Hoisington
Quarterly Review and Outlook
– 4Q2015
John Mauldin
Recession
or no recession for the US in 2016? I’m looking at what a lot of people think
about that question, and my good friend Lacy Hunt’s take on it has really added
to the clarity of my own thinking. In today’s Outside the Box, Lacy focuses first on the factors
that made 2015 a disappointing year for the economy, and he points out that we
were losing momentum as the year closed.
At
this point we have to ask, “Why?” Why, after seven years of post-recession
central bank stimulus, a doubling of US federal debt, and humongous
stock-market gains, is the economy still limping along at stall speed? Well,
it’s about that stimulus, says Lacy:
Since the introduction of unconventional and
untested monetary policy operations like quantitative easing (QE) and forward
guidance, an impressive amount of empirical evidence has emerged that casts
considerable doubt on their efficacy. The historical facts regarding the grand
experiment by the Federal Reserve Open Market Committee (Fed) are worth
considering.
Indeed.
Lacy cites a study titled “Persistent Overoptimism About Economic Growth,” by
Kevin J. Lansing and Benjamin Pyle of the Federal Reserve Bank of San
Francisco, published in February 2015. The study systematically examines the
Fed’s forecasting record – a topic I’ve been pounding away on for years, as you
well know. Their conclusion:
Since 2007, Federal Open Market Committee
participants have been persistently too optimistic about future U.S. economic
growth. Real GDP growth forecasts have typically started high, but then are
revised down over time as the incoming data continue to disappoint.
And
the failure of QE, unrelenting forward guidance, and other radical (not to say
desperate) central bank measures has not been limited to the efforts of the
Federal Reserve – the central banks of Europe, Japan, and China have had no
better results.
But
again, “Why?” Why haven’t the best efforts of our earnest central bankers and
their legions of computer-equipped economists turned the global economy around?
A causal mechanism has been needed to explain their failure. And now we have
it, Lacy tells us, in the form of a new book, Growing Global: Lessons for the New Enterprise, by
Michael Spence (2001 recipient of the Nobel Prize in economics) and Kevin M.
Warsh (former governor of the Federal Reserve), published in November 2015.
Here
is their causal argument:
QE is unlike the normal conduct of monetary
policy. It appears to be qualitatively and quantitatively different. In our
judgment, QE may well redirect flows from the real economy to financial assets
differently than the normal conduct of monetary policy…. We believe the novel,
long-term use of extraordinary monetary policy systematically biases
decision-makers toward financial assets and away from real assets.
Financial
assets, huh? Whoodathunkit? Lacy has much more to say on this, um, delicate
subject – all of it worthwhile – but without stealing any more of his thunder,
let me just mention that he will be one of the featured speakers at our
upcoming Strategic Investment Conference, May 24–27 in Dallas. It’s
about time to hop on the bandwagon – if you register by January 31, you’ll save
$500 off the later rate.
And
have I mentioned that, in addition to all the fabulous speakers that are
already on the program, Niall Ferguson and Jim Grant have both just committed
to come to the conference and share their latest views? We’ll be adding another
half-dozen speakers in the next few weeks. We’re still nailing down a few major
names, but it looks like my goal of making sure the conference is better every
year is very attainable.
Now,
without any further personal comments (as is my usual wont), let’s jump into
Lacy’s latest and greatest. You have an excellent week!
Your
didn’t know he could be this busy analyst,
John Mauldin, Editor
Outside the Box
Outside the Box
Hoisington Quarterly Review and Outlook – 4Q2015
A Weak Finish to
a Disappointing Year
The economy was supposed to fire on all cylinders
in 2015. Sufficient time had passed for the often-mentioned lags in monetary
and scal policy to finally work their way through the system according to many
pundits inside and outside the Fed. Surely the economy would be kick-started
by: three rounds of quantitative easing and forward guidance; a record Federal
Reserve balance sheet; and an unprecedented increase in federal debt from $9.99
trillion in 2008 to $18.63 trillion in 2015, a jump of 86%. Further, stock
prices had gained sufficiently over the past several years, thus the so-called
wealth effect would boost consumer spending.
The economic facts of 2015 displayed no impact
from these massive government experiments. The broadest and most reliable
measure of economic performance – nominal GDP – decelerated. The 3% estimated
gain registered in 2015, measured by the year ending quarter, was down from
3.9% and 4.1%, respectively, in 2014 and 2013. In fact the gain in nominal GDP
in 2015 was less than the gain for any year since the recession. The two
components of nominal GDP also decelerated in 2015. Real GDP slowed to 2%, down
from 2.5% in the prior two years, and the implicit price deflator rose by 1%
compared with a 1.4% and 1.6% rise in 2014 and 2013, respectively. All of the
above economic measures were expanding at, or near, their weakest yearly growth
rates in the final quarter of 2015, indicating that the economy possessed
little forward momentum moving into 2016.
Personal consumption, the largest category of
nominal GDP, decelerated to an estimated 3% rise in the latest twelve months,
down from 4% at year-end 2014, the smallest year end annual increase since
immediately after the 2008-09 recession.
The faltering consumer pattern
occurred despite a significant lowering of credit standards that accelerated
automotive lending. The percentage of total auto loans in the subprime category
hit a ten-year pre-crisis high in the third quarter, according to the New York
Fed. In addition, the Affordable Care Act has caused health outlays to surge.
Excluding these two special circumstances, consumer spending was notably weak,
providing additional confirmation that the so-called wealth effect remains
elusive.
Other important economic indicators reported
outright contractions last year. Industrial production slumped 1.4% over the
first eleven months of 2015, with a drop of 2% outside of the automotive
sector. Only about 10% of private payroll employment is accounted for in the manufacturing
sector. This fact distorts the true impact of this critical part on GDP.
According to the Federal Reserve Statistical Release on Industrial Production,
the industrial sector accounts for about one quarter of real GDP on a value
added basis. The importance of this sector to corporate profits is considerably
greater. Not surprisingly, corporate profits registered year-over-year declines
in the latest two quarters available.
According to the BEA, corporate profits
in the latest quarter were below the level reached in the fourth quarter of
2011 (Chart 1). The profits picture is a worrisome portent for 2016 since it
has fallen prior to all the economic contractions since 1929, albeit it has
also had a few false signals.
The 2015 global picture was just as disappointing.
By some measures, worldwide economic growth was the poorest since the last
recession. Reflecting the depth of the underperformance, world trade was
essentially flat for the first time since 2009. Commodity prices, a sensitive
and impartial barometer of global final demand, dropped sharply. At the
December lows, the S&P GSCI Commodity Index was 59% below the April 2011
peak and at the lowest point since December 2004.
The alternative Bloomberg
Commodity Price Index, which is reweighted largely based on futures contract
volume and includes gold, slumped to the worst level since 1999 (Chart 2). As
in the United States, economic growth was ebbing in Japan, China, Canada,
Australia, Europe and virtually all of Latin America as the books closed on
2015. As an indication of the Chinese problem, the Yuan has recently dropped to
the lowest level since 2011. Thus, the global economy confirms that the entry
point for 2016 i s fragile.
Empirical Evidence on the Counter-
productiveness of QE and Forward Guidance
Since the introduction of unconventional and
untested monetary policy operations like quantitative easing (QE) and forward
guidance, an impressive amount of empirical evidence has emerged that casts
considerable doubt on their efficacy.
The historical facts regarding the grand
experiment by the Federal Reserve Open Market Committee (Fed) are worth
considering.
The trend in economic growth in this expansion has
been undeniably weak and perhaps unprecedentedly so. Real per capita GDP grew
only 1.3% in the current expansion that began in mid-2009; this is less than
one half the growth rate in the expansions since 1790 (Chart 3).
Based on their theoretical expectations of QE, the
Fed and multilateral economic agencies (such as the International Monetary
Fund) constantly projected that economic growth would accelerate significantly
and that inflation would return to the 2% level targeted in the Fed’s dual
mandate. These forecasts widely and consistently over-estimated both real
growth and inflation.
The study “Persistent Overoptimism About Economic
Growth” by Kevin J. Lansing and Benjamin Pyle and published in the Federal
Reserve Bank of San Francisco Economic Letter of February 2, 2015
systematically examined the Fed’s forecasting record. Specifically, Lansing and
Pyle examined the real GDP projections made four times per year by the Fed that
began in November 2007. Their overall conclusion reads: “Since 2007, Federal
Open Market Committee participants have been persistently too optimistic about
future U.S. economic growth. Real GDP growth forecasts have typically started
high, but then are revised down over time as the incoming data continue to
disappoint.” Even Mrs. Yellen in her December press conference admitted the
Fed’s models were not working.
Central banks in Japan, the U.S. and Europe tried
multiple rounds of QE. That none of these programs were any more successful
than their predecessors also points to empirical evidenced failure. The pattern
is shown in year-over-year growth in U.S. nominal GDP (Chart 4). Three weak
transitory mini growth spurts all reversed, and the best rate of growth in the
current expansion was weaker than the peak levels in all of the post 1948
expansions.
Several academicians have found that the data does
not validate the efficacy of QE and forward guidance. In a paper presented at
the Fed’s 2013 Jackson Hole Conference, Robert Hall of Stanford University and
Chair of the National Bureau of Economic Research Cycle Dating Committee wrote
“an expansion of reserves contracts the economy.”
Negative interest rates would have the same
non-productive characteristics as QE and forward guidance.
A Causal Mechanism Explaining the Counter-
Productiveness of QE and Forward Guidance
A Causal Mechanism Explaining the Counter-
Productiveness of QE and Forward Guidance
This empirical data notwithstanding, a causal
explanation of why QE and forward guidance should have had negative
consequences was lacking. This void has now been addressed by “Where Did the
Growth Go?” by Michael Spence (2001 recipient of the Nobel Prize in economics)
and Kevin M. Warsh (former Governor of the Federal Reserve), a chapter in a new
book Growing Global: Lessons for
the New Enterprise, published in November 2015 by The Center for
Global Enterprise.
The Spence and Warsh point is that the “the post-crisis
policy response” contributed to and helps to explain the slower economic growth
during the past several years. Their line of reasoning is that the adverse
impact of monetary policy on economic growth resulted from the impact on
business investment in plant and equipment. Here is their causal argument:
“...QE is unlike the normal conduct of monetary policy. It appears to be
qualitatively and quantitatively different. In our judgment, QE may well
redirect flows from the real economy to financial assets differently than the
normal conduct of monetary policy.” In particular, they state: “We believe the
novel, long-term use of extraordinary monetary policy systematically biases
decision-makers toward financial assets and away from real assets.”
Quantitative easing and zero interest rates
shifted capital from the real domestic economy to financial assets at home and
abroad due to four considerations:
First, financial assets can be short-lived, in the
sense that share buybacks and other financial transactions can be curtailed
easily and at any time. CEOs cannot be certain about the consequences of
unwinding QE on the real economy. The resulting risk aversion translates to a
preference for shorter-term commitments, such as financial assets.
Second, financial assets are more liquid. In a
financial crisis, capital equipment and other real assets are extremely
illiquid. Financial assets can be sold if survivability is at stake, and as is
often said, “illiquidity can be fatal.”
Third, QE “in effect if not by design” reduces
volatility of financial markets but not the volatility of real asset prices.
Like 2007, actual macro risk may be the highest when market measures of
volatility are the lowest. “Thus financial assets tend to outperform real
assets because market volatility is lower than real economic volatility.”
Fourth, QE works by a “signaling effect” rather
than by any actual policy operations. Event studies show QE is viewed
positively, while the removal of QE is viewed negatively. Thus, market
participants believe QE puts a floor under financial asset prices. Central
bankers might not intend to be providing downside insurance to the securities
markets, but that is the widely held judgment of market participants. But, “No
such protection is offered for real assets, never mind the real economy.” Thus,
the central bank operations boost financial asset returns relative to real
asset returns and induce the shift away from real investment.
Additional empirical evidence, cited by Spence and
Warsh, supports these fundamental arguments. From 2007 to 2014 gross private
investment registered extremely substandard growth. Growth in nonresidential
fixed investment fell substantially below the last six post-recession
expansions. Spence and Warsh calculate that S&P 500 companies spent
considerably more of their operating cash flow on financially engineered
buybacks than on real capital expenditures in 2014; this has not happened since
2007. According to them, during the past five years, earnings of the S&P
500 have grown about 6.9% annually, versus 12.9% and 11.0%, respectively, from
2003-2007 and 1995-1999. Inadequate real investment means demand for labor is
weak. Productivity is poor, which in turn, diminishes returns to labor.
According to a Spence and Warsh op-ed article in the Wall Street Journal (Oct.
26, 2015), “... only about half of the profit improvement in the current period
is from bu siness operation; the balance of earnings-per-share gains arose from
record levels of share buybacks. So the quality of earnings is as deficient as
its quantity.”
Do Decision Makers Need to Understand the
Transmission Mechanism?
Do Decision Makers Need to Understand the
Transmission Mechanism?
It is quite possible that corporate decision
makers do not understand the relationships that cause QE and forward guidance
to redirect resources from real investment to financial investment. It is also
equally likely these executives do not understand that this process reduces
economic growth, impairs productivity and hurts the rise in wage and salary
income. But, does a lack of understanding of economic theory by key market
participants render the causal relationships invalid?
Spence and Warsh elegantly argue corporate
executives do not need to know these fundamental relationships. Here is their
key passage: “ Market participants may not be expert on the transmission
mechanism of monetary policy, but they can deduce that the central bank is
trying to support financial asset prices. The signal provided by central banks
might be the essential design element.” Real assets market participants simply
need to know that the central bank does not offer such protection. In other
words, the corporate managers merely need to realize that one asset group is
protected and the other is not.
The Asymmetric State of Monetary Policy
The Asymmetric State of Monetary Policy
Our assessment is that monetary policy has no
viable policy options that are capable of boosting economic activity should
support be needed. In fact, the options available to the central bank, at this
stage, are likely to be a net negative.
This, however, does not mean that
conventional and tested monetary operations that are designed to restrict
economic activity and inflation are ineffectual. In fact, standard restraining
operations remain effective. Monetary restraint may even be more effective than
historically because of the extreme debt overhang of the U.S. economy. The
increase in short-term interest rates that the Fed has thus far achieved is
small, but public and private debt stands at 375% of GDP, far above the
historical average of 189.4% from 1870 to 2014. Thus, the higher cost
reverberates much more significantly through the U.S. economy.
The extremely high level of debt suggests that the
debt is skewed to unproductive and counterproductive uses. Debt is only good if
the project it finances generates a stream of income to repay principal and
interest. There are two types of bad debt: (1) debt that does not generate
income to repay interest and principal (Hyman Minsky, “The Financial
Instability Hypothesis”); and (2) debt that pushes stock prices higher without
a commensurate rise in corporate profits (Charles P. Kindleberger, Manias, Panics and Crashes).
When the composition of debt is adverse, less flexibility exists for the end
users of the debt to absorb the higher costs engineered by the Fed. Even if
this is not the case, the small increase in the federal funds rate serves to
shift both money growth and velocity downward, which has the effect of
weakening nominal GDP at a time when it is already slow and decelerating.
Prior to the Fed’s December rate hike M2 grew at
annual rates of 5.3% and 5.6%, for the three and six month perods,
respectively. Subsequent to the Fed’s change in policy, three conventional
monetary influences have turned more restrictive. First, in the reserve
maintenance period ending January 6, the monetary base, as measured by the
Federal Reserve Bank of St. Louis, dropped $258 billion, versus the reserve
period immediately prior to the Fed rate hike. Consequently, the base was at
the lowest level since October 2013, when the Fed was still executing QE3.
The
base, as measured by the Federal Reserve Board, registered a slightly larger
contraction of $294 billion. Second, the Federal funds rate rose by about
0.25%, from roughly 0.125 to 0.375%. Third, the short to intermediate Treasury
note yields rose relative to the ten-year and thirty-year Treasury security
yields. Thus, the yield curve between the two-year and ten-year Treasury notes
as well as the between the two-year note and thirty-year treasury bond
flattened considerably.
All three of these actions will, in time, serve to
lower M2 growth and reduce the velocity of money. The absorption of reserves
places downward pressure on M2 growth, while the higher short-term rates
encourages households and businesses to minimize transactions balances. The
higher short- and intermediate-term yields encourage households to save a
little more by spending less. The flatter yield curve reduces the earnings
potential of the depository institutions, which, in turn, reduces the lending
directly and M2 indirectly. Thus, the Fed tightening could serve to push M2
annual growth toward 5% or below. If velocity continues to remain in the persistent
3% downward trend, nominal GDP’s growth rate could fall to 2%, a third lower
than in 2015. This leaves little room for a sustained acceleration in either
real growth or inflation.
The flatter yield curve is also a reliable leading
indicator of economic activity, as well as the above-mentioned source of
monetary restraint. A rise in short-term rates relative to the long ones is an
indication that investors expect economic activity and/or inflation to fall in
the future. Such an expectation is consistent with the likely trends in M2,
velocity and nominal GDP.
Treasury Bond Yields
Treasury Bond Yields
With the trajectory in the nominal growth rate
moving down, U.S. Treasury bond yields should work lower, thus reversing the
pattern of 2015 and returning to the strong downtrend in place since 1990. In
the United States, ten- and thirty-year yields are considerably more attractive
than in virtually all of the major industrialized countries (Table 1). At year
end 2015, the U.S. thirty-year Treasury bond yield was 154, 176 and 240 basis
points higher, respectively, than in Germany, Japan and Switzerland. The U.S.
thirty-year Treasury yield was even 88 basis points higher than in Canada.
These wide differentials indicate that ample downside still exists for longterm
U.S. Treasury bond yields to decline since the attractive U.S. yields should
incent global investors to continue to move funds into the United States.
A firm dollar should serve to depress price levels
in the United States and restrain the already low pace of domestic inflation. A
stabilization of the oil price around current levels could cause the
year-over-year increase in the consumer price index (the base effect) to move
up from 0.4% currently to around 1.2% this winter, since oil prices will not be
as much of an offset to government controlled prices such as medical care,
utility bills, taxes or artificially calculated prices captured by home owners’
equivalent rent. This base effect of oil on the CPI, however, will reverse in
the late spring and summer and be reinforced by a firm dollar that will have a
much more lasting effect on domestic inflation. Moreover, the 34% rise in the
dollar from May 2011 has not been fully captured in the imported non-oil prices
which have only declined by a mere 3.4%. The pipeline of foreign goods for the
U.S. is likely to be filled with lower priced goods for a considerab le time.
The minimal adjustment of non-oil import prices relative to the higher dollar
indicates that the damage to the trade balance and corporate profits is far
from complete. Thus, poor foreign business conditions will continue to be a
drag on domestic economic activity while depressing inflation.
The firm dollar will remain a restraining force on
economic activity and should cause the year-over-year increase in the CPI to
reverse later in the year. Under such circumstances, lower, rather than higher,
inflation remains the greater risk.
Such conditions are ultimately consistent
with an environment conducive to declining long-term U.S. Treasury bond yields.
In short, we believe that the long awaited secular low in long-term Treasury
bond yields remains ahead.
Van R. Hoisington
Lacy H. Hunt, Ph.D.
Lacy H. Hunt, Ph.D.
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