Who's Buying?

For all the not-so-good economic news that is streaming out of most developed, and some developing economies, the news out of the US is interestingly upbeat. The same economy that just lead the world into and out of a Global Financial Crisis, is now the measure of growth amoung its peers. Inflation is below the Fed’s long-term target, and the unemployment rate is within range of what is considered full employment. In addition, the Federal government can borrow for long periods at relatively low rates, and stock market indexes are at record highs. But looking closer, there appears to be several details of this rosey picture that do not align with the overall sentiment.  

 

Retail Sales is an interesting starting  point. Since 2011, the year-over rate of growth in Retail Sales [in both the broad and adjusted sence] has been slowing. This trend represents a period of restraint on the part of the US consumer, typically seen leading up to a recession as illustrated by U.S. Census Bureau data. The outcome of this slowdown in retail sales growth may not necessarily be an outright recession because most measures of consumer sentiment are at levels not seen since the run-up to the 2008 – 2009 recession. What this slowdown, in retail sales, may be signaling is an overshoot from the momentum of the recovery to a level above the a new [lower] equilibrium, and its inevitable correction. All the same, a lower equilibrium level for retail sales growth would ultimately mean  subdued demand behind consumer spending. However, this does not lineup with the strong growth picture being painted by the labor market and other measures of economic progress.

The QE Effect: US vs EU

Whether faced with deflation, or economic malaise, or recession, central banks around the world are turning to Quantitative Easing (QE) to solve issues to which normal monetary policy would otherwise be the solution. The most recent to embark on the journey down the rabbit hole is the European Central Bank (ECB). However, due to structural differences in how the financial system intertwines with households and corporations in the US vis-a-vis the EU, the outcomes of similar monetary policy approaches will be inherently different.

In the US, corporations tend to tap the financial markets directly for funding via debt and equity issuances, which allow them more direct access to and benefit from new money created by the Federal Reserve. In the European Union (EU), on the other hand, corporations tend to tap the banking system for funding, which in-turn taps the financial markets. That additional step lets the banks in the EU play an even greater role in transmitting monetary policy into the real economy. In the US, the inflationary effects of QE were nullified by the banks, as the new money created by the Fed never left the Fed. The banks simply held the new money from the Fed on deposit at the Fed, and continue to collect the interest on it. Capital that wasn't held as reserves was invested in short-term market securities and equities. The Federal Open Market Committee (FOMC) is not agile enough to calm jittery financial markets and deal with run-away inflation simultaneously, so it worked out in their favor that the only price increases were in the financial markets, which are the beneficiaries of lowered funding costs.

If the banks in the EU do what banks around the developed world have done when new money is created and made available by their central banks, they will simply pad their balance sheets with cash and securities. This is fine if the issue is with the quality of assets held by the banks; but, when the issue is a lack of credit creation through loans, this is counterproductive.

European QE will amount to the ECB refinancing sovereign debt across the continent via the commercial banks, since banks can post government debt as collateral for cheap money from the central bank. Because of almost no opportunity cost due to a lack of inflation and current nominal interest rate levels, banks can invest in market securities whose prices will be supported by the ECB's QE policy. At this point consumer and business loans are not very appealing to the banks, as the viability of those loans is tied to underlying macro-economic performance, which has been lackluster of late. Instead, based on the design of the EU monetary transmission mechanism, this type of monetary policy could lead to a lowering of borrowing costs for banks and sovereigns and as a by-product, rising equity markets. The one thing that might be conspicuously absent is inflation; with QE from most other central banks, monetary policy at the zero lower-bound is very inefficient at generating inflation as wages remain outside of the sphere of influence.

Commodities Lead and the Dollar Follows

The US dollar (in broad trade-terms) has been acting weird lately, and by lately I mean since early 2011. Going back to the turn of the millennium (15 years ago), the tech bubble burst and there was a lot of speculative money that found itself without a purpose. Going back even further, the US focal shift from manufacturing to tech-based services during the 1980s and 1990s, saw raw materials ignored for computer-based research, development, and production as an investment theme. Speculative investment capital flowed in particular out of commodities and commodity exporting currencies.

The 20-year trend officially reversed in 2002, aided by the Fed's easy monetary policy in response to the recession associated with the September 11th attach. The liquidity made available by the Federal Reserve system accomplished two things; the housing market inflated with speculative capital flows, and globalization-driven growth in emerging and developing markets attracted dollar denominated investment flows. As dollars got to their foreign destinations, they had to be sold to acquire local currency. The foreign-financed growth fueled new demand for raw materials, and supported commodity prices and commodity exporting currencies.

 

 



From 2002 through to 2008, commodity prices trended higher as the dollar trended lower, representing an expanding appetite for risk by international investors. Then the Global Financial Crisis hit, and the reflex reaction of investors around the world was to find safety at all costs. Almost all risk-assets saw a tumble in prices, as short-term US-government debt was bought en masse for its apparent safety and liquidity. Commodity prices, not to be excluded, also fell. Once the financial markets stabilized in 2009 with a monetary commitment from the Fed and other central banks, the trends seen in commodity prices and the dollar from 2002 resumed.

In April of 2011 (as reported by the Federal Reserve Bank of Atlanta), commodity prices peaked. At that point it was becoming clear to investors that the long-term trajectory of global growth was shifting lower, and the demand for raw materials would be depressed, at least for the immediate future. The Fed however, did not incorporate this view into monetary policy until later the following year, when they announced the third round of quantitative easing. This was viewed as final confirmation that slower global growth would hamper the US recovery, and by virtue, perpetuate slower global growth, and so the dollar once again started appreciating as commodity prices continued to slide.

The relationship between the US dollar and commodity prices has been, and continues to drive macro cycles in the global economy. From a fundamental basis, the dollar's appreciation is driven by uncertainty. As the customer of first and last resort, global economic strength and stability resides with the United States. Yet, the US depends just as much on its trading partners for growth as they do on the US. In this age of uncertainty, one thing is fairly certain; the global economy is underperforming its long-term potential. So while everyone waits for a new (lower) equilibrium to be reached, from which point the global growth outlook can improve, the US dollar will remain the safest bet.

Infrastructure and Taxes: Who should have to pay?

According to the November 10th 2014 edition of the Federal Reserve Bank of San Francisco's Economic Letter, the Federal Open Market Committee (FOMC), the Congressional Budget Office (CBO), and Blue-Chip Forecasters have all been lowering their projections for long-term GDP growth following the Great Recession. The Economic Letter cites, "The aging of the labor force, weak productivity growth, and possible long-run supply-side damage from the Great Recession have all suggested recently that the potential growth rate of the US economy may be lower in the years ahead." At this point I digress from the subject content of the Economic Letter, as it proceeds to explain conclusions about the possible links between lower output growth and lower short-term real interest rates. I have decided instead, to focus on a few implications of lower potential growth on the looming infrastructure needs of the United States.


If it was not for the obvious question, how would the mammoth price of a full upgrade, and in some cases rethinking of the current infrastructure layout that exists, the failing US transportation and energy infrastructure would have already been replaced. Left up to the states, the cost would be covered from a patchwork increase in taxes. But, left up to the Federal government, the cost would be covered by borrowing vast amounts of money.


Letting the costs of upgrading the public infrastructure fall on the states would mean the total costs of the improvements must be squared away from the onset. Any given state would either find a way to raise the revenue, or collateralize debt with future tax revenues. This approach lets [for the most part] the people that utilize the infrastructure bare the bulk of the burden of financing it.  States will also have the opportunity to exploit, in some cases, regional disparities in customizing their revenue generating approaches. For the most part, the costs will be distributed in concentration with need and urgency.


The Federal government on the other hand will follow the path of least resistance, and borrow. The administration of federal infrastructure spending as it would be a monolithic project if done right, would also be a bureaucratic mess. Costs would become overblown, and inefficiency would be abound. Costs for the most part will be spread disproportionately evenly, as both Federal government borrowing or hopefully tax policy change will apply universally, instead of in concentration with need and urgency.


It doesn't really matter how you slice it, in order for a comprehensive upgrade of the US transportation and energy infrastructure to be undertaken by any level of government, tax revenues would need to be raised and/or spending levels reduced. This feat would be much easier to accomplish when the economy is growing and profit generating activities can be taxed. During growth and expansionary times, as the income prospects of households and individuals improve, higher taxes are more easily accommodated. Without the rising tide of accelerating growth to lift all boats, it is hard to see how government [especially at the federal level] would be able to sustainably fund large spending projects.


The states in this instance, seem to be better capable in terms of experience and fiscal constraints to administrate infrastructure upgrading and replacement spending. Wherever need and urgency are disproportionately high, the Federal government can use expansionary fiscal policy to subsidize funding. This approach allows for some fiscal restraint due to the structure of the state finance model, while the Federal government plays a smaller role as a funding backstop. The objective here being to upgrade the nation's energy and transportation infrastructure, while not exacerbating the already horrendous fiscal position of the Federal government.

Greater Expectations

What Did You Expect?

The lack of inflation in the US economy, and by extent the rest of the developed world has been [and still is] one of the most discussed topics in macroeconomics of recent. The timing of the macroeconomic pendulum swinging from a period of high inflation to one of low inflation, is more interesting relative to the Global Financial Crisis, than is the fact that the economy is growing slowly, and inflation is low. The labor market is transforming to facilitate a different "take" on an adult working life, that will come to dominate as Baby Boomers exit stage left, and millennials take the reins to the US economy.

As the demographics of consumption change, the Baby Boomers, who came of age at a time when inflation was growing, built expectations of rising inflation that carried them through to the early 1980s. At which point, Congress deemed inflation to be worth the full-time attention of the Federal Reserve System. And so, for the last 30 plus years, the Fed has been actively targeting inflation expectations. They have been working on building credibility for their policies and policy targets. Now it seems their efforts have been rewarded with the macroeconomic reality of today being in-line with the long-held expectations they have been cultivating, unintended consequences included.

 

Another point of interest has been the amount of inflation risk premium demanded by investors. Inflation risk premium has been fairly flat for the duration of the Fed's inflation targeting. This indicates that market participants have placed a high degree of confidence in the Fed's ability to actively manage inflation over the long-term.

 

While the US economy has been shifting focus from manufacturing to services, from about the same time the Fed received its dual mandate, real interest rates have been on the decline. The services sector, tending to be more capital intensive relative to manufacturing, attracted investment capital from around the world, as represented by the Trade Weighted U.S. Dollar Index: Broad.

 



 

Interestingly, the upward trend in the dollar that prevailed during the 1980s and through to the 1990s, reversed in proximity with the bursting of the dot-com bubble and the introduction of the euro currency at the turn of the millennium.

 

Effectively, global speculative capital 1) saw an apparent end to the US tech dominance, and 2) had a seemingly viable dollar alternative in the newly minted euro currency. Simultaneously, emerging market economies started becoming developing economies on the back of globalization accelerated by the telecommunications infrastructure that spawned from the dot-com bubble. Investors worldwide had credible (some more so than others) alternatives to investing in the US economy when seeking sensible capital appreciation.

 

Meanwhile, in the US, the investment capital that was not diverted outward found its way into the real estate market. When that investment reached critical mass, money moved into energy commodities and some softs. When that investment reached critical mass, and the money markets were in disarray, money moved into gold out of fear.

 

 

 

The Fed Effect

 

Monetary policy that supports positive inflationary pressures in the face of falling nominal interest rates will drive down real interest rates (rates of return) down.

 

Since the early 1980s, as actual inflation fell in line with expected inflation, the FOMC managed its interest rate targets lower, taking market rates with them. Through times of economic uncertainty and financial instability, the Fed followed conventional monetary policy and lowered short-term interest rates to provide liquidity. Any additional liquidity however, provided by the Fed is supportive of positive inflationary pressures in the short-term, which counteracts with long-term expectations of falling inflation.

 

 



Looking at real interest rates going back to the early 1980s, there have been brief periods, usually coinciding with a recession, in which real interest rates where actually negative. By contrast, the last two recessions have seen real interest rates go negative for longer and longer periods of time. Since the Global Financial Crisis and the ensuing recession of 2008 - 2009, real interest rates have spent only a few brief periods positive, compared to the majority of the time being spent negative.

 

This has many fundamental implications for investors, as they tend to hold assets over time, their financial assets are losing value in real terms. This is conducive to an environment where the financial markets place a premium on liquidity.

 

Both US equities and debt appear to be over-priced at current levels, when compared to the real macroeconomic environment. Due in part to banks choosing to hold liquid assets in the form of financial securities, instead of making loans and extending credit out of precaution from uncertainty

and negative real interest rates. As long as an air of uncertainty persists, equity and bond markets will be buoyed by the liquidity preference in the banking system.

 

On the flipside, it's a borrower's market. With the amount of liquidity being created by near-universal easy monetary policy, corporations and governments have a rare opportunity to borrow vast amounts of money for long periods of time, and take comfort in knowing that they're getting a deal.

 

 

 

What to Expect When You're Expecting

 

Looking forward, the Fed now has to get inflation expectations and eventually inflation up to and above their current 2% target, after thirty-plus years of trying to push it lower. Looking at the evolution of an Expected Inflation Yield Curve, market participants do not seem to expect inflation to be back at or above the Fed's current 2% target for another ten-plus years.

 



 

From the position of the banking system, until inflation increases due to sustainable economic growth and expansion, the liquidity and market depth of simple stocks and bonds will remain appealing. The banking system plays a pivotal role in ensuring that any inflation that manifests is based on real world supply-demand shifts and not monetarist accounting. The liquidity preference substitutes market securities for loans, and so diminishes the fractional reserve banking system's ability to get money into the hands (or accounts) of everyday people. Instead, the banking system is expanding on its ability to get money into the hands (or accounts) of corporations and governments via the financial markets.

Deflation, or Something to that Effect

The Age of Uncertainty

Deflation: a fall in the general price level or a contraction of credit and available money. This is the simple definition provided by Dictionary.com; from there it only gets more complicated.

In one form or another, from Asia, to Europe, and on to the Americas, the specter of deflation is present. Usually, in order for general price levels to fall, there also needs to be a drop in wages. Workers earn less relative to before, so they spend less relative to before, which puts downward pressures on prices. During the boom times leading up to the Great Recession, low wage growth was offset by borrowing. The borrowed money was consumed, and put upward pressure on prices, which resulted in inflation, and hence more production to capitalize on higher prices.

Now, in the age of uncertainty, driven by household deleveraging (in developed economies at least), borrowed money is not being used to offset low wage growth. Household consumption is therefore subdued, producing very little inflationary pressure on prices.

 

 

Another driver of inflationary pressures which is no longer present in the global macro environment is government spending. Again, in the boom times leading up to the Great Recession, governments around the world competed to attract multinational business by lowering tax rates, while in most cases increasing the services that they offered, with shortfalls being covered with borrowed money.

But, in the age of uncertainty, the fiscal sustainability of many governments is being questioned. In many cases fiscal consolidation, and even austerity programs are being pursued. Services are being watered down, reduced, or cut all together. The next step in the fiscal consolidation march is to start raising tax rates.

The third leg in the borrow-and-spend trifecta are corporations. Of the three, they tend to be the most logical, and in many cases realistic with spending borrowed money. In the boom times leading up to the Great Recession, corporations invested in expanding capacity and territory to capitalize on global economic growth, as well as reshuffling addresses to capitalize on competing tax regions.

Post crisis, in the age of uncertainty, corporations have been spending 10s of billions at a time. But at this point the spending is more defensive in nature. Mergers and Acquisitions have been occurring in record numbers and with record price tags. Money is being spent to combine efforts and abilities instead of in outright competition. This has the overall effect of putting upward pressures on equity prices, but not much else, and of course synergies reduce the need for as much labor.

 

Who Really Benefits?

With easy monetary policy being the prevailing trend around the world, the idea being to entice households in particular to borrow more and spend to stimulate growth. But, since the bursting of the dotcom bubble, households around the world had ramped up borrowing to unsustainable levels, in tune with governments. The households, governments and even some corporations that were over-leveraged have been foreclosed, bailed out, or bankrupted in that order (with a few exceptions). Since then the macro environment has had an air of debt aversion, especially among households, as they are the last to receive assistance in times of crisis. 

 

Governments have been an obvious benefactor of the easy monetary policy trend, as the use of their debt instruments as collateral for central bank lending has helped to keep borrowing costs low.

 

The search for yield resulting from the low returns on government debt has spilled over into the corporate debt market, allowing corporations to borrow at relatively lower rates as well to fund the rash of Mergers and Acquisition transactions in recent years.

Households have seen their main source of collateral; real estate, struggle to regain values lost during the Great Recession. Uncertainty in the labor markets have receded from crisis levels, but a residual uncertainty still remains as corporate employers and governments continue to consolidate in one form or another. Debt also has to be repaid with money that is worth a little more in the now low-inflation environment, than when it was borrowed during the previous higher-inflation environment.

By the time households have paid down their debt (or GDP has caught up) to levels that allow a reintroduction of an appetite for more (hopefully sustainable) borrowing, it would be time to start tightening monetary policy. Governments would have had the opportunity to refinance mountains of debt at lower rates, corporations would have had the opportunity to strategically invest for competing in a low growth environment, and household would get to borrow again at higher rates. Hopefully, and I do mean hopefully on top of higher tax rates to hasten the fiscal healing that is needed in most (if not all) developed economies. 

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.