Quarterly CPI fell to 4.1% for the 12 months to December, while the trimmed mean is not far behind at 4.2%.
Household rent increases remain strong, however, boosted by a surge in immigration.
Inflation, apart from rents is generally falling as the economy slows. But the RBA is unlikely to cut rates soon unless we see a sharp contraction in household consumption.
What economic path are the US and major allies likely to take over the next decade? Here is my take on how this is likely to pan out.
First, let’s start with a template of what a healthy, growing economy looks like.
Growth is dependent on two factors:
Growth requires not only a growing population but a growing workforce. An ageing population or large population under the age of 25 is unlikely to contribute much to output. What is needed are people of 25 to 55 who hold down productive jobs. We also need to ensure that they have the necessary skills — productivity tends to rise with education levels. Education that is skills-based is worth a lot more than a barista with a bachelors degree.
The most important source of productivity growth, however, is investment. More specifically, private investment — government investment tends to provide a short-term boost to the economy but acts as a long-term drag on growth (Dr Lacy Hunt). Mechanization and automation increase the output per worker, boosting productivity.
The chart below shows US private domestic non-residential investment (blue) at a healthy 13.5% of GDP, while productivity (magenta), calculated as real GDP/total non-farm employees, has grown steadily since the 1950s.
Savings are needed to fund private investment. Either domestic savings or offshore borrowings. Domestic savings are better than foreign debt, especially if debt is denominated in a second currency which can cause volatile short-term capital flows. Workers tend to consume what they earn, with low rates of savings, while the wealthy tend to have far higher savings rates. High levels of inequality increases the amount of saving but depresses consumption. Low consumption leads to fewer investment opportunities, so it is important to get the balance right. Forcing workers to save (e.g. through compulsory superannuation) is one solution.
Low deficits are essential to ensure that government borrowing does not crowd out private investment. Government investment — as we mentioned earlier — is no substitute for private investment as it leads to low productivity and low growth.
Monetary policy is often used to prime the pump — stimulating consumption and investment through low interest rates. But cheap debt has short-term benefits and long-term costs that are often not carefully considered. First, low interest rates discourage private savings which are the lifeblood of a healthy economy. Second, low interest rates are effected by the Fed (or central bank) growing the supply of money at a faster rate than output (GDP). But that causes inflation after a lag of one to two years, forcing the Fed to contract the supply of money and destabilize growth. Third, cheap debt and high inflation (with negative real interest rates) encourage malinvestment in speculative assets that are expected to grow in price without necessarily growing output. The net result is that productive investment is crowded out by both malinvestment (speculation) and government deficits, harming long-term growth.
There is also a fourth, far more insidious factor, that operates with much greater lags. Home prices tend to grow at a much faster rate than incomes during times of low interest rates, reducing access to homes by younger workers entering the workforce. New household formation slows and so does the birth rate, undermining long-term demographics. This can be remedied to some extent by skilled immigration but often migrants are unskilled and face both language and cultural challenges that lead to poor assimilation and a two-tier economy.
In summary, what is needed is a growing, skilled workforce with rising productivity from healthy private investment. Private investment requires stable growth — to facilitate reliable projections rather than unstable boom-bust cycles — and sufficient funding from private saving. Government deficits need to be kept low and real interest rates reasonably high (say 3%) to ensure low inflation and encourage efficient allocation of capital (to productive private investment).
We are a long way from the above ideal.
The chart below shows the decline in 10-year average real GDP growth, since 1960, and rising debt relative to nominal GDP.
Growth is slowing due to poor demographics, rising government deficits, and malinvestment from negative real interest rates. Geopolitical tensions and the need to secure supply chains and sources of energy mean that government spending is likely to exceed tax revenues by a wide margin for the foreseeable future.
Ballooning government debt is likely to crowd out private investment, ensuring low future growth. The chart below shows CBO projections of debt-to-GDP for the next thirty years.
The Fed will likely have no choice but to suppress long-term interest rates in order to assist government in servicing the massive interest burden on its debt. That is likely to lead to high inflation, negative real interest rates, malinvestment in speculative assets, low growth, and rising instability (Hyman Minsky).
We are likely to face a decade of stagflation, with low growth, high inflation and unstable financial markets.
Hopefully, inflation will boost nominal GDP relative to government debt, increasing serviceability, over time. That would provide an opportunity to reduce fiscal deficits and establish healthy monetary policy.
In the meantime, don’t fight the Fed. When interest rates are low and inflation is high, invest in real assets. Look for value — with stable income streams which can withstand tempestuous cycles — rather than speculative growth.
Professor Percy Allan, University of Technology Sydney: Looking Beyond 2024
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.
Both are right, just in different time frames.
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.
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.
In the housing market, prices rise as cheap mortgage finance attracts buyers, pushing up demand and facilitating greater leverage.
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.
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.
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.
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.
Jim Bianco from Bianco Research:
“The problem the stock market has in 2021 is by most standard metrics (P/E, Market Cap/GDP, etc.) it’s overvalued. Now a lot of people expect it to stay that way for another year. If we don’t get inflation, that can actually happen and you could actually have the market stay at these elevated levels. But if you do get rising interest rates on inflation……that will frip earnings, make mortgage rates go up and lift interest rates. That has historically not been good for risk assets….”
The problem if we don’t get inflation will be far worse. MMT theorists will take this as validation and we are likely to see more calls for far higher stimulus checks. Why not $200,000 stimulus checks someone on Twitter asked. The bubble will keep expanding without any visible effect …..until it bursts.
The Fed did a sharp about-turn on interest rates this week: a majority of FOMC members now expect no rate increases this year. Long-term treasury yields are falling, with the 10-Year breaking support at 2.55/2.60 percent. Expect a test of 2.0%.
While the initial reaction of stocks was typically bullish, the S&P 500 Volatility Index (21-day) turned up above 1.0%, indicating risk remains elevated.
The reason for the Fed reversal — anticipated lower growth rates — is also likely to weigh on the market.
Stocks are already over-priced, with an S&P 500 earnings multiple of 21.26, well above the October 1929 and 1987 peaks. With earnings growth expected to soften, there is little to justify current prices.
The current rally is largely driven by stock buybacks ($286 billion YTD) which dwarf the paltry inflow from ETF investors into US equities ($18 billion YTD). We are also now entering the 4 to 6-week blackout period, prior to earnings releases, when stock repurchases are expected to dip.
Why do corporations continue to repurchase stock at high prices? Warren Buffett recently reminded investors that buybacks at above a stock’s intrinsic (fair) value erode shareholder wealth. If we look at the S&P 500 in the period 2004 to 2008, it is clear that corporations get carried away with stock buybacks during a boom and only cease when the market crashes. They support their stock price in the good times, then abandon it when the market falls.
source: S&P Dow Jones Indices
Shareholders would benefit if corporations did the exact opposite: refrain from buying stock during the boom, when valuations are high, and then pile into the stock when the market crashes and prices are low. Why doesn’t that happen?
The culprit is typically low interest rates. It is hard for management to resist when stock returns are more than double the cost of debt. Buybacks are an easy way of boosting stock performance (and executive bonuses).
Corporations are using every available cent to buy back stock. Dividends plus buybacks [purple line below] exceed reported earnings [green] in most quarters over the last five years.
That means that capital expenditure and acquisitions were funded either with new stock issues or, more likely, with debt.
Corporate debt has been growing as a percentage of GDP since the 1980s. The pace of debt growth slowed since 2017 (shown by a down-turn in the debt/GDP ratio) but continues to increase in nominal terms.
Low interest rates mean that stock buybacks are likely to continue — unless there is a fall in earnings. If earnings fall, buybacks shrink. Declining earnings mean there is less available cash flow to buy back stock and corporations become far more circumspect about using debt.
S&P forecasts that earnings will rise through 2019.
But forecasts can change. Expected year-on-year earnings growth for the March 2019 quarter has been revised down to 3.5%. Forecasts for June and September remain at 12.0% and 11.4% (YoY growth) respectively.
If nominal GDP continues to grow at around 5% (5.34% in Q4 2018) and the S&P 500 buyback yield increases to 3.0% (2.93% at Q3 2019 according to Yardeni Research) then earnings growth, by my calculation* should fall to around 8.2%.
*1.05/0.97 -1.
With an expected dividend yield of 2%, investors in the S&P 500 can expect a return of just over 10% p.a. (dividend yield plus growth).
But the Fed now expects growth rates to fall by about 1.1% in 2019 and 1.2% in 2020, which should bring investor returns down to around 9% p.a. Not a lot to get excited about.
I knew something was wrong somewhere, but I couldn’t spot it exactly. But if something was coming and I didn’t know where from, I couldn’t be on my guard against it. That being the case I’d better be out of the market.
~ Jesse Livermore
From Bob Doll at Nuveen Investments. His weekly top themes:
1. We think the odds of a U.S. recession are low, but we also believe growth will remain soft for a couple of quarters. U.S. growth may bottom in the first half of 2019 following a relatively disappointing fourth quarter and the recent government shutdown. We expect growth will improve in the second half of the year.
Agreed, though growth is likely to remain soft for an extended period. The Philadelphia Fed Leading Index is easing but remains healthy at above 1.0% (December 2018).
2. Inflation remains low, but upward pressure is mounting. With unemployment under 4% and average hourly earnings rising to an annual 3.6% level, we may start to see prices rise. So far, better productivity growth has kept the lid on prices, but this trend bears watching.
Agreed. Average hourly earnings are rising and inflation may follow.
3. Trade issues remain a wildcard. The U.S./China trade dispute appears to be making progress, but the timeline is slipping and significant disagreement remains over tariff levels and intellectual property protections.
This is the dominant issue facing global markets. Call me skeptical but I don’t see a happy resolution. There is too much at stake for both parties. Expect a drawn out conflict over the next two decades.
4. We do not expect Brexit to cause widespread market issues. We think the risk of a hard Brexit is low, since no one wants to see that outcome. Some sort of soft separation or even a Brexit vote redo appears more likely.
Agreed. Hard Brexit is unlikely. Soft separation is likely, while no Brexit is most unlikely.
5. The health care sector may remain under pressure due to political rhetoric. Health care stocks in general, and managed care companies in particular, have struggled in light of talk about ending private health care coverage. We think Congress lacks the votes to enact such legislation. But this issue, as well as drug pricing policies, are likely to remain at the center of the political dialogue through the 2020 elections.
Health care is a political football and may take longer to resolve than the trade war with China.
6. Downward earnings revisions may present the largest risk for stocks. As recently as September 30, expectations for first quarter earnings growth were +7%. That slipped to +4% by January 1 and has since fallen to -3%.
A sharp fall in earnings would most likely spring from a steep rise in interest rates if the Fed had to combat rising inflation. That doesn’t seem imminent despite rising average hourly earnings. The Fed is maintaining money supply growth at close to 5.0%, around the same level as nominal GDP, keeping a lid on inflationary pressures.
7. Equity returns may be modest over the next decade compared to the last. Since the bull market began 10 years ago, U.S. stocks have appreciated over 400%. It’s nearly impossible to imagine that pace will be met again, but we feel confident that stocks will outperform Treasuries and cash over the next 10 years.
Expect modest returns on stocks, low interest rates, and low returns on bonds and cash.
First, the good news from the RBA chart pack.
Exports continue to climb, especially in the Resources sector. Manufacturing is the only flat spot.
Business investment remains weak and is likely to impact on long-term growth in both profits and wages.
The decline is particularly steep in the Manufacturing sector and not just in Mining.
But government investment in infrastructure has cushioned the blow.
Profits in the non-financial sector remain low, apart from mining which has benefited from strong export demand.
Job vacancies are rising which should be good news for wage rates. But this also means higher inflation and, down the line, higher interest rates.
The housing and financial sector is our Achilles heel, with household debt climbing a wall of worry.
House prices are shrinking despite record low interest rates.
Broad money and credit growth are slowing, warning of a contraction.
Bank profits remain strong.
But capital ratios are low, with the bulk of profits distributed to shareholders as dividends. The ratios below are calculated on risk-weighted assets. Raw leverage ratios are a lot weaker.
One of the primary accelerants of the housing bubble and household debt has been $900 billion of offshore borrowings by domestic banks. The chickens are coming home to roost, with bank funding costs rising as the Fed hikes interest rates. In the last four months the 90-day bank bill swap rate (BBSW) jumped 34.5 basis points.
The banks face a tough choice: pass on higher interest rates to mortgage borrowers or accept narrower margins and a profit squeeze. With an estimated 30 percent of households already suffering from mortgage stress, any interest rate hikes will impact on both housing prices and delinquency rates.
I continue to avoid exposure to banks, particularly hybrids where many investors do not understand the risks.
I also remain cautious on mining because of a potential slow-down in China, with declining growth in investment and in retail sales.
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.
Personal savings are low.
And credit growth is modest.
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.
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.
A quick snapshot from the latest RBA chart pack.
Manufacturing is holding its head above water (50 on the PMI chart) and industrial production shows a small upturn but investment growth is falling, as in many global economies including the US and Australia. Retail sales growth has declined but remains healthy at 10% a year.
Electricity generation continues to climb but steel, cement and plate glass production all warn that real estate and infrastructure development are slowing.
Interest rates remain accommodative.
Real estate price growth is slowing but remains an unhealthy 10% a year. Real estate development investment rallied in response to lower interest rates but is clearly in a long-term decline.
There are no signs of an economy in immediate trouble but there are indications that the real estate and infrastructure boom may be ending. Through a combination of fiscal stimulus and accommodative monetary policy the Chinese have managed to stave off a capitalism-style correction. But failure to clear some of the excesses of the past decade will mean that the inevitable correction, when it does come, is likely to display familiar Asian severity (Japan 1992, Asian Crisis 1997).
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