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!

Was the US Q2 GDP revision so great?

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):

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Making sense of US employment data and the interest rate decision.

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.

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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!

US Manufacturing Orders

After a strong mid 2014 new orders had fallen heavily with nominal order data especially hard hit.  After an initial slide the trend seems to be levelling out, but levelling out is not what the economy needs.

Long term, the order profile is flat if we adjust for prices – note I have adjusted for producer prices not order prices, although over time I expect little difference.

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Annual growth rates have taken a punch to the gut, but if we adjust for monthly variance and producer prices we find that the downturn is less marked, although not necessarily insignificant:

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What I do find interesting, and which backs up my thoughts re last summer’s surge in activity, is the fact that the rise in activity towards the middle of last year is more or less reflected in the downturn in the early part of this year.   This pattern comes about after adjusting for PPI and basing % changes on rolling 6 month average data to arrive at a better fix of actual capacity and order flow:

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Motor vehicles and parts seems to be the notable exception, but I do have concerns over debt financing and weak income growth.

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World Trade

Some charts and brief comments I forgot to post:

Growth in world trade volumes has fallen off significantly since summer 2014:

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Interestingly US trade data shows a tail off in US auto exports and a rise in Auto imports.  Imports rose strongly in March and fell back in April (opposite for exports), although much of this has been ascribed to the impact of West Coast port strike issues.

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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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Overtaxing the rich: A cautionary tale

We need to look at increasing inequality as an unfair tax on social and economic stability.  And so, my brief thoughts on this Tim Cestnick article in the Globe & Mail;

At a very simple level the economy spends what it earns  (Output=expenditure=C+I=C+S, where S is income spent but not consumed).  In reality the picture is somewhat different in that we have monetary loan expansion that over time has served to increase the demand/expenditure for goods/services and investment expenditure.

Economic growth is the growth of expenditure whether it be consumption or investment goods.   If we start to allocate increasing amounts of income towards a very small % of the population what we end up doing is to constrain the ability of the economy to grow. 

For one lower income growth limits borrowing ability (something which had sustained GDP growth) and it may retroactively impact the ability to repay previous loans based on lower ex post income growth.

Greater allocation of income to one small segment of society also risks a higher allocation of money towards assets and away from consumption.  Increasing income inequality results in lower recycling of income into demand, and as the growth rate of demand slows so does the growth rate of investment.  

Importantly future flows determine the valuation of assets, so rising inequality amidst weaker GDP growth poses risks to assets prices.  The significance of this circularity has been lost on the very wealthy in a time when monetary policy has been outwardly in favour of asset price support in a weakening growth environment.

If we had less income inequality then tax rates would also likely be lower and we may also have a smaller state and a more outwardly capitalist economy.   The need for higher tax rates is partly due to structural imbalances like income inequality: think of two monkeys swinging through the trees, one with all its limbs and the other with only one arm.

Clearly we need incentives for people to take risks with capital, but we also need to make sure that the system has the necessary circularity of flow.  The income of the very wealthy is dependent on the expenditure of all and the valuation of their assets too.  This is something many have lost sight of: today’s high market valuations relative to historical benchmarks (note the Shiller CAPE) are assumed by some to reflect a different set of dynamics supporting valuation whereas many of the growth engines of the past are collapsing.  

At a time when there are so many negative forces impacting the stability of the economy a more efficient, though still incentivised, distribution of income would go a long way to alleviating economic and geo-politic stress.  Otherwise we risk increasing social instability and greater threat to income and wealth.  

The post World War II years are a very short space in time and certainly not long enough to assume that the having your cake and eat it too mentality is a natural economic dynamic.  In reality increasing income inequality is a de facto tax on economic and social stability in that shifting income and wealth from one set of people to another creates dangerous imbalances and inefficiencies.  The present need to raise taxes is an ex post not an ex ante action.

http://www.theglobeandmail.com/globe-investor/personal-finance/taxes/how-splitting-the-dinner-bill-relates-to-tax-cuts/article24441644/

“Marketplace lenders step out of the shadows in Canada — should we be worried?”

Brief thoughts re a recent Barbara Schechter article: Marketplace lenders step out of the shadows in Canada — should we be worried?

I tweeted on this. Some additional comments.  Peer to peer lending is different from bank lending in that it does not result in an increase in money supply growth.  It may result in an increase in velocity of money supply, something which has been dropping of late in many economies as a result of quantitative easing and a number of other dynamics.  It should also increase the efficiency of the intermediation system by offering lower interest rates and quicker access to credit to many borrowers.   There are some cons: one of which is that it will increase the liquidity risks in the system in the event of an economic downturn/ financial market crisis.  This of course depends on how many may view their loans as money like when they have been transformed and how this market place securitises the loan book.   At the present moment in time it may also increase the amount of consumer debt over and above safe levels, although this would not necessarily be an issue in less leveraged environments.  

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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Not a Savings Glut, a much more complex dynamic of global imbalance and monetary excess.

For me the “Savings Glut” Hypothesis falls down on a number of key areas:

The first and most important is that it appears to ignore significant loan/monetary growth which breaks the point in time National Income Identity on which “Savings Glut” arguments apparently rest. I say apparently because much of the discourse supporting the SG hypothesis is either couched in nuanced semantic surfing and/or bereft of argument that you can trace directly back to the source of the flows from which they derive savings. Many supporters of the SG hypothesis either ignore these monetary dynamics totally or disavow them without cause.

The second is that it ignores the foreign exchange and central bank monetary dynamics involved in much of the FX/asset purchases. Key components of the trade balance/net investment position were orchestrated by Central banks creating new money to buy dollars and thence assets.

The third is that it ignores the fact that the major mega surplus economy, China, was and remains to a very large extent driven by loan financed (new money) gross fixed capital investment. Again the basic National Income Identity model misses a myriad of inter temporal dynamics. The SG argument was that it was excess savings and not monetary and financial system excess that caused the crisis and to fully understand the imbalances you have to look at where National Income/output is derived.

The fourth is that it ignores the very important development of emerging Asia as a global production hub and the off shoring dynamics that saw significant components of US and other international manufacturers move tranches of their manufacturing base to these countries. This issue is well covered and documented.

Finally, as discussed in numerous papers, focussing only on the net investment flows ignores vast sources of excess demand for assets that were also instrumental in pushing financial markets out of synchonisation with their economic fundamentals.

I will look to explore and illustrate these arguments in coming posts. 

Some brief thoughts on US Incomes and expenditures

Inflationary dynamics have brought about a large relative increase in real incomes over the last six months or so. 

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Yes it looks as if much of the most recent improvement has not been “spent”, but it is only 1 or 2 months into this gap which must itself be set against strained income increases over the last decade.  Longer trends and frames remain important for the sustained growth rates over time and the current frame remains a weak one.  Personal consumption expenditures as a % of disposable income remain at historically high levels and consumer credit growth may also be a notably factor weighing against leeway for growth in consumption (see end of post).

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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.

Are we in a financial bubble? Yes of course, we always are, but this one is different!

Many will be forgiven for feeling and being confused by the constant divergent chatter over market bubbles. 

Yes, we are in a bubble: I believe an extreme one in fact, but the natural state of the financial world relative to the economic is always one of a bubble; asset markets are always discounting the future, and the money supply that creates demand for assets and also goods and services has been growing for some time, as has the economy.  If a market is priced at x times historical earnings it is discounting future earnings and by doing so providing a valuable medium, or at least should be, for financing new investment and for facilitating the transfer of assets.   As the economy grows, so will assets and their prices and so will the bubble….and the bubble is the difference between now and future cash flows and the pricing of those cash flows. 

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The Fed is slowly shaking the tree, but will it start to climb?

Over the last 20 or more years interest rates have fallen, for reasons other than falling inflation, and as interest rates have fallen so has nominal growth in a great many developed economies, and so has inflation fallen further.  On the other hand debt has risen and so have asset prices, quite remarkably so in fact.  But through this period we have also had a succession of financial and economic crisis, with the risk mostly of a financial nature, and in response to these asset price risks, interest rates were either cut or held low for, in my opinion, far too long.

The Fed would now like to raise interest rates, and so too would other seemingly “well on the way to economic recovery nations”.  The trouble is the “economy and our markets” are now more than ever sensitive to changes in interest rates.   The Fed partly knows this, is partly concerned that interest rates lie at close to zero (and unless they want to go negative, a place they probably worry they may never climb out of) would like to see them a bit higher, to allow them to cut interest rates in a subsequent crisis. 

In the last cycle the the Fed Funds rate rose to 5.25 and currently loiters around the 0.11 to 0.12 range.  I would suspect that a Federal Funds rate of 4% was too high for the last upward cycle and would also posit that rates would be hard pressed to rise above 2% in the current cycle before we saw the type of wrenching market reaction…but this all assumes everything else being equal.  Markets are too well worn around the interest rate, money supply asset price equation to lay back and wait for the interest rate cycle to hit economic growth.   The question is though how much of an asset price shock can the “economy take as interest rates rise before that asset price shocks impacts the economy?  I guess that is the question and the Fed is trying to work out just how sensitive the world is to a rise in interest rates.  It just does not know and while the risk of rising rates may be extremely high it may well have figured that “the Fed’s got to do, what the Fed has got to do…”.  

As many other commentators have pointed out, a whole panoply of other risks have started to move out of the closet (namely the many risks posed by a sharply appreciating US dollar), risks that may already constrain the Fed from acting.

Current rates on 5 year treasuries are around 1.5% and stood at some 4% in early 2007.  I would have thought that the peak rate for the Fed rate would be around this level at the current juncture, but just how to get through to it is the question? 

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Some important dynamics from US Q4 GDP Update

A weak frame:

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Personal consumption expenditure is the most important component of US GDP and growth in real Personal Consumption Expenditure (PCE) is tied to the productive capacity of the economy.  So why on a real per capita basis has the economy failed to produce sustained increases in consumption capacity post the early 1980s?  And note that this is despite an increase in PCE as a % of GDP over the post war period. 

And also on a nominal basis:

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How reliant in fact has GDP been on the PCE component? Growth in PCE has eclipsed both GDP and equipment investment over the post war period, and significantly so.   The question begging to be asked is,”where is growth going to come from?”

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In another recent blog I exposited about asset valuations relative to GDP growth.  Now the charts above show the increasing reliance of US GDP on PCE, a component which appears to have outsized importance in GDP terms.  Well the following shows even PCE growth being dwarfed by increases in household asset values:

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In fact we can see that PCE expenditures have been less reliant on income growth post 2000s:

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And looking at nominal GDP only, if we adjust for inventories and the impact of changes in consumer credit we find a much subdued trend in growth:

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And nominal growth in expenditures have been declining:

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And motor vehicles etc continue to be an important part of consumer expenditure…

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And relative to the prior debt fuelled cycle we find that expenditure on MVPs and RV combined is a much greater…I have pointed out concerns with respect to the growth in non revolving consumer credit relative to income growth, a ratio which stands at historically high levels.

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Services expenditure has been increasingly volatile:

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And note the importance of health care expenditure:

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Interestingly if we take out healthcare expenditure from PCE, PCE as a % of GDP has been more more stable..

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And financial services expenditure has also picked up since Q1 2013:

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Interestingly, all the domestic investment components (on a nominal basis) are turning down in a synchronised way:

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Exports have been an important driver of growth recently, but more recently has fallen back as a nominal driver of expenditure: there are many explanations for this amongst them the recent decline in the oil price and weakening global demand growth.

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And of course the chart raises the question, where is the growth going to come from?

Finally, a quick peek at growth in commercial bank deposits relative to nominal GDP growth:

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Too Big Too Fail: a graphical analysis of the US asset bubble..

I have been tweeting about the relationship between asset valuations and GDP and a number of other metrics recently. 

My point for some time has been that the relationship between asset valuation and GDP, amongst other reference points, is excessive and out of alignment with slower GDP and income growth.  As with many of my other posts the point is this: the financial economy, asset and debt valuations and the complex financial system linking them, has become much bigger and therefore much more important to keep alive.  I would go as far as saying that the financialization of the global economy has become too big too fail, an extension no less of the banking dilemma.  

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