Category: Economy

Analysis of the global economy

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Be Data-driven not Fear-driven

A few months ago, markets feared a nuclear war on the Korean peninsula. Those fears have now largely dissipated but been replaced by fears of a massive trade war with China. There is always a small probability that our fears may be realized but most market fears are not.

Unless you want to follow in the footsteps of some media-driven forecasters, and anticipate ten of the next two recessions, you need to focus on the data and not on your fears.

I have always used Fedex as a bellwether of economic activity in the USA. Shipments of goods are an excellent barometer of the economic climate — and closely tied to quarterly earnings which in the long-run drive prices.

Fedex

Unfortunately Fedex stock price is likely to become less reliable over time as an indicator of economic activity, with the entry of a new competitor: Amazon.

But Fedex produces excellent quarterly statistics of parcel shipments which remain a useful gauge of economic conditions.

Fedex Express Parcel Statistics

Parcel shipments for the quarter ended May 31, 2018 are up 1.1% on the same quarter in 2017. And the annual average is rising. Not fantastic but a step in the right direction, suggesting that earnings for the next quarter will improve.

The S&P 500 is testing its long-term rising trendline. Respect of support at 2700 would suggest another advance. Breakout above 2800 would strengthen the signal.

S&P 500

The Nasdaq 100 retraced to test its new support level at 7000. Bearish divergence on the Trend Index hints at selling pressure. Breach of support would warn of another test of primary support at 6300. Lengthy consolidation would be likely. Respect of 7000, while less likely, on the other hand, would signal a fresh advance.

Nasdaq 100

Discount the obvious, bet on the unexpected.

~ George Soros

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Zombie banks or zombie economies?

The last three decades was the era of zombie banks, with financial crises threatening the very survival of our financial system. Major banks close to the edge of the precipice, first in Japan but followed by the USA and Europe, were only rescued by drastic action by central banks. The flood of easy money kept the zombie banks afloat but every action has unintended consequences, especially when you are the Fed, BOJ or ECB.

Fed Balance Sheet and Funds Rate Target

Now that the Fed is attempting to unwind its swollen $4.4 trillion balance sheet — see The Big Shrink Commences — and normalize interest rates, Stephen Bartholomeusz at The Age highlights some of the unforeseen consequences:

US rate hikes are already sending threatening ripples through other economies as capital flows towards the US and the US dollar strengthens.

Argentina has sought assistance from the International Monetary Fund. Turkey, Indonesia, the Philippines, Brazil, India and Pakistan have all been forced to raise their rates to defend their currencies.

US monetary policy and its rate structure is setting it apart from most of the rest of the developed world in a fashion that will impose pressure on economies that may be more fragile than they might previously have been regarded in an ultra-low global rates environment.

…..A consequence of the policies pursued by the Fed, the ECB and the Bank of Japan since 2008 has been a significant increase in global debt – at government, corporate and household levels – as ultra-low rates and torrents of liquidity ignited a global borrowing binge.

There was a particular appetite in developing economies for US dollar-denominated debt, which became abundant and cheap as US investors were incentivised and enabled by the Fed to take on more risk in return for higher returns.

The US rate rises, combined with a stronger US dollar, are now putting a squeeze on emerging market economies.

If the ECB were to also start unwinding its stimulus, economies and banking systems within the weaker southern regions of the eurozone would come under intense pressure, along with more debt-laden companies.

It shouldn’t come as a surprise to anyone that after a decade of unprecedented policy interventions in economies and markets there could be unintended consequences that emerge as those policies are wound back.

The ECB indicated overnight that it will halt bond purchases at the end of 2018 and plans to keep interest rates accommodative “through the summer of 2019 and in any case for as long as necessary…”

ECB unwinding still appears some way off but tighter monetary conditions emanating from the Fed may be sufficient. Developing economies that gorged on low-rate US dollar-denominated debt during the liquidity surge are finding themselves in difficulties as the tide goes out.

Meanwhile in Australia

From Karen Maley at the AFR:

Australian banks are being squeezed by higher borrowing costs as the US Federal Reserve accelerates its interest rate hikes and drains liquidity from global financial markets…..

The woes of the local banks have been exacerbated by an unexpected and savage spike in a key Australian short-term interest rate benchmark – the three-month bank bill swap rate, or BBSW, in the past few weeks.

Analysts estimated that the spreads paid by Australian banks have climbed by close to 40 basis points since the beginning of the year, which has swollen the wholesale borrowing costs of the country’s banks by some $4.4 billion a year.

The ASX 300 Banks Index is headed for a test of primary support at 7000/7200. Breach of 7000 would warn of another decline, with a long-term target of the September 2011 low at 5000.

ASX 300 Banks Index

Aussie banks are being squeezed by higher interest rates on their international borrowing but are unable to pass this on to borrowers for fear of upsetting the local housing market. House prices are already under the pump, especially in the top end of the market.

Zombie banks would be too harsh but Aussie banks are in for a rough time over the next year or two.

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12 Charts on the Australian economy

Australian GDP grew at a robust 3.1% for the year ended 31 March 2018 but a look at the broader economy shows little to cheer about.

Wages growth is slowing, with the Wage Price Index falling sharply.

Australia: Wage Price Index Growth

Falling growth in disposable income is holding back consumption (e.g. retail spending) and increasing pressure on savings.

Australia: Consumption and Savings

Housing prices are high despite the recent slow-down, while households remain heavily indebted, with household debt at record levels relative to disposable income.

Australia: Housing Prices and Household Debt

Housing price growth slowed to near zero and we are likely to soon see house prices shrinking.

Australia: Housing Prices

Broad money growth is falling sharply, reflecting tighter financial conditions, while credit growth is also slowing.

Australia: Broad Money and Credit Growth

Mining profits are up, while non-mining corporation profits (excluding banks and the financial sector) have recovered to about 12% of GDP.

Australia: Corporate Profits

But business investment remains weak, which is likely to impact on future growth in both profits and wages.

Australia: Investment

Exports are strong, especially in the Resources sector. Manufacturing is the only flat spot.

Australia: Exports

Iron ore export tonnage continues to grow, while demand for coal has leveled off in recent years.

Australia: Bulk Commodity Exports

Our dependence on China as an export market also continues to grow.

Australia: Exports by Country

Corporate bond spreads — the risk premium over the equivalent Treasury rate charged to non-financial corporate borrowers — remain low, reflecting low financial risk.

Australia: Non-financial Bond Spreads

Bank capital ratios are rising but don’t be fooled by the risk-weighted percentages. Un-weighted Common Equity Tier 1 leverage ratios are closer to 5% for the four major banks. Common Equity excludes bank hybrids which should not be considered as capital. Conversion of hybrids to common equity was avoided in the recent Italian banking crisis, largely because of the threat this action posed to stability of the entire financial system.

Australia: Bank Capital Ratios

Low capital ratios mean that banks are more likely to act as “an accelerant rather than a shock-absorber” in times of crisis (2014 Murray Inquiry). Professor Anat Admati from Stanford University and Neel Kashkari, President of the Minneapolis Fed are both campaigning for higher bank capital ratios, at 4 to 5 times existing levels, to ensure stability of the financial system. This is unlikely to succeed, considering the political power of the bank sector, unless the tide goes out again and reveals who is swimming naked.

The housing boom has run its course and consumption is slowing. The banks don’t have much in reserve if the housing market crashes — not yet a major risk but one we should not ignore. Exports are keeping us afloat because we hitched our wagon to China. But that comes at a price as Australians are only just beginning to discover. If Chinese exports fail, Australia will need to spend big on infrastructure. And infrastructure that will generate not just short-term jobs but long-term growth.

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Falling bond yields fail to tame Gold bears

10-Year Treasury yields retreated below 3.0 percent after threatening a bond bear market for the past week.

10-Year Treasury Yield

Breakout above 3.0 percent would complete a large double bottom reversal in the secular down-trend.

10-Year Treasury Yield

Rising bond yields would be expected to weaken demand for gold as the opportunity cost of holding precious metals increases.

The other major influence on gold prices, the Dollar, continues to strengthen. A strong Dollar would weaken the Dollar-price of gold.

The Dollar Index is rallying to test resistance at 95. Penetration of the long-term descending trendline in April suggests that a bottom is forming. Bullish divergence on the Trend Index indicates buying pressure.

Dollar Index

Spot Gold retraced to test the new resistance level at $1300/ounce — the former support level. The declining Trend Index indicates selling pressure and respect of the descending trendline would warn of a test of primary support at $1250/ounce.

Spot Gold

Australian gold stocks fared better, with the All Ordinaries Gold Index finding support at 4950 and the rising Trend Index signaling buying pressure. Respect of the long-term trendline would confirm another primary advance.

All Ordinaries Gold Index

The reason is not hard to find. The Australian Dollar is at a watershed, testing primary support at 75 US cents as the greenback rallies. A Trend Index peak below zero would warn of strong selling pressure. And breach of primary support would signal a decline to 69/70 US cents.

AUDUSD

Offering a potential bull market for Aussie gold stocks.

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Low inflation risk keeps yield curve safe

The Fed is advancing interest rates at a measured pace, with the objective of restoring balance in financial markets rather than to curbing inflationary pressures. Only if inflation spikes is the Fed likely to adopt a restrictive stance.

Elliot Clarke from Westpac sums up the FOMC (Fed Open Market Committee) view from their latest minutes:

Beginning with inflation, whereas the market has recently been concerned that inflation may be getting away from the FOMC (given annual CPI inflation at 2.5%yr and persistent strength in the oil price), the Committee is unperturbed.

Instead of the CPI, the FOMC’s benchmark remains PCE inflation, which is currently 2.0%yr on a headline basis and 1.9%yr for core…..

To see upside inflation risks build, a stronger wage inflation pulse is necessary. At present the employment cost index is only reporting “a gradual pickup in wage increases”, and the signal from other wage measures is “less clear”. Two other important considerations for the pass through of wages to activity and thus inflation is that real hourly earnings growth is currently flat and the savings rate near historic lows. The capacity of households to boost consumption and thus inflation is therefore very limited.

Hourly wage rates are growing at a gradual pace.

Hourly Wage Rate Growth

Personal savings are low.

Personal Savings

And credit growth is modest.

Credit Growth

So not much sign of inflationary pressure.

….Turning to financial conditions, as yet there is no concern of them becoming an impediment to growth or policy. The 10yr yield has moved back to the highs of 2013, but the US dollar has only partly retraced its 2017 depreciation. Further, asset markets remain near recent highs.

Equally significant however is the reference to being nearer neutral and a clear desire to keep the yield curve’s positive slope…..

We do not believe that the yield curve will invert in this instance, in part because higher deficits should see the term premium rise. However, the curve will remain comparatively flat versus history, restricting both the timing and the scale of further rate hikes. This is a key justification for both the market’s and our own view of only two further hikes in 2018 and two more in 2019 – a stark contrast to the FOMC’s seven hikes to end-2020.

Yield Differential

A negative yield curve — when 10-year minus 3-month Treasury yields falls below zero — would give a strong recession warning. But the yield curve is only likely to invert if the Fed steps up interest rate increases. With little sign of rising inflationary pressure at present, the prospect seems remote.

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No Fed Squeeze in Sight

In January I warned that the Fed’s normalization plan, which will shrink its balance sheet at the rate of $100 billion in 2018 and $200 billion a year thereafter, would cause Treasury yields to rise and the Dollar to weaken.

10-Year Treasury yields are now testing resistance at 3.0 percent. Breakout would signal the end of a decades-long bull market in bonds and start of a bear market as yields rise.

10-Year Treasury yields

The Dollar Index is in a primary down-trend but the recent rally above the descending trendline suggests that a bottom may be forming.

Dollar Index

Commodity prices, which I suggested would climb as the Dollar weakened, are strengthening but remain in an ascending triangle, testing resistance at 90 on the Dow Jones – UBS Commodity Index.

Dow Jones - UBS Commodity Index

Crude, however, is surging and commodities are likely to follow.

WTI Light Crude

Rising commodity prices — especially crude — would lift inflation, raising the threat of tighter Fed monetary policy.

Until now, financial markets have absorbed the Fed shrinking its balance sheet. Primarily because there hasn’t been any contractionary effect at all.

The orange line on the chart below shows Fed assets net of excess reserves of commercial banks on deposit at the Fed. If commercial banks withdraw excess reserves at a faster rate than the Fed shrinks its balance sheet then the net effect is expansionary, with a rising orange line as at present. There are still $2 trillion of excess reserves on deposit at the Fed, so this could go on for years.

Fed Assets Net of Excess Reserves

The Fed funds rate is climbing, but at a measured pace. I doubt that the market will be too concerned by the FFR at 2.0 percent. The threat is if the Fed accelerates rate hikes in response to rising inflation, as in 2004 to 2006.

Fed Funds Rate and MZM Money Stock

Inflationary forces remain subdued, with the average hourly wage rate growing at a modest 2.6 percent a year.

Average Hourly Wage Rate Growth

A spike above 3.0 percent would spur the Fed into action but there is no sign, so far, as rising automation and competition from offshore labor markets ease upward pressure despite low unemployment.

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Bob Doll: First quarter earnings continue to impress

Bob Doll

More positive news on earnings from Bob Doll’s weekly newsletter:

…..2. First quarter earnings results continue to impress, helped by tax cuts. With 85% of companies reporting, earnings are ahead of expectations by an average of 7.3%.1 Earnings-per-share growth is on track for 25%.1 Were it not for the effects of tax cuts, that number would be only 18%.1

3. Even if earnings are peaking, that does not necessarily mean the equity bull market is ending. According to one study, since the 1950s, a cyclical peak in earnings growth has tended to be followed by stock prices moving higher: From a peak in earnings-per-share growth, stock prices were still higher six months later 74% of the time and were higher 12 months later 68% of the time.2.

Fears of an earnings peak may be overblown, with inflation low, rate hikes at a measured pace, consumption strong and inflation contained despite low unemployment. Upside and downside risks appear balanced in this summary adapted by Nuveen from Morgan Stanley:

Reasons to be optimistic

1) First quarter earnings are very strong.
2) Equity valuations are reasonable.
3) Corporate America is flush with cash.
4) U.S. growth momentum may be plateauing, but is not slowing.
5) Trade restrictions have not been as severe as feared.
6) Global monetary policy remains accommodative.
7) North Korea risks have eased.

Reasons to be cautious

1) Margin pressures could hurt future earnings.
2) Higher rates could represent a headwind for valuations.
3) Political risks may rise as the midterm elections approach.
4) Global growth may start to slow in the coming years.
5) Trade policy remains a long-term risk.
6) Investors may be too complacent about monetary tightening.
7) President Trump’s legal issues could escalate.

But it would be foolish to ignore either upside or downside risk. Adopting a balanced strategy may be the most sensible approach.

1Source: Credit Suisse.
2Source: BMO Capital Markets

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Is GDP doomed to low growth?

GDP failed to rebound after the 2008 Financial Crisis, sinking into a period of stubborn low growth. Economic commentators have advanced many explanations for the causes, while the consensus seems to be that this is the new normal, with the global economy destined to decades of poor growth.

Real GDP Growth

This is a classic case of recency bias. Where observers attach the most value to recent observations and assume that the current state of affairs will continue for the foreseeable future. The inverse of the Dow 100,000 projections during the Dotcom bubble.

Real GDP for Q1 2018 recorded 2.9% growth over the last 4 quarters. Not exactly shooting the lights out, but is the recent up-trend likely to continue?

Real GDP Growth and estimate based on Private Sector Employment and Average Weekly Hours Worked

Neils Jensen from Absolute Return Partners does a good job of summarizing the arguments for low growth in his latest newsletter:

The bear story

Putting my (very) long-term bearishness on fossil fuels aside for a moment, there is also a bear story with the potential to unfold in the short to medium-term, but that bear story is a very different one. It is a story about GDP growth likely to suffer as a consequence of the oil industry’s insatiable appetite for working capital, which is presumably a function of the low hanging fruit having been picked already.

In the US today, the oil industry ties up 31 times more capital per barrel of oil produced than it did in 1980, when we came out of the second oil crisis. ….Such a hefty capital requirement is a significant tax on economic growth. Think of it the following way. Capital is a major driver of productivity growth, which again is a key driver of economic growth. Capital tied up by the oil industry cannot be used to enhance productivity elsewhere, i.e. overall productivity growth suffers as more and more capital is ‘confiscated’ by the oil industry.

I am tempted to remind you (yet again!) of one of the most important equations in the world of economics:

∆GDP = ∆Workforce + ∆Productivity

We already know that the workforce will decline in many countries in the years to come; hence productivity growth is the only solution to a world drowning in debt, if that debt is to be serviced. Why? Because we need economic growth to be able to service all that debt.

Now, if productivity growth is going to suffer for years to come, all this fancy new stuff that we all count on to save our bacon (advanced robotics, artificial intelligence, etc.) may never be fully taken advantage of, because the money needed to make it happen won’t be there. It is not a given but certainly a risk that shouldn’t be ignored.

….For that reason, we need to retire fossil fuels as quickly as possible. Ageing of society (older workers are less productive than their younger peers) and a global economy drowning in debt (servicing all that debt is immensely expensive, leaving less capital for productivity enhancing purposes) are widely perceived to be the two most important reasons why productivity growth is so pedestrian at present.

I am not about to tell you that those two reasons are not important. They certainly are. However, the adverse impact the oil industry is having on overall productivity should not be underestimated.

I tend to take a simpler view, where I equate changes in GDP to changes in hours worked and in capital investment:

∆GDP = ∆Workforce + ∆Capital

Workers work harder if they are motivated or if there is a more efficient organizational structure, but these are a secondary influence on productivity when compared to capital investment.

The chart below compares net capital formation by the corporate sector (over GDP) to real GDP growth. It is evident that GDP growth rises and falls in line with net capital formation (or investment as it is loosely termed) by corporations.

Net Capital Formation by the corporate sector/GDP compared to Real GDP Growth

A quick primer (with help from Wikipedia):

  • Capital Formation measures net additions to the capital stock of a country.
  • Capital refers to physical (or tangible) assets and includes plant and equipment, computer software, inventories and real estate. Any non-financial asset used in the production of goods or services.
  • Capital does not include financial assets such as bonds and stocks.
  • Net Capital Formation makes allowance for depreciation of the existing capital stock due to wear and tear, obsolescence, etc.

Net Capital Formation peaked at around 5.0% from the mid-1960s to the mid-1980s, made a brief recovery to 4.0% during the Dotcom bubble and has since struggled to make the bar at 3.0%. Rather like me doing chin-ups.

Net Capital Formation Declining in the Corporate Sector

There are a number of factors contributing to this.

Intangible Assets

Capital formation only measures tangible assets. The last two decades have seen a massive surge in investment in intangible assets. Look no further than the big five on the Nasdaq:

Stock Symbol Price ($) Book Value ($) Times Book Value
Amazon AMZN 1582.26 64.85 24.40
Microsoft MSFT 95.00 10.32 9.21
Facebook FB 173.86 26.83 6.48
Apple AAPL 169.10 27.60 6.12
Alphabet GOOGL 1040.75 235.46 4.42

Currency Manipulation

Capital formation first fell off the cliff in the 1980s. This coincides with the growth of currency manipulation by Japan, purchasing excessive US foreign reserves to suppress the Yen and establish a trade advantage over US manufacturers. China joined the party in the late 1990s, exceeding Japan’s current account surplus by 2006. Currency suppression creates another incentive for corporations to offshore or outsource manufacturing to Asia.

China & Japan Current Account Surpluses

Tax on Offshore Profits

Many large corporations took advantage of low tax rates in offshore havens such as Ireland, avoiding US taxes while the funds were held offshore. This created an incentive for large corporations to invest retained earnings offshore rather than in the USA.

The net effect has been that retained earnings are invested elsewhere, while new capital formation in the USA is almost entirely funded by debt.

Net Capital Formation by the corporate sector/GDP compared to Corporate Debt Growth/GDP

Donald Trump’s tax deal will make a dent in this but will not undo past damage. The horse has already bolted.

Offshore Manufacturing

Apart from tax incentives, lower labor costs (enhanced by currency manipulation) led large corporations to set up or outsource manufacturing to Asia and other developing countries. In effect, offshoring capital formation and — more importantly — GDP growth to foreign destinations.

Offshoring Jobs

Along with manufacturing plants, blue-collar jobs also moved offshore. While this may improve the company bottom-line for a few years, the long-term, macro effects are devastating.

Think of it this way. If you build a manufacturing plant offshore rather than in the USA you may save millions of dollars a year in labor costs. Great for the bottom line and executive bonuses. But one man’s wage is another man/woman’s income (when he/she spends it). So, from a macro perspective, the US loses GDP equal to the entire factory wages bill plus the wage component of any input costs. A far larger figure than the company’s savings. As more companies offshore jobs, sales growth in the USA is affected. In the end this is likely to more than offset the savings that justified the offshore move in the first place.

Stock Buybacks

Stock buybacks accelerate EPS (earnings per share) growth and are great for boosting stock prices and executive bonuses. But they create the illusion of growth while GDP stands still. There is no new capital formation.

Can GDP Growth Recover?

Yes. Restore capital formation and GDP growth will recover.

How to do this:

Trump has already made an important move, revising tax laws to encourage corporations to repatriate offshore funds.

But more needs to be done to create a level playing field.

Stop currency manipulation and theft of technology by developing countries, especially China. Trump has also signaled his intention to tackle this thorny issue.

Repatriating offshore manufacturing and jobs is a much more difficult task. You can’t just pack a factory in a box and ship it home. There is also the matter of lost skills in the local workforce. But manufacturing jobs are being lost globally at an alarming rate to new technology. In the long-term, offshore manufacturing plants will be made obsolete and replaced by new automated, high-tech manufacturing facilities. Incentives need to be created to encourage new capital formation, especially high-tech manufacturing, at home.

Stock buybacks, I suspect, will always be around. But remove the incentive to boost stock prices by targeting the structure of executive bonuses. It would be difficult to isolate benefits from stock buybacks and tax them directly. But removing tax on dividends — in my opinion far simpler and more effective than the dividend imputation system in Australia — would remove the incentive for stock buybacks and make it difficult for management to justify this action to investors.

We already seem to be moving in the right direction. The last two points are relatively easy when compared to the first two. If Donald Trump manages to pull them (the first two) off, he will already move sharply upward in my estimation.

Judge a tree by the fruit it bears.

~ Matthew 7:15–20

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