Inflationary Inflection Point or Temporary Blip?

Inflationary Inflection Point or Temporary Blip?

During the last three months inflation has become a much debated topic. This article, which was published in March, may still add something to the increasingly heated debate: –

Inflationary Inflection Point or Temporary Blip?

Commodities, Supply-chains and Structural Changes in Demand

Commodities, Supply-chains and Structural Changes in Demand

Macro Letter – No 139 – 18-06-2021

Commodities, Supply-chains and Structural Changes in Demand

  • Talk of a new commodity super-cycle may be premature
  • Once GDP growth returns to trend, commodity demand will moderate
  • Fiscal and monetary relief are key to maintaining growth and demand
  • Structural changes in energy demand will prove more persistent

As the spectre of inflation begins to haunt economists, many market commentators have started to focus on commodity prices in an attempt to predict the likely direction of the general price level for goods and services. This indexing of the most heterogeneous asset class has always struck me as destined to disappoint. Commodity prices change in response to, often, small variation in supply or demand and the price of some commodities varies enormously from one geographic location to another. Occasionally the majority of commodities rise in tandem but more frequently they dance to their own peculiar tunes.

Commodity analysts tend to focus on Energy and Industrial Metals foremost; Agricultural Commodities, which are more diverse by nature are often left as a footnote. Occasionally, however, a demand-side event occurs which causes nearly all sectors to rise. The Covid-19 event was just such a shock, disrupting global supply-chains and consumer demand patterns simultaneously.

The chart below shows the CRB Index since 1995: –

Source: CRB, Yardeni

This chart looks very different to the energy heavy GSCI Index, which is weighted on the basis of liquidity and by the respective world production quantities of its underlying components: –

Source: S&P GSCI, Trading Economics

The small rebound on the chart above is not that insignificant, however, it equates to a 55% rise since the lows on 2020. The fact that prices collapsed, as the pandemic broke, and subsequently soared, as vaccines allowed economies to reopen, is hardly surprising. Economic cycles wield a powerful influence over commodity prices; short-term, inelastic, supply, confronted by an unexpected jump in demand, invariably precipitates sharp price increases.

The lockdown which followed the initial outbreak of the virus, led to an abrupt change in consumer demand; hotels and travel were out, remote working was in. Whilst house prices were already supported by a sharp lowering of interest rates and debt forbearance measures, the price of lumber, for home improvements and property extensions, exploded: –

Source: Trading Economics

Similar patterns were evident in Steel and Copper, but also due to shortages and bottlenecks in the semiconductor supply-chain, which led a slowing of automobile production, in turn prompting a rise in the price of both for new and used cars.

The recent resurgence in commodity prices has encouraged suggestions that a new commodity super-cycle is underway, however, these are relatively rare events. The most recent cycle is generally thought to have begun with the rise of Chinese demand in the late 1990’s and ended abruptly with the financial crisis in 2008/2009. Since the crisis Chinese growth has moderated, although the rise of India may see another wave of rapid industrialisation at some point. The chart below, however, portrays a different narrative, suggesting that the 2008 peak was merely a corrective wave from the 1980 peak. The new super-cycle has just begun, it will peak some-time around 2045: –

Source: Janus Henderson, Stifel Report June 2020. Note: Shown as 10yr rolling compound growth rate with polynomial trend at tops and bottoms. Blue dotted line illustrates a forecast estimation. Warren & Pearson Commodity Index (1795-1912), WPI Commodities (1913-1925), equal-weighted (1/3rd ea.) PPI Energy, PPI Farm Products and PPI Metals (Ferrous and Non-Ferrous) ex-precious metals (1926-1956), Refinitiv Equal Weight (CCI) Index (1956-1994), and Refinitiv Core Commodity CRB Index (1994 to present).

Another short-term factor, which has exacerbated the rise in the price of key commodities over the past year, is the ongoing trade tensions between the US and China. Tariff increases have increased costs for importers and wholesalers, meanwhile the effect of the Great Financial Crisis has been evident for the past decade in the shortening of global supply-chains. Covid accelerated this de-globalisation, forcing many firms to seek out new sources of supply. The long-run effect of these adjustments will be stronger, deeper supply-chains, but the short-run cost must be paid for by the importer, the producer or the consumer.

A part of the new commodity super-cycle argument is based on more structural factors. The reduction of carbon emissions will entail the use of vast amounts of metals. Electrification calls for copper; silver will be needed for photovoltaic panels; electric vehicles require aluminium, nickel, graphite, cobalt and lithium, together with numerous rare-earth metals – of which China is fast becoming the monopoly supplier.

The last great structural shift in energy was from coal to oil. Colonel Drake’s discovery in Pennsylvania in 1859 and the Spindletop find in Texas in 1901 set the stage for the new oil economy, yet it took until 1919 for gasoline sales to exceed those of kerosene.

Although coal-gas was used for most of the 19th century and the first US natural gas pipeline was built in 1891, prior to the 1920s, the vast majority of natural gas produced as a by-product of oil extraction was simply flared away. Superior welding techniques during the interwar years marked a boom in natural gas adoption, but major pipelines were still under construction as late as the 1960’s.

The time-line from Colonel Drake striking pay-dirt in 1859 to mass natural gas adoption took more than a century. Technology and innovation move at a much faster pace today, yet the infrastructural investment needed to transform from carbon to renewable energy will take decades rather than years.

Meanwhile, there remain shorter-term reasons to doubt the arrival of a new commodity super-cycle so precipitously upon the last. Chinese GDP growth has fallen sharply from the double-digit rates of the last decade. Its working age population is shrinking, added to which the People’s Bank of China seem reluctant to allow credit expansion on the scale of previous cycles. Rebalancing towards domestic consumption continues to be official policy.

There is near-term evidence of energy supply constraints but over the longer-run oil and gas production, especially from the likes of the US frackers, can raise output rapidly in response to increases in the price of Crude. The chart below shows the fluctuations in the Baker Hughes US Oil Rig count over the past decade, no shortage of capacity is apparent here: –

Source: Baker Hughes, Trading Economics

Agricultural commodities tend to operate on even shorter supply cycles. If supply constraints send Wheat prices higher, farmers respond by switching away from Corn. Seasonal adjustments can be rapid.

The GSCI may have hit its lowest since the 1980’s last April and prices may have doubled since then, but it is still more than 75% below its June 2008 peak. Further upside may be seen as the global economy makes up for a year of lost economic growth, but as economic growth returns to normality demand for energy is likely to moderate just as fresh supply comes on stream.

The spending plans of the US administration may maintain demand in the US but China seems determined to nip its domestic credit bubble in the bud. In broad terms these factors counter-balance one another. According to the Federal Reserve, US GDP is forecast to range between 5% and 7.3% in 2021, falling to 2.5% to 4.4% in 2022 and 1.7% to 2.6% in 2023, meanwhile, according to the OECD, Chinese growth will moderate from 8.5% in 2021 to 5.8% in 2022.

Conclusion and Investment Opportunities

Back in January Goldman Sachs predicted a new commodity super-cycle. They see rising wages leading to faster, commodity price positive, home formation and more synchronised social policies, akin to those of 1960s ‘War on Poverty’ campaign. In other respects they believe this cycle has stronger parallels to the 1970s than the 2000s. Goldman expect industrial capex to run at 2000 levels whilst social rebuilding generates a 1970s style consumer boom.

S&P present some of these arguments in a useful infographic: –

Source: S&P Global

US unemployment has fallen from 11.1% to 5.8% during the last 12 months, even in the harder hit Euro Area it has declined from 8.7% to 8%, whilst Chinese data has followed a similar trajectory, falling from 6.1% to 5% since February 2020. Nonetheless, much of the global economy remains in some form of lockdown, with economic activity fuelled by fiscal spending. It remains difficult to envisage the conditions for a near-term sustainable economic boom. Remove global monetary and fiscal relief and commodity demand will evaporate.

As a general rule, in commodity and financial markets, what goes up price must eventually come back down. The price of US Stud Lumber (chart above) is well off its highs. Governments and their central bankers can attempt to remove the punch-bowl, but the markets are unlikely to take it well.

First In, First Out – China as a Leading Indicator

First In, First Out – China as a Leading Indicator

Macro Letter – No 138 – 21-05-2021

First In, First Out – China as a Leading Indicator

  • China was the first country to recover from the Covid-19 pandemic
  • The PBoC began tightening monetary conditions in May 2020
  • Chinese housing and stocks remain strong despite official policy
  • Chinese contagion remains a risk to the global recovery

Whilst there are many aspects of the Chinese command economy which differ radically from that of the US, it is worth examining the performance of China’s economy, fiscal and monetary policy, and its financial markets. They may afford some insight into the future direction of other developed and developing markets as we gradually emerge from the Covid crisis: –

Source: Trading Economics

As can be seen from the chart above, whilst China was the first country to be struck by the Covid-19 pandemic it was also the first country to recover, however, a comparison of the Chinese and US bond markets provides a rather different picture: –

Source: Trading Economics

Chinese bond yields reached their lows at roughly the same time as those of the US, since when they have returned more rapidly to their pre-pandemic levels. If the US follows a similar trajectory the yield on US Treasuries is set to rise further.

It can be argued, however, that the plight of the Chinese bond market is a function of the monetary stance of the People’s Bank of China (PBoC). When the crisis first erupted the PBoC cut its interest rate corridor by 0.3% and also drove down Chinese interbank rates by around 1.2% through its open market operations. By May 2020 that policy had changed, accommodation was replaced by a steady drain of liquidity.

The chart below shows the, rather volatile, 3 month Shibor rate, this is in marked contrast to the ‘lower for longer’ approach taken after the 2008 crisis. The Covid accommodation has been remarkably short-lived: –

Source: Trading Economics, PBoC

This PBoC tightening, which began in May 2020 and has been accompanied by official talk of the need for stability and the desire to avoid creating asset bubbles, is finally becoming evident in the money supply data: –

Source: Trading Economics

This contrasts with the continued expansion of US monetary aggregates: –

Source: Trading Economics

One of the challenges facing all central bankers is that interest rates are a blunt tool. Not all China’s asset markets have heeded the PBoC advice. The residential property market, for example, remains red hot despite the introduction of the three red lines policy – which aims to limit their liability-to-asset ratio (excluding advance receipts) to less than 70%, or their net gearing ratio to less than 100%, or their cash-to-short-term debt ratio to less than 1x, or a combination of all three. New home prices surged on regardless, gaining 4.8% in April, led by luxury real estate in Shenzhen, Shanghai and Guangzhou which is up 16% to 19% over the last year – a further tightening of regulation seems inevitable.

The PBoC has had greater influence elsewhere, Total Social Financing, their favoured measure of lending across the entire domestic financial system, rose by 12% in March, its slowest pace since April 2020:-

Source: Financial Times, CEIC

Another sign that official policy measures may be biting was seen in April’s retail sales which, whilst they rose by 17.7%, were down from a 34.2% in March, and came in well below the consensus forecast of 24.9%. Here again, China appears to be a leading indicator of the direction that the US economy might take: –

Source: Trading Economics

Interestingly, unlike 2015, the Chinese stock market has, thus far, reacted in a more measured way to the general tightening of monetary conditions. The next chart shows the relative performance of the Shanghai Composite versus the S&P 500 Index: –

Source: Trading Economics

As mentioned above, money supply data points to a slowing of the Chinese economy but, like so many other countries, China saw a sharp rise in its, already high, household saving rate. The Paulson Institute estimates that Chinese households saved 3% more of their income than prior to Covid; Pantheon Macroeconomics equate this pool of savings to roughly 3% of GDP. While many commentators suggest that in China’s case this is a pool of precautionary saving, consumption will likely resume its long-term growth, now that employment prospects have begun to improve. The chart below shows the lagged trajectory of unemployment in US compared to China: –

Source: Trading Economics

US unemployment remains elevated relative to its pre-Covid rate but the economic recovery continues to gather momentum.

In China, as elsewhere, that portion of excess savings not consumed will either be left on deposit, used to reduce debt or invested. Even though interest rates have risen, the liquidity of Chinese capital markets should remain plentiful for the next six months to a year, sufficient to cushion any sudden downturns in the post-Covid recovery.

Conclusions and Investment Opportunities

In the analysis above, I have produced a strew of charts suggesting that the US may follow the trajectory of China as the post-Covid recovery unfolds. This is almost certainly too simplistic. Above all else Beijing craves stability, it knows its pace of economic growth is slowing, this is structural. The investment-led growth model which has transformed the economy over the last four decades, requires the methadone of more credit to sustain even these lower rates of return. The policy of rebalancing towards domestic consumption offers longer-term hope, but China’s recovery from the Covid crisis was driven principally by investment and, to a much lesser extent, exports. The chart below, from George Friedman of Geopolitical Futures, shows the damage done to Chinese consumption by the pandemic and the subsequent rebound: –

Source: Geopolitical Futures, IMF, CEIC

The new(ish) US administration is also different from any we have seen for several decades. Markets believe in the arrival of a New New Deal fuelled by a gargantuan monetary and fiscal tonic which will heal-all. Asset prices continue to rise as The Everything Bubble inflates further.

We are still in the early stages of the economic recovery. Supply-chain constraints and labour shortages, even whilst under-employment remains elevated, have driven inflation expectations higher in the near-term, yet asset markets look beyond these shorter-term factors to the productivity gains, which have, in many cases, been a long overdue response to the crisis itself.

A few brave central bankers are seeking to temper the speculative frenzy. The majority, however, will place their emphasis on outcomes rather than the outlookas Federal Reserve Governor Lael Brainard recently stated. This politically expedient approach means fiat currencies will continue their race to the bottom, bond markets will remain neutered by the policy of QE; that leaves assets as the solitary safety-valve, somewhere between a store of wealth and thar she blows. They afford some protection against debasement and, with the advent of Decentralised Finance, there is a non-zero possibility that some of these assets might even become a means of exchange.

In the near-term we have seen the Norges Bank indicate that it may raise rates in H2 2021. The Bank of Canada has announced a tapering of government bond purchases, inking in a potential rate increase for late 2022, meanwhile the Bank of Japan, whilst it has made no bald statements, has moderated its ETF purchases and stands accused of taper by stealth because the scale of its bond-buying has actually slowed since it adopted yield curve control in 2016. These isolated actions are but clouds in a blue sky of endless liquidity but financial markets prefer to travel rather than to arrive. Choppier markets are likely over the next few months, there may be some excellent asset buying opportunities on sharp corrections.

Digital Currencies and US Dollar Dominance

Digital Currencies and US Dollar Dominance

I published this essay at the end of last year but as Cryptocurrencies and Digital Asset gain further prominence, I take the liberty of sharing once more. Central Bank Digital Currencies will be the next ‘innovation’ but we may see money, traditionally a store of value and a means of exchange, become either one or the other.

Digital Currencies and US Dollar Dominance

Relax, Rotate, Reflate

Relax, Rotate, Reflate

Macro Letter – No 134 – 27-11-2020

Relax, Rotate, Reflate

  • With US elections over and a vaccine in sight, financial market uncertainty has declined
  • Rotation has seen a resurgence in those stocks battered by the onset of the pandemic
  • Monetary and fiscal spending will continue until inflation returns

November has been an interesting month for financial markets around the world. The US Presidential election came and went and with its passing financial market uncertainty diminished. This change of administration is undeniably important, but its effect was overshadowed by the arrival of three vaccines for Covid-19. As I write (Thursday 26th) the S&P 500 Index is within 30 points of its all-time high, amid a chemical haze of pharmaceutical hope, whilst the VIX Index has tested its lowest level since February (20.8%). The Nasdaq Composite is also near to its peak and the Russell 2000 Index (an index of smaller capitalisation stocks) burst through its highs from February 2020 taking out its previous record set in September 2018. The chart below shows the one year performance of the Russell 2000 versus the S&P500 Index: –

Source: Yahoo Finance, S&P, Russell

It is worth remembering that over the very long term Small Caps have outperformed Large Caps, however, during the last decade the rapid growth of index tracking investments such as ETFs has undermined this dynamic, investment flows are a powerful force. I wrote about this topic in June in – A Brave New World for Value Investing – in which I concluded: –

Stock and corporate bond markets have regained much of their composure since late March. Central banks and governments have acted to ameliorate the effects of the global economic slowdown. As the dust begins to settle, the financial markets will adjust to a new environment, one in which value-based stock and bond market analysis will provide an essential aid to navigation.

The geopolitics of trade policy, already a source of tension before the pandemic struck, has been turbo-charged by the simultaneous supply and demand shocks and their impact on global supply chains. Supply chains will shorten and diversify. Robustness rather than efficiency will be the watch-word in the months and years ahead. This sea-change in the functioning of the world economy will not be without cost. It will appear in increased prices or reduced corporate profits. Value-based investment analysis will be the best guide in this brave new world.

To date, evidence of a return to Value Investing seems premature, Growth still dominates and the structural acceleration of technology trends seems set to continue – one might say, ‘there is Value in that.’

The vaccine news led to a rotation out of technology stocks but this was more to do with profit taking, new ‘Tech’ buyers quickly emerged. The rotation into Small Caps was also echoed among a number of out of favour sectors such as Airlines and Energy. It was enough to prompt the creation of a new acronym – BEACHs – Booking, Entertainment, Airlines, Cruises and Hotels.

Source: Barchart.com, S&P

Above is the one year performance of the 11 S&P 500 industry sectors. Information Technology remains the leader (+38%) with Energy bringing up the rear (-32%) however the level of dispersion of returns is unusually which has presented an abundance of trading opportunities. The table below shows the one, three and six month performance for an expanded selection of these sectors: –

Source: Tradingview

Beyond the US, news of the vaccines encouraged both European and emerging markets, but the latter (EEM), helped by the strong performance of Chinese stocks, have tracked the US quite closely throughout the year, it is Europe (IEUR) which has staged the stronger recovery of late, although it has yet to retest its February highs: –

Source: Yahoo Finance, S&P, MSCI

In the aftermath of the US election, US bond yields have inched higher. From an all-time low of 32bp in March, 10yr yields tripled, testing 97bp in the wake of the Democrat win. Putting this in perspective, the pre-Covid low was seen at 1.32% in July 2016. The current concern is partly about the ‘socialist’ credentials of President-elect, Biden, but the vaccine announcement, together with the prospect of a return to some semblance of normality, has also raised the spectre of a less accommodative stance from the Fed. There was initial fear they might ‘take away the punch-bowl’ before the global economy gets back on its knees, let alone its feet. Governor Powell, quickly dispelled bond market fears and yields have since stabilised.

Longer-term, these bond market concerns may be justified, as this infographic from the McKinsey Institute reveals, combined central bank and government fiscal stimulus in 2020 has utterly eclipsed the largesse witnessed in the wake of the 2008 crisis: –

Source: McKinsey

Bond watchers can probably rest easy, however, should the global economy stage the much vaunted ‘V’ shaped recovery economists predicted back in the spring, only a fraction of the fiscal stimulus will actually materialise. Nonetheless, prospects for mass-vaccination, even in developed countries, remains some months away, both monetary and fiscal spigots will continue to spew for the present.

On the topic of monetary policy it is worth noting that the Federal Reserve previously employed ‘yield curve control,’ though it was not called by that name, back in April 1942, five months after the attack on Pearl Harbor. Under this arrangement the Fed committed to peg T-Bills at 3/8th and implicitly cap long-dated T-Bonds at 2.5%. The aim was to stabilize the securities market and allow the government to engage in cheaper debt financing during the course of WWII. This arrangement only ended with the Treasury – Fed Accord of 1951 in response to a sharp peace-time resurgence in inflation. This chart shows the period from 1941 (when the US entered WWII) up to the middle of the Korean War: –

Source: US BLS

I believe we will need to see several years of above target inflation before the Fed to feel confident in raising rates aggressively. The experience of Japan, where deflation has been lurking in the wings for decades, will inform Fed decision making for the foreseeable future.

Returning to the present environment; away from the stock and bond markets, oil prices also basked in the reflected light shining from the end of the pandemic tunnel. West Texas Intermediate, which tested $33.64/bbl on 2nd, reached $46.26/bbl on 25th. The energy sector remains cautious, nonetheless, even the recent resurgence leaves oil prices more than $15/bbl lower than they were at the start of the year.

Looking ahead, the stock market may take a breather over the next few weeks. A vaccine is coming, but not immediately. US politics also remains in the spotlight, the Republicans currently hold 50 Senate seats to the Democrats 48. If Democrats secure the two seats in Georgia, in the runoff election on 5th January, VP Elect, Harris, will be able to use her ‘tie-break’ vote to carry motions, lending the Biden Presidency teeth and hastening the expansion of US fiscal policy.

The stock market has yet to make up its mind about whether Biden’s ‘New New Dealers’ are a positive or a negative. Unemployment and under-employment numbers remain elevated as a result of the pandemic: and, whilst bankruptcies are lower than at this time last year, the ending of the myriad schemes to prolong the existence of businesses will inevitably see those numbers rise sharply. Does the stock market benefit more from the fiscal spigot than the tax increase? This is a question which will be mulled, chewed and worried until long after Biden’s inauguration on January 20th.  

Meanwhile the trend accelerations in technology which I discussed in – The prospects for Emerging and Frontier Markets in the post-Covid environment – earlier this month, continue. The chart below shows how information industries have been transforming the makeup of global trade ever since the great financial crisis: –

Source: ECIPE, OECD, TiVA, van der Marel

Manufacturing trade is in retreat, trade in digital services is accelerating. The chart above stops at 2015, when we have the data to incorporate the period of the current pandemic, I expect the pace of growth in information industries to have gain even greater momentum.

Back in 1987, MIT economist and Nobel Laureate, Robert Solow, observed that the computer age was everywhere except for the productivity statistics. During the 1990’s technology productivity growth was finally observed, but the past decade has seen a string of disappointing productivity growth statistics, yet they have coincided with digitisation transforming vast swathes of the global economy, perhaps the next decade will see the fruit of these labours. I believe we can look forward to significant productivity improvements in the coming years. Stock prices, however, are forward looking, their valuations may seem extended but this may be entirely justified if technology ushers in a new golden age.

Global Money Supply Growth and the Great Inflation Getaway

Global Money Supply Growth and the Great Inflation Getaway

Back in June I wrote about the prospects for inflation in the wake of global money supply growth. The deflationary forces of the pandemic and demographic aging still maintain the upper hand for now, but there’s a tug of war which governments need to win if debt is to be inflated away.

Global Money Supply Growth and the Great Inflation Getaway

The prospects for Emerging and Frontier Markets in the post-Covid environment

The prospects for Emerging and Frontier Markets in the post-Covid environment

Macro Letter – No 133 – 06-11-2020

The prospects for Emerging and Frontier Markets in the post-Covid environment

  • The Covid pandemic has accelerated several economic trends
  • Technology industries will benefit
  • Less developed countries will suffer
  • This crisis could see ‘The African Century’ postponed

During the past six months the global economy has been assailed by a multitude of vicissitudes. But on closer inspection, the pandemic has served to accelerate a number of economic and political trends which were in train long before the outbreak in Q1 of this year.

Back in February, when the crisis was largely confined on China and financial markets were still in denial, I wrote in – When the facts change: –

Global supply chains have been shortening ever since the financial crisis, the Sino-US trade war has merely added fresh impetus to the process. As for financial markets, stock prices around the world declined in January but those markets farthest from the epicentre of the outbreak have since recovered in some cases making new all-time highs.

Then came the panic of March. Stocks collapsed, developed market government bonds rallied, the VIX Index quadrupled: and central banks and government Treasuries intervened to an unprecedented degree in order to right the ship. Our leaders triumphed, stock markets recovered, bond yields moderated, short-term interest rates in several emerging market economies were slashed and the policy of quantitative easing spread, from the ‘developed’ core, to countries which could barely have contemplated such asset purchases during previous global crisies. Here are few of the actions taken by EM central banks: –

Source: VoxEU CEPR, Hartley and Rebucci

To some degree, masked by the gyrations of the stock market, certain longer-term economic trends have simply accelerated. Technology companies have taken centre-stage, with digital transformation changing the working practices of, perhaps, half the global labour-force. In the US it is estimated that the percentage of people now able to work remotely has risen from 41% to 59%, but whereas prior to the pandemic, remote work amounted to the occasional day, here or there, remote working has now become the new normal.

There has been a seismic shift in the real-estate market. Demand for commercial office space has declined, demand for larger residential units and for houses (with outdoor space) rather than apartments. This is an entirely predictable response to these changes in the nature of work.

Other technological trends have also accelerated. The robotics revolution is replacing humans in a wide array of industries in the way it transformed the car assembly line some decades ago. Add in advances in the digitisation of logistics and the era of ‘just in time production’ can much more effectively offset the higher cost of domestic manufacture. Global supply chains have been shortening since the great financial crisis. Since the spring these trends have gained additional momentum.

In March, in an article for AIER I asked – Is this the End of Globalization?Among the topics I discussed was the impact these supply chain trends may have on Emerging and Frontier markets: –

In his July 2019 essay for Project SyndicateIn Praise of Demographic Decline, Adair Turner observes:

Our expanding ability to automate human work across all sectors – agriculture, industry, and services – makes an ever-growing workforce increasingly irrelevant to improvements in human welfare. That’s good news for most of the world, but not for Africa.

The author goes on to suggest that for countries in demographic decline, automation of manufacturing processes is an economic boon, whereas for countries with rising fertility it is an impediment to improvements in their per capita standard of living. 

As with many trends among developed countries, Japan, where deaths outnumber births by an average of 1,000 people per day, is in the vanguard in embracing technology to counter the demographic deficit. The shortening of GVC’s will simply hasten their innovation in automation.

I went on to look at the rising use of robots: –

Source: IMF, International Federation of Robotics

The infographic above comes from a June 2018 IMF publication entitled, Land of the Rising Robotsin which the authors’ conclude: –

…the wave of change is clearly coming and will affect virtually all professions in one way or another. Japan is a relatively unique case. Given the population and labor force dynamics, the net benefits from increased automation have been high and could be even higher, and such technology may offer a partial solution to the challenge of supporting long-term productivity and economic growth.

Last year, the McKinsey Global Institute looked at the job security of different occupations in the face of automation in the US. Countries with lower average earnings will be slower to adopt automation but their comparative advantage is likely to be eroded, especially if the worlds’ trade policies grow more protectionist: –

Source: Mckinsey Global Institute

In labour-force terms, most of the roles which can be automated are unskilled. As long as EM and Frontier countries can maintain a comparative advantage in labour input costs, their unemployment rates will remain low. The threat of developed nation automation, however, imposes a ceiling on wages in all countries and developing nations will feel the effect most directly.

Returning to Lord Turner’s article for Project Syndicate – In Praise of Demographic Decline– the author quotes from the UN 2019 population projection which indicates that Asia, Europe and the Americas have almost achieved population stability. The problem of automation on employment prospects is therefore lower in these countries. It is poorer countries whose populations are young and still growing which are most at risk . This is especially true of Africa where the UN projects the population will soar from 1.34bln to 4.28bln by the end of the century.

Turner tentatively suggests there may be a universal rule of human behaviour; that rich, successful societies choose to adopt fertility rates which lead to gradual population decline. He also challenges the concept of the ‘working age’ population (15 to 64 years) questioning why, if longevity is increasing, that upper bound should still apply, going on to surmise: –

…in a world of rapidly expanding automation potential, demographic shrinkage is largely a boon, not a threat. Our expanding ability to automate human work across all sectors – agriculture, industry, and services – makes an ever-growing workforce increasingly irrelevant to improvements in human welfare. Conversely, automation makes it impossible to achieve full employment in countries still facing rapid population growth.

The author compares India, where the population continues to expand, with China, which has been aggressively embracing automation as its population ages and the effect of its ‘one child’ policies has caused its population to plateau – growing old before they grow rich.

If the greatest demographic challenges face countries with rapid population growth, then Africa may find its route to middle income status impeded, especially if developed nation manufacturing can be almost entirely automated.

As Turner concludes: –

Automation has turned conventional economic wisdom on its head: there is greater prosperity in fewer numbers.

The Covid-19 pandemic has caused other weaknesses of emerging economies to be laid bare. The IMF – How COVID-19 Will Increase Inequality in Emerging Markets and Developing Economies – published earlier this month, observes that, several years prior to the crisis, EM income inequality had begun to rise, along with worryingly high levels youth inactivity. They also note increasing educational inequality and an absence of economic opportunities for woman. All these trends have accelerated during the past nine months, to such an extent that the improvements of the last decade have been swept aside: –

Source: IMF

In their 2nd May briefing on EM bonds, The Economist took up this theme asking – Which emerging markets are in most in peril?The authors listed several EM bond issuers who had defaulted even before the current crisis had begun: –

Argentina has missed a $500m payment on its foreign bonds. If it cannot persuade creditors to swap their securities for less generous ones by May 22nd, it will be in default for the ninth time in its history… Ecuador, which has postponed $800m of bond payments for four months to help it cope with the pandemic; Lebanon, which defaulted on a $1.2bn bond in March; and Venezuela, which owes barrelfuls of cash (and crude oil) to its bondholders, bankers and geopolitical benefactors in China and Russia… Zambia, which is seeking to hire advisers for a “liability-management exercise”, an agreement to pay creditors somewhat less, somewhat later than it promised.

Anticipating trouble ahead they also produced this most informative table: –

Source: The Economist

The Economist notes that the 66 countries listed need to find $4trln to service their existing debt this year – which drops to $2.9trln once China is excluded. With luck this refinancing will be manageable. Global capital markets have matured and deepened greatly since the Asian crisis of 1997. The table below shows the percentage of local currency bonds issued by various EM borrowers today: –

Source: Institute of International Finance

On average 79% of these issuers tapped their local currency markets, rendering them relatively immune to speculative abuse on the foreign exchanges. By contrast, those countries which were obliged to tap the international market, raising capital primarily in US$, were forced to pay a substantial credit premium for the privilege.

The IMF, concerned by the rapidity of the capital flight from EM bond markets at the start of the pandemic, focussed their research on the risks of a sudden stop in credit markets and the policy actions which should be undertaken to avert disaster. The next chart shows the initial divergence and subsequent re-convergence of global government bond markets since Q1: –

Source: IMF

Surprisingly, international investor exposure to EM bonds has remained fairly static over the last five years, as the chart below reveals: –

Source: Institute of International Finance

As developed nation central banks have lowered interest rates and increased QE so the quest for yield has risen. Given the attractive yields offered by EM issuers one might have expected a significant increase in international exposure. It seems the risks of EM sovereign default has leant investors some degree of sobriety.

Of course the BIS has been keen to observe the synchronicity between this years’ EM bond rebound and the advent of EM central bank QE. Perhaps this new approach will strengthen the resolve of yield hungry investors: –

Source: EPFR, JP Morgan, BIS

Conclusions and Investment Opportunities

As a watcher (and trader) of the European government bond markets over more than three decades, I have observed the convergence and divergence of yield spreads between the periphery and the core. When looking beyond the Eurozone, one has to account for currency, as well as interest rate and duration risk. In the past EM bonds lacked of local currency liquidity which meant the credit risk could be taken through a spread between the US$ sovereign issuer and US Treasuries. Today the EM capital markets have matured, nonetheless, local currency bonds need to be hedged against adverse currency movement. Meanwhile, those issuers, forced to raise capital in the US$ markets are likely to be less liquid and, in many cases, less credit worthy.

The new paradigm for EM bond traders is the introduction of EM central bank QE. This is a ‘whatever it takes’ moment for many emerging nations. If they can successfully defend their currencies and their bond markets from speculative capital flight they will foster increased liquidity and with it increased capital raising capacity for the governments. We stand upon the threshold of a brave new world where an EM country, with a flexible exchange rate regime and well-anchored inflation expectations, can suspend disbelief and print its way out of a credit crisis. A recent BIS paper – Inflation at risk in advanced and emerging market economies– found that EM countries success in taming inflation, together with their adoption of inflation targeting frameworks, has greatly reduced upside inflation risks.

For the developed nation central banks, for whom the Bank of Japan has been the leader of innovation, for almost two decades, the efforts of EM central banks to wield QE, will be watched with bated breath. It still remains unclear how far a central bank can expand its balance sheet before the currency market calls it to task. Given that the Bank of Japan has yet to do so, it falls to an EM country will discover those limits. Until then, the widening of EM credit spreads will (selectively) provide an excellent buying opportunity.

In the longer term the demographic dividend of a young population may no longer be the panacea it once was hoped. Technology, and especially the automation of manufacturing means that countries which might have adopted a mercantilist, export driven approach to raise themselves out of poverty will find the road is longer and less rapid. Emerging economies will bifurcate into those that can afford to automate and those that need to support their unskilled youth. This will determine their economic growth trajectory, their government finances and the success of their domestic businesses. For emerging, and particularly Frontier economies, their youth, without education, is no longer unalloyed stuff of economic prosperity.

Step-change at the Fed – Reaching for the stars

Step-change at the Fed – Reaching for the stars

Macro Letter No 132 – 04-09-2020

Step-change at the Fed – Reaching for the stars

  • The Federal Reserve has changed the emphasis of their dual mandate
  • Inflation targeting will become more flexible in the long-run
  • Full employment has become the Bank’s priority
  • Asset markets will be the immediate beneficiaries

In a speech entitled – New Economic Challenges and the Fed’s Monetary Policy Review – given on August 27th, at the Jackson Hole, Kansas City Federal Reserve Economic Policy Symposium, Federal Reserve Chairman, Jerome Powell, announced a change in the emphasis of the dual mandate. The new focus is on promoting full-employment even at the expense of price stability.

The policy review was, of course, more nuanced. Past policy decisions were analysed and found wanting – especially the rate increases witnessed between 2015 and 2018. The extraordinary flatness of the Phillips Curve was noted; the lower trend rate of economic growth, contemplated; the stickiness of inflation expectations, contextualised: and the ever rising, pre-pandemic participation rate, considered. What the speech omitted was any discussion of forward guidance or expectations of the change in size, composition or direction of the Fed’s, already historically large, balance sheet.

For financial markets the key change is contained in this paragraph: –

Our statement emphasizes that our actions to achieve both sides of our dual mandate will be most effective if longer-term inflation expectations remain well anchored at 2 percent. However, if inflation runs below 2 percent following economic downturns but never moves above 2 percent even when the economy is strong, then, over time, inflation will average less than 2 percent. Households and businesses will come to expect this result, meaning that inflation expectations would tend to move below our inflation goal and pull realized inflation down. To prevent this outcome and the adverse dynamics that could ensue, our new statement indicates that we will seek to achieve inflation that averages 2 percent over time. Therefore, following periods when inflation has been running below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.

The initial market response saw stocks rally whilst 10yr T-bond yields rose – testing 0.79%. During the week which followed, 10yr yields slipped back to 0.62%. Equity markets subsequently switched focus and moved on, returning to their obsession with the ever rising tide of technology stock earnings expectations. Even the Dow Jones Industrials Average Index has been effected by the tech boom, as reported by S&P – Dow Jones Industrial Average: 124 Years and It Keeps Changing – the index changes, announced on August 31st included, Salesforce.com (CRM) replacing Exxon Mobil (XOM), Amgen (AMGN) replacing Pfizer (PFE), and a tech switch with Honeywell International (HON) replacing Raytheon Technologies (RTX).

Returning to monetary policy, the Fed announcement was hardly a surprise, the August 10th, FRBSF Economic Letter – Average-Inflation Targeting and the Effective Lower Bound had already set the tone. The chart below reveals the Fed’s inflation targeting dilemma: –

Source: FRBSF

If the average for Total PCE over the last decade has been less than 1.5%, allowing it to rise above 3% for a few years is just what is needed for the Fed to get back on track.

Setting aside the vexed questions of whether an Inflation Target is appropriate or, deflation, a good or bad phenomenon, we need to investigate the structural cause of the decline in inflation. Here I will resort to the monetary equation of exchange: –

MV = PQ

Where: –

M            is the total nominal amount of money supply in circulation on average in an economy.

V             is the velocity of money, or the average frequency with which a unit of money is spent.

P             is the price level.

Q             is an index of real expenditures for newly produced goods and services.

The basic problem for the Fed is that, despite their success in expanding money supply (see below): –

Source: Federal Reserve Bank of St Louis

The velocity of circulation has continued to plummet: –

Source: Federal Reserve Bank of St Louis

I discussed the rapid expansion of money supply in more detail in a June article for AIER – Global Money Supply Growth and the Great Inflation Getaway:

I suspect, fearful of repeating the mistakes made by the Bank of Japan, that once the inflation genie is finally out of the bottle, central bankers will forsake the hard-learned lessons of the 1970’s and 1980’s and allow inflation to conjure away the fiscal deficits of their governments at the expense of pensioners and other long-term investors.

Of course, consumer price inflation may not return, even with such egregious debasement as we have seen thus far, as Michel Santi suggests in Japan: a sleeping beauty: –

A global battle has thus been raging on pretty much since the deflationary episodes of the 2010s in an attempt to relaunch economies by dint of inflation. In this respect, the Japanese experiment, or rather multiple experiments, remains a case study to show that inflation is still proving a difficult spectre to revive.

Santi, points to demographic decline, a trend in which Japan is a world leader, together with, what he considers to be, an irrational fear of debt and deficits, which renders people unwilling to spend. In this scenario, government, corporate and consumer debt cannot be inflated away and sits like a giant toad atop all the animal spirits that might reignite economic growth. He also alludes to the profound changes in the nature of work – from permanent to temporary, from employed to self-employed, from office based to remote. These changes have rendered the Phillips Curve redundant.

The dual mandate of full employment and price stability has never been so easy for the Federal Reserve to achieve. That, at least, was the case until the global pandemic unknit the fabric of the global market economy. Now, the Federal Reserve – and central bankers in general – are faced with the prospect that printed money, whether it be sterilised or not, will either be invested or hoarded. In this scenario, the greater the debt the less likely prices are to rise as a result of demand-pull inflation. On the opposite side of the inflation equation, the shortening of global supply chains and the need for dual-redundancy, agin another unwelcome and unexpected lockdown, has created the classic bottlenecks which lead to product scarcity, personified in cost-push inflation.

Interest Rates, Global Value Chains and Bank Reserve Requirements– published in June of last year, notes that Global Value Chains have suffered and shortened since 2009; that, despite low interest rates, financing costs remain too high and yet, at the same time, bank profitability has not recovered from the damage caused by the great financial recession. Nonetheless, those same banks, which were supposed to have been broken up or dramatically deleveraged, remain still too big to fail. My conclusion looks dismally prescient: –

The logical solution to the problem of the collapse of global value chains is to create an environment in which the credit cycle fluctuates less violently. A gradual normalisation of interest rates is the first step towards redemption. This could be accompanied by the removal of the moral hazard of central bank and government intervention. The reality? The societal pain of such a gargantuan adjustment would be protracted. It would be political suicide for any democratically elected government to commit to such a meaningful rebalancing. The alternative? More of the same. Come the next crisis central banks will intervene, if they fail to avert disaster, governments’ will resort to the fiscal spigot.

US interest rates will converge towards those of Europe and Japan. Higher stock/earnings multiples will be sustainable, leverage will increase, share buy-backs will continue: and the trend rate of economic growth will decline. Economics maybe the dismal science, but this gloomy economic prognosis will be quite marvellous for assets.

Conclusion and Investment Opportunities

According to data from S&P, US share buybacks were lower for the second quarter in a row in Q2, 2020. They amounted to $166bln, versus $205bln in Q1 and $190bln in Q2, 2019 – this is still the seventh highest quarterly amount ever recorded. The chart below shows the evolution of buybacks over the last two decades: –

Source: S&P, FT

The consolidation of the US equity market continues – from a high of 7,562 on July 31, 1998, the Wilshire 5000 Index list of constituents has shrunk to just 3,473 names. This is a side effect of the fact that debt finance remains cheaper than equity finance. According to a recent article published by the Financial Times – US corporate bond issuance hits $1.919tn in 2020, beating full-year record corporate issuers have raised more capital in the first eight months of 2020 than in any previous full year. Low rates going to no rates, thanks to the actions of the Fed, is said to have driven this step-change in activity. The reticence of commercial banks to extend finance, despite the favourable interest rate and liquidity environment, is a contributing factor: –

Source: Refinitiv, FT

The Covid pandemic has accelerated many of the economic and financial market trends which have been in train since the end of the 2008/2009 financial crisis. Lower interest rates, more quantitative easing, further share buy-backs and greater debt issuance – by borrowers’ individual, corporate and national – look set to continue.

A global economic depression is looming, yet the price of many assets continues to rise. In a similar manner to the Tech bubble of the late 1990’s, today’s valuations rely more on the willing suspension of disbelief than on any sober assessment of earnings potential. The US stock market has outperformed partly due to the high proportion of technology stocks, as the chart below (from May) shows: –

Source: FactSet, Goldman Sachs

The magnitude of this fiscal and monetary response has already reached far beyond the United States. The table below shows those national stock markets with a positive year to date performance exceeding 5%: –

Source: Trading Economics, Local Stock Exchanges

I have deliberately excluded the Nasdaq 100 which is currently up more than 57%. Other countries will catch up. The US$ has weakened, since February, on a trade weighted basis: –

Source: BIS, Federal Reserve Bank of St Louis

In a competitive race to the bottom, other central banks (and their governments) will expand monetary (and fiscal) policy to stop their currencies appreciating too fast.

Global bond yield convergence will continue, stock market strength will endure. Inflation will creep into consumer prices gradually and the central banks will turn a blind eye until it is too late. The world economy may be on its knees but, in general, asset prices will continue to reach for the stars.