBA shouldn’t cut interest rates

There are growing cries in local media for the RBA to cut interest rates in order to avoid a recession. House prices are falling and shrinking finance commitments point to further price falls. Declining housing values are likely to lead to a negative wealth effect, with falling consumption as household savings increase. Employment is also expected to weaken as household construction falls. Respected economist Gerard Minack thinks “a recession in Australia is becoming more likely”.

The threat should not be taken lightly, but is cutting interest rates the correct response?

Let’s examine the origins of our predicament.

A sharp rise in commodity prices in 2004 to 2008.

Commodity Prices

Led to a massive spike in the Trade-weighted Index.

Australia Trade Weighted Index

And a serious case of Dutch Disease: the destructive effect that offshore investment in large primary sector projects (such as the 1959 Groningen natural gas fields in the Netherands) can have on the manufacturing sector.

Business investment in Australian has fallen precipitously since 2013.

Australia Business Investment

With wages growth in tow.

Wages Index

Instead of addressing the underlying cause (Dutch Disease), Australia tried to alleviate the pain by stimulating the housing market. Housing construction boosted employment and the banks were only to happy to accommodate the accelerating demand for credit.

Leading Index

But house prices have to keep growing and banks have to keep lending else the giant Ponzi scheme unwinds. When house prices and construction slows, the economy is susceptible to a severe backlash as Gerard Minack pointed out.

How to fix this?

The worst response IMO would be to pour more gasoline on the fire: cut interest rates and reignite the housing bubble. Low interest rates have done little to stimulate business investment over the last five years, so further cuts are unlikely to help.

The only long-term solution is to lift business investment which creates secure long-term employment. To me there are three pillars necessary to achieve this:

  1. Accelerated tax write-offs for new business investment;
  2. Infrastructure investment in transport and communications projects that deliver long-term productivity gains; and
  3. A weaker Australian Dollar.

Corporate tax write-offs

Accelerated corporate tax write-offs were a critical element of the US economic recovery under Barack Obama. They encourage business to bring forward planned investment spending, stimulating job creation.

Infrastructure

Government and private infrastructure spending is important to fill the hole left by falling consumption. But this must be productive investment that generates a market-related return on investment. Else you create further debt with no income streams to service the interest and capital repayments.

A weaker Australian Dollar

Norway is probably the best example of how an economy can combat Dutch Disease. They successfully weathered an oil-driven boom in the 1990s, protecting local industry while establishing a sovereign wealth fund that is the envy of its peers. Their fiscal discipline set an example to be followed by any resource-rich country looking to navigate a sustainable path through a commodities boom.

In Australia’s case that would be closing the gate after the horse has bolted. The benefits of the boom have long since been squandered. But we can still protect what is left of our manufacturing sector, and stimulate new investment, with a weaker exchange rate.

I doubt that the three steps are sufficient to avert a recession. But the same is true of further interest rate cuts. And at least we would be addressing the root cause of the problem, rather than encouraging further malinvestment in an unsustainable housing bubble.

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Robust US employment but global bear market warning

The US economy remains robust, with hours worked (non-farm) ticking up 2.2% in January, despite the government shutdown. Real GDP growth is expected to follow a similar path.

Real GDP and Hours Worked

Average hourly earnings growth increased to 3.4% p.a. for production and non-supervisory employees (3.2% for all employees). The Fed has limited wiggle room to hold back on further rate hikes if underlying inflationary pressures continue to rise.

Average Wage Rate Growth

History shows that the Fed lifts short-term interest rates more in response to hourly wage rates than core CPI.

Average Wage Rate Growth, Core CPI and 3-Month T-Bills

The Leading Index from the Philadelphia Fed ticked down below 1% (0.98%) for November 2018. While not yet cause for concern, it does warn that the economy is slowing. Further falls, to below 0.5%, would warn of a recession.

Leading Index

Markets are anticipating a slow-down, triggered by falling demand in China more than in the US.

S&P 500 volatility remains high and a large (Twiggs Volatility 21-day) trough above 1.0% (not zero as stated in last week’s newsletter) on the current  rally would signal a bear market. Retreat below 2600 would strengthen the signal.

S&P 500

Crude prices have plummeted, anticipatiing falling global (mainly Chinese) demand. Another test of primary support at $42/barrel is likely.

Light Crude

Dow Jones-UBS Commodity Index breached primary support at 79, signaling a primary decline with a target of 70.

DJ-UBS Commodity Index

China’s Shanghai Composite Index is in a bear market. Respect of resistance at 2700 would confirm.

Shanghai Composite Index

Bearish divergence on India’s Nifty also warns of selling pressure. Retreat below 10,000 would complete a classic head-and-shoulders top but don’t anticipate the signal.

Nifty Index

DJ Stoxx Euro 600 rallied but is likely to respect resistance at 365/370, confirming a bear market.

DJ Stoxx Euro 600 Index

The UK’s Footsie also rallied but is likely to respect resistance at 7000. Declining Trend Index peaks indicate selling pressure, warning of a bear market.

FTSE 100 Index

My conclusion is the same as last week. This is a bear market. Recovery hinges on an unlikely resolution of the US-China ‘trade dispute’.

Concessions to adversaries only end in self reproach, and the more strictly they are avoided the greater will be the chance of security.

~ Thucydides (460 – 400 B.C.)

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Get ready for economic slowdown | Trivium China

While we cannot rule out the chance of a large Chinese stimulus, senior officials are talking this down. In 2008/2009, China injected a whopping 19% of GDP to revive its flagging economy, compared to roughly 6.5% of GDP by the Obama administration at the height of the GFC. The size and scope of the stimulus achieved the desired result but had several undesirable side effects, including accelerating the property bubble and rapid growth expansion of the informal shadow banking sector as speculative fever grew.

From Trivium China:

At his meeting with businessmen on Tuesday, Li Keqiang [Premier of the State Council of the People’s Republic of China] also laid out his views on the economy.

In a nutshell: Things do not look good (Gov.cn).

  • “Downward economic pressure is increasing.”
  • “[We must] thoroughly prepare to react to difficulties and challenges.”

But Li stressed (again!) that the government’s response to this slowdown will be different than in the past:

  • “[We] will not rely on traditional measures.”

Instead, Li wants to take a more measured, precise approach:

  • “Macro policies should be stable, precise, and effective in order to counter external uncertainties.”

The top priority will continue to be improving the business environment, with a focus on three areas:

  • Eliminating government interference in business operations
  • Reducing taxes and fees
  • Making financing easier and cheaper to get

Get smart: If you haven’t gotten the message yet, you have not been listening. The government is not going to repeat the massive stimulus that it enacted 10 years ago in response to the financial crisis.

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It’s a funny kind of bear market

The US economy continues to show signs of robust good health.

Total hours worked are rising, signaling healthy real GDP growth.

Real GDP and Total Hours Worked

Growth in average hourly wage rates is rising, reflecting a tighter labor market. Underlying inflationary pressures may be rising but the Fed seems comfortable that this is containable.

Average Hourly Wage Rates

The Leading Index from the Philadelphia Fed maintains a healthy margin above 1.0% (below 1% is normally a signal that the economy is slowing).

Leading Index

But market volatility remains high, with S&P 500 Volatility (21-day) above 2.0%. A trough above 1% on the next multi-week rally would confirm a bear market — as would an index retracement that respects 2600.

S&P 500

The Nasdaq 100 is undergoing a similar retracement with resistance at 6500.

Nasdaq 100

The primary disturbance is the trade confrontation between the US and China. There is plenty of positive spin from both sides but I expect trade negotiations to drag out over several years — if they are successful. If not, even longer.

I keep a close watch on the big five tech stocks as a barometer of how the broader market will be affected. So far the results are mixed.

Apple is most vulnerable, with roughly 25% of projected sales to China. Recent downward revision of their sales outlook warns that Chinese retail sales are falling. AAPL is testing its primary support level at 150.

ASX 200

Facebook and Alphabet are largely unaffected by a Chinese slowdown, but have separate issues with user privacy. Facebook (FB) is in a primary down-trend.

ASX 200

While Alphabet (GOOGL) is testing primary support at 1000.

ASX 200

Amazon (AMZN) is similarly isolated from a Chinese slow-down although there may be a secondary impact on suppliers. Primary support at 1300 is likely to hold.

ASX 200

Microsoft (MSFT) is the strongest performer of the five. Their segment reporting does not provide details of exposure to China but it appears to be a small percentage of total sales.

ASX 200

The outlook for stocks is therefore mixed. Be cautious but try to avoid a bearish mindset, where you only see problems and not the opportunities. Even if China does suffer a serious slowdown we can expect massive stimulus similar to 2008 – 2009, so the impact on developing markets and resources markets may be cushioned.

Best wishes for the New Year.

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Significant divergence

Market commentators are sifting through the data, looking for reasons to explain the sharp sell-off in stocks over the last two months. But everything they examine is likely to be shaded by their bear-tinted spectacles after the S&P 500 broke primary support at 2550.

S&P 500

The Nasdaq 100 also broke primary support, confirming the bear market.

Nasdaq 100

Of the big five tech stocks, Apple and Google are both testing primary support, threatening to follow Facebook into a primary down-trend. If the two break primary support, that would further strengthen the bear signal.

Big Five tech stocks

Volatility (21-day) is now close to 2% but the key is how volatility behaves on the next multi-week rally. If volatility forms a trough above 1% that would confirm the elevated risk.

S&P 500

Divergence? What Divergence?

Why do I say there is a significant divergence? Look at the fundamentals.

Fedex has just released stats for its most recent quarter, ended November 30. Package volumes are rising, not falling.

Fedex Stats

Supported by a very bullish Freight Transportation Index.

Freight Transportation Index

Consumption is strong, with Services and Non-durable goods rebounding. No sign of a recession here.

Consumption

Light vehicle sales are at a robust annual rate of 17.5 million.

Light Vehicle Sales

Retail sales growth (ex motor vehicles and parts) weakened in the last month but is still in an up-trend.

Retail

Housing starts and authorizations are still climbing.

Housing

Real construction spending (adjusted by CPI) is strong.

Construction

Manufacturers new orders (ex defense and aircraft) have rebounded after a weak 2015 – 2016.

Manufacturers New Orders

Corporate investment is growing at a faster rate than the economy, with rising new capital formation over GDP.

New Capital Formation

The Fed is shrinking its balance sheet which is expected to impact on liquidity. But commercial banks are running down excess reserves on deposit at the Fed at a faster rate, so that Fed assets net of excess reserves (green line) is actually rising. Hardly a drain on liquidity.

Fed Balance Sheet

Market pundits are watching the yield curve with bated breath, waiting for the 10-year to cross below the 2-year yield.

Yield Differential 10-Year minus 2-Year

In the past this has served as a reliable early warning, normally 12 to 24 months ahead of a recession. But the St Louis Fed Financial Stress Index is well below zero, signaling an accommodative financial environment.

Financial Stress Index

Why the mismatch? Fed actions — QE, Operation Twist, and even steps to shrink its balance sheet — have all suppressed long-term interest rates. We need to be wary of taking signals from a distorted yield curve.

Why have stocks reacted?

This is not a Pollyanna outlook. Never argue with the tape — we are clearly in a bear market. So why are stocks diverging from the economy?

The answer is China.

The impact of a trade war with the US would most likely cause a recession in China. Oil prices are already plunging in anticipation of falling demand.

Nymex Light Crude and Brent Crude

Commodities are likely to follow.

DJ UBS Commodities Index

The impact of a Chinese recession would be felt around the globe. Europe has its own problems and could easily follow.

DJ Europe Financial Index

The US is likely to emerge relatively unscathed but Wall Street is going to be exceedingly cautious until some semblance of normality is restored.

I do not suggest selling all your stocks but make sure that there is enough cash in the portfolio to take advantage of opportunities when they arise.

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