Category: GDP and Activity

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David Woo: Prelude to volatility

The bond market had a heart attack last week. Rising inflation caused a massive back up in bond yields in the short end of the market. The market is now pricing in two rate hikes in 2022. The Fed will have to raise real interest rates in order to tame inflation.

Real interest rates are falling. The stock market is taking its cue from the bond market and is rising. Stock prices represent discounted future cash flows, so negative real interest rates make a big difference to earnings multiples.

The Democrats are determined to spend their way to a mid-term election victory, with a $1T infrastructure bill and $1.75T social spending, both light on tax revenue. The GOP will try to stop them when the debt ceiling issue returns in December but they don’t have much leverage.

Financial conditions will have to tighten a lot more in 2022. The Fed is way behind the curve and is going to have to play catch-up.

Conclusion

Inflationary pressures in the US economy are growing, while the Democrats plan a further $2.75T in fiscal stimulus which is light on tax revenues.

Long-term yields lag far behind inflation, with real interest rates growing increasingly negative. The assumption is that the Fed will tighten sharply in 2022 to curb inflation. We expect that the Fed will taper but is not going to rush to hike interest rates for three reasons:

  1. The Fed would be tightening into a slowing economy, with growth fading as stimulus winds down;
  2. High energy prices will also help to cool demand; and
  3. US federal debt levels — already > 120% of GDP and likely to grow further with proposed new stimulus measures — are a greater long-term threat than inflation. The Fed and Treasury are expected to work together to boost GDP and tax revenues through inflation, keeping real interest rates negative to alleviate the cost to Treasury of servicing the excessive debt burden.
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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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