Yellen in the headlights


The decision by the Fed to hold rates seems to have met with renewed sighs of failure from many observers.  In their minds, interest rates need to normalise to prevent the (continued) build-up of asset bubbles (which cheap money is creating) and bring the Fed back to the curve (which it is ever behind), reducing overheating risks.  Their view remains that inflation will invariably rise with such a tight labour market, holding faith in the resurrection of Phillips curve.

The reality could not be further from the truth.  Headline unemployment may have fallen below levels previously thought to be “full employment” or below the NAIRU rate, for want of another term.  But there is ample evidence of remaining labour market slack, from the U6 rate (which is a better measure of broader underemployment) to the still elevated numbers of long-term unemployed (those out of work for over 27-weeks as classified by the BLS).

The story is equally grim looking at the activity data (which the Fed glossed over when assessing current economic health).  Industrial production has been on a downward tear ever since the Fed first hiked last December.  Retail sales growth continues to fall; advance sales rose at just 1.9% y/y in August in nominal terms.  Meanwhile, inventories continue to build, suggesting further adjustments are needed.  Housing activity looks to be stagnating.  Imports are down.  Exports are down even more.  Investment remains weak, and that stands even after you strip out the effects of the collapse in energy.

And alongside all this, wage growth has continued to be tepid. In fact, in real terms wages are now falling as inflation has inched up (as oil prices drop out of the annual comparisons).

On the structural side, the problems of low productivity remain.  The effect of that is that even with moribund wage increase unit labour costs are rising rapidly.  So it’s worrying to see weakness not just in corporate profits but also sales.  Against such a backdrop any acceleration in supply driven wage growth would be self-defeating.  Businesses would be more likely to try and sweat a smaller headcount (i.e. start firing) than increase the total wage bill, thus further eroding profits.  There is a good relationship between declines in profits and investment and recessions.

The only good data is the jobs data.  And that has a terrible track record of predicting future growth.  If it gets to a point where the labour market is flashing red you’ll probably find the economy has already been in recession a good nine or twelve months.  Labour data gets heavily revised, smoothing this lag over time.  But initial unrevised data is very revealing.  Indeed, by March 2009 (when the stock market based) the headline non-farm payrolls number had undercounted the jobs lost to that point of the downturn by 2.7mn.  The true scale of the loss was only becoming evident in early 2010 when BLS revisions or the revisions arrived.

What is more relevant now seems to be growth.  That constantly disappoints the market but in reality has been above the Fed’s estimates of long-term growth for the past five years.  And that estimate continues to fall, the median down to just 1.8% in the September summary of economic projections, down from 2.0% in July.  It has fallen in lock-step with the Fed’s long-term interest rate dots.  It’s difficult to square the idea that monetary policy is too loose if trend growth is also slowing. Year-on-year GDP expansion peaked in March 2015 and has slowed in every single quarter since then. It stood at just 1.2% in Q2 and that was only because consumers dipped into savings to spend.

Yellen has finally conceded this point.  Monetary policy is now only “modestly accommodative” in the eyes of the FOMC, and that comes from a board that has persistently overestimated the neutral level of interest rate.  The door remains open to a December hike (data dependent), but one and done might be a more realistic assessment of where policy is heading beyond that (rather than four and more the market was pricing at the turn of 2016).  It’s highly doubtful the Fed could deliver more without tipping the economy back into the abyss.

Perhaps the time has come for central banks to change tact entirely, embrace the structural forces (demographics, over capacity – which comes through via falling good prices – and the legacy damage inflicted by both the credit bubble and ensuing “great recession”, for example) that are creating low inflation and low growth and allow markets a freer hand in setting prices.

Deflation should be seen as complementing the adjustment process (helping remove excess capacity).  Rekindling some creative destruction seems to be the only way to address these problems and create the foundations for the productivity driven recovery that we really need.  Productivity after all determines living standards.  Until that nut is cracked any effort to tighten policy will be self-defeating.  What’s needed now is not dissimilar to the adjustment Volker kick-started; there was an acceptance of the need to repair structural damage and an acceptance that there would be a cost to this process.  Unfortunately that seems to be missing from today’s debate.

Who should pay for the mistake of Brexit?

The UK referendum debate has been truly awful.  Neither side has made a clear argument balancing the pros and cons of membership, which of course there are both. Instead it’s been a litany of half-truths and speculation, spun by each side with ruthless political inefficiency.

Let’s take the touted “£350mn the UK sends to the UK each week”, taken from the side of the Leave campaigns snazzy German made bus (a Neoplan made in Stuttgart).  This is true to the extent this is the starting point of what the UK should pay the EU.  But it excludes the rebate we have secured.  So that knocks off £100mn or so.  It also excludes the money we get back from the EU (that is what the EU does with the money sent to it, it spends it in the Union).  So really it’s about £160mn per week (what Britons spend on the lottery each week, where there is a 1 in 14 million chance of winning). Basically a pittance in a £1.8 trillion economy of over 60 million people. Fullfacts break it down nicely:

The result is, the only thing voters really know is that they can’t believe a word that comes out of politicians mouths.  Project fear then morphs into the psychological damage inflicted over the past twenty or more years by the British media’s ardent anti-EU agenda and borderline xenophobic fear mongering.  A fact successive governments have used to hide their own economic and political incompetence (or pursuit of agendas that they support, but which doesn’t wash so well with the electorate).  Immigration is vital for the UK economy as the costs of aging and underfunded pensions bite.

The notion that all our regulations are imposed by the EU and can be simply abolished is pure fantasy too.  Standardisation of rules actually helps cut costs.  And a UK manufacturer would still have to abide by these rules if they wanted to export to Europe whether we are in or out.  A UK consumer would still demand high safety and quality standards whether we are in or out.  A cheaper but more flammable UK sofa is not that appealing.

Cheap air travel happened due to EU regulation, not because of some vision in Westminster.  Free mobile phone roaming is happening due to EU regulations, the same bureaucrats that ruled mobile phone connection charges were unlawful, which is why your phone plan now includes 1000’s of free minutes. There are plenty of other examples that the Remain campaign miserably fail to sell to voters but are a huge benefit to them.

The fact is a lot of the harmful red tape is self-inflicted, there is ample room for reform within the confines of EU membership.  Perhaps that debate is not so politically convenient for the Westminster elites.  It is always politically easier to blame someone else.

It is ironic the one key voter group that backs Brexit is the one which has actually gained the most from the mass immigration that motivates them to vote to leave. Pensioners. It may have escaped their notice, but they were the only income group to see income growth over the post-crisis period.  While other government departments were torn to shreds and benefits for those of working age cut back and means tested, pensions and pensioner benefits faced no scrutiny whatsoever.  The government managed to reward their key voting constituency because they got the economy growing again, immigration has contributed significantly to that growth.

Cheap foreign labour from the new EU entrants might well have kept wages low (after all real per capita income is barely above where it was in 2008). But it boosted the working age population.  That’s the group that pay the vast majority of taxes and draw the fewest benefits.  They are not the real benefit scroungers, the real scroungers are the people on £50k pensions who still receive a free TV license, bus pass and £250 winter fuel allowance (still paid despite the collapse in energy costs).

The grey generation, it should be noted, has also gained from the squeeze in demand for goods this population growth has created, they own the bulk of housing assets, they also are the Nimby’s who try and block housing (or any form of) development needed to meet this new demand.  They have no need for schooling anymore, so care not about the lack of places or workload of teachers.  They care not Students are burdened with debt to pay for their triple locked pensions.  They care not government investment has been slashed.  They care not because by the time these problems manifest themselves they will be pushing up daisies.

It seems clear – if the UK makes the huge mistake and votes to the leave the EU – which group should bear the economic costs of leaving.

From an investment perspective given how the polls look (being UK based and a natural GBP long) one could do worse than buying dollar exposure,  the pound will suffer severly (the euro would suffer too).  It would also be a shock to global markets. I’ll probably buy a mix of short S&P500 ETF (benefitting from FX ains and an equity short) and some short-dated US bonds (2-5yr) as a low risk counter weight to balance that.  But do your own research.

The real risk of Artificial Intelligence

Creeping automation and the advent of increasingly intelligent autonomous machines has been one of the drivers of labour market distortions, both pre- and more noticeably post-GFC.

This ongoing transition has been blamed for hollowing out the middle classes, driving them down the wage curve and raising income inequality.  This is true to some extent.  While the industrial revolution displaced human manual labour, ultimately freeing man up to pursue more creative endeavours (after the initial and now forgotten disruptions), the information age is displacing human brain power directly.  And we haven’t come up with anything to advance to, beyond spending a disproportionately large amount of time on YouTube, Facebook and Pintrest. Or, leveraging our sociology degree to start a career as a dog walker.

While computer algorithms are still rather basic, for certain tasks they are already superior to human efforts, such as data processing and even more technical roles, for example cancer diagnostics.  Google IBM Watson and you’ll get the idea.  And they don’t get tired, call in sick or lose concentration halfway through the task.  Or wander off with your pen.  Although they will probably still need rebooting from time to time, which will mean some level of human action will be retained, it’s clear that a lot of jobs we view as ‘skilled’ and thus ‘safe’ are on the cusp of being replaced.

The blame of course will be placed on AI and there is already an unsophisticated debate about what to do about it.  Hope seems to centre on the view that AI will be just that, artificial, and never have the capacity or adaptability to replace humans entirely.  This is partly based on vanity (superior to humans, you jest) and partly on the Terminator.

But this outcome is perhaps the most dystopian for the middle classes, or even upper-middle class worker.  The technology will be sophisticated enough to compete with him, keep his wages down, but will never reach that breakout point where it can displace all human labour entirely.  This would imply that overall control and wealth will remain with those that own and operate these AI technologies, while the rest are forced to compete directly with it.

This level of AI will not be sufficiently advanced for us to begin to debate the infinite opportunities of more leisure time or enhancing our own creativity, it will be just a less empowered serfdom where people are constantly threatened with automation.  This will force people to try and be more creative, but given that the value of creativity is derived largely from its uniqueness it will not be an effective route for social mobility.

Contrast this with a situation where AI technology breaks out and surpasses the abilities of even those at the top of the economic and creative food chain.  I am not talking the ‘singularity’ after which point follows some exponentially improving super intelligence that can solve all the universe’s ills.  But imagine computer systems/networks that can simulate most human brain characteristics and come in with a 450 IQ.  It should provide resources for universal improvement.  It would be a true human leveller (the gap between humans would be trivial compared to the gap between man and machine) and mark a point where we can start to think about that sci-fi utopian future.  One would also hope such intelligent machines would have the insight to tackle society’s ills rather than profit from it.

The fact that the debate is moving towards what we can do to curtail artificial intelligence isn’t a function of concern for humanities well-being, but recognition that the biggest risk to the status quo is smarter than human intelligence that might be able to deliver a more equal society.  More equal meaning far richer on average, but a big step down for those currently circling the globe with Netjets.

SNB – the straw the breaks the camel’s back?

The SNB’s decision to drop the peg is one of those rare market events that starts with a big bang and then fizzles a little bit as the market surmises that it’s only a small country and the real loser (aside from some badly hedged brokers) is the SNB and Swiss exporters.

This overlooks the real story though, which is; what are the real risks in a world stalked by deflation?  Which was what ultimately forced the SNB’s hand. It’s taken a while to get to this point from the deflationary shock that was the global financial crisis back in 2008/09.  Money printing proved pretty effective at halting falling prices, inflating asset prices even as output gaps grew.  But global growth has continued to disappoint.

The US has been more successful, its QE programmes having proved effective enough to not only bring the unemployment rate down at a decent clip, but do this alongside an improving fiscal position.  But even here prices have lagged.  Wage growth has been especially tepid and the employment participation rate has continued to slide.  Demand, in other words, remains deficient and the economy is stuck below what could once have been spun as ‘potential’.  This shift is partly demographic; retiring boomers mean trend growth should slow.  And combine this with increasing automation displacing higher and higher skilled labour, the disappointments of the US story can at least be explained (with some degree of credibility).  But pretty much everywhere else has been running to standstill.

Chinese growth has reached its limits, there are now insufficient returns to be found via investment. Credit, which had been used as a substitute since 2008, has also run out of power.  Quite simply, the Chinese can’t add enough of both to maintain its targeted growth rates.  So the economy must rebalance and growth will slow.  The investment boom has also delivered huge overcapacity.  Housing and steel is often highlighted but it’s broader than that, evident in the producer price index which has been falling for three years.  The slowdown was also clearly evident in global hard commodity prices last year.  Consumer prices are catching up, and with the recent decline in oil, negative CPI is looming.  The even-faster slowdown of nominal GDP growth is particularly dangerous for an economy that has added over 80% of GDP of debt over the past six years.  And you can tack on demographics to that. The working population has already peaked, which means growth increasingly depends on productivity, which is falling.

Deflationary forces in the Eurozone have been evident since the debt crisis.  Growth above 1% in any member state was something to cheer.  Italy has been in a perma-recession, Spain’s recent recovery has been more of a bounce off a very low base and Greece is around 25% smaller than it was. If you look at the pre-crisis trend mirage the Greek economy is half where it could have expected to be now.  The ECB’s failure to accept disinflationary forces has been more a function of internal politics and the flawed ideology of the core states, to which it remains hostage, rather than incompetence.  Being behind the curve is bad at any time, but it’s even more damaging in today’s world.  Doing this to protect Germany from ‘theoretical’ losses will be viewed savagely by future historians, a classic example of Lutheran self-flagellation.

Europe too faces poor demographics and the increasing incentives for businesses to opt for technology over human labour.  But it also suffers from extreme structural rigidities that amplify these dangers as well as a political and economic system built on reactive compromise.  It is simply ill-equipped to deal with the challenges at hand.  The recent decline in oil prices will add to immediate deflation. Although it will provide a modest boost to incomes, there will be no multiplier effect due to the weak starting point.  It will merely accelerate the slide into broader deflation as lower inputs are passed through to cope with persistently weak demand.

The ECB will have to begin QE. But it will be in some bastardised form to appease Berlin.  This won’t allow the Eurozone to escape disinflation and the ECB will have to do more (the irony of the German position).  This is what the SNB clearly saw.  It knows that, in a deflationary Europe, the rate of money printing that the ECB will have to engage in is simply overwhelming for a small country still perceived as one of the ultimate safe-havens.  Committing to defending the EURCHF peg was a commitment to potentially infinite balance sheet inflation.  Taking a hit on 80% of GDP is one thing, taking a hit on 800% quite another.

But the SNB’s move was not exclusively an FX one; the greater event was pushing interest rates deeper into negative territory and seemingly committing to cut even further into the red to meet its monetary policy goals.  This is the only way they will actually be able to neutralise the underlying demand for Swiss francs as a safe-haven asset, by creating a cost of carry.  Credit Suisse guestimated that the resulting CHF appreciation on the peg break was equal to 200-300bps of tightening.  If you assume that policy was already too tight, then negative rates of -5.0% don’t look an unreasonable equilibrium point.  But as we know from EM travails, the cost of carry isn’t always enough to deter immediate speculation.

The move also alters bond market dynamics.  Bond bears have often cited the bond bubble, framing this in the context of a zero yield.  But in a world where there is no floor to rates, bond prices can continue to rise (and curves steepen).  This marks a new era of unconventional monetary warfare.  It’s an environment that favours positive yield/carry. It should mark an upturn in gold’s fortunes, which until recently had lacked much appeal.  The multiplier effect should apply to other positive yielding assets too (extending the property bubble, where leverage is directly linked to the cost of capital).

Global growth meanwhile will fall yet further.

Humans Need Not Apply

Great explanation of the impact of AI

Has Abe’s third arrow become a boomerang?

While the Nikkei performance might look OK against some of the shakier core equity markets it recent performance is actually quite dismal.  While it is flirting with new multi-year highs its relative performance versus the yen, to which it has been tied at the hip to since Abenomics was launched to much fanfare at the end of 2012, is poor.  Indeed, the 225 was trading at these levels back at the start of the year, when USD/JPY was at a lowly 105.00.  It is now 110.00.  If the relationship between the pair was holding true Nikkei should be comfortably above 17,000.

USDJPY vs NKY 011014


Of course, the equity market could still catch up (unlikely), or the yen could recoup some of its recent losses which would bring the two back into equilibrium.  Alternately, you could start to view this as confirmation the market is starting to believe, and price in, that Abenomics as a policy has failed.  And that the boost to equity values that a weaker yen should be delivering has consequently reached its limits.  In fact the correlation could invert.

This view is supported by flagging economic performance, with industrial production continuing to decline post-consumption tax hike. More worryingly this is occurring along with a big rise in inventories suggesting that even with falling levels of production output is still running ahead of underlying demand.  We’ve discussed the trade account side before so won’t go over that again bar saying there has been no increase in exports, even in value let alone volume terms.  Imports have meanwhile risen in cost, effectively a tax on demand. Economic escape acts are not made out of this type of reaction.

Japan IP & Inventories 011014


There is much hype about the lift seen in capital spending but in this environment the sustainability of the investment boomlet is questionable.  There have also been improvements in labour markets and nominal wages have risen too.  This would usually be a positive story, but in the case of Japan the rise in inflation which the weak yen policy and consumption tax hike has facilitated means in real terms household incomes are collapsing at crisis type rates.

Recent yen weakness, seen in this context, more than explains the relative under-performance of the Nikkei. Yen losses should feed into another round of income sapping import price rises.  Exporters might break ranks and opt to discount and grow sales rather than just take the income gains a weaker yen has created for those foreign sales. But it would be a case of running to standstill now given the negative risks for domestic demand, particularly with a further sales tax hike due next year. Markets might find some temporary relief from further BoJ easing, but it won’t solve Japan’s still substantial structural problems which require the tax rise. Locals should be increasingly focused on how to protect their cash assets, and that means offshore and not local stocks.

Ironically, if the government baulks at enacting the planned increase it would merely confirm that PM Abe’s third arrow has become a boomerang.



Bad debt, terrible demographics. Perfect for rising living standards

Total economy real GDP growth is obviously important in securing debt sustainability, particularly in an aging world.  Deteriorating demographics not only increase the social security/health/welfare burden (and deters reform of these sectors given the voting weight this group carries) but it also means there is a concurrent contraction in the working age population, left to pick up the tab.

But real GDP growth itself does not tell you how the average man on the street is gaining/losing from these demographic shifts. Neither does GDP per capita matter all that much.  What matters is the share of GDP that each demographic segment controls relative to the number within each cohort. This figure obviously corresponds with their propensity to spend and save and level of disposable income they need to maintain a standard of living.

So understanding how incomes across the varying age groups are developing should take on increased importance.  Someone in their 30s or 40s for example needs to pay childcare, save for a house/service a mortgage and begin to save for retirement. So has high income needs.  But once in retirement, the same lifestyle can be maintained with a far lower income, owning their home outright, no children to clothe and feed.  They just need enough money for bingo and dinner/theatre. Luxury items for someone two or three decades younger suffering under the weight of their fixed costs.

Scaling this up on an economy wide basis one can see that total GDP needed to maintain or raise overall living standards is lower in an aging economy with a shrinking workforce and vice versa. The picture hopefully shows an incredibly simple example of an economy where individuals have the same standard of living at each specific age but need varying levels of income to meet these static needs.

Demographics & Living Standards

Of course, for governments the issue is more complex as they have liabilities that come with an elderly population, and to stay elected they have never put in place the savings plan that was needed to pay for ageing. The relentless rise in longevity has compounded this problem. So, if overstretched, as is the case currently, they have a problem of debt sustainability.  This has effectively been the Japan story, although at least they have high levels of private sector savings to allow the government to run a gross debt load of some 240% of GDP, effectively the other side of the savers balance sheet.  But where there is no such provisioning in an economy, the debt issue is far more sensitive to low growth or even shrinking GDP.  In other words it is tougher to delay the day of reckoning.

But this low growth/shrinking GDP backdrop still misconstrues the true picture of actual living standards.  It also suggests that economies/electorates might be more tolerant to a low growth environment than has historically been the case and that the dangers presented in the secular stagnation argument (aside from government debt) are overblown.

Obviously there are a lot more moving parts than outlined here, but the notion that slow growth means people are poorer is not necessarily true if the demographic shift is greater than the reduction in growth rates. In other words pre-crisis levels of income growth can be matched even with lower levels of GDP growth.