E-piphany

An uneducated fellow was laid up in bed with a broken leg. The vicar’s wife, visiting him, asked what he did to pass the time, since he was unable to read and couldn’t leave the bed. His answer was “sometimes I sits and thinks, and sometimes I just sits.”[1]

The reason I haven’t written a column since the CPI report is similar. Sometimes I sits and writes, and sometimes I just sits.

That isn’t to say that I haven’t been busy; far from it. It is merely that since the CPI report there really aren’t many acts left in the drama that we call 2015. We know that inflation is at 6-year highs; we know that commodities are at 16-year lows (trivia question: exactly one commodity of the 27 in the Goldman Sachs Commodity Index is higher, on the basis of the rolling front contract, from last year. Which one?)[2]

More importantly, we know that, at least to this point, the Fed has maintained a fairly consistent vector in terms of its plan to raise interest rates this month. I maintained after the CPI report that the Chairman of the Federal Reserve, and at least a plurality of its voting members, are either nervous about a rate hike or outright negative on the desirability of one at this point. I still think that is true, but I also listen. If the Fed is not going to hike rates later this month, then it would need to telegraph that reticence well in advance of the meeting. So far, we haven’t heard much along those lines although Yellen is testifying on Thursday before the Congressional Joint Economic Committee; that is probably the last good chance to temper expectations for a rate hike although if the Employment data on Friday are especially weak then we should listen attentively for any scraps thereafter.

The case for raising rates is virtually non-existent, unless it is part of a policy of removing excess reserves from the financial system. Raising rates without removing excess reserves will only serve to accelerate inflation by causing money velocity to rise; it will also add volatility to financial markets during a period of the year that is already light on market liquidity, and with banks providing less market liquidity than ever. It will not depress growth very much, just as cutting rates didn’t help growth very much. So most of all, it is just a symbolic gesture.

I do think that the Fed should be withdrawing the emergency liquidity that it provided, even though the best time to do that was several years ago. Yes, we know that Chinese growth is slowing, and US manufacturing growth is slowing – the chart below, source Bloomberg, shows the ISM Manufacturing index at a new post-crisis low and at levels that are often associated with recession.

To be fair, we should observe that a lot of this is related to the energy sector, where companies are simply blowing up, but even if the global manufacturing sector is heading towards recession, there is no need for emergency liquidity provision. Actually, as the chart below illustrates, banks have less debt as a proportion of GDP than they have in about 15 years.

Households have about as much debt as they did in 2007, but the economy is larger now so the burden is lower. But businesses have more debt than they have ever had, in GDP terms, other than in the teeth of the crisis when GDP was contracting. In raw terms, there is 17% more corporate debt outstanding than there was in December 2008. Banks have de-levered, but businesses are papering over operational and financial weakness with low-cost debt. Raising interest rates will cause interest coverage ratios to decline, credit spreads to widen, and net earnings to contract – and with the tide going out we will also find out who has been swimming naked.

In 2016, if the Fed goes forward with tightening, we will see:

• Lower corporate earnings
• Rising corporate default rates
• Rising inflation
• Lower equity prices; higher commodity prices
• Banks vilified. I am not sure why, but it seems this always happens so there will be something.

All of that, and raising rates the way the Fed wants to do it – by fiat – does not reduce any of the emergency liquidity operations.

To be clear, I don’t see growth collapsing like it did in the global financial crisis. Banks are in much better shape, and even though they cannot provide as much market liquidity as they used to – thanks to the Volcker rule and other misguided shackles on banking activities – they can still lend. Higher rates will help banks earn better spreads, and there will be plenty of distressed borrowers needing cash. Banks will be there with plenty of reserves to go. And if the financial system is okay, then a credit crunch is unlikely (here; it may well happen in China). So, we will see corporate defaults and slower growth rates, but it should be a garden-variety recession but with a deeper-than-garden-variety bear market in stocks.

The recipe here is about right for something that rhymes with the 1970s – higher inflation (although probably not double digits!) and low average growth in the real economy over the next five years, but not disastrous real growth. However, that ends up looking something like stagflation, which will be disastrous for many asset markets (but not commodities!) but doesn’t threaten financial collapse.

[1] This story is attributed variously to A.A. Milne and to Punch magazine, among others.

[2] Cotton is +3% or so versus 1 year ago.