June 6th, 2014
Macro Strategy Review for June 2014
According to Congress's Joint Economic Committee, average gross domestic product (GDP) growth over the 19 quarters of our current economic recovery has been 2.2%, with total growth of 11.1%. The average for the seven post-1960 recoveries is 4.1%, with total growth of 21.1%. The 10% spread between the average recovery and the current recovery represents almost $1.6 trillion in unrealized GDP and $300 billion in lost federal tax revenue. Overall job growth has been well below the historical average since the recovery began in June 2009, and the quality of the jobs created has also not been good.
According to analysis by the National Employment Law Project published in April, 22% of the jobs lost during the Great Recession were in low- wage sectors such as food service and retail. However, those low-wage sectors accounted for 44% of all new jobs during the recovery. Mid-wage jobs accounted for 37% of the job losses, but only 26% of recovery jobs. Higher wage jobs have represented 30% of the increase in jobs, but were 44% of the losses. This analysis suggests the entire wage structure has dropped a notch during the recovery. The downshift in wages is corroborated by Department of Labor data, which shows employee compensation as a percentage of national income has fallen to 66%, the lowest since 1951.
In April, 288,000 jobs were created, raising the 12-month average to 197,000 from 185,000 and the best one-month increase since January 2012. Average hourly earnings though were flat and have only increased 1.9% over the past year. More importantly, average hourly earnings have been stuck at 2% annual growth for four years-well below the 3.5% to 4.0% experienced during the average post-World War II recovery. Meanwhile, the Consumer Price Index has risen 2% over the last year, effectively wiping out any increase in purchasing power for most workers.
The lack of real income growth caused consumers to maintain spending by dipping into their savings, with the savings rate falling to 3.8% in April, the lowest in six years. Food prices rose 0.4% in April and have risen four consecutive months. Just in time for the barbeque season, meat prices posted their largest jump since 2003.
GDP growth will likely pick up markedly in the second quarter, after an especially weak weather-induced first quarter. The consensus is that GDP will continue to grow by more than 3% in the third and fourth quarters. Unless income growth really picks up soon, our expectation is that growth is more likely to moderate in the second half of the year, after bouncing back in the second quarter.
We discussed the state of our nation's bridges in our November 2013 Macro Strategy Review (MSR), in a section entitled, "The Clues to a Future Crisis Are Usually Hiding in Plain Sight." Bridges are an important part of our transportation system, since they make it possible to travel in a straight line, rather than wasting millions of hours and incurring additional transportation costs in circumventing rivers, canyons and other natural obstructions. Bridges help lower the cost of shipping goods anywhere in the country, and save valuable time for millions of commuters every day. According to the U.S. Department of Transportation and its 2013 National Bridge Inventory database, there are 607,000 bridges in the United States and more than 10% of them are deemed "structurally deficient" or "fracture critical." The Department of Transportation estimates that cars, trucks and school buses cross the 63,000 structurally compromised bridges 250 million times each day. At least 20% of the bridges in Pennsylvania, Rhode Island, Iowa and South Dakota are structurally deficient. The Laborers' International Union of North America recently launched a $1 million campaign in Pennsylvania, Ohio and Michigan for radio ads and billboards to highlight the costs and safety perils of deteriorating highways and bridges. The AAA Automobile Club has estimated that poorly maintained roads cost each motorist an extra $324 annually for repairs and operating costs.
Funding to maintain our roads and bridges comes from the federal government via gasoline taxes of $0.183 per gallon for unleaded fuel and $0.244 for diesel fuel. However, since cars are getting much better mileage (a good thing), the amount of revenue has been declining in recent years. The Federal Highway Administration estimates that the national annual bridge and road repair would cost $21 billion. The longer Congress fails to address our infrastructure problem the more likely it is that costs are going to rise, since it is more expensive to replace or rebuild a bridge than maintain it. According to the American Society of Civil Engineers, inadequate surface transportation is projected to cost U.S. businesses $430 billion in operating expenses by 2020 and cause $1.7 trillion in lost sales opportunities. Given election politics, it is unlikely that funding for this long-term need will be addressed.
Unfortunately, funding for road and bridge repairs and maintenance may run out by fall unless Congress acts soon. The U.S. Highway Trust Fund's account balance will fall to $2 billion by September 30, and the Mass Transit Account to only $1 billion, according to the Congressional Budget Office (CBO). Without congressional action there will be no Highway Trust Fund support for any new or existing road, bridge or public transportation projects in any state during the fiscal year starting on October 1, 2014. U.S. Transportation Secretary Anthony Foxx told a Senate panel in early May that congressional inaction could force states to delay or halt projects already underway, costing up to 700,000 jobs. The CBO estimates $18 billion is needed to maintain current funding through the fiscal year 2015, which ends on September 30, 2015, and $100 billion to fund the traditional six-year transportation bill.
Even if members of Congress were able to agree on funding infrastructure fully, there is another problem. When Congress passed the $830 billion stimulus package in 2009, a portion of the funds were to go to "shovel ready projects." But few projects were actually started, since many projects were mired in the approval process. According to the Regional Plan Association, regulatory approval for infrastructure projects can take up to a decade or longer. For instance, the expansion of the Panama Canal will allow larger container ships to pass through the canal, so it is important for U.S. ports to be able to handle the larger ships. If a port is unable to handle the larger ships, it will lose business and jobs to ports on each coast that are capable. Savannah, Georgia, is the fourth largest container ship port in the U.S. and the fastest growing port over the last decade. In order to handle large container ships, the Savannah River needs to be dredged to increase its depth to 48 feet from its current depth of 42 feet. The original application to deepen the port was submitted in 1999. The environmental review statement for dredging the Savannah River has taken 15 years to complete. New Jersey's Port Newark Container Terminal wanted to be able to accommodate a new generation of efficient large ships, and submitted an application to raise the Bayonne Bridge almost five years ago. This project has been bogged down by environmental litigation, even though it requires no new foundations or right of way.
Regulatory review is supposed to serve and protect a free society, not paralyze it. Part of the problem is that regulatory approval is spread among federal, state and local agencies. No single authority possesses the power to decide when there has been enough review. Since coordination between federal, state and local agencies is at times poor, duplication of environmental requirements adds to delays and costs. Ironically, environmental groups often work at cross purposes, delaying projects that advance the green agenda they proclaim to support. The Cape Wind project, located off the coast of Massachusetts, has been reviewed by 17 agencies over the last 12 years. The Gateway West Transmission Line project will carry electricity from Wyoming wind farms to the Pacific Northwest. The approval process began in 2007, and must be approved by each county in Idaho that the power line will traverse, which is why the approval process has not yet been completed. All it takes to halt a project of this scope is one lawsuit in one county. Can you imagine how people would react if the Internet or cell phones worked like this?
In 1835, French political thinker Alexis de Tocqueville warned that the real threat to American democracy wasn't forceful tyranny, but a new kind of challenge; he claimed that society would develop a new kind of servitude that
"covers the surface of society with a network of complicated rules, minute and uniform, through which the most original minds and the most energetic characters cannot penetrate...it does not tyrannize but it compresses, enervates, extinguishes, and stupefies a people, till each nation is reduced to be nothing better than a flock of timid and industrious animals, of which the government is the shepherd."
Enervates means to weaken or destroy the strength and vitality of something. The cumulative impact of a network of complicated rules over time certainly has the potential to weigh on economic growth and sap its vitality.
The Federal Register is a daily digest of proposed regulations from agencies, notices, corrections and finalized rules. It was first published in 1936 and contained 2,620 pages. By 1966, the Federal Register had reached 16,850 pages and mushroomed to 87,012 pages in 1980. Obviously, some rules and regulations are more costly to implement than others, but the number of pages in the Federal Register provides a fairly good representation of the regulatory burden being placed on our economy and the hurdles and costs of doing business. Since 1993, the Federal Register has averaged 71,470 pages per year, which means 286 pages were added every single work day for the past 20 years. In 2013, the Federal Register contained 3,659 final rules and 2,594 proposed rules, with another 3,305 regulations moving through the regulatory pipeline. Of these regulations, 189 are "economically significant," which means the government estimates they will each have a cost of at least $100 million. Frequently, the actual cost of a new regulation often exceeds the government's initial estimate. Compiling reports of compliance costs from government agencies and outside sources, the Competitive Enterprise Institute estimates $1.86 trillion is now spent annually by individuals and companies in pursuit of regulatory compliance. This amounts to more than 10% of GDP, and since businesses must pass along at least a portion of this regulatory compliance cost to consumers in the form of higher prices, it represents an unseen regulatory "tax."
It is also having an impact on the willingness of people to assume the risk of starting a business. For the first time in the last 30 years, the Brookings Institution has found that fewer businesses are being formed than are closing their doors. This is significant since small businesses are responsible for 60% of the new jobs created, and one of the reasons why job growth during this recovery has been the weakest of any recovery since World War II. The Heritage Foundation has compiled its Index of Economic Freedom since 1993, by evaluating 10 categories, such as property rights, the size of government and fiscal soundness. After seven straight years of decline, the U.S. has dropped out of the top 10 most economically free countries for the first time. As the government assumes more of the role of a shepherd, economic freedom and growth are receding.
In April, Toyota made big news when it announced it will move its U.S. sales unit and more than 3,000 jobs from Southern California, where it has been located since 1957, to Texas in 2016. In 2011, workers in Texas paid 7.5% of their income in state and local taxes compared to 11.4% for California workers. Those earning more than $48,000 annually pay a top income tax rate of 9.3% in California, which is more than what millionaires pay in 47 other states. Between 2005 and 2012, almost 250,000 people moved from California to Texas, according to the U.S. Census Bureau. According to the Tax Foundation, the migration out of California represents $15.8 billion in lost income and almost $1.5 billion in lost tax revenue annually. Businesses are leaving due to regulatory burdens, high taxes and high costs. California has the 48th worst business tax climate, and green energy mandates have driven up electric utility costs to the level of being 50% higher than the national average. In response to criticism of California's regulatory, energy costs and tax burdens, California Governor Jerry Brown offered this assessment,
"We've got a few problems, we have lots of little burdens and regulations and taxes...But smart people figure out how to make it."
Unless California is able to reverse current trends, at some point, only "smart" people will be living in California.
Although private employment has exceeded its pre-recession level, total employment, which includes federal, state and local jobs, is still below its December 2007 high. In the 11 recessions since World War II, all the jobs lost during the recession in nine of the recoveries were recovered within 32 months. Total employment will likely exceed its 2007 high in May, a mere 76 months after the recession's start. As noted earlier, since the recession ended in June 2009 the quality of jobs has been poor, and income growth has not kept up with the cost of living for many hard working and industrious Americans.
Given this backdrop, the U.S. State Department's April 18 decision not to proceed with the Keystone Pipeline System is surprising, and for true environmentalists, perplexing. On January 31, the State Department released its fifth environmental report on the pipeline and stated the pipeline would have no marginal effect on the climate since the oil will be used whether or not the pipeline is built. However, the State Department also evaluated the climate impact if the pipeline was not built. Greenhouse gas emissions will increase between 27.8% and 41.8% if the oil is instead transported by tanker or rail to a myriad of existing pipelines. Furthermore, they estimate the 830,000 barrels of oil a day flowing through the Keystone Pipeline would likely result in 0.46 accidents (spills) annually, resulting in one injury and no deaths. In comparison, transporting the oil by railroad would result in 383 annual spills, causing six fatalities and 49 injuries. Last summer, a train derailment in Lac- Mégantic, Quebec, killed 47 people. The State Department also estimates rail transport will result in 1,335 barrels being spilled annually, versus 518 barrels for the Keystone Pipeline. Based on these statistics, the Keystone Pipeline would be a net benefit for the environment and save lives. Economically, the State Department says the pipeline would create 42,100 "direct, indirect, and induced" jobs. The construction of the pipeline would create 2,000 construction jobs, with many of those jobs going to union workers.
Terry O'Sullivan runs Laborers' International Union of North America, which represents 500,000 construction workers. O'Sullivan and his union supported candidate Barack Obama in 2008 and President Obama in 2012, saying he is a leader "who will fight to create jobs." O'Sullivan was understandably upset when the Obama administration announced on April 18 it was delaying its decision on the Keystone Pipeline until after the November election. In a public statement O'Sullivan said:
This is once again politics at its worst...In another gutless move, the Administration is delaying a finding on whether the pipeline is in the national interest based on months-old litigation in Nebraska regarding a state level challenge to a state process- and which has nothing to do with the national interest. They waited until Good Friday, believing no one would be paying attention. The only surprise is they didn't wait to do it in the dark of night...It's not the oil that's dirty, it's the politics. Once again, the Administration is making a political calculation instead of doing what is right for the country. This certainly is no example of profiles in courage. It's clear the Administration needs to grow a set of antlers, or perhaps take a lesson from Popeye and eat some spinach...This is another low blow to the working men and women of our country for whom the Keystone XL Pipeline is a lifeline to good jobs and energy security.
The recovery that began in June 2009 has been the weakest of any post-World War II recovery, despite unprecedented monetary accommodation and fiscal stimulus. There are many reasons why this recovery has been so disappointing and we are not suggesting that regulation has been the largest contributor. However, overlooking the progressive burden of regulation and its effect on business formation, job growth and economic vibrancy is a mistake. The slowdown in GDP growth began long before the financial crisis in 2008 and the weak recovery that started in June 2009. If you review the aforementioned chart regarding the increase in the number of pages in the Federal Register, you can see there was an enormous increase in regulations between 1966 and 1980. Given the lag time as all these new regulations were implemented and their cumulative drag on growth, it is not surprising that the downtrend in the 20-year average of GDP growth reemerged around 1980.
There is a demographic tsunami that has the potential of swamping our fiscal finances over the next 10 to 20 years, as baby boomers leave the labor force and government spending soars. Unless economic growth accelerates and is sustained, it is likely there will not be enough money for the government to make good on the future liabilities embedded in the Medicare and Social Security programs. The clock is ticking and a network of excessive regulations, or using regulation for political gain, rather than a tool of common sense for the common good, is an indulgence we may not be able to afford. As Alexis de Tocqueville wrote in the nineteenth century,
"There are many men of principle in both parties in America, but there is no party of principle."
Eurozone GDP grew 0.8% in the first quarter, with Germany and Spain up 3.2% and 1.5%, respectively, while France was flat, Italy was down 0.5%, and GDP in Portugal was off by -2.8%. We do not expect GDP growth in the eurozone to exceed 1% by much in 2014, so the first quarter was in line. Since banks provide 80% of the credit creation in the eurozone, a solid recovery is not likely until lending and credit availability improves. A recent report by the European Central Bank (ECB) noted that the credit squeeze throughout the eurozone had eased modestly in recent months, but has a long way to go. New bank loans are still only half of their pre-crisis level. Since small- and medium-size businesses represent two-thirds of all jobs, unemployment is not likely to come down quickly in many eurozone countries until credit availability improves materially. The ECB report also noted that 60% of businesses in Greece, 52% in Italy and 43% in Portugal still face a real problem in gaining access to credit. When they can obtain a loan, they are often paying rates two to three times higher than German businesses. The lack of access and cost of credit will make it especially difficult for businesses in Southern Europe to not fall further behind Germany in terms of productivity.
Entering 2014, we expected the ECB to engineer a decline in the value of the euro. As we discussed in the April MSR, the simplest way for the ECB to lift inflation and further support growth would be to communicate a desire for the euro to decline. The ECB has estimated that the 15% rise in the euro over the last 18 months has shaved 0.4% off eurozone inflation. Since imported goods will cost more and add to inflation, a weaker euro should alleviate some of the downward pressure on inflation. A weaker euro would also likely make exports from every EU country cheaper for the rest of the world to buy, which would likely lead to an increase in exports and GDP growth. A cheaper euro would especially help Italy, Spain and France, which have higher labor and production costs than Germany. After the ECB's meeting on May 8, ECB President Mario Draghi stated that the ECB's governing council is "comfortable with acting next time" and easing policy at their meeting in early June. He also reiterated the connection between the euro and the low rate of inflation.
"The strengthening of the exchange rate in the context of low inflation is a cause for serious concern."
It appears currency traders have gotten the message since the euro peaked on May 8 at 139.93. As we discussed in April, the 50% retracement of the decline from the July 2008 high of 160.38 to the low in June 2010 at 118.77 was 139.57. The May 8 peak was just 0.46 from a perfect 50% retracement, which technically is significant. During the week of May 9, the euro posted a weekly key reversal when it made a higher high, lower low than the previous week, and closed lower. In fact, the May 9 weekly reversal encompassed the three prior weeks, which adds to its importance. This is another technical indication that the trend in the euro versus the dollar has turned down. This is one of those times when the fundamentals and the technicals are aligned, which should increase the probabilities that our forecast of a decline in the euro is on target. As we wrote in the May MSR, "Shorting the euro has the potential to result in a profitable trade over the next year." From a risk management point of view, a stop on a short trade should be either just above the May 8 high or pennies below it.
On March 7, the S&P 500 Index traded just over 1,883. On May 22 (10 weeks later) the S&P 500 closed at 1,892, about 0.5% from where it traded on March 7. Basically, the S&P 500 has been sloshing around in a 4% range. However, that benign description belies what has been happening under the surface. Two days after the S&P 500 made a new high on May 13 the Russell 2000 Index was down more than 10% from its high, making a new low for the year. This type of bifurcation within the market is fairly rare. When an important sector like small cap stocks undergoes a meaningful correction, more often than not, the rest of the market is tugged down too, even if it's to a lesser extent.
The pattern of higher price highs accompanied by less upside momentum continues. Although the S&P 500 made a new intraday and closing high on May 13, the Major Trend Indicator (MTI) only reached 2.50 on May 14. That's quite a bit lower than the 4.38 it reached on January 2, when the S&P 500 was 3.3% lower. As I have stressed for quite a while, the technical deterioration that has taken place in recent months only sets the stage for the market to potentially experience a decline. A meaningful decline (greater than 7%) is not likely until investors have a reason to sell all stocks. Currently, most investors are constructive on the economy, especially for the second half of this year. With that as the dominant outlook, most institutional investors are only interested in identifying which groups to be invested in, rather than questioning whether they should be fully invested in the market. As small cap stocks were sold, the proceeds were used to buy large cap stocks institutions viewed as having greater value. That's why the correction has been rotational in nature, rather than a true correction in which the majority of stocks are sold. The S&P 500 should run into resistance at the red trend line above the S&P 500, which is near the range of 1,915-1,925 (see nearby chart). If the S&P 500 falls below 1,810, it would violate the mid-April low at 1,814 and the dark blue trend line from the low in June of last year. This would indicate that a test of the 1,737 low in early February and red trend line below the S&P 500 was likely.
At the beginning of this year, the almost universal opinion was Treasury bond yields were only going higher. This view was easy to embrace since the Federal Reserve had decided at the December Federal Open Market Committee meeting to begin tapering their debt security purchases by $10 billion a month. With less demand coming from the Fed, yields had to go up! However, from the end of December, Treasury yields began a resolute march lower, confounding most experts. In recent weeks, analysts have been scrambling to explain why Treasury yields have been falling, since so many had expected the opposite.
Since the January MSR, our view has been that Treasury yields were likely to come down based solely on the chart pattern of the 10-year Treasury bond. In the January MSR we said, "Our guess is that the 10-year Treasury yield will come down, possibly to 2.5%- 2.7%." In March we wrote, "The 10-year Treasury yield is likely to fall below 2.58% and approach 2.46%, before any sustained rise in yield occurs." In the April and May MSR's we stated, "The pattern of the 10-year Treasury yield suggests that it is likely to fall below 2.58% and approach 2.46%." On May 15, the 10-year Treasury yield dropped to 2.47%. Close enough.
So, where does the 10-year Treasury yield go from here? We don't know with any degree of confidence. The yield could dip below 2.40%, but to drop appreciably further would take a geopolitical event resulting in a flight to quality, or far weaker economic data than we expect. Our guess is that the 10-year Treasury yield is more likely to just drift higher in coming weeks.
- De Tocqueville, Alexis. (2002). Democracy in America. Chicago: University of Chicago Press.
- The Wall Street Journal, “Jerry Brown’s ‘Little Burdens’,” May 2, 2014.
- Forbes, “Even Obama’s State Department Knows Keystone XL Is Not An Environmental Hazard,” July 23, 2013.
- The Wall Street Journal, “Keystone Uncensored,” April 24, 2014.
- The Wall Street Journal, “Draghi: ECB ‘Comfortable With Acting Next Time’ -- 3rd Update,” May 8, 2014.
Definition of Terms
10-year Treasury is a debt obligation issued by the U.S. Treasury that has a term of more than one year, but not more than 10 years.
Consumer Price Index (CPI) is an index number measuring the average price of consumer goods and services purchased by households. The percent change in the CPI is a measure of inflation.
Federal Open Market Committee (FOMC) is a branch of the Federal Reserve Board that determines the direction of monetary policy.
Gross domestic product (GDP) is the total market value of all final goods and services produced in a country in a given year, equal to total consumer, investment and government spending, plus the value of exports, minus the value of imports. The GDP of a country is one of the ways of measuring the size of its economy.
Index of Economic Freedom is a ranking of countries or states based on the number and intensity of government regulations on wealth-creating activities. It compares countries to each other and compares overall levels of economic freedom across time.
Russell 2000 Index measures the performance of the 2,000 smallest companies in the Russell 3000 Index. The Russell 3000 Index represents approximately 98% of the investable U.S. equity market.
S&P 500 Index is an unmanaged index of 500 common stocks chosen to reflect the industries in the U.S. economy.
One cannot invest directly in an index.
RISKS: Investing involves risk, including possible loss of principal. The value of any financial instruments or markets mentioned herein can fall as well as rise. Past performance does not guarantee future results. This material is distributed for informational purposes only and should not be considered as investment advice, a recommendation of any particular security, strategy or investment product, or as an offer or solicitation with respect to the purchase or sale of any investment. Statistics, prices, estimates, forward-looking statements, and other information contained herein have been obtained from sources believed to be reliable, but no guarantee is given as to their accuracy or completeness. All expressions of opinion are subject to change without notice.
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