Category: Economy

Analysis of the global economy

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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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Job openings flag upward pressure on wages

Job openings fell by 660k in August, from 11.10 million to 10.44 million. Unemployment fell by less, from 8.70 million to 8.38 million (-320k), as absentees return to the workforce. Unemployment declined steeply (-710k) to 7.67 million in September and we expect an even larger decline in job openings as more return to the workforce.

Job Openings & Average Hourly Wage Rates

Job openings in August exceed unemployment by 2.06 million. While this is expected to reduce over the next few months, as stragglers return to the workforce, the persistent gap is likely to add upward pressure to wages. Average hourly earnings growth, currently at 4.6% YoY, is expected to rise in the months ahead.

Small Business - Difficulty in Finding Workers

The number of people who quit jobs voluntarily – to work for another company that offered higher wages and benefits and a signing bonus; to change careers entirely; to stay home and take care of the kids; to spend more time with their money; or whatever – spiked by another 242,000 people to a record of 4.27 million in August, up 19% from August 2019…….This enormous number of quits is the hallmark of a tight and competitive labor market that encourages workers to switch jobs to seek the greener grass on the other side of the fence. (Wolf Richter)

Job Quits

Conclusion

The economy is recovering but the persistent gap between job openings and unemployment suggests that upward pressure on wages is likely to continue into next year. Rising wage rates add pressure on prices of consumer goods and services, adding to the inflationary spiral.

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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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End game for the Dollar

The end game for the Dollar: China vs the US, with Grant Williams and Luke Gromen:

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RBA tapers

From Bill Evans at Westpac:

The Governor of the Reserve Bank has announced the intention to reduce the weekly purchases from $5 billion to $4 billion and not to extend its Yield Curve Target from the April 2024 bonds to the November 2024 bonds – two clear signs that policy is tightening…..

The decision to not extend the Yield Curve Target program to the November 2024 bonds….Giving up the option to extend the purchases at 0.1% to a 3 year 4 month bond from a 2 year 9 month bond, is effectively tightening policy.

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Global minimum corporate tax rates

There appears to be widespread support for a global minimum corporate tax rate of 15%.

From CNBC:

Treasury Secretary Janet Yellen announced Thursday that a group of 130 nations has agreed to a global minimum tax on corporations, part of a broader agreement to overhaul international tax rules.

If widely enacted, the GMT would effectively end the practice of global corporations seeking out low-tax jurisdictions like Ireland and the British Virgin Islands to move their headquarters to, even though their customers, operations and executives are located elsewhere.

Conclusion

We expect a global minimum tax on corporations of 15% to be passed and are adjusting our valuation models to ensure that all earnings projections include a minimum tax rate of 15% on international income.

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Fed’s favorite inflation indicator surges

The Fed’s preferred measure of inflation, the Personal Consumption Expenditure (PCE) Index grew by 3.9% in the 12 months ended May ’21, while Core PCE (excluding food & energy) came in slightly lower at 3.4%.

Personal Consumption Expenditure Index: Annual Change

We still have to watch out for base effects, because of the low readings in May last year, but growth for the past 6 months is even higher, registering 5.3% (PCE) and 4.6% (core PCE) annualized gains.

Personal Consumption Expenditure Index: 6-Month Change

Conclusion

Excluding temporary price spikes due to supply chain disruption, we expect inflation to average a minimum of 4.0% over the next three years.

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Deflationistas and base effects

Deflationistas like respected economist David Rosenberg point to a sharp decline in bank credit over the past 12 months as evidence of deflation.

By the end of April, commercial bank loans and leases had declined by $510 billion, or 4.7% of total, over the past 12 months.

Commercial Banks: Loans & Leases

That would be cause for concern but it does not take into account the massive $742 billion surge in lending in the preceding two months, March-April 2020, when borrowers drew on lines of credit to ensure that they had sufficient liquidity during the pandemic. They were afraid that banks would withdraw credit facilities in anticipation of widespread corporate defaults.

Commercial Banks: Loans & Leases

Conclusion

There is no credit contraction.

Bank credit did shrink by $510 billion in the past 12 months but this followed an unusual $742 billion surge in credit as borrowers drew on credit facilities to ensure liquidity during the first two months of the pandemic. What we have witnessed is the normalization of bank credit, with borrowers repaying credit temporarily drawn at the height of the liquidity crunch.

We expect normal credit growth to resume.

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