Please enjoy this Blomberg column published this morning.
FEDERAL RESERVE: Rebuild the Fed From the Bottom Up
Please enjoy this Blomberg column published this morning.
For a moral compass, many look to the Bible. For political directives, Machiavelli’s succinct and direct The Prince. But for matters of war, the Chinese have a lock; they’ve literally raised the wisdom guiding generals engaged in battle to an art form. Here is a but a sampling from the Top 500 List of quotes from Sun Tzu’s fifth century masterpiece, The Art of War:
“Appear weak when you are strong, and strong when you are weak.”
“Strategy without tactics is the slowest route to victory. Tactics without strategy is the noise before defeat.”
“The best victory is when the opponent surrenders of its own accord before there are any actual hostilities… It is best to win without fighting.”
“The general who advances without coveting fame and retreats without fearing disgrace, whose only thought is to protect his country and do good service for his sovereign, is the jewel of the kingdom.”
“All warfare is based on deception.”
“Speed is the essence of war. Take advantage of the enemy’s unpreparedness; travel by unexpected routes and strike him where he has taken no precautions.”
The essence of the last two quotes is what has many market watchers on tenterhooks as Inauguration Day and the Chinese yuan sporting a seven-handle fast approach. For those of you following the Vegas odds, January 20th is sure to mark both Trump’s taking office and the yuan falling to 7-something, as if they’re somehow in simpatico and synched at the hip.
Does this psychological threshold suggest that China is on a pre-ordained path to freely floating the yuan? That’s certainly where Wall Street’s sell-side sides, especially if Trump swiftly moves to impose trade sanctions. In that event, odds for a free float are 50-50 this year. If Trump’s freshly announced Trade Czar Robert Lighthizer holds off on immediate measures, count on a free float becoming reality in 2018.
If ‘speed is the essence of war,’ a freely floating yuan is a surefire way for the Chinese to counter sanctions. That said, the disruption caused would trigger a global recession and catalyze a concomitant correction in dearly valued risky assets. The attendant insult would arrive in the form of China’s wealthiest citizens’ increased impetus to ferry their fortunes overseas.
“There’s no arithmetic or economic reason Beijing would make that decision which means the only reasons they would float the currency would be out of sheer panic or because they were locked in a trade war and just said, ‘What the hell,’” said Leland Miller, president of China Beige Book (CBB) International, a research firm that produces a private survey on the Chinese economy.
At the most fundamental level, China lacks sufficient funds to take adequate precautions on the heels of 2016’s carnage; last year the yuan suffered its steepest annual decline in more than two decades. Managing that devaluation was anything but free of charge. Estimates suggest China’s foreign reserves will hold at $3.01 trillion when the latest batch of data are released January 7th. Still, that’s down a cool trillion to a five-year low. More to the point, it’s going to continue to be costly to continue to defend the yuan given the trajectory of the currency’s sickly slide. That’s saying something considering some estimates suggest $2 of the $3 trillion are inaccessible — $1 trillion earmarked to construct the Silk Road and another $1 trillion that’s illiquid.
That math is the main reason the “float” argument is reserved for headline writers. So said Neil Azous, founder of Rareview Macro LLC, a Stamford, Connecticut-based research firm. “Professional investors have three concerns,” Azous explained. “The first of these is the pace of foreign exchange reserve outflows, specifically how many months it will take to draw down China’s USD-related holdings. The second is the funding stress in the interbank lending market; the cost of funds and a key measure of counterparty risk has set higher for 53 consecutive days. The third is whether Chinese debt surpassing $18 trillion in 2017 (vs. the current $17.3 trillion) will be a precursor to a more pronounced credit crunch that exports deflation to the rest of the world”
The good news is our new head of Trade is no negotiations newbie and will be highly cognizant of all the moving pieces. In the spirit of not taking any chances, Trump literally reached back into Reagan’s cabinet for his nominee who served back then as a trade representative. Lighthizer surely has a vivid recollection of the recession that greeted Reagan shortly after he took office. Treading lightly will presumably be at the forefront of his mind despite his vociferous aversion to the very imbalances emanating from previous trade agreements that got us to point blank range.
And then there’s the delicate business of those other dithering deals to consider. All you capitalists out there, close your eyes and envision the most formidable foursome the antitrust forces on the DOJ, FTC, Treasury and FCC could combine to conceive. Throw in propaganda perfected and you get to acrimonious acronym MOFCOM, or the Ministry of Commerce for the People’s Republic of China. Of late, this auspicious agency has put the red back in China, as in red tape, dragging out the approval of three major deals that, on a relative basis, swept through its international counterparts’ gauntlets. Call that strategy with tactics intact in the subtle message department even as Chinese firms pursue deals abroad with abandon.
As for the deception aspect of this tentatively tenuous trade war, look no further than the basket the China Foreign Exchange Trade System (CFETS) uses to “manage” the exchange rate of the yuan on a trade-weighted basis. Manage is in quotes as the basket is but one factor deployed to set the rate. Brute force is the other, as in onshore swings in the spot price of two percent in either direction are simply not permitted. It’s no coincidence that the basket was born in December 2015 as the Fed was raising interest rates for the first time in nine years. The driving force behind the establishment of the basket was the creation of a mechanism by which the yuan can eventually decouple from the dollar.
Where does the deception come in? At birth, the dollar’s weight within the basket was 26.4 percent. Bear in mind, it’s only been three months since the IMF granted China entry into the special drawing rights (SDR) club of big boy currencies; the yuan joined the dollar, the euro, the yen and the British pound. Hence the market’s surprise at the CFETS’ December 29th announcement that the original basket of 13 currencies would be expanded by an additional 11 currencies. Oh, and the new and improved basket’s dollar weighting would be reduced to 22.4 percent.
The stated motive for the move is to better maintain stability against the dollar, which is on a tear and against which the yuan sits at an eight-year low. In telling fashion, a good number of the basket’s new additions are currencies over which China holds great sway. Of course, China can also take more traditional routes to exert control such as relaxing its banks’ Loan-to-Deposit ratio and cutting the Required Reserve Ratio.
“China has many counteracting levers at their disposal to fend off bomb-throwers,” Azous added. “What professional investors have learned over the years is China can remain irrational longer than they can remain solvent trying to fight them. It’s more prudent to hedge tail risk and monitor the risk profile, to be reactive rather than making a big speculative call in advance of a perceived hard landing.” (Any squeezed short worth their salt can validate that statement’s veracity.)
In the near term, investors positioned for a landing of any kind are likely to continue to get burned. By most metrics, China bounced back in fine form in the final three months of last year, albeit off 2015’s historically weak fourth quarter. The Miller’s CBB reported that profits, job growth, capital expenditures and revenues all posted robust gains. The persistent paradox presented is that improvement, especially on the jobs front, dictates the stimulus spigot will be turned off.
That’s not to say the entire Chinese economy merits a clean bill of health. Corporate cash flow showed a marked deterioration, an affront to the prosperous profits picture. The CBB noted multiple culprits including weakness in receivables and payables across a full range of sectors including services, property, transport and especially retail. Weak cash flow goes hand in hand with firm borrowing in the third and fourth quarter hitting the highest level in three years. Miller warned that stronger profits and weaker cash flow can only co-exist for so long: “One will have to give way in 2017.”
With that as a backdrop, you can bet your bottom yuan that China has no desire to float its currency any time soon.
“It would hurt them much more than anyone else and be greeted with massive retribution from every corner of the world. There would be countervailing devaluations and it would cause global contagion,” Miller said. “It would also be a major blow to (President) Xi’s credibility during a politically sensitive year, since he’s pledged not to float the currency. And it would certainly NOT staunch outflows; all it would do is exacerbate them.”
The technical term for such an outcome, for the global economy, mind you, is ‘Lose-Lose.’ Remember that the next time you wake to a tough-talking tweet. For good measure, keep yet another of Tzu’s sublime maxims in mind: “The supreme art of war is to subdue the enemy without fighting.” As the United States ponders future relations with its largest trading partner, it might want to consider deploying ambassadors skilled in that other fine art, that of the use of velvet rather than barbed tongues.
That was the word Jackie Gleason used to characterize the proposed reprisal of ‘Minnesota Fats’ in The Color of Money, 1986’s sequel to The Hustler. Chances are Paul Newman himself, who had at least 36 script conferences with the screenwriter, didn’t take offense to Gleason’s rebuff. “We desperately wanted the character to return,” Newman told the New York Times of Gleason’s ‘Fats,’ “but every time we put him in, it seemed like we were trying to glue an arm on a man and make it stick.”
Under the brilliant direction of Martin Scorsese, Newman would go on to win an Oscar for his role in Color. Still, as a whole, the sequel simply couldn’t stand up to the 1961 original. Hence the irony of Newman’s Oscar, which critics suggested was in belated recognition of his original performance as an ace pool player in The Hustler. In his young, glory days, Newman so deeply penetrated his characters’ roles that he literally vanished into them. His brilliance as an actor shined brightest in one scene when Eddie lost to Fats; rather than hostility or animus, his fascinated adoration for his idol was unabashedly on display, reflected in his bright eyes and amused expression. Now that’s Hollywood.
As for Wall Street, it’s recent performance has also laid the drama on thick and in perfect form as stocks pierce record highs. The investor community, the Street’s audience, couldn’t agree more. According to the latest survey from the Conference Board, retail investors’ enthusiasm for the stock market’s prospects is at the highest level since February 2007. A stroll down memory lane reveals that similar readings on the giddiness gauge were contrarian in nature, aka sell signals. That is, unless you’re referring to 1996 as a step-off point. In that case, today’s positive parallels suggest stocks’ 2017 sequel could best the original rally that culminated in the S&P 500 peaking in 2001.
What’s driving the train to stock market stardom? The singular theme since Trump was elected has been happiness bordering on euphoria. The overall December Conference Board survey hit a 15-year high. This echoed the most recent University of Michigan December survey, which hit a 12-year high. But it’s not just your average Joe on the street, as in Main Street. Small business confidence also witnessed its biggest one-month surge since 2009, while regional manufacturing surveys have uniformly topped forecasts. Based on an average of five regional Fed surveys, Morgan Stanley raised to a two-year high its expectations for the upcoming release of the national manufacturing survey.
The question is, can the economic fundamentals Trump the (over?)-heated hope? For that to happen, every bit of optimism has to be substantiated. And that supremely sublime stage has yet to be set.
The entirety of the Conference Board spike was due to expectations; current conditions, which remain high, actually fell on the month. Similarly, small business owners’ expectations for future sales rose smartly, which runs counter to actual sales, hiring and capital expenditures declining last month. And finally, one red flag that’s popped up in multiple places centers on the jobs market. While consumers’ expectations for income growth rose to the highest level in a decade, their perceptions of jobs being ‘plentiful,’ fell while those lamenting jobs were “hard to get” rose, affirming the recent drift upwards in jobless claims.
Some of the regional Fed surveys also showed employment had unexpectedly hit reverse gear, contrary to respondents’ effusive outlook for the future. Most surprising, perhaps, were the losses reported in Texas’ manufacturing sector in November; they defy the recent uptick in rig counts. Renmac’s chief economist Neil Dutta figures the number of operating rigs has surged 120 percent over the third quarter average. That puts the current number of drilling wells at the highest since January; oil maintaining its price gains implies more to come, reflected in Texas manufacturers’ outlook, which hit its highest level in 12 years. Presumably job growth will follow, according to the script, that is, and not just in the Lone Star State. Presumably.
Continuing along the contented motif, homebuilders are downright ecstatic – their optimism is ringing in the new year at the highest level since 2005. As per the National Association of Home Builders (NAHB):
“Builders are hopeful that President-elect Trump will follow through on his pledge to cut burdensome regulations that are harming small businesses and housing affordability. This is particularly important given that a recent NAHB study shows that regulatory costs for home building have increased 29 percent in the past five years.”
Potential homebuyers are also buying in to the potential for falling prices; the NAHB sub-index that measures Prospective Buyers Traffic registered its first print in expansionary territory since August 2005. There’s a good chance the cheery potential homebuyers overlap with the record number of consumers (18 percent) who the University of Michigan reported “spontaneously mentioned the expected favorable impact of Trump’s policies on the economy.” This figure is twice as high as its prior peak, recorded in 1981 as Reagan was taking office.
The teensiest of caveats before continuing – all of this rhapsody is not free; it’s been more than reflected in higher interest rates which have notably manifested themselves in the highest mortgage rates since the bond market threw a taper tantrum in the summer of 2013. Not even Yale economist Robert Shiller can predict which way the winds will blow, good or bad, as he told Bloomberg News:
“I don’t know how people react to rising mortgage rates. One thought is they want to lock in right now. And that’s why we’ve had good home sales recently. And it might continue as mortgage rates rise. This thing could feed a boom. I’m not saying it will.”
Talk about measured!
Paradoxically, households’ inflation expectations looking out five years over the horizon sank to their lowest level on record in data going back to 1979, even as businesses whine about the highest input costs in years.
If you think you’re hearing a wee bit of a mixed message emanating from households and businesses, you’re not losing your marbles. Policymakers and politicians have a heck of a lot to make good on when Congress takes to the Hill and the new administration sets foot in the White House next month.
We can all hope that breaking the gridlock and freeing businesses to conduct business the old-fashioned American way will unleash animal spirits among employers. Job creation, of a meaningful, high-income-generating sort, would thus beget consumption. This in turn would spur the best sort of economic growth we can hope for, and at the same time reflect businesses carrying through on their stated confidence with actions, by expanding their payrolls, inducing a lovely, virtuous cycle that feeds on itself. How economically endearing indeed.
Would you be surprised to discover there are a few skeptics who doubt Goldilocks is primed to whip out those golden locks, validating, well, just about everyone’s cockiness?
Though other perpendiculars have already been posited, it’s fair to interject a friendly reminder that we are not in 1982, the last time stocks were trading at a single-digit price-to-earnings multiple and Baby Boomers were less than half their age. Is it relevant that productivity growth was running at eight times its current pace with the saving rate double where it is today and household debt to income half of where it is? Wait…won’t rising rig counts cap oil prices? And does it matter that Uncle Sam’s debt load has grown to 105 percent of GDP compared to 30 percent back then? Does this country and its inhabitants technically have to have a pot that’s growing in size to piss in?
Not according to the measured volatility on the stock market, which is near the lowest in recorded history. We have nothing to worry about and that’s that. Hence the perplexing pessimism among institutional investors. The State Street Investor Confidence Index (ICI) peaked in March of this year, and after a wimpy stab at a comeback, has retreated anew.
The developers of the ICI observed that 2016 ended on a downbeat note as institutional investors continued to shun the stock market, preferring instead to wait for follow-through from the incoming administration and greater clarity on just how serious the Federal Reserve is about hiking rates in 2017.
“While markets increasingly look to be ‘priced for perfection’ over the US economic outlook for 2017, it is interesting that institutional investors are more circumspect,” said Lee Ferridge, State Street’s head of North American strategy. “Most noteworthy for me is the decline in the North American index even as US equities and the US dollar continue to rise.”
If the stars don’t align perfectly, if the sequel doesn’t best the original, smaller investors might want to wise up to the fact that they’re being hustled by the equivalent of professional gamblers. Know that they’ve been at this game for long enough to cash out their winnings while they can still be put to good use. What’s the alternative? That would be investors finding themselves in naïve form, as Fast Eddie did, just before he lost to Minnesota Fats, asking, “How can I lose?
“Government is a just execution of the laws, which were instituted by the people for their people’s preservation: but if the people’s implements, to whom they have trusted the execution of those laws, or any power for their preservation, should convert such execution to their destruction, have they not the right to resume the power they once delegated, and to punish their servants who have abused it?”
—John Wilkes, The North Briton, October 19, 1762
No truer words have ever been penned to the betterment of a people struggling to break free of tyranny. Indeed, John Wilkes is considered by some historians to be the primary source of inspiration for revolutionary colonial Americans given his staunch defense of religious liberty, prisoners’ rights and freedom of the press, rights we hold dear to this day.
So idolized was Wilkes, our forefathers named countless towns and babies in his name, quite the honor all things considered. You see, Wilkes was also an infamous pornographer and relished his notoriety, raising self-promotion to an art form. Even Benjamin Franklin was disturbed by the raunchy rake, which is saying something considering Franklin’s own proclivity for dalliances.
But what if the colonials, the “We the People” to be, assigned added value to Wilkes’ brand of self-cultivated ill-repute? What if he rose to such fascinating infamy precisely because he launched vicious attacks on the privileged? What better way to become a champion of the powerless? Ring any bells?
On November 8, 2016, a stunned TV audience bore witness to Wilkes’ legacy playing out across this great land. Millions of voters joined forces to punish their elected servants who had so egregiously abused their power. The establishment was disenfranchised overnight.
Since the election, a not entirely unexpected pivot has taken place. President-elect Donald J. Trump is sure to have recruited cabinet members whose rich resumes no doubt raise the hair on the backs of some of his most radical supporters. We can only hope the promised, the demanded, reforms are not sacrificed on the altar of deal-making. It will come as no surprise to regulars of these missives what the deepest betrayal would be for yours truly. Trump must hold firm on his commitment to return the Federal Reserve to its right place as an apolitical institution. The very future of the American dream depends upon our new president being true to his word.
Reams upon reams have been written on the downfall of the American Dream. Social mobility stunted. Generations of stagnant incomes. The decline in new business formation. Income inequality the likes of which hasn’t persisted since the days preceding the Great Depression. Money in the bank is a theory for most Americans, even those fast approaching retirement. If you do have savings, by the way, you are punished with insulting levels of interest rates.
And just so we’re clear here and inside the trust tree, let’s be honest and acknowledge how and especially where the anger this trap incites will manifest itself — that is, shout-out-loud, hostile and open conflict and on our streets. An exaggeration? If only that were the case.
Two weeks ago, Real Vision aired an interview conducted with me right after the elections were held. Many subjects were covered over the hour. But the one that struck the loudest chord with viewers was the issue of underfunded public pensions, which stands to reason given the headlines of late.
But the reaction from viewers was anything but expected. The bile, the contempt, the malicious back and forth in the comments between public and private sector workers stunned me speechless.
It was the teachers, firefighters and policemen vs. you name the line of work among those in the private sector. No side won in the event you’re holding your breath. And both made great points. Promises made should not be broken. Teaching our children, protecting our citizens from harm – noble, often thankless professions without question. By the same token, why should someone who has worked their entire life swallow a spike in their property taxes to foot the bill? It’s not as if the investments in their 401ks are not on the same vulnerable footing as those in pensions.
The outrage prompted a private conversation with a great friend who also happens to be the most insightful municipal bond strategist out there (a subtle way to say the following comments must remain anonymous).
The first order of business was a correction to my concern that Uncle Sam would be forced to bail out weak pensions in the end: “The federal government is most definitely NOT going to write checks to state and local government! If anything, the current lineup on the Hill wants to move more responsibility to the states (and they have no money anyhow).”
There’s no arguing with the no money part. But indulge the rest of the conversation as here’s where we get down to causality, to culpability.
“I would lay more blame on your friend, the Fed. Remember that public pensions were funded in 2000 and prior to that, earning a seven-to-eight percent return on assets was no sweat. For the last 15 years though, we’ve had nothing but volatility and low interest on fixed income, the place where conservative investors are supposed to go to deal with retirement investment. This has clobbered long-term investors of all shapes and the feedback to the economy is not fully being taken into account (in my opinion). If you are approaching retirement (read: baby boomers) and know you don’t have enough money in your 401k, you are not likely to run out and buy stuff.”
Few would dispute that Keynes’ Paradox of Thrift is alive and well. The ravages of the Fed’s low interest rate policy have forced an increasing number of Americans to save more to offset what they are not earning on their savings. The resulting decline in aggregate demand goes a long way to explaining the current economic recovery’s refusal to accelerate – even factoring in the third quarter’s 3.2-percent pace, current forecasts calling for 2.3-percent growth in the fourth quarter leave 2016 full year growth just shy of the two-percent mark.
But that’s the point of the Paradox. The millions of baby boomers retiring are going to cash, as they should to provide for this little thing called security. Still, the forced frugality sets an anything but virtuous cycle in motion, glaringly reflected in the economic health of the generations behind the boomers, an alarming number of whom still live with their parents. Bunking up remains altogether too common, which of course reflects mobility, or better said, the lack thereof.
The tie that binds the generations comes down to one word: debt. That’s where the Federal Reserve has inflicted the greatest damage. Set aside for a minute U.S. sovereign and corporate debt. While they’re mammoth challenges for tomorrow’s policymakers, it is household debt that has torn at the fabric of our culture and fueled the fury.
The latest figures from NerdWallet, produced by aggregating Fed and Census Bureau data reveal that the average household carries $132,529 in debt, including mortgages. That’s up from $88,063 in 2002. The cost of living, which the Fed lectures us is running too cold, has risen by 30 percent over the past 13 years, surpassing income growth of 28 percent over the same period.
What makes up the deficit? We read nonstop about student loans helping to bridge the gap. But it’s credit cards that have taken up the slack of late. The average indebted household is sitting on $16,061 in credit card debt, a hair shy of 2008’s high. As for those low interest rates, the average credit-card interest rate is 18.76 percent which translates into $1,292 in annual interest payments.
Add it all up and total household debt is $12.35 trillion. Estimates call for the prior housing boom peak to be surpassed by the end of this year.
Putting a face on these nameless numbers, these ‘indebted households,’ provides much-needed perspective. Imagine you’ve grinded out a living as a building engineer in Western Pennsylvania for over 35 years. Your pension was long ago converted into a fee-laden 401k that’s taken plenty of hits over the years. Meanwhile, the guy who works on the top floor of your building makes multiples of your income, a reality you don’t even resent. Your pride runs too deep to throw a pity party. But that’s not to say you don’t have your limits.
How exactly do you take the latest headlines in the Post-Gazette that at over $60 billion, the shortfall in Pennsylvania’s pension fund makes it the ninth-worst in the country? That state Democrats are battling to raise your already high taxes to cover the funding gap? Do you fall in line with the lemmings, taking your lumps? Do you apply for yet another credit card to cover your own newfound budgetary shortfall? Do you slip further behind, accepting your station and the demise of the American Dream?
Or do you switch sides and vote for the party that’s vowed to tackle pension reform come hell or high water? The outcome of Pennsylvania’s state legislative elections speaks for itself. Democrats lost seats in Harrisburg, Johnston and Erie. Outside Pittsburgh, there are no Democrats west of the Susquehanna leaving Republicans with a 34-16 majority, enough to override the governor’s veto. An override in the House is not in the cards — Republicans hold only 122 of the 203 seats. Still, it’s the largest GOP majority since the 1950s.
Now, back out to the rest of the country. Take a moment to study “The Two Maps of America.” A gracious reader suspecting I might miss the dueling visual wonders was kind enough to forward me the article published in the New York Times on November 16th, days after the election. In the spirit of paying forward good deeds at this time of giving, a link to the article can be found below.
What do these maps convey? Rather than a geographically divided nation, the first map reveals Donald Trump won most of the land mass. A stunning 80 percent of the counties voted Republican, many in traditionally blue states like Michigan, Minnesota and Wisconsin, and yes, Pennsylvania.
Meanwhile, so illustrative is the NYT’s Tim Wallace’s description of the second map, it would be criminal to paraphrase: “Hillary Clinton overwhelmingly won the cities, like Los Angeles, Chicago and New York City, but Mr. Trump won many of the suburbs, isolating the cities in a sea of Republican voters. Mrs. Clinton’s island nation has large atolls and small island chains with liberal cores, like college towns, Native American reservations and areas with black and Hispanic majorities.”
A separate publication recently highlighted the irony of Clinton’s staunch support in the ‘liberal core college towns.” According to the Economist, a college education in America equates to more in lifetime earnings than is the case in every other developed country save Ireland. As for the why: “the use of maths in the workplace is 10 percent greater than the OECD average. The supply is limited, since Americans are not particularly numerate.”
In the event you bristled at the pretense, at the elitist tone, you’re not alone. Our being “innumerate” means we’re incapable of conceptualizing and working with numbers. It means we don’t educate our children, that we’ve given up on the American Dream as evidenced by our de facto indentured servitude. To think, some still wonder how the media and the establishment drove our electorate to revolt.
President-elect Trump, consider this to be an open letter. The time has come to quit placating the masses with subprime this and that to still their spirits. Please fulfill your promises to represent them and their children with integrity, knowing the road ahead will be anything but easy, and that the temptation to allow business as usual to continue at the Fed will be enormous.
Millions upon millions of your supporters voted to do just as John Wilkes urged the oppressed colonials to do on October 19, 1762. They punished the servants who so abused their power by voting them out of office. Serve your country by refusing to squander their hard-fought liberty.
If you have any doubts, pop on over to Seville, yes, the one in Spain, and have a look at the original Torre de Oro. Particularly entrancing is the vision of this 13th century dodecagonal watchtower at night. The gilded color reflected on the waters of the Guadalquivir River is as rich as you’ll ever be fortunate enough to behold.
The Spanish tower was originally one of two anchor points for a massive chain that blocked the river forming a defense against the Castilian fleet under Ramon de Bonifaz in the 1248 Reconquista. Unfortunately for the city’s residents, the chain did not hold and the besieged Muslim mecca eventually succumbed to the Christian forces. Despite its having been repeatedly under assault down through the ages, the Torre has withstood a series of attacks of the sort Mother Nature and revolutionary looters have thrown at it. So adored was the golden edifice, its destruction was never allowed. The Sevillians have demanded it be restored and re-restored over and over again. The time value of the building has clearly held strong to our aesthetic and architectural benefit.
As for the current generation of erected structures, today’s investors in commercial real estate (CRE) can be forgiven if they’ve got the urge of late to go soft on the sector. Fine, so the current CRE cycle is long in the tooth. The same could be said for the length of the rally in just about every other asset class and for that matter the current economic expansion.
What differentiates CRE from other asset classes is that it’s been hyper-driven by monetary policy gone wild. Flows into both U.S. commercial and high end residential real estate reflect the currency tug of war that started over three years ago. You remember that hissy fit the bond market threw at the mere mention the Fed might throttle back on its quantitative easing (QE) machine. Would inflation waltz hand in hand back onto stage? If so, might an inflation hedge into a hard asset naturally, dare say, logically follow? Well, then – let’s all join hands and pile hand over fist into real estate! For safety (never works out that way in numbers) that is.
In what can only be described as a full 360-degree turn from the initial days that followed the summer of 2013’s ‘taper tantrum,’ the Wall Street Journal recently ran an article titled, “Chinese Rethink U.S. Plans.” To say those trolling the Twittersphere took umbrage is an understatement. Vitriolic accusations of pots calling kettles black and casting stones in (overpriced) glass houses flew for days (good thing Tweets are capped at 140 characters as less is blessedly less when tempers flare).
Though few real estate consultancies are foolish enough to bite the hand that feeds them, there is a nascent acknowledgement that supply is becoming conspicuous in its abundance. “Supply rising but generally not over supply,” and “Real estate is late cycle,” are but two tentative subtitles to one to remain unnamed firm’s 2017 outlook. The real kicker, though, was, “Foreign buyers – from tailwind to headwind.” That gem speaks to the nitty gritty in the WSJ article, namely that foreign buyers, for all of their enthusiasm to jettison their capital, have hit their valuation threshold.
The specific deal punctuating the article draws the reader to a Street in Brooklyn, or more precisely, “a 22-acre, 15-building mixed use project in various stages of construction (that) is facing stiff headwinds.” As a nominal nod to said headwinds, the U.S.-based partner of the Chinese investor has taken a $307.6 million impairment charge and declared it will, “delay future vertical development.” The Chinese unequivocally deny any construction interruptions, insisting that they are, “meeting the goals and targets that were established when we invested in 2014.” Hmmm. Raise your hands if you want to read between those lines, in Mandarin, no less.
Rather than be plagued by such deep thoughts, perhaps at this point it would be best to step back and examine some basic metrics gauging the health of the commercial real estate market. If we start in the most amply supplied sectors and move our way down the spectrum, you may note that a pattern begins to emerge.
Let’s start with home away from home, as in hotels. To say we’ve built a few more lodging units in recent years than justified by the fundamentals insults veteran developers. In polite parlance, hotel room supply will outstrip corporate demand in 2017. In less genteel jargon, the main metric measuring the health of hotel profitability, as in RevPar, the product of a hotel’s daily room and occupancy rates, has tanked. The latest month’s read has RevPar nationwide growing at 1.6 percent over last year. In the event you like to keep score, that’s half the 3.2-percent rate thus far this year, and half the rate again of the 6.3-percent pace clocked in 2015. So yes, there’s a light on at the inn.
As for that stopover station in life, otherwise known as your apartment years, it’s a good thing cultural norms have shifted. It’s now cool to rent well into your prime earning years. Coming soon: it will also be economical as record supply finally chokes off rent growth. Over the past 12 months, 190,000 units were delivered across the 54 largest U.S. metros, a tad bit more than the 140,000 15-year average. But wait, there’s more! Another 244,000 units are slated for delivery in 2017, taking the bull run that started in 2013 in multifamily construction to a neat million unit. In the supply crosshairs, and in order of expected deliveries, are Houston, Dallas, New York, Washington D.C. and Austin. The deluge has finally cooled nationwide rental growth to 2.99 percent from a five percent pace a year ago.
It will come as no surprise that rents are outright falling in Houston (what’s the opposite term for ‘liftoff’?). But sliding rents are also a reality in New York. Would you believe Kings County, aka Brooklyn, is largely to blame? Just two years ago, as the Chinese were breaking ground on that mixed-use monster, 18 percent of the Big Apple’s supply entering the market was in Brooklyn; as of the third quarter that share had doubled.
It’s easy enough to attribute emerging stresses in CRE loans to oil patch woes. Take a drive through anywhere in suburbia and you’ll conclude quickly enough that retail is the next major source of loans behaving badly. Retail is a subject in and of itself. Rather than take a deep dive, take it on faith that there’s no way all of the excess supply can be absorbed and repurposed. E-commerce momentum cannot be contained and will push more household names into the netherworld. The true visionaries among real estate developers have long since slipped away from brick and mortar’s never ending funeral. They’ve got their sights set squarely on the lucrative potential for the fire sales of the land sitting under all those shuttered stores.
Less visible to the naked eye is the trouble brewing in office space. Be that as it may, the numbers don’t lie. Commercial mortgage-backed securities (CMBS) comprise a mere tenth of CRE debt. Still, they provide an ideal prism into the health of the overall market given they are publicly traded; performance metrics are readily available. With that said, the most recent batch of data reveal that office delinquencies have been ticking up since midyear. Moreover, at $5.1 billion, the balance of delinquent office CMBS is second in size only to retail, which is saddled with a $5.9 billion pool of debt gone bad.
Did a lightbulb just gone off over your head as you pondered the preponderance of pressured properties peppered across this great nation? Is it time to head for the hills? Even short real estate, which we already know to be underperforming the broad market? The short answer to your urge to swiftly short the sector is, “It depends.”
It’s no secret that rising interest rates are an enemy of real estate in all its forms. Tack on the slow grind of the current economic recovery and you quickly conclude that the insufficient income thrown off by plenty of properties will easily be engulfed by higher financing costs. It’s critical to note that this dynamic was rendered moot in a zero interest rate environment. Refinancing you name it – from junk bonds to malls in the morgue – wasn’t near the challenge it would have been otherwise.
The reality of, “It’s the level of interest rates, stupid!” has Morgan Stanley’s CRE team a bit worried headed into the new year. First, a term of endearment, for developers, that is. ‘Net operating income’ (NOI) is the revenue a property generates after deducting the expenses required to operate the property. Word is, the higher the better. Enter Richard Hill & Jerry Chen at Morgan Stanley and the aforementioned rising interest rates. To keep things simple in formulating their forecast, they assumed a one percentage point increase in rates, which happens to be one in the same with the rise in the yield of the benchmark U.S. Treasury, give or take a basis point.
“We estimate that NOI growth would need to average nearly five percent over 10 years to produce the same levered return as today,” Hill and Chen wrote. “If NOI growth remained stable at three percent, near the historical average, then property prices would fall over eight percent to produce the same levered return as today.”
At the risk of mixing apples and oranges, the flashy new Standard & Poor’s real estate sector in the S&P 500 is off by precisely that much since it premiered September 19th.
As for what’s to come…did someone mention an election upset in the United States?
Animal spirits are the one thing that can rescue CRE in the year to come as a magnificent wall of maturing debt comes due. Some $120 billion in CMBS is up for refinancing in 2017. Tack on all other forms of CRE debt and the figure rises to $400 billion. A special feature of this debt vintage is that only 40 percent produces sufficient income to ensure refinancing is a sure thing (For any CRE types out there reading this, pardon the paraphrasing of industry terminology. This ain’t easy stuff to communicate to us laypeople.)
Add up all the factors and throw in tightening lending conditions for good measure. Hill and Chen estimate that 60 percent of the debt maturing in 2017 will be successfully refinanced while 20 percent is modified and 20 percent liquidated. Call that the base case scenario.
How to improve upon that projection? In two words, premature allocation on the part of investors either hungry for management fees or starved for yield.
Private equity is sitting on a $230 billion mountain of dry powder, as in funds earmarked to buy up real estate. That’s up from $210 billion at the end of 2015 and a mere $156 billion four years ago due in large part to pensions chasing returns. Meanwhile, it looks like CMBS issuance will rise to $65 billion next year pushing up the sector’s market share to 15 percent. And don’t count out insurance companies. Some analysts predict their market share could double or more from 2016’s 13-percent base, a prediction that’s been validated by insurers’ rising share of lending volumes in recent months. No doubt some of these insurers are international, which is understandable given negative, albeit rising, yields in so many countries. For identical reasons, many other types of foreign investors, especially of the sovereign wealth fund ilk, continue to flood the U.S. market with funds.
Global property investment will easily top $1.5 trillion this year. And New York will be crowned as the top-ranked target city, unseating London. The US will also boast the largest share of growth, with 15 of the top 25 cities on the top-ranked investment list.
If I’ve just talked you back into your own personal real estate investments, you may want to beg to differ…with yourself. Recall that the outlook remains iffy at best. At this late stage in the cycle, it can be prudent to be early and live to be liquid another day.
Not every tower, you see, maintains its golden allure forever. Real estate developers are the first to say they must be optimists to succeed in their chosen line of work. That said, many developers have gone down in flames, denying that the party has ended. Like Lot’s wife, they refuse to relinquish the past. They too look back, destroying what riches they had built, turning them into pillars of salt.
You already know I’m referring to that perfect moment in Nine to Five. Franklin Hart, Jr., the 1980 film’s dredge of humanity boss, laboriously labeled a “sexist, egotistical, lying, hypocritical bigot,” had just been caught attempting to make a break from his exasperated employees’ bondage. Seeing that he was about to spring an attack in a mirror image, a fleet-footed Dolly Parton, who shines as the harassed Doralee, hits the contrived garage door clicker, hoisting her grab-happy boss into the rafters.
The movie provides a great case study in the power of productivity. Multitudes of Millennials would be hard pressed to even identify the clickety typewriters in the opening scene to say nothing of the grid layout of miles of cubicles. Long since displaced by the ubiquitous PC and virtual workplace, today we find ourselves in a completely different world. But then, productivity gains have also died off in this new era leaving economists in a constant funk trying to conceive a way out of the conceptual conundrum.
Without question, job creation has not been an issue of late. Hopes headed into November’s job market report were particularly high with the positives outweighing the negatives by a wide margin. The flip side of Hurricane Matthew was expected to tack on an extra 20,000 jobs, give or take. The ADP report topped predictions while announced layoffs validated uber-low jobless claims, coming in at their lowest pace of the year. For good measure, the Conference Board’s gauge of job availability improved, reversing October’s weakness.
Meanwhile, the economists over at Goldman Sachs sweetened expectations with a friendly reminder that November is a seasonal sweetheart, tending to deliver an upside surprise two-thirds of the time to the tune of 27,000 extra jobs. Tack on last month’s warm weather and the groundwork was laid for a blowout report.
Hence the inducement of carpal tunnel among the instant reaction folks as they furiously revised what they’d prewritten to conform to the confusion in the actual data.
Rather than the whispered 200,000-plus handle, CNBC’s Hampton Pearson revealed a mere 178,000 jobs had been created. While close to the forecasted 180,000, private payroll growth of 156,000 was shy of the predicted mark by 20,000.
And what about that unemployment rate? The 4.6 percent reported wasn’t even in the same zip code as consensus projections of a 4.9-percent rate. As has been the case so often in the current recovery, the decline cannot be categorized as unequivocally good news. While the lowest since August 2007 makes for a great sound bite for the current administration, the fine print exposed the weightier factor dragging the rate down was shrinkage in the size of the workforce: at 62.7 percent, the labor force participation rate slumped back to a six-month low.
Broadening out to the entire pool of possible participants, those absent from the labor force increased by almost half a million to 95.05 million, a fresh record high. Bookmark Advisors’ Peter Boockvar incredulously asked, “WTF are so many of them doing?” Great question.
One thing they’re not doing is adding to the ranks of those gainfully employed on our nation’s factory floors.
According to the Liscio Report, the best days of the current cycle for manufacturing employment are in the rearview mirror. “Since the depths of the recession, overall manufacturing employment has been on the upswing, although currently teetering. As the culmination of a multi-decade decline, manufacturing employment fell from over 14 million workers in 2007, to 11.3 million in 2010, and then rose to 12.3 million in 2016.”
Before it slips off your tongue, yes, yes, we’re a services economy. While that’s all good and well, a recent visit with Dr. Gates, yours truly’s business cycle sleuth extraordinaire, whose identity must remain in the realm of the unknown, added some much-needed historic perspective. (Does no one read history anymore?)
“Durable manufacturing is the single most important employment engine,” explained Gates. “Why? It has lost the most jobs in all 12 recessions since and including World War II.”
Granted, you’d best not set your clock by this indicator. Sometimes manufacturing peaks on the early side, up to 24 months before the onset of a recession; at others, the peak lags, though not by any longer than 12 months. In case you’re wondering, in the current cycle, the peak occurred 19 months ago, in May 2015. Since then, durable manufacturing jobs have fallen by 113,000.
Does that mean the patient we know as the U.S. economy is already dead on arrival? Well, not exactly.
“Not every business cycle falls on its face; some erode over time. That erosion creates vulnerabilities which surface in the late stage of the cycle,” said Gates. “That’s where durable manufacturing steps in, giving an early warning signal that the business cycle is coming to a close.”
Another signpost that signals the end is nigh is a rolling over in re-postings of job openings. Some discount online help wanted ads as false indicators given the rise in the cost to post them. Fair enough. If a company really needs to fill a position to grow their top and bottom lines, though, it’s going to pony up the expense to land that laborer. That is, unless and until prospects for revenue and profit growth are ratcheted downwards, at which point they’re compelled to delist that opening. That’s exactly what’s been happening since November 2015, when re-postings peaked.
Will you read about any of this in your weekend newspaper? Probably not. The mass media will focus on that 4.6-percent unemployment rate and the stellar news it conveys at the surface. The job market will be pronounced to be as healthy as a horse, working 9 to 5, and maybe even a bit of overtime.
The truth is probably closer to what Dolly belted out in the Academy Award winning song that shares the movie’s title, that serious job seekers should pour themselves a “cup of ambition” given the late stage of the current cycle. On second thought, if the end really is near, they might need to make it a double espresso.
For a dose of not so jolly Christmas cheer, you can actually experience the cinematic pleasure of both simultaneously in the dual opening scenes of the first Rated-R movie to win the Oscar for Best Picture. That is, if you’re keen to watch for the first or umpteenth time 1971’s The French Connection. This raw, gritty semi-documentary film chronicles what was then the largest narcotics bust of all time. The 1962, $32 million seizure equates today to over $256 million.
But don’t watch the film as an exercise in calculating the street and time value of money. Rather sit back and enjoy the display of contrasts between the good(ish) cops and the bad guys. Gene Hackman commands his first Best Actor Oscar as Jimmy “Popeye” Doyle alongside his partner Buddy “Cloudy” Russo, an exceedingly young Roy Scheider. These two relentlessly pursue Alain Charnier, portrayed elegantly by Fernando Rey, and his ruthless hitman Pierre Nicoli, played by Marcel Bozzuffi. The cops tend to eat cold pizza on street corners in the brutal winter cold as they surveil the smug smugglers indulging in the finest cuisine on offer in the cozy warmth of Manhattan’s fanciest restaurants. Thankless pursuits to be sure, but ultimately for the greater good except for the glaring fact that in the end, Charnier escapes.
And as for the greater good in the here and now? Well, despite what we’re told by the mainstream media and the condescending tone they refuse to renounce, a cresting wave of discontent has crashed onto our country’s shores. This repudiation of perceived injustice will no doubt also be manifest at European polls in the year to come. Voters are increasingly convinced that the bad guys have been winning for a very long time. So they continue to reject the status quo even given the lack of viable alternatives other than pure and simple ‘change,’ regardless of the form that change happens to take.
It will therefore come as no surprise if the Italians vote down the balloted referendum this Sunday. Forget for a moment the relative irrelevance of what’s the vote actually addresses. OK, if you must know, at issue is gridlock that allows legislation to enter a perpetual cycle, as in nothing ever gets done. The two chambers of Italy’s parliament can effectively veto each other’s decisions in perpetuity. Separately, the regions retain great powers. A ‘yes’ to Prime Minister Matteo Renzi’s constitutional reform referendum brain child would limit both the powers of the Senate and local governments.
The funny thing is, the Italians pass a lot of laws — more than their peers in France, Germany, the UK and the US. They just aren’t enforced. That nagging detail helps explain why the country has had over 60 governments in the past 70 years. Add to this the high stakes game of chicken Renzi is playing. A ‘yes’ vote will also award the party that wins future elections bonus seats in the dominant chamber of parliament and a guaranteed majority for five years, laying the groundwork for the rise of a strongman. It’s safe to say the Italians have long and bad memories of past dictators.
A recent visit to Italy and chats with men and women on the street revealed a general mistrust of Renzi and his Machiavellian ways. One PhD-educated Florentine resident was bitter in recounting that Renzi, the city’s former mayor, took his current post by force, pushing his party colleague Enrico Letta to resign as prime minister. This shrewd move prompted Italy’s President to ask Renzi to form a government, which he gladly did with himself as head of the leading party. He maneuvered his way into office with no say on the people’s part. For some reason, this act enraged the electorate.
In fact, the majority of those in the Five Star Movement, the main opposition party, are generally well-educated. They wholeheartedly support their leader, former comedian Beppe Grillo, who enjoyed wild success before he was banished from publicly owned television for his satirical political attacks. Rather than skip a beat, Grillo began to blog and became a powerful voice of the people, demanding freedom of speech and speaking out against political and corporate corruption, child labor and globalization. Given its druthers and a power seat, Five Star has promised to give Italians a vote to leave the euro, the currency bloc, rather than the European Union. Not surprisingly, the media and establishment relish in besmirching Grillo’s name, which of course only serves to endear him to the people that much more. Sound familiar?
Atop this icy slope, Renzi precariously teeters; he has vowed to step down if his referendum fails, which seems likely. This would open the door for general elections, possibly as soon as early next year. Grillo could then conceivably ally with another opposition party and rise to become the next prime minister. Connect the dots and you see what has markets so worried and that’s without one word of mention of the tenuous state of Italian banks.
That brings us north, to France, the next major country scheduled to hold elections come May. How will the outcome of the Italian referendum connect the French to the Italians, and by extension, the rest of the world’s economy and financial system? It sure would be nice to know the answer to that question, especially if your first name is Angela and your last, Merkel.
According to the German newspaper Die Welt, French banks’ total exposure to Italian debt is in excess of €250 billion, three times that of Germany (though Deutsche Bank alone has €12 billion of exposure, which raises yet another red flag on the bank’s viability.) Spain (€45 bn), US (€42 bn), the UK (€30 bn) and Japan (€28 bn) follow. If these numbers seem rather large, it bears repeating that after the US and Japan, Italy boasts the world’s third largest sovereign bond market, hence the potential to inflict damage on the masses in one fell swoop.
If you think populist pugilism is rampant now, imagine what a banking crisis would stir up among the protestors. While a far-right Marie Le Pen might have seemed a stretch to be France’s next president, the surprise victory of the less-right Francois Fillon all but ensures France will follow in the footsteps of Great Britain and America in electing dark horses. Lest you suffer undue levels of suspense, yes, Fillon was publicly derided. Nicolas Sarkozy, the ex-president, was assured by his advisors that Fillon was not to be taken seriously, nicknaming the front runner, “Mister Nobody.”
Are you beginning to detect a trend? Do you think the so-called elites also sense a meme? Or will they continue to label the rise of change agents as one-offs, maintaining their arrogant dismissiveness that continues to work against them?
The most startling development that’s shot up through the grassroots is the identity of those raising their fists in concert. Fillon didn’t just win his primary run-off; he ran away with two-thirds of the vote. That’s saying something for a candidate who has vowed to curb union power, end France’s 35-hour work week, shrink the country’s labor code to 150 pages from 3,000 (!), and by the way is a social conservative and practicing Catholic. In other words, he’s the last person you’d expect the French to embrace. Public spending as a percentage of France’s GDP is 57 percent, appreciably higher that the generous Eurozone average of 49 percent.
Perhaps the true underlying message is that globalization, for all of its merits, simply didn’t work out the way it was designed on paper. The hollowing out of the middle class is anything but contained to one country or even a handful of them; it too is a global phenomenon as evidenced by the breadth of the countermovement. It can’t help that the monetary policy response has not only widened the global inequality gap further, but managed to do so in such a deeply insulting way as to incite economic riots.
When, thus, does political risk become economic, financial and the dreaded systemic? And how far does the contagion spread? Technocrats under the influence of truth serum must be asking themselves if populism will be contained within the developed world or spread to the likes of Cuba and Venezuela. Is blood shed within the realm of possibilities? Has it really come to that?
One thing is for certain. Angela Merkel will run for a fourth term just in case. More than anyone else, she ties her legacy to the survival of the euro. Her moment of truth arrives as the leaves begin to turn next fall, as Germans head to the polls. Merkel will bank on her savvy Deutschland constituents’ appreciation of the economic benefits of an artificially weak currency. Surely they will not bite the hand that’s fed them so well all these years.
If you prefer a bit of certainty to second-guessing the future, do yourself a favor and bookmark the spread differential between Italian and German bonds first and French bonds second. They’ve widened dramatically in recent weeks and will be your most reliable gauge as to whether prosciutto or steak tartare will be on the never-to-be-served list in the Merkel household a year from now. For good measure, keep Deutsche Bank on your radar in the event tough choices lie ahead (“My precious € or my fatherland’s biggest bank? If only the balance in the country’s checking account could cover both!”)
Gene Hackman’s Popeye also came up shy in the end. But he did seize the drug stash, and as a bonus, got to whack that nasty hit man employed by the drug smuggler mastermind. But alas, the bad guy, that slippery Frenchman, slipped away, severing the Connection by living for another day. Ask yourself: Will the establishment have such luck?
It didn’t take you but a nanosecond to picture Jerry Maguire screaming that line into his phone. The shame, for lack of a better word, is that another quote from the same movie, that’s almost as good, will only live on to minor fame.
Getting to the not quite as famous quote requires that you navigate not one, but two scenes in the 1996 Tom Cruise blockbuster. Sports agent Maguire has landed an Odessa, Texas high school superstar quarterback. In perfect stereotypical form, the boy’s father is chief negotiator. Out Maguire drives to dusty West Texas to seal the deal, on paper, to which the father replies: “You know I don’t do contracts, but what you do have is my word. And it’s stronger than oak.” One firm handshake later, we see an elated Maguire driving off singing and pounding his steering wheel to the beat of Tom Petty’s “Free Falling.”
Of course, a betrayal follows as sure as night follows day and the father signs, yes signs, with a rival agent offering a sweeter as in “Sugar” deal. But what about the strength of that oak? A pumped-up Maguire arrives for the young star’s big moment and learns that in all likelihood Cushman Senior does sign contracts. To that Maguire bitterly retorts, “I’m still sort of moved by your, ‘My word is stronger than oak’ thing.” The moral we saw coming: Always get it in writing.
But what happens when those written words still aren’t good enough? The occasion of the release of most Federal Open Market Committee (FOMC) Meeting Minutes would seem to be a great opportunity to get a behind-the-scenes take on all those round the table machinations. Minutes of lame duck meetings – no press conference, no action – hold even greater appeal, especially if multiple dissents accompany the decision. Hence the media jockeying for instant live reaction at 2 pm EST three weeks to the minute from the moment the statement is released. Hey, it beats waiting around five years for the meeting transcripts.
Did someone mention transcripts? In 2008, Janet Yellen herself suggested – in plain English, mind you – that the FOMC deploy the Minutes as they would any other tool in their quickly dwindling toolbox of conventionality. In the event the data or the markets have not reacted to the meticulously crafted statement in the manner Fed officials intended, whip out the Minutes to reshape the public’s thinking. Rather than become a monkey on her back, Yellen’s suggestion to outright manipulate the Minutes has been embraced by her peers and the public alike; parsing the message in the Minutes has become a favorite Wall Street parlor game.
That is, until today. A massage is one thing, a machete that leaves a blood trail quite another; hence the impossible task of weaving an entirely unexpected election result (especially for those on the FOMC) into the Minutes of a meeting that took place a week beforehand. Today, in other words, we will see relatively clean minutes, the prospect of which holds a whole different kind of appeal. (It may also explain the downright deluge of Fedspeak since the election. Do you get the sense there’s an unwritten Fed policy that dictates more is more when the Minutes have been disengaged?)
Given the violent reaction in the bond market to the election, it’s bound to be killing Yellen to not nod as to how the Fed is apt to react come December 14th. But the truth is the market has already placed its bet, pegging the probability of a quarter-percentage-point hike at a neat 100 percent. That gets us to the “What’s next?” portion of the program, which is when things begin to look a little hazardous.
The brilliant (word not used with even a scintilla of hyperbole) William White was recently honored with the Adam Smith prize, the highest on offer from the National Association of Business Economics. White’s career has been long and esteemed. In 2008, he retired from the Bank for International Settlements (BIS) and is now chairman of the Economic Development Review Committee of the OECD in Paris. On a personal level, yours truly has been honored to get to know White as fellow participants at The Ditchley Foundation’s annual gatherings.
But back to that, “What’s next?” for Yellen et al. Let’s just say White has uncovered the answer. To mark the occasion of his receiving the Adam Smith award, White penned, “Ultra-Easy Money: Digging a Deeper Hole?” Gotta love the subtlety in that title.
Do yourself a favor and Google the paper and read it in its entirety. It is blessedly readable and free of econometrics, as in approachable by those outside the insular field of economics.
White has never been one to kowtow to his peers. Rather than blindly acquiesce to the notion that monetary policy can solve all the world’s problems, White rightly recognizes the elephant in the room, namely that, “by encouraging still more credit and debt expansion, monetary policy has ‘dug a deeper hole.’” White’s basic premise is that central bankers’ hubris (my word) has deluded them into believing the economy can be modelled, “as an understandable and controllable machine rather than as a complex, adaptive system.”
Prior to the financial crisis, monetary policy was “unnaturally easy” and after the crisis broke, “ultra-easy.” Put differently, the failure of lower for longer was not recognized as a failure and taken as an opportunity from which to learn and grow into a new paradigm. Rather, monetary policymakers dug the hole deeper, insisting that failure be not acknowledged, but instead institutionalized. And so policy has been lower for even longer, exit delayed time and again.
Into this breach, Yellen steps again, one year after her first stab at a rate hike. The rest of the world can be thankful she wears sensible shoes, as opposed to strappy, red stilettos, given the potentially dangerous landing for this second rate hike since 2006. Maybe the Minutes will reveal how heated the discussion was about the impending December hike and its aftermath. We can only hope.
Most of the market’s focus since the election has been on major currencies’ moves against the dollar in reaction to the near one percentage point rise in the benchmark 10-year Treasury off its post-Brexit lows. No doubt, the move in the euro has been nothing short of magnificent. The powers that be at the Bundesbank have to be sweating out the ramifications of the next potential move given the double whammy of an interest rate increase here and a losing vote for Italian Prime Minister Matteo Renzi’s referendum on December 4th.
You’d never know it given the euphoria in the stock market, but a strong dollar can be harmful to the global economy’s health. While in no way inconsequential, the euro’s weakness pales compared to that of the shellacking underway in emerging market (EM) currencies. According to the BIS, since the financial crisis, outstanding dollar-denominated credit extended to non-bank borrowers outside the United States has increased from $6 trillion to $9.8 trillion.
The game changer in the current episode is the catalyst that drove the growth in EM dollar-denominated debt, namely unconventional Fed policy. The yield drought created by seven years of zero interest rate policy and quantitative easing pushed investors to show EM debt issuers the money. In prior periods, cross border bank loans were the source of the growth. Let’s see. Is it investors or bankers who are more likely and able to panic and run?
“This raises the specter of currency mismatch problems of the sort seen in the South Eastern Asia crisis of 1997,” worries White. “The fact that many of the corporate borrowers have rather low credit ratings also raises serious concerns, as does the maturity profile. About $340 billion of such debt matures between 2016 and 2018.”
Talk about a black box of uncertainty that’s sure to dominate the discussion at the upcoming FOMC meeting. The differences between last December and now, however, cannot be captured in any model. That should prove vexing to current members of the FOMC who’d prefer to not wander blindly onto a field littered with landmines.
As White forewarns, “Future economic setbacks tied to ultra-easy money could threaten social and political stability, particularly given the many signs of strains already evident worldwide. In short, the policy stakes are now very high.”
Oh how the Fed must long for the days of yore, when it was feasible to make policy in a domestic vacuum. Though the new reality set in over a matter of years, last August’s rude reminder on the part of People’s Bank of China abruptly ended that bygone era once and for all. The Fed can jawbone all it likes, in tiptoe style in the Minutes, or in gaudy fashion in an endless parade of FedSpeak.
But the reality of it is, if the rest of the world’s economic vulnerabilities and systemic fault lines are laid bare by this December’s hike, Fed officials’ words won’t amount to much more than trash talk, kind of like their vociferous vows to raise rates four times this year. In the end, their word proved to be as strong as, well, West Texas Oak.
Mention Preppies and visions of Izods with popped collars and boat shoes may come to mind. The Official Preppy Handbook, published in 1980, regaled readers with the “merits of pink and green,” instructing that, “socks are frequently not worn on sporting occasions or on social occasions for that matter. This provides a year-round beachside look that is so desirable that comfort may be set aside.”
Reference “Preppers,” on the other hand, and fashion goes out the window replaced by sturdy wears and wares. Gucci is supplanted by the “Bug Out Bag (BOB)” and “Get Out of Dodge (GOOD) Kit.” Modern day survivalists have upgraded their essentials to include electric generators, water purifiers, and several years’ worth of provisions. Who’s to blame them? Go big if you can’t go home.
In the blink of an election, the two worlds of Preppy and Prepper have collided. Rather than the possibilities being remote as doomsday scenarios suggest, potential outcomes are conspicuous in their size, abundance and mystery. Hence the logic when yours truly received this warning from a reader logged into a posh investment website in the wake of last week’s upset win for Donald Trump: “Buy brand name defensive ammo for handguns. It will hold its value better than gold. It is an inflation hedge. Buy a box every month. Diversify the calibers.”
Such sophisticated language and tone for a disturbingly dire forecast. And his admonitions came before the tizzy the bond market has thrown in recent days in anticipation of all manner of fiscal stimulus. The question on everyone’s mind is how far does the backup in bond prices in anticipation of inflation have to run?
Theories abound: Is this simply a boomerang reaction to Trump’s more hawkish tone on Fed policy? Will the $500 billion in infrastructure spending arrive as fast as Dr. Copper’s moves suggest? What of all that debt that’s still out there? Haven’t we been lectured by monetary authorities for years that it’s only the cost to service the debt that matters? OK, now what if it’s looking like debt service costs will matter and in a hurry?
Perhaps it would be best to catch our collective breath and take a step back for a moment and assess how underlying inflation has been behaving. In the spirit of keeping things on Planet Earth, let’s look at the consumer price index (CPI). In September (October due out manana), headline CPI rose 0.3 percent over August and 1.5 percent year on year, the quickest pace since October 2014 but tame nevertheless historically speaking. Meanwhile, core CPI, which excludes necessities one and two in life – food and energy – was up 2.2 percent over last year.
If you just said, “Huh?” get in line. Yes, it’s unusual for the core to be rising at a faster pace than headline, and that’s only half the story. The fact is, core has been above two percent for nearly a year making one wonder about Janet Yellen’s initial promise that the upside-down dynamic would be ‘transitory’ in nature. What gives?
It comes down to the services side of the equation, which has been fueled by the Affordable Care Act and rental inflation that’s risen into the stratosphere care of the low interest rates that have encouraged luxury unit construction. To be precise, the CPI tells us rents are up by 3.7 percent in the last year, which is apt to be understated for reasons you need not be bored with, while medical care prices are up by 4.9 percent over 2015. So it’s safe to say services inflation has been driving the train.
The Daily Shot’s Lev Borodovsky is an avid observer of just about every economic and financial market trend out there. From his vista, a switch could be in the process of being flipped.
“We are now seeing price stabilization in the goods sector with a number of indicators such as manufacturing surveys around the world showing rising prices” said Borodovsky. “Perhaps the greatest single indicator is the end of producer price deflation in China, which started about five years ago.”
By the looks of some of the metals charts, ‘end,’ timed conveniently at the end of last year, has segued into ‘frenzy.’ Since mid-December of last year, coal prices have more than doubled; steel prices have increased by 50 percent. A similar story can be told across the entire industrials metals complex, which is best reflected in the Baltic Dry Index (BDI), a broad shipping gauge treated as a proxy for global trade. According to Hellenic Shipping News, after bottoming at a record low on February 11, at 290, the BDI has more than tripled, most recently closing at 1,084.
What does this all mean? Could China truly be in the position to finance a fresh round of infrastructure spending? The answer is, sort of. The government has doubled the funds it funnels into Chinese public-works projects, which naturally drives up demand for primary commodities. At the same time, though, authorities have broadcast their intention to cut supply output from the country’s bloated industrial sector. So boost credit and restrain supply?
This dichotomy was sufficient to bring out the hot money. According to Bloomberg data, trough-to-peak daily turnover in steel spiked by nearly 9,000 percent, a boon for traders and metals and mining firms, a bummer for consumers of said goods.
The bottom line is, before the election, some of the underlying demand that raised the specter of inflation was real, but a good bit of it was fabricated. Looking out to 2019, China’s aggregate demand for base metals is forecast to be about one-fourth of what it was in the five years ended 2015. Of course, China is but one country, albeit a biggie.
Fast forward one week, to a Trumpian reality, and all the world is atwitter pondering the magnitude, the majesty, of potential public works projects in the United States, ones that bring us back in line with first world standards.
Does this new world of possibilities now justify speculative bets on metals hovering at mid-2014 levels, when oil was still at its cycle highs? In his typical dry fashion, Borodovsky asked, “Is the rally overdone?” If so, he answered rhetorically, “the unwind could get ugly.” As if on cue, over the last few trading days, many of the metals have come off their highs, in part because they’d risen too far, too fast. But on a more fundamental level, the U.S. is simply incapable of displacing China in its peak commodities consumption years, regardless of the size of infrastructure spending Trump succeeds in securing.
If you listen to campaign promises, that figure could be in the half a tillion dollars a year vicinity. The economists at Goldman Sachs estimate a much tamer $150 billion a year fiscal boost. Their number crunching equates that figure to a 0.6 percent marginal increase in economic output. The author of the report, Daan Struyven, added that timing must be taken into account: “The late-stage cyclical position of the economy makes the multiplier smaller than it would have been in recession or early recovery, especially if the Fed offsets the fiscal impulse.”
Lest we forget the Fed’s role at this late stage. As things stand, all indicators point to a ‘go’ in December. Wages are increasing at the fastest pace since 2008, inflation expectations looking out five years are upwards of 2.6 percent and most importantly, the market is pricing in a 94 percent probability the Fed will pull the trigger.
As for 2017, ‘gradual’ best characterizes the markets’ hopes for just about everything from the aforementioned inflation to the Fed’s reaction function. Steady as she goes to push the second longest bull market in history to first place.
At the risk of injecting the equivalent of a cold shower into this perfect scenario, what if (about to use a four-letter word, so close eyes if under 18) mean reversion applies to the bond market, and in turn the stock market and commercial real estate? What if, after 35 long years, the inflation genie really has been let out of its bottle?
Well then, you’d best take cover. Which brings us back to those smartly dressed preppies, who will inevitably go all in on gold. After all, as The Official Preppy Handbook reminds us, “In a true democracy everyone can be upper class and live in Connecticut. It’s only fair.” Hmmm.
Do any of you doubt that this traditional hedge proffers adequate protection in a world awash in over $200 trillion in debt? If that’s the case, you might consider sturdier shelter. Yes, we’re talking about taking the prepper path, a.k.a. farmland. The bonus is, unlike some other asset classes, farmland prices have fallen at the fastest pace and for the longest stretch since the 1980s.
So stock up on dehydrated water, canned goods and maybe even that brand name ammo, as the sophisticated reader suggested. While you’re at it, take up hunting and gardening in your free time. In a world full of surprises, it’s better to be prepared than not.
England’s future King Richard is not lamenting what’s to come but rather embracing the season just over time’s horizon, “Made glorious summer by this son of York.” His brother Edward IV, who has just wrested the crown from Henry VI, ended his family’s long winter of oppression.
Under similar circumstances, England’s Margaret Thatcher rose to power ending central London’s own Winter of Discontent. In Thatcher’s case, Labour Prime Minister James Callaghan’s loss of confidence vote represented the opportunity to defeat what she called the “enemy within” the U.K. The irony is the garbage collectors’ strike, which had left the streets filled with refuse and the electorate infuriated, occurred under Callaghan, a leader who relied on union support.
There can be no doubt that the electorate here in our country was equally compelled to end its own Winter. It came down to the known devil we knew vs. the devil about whom we knew far too much or precious little, if policy was to be the sole sway factor.
For all the sighs of relief that Election Day has blessedly come and gone, and with it hopefully a healing peace, Winter remains upon Us with a huge portion of the population restless at best, scarred at worst.
Pick your poisonous poll, or better yet, average them all together. No matter how you slice it, 60 percent of Americans couldn’t stand either candidate in this year’s presidential race to the bottom rung of hell. We can only hope that the most discontented portion of that 60 percent doesn’t make up the one in six Americans who’ve found this election season the perfect time to purchase that gun they’ve had their eye on. In the hitting close to home category, one in four Gneration X-ers, to which your truly belongs, are among those with plans to start packing iron. For what exact fate are we preparing, or better said, prepping?
It comes down to where we once were as a nation and where we are once again. As was the case in the 1930s, the top one percent controls 45 percent of the wealth and 22 percent of its income. If you want to foment division, burn the rungs of the economic ladder to freedom and see how those who’ve been told the fairy tale of the American Dream react (spoiler: by buying guns). It can’t help that many of the have nots are segueing from just getting by to struggling under the weight of budgetary distress.
In the event you harbor doubts, look no further than the recent Financial Times headline, “Repo Men See Dark Side of Car Sales Boom.” The best that can be said is that repossessions are shy of their 2008 and 2009 record levels. In all, net losses in the subprime auto space are at 9.3 percent, up 23 percent from last year. As for what’s to come, “It’s a big problem, I’m worried.” Those words from a repo man who only agreed to speak behind the veil of anonymity.
And yet, we’re told to praise the recent surge in consumer credit growth as evidence of robust economic growth to come against a backdrop of the weakest doggedly drawn-out postwar recovery in recorded history. First, the numbers, which are terribly lagged. September was punk in one and only one sense – it wasn’t as on fire as August. At $19.3 billion, consumer credit outstanding rose to a record $3.7 trillion. That compares to $2.6 trillion in June 2009 as we technically emerged from recession. As has been the case for years, auto loans and student debt led the charge, but credit cards have continued to bring up the rear; total outstanding is within $20 billion of the $1 trillion mark.
Could it be that the good news about tapping into those credit lines has gone bad, turned rancid as the screws have turned on working middle class families across this fine land? Buy or rent – they’re both unattainable for far too many gainfully employed, despite mortgage lending standards easing for 10 consecutive quarters. Healthcare? More and more out of reach with every passing month. Thank you, Obamacare. Sending your kids to college without incurring debt? Good luck with that.
If you detect a trend, you’re right – the household budget line items listed above are what we call non-discretionary and non-negotiable. At least, that’s the case if you want your kids to grow up in a public school district that renders its stewards literate, healthy and ready to aspire to the American Dream.
Is it any wonder weekly retail sales growth has been running south of one percent for the past six months? And what of a survey reported by CNBC the day before the election? According to consumer consultancy Technomics, 17 percent of households planned to cut back on their discretionary spending at eateries regardless of who emerged victorious. CEOs from McDonald’s Steve Easterbrook to Starbuck’s Howard Schultz to YUM Brands’ Greg Creed echoed the data.
These anecdotal yarns were validated in the most recent decline in consumption’s contribution to economic growth. But by the same token, they contrast with the aforementioned surge in consumer credit. Unless, that is, households are running up their credit card balances to finance nondiscretionary spending. Who, after all, needs credit to get by, has money to spare on life’s little luxuries, when the cost to cover those nagging necessities is quickly escaping the reach of those stuck in the middle?
The media loudly lament the unfounded and unjustifiable anger of the ignorant masses who simply don’t recognize the bevy of opportunities staring them in the face. But has anyone stopped to ask the supposed Fourth Estate’s cocksure cohort how it feels to run in place at full speed and get nowhere?
The answer to that question is actually yes. Bill Clinton posed that very query in an Ohio speech this past November. After asking himself rhetorically why the death rate among white, working-class Americans has been on the rise, he answered, “Why? Because they don’t have anything to look forward to when they get up in the morning. Because their lives are sort of stuck in neutral.”
As is the case with the former president, whose posh future existence promises a permanent vista from which to continue studying those left behind from a safe distance, many among the liberal elite will continue to pour their energies into relieving the suffering of the less fortunate among us.
A word of caution: This approach enflames their anger, rather than suffusing it.
But why bother looking within and asking why condescension incenses those you perceive to be beneath you? The view from your perfect perch is too pristine to bother with such trivialities.
Consider the recent slew of encouraging consumer sentiment data. Expectations for income gains, job creation and favorable news have all turned up of late. Funny thing, this optimism is in sync with income growth among the top 20 percent of earners, even as that of the bottom 80 percent continues its descent. (In the event you’re keeping macroeconomic score, that 20 percent spends enough to carry our economy, for a while at least.)
As for the rest, maybe those fast food CEOs are on to something after all given that the bottom 80 percent consumes 60 percent of food away from home. (Why settle for a McAnything if you can indulge on whatever your heart delights en masse?)
The latest data suggest there could be shorter lines yet at the end of the yellow brick drive through. Job openings and hiring for construction, manufacturing, wholesale and retail trade all failed to make new highs in September, the latest month for which we have data. Is the current cycle peaking and rolling over as these economically sensitive sectors suggest?
And if that’s the case, should we have expected the unrequited electorate to simply go quietly into the night? Or have we just witnessed the break point for those who no longer cotton to taxation without representation? The fact is, as a nation, we are past our due date for a radical remake of our political infrastructure.
Of all the historic insights that shed light on what could come to pass in the aftermath of this historic election, it was a tweet that reminded us all that we are a standout nation due to our conspicuous dearth of political parties. Great Britain has 13 parties represented in its equivalent of our House of Representatives, Japan has ten and Italy nine. What say us? How could we know without a microphone to call our own?
For any who question what’s at stake, appreciate that the very soul of our country has been laid bare. You can choose to reflect back on Shakespearean times or relate to a modern day equivalent.
Though the writers of Game of Thrones will never be in the same literary sphere as The Bard himself, their scripted world of late has nevertheless been prescient, at least in the political arena. To wit, their “Winter is Coming,” delivers a warning to all of those who’ve long stopped worrying about the metaphorical winter to come. Denying our collective vulnerability risks a downfall surpassing that of Lucifer himself. To our just fate we have just marched. May summer now shine down upon us.