posted on 08 December 2016
Written by Jim Welsh
Macro Factors and their impact on Monetary Policy, the Economy, and Financial Markets
Macro Tides Investment Outlook - December 7, 2016
The recovery since June 2009 has been 60% as strong as the average of the 10 prior post World War II recoveries. There is more than one reason for this lackluster performance. One of the reasons has been the low level of business investment. One of the keys to the success of Trumpsternomics will be whether Trump’s plan to lower corporate tax rates and repatriation of overseas profits leads to an increase in business investment.
I suspect that expectations are higher than the outcome is likely to prove. The low level of capacity utilization in many industries is likely to lead most companies to wait until firm signs of increased demand materialize for their products. In October capacity utilization was 75.3%, which isn’t much above the low of 73.7% in December 2001, when the economy was in a recession.
The decline in utilization since its peak of 78.9 in November 2014 is primarily due to the significant decline in energy utilization. But the November 2014 high in utilization was comfortably below the prior peak in May 2007 of 80.9, continuing a multi-decade trend of lower peaks in the rate of utilization. The key point is that even as utilization was climbing during 2013 and prior to the peak in November 2014, corporations chose to use cash flow and borrowed money to buy back their stock, rather than increasing business investment. It seems unrealistic to assume that corporations would radically alter their behavior if cash flow improves after tax rates are lowered.
In 2004 the “Homeland Investment Act" was passed which allowed multinational firms to bring overseas profits back home and pay a tax rate of 5.25%, rather than the normal 35% corporate tax rate. It was ‘sold’ as a way to spur investment in new plants, research and development, and new jobs. In a June 2 2009 paper, the nonpartisan National Bureau of Economic Research (NBER) reported that 843 corporations took advantage of the Homeland Investment Act and repatriated $362 billion. In the prior five years, the average annual amount of repatriated earnings was $60 billion, so the Act resulted in an additional $300 billion coming home in 2005.
The Bush administration and Congress estimated the tax holiday would create more than 500,000 new jobs, while J.P. Morgan Securities expected businesses would increase capital spending by 2% to 3%. NBER concluded in its 2009 analysis that “the decreased costs of assessing earnings retained abroad under the Homeland Investment Act did not increase domestic employment, investment, or research and development." For each $1.00 of earnings repatriated, domestic investment increased less than $.01.
The Homeland Investment Act specifically said repatriated money could not be used to raise dividends or to repurchase shares, since it was intended to spur economic activity. A 2010 study by academics at Harvard University, the University of Chicago, and the Massachusetts Institute of Technology estimated that for every $1.00 that was repatriated, stock buy backs increased by $0.79. This study verified the results of the 2009 NBER paper which found that buybacks represented a $0.79 increase in share repurchases and $0.15 increase in dividends.
I have no doubt that Trump’s proposed repatriation program will be trumpeted as a way to increase business investment, research and development, and job creation. While these goals are worthwhile, the result from the Homeland Investment Act suggests we shouldn’t believe the marketing of Trump’s program. Money is fungible and corporations are likely to circumvent whatever restrictions that are put into place, just as they did after bringing $300 billion in overseas profits home in 2005.
While the repatriation of overseas profits is unlikely to boost the economy as promised, it will help the stock market. Some market participants want to believe the hype and are busy increasing their estimates of GDP growth and corporate earnings for 2017. Although earnings will benefit, it is more likely to come from increased stock buybacks, rather than organic earnings growth due to better economic and revenue growth.
In the last five years, stock buybacks have exceeded $3 trillion, but weak revenue growth and lower profit margins in 2016 were beginning to slow the pace of buybacks. According to Factset, S&P 500 share buybacks declined -6.8% in the second quarter to $125.1 billion. The number of S&P firms executing buybacks dropped to 350 from 380 in the first quarter. More importantly, 137 companies (39.1% of the 350 firms) spent more on buybacks in the trailing twelve months than they generated in earnings. Finally, of the $2.5 trillion in overseas earnings, almost 20% of the total is held by just 5 companies - Microsoft, General Electric, Apple, Pfizer, and IBM. With so much overseas profits concentrated in a small number of companies, it seems more likely that these firms will merely increase the size of their already large buyback programs.
Stock buybacks have been a huge support under the stock market and have certainly played a role in limiting the time and depth of corrections in recent years. A resurgence of stock buybacks is coming, after the overseas profit repatriation bill is passed.
Globalization has fostered intense competition and made it difficult for companies to increase the price of their goods and services. This is one reason why inflation has remained low, despite extraordinary monetary accommodation by every major central bank.
The level of corporate tax rates matters in a global economy, which is why a number of U.S. companies have moved their headquarters to other countries with far lower tax rates. Among 188 countries, the U.S. has the third highest corporate tax rate in the world at 35%, according to the Tax Foundation. Since 2000, most of the U.S.’s major trading partners have lowered their country’s corporate tax rates.
While some U.S. companies are able to utilize tax law attorneys to lower their tax burden, most can’t, and none can compete with Ireland’s 12.5% tax rate. In terms of global competitiveness, U.S. companies are at a substantial disadvantage, since taxes are a cost of doing business. Taxes are no different than labor and material costs, and help determine the price of every service or good sold. Lower corporate tax rates in the U.S. will help U.S. corporations become more competitive in the global economy.
While Trump’s plan to allow companies to repatriate overseas profits at a low tax rate is more likely to increase stock buybacks and dividends than worker’s earnings, cutting the federal corporate tax rate from 35% is likely to result in higher wages for American workers. In a 2007 paper Federal Reserve economist Alison Felix used data from the Luxemborg Income Study, which tracks individual incomes across 30 countries. The analysis found that a 10% increase in corporate tax rates reduced wages by about 7%. In a 2009 paper Ms. Felix found that states in the U.S. with higher corporate tax rates had significantly lower wages, (ironically) especially for union workers.
The American Enterprise Institute gathered international tax rates and manufacturing wages in 72 countries over 22 years. Their analysis found that increases in corporate tax rates are for the most part paid for by workers receiving lower wages. In May, Canadian economists Kenneth McKenzie and Ergete Ferede found that when corporate tax revenue was increased by a dollar, wages dropped by more than a dollar.
Since consumer spending represents 68% of GDP, a reduction in corporate tax rates should lead to wage growth that may prove more beneficial than tax cuts for individuals. In 2014, a little more than 40% of all tax payers paid no federal income taxes, and those between the 40th and 60 th percentile, paid just 5.9% of total individual income taxes. (Table below.) This suggests that 60% of taxpayers would only benefit marginally from a tax cut, but all of them would be better off if their wages grew faster as a result of lower corporate tax rates. The progressivity of the tax code illustrates why it is difficult to pass a tax cut that doesn’t appear to benefit the “wealthy’, since the top 20% of earners accounted for 83.9% of total individual income taxes paid in 2014.
On November 30, Trump’s nominee for Treasury Secretary Steven Mnuchin said that most of the tax cuts for the wealthy would be offset by the elimination of various deductions, so the middle class would receive a larger tax cut. If true, the economy would benefit since those in the top 20% are more likely to save most of their tax cuts, while those in the middle would probably save less and spend more.
Since 2005 corporations have been on a borrowing binge and the sales of investment grade corporate debt have more than tripled. As a result, corporate debt, exclusive of liquid assets, was 71% of revenue at the end of the second quarter, the highest ever.
Corporate bonds plus nonfinancial business loans as a percent of GDP totaled 44.88% as of June 30, which is above the 2001 peak of 43.5% and higher than 43.96% in 2008. In the last 4 quarters corporations have repurchased $620 billion of their stock and spent $1.69 trillion on capital expenditures. This is a problem since it exceeds corporation’s free cash flow and net borrowing by $248 billion. During the last two years, revenue growth has been difficult to come by, and with debt levels already high, corporations began to pare stock buybacks in the second quarter. Corporations are likely to divert some of the increased cash flow from a reduction in corporate tax rates to paring debt levels, especially with interest rates rising. While this would be good for corporate balance sheets, it wouldn’t add to economic growth.
It has been reported that Trump wants to increase infrastructure spending by $1 trillion, which sounds like a lot of money. However, that spending would be spread out over ten years, with very little occurring in 2017 given the time it will take to pass the bill, complete engineering analysis, fulfill environmental requirements, and sign contracts with construction firms.
If the $1 trillion is compressed into nine years, that works out to $111 billion per year or 0.4% to 0.5% of GDP per year. All else being equal (it never is) that would provide the economy, which has averaged just 2.2% annual GDP growth since 2009, a nice lift.
There is no question that an infrastructure face lift is needed. According to the Federal Highway Safety Administration, in 2015 58,495 bridges (9.6%) out of the 609,539 bridges in the United States are currently rated as structurally deficient. Every day more than 200 million drivers use these deficient bridges. Between 2014 and 2015, the number of structurally deficient bridges overall in the United States decreased by 2,574, and by 8,254 since 2012. At this rate of improvement it will take almost 20 years to repair all the structurally deficient bridges. The American Society of Civil Engineers says 32% of our major roads are in “poor" or “mediocre" condition, and 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. AAA estimates that potholes alone cost American drivers $3 billion a year in car repairs. Overall the American Society of Civil Engineers gives America a D+ for infrastructure.
Funding to maintain our roads and bridges comes from the Federal government via gasoline taxes of $0.183 per gallon on unleaded fuel and $0.244 for diesel fuel, and hasn’t been changed since the Omnibus Budget Reconciliation Act of 1993. However, since cars are getting much better mileage (a good thing), the amount of revenue has been declining in recent years. A modest increase ($0.03 per gallon?) in the federal gasoline tax makes sense since it amounts to a user fee.
The bigger issue confronting the ramp up in infrastructure projects is the approval process. 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. 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, with no one authority possessing 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. All it takes to halt a project of this scope is one lawsuit in one county.
The slowing of GDP growth since the mid 1970’s coincides with a huge increase in government regulation as measured by the number of pages published in the Federal Register, which details every rule and regulation passed by Congress. In the 1970’s the number of pages in the Federal Register exploded from 170,325 pages to 450,821 pages, an increase of 265%. In the 1980’s, 1990’s, and the first 10 years of the 21st century, the number of pages grew 117% in each decade.
Between 1993 and 2015 the actual number of rules and regulations soared from 4,369 to 94,246 in 2015. During this 23 year period average annual GDP growth was 2.54%. The compounded annual increase in final rules and regulations grew 14.2%, or 5.5 times faster than GDP growth. According to the Competitive Enterprise Institute’s annual survey, Federal regulatory costs in 2015 were $1.885 trillion, or roughly 10% of GDP.
Researchers at Lafayette University in 2010 found that per employee cost of federal regulatory compliance was $10,585 for businesses with 19 employees or less, and $7,755 for employers with more than 500 employees. Given the increase in regulation since 2010 (Affordable Care Act), these per employee costs are probably higher today. The mounting surge in regulatory compliance costs is certainly a contributing factor in wage stagnation, fewer business formations, and slowing growth during the past 30 years. Trump has promised a rollback in regulation and these charts show it is warranted. Even if he is successful, the impact on the economy will be positive but stretched out over a period of time (years) with little positive effect on growth in 2017.
In 1835 Alexis de Tocqueville warned that the real threat to American democracy wasn’t forceful tyranny, but a new kind of challenge:
For the first time in decades more small businesses are closing than opening, which is important since small business create 60% of all new jobs. Surveys by the National Federation of Independent Business in recent years have shown that regulation is one of the biggest concerns shared by owners of small businesses. Trump has vowed to lower the overall burden of regulation and expedite infrastructure projects in coming months. This process will take a long time to accomplish and more time to implement. If Trump is successful, the most original minds and energetic characters will have more opportunity to improve productivity and growth.
Expectations for the economy have improved with Trump’s election and investors have responded by bidding stock prices up for the sectors perceived to benefit most, sold Treasury bonds and interest sensitive equities, and boosted the value of the dollar. Financial markets have set the stage for the hurry up and wait experience, which is likely to test their patience in coming months. I suspect investors won’t have the patience required to calmly wait for the economic response that has already been priced into stocks, bonds, and currencies.
In the last four years, first quarter GDP growth was below the average for the year, and in the last three years has been the weakest quarter of each year. In 2014, the Polar Vortex caused the economy to actually contract by -0.9%, but in 2015 GDP grew just +0.6% and +0.5% in 2016. Whether seasonal factors are contributing or not, the pattern is pretty clear.
The 2017 Farmers’ Almanac forewarns that ‘exceptionally cold, if not downright frigid weather will predominate over parts of the Northern Plains, Great Lakes, Midwest, Ohio Valley, the Middle Atlantic, Northeast, and New England this winter. The Farmers’ Almanac’s longrange weather predictions also suggest shots of very cold weather will periodically reach as far south as Florida and the Gulf Coast. The Farmers’ Almanac, which breaks the country into 7 zones, forewarns of a mixed bag of wintry weather for both December and January. But it’s really February when the frigid temperatures take hold (northern tier states could see ambient air temperatures as low as 40 degrees below zero!).
Even if this winter is not as cold as forecast, it follows two winters where temperatures were milder than normal. This allowed those in the northern portion of the U.S. to spend less money on heating oil and heat in general. If this proves a colder than normal winter, consumers will spend more money trying to stay warm and less money on everything else.
There are other factors beyond seasonal adjustments of raw data used by the Bureau of Economic Analysis and Labor Department that come into play in the first quarter. Insurance premiums increase at the beginning of each year and the increases in 2017 will be larger than in prior years.
For those who earned more than $118,500 in 2016, the first paycheck of 2017 will be 6.2% less in net pay due to social security taxes than the last number of checks received in 2016. Most consumers don’t pay cash for all their Christmas and Holiday gifts, so they allocate more money to pay down their credit card balances in the first quarter, which directs spending away from everything else.
Since the election, mortgage rates have jumped about 0.6%, from 3.4% to 4.0%. Since it takes 45 to 60 days for a home sale to close, the full impact from higher mortgage rates won’t be fully known until March, when February data is released. Since November of 2015, the 6-month London Inter Bank Offered Rate (LIBOR) has risen from 0.62% to 1.29% on December 2, while the 3-month LIBOR has increased from 0.38% to 0.95%. Globally, LIBOR rates are used to determine the interest rate on more loans than any other benchmark. Even though the ECB and the Bank of Japan have not raised rates, and the Fed has only increased rates 0.25% since November 2015, most borrowers around the world are paying more for their adjustable rate loans. In this respect, monetary conditions have already been tightened modestly by the market. By the time the Fed raises the federal funds rate on December 14 by 0.25%, it will represent a fait accompli.
The Dollar dropped 8% from a high in late November 2015 until the first week of May. Changes in the value of the Dollar impact the domestic economy about 9 months after a significant change. The decline between November 2016 and early May has been providing the economy a lift, which should begin to diminish in early 2017.
The Dollar’s 10.8% rally since the low in early May through last week will begin to weigh on the economy before the end of the first quarter of 2017, and more so in the second and third quarter, since the bulk (7.4%) of the Dollar’s strength has come since early September. The strength in the Dollar represents a modest tightening of financial conditions.
Although vehicle sales were up 3.5% in November compared to last year, they were down from an annual rate of 18.25 million to 17.87 million on a seasonally adjusted rate. The November increase was assisted by an increase in discounts which amounted to nearly 11% of the selling price compared to 9.4% in November 2015. New car purchases are being made even though the buyer owes a record $4,832 on their trade in. Through September 30, a record 32% of all trade-ins had negative equity, up from 30% in September 2015, and just 22% five years ago, according to Edmunds. When a buyer adds the unpaid balance to the new car loan, the loan-to-values ratio tops 100%.
The length of the average car loan has increased to 69 months from 63 months five years ago, as consumers try to keep the monthly payment manageable. Increasingly, new car sales have been financed by sub-prime auto loans, which are up a stunning 124% since 2010, according to Equifax. Although the percent of sub-prime loans as a percent of total car loans decreased from 23.3 percent in 2015 to 22.8 percent in 2016, default rates are climbing. According to the Federal Reserve of New York, 2% of subprime auto loans became at least 90 days delinquent, up 25% since 2014. As the NY Fed noted:
When a default occurs, the recovery value is less than lenders projected since used car prices have been falling faster than expected, according to Edmunds.com.
As discussed last month, since June 30, 2009, leasing grew from 13.5% of sales to a record 31.5% of sales in June 2016, according to Experian Automotive. Since most leases are for 2 or 3 years, 3.1 million cars are expected to come off a lease in 2016, an increase of 33% from 2015, according to NADA Used Car Guide.
With so many cars hitting used car lots, used car prices are down 3.6% through September, the most recent month available. Falling used car prices typically pressure new car prices, so automakers will have to offer larger discounts to sell new cars. It’s too soon to suggest vehicle production will be cut, but reasonable to expect auto sales will not add much to GDP in 2017.
The lag time between when Trump is inaugurated and when the economy will actually benefit from Trump’s economic plan will seem like forever for investors who think the Republicans can merely snap their fingers and make it all happen next month, since they control Congress and the White House. It is going to take a number of quarters before lower individual and corporate tax rates, a reduction in the burden of excessive regulation, and infrastructure spending lift growth as much as expected.
The debt ceiling issue could pose a true hurdle for conservative republicans. The discord that is possible from the debate about deficits and existing government debt levels could be the wake-up call that most investors don’t want to get. It’s not a good omen that the current debt ceiling limit comes to an end on March 15, the Ides of March.
Trump’s tax cut proposal could ignite a lively bipartisan debate. More than 40% of workers pay no federal income tax and the top 20% of earners accounted for 83.9% of total individual taxes collected in 2014. The U.S. tax system is already fairly progressive, (Table - Who's Paying What, earlier above.) but democrats and the media are not likely to explain the math, or the difficulty in giving a tax cut to a worker who hasn’t paid any federal taxes. The Earned Income Tax Credit program actually provides low income families income above whatever federal taxes they paid. This is why the Table shown earlier shows the bottom 40% of taxpayers contributing less than 0% of individual income taxes paid.
Whatever the specific tax cut proposal turns out to be, the democrats won’t be bashful in noting that most of the tax cut is going to the wealthy, who don’t deserve it, rather than the white blue collar workers who voted from Trump. I expect Elizabeth Warren and Bernie to be in fine form on the Sunday talk shows, as they denounce the failure of trickle-down economics and the unfairness of it all.
I think investors will become impatient when they realize the economy is not going to benefit from Trump’s proposed changes until the second half of 2017 at the earliest, and the legislative progress isn’t as smooth as currently expected. If the economy slows a bit in the first quarter, investor’s impatience could become disappointment and lead to a reversal in the market’s that have rallied and declined in the wake of the election. This suggests that financials, small caps, industrials, and oils could experience a bout of profit taking, especially since the capital gains tax rate will act as an incentive to book profits in 2017.
The Dollar is also vulnerable to a correction, although a flare up in the Italian banking system could cause the Euro to make a run par, or 1 to 1 versus the Dollar. Conversely, Treasury bond yields have room to fall, utility stocks can rally, and gold and gold stocks could rally sharply.
As previously noted, the 6-month London Inter Bank Offered Rate (LIBOR) rate has increased from 0.62% since November 2015 to 1.29% on December 2, while the 3-month LIBOR has increased from 0.38% to 0.95%. The 10-year Treasury yield has jumped from 1.75% two weeks before the election to 2.492% on November 30, before slipping back to 2.40% on December 6. The increase in each of these interest rates exceeds 0.50%, so when the Fed does increase the federal funds rate on December 14 by 0.25%, the Fed will merely be catching up to where market rates already are. Ironically, the Fed’s decision to raise its policy rate will not represent a tightening of policy since global markets have already done the Fed’s work for them.
In the wake of the election, investors have concluded that inflation is headed higher, since Trump has proposed fiscal stimulus from infrastructure spending and tax cuts for individuals and corporations. The assumption is that faster GDP growth will lead to higher wages and higher inflation. This has led Goldman Sachs to project 3 rate increases by the Fed in 2017 as the Fed is forced to respond to stronger GDP growth and higher inflation. There are a number of reasons why the Fed is not likely to be so aggressive.
Global GDP growth is not likely to improve significantly in 2017, so the issue of excess capacity around the world and in the U.S. will keep a lid on business investment and won’t create an environment that allows companies to increase prices in the U.S. or globally.
Although the markets shrugged off the result of the Italian referendum, the Italian banking system is on life support, and the Italian economy, the third largest in the European Union (EU), has been dead in the water for years. See chart above. There is a risk that the negative sentiment toward the EU in Italy will increase and feed the populist movement that is sweeping Europe.
Last week French President Hollande looked at his approval rating languishing well below 20% and decided not to seek a second term, so France will elect a new President in April. France is the EU’s second largest economy and in the third quarter GDP growth slowed to an annual rate of 1.1%. France’s unemployment rate is 9.9%, while youth unemployment was 23.9% at the end of September. With the second and third largest economies in the EU undergoing political change and potential social turmoil, overall growth in the EU is not likely to accelerate much in the first half of 2017.
Globally, there is over $10 trillion of nonbank dollar denominated debt, which becomes more expensive to repay and service as other countries currency lose value versus the dollar. For instance, the dollar has risen by 10% since May, so a $100 million loan that is non-hedged may now be effectively $110 million if the currency of the loan holder has fallen 10%. Of the $10 trillion of nonbank dollar denominated debt, more than $3 trillion is to emerging economies.
According to the Bank for International Settlements, EM countries will need to repay $340 billion of debt in 2017 and 2018, which is 40% more than during the past three years. In order for this debt to be rolled without a disruption, global investors will need to have confidence in many EM countries.
Unfortunately, confidence ebbs and flows and so do money flows into and out of emerging market bonds. In the week ended November 16, a record $6.6 billion was pulled from emerging market bond strategies according to EPFR Global data. In recent months, Fitch Ratings, Moody's Investors Service and S&P Global Ratings have taken 3.1 times as many negative actions as positive on sovereign and government-related bonds from emerging markets this year. The last time the ratio was this high was in 1998, in the middle of the Asian financial crisis. Although growth in Emerging economies is likely to pick up in 2017, the rally in the Dollar and its impact on dollar denominated debt could act as a big headwind, especially if EM currencies fall more and the rebound in commodities since the first quarter reverses.
The Fed is aware that the strength in the dollar is a double whammy, as it represents a burden for emerging economies specifically and in general for those holding dollar denominated debt. S&P 500 companies derive 45% of their sales outside of the U.S. A stronger dollar puts them at a competitive disadvantage, as U.S. products and services become more expensive. The Fed will be patient in the speed and timing of additional rate increases, which is one more reason why three rate hikes in 2017 seems unlikely.
There are two types of inflation. When inflation rises because wage growth is strong, prices rise due to a demand push that allows companies to raise prices. This can lead to embedded inflation that requires the Fed to address by raising rates more aggressively to slow the economy. A number of Fed governors are concerned that this dynamic could develop in 2017 and force the Fed to hike rates faster and thus put the recovery at risk. However, wage growth in November showed average hourly earnings grew by 2.45%. While wage growth has been inching higher during the past six months from the 2.2% average of the prior 6 years, it can’t be described as strong. The risk of wage push embedded inflation for now remains low.
The second type of inflation comes from nonwage price increases from healthcare costs, food costs rising due to crop shortages, or a sharp increase in oil prices as a result of supply cuts. This type of inflation is actually somewhat deflationary since it diverts spending away from discretionary spending, especially if wage growth is relatively weak as it has been for years.
Since 2000 overall inflation, as measured by the Consumer Price Index, (CPI) has risen by 43.6% and core inflation (ex food and energy) is up by 39.9%.
According to the Federal Reserve of St. Louis, real disposable income is up 46.3%, slightly above the 43.6% increase in consumer prices. However, medical care has soared 84.6%, almost double the overall inflation. Energy is up 73.6% despite the plunge since 2014, and college tuition has gone ballistic, up 150.9%. For the elderly or those who have had health problems since 2000, inflation has consumed a far greater share of their income than average inflation. For parents with children attending college since 2000, inflation has been an entirely different proposition. Although rising medical costs will contribute to higher inflation next year, consumers will have less money to spend on everything else, as healthcare costs rise faster than income growth in 2017. Although healthcare represents only 8.4% of the CPI, it comprises 18% of GDP. Since the goal is to have no time gap between the repeal or revamp of the Affordable Care Act and the republican health care program, the transition isn’t likely to occur until 2018.
Janet Yellen suggested in late October that the Fed might tolerate a ‘high pressure’ economy and allow the unemployment rate to drop below what is considered full employment, with inflation permitted to run hotter than its goal, before the Fed would start tightening policy and raising interest rates. Her comment suggests she wants to see wage growth to be comfortably higher than the current level of 2.45% before she would support higher rates.
Members of the Federal Reserve have said that monetary policy can only do so much and that fiscal stimulus would improve growth. Trump has promised to deliver it, but at this point, the size, timing, and focus of the coming fiscal stimulus plan is unknown, until Congress actually passes legislation. Only then can the Fed assess and estimate the impact the stimulus plan will have on the economy and when that impact will kick in. Until the FOMC has this information, they will be in no rush to further increase rates.
After the Fed raises rates on December 14, I expect numerous FOMC members and district presidents will give speeches emphasizing their bias to be patient until wage growth picks up and they have a better idea of the fiscal stimulus plan. If GDP growth moderates in the first quarter as I expect, the Fed will have even more incentive to remain patient. This could provide a window in which bond yields can fall, the dollar weakens, gold rallies, and stocks stumble.
As discussed in detail in the November issue of Macro Tides, the Chinese economy is more vulnerable to a dislocation than any time in decades. According to McKinsey Research, China added $26.1 trillion in debt between 2000 and 2014, which is more than the combined GDP of the U.S., Japan, and Germany. Most of the increase occurred in the wake of the 2008 financial crisis. Between 2005 and 2015 total debt rose 465%, rising from 160% of GDP to 247%, according to Bloomberg Intelligence.
Capital Economics has studied more than 25 years of collapses in developing economies. Their conclusion is that the pace of debt accumulation is more important than the overall level of debt in determining whether a country is vulnerable to a financial crisis. China’s pace of debt accumulation is well above the threshold Capital Economics identified as the potential for a crisis. China’s state owned enterprises have accumulated too much debt, and nonperforming loans held by Chinese banks are significant and rising. On October 11 S&P Global reported that rising debt levels will worsen the credit profiles of China’s top 200 companies and their study sees little improvement in 2017 amid worsening leverage and excess capacity in almost all sectors. Of the companies analyzed by S&P Global, 70% were state owned and accounted for $2.8 trillion of respondent’s debt, 90% of the total.
According to the China Banking Regulatory Commission, Chinese banks’ nonperforming loans are 2%, the highest since 2009. The International Monetary Fund (IMF) estimates China’s nonperforming loan ratio at 15%. The difference is due to the way bad loans are recognized. I suspect the IMF’s estimate is more accurate. China’s banks may be required to raise as much as $1.7 trillion to cover the coming surge in bad loans by 2020, according to S&P Global.
During the last five years, China’s began the transition away from economic growth dependent on exports and government infrastructure spending to an economy based on domestic consumption. Although wages have quadrupled since 2005, the middle class is not yet large enough to power the Chinese economy. This is why China policy makers last year blinked and reverted to the old growth formula of infrastructure spending, housing appreciation, and exports. China’s decision in August of 2015 to devalue the Yuan confirmed its dependence on exports and worry about the overall health of the economy.
Property prices in China have rocketed higher since mid 2015 and have reached bubble territory. See chart above. The coming decline in property prices will undermine consumer spending and confidence in China. The vulnerability of the Chinese economy provides the U.S. more leverage than we’ve had in a long time in trade discussions with China, since China needs exports to remain strong, and the U.S. is China’s second largest customer. While Trump’s decision to accept a call from the President of Taiwan has been roundly criticized, it sent a message to China’s leadership that future negotiations on trade, intellectual property rights, and military expansion will be conducted under a new set of ground rules.
Whenever the status quo is changed risk increases, but that is the platform on which opportunity is created. The challenge is crafting agreements in such a way that both parties can point to benefits that can be sold domestically. The coming negotiation process between the U.S. and China certainly has the potential to become rocky and likely will at some point, and no one should be surprised if it does. Both countries have military assets in the South China Sea, so an ‘accident’ could prove very unsettling. The negotiations with China are justified and overdue, as long as tariffs are avoided.
Jim Welsh @JimWelshMacro
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