Saturday, November 14, 2015

Global Economy: At Your Service (excerpt)

The evolution of national economies tends to follow a well established pattern. They all start out as mostly agricultural economies. They evolve into manufacturing economies. In the next stage of development, services increasingly predominate. In the final stage, economies become knowledge-based. Most emerging economies are currently based on labor-intensive agricultural and manufacturing businesses, but moving towards more services. On balance, most developed nations around the world are in the third stage, with services outpacing manufacturing.

While the recent batch of weak industrial production indexes for Germany (down 1.1% in September), the US (-0.2), the UK (-0.2), Brazil (-1.3), Taiwan, and Singapore (both little changed after big declines) suggests that a global manufacturing downturn may be underway, the increasingly services-led global economy isn’t falling into a recession. Indeed, it seems that services industries are creating enough jobs to boost some of the demand for what factories make, especially autos. Let’s have a closer look:

(1) Global perspective. All this is increasingly evident in the JP Morgan Global PMIs for manufacturing (M-PMI) and non-manufacturing (NM-PMI). The available data we have since 2010 show that the global NM-PMI has generally exceeded the global M-PMI. The spread between the two has actually widened since early 2014. During October, the NM-PMI was 53.7, while the M-PMI was 51.4.

(2) Country perspective. Not surprisingly, these trends--which admittedly are still relatively new and therefore open to debate--can be seen in most of the major economies of the world, since they must add up to the totals compiled by JP Morgan. During October, the spread between the NM-PMI and M-PMI in the US was 9.0ppts, the most since February 2001, and the fourth highest in the history of the series going back to July 1997.

In the Eurozone, the two were nearly identical from 2010 through 2013; but since then, the region’s NM-PMI has been consistently higher than the M-PMI. In China, the NM-PMI has exceeded the M-PMI every month since the start of 2010, with an average spread of 4.4ppts. Interestingly, over the past two years since October 2013, NM-PMIs among emerging market economies have averaged 51.3, while the comparable measure for developed countries has averaged 54.7.

(3) Third-stage economies. Of course, this is all circumstantial evidence of a global transformation from manufacturing to services. However, there is plenty of evidence showing that the major “industrial” economies--including the US, the UK, Canada, Australia, Japan, and the Eurozone countries--have evolved into “services” economies. That’s easiest to see by comparing employment in the services-producing and goods-producing sectors of these economies. The former has been outpacing the latter for at least three decades. A similar conclusion can be deduced by comparing real GDP of goods versus services.

So, for example, in the US, payroll employment in goods-producing industries accounts for only 14% of total payroll employment, down from 44% during 1943. During Q3, services accounted for $9.9 trillion (saar) of real GDP, while goods accounted for $5.3 trillion of real GDP. Since services-producing businesses tend to be less cyclical than goods-producing ones, this transformation should moderate the business cycle.

(4) Know-it-alls. On the other hand, the transformation of the US economy from services-producing industries to knowledge-producing ones may increase the problem of structural unemployment for some workers. That’s because knowledge workers spend their entire workday trying to figure out how to put the rest of us out of work.

They’ve already figured out how to replace factory workers with robots. Indeed, robots are even starting to displace workers in China’s factories. Last year, China was the single largest market for industrial robot sales, according to the International Federation of Robotics (IFR), and within two years there will be more industrial robots in Chinese factories than in either the European Union or the United States.

This is just the start. There are only 30 robots for every 10,000 manufacturing workers in China, compared with 323 per 10,000 in Japan and 437 per 10,000 in South Korea, IFR data show. Automation is also coming to the services sector. San Francisco start-up company Momentum Machines, Inc. has set out to fully automate the production of gourmet-quality hamburgers. McDonald’s is well on the way to offering self-serve kiosks at a majority of their stores instead of paying employees to ask, “Do you want fries with that?”

Thursday, November 5, 2015

The Grand Delusion (excerpt)

Is it possible that monetary policy can’t fix all of our economic problems? That was one of my main discussion points with our accounts in Boston last week. In recent years, the major central banks have been taken over by macroeconomists who believe that they have the power to tame the business cycle. Since the financial crisis of 2008, they’ve led us to believe that they can revive self-sustaining economic growth and stabilize inflation around 2%. That’s because they strongly believe in their powers--even though they’ve been providing abnormally easy monetary policy since the crisis yet economic growth remains subpar with inflation below 2%.

I believe that the macroeconomists at the central banks (a.k.a. central monetary planners) have failed to achieve their goals because they are blindly fighting very powerful economic forces that are microeconomic in origin. They are also fighting the forces of technology and demography. Technological innovation, one of the primary drivers of “creative destruction,” disrupts and displaces the old ways of doing things with better goods and services at lower prices (BGSALP). Demographic trends are disruptive too, as people are living longer while baby creation is tanking, as evidenced by plunging fertility rates around the world, with deflationary consequences.

By ignoring these forces, the macroeconomists are unknowingly disrupting the microeconomic adjustment mechanisms that automatically eliminate economic and financial excesses on a regular basis. In other words, their obsession with moderating the business cycle is actually contributing to the problems they are trying to fix, because they won’t let Mother Nature--who is a microeconomist--manage the business cycle. Consider the following:

(1) Tolstoy. Last Thursday, we learned that real GDP rose just 1.5% (saar) during Q3. That was widely reported. Not as widely reported was that the GDP deflator rose just 0.9% y/y. Excluding food and energy, it was up just 1.1% y/y, the lowest since Q1-2010. The deflator for personal consumption expenditures excluding food and energy rose only 1.3% y/y, with the comparable market-based core inflation rate at just 1.1%.

Why has the Fed’s ultra-easy monetary policy failed to boost inflation? The answer may be in Leo Tolstoy’s War and Peace. A chart of the US CPI since 1800 shows very clearly that inflationary periods have been associated with wartime conditions during the War of 1812, the Civil War, World War I, and World War II through the Cold War. The restoration of peace is associated with outright deflation, i.e., falling prices after each one of these wars with only one exception. There has been no deflation since the end of the Cold War, though the CPI inflation rate has declined from 4.7% y/y during November 1989, when the Berlin Wall was toppled, to zero today.

During wartime, government takes command of the economy since all resources must be mobilized to win the war. Global trade is disrupted since there can be no trade among combatants, and it can be hard to trade with allies. In other words, wars are trade barriers. During peacetime, globalization occurs. There is more free trade even among former adversaries, and markets become freer from government controls and also more competitive.

The end of the Cold War in 1989 was the end of biggest trade barrier of all time. It led to China joining the World Trade Organization during December 2001. So far, it has been different this time because there has been no deflation. That’s because so far the central banks have succeeded in averting it with ultra-easy monetary policy. But that doesn’t mean that there won’t be adverse consequences.

Macroeconomists don’t spend much time thinking about markets, especially competitive ones. These markets tend to be very deflationary because having fewer barriers to entry during peacetime means that established, profitable producers are constantly under attack from startups hoping to take some if not all of their profits by providing BGSALP. It’s one of Mother Nature’s great wonders because it greatly benefits the one and only economic class that should matter--that is, the Consuming Class!

Competition exists in nature for only one reason, which is to improve the standard of living of consumers. It is not designed to enrich companies, shareholders, trade unions, or workers. The protagonist in this natural narrative is the entrepreneurial capitalist. (Along the way, those who succeed among them have a tendency to turn into crony capitalists, but that’s a subject for a book that I will write someday.)

(2) Turing. These days, the hero of entrepreneurial capitalists is Alan Turing, the British mathematician who is widely credited with having invented the computer. As a result of the IT revolution, entrepreneurs are able to disrupt business models in every industry with innovations that provide consumers with BGSALP. Steve Jobs, who was a big fan of Turing, was the entrepreneurial capitalist who started the personal computing revolution by inventing operating systems that could run PCs, laptops, smartphones, and iPads. All these devices have become increasingly affordable, compact, portable, and powerful thanks to the Cloud and other innovations.

In the GDP accounts, the price deflator for IT capital equipment spending has declined 79% since 1977 when Apple introduced the Apple II, a color computer with expansion slots and floppy drive support. Capital spending, in current dollars, on IT equipment, software, and R&D now accounts for over 40% of the total of such spending, up from just 23% during 1977.

(3) Bismarck. The welfare state originated in Germany during 19th century with the policies implemented by German Chancellor Otto von Bismarck. The welfare system in the United States began in the 1930s, during the Great Depression. After the Great Society legislation of the 1960s, for the first time a person who was not elderly or disabled could receive need-based aid from the federal government. The notion that government has an obligation to provide a social welfare safety net is now widely accepted in all developed nations.

The good news is that people are living longer and more comfortably in their old age. The problem is that government deficits have swelled to finance entitlement spending rather than public investments in infrastructure. It’s conceivable that the plunge in fertility rates might be partly attributable to the perception that raising children is expensive and not a good investment if the government will support us in our old age, obviating the need for adult children to do that.

The result is that the number of social welfare beneficiaries are increasing faster than workers who can support them. In the US, the ratio of 65-year-olds who are not in the labor force rose to a record 24% of the civilian labor force during September, up from 20% only 10 years ago.

In any event, these demographic trends are likely to be deflationary, since older people tend to consume less than younger people with children. This might explain the strong secular correlation between the inflation rate in the US and the Age Wave, which is the percent of the labor force that is 16 to 34 years old. The Age Wave has dropped from a record 51.2% during January 1981 to only 35.4% currently. Over that same period, the CPI inflation rate has plunged from over 10% to under 2%.

Last week, the Chinese government abandoned its one-child policy, which over the past 35 years has led to a myriad of social and economic ills in China. All Chinese couples will be allowed to have two children. The move is most likely too little too late, as China already faces a declining, graying population without the workers it needs for its vast economy.

(4) Bernanke. The macroeconomists who are running the major central banks seem oblivious to these secular forces of deflation. Nonetheless, they can be credited with successfully countering the natural forces of deflation, so far, with ultra-easy monetary policy. Perhaps they eventually will be proven right in their belief that if they persist, then self-sustaining growth will make a comeback and inflation will stabilize around 2%.

More likely, in my view, is that easy money has lost its effectiveness and won’t boost demand as still widely expected by the demand-side macroeconomists who steer the central banks. Meanwhile, on the supply side, easy money has disrupted the economic laws of nature by propping up ““zombie” producers, who would have been buried for good, and for the good of the economy, in a competitive market. The living-dead companies exacerbate deflation with their excess capacity and weaken profits for healthy companies, thus depressing the overall economy.

As I’ve often noted, no one has been as committed to moderating the business cycle with monetary policy as former Fed Chairman Ben Bernanke. He reiterated this view in a 10/4 WSJ op-ed titled “How the Fed Saved the Economy,” timed to coincide with the release of his new book, The Courage to Act: A Memoir of a Crisis and Its Aftermath:

“What the Fed can do is two things: First, by mitigating recessions, monetary policy can try to ensure that the economy makes full use of its resources, especially the workforce. High unemployment is a tragedy for the jobless, but it is also costly for taxpayers, investors and anyone interested in the health of the economy. Second, by keeping inflation low and stable, the Fed can help the market-based system function better and make it easier for people to plan for the future. Considering the economic risks posed by deflation, as well as the probability that interest rates will approach zero when inflation is very low, the Fed sets an inflation target of 2%, similar to that of most other central banks around the world.”

In his memoir, Bernanke does acknowledge that the “experience of the Great Moderation had led both banks and regulators to underestimate the probabilities of a large economic or financial shock.” In my opinion, attempts by the central banks to moderate the business cycle make the economy more vulnerable to financial instability and deeper recessions. Consider this: After so many years of attempting to revive economic growth and stabilize the financial system, Fed officials have hesitated to hike the federal funds rate by a measly 25bps, fearing the consequences. By the way, I looked in the index of Bernanke’s book for the word “capitalism.” It isn’t there.

Wednesday, September 30, 2015

Lower Oil Prices Boosting Oil Demand & Global Growth (excerpt)

Repeat after me: “The best cure for low commodity prices is low commodity prices.” This mantra isn’t very comforting if that’s mostly because producers are forced to slash their output of commodities to match the world’s depressed demand for commodities, which is depressed by the economic and financial repercussions of the producers’ retrenchment.

Cheer up! There is already some evidence that low oil prices are boosting global oil demand, which also strongly suggests that low oil prices are boosting global economic growth. The flood of global liquidity provided by central banks is now being supplemented with a flood of cheap oil. I am a big fan of the monthly demand and supply data compiled by Oil Market Intelligence (OMI). I track the 12-month averages to smooth out seasonality. Consider the latest data through August:

(1) World oil demand rose 2.0% y/y to a new record high last month. That’s the best growth rate since August 2011.

(2) Developed and developing oil demand are both growing faster with gains of 0.9% and 3.1%, respectively.

(3) World oil supply, however, continues to outpace demand. I use OMI data to calculate a ratio of demand to supply. It fell last month to the lowest reading since January 1999.

There are plenty of other global economic indicators suggesting that the global economy is growing, and benefitting, on balance, from the drop in commodity prices.

Today's Morning Briefing: Commodity Bubble Pops. (1) Not so superlative. (2) When bubbles burst, bad things happen. (3) Is it different this time? (4) A bubble pops with more winners than losers, maybe. (5) A brief (and proud) review of our commodity bubble forecast. (6) Still falling. (7) CAT & GLEN marked the top in commodities during 2010 & 2011. (8) Marking the bottom now? (9) EME stock prices still tied more to commodity prices than to their emerging middle classes. (10) The best cure for low commodity prices. (11) World oil demand growth is picking up! (12) No recession in US and Europe confidence measures. (13) Focus on market-weight rated S&P 500 Energy. (More for subscribers.)

Tuesday, September 29, 2015

What Will It Take to Revive the Bull? (excerpt)

In the past few days, I’m being asked more frequently: “What will it take to revive the bull market?” Yesterday’s decline was the fifth consecutive daily drop. The S&P 500 may very well retest its August 25 correction low, which was 12.4% below the record high on May 21. The recent low nearly matched last year’s mini-correction low on October 15, which was attributable to fears about the termination of QE4 at the end of that month. There were also concerns about the impact of plunging oil prices and the soaring dollar on earnings.

Yet stocks managed to rally 14.4% from last October’s low through this year’s record high on May 21. It was yet another relief rally as investors concluded that outside of the Energy sector, earnings were holding up surprisingly well. Nevertheless, here we are again, right where we were about a year ago. The correlation between the S&P 500 and the Fed’s holdings of bonds is working all too well.

During the current bull market, many of the relief rallies were triggered by central bank moves to provide more liquidity into financial markets. As I observed yesterday, the central bankers may be starting to lose their credibility. In my opinion, investors would have favorably greeted the widely expected Fed rate hike following the September 16-17 meeting of the FOMC. It would have demonstrated the Fed’s confidence in the strength and resilience of the US economy.

Instead, the FOMC passed on doing so, emphasizing for the first time concerns about the global economy and financial system. Yet on Thursday, Fed Chair Janet Yellen said that she still expected a rate hike before the end of the year. Yesterday, FRB-NY President Bill Dudley said the same. The Fed’s transparency makes it transparently clear that Fed officials are clueless. That’s not good for investor confidence.

Yesterday, Dudley said that the US economy is “doing pretty well.” Notwithstanding the recent puzzling hawkishness of the Fed’s two leading doves, they and their colleagues on the FOMC will continue to confront a weak global economy when the committee meets on October 27-28 and December 15-16. They will have to be concerned that combined with the strong dollar, the US economy won’t continue to do so well.

That’s what’s unnerving investors right now. Yesterday’s implosion in Glencore’s stock price was the latest confirmation that the global commodity industry is in a major bust, which is also depressing capital goods producers of mining equipment. In addition, yesterday we learned that profits at Chinese industrial companies plunged 8.8% y/y in August, with losses deepening even after five interest-rate cuts since November and government efforts to accelerate projects. Leading the losers were Chinese coal companies.

I am starting to think that getting a relief rally this time might be more challenging than in the past, when central banks had more ammo and more credibility. If the market’s main concern is the slowdown in global economic growth, there’s not much reason to expect any upside surprise anytime soon. If the US economy remains strong, it is unlikely to be strong enough to lift global growth. Meanwhile, investors may continue to fear that the poor economic performance of the rest of the world will increasingly weigh on the US.

So what will it take to revive the bull given this assessment of the global economic situation? As long as it doesn’t all add up to a global recession, the bull should find comfort in good companies that can continue to find growth in a world of secular stagnation. Commodity users should continue to benefit from the woes of the commodity producers. Valuation multiples are also more attractive now than they were earlier this year. Needless to say, earnings have to keep growing and US consumers have to keep consuming for the secular bull to survive this latest challenge.

Today's Morning Briefing: What Will It Take? (1) The fourth FAQ. (2) No bull with stocks basically flat y/y. (3) No bull since end of QE. (4) Fed is transparently clueless. (5) Hawkish doves. (6) A sensible message from the trenches. (7) “Doing pretty well.” (8) Glencore’s meltdown. (9) China’s profits are MIA. (10) Seeking growth in a world of stagnation. (11) Forward revenues and earnings remain on bull market’s uptrends. (12) Buybacks and M&A will likely continue to shrink supply of equities. (13) Stocks are cheaper. (14) Consumers of last resort. (More for subscribers.)

Monday, September 28, 2015

The Canaries in China’s Coal Mine (excerpt)

The most frequently asked question in my meetings with accounts in recent weeks has been: “What’s your take on China’s economy?” I have been pessimistic on China’s economy for well over a year, mostly because of the producer price deflation. However, pessimism may be too widespread and excessive now.

Since the yuan was devalued on August 11, the US stock market has been much more sensitive to any indicator coming out of China. The latest one, released on 9/23 by Markit, showed that September’s flash M-PMI fell to 47.0, with the output component down to 45.7--both at 78-month lows.

Commodity prices remain under downward pressure, confirming the weakness in China’s factory sector. Also confirming China’s weakness are production indexes among its major trading partners. Industrial production indexes are falling in both Taiwan and Singapore, with the average of the two down 8.3% over the past five months through August. Brazil’s factory output is down 8.3% y/y to the lowest since May 2009.

Today's Morning Briefing: What’s the Matter? (1) Just another normal correction? (2) An ugly technical picture. (3) More Death Crosses. (4) Dow Theory looking bearish. (5) Fallen leaders. (6) Advance/decline lines in retreat. (7) Bearish sentiment, volatility, and junk spreads all elevated. (8) Three FAQs while waiting for Godot. (9) China’s canaries may be Brazil, Taiwan, and Singapore. (10) Draghi is waiting for lenders to lend more. (11) Abenomics 2.0 has three new darts. (12) US looking good, regional business surveys aside. (13) Resigned to more congressional partisanship. (14) “Pawn Sacrifice” (+ + +). (More for subscribers.)