Category Archives: Federal Reserve

Where the Skeletons, economically speaking, are laying down

Not yet buried, not even dead, firms are taking on more leveraged debt. In last week’s US print edition of the Economist, two articles make for chill reading.

The first article that heads the Finance and Economics section is titled, What Goes Up – The American economy. After emailing the current economic growth and the causes of it, the article suggests that things are likely to change. And this was written before last week’s midterms.

The theory is that the impact of the recent tax cuts will start to fade. Yes, this must be the case though there will surely be some residual net-increase in spending and change in behavior as a result. Tariffs are brought up as drag on demand; again this is likely true though there will also likely be some positives as local businesses, shielded from foreign imports, may seek new money to build up local services and supplies leading to some organic growth.

For me, the real risk is investment. Apparently that is falling again, after an uptick (due to tax breaks?). Investment, from primary R&D by central government through to capital investment by firms for plant and equipment, is really important. It is a key part of what will drive the next wave in productivity. We need to keep a watchful eye on all aspects of investment.

Finally the consumer is held up as the trump card, if growth is not to decline in the next year or so. Consumer spending is by far the largest component of US GDP. If spending here keeps up, business may yet increase again investment in response to growing demand.

With Congress split, the likelihood is that broad policy changes will not change- either the House won’t pass the Presidents policies or the President will veto, or the senate will not pass, anything significant the House desires. So my feeling is that growth may yet continue but slow down slightly, which would still be a good thing.

The second article is titled, Load Bearing. It reports that, “Authorities from the IMF to the Fed’s ex-boss are worrying about a booming corporate-credit market”. The credit being analyses here are leveraged loans. These loans are being chopped up into smaller trenches and sold to buyers with different risk appetites. Sound familiar?

The more important news is that we are talking of about $1.2 trillion dollars. Yes, that’s a big number and apparently it is twice as much as six years ago. Some of these loans are refinancing debt (about a 1/3, according to the article) and more is used to finance M&A.

These leveraged loans are attractive to some investors as they have offered good returns at a time when interest rates are low. This is a good example of unexpected and unintended consequences (and economic behavior) that has come about due to excessive periods of low or near-zero interest rates. Such rates mess with your funding approaches. Couple this with the principle, put up long ago, that lowering interest rates drives investment: not many IT or business transformation (i.e. large) projects I know about were conceived of simply because the Fed dropped rates.

The article explains how demand for these loans has led to lowering of standards, and a likely rise in defaults. Again, sound familiar?

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What Will Go Wrong in 2018?

James Mackintosh of the Wall Street Journal posts in today’s US print edition on “The 3 Things That Can Go Awry in 2018“. The article details three dynamics that, if played out as he suggests, could cause the global economy to trip in 2018. His summaries are good and compelling and, given our amazingly positive outlook today as 2017 comes to a close with all major nations growing at roughly the same time (an odd occurrence in its own right), they come at a good time to consider conservative actions against possible shifts next year.

The three are:

  1. Monetary Tightening. The story here looks at Fed and central bank interest rate hikes. We all know that interest rate raises have started, at least in the UK and US, even though the EU remains firmly stuck taking that drug. Japan is taking it slow, even as its economy shows much signs of improved life – Japan will have to continue pushing rates up in 2018, just as the EU will have to follow the US’s lead. The problem with this item is that there are us a lot of debt out there – corporate debt, public debt and yes, some consumer debt. It is not the same kind of debt that was part of the run-up to the crash that put us where we are today, but for some firms and some governments its big risky debt. As an example, and tangentially related, another article in the WSJ reports on a few firms that are high in debt that will be financial impacted by Trump’s tax reform – see Tax Plan Downside for Dell, Others in Debt. A lot firms have issues debt in the last few years in response to QE and near zero interest rates. As rates increase, debt load and repayments will increase. If inflation were to join the party, it could be a messy time for a number of firms and governments.
  2. China. This story has been used before since China has been the source of two recent periods where the US stock market (in fact the global stock market) fell by about 10%. As such, China’s management of its economy – shifting from a producer-based to consumer-based economy – is a major challenge. Debt remains a problem, and capital controls and currency exchange rates just add more menu items for Chinese leadership to wrestle with. Should China sneeze, so the saying goes, we would all fall could of a cold or something worse. Worse, there is no coordination between east and west – so we are somewhat at the behest of the Fed and People’s Bank of China – and we all hope they do the right thing. Of course, they will both do the right thing for their own constituents – or try to. Hence the lack of cooperation.
  3. A Correlation Correction. This for me is the more interesting and most likely issue to blow up in 2018, and it is the least talked about in the press since it is not as well understood. Mr. Mackintosh states, “one reason investors hold bonds is to cushion losses in a stock-market downturn.” This approach has worked for quite a while, as prices have diverged short-term all the while converging over the long-term. The risk is that should inflation appear in 2018 the relationship between stocks and bonds may revert to how it was in the 1980s and early 1990s, with rising bond yields being bad for share prices. The problem for me is that I think inflation will rise in 2018 to just levels that this will be the catalyst for change in the markers. If you read the tea leaves, there is ample evidence of a change underway. Many commodity prices are doing very well. Copper prices are, as an example, reportedly at recent high’s due to increased production. If you look at producer prices in the US, they are inching up now over 3%. Even though wage pressures remain subdued, the pressure is building. Though participating rates for males in the US aged 25-54 are at near all-time lows, yes the employment rates seems low and may go lower, but there remains some slack to take up the growth we will see. But that pressure is there. I think that by the second half of the year, certainly by Q3, US inflation forecasts will show that 3.5-4% are on the horizon. This won’t cause a panic, but it will lead the change and correction that will come. On top of this the author suggests that the Fed may just “give in” to the needs to cap the bloated asset prices we see all around us, to nip the bubble before it becomes unsustainable. Trump’s tax deal will push this peak out a year or two, but the dynamics are in play.

Reading between the lines you can see that all three of the authors ideas overlap and intersect. Inflation is mentioned directly in 2 of the 3; growth is everywhere; public policy too. As such he has hedged his bets and tried to call out the category of challenge. I will try to break the triggers into more simplistic sections.

As such, I give the following percentage probability for each driving a correction by the end of 2018:

  1. Monetary Tightening, most likely US led, due to over heating: 15%
  2. China growth, debt to currency issues: 28%
  3. EU or euro-zone debt or banking crisis: 15%
  4. Inflation-driven policy changes: 22%
  5. Japan public debt or growth challenges: 10%
  6. Emerging Market currency or debt issues: 5% (this one won’t trigger in isolation but might follow from one of the others, namely 1, causing a currency drain)
  7. Significant War triggering financial panic: 5%

Trouble for The Eurozone with Trump’s Tax Deal

There was an excellent Opinion piece in today’s Wall Street Journal that calls out the less thought through implications of Trump’s domestic tax deal on international business. The piece, US Tax Reform Has Europe Worried, by Joseph C Sternberg, explores the writings of a German research group that details some thinking suggests some organizations will think twice about new investments in Europe – specifically Germany – with the new US corporate tax rates being leveled. The research piece is from ZEW and is here: Germany loses out in US Tax Reform. This is another dimension not modeled by US economists when they try to determine the impact of the tax reform on US growth.

The more important point however in Mr. Sternberg’s piece comes toward the end of his excellent article. The author suggests that US tax reform highlights a different opinion for taxation from an ideological perspective. This point needs to be talked about more since we have lost our Mojo for ideology in favor of a left-right populist dichotomy. The US reform is being used to alter tax incentives to drive growth, investment and job creation. Most of Europe, with is more socialist (and Democratic-leaning) policies, uses tax incentives mostly as a redistributive process for sharing an assumed pie. There is much less effort in driving growth or influencing investment to grow jobs. This is the dialog we had in the 1980s and it leads to the dialog about big government versus small government.

It is about time ideology got a fair crack again!

Financial Times’ Martin Wolf Finally Get’s it Right

In “Fix the Roof while the sun is shining“, on Wednesday December 6th, Martin Wolf reports on how excessive low interest rates and quantitive easing create conditions that lead to rampant and growing debt, and now this might hold our newly growing global economy back. No kidding. It is about time that Mr. Wolf caught up with the rest of us. QE and near-do rates have were useful in saving the economy, but after a very short period of time we should have pushed rates up and had the Fed (and other central banks) withdraw from QE. If we had any form of real global central bank collaboration, this could have been coordinated together and thus no single region would have been subject to any disruption. We don’t have any form of Bretton Woods 2.0 and so we were all left to figure this out alone.

Now the newly recoding and growing global economy is now dunk on debt. We have sovereign states, states, cities and the public sector that have stoked up on cheap money. Worse this cash has not been used to drive growth economy that would have spun off profits to feed the governments, such that recovery would have improved sooner. If your home is anything like mine, the State of Georgia has rebuilt roads that were perfectly good before; and not added valuable new roads or services. The private sector has been buying back shares to drive EPS to feed the bonus needs of executives; and been gorging on M&A activity that was not driven by weak firms failing but hostile acquisitions of reasonably performing assets. On top of this, in some regions of the world (see Italy as a good example), zombie banks and firms have been hogging underperforming assets in the interests of keeping employment going. Thus the Nannie state is alive and well, dressed up in a veneer of free market economics.

Much has been written since the financial crisis about how moribund the state of economics are. It seems we no longer have a core base of trusted economists guiding anyone, let alone our political leaders. The economists are almost as decided as the politicians are. Yet even in the most basic of areas, debt and credit, we have failed. How on earth unrelenting debt, massive imbalances, and market-inflicting Federal involvement in the bond market would be a good idea but for a fleeting while is beyond me. The blind were leading the blind. At least Mr. Wolf has removed his blind. Let’s hope the rest do – and soon.

One small picture says it all

Standing about 2-3 inches tell and 1-2 inches across, a small chart in page A6 of this last weekend’s Wall Street Journal, sums up our economic predicament. The article, Japan Firms End Yearslong Price Freezes, reports that a growing number of businesses are reporting that labor shortages and increasing demand are leading to price increases. The chart shows a pleasing, gradual but clear rise in prices in Japan over the last year, now approaching 1%. This is important.

Though 1% inflation sounds measly for Japan it could be a short-term boon. The nation has been bedeviled for over 20 years with meager growth, stagnant wages, and tepid productivity growth. In fact some economist suggest that Japan’s fall from economic grace that preceded the West’s financial crisis of 2007, demonstrated early what would happen in a deflationary economy with massive quantitative easing. QE did not drive Japan’s economy to growth; it does not seem to have done so in the west, though it may have saved it from crashing and now we see how it’s persistence has led to financial and investment dislocation.

The news all around us is quite positive:

  • Most recent quarterly GDP in US was restated up to 3.3%, almost unimaginable a year ago.
  • EU economic growth rates are forecasted to grow above their recent meager levels in recent OECD reports
  • ‘Currency war’ reports appear in the press infrequently, even though global trade remains torn by the idea that the US wants a stronger negotiating position (for what is, essentially, a very small part of the US economy).

But inflation remains stubbornly low almost everywhere. If Japan soon demonstrates ongoing growth in inflation, and global commodity prices push up, the result will be a wave of input price increase around the world. Some months later the US and more clearly the EU will see producer price increase and so consumers may see pass-through increases. This will encourage central banks to continue their march toward normality.

The downside with a return to inflation: Debt servicing becomes more onerous as interest rates increase in response to inflation increases. As such, governments and businesses that stocked up on cheap debt during QE and the near-zero interest rate period will have to squirrel away more cash to pay their interest charges. This will reduce what’s available for investment, thus slowing down growth.

The cycle feeds on itself so it can sometimes stabilize or other events can kick it into maddening swings. We will just have to see what happens. It may depend on how fast inflation growth returns. But for now, that little picture on page A6 looks very nice in a chilly autumn morning.

US Economy Not Out of the Woods – Beware the Hype that Says Otherwise

You would think that, given the press coverage, much of the US economy is making great progress.  Apparently interest rates will continue to rise in response to the Fed’s feeling that the economy is doing well; near-full employment, GDP recovery, stock market growth, bond and dollar strength and all that jazz.  But these data points mask some other troubling items that suggest any recovery will likely be lopsided and even short-term based.  You only have to look under the covers at, say, unemployment, credit, or housing.  

  • Unemployment: despite low levels of reported unemployment many economists are concerned that the participation rate is at very low levels.  In other words, there is a lot of unemployed that is not being reported in the official KPI.  Some economists suggest that real effective unemployment maybe nearer 6 or even 9 percent.  Thus the result of economic growth may not lead to wage price pressure so soon, since the participation rate may improve the so pick up some of the slack.  This is good news overall but not if the Fed believes that they need to head off wage inflation likely to appear due to pressure on a really tight labor market
  • Consumer Credit:  Student and auto loans are running ahead at full steam, and mortgage debt continues apace.  While many firms have cleared their balance sheets of bad debts, consumers – which drive a massive part of the US economy – are amassing debt easier than looking for a hot meal.  On February 27th the US print edtion of the Financial Times carried an article, More US car owners behind on loan payments than at any time since 2009.  What is realy funky here is that if you go into the market now to look for a new or used car, you will be offered a loan for repayment now past the 5 year window.  It used to be that 5 years was the maximum and this was only a few years ago.  Now you can get a loan over 6 years or longer.  So the consumer part of the market is building up a nice bad-debt situation.
  • House prices: Yes, house prices have recovered, so we are told, to near pre-crisis levels.  So that part of the market is secure, right?  Wrong.  Home ownership is a its lowest levels in years.  It turns out that the buyers that are driving up prices are investment firms and conglomerates that are snapping up property then leasing them to. So first time buyers are being squeezed out.  The housing market has not recovered in the way we would want it or need it to for effective sustainment.

So we have a very lopsided economic recovery.  It is not stable and even the strong shoots are some challenging weeds hiding just under the covers.  Even if Trump can delivery on +2% GDP growth, I am not altogether sure that woudl mask the issues that are building up today.

The Home Owners/Renters Market is Upside Down

Two articles today suggest that two of the world’s largest economies are swapping roles and focus for home ownership and renting. Germany has been a nation of renters; home ownership has run at relatively low levels compared to the UK or US. The US has operated under the assumption that home ownership is central to the American Dream.

As we all now know, policies adopted by the US government in the 1980s led to a relaxation of requirements for those seeking a mortgage and low income, even zero-income families, obtained mortgages they could never afford. The result, when combined with human greed both by home buyers and the investment community, led to the financial crisis that is the cause of the situation we are in today: near zero interest rates and massive influx of quantitive easing that has filled the coffers of the investor class.

But what is happening now? It seems that the near zero interest rates in Germany are driving record levels of home ownership and low interest rates in the US is driving up demand for rental property with record low-levels of home ownership. The world is turning upside down!

In the US print edition of the Financial Times, the article, “German’s switch to home ownership fuels bubble fears“, reports that house prices are rising as demand for mortgages continues to rise. The good news is that many of these new mortgages are fixed rate plans- which protects home owners as interest rates increase.  Germany has been a relative laggard when it comes to home ownership. See Most Germans don’t buy their homes: Theey rent.  Here’s why.  

In the US print edition of the Wall Street Journal, in an article, “Millennials Fuel House Rental Boom“, we hear of the later boom afflicting the US market. It turns out that US home ownership is at record lows, yet house prices around the country are recovering and in some regions, back to pre-crisis levels. How can this be?   Turns out that firms flush with cash and low cost loans have been buying up property in the cheap and renting them. The article above goes even further and explains how firms are now increasing investing in entirely new property developments specifically for the rental market.  

This all might alarm you. The American Dream, perhaps western democracy, was assumed to be predicated on home ownership. But this is not the case. The German economy has done very well with relatively low home ownership rates. The US might have to learn from the Germans how to run such an economy; likewise the Germans need to take a leaf out of the US’ books to avoid bubble blow-out.  

But in all practical terms we should be alarmed. Germany is an export-based economy. Other counties want (or need) to buy Germany’s products. Exports from the US is vastly less of a proportion of it’s GDP than it is for Germany. So there is little room for the US to behave more like Germany. Additionally Germany cannot set its own interest rates; even now the stresses between the EU center and periphery are growing again. Greece, Spain and Italy continue to need low interest rates to help nurture their local economies to recovery. Germany, never near a recession, is showing signs of too rapid growth (and growing inflation) and may approach overheating before the periphery is even back to positive growth.  

Bottom line: zero interest rates and quantitive easing (and resulting central bank balance sheet ballooning) is changing our economic foundations. This will impact our societies in ways it is hard to predict. Hang on guys, it’s gonna be a bumpy ride!