Monday, November 17, 2014

Next Year's Economy (2014)

Follow the Money
The biggest story in the foreign exchange market for 2014 was the strength of the US dollar against most of its trading counterparts. This has been more of a safety play in a world of uncertainty, than as a show of resounding strength in the US economy. We got to see the spillover into the equity market with record stock prices, and in the debt market with uncannily low borrowing rates for the Federal Government. Most of this has been attributed to the Quantitative Easing (QE) program that the Federal Reserve has been operating, though I see a fundamental flaw in that logic with regards to the currency market at least. The Fed has been creating money in the form of bank reserves and even purchasing government and agency debt (in the open market) all in the name of providing liquidity. These actions from a central bank should lead to its currency depreciating, not appreciating as can be observed with the US dollar. In spite of this fundamental conundrum, international speculative capital needs to go somewhere. A very clear example of this is highlighted during the 2008-2009 recession which was global. Though the contagion started in the US, international capital flooded in as uncertainty overtook the global financial markets.

The “crisis” has been over for quite some time now, but the uncertainty still remains. So as the macroeconomic picture suffers a pernicious deterioration in the Eurozone, Japan struggles with using monetary and fiscal policy to reverse demographic shifts, and China’s growth model is becoming inefficient, the paltry growth in real terms seen in the US is once again starting to luster. These trends are sure to continue well into next year as the Trade-Weighted Exchange Value of the US dollar should approach levels seen at the height of the Global Financial Crisis.

On a technical note, the dollar has broken a trend-line set by the two previous recessions [dashed green line], which highlights in my book a break from the secular downtrend it has been in since the effective end of the tech bubble of the 1990s. In a nutshell, a range has been defined [black lines] that the dollar can oscillate between representing little change in global balances of trade and macroeconomic developments. If the dollar breaks through either the upper or lower limits of the range, that would highlight either above average growth in the US relative to its major trading partners, or foreign led growth and a return to the deterioration of US global competitiveness.

Fueling Future Growth
The second biggest story [foreign exchange market or otherwise], for 2014 was the boom in US shale oil and gas production. This a shorter, less complex story but important all the same. Industrial production as a whole, and manufacturing in particular as a share of GDP has been on a steady decline since the 1980s discussed here in a previous post. With the advent and development of hydraulic fracturing (fracking) technology, Oil and Gas companies have gained commercially viable access to vast reserves of US Shale Oil and Gas. As there is a ban on exporting US Oil, supplies are building and helping to lower the overall cost of manufacturing in the US. As the industry is still in its nascent state, growth in production capacity, and even the eventual export of refined and other oil byproducts hold an enormous opportunity for the US economy for both domestic industrial production, and export growth.

This is however, an industry that in the coming half century could enter its death-throws as renewable and eco-friendly technologies are being researched and developed as not only individuals, but corporations and countries are planning for the longer term. Next year should bring more growth and expansion in the extraction, and especially the transportation infrastructure to get the oil and gas out of the ground and to the Gulf of Mexico, where the bulk of US oil refining and processing capacity lies.

What Inflation?
Inflation (or the lack thereof), has been another hotly discussed topic in 2014. I has even discussed consumer behavior with regards to its effects on measured inflation here in a previous post. Looking a measure of Sticky consumer prices, which focuses on the prices that are slow to change over time relative to a changing macroeconomic environment, we observe a clear and persistent downward trend going back to the early 2000s [red lines]. A clear break above the dashed red line would bode well for the US consumer (not initially but over time) as it would put upward pressure on wages and should signify an economy growth at or above its long-term potential, in other words a negative output gap.

The slide however, may be indicative of an even longer term trend of no real wage growth in the US since the 1980s, which was once disguised by the boom times of the 1990s. When the economic tide went out after the dotcom bubble, a much clearer picture started emerging.

Home is Where the Equity Is
The last story of 2014 that I thought was interest, but surprisingly received little to no coverage except for updates to statistical data, was the one of housing prices. As even a loose translation of how the ‘average’ American is faring at this point in the recovery from the Great Recession of 2008 – 2009, the trend in housing prices paints a rather vivid picture.

From the height of the boom in 2006 to the depths of the crisis in 2008 the contraction in prices was mind-boggling. The subsequent surge in investor interest appeared to have the momentum to lift prices back to pre-crisis levels, but instead once to low hanging fruit was bought-up, interest fizzled, and so went the opportunity for many homeowners to see their biggest investment be worth more than they paid for it. And, according to three well-followed measures of house prices, the average growth rates for prices of homes has begun to slow.
The overall trend, when looking back to the year 2000 is downward, highlighted by the red line connecting consecutive peaks. This downward trend may also be representative of the inflation narrative that is finally emerging, and being highlighted by the world focus on the dual mandate of the Federal Reserve. Without much in the way of wage growth, and in the midst of a deleveraging cycle, along with a drop in New Household Formation (kids leaving home), it's hard to see a fundamental reason for house prices to sustainably continue much higher. One bright spot, however, is that the bulk of distressed real estate have been acquired with cash so private debt levels do not play as much of a pivotal role as it once did.

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