The rise of the internet retail GIANTS, terra retail property value and future cash flows.

I have not blogged for a while.  Why?  A number of large projects for one that required immersion, but more simply that while there was a lot of noise, the fundamentals had not changed with respect to two key areas of interest.  The first that of investor protection concerns in Canada, the second, that of economic, market and financial imbalances in the global economy.

As far as investor advocacy is concerned, no change here: the CSA has stalled and more or less reversed course on two major initiatives, getting rid of mutual fund commissions and the move to best interest standards.  The move towards upgrading a transaction led retail financial services framework, with minimal change to industry accountability, continues unabated; there is still no recognition of the fundamental responsibilities surrounding the provision of personalised investment advice in Canada (within the advisory sphere), even within the new targeted reforms and so called proposed “best interests standards”, and vested interests and regulatory infighting are stymieing any possibilities of change. 

With respect to global financial, market and economic imbalances, again, no real fundamental change here: we remain in a deeply unsettling paradigm of low growth dynamics supported by debt and asset focused monetary excess; the marginal dynamic in the US is that of rewind vis a vis monetary excess, which will be destabilising.

There is however one dynamic that I would like to shine a light on: this is the hollowing out of the terra retail space by the likes of Amazon and the move by shareholder activists in a number of companies to ditch the business and sell the real estate.

The rise in income inequality and debt to help finance the growth deficit has led to lower interest rates, numerous financial crisis and a focus on asset price support by central banks.  The asset price focus has raised real estate prices which has increased the attractiveness of selling retail properties relative to present values of terra retail profits.   The rise in property prices has also increased the costs of terra retailing, increasing the attractiveness of remote online sales.   The pressure on salaries and ultimately on operating margins by this dynamic risks further exacerbating income inequalities etc.

To me the cycle is one of concern:

Rising inequality forces an increase in debt.

Rise in debt increases sensitivity of economy to interest rates.

A rise in interest rates leads to financial and economic crisis, imperilling financial system.

Financial system supported via low interest rates and asset focused money supply without addressing income inequality dynamics.

Asset prices rise, present values of economic flows decline, income growth dynamics remain weak force move to lower costs and lower prices.

High asset prices, cost competitive imperatives forces retail to move out of terra, selling assets attractive.

Retail property turned into residential real estate for investors/higher net worth individuals.

Loss of service jobs further weaken consumption dynamics, increase reliance on low interest rates and asset price support.

Go figure!

We have lost sight of the fact that system design is critical to what you do within it.  I see little or no evidence of any awareness of the overall system we are meant to be working towards.  

Debt and wealth in a monetary system, part 2: discounted valuation issues in a declining frame with inequalities.

We are presently building up conflicts within the asset price frame:

  • Conflicts between asset values and GDP flows and their growth rates;
  • Between asset prices and return expectations;
  • Between human capital values and the distribution of those values and their impact on the overall wealth equation with respect to future consumption risks as well as asset pricing via increased asset focus of flows due to distribution dynamics;
  • Within portfolio structure and relative to the liquidity and capital security dynamics of liability streams. 

All of this tied to the relationship between frame transitions, emergent properties and structural imbalances and unconventional monetary policy focused overly on asset price support.

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Perspectives on US New Manufacturing Order data:

Key takeaways:

  • The frame should dominate analysis of new order fundamentals: long term weakness dominates.
  • The new order bounce back in March/April was led by the transportation sector (MVPs in particular), but the bounce back should be set against the depth of the declines.
  • Outside transportation the trend is very weak.
  • Consumer durable goods orders on a smoothed 6 monthly basis have weakened noticeably since the start of the year.

Commentators are increasingly concerned about the risk of a recession in the US Economy.  Recessions are typically short term step backs/retracements within expanding frames whereas we are in a rather complicated contracting one the one hand (developed economies) and transitioning frame (developing economies moving from investment dependence to consumption/service sector dependence) on the other characterised by excessive debt levels, unconventional monetary policy and increasing income inequality to name but a few fundamental issues. 

So let us look at US manufacturing new order data, at first in terms of the frame, which bounced back on a monthly basis in April:

The frame

We can see from the following chart that annualised real growth rates over rolling 10 year time frames (using new order data adjusted for PPI and smoothed) have been heading downwards since the start of the decade.  The real annualised rate of growth over rolling 10 year time frames shows that the current cycle is much weaker than the pre 2008 cycle.

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We can see the step down in growth more easily if we just view the high water mark dynamics (which ignores the current index level if it remains below the HWM).

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In reality given the declines in flows since 2014, new orders for manufacturing adjusted for the PPI stand below levels reached at the end of the 1990s, and yet, here we are all worried about the risk of recession when the risk of something far greater has already occurred.  Tied into the frame is the key dynamic of global rebalancing: cheap labour in emerging/developing economies had offshored a significant amount of manufacturing output from the late 1990s onwards (the weak order data partly reflects this) and the expected maturing of developing economies consumers and rising wage costs was anticipated by many to create a rebalancing of global economies.  This is presently at risk a) due to the time frame of transition being longer than many expect and b) given that technology is driving out labour in key industries.

And in the next chart we see nominal annualised rates for new orders over rolling 10 year time frames: clearly the structure and balance and dynamics of the US economy and the attendant global economic dynamics are unable to support the type of growth the economy had experienced in post WWII years.  The primary issue we are facing today is not one of a prospective recession but of a weakening frame:

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A few thoughts on “Rise of the Robots”, risks to global rebalancing and much more

Foxconn replaces ’60,000 factory workers with robots’” was a recent headline in a BBC news report, and of course many other stories.

The global rebalancing story goes as follows: developed economies offshore production of goods in cheap labour emerging markets with strong growth prospects, benefiting from cheaper labour and also entrance into consumer markets with vast potential.  Developed economies experience declines in wage growth as manufacturing declines and service sector expands in relative terms, interest rates are lowered and consumer credit growth stimulated.   Lower cost goods and low interest rates cushion the impact of lower wage growth but the economy moves out of balance, towards consumption and debt (increasingly asset focussed) and away from production and investment.  

Ultimately this story depended on developing markets maturing their own consumer stories and wage growth/currencies rising to erase or at least obfuscate wage price differentials.  This rebalancing of developing economies to consumption and away from manufacturing/investment would have created demand for goods, services and expertise of developed economies, rebalancing GDP away from consumption and towards production and investment, raising wages and reducing dependence on credit for consumption with interest rates slowly re-ascending.

The story about Foxxconn factory workers being replaced with robots takes away important marginal flows from the rebalancing equation and reemphasises emergent income distribution inequalities: less income to labour, more to capital; reduced consumer expenditure growth to rebalance growth in developing/developed areas; greater stress on high debt levels accumulated in both areas, debt levels used to finance consumption in one and infrastructure and manufacturing in the other.  And of course, all the attendant asset price issues that have arisen as a result of low interest, financial shocks, asset price support and other unconventional monetary policy actions.

Technology is a good thing and we should always be striving to produce more efficiently and effectively and part of the move to robots in these developing markets is the reallocation of labour capital across the broader economy and the need to produce ever more goods for growing demand in many of these vast economies. 

But the separation of income flows, or at least higher growth higher value income flows to labour, is a disconcerting one and especially so given the ongoing deceleration of global economic growth and asset price divergence.  This not only accentuates the trend towards increasing income inequality and therefore damages the eco system’s ability to regenerate demand (and support asset prices), increasing reliance on loan growth (and hence debt support), but it also risks prevent a more rigorous and necessary rebalancing of growth between developing and developed that would have re-established the balance of power between labour capital and financial capital that would be necessary to keep the eco system’s flows at regenerative levels. 

Within the capitalist system there are numerous subtleties.   Human beings need a reason for being and the economic dreams of home ownership, durable goods consumption and various other lifestyle goals are gradually being hammered away and left to an increasingly small percentage of the population.   The objective of a capitalist system should be productive efficiency on the one hand and the regeneration of the model’s ability to support its asset, human and of course natural frame.   Technology has not historically been a blight on humanity, but that has been because of various forces that have coincidentally expanded the frontier of consumption and production capabilities.   

Productive efficiency is only one side of the equation and it requires balancing forces on the other to maintain a healthy “equilibrium” of sorts between all factors of production.   Talk of helicopter money, the drive for increasingly perverse unconventional monetary policy all strongly suggest that the equation that drives the eco system is out of balance.

US Employment data, key points and filler!

Unlike retail sales, industrial production, new orders or a number of other economic data, the employment report comes with a lot of extra filler.  You need to dig down into the ingredients to figure what is and what is not good.  On the surface we have seen a recent deceleration, but nothing which looks out of the ordinary post 2009.

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But what do we see when we dig? 

  • Productivity growth at post war lows!  Employment data is producing less and less and becoming in GDP, asset price support and income growth terms, increasingly diluted.
  • Health care and social assistance has been key to recent employment growth but the growth rate is falling off.  Looking after an aging society may not produce the growth needed to sustain the liabilities attached to the economic frame.  Indeed, many of these liabilities may not be adequately accounted for within asset valuations.
  • If we exclude health care and social assistance from employment date, employment levels only returned to growth on an annual basis in October 2014, making the current employment growth cycle a short one to date.
  • Add food service and drinking places employment (to health care and social assistance) and we have the sum total of jobs created since the recession started.  But even food services and drinking places employment growth has shown a recent declining trend.   Again, the income/productivity dynamics of this type of employment is unsupportive of the current asset/liability frame.
  • Retail trade employment growth was especially strong during the latter part of 2015 (dominated by motor vehicles and parts dealers), although we have seen weakening of late.  Watch out for MVP employment (which means an eye on consumer credit) and buildings and materials (which means an eye on construction).  There has been weakness on the retail side that is obscured by recent April data
  • The weakness in the goods producing industries, construction excepted, and trade and transport is noteworthy in the light of weakness in output, new orders and exports.  These are all key industries in terms of the economy’s ability to provide generate long term GDP, income and productivity growth.   Manufacturing and trade are important cogs in the economic machine.
  • The one relatively strong point in the data remains the professional and technical sub sector of professional services.  Relative to service sector (and hence all employment) it has continued to rise in importance, but the growth rate of this dynamic has slowed in the current cycle.  This may not be a positive for income flows if it represents a movement towards rationalisation of processes (reduced employment at the front end and a small increase at the operational core), reflective of cost reduction and other operational rationalisation.
  • Long term dynamics  – employment growth rates/part time versus full time/self employment versus employed – are all weakening or stuck in a post recession rut.  A lot of recent employment gains look like they are due to a rise in part time employment (which may be a positive if it signals increasing willingness to hire) so growth fundamentals are still very weak and possibly weakening. 

What makes employment growth and the make up of employment growth so important is that it impacts productivity and earnings growth, two key factors that require vigour if we are to accommodate high debt levels and high asset prices.  Other relevant relationships include capital investment (historically weak), income inequality and a slowdown in population growth as well as a shift in its demographics.   Finally, with weak global trade dynamics we have considerable pressure on areas of the economy that have traditionally been important to productivity and earnings growth.  

There is nothing wrong in a declining population and declining growth rates of employment as long as the relationship between asset values (debt/equity) and consumption/investment dynamics are in keeping.   I very much doubt whether it is and this is why employment growth today is a much more important indicator of financial health than it is fundamental economic health.  There are so many straws in the wind!

And the graphics:

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US Q1 GDP..big picture concerns conflate with shorter term weakness!

The big picture is the risk that growth may well have peaked in the current cycle:

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And personal consumption expenditure flows (population adjusted) have arced in a worrying sign of secular decline for some time:

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GDP growth less private employment growth has been negative since Q4 2010, one of the very few such periods in the post war period and the weakest to date and symptomatic of weak productivity and wage growth:

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Preliminary US GDP grew by a real $22bn in the first quarter.  Given that we are unlikely to see the weather related bounce back in growth that we saw last year, we are left wondering where growth is going to come from in the second and third quarters, especially if global trade fundamentals remain weak.

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“Investing in social infrastructure as an anti-recession tool”

…is the title of a Washington Centre For Equitable Growth article.  I think that there is some logic to investing in social infrastructure in a slowing growth frame. 

WHY?

In a slowing growth frame less of a corporation’s revenue flows are likely to be reinvested and productive capital is likely to be increasingly depreciated over time, depending on the rate of decline of the frame.  At the moment this cash flow, distributed as either dividends or buybacks, is likely to go disproportionately to those with higher wealth and hence more likely to be reinvested in existing assets, driving up their prices.

In a competitive economic model cash flows would be used to finance the transition to lower growth, with flows consumed and/or used to reduce debt.  As people age the costs associated with complex medical and personal  care needs rise, but these are liabilities that are presently not that well funded.  It makes sense to optimise the allocation of flows to a) fund the economic costs of older adult communities and b) make sure that those at the younger end of the scale continue to receive the necessary education and employment skills training.   This would ensure that the expenditure flows in the economic habitat would be healthier in terms of optimising expenditure and investment.  Imbalances due to inefficient distribution of flows are likely to lead to higher asset price and financial system risks.

In a growth frame where higher levels of productive capital investment is needed it makes sense to have lower corporate tax rates, but in a slower growth frame where higher percentages are distributed it would make sense to tax these distributions at higher levels for more efficient distribution.   In a competitive efficient market place without asymmetric properties we would be less likely to have the present skewed distribution of income and wealth and associated funding pressures on key aspects of social infrastructure.

US debt/asset dynamics……the bubble the Fed appears not to see

In last week’s “Decision Making at the Federal Reserve” at the International House of New York Janet Yellen said that the US economy had made tremendous progress in recovering from the damage caused by the financial crisis, that labour markets were healing and that the economy was on a solid course.  She also said the economy was not a bubble economy, and that if you were to look for evidence of financial instability brewing you would not find it in key areas: over valued asset prices, high leverage and rapid credit growth.  She and the FRB did not see those imbalances and despite weak growth would not describe what we currently see in the US as a bubble economy.

Perhaps the question was the wrong one.   The bubble, indeed most bubbles, are financial in nature and relate to both the flow of financing and the current stock of financing.   We are always in a bubble to some extent given that one of the key facets of the monetary system is the discounting of the present value of future flows through the allocation of assets, principally of money relative to all other assets.  Today’s differential between what the economy can produce over time and the value and supply of assets that represent the future expenditure flows from our economy, are I believe, in excess of the present value of those flows.  Part of this is due to monetary stimulus designed to drive growth forward in the face of demographic change, increasing income inequality (which weakens the expenditure base of the economy) and important transitions in key emerging economies that have numerous structural relationships.

We are in a bubble and while the economic issue today is one of a deflating frame (i.e. not one with inflationary characteristic usually associated with economic overheating), the differential between the financial frame and the economic has arguably never been so wide.  Perhaps the Federal Reserve should have defined what they believed to be a bubble or rather the moderator should have been a bit cleverer! 

Some may say that excess financial leverage of households has moved back to more sensible levels:  the following chart shows that consumer debt levels have moved back to early 2004 levels but that these levels were associated with much higher longer term real GDp growth rates.  In this context debt has not really fully adjusted.

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And, looking at shorter term real growth trends we see that real GDP growth has peaked at much lower levels relative not just to total debt to the rate of increase in consumer debt.  One would be forgiven for thinking that the last 5 years included a recession in the data, but it has not:

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Helicopter watch..PMIs

We do not need a global recession or a financial shock to precipitate a “Helicopter Money” operation, all we need is slow to anaemic growth given a heavily indebted economic and financial system challenged by demographics, productivity growth constraints, structural imbalances and increasing inequalities.  Anaemic to weak growth will itself precipitate a crisis. 

Today’s global PMI reports suggest that manufacturing growth globally remains constrained by weak/weakening export demand and that such demand growth that there is remains dependent on domestic demand conditions.  All cycles are punctuated by dips and rebounds but the relationship between the dip and the rebound and the strength of the latter provides clues as to the ultimate strength and direction of the cycle.  Today’s rebounds are lacklustre and this is cause for concern: 

PMI reports are littered with:

US Markit: “expansion remained subdued”, “weakest quarterly upturn since Q3 2012”, “stabilization in new export orders”, “generally improving global economic conditions”, “output growth remained below its post crisis trend”, “subdued client spending”, “cautious inventory policies”, “competitive pricing”;

Euro Zone: “weakest”, “ticked”, “stagnation”, “disappointing export trends”, “marginal”, “weak domestic demand”, “reduction in selling prices in response to competition”, jobs growth issues, “intensification of deflationary pressures”, “discounting”;

UK: “weakest performances”, “doldrums”, “challenging global economic conditions”, “poor levels of new orders from home and abroad”

(Russia): “worsening downturn”;

Indonesia: “output emerged from its prolonged slump”

TAIWAN: “moderate expansion of purchasing activity”, “client demand was relatively subdued”,”cautious inventory policies”, “raised staff numbers only slightly”, “renewed pressure on operating margins”, “new export work declined for the third month in a row”, “ companies continued to discount”, “Unless global economic conditions start to improve…”

Japan: “lowest for over three years”,”New orders…contraction was the sharpest in nearly two years”, “sharp drop in international demand”, “instability in the wider Asian economy”, “client negotiations and competition driving down selling prices”;

China: “fractional deterioration”, “continued to cut their staff numbers”, “relatively cautious stock policies”, “Weak foreign demand”

South Korea: “contracted for the third consecutive month in February”,”rate of decline was only marginal overall”, “slump in demand and challenging economic conditions”, “new orders stabilised….followed two months of contraction”, “increased competition and an unstable global economy”, “international demand declined for the second successive month”, “goods producers cut back on their staffing levels”, “increased competition encouraged companies to reduce their selling prices.“

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Helicopter drops: feeding the animals in order to keep the zoo in business..

I was reading “Helicopter drops might not be far away” by Martin Wolf in the FT.  By now those interested in macro economics/monetary policy/asset markets should be well aware of the long gradual easing in interest rates, especially since the 1990s.  Lower interest rates did not just encourage people to borrow for consumption, but they also boosted the amount of borrowing for asset purchases with rising asset values also looping back into consumption for a while.   During this period, global money supply growth also became ever more asset focussed. 

For a while this helped stimulate consumption in key economies, also aiding in developing economy growth.   Developed economy consumers became ever more indebted at a time when income growth was also slowing, but given that asset markets kept rising and interest costs kept falling, everything was able “to keep on going for a while”…many felt that this period of low interest rates and rising asset markets was a “great moderation” and few seemed to notice the enveloping divergence. 

While the financial crisis was the bursting of this particular reality, it also marked the onset of a period of unprecedented financial engineering in response, itself a denial of that reality. 

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Correlations, volatilities and expected returns as the monetary tide reverses flow..

I note comments by El-Erian over Central Bank’s inability to suppress volatility as a bigger risk than China and I would agree although I would qualify this in terms of the immediate asset price risk.   Asset focussed money supply growth and asset price relatives (relative to GDP growth and income growth as well as its distribution) are all deeply negative for asset markets when liquidity dynamics, amongst others, change.

Recent commentary by Zero Hedge on the winding up of Nevsky Capital is also worth reading: the Nevsky Capital report suggested that a disciplined structure can no longer be counted on to realistically manage risk and return given the uncertainty of an increasingly skewed distribution of possible outcomes in an environment worryingly distanced from fundamentals/exposed to unconventional monetary policy; liquidity dynamics in the market place also impacted.  

Another interesting piece of data shows the 10 year rolling returns on commodities that I found in a tweet from @zatapatique.

I have written on the issues of excess asset focused money supply and liquidity for some time (relevant posts of mine).

Many portfolio management structures depend on expected return/correlation/standard deviation assumptions that would be very much exposed to a break in the direction of money flows towards assets.  All statistical measures of risk and co variance are drawn from the impact of monetary demand flows for assets.  In an environment where monetary policy is accentuating flows to asset classes as well as expanding the quantity of money and reducing the supply of certain asset classes the natural flow response to risk and return in the environment are muted.  As unconventional monetary policy recedes, additions to the quantity of asset focussed money and interest rate support reverses, the natural flows not only start to reassert but the prior excess flows adjust to the new environment.  We get a break out of trading ranges and covariances.

This is all incredibly risk and uncertain for those dependent on traditional statistical measures of asset price sensitivities and covariances.

“Solving the UK Housing Crisis , the Bow Group”, so what about Canada?

“Denmark prohibits non-EU nationals from buying a home unless they have lived in the country for five years”

This is a worthwhile read.  A report on the UK housing market’s affordability crisis by a UK Right Wing think tank that recommends limiting foreign ownership of the property market.  I can definitely see some relevance to Canadian property markets here and the issues raised are very much in line with those expected by the considerable excess asset focussed money supply growth we see globally.   Unconventional monetary policy and increasing income inequality running alongside slowing economic growth have increased the asset focus of global money supply, especially towards hard real assets such as property that will not disappear in an economic/financial crisis.  

You can see this in the Canadian asset market:

The real return on the S&P/TSX composite since the market peak in September 2007 has been –23% to mid December 2015:

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Yet the value of the Canadian residential property and land has moved the other way:

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Interestingly the MLS Canadian Composite Home Price Index shows an increase of 33% since since September 2007 and the Greater Toronto component an increase of 59.2%.  

And there has been an increasing dialogue on the issue in the Canadian press:

Affordable housing crisis affects one in five renters in Canada: study” “One in five Canadian renters face an affordable housing crisis, spending more than half their income on shelter costs, a problem that appears to be even more acute in suburbs and small cities than in major urban centres.”

Moody’s, The Economist warn of high Canadian debt, housing prices” “”The risks are less around the rapid house price appreciation per se, than the fact that, relative to incomes, homes in Toronto and Vancouver are increasingly becoming unaffordable either to own or to rent,”

Before we step any further we need to reassess the economic engine, its habitat and condition and the conflict between the two.

Capitalism and its economics have been the subject of much debate since at least 2007.  At its heart it represents the engine of economic growth, of technological progress, of the efficient allocation of resources, the determination and distribution of return/prices (wages, interest, dividends) key to attracting risk takers and capital and of the accumulation of capital required to produce as well as the development of markets for the trading of goods, services and assets.

Capitalism’s core engine has taken us far in at least one direction.  Two of its main alternatives socialism and communism have long since foundered on the human condition and the many issues associated with their decision making structures, and while less susceptible to the same issues, capitalism is nonetheless not immune to corruption of its process, concentration of power (asymmetries etc) and impairment by its own emergent traits.   

As an ever lasting engine of growth, capitalism has been increasingly beset with  problems: it has required ever lower interest rates and monetary stimulus to keep it chugging along, at a rate of growth set by man, I must add, and not its own mechanics; it has become increasingly burdened with higher levels of debt, financial instability and as a result has become itself susceptible to natural demographic realities; indeed, the financial instability has not been wrought of its mechanics but the aims and objectives of the social and moral structure it inhabits.  It appears as if the construct we know as capitalism has been thus engineered for one trajectory and one alone, whereas outcomes of natural forces would adjust to fit the natural dynamics of the universe it inhabits.   For anyone doubtful of what I believe is an overly “consumerism” bent of capitalism I would suggest watching the BBC documentary “The Century of the Self”.

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Why do economists like Paul Krugman completely ignore financial imbalances and their structural accentuators?

In a recent post Paul Krugman challenged the “rationale” for the Minneapolis Fed appointment of Neel Kashkari.

His objection lay with “the view” of the new chair (Kashkari) that growth prior to the breaking of the financial crisis was artificially fast due to the leveraging of the economy.  Krugman’s point was that just “because we had a bubble, in which some people were borrowing too much,” does not mean that the output produced from 2000 to 2007 wasn’t real and therefore the problem we have now is 100% one of insufficient demand as opposed to supply. 

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The paradox of monetary policy: reducing IRs below the lower bound is a seriously flawed policy

What we are seeing is a misconstrued extenuation of policy applied to a once rising frame, and indeed it is plausible that we have been following a path of unconventional monetary policy for a much longer time.   What we thought were monetary shocks on the way up were merely reactions to divergences occasioned by overly aggressive expansion of money supply. 

In its recent World Economic Review the IMF nicely, if not completely, summarised many of the world’s economic issues.  One thing clearly communicated was that global economic growth is both slowing down and in transition and that this must have consequences for monetary policy. 

The world has become increasingly dependent on debt (principally new money supply growth originated debt and asset focussed MS’s velocity dynamic within the asset sphere) to finance consumption, investment (and increasingly to a much greater extent, financial leverage), and while this was fine as long as growth barrelled along, incomes rose and populations continued to grow, it all started to go pear shaped as the engine started to wobble.  Lower interest rates designed to encourage consumption and investment, and loan growth financing the two, did just that and more so: in fact one of the consequences of lower interest rates was to increase the asset focus of money supply growth; a secondary consequence was to provide a source of additional expenditure (US especially) via home equity lines of credit drawing off rising asset values, at least until 2007. 

An inversion of many of the factors that had at one time driven growth were reversing at precisely the same time that debt and debt financed consumption expenditure was rising (1990s) and this is well evidenced in Japan.  Well we all know what happened next, ultimately the 2007/2009 financial crisis, but also a string of financial wobbles along the way. 

Slowing growth and rising debt could not coexist within the rising interest rate environment of the mid 2000s and hence we arrived at 2007 and onwards.  In truth, declines in interest rates and growth rates, combined with rising debt, on a global basis, have created a veritable choke hold and “post much greater QE”, one with increasing volatility and sensitivity to changes in monetary flows.  The overall complex whole is full of transitional issues, and these are discussed at length in many previous posts: understanding these various strands impacting demand and supply, loan growth and structural imbalances both domestically and globally is important if you are to be able to translate the many competing nuanced arguments being expounded both for and against unconventional monetary and dare I say it fiscal policy.

That said, we have remained remarkably transfixed on the one size fits all monetary policy to drive growth forward, hoping that low interest rates will spur borrowing for consumption and investment and somewhat erroneously hoping that those with cash will spend it.  Ultimately we are hoping that QE will drive the animal spirits and re awake the growth of good times past.

In the typical economic model with its rationale agent, the agent would be focussed on maximising short and long term consumption/saving from a given income.  Changing interest rates and inflation assumptions would immediately impact key consumption/saving decisions, and so the balance of expenditure between consumption and investment/savings.  But agents on average are neither wholly rationale nor are resources (income and wealth) equitably spread.  Moreover, the resources available for consumption and expenditure are not necessarily constrained to income/capital, but extend to new bank originated loans. 

Indeed the accumulation of imperfect decisions and growing imbalances as well as emergent dynamics (deflating/inflating economic frames and the changes they bring to key economic relationships) can constrain the impact of IRs and money supply on natural adjustment mechanisms.  In other words simple models ignore the actual balance of factors and the impairment of those factors in terms of their sensitivity to policy tools such as interest rates.  

The problem is that as growth slows, the amount of new money supply growth (loan or QE originated) should also decelerate, something which has not really happened.   In a slowing growth environment (one that may be characterised by a declining economic frame: population growth, demographics, productivity, increasing income inequality) we become ever more dependent on a market’s balance and allocational efficiency, that is the relationship between productive capacity/asset and debt values to changes in supply and demand dynamics and the distribution of income/wealth needed to maintain an appropriate balance of consumption and investment in a frame as it transitions.

What we have been doing is increasing money supply growth as growth falters and falls, all the while accentuating many of the imbalances hindering necessary frame transitions.  This has raised debt/equity values as GDP and income growth slows, increasing the sensitivity of the markets and the financial system to growth and changes in growth and raising the latent size of associated future demand shocks.   The solution has been to continually lower interest rates and when interest rates have been as low as they can go to swap debt assets for newly created central bank money.  We now appear to be about to extend this sequence, by reducing interest rates below the lower bound.

What we appear to have confused are the one time solutions to recessions occasioned by monetary tightening, that is to reduce interest rates as activity declines, in expanding frames, to applying the same medicine for a declining growth/deflating frames.  The argument being that the recessions were caused by monetary shocks impacting demand and hence any demand deficiency can be dealt with by monetary stimulus: well, of course, monetary stimulus can of course influence demand, but not without creating imbalances between assets and their value and the frame and capacity, at times, and the growth rate of the frame.    

In short, we do not need more money supply growth as a frame deflates, but an adjustment of the capacity and related capital (debt/equity values) so as to minimise divergences between growth and capital, including debt and its many forms, and hence to minimise shocks to the financial and the economic re maintaining balance between the two.

What we are seeing is a misconstrued extenuation of policy applied to a rising frame, and indeed it is plausible that we have been following a path of unconventional monetary policy for a much longer time.   What we thought were monetary shocks on the way up were merely reactions to divergences occasioned by overly aggressive expansion of money supply. 

I personally feel that arguments to reduce interest rates below the zero bound are seriously flawed, but flaws themselves ingrained into the body economic and financial for too long for many to be able to differentiate the reality of the trajectory. 

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A brief “thought” on debt defaults, asset prices, MS velocity and consumption expenditure risks.

When a private non bank debt collapses the money supply itself is not impacted.  There is however a collateral impact on future expenditure and the velocity of money supply itself.

Asset values are extremely sensitive to portfolio cash allocations.  A given reduction in preferred cash holdings relative to other assets, all other things equal, raises asset prices by a much greater magnitude and vice versa. 

However not all transactions represent closed loops: a disposal of an asset for future consumption transfers asset focussed money supply to consumption focussed money supply.  With money also being transferred in to the asset portfolio the net impact on asset values of consumption related transactions tends to be much smaller.

A default in non bank debt, or loss of any asset, should therefore have an impact on future MS velocity and expenditure while also possibly increasing the asset focus of money supply (all else being equal).  In the event of default, assets/collateral are no longer available for sale in exchange for money for consumption expenditure purposes (and of course investment expenditure purposes) and the potential velocity of money supply falls, specifically with respect to consumption and possibly also with respect to assets. 

Likewise a fall in asset values, especially the significant declines seen in recent decades, also impacts expenditure and MS consumption focussed velocity. Typically asset price declines have been short lived and given the fact that marginal transfers out of the global asset portfolio for consumption purposes has tended to be small in % terms, the impact of price declines etc on expenditure has also historically been small – this is especially so where asset focussed money supply growth has been expanding, demand for assets have been expanding (+ve population growth and demographic dynamics), where there is increasing income inequality (less MS flows out of the asset portfolio etc), but much less so in the reverse scenario.  

QE on the other hand has tended to focus primarily on supporting the financial system and high quality assets with minimal risk of default.   Whether it impacts expenditure decisions depends on the liability profiles of asset holders in general.  In a world of increasing income and wealth inequality asset price support may have only declining marginal benefits for consumption expenditure even though the resulting increase in asset focussed MS has affected a much wider range of asset prices. 

QE and low interest rate policy may well have supported potential expenditure based relationship loops from assets to consumption via asset price support based solely on asset valuations (not re yields) but may also, via increased risk taking within the higher yield/shadow banking asset spectrum, have increased the consumption sensitivity of assets; higher yielding assets are likely to be more consumption sensitive than lower yielding equity type assets.  

QE and lower IRs may well have increased the exposure of consumption and possibly also investment expenditure to future asset price shocks via two routes:

Increased exposure to leveraged loans, emerging market debt, high yield bonds, collateralised debt/loan investments, “wealth management products” (China) etc, exposes future consumption expenditure to higher default based risks, especially in high debt/low growth environments.  This depends on the extent to which QE has pushed investors out of lower risk higher yielding assets into higher risk/relatively higher yielding assets and the changing composition of the market portfolio especially with respect to those investors exposed to higher future liability demands.

Higher asset prices in low growth environments with increasing debt to GDP ratios also exposes consumption and investment expenditure to greater asset price volatility: we have seen quite extreme fluctuations in asset prices since the late 1990s.  As populations age the sensitivity of expenditure to asset prices increase.

The issue of default and asset price shock is compounded by issues of liquidity, especially with regard to many shadow banking products that investors may confuse as being cash like and therefore exposed to greater liquidity risks in risk events.

It is probable given the higher debt to GDP ratios, slower growth profiles and the many transition risks in the global economy, that global asset price consumption risks are not insignificant.  Another reason to support asset prices, another reason for QE and negative IRs, but not necessarily a solution.

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China rebalancing, a crisis? Yes, and one of magnitude and complexity.

China did not end up with its current imbalances as part of a natural process and therefore the transition itself is unlikely to be natural. 

China is both the here and now and the future, it has untold potential, a growing debt problem (here, here, here, here, here and more in the links below) and a “government” still “seemingly” capable of pissing great distances into the wind.  But working out China for many is tougher than working out the meaning of life itself.

I have concerns over the ease and the speed with which many believe China can rebalance itself from an export led/debt financed investment growth model to a debt financed services and consumption growth led model.  That is how China can transform itself from a manufacturer of goods to the world and builder of infrastructure, to a perfect model of advanced western capitalism? Odd really given that neither model appears to be stable or perfect in its entirety, both representing forms of economic extremism, excess and various levels of maturity/immaturity. 

The issue is not debt alone, but the rate at which it has recently accumulated, especially post 2008 and the imbalanced nature of the economy upon which it rests.  Just because an economy has potential, just because compared to more mature developed country metrics China has some way to go in absolute terms, does not mean that the current force exerted at the turning point is inconsequential.

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The Centre of Gravity of Risk and its Sensitivity has long since shifted towards the financial.

China is a key piece of the puzzle and much more so than people understand.  Without weighty Chinese domestic demand growth the transition out of untoward monetary policy towards financial and economic stability is jeopardised further.  Monetary policy had stabilised and propelled markets higher, but the time horizon for economic and financial normalisation is highly dependent on the timing of key transitions. 

The world economy is changing, decelerating, maturing and transitioning.  The world’s central banks, from the late 1990s onwards, co-opted the financial system to drive growth forward.  We have suffered a number of shocks as a result, but the strategy of juicing growth has continued. 

Our biggest immediate problem is not that the growth rate of expenditure is decelerating, or that populations are aging, but that the debt (and other contingent liabilities) that has been built up through a low interest rate and asset focussed monetary policy in the developed world and more recently, through infrastructure and other capital investment expenditure in the developing world, has created a mismatch between the supply and pricing of assets (debt and equity) and the economic growth rate on the other hand.

It is not that the fundamentals of underlying economic growth have become more volatile but that the relationship between monetary policy and assets and that growth has widened. 

I have written on this issue many times in my posts: it is not the economy we should fear but the financial system, its volatilities, risks and divergence.  Many still are ignorant of the shift in sensitivities from the economic to the financial: whereas in previous asset market history asset market movements had less impact on the here and now, their impact has become increasingly important.  The centre of gravity has shifted as the weight and importance of assets and debt to growth and the financial system has ballooned.

There are of course other problems that are making things worse: increasing income inequalities and falling productivity growth and of course the global structural imbalances that have arisen as China took centre stage in global manufacturing supply chains.

Slower growth and aging populations are likely inevitable and natural depreciation of the capital stock at the margin, in the absence of a shift upwards in productivity, via a shift of flows towards current consumption and away from investment is natural and self adjusting.  As flows shift away from capital investment we will also likely see lower growth rates in debt and money supply growth and the natural dynamics of decline means that this shift in flows may ultimately result in a decline in endogenous money supply growth, loans and other forms of debt and declining asset values. 

What is happening  is that the financial system is fighting demographic shifts, income inequality dynamics, transitional shifts between developed and developing economies, productivity stagnation in the hope that these dynamics are all transitory.  Apart from the transitional shifts between global economies there is much less certainty with respect to the other factors.  Importantly within discounted present value calculations, the largest component of value is held within the short to medium term horizon. So even if certain dynamics are transitory, the horizons are in conflict.

I see much potential volatility in the near term and much uncertainty with respect to fiscal and central bank accommodation of the divergence itself.   What the slowdown in China is bringing into the open is the divergence, the importance of the time horizon and the risk that normalisation of the growth trajectory is not going to happen, at least within a time frame meaningful to supporting the asset price/GDP dynamic divergence.  This is why markets are currently highly volatile and the major reason why the price adjustment is likely to continue.

See also:

A world in transition, but so many straws in the wind, some thoughts!

Not a “Savings Glut” per se but a monetary excess amidst a period of complex global structural economic change!

US – Some interesting charts on income, GDP and new manufacturing orders from recent data

There are some interesting patterns and trends in US data: so I do ask myself, are we at the peak of the current cycle, are we as far as debt and low interest rates can take us?

US income growth has long been acknowledged to have weakened considerably yet recent data shows that the trend has indeed been weaker than first thought.  Note the following chart showing pre and post revisions to chained per capita personal disposable income:

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A Foray into the Fundamentals of Austerity in Anticipation of the Outcome.

A recent IMF report pointed out some supposed vast amounts of room available for the world’s economies to step up government borrowing to finance consumption, investment and production decisions.   Oddly the report appeared to ignore other forms of debt and material deterioration in key areas of the economic frame.  

When the crisis broke back in 2007 it was clear to me that monetary and fiscal policy would likely need to go for broke to support economic growth and employment at a time of collapsing asset values, debt defaults and a world wide retrenchment in expenditure of all kinds.   As it happened a great deal of that support went into asset prices and financial institutions.

But some years after the crisis, after a slow and drawn out recovery with interest rates locked to the floor, economies still appear to be borderline reliant on debt financed government expenditure.  Any attempt to reduce borrowing, to either raise taxes or cut expenditure to pay back debt would be considered by many to have an adversely negative impact on economic growth, especially at such low growth rates. 

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In the context of interest rate decisions you have to ask yourself just what are we waiting for?

I have seen that the IMF has asked the Fed to defer interest rate increases until we see clear signs of wage increases and inflationary pressure.

The request IMO is both scary and rationale given that so much of today’s National Income Accounting Identity (output=C+I+X-M) relies on factors that lie outside of its operation.  I speak of new bank generated loan growth given that income growth/distribution and investment growth still appear to be weak in the scheme of things..i.e. C+I the drivers. 

The last time the FRB delayed interest rate increases we had a debt financed consumption boom in the US followed by IR increases and a de facto financial collapse.   By raising rates we likely restrict one of the few modes of generating consumption growth in the US (note auto loans) and many other countries.  We also likely raise the impact of existing debt burdens on what are to date still historically low rates of income/wage growth.  

As such you have to ask yourself just what are we waiting for?  Well we need higher income growth, but not just higher income growth: we need a more equitable and fair distribution so that economic growth itself becomes less reliant on debt and low interest rates, and less exposed to the scary divergence of asset values. 

But the world is also changing in ways that question whether we can effectively outwait the inevitable: populations are aging and declining.  Areas where the frame can still expand in consumption terms, areas such as China, may be heading into their own period of slow growth and low IR debt support. 

Importantly will the status quo submit to a reconfiguration of the pie and can the world assume a less debt dependent economic raison d’etre?  

So yes, the rationale to defer interest rate rises is both scary and realistic, but it fails to answer important questions: what are we waiting for, how long can we wait, and are our hopes realistic? 

This is just a quick 3 minute post, but the issues are critical!

Is Private Investment Expenditure in the US really looking strong?

Is investment expenditure in the US really looking strong?   I picked up some tweets on this the other day which stated that it was indeed.

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The above graph shows domestic investment of US private business net of capital depreciation. A couple of points should strike you immediately: one nominal expenditure peaked back in the late 1990s; two, a lot of the retracement (or the pluck as Friedman might have said) is a consequence of the unprecedented decline seen during the dark days of 2009.  

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A world in transition, but so many straws in the wind, some thoughts!

Everybody is asking and at times hoping to answer the question as to why world economic growth is slowing down, why is it so sub par, why has it not recovered post the turbulence of 2007 to 2009?   There are many straws in the wind, but which ones are cause, which ones are consequence and which are accommodation linking both?  In a world where diverging tiny margins can accumulate into significant distances it is hard to determine just what and which is the key.

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Not a “Savings Glut” per se but a monetary excess amidst a period of complex global structural economic change!

If you stream through the data it is pretty clear that developed economy growth has been slowing for some time and that monetary policy has accommodated this adjustment with lower interest rates and a relaxed attitude towards money supply growth.  At about the same time these trends were moving ever closer to their sweet spot on the horizon (because we are not yet at peak of this particular movement) certain developing markets really got going, with the help of a fair amount of their own monetary stimulus but also by a reconfiguration of global supply chains and offshoring in key economies.  All factors combined to create a heady and dangerous global financial imbalance, a weak bridge cast across a widening economic divide.  No wonder it all came crashing down..but who was to blame?  The world’s central bankers who were blindsided into excessively lax monetary policy by a low inflationary world that had become obsessed with laying off and chopping and dicing of risk to those “who could best absorb and bear it”, or some of the finer strings in the mesh?  Well, some have chosen to blame excess savings in the emerging/developing part of the world, principally China, but this is all too pat.   The “savings glut” theory, if you can really call it “excess savings”, was merely a return of serve of part of the vast ocean of financial and monetary excess that barrelled through the early to mid 2000s.

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Re Andy Haldane: my brief comments on deflationary risks and interest rates

This is a quickly penned thought on Andy Haldane’s recent comments on interest rates and deflation:

In a recent speech Andy Haldane of the Bank of England suggested that interest rates may well need to fall as opposed to rise following on from recent falls in inflation.   I would agree that the secondary impacts of price declines need to be seen before we can assess whether or not these price falls could indeed trigger stronger deflationary forces.

For one, price declines may lead to lower revenues (note US retail sales) and lower revenues may impact on wage increases.

Secondly, lower revenues impact cash flows and cash flows impact asset prices, especially for high yield debt in sensitive sectors.   Global markets remain especially sensitive to asset price movements and factors which may impact asset prices.

Thirdly, we are in a complex deflationary frame where aging populations, slowing population growth and relative weakness in corporate investment (note buybacks) is already a significant drag on the global economy.  Falling prices could well trigger latent dynamics in this structure.

And finally, areas of the world which could well create the demand necessary to reinvigorate the frame, for example China where growth appears to be slowing sharply, may also be adding to tensions within the global growth frame.

So yes, interest rates could fall, in the sense of defending asset prices and attempting somehow (I do not quite know how) to reinvigorate or at least support demand, or rather maintain marginal cash flows.

But in reality we do not know because we lack at the moment a measure of the sensitivity of the frame to short term shocks of any financial or economic nature.  We know the frame is weak and has been for some time but as to its sensitivity, we know very little.