Category: GDP and Activity

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Deconstructing Evergrande’s effect on China

Elliot Clarke at Westpac says that China will be able to withstand the shock of Evergrande’s collapse and that power outages are a bigger threat.

We still think that the property sector contagion is part of a broader issue that China will struggle to overcome, as Michael Pettis succinctly explained:

China’s debt problem

Tweeted by Prof. Michael Pettis:

In the past — e.g. the SOE reforms of the 1990s, the banking crisis of the 2000s, SARS in 2003, the collapse of China’s trade surplus in 2009, COVID, etc. — whenever China faced a problem that threatened the pace of its economic growth, Beijing always responded by accelerating debt creation and pumping up property and infrastructure investment by enough to maintain targeted GDP growth rates. It didn’t adjust, in other words, but rather goosed growth by exacerbating the underlying imbalances.

That is why it had always been “successful” in seeing off a crisis. But when the main problem threatening further growth becomes soaring debt and the sheer amount of non-productive investment in property and infrastructure, it is obvious, or should be, that accelerating debt creation and pumping up property and infrastructure investment can no longer be a sustainable solution. All this can do is worsen the underlying imbalances and raise further the future cost of adjustment.

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Beware of the GDP “spike”

Hours worked jumped to a massive 13.5% (YoY) spike in April and GDP is expected to follow.

Real GDP & Hours Worked

Jim Stock’s Weekly Economic Index predicts a similar 12.2% (YoY) spike in Q2 GDP.

Weekly Economic Index

Apologies for being the bearer of bad news but that spike is entirely due to base effects: the year-on-year change is measured from the pandemic low of April 2020.

In real terms, hours worked are still 3.8% below their Feb 2020 level and GDP for Q2 2021 is expected to come in at close to the peak in Q4 of 2019.

Real GDP & Hours Worked

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Westpac: US Dollar capped by dovish Fed (video)

Elliot Clarke - Video

Good short video from Elliot Clarke & Richard Franulovich at Westpac IQ about Aussie/US Dollar prospects and the outlook for the US economy.

Rising yields are lifting the Dollar but the Fed’s dovish stance is expected to cap the Dollar going forward, with the Aussie likely to strengthen above 80 US cents.

The Biden stimulus is likely to help the US economic recovery this year but will wear off by year-end. There are many obstacles to passing a major infrastructure bill but that would be the best way to lift growth prospects over 2022/3 and beyond and help the US keep pace with growth in Asia, where there are more development opportunities.

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Modern Monetary Theory (MMT)

A reader asked me to explain MMT. I am not an economist and will try to avoid any jargon.

The basic tenet of MMT is that government has the power to reduce unemployment by increasing stimulus spending. Government spending in excess of tax revenues (a deficit) is funded by an increase in public debt. Deficits are likely to cause inflation but MMT holds that inflation can be reduced by raising tax revenues.

Problem with Lags

There is normally a lag between an increase in debt and the resulting increase in inflation. If you wait for inflation to rise before raising taxes, underlying inflationary pressures have already built and will be hard to contain.

There is also likely to be a lag between raising taxes and a resulting fall in inflation. This means that authorities will keep raising taxes for longer, causing an eventual contraction in employment.

The second problem is that it is far easier to increase government spending than it is to raise taxes. Voters seldom object to an increase in public spending but are likely to punish any government that increases taxes. This is likely to make the lag between identifying inflation and raising taxes even bigger.

Third, regular increases in government spending followed by tax increases (to subdue inflation) are likely to ratchet up government spending relative to GDP. Rising levels of public spending followed by rising taxes is simply creeping socialism and is likely to slow long-term economic growth.

Finally, sharp increases in public debt no longer deliver bang for buck.

Real GDP & Public Debt

Has inflation been tamed?

The consumer price index (CPI) is nowadays a lot less volatile than producer prices (PPI) which it tracked quite closely in the 1960s and 70s. Some of this can be attributed to better management at the Fed but the primary reason is the offshoring of manufacturing jobs to Asia.

CPI, PPI & Hourly Earnings

The service sector is largely immune from producer prices and fluctuations in offshore manufacturing costs are partially absorbed through a floating exchange rate.

We have witnessed a decline in global trade over the past two years and this is likely to develop into a long-term trend towards on-shoring key supply chains in both Europe and North America. On-shoring is likely to drive up prices.

Conclusion

Inflation is not dead. On-shoring of supply chains is likely to drive up prices. Rapid expansion of public debt is expected to weaken the Dollar, slow growth and fuel inflation. Long-term costs of bringing inflation under control are likely to outweigh the shorter-term benefits of MMT-level stimulus.

Notes

Hat tip to Neils Jensen at Absolute Return Partners and Luke Gromen at FFTT.

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USA: Sales up, daily COVID-19 cases down but jobs still scarce

Daily new COVID-19 cases in the US are clearly falling as the vaccine roll-out takes effect.

USA: COVID-19 Daily Cases

But daily deaths are still rising and may take another few weeks to level off.

USA: COVID-19 Daily Deaths

January payroll figures show the economic recovery has stalled, with total jobs contracting by 6.08% compared to January 2020.

Payroll Growth

Hours worked are down 4.4% compared to last year.

Real GDP & Hours Worked

Average hourly earnings jumped 5.44% for production and non-supervisory workers but these are distorted by strong job losses in the lowest pay grades.

Hourly Wage Rates

Retail sales (excluding food) have also been artificially boosted by government stimulus which added roughly 20% to disposable income.

Retail Sales Excluding Food

Light vehicle sales are similarly boosted.

Light Vehicles

While housing starts are climbing in response to record low mortgage rates.

Housing Permits & Starts

Total unemployment claims (state and federal) declined to a still high 17.8 million for the week ended January 16th.

DOL: State & Federal Unemployment Claims

The proposed Biden stimulus will support households and businesses but employment is likely to remain weak until the COVID-19 outbreak is clearly under control.

Conclusion

Economic activity is expected to remain weak in the first half of 2021. A key determinant will be the length of time it takes to bring the COVID-19 outbreak under control. Subsequent recovery is likely to need strong fiscal support, with federal debt expected to grow faster than GDP in 2021. This will require continued Treasury purchases by the Fed and commercial banks, with interest rates remaining low throughout 2021.

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Can the Fed keep a lid on inflation?

Jeremy Siegel, Wharton finance professor, says the Fed has poured a tremendous amount of money into the economy in response to the pandemic, which will eventually cause higher inflation. David Rosenberg of Rosenberg Research argues that velocity of money is declining and the US economy has a large output gap so inflation is unlikely to materialize.

CNBC VideoClick to play

Both are right, just in different time frames.

Putting the cart before the horse

The velocity of money is simply the ratio of GDP to the money supply. Fluctuations in the velocity of money have more to do with fluctuations in GDP than in the money supply. If GDP recovers, so will the velocity of money. Equating velocity of money with inflation is putting the cart before the horse. Contractions in GDP coincide with low/negative inflation while rapid expansions in GDP are normally accompanied, after a lag, by rising inflation.

CPI & GDP

Money supply and interest rates

Inflation is likely to rise when consumption grows at a faster rate than output. Prices rise when supply is scarce — when we consume more than we produce. Interest rates play a key role in this.

Low interest rates mean cheap credit, making it easy for people to borrow and consume more than they earn. Low rates also boost the stock market, raising corporate earnings because of lower interest costs, but most importantly, raising earnings multiples as the cost of capital falls. Speculators also take advantage of low interest rates to leverage their investments, driving up prices.

S&P 500

In the housing market, prices rise as cheap mortgage finance attracts buyers, pushing up demand and facilitating greater leverage.

Housing: Building Starts & Permits

Wealth effect

Higher stock and house prices create a wealth effect. Consumers are more ready to borrow and spend when they feel wealthier.

High interest rates, on the other hand, have the exact opposite effect. Credit is expensive and consumption falls. Speculation fades as stock earnings multiples fall and housing buyers are scarce.

Money supply is only a factor in inflation to the extent that it affects interest rates. There is also a lag between lower interest rates and rising consumption. It takes time for consumers and investors to rebuild confidence after an economic contraction.

The role of the Fed

Fed Chairman, William McChesney Martin, described the role of the Federal Reserve as:

“…..to take away the punch bowl just as the party gets going.”

In other words, to raise interest rates just as the economic recovery starts to build up steam — to avoid a build up of inflationary pressures.

The Fed’s mandate is to maintain stable prices but there are times, like the present, when their hands are tied.

Federal government debt is currently above 120% of GDP.

Federal Debt/GDP

GDP is likely to rise as the economy recovers but so is federal debt as the government injects more stimulus and embarks on an infrastructure program to lift the economy.

With federal debt at record levels of GDP, raising interest rates could blow the federal deficit wide open as the cost of servicing Treasury debt threatens to overtake tax revenues.

Conclusion

Inflation is likely to remain low until GDP recovers. But the need to maintain low interest rates — to support Treasury markets and keep a lid on the federal deficit — will then hamper the Fed’s ability to contain a buildup of inflationary pressure.

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Stock prices: Jay Powell is talking through his hat

Daily COVID-19 cases in the US continue to climb, reaching 236,211 on Thursday 17th.

USA: COVID19 Daily Cases

Unemployment claims jumped by 1.6 million in the week ending November 28, exceeding more than 1 in 8 of the total workforce (Feb 2020).

DOL: Total Unemployment Claims, 28Nov2020

Initial claims under state programs climbed to 935,138 (unadjusted) by week ending December 12, compared to 718,522 for w/e November 28, while initial claims under pandemic assistance programs run by the federal government jumped to 455,037 compared to 288,234 for w/e November 28.

Further escalation of both daily COVID-19 cases and unemployment claims is likely before vaccine distribution achieves a wide enough reach to make a difference. A major obstacle will be public reluctance to get the vaccine shot:

As states frantically prepare to begin months of vaccinations that could end the pandemic, a new poll finds only about half of Americans are ready to roll up their sleeves when their turn comes.

The survey from The Associated Press-NORC Center for Public Affairs Research shows about a quarter of U.S. adults aren’t sure if they want to get vaccinated against the coronavirus. Roughly another quarter say they won’t. (Associated Press, December 10, 2020)

Federal assistance

Further federal assistance may soften the impact of rising unemployment on the economy but Senate leaders are yet to conclude a deal. Both sides claim to want a deal but it seems unlikely that agreement will be reached before the Georgia run-off elections on January 5th. If the Democrats win both seats, and a Senate majority, they will not need to compromise. Unfortunately, large numbers of the least fortunate will suffer before then. Real leadership from the White House, needed to break the logjam, is sadly absent.

Jay Powell and stock prices

Jay Powell says he is relaxed about stock prices:

Stocks at record highs and bond yields not far from their historic lows are telling two different stories, but Federal Reserve Chairman Jerome Powell said he isn’t worried about the disparity.

In fact, the central bank chief said during a news conference Wednesday, the low rates are helping justify an equity surge that has gone on largely unabated since the March pandemic crisis lows.

“The broad financial stability picture is kind of mixed I would say,” Powell said in response to a CNBC question at the post-meeting media Q&A. “Asset prices are a little high in that metric in my view, but overall you have a mixed picture. You don’t have a lot of red flags on that.” (CNBC, December 16, 2020)

There is just one problem: bond yields are distorted by the Fed and do not reflect market forces.

S&P 500 PEmax

If we take the S&P 500 Price-Earnings ratio based on the highest trailing earnings (PEmax), this eliminates distortions from sharp falls in earnings during a recession. The current multiple of 26.69 is the second highest peak in the past 120 years, exceeded only by the Dotcom bubble. By comparison, peaks for the 1929 stock market crash (Black Friday) and 1987 (Black Monday) both had earnings multiples below 20.

S&P 500 PE of Maximum Trailing Earnings (PEmax)

Payback model

If we use our payback model, we arrive at a fair value estimate of 2169.50 for the S&P 500 based on:

  • projected earnings for the next four quarters as provided by S&P;
  • a long-term growth rate of 5%, equal to nominal GDP growth in recent years; and
  • a payback period of 12 years, normally used for the most stable companies (with a strong defensive market position).

The LT growth rate required to match the current index value (3709.41) is 14.0%. The only time such a growth rate was achieved, post WWII, is in the 1980s, when inflation was spiraling out of control.

Nominal GDP & Inflation (CPI)

Conclusion

Stock prices are in a bubble of epic proportions. Risk is elevated and we are likely to witness a major collapse in prices in 2021 unless inflation spikes upwards as in the 1970s to early 1980s.

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