Nominal retail sales data is typical of a recessionary environment, but much of this is due to declining gas prices. Manufacturing output and new order data is also typical of recessionary conditions. Motor vehicles and parts sales/new orders/output are still strong data points albeit showing signs of weakening, especially in the auto components. Cycle to cycle we see retail sales, orders and output all failing to establish a clear positive post crisis fundamental growth trajectory. That said there does not appear to any abrupt collapse in the data which is not necessarily a positive.
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.
“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:
Yet the value of the Canadian residential property and land has moved the other way:
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,”
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”.
The golden age of stock market returns for Canadian investors looks to have ended sometime in 2007:
Adjusted for inflation, the S&P/TSX has literally only provided returns for those able to take advantage of the significant dips in valuations post 2000:
If we look at annual returns for holding periods of 10 and 15 years we can see capital gains in decline:
For those investors unfortunate enough to be paying through the nose for closet indexing mutual fund investments, the real capital returns are likely to be lower still, and more so after tax. The golden age looks to have peaked in and around 2007. This is around about the same time that debt and GDP growth took their separate routes.
If equity markets and commodity prices remain depressed they are clearly going to detract from economic momentum going forward and may well exacerbate the latent fissures in the residential property market that we already know off (i.e. high consumer debt loads and historically high valuations).
Wage and salary growth has also been on a slide:
So yes the drop in market valuations is a concern given the accompanying commodity price weaknesses and other structural risks that have built up in the Canadian economy over the decade. This will likely raise the odds of much more aggressive monetary and fiscal policy.
This is more or less a follow up from a December 2014 post:
Is Canada’s Mini Golden Age behind it? http://blog.moneymanagedproperly.com/?p=3969
And in the context of the above, this is worth a read – http://tcglobalmacro.blogspot.ca/2015/12/recession-made-in-canada-definition.html?m=1
A number of commentators have questioned the underlying momentum in the US economy. If we assume that today’s birth death adjustments are based on latest data as of Q4 2014, and 2014 Q4 showed the largest increase in employment since 1983, and the latter half of 2014 represented a relatively strong period of economic growth in the current cycle, then just maybe, if the cycle is turning, then there is a risk that current employment data may be increasingly wide of the mark.
In the latest report on US employment we see private jobs growth averaging 222,000 a month over the last three months. On the face of it, employment growth suggests that all is well with the economy despite the slowdown in manufacturing and world trade.
Durable goods consumption expenditure rose at an annualised pace of 9.4% (autos?) in the third quarter; business gross fixed capital formation (Commodities?) has fallen for three quarters in a row following a weak Q4 in 2014; inventory accumulation slowed dramatically (?); imports of goods and services fell for the second straight quarter running off the back of two weak quarters in Q4 2014 and Q1 2015.
The change in net exports that contributed SO MUCH to GDP showed an historically large bounce, shown here as a rolling two month data piece:
The growth trend is still fundamentally weak, over reliant on consumer credit and exposed to a potential inventory correction.
Post the debt fuelled 90s and 00s, growth has tailed off as shown by the annualised real growth rate over rolling 5 year time periods. As noted in prior posts, growth between the 90s and onset of the “crisis” was very likely overly leveraged:
Growth is still historically weak and if we take away increases in consumer credit and adjust for inventories, the trend remains so:
I just read a post on the subject of reversing quantitative easing. Just a quick few points:
For a given velocity of asset focussed money supply and a given preferred allocation of money within the “asset portfolio”, the withdrawal of liquidity will impact the demand for assets via a) increased supply of certain assets, b) the reduced amount of money and hence readjustment of preferred percentage money allocation and c) via changes in asset preferences, in particular preferences for assets that may have increased in supply as QE was taking place.
With QE, we have the introduction of higher levels of portfolio focussed cash with a reduction in relative supply of higher quality assets and this would cause problems if this also skews the universe of demand and supply for higher risk/less liquid assets: that is the universe pushes outwards.
As QE is reversed and money is withdrawn and lower risk/more liquid assets are injected into the asset portfolio, demand for higher risk/less liquid assets may drop as these assets are displaced within the asset portfolio: that is the asset universe contracts.
The issue here is that we risk a secondary asset impact over and above the expected price adjustment of all assets as portfolio liquidity is withdrawn. Unconventional monetary policy is likely to have altered the asset profile of the asset portfolio and this adjusted profile is likely to be hit most at its weaker newly developed extremities .
The risk is that certain asset classes get crushed in the rush for the exits. The question is how much does the market for these asset classes at the outer edge of the universe get impacted and to what extent will this likewise impact consumption and future consumption expectations? If you cannot sell an asset you bought at a certain price with an expectation over a future value with any degree of certainty, then we have a discounted present value demand shock. If QE is substantial and the potential reverse substantial too, this shock can be quite large.
QE may not just have impacted pricing but also market structure, liquidity, and introduced larger amounts of higher risk/less liquid assets into core portfolio destinations than would have occurred without it.
This is not a complete analysis by any means but we have changed the nature and structure of asset markets and therefore the relationship with asset markets and consumption functions.
I discussed some of these issues in another related post:
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.
Looking at new Canadian retail sales data one would be forgiven for thinking that all is well on the retail front: yes we had a downward blip, but we have stabilised and things seem mildly resurgent in the year to August.
But just as in the US, Auto sales appear to be driving the headline growth rate, which if you have been keeping an eye on my US data missives should give pause for thought:
So is this not necessarily a good thing? We know that consumer debt has been on the rise and now stands at historical levels:
And recent independent commentary has also pointed out the large increase in auto related debt: When will Canada’s subprime car loan bubble burst?
But the clincher is the relationship between sales of motor vehicles and parts and wage growth: the following chart looks at annual rates of changer over rolling 5 year periods to average out short term ups and downs, to get a better look at the strength of the data relationships:
As we can see, auto related spending has taken a manifold hyper leap relative to the rate of change of employee wage growth. This is all deeply disturbing.
The natural rate of interest and its determination, especially with respect to when and how the Fed and other world central banks should raise interest rates, is a hotly debated topic. Many suggest that the only way to get back to trend GDP growth is to push interest rates below ZERO, into negative space, and/or to raise inflationary expectations.
The trouble, as I see it, is that the models used to determine the natural rate, or what the current policy rate should be, focus almost entirely on equilibrium concepts and a restricted set of difficult to define inputs, and can therefore miss key turning points in the domestic and global economic frame. These are after all, in most cases, simple rule of thumb models.
From a brief consideration of the subject and given my own historical stance with regard to key developing structural imbalances, I have the following simple propositions on the natural rate/negative interest rate debate
Natural Interest Rate models ignore accumulated financial and structural economic imbalances, imbalances that are also likely occasioned and accentuated by transitions and policy responses to those transitions. Importantly the build up phase (excess) can raise growth (note US consumer debt/consumption expenditure) and mask changes in trend, while the build up itself can serve to push growth lower post crystallisation. Additionally, point in time models are insensitive to the impact of the power of compound errors: policy that miss changes in trend and accommodate divergence from trend can last as know some time.
At critical turning points IR policy may ignore transitions and accumulating imbalances and risks creating significant divergences between the financial and the economic that collapse back through the core financial system as we saw in 2008/2009. In this case, a deceleration in growth may be viewed as a below trend growth phase (for whatever reason) with policy lowering rates: note the increase in debt and debt relative to income and GDP growth in recent times. Outsize increases in debt due to lax monetary policy may also impact global structure.
The financial and economic shocks that arise from this insensitive IR policy feed back into GDP and key relationships with negative consequences. Imbalances are accentuated and transition dynamics ignored. For example a transition to lower growth due to issues of frame may end resulting in a crisis of frame.
The big question is how does IR policy fit into the big picture when we have transitions and accumulating structural economic and financial imbalances not captured by models? Which problem do we deal with, since we now have more than 1?
In a world of many transitions and imbalances there may be more than one interest rate: one to accommodate financial imbalances and preventing their adjustment in a lower growth frame; another to offset some of the many negative trends impacting growth (thereby risking further financial and structural economic imbalances); another that would better reflect the balance of factors in emergent growth dynamics of a given frame once imbalances had adjusted and transitions completed. A lower IR is needed for the first 2, a higher for the latter. Of course, at the moment, our tool box only affords room for one interest rate, so who are you going to throw to the dogs? I guess the objective is to keep all rates aligned as close to each other as possible and to minimise intervention.
If we ignore imbalances and transitions and assume that deviations from a given trend growth in output are all temporary and due to excess of saving over investment and not any other argument, then we risk more of the same. Accumulated monetary policy errors weigh on time and are not necessarily washed out by time.
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.
The US economy is no ordinary cake in the oven and the release of the latest employment numbers do nothing to disprove this analogy. Global economic growth is continuing to slow as evidenced by trade numbers, manufacturing data and a host of PMIs. The direction of cause in this most recent of trends has been from key emerging economic regions. The direction of cause is one for concern given the importance of the development of consumer markets in emerging economies to aging and slowing developed economies. A slowdown in emerging market growth is important for asset markets and financial stability (loan servicing and financing) given that asset values and debt financing are heavily predicated on a discounted future. The possible impact on global growth and financial stability of this reversion of cause and hence flows may well prove to be of significance.
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.
Irrespective, deflation is not the issue, but slowing growth within a complex frame over burdened with financial excess and key structural imbalances.
A recent speech by Andy Haldane has kept the interest rate/zero lower bound debate “bubbling”. In this speech, “How Low Can You Go”, Haldane broached the issue of monetary policy in the event of another demand shock. He is quite right to do so since monetary policy would have little room for manoeuvre with interest rates only a scuff mark away from 0%. His musings suggested getting rid of cash and bringing in negative rates.
I do not think that anyone really suspects that we are at the start of an aggressive tightening of interest rates by the Federal Reserve. A 1/4 point increase in rates would be unlikely to do anything much to growth even at today’s relatively low rate of GDP growth.
In truth, the problems with GDP are not necessarily to do with interest rate costs in the sense that growth is not being held back by the cost of money. Today’s low interest rates are here pretty much as part of an asset price support operation, as is QE. The reason why they have remained so low, post 2008 (in the US at least), is because of the increasing importance of asset market stability (given debt levels) to the financial system in a low growth, post financial shock, environment.
As such, interest rate and monetary policy have been supporting the asset price/GDP disconnect post the financial crisis on the assumption that the shock to growth was temporary and transitory. Unfortunately the impact of the financial crisis on growth was neither, partly because debt levels were higher than could be supported by GDP growth pre crisis, but also because underlying growth, ex monetary/debt stimulus, was declining, for a number of reasons.
Post crisis, what we have had globally is an increase in debt levels, while pre crisis growth levels have not recovered. The temporary asset price support operation has lasted longer than expected and has facilitated a further increase in asset focussed MS (increasing instability of the financial system), asset prices and asset focussed debt.
Do interest rates need to rise to prevent inflation surging ahead in the US economy?
Wage growth remains weak and there does not appear to be material capacity constraints at any level. The only real concern is rising consumer credit: consumer credit relative to income growth, especially non revolving credit, has been rising at historically high levels post crisis. This hearkens back to fundamental issues in the structure and distribution of key growth drivers that are independent of interest rate factors.
Low interest rates/QE have enabled further divergence between assets and debt and GDP and income growth, something that I do not believe was originally intended by Fed monetary policy. The key decision factor for the Fed is not whether this is the right time to raise interest rates at an economic level, but whether there are other more critical forces restricting growth and, as such, whether it is prudent to continue to juice asset/debt markets. In a low growth environment a ZLB interest policy is only going to create further divergences between asset prices, asset focussed MS/debt and GDP and other key flows supporting GDP.
I also believe that China’s current problems are signalling an end to the belief that weak growth post crisis was temporary and that unconventional and unusual monetary policy supporting asset prices/debt was valid and the risks containable. Otherwise, well, interest policy is no more than a “hope and pray” one that supports the build up of market and financial risks relative to growth.
Thus the Fed when deciding whether or not to raise rates is ultimately deciding the size and timing of the end game: a greater risk later or a lesser, but by no means small, risk now. I suspect the Fed realises it has delayed a rate rise for far too long, but I also question whether it wishes to sustain the impression that it can be swayed by short term market movements forever. Does it want to be looked upon as Sisyphus eternally dropping the interest rate ball?
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.
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.
The main changes to Q2 GDP came from revisions to non residential fixed investment, inventories and government spending. But we must a) also remember that the prior GDP base had also been reset lower following the most recent GDP revisions and b) consumer credit growth has become increasingly important to GDP growth of late (as it has in places like UK):
We have relative strength in certain sectors supported by a steady increase in employment and growth in consumer credit. The backdrop is weak domestic productivity and income growth, an unsettling composition of employment growth and global economic weakness, in particular a possible global trade shock centred in China. The US is still growing slowly and while there are signs the labour market is tightening there remains considerable structural slack and remaining structural imbalances of concern.
A rise in interest rates may well be needed in the light of growth in consumer credit, but I have concerns over the fact that wage growth has yet to ignite, that capital investment expenditure remains weak and that the Federal Reserve’s own views of economic growth potential may well be above that which the economy itself is able to produce. Has the US economy returned to the normalcy envisioned by policy makers and with it its interest rate setting policy? I think not, but I also feel that the divergence between income growth and consumer credit growth is a considerable problem and one that may come back to bite the US if China weakens further.
Has demand moved to a level that would generate capital expenditure that many feel is necessary to push growth back to higher levels and would a rising interest rate scenario cut this particular and necessary part of the cycle short? This critical intersect may be a key consideration in any interest rate decision.
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:
If you have been “watching” you will have noticed a fairly sharp deceleration in global economic activity since the middle of 2014. World trade volume growth in particular has been heading into recession type territory:
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.