10 March 2018

Inflation Expectations can kill the recovery - soon

This continues my series of closer looks at the seven areas I think can bring the 103 (now 104?) month economic expansion in the US to an end. The previous articles are here (overview) and here (interest rates).

Since the onset of QE (Quantitative Easing), also known as the printing of money, by the US, the UK, ECB, BoJ and others in the wake of the Global Financial Crisis, there have been dire warnings that this "new" money would create out-of-control inflation. We have yet to see that, but we will. TARP poured $700 billion into failing banks to prop up the economy, with too much of it ending up as bonuses in the pockets of the very bankers who almost killed their banks, and the economy with them. The FED then created $3.7 trillion more in QE . In Europe, the BoE created £375 billion more, and the ECB has bought €1.1 trillion in assets through the course of their Quantitative Easing (QE) programme.

Much of that money sent to major banks or corporations. The banks were able to take advantage of "cheap money" to rebuild their balance sheets and solvency margins, by passing on only a limited amount of the reduced borrowing costs of Fed (or ECB or BoE) money. In his Bank Performance Outlook for 2018, Chris Whalen points out the "Fed is still effectively transferring $80 billion per quarter from depositors to banks."

Additional stimulus has flowed into global economies in the form of budget deficits piling on debt to record levels. Yet still there is no meaningful inflation, and central banks continue to lament their failure to reach the vaunted 2% level.

Where is the inflation, and will there be an inflation shock? Spoiler alert, yes, but from wages and probably not from the cost of goods and services, although the recent announcement of tariffs may push inflation expectations in other areas.

First, we need to remember what inflation is, and why it occurs. Inflation is the general increase in the cost of goods and services across an economy, or the devaluation of a currency and the associated resetting of the costs of goods and services in that currency. We are told that inflation is caused by an increase in money supply over the increase in the supply of desired goods or services. Where there are too few mangoes (for example) and a high demand for mangoes, the price of mangoes will go up - inflation and good old fashion "supply and demand".

We cannot doubt that there has been significant increase in the supply of money over the past decade. M2 in the US, has almost doubled in the past 10 years, from under $8000 (billions) to just under$14000 (billions). As a reminder, "M2 is a measure of the money supply that includes all elements of M1 as well as "near money." M1 includes cash and checking deposits, while near money refers to savings deposits, money market securities, mutual funds and other time deposits.". Strangely that almost doubling of the money supply has not resulted in inflation in the average cost of goods and services.

Looking at the BLS (Bureau of Labor Statistics) there appears to have been embarrassingly low inflation over the past 20 years. One inflation calculator puts total inflation between 2008 and 2018 at 13.7%, or in dollars, it will cost $113.70 today to purchase what would have cost $100.00 in 2008.

The same money supply and inflation sites tells us that UK money supply, UK M2, has increased by 50% in the past decade, while we are told that inflation has been a "brisk" 29.4% over that decade. So while the money supply has grown from £1600 (billions) to £2400 (billions), it "only" costs £129.40 to purchase today what would have cost £100.00 in 2008.

Certainly the housing market in the UK has been on a multi-year boom, at least in and around London, and in the almost continually expanding London commuter belt. Property price inflation outside of the London catchment has been muted at best, and has artificially moderated the national average inflation.

So if inflation is the result of money supply growing faster than the supply of good and services, then where is the money going, and what does that tell us about what might happen?

We then need to consider a key attribute of inflation; not all goods, service or assets increase in price equally. The first set of US inflation data that I shared above seem to tell us that inflation is under control, or in fact not under control at all, if there is a target of 2% inflation. But over at the American Enterprise Institute, they have a chart that shows inflation broken out quite differently, and they should a roughly 55% inflation over the past twenty years. John Mauldin uses this table in his recent "thoughts from the Frontlines" on 3 March 2018.

What is so interesting about this chart is that the elements that link to a higher standard of living and higher potential income are the elements that are rising the fastest. While it also shows that wages have increased at a rate faster than inflation, there is ample evidence that such wage growth has been skewed to the higher income earners.

It shows healthcare and education growing at well over 100%, and far outpacing most other goods and services. These are the two key areas where potential impact on future standard of living are felt the strongest. Education directly contributes to an individual’s ability to find and retain higher paying work, and without that higher paying work, healthcare becomes less and less affordable. Without good healthcare, and the economic capacity to purchase quality healthcare, the ability to continue to earn at any level of income is impaired.

Which leads back to the original question; will an inflation shock kill the markets?

Not the inflation we have been seeing. The markets do not, and will not care about inflation in costs of goods and services that upper income earners consume. The increases, while nose-bleed levels for some goods and services, the incomes of consumers of those goods and services have risen at pace. This is not where the shock will come from. 

Inflation in almost all other categories has been constant, but as the BLS numbers show in the earlier graph, there has been little inflation in most goods and services. Fundamentally this is because there has been no shortages in those areas, and therefore no supply and demand need for costs to inflate.

However, the market "correction in February has already shown us what inflation can do, when that inflation is in the form of increased wages, when that increase is in lower and middle income wages, not those at the top. We can expect more.

If inflation is too much money chasing too little of a given resource, then the low unemployment rates in the US today, if you believe the 4.1% number reported by the BLS for January 2018, is that "too little" resource. Wages will need to increase to attract that resource, reducing future expected incomes for employers.

The name of the business function has said it all for the past few decades: Human Resources. Resources just like copper and wood, cash, electricity and fuel. Humans are now a commodity, and have been for decades, and that commodity price is about to rise. Inflation in the cost of this now theoretically scare "resource" will push up prices across the board.

Fourth Quarter 2017 (US) numbers should give us any comfort, with Productivity growth at 0%, yet Labor Unit Costs and Hourly Wages both being revised upward. This is not sustainable without real wage inflation, and inflation moving beyond the human commodity and into the wider economy. These number tells us that we should expect lower corporate profitability, lower free cash, and lower expected returns in appreciation of already overpriced shares.

So watch the monthly unemployment rate (with ADP projecting a 235,000 increase in payrolls for February 2018) and an announced 313,000 BLS-reported increase for February, and watch the wage data from the BLS.

These two provide an indicator of future inflation in the one major commodity area where the only way to "mine" new resources is to pay a higher price. The mangoes in case are humans, and there are not enough to go around. This means the mangoes (humans) will cost more - the classic definition of inflation, and the warning of problems to come across the economy.

Next week I aim to tackle another of the seven areas that could kill this recovery.

02 March 2018

Will Interest Rates kill the recovery?

In my "103 Months" post last week, I specifically mention seven areas that could bring about the end of the Bear market, and result in the end of this business cycle. First on the list was Interest Rates. I also specifically stated that none of the seven areas could take sole credit for a fall in the markets (and flow on negativity and economic contraction), and that each may be impacted by others, and impact others. Which will come first, an Interest Rate hike generated collapse in house sales, or a collapse in house sales spreading uncertainty resulting in an interest rate spike?

Markets exist to facilitate the effective application of capital. As such, capital will flow to the markets in which capital can be expected to deliver the greatest return to the owners of the capital. Capital will flow to assets with the greatest probability or generating the highest risk-weighted return. And while markets do not get this right all the time, generally markets sense where returns will be achieved, high or low, and move capital to those asset classes. The result has been capital allocation distortions. (It was interesting to write that first sentence, then to google the exact words - first place returned was the SEC

The mythical Rational Market Hypothesis tells us that open access to information ensures that capital will flow efficiently. This or course does not and cannot happen, as there is not free and open access to all information relevant to investment decision making. Different players have and always will have access to market moving information that is not available to all investors. In addition, a range of human and even algorithmic factors will ensure a different weighting of information by different market participants, ensuring a less than efficient market.

What does this have to do with interest rates?

Each time the Fed or the BoE talks rate hikes, the markets pause (for milliseconds sometimes) and asks if the higher rate will have a negative impact of economic activity, and thus on market value, or if Treasury Bills will deliver a higher capital growth, and therefore, is it time to leave one market and enter another (leave stocks, enter treasuries or other bonds). Business and investors have become so numbed to ZIRP (Zero Interest Rate Policy) that they have come to see any hikes as potential speed bumps on the economic highway.

Continued ZIRP has resulted in behavioural distortions, with a new set of assumptions, including current market reactions reinforcing self-delusional assumptions of market rationality. In the middle 2000s we were convinced that we had become expert at managing risk, now we believe in the power of monetary policy to ensure ever-expanding market value. This cannot end well.

In the UK, the change in the "Ogden rate" (the discount rate applied to large insurance claims, predicated on the assumption that large claims will be invested in the most conservative manner) in early 2017 provides a wonderful example of a political decision designed to reinforce the "end of boom and bust" narrative. A change in a long term discount rate from 2.5% to -.75% both boosted insurance pay-outs and imposed massive loses on the insurance industry (The rate is now under review). The political nature of the decision was in effect a reiteration of the UK government’s assumption or expectation that interest rates would remain in the ZIRP range for the foreseeable future.

ZIRP ensured a limiting of the range of options for capital, be effectively removing treasuries, US, British Gilts, Japanese, from the portfolios of available return generating assets.

The end of ZIRP has seen a steady increase in the retail cost of money. At some stage, that increase will be perceived as reaching a point at which users of credit will begin to make decisions to not invest, or not spend. Owners of capital will begin to ask if the markets will therefore continue to increase at a rate significantly higher than "safe haven" investments.

So what is that interest rate number that will move the markets?

Only this past week the Chairman of the Federal Reserve presented to Congress for the first time, with his upbeat assessment of the US economy having quite a strange impact. The Wall Street Journal reported: "On Tuesday, Mr. Powell made his first Capitol Hill appearance since taking over as Fed chief this month, where he underscored the improvement in economic prospects, which many investors took as a suggestion that the central bank will lift borrowing costs four times this year. “It now looks more likely that the Fed is going to tighten more quickly,” said Peter Elston, chief investment officer at Seneca Investment Managers."

The markets seem to be at a point where positive economic news itself causes concerns about interest rates, upsetting the fragile balance between shares as the probably area of best return on capital, and fear that shares will fall resulting in negative returns.

That fragility could tip either way, although the messaging would suggest a greater probability of a negative shock. Bad economic news (such as the reported fall in new housing starts) could hint at a slower pace of rate hikes while at the same time undermining confidence. Alternatively, stronger economic news could cement more rate hikes sooner, again undermining confidence in the markets as the source of future capital appreciation.

Further, that fragility is all about perceptions and perceptions of perceptions. Will rates increase? If rates increase, will shares fall? If shares fall, will that force rates higher, or will a continued fall in shares erase gains. Should gains be "locked in" by selling now and putting the capital into "safe" options, and ride out a fall in share values, while earning more interest on the bonds / treasuries?

The Fed rate after all flows through into mortgage rates, auto loan rates, student loans, and credit card interest rates. All of these have a direct impact on individuals' economic behaviours and choices.

So if we game this situation, it looks something like:

  1. Fed increases interest rates, reaching an eye-watering 2.5% by mid-2018.
  2. Following a Fed rate rise event, markets expect reduction in mortgage lending, increase in credit card interest, reduction in auto loans.
  3. Market data is released showing a drop in new mortgage applications.
  4. Home builder and real estate stocks hit.
  5. REITs drop on expectation that housing prices will stabilize or fall.
  6. Contagion across industries creates further falls in equities.
  7. Holders of capital determine that treasuries will provide a "no loss of capital" position and that shares have created a "capital at risk" situation.

As the "rational" market distributes and creates information with an inequitable and non-transparent distribution, individual market participants reach widely different conclusions, ultimately coalescing into a consensus that the stock markets are no longer the best place to hold or invest capital for a time long enough for stable bottom to be found.

In this way Interest Rates may provide one of the catalysts for a substantial and sustained drop in market values. This is only one of the seven situations that I discussed last week. Next week we'll look at another of the seven.

What remains clear is that in a world with so many potential contributors or drivers of a change from Bull to Bear, there is no single non-interconnected economic or political situation that will be "the cause" of the coming end of this expansion. The big question will be which, through the lens of history, will carry the "blame".

24 February 2018

103 Months of recovery, what could end it

After years of single-direction trajectory for the markets, the recent correction has jolted people from their complacency. Well, many people. The subsequent rallies are proof to one set that pressure has been taken out of the markets, and the upward track can restart. To others, the expression "dead cat bounce" continues to be the phrase of the week.

Being very clear, I do not know if the top has been reached, or is there more headroom in this market. I have no idea. None. Also being clear, while the discussion focuses on the US markets, there is nothing in here that either does not have or is not impacted by events and economic situations in other countries.

If the markets continue their advances, how far can they go, and for how long? Is theUS in the "demographic sweet spot" that I wrote about in August 2017? I asked if the fall in the US labour market participation rate had been strong enough to create sufficient pools of surplus labour to allow for multi-year growth as that surplus labour drip-feeds into the workforce. If it is, then there may actually be a few more years of growth in the economy and the markets. If not, then the third longest recovery in US history may come to a sudden end.

So what happens when this recovery comes to an end, and the US enters recession? At 103 months as of writing, this recover is the third longest since the end of theGreat Depression, and only 4 months short of being the second longest. The fourth longest was only 92 months, and the fifth a mere 73. This recovery is almost a year longer than its number four, and two and a half years longer than the fifth. Interestingly the longest lead up to the “dot-com” bubble and subsequent crash. Does this recovery have another 17 months, another year and a half, of additional steam, to tie the longest recovery? And if so, will we see continued growth in bubbles that we saw leading up to 2000? Or, do we have enough bubbles already?

Again, I cannot answer that because I simply do not know. The recent market "correction" was a wake-up call, and a reminder that it is not all "sunshine and lollipops". There are systemic pressures building up, and one day, the markets will switch from Bull to Bear. What might make that happen?

There are a number of potential catalysts that could provide the tipping point, and with that a sustained downward trajectory for the markets. The following list is not complete by any means, but gives an idea of the range of potential situations that could, once the fall is well underway, be pointed to as the catalyst.

Most important, there is not one situation that will cause the coming crash, and all are interlinked and interdependent. Each can, and probably will, impact and potentially exacerbate another or multiple others. If housing starts collapse, so will house prices, and with that the “wealth effect” tripping over into consumer credit (although in this example, consumer credit may stabilise instead of continuing to grow) and potentially rising default rates.

I will delve deeper into each one of these in coming posts, but for now, the following outline of each should serve to set the scene, so to speak.

Interest Rates: Off the back of rate hikes by the Fed, the Feb rate could reach as high as 3.25% or even 3.5% by late 2018. This will flow into the 10-year Treasury, already hovering around 2.9% up from a low of 2.06% only six months ago. Should the rate continue to rise, the flow-on effects will be felt throughout the debt-driven economy. At some stage, the forward potential negative impact on consumer credit creation and utilization capability will strike, and with that a sudden loss of confidence.

Inflation shock: Years of QE, QEII, Twist, Abbenomics, and ECB purchases has flooded the system with new money. Where has it gone, what why hasn't inflation appeared as so frequently predicted? Countering the assumption that the new money should be driving inflation, there is an argument that surplus labour is keeping wage inflation in check, and with the, general economy-wide inflation. If they are not making more money, then the average worker cannot drive up prices. What happens when a really bad inflation number prints - in the US, UK or Germany for example?

Budget deficits: But what is the single event that is used by media pundits to 20/20 explain what happened. Could it be a Congressional Budget Office projection stating that servicing of the national debt will exceed 8% of the 2019 federal budget (from a current 6% of the federal budget)? Or could it be a projection for $1 trillion budget deficits for the next four years? After all, no one believes the projected temporary increase in spending followed by a drop to a balanced budget level.

External Shock: Or maybe the markets will react to an external event or geopolitical risk event, such as a US strike against the nuclear capabilities or Iran or North Korea. The intervention in northern Syria by Istanbul has already resulting in a sharp drop in the Turkish stock markets. Such a shock could undermine confidence in international trade or fuel expectations of increased in input costs and commodity costs. The markets have been remarkably resilient to geopolitical risk over the past year, so any shock will probably need to be a big one. Ultimately, the list of potential geopolitical shocks is as long as you wish to spend reading or writing.

We should not forget that there are a number of major economies each under their own strains, with many of those strains being similar to those witnessed in the US economy. The UK has suffered a 5.7% drop in year on year private auto sales, with predictions for a further drop in car sales in 2018. And before saying "but they are a small country" remember that they represent 65 million people, and that this slowdown will impact German auto makers as well, providing some stress, albeit minor, to the German economy. 

Housing market: Bad news in the housing market could tip the scales, and send the marketing into a self-reinforcing negative spiral. This potential shock is tied closely to underlying interest rates, inflation, and the Wealth Effect based on an ever-raising stock market. A multi month sustained drop in housing starts, completed sales, or house prices could shock the markets, and become the 20/20 hindsight event that causes a crash.

Automotive Loans default rates: Current default rates are increasing, and the total outstanding loan period is also at a record high. In 2016 the average outstanding car load was 5.5 years. It is possible to get an auto loan at 72 or even 84 months duration. In addition, over 30% of used car trade-ins areunder water. Combine the two, and the consumer is likely to become trapped in the vehicle they are in, and with that trap will come a reduction in car sales, and an expectation of future poor performance by the automotive section, a sector that accounts for X% of the US economy.

Credit Card default rates: The American binge on consumer credit continues, and in fact never really stopped. Net savings rates are at historic lows of around 2% (average across the entire economy) while credit card debt continues to rise. This is unsustainable. The only questions are, what is sustainable and when will the bubble pop, and will we recognise that it has popped. A failure in confidence that consumers will be able to afford the current credit load will not come as a slow dawning, but will come as a sudden shock, and that shock could rock the markets.

Productivity: Linked so closely with that credit crisis is the concept that worker productivity will continue to improve. Yet for the past few quarters that has not been the case, or has been true at a much reduced level. A failure to continue to increase productivity will directly impact worker wages, company profitability and therefore achievement of earnings expectations. Again, a sudden realisation of future down-trend impact on company values may arrive as a shock, and may be the catalyst for a market collapse.

Environmental event: To this point I’ve focused purely on potential economic events or situations, and have avoided environmental events. These could range from the hurricane that breaks the insurance industry, storms in Europe that result in a short term economic downturn, or a major earthquake on the West Coast of the US. I’m ruling out volcanos and meteors, as the probability is simple too low. I’m not ruling out Climate Change related events or situations, major droughts, or resource depletion such as a collapse of the water table in the San Joaquin valley of California.

Maybe the "dead cat bounce" is just a slightly longer bounce, and the fall is already coming.

Whatever the trigger, when the fall in the markets come, it will be steep and quick, followed by months if not quarters of a cyclical bear market. And while I am writing based on the US economy and markets, the same issues highlighted above are true for so many economies, and any individual large economy could provide the trigger for a global rout.

19 January 2018

Panama traffic is horrible

If there is a (tongue in cheek) truth, it is that every city claims to have the worst traffic in the world, and I can say that I have lived in some cities that could reasonably make that claim. None however compare with Panama City, and Panamanian drivers in general. Going to Google Maps, it frequently tells you that is will take significantly less time to walk between locations than it will take you to drive.

When we lived in the South of France, I used to say that I finally found out who taught the Malaysians to drive – the French from Nice. If that was true (probably not), I now know who the French took as their role model.

It is standard for a right hand turning vehicle to start the turn from the left-most lane (for those of you in the UK, NZ or Australia, a left hand turn from the far right lane). This is so common that we simply refer to it as the "Panama Turn" when it happens directly in front of us, sometimes requiring rapid braking on our part. Furthermore, the roads are actually configured to require the traversing of multiple lanes in fairly short distances, causing no end of start/stop driving.
My personal bet is that he was cut off.

Turn signals are, or course, optional. So optional that I suspect many cars don't actually have any turn signal mechanics inside the car. Swerving is common, as much to avoid potholes as to think about changing lanes and then deciding to stay in your current lane.

Some people have gone so far as to tell me that rear view mirrors are a waste in Panama, as the only thing you should care about are the cars in front of you. That certainly seems to sum up drivers - lane changes that cut you off, no blinkers, stopping anywhere, driving into traffic from side roads at speed, and of course the ubiquitous “Panama Turn”.

Remarkably perhaps, the traffic accident death rate per 100,000 peopleis 10, just under the US rate of 10.6, but far higher than the 2.9 rate for the UK, and below the rest of Latin America. So the horror of Panamanian driving is not the death rate, but the terrible traffic. 

While death rate are first world, sort of, the accident rate is pretty amazing, and the insurance and court system manages the volume poorly. Anecdotally, I know of a case in which a rear-ended insurance claim remains outstanding because the driver at fault simply ignores the court summons.

Flipping Cars onto their sides seems to a local speciality.

As the Panama economy has grown, so have the number of cars and trucks on the roads; a growth rate that has exceeded the rate of growth of paved road surface in the city. Partial solutions have included new roads, a confusing one-way system, widened roads, and increasing the number of lanes - where two lanes existed in the past, there are now three lanes. Three very cosy lanes. In some cases you can still see the original lane makers.

Add to this a history of corruption, with the issuance of17,000 "no test" drivers licenses between 2011 and 2014, and Panama City has not only a strained infrastructure, but thousands of drivers who have not passed even the most basic of driving tests.

I can attest to the "most basic of driving tests". The theory test includes such critical questions such as how far away from a truck carrying dynamite do you have to be before you can smoke a cigarette? (The answer is 150 meters, if you really want to know). Sure, there are real questions in the theory test, but many of the questions are contradictory and in some cases simply silly. For example, the proper answer to what is the impact of heavy rain? Your car stops. The only reason that this answer is sort of correct, is because the roads flood, and it you do not know from good experience just how deep that water is, don’t go there.

The only practical test required of a driver is to prove you can park. Yes, that is the only practical test. Park forward into a space. Park backward into a space. Parallel park. Full disclosure, I failed the parallel parking the first time; I mounted the curb, and had to return a week later to repeat the test. A Nissan Patrol is not a small car, and simple arrogance on my part was my undoing. The next time, we rented the smallest car we could find, and parallel parking was a breeze.

While this all sounds terrible, there is hope. Panama City has afantastic subway system, which is cheap ($.35 per trip, $.70 round trip), clean, fast and growing. The stations can cater for trains of 5 carriages instead of the current 3 per train. Current passenger numbers on the Metro are around 200,000 per day, in a city of 1.5 million. That number will increase with the expanding of the line, and the introduction of the second line, due in late 2018 in time to move the hordes expected for the Pope’s visit.

Still, the roads will be full, and fuller with each month and year. And with the driving style here, I am very happy with our beast, the Nissan Patrol. It is high enough for the puddles and floods, ugly enough that people cannot miss seeing it, and big enough that it tends to make smaller car worried about the outcome. All factors that give me much comfort driving in Panama.

(Photos are from one day only - from the Trafico Panama Facebook page)