Category: Economy

Analysis of the global economy

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The high cost of uncertainty

High levels of uncertainty in international trade, geopolitical outlook, and domestic politics in the USA are likely to have a domino effect on business and consumer confidence.

Business is likely to postpone or curtail new investment decisions. This is already evident in a down-turn in new capital formation, along with GDP growth, in the first half of the calendar year.

New Capital Formation

A similar picture is emerging in construction spending.

Construction/GDP

CEO confidence levels are way down.

CEO Confidence Levels

A slow-down in business investment in turn impacts on employment, causing a decline in payroll growth and average weekly hours worked.

Non-farm Payroll Growth and Weekly Hours Worked

Which in turn impacts on consumer sentiment as employees’ anticipation of future earnings declines.

Consumer Sentiment

The feedback loop will be completed if consumption falls. Retail sales dipped sharply in late 2018 but are keeping their head above water.

Retail Sales

And purchases of durables, like light motor vehicles, have leveled off but there is no significant decline so far.

Light Vehicle Sales (Units)

New housing starts and building permits even kicked up in August in response to lower interest rates.

Housing Starts

Consumers have, so far, continued spending but a down-turn in the stock market would weigh heavily on sentiment and consumption.

The S&P 500 broke its rising trendline, indicating a correction. Bearish divergence on Twiggs Money Flow warns of secondary selling pressure and a test of support at 2800. Breach of support is by no means certain but would offer a target of 2400.

S&P 500

We have reduced our equity exposure for International Growth to 34% of portfolio value because of our bearish outlook for the global economy.

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The canary in the coal mine

Bellwether transport stock Fedex (FDX) is testing long-term support at 150. Peaks close to zero on the Trend Index warn of selling pressure. Breach of support would warn of a decline with a long-term target of 100.

Fedex

Breach of LT support would also be a bearish sign for the US economy, warning that economic activity is weakening.

The S&P 500 is testing resistance at 3000. Expect stubborn resistance followed by a test of support at 2800. Breach of 2800 would flag a reversal with a target of 2400.

S&P 500

Dow Jones – UBS Commodity Index rallied strongly with the Saudi oil price shock but finished the week with a strong bearish reversal signal. Expect another test of support at 76. Breach would signal a (primary) decline. We maintain our bearish long-term outlook for commodities.

DJ-UBS Commodities Index

We have reduced our equity exposure to 36% of (International Growth) portfolio value because of our bearish outlook on the global economy.

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ASX 200 tests resistance, Iron ore tests support

Iron ore found resistance at $95/ton and is likely to again test short-term support at $90. Support is unlikely to hold and breach would offer a medium-term target of $80 per ton.

Iron Ore

The ASX 300 Metals & Mining index found support at 4100 but the rally is weak. Breach of 4100 would complete a head and shoulders reversal, giving a target of 3400.

ASX 300 Metals & Mining

A fall in iron ore prices would increase downward pressure on the Aussie Dollar.

The Financial sector continues to look bullish, testing resistance at 6500, with Trend Index troughs above zero indicating buying pressure. Housing woes are far from over, despite improved auction clearance rates, and we expect the sector to remain a drag on growth for the next three to five years — unless the RBA & APRA go “all-in” on a housing bubble to “rescue” the economy.

ASX 200 Financials

The ASX 200 is edging upwards, towards a test of resistance at the 2007 high of 6800. Expect stubborn resistance. Reversal below 6400 would warn of a decline to test primary support at 5400.

ASX 200

We maintain exposure to Australian equities at 25% of portfolio value, with a focus on defensive and contra-cyclical stocks, because of our bearish long-term outlook.

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Australia: Leading Index of Employment in 16th month of decline

The Department of Employment, Skills, Small and Family Business released their Monthly Leading Indicator of Employment for September 2019, recording its 16th straight month of decline.

Hat tip to Macrobusiness, this is a peach of an indicator, predicting Australia’s economic performance.

I have added % retracement in the ASX 200 to the graph below. Each of the significant past troughs in the Leading Index coincides with a drawdown of more than 20% in the ASX 200.

Leading Index of Employment

Is the current fall in the Leading Index a false alarm, as in the 2005/2006 raging commodities bull market, or are we in for another retracement?

Leading Index of Employment - Components

My money is on the retracement.

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Robert Shiller’s warning

Nobel prize-winning economist Robert Shiller warns that cracks are once again surfacing in the US housing market.

“We have had a strong housing market for pretty much all the time since 2012. Just after the financial crisis, the housing market didn’t recover, maybe because banking was in disarray and people were still expecting declines after the event. After 2012, it started going up at more than 10 per cent a year nationwide in the US, and has been slowing down since.”

Shiller says that a worrying pattern emerging in house prices is reminiscent of the property market in the run-up to the Great Recession.

The bursting of the US housing bubble in 2006-07 was a key trigger of the financial crisis…… “I have seen this happen before, we’re like back in 2005 again when the rate of increase in home prices was slowing down a lot but still going up.

Case Shiller Index

Growth in the Case Shiller National Home Price Index is clearly weakening but we need to be careful of confirmation bias where we “cherry-pick” negative news to reinforce a bearish outlook. I would take the present situation as an “amber” warning and only a drop below zero (when house prices fall) as a red flag.

Shiller has an enviable reputation for predicting recessions, having warned of the Dotcom bubble in tech stocks and the housing bubble ahead of the 2008 global financial crisis. He is correct that narratives (beliefs) can become self-fulfilling prophecies. If the dominant view is that the economy will contract, then it probably will — as corporations stop investing in new capacity and banks restrict lending. Geo-political tensions — US/China, UK/EU Brexit, and Iran/Saudi Arabia — combined with massive uncertainty in global trade and oil markets, could quickly snowball into a full-blown recession.

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Predicting recessions with payroll and unemployment data

Recessions are notoriously difficult to measure (even the NBER occasionally gets it wrong) and an official declaration of a recession may be lagged by more than 6 months. Economist Claudia Sahm devised the Sahm Rule, using changes in unemployment levels, as a more timely predictor of recessions.

Sahm rule: US Data

But the signal repeatedly lags the official start date of recessions by several months, limiting its usefulness for investment purposes.

In previous articles I observed that payroll growth is a good predictor of recessions. But payroll growth has been declining for decades; so it has been difficult to devise a one-size-fits-all-recessions rule. Until I turned to using momentum.

Twiggs Momentum is my own variation on the standard momentum formula and I applied this to monthly payroll data to arrive at a 3-month TMO.

Sweden: Sahm rule

The orange band on the above chart reflects the amber warning range, between 0.5% and 0.3%, where recession is likely. If TMO crosses below the red line at 0.3%, risk of recession increases to very high.

When the TMO falls below 0.5%, a recession is likely, but there is one false reading at 0.49% in 1986. So I treat 0.5% as an amber warning level.

There are no false signals below 0.3% in the last 50 years. So I treat the 0.3% level as a red warning — that recession risk is very high.

Some of the signals (e.g. 1975) are late but the TMO has a far better record, than the Sahm Rule, at giving timely warning of recessions.

The August 2019 TMO reading is an amber warning of 0.5%.

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Sahm Rule: Sweden tips into recession

Sweden: Sahm rule

What is the Sahm Recession Rule?

Recessions are notoriously difficult to measure (even the NBER occasionally gets it wrong) and an official declaration of a recession may be lagged by more than 6 months. Economist Claudia Sahm uses the following rule as a timely indicator of recessions:

Sahm RuleSahm RuleSahm Rule Graph

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NY Fed conducts first overnight repo in 10 years as rates surge

The last time that the New York Fed had to inject liquidity into financial markets via overnight repo operations was during the 2008 global financial crisis, when concerns over Bear Sterns and Lehman Bros were threatening to bring the financial system to its knees. From The Street:

The New York branch of the U.S. Federal Reserve said Tuesday that it was prepared to add as much as $75 billion in cash to broader markets in order to hold the Fed’s key rate inside its target range.

The so-called Repo operation, during which twenty four Primary Dealers in the Fed system can exchange eligible collateral, such as U.S. Treasury bonds or mortgage-backed securities, for cash. The move comes amid a massive surge in the price of what is known as ‘general collateral”, which is normally the cheapest batch of securities that banks use to pledge against cash, or other assets.

The costs for borrowing general collateral, often referred to as GC, spiked by 2.5% on Monday, and was followed by a 6% surge today, taking the price to as high as 8.75% at one point, some 6.5% higher than the upper-end of the Fed’s target rate range.

The Fed’s announced operation, however, pushed that overnight rate back down to 0% shortly after it was launched….

Steven Bartholomeusz at The Age suggests that the liquidity squeeze may be an anomaly:

There was an unusual confluence of events in the past few days that may have exacerbated underlying structural problems within the market.

US companies paid their quarterly taxes on September 15. They often prepare for the payment by parking the funds in short term money market fund accounts to generate a return.

The payments of those taxes, estimated at more than $US100 billion, meant a large amount of cash was withdrawn from those funds, which are a source of the cash for repo deals.

At almost the same time there was a settlement of auctions of about $US78 billion of Treasury bonds. With only about $US24 billion of bonds maturing at the same time that meant about $US54 billion of net cash was drained from the market to pay for those bonds.

The Financial Times’ Alphaville blog posited another strand to the explanation for the dollar shortage, albeit one it described as “highly speculative,’’ suggesting that the severe spike in oil prices after the drone attacks on Saudi Arabia’s most important oil processing complex might have triggered margin calls in oil futures markets, forcing a frantic scramble for US dollar-denominated cash.

Quarterly tax payments are a regular occurrence and the markets are accustomed to dealing with them as part of the quarterly cycle. Large fiscal deficits causing a net issue of $54 billion in Treasuries is a more likely culprit. The first rule of margin calls is never meet a margin call, so that seems an unlikely cause, but the spike in oil prices may have impacted elsewhere on financial markets.

We need to be on the lookout for a repeat. Demand for cash is surging. The graph of broad money (MZM plus time deposits) below shows a surge in broad money ahead of the last two recessions. And another worrying rise this year.

Broad Money: MZM plus Time Deposits

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Tectonic shift threatening the global reserve currency system

As Mark Carney observed at Jackson Hole: the global reserve currency system is broken — it has been since Nixon defaulted on gold backing for the Dollar in 1973 — and there is no fix. We have to find a replacement along the lines of Carney’s suggestion. On Macrovoices, two experts on the EuroDollar system, Jeffrey Snider and Luke Gromen discuss the massive tectonic shift facing the global financial system.

https://www.macrovoices.com/683-macrovoices-184-luke-gromen-jeff-snider

This is a complex topic but it is important that we grasp the implications before a tsunami appears on the horizon.

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S&P 500: Upside limited, while downside risks grow

Corporate profits (before tax) ticked up slightly in the second quarter of 2019 but remain below 2006 levels in real terms. The chart below shows corporate profits adjusted for inflation using the GDP implicit price deflator.

Real GDP and Hours Worked

Growth in production of durable consumer goods remains week, reflecting poor consumer confidence.

Durable Goods Production

The chart below shows growth in bank credit and the broad money supply (MZM plus time deposits). Credit growth (blue) remains steady at around 5%, slightly ahead of nominal GDP growth (4.04% for 12 months ending June); a healthy sign. Broad money (green) surged upwards in the first three quarters of this year. Not an encouraging sign when there were similar surges in broad money before the last two recessions.

Broad Money & Credit Growth

The S&P 500 is testing resistance at 3000. Bearish divergence on Twiggs Money Flow warns of secondary selling pressure. Expect a test of support at 2800. Breach would flag a reversal, with a target of 2400.

S&P 500

The cyclical Retailing Index displays a similar pattern, with resistance between 2450 and 2500.

Retail

Our view is that upside is limited, while downside risks are growing.

On the global front, the outlook is still dominated by the prospect of a prolonged US-China trade war. More great insights from Trivium China:

Tariff delays may be aimed at creating warm, fuzzy feelings before the next round of talks in early October, but……These small gestures do nothing to resolve the underlying trade conflict. We’re still pessimistic on prospects for a deal.

Zhou Xiaoming – China’s former top diplomat in Geneva – expressed the same view in a recent interview (Guancha):
“The two sides disagree too much on the objectives of the negotiations……It is almost impossible to reach an agreement in the short term.”

Zhou urged Chinese officials to be clear on the US’s objective:
“Economic and technological decoupling is the objective of the entire US government.”

Zhou said that officials must prepare for that potentiality, even if it is not their desired outcome.

So should we.

Dow Jones – UBS Commodity Index found support at 76 before rallying to 79. Rising troughs on the Trend Index reflect increased support. Consolidation between 76 and 81 is likely but we maintain our bearish long-term outlook for commodities.

DJ-UBS Commodities Index

On the global front, weak crude oil prices flag an anticipated slow-down in the global economy. Trend Index peaks below zero indicate selling pressure. Breach of support at $50/$51 per barrel would be a strong bear signal, warning of a decline to $40 per barrel.

Nymex Light Crude

We maintain our investment in quality growth stocks but have reduced equity exposure to 40% of (International Growth) portfolio value.

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