Category: Economy

Analysis of the global economy

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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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Luke Gromen: Bitcoin alarm

“We do not think BTC is a bubble; we think BTC is the last remaining functioning fire alarm that has not been disabled by policymakers, and it is issuing an increasingly shrill alarm about the USD and fiat currencies more broadly. We have little doubt that policymakers will attempt to disable BTC as a functioning fire alarm as well, but its traits make that far more difficult to do to BTC than they have thus far done with gold.”

~ Luke Gromen, Treerings.com

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Danielle DiMartino Booth On The Future Of The Federal Reserve

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Jim Bianco forecasts higher inflation in 2021

Jim Bianco from Bianco Research:

“The problem the stock market has in 2021 is by most standard metrics (P/E, Market Cap/GDP, etc.) it’s overvalued. Now a lot of people expect it to stay that way for another year. If we don’t get inflation, that can actually happen and you could actually have the market stay at these elevated levels. But if you do get rising interest rates on inflation……that will frip earnings, make mortgage rates go up and lift interest rates. That has historically not been good for risk assets….”

The problem if we don’t get inflation will be far worse. MMT theorists will take this as validation and we are likely to see more calls for far higher stimulus checks. Why not $200,000 stimulus checks someone on Twitter asked. The bubble will keep expanding without any visible effect …..until it bursts.

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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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To infinity and beyond Part II

Watch from 5:00

Luke Gromen: “Their game plan is to keep treasury yields below the GDP growth rate. The last time they did this was 1945 to 1980.”

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A stock market bubble of epic proportions

A great deal has been written in recent years about real estate bubbles, stock market bubbles and even bond market bubbles. But there is really only one kind of bubble — that is a debt bubble. Without low interest rates fueling rapid debt growth, any form of bubble would wither on the vine.

The Wilshire 5000 broad market index, compared to profits before tax, recently peaked above 15.0 for only the second time in history before retreating to 13.97 in Q3. The fall in Q3 is attributable to recovering profits rather than falling stock prices, so a return to above 15.0 seems likely if the index rises in response.

Wilshire 5000 Index/Profits

The reason for the surge in stock prices is clear on the chart below: interest rates at close to zero for an extended period act like rocket fuel.

Wilshire 5000 Index/Profits & 3-Month T-Bill Yield

Anna Schwartz, co-author of A Monetary History of the United States (with Milton Friedman, 1963) once said:

If you investigate individually the manias that the market has so dubbed over the years, in every case, it was expansive monetary policy that generated the boom in an asset. The particular asset varied from one boom to another. But the basic underlying propagator was too-easy monetary policy and too-low interest rates.

That is particularly true of the current bubble.

When will it end?

The Fed seems unlikely to change course and is expected to keep interest rates near zero for an extended period, so when is the bubble likely to end?

If bank credit growth stalls, falling to zero (the red line) as it did before the last three recessions, stock prices are likely to tumble.

Wilshire 5000 Index/Profits & Bank Credit

There may be three possible causes of slowing credit growth:

  1. Inflation surges, forcing the Fed to raise interest rates;
  2. Low interest rates cause investment misallocation, as in the Dotcom and subprime bubbles, leading to rising defaults and tighter bank credit; or
  3. An external shock causes falling aggregate demand and high unemployment, with banks tightening credit policies in anticipation of rising defaults.

Chairman Jay Powell has assured us that the Fed will tolerate higher inflation, with its new policy of inflation averaging, so higher interest rates do not seem to be a major risk. While there has been some investment misallocation, falling aggregate demand and high unemployment seem to be the greatest threat.

Initial claims for unemployment insurance jumped to 853,000 for the week ended December 5th, while initial claims for pandemic unemployment assistance surged to 427,600.

Initial Claims

Latest Department of Labor figures (November 21) show total unemployment claims remain high at 19 million — or 1 in 8 people who had a job in February 2020.

Bank credit standards have tightened significantly.

Bank Credit Standards

Conclusion

Keep a close watch on bank credit growth. If this falls to zero, then stock prices are likely to tumble.

Bank Loans & Leases

Commercial paper often acts as the canary in the coal mine, giving advance warning of a credit contraction.

Commercial Paper Outstanding

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US healthcare killing the host

This chart sums up the size of the challenge facing President-elect Joe Biden.

Health Care Costs

Mancur Olson (The Rise and Decline of Nations) identified special interest groups as one of the primary obstacles to efficient functioning of the economy, whether they be oil producers, banks, trade unions, or the medical profession. And the more powerful they grow, the greater the obstacle they become.

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