Stocks: Winter is coming

GDP grew by a solid 10.64% for the 12 months ended March ’22 but that is in nominal terms.

GDP

GDP for the quarter slowed to 1.58%, while real GDP fell to -0.36%. Not only is growth slowing but inflation is taking a bigger bite.

GDP & Real GDP

The implicit price deflator climbed to 1.94% for the quarter — almost 8.0% when annualized.

GDP Implicit Price Deflator

Growth is expected to decline further as long-term interest rates rise.

10-Year Treasury Yield & Moody's Baa Corporate Bond Yield

Conventional monetary policy would be for the Fed to hike the funds rate (gray below) above CPI (red). But, with CPI at 8.56% for the 12 months to March and FFR at 0.20%, the Fed may be tempted to try unconventional methods to ease inflationary pressures.

Fed Funds Rate & CPI

That includes shrinking its $9 trillion balance sheet (QT).

During the pandemic, the Fed purchased almost $5 trillion of securities. The resulting shortage of Treasuries and mortgage-backed securities (MBS) caused long-terms yields to fall and a migration of investors to equities in search of yield.

The Fed is expected to commence QT in May at the rate of $95 billion per month — $60 billion in Treasuries and $35 billion in MBS — after a phase-in over the first three months. Long-term Treasury yields are likely to rise even faster, accompanied by a reverse flow from equities into bonds.

S&P 500 & Fed Total Assets

S&P 500 breach of support at 4200, signaling a bear market, would anticipate this.

Conclusion

Fed rate hikes combined with QT are expected to drive long-term interest rates higher and cause an outflow from equities into bonds.

A bear market (Winter) is coming.

Dr Lacey Hunt, Hoisington Asset Management | The debt trap

From Dr Lacey Hunt at Hoisington Asset Management on the declining velocity of money:

M2 Velocity

The Fed is able to increase money supply growth but the ongoing decline in velocity (V) means that the new liquidity is trapped in the financial markets rather than advancing the standard of living by moving into the real economy…..

GDP/Debt

Money and debt are created simultaneously. If the debt produces a sustaining income stream to repay principal and interest, then velocity will rise since GDP will eventually increase beyond the initial borrowing. If advancing debt produces increasingly smaller gains in GDP, then V falls. Debt financed private and governmental projects may temporarily boost GDP and velocity over short timespans, but if the projects do not generate new funds to meet longer term debt servicing obligations, then velocity falls as the historical statistics confirm.

The increase in M2 is not channeled into productive investment — that fuels GDP growth — but rather into unproductive investment in financial assets. The wealthy invest in real assets, as a hedge against inflation, but these are mainly speculative assets — such as gold, precious metals, jewellery, artworks and other collectibles, high-end real estate, or cryptocurrencies — which seldom produce much in the way of real income, with the speculator relying on asset price inflation and low interest rates to make a profit. Many so-called “growth stocks” — with negative earnings — fall in the same category. Debt used to fund stock buybacks also falls in this category as their purpose is financial engineering, with no increase in real earnings.

In 2008 and 2009 Carmen Reinhart and Ken Rogoff (R&R) published research that indicated from an extensive quantitative analysis of highly indebted economies that their economic growth was significantly diminished once they become highly over-indebted.

…..Cristina Checherita and Philip Rother, in research for the European Central Bank (ECB) published in 2014, investigated the average effect of government debt on per capita GDP growth in twelve Euro Area countries over a period of about four decades beginning in 1970. Dr. Checherita, now head of the fiscal affairs division of the ECB and Dr. Rother, chief economist of the European Economic Community, found that a government debt to GDP ratio above the turning point of 90-100% has a “deleterious” impact on long-term growth. In addition, they find that there is a non-linear impact of debt on growth beyond this turning point. A non-linear relationship means that as the government debt rises to higher and higher levels, the adverse growth consequences accelerate……Moreover, confidence intervals for the debt turning point suggest that the negative growth rate effect of high debt may start from levels of around 70-80% of GDP.

…..Unfortunately, early-stage economic expansions do not fare well when inflation and interest rates are not declining at this stage of the business cycle, which is not the normal historical role, or the path indicated by economic theory. As this year has once again confirmed, in early expansion inflationary episodes, prices rise faster than real wages, thereby stunting consumer
spending. The faster inflation also thwarts the needed continuing cyclical decline in money and bond yields, which are necessary to gain economic momentum.

…..The U.S. economy has clearly experienced an unprecedented set of supply side disruptions, which serve to shift the upward sloping aggregate supply curve inward. In a graph, with aggregate prices on the vertical axis and real GDP on the horizontal axis, this causes the aggregate supply and demand curves to intersect at a higher price level and lower level of real GDP. This
drop in real GDP, often referred to as a supply side recession, increases what is known as the deflationary gap, which means that the level of real GDP falls further from the level of potential GDP. This deflationary gap in turn leads to demand destruction setting in motion a process that will eventually reverse the rise in inflation.

Currently, however, the decline in money growth and velocity indicate that the inflation induced supply side shocks will eventually be reversed. In this environment, Treasury bond yields could temporarily be pushed higher in response to inflation. These sporadic moves will not be maintained. The trend in longer yields remains downward.

Negative real yields

A negative real yield points to the fact that investors or entrepreneurs cannot earn a real return sufficient to cover risks. Accordingly, the funds for physical investment will fall and productivity gains will erode which undermines growth. Attempting to counter this fact, central banks expand liquidity but the inability of firms to profitably invest causes the velocity of money to fall but the additional liquidity boosts financial assets. Financial investment, however, does not raise the standard of living. While the timing is uncertain, real forward financial asset returns must eventually move into alignment with the already present negative long-term real Treasury interest rates. This implied reduction in future investment will impair economic growth.

….research has documented that extremely high levels of governmental indebtedness suppress real per capita GDP. In the distant past, debt financed government spending may have been preceded by stronger sustained economic performance, but that is no longer the case. When governments accelerate debt over a certain level to improve faltering economic conditions, it actually slows economic activity. While governmental action may be required for political reasons, governments would be better off to admit that traditional tools would only serve to compound existing problems.

Carmen Reinhart, Vincent Reinhart and Kenneth Rogoff (which will be referred to as RR&R), in the Summer 2012 issue of the Journal of Economic Perspectives linked extreme sustained over indebtedness with the level of interest rates…… “Contrary to popular perception, we find that in 11 of the 16 debt overhang cases, real interest rates were either lower or about the same as during the lower debt/GDP years. Those waiting for financial markets to send the warning signal through higher (real) interest rates that governmental policy will be detrimental to economic performance may be waiting a long time.”

Growth Obstacles

In 2022, several headwinds will weigh on the U.S. economy. These include negative real interest rates combined with a massive debt overhang, poor domestic and global demographics, and a foreign sector that will drain growth from the domestic economy. The EM and AD (Advanced) economies will both serve to be a restraint on U.S. growth this year and perhaps significantly longer. The negative real interest rates signal that capital is being destroyed and with it the incentive to plough funds into physical investment.

Demographics continue to stagnate in the United States and throughout the world……..Poor demographics retard economic growth by lowering household, business and state and local investment. This keeps intact the observable trend in numerous countries – extreme over-indebtedness reduces economic growth which, in turn, worsens demographics, which reinforces the weakness emanating from the debt overhang. William Stull, Professor of Economics at Temple University, makes the case that for nations’, “demographics is destiny” (a phrase coined by Ben Wattenberg and Richard M. Scammon), highlighting the importance of its critical secular growth in determining economic fortune.

Although fourth quarter numbers are not yet available, the global debt to GDP average for 2020-21 is almost certainly the highest on record for any two-year period. Transitory growth spurts, like the one Q4 2021, are unlikely to be sustained. The sporadic but weakening growth trend evident before the pandemic hit in 2019 will return, reinforcing the debt trap.

Inflation

The University of Michigan indicates consumer sentiment in the fourth quarter was worse than during the height of the 2020 pandemic and at the levels of the beginning of the very deep 2008-09 recession. Consumers cut back significantly on their buying plans as expectations for increases in future income slumped. To fund the sharply higher cost of necessities, households have been forced to reduce the personal saving rate in November to 6.9%, or 0.4% less than in December 2019. Needing to tap credit card lines undoubtedly contributed to the erosion in consumer confidence measures. Without the sizable cut in personal saving, real consumer expenditures were barely positive in the fourth quarter. With money growth likely to slow even more sharply in response to tapering by the FOMC, the velocity of money in a major downward trend, coupled with increased global over-indebtedness, poor demographics and other headwinds at work, the faster observed inflation of last year should unwind noticeably in 2022.

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.

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.

ASX and 3 headwinds

Despite recent strong performance, investor enthusiasm may be cooling, with the Australian economy facing three headwinds.

Declining Household Spending

Household income growth is faltering and weighing down consumption. Household spending would have fallen even further, dragging the economy into recession, if households were not digging into savings to maintain their living standards.

Australia: Disposable Income, Consumption and Savings

But households are only likely to draw down on savings when housing prices are high. Commonly known as the “wealth effect” there is a clear relationship between household wealth and consumption. If housing prices were to continue falling then households are likely to cut back on spending and boost savings (including higher mortgage repayments).

Consumption is one of the few remaining contributors to GDP growth. If that falls, the economy is likely to go into recession.

Australia: GDP growth contribution by sector

Housing Construction

The RBA is desperately trying to prevent a further fall in house prices because of the negative effect this will have on household spending (consumption). But rate cuts are not being passed on to borrowers, and households are maintaining their existing mortgage repayments (increasing savings) if they do benefit, rather than increasing spending.

House prices ticked up after the recent fall, in response to RBA interest rate cuts. But Martin North reports that the recovery is only evident in more affluent suburbs with lower mortgage exposure (e.g. Eastern suburbs in Sydney) and that newer suburbs and inner city high-density units are experiencing record levels of mortgage stress.

Housing

Building approvals reflect this, with a down-turn in detached housing and a sharp plunge in high density unit construction.
Building Approvals

Dwelling investment is likely to remain a drag on GDP growth over the next year.

Falling Commodity Prices

Iron ore and coal, Australia’s two largest commodity exports, are falling in price as the global economic growth slows. Dalian Commodity Exchange’s most-traded iron ore contract , with January 2020 expiry, closed at 616 yuan ($86.99) per tonne, close to a seven-month low. Falling prices are likely to inhibit further mining investment.

Iron Ore and Coal Prices

Metals & Mining

The ASX 300 Metals & Mining index is testing long-term support at 4100. Breach would complete a head and shoulders reversal, with a target of 3400.

ASX 300 Metals & Mining

Financials

The Financial sector recovered this year, trending upwards since January, but faces a number of issues in the year ahead:

  • customer remediation flowing from issues exposed by the Royal Commission;
  • net interest margins squeezed as the RBA lowers interest rates;
  • continued pressure to increase capital ratios are also likely to impact on dividend payout ratios;
  • low housing (construction and sales) activity rates impact on fee income; and
  • high levels of mortgage stress impact on borrower default rates.

ASX 200 Financials index faces strong resistance at 6500. There is no sign of a reversal at present but keep a weather eye on primary support at 6000. We remain bearish in our outlook for the sector and breach of 6000 would warn of a primary decline with a target of 5200.

ASX 200 Financials

REITs are experiencing selling pressure despite an investment market desperate for yield. Dexus (DXS) may be partly responsible after the office and industrial fund reported a 26% profit fall in the first half of 2019.

ASX 200 REITs

ASX 200

The ASX 200 is showing signs of (secondary) selling pressure, with a tall shadow on this week’s candle and a lower peak on the Trend index. Expect a test of support at 6400; breach would offer a target of 5400.

ASX 200

We maintain exposure to Australian equities at 22% of portfolio value, with a focus on defensive and contra-cyclical stocks, because of our bearish outlook.

Australia: The elephant in the room

June quarter real GDP growth slowed to an annual 1.4%, the lowest since the 2008 global financial crisis (GFC). Major contributors to growth are household consumption, public demand and exports; while the biggest handbrake is investment.

Australia: GDP

A quick look at the RBA chart shows that consumption is slowing but at a slower rate than disposable income. Households are dipping into savings to support consumption, with the savings ratio (savings/disposable income) declining to near GFC lows.

Australia: Disposable Income, Consumption and Savings

Gerard Minack warned of the danger that households will dramatically increase savings, and cut consumption, if employment prospects grow cloudy.

That brings us back to investment. Low investment is a drag on employment growth.

Australia: Job Ads

Low interest rates, on the other hand, are a tailwind at present. They seem to have shored up housing prices,

Australia: Housing

And states are taking advantage of ultra-low interest rates to boost infrastructure spending.

But low interest rates are a double-edged sword. Bank net interest margins are under pressure.

Australia: Bank Net Interest Margins

And credit growth is plunging.

Australia: Credit Growth

The housing recovery will be short-lived if there is not a dramatic increase in loan approvals.

Australia: Housing Loans

AMP chief economist Shane Oliver believes that:

“growth will remain soft and that the RBA will have to provide more stimulus – by taking the cash rate to around 0.5% and possibly consider unconventional monetary policy like quantitative easing. Ideally the latter should be combined with fiscal stimulus which would be fairer and more effective. While Australian growth is going through a rough patch with likely further to go, recession remains unlikely barring a significant global downturn.”

But that ignores two factors:

  1. increased pressure on bank net interest margins from lower interest rates; and
  2. the elephant in the room: China.

China: Activity Levels

China’s economic model is built on a shaky foundation and trade war with the US is likely to expose the flaws.

Chinese leaders are growing increasingly worried about the economy. Premier Li Keqiang said at this week’s State Council meeting:

“The current external environment is increasingly complex and grim.
….Downward pressure on the domestic economy has increased.”
(Trivium)

Twitter: Simon Ting

BEIJING, Sept. 5 (Xinhua) — Chinese and U.S. chief trade negotiators agreed on Thursday to jointly take concrete actions to create favorable conditions for further consultations in October.

The agreement was reached in a phone conversation Chinese Vice Premier Liu He, also a member of the Political Bureau of the Communist Party of China Central Committee and chief of the Chinese side of the China-U.S. comprehensive economic dialogue, held upon invitation with U.S. Trade Representative Robert Lighthizer and Treasury Secretary Steven Mnuchin. (Xinhua)

…Extend and pretend. Neither side wants a full-blown trade war. But they are miles away from an agreement.

ASX 200 gravestone

Australian housing prices are falling.

Australia: Housing Prices

Fueled by declining credit growth.

Australia: Housing Credit growth

With falling contribution to GDP growth from dwelling investment, and mining investment shrinking….

Australia: GDP Contribution

GDP growth is expected to weaken further.

Australia: GDP growth

The gravestone candlestick on the ASX 200 weekly chart warns of selling pressure. The primary trend is down and the index unlikely to break through resistance at 6300. Expect a correction to test support at 5650; breach would warn of another decline.

ASX 200

I remain cautious on Australian stocks and hold more than 40% in cash and fixed interest in the Australian Growth portfolio.

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.

Should we Worry that Velocity of Money is plunging?

Some writers have attributed slow GDP growth in the US to the plunging velocity of money.

In layman’s terms, the velocity of money is the ratio between your bank balance and the amount you spend. For the economy as a whole, it is measured as the ratio of GDP (or national income) against the total stock of money (or money supply).

When the economy is hot, consumers have a higher propensity to spend — or invest in the latest hot stock — and the ratio normally rises. When the economy cools, the ratio falls.

If the ratio was fixed, the job of central bankers would be simple: print more money and GDP would rise.

M1 Money Supply and GDP Growth

Unfortunately that is not the case. GDP growth has remained slow, post-2007, despite a sharp boost in the money supply.

M1 is a narrow definition of money: cash in circulation plus travelers checks, demand deposits (at call) and check account balances.

The ratio of GDP to M1 money (or M1 Velocity) has almost halved, from a 2007 high of 10.7 to a current low of 5.5.

M1 Money Supply and GDP Growth

Does this mean that consumers are feverishly stuffing cash into mattresses as the economy goes into a death-dive or is there a more rational explanation?

Examine the above chart more closely and you will see a clear relationship until 1980 between the velocity of money and interest rates (in this case the Fed funds rate). When interest rates rise, the velocity of money rises. So when interest rates fall, as they have post-2007, to near zero, the velocity of money should fall. As it has done.

The anomaly is not the current fall in the velocity of money but the rise in velocity of money between 1990 and 2000, when interest rates were falling. There are two explanations that I can think of. One is the digital revolution, with the advent of online bank accounts and automated clearing of business checking accounts which enabled depositors to minimize balances in non-interest bearing accounts. Second, is the rapid growth of money market funds which fall outside the ambit of M1 and M2.

Velocity of money measured as GDP/MZM gives a clearer picture, with velocity rising when rates rise and falling when rates fall. MZM is M1 plus all savings deposits and money market funds that are redeemable (at par) on demand.

M1 Money Supply and GDP Growth

We should expect to see the velocity of money recover as interest rates rise. If that doesn’t happen, then it will be time to worry.

Strange as it may seem, we could witness something really unusual: if higher interest rates stimulate GDP.