Category: Economy

Analysis of the global economy

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Still cautious

Inflationary pressures are easing, with average hourly earnings growth declining to 3.35% in June, for Production and Non-Supervisory Employees, and 3.14% for Total Private sector.

Average Wage Rates

But this warns that economic growth is slowing. Annual growth in hours worked has slowed to 1.25%, suggesting a similar decline in GDP growth for the second quarter.

Real GDP and Hours Worked

Jobs growth held steady at 1.5% for the 12 months ended June 2019, after a decline from 2.0% in January.

Payroll Growth

Further decline in jobs growth is likely in the months ahead and a fall below 1.0% would warn that recession is imminent.

The Case Shiller index warns that growth in housing prices is slowing.

Case Shiller Index

Growth in construction expenditure (adjusted for inflation) has stalled.

Construction Expenditure/CPI

Retail sales growth is faltering.

Retail Sales

Units of light vehicle sales has stalled.

Light Vehicle Sales

And capital goods orders (adjusted for inflation) are faltering.

Manufacturers Orders for Capital Goods

One of the few bright spots is corporate bond spreads — the difference between lowest investment grade (Baa) and equivalent Treasury yields — still low at 2.3%, indicating that credit risk is benign.

Corporate Bond spreads

The S&P 500 broke through 2950 and is testing 3000. The 3000 level is an important watershed, double the 2000 and 2007 highs at 1500 (1552 and 1576 to be exact), and I expect strong resistance.

S&P 500

A rising Trend Index indicates buying pressure but this seems to be mainly stock repurchases and institutional buying. Retail money, as indicated by investment flows into ETFs, favors fixed income over equities despite the low yields.

ETF Flows source: ETF.com

It’s still a good time to be cautious.

The prevailing wisdom is that markets are always right. I take the opposite position. I assume that markets are always wrong……I watch out for telltale signs that a trend may be exhausted. Then I disengage from the herd and look for a different investment thesis. Or, if I think the trend has been carried to excess, I may probe going against it. Most of the time we are punished if we go against the trend. Only at an inflection point are we rewarded.

~ George Soros

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S&P 500: Plan B

The S&P 500 is testing its all-time high at 2950. Bearish divergence on Twiggs Money Flow warns of secondary selling pressure. Respect of resistance is likely and would signal retracement to test support at 2750.

S&P 500

The 10-Year Treasury yield has fallen to 2.0%, indicating that the Fed is expected to cut interest rates in the second half of 2019.

10-Year Treasury yield

Stocks are still running on hope of a deal in the US-China trade dispute. Xi Jinping and Donald Trump will meet this weekend to discuss the way forward. Chinese preconditions for a trade agreement are likely to include the US lifting its ban on the sale of technology to telecommunications giant Huawei and removal of US tariffs on Chinese imports, according to The Wall St Journal. The US is unlikely to accede and chances of a deal are slim to nonexistent.

Trump doesn’t seem concerned: “My Plan B with China is to take in billions and billions of dollars a month and we’ll do less and less business with them……My plan B’s maybe my plan A.” (Bloomberg)

Plan B is the likely outcome, with a moderate impact on US corporate earnings and Fed rate cuts to keep the market on track. Risks rise while the potential upside declines. It’s a good time to be cautious.

We must recognize that as the dominant power in the world we have a special responsibility. In addition to protecting our national interests, we must take the leadership in protecting the common interests of humanity……There is no other country that can take the place of the United States in the foreseeable future. If the United States fails to provide the right kind of leadership our civilization may destroy itself. That is the unpleasant reality that confronts us.

~ George Soros: The Age of Fallibility

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Australia needs to break the downward spiral

Ross Gittins, Economics Editor at The Sydney Morning Herald, sums up Australia’s predicament:

“The problem is, the economy seems to be running out of puff because it’s caught in a vicious circle: private consumption and business investment can’t grow strongly because there’s no growth in real wages, but real wages will stay weak until stronger growth in consumption and investment gets them moving.

Policy has to break this cycle. But, as [RBA governor] Lowe now warns in every speech he gives, monetary policy (lower interest rates) isn’t still powerful enough to break it unaided. Rates are too close to zero, households are too heavily indebted, and it’s already clear that the cost of borrowing can’t be the reason business investment is a lot weaker than it should be.

That leaves the budget as the only other instrument available. The first stage of the tax cuts will help, but won’t be nearly enough…..”

Cutting already-low interest rates is unlikely to cure faltering consumption and business investment. Low wage growth and a deteriorating jobs market are root causes of the downward spiral and not much will change until these are addressed.

Low unemployment is misleading. Underemployment is growing. Trained barristers working as baristas may be an urban legend but there is an element of truth. The chart below shows underemployment in Australia as a percentage of total employment.

Australia: Underemployment % of Total Employment

How to halt the spiral

Tax cuts are an expensive sugar hit. The benefit does not last and may be frittered away in paying down personal debt or purchasing imported items like flat-screen TVs and smart phones. Tax cuts are also expensive because government is left with debt on its balance sheet and no assets to show for it.

Infrastructure spending can also be wasteful — like school halls and bridges to nowhere — but if chosen wisely can create productive assets that boost employment and build a healthy portfolio of income-producing assets to offset the debt incurred.

The RBA has already done as much as it can — and more than it should. Further rate cuts, or God forbid, quantitative easing, are not going to get us out of the present hole. What they will do is further distort price signals, leading to even greater malinvestment and damage to the long-term economy.

What the country needs is a long-term infrastructure plan with bipartisan support. Infrastructure should be a national priority. There is too much at stake for leadership to take a short-term focus, with an eye on the next election, rather than consensus-building around a long-term strategy with buy-in from both sides of the house.

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A good time to be cautious

Markets are buoyant with the S&P 500 headed for another test of its all-time high at 2950. Bearish divergence on Twiggs Money Flow warns of secondary selling pressure but the overall technical outlook looks promising.

S&P 500

So why should it not be a good time to invest in stocks?

First, the yield curve warns of a recession in the next 6 to 18 months. The 10-year Treasury yield is below the yield on 3-month T-bills, indicating a negative yield curve. This is our most reliable recession signal, with 100% accuracy since the early 1960s.

Yield Differential

Annual jobs growth has declined since January. Further declines in the next few months would further strengthen the recession warning.

Annual Growth in Total Payrolls

Small cap stocks in the Russell 2000 lag well behind the S&P 500, indicating that investors are de-risking.

Russell 2000 ETF

Cyclical sectors like Automobiles & Components also offer an early warning, anticipating slower consumer spending on durables such as housing, clothing and automobiles.

S&P 500 Automobiles & Parts

Lastly, the historic Price-Earnings ratio is above 20 (PE and PEmax are equal at present), indicating stocks are over-priced.

S&P 500 historic PE ratio based on highest prior earnings

It’s a good time to be cautious.

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No US-China trade deal

“On Monday, US President Trump told reporters that he would impose tariffs on an additional USD 300 billion of Chinese goods if Xi Jinping doesn’t meet with him in Japan.” ~ Trivium China, June 12, 2019

Trump is doing his best to kill any chance of a trade deal. He is making it impossible for Xi to turn up for a G20 meeting. To do so would be admitting defeat. Kow-towing to Trump would totally undermine Xi’s standing in China.

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If earnings undershoot, stocks will fall

Annual employment growth is falling while average hourly earnings growth remains high. This is typical. Ahead of the last two recessions (gray bars below), average hourly earnings growth (green) held steady while employment growth (blue) declined.

Employment Growth & Average Hourly Wage Rate

If annual employment growth (blue line on the above chart) falls below 1.0% then a Fed rate cut is almost guaranteed. Not something to celebrate though, as the gray bars and further job losses illustrate.

Declining growth in hours worked points to lower GDP growth in the second quarter.

Real GDP & Hours Worked

From Bob Doll at Nuveen:

“China is taking a tough stance toward the U.S. on trade. Chinese officials appear open to ongoing negotiations, but a recently released statement denies the country’s role in intellectual property theft, blames the U.S. for negotiation breakdowns and calls out the damage done to the American economy as a result of the dispute. All of this suggests that trade issues will persist for some time.”

The CCP is upset that they are now being called out for bad behavior when this should have been addressed years ago. Conflict can no longer be avoided and is likely to last for a generation or more.

“On Monday, US President Trump told reporters that he would impose tariffs on an additional USD 300 billion of Chinese goods if Xi Jinping doesn’t meet with him in Japan.” ~ Trivium China, June 12, 2019

Trump is doing his best to kill any chance of a trade deal. He is making it impossible for Xi to turn up for a G20 meeting. Kow-towing to Trump would totally undermine Xi’s standing in China.

Xi wants a trade deal that is a handful of empty promises, so the CCP can continue on their present course. The US wants an enforceable undertaking, so that the CPP is forced to change course. Chances of both achieving what they want are negligible.

Both sides need to guard against economic war (time to call it what it is) slipping into a full-scale conflict. All it takes is a spark that sets off tit-for-tat escalation where neither side will back down.

Proxies such as North Korea, Syria and Pakistan are especially dangerous as they are capable of dragging great powers into direct confrontation (think Serbia before WWI, Korea after WWII).

Wannabe great powers like Russia will also do their best to foment conflict between their larger rivals. Stalin achieved this with the Korean War in the 1950s and Vladimir Putin is more than capable of attempting the same. The world is a dangerous place.

Upside potential for stocks is declining while downside risks are growing. Investors are flowing out of equities and into Treasuries despite minimal yield (10-year yield is negative after inflation and tax).

Stocks are being supported by buybacks but that can only continue for as long as cash flows (from earnings) hold up. Buybacks plus dividends for the S&P 500 exceeded reported earnings by more than $100 billion in Q4 2018.

S&P 500 Buybacks, Dividends & Reported Earnings

That is unsustainable. If earnings undershoot, stocks will fall.

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S&P 500: Short-term versus long run

The market is excited at the prospect of Fed rate cuts (in response to the US-CCP trade war), with the S&P 500 headed for another test of its earlier high at 2950. A Trend Index trough above zero indicates short-term buying pressure.

S&P 500

Falling bond yields, however, warn of a flight to safety. 10-Year Treasury yields have fallen close to 120 basis points (bps) since late 2018, as investors shift from equities to bonds. Prices are being supported by stock buybacks rather than investor inflows.

10-year Treasury Yields

The Yield Differential between 10-year (purple) and 3-month (lime) Treasury yields is now negative, a reliable early warning of recession.

Yield Differential: 10-Year and 3-Month Treasuries

Corporate bond spreads, the difference between lowest investment grade (Baa) and Treasury yields, are rising. An indicator of credit risk, a spread above 2.5% (amber) is an early warning of trouble ahead, while 3.0% (red) signals that risk is elevated.

10-Year Baa minus Treasury Yield

Falling employment growth is another important warning. Annual employment growth below 1.0% (amber) would normally cause the Fed to cut interest rates. In the current scenario, that is almost certain.

Employment Growth & FFR

What is holding the Fed back is average hourly wages. Annual growth above 3.0% is indicative of a tight labor market and warns against cutting rates too hastily.

Average Hourly wage Rate

Stats for Q1 2019 warn that compensation is rising as a percentage of net value added, while profits are falling. As can be seen from the previous two recessions (gray bars), rising compensation (as % of NVA) normally leads to falling profits and a recession. Cutting interest rates would accelerate this.

Profits & Compensation % of Value Added

Annual GDP growth came in at 3.2% (after inflation) for the first quarter, but growth in hours worked is slowing. GDP growth is likely to follow.

Real GDP & Hours Worked

Personal consumption expenditure for Q1 was largely positive, with an uptick in services and non-durable goods. But consumption of durable goods fell sharply, warning that consumer confidence in the medium-to-long-term is declining.

Consumption

On the global stage, commodity prices are falling, indicating an anticipated drop in demand, especially from China.

DJ-UBS Commodity Index

Nymex crude is following, and expected to test support between $40 and $45 per barrel.

Crude Oil

Short-term prospects may appear reasonable, but the long-term outlook is decidedly negative.

In the short run, the market is a voting machine but in the long run, it is a weighing machine.

~ Benjamin Graham

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Trade war reality sinks in

Realization that we are slipping into a trade war is starting to sink in.

The S&P 500 broke medium-term support at 2800, warning of a correction. The target is primary support at 2400. Volatility is flashing an amber warning, above 1.0%.

S&P 500

Nymex crude is plunging as anticipated global demand falls.

Crude Oil

Long-term Treasury yields are falling, with the 10-Year headed for a test of support at 2.0%. The Yield Differential (purple line) is back below zero, warning of a recession.

Yield Differential: 10-Year and 3-Month Treasuries

As I have mentioned earlier, a negative yield curve is a reliable early indicator of recession but trouble is imminent when it recovers above zero. Normally caused by the Fed cutting interest rates in response to falling employment growth. The critical indicator to watch is non-farm payroll growth. When that falls below 1.0% (right-hand scale), watch out!

Employment Growth and Fed Funds Rate

War is an evil thing; but to submit to the dictation of other states is worse…. Freedom, if we hold fast to it, will ultimately restore our losses, but submission will mean permanent loss of all that we value…. To you who call yourselves men of peace, I say: You are not safe unless you have men of action on your side.

~ Thucydides (circa 400 BC)

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Market uncertainty is likely to persist as US-China negotiations stall | Bob Doll

From Bob Doll at Nuveen:

“There have been several risk-off phases this decade, triggered by economic threats due to politically induced setbacks. However, the current sluggish global economy and weak trade, coupled with escalating trade tariffs and non-tariff barriers, is a worrisome combination. This is especially true because once protectionism has gained momentum, it may prove difficult to stop or reverse. While many risk asset prices are only off modestly from April highs, there’s an ominous undercurrent in global financial markets.

We have assumed that the pro-growth bias of both the U.S. and China would lead to a trade truce. That premise looks increasingly questionable, although a deal is always possible. Given that financial markets have not reacted more significantly, investors are still generally expecting the global economic expansion to persist.

Despite the longer-term power struggle, the constructive case for a trade deal between the U. S. and China was predicated on President Trump focusing on the short-term win, while the Chinese look to the longer-term. This difference in political time horizons made a deal possible. Now, the focus for both parties has shifted to long-term strategic objectives, resulting in a stalemate. A financial market downturn may be needed to break the impasse. An extended period of churning could develop if trade talks resume, but without signs of a resolution.

The current market weakness differs from prior periods of economic uncertainty during this decade. There has always been a path to a positive outcome for growth and risk assets, primarily via additional policy stimulus. However, the economic and market outcome this time has become more uncertain, and time will not work towards a positive outcome unless trade negotiations improve. Business sentiment will erode if mounting trade roadblocks and uncertainty do not diminish. Protectionism tops the list of recession catalysts, and a permanent deterioration in U.S./China trade relations could have adverse long-term revenue ramifications for global trade and growth.”

My thoughts:

  • A trade deal was never going to happen. Long-term objectives of the CCP and the US are in direct conflict and headed for a collision.
  • Trump deserves credit for confronting the issues rather than kicking the can down the road as Obama did (Paul Krugman highlighted the problem in 2010).
  • Trump is the least likely President to negotiate a peaceful resolution to this hegemonic struggle. Diplomacy and building trust are not his forte.
  • Trust is low, eroding any chance of a face-saving public accord.
  • An agreement would simply be a band-aid, not a long-term solution (see my first point).
  • The impact on business will not be catastrophic but earnings growth will slow.
  • The market is unsure how to react. Yet. If it does make up it’s mind that this is bad for business, there won’t be enough room in the lifeboats. A down-turn could be sharp and hard.
  • Sell down to the sleeping point.

” I am carrying so much cotton that I can’t sleep thinking about it. It is wearing me out. What can I do?”
“Sell down to the sleeping point,” answered the friend.

~ Edwin Lefevre: Reminiscences of a Stock Operator (1923)

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