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Is European Money Growth Helping Stoke U.S. Inflation?
The monthly European M2 numbers are out (they are released with approximately a one-month lag), and so we can get a look at the monetary conditions through the end of October.
The chart above (source: FRB and ECB) shows that whatever the ECB is claiming about not conducting QE, money supply growth is most definitely accelerating.
The data also allows me to update one of my current-favorite charts, showing the connection between developed markets money growth (proxied here by US M2 plus Euro M2) and core U.S. inflation. The chart is below (source: BLS, FRB, ECB, Enduring Investments calculations).
What is most amazing to me about this pretty reasonable (correlation= 0.6) relationship is that it is contemporaneous. This is really important, because what it means is that we can argue that money velocity may not actually have fallen in the U.S. as much as it is commonly believed to have. If the proper measure, now that all of our economies are so interconnected, is global money rather than narrowly domestic money, then one answer to the question “why did the 10% growth in the U.S. money supply not lead to much higher inflation, much higher real growth, or both” (the correlation between U.S. M2 growth and U.S. core inflation is only 0.44) could be “because Europe’s tight money was counterbalancing our loose money.”
If this speculation is right, then it makes the ubiquity of QE much more worrisome, because it means that even if the Fed stops throwing wood on the fire, if everyone else is doing so we may still see domestic inflation (although, in that case the dollar would likely strengthen appreciably, blunting that effect).
The Gravity of the European Situation
Markets continue to gyrate in what seems like wider and wider arcs as volumes gradually decline but the density of news headlines does not. Today, at least one meaningful piece of news that pressured stocks early was that hedge fund (and market-maker) SAC Capital told its investors that it has received a Wells notice from the SEC (indicating that the SEC has determined it may bring legal action against the firm), alleging insider trading. An allegation against the firm, as opposed to individuals within the firm, is a much bigger deal and the concern is that if SAC is impacted or distracted by the charges that liquidity in certain parts of the market may suffer.
This concern didn’t linger very long, though, as stocks were back in the black by lunchtime.
New Home Sales were reported significantly weaker-than-expected, with a downward revision to the prior month’s reported sales. While sales of existing homes have been on a steadily improving pace for a while, New Home Sales have been stuck around 365k since January. Economists had expected a number more like 390k, which sounds aggressive when you look at the chart (source: Bloomberg) below but recall that last month’s figure had been previously announced at 389k and the economists’ estimates don’t seem so outlandish.
This figure doesn’t appreciably change my positive view of the housing market (and more important for me, price change in the housing market) going forward, for two reasons. First is that sales of new homes are dwarfed by sales of existing homes, so that the latter is simply lots more important and the data more statistically useful (e.g., the year-on-year change in the median price follows the same path, but as you can see below in the Bloomberg chart, the new home sales number is dramatically more volatile).
The second reason is that I suspect one reason for the failure of New Home Sales to rise more aggressively is that the gross inventory of new homes has recently been at the lowest level on record (dating to at least 1963). This is a better number to look at, incidentally, than the “months of inventory,” which still shows slower inventory turns than was normal back prior to the bubble. But that’s because of the denominator (monthly sales), not the numerator (houses for sale). And at some level, there are just not enough of the right kind of homes where they are needed. With just 147,000 new homes available for sale, there is only 1 new home for every 2,200 Americans. And they’re mostly bunched together. I suspect this dampens new home sales, and so I am looking much more closely at existing home sales for both activity indications and for price indications.
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I had the honor of speaking today at the Euromoney Forex Forum 2012 in New York, on a panel concerning the future of the Euro and how much that future depended on individuals as opposed to bigger historical/economic forces. Readers will be unsurprised to hear that I was fairly firmly on the side of “in the long run, economics wins.”
But as often happens when I am running my mouth, I hit on what I think is an interesting analogy for the Euro and the Euro crisis, and for why “kicking the can” makes at least a certain kind of sense.
The analogy is astronomical in nature, and concerns the process of accretion as it applies to planets. The way that planets are thought to form is by the gradual accretion of small bits of matter – asteroids, rocks, dust into larger and larger bodies until the resulting body is able to sweep its orbit clean of anything which might otherwise accrete. But in the process of that accretion, there are two main determinants of how quickly the accretion occurs (actually, there are probably hundreds, but an analogy is supposed to be a simplification, right?). One is the speed of rotation of the body. A body that is spinning rapidly has a greater tendency to fling stuff outward, while a body that is spinning slowly allows more stuff to clump together. The second is the radius of the body: the larger the body, the greater the angular momentum of the outlying bits for a given rotational speed.[1]
Now, the unification of the Euro was like the creation of a planetoid from seventeen different asteroids, each of which was originally moving with a different vector. As you may recall, the Maastricht Treaty described convergence criteria that required all of the member states to essentially match their inflation rates, their debts, deficits, and interest rates, because the treaty signers wisely realized that if the countries were all moving at different speeds when they joined, there was no chance that they would accrete into a single, unified entity (a planet in my analogy).
But the planet never entirely formed, and some pieces of it on the outer fringe are in danger of being ejected by inertia. The crisis is effectively spinning the planetoid faster and faster, making it harder and harder for the pieces on the outside to avoid flying off into new orbits of their own. In this context, it makes sense to try and slow the rotation, on the theory that if everything just stops spinning long enough, the natural gravity will take over and the pieces will fall back in towards the center and everything will be okay. So policymakers kick the can down the road, assuming that if they can just keep everything together for long enough, it will get easier and easier to do so.
The problem, though, is that this body isn’t acting in isolation. There are tidal forces acting to rip the body apart, in the same way that the comet Shoemaker-Levy 9 was ripped to pieces as it approached Jupiter – the difference in the the pull of Jupiter’s gravity from one side of the comet to the other was so significant that there was no way that the object’s gravity could hold it together .
In the same way, in my view, the many significant differences between the periphery and the core of Europe, combined with the effects of over-indebtedness and a debt market no longer willing to ignore the question of a state’s ability to repay the debt, are tidal forces that are destined to rip the periphery from the core, eventually. I recognize that Europeans will tell me that the gravity of the Euro itself is far greater than I think it is, and if they’re right then the Euro will not splinter and the policymakers are correct to kick the can. But I don’t think they’re right.
[1] These two forces work against one another, for when the radius of the body decreases because stuff falls towards the center, the speed of rotation accelerates because of the conservation of angular momentum, but that little detail doesn’t enter into the analogy.
Do Androids Shop With Electric Money?
“Cyber Monday” sounds like something dreamed up by Philip K. Dick for his book “Do Androids Dream of Electric Sheep?” (which later, of course, became the basis for the movie Blade Runner). So, how did it go?
Who cares?
The amount of time, money, and energy spent figuring out how “Black Friday” and “Cyber Monday” is going is all out of proportion to the amount of money actually being made by retailers those days. To be sure, this is an important selling season, and these are some of the most important days in that season. But it’s still a small number. Today eBay gained 4.9% and Amazon.com gained 1.6% in a market that was flat-to-lower all day (the S&P ended -0.20%).
Having said that, the frenzy seemed to be less intense than in years past, perhaps because the global economy (and the markets) face very real challenges in the next month, quarter, and year. On Friday, the tiny European nation of Cyprus asked for, and received, a financial bailout, according to government officials there (although denied by the EC). It’s good to be small – allegedly, their bailout could be as much as 100% of Cypriot GDP, but that’s only about $28bln. According to the story, the bailout includes “unpleasant measures.”
Not half as unpleasant, I’ll wager, as what would have happened if Cyprus had been forced to leave the Euro. As small as Cyprus is, it’s a cinch that no one would let that be the first domino. The first domino will fall when everyone has lost the capacity, or the will, to force the unmatched puzzle pieces to artificially jam together in an apparently cohesive unit. This denouement may still be some time away. As my friend Andy F wrote in his daily (FX markets) commentary today, “German Chancellor Merkel has been very clear that Greece will not fail, regardless of the fact that it already has.”
Now tonight, supposedly, we can again temporarily put aside the fears of a Greek exit from the Euro as the IMF and European finance ministers reached a deal on the (revised) terms of the Greek bailout. ECB President Draghi said that the agreement “will certainly reduce the uncertainty and strengthen confidence in Europe and in Greece,” and we will doubtless be told that repeatedly over the next few days.
Here is the full text of the Eurogroup statement on Greece, if you are curious, but in the interest of summarizing, I present here just the beginnings of the paragraphs, except for one paragraph worth quoting in full, and you can judge how much important content there is and how much progress was made in this meeting:
The Eurogroup recalls that…
The Eurogroup in particular welcomes…
The Eurogroup noted with satisfaction that…
The Eurogroup again commended the authorities…
The Eurogroup noted that the outlook for the sustainability of Greek government debt has worsened…
The Eurogroup considered that…
The Eurogroup was informed that Greece is considering certain debt reduction measures in the near future, which may involve public debt tender purchases of the various categories of sovereign obligations. If this is the route chosen, no tender or exchange prices are expected to be no higher than those at the close on Friday, 23 November 2012.
The Eurogroup considers that, in recapitalizing Greek banks…
Against this background and after having been reassured of the authorities’ resolve to carry the fiscal and structural reform momentum forward and with a positive outcome of the possible debt buy-back operation, the euro area Member States would be prepared to consider the following initiatives:
- A lowering by 100 bps of the interest rate charged to Greece…
- A lowering by 10 bps of the guarantee fee costs paid by Greece…
- An extension of the maturities of the bilateral and EFSF loans by 15 years and a deferral of interest payments of Greece on EFSF loans by 10 years…
- A commitment by Member States to pass on to Greece’s segregated account, an amount equivalent to the income on the SMP portfolio accruing to their national central bank as from budget year 2013.
The Eurogroup stresses, however…
The Eurogroup is confident that…
As was stated by the Eurogroup on 21 February 2012…
The Eurogroup concludes that the necessary elements are now in place for Member States to launch the relevant national procedures required for the approval of the next EFSF disbursement…
The Eurogroup expects to be in a position to formally decide on the disbursement by 13 December…
To my mind, the interesting part was the “Eurogroup was informed that Greece is considering” part, where what Greece is considering is “certain debt reduction measures” in which debt that is trading at, say, 34 cents on the dollar would be paid 34 cents on the dollar. Now, I am no expert on international bond law, but since the last “rescue” deal resulted in Greece taking on more debt, in terms of notional, in exchange for lower current interest rates, it seems like it may eventually dawn on the Greeks that if the Germans and Finns and French really want to keep the Euro inviolate, they might consider actually writing down some of the debt burden.
I have no idea how such a deal would work mechanically, and clearly it would have to be coercive (since if Greece is offering to buy all bonds at $0.35, they clearly will trade a tiny bit above that since there’s a chance they may be worth more). But I have long scratched my head about why the Greeks were so keen to stay in the Euro at the cost of extended deflationary economic depression in Greece. Could leaving the Euro really make things dramatically worse? Maybe before, when there was hope that the bailout deal would improve conditions, it was worth a smidge of obsequiousness. But nothing between the first loan request in April 2010 and the bailout/restructuring in February 2012 has had any effect at all on the suffering in Greece (and many people think it has exacerbated it). The chart below (source: Bloomberg) shows the Greek Unemployment Rate.
Moreover, as we recently pointed out in our Quarterly Inflation Outlook to our clients, the effect of having one rigid currency rather than 17 has been that inflation experiences have diverged dramatically rather than, as between nations which freely float a currency, tending to equalize. In the first 10 months of 2012, inflation has risen 0.1% in Germany, 0.8% in the Netherlands, and 0.8% in Finland (collectively representing a third of Euro GDP) while in Italy it has declined 1.2%, it is -1.3% in Portugal and -1.3% in Greece (collectively adding up to a quarter of Euro GDP). Interestingly, in France inflation has fallen -0.4%, as it has begun to migrate PIIGS-ward. The chart below (Source: Eurostat, Bloomberg) shows the acceleration in inflation for these countries (and Austria, -0.1%) versus their 10-year bond yields. The logarithmic function fit to those points shows an R2 of 0.73, which actually gets better if Greece is removed.
Clearly, the weaker countries are being forced into deflation as an alternate leveling mechanism because they cannot float their own currency lower. Why Greece, Portugal, and Italy would want to allow this to happen (rather than leaving the currency union) is beyond us, and if the trend continues then Finland and the Netherlands will be none too pleased as well for the opposite reason.
But for today, we can all pop champagne corks and celebrate the “Grexit has been averted again!” all the while ignoring the fact that the countries themselves have not voted on the “agreement” and Greece is at least tacitly threatening to take matters into its own hands unless the deal is pretty good.
This is not to say that last week’s U.S. equity rally had anything, really, to do with optimism about the European circumstances, our own fiscal cliff, or Japan’s election. Immediately after our own election, intelligent taxpayers began to try and realize gains in 2012 so that the potentially drastically-higher tax rates to be imposed next year will occur on profits realized from a higher tax basis. But as I noted at the time, that by itself is not a net negative for the market, since sellers will rotate into other names that they consider bargains at lower prices. So, while Apple plunged from $700 in late September to nearly $500 in mid-November, it is back to $589 today as some investors (including some who sold in September and have waited the requisite 30 days) have leapt back in with delight. It has also helped that a number of companies have paid large cash dividends in 2012 to beat the tax hikes, making the index dividend yield look artificially higher (and therefore the market look cheaper) than it really is.
There are other reasons to be skeptical about the medium-term trajectory of the market, of course, and I am not sanguine about the opportunities which the equity market offers at the moment. I think the key thing to keep in mind is that we are on the cusp of December, and “holiday style trading volumes” have been happening earlier and earlier every year it seems. Today’s volume was on less than 600mm shares, and fully one-third of that was in the last fifteen minutes of trading. Expect volatility to continue, but don’t get married to the price action.
Does ‘Straight Up’ Qualify As Volatility?
The stock market gained 2% today, and commodities jumped 1.25% led by energy, metals, and softs. There was no news that could have rationally justified such a move, and volumes were as light as they have been in two weeks. Some commentators, grasping for straws, suggested that the decent NAHB Housing Market Index number (up to 46 versus 41 expected, to the highest level since 2006) and modestly stronger-than-expected Existing Home Sales figure (4.79mm versus expectations for 4.74mm) triggered the rally, but that ignores the fact that most of the equity move was completed prior to the 10:00ET release of these figures.
Others resolved the conundrum by saying that “apparent progress on the fiscal cliff” led to the rally, but the only progress made was that neither side was hurling epithets at the other in public. There is no sign of any agreement being made, and certainly no chance of any agreement being made that would persuade investors with big gains to avoid realizing taxes this year (since it is exceedingly unlikely that the upper end of the tax structure will be unchanged or lower next year). Now, I’d suggested last week that “this is mostly a cycling of positions, a re-setting of tax basis at a higher level, and shouldn’t amount to a major selloff by itself,” but there are other reasons to be less-than-exuberant about the market’s immediate prospects too.
One of these is the conflict in and around Israel and the territories under her control. While there is loose talk about a ‘cease-fire,’ Israel is demanding a long-term agreement to stop the rocket fire and Hamas is saying “Israel started it.” I think it says something about our political discourse here that it is probably easier to resolve the Israeli-Gaza-Syria-Egypt-Iran conflict than to resolve the Fiscal Cliff discussions, but also keep in mind that Israel still wants to do something about Iran’s nuclear capabilities, so a cease-fire strangely may not be in her interest at the moment.
There is no doubt that our domestic housing market is getting better, to be sure. I’ve pointed out periodically (see here, here, and here for example ) that home prices are rising again and not surprisingly that is making home builders happy again. The chart below (source: Bloomberg) shows the NAHB index I alluded to earlier.
It looks suspiciously like the chart of home builder Toll Brothers (TOL) shown below (source Bloomberg), suggesting that there is not a lot of true analysis going on among the buyers of that stock. Toll Brothers has a current P/E of 61 on trailing earnings, and 50 on estimated forward earnings. I don’t have a position in TOL, nor do I plan to; I just point this out in case your child was thinking of becoming an equity analyst. Help him or her along a different path.
Part of the reason for today’s surprise in home builder sentiment might be the sudden promise of new home building activity along parts of the eastern sea board, courtesy of Sandy, but the trend has been well established for a while. While there is ample inventory of existing homes (though these are being drawn down as well, slowly), the inventory of new homes has been at a 50+ year low for more than a year (see chart, source Bloomberg) and it was just a matter of time before more were built. An existing home is a good, but imperfect, substitute for a new home.
Now, as an inflation guy the reason I care is because the decline in home inventory, coupled with virtually free money for builders and home buyers who can qualify, is pushing up the cost of a big chunk of the consumption basket. Owner’s Equivalent Rent (which is 60% of housing, which in turn is 40% of CPI) has been rising at slightly faster than that of core inflation. As the chart below shows, there is a distinct relationship between prices in the market for existing homes and the general increase in rents (both direct and imputed) 15 months later.
It’s not a new story, but rather one I’ve been talking about for some time, and remains a key reason I remain bullish on inflation despite global central bank protestations (and asset manager convictions, as far as I can tell) that deflation is a more proximate threat.
Meanwhile, other economists have concluded that the reason inflation has been rising rather than falling despite huge amounts of slack globally must be that … their Phillips curve needs recalibration. In a recent funny note by Goldman’s economics group – though it was not meant to be funny – entitled “A Flatter and More Anchored Phillips Curve,” they said
“We have long argued that labor market slack would weigh heavily on inflation in the aftermath of the Great Recession. This view has generally worked well as core (ex food and energy) inflation has fallen substantially since 2007. But the decline in core inflation abated in late 2010 and—despite recent signs of renewed disinflation—core inflation has generally been stickier than the large amount of slack would have suggested.
“A candidate explanation is that the inflation process (or “Phillips curve”) has changed in recent years. Economists have argued for some time that improved central bank credibility, globalization and downward rigidity of nominal wages have altered inflation dynamics since the inflationary 1980s.
Considering that the Great Recession didn’t really kick in until late 2008, and core inflation (ex-shelter, which was suffering from the implosion of a giant bubble) rose from 2007 until late 2009, another ‘candidate explanation’ would be that their model was not mis-calibrated but rather completely mis-specified. The Phillips Curve, which relates wages, not core inflation, to slack in the labor market, is not useful in forecasting inflation. This is well known, and yet expensive economists have worked incredibly hard to resurrect the theory. (Here’s a fuller illustration/explanation of why the Phillips Curve as typically used is wrong).
But beyond that – if you need to keep changing the calibration of your model to fit the facts, then it’s not a good model. That’s sort of Modeling 101. The economists explain/plead further:
Economic principles suggest that core inflation is driven by two main factors. First, actual inflation depends on inflation expectations, which might have both a forward-looking and a backward-looking component. Second, inflation depends on the extent of slack (or spare capacity) in the economy. This is most intuitive in the labor market: high unemployment means that many workers are looking for jobs, which in turn tends to weigh on wages and prices. This relationship between inflation, expectations of inflation and slack is called the “Phillips curve.”
Well, no. Economic principles suggest that inflation is mainly driven by money and the velocity of money. Some discredited principles suggest what they say, but it’s not working. Their own chart, showing they’re off by some 100%, is reproduced below.
On to happier items. In case anyone still thought France was a AAA nation, Moody’s announced their opinion this afternoon that it is not, in downgrading the nation from Aaa to Aa1. Moreover, France remains on watch negative, due to structural challenges and a “sustained loss of competitiveness” in the country. I guess on second thought, that’s not so happy. How did France lose competitiveness? Do you think it has anything to do with the incredibly expensive social contracts and the short working week and year? But no, perhaps they didn’t spend enough on education and national health care.
Honest, Abe?
Today was CPI day, which after Christmas and Thanksgiving is one of my most favorite of days. Here is what I tweeted earlier today (and there’s lots more commentary below):
- unrounded core CPI at +0.18%, a bit higher than what dropped off. Not exactly alarming, but higher than Street expectations.
- y/y core to almost exactly +2.000%. Apparel rose again after the recent rise had slowed in the last couple of months.
- Subindices: ACCEL: Housing, Apparel, Transp, Food/Bev (75.2% of basket). DECEL: Med Care (6.9% of basket). UNCH: Recreation, Comm/Ed, Other
- OER was unch…rise in Housing came from primary rents (that is, you actually pay rent) and lodging away from home.
- Core goods inflation stayed stable at +0.7% y/y; core services stable at +2.5%. I think the former number is going to rise.
This was actually something less than the most exciting CPI report in history. It was better than the Street expected, and although the year/year figure barely nudged higher the components of the number were strong. The rise came from Housing, which ought to continue to accelerate for a while given rental tightness and other forward-looking indicators, and Apparel resumed its rise as well. See the chart below (source: Bloomberg) for the update to what is rapidly becoming one of my favorite inflation-related charts.
The Cleveland Fed’s Median CPI dropped just enough to round down to +2.2% on a y/y basis, and the Atlanta Fed’s “Sticky” CPI is also at 2.2%. These measures are other ways to look at the central tendency of the inflation figures, and suggest that the current 2.0% from the traditional Core CPI is likely to converge higher rather than vice-versa.
But today didn’t change any inflation paradigms.
There was other news, however, that struck me as inflation-related and worth commenting on.
One was a story in the UK Daily Mail citing the case of a Denny’s franchisee (he owns a few dozen Denny’s restaurants) who is planning to add a 5% “Obamacare surcharge” to customer dining checks.
Now, the sum of all of the sales of this man’s Denny’s restaurants is a tiny part of the CPI category “Food away from home,” which is itself a small part of CPI, so it won’t have any impact on the numbers. Even if lots of restaurants followed suit, it wouldn’t have much of an impact since “Food away from home” is only 5.6% of the consumption basket (so a 5% surcharge on all checks would cause a rise in CPI of 0.28%), but it serves as a good reminder of one important point.
The higher taxes and other costs of doing business that are going to be targeted at business is going to show itself to individuals one way or the other. The higher cost of Obamacare compliance, and any other increased business taxes, will not be paid by businesses for the simple reason that businesses are pass-through entities. That is, businesses don’t make money; people who own businesses (partners or shareholders) make money. So whether the higher costs show up as higher prices to the consumer (in which case the government’s attempt to raise revenue from business will result in higher inflation prints, as the transition takes place) or as lower profits to the businesses themselves, the cost will end up being borne by real humans.
At the end of the day, how much of these costs is absorbed by the owners and how much is paid by the consumers is determined by the elasticity of supply and demand for the product. For example, if the elasticity of demand is infinite, then the owners will bear the entire cost; if the elasticity is zero, then consumers will pay it all. My personal guess is that given the current level of gross margins, more of these taxes and higher costs will be paid by owners – implying lower equity earnings – than by consumers, but we will see. But notice that either way, you get lower real earnings. Either nominal earnings fall, or prices rise. Not good for stocks in either case; bad for bonds in the latter case, too.
Then there are the actions of several central banks in the other hemisphere. A story in the Wall Street Journal, and echoed elsewhere such as in this Australian news outlet, suggests that the Reserve Bank of Australia has adopted a form of QE by allowing its foreign currency reserves to rise in order to push down the currency. The RBA has been one of the bastions, at least relatively, of ‘hard money’ in a world of central banks that have gone wild, so this isn’t a positive development unless you’re long inflation-related assets.
And also hard to miss were the comments by the leader of Japan’s main opposition party, Shinzo Abe, who may become the next prime minister quite soon. Abe suggested that the Bank of Japan should target 3% inflation, rather than 1% inflation, and threatened to revise the law that (supposedly) insulates the BOJ from politics. Note that 5-year Japanese inflation swaps are near all-time highs, but still only at 0.77%, and 10-year inflation swaps are at only 0.48%. Under Abe’s pressure, we would likely see a substantial acceleration in QE by the BOJ, which has already succeeded in pushing core inflation in Japan from -1.6% to -0.6% over the last two years (see chart, source Bloomberg).
We are increasingly moving into a one-way street for central bank policy. Central bankers are essentially engaging in a sophisticated version of competitive devaluations. The Fed does QE, the BOE does QE, the ECB does QE (but claims it doesn’t), the SNB and BOJ and now the RBA does QE. It is a one-way street because whoever stops printing first will see his currency shoot higher as investors flock to the harder currency. The chart below shows what has happened to the Aussie dollar over the last decade versus the USD. While the strengthening trend was interrupted by the 2008 flight-to-quality, it quickly resumed. Since that time, it has risen roughly 50% (and 100% overall since 2001).
Now, a strong currency is good. It makes foreign goods cheaper and raises the standard of living overall. However, it also hurts exports, which slows the economy and results in visible layoffs while the economy adjusts. There’s only so much of this a country’s politicians are willing to take, and it seems Australia may have reached its limit.
If everyone is printing, exchange rates may not move at all. It has frustrated many dollar bears that the greenback hasn’t declined under the profligate printer Bernanke; printing money is supposed to destroy a currency. It has done so repeatedly over the course of history, and it happens for obvious reasons: when you get a bumper crop of something, its price tends to fall. More supply induces lower prices. In this case, it induces a lower price of a currency unit in terms of other currency units.
But that only happens if the relative supply of a currency is changing. If everyone is printing at roughly the same pace, there is no reason that currencies should move at all relative to each other. They should all fall relative to non-printers, or to hard assets. And that’s why it’s even more incredible that commodities are not shooting higher. Yet.
Those effects, in my view, absolutely swamp in importance the weak growth news we’re getting these days. Today, the Philly Fed report and Initial Claims were both quite weak, but the data is going to be polluted by hurricane Sandy for a while and hard to interpret. I don’t think the hurricane had anything to do with this story, or its timing for that matter:
FHA Needs Bailout From Treasury to Plug Budget, Bachus Says
“Nov. 15 (Bloomberg) — The Federal Housing Administration will need billions of dollars in aid from the U.S. Treasury before the end of the year to fill a financial hole caused by defaults on mortgages it insures, House Financial Services Committee Chairman Spencer Bachus said today.
“… The agency is “burning through” its last $600 million and FHA officials have briefed him that they will need a financial backstop within a month, the Alabama Republican said during a press conference in Washington.”
So, we are trying to figure out how to raise a trillion dollars over ten years to start closing the budget gap, but it helps to remember that there are other groups who are going to be bellying up to the bar for a hit of government help. The FHA, the postal service (-$15.9bln this year, although they expect to lose only $7bln next year), probably California before long. We’d better get our act together quickly…but as yet, there is no sign of it. Nice of Bachus to wait until less than a month before the FHA runs out of money to mention this, by the way.
And I haven’t even mentioned the sudden explosion of violence in Israel, which doesn’t give the impression of a fire that will quickly burn out. It may not spin out of control, either, but it bears watching very closely since our influence in the region has significantly ebbed since the change of control in Egypt, our exit from Iraq, and our distancing from Israel.
I don’t think 2013 is shaping up to be a very fun year. But we’re not there yet!
Clearer Communication in the Wrong Quarters
Whether it is that the passage of the U.S. election released Europe to begin fighting amongst themselves again about Greece, or instead that they’ve been fighting the whole time and we just didn’t notice because we were so introspective, it’s certainly happening and heating up again. The Eurozone finance ministers are bickering, publicly, over whether Greece should be given two more years to hit its financial targets. (See articles here and here.) Also, and more importantly, the IMF wants the government owners of Greek bonds to write off some of their losses and lessen the Greek burden while some of the finance ministers (e.g., German Finance Minister Schauble) insist “that’s not legally possible.” Guess what? It’s going to happen whether it’s legally possible or not – but not this month. Greece will probably eventually get its tranche/lifeline this month, but the battle will be engaged with increasing intensity as time goes on.
That, however, is not the reason why stocks keep sliding (S&P -1.4% today) and bonds keep rallying (albeit gently today, with the 10y note yield down to 1.59%). I think that is happening because one week post-election, there is no sign that either Democrats or Republicans are budging on their positions vis a vis the fiscal cliff. The Democrats are winning on messaging, as they usually do these days, with the “Papa John’s Pizza approach” in which they have seized on the part of Romney’s budget proposal that they liked (reducing deductions for high-income taxpayers) while ignoring the connection of that element with the intention to keep tax rates down. I call it the Papa John’s Pizza approach because it reminds me of the commercial with Peyton Manning.
Republicans: So how are we going to do this?
Democrats: We loved Romney’s idea, and we agree with you. We’ll cut deductions.
Republicans: No, no, no, no, no…you mean we’ll cut deductions and keep income tax rates from rising.
Democrats: Right. We’ll cut deductions.
Republicans: …you mean we’ll cut deductions and keep rates from rising.
Democrats: I’m glad we agree. We’ll cut deductions. See how open minded we are? We’re using Romney’s plan!
Say what you want about the class warfare approach, the Democrats run rings around the Republicans when it comes to communication.
One place where better communication is actually destructive, but ironically one of the only places where we’re actually moving towards better communication, is at the Federal Reserve. A Wall Street Journal article today was entitled “Fed Leans Toward Clearer Guidance,” and indicated that “the Fed would state how high inflation would have to rise or how low unemployment would have to fall before it would begin moving rates, which have been near zero since late 2008.” This was the main newsworthy point that Fed Vice-Chair Janet Yellen made yesterday, and it was driven home today in the release of the minutes from the October Fed Meeting:
“A number of participants questioned the effectiveness of continuing to use a calendar date to provide forward guidance….Many participants thought that more-effective forward guidance could be provided by specifying numerical thresholds for labor market and inflation indicators.”
Since June, a “soft” Evans Rule based on this idea has been in place, as I pointed out at the time. It is not terribly surprising that the Fed would move towards a more explicit formulation of the rule, because Fed economists have never figured out why ambiguity is a good thing when it comes to policy-making. If they really do manage to reduce the Fed’s deliberations to a series of simple and public rules, then they should just finish the job and replace the Fed with a computer, as Milton Friedman proposed many years ago.
As I’ve written frequently (and borderline obsessively), clarifying the exact path that the Federal Reserve will take in the future reduces the uncertainty that investors face. This is good in the absence of leverage, but if the opportunity to leverage exists then the decrease of apparent uncertainty causes an increase in the leverage desired by investors. The problem is that a margin of safety doesn’t only protect an investor from known uncertainties, which would decrease in this instance, but also from unknown uncertainties, which would not be affected and for which a margin of safety is absolutely crucial if we desire to avoid another financial market meltdown. But no one is listening to me.
Commodities rose today, despite the continued decline in equities. This is not unreasonable. I think that commodities and stocks are telling two different stories. If there’s a recession, it should hurt stocks and commodities (but more directly should hurt stocks) while further QE3 ought to help them (but more directly help commodities). Right now stocks are going up on QE3 while commodities are going down on the recession … exactly the opposite of what ought to be happening. To my mind that just means the ‘value gulf’ is getting wider and wider. The chart below (Source: Bloomberg) shows the ratio of the S&P total return index to the DJ-UBS index.
Right now there is an enormous loathing for commodities that I don’t really understand – it seems to me to be the bipolar nature of commodities investors that they either love or hate the stuff. It probably comes from the fact that there are no “value” investors in commodities since the theory on what constitutes “value” is so light. Right now it looks to me like stocks are relatively expensive, although they’ve been that way for a while.
For tomorrow’s CPI figures, the consensus forecast calls for an 0.1% rise month/month for both the headline and core indices (seasonally adjusted), maintaining the y/y core increase at 2.0%. Last month, core rose to 1.98%, and we’re ‘dropping off’ a +0.17% on the y/y comparison. If economists are right, and 0.1% is the rounded change in core inflation on the month, then the y/y rise in core inflation will more likely decline to +1.9% than stay at +2.0% (of the possible prints that would lead to +0.1% on the monthly, from +0.05% to +0.149%, anything from +0.05% to +0.129% would cause a downtick in the y/y figure while only monthly changes in the range of +0.130% to +0.149% would keep the number stable.
However, I don’t see what will cause core to droop like that. I think economists are paying too much attention to the last several monthly changes and ignoring the fact that the weak prints were caused by outlier points (as evidenced by the fact that the Median CPI of the Cleveland Fed and the Sticky CPI of the Atlanta Fed, both different measures of central tendency, remain at +2.3% and +2.2% respectively). Moreover, housing CPI – the main driver of core inflation – is accelerating with both primary rents and owner’s equivalent rent rising last month, and all indicators of housing tightness from housing inventories to apartment tightness continue to suggest that higher price increases are more likely than lower price increases ahead. Moreover, we’re seeing upside surprises in other countries, such as in Greece that I mentioned yesterday, the in the UK where core inflation rose to +2.6% y/y versus 2.2% expected (see Chart, Source Bloomberg), befuddling most economists there.
That doesn’t mean the y/y core figure in the U.S. will definitely rise back to +2.1% this month; to do that, core would need to print +0.23% for the month, meaning the main body of the economist profession was off by half. Come to think of it, that’s not so far-fetched. If the last three months of core prints (+0.090%, +0.052%, and +0.146%) are quirky-low, then there should be a payback at some point. It’s hard to call for that in any given month, though.
Conservative Positions For A Liberal World
Wow, where do we begin after a hurricane-induced hiatus? So much has happened. Since I last wrote, the U.S. elections have fallen into the rear-view mirror, the Bank of Japan has increased its asset purchases again, Greek inflation has accelerated to 0.9% from 0.3% (while Greek Industrial Production contracted for the 49th of the last 53 months, illustrating again how helpful it is to look at the growth rate of a country as a guide to deflationary pressures), and the stock market has moved to 3-month lows (and 10y note yields to 2-month lows) while the dollar has strengthened.
By far the largest event of the last couple of weeks, besides the restoration of power to my home, has been the U.S. elections. The immediate weakness in equity markets is completely understandable, but for the most part doesn’t reflect a vote against the President. Real equity market returns will be weaker over the next couple of years, but that’s because current valuation levels are high and future earnings will be lower than they would be under a more capitalist government. I don’t think investors are putting prices lower on that theory; indeed, as I wrote just before Sandy I thought that stocks are more likely to go higher than lower in the short-term with an Obama victory.
But let me define short-term, because in that post I completely neglected the very short-term effect of the days just after an Obama victory. I think an important part of the selling of equities now is reflecting investor realization of tax gains now, versus in the future when capital gains and income tax rates are likely to be at least somewhat, and potentially significantly, higher. That’s not a long-term effect, because those investors will also buy companies they perceive to be relative bargains in the case of a profligate spending policy (which is what everyone agrees we are likely to get – although some people think that’s a good thing; I suppose your own feeling on that matter likely defines how you voted). So this is mostly a cycling of positions, a re-setting of tax basis at a higher level, and shouldn’t amount to a major selloff by itself.
There still may be some net selling while the twin risks of the “fiscal cliff” and the Greek exit from the Euro remain uncertain and near-term. And here is where I am getting somewhat uneasy with my bullish argument (which hinged on the notion that typically myopic investors would prefer a 2013 recession that is shallower, due to heavy government spending, than a deeper one due to a Republican shrinking of government aka “austerity”). I think there are some bigger issues that are hard to look past right now, and they are related to those twin risks I just mentioned.
One of those issues concerns the “fiscal cliff.” Perhaps I am cynical, but I have long expected the issue to be averted at the eleventh hour (as usual – for example, see the annual ‘doc fix’ for Medicare). But it now occurs to me that the Republicans have absolutely no reason to compromise on their demand for no increase in taxes. Under a President Romney, the Republicans would have been able to leverage their control, make a few key concessions, and avert much of the damage. Under a President Obama, forcing the cliff to take effect is now the only way that the minority party of smaller government can force any austerity over the next few years. Especially if you believe – and I think it’s worth considering – that the failure of the Republicans to unseat a President with sub-50% approval ratings and an ~8% Unemployment Rate indicates that the argument is lost that we should take short-term pain in order to restore fiscal sanity, this represents the best remaining hope for fiscal sanity. The only way I can see the Republicans giving in on the ‘fiscal cliff’ is if (a) they sell their principles, which is always a possibility, or (b) the Democrats promise considerable compensation in terms of future legislation. I can’t imagine what that would be. So, in short, I think the odds that there will be a resolution of the ‘fiscal cliff’ have dropped considerably.
The second issue is the one of Greek exit from the Euro. I think I have been very consistent on this issue: I do not believe there is a viable future path in which Greece remains in the Euro. Whether the exit is clean and negotiated or sudden and traumatic or painful and drawn-out is the issue. This has been clear for months, even years, now. Yet, for a couple of months there has been relative quiet on this front, until the last week or two as the Eurogroup considers the distribution of the next aid tranche to Greece. We’ve also stopped hearing much about Spain, Italy, and Portugal although the Spanish 10-year bond yield is creeping back to 6% again (5.88% today). I don’t think this silence heading into the U.S. elections was accidental. The relationship between the U.S. President and the citizens of the world ex-U.S. is a very strong one, and I have no doubt that the politicians in Europe recognized that their chances of getting help from U.S. taxpayers would be much better after November 6th if Obama won re-election. Now that he has, the European issue must be confronted as world growth is weakening again. I have no idea whether the U.S. will try and contribute to a solution (which would ensure a painful and drawn-out resolution in which Greece would still, at the end, leave the Euro), but in any event this set of events is back in motion, and is not positive in the short-term for world growth or equity markets.
So in short, while I still think we can trust the myopia of equity investors to push markets higher over the next couple of months, I am less sure of that than I was. The election was a trigger for a lot of potentially bad outcomes, and with equity markets remaining rich I would certainly be maintaining a conservative risk posture here.
At least something can be conservative.
Kissing Assets Goodbye
No, thanks for asking but the power is not back on, and not likely to be coming back on for some time. But one finds a way – after all, this is the whole point of a “disaster recovery” plan. I won’t be penning many articles in the next few days, but given the circumstances I thought it relevant to comment on disasters and economic growth.
After a hurricane or other natural disaster, there is always a significant confusion among economists about whether the disaster will hurt U.S. GDP, because many consumers and businesses are unable to consume for a period, or help GDP because of reconstruction expenditures.
This is a crazy debate, and it underscores a key shortcoming of economic statistics. The usual economic result is a short-term (a couple of weeks, perhaps, or a month) of softness in private expenditures, followed by an increase in GDP because of rebuilding. Disasters, measured by GDP, are usually additive: that is, growth in the quarter immediately after the event is higher than it would otherwise be, because more money is spent from savings and government expenditures rise (because of explicit relief payments but also because of increases in automatic expenditures such as unemployment claims and other such things).
But that’s clearly nonsense, to the dispassionate observer. The citizen’s welfare, his standard of living, is clearly lower than it was before the disaster; if it was not, we could regularly ignite the economy by destroying buildings and homes and rebuilding them.
Yet, the numbers are not wrong, per se. By definition, GDP=C + I + G + (X-M), and total expenditures clearly rise as savings (public and private) decline in the aftermath of a disaster. The problem isn’t that the numbers, such as they are, are wrong but that there is a deeper philosophical problem. Most economic data measures flows, not levels (the proper term is “stocks,” but I didn’t want to confuse readers by sounding like I was talking about equities – I am not). There is no economic “asset” and “liability” account for the nation. If the disaster occurred to a company instead of to a nation, the company would record an expense for the impairment of an asset (a destroyed building, equipment, etc) as one transaction and then separately record the purchase of a replacement asset (if it was a durable asset, this second transaction would merely exchange one asset, cash, for a durable asset). The net result would clearly be a decline in the net value of the company. But there is no national asset or liability accounts to credit for the destruction of national assets.
And there should be. If policymakers had to focus not on increasing the expenditures of the nation, but on building its “net worth,” I suspect we would see more sensible national policies.
However, that’s not the way it works – but we all know that disasters hurt our economy, whatever effect they have on GDP.
