Technology Today & Tomorrow

January 31, 2019 (Thursday)

Strategy: Something for Worriers. The S&P 500 is one of the 10 components of the Index of Leading Economic Indicators (LEI). The LEI stalled during the last three months of 2018—falling 0.3% in October, rising 0.2% in November, then falling again by 0.1% in December. The drop in stock prices accounted for much of that weakness. The rebound in the S&P 500 so far in January is a relief.

However, the selloff late last year and the partial government shutdown early this year depressed the expectations sub-index of the Consumer Optimism Index (COI) during January (Fig. 1). This is the average of the expectations components of the Consumer Sentiment Index (CSI) and the Consumer Confidence Index (CCI). That average is also one of the LEI indicators, and it has fully reversed the jump it took after Trump was elected president.

The good news is that the current conditions component of the COI remains at a cyclical high, edging down only slightly during January. That reflects the continued strength in the labor market. So does the 213,000 increase in ADP payrolls during January.

However, if you are a worrier, then you can certainly worry about the ratio of the current conditions and expectations components of the CCI, which tends to spike higher at the start of recessions, as it did this month (Fig. 2). It also tends to spike after a bear market has started (Fig. 3).

Debbie and I expect that expectations will rebound along with stock prices, assuming that there isn’t another government shutdown in the offing. We also expect that an amicable resolution in the US-China trade talks will boost stock prices and consumer confidence.

Helping to boost sentiment for both stock investors and consumers is yesterday’s decision by the FOMC to pause rate-hiking. Yesterday’s FOMC statement didn’t include the 12/19 statement’s language that “further gradual increases” in interest rates were warranted. Instead, a more cautious approach was signaled: “In light of global economic and financial developments and muted inflation pressures, the Committee will be patient as it determines what future adjustments to the target range for the federal funds rate may be appropriate to support these outcomes.”

In a separate statement released yesterday too, the FOMC also signaled a more flexible approach to QT, i.e., the paring of the Fed’s balance sheet: “The Committee is prepared to adjust any of the details for completing balance sheet normalization in light of economic and financial developments.” At 2681, the S&P 500 is now up 14.0% from the 12/26 low of last year, and is only another 9.3% gain away from its 9/20 record high of 2930. Our year-end target of 3100 is looking more achievable.

Tech I: A Slowdown Arrives. Wall Street was braced for bad news from the Titans of Tech, and they got it this week. Apple phone sales slowed. Intel’s forecast for chip sales into the cloud servers disappointed, as did AMD’s Q1 revenue forecast. Much of the blame was laid on a stronger dollar, excess inventory, and slower sales in China. Meanwhile, Nvidia warned that Q4 would come in far shy of expectations.

The damage has been intense. Intel’s share price is down 18.5% from its June high through Tuesday’s close. Apple’s has lost about a third of its value since October. AMD’s has dropped 41%, and NVIDIA’s has suffered the most damage, having dropped 54% since October. Some of the shares did rally after the earnings reports hit the market this week, indicating that much of the negative news was already baked into share prices.

Given the severe drops, one must still wonder whether all the bad news is priced into the shares. The slowdown in China could continue. China’s GDP has slowed from 12.2% y/y during Q1-2010 to 6.4% during Q4-2018, and the China MSCI stock price index (in yuan) is down 22.7% y/y (Fig. 4 and Fig. 5). The slowdown in smartphone and server sales could reflect saturated markets for these devices. Even if the US-China trade war is resolved amicably, tech companies may have concluded that they need to spend more on diversifying their supply chains out of China.

Our guess is that things often take longer to unwind than expected. And these shares, while down sharply from their highs, are still up tremendously over the past three years: AMD (825.5%), NVIDIA (369.2), Apple (64.4), and Intel (55.3) as of Tuesday’s close.

Semiconductor sales have just begun to fall on a m/m basis using a three-month moving average (-1.1% in November) and are still up y/y (9.8% in November), according to the Semiconductor Industry Association report (Fig. 6). Month-over-month declines are occurring in two geographic areas: The Americas (-2.2% to $9.5 billion) and China (-2.7% to $14.0 billion). Some managements weren’t sounding very optimistic on their conference calls this week. Let’s take a quick look at some of the highlights:

(1) Intel reported that Q4 revenues rose 9% but came in shy of analysts’ expectations ($18.7 billion vs $19.0 billion). Intel’s Q1 forecast of around $16 billion also disappointed compared to analysts’ forecast for $17.4 billion of revenue. Analysts were expecting Q1 EPS of $1.01, and the company said 87 cents a share was likely. For the full year, Intel warned investors to expect revenue growth of less than 1%.

Intel, which is still looking for a CEO, blamed the shortcoming on a number of factors including “dramatically weakening modem demand, lower overall growth in China, cloud service providers absorbing capacity and a weakening NAND pricing environment,” said Interim CEO and CFO Bob Swan. He pinned the weaker modem demand on weaker smartphone demand and expected sales into cloud service providers to pick up in H2-2019.

Swan also noted that the environment had worsened since October: “Since that time, trade and macro concerns, especially in China have intensified. Cloud service providers shifted from building capacity to absorbing capacity and the demand pricing environment has further deteriorated. Those incremental headwinds are impacting our revenue expectations and slightly reducing our operating margin percentage forecast.”

(2) AMD. While Intel told investors to expect 2019 revenue growth of less than 1%, AMD forecast a high-single-digit revenue increase for this year. Granted, that’s slower than the 23% revenue growth AMD posted in 2018, and much of the projected improvement would come in H2, which is always dangerous to count on. Nonetheless, investors jumped on the news and sent AMD shares up 20% on Wednesday.

The company warned that Q1 revenue could drop about 24% y/y due to excess inventory in the graphics channel, a lack of blockchain-related revenue, and lower memory chip sales. The company didn’t call out the weakness in the cloud business that Intel mentioned. Server unit shipments more than doubled in Q4, boosting the company’s server unit share to mid-single-digit levels.

Amazon announced it will offer AMD’s chip as an option in its Elastic Compute Cloud service. “Businesses can easily migrate … to AMD and save 10% or more based on the technology advantages of our platform,” said CEO Lisa Su in the Q4 conference call. AMD’s new line of seven nanometer chips may give it a technological advantage over Intel for the first time in a decade, a 1/30 MarketWatch article stated. Intel, conversely, has had difficulty rolling out its 10 nanometer chips.

“Our story is really a share gain story. … We feel very good about the opportunity to gain share as we go through the year, particularly given how competitive the product set is,” said Su.

(3) Nvidia, the chip maker, reduced its fiscal Q4 revenue forecast to roughly $2.2 billion from prior guidance of $2.7 billion. That news followed company guidance in November that was below analysts’ expectations. CEO Jensen Huang cited in a letter to shareholders three areas that resulted in the disappointing fiscal Q4 results: Cryptocurrencies, China, and data centers.

Nvidia already had warned investors in November that Q4 results would be hurt by excess inventory of chips sold to customers in the cryptocurrency business. It expects the inventory overhang to be depleted between February and April. The price of bitcoin is down 82% from its high of $18,961 on December 18, 2017, putting a damper on the craze (Fig. 7).

As the economy decelerated in China and around the world, Huang told shareholders, consumer demand for Nvidia’s gaming chips declined. “China accounts for about 20% of Nvidia’s revenue,” the 1/28 WSJ reported. Finally, “[a]s the quarter progressed, [data center] customers around the world became increasingly cautious due to economic uncertainties. A number of deals did not close in the last month of the quarter,” the CEO explained.

(4) Apple. Investors were braced for the worst, and that’s what they got when Apple reported its fiscal Q1 earnings on Tuesday night. However, because the results weren’t worse than expected, the shares rallied almost 7% on Wednesday.

The December quarter’s revenue dropped 4.5% y/y to $84.5 billion, and operating income dipped to $23.3 billion from $26.3 billion a year earlier. The company also forecast weaker-than-expected results for its March quarter: revenue of $55 billion to $59 billion, versus analysts’ consensus estimate of $59 billion and the year-ago $61.1 billion.

Sales of the iPhone dropped to $51.98 billion in the December quarter, down from $61.1 billion in the year-ago quarter. The drag came from Greater China, where total sales fell 27% and iPhone shipments 22% per a 1/29 WSJ article. Blamed were iPhone launch timing, consumers holding onto their iPhones for longer periods, the strong dollar, supply constraints on certain products, macroeconomic conditions in emerging markets, and fewer iPhone subsidies for consumers. The JP Morgan trade-weighted dollar was up 4.9% at the end of Q4 versus a year ago (Fig. 8).

The bright spots of the quarter included services revenue growth of 19%, with a 40% jump in cloud services revenue.

(5) Much damage done. The S&P 500 Semiconductors stock price index is down 31% from its March 12, 2018 high, but the index is still 155% above the lows in hit in 2015 (Fig. 9). Analysts have cut earnings estimates over the past three months and now expect the industry’s earnings to decline by 6.2% this year (Fig. 10 and Fig. 11).

The one thing the S&P 500 Semiconductors industry has going for it is valuation. The industry’s forward P/E is 12.0, down sharply from a high of 16.5 in November 2017 (Fig. 12). In years past, that has often been a profitable level at which to buy this industry’s shares (Fig. 13).

(6) Future is bright. Future technologies that require semiconductors and should fuel the industry’s growth include the 5G rollout, artificial intelligence, and autonomous driving. Intel’s Swan noted that the demand for computing power, storage, and retrieval continues to grow. The bad news is that demand still might take a while to catch up with supply.

Tech II: The Future Is Now. Many of the technologies we have written about are already being used in Shenzhen, a Chinese city with 13 million people that’s just across a river from Hong Kong. A 1/24 video by Bloomberg BusinessWeek’s Ashlee Vance does a great job showing the pros and the cons of a future that has already arrived in this high-tech hub. Some salient points:

(1) Payments. Cash is a thing of the past in Shenzhen. So are credit cards. Purchases are made by scanning QR codes with a smartphone. It works for groceries, at restaurants, for bike rentals, and even to pay street performers.

The drawback: The transactions occur over two dominant payment systems—Alipay and WeChat—which the Chinese government can access. The government will use the data from these payment systems to track behavior, presumably as part of their Social Credit Score system to rank people on their “obedience.”

A foreigner working in China told Vance a disconcerting anecdote: The face-recognition software in the Chinese government’s camera surveillance system had spotted him jaywalking; within 20 seconds, a fine was taken directly out of his WeChat account—without the jaywalker’s authorization!

(2) Robots. Vance visited Zowee’s huge smartphone manufacturing facility, which has company-sponsored housing right next door. Some employees are developing robots that can manufacture smartphones from start to finish, requiring only one human to inspect the final product. By using robots, Zowee aims to improve product quality, decrease costs, and fend off low-priced competition from Southeast Asia. Just how China’s large labor force will adjust to the onslaught of robots is not addressed.

(3) Internet freedom? The Chinese government also controls much of the Internet. Most US websites are blocked, and in their places are Chinese equivalents that the government can monitor. Instead of shopping on Amazon, Chinese go to JD.com or Taobao. There are Baidu instead of Google, Youku and iQiyi instead of YouTube, and WeChat instead of Facebook.

The government can be bypassed by using a VPN to access Instagram and other western sites. Some young Chinese are reportedly using this route. It will be interesting to see how long they’re given the freedom to do so.

Tech III: Dystopia. Last year in a 10/4 speech, Vice President Mike Pence observed: “And by 2020, China’s rulers aim to implement an Orwellian system premised on controlling virtually every facet of human life—the so-called ‘Social Credit Score.’ In the words of that program’s official blueprint, it will ‘allow the trustworthy to roam everywhere under heaven, while making it hard for the discredited to take a single step.’”

China is barreling headlong into the future, led by technological innovations. Sadly, the government sees its role expanding dramatically. Instead of a tech-led Utopia, China is heading toward a tech-led Dystopia. Bill Gates invented the Disk Operating System (DOS). China is creating the Digital Orwellian State (DOS).

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The Global Birth Dearth

January 30, 2019 (Wednesday)

US Demography I: A Drag on Housing. There is some good news and some bad news in the latest data on US household formation. The good news is that the number of households is increasing, led by owner-occupiers rather than by renters. That should be good for both new and existing single-family home sales. The bad news is that some of this relatively new cyclical trend in household formation may simply reflect the secular trend of people living longer, resulting in longer lifetimes for households. The change in households reflects new minus terminated households. If fewer are terminating, the net will increase. Consider the following:

(1) Household count increasing, led by owner-occupiers. Over the past four quarters through Q3-2018, the number of households rose by 1.56 million, led by a 1.50 million increase in owner-occupiers of their homes, while the number of renting households rose only 60,000 (Fig. 1 and Fig. 2).

(2) Baby Boomers living longer. Annual data available through 2017 show that the number of owner-occupied households 65 years old and older rose by 4.4 million from 2011, when the oldest Baby Boomers first turned 65 (Fig. 3). They accounted for 31.0% of all owner-occupied households, up from 26.2% during 2011 (Fig. 4). The Millennial cohorts remained near their 2016 lows during 2017 at 11.7 million for the under 35 crowd and 15.5 million for the 35-44 group of owner-occupied householders.

(3) A shortage of housing. The longer lives of the Baby Boomers may be weighing on the supply of existing homes for sale. In turn, the tight supply of these homes is depressing sales (Fig. 5). Of course, not only are fewer houses for sale but also their rising prices reduce their affordability for first-time homebuyers (Fig. 6). The rise in mortgage rates last year exacerbated the affordability problem. The recent drop in those rates should help, but the tight supply may be driven by the demographics of people living longer and staying put in their homes.

(4) A glut of houses. While home prices have been rising in response to the shortage of inventory, they could soon start to flatten or decline if more Baby Boomers retire and decide to sell their homes. Their kids are now young adults with their own households, so it may be time for the Baby Boomers to turn into minimalists. The problem is that the demand for their homes may by stymied by the minimalist tendencies of the Millennials.

US Demography II: Millennials Aren’t Procreating Enough. According to a report from Bloomberg, women between the ages of 25-34 accounted for 46% of the gains in the prime-age labor pool in the US from 2015 until December 2018. That may be good news for the labor force for now. But it could also signal further delays in child-rearing among these young women.

An Evercore ISI analysis found that the increase was driven by single mothers, while married women without kids came in second. The fact that women getting married later is a critical factor behind declining fertility rates comes as no surprise. Also, couples today may simply have a cultural proclivity toward smaller families. These developments would certainly explain why the number of live births in the US over the 12 months through March totaled just 3.8 million, the lowest pace since 1997 (Fig. 7).Here are a few more relevant points:

(1) Too late to reproduce? The oldest Millennials are now in their late 30s, the women nearing the end of their reproductive years. Even the promise of treatments involving medication and in vitro fertilization can only skew the stats so far. Those who have delayed having children will soon need to decide whether to have any at all in their lifetimes.

(2) Debunking a fertility rebound. Is it possible that many Millennials could change their minds on having kids, causing a reversal in the US fertility rate? A 9/26 article in Forbes observed that the US Social Security Trustee’s Report’s projections “assume that the total fertility rate rebounds from its present 1.76 back up to 2.0 births per woman.” That’s possible. However, a 2018 report by the Center for Retirement Research also mentioned in the article—titled “Is the Drop in Fertility Temporary or Permanent?”—debunked expectations of a fertility rebound.

The report disproved any relationship between the latest recession and delays in having children. It attributed the drop in the US rate to the following, among other factors: increased education levels, which is correlated with lower fertility; the decline in religious practice, as less religious women tend to have lower fertility rates; and the decline in the wage gap (between men and women), as the opportunity costs of having children have increased. None of these trends are likely to be temporary.

Global Economy: Does Declining Fertility Matter? Fertility rates around the world have fallen below a level that can support population growth. The global average total fertility rate of 4.7 children per woman of child-bearing age in 1950 fell to 2.4 in 2017, according to a comprehensive November 2018 global health study published in The Lancet medical journal (Fig. 8). All countries and territories examined in the study saw declines in the total fertility rate, which represents the average number of children a woman would have if she lived through all her reproductive years.

The latest rate of 2.4 is just above the 2.1 rate considered necessary for a population to sustain itself absent other factors. That is slightly higher than the 2.0 parent-replacement rate, because not all children survive past childhood and babies are slightly more likely to be male (so the number of males doesn’t line up with the number of females 1:1).

Does that mean that some countries around the world are doomed to population decline? Before older people meet their demise, will some countries lack enough working-age people to support them? For those countries, would that spell social and economic disaster?

In the US, immigration is a big offsetting factor to declining fertility. For countries with stricter immigration policies like China, the decline in the fertility rate is a much bigger problem. I’ve been saying it for a while, and I’ll say it again: “China is destined to become the world’s largest nursing home.” Today, I’ve asked Melissa to further explore the global decline in fertility and what that means for the global economy:

(1) What areas are below replacement? Fertility rates by region may indicate which populations are sustainable and which are not. The US fertility rate is 1.8 children per woman, which is not much higher than China’s rate of 1.5 (Fig. 9 and Fig. 10). In Western Europe, the rate is 1.6 (Fig. 11).

Despite reductions in the total fertility rate, the global population has increased by 197.2% since 1950, from 2.6 billion to 7.6 billion people in 2017 (Fig. 12). That has been driven by the growing proportion of the global population in sub-Saharan Africa and South Asia. The study reported that these regions have total fertility rates of 4.6 and 2.3, respectively.

(2) Where are the working-aged? The fertility rate is important not only as a predictor of total population growth but also as a determinant of population-age composition. But it is not the only factor, as discussed below. Nevertheless, population-age composition is a critical driver of a nation’s ability to achieve and maintain economic prosperity. Societies that lack a robust and flourishing working-age population to support younger and older dependents at any point in time are unlikely to perform as well as those that do.

Populyst, an independent website focused on demographic trends, reviewed working-age population data around the world starting from 1960 and projected to 2100 in a 2015 post. These data were compiled from the 2015 edition of the UN’s “World Population Prospects.” The post analyzed the annual rate of change in the population aged 15-64 for various regions.

It showed the following growth rates for 1960-1990, 1990-2015, 2015-2050, and 2050-2100: US (1.3%, 1.0%, 0.3%, 0.2%), Europe (0.7, 0.1, -0.6, -0.2), and China (2.5, 1.1, -0.7, -0.8) (Fig. 13, Fig. 14, and Fig. 15). Thus, the US working-age-population will grow for the rest of the century, but at a much lower rate than in earlier years. “Barring a massive inflow of immigrants or a sharp rise in the birth rate,” the working-age population of Europe will decline steadily for the rest of this century. Over the same timeframe, the growth in China’s working-age-population will decline sharply.

(3) Is migration the silver lining? Population growth is determined not only by fertility but also by mortality and migration. Longer life spans account for the population growth in regions where the fertility rate has fallen below the replacement rate. Longer life spans along with lower fertility rates have resulted in aging populations around the world. The demographic key to economic growth is working-age population growth. In regions where fertility rates have declined, immigration is an important balancing factor.

The US is one of those places where immigration has been a crucial offset to population decline. But in regions like Europe and China, immigration policies have been more restrictive. An expert quoted in a 12/26 article in The Guardian shared an interesting view on Europe’s challenges: “I believe that one of the reasons why Angela Merkel took the million refugees was because she desperately needed to boost her working population.”

Data from the UN’s “World Population Prospects: The 2017 Revision” confirms that the US’s net migration rate, at 2.9 for 2010-2015, significantly exceeds Europe’s (at 1.1) and China’s (-0.2). From 1999-2000, the US rate was all the way up to 6.3. The net migration rate represents the number of immigrants minus the number of emigrants over a period, divided by the person-years lived by the population of the receiving country over that period. It is expressed as average annual net number of migrants per 1,000 people in the population.

(4) More Chinese grandparents than children? Especially without immigration to save the day, the damage done from China’s recently lifted “one-child” policy may be insurmountable. The medical journal’s study shows that for every 100 girls born in China in 2017, there were 117 boys born, implying “substantial sex-selective abortion and even the possibility of female infanticide.” One can safely assume that the sex ratio was skewed even more male over the years when the one-child policy was in effect (1979-2015). As a result, there may not be enough reproductive-age women in the foreseeable future to overcome the decline in the fertility rate.

The working-age population in China has already started to decline, which “has an immediate effect on economic growth potential,” observed the study’s author Dr. Christopher Murray, director of the Institute for Health Metrics and Evaluation at the University of Washington, according to a CNN article.

Brookings sounded the alarm about China’s pending demographic demise back in 2010 in an article titled “China’s Population Destiny: The Looming Crisis.” Brookings’ observations are becoming reality today: “Such a compressed process of demographic transition means that, compared with other countries in the world, China will have far less time to prepare its social and economic infrastructure to deal with the effects of a rapidly aging population. … While China continues to transform itself from an agrarian to an industrial and post-industrial society and from a planned to a market-based economy, it … will need … to provide health care and pensions for a rapidly growing elderly population.”

(5) Why have less children? But why have fertility rates declined in nations without population-control policies as seen in China? Reporting on The Lancet study, the BBC collected insights from women around the world who decided to have fewer or no kids. Several of the reasons cited were as follows: wanting to give fewer children “the best” rather than spreading resources among multiple children, the ability to afford vacations, concern for the effect of population growth on the environment, and career-minded focus over family. By the way, lower teen births were cited in multiple sources as a “good” reason why fertility rates have declined.

Aside from couples’ greater control over their reproductive capacity with the advent of birth control in the 1960s, pursuing higher education later in life and prioritizing work seem to us to be the most prevalent reasons for US families to have fewer children. Moreover, many working women don’t have parental leave and pay policies at work—or generous enough ones—to make having a lot of children economically feasible.

Even if the baby bust suddenly reverses, that won’t help the working-age population in the near term, as more babies will add to the number of dependents who need to be supported for at least the next couple of decades.

(6) Are the children our future? Will the future of our societies be held in the hands of those who more frequently procreate? The late Swedish professor and demographic expert Hans Rosling was quoted in a 3/16/17 BBC article saying that fertile countries have a far brighter future. And as such, they are a good place to invest. We agree that declining fertility rates are an important trend for global investors to monitor, but focusing only on that may be short-sighted.

The 12/26 article in The Guardian linked above explored the views of Sarah Harper, an expert on population change working at the University of Oxford. Harper pointed out that artificial intelligence, migration, and a healthier old age mean that countries can grow economically without booming population growth.

The bottom line is that declining fertility rates may not be the end of the world for many countries, especially those that have more relaxed immigration policies. Even countries with high fertility rates may not have the resources to raise all those babies to productive adults. Education, infrastructure, and technology matter for a society’s ability to produce and utilize productive human resources. Productivity matters more in a world where humans aren’t procreating sufficiently to replace themselves.

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On the Margin

January 29, 2019 (Tuesday)

Strategy I: The Revenues Puzzle. Joe and I have observed that analysts are cutting their 2019 estimates for S&P 500 earnings but remaining optimistic on revenues. That means that they are lowering their expectations for profit margins. We are a bit puzzled, since they tend to lower their estimates for both revenues and earnings when company managements’ guidance during earnings-season conference calls suggests weakness ahead. Given mounting evidence of a global economic slowdown in recent months, it isn’t surprising that analysts are lowering their earnings estimates. What’s surprising is that they aren’t doing the same for revenues.

The decline in analysts’ expectations for profit margins is supported, however, by mounting evidence that labor costs are rising at a faster pace. Slower economic growth could also weigh on productivity. Trump’s tariffs have increased costs for some companies. Trump’s escalating trade war with China may be forcing manufacturers to spend more on diversifying their supply chains away from China. Trump’s tax cut had a one-shot positive impact on profit margins last year, and the negatives may be starting to chip away at it.

Keep in mind that analysts have a tendency to be too optimistic. As earnings seasons approach, they become more realistic. Often in the weeks before earnings seasons, they turn too pessimistic, setting company managements up to beat their more cautious estimates. As we are about to show, the drop in their profit-margin estimates may simply reflect a typical realistic adjustment to their overly optimistic bias.

Consider the following:

(1) Revenues. As we observed last week, analysts have been raising their estimates for both 2019 and 2020 revenues growth (Fig. 1). During the 1/17 week, they estimated growth rates of 5.5% this year and 5.0% next year. At the end of last September, before the stock market meltdown during Q4, they were projecting 5.2% and 4.1%, respectively. They did that despite headline news reports about slower global economic growth. They also did that despite the 29% drop in the price of oil since October 3, which will weigh on the revenues of oil companies.

(2) Earnings. On the other hand, they’ve scrambled to lower their earnings growth rate for this year from 10.3% at the end of September to 6.0% during the 1/17 week (Fig. 2). However, true to their optimistic bias, their 2020 earnings estimate is up a bit over this period to 10.9%.

(3) Profit margin. Joe and I closely monitor weekly data on forward earnings and forward revenues, which are time-weighted averages of analysts’ expectations for these two variables during the current year and the coming year (Fig. 3).

Forward revenues tends to be a very good coincident indicator of actual S&P 500 revenues. The former rose to record highs so far during January. Forward earnings tends to be a leading indicator for actual earnings. The former rose to a record high of $175.48 per share during the 10/25 week. It has declined slowly for the past 13 weeks through the 1/24 week to $172.14.

We can derive the actual and forward profit margin from the earnings and revenues data. The former rose to a record high of 10.9% during Q4-2017 before the corporate tax cut was enacted on December 22, 2017. After the tax cut, the profit margin jumped to 11.9% during Q1, 12.3% during Q2, and 12.5% during Q3.

The forward profit margin peaked at a record 12.4% during the 9/13 week. It was down to 12.1% during the 1/17 week. The analysts’ consensus estimate for the 2019 profit margin has dropped from 12.4% at the end of September to 12.0% during the 1/17 week, unchanged from their estimate for 2018 (Fig. 4). Their 2020 estimate has dropped from 13.1% to 12.7% over this same period. Undoubtedly, it will continue to fall down to at least 12.0%, maybe lower.

(4) Earnings math. All of the above suggests that the lowering of analysts’ consensus earnings expectations in recent weeks reflects a more realistic, but still optimistic, outlook for the profit margin. The latest 2019 and 2020 profit-margin estimates remain at record highs near the 2018 record level. So it is premature to conclude that analysts are starting to warn that labor and other costs are cutting into profit margins.

That may be the next shoe to drop for earnings. If the profit margin remains unchanged, then revenues growth will determine earnings growth. If the profit margin gets squeezed by rising costs, then earnings growth will fall below revenues growth. Joe and I are expecting that earnings will grow at the same pace as revenues this year (4%) and next year (5%).

In other words, we don’t expect that labor compensation and other costs will squeeze margins. Nor do we expect that an increase in those costs will boost prices. Rather, we are betting on improving productivity.

Strategy II: Profit Margin & the Cost of Doing Business. Last week, Melissa reviewed the Fed’s latest Beige Book. There has been a clear trend of increasing labor shortages and rising labor costs mentioned in recent months by this survey of business conditions. That’s consistent with the decline in the unemployment rate below 4.0% since last April (Fig. 5). The average hourly earnings measure of wages for production and nonsupervisory workers rose 3.3% y/y through December, the highest pace since April 2009.

This suggests that the Phillips Curve Model is finally working. Does this mean that price inflation is bound to head higher, assuming that companies can mark up selling prices to pass on the rise in their costs? That’s not necessarily a good assumption. A comparison of wage inflation and price inflation (using the core PCED) shows that the two were relatively close during the 1970s and 1980s, when companies had less competition and more pricing power than now (Fig. 6). Since the mid-1990s, wage inflation has almost always exceeded price inflation. That’s as a result of deregulation and globalization, which have increased competitive pressures on prices.

Let’s have a closer look at the historical record for the profit margin. Keep in mind that the S&P 500 profit margin is available only since Q1-1993. To get a longer-term view, we can construct a profit margin for all US corporations using the National Income & Product Accounts (NIPA) starting in 1947 (Fig. 7). The two have diverged, particularly since 2015. That’s not surprising since the two are not strictly comparable. For example, the NIPA proxy includes the profit margin of sole proprietorships. Here goes:

(1) During the first half of the 1980s, the NIPA profit margin fell sharply. During the second half of the 1980s, it rebounded. Data available for the S&P 500 profit margin show that the uptrend continued through Q3-2018. On the other hand, the NIPA profit margin hit a record high of 11.7% during Q1-2012. It has been on a downward trend since then. Unlike the S&P 500, it did not get a boost last year from the tax cut, which obviously doesn’t make much sense.

(2) Notwithstanding the recent puzzling behavior of the NIPA profit margin, especially compared to the S&P 500 profit margin, the former does show a plausible inverse relationship with the cost of doing business. Debbie and I derive this cost by adding the NIPA series on compensation of all employees to NIPA private fixed investment and dividing the total by nominal GDP (Fig. 8).

The NIPA profit margin tends to increase (decrease) when the cost proxy decreases (increases). While the latter has been on an uptrend since 2010, it has remained at the lowest levels in recent years (through Q3-2018) since the early 1960s. The relatively slow pace of hiring and capital spending during the current expansion has boosted the S&P 500 profit margin, though not the NIPA proxy (Fig. 9).

(3) Joe and I have often opined that the “Trauma of 2008” caused company managements to make maintaining and boosting their profit margins their number-one priority. In the past, they responded to economic booms by rapidly increasing their payrolls and expanding their capacity. So their profit margins started to erode during the booms, then to dive during the busts that inevitably follow the booms. That pattern is very clear in the NIPA profit margin series. This time, at least based on the S&P 500 profit margin, they are keeping a tighter rein on their costs. As a result, the economy isn’t booming, which reduces the risk that it will bust anytime soon, in our opinion.

Strategy III: Drilling into the S&P 500 Sectors’ Margins. Now let’s see what is happening to the forward profit margins for the 11 sectors of the S&P 500 (Fig. 10). All except Health Care, Communication Services, and Utilities have been looking toppy in recent weeks. Here is the sectors’ latest performance derby through the 1/17 week: Information Technology (22.3%), Financials (18.9), Real Estate (15.4), Communication Services (14.8), Utilities (12.9), S&P 500 (12.1), Materials (11.0), Health Care (10.5), Industrials (10.3), Consumer Discretionary (7.5), Consumer Staples (7.5), and Energy (6.7).

We have weekly data for the forward profit margins of the sectors starting in 2006. The standout performer over this period is Information Technology. Its forward profit margin has widened from about 12% in 2006 to 22%. Another notable champ has been Utilities, with its forward margin increasing from about 9% to 13%. The Financials sector has been on a rollercoaster, going from 17% during 2006 down to 6% in 2009, before rising most recently to a record high of 19%. Health Care has been surprisingly bound over those years in a tight range around 10.5%.

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The Next Recession

January 28, 2019 (Monday)

Strategy: Climbing the Wall. Joe and I have often observed that the current bull market is the most widely hated one ever because the next recession has been the most widely anticipated downturn ever. Recessions tend to be preceded by periods when growth is very strong and widely expected to remain so for the foreseeable future. As a result, speculative excesses develop, fueled by rapidly rising debt. Inflationary pressures mount in consumer prices and/or asset prices. The Fed responds by raising interest rates, which triggers a financial crisis, followed by a credit crunch and a recession. In the current business cycle, fears of a recession have reduced the likelihood of a boom, which reduces the likelihood of a bust.

Notwithstanding our “no-boom-no-bust” hypothesis, we suppose it’s possible that fears of a recession could cause one. In the next section, we acknowledge that the stock market’s “flash crash” during December might have caused a “flash downturn” in economic activity during the month. The next recession is a good story for the financial media to cover because bad news tends to grab attention. For example, on Friday, CNBC posted a story titled “Five financial heavyweights weigh in on whether the next recession is nearing.”

The stock market rally since the day after Christmas suggests that investors are a bit more relaxed about an impending recession than they were earlier last month (Fig. 1). Helping to bolster confidence are the following developments:

(1) Taking QT off autopilot. Stock prices rose on Friday in response to a WSJ article titled “Fed Officials Weigh Earlier-Than-Expected End to Bond Portfolio Runoff.” The story suggests that Fed Chairman Jerome Powell is preparing to back off from his 12/19 presser statement about the pace of quantitative tightening (QT): “So we thought carefully about this, on how to normalize policy, and came to the view that we would effectively have the balance sheet runoff on automatic pilot and use monetary policy, rate policy, to adjust to incoming data.”

A careful reading of the article suggests a more nuanced interpretation of the Fed’s adjustment in the pace of QT: “The Fed’s decision about the size of its portfolio is being driven by a technical debate inside the central bank about reserves in the banking system, not over whether officials want to provide more or less stimulus to the economy.” In any event, news that the Fed is likely to pause its rate hiking and balance-sheet tapering is certainly viewed as bullish by stock market investors (Fig. 2 and Fig. 3).

(2) Ending the trade war. Stock prices fell last Thursday after Commerce Secretary Wilbur Ross said that trade negotiations with China were far from complete. “We would like to make a deal but it has to be a deal that will work for both parties,” Ross told CNBC. “We're miles and miles from getting a resolution.” A few hours after Ross spoke, Treasury Secretary Steve Mnuchin told Reuters that both sides were “making a lot of progress” in the talks. He added that he is looking forward to speaking with Chinese Vice Premier Liu He next week when the representative visits the US. It’s been my view that both President Xi Jinping and President Donald Trump need a deal to end their escalating trade war. The market seems to agree.

(3) Opening the government. On Friday, there were widespread flight delays out of several major eastern US airports owing to a shortage of air-traffic controllers, who weren’t getting paid during the partial government shutdown. That most likely convinced Trump and congressional leaders to reach a deal later that day to reopen the government for three weeks. Trump said that, as part of the deal, the parties would set up a conference committee to put together a Department of Homeland Security appropriations bill. He backed off from his demand for a down payment on his wall along the Mexican border, but he still wants to build it.

Since the day after Christmas, stock prices have been doing a great job of scaling both the Great Wall of China and the wall along the Rio Grande.

US Economy: Is the Flash Recession Over? So is there nothing to fear but fear itself? As noted above, it’s possible that fear of a recession could cause a recession. Debbie and I don’t expect that will happen, but there is some evidence that fear depressed the economy during December and January. Before we take a dive into the data, allow us to predict when the next recession is most likely to occur.

In our opinion, it might start the day after Election Day, November 3, 2020. We see this happening if Trump is defeated in his bid for a second term by a Democratic candidate, who promises during the campaign season to undo Trump’s deregulations and tax cuts. The Democratic party continues to move to the left on all sorts of issues, including higher taxes on high incomes, a wealth tax, and lots of regulations under the so-called “Green New Deal” (GND).

Don’t misunderstand: We aren’t making a political judgment call or opining on the merits of the GND. All we are saying is that an abrupt reversal of Trump’s relatively stimulative policies could trip up the economy and trigger a bear market. For now, let’s review the economy’s recent hits and misses:

(1) Leading indicators. As Debbie discusses below, the Index of Coincident Economic Indicators (CEI) rose to yet another record high during December, gaining 2.1% y/y (Fig. 4 and Fig. 5). Back in 2014, we projected that the next recession might start during March 2019 based on the average length of post-recovery expansions (Fig. 6). Now we are thinking that this expansion is likely to be the longest one on record, hitting that mark in July of this year, and might not end until late 2020.

The Index of Leading Economic Indicators (LEI) stalled in record-high territory during the last three months of 2018. The biggest negative contributor to the LEI was the S&P 500 (Fig. 7).

(2) Jobless claims. Initial unemployment claims is also a component of the LEI. It fell to 199,000 during the 1/19 week—the lowest reading since mid-November 1969—confirming that the labor market remains hot (Fig. 8). We derive our Boom-Bust Barometer (BBB) by dividing the CRB raw industrials spot price index by the four-week average of jobless claims (Fig. 9). Our BBB fell late last year and may be starting to recover.

(3) Regional business surveys. January data are available for four surveys of business activity conducted by five of the 12 Federal Reserve Banks—New York, Philadelphia, Richmond, and Kansas City. The average of the general business indexes edged up from 4.7 to 6.0—only one-quarter the pace of May’s 24.0 peak rate (Fig. 10). The average of the new orders indexes showed the slowest growth since September 2016, sinking to 3.7; it was as high as 26.0 in May. The average of the employment indexes show hirings were the slowest since July 2017, falling from 15.2 to 10.8 this month—still a respectable rate.

The average of the general business indexes tends to be highly correlated with the ISM M-PMI, which will be released through January at the start of February. Meanwhile, the Markit estimate for the US M-PMI climbed from 53.8 to 54.9 this month, boosted by the strongest growth in production since May 2018 (Fig. 11).

(4) Trucking. Another sign of a flash downturn during December is the ATA truck tonnage index, which fell 4.3% m/m during the month but remains in record-high territory (Fig. 12).

Europe: Edging Toward a Downturn. If you are looking for a recession, there is more compelling evidence that Europe is heading in that direction than the US.

Sandra Ward, our contributing editor, and I have been monitoring the European region’s slowdown in recent months. Brexit, the “Yellow Vest” protests in France, anti-immigration reactions in Germany, and anti-unification movements in Italy and Eastern Europe all are weighing on European economies. Trump’s trade war is also a drag. European companies are more exposed to the weakness in emerging market economies than are American ones. A geriatric demographic profile poses yet another challenge for the health of European economies.

Consider the following recent developments:

(1) ECB. Following last Thursday’s meeting of the European Central Bank’s (ECB) Governing Council, the bank’s president, Mario Draghi, said: “The risks surrounding the euro area growth outlook have moved to the downside on account of the persistence of uncertainties related to geopolitical factors and the threat of protectionism, vulnerabilities in emerging markets and financial market volatility.”

That explains why the ECB took no action on Thursday, leaving its official deposit rate at -0.40%. That’s after the central bank ended its bond-buying program last month. So such purchases fell from €15 billion per month to zero, though cash from maturing bonds will be reinvested for an extended period of time beyond its next interest-rate hike, which is looking less and less likely anytime this year.

(2) GDP growth. Eurostat last month reported that the 19-member Eurozone grew at its slowest pace in four years during Q3-2018. In its latest economic outlook report, the International Monetary Fund lowered its 2019 forecast for the region’s economy from 1.9% to 1.6%, led by a downward revision for Germany from 1.9% to 1.3%.

Real GDP in the Eurozone rose 1.6% y/y during Q3-2018 (Fig. 13). This growth rate is highly correlated with the region’s Economic Sentiment Indicator, which deteriorated last year from 115.2 at the end of 2017 to 107.3 at the end of 2018.

(3) Industrial production. After rising 5.0% from December 2016 through December 2017, Eurozone industrial production fell 2.7% during the first 11 months of 2018, led by a 4.7% decline in Germany (Fig. 14).

January’s M-PMI for the region was down from 59.6 a year ago to only 50.5 based on the Markit survey’s flash estimate (Fig. 15). Over this same period, the NM-PMI dropped from from 58.0 to 50.8. During January, the M-PMI fell below 50 for Germany (49.9), while the NM-PMI for France plunged to 47.5. Sacré bleu!

(4) Germany. As Debbie discusses below, Germany’s Ifo business confidence index fell for a fifth month in a row through January, led by a big drop in expectations (Fig. 16).

Movie. “Serenity” (+) (link) is a controversial movie. Some reviewers loved it, while others hated it. I thought it was interesting. The first hour is slow and quirky. But then it starts to make sense, though it remains somewhat contrived. The fun is seeing how early on you can figure out the premise of the movie. On a remote island, Matthew McConaughey plays a fishing boat captain who is obsessed with catching a big fish he calls “Justice.” His ex-wife, played by Anne Hathaway, tracks him down over the Internet and begs him to kill her current abusive husband for the sake of their son, who is a computer geek. The movie is reminiscent of “Body Heat,” “Moby Dick,” “Tron,” and “Key Largo” (with Bogart and Bacall).

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Analysts Cutting Earnings Estimates

January 24, 2019 (Thursday)

Video Podcast: China Getting Less Bang per Yuan. In this podcast, I review the latest batch of Chinese economic indicators. I argue that the downward trend in China’s economic growth is probably attributable to its increasingly geriatric demographic profile. In other words, China’s economic problems are mostly homegrown—all the more reason for the Chinese to do a trade deal that placates the Trump administration’s demand for fairer trade.

Strategy I: Downward Earnings Revisions. Industry analysts are getting the message. The global economy is slowing. They are hearing more about that from company managements. On Tuesday, the International Monetary Fund (IMF) lowered its outlook for 2019’s global real GDP from 3.7% to 3.5%. The European growth rate was lowered from 1.9% to 1.6%, led by a cut in the German growth rate from 1.9% to 1.3%. China’s growth forecast remained at 6.2%. The IMF’s forecast for US growth for this year was also unchanged at 2.5%, although a continuation of the partial government shutdown poses a risk.

The Atlanta Fed’s GDPNow model is still focusing on Q4-2018, for which it estimates that real GDP rose 2.8%. That estimate is as of January 16, but the website notes that the timing of future estimates will be affected by the partial government shutdown, as the model depends on economic releases from the Census Bureau and Bureau of Economic Analysis.

The latest estimate is likely to be lowered by Tuesday’s report that existing home sales fell 6.4% during December to 4.99mu (saar), the lowest pace since November 2015 (Fig. 1). That unexpectedly large drop contributed to the stock market selloff on Tuesday. On the other hand, mortgage applications for new purchases jumped 24% during the first three weeks of 2019 (Fig. 2).

Joe and I are puzzled to see that while industry analysts have been scrambling to lower their earnings estimates for this year, they aren’t doing the same for their revenues estimates, notwithstanding all the downbeat news about the prospects for global economic growth. So their revisions imply that they expect pressure on profit margins this year. Consider the following:

(1) Revenues. Forward revenues is down just 0.8% from its record high in early January (Fig. 3). Remarkably, the consensus revenues growth forecast for 2019 has remained steady at 5.5% since the end of October (Fig. 4).

(2) Earnings. Since we lowered our earnings forecasts in late October, analysts have followed suit. Forward earnings has dropped 1.7% from its record high at the end of October, much faster than the decline in forward revenues (Fig. 5). The consensus 2019 growth forecast is down from 10% then to 6% as of January 17 (Fig. 6). Analysts now figure quarterly earnings growth will slow to rates in the low single digits during Q1-Q3, with a return to double-digit percentage growth in Q4 (Fig. 7). We think, however, Q4 earnings growth more likely will drop into the single digits too; we wouldn’t rule out the possibility of a y/y decline in earnings sometime during Q1-Q3.

(3) Profit margins. With the decline in earnings forecasts in the face of steady revenues, the implied profit-margin forecast for 2019 has dropped from 12.4% in October to 12.0%, which is expected to be unchanged from the 2018 level (Fig. 8).

(4) Valuation multiples. We were surprised by the ferocity of the valuation meltdown during Q4, but believe the December 24 low P/E of 13.5 marked the bottom. The P/E was back up to 15.3 as of Tuesday’s close, up from around 16.0 prior to the selloff. We expect inflation and interest rates to remain low, which should continue to aid the valuation recovery (Fig. 9).

(5) Undertow in Q4 earnings surprise. With the Q4 reporting season kicking into high gear, the results so far show a smaller earnings surprise than the substantial ones in Q1-Q3 of 2018. However, the early reports are dominated by the banks and brokers, which were hurt by the market’s turmoil at year-end 2018. The Financials sector accounts for half of the S&P 500’s earnings total through Wednesday morning, and has the weakest surprise so far, beating estimates by only 0.6% compared to 4.3% for S&P 500 ex-Financials.

Strategy II: Mixed Guidance. CEOs are often an optimistic bunch, but in their Q4 conference calls the folks at Capital One and Stanley Black & Decker sounded like they were battening down the hatches. Conversely, executives at United Technologies extolled the continued strength of the aerospace cycle. In all, it’s enough to be moderately concerned that CEOs planning for a recession could actually cause one. On the other hand, since the next recession has been the most widely anticipated downturn in world history, it is probably less likely to happen given my “no-boom-no-bust” working hypothesis. In any event, read on:

(1) Warnings about cycle’s old age. Capital One’s shares fell more than 5% after the market closed on Tuesday because its Q4 results missed Wall Street analysts’ forecasts. The company reported adjusted earnings of $1.87 a share, while the Street was calling for $2.39. While the company acted offensively in Q4, its executives spoke defensively on the conference call.

Playing offense, Capital One agreed in July to be the exclusive issuer of Wal-Mart credit cards, beating out Synchrony Financial. During the Q4 conference call, Capital One announced it had also purchased Wal-Mart’s credit card receivables. Separately, the company sharply increased the amount spent on marketing to $831 million in Q4, up from $460 million in Q4-2017. The increased marketing spending funded the launch of a national marketing campaign and helped grow the number of its new accounts.

However, company executives repeatedly mentioned in the Q4 conference call their caution about extending credit lines given the late stage of the credit cycle. CEO Rich Fairbank explained: “While our credit numbers are great … we’re deep into the credit cycle and nobody knows when this thing is going to turn. … [W]e believe that the prudent thing to do is have our foot on the gas of account originations and our foot a little bit on the brake with respect to credit line extension.”

Of further concern, Capital One’s net interest margin narrowed by seven basis points y/y. The company noted upward pressure on deposit rates from rising interest rates, increasing competition, and changing product mix. Conversely, “strong increasing competition from non-banks continues to drive less favorable lending terms in the marketplace.”

(2) Playing defense. While several headwinds faced by Stanley Black & Decker in 2018 will be anniversaried by H2-2019 (specifically, increased commodity prices, a rising dollar, and tariffs), executives do believe the economy is slowing. They noted on their Q4 conference call that as the Fed increased interest rates, the auto and housing markets slowed in Q3 and Q4. And the company seems to be preparing for the end of the economic cycle.

CEO James Loree explained: “I think the reality is setting in. Hopefully, not just us but most industrial companies are facing slower economic growth in …essentially the whole world except for a few bright spots like India … [T]he reality is that economic growth that we see for 2019 … is probably a good point lower than it has been in the recent couple of years. … [I]t's no secret that the construction markets in the United States have slowed as well. So baked into our guidance is a reality check on the slowing markets.”

The company plans to improve its operating margin and pay down debt as insurance against a possible economic downturn in the back half of 2019 or in 2020. “We have redirected our capital allocation in the short term to a deleveraging posture, keeping the balance sheet in a prudent place, as is appropriate for this stage of the cycle,” said Loree. By doing so, the company aims to be in a position to act proactively in the wake of any potential slowdown.

Stanley Black & Decker reported a 4.9% increase in Q4 net sales and adjusted earnings of $2.11 a share, which beat analysts’ estimates by one cent. Stanley forecast 2019 adjusted EPS growth of 4%-6% to $8.45-$8.65, below analysts’ forecast of $8.79.

(3) Aerospace still flying high. United Technologies reported strong Q4 earnings and projected 2019 results that beat analysts’ expectations. Q4 adjusted earnings came in at $1.95 a share, above the $1.55 Wall Street estimate. And the company forecast 2019 adjusted EPS of $7.70-$8.00 versus the consensus estimate of $7.80.

Earnings benefitted from a 24% revenue increase at Pratt & Whitney, which makes aircraft engines, and a 29% revenue increase at Rockwell Collins, the airplane parts manufacturer UTC acquired last year.

“We are seeing really solid trends in aerospace across the board, with continued (airline traffic) growth and production increases at both Boeing and Airbus,” CEO Greg Hayes said according to a 1/23 Reuters article. The company is doubling down on aerospace this year as it aims to spin off the Otis elevator operation, which had flat sales in Q4, and the Carrier air conditioner business, which had a 3% increase in sales.

By the way, one of our favorite airline statistics is the number of passengers arriving at and departing from Las Vegas’s McCarran International Airport. In November, the figure was up 4.4% y/y following last year’s 1.3% y/y increase in November, according to the airport’s data.

Tech: Batteries Charging Ahead. Tesla’s plans to lay off 7% of its workforce rightly concerned investors last week. The company has yet to sell the Model 3 for the promised $35,000 price tag, and an upcoming debt payment means the company’s bottom line is of growing concern.

In addition to cutting labor costs, Tesla undoubtedly is looking at how it can continue reducing the cost of its cars’ batteries. Electric vehicles’ batteries have come a long way in recent years, but only continued improvement in the cost, power, and stability of batteries will ensure the broad future adoption of electric vehicles.

Lithium ion batteries hold a lot of energy in a small space, so they’re great for powering cell phones or watches. However, they have drawbacks. Under certain conditions, lithium ion batteries have caught fire. Also, the ingredient cobalt is expensive and in short supply. Scientists are exploring making batteries with more plentiful and less combustible materials. Here are some of the latest breakthroughs that may determine whether we’re all driving electric vehicles in the future:

(1) Look to the sky. For years, scientists have been working on a battery that uses lithium and air. Such a battery would be much lighter than a lithium ion battery and hold five times as much energy. The problem: The reaction in a lithium air battery has historically caused the production of materials that “gummed up” the cathode, preventing the battery from working soon after.

Researchers at the University of Illinois at Chicago and at Argonne National Laboratory have figured out how to avoid this, by coating the lithium anode with a thin layer of lithium carbonate, according to a 3/21 article in UIC Today.

Separately, MIT researchers have been investigating how to use the carbon dioxide released by power plants in the electrolyte solution of a battery. “Currently, power plants equipped with carbon capture systems generally use up to 30 percent of the electricity they generate just to power the capture, release, and storage of carbon dioxide,” a 9/21 article in MIT News explained. In experiments, the carbon-dioxide battery produced as much energy as a lithium-gas battery but stopped working sooner, after only 10 charge-discharge cycles.

(2) Rock solid. Scientists are also working on solid-state batteries, which replace the liquid electrolyte in a traditional lithium-ion battery with solid material. Benefits include longer battery life (500% more capacity), faster charging (one-tenth of the time), greater safety, and smaller size than a traditional battery, according to an 11/9 Howtogeek.com article. The problem: Solid-state batteries are extremely expensive to produce ($15,000 each) because there are no economies of scale.

That may change. A Chinese startup, Qing Tao Energy Development, says that “it started a production line of solid state batteries that will lead to volume production,” according to an 11/20 article in Electrek. The batteries currently are used in special equipment and high-end digital products, but the company says several automakers may consider using the batteries in electric vehicles. “The executive claims that they have achieved an energy density of ‘over 400 Wh/kg’ compared to the new generation Li-ion battery cells having a capacity of 250 to 300 Wh/kg.”

On Tuesday, Toyota and Panasonic announced a joint venture to produce traditional lithium ion batteries for electric vehicles and also to develop solid-state lithium ion batteries, according a 1/22 Green Car Reports article.

(3) Batteries that live forever. Researchers from the University of California Irvine have developed a battery made with nanowires that can be charged thousands of times without degrading. The gold nanowires, which are thousands of times thinner than a human hair, are coated in manganese dioxide shells encased in an electrolyte of jell, according to a 4/21/2016 article in Pocket-lint.com. It explains: “The result is no loss of power even when recharged 200,000 times over three months. Now we simply need nanowires to get manufactured en masse, while advancing capacity and there could be a viable alternative to current battery options. We say simply.”

(4) Silicon to the rescue. Sila Nanotechnologies has partnered with BMW to put silicon on the anode of a lithium battery instead of graphite in order to make the battery much more powerful.

Using silicon to enhance a battery’s power has historically been problematic because when silicon bonds with lithium ions, its volume expands, and it can crumble and reduce the battery’s performance. But the rigid silicon-based nanoparticles Sila produces can accommodate significant volume changes, a 4/11 article in MIT Technology Review explained. The company hopes to see its battery used in consumer electronics this year and in cars around 2023.

Sila believes that the new material will boost battery capacity by 20% initially and 40% or more eventually, according to a 1/6 article in IEEE Spectrum. It also reduces the thickness of the anode by 67%, which may allow the battery to be charged nine times faster than current batteries. The battery is less likely to be flammable than traditional lithium ion batteries and can perform well for 400-1,000 full charge cycles. Another company, Enovix, is working on a similar battery.

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The Latest Word from the Fed

January 23, 2019 (Wednesday)

China: Less Bang per Yuan. The Chinese government continues to rely on bank loans to finance China’s economic growth. The Chinese seem to be getting less and less bang for their yuan borrowed from the banks. There is mounting evidence that too much of that debt has been used to create too much excess capacity.

There is also mounting evidence that China’s one-child policy, implemented from 1979 through 2015, is now coming back to weigh on China’s economy. The children born during that period are now 4-40 years old. The older ones must care for their old parents. There aren’t enough young ones to offset the decline in workers who are retiring or passing away, so the working-age population is starting to decline.

YouTube has lots of videos showing China’s impressive spending on infrastructure. There are also videos showing China’s “ghost” cities with magnificent high-rise apartment buildings and shopping malls that are mostly empty. China’s demographic profile suggests that the country is rapidly evolving into the world’s largest nursing home. If so, then all those impressive bullet trains, airports, and highways may be for ghosts too.

Consider the following developments:

(1) Bank loans. Over the past 12 months through December, Chinese bank loans rose at a record 15.7 trillion yuan, or $2.4 trillion (Fig. 1). Since December 2008, when the global financial crisis was at its worst, bank loans are up a staggering $15.4 trillion to $19.8 trillion (Fig. 2). The good news is that the Chinese owe all this debt to themselves since they have a very high savings rate, which has boosted M2 by $19.6 trillion to $26.5 trillion over this same period.

(2) Economic growth. The bad news is that bank loans have been growing faster than industrial production, suggesting that the Chinese are getting less bang per yuan of bank loans. The ratio of industrial production to bank loans has been on a steady downward trend since late 2008 (Fig. 3).

Industrial production growth has been hovering mostly between 6%-8% y/y from 2015 through mid-2018 (Fig. 4). It was just below 6% during the second half of last year. Real GDP growth slowed to 6.4% y/y during Q4-2018, matching its low for the series (going back to 1992), recorded in Q1-2009 (Fig. 5). Haver Analytics estimates that during both Q3 and Q4, growth was down to 6.0% (saar).

(3) Retail sales. The growth rate in nominal retail sales was flat at 8.2% y/y during December, while the CPI inflation rate edged down to 1.9% (Fig. 6). As a result, real retail sales growth edged up to 6.3%. However, the 12-month average of this growth rate remains on a steep downward trend (Fig. 7). I believe that this confirms that China’s geriatric demographic profile is already weighing on the country’s growth.

(4) Demography. On a yearly-percent-change basis, China’s working-age population stopped growing during 2015, and is projected to be falling for the demographically foreseeable future (Fig. 8). From 1950-2014, this group rose 674 million to a peak of 1.01 billion. It is projected to decline by 200 million through 2050.

By the way, on Monday, China reported that there were 15.23 million births last year—the lowest since 1961, when 11.87 million births were reported. If you are a young married couple in China responsible for supporting four elderly parents, having even one child may be too much of a financial burden!

(5) Trade and capital flows. The Chinese reportedly have offered to buy $1 trillion more in US goods over the next six years in an effort to placate the Trump administration’s demand for fairer trade. It’s not clear what they might want to buy from the US, especially if their population is rapidly aging. Healthcare supplies and other products used by seniors come to mind.

It’s getting harder and harder to find upbeat data for China. The sum of Chinese imports plus exports (saar) took a dive at the end of last year (Fig. 9). This series is somewhat correlated with the more volatile series on railway freight traffic, which edged down last month from a record high during October.

Meanwhile, our monthly proxy for implied international capital flows shows that outflows were mounting again last year after a couple of years of diminishing (Fig. 10).

US Energy: Gushing Oil & Gas. Global demographic trends suggest that global growth will be slowing. That’s not a wonderful outlook for commodity producers, but it’s not stopping US frackers from fracking like mad. Consider the following:

(1) Oil. US oil field production jumped to a record 11.9mbd during the 1/11 week (Fig. 11). That’s up 2.4mbd since the start of last year. Texans are leading the way, with a 1.2mbd increase over this period (Fig. 12).

US exports of crude oil and petroleum products rose to 7.8mbd during the 1/11 week, up 1.2mbd since the start of 2018 (Fig. 13). Net imports fell to just 1.8 mbd. The US is awfully close to energy independence.

(2) Gas. In the US, the 12-month sum of natural gas production has exceeded consumption (on the same basis) since early 2015 (Fig. 14). Both were at record highs through October.

The Fed: The Latest Word. Sometimes a single word can be a more powerful guide for turning over a new leaf than any New Year’s resolution or goal. Fed officials seem to have embraced a new word to guide their monetary policy-setting: “patient.”

During former Fed Chair Janet Yellen’s era, the Fed’s favorite word to characterize the pace of monetary policy normalization was “gradual.” It suggests a slow progression and thus is less dovish than “patient,” implying tolerance for delays. But “patient” doesn’t necessarily mean that “gradual” hikes won’t occur at some point. Fed officials have been stressing the concept of data dependence to guide the path of policy, moving away from any sort of commitment to a particular policy path. Consider the following:

(1) History of “gradual.” The word “gradual” came into focus around year-end 2014. The Federal Open Market Committee’s (FOMC) 12/16-12/17 Summary of Economic Projections that accompanied the Minutes that year stated (italics ours) that “all but a couple of participants anticipated that it would be appropriate to begin raising the target range for the federal funds rate in 2015, with most projecting that it will be appropriate to raise the target federal funds rate fairly gradually.” True to its word, the Fed began raising the federal funds rate during December 2015 after keeping rates near zero for seven years. Since then, the Fed has increased rates nine times through December 2018.

“Gradual” remained the operative word through year-end 2018. The 11/7-11/8 FOMC Minutes stated that “members continued to expect that further gradual increases in the target range for the federal funds rate would be consistent with sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee’s symmetric 2 percent objective over the medium term.”

(2) Introduction of “patience.” “Patient” in reference to the pace of monetary policy tightening debuted in the FOMC Minutes last month. The 12/18-12/19 Minutes stated that “many participants expressed the view that, especially in an environment of muted inflation pressures, the Committee could afford to be patient about further policy firming.”

(3) Participants to members. Two words that are always important in the FOMC Minutes are “participants” and “members.” Participants contribute to the FOMC meeting discussions, whereas members contribute to discussions and get to vote on monetary policy-setting decisions. Note that the word “gradual” had been adopted by FOMC members in the Yellen administration, but the word “patient” was initiated by FOMC participants under Powell.

The December Minutes stated: “Members judged that some further gradual increases in the target range for the federal funds rate would be consistent with sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee’s symmetric 2 percent objective over the medium term.”

(4) New voters in. Such statements and similar ones in the December Minutes suggest possible discord among FOMC meeting participants and members—i.e., with voting members (whose opinions matters more) favoring faster rate increases than participants. Importantly, though, some officials who were members in December become nonvoting participants in January. The annual rotation of four of the FOMC Fed presidents means they won’t be voting at the 1/29-1/30 FOMC meeting.

For 2019, the following 2018 FOMC members are now just meeting participants: Thomas I. Barkin (Richmond), Raphael W. Bostic (Atlanta), Mary C. Daly (San Francisco), and Loretta J. Mester (Cleveland). The following Fed district presidents will replace them on the FOMC, temporarily joining the six permanent voting members: James Bullard (St. Louis), Charles L. Evans (Chicago), Esther L. George (Kansas City), and Eric Rosengren (Boston).

The four folks rotating in all appear willing to be patient. In a 1/9 WSJ interview, Bullard warned that more rate rises could lead to a recession, adding that the Fed is aware of the “cross currents in the global economy and will be flexible and patient in implementing monetary policy.”

“Because inflation is not showing any meaningful sign of heading above 2 percent (target)...I feel we have good capacity to wait and carefully take stock of the incoming data and other developments,” Evans said on 1/9.

“It seems to me that we should proceed with caution and be patient as we approach our destination,” George said in 1/15 prepared remarks.

In a 1/9 speech, Rosengren said: “The Federal Reserve’s current monetary policy seems appropriate for now, and can patiently observe future economic developments.”

(5) Powell’s patience matters. Of course, what Fed Chair Jerome Powell says matters the most. Powell has recently run into some communication issues with the financial markets, as we discussed in our 1/7 Morning Briefing. The Fed chair’s words have consequences. Powell upset markets when he said in a 10/3 off-the-cuff interview that the federal funds rate was a long way from neutral, suggesting a not-so-gradual approach to policy. The markets were also disturbed when Powell said during his 12/19 press conference that the Fed’s balance-sheet reduction is on “automatic pilot.”

Later, Powell walked back these comments, calming the markets by using the word “patient” on a 1/4 panel (at minute 5:30 on the video) with former Fed Chairs Janet Yellen and Ben Bernanke, adding that the Fed is open to changing the approach on the balance sheet if necessary.

Interestingly, however, Powell did not use the word “patient” in his 12/19 presser following the December FOMC meeting—a departure from the language of the “patient” participants that might suggest he’s in the “gradual” versus “patient” policy camp. However, it is possible that Powell is becoming more patient, consistent with what seems to be the emergent consensus on the FOMC for 2019.

(6) Patient permanent voters. In addition to Powell, the other five permanent members of the FOMC currently are the New York Fed President John C. Williams and the four standing Board of Governors: Michelle W. Bowman, Lael Brainard, Richard H. Clarida, and Randal K. Quarles. At this time, there are two Board vacancies.

Williams told bankers at a 1/18 forum: “The approach we need is one of prudence, patience, and good judgment.”

Brainard said in a 1/18 interview that “monetary policy is positioned to sustain the expansion, that it can be patient.”

In a 1/10 speech, Clarida used the word “patient” twice. He concluded: “Speaking for myself, I believe we can afford to be patient about assessing how to adjust our policy stance to achieve and sustain our dual-mandate objectives.”

Quarles seems to be the only potentially impatient 2019 FOMC member aside from Powell, as he said that the “core base case remains very strong” on 1/17.

Bowman was sworn in to the Fed’s Board of Governors 11/26 and has yet to make public remarks on monetary policy in her new role.

(7) Data dependence. While Fed officials are increasingly committed to being “patient,” they are also becoming increasingly noncommittal regarding the course of policy. Here are just a few comments on data dependence from the permanent FOMC voting Board of Governors:

At the forum on 1/18, Williams said: “The motto of ‘data dependence’ is more relevant than ever.”

Brainard said in her 1/18 interview that “data is vital for business decision-making, for household decision-making, and of course for policy makers. So we certainly rely on it.”

Clarida said in his 1/10 speech that “at this stage of the business cycle and with the economy operating close to our dual-mandate objectives, it will be especially important for our policy decisions to continue to be data dependent.”

Quarles feels that data dependence is crucial to policy-setting too. However, he doesn’t think that the Fed should be “reacting to every wavering of the needle across the dial,” he said in early December. That’s not surprising given his inclination to be less patient than his counterparts, as discussed above.

(Kudos to Melissa, who did most of the brilliant analysis in this section. She has become a true Jedi Fed watcher since she joined YRI during May 2015.)

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Happy New Year!

January 22, 2019 (Tuesday)

Strategy: Relief Rally #62. Panic attack #62 has been followed by relief rally #62. The S&P 500 dropped 19.8% from September 20 through December 24 (Fig. 1). It felt like a bear market, but technically speaking it was the sixth 10.0%-19.9% correction of the current bull market. The S&P 500 index is now up 13.6% since the December 24 low and down 8.9% from the September 20 record high. It is still slightly below its 200-day moving average (Fig. 2). The index is now unchanged from where it began 2018, instead of down 12.1% ytd as it was on December 24 (Fig. 3). Consider the following related developments:

(1) The Trump Put. The S&P 500 is up 24.8% since Election Day November 8, 2016. President Trump can still take some credit for that gain as a result of his deregulation policies and tax cuts. However, his escalating trade war with China certainly accounted for some of last year’s stock market losses. Trump seems to believe that the stock market is the best measure of his success or failure as the President. So not surprisingly, he responded to December’s plunge in stock prices by getting the word out that trade talks with China are going very well.

Last Thursday, stock prices rose sharply on news reports that the Treasury was pushing to reduce some of the current tariffs on Chinese imports to get a better deal in the talks. That was quickly denied by a Treasury spokesperson. Then on Friday came reports that, in early January, the Chinese offered to buy $1 trillion of US goods over the next six years. Stocks jumped again despite reports that Trump’s negotiators want to see that happen over a shorter time span.

(2) The Fed Put. Trump likes to take credit for the sun rising in the morning. So he undoubtedly believes that the Fed’s recently announced policy of “patience” and “flexibility” is all because he threatened to fire Fed Chairman Jerome Powell. All the market cares about is that Fed policy is no longer set on autopilot. That’s the message conveyed by numerous Fed officials so far this year.

(3) Earnings beat. The Q4 earnings-reporting season is still underway. But so far, it hasn’t put a damper on the relief rally. That’s mostly because analysts cut their estimates following the Q3 season as companies provided lots of cautious guidance. At the start of October, analysts predicted an 18.2% y/y growth rate for the S&P 500’s Q4 earnings (Fig. 4). The estimate dropped to 12.5% during the 1/10 week. This increases the odds of yet another upward hook in earnings results relative to analysts’ forecasts.

(4) Oil-price bounce. The price of a barrel of Brent crude oil plunged 42% last year from October 3 through December 24 (Fig. 5). It is up 24% since then. The rebound reflects more confidence in the global economic outlook in the beliefs that the Fed will pause as promised and the US and China will work out a trade deal by the start of March. With oil prices moving higher and the Fed on pause for now, the trade-weighted dollar is down 2.0% since mid-December. With a weaker dollar and the Fed on hold, the Emerging Markets MSCI stock price index (in local currency) is showing signs of bottoming (Fig. 6).

(5) Cyclical sectors on fire. Since the December 24 low, the cyclical sectors of the S&P 500 have led the way in the recent rebound: Energy (18.4%), Consumer Discretionary (17.1), Financials (16.5), Industrials (16.3), Communication Services (14.4), S&P 500 (13.6), Information Technology (13.4), Materials (13.0), Health Care (11.6), Real Estate (9.3), Consumer Staples (7.5), and Utilities (3.1) (Fig. 7). Also rebounding have been the forward P/Es of the S&P 500 (from 13.5 on Christmas Eve to 15.5 on Friday), the S&P 400 (12.6 to 14.7), and the S&P 600 (13.4 to 15.6) (Fig. 8).

(6) Credit-spread narrowing. The Bank of America Merrill Lynch composite for the yield on US high-yield corporate bonds fell 112bps from 8.05% on December 26 to 6.93% on Friday (Fig. 9). Over this same period, the yield spread between this composite and the 10-year Treasury yield dropped from 524bps to 426bps.

(7) Treasury-yield bounce. Although the Fed may be on hold, the 2-year Treasury yield, which tends to reflect the market’s prediction of the federal funds rate a year ahead, increased from a recent low of 2.39% on January 3 to 2.62% on Friday (Fig. 10). The Fed’s current target range for the federal funds rate is 2.25%-2.50%. So the 2-year yield suggests either none-and-done or one-and-done this year. The 10-year Treasury yield has increased from its recent low of 2.56% on January 3 to 2.79% on Friday.

(8) Déjà vu all over again. If all of the above triggers the feeling that we’ve seen this video before, that’s because it’s remarkably similar to the scenario at the beginning of 2016. That was a happy new year. So far, Joe tells me that the performance of the S&P 500 ytd through Friday is the fifth best for those dates in any year since the start of the daily data during 1929.

US Economy I: Data MIA. All of the above also reflects a remarkable V-shaped shift from risk-off to risk-on pricing of financial assets. The tail (stock prices) has been wagging the dog (the economy). The fear has been that even if the plunge in stock prices wasn’t foreshadowing a recession, it might actually cause one! The problem is that as a result of the partial government shutdown, several economic indicators will be MIA. For example, December’s retail sales report is not available.

Nevertheless, there are enough indicators available to conclude that the economy is still growing. The Atlanta Fed’s latest GDPNow forecast for Q4 real GDP, at 2.8%, suggests little evidence of an imminent recession. So does industrial production, as Debbie discusses below. It rose 0.3% m/m during December, led by a 1.1% increase in manufacturing output (Fig. 11). Defense & space equipment rose 2.3% m/m (Fig. 12). There was also notable strength in automotive products (4.5%), transit equipment (2.9), and information processing equipment (1.3) (Fig. 13 and Fig. 14).

US Economy II: Fed’s Beige Book Is Neither Black nor White. In response to the plunge in stock prices late last year, Fed officials have been scrambling in recent weeks to assure us that they are “data dependent” rather than set on a rigid course of rate hikes and balance-sheet tapering. Of course, thanks to the government shutdown, there is less data that they can depend on. However, the Fed is open for business and produces a number of economic reports, including industrial production. Last Wednesday, the Fed released the latest Beige Book, which is a qualitative survey of businesses in each of the 12 Fed districts. Here’s Melissa’s summary of the latest findings:

(1) Activity & outlook have dimmed. Eight districts reported “modest to moderate growth” compared to 10 in the previous 12/5 Beige Book. In the New York and Kansas City regions, economic activity was flat compared to the last update. St. Louis reported that the pace of growth had slowed. Economic activity increased “slightly” in the Cleveland district. Although outlooks for the US economy “generally remained positive,” many districts reported less optimism “in response to increased financial market volatility, rising short-term interest rates, falling energy prices, and elevated trade and political uncertainty.” Insufficient labor supply also was noted as a growth deterrent.

(2) All workers wanted. Labor shortages were characterized with stronger language than in previous editions. The latest Beige Book said, “[A]ll Districts noted that labor markets were tight” and “firms were struggling to find workers at any skill level.” The previous one suggested that severe labor shortages were seen mainly at the low- and middle-skill levels.

Dallas contacts noted a lack of both high- and low-skilled workers, especially in construction, energy, hospitality, health care, banking, and transportation. Contacts across the San Francisco region “observed intense compensation pressures for more highly skilled workers.” A majority of Kansas City area respondents “continued to report labor shortages for low- and medium-skill workers.”

(3) Higher wages boosting hiring. Boston contacts noted that finding workers was difficult, especially skilled engineers. However, “one contact reported that after a ‘market adjustment’ raised compensation by 10 percent to 15 percent, difficulties in hiring and retention dramatically eased.”

In contrast, Minneapolis area staffing firms noted “continued reluctance among some clients to raise wages enough to change hiring difficulties.” A Minneapolis retailer noted that “every business is hiring and the hiring pool is shallow.”

(4) Wage pressures rising. Wage growth is on the rise, with the “majority of Districts reporting moderate gains.” The previous Beige Book indicated that wage increases were on the “higher side of a modest to moderate pace.” The January book reported wage increases across all skill levels.

New York district employers are “budgeting for moderately larger wage increases in 2019 than they did for 2018.” Philadelphia area contacts “typically cited increases for wages and benefits that averaged 3.0 to 3.5 percent. In one of the District’s tightest labor markets, average wage rates were up 6.0 percent over the prior year.” Dallas firms reported 4.5% annual wage growth in 2018, slowing to 4.0% in 2019.

(5) Starting wages moving up. Across districts, employers are increasing starting wages to attract talent. Richmond area contacts indicated “sharp increases in starting wages for particular positions.” St. Louis region contacts in information technology and manufacturing reported that labor market tightness led to increases in starting wages. San Francisco employers “with vacancies in the information technology, cybersecurity, and management fields continued to boost starting salaries to attract qualified candidates.”

(6) Minimum-wage pressures. New York area business contacts “expressed concern about the recent hike” in New York State’s minimum wage. Atlanta business contacts “noted that announcements by large national companies to raise their minimum wage intensified pressure among similar jobs.” St. Louis contacts cited starting-wage increases in healthcare and the public sector.

(7) Price pressures mixed. Not much changed since December’s edition in terms of prices. “Modest to moderate” increases in prices were noted across districts. Input prices rose, but the nationwide summary called reports “mixed” in terms of firms’ ability to pass higher costs on to customers. The input cost increases were attributed to rising material and shipping costs as well as tariffs.

The report detailed more instances of firms not passing costs on than doing so. Most Philadelphia area manufacturing firms “continued to anticipate paying higher prices for inputs, while those firms expecting to receive higher prices for their own goods” fell to less than half. Kansas City contacts said that “gains in input prices continued to slightly outpace those of selling prices.” Most Dallas area firms were “not able to raise selling prices fully in step with cost increases.”

(8) Industry growth mixed. Nationwide, growth across industries was mixed. Modest growth was seen for nonauto retail sales, non-financial services, and financials. Flat growth was seen in auto sales and residential and commercial real estate. Growth slowed for many manufacturers and for the energy and agriculture industries.

Outlooks among Dallas manufacturers “turned slightly negative in December” because of “declining oil prices, labor constraints, political uncertainty, higher interest rates, and reduced activity in the housing and energy sectors as factors restraining growth or damping outlooks.” Energy activity in the Dallas district “remained strong but growth slowed notably, and outlooks worsened.” Contacts in San Francisco attributed agricultural product sales weakness to “trade policy changes and the appreciation of the dollar.”

On the other hand, retailers were upbeat. Upstate New York retailers characterized “sales as fairly strong.” Retailers in Boston reported 2.0%-4.0% y/y same-store sales growth, with consumer confidence high. Districts continued to see high levels of online sales.

(9) Capital spending mixed. Lower nationwide energy prices curtailed capital-spending expectations in the energy sector, specifically in Kansas City and Dallas. Dallas contacts said that worry about lower energy prices caused about half of the region’s energy firms to lower capital-spending plans for 2019.

Cleveland manufacturing contacts suggested that trade uncertainty and financial market volatility contributed to a pullback in capital spending. Several auto contacts in the Kansas City district noted recent “downward revisions to capital spending plans for 2019.”

However, Kansas City manufacturers “expected modest increases in capital spending in the coming months.” Chicago business contacts said that capital spending increased “modestly” and expect that to continue.

Movie. “Stan & Ollie” (+ +) (link) is a very sweet movie about two sweet comedians, Laurel & Hardy, played with great affection by Steve Coogan and John Reilly. They remind us of bygone days when people laughed at jokes, slapstick, and skits that weren’t political, crass, and vulgar. They were very close friends, which occasionally led to disappointments and inevitable reconciliation. We need more of their simple humor in our lives and close friendships even with people with different political views.

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Is the Bear Market Over?

January 17, 2019 (Thursday)

Video Podcast. Analysts Lower the Bar for Earnings Season. The Q4 earnings-reporting season is underway. Industry analysts responded to cautious guidance from company managements during the Q3 earnings season by cutting their Q4 estimates, making them easier to beat.

Strategy: Rollercoaster. Joe and I have compared the correction from September 20 through December 24 to the 1987 bear market. In both cases, there was no recession and earnings continued to grow. The 1987 event was a one-day flash crash exacerbated by computer-driven “portfolio insurance” algorithms. The most recent selloff felt like a series of flash crashes, especially during December, which also were worsened by algos.

While the S&P 500 was down 19.8%, just shy of a 20%+ bear market, six of the composite’s sectors were in bear-market territory (Fig. 1). Here is their performance derby from worst to best: Energy (-27.9%), Consumer Discretionary (-22.6), Industrials (-24.1), IT (-23.1), Financials (-22.7), Materials (-22.2), S&P 500 (-19.8), Communication Services (-16.8), Health Care (-14.3), Consumer Staples (-11.5), Real Estate (-9.9), and Utilities (-2.4).

The 11.0% rally in the S&P 500, which started the day after Christmas and ran through Tuesday’s close, was led by the sectors with the biggest losses. So none of those sectors are in bear-market territory for now (Fig. 2).

Helping to revive stocks around the world have been assurances by Fed officials that they might pause their rate-hiking. The other major central banks are also moving toward providing more liquidity. As we noted yesterday, European Central Bank officials are considering alternative measures to do so now that they have terminated their QE program as of year-end. Yesterday, the People’s Bank of China injected a record US$83 billion into the country’s financial system to avoid a cash crunch—this after having slashed reserve requirements on January 4.

Bear markets often are preceded by a decline in stock prices in the Financials sector. So it was good to see that the S&P 500 Financials sector rallied 11.5% since December 24 through Tuesday’s close after falling 22.7% during the preceding correction. In the next section, Jackie and I examine the latest developments in the US banking industry, which remains very healthy.

Financials: Not Bad Is Pretty Good. It’s earnings week for the banks, and while not everything about the results coming in is perfect, bottom lines have been good enough—and expectations were low enough—for bank stocks to rally. In general, results were helped by higher net interest income, moderate loan growth, and lower tax rates. Banks continued to return capital to shareholders by paying dividends and repurchasing shares. Those positives were moderately offset by weakness attributable to declines in the equity and fixed-income markets as well as a drop in mortgage originations.

With a handful of banks’ earnings reports in hand, Q4 credit quality remained solid as the economy plugged along. Those solid results probably helped the S&P 500 Financials stock price index outperform both the broader S&P 500 composite and six of the other S&P 500 sectors through Tuesday’s close: Energy (8.2%), Communication Services (7.4), Consumer Discretionary (6.5), Industrials (5.0), Financials (4.3), S&P 500 (4.1), Real Estate (3.9), Information Technology (3.1), Health Care (2.2), Consumer Staples (2.1), Materials (2.0), and Utilities (-0.4) (Fig. 3).

Certainly, the strong start to the year could be in peril, a number of bank executives warned, if the federal government shutdown continues and if a trade agreement with China remains elusive. With that in mind, let’s take a look at some of the highlights from earnings out of JP Morgan, Citigroup, Wells Fargo, and First Republic:

(1) Improved interest income. One worry weighing on bank stocks has been the flattening yield curve. In theory, the flatter the curve, the smaller is the difference between what banks earn on their loans and what they have to pay on their deposits. The difference between the 10-year Treasury yield and the federal funds rate shrank to 32 basis points in the early weeks of 2019, down from 115 basis points at the end of Q3 (Fig. 4).

Despite the pancake-flat yield curve, banks reported improved net interest income in Q4 helped by loan growth. Commercial and industrial loans rose $221 billion y/y to new record highs (Fig. 5 and Fig. 6).

JPMorgan’s net interest income rose 9% y/y to $14.5 billion “driven by the impact of higher rates as well as loan growth,” the company’s press release stated. C&I loans were up 1% at JPMorgan, “reflecting a decline in our tax exempt portfolio given tax reform. Adjusting for this, we would have been up 4%, which is still below the industry as we focus on client selection, pricing and credit discipline,” said CFO Marianne Lake on the company’s conference call.

At Citi, the overall net interest margin (NIM) improved slightly to 2.71% in Q4, up from 2.65% a year earlier. Citigroup’s corporate lending in its Institutional Clients Group rose 9% y/y. Citi’s net interest revenue on core loans (which excludes trading securities and legacy assets) jumped to $11.7 billion, up from $10.3 billion a year earlier.

First Republic’s total net interest income jumped 16.3% in 2018 y/y to $2.5 billion even though the net interest margin dropped to 2.96% in 2018 from 3.13% the year prior. First Republic grew its loan portfolio, which is heavily tilted toward single-family mortgage loans, by 20.7% last year.

(2) Rough capital markets. The selloff and volatility in the stock and bond markets during Q4 took their toll on banks’ trading and asset management operations. During the quarter, the S&P 500 fell by 14.0%, and the yield on US high-yield corporate bonds jumped by 1.87ppts to peak at 8.05% on December 26 (Fig. 7 and Fig. 8).

JPMorgan’s Q4 trading revenue fell 5.7% to $3.2 billion, with fixed-income revenue dropping by 15%. At Citi, fixed-income markets revenues fell 21% y/y, which the company attributed to “volatile market conditions and widening credit spreads, particularly in December,” its earnings press release stated.

The stock market’s decline also took a toll on banks’ asset management arms. At Wells Fargo, total assets under management declined 8% y/y, hurt by equity and fixed-income net outflows, the sale of an asset manager, and lower market valuations.

JPMorgan’s asset and wealth management arm attributed a 2% decline in assets under management, to $2.0 trillion, to lower market levels, offset by inflows into “liquidity and long-term products.” The division’s net revenue dropped 5% y/y and its net income fell 8%.

(3) Fewer home sales, fewer mortgages. The backup in interest rates and the drop in new and existing home sales last year took a toll on the mortgage market. The 30-year mortgage rate spiked up to 4.99% during November 2018, from a recent low of 3.73% during September 2017, falling back a bit to 4.42% in mid-January (Fig. 9). The backup has hurt new plus existing single-family home sales, which tumbled 10.4% from November 2017’s cyclical high of 5.76 million units (saar) to 5.16 million units by October 2018—the lowest level since February 2016 (Fig. 10). Likewise, refinancings dried up (Fig. 11).

Wells Fargo is one of the banks that’s most exposed to the mortgage market. Its mortgage originations of $38 billion were down 17% q/q and 28% y/y, according to the company’s Q4 Quarterly Supplement. The bank wasn’t alone. Citi’s mortgage originations fell 23% y/y, and JPMorgan’s were down 30%, according to a 1/15 MarketWatch article.

In addition to a tough mortgage market, banks are facing tough competition from non-bank lenders, the MarketWatch article concludes. “Among those people who do find houses to buy or a reason to take out a different mortgage, more are using ‘non-banks’ like Quicken Loans and LoanDepot than old-fashioned deposit-taking institutions. As of the end of last year 59% of all mortgages were made by non-banks,” according to Urban Institute data quoted in the article.

(5) Lower taxes and bigger buybacks. Banks continued to benefit from the tax-rate cut put in place at the start of this year by the Trump administration. Next year, those cuts will be anniversaried, making y/y comparisons tougher. JPMorgan’s full-year tax rate was a bit above 20%, and in Q4 Citi’s effective tax rate was 21%.

Share buybacks continued to have an impact. At Citi, average diluted shares outstanding fell 8%, and at Wells Fargo and JPMorgan diluted shares were down 5% y/y.

(6) Banking on earnings. JPMorgan, Citi, and Wells Fargo each are members of the S&P 500 Diversified Banks stock price index, along with Bank of America and U.S. Bancorp. The index has had a strong start to 2019, rising 6.8% ytd, after having a miserable 2018, when it fell 17.8% (Fig. 12).

Last year’s decline has sent valuations in the industry tumbling. The industry’s forward P/E stands at 9.3, down from 12.9 a year ago (Fig. 13). While earnings forecasts were trimmed by analysts in December, both revenue and earnings growth are expected to be respectable (Fig. 14). The industry is forecast to produce a 2.5% increase in revenues this year and an 11.3% improvement in earnings (Fig. 15 and Fig. 16).

Tech: The Battle over AI. Last weekend, “60 Minutes” ran an insightful piece about how China aims to lead the world in artificial intelligence (AI). Scott Pelley interviewed venture capitalist Kai-Fu Lee, who has funded 140 AI startups, including Face++, a visual recognition system. While the US may be ahead in AI today, he contends China is right on Silicon Valley’s heels, aided by the vast quantities of data produced by millions of Chinese citizens, who don’t have the privacy hang-ups of their American counterparts.

Dominating in AI is a priority for the Communist Party, according to its “Made in China 2025” plan. And China’s President Xi Jinping has said: “Advanced technology is the sharp weapon of the modern state.”

Well aware of China’s goals, the Trump administration has made ensuring the security of US corporations’ technology part of the trade negotiations with China. Vice President Pence, in a now-infamous speech to the Hudson Institute in October, made clear that the US has its eyes open.

“To win the commanding heights of the 21^st century economy, Beijing has directed its bureaucrats and businesses to obtain American intellectual property –the foundation of our economic leadership—by any means necessary,” Pence said. “Beijing now requires many American businesses to hand over their trade secrets as the cost of doing business in China. It also coordinates and sponsors the acquisition of American firms to gain ownership of their creations. Worst of all, Chinese security agencies have masterminded the wholesale theft of American technology—including cutting edge military blueprints. And using that stolen technology, the Chinese Communist Party is turning plowshares into swords on a massive scale.”

When it comes to AI, Pence says the Chinese have built “an unparalleled surveillance state,” which includes the Great Firewall of China to restrict the flow of information to Chinese people. The country also aims to introduce the “Social Credit Score,” a ranking of citizens based on a secret methodology.

One’s Social Credit Score could be hurt by “bad driving, smoking in non-smoking zones, buying too many video games and posting fake news online,” a 10/29 article in Business Insider stated. Infractions are punished in various ways, including restricting travel (9 million people with low scores have been blocked from buying tickets on domestic flights, according to the article), banning one’s kids from the best schools, and blocking one from getting the best jobs.

Chinese newspaper People’s Daily may not cover China’s plans to use AI to control its citizens, but it does write often about AI advancements being put to use. Here’s a recap of some recent articles:

(1) Bloomberg sees China winning. China’s push to commercialize AI technologies and its 5G network rollout could help it become the global leader for technology and innovation, per a Bloomberg Intelligence study. Nowhere else in the world is the government so strongly backing AI dominance, said an analyst quoted in the article, who sees China out-producing the US in global technology patents by 2025 and dominating AI by 2030, “led by developments in transportation, corporate services, health care and finance” (12/10).

(2) AI powers smart Chinese hotels. Alibaba opened a hotel of the future powered by AI and robots last month. At the FlyZoo Hotel in Hangzhou, facial recognition systems allow customers to check in, open rooms, and access other hotel services. Lights, TVs, and curtains are controlled by Alibaba’s voice-activated digital assistant. Robots serve dishes, cocktails, and coffee (12/18).

(3) AI directing traffic. DiDi Chuxing, a Chinese ride-hailing company, has partnered with traffic police and Shandong University to use AI and big data to ease traffic. The system, called “JTBrain,” can cover 36 streets and 450 crossroads and “uses AI, big data and cloud computing to search for optimal traffic solutions.” In six-month tests, the system cut average commutes by 11% (12/28).

(4) Alibaba and AI. Alibaba has launched facial recognition payment equipment, dubbed “Dragonfly” (12/28). Working with China’s state-run Xinhua News Agency, Alibaba also has launched an AI-powered production platform, magic.shuwen.com, which will produce short news videos (12/28).

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European Tour

January 16, 2019 (Wednesday)

YRI Video Podcast. Has the stock market discounted all the bad news? That’s the implication of the recent plunge in the Bull-Bear Ratio. In my latest video podcast I observe that it is very bearish, which is bullish if you happen to be a contrarian.

Europe I: Significant Slowdown in Eurozone. The European Central Bank (ECB) ended its four-year-old bond-buying stimulus program in December, but it may yet have to reach into its bag of easy-money tricks.

Weakness persists across the Eurozone in the early days of 2019 as heightened trade tensions, a slowdown in China, uncertainty surrounding the UK’s Brexit plan, political unrest in France, and lingering concerns over Italy’s debt levels depress business and consumer confidence. After Eurozone growth reached the highest pace in a decade during 2017, it slowed markedly in 2018. Eurozone GDP barely grew, rising by just 0.6% q/q (saar) in Q3-2018, its slowest pace in four years (Fig. 1). Forecasts put Eurozone GDP growth at below 1.6% this year, compared with expected growth of 1.9% in 2018 and 2.4% in 2017, noted a 1/7 FT piece.

The MSCI EMU share price index decline of 14.7% (in euro) in 2018 was the second-worst performance of the 11 major market indexes we track, with the bulk of the bad performance coming in Q4, when it dropped 12.9%. Only EM Asia’s drop of 15.0% was worse in 2018. The woes continue for MSCI’s EMU index in 2019: Its ytd gain of 3.0% (local currency) is the third-worst performance among the pack, slightly ahead of EM’s 2.8% and EM Asia’s 2.3%. In dollar terms, the EMU index was the worst performer of 2018, dropping 18.8%. Much of the decline occurred in Q4, when again the index’s 14.3% skid put it at the bottom of the pack (Fig. 2).

Newly released minutes from the ECB’s December 12-13 policy meeting reveal officials understood the risks to the economy, which remained “fragile and fluid” when they ended their quantitative easing program at year-end. Publicly, they referred to the risks as “balanced” and “moving to the downside,” while behind closed doors they voiced greater concern that “risks could quickly regain prominence or new uncertainties could emerge,” according to a 1/10 Reuters report. The bankers recognized that by cutting their 2019 growth forecast for the region, they were tacitly acknowledging the increased risks, noted a 1/10 Bloomberg article.

There was talk, too, of adding a new targeted longer-term refinancing operation (TLTRO) to the monetary tool kit. TLTROs inject liquidity into the system by giving incentives to commercial banks to lend to businesses and consumers. The ECB has undertaken two rounds of TLTROs, in 2014 and 2016. Loans made under the previous four-year TLTRO expire in 2020, Reuters observed in an 11/2 piece.

Cushioning the blow of the bond-buying program’s end, the ECB said in December it will reinvest the proceeds from maturing debt back into bonds to alleviate potential volatility that could raise borrowing costs. While the central bank said it will raise interest rates in 2019 sometime after summer, it left itself room to be flexible.

Let’s review the latest information on the risks facing the Eurozone:

(1) Slowdown continuing. Leading indicators released Monday by the Paris-based Organization of Economic Cooperation and Development (OECD) suggest the Eurozone slowdown will continue, according to a 1/14 WSJ article. The Eurozone leading indicator fell below 100 for the fourth straight month in November and marked its 11th straight decline (Fig. 3 and Fig. 4). The leading indicators are designed to signal turning points in an economy six to nine months in advance.

(2) Sentiment softening. The latest (1/8) release of the European Commission’s (EC) Economic Sentiment Indicator (ESI) showed increasing pessimism in December. The ESI fell 2.2 points to 107.3, its lowest level in two years. The industry, construction, services, and consumer sectors all showed declines in confidence. The lone exception was retail, which showed a tiny gain (Fig. 5 and Fig. 6). The ESI weakened in the Eurozone’s five largest economies: Spain (-3.0), France (-2.0), Germany (-1.9), Italy (-1.4), and the Netherlands (-0.3).

(3) Industrial production down sharply. Industrial production in the Eurozone fell by 1.7% m/m (sa) in November, and 3.2% y/y, according to a 1/14 release from Eurostat, the statistical office of the EC. It marked the steepest drop since February 2016, and cast doubt on any chance of a rebound in Q4, noted a 1/14 piece in the FT (Fig. 7 and Fig. 8). Production was down m/m across the board in capital goods (-2.3%), durable goods (-1.7), intermediate goods (-1.2), non-durable consumer goods (-1.0), and energy (0.0, or more specifically -0.06). Hardest hit m/m were Ireland (-7.5), Portugal (-2.5), and Germany and Lithuania (both -1.9).

Compared with a year earlier, energy production fell 5.2%, capital goods dropped 4.5%, durable consumer goods fell 3.5%, intermediate goods declined 3.0%, and non-durable goods dropped by 0.1%. The member states showing the steepest y/y declines in industrial production were Ireland (-9.1%), Germany (-5.1), Portugal (-2.9), and Spain (-2.8).

(4) Germany’s economy teetering. Weighing heavily on the region is the possibility that Germany, the region’s biggest economy, is close to entering a recession after three straight months of declining industrial production. A 1/15 report by Germany’s federal statistics office said Tuesday GDP grew 1.5% in 2018, the weakest rate of growth since 2013. In the two prior years, the economy expanded by 2.2%.

Still, the number suggests growth in Q4 was positive, following Q3’s 0.2% contraction. Robust domestic demand buoyed by a strong labor market offset weak export sales in the quarter, according to a 1/15 piece in the FT. Unless the figures are revised when the Q4 figures are released next month, Germany appears to have narrowly averted meeting the technical definition of a recession: two consecutive quarters of negative growth. Trouble for Germany is trouble for the entire region. Germany accounts for one-third of total economic output in the Eurozone (Fig. 9).

German industrial production fell 1.9% m/m in November, well below consensus expectations for growth of 0.3%. Declines were broad-based across all industries, suggesting Germany’s problems extend beyond the automotive sector, which has been plagued by quality-control issues as carmakers struggle to comply with new stricter emissions standards that went into effect September 1. On a y/y basis, output fell 4.7% (Fig. 10 and Fig. 11). “There is more to it than just cars,” ING Chief Economist Carsten Brzeski told CNBC in a 1/8 report. “The last significant quarterly surge in industrial production dates to the fourth quarter of 2017. Since then, industrial production has been treading water.”

There’s no question of the importance of the German auto industry to the health of its economy and that of the Eurozone. It’s the largest industry in Germany, accounting for 20% of total industry revenue according to Germany Trade and Invest (GTAI), the country’s economic development agency. It is Europe’s No. 1 auto market. More than 30% of all passenger vehicles in the region are made in Germany, and about 20% of all new car registrations occur in Germany, according to a GTAI report.

December proved to be a dismal month for German automakers and followed a poor November. The number of newly registered passenger cars in Germany dropped 7% y/y in December to 237,100, according to statistics from VDA, the trade group for German automakers. German car makers made 18% fewer vehicles, or 296,000, in December and saw exports drop to 246,800, a 20% y/y decline (Fig. 12).

Last summer’s drought and subsequent drop in water level on the Rhine River also wreaked havoc with industrial production, as shipping was disrupted and supplies limited. The waterway, on which 80% of the 223 million tons of cargo shipped by water in Germany travels, was impassable for much of the summer, creating logistical bottlenecks for important raw materials such as coal, oil, and gas, according to an 11/4 NYT article.

(5) France’s political travails depressing production. Industrial production in France slid by an unexpected 1.3% m/m in November, following gains in two of the prior three months; the result was well below expectations for no change, a 1/10 FT piece pointed out. Manufacturing output fell 1.4% m/m. Blame it on the so-called “yellow-vest” demonstrators who took to the streets to protest the government’s economic policies, forcing business shutdowns (Fig. 13).

In light of the economic weakness, France’s top central banker urged the ECB to take a “gradual and pragmatic” approach as it winds down its stimulus programs. François Villeroy de Galhau, a member of the ECB’s governing council, cautioned the ECB to “keep its options open in the face of current uncertainty,” a 1/10 FT article reported.

Europe II: The Brexit Question. The English punk rock group The Clash famously asked the question, “Should I stay or should I go?” in its hit song from 1981. UK citizens answered that question definitively in a referendum more than two and half years ago when they voted to leave the EU, but their government wrestled endlessly with the question of how best to go about executing such a wrenching split.

Lurching toward a deadline of March 29 without any agreed-upon plan has created huge uncertainty in financial markets and helped to drive down the British pound as well as the euro to levels approached following the Brexit vote in June 2016 (Fig. 14 and Fig. 15). Fearing the worst, companies began triggering contingency plans in December when Prime Minister Theresa May postponed a critical vote, as her agreement with the EU appeared doomed to defeat and her job imperiled.

The “meaningful vote” occurred last night in the House of Commons, and May’s withdrawal agreement was soundly defeated, 432-202. With no Plan B and 10 weeks to go until the end of March, lawmakers in the UK will have to decide quickly on a path forward: negotiating a softer Brexit agreement, holding a second referendum, or facing the chaos of a hard Brexit. Labor Leader Jeremy Corbyn has called for a vote of “no confidence” in May, which could lead to a general election. A 1/15 NYT story reported that few analysts thought Corbyn could get enough votes for such a move.

Europe III: The Good News. Not all is doom and gloom in the Eurozone. Let’s look at some bright spots:

(1) Jobs. The seasonally adjusted unemployment rate in the Eurozone registered 7.9% in November, the first time it has fallen below 8% since October 2008, according to a 1/9 release from Eurostat (Fig. 16). Unemployment was down from October’s 8.0% level and the 8.7% recorded in November 2017. Germany’s 3.3% unemployment rate is the second-lowest in the region, behind the Czech Republic’s 1.9%. Germany’s tight labor market drove stronger domestic demand in Q4, helping to produce positive growth and avert a technical recession.

The picture brightened meaningfully for even those countries plagued by high unemployment. Greece’s 18.6% rate as of September 2018 ranks as the highest, but that is meaningfully down from 21.0% during September 2017. Spain’s unemployment rate is next highest, at 14.7% in November but down from 16.5% a year ago.

(2) Inflation. Inflation in the Eurozone for December is forecast at 1.6%, the lowest level in eight months, thanks to a slower pace of growth in energy costs, according to a 1/4 Eurostat flash estimate (Fig. 17).

(3) Sovereign debt in demand. Investors showed strong appetite for Eurozone sovereign bonds last week, the first sale in the post-QE period, according to a 1/14 piece in the WSJ. More than €37 billion in bonds sold during the first week of 2019, placing the week among the strongest issuances since 2010. Some issuers were urged to come to market ahead of the UK’s Brexit vote. Yields closed lower, and spreads tightened. There was some concern that investors were turning to less risky assets to protect themselves from an economic slowdown.

(4) Whatever it takes. Mario “Whatever-It-Takes” Draghi is still the president of the ECB until October 31. Yesterday, speaking to the European Parliament in Strasbourg, he acknowledged the Eurozone economy is weaker than expected and noted, “a significant amount of monetary policy stimulus is still needed,” according to a 1/15 CNBC report.

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Liquidity: Plenty or Not Enough?

January 15, 2019 (Tuesday)

Strategy: Beauty & Liquidity. Liquidity, like beauty, is in the eye of the beholder. The stock market’s bears have been anticipating a very ugly scenario for a very long time. They’ve claimed that the bull market has been mostly driven by the excessive amounts of liquidity provided by the Fed’s various QE (a.k.a. quantitative easing) programs. They’ve noted a strong correlation between the S&P 500’s performance and the Fed’s holdings of bonds (Fig. 1). They’ve said that once the Fed terminated the provision of additional liquidity through QE net bond purchases, stock prices would take a dive. The Fed did so on October 29, 2014, when its holdings plateaued around $4.2 trillion, yet the bull market proceeded apace, with the S&P 500 rising to a record 2,931 on September 20, 2018.

Then the bears said that the next bear market would start once the Fed pared its holdings of bonds. The Fed began to do so on October 1, 2017. The Fed announced a schedule of QT (a.k.a. quantitative tightening) that would reduce its holdings of bonds from $4.2 trillion to $750 billion by the end of 2023, matching the level just before the adoption of ultra-easy monetary policies during late 2008 (Fig. 2).

The bears also warned that the European Central Bank was likely to terminate its QE program this year, which is what the central bank announced at the end of last year (Fig. 3). The Bank of Japan hasn’t made any such announcement, but reserve balances didn’t rise as rapidly last year as they did from 2013-2016, suggesting that Japan’s central bank may be running out of securities to buy (Fig. 4).

Needless to say, after the sharp selloff in stock prices around the world during the final three months of 2018, the bears are doing high-fives and telling the bulls, “We told you so.” The drying up of central bank liquidity has triggered a bear market, in their estimation.

If liquidity suddenly dried up late last year, why did stocks rebound so strongly since December 24 through last Friday’s close, with the S&P 500 up 10.4% and the Nasdaq up 12.6% over this period? Did liquidity suddenly reappear? If it didn’t, then stocks should resume their slide into bear-market territory.

Then again, I’m not a big fan of liquidity, which makes conceptual sense but is hard to measure and is less useful for predicting markets than for explaining what they’ve already done. By definition, liquidity always flows when asset prices are rising and ebbs when asset prices are falling. In other words, we know this once it has happened. For now, Debbie and I believe the data show that there is plenty of liquidity based on several measures other than the balance sheets of the central banks:

(1) International reserves. One of the few measures of global liquidity is the data series compiled by the International Monetary Fund for the non-gold international reserves of the world’s central banks. The yearly percent change in this variable is very cyclical and tends to be highly correlated with the growth rate of the value of world exports, also on a y/y basis (Fig. 5). Debbie and I think that the reserves indicator is a proxy for the strength of the global economy, especially relative to the US. When the global economy is strong (weak), commodity prices tend rise (fall) and commodity exporting countries tend to accumulate more (fewer) reserves (Fig. 6).

The global economy has been relatively weak over the past year. So international reserves growth was zero in November. That might be bearish for stocks overseas. However, the US economy and corporate earnings are still growing, which should make US stocks relatively attractive for global investors. The absence of a global boom is also helping to keep both inflation and interest rates subdued, which should boost valuation multiples that were beaten down last year on exaggerated fears of a global recession.

(2) US savings flows and liquid assets. Last year, the Bureau of Economic Analysis revised both personal saving and the personal saving rate significantly higher. The 12-month sum of personal saving has averaged $895 billion since the start of 2009, more than double the average from 1990-2008 (Fig. 7). Over the past 12 months through November, Americans saved $1.0 trillion.

Much of their savings have been pouring into mutual funds, ETFs, and savings deposits (Fig. 8). The total liquid assets held by individuals and institutions soared to a record $12.6 trillion dollars at the end of last year, up from $9.1 trillion at the end of 2008 (Fig. 9). Considering that money market and bank deposit rates remain historically low, could it be that Americans remain overly cautious and their financial holdings atypically liquid as a result of their traumatic experiences during the financial crisis of 2008?

(3) Stock buybacks and dividends. It’s hard to blame the stock market rout at the end of last year on a liquidity drought when stock buybacks plus dividends jumped to a record $1.3 trillion at an annual rate during Q3 (Fig. 10). Buybacks might have been temporarily boosted by repatriated earnings, as they rose to a record high of $815 billion at an annual rate—but should remain high—while dividends rose to yet another record high of $461 billion at an annual rate during Q4.

(4) Commercial bank assets. While Fed watchers have been blaming the Fed’s QT program for some of the stock market’s rout late last year, they’ve been missing that US commercial banks and foreign central banks continue to buy and hold US Treasury and agency securities (Fig. 11). So while the Fed’s portfolio of these securities is down $385 billion since the start of October 2017, the holdings of commercial banks and foreign central banks are up $240 billion and $20 billion, respectively, over the same period.

Meanwhile, commercial and industrial loans held by all US commercial banks soared to a record $2.34 trillion at the start of this year (Fig. 12). That’s up $221 billion y/y.

(5) Mutual funds and ETFs. Perhaps last year’s selloff had more to do with a massive shift to risk-off investing from risk-on rather than a sudden shortage of liquidity. That would certainly explain the recent rebound so far in risk-on asset prices around the world. Late last year, exaggerated fears of a recession caused significant slowdowns in the 12-month net inflows to equity and bond mutual funds and ETFs (Fig. 13).

(6) Credit spreads and distressed asset funds. The risk-off nature of last year’s selloff was reflected in the plunge in stock market valuation multiples. It was also reflected in the widening yield spread between high-yield corporate bonds and the US Treasury bond, which is closely correlated with the S&P 500 VIX (Fig. 14).

The spread recently jumped to 530bps. That was still below the 844bps peak in the spike that occurred in early 2016. Back then, the collapse in oil prices and weakness in other commodity prices raised the risks of a global credit crunch and recession led by commodity-related industries.

That scenario was averted because the Fed backed off from raising the federal funds rate until the end of 2016. In addition, OPEC producers cut production to boost oil prices. So it could be déjà vu all over again this year. Also during 2016, distressed asset funds acted as shock absorbers in the credit markets. They could do so again this year if distress shows up in corporate credits, including leveraged loans and junk bonds.

(7) Treasury bonds & the yield curve. There’s certainly plenty of liquidity in the Treasury bond market. When the 10-year Treasury bond yield rose to last year’s high of 3.24% on November 8, there was much chatter about it going to 4.00% and even to 5.00%. That made sense when the Fed seemed to be on a set course to raise the federal funds rate and taper its balance sheet at the same time as the US federal budget was swollen by Trump’s tax cuts. Yet here it is below 3.00%, at 2.70% yesterday.

As I’ve often observed and reviewed in my book Predicting the Markets, flow-of-funds analysis doesn’t have a good forecasting record for the bond yield. More useful is an analysis of how the Fed is likely to respond to actual and expected inflation. The same can be said for the shape of the yield curve, which is currently relatively flat. That may be signaling an impending recession. More likely, in our view, is that it is consistent with our prediction that inflation is dead. If so, then the Fed may be done raising interest rates for the foreseeable future.

In our opinion, the drop in Treasury yields and the widening of credit-quality spreads late last year reflected a shift from risk-on to risk-off, rather than a shortage of liquidity. There have been several such shifts during the current bull market. By our count, there have been 62 panic attacks including the latest one. They were all followed by risk-back-on relief rallies. So far so good for #62, but it remains the latest challenge to our bullish stance on the market.

(8) HFT and algos. The promoters of high-frequency trading (HFT) claim that it increases the stock market’s liquidity. That’s a controversial issue, of course. Less controversial is that algorithm computer trading increases the stock market’s volatility. Long-only investors tend to complain about that during meltdown days rather than melt-up ones. The jury is out on HFT and algos. In any event, computer-driven trading isn’t going away, and probably does contribute to volatility. Humans will just have to adjust to this reality and focus on the fundamentals with a longer-term time horizon.

Global Economy: Falling Into a Recession? While the US economy continues to grow, there seems to be mounting anxiety about the outlook for the global economy. If the latter is falling into a recession, it is hard to imagine that the US can decouple sufficiently from the rest of the world’s woes. Then again, the data show that while the global economy may be slowing, it isn’t contracting. Muddling along is our outlook for the global economy. Let’s review the muddle:

(1) Global indicators are mixed. As Debbie discusses below, the OECD Leading Indicators dipped below 100.0 last year during June and has continued to fall, down to 99.3 during November—the lowest since October 2012 (Fig. 15).

Confirming the slowdown in the global economy last year was the sharp drop in the Goldman Sachs Commodity Index, which is heavily weighted with oil. The CRB raw industrials index was weak during the first half of 2018, but stabilized during the second half of the year (Fig. 16). The plunge in the price of oil had to do with too much supply rather than a shortfall of demand, similar to the situation during the second half of 2014 through early 2016.

The resilience of the global economy is reflected in forward revenues, which is analysts’ consensus expectation for revenues over the coming 52 weeks using the time-weighted average of their current-year and coming-year estimates. The MSCI forward revenues for the US, Developed World ex-US, and Emerging Markets are still on uptrends, though they may be starting to flatten (Fig. 17).

(2) China is maturing. Rapidly growing small companies tend to become big companies. As they mature, their growth rates naturally slow. The same can be said of China’s economy. It is maturing and slowing. This natural process was exacerbated by China’s one-child policy, as we have previously observed.

In recent months, stock markets around the world have been much more sensitive to China’s economic indicators than in the past. Investors seem to be realizing that they can no longer count on China to be a major engine of global growth. We agree with that assessment, but don’t want to exaggerate the negative magnitude of this development.

For example, global stock prices took a hit on news that China’s exports dropped sharply during December. CNBC reported yesterday: “China’s exports unexpectedly dropped 4.4 percent, defying projections of a 3 percent gain. The news appeared to reinforce worries that U.S. tariffs on Chinese goods were starting to take a heavy toll on the world’s second-largest economy.” That’s based on the official data, which are not seasonally adjusted and are volatile from month to month.

Seasonally adjusted data show that China’s exports fell even more, by 7.7% m/m (Fig. 18). A much bigger drop of 16.1% occurred for imports, partly because the price of crude oil dropped at the end of last year. Belying the weakness in the trade data is the railways freight traffic measure, which remained high during November (Fig. 19). We will be watching out for the December figure.

(3) Europe is weakening. The latest batch of European data has been awfully weak, if not downright awful. However, the volume of retail sales excluding autos rose to a record high during November (Fig. 20). That’s about all the good news we can find for Europe. The OECD Leading Indicators for Europe all moved below 100.0 last year through November (Fig. 21). The Eurozone’s Economic Sentiment Indicator also declined all last year, auguring a slowdown in the region’s real GDP growth (Fig. 22).

By the way, today British lawmakers are poised to vote on Prime Minister Theresa May’s Brexit deal, with less than 75 days to go before the country leaves the European Union. Her plan is widely expected to be defeated. As CNBC noted in the story cited above: “That leaves the prospect of a complete collapse of government, a disorderly exit from the bloc or even the entire Brexit process being scrapped altogether over the coming weeks.” Or Brexit will happen, which will still make for a messy situation in Europe.

Movie. “Mary Queen of Scots” (+) (link) has a great cast working with a disappointing script that is rife with historical inaccuracies. Top-notch performances are delivered by Saoirse Ronan as Mary Stuart and Margot Robbie as Elizabeth I. There’s lots of bad blood in the relationship of these two royal sisters, especially since Mary was a Catholic and Elizabeth was a Protestant. The movie does remind us that as awfully uncivil as our political divisions have become in the US today, it was often much worse in the past when monarchs reigned supreme. There was constant intrigue, deception, and backstabbing both in and among their courts. It hasn’t gotten that bad yet in our nation’s capital. Then again, as George Santayana observed, “Those who cannot remember the past are condemned to repeat it.” Note: Best (+ + +) to worst (- - -).

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Lesson Learned in 2018

January 14, 2019 (Monday)

Strategy I: Sentimental Journey. I was the headliner at the annual North Carolina CFA forecasting dinner last Wednesday in Charlotte. There were over 350 people in the room. I asked them to raise their hands if they were bullish, and then if they were bearish. To me, it seemed like 35% were bullish, 25% were bearish, and the rest chose not to raise their hands.

A much better sentiment survey is the weekly one of market commentators conducted by Investors Intelligence. Debbie and I track the survey’s bull-to-bear ratio (BBR). It hit a near-record high of 5.25 during the week of January 16, 2018 (Fig. 1). The S&P 500 peaked at a then-record high of 2872.87 on January 26 (Fig. 2).

That was followed by a 10.2% correction in the S&P 500 lasting 13 days. The index proceeded to make an all-time record high of 2930.75 on September 20, with the BBR down to 3.26. That was followed by a 19.8% correction lasting 95 days. The BBR plummeted to 0.86 during the 1/1 week and rebounded modestly to 1.18 last week. Both of the latest readings were the lowest since early 2016, which was a great buying opportunity. We’ve found that the BBR has provided a very good buy signal whenever it fell to 1.00 or less (Fig. 3). Apparently, it’s still working, since the S&P 500 is up 10.4% since it bottomed on Christmas Eve.

Strategy II: The Upside of 2018. I also asked the audience in Charlotte to raise their hands if they sold all their equities on September 20 and bought them back on December 24. No one raised a hand. Playing corrections, and even bear markets, isn’t so easy. Even if you pick the top in the bull market, you then have to pick the bottom in the correction or the bear market.

Then again, let’s give the bears some credit. They can rightly claim that they finally got their long-predicted bear market. While it remains in the record books as a correction rather than a bear market, it certainly felt like a bear market, with lots of industries and stocks down 20% or more. Indeed, of the 126 S&P 500 industries Joe and I track, 54 fell into bear-market territory from September 20 through December 24 (Table 1).

Yet from September 20 through this past Friday, the S&P 500 is down only 11.4%, with just 19 industries still in bear-market territory (Table 2). Since the December 24 low, the S&P 500 is up 10.4%, with 74 industries up as much or more (Table 3).

In many ways, the latest correction is reminiscent of the 1987 bear market. Back then, it was really a one-day flash crash that occurred on October 19. It was attributable to computer-driven selling by “portfolio insurance” algorithms. There was no recession. The economy and earnings continued to grow. The S&P 500 rose above its previous record high reached on August 25, 1987 on July 26, 1989 (Fig. 4). The current selloff was also exacerbated by algorithms. It certainly was volatile and felt like a flash crash during the final month of last year, which was the worst December since 1931 for stocks.

Meanwhile, as in 1987, there’s no solid evidence of an imminent or impending recession. The current GDPNow model estimate for real GDP growth in Q4-2018 remained at 2.8% on January 10. Payroll employment rose 254,000 per month, on average, during the final three months of 2018. Earnings growth is slowing rapidly, as Joe and I anticipated when we “curbed our enthusiasm” for stocks at the end of last October. But growth should remain positive in the low single digits.

I turned more enthusiastic on stocks the day after Christmas, noting in a CNBC interview that stocks were cheap and that the extraordinary rally that day suggested that “Investors are coming back to their senses. There was way too much fear driving this market.” I reiterated our S&P 500 target of 3100 for the end of 2019. (Of course, I also got the word out to our subscribers in 12/26 and 1/1 video podcasts during our holiday vacation.)

While 2018’s 9.6% gain through September 20 was turned into a 6.2% loss by the end of the year, perhaps we learned something important from last year’s volatility. As both Warren Buffett and Jeremy Seigel have often observed, stocks should be held for the long run. If algorithms are here to stay, they are likely to create more volatility, as was demonstrated last year—all the more reason for long-only investors to stay the course and avoid getting whipsawed. Most investors don’t complain about algos when stock prices are melting up. They only do so when stocks are melting down. However, those meltdowns create buying opportunities.

Then again, selling at the top and buying at the bottom is an achievement that neither humans nor computers are likely to score on a regular basis.

Strategy III: Yearnings Season. As Joe and I anticipated in late October, investors are likely to be yearning in 2019 for the double-digit earnings growth experienced last year. We curbed our enthusiasm for earnings growth back then because we noted that the S&P 500 profit margin had risen to a record high of 12.5% during Q3-2018 thanks to Trump’s corporate tax cut (Fig. 5). We doubt that it can go any higher anytime soon.

So earnings growth should equal revenues growth. The former could be weaker than the latter if the profit margin declines. If earnings growth stays positive in the low single digits (with the help of buybacks), then there is plenty of room for the stock market to move higher along with valuation multiples, which were beaten down during the latest correction. Remember: Instead of discounting last year’s extraordinary gain in earnings, investors chose to ignore it all by slashing multiples in anticipation of a recession that is a no-show so far. Let’s review the latest relevant data:

(1) Q3’s uninspiring earnings season. Industry analysts have been scrambling to slash their earnings estimate for Q4-2018 ever since they received cautious earnings guidance during October’s earnings season for Q3-2018 (Fig. 6). Interestingly, the actual result for that prior quarter turned out to be 5.0% better than analysts estimated at the start of the prior earnings season. Yet they’ve cut the Q4-2018 estimate by 4.0% since early October. Odds are that there will be another better-than-expected hook in earnings, as there often tends to be in this quarterly game.

In any event, analysts are also paring their estimates for earnings during each of this year’s four quarters (Fig. 7). So while they still expect a double-digit gain of 13.4% for the last quarter of 2018, it’s all low-single-digit gains for the first three quarters of this year, at 5.3% (Q1), 4.8% (Q2), and 5.0% (Q3). A double-digit gain of 11.7% is currently expected during the final quarter of this year.

(2) Annual earnings estimates falling. According to the analysts’ consensus, last year’s S&P 500 operating earnings per share soared 22.7% to $162.00 (Fig. 8). Their 2019 and 2020 estimates are falling toward our forecasts of $170 this year and $179 next year. Their current estimates are $173.63 for this year and $192.96 for next year.

The consensus expected growth rate for this year peaked at 10.3% late last year and was down to 7.3% at the start of this year (Fig. 9). The 2020 consensus is up 10.8%. We are forecasting growth rates of 4.3% this year and 5.3% next year. (See YRI S&P 500 Earnings Forecasts.)

(3) Less sizzle in revenues. Industry analysts are estimating that S&P 500 revenues rose 8.8% y/y last year, the best performance since 2010 (Fig. 10). They are expecting less growth this year (6.4%) and next year (4.8%). However, both estimates have actually been rising in recent weeks!

(4) Peaking profit margins. We can use the analysts’ consensus earnings and revenues estimates to derive their implied profit margin expectations for the S&P 500 (Fig. 11). At the beginning of this year, their numbers showed that the margin rose to a record 12.0% for 2018. They are expecting even higher margins this year (12.1%) and next year (12.8%). However, both of these estimates have been falling since late last year. The forward profit margin peaked at a record 12.4% during the 9/13 week, and fell to 12.2% during the 1/3 week.

(5) Valuation’s upside. The forward P/E of the S&P 500 peaked last year at 18.6 on January 23 (Fig. 12). It troughed at 13.5 on December 24. On Friday, it was back up to 14.9. Joe and I believe that this multiple could move higher over the rest of this year. Inflation remains subdued. The Fed may be done raising interest rates for a while. The 10-year Treasury bond yield could remain just below 3.00%. China and the US are likely to hammer out a trade deal by the end of February. Brexit might not happen after all if another referendum is called. The price of oil could stabilize if the Saudis and Russians cut their exports. The dollar could ease a bit. The global economy could show some strength later this year in this scenario.

If so, then Panic Attack #62 was a correction, not a bear market. Whatever we call it, though, it was another great buying opportunity in this bull market.

Movie. “On the Basis of Sex” (+ +) (link) is an interesting, if formulaic, biopic about the life and times of Supreme Court Justice Ruth Bader Ginsburg. The film stars Felicity Jones in the title role of a young woman who excelled at Harvard Law School, but couldn’t find a job at a law firm. Instead, she accepted a teaching position at Rutgers. However, she teamed up with her husband, a prominent tax attorney, to bring a precedent-breaking case before the US Court of Appeals. They won their case, overturning a century of gender discrimination. The movie reminds us of the importance of the rule of law in America. When the rules become antiquated and even oppressive, it’s good to be reminded that there is a very civil legal process for adapting them to conform to our society’s changing needs. It may be a slow process, but it beats the alternatives of radical change.

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5G or Not 5G?

January 10, 2019 (Thursday)

Tech I: 5G at CES. Is 5G the next New, New Thing? Apple and Samsung reported horrendous handset sales in Q4, confirming that the 4G LTE handset market is officially saturated. Anyone who wants a spiffy phone has one, and in Q4 they didn’t see a need to upgrade. But that may change over the next year or two as US phone carriers begin deploying fifth generation—or 5G—wireless networks. To tap into a 5G network, with its faster speeds and lower latency (i.e., delay), users will need new, upgraded phones.

All of the promise and hype surrounding 5G is on display at this week’s Consumer Electronics Show (CES) in Las Vegas. Manufacturers are showing off devices that tap into a 5G network that doesn’t exist in most areas of the US. In addition, the 5G technology has some serious quirks that could prevent mass adoption. But trade shows are not staffed by pessimists. So read on to hear about both the good and the bad that 5G purports to offer:

(1) What the 5G bulls see. The main benefits of a 5G network are faster speed and lower latency. “Qualcomm, the wireless chip maker, said it had demonstrated peak 5G download speeds of 4.5 gigabits a second, but predicts initial median speeds of about 1.4 gigabits. That translates to roughly 20 times faster than the current 4G experience,” a 12/31 NYT article reported. So downloading a movie should take 17 seconds with 5G compared to six minutes for 4G.

A 5G network will facilitate more realistic virtual reality (VR) experiences because it will enable wireless headsets and thus more user mobility—i.e., no need for the VR headsets to be tethered to a personal computer. The lack of latency and faster connections will also make automated cars possible and empower the smart home of the future.

Verizon and AT&T have started upgrading their networks. Verizon has rolled out its Verizon Home 5G service in Houston, Indianapolis, Los Angeles, and Sacramento, while AT&T has upgraded its network in Atlanta, Charlotte, Dallas, Houston, Indianapolis, Jacksonville, Louisville, New Orleans, Oklahoma City, Raleigh, San Antonio, and Waco. This year, AT&T will add Las Vegas, Los Angeles, Nashville, Orlando, San Diego, San Francisco, and San Jose to that list.

(2) What the 5G bears see. Carriers may have started rolling out their 5G networks, but it will be many years before nationwide coverage is available. In the interim, 5G phones will also need to operate on 4G networks, making the phones bulkier and less energy-efficient.

Verizon will be first to offer a 5G phone by offering a device that will attach to the back of Motorola’s Z3, a 4G phone. A 1/8 FierceWireless article anticipated the phone’s arrival in the next month or so. Verizon and AT&T also have plans to offer 5G phones from Samsung later this year. Apple, however, plans to wait until 2020 before rolling out a 5G phone.

Until its phones are developed, AT&T is offering “a 5G mobile hotspot via Netgear's Nighthawk, and free data for up to 90 days. Data will cost $70 a month for 15GB thereafter,” a 12/20 article in Tom’s Guide explained. The Nighthawk works on both 4G LTE and 5G networks.

5G does have some drawbacks, including “worse penetration, smaller range, and more susceptibility to weather when compared to [4G] LTE. A [5G] signal can be blocked by your hand, a tree, a building and even rain or fog,” concluded a 12/20 article in Ars Technica. As a result, 5G networks will need to have more towers and many more antennas. That could limit 5G rollouts to urban areas.

5G phones will have drawbacks as well. 5G phones will need to include more hardware, including a modem and extra antennas. The 5G phones will be more complex and require more power, but the extra hardware in the phones means there will be less space for a battery. The additional hardware needed may also make the phones more expensive, by $200-$300, according to an estimate by OnePlus. As the technology improves, these negatives will likely be reduced, if not overcome.

(3) Implementation. Verizon’s CEO Hans Vestberg gave a number of examples of how 5G will change our world in his keynote address at CES on Tuesday. At last year’s Indianapolis 500, Verizon put a driver in a car that had blacked-out windows and told him to drive the track fast, according to Vestberg’s prepared remarks. The driver wore a 5G head cam that allowed him to “see” the track and with much less latency versus a 4G product.

Vestberg said the Verizon 5G network “will support one million connected devices per square kilometer. By comparison, 4G enables connection of maybe 100,000 devices per square kilometer. That increase has all kinds of amazing implications including the emergence of meaningful device-to-device connectivity, a true Internet of Things.”

Verizon plans to connect 1 million drones to its 5G network through a company it owns, Skyward. The company’s clients use drones for safety inspections when lines of sight from land are obstructed. Low-latency 5G is also expected to be used by the medical profession. Low-latency wireless AR glasses could enable a doctor to look at both a patient’s CT scan and the patient at the same time, allowing a procedure to be done more carefully and precisely.

(4) Carriers vs equipment companies. Verizon and AT&T are the sole members of the S&P 500 Integrated Telecommunication Services industry, which has risen 6.6% ytd and has lost only 4.9% y/y as of Tuesday’s close (Fig. 1). That’s a far sight better than the performance of the S&P 500 Technology Hardware, Storage & Peripherals industry, which has fallen 3.6% ytd and 13.9% y/y (Fig. 2).

The Integrated Telecommunication Services industry is forecast to have revenue growth of 5.1% this year and earnings growth of only 1.4% (Fig. 3 and Fig. 4). The industry’s forward P/E has fallen to 9.8, down from 13.0 a year ago (Fig. 5).

Meanwhile, analysts expect the Technology Hardware, Storage & Peripherals industry will see revenue decline by 1.0% this year and earnings rise only 0.7% (Fig. 6 and Fig. 7). The industry’s forward P/E stands at 11.6, down from 14.0 a year ago (Fig. 8).

Tech II: Quantum Computing at CES. There weren’t any quantum leaps in quantum computing announced at CES, but IBM used the trade show to showcase some incremental advancements highlighting the technology’s progress.

IBM introduced the Q System One, the first quantum computer to “fully integrate high-precision electronics and cryogenic cooling into a stand-alone system,” reports a 1/8 Digital Trends article. The new computer “allows quantum computing to be run outside of the confines of a lab environment—a first for quantum computers, which typically require particular environmental conditions to operate.” The computer is sealed in an airtight container because the slightest vibration from noise or change in temperature prevents it from operating properly.

This still isn’t a computer that a typical corporation would buy. It stands nine feet tall and nine feet wide. But IBM continues to give companies and researchers access to the company’s quantum computers via the Cloud. To that end, the company announced plans to open Q Quantum Computation Center later this year in Poughkeepsie, New York.

In addition, ExxonMobil and CERN, the European Laboratory for Particle Physics, have joined the IBM Q Network, a research effort to advance quantum computing. “Quantum computing can potentially provide us with capabilities to simulate nature and chemistry that we've never had before,” said Vijay Swarup, vice president of research and development for ExxonMobil Research and Engineering in a 1/8 press release. It should help the company to develop new “energy technologies.”

CERN will explore how quantum computing will advance scientific knowledge of the universe. The organization plans to “apply quantum machine learning techniques to classify collisions produced at the Large Hadron Collider, the world’s largest and most powerful particle accelerator.”

IBM laid out how other labs are using IBM’s quantum computers:

(1) The Argonne National Laboratory is developing quantum algorithms to “tackle challenges in chemistry and physics.”

(2) Fermilab is using quantum computers to better understand the results of hadron collisions and to study neutrino-nucleon cross-sections.

(3) Lawrence Berkeley National Laboratory is using them to study “strong correlation, environmental coupling, and excited state dynamics in molecular complexes and materials; novel error mitigation and circuit optimization techniques, and theories resembling the standard model in high-energy physics.”

Tech III: Can Plants Save the World? This past weekend’s “60 Minutes” episode on CBS profiled an amateur scientist, 81-year-old Marshall Medoff, who invented a way to unlock the energy inside plants and use it to create clean fuel for cars, a plastic equivalent that disintegrates, and a sweetener that isn’t fattening.

It’s an amazing story that seems too good to be true. According to “60 Minutes,” 25 years ago Medoff became obsessed with the environment and global warming. He ended his business career and became a scientist, working out of a garage in a storage facility for 15 years in an effort to transform plants into clean and cost-effective transportation fuel.

Medoff knew there was a lot of energy in sugar molecules locked inside cellulose, part of a plant’s cellular walls. He used an electron accelerator and its beams of electricity to break apart the plants and unlock the sugars and trapped energy. Medoff formed a company, Xyleco, and investors gave it “hundreds of millions of dollars” to build a factory. The factory takes agricultural residue, like corn cobs from farms, puts it through the electron accelerator, and combines it with enzymes to release the plant sugars.

One of the plant sugars, xylose, is sweet but not caloric. Medoff is also using the plants to make plastics that can disintegrate as fast as 11 weeks. And perhaps most importantly, he is taking the sugars and converting them into ethanol, gasoline, and jet fuel. The gasoline can be used in cars currently on the road and distributed through existing gas stations. But Medoff’s gasoline emits 77% less greenhouse gas than traditional gasoline.

Xyleco has a Who’s Who board of directors, including Bob Armstrong, the former head of MIT’s chemical engineering department; former Shell Oil executive Sir John Jennings; Steve Chu, former head of the US Department of Energy; George Shultz, former Secretary of State; and William Perry, former Secretary of Defense.

A quick Google search turned up patents held by Medoff, who has no scientific background, but little else about him. The same is true of a Xyleco search. But for Earth’s sake, we hope the story is accurate.

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The Dark Side of the Moon

January 09, 2019 (Wednesday)

China I: In a Dark Place. China landed a probe on the “dark side” of the moon last Thursday. The landing “heats up competition with U.S. to become the first country in half a century to land astronauts on moon,” observed the 1/3 WSJ. A rover deployed from the probe will gather samples intended to provide insights into the moon’s composition. The successful space effort won favorable publicity for Chinese President Xi Jinping, who had personally endorsed the mission.

Xi needs all the positive limelight that he can get. Back at home, China has a serious homegrown economic problem. “China’s one-child policy has created a demographic nightmare for the country,” I noted in a 12/13 presentation that I gave to senior members of Trump’s economic advisers at the White House. I pointed to slowing retail sales growth as an indicator of the country’s economic health. “Hiding in plain sight is that China is seeking to become a super-power before it turns into the world’s largest nursing home,” I explained. The country is still heavily dependent on trading with the rest of the world. So the Chinese government will likely make an acceptable trade deal with the Trump administration, I predicted.

I anticipated China’s recent economic weakness in our 10/1 Morning Briefing: “I’m coming around to a new working hypotheses on the outlook for China’s economy. I think it could be much weaker much sooner than widely recognized. A significant slowing in the growth rate of inflation-adjusted retail sales over the past couple of years suggests that the aging demographic factor—attributable to the government’s previous population control measure—may be hitting consumer spending significantly already. As a result, Trump’s escalating trade war with China may very well hurt China’s economy much harder than widely realized.”

Lately, it seems to have gotten so bad for China domestically that it may have no choice but to make a trade deal in favor of the US, which could be a boon to US and global equity markets.

China II: Dimming Domestic Economy. More evidence recently has confirmed my earlier hypothesis about China’s weakness. Last week, following Apple’s announcement that it had lowered its fiscal Q1 revenue guidance, the company’s CEO Tim Cook told CNBC: “If you look at our results, our shortfall is over 100 percent from iPhone, and it’s primarily in greater China.” He added: “It’s clear that the economy began to slow there for the second half, and what I believe to be the case is the trade tensions between the United States and China put additional pressure on their economy.”

Macroeconomic trends in China are indeed weak. However, Melissa and I agree with Commerce Secretary Wilbur Ross that China’s soft economic data may have less to do with the trade dispute and more to do with China’s domestic economic problems. “I don’t think Apple’s earning miss had anything to do with the present trade talks,” Ross said on CNBC’s Squawk Box on Monday. “Think about it, there have been no tariffs put on Apple products. So that’s not it.”

As more corporate earnings announcements are released, we expect more multinationals to cite China’s economic deterioration. However, we aren’t overly concerned about a slowdown in China spilling over to the US because we think that any impact on US multinationals from China’s slowdown could be offset by the benefit of more favorable trade terms with China.

Reviewing China’s weak trends amid the softening domestic economy and pressure from US tariffs, Ross said: “You look at this morning’s paper: Rate of growth in GDP heading down; rate of growth in retail sales heading down; rate of growth in capital investment heading down.” Let’s have a look at China’s latest macroeconomic data:

(1) Manufacturing contracting. The official M-PMI, which focuses on larger companies, showed a slowdown in activity for December at a reading of 49.4. It contracted below 50.0 for the first time in 29 months (Fig. 1).

China’s manufacturing activity tends to slow down before the Lunar New Year holiday, which starts in early February. But the concern is that these softening trends don’t just reflect seasonal factors but also signify weak demand. The new orders component of the M-PMI was down to 49.7 compared to 53.4 at the same time last year.

The Caixin/Markit Manufacturing Purchasing Managers’ Index, a private survey focusing on small and medium companies, also dropped in December, to 49.7 from 50.2 in November.

(2) Retail sales declining. Every month, the Chinese report retail sales and the consumer price index (CPI). We’ve been monitoring the yearly percent changes in both for many years (Fig. 2). The difference between the two is the growth rate in real retail sales. It has been on a downtrend since 2008-2010, when it typically exceeded 15%. During November, it was down to 5.9%, the lowest reading since May 2003. It is down from 10.0% during March 2017.

(3) GDP. China’s economic growth slowed to 6.5% y/y in Q3 from 6.7% during Q2 and 6.8% during Q1 (Fig. 3). The Q3 number was the weakest pace since Q1-2009, according to official Chinese data released during October.

(4) Auto sales stalling. “Car sales have been shrinking for the first time since 1990, when most of the country was pedaling bicycles,” observed the 1/3 WP. The 12-month sum of China’s auto sales dropped 4.1% during November since peaking in June (Fig. 4). Auto production, which is highly correlated with auto sales, also declined, by 4.3%, over the same period.

The downturn in China’s car market has left foreign automakers with idle factories. The 12/25 WSJ reported that the lack of production at “one Peugeot factory” has meant that “skilled workers spend their days washing floors or attending Communist Party political study sessions at work. At a Ford plant, workers’ shifts have been reduced to a few days a month, according to employees.”

(5) Apartments not selling. A 12/30 NYT article titled “Empty Homes and Protests: China’s Property Market Strains the World” discussed dropping property sales in China. Unwanted and unsold apartments are “weighing on China’s economy.” Lots of developers who made big bets on China’s property market are deep in debt.

China III: Bright Spot for the US. On Friday, President Trump told reporters at the White House that he thinks that “China wants to get it resolved. Their economy’s not doing well. I think that gives them a great incentive to negotiate,” reported Reuters. After a previous call with China’s President Xi on 12/29, Trump tweeted: “Deal is moving along very well. If made, it will be very comprehensive, covering all subjects, areas and points of dispute.”

Beijing is learning how much it depends on the US, Ross said in the Squawk Box interview. Ross added that China’s economic slowdown is a “big problem in their context of having a very big need to create millions of millions of jobs to hold down social unrest coming out of the little villages.” He argued that Chinese workers are migrating to cities to find jobs but are coming back home empty-handed. That’s “a very disgruntled group of people,” he said. He also said that companies are moving manufacturing out of China.

Reuters wrote on Monday that US venture-backed tech companies are “staying on the safe side of the fence,” avoiding making deals with Chinese investors for “optical reasons.” Considering China’s economic and social ills, the latest round of talks appears to be going quite well for the US. Let’s discuss:

(1) Where there’s a will. Beijing and Washington have “expressed a will to work together,” reported CNBC according to Lu Kang, a representative of China’s foreign ministry on Monday. The Chinese official’s comments were made amid US-China trade talks led by Deputy US Trade Representative (USTR) Jeffrey Gerrish in China. The two-day round of talks ended yesterday.

(2) China taking this seriously. A photo posted on Twitter of Liu He, Chinese vice premier and top trade negotiator, at the talks prompted Scott Kennedy, a China expert at the Center for Strategic and International Studies, to comment that Liu He’s attendance and the number of people in the room were “good signs” that “serious working-level discussions” were happening. Also sanguine about the talks is Larry Kudlow, the administration’s chief economic adviser, who told Bloomberg TV on Friday that preliminary discussions were “a little more optimistic than usual.”

Liu’s appearance signals that China is attaching high importance to the talks. On 1/7, Bloomberg reported: “Liu is the top economic adviser to Chinese President Xi Jinping, who led previous negotiations in Washington that produced a deal that President Donald Trump then repudiated. China had previously said the talks would be led by a lower-ranking official from the Ministry of Commerce.”

(3) So far, so good. As we write this, the talks in China are carrying on and expected to continue into Wednesday for an unscheduled third day. Yesterday’s WSJ reported: “‘Talks with China are going very well!’ President Trump wrote in a tweet while the negotiations were wrapping up for the day Tuesday after 9 p.m. Beijing time. A Chinese official with knowledge of the talks described the conversations as ‘constructive.’”

More senior-level discussions are anticipated later this month with Liu, USTR Robert Lighthizer, and US Treasury Secretary Steven Mnuchin meeting soon after in Washington, reported the 12/29 WSJ.

The goal of the talks is to ensure that Beijing makes good on promises made since previous talks in early December. US negotiators want specifics from China, like what goods and services it will purchase from the US by specific dates. The US side also wants assurance from Beijing that it won’t use government authority over licensing and environmental regulation to hinder US companies if further access is granted to Chinese markets, explained the 12/31 WSJ. China previously has resisted giving details around these pledges, having a “poor follow-up record.”

China IV: The End Is Near. China has until March 1 to work out a deal with the US or it will face the higher tariffs. Last year, the US imposed 25% tariffs on $50 billion of Chinese imports in two phases: $34 billion (effective July 6, 2018) and $16 billion (effective August 23, 2018). Further tariffs of 10% were imposed on an incremental $200 billion in Chinese imports effective September 24, 2018. (See our chart as well as this helpful timeline from Peterson Institute for International Economics.) On September 17, the White House released a Statement from the President stating that the tariffs on the $200 billion were set to rise to 25% on January 1.

On September 7, President Trump threatened to impose tariffs on all Chinese imports to the US, which amounts to about $500 billion in total. During December, Trump softened on the matter following trade meetings with Chinese leadership. According to a 12/1 White House press release, Trump agreed to leave the tariffs on the $200 billion at 10% for a 90-day grace period until a deal is reached. If no deal is reached by 3/1, the 10% tariffs will be increased to 25%.

The 1/1 NYT reported that Lighthizer has taken a consistently harsh stance in negotiations with China. Lighthizer “has warned Mr. Trump that the United States may need to exert more pressure through additional tariffs in order to win true concessions.”

Lighthizer said on Face the Nation on 12/9 that March 1 is a hard deadline. He explained: “When I talked to the President of the United States, he’s not talking about going beyond March. He’s talking about getting a deal. If there is a deal to be gotten, we want to get it in the next 90 days.”

China V: Not So Easy. China will likely need to do something more to reinvigorate its darkening economic outlook. On Friday, the People’s Bank of China (PBOC) cut bank reserve requirements by a full percentage point to support China’s slowing economy amid pressure from US tariffs on imports of Chinese goods (Fig. 5).

The PBOC’s reserve cut was the first for 2019 but the fifth in a year. The PBOC introduced a new tool in December, the targeted medium-term lending facility, to encourage commercial banks to give out more loans to smaller firms. The government has said it will step up other policy support as well, such as infrastructure spending and tax cuts.

Late in December, Chinese leaders had pledged to keep monetary policy prudent, striking an “appropriate” balance between tightening and loosening in 2019. It dropped “neutral” as a policy description. Bloomberg observed that the new language, along with moves to boost private-sector funding, prompted speculation that cuts to bank reserve-ratio requirements or benchmark interest rates would be forthcoming in 2019.

Meanwhile, China’s M2 measure of money supply has been declining since reaching a 14.0% y/y growth rate in January 2016, falling to 8.0% in November—the lowest rate in the history of the series going back to January 2000 (Fig. 6). Significantly, China’s real retail sales growth is highly correlated with China’s real M2 (Fig. 7). Both have been trending in the wrong direction for China.

Staving off China’s economic slowdown would likely take further action from the central bank as well as significant concessions in the trade talks with the US.

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Deflationary Demographic Developments

January 08, 2019 (Tuesday)

Global Demography: Death Toll. In Chapter 16 of my book Predicting the Markets, I observe that fertility rates have dropped below replacement rates around the world as a result of urbanization. Only in India and Africa are couples having enough babies to replace themselves. Humans are on a demographic path of self-extinction.

Leading the way has been Japan. I have often described the country as the world’s largest nursing home. That distinction undoubtedly will soon belong to China. All around the world, nursing homes will be bulging with more occupants, while the maternity wards will have lots of vacant cribs.

The economic consequences of these demographic trends will be slower growth and subdued inflation, if not outright deflation. That means that interest rates most likely will remain historically low for a very long time. That could be positive for the valuation multiples that investors are willing to pay for the stocks of companies that are able to grow their earnings at an above-average rate. It should also be very positive for the stocks of companies that are able to grow their dividends in this demographically challenged environment.

A global shortage of workers should stimulate more labor-saving and labor-replacing technological innovations. The result should be faster productivity growth. That should give a lift to real wages that should offset some of the slowdown in employment growth attributable to labor shortages.

The scenario I just sketched isn’t a forecast. It is a description of exactly what has been happening in Japan. The forecast is that most of the rest of the world will follow suit. Japan is the poster child for the rest of us who aren’t having enough babies to replace ourselves. Consider the following:

(1) Japan. On a 12-month basis, the number of deaths in Japan exceeded the number of live births for the first time during July 2007 (Fig. 1). On this basis, during July of this year, deaths exceeded live births by a record 351,000 (Fig. 2). The situation has been exacerbated by a record low of only 586,700 marriages over the past 12 months through July (Fig. 3).

So Japan’s population has been falling in recent years and rapidly aging. The percentage of the population that is 65 or older has increased from 25.2% at the start of 2014 to 28.2% at the end of last year (Fig. 4). Yet the total labor force has actually been rising gradually over the past few years (Fig. 5). That’s because the labor force participation rate has been moving higher (Fig. 6). The problem is that more Japanese women have been entering the labor force and not getting married, which depresses the number of births. If that continues, the number of births will remain depressed.

These demographic trends go a long way toward explaining why Japan’s inflation rate remains near zero, despite the ultra-easy monetary policies of the Bank of Japan, which has been targeting a 2.0% inflation rate since January 22, 2013 (Fig. 7). Older people and fewer children aren’t conducive to home-building, car-buying, or the consumption of other durable goods.

(2) China. The demographic profile of China isn’t as geriatric as Japan’s, but it is heading in the same direction, accelerated by the government’s one-child policy that was in force from 1979 through 2015 (Fig. 8). For the first time ever, the percentage of seniors in the population, at 6.6%, matched the percentage of children under five years old during 1998 (Fig. 9). By the middle of this century, the former is projected by the UN to rise to 26.3%, while the latter falls to 4.6%.

Young married adults who have no siblings must accept the burden of taking care of four aging parents. Now that the government has declared that couples can have more than one child, many are likely to be overburdened having even one child.

As I’ve noted in recent months, all this is weighing on Chinese real retail sales growth, which has been on a downtrend for the past several years (Fig. 10).

(3) United States. The good news in the US is that the fertility rate is in line with the replacement rate. However, the demographic trends are heading in the wrong direction. Young people are staying single longer. Newly married older couples are likely to have fewer children than younger couples. The cost of college education is also a downer for many couples, forcing them to consider how many children they can afford.

The proof is in the maternity wards. Over the past 12 months through March, live births in the US totaled 3.84 million, the lowest since November 1997 (Fig. 11). Over the same period, the number of deaths totaled a record 2.36 million. So births exceeded deaths by 1.48 million, the lowest reading on record, dating back to December 1972 (Fig. 12).

Meanwhile, as the Baby Boomers age, they are turning into minimalists. They don’t need their big houses anymore. They don’t need minivans to take the kids to soccer practice. The Millennials are natural-born minimalists, for reasons that Melissa and I have reviewed in the past on many occasions.

We don’t view this as necessarily bad news for the US economy. Rather, we see these demographic trends as reducing the likelihood of an economic boom, which reduces the likelihood of a bust. The business-cycle expansion should continue, and inflation should remain subdued.

Inflation: Moderating Cost Pressures. While wage inflation has been moving higher, price inflation remains subdued, as Fed Chairman Jerome Powell observed at the end of last Friday. The day before he said so, the Institute for Supply Management (ISM) reported that the prices-paid index in their December manufacturing survey dropped sharply. It was down to 54.9 last month from 60.7 during November and a 2018 high of 79.5 during May. The sharp drop in the price of oil since October 3 clearly has contributed to the drop in this price index. So has the weakness in other commodity prices (Fig. 13 and Fig. 14).

Yesterday, the ISM reported a noticeable easing in inflationary pressures in the service sector as well, with the price index sinking from 64.3 to a 17-month low of 57.6, as three-quarters of respondents reported no change in prices-paid, while 8% reported lower prices. The index peaked at 65.9 during September 2017, remaining at an elevated level above 60.0 until last month’s 6.7-point drop.

Strategy: Earnings Season Starting. The Q4 earnings reporting season is about to get underway. We think there will yet another positive surprise, but it’s sure to mark the beginning of the slowdown in profits growth. Analysts expect S&P 500 earnings to rise 13.4% y/y in Q4, down from 27.5% in Q3-2018. Still, that marks the tenth straight quarter of positive y/y earnings growth and the fifth with double-digit percentage gains.

Of the 10 sectors expected to record positive y/y earnings growth, six are forecasted to rise at a double-digit percentage rate, down from 10 during Q3. Here are the latest forecasted Q4-2018 earnings growth rates on a proforma same-company basis versus their final Q3-2018 growth rates: Energy (64.3% in Q4-2018 versus 114.2% in Q3-2018), Industrials (24.8, 18.9), Financials (22.1, 44.8), Communication Services (17.5, 26.1), S&P 500 (15.1, 28.4), Consumer Discretionary (13.2, 25.4), Health Care (11.1, 16.5), Tech (8.9, 29.1), Real Estate (6.9, 5.3), Materials (6.0, 30.1), Consumer Staples (2.8, 11.4), and Utilities (-9.0, 10.9).

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Patient Powell’s Put

January 07, 2019 (Monday)

US Economy: Flash Recession? There’s still no recession evident in the Atlanta Fed’s GDPNow forecasting model or in our forecast for this year. On Thursday, January 3, the model’s estimate for real GDP growth in Q4-2018 was revised down to 2.6% from 2.7% on December 21. The Nowcasts of Q4’s real consumer spending growth and real private fixed investment growth decreased from 3.7% and 2.7%, respectively, to 3.6% and 2.4%, respectively, after the release of the weak Manufacturing Report On Business from the Institute for Supply Management (ISM) last Thursday. After Friday’s blowout employment report, the GDP forecast is bound to be revised higher.

The weakness in December’s M-PMI was foreshadowed by the month’s regional business surveys conducted by five of the Fed’s district banks. They all suggested that economic growth is slowing rapidly and that inflation is moderating. The rapid falloff in these indicators during December was signaled by the flash crash in the S&P 500, which fell 9.2% during the month, the worst December since 1931. Arguably, the plunge in stock prices might have triggered a “flash recession” in the economy.

The “most hated bull market in history” has had frequent panic attacks on fears that “the most widely anticipated recession in history” is imminent. They were followed by relief rallies when the downturns didn’t happen. While some of the latest data may be raising the odds of a recession, they are also raising the odds that our “data-dependent” Fed won’t be raising interest rates in 2019, and might actually have to lower them, which would lower the odds of a recession and quickly reverse any flash recession that might be out there.

That’s certainly the forecast of the fixed-income markets. Consider the following:

(1) Interest rates going south. The 12-month forward federal funds rate has dropped 64bps from last year’s high of 2.88% on November 8 to 2.24% last Thursday (Fig. 1). In other words, this indicator suggests that the Fed won’t be hiking the federal funds rate this year. The two-year Treasury note yield also tends to be a good year-ahead indicator of the federal funds rate. At 2.50% on Friday, it too is predicting that the Fed is done for the foreseeable future.

The bond market is sending the same message, as the 10-year Treasury yield has dropped from last year’s high of 3.24% on November 8 to 2.67% on Friday (Fig. 2). Leading the way down has been the embedded inflation expectations component of the bond yield. It has declined from 2.17% late last year to 1.76% on Friday (Fig. 3). The yield curve remains positive, but barely so at 30bps for the spread between the 10-year yield and the federal funds rate (Fig. 4).

Meanwhile, credit quality spreads have deteriorated as the high-yield corporate bond rose from 5.8% at the start of last year to 7.6% on Friday, with its spread over the 10-year Treasury at 491bps, well above the stable readings of around 350bps over the past two years (Fig. 5 and Fig. 6). Memo to Fed officials from the credit markets: Take the year off.

(2) Business surveys taking a dive. The big shocker recently was the plunge in the average of the composite business indicators compiled by five of the Fed’s district banks (Fig. 7). It dropped from 16.6 during November to 2.0 last month, the lowest reading since October 2016. The weakness was led by a flash crash in new orders, while employment remained solid. The orders index plummeted from 15.2 during November to 7.7 in December.

The national M-PMI is highly correlated with the average of the regional indicators. The overall M-PMI wasn’t as weak as the regional average, but the orders component of the M-PMI flash crashed from 62.1 during November to 51.1 during December, the lowest reading since August 2016 (Fig. 8).

Previously, we’ve shown that the y/y growth rate in S&P 500 revenues per share is highly correlated with the M-PMI (Fig. 9). So the recent weakness in the latter suggests slower growth in the former. Then again, December’s flash crash in the stock market (along with the “Tariff Man” in the White House and the Fed’s “autopilot” for tapering its balance sheet) may have triggered the flash crash in new business orders last month. If China and the US make a trade deal and if the Fed turns dovish, then the flash recession could be just that.

(3) Leading indicators peaking? Then again, Debbie and I are keeping track of the 10 components of the Index of Leading Economic Indicators (LEI), and more of them have stopped flashing green. None are flashing red (though the bears are seeing this color in the S&P 500 component), but yellow is coming into fashion (Fig. 10).

We note that initial unemployment claims may have bottomed during December simply because they can’t go much lower. The new orders component of the M-PMI is also a component of the LEI, and it took a dive last month, as noted above. There may not be much upside in building permits. Consumer expectations indexes were weak at the end of last year. The yield curve spread may be getting closer to zero, but it remains positive, which means it is one of the few components that actually might have boosted December’s LEI!

(4) Labor market still booming. Widespread reports of labor shortages don’t seem to jibe with the strength of monthly payroll gains. It may be taking longer to hire suitable candidates, and some may require training to make them suitable. However, Friday’s December jobs report certainly helped to dispel the notion that the economy is either running out of workers because it is too strong or falling into a recession because it is too weak! There was no sign of a flash crash in that report. Instead, as Debbie discusses below, payrolls soared 312,000 last month, the best m/m gain since February 2018. Last year’s gain was 2.6 million, up from 2.2 million during 2017.

Wages for all workers rose 0.4% m/m and 3.2% y/y (Fig. 11). Our Earned Income Proxy for total private-sector wages and salaries jumped 0.9% m/m during December—its biggest monthly gain since March 2014 (Fig. 12).

(5) Truckers still trucking. Furthermore, there’s no recession in the trucking industry. It remains crash-free as the trucks continue to barrel down our highways and byways. While there is a shortage of truck drivers, so far it hasn’t depressed the ATA truck tonnage index, which rose to another record high in November (Fig. 13). Also at a new record high last month: payroll employment in the industry (Fig. 14).

The Fed: Powell Turns Dovish. On Friday, along with the blowout employment report, dovish remarks from Federal Reserve Chairman Jerome Powell sent the DJIA up 746 points. Speaking on a panel with former Fed chairs Janet Yellen and Ben Bernanke at the annual meeting of the American Economic Association and Allied Social Science Association in Atlanta, Powell emphasized that the monetary policy path is not on autopilot.

Powell’s pronouncements over the past several months have contributed to the markets’ going haywire since early October. In a 10/3 interview, Powell said that the federal funds rate was a long way off from neutral. He also signaled that the Fed would not hesitate to raise interest rates beyond what is considered neutral and maybe even to restrictive heights. Since then, I have been in the Fed-watchers’ camp that argues that the Fed should press the pause button on rate-hiking.

Powell inadvertently freaked out the markets again at his 12/19 press conference when he responded to a question on monetary policy as follows: “So we thought carefully about this, on how to normalize policy, and came to the view that we would effectively have the balance sheet runoff on automatic pilot and use monetary policy, rate policy, to adjust to incoming data.”

The market has been adjusting—perhaps with unwarranted volatility—to Powell’s pragmatic and transparent style. Meanwhile, Powell seems to be tweaking his messaging to achieve less haphazard market reactions. Powell tends not to be shy about speaking off the cuff. But after the two gaffes noted above, Melissa and I noticed that he read his preliminary comments on Friday from carefully prepared notes.

Back in September, the Fed had projected about three rate hikes for 2019. Following the December 18-19 meeting of the FOMC, Powell lowered that to two hikes. Investors are now speculating about the possibility of no rate increases or even a rate cut for 2019, with both scenarios consistent with Powell’s dovish remarks. Powell’s Friday comments on the Fed’s balance sheet also suggested a marked shift in policy, as we discuss below.

Another big deal, in our opinion, is that equity markets suddenly seem to matter a lot more to Powell. According to him, the Fed is listening to the markets and may pause rate-hiking for a while. The Dow Vigilantes may have gotten their Powell Put! So equity investors may shift their focus to global economic growth, the China-US trade negotiations, the Q4 earnings season, and the government shutdown.

For now, let’s have a closer look at Powell’s dovish remarks:

(1) Patience and flexibility. Powell said that the Fed is willing to be “patient.” He noted that to keep the US economic expansion on track, “there is no preset path for policy.” He stated: “We will be prepared to adjust policy quickly and flexibly and use all of our tools to support the economy should that be appropriate.”

Interestingly, Powell brought up the example of 2016 when the Fed expected to raise rates four times, but only did so once as the economy weakened. Later, the gradual path of rate hikes resumed. “No one knows whether this year will be more like 2016,” he said. “But what I do know is that we will be prepared to adjust policy quickly and flexibly.”

However, Powell sees US economic momentum moving into 2019 with strong jobs growth, low unemployment, higher labor force participation, and higher wages. He noted that the latest below-expectations ISM data isn’t all bad, as it is consistent with ongoing growth and had previously been elevated above historical averages. In other words, these data aren’t what is driving Powell’s dovishness.

(2) Muted inflation. In the past, Powell has been wary of the models that drove policy for his predecessors. Powell has specifically questioned the relationship between wages and broader inflation. Confirming this view, he said on Friday that the “link between … wage inflation and price inflation is pretty weak.” He added: “Wages going up isn’t necessarily inflation.”

As noted above, average hourly earnings rose 3.2% y/y during December, the highest since April 2009. However, November’s reading for the personal consumption expenditures deflator, the Fed’s preferred inflation measure, was up 1.8% y/y in November, which is just shy of the Fed’s stated 2.0% goal. Powell said: “With the muted inflation readings that we’ve seen coming in, we will be patient as we watch to see how the economy evolves.”

Going forward, he said: “We have inflation under control” and “that’s a pretty good outcome,” which we expect to continue despite strong job growth, low unemployment, and stronger wage gains.

(3) Markets matter. Markets are “obviously well ahead of the data,” but “we’re listening very carefully,” Powell said. The downside risks priced into the markets are “about slowing global growth, particularly related to China, about ongoing trade negotiations, about general policy uncertainty coming out of Washington,” among other factors.

Powell noted that weak China data may be spilling over into emerging Asia and commodity prices, especially copper. However, he added that the Chinese authorities are stepping in with stimulus. The rest of the world is showing consistent growth, he said. Nevertheless, he stated that “policy is very much about risk management.” And the Fed is considering the disconnect between the economy and the markets.

(4) Balance sheet not on autopilot. The Fed’s balance-sheet reduction is not an “important part of the story,” according to Powell. But “if we reached a different conclusion, we wouldn’t hesitate to make a change.” Following the 2008 recession, the Fed’s quantitative easing programs led the Fed to grow its balance sheet to more than $4.5 trillion. It has been rolling off $50 billion per month since October 2017.

Some view this as quantitative tightening. So Powell’s statement that the Fed is flexible (and not on “automatic pilot,” as he had said during his December 19 presser) came as a relief to investors.

(5) Declaration of independence. Powell curtly responded to the question “Would you resign if Trump asked you to?” with a simple “no.” In recent weeks, the media reported that the President would like to meet with Powell to discuss policy. Trump has been a vocal opponent of the Fed’s interest-rate hikes. For now, it sounds as if there is no meeting scheduled between Powell and the President. Powell doesn’t seem to be overly influenced by Trump’s rhetoric. But Powell does seem to be increasingly influenced by the financial markets, which happen to agree with Trump.

Movie. “Vice” (-) (link) is another historical docudrama that is rife with inaccuracies, which reduces its credibility. The movie is about the political life of Dick Cheney, who served as vice president under George W. Bush. The movie’s unflinching theme is that Cheney was power hungry and was directly responsible for the war in Iraq, waterboarding, global warming, and everything bad that has happened to us since 9/11. At the end of the movie, Cheney’s character, played eerily well by Christian Bale, addresses the movie’s audience directly. He snarls and growls that he does not care how he is portrayed because he made the country safe. One person stands out as able to have stood up to Cheney, Secretary of State Colin Powell. He gave a speech at the UN on February 5, 2003 to drum up support for overthrowing Saddam Hussein. It was based on flimsy intelligence, and Powell knew it. In September 2005, Powell was asked about the speech during an interview with Barbara Walters and responded that it was a “blot” on his record. Imagine if he had refused to support the war. Note: Best (+ + +) to worst (- - -).

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Unhealthy Developments

December 20, 2018 (Thursday)

The Fed: Powell Is No Santa. Yesterday, Fed Chairman Jerome Powell confirmed that his Fed remains independent of the White House. On Monday, President Donald Trump berated the Fed for even considering raising rates. Yet that’s exactly what Powell and the Federal Open Market Committee voted to do at yesterday’s monetary policy meeting. The stock market fell on the news that Powell was not wearing his Santa outfit.

Interestingly, the 10-year Treasury bond yield fell, signaling that the Bond Vigilantes are leaving it to the Dow Vigilantes to punish the Fed for its Grinch-like decision. In my opinion, by proceeding with yesterday’s rate hike and suggesting that two more are on the way for 2019, the odds that there will be no rate hikes in 2019 have increased. That’s confirmed by the reaction in the bond market.

I still don’t expect a recession in 2019, but slower economic growth and possibly even lower inflation should dissuade the Fed from hiking rates in 2019. While the outlook for earnings growth remains challenging, as Joe and I have been discussing since late October, we are sticking with our target for the S&P 500 of 3100 by the end of next year based on our view that the economy will continue to grow in 2020.

Strategy: Mnuchin vs HFTs. As I previously reported, I attended a White House lunch of the President’s top economic advisers last week on Wednesday (12/12). While I can’t disclose who was there, I was pleased to read a 12/18 Bloomberg article titled “Mnuchin Blames Volcker Rule, High-Speed Trading for Volatility.” This was one of the four issues I brought up in my presentation. I didn’t mention the Volcker Rule. But I did opine that high-frequency trading (HFTs) may account for some of the volatility in the stock market this year, and I advocated for restoring the Securities and Exchange Commission’s uptick rule, which Melissa and I discussed in the 12/12 Morning Briefing.

The Bloomberg article mentioned the HFT issue, but not the uptick rule. The article noted: “U.S. Treasury Secretary Steven Mnuchin blamed volatility in equity markets partly on high-speed trading and the effect of the Volcker Rule, adding that he planned to conduct an inter-agency review of market structure. … Mnuchin said he will ask the Financial Stability Oversight Council, which he heads, to study stock market volatility. While he has not ‘pre-judged’ what exactly is behind the sharp moves before a review is complete, Mnuchin said problems with market structure ‘may be one of the reasons.’”

Health Care: Wounded by the Courts, I. When we were sitting down for Thanksgiving dinner, the S&P 500 Health Care sector was outperforming other sectors in the index ytd. Since then, the sector’s ytd gain has been halved to 4.3%. Headlines out of the judicial system calling into question the legitimacy of the Affordable Care Act (ACA) sent shares of some of the largest companies in the sector tumbling. The best-performing sector ytd is one of the worst-performing sectors so far in December.

Here’s the dismal performance derby for the S&P 500 sectors in December through Tuesday’s close: Utilities (-2.0%), Real Estate (-4.3), Communications Services (-4.9), Tech (-6.4), Consumer Staples (-6.9), Consumer Discretionary (-7.1), Materials (-7.5), S&P 500 (-7.8), Industrials (-8.8), Health Care (-9.1), Energy (-10.2), and Financials (-11.7) (Fig. 1).

Ytd results for the S&P 500 sectors look a bit better: Health Care (4.3%), Utilities (2.9), Consumer Discretionary (1.0), Tech (0.7), Real Estate (-2.0), S&P 500 (-4.8), Consumer Staples (-8.7), Industrials (-13.0), Communication Services (-14.2), Financials (-14.9), Materials (-16.7), and Energy (-18.1) (Fig. 2).

Let’s examine what’s dimming the performance of the top-performing sector as the year comes to a close:

(1) Obamacare drama. Last Friday, a US district judge ruled that the ACA is unconstitutional because it requires Americans to obtain medical insurance. The ruling upheld a lawsuit brought by 20 Republican states. The ACA will remain in place if the Democrats appeal the decision, as is expected.

The ruling may put Republicans in a difficult situation because the ACA has grown in popularity. There are about 11.8 million Americans enrolled in Obamacare insurance plans.

“Senior Republicans are divided over whether to continue their push to repeal the act, or whether to move instead towards more moderate bipartisan action to change its terms. While the party has campaigned heavily to repeal the act in the past, the law has gained in popularity over recent years, and is now supported by more Americans than oppose it,” a 12/16 FT article reported.

President Trump has called for Congress to pass a new health care law that would protect those with pre-existing conditions. Republican Senator Susan Collins wants to see the ACA’s requirement to purchase health care struck down even though Congress has eliminated the penalty for failing to take out insurance. Meanwhile, some Democrats would like the law strengthened and turned into Medicare for all.

(2) From best to worst. The ACA has been a boon for health care companies as more patients had health insurance, sought care, and could pay for the care they received. In the wake of the judge’s ruling, the S&P 500 Health Care sector’s stock price index tumbled 6.2%. The sector was dragged down by many of its industries, including Health Care Distributors (-9.0%), Health Care Facilities (-8.4), Pharmaceuticals (-7.5), and Managed Health Care (-7.5) (Fig. 3). They were each among the worst-performing industries we track.

The S&P 500 Health Care sector contains numerous industries with above-market earnings growth expected for 2019, but they also have above-market forward P/Es. Here are the Health Care industries expected to see faster earnings growth next year than the 8.1% forecasted for the S&P 500 as a whole, along with their 2019 earnings growth forecasts and forward P/Es: Managed Health Care (14.0%, 17.1), Life Sciences (11.3, 23.8), Technology (9.2, 20.9), Health Care Equipment (9.2, 22.1), and Health Care Supplies (9.0, 24.8). The sector’s forward P/E of 15.7 is dragged down by the Pharmaceuticals industry, which has a forward P/E of 15.6. Pharmaceuticals is expected to grow earnings by 3.4% in 2019 versus the sector’s 7.1% expected earnings growth (Fig. 4 and Fig. 5).

Consumer Staples: Wounded by the Courts, II. Despite its involvement with all things health related, CVS Health is actually a member of the S&P 500 Drug Retail industry, which is part of the Consumer Staples sector. It too took one on the chin after a federal judge’s ruling.

US District Judge Richard Leon questioned the Justice Department’s decision to allow CVS Health’s acquisition of Aetna. The federal judge noted that the American Medical Association objected to the merger, stating it would substantially reduce competition in health care to the detriment of patients.

Judge Leon initially threatened to halt the integration of the two companies while he considers the deal’s implications, a 12/3 WSJ article reported. The decision was highly unusual because judges typically rubber-stamp agreements between the Justice Department and two companies involved in a deal.

This week, CVS offered to maintain control over the pricing of its products and services for its insurance customers and said the two companies wouldn’t exchange competitively sensitive information, a 12/18 WSJ article reported. The federal judge agreed to CVS’s offer and suggested bringing in an outside monitor to ensure that the offer was upheld. His review of the acquisition could take “at least several months.” Ironically, this is the same judge that stopped the Department of Justice from preventing the merger of AT&T and Time Warner.

CVS shares are down 13.3% since the judge’s first ruling on 12/3. The stock’s performance has weighed on the S&P 500 Drug Retail stock price index, which is down 10.9% so far in December and up 6.9% ytd (Fig. 6). The S&P 500 Drug Retail industry, which also includes Walgreens Boots Alliance, is expected to grow revenues by 4.6% and earnings by 8.6% in 2019 (Fig. 7 and Fig. 8). The industry’s forward P/E at 12.3 is near the low end of its two-decade range (Fig. 9).

Technology: Autonomous Vehicles Hitting the Streets. Driverless cars and trucks are inching closer to reality, with numerous test programs occurring in various countries around the world. Here’s a quick look at the latest at home and abroad:

(1) AVs delivering groceries. Kroger has started using unmanned autonomous vehicles to deliver groceries in Scottsdale, Arizona. The company is working with Nuro’s R1, a custom unmanned vehicle that uses public roads and will only transport goods, a 12/18 Reuters article reports. Kroger’s Fry’s Food Stores will offer the service for $5.95 with no minimum order requirement for same-day or next-day deliveries.

(2) Honking at no one. According to an 8/28 article in The Information, Waymo’s autonomous cars in Chandler, Arizona are annoying fellow drivers. “More than a dozen local residents who frequently encounter one of the hundreds of Waymo test vehicles circulating in the area complained about sudden moves or stops. The company’s safety drivers—individuals who sit in the driver’s seat—regularly have to take control of the wheel to avoid a collision or potentially unsafe situation,” the article reported.

The vans were reportedly having trouble crossing a T-intersection, making unprotected left turns, and merging into heavy traffic, especially on highways. Sometimes the vans don’t understand features like metered red and green lights that regulate cars merging onto freeways. And they are challenged by humans who don’t follow traffic laws. That said, Waymo’s autonomous vehicles are considered to be ahead of the competition.

(3) Swedes in the fast lane. Einride, a startup company, has an electric, autonomous truck driving on a commercial route between warehouses in the southern Swedish city of Jönköping, reports a 11/5 article in Wired. The truck, with no cab and no human driver, covers about six miles a day at speeds below 25 miles per hour. An Einride employee in a call-center-like facility can drive the truck remotely if a problem occurs.

(4) Honda goes AV. Honda Motor is developing an Autonomous Work Vehicle, according to a 12/13 article on Trucks.com. The vehicle can be used for landscape and agriculture tasks. It has been used to carry supplies and equipment to firefighters and then can trail behind the firefighters in “follow-me” mode. The vehicle has also been used on a farm, where workers load it with produce that the vehicle drives to an area for unloading.

(5) Hello, Vera. Volvo’s Vera looks like a sporty car that’s connected wirelessly to a remote transport control center, which would have operators to monitor Vera’s location. Vera can be attached to existing truck trailers, thereby limiting the need to build new systems. Volvo hopes Vera will operate in restricted areas, like ports or warehouse districts, “to carry big loads along fixed routes,” reports a 9/13 article on Trucks.com.

(6) Plug in and go. Anthony Levandowski, the engineer named in the trade-secret lawsuit against Uber by Waymo, has a new company, Pronto AI, that has developed Copilot. It’s a $4,999 driver-assistance-system kit for long-haul trucks driving on the highway.

“Levandowski said the Pronto system—which he tested with a hands-off, 3,100-mile cross-country drive of his own Toyota Prius sedan in October—uses predictive software paired with an array of six cameras. The cameras send images of the road to a pair of computerized ‘neural networks’ that analyze the images and makes instantaneous decisions regarding steering, acceleration and braking. Neural networks function much like the human brain, learning from the information they take in and continually updating their responses in reaction to new information,” according to a 12/18 article on Trucks.com. “Levandowski says the system is faster, more accurate and more responsive than the radar and lidar-based technology on which most autonomous driving systems are based.” That said, driving on the highway is the easy part. Driving on side roads in populated areas is far more difficult.

Looks like a drag race among autonomous driving systems is shaping up.

Industrials: Shifting Production. Rising wages and higher taxes have been pushing some manufacturing jobs out of China and into less expensive Southeast Asian countries for awhile. But the shifts may be accelerating due to US tariffs on goods imported from China and the weak yuan. Those manufacturers who remain in the country are increasing the automation in their factories and producing higher-end, more complex products.

Samsung Electronics plans to close a Chinese smartphone factory by year-end and shift production to India, a 12/13 WSJ article reported. It attributed the move to China’s rising labor costs and global trade uncertainties. The move affects about 2,000 Samsung employees in a factory that produces about a third of the company’s China-made phones. Samsung continues to operate another handset factory in southern China as well as factories that produce other items, like batteries and memory chips.

“Between 50% and 60% of the roughly 300 million Samsung handsets shipped annually are assembled in Vietnam, 20% to 30% in China and 10% in India, according to a July report by Simon Woo of Bank of America Merrill Lynch. Following the expansion of the India facility, the percentage of Samsung phones made in China could eventually drop to about 10%,” the WSJ article stated.

Smaller manufacturers are also on the move. A 9/21 article in the South China Morning Post tells of Xie Xusheng, who laid off 160 workers in his processing factory in southern China after opening a new factory in Vietnam’s Ho Chi Minh City earlier this year. It makes shoes, bags, and accessories for American brands. Only 40 senior skilled workers remain in the Chinese plant for complicated sample development.

“Small businesses are increasingly struggling with shrinking foreign orders due to US tariffs, a depreciating yuan that raises the cost of imported materials and soaring domestic costs for energy, taxes, rent and labour,” the article stated. “This year, the number of lay-offs at small and medium-sized manufacturing firms, tech start-ups and financial organizations has grown at a double-digit rate in percentage terms, according to industry analysts. The situation threatens to get worse, given the escalating trade war with the US.”

“The Global Manufacturing Industry is Moving Out of China” is the title of a 10/19 article in The Epoch Times, a New York City-based newspaper founded by a group of Chinese Americans with a focus on news about China and human rights issues. It states that over the past decade, China’s manufacturing wages have tripled as taxes, energy prices, and exchange rates have increased.

“China’s average direct production cost in 2004 was 6 percent lower than Mexico’s, but by 2014, Mexico’s production cost was 4 percent lower than China’s …The current average manufacturing cost in China is only about 5 percent lower than in the United States,” according to a Boston Consulting Group report sited in the article.

The article notes that Taiwanese factories in China that manufacture shoes for Nike, Adidas, Under Armour, and other brands have moved their production lines to Southeast Asia and India and “Kerry Logistics Network Ltd, Asia’s largest shipping and logistics company based in Hong Kong, is currently moving its production lines from China to Malaysia, Vietnam, Myanmar and even Laos.”

The march of progress continues, with a little extra push from US tariffs.

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European Disunion

December 19, 2018 (Wednesday)

Strategy: Analysts Curbing Their Enthusiasm. Joe and I curbed our enthusiasm for the S&P 500 earnings outlook at the end of October. Now industry analysts are doing so as well. Keep in mind that they have only just started to lower their estimates, which remain well above our own for 2019 and 2020. Of course, investors haven’t been waiting for the analysts, as evidenced by the severe drop in valuation multiples since the record high in the S&P 500 on September 20.

The problem, as we have observed before, is that comps are going to be tough in the coming year following this year’s earnings, which were boosted by the tax cut, record profit margins, and above-average growth in revenues. This suggests that earnings growth at best should be in the low single digits next year, not the high single digits as analysts still expect. Investors perceive that the risk is on the downside if the trade war persists next year, if global economic growth slows, and if profit margins get squeezed. Let’s look at the latest data:

(1) Annual revenues and earnings estimates. Remarkably, consensus analysts’ expectations for S&P 500 revenues during 2019 and 2020 remained on uptrends during the 12/6 week even though a slowdown of revenues growth is expected, from 8.8% this year to 5.8% next year and 4.6% in 2020 (Fig. 1 and Fig. 2).

In the past few weeks, the analysts have started to reduce their earnings estimates for the next two years (Fig. 3). The 2019 earnings growth rate has been lowered from a high of 10.3% during the 10/7 week to 8.5% during the 12/6 week (Fig. 4). The growth rate for 2020 remains around 10%.

Joe and I are currently projecting revenues growth of 5%, and the same for earnings growth. Our earnings estimate for next year is $170 per share, while the analysts are well above us at $175.60.

(2) Quarterly earnings estimates. Analysts are doing what they typically do as an earnings season approaches: They are cutting their estimates (Fig. 5). The growth rate for Q4-2018 has been reduced from 18.2% at the end of September to 14.5% currently (Fig. 6). That’s not unusual. They often do so only to find that the earnings season was better than their downwardly revised estimates. What is unusual is that they’ve been lowering their estimates for all four of next year’s quarters, which is reflected in their 2019 estimate (Fig. 7).

(3) Next year’s profit margin. The strength in consensus revenues estimates relative to consensus earnings estimates shows that analysts are starting to chip away at their profit margin expectations (Fig. 8).

(4) Bottom line. So we are still expecting revenues and earnings to grow next year because we aren’t in the recession camp. It’s just that we foresee slower growth than analysts are expecting, and their expectations are very likely to come down to our numbers. The latest correction seems to be discounting the possibility that earnings growth will be flat to down next year. We doubt it, but the jury is out.

European Union I: Happy Anniversary? January 1 marks the 20^th anniversary of the Eurozone’s adoption of the euro as the region’s official single currency. There is good reason to celebrate, especially since skeptics have been predicting the euro’s demise since its inception. But hold the bubbly. Other than a #EUROat20 hashtag on Twitter and an event in Brussels held earlier this month, the day is likely to come and go with little commemoration and seems to be actively being downplayed.

Two decades on, the Eurozone and its single currency continue to confront more than their share of critics, as nationalistic and anti-democracy movements gain traction in the region and the current US administration heaps criticism on the bloc, even referring to it as a “foe,” as a 12/24 New Yorker article points out. It’s a sharp contrast to the hoopla that greeted the then electronic-only currency when it made its trading debut on January 4, 1999.

Launched first on the Frankfurt Stock Exchange by virtue of an 8:30 a.m. start, the occasion was marked with flashing blue lights, images of the euro projected on the wall with a sign declaring “Der Euro Ist Da” (“The Euro Is Here”), and Beethoven’s Ode to Joy broadcast across the trading floor, according to a 1/5/99 report in the Washington Post marking the historic event. In a sign of the giddiness surrounding its introduction (with some imagining the new currency challenging the US dollar as the world’s reserve currency), the euro closed that first day at $1.1747 from the $1.1686 value assigned to it. Thin trading volume also helped give it a lift. Still, its value quickly depreciated by the end of the year, and G7 countries stepped in to support the fledgling currency (Fig. 9). Only when physical coins and notes began widely circulating in 2002, replacing the legacy currencies of the individual nations, did the euro begin to appreciate markedly.

The goal of the single currency: stimulating trade by establishing stable, secure, and transparent cross-border pricing, reducing costs, and strengthening the Eurozone’s hand in global commerce. The challenge: managing monetary and fiscal policy in a way that balances the needs of all members. The vision: European unity.

Fast-forward to today. After rising through much of 2017 and reaching a three-year high of $1.24 in early 2018, the euro ended Monday at $1.136, down 5.3% ytd and off 8.0% from its January high. It reached an all-time high of $1.60 in July 2008 before being dragged lower by the global financial crisis that unfolded later that year.

Political unrest in France, political uncertainty surrounding the UK’s “Brexit” departure from the broader European Union (EU), political defiance from Eastern European members of the EU, political change in Germany, and a political standoff with Italy over its proposed budget have strained both the EU and the Eurozone. A serious economic slowdown looms across the region, exacerbated by global trade wars and a slump in auto sales. To top it off, the European Central Bank (ECB) is ending its three-year QE stimulation program this month and suggesting the possibility of raising interest rates in the fall of 2019. Not since the debt crisis has the EU faced such serious tests. Let’s review what currently ails the EU:

(1) Business lagging. Growth in business activity across the EU slowed in December to the weakest level in four years, according to a 12/14 IHS Markit Flash PMI survey. The Flash Eurozone Composite Output Index fell from 52.7 last month to 51.3 in December, the lowest reading in 49 months (Fig. 10). New business orders came to a near standstill, job creation fell to a two-year low, and business optimism faded further.

The Eurozone’s economic sentiment index—which is highly correlated with real GDP growth—has been in a downtrend since late 2017 (Fig. 11). Auto sales weakness in the EU and violent protests in France have played a role. Yet Chris Williamson, the chief business economist at IHS Markit, noted “the weaker picture also reflects growing evidence that the underlying rate of economic growth has slowed across the euro area as a whole.”

(2) ECB cuts forecasts. ECB President Mario Draghi last week cut growth forecasts for the Eurozone to 1.9% in 2018, down from 2.0% projected in September, reported a 12/13 CNBC article. Also, estimates for 2019 GDP growth were revised lower to 1.7% from 1.8%. Draghi noted the “balance of risk is moving to the downside” and cited the “persistence” of geopolitical factors, protectionism threats, as well as emerging market “vulnerabilities” and volatility in the financial markets.

(3) ECB ceases bond-buying. The ECB issued a 12/13 statement prior to Draghi’s press conference confirming that its asset purchase program will end this month. The central bank revealed it plans to reinvest principal payments from maturing bonds for an extended period, past the date when it starts raising key rates and “for as long as necessary to maintain favorable liquidity conditions and ample monetary accommodation.” The central bank will keep interest rates at current levels “at least through the summer of 2019” (Fig. 12).

(4) MSCI Valuation. On a local currency basis, the MSCI EMU Share Price Index is the second worst performer ytd of the 49 countries tracked, down 12%. Only Emerging Markets Asia has fared worse, with a drop of 13.5%. Its decline of 10.1% in Q4 to date puts it just ahead of the Developed World ex-US’s loss of 10.4% so far this quarter. The story changes in dollar terms, with the MSCI EMU Share Price Index dead last in the performance derby, with a loss of 17.1% ytd and down 12.5% Q4 to date. Except for Telecommunications and Utilities, all of the MSCI EMU sectors are trading below their 200-day moving averages (Fig. 13).

European Union II: Brexit Pains. Chief among the contributors to economic uncertainty in the EU is the UK’s tortuous attempt to leave the union as directed by its citizens following a referendum in June 2016. While it opted out of joining the monetary union, the UK has been a member of the EU common market for 40 years. Here are the latest developments of the circus-like spectacle known as “Brexit,” which we covered at length in the 11/28 Morning Briefing:

(1) Shelved vote. Prime Minister Theresa May postponed a parliamentary vote last week on her Brexit agreement with the EU, acknowledging that it would be defeated by a wide margin, according to a 12/10 BBC report.

(2) Move to shelve PM. The shelved vote led to a movement by members of her own Conservative party to shelve May. She won the confidence vote by 200-117, but emerged badly diminished from the fray and now faces the prospect that no deal she proposes will be backed by Parliament, as a 12/12 WSJ article pointed out. A bid by May to secure more concessions from EU leaders failed.

(3) New vote. May scheduled more parliamentary debate for January 7, with a vote on the agreement to come a week later, moving the country closer to a “her deal or no deal” choice, despite calls for a second referendum. An EU court ruled that the UK could unilaterally cancel Brexit, but May has dismissed that option as a betrayal of the voters’ rights, according to a 12/10 Guardian article.

(4) Currency sell-off. The pound has lost 6.6% ytd, ending Monday at $1.26 amid growing prospects of a chaotic and disorderly exit from the EU and concerns about the Labour party gaining power if May’s government falls (Fig. 14).

(5) Capital flight. Credit Suisse has advised its ultra-wealthy clients to consider accelerating plans to move assets out of the UK ahead of the January 14 vote, according to a 12/18 piece in the FT.

(6) MSCI valuation. The MSCI UK Share Price Index has fallen 11.0% ytd in local currency terms and is off 8.80% qtd. In dollar terms, the UK index is off 17.4% ytd and 12.1% qtd (Fig. 15).

European Union III: Continental Discontent. A funny thing happened as French President Emmanuel Macron was busy pushing his bold economic reform plans while focusing on holding the center of the EU together: He overlooked the wave of discontent roiling the middle and under classes in his own country. That discontent erupted in November in violent street protests known as the “Gilet Jaunes,” or “Yellow Vests,” movement, so-called because of the demonstrators’ reflective vests.

Higher fuel taxes and reduced job protections, amid regulatory rollbacks for businesses and the repeal of a wealth tax, sparked the demonstrations. Macron, his approval ratings plummeting, responded immediately by suspending the fuel tax increase for six months, raising the minimum wage, cancelling a planned tax increase on low-income pensioners, repealing a tax on overtime pay, and encouraging employers to pay a year-end bonus. He easily survived a no-confidence vote in the French parliament because of his responsiveness, observed a 12/13 WSJ piece.

The new measures have put France’s budget on track to reach 3.4% of GDP in 2019, exceeding the EU’s limit of 3.0% of GDP and its previous budget proposal of 2.8%, according to a 12/16 Reuters article. Due to the budget squeeze, France will move independently to impose a tax on international tech giants such as Google and Facebook beginning January.

Italy’s hardline deputy prime ministers, meanwhile, softened their stance and agreed to cut planned spending to appease Brussels and avoid sanctions. Under a proposal, Italy will produce a budget of 2.0% of GDP instead of the 2.4% initially put forth, according to a 12/17 FT report.

Germany’s CDU party elected to embrace continuity and the legacy of Chancellor Angela Merkel by electing her protégé Annegret Kramp-Karrenbauer as its new leader in elections held December 7.

The only reason to break out the bubbly in the EU is that New Year’s is coming.

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The True Story

December 18, 2018 (Tuesday)

True Story I: Dow Vigilantes & Santa. If you had any doubts about the existence of the Dow Vigilantes, two have stepped forward to identify themselves as such. The 12/16 WSJ included an op-ed by Stanley F. Druckenmiller and Kevin Warsh titled “Fed Tightening? Not Now.” They warn that the combination of quantitative tightening and interest-rate hiking could cause serious damage to the global economy and financial markets. They conclude:

“This is a time for choosing. We believe the U.S. economy can sustain strong performance next year, but it can ill afford a major policy error, either from the Fed or the rest of the administration. Given recent economic and market developments, the Fed should cease—for now—its double-barreled blitz of higher interest rates and tighter liquidity.”

The recent selloff in stock prices shows that the Dow Vigilantes are screaming “no mas!” We will find out tomorrow whether the Fed will take their advice, during Fed Chairman Jerome Powell’s press conference following the FOMC’s two-day meeting. Let’s see if he will be wearing a Santa suit. The odds are increasing that the FOMC might vote to hold off on another hike this year. In any event, Powell will certainly signal that the process of raising interest rates will be even more gradual than previously indicated by the Fed’s dot plot. Yes Virginia, there is a Santa Claus—we hope.

True Story II: Banks Are Very Profitable. Why does the yield curve have such a good track record of forecasting recessions when it inverts? Prior to the last six recessions, it inverted for 56 weeks, on average, before the downturns (Fig. 1). That’s the widely accepted story. However, a closer look at the weekly spread between the 10-year US Treasury yield and the federal funds rate (which is the “official” version of the spread in the monthly Index of Leading Economic Indicators) shows that it has also inverted in the past prematurely, giving false alarms. For example, during the longest economic expansion to date, it turned negative a couple of times during 1995 and again during 1998. The recession actually started in March 2001.

Notwithstanding the false alarms, the question of why the yield curve has consistently inverted prior to recessions remains. One widely held view is that banks stop lending when the rates they pay in the money markets on their deposits and their borrowings exceed the rates they charge on the loans they make to businesses and households. So an inverted yield curve heralds a credit crunch, which inevitably causes a recession.

In a 12/5 post on Eaton Vance’s Advisory Blog, Andrew Szczurowski convincingly argues that “the market is looking at the wrong curve. It’s not an inverted 2s-10s, or 2s-30s, or 2s-5s curve that matters. What really matters, in my mind, is what is happening to the curves at banks.” He observes:

“At the same time, the rates banks are charging for a mortgage are up 150 basis points from their lows. This is the first hiking cycle where banks’ margins are actually increasing as the Fed is hiking rates. The reason being, they aren’t paying their depositors much more today than they were over the past few years.”

So what really matters is the net interest margin of the banks. Consider the following:

(1) Interest margin. Data available for all FDIC-insured financial institutions show that the margin has increased from a recent low of 3.0% during Q1-2015 to 3.5% during Q3-2018 (Fig. 2). That has coincided with the Fed’s program to normalize the federal funds rate (Fig. 3). It is up 200bps from 0.00%-0.25% in late 2015 to 2.00%-2.25% currently. Yet the net interest income of FDIC-insured institutions rose to a record $137 billion during Q3-2018 (Fig. 4).

(2) Charge-offs and dividends. There’s no sign of distress, or even stress, in the FDIC data. Net charge-offs have been relatively stable around $10 billion per quarter for the past few years (Fig. 5). Provisions for loan losses have matched the charge-offs. Cash dividends rose to a record $43.8 billion last quarter (Fig. 6).

(3) Business loans. Remember the scare about the near-zero slowdown in the growth of commercial and industrial loans at the beginning of this year (Fig. 7)? Fuhgeddaboudit: Loan growth has picked up since then, rising 8.9% y/y to a record $2.3 trillion through the 12/5 week (Fig. 8).

(4) Bottom line. Despite this year’s flattening of the yield curve, there’s no sign of a credit crunch at the banks.

True Story III: Capital Spending at Record High. Another widely held view is that corporations aren’t spending enough on plant and equipment because they’re spending too much on buying back their shares with too much money borrowed in the bond market. Au contraire: The GDP data show that nominal capital spending rose to a record high of $2.8 trillion (saar) during Q3-2018 (Fig. 9). Over the past year through Q2-2018, S&P 500 buybacks totaled $646 billion. That’s a lot, but it wasn’t enough to slow capital spending. Consider the following:

(1) Buybacks and dividends. It’s true that the sum of buybacks and dividends paid by S&P 500 companies has equaled close to 100% of their operating income over the past few years (Fig. 10). Specifically, buybacks plus dividends equaled $1.08 trillion over the past year through Q2, while operating income totaled $1.20 trillion. “What a waste of money that could have been used to expand capacity and boost labor compensation,” say progressive do-gooders.

(2) Capital spending and cash flow. So how did capital spending rise to a record high if most of corporate profits were used for buybacks and dividends? Corporate Accounting 101 teaches that corporate cash flow is the driver of corporate income statements. Data collected by the Fed for nonfinancial corporations show that internal cash flow fully covered gross fixed investment—which rose to a record $2.0 trillion—over the past year through Q3 (Fig. 11). The overwhelming majority of cash flow is attributable to the capital consumption allowance, i.e., depreciation, which in effect serves as a huge tax shelter for corporate income (Fig. 12).

(3) Corporate bond borrowing. It’s true that nonfinancial corporate bond debt rose to a record $5.5 trillion during Q3 (Fig. 13). However, the y/y change in this series shows that the pace of net borrowing has fallen from a record $462 billion during Q3-2015 to $125 billion during Q3 (Fig. 14). Gross issuance typically well exceeds net issuance, as it has during the current expansion, suggesting that lots of bonds have been refinanced at relatively low interest rates (Fig. 15).

The Fed: Magical Mystery Tour. While I’ve been moonlighting as a movie reviewer for several years, Fed Vice Chairman Richard Clarida has been moonlighting as a folk-rock singer. The former PIMCO executive was sworn into his starring role at the Fed during September of this year. We found some of his musical tracks here on YouTube.

Clarida is about to lead the Fed on a magical mystery tour over the coming year to reassess the making of monetary policy. The idea was proposed by Clarida on behalf of the Fed’s Subcommittee on Communications and mentioned in the minutes of the 11/7-8 FOMC meeting, which stated: “The goal of these discussions would be to identify possible ways to improve the Committee’s current strategic policy framework in order to ensure that the Federal Reserve is best positioned going forward to achieve its statutory mandate.”

The Fed is open to suggestions, as suggested by its 11/15 press release, “Federal Reserve to review strategies, tools, and communication practices it uses to pursue its mandate of maximum employment and price stability.” It stated that the district “Reserve Banks will host a series of public events around the country to hear from a wide range of stakeholders” over the coming year. The Chicago Fed will sponsor a research conference on June 4-5 next year with speakers and panelists from outside the Fed system. Then, around the middle of 2019, “Federal Reserve policymakers will discuss the perspectives offered during the outreach events as part of their review of how to best pursue the Fed’s statutory mandate. At the end of the process, policymakers will assess the information and perspectives gathered during the year of review and will report their findings.”

That’s all that the announcement said. So I asked Melissa to dig around for more specifics about what is likely to be discussed at these events. Her findings suggest that members of the Fed are seriously considering alternative options to inflation targeting. The Fed’s dual mandate as dictated by Congress is to achieve maximum employment and stable prices. Currently, the Fed aims to achieve a 2.0% inflation target. In an 11/27 speech, Clarida outlined the Fed’s challenge in meeting its objectives with a question: “What might explain why inflation is running at or close to the Federal Reserve’s long-run objective of 2 percent, and not well above it, when growth is strong and the labor market robust?”

To solve for this problem, Fed members are considering new monetary policy tactics that we discuss below. Most involve purposefully overshooting this target in “good” times to offset expected undershoots during “bad” times. To us, it seems Fed members are searching for ways to justify holding interest rates lower for longer. Consider the following:

(1) Embarking on the journey. Clarida seems to be spearheading the pursuit to reset the Fed’s framework. Supporting the effort is New York Fed President John Williams. In June, Williams was promoted to his current post from his former position as the San Francisco Fed President. The Fed vice chairman and head of the New York Fed are the most influential policymakers after the Fed chairman. The head of the New York Fed serves as the vice chairman of the Federal Open Market Committee (FOMC) and is a permanent (versus rotating) voter at policy meetings.

In a 12/3 video interview with Bloomberg, Clarida gave a nod to Williams’ 11/30 speech. In it, Williams provided some clues as to what sort of monetary policy tools the heads of the Fed are most interested in reevaluating. It was titled “Monetary Policy Strategies for a Low-Neutral-Interest-Rate World.” Williams explained that the reason the Fed is embarking on this journey is that low interest rates are likely here to stay. Factors contributing to historically low interest rates are structural and outside of the Fed’s control, including aging demographics, low productivity, and the demand for safe assets.

Structurally low interest rates are a problem for monetary policymakers. If a recession hits, “central banks may not be able to reduce interest rates well below their neutral level to stimulate the economy as warranted because of the effective lower bound on nominal interest rates. This shortfall of monetary accommodation would result in less desirable economic outcomes during the recession and recovery. In particular, inflation would typically undershoot its desired target during these episodes.”

(2) Alternative ways to target inflation. Williams proposes three solutions to the problem, which are sure to be extensively discussed during the Fed’s strategic review process. The first option is for the Fed to continue to target 2.0% inflation. When economic downturns hit, the Fed will be forced to use a combination of “aggressive conventional and unconventional policy actions” to offset the effects of being limited by a low-interest-rate floor. But doing so carries the “risk that inflation expectations become anchored at too low a level.”

The second option is for the Fed to move to “average-inflation targeting.” With that, the central bank intentionally aims to overshoot the inflation rate in “good” times. That can offset inflation rates below desired levels during “bad” times, ensuring that the longer-run average inflation rate and inflation expectations stay in line with the target.

The third option is “price-level targeting,” as well as its “various offshoots” such as nominal GDP targeting and temporary price-level targeting. With price-level targeting, the central bank “commits to keep the price level near a steadily growing target path.” Like average-inflation targeting, an overshoot of the target inflation rate in “good” times purposefully offsets an undershoot of inflation “when policy is constrained” under price-level targeting.

By the way, Williams didn’t specifically mention it, but FRB-SL President James Bullard, a non-voter on the FOMC this year, recently suggested another alternative to policy-setting. Bullard argued that the Fed should modernize the Taylor Rule, a policy-setting tool first introduced by John Taylor in 1993. In a 12/7 speech, Bullard recommended lowering the values of two of the key variables in the Taylor Rule equation: inflation and the natural rate of interest (i.e., the rate that keeps the economy moving at an even keel). Bullard concludes that this modernized rule would suggest that the Fed should maintain the current policy rate for longer, whereas the original version of the rule would suggest raising it.

(3) Ex Fed heads weigh in. Two former Fed chairs have recently discussed different approaches to inflation targeting. In a 10/12 opinion piece for Brookings, former Fed Chair Ben Bernanke proposed “an option for an alternative monetary framework” that he calls a “temporary price-level target—temporary, because it would apply only at times when short-term interest rates are at or very near zero.” Bernanke describes the approach in detail. The gist is that the Fed would pursue an overshoot during times when the Fed perceives structurally low interest rates as a challenge. When interest rates are behaving more normally, then the Fed would return to its 2.0% target.

In a 12/6 opinion piece for Yale Insights, former Fed Chair Janet Yellen advocated for average-inflation targeting. She wrote: “I frankly think it’s appropriate after a long period when inflation’s run shy of 2% to then allow inflation to run above 2%. I would be inclined to establish as a target something like 2% on average over the business cycle.”

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Deflationary Demographics

December 17, 2018 (Monday)

Strategy I: Correction or Bear? The S&P 500 dropped 1.9% on Friday to 2599.95, the lowest reading since April 2 (Fig. 1). Panic Attack #62 isn’t over yet. Instead, it is back in correction territory. The S&P 500 is now down 11.3% from the 9/20 record high of 2930.75 (Fig. 2). This makes it the sixth correction since the start of the bull market.

The latest panic attack has been mostly driven by fears that the Fed has been hiking the federal funds rate too rapidly, raising the odds of a recession, as evidenced by the flattening of the yield curve. In addition, the escalating trade war between the US and China has been a concern. Yet in recent weeks, Fed officials have indicated that they are likely to pause their rate-hiking, and the two sides declared a ceasefire in the trade war. So why hasn’t there been a relief rally to new highs, or at least a retest of the previous record high?

The yield curve remains relatively flat, and there are some signs of distress in the corporate credit markets, especially in the collateralized loan obligation (CLO) segment. Furthermore, ceasefires are often broken in wars, though there are preliminary signs that the Chinese are getting serious about meeting some of America’s demands for fairer trading practices. Friday’s selloff seemed to be triggered mostly by a batch of weak Chinese economic indicators, suggesting that the trade war is hurting China’s economic growth.

In addition, Europe’s prospects are souring as Britain, France, Germany, and Italy are facing domestic economic and political challenges. The US economy is in good shape, but economic growth may be slowing a bit. In any event, year-over-year comparisons for S&P 500 earnings will be challenging in the coming year given the boosts to earnings this year from the corporate tax cut and strong revenues growth. So investors may be lowering their expectations for global economic growth across the board.

While the S&P 500 is still in a correction rather than a bear market, quite a few of its industries have crossed the 20% downside demarcation, putting them in bear-market territory since the 9/20 record high in the overall index. Here are some stats:

(1) S&P 500 sectors. The performance derby of the S&P 500 sectors since the record high is as follows: Utilities (6.8%), Real Estate (0.0), Consumer Staples (-1.8), Health Care (-5.8), Communication Services (-8.2), S&P 500 (-11.3), Consumer Discretionary (-13.6), Information Technology (-14.2), Materials (-16.1), Industrials (-16.1), Financials (-16.4), and Energy (-17.5) (Fig. 3). So six of the 11 sectors are in a correction.

(2) S&P 500 industries. We track over 120 of the S&P 500 industries. Only 17 of them are up since the 9/20 high in the overall index, while 49 are in corrections (with declines of 10%-20%). So far, 27 industries are in bear markets (down by 20% or more). (See our Performance Derby: S&P 500 Sectors & Industries for the 9/20-12/14 timeframe.)

(3) S&P 500/400/600. Since the 9/20 top, the S&P 500/400/600 are down 11.3%, 15.3%, and 18.7% (Fig. 4). However, the S&P 400 and the S&P 600 are down 15.5% and 20.1%, respectively, from their tops at the end of August. So LargeCaps and MidCaps are in a correction, while the SmallCaps are verging on a bear market. On Friday, the forward P/Es of the S&P 500/400/600 were down to 14.8, 13.9, and 14.6. That’s the lowest P/E for LargeCaps since February 2016 and the lowest reading since November 2012 for MidCaps and SmallCaps. Those three peaked at the beginning of this year at 18.6, 18.6, and 20.1.

(4) MSCI major indexes. Since the 9/20 top, here is the performance derby of the major MSCI stock market indexes around the world in local currencies: Emerging Markets (-6.4%), the United Kingdom (-7.0), All Country World (-10.0), Japan (-10.6), EMU (-10.7), and the United States (-11.4) (Fig. 5). Here is the same comparison ytd: the United States (-2.8%), All Country World (-6.5), the United Kingdom (-11.0), Emerging Markets (-11.2), Japan (-11.4), and EMU (-12.0) (Fig. 6). China’s MSCI is down 7.1% over this period and 17.5% ytd.

Strategy II: Correction Case. Investors certainly remain panic-prone. They haven’t found any relief from recent headlines suggesting that the Fed may slow its rate-hiking and that the US and China are working to de-escalate their trade war. Investors continue to accentuate the negatives rather than the positives. Their adverse reaction to Friday’s economic news out of China suggests the new worry is that the damage has already been done to the global economy. Below, I reiterate my view that China’s problems are homegrown.

Meanwhile, US economic growth remains solid, as evidenced by Friday’s strong readings for November retail sales and industrial production, which Debbie reviews below. As a result, the GDPNow model raised the estimated Q4 growth rate for real GDP from 2.4% to 3.0%, with real consumer spending now estimated at 4.1%, up from 3.3%. Those numbers were obviously ignored by the market on Friday.

There’s no sign of recessionary conditions in the US labor market and consumer spending. On Thursday, we learned that initial unemployment claims fell sharply during the 12/8 week to 206,000, suggesting that the recent upturn might have been weather-related rather than a harbinger of weaker employment (Fig. 7). Retail sales continue to grow in line with our Earned Income Proxy, with November y/y growth rates of 4.2% and 4.7%, respectively (Fig. 8).

Yes, we know: There are stresses in the CLO market, but they’re not likely to lead to a systemic credit crunch. The housing industry seems to have hit a brick wall recently, but that might have more to do with Millennials demographics than mortgage rates, as we discuss below. Labor shortages could slow economic growth, but that could stimulate productivity. It’s especially hard to find truck drivers; yet employment in the trucking industry is at a record high, and so is truck freight tonnage.

We also know that the European Central Bank (ECB) confirmed last week that it will terminate its bond-buying program by the end of this year. The bears have been growling that without the QE programs of the major central banks, the bull market in stocks would never have occurred. Our response has been: “So what’s your point?” Their point now is that they are finally about to be proven right by a global bear market in stocks.

Maybe so, but keep in mind that neither the ECB nor the Bank of Japan has announced any plans to raise their official interest rates back above zero anytime soon. And the Fed might hike rates one more time Wednesday, after the FOMC’s 12/18-19 meeting, but then pause for a while.

It may all add up to slower global growth. That’s not very bullish; but it isn’t bearish either, especially if it means that inflationary pressures will remain subdued.

Demography I: Rapidly Aging in China. In recent months, I’ve observed that the Chinese government’s one-child policy, which was in place from 1979 through 2015, may be starting to weigh heavily on China’s economic growth. I’ve been focusing on the growth rate in the country’s inflation-adjusted retail sales. November data came out on Friday showing that the growth rate in nominal retail sales fell to 8.1% y/y, the lowest since April 2003 (Fig. 9). Adjusting this number for the CPI inflation rate shows that real retail sales growth was 5.9% y/y last month. It’s been on a downtrend since 2010. It’s been falling at a faster pace since March 2017, when it was 10.0%.

The US stock market never paid any attention to this number until Friday. That same day, we learned that Chinese industrial production growth slowed more than expected to 5.4% (Fig. 10). The widespread interpretation was that this confirms that the trade war is depressing China’s economy. I disagree. I think that rapidly aging demographic forces are depressing domestic retail sales growth, which is weighing on production.

The trade war may exacerbate these trends if manufacturers move their supply chains out of China. Recognizing these developments, the Chinese government may already be scrambling to placate the Trump administration’s demands for fairer trade practices.

Demography II: Proliferating Minimalists in US. Demography may also be starting to weigh on US consumers’ demand for autos and single-family homes. The Baby Boomers are now 54-72 years old (Fig. 11). Many of them are retiring. They are mostly empty-nesters. They are downsizing and turning into minimalists.

The Millennials are 22-37 years old. They are natural-born minimalists, as Melissa and I have often discussed in the past. There are a few signs that some are finally getting married and starting to have children. However, many apparently prefer staying single while living and working in cities. So they aren’t buying houses. They also aren’t buying cars, opting to use Uber and Lyft instead.

November data released in the latest employment report show that single persons continue to exceed married persons (Fig. 12). Last month, there were 131 million of the former and 128 million of the latter. Those who have never married numbered 81 million, while those who’ve been divorced, separated, and/or widowed numbered 50 million.

We could put a negative spin on all this, but we prefer a positive spin: US demographic trends suggest that a consumer-led boom is unlikely. That increases the chances that the current economic expansion will continue for the foreseeable future.

Movie. “The Mule” (+) (link) was directed and produced by Clint Eastwood. He is also the film’s star. He plays Earl Stone, an elderly horticulturist who is broke, alone, and facing foreclosure of his business. He turns into a drug runner for the Mexican cartel. It’s funny and entertaining, but disappointing. It seems almost like a bittersweet reflection on Eastwood’s own life. His daughter is in the movie, playing Earl’s daughter. The problem is that it is full of clichés. The movie could have been titled “Make My Day Lilies!”

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Unloved Industrious Industrials

December 13, 2018 (Thursday)

Lunch at the White House. Larry Kudlow, director of the National Economic Council under President Donald Trump, invited me to speak at the White House Economic Advisers’ lunch yesterday. Joining us was Jason Trennert, chairman, CEO, and chief investment strategist of Strategas. Several of the President’s top economic advisers were in attendance. Their comments were off the record. I brought along a chart package with the following four talking points:

(1) US-China Trade & National Security. America is the crouching tiger, while China is the hidden dragon. Hiding in plain sight is that China is seeking to become a super-power before it turns into the world’s largest nursing home.

(2) Monetary & Fiscal Policies. Fiscal policy has been stepping on the economy’s accelerator, while the Fed has been tapping on the brakes. Monetary policy has been based on failed macroeconomic models and phantom variables that aren’t observable.

(3) Productivity & the Supply Side. Rapid technological change is both disrupting and energizing our economy. The first effect tends to dampen productivity, while the second tends to boost it. Better productivity growth may be starting to show up in real wages.

(4) The Stock Market. The stock market has been very volatile this year as a result of the bullish and bearish mix of government policies. The volatility has been greatly exacerbated by high-frequency algorithm trading systems. It’s time to bring back the uptick rule.

Industrials: Cheap for No Reason? If the US isn’t on the verge of a recession—and we don’t think it is—the S&P 500 Industrials sector looks extremely inexpensive. The sector’s stock price index has fallen by 11.0% ytd through Tuesday’s close, and its forward P/E has dropped by more than four percentage points to 14.6, compared to 19.0 roughly a year ago (Fig. 1 and Fig. 2).

The sector could certainly get cheaper if the economy does fall off a cliff and earnings estimates are slashed. That could happen if the US and China can’t resolve their simmering trade war. The S&P 500 Industrials sector generates 12.8% of its revenue from Asia/Pacific, according to a 12/5 WSJ article. Some companies in the sector may also have manufacturing operations in China that they will need to relocate if the business environment doesn’t thaw.

However, if the two super-powers come to their senses, investors are looking at a rare buying opportunity. Yesterday, because things on the negotiating front were looking up, the DJIA rallied by 157.03 points. Investors were cheered by reports that China would grant foreign companies greater access to its markets, would buy more soybeans, and would reduce tariffs on automobiles. The progress followed Tuesday’s short-lived rally on a tweet by President Trump saying that the US and China were having “very productive conversations.” This is a market looking for a reason to head higher.

Here’s how the ytd performance of the Industrials stock price index stacks up to that of the other 10 S&P 500 sectors through Tuesday’s close: Health Care (10.1%), Utilities (7.0), Consumer Discretionary (4.3), Tech (3.7), Real Estate (2.4), S&P 500 (-1.4), Consumer Staples (-4.1), Industrials (-11.0), Financials (-12.6), Communication Services (-12.7), Energy (-13.0), and Materials (-14.7) (Fig. 3).

Let’s take a look at some of the relevant economic data and dive deeper into the industries that make up the Industrials:

(1) Still trading and trucking. The squabbling between the US and China makes daily headlines; but, so far anyway, the disagreements haven’t affected the volume of goods traded by the US. Real merchandise exports and imports rose 6.0% y/y in October and dipped by an ever so slight 0.4% m/m (Fig. 4).

Along the same lines, traffic at the West Cost ports is humming, and railcar loadings hit a new high in October (Fig. 5). Even the ATA Truck Tonnage Index hit new highs in September (Fig. 6).

The stock price indexes of S&P 500 transportation-related industries have had a mixed showing this year, but analysts are still optimistic about their earnings potential in 2019. The S&P 500 Railroads industry has been the standout, rising 11.9% ytd, while others are in negative territory, including Trucking (-14.2%), Air Freight & Logistics (-14.6), and Airlines (-9.9). Those stock price declines have sent the Dow Transports stock price index into negative territory (-7.4% ytd), an admittedly ominous sign for the broader markets that we’ll continue to watch (Fig. 7).

That said, the economy continues to grow, the price of Brent crude oil has fallen recently to $60 per barrel, and analysts are calling for double-digit earnings growth in 2019 for several of these industries: Air Freight & Couriers (11.1%), Airlines (18.9), Trucking (18.7), and Railroads (12.7) (Fig. 8).

(2) Manufacturers manufacturing. Despite the handwringing over the economy, the data out of the manufacturing sector continues to be positive. Manufacturing production rose 4.6% (saar) during the three months ending October, based on the three-month average (Fig. 9). Both industrial production and its manufacturing subsection have been rising strongly since 2017 (Fig. 10).

Despite these strong macro numbers, many S&P 500 manufacturing-related industries have had a tough year. The Industrial Conglomerates stock price index has fallen 28.1% ytd, dragged down by GE, followed by Construction Machinery & Heavy Trucks (-21.7%) and Industrial Machinery (-13.4%) (Fig. 11, Fig. 12, and Fig. 13).

Earnings growth targets for next year belie the gloomy stock price returns this year. Cases in point: the 2019 earnings growth forecasts of analysts for Industrial Conglomerates (9.2%), Construction Machinery & Heavy Trucks (9.0), and Industrial Machinery (11.4) (Fig. 14, Fig. 15, and Fig. 16).

Because share prices have dropped while earnings forecasts have remained strong, forward P/Es have fallen dramatically. Here’s where P/Es stand today and where they were roughly a year ago for the three industries: Industrial Conglomerates (15.3, 20.7), Construction Machinery & Heavy Trucks (9.9, 16.5), and Industrial Machinery (16.1, 20.4). An article in last weekend’s Barron’s favorably discussed Caterpillar, a member of the S&P 500 Construction Machinery & Heavy Trucks industry. Despite the company’s sharp stock price decline, it enjoys improved margins, lean dealer inventories, and a strong sales pipeline. China represents 5%-10% of sales.

(3) Housing humbled. One area of the economy that has shown cracks is housing. The 10-year Treasury yield’s move from roughly 2% at the end of last year to north of 3% a few months ago made financing homes more expensive and put a damper on sales (Fig. 17). New home sales dropped 8.9% y/y in October and are now 23.6% below their November 2017 peak (Fig. 18). The slowdown in sales sent inventories of new homes available for sale climbing (Fig. 19). Nonresidential construction has held up a bit better (Fig. 20).

Nonetheless, stocks with any relation to housing or building have been clobbered this year. The S&P 500 Building Products stock price index has fallen 21.0% ytd, and the Construction & Engineering stock price index is down 21.4% (Fig. 21 and Fig. 22). Earnings expectations for 2019 are modest for the Building Products industry (7.9%), but much more optimistic for Construction & Engineering (27.9) (Fig. 23 and Fig. 24). Both industries have forward P/Es that are lower than the S&P 500: Building Products (12.2) and Construction & Engineering (11.5).

(4) Services lead. The service-providing industries within the Industrials sector have outperformed the sector and the broader market. The Diversified Support Services industry’s stock price index has jumped 6.3% ytd, while Environmental & Facilities Services has gained 2.5%, and Human Resources & Employment Services has risen 6.9%. Those three industries are expected to grow earnings next year by 16.3%, 5.8%, 10.1%, respectively. Their strong performances this year have left them with forward P/Es that aren’t as attractive as the P/Es of industries that have sold off sharply this year. Here’s where the three industries’ forward P/Es stand: 22.7, 21.5, and 15.4.

If a recession doesn’t come along, Industrials stocks look positioned to soar. And even if one does come along, the shares might not get too punished because they’re already pricing in a lot of bad news.

Consumer Discretionary: Retailers Arise. Never underestimate the power of fear to motivate. Amazon’s entrance into the business of selling drugs and groceries has prompted traditional retailers to innovate more rapidly than we’ve ever seen—testing new delivery methods, entering joint ventures, and embracing technology as never before. Let’s take a look at some of the recent developments:

(1) Faster drug delivery. This summer, Amazon acquired PillPack, an online pharmacy that delivers drug packets with presorted doses of multiple medications. The deal was seen as jumpstarting Amazon’s entrance into the new category.

“The PillPack acquisition gives Amazon a foothold in the regulated pharmacy business. PillPack has pharmacy licenses in all 50 states and brings in-house expertise that could help Amazon move more quickly into a space filled with regulatory obstacles,” said Michael Rea, chief executive of Rx Savings Solutions, in a 6/28 Washington Post article.

The competition isn’t standing still. Last week, Walgreens announced it has partnered with FedEx to provide national, next-day prescription delivery for $4.99, starting with 7,100 of the 9,560 Walgreen pharmacies; same-day delivery will be available in Dallas, Chicago, New York City, Gainesville, Miami, Tampa, and Fort Lauderdale. This deepens an existing relationship with FedEx, which already has counters in Walgreens stores where customers can drop off or pick up FedEx packages, a 12/8 Business Insider article reported.

CVS started offering delivery of prescriptions and over-the-counter products through the US Postal Service this summer. CVS charges $4.99 for one- or two-day delivery and $8.99 for same-day delivery, which is available in New York City, Boston, Miami, Philadelphia, San Francisco, and Washington, DC.

Both retailers are also providing more health services in their stores to get customers through the door. CVS has more than 1,100 retail MinuteClinics in CVS and Target stores, staffed by nurse practitioners and physician assistants. Walgreens has also increased the services available in its retail stores, and it is partnering with UnitedHealth Group’s Optum by opening Walgreens stores next to Optum’s MedExpress urgent care centers.

If they can provide care less expensively, expect the health insurers to get on board. These small clinics “are emerging as a model health insurers want to do business with as fee-for-service medicine gives way to value-based care that keeps patients out of the hospital,” noted a 10/2 article in HeatlhLeaders. The threat to the hospital industry is a story for another day.

CVS and Walgreens are also entering the insurance business. CVS closed on its $70 billion acquisition of Aetna last month, while Walgreens and Humana are talking about swapping equity stakes. One can imagine a day when an insurer might direct where you purchase your prescriptions or receive care.

(2) Battling over bananas. Amazon’s 2017 acquisition of Whole Foods has also pushed retailers to get creative. Last week, Kroger announced plans to sell groceries in the branded sections of Walgreens.

A 12/4 WSJ article reported: “The first ‘Kroger Express’ sections will open by early next year in 13 Walgreens stores near the grocer’s Cincinnati headquarters. The companies said they would add more of the 4,000-square-foot displays of produce, Home Chef meal kits and other products if customers take to them. They will account for roughly a third of an average Walgreens selling space.”

(3) Harnessing technology. Meanwhile, Walmart has been both making acquisitions and using technology to keep its offerings fresh and lower its costs. Walmart has purchased online retailers Shoes.com, Moosejaw, Bonobos, Eloquii, Jet.com, and Bare Necessities, in addition to delivery companies Parcel and Cornerstone. Internationally, it has expanded online by buying Flipkart in India.

Last week, Walmart introduced 360 robotic floor sweepers that look like a small Zamboni and act like a Roomba, a 12/4 Washington Post article explained. The machines can both scrub floors and collect data about their environment, including information on store traffic and empty shelves.

Another Walmart robot has a tall tower that scans shelves to see if they’re stocked. A human is still needed to restock the shelf when necessary. A potential fly in the ointment: teenagers kicking and pulling pranks on the machines, noted a 3/26 Fortune article. So the robots are built to withstand being hit with cans of tomato soup!

Walmart is also testing a robot that can gather items ordered online from a store’s storage area and deliver them to a human packer who prepares the order for in-store pickup, according to an 8/3 article in Engadget. “Alphabot is the latest technology to be tested by Walmart. Other pilots include shelf-scanning inventory robots, self-driving floor-scrubbing robots and a partnership with Waymo that provides autonomous vehicle transportation for grocery order pickup. Walmart has also been expanding its Pickup Tower feature as well as its grocery delivery service with the help of DoorDash and Postmates. Looking to the future, recent patents filed by the company include designs for smart carts, wearables, a drone and an audio surveillance system,” the article explains.

Who would have expected the retailer with humble Bentonville, Arkansas roots to evolve into a hotbed of innovation?

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HFT Algos

December 12, 2018 (Wednesday)

Algo I: Ban Them? Capital markets play a crucial role in the economic system known as “Capitalism.” They provide a very efficient means for capitalists to raise money to expand the capacity and payrolls of their enterprises. The capital markets provide investors with a very sound and liquid way to accumulate wealth in the stocks and bonds issued by corporations.

In a free market system, the main trading exchanges play a vital role in providing both regulation and supervision to ensure that buyers and sellers of securities all are on a level playing field by reducing the potential for unfair manipulation of the trading system. In a perfect world, the exchanges alone would provide enough self-regulation to quickly identify and stop corrupt practices. In the imperfect real world, the government also imposes regulations on the capital markets and supervises them.

Ideally in a free market, all information necessary for judging the values of securities should be publicly available. To that end, banning insider trading tends to be one of the main objectives of regulators. In the following, Melissa and I discuss the impact of high-frequency trading systems driven by computer algorithms (HFT algos) on our capital markets.

There is no universal or legal definition of HFT, according to a 2016 Congressional Research Service (CRS) report. Neither the SEC, which oversees securities markets, nor the Commodity Futures Trading Commission (CFTC), which regulates most derivatives trading, has specifically defined the term. Regulating something without a clear definition of what that something is presents a problem on its own.

However, the CRS report does say that HFT “generally refers to trading in financial instruments, such as securities and derivatives, transacted through supercomputers executing trades within microseconds or milliseconds (or, in the technical jargon, with extremely low latency).”

HFT has grown substantially over the past 10 years. According to CRS, HFT accounted for roughly 55% of trading volume in US equity markets and about 40% in European equity markets around the time of the report. Likewise, HFT has grown in futures markets.

The question is whether the useful function they serve—increasing liquidity in the capital markets—comes with a distortion of price signals that amounts to market manipulation in their favor.

We don’t have the definitive answer, but we have lots of questions. Isn’t it unfair for the exchanges to allow the computer systems of high-frequency traders to collocate at the exchanges to gain nanosecond edges in executing trades? Other than providing fees to the exchanges, what are the benefits, if any, to low-frequency traders? Do the exchanges employ the rocket scientists necessary to keep track of what the rocket scientists employed by the HFTs are doing?

Is it possible for HFT algos to be profitable without having any special edge? Is their edge simply that the algos are faster and smarter than human traders? If not, then what is their edge? Might it be that they can game the system faster than the regulators can detect their manipulations? Do HFTs increase liquidity in the capital markets in all market situations? What if they do so during normal times, but also increase volatility during abnormal times along with the risk of recurring flash crashes? Is this an acceptable tradeoff? Is the risk of extreme volatility a price that market participants should be forced to pay for more liquid markets?

In short: Does Capitalism need HFTs? Should they be banned?

Algo II: Tax Them? When I was a graduate student at Yale University, one of my professors was Gary Smith. He is now the Fletcher Jones Professor of Economics at Pomona College. He is a widely cited expert on financial markets, statistical reasoning, and artificial intelligence. His research focuses on stock market anomalies, statistical fallacies, and the misuse of data. I asked him to weigh in on HFT algos. Here is his response:

“Keynes wrote that, ‘When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.’ Using computers to pick stocks or time the market by using screening devices created by humans may be valuable, and it is hard to draw a line between this and standard fundamental and technical analysis.

“The counter-argument to a ban on algo trading is going to be that high-frequency algos drive prices toward the ‘correct prices,’ but that is nonsense since algos have no way of knowing what the correct prices are. Arbitraging prices in seconds or nanoseconds has no real economic value. The resources used to build infrastructure to facilitate trading in nanoseconds is a waste of society’s resources.

“The stock market as a whole generates cash for investors through dividends and stock buybacks, but trades that are reversed in nanoseconds are a zero-sum game; if such trades are profitable enough to pay for the infrastructure, it is at the expense of other investors. And they create the danger of flash crashes.

“We should consider two possible ways to kill high-frequency trading: (1) Make it illegal to sell a stock unless it has been held for some short amount of time—at least 10 seconds? A minute? (2) Put a small tax on trades, e.g., 0.01% (which would be a penny a share for a round-trip trade on a $50 stock).

“Computers can do many difficult tasks (like calculating cube roots and searching the Internet) much better than humans, but computer ‘intelligence’ is very different from human intelligence in that computers do not have the common sense, wisdom, and critical thinking skills that humans have accumulated by living. Stock trading algorithms are particularly dangerous because computers are so efficient at discovering statistical patterns—but utterly useless in judging whether the discovered patterns are meaningful or merely coincidental and therefore fleeting and useless.” (See Gary’s new book, The AI Delusion.)

Algo III: Bring Back the Uptick Rule? “Get somebody from the SEC [Securities and Exchange Commission] to explain why they eliminated the Uptick Rule and what do they think about these quantitative trading systems that have created a tremendous amount of volatility in the market, scared the public, [and] effectively raised the cost of capital to business,” Leon Cooperman, the billionaire investor and founder of Omega Advisors told CNBC in a 12/6 interview.

So Cooperman agrees with what I wrote in our 7/20/10 and again in our 8/17/11 Morning Briefings, which may as well have been written yesterday. I wrote: “Raise your hand if you believe that High Frequency Trading (HFT) contributed significantly to the insane volatility of the market over the past two weeks. I see lots of hands up in the air when I ask our accounts to do so. … [G]iven that only a tiny group of traders are making a very comfortable living in the HFT trade, why not put them out of business and see if there is less volatility in the market?”

I added: “The question is whether HFT serves a useful purpose by increasing liquidity among the dispersed markets. Or do they compound the volatility of these markets? … Let’s also bring back the Uptick Rule while we are at it. It was eliminated by the SEC on July 6, 2007, just in time for speculators to launch numerous bear raids that nearly destroyed the financial system.”

I bet that if Cooperman were to get his desired explanation from the SEC on why they eliminated the rule in the first place, the answer would be something like: “At the time, we didn’t think the rule contributed significantly to reducing market volatility or other adverse market outcomes. On the contrary, we think that short sellers may provide some liquidity and price efficiency in the market.” How do I know this? Because those were the reasons given by the SEC in 2007 when the rule was eliminated and in 2010 when a less restrictive version of the rule was brought back, as Melissa and I discuss below.

Melissa and I wonder if bringing back the full-version rule instead of the less restrictive one would have been better for markets. Apparently, so does the White House. On 1/31/17, @WestWingReport tweeted: “Treasury Dept. source: Trump admin. looking at uptick rule, which became rather infamous during econ. collapse of a decade ago.” We haven’t found an update on that. And we agree that the more restrictive version of the uptick rule should be revisited.

Even that may not go far enough, however. We’d also advocate for more studies and broader oversight of HFT. Maybe it’s high time that Congress takes another look at HFT, updating its 2016 review in light of all the recent head-spinning headline-driven market volatility.

Consider the following:

(1) SEC’s pilot program. In July 2004, the SEC adopted Regulation SHO, which allowed the Commission to establish a pilot program to examine the efficacy of price restrictions. A 2/6/2007 SEC report titled “Economic Analysis of the Short Sale Price Restrictions Under the Regulation SHO Pilot” detailed the findings of the pilot program: “Our evidence suggests that removing price restrictions for the pilot stocks has had an effect on the mechanics of short selling, order routing decisions, displayed depth, and intraday volatility, but on balance has not had a deleterious impact on market quality or liquidity.” These findings became the basis for eliminating the uptick rule later that year.

The study provided background on the uptick rule: “Short selling in exchange-listed stocks (“Listed Stocks”) in the U.S. has been subject to a ‘tick test’ since 1938. Rule 10a-1 under the Securities Exchange Act of 1934 allows short sales to occur only at an uptick or a zero uptick … for Listed Stocks. That is, short sales in Listed Stocks may be effected above the last trade price or at the last trade price if the last trade price is higher than the most recent trade at a different price.”

(2) Alternative uptick rule. Fast forward to February 24, 2010 when the SEC adopted a new version of the uptick rule, i.e., the “alternative” uptick rule, “intended to promote market stability and preserve investor confidence” following the financial crisis. The SEC’s same-day press release stated: “This alternative uptick rule is designed to restrict short selling from further driving down the price of a stock that has dropped more than 10 percent in one day. It will enable long sellers to stand in the front of the line and sell their shares before any short sellers once the circuit breaker is triggered.”

The features of the rule (a.k.a. “Rule 201”) are such that the circuit breaker would be triggered for a security any day in which the price declines by 10% or more from the prior day's closing price. Once triggered, the alternative uptick rule would apply to short-sale orders in that security for the remainder of the day as well as the following day. The rule applies broadly to all listed equity securities, whether traded on an exchange or in the over-the-counter market.

The alternative uptick rule was intended to strike a balance between the views of short selling’s detractors and proponents—i.e., those who think that short selling contributes unduly to market volatility and those who think that short sellers provide an important source of liquidity to the markets. A thorough 2013 Seton Hall University Law School Student Scholarship paper explained this well.

The SEC’s 2010 rule adoption was preceded by a hefty comment period from market participants. Upon the adoption of the alternative uptick rule, the then SEC Chair Mary Schapiro acknowledged both sides of the argument, stating: “Short selling can serve useful market purposes, including providing market liquidity and pricing efficiency. However, it also may be used improperly to drive down the price of a security or to accelerate a declining market in a security.”

(3) Will algos ever learn to read between the headlines? While we applaud the SEC for bringing back a version of the rule, we aren’t sure if it is restrictive enough. We wouldn’t put it past the short-selling HFT wizards to figure out a way to game the rule. But that’s just based on speculation and our admittedly limited knowledge of the murky space. If anything, we do have anecdotal evidence in the recent wild headline-driven swings in markets that something further needs to be done. What we don’t like is seeing market swings that are based not on fundamentals but on surface headline news.

A case in point: Last Thursday, when the DJIA plunged by more than 700 points on the news of the arrest of Huawei CFO Meng Wanzhou only to close the day down just 79 points. If humans were more involved in the trades that moved the market that day, maybe they would have paused to put the news in proper perspective before panicking? The arrest had little do with US-China trade tensions, as we all soon learned and as Melissa and I discussed in our 12/10 Morning Briefing.

Moreover, it didn’t take Melissa much research to determine that the timing of the arrest on the day that US and China officials agreed to a trade ceasefire was just coincidental. Per her email to me on that eventful day (before the press began reporting on the official reason for the arrest and before we learned that Trump didn’t know about it at the time): “[T]he trade cease fire isn’t relevant to Meng. The allegations [based on Iran sanctions violations] have been going on since [at least] 2013. … Meng was apparently arrested on the same day that Xi and Trump met. It’d be an insane coincidence if [the arrest] really had nothing to do with the recent trade dispute, but it looks like it might not!”

The point isn’t that we were right but that it only took a quick Google search to find a 2013 Reuters article on the violations to deduce what had happened. The problem is that the computer algos haven’t been programmed to read between the lines! Gary observes that while computers can spell-check words, search the Internet for words, and count the number of times that a word is used in a document, they do not understand what words convey to humans. They do not understand what words mean in any meaningful sense.

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Bonds, Stocks & the Latest Recession Scare

December 11, 2018 (Tuesday)

Credit: Bonds Having Fun Again. The drop in the 10-year US Treasury bond yield has unnerved stock investors recently. That’s a bit ironic, since the yield fell partly on perceptions that Fed officials might pause their rate-hiking after they hike the federal funds rate at the December 18-19 FOMC meeting. They seem to be willing to move at an even more gradual tightening pace to reduce the risk of causing a recession. Stock investors should love that, but instead they are fretting that the lower bond yield is flattening the yield curve, which could be signaling that it’s too late: Run for the hills, a recession is coming!

We don’t agree. We think that lower inflation may be coming, and that other non-recessionary forces are causing bonds to have more fun than stocks. Consider the following:

(1) A very short history of the bond yield. The bond yield rose sharply at the end of 2017 and early 2018 after Republicans succeeded in passing the Tax Cuts and Jobs Act on December 20 (Fig. 1). The day before, the yield was 2.46%. It rose to 2.94% on February 21. It remained range-bound, mostly just below 3.00%, through September 17, when the range rose to 3.00%-3.25%. It dropped below 3.00% on December 3 from 3.24% on November 8; it was at 2.85% yesterday.

The recent drop in the bond yield was triggered by Fed Chairman Jerome Powell. After setting off alarm bells on October 3, when he said that the federal funds rate was “a long way from neutral,” he said on November 28 that it was actually “just below” neutral. The bond yield’s decline was also attributable to the latest stock market selloff on fears that the US-China trade war could escalate and cause a recession. The bond market has benefitted from risk-off trades lately.

There has been a good correlation between the trends in nominal GDP growth on a y/y basis and the 10-year US Treasury bond yield (Fig. 2). I’ve dubbed this the “Bond Vigilantes Model.” I use the model to explain why the two aren’t the same at any point in time. During the 1960s and 1970s, bond investors weren’t vigilant enough, as the yield remained consistently below the rapidly rising growth rate in nominal GDP, led by soaring inflation. That reversed during the 1980s, when the yield remained consistently above nominal GDP growth as the Bond Vigilantes turned more vigilant about inflation. Inflation remained low and subdued during the 1990s, so there was less need to be vigilant. Since the financial crisis of 2008, the bond yield has been held down well below nominal GDP growth by the ultra-easy monetary policies of the Fed and the other major central banks.

(2) Dow Vigilantes muscling in. Now, the Dow Vigilantes may be the new force to be reckoned with in the financial markets. They are the ones who are reacting most aggressively to the increasingly incompatible mix of monetary, fiscal, and trade policies coming out of Washington. There was a significant correction at the beginning of this year and another one that started in late September, both protesting the disconnect of fiscal policy stepping on the economy’s accelerator while monetary and trade policies tap on the brakes (Fig. 3).

Apparently, Fed officials have already gotten the message and are considering an even more gradual pace of monetary tightening. The initial fiscal stimulus from the tax cuts may be waning, though the resulting federal government deficits will continue to widen. Trade policy remains the biggest and most immediate concern for the Dow Vigilantes. If they are going to be vigilant, the bond posse doesn’t need to be as vigilant.

(3) Less curve in the yield curve. The recent drop in the bond yield has flattened the yield curve. That’s heightened recession fears, since the yield curve is one of the 10 components of the Index of Leading Economic Indicators (LEI). In the LEI, the yield-curve spread is measured as the 10-year yield minus the federal funds rate (Fig. 4). It has a good track record of calling recessions when it turns negative. It tends to lead the y/y growth rate in the Index of Coincident Economic Indicators by about 12 months.

The yield-curve spread remained at 72bps yesterday, the lowest reading since March 17, 2008 (Fig. 5). So it is still solidly in positive territory. As long as it stays that way, it will be a positive contributor to the LEI. Focusing on the weekly spread, Debbie observes that the yield curve inverted 74 weeks before the previous recession, 41 weeks before the one before at the start of the 2000s, and 77 weeks before the one in the early 1990s, though the latter turned positive before the recession began (Fig. 6).

Slicing and dicing the yield curve has become the new rage. Doomsters are looking for any yield-curve spread that is inverting. So they are especially alarmed about the 10-year versus 2-year spread, which fell to just 13bps yesterday. The 5-year versus 2-year spread was -1bp (Fig. 7).

(4) Inflation indicators moderating. In the 12/3 Morning Briefing, Debbie and I observed: “Evidence mounted that following another likely rate hike at the FOMC meeting on December 18-19, the monetary policy committee might pause during the first half of next year to reevaluate the course of monetary policy. Not as widely noticed last week was that inflationary pressures may be ebbing, which would also argue for a pause.”

This may also explain why the bond yield has declined lately. December’s purchasing managers surveys showed that the M-PMI’s prices-paid index dropped to 60.7 last month from a recent high of 79.5 during May (Fig. 8). On the other hand, the NM-PMI’s prices-paid index remained relatively flat at 61.5, though that’s down from a recent peak of 68.0 during May. Expected inflation as measured by the yield spread between the 10-year Treasury and its comparable TIPS fell to 1.86% yesterday, down from a recent high of 2.17% on October 9.

(5) JGB and bund yields nearing zero again. Also holding down the US bond yield is that comparable 10-year government bond yields in Japan and Germany have been moving back down even closer to zero recently (Fig. 9). On Friday, the yield on the Japanese JGB was only 0.07%, while the German bund yield was only 0.25%. I’ve heard that the cost of hedging the currency risk reduces the relative attractiveness of US bonds. Then again, there may be plenty of overseas investors who aren’t hedging but instead are taking the currency risk, which may be relatively low in any event given the huge yield advantage in the US over both Japan and Germany.

(6) Benefitting from algos gone wild. Of course, the Dow Vigilantes may not be humans at all. Instead, they may be algorithm-driven computer trading systems. They were designed and coded by humans. But like HAL 9000, the rogue computer in the classic movie “2001: A Space Odyssey” (1968), they may have turned against us.

I agree with Leon Cooperman. In a 12/6 CNBC interview last Thursday, the founder of Omega Advisors blamed the SEC for failing to address the impact of algos on stock market volatility: “I think your next guest ought to be somebody from the SEC to explain why they have sat back calmly, quietly, without saying anything and allowing these algorithmic, trend-following models to wreak havoc with what has, up to now, been the best capital market in the world,” Cooperman told CNBC’s Scott Wapner on the Halftime Report. “In the mid-1930s, they instituted the Uptick Rule to deal with the abuses of 1929. It worked effectively for 70-odd years. They took it out in 2008 for some unexplainable reason,” he added. “And they created a wild, Wild West environment in the stock market.”

US Economy: No Recession in GDPNow. The stock market seems to have a sense of impending doom, or at least an imminent recession. The S&P 500 is also one of the 10 components of the LEI. Ironically, it has been down since peaking at a record high on September 20, partly on fears that the yield-curve spread is signaling a recession, which it isn’t so far as discussed above.

Meanwhile, both the LEI and the CEI rose to record highs during October (Fig. 10). That doesn’t mean that the LEI couldn’t soon be making a top, though we doubt it. Looking at the 10 components, we see some potential downside contributions to the LEI coming from initial unemployment claims, building permits, and the S&P 500 (Fig. 11). The other seven look alright to us.

The GDPNow model estimate for real GDP growth in Q4-2018 is 2.4% as of December 7, down from 2.7% on December 6. That’s still solid growth following a gain of 3.5% during Q3 and 4.2% during Q2. Here are a few other upbeat, and a bit offbeat, economic indicators:

(1) Keep on trucking. Notwithstanding all the chatter about a shortage of truck drivers, payroll employment in the truck transportation industry rose to a record high during November. It tends to be a good leading indicator of the economy too (Fig. 12).

Debbie and I also like to track the economy by tracking intermodal railcar loadings. The y/y growth rate in the 26-week average of this series is up at a solid 4.3% through the 12/1 week (Fig. 13). Interestingly, this series also tends to track the growth rate in the CEI.

(2) Full employment. Yesterday, we noted that full-time employment jumped by 543,000 to a new record high during November. Yesterday’s JOLTS report showed that job openings have exceeded the number of unemployed workers since March (Fig. 14).

(3) M-PMI & S&P 500 revenues. Another sign that the economy continues to perform well is November’s M-PMI, which remained elevated at 59.3 (Fig. 15). This series is highly correlated with the y/y growth rate of S&P 500 revenues per share, which has been surprisingly strong this year, rising 10.7% through Q3.

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Optimistic Analysts vs Pessimistic Investors

December 10, 2018 (Monday)

Saturday Night Special. I spent the past weekend reading the stories explaining the background behind the arrest of Huawei Technologies Co. Finance Chief Meng Wanzhou a week ago Saturday. That was the very same day that President Donald Trump and Chinese President Xi Jinping agreed on a 90-day ceasefire in the trade war between the US and China. The arrest became known to the public this past Thursday morning. On Friday, White House adviser Larry Kudlow told Fox Business that “President Trump did not know—none of us knew as a matter of fact … period full stop” about the arrest during the weekend negotiations. Kudlow explained that this is a law enforcement action and not related to trade, but admitted that the Chinese could take it the wrong way.

Ms. Meng was arrested in Vancouver at the request of US authorities, who are charging her with committing fraud and will now seek her extradition to the US. Meng is believed to have helped Huawei circumvent US sanctions on Iran by telling financial institutions that a Huawei subsidiary was a separate company, Canadian prosecutors said at a hearing Friday. The accusations against Meng are not new, with the investigation dating back to at least 2013.

The US and many of its allies have become increasingly concerned that Huawei is controlled by the Chinese government and will be able to use the company’s 5G technology to spy on them and potentially to disrupt vital infrastructure systems that depend on it.

Reportedly, the Chinese government initially saw the arrest as a major escalation in the trade war, and a direct threat to their ambitions to dominate 5G and other technologies that they deem essential to their “China 2025” initiative. In a statement Saturday, the Vice Minister of the Chinese Foreign Ministry Le Yucheng said the arrest "severely violated the Chinese citizen's legal and legitimate rights and interests, it is lawless, reasonless and ruthless, and it is extremely vicious." However, a NYT article on Sunday covered comments from a senior adviser to Chinese leadership made during a conference that seemed to “compartmentalize” the Huawei issue from trade.

Strategy I: Analysts Looking Forward Optimistically. Did the latest bull market in stocks make a top at 2930.75 for the S&P 500 on September 20? Is “the most widely hated bull market of all time” over? That’s what the bull market since March 2009 has been called. The answer is “yes” if “the most widely anticipated recession of all time,” as I like to call it, is finally about to happen.

Then again, it’s conceivable that a bear market might be underway even if the economy continues to grow. An extremely rare phenomenon, that alignment has occurred only once since the end of World War II: during late 1987, when the S&P 500 plunged 33.5% yet real GDP and earnings both continued to rise to new highs over the next six quarters.

Apparently, industry analysts who cover the S&P 500 companies have yet to get the recession memo. The flattening of the yield curve hasn’t curbed their enthusiastic outlook for their companies. Neither has the trade war between the US and China. The problem with analysts is that they tend to like the companies they follow, which biases them toward optimism about the companies’ prospects. So they don’t see recessions coming. If, however, no recession is coming over the coming year, as I believe, then their consensus forward revenues and earnings forecasts tend to be accurate. Currently, these forecasts remain remarkably upbeat:

(1) Forward revenues. Joe and I have often noted that S&P 500 forward revenues is a very good coincident indicator of S&P 500 actual revenues (Fig. 1). The former is available weekly, while the latter is a quarterly series. Forward revenues is a time-weighted average of analysts’ estimates for S&P 500 revenues during the current and coming years (Fig. 2). It is available through the 11/29 week, and continued to make new highs during November as analysts continued to raise their revenues estimates for both 2018 and 2019.

Analysts have also been raising their 2020 revenues estimates to new highs. That will boost forward revenues as that year’s estimates start to figure into the forward revenues calculation starting next year. The latest estimates show that revenues are expected to grow 8.8% this year, 5.8% next year, and 4.6% in 2020.

(2) Forward earnings. S&P 500 forward earnings tends to lead actual earnings by a year (Fig. 3). But again, analysts don’t anticipate earnings recessions. However, they may be starting to curb their enthusiasm slightly, as their estimate for 2019 has edged down recently while their 2020 estimate has flattened (Fig. 4).

Then again, their latest earnings estimates, as of the 11/29 week, remain astonishingly elevated at $176.15 per share for 2019 and $194.47 for 2020. In other words, after jumping 24.0% this year, earnings are expected to grow 8.3% in 2019 and 10.4% in 2020. As Joe and I have been explaining since late October, we doubt that earnings will grow more than half as fast. We don’t really have a problem with analysts’ expectations for revenues growth. However, analysts may be too optimistic on the outlook for the profit margin.

(3) Forward profit margin. Analysts may be starting to curb their enthusiasm for the profit margin, however, the latest data suggest. We use their weekly revenues and earnings consensus forecasts to calculate the forward profit margin, which is a good coincident indicator of the actual quarterly variable (Fig. 5 and Fig. 6). The forward profit margin peaked at a record 12.4% during the 9/13 week. It edged down to 12.2% during the 11/29 week.

Strategy II: Investors Looking Ahead Pessimistically. While industry analysts remain bullish on the outlook for earnings, investors have soured on stocks. The divergence between S&P 500 forward earnings and the valuation of those earnings has been extraordinary. Our Blue Angels analysis shows that the former is up 18.9% ytd through the 11/29 week, while the latter has dropped 14.0% from 18.2 to 15.6 over this same period (Fig. 7). As a result, the S&P 500 has been basically flat so far this year, despite the fact that I/B/E/S’ actual earnings rose 27.6% y/y through Q3 (Fig. 8).

Sometimes, life just isn’t fair. Investors have been looking past this year’s great earnings and fretting about an imminent recession. Consider the following:

(1) Interest rates. Until recently, investors feared that the Fed’s set course of “gradual,” every-three-month 25bps hikes in the federal funds rate might not be gradual enough. In recent weeks, Fed officials have indicated that they are likely to take longer pauses, as I have been advocating.

But now, investors are fretting that the flattening yield curve suggests that the Fed has already gone too far. Of course, the recent decline in the 10-year US Treasury bond yield was partly attributable to the Fed’s sudden willingness to pause its rate-hiking to reduce the risks of a recession!

(2) Trade. Then again, some of the drop in the bond yield in recent weeks has been attributable to the escalating trade war between the US and China. The truce announced a week ago was immediately undermined last week by President Trump’s tweeting that he is “Tariff Man.” Then the DJIA dropped about 800 points on Thursday on news that the CFO of Huawei had been arrested in Canada on behalf of the US. It recovered almost all of that lost ground by the end of the day, only to plummet 558 points on Friday.

Perhaps investors initially hoped that the arrest was a badly timed mistake, then realized on Friday that it might have significantly ratcheted up the risks of an out-of-control trade war, which we don’t expect will happen. On the other hand, some corporate managements may be quickly concluding that the “truce” announced a week ago basically gives them 90 days (or less) to move their supply chains (and arrestable executives) out of China.

(3) Trump. Adding to the tumult over trade may be the legal problems for Trump that surfaced at the end of last week. Special Counsel Robert Mueller’s investigation into Russian interference in the 2016 election has been aided by helpful information provided by Michael Cohen, President Trump's former personal lawyer, according to a new filing Friday. In recent days, Trump has issued more disparaging tweets about the Mueller probe. It’s getting hard to assess the extent to which the stock market’s volatility is attributable to Trump’s tweets about China, Mueller, or both.

(4) Dow Vigilantes. On Friday afternoon, the WSJ posted a story titled “As Trade Battle Unfolds, Trump Keeps Close Focus on Markets.” According to the article, one person close to the White House said that Trump keeps his TV tuned to business channels and is “glued” to the stock market. Last week, as the stock market churned, “President Trump anxiously called advisers both inside and outside the White House looking to ensure that his talks with China were not driving the selloff.”

In a sign of how unsettled investors were, stock-index futures dropped so precipitously last Thursday on news of the Huawei arrest that the Chicago Mercantile Exchange (CME) triggered circuit breakers to avoid worse losses. Those futures spiked down to 2,659, a drop of 1.9%, before the CME stopped trading.

This raises an interesting and worrisome possibility. We and other market commentators have blamed much of this year’s market volatility, especially the one-day meltdowns, on algorithm trading systems. We know that government-sponsored foreign bad actors have been hacking our computer systems and flooding us with fake news. What if they start manipulating our markets too, to influence our President?

Employment I: Full of Full-Time Jobs. Investors are so twitchy about an imminent recession that Friday’s weaker-than-expected payroll report might have contributed to Friday’s selloff. They’ve also taken note of a recent upturn in initial unemployment claims, which actually remain near record-cyclical-low levels. Then again, that upturn has been reflected in our very own Boom-Bust Barometer, which has dropped in recent weeks (Fig. 9). It has been a good coincident indicator of the S&P 500 since the late 1990s.

Nevertheless, Debbie and I found lots of good news in the latest employment report, and attribute any weakness to shortages of workers rather than weakness in demand for labor, as confirmed by Melissa’s review of the Fed’s latest Beige Book in the next section. Of course, stock investors may also be worrying that the labor shortages will dampen economic growth. That’s conceivable, but so is a rebound in the growth of productivity, in our opinion.

While payroll employment rose only 155,000 during November, the household measure increased 233,000, led by a 543,000 increase in full-time household employment to yet another record high (Fig. 10). Wage gains continued to outpace consumer price inflation last month, with the former up slightly above 3.0% while the latter continued to hover around 2.0% (Fig. 11). The unemployment rate was unchanged at just 3.7%, with the short-term rate at 2.9% and the long-term at only 0.8% (Fig. 12).

Employment II: Ghost Town. Workers are quitting their jobs simply by not showing up, giving no notice, and providing no future contact information—leaving their employers high and dry. Employees “ghosting” employers in this way was discussed anecdotally in the Fed’s December Beige Book, which was released last week on Wednesday. Other anecdotal evidence of the “exceptionally” tight US labor market suggested that new hires are leaving jobs soon after—and sometimes even before—their start dates. Employees have a lot of leverage in this job market, according to the Fed’s report.

These anecdotes capture a nationwide challenge among the Fed districts’ business contacts: lots of job openings and a lack of qualified workers to fill them. Published eight times per year, the Beige Book includes helpful commentary from Fed district surveys of businesses. The commentary is not scientific or data-driven, but it can be a leading indicator of trends that eventually show up in the data. So it’s worth some attention.

One might think that the uncertainty surrounding trade and interest rates could be responsible for slower (albeit still solid) employment trends. It would make sense for employers to take a wait-and-see approach before committing to incremental labor resources even though the US economy remains strong. However, we don’t see much evidence of caution on hiring in the latest Beige Book. (See our Table 1, which captures the December Beige Book commentary pertinent to the labor market as discussed in the following.)

Rather, Fed district business contacts noted that labor shortages for qualified workers are continuing to constrain employment and output growth. Some manufacturers say orders are being left on the table due to worker shortages. So the relative slowdown in employment during November (below the 200,000 mark)—as noted in Debbie’s commentary below—likely reflects a lack of qualified labor supply rather than a lack of labor demand. Employers are upping wages to attract and retain workers, but that doesn’t seem to be solving the problem. Hiring people with the right skills and keeping them remain challenges.

More takeaways from December’s Beige Book report:

(1) “Moderate” wage growth. Nationwide, employment growth is on the “slower side of modest to moderate”; meanwhile, wage growth is on the “higher side” of modest to moderate. Most district contacts reported increasing wages around 3.0%-4.0%. Among the exceptions, some Boston contacts noted that a shortage of IT workers is driving wage increases for that market of up to 10.0%. Nevertheless, “moderate” was the word that districts used most to describe wage growth.

(2) More non-wage incentives. Businesses are increasing nonwage incentives to attract and retain employees. These include: better health benefits, profit-sharing, bonuses, and paid vacation days. For example, Atlanta contacts noted that businesses are engaging in “internal programs and marketing initiatives to promote culture, build loyalty, and create a positive environment for workers.”

(3) Low- and middle-skilled workers wanted. Labor shortages are broad-based across occupations and industries. The neediest industries are those requiring low- and medium-skilled workers, such as construction, manufacturing, and transportation. However, IT and other professional services workers are also in high demand.

(4) Off-schedule capital investment. It’s interesting that low- and medium-skilled workers are highly sought when employment for goods-producing industries (that often utilize that skill level) recently has tapered off more dramatically than for service industries, as Debbie notes below. One reason we see that manufacturers may be challenged to find qualified workers is that the work has become highly specialized by industry. Some district contacts noted that enhanced productivity is allowing them to slow hiring. Some even said that they are investing in “off-schedule” labor-saving capital projects to offset employee turnover and the shrinking pool of qualified applicants.

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Humans vs Machines

December 06, 2018 (Thursday)

Strategy I: Trigger-Happy Algos. It has undoubtedly been a Grinchy 11 weeks since the S&P 500 peaked at a record high on September 20. Uncertainty about trade wars, interest rates, and corporate earnings have combined to cause lots of sideways volatility this year. Two record highs were set this year, yet the S&P 500 is basically flat for the year at this point! Both record highs were followed by 10.2% corrections (Fig. 1). Given the abundance of negativity baked into stock prices after Tuesday’s rout, the holiday spirit has moved us to look for anything that might bring some cheer.

Some market developments suggest this week’s selloff may be closer to an end than a beginning. For starters, when the S&P 500 fell 90 points on Tuesday, 10 of its 11 sectors were in the red for the day and only six industries—including Electric Utilities, Gold, and Automotive Retail—in the black. When nearly everything wipes out—from the go-go tech names right down to safety sectors—it’s often a sign that selling may be approaching an end.

Such widespread and intense selloffs tend to signal so-called “capitulation bottoms.” Such bottoms don’t always occur in just one day. The bottom of the latest correction in the S&P 500 occurred on November 23 (Fig. 2). It could be retested and even breached, of course. While Joe and I are looking for a bottom, others viewing the same chart of the S&P 500 see a major bull market top and are looking for the beginning of a bear market.

However, this year has seen a number of one-day meltdowns like Tuesday’s. We strongly suspect that they were not driven by capitulating humans but engineered, literally, by computer-driven trading algorithms. The “algos” seem to have been triggered to sell by news events suggesting escalating trade wars and flattening yield curves. They tend to be programmed to sell large, liquid exchange-traded funds (a.k.a. ETFs), which amounts to a “sell-everything” trade.

So far this year, the market action suggests that shortly after algo-meltdown days, humans emerge from behind the rocks and start buying stocks that now look especially cheap. We expect they will be doing so again in coming days.

While Joe and I aren’t capitulating either, we did curb our enthusiasm for earnings and stock prices at the end of October. The problem is that the S&P 500 profit margin spiked to a record high this year thanks mostly to the cut in the corporate tax rate (Fig. 3). At best, it might remain flat in 2019 if productivity makes an unexpected comeback. If so, then earnings growth will match revenues growth, which is bound to slow from around 8% annually this year to 4% next year, as we have previously explained (Fig. 4). Of course, if the profit margin declines next year, earnings growth could be closer to zero.

In any event, the Q4 earnings-reporting season conference calls at the start of the new year are likely to be full of even more downbeat guidance than Q3’s calls were. The same can be said of all four of next year’s earnings seasons, since earnings comparisons to this year’s results will be in the low single digits.

Now let’s have a closer look at Tuesday’s stock-market action:

(1) Trade. Of course, humans have also been concerned about Trump’s escalating trade war with China. It seemed to have been deescalated over the past weekend when the US and China agreed to a 90-day ceasefire. However, as the markets opened Tuesday, Trump began tweeting about his administration’s trade negotiations with China: “President Xi and I want this deal to happen, and it probably will. But if not remember … I am a Tariff Man.” Adding to the uncertainty, Larry Kudlow, Trump’s top economic adviser, said Monday the truce would start on January 1, with the White House later saying the 90-day period began on December 1. The stocks of trade-sensitive industrials were hit hard, with Caterpillar falling 6.9% and Deere dropping 6.6%.

(2) Yield curve. Bank stocks were pummeled on Tuesday as longer-term US Treasury yields fell faster than did short-term yields, resulting in a flattening of the yield curve (Fig. 5 and Fig. 6). The yield spread between the 10-year and 2-year notes dropped to 11bps, the lowest since June 15, 2007. The spread between the 5-year and 2-year turned negative by 1bp.

Are contraction and inversion of the yield spread all that worrisome? We don’t think so, but ours is the minority view. The “official” yield curve spread is the one between the 10-year and the federal funds rate. It is one of the 10 components of the Index of Leading Economic Indicators (LEI). It fell to 79bps on Tuesday. So it remains well in positive territory, and therefore a positive contributor to the LEI! Ask us again what we think if and when it actually turns negative.

(3) Economic growth. A few stories in the financial press noted that the latest one-day meltdown was triggered by concerns about global economic growth. November’s global M-PMI edged down to 52.0, the lowest reading since November 2016 (Fig. 7). These indexes were especially low in the Eurozone (51.8, the lowest since August 2016) and China (50.0, the lowest since July 2016). But the US M-PMI remained high at 59.3 last month. This series is highly correlated with the y/y growth in S&P 500 revenues per share (Fig. 8).

Strategy II: Searching for Diamonds amid Lumps of Coal. If you can bear to look at the latest bearish action, here’s how the S&P 500 sectors performed during Tuesday’s rout: Utilities (0.1%), Real Estate (-1.3), Consumer Staples (-1.6), Health Care (-2.3), Energy (-2.9), Materials (-3.1), Communication Services (-3.1), S&P 500 (-3.2), Tech (-3.9), Consumer Discretionary (-3.9), Industrials (-4.4), and Financials (-4.4) (Table 1).

The selloff over the past 11 weeks has left the S&P 500’s industries and sectors far more reasonably priced compared to year-ago levels. The S&P 500’s forward P/E has dropped 2.5 points to 15.9 (Fig. 9).

Here’s where the S&P 500 sectors’ forward P/Es stand as of the latest available data, on November 29, compared to a year ago: Real Estate (39.8, 39.9), Consumer Discretionary (20.0, 20,6), Consumer Staples (18.4, 19.5), Communications Services (16.9, 12.7), Utilities (16.7, 18.6), Tech (16.4, 18.8), Health Care (16.1, 16.7), S&P 500 (15.9, 18.4), Industrials (15.1, 19.0), Materials (14.6, 18.4), Energy (13.7, 25.1), and Financials (11.7, 14.8).

Some of the hardest hit areas of the market are showing faint glimmers of life. Specifically, the S&P 500 Homebuilders stock price index is one of the year’s worst performers, down 30.5% ytd. However, since November 16, it has outperformed the S&P 500, rising 2.3% versus the broader index’s 1.3% decline. Might the industry’s outperformance be a short-lived, last hurrah? Certainly. But the fact that it coincided with the drop in the 10-year Treasury yield from 3.24% on November 8 to 2.91% as of Tuesday’s close suggests otherwise. Lower mortgage rates will go a long way toward improving home affordability.

The S&P 500 Semiconductor Equipment industry also sold off early and hard this year. It’s down 23.4% ytd, but up 0.2% since November 16. That return won’t set the world on fire, but perhaps it’s a start.

And finally, the dollar’s sharp ascent may be over now that expectations for the Fed’s rate-hiking have moderated. If so, the dollar’s drag on international corporations’ earnings could abate in the second half of 2019 (Fig. 10).

Energy: Tug of War. In a major about-face, the price of a barrel of Brent crude oil has dropped 28% to $62.08 in just nine weeks (Fig. 11). Among the numerous factors dragging it down are lowered expectations for global economic growth, which may be further reduced if US tariff squabbles with China don’t end favorably. Understanding the direction of oil prices is further complicated by the lack of pipeline availability in the US, the death of a Saudi dissident, and the declining production rates of shale oil fields.

Ultimately, however, the price of oil is controlled by the largest producers: Saudi Arabia, the US, and Russia. Saudi Arabia needs oil prices to be high enough to fund its budget. We’d bet that it will cajole OPEC members into cutting production; less production today will mean more profits tomorrow. Let’s take a look at developments in the oil patch:

(1) Lots of meetings. OPEC is scheduled to meet today, and its members have been trying to negotiate an oil production cut of “at least” 1.3mbd, according to a 12/3 Reuters article. It stated: “Russia’s resistance to a significant production cut was so far the main stumbling block.”

The reduction would come in the wake of production cuts of 325,000bpd planned for January by producers in Canada’s province of Alberta, the first cuts they’ve had since the 1980s. There’s a glut of stored oil in Alberta due to a shortage of pipeline capacity, a 12/4 Bloomberg article reported. “The province is working to buy rail cars as an alternative transport method,” and there are three pipeline construction projects that will help move the oil to the coast over the long term.

(2) Budgets matter. With the price of Brent crude oil at $62.08 a barrel, many OPEC members will have gaping holes in their budgets. According to an 11/27 WSJ article, most OPEC members need Brent north of $70 a barrel to fund a balanced budget. Saudi Arabia needs $88 Brent oil, while Russia has more wiggle room ($53).

US shale producers have a much higher pain threshold. Most US frackers break even when oil is at $50 a barrel. But as a 12/4 WSJ article explained, breakeven levels don’t include overhead costs or the cost of land, which can push the breakeven point to $55-$60 a barrel. While US shale producers can remain profitable at lower oil price levels, they depend on the capital markets to fund expansion and refinance existing debt. Capital markets have a funny way of being willing to lend money when it’s not needed and being unwilling to lend in tough times when the capital is needed.

(3) Politics play a leading role. A supply cut by Saudi Arabia would be a no-brainer if it weren’t for politics. President Trump has made crystal clear his desire for low oil prices, equating them to a big tax cut for US consumers. Normally, we wouldn’t expect OPEC to bow to entreaties from a US president. But Trump is one of the few supporters of Saudi Arabia after the Saudi’s Prince Mohammed bin Salman had dissident Saudi journalist Jamal Khashoggi killed, according to the CIA.

President Trump has relied on Saudi Arabia and OPEC to keep their taps open after the US withdrew earlier this year from the 2015 Iran nuclear deal and restored sanctions on the country, the world’s third largest producer of oil. However, when the sanctions were implemented in November, Trump granted exemptions to Iran’s largest oil customers, China and India, along with Italy, Greece, Japan, South Korea, Taiwan, and Turkey. Doing so has resulted in a glut of oil.

(4) Threats from Iran. In the latest twist on Tuesday, Iranian President Hassan Rouhani threatened to halt oil shipments from other countries through the Gulf if the US moves ahead with plans to halt Iranian exports as part of sanctions. “If one day they want to prevent the export of Iran’s oil, then no oil will be exported from the Persian Gulf,” said Rouhani, according to a 12/4 Reuters article.

(5) Threats from Congress. Congress is reportedly considering a bill that would open the door to sue OPEC under US antitrust laws. Historically, former US presidents have opposed similar legislation, but a 12/4 CNBC article suggested President Trump might support it given his desire for low oil prices. A bill is unlikely to be completed before Congress recesses, but next year is another matter.

Separately, Qatar, one of OPEC’s smallest producers, quit the organization this week, citing plans to focus on gas production instead of oil and disavowing any linkage to the 18-month political and economic boycott of the country by Saudi Arabia and three other Arab states.

(6) Looking ahead. OPEC may want to reduce oil inventories today before US pipeline projects are completed in late 2019 and 2020. The lack of pipeline capacity in the Permian Basin has been constraining production growth in the region. There is 3.1mbd of pipeline takeaway capacity plus another 300,000bpd of local refining capacity, according to an 8/27 OilPrice.com article. At the time the article was written, the Permian was already producing about 3.4mbd.

S&P Global Platts estimates 2.6mbd of pipeline capacity will come online by 2020 and another 1mbd is under consideration. Some of the additional pipeline capacity will increase the ability of shale producers to get their oil from the well head to ships for export.

There are some extremely optimistic forecasts about just how much oil can be pumped from the rocks in the Permian Basin. One comes from Will Giraud, executive vice-president of Concho Resources, one of the leading Permian producers. He “told investors last month: ‘I think there are several more years of very high growth, and it’s likely that the Permian gets into the 5m-6m or maybe even 7m b/d of production and then sustains that for a decent period,’” a 12/4 FT article reported.

Offsetting increased production are the high depletion rates that fracking wells experience. The oil produced by fracking wells drops more quickly than the oil produced by conventional wells. Frackers must drill new wells just to keep their production static and offset production declines at older wells. According to a November report by the US Energy Information Administration, the decline rate at older wells is expected to be greater in December 2018 than it was in the same month last year. However, more total oil is being produced because more wells are pumping oil this year than were pumping last year. Just how long oil companies can keep that hamster wheel turning is up for debate.

(7) Downward revisions starting. When wrote about oil in the 11/15 Morning Briefing, we expected downward revisions to earnings, and they have started to arrive. The S&P Energy sector is expected to have revenue growth of 9.7% and earnings growth of 21.6% in 2019 (Fig. 12 and Fig. 13). That’s down from the 10.6% and 28.0% growth rates expected when we wrote on the topic last month. If OPEC doesn’t announce cuts this week, expect the downward revisions to keep rolling in.

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Trump Put

December 04, 2018 (Tuesday)

Strategy I: Santa & Two Elves. Last Wednesday, Fed Chairman Jerome Powell spoke in a way that brought joy to investors. In a speech before The Economic Club of New York, he took back what he had said in a 10/3 interview. Instead of the current federal funds rate range of 2.00%-2.25% being a “long way from neutral at this point,” it was now “just below” neutral.

That implied that the rate might be hiked to 2.25%-2.50% at the next meeting of the FOMC, on December 18-19, after which the Fed might pause for a while, no longer hiking rates every three months as it had for the last three hikes (Fig. 1). The two-year US Treasury note yield, which tends to be a good year-ahead leading indicator for the federal fund rate, fell from this year’s high of 2.98% on November 8 to 2.80% last Friday (Fig. 2). That implies only one or maybe two rate hikes next year.

Powell was playing the Grinch during October. Last week, he was playing Santa. Over the weekend, Presidents Donald Trump and Xi Jinping were Santa’s helpers, when they announced a 90-day ceasefire in the trade war between the US and China. With high hopes for the holiday season, investors started this year’s Santa Claus rally a week ago Monday following a 10.2% correction in the S&P 500 from September 20 through November 23 (Fig. 3).

That was identical in size to the market’s last correction, from late January through early February of this year. Both were caused by high anxieties about Fed rate-hiking and Trump’s trade wars. Those fears have abated for now, resulting in Relief Rally #62 following Panic Attack #62. There have been six corrections so far during the current bull market.

The 90-day ceasefire in the US-China trade war means that firing will commence if the two sides fail to settle their disputes within this timeframe. Of course, the ceasefire could always be extended. The White House press release stated:

“President Trump has agreed that on January 1, 2019, he will leave the tariffs on $200 billion worth of product at the 10% rate, and not raise it to 25% at this time. China will agree to purchase a not yet agreed upon, but very substantial, amount of agricultural, energy, industrial, and other product from the United States to reduce the trade imbalance between our two countries. China has agreed to start purchasing agricultural product from our farmers immediately.

“President Trump and President Xi have agreed to immediately begin negotiations on structural changes with respect to forced technology transfer, intellectual property protection, non-tariff barriers, cyber intrusions and cyber theft, services and agriculture. Both parties agree that they will endeavor to have this transaction completed within the next 90 days. If at the end of this period of time, the parties are unable to reach an agreement, the 10% tariffs will be raised to 25%.”

In effect, the Dow Vigilantes have taken over for the Bond Vigilantes. The steep decline in stock prices during October caused Treasury bond yields to decline a bit, while getting the attention of Messrs Powell and Trump. As a result, they gave the markets a Powell Put and a Trump Put, with many happy returns, at least since last Monday.

Last week, it was as though Powell said, “On your mark, get set, pause!” That was the title of our 11/19 Morning Briefing. This weekend, Trump in effect said, “Ready, set, ceasefire!”

Strategy II: The Long Good Buy. In all of my meetings with our accounts in London last week, we discussed how long the current expansion might last. I think it will continue at least through next July, which would make it the longest expansion on record (Fig. 4). I didn’t say that there will never be another recession again, but I did posit that perhaps downturns rolling through a few industries could result in growth recessions rather than a severe enough recession to cause a bear market in stocks.

In fact, there was a severe recession during 2015 that rolled through the global commodity industries, hitting energy companies especially hard. As a result, the growth rate of S&P 500 revenues, on a y/y basis, turned negative during most of the year (Fig. 5). The recovery started in early 2016. Over the past three years, the plunge in the stock prices of US department stores suggested that malls were heading toward extinction (Fig. 6). Instead, they are among the best-performing stocks so far this year.

The stock prices of homebuilders have been signaling trouble for their industry since the index peaked on January 22 (Fig. 7). But they are starting to show signs of a relief rally. The same can be said for the stock prices of semiconductors (Fig. 8). The stock prices of Caterpillar and PPG, which were widely followed on the way down this year, have also been showing signs of bottoming recently (Fig. 9 and Fig. 10).

The S&P 500 has rebounded 6.0% since Friday a week ago through Monday’s close. The index is up 4.4% ytd, and only 4.8% below the 9/20 record high of 2930.75. Joe and I expect that the current relief rally will get us back there again or higher before year-end, thanks to Santa and his two elves.

Strategy III: Profits on the Margin. In London, I was frequently asked why Joe and I had curbed our enthusiasm for earnings growth in 2019 at the end of October. The problem for us is that the S&P 500 profit margin rose to yet another record high during Q3. Given all the chatter about rising costs during the last earnings season’s conference calls, it’s hard to imagine that the margin can go higher. At best, it might remain flat at the current record high next year.

If so, then earnings growth will be determined by revenues growth, which was remarkably strong this year. Again, it is hard to imagine that it will be stronger next year; it’s more realistic to expect that it will slow. That’s consistent with our view that 2015 and 2016 were recession-like years, while 2017 and 2018 were more like recovery years. That suggests that 2019 and 2020 will be more like late-cycle expansion years, when revenues growth tends to slow to its historical 4% annual trend (Fig. 11).

Let’s focus on the profit margin for now:

(1) S&P vs I/B/E/S. Joe and I monitor the profit margin using both S&P and I/B/E/S operating earnings data (Fig. 12). The former tends to be a bit below the latter. During Q3, they both rose to record highs of 12.4% and 12.8%, respectively.

(2) Forward profit margin. Following October’s Q3 earnings season, industry analysts have been trimming their profit margin expectations for 2019 and 2020 (Fig. 13). We derive these estimates using analysts’ consensus expectations for S&P 500 revenues and earnings (using I/B/E/S data). The forward profit margin, which is the time-weighted average of the estimates for the current year and the coming year, is looking toppy. It tends to be a good leading indicator of the four-quarter average of the actual profit margin (Fig. 14).

(3) Sectors. The profit margins of several of the S&P 500 sectors rose to or near record highs during Q3 based on their four-quarter averages and S&P operating earnings data (Fig. 15). Here is the performance derby: Information Technology (record 22.7%), Real Estate (18.7), Financials (16.1 record), Communication Services (12.5 record), Utilities (12.4 record), S&P 500 (11.4 record), Industrials (10.0 record), Materials (10.0 record), Health Care (8.7), Consumer Discretionary (7.8 record), Consumer Staples (7.2), and Energy (6.1).

The Fed: Seeking Financial Stability. In addition to Powell’s gift to the markets last week, the Fed also gave us the first installment of a brand new publication. The Fed’s 11/28 Financial Stability Report is designed to enhance public understanding, increase transparency, and promote financial stability in keeping with the Fed’s dual mandate.

The report explains that the adverse events that occurred during the 2007-2009 financial crisis were dramatically worsened by an unstable financials system. The report notes that “adverse events are more likely to result in severe financial stress and disrupt the flow of credit, leading to high unemployment and great financial hardship.”

Melissa and I read the report. We didn’t come across any risks that we didn’t already know about. Nevertheless, the report provided a good summary of the risks (or lack thereof, rather) present in the financial system.

Some of the statistics in the report mitigated potential concern about macro financial vulnerabilities. All in all, the report came across as a way for Fed officials to cover themselves: If any risks noted were to materialize, the Fed can say that they were monitoring them.

We usually let you know if a report is worth reading, but you can probably skip this one. The upshot of the 38 pages is that financial stability is markedly improved from where it was leading up to the financial crisis. The Fed is monitoring elevated asset valuations and high levels of corporate borrowing, but isn’t concerned about household borrowing, financial sector leverage, or funding risks. Here’s more:

(1) Concerned about corporate debt. One area of vulnerability has caught the eyes of the Fed and investors: elevated leverage in the nonfinancial business sector. The report noted a pickup in the issuance of risky debt and the continued deterioration in underwriting standards on leveraged loans. We’ve been on top of this issue for a while and aren’t overly concerned (see our 11/27 Morning Briefing). Despite presenting reasons to worry about a possible bubble in the nonfinancial corporate debt market, the newly issued Fed report didn’t change our conclusion. We remain not too worried.

(2) Bond mutual funds at risk. It seems that the primary reason to worry about this market is that corporate bond mutual funds are at risk of getting hit. That’s consistent with our previous line of thinking that corporate distressed debt investors could get hurt. But we still don’t think that is likely to translate into a wider systemic problem, as we’ve previously discussed. These funds are “estimated to hold about one-tenth of outstanding corporate bonds, and loan funds purchase about one-fifth of newly originated leveraged loans,” observed the report. Valuation pressures “may make large price adjustments more likely, potentially motivating investors to quickly redeem their shares.”

(3) But CLOs below crisis levels. Supporting our not-to-worry case are these two facts from the report: Issuance volumes of non-agency securitized instruments (including CLOs, discussed in our 11/27 note) have been “rising in recent years but remain well below the levels seen in the years ahead of the financial crisis” (see figure 3-8 in the Fed’s report). Secondly, data on bank’s lending to the “shadow” banking sector is below capacity. Nonbank financial institutions “have access to about $1 trillion in committed lines of credit, an increase of about two-thirds over the past five years.” However, borrowing institutions have utilized only $300 billion of this credit.

(4) Concerned about asset valuations. Our key takeaway from the Fed’s discussion on elevated asset valuations is that they are so high because investors’ risk tolerance is elevated, demonstrated as follows: Spreads on high-yield corporate bonds and leveraged loans over benchmark rates are near lows seen during the financial crisis. Equity P/E ratios have been rising since 2012 and are above the median values tracked over the past 30 years. The return on commercial real estate is near the post-crisis bottom.

(5) Equity valuation elevated, but okay. Table 1 of the Fed’s report provides the size of selected asset markets against the growth of those markets from Q2-17 to Q2-2018 versus average annual growth from 1997 to Q2-2018. Equities are the clear frontrunner in terms of both asset size ($33.8 trillion outstanding) and recent growth over historical average annual growth (3.9 percentage points above).

Indeed, the forward P/E ratio of S&P 500 firms (around 17x) is above the 30-year median (around 15x), as the report notes. However, our take on the Fed’s figure 1-9 is that the ratio is nowhere near above where it had been during the late 1990s tech bubble (around 26x). Sure, the ratio is slightly above where it was leading up to the financial crisis (around 15x), but it wasn’t an equity bubble that caused that meltdown. It was consumer mortgages, an area that’s significantly strengthened since the crisis.

By the way, note in the Fed’s Table 1 that leveraged loan growth was lower during the more recent period than in the historical period (12.9% versus 15.1%).

(6) Not concerned about. Besides those mentioned above, the report gives lots more reasons not to worry about financial stability, notwithstanding the risks present. Borrowing by households “has risen in line with incomes and is concentrated among low-credit-risk borrowers.” Outstanding mortgage debt credit risk “appears to be generally solid.” Further, financial sector leverage has “been low in recent years.” Perhaps most importantly, banks have “strong capital positions.” Finally, broker-dealers and insurance companies have “strengthened their financial positions since the crisis” even as “there are signs of increased borrowing at other nonbank financial firms.”

(7) Other potential risks. Not covered in detail in the report are cybersecurity and the risk in crypto-assets, but these are mentioned as areas of potential vulnerability that the Fed is monitoring. Potential spillovers from financial weaknesses abroad are also noted, specifically the transition of the UK out of the European Union and Italian banking woes. Duly noted is the risk of escalating geopolitical tensions, specifically the ongoing trade dispute between the US and China.

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Restricting ‘Restrictive’

December 03, 2018 (Monday)

Inflation: Less of It. While I was away visiting our London accounts last week, the Fed made lots of headlines. Evidence mounted that following another likely rate hike at the FOMC meeting on December 18-19, the monetary policy committee might pause during the first half of next year to reevaluate the course of monetary policy. Not as widely noticed last week was that inflationary pressures may be ebbing, which would also argue for a pause. Consider the following:

(1) PCED. While the labor market continues to tighten and wage gains are picking up, price inflation remains subdued according to the most currently available data. For starters, the core PCED rose 1.8% y/y during October, the lowest such pace since February (Fig. 1). Over the past three months through October, this measure is up just 1.1% (saar), the lowest reading since May 2017 (Fig. 2).

(2) Goods. The core PCED for goods fell -0.6% y/y during October (Fig. 3). The US import price index excluding energy has been moving higher since early 2017 after falling the previous two years. Nevertheless, it was up only 0.7% y/y during October, as a strong dollar this year mostly offset Trump’s tariffs.

(3) Services. The PCED for services excluding energy rose 2.6% y/y during October, an eight-month low (Fig. 4). Wireless telephone services prices fell sharply during 2017, but stabilized this year. So some of the upward pressure on inflation this year simply reflected much less deflation in this services category (Fig. 5).

(4) Rent. More importantly, the rate of inflation for rent of primary residence has been moderating over the past two years after rising sharply during most of the current expansion (Fig. 6). It was still high at 3.6% during October. But the boom in multi-family housing construction in recent years may be closing the gap between the demand and the supply of rental housing units.

(5) Medical care. Of even greater importance may be what is happening to prices in the health care industry. They aren’t rising much at all (Fig. 7). Over the past 12 months through October, the PCED for medical care is up just 1.3%, with hospital and physician services up only 1.5% and 0.7%, respectively, and prescription drug prices up just 0.8%! The moderation in the latter might reflect pressure from the Trump administration on drug companies to keep a lid on their prices. The services components of health care may finally be experiencing long-overdue upturns in their productivity, which may be a long-term phenomenon as new competitors—most notably Amazon—enter the field.

(6) Regional price surveys. Five of the Fed’s regional district banks include questions on prices paid and prices received in their monthly surveys. Debbie and I monitor the averages of each of these two series (Fig. 8). Both peaked during July and have been edging down since then through November.

(7) Oil. Helping to moderate inflationary expectations has been the recent 31% plunge in the price of a barrel of Brent crude oil since October 3 through Friday (Fig. 9). Technological innovation continues to disrupt the global oil industry, as US frackers are now producing almost 12.0mbd (Fig. 10). US crude oil exports have doubled since mid-January 2015 to 7.4mbd currently (Fig. 11).

(8) Real wages and productivity. Average hourly earnings rose 3.2% y/y during October, while the overall PCED rose 2.0% over the same period. As a result, inflation-adjusted wages rose to yet another record high (Fig. 12). This measure has been on a solid uptrend since the mid-1990s, blowing away the myth that real wages have stagnated for decades.

This couldn’t have been happening unless productivity has also been performing better than suggested by the data, which were revised higher for the late 1990s and may be revised higher for the current expansion, in our opinion. Another reason to believe that productivity is underestimated is the S&P 500 profit margin, which has been soaring to new record highs since late last year (Fig. 13). How did that happen if productivity has been as weak as widely believed? (It can’t all be explained by the cut in the corporate tax rate at the end of 2017.)

In an 11/27 speech, Fed Vice Chairman Richard Clarida acknowledged as much when he rhetorically asked: “What might explain why inflation is running at or close to the Federal Reserve's long-run objective of 2 percent, and not well above it, when growth is strong and the labor market robust?” He concluded that the answer might be that while “growth in aggregate demand in 2018 has been above the expected long-run growth rate in aggregate supply, it has not been exceeding this year's growth in actual aggregate supply.” The explanation is better-than-expected growth in productivity. If this keeps up, we will all be supply-siders.

The Fed: Less Accommodative & Less Restrictive. Most of the disinflationary news reviewed above came out last week. The minutes of the latest, 11/7-8 FOMC meeting also came out last week, on Thursday. Fed officials had a balanced view of the outlook for inflation, suggesting that they believed that inflation would remain around their 2.0% target for the core PCED. The latest data suggest they may need to consider that there might be more downside than upside risk in their inflation outlook, justifying a pause in their rate-hiking. In any event, let’s review the recent rapid evolution of group-think at the Fed:

(1) No longer accommodative. It was widely noted that the 9/26 FOMC statement deleted the following language that had appeared in previous statements: “The stance of monetary policy remains accommodative.” This sentence had been in every FOMC statement since December 16, 2015, when the Fed started its latest rate-hiking program. Some interpreted this to mean that the Fed is setting up for more aggressive rate increases. On the contrary, Fed Chairman Jerome Powell reassuringly said at his 9/26 press conference that the language simply had outlived its “useful life.” So the Fed will continue its gradual rate increases toward a neutral stance.

That stance was confirmed in the minutes of that 9/25-26 FOMC meeting, released on October 17: “Almost all considered that it was also appropriate to revise the Committee’s postmeeting statement in order to remove the language stating that ‘the stance of monetary policy remains accommodative.’ Participants discussed a number of reasons for removing the language at this time, noting that the Committee would not be signaling a change in the expected path for policy…”

(2) Restrictive. Notwithstanding the above, in a 10/3 interview, Powell shocked the markets when he stated: “So interest rates are still accommodative but we're gradually moving to a place where they will be neutral, not that they'll be a restraint on the economy. We may go past neutral but we're a long way from neutral at this point, probably.”

During his 9/26 press conference, Powell was asked whether the Fed might end the tightening cycle in a “restrictive posture,” as Fed Governor Lael Brainard suggested in a 9/12 speech. Powell responded: “It’s very possible.” He added: “Maybe we will keep our neutral rate here [i.e., at 3.00%], and then go one or two rate increases beyond it.”

The minutes of September’s FOMC released on October 17 mentioned the word “restrictive” twice as follows:

“A few participants expected that policy would need to become modestly restrictive for a time and a number judged that it would be necessary to temporarily raise the federal funds rate above their assessments of its longer-run level in order to reduce the risk of a sustained overshooting of the Committee’s 2 percent inflation objective or the risk posed by significant financial imbalances. A couple of participants indicated that they would not favor adopting a restrictive policy stance in the absence of clear signs of an overheating economy and rising inflation.”

In a 10/25 speech, Clarida in effect endorsed Powell’s interview comment and contradicted September’s FOMC statement, saying, “However, even after our September decision, I believe U.S. monetary policy remains accommodative.” Melissa and I called it a rookie mistake, for sure, but Powell should have known better.

(3) Open to suggestions. Then we noticed that Clarida walked that statement back for himself, and maybe for Powell too, saying in a 11/16 CNBC interview: “As you move in the range of policy that by some estimates is close to neutral, then with the economy doing well it’s appropriate to sort of shift the emphasis toward being more data dependent.”

In an 11/14 Q&A session led by Dallas Fed President Robert Kaplan, Powell turned more dovishly cautious, comparing monetary policy to walking through a room full of furniture when the lights go out. “What do you do? You slow down. You stop, probably, and feel your way,” he said. “It’s not different with policy.” He also warned about relying too much on data that are revised frequently. He said, “You pick things up sooner talking to business people because they start to feel it, and then it shows up in the data.”

Another hint that the Fed might be turning less hawkish—or at least more open to suggestions—occurred the day before. In a short 11/15 press release, the Fed announced a year-long review of the “the strategies, tools, and communication practices it uses.” It was described as an “outreach effort,” promising a “series of public events around the country to hear from a wide range of stakeholders.”

The timing seemed odd to us given that monetary policy appeared set on a “gradual” tightening course of 25bps hikes every three months through next year. Also odd is that the review was announced following recent criticism of monetary policy by none other than President Trump. Presidents aren’t supposed to butt into monetary policymaking, and the Fed is supposed to resist such political interference in its independence.

(4) Data dependent again. The Tuesday 11/27 WSJ included an article titled “Fed Shifts to a Less Predictable Approach to Policy Making.” It was based on interviews with Fed officials who “will be deciding whether and when to raise interest rates more on the basis of the latest signs of economic vigor—such as in inflation, unemployment and growth—and less on forecasts of how the economy is expected to perform in the months and years to come.”

They are admitting that they are more uncertain about the level of the neutral interest rate and “are looking for clues in markets and economic data that might suggest whether this point might be higher or lower.”

The very same day, in an 11/27 speech, Clarida reiterated that both the neutral rate of interest and the unemployment rate consistent with stable inflation are unmeasurable. So to get a fix on them “supports the case for gradual policy normalization, as it will allow the Fed to accumulate more information from the data about the ultimate destination for the policy rate.” That also supports the case for longer pauses in between rate hikes.

In his Wednesday 11/28 speech at The Economics Club of New York, Powell said: “Interest rates are still low by historical standards, and they remain just below the broad range of estimates of the level that would be neutral for the economy—that is, neither speeding up nor slowing down growth.” In effect, he was admitting that the 10/3 long-ways-off comment was a gaff, and he took it back.

The next day, the minutes of the latest, 11/7-8 FOMC meeting came out on Thursday 11/29. The word “restrictive” did not appear even once.

Movie. “Widows” (- - -) (link) is a great way to get a snooze at a movie theater. Viola Davis stars as the ringleader of four women who are forced to commit a heist to pay off the debt of their four husbands, killed after their last botched robbery. This is an action movie without much action or any action hero. From now on, I think I will pass on any movie starring Liam Neeson (who plays Viola’s husband); he has been appearing in lots of forgettable low-wattage action movies of late.

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Powell Put

November 29, 2018 (Thursday)

Fed: In Powell We Trust. We nailed it in the 11/19 Morning Briefing, titled “On Your Mark, Get Set, Pause.” We wrote: “President Donald Trump and Larry Kudlow, his economic adviser, have been calling for Fed officials to pause their interest-rate hiking. So has CNBC’s Jim Cramer. And so have I. Fed Chairman Jerome Powell and his colleagues may be starting to get the message and act accordingly.”

Yesterday, in his speech at The Economics Club of New York, Powell confirmed our assessment when he said, “Interest rates are still low by historical standards, and they remain just below the broad range of estimates of the level that would be neutral for the economy—that is, neither speeding up nor slowing down growth.”

Stock investors jumped for joy on Wednesday, as we predicted they would on Tuesday. What about last month’s stock market rout? It was triggered on October 3, when Powell said the following in an interview: “Interest rates are still accommodative, but we’re gradually moving to a place where they will be neutral. We may go past neutral, but we’re a long way from neutral at this point, probably.” Now they are “just below” neutral. In other words, the October 3 comment was a gaff, and Powell took it back yesterday. We applaud his flexibility.

The Fed’s critics will say that now we have a fourth Fed chair in a row providing the stock market with a put, i.e., the Powell Put. Maybe so. However, if Janet Yellen was the “Fairy Godmother of the Bull Market,” as we often fondly called her, then Powell for now is the bull market’s Santa. The Santa Claus rally that started on Monday should drive the S&P 500 back to retest its 9/20 record high around 2900 by the end of this year.

Financials I: Following Buffett. Berkshire Hathaway recently revealed that during Q3 it purchased 35 million shares in JP Morgan and smaller stakes in PNC and Travelers. The holding company, led by Warren Buffett, has been steadily adding to its holdings of financials and now counts American Express, Bank of America, JP Morgan, Wells Fargo, US Bancorp, and Goldman Sachs among its top 10 positions, according to an 11/14 CNBC article.

Despite Buffett’s blessing and much to our chagrin, financials have not fared well this year. Here’s how the ytd performance (through Tuesday’s close) of the S&P 500 Financials sector stacks up against its peers: Health Care (10.4%), Consumer Discretionary (5.0), Tech (3.9), Utilities (3.7), Real Estate (0.5), S&P 500 (0.3), Consumer Staples (-3.7), Financials (-5.2), Industrials (-7.9), Energy (-10.7), Materials (-12.2), and Communication Services (-12.3) (Fig. 1).

Financials sold off, as the Federal Reserve has raised the federal funds rate three times in 2018 and the yield curve unexpectedly flattened (Fig. 2). If the economy does roll over in the upcoming quarters, banks and brokers may have to boost their loan loss reserves, which would hurt earnings (Fig. 3). Though that has yet to occur, recent news out of the housing industry and the threat of more tariffs have everyone on the lookout. And then there’s always issuer-specific news (like the 1MBD scandal that cost Goldman Sachs shares nearly a quarter of their value ytd).

Two S&P 500 Financials industries’ stock price indexes have outperformed this year: Financial Exchanges & Data (13.7%) and Insurance Brokers (11.7). But that’s not where Buffett is buying. The S&P 500 Diversified Banks stock price index has dropped -5.7% ytd, and the S&P 500 Investment Banking and Brokerage stock price index has tumbled 16.7% (Fig. 4 and Fig. 5). Let’s see what analysts expect for these industries:

(1) The S&P 500 Diversified Banks industry is expected to increase revenue 3.2% this year and 3.3% in 2019 (Fig. 6). Earnings are forecast to slow from this year’s torrid 26.8% pace to a still-respectable 11.9% (Fig. 7). Analysts’ net earnings estimate revisions have actually been positive for the Diversified Banks industry in recent months, with NERI (our Net Earnings Revision Index) readings of 3.1 in November, 6.1 in October, and 8.3 in September (Fig. 8). And the industry’s forward P/E has retreated to a more reasonable 10.1 from 13.1 earlier this year (Fig. 9).

(2) The S&P 500 Investment Banking & Brokerage industry’s revenue growth is forecast to decelerate sharply, from 12.7% in 2018 to 3.6% in 2019 (Fig. 10). Analysts see a screeching slowdown for earnings growth too, from 35.3% this year to only 5.7% in 2019 (Fig. 11). This industry has enjoyed positive net earnings estimate revisions over the past three months, with NERI readings of 15.9 in November, 15.2 in October, and 11.2 in September (Fig. 12). And its forward P/E has slid to 9.5 from a high of 14.3 in January.

The S&P 500 Financials sector is a one of the few sectors where the share of its earnings contribution to the S&P 500 (18.6%) far exceeds its market-capitalization share (13.9) (Fig. 13). The gap has been both wider and narrower in the past. In our opinion, Financials stocks are cheap. In Buffett’s opinion, they should be overweighted.

Financials II: Lurking in the Shadows. Massive disruption is occurring throughout the Financials sector, as new entrants capitalize on technology and the impact of changing regulations. In the past, we’ve noted that an online player, Quicken Loans, made more home mortgage loans last year than Wells Fargo or Bank of America. Likewise, Apple and PayPal are elbowing their way into the payments business, while robo advisors are offering retail investors inexpensive financial advice.

The “Debanking of America” is also occurring in middle-market lending. Nonbank private firms are now among the largest lenders to middle-market companies. The market was primed for change when in the 1990s banks began merging. The number of FDIC-insured institutions has shrunk more than 45% since the late 1990s, according to an April 2018 report by Ares Management. The industry also changed after capital regulations grew stricter in the wake of the recession, making holding onto certain loans and securities less profitable.

Opportunistic institutional investors filled the void, raising capital in numerous ways to lend to middle-market companies. Ares estimates that $354 billion of middle-market loans were made last year and that the size of the outstanding loan market is $909 billion. Nonbanks have grown their share of leveraged loan holdings from 29% in 1994 to 55% in 2000, 82% in 2006, and 91% in 2017, Ares’ report states. Their market-share gains were helped by the low interest-rate environment and investors willing to look at unconventional investments in their search for yield.

The Federal Reserve’s Financial Stability Report released yesterday noted that institutional leveraged loans have had 15.1% average annual growth from 1997 through Q2 2018, more than twice as fast as other loan areas. And while these loans have performed well so far, the Fed noted that more of the new loans hitting the market are issued by more highly leveraged companies.

I asked Jackie to continue our look into the world of middle-market shadow banking:

(1) Naming names. One of the largest of the nonbank lenders is Antares Capital, a private debt credit manager and leading provider of financing solutions for middle-market, private equity-backed transactions. Last year, the firm issued more than $21 billion of loan products and equity investments.

Antares was the most active Q3 lender to middle-market, private equity deals, ahead of Madison Capital Funding, Twin Brook Capital Partners, NXT Capital, and Golub Capital, according to a Q3 report on the US PE Middle Market by PitchBook. Note that not one traditional bank is among the top five lenders. Citizens Bank and ING Group both rank 16th, while Goldman Sachs, Credit Suisse, and Deutsche Bank all rank 20th, with four deals each.

Many of the lenders have relationships with insurance companies or other firms with deep pockets. Antares was acquired by GE Capital in 2005 and sold to the Canada Pension Plan Investment Board in 2015. Opened in 2001, Madison Capital is a subsidiary of New York Life Insurance. Twin Brook Capital Partners is a subsidiary of Angelo, Gordon & Co., a privately held alternative investment firm with $32 billion under management. NXT Capital is owned by a unit of ORIX Corp., a Japanese financial services company.

(2) Where’s the funding? Nonbank middle-market lenders can tap the deep pockets of their owners. But they also raise private funds from institutional investors, and many of them manage collateralized loan obligations (CLOs). Of the 10 recently priced CLOs listed on creditflux.com, the managers were largely these private lending firms. Among the deals sold last month was a $1 billion CLO that Antares Capital will manage, a $510 million CLO managed by Ares Management, and a $638 million CLO managed by Oak Hill Advisors.

A September 2018 report from Maples and Calder, a law firm specializing in CLOs, says that as of 9/4, $92.5 billion was raised in 169 new CLO deals, up from $73.3 billion in 132 deals during the same period last year. The Fed’s Financial Stability Report notes that CLOs now purchase about 60% of leveraged loans at origination. The report concludes: “It is important to continue to monitor developments in this sector.”

(3) What does this mean for banks? Hopefully, the dispersion of loan activity outside of the traditional banking channel should mean that traditional banks will be better positioned to withstand the inevitable economic downturn. Large banks have become more like agents, distributing large, liquid bank loans to the country’s largest investors.

However, banks do still own an awful lot of loans, and some have large holdings of CLOs, perhaps because they structure and sell CLOs. Wells Fargo had $36.7 billion of collateralized loan and other debt obligations, according to its 2017 annual report. They equated to 8.8% of Wells Fargo’s investment securities portfolio. JP Morgan had $20.9 billion of CLOs, representing 5.5% of its total trading assets, down from $27.4 billion in 2016, according to its annual report.

(4) Back in the pond? As regulations around CLOs and CDOs (collateralized debt obligations) loosen up, large banks and brokers likely will try to become managers of these securities pools once again. In February, the US Court of Appeals for the District of Columbia Circuit ruled that firms managing CLOs do not have to retain 5% of the deals’ credit risk anymore. The ruling overturned a risk-retention rule dating back to the Dodd-Frank Act.

Regulators are also looking at the part of the Volcker Rule that prevents banks from owning CLOs that include anything other than loans. “The LSTA is urging regulators to ease that rule by allowing banks to own CLOs that mostly hold loans but can invest up to 10% in junk bonds—a move that could give an extra jolt to the already red-hot CLO market,” an 11/7 WSJ article noted.

Meanwhile, the FDIC has proposed that “banks with less than $10 billion in assets could be subject to a single leverage ratio for their capital holdings, replacing a more complex set of requirements that applies to larger banks,” an 11/20 WSJ article reported. To qualify for the looser regulation, the small bank must have 9% of equity to total assets. Looser rules and regulations may help banks and brokers return to the middle-market lending business, but it’s awfully hard to put the chicken back in the coop once it has flown out.

Consumer Durables: Car Wreck, Housing Slump. It makes sense on paper: Sales of crossover vehicles and light trucks are rising, while sales of cars are declining, so GM decided to cut production in plants that produce cars. It’s a trend that began in 2000 for the entire auto industry and has accelerated over the past four years. Sales of light trucks continued to climb from 7.4mu (saar) in August 2014 to 9.5mu in October, but sales of cars dropped from 6.1mu to 4.2mu over the same period (Fig. 14).

That pencil-and-paper analysis, however, fails to factor in politics. President Trump recently tweeted his displeasure with GM CEO Mary Barra, who once sat on his Strategic & Policy Forum. He reminded the world that the US government “saved” GM and warned that his administration is considering ending subsidies for electric cars. Lost in the Twitter storm was GM’s plan to add a third vehicle—a Cadillac crossover—to production at its Spring Hill plant in Tennessee, per an 11/26 article in The Tennessean.

Importantly, the move from cars to light trucks hasn’t hurt overall auto sales, which have been plateauing at a high level. The 12-month moving average for US motor vehicle sales was 17.2 million (saar) in October, little changed over past three years (Fig. 15).

Those decrying economic drag should point fingers not at the auto industry but at housing. Auto sales have recovered to their pre-recession sales volume levels, but housing completions have never fully recovered from their sharp downturn (Fig. 16). New home sales fell 8.9% m/m to 544,000 (saar) in October, and unsold homes has jumped to a 7.4 months’ supply. Hopefully, the recent decline in the 10-year Treasury yield will help lift housing out of its slump (Fig. 17).

Tech: 3D Printing but Faster. Carbon—the company, not the material—is turning 3D printing on its head, literally. 3D printing usually involves adding layer after layer of a material until a product is produced from the bottom up. The ability to produce something on site, on demand is game-changing, but its mass adoption is limited by the length of time it takes to make an object.

Inspired by the “Terminator 2” movie scene where a terminator emerges from a puddle of liquid metal, Carbon turned 3D printing upside down. Its machine uses light and oxygen and pulls a product out of a pool of resin. CEO Joseph DeSimone said in his 2015 TedTalk that the process is 25-100 times faster than traditional 3D printing. For those looking to take a deep dive into the subject, try this 5/16/16 video.

The company has helped Adidas produce sneaker soles, a dental lab produce models and castings, and a manufacturer make cell phone cases. Who says life doesn’t imitate art?

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Brexiting Is Hard To Do

November 28, 2018 (Wednesday)

UK I: The Travellers Club. I’m in London through Thursday. Most of our accounts here tend to invest globally. So they are very interested in the outlooks for both the US and global economies, particularly those of the emerging economies.

I’ve been telling them that I still lean toward a Stay Home investment strategy, rather than the Go Global alternative (Fig. 1). However, in the very short term through the end of this year, Go Global might outperform. That’s because I expect that Fed Chairman Jerome Powell, in his speech before The Economic Club of New York at 11:30 this morning, will strongly hint that the Fed might pause its rate-hiking during the first half of next year as he and his colleagues reassess their monetary policymaking, as we discussed in last Monday’s Morning Briefing titled “On Your Mark, Get Set, Pause.”

If so, the dollar could weaken, which would likely boost commodity prices (Fig. 2). A pause in the Fed’s rate-hiking combined with a weaker dollar would be bullish for emerging market stock prices (Fig. 3). If the FAANG (Facebook, Amazon, Apple, Netflix and Google’s parent Alphabet) stocks remain under pressure in the US, that could also favor Go Global for a while, since they led the S&P 500 Growth index higher this year until they led it lower since September 20 (Fig. 4). Interestingly, the ratio of the S&P 500 Growth Index to the Value index has been highly correlated with the ratio of the US MSCI stock price index to the All Country World ex-US MSCI since 1995.

One of our accounts graciously hosted a lunch meeting for me yesterday in the library of The Travellers Club, which was founded in 1819 and moved to its present clubhouse in 1832. It counts many foreign ambassadors and high commissioners in London among its members. In the spirit of the club, I asked everyone to go around the table and relate a favorite travel adventure. It was great fun, actually.

Every time I come to visit our London accounts, I hire the same taxi driver to take me to all my meetings. He knows how to negotiate the narrow roads and heavy traffic to get me to my meetings on time. In fact, he knows a lot about everything, since he talks to business people all day long. He has a good book of business with other professionals who use his service to get to their meetings.

On Monday morning, as he was driving me to my first appointment, he brought me up to speed on Brexit. He doesn’t think the deal that Prime Minister Theresa May struck with the EU is a good one, and expects her to lose the vote on it in Parliament and to step down from her office. I asked Sandra Ward, our contributing editor, to explore the issue in greater detail, which she does in the following two sections.

UK II: Brexit—Messy Divorce. No one ever said Brexit would be easy. No one ever imagined how hard it could be either. And there’s still a chance that it won’t happen after all.

Nearly two and a half years after the UK voted to leave the European Union (EU), Brexit inched closer to becoming a reality in the past two weeks. First, Prime Minister Theresa May reached agreement with the EU on terms of exiting the bloc, as detailed in an 11/14 FT explainer. After lots of handwringing over whether it would be a “hard” Brexit or a “soft” Brexit, the deal May struck is somewhere in between. In the initial phase, the UK will remain closely aligned with the EU and subject to many of its rules, yet it will have no role in formulating policy and will continue to contribute to its budget.

Chaos ensued as six members of May’s government resigned in protest over the draft agreement, including Brexit secretary Dominic Raab, an architect of the plan. This could lead to May’s leadership being challenged, the WSJ observed in an 11/15 article. Raab is the second Brexit secretary to resign this year: David Davis quit the negotiating post in July after May introduced her Chequers plan. May also lost the support of Northern Ireland’s Democratic Unionist Party, the group that props up her minority government. And leading Conservative and hard-Brexit backer Jacob Rees Mogg submitted a letter of “no-confidence” in May, tantamount to instigating a coup against her. A snap general election—or even a second referendum on Brexit—is possible. Or there could very well be a “no-deal” Brexit, in which the deadline comes and goes with no agreement in place.

The pound took a shellacking as a result of the government disarray, falling 1.67% on the day of the resignations—November 15—to post the biggest daily decline since October 2016. It has steadied around 1.27 to the dollar, but it is down 13.6% from its 1.47 closing value prior to the Brexit referendum on June 23, 2016 (Fig. 5).

Nonetheless, the 27 other EU leaders voted in unison to support the split on Sunday, November 25. European Council President Donald Tusk declared approval of the historic withdrawal in a tweet. EU leaders cautioned that negotiations won’t be restarted if the British Parliament fails to approve the agreement, according to an 11/25 piece in the NYT. “This is the deal,” said Jean-Claude Juncker, the president of the European Commission, in the NYT report. “The European Union will not change its fundamental position.”

Parliament will vote on Brexit amid a serious economic slowdown across the Eurozone, with growth weighed down by trade tensions; rising political uncertainties, including Brexit; and softening demand, according to an 11/23 IHS Markit release of its latest purchasing managers’ survey (Fig. 6 and Fig. 7).

And Bank of England Governor Mark Carney warned that a no-deal scenario could plunge the UK economy into a recession on a par with that caused by the oil crisis in 1973, the year the UK joined the EU, Reuters reported in an 11/20 article.

Let’s examine what’s next in this tortuous endeavor and how it’s impacting the UK:

(1) The vote. A vote in the House of Commons is expected to be held on the 585-page legally binding withdrawal treaty before members break for the Christmas holiday. Parliament will also be voting on a non-legally-binding statement declaring goals for a future partnership between the UK and the EU on a wide swath of interests including trade, law enforcement, foreign policy, and security and defense. EU officials have been told to expect a Parliamentary vote before the next meeting of the European Council scheduled for December 13, an 11/25 article in the Independent noted.

(2) The deal. The UK is set to withdraw from the EU as of March 29, deal or no deal. (Fun fact: Meghan Markle, bride of Prince Harry, was once a briefcase model on the game show, Deal or No Deal.) If the deal passes, the UK would continue to follow the rules and regulations of the EU until at least December 2020 under a transition period agreed to in the current plan. It will have no decision-making or rule-making power. The UK will continue to pay existing dues under the current long-term budget, estimated at €41.4 billion, and continue to contribute to the EU budget during the transition period. The transition period can be extended, only once and for a limited time, if the decision is made July 2020, according to an 11/15 piece in EUobserver outlining the key points of the Brexit agreement.

(3) The backstop. The agreement includes a controversial “backstop” provision to prevent a hard border from being established between Northern Ireland and the Republic of Ireland to avoid the potential threat of a return to sectarian conflict. It will also be the new post-Brexit border for the UK and EU. If the parties can’t agree on a future trade agreement before the end of the post- Brexit transition period, it could trigger the creation of a UK-EU customs territory, explained an 11/15 report in The Guardian. In the territory, no custom checks and no customs duties would be levied between Northern Ireland, a province of the UK, and the Republic of Ireland, an EU member, and minimal checks would occur between the UK and Northern Ireland on all goods except fishery products. Goods will be covered under the agreement, but not services.

(4) The sticking point. The UK would be required to apply EU rules in the customs territory to prevent UK businesses from getting an unfair advantage. Also, the UK would not be able to leave the arrangement unilaterally. This arrangement is what the hardline Brexiters can’t abide, describing it as a “trap,” a point made in an 11/11 BBC article.

(5) No deal. If there is no deal, the consequences of withdrawal would be immediate, and the free movement of people and goods between the UK and the Continent would be disrupted, as an 11/27 piece on iNews outlines. The UK would be forced to follow the World Trade Organization’s rules on trade and be on the hook for the EU’s external tariffs. Prices on goods in the UK would rise. British-made goods might be subject to new certification and regulations by the EU. Manufacturers could move plants to the EU to avoid delays. Work and residency rules for expatriates would be thrown into question. Travel between the EU and UK could be disrupted. And the border issue between Northern Ireland and the Republic of Ireland could be a potential problem.

UK III: Brexit—Expensive Divorce. Breaking up is hard to do. Usually, there is a steep price to pay. This particularly messy divorce is no different, except for the scale of it. Below, we consider some of the costs of disruption:

(1) The business of Brexit. Companies have had to prepare for all outcomes, including the worst-case scenario of a no-deal, by stockpiling goods, relocating manufacturing plants, and making acquisitions in EU countries to ensure access to markets. Some have moved or laid off staff, while others have abandoned plans to build new plants. An excellent tool to assess the extreme measures that businesses are taking to stave off supply disruptions and cope with potential regulatory issues is Bloomberg’s Brexit Impact Tracker.

Here you will see that many insurers are moving their headquarters to Luxembourg, and major drug makers are stockpiling as much as six months of drug inventories. AstraZeneca is spending $51.0 million to duplicate its UK-based testing facilities for drug distribution. On the darker side, Smurfit Kappa Group jettisoned plans for a $63.9 million plant in the UK that was projected to employ 50 people, and Telefonica will postpone an IPO of its UK O2 unit because of the uncertainty.

(2) Weak pound, poorer consumers. Some businesses are beginning to see a drop in demand as weakness in the pound impacts consumer spending. Airline operators Virgin Atlantic Airways, Jet2, and Ryanair Holdings have noted that demand is being negatively affected because of the slide in sterling, Bloomberg reported in an 11/27 article. There is the added concern about potential flight disruptions from a no-deal Brexit.

Weakness in the pound partly reflects concerns about the impacts on business and investment as Jeremy Corbyn’s Labour Party gains popularity. Corbyn has advocated for nationalizing rail, water, and energy companies in addition to raising taxes.

While a weaker pound has provided some support for multinational companies, and can be a boon to attracting tourism, many sectors are feeling the pain as the outlook for domestic earnings darkens and political risks heighten, according to an 11/15 piece in the FT. The stocks of financial services firms, homebuilders, leisure companies, and utilities have suffered. The FTSE 100 is off more than 8.4% ytd as of Monday’s close, and down 11.0% since its mid-May high of 7036 (Fig. 8). Yet Deutsche Bank strategist Oliver Harvey told the FT that a no-deal Brexit is “significantly underpriced” by the market.

(3) Hit to GDP. The International Monetary Fund puts the price to the UK of a no-Brexit deal at 6% of GDP, or about four years of economic growth, an 11/14 Reuters report observed (Fig. 9).

(4) $1 Trillion in Outflows. Outflows from UK equity funds surged to $19.4 billion in the week when May presented the withdrawal plan to the cabinet, the highest level since the 2007-08 financial crisis, according to an 11/25 report in the Irish Times. More than $1 trillion has flowed out of UK equity funds since the 2016 Brexit referendum, as investors have withdrawn money every week in the aftermath. In the year prior to the Brexit vote, UK equity funds attracted $127 billion in inflows.

(5) Valuation. The MSCI UK share price index is off 8.5% ytd in local currency, compared with a drop of 9.1% for the EMU and a loss of 0.1% in the US. MSCI UK’s forward P/E of 11.8 is at levels last seen five years ago (Fig. 10). NERI (our Net Earnings Revision Index) has been negative through much of the year and is at levels last touched in late 2015 (Fig. 11). Consensus earnings forecasts for companies in the UK MSCI index imply 7.8% growth in 2019, down from 10.3% estimated in 2018 and compared with earnings growth of 24.9% registered in 2017.

As Winston Churchill noted, “Fear is a reaction. Courage is a decision.” We shall see how courageous the UK is in the coming weeks.

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Corporate Debt Bombs?

November 27, 2018 (Tuesday)

US Economy: Land Mines in the Corporate Debt Market? Debt owed by nonfinancial corporations (NFC) is at a record high, according to the latest (9/20) Financial Accounts of the United States compiled by the Fed. It rose to $9.4 trillion during Q2 (Fig. 1). This total includes $5.4 trillion in bonds and $3.2 trillion in loans (Fig. 2).

Is this the next bubble to burst, causing the next financial contagion and recession? Each time that Melissa and I have considered the question, we have come to the same conclusion: While there may be reasons to worry about a possible bubble in the NFC debt market, we aren’t overly concerned. (For more, see our 6/19, 7/2, 7/3, and 10/10 Morning Briefings.)

But the story isn’t going away. Last week, the subject made for especially good media fodder for a relatively slow holiday news week. There are mounting worries that the Federal Reserve, by raising interest rates, is steadily eroding companies’ ability to service swollen debt levels. That could turn into especially bad news if the US economy weakens, further squeezing corporate profit margins and depressing cash flow. Nevertheless, we think that most of the debt outstanding should continue to be manageable for firms.

CNBC’s Jeff Cox is a very thorough reporter, and he wrote a very balanced 11/21 article on this subject. It wasn’t alarmist at all, suggesting that the outlook remained fairly bright for corporate credit. Yet his story was titled “A $9 trillion corporate debt bomb is ‘bubbling’ in the US economy.” We are assuming his editor decided the article would attract more readers if the title implied that there’s a big bomb in the credit markets. Given the traumatic impact of the last financial crisis, it’s easy to scare people into thinking that a repeat of the calamity, perhaps one that’s even worse than the last, is on its way.

Of particular concern are collateralized loan obligations (CLOs). The Fed’s quarterly data show NFC loans at depository institutions and those not classified elsewhere. Presumably, the latter category counts loans made by the shadow banking system including CLOs. During Q2, NFCs’ bank loans rose $54 billion y/y to a record $1.1 trillion (Fig. 3). NFCs’ other loans jumped $267 billion y/y to a record $1.5 trillion.

“I am worried about the systemic risks associated with these loans,” said former Fed Chair Janet Yellen in a 10/25 interview with the Financial Times. “There has been a huge deterioration in standards; covenants have been loosened in leveraged lending,” she added. Yellen suggested that the US needs to focus on fixing weaknesses in the system rather than going in a “very deregulatory direction.”

Her main concern is that while banks may be well capitalized against leveraged loans, the debt is being repackaged and sold elsewhere. She added: “If we have a downturn in the economy, there are a lot of firms that will go bankrupt, I think, because of this debt. It would probably worsen a downturn.”

Senator Elizabeth Warren (D-MA) echoed Yellen’s remarks during an 11/15 congressional hearing. “The Fed dropped the ball before the 2008 crisis by ignoring the risks in the subprime mortgage market,” Warren said. “What are you doing differently this time in coordination with other federal regulators so that you’re limiting the risk that leveraged loans cause serious harm to the financial system?”

Warren addressed her question to Fed Governor Randal Quarles, vice chairman for supervision and thus the central bank’s leading bank regulator. He responded rather lamely, saying that banks received “guidance” on the issue several years ago and that it’s not the central bank’s duty to “enforce” something that was not codified as a rule. “We are holding them to standards of safety and soundness,” he said. “We are not in any way abrogating or not looking at leveraged lending.”

Are there really bombs in the debt markets? Before we address this question in the following three sections, let’s review some of the economic indicators confirming that the US economy remains strong and that, while corporate profits growth is bound to slow, it will do so as it continues to rise to record highs. Consider the following:

(1) Truck tonnage and railcar loadings. During October, the ATA Truck Freight Index soared 9.5% y/y to yet another record high (Fig. 4). There’s no sign that a shortage of truck drivers is hampering the trucking industry from delivering the goods. Similarly, intermodal railcar loadings soared to a record high in the 11/17 week (Fig. 5). The y/y growth rate of this series (using the 26-week average) is highly correlated with the comparable growth rate in industrial production. The former is up 4.4%, while the latter rose 4.1% during October.

(2) Regional business surveys. So far, November regional business surveys are available for four Fed district banks. The average of their composite business indicators fell during November, but remained around the elevated levels since Election Day 2016 (Fig. 6).

(3) Forward revenues. S&P 500 forward revenues rose 9.7% y/y to yet another record high during the 11/15 week (Fig. 7). This weekly series, reflecting industry analysts’ consensus expectations, is a very good coincident indicator of actual quarterly S&P 500 revenues, which may be rising to yet another new record high during the current quarter.

Corporate Debt I: Record Bond Debt Poses Some Risk. Is there a bomb in the NFC bond market ready to go off? We’re now seeing “some spreads widening, which will be more impactful on high yield. We could see triple-B credits, some of them, move from investment grade to high yield,” George Rusnak, co-head of Global Fixed Income for the Wells Fargo Investment Institute, was quoted as saying in the 11/21 CNBC article cited above. Let’s consider this and other reasons to worry and not to worry about the corporate bond market:

(1) BBBs could go south. One current high-profile case of the BBB downgrade threat is General Electric, which is bordering on junk status. Some say GE’s problem is idiosyncratic. Others say that it is reflective of a wider corporate debt problem, as an 11/26 CNBC article discussed. If the creditworthiness of BBBs sours, especially high-profile ones, that could create a downward spiral where investors start demanding higher yields to offset the risk of downgrades.

(2) Defaults low. Despite the level of corporate debt and the risks presented, the credit market has performed well, CNBC’s 11/21 article observed—that is, other than some “turbulence” in the energy sector from late 2015 to 2016. For 2019, Fitch Ratings expects bond defaults to be the lowest since 2013. Eric Rosenthal, Fitch’s senior director of US Leveraged Finance, said that he isn’t worried about “systemic” risk caused by the corporate debt load now.

(3) Deceiving debt ratios? Total NFC debt (including debt securities and loans) is at a record high. But it is also notable that the liquid assets (excluding equities and mutual fund shares) position held by NFCs is strong. The ratio of NFCs’ total debt to liquid assets (excluding equities and mutual fund shares) has remained low by historical standards (Fig. 8).

However, the top companies may skew these data. S&P Global reported that US companies were holding about 33% in cash relative to debt as of mid-2018. But most of that cash is held by large corporations, noted a 9/12 CNBC article. The article on GE noted that about eight companies hold the bulk of that cash. The cash-to-debt ratio of speculative-grade borrowers reached a record low of 12% in 2017 compared to 14% during 2008, according to S&P Global.

(4) Tax-cut cushion. It was nearly a year ago that corporations received a big tax boost from the Tax Cuts and Jobs Act, which slashed the federal statutory corporate tax rate to 21% from 35%. Since the tax cut took effect, according to data from Moody’s Investors Service, the top 100 NFCs have contributed $72 billion of new cash flows to pay down debt. That is just slightly less than $81 billion transferred to shareholders through buybacks and dividends, reported the 11/21 CNBC article.

So companies are spending “a much larger percentage of incremental dollars on debt reduction,” Moody’s said in a report, according to CNBC. “What we see when we look at the annual net borrowing activity is a big swing from issuers changing from a net borrower each year pre-tax overhaul to a net-payer of debt post-tax overhaul.”

(5) Comfort in refinancing. Many firms have been refinancing their debt with longer maturities at the historically low interest rates of recent years. The ratio of NFCs’ short-term debt to total debt has been on a downtrend since the mid-1980s. It is down from 40%-45% during the 1980s and 1990s to roughly 28% during the current economic expansion (Fig. 9).

Further implying lots of refinancing activity, the spread between gross and net NFC bond issuance rose to a record high, exceeding $600 billion during the four quarters through Q2-2018 (Fig. 10). Interestingly, net issuance has dramatically dropped 65% since peaking during Q3-2015 and is now the lowest since Q3-2011.

The tax reform act at the end of last year may have reduced the tax benefit of raising money in the bond market. Increased regulation in the public markets following the financial crisis of 2008 may have pushed financing, especially for leveraged lending, into the shadow markets, as discussed below.

Corporate Debt II: CLO Risk May Be Overblown. The value of the US leveraged loan market has doubled in the past six years to $1.1 trillion, according to an article in the 10/2 Financial Times and S&P Global Market Intelligence. Leveraged loans are debts from non-investment-grade borrowers.

Leveraged loans underlie collateralized loan obligations (CLOs), which are structured similarly to the mortgage lending instruments that blew up during the financial crisis, i.e., collateralized mortgage obligations (CMOs). Let’s review the risks and risk-mitigating factors associated with these products:

(1) Risky loans repackaged. CLOs purchase a diversified pool of senior secured bank loans made to companies, which are typically rated below investment grade. CLO debt is divided into tranches, each of which has a unique risk/return profile. “Just because leveraged loans get packaged into CLOs does not make risk disappear. The credit risk of these loans is simply being transferred to the CLO holders,” Forbes contributor Mayra Rodriguez Valladares noted in an 11/5 article.

(2) Heavy on cov-lite. The value of CLOs has increased by about 130% from the start of 2008 through Q3-2018 to $600 billion, the article observed, with over 70% of those loans covenant-lite.

(3) Not riskier per-se. On the other hand, a “covenant-lite loan isn’t necessarily riskier just because it is light on covenants, and it will not be the single determinant of losses in the next credit downturn. Other relevant considerations such as the quality of the capital structure, financial health of the enterprises, and the ability of the sponsor to [recapitalize] the company are necessary to determine the riskiness of a loan,” argued an op-ed letter in the 5/9 Financial Times.

(4) Once again, defaults low. One reason not to worry about CLOs today is that they are structured in a much more “plain-vanilla” fashion than the instruments that worsened the financial crisis, as we detailed in our 7/2 Morning Briefing, linked above. Further, while CLOs have a bad reputation, those rated AA or above never experienced a default even during the financial crisis, as we have previously discussed. For 2019, Fitch Ratings expects leveraged loan defaults to be the lowest since 2011.

Corporate Debt III: Distressed Asset Funds to the Rescue. Bloomberg reported in a 7/10 article that Morgan Stanley data indicates that corporate debt breaks down to 34% (high-grade bonds), 34% (BBB bonds), 16% (high-yield bonds), and 16% (leveraged loans). Let’s assume that this mix hasn’t changed much in 2018. That breakdown was characterized as alarming in the article. However, our take is less so.

For starters, we can safely set aside investment-grade debt (34% of NFC debt), because the likelihood of default there is low. High-yield bonds (16%) can also be put aside, as the investors in this debt presumably are well informed of the risk involved and receiving commensurate compensation. It’s the negative surprises that could cause the most pain in the corporate debt market, so let’s focus where they could happen:

(1) BBBs. Indeed, BBBs (34%) may be susceptible to downgrades and defaults, but not all BBBs. PIMCO estimated back in January that about $80 billion in BBB-rated bonds potentially could be downgraded in 2018. Assuming that as a ballpark would put potentially troublesome BBBs at a very small percentage of the total triple-B market and a miniscule fraction of overall NFC debt.

By the way, GE carries a total debt load of about $122 billion, according to an 11/20 WSJ article. Bloomberg reported in a 10/2 article that the company decreased its total debt by around $300 billion since the end of 2010 through the end of June. An 11/26 Seeking Alpha blog post noted some good reasons why GEs problems may be self-inflected and isolated.

(2) CLOs. The concern with leveraged loans (16%), as discussed above, is that a large percentage of these are cov-lite. That potential risk may not be so transparent to the ultimate buyers of the structured products composed of these risky loans. While sizable, however, leveraged loans represent the smallest share of the US corporate lending pie. CLOs now compose about 60% of the $1 trillion leveraged loan market,” reported the 6/26 WSJ.

(3) Shock absorber. But what if some share of NFC debt unexpectedly goes bust? As I wrote in the 6/19 Morning Briefing: “My working hypothesis is that distressed asset and debt funds with billions of dollars waiting to scoop up distressed assets and debt at depressed prices may mitigate credit crunches. They may be the credit market’s new shock absorber. I believe that’s why the calamity in the oil patch was patched up so quickly without turning into a contagion and a crunch.”

Bargains scooped up by these distressed asset funds, of course, expose someone to big hits. This time, it probably won’t be the banks. More likely, the losses will simply reduce the rates of return among some large institutional investors and perhaps some bond funds (including exchange-traded funds), ending there. In other words, the odds of a systemic calamity like we saw in 2008 remain low, in our opinion.

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Turbulence

November 26, 2018 (Monday)

Strategy I: Headwinds. I will be meeting with our accounts in London all week. Given the tortuous Brexit negotiations that have just been completed, it is an interesting time to be here. Now it’s up to Parliament to say “nay” or “yah.” There are reportedly more of the former than the latter votes. I asked Sandra Ward, our contributing editor, to provide an update on this thorny issue, which she will do on Wednesday.

My flight here had a fair bit of turbulence. The same can be said about the stock market this year. The question is: Will it last into next year? The short answer is: Probably.

Joe and I curbed our enthusiasm for the bull market at the end of October. We lowered our earnings outlook for 2019 and 2020. We are currently estimating that S&P 500 operating earnings growth will drop from 22.7% this year to 4.9% in 2019 and 5.3% in 2020. Industry analysts are currently predicting 8.8% for next year and 10.3% for 2020 (Fig. 1). We lowered our 2019 target for the S&P 500 from 3500 to 3100, which had been our year-end target for this year.

During October, we concluded that the two major issues hanging over the market since the start of this year could continue to do so through 2019. Meanwhile, there are other issues that have come to the fore lately that may linger well into 2019. Consider the following:

(1) China. I identified the first problem in the 10/1 Morning Briefing titled “China’s Syndromes.” I concluded that the US was aiming to thwart China’s superpower ambitions by challenging not only China’s trade practices but also its aggressive foreign policy.

My analysis was validated only three days later by a belligerent 10/4 speech delivered by Vice President Michael Pence detailing all the major complaints that the Trump administration has with China. He did it again in an 11/16 speech at the 2018 APEC CEO Summit. President Trump will meet with China’s president-for-life Xi Jinping this weekend at the G-20 gathering in Buenos Aires. Given that Xi expects to outlive Trump, at least politically, the Chinese President is unlikely to give Trump any reason to declare that the trade war is over. So Trump is bound to make good on his threat to impose a 25% tariff on all Chinese goods imported by the US at the start of 2019. Then again, with Trump anything is possible.

(2) Central banks. Trump is clearly upset with Fed Chairman Jerome Powell’s interest-rate hikes. Trump appointed him to that position at the beginning of the year. Since then, Powell raised the federal funds rate in March, June, and September. He is expected to do so again in December, bringing the top of the fed funds rate range up from 1.50% to 2.50% this year. If he keeps going at this pace, the top of the range will be 3.50% by the end of 2019 (Fig. 2).

However, the Dow Vigilantes are starting to scream that history shows that Fed rate hikes inevitably cause a financial crisis, which often turns into a credit crunch (even for good borrowers) and a recession (Fig. 3). They want the Fed to pause for a while to give the economy time to adjust to the rate hikes so far and to provide more data for assessing whether the “neutral” federal funds rate may be closer to 2.00% than to 3.00%. We side with the Dow Vigilantes.

Powell may not be as sensitive to the needs of the Dow Vigilantes as were his three predecessors. However, he can’t ignore recent signs of stress in the credit markets. For example, the yield spread between high-yield bonds and the 10-year US Treasury bond has started to widen recently from a very low and narrow range since early October (Fig. 4). The extraordinary 27% plunge in the price of a barrel of crude oil since October 3 may be contributing to this development, as it did in a similar episode during the second half of 2014 through early 2016. The latest oil price freefall is reducing the inflationary expectations spread between the 10-year US Treasury bond yield and the comparable TIPS yield (Fig. 5). It has dropped 21bps since October 9 to 1.96% on Friday.

As Melissa and I noted last Monday, the Fed announced on November 15 a program to reassess the process of making monetary policy that should be completed by mid-2019. This should provide a good excuse for Powell to pause rate-hiking during the first half of next year. (See the press release, “Federal Reserve to review strategies, tools, and communication practices it uses to pursue its mandate of maximum employment and price stability.”)

On Wednesday, Powell addresses the Economic Club of New York. If he hints that a pause is coming, that should at least stabilize stock prices for a while and possibly allow them to recover some of what they lost since late September. The problem is that the Fed probably won’t pause in tapering its balance sheet by $50 billion per month (Fig. 6). In addition, the European Central Bank and the Bank of Japan are expected to terminate their QE programs in coming months. So central bank liquidity may remain a headwind for the stock market during 2019 (Fig. 7).

(3) Commodity prices. The plunge in the price of oil shouldn’t be a big surprise (particularly with the benefit of hindsight), since it tends to be highly inversely correlated with the trade-weighted dollar (Fig. 8). The surprise this year was that the price of oil rose sharply even as the dollar soared. That might have had something to do with Trump’s decision on May 8 to drop out of the Iran nuke deal and to impose sanctions on Iran’s oil exports. He did so in early November, but also provided six-month waivers for six countries that are major buyers of Iranian oil. Meanwhile, US frackers continued to frack, pushing US oil production up to a record 11.7mbd, up 3.0mbd over the past two years (Fig. 9). An 11/21 Bloomberg story reports that OPEC’s recent nightmare may get worse next year, “when Permian producers expect to iron out distribution snags that will add three pipelines and as much as 2 million barrels of oil a day.”

So while the recent freefall in the price of oil may be contributing to the stress cracks in the credit markets, it’s unlikely to be signaling a significant drop in global oil demand. The problem is too much supply rather than a sudden weakening in the global economy.

Nevertheless, the weakness in the CRB raw industrials spot price index (which does not include petroleum or lumber products) since the start of this year has been signaling that the mighty dollar, rising interest rates, and the trade war are weighing on global growth (Fig. 10). Debbie and I derive our Boom-Bust Barometer (BBB) by dividing the CRB index by US initial unemployment claims (Fig. 11). It has been highly correlated with the S&P 500 since 1998, and exceptionally tight since 2014. It is currently confirming the stock market’s stalling in record-high territory.

Looking toward 2019, it’s hard to imagine that jobless claims can fall much lower. So the outlook for our BBB will be mostly (or solely) determined by the CRB index, which will be determined by the strength or weakness of the global economy. Our outlook is for more of the same mediocre growth with neither boom nor bust, as US strength continues to offset weakness elsewhere in the world economy.

(4) Credit quality. Melissa and I are researching and updating our analysis of the credit markets, and expect to have more to say about it all tomorrow. The recent stock market correction has raised lots of concerns about credit-quality issues. We are concerned enough to spend some time examining the potential for trouble. However, we aren’t convinced that another financial crisis is imminent, as the reenergized bears are warning. We also believe that distressed asset funds can act as a shock absorber in the credit markets, as they did during 2015. More on this tomorrow.

Strategy II: Value Holding Up Better Than Growth. Panic Attack #62 of the current bull market started after September 20, the day that the S&P 500 rose to a record high of 2930.75. On Friday, it closed at 2632.56, down 10.2% from that record high, making #62 an outright correction that has lasted 64 days so far (Fig. 12). Earlier this year, Panic Attack #61 also saw the S&P 500 down 10.2% (putting it also above the 10% correction threshold), but over a 13-day period.

Both selloffs shared common worries about President Trump’s escalating trade war, especially with China, and the Fed’s seemingly set course to hike the federal funds rate every quarter through 2019. The latest one, however, was exacerbated by significant selling of the FAANG (Facebook, Amazon, Apple, Netflix, and Google’s parent Alphabet) stocks as investors worried about mounting calls for government regulation of their activities, even by a few of their very own CEOs! In addition, the FAANGs’ Q3 earnings results reported in October suggested that their growth rates were slowing, a sign that they are maturing companies that have saturated their established markets.

Even mighty Amazon may be running out of running room. Reflecting this concern, its stock price peaked at a record $2039.51 on September 4, giving it a market capitalization of $988 billion. On Friday, its stock price was down 25.6% to a market cap of $734 billion. Apple’s share price peaked at $232.07 on October 3, giving it a market cap of $1.1 trillion. On Friday, its price was down 25.8% to a market cap of $818 billion. Apple cut its orders from suppliers, suggesting that the latest iPhone models aren’t sexy enough to stimulate cell phone users to ditch their older models. Even mighty Apple may be facing a global cell phone market that has become commoditized. An escalating trade war with China is also bad news for Apple. Both Amazon and Apple are validating the curse of building new corporate headquarters.

The FAANGs have been powering the S&P 500 Growth stock price index, which has been outperforming the S&P 500 Value index during most of the current bull market. It may now be Value’s turn to outperform. Consider the following:

(1) Since the start of the bull market on March 9, 2009, S&P 500 Growth is up 329.8%, while S&P 500 Value is up 247.7% (Fig. 13, Fig. 14, and Fig. 15).

(2) Since Election Day on November 8, 2016, Growth is up 30.3%, while Value is up 14.7%. Since the start of the year through the 9/20 record high in the S&P 500, Growth (led by the FAANGs) rose 15.7%, while Value edged up 3.2%. Since that record high, Growth is down 11.8% (again, led by the FAANGs), while Value is down 8.2%.

(3) The forward P/E of Growth is down from its bull-market peak of 21.8 during the 1/26 week to 17.7 currently (Fig. 16). The forward P/E of Value peaked at 16.6 during the 1/5 week, and is down to 13.0 now. Our Blue Angels analysis shows that the forward earnings of both continued to set record highs during the 11/15 week (Fig. 17 and Fig. 18).

(4) How many companies are counted as Growth versus Value in the S&P 500? I asked Joe, and he reports that companies can be in both indexes. There are 500 companies in the S&P 500 with 300 in Growth, and 376 in Value. “The same goes for Russell too,” says Joe. According to Refinitiv, there are 958 companies in the Russell 1000, with 535 in Growth and 704 in Value.

Here are the top 10 S&P 500 Growth stocks by market value: Apple ($818 bn), Microsoft ($791 bn), Amazon ($734 bn), Alphabet ($714 bn), Johnson & Johnson ($381 bn), Facebook ($379 bn), Visa ($293 bn), Bank of America ($265 bn), UnitedHealth Group ($252 bn), and Pfizer ($250 bn).

Here are the top 10 Value stocks: Berkshire Hathaway ($510 bn), Johnson & Johnson ($381 bn), JPMorgan Chase ($355 bn), Exxon Mobil ($320 bn), Walmart ($279 bn), Bank of America ($265 bn), Pfizer ($250 bn), Wells Fargo ($244 bn), Verizon Communications ($242 bn), and Procter & Gamble ($228 bn).

Movie. “Green Book” (+ + +) (link) is a very entertaining and mostly comic movie about Dr. Don Shirley, an African-American classical piano virtuoso played stoically by Mahershala Ali. Shirley hired Italian-American Tony “Lip” Vallelonga, a night club bouncer played by Viggo Mortensen, to drive him through southern states on an eight-week music tour before Christmas in the 1960s. It’s funny notwithstanding the ugly reality of racism the two encountered. The script was written mostly by Tony’s son, so his character is more fully developed than is Shirley’s. Still, Tony remains a knucklehead during the entire film, though he overcomes some of his racism as a result of the road trip. Shirley’s patrician character also connects with Tony, but remains mostly disconnected from all but his music, though his tour de force in the South at that time was clearly gutsy.

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Thanksgiving

November 20, 2018 (Tuesday)

Holiday Season: Giving Thanks. This is the time of year we all give thanks to our families for being there for us. We thank our friends for being our friends. Many of us thank the men and women serving our country as first responders and in the military. I also thank our nation’s founders for our political system of checks and balances. And of course, we at Yardeni Research thank you for your loyal support of our research service. We wish you all the very best of times with your family and friends during Thanksgiving.

Strategy: Earnings Cornucopia. Corporate America should give thanks to President Donald Trump for slashing the effective corporate tax rate from 35% to 21% at the end of last year. The result has been a spectacular increase in S&P 500 earnings per share, as Joe and I discussed yesterday. We want to review the Q3 data released on Friday one more time to show how truly bountiful a year this has been for earnings. The results were boosted not just by the tax cut but also by revenues and the impact of repatriated earnings on buybacks. Consider the following:

(1) Aggregate and per-share revenues. S&P reported that S&P 500 revenues per share rose 8.5% y/y during Q3 (Fig. 1). Joe uses the divisor provided by S&P to calculate aggregate S&P 500 revenues, which rose 6.8% y/y. The difference is attributable to index changes and net share buybacks, which rose to new record highs during the first half of this year thanks to repatriated earnings (Fig. 2).

(2) Aggregate and per-share earnings. At an annual rate, aggregate S&P 500 revenues came in at $11.3 trillion during Q3 (Fig. 3). S&P data for aggregate operating earnings show that this series rose to a record $1.4 trillion at an annual rate during Q3. That’s up 30.5% y/y, with revenues accounting for 6.8 percentage points of the increase and the tax cut accounting for much of the remaining 23.7 percentage points.

On a per-share basis, Joe and I prefer the operating earnings measure compiled by I/B/E/S (formerly Thomson Reuters). It is based on industry analysts’ estimates of the operating earnings reported by the corporations they follow. S&P’s comparable measure relies on the estimates of S&P’s own analysts on the one-time adjustments that are applied to reported earnings. The two measures tend to track one another closely, with the I/B/E/S series usually exceeding the S&P measure (Fig. 4). That’s mostly because the former does not account for the expense of stock compensation plans while the latter does.

In any event, during Q3, operating earnings per share soared 27.5% y/y based on the I/B/E/S data and 32.5% using the S&P measure.

(3) Profit margin. Yesterday, we reported the S&P 500 profit margin using the four-quarter-trailing sum of operating earnings as reported by the S&P. It rose to a record 11.4% during Q3. Today, let’s look at the profit margin on a quarterly basis using both the S&P and I/B/E/S data for operating earnings. The former rose to 12.4%, while the latter increased to 12.8% during Q3 (Fig. 5). Both are record highs. Both were at record highs of 10.3% and 10.9%, respectively, at the end of last year before the tax cut.

As we noted yesterday, the Q3 record high in the S&P 500 profit margin is truly impressive given that many companies warned during their Q3 earnings conference calls that their labor and material costs have been rising as a result of the tightening labor market and Trump’s tariffs.

US Inflation: Range-Bound. In meetings with our accounts, I am most frequently asked about the biggest risk to my optimistic outlook for the US economy and financial markets. I believe a rebound in inflation is the biggest risk. I’m not expecting it, but Debbie and I are monitoring the inflation indicators closely. Here is a brief look at some of the latest data:

(1) Wage curve. At long last, the Phillips wage curve appears to be making a comeback. The unemployment rate fell to 3.7% during October. It is well below the Fed’s 4.5% estimate of NAIRU (the non-accelerating inflation rate of unemployment). The Employment Cost Index (ECI) for private-sector workers’ wages and salaries edged up to 3.0% y/y during Q3 (Fig. 6). That is the highest rate seen since Q2-2008 for this quarterly compensation measure. Average hourly earnings, a measure of wages, rose 3.2% y/y during October. That’s the highest reading since April 2009 (Fig. 7).

(2) Productivity. Productivity is one of the key factors that can mitigate so-called cost-push inflation, when rising labor costs are passed through into prices. The ratio of the yearly percent change in the ECI to nonfarm business productivity on the same basis has remained low at around 2.0% since the mid-1990s. This measure of unit labor costs pressure is highly correlated with the core PCED inflation rate, the Fed’s preferred measure of price inflation (Fig. 8).

(3) PPI finished goods. The Producer Price Index (PPI) for finished goods eased to 3.4% y/y during October from a recent peak of 4.2%. It hasn’t moved much above 4.0% since mid-2017. For historical comparison, the PPI for finished goods reached 9.9% and 7.2% during July 2008 and July 2011, respectively (Fig. 9). Excluding food and energy, the PPI for finished goods was 2.3% during October. That hasn’t moved above 3.0% since February 2012. So there isn’t any evidence that producers are rushing to raise their prices.

(4) Import prices. US import prices have remained subdued despite the aluminum, steel, Chinese import, and other tariffs recently imposed by the Trump administration. The US import price index was up 3.5% y/y during October, but only 0.8% excluding petroleum imports (Fig. 10).

Obviously, US import prices have less to do with domestic unemployment and more to do with the relative strength of the US dollar and the impact of recent tariffs (Fig. 11). Interestingly, US import prices from China have remained remarkably subdued, rising just 0.3% y/y last month (Fig. 12).

(5) Consumer prices. Despite higher wage growth, productivity and subdued producer prices as well as import prices among other factors have translated into moderate consumer price inflation. The headline CPI was up 2.5% y/y during October, but just 2.1% when food and energy are excluded.

As we’ve previously discussed, rent inflation has been looking toppy in the past couple of years and recently has started to come down. The CPI tenant rent inflation rate was down to 3.6% y/y during October from a recent peak of 3.9% at the start of 2017.

We have been watching for signs of a possible pickup in healthcare inflation, as we’ve discussed before. But so far, the CPI for medical care has remained remarkably low, up just 1.7% y/y during October (Fig. 13).

(6) Range-bound. Interestingly, the CPI excluding food and energy has remained range-bound above 0.5% and below 3.0% on a y/y basis all the way from the mid-1990s until now. The range became even tighter following the 2008 financial crisis, floating between about 1.5% and 2.5% (Fig. 14).

While the painful inflationary experience of the 1970s remains in the minds of many investors, inflation today poses no clear and present danger. Numerous disinflationary developments since then have contributed to the tight lid that’s on inflation now (Fig. 15). Walmart went public during 1970. Fed Chairman Paul Volcker proved that monetary policy could bring inflation down rapidly by causing a severe recession. Private-sector unions lost their clout during the 1980s. The end of the Cold War at the end of that decade, and China’s entrance into the World Trade Organization during December 2001 unleashed the competitive forces of globalization. The high-tech revolution that started during the 1990s enabled Amazon to perfect online shopping.

Fed Governor: On Regulating AI. Banks and brokers have embraced artificial intelligence (AI), developing and using AI applications to do things quicker, cheaper, and smarter. This summer, JPMorgan started experimenting with the use of AI in its Treasury operations, a 6/20 CNBC article reported. A bit earlier this year, Bank of America introduced Erica, its chatbot, to millions of its digital banking clients. And Morgan Stanley launched Next Best Action, an AI system that will send financial advisors’ customers emails, suggestions, and information, a 10/20 CNBC article reported.

Regulators are well aware of the growing influence of AI on financial services. An 11/13 speech by Fed Governor Lael Brainard titled “What are we learning about Artificial Intelligence in Financial Services?” focused on several important ways that regulation will evolve as AI rolls out. Let’s take a look:

(1) Increasingly available to all. While the largest banks and brokers may have the deep pockets needed to experiment with AI today, the costs are dropping quickly, and soon even the smallest players in financial services will have access to AI technology.

“Due to an early commitment to open-source principles, AI algorithms from some of the largest companies are available to even nascent startups. As for processing power, continuing innovation by public cloud providers means that with only a laptop and a credit card, it is possible to tap into some of the world's most powerful computing systems by paying only for usage time, without having to build out substantial hardware infrastructure,” Brainard said. In addition, players around the world are creating gobs of data to feed into the models.

(2) How to regulate. Regulation should balance the importance of keeping the financial system safe with allowing innovation to flourish. Likewise, the level of regulatory scrutiny should be related to the potential risk involved with using an AI tool or process. The higher the risk involved, the greater the regulatory scrutiny that’s justified, with the reverse being true as well. Heavy-handed regulation might only push AI innovation into less regulated, more opaque institutions.

Some regulations already on the books will help guide AI development. For example, the Federal Reserve’s “Guidance on Model Risk Management” discusses how financial institutions should use models, including complex AI algorithms. Such models should be reviewed and challenged by a second “set of eyes” that are independent from the model’s development, implementation, and use. Firms are required to confirm that the models are working as expected.

Reviewing models can be difficult when some aspects of models purchased from vendors aren’t transparent enough. Regulators have rules relating to such models, requiring banks to offset this extra risk by having external controls, such as circuit breakers. There’s also existing guidance that financial services firms should follow when managing their vendors.

(3) AI defense. Firms will need strong AI defenses because the bad guys are also developing AI systems. Brainard notes: “AI tools could be used to make Internet fraud and phishing highly personalized. By accessing data sets with consumers’ personally identifiable information and applying open-source AI tools, a phisher may be able to churn out highly targeted emails to millions of consumers at relatively low cost, containing personalized information, such as their bank account number and logo.”

Firms should be extremely careful about the quality and the suitability of the data being fed into their AI systems. Problems “with the input data can lead to cascading problems down the line.”

(4) AI in lending. AI systems are being developed to look at unorthodox data points when deciding a consumer’s credit quality. AI systems set up properly may increase the number of people to whom credit is made available. Conversely, biased AI systems could reduce the available credit. Brainard pointed to the human resources software used by Amazon that was trained by looking at past successful hires. Because most of the past hires were men, the software was biased against women and the Amazon dropped the software.

Here, too, consumers have some protections already on regulators’ books. “Importantly, the Equal Credit Opportunity Act (ECOA) and the Fair Credit Reporting Act (FCRA) include requirements for creditors to provide notice of the factors involved in taking actions that are adverse or unfavorable for the consumer,” she said. “Compliance with these requirements implies finding a way to explain AI decisions. However, the opacity of some AI tools may make it challenging to explain credit decisions to consumers, which would make it harder for consumers to improve their credit score by changing their behavior.” The AI community has responded by developing “explainable” AI tools.

(5) Many unknowns. Because not all potential consequences are knowable, firms need to be vigilant in monitoring their AI systems. Brainard concludes: “Accordingly, we would expect firms to apply robust analysis and prudent risk management and controls to AI tools, as they do in other areas, as well as to monitor potential changes and ongoing developments.”

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On Your Mark, Get Set, Pause

November 19, 2018 (Monday)

The Fed: Open to Suggestions. President Donald Trump and Larry Kudlow, his economic adviser, have been calling for Fed officials to pause their interest-rate hiking. So has CNBC’s Jim Cramer. And so have I. Fed Chairman Jerome Powell and his colleagues may be starting to get the message and act accordingly. Here are the latest developments:

(1) Closing in on neutral. In the 10/29 Morning Briefing, I wrote: “What’s the rush to raise interest rates? Why not pause the rate hikes and assess how the economy is responding to them so far? … In my opinion, the plunge in stock prices, especially the ones of cyclical companies, suggests that the economy may not be as strong as the Fed perceives and that inflationary risks remain low.”

Last month’s stock market rout was triggered on October 3 when Powell said the following in an interview: “Interest rates are still accommodative, but we’re gradually moving to a place where they will be neutral. We may go past neutral, but we’re a long way from neutral at this point, probably.” That was especially shocking since the 9/26 FOMC statement deleted the following language that had appeared in previous statements: “The stance of monetary policy remains accommodative.” This sentence had been in every FOMC statement since December 16, 2015, when the Fed started its latest rate-hiking program. In his press conference that same day, Powell minimized the import of this development, saying that the language simply had outlived its “useful life.”

Yet only a few days later, he said interest rates were still accommodative and had to go higher. In his first public speech as Fed Vice Chairman, Richard H. Clarida said on October 25: “However, even after our September decision, I believe U.S. monetary policy remains accommodative.” That was a rookie mistake, for sure, but Powell should have known better!

Clarida walked that statement back for himself, and maybe for Powell too, on Friday, saying in a CNBC interview: “As you move in the range of policy that by some estimates is close to neutral, then with the economy doing well it’s appropriate to sort of shift the emphasis toward being more data dependent.” He was actually seconding Atlanta Fed President Raphael Bostic, who said last Thursday that the Fed is “not too far” from reaching a “neutral” rate. There’s a big difference between Clarida’s “close to” and Bostic’s “not too far” on the one hand, and Powell’s “a long way off from” on the other hand.

(2) Asking for suggestions. At the end of last week, Reuters reported: “The Federal Reserve, under pressure from a critical White House even while it largely hits its inflation and employment targets, will conduct an extensive review next year of how it guides the U.S. economy as it seeks to become more open and accountable. The U.S. central bank said on Thursday it will hold a series of forums across the country to hear from a ‘wide range’ of stakeholders. By the time the review wraps up around mid-2019, it could lead to a rethink of the tools the Fed uses to achieve its goals and the way it communicates policy to the public and financial markets.”

In an 11/15 statement, Powell explained the reason for this “outreach” program as follows: “With labor market conditions close to maximum employment and inflation near our 2 percent objective, now is a good time to take stock of how we formulate, conduct, and communicate monetary policy.”

Since Fed officials now are open to suggestions from the public, may I suggest that they consider this: If the economy is exactly where it should be, then perhaps the neutral federal funds rate is 2.00% rather than 3.00%?! What if NAIRU (the non-accelerating inflation rate of unemployment) isn’t 4.5%, as indicated in the FOMC’s latest dot plot, but closer to the current unemployment rate of 3.7%? Why raise interest rates further if the labor market continues to produce 212,500 jobs per month—as it has on average during the first 10 months of this year—without pushing up price inflation above the Fed’s 2.0% target? (For more on the role of NAIRU in monetary policymaking, see my 11/16 video podcast.)

(3) More pressers. Back in June, Powell announced that starting at the beginning of next year, he will be holding press conferences after all FOMC meetings. Rather than the customary four pressers a year (in March, June, September, and December), he will have eight. That should give the Fed more flexibility on the timing of rate hikes, as it will break the financial markets’ habit of expecting a hike after every presser-followed FOMC meeting this year and next year.

(4) Data dependent again. In any event, Clarida suggested that the Fed is back to hiking rates (or not) based on the economic data rather than Powell’s quarterly pressers. The latest 11/8 FOMC statement noted: “Household spending has continued to grow strongly, while growth of business fixed investment has moderated from its rapid pace earlier in the year.” The previous (9/26) one had observed that both “have grown strongly.” That might have been a faint hint of a pause in the rate hikes.

Last Thursday, the Atlanta Fed reported: “The GDPNow model estimate for real GDP growth (seasonally adjusted annual rate) in the fourth quarter of 2018 is 2.8 percent on November 15, down from 2.9 percent on November 9. The nowcast of fourth-quarter real personal consumption expenditures growth declined from 2.9 percent to 2.7 percent after this morning’s retail sales report from the U.S. Census Bureau.” The latest estimate for Q4 would be a slowdown from Q3’s 4.0% (saar).

October’s core CPI was up 2.1% y/y—in line with the Fed’s target—showing that a tight labor market, with wages rising at a somewhat faster pace than a year ago, isn’t putting upward pressure on price inflation (Fig. 1). The three-month core CPI was up just 1.6% at an annual rate (Fig. 2). This suggests that productivity may be making a comeback. That’s confirmed by the record high in the S&P 500’s profit margin during Q3, as Joe and I discuss below, despite lots of chatter about rising cost pressures!

The recent plunge in oil prices will also take some pressure off both the headline and core inflation rates. The 10-year US Treasury bond yield fell to 3.08% on Friday as the expected inflation rate fell to 2.02%, holding around its lowest readings since the start of the year (Fig. 3 and Fig. 4).

(5) Three and done? The two-year Treasury note yield dropped from its recent high of 2.98% on November 8 to 2.81% by the end of last week (Fig. 5 and Fig. 6). It tends to signal investors’ expectations for where the federal funds rate will be in a year. The drop was attributed to Clarida’s relatively dovish CNBC interview on Friday.

The federal funds rate range was raised to 2.00-2.25% at September’s FOMC meeting. It will probably be raised to 2.25-2.50% at the December meeting. But then, Melissa and I expect that the Fed will signal a pause in the rate hikes in the new year. So we don’t expect a rate hike during the first six months of 2019, especially if the Fed’s cover story is that a re-evaluation of monetary policy is underway. We don’t rule out two more hikes before the end of next year, bringing the federal funds rate up to 2.75-3.00%. However, we expect that the word “restrictive”—which appeared twice for the first time in the September FOMC minutes, suggesting a rate above 3.00%—will be dropped from FOMC minutes and speeches by FOMC officials for a while.

Strategy: The Last Great Earnings Season. Joe reports that S&P 500 revenues and earnings are out for Q3-2018. It’s all good news across the board, but company guidance released during the season indicated that Q3 would likely mark the top of the growth cycle during the current economic expansion. Let’s review:

(1) Revenues stall at all-time high. Most extraordinary is that S&P 500 revenues per share jumped 8.5% y/y last quarter and has been above the long-term growth trend since the presidential election in Q4-2016 (Fig. 7 and Fig. 8). Normally this far into an economic expansion, revenues growth tends to be around 4%-6% y/y. However, quarterly revenues was down 0.1% q/q. If that decline holds as the remaining 38 companies report, it would mark the first time that Q3 revenues have fallen q/q since Q3-2008.

(2) Earnings at all-time high. S&P 500 earnings, as measured by I/B/E/S, soared 27.5% y/y last quarter, its strongest growth since Q4-2010 and up from 25.8% y/y during Q2. Q3’s results continue to reflect the strength in revenues as well as the cut in the corporate tax rate (Fig. 9 and Fig. 10).

(3) Profit margin at all-time high. Despite the increasing chatter about rising costs, companies surprised us in Q3 as the S&P 500 corporate profit margin, based on S&P’s trailing-four-quarter operating earnings data, rose once again to a record high of 11.4% (Fig. 11). It was at a record 10.1% during Q4-2017 before the tax cut, before rising to 10.5% during Q1-2018 and 10.9% in Q2-2018 thanks to the tax cut. Yet here it is at yet another record high, and we suspect it will edge even higher during Q4 as the old tax rate ages out of the y/y comparison.

While the bears have been growling during most of the current bull market that the margin is about to revert sharply lower to the historical mean of 7%-8% or lower, we think it will ease a lot less beginning in 2019 toward a higher new normal, because of the lower corporate tax rate and our expectation of a pickup in productivity growth.

(4) Lots of happy sectors, but some big changes. I asked Joe to drill down into the 11 sectors of the S&P 500, and delve further through the noise that popped up. To recap the biggest classification changes by S&P at the end of September, companies in the Media industry and three of the FANGs (all but Amazon) were moved from their two sectors (Consumer Discretionary and Information Technology) to the old Telecommunication Services sector, which was then renamed “Communication Services.” Since S&P’s policy is to “freeze” the revenue and earnings actuals as each quarter is completed, the y/y growth comparisons and profit margins during Q3-2018 compared results for the new sectors with their old alignments. However, I/B/E/S (now a part of Refinitiv instead of Thomson Reuters), provides an apples-to-apples comparison, which Joe also shares below.

Joe reports the following y/y growth rates for revenues based on S&P’s methodology: Materials (27.3%), Energy (26.9), Information Technology (21.7), Consumer Discretionary (17.0), Health Care (16.3), Real Estate (11.3), Financials (8.7), Industrials (8.5), S&P 500 (8.5), Utilities (0.3), Consumer Staples (-5.0), and Communication Services (-51.0) (Fig. 12). The growth rates for the sectors as calculated by I/B/E/S are mostly similar, with the exception of the following apples-to-apples comparisons for Communication Services (12.3), Consumer Discretionary (7.6), and Information Technology (10.6).

Here is the comparable derby for operating earnings growth as compiled by S&P: Energy (126.3%), Financials (61.6), Information Technology (39.2), S&P 500 (32.5), Materials (26.1), Industrials (22.7), Consumer Discretionary (17.0), Health Care (16.1), Utilities (10.1), Consumer Staples (8.9), Real Estate (7.7), and Communication Services (-23.0) (Fig. 13). The growth rates from I/B/E/S for the affected sectors are as follows: Communication Services (26.1), Consumer Discretionary (24.9), and Information Technology (28.5).

And here are the latest trailing-four-quarter profit margins based on S&P’s operating earnings data: Information Technology (22.7%), Real Estate (18.7), Financials (16.1), Utilities (12.4), Communication Services (12.5), S&P 500 (11.4), Materials (10.0), Industrials (10.0), Health Care (8.7), Consumer Discretionary (7.8), Consumer Staples (7.2), and Energy (6.1).

Based on S&P’s method, Q3-2018 marks the first quarter of “misleading” margins for three sectors, which will persist through Q2-2019, with the apples-to-oranges data finally aging out in Q3-2019. However, here are I/B/E/S’s estimates of the Q3-2018 profit margin for those sectors: Communication Services (16.5%), Consumer Discretionary (8.0), and Information Technology (23.1).

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Better To Be Healthy Than Techie

November 15, 2018 (Thursday)

Social Media. Who says you can’t teach an old dog new tricks? I’ve been learning about and using social media to promote my book Predicting the Markets: A Professional Autobiography. I’ve had some success, especially on LinkedIn, which just named me one of the 10 “Top Voices” on the economy and finance in 2018. What’s next? We are working on a YouTube channel with video podcasts organized in playlists corresponding to the chapters of the book. And I just signed a contract with Netflix: For $7.99 a month, I can stream any of their movies on my digital devices. (Old joke.)

Strategy I: Leadership Cha-Cha-Changes. The S&P 500 sector leadership for 2018 has officially changed. The S&P 500 Tech sector, which led the market for the vast majority of the year, has lost its crown to the Health Care sector. The move is quite a comeuppance. Tech’s ytd return has fallen by 13.7 percentage points since October 3, when it was up 20.5% ytd.

Here’s the performance derby for the S&P 500 sectors ytd through Tuesday’s close: Health Care (10.1%), Consumer Discretionary (8.3), Tech (6.8), Utilities (4.3), S&P 500 (1.8), Real Estate (0.7), Consumer Staples (-1.5), Financials (-4.5), Industrials (-6.1), Energy (-9.4), Materials (-10.9), and Communications Services (-11.5) (Fig. 1).

The Technology sector has fallen victim to the market’s vicious rotation into safety sectors and out of growth sectors since the S&P 500 peaked on September 20. Here’s the S&P 500’s performance derby since then: Utilities (4.0%), Consumer Staples (2.2), Real Estate (-0.2), Health Care (-3.4), Communication Services (-6.6), S&P 500 (-7.1), Financials (-7.6), Consumer Discretionary (-9.0), Tech (-10.2), Materials (-11.4), and Energy (-12.6) (Table 1).

It’s notable that the sectors leading the market since the September peak are not the sectors that analysts expect will produce the strongest earnings growth next year. Here are analysts’ 2019 earnings growth estimates: Energy (96.9%), Industrials (19.3), Consumer Discretionary (9.8), Financials (9.4), S&P 500 (9.0), Tech (7.6), Health Care (7.0), Materials (6.6), Communications Services (6.3), Consumer Staples (5.0), Utilities (4.8), and Real Estate (-3.7).

Strategy II: Beware New HQs. Could Tech’s recent woes have something to do with the Curse of New Headquarters? The Curse may be an old wives’ tale, but there are some awfully good examples of companies that have gone downhill shortly after moving into expensive new digs.

Perhaps building a glitzy new HQ is a sign of self-congratulatory hubris, indicating a laurels-resting management that is no longer focused on the bottom line. Perhaps the downfalls after ribbon-cuttings are just coincidental. But we were reminded of the legend when Amazon announced this week that it would open not just one, but two, new headquarters. Granted, Amazon appears to be moving into existing buildings, and the curse historically has applied just to new construction. However, the tech sector could worry instead about Apple’s new headquarters, which had a reported price tag of almost $5 billion when it opened to employees last year.

Dare we mention that GE broke ground on a new headquarters in Boston last year? Additional examples of the new-HQ-cursed companies are mentioned in this 11/10/09 Business Insider article. Some standouts: Bear Stearns opened a new building in 2002, and the AOL Time Warner Center broke ground in 2000. It’s now the Time Warner Center.

Energy: Return of the Glut. There can be too much of a good thing. That’s especially true in the commodity markets, where the slightest shift in supply or demand can throw a market out of whack. So when OPEC reported on Tuesday that global demand was a touch softer, and global supply a bit higher, than the organization had forecast, already weak crude prices continued to tumble.

The price of Brent crude oil futures has fallen to $65.47 a barrel as of Tuesday, down 24% from its October 3 peak of $86.29, and the price of West Texas Intermediate crude futures has declined to $55.69, 27% below its October 3 peak of $76.41 (Fig. 2 and Fig. 3). The decline has sent the S&P 500 Energy industries tumbling ytd anywhere from 4.4% (Oil & Gas Refining & Marketing) to 28.4% (Oil & Gas Equipment & Services) (Fig. 4).

The oil cartel explained: “Although the oil market has reached a balance now, the forecasts for 2019 for non-OPEC supply growth indicate higher volumes outpacing the expansion in world oil demand, leading to widening excess supply in the market. The recent downward revision to the global economic growth forecast and associated uncertainties confirms the emerging pressure on oil demand observed in recent months.”

The organization appears to be making a case to cut production at its next meeting, on December 6, despite President Trump’s tweets calling for the continuation of today’s low prices. OPEC is reportedly considering a 1.4mbd cut in oil production, according to unnamed sources cited in an 11/14 Reuters article. The news report helped crude oil prices enjoy a small bounce yesterday. Let’s take a look at OPEC’s projected global supply and demand data:

(1) Swimming in oil. OPEC reported that its oil output rose by 127,000bd to 32.9mbd in October. The problem: The world only needs 32.6mbd from OPEC members this year—a y/y drop of 0.9mbd—and will only need 31.5mbd from them in 2019, according to the organization’s forecast.

The excess occurs in part because supply is rising faster than expected. OPEC sees non-OPEC supply rising to an average of 62.09mbd in 2019. That’s an increase over the 59.86mbd produced this year and the 57.55mbd produced in 2017. The 2019 estimate was boosted by 0.12mbd in the November report. Most of the increase this year comes from the US (2.06mbd) and former Soviet Union (0.13mbd). Next year, the vast majority of the increase also comes from the US (1.69mbd).

(2) Economies slowing. Additional pressure on oil prices comes from slower-than-expected demand for black gold as a result of lighter world economic growth than previously thought. OPEC forecasts that oil demand will average 100.08mbd in 2019, an increase of 1.29mbd over the 2018 forecast—which is 70,000bpd less than the organization predicted in October. It’s the fourth consecutive reduction of its demand forecast, a 11/13 Reuters article reported.

(3) Blame the US. The US shale miracle has played havoc with the global oil market, as the US has swung from an oil importer to an oil exporter. US net imports have fallen to 1.8mbd (four-week ma), down from 13.6mbd at the peak in November 2005 (Fig. 5). Exports have increased even as a lack of capacity on certain pipelines has constrained growth.

Adding to the pressure on oil and other commodity prices is the US dollar’s appreciation in response to Fed tightening. The dollar is up 10% since February 1 (Fig. 6).

(4) Expect downward revisions. If crude oil prices remain at current levels, it’s highly likely that industry analysts in the energy sector will need to reduce their earnings forecasts. The S&P 500 Energy sector is expected to grow revenues by 22.4% this year and 10.6% in 2019 (Fig. 7).

Earnings were expected to recover this year from a weak environment in 2017. So analysts have been boosting their earnings estimates throughout this year, and now forecast earnings growth of 96.9% in 2018 and 28.0% in 2019 (Fig. 8). The industry’s forward P/E has fallen sharply to 14.1 as its earnings have improved (Fig. 9).

Eye on Innovation: Quantum Power. Quantum computers are still at their nascent stage, but scientists are already using them to solve problems that were previously unsolvable on classic computers. Many of the problems involve optimization. Problems of optimization typically have many variables that can be combined in many different ways before arriving at the ultimate answer.

D-Wave Systems, a privately held Canadian company, and IBM both are helping companies figure out how to use quantum computers in the fields of medicine, materials, traffic flows, and investing. Let’s take a look:

(1) Easing traffic jams. Volkswagen is using a D-Wave quantum computer to develop a traffic management system that will “improve the performance of fleet services like taxis and public buses,” an 11/5 article in Engadget reported. Volkswagen’s quantum algorithm uses data collected from smartphones and transmitters in vehicles to arrive at the fastest way to travel and reduce congestion. The company would like to test its program in Barcelona, but it theoretically could be used in any city. A more detailed description of Volkswagen’s research is available in this 9/27/17 company presentation.

(2) Lighter, stronger materials. Earlier this year, D-Wave and the Vector Institute programed a quantum computer to simulate how a material behaves during a phase transition, according to a company synopsis. The hope is the company will continue to harness the power of quantum computers to help scientists develop and understand the properties of new and existing materials.

Lockheed Martin hopes that quantum technology will help it develop new, lightweight materials for its airplanes and tougher materials to help its spacecraft survive the harsh environs of space, explained Kristen Pudenz, a quantum research scientist at Lockheed Martin, in this video. Novel materials developed with quantum computers could be used in new medications or batteries.

(3) Optimizing radiation. Roswell Park Cancer Institute used a D-Wave quantum computer to determine the optimal amount of radiation for treating a patient. It compared the outcome of the quantum computer to two other traditional methods of coming up with a radiation plan. The quantum computer arrived at an answer similar to that derived by one traditional method, but its answer was less effective than that derived by the second traditional method. In both cases, the quantum computer arrived at the answer three to four times faster than the traditional methods. The scientists concluded that more research into using quantum computers in this area is warranted, especially as the technology improves, according to a 5/21/15 abstract of their research.

(4) JPM and IBM. More than 94,000 researchers have accessed IBM’s quantum computers via the cloud. IBM also allows certain corporate clients to access 20 of its most powerful quantum computers. IBM’s partners in financial services, including JPMorgan, are exploring how to use quantum computing to optimize trading strategies, analyze risk, and construct the best-performing investment portfolios, explained Kathryn Guarini, vice president of IBM Industry Research, in an 10/12 podcast. IBM believes that quantum computers’ much faster speed relative to traditional computers might allow some investing-related tasks to be done twice a day instead of just at the close of business.

Guarini suggests that companies start thinking about what quantum computing will mean for their businesses and learn quantum programing. “This is something people want to get ahead of.”

Correction: Driving Lesson. Yesterday, we wrote: “The situation is akin to driving a car with the left foot bearing down on the accelerator while the right foot taps the brakes, as we’ve noted frequently this year.” I received a number of emails reminding me that the right foot goes on the accelerator and the left foot goes on the brakes. I’ll do that next time I go for a drive, and remind my colleagues to do the same. That should lower our auto insurance premiums.

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Volatile Situations

November 14, 2018 (Wednesday)

Strategy: Getting Messier. This certainly has been a volatile year for stocks, and it isn’t over yet. The volatility has mostly been attributable to the tug of war between President Trump’s bullish and bearish policies. On the bullish side are deregulation and tax cuts. On the bearish side are widening federal deficits and an escalating trade war with China.

On balance, Trump’s policies have boosted economic growth and further tightened the labor market. As a result, Fed officials—who did a good job of prepping the financial markets for a gradual course of hikes in the federal funds rate, aiming for a “neutral” 3.00% level by the end of next year—have recently been chattering about even higher rates, i.e., turning restrictive. Consequently, the trade-weighted dollar has soared. The combination of higher US interest rates and a stronger dollar is suppressing US inflation while depressing commodity prices as well as the global economy, particularly emerging market economies. The situation is akin to driving a car with the left foot bearing down on the accelerator while the right foot taps the brakes, as we’ve noted frequently this year.

The outlook for 2019 is most likely for more volatility. That’s assuming that tensions between the US and China continue to mount, as discussed below. On the bullish side, the latest FOMC statement did hint faintly that a pause in the Fed’s quarterly rate hiking might be possible next year. Meanwhile, the global economy continues to weaken. In any event, the growth rates of both S&P 500 revenues and earnings will certainly be slower in 2019 than this year.

It’s widely believed that the stock market likes gridlock, which now is assured for the next two years given the mid-term election results. However, the country has been experiencing an escalating uncivil war between the Left and the Right. It will only get worse, as explained in the cover story of the latest Bloomberg BusinessWeek titled “Republicans Weaponized the House. Now, Democrats Will Use It Against Trump.” That may contribute to more stock market volatility next year.

Joe and I curbed our enthusiasm for the stock market’s upside in the 10/30 Morning Briefing. We lowered our outlook for earnings growth over the next two years, as we reviewed yesterday. At the end of last month, we also reduced our target for the S&P 500 from 3100 to 2900 for the end of this year and from 3500 to 3100 by year-end next year. We aren’t bearish because we expect that the US economy will continue to grow over the next two years. Furthermore, we remain open to the possibility that productivity will make a long-awaited comeback.

In my meetings with our accounts in Toronto last Thursday, one seasoned equity investment strategist suggested that, given the slowdown in global growth, perhaps it’s time to overweight value and underweight growth (Fig. 1 and Fig. 2). That was a good call based on nature of Monday’s stock market rout.

What about the “Panic-Attack-Relief-Rally” model that has worked so well for us, reassuring us that downdrafts in this bull market are typically short-lived? It worked because in all of the first 60 episodes, there tended to be just one major frightful concern that turned out to be a false alarm. This year’s panic attacks #61 and #62 share common concerns about several issues that might linger into next year (Fig. 3). (See our S&P 500 Panic Attacks Since 2009.) The alarm has yet to be proven false.

China I: Hardline on China. “Economic security is national security. If you think about everything the Trump administration has been doing in terms of economic and defense policy, you understand this maxim really is the guiding principle,” said Peter Navarro in an 11/9 speech at the Center for Strategic and International Studies. The White House National Trade Council Director has advised that the US take a hardline with China, calling the country out as a “strategic rival.”

During the speech, Navarro commended United States Trade Representative (USTR) Robert Lighthizer for invoking his department’s Section 301 power on China. The Section 301 report should be required reading for everyone in this country, Navarro said, because—per its title—the report outlines “China’s [Unfair] Acts, Policies, and Practices Related to Technology Transfer, Intellectual Property, and Innovation.” (In March and April, we devoted portions of several Morning Briefings to providing an overview of the 215-page Section 301 report. See our Morning Briefings dated 3/19, 3/26, 3/27, 3/29, and 4/5. And for more on Navarro’s perspective, see our 3/8 Morning Briefing titled “Meet Peter Navarro.”)

One comment Navarro made during his speech stuck out to us, because it implied that without stealing US technologies, China’s economy would fall apart. Navarro stated: “If they make the kind of structural reforms that are necessary for them to be reasonable, fair, responsible citizens of the global trading system, they will not be able to compete.” He might be right.

The USTR report details the ways in which China has unfair advantages. Navarro explained that Chinese companies don’t have to incur the typically heavy R&D costs required to develop new technologies because Chinese companies are usurping US technology at little to no cost. That creates an obvious strategic low-cost advantage over US companies, which do incur these costs, says Navarro.

The implication is that there is no end game for a US-China trade deal, because it’s a lose-lose for China. Navarro pointedly asks: How can you negotiate with someone who won’t even acknowledge the issues you bring to the table? He cites instances where the Chinese government repeatedly made empty promises to change its practices, then failed to deliver.

Trump is meeting with President Xi Jinping of China late this month at the Group of 20 (G20) leaders’ summit in Buenos Aires. So far, the US has imposed tariffs on $250 billion of China-made goods, and has threatened to do the same on the remaining $267 billion of imports from China. So far, the tariffs don’t seem to be breaking the backs of US companies or consumers.

The question is: Will the Trump administration’s hardline on trade break China? If the matter were as simple as two free-market economies working together to develop free, fair, and reciprocal trade deals (which is the administration’s goal), then the answer would probably be that China will be fine. In reality, the escalating dispute with the US is over national security as well, not just trade, and it might push China over the edge if Navarro has his way.

Navarro’s battle is not just an external one with China; there is a domestic dispute too. During his speech, Navarro railed against the so-called “shuttle diplomacy that is now going on by a self-appointed group of Wall Street bankers and hedge fund managers between the US and China.” Under the influence of the Chinese government, “globalist billionaires are putting the full court press on the White House in advance of the G20,” Navarro said. He called on these “globalist elites” to “stand down,” adding that Trump has done an “amazing job” addressing this issue and doesn’t need Wall Street’s help to solve it.

Navarro’s “comments reflect the ongoing divisions inside the Trump administration between free traders—including those with Wall Street backgrounds like Treasury Secretary Steven Mnuchin and economic adviser Larry Kudlow—and the so-called nationalists, who hew to the ‘America First’ stance laid out during the campaign and early months of Trump's presidency by former chief strategist Steve Bannon,” an 11/9 CNN article observed. Navarro has said that he isn’t a protectionist but a proponent of “fair” trade.

In any event, we are anxious to learn the outcome of the G20 meeting. We doubt any sort of clear-cut “win-win” deal will be made with China. But it’s possible that the “globalists” will smooth US-China trade tensions over, at least temporarily.

China II: Mounting Stress Cracks. China’s economy is showing more and more homegrown problems that have nothing to do with Trump’s tariffs. On the contrary, China’s latest merchandise exports and imports rose to record highs during October (Fig. 4). Then again, China’s M-PMI has been weakening in recent months, led by declines in its overall and export orders indexes (Fig. 5).

Meanwhile, the government’s efforts to transform the Chinese economy from export-led to consumer-led growth aren’t going so well. As we’ve previously discussed, China’s rapidly aging demography (stemming from the country’s longstanding one-child policy, which has only recently been lifted) is starting to weigh heavily on the Chinese economy.

Several areas of the Chinese economy are showing stress cracks. Here are a few examples in the media over just the past week:

(1) Big debt pile showing more signs of distress. Bloomberg ran a story on 11/7 titled “China Has More Distressed Corporate Debt Than All Other EMs.” Reportedly, the distressed debt has built up in a span of just 11 months. Before that, China had no distressed dollar-denominated corporate bonds, according to a Bloomberg Barclays index.

A 9/11 MoneyWeek article provided this backdrop: “The latest move [from China] to try to help buoy the economy without embarking on full-blown stimulus was for the government to tell banks exactly how much they have to lend to the private sector. … The problem is, if you set targets for lending like this (particularly when failure to meet government targets in a country like China is not a recipe for a long and happy life), then you are creating a huge incentive for yet more bad loans to be written. And it also smacks of desperation.”

“Property developers in particular are facing surging borrowing costs as refinancing pressures intensify amid the government’s effort to rein in real estate prices,” observed the Bloomberg article. At least four property-related firms defaulted on debt this year. There could be more to come. China’s second-largest builder (by sales) priced a dollar bond at “the highest interest rate it has ever paid on a dollar issue.” Many are rightly concerned that the Federal Reserve’s hikes will increase borrowing costs on dollar-denominated debt.

(2) Property speculators own lots of empty apartments. Bloomberg ran a story on 11/8 titled “A Fifth of China’s Homes Are Empty. That’s 50 Million Apartments.” That’s the highest vacancy rate of any country, according to the article. It’s not because these apartments are unsold or wanting for tenants. Rather, they’re owned by lots of real estate speculators.

The article observed: “The nightmare scenario for policy makers is that owners of unoccupied dwellings rush to sell if cracks start appearing in the property market, causing prices to spiral. The latest data, from a survey in 2017, also suggests Beijing’s efforts to curb property speculation—considered by leaders a key threat to financial and social stability—are coming up short.”

It also noted: “There’s an economic cost to vacancies too because they’re a drag on supply, which puts upward pressure on prices and crowds young buyers out of the market, according to Kaiji Chen, who co-authored a Federal Reserve Bank of St. Louis working paper called ‘The Great Housing Boom of China.’”

(3) Capital flight may be increasing again. Trump’s escalating trade war, the Fed’s rate hikes, and China’s weakening economy have caused the yuan to fall 10% against the dollar since this year’s peak on February 7 through Friday (Fig. 6). The weaker currency should offset some of the damage to Chinese exports from US tariffs. The problem is that when the yuan has fallen in the recent past, as it did in 2015 and 2016, global investors pulled capital out of China, fearing that the yuan had further to fall (Fig. 7). Beijing was forced to step in and prop up the yuan and take measures to reduce capital outflows.

An 11/9 CNN article quoted Manu Bhaskaran, the founder of Singapore-based research firm Centennial Asia, saying that a “rapidly falling yuan could become a vicious cycle.” And “a huge capital outflow” from China “could feed on itself.”

(4) M2 confirming retail sales slowdown. On Friday, the People’s Bank of China released its quarterly monetary policy report, which stated: “External conditions are undergoing profound changes, downward pressures are increasing, some companies are seeing more difficulties in their operations, risks accumulated over the long term are being exposed.” The bank will “preemptively adjust and fine-tune policies according to the changing conditions.”

The bank’s efforts may be running into China’s great wall of demography. Previously, we’ve noted that the significant slowing in China’s retail sales growth may be showing the effects of the population’s aging. Retail sales growth has been highly correlated with the growth in M2 growth, both on a y/y basis (Fig. 8). Of course, the same can be said about the inflation-adjusted versions of both metrics (Fig. 9). During September, real retail sales growth was down to 6.9%, while real M2 growth was down to 5.6%. For the former, it was among the weakest readings going back to 2004; for the latter, it was the weakest in the history of the series going back to 2001.

(5) Happy Singles’ Day cheering up depressed shoppers? A glimmer of hope came from Alibaba’s early results for its decade-old annual Singles’ Day sales event. The company reported that the kickoff beat last year’s record sales. Perhaps having lots of single friends to mingle with is a rare bright spot for cash-strapped Chinese consumers.

The event was started as a tongue-and-cheek way to mend all the lonely hearts of China’s single bachelors. Because of the only-child policy, the country’s bachelors significantly outnumber the bachelorettes. That will make it difficult for all of these men to form couples, get married, and have children. And that will only worsen China’s aging demographic problem. Peter Navarro wants to kick the country when it is down.

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Slowdown Ahead

November 13, 2018 (Tuesday)

Strategy: Analysts Still (Too) High on Earnings. The latest earnings season seemed to contribute to the sharp selloff in stocks during October, as some companies reported bullish earnings that were more than offset by bearish guidance about future earnings prospects. Collectively, however, the S&P 500 results through the 11/8 week were 4.9% better than analysts expected during the 9/28 week (Fig. 1). As we’ve noted many times before, such positive earnings hooks are par for the course. (See our S&P 500 Earnings Squiggles Annual & Quarterly.)

In aggregate, the negative guidance corporate managements provided during earnings conference calls didn’t deflate analysts’ consensus earnings estimates for Q4-2018 and the four quarters of 2019 (Fig. 2). In fact, the 2018 estimated earnings growth rate was steady during the 11/1 week at 23.6%, the highest reading for this series (Fig. 3 and Fig. 4). The 2019 estimated growth rate edged down to 9.4%. The 2020 projected growth rate remained solid at 10.2%.

In other words, the Q3 results didn’t curb analysts’ enthusiasm for earnings growth over the rest of this year and the coming two years. Joe and I, however, curbed our enthusiasm for the earnings outlook in the 10/30 Morning Briefing. Here’s more on why we did so:

(1) Us vs them. We lowered our estimates for earnings growth during 2019 and 2020 to 4.9% and 5.3% from 6.8% and 8.8%. We are predicting S&P 500 earnings per share will be $162 this year, $170 next year, and $179 in 2020 (Fig. 5). During the 11/8 week, the comparable analysts’ consensus estimates were $162.67, $177.69, and $194.55.

(2) Revenues slowdown ahead. The growth rate of S&P 500 revenues has been remarkably strong this year, which has contributed—along with the corporate tax rate cut at the end of last year—to the strength in earnings growth. Revenues per share rose 11.2% y/y during Q2, the highest growth rate since Q2-2011 (Fig. 6).

Industry analysts are expecting a slowdown in revenues-per-share growth from 8.5% this year to 5.5% in 2019 and 4.4% in 2020 (Fig. 7). That makes sense to us, since the trend growth rate of revenues has been roughly 4.0% (Fig. 8).

In addition, the global economic outlook is deteriorating, as evidenced by the weakening trends in recent months in both the OECD Leading Indicators and the Global Composite PMI (Fig. 9 and Fig. 10).

(3) Profit margin unlikely to set new records. What doesn’t make sense to us is the implication of analysts’ consensus earnings and revenues estimates that the S&P 500 operating profit margin will continue to rise to record highs. Their latest numbers imply that the profit margin will rise from 11.9% this year to 12.4% next year and 13.1% in 2020 (Fig. 11). Thomson Reuters data show that the operating profit margin rose to a record-high 10.9% at the end of 2017 before the corporate tax cut. After the cut, it rose to fresh record highs of 11.9% during Q1 and 12.3% during Q2 (Fig. 12).

During the Q3 earnings season, many company managements warned that, in addition to their revenues growth being weighed down by the global economic slowdown, their profit margins were likely to be squeezed by higher labor costs as well as the impacts of tariffs, which were raising their materials costs and disrupting their supply chains. They didn’t say whether they expected to offset some of those higher costs with productivity gains.

So we don’t expect the S&P 500 profit margin to rise further from here. If it remains flat in record-high territory over the next two years, then earnings growth will match revenues growth. And if that happens, then industry analysts will be lowering their heady growth rates for earnings.

Commodities: Lots of Crude. The price of crude oil is no longer diverging from other commodity prices, as it has been doing for most of this year until early October (Fig. 13). The traditional inverse correlation between the trade-weighted dollar and the price of oil was also a no-show this year until recently (Fig. 14). Now all is right with the world, as the oil price has been dropping along with the CRB raw industrials spot price index, while the dollar has remained strong.

Actually, all may not be right with the world if the 19% drop in the price of a barrel of Brent crude oil from this year’s peak of $86.29 on October 3 through Friday’s price of $70.18 is signaling a major slowing in the global economy. That’s certainly part of the story. Another piece of the story is that oil prices rose this year partly as a result of crude oil output collapsing in Venezuela and President Trump withdrawing from the Iran nuke deal on May 8 and imposing renewed sanctions on Iran effective November 5 (Fig. 15 and Fig. 16). However, several days before the mid-term elections, Trump handed out waivers to some of the countries that rely on Iranian crude, which triggered the recent drop in the oil price.

In any event, the Saudis and the Russians are scrambling to reduce their oil output to shore up prices. Their big problem is that American and Canadian producers are increasingly outproducing each of them. The latest available data from the US Energy Information Administration show that the US and Canada combined produced 15.2mbd during July, while Saudi Arabia and Russia produced 10.5mbd and 10.8mbd, respectively (Fig. 17). During the 11/2 week, US crude oil production soared to a record 11.7mbd, up 2.1mbd from a year ago (Fig. 18).

While lower gasoline prices should boost consumer spending, the lower oil price is likely to weigh on capital spending. Yesterday’s WSJ Real Time Economics email observed:

“Consumer demand is the major driver of economic growth in the U.S. If oil prices stay relatively low, cheaper gasoline should help consumers spend elsewhere. Cheap oil also would be a check on inflation. But the energy sector is a major driver of business investment. Oil prices bottomed out in early 2016. As the industry caught up with rising prices and demand, spending soared. Since the start of 2017, investment in mining exploration, shafts and wells is up 53.2%. That blows away other business investment categories—software is next at 16.5%, overall investment is up a moderate 9.2%. With business investment already struggling, cheaper oil could dent a key engine of economic growth.”

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The Hysteresis Hypothesis

November 12, 2018 (Monday)

The Fed: Powell vs Yellen. “Hysteresis” is the controversial concept that the sharp downturns in aggregate demand that occur during recessions can have a persistent negative impact on aggregate supply. When demand takes an extended and deep dive, the supply of labor and the skills of the labor force, as well as the long-term productivity of business capital, all may deteriorate.

Hysteresis is one possible explanation for why the latest recovery has been relatively weak for so long. The Great Recession ended in June 2009, meaning that the recovery is the second-longest on record, at 113 months old through November. The current expansion will become the longest on record if it surpasses 120 months through July 2019 (Fig. 1). Notwithstanding its longevity, the current expansion is the second weakest of the seven since 1961 (Fig. 2).

In a 10/14/16 speech, former Fed Chair Janet Yellen wondered: “If we assume that hysteresis is in fact present to some degree after deep recessions, the natural next question is to ask whether it might be possible to reverse these adverse supply-side effects by temporarily running a ‘high-pressure economy,’ with robust aggregate demand and a tight labor market. One can certainly identify plausible ways in which this might occur.” She was suggesting that prolonging monetary easing would allow the economy to overcome the negative consequences of hysteresis with positive ones. As always, Yellen supported her comments with a plethora of footnotes and corresponding studies that are worth a skim.

So far, Fed Chairman Jerome Powell doesn’t seem to have bought into the concept. In a 6/20 speech this year, Powell stated: “While persistently strong economic conditions can pose risks to inflation and perhaps financial stability, we can also ask whether there may be lasting benefits.” He added: “The persistence of any such ‘positive hysteresis’ benefits is uncertain, since, again, the historical evidence is sparse and inconclusive.”

To be fair, Powell’s statement didn’t completely dismiss the hysteresis hypothesis. Nor did Yellen’s statement completely endorse it. But the trajectory of the monetary policy path under Powell (tightening) versus Yellen (accommodating) speaks louder than words. Who is right? Melissa and I side with Yellen on this one. There are a lot of issues to discuss. But stay with us, we think it’s worth it. Here we go:

(1) Hysteresis channels. London Economist Rhys Williams neatly described the effects of hysteresis in a 2015 blog post. He explained: “Hysteresis is the argument that [negative] short-term [economic] effects manifest themselves into long term problems which inhibit growth and make it difficult to return to pre-recession growth trends.” The long-term effects occur through these main channels: skills atrophy (unemployed workers lose productive skills), signaling effects (employers are reluctant to hire unemployed workers with a time gap), cognitive dissonance (discouraged would-be-workers exit the labor force), capital depreciation (capital goods deteriorate beyond repair if not maintained or upgraded), and beachhead effects/trade penetration (domestic producers lose ground to foreign competitors).

(2) Labor hysteresis. In our view, several of these effects persisted following the Great Recession, especially in the labor market. Two key pieces of evidence come to mind:

The labor force participation rate dropped sharply since the Great Recession, falling from 65.8% at the end of 2008 to 62.9% during October, holding near lows not seen since 1977 (Fig. 3). Granted, a good portion of that is because of Baby Boomer retirements. However, as a result of the previous recession and weak recovery, lots of discouraged unemployed people exited the labor force. More recently, the labor force participation rate has picked up, especially for prime-age workers who are 25-54 years old (Fig. 4 and Fig. 5).

During September, the number of job openings exceeded the number of unemployed workers by 1.05 million (Fig. 6). Previously sidelined workers who are looking for work may be having a difficult time getting hired because of a skills mismatch to available jobs (i.e., skills atrophy) and an employment time gap (i.e., signaling effects). Geographical mismatches may also be a reason why job openings well exceed unemployed workers.

(3) Hysteresis flattens the Phillips curve. Labor hysteresis may be an important reason why the natural rate of unemployment, i.e., the nonaccelerating inflation rate of unemployment (NAIRU), seems to have fallen to a lower level than predicted by the Fed’s models. Employers may be unwilling to pay up for new hires who lack the exact right skills. In other words, labor hysteresis may have contributed to the flattening Phillips curve, the inverse relationship between unemployment and inflation.

As we discussed in our 11/6 Morning Briefing, the Phillips wage curve may finally be making a long-awaited comeback now that the unemployment rate is the lowest since December 1969. The wage inflation rate for production and nonsupervisory workers is up from 2.2% a year ago to 3.2% last month (Fig. 7). However, that may not boost price inflation if productivity makes a long-awaited comeback.

(4) Productivity puzzle solved by hysteresis. Last week, we noted that the tight labor market may be boosting productivity growth, which would allow wages to increase without boosting price inflation. To tie that point into today’s discussion, consider the damage to productivity following the Great Recession, which the hysteresis thesis explains.

Nonfarm business (NFB) productivity growth may be just starting to recover after a long lull. It peaked at 6.1% (y/y) during Q4-2009, then fell to a post-recession low of -0.7% during Q3-2011 (Fig. 8). Since then, productivity growth hasn’t risen above 1.9%. However, the q/q growth rates in productivity for Q2 and Q3 are more promising, with gains of 3.0% (saar) and 2.2%, respectively (Fig. 9). Yellen had said that positive hysteresis effects resulting from running a high-pressure economy with prolonged monetary easing could eventually lead to more productive job matches as job-to-job transitions are encouraged. Maybe that’s starting to happen. If so, then Powell needs to consider raising interest rates even more gradually than he has been signaling.

(5) Potential output boosted by hysteresis. Real NFB output growth during Q3 was solid at 3.7% y/y. However, the growth was driven largely by an increase in hours worked (2.4%) and relatively weak productivity growth (1.3%). The growth rates of real NFB output and real GDP are highly correlated on a y/y basis. Real GDP rose 3.0% y/y during Q3 (Fig. 10).

The key question for monetary policy is: How far off is actual output from potential output? Potential output growth is the rate at which the economy could grow if it were operating at full capacity. The spread between actual and potential output is an important variable in Taylor Rule models for setting the federal funds rate. If it is positive, then the Fed should continue to increase interest rates. That’s because as actual output rises toward, or exceeds, potential output, the demand for the factors of production rises, with potential inflationary consequences. (That’s in theory, of course.)

(6) Fiscal boost vs Fed restriction. However, potential economic output is a moving target. If “negative” hysteresis explains why the recession dampened long-term potential output, then “positive” hysteresis could restore it. The two primary policy tools that could do so are stimulative fiscal policy combined with accommodative monetary policy.

Even better, a combination of supportive fiscal and monetary policies could boost potential output so that there is a wider gap between potential output and actual output. In other words, there is room for further supportive policies without risking a rise in inflation! (That too is in theory, of course.)

No wonder the Trump administration has voiced objection to the Fed’s interest-rate hikes. And besides the monetary tightening of higher rates, there’s also quantitative tightening occurring in the background. We’ve previously described the current mix of policies as akin to stepping on the economy’s accelerator with fiscal policy while tapping on the brakes with monetary policy. No wonder stock prices have been so volatile this year.

The administration’s fiscal stimulus is working, in our opinion. There is mounting evidence that prime-age workers are starting to return to the labor force, wage growth and productivity are starting to pick up, and output is improving while price inflation remains low. So why are Fed officials already talking about moving to restrictive monetary policy?

In his 9/26 press conference, Fed Chair Powell said that he could see the Fed making a couple of hikes beyond the neutral rate of interest, the rate where monetary policy is neither stimulative nor accommodative. He hammered the point home, and hammered the stock market, in a 10/3 interview, when he said: “So interest rates are still accommodative but we're gradually moving to a place where they will be neutral, not that they'll be a restraint on the economy. We may go past neutral but we're a long way from neutral at this point, probably.”

In fairness, it’s possible that Powell’s game plan is a pragmatic one: raise the federal funds rate as high as possible without causing a recession so that the Fed will have more room to lower rates come the next recession. That’s fine as long as the pace of rate hikes includes relatively long pauses of, say, six months (rather than three months) to assess the reaction of the economy to tightening. Alternately, Powell may simply be convinced that running a high-pressure economy is bound to boost inflation.

(7) Reversing the damage. We aren’t very concerned about inflationary risks, because we think that the damage done to aggregate supply following the recession is reversible under the right fiscal and monetary conditions. We believe that the right mix of policies can create more room for the US economy to run.

In her speech, Yellen observed: “Hysteresis effects—and the possibility they might be reversed—could have important implications for the conduct of monetary and fiscal policy. [I]f strong economic conditions can partially reverse supply-side damage after it has occurred, then policymakers may want to aim at being more accommodative during recoveries than would be called for under the traditional view that supply is largely independent of demand.”

(8) More flexible Fed? As it so happens, there was a (very) faint hint of support for the Fed to pause its rate hikes in the FOMC’s 11/8 Monetary Policy Statement. The language was adjusted to say: “Household spending has continued to grow strongly, while growth of business fixed investment has moderated from its rapid pace earlier in the year.” Positive hysteresis would justify running a high-pressure economy to further boost household spending to stimulate business spending.

It’s possible that Fed officials could come around to the hysteresis thesis, especially if price inflation remains low and productivity shows more signs of rebounding. But the damage from “restrictive” talk may already have been done. The Fed may opt to stay the course to maintain credibility as well as the appearance of independence from fiscal policymakers. Further hikes might weigh on the upside potential of potential output.

We are watching for more evidence of “positive” hysteresis and hope that members of the FOMC are too. We are encouraged that Powell now intends to hold a press conference after each of the FOMC’s eight meetings a year, rather than just four of them (the prior pattern of holding press conferences after every other meeting was instituted by former Fed Chairman Ben Bernanke). As our good friend Mike O’Rourke, the Chief Market Strategist of Jones Trading, recently observed in an email commentary:

“Here we are today 8 interest-rate hikes into a cycle, and the FOMC has fallen into the pattern of each hike occurring at a press conference meeting, just as the next one will. The FOMC has unintentionally limited its flexibility by only making half of its meetings live for a policy move. How did anyone survive the days when the policy statement was released with or without an interest-rate move or even the days of a surprise move? Back then, investors had to discern the FOMC’s intentions on their own. That small amount of policy uncertainty was healthy because it kept investors honest. There had to be a certain level of conviction in order to allocate capital to an investment. Instead, a decade of predictability fostered a structural environment of ‘set it and forget it’ passive investing. Although the FOMC will still be providing multiyear forecasts of interest-rate policy, Chair Powell’s decision to hold press conferences at every meeting is a small step in the right direction. The FOMC will be able to make a policy move based upon need, as opposed to a press schedule.”

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‘Don’t Be Evil’

November 08, 2018 (Thursday)

Consumer Discretionary: Santa’s Coming.  Before the Trick-or-Treaters had rung the first bell, we started seeing stores restocking their shelves with holiday items. Yes, the annual holiday shopping surge is officially underway, and this year it looks to be bountiful. Analysts are calling for a y/y sales increase north of 4% thanks to a healthy and optimistic consumer. By some estimates, holiday sales could amount to a record $1.0 trillion. But if the tariff tug of war continues between the US and China, 2019 could deliver a lump of coal to the retail industry in the new year. Consider the following:

(1) Consumers ready, willing, and able to spend. Consumers are a relatively predictable bunch. If they have cash, they’ll spend it, and right now they’re flush. The US unemployment rate has fallen to 3.7%, a 49-year low (Fig. 1). Real average hourly earnings for production and nonsupervisory workers has risen 0.8% y/y to a new high (Fig. 2).

As a result, consumer spending has been healthy. Personal consumption expenditures rose 5.0% y/y in September, a touch more than the 4.9% increase in disposable personal income (Fig. 3). Meanwhile, the gasoline futures price has fallen to $1.69 a gallon, down from $2.27 in late May, suggesting the price of gasoline at the pump should continue to fall from its recent peak of $2.45 per barrel (Fig. 4). It all adds up to a happy consumer; the October Consumer Optimism Index (which averages the Consumer Sentiment Index and the Consumer Confidence Index) is at its highest level since November 2000 (Fig. 5).

(2) Happy consumer, happy forecasts. With the US consumer employed and jolly, forecasters are calling for solid increases in holiday spending. The National Retail Federation (NRF) expects holiday retail sales in November and December to increase 4.3%-4.8% y/y. The association’s estimate excludes sales of autos, gas, and restaurants, and it includes online sales.

The NRF’s estimate is higher than the average annual increase of 3.9% over the past five years, but it’s a touch lower than the 5.3% increase enjoyed last year.

Craig Johnson, president of Customer Growth Partners, is calling for a 5.1% jump in in-store and online spending this holiday, reported a 10/28 article in Chain Store Age. He forecasts online sales surging 9.9%, compared to the 11.4% jump last year. Industries expected to rake in higher sales this season will include health and personal care (3.8%), clubs and superstores (5.2), apparel (5.4), and consumer electronics (6.1), thanks to new products including the iPhone, the Galaxy Note 9, and Sony’s audio products.

Conversely, Johnson warns that sports/toys/books sales are projected to decline almost 6.5% due to the demise of Toys R Us, and department stores sales will likely fall around 2.0% due to Sears’ stores closures.

(3) A leading sector. A broad swath of Consumer Discretionary stocks has performed well this year despite the market’s October swoon. The sector is up 9.1% ytd, near the top of the leaderboard.

Here’s how the sectors stack up year-to-date through Tuesday’s close: Tech (9.6%), Health Care (9.5), Consumer Discretionary (9.1), S&P 500 (3.1), Utilities (3.0), Real Estate (-1.0), Consumer Staples (-1.6), Financials (-3.8), Energy (-4.2), Industrials (-5.0), Materials (-9.2), and Communication Services (-9.5) (Fig. 6).

The Consumer Discretionary sector was driven higher ytd by the Department Stores industry (46.2%), Automotive Retail (27.2), Specialty Stores (19.0), General Merchandise Stores (13.6), and Hypermarkets & Super Centers (12.8) (Fig. 7).

Something to keep an eye on is the impact tariffs may have on the prices of the goods retailers sell. Large retailers tend to order goods and have them shipped well in advance of the holiday season. So they should evade the impact of tariffs this season, a 9/18 WSJ article reported.

The initial round of tariffs imposed this summer on $50 million of goods affected primarily intermediate inputs or capital equipment, with only 1% of the tariffs affecting consumer goods. However, on September 24 the latest round of tariffs affecting another $200 million of goods went into effect, and 24% of those goods were consumer goods. The 10% tariff will more than double to 25% on January 1, according to a 9/24 guide from the Peterson Institute for International Economics.

The stronger dollar will help offset any initial tariff costs. And retailers can push suppliers to absorb some of the cost increases. But if the trade war continues into 2019, retailers may not be able to escape the ramifications of the tariff tiffs for much longer.

Tech I: Google Being Evil? Since 2000, Google was known by its unofficial motto: “Don’t be evil.” The saying appeared at the start of the tech titan’s code of conduct, which eschewed the corporate-babble of “old” companies. But this spring, the phrase moved from the first line of Google’s code of conduct to the last line, a 5/18 Gizmodo article reported.

Is this a difference without a distinction? Perhaps. However, the company, which turned 20 this year, has been entangled in numerous problematic situations recently that have taken the shine off the stock. Alphabet, Google’s parent, has come under fire for how it has handled employee harassment cases. President Trump is threatening to break the company into pieces. Europe wants to tax its revenues. And the company appears to be wading into a hornet’s nest by putting news on its search page.

One piece of good news: Alphabet’s Waymo subsidiary just received a permit for autonomous driving in San Francisco, and it’s expected to launch an autonomous driving service in Phoenix by year-end.

I asked Jackie to have a closer look at Google’s world. Here is her report:

(1) Employees disgruntled. A 10/25 NYT article on how Google had dealt with sexual misconduct cases involving senior employees so enraged employees that nearly 17,000 walked off the job in protest last Thursday in locations scattered around the world, an 11/2 Vox article estimated. In the most egregious allegation, the former head of Android was given $90 million when he left in 2014 after being accused of sexual misconduct by an employee with whom he had been having an extramarital relationship.

The example was one of three where Google protected senior executives accused of sexual misconduct and paid them millions, the NYT claimed. In response to the story, Google noted that 48 people were fired for sexual harassment over the last two years without receiving an exit package.

Organizers of the walkout, which was sanctioned by management, also produced a list of demands. They want Google to change how it “handles sexual harassment, including ending its use of private arbitration in such cases. They also asked for the publication of a transparency report on instances of sexual harassment, further disclosures of salaries and compensation, an employee representative on the company board, and a chief diversity officer who could speak directly to the board,” a 11/1 NYT article reported.

Management has responded to employees’ calls for action in the past. Earlier this year, the company decided not to renew a Pentagon contract to use Google artificial intelligence to analyze drone videos after employees objected to using company technology in warfare.

(2) On Trump’s radar. In an 11/4 interview with Axios on HBO, President Trump said his administration is looking at antitrust investigations of Google, Facebook, and Amazon. Technically, any case would arise out of the Federal Trade Commission and the Department of Justice.

While he raised the issue, President Trump hedged by saying: “I’m not looking to hurt these companies; I’m looking to help them. As far as antitrust is concerned, we’ll have to take a look at that, but I want them to do well. I want Amazon to do well. I want Google to do well. I want Facebook—I want all of ’em to do [well]—these are great companies.”

Breaking up the large tech companies is an idea that has been raised by others including Tim Berners-Lee, a founder of the Internet. He told Reuters that companies like Facebook and Google “had grown so powerful they might need to be split up unless rivals could reduce their influence,” the 11/5 FT reported.

(3) On the EU’s radar. While the US President threatens, the European Union (EU) is already taking action. In July, the EU hit Google with a $5 billion antitrust fine because of Android’s dominant mobile operating system, a 7/18 CNBC article reported. It claims Google “forced smartphone makers to pre-install Google apps Chrome and Search in a bundle with its app store, Play. … [It also] violated competition rules by paying phone makers to exclusively pre-install Google search on their devices and preventing them from selling phones that run other modified, or ‘forked’ versions of Android.” If the illegal conduct isn’t ended, Alphabet could face additional charges of up to 5% of its average daily worldwide revenue.

Were that not enough, the EU is considering taxing Google, Facebook, and other Internet companies 3% of their revenue because they believe the companies are not paying their fair share of taxes. However, support for the proposal is mixed. France supports the proposal, while Ireland, Sweden, and Denmark are against it. Germany initially supported the bill, but now is looking to water down and delay the proposal, a 10/29 Guardian article reported. The UK and Spain are going forward with their own tax plans.

(4) New ventures. In a move that seems slightly tone-deaf, Google has introduced Discover, a reformatted version of its news feed. Discover articles appear under the Google search box. The company promises to deliver articles that are relevant to users. So if Google knows you’re planning a trip, it may show the best places to eat or sights to see at your destination, explained a company blog. The blog doesn’t say how Google will know your interests.

The new offering reinforces the fact that Google knows an awful lot about everyone and is constantly trying to monetize that information. Perhaps not the best thing to do when there’s a backlash against privacy invasion by large Internet companies.

Fortunately, the company does have some positive news. Alphabet’s Waymo division is testing pricing models for rides in its autonomous vehicles in Phoenix, a recent article in Techcruch relayed. In addition, the company received permission to begin testing driverless vehicles on public roads in California, a 10/10 CNBC article stated.

Of course, this begs the question: If you take a Waymo car to an Italian restaurant, will Discover deliver articles about the tastiest pasta to eat?

(5) The numbers. Google and Facebook are both members of the new S&P 500 Interactive Media & Services industry, added to the revamped Communication Services sector in late September. The industry has seen its price index fall 10.8% from its peak on September 27, and trades at a forward P/E of 22.4. This new industry is expected to grow revenues at a healthy 27.9% pace in 2018 and 26.6% in 2019. Earnings are forecast to rise 25.4% in 2018, but slow substantially to 9.0% next year. The industry’s profit margin is forecast to decline from an expected 23.3% in 2018 to 21.1% in 2019, whereas most industries in the S&P 500 are expected to see margins expand next year.

As for Google, its stock trades at 22.3 times expected 2019 earnings of $47.38 per share, which represents 13.3% growth over expected earnings in 2018. One item that jumped out from the company’s Q3 earnings was the bounty of cash Alphabet has stashed: $106.4 billion. That can purchase an awful lot of stock.

(6) Hedge clause. As noted in our hedge clause, the above discussion “should not be construed as recommendations to buy, sell, or hold any security.” In addition, as we’ve noted before, we aren’t preachers: We don’t make judgments on good vs evil. As investment strategists, we do bullish vs bearish. We remain bullish on the US stock market, and expect that the FANG stocks will continue to participate in the rally, though they might be laggards for a change given some of the challenges discussed above. That would be a healthy development for the stock market, in our opinion.

Tech II: AR Gets Real. Fantasy and reality just moved one step closer. The opening ceremony for the League of Legends (LOL) 2018 World Championship in South Korea combined augmented reality (AR) characters and real human singers in a performance that left you wondering just how the magic was made.

A little background for those readers who aren’t 13-18 years old: LOL is the world’s most popular video game. It’s a multi-player online battle arena played on personal computers and was created by Riot Games, a video game company owned by Tencent. Peak viewership at this year’s world championships was 205.3 million people, more than 200 million of whom were in China.

Riot introduced four new female characters who are part of a fictional K-pop band, K/DA. These characters each have names, personalities, and backgrounds laid out on the LOL website. They also have an animated hit song and video, “Pop/Stars,” that has had more than 19 million views on YouTube since its released on November 3.

The fictional band’s AR appearance at the LOL World Championships’ opening ceremony last week has the Internet buzzing. On stage were the real humans singing the hit song. But those watching the jumbotrons or watching the event from home saw both the humans and the AR characters performing on stage together.

Riot has produced original music in the past, and it had a AR dragon flying around the stadium at last year’s World Championship, reported an 11/5 article on The Verge.

By merging AR and reality, Riot’s opening ceremony production this year gives us a peak into the future. The AR characters have tails and wings, making them easy to distinguish. But it might not be long before the distinction between AR and humans gets tougher to make.

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Europe Splintering

November 07, 2018 (Wednesday)

Germany I: Auf Wiedersehen, Madam Chancellor. Embattled German Chancellor Angela Merkel stunned the world by announcing she would relinquish her role as leader of the ruling Christian Democratic Union (CDU) in December. She dropped her bombshell on October 29, the day after the party she has led for 18 years suffered its worst showing ever in the Hesse regional election. Germans had dubbed the Hesse vote a “schicksalswahl,” or vote of destiny, according to a 10/28 BBC News article. It certainly sealed the fate of the party’s 64-year-old leader.

The end of the Merkel era has been unfolding for the past year. A general election in September 2017 resulted in no clear majority for any party, and it took six months for Merkel to form the most tenuous of coalitions. She has been battling competing forces and opposition within her own cabinet and had to make major concessions to persuade the SPD to form a coalition government, as we pointed out in the 3/7 and 6/25 Morning Briefings.

While it was a surprise that she conceded defeat, it is hardly surprising that her time is up. Her biggest political mistake was allowing more than a million asylum seekers, mostly Syrian refugees escaping civil war, into Germany in 2015. The move created a huge backlash, rending a rift within the ranks of her conservative party. Moreover, it provoked President Trump to lob an unprecedented personal attack on an ally by a US President when he taunted her in a tweet over her immigration policy.

The backdrop for the shifting and uncertain German political scene includes a sputtering economy, a Eurozone that’s splintering over immigration and fiscal responsibility, and the effects of a global trade war. The German stock market has been steadily declining since May and is now off 14.7% y/y and down 11.0% ytd, making it the worst performing of the core European financial markets (Fig. 1). The euro weakened in the wake of the news and recently traded at €1.14 per US dollar (Fig. 2).

I asked Sandra Ward, our contributing editor, to take a closer look at the ramifications of Merkel’s decision and what it means for Germany and the EU:

(1) A miracle. In giving up her party’s leadership, Merkel also said she hoped to remain chancellor until 2021. The chances of that happening are considered slim: It’s highly unusual in German politics to split the roles, noted an 11/4 WSJ article. It explained that in the rare cases in which the roles have been split, the chancellor’s power has been undercut by power battles. Merkel herself, who has been chancellor since 2005, has long made the case for linking the positions. Former Defense Minister Karl-Theodor zu Guttenberg told the WSJ that he thought it would be “a miracle” if Merkel were to stay on as chancellor. He also thought it unlikely that the fragile governing coalition with the Social Democrats (SPD) would survive.

(2) Collateral damage. The SPD took a beating in the Hesse election along with its coalition partner CDU as gains by the Greens and the far-right Alternative for Germany (AfD) eroded support for the governing parties. Hesse was a replay of elections in Bavaria a few weeks earlier when the Christian Social Union, a conservative sister party to Merkel’s CDU, and the SPD saw their support dwindle in favor of the Greens and AfD. Many in the SPD blame their party’s woes on the alliance with Merkel’s conservative CDU, observed a 10/28 BBC article. The threat is the SPD could withdraw from the coalition and bring down the government.

Commenting on the outcome of the Hesse vote, SPD leader Andrea Nahles said the state of the government was “unacceptable,” according to the report, and cautioned that it would be reviewing whether the coalition with the CDU “is still the right place for us.”

(3) Three candidates. Immediately following Merkel’s announcement, three contenders surfaced to succeed her at the CDU annual convention on December 7 and 8. Friedrich Merz, a 62-year-old lawyer who is supervisory board chairman of Blackrock’s German asset management unit, is a longtime adversary of Merkel’s since she emerged victorious in a leadership power struggle against him 16 years ago, according to a 10/30 Bloomberg story. The pro-business Merz has declared himself a “convinced European and trans-Atlanticist” and aims to return the CDU to its social conservative roots.

Another candidate, Health Minister Jens Spahn, 38, is known for his criticism of Merkel’s open-border migration policy, his advocacy of banning burkas, and his emphasis on law and order.

Lastly, 56-year-old Annegret Kramp-Karrenbauer, a Merkel protégé handpicked to serve as secretary-general of the CDU, is making a bid. Known as “AKK” and nicknamed “mini-Merkel” by the press, she was the chief minister of Saarland from 2011 to 2018, the first woman to hold the post and the fourth to lead a state government. A win by AKK in December is seen as Merkel’s best chance at remaining chancellor, according to the 11/4 WSJ article. Polls by Handelsblatt Daily and Spiegel Online put Merz as the frontrunner, with AKK coming in second and Spahn a distant third, according to a 10/31 piece in the Guardian.

(4) EU reform. Kanzlerin dämmerung, the twilight of Chancellor Merkel, the EU’s longest-serving leader, leaves French President Emmanuel Macron as the lone champion of reform and greater integration amid a sea of populism across the Eurozone, explains an 11/3 report in the Daily Express. His divisive style may make it difficult for Macron to achieve his goals. He is the last pro-EU leader standing at a time when his approval ratings are ebbing, his labor reforms have proved unpopular, unemployment is rising, and economic growth is slowing, according to a 10/28 piece in the Guardian.

The EU’s Parliamentary elections in May should prove pivotal in determining who will lead Europe, especially as Italy’s Matteo Salvini and France’s Marine Le Pen have said they will fight against the EU in its current form and campaign for a “Europe of nations, a 10/16 story in Spiegel Online reported. The UK can be counted on to continue to dither over its Brexit strategy.

Germany II: Achtung, Baby. The changing of the guard is coming amid a slowdown in German economic growth and more pessimistic business expectations (Fig. 3). Consider some recent data:

(1) Manufacturing PMI. Growth in the manufacturing sector was the weakest in two and a half years in October, according to an 11/2 release of an IHS Markit/BME Germany Manufacturing survey. Order books fell for the first time since late 2014. Auto industry emission-standards issues and a drop-off in demand from international clients were blamed for the poor showing. Worse, production is expected to fall over the next 12 months, the first negative outlook among manufacturers in four years.

The headline IHS Markit/BME Germany Manufacturing PMI fell in October for the third straight month, to 52.2 from 53.7 in September. Export sales fell for the second straight month. Facing the sharpest drop in new export business in five years, manufacturers curtailed their purchasing activity for the first time since early 2015.

(2) Business sentiment. Confidence among business owners weakened in October, to a reading of 102.8 on the ifo Business Climate Index, down from 103.7 in September. Manufacturers’ business outlook sank to its lowest level since March 2017 (Fig. 4). A bright spot: Optimism in the construction industry hit another record high (Fig. 5).

(3) Inflation. Consumer prices spiked in October at the fastest rate in six years, rising 2.4% y/y on soaring energy prices, according to data released by Germany’s national statistics agency, Destatis (Fig. 6).

(4) Consumer confidence. Consumer confidence remained steady in November, with GfK’s latest Consumer Climate Indicator unchanged at 10.6. Consumers’ willingness to make purchases increased to 55.9 from 52.9, buoyed by strong labor markets and a sense of job security. However, economic and income expectations weakened slightly on ongoing global trade uncertainty, but remain at relatively high levels (Fig. 7).

(5) Valuation. The MSCI Germany share price index has fallen 12.1% ytd (in euros), compared with a drop of 7.8% in the MSCI EMU index and a gain of 2.4% in the US, through Monday (Fig. 8). MSCI Germany’s forward P/E of 11.4 is near the lowest levels of the past five years, but that’s not surprising with NERI (our Net Earnings Revisions Index) solidly negative since mid-2017 and down to a 29-month low in October (Fig. 9 and Fig. 10).

The end of the Merkel era brings a new era of uncertainty to Germany, and markets hate uncertainty.

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All About Inflation

November 06, 2018 (Tuesday)

Inflation I: The Long View. Now that the unemployment rate is back down near or below previous cyclical lows, there is mounting concern that price inflation will soon make a comeback. That concern undoubtedly was heightened by Friday’s payroll employment report showing that October’s wage inflation rose to 3.1% y/y, the highest since April 2009 (Fig. 1). That’s based on the average hourly earnings series for all workers, a series starting in 2006. It is up 3.2% for production and nonsupervisory workers (P&NSW), which starts in 1964.

Is the Phillips curve finally starting to work? Apparently so, but Debbie and I believe that the tight labor market may be boosting productivity growth, which would allow wages to increase without boosting price inflation. Consider the following:

(1) The wage curve. The Phillips wage curve, which posits an inverse relationship between the unemployment rate and wage inflation, may finally be making a long-awaited comeback now that the unemployment rate is the lowest since December 1969 (Fig. 2). The comeback is even more impressive using the short-term unemployment rate (for joblessness under 27 weeks), which fell last month to 2.9%, the lowest since the early 1950s (Fig. 3). The wage inflation rate for P&NSW is up from 2.2% a year ago to 3.2% last month.

(2) The price curve. On the other hand, the Phillips price curve remains broken. Price inflation is still missing in action. The core PCED rose 2.0% y/y during September (Fig. 4). Actually, this measure of inflation has been remarkably subdued for a very long time. Since the start of 1995, it has ranged between 0.9% and 2.5%. Over that same period, P&NSW wage inflation ranged between 1.2% and 4.3% (Fig. 5).

(3) The markup curve. The popular notion that wage costs are marked up into prices hasn’t been happening since at least the mid-1990s. Debbie and I attribute that to a number of developments. Labor unions (with their union contracts including automatic cost-of-living adjustments) lost their power starting in the 1980s. Globalization increased worldwide competition (first from Germany and Japan, then from China and other emerging economies), which continues to keep a lid on inflation. In addition, the high-tech revolution of the 1990s continues to disrupt business models while providing productivity-enhancing innovations. Aging demographic trends around the world are also inherently disinflationary, in our opinion.

Inflation II: The Global View. These disinflationary forces are global in nature. As a result, inflation remains subdued around the world. Consider the following:

(1) G7. The core CPI inflation rate for the G7 industrial economies has been low for a long while as well, hovering between 0.6% and 2.3% since 1997 (Fig. 6).

(2) Eurozone and Japan. The core CPI inflation rate in the Eurozone was just 1.1% during October, according to the flash estimate (Fig. 7). It’s been under 2.0% since January 2003. Japan’s core CPI inflation rate was just 0.1% during September (Fig. 8). It has been mostly hovering between zero and minus 1.5% since 1999!

(3) The world. The International Monetary Fund compiles CPI inflation rates for the advanced and emerging economies (Fig. 9). The former has been hovering around 2.0% since the late 1980s, and was 2.0% y/y during July, the latest available data. The latter has been much higher over this period. However, it fell to 3.8% y/y during April and May (near its record low of 3.6%, recorded in early 1969), before accelerating to 5.1% and 5.4%, respectively, in June and July—still relatively low levels.

Inflation III: Made in the USA. During their Q3 earnings conference calls, many company managements reported that they are experiencing inflationary cost pressures. Almost everyone agrees that the labor market is tight. Yet the latest macro data show that employment increased during October by 227,000, 250,000, and 600,000 according to the ADP, payroll, and household surveys. Furthermore, the labor force participation rate of prime-age workers (25-54 years old) rose to a cyclical high last month (Fig. 10).

Many company managements also have warned that tariffs are driving their materials costs higher, and that they may have to spend more on rerouting their supply chains if the trade war with China continues to escalate. The recent drop in oil prices might be sustainable given recent stories that Saudi Arabia, Russia, and the US are pumping oil at record rates and that global demand for oil is weakening along with the global economy. If so, cheaper oil should help to offset some of the other cost pressures.

While global forces on balance remain disinflationary, in our opinion, what about homegrown inflationary pressures? Consider the following:

(1) Goods vs services. Like the core PCED inflation rate, the core CPI inflation rate has also been remarkably subdued since 1995 (Fig. 11). The latter was 2.2% during September even as P&NSW wage inflation rose to 3.2% last month. Leading the way was wage inflation in goods-producing industries, which rose to 3.8%. Yet the inflation rate for CPI goods excluding food and energy remains just below zero, as it has since 2013. Global competition and technological innovation are keeping a lid on goods inflation. So is the Amazonification of retail sales, as consumers find the lowest prices on shopping websites.

Wage inflation in services-producing industries rose to 3.1% last month, up from 2.1% a year ago. The CPI services ex-energy inflation rate was 3.0% during September, continuing to hover around this pace since 2015. Two of the major components of services inflation are rent of shelter and healthcare, which could offset each other in the next few years.

(2) Rent. There has been an interesting inverse relationship between the unemployment rate and the inflation rate of the CPI’s rent of shelter component (Fig. 12). It accounts for 40.0% of the core CPI and 17.8% of the core PCED.

Rent inflation has actually been looking toppy over the past couple of years even though more people are finding jobs and getting better wage increases, which should be boosting housing demand and rents. However, a lot of demand in recent years has been for rental units, which has stimulated a building boom in multifamily housing construction. In other words, supply may be catching up with demand. If so, then rental inflation could ease a bit over the next few years. That has already been happening to the CPI tenant rent inflation rate, which was down to 3.6% during September from a recent peak of 3.9% at the start of 2017 (Fig. 13).

Inflation IV: Unhealthy Inflation? One of the hardest-to-predict components of both the core CPI and core PCED is healthcare, which accounts for 10.9% of the former and 23.3% of the latter. The CPI component is limited to out-of-pocket expenditures by consumers, while the PCED also reflects payments made by government programs, i.e., Medicaid and Medicare.

During September, medical care inflation was 1.7% y/y for both measures (Fig. 14). In the past, the CPI medical care inflation rate usually exceeded the comparable PCED measure, as government programs restrained inflation in the hospitals and physician services components of the PCED relative to the CPI. Inflation for drug prices tends to be the same for both measures.

The above suggests that even excluding the moderating effect of government programs on healthcare pricing, inflationary pressures remain subdued in this important sector of the economy. That’s a bit surprising given the aging of the Baby Boomers, who started turning 65 years old in 2011. It also is at odds with rapidly increasing healthcare insurance premiums, which account for only 1.3% of the core CPI and 1.5% of the core PCED.

At a recent meeting I had in Kansas, one of our accounts expressed concern about healthcare inflation, citing news that Medicare and Medicaid reimbursements were just increased for next year. I asked Melissa to have a look. She found that only Medicare Advantage Plans (MAP) reimbursement rates were raised, not those for Original Medicare or Medicaid. For 2019, MAP reimbursement rates will be increased 3.4%, according to Deloitte.

In 2017, one-third of the 57 million people on Medicare were enrolled in a MAP. So the inflationary effects of MAP rates are not the whole story when it comes to rising federal healthcare costs, though they are a significant part.

What about the Original Medicare rates that apply to the other two-thirds of people on Medicare? These are fee-for-service rates that vary by (highly specific) type of services rendered. Admittedly, we aren’t healthcare experts. In short order, we couldn’t find anything on 2019 across-the-board rate increases that would apply to Original Medicare.

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Relief Rally #62?

November 05, 2018 (Monday)

Strategy: Betting on Santa. Stock investors had lots of background worries come to center stage during October. As a result, the S&P 500 dropped 9.9% from 2930.75 on September 20 to 2641.25 through October 29 (Fig. 1). That was just shy of a 10% correction. However, it still counts as Panic Attack #62 as Joe and I have been tracking these events since the start of the bull market. (See our S&P 500 Panic Attacks Since 2009.)

The index is up 3.1% since October’s low through Friday’s close. Is this the beginning of Relief Rally #62, which will take the S&P 500 to new record highs as previous relief rallies have done? We think so. However, we did curb our enthusiasm in last Tuesday’s Morning Briefing titled “Lowering Our Targets.” We reduced our year-end target for the S&P 500 from 3100 to 2900—a rebound to the 9/20 record high. Next year could be a more challenging one for the S&P 500 if revenues growth slows and the profit margin stops rising, as we expect. So we are using 3100 as our target for next year. But our confidence in the staying power of the economic expansion is reflected in our 3500 target for 2020. That would be a 28.5% increase from Friday’s close.

With the benefit of hindsight, there were two major triggers of October’s selloff:

(1) The Fed. On October 3, Fed Chairman Jerome Powell said in an interview: “So interest rates are still accommodative but we're gradually moving to a place where they will be neutral, not that they'll be a restraint on the economy. We may go past neutral but we're a long way from neutral at this point, probably.” That meant that while Trump’s fiscal policy (i.e., deregulation and tax cuts) was akin to stepping on the economy’s accelerator, Powell’s monetary policy was moving toward tapping on the brakes more forcefully than had been anticipated by the financial markets. That seemed to trigger the October stock market drop (Fig. 2).

(2) China. In the Monday 10/1 Morning Briefing titled “China’s Syndromes,” I wrote: “The Trump administration’s overarching policy goal vis-à-vis China, therefore, may be first and foremost to use America’s economic power to slow, or even halt, the ascent of China into a superpower, which will challenge America’s interests around the world. If so, then any concessions that the Chinese make on trade and technology are likely to be rejected by the Trump administration. In other words, they have nothing to offer that would satisfy Trump other than an unconditional retreat from their geopolitical expansion plans, which they will never do voluntarily.”

Only three days later (and one day after the Powell interview), in a blistering 10/4 speech, Vice President Mike Pence berated China for using “an arsenal of policies inconsistent with free and fair trade, including tariffs, quotas, currency manipulation, forced technology transfer, intellectual property theft, and industrial subsidies that are handed out like candy to foreign investment.” He included an attack on China’s hostile policies abroad and human rights abuses at home.

Pence’s speech raised the risks of a protracted US trade war with China aimed at forcing manufacturers to move out of China. The potential disruptive impact on supply chains and the possible loss of sales in China were mentioned by some company managements during their Q3 conference calls last month.

(3) Santa. These two issues aren’t going away anytime soon. After Friday’s remarkably strong employment report, Fed officials are likely to continue raising the federal funds rate toward 3.00%—the level they deem to be “neutral” in terms of economic impact—through next year. More of them might talk about possibly moving higher to “restrictive” levels, with the R-word mentioned twice in the September 25-26 FOMC meeting minutes. Stock prices zig-zagged on Friday, moving higher on scuttlebutt (originating from President Trump) that a trade deal with China was in the works, only to fall on denials from unnamed White House sources.

So what might fuel last week’s relief rally through year-end? Getting the mid-terms over with might be a plus, removing that source of uncertainty. To quote Randy Forsyth in his Barron’s column this week: “According to data compiled by Yardeni Research, the S&P 500 has been up in the 12 months following every midterm election since the middle of the last century, with gains from 1.1% in the post-1986 vote stretch (which included the October 19, 1987, crash) to 33.2% in the year after the 1954 election” (Fig. 3).

More fundamentally, the most recent batch of economic indicators shows that the near-term economic outlook remains strong. Improving wage gains and record-high employment should result in one of the best holiday seasons on record for retailers.

Furthermore, while corporate earnings have been boosted this year, mostly by the tax cut at the end of last year, corporate revenues growth has also been remarkably strong. The growth rate of S&P 500 revenues per share on a y/y basis was 11.2% during Q2, the highest pace since Q2-2011 (Fig. 4). This series is highly correlated with the US M-PMI, which during October remained near the cyclical highs of the past year or so. This explains why S&P 500 forward revenues continued to climb into record-high territory through the 10/25 week, rising 9.9% y/y (Fig. 5). That gave forward earnings, which rose 22.5% y/y, an additional lift besides the tax cuts, which accounted for most, if not all, of the remaining 12.6% boost (Fig. 6).

This year, let’s hope that the Grinches in the White House and the Fed don’t trip up Santa and ruin the holidays for investors. We are betting on Santa. If we are right to do so, that would be a big relief.

US Economy: Better than Goldilocks. The latest batch of economic news well exceeded even Goldilocks’ exacting standards. She likes her porridge not too hot and not too cold. Of course, most of us like a hot meal followed by a cold dessert.

The labor market is hot, with wages rising at a faster pace. However, productivity gains are hot too, and cooling the inflationary consequences of this development while at the same time boosting GDP growth. Supply-siders should be rightly pleased, even proud, since they can take some credit for this happy combination of hot growth with cool inflationary pressures. Consider the following cornucopia of good news as we approach the holiday season:

(1) Better than GDP. The quarterly productivity and labor costs for nonfarm business (NFB) report was released last Thursday. It was a beauty! The growth rates of real NFB output and real GDP are highly correlated on a y/y basis (Fig. 7). The former rose 3.7% during Q3, outpacing the 3.0% gain of the latter. The increase in real NFB output was led by a solid 2.4% increase in hours worked and a relatively weak gain of 1.3% in productivity. However, the q/q growth rates in productivity are promising, with solid gains of 3.0% (saar) during Q2 and 2.2% during Q3 (Fig. 8).

(2) Unit labor cost pressures remain moderate. Also encouraging is that the y/y growth rate of NFB unit labor costs has been moderating over the past four quarters, from 2.5% to 1.5% (Fig. 9).

Granted, wage “inflation” has picked up lately. However, wage gains offset by productivity gains are not inflationary. Debbie and I believe that some of the upward pressure on wages resulting from the tight labor market is forcing companies to increase productivity. That’s allowing wages to rise faster than prices, resulting in real pay increases, which boost economic growth without heating up inflation. That’s better than a Goldilocks scenario.

Here is a quick roundup of the major compensation measures on a y/y basis: Average hourly earnings all workers (3.1% through October), Average Hourly Earnings Production & Nonsupervisory Workers (3.2%, also through October), Employment Cost Index (ECI) (2.9% through Q3), and NFB hourly compensation including benefits (2.8% though Q3). The first data series doesn’t start until 2006, and the last one tends to be too noisy, so we focus on the second and third measures (Fig. 10).

Both are showing signs that the Phillips curve is finally starting to work. So the labor market has finally tightened enough to boost wage inflation, which should then boost price inflation.

Hold on: We beg to differ with this conventional wisdom. A good measure of unit labor costs is the ratio of private-sector ECI (including wages, salaries, and benefits) to NFB productivity. The y/y growth rate of this series was just 1.6% during Q3 (Fig. 11). It’s actually been hovering around this rate since 2011, and even since the mid-1990s excluding the volatile moves around the Great Recession.

In other words, this measure of unit labor costs is showing that productivity gains have been and continue to offset (and to justify) a significant portion of compensation gains. That certainly helps to explain why the core PCED inflation rate has stayed within a low range between 0.9% and 2.5% since 1995!

The result has been that average hourly earnings divided by the headline PCED rose to a record high during September. This series has been on an upward trend since the start of 1995—rising 30% over this period (Fig. 12). The widespread notion that real wages have been stagnating for the past couple of decades is just dead wrong!

(3) No shortage of workers. Another widespread and erroneous notion is that we are running out of workers because the unemployment rate is so low. The labor force jumped 711,000 during October, and 2.04 million ytd. It may be harder to fill jobs right away, yet 250,000 positions were filled on balance during October and 2.13 million ytd. That’s based on the payroll employment survey. The household survey showed a gain of 600,000 during October, and 2.54 million ytd.

By the way, payroll employment in the trucking industry rose during October to a record high with a m/m gain of 2,400 and a y/y gain of 36,600. So even the industry that purportedly has the worst trouble finding labor is finding truck drivers after all.

(4) Full employment at record high. Full-time employment rose to yet another record high during October. Not widely reported is that the 3.7% unemployment rate can be disaggregated into the short-term rate at 2.9% and the long-term rate at 0.8% (Fig. 13). The former reflects unemployment for less than 27 weeks. It is the lowest since the early 1950s!

Credit: Bad News for Bonds. Bond yields rose sharply after Friday’s employment report. When the stock market dropped during October, the 10-year Treasury bond yield dipped from a high of 3.23% on October 5 to a low of 3.08% on October 29 (Fig. 14). It was back up to 3.22% on Friday on expectations that the Fed remains on course for another rate hike at the December 18-19 FOMC meeting, with three to four additional hikes next year.

Interestingly, the recent backup in the 10-year yield was led by the TIPS yield, while the expected inflation component declined (Fig. 15). We aren’t sure how to read that odd combination. But it is unsettling to see that the bond yield can go up as a result of its TIPS component reacting badly to good news on the economy even as actual and expected inflation rates remain subdued.

While we still believe that the US bond yield is being held down to a certain extent by near-zero yields for comparable bonds in Germany and Japan, more chattering by Fed officials suggesting that the FOMC needs to consider going beyond neutral to restrictive monetary policy could push the bond yield as high as 4.00%. In this scenario, the TIPS yield would normalize to 2.00%, which is where it was during the four years prior to the 2007-2008 financial crisis, and the expected inflation component would remain around 2.00%.

The question is: Will Fed officials chill out about strong growth if price inflation remains subdued? We don’t have a good answer, but we still expect that the 10-year yield should remain in a range of 3.00%-3.50% through the middle of next year. That’s mostly because we believe that price inflation will remain subdued as productivity gains offset wage gains.

Movie. “Bohemian Rhapsody” (+ + +) (link) is an extremely interesting and entertaining biopic about the rock band Queen and its lead singer Freddie Mercury, brilliantly played by Rami Malek. Freddie was a musical genius, and Queen is renowned for such great classic rock hits of the 1970s and 1980s as “We Will Rock You,” “Another One Bites the Dust,” and “We Are the Champions.” The movie has been criticized for not doing full justice to Freddie’s amazing story and legacy because the musical rights were owned by two of the surviving band members, who made sure they were properly depicted. Freddie tragically died of AIDS at the age of only 45. He certainly lives on in the incredible music he helped to create.

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FANG Bite

November 01, 2018 (Thursday)

Technology I: De-FANG-ed? Given that the S&P 500 has dropped 7.5% since the market’s peak on September 20, it’s fitting that the stocks of aspirin sellers would be soaring: The S&P 500 Drug Retail industry, home of the drug stores, is the top-performing industry since the market peak; it has returned 9.4% over that span, nearly as much as the S&P 500 has relinquished.

Certainly, anyone owning FANG stocks has a big headache from October’s stock swoon. The FANGs’ market value has fallen 11.8%, or $281 billion, from the S&P 500 peak on September 20 through yesterday’s Halloween close. Each of its constituents contributed to the pain, having fallen as follows: Facebook (-8.5%), Amazon (-17.8), Netflix (-17.4), and Alphabet (-9.3), parent of Google (Fig. 1). But even those poor performances understate the damage each of the stocks has suffered individually since they hit their respective highest levels of the year.

Facebook’s stock has had the worst performance, falling 30.2% from its July 25 peak through yesterday’s close thanks to the difficulties and costs involved with trying to stamp out fake news on the platform. Not far behind it are the drops in the shares of Netflix (down 28.0% since July 9), Amazon (down 21.6% since September 4), and Google (down 15.1% since July 26). Let’s take a look at what has taken a bite out of these stock prices:

(1) Policing social media. Facebook shares have been hit hard as the massive cost of ridding fake news and hateful groups from social media becomes clear. The issue rose to national attention when it was discovered that foreign organizations had put fake news on Facebook pages to sway the electorate during the 2016 presidential election campaign. Angst about the problem only grew last spring as CEO Mark Zuckerberg’s testimony before governing bodies in the US and Europe made it clear the company did not have its hands around the problem.

This week, investors received a stark reminder of just how expensive combating this problem will be. Facebook’s revenues climbed 32.9% y/y in Q3, but the company’s expenses grew even faster: 52.6%. And the company warned that expenses will continue to grow 40%-50% y/y in 2019. While no numbers were given, Zuckerberg did say on the company’s 10/30 conference call: “[T]he last few years and next year are probably going to be the biggest growth in the investment in the security efforts that we will see.”

Despite the elevated expenses, Facebook’s Q3 results beat Wall Street’s estimates. Earnings of $1.76 a share, up 10.7% y/y, came in above analysts’ target of $1.46. The shares rose 3.8% yesterday.

(2) Defending privacy. A push to improve consumer privacy on the Internet also looks like it will be costly for Internet companies like Google and Facebook. Those fears were inflamed by news in September 2017 that security at credit reporting agency Equifax was breached, compromising the personal information of millions of US Internet users.

The European Union (EU) first acted to safeguard personal data privacy by passing the General Data Protection Regulation (GDPR), which went into effect in May. The privacy law “restricts how personal data is collected and handled. … [It] focuses on ensuring that users know, understand, and consent to the data collected about them,” according to a 3/19 article in Wired.

It continued: “Under GDPR, pages of fine print won’t suffice. Neither will forcing users to click yes in order to sign up. Instead, companies must be clear and concise about their collection and use of personal data like full name, home address, location data, IP address, or the identifier that tracks web and app use on smartphones. Companies have to spell out why the data is being collected and whether it will be used to create profiles of people’s actions and habits. Moreover, consumers will gain the right to access data companies store about them, the right to correct inaccurate information, and the right to limit the use of decisions made by algorithms, among others.”

The GDPR rules are far-reaching. They cover EU residents even if the data are processed outside of the EU. Google and Facebook have made changes to their policies globally because it is simpler to have one system, the Wired article contends. Violators face fines of up to 4% of annual global revenue or 20 million euros, whichever is higher.

The US government is getting in on the act. The US Commerce Department is “seeking comments on how to set nationwide data privacy rules” a 9/25 Reuters article reported. Also, Congress and the Trump administration have held meetings on the subject, and California has enacted privacy legislation.

(3) The taxman cometh. European policymakers are developing rules that would tax the revenues tech companies generate in the EU. “Calls to tax big tech have been fueled by the relatively small amounts paid in Europe by tech companies, some of which route profits to low-tax countries in the region. Tech companies fear the rules could set a precedent that would be followed by governments elsewhere,” a 10/30 CNN article reported. French President Emmanuel Macron supports a European Commission plan for a 3% tax on sales of certain online services, which could be in place by 2020.

The UK may beat the EU to the punch. UK Treasury Chief Philip Hammond said Monday the country will implement a 2% tax on the sales of digital services starting in April 2020. The tax will apply to profitable companies with global revenues of at least 500 million pounds, a 10/29 CNN Business article stated. Facebook, Google, and Amazon reportedly will be affected, and the UK expects to raise about 400 million pounds a year in tax revenue.

(4) Law of large numbers. The FANG giants may be entering middle age—a period of growth, but at a slower pace than they enjoyed in their youth. Facebook’s daily active users grew 1.6% q/q, down from the 4% and 5% rates enjoyed in years past. Amazon projected 10%-20% sales growth in Q4, which is fabulous for most retailers but far below the 30% growth in Q4 last year.

Netflix is perhaps the most youthful of the FANG crowd. It surprised investors by continuing its strong subscriber growth in Q3: 5.4% q/q. Google’s Q3 earnings beat expectations, but its revenues missed despite 21% y/y growth.

(5) A game of expectations. With FANG shares falling into bear market territory last month, it’s fair to wonder whether all the bad news is priced into the stocks. FANG shares sport a forward P/E of 46.8, down from 60.0 at the start of the year (Fig. 2). The FANG average forward P/E is lifted by Netflix (76.0) and Amazon (66.0) and depressed by the 23.5 forward P/E of Google and 18.0 multiple of Facebook (Fig. 3, Fig. 4, Fig. 5, and Fig. 6).

The FANG shares have historically traded with a forward P/E closer to 60 times, dropping below 50 briefly in 2016. But the world may have irrevocably changed for the shepherds of digital data. It’s certainly possible that the harsher operating environment they now face, with new rules and taxation, will prevent P/E expansion. If we had to guess, the market still needs to adjust to the bite a revenue tax will take out of tech company profits because it wasn’t discussed in Facebook’s earnings conference call.

Over the past three months, analysts have trimmed Facebook’s 2018 earnings-per-share estimate by three cents to $7.11, and its 2019 estimate by 11 cents to $8.08. Netflix earnings were trimmed over the past three months to $2.63 a share this year, down seven cents, and $4.13 next year, down 28 cents.

Google’s 2018 earnings-per-share estimates have improved over the last three months to $41.76, up $1.48, but 2019 targets fell slightly to $47.41, down from $47.91 three months ago. And Amazon’s 2018 earnings estimates have improved, jumping to $19.66 this year, up $2.58 from three months ago, and next year’s earnings target stands at $26.81, up from $25.29 three months ago.

Technology II: Semis Recharging? After their terrible losses earlier in October, we were glad to see that semiconductor stocks were among the leaders in the market rally of the past two days. The S&P 500 Semiconductors stock price index and the S&P 500 Semiconductor Equipment stock price index each added 5.6%, sharply outpacing the 2.7% gain in the S&P 500.

Granted, two consecutive days of big gains do not make a trend. Those indexes are still laggards, with Semiconductors experiencing a small drop of 1.8% and Semiconductor Equipment seeing a big loss of 28.0% ytd (Fig. 7 and Fig. 8). But the rally of the past two days was a nice start, especially since it wasn’t prompted by good news. The latest batch of earnings was mostly disappointing, with the exception of Intel’s report last week. Thanks to a surge in demand for personal computers, the company reported a 42% jump in earnings, and its Q4 guidance was above analysts’ estimates, a 10/25 WSJ article reported.

Analysts have steadily been raising their earnings estimates for the S&P 500 Semiconductors industry over the past two years (Fig. 9). Conversely, they’ve been sharply cutting estimates for the S&P 500 Semiconductor Equipment industry over the past five months (Fig. 10). As a result, the Semiconductors industry now is expected to grow revenues 3.2% and earnings 1.8% next year, while the Semiconductor Equipment industry experiences declines in both, with revenues falling 3.9% and earnings down 8.9% next year (Fig. 11, Fig. 12, Fig. 13, and Fig. 14).

Bulls can take heart in the Semiconductor Industry Association’s (SIA) report that shows worldwide semiconductor sales in September grew 13.8% y/y and 2.0% m/m, according to the SIA’s press release. The y/y sales growth was a modest deceleration from earlier this year when growth topped 20%. However, total revenue generated has continued to climb to record highs.

Technology III: Material Made from Spinach Grows & Eats CO2. Scientists at MIT have invented a new material that can grow when exposed to sunlight. It’s a synthetic gel that uses the chloroplasts from spinach leaves to capture carbon from CO2 in the air, according to a 10/11 MIT News article. In the future, the chloroplasts will be replaced by nonbiological catalysts.

“The material might, for example, be made into panels of a lightweight matrix that could be shipped to a construction site, where they would harden and solidify just from exposure to air and sunlight, thereby saving on the energy and cost of transportation,” the article explains.

The material also repairs itself when exposed to sunlight or indoor lighting. So if it was scratched or cracked, the material could grow on its own to fill in the void.

And finally, the material’s ability to take carbon dioxide out of the air would benefit the environment. “Our work shows that carbon dioxide need not be purely a burden and a cost,” says Professor Michael Strano in the article. “Making a material that can access the abundant carbon all around us is a significant opportunity for materials science. In this way, our work is about making materials that are not just carbon neutral, but carbon negative.”

The article does not say how one stops this material from growing—which conjures up spooky images from the movie “The Blob” (1958) starring a young Steve McQueen.

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Consumers Getting Older

October 31, 2018 (Wednesday)

Global Economy: Elderly-Led Slowdown. Industrial conglomerate 3M reported disappointing Q3 results on October 23. The company missed analysts’ estimates for Q3, and management lowered full-year growth and earnings estimates. The company’s stock price is widely viewed as an indicator of not only the US economy but also the global economy. If so, then it is signaling tough times ahead globally. It started doing so when it peaked on January 26 (Fig. 1). It is down 28% since then through Monday’s close, and down 21% y/y, the lowest such comparison since May 2009.

After last week’s clunker, one of the most widely distributed finance-related charts on the Internet showed the y/y percent change in 3M’s stock price versus the manufacturing purchasing managers index (M-PMI) (Fig. 2). There’s a reasonably close correlation between the cycles of these two variables. So it is obviously an alarming chart. A similar chart replacing the US M-PMI with the global M-PMI is also unsettling (Fig. 3). The same can be said of a chart showing 3M’s stock price versus the Eurozone’s M-PMI, which has been weakening all year (Fig. 4).

Joe and I aren’t convinced that 3M is a perfect barometer for domestic and global manufacturing. The company has its own issues that may not reflect widespread problems for the economy. However, there is no getting around the fact that the global economy is slowing.

The question is: Is it all Trump’s fault? Another question: Is the problem cyclical or structural? Debbie and I don’t believe that it is Trump’s fault. It’s easy to blame him for starting a trade war earlier this year with most of America’s major trading partners. But US negotiations with both Mexico and Canada occurred rapidly and successfully. Negotiations are underway with the European Union, without any significant actions or threats to disrupt our trading relationships.

The major trade confrontation is with China, which may be slowing as a result of tit-for-tat tariffs, with more probably to come. China’s slowdown may actually have more to do with slowing consumer spending as a result of the country’s rapidly aging population, which seems to be an increasingly widespread global problem. Consider the following:

(1) China. I have previously discussed the significant slowdown in the growth rate of real retail sales in China in recent years and especially over the past year (Fig. 5 and Fig. 6). Thanks to the government’s one-child policy, which was imposed during 1979 and terminated during 2015, most young adults have no siblings and two old parents to support. If they get married, the couple will be burdened with four old parents. In China, children are still expected to take care of their elderly parents, since public support programs are very limited.

(2) Europe. Europe also has a problem with a rapidly aging population. European governments have very generous support programs for their senior citizens. But that means that public funds are increasingly being used to support these social security programs rather than to repair and build new infrastructure. The consequences of that were plain to see in the disastrous bridge collapse in Italy on August 14.

Italy’s new populist government is proposing to reduce Italy’s retirement age to 62 (from 66.7 currently for men and 65.7 for women) for those who have paid their contributions for at least 38 years. The goal is to pump new blood into its workforce, but Tito Boeri, president of the Istituto Nazionale Previdenza Sociale, told parliament the move will increase the retirement system’s debt by “about 100 billion euros.”

(3) Brazil. Another example of the burden that aging demographics and pensions are putting on growth is Brazil. The AP reported yesterday: “Brazil’s President-elect Jair Bolsonaro signaled Monday his administration would make tackling the country’s budget-crushing pension system a top priority, doubling down on a campaign promise that made him the choice of the business community despite frequently saying he doesn’t understand the economy. … Attempts to reform the bloated pension system have failed repeatedly and will again be met with opposition over everything from the retirement age—currently many retire in their early 50s—to who gets excluded from reforms. Bolsonaro has said he wants to exclude military personnel and police from any reduction in benefits.”

US Consumers: Happier Than P/Es Show. In the past, a happy consumer was associated with cyclically high valuation multiples. The latest surveys show that consumers are very happy indeed, yet S&P 500/400/600 forward P/Es have been declining all year. What gives? Let’s first review the data:

(1) Low Misery Index. The Consumer Confidence Index (CCI) is inversely correlated with the Misery Index, i.e., the sum of the inflation rate (using the y/y percent change in the CPI) and the unemployment rate (Fig. 7). At 6.0% during September, the Misery Index remains near previous historical lows. The CCI rose during October to the highest reading since September 2000.

There is an inverse correlation between the Misery Index and the forward P/E of the S&P 500 (Fig. 8). That inverse relationship worked for quite a while since the start of the bull market during March 2009. It hasn’t worked well this year, as the forward P/E dropped from 18.5 during January to a low of 16.2 during October, using monthly data, and as low as 15.0 using daily data.

The problem may be that investors have learned that when the unemployment rate gets down to previous cyclical lows, a bear market isn’t far behind (Fig. 9). They fear that a tight labor market is inherently inflationary, which implies tighter monetary policy.

(2) Labor market is source of confidence. This time may or may not turn out to be different. So far, though, it has been different. During September, average hourly earnings rose at a subdued pace of 2.8% y/y, while both the headline and core PCEDs rose 2.0% y/y—right at the Fed’s target (Fig. 10).

Meanwhile, the “jobs plentiful” series included in the CCI survey jumped to 45.9% during October, the highest since January 2001 (Fig. 11). In the past, this series was highly correlated with wage inflation, which has not been the case so far during the current business-cycle expansion (Fig. 12 and Fig. 13).

(3) For your Bloomberg terminal. Finally, we should note that there has also been a close correlation between the S&P 500 forward P/E and Bloomberg’s Weekly Consumer Comfort Index since 1995 (Fig. 14). That was no longer true this year, as the former fell while the latter rose. (We lost access to the Bloomberg series in mid-August, when limits on its availability were imposed.)

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Lowering Our Targets

October 30, 2018 (Tuesday)

The Fed: Mystery Solved. Yesterday I noted that neither the video nor the transcript of Judy Woodruff’s 10/3 interview of Jerome Powell included some comments that were widely attributed to him by the financial press and may have contributed to the October rout in stocks. A reporter sent me the full transcript, which had been chopped by PBS—along with the video—to fill 13 minutes. A video of the entire session is available here.

Powell did in fact say (at minute 11:17 on the video): “So interest rates are still accommodative but we're gradually moving to a place where they will be neutral, not that they'll be a restraint on the economy. We may go past neutral but we're a long way from neutral at this point, probably.”

He said that only a few days after the 9/26 FOMC statement removed the following sentence that had appeared as boilerplate: “The stance of monetary policy remains accommodative.” This sentence had been in every FOMC statement since December 16, 2015, when the Fed started its latest rate-hiking program. Some interpreted its removal to mean that the Fed is setting up for more aggressive rate increases. On the contrary, in his 9/26 press conference, Powell reassuringly said that the language simply had outlived its “useful life,” suggesting that the Fed will continue its gradual rate increases toward a neutral stance, which wasn’t a long way off. He contradicted that assessment on October 3, helping to set the stage for October’s stock market meltdown.

Strategy: Tougher Comps in 2019. It may not be too hard for the S&P 500 to beat its depressing 2018-to-date performance during 2019. However, topping the 2018 growth rates in US real GDP, as well as S&P 500 revenues and earnings, next year would be next to impossible. That’s because this year’s growth was boosted by the tax cuts passed at the end of 2017 and the jump in government spending early this year.

During the current earnings seasons, both revenues and earnings results have mostly surprised to the upside. The problem is that the good news came with bad news, as companies increasingly warned that the outlook is likely to be more challenging for their businesses. In addition to tougher y/y comparisons for both revenues and earnings next year, there are mounting signs that the global economy is slowing. Consider the following:

(1) Real GDP. Yesterday morning, the WSJ “Real Time Economics” daily email reported: “Few believe a recession is near, and the expansion is widely expected to become the longest on record next year, Jon Hilsenrath and Harriet Torry write. But two big drivers of growth this year—consumers and government spending—will likely slow in the months ahead: Consumers because the impetus from income-tax cuts will diminish and government when a deal to boost spending runs out next September. Finally, the White House projection of sustained 3% growth hinges on a business-investment boom. It looked like that was happening early in the year but has faded since, suggesting corporate tax cuts may not have the long-lasting impact that was intended.”

The actual article cited observes: “However, private analysts and the Federal Reserve say a slowdown is looming. Economists surveyed by the WSJ estimate the growth rate will slow to 2.5% by the first quarter of next year and 2.3% by the third quarter of 2019. The Fed is expecting growth to slow further to a 1.8% rate by 2021.” The article starts with the following question: “What if that was as good as it gets?” Someone should convince Fed officials that it may be time to stop tapping on the brakes for a while.

(2) Q3 S&P 500 revenues and earnings. We will soon have the final results for the Q3 earnings season. Joe continues to track company results. While there have been some notable disappoints, the actual results have been mostly quite good. It’s been some managements’ cautious guidance that has unnerved stock investors. Since the end of last month through the 10/25 week, the Q3 blend of actual and estimated results rose 1.3%, while the estimate for the coming Q4 declined 0.6% (Fig. 1).

(3) S&P 500 forward revenues. S&P 500 forward revenues rose to yet another record high during the 10/18 week, raising some doubts in our minds about the widely heralded unfolding global economic slowdown (Fig. 2). This series is highly correlated with the actual quarterly revenues reported by the S&P 500 (Fig. 3). Then again, analysts are expecting a slowdown in revenues growth from 8.5% this year to 5.5% in 2019 and 4.1% in 2020 (Fig. 4). That makes sense since this year’s revenues growth has been well above the more normal pace of 4% during global economic expansions (Fig. 5).

(4) S&P 500 forward earnings. S&P 500 forward earnings rose to another record high during the 10/25 week (Fig. 6). However, the 2018, 2019, and 2020 consensus earnings estimates have flattened out at record highs in recent weeks. Industry analysts are currently expecting that earnings growth will slow from 23.1% this year to 10.2% and 10.4% in 2019 and 2020 (Fig. 7).

(5) Our revised estimates for earnings. The analysts’ estimates for 2019 and 2020 are probably much too optimistic. If revenues growth normalizes to 4.0%, then their forecasts imply that the S&P 500 profit margin will continue to rise to record highs (Fig. 8). That margin did rise to a record high of 10.9% at the end of 2017 before the cut in the corporate tax rate. It rose to yet more record highs during Q1 (11.9%) and Q2 (12.3%) this year thanks to the tax cut.

However, it’s very unlikely that the profit margin will continue rising given that labor and materials costs are starting to cut into margins, according to several of the Q3 earnings season conference calls. Pushing margins higher would require a remarkable surge in productivity. Debbie and I expect that productivity growth will make a comeback over the next two years, but just enough to keep the profit margin from falling. So Joe and I are assuming it will stay flat.

If so, then the growth of S&P 500 earnings per share will be determined by revenues growth and net share buybacks. Therefore, we are lowering our estimates for 2019 and 2020 earnings growth from 6.8% and 8.8% to 4.9% and 5.3%, respectively. We now project that earnings per share will be $170 in 2019 and $179 in 2020 (Fig. 9). (See Table 1 in our YRI S&P 500 Earnings Forecast.)

Industry analysts are currently projecting $178.30 and $195.37 per share for the next two years. They may be inhaling second-hand smoke from the pot stocks.

(6) Curbing our enthusiasm. We believe that despite October’s awful performance, the bull is still alive. However, given the downward revisions in our earnings growth estimates, we are lowering our S&P 500 price index targets. The S&P 500 got close to our year-end target of 3100 on September 20, when it rose to a record high of 2930.75. But getting all the way to 3100 by the end of the year from recent levels around 2600 may be a stretch. Now we are aiming for a retest of the record high around 2900 by the end of this year, 3100 for next year, and 3500 for 2020.

Admittedly, the bears are right that the collective monetary accommodation provided by the major central banks is diminishing. The aggregate assets of the Fed, ECB, and BOJ (priced in dollars) are looking toppy (Fig. 10).

Our Boom-Bust Barometer (BBB), which historically has been highly correlated with the S&P 500, has been flat at a record high all year (Fig. 11). The BBB is the ratio of the CRB raw industrials index and initial unemployment claims. The former has been weakening all year, while the latter probably can’t fall much lower (Fig. 12). The weakness in the CRB index reflects the slowdown in global economic growth.

Offsetting these headwinds should be rising revenues and earnings, albeit at mid-single-digit rates. The main risk, as we saw in yesterday’s market action, is an escalating trade war with China. Big gains in stock prices during the start of the day turned into losses by the afternoon after Bloomberg News reported that the US is planning to slap tariffs on more Chinese products if upcoming talks between President Donald Trump and Chinese President Xi Jinping falter.

One of our accounts emailed me near the end of trading yesterday, “Who are the traders who can turn a market from up 300 to down 560 so quickly?” My response: “Algos, not humans.”

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Trump’s Regrettables

October 29, 2018 (Monday)

The Fed I: Let’s Pause. The 10/26 WSJ included an op-ed by FRB Minneapolis President Neel Kashkari titled “Pause Interest-Rate Hikes to Help the Labor Force Grow.” He observed:

“The Fed has raised the federal-funds rate eight times in the past three years, and inflation now stands right at the 2% goal. A hard inflation ceiling would justify pre-emptive rate increases to ensure inflation doesn’t climb any higher. But the symmetric objective gives the Federal Open Market Committee the flexibility to see how the economy evolves before determining if further rate increases are necessary.”

His basic message is: What’s the rush to raise interest rates? Why not pause the rate hikes and assess how the economy is responding to them so far? I agree. In my opinion, the plunge in stock prices, especially the ones of cyclical companies, suggests that the economy may not be as strong as the Fed perceives and that inflationary risks remain low.

I was on CNBC on Friday. My message was: “We need the Fed to pause here and just take a breather. Let’s see how the economy plays out, and that will help the stock market a lot.” I concluded: “Fed officials have been talking like mission accomplished—that it’s the best economy that we’ve ever had. If it’s the best economy that we ever had, why raise interest rates? Why not leave it be if it’s growing with low inflation?”

A close look at the latest data suggests that the fast pace of economic growth during Q2 and Q3 may also be about to take a pause, which should increase the chances of a pause by the Fed. Consider the following:

(1) GDP. Real GDP rose 3.5% (saar) during Q3 following a gain of 4.2% during Q2. The latest quarter was boosted by inventory building, probably in advance of tariffs. The prior quarter was boosted by soybean exports for the same reason. On a y/y basis, real GDP rose 3.0% during Q3. That’s at the top end of the range since the start of the current expansion (Fig. 1). Now might be a good time for the Fed to pause to see if GDP is on a fundamentally faster track.

(2) Housing. Private residential investment in real GDP has flattened out over the past six quarters (Fig. 2). Rising mortgage rates are weighing on both new and existing home sales (Fig. 3). Let’s pause so that would-be home buyers can reassess their house-buying budgets.

(3) Durable goods orders. Private nonresidential investment in real GDP rose just 0.8% (saar) during Q3. Industrial equipment rose to a record high, but transportation and other equipment stalled (Fig. 4). Nondefense capital goods orders excluding aircraft remain in record-high territory, but edged down in September (Fig. 5). Let’s pause to see if higher interest rates, a stronger dollar, and tariffs might be weighing on capital spending.

(4) Inflation. The personal consumption expenditures deflator in GDP is exactly where the Fed wants it to be. During Q3, it was up 2.2% y/y (Fig. 6). The core rate was 2.0%.

Five of the Fed’s regional districts conduct monthly surveys of business conditions that include prices-paid and prices-received indexes (Fig. 7). The latest data through October show that three of them (Kansas City, New York, and Philadelphia) continue to look toppy, as they have in recent months. September data for Dallas show the same pattern. Richmond, for some reason, shows big spikes in its two price indexes. Let’s pause to see whether inflationary pressures might actually be abating.

So Kashkari and I are singing the same song: “All we are saying is give growth a chance.” President Trump and his economic adviser Larry Kudlow are singing it too, as is CNBC’s Jim Cramer … and everybody who is long stocks!

The Fed II: We Miss You, Janet! President Donald Trump must regret that he didn’t renew Janet Yellen’s contract to head the Fed for another four years. She probably would have been more accommodating to his supply-side policies. They both are populist do-gooders at heart. They want as many people to get jobs as possible.

Instead, Trump appointed Jerome Powell to be the new Fed chairman at the start of this year. Powell had been the vice chairman under Yellen. Trump appointed Richard H. Clarida to fill Powell’s vacant position after he was promoted. Both of them are all for continuing to raise interest rates. Both see strong economic growth and a tight labor market as potentially inflationary. So they want to raise interest rates to avert this scenario, by slowing the economy down.

No wonder that the 10/23 WSJ reported that President Donald Trump directly accused Powell of endangering the US economy by raising interest rates: “I’m just saying this: I’m very unhappy with the Fed because Obama had zero interest rates.” He also complained that “[e]very time we do something great, [Powell] raises the interest rates.”

Melissa and I are increasingly convinced that this month’s stock market rout started on October 3, when Fed Chairman Jerome Powell said in an interview with Judy Woodruff of PBS: “The really extremely accommodative low interest rates that we needed when the economy was quite weak, we don’t need those anymore. They’re not appropriate anymore.” CNBC also reported that Powell said: “Interest rates are still accommodative, but we’re gradually moving to a place where they will be neutral. We may go past neutral, but we’re a long way from neutral at this point, probably.”

We couldn’t find this widely reported quote in either the video or transcript of the interview! So we sent the Fed a request to confirm Powell had actually said that. Whether he said it or not, the CNBC article cited above was alarmingly headlined as follows: “Powell says we're 'a long way' from neutral on interest rates, indicating more hikes are coming.” We will let you know the Fed’s response to our request.

The S&P 500 dropped 9.1% from the close on October 2 through Friday’s close as Fed officials continued to hammer home Powell’s narrative (Fig. 8).

For example, in his first public speech as vice chairman last Thursday, Clarida explained why he thinks higher interest rates are in order. Sadly, it’s the same old party line that Fed officials have been spouting for a while to explain their gradual normalization of monetary policy. Here it is in brief:

(1) Star struck and star stuck. Clarida along with other Fed officials are all star struck. They are stuck on the fanciful notion that actual interest rates should be set relative to “the longer-run neutral real rate, often referred to as “r-star,” or “r*.” Clarida acknowledges that it is an “unobservable and time varying” variable. However, fear not: It is “computed from the projections submitted by Board members and the Reserve Bank presidents.”

It gets even worse: Clarida admits that r* “must be inferred as a signal extracted from noisy macro and financial data. That said, and notwithstanding the imprecision with which r* is estimated, it remains to me a relevant consideration as I assess the current stance and best path forward for policy.”

He then goes on to quote a reputable authority on matters of economic astronomy (astrology, actually): “The reason for this is because, as Milton Friedman argued in his classic American Economic Association presidential address, a central bank that seeks to consistently keep real interest rates below r* will eventually face rising inflation and inflation expectations, while a central bank that seeks to keep real interest rates above r* will eventually face falling inflation and inflation expectations.” (Friedman, of course, was the father of monetarism, which has been mostly relegated to the dustbin of economic history.)

By the way, unobservable stars tend to be black holes!

All this suggests that the best measure of whether the federal funds rate is too low or too high relative to the phantom r* is the actual inflation rate. So by Clarida’s own logic, if inflation remains subdued, why should the Fed raise interest rates at all?

(2) The new abnormal. That’s a good question. The Fed’s house view is that monetary policy has been set on a course of “normalization,” with the aim of raising the federal funds rate to a more normal and neutral level of 3.00%, after interest rates were near zero from 2009 through 2015. The problem is that no one really knows if that’s the right level after so many years of abnormally easy monetary policy. What if the neutral federal funds rate is 2.00% rather than 3.00%? In that case, further rate hikes will be restrictive even though inflation remains subdued. (See our tables on the FOMC September 2018 Summary of Economic Projections, September 2018-2021 & Beyond.)

That’s why the stock market plunged in October. Instead of setting the course of normalization on autopilot with 25bps hikes following the March, June, September, and December meetings of the FOMC, why not try a more gradual pace of increases with longer pauses to assess whether the course of normalization needs to be recalibrated?

(3) Accommodative or not? Recall that the latest, 9/26 FOMC statement deleted the following language that had appeared in previous statements: “The stance of monetary policy remains accommodative.” This sentence had been in every FOMC statement since December 16, 2015, when the Fed started its latest rate-hiking program. In his press conference that same day, Powell minimized the import of this development, saying that the language simply had outlived its “useful life.”

How does that square with Clarida saying that the federal funds rate needs to be raised some more because it is still below r*? There certainly is a big inconsistency between the change in the 9/26 statement and Clarida stating, “However, even after our September decision, I believe U.S. monetary policy remains accommodative.” (By the way, Powell said the same in his 10/3 interview, according to the CNBC report cited above.)

The 9/26 meeting was Clarida’s first one on the FOMC. Maybe he made a rookie mistake. However, the September dot plot shows that the federal funds rate remains well below the median “longer-run federal funds rate” forecast of 3.00%, and is expected to be hiked closer to this consensus guesstimate of the value of r*.

(4) Phillips’ disciples. Now that the unemployment rate is down to 3.7%, the lowest since December 1969, Fed officials seem most concerned that the tight labor market will boost inflation. They’ve mostly admitted that the Phillips curve trade-off between unemployment and inflation has flattened out. Yet they still fear that it will make a big comeback unless they continue to raise interest rates.

They figure that by raising the federal funds rate to a neutral rate of 3.00%, they will keep price inflation around their cherished 2.0%. However, their latest dot plot shows that the FOMC’s median estimate of the longer-run unemployment rate—a.k.a. “NAIRU,” the nonaccelerating inflation rate of unemployment—is 4.5%.

In other words, they are saying that to keep a lid on inflation, they have to raise the federal funds rate—up to a restrictive 3.40%, they currently reckon according to the latest dot plot—until the jobless rate rises back from 3.7% to 4.5%! That would imply a sharp economic slowdown indeed. So they figure that they could then lower the federal funds back down to their cherished 3.00% r-star.

Yet Clarida admits that NAIRU might be lower than 4.5%. So far, it certainly seems to be lower given that a 3.7% jobless rate isn’t boosting inflation much at all (Fig. 9). In his speech, Clarida said that NAIRU “may be somewhat lower than I would have thought several years ago.” He added: “With unemployment falling and wage gains thus far in line with productivity and expected inflation, the traditional indicators of cost-push price pressure are not flashing red right now.” You think?

(5) Raising rates to lower them. Melissa and I believe that Powell is more of a pragmatist than Yellen. His unspoken game plan may simply be to raise the federal funds rate to 3.00% or even 3.50% so that when the next recession occurs, the Fed will have 300-350bps of leeway between the federal funds rate and zero.

(6) Trump’s regrets. It’s no wonder that in the 10/23 WSJ interview linked above, Trump said: “To me the Fed is the biggest risk, because I think interest rates are being raised too quickly.” As for why he thought Powell was raising rates, Trump said: “He was supposed to be a low-interest-rate guy. It’s turned out that he’s not.” Does Trump regret nominating Powell? It’s “too early to say, but maybe,” the President said.

By the way, the WSJ article cited above notes: “The law isn’t clear about whether Mr. Trump could dismiss Mr. Powell even if he wanted to do so. The Federal Reserve Act, as amended in 1935, says Fed governors can be removed by the president ‘for cause.’ The stipulation applies to the board’s governors, who serve 14-year terms, and not to the Fed chairman, who serves a four-year term concurrent with a 14-year term as governor.”

The Fed III: Green Light in Beige Book. Since this tricky month began, we’ve been covering all the reasons for the market’s recent downturn and volatility. To add to that, Melissa and I noticed that the Federal Reserve’s October Beige Book was released at 2:00 pm on Wednesday, October 24. That was just minutes before the S&P 500 took an especially ugly turn downwards, starting around 2:35 pm.

Perhaps computer trading algorithms were triggered to sell based on a quick artificially intelligent scan of the inflationary pressures noted throughout the Fed’s report. Maybe the algos were programmed to do so in expectation of further Fed rate increases. That day, the S&P 500 dropped 1.5%, with the DJIA down 2.4%, or 508 points. By Friday’s close, the S&P 500 was down 9.3% from its September 20 record high, just shy of the 10.0% need for an outright correction.

We were less alarmed by the report’s contents than were the algos. The picture of the US economy painted by the Fed District contacts surveyed for the report seemed to us to be unchanged from that of the previous, 9/12 report. Economic growth continued to pick up at a modest to robust pace for most industries and regions. Price pressures mounted, but there was no indication of any sharp rise in prices.

The labor market remains tight, with labor shortages continuing to be a problem. Some employers have started to moderately raise wages, but others are exploring alternatives. The outcome of the US trade dispute with China continues to be uncertain, raising concerns about supply chains. The tariffs already implemented are causing some price pressures. Some firms are passing on rising input and labor costs. Some are absorbing them, and have plenty of room in profit margins to do so.

For more details, have a look at our tables of excerpts from the latest Beige Book, organized into the following categories: economic activity, tariffs, employment and wages, and prices. Here are some of the highlights:

(1) Economic activity. “Moderate” is the word that best summarizes Fed District commentary in the latest report. Specifically, the report said: “Economic activity expanded across the United States, with the majority of Federal Reserve Districts reporting modest to moderate growth.” Eight of the 12 District banks used the words “moderate” or “modest” in summarizing activity in their regions. Of the four that did not, contacts in Dallas were the most upbeat, reporting that economic activity “expanded at a solid pace”; those in Boston reported “continued expansion”; New York and St Louis contacts both saw their economies grow “slightly.”

(2) Employment and wages. As in the previous report, nationwide labor shortages were “broadly noted and were linked to wage increases and/or constrained growth.” Employers continued to report “difficulties finding qualified workers, including highly skilled engineers, finance and sales professionals, construction and manufacturing workers, IT professionals, and truck drivers.”

We noticed a bit more evidence of employers raising wages to attract and retain employees than in September’s report. But the wage increases mentioned were generally no more than 3.0%-4.0%. Employers are continuing to find ways around increasing wages, such as using technology to keep headcount down. Some firms are offering incremental non-wage benefits to employees and lowering job standards for prospective employees rather than offering higher wages.

(3) Prices. Inflationary pressures seemed slightly more pervasive than depicted in September. Price increases were noted across the Fed Districts for input prices, selling prices, and the cost of labor. October’s report noted: “Prices continued to rise, growing at a modest to moderate pace in all Districts. Manufacturers reported raising prices of finished goods out of necessity as costs of raw materials such as metals rose, which they attributed to tariffs. Construction contract prices increased to cover rising costs of labor and materials. Retailers and wholesalers in some Districts raised selling prices as they continued to see increased costs in transportation and also worried about impending cost increases resulting from tariffs. Districts reported rising oil and fuel prices.”

(4) Tariffs. Previously, we reported that the tariff commentary seemed a bit more alarming in the September book than the July one (see our 9/18 Morning Briefing). But the latest tone seemed to slide back in the other direction. Contacts continued to express concerns about the tariffs in the October report, especially higher input prices. But they didn’t seem quite as worried about tariffs as they did last month.

Firms seem to be adjusting to the tariffs that already have been implemented, passing some of the cost on to customers. For example, Boston firms “expected to pass on (or had already passed on) to consumers at least some of the tariff burdens.” In Chicago, “[r]etail contacts across numerous sectors indicated that they expected consumers to see the impact of US tariffs on imports by early 2019.”

Concern about the tariff-related uncertainties that lie ahead was expressed by several Fed Districts. Some contacts expect an impending orders dip because some customers have accelerated orders ahead of expected tariff implementation.

Movie. “Beautiful Boy” (+) (link) is a disturbing film about the terrible consequences of drug addiction, not only for the addict but also for the addict’s family. The movie is based on the actual experience of a teenager who had a very bright future that turned very dark very quickly as he experimented with drugs until his addiction to crystal meth almost killed him. In this case, the “beautiful boy” had a very supportive father played very convincingly by Steve Carell. Sadly, many families can’t cope with such stress, and the addicted become homeless people, often with mental illnesses. Just as sad is that our communities haven’t done enough to help the desperate people who are living under blue tarps on the streets of Los Angeles and other metropolitan centers.

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‘Something Has To Give’

October 25, 2018 (Thursday)

Strategy I: What’s the Problem? The S&P 500 is one of the components of the Index of Leading Economic Indicators (LEI). The LEI rose to a record high during September. The S&P 500 did the same on September 20, but is down 9.4% since then through yesterday’s awful close (Fig. 1). The downdraft is not officially a correction yet, but it is almost there.

The technical picture has turned increasingly bearish this month. The S&P 500 is slightly below its 200-day moving average (dma), as are all of its cyclical sectors (Fig. 2 and Fig. 3). The percentage of S&P 500 companies trading above their 200-dmas was down to 37% after yesterday’s debacle from 44% last Friday (Fig. 4). The ratio of the equal-weighted to the market-cap-weighted S&P 500 price indexes is the lowest since October 2012 (Fig. 5).

Wait a minute! Since the start of the current bull market, such negative technicals have marked buying opportunities. If this is still a bull market, as we believe it is, then the latest bearish technicals and October’s swoon should mark the latest buying opportunity.

The fundamentals still look good to us. They also look good to industry analysts, who certainly haven’t gotten the “recession memo” yet; they haven’t received the “global slowdown memo” either—as neither memo has been issued! Admittedly they (along with almost all economists) tend to be among the last ones to see a recession coming. However, the analysts are actually raising their S&P 500 revenues estimates for 2018, 2019, and 2020 (Fig. 6). As a result, S&P 500 forward revenues rose to yet another record high during the 10/18 week, and remains on a steep uptrend. That was just before the start of the Q3 earnings season, which so far is showing mostly solid revenues reports.

S&P 500 forward earnings also rose to yet another record high during the 10/18 week (Fig. 7). However, the upward slopes of analysts’ consensus earnings expectations for 2018, 2019, and 2020 are flattening, reflecting expectations that profit margins may be getting squeezed, as already mentioned in several of the Q3 earnings calls. Nevertheless, analysts are currently predicting that S&P 500 earnings will grow 22.6% this year, 10.3% next year, and 9.5% in 2020 to $195 per share.

Investors aren’t buying what the sell-side analysts are selling. On Wednesday, the forward P/Es of the S&P 500/400/600 were down to 15.2, 14.4, and 15.0 (Fig. 8). They seem to be fretting that the Fed will make a mistake and push interest rates up to levels that will cause a recession in 2019. They may also be worrying that profit margins will get squeezed by rising labor and materials cost. They have concerns about the outlook for overseas economies, particularly emerging market economies.

We aren’t as worried about these issues. We aren’t even sure that the market is down so hard during October because of them. However, one loyal follower of our research suggested that perhaps the market is spooked about the mixed-up mix of US fiscal, monetary, trade, and foreign policies. I’ve recently been describing them as akin to driving a car with one foot pushing hard on the accelerator while the other is tapping on the brakes.

Trump is making a big bet that his supply-side policies will boost growth while keeping inflation down. He believes that these policies will partly offset the widening federal deficit resulting from those very same policies. Meanwhile, the Fed is tapping on the brakes, which is why Trump is blasting Fed Chairman Jerome Powell so publicly. All of these developments have boosted the dollar, which is keeping a lid on inflation at home while depressing emerging markets. Also depressing global growth is Trump’s trade war, especially against China. So is the surge in oil prices this year, which is mostly attributable to Trump’s sanctions on Iran.

Put it all together, and the conclusion is: “Something has to give,” according to our friend. At the beginning of the month, bond prices cracked, pushing yields higher. They stopped doing so when the stock market cracked on fears of higher bond yields as a result of more restrictive monetary policy. What’s next? We expect that inflation data will confirm that inflation remains subdued, which might convince Fed officials to give supply-side forces a chance to work. Of course, one possible worst-case scenario is that the Fed persists in fighting these forces. That would be unfortunate.

We can’t dismiss the possibility that yesterday’s rout was also attributable to the pipe bombs that were sent to leaders of the Democratic Party. In the past, gridlock has been mostly bullish for stocks. The nation’s Founders devised a system of political checks and balances to avert extremism. However, the country has been experiencing an increasingly uncivil war between liberals and conservatives that has been marked by only a few acts of violence so far. That trend is heading in the wrong direction, and may be starting to unnerve investors, who may be worrying that no matter who wins the mid-term elections, the uncivil war will get worse.

Strategy II: Remember Earnings. The market has been hit with a deluge of bad news. The US trade war with China looks like it will remain in the headlines as both sides dig into their positions. The 10-year Treasury yield rose above 3.00% as Fed officials pursued their gradual normalization of monetary policy while chattering about turning restrictive (Fig. 9). And record-high profit margins may get squeezed a bit by higher wages and energy costs (Fig. 10).

The current selloff has been broad-based. Since the S&P 500 peaked on September 20, almost every sector has been taken out to the woodshed, leaving only the S&P 500 Utilities sector in positive territory. Here’s how the S&P 500 sectors have performed from the market’s peak through yesterday’s close: Utilities (4.4%), Consumer Staples (-0.5), Real Estate (-4.0), Communication Services (-7.0), Health Care (-7.3), S&P 500 (-9.4), Tech (-10.4), Energy (-11.1), Consumer Discretionary (-11.9), Financials (-12.7), Industrials (-12.9), and Materials (-17.1).

But now that fears about these items are gripping the market, it may be time to focus once again on earnings that remain remarkably strong. S&P 500 constituents’ earnings are expected to grow by 22.4% y/y in Q3, according to data from Refinitiv. While that’s down from the 23.4% analysts were forecasting for Q3 on July 1, it’s still awfully impressive. Likewise, Q4 earnings are forecast by industry analysts to grow 19.5% y/y. Next year’s y/y comparisons will be back in single digits during H1, but still showing good growth. The Q1-2019 earnings growth estimate, at 8.0%, is actually up from 7.2%, where it stood on July 1, and the Q2-2019 earnings growth consensus has been trimmed to 9.0% from 10.6% on July 1.

Investors can continue to hide out in the Consumer Staples and Utilities sectors, but analysts aren’t expecting strong earnings from either. The S&P 500 Consumer Staples sector is forecast to grow earnings by 8.9% in Q3 and 4.6% in Q4, while the Utilities sector is expected to grow earnings by 5.7% and -4.5% over the same periods.

Meanwhile, many of the other S&P 500 sectors are expected to grow their earnings much faster during Q4. Here’s how all the sectors’ earnings growth forecasts stack up in the year’s last quarter: Energy (87.6%), Industrials (27.9), Financials (27.1), Communication Services (19.8), S&P 500 (19.5), Consumer Discretionary (16.7), Technology (13.8), Health Care (12.9), Materials (12.4), Real Estate (9.4), Consumer Staples (4.6), and Utilities (-4.5).

Here is the same comparison for all of 2019: Energy (30.3%), Industrials (11.6), Consumer Discretionary (11.3), Communication Services (11.0), Financials (9.6), Technology (8.2), Health Care (8.2), Materials (6.4), Real Estate (6.1), Consumer Staples (5.9), and Utilities (5.5).

So when reading headlines filled with dire news about tariffs, the Fed, and wage pressures, remember that—so far, anyway—earnings are still expected to be strong.

Strategy III: A Look Back & Forward. Each week, we try to bring you news that’s a bit off the beaten path but may be of major importance in the future. It’s often tech-related and veering toward geeky, but hopefully you find it as interesting as we do. Here’s a quick update of some of the themes we’ve touched upon, including quantum computing, artificial intelligence (AI), and new clean fuel rules:

(1) Ford learns quantum. In the 7/11 Morning Briefing, we dove into the world of quantum computers, those that use quantum physics to become far, far more powerful than today’s computers. Google, IBM, Microsoft, and Uncle Sam along with some smaller players are in a race to develop quantum computers in the US. They face competition from around the globe, as the Chinese and others also hope to be the first to harness quantum computing.

Quantum computers can compute many problems at the same time. Governments are in the game because it’s believed these computers will be able to break the cryptography that keeps all our information private. But it’s hoped that quantum computers will be able to develop new molecules, advance AI, develop profitable investment portfolios, and map out the optimal way to get from Point A to Point B.

That last point seems to have caught the attention of Ford Motor, which recently hired a quantum physicist and signed a one-year contract to work with NASA’s Quantum Artificial Intelligence Laboratory, the 10/22 WSJ reported. “Our mission is to be early enough in the game so that when it’s evolved to the point of maturity and applications that matter to the business, we’ll have an advantage,” Ken Washington, Ford’s chief technology officer and vice president of research and advanced engineering, told the WSJ.

“Ford in one scenario is experimenting with how quantum computing could quickly optimize routes for multiple delivery vehicles making stops at many locations, with the goal of efficiently managing their diesel energy consumption. Quantum computing could also be useful for discovering new materials that could improve the structure of batteries for electric vehicles,” the article stated.

As it turns out, Volkswagen is working on quantum computing too. The auto company and Google are in a partnership that’s investigating how quantum computing can be used in areas like self-driving cars, batteries for electric vehicles, and supply-chain management.

(2) AI’s blackeye. In the 8/2 Morning Briefing, we examined the dark side of AI, how AI-empowered robots could make serious—and in the context of war, potentially lethal—mistakes because they are too literal. We highlighted Zeynep Tufeki, a techno-sociologist and a Fellow at the Berkman Center for Internet and Society at Harvard University. She warned that people are abdicating their decision-making responsibilities, offloading them to AI-empowered computers without understanding the algorithms driving AI. She noted that AI is sometimes behind important decisions like who should be hired and who should get parole.

Amazon learned the downside of using AI in hiring. A 10/9 Reuters article revealed that Amazon’s AI-empowered recruiting program was biased against women. The program was developed in 2014 to review resumes and gave applicants scores ranging from one to five stars.

The system was trained to observe patterns in resumes submitted over the prior 10 years. Most came from men, so the computer penalized resumes that included the word “women’s.” Accordingly, resumes that mentioned belonging to a women’s chess club or graduating from an all-women’s college were docked. Amazon identified the problem in 2015 and fixed it, but couldn’t guarantee that the machines “would not devise other ways of sorting candidates that could prove discriminatory.” In early 2017, Amazon pulled the plug on the program.

Gary Smith, an economics professor at Pomona College, has used the Amazon experience to buttress his case that while computers can identify patterns, they still can’t assess those patterns’ meaning or tell whether the patterns have meaning at all. That’s because they lack humans’ general intelligence and wisdom. Human reasoning is fundamentally different than AI, the author of The AI Delusion notes.

Smith sees reason for societal concern in organizations’ blind reliance on AI: “The combination of AI with digital advertising and highly personal data broadens the scope of the potential damage. … The avalanche of personal data collected by business and government is being used to push and prod us to buy things we don’t need, visit places we don’t enjoy, and vote for candidates we shouldn’t trust,” he wrote in a 10/12 Fast Company article.

His advice: Beware companies hyping AI products, and have a little faith in humanity.

Apple CEO Tim Cook also sounded the alarm about data privacy and AI in his keynote address at a privacy conference in Brussels yesterday. According to CNBC, he said: “Every day, billions of dollars change hands, and countless decisions are made, on the basis of our likes and dislikes, our friends and families, our relationships and conversations. … These scraps of data, each one harmless enough on its own, are carefully assembled, synthesized, traded, and sold. … Your profile is then run through algorithms that can serve up increasingly extreme content, pounding our harmless preferences into hardened convictions. … We shouldn't sugarcoat the consequences. This is surveillance. And these stockpiles of personal data serve only to enrich the companies that collect them. … At its core, [artificial intelligence] promises to learn from people individually to benefit us all. Yet advancing AI by collecting huge personal profiles is laziness, not efficiency. For artificial intelligence to be truly smart, it must respect human values, including privacy. If we get this wrong, the dangers are profound. We can achieve both great artificial intelligence and great privacy standards.”

As a result, Cook recommends establishing federal privacy laws based on the right to have personal data minimized, the right to knowledge, the right to access, and the right to security.

(3) Shippers cleaning up. We addressed the new fuel regulation for which the shipping industry is preparing in the 7/26 Morning Briefing. The International Maritime Organization (IMO) introduced a rule in 2016 that requires ocean vessels to use fuel with sulfur content of less than 0.5% m/m (mass by mass) starting January 1, 2020, far below the current 3.5% limit.

We noted that shippers have two options, both expensive: They can either buy low-sulfur fuel or install scrubbers on the ships to clean the exhaust before it’s expelled. Industry executives have estimated the move to cleaner fuel will cost shipping companies $15 billion a year, which they’re expected to pass on to their customers.

Earlier this month, the Trump administration asked the IMO to phase in the rules in the name of “experience building,” a White House spokesman said in a 10/18 WSJ article. The administration believes the move is necessary to “mitigate the impact of precipitous fuel-cost increases on consumers” and the global economy.

Greece, home to a number of shipping companies, and flag states Panama, Liberia, and the Marshall Islands have also been skeptical that there will be enough clean fuel available for the ships. They appear to be allying themselves with the US, and the Union of Greek Shipowners would like the adjustment period to extend from one to three years, noted a 10/22 WSJ article. At this point, however, the IMO is only considering extending the rule’s implementation to March 2020 and examining the safety and availability of cleaner new fuels.

The airline industry is also paying attention to whether the new rule sets sail. “Delta Air Lines Inc. finance chief Paul Jacobson said earlier this month that rising crude prices and the fuel switch for oceangoing vessels represented a “net ‘bad’ for the airlines,” adding that Delta’s in-house refinery should help offset the negative impact,” noted a 10/22 WSJ article. It included an estimate that large airlines’ per-share earnings could fall by 2%-4% in 2020 due to higher fuel costs, according to Raymond James analysts.

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Geopolitics Matters

October 24, 2018 (Wednesday)

Global Stocks: Coupling. Since early February through late September, US stocks were on a tear, while stocks overseas were mostly stumbling (Fig. 1). US stocks decoupled from the rest of the world, supporting our preference for a Stay Home investment posture over the Go Global alternative.

So far this month, the US has coupled with the bearish sentiment overseas. In the past, I’ve observed that during bull markets, especially the latest one, geopolitical crises rarely matter. Instead, they create buying opportunities. However, this year, geopolitical issues have increasingly come to the fore as a concern for global stock investors.

US investors have been insulated by the strength of the US economy. The Trump tax cuts at the end of last year certainly helped to decouple the US from the rest of the world. However, the outperformance of the US economy pushed US interest rates higher and caused the dollar to soar. Both developments hurt emerging market economies, as we’ve discussed before and do further below.

In addition, Trump’s sanctions on Iran boosted oil prices, which also are weighing on emerging market economies. In recent days, the outlook for oil prices has been complicated by the crisis over Saudi Arabia on mounting evidence that Crown Prince Mohammad bin Salman may have ordered the murder of a reporter.

Also complicating the geopolitical scene and weighing on global growth is Trump’s escalating trade war with China. In the European Union (EU), Italy’s new government is pushing for a budget that violates EU rules, and Brexit negotiations are going nowhere.

In the US, S&P 500 stocks have been hit hard this month, with downspins led by the cyclical ones that are most exposed to the global economy and geopolitical risk (Fig. 2). The 4% y/y increase in the trade-weighted dollar is another negative for these companies. Cyclical stocks of companies that do most of their business in the US, particularly those in housing-related businesses, have been getting hammered by rising interest rates as well.

An unnerving recent development is the caravan of illegal wannabe immigrants streaming through Mexico toward the US border. The issues raised could certainly impact the midterm congressional elections in the US—yet another source of uncertainty. Future political developments in some emerging economies—particularly Brazil, as we discussed last week—are also uncertain.

We know with certainty that Halloween is coming on October 31. The US midterm elections will be settled a few days later on November 6. The Fed may have to hold off on another rate hike in December if more signs of economic weakness emerge, as suggested by the cyclical stocks. In any event, S&P 500 revenues and earnings should continue to grow along with the economy next year, albeit at slower rates than this year.

Valuation multiples have dropped sharply this month, making stocks attractive. Joe and I still believe that October’s selloff is Panic Attack #62 rather than the beginning of a bear market; we believe that the bull market will continue into next year. The next relief rally should be triggered by continued signs of economic growth combined with subdued inflation. That might provide some relief on the interest-rate outlook. There might be less relief in geopolitical tensions, especially between China and the US for the foreseeable future. Can’t have everything.

Emerging Markets I: Capital Outflows. In its just-released October Global Financial Stability Report (GFSR), the International Monetary Fund (IMF) warned that a confluence of factors has started to drive capital out of emerging markets: the stronger dollar, tighter financial conditions, trade tensions, and political risks. Could these net capital outflows worsen and trigger a full-blown emerging market crisis?

They could worsen, Melissa and I believe after reviewing the 81-page report; however, we don’t anticipate a widespread crisis among emerging market economies as a result. Rather, there could be country-specific problems that are exacerbated if interest rates continue to rise and the US dollar strengthens some more, as seem likely.

So our advice is: Be wary of emerging markets as a broad asset class, but don’t count them all as equal. Pockets of opportunity may be found in countries that have demonstrated increased financial resilience since the 2008 crisis and relative political and policy stability.

Before reviewing the IMF’s worry list for emerging markets, let’s review recent related developments:

(1) Flows have turned negative. Foreign portfolio flows (i.e., net nonresident purchases of emerging market stocks and bonds) turned negative in mid-April. (See the GFSR Figure 1.10, panel 1.) Emerging market stock and bond mutual funds had experienced strong inflows in 2017 and early 2018. Since then, about $35 billion has poured out of these funds, according to the GFSR.

Yet the outflows from emerging market investment funds so far have not been as severe as in past emerging market crises. Previous episodes, such as the 2013 taper tantrum and the 2015 China devaluation, resulted in about $60 billion in outflows each, measured from peak to trough. However, the GFSR stated: “In the event of a sharp deterioration in global risk sentiment, portfolio outflows could intensify.” Nevertheless, “overall vulnerabilities in emerging market economies remain moderate compared with historical levels,” the report said.

(2) The drivers are region-specific. The IMF report noted that, so far, the spillovers across emerging markets have been “relatively contained and idiosyncratic factors explained much of the outsized asset price moves.” The initial pressure was seen across countries with “large external vulnerabilities” and “weaknesses in policy frameworks,” such as Argentina and Turkey. As the US dollar gained strength and US long-term yields rose, those countries experienced sharper currency depreciation and widening of external credit spreads than their peers.

Market selling pressures then shifted mostly to Asian emerging market equities amid heightened trade tensions. During August, homegrown political risks drove selling pressure in select emerging market countries, including Brazil, Turkey, and South Africa. (See Figure 1.10, panel 2 and panel 3 in the GFSR.)

(3) Outflows & the stronger dollar correlate. Debbie and I have our own homegrown monthly proxy for international capital flows, calculated as the 12-month change in non-gold international reserves minus the 12-month sum of the merchandise trade surplus with the US. The world outside the US experienced increasingly large net outflows during the 2015 global growth recession. They diminished in size during 2016 and 2017 as the global economy recovered until they were close to zero in early 2018. They’ve mounted again this year through August (Fig. 3). Leading the way over this period was our proxy for Chinese net capital outflows (Fig. 4).

Not surprisingly, our proxy is highly correlated with the y/y percent change in the US dollar. It remains bullish for the greenback.

Emerging Markets II: Could It Get Worse? The IMF has no shortage of reasons why there could be more pain for emerging market assets ahead. Consider these, outlined in the GFSR:

(1) US monetary tightening to exacerbate outflows. Actual outflows have been greater than the IMF expected as a result of US monetary policy normalization. “Retail outflows have been sizable and inflows from institutional investors have slowed considerably.” (See GFSR’s Figure 1.15, panel 1.) The IMF figures that there “could be a further drag on portfolio flows of about $10 billion by the end of 2019, in addition to a realized impact so far of an estimated $20 billion.” Further, as a result of the Fed’s balance-sheet normalization, a “deterioration in external factors could lead to a $50 billion reduction of inflows in 2018, which will ease only modestly to an additional $40 billion in 2019.” (See the GFSR’s Figure 1.15, panel 2.)

Under a worst-case scenario analysis, “medium-term debt outflows could reach 0.6 percent of the combined GDP of emerging market economies (excluding China), on par with the outflows seen during the global financial crisis.” However, the IMF’s analysis suggests that this is highly unlikely to occur. It could become more probable if there were a spike in risk aversion and a corresponding “sharp reversal of portfolio debt flows.”

(2) Rise in external, public-, and private-sector debt. Easy financial conditions since the 2008 financial crisis have led “to a sharp rise in external borrowing, with external debt increasing much faster than exports in many emerging markets.” The GFSR noted that a “combination of high external debt and relatively weak reserve coverage levels would make a country particularly vulnerable to external shocks.”

Further, the share of emerging market countries (excluding China) with high public debt relative to the aggregate GDP of emerging markets has more than doubled since 2008. In the private sector, high leverage has stretched nonfinancial firms so that the debt-repayment capacity of firms in some economies is at risk. Although the median debt at risk has declined recently across regions, it remains elevated for countries in regions such as Latin America and in emerging Asia. Some countries have strong reserve buffers, however, which may increase their resilience to external shocks.

(3) Investor base shift to nonbank, domestic. The mix of funds flowing into emerging markets has changed. But it’s hard to tell whether that could worsen capital outflows on a broad scale. Before the 2008 crisis, financing to emerging markets was mostly bank-related. Now portfolio investors provide more cash to emerging markets than banks do, making emerging markets more vulnerable to withdrawals of foreign cash. Bank lending tends to be longer term and less volatile than portfolio investing.

Notably, however: “[D]ifferent types of nonbank investors (such as pension funds, insurance companies, and mutual funds) have different risk appetites and investment mandates.” Recent years have seen rising emerging market investing via mutual funds and ETFs, which may be more sensitive to global financial conditions. Additionally, opportunistic global funds that have highly concentrated positions in markets could “suddenly shift their allocations.”

Yet a 10/15 WSJ article titled “Emerging-Markets Selloffs: This One Is Different” noted that emerging markets are less vulnerable to withdrawals of foreign cash now than before the 2008 crisis. “In 2017, overseas capital flows to emerging markets equaled 4.35% of gross domestic product compared with almost 9.00% in 2007, according to the Institute of International Finance [IIF],” observed the article. Foreign investors play a larger role in Latin America and emerging Europe than they do in Asia.

(4) Banks stronger, but not bullet proof. Regarding global bank stability, here’s the bottom line: “Banks have strengthened their balance sheets since the global financial crisis: they now have higher levels of capital and more liquidity in aggregate. But weaknesses in the global banking system are still apparent. Increasing debt in the household and corporate sectors has left banks in some countries exposed to borrowers with high debt-service burdens. The combination of some highly indebted sovereigns and bank holdings of government bonds risks reigniting the sovereign bank nexus. In addition, some banks are exposed to opaque and illiquid assets, or are reliant on foreign currency funding.”

Emerging Markets III: Fed’s View. Fed Chairman Jerome Powell believes the concern over emerging markets is overblown. Some observers agree with him that, on balance, emerging markets will be able to handle a gradual rise in US interest rates; others disagree. Some considerations with bearing on the question include:

(1) One-two interest-rate, dollar punch. Emerging markets could be particularly vulnerable to greater outflows if investors grow increasingly wary of leverage in these countries, as discussed above. Sentiment toward these regions could further sour if investors perceive emerging markets as especially sensitive to US monetary tightening. As US interest rates rise, there could be greater demand for US fixed-income assets and a flow away from emerging markets, all else being equal.

Further, emerging markets may experience a one-two punch as interest rates push the demand for dollars up. Emerging markets’ dollar-denominated debt composes a significant portion of emerging markets debt outstanding. A rising dollar makes it more expensive to service that debt.

(2) Commodity prices or the Fed? In his 5/8 speech, “Monetary Policy Influences on Global Financial Conditions and International Capital Flows,” Powell stated: “Since the Fed is the central bank of the world's largest economy and issuer of the world’s most widely used reserve currency, it is to be expected that the Fed's policy actions will spill over to other economies.”

But he doesn’t attribute the brisk capital inflows to emerging markets seen in most years since the financial crisis primarily to the Fed’s monetary stimulus but to rising commodity prices and growth in those regions. So the reverse scenario—capital outflows from emerging markets—would not be expected to result from the Fed’s tightening, he reasoned.

Powell is right about the relationship between emerging markets and commodity prices. The Emerging Markets MSCI stock price index (in dollars) has been highly correlated with the CRB raw industrials spot price index (Fig. 5). Commodity prices have held up relatively well in the face of the recent strength of the dollar. If they continue to do so as the Fed continues to normalize, then Powell might be right not to worry too much about the fragility of emerging markets.

Following a sharp decline during 2015, the Emerging Markets MSCI stock price index bottomed on January 21, 2016, then soared 65.5% in local currency and 84.9% in US dollars through January 26, 2018 (Fig. 6). Since then through Monday’s close, the former is down 17.2%, while the latter is down 22.8%. Over the same two periods, the Emerging Markets MSCI currency index rose 22.1%, and then it fell 7.3% (Fig. 7).

Here is the ytd performance derby of the major MSCI global stock market indexes in local currencies through Monday’s close: US (3.0%), All Country World (-2.1), Japan (-5.9), UK (-8.4), EMU (-8.6), and Emerging Markets (-10.5) (Fig. 8).

(3) Emerging markets are not equal. Counter to Powell’s relaxed view, the September 2018 BIS Quarterly Review stated: “In all major emerging market regions, the growth of US dollar-denominated credit has outpaced that in other foreign currencies. The high share of dollar borrowing foreshadows risks that could [materialize] in the case of a persistent dollar appreciation.” However, the report noted that “dollar exposures in emerging market economies vary substantially across countries and sectors.”

Powell also pointed out in his May speech that not all emerging markets are created equal: Some have already revealed stress fractures because of the rising US interest rates and US dollar. Others may continue to weather the storm. We think that among the latter could be Asian emerging markets that stand to benefit as production moves to them out of China if Trump continues to escalate his trade war with the country.

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Crouching Tiger, Hidden Dragon

October 23, 2018 (Tuesday)

China: On the Ropes. Under President Donald Trump, the United States is the crouching tiger. China is the hidden dragon.

Trump has already slapped a 25% tariff on $50 billion of imports from China and a 10% tariff on $200 billion Chinese imports. He is threatening to raise the tariff rate on the latter to 25% too by January 2019. He has also warned about a “phase 3” plan to place a 25% tariff on all the rest of US imports (about $267 billion) from China. (See Peterson Institute’s 9/20 summary.)

As I wrote in the 10/1 Morning Briefing titled “China’s Syndromes,” Trump’s beef with China is about much more than trade. It’s about China’s ambition to become a superpower at the expense of US interests:

“The Trump administration’s overarching policy goal vis-à-vis China, therefore, may be first and foremost to use America’s economic power to slow, or even halt, the ascent of China into a superpower, which will challenge America’s interests around the world. If so, then any concessions that the Chinese make on trade and technology are likely to be rejected by the Trump administration. In other words, they have nothing to offer that would satisfy Trump other than an unconditional retreat from their geopolitical expansion plans, which they will never do voluntarily.”

In the 10/9 Morning Briefing titled “Trump’s Poison Pills,” I discussed the 10/4 speech about China by Vice President Michael Pence. It comprised a long list of complaints about China’s unfair trade practices and belligerent foreign policy. The speech even attacked the Chinese Communist Party’s totalitarian domestic policies. In other words, the speech confirmed my view that America’s relationship with China is likely to remain rocky for the foreseeable future.

It was interesting to note Pence mentioning that the Chinese stock market had taken a dive in response to the Trump administration’s pushback. The latest data out of China suggest that the country’s economy has some signs of structural weakness, which Trump’s policies are likely to exacerbate. Consider the following:

(1) Real GDP. During Q3, China’s real GDP rose 6.5% y/y (Fig. 1). It’s been hovering at this pace since Q1-2016. Hidden in the latest y/y growth rate is the implied quarterly growth rate of 5.8% (saar), which is the lowest since Q4-2008. The Chinese government doesn’t provide that information; our friends at Haver Analytics derive it from the y/y growth rate.

(2) Bank loans and production. Also visible has been the relatively stable y/y growth around 6.0% in China’s industrial production index since 2015 (Fig. 2). It rose 5.8% during September.

Hiding in plain sight is that China is getting less bang per yuan from the rapid expansion of bank loans, which has been rising around 13.0% y/y since mid-2016 (Fig. 3). The ratio of Chinese industrial production to bank loans has dropped by roughly 50% since late 2008 (Fig. 4).

(3) Real retail sales. Every month, the Chinese government reports the growth rate in nominal retail sales and the y/y percent change in the CPI (Fig. 5). The former rose 9.2% and the latter 2.5% during September.

It dawned on me only recently that the difference between the two measures—i.e., the growth rate in inflation-adjusted retail sales—would be telling. As soon as I saw the chart of this series—especially its 12-month smoothed version—the conclusion was obvious: Aging demographic factors, which were exacerbated by China’s one-child policy, may already be weighing on Chinese consumer spending (Fig. 6). During September, the smoothed growth rate fell to 7.4%, the lowest since the end of 1999.

(4) Stock prices and earnings. The major Chinese stock price indexes have certainly tumbled so far this year (Fig. 7 and Fig. 8). The China MSCI stock price index is down 19.9% ytd in local currency and 20.2% ytd in US dollars through last Friday.

Both the forward revenues and forward earnings of the China MSCI have been trending lower this year (Fig. 9 and Fig. 10). The composite’s Net Earnings Revisions Index has been moving deeper into negative territory over the past three months through September (Fig. 11).

Chinese stock prices rallied on Monday and Tuesday following assurances by the government that policies will be implemented to stimulate the economy. However, it’s way too late to stimulate more procreation.

(5) Currency and capital flows. Along with aspiring to be a superpower, the Chinese government has been trying to raise the stature of its currency, the yuan, to a reserve currency comparable to the dollar, the euro, and the yen. That ambition may get derailed for awhile if the yuan continues to come under pressure as a result of Trump’s escalating trade war with China.

The Chinese currency has dropped from a peak of 6.512 yuan/dollar at the start of this year to 6.937 yuan/per dollar yesterday (Fig. 12). Our monthly proxy for implied capital outflows for China shows that these are increasing again this year (Fig. 13 and Fig. 14).

(6) Debt-trap diplomacy. CNBC reported yesterday that Mike Pompeo, the US Secretary of State, warned about China’s “predatory economic activity” last Thursday in Mexico City. “When they show up with a straight-up, legitimate investment that’s transparent and according to the rule of law, that’s called competition and it’s something that the United States welcomes,” said Pompeo. “But when they show up with deals that seem to be too good to be true it’s often the case that they, in fact, are.” He took issue with how Chinese “state-owned enterprises show up in a way that is clearly not transparent, clearly not market-driven, and is designed … to benefit the Chinese Government.”

Stocks: On the Ropes. Among the hardest hit stocks during the latest selloff in the US have been the ones of companies most exposed to the global economy. That makes sense since US regulatory, tax, trade, monetary, and foreign policies have pushed up the dollar, interest rates, and the price of oil. This has been a triple whammy for emerging market economies. The fourth whammy for the global economy has been Trump’s escalating trade war with China. Now consider the following:

(1) EM stock prices. Debbie and I track the daily CRB raw industrials spot price index to monitor the strength of the global economy. The index is down 6% ytd through Friday (Fig. 15). The Emerging Markets MSCI stock price index (in local currency), which is highly correlated with this index, is down 11.4% ytd.

(2) Materials stock prices. The weakness in industrial commodity prices has been weighing on the S&P 500 Materials stock price index (Fig. 16). It is down 12.1% ytd, while the S&P 500 is up 3.5% through Friday.

(3) Stock prices of PPG and CAT. I asked Joe to run the CRB index versus the stock prices of PPG (which is in the S&P 500 Materials sector) and CAT (which is in the S&P 500 Industrials sector) (Fig. 17 and Fig. 18). They are both highly correlated with the index, which explains their recent weakness.

(4) Jobless claims vs commodity prices. Our Boom-Bust Barometer (BBB) is the ratio of the CRB raw industrials spot price index to initial unemployment claims. It is highly correlated with both the forward earnings and the stock price index of the S&P 500 (Fig. 19 and Fig. 20). The BBB hit a record high during the May 12 week. It has stalled since then, as weakening commodity prices have been offset by falling jobless claims. The stock market rally has also stalled since late September, as investors have fretted about whether the strength of the US economy (thanks to Trump’s fiscal policies) will offset the weakness in the global economy (thanks to Trump’s trade policies).

Gold: On the Ropes. Given the recent volatility in global stock markets, I am fielding more questions about whether this might be a good time to own some gold. The short answer is “no.” Here’s why:

(1) Over the years, I’ve found that the price of an ounce of gold tends to follow the trend of the CRB raw industrials spot price index, which has been downwards this year, as noted above (Fig. 21). Gold serves a number of purposes, including as a hedge against inflation, an alternative to the dollar, and ornamental jewelry. First and foremost, it is another commodity. The weakness in the global economy is depressing commodity prices across the board, including gold but excluding oil, which has been boosted by Trump’s sanctions against Iran.

(2) Furthermore, there is a good inverse correlation between the price of gold and the 10-year US Treasury TIPS yield (Fig. 22). That’s because rising (falling) real interest rates increase (decrease) the cost of leveraged positions held by speculators in gold, causing the price of gold to decrease (increase). The TIPS yield has increased from 0.49% a year ago to 1.09% last Friday.

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The Fed: Mind Games

October 22, 2018 (Monday)

US Economy: Running Hard, Not Hot. The US economy continues to grow at a solid pace without reviving inflationary pressures. The Atlanta Fed’s latest GDPNow model estimate for real GDP growth is 3.9% for Q3-2018, following a gain of 4.2% during the previous quarter. On a y/y basis, the latest estimate would place real GDP growth at 3.2%, the highest since Q2-2015 (Fig. 1). That’s running hard, but not hot. The same can be said about y/y growth in the Index of Coincident Economic Indicators (CEI), which is closely correlated with the comparable growth in real GDP (Fig. 2). The former logged in at 2.4% during September.

Notwithstanding the recent volatility in the stock market amid renewed fears about the prospects for the economy, both the CEI and Index of Leading Economic Indicators (LEI) rose to record highs in September, as Debbie discusses below (Fig. 3). One of the 10 components of the LEI is the yield curve spread, which edged up to 105bps last month from August’s 98bps reading, which was the lowest since March 2008. Keep in mind that as long as this spread remains above zero (even if it has narrowed significantly), it remains a positive contributor to the LEI. Here are a few more interesting observations about the yield spread and the economy:

(1) The jobless rate and the yield curve spread. The LEI’s yield curve spread is highly correlated with the national unemployment rate (Fig. 4). The latter was down to 3.7% during September, the lowest since the end of 1969. Often in the past when the jobless rate fell to such a low level, wage and price inflation would rise rapidly, after having fallen when the unemployment rate had been rising (Fig. 5).

This inverse relationship is commonly called the “Phillips curve.” The Fed typically has responded to the tightening of the labor market and rising inflation by raising interest rates until monetary policy tightening caused a recession. The coincident flattening, and sometimes inverting, of the yield curve would anticipate the economic downturn. So far, there’s no sign of this happening in the LEI’s yield curve spread component, which remains solidly in positive territory; nor do the LEI’s other components signal a downturn.

(2) The Phillips curve and the yield curve spread. Interestingly, since the early 1980s there has been a strong inverse relationship between wage inflation (measured using the y/y percent change in average hourly earnings) and the yield curve spread (Fig. 6). That’s not surprising given that the spread is so highly correlated with the unemployment rate. What is the current relationship of these variables telling us? The yield curve spread, comfortably in the positive zone, seems to confirm that while the economy is running hard, it isn’t running hot enough to significantly boost inflation, which would trigger the kind of monetary tightening that would cause a recession, and an inversion of the yield curve.

(3) A couple of regional business surveys. Debbie reports below on October’s regional business conditions surveys conducted by the Federal Reserve Banks of New York and Philadelphia. Their overall business conditions indexes remained near this year’s elevated levels (Fig. 7). Interestingly, their price indexes have been trending lower in recent months (Fig. 8).

The Fed I: Too Much of a Good Thing? In recent weeks, Fed officials have been signaling that the economy may be too strong. No doubt, it has been running hard thanks, in part to President Donald Trump’s tax cuts. But it has yet to show any sign of running too hot—i.e., hot enough to kindle inflation fires—based on the latest data from inflation barometers including the core CPI, PPI, import prices, and average hourly earnings (the most widely followed wages measure).

Indeed, average hourly earnings has been rising at a remarkably subdued pace despite the tight labor market. No wonder both the President and Larry Kudlow, director of the White House’s National Economic Council, are upset with the Fed for raising interest rates. They believe that their supply-side policies can boost productivity-led economic growth without heating up inflation. While they are stepping on the accelerator, the Fed is tapping on the brakes.

That conflicting mix of fiscal and monetary policies has sent stock prices spinning over the past couple of weeks. Recently released Q3 corporate earnings reports have just compounded the instability: Some companies are reporting results confirming that the economy is doing just fine, while others—particularly the more cyclical ones—have been bruised by rising interest rates, rising oil prices, and the strong dollar; their earnings reports have raised warning flags about the economy. The mounting fear is that Fed officials are on course to make a serious policy mistake, i.e., moving interest rates higher too rapidly despite the cracks showing up in some earnings reports.

Perhaps most unsettling: Some Fed officials have signaled in the weeks since their September 25-26 meeting that the economy may be so strong that they might have to raise the federal funds rate higher than they had mentioned doing in the past. That would be unfortunate given how well they’ve prepared the financial markets for a federal funds rate raised to 3.00% by the end of 2019. Now they’re talking more about 3.40% in 2020. Is that really necessary? A “gradual normalization” of the federal funds rate to what they’ve claimed is a “neutral” rate (3.00% in 2019) has been clearly telegraphed and is widely anticipated. Why suddenly speculate about turning restrictive in 2020?

In meetings with our accounts in Kansas last week, many expressed concerns that the Fed could trigger a financial crisis and cause a recession. That’s been the modus operandi of the Fed near the tail-end of every business-cycle expansion, especially when the economy was running both hard and hot (Fig. 9 and Fig. 10). If it is currently showing few if any signs of mounting inflationary pressures, what’s the rush to start talking about pushing the federal funds rate above neutral? Indeed, why not raise the federal funds rate even more gradually to assess how the economy is responding to monetary normalization after roughly 10 years of abnormal ultra-easy monetary policy? Good questions.

In the next section, we review the recent pronouncements from Fed officials suggesting that they may not be as level-headed as my friends in Kansas. But before we go there, let’s go straight to our conclusion: We think that the economy will remain strong, on balance, with some weakness in interest-rate-sensitive sectors. We think that inflation will remain subdued. We expect to see more evidence that productivity is making a comeback, especially in manufacturing as manufacturing comes back to the US.

If that happens, then Fed officials may have to acknowledge that NAIRU, the non-accelerating inflation rate of unemployment, might be lower than they currently believe. The Congressional Budget Office (CBO) estimates that NAIRU is currently between 4.5% and 5.0% (Fig. 11). The actual unemployment rate fell well below that range, to 3.7%, during September, yet inflation hasn’t accelerated. Could it be that NAIRU, which is unobservable, might be lower than the CBO’s model estimates? We think so. By the way, the CBO’s model also shows the ratio of actual real GDP to potential at 1.0 during Q2, the highest since Q4-2007 (Fig. 12).

Fed II: Talking About Going Restrictive. It was widely noted that the 9/26 FOMC statement deleted the following language that had appeared in previous statements: “The stance of monetary policy remains accommodative.” This sentence had been in every FOMC statement since December 16, 2015, when the Fed started its latest rate-hiking program.

Some interpreted the omission to mean that the Fed is setting up for more aggressive rate increases. On the contrary, at his 9/26 press conference, Fed Chairman Jay Powell reassuringly said that the language simply had outlived its “useful life.” So the Fed will continue its gradual rate increases toward a neutral stance.

Nevertheless, the markets are starting to fear that the Fed may be heading toward restricting economic growth. Consider the following:

(1) The dot plots. The Fed’s quarterly dot plot has become the semi-official playbook for the FOMC. It showed that on March 21, the committee’s median forecast for the federal funds rate was raised from 3.1% in 2020 to 3.4%, further above the “longer-run” forecast of 2.9%, which had also been raised from 2.8%, as shown in Table 1.

By the way, the dot plot is included in the quarterly Summary of Economic Projections (SEP) provided after the March, June, September, and December FOMC meetings. The SEP notes: “Each participant’s projections are based on his or her assessment of appropriate monetary policy. Longer-run projections represent each participant’s assessment of the rate to which each variable would be expected to converge under appropriate monetary policy and in the absence of further shocks to the economy.”

(2) The latest minutes. Despite the March 21 increase in the 2020 federal funds rate forecast, the S&P 500 rose 13.6% from this year’s low on February 8 to a record high on September 20. It’s down 5.6% since then, partly because Fed officials have upped the ante by signaling that their policy might have to turn from accommodative to neutral to outright restrictive given the strength of the economy. That gave the 3.4% forecast for 2020 more credibility. So, for example, the word “restrictive” appeared in September’s FOMC minutes for the first time during the current economic expansion as follows:

“Participants offered their views about how much additional policy firming would likely be required for the Committee to sustainably achieve its objectives of maximum employment and 2 percent inflation. A few participants expected that policy would need to become modestly restrictive for a time and a number judged that it would be necessary to temporarily raise the federal funds rate above their assessments of its longer-run level in order to reduce the risk of a sustained overshooting of the Committee’s 2 percent inflation objective or the risk posed by significant financial imbalances. A couple of participants indicated that they would not favor adopting a restrictive policy stance in the absence of clear signs of an overheating economy and rising inflation.”

(3) Brainard & Powell open to overshooting neutral. During the Q&A of his press conference, Powell was asked whether the Fed might end the tightening cycle in a “restrictive posture,” as Fed Governor Lael Brainard had suggested in a 9/12 speech. Powell responded: “It’s very possible.” He added: “Maybe we will keep our neutral rate here [i.e., at 3.00%], and then go one or two rate increases beyond it.” If the US economy continues to perform as the Fed expects, we expect that the Fed will stop tightening at around 3.25%-3.50% during 2020. That would be two 25-basis-point hikes above the SEP’s longer-run projection of 3.00% for the federal funds rate.

In her speech, Brainard explained: “In the latest FOMC SEP median path, by the end of next year, the federal funds rate is projected to rise to a level that exceeds the longer-run federal funds rate during a time when real GDP growth is projected to exceed its longer-run pace and unemployment continues to fall. The shift from headwinds to tailwinds may be expected to push the shorter-run neutral rate above its longer-run trend in the next year or two, just as it fell below the longer-run equilibrium rate following the financial crisis.”

Fed III: Deep in the Weeds. Above, Melissa and I reviewed this year’s path of the SEP’s median federal funds rate forecasts through 2021. It’s interesting to do the same for real GDP growth.

Table 2 shows that the median forecast of the FOMC has increased from 2.5% at the end of last year for this year to 3.1% in September’s SEP. Growth is expected to decelerate to 2.5% next year, to 2.0% in 2020, and to only 1.8% in 2021, which is deemed to be the long-run potential of the economy.

That’s a fairly dour outlook. FOMC participants aren’t buying the supply-side story that tax cuts may boost productivity. So they feel compelled to raise rates to slow the economy back down to its long-run potential to keep inflationary pressures from rising as a result of the short-run stimulative impact of Trump’s tax cuts. No wonder Trump isn’t happy with Powell. He probably regrets not having extended Janet Yellen’s employment contract.

The SEP also shows that the median forecast for the unemployment rate fell from 3.9% at the end of last year for this year to 3.7% last month. Next year, it is expected to fall to 3.5% and stay there through 2020. But then it is projected to edge back up to 3.7%. The long-run jobless rate is deemed to be 4.5%, the same as the CBO’s estimate for NAIRU (Table 3). No wonder Fed officials are talking about turning restrictive: They believe the unemployment rate is already well below its non-accelerating inflation rate! What if they are wrong and inflation remains subdued, as we expect?

Finally, the SEP’s median inflation forecast, based on the core PCED, is remarkable. For this year, it was raised from 1.9% at the end of last year to 2.0%. Over the next two years, it is expected to be 2.1%. FOMC participants believe that, thanks to their monetary policymaking, inflation will remain right in line with their 2.0% target for the foreseeable future (Table 4).

Fed IV: Too Much Free Time? Could it be that Fed officials have too much free time on their hands, and that’s why they concoct all sorts of cockamamie theories? For example, consider the 10/18 speech by Fed Governor Randal K. Quarles titled “Don’t Chase the Needles: An Optimistic Assessment of the Economic Outlook and Monetary Policy.” He starts with two Hamletesque questions:

“How long can this strong growth be sustained? The answer depends largely on what form growth takes. Growth that is supported by increases in the productive capacity of the economy should be durable. However, if growth primarily reflects strong demand that stretches production beyond its sustainable capacity, the economy will run into constraints that will result in slower growth, higher prices, or a potentially destabilizing buildup of financial imbalances. So, which is it?” He isn’t sure, which is why he supports the Fed’s gradual normalization of monetary policy.

Quarles hopes that there is still enough slack in the labor market and that technological innovations will boost productivity growth enough to boost potential output without reviving inflation. He fears that if that doesn’t happen, then strong demand could lift inflation.

He acknowledges that “potential output is unobserved and can only be inferred from the behavior of other measured economic indicators.” He states that inflation is “the primary indicator of the economy’s position relative to [its] potential.” Now put on your thinking caps:

“Perhaps inflation is just sending a signal of people’s trust in the Fed’s ability to meet its inflation objective. If so, no complaints here. That is a good thing. However, a problem does arise if the Fed remains reliant on inflation as our only gauge of the economy’s position relative to its potential. There are risks in pushing the economy into a place it does not want to go if we limit ourselves to navigating by what might be a faulty indicator. Anchored inflation expectations might mask the inflation signal coming from an overheated economy for a period, but I have no doubt that prices would eventually move up in response to resource constraints. The ultimate price, from the perspective of the dual mandate, would be an unanchoring of inflation expectations.”

I hope no further explanation is required, because I’m not sure there is much more I could add to explain this head-spinning concept.

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Bankers, Truckers & Fakers

October 18, 2018 (Thursday)

Financials: Banks Give ‘All’s Clear.’ Jackie and I like to skim through lots of transcripts of earnings conference. We are particularly fond of those of Bank of America and JP Morgan because both institutions touch so many different areas of the US economy. Together, they have $2.8 trillion of total deposits, $1.9 trillion of loans and leases, and $3.2 trillion of assets under management. Despite stock investors’ recent handwringing about the economy, executives from both behemoths have reported that their businesses are doing just fine, thank you. Their confidence undoubtedly helped spark Wednesday’s 547.87 point rally in the DJIA. Here are highlights from their recent conference calls:

(1) Economy growing nicely. Executives from both JP Morgan and Bank of America noted the economy’s strength in Q3 and seemed optimistic about the future, even if the future includes higher interest rates.

“The economy is strong, rates are going up. Most of us consider it a healthy normalization and going back to more of a free market when it comes to asset pricing and interest rates, et cetera. And we need that,” said CEO Jamie Dimon on the 10/12 Q3 earnings conference call. He added that the economy’s strength could continue for “a while,” as it’s benefitting from rising wages and higher participation rates, pristine credit quality, housing that’s in short supply, and extraordinarily high small business and consumer confidence.

The glass is also half full at Bank of America: “We are in [an] operating environment that has a strong, growing US economy, low unemployment, growing wage growth and strong consumer spending levels. Client engagement, optimism and activity remain good,” said CEO Brian Moynihan in the company’s Q3 conference call on 10/15.

(2) Loans growing. JPMorgan reported that core loans rose 7% y/y in Q3, and the net yield on interest-earning assets improved to 2.51%, up from 2.37% a year earlier. Banks haven’t gotten much help from the Treasury yield curve—or the 10-year Treasury less the federal funds rate—which remains relatively flat, having stabilized just above 100, not far from readings posted last summer (Fig. 1). However, even the small improvement in yield on JPM’s interest-earning assets has a big impact on the bank’s large, growing loan book. Net interest income was up 8.7% to $13.9 billion in Q3. A little less than half of JP Morgan’s loans are variable rate, so they’ll continue to reprice if interest rates increase.

One area of softness to watch: home mortgages. Mortgage fees and related income dropped 38.9% in JPMorgan’s Q3 y/y. The bank is not alone, as higher interest rates and lofty home prices are slowing home sales and reducing the demand for mortgages. New plus existing single-family home sales dropped to 5.38mu (saar) in August from a recent high of 5.76mu last November (Fig. 2). Higher rates also took a bite out of the index for applications to refinance mortgages, which fell to 913 last week, based on the four-week average, the lowest level since the end of 2000 (Fig. 3).

At Bank of America, loans grew on average by more than 3% across business lines during the quarter. One sluggish area was corporate loans, where demand for borrowing was low because companies are flush with cash. Companies “continue to make good money, and they also have cash they are repatriating. And lastly, they continue to benefit from tax savings, and they’re using that to keep their debt levels in check,” said Moynihan. Bank of America calculates that a 100bpt parallel increase in rates above the forward yield curve would increase net interest income by $2.9 billion over the subsequent 12 months.

Bank of America’s observation about sluggish loan growth jibes with Fed data. Commercial and Industrial (C&I) loans at all banks plus nonfinancial commercial paper has declined modestly, by 2.0%, after hitting a peak during the week of June 20 (Fig. 4). C&I loans have been in a flat trend since late June, and nonfinancial commercial paper has declined 16.6% over the period, though the former moved to the top of its range during first week of October (Fig. 5). The Fed’s July survey indicated that banks reporting weaker C&I loan demand cited the following reasons: increases in internally generated funds, reduced investment in plant or equipment, and the shift of customers’ borrowing to other lenders. US companies repatriated $169.5 billion in foreign profits in Q2, after repatriating $294.9 billion in Q1, a 9/19 WSJ article reported.

(3) Credit quality holding. JP Morgan reduced its provision for credit losses to $948 million in Q3, down $504 million from year-ago levels. Likewise, Bank of America’s provision for credit losses fell to $716 million in Q3, down from $834 million a year ago. Provisions for loan and lease losses and net charge-offs at FDIC-insured institutions have come down sharply from their recessionary peaks, and are slowly inching higher (Fig. 6).

(4) Returns improved. Both banks’ returns on tangible common equity have risen to levels unthinkable during the Great Recession: 17% at JPMorgan and 16% at Bank of America were reported for Q3.

(5) Expanding geographically. JP Morgan and Bank of America both are expanding—even though their branch networks shrank over the past year. JP Morgan recently opened its first branch in Washington, DC and plans hundreds of more branch openings in cities including Philadelphia and Boston. The bank’s total branch count has declined to 5,066 in Q3 from 5,174 a year earlier.

Bank of America is expanding organically because banking laws prohibit it from making acquisitions. The bank is opening retail branches in cities where it already has other operations, such as asset management or commercial banking. Bank of America recently opened branches in Denver, Minneapolis, Indianapolis, and Pittsburgh and has plans to jump into Cincinnati, Columbus, Lexington, Cleveland, and Salt Lake City. That said, the number of its financial centers has declined to 4,385 from 4,515 a year ago. The bank believes its future success will require offering both digital and physical access to banking services, something it describes as a “high-touch/high-tech” service model.

(6) Preparing for CECL. Both banks were asked to estimate the impact of changes to accounting rules affecting current expected credit loss, or CECL. Under the new system, banks will need to estimate the expected credit loss over the life of the loan. That differs from the current system where banks recognize losses when they “reached a probable threshold of loss,” explains a primer by SAS. JP Morgan’s CFO Marianne Lake noted that analysts have estimated that in general bank reserves might need to increase by 20%-30%.

Bank of America’s CFO Paul Donofrio was a bit vaguer: “[T]here will likely be some increase to allowance upon adoption, but the amount of increase, the impact, is going to be dependent on the economic outlook and credit conditions on the date of adoption, and that’s not until 1/1/2020. So, we’ll just have to wait.” An article in yesterday’s WSJ indicated a handful of regional banks have met with Washington politicians and regulators in an effort to modify the rule. Proponents believe the rule will give investors more timely information. Detractors warn it will make banks less willing to loan during a recession.

(7) Blockchain in action. JPMorgan’s Interbank Information Network (IIN), a blockchain for international payments, has 75 banks signed up. Here’s how the bank describes its project: “IIN … minimizes friction in the global payments process, enabling payments to reach beneficiaries faster and with fewer steps. Using blockchain technology, IIN reduces the time correspondent banks currently spend responding to compliance and other data-related inquiries that delay payments.”

(8) An underwhelming year. JPM and BAC both are members of the S&P 500 Financials sector, which is down 4.3% ytd through Tuesday’s close. Here’s how that stacks up to the ytd performance of the other 10 S&P 500 sectors: Tech (13.9%), Health Care (12.5), Consumer Discretionary (12.1), S&P 500 (5.1), Utilities (2.1), Energy (1.4), Industrials (-0.7), Real Estate (-4.2), Financials (-4.3), Communications Services (-6.7), Consumer Staples (-6.7), and Materials (-9.8) (Fig. 7).

The two banking giants are part of the S&P 500 Diversified Banks stock price index, which is also down by 4.2% ytd (Fig. 8). The index may just be consolidating after enjoying a strong run from early 2016 through late last year. Or investors may be anticipating the above-mentioned CECL accounting change before analysts include it in their estimates. Analysts call for the industry to grow revenues by 3.3% this year and 3.6% in 2019 (Fig. 9). Earnings are forecast to jump 26.0% and 13.2% this year and next (Fig. 10).

Because the industry’s stock price index has stalled while earnings have continued to climb, its forward P/E has fallen to a reasonable 10.9, down from 13.7 in December 2017 (Fig. 11). On a price-to-book basis, the stocks don’t look quite as attractive. JPM’s tangible book value per share is $55.68, just around half of the bank’s Tuesday closing stock price of $108.62. Similarly, BAC’s tangible book value is $17.23, well below its stock price of $28.53.

Transports: Driven by Labor. Our 10/4 Morning Briefing pointed out the sharp divergence in the recent performances of the S&P 500 Railroads and Trucking stock price indexes. Starting this summer, the Railroad index continued to chug higher while the Trucking index went into reverse (Fig. 12).

The two transportation indexes moved in opposite directions even as the freight indicators we watch continued to climb or remain in record territory. Both indexes fell sharply in the market’s recent selloff, but the S&P 500 Railroad stock price index remains up ytd, by 18.4%, while the S&P 500 Trucking stock price index has lost 0.9% ytd.

We speculated that the Trucking index was faltering because the industry is much more labor intensive (one truck, one driver) and much less fuel efficient than the railroad industry. Railroads can have one or two conductors manning trains with more than 100 railcars. Tuesday’s earnings reports from JB Hunt Transport Services and CSX largely confirmed our theory. Let’s take a look:

(1) Peer beyond the bottom line. JB Hunt’s top and bottom lines look great. It’s what’s in the middle that may worry investors. The trucking company’s total revenue, including fuel surcharges, jumped 19.9% in Q3 y/y to $2.2 billion. However, its operating expenses jumped even more sharply, by 21.3%, to $2.0 billion.

Part of the surge in expenses can be blamed on the double-digit percentage increase in drivers’ salaries, which sent JB Hunt’s salaries, wages, and employee benefits 21.3% higher y/y to $495.4 million in Q3. Other expenses jumped sharply too: Operating supplies and expenses rose 17.2% to $79.2 million, general and administrative expenses, net of dispositions, increased by 44.4% to $42.4 million, insurance and claims soared 72.3% to $45.6 million, operating taxes and licenses rose 22.9% to $13.2 million, and communications and utilities came in at $7.1 million, up 23.5% y/y.

Because expenses rose so much faster than revenues, operating income increased by only 5.9%. However, the company’s bottom line grew far faster than 5.9% because JB Hunt’s income taxes fell sharply thanks to the Trump administration’s tax cuts. After taxes are accounted for, net earnings rose by 30.6% y/y to $131.1 million.

(2) Same sector, much different picture. CSX also enjoyed gains in its top line: Revenue improved by 14.1% in Q3 y/y, bringing it up to $3.1 billion. However, at the railroad company, labor and benefits in the quarter actually fell 4.1% y/y to $695 million. The company also benefitted from an 18.3% drop in equipment and other rents to $89 million. Those declines were somewhat offset by a 30.7% jump in fuel expense.

All tallied, total expenses at CSX dropped 2.1% y/y to $1.8 billion, allowing the company’s operating income to soar 49.0% to $1.3 billion. Like JB Hunt, CSX also enjoyed a reduction in its tax bill. As a result, its net earnings after taxes almost doubled to $894 million last quarter, from $459 million a year earlier. Share repurchases meant the company’s earnings per share fared even better, rising by 105.9% y/y.

The moral of the story: Sometimes the bottom line is not the bottom line.

Tech: Beware Deepfakes. If fake news is bad, fake videos—known as “deepfakes”—have the potential to be even worse. The technology exists to use the images of people saying and doing things that they’ve never said or done.

At first, this functionality seemed harmless and comical. Who wouldn’t like to see a young Harrison Ford inserted into “Solo: A Star Wars Story,” a deepfake video brought to our attention by a 10/16 Gizmodo article? Turns out, the video is just one of many broadcast on the YouTube channel derpfakes. The creator has fake videos of Nicolas Cage, Hillary Clinton, and Vladimir Putin among others, which are comical primarily because it’s clear that they’re fake. We know that Harrison Ford is 76 and couldn’t really be in the recent “Star Wars” film looking youthful.

But the 10/15 WSJ did a thought-provoking piece about the dark side of deepfakes. Fake videos become more problematic when they feature regular people or politicians doing or saying things that aren’t obviously bogus, leaving viewers unable to judge the video’s veracity. In addition, the mere existence of deepfakes is problematic because it theoretically allows politicians to disavow real videos by calling them “deepfakes.”

Perhaps most disconcerting is the idea of a fake video of a President saying he (or she) launched a nuclear war. If that fake video is sent to another country, say North Korea, that country might retaliate by launching nuclear weapons. Something funny has the potential to turn serious awfully quickly.

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Brazil & Italy: From Right to Left

October 17, 2018 (Wednesday)

YRI on Your Smartphone. Our extensive website of automatically updated chart publications is now available to you on your smartphone. Our website is also now an app that works across all digital devices. So:

(1) If you have an Android phone, simply link to www.archive.yardeni.com on your phone’s browser. Then click on “Add to Home Screen” on the browser’s settings. The YRI icon should appear on your home screen along with your other app icons.

(2) If you have an iPhone, open up Safari and load www.archive.yardeni.com. At the bottom of the screen, you'll see an icon showing an arrow that is in a square. Tap this button. On the bottom row, tap “Add to Home Screen.” You'll be asked to choose a name for the home screen icon. When you're done, it'll show up on your home screen.

Brazil I: Betting on Bolsonaro. One of the hottest stock markets in the world right now is Brazil’s, as investors bet that the strongman frontrunner set to become the next President in an October 28 runoff election will embrace reforms to revive Latin America’s largest economy.

The Brazil MSCI stock price index leads all others so far in October through Monday, up 5.0% in local currency (real) and 12.5% in US dollar terms (Fig. 1). It’s the only stock market in positive territory in local currency terms so far this month. In contrast, the US MSCI index is off 5.7% so far in October. Additionally, the Brazil index (in real) is up 8.0% ytd and 9.0% during Q3. Those gains compare with the US MSCI’s advances of 2.9% ytd and 7.0% during Q3.

Brazil’s gains have come as Jair Bolsonaro, a retired army captain and evangelical Christian who espouses far-right views and speaks admiringly of the brutal dictatorship that ruled the country between 1964-85, won 46% of the vote in the October 7 election, according to a 10/8 report on Vox. Leftist candidate Fernando Haddad of the Workers’ Party (PT)—a former mayor of Sao Paolo and successor to the popular jailed former President Luiz Inacio (“Lula”) da Silva who was banned from running—garnered 29% of the vote and will be challenged to close the gap in the runoff.

Following the election and on a day when most emerging markets were pressured, the Ibovespa stock index rallied by the highest percentage in two years, 4.1%. Brazil’s currency, the real, hit a two-month high against the US dollar (Fig. 2). Bonds rallied. The Brazil iShares MSCI ETF rose to its highest level in 17 months on quadruple its average daily turnover in the past year, Bloomberg reported in a 10/9 article.

Pioneering emerging markets investor Mark Mobius told Bloomberg he is investing in Brazilian stocks in two new funds offered by his Mobius Capital Partners. “We think there are good opportunities in Brazil and expect to have a heavy weighting, provided that the market prices do not go up too high,” Mobius said in the 10/10 report. He noted that Bolsonaro’s strong showing indicates efforts to bolster the economy are “alive and well.”

A lot is riding on the relatively unknown Bolsonaro, whose middle name is “Messias,” Portuguese for “messiah.” Whether he represents the country’s salvation or its damnation remains to be seen. I asked Sandra Ward, our contributing editor, to take a closer look at the candidate, whose path to the presidency appears to be modeled after Donald Trump’s:

(1) From fringe to frontrunner. Bolsonaro served in relative obscurity representing the state of Rio de Janeiro in Brazil’s congress for seven terms before emerging in 2014 as a political force railing against corruption and crime amid the worst recession in decades, a 10/7 profile in Al Jazeera pointed out. “He was always an unimpressive backbencher, he was never a party boss … or had a programmatic agenda that was of any significance,” Matias Spektor, a professor of international relations at the Brazil-based Getulio Vargas Foundation, told Al Jazeera. “Until four years ago, Bolsonaro was not a household name in Brazilian politics.”

A candidate of the conservative Social Liberal Party (PSL), which he joined in January, Bolsonaro has a history of shifting party alliances. In his sons—Eduardo, a congressman, lawyer and former federal officer; Flavio, a senator; and Carlos, a city councilor in Rio, all by his first wife—some see the makings of a political dynasty, notes a 10/12 article in the Financial Times.

(2) “Trump of the Tropics.” The Brazilian media have dubbed Bolsonaro the “Trump of the Tropics.” More ominously for Brazil’s democracy, he is also often compared to Philippines President Rodrigo Duterte or Egyptian dictator General Abdel El-Sisi, Newsweek noted in a 10/7 piece.

Like Trump, Bolsonaro relishes the role of outsider and ascended to power by deftly capitalizing on the rage and frustrations of average Brazilians fed up with a government they see as failing them. He relies on social media outlets such as Twitter, Facebook, and WhatsApp to communicate directly to his supporters. He disparages the press, most recently calling it “trash,” according to a 10/12 Reuters report, before backpedaling and calling journalists “friends.” His contempt for the media was evident again when he skipped a recent pre-election debate, preferring to give a one-on-one interview to an outlet owned by a supporter, the evangelical Christian bishop and media mogul Edir Macedo, Reuters reported in a 10/5 article.

Bolsonaro’s offensiveness is legendary. For more on that, see the cover story in the 9/20 Economist, which labeled Bolsonaro a “menace.” A 10/8 report in the Independent discussed his nostalgia for Brazil’s years of dictatorship and has noted that his only criticism of the government back then was that it relied too heavily on torture rather than engaging in more killing—even though there were plenty of killings.

Six former generals advise Bolsonaro, and his running mate is retired General Antonio Hamilton Mourao, who has suggested on numerous occasions that a military coup could be a solution to ending corruption and bringing order to Brazil, according to a 9/11 Huffington Post article. Bolsonaro wants to double the number of Supreme Court justices, which would allow him greater control over constitutional decisions.

(3) Political platform. Bolsonaro’s campaign slogan is a variation of Trump’s America First campaign: “Brazil before everything, and God above all,” according to a 10/10 piece in Vox. Improving safety and security are key features of Bolsonaro’s political agenda. His approach: make punishment harsher, militarize the police, and loosen restrictions on gun ownership. The candidate knows firsthand about the escalating violence in Brazil: He survived a knife attack during a street rally on September 8, a development that further bolstered his ratings in the polls.

(4) Economic agenda. Details of Bolsonaro’s plans for the economy are scant, and he has professed ignorance about economic matters, as a 10/5 report on CNBC highlighted. If elected, he plans to name banker Paulo Guedes, a University of Chicago-trained economist, a “super minister” overseeing the entire economy.

Guedes has proposed cutting public debt by 20% through privatizing state-owned assets and cutting spending, according to a 10/15 report on France24. Guedes favors fully privatizing state-owned oil company Petrobras to pay down its US$74 billion debt. That’s put him at odds with the military generals advising Bolsonaro, who view Petrobras as a strategic asset, according to a 10/12 Reuters story. Bolsonaro has vowed to cut spending to address an expected budget deficit of US$39 billion in 2019; yet he also promised to cut taxes and simplify the tax code, according to a 10/7 Associated Press report.

Guedes and Bolsonaro have also clashed over Guedes’ plan to reintroduce a financial transaction tax to guarantee the social security program while restructuring the pension system. Bolsonaro disavowed the plan.

Guedes has come under a cloud in the last week as federal prosecutors in Brazil said they were investigating him over alleged investment fraud at state-controlled pension funds in which the pension funds lost sizeable amounts while Guedes pocketed outsized gains, according to a 10/10 story in the WSJ.

(5) The Bolsonaro effect. Brazilian stocks that have been rallying since Bolsonaro’s strong showing include those of the energy company Petrobras, which could benefit from asset sales; gun-maker Forjas Taurus, which could benefit from increased gun ownership; and power company Eletrobras, which could benefit from Bolsonaro’s plan to expand nuclear and hydro energy projects to reduce energy shortages.

(6) The Trump effect. Brazil has been slowly recovering since it emerged from recession last year. GDP grew 1.0% y/y in Q2, impacted by a nationwide truckers’ strike, which Bolsonaro fully supported (Fig. 3). Estimates put full-year growth at 1.5% this year, according to an 8/31 Reuters report, slightly less than the government’s official 1.6% forecast and far below the 2.5% estimates before the late-May strike.

Yet there’s a bright spot amid the gloom: agriculture. Brazilian soybean farming is booming as Chinese hog farmers have turned to Brazil for their grain needs as a result of tariffs resulting from Trump’s trade war. Brazilian exports to China rose 22% between January and September, according to a 10/11 piece in Reuters. China now claims close to 80% of Brazil’s soy exports. Brazilian soybeans are also commanding a premium of $2.83 more per bushel than US beans, which have fallen to decade lows.

Brazil is benefiting now from the fallout from Trump’s trade wars with other countries. But it may be just a matter of time before Trump turns his attention to prying better trade deals from the country he calls one of the “toughest in the world” in terms of protectionism, according to a 10/1 Reuters story
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By then, he might be dealing with a strongman cut from the same cloth as him. Investors, however, would be wrong to assume Bolsonaro has the same free-market resolve as Trump.

Brazil II: Bolsonaro Bump? We had an internal debate about whether the runup in Brazil’s stock market is related to a “Bolsonaro bump”—i.e., anticipation that Bolsonaro’s policies would be as bullish for Brazil as some of Trump’s have been for the US—or is based on fundamentals. It may be both. But we can’t shake the thought that if Brazil is headed for a dictatorship again, any investor hopes pinned on Bolsonaro might be misplaced.

Political and economic uncertainty aside, Brazil’s corporate earnings are expected to post stellar growth heading into 2019. Economically, the country has recovered from the slump during 2016, but it isn’t anything too impressive at the moment, as noted above. Perhaps investors are banking on political resolution and earnings growth to fuel economic growth in the coming years. To put some numbers to the story:

(1) Earnings expectations way up. The forward earnings per share of the Brazil MSCI has risen 78.2% from a recent low during February 2016 through the week of October 4 (Fig. 4). The 2019 consensus earnings estimate has climbed 15.3% since it bottomed in late January.

(2) Revenues per share up too. The forward revenues per share of the Brazil MSCI has risen recently too, but not as dramatically as EPS has. The former is up 9.7% since a rout before the start of 2018 (Fig. 5). It’s up 6.8% since February 2016 compared with the 78.2% for EPS cited above.

(3) Relatively inexpensive forward P/E. One reason global investors have taken notice of the Brazilian stock market is its relative valuation both historically and compared to other countries. The Brazil MSCI’s forward P/E of 10.5 is well below both its recent highs, closer to 14.0, and the All Country World MSCI index’s P/E of 14.8. So Brazil looks inexpensive, but perhaps with good reason given the country’s political and economic uncertainties (Fig. 6).

Italy: Collision Course. Italy’s coalition government approved a 2019 draft budget Monday that is sure to lead to a showdown with the European Union (EU). Worried investors have already driven yields on Italian bonds to nearly five-year highs. The budget will be sent to the Italian parliament Saturday for approval by year-end. Let’s review what’s at stake:

(1) Widening deficit. Ignoring warnings by the International Monetary Fund and criticism by European Central Bank (ECB) President Mario Draghi, Rome pushed ahead with its plans to raise welfare and pension spending and to cut taxes, widening the budget deficit by an estimated 2.4% of GDP. EU officials have warned that the budget as proposed will put Italy in violation of spending rules, and there is concern that the deficit could be much higher, according to a 10/15 WSJ article. The fear is that Italy won’t be able to meet its obligations on its outsized public debt, which stands at 130% of GDP.

(2) “Enemies of Europe.” The move follows last week’s outburst by Matteo Salvini, co-deputy prime minister of Italy, in a joint press conference with France’s far-right firebrand Marine Le Pen, declaring the European Commission leaders “enemies of Europe” whom “we are against,” noted a 10/8 FT article.

(3) The “Soros” factor. Yields on 10-year government bonds climbed as high as 3.71% in the last week before settling at a recent 3.49% (Fig. 7). The spread between the Italian 10-year and the comparable German bunds has risen to 306bps as investors have demanded a higher risk premium (Fig. 8). Salvini dismissed the rising yields as the work of speculators “like [George] Soros,” according to the FT referenced above, and said “we are not going back.”

A 10/16 Bloomberg article notes that at current yield levels, Italy’s debt is ballooning at a faster rate than the economy is growing, risking a dangerous debt spiral.

(4) The euro. The escalating conflict is pressuring the euro as fears about the single-currency’s future mount (Fig. 9).

(5) The economy. The budget drama is being played out against an economy that continues to soften. Q2 GDP eked out an advance of 0.8% q/q (saar), as household spending weakened considerably (Fig. 10). Industrial production fell 0.8% y/y in August, the second straight monthly decline (Fig. 11).

With the ECB signaling that it will hold fast to its intention to end its quantitative easing program in December, Italy could be in for more interesting times.

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Stepping on the Accelerator and the Brakes

October 16, 2018 (Tuesday)

Trump's World: Head-Spinning Policies. I’ve said it before: There has never been a President with policies so simultaneously bullish and bearish as Donald Trump! He is stepping on the economy’s accelerator and brakes at the same time.

Deregulation and tax cuts are bullish for the US economy as well as for corporate earnings and stock prices. On the other hand, the ballooning federal deficit—attributable to the tax cuts and spending increases—is putting upward pressure on bond yields at the same time that the Fed has moved to raise interest rates and taper its balance sheet.

No President has ever provided this much fiscal stimulus at this stage of the business cycle. In the past, such stimulus was provided during recessions or early recoveries, when the unemployment rate was at a cyclical high, not when it was near previous cyclical lows as it is today. Trump is making a very big bet on supply-side economics. The idea is that tax cuts will boost growth by boosting productivity, so inflation should remain subdued. That could work as long as growth isn’t weighed down by rising interest rates. If inflation does come back, then the latest supply-side experiment will end very badly indeed. (I expect that inflation will remain subdued, and I am open to the possibility that supply-side economics might work as advertised by its promoters.)

Trump’s geopolitical policies may eventually be bullish. But for now, they are bearish. His sanctions against Iran have caused oil prices to rise. The higher cost of gasoline will offset some of the benefits of Trump’s tax cuts for consumers. Higher energy costs will also squeeze profit margins, which were significantly boosted by Trump’s corporate tax cut.

Also on the bearish side, Trump’s worldwide tariffs on aluminum and steel and on Chinese imports may be disrupting US multinational supply chains and earnings, especially in the short term. But longer term, Trump’s policies may force more companies to move their production out of China and into the US or countries that have signed bilateral trade deals with the US.

On the whole, Melissa and I continue to believe that Trump’s polices are bullish for the US economy. We remain optimistic on the outlook for earnings and expect the stock market to recover from its latest selloff and make new highs next year. Nevertheless, we are very aware of the downside risks attributable to Trump’s head-spinning policy initiatives. Let’s update some of the top effects of Trump’s policies so far:

(1) Bullish corporate tax cut boosting earnings. S&P 500 earnings got a big boost from Trump’s tax bill passed at the end of last year. The Tax Cut and Jobs Act (TCJA) lowered the federal statutory corporate tax rate to 21% from 35%. Since its enactment, analysts have continued to raise their earnings expectations for this year and next: Forward earnings—i.e., the time-weighted average of analysts’ consensus 2018 and 2019 earnings expectations—for the S&P 500/400/600 are up 20.1%, 20.2%, and 32.3%, respectively, since the week of December 15. They rose to record highs during the 10/11 week (Fig. 1).

During Q1 and Q2 of this year, S&P 500 operating earnings in aggregate jumped 25.9% y/y to $1.25 trillion and 25.3% y/y to $1.31 trillion, respectively (Fig. 2). For Q1 and Q2, S&P 500 operating earnings per share (using Thomson Reuters data) jumped 23.2% y/y and 25.8% y/y, respectively. S&P 500 revenues per share increased impressively for the same periods, by 9.4% and 10.3%. Looking at the difference in the revenues-per-share and earnings-per-share growth rates for Q2-2018 implies that Trump’s tax cut might have added as much as 15 percentage points to earnings growth (Fig. 3).

This effect can also be seen in the profit margin, which jumped from a record 10.9% during Q4-2017 (before Trump’s tax cut) to a new record high of 12.3% during Q2-2018 (Fig. 4).

(2) Bullish deregulation boosting small business confidence. It’s impossible to measure the impact of Trump’s deregulation of business on S&P 500 earnings. Our guess is that deregulation, which started early last year, might amount to $4 per share in additional earnings.

The monthly survey conducted by the National Federation of Independent Business (NFIB) shows that significantly fewer small business owners have been reporting concern about government regulation and taxes since Trump was elected (Fig. 5 and Fig. 6). After all is said and done, the earnings component of the NFIB survey is the highest on record since the start of the data during 1974. This series is highly correlated with the NFIB’s “expecting to increase employment” series, also at a record high (Fig. 7).

(3) Bullish depreciation allowances boosting capital spending. Thanks in part to Trump’s tax reform, there has been plenty of cash flow to finance capital spending, share buybacks, and dividends. Progressives have argued that corporations are not making productive use of their resources. They say that firms are using incremental cash flow for the short-term benefit of shareholders rather than investing in future earnings potential. It is true that buybacks and dividends have been about the same as after-tax operating profits for the S&P 500 in recent years (Fig. 8).

However, focusing on this fact overlooks the record amount of corporate cash flow, provided by depreciation allowances, that has been fueling corporate capital spending. The data show that nonfinancial corporations’ (NFCs) capital expenditures are at a record high (Fig. 9). Private nonresidential fixed investment in real GDP rose solidly by 8.7% (saar) during Q2, following an 11.5% gain during Q1. Thanks in part to Trump’s tax cuts, there has been plenty of cash flow to finance capital spending, share buybacks, and dividends. In addition, TCJA helped to boost NFC’s capital consumption allowance by 19.4% y/y during Q2 to a record high (Fig. 10).

(4) Bearish federal deficits worsened by Fed’s monetary normalization. In addition to gradually raising interest rates, the Fed started tapering its balance sheet during October 2017. Since the start of that month through September, the Fed’s holdings of Treasuries and mortgage-backed securities have dropped by $152 billion and $86 billion, respectively (Fig. 11). The pace of tapering was upped this month for Treasuries from $25 billion per month to $30 billion. In effect, the Fed is adding $360 billion at an annual rate to the federal budget deficit. In the past, I’ve found that a supply/demand analysis of bond yields isn’t very useful. However, given that the Congressional Budget Office is projecting federal deficits averaging roughly $1.0 trillion per year, deficits may be starting to weigh on the bond market.

(5) Bearish impact of higher oil prices resulting from sanctions on Iran. Although they may be earning more lately thanks to Trump’s tax cuts, consumers are also paying more at the gas pump. The price of a barrel of Brent crude has been soaring ever since President Trump withdrew from the Iran nuke accord on May 8 (Fig. 12). At that time, the US announced it would reinstate sanctions against Iran and any companies doing business in Iran, leading to potential oil production decreases from Iran in the future. Iran is the third-largest OPEC producer, behind Saudi Arabia and Iraq. That’s bad news for consumers and businesses that must pay more for fuel. Of course, higher oil prices may also depress economic growth around the world, which seems to be happening already among emerging economies.

(6) Bearish superpower rivalry between US and China. Our 10/1 Morning Briefing was titled “China’s Syndromes.” I wrote that the Chinese government is scrambling to expand its overseas military and economic power to counter structural weaknesses at home, mainly related to aging demographics. I argued that President Donald Trump is implementing policies aimed at either slowing or halting China’s drive to become a superpower. Trump’s endgame is that the US would no longer be financing China’s ascent with our trade deficit and providing technological knowhow that has been either stolen or extorted. To that effect, I covered recent harsh words and accusations spoken against China by the President and Vice President in the 10/9 Morning Briefing.

The bottom line is that the US’s relationship with China is not good and might get worse. In a worst-case scenario, Trump could up the ante by placing 25% tariffs on all imports from China indefinitely. That would be bad for US multinationals, depending on Chinese supply chains, especially in the short term. But I expect that US companies will reconfigure their supply chains outside of China accordingly, which would be bad for China’s foreign-demand-fueled economy.

Trump also has the power to limit US trading partners’ ability to do business with China. As I’ve noted before, the so-called “new NAFTA” agreement gives Washington the ability to veto any of Canada’s and Mexico’s trading partners that don’t abide by free-market principles—a veritable “poison pill” aimed at China. He could place such limits on other US trading partners as well.

Even though the escalating trade dispute with China is getting uglier by the day, I doubt it will be the event that ends the bull market in the US. However, it may mark the beginning of a severe and prolonged bear market in China.

(7) Bearish consequences for emerging economies. Most signs point to a “Stay Home” investing strategy right now. That’s because capital will likely continue to flow away from emerging economies. When that happens, greater demand for dollars relative to emerging market currencies raises the relative value of the dollar. Emerging market economies with lots of dollar-denominated debt get hit with a one-two-punch: weakening local currencies and rising interest rates.

Furthermore, China could fall hard because of the escalating trade dispute. That could contribute to further challenges for other emerging economies that depend on China for trade. It’s no wonder that the IMF recently warned about a potential slowdown in global growth. For some time, the IMF has been warning about the vulnerabilities in emerging economies as interest rates rise in advanced economies.

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Panic Attack #62?

October 15, 2018 (Monday)

Stocks I: Rounding Up the Usual & Unusual Suspects. The current bull market in stocks, which started on March 9, 2009, has been widely described as “the most hated bull market in history.” Google-search that phrase, and you’ll see over 15 million results. It’s been that way because ever since the financial crisis of 2008 and the resulting severe recession, the next downturn has been the most widely anticipated recession of all time. It’s been widely feared to be lurking just around the corner since the last recession.

As a result, there have been almost countless corrections and selloffs during the current bull market. Actually, Joe and I have been keeping track of them in our S&P 500 Panic Attacks Since 2009. By our count, there have been 62 panic attacks since the start of the bull market including last week’s plunge. These include five outright corrections with the S&P 500 down by 10% or more but not 20% or more (which would mark a bear market) (Fig. 1). The panic attacks include the two-day Brexit selloff and lots of other minor downdrafts.

We’ve had no trouble identifying the major events/fears that triggered the first 61 of the panic attacks, all of which were followed by relief rallies. Most of the relief rallies since February 2013 swept the market to new record highs. But Joe and I are struggling to identify the main cause of last week’s freefall specifically on Wednesday and Thursday October 10 and 11. There are lots of candidates, and we may need to identify the cause as “all of the above.” For now, we’re labeling it “Global growth slowdown fears.”

We are kicking ourselves because we actually listed and discussed potential “bear traps” for stocks in the 9/24 Morning Briefing titled “Bear Tracks.” By the way, we also listed a bunch of bear traps for bonds. However, we stuck with our relatively upbeat outlooks for both. We didn’t anticipate that a recession is imminent, so we remained bullish on stocks, and still are. We listed lots of reasons to hate bonds, but argued that US yields would be held down by near-zero yields in Japan and Germany. In the 10/8 Morning Briefing, we sanguinely acknowledged that while the tether to bunds and JGBs may be fraying, it was holding still.

Now, there’s a widespread, perhaps even consensus, forecast that the 10-year US Treasury bond yield is heading toward 4.00%. Last Friday, JPMorgan Chase & Co. (JPM) CEO Jamie Dimon reiterated his view that this yield is heading to 4.00% and maybe 5.00%. However, he stressed that this is just a reversion to normal yield levels, consistent with solid economic growth. The Dow Vigilantes kept the Bond Vigilantes in check as the yield dropped back down to 3.16% at the end of last week from an intraday high topping 3.25% on Tuesday.

Without further ado, let’s assess all the reasons proffered for last week’s stock market selloff, to assess whether it was just the latest panic attack (i.e., #62) or the first growl of a newborn bear market:

(1) Blame the Fed and Trump’s supply-siders. The 10-year US Treasury bond yield rose decisively above 3.00% on September 18 (Fig. 2). It topped 3.25%, on an intraday basis, on Tuesday, October 9 for the first time since late April 2011. Along the way, on Wednesday, October 3, stronger-than-expected increases in September’s ADP payrolls and the ISM nonmanufacturing PMI contributed to the rout in the bond market in subsequent days (Fig. 3 and Fig. 4). These and other strong economic indicators have been boosting the Atlanta Fed’s GDPNow forecast for Q3, which was 4.2% on October 10.

Meanwhile, since the last meeting of the FOMC ended on September 26, Fed officials have been reiterating their commitment to continue to gradually normalize monetary policy. That means getting the federal funds rate up to a “neutral” level of 3.00% and paring the Fed’s balance sheet. They’ve suggested that by 2020, they might have to overshoot the neutral rate and push the federal funds rate to 3.40% to keep a lid on inflation by slowing the economy down.

Not surprisingly, President Trump and his supply-side economic advisers aren’t happy with what the Fed is doing. In their opinion, their tax cuts are working to boost real economic growth without reviving inflation. They can point to last week’s batch of inflation indicators showing tame increases in the PPI and CPI, with the latter up just 1.8% at an annual rate during the three months through September excluding food and energy (Fig. 5). Helping to hold down the PPI finished goods inflation rate is the recent moderation in the import price index excluding food and energy to only 0.6% y/y through September (Fig. 6). That may seem surprising given that Trump has been imposing tariffs. It’s not so surprising given that the trade-weighted dollar is up 3.8% y/y through the end of last week.

The bottom line for the stock market is that monetary policy is in conflict with fiscal policy. On Saturday, I spoke at Jim Cramer’s investment conference in NYC. Jim is convinced that the economy is slowing based on what he is hearing from companies. As a result, he blames the Fed for last week’s market plunge. While he therefore is very concerned about the market, he believes it could rebound sharply once the Fed comes around to its (or his) senses.

(2) Blame PPG. While the US economy’s macroeconomic indicators support the supply-siders’ spin that tax cuts are boosting economic growth, Cramer mentioned that a few companies warned last week about rapidly deteriorating economic conditions. Certainly helping to set the stage for last week’s stock market freefall on Wednesday and Thursday was depressing earnings guidance by PPG Industries after the market close on Monday, October 8.

The company reported “we saw overall demand in China soften, and we experienced weaker automotive refinish sales as several of our U.S. and European customers are carrying high inventory levels due to lower end-use market demand.” Margins are getting squeezed as a result of “significant raw material and elevating logistics cost inflation, including the effects from higher epoxy resin and increasing oil prices….inflationary impacts increased during the quarter and, as a result, we experienced the highest level of cost inflation since the cycle began two years ago.”

So while Trump is stepping on the accelerator with his supply-side policies, he is also stepping on the brakes as his trade war with China is slowing that economy down and his sanctions on Iran are boosting oil prices. The US economy might still be doing well on balance, but the increases in interest rates, the dollar, and oil prices are clearly depressing the global economy as evidenced by the drop in the CRB raw industrials spot price index to the lowest readings since early November 2016. This index is highly correlated with the Emerging Markets MSCI stock price index (in local currencies), which fell last week to the lowest reading since May 2017 (Fig. 7). The relative performance of the S&P 500 Materials sector (which includes PPG) is also highly correlated with the CRB index and has taken a dive in recent days (Fig. 8).

Meanwhile, here in the US, Jackie and I observed last week on Thursday that several cyclical S&P 500 sectors have been signaling trouble for a while this year. They include Copper (-32.8% ytd), Homebuilding (-29.8), Paper Packaging (-26.7), Semiconductor Equipment (-26.6), Automobile Manufacturers (-26.5), and Hotels, Resorts & Cruise Lines (-9.4). ”Some of these industries take the pulse of the consumer,” we noted. “Others home in on the health of manufacturing. All may be reacting badly to rising interest rates and oil prices.”

(3) Blame Mike Pence and Businessweek. Also setting the stage for last week’s selloff was a 10/4 speech by Vice President Mike Pence detailing the Trump administration’s long list of complaints against China. It wasn’t just about trade. He started out by warning: “Beijing is employing a whole-of-government approach, using political, economic, and military tools, as well as propaganda, to advance its influence and benefit its interests in the United States.” In other words, Pence’s speech made it clear that the problem is that China aspires to be a superpower at the expense of the US.

While Trump seems to be winning his trade wars with most of America’s major trading partners, the conflict with China is likely to worsen because it isn’t just about trade. It is about national security. That’s raising alarms, particularly among US technology companies that have integrated China into their supply chains. A 10/5 Bloomberg Businessweek report alleging that the country’s spooks have been planting spyware into widely used motherboards only heightens the national security concerns.

(4) Blame the tech sector and the FANGs. The hardest hit sectors of the S&P 500 during October’s witching season so far have been Consumer Discretionary (-7.7%) and FANG-less Information Technology (-6.0) (Fig. 9). Also underperforming so far is the new Communication Services sector (-5.3). They’ve been led down by their FANG components, which Joe discusses below. The FANGs (Facebook, Amazon, Netflix, and Google’s parent Alphabet) don’t have supply-side issues in China. However, numerous other tech companies do rely on China for lots of what they make. Scrambling to get out of China is expensive and could hinder companies that do so from conducting business in China. Nevertheless, the tech selloff, and especially the drop in the FANGs, may be overdone, as Joe explains below.

By the way, the S&P 500 was recently rearranged with some stocks moved out of the Consumer Discretionary and Information Technology sectors into the new Communications sector, which replaces the Telecom Services sector. We doubt this had anything to do with last week’s selloff.

However, it is interesting to note that all three affected sectors’ earnings shares of the S&P 500 were in line with their market-cap shares prior to the selloff, suggesting that they aren’t out of whack on a valuation basis (Fig. 10, Fig. 11, and Fig. 12). Here are the market-cap and earnings shares of the 11 sectors as of the 10/4 week: Communication Services (10.0%, 9.4%), Consumer Discretionary (10.0, 7.8), Consumer Staples (6.6, 6.3), Energy (6.1, 6.3), Financials (13.4, 18.5), Health Care (15.0, 15.3), Industrials (9.8, 10.0), Information Technology (21.1, 19.5), Materials (2.4, 2.7), Real Estate (2.6, 1.2), and Utilities (2.8, 2.9).

(5) Blame valuation multiplies. Notwithstanding the recent burst of bearishness, the earnings outlook remains bullish overall, which is why Joe and I remain bullish. Our Blue Angels show that the forward earnings of the S&P 500/400/600 continued setting new altitude records through the 10/4 week (Fig. 13).

The Blue Angels show that last week’s plunge was entirely attributable to sharp declines in the forward P/Es of the S&P 500 (by 0.7ppt to 15.8), S&P 400 (by 0.8ppt to 15.1), and S&P 600 (by 0.9ppt to 15.8), as Joe discusses below. If you liked stocks a week ago, you have to like them even more now that they sport lower valuation multiples partly because their prices fell while their earnings outlook continues to improve. That improving outlook is the consensus of industry analysts, with whom we concur by the way.

(6) Blame artificially unintelligent bearishness. Last but not least (and maybe not even last), we can always blame ETFs and algorithms. We wouldn’t attribute last week’s selloff to an ETF meltdown. But ETFs undoubtedly worsened and broadened the selloff. As noted above, the FANGs don’t have supply-chain issues, yet they got whacked because they are the biggest components of the most popular ETFs. The same can be said for the S&P 500 Health Care sector, which was down 3.5% last week. Algorithms might have been triggered to sell stocks by the 3.00% threshold on the bond yield or some other variables.

(By the way, Cramer asked the audience of 200 mostly individual investors if any of them sold stocks last week. Two people raised their hands.)

The S&P 500 swung from being 4.4% above its 200-day moving average a week ago Friday to less than 0.1% below it at the end of last week (Fig. 14). Will that trigger even more selling this week? Perhaps, but since the start of this bull market, such selloffs to the 200-dma have been buying opportunities. We think that’s the case again now.

Stocks II: FANGs Get Root Canals. Since the week ended July 13, the share of the S&P 500’s market capitalization attributable to the FANG stocks has fallen from record highs as their lofty valuations were cut substantially. Importantly, however, their forward revenue and earnings are still trending higher (Fig. 15, Fig. 16, and Fig. 17). Let’s put some numbers behind that observation:

(1) FANG valuation hits. The FANG index’s aggregate forward P/E of 49.2 is the lowest since January 2017. It’s down by 24% from a 2018 high of 65.1 (in late January) and by 31% from a record high of 71.8 (February 2014).

The S&P 500’s forward P/E of 16.1 looks substantially cheaper without the FANG stocks—it drops to 15.0. However, the current 1.0ppt P/E boost contributed by the FANGs is the lowest such boost since mid-April and down from a record high of 1.3ppts in mid-July. Since the market’s peak in late January, the S&P 500’s P/E with FANGs is down 13%, from 18.6, and the ex-FANG P/E is down 14%, from 17.4.

(2) No commensurate hits to FANG fundamentals. While valuations have come down sharply for the FANG aggregate, their revenue and earnings performance remains unsullied. Since the end of 2012, forward revenues have gained 270% for the FANGs vs a 25% rise for the S&P 500, and forward earnings has soared 504% vs a 55% jump for the S&P 500.

The FANGs now account for 9.4% of the market cap for the S&P 500, down from a record high of 10.5% in mid-July. The FANGs’ share of S&P 500 forward revenues and earnings continues to rise to record highs—0.4% for revenues and 3.1% for earnings, up from 0.3% and 2.6%, respectively, at the end of 2017.

Stocks III: SMidCap Valuations Get Banksy-ed. On September 28, one of the most recognized works of the England-based street artist known as “Banksy,” “Girl With Balloon,” sold at a Sotheby’s auction in London for $1.37 million (£1.04 million). In a bizarre twist after the auctioneer’s hammer fell, the painting was cut into strips by a shredder hidden inside the picture frame by the artist. On his Instagram account, Banksy dubbed the painting “Going, going, gone ...” in a captioned photo of the work. Banksy also released a video of the stunt with a caption he attributed to Pablo Picasso that read: “The urge to destroy is also a creative urge.” In a statement on the auction house's website, Alex Branczik, Sotheby's head of contemporary art in Europe, said: “It appears we just got Banksy-ed.”

S&P MidCap and SmallCap valuations got Banksy-ed recently too (Fig. 18):

(1) After last week’s selloff, MidCap ended the week with its forward P/E at 15.1, the lowest since February 2016 and below those of LargeCap and SmallCap. LargeCap’s and SmallCap’s forward P/E were as low as 15.6 and 15.8 on Wednesday before both settled at 15.8 at Friday’s close. Those readings were also their lowest levels since February 2016. Through Friday’s close, LargeCap’s premium to MidCap’s P/E rose to 4.6%, the largest since February 2009. SmallCap now trades at a discount to LargeCap for the first time since September 2004, with LargeCap’s 0.6% P/E premium to SmallCap the largest since August 2004.

(2) Since 1999, SMidCap’s forward revenue and earnings have easily outperformed LargeCap’s (Fig. 19). The recent shredding of SMidcap valuations suggests that investors may be surmising that SMidCap companies are more susceptible than LargeCap firms to the impact of higher labor costs. On the other hand, we still believe that they benefit more from deregulation and the corporate tax rate cut than bigger companies do.

In the art world, beauty is in the eye of the beholder. The same could be said of the investing world and valuation. After the head-turning display at the Sotheby’s auction, social media commenters suggested that the shredded Girl With Balloon will soar in value once the shredded pieces are patched back together. Perhaps SMidCaps will recover and do the same once the latest correction is over.

Movie. “First Man” (-) (link) is a very disappointing movie. It is very slow and undramatic for a film about the US space program. Perhaps that’s because the story is well known. Not so well known is that Neil Armstrong, who was the first man to land on the moon, was emotionless and wasn’t a great husband or father. That’s if the movie’s depiction of him is true, as played by Ryan Gosling, who is especially good at playing unemotional roles. The film does raise the question of what was accomplished by the program, but doesn’t attempt to answer it. We learn that the moon’s surface is covered with a fine white powder. Elon Musk wants to go to Mars. We already know that it is covered with red dust. Perhaps we should stay on the Planet Earth and make it a better place so we don’t have to leave on short notice.

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Respecting the Tape

October 11, 2018 (Thursday)

Strategy I: The Witching Season. The S&P 500 is down 4.9% from its record high on September 20. It was an especially bad day for the index yesterday, as it dropped 3.3%. Stocks have been struggling ever since the 10-year US Treasury yield jumped decisively above 3.00% on October 3. That’s bad news for interest-sensitive consumer-related stocks, as Jackie and I discuss in the next section.

However, the recent selloff isn’t just about rising interest rates. The price of a barrel of Brent crude has been soaring ever since President Trump withdrew from the Iran nuke accord on May 8, and moved to impose sanctions on the country. While that’s good for energy companies and their stocks, it’s bad news for consumers and businesses that have to pay more for fuel.

Furthermore, while Trump seems to be winning his trade wars with most of America’s major trading partners, the conflict with China is likely to worsen because it isn’t just about trade. It is about national security. That’s raising alarms, particularly among US technology companies that have integrated China into their supply chains. News that the country’s spooks have been planting spyware into widely used motherboards only heightens the national security concerns.

Rising interest rates, higher oil prices, and a strong dollar are a triple whammy for emerging market economies. The fear is that while the US economy has been supercharged by Trump’s tax cuts, it may not decouple for long from the slowdown overseas.

The rally since early February may be stalling out on confusion about Trump’s policies. He seems to be stepping on the accelerator and brakes at the same time. Deregulation and tax cuts are bullish for the US economy as well as for corporate earnings and stock prices. On the other hand, the ballooning federal deficit attributable to the tax cut and spending increases is putting upward pressure on bond yields, at the same time that the Fed has moved to raise interest rates and taper its balance sheet.

A prolonged trade war with China may disrupt supply chains, but is more likely to depress China’s economy as manufacturers around the world isolate their supply chains from China.

The bottom line for us: We’ve been flagging these concerns in recent weeks, but still don’t expect them to cause a recession in the US. We remain bullish on the outlook for earnings, and expect the market to recover and make new highs going into next year. October can be a wicked month; Halloween started early this month for investors. Nevertheless, we are monitoring the bearish market signals discussed in the following section.

Strategy II: Market Signals. If you believe the stock market is a discounting mechanism—pricing in today what it forecasts will happen six months in the future—then Mr. Market may be worried that an economic slowdown will arrive in 2019. The stock price indexes of certain industries that led the market up over the past few years are solidly in negative territory this year.

Consider the performance of the following S&P 500 industries ytd through Tuesday’s close: Copper (-30.5%), Homebuilding (-27.1), Automobile Manufacturers (-24.2), Semiconductor Equipment (-23.4), Paper Packaging (-22.4), and Hotels, Resorts & Cruise Lines (-6.6). Some of these industries take the pulse of the consumer. Others home in on the health of manufacturing. All may be reacting badly to rising interest rates and oil prices.

Another factor unites these disparate industries: Most have added capacity in recent years and now are either experiencing or fearing declines in the prices of their end products.

In any event, these industries’ share price gains in recent years shored up our confidence to remain bullish, so their downward movement is reason for concern. In an effort to “respect the tape,” let’s take a deeper look at what the stock price action of these industries could be saying:

(1) Driving in reverse. Given the strength in the job market and the overall economy, auto sales should be on fire. Instead, they’ve been stagnating at flat-to-slightly-down levels in 2018. The 12-month sum of US motor vehicle sales peaked at 17.7 million units during February 2016, and it came in at 17.4 million in September (Fig. 1). Not even a sharp rise in the domestic light truck market has been enough to offset the decline in domestic car purchases (Fig. 2).

Buyers apparently are opting to buy used cars, according to a 9/23 WSJ article: “The gap between the price of a new and used vehicle is as wide as it has been in years, pushing an increasing number of consumers to the used-car lot and putting pressure on auto makers to deepen discounts on new cars to keep them competitive. … Used-car buyers are finding a growing selection of low-mileage vehicles that are only a few years old,” thanks to the leased cars being returned to dealerships.

Were that not enough, the industry has had to deal with additional costs relating to steel tariffs, which went into effect on July 1. General Motors and Ford are also facing the expense of developing electric and autonomous cars, as industry upstarts—including Tesla, Waymo, and Uber—aim to disrupt the industry.

The S&P 500 Automobile Manufacturers stock price index has fallen 24.2% ytd (Fig. 3). The index basically has traded sideways for much of the last eight years after bouncing off 2009 lows. The industry is expected to grow revenue by 0.2% this year, but revenue is expected to drop next year by 0.2% (Fig. 4). Analysts have been trimming earnings estimates over the past two months and now expect the industry to have a 16.8% decline in earnings in 2018, followed by a 0.4% increase next year (Fig. 5 and Fig. 6).

The industry has a very low forward P/E, 6.2. However it’s a cyclical industry, so it’s often best to buy when P/Es are high and earnings are depressed.

(2) No more vacations? Consumers’ willingness to go on vacation is one of the indicators we’ve watched to confirm the economy’s health. And while data on hotel rooms still look positive, the stocks are acting pretty awful, primarily on concerns about too much future supply and rising costs.

On the surface, all looks fine, as the industry has enjoyed strong results this year. Most recently, US hotel occupancy rose 1.7% y/y to 71.5%, and the average daily rate jumped 7.3% to $137.31 during the week of September 23, according to a 10/4 article on Hotel News Now. Revenue per available room rose even faster, 9.1% to $98.15.

One concern is inflation, particularly if low-wage employees push for raises. “The real wild card is labor costs,” said Jan Frietag, senior vice president for research firm STR, in a 8/27 article in National Real Estate Investor. “I don’t worry about the U.S. hotel industry’s ability to put heads in beds. I worry about its ability to make the beds.”

Another issue is supply, which is being added at record levels. “[T]otal global construction pipeline stands at 12,839 projects/2,158,422 rooms which are at all-time highs. The construction pipeline is up an extraordinary 86% by projects over the cyclical low established in 2011 when global counts were at 6,907 projects/1,257,296 rooms,” according to a 9/21 report by Lodging Econometrics. In the US, nonresidential construction of lodging is at its highest levels in nearly a decade (Fig. 7).

Supply is also dogging the cruise industry. There are 13 new cruise ships slated for delivery this year, 25 in 2019, 19 in 2020 and 20 in 2021, according to data in Cruise Industry News. Those orders are up sharply from 2017, when 10 ships were delivered.

Investors aren’t waiting around to see the impact of additional supply. The S&P 500 Hotels, Resorts & Cruise Lines stock price index is down 6.6% ytd (Fig. 8). But forecasts remain optimistic, with revenues targeted to grow 1.9% this year and 7.2% in 2019, and earnings set to increase by 22.5% and 11.2% (Fig. 9 and Fig. 10). Meanwhile, the industry’s forward P/E has fallen from a high of 19.6 this year to a more reasonable 15.9.

(3) Canary in the copper mine? Despite the US economy’s strength, the prices of numerous key commodities have fallen this year. Dragged down by a strong dollar and the slowdown in the Chinese economy, the price of copper has dropped 12% ytd, and the CRB raw industrials spot price index is 8% lower (Fig. 11).

The sharp drop in copper prices has weighed on the S&P 500 Copper stock price index, which is down 30.5% ytd (Fig. 12). The industry’s revenues are forecast to surge 15.5% this year, only to drop 18.6% in 2019. Likewise, analysts see earnings jumping 53.9%, only to tumble 43.2% next year (Fig. 13 and Fig. 14).

(4) Fading paper profits. The picture in the S&P 500 Paper Packaging industry is a bit murkier. The industry should be flying, given strong consumer spending and the number of packages on doorsteps; however, the index has fallen 22.4% ytd (Fig. 15).

Here too, there’s some concern about the industry’s ability to absorb new capacity. Nine Dragons Paper Holdings, a Chinese manufacturer of containerboard products, purchased two existing paper mills in the US, which it intends to expand, according to a 5/26 article in the South China Morning Post. US manufacturers have also expanded capacity. That was enough to prompt BMO Capital Markets analyst Mark Wilde to downgrade a number of the industry’s stocks.

“Demand growth has slowed despite a strong macro economy, and industry leaders will be forced to fight to maintain pricing while protecting market share from smaller players looking to steal small amounts of market share,” Wilde said, according to a 10/9 article on Benzinga. “It’s unclear how all the new capacity will be absorbed, and the analyst’s supply-demand model calls for operating rates to fall from 97.5 percent in 2017 to 90.9 percent by 2021.” Meanwhile, the price of recycled paper has plummeted as China has stopped accepting used paper.

So far, financial forecasts for the Paper Packaging industry have held up. Revenues are expected to increase 8.3% this year and 2.9% in 2019, while earnings soar 43.5% and 9.7%, respectively (Fig. 16 and Fig. 17). Because stock prices have fallen but earnings have held up, the industry’s forward P/E has dropped to 11.1, a level last hit in 2015 before the industrial slowdown of 2016 (Fig. 18).

(5) Semi equipment stalls. Shares in the semiconductor equipment industry have dropped sharply on concerns that the robust spending on semi equipment in recent years is slowing. These fears were reinforced this summer on reports that Samsung and Taiwan Semiconductor Manufacturing “seemed to be trimming their outlays again,” an 8/18 WSJ article reported.

Capacity issues may escalate as China makes good on its aim to enter the semiconductor industry. Foxconn Technology Group is partnering with a local government in China’s Pearl River Delta to build a chip fabrication plant, according to an 8/17 WSJ article, which can only exacerbate excess capacity in the industry.

The S&P 500 Semiconductor Equipment stock price index has fallen 23.4% ytd (Fig. 19). The industry’s revenues are expected to swing from a 24.3% increase this year to a 1.9% decrease in 2019 (Fig. 20). Likewise, its earnings are forecast to grow 48.3% this year, only to decline 5.8% in 2019 (Fig. 21). The industry’s forward P/E has fallen to 9.7, a level last seen during the years shortly after the recession (Fig. 22).

Technology: Mind Blowing. Scientists are working on ways we can chat without saying or writing a word. Scientists at the University of Washington have linked humans’ brains and enabled them to communicate while in different rooms. The experiments began in 2013 and have become more sophisticated over the years; a video of a 2013 pilot study showing direct brain-to-brain communication can be seen here.

Two years later came the first experiment showing “that two brains can be directly linked to allow one person to guess what’s on another person’s mind,” a 9/23/15 press release by the University of Washington explained.

This experiment was taken one step further this year, creating a network of brains, or a BrainNet, by connecting three subjects who played a Tetris-like game, a 9/29 article in MIT Technology Review reported.

The researchers believe that many brains located anywhere in the world could be connected over the Internet. Now that’s mind blowing.

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Looking for Stress Cracks in Corporate Debt

October 10, 2018 (Wednesday)

Corporate Debt I: Staying Calm. Last week, Melissa and I reviewed Federal Reserve Chairman Jerome Powell’s 9/26 press conference. He was optimistic about the US economy. He reiterated the Fed’s intention to continue gradually raising interest rates.

During the Q&A, Powell was asked if he is concerned about the high levels of nonfinancial corporate (NFC) debt. Powell responded that he sees this as just a “moderate” financial vulnerability. More significantly, from his perspective, “[t]he banking system [has] much higher capital, much higher liquidity, is much stronger.” In other words, any problems caused by NFC debt aren’t likely to become systemic ones for the banks, which the Fed supervises and regulates.

In our opinion, there are also other reasons not to worry too much about this issue. True, US NFCs’ debt is at a record high and well above where it was before the 2008 financial crisis. So investors are right to wonder whether servicing it will become too onerous for US companies as interest rates rise. But many firms have refinanced their debt with longer maturities at the historically low interest rates of recent years. We conclude that interest costs will continue to be manageable for firms across most sectors, for reasons discussed below—including the fact that corporate earnings, cash flow, and liquid assets are at record highs and likely to move still higher.

Let’s have a closer look at NFCs’ income statements and balance sheets with the help of the Fed’s latest Financial Accounts of the United States, which recently was updated through Q2-2018:

(1) Corporate debt at record highs. NFC debt (which includes debt securities and loans) is at a record high, having risen from $6.0 trillion at the end of 2010 to $9.4 trillion during Q2-2018 (Fig. 1). Over that same period, the outstanding value of NFC bonds rose $2.1 trillion to a record $5.4 trillion (Fig. 2). At $3.2 trillion, NFCs’ bank loans exceeded their previous record high posted just before the 2008 financial crisis.

(2) Corporate cash flow at record high. Both NFC cash flow and liquid assets also continue to set new highs. The four-quarter sum of total internal funds including the Inventory Valuation Adjustment (which removes inventory profits and losses) remains in record-high territory at $1.9 trillion (Fig. 3). The latest reading, for the four quarters through Q2-2018, received a big boost from the Capital Consumption Allowance (a.k.a. depreciation expense), which increased 15.4% y/y to a record $1.6 trillion. Providing a big boost to this major component of cash flow was the tax bill enacted at the end of last year. It increased the rate of bonus depreciation (which allows an immediate first-year deduction on the purchase of eligible business property) to 100% for 2018 until 2023.

(3) Liquid assets at record high. Liquid assets held by NFCs was recently redefined by the Fed to include equities and mutual fund shares (Fig. 4). The total was little changed near Q4’s record high, at $4.4 trillion, during Q2-2018. Excluding equities and mutual fund shares, it was $2.2 trillion. We prefer the old measure since during periods of financial stress, the value of equities often dives. Measured either way, however, the ratios of NFCs’ debt to liquid assets have remained relatively low by historical standards (Fig. 5). That’s also true for the ratios of NFCs’ short-term debt to liquid assets measured either way (Fig. 6).

(4) Extending maturities at lower rates. The ratio of NFCs’ short-term debt to total debt has been on a downtrend since the mid-1980s. It is down from 40%-45% during the 1980s and 1990s to roughly 28% during the current economic expansion (Fig. 7). This confirms that NFCs have been extending the maturity of their debt to lock in lower interest rates (Fig. 8).

Furthermore, the spread between gross and net NFC bond issuance rose to a record high, exceeding $600 billion during the four quarters through Q2-2018 (Fig. 9 and Fig. 10). That certainly implies lots of refinancings. Interestingly, net issuance has dropped 65% since peaking at $462 billion during Q3-2015. It is now the lowest since Q3-2011. The tax reform act at the end of last year may have reduced the tax benefit of raising money in the bond market. Increased regulation in the public markets following the crisis may have pushed financing into the private markets, as discussed below.

(5) Buybacks not at the expense of capex. Progressives have argued that corporations are not making productive use of their resources. They say that firms are using borrowed funds for share buybacks rather than investing in future earnings potential. But the data show that NFCs’ capital expenditures are at a record high (Fig. 11). The data also show that net bond issuance has been relatively small compared to cash flow (Fig. 12). There has been plenty of cash flow to finance both capital spending and share buybacks.

Corporate Debt II: Fed Does Hypothetical Stress Test. In an 11/15/17 study titled “The Potential Increase in Corporate Debt Interest Rate Payments from Changes in the Federal Funds Rate,” Fed researchers analyzed the aggregate impact on NFCs’ debt burden of an increase in the federal funds rate to 3.00% by 2019. We reached out to ask whether they had an update and learned they’re considering working on one. Let’s go with last November’s analysis for now because the federal funds rate assumption isn’t far from where we expect the rate to be by year-end 2020 and we think the study’s conclusions still apply.

The Fed researchers found that the aggregate interest coverage ratio (the ratio of EBIT to interest expenses on bonds and loans) for US NFCs would decline in 2019 from 4.6 in a scenario in which rates remain at current levels to 4.1 in a scenario in which rates rise to 3.0%. The researchers qualified that burden as “modest” and explained that it is not evenly distributed among sectors. They concluded that “significant vulnerabilities to higher rates appear to be restricted to the real estate sector, mostly because of the large fraction of floating-rate debt in that sector.”

Corporate Debt III: Real Stress Tests Ahead? The reasons not to worry about NFC leverage are compelling. But we have a couple of caveats: One is that the aggregate data do not reflect the distribution of cash among nonfinancial corporates; the other is that the aggregate data do not reflect the mix of debt maturities or credit ratings. While we give some weight to these qualifications, we doubt that the credit markets are headed for doomsday unless a severe US economic downturn occurs. Let’s discuss:

(1) Top cash holders removed. In our 7/3 Morning Briefing, we covered a 6/26 report by S&P Global. It observed that removing the top 25 cash holders from the cash-to-debt equation paints a more sobering picture than the data for all the corporations that S&P Global analyzed. According to S&P Global, “More than 450 investment-grade companies that aren't among the top 1% have cash-to-debt ratios more similar to those of speculative grade issuers than to those in the top 1%.” Sure, that’s concerning. But for now, NFCs across most sectors have enough earnings to cover their interest expenses even if rates rise, as the Fed study found.

(2) Lots of BBBs. S&P Global’s observation was picked up by an 8/17 Barron’s article, which was referenced in a 10/5 Barron’s article. The 10/5 article quoted our friend David Rosenberg, chief economist and strategist for Gluskin Sheff, who wrote: “One could be forgiven for wondering aloud about how rising interest rates in the most leveraged economy of all time, with over half the $6 trillion investment-grade corporate bond market now rated BBB (and a tsunami of refinancing due in the next three years), will play out from a default perspective.”

We can’t help but wonder along with Rosenberg what would happen if these bonds, just a step above junk, were to be downgraded. Large institutional investors that are allowed to hold only investment-grade debt would be forced to sell. But that scenario isn’t likely to play out if the US economy continues to expand, earnings continue to grow, and interest costs remain coverable.

(3) Not maturing so fast. But the dollar amount of BBBs out there could become a serious problem if any of those dynamics change. A downgrade cycle could worsen the pressure from all the bonds up for refinancing over the next few years, as Rosenberg observed.

Roughly 20% of outstanding NFC bonds will come due during 2021 to 2022, according to data from the Mergent’s Fixed Income Security Database used in the Fed analysis. The good news (for now) is that slightly more than 40% of these bonds don’t mature until after 2024. However, the mix of maturities is skewed earlier for speculative-grade (about 30% mature in 2021 to 2022) than investment-grade (about 15%) NFC bonds.

Corporate Debt IV: Private vs Bank Lenders. On the subject of potential doomsday scenarios, some say that the types of risky loans that blew up during the financial crisis haven’t gone away. Instead, they have been transferred from (now) highly regulated bank lenders to nonbank lenders that are not held to the same scrutiny, or transparency. The concern is that nonbank lending could pose a systemic risk to financial stability.

Lots of risky private loans are being bundled into financial products reminiscent of the collateralized loan obligations that severely worsened the financial crisis. In the search for yield following the crisis, lots of pension funds have bought these loans. Banks are still indirectly involved with these loans, lending funds to the private firms that repackage them.

If these nonbank loans implode, it may reduce the rates of return realized by the institutional portfolios that own them. But since bank capital is highly regulated and well monitored these days, it probably isn’t vulnerable to significant hits as it was during the crisis. Keep in mind too, as discussed above, that corporate bonds compose the majority of the NFC debt market whereas corporate loans represent a smaller share.

The bottom line is that we don’t think that there is a big failure issue. But our lingering concern is the risk that we can’t see. Nonbank lending isn’t nearly as transparent as bank lending. Covering the issue from both sides, the 4/10 WSJ included an article titled “Big Banks Find a Back Door to Finance Subprime Loans.” Here are some of the key points:

(1) Indirect lending. Bank loans to nonbank financial firms have increased “sixfold between 2010 and 2017 to a record high of nearly $345 billion, according to a Wall Street Journal analysis of regulatory filings. They are now one of the largest categories of bank loans to companies.”

(2) Better structure. “Banks say that this time around they have figured out how to structure the credits to avoid problems.” Banks typically “require the nonbanks to commit the loans they make as collateral for the bank loan. And they will only lend the nonbanks an amount equivalent to a portion of the collateral.” That means that “a much higher-than-expected share of the loans would have to go bad for the bank to lose money.”

(3) Manageable exposure. During 2016, “officials from the Office of the Comptroller of the Currency reviewed the exposure at more than a dozen banks.” Regulators “looked at the types of nonbanks the banks were lending to, whether those loans were properly secured by collateral and whether there were any concentrations of risk … At the time, the OCC found the exposure manageable.”

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Trump’s Poison Pills

October 09, 2018 (Tuesday)

Thinking Ahead. The holidays are coming. May we suggest the perfect gift from you to your colleagues, friends, and family? Consider giving them Dr. Ed’s “Predicting the Markets: A Professional Autobiography.” You’ll get a 25% discount for orders of five or more books purchased on our shopping cart (with free shipping in the US). Avoid the rush, and have Dr. Ed sign them if you order before Thanksgiving Day.

China: Trumped Again. A week ago Monday, the Morning Briefing was titled “China’s Syndromes.” I wrote that aging demographic forces, which were significantly exacerbated by the Chinese government’s one-child policy, are already depressing the growth rate of real retail sales in China (Fig. 1 and Fig. 2). As a result, the government is scrambling to expand its overseas military and economic power to counter the structural weakness at home.

I argued that President Donald Trump is implementing policies aimed at either slowing or halting China’s drive to become a superpower. He wants to reduce America’s huge trade deficit with China by forcing US and other manufacturers to move out of that country. In the process, the US would no longer be financing China’s ascent with our trade deficit and providing technological knowhow that has been either stolen or extorted.

I didn’t have to wait long to get confirmation of my working hypothesis. Consider the following fast-paced developments:

(1) The President’s speech. In his 9/25 speech before the United Nations General Assembly, Trump said only the following about China, focusing on trade: “The United States lost over 3 million manufacturing jobs, nearly a quarter of all steel jobs, and 60,000 factories after China joined the WTO. And we have racked up $13 trillion in trade deficits over the last two decades. But those days are over. We will no longer tolerate such abuse. We will not allow our workers to be victimized, our companies to be cheated, and our wealth to be plundered and transferred. America will never apologize for protecting its citizens. … China’s market distortions and the way they deal cannot be tolerated.”

(2) The Vice President’s speech. In a 10/4 speech at the Hudson Institute, Vice President Mike Pence discussed the administration’s policy toward China in far greater detail. He started out by warning: “Beijing is employing a whole-of-government approach, using political, economic, and military tools, as well as propaganda, to advance its influence and benefit its interests in the United States.”

He accused the Chinese Communist Party of using “an arsenal of policies inconsistent with free and fair trade, including tariffs, quotas, currency manipulation, forced technology transfer, intellectual property theft, and industrial subsidies that are handed out like candy to foreign investment. These policies have built Beijing’s manufacturing base, at the expense of its competitors—especially the United States of America.”

He specifically berated the party’s “Made in China 2025” plan for aiming to control 90% of the “world’s most advanced industries including robotics, biotechnology, and artificial intelligence. To win the commanding heights of the 21st century economy, Beijing has directed its bureaucrats and businesses to obtain American intellectual property—the foundation of our economic leadership—by any means necessary.” He accused the Chinese of stealing US technology including cutting-edge military blueprints. “And using that stolen technology, the Chinese Communist Party is turning plowshares into swords on a massive scale,” he said.

He point-blank accused China of economic and military aggression abroad: “[W]hile China’s leader stood in the Rose Garden at the White House in 2015 and said that his country had, and I quote, ‘no intention to militarize’ the South China Sea, today, Beijing has deployed advanced anti-ship and anti-air missiles atop an archipelago of military bases constructed on artificial islands.” The result has been provocative and dangerous near misses between our two navies in the South China Sea.

Pence also documented instances of China using so-called “debt diplomacy” to expand its influence: “Today, that country is offering hundreds of billions of dollars in infrastructure loans to governments from Asia to Africa to Europe and even Latin America. Yet the terms of those loans are opaque at best, and the benefits invariably flow overwhelmingly to Beijing.”

The US has responded by boosting defense spending and slapping tariffs on China. These “exercises in American strength” explain why China’s largest stock exchange fell by 25% in the first nine months of this year. Got that? The US is targeting China’s stock market!

Pence accused the Chinese government of oppressing its own people at home. He railed about the Great Firewall of China “restricting the free flow of information to the Chinese people.” Even more frightening, he said, is the “Social Credit Score,” which, according to the official blueprint, will “allow the trustworthy to roam everywhere under heaven, while making it hard for the discredited to take a single step.” It will be implemented in 2020.

Pence also attacked the Chinese government for meddling in US politics in an effort to weaken America. He claimed that in June, “Beijing itself circulated a sensitive document, entitled ‘Propaganda and Censorship Notice.’ It laid out its strategy. It stated that China must, in their words, ‘strike accurately and carefully, splitting apart different domestic groups’ in the United States of America.”

There are lots more complaints about China in Pence’s speech. Clearly, the Trump administration’s policy toward China isn’t just about trade. A 10/5 NYT article critically stated that Pence in effect had declared a “New Cold War” with China. An alternative spin is that Pence was simply recognizing that China has launched an ever-expanding war against American interests.

(3) The poison pill placed in USMCA. A 10/5 CNBC article noted that there is a provision in the newly passed North American trade agreement, the United States-Mexico-Canada Agreement (USMCA, a.k.a. “the new NAFTA”), “which effectively gives Washington a veto over Canada and Mexico’s other free trade partners to ensure that they are governed by market principles and lack the state dominance.” In effect, that’s a “poison pill” aimed at China.

When Trump was elected, I observed that after eight years of government by community organizers, we were about to have a major regime change with government by dealmakers. US Commerce Secretary Wilbur Ross, a consummate wheeler-dealer when he was in the private sector, signaled on Friday that Washington may insist on including this poison-pill provision in future bilateral trade deals. “People can come to understand that this is one of your prerequisites to make a deal,” he said.

(4) JP Morgan’s bearish call. Last Wednesday, JPMorgan strategists wrote in a note that “[a] full-blown trade war becomes our new base case scenario for 2019” with 25% US tariffs imposed on all Chinese goods. They added, “There is no clear sign of mitigating confrontation between China and the U.S. in the near term.” In his 10/5 Barron’s column, Randy Forsyth noted that the bank’s strategists “estimate that 25% levies on all Chinese imports to the U.S. would trim earnings for the S&P 500 by $8 a share, from their original projection of $179 for 2019. ‘Such a downgrade would mark the first of the Trump era and potentially end the U.S. stock market rally, even assuming a forward [price/earnings] multiple of 17, unless some other offset materializes,’ they conclude.”

I agree that Trump will probably slap Chinese goods with an across-the-board 25% tariff. I think that the US economy will be strong enough to boost S&P 500 earnings by 6.8% to $173 per share, which has been our number for next year for a while. I don’t think that the escalating trade war with China will be the event that ends the bull market in the US (Fig. 3). However, it may already be marking the beginning of a severe and prolonged bear market in China (Fig. 4).

While financial markets were closed all last week in China for the Golden Week vacation, Hong Kong stocks fell for four consecutive days as investors grew increasingly concerned that the impact of the trade war is starting to show.

On Sunday, the People’s Bank of China slashed the reserve requirement ratio for large banks (currently 15.5%) and small banks (13.5%) by 100 basis points effective October 15 (Fig. 5). This is the fourth such cut this year. The prime rate is also likely to be cut soon (Fig. 6). Beijing has pledged to expedite plans to invest heavily in infrastructure projects as the economy shows signs of cooling further, with investment growth recently slowing to a record low.

CNBC reported yesterday, “On the back of the central bank’s announcement, China’s mainland markets traded in negative territory for much of their first trading day following the Golden Week holiday. Both the Shanghai composite and the Shenzhen composite fell more than 3.7% by the end of the trading day.” The two indexes peaked this year on January 24 and are down 23.7% and 25.0%, respectively (Fig. 7). China’s MSCI is down 26.0% from its peak on January 26. Hong Kong’s Hang Seng is down 21.0% from its peak also on that day (Fig. 8).

(5) Cyber war. The 10/4 Bloomberg Businessweek included a cover story titled “The Big Hack: How China Used a Tiny Chip to Infiltrate U.S. Companies.” The story is based on information from multiple intelligence and business sources who confirmed that Chinese spies attacked almost 30 US companies, including Amazon and Apple, “by compromising America’s technology supply chain, according to extensive interviews with government and corporate sources.” Operatives of the People’s Liberation Army inserted tiny microchips designed for spying in motherboards made in China and sold to American companies.

Both Amazon and Apple denied they had been hacked. Whether accurate or fake news, the story certainly could convince many companies to cut China out of their supply chains. That would fit in nicely with the Trump administration’s campaign to move production out of China back to the US.

North Korea: The Big Stick. President Theodore Roosevelt famously stated that his foreign policy was based on a simple principle: “Speak softly and carry a big stick; you’ll go far.” President Trump’s foreign policy is based on speaking loudly and tweeting often, while carrying a big stick.

On August 13, Trump approved a sizeable defense policy bill authorizing a top-line budget of $717 billion to cover a litany of defense spending on military hardware. In his foreign policy speech discussed above, Veep Pence clearly stated that the US is upping its defense spending partly to counter China’s military expansion.

After he was elected President, Trump met with President Barack Obama. The outgoing Commander in Chief told the incoming one that his number-one problem and priority was to do something about North Korea. Trump immediately responded by aiming his big stick, and some very bellicose tweets, at the country’s regime, with the following brief highlights:

(1) Yesterday. A year ago, in his first speech at the UN, Trump directed his big stick at North Korea as follows: “The United States has great strength and patience, but if it is forced to defend itself or its allies, we will have no choice but to totally destroy North Korea. Rocket Man is on a suicide mission for himself and for his regime. The United States is ready, willing and able, but hopefully this will not be necessary. That’s what the United Nations is all about; that’s what the United Nations is for. Let’s see how they do. It is time for North Korea to realize that the denuclearization is its only acceptable future.”

(2) Today. This year at the UN, Trump said: “In June, I traveled to Singapore to meet face to face with North Korea’s leader, Chairman Kim Jong Un. We had highly productive conversations and meetings, and we agreed that it was in both countries’ interest to pursue the denuclearization of the Korean Peninsula. Since that meeting, we have already seen a number of encouraging measures that few could have imagined only a short time ago. The missiles and rockets are no longer flying in every direction. Nuclear testing has stopped. … I would like to thank Chairman Kim for his courage and for the steps he has taken, though much work remains to be done. The sanctions [i.e., the big stick] will stay in place until denuclearization occurs.”

(3) Tomorrow. On Monday, Secretary of State Mike Pompeo said that in his meeting with Kim Jong Un on Sunday, the leader of North Korea had agreed to allow inspectors into a key nuclear testing site that the North has claimed it blew up, a down payment on the country’s commitment to denuclearize the country.

Iran: Aiming for Regime Change. Needless to say, Obama thought that he and his Secretary of State, John Kerry, had fixed the Iran problem. Trump disagreed, and on May 8, 2018 withdrew US support for the 2015 nuclear deal between Iran and a group of world powers: the P5+1 (i.e., the permanent members of the United Nations Security Council—the US, the UK, Russia, France, and China—plus Germany) as well as the European Union. He followed up with US sanctions on Iran.

Obama expressed regret about Trump’s decision. Kerry met with Iranian officials and reportedly advised them to wait out Trump. The European Commission declared that the sanctions were illegal in Europe and banned European citizens and companies from complying with them.

Meanwhile, on August 16, Pompeo formed the Iran Action Group, comprising a handful of employees from the US State and Treasury departments. According to a 10/4 Bloomberg Businessweek article, they’ve “quietly toured the globe, visiting world capitals and corporate headquarters to persuade foreign governments and companies to shun the Iranian market. The choice they present has been simple: Do business with America, the biggest economy in the world, or do business with Iran and face sanctions and banishment from the U.S. financial system.”

The article also observes: “The group’s effort is putting to the test the proposition that the U.S. economy and dollar are so central to the global economic system that American sanctions alone will isolate Iran’s economy. That runs counter to the conventional wisdom that Obama-era sanctions against Iran were effective only because other nations participated, particularly U.S. allies in Europe. …

“Trump is going further than any previous president in using American financial power as a weapon—in direct confrontation with his allies, daring them to keep doing business with Iran, even if that brings the threat of U.S. economic punishment and denial to the American market, which is 60 times the size of the Iranian economy.” Put simply: Trump has warned that anyone who does business with Iran won’t do business with America.

The impact on Iran’s economy is severe already:

(1) Big toll from lower oil exports. Iran’s exports of oil products have fallen 60% from a high point of 2.8 million barrels a day in April, the month before Trump backed out of the nuclear accord, to 1.1 million barrels per day during the first week of October. Iran derives 80% of its tax revenue from oil sales.

(2) High inflation and unemployment. Iran’s central bank projects its inflation rate will reach 60% this year, observed a 9/19 UPI analysis by Struan Stevenson, coordinator of Campaign for Iran Change (Fig. 9). The Iranian rial has hit a record low against the US dollar (Fig. 10). The country’s active work force is 26 million, of whom at least 10 million are jobless. Youth unemployment is at a staggering 40%.

(3) Social unrest. The same UPI report noted: “Nationwide protests and strikes, which began in December and quickly spread across the whole country, are continuing. Where the protests were initially aimed at the soaring price of food and other basic commodities and the failure to pay wages, the demonstrations have now turned against the despotic clerical government.”

Trump’s fiscal and trade policies have boosted the dollar, oil prices, and interest rates. The risk, of course, is that these developments could punish not only China but lots of other emerging market economies as well. In the US, higher oil prices along with higher interest rates could also weigh on the US economy. Those are the major foreseeable risks. For now, I don’t see this all leading to a financial crisis or a recession. But I’m on alert: There sure are lots of poison pills out there!

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Bonds’ Tether Tantrum

October 08, 2018 (Monday)

Bonds: Rerating the Fed. In the 9/24 Morning Briefing, I noted that there are “[s]ix good reasons to dump bonds and one really good reason to hold onto them.”

I added: “Perhaps this will all end badly when the 10-year US Treasury bond yield soars from 3.00% to 4.00% or higher. There is absolutely no reason to like bonds when the 10-year Treasury yield is hovering around 3.00%. Actually, there is one good reason.”

The one good reason is that “the US 10-year government bond yield has been tethered to the comparable yields in Japan and Germany, which are around 0.00%” (Fig. 1). The latter two yields remain near zero because the ECB and BOJ continue to peg their official interest rates slightly below zero (Fig. 2).

The tether seems to be fraying, as the 10-year US Treasury yield rose to 3.23% at the end of last week to the highest level since May 10, 2011. Altogether, the six bearish factors suggest that the 10-year Treasury bond yield could rise to 4.00%. I’m not giving up on the tether, and I am expecting that it will keep the yield from rising above 3.50%. Furthermore, the bond yield has long been tied to the inflation rate, which is likely to remain subdued around 2.0%, in my opinion. Let’s review and update the six bearish factors:

(1) Bond Vigilantes Model. There has been a good (not great) correlation between the y/y growth rate in nominal GDP and the 10-year US Treasury bond yield (Fig. 3 and Fig. 4). I’ve used this simple model since the early 1980s to explain why the two often have diverged rather than converged, as they eventually tend to do—though “eventually” can be a long time. In any event, nominal GDP rose 5.4% y/y during Q2. With GDP growth so high, this seems like one of those times when the bond yield may start to move toward the GDP growth rate. (To keep track of this relationship for the US, UK, Germany, France, and Japan, see our Bond Vigilantes Model.)

(2) Inflation. Interestingly, expected inflation over the next 10 years has remained remarkably subdued and stable so far this year around 2.1% (Fig. 5). This variable is simply the spread between the nominal 10-year Treasury yield and its comparable TIPS yield (Fig. 6). So the backup in the nominal yield in recent weeks—to 3.23%, the highest reading since May 10, 2011—is mostly attributable to the rise in the TIPS yield, to 1.07%, the highest level since March 3, 2011. The last time that the TIPS yield was this high, on March 3, 2011 (at 1.09%), the nominal yield was 3.58% with expected inflation at 2.49%. During the early 2000s, the TIPS yield hovered around 2.00%. If it goes there again and expected inflation remains around 2.0%, then the nominal yield would rise to 4.00%.

What about expected inflation? The latest inflation news should help to keep a lid on inflationary expectations. Despite tight labor market conditions, wage inflation remains remarkably subdued. The unemployment rate fell to 3.7% during September, the lowest since December 1969. Yet average hourly earnings rose only 2.8% (Fig. 7). The Phillips curve may not be dead, but it remains on life support.

Here is the latest performance derby for wage inflation for all workers in the following industries: Information Services (4.7% y/y), Financial Activities (4.6), Utilities (4.2), Retail Trade (3.5), Construction (3.1), Service-Producing (2.9), Leisure & Hospitality (2.9), All Workers (2.8), Natural Resources (2.8), Professional & Business Services (2,7), Wholesale Trade (2.2), Goods-Producing (2.1), Education & Health Services (2.1), Transportation & Warehousing (1.9), and Manufacturing (1.3).

It’s interesting to note that the industries with above-average wage gains tend to be very competitive, making it hard to pass costs through to prices. Also of note is that wage inflation is very low in Transportation & Warehousing and Manufacturing, where there has been lots of anecdotal evidence of severe labor shortages! Wages for truck drivers rose just 2.4% y/y during August (Fig. 8).

By the way, among the five Fed districts that produce monthly surveys of business conditions, only the Richmond Fed tracks wage trends. During September, the wage index for manufacturing rose to a record high, while the one for services remained at the record highs recorded since late 2016 (Fig. 9). Yet none of those trends showed up in the national data for wages.

Of course, President Donald Trump’s policies on tariffs and sanctions also have inflationary potential consequences—especially if he slaps a 25% tariff on all goods imported from China. However, that might not be as inflationary as his sanctions on Iran, which are driving the price of a barrel of Brent crude oil higher (Fig. 10). Of course, higher oil prices may also depress economic growth, as they seem to be doing already among emerging economies.

(3) The Fed. As Fed Chairman Jerome Powell noted during his 9/26 press conference, there’s plenty of anecdotal evidence of tight labor markets, but it isn’t showing up in the macro data on wages so far. Powell followed up with a 10/2 speech in which he discussed whether the Phillips curve might be dead. He concluded (as we have) that it’s probably still alive, but flat on its back.

Again, Powell mentioned “widespread anecdotes” about the tightness of the labor market, noting “the words ‘shortage’ and ‘bottleneck’ are increasingly appearing in the Beige Book, the Federal Reserve’s report summarizing discussions with our business contacts around the country.” Nevertheless, he conceded that it’s possible that the natural rate of unemployment might be lower than current estimates suggest. “[T]hat would imply less upward pressure on inflation,” said the Fed chairman, and all the more reason to raise rates gradually.

He concluded: “This historically rare pairing of steady, low inflation and very low unemployment is testament to the fact that we remain in extraordinary times. Our ongoing policy of gradual interest rate normalization reflects our efforts to balance the inevitable risks that come with extraordinary times, so as to extend the current expansion, while maintaining maximum employment and low and stable inflation.”

While Powell reiterated that the Fed’s policy remains on course for gradually raising interest rates, the fixed-income markets concluded last week that rates may be going up sooner and higher. The two-year US Treasury note yield, which tends to signal where the federal funds rate will be in a year, rose 17bps over the last four weeks to 2.88% (Fig. 11). Some of that increase occurred last Wednesday on news that ADP payrolls rose by 230,000 during September and that the ISM nonmanufacturing PMI leapt to the highest reading since August 1997 (Fig. 12). Both the nominal and TIPS 10-year yields popped on the news.

Friday’s lower-than-expected payroll increase of 134,000 didn’t stop yields from rising further. That’s because 299,000 workers said that bad weather (likely hurricane related) hindered them from going to work, according to the household survey of employment. That compares to an average of 85,000 for a normal September. Meanwhile, the household measure of employment still rose 420,000, and the payroll measure of employment was revised higher by 87,000 during July and August. The labor market is hot, but not overheating—so far.

(4) Federal deficit. In addition to gradually raising interest rates, the Fed started tapering its balance sheet during October 2017. Since the start of that month through September, the Fed’s holdings of Treasuries and mortgage-backed securities are down $152 billion and $86 billion, respectively (Fig. 13). The pace of tapering was upped this month for Treasuries from $25 billion per month to $30 billion. (See our Winding & Unwinding QE.)

In effect, the Fed is adding $360 billion at an annual rate to the federal budget deficit. In the past, I’ve found that a supply/demand analysis of bond yields isn’t very useful. However, given that the Congressional Budget Office is projecting federal deficits averaging roughly $1.0 trillion per year, deficits may be starting to weigh on the bond market.

(5) Pension funds. In the “Bear Traps for Bonds” story of my 9/24 Morning Briefing commentary, I noted that an 8/21 CNBC article observed: “But now that it’s getting into September, many pension funds, after diving in big time, may be ready to get out of the pool temporarily—or at least slow fixed income investments as summer moves into fall. That’s because when the tax law changed last year, many companies were given until mid-September to deduct their pension contributions at last year’s tax rate instead of the new 21 percent rate.” That seemed to be a good call: The bond yield is up 26bps since mid-September.

There’s one problem with the narrative that pension fund activity is driving the bond yield up: It’s not really supported by the data. The Fed’s Financial Accounts of the United States is available through Q2-2018. Table F.210 shows net purchases of US Treasuries by various investors. During the H1-2018, US private pension funds purchased Treasuries at an annual rate of just $69.7 billion (Fig. 14)! That’s a big pace of purchases for pensions, but relatively small compared to the federal deficit. It’s possible that pensions scrambled to buy much more during Q3, though I doubt it. We will see when the Fed’s accounts are updated with Q3 data during December.

(6) Foreign and other buyers. The data also don’t confirm that China and other foreign investors responded to Trump’s trade war by dumping their US Treasuries. Au contraire, mon frère: The Fed’s accounts show that the “rest of the world” snapped up US Treasuries at an annual rate of $267.5 billion during H1-2018 (Fig. 15). By the way, the biggest buyer of US Treasuries was the US household sector, which purchased these securities at an annual rate of $922.8 billion during the same period (Fig. 16).

(7) Bottom line. The data do confirm that foreign investors have tethered the US bond yield to comparable yields in Germany and Japan. So does the strength of the dollar (Fig. 17). The dollar’s strength is attributable to the outperformance of the US economy—thanks in no small part to Trump’s regulatory, tax, and trade policies.

This is clearly visible when comparing September’s M-PMI and NM-PMI in the US (59.8, 61.6) to the Eurozone (53.2, 54.7), UK (53.8, 53.9), and Japan (52.5, 50.2) (Fig. 18 and Fig. 19). The US indexes have been getting stronger this year, while the others have mostly been getting weaker, including the comparable composites for emerging economies (Fig. 20).

The bottom line for the stock market remains bullish. The US has the world’s largest economy with one of the lowest corporate tax rates on the planet after Congress cut it to 21% in the US at the end of last year. I’m betting that supply-side forces will jump-start productivity growth, keep a lid on price inflation, boost real wages, pump up government revenues, and keep the dollar strong.

I’m betting that Trump soon will win his trade skirmishes with all of America’s trade partners except China, which is likely to experience a big exodus of manufacturing to the US and/or all the other countries that have struck bilateral trade deals with the US. These countries would benefit significantly from this scenario.

Nevertheless, I’m still recommending a Stay Home posture on stocks, i.e., overweighting the US in a global stock portfolio. My S&P 500 targets remain 3100 by the end of this year and 3500 by the end of next.

I’m betting that the bond yield won’t rise any higher than 3.50%. I recognize that Powell and his colleagues are aiming to raise the federal funds rate to 3.40% by 2020. They would like to have 340bps between the federal funds rate and zero when the next recession occurs. However, the latest rate hikes may already be enough to slow housing activity and auto sales.

In any event, America always has been great, and remains great!

Movie. “A Star Is Born” (+ +) (link) is a remake of the 1954 classic with Judy Garland and the 1976 remake with Barbara Streisand. It stars Lady Gaga and Bradley Cooper, who also directed the film. The movie is a bit slow at times, but Lady Gaga really is an amazing singer, and also a very good actress in her first movie role. Cooper is convincing as a self-destructive rock star heading toward oblivion. Coincidentally, FRBNY President John Williams recently suggested that the star quality of the neutral rate of interest, or r-star, is fading: “[A]t times r-star has actually gotten too much attention in commentary about Fed policy. Back when interest rates were well below neutral, r-star appropriately acted as a pole star for navigation. But, as we have gotten closer to the range of estimates of neutral, what appeared to be a bright point of light is really a fuzzy blur, reflecting the inherent uncertainty in measuring r-star.” Williams had been one of the biggest promoters of the star; now, he’s saying it’s a has-been!

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On the Road Again

October 04, 2018 (Thursday)

Transports: A Fork in the Road. A few weeks ago, the Morning Briefing highlighted the market’s latest rotation: Safety sectors Utilities, Health Care, and Telecom are in rally mode. They had been trouncing the performance of the Tech sector, the previous market leader, until the past few days when risk-on sectors made a comeback and the bond yield rose above 3.10%.

This week, another divergence caught our attention: Since June 12, the S&P 500 Railroad stock price index has climbed 12.0%, while the S&P 500 Trucking stock price index has been in reverse, falling 8.0% (Fig. 1). That 20ppt gap in performance is all the more interesting because the S&P 500 Trucking index, comprising only JB Hunt, had been outperforming the railroads for much of the first half of the year.

The Railroad industry accounts for 46.0% of the market cap of the S&P 500 Transportation index, which has been chugging along into record-high territory along with the Rails this year (Fig. 2). The Transports index is up 8.9% ytd through Tuesday, while the S&P 500 is up 9.3%. Let’s have a closer look at what’s happening on the rails, on the roads, and at the ports:

(1) Driven by strong profits. Analysts expect that the Railroad and Trucking industries will have strong revenue and earnings growth both this year and next. The former is expected to increase revenues by 7.1% this year and 4.4% in 2019, and its earnings are forecast to jump 39.1% in 2018 and 12.4% in 2019 (Fig. 3 and Fig. 4).

The numbers in the Trucking index are also strong: Revenue is expected to grow 19.7% this year and 10.5% in 2019, earnings 51.1% this year and 19.1% next (Fig. 5 and Fig. 6).

(2) Lots of stuff moving. The railroads and truckers certainly have plenty of freight to transport. Business sales of goods, adjusted for inflation, rose 2.6% y/y in July to another record high (Fig. 7). Despite Trump’s trade war, West Coast ports’ total container traffic—both inbound and outbound—climbed 4.0% y/y in August into record-high territory (Fig. 8).

Railcar loadings are up 4.7% y/y, continuing the rebound that started in early 2016 (Fig. 9). The industry looks even healthier if carloadings of coal are excluded (Fig. 10). The use of coal by utilities has dropped sharply in recent years, as it became more cost effective to burn inexpensive natural gas. Conversely, the industry has been helped by a surge in railcar loadings since early 2016 of chemicals and petroleum products mostly attributable to the fracking industry (Fig. 11).

During August, the ATA Truck Tonnage Index dipped 1.8% m/m, but rose 4.5% y/y, according to the American Trucking Associations’ press release (Fig. 12). It remains solidly in record-high territory.

(3) Labor-cost divergence. The divergence in the recent performance of the Railroads and the Trucking industries may be attributable to the greater labor intensity involved with trucking. At a minimum, there’s one person per truck. Trains, on the other hand, are able to move more than 100 railcars with one to two people on the job.

The difference may go far in explaining the large divergence between the two industries’ profit margins. The railroad industry has an enviable estimated profit margin of 24.6% this year, which is forecast to improve to 26.5% in 2019 (Fig. 13). Those margins are much more attractive than the 6.9% operating margin expected this year and 7.4% targeted next year for the S&P 500 Trucking industry (Fig. 14).

Both industries are facing a tight labor market. The latest sign of stress was laid out in a 10/1 WSJ article: “Truck drivers and Teamsters union members picketed at freight-handling sites in Southern California on Monday, calling on companies to convert independent-contractor drivers to full-time employees.”

(4) Fuel-efficiency divergence. Truckers may also be underperforming their rail counterparts because the price of oil has spiked ytd and truckers are notoriously less fuel efficient than railroads. A barrel of Brent crude oil has jumped to $84.80, up 27% from the start of the year (Fig. 15).

The jump in oil prices has a much larger impact on the truckers. “Moving freight by rail is four times more fuel efficient than moving freight on the highway,” according to the CSX website. A CSX train can move a ton of freight 471 miles on a gallon of fuel, according to 2015 data, vs just 134 miles for a truck.

The divergence may continue until either electric, automated trucks are introduced or a recession comes along.

Amazon: Bricks Over Clicks? Amazon is an amazing amalgamation of technology and retailing. As the world’s largest Internet retailer, a major provider of cloud computing services, and developer of Alexa, no one can doubt the company’s tech bonafides. However, recent headlines have highlighted Amazon’s aggressive expansion into the physical world of bricks and mortar.

Amazon announced on Tuesday its warehouse workers’ wages will be bumped to $15 an hour, a move that will pressure other retailers to boost their starting wages as well. In the last month, it has been reported that Amazon may open 3,000 convenience stores and that it has invested in a prefab housing manufacturer. Let’s take a look at the recent pronouncements that accelerate the melding of click and bricks:

(1) Stores made of bricks. Amazon’s expansion into the “real” world accelerated last year when the company purchased Whole Foods’ 470 grocery stores. The same year, Amazon began opening book stores, which now number roughly 20. And last week, the company launched a novelty store concept, 4-Star, which is stocked with goods that have at least four-star customer ratings on Amazon.com (note to Jeff Bezos: Save shelf space for Predicting the Markets!).

Still under consideration: the rollout of AmazonGo—its urban convenience store concept—to 3,000 locations by 2021, according to a 9/19 Bloomberg article. The company currently has just two AmazonGo stores that offer grab-and-go food, like sandwiches and salads, and another two that stock groceries as well. Adding 2,996 stores would mean a lot of bricks.

At AmazonGo, customers enter by scanning their phones at a turnstile, grab the desired goods, and exit without having to pay a cashier. Sensors note what shoppers take and bill them directly. “The challenge to Amazon’s plan is the high cost of opening each location. The original AmazonGo in downtown Seattle required more than $1 million in hardware alone, according to a person familiar with the matter,” the Bloomberg article stated.

The company that made grocery store and book store operators quake now has a target on convenience stores, like 7-11, and fast-food eateries, like Subway and Panera.

(2) Homes, sweet homes. Amazon also entered the home-building business last month, presumably with an eye toward filling its newly built homes with its Alexa-powered smart home devices. The Internet retailer invested in a home-building startup, Plant Prefab, through its Alexa Fund. Amazon has given the Alexa Fund $200 million since it launched in 2015 to invest in companies, at home and abroad, that integrate its Alexa Voice Services into their products.

Plant Prefab “says it uses sustainable construction processes and materials to build prefabricated custom single- and multifamily houses. The start-up is aiming to use automation to build homes faster and bring down costs,” according to a 9/25 CNBC report. It hopes to reduce construction time by 50% and reduce cost by 10%-25% in major cities.

This announcement comes after Amazon struck a separate deal with Lennar to pre-install Alexa in each of the 35,000 smart homes that Lennar expects to build this year. (Now that’s a REAL lot of bricks!)

(3) Bricks with wheels. Product delivery may not be cool by tech wizard standards, but Amazon certainly has its eye on the real-world problem of transporting goods over the last mile to customers’ homes. The company announced early last month that it will order 20,000 new Mercedes-Benz Sprinter vans for its delivery program.

The vans will be owned by fleet-management companies that will buy the vehicles and lease them to small delivery service providers, a 9/5 WSJ article reported. Amazon had previously announced its plans to invite entrepreneurs to create delivery companies—which each could employ up to 100 drivers and lease between 20 and 40 vans sporting the Prime logo—to handle Amazon deliveries. The company says it has received tens of thousands of applications. FedEx and UPS are undoubtedly watching closely.

(4) Amazing growth. The S&P 500 Internet & Direct Marketing Retail industry, in which Amazon resides, is expected to continue its rapid growth both on the top and bottom lines. Revenues are forecast to jump 28.9% this year and 20.3% in 2019 (Fig. 16). Earnings are forecast to improve even more rapidly: 79.5% in 2018 and 30.1% next year (Fig. 17). The industry’s forward P/E, at 54.6, is down from its peak of 85.8 at the start of the year and from 62.4 just a week ago, before Netflix was transferred into the newly created Communication Services sector (Fig. 18).

Tech: Elon Houdini. Harry Houdini was renowned for his ability to defy the odds and escape from tight spots of his own making. He escaped from the belly of a whale’s carcass despite being wrapped in chains. He could swallow 100 needles and 20 yards of thread. And who can forget the well-photographed image of Houdini in a strait jacket and chains, hanging upside down from a building crane?

Elon Musk in recent weeks attracted gawkers wondering how he’d get out of his self-made predicaments. He tweeted his intention to take Tesla private and followed that with smoking pot during a podcast. Musk’s tweet prompted securities fraud charges by the Securities & Exchange Commission (SEC), which he first fought but then settled this week. Musk didn’t escape completely unscathed. He has to step down as Tesla’s chairman and add two independent directors to the board, and he and the company each has to pay a $20 million fine. But at least he was able to remain Tesla’s CEO.

The SEC settlement capped a week of good news. Tesla hit Q3 production goals. Norway is adopting electric cars at an amazingly fast pace. And Musk’s vision of a hyperloop took a large step toward becoming a reality. Here’s a quick rundown:

(1) Delivery goal hit. Tesla hit its Q3 production goals. “Deliveries totaled 83,000 vehicles, of which 55,840 were Model 3s. … Analysts polled by FactSet had expected Tesla to deliver about 80,000 vehicles in the quarter including 55,000 Model 3 sedans,” a 10/3 MarketWatch article reported. The news was even more impressive given that most traditional auto players saw their monthly sales decline in September. Now analysts await the company’s earnings release to see if Tesla can deliver on its promises to be profitable and cash-flow positive in Q3 and Q4.

(2) Norway loves EVs. Electric vehicle (EV) sales in Norway hit record levels in September. For the month, 45% of new passenger cars registered were all-electric vehicles, and 60% were either electric or plug-in hybrids, a 10/1 article in Electrik reports.

Granted, the absolute number of total cars sold in Norway, 10,620, is far smaller than the number sold in the US. However, the quick uptake of electric cars is notable nonetheless, and makes the country’s goal of all new cars being electric by 2025 potentially achievable— if the country continues its policy of juicy incentives.

A 7/2 article in The Guardian laid out the benefits of buying an EV in Norway: Motorists escape heavy import and purchase taxes. They’re exempt from a 25% value-added tax, aren’t subject to road taxes, and have no drive-by road tolls. Electric car drivers get free municipal parking, free charging, and can often use bus lanes. Ironically, Norway pays for these incentives with the proceeds it receives from selling its oil.

Norway’s perks have been enough to prompt residents to buy EVs as a second car, and in time we’ll see if they can let go of their gas-guzzling autos entirely. The move to EVs is occurring despite the limited options buyers have. The Model 3 and Audi’s e-tron aren’t yet available in Norway. However, Tesla did sell roughly 2,000 of its older models in the green country last quarter.

(3) Hyperloop excitement. Musk touted the potential of a hyperloop in 2013, and this week his vision got one step closer to becoming a reality. Hyperloop Transportation Technologies—a company unrelated to Musk—unveiled its first full-scale passenger capsule intended for use in a hyperloop, a 10/2 CNBC article reported.

A hyperloop would theoretically move passengers in train-like capsules through low-pressure tubes at more than 750 miles per hour. It would provide a speedy alternative to our clogged highways and pokey train system. The capsule was shown in Spain and will be moved to California, where it can be used on one of the first commercial tracks.

All in all, Musk had a good week, defying his many critics by escaping from a number of tricky situations. But given his track record, we’d be prepared for more Musk drama in the future.

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Stocks Tracking Earnings Higher

October 03, 2018 (Wednesday)

Strategy I: Flying with the Blue Angels. “Off we go into the wild blue yonder” is the first line of the official song of the United States Air Force (USAF). It has also described the current bull market ever since it first rose to record-high territory on March 28, 2013. Since then, the S&P 500 is up 86.4% (Fig. 1). The S&P 400 rose to a record high on January 14, 2011 and is up 115.3% since then. The S&P 600 rose to a record high on March 31, 2011 and is up 134.3% since then. Let’s have a closer look at this year’s performance so far:

(1) Record-high forward earnings. After taking hits in early February, all three indexes continued to make record highs this year. Our Blue Angels analysis shows that they’ve been doing so by simply tracking their respective forward earnings, which were dramatically boosted by Trump’s corporate tax cut at the end of last year (Fig. 2). All three forward earnings have been making record highs almost every week since then. (Just to be precise: The Blue Angels fly for the Navy, while the Thunderbirds fly for the USAF.)

(2) Reasonable valuations. Both the S&P 500 and S&P 400 sported forward P/Es of about 18.0 at the start of the year, prior to the latest correction. Since the correction, both indexes have been rising along with their forward earnings, with their forward P/Es remaining around 16.0. The S&P 600’s forward P/E dropped from 20.0 before the correction to 18.0 after it, and has held that level since as the index rose along with its forward earnings.

(3) Remarkably strong revenues. In addition to the tax cut, forward revenues for all three have also been bolstering forward earnings. Forward revenues per share for the S&P 500/400/600 are all on uptrends and in record-high territory (Fig. 3). For the S&P 500, industry analysts are estimating that revenues will increase 8.4% this year, 5.2% next year, and 4.1% in 2020.

As Joe and I have noted before, this year’s strength in revenues is remarkable given that Trump launched a trade war earlier this year. Despite signs of weakness in emerging markets and sagging industrial commodity prices, S&P 500 forward revenues—which is a great coincident indicator of actual revenues—suggests that the global economy is weathering the storm remarkably well (Fig. 4). That, or weakness overseas has been more than offset by fiscal stimulus at home.

(4) Even higher profit margins ahead? So rising forward revenues are providing solid support for rising forward earnings. However, since the tax cut, forward earnings have greatly outpaced forward revenues (Fig. 5). As a result, the S&P 500 forward profit margin—which is a good coincident indicator of the actual quarterly series—has continued rising to a record 12.4% in late September (Fig. 6).

(5) Wild animal spirits. It’s hard to believe that margins can continue to make new highs if labor costs start to increase significantly given the extreme tightness of the labor market. However, maybe the industry analysts all have turned into supply-side economists, betting that productivity will make a comeback that offsets, or at least reduces, the squeeze on profits from labor costs (Fig. 7). Joe and I are natural-born optimists and are open to the possibility that the supply-side fairy tale will come true.

We doubt that analysts are turning into supply-siders, though. Like us, they tend to be optimists, and are often forced to lower their revenues and earnings estimates as the time for the actual results approaches (Fig. 8 and Fig. 9). However, their current unrelenting optimism suggests that they’ve been infected with animal spirits, just as measures of consumer and business confidence suggest has happened to the rest of us. (See our Animal Spirits.)

(6) Blue Angels heading higher into the wild blue yonder. So where do we go from here? We think that the stock market will continue to make new record highs over the rest of the year. The S&P 500 is only 6.0% away from our 3100 target for the end of this year, which we predicted at the end of last year. That would be a 15.9% increase in 2018. For next year, our target is 3500, a 13% increase for 2019.

Earnings should continue to drive the market higher. We have often noted that the bull market has been a series of panic attacks followed by relief rallies. Recent record highs have been achieved on relief rallies triggered by news that Trump is winning his trade wars.

(7) Nothing to fear but higher inflation. Nevertheless, there is widespread concern that the tight labor market will cause wage inflation to soar, which would force the Fed to raise interest rates more aggressively. So the drop in initial unemployment claims to the lowest levels since 1969 is worrisome to some. We are in the bullish camp on this issue.

Our Boom-Bust Barometer (BBB)—which is the ratio of the CRB raw industrials spot price index to jobless claims—remains in record-high territory because the strength in claims offsets the recent weakness in the commodity index we use. Our BBB is highly correlated with S&P 500 forward index as well as the S&P 500 stock price index (Fig. 10 and Fig. 11).

Reassuringly, in a speech yesterday, Fed Chairman Jerome Powell said: “As I mentioned, the FOMC carefully monitors a wide array of early indicators of inflation pressure to evaluate this risk. Wages and compensation data are one important source of information. These measures have picked up some recently, but in a way that is quite welcome. Specifically, the rise in wages is broadly consistent with observed rates of price inflation and labor productivity growth and therefore does not point to an overheating labor market. Further, higher wage growth alone need not be inflationary. The late 1990s episode of low unemployment saw wages rise faster than inflation plus productivity growth without an appreciable rise in inflation.”

In other words, Powell is clearly saying: Don’t freak out if Friday’s employment report shows wage inflation moving higher. By the way, Amazon hiked its minimum wage to $15 an hour yesterday. The company can afford it. Other companies that compete with Amazon probably can’t raise prices and may see their profit margins squeezed if they are forced to raise wages too. Or else, they can scramble to boost their productivity.

Strategy II: Buybacks Binge. Back in February, Melissa analyzed Blue Chip company managements’ comments about how their firms might use the unexpected windfalls that had just blown into their laps, courtesy of the Trump administration’s Tax Cut and Jobs Act (TCJA) passed in December 2017. “Giddy” was how they collectively sounded as they surveyed their many options like kids in a candy shop (see our 2/28 Morning Briefing).

Executives’ first priority for use of the additional cash at that time seemed to be capital investment to support organic growth. Second came share buybacks and dividend increases to create shareholder value, followed by employee givebacks and letting the benefits drop directly to the bottom line. Whatever other moves they’ve made by now, seven months later, we know one thing for sure: They weren’t kidding about buying back shares.

Joe reports that Q2-2018 was a quarter for the record books in terms of S&P 500 companies’ share repurchases. S&P 500 quarterly buybacks edged up 0.8% q/q to a record-high $190.6 billion during the quarter, and its 58.7% y/y gain was its strongest since Q1-2014 (Fig. 12). That $190.6 billion is the highest quarterly buyback amount on record, dating back 82 quarters to Q1-1998; exceeds the prior cycle’s record high of Q3-2007 by 10.9%; and represents an improved q/q for a fourth consecutive quarter. Notably, there haven’t been four consecutive quarters of improvement in buyback amounts for nearly five years, since Q4-2013.

More slices and dices of the Q2 buyback data, courtesy of Joe:

(1) That’s some four-quarter sum! The four-quarter sum of buybacks jumped 12.3% q/q to $645.8 billion from $575.3 billion in Q1-2018. That was its best pace since Q1-2014 (Fig. 13). The four-quarter sum hit a record high for the first time since Q1-2016’s record of $589.4 billion (which at the time was its first since Q4-2007).

(2) Increased repurchase activity in more sectors than not. Buybacks rose q/q during Q2-2018 for seven of the 11 sectors and fell for four (Fig. 14). That compares to seven rising and four falling during Q1-2018. The biggest q/q buyback gainers on a percentage basis in Q2-2018: Telecom (up 146.5% q/q to a 10-quarter high of $419 million from $170 million), Utilities (130.7%, to a 12-quarter high of $413 million from $179 million), Materials (41.8%, to a 10-quarter high of $3.2 billion from $2.3 billion). Industrials (40.9%, to a nine-quarter high of $23.4 billion from $16.6 billion), Consumer Discretionary (21.3%, to a three-quarter high of $22.7 billion from $18.7 billion), Tech (12.8%, to a record high of $71.5 billion from $63.4 billion), and Real Estate (0.1%, to $884 million from $883 million).

(3) Repurchasing shares favored over hiking dividends. During Q2-2018, the S&P 500 companies continued their long-established trend of spending more on buybacks than dividends, as record-high buybacks of $190.6 billion outpaced the record-high quarterly dividend payments of $111.0 billion. Buybacks have exceeded dividends in 42 of the past 47 quarters, except during the financial crisis from Q4-2008 to Q4-2009, when all sectors cut buyback spending drastically.

(4) Cash returning to investors. With the pace of buybacks and dividends rising in Q2, the four-quarter sum of buybacks and dividends, or cash returned to investors, improved for a fifth straight quarter to a record high of $1.1 trillion from $1.0 trillion during Q1. During Q2-2018, nine of the 11 sectors had enough operating earnings on a trailing-four-quarter basis to cover their buybacks and dividends (cash returned to investors), up from eight in Q1-2018.

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The World According to Jay

October 02, 2018 (Tuesday)

Fed I: Still Gradually Normalizing. Investors need to know when and at what level the Fed will end its rate-hiking cycle. The best answers to these two questions are in the Fed’s September Summary of Economic Projections (SEP), which was released following last Wednesday’s FOMC meeting. Before we go there, let’s have a quick look back at the Fed’s slow and steady path of rate increases to date.

During December 2015, the Fed lifted the federal funds rate from 0.00%-0.25%, where it had been for nearly seven years, to 0.25%-0.50%. Since then, the Fed has raised rates seven additional times: one time during 2016 to 0.50%-0.75%, three times during 2017 to 1.25%-1.50%, and three times during 2018 to 2.00%-2.25% so far, including the 9/26 rate hike (Fig. 1).

If the FOMC continues to hike by 25bps on a quarterly basis, the federal funds rate would rise to 3.40% by the end of next year (Fig. 2). Melissa and I expect that the Fed will increase rates one more time this year to 2.25%-2.50%, three times in 2019 to 3.00%-3.25%, and one more time in 2020 to end at 3.25%-3.50%. Why do we expect that’s where the Fed will stop? We simply agree with the FOMC’s median forecast for the federal funds rate in the latest SEP. For the first time, it showed the Fed’s 2021 federal funds rate projection, which is the same as that for 2020, at 3.40%.

These projections were endorsed by Fed Chairman Jay Powell during his 9/26 press conference. None of what he said was a surprise because his latest pronouncements are consistent with his statements since becoming Fed chairman on February 5.

During his press conference, Powell stated that the Fed’s latest move reflects the strength of the US economy “and is one more step in the process that we began almost three years ago of gradually raising interest rates to more normal levels.” But what is normal, and when will we get there? Consider the following:

(1) Dropping accommodative. It was widely noted that the latest FOMC statement deleted the following language that had appeared in previous statements: “The stance of monetary policy remains accommodative.” This sentence had been in every FOMC statement since December 16, 2015, when the Fed started its latest rate-hiking program. Some interpreted this to mean that the Fed is setting up for more aggressive rate increases. On the contrary, Powell reassuringly said that the language simply had outlived its “useful life.” So the Fed will continue its gradual rate increases toward a neutral stance.

(2) What is neutral? The neutral level of the federal funds rate neither speeds up nor slows down the US economy. Instead, a neutral rate keeps the US economy moving ahead on an even keel. Policymakers have two main problems with achieving this outcome: The neutral rate cannot be directly observed, and it may be a moving target. Powell commented that he doesn’t “want to suggest” that the Fed has a “precise understanding of where accommodative stops.” He added that the Fed could change its estimate of the neutral rate.

(3) Modestly restrictive. During his press conference, Powell was asked if the Fed might end the tightening cycle in a “restrictive posture,” as Fed Governor Lael Brainard suggested in a 9/12 speech. Powell responded: “It’s very possible.” He added: “Maybe we will keep our neutral rate here [i.e., at 3.00%], and then go one or two rate increases beyond it.” If the US economy continues to perform as the Fed expects, we expect that the Fed will stop tightening at around 3.25%-3.50% during 2020. That would be two 25-basis-point hikes above the SEP longer-run projection of 3.00% for the federal funds rate.

In her speech, Brainard explained: “In the latest FOMC SEP median path, by the end of next year, the federal funds rate is projected to rise to a level that exceeds the longer-run federal funds rate during a time when real GDP growth is projected to exceed its longer-run pace and unemployment continues to fall. The shift from headwinds to tailwinds may be expected to push the shorter-run neutral rate above its longer-run trend in the next year or two, just as it fell below the longer-run equilibrium rate following the financial crisis.”

(4) Future guidance. That all sounds consistent with the idea that the Fed will probably halt its tightening cycle in the next couple of years. But what happens over the longer run is much more uncertain than it was when there was little room for rates to go anywhere but up. Just yesterday, New York Fed Governor John C. Williams gave a speech in which he suggested that “the case for strong forward guidance about future policy actions is becoming less compelling.”

Exploring the concept of the neutral rate, sometimes referred to by economists as “r-star,” Williams said: “Back when interest rates were well below neutral, r-star appropriately acted as a pole star for navigation.” But he added: “[A]s we have gotten closer to the range of estimates of neutral, what appeared to be a bright point of light is really a fuzzy blur, reflecting the inherent uncertainty in measuring r-star. More than that, r-star is just one factor affecting our decisions, alongside economic and labor market indicators, wage and price inflation, global developments, financial conditions, the risks to the outlook.”

Fed II: Jay Talking. Fed Chairman Powell has done a very good job of communicating with the financial markets community. Unlike the previous three Fed chairs, there’s not much ambiguity or jargon in his public pronouncements. We find it very refreshing to have a Fed chair who isn’t a trained economist. He has also managed to significantly reduce the often useless chatter coming from the Federal Open Mouth Committee, whose members have been known to pontificate regularly on monetary policy, often sowing confusion. There seems to be more signal and less noise under Powell.

In his latest press conference, Powell said he prefers the gradual pace of rate hikes because it gives the Fed the ability to “wait and see” how the US economy will absorb them. Powell said that he is equally concerned with risks to the upside and to the downside. Raise too quickly, and the Fed can “snuff out a recovery unnecessarily and inflation falls short” of its 2.0% target. Raise too slowly, and risk inflation overheating.

As Powell has said before on numerous occasions, he sees the risks to the economic outlook as “roughly balanced.” Powell listed several US economic strengths and potential vulnerabilities that could tip that balance in either direction. Let’s review:

(1) Fiscal positives. In September, the Fed increased its real GDP forecast for 2018—for the third time in a row this year—to 3.1%, up from 2.8% in June and 2.7% in March. When asked to confirm that fiscal policy had been factored into the Fed’s forecasts for growth, Powell responded that some of it is “no doubt” fiscal policy. Specifically, he referred to the tax cuts and spending increases as beneficial for growth and jobs.

“Fiscal policy is boosting the economy” and “ongoing job gains are raising incomes and confidence,” he said. Powell mentioned a couple of times that he has been pleasantly surprised by labor force participation.

(2) Protectionism negatives. Regarding Trump’s trade war, Powell said, “We’ve been hearing a rising chorus of concerns from businesses all over the country about disruption of supply chains, materials and cost increases, and a loss of markets.” Yet he brushed off those concerns. Interestingly, Powell noted that the tariffs “might provide a basis for companies to raise prices in a world where they’ve been very reluctant” to do so because of consumers’ ability to “compare prices on the internet.”

Further, Powell observed that it’s hard to see the impact of the tariffs on the US economy at the aggregate level. If all the tariffs announced were applied, Powell thinks the impact would still be small. The major risk for the outlook that Powell can foresee is the possibility of the tariffs being made permanent and impacting business confidence.

“Fair trade under internationally accepted rules can be a good thing,” stated Powell. “I think if this perhaps inadvertently goes to a place where we have widespread tariffs that remain in place for a long time for a more protectionist world, that is going to be bad for the US economy” and “other economies” too, he said.

(3) Worry list. Outside of trade, Powell discussed three other US economic vulnerabilities. One is that asset prices are in the “upper range” relative to historical averages. The second is elevated levels of nonfinancial corporate (NFC) debt. The third is that unstable emerging markets with dollar-denominated debt are vulnerable to rising interest rates in the US.

However, Powell sees these issues as posing only moderate risks to the outlook. Powell isn’t too worried about NFC debt and added that banks have taken on less risk now than they previously did. Likewise, Powell isn’t overly concerned about a correction in asset prices unless it were to coincide with a decrease in consumption. He mentioned that the Fed is monitoring emerging economies, but noted that only a few are at risk.

(4) Another supply-sider? We were most impressed by Powell’s HUGE endorsement of supply-side economics. Okay, we are exaggerating, but here is what he actually said during the Q&A:

“Oh, supply side effects, yeah. … [W]e hope they’re huge, frankly. You know, the idea is … you reduce taxation on corporations … and allow faster expensing for investment. The idea is to encourage more investment and that is one of the things that drives productivity, which is one of the main things that drives rising incomes. [Supply side] effects are very uncertain ... [T]here’s no clear answer to exactly how these mechanisms work or how effective they are. And it would be soon to be seeing supply side effects. ... But … I certainly hope … that we’ll be marking up our estimates of potential growth.” Nice to know we are in the same camp as the Fed chairman!

Fed III: Regional Prices Surveys. Is the Phillips curve dead? The latest SEP suggests that Powell’s Fed is much more inclined to think so than was Yellen’s Fed. The latest SEP projections show real GDP growing 3.1% this year and 2.5% next year. The unemployment rate is projected to fall to 3.5% in 2019. Yet the core PCED inflation rate remains around 2.0%. There’s no tradeoff between the unemployment rate and inflation in this forecast, even though the labor market is the tightest in decades and is expected to get even tighter.

Debbie and I tend to agree with this outlook, though we wouldn’t be surprised if Trump’s supply-side policies stimulated faster growth fueled by rebounding productivity, which would allow real wages to increase and inflation to remain subdued. For now, the latest national and regional surveys of business conditions show that both “prices paid” and “prices received” by manufacturers dipped during September but remained elevated compared to a year ago. That may reflect rising costs—including labor compensation, oil prices, and tariffs. However, they also moderated a bit last month.

Based on the five regional surveys conducted by the Fed district banks in Dallas, Kansas City, New York, Philly, and Richmond, the average of the prices paid and prices received indexes dipped in September by 6.3 points and 7.6 points to 42.0 and 18.6, respectively, from their July peaks. Both sets of indexes were below zero from about mid-2015 to mid-2016. They recently peaked at about 50.0 and 30.0, respectively, before tapering off in September (Fig. 3).

The regional prices paid composite is highly correlated with the national prices paid index included in the ISM manufacturing purchasing managers survey (Fig. 4). The ISM index is down from a recent peak of 79.5 during May to 66.9 during September. Similar dips were seen across the five Fed districts, with the exception of Richmond (Fig. 5).

Several of the regional survey reports mentioned the tightness of the labor market. Kansas City’s September Manufacturing Survey noted: “Finding people to work still is our greatest challenge. We are working 6 days a week and have a very difficult time getting people to show up. Overtime is taking a toll on the financial statement and on our employees. They want time off and it’s hard to give it to them.” As we’ve discussed previously, a similar story was told in the last several Federal Reserve Beige Books, the most comprehensive qualitative Fed survey of business conditions.

It seems reasonable to expect that employers may have to increase wages at a faster pace in order to attract hard-to-get employees. The question is: Will they do so or instead increase capital spending and boost productivity? Another question: Will they be able to pass through cost increases in industries that are competitive and being disrupted by technological innovations? We continue to believe that powerful secular forces will keep inflation at bay.

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China’s Syndromes

October 01, 2018 (Monday)

China I: Getting Trumped. I’m coming around to a new working hypotheses on the outlook for China’s economy. I think it could be much weaker much sooner than widely recognized. A significant slowing in the growth rate of inflation-adjusted retail sales over the past couple of years suggests that the aging demographic factor—attributable to the government’s previous population control measure—may be hitting consumer spending significantly already. As a result, Trump’s escalating trade war with China may very well hurt China’s economy much harder than widely realized.

Furthermore, what if Trump’s trade war with China isn’t just about trade? Yes, we all know it is also about intellectual property rights. But what if at heart it’s about China’s superpower ambitions—as evidenced by its moves to control the South China Sea, to build the “Silk Road” linking China to Europe by way of Central Asia, and to exploit the resources of Africa? The Chinese government, under President-for-life Xi Jinping, is intent on challenging America’s status as the world’s sole superpower. So why should the US continue to enable Xi’s geopolitical masterplan by allowing the Chinese to run a huge trade surplus with the US and to steal US technology?

The Trump administration’s overarching policy goal vis-à-vis China, therefore, may be first and foremost to use America’s economic power to slow, or even halt, the ascent of China into a superpower, which will challenge America’s interests around the world. If so, then any concessions that the Chinese make on trade and technology are likely to be rejected by the Trump administration. In other words, they have nothing to offer that would satisfy Trump other than an unconditional retreat from their geopolitical expansion plans, which they will never do voluntarily.

So Trump may very well raise the ante soon by slapping a permanent 25% tariff on all goods that the US imports from China. The goal isn’t to force concessions out of China but rather to get manufacturers out of China and into either the US (ideally) or to countries such as Mexico that do agree to the terms of bilateral trade deals with the US!

Of course, manufacturers who stay in China won’t be paying the 25% tariff: US consumers who buy China-made goods will be hit with that price hike. However, to remain competitive in the US, manufacturers are likely to scramble to other countries that can export to the US without having the US dollar price of their goods marked up by 25%.

I have one piece of anecdotal evidence that companies may be starting to move out of China already. A good friend of mine has a small business in Manhattan designing and selling high-end raincoats in the US. He has been manufacturing them in Vietnam. He stopped making them in China a few years ago because labor costs have been rising there, while they remain low in Vietnam. He told me he was shocked recently when his Vietnamese vendor had to lengthen delivery schedules from four months to six months because it was swamped with orders that used to be filled in China prior to Trump’s trade war.

Now consider the following recent developments before we review China’s depressing demographic outlook:

(1) Peter Navarro’s view. A Monday 9/24 CNBC article reported that Peter Navarro, director of the National Trade Council at the White House, said getting a trade deal with China will be tough: “The challenge is, they've engaged in so many egregious practices that it's far more difficult to make a deal with China than it would be with Mexico.” Navarro is a former economics professor and author of The Coming China Wars: Where They Will Be Fought, How They Can Be Won (2006).

A 6/24 Axios article quoted Navarro saying: “Since China joined the WTO [i.e., the World Trade Organization] in 2001, the U.S. has lost over 70,000 factories, more than five million manufacturing jobs, and suffered from substantially lower real GDP growth rates. As America’s manufacturing and defense industrial base has weakened, China’s has strengthened and we now face a strategic rival in places like the South China Sea whose military forces have been largely financed by the massive trade deficits the U.S. runs with China.”

Navarro had more to say on this subject in a 6/20 WSJ article titled “Trump’s Tariffs Are a Defense Against China’s Aggression: Beijing seeks economic and military domination by taking U.S. technology and intellectual property.” His opening paragraph said it all: “The Chinese government’s Made in China 2025 blueprint reveals Beijing’s audacious plans to dominate emerging technology industries. Many of these targeted sectors, such as artificial intelligence and robotics, have clear implications for defense. China seeks to achieve its goal of economic and military domination in part by acquiring the best American technology and intellectual property. President Trump’s new tariffs will provide a critical shield against this aggression.”

(2) Higher tariffs. Also on Monday 9/24, Washington slapped tariffs of 10% on $200 billion of Chinese products that include furniture and appliances, and the rate will increase to 25% by the end of the year. President Xi Jinping's government retaliated by imposing taxes on 5,207 US imports, worth about $60 billion. Products such as liquefied natural gas, coffee, and various types of edible oil will see a 10% levy, while a 5% tax will be imposed on items such as frozen vegetables, cocoa powder, and chemical products.

The US and China already had applied tariffs to $50 billion of each other's goods. Trump has warned that any retaliation by China would prompt Washington to "immediately pursue phase three, which is tariffs on approximately $267 billion of additional imports."

Trump has overtly expressed his desire to narrow the US trade deficit with China significantly and to bring back manufacturing capacity to the US, so he may not declare victory in his trade war with China until Apple is making most of its iPhones in the US. It’s also conceivable that Trump may be mollified if Chinese leaders relinquish at least some of the country’s unfair trade practices, especially those related to foreign technology investment. But even if Trump’s negotiations with China and other countries don’t succeed in getting what he wants, they may succeed in providing more opportunities for the US to shop around for fairer trading partners.

Interestingly, cell phones and other household items is the largest category of imports to the US from China, according to the World Economic Forum. China isn’t the only place in the world to make cell phones, though. South Korean electronics giant Samsung is “now looking to fend off Chinese companies trying to dominate the market for inexpensive phones” by expanding manufacturing into India, according to an article in the 9/4 WSJ. The company’s new facility in a New Delhi suburb, to be completed in 2020, will eventually make 120 million handsets a year, or roughly one of every 13 phones in the world. Around 30% of those will be exported.

(3) Arms race. On Thursday 9/20, Washington imposed sanctions on a Chinese military unit for purchasing Russian weapons, claiming the transaction violated a US sanctions law known as “Countering America's Adversaries Through Sanctions Act,” which was signed by President Trump on August 2, 2017. The act imposed sanctions on Iran, North Korea, and Russia. The Chinese government summoned the US ambassador in Beijing over the matter and said Beijing would recall its navy chief from a visit to the US.

On 9/25, the US approved a $330 million arms sale to Taiwan in another sign of Washington’s support for the government in Taipei amid rising Chinese pressure on the country. In the latter years of George W. Bush’s presidency, Washington dropped annual weapons sales to Taiwan in favor of bundling sales every few years, a move that was seen as acquiescence to pressure from China. Under Trump, there may be a return to the routine sale of weapons to Taiwan, despite protests from China.

Meanwhile, China has sought to strengthen its claim to the South China Sea by building seven islands on reefs and equipping them with military facilities such as airstrips, radar domes, and missile systems. Five other governments claim territory in the oil- and gas-rich area, through which an estimated $5 trillion in global trade passes annually. Last Thursday, China called a recent mission by nuclear-capable US B-52 bombers over the disputed South China Sea "provocative."

China II: Why Trump Won. Trump won on November 8, 2016 because he appealed to voters who lost manufacturing jobs after China entered the WTO and manufacturers left the US. Previously, I’ve shown a chart that clearly shows this development. It tracks US manufacturing production and capacity since January 1948 (Fig. 1). The two were on similar and solid uptrends—tracking at about 4% per year on average—until China joined the WTO during December 2001. Both have been flat ever since. Debbie and I estimate that if the trend prior to December 2001 had persisted, US manufacturing capacity would be 77% higher than it was during August of this year (Fig. 2)!

We can also guesstimate China’s impact on jobs. Factory payrolls dropped 4.3 million from December 2001 (when China joined the WTO) through March 2010 to the lowest level since March 1941 (Fig. 3). They were still down 3.4 million through Election Day 2016 and 3.0 million through August of this year.

The ratio of US factory jobs to capacity has declined 24% since the end of 2001 through August of this year, presumably reflecting productivity gains (Fig. 4). If capacity had remained on its uptrend prior to China joining the WTO, factory employment arguably would be 53%, or 6.7 million jobs, higher than August’s level of 12.7 million. (We derived the percentage increase by subtracting 77% from 24%.)

So Trump’s victory on Election Day 2016 may largely reflect the hostile reaction of America’s manufacturing Heartland to China’s ascent, presumably at US factory workers’ expense.

China III: The Most Important Indicator. While manufacturing employment may be the key indicator explaining why Trump beat Clinton, inflation-adjusted retail sales in China may be the most important variable for tracking the impact of China’s increasingly dismal demographic profile on its economy. Consider the following:

(1) Real retail sales. Every month, the Chinese report retail sales and the consumer price index (CPI). We’ve been monitoring the yearly percent changes in both for many years (Fig. 5). The difference between the two is the growth rate in real retail sales. It has been on a downtrend since 2008-2010 when it typically exceeded 15%. During August of this year, it was down to 6.7%, one of the lowest readings since China joined the WTO at the end of 2001. It is down from 9.3% two years ago.

(2) Industrial production. Real retail sales has actually been growing faster than industrial production since early 2012 (Fig. 6). The latter has been growing around 6.0% y/y since 2015. It is likely to fall sooner rather than later if the downtrend in real retail sales persists (as suggested by the demographic trends discussed below) and Trump’s trade war weighs on exports.

(3) Credit. All of the above suggests that the Chinese government may have no choice but to continue propping up economic growth with debt-financed infrastructure spending. Bank loans (in yuan) have quadrupled in China since February 2009 (Fig. 7). Yet the Chinese are getting less and less bang per yuan. The ratio of Chinese industrial production to bank loans has dropped by roughly 50% since late 2008 (Fig. 8).

It’s possible that my analysis so far is too negative. Missing is the growing importance of services industries in China. Nevertheless, demography is destiny, and the Chinese government made an increasingly dismal global outlook on this front much worse in China.

China IV: Depressing Demographic Destiny. In Chapter 16 of my book, Predicting the Markets, I discuss China’s depressing demographic destiny. That discussion is especially relevant to today’s commentary:

“The fertility rate in China plunged from 6.1 in the mid-1950s to below 2.0 during 1996 (Fig. 9). Still below 2.0, it’s projected to remain so through the end of the century. Initially, the drop was exacerbated by the government’s response to the country’s population explosion, which was to introduce the one-child policy in 1979. While that slowed China’s population growth—to a 10-year growth rate of 0.5% at an annual rate in 2016 from a 3.0% pace in 1972—it also led to a shortage of young adult workers and a rapidly aging population.

“So the government reversed course, with a two-child policy effective January 1, 2016. Births soared by 7.9% that year with the deliveries of about 18 million newborns. But that was still short of the government estimates and might not be sustainable. At least 45% of the babies born during 2016 were to families that already had one child. [For more, see link.]

“Meanwhile, urbanization has proceeded apace, with the urban population rising from about 12% in 1950 to 49% during 2010; it was an estimated 57% in 2016 (Fig. 10). The urban population has been increasing consistently by around 20 million in most years since 1996 (Fig. 11). To urbanize that many people requires the equivalent of building one Houston, Texas per month, as I discuss in Chapter 2. I first made that point in a 2004 study.

“The move to a two-child policy is coming too late, in my opinion. China’s primary working-age population peaked at a record high of just over 1.0 billion during 2014 and is projected to fall to 815 million by 2050 (Fig. 12). By then, the primary working-age population in China will represent 60% of the total population, below the peak of 74% during 2010 (Fig. 13). The elderly dependency ratio will drop from 7.5 workers per senior in 2015 to 2.3 by 2050 (Fig. 14).

“In any event, despite the initial mini baby boom, the fertility rate is unlikely to rise much in response to the government’s new policy. Many young married couples living in China’s cities are hard-pressed to afford having just one child. An October 30, 2015 blog post on the Washington Post website, titled “Why Many Families in China Won’t Want More than One Kid Even if They Can Have Them,” made that point, observing that education is particularly expensive, as parents feel compelled to prepare their child to compete for the best colleges and jobs. Another problem is that most couples are the only offspring of their aging parents, who require caregiving resources that rule out having a second child. As it says in the Bible, ‘As you sow, so shall you reap.’”

Movie. “A Simple Favor” (+ + +) (link) is a really clever and entertaining movie. Stephanie is a widowed, single mum who runs a mommy vlog. She seeks to uncover the truth behind the disappearance of her best friend. Anna Kendrick plays the part as a quirky nerd with lots of bravado and comic energy.

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Home in the Range

September 27, 2018 (Thursday)

Housing: Under Construction. The Internet is chock-full of lists that make you chuckle. One list of things that don’t make sense asks: Why are pizza boxes square, when pizzas are round? Why do school grades include A, B, C, D, and F but not E? And why do we say ‘a pair of pants’ when referring to only one piece of clothing?

Right now, the housing market doesn’t make a lot of sense. Why, when the unemployment rate is near record lows and the stock market is at record highs, does the housing market appear to be stalling?

Perhaps the pent-up demand created during the recession has been satisfied, and now we’re seeing what “real” demand is? Perhaps real demand is being held back by high student loan balances? However, it’s more likely that housing prices rose too far, too fast, and the market is pausing until the two return to balance. Let’s take a look at this puzzle:

(1) Huge underperformance. The S&P 500 Consumer Discretionary sector is one of the best-performing sectors ytd in a strong stock market. Here’s the performance derby for the S&P 500 stock price indexes ytd through Tuesday’s close: Tech (18.9%), Consumer Discretionary (18.7), Health Care (14.0), S&P 500 (9.0), Energy (6.4), Industrials (3.4), Financials (1.4), Real Estate (-1.3), Utilities (-1.4), Materials (-1.6), Communications Services (-4.1), and Consumer Staples (-5.6).

The Consumer Discretionary sector would have even better results if it weren’t held back by the S&P 500 Homebuilding stock price index, which has fallen 20.2% ytd, making it one of the worst-performing industries we track (Fig. 1). All of the industry’s constituents have felt the pain. DR Horton shares have fallen 15.8% ytd, Lennar shares are down 22.7%, and PulteGroup shares have dropped 22.1%. Toll Brothers shares, which aren’t in the index, have sunk by a bruising 26.6%.

(2) Healthy consumers–for the most part. Consumers are sitting pretty these days. Initial claims for state unemployment benefits fell last week to the lowest level since 1969, and the number of people receiving benefits after an initial week of aid fell to the lowest level since 1973 (Fig. 2).

Household net worth rose to a record $106.9 trillion in Q2, a 2.1% increase from Q1 and the 11th straight quarter of rising US wealth, reported a 9/20 WSJ article (Fig. 3). Households benefited from the rising prices of stocks and real estate, which more than offset the 2% jump in household debt. Consumers have spent roughly the last 10 years paring down their mortgage debt, as a percent of total liabilities, from a peak of 74.0% in Q2-2009 to 64.7% last quarter—which was the lowest percentage since Q1-1988 (Fig. 4).

This rosy employment and financial situation has boosted spirits: The Consumer Board’s index of consumer confidence rose to 138.4 this month, up from 134.7 in August and not far from the all-time high of 144.7 hit in 2000 (Fig. 5).

(3) Mixed signals. Despite the solid financials underpinning the consumer, the housing industry’s foundation has some cracks. One of the biggest problems is home affordability. After prices fell sharply from roughly 2007 through 2009, they rebounded and have been rising by more than 5% annually for the past six years, pushing the value of homes into record territory (Fig. 6 and Fig. 7).

In addition to higher prices, buying a home has gotten tougher because home mortgage rates have climbed to 4.86%, up from a low of 3.44% in 2016 (Fig. 8). Higher prices and costlier mortgages have resulted in a decline in housing affordability, which peaked in January 2013 and has been falling in subsequent years (Fig. 9).

So far, there have been conflicting signals from the housing market. US existing home sales fell in August by 1.5% y/y, marking the sixth month of yearly declines (Fig. 10). Sluggish sales had been blamed on a lack of inventory; however, last month inventories were 2.7% above a year ago—the first yearly increase in three years (Fig. 11). Lawrence Yun, National Association of Realtors chief economist, noted, “With inventory stabilizing and modestly rising, buyers appear ready to step back into the market.” The median existing home price rose 4.6% y/y last month, in line with prior readings.

New home sales perked up a bit in August after a tough summer. New home sales rose 3.5% m/m in August, and the median sales price for a new home dipped to $320,200, down from $328,100 in July but above the year-ago median of $314,200 (Fig. 12). Inventories slipped a touch to 6.1 months supply in August, down from 6.2 in July. There were 318,000 new homes on the market last month—the most since February 2009; however, the level is roughly half what it was at the peak of the housing market boom in 2006.

(4) Opportunity knocking? Homebuilders shares have fallen so sharply that they may be pricing in a more dour outlook than will unfold. If consumer incomes continue to climb, and if home prices fall only modestly, the housing market could stabilize as home affordability improves.

Despite some recent downgrades in the sector, industry analysts overall remain optimistic. They’re calling for the S&P Homebuilding industry to grow revenue 33.9% this year and 12.1% in 2019 (Fig. 13). And despite expected jumps in the costs of land, labor, and materials, they’re forecasting earnings will rise 58.0% this year and 17.9% in 2019 (Fig. 14).

Could our optimism be misplaced? Certainly. The Trump tax law limits the amount of mortgage interest expense that can be used to reduce taxable income. The change could dampen demand for real estate, as could higher interest rates if the Federal Reserve tightens monetary policy faster than expected or the 10-year Treasury yield jumps well beyond 3.00%. Also, the vast amounts of student loans could prevent new home buyers from entering the market.

That said, we’re betting the US 10-year Treasury yield will remain tethered to 3.00% as long as Japanese and German bond rates hover around 0.00%. Also, history suggests it’s very unlikely that the area that dragged the stock market down in the last recession will be the same one that does so in the next recession. And with homebuilders stocks down by roughly 20%, investors don’t have to pay up to bet that this is the pause in the housing market that refreshes.

Technology: Vulnerable Data. Back in July, the Morning Briefing took a look at the development of quantum computers, the uber-powerful machines that are expected to have computing power that’s multiples of what today’s computers offer. The new computers will be able to devise new molecules to cure illnesses and power artificial intelligence.

The problem: Quantum computers are also expected to be so powerful that they can crack the encryption that keeps our data safe on traditional computers, even if it’s housed at the US government or the nation’s largest banks. Fortunately, the problem has been under discussion for many years, and cryptologists are racing to devise a new encryption method before quantum computers come to the fore. Here’s a little history and a look into the future:

(1) Uncle Sam’s on the job. The good news is that top US government agencies—including the National Security Agency (NSA) and the National Institute of Standards and Technology (NIST)—are well aware of the threat quantum computers pose to keeping today’s data safe. The bad news is they don’t have a solution quite yet.

“How close are we to quantum computers that could crack cryptography? The NSA isn’t making any bets, at least not publicly. It will only say that recent advances in the field should make us worry about future-proofing systems being built today to protect critical national infrastructure that will be in service for perhaps decades,” according to a 2/3/16 article in MIT Technology Review.

The article continues: “Our cryptography may be undefeated for a while even after the quantum computing era properly arrives, perhaps giving us enough time to update it. However, many computers and software in use today aren’t patched against even known security problems for which fixes are readily available.”

The NIST has said government agencies should have post-quantum encryption by 2023. In an effort to find a solution, the NIST put out a call for proposals to solve the problem and received 69 algorithms last year. “Now, they must evaluate each one against both classical and quantum attacks to ensure that the problems are still difficult to solve, with the hopes of drafting updated standards by 2022 to 2023,” explained a 2/16 article in Gizmodo.

(2) Private enterprise involved. There are companies—large and small—working on a solution as well. “Cisco and Amazon have been involved with efforts from European and international standards groups to study the situation, for example. Microsoft has tested a quantum-resistant variant of the encryption used to secure webpages. Google is even testing a post-quantum algorithm dubbed ‘New Hope’ in its Chrome Web browser,” a 1/30/17 MIT Technology article reported.

Microsoft has a whole group dedicated to the problem, and it submitted four proposals to NIST. In explaining the problem, the firm’s website states: “[W]e must do all this quickly because we don’t know when today’s classic cryptography will be broken. It’s difficult and time-consuming to pull and replace existing cryptography from production software. Add to all that the fact that someone could store existing encrypted data and unlock it in the future once they have a quantum computer, and our task becomes even more urgent.”

Just to recap: The encryption vulnerability will hit at an undetermined time, there is no current solution, and it affects data of grave importance. No problem.

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The Next Gen

September 26, 2018 (Wednesday)

Demography: Generation Z Coming of Age. Evaluating demographic cohorts can be helpful for predicting economic trends, as generational shifts in behavior have significant ripple effects throughout the economy. Melissa and I have given lots of attention to the Millennials over the past few years; now it’s time to turn our attention to Generation Z, an important group of up-and-coming labor force participants and consumers.

While the oldest Millennials are now around 37 years old, the oldest Gen Zers are around 21—thus on the verge of becoming productive adult participants in the US economy. Although the cutoff years defining Gen Z haven’t been firmly established, the rough timeframe that makes sense to us encompasses those born between 1997 and 2010, as discussed a 3/1 Pew Research Center article and a 3/29/17 Forbes article, respectively (Fig. 1).

While Gen Zers share some similarities with their older counterparts, Gen Zers are not mini-Millennials. Many Gen Zers were born into a post-9/11 world. Growing up in an atmosphere of terrorism and financial instability, Gen Zers are generally a risk-averse lot. Many were just young children during the Great Recession and watched their parents suffer financial hardships. Many witnessed the Millennials struggling to make it on their own.

These influences have played out to make Gen Zers more realistic, career-minded, and better prepared than the Millennials. Gen Zers are instinctively digital, while Millennials are merely tech savvy. Gen Zers are characterized as active volunteers, culturally blended, mature, makers, future focused, and hard workers. Millennials are characterized as “slacktivists” (who care, but don’t act), multi-cultural, immature, “sharers” (rather than makers), focused on the now, who want to be discovered. Those characteristics were compiled from multiple sources by advertising firm Sparks & Honey and presented in a comprehensive 2014 slideshow.

Gen Zers are often characterized as motived and self-directed. Their motto: “Good things come to those who act,” according to Ford’s 2015 Trend report. (Meet some Gen Z “doers” in this video by JWT Intelligence.) Since Gen Zers are still young, their impacts once they reach full independence are still unknown, but their ambitious aspirations suggest big change. I asked Melissa to further explore the emerging characteristics of Gen Zers and how they might influence various aspects of the US economy as they grow up. Here is her report:

(1) Gaining on the working population. As more and more Baby Boomers retire, senior management positions are starting to be filled by Millennials and Gen Zers are starting to step into entry-level positions. Ethnically, America’s Gen Zers are more diverse than any previous generation: 55% Caucasian, 24% Hispanic, 14% African American, and 4% Asian, cited a 10/20/17 Huffington Post article, according to Frank N. Magid.

(2) Ladder hoppers. We think that a few possible economic outcomes of Gen Zers’ influence could be higher labor force participation, higher wage growth, and faster job turnover. Born and raised when their parents were suffering financial losses, many Gen Zers are motivated by a quest for financial security. More than half of high-school students already feel pressured to gain early professional experience, observed Sparks & Honey.

Flexible work arrangements may be enticing for Millennials, but Gen Zers are more likely to respond to career advancement opportunities and money down the line, according to a 2014 study by Millennial Branding, a Gen Y-focused research firm. However, Gen Zers aren’t loyalists. Millennial Branding observes that when asked about the number of employers they expect to work for over their lives, Gen Zers and Millennials say four and five, respectively.

(3) Entrepreneurial at heart. Soon, the labor force may consist of an increasing number of self-employed individuals. Self-directed and resourceful, many Gen Zers have expressed the desire to start their own business one day. Specifically, 72% of high-school students say they want to do so, observed Sparks & Honey. The Millennial Branding study said that 17% of Gen Zers, vs 11% of Millennials, want to start a business and employ others. Ford estimates that Gen Zers are 55% more likely to do so than Millennials.

(4) Highly self-educated. Gen Zers are likely to be the most self-educated generation yet. However, they are acutely aware of the cost of a traditional college education and worried about accumulating student debt. Of Gen Zers, 64% are considering earning an advanced degree, vs 71% of Millennials, according to Ford. Some Gen Zers are expected to explore less expensive alternatives to traditional schooling, preferring online study and other lifestyle options. Some Gen Zers may pursue online degrees while working simultaneously right after high school.

Many Gen Zers are focused on constantly developing their skills. And they have unlimited access to lots of online learning tools. Sparks & Honey noted that 85% of Gen Zers have done research online. The Ford study observed that 52% of Gen Zers use YouTube or social media for typical research assignments. Thirteen-year-old Logan LaPlante’s 2013 TED talk titled “Hackschooling Makes Me Happy” explores nontraditional self-directed learning and has received nearly 10 million views on YouTube.

(5) Consumers of convenience. The jury is still out on whether Gen Zers will be quite as minimalistic as Millennials in their adulthood. Gen Zers already strongly influence household purchases, according to Sparks & Honey. According to an infographic by Deep Focus, 60% of Gen Zers would prefer a cool product over a cool experience vs just 23% of Millennials. They value ethically made and DIY products, per the 2017 JWT Intelligence video linked above.

As consumers, Gen Zers highly value convenience. They prefer not to carry around a lot of baggage, the Ford study indicated (having to carry a book bag heavy with text books when e-books exist is a particular pet peeve of one Gen Zer we know). Many may opt to pay for stuff on their mobile phones or wearable devices rather than carrying around bulky wallets. They also love to shop online, observed Sparks & Honey. Hardly remembering the days before Amazon Prime, Gen Zers want their products delivered fast.

(6) Heavy multi-tech users. “Digital natives,” Gen Zers are heavy tech users and influencers, having been raised on iPads and smartphones. Whereas Gen X began life with cable, the Millennials with dial-up Internet, younger Gen Zers can’t remember a time before 24/7 WiFi-connected HD devices. They learned to swipe before they could type. (See this real-life 2011 clip of a one-year-old disenchanted with a print magazine that won’t work like an iPad.)

As hyper-connected individuals, many Gen Zers view their technology as an extension of themselves. Indeed, a 2011 Time article reported that a majority of youth would rather lose their sense of smell than their technology, according to a study by McCann. Yet they seem to be as disassociated from their parents’ and grandparents’ technology as they are tied to their own. Several YRI team members with Gen Z kids complain that they typically tune out ringing landlines!

Nearly all Gen Zers in the US have a digital footprint, a trail of their personal data created either intentionally or unintentionally online, noted a 9/21/17 Forbes article. Gen Zers are great multi-taskers, their neurobiology having adapted to toggling among multiple screens at one time. On average, they use five different screens daily, according to Sparks & Honey.

(7) Communication matters. Technology is an essential component of Gen Zers’ relationships. Surprisingly, however, 53% of Gen Zers prefer person-to-person communication over digital communication, according to the Millennial Branding study. Maybe that’s because they’ve grown up on FaceTime, whereas the Millennials grew up typing back and forth over Instant Messenger. Gen Zers can connect face-to-face with anyone in their network at any time (except when forbidden by parents or schools, still run by Boomers and Millennials!), and many have large, global social media networks. Sparks & Honey notes that 26% of Gen Zers would need to fly to visit most of their social network friends.

(8) “Framily” values. With all that access, many Gen Zers may have trouble forming committed relationships. That may influence household composition in the future. Many Gen Zers may opt for alternatives to traditional relationships, having a different concept of family than the traditional nuclear family. Sprint recently unveiled its “framily” plan, which includes close friends in family networks; that term may come closer to describing Gen Zers’ familial attitudes than “family” in the nuclear sense. By the way, of US adults under age 35, 40% agree that changing your last name when you get married is old fashioned, observed Ford.

(9) Generation Alpha. Gen Zers are growing up fast. But look out! The budding Generation Alpha, now loosely defined as those born after 2010, is next. The aptly named Generation Z captures the last of those born in the 1900s. Generation Alpha will be the first generation wholly born in the 21st century. They are mostly the children of the Millennials, who started having kids around 30 years old, which is later in life than preceding generations did.

Just as Melissa, an older Millennial, was writing this piece, she got an early inkling of the forces that will shape the research piece on Generation Alpha I’ll be asking her to write in about 10 years: She was informed that her four-year-old daughter will be learning about coding, 3-D printing, and drones in her pre-K class!

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See You in 2020!

September 25, 2018 (Tuesday)

Strategy I: Something To Look Forward To! Now that pot stocks are smoking, could it be that the second-hand smoke is getting S&P 500 industry analysts high too? Joe and I just added weekly analysts’ consensus expectations for 2020 S&P 500 revenues and earnings to our various chart publications, which are updated automatically. We always do so during September for the year following the coming year. So until this week, we’ve focused only on weekly consensus expectations for 2018 and 2019. We continue to do so, but 2020 is now on our radar screen as well.

In our opinion, the stock market is forward looking and tends to discount analysts’ consensus expectations for revenues and earnings over the next 52 weeks. So in addition to tracking annual expectations, which are available (and change) weekly, we also calculate forward revenues and earnings, which are the time-weighted averages of the weekly data for the current year and the coming year.

At the end of this year, forward revenues and earnings will be identical to the respective consensus expectations for 2019. Then as 2019 progresses, 2020 expectations will get increasingly more weight. So without further ado, let’s see why the 2020 estimates suggest that industry analysts are smoking something that is making them very high:

(1) Revenues. Former Fed Chairman Ben Bernanke famously warned in June that Trump’s tax cuts at the end of last year and Congress’s big fiscal spending boost at the beginning of this year were big mistakes. “It’s going to hit the economy in a big way this year and next,” Bernanke said. “And then in 2020, Wile E. Coyote is going to go off the cliff and look down.” According to the 6/7 Bloomberg article on this subject:

“The Congressional Budget Office forecast in April that the stimulus would lift growth to 3.3 percent this year and 2.4 percent in 2019, compared with 2.6 percent in 2017. GDP growth slows to 1.8 percent in 2020 in the CBO projections. Fed officials predicted 2 percent growth in 2020 in their March median projection. The degree of slowdown as stimulus fades is a matter of debate among economists, with some predicting the effects could last beyond two years if the U.S. boosts its capital stock and upgrades its workforce during this period of strong growth. Congress could also write new spending laws to smooth out the program, Bernanke noted.”

Industry analysts didn’t get Bernanke’s fiscal-cliff memo. They are currently forecasting that S&P 500 revenues will increase 4.1% in 2020 following gains of 5.2% in 2019 and 8.4% this year (Fig. 1). Joe and I are predicting 8.5% this year, 4.0% next year, and 3.0% in 2020. We’ve observed that this year’s revenues performance has been unusually strong given that the economic expansion is no youngster. We attributed it to the ongoing rebound from the 2015 global growth recession. In addition, there has been a lot of fiscal stimulus this year, as Bernanke observed. Also, we are open to the possibility that business deregulation and the corporate tax cut are boosting economic growth, just as supply-siders had predicted.

(2) Earnings. Now let’s inhale industry analysts’ heady expectations for S&P 500 earnings for 2019 and 2020. They are currently forecasting $178.86 per share for next year, a 10.3% increase following this year’s 22.9% tax-rate-cut-supercharged boost. The predicted slowdown isn’t surprising since earnings growth should return to its trend. But trend growth has been around 5%-7%, not 10%. Oh, and in 2020, industry analysts are estimating $194.92 per share, a 9.0% increase and a fourth straight year of above-trend growth.

Are industry analysts all supply-siders now? That’s extremely unlikely. More likely is that they are displaying their long-established tendency to be overly optimistic about the prospects for their companies’ results well ahead of the release of those results.

Joe and I are high on life, but we aren’t as high as the industry analysts. We are predicting $173 per share next year, i.e., a 6.8% increase. Then for 2020, we are predicting $185 per share, a 6.9% increase. (See YRI S&P 500 Earnings Forecast.)

(3) Profit margin. The S&P 500 profit margin using Thomson Reuter’s operating earnings rose to a record high of 10.8% during Q4-2017. The cut in the corporate tax rate at the end of 2017 boosted the margin to a record high of 11.5% during Q2-2018. The analysts’ latest revenues and earnings projections imply that the profit margin will rise from 10.8% during 2017 to 11.9% this year. Then they see it going to 12.5% in 2019 and 13.2% in 2020!

Apparently, industry analysts didn’t get the memo about rising labor costs that could squeeze profit margins if competitive forces make it hard to raise prices. Then again, if the supply-siders are right, then productivity growth should make a comeback. In this scenario, inflation-adjusted wages can rise, fueled by productivity gains, without putting upward pressure on prices. That would be very bullish. It is a scenario that we think might be an alternative to Bernanke’s Wile E. Coyote outlook. Beep, Beep!

Strategy II: Safe To Go Global Already? It’s amazing how simple this business can be. When the US economy is outperforming the rest of the world, the dollar tends to be strong. Commodity prices tend to be weak. US stock prices tend to outperform foreign stocks, particularly those of emerging market economies. When the rest of the world is doing well relative to the US, the dollar tends to be weak, commodity prices tend to be strong, and emerging market stock prices tend to do very well.

Last week, the financial markets flipped from the former to the latter narrative. Why is a bit of a mystery. One possibility is that investors and traders around the world decided that perhaps Trump’s trade war was more of a skirmish than a war. JP Morgan CEO Jamie Dimon made that very point on September 20. Trump slapped a 10% tariff on $200 billion of US imports from China. That’s a $20 billion dollar hit that is a drop in the bucket, no matter whether the bucket is in China or the US.

Trump’s trade war and Fed Chairman Jay Powell’s gradual normalization of US monetary policy seem to have triggered an emerging market (EM) crisis this year with significant drops in the stock prices and currencies of numerous EMs (Fig. 2 and Fig. 3).

In recent meetings with some of our accounts, I heard some money managers opine that the current emerging market crisis didn’t seem as widespread and troublesome as previous episodes. In addition, they observed that forward P/Es in EM markets are downright cheap if the worst is over for those economies; in other words, there isn’t much more downside from here. Here is the forward P/E derby for the major MSCI stock price indexes through September 13: Emerging Markets (10.8), EMU (12.8), Japan (12.4), United Kingdom (12.3), and the United States (16.9) (Fig. 4). The EM valuation multiple has dropped from a 2018 high of 13.1 during January to 10.8 in mid-September. It’s true that this is well below the valuation multiple in US markets, but that’s the way it has been, more often than not, for a very long time (Fig. 5).

Notwithstanding the US stock market’s underperformance last week, Joe and I are inclined to stick with our Stay Home investment strategy rather than switch to the Go Global alternative (Fig. 6). That just means we continue to recommend overweighting the US. It doesn’t mean that there aren’t some attractive opportunities in overseas stock markets. For example, we are keen on Mexico and India for reasons deftly covered in recent months by Sandra Ward, our contributing editor (Fig. 7 and Fig. 8). However, last week’s EM rebound was led by China’s MSCI stock price index (Fig. 9). China, of course, remains at the epicenter of Trump’s trade war, while Mexico has dodged his bullets.

By the way, since the start of the current bull market, here is the performance derby of the major MSCI stock market indexes in dollars: United States (332.3%), Japan (116.8), Emerging Markets (116.7), EMU (110.1), and the United Kingdom (97.1) (Fig. 10). Here it is in local currencies: the United States (332.3%), Japan (146.7), Emerging Markets (132.7), EMU (125.9), and the United Kingdom (107.1) (Fig. 11).

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Bear Tracks

September 24, 2018 (Monday)

Strategy I: Bear Traps for Stocks. In the past, the worst time to buy stocks typically has been when the unemployment rate was making a cyclical low (Fig. 1). Needless to say, initial unemployment claims was doing the same at the same time—and screaming “Get out! Get out!” (Fig. 2). Buying stocks when the yield curve was flat and on the verge on inverting has also been a bad idea (Fig. 3). Buying stocks when the Fed is raising interest rates can work okay for a while, until higher rates trigger a financial crisis, which often turns into a credit crunch and a recession (Fig. 4 and Fig. 5). Rising bond yields aren’t always bad for stocks, until they are (Fig. 6). Those times late in an expansion when the profit margin exceeds its mean tend to set it up for a bruising reversion to the mean and even below, which is bad for profits and bad for stocks (Fig. 7). As for buying stocks when valuations are extremely high, anyone could tell you “fuhgeddaboudit!” (Fig. 8).

All of the above bear traps may be set to snare the current bull market. A 9/10 Bloomberg article was titled “Goldman Bear-Market Risk Indicator at Highest Since 1969: Chart.” The Goldman indicator neatly converts all of the major bear traps into one series:

“A Goldman Sachs Group Inc. indicator designed to provide a ‘reasonable signal for future bear-market risk’ has risen to the highest in almost 50 years. The firm’s Bull/Bear Index, which is based on measures of equity valuation, growth momentum, unemployment, inflation and the yield curve, is now at levels last seen in 1969. While the gauge is at levels that have historically preceded a bear market …”

So why does the stock market bull continue to charge ahead? On Friday, the S&P 500 closed a whisker below its record high of 2930.75, hit on Thursday—rapidly approaching our 3100 target for this year (Fig. 9). It is up 9.6% ytd. It has recovered smartly from the nasty 13-day correction earlier this year with a gain of 13.5% since the year’s low on February 8 (Fig. 10). During the current bull market, Joe and I count five corrections (exceeding 10%), one near correction (that rounds up to 10%), and a total of 61 “panic attacks” that were followed by relief rallies.

The latest relief rally reflects mounting confidence that Trump’s trade war won’t escalate into one that depresses the economy and corporate earnings, which continue to soar. In addition, there is less fear lately that the Fed’s policy normalization will trip up the bull market. Earlier this year, there was fear that a 10-year US Treasury bond yield above 3.00% would be bearish for stocks. It recently rose back slightly above that level, yet it was widely deemed to be bullish for financial stocks. Go figure!

So what will it take to snare the bull in the bear traps? It will take a recession. That’s all there is to it. While Goldman and everyone else is on the lookout for this event, both the Index of Leading Economic Indicators (LEI) and the Index of Coincident Economic Indicators (CEI) rose to new record highs during August, as Debbie discusses below (Fig. 11). The LEI did so even though the yield curve spread, which is only one of this index’s 10 components, has been narrowing fairly steadily since 2013, but remains positive. It only subtracts from the LEI when it is negative. So it is still contributing positively to the LEI, though to a lesser extent. History shows that the CEI, which is a good monthly proxy for quarterly real GDP, falls when a financial crisis occurs, triggering a credit crunch and a recession. There’s no sign that scenario is about to play out again anytime soon.

We have argued that there was a growth recession during 2015 caused by the collapse in commodity prices. Credit quality yield spreads widened dramatically, especially in the junk bond market. Yet here we are at a record high in the S&P 500. Arguably, there has been an emerging markets crisis this year, yet here we are at a record high in the S&P 500.

Strategy II: Bear Traps for Bonds. Perhaps this will all end badly when the 10-year US Treasury bond yield soars from 3.00% to 4.00% or higher. There is absolutely no reason to like bonds when the 10-year Treasury yield is hovering around 3.00%. Actually, there is one good reason. But before we go there, let’s list all the reasons why bond yields “should” be moving higher:

(1) Bond Vigilantes Model says so. There has been a good (not great) correlation between the y/y growth rate in nominal GDP and the 10-year Treasury bond yield (Fig. 12). We’ve used this simple model since the early 1980s to explain why the two have often diverged rather than converged, as they eventually tend to do. However, “eventually” can be a long time. In any event, nominal GDP rose 5.4% y/y during Q2. This could be a good time for the bond yield to converge with this growth rate. (To keep track of this relationship for the US, UK, Germany, France, and Japan, see our Bond Vigilantes Model.)

(2) Inflationary pressures may be mounting. Perhaps the biggest bear trap for bonds, and therefore for stocks, is a significant rebound in price inflation. Wage inflation is finally showing some signs of picking up as the labor market continues to tighten. However, as we have observed many times before, technological innovation, global competition, and aging demographic factors are keeping a lid on both wage and price inflation. Even if wage inflation continues to move higher, it might not be passed through into price inflation if companies absorb the costs by lowering their profit margins. More likely, in our view, is that companies will finally boost their productivity, allowing them to increase labor costs without raising prices.

(3) The Fed is tightening and tapering. Fed Chairman Jay Powell has clearly communicated to financial market participants that the FOMC will continue to gradually normalize monetary policy by raising the federal funds rate to 3.00% by the end of next year while tapering the Fed’s holdings of Treasury and mortgage-related securities. The two-year Treasury note yield reflects expectations for the federal funds rate a year from now (Fig. 13). It rose to 2.81% at the end of last week. As of October this year, the pace of tapering will increase from $40 billion to $50 billion per month, with Treasuries pared by $30 billion per month and mortgage securities holdings cut by $20 billion per month through 2024 (Fig. 14).

(4) The federal deficit is out of control. The Fed is cutting back on its holdings of Treasury securities at an annual rate of $360 billion just as the federal deficit is on course to average around $1.0 trillion per year over the next 10 years (Fig. 15).

(5) Pensions funds have stopped buying. An 8/21 CNBC article observed: “But now that it’s getting into September, many pension funds, after diving in big time, may be ready to get out of the pool temporarily—or at least slow fixed income investments as summer moves into fall. That’s because when the tax law changed last year, many companies were given until mid-September to deduct their pension contributions at last year’s tax rate instead of the new 21 percent rate.”

(6) The Chinese have stopped buying. Last week on Tuesday, US government bond yields rose to 3.06% on news that Chinese investors had been net sellers of US Treasuries during July. The trade war might be turning ugly for the US if foreigners retaliate by reducing their holdings of US Treasuries. In fact, US Treasury data show that foreign holdings rose $39.9 billion during July. China was the biggest holder, with $1,171.0 billion in US Treasuries, down just $7.7 billion for the month.

(7) The bottom line. So why aren’t we there yet, i.e., closer to 4.00%? The most obvious answer is the one we have been coming up with all year: The US 10-year government bond yield has been tethered to the comparable yields in Japan and Germany, which are around 0.00% (Fig. 16). Last week, Melissa and I reviewed the latest policy positions of the ECB and BOJ, and neither central bank seems intent on raising their slightly negative official interest rates anytime soon.

Movie: “White Boy Rick” (+ +) (link) is based on a true story about a teen growing up in a very rough neighborhood in Detroit during the 1980s. It stars the talented Matthew McConaughey as the father of Richard Wershe, Jr., who is played well by Richie Merritt. Richard became an undercover informant for the FBI and was encouraged by the agency to get involved in the local narcotics trade. Yet he was ultimately arrested for drug trafficking and sentenced to life in prison. He’d thought he had a deal with the FBI, but he was wrong. The moral of the story: When you cut a deal with the FBI, get it in writing.

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Rotating Tech & Flying Taxis

September 20, 2018 (Thursday)

Tech I: Rotating Sectors. While the S&P 500 has recently been hitting new highs, the performance of its underlying sectors has changed radically in the past three months (Fig. 1). The market’s growthiest sector, Technology, has gotten trounced by some of the market’s most defensive sectors.

The S&P 500 Utilities, Health Care, and Telecom sectors have outperformed the Tech sector by more than six percentage points since June 14. Here’s the performance derby through Tuesday for the S&P 500 sectors’ stock price indexes: Utilities (9.7%), Health Care (9.5), Telecom Services (9.2), Consumer Staples (7.0), Real Estate (5.5), Industrials (5.5), S&P 500 (4.4), Consumer Discretionary (4.2), Tech (2.7), Financials (2.4), Materials (-1.0), and Energy (-1.6) Table 1

The market’s defensive turn continued during September with the Tech sector straggling  behind the other 10 S&P 500 sectors. Here’s September’s derby for the S&P 500 sectors’ stock price indexes: Industrials (3.5), Telecom Services (3.1), Consumer Staples (1.5), Utilities (1.5), Health Care (0.9), Energy (0.5), Materials (0.3), S&P 500 (0.1), Consumer Discretionary (-0.1), Financials (-0.4), Real Estate (-1.2), and Tech (-1.9) (Fig. 2).

The Tech sector’s impressive earnings growth this year hasn’t been enough to offset concerns about the threat of government regulation, tariffs, and slowing growth among some of Tech’s largest industries, particularly the S&P 500 Internet Software & Services industry and the Semiconductor Equipment industry. Let’s take a deeper look into the S&P’s largest sector, which represents 26.2% of the S&P 500’s market capitalization and kicks in 23.5% of its earnings (Fig. 3).

(1) Washington’s punching bag. Several high-profile tech stocks have been wilting under the hot glare of Washington’s politicians. And unfortunately, there’s little indication that they’ll be allowed off the hot seat any time soon. Facebook, Twitter, and Google were all asked to appear before Congressional committee hearings earlier this month. The first two showed up.

Facebook shares are down 9.2% ytd and down 26.3% from its July 25 peak through Tuesday’s close. The stock plunged 19.0% on July 26, after Facebook reported disappointing Q2 earnings, in which the company warned sales growth would slow and spending would rise to enhance users’ security and privacy.

Twitter is actually up 21.7% ytd, but it too is down from July 25 by 33.9%. Perhaps, Google made the right decision by not showing up for a congressional grilling; its shares are up 10.8% ytd, but down only 9.2% from July 25. With Facebook under pressure, the S&P 500 Internet Software & Services stock price index has fallen 7.7% since June 14.

Analysts have been cutting their forecasts for Facebook’s earnings. This week JP Morgan’s analyst reduced his 2019 earnings target to $7.40 a share from $7.89. Facebook’s “investments in 2019 could be larger than anticipated in consensus estimates. We expect the narrative of heavy investment spending to continue at 3Q earnings,” the JP Morgan analyst wrote, according to a 9/18 CNBC article. “Safety and security, around which FB will add 20k+ heads this year, will fall across multiple opex lines, but comes with little/no immediate revenue return.”

That said analysts continue to call for the S&P Internet Software & Services industry to grow earnings by 20.4% this year and 18.5% in 2019. That’s down from the 2019 22.5% earnings growth that was expected during June 2017, but it’s not exactly shabby either (Fig. 4).

(2) Semi equipment hurting. Among the worst performing industries in the entire S&P 500 since June 14 is the Semiconductor Equipment industry, down 17.0% (Fig. 5). A decline in capital spending on equipment by semi chip makers has hurt the semi equipment companies.

“In mid-July, [Taiwan Semiconductor Manufacturing] lowered its projected capital expenditures by 13%. Samsung hasn’t formally changed its projected capex yet for this year, though several analysts have reported the company delaying equipment orders as it adjusts its manufacturing operations. Samsung and TSMC combined accounted for about 46% of the chip industry’s total capital spending last year, according to estimates from Wes Twigg of KeyBanc Capital Markets,” a 8/18 WSJ article reported.

So far, sales of semiconductors continue to increase, implying the drop in equipment sales may be short lived if the US/Chinese trade war is not protracted. Global sales of semis hit $39.5 billion in July, based on the three-month average, up 17.4% y/y and up 0.4% m/m, according to the Semiconductor Industry Association (Fig. 6).

Analysts aren’t optimistic. The S&P 500 Semiconductor Equipment industry is expected to see revenues swing from a 24.3% increase this year to a 0.8% decline in 2019 (Fig. 7). Likewise, earnings, which are forecast to grow 48.5% this year, are targeted to drop 3.0% next year (Fig. 8). And analysts have been reducing their forecasts over the past two months through August after increasing them every month since January 2016 (Fig. 9).

(3) Lots of margin to lose. Looking into 2019, Tech earnings look attractive in isolation and relative to other industries in the S&P 500. Here’s the earnings growth analysts are forecasting for the S&P 500 sectors next year: Energy (26.0%), Industrials (12.4), Consumer Discretionary (12.0), Tech (11.0), S&P 500 (10.3), Financials (9.6), Health Care (8.1), Materials (7.6), Consumer Staples (5.9), Utilities (4.7), Telecom Services (3.3), and Real Estate (0.0).

Investors should keep an eye on Tech operating margins, which are extraordinarily high relative to the sector’s history and relative to the margins of other sectors. Tech’s record high forward profit margin of 23.0% has climbed sharply since hitting a recession low of 11.7% in February 2009, and it’s well above the pre-recession high of 13.9% in August 2008  (Fig. 10).

Here’s how forecasts for the S&P 500 Tech sector’s 2019 operating profit margins stack up relative to other S&P 500 sectors: Tech (23.0%), Financials (19.3), Real Estate (16.0), Telecom Services (14.0), Utilities (12.7), S&P 500 (12.5), Materials (11.5), Health Care (10.8), Industrials (10.5), Consumer Discretionary (8.2), Energy (7.9), and Consumer Staples (7.6).

Tech II: ChaChaChaChanges. This may be the last time we pen a piece on the “old” S&P 500 Technology sector because on September 21 it’s changing radically. Facebook, Alphabet, Twitter, Activision Blizzard, Electronic Arts, and Take-Two Interactive are expected to be plucked from the Tech sector and inserted into a new S&P 500 Communication Services sector. In addition, eBay will move from Tech to the Consumer Discretionary sector.

That means companies representing roughly 21% of the current S&P 500 Technology sector’s market cap are being shifted into the new Communication sector, according to calculations by State Street Global Advisors. The firm put out a detailed report on what these changes will mean for investors. Here are some of the highlights:

(1) Consumer Discretionary changing too. The Consumer Discretionary sector will also be undergoing major surgery. About 22% of the current sector’s market weight will be shifted into the Communication sector. The companies being transferred are expected to include: Omnicom Group, Interpublic Group, CBS, Discovery Communications, Comcast, Charter Communications, Dish Network, Walt Disney, Twenty-First Century Fox, Viacom, News Corp., Netflix, and TripAdvisor. The Communication sector will also absorb the Telecom Services sector.

(2) The new sector’s stats. When all the shuffling is complete, the new Communication Services sector will owe 27% of its market cap to companies that were formerly in the Consumer Discretionary sector, 54% of its market cap to names that were formerly in the Tech sector and 19% of its market cap to the Telecom Services sector.

The new Communication Services sector will represent about 10% of the S&P 500’s market cap, replacing the Telecom Services sector which only represented 2% of the S&P 500’s market cap. The new Communication sector will also be more global, with 35% of its revenues coming from overseas, versus the Telecom Services sector, which has 3% of revenues from overseas.

(3) More growth, less value. Because of its constituents, the new Communication Services sector will be far more “growthy” than the old Telecom Services sector, which includes high-dividend payers AT&T and Verizon. State Street calculates that 61% of the new Communication Services sector will be composed of growth stocks, compared to the current Telecom Services sector, which holds 100% value stocks.

This new, growthy Communication Services sector has historically produced above-market revenue and earnings growth. The new sector would have generated 19.8% revenue growth over the past three years and 26.0% earning per share growth over the same period, compared to the S&P 500’s 6.1% and 11.3% growth. The new Communication Services sector is expected to have a P/E of 15.7, based on data from July 31, far higher than the Telecom Services 6.6 P/E.

As a result, Communication Services won’t be the bond proxy the Telecom Services sector has been considered. State Street believes the new sector will be more sensitive to the equity market than the bond market, which isn’t surprising given the dividend yield of Communication Services is under 2%, while the dividend yield was more than 5% for the Telecom Services sector. The new sector is also expected to be more cyclical than the historically defensive Telecom Sector.

Tech III: Up, Up and Away. Last week during his Potcast, Elon Musk spoke about solving city congestion by either building underground tunnels or inventing flying cars. He has concluded that flying cars aren’t viable because they are too noisy and create too much air flow, we reported in last Thursday’s Morning Briefing.

Don’t tell that to the numerous companies working to develop flying cars, which often look like mini-helicopters. Here’s a peek at what the believers are working on.

(1) Uber on the job. Uber is well aware that the noise levels of flying taxis need to be reduced. The company is working with the University of Texas to address the problem and make its flying taxis one half as loud as a medium-sized truck passing a house. “In order to make that happen, researchers plan to design stacked rotors that travel in the same direction, an evolving concept that they say would decrease noise,” according to an 8/9 article in The Austin American Statesman.

The firm, which aims to begin demonstration flights in 2020 and start commercial flights in 2023, has chosen Dallas, Los Angeles, and Dubai as its launching cities.

“Uber has said it is looking for partners that can meet its technology specifications — electric-powered, minimal noise, and vertical take-off and landing capabilities — as well as a company that can scale production to build tens of thousands of vehicles to meet the demand of Uber’s on-demand service,” noted a 5/8 article in The Verge. The company was working with established companies Embraer and Bell Helicopter, along with new comers Aurora Flight Sciences, which was purchased by Boeing last year, Karem, and Pipistrel Vertical solutions.

(2) Japan’s flying car project. Japan hopes that it will have a flying car that can light the torch at the 2020 Tokyo Olympics. “Major carrier All Nippon Airways, electronics company NEC Corp. and more than a dozen other companies and academic experts hope to have a road map for the plan ready by the year’s end,” according to a 9/18 CBS News report.

The Asia Times brought up a number of obstacles the country will have to surmount, in an 8/30 article. Japan is only spending $40 million on the effort. It will have to open its wallet much wider if it is serious. There are also the regulatory problems that flying cars will face in any city; everything from safety, insurance, liability, zoning, and training requirements, just to throw out a few roadblocks.

(3) Many contenders. There are many companies and innovators trying to turn flying cars into a reality. Digital Trends highlighted six flying cars in an 8/19 article. Some consider themselves VTOLs, or vertical take-off and landing aircraft. Opener Blackfly has a single seat, electric VTOL that can travel 25 miles on a charge at a top speed of 62 miles per hour.

Passenger Drone is developing a self-driving, 16-rotor drone a human can ride in. “The machine will be controlled by a touchscreen, and promises to take off with just one button. Users can then draw their route on a map, and have the drone fly them there, using a range of smart autonomous technologies to do so without accidentally running into anything on the way,” the article explains.

Aston Martin is in the game with Volante Vision, a hybrid-electric flying car, which can takeoff and land vertically. It holds three passengers. While Lilium Aviation has a VTOL jet, which it hopes will carry either two or five people. The five-seater should fly for 60 minutes on a single charge.

Perhaps the most mind-blowing idea comes from British inventor Richard Browning, who’s developing Gravity Industries’ flying exosuit. It’s a jet suit that has five engines and retails for $446,000. The company expects the price will come down and an electric version will be available. If you want your jaw to drop, check out the video at the end of the article. Hello Iron Man.

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Remarkable Revenues

September 19, 2018 (Wednesday)

Strategy: Slicing & Dicing. Joe and I have been very impressed with the strength of S&P 500 revenues this year. They’ve been strong despite the escalating trade war and the proliferating emerging markets crisis. The dollar has also been strong this year, which should have weighed on the dollar value of revenues earned abroad. We decided to slice and dice the data to determine if there is something funky going on.

The bottom line is that the top line is all good: Revenues are strong across the board. This suggests that US corporate managements are doing a remarkably good job of bolstering their worldwide sales despite the challenging global environment. It may also be, dare we say, that Trump’s policies of deregulation and tax cuts are working to stimulate the US economy, just as supply-siders predicted. Deregulation may be opening up more business opportunities. The 20% corporate tax rate makes America a great place to do business. Let’s slice and dice the revenues data:

(1) Business sales. Each month, along with retail sales, the government releases data on manufacturing shipments, wholesale sales, and retail sales. These business sales include only goods that are either sold at home, exported, or added to inventories. There are no monthly data series for services.

Nevertheless, the growth rate of business sales on a y/y basis is remarkably well correlated with the comparable growth rate of S&P 500 aggregate revenues, which includes sales of goods and services (Fig. 1). The former was up 8.1% during July, while the latter was up 9.1% during Q2. Both are very solid readings. It’s been a nice recovery for both since 2015 when these growth rates were negative as a result of the worldwide growth recession. That event was attributable to the retrenchment in the commodity industry, when oil and other commodity prices plunged.

The latest data show that all three components of business sales are at record highs: manufacturing ($6.02 trillion, saar), wholesale ($6.07 trillion), and retail ($5.37 trillion) (Fig. 2). Their latest respective growth rates are 8.1%, 9.8%, and 6.2% y/y (Fig. 3).

(2) Forward revenues. In addition to monitoring the monthly business sales data, Joe and I track the close relationship between quarterly S&P 500 revenues per share and weekly S&P 500 forward revenues per share (Fig. 4). The latter tends to be a coincident indicator of the former. S&P 500 forward revenues per share has been rising to record highs this year through the 9/6 week. This augurs well for the quarterly data series, suggesting that it will also be at a new record high during Q3.

The y/y growth rates of the quarterly and weekly series are very close (Fig. 5). The weekly series is up 9.7% y/y. So the prospects for revenues growth and earnings growth remain very good (Fig. 6). S&P 500 forward earnings (a leading indicator for actual earnings) has been boosted this year not only by the tax cut, but also by the solid upward trend in revenues.

(3) Sectors. Following the end of the Q2 earnings season, we showed that revenues are strong in most of the 11 S&P 500 sectors (Fig. 7). Here is the y/y performance derby for the revenues per share of these sectors: Energy (33.6%), Materials (17.8), Health Care (15.4), Tech (14.9), S&P 500 (10.4), Industrials (9.7), Financials (9.3), Consumer Discretionary (8.5), Real Estate (6.1), Consumer Staples (-1.6), Utilities (-3.0), and Telecom Services (-6.4).

S&P 500  forward revenues are at record highs for the following sectors: Consumer Discretionary, Health Care, Industrials, and Tech (Fig. 8). With the exception of Telecom Services and Utilities, all of the sectors have solid uptrends.

Here are analysts’ consensus expectations for revenues growth this year and next year for the 11 sectors: Consumer Discretionary (7.4%, 5.9%), Consumer Staples (4.4, 3.5), Energy (20.8, 4.9), Financials (4.6, 4.7), Health Care (6.1, 5.2), Industrials (8.2, 5.2), Tech (12.5, 7.6), Materials (11.2, 2.5), Real Estate (12.1, 4.6), Telecom (7.4, 4.1), and Utilities (1.4, 2.1).

(4) The dollar & exports. Interestingly, there is also a very strong correlation between the growth rate in S&P 500 aggregate revenues and the OECD leading economic indicator (Fig. 9). Over the past couple of years, the former has been much stronger than the latter. This suggests that the US economy is outperforming the rest of the world. More ominously, it might also suggest that the US won’t decouple for much longer from the rest of the world, in which case revenues growth will weaken.

There is also a good correlation between the y/y growth rates of S&P 500 aggregate revenues and US merchandise exports (Fig. 10). So far, the escalating trade war hasn’t depressed US exports, which were up 9.6% y/y during July.

The trade-weighted dollar jumped sharply since February on mounting concerns about Trump’s escalating trade war (Fig. 11). There is a weak correlation between the y/y growth rate in S&P 500 revenues per share and the inverted percentage change in the trade-weighted dollar (Fig. 12). It is especially weak now given that the dollar is up 5.3% y/y, while S&P 500 revenues per share is up 10.3% y/y.

Central Banks I: ECB’s Contradictions. Last week, the European Central Bank (ECB) slightly lowered its economic growth forecasts for the Eurozone in 2018 and 2019, mainly due to weaker foreign demand. As previously forecast, the region’s CPI inflation rate is expected to be 1.7% in 2018, 2019, and 2020, which is below the ECB’s 2.0% medium-term target. The headline rate was 2.0% during August, but the core was only 1.0% (Fig. 13).

One would think that this would put into question the bank’s previous plan to phase-out monetary easing by stopping its bond purchases. But the bank reaffirmed its commitment to doing so at its September 13 meeting. However, at his post-meeting press conference, ECB President Mario Draghi reiterated a previous commitment to keep the ECB’s key interest rates “at their present levels at least through the summer of 2019, and in any case for as long as necessary” to ensure that the bank’s inflation goal is achieved. Let’s consider the ambiguous reasoning for these apparent contradictions:

(1) Bye buy bonds. The ECB said in a September statement that it still plans to terminate its bond purchase program by yearend as initially promised in June. Since the program started, bond purchases have totaled approximately €2.5 trillion. The ECB committed to purchase an additional €30 billion in bonds this month and €15 billion per month until the end of the year when purchases will end. Melissa and I tend to agree with analysts who have suggested that the end of the bond-buying program probably has more to do with the ECB’s inability to sustain it rather than the bank’s desire to substantially pullback on easing.

(2) Deposit rates to stay negative for now. To that point, at his latest press conference, Draghi said: “When we stop [purchasing bonds], this doesn’t mean our monetary policy stops being” accommodative. He added: “The amount of accommodation will remain very significant, through our reinvestment policy and through our forward guidance and interest rates.” Further, the ECB President indicated concern over risks to the outlook from US protectionism and potential spillover from emerging market vulnerabilities. The interest rates on the main refinancing operations, the marginal lending facility, and the deposit facility are presently held at 0.00%, 0.25% and -0.40%, respectively.

(3) 2019 policy TBD. Equally as unclear is where ECB monetary policy is headed next. Draghi was asked at his press conference how the ECB would respond to slowing growth or inflation. Draghi gave a non-answer: “I’m pretty sure there will be a time when we will have to discuss these questions, but it’s premature.”

In his opening remarks, Draghi provided little detail on the reinvestment of maturing bonds, saying it will continue “for an extended period of time after the end of our net asset purchases, and in any case for as long as necessary.” To a question on how the bank might handle reinvesting proceeds from maturing bonds next year, Draghi replied: “Frankly, … we haven’t even discussed when we are going to discuss it.” Having said that, there are only two more meetings left this year, he noted. So it will probably be discussed before December.

Central Banks II: BOJ’s Contradictions. The Governing Board of the Bank of Japan (BOJ) also made seemingly contradictory policy adjustments at its July meeting. Essentially, these adjustments gave BOJ Governor Kuroda more wiggle room on policy without having to make any further announcements. Japan’s economy has chugged along. But despite the BOJ’s unconventional easing, Kuroda hasn’t been able to lift inflation much above zero since he took office in March 2013 (Fig. 14). Soon after taking office, the Governor set an inflation target of 2.0% in two years, but later removed the time-frame for the target.

As it stands now, the BOJ is expected to leave monetary policy unchanged from July at its September meeting, held yesterday and today. Bankers are presumed to be wary of a sales-tax increase, which is set to hit Japan’s economy in October 2019. Further adjustment is not expected until after that point. For now, let’s review the background leading up to the latest meeting:

(1) Key easing elements unchanged. The key components of the BOJ’s monetary policy include: maintaining a negative interest rate on commercial bank deposits, conducting yield curve control (YCC) by targeting a zero-yield on 10-year Japanese government bonds (JGBs), and annually purchasing about 80 trillion yen in JGBs. So far this year, the BOJ has been tracking below its target level of purchases on an annualized basis.

(2) Confusing adjustments in July. Contradictory tweaks were made at the bank’s July 30-31 policy meeting, confounding markets. On the one hand, the post-meeting statement was softened with the introduction of forward guidance for policy rates. In the statement, a line was added saying that “the current extremely low levels of short- and long-term interest rates” would continue for an “extended period,” taking into account the timing of the scheduled tax hike.

On the other hand, the bank pulled back on YCC. Kuroda said in a post-meeting briefing that he would keep the key deposit rate unconventionally low, but also allow the 10-year yield on JGBs to rise up to 0.2% or as low as low as -0.2% (from 0.1% previously), according to Reuters. That upper limit potentially enables the BOJ to buy fewer bonds than it needed to before to maintain the 10-year yield target.

(3) Stealth tightening or still easy? Some investors interpreted the BOJ’s adjustments as a “stealth tightening” while others focused on the “extended period” language as further easing. We tend to be in the stealth camp. Bankers are probably wary of being out of policy options if Japan’s economy takes a turn for the worse, especially after the sales-tax increase. So, they probably feel inclined to take at least a little ease out of policy to save it for a rainy day. Like the ECB, the BOJ may also be facing some sustainability issues with the level of its purchases.

We agree with ex-BOJ official Takashi Kozu who was quoted in a 9/9 Bloomberg article saying: “The BOJ has reached a limit to the ambiguous rhetoric used in July, which can’t be repeated anymore. The next move will have to be explained based on fundamentals.”

Ideally, Kuroda and the BOJ will start to make more sense after the BOJ statement in the wake of today’s meeting. But that might be wishful thinking.

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Debt Roundup

September 18, 2018 (Tuesday)

Debt: Lots of It. As we observed yesterday, worrying about record amounts of debt is making a comeback. The calamity in the debt markets during 2007 and 2008 was the epicenter of the financial crisis that occurred back then. There was lots of talk about “deleveraging,” which didn’t play out as its proponents expected. The major central banks responded to the crisis with zero interest rates and QE bond purchasing programs. Ultra-easy monetary policies allowed borrowers to refinance their debts and to borrow more. Among the most profligate borrowers have been governments around the world. So their debts continue to rise to record highs.

That didn’t matter as long as the Fed, the ECB, and BOJ were ballooning their balance sheets with lots of government bonds (Fig. 1). However, the Fed stopped doing so during October 2014, and started to taper its holdings last October (Fig. 2). The ECB is planning on halting its QE program by the end of this year. The BOJ has yet to announce similar plans to discontinue its QE program.

The answer to the question “Does debt matter?” was generally “No” since the start of the current bull market, with the obvious exception of Greek debt a few years ago, and Italian debt in recent months. It may matter if inflation makes a comeback, which we don’t expect. We still aren’t convinced that a supply/demand analysis of the debt markets has much usefulness in forecasting inflation and interest rates.

However, we are on alert given that more debt with less QE might push rates higher than we expect and pose more of a problem for stocks. Yesterday, we discussed the US debt outlook and focused on the surge in interest paid by the US government. We have a few more thoughts on this today and want to address the issue of Chinese debt. Consider the following:

(1) US government interest expense soaring. Since the Fed started raising the federal funds rate again at the end of 2015, net interest paid by the US government soared from $225.5 billion during the 12-months through December 2015 to a record high of $320.3 billion over the 12-months through August (Fig. 3). Over this same period, publicly-held US Treasuries jumped by $2.1 trillion to a record $15.8 trillion (Fig. 4).

We can use these two series to calculate the effective interest rate paid by the federal government (Fig. 5). We reckon it rose in August to 2.1%, up from 1.8% a year ago and the highest since August 2012. Keep in mind that the average maturity of the government’s debt is around 70 months (Fig. 6). So the effective interest rate will move higher as maturing securities have to be refinanced at higher actual rates.

If the Fed succeeds in gradually normalizing monetary policy so that the federal funds rate rises to 3.00% by the end of next year, the current amount of debt outstanding would push the government’s interest expense to over $500 billion annually by 2020 (Fig. 7).

(2) Chinese bank loans swelling. Chinese bank loans soared to a record high of 132 trillion yuan during August (Fig. 8). They’ve doubled since April 2013, tripled since May 2010, and quadrupled since February 2009. In US dollars, Chinese bank loans totaled $19.3 trillion during August, more than twice as much as US bank loans (Fig. 9). Over the past 12 months through August, Chinese bank loans are up $2.3 trillion (Fig. 10).

Trade: Braking China? China has clearly relied on lots of debt to finance its growth. The question is whether China may be getting less bang per yuan from all this debt. Another, more immediate concern is whether Trump’s escalating trade war with China might depress Chinese growth and trigger a credit crisis? That worry seems to explain the awful performance of China’s major stock indexes since the start of this year.

Here is the ytd performance derby through Monday’s close of these Chinese indexes in yuan: Shanghai Shenzhen CSI 300 (-20.5%), Shanghai A-Share Stock Price (-19.8), China MSCI (-12.5), Hang Seng China Enterprises (-10.7), and Hong Kong Hang Seng (-10.0) (Fig. 11). Investors are likely anticipating that Chinese officials are running out of room to pump up economic growth, especially in the face of looming incremental tariffs from the US.

Disclosing the details of its latest Five-Year Plan during 2015, the Chinese government pledged to increase consumer spending to grow the economy. At this point, this pledge seems to be losing out to China’s aging population and declining fertility rates despite the government having replaced the one-child per family limit with a two-child limit during 2015.

China’s government more recently has discussed completely eliminating the limit on the number of children in a family, reported an 8/27 Bloomberg article. But that may come too late to restore economic growth anytime soon. The revised family planning guidance probably won’t become effective until 2020. In the meantime, consider the following economic data:

(1) Industrial production & real GDP. So far, there isn’t much evidence that Trump’s trade war is depressing Chinese industrial production growth. Since 2015, it has hovered around 6.0% y/y. It was 6.1% during August (Fig. 12). Naturally, there is a good correlation between China’s industrial production and real GDP. This suggests that real GDP growth is also continuing to hover around 6.5%, as it has since 2015.

(2) Real retail sales. The problem is that inflation-adjusted retail sales growth has been trending lower in recent years, and seems to have weakened more rapidly over the past year (Fig. 13). It was 6.7% y/y during August versus 8.3% a year ago. Aging demographics may be starting to weigh on Chinese consumer spending. So the government’s goal of replacing export-led growth with consumer-led growth may be tough to achieve.

(3) Industrial production & bank loans. China has been getting less output bang per yuan of bank credit according to the ratio of industrial production to bank loans outstanding in yuan. Since early 2008, the ratio has been on a steep downward trajectory to a record low last month (Fig. 14).

We conclude that China’s economy may be more vulnerable to Trump’s trade war than widely recognized. If so, then the Chinese may work out a deal with Trump sooner than expected.

US Beige Book: Green, Yellow, and Red Signals. Business contacts surveyed by the 12 Federal Reserve Bank districts are mostly positive about the US economy. That’s according to The Beige Book released on 9/12. This report collected anecdotal information about business activity on or before August 31, 2018.

While most contacts were optimistic about business activity, there was widespread concern about labor shortages constraining growth. Additionally, price pressures were noted as building, especially because of the trade dispute between the US and China and US labor shortages. Some firms are starting to pass input price increases along by increasing the price of their goods sold. However, there were some indications of a limit to the degree that higher input prices, especially labor costs, can be passed on without harming business activity.

The Beige Book is organized by Federal Reserve Districts. I asked Melissa to select excerpts from it and to reorganize them into macro categories: economic activity, employment and wages, prices, and tariffs (See Tables 1 to 4 here.) Here are a few key observations based on this exercise:

(1) Green signals. Most industry contacts within the 12 Fed Districts reported moderate to accelerating growth in economic activity. Retail demand generally improved with retailers expecting “continued positive momentum” for the remainder of the year. Manufacturers mostly indicated that activity continued to expand at a “brisk” pace. Some attributed increased demand to “a strong overall economy and pro-growth fiscal policy.” On balance, residential and commercial real estate markets showed solid sales activity.

Service sector firms largely reported moderate growth in activity. Competition for small business customers in banking and finance was noted as particularly strong. Rising interest rates did not appear to be too much of a concern for the financial services sector. Energy activity reportedly remained steady. Agricultural reports were mixed with most of the downside attributable to weather conditions rather than economic ones.

(2) Yellow signals. Contacts in all the 12 Fed Districts cited the tightness of the labor market. One staffing contact said: “Companies are expanding or want to expand. Their challenge is finding enough workers.” Labor shortages were observed across many occupations and skillsets, including restaurant workers, truck drivers, construction workers, skilled machinists, engineers, and IT workers. For firms in construction, the widespread labor shortage has prevented many companies from “being able to meet current levels” of demand.

Meanwhile, wage increases were moderate. Where wages did pickup, the growth was described as “inched up” or modest rather than intensified. Further moderate wage growth is widely expected in the coming months. Some staffing firms noted that companies are spending more to attract and retain talent. Most firms reported “rising benefit costs.” To solve for the skills-gap reported in many industries, many firms are “boosting training efforts” and “forming partnerships with local high schools to prepare students” for careers. Some firms are offering flexible work arrangements.

Some contacts reported considering or finding alternatives to “alleviate” the worker shortage. Some business contacts “shared plans to move to locations with larger labor pools, to change/reduce personnel standards and requirements, or continue to pursue automation to replace workers.” Some firms unable to pay higher wages demanded by experienced job seekers decided to “wait it out” and not fill open positions.

(3) Red signals. Nonlabor price pressures are also building, but mostly modestly, according to many District business contacts. Input prices, especially for nonlabor costs like metals, lumber, concrete, and transportation, are generally rising faster than sales prices. Some firms reported beginning to pass price increases on to producers or consumers. Some construction firms said they were able to pass on price increases to preserve margins, but that rising prices were weighing on sales. Despite beginning to pass on nonlabor costs, some firms said that they were unable to pass higher labor costs to consumers.

Tariffs were noted among the District contacts as one of the major contributors to rising prices, particularly in the manufacturing sector. Many contacts explained that the uncertainty related to tariffs was also causing them to scale back capital investment plans a bit, or wait to make major business investment decisions. Melissa reports that the tariff commentary seemed a bit more alarming in the current book than the previous one. However, it wasn’t all bad this time as some contacts said they didn’t expect “too much damage” if the tariffs are expanded.

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Countering a Rash of Pessimism

September 17, 2018 (Monday)

Strategy I: US Going to the Supply Side? Lehman Brothers imploded on September 15, 2008. So naturally, there has been a rash of 10-year anniversary articles on the financial crisis of 2008. I posted a seven-part series on the subject on LinkedIn. It is based on Chapter 8 of my book, Predicting the Markets. There has also been a rash of pessimistic articles about the outlook for the US economy and the stock market.

Our accounts have been sending me more emails lately asking me to respond to such articles as “What Next for the US Stock Market?” The 8/28 article by Martin Feldstein—a paragon of financial conservatism and chair of the Reagan administration’s Council of Economic Advisers—warned: “My judgment is that the greatest risk to the stock market is the future increase in long-term interest rates.” He sees higher inflation, attributable to tighter labor markets, forcing the Fed to raise the federal funds rate more aggressively. In his opinion, the major bearish factor for bonds, and therefore stocks, is the massive federal deficit. He observes: “The Congressional Budget Office projects that the federal debt held by the public will grow from 78% of GDP now to nearly 100% over the next decade.”

Feldstein concluded: “The rise in long-term rates will reduce the present value of future corporate profits and provide investors with an alternative to equities. The result will be a decline in share prices. I don’t know when that will happen, but I am confident that it will.”

A similarly bearish cover story in this week’s Barron’s by Jack Hough is titled “‘We’re Using the Future for a Fiscal Dumping Ground.’ Beware Trillion-Dollar Deficits.” It too focuses on the mountain of mounting federal debt as a looming threat to the bond and stock markets as well as the economy. After convincingly and thoroughly making his case about the alarming trajectory of US federal debt, Hough quoted a couple of economists who agree that it is a worrisome problem but also that it may be too early to worry. I agree. Consider the following:

(1) Wage & price inflation. I would be much more worried now if I believed that inflation was about to spurt higher. August’s batch of price inflation data arrived last week. Despite signs that wage inflation is finally picking up, price inflation remains fairly subdued. The labor market is very tight, as confirmed by July’s quit rate, which was the highest since April 2001 (Fig. 1 and Fig. 2). August’s average hourly earnings for all employees was 2.9% y/y, the highest since June 2009. It was 2.8% for production and nonsupervisory workers.

Yet the core CPI inflation rate edged down to 2.2% y/y during August (Fig. 3). It has remained range-bound between 1.6% and 2.4% since 2012. There has been upward pressure on the PPI finished goods inflation rate since early 2016, which is also visible in the CPI goods inflation rate (Fig. 4). However, most of the uptrend since then is attributable to the surge in oil prices.

Trump’s trade war has yet to show up in the US import price index’s inflation rate. Excluding petroleum, it was down to 1.0% y/y during August, the lowest since August 2017 (Fig. 5). The strong dollar may be offsetting some of the tariffs already imposed by the Trump administration. If Trump proceeds to slap tariffs on all Chinese imports, there could be some upward pressure on import prices.

(2) Productivity & technology. Last week, in meetings with some of our accounts in Philadelphia, Wilmington, Baltimore, and Washington DC, I was frequently asked why I’m not convinced that labor costs will rise much more rapidly, and if they do why that won’t boost price inflation. I’m betting that economic growth will remain strong and force companies to use more technology to overcome labor shortages. In other words, I think productivity growth finally may be making a comeback. I believe that companies remain very focused on maintaining their record-high profit margins. That means they will have to push for more productivity as competitive forces limit their ability to pass on costs into prices.

Debbie and I monitor the 20-quarter annualized growth rate of productivity (Fig. 6). It may have bottomed at 0.5% during Q4-2015, rising to 1.0% during Q2-2018. This is actually a remarkable performance given that the growth rate of manufacturing productivity, measured the same way, has been slightly negative since mid-2015.

The widespread view is that services productivity has been the drag on overall productivity. The data clearly show that manufacturing is the drag. I’ve previously attributed that to US manufacturers moving overseas and letting their remaining capacity in the US languish. (And that’s why Trump won the presidential election!) That may be about to change.

By the way, if productivity growth rebounds, so will the comparable growth rate in real hourly compensation (Fig. 7). This creates a virtuous cycle whereby better productivity growth boosts consumer spending, which boosts productivity.

(3) Corporate tax rate & robots. Change may be coming as manufacturing and other businesses are attracted to expand in the US by the 20% corporate tax rate enacted at the end of last year. That makes the US one of the lowest-cost countries for doing business. So does the ample supply of natural gas and oil. Labor costs are rising all around the world, so that issue may no longer favor moving out of the US. Global labor shortages attributable to demographic factors are stimulating a worldwide automation/robotics/AI revolution. Robots are just as efficient when they operate in the US as anywhere else around the world. 3D manufacturing technologies mean that supply chains can be kept very local, with necessary parts made at home rather than overseas.

(4) Demography. In the 8/28 Morning Briefing, Melissa and I wrote: “[Millennials] are [mostly single] minimalists who aren’t big earners or spenders because they need only support themselves. The Baby Boomers were big spenders when they were getting married and having kids. They too are turning into minimalists as they trade down to smaller houses and apartments now that they are empty nesters. These demographic trends suggest that the pace of consumer spending growth will remain lower than during the heydays of the Baby Boomers. If so, this may keep a lid on economic growth and reduce the likelihood of a boom. If there is no boom, there is less likelihood of a bust.”

(5) Bonds & debt. In the 8/1 Morning Briefing, I opined as follows: “Why aren’t bond yields rising in anticipation of all the debt that will need to be financed? There is already a record amount of debt everywhere, and more coming can’t be good for bonds. There is also a record amount of wealth in the world. Some of it tends to be managed with a risk-off bent. Ironically, people who expect that ‘this will all end badly’ tend to buy government bonds because they are deemed to be among the safest assets.”

You may be starting to suspect that I am turning into a supply-sider. I’ve often noted that YRI’s analysis is fact-based rather than faith-based. If the data continue to suggest that the tax cuts, along with technological and demographic factors, are boosting productivity and real compensation while keeping a lid on inflation—and also partly paying for themselves with higher tax revenues—then yes, I will be a supply-side believer.

For the here and now, the facts about the federal deficit are showing no beneficial supply-side effects so far. The 12-month sum of the budget shortfall jumped to $890 billion during August, the widest gap since March 2013 (Fig. 8). The 12-month sum of net interest paid by the federal government soared to a record $320 billion last month (Fig. 9).

Federal outlays over the past 12 months rose to a record high of $4.2 trillion through August, while receipts have flattened out following the tax cut at the end of last year (Fig. 10). The former has been boosted by record spending on Medicare and Social Security as spending on defense has started to rebound under Trump (Fig. 11). Weighing on receipts, of course, is the cut in the corporate tax rate (Fig. 12).

So why is the 10-year US Treasury yield still hovering around only 3.00%? Perhaps the best explanation remains that it is tethered to comparable yields in Germany and Japan, which remain near zero (Fig. 13).

(6) Corporate revenues & earnings. Given the mounting concerns about the federal deficit, why are US stocks in record-high territory? Stock investors are probably nervously watching the bond market. As long as bond yields remain subdued, they can remain bullish on earnings.

The latest indicators for S&P 500 revenues and earnings remain upbeat. S&P 500 forward revenues continues to rise into record territory and is a great weekly coincident indicator of actual quarterly results (Fig. 14). S&P 500 forward earnings likewise is still climbing to record highs and is a great leading indicator of actual operating earnings (Fig. 15).

Strategy II: Subpar Returns Ahead? It’s logical: Periods of above-average returns should be followed by periods of subpar returns. Returns have been great during the current bull market, so they are likely to be weak in coming years. The problem with this simplistic insight is that it is simplistic.

If you had gotten out of the S&P 500 just before the previous bear market started, gotten back in during March 2009, when the bull market began, and remained in through August of this year, your annualized simple average annual return over the past nine years and five months would be 29.5%, or 15.1% compounded (Fig. 16). That should be hard to match, let alone beat, over the next comparable period.

If you had become fully invested during August 2008, when the financial crisis was about to be worsened by the collapse of Lehman, and remained so until now, your 10-year average return would be 13.5%, or 8.9% compounded (Fig. 17).

I think this means that to enjoy the kind of returns we have had over the past nine years and five months, we need to get out just prior to the next bear market and get back in right at the bottom. I did tell everyone to get into stocks during March 2009. While I did turn bearish on Financials during June 2007, I forgot to tell everyone to sell everything during October 2007. I’ll try to do better next time.

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Healthy M&A, Musk’s Potcast & Digital Tulips

September 13, 2018 (Thursday)

Health Care: Looking Fit. The S&P 500 Health Care sector might have started 2018 looking sickly, but it’s entering the homestretch as one of the top-performing sectors ytd. Threats by the Trump administration to force price cuts have yet to materialize. Instead, a robust market for mergers and acquisitions along with IPOs have helped lift stock prices.

Here’s the ytd performance derby for the S&P 500 sectors through Tuesday’s close: Consumer Discretionary (18.3%), Information Technology (17.8), Health Care (11.3), S&P 500 (8.0), Industrials (2.3), Utilities (2.1), Real Estate (1.5), Energy (1.2), Financials (1.0), Materials (-2.2), Consumer Staples (-5.2), and Telecom Services (-5.7) (Fig. 1).

Driving the Health Care sector’s robust ytd performance are the following industries: S&P 500 Health Care Equipment stock price index (20.6%), Managed Health Care (16.6), Health Care Services (11.7), and Pharmaceuticals (8.7). Lagging behind is Biotechnology, up only 1.1% ytd (Fig. 2).

(1) Small but mighty. Even more impressive is the performance of small- and mid-cap Health Care stocks. The S&P 400 Health Care stock price index has risen 31.7% ytd, and the S&P 600 Health Care stock price index has soared 45.2% (Fig. 3). That makes Health Care the best performing of the 11 sectors in S&P’s small- and mid-cap indexes.

The industries driving the ytd performance of the S&P 400 and S&P 600 Health Care indexes include Managed Health Care (64.3%, 43.9%), Services (47.7, 23.4), Facilities (39.1, 18.2), Equipment (36.3, 48.1), Life Sciences (30.0, 41.8), Supplies (26.0, 40.4), Biotechnology (25.4, 39.8), Technology (14.8, 63.1), and Pharmaceuticals (-6.7, 43.0) (Fig. 4 and Fig. 5).

(2) Deals galore. Mergers and acquisitions have likely helped the performance of health care stocks. There have been $381.0 billion deals done in the global health care sector ytd, up from $240.1 billion over the same period in 2017, according to Dealogic data on wsj.com. That makes Health Care the second most active sector for M&A this year, trailing only the Tech sector.

Health Care companies also top the listing of the largest global M&A deals done ytd. Takeda Pharmaceutical announced in April plans to acquire Shire for $81.5 billion, making it the largest acquisition announced in 2018. Right behind it is Cigna’s pending acquisition of Express Scripts for $69.8 billion.

In addition, the IPO market has welcomed offerings from the Health Care sector. The sector has raised $15.0 billion in the global IPO markets this year compared to $10.7 billion raised at the same point in 2017. It’s the fourth most active S&P sector in IPOs this year, behind Tech, Finance, and Telecom.

(3) Digging down. Analysts are expecting the strong financial results from the S&P 500 Health Care sector to continue into next year. Revenue is forecast to climb by 6.1% this year and 5.2% in 2019, and earnings are forecast to improve by 14.6% and 8.1%, respectively (Fig. 6 and Fig. 7). The sector’s forward P/E, at 16.1, doesn’t appear stretched looking at its history over the past 25 years (Fig. 8).

As we mentioned above, the S&P 500 Health Care Equipment stock price index has been the best-performing industry within the sector. It’s expected to produce 12.5% earnings growth this year and 10.3% growth in 2019 (Fig. 9). However, its strength is no secret. The industry has a forward P/E of 22.5 (Fig. 10).

Three of the Health Care Equipment industry’s top-performing stocks are Idexx, Intuitive Surgical, and Boston Scientific. They each play into three strong trends driving the sector: pets, robots, and M&A. Idexx provides testing and other services to veterinarians and research facilities, among other things. Its stock has rallied 55.0% ytd, making it the industry’s top performer. Not far behind with a 49.7% ytd return is Intuitive Surgical, which makes the da Vinci robotic surgery platform. And Boston Scientific has rallied 45.8% ytd, after announcing a number of smaller acquisitions to bolster its growth.

Technology: Musk’s Potcast. The web went wild over comedian Joe Rogan’s podcast with Elon Musk—CEO of Tesla, Neuralink, and SpaceX—last Friday. During the two-hour-plus bro-mance, the two sipped whiskey and Musk took a drag of Rogan’s pot/tobacco joint. After watching the interview, Jackie walked away unfazed by Musk’s one pot puff, but wondered how a guy so smart could be so foolish about public relations.

After the puff, Musk said: “I don’t find [pot is] very good for productivity … it’s like a cup of coffee in reverse. … I like to get things done.” But his admonition never made the headlines, and comments on his many projects, including AI, tunnels, and electric cars, were drowned out by the pot controversy. Let’s go beyond the smoke-filled headlines to get a better idea about what’s going on inside Musk’s head:

(1) Neuralink. Musk has long warned that artificial intelligence (AI) could be a threat to humanity. (“It could be terrible, and it could be great. It’s not clear. But one thing’s for sure: We won’t control it.”) But he also explained how we might all tap into AI in the future.

Humans are vastly smarter because we have a phone or computer that allow us to do computations and access facts faster than we’d ever be able to do otherwise. “You are already a cyborg.” But accessing information from a computer or cell phone is slow. It’s like getting information from a tiny straw, limited by how fast your fingers can type.

Musk aims to make the flow of information between human brains and machines more like a “huge river.” His company, Neuralink, plans to “create a high-bandwidth interface to the brain.” AI will become an extension of oneself. It will allow humans to have super-human cognition. People will decide whether to retain their biological self or download themselves into another unit.

And he teased: “I think we’ll have something interesting to announce in a few months.”

(2) Digging deep. Another of Musk’s ventures is the Boring Company, which aims to dig a tunnel under Los Angeles to alleviate traffic. Here’s how he sees the traffic problem: Cities have three-dimensional buildings that hold tons of people. Roads are two dimensional and can’t possibly carry all the people to buildings without traffic. To reduce traffic, we need to create a 3D transportation system with flying cars or with tunnels.

Flying cars aren’t viable because they are too noisy and create too much air flow. But tunnels can be stacked and go down 10,000 feet. Tunnels “will work for sure.” The hardest part of the project: working through the paperwork.

(3) Sustainable energy. Musk believes we need to accelerate the push toward sustainable energy. Oil will run out, and at some point the carbon being taken out of the earth and put into the air and oceans will cause an environmental problem. Vehicles that run on fossil fuels are subsidized by the environmental cost to the earth, for which humans will ultimately pay.

In addition to starting Tesla, Musk also helped found solar panel company SolarCity, which Tesla purchased in 2016 after it struggled financially. The solar panels Musk is developing will supply 50%-150% of a home’s electric needs. The swing factor is how much electricity a home uses to run its air conditioning. Musk implied he has considered how to make more efficient air-conditioning systems and an electric plane.

(4) A lot of crazy. The podcast is just the latest oddity coming from Musk in recent weeks. He ruffled the markets by tweeting the idea of taking Tesla private in August, and then walked away from it. He was rude to analysts on the company’s Q1 earnings call and has become a frequent tweeter.

Taken together, this behavior was enough for Nomura Instinet analyst Romit Shah to lower his rating on the stock to neutral and to publish a report entitled “No Longer Investable,” a 9/11 CNBC article reported. Mad Money’s Jim Cramer has suggested Musk should take a medical leave.

Perhaps they would feel more comfortable about Musk’s state of mind after reading a 9/10 Bloomberg interview with Melissa Schilling, a NYU Stern School of Business professor who recently wrote the book Quirky: The Remarkable Story of the Traits, Foibles, and Genius of Breakthrough Innovators Who Changed the World. Musk is one of the eight geniuses profiled.

His recent behavior didn’t surprise Schilling because all of the innovators she studied have “low self-monitors” and don’t care much about how others perceive them. This characteristic allows them to generate unusual ideas and persist in the face of criticism. All of the creators were “quite arrogant,” but they delivered.

She believes these creators all have elevated dopamine, which makes a person think fast for long periods, work harder, and results in problems sleeping, which afflicts Musk. Innovators are also idealistic. So investors shouldn’t worry about the Model 3 hitting its goals. She thinks the bigger risk is that Musk takes the proceeds from the Model 3 and uses them to fund the development of the next great thing he believes will save the world. That may not be good for shareholders, but it could be good for the world.

(5) Lost in translation. Were Musk’s state of mind not enough to worry about, investors have also grown concerned that various automakers have new models of electric cars on the way; but from what we can tell, Tesla’s cars can still drive the farthest when fully charged. And so far, anyway, car people are still drooling over Tesla’s cars. This from a recent review on Business Insider of the $78,000 Model 3 Performance vehicle: “What we have here, admiring ladies and gents and drop-jawed children, is the complete package. Beautiful outside, cool as heck inside, and a car that gets your pulse pounding when you step on it. I’m crazy about this thing. It’s pure joy with four wheels and four doors.” Sounds like a guy who would have enjoyed last Friday’s podcast.

Finance: Digital Tulips. The crypto craze—the first truly worldwide bubble fueled by investors connected by the Internet—has turned into a crash. We cast a skeptical eye at bitcoin through much of last year, crowning it the “first digital tulip bubble” in the 12/14/17 Morning Briefing. Turns out, bitcoin rose to a peak of $18,960.52 on December 18 before tumbling more than 60% to $6,282.92 as of Tuesday’s close (Fig. 11).

Other cryptos have fallen as well. The price of Ethereum, which topped $1,300 in January, now trades around $177. Ripple traded hands in January at $3.49, and today it fetches only a bit more than a quarter. A 9/11 CNN article estimated that the major cryptocurrencies collectively have lost $400 billion since January.

There were a number of reasons behind the run-up. Investors, perhaps singed by the 2008 financial crisis and unhappy with the Federal Reserve’s bloated balance sheet, were looking for a currency that they felt would not lose value because the supply of that currency was limited by an algorithm. Nefarious types were attracted to crypto currencies’ anonymity. And, as is the case in most crazes—tulip or otherwise—people piled in when they saw the profits being made by others.

This year, doubts that cryptocurrencies will become a mainstream have been growing. There have been reports that Goldman Sachs may drop plans to start a crypto trading desk. The Securities & Exchange Commission blocked a number of bitcoin exchange-traded funds. And regulators started cracking down on crypto fraud. Just this week, a federal judge in the Eastern District of New York ruled that a businessman would have to stand trial on fraud charges related to initial coin offerings (ICOS), denying his lawyers’ argument that ICOS weren’t securities, the 9/11 WSJ article reported.

One of the largest problems with bitcoin, we’ve maintained, was the assumption that its supply was limited. Thanks to ICOs, the supply of cryptocurrencies has soared. ICOs have raised roughly $20 billion, primarily over the past year, according to data from Coindesk.com. The number of monthly deals peaked in December at 78, but the dollar amount raised peaked in June at $5.5 billion.

With currency crises in Turkey and Argentina, now should be the ideal time for citizens of those countries to turn to bitcoin. Instead, there has been a waterfall of selling. And with no way to value crypto currencies, and no central bank to support the currencies, it’s tough to say where the bottom will be.

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All About Wages

September 12, 2018 (Wednesday)

US Labor Compensation I: Can Companies Mark up Labor Costs? There’s no debate about the US labor market: It is tight. There is some evidence that it is finally tight enough to boost wage inflation. The inverse Phillips curve relationship between wage inflation and the unemployment rate has been missing in action for a very long time during the current economic expansion.

Has Godot finally arrived? Maybe, but Melissa and I aren’t totally convinced. Recall that during her first press conference as Fed chair on March 19, 2014, Janet Yellen, who is one of the country’s leading labor economists, said that 3%-4% wage inflation would be “normal.” It was running around 2% at the time, and the jobless rate was 6.7%. Last month, the jobless rate was down to 3.9%. However, the wage inflation rate was 2.9% (Fig. 1). That was the highest since June 2009, but still shy of 3.0%. Nevertheless, it is getting easier to see an inverse correlation between the jobless rate and the wage inflation rate (Fig. 2).

The same cannot be said for the relationship between the unemployment rate and the core PCED measure of consumer price inflation (Fig. 3). As the former fell from a cyclical peak of 10.0% during October 2009 to 3.9% last month, the latter has been eerily range bound between 0.9% and 2.1%.

While there is now a more discernable uptrend in wage inflation since late 2012, the same cannot be said for price inflation (Fig. 4). Rising labor costs don’t automatically get passed through to prices. They can be offset by productivity and also can be absorbed by lowering profit margins. The puzzle is that productivity growth has been running around an annual rate of barely 1.0% for the past five years (Fig. 5). Furthermore, the S&P 500 profit margin rose to record highs in recent quarters (Fig. 6). This suggests that productivity growth may be higher than the official data show.

On Monday, we highlighted the following derby for wage inflation in the Bureau of Labor Statistics’ (BLS) major industry groupings: utilities (4.8% y/y), financial activities (4.7), information services (3.4), construction (3.3), retail trade (3.2), leisure & hospitality (3.2), professional & business services (3.0), all industries (2.9), education & health services (2.6), durable goods manufacturing (2.3), transportation & warehousing (2.3), wholesale trade (2.0), mining & logging (1.5), and consumer nondurable manufacturing (0.9).

Most of the industries with wage inflation rates above the average don’t have much pricing power to pass through labor costs, either because they are regulated or because they are highly competitive. The former applies to utilities. Financial activities, information services, retail trade, leisure & hospitality all are competitive.

Remarkably, notwithstanding widespread reports of a trucker shortage, average hourly earnings in the truck transportation industry rose just 3.1% y/y during July (Fig. 7). Thanks to the IT logistic revolution, there has been a remarkable increase in the industry’s productivity, as evidenced by the record high in the ratio of the ATA truck tonnage index to truck transportation payroll employment (Fig. 8). Also of note is that wage inflation is well below average in both durable and nondurable goods manufacturing.

US Labor Compensation II: Primer on Wage Measurement. The widespread mythical contention that wages have stagnated over the past couple of decades irks us because the comprehensive data show otherwise. One of the most widely cited statistics to support this claim is the Census Bureau’s median money income per household, which is more or less just workers’ earned income and social security (Fig. 9). It has been relatively flat since 2000. However, that data series was never intended to be a measure of the standard of living but rather a baseline for determining the poverty line and to whom government transfers should go. Other measures of mean household income and consumption per household haven’t stagnated at all since 2000.

We have shown on a regular basis that the real wage rate (based on average hourly earnings of production and nonsupervisory workers divided by the PCED) has been on a solid uptrend since the mid-1990s (Fig. 10)! But this measure never makes headlines.

So it’s refreshing to see the topic of wage measurement attracting wider attention, including from the White House. Recently, the Council of Economic Advisers (CEA) released a paper supporting the conclusion that compensation growth has been much better than widely believed with points that make sense to us (notwithstanding the CEA’s inherent possible bias toward making the administration look good).

The paper’s three basic parts cover the three main flaws with traditional wage metrics: the failure to incorporate additional employment benefits, the failure to account for compositional changes in the workforce, and the failure to use more accurate measures of inflation to deflate nominal wage growth. Accounting for these issues, the CEA calculates that real average hourly after-tax compensation has risen by a solid 1.4% over the past year (Q2-2017 to Q2-2018) instead of the near-zero growth reported in the headlines. Let’s take a closer look:

(1) Benefits. Specifically, the CEA focuses on debunking the myth of wage stagnation demonstrated by the BLS’s Current Employment Statistics (CES) survey. Benefits—such as employer-paid health insurance premiums, paid leave, and retirement plans—are important compensation components that the CES measure leaves out. Nonwage benefits, including bonus payments, represented nearly one-third of total compensation in 2018, according to the CEA (see Figure 2 in the White House report).

(2) Composition. Changes in labor force composition are important for assessing aggregate real wage growth. Shifts in the mix of age and demographic profiles influence aggregate wage changes. Most prominently, the Baby Boomers, who started to turn 65 during 2011, are retiring and being replaced by younger, less experienced workers. With this, the downward bias of aggregate wage changes is “extraordinary,” according to the CEA.

By the way, the CEA didn’t point it out, but we have previously observed that many Baby Boomers are retiring later in life and likely experiencing slower wage growth than during their prime working years—another depressor of aggregate wage growth.

Demographics aside, entry and exit into the workforce also strongly influence workforce composition over the course of a business cycle. According to the CEA report: “During a recession, the entry of inexperienced workers slows, and those losing their jobs also tend to have less work experience than average, which artificially (relative to what individual workers experience) increases the national average wage. … The reverse tends to occur during an expansion.”

From 2013 to 2018, when the fraction of the population that works significantly increased and the workforce’s share of younger workers rose, “the potential for composition changes to mask wage growth is particularly high,” according to the CEA.

(3) Inflation. Using the PCED to deflate nominal wages, the CEA observes faster real wage growth than yielded with the more commonly used CPI for Urban Consumers, which often shows “systematically more inflation” than the PCED (see the CEA report’s Figure 8).

Many economists, including Fed members, prefer the PCED as a more accurate measure of consumer price inflation for four main reasons. These relate to accounting for the substitution of goods and services, the relative weights placed on categories of goods and services, the scope of goods and services covered, and seasonal adjustment factors.

US Labor Compensation III: Declining Labor Share Is a Myth. Gene Epstein, Barron’s crackerjack economics editor from 1993-2017, recently shared an article with us that he wrote for Reason, the monthly print magazine of “free minds and free markets.” The article counters a widely accepted media narrative that labor’s share of economic output is on the decline. Setting up the strawman, Gene writes: “Greedy capitalists have been helping themselves to an ever-growing share of our economic output. The decline of labor unions and factory jobs, our dependence on cheap foreign labor, and businesses’ growing ‘monopsony’ power are shafting American workers.”

Making that same point in a 7/13 article, the NYT ran a simple chart of Bureau Economic Analysis’ (BEA) data. It shows that “paychecks account for much less of the nation’s total income since the last recession, and the profits of businesses account for more.” The problem, according to Gene, is that these data need tweaking before accurate conclusions can be drawn. After having former BEA Chief Statistician Robert Parker vet his approach, here’s what Gene presents:

(1) Annualizing the trend. To “smooth out intra-year volatility,” Gene took Parker’s suggestion to express the data annually rather than quarterly, as a quarterly representation masks the cyclicality of the data and makes it appear to be on a sustained long-term downtrend. Gene observes that the “entire historical range” is “pretty well captured from 1947’s high of 70.4 percent to 1965’s low of 65.9 percent.” He adds: “Labor’s current share, at 67.1 percent, is on the low side of that range, but it is equal to or greater than the years from 1994 to 1997.”

(2) Excluding government, including self-employed. Further, Gene calls into question the NYT’s use of national income in the denominator for two reasons. For one, the government is included, but should be excluded, since the story “concerns the capitalist private sector.” Second, “by starting with national rather than domestic income, it includes the distorting effects of inflows and outflows from foreign countries.” Additionally, the numerator is flawed not only because it includes compensation of government workers but also because it excludes self-employment income, an important component of private-sector income.

(3) Revised ratio. Gene’s newly calculated denominator starts with the BEA’s “net domestic product” and “net domestic income,” then “takes out the portion attributed to all levels of government.” Next, the revised denominator “takes an average for each year of private sector net domestic income and net domestic product, since each is using different sources to measure the same concept.” Finally, the numerator of the new ratio deducts compensation of government employees from total compensation and includes “proprietor’s income.” See the outcome in chart form here.

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Red, Blue, and Green Waves

September 11, 2018 (Tuesday)

Strategy I: Giving Bull-Market Haters Their Due. The S&P 500 rose to a record new high of 2914.04 on Tuesday, August 28 (Fig. 1). Lately, I’ve been following some of the social media websites that focus on the stock market. The comments that appear after most stories about the market tend to be dominated by bull-market haters.

They have been foaming at the mouth since the start of the bull market in 2009 right through the recent high for the record books. They are convinced that the bull’s recent feats signify a bubble—fueled by too much central bank liquidity, too much corporate debt, too many corporate share buybacks, lots of fake earnings, and dangerously inflated valuation. Trump’s stimulative policies are making the top by pumping up stock prices with tax cuts that have temporarily pumped up earnings. But supply-side voodoo won’t pay for the tax cuts. The resulting mounting government deficits will lead to higher interest rates, which will balloon government interest payments and inevitably kill the bull. Or so their thinking goes.

More imminently, they see a threat to the stock market unfolding in the emerging markets crisis that could trigger a global bear market—right now! The Fed is on course to continue raising interest rates because the US economy is on course to grow at a solid pace thanks to Trump’s stimulative policies. But higher US interest rates are starting to wreak havoc in emerging market economies.

Furthermore, Trump’s red wave may be about to be overwhelmed by the Democrats’ blue wave during the mid-term congressional elections on November 6. If so, then Trump is finished. The Democrats will bury him with special prosecutors and even impeachment proceedings. The resulting political chaos and uncertainty could also kill the bull.

Before I take up a defense of the bull, I will concede that the bull-market haters are right about most of the bad stuff that obsesses them. The problem is that the bad stuff has been out there for quite some time, and it has mostly gotten worse. Yet lo and behold: The bull market rose to a new record high in late August. I don’t have a problem with that. Those who do have missed out on either the best (or second-best) bull market ever, so far.

The red political wave since Trump’s election on November 8, 2016 has seen lots of red ink in the government’s financial accounts. But that was true over the previous eight years when the blue wave dominated our political establishment. Under the Obama administration, publicly held federal debt more than doubled from $6.3 trillion during January 2009 to $14.4 trillion during December 2016 (Fig. 2). It is set to almost double under Trump if he gets a second term, as the federal deficit continues to mount again (Fig. 3).

Most unsettling is that US federal government interest payments are already soaring along with the debt as the Fed notches up interest rates. The Fed started normalizing the federal funds rate at the end of 2015. The two-year US Treasury note yield is up from 0.88% to 2.71% since then (Fig. 4). The federal government’s net interest paid has jumped from $225.5 billion during 2015 to $313.7 billion over the 12 months through July of this year (Fig. 5). I’m not as unsettled by the record $5.4 trillion in corporate bonds outstanding, which is up $2.3 trillion since the start of the bull market in March 2009 (Fig. 6). The funds those bonds raised for companies were issued at historically low interest rates and locked in for many years.

I’ve frequently explained in the past why share buybacks aren’t a concern for me. Joe and I regularly write about the impressive performance of corporate earnings, which aren’t fake, in our opinion. Valuations aren’t cheap, but it’s recessions that usually kill bull markets, not lofty valuations.

Strategy II: US Stocks Hanging 10 on the Green Wave. I am troubled by the proliferating emerging markets crisis. It is weighing on my favorite global economic indicator: The CRB raw industrial spot price index is down 8% since this year’s high on June 12 (Fig. 7). It is one of the three components of my Fundamental Stock Market Indicator (FSMI), which has been closely tracking the S&P 500 since 2000 (Fig. 8). The FSMI is a coincident indicator of the market. I designed it to determine whether the underlying fundamentals justify the underlying trend in stock prices in the US. Consider the following:

(1) Boom-Bust Barometer remains near record high. The FSMI includes our Boom-Bust Barometer (BBB), which is the CRB raw industrials spot price index divided by initial unemployment claims (Fig. 9). The BBB is also highly correlated with the S&P 500. The BBB remains elevated despite the recent weakness in the commodity index because jobless claims have fallen to their lowest level in 49 years (Fig. 10). The global economy may be weighed down by an emerging markets crisis, but the US labor market is booming.

(2) US consumers are elated. While the BBB has stalled at a record high in recent weeks, the third component of the FSMI is soaring. In mid-August, the Weekly Consumer Comfort Index jumped to the highest reading since the end of 2000 (Fig. 11). It is up 38% since Trump was elected and 20% since the tax cuts at the end of last year.

(3) Earnings remain fundamentally bullish. Of course, there is nothing more fundamentally important to the stock market than earnings. It turns out that both our FSMI and BBB are very highly correlated with S&P 500 forward earnings (Fig. 12 and Fig. 13). This time-weighted average of analysts’ consensus expectations for earnings during the current and the coming year has been flying into record-high altitudes since the tax cuts at the end of last year. It was $173.76 per share during the 9/6 week, up 18.0% since the end of last year.

Conclusion: The economy’s green wave matters much more to the stock market than the political red and blue waves!

Strategy III: On the Verge of a US Tech Wreck? Yes, but what about valuation? What about it? We all know that stocks aren’t cheap. They did get cheaper as a result of the 10.2% correction in the S&P 500 from January 26 through February 8. Did the bull-market haters turn bullish given that opportunity? Of course not.

I’m getting older and starting to repeat myself, but this is worth repeating: High valuation doesn’t kill bull markets; recessions do that. It just so happens that often prior to recessions valuation multiples tend to be elevated when investors forget that recessions naturally occur from time to time. This time, everyone has been on recession watch, especially as the yield curve has flattened.

Furthermore, there are more jitters about high valuations this time than there were during previous bull runs, when valuations were high but bubble concerns explained away as justified by the fundamentals. That’s especially true for the S&P 500 Information Technology sector. Granted, there are a few large-cap tech stocks with nosebleed valuations today. However, the forward P/E of the sector was 18.4 during August (Fig. 14). During the great tech bubble, multiples were more than twice as high. Furthermore, back then the earnings share of the sector peaked at a then-record high of 18.2% during September 1999 (Fig. 15). Last month, it rose to a record high of 23.4%, justifying the current market-cap share, in my opinion.

So what about the recent weakness in the S&P 500 Semiconductors industry? If there is trouble ahead for it and the economy, as some vocal bears proclaim, that isn’t apparent yet in the industry’s forward revenues and forward earnings (Fig. 16 and Fig. 17). Both rose to new record highs at the end of August. The Net Earnings Revisions Index (NERI) remained solidly positive last month for the 27th month in a row (Fig. 18). Our Blue Angels analysis shows that the industry’s stock price index has been rising along with forward earnings since early 2013, with the forward P/E remaining around 15 most of the time since then.

On the other hand, Joe warns that the S&P 500 Semiconductor Equipment stock price index is down 22.9% since the industry’s January 25 high of the current bull market. The industry’s forward revenues and earnings are also looking toppy lately, and NERI has been negative for two months in a row. This may be one industry that is already getting pinched by Trump’s escalating trade war. (See our S&P 500 Industry Briefing: Semiconductor Equipment.)

Strategy IV: Trusty Financials Are Calm in US, Jittery in Europe. One of the stock market’s more reliable coal-mine canaries has been the ratio of the S&P 500 Financials stock price index to the S&P 500. It tends to give an early warning sign of both recessions and bear markets (Fig. 19 and Fig. 20). So far, no news is good news in the US. The S&P 500 Financials stock price index is up 1.0% ytd. So far, the emerging market crisis isn’t emerging as a problem for the US financial system.

On the other hand, fears of an Italian debt crisis, along with the emerging market crisis, have weighed on the Europe Financials MSCI, which is down 14.9% ytd and 22.9% from its January 25 peak (in local currencies) (Fig. 21). While the NERI for the S&P 500 Financials sector remained positive for the 23rd month in a row during August, it was negative for the fifth month in a row in Europe (Fig. 22).

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US Stocks’ Boon Is Global Stocks’ Bane

September 10, 2018 (Monday)

Strategy: Strength Here, Weakness There. After Friday’s strong employment report, the 9/5 GDPNow estimate for Q3’s real GDP growth is likely to be raised a bit from 4.4% when it is revised tomorrow. It follows a 4.2% increase during Q2. If the 9/5 estimate is on target, real GDP rose 3.3% y/y during Q3, the best such growth rate since Q2-2015 (Fig. 1). That’s obviously good news for the US economy. Less obvious is that this is bad news for the rest of the global economy. Here’s why:

(1) Trump has a winning hand. President Donald Trump’s tax cuts clearly have boosted the US economy, and given him more confidence that he can escalate his trade war with our major trading partners without damaging the US economy. So far, the evidence suggests that Trump’s blustering that “trade wars are good, and easy to win” may not be as farfetched as widely believed, especially by almost all economists.

(2) Powell wants to normalize. The strength of the US economy is also giving Fed Chairman Jerome Powell and his colleagues confidence that they can continue to raise the federal funds rate. They want to “normalize” monetary policy by raising this rate to 3.00% by the end of next year. On Friday, the two-year US Treasury note yield rose to 2.71% (Fig. 2). It tends to be a good proxy for the market’s expectation for the federal funds rate a year from now.

(3) Emerging markets get hit by triple whammy. The problem is that the rest of the world, particularly emerging market economies, became dependent on the abnormally low rates at which dollars could be borrowed and borrowed lots of funds in dollars. Now they are getting hit by the triple whammy of rising US interest rates, weaker local currencies relative to the dollar, and capital outflows. The Emerging Markets MSCI currency ratio is down 7.7% through Friday since peaking this year on January 25 (Fig. 3). The Emerging Markets MSCI stock price index is down 13.9% (in local currencies) and 23.5% (in dollars) over this same period (Fig. 4).

(4) European Union under stress. Meanwhile, as we discussed last Wednesday, the European Union (EU) is struggling with a number of issues. A new Italian government is pushing to bust the EU rule prohibiting fiscal deficits from exceeding 3% of GDP. Italian bond yields have been soaring in recent weeks (Fig. 5). The UK pound has tumbled 4.3% since the start of this year on mounting concerns of a “hard” Brexit (Fig. 6). Trump’s trade war and the emerging markets crisis are weighing on Germany’s factory orders, which dropped 8.1% from their record high at the end of last year through July, led by an 11.9% drop in foreign orders (Fig. 7).

The bottom line is that Stay Home continues to outperform Go Global. The ratio of the US MSCI stock price index to the All Country World MSCI ex US MSCI stock price index has been soaring in both dollars and local currencies since Trump launched his trade war in early February of this year (Fig. 8). Here is the ytd performance derby of the major MSCI stock price indexes in local currencies: US (7.5%), EMU (-4.3), UK (-5.6), Emerging Markets (-6.0), and Japan (-6.7) (Fig. 9). Furthermore, the trade-weighted dollar is up 4.1% ytd.

US Economy: Over Here. The 10-year US Treasury bond yield rose on Friday by 6 bps to 2.94% following the employment report. That still leaves the yield in the remarkably narrow and subdued range mostly just south of 3.00% since the start of this year (Fig. 10). Let’s see why the bond yield remains so listless:

(1) Employment. As Debbie discusses below, payrolls rose 201,000 during August, but the previous two months’ gains were revised down by 50,000 in total (Fig. 11). The past three months registered average gains of 185,300, i.e., not too hot and not too cold. The more volatile household measure of employment fell 423,000 during August following a gain of 389,000 the previous month.

(2) Wages. It was the 2.9% y/y increase in the average hourly earnings measure of wage inflation for all workers that triggered the selling pressure in the bond market (Fig. 12). That was the highest reading since June 2009. However, it remains stubbornly below 3.0%, as does the measure for production and nonsupervisory workers, which stood at 2.8% last month. Here is the derby for the Bureau of Labor Statistics’ major industry groupings: utilities (4.8% y/y), financial activities (4.7), information services (3.4), construction (3.3), retail trade (3.2), leisure & hospitality (3.2), professional & business services (3.0), education & health services (2.6), durable goods manufacturing (2.3), transportation & warehousing (2.3), wholesale trade (2.0), mining & logging (1.5), and consumer nondurable manufacturing (0.9).

By the way, our Earned Income Proxy for private-sector wages and salaries rose solidly by 0.6% m/m during August, and 5.2% y/y This augurs well for consumer spending, and should raise the 9/11 GDPNow revised estimate for Q3 real GDP (Fig. 13).

(3) Global issues. Meanwhile, German and Japanese 10-year government bond yields remain close to zero. We’ve previously noted that the globalization of the US bond market explains why US bond yields haven’t risen more and why the yield curve has flattened (Fig. 14). Now the emerging markets crisis may also be triggering risk-off portfolio moves that favor US bonds.

The Fed is widely expected to hike the federal funds rate from 1.75%-2.00% to 2.00%-2.25% at the September 25-26 meeting of the FOMC. It will be interesting to see whether the US 10-year yield can break above 3.00% as that meeting approaches or right after it. Our hunch is that the yield will rise just above 3.00%, then remain awfully close to this level over the remainder of the year even if the FOMC hikes again to 2.25%-2.50% at its December 18-19 meeting.

Global Economy: Over There. Confirming the strength in the US economy is the recent record high in the forward revenues of the US MSCI (Fig. 15). Lagging behind, but also at a record high, is the forward revenues of the All Country World ex US MSCI (in local currencies). By the way, so far, there is no sign that the troubles of the emerging market economies are depressing the forward revenues of the EM MSCI (in local currencies) (Fig. 16).

Then again, there are plenty of signs of a global economic slowdown in the global M-PMI and NM-PMI indexes, as Debbie discusses below. Notably, the global M-PMI most recently peaked at 54.5 during December, and fell to 52.5 during August, the lowest reading since November 2016 (Fig. 17).

Furthermore, the CRB raw industrials spot price index has declined in recent weeks to the lowest readings since late 2016 when it was recovering from the global growth recession of 2015 (Fig. 18).

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Inflation, Where Art Thou?

September 06, 2018 (Thursday)

US Inflation I: Disruptive Technologies. Much has been written about industries that have raised wages because they’ve had a tough time finding employees. Home building, trucking, and lawn maintenance are three of many examples. Seems no one wants to drive a truck anymore (perhaps because autonomous trucks may arrive in the not-so-distant future), and tighter immigration policy has left businesses scrambling to fill seasonal positions.

Despite these inflationary pressures, July’s seasonally adjusted CPI was 2.0% (saar), using a three-month percentage change (Fig. 1). When food and energy are excluded, the figure rises to just 2.3% (Fig. 2). As we’ve noted before, technology has unleashed some awfully strong deflationary forces exerting downward pressure on both wage and price inflation; one such force is the little guy’s improved ability to compete locally and globally via the Internet. Here’s a look at some recent examples of technology’s outsized impact on prices:

(1) Services go online. Sites like Upwork, Fiverr, and Freelancer.com list the services of folks willing to write, market, make videos, and create computer programs, among other work. More than 48 million people have registered globally on websites facilitating the sale of their labor. The bad news for workers in developed nations is that those in emerging economies will work for extremely low wages. Outsourcing to emerging markets, once mostly the scourge of just US manufacturing workers and telemarketers, is now hitting college-educated workers.

An 8/31 article in The Atlantic brought the issue to our attention: “On Fiverr, one of the most popular of these platforms, you’ll find offers for someone who will write an e-book ‘on any topic’; a person who will perform ‘a Voiceover as Bernie Sanders’; someone who will write your Tinder profile for you, and someone who will design a logo for your real-estate company. The people selling this labor live in Nigeria, Mexico, the United Kingdom, and Bangladesh, respectively. Each of them charge $5 for these tasks.”

While these websites purport to exist to make freelancing easier for both the worker and the employer, they’re also helping buyers find labor at the lowest cost anywhere on Earth. Underdeveloped countries like Malaysia and Nigeria are training citizens to use the online platforms, helping their workers to compete on the global stage.

(Notably, only 5% of services on Fiverr actually cost $5; “Fiverr Pro” lists workers, vetted by Fiverr, who typically charge more, e.g., $375 and up for logo designers. That said, every $375 designer knows there’s a worker somewhere in the world willing to do the job a heck of a lot cheaper.)

(2) More pressure on services. The WSJ’s David Pierce put together a guilt-ridden article on Monday about all the services he enjoys at insanely low costs despite the harm it may do to workers’ wages or to Mother Earth. On his list: MealPal, a lunch subscription service where restaurants offer one dish each day at $6.39, even though the normal cost may be 50% more for those buying at the restaurant. Uber Pool gets Pierce a lower price for a ride even if no one else gets in the car. MoviePass provides a movie a day for under $10 a month. Amazon’s Prime offers free, two-day shipping—and few frequent users likely fret over the environmental impact. Those willing to listen to a commercial or two can hear the world’s music for free at Spotify.

Only companies with products we can absolutely not live without—like Amazon and Netflix—have pricing power. Everyone else may find their pricing is in a downward spiral, certainly not an environment that’s conducive to rising wages.

(3) Lower fees in financials. The introduction of ETFs and index funds long have put pricing pressure on the asset management industry. However, the pricing war among index fund and ETF providers hit a new low last month: zero fees. Fidelity is offering retail investors equity index mutual funds covering the US and international markets that don’t charge a fee and have no minimum required investment. The funds are Fidelity Zero Total Market Index Fund and the Fidelity Zero International Index Fund.

In their first month, investors poured almost $1 billion into the two index funds, a 9/4 Bloomberg article reported. The hope is investors will also buy other Fidelity funds that do charge a fee. So far, no other firms have matched Fidelity’s ultimate race to the bottom.

JPMorgan Chase’s online trading fees also hit rock bottom last month. JPMorgan will offer any bank customer at least 100 free stock or exchange-traded-fund trades for a year, with no account minimums, an 8/21 WSJ article reported. ”That is a sea change in pricing. The bank had charged $24.95 for online trades as recently as last year … The service, dubbed You Invest Trade, will be embedded in the bank’s app and website.”

The firm is hoping to attract first-time investors and customers of the bank who invest elsewhere. The move has hurt the shares of rivals like TD Ameritrade Holding and E*Trade, which charge customers $6.96 a trade, and Charles Schwab, which charges $4.95.

US Inflation II: Are Tariffs Inflationary? Some folks fret about the impact of Trump’s China tariffs on US inflation. Melissa and I agree that certain categories of goods, like cell phones and washing machines, may see tariff-induced rising prices, but we aren’t worried about the impact on headline inflation.

In addition to implementing worldwide tariffs of 25% on steel and 10% on aluminum, the Trump administration has imposed tariffs on $50 billion of Chinese goods in two phases. Looking ahead, Trump has threatened to impose tariffs of up to 25% on another $200 billion of imported Chinese goods. The President may move forward with these plans as soon as today when a public-comment period ends, according to an 8/30 article in Bloomberg. The amount of goods subject to tariffs is approaching nearly half of the $500 billion plus in total annual US imports from China.

So why aren’t we worried about these tariffs causing inflation? One big reason is that secular forces—including aging demographics, technology innovation, and the “Amazonification” of prices—continue to keep a lid on inflation, as we’ve often discussed. Additional reasons specific to China include:

(1) Not in import prices (yet). The y/y changes in US import prices from China have been markedly subdued since peaking in early 2012. The measure fell below zero during early 2015. It rebounded to zero at the end of 2017, and reached 0.5% by June, easing to 0.2% in July (Fig. 3). So the tariffs that have gone into effect thus far haven’t had a significant impact so far. By the way, only about 2.0% of US steel imports came directly from China during 2017. But that doesn’t count the steel that is exported from China to third-party countries for further processing before being shipped to the US.

Not only have US import prices from China remained muted but so have China’s domestic consumer prices. Interestingly, China’s measure of producer prices paid surged 7.8% y/y during February 2017. In the latest reading, the y/y percent change fell back down to 4.6% in July, still sizable. From the start of 2017 through July, the y/y percent changes in China’s consumer prices have bounced between 0.8% and 2.9% (Fig. 4). That may indicate that China’s producers are hesitant to raise prices for domestic consumers as well as those abroad.

(2) Not all trade is with China. Estimates suggest that the impact on consumer price inflation (CPI) from the tariffs could range 0.3-0.4ppts, according to a PIMCO analysis cited in an 8/9 Bloomberg article. That doesn’t sound as alarming as the $250 billion in goods possibly subject to tariffs, so why isn’t the percentage point impact higher? China is the US’s largest trading partner, but US imports from China account for 21.4% of total US merchandise imports, and only 2.6% of US nominal GDP (Fig. 5).

And the US can shop around. Cell phones and other household items are currently the largest category of imports to the US from China, according to the World Economic Forum. China isn’t the only place in the world to buy cell phones. For example, Samsung, the South Korean electronics giant, is “now looking to fend off Chinese companies trying to dominate the market for inexpensive phones” by expanding manufacturing into India, according to an article in Tuesday’s WSJ. The article reported that the company’s new facility in India will be fully built in a New Delhi suburb by 2020. It will eventually make 120 million handsets in a year, or roughly one of every 13 phones in the world. Around 30% of those will be exported.

(3) Absorbing the impact. It typically takes time for the inflationary effects from tariffs, which directly impact producer prices, to indirectly flow into consumer prices. Typically, producer prices lead consumer prices as companies figure out how to handle cost increases. They must decide whether to pass price increases onto consumers without disrupting demand too much or absorb the price increases in the profit margin, and/or increase productivity.

So far, US producer prices have increased partially due to the worldwide tariffs imposed on steel and aluminum. However, as discussed below, that doesn’t seem to have impacted consumer prices. Already, companies including General Motors, Boeing, and United Parcel Services have suggested that Trump’s tariffs are expected to negatively impact profitability. Corporations like these may be more willing to absorb price increases given the boost to profit margins that has come from Trump’s tax cuts. Despite historically low unemployment, wage inflation consistently has been subdued. If wage inflation were to pick up, then corporations might raise consumer prices. But again, that hasn’t happened yet.

(4) Productivity comeback. US manufacturers are already hard-pressed to find skilled labor in the US. Instead of raising wages to attract such labor, US producers might start to focus on increasing domestic productivity. If productivity makes a surprising comeback, then a related decrease in domestic producer prices could offset price increases abroad. US manufacturers are most likely to refocus on boosting domestic productivity if Trump succeeds in bringing manufacturing plants back to the US. In addition to the protectionist tariff measures, Trump recently has threatened to pull the US out of the World Trade Organization (WTO). Since China entered the WTO in 2000, both manufacturing production and capacity in the US have been flat. Lots of US manufacturers moved their operations to China and didn’t focus on enhancing their productivity within the US.

(5) Deal, or no deal? Trade talks between China and the US at the end of last month ended without any agreement. Nevertheless, it’s possible that a deal will be made and the $200 billion in incremental tariffs threatened won’t be implemented or that further talks will delay them. It’s also possible that some tariffs already imposed may be reversed. Moreover, the $200 billion threat may be enough to force China to concede where it counts, like on its unfair advantages in technology.

US Inflation III: Rounding Up Inflation. Inflationary pressures have been building at the producer price level since September 2016. Cost-push inflationary pressures may have started to push consumer price inflation slightly higher. But Debbie and I don’t think these measures of inflation will rise much from here. Competitive pressures should keep a lid on the CPI inflation rate. Think: “Amazonification.” It’s so easy for consumers to compare prices online that no seller can price its products dramatically higher than levels its global competitors have set.

While producer price inflation has risen more rapidly than consumer price inflation, producer price inflation looks like it may be topping out already. Even if producer prices continue to outpace consumer prices, as we expect they will, we aren’t too concerned about corporate profitability. Profit margins have received a generous boost from Trump’s tax cut, which has made more than enough room for companies to absorb some price increases. Let’s round up some of the latest data supporting our relatively benign inflation outlook:

(1) ISM surveys. The monthly ISM survey of purchasing managers includes prices-paid indexes for manufacturing and nonmanufacturing companies (Fig. 6). The former jumped to its highest reading since April 2011 during May (79.5). That was a significant rebound from the second half of 2014 through all of 2015 when this index was below 50.0. During August, the index fell back down to 72.1, though that’s still well above 50.0. The nonmanufacturing prices-paid index has been on a more muted uptrend since early 2016, rising to a recent peak of 68.0 during May. As of July, it fell back 64.5.

(2) Regional Fed surveys. Five of the 12 Federal Reserve district banks (FRBs) conduct monthly business surveys in their regions—Dallas, Kansas City, New York, Philly, and Richmond. All inquire about both prices paid and prices received (Fig. 7). The diffusion indexes for prices paid almost always exceed those for prices received, confirming that it isn’t easy to pass costs on into prices.

As with the ISM series, there have been noticeable uptrends in both indexes for the five districts since early 2016. More recently, the series may have crested, having fallen back down in latest readings. The average of the five FRBs prices-paid indexes is highly correlated with the ISM manufacturing prices-paid index (Fig. 8).

(3) Producer prices. The regional average prices-paid index is also highly correlated with the PPI for final demand (Fig. 9). During July, the former was its highest since May 2011, while the latter reached its highest rate since November 2011 in June. These measures since have fallen, but remain elevated.

(4) Consumer prices. The average prices-paid index based on the Fed’s regional surveys reflects pricing pressures in the goods sector more than in the services sector. That’s evident from its high correlation with the ISM manufacturing prices-paid index and with the PPI for final demand. The recent pricing pressures evident in those three prices-paid indicators are only just starting to show up in the CPI for goods, but are not so evident when food and energy are excluded (Fig. 10).

(5) Import prices. Pressure from the weaker dollar, which was down -9.4% y/y through January 25, didn’t show up in the CPI for goods excluding food and energy either. That’s because the index of imported consumer goods excluding energy has been hovering around zero on a y/y basis since early 2017 despite the weaker dollar (Fig. 11). More recently, the trade-weighted dollar is back up 5.7% y/y through yesterday, and the index of imported consumer goods excluding food and energy remains near zero.

(6) Services. The cost-push inflationary pressures evident in the ISM, FRB, and PPI prices-paid indexes may relate mostly to the rise in oil prices since early 2016. On the other hand, the CPI services inflation rate is up 3.1% y/y with, and 2.9% without, energy services (Fig. 12). A major contributor to the CPI services inflation rate as well as the headline inflation rate is rent inflation. Excluding food and energy, the overall CPI is up 2.3%. But also excluding shelter lowers the inflation rate to just 1.5% (Fig. 13). Rent inflation has been declining since late 2016 as a surge in multifamily housing construction has increased the supply of rentable apartments.

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US vs Them

September 05, 2018 (Wednesday)

Trump’s World. I’ve said it before, and I’ll say it again: “There is method in Trump’s madness.” Hamlet said it first in 1602: “Though this be madness, yet there is method in it.” The difference this time is that I expect a happier ending than in Shakespeare’s play. President Donald Trump’s policies are boosting US economic growth despite his escalating trade war, which is depressing economies in the rest of the world. This is putting pressure on the rest of the world to come to terms with Trump’s demands for fairer and more bilateral trade. The risk is that Trump’s policies may be causing a widespread emerging markets crisis. We live in interesting times:

(1) US. Real GDP rose by 4.2% (saar) during Q2, and is on track to grow by 4.7% during Q3, according to the 9/4 GDPNow estimate, up from 4.1% on August 30. Nonfarm productivity rose 2.9% (saar) during Q2, and may be on track to do about the same during Q3. The long-awaited productivity rebound may be underway. If so, supply-siders should rejoice, and I will join them in their celebration.

For now, we can rejoice in yesterday’s M-PMI, as August readings exceeded 60.0 for the overall index (61.3), production (63.3), and new orders (65.1). Employment was solid at 58.5. The overall index was the highest since May 2004 (Fig. 1)!

This is great news for the y/y growth rate of S&P 500 revenues per share, which is highly correlated with the M-PMI (Fig. 2). The former was up 10.3%, the best reading since Q3-2011. As Joe and I have noted before, this is the kind of strength that typically occurs during recoveries, not this late into an economic expansion.

Also rejoicing are American consumers. Debbie and I average the Consumer Sentiment Index and the Consumer Confidence Index to derive our Consumer Optimism Index (COI), which remained at a cyclical high during August. The current conditions component of the COI rose to the highest reading since December 2000 (Fig. 3).

Consumers are happy because their “jobs hard to get” response plunged to 12.7% in August, the lowest since March 2001, implying that the unemployment rate may be on the way to falling to 3.0% (Fig. 4 and Fig. 5)!

(2) China. There’s much less exuberance in China, which is feeling some pain from Trump’s trade war. This is most visible in the recent plunge in the price of copper, which is highly correlated with the China MSCI stock price index (in yuan), which has been in a bear market since early August and is down 21.1% since January 26 (Fig. 6). There isn’t that much pain yet in China’s M-PMI, but there isn’t any exuberance either (Fig. 7).

(3) Emerging market economies. The pain is mounting among several emerging market economies (EMEs). That explains why the CRB raw industrials index has been falling this summer despite the boom in the US (Fig. 8). Also falling sharply is the Emerging Markets MSCI stock price index in both dollars and local currencies, as well as the All Country World MSCI index currency ratio in dollars per local currencies (Fig. 9 and Fig. 10). Trump’s fiscal stimulus has increased the likelihood that the Fed will continue to raise interest rates, which is contributing to capital outflows from EMEs.

All of the above supports our Stay Home investment strategy. Perhaps once Trump declares victory in his trade war with the rest of the world, it will be time to Go Global. But what about Europe? I asked Sandra Ward, our contributing editor, to have a look. It’s not pretty over there.

Europe I: State of the Union. No sooner did one financial crisis in the European Union (EU) come to a symbolic end this summer than the prospect of another began to loom large.

Greece emerged from eight years of fiscal oversight on August 20, marking the finale of a financial rescue program that totaled $331 billion in emergency loans from the European Central Bank and the International Monetary Fund. It was the biggest bailout of a country in history, as an 8/20 article in the WSJ pointed out. The EU and its single currency came through intact. Despite the tremendous economic toll on its citizenry from higher taxes, fewer public services, lower pensions, and high unemployment, Greece decided it was better to be in the EU than out.

Yet Greece’s recent milestone received little more than glancing attention as investors focused on a fresh threat to the EU: Italy. The fourth-largest economy in Europe has a new coalition populist government that’s chafing at budget constraints despite the country’s precarious financial state, with government debt equaling 132% of GDP. Rome and Brussels appear to be on a collision course over spending levels ahead of Italy’s 2019 budget announcement later this month. Italian bond yields have spiked sharply on fears of a potential crisis.

Other challenges face the EU too. Anti-immigration sentiment and a new nationalism sweeping the continent threaten to tear the fabric that binds the union. A form of “civil war” is how French President Emmanuel Macron characterized the political divisions among the EU’s member countries in his inaugural speech to the European Parliament, as highlighted in a 4/17 article in The Guardian.

Brexit, the UK’s plan to exit the EU, continues to weigh heavily on European markets. Increasingly, the talk is of a “hard Brexit,” also being called a “no-deal Brexit,” in which the split occurs without a formal agreement in place. The UK is scheduled to leave the EU on March 29, 2019. Fears have resurfaced of a domino effect from Brexit, leading other countries to depart, according to an 8/30 article on Bloomberg.

As if all that weren’t enough, escalating trade tensions with the US are undermining economic growth and creating added uncertainty. And US President Donald Trump continues to lob denigrating Twitter bombs at our European allies and the NATO alliance.

The EMU MSCI share price index fell 2.7% (in euros) in August, tying Latin America for the worst-performing regional index last month. The Italy MSCI share price index dropped 9.0% in August, and the Greece MSCI slumped 9.5%. The Stoxx Europe 600 Index turned in its weakest performance since March, slumping 2.40% in August, according to an 8/30 piece in MarketWatch. Economic growth in the Eurozone continues to be subdued, and the revised 1.5% (saar) expansion during Q2 matches Q1’s rate, which was the weakest since Q3-2016 (Fig. 11).

Let’s take a closer at Europe and what ails it.

Europe II: Italy First. Italy is hurtling toward a showdown with the EU over its ability to keep its budget in check and reduce its gargantuan debt load, raising concerns about the eurozone’s financial stability. Some details:

(1) Promises, promises. Reassurances by Italy’s pro-euro finance minister that EU budget deficit rules would be respected were at odds with outlooks presented by the two deputy prime ministers representing the populist ruling coalition.

Finance Minister Giovanni Trio urged the governing parties to keep the budget deficit below 2% of GDP. Deputy Prime Minister Matteo Salvini said next year’s budget will double, bumping up against the deficit ceiling limit of 3%. “The government will ‘try to respect all the hurdles Europe imposes, but the well-being of Italian citizens comes first,’” Salvini said, according to a 9/3 Bloomberg report. His counterpart, Luigi Di Maio, is promising that a citizens’ poverty relief plan and income tax cuts will be included in the 2019 budget.

A nationwide infrastructure investment program planned in the aftermath of the Genoa bridge collapse could push the deficit above the ceiling, a senior official warned on Friday, noted an 8/31 Reuters report.

(2) Bond selloff. Borrowing costs on 5-year and 10-year Italian debt surged to the highest levels in four years last Thursday as investors grew concerned about rising debt levels, according to an 8/30 report on Reuters (Fig. 12 and Fig. 13). Demand was strong for the two fixed-rate bonds and two floating rate bonds, and the Treasury raised €7.75 billion ($9.06 billion).

(3) Fitch downgrade. Fitch Ratings downgraded Italy’s debt outlook to negative last Friday, noting in the 8/31 report that its “fiscal loosening” combined with already high debt levels make the country vulnerable to potential shocks. Fitch maintained its triple-B rating on Italian debt.

(4) More threats. Italy’s coalition government threatened to withhold €20 billion in budget contributions to the EU as a negotiating tactic to force other member countries to take some of the 140 migrants on a Coast Guard vessel docked in a Sicilian harbor, according to a 8/24 report in the FT. Eventually, the Catholic Church brokered a deal under which Albania, which is not in the EU, and Ireland took in about 20 each, with the church itself harboring the rest.

Europe III: Hard Brexit. Two years after British voters agreed to leave the EU, there is still no agreement on the form such an exit will take. The lack of agreement is reviving concerns that other countries will follow the UK’s lead, especially at a time when nationalist forces are on the rise in Europe, the benefit of EU membership is being questioned, and the EU’s democratic values are getting tested, an 8/30 piece on Bloomberg pointed out. A couple of key points:

(1) Deadline looming. With time running out on an October deadline for negotiating and a scheduled March 29, 2019 departure date, concern is growing about the upheaval that will result if no deal is struck. “In a no-deal scenario, and without a transition phase, we would end up with a border and customs regime that no one is prepared for,” Joachim Lang, director-general of Germany’s BDI industry federation, told the FT according to a 9/2 piece. “There would be considerable uncertainty, there would be interruptions to the supply chains and the UK industrial base would take a hit.”

(2) Sticking points. The UK proposal envisions the free trade of goods but not of people, capital, or services. The EU’s chief Brexit negotiator, Michel Barnier, opposes the British proposal, rejecting the notion that goods and services can be separated in the modern economy, according to a 9/2 BBC article. Barnier is also concerned about the precedent that would be established if Britain were allowed to choose the EU rules it will abide by. Another thorny issue concerns the border between the British province of Northern Ireland and the Republic of Ireland, which would be the only land border with the rest of the EU. Would EU or UK law take precedence? Ireland would like the border to stay open and accessible, according to a 6/26 report on Marketplace.org.

Europe IV: Trade. The Eurozone has not escaped Trump’s obsession with tariffs:

(1) Non-autos. Last month, President Trump met with the European Commission President Jean-Claude Juncker, and the two agreed to work toward eliminating tariffs for non-auto industrial goods.

(2) Autos. Last Thursday, EU Trade Commissioner Cecelia Malmström went a step further, saying that the EU was willing to bring its “car tariffs to zero, all tariffs to zero, if the US does the same.” The EU imposes a 10% tariff on all passenger vehicles. The US imposes a 25% tariff on light trucks and pickups and a 2.5% tariff on smaller cars.

(3) A smaller version of China. Trump rejected the EU no-tariff offer, saying it wasn’t “good enough,” according to an 8/30 CNBC story. He noted that Europeans tend to buy European-made vehicles and not “our cars.” He added that the EU is “almost as bad as China, just smaller.”

Europe V: Slowing Growth. With deadlines fast approaching for Italy’s budget proposals and Brexit negotiations, investors soon should be getting a clearer sense of what’s in store for the EU. For now, expansion continues in the region, but uncertainty about global trade and tariffs is resulting in a slower rate of growth, as evidenced by:

(1) Manufacturing PMI. The IHS Markit Eurozone M-PMI reading fell from 55.1 during July to 54.6 in August, the slowest since November 2016 and six points lower than December’s record high, according to the most recent 9/3 report (Fig. 14). Growth in new orders hit a two-year low on worries about the outlook, according to Chris Williamson, chief business economist at IHS Markit. Weaker gains in new export orders were seen in Germany, Italy, and Spain.

(2) Economic sentiment. August’s Economic Sentiment Index (ESI) for the Eurozone fell for the eighth time this year during August, sinking from December’s 17-year high of 115.2 to 111.6, its lowest level in a year (Fig. 15). This index closely tracks y/y real GDP growth in the region, which rose 2.2% in Q2, down from 2.5% in Q1, and 2.8% in the previous two quarters.

(3) UK indicators. The bungled Brexit strategy is weighing heavily on the outlook for business in the UK, with sentiment sinking to a 22-month low, according to the 9/3 IHS Markit/CIPS survey of manufacturers.

While manufacturing continued to expand in the UK in August, the reading of 52.8 was the lowest registered in 25 months (Fig. 16). Job creation was practically nil in the sector as job cuts at big companies offset gains at smaller companies. Manufacturing production rose at the slowest pace in 17 months on weak new order flows. Despite weakness in the pound, foreign demand decreased for the first time since April 2016 (Fig. 17).

The latest PMI report suggests the manufacturing sector is unlikely to provide any meaningful support to the broader UK economy in Q3, according to Ron Dobson, director at IHS Markit.

As they say in HBO’s Game of Thrones, “Winter is coming.”

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A Sustainable Meltup?

September 04, 2018 (Tuesday)

Strategy I: Diary of a Meltup. Now that the major US stock market indexes are back in record-high territory, I am starting to get more questions from our accounts along this line: “Is the meltup you’ve been expecting happening now?” The short answer is “Yes.”

The problem with the term “meltup” is that it suggests the runup in stock prices is speculative, thus raising the odds of a meltdown. However, it’s important to note that the meltup in stocks may be more sustainable because it is based on a meltup in earnings, as I discuss below.

I started writing about a potential meltup in the stock market in early 2013. I did so because the widely feared “fiscal cliff” at the end of 2012 was averted on New Year’s Day 2013. I concluded that there was “nothing to fear but nothing to fear.” The S&P 500 fell 7.7% in late 2012 on fiscal cliff fears, but still managed to gain 13.4% for the year (Fig. 1). It proceeded to gain 29.6% during 2013 on a big relief rally (Fig. 2).

An 11/9/13 Barron’s interview with me was titled “Lifting the Odds for a Market Melt-Up.” I said:

“I have met a lot of institutional investors I call ‘fully invested bears’ who all agree this is going to end badly. Now, they are a bit more relaxed, thinking it won’t end badly anytime soon. Investors have anxiety fatigue. I think it’s because we didn’t go over the fiscal cliff. … Investors have learned that any time you get a selloff, you want to be a buyer. The trick to this bull market has been to avoid getting thrown off.”

I also said: “Since the beginning of the year, I’ve been forecasting 60% probability of a rational exuberance scenario, 30% melt-up, and 10% meltdown. I’m still there, but I’m wavering and leaning toward the melt-up.”

The S&P 500 rose only 11.4% during 2014 and was relatively flat in 2015 as a result of a meltdown in commodity prices, particularly the price of a barrel of Brent crude oil, which plunged 76% from the summer of 2014 through the start of 2016. There was a 13.3% correction in the S&P 500 from November 3, 2015 through February 11, 2016.

It’s been mostly a meltup since that low in early 2016, with the S&P 500 up 58.6% through Friday’s close. The index is up 35.6% since Election Day, November 8, 2016.

The 12/9/17 Barron’s included an article titled “Outlook 2018: The Bull Market’s Next Act.” I was one of the 11 investment strategists surveyed by the author, Vito J. Racanelli. He wrote: “Edward Yardeni, President of Yardeni Research, is no stranger to Wall Street but a newcomer to our panel—and its most exuberant bull. He sees the S&P 500 ending next year at 3100, which would reflect a gain of about 17% from current levels.”

It sure seemed like a meltup was under way as the S&P 500 soared 9.3% from its low at the start of December 2017 through its new record high of 2872.87 on January 26. From that peak, the S&P 500 plunged 10.2% in 13 days through February 8. Since then, it is up 12.4% through Friday and only 6.8% from my year-end target of 3100. I suppose we have nothing to fear but a trade war and an emerging markets crisis. Strong earnings should continue to help us overcome those fears. The trade war will be resolved in a bullish fashion, in my opinion. Emerging market crises come and go.

Strategy II: Profits Meltup. The word “meltdown” originated with the invention of nuclear power reactors, referring to the accidental melting of the core of a reactor. The term has been widely used in the financial community to describe a precipitous and disastrous decline in an asset price. So it makes sense to describe a rapid increase in an asset’s price as a “meltup.” The implication, though, is that the price is rising faster than justified by the fundamentals, setting it up for a meltdown.

A price meltup that is justified by the fundamentals isn’t likely to be followed by a meltdown as long as the fundamentals hold their ground or get even stronger. This accurately describes the current situation in the stock market, in my opinion. Stocks are soaring because profits are doing the same. Consider the following:

(1) S&P 500 operating earnings in aggregate jumped 25.5% y/y during Q2-2018 to an all-time record high of $1.3 trillion (at an annual rate) (Fig. 3). The series was up 5.4% q/q, suggesting that the strong performance in after-tax profits isn’t attributable only to Trump’s cut in the corporate tax rate at the end of last year.

The Bureau of Economic Analysis (BEA) computes “book profits,” an after-tax series based on tax returns. It rose 6.7% y/y to a record $1.97 trillion (saar). Much more impressive is the 16.1% gain in after-tax profits from current production, which eliminates gains and losses attributable to inventory and depreciation accounting based on the Inventory Valuation Adjustment (IVA) and the Capital Consumption Adjustment (CCAdj).

(2) S&P 500 operating earnings per share (using Thomson Reuters data) jumped 25.9% y/y during Q2-2018, also to a record high of $41.03 (at a quarterly rate) (Fig. 4). S&P 500 revenues per share increased impressively over this same period by 10.4%. This implies that Trump’s tax cut might have added as much as 15 percentage points to earnings growth.

This effect can also be seen in the profit margin, which jumped from a record 10.9% during Q4-2017 (before Trump’s tax cut) to a new record high of 12.3% during Q2-2018 (Fig. 5).

(3) Cash flow received a big boost from Trump’s tax reforms, according to the BEA’s data. Corporate income taxes dropped from $351 billion during 2017 to $225 billion during H1-2018 (saar) (Fig. 6). Undistributed profits with IVA and CCAdj jumped from $533 billion during 2017 to $771 billion (saar) during H1-2018 (Fig. 7).

The bottom line is that cash flow increased significantly from $1,941 billion during 2017 to $2,531 billion during H1-2017 (Fig. 8).

Strategy III: Anatomy of a Meltup. Contributing to the bull run in the US since March 2009 have been occasional stampedes out of overseas stock markets as a result of European financial crises and troubles in various emerging market economies. That seems to be happening again this year. Consider the following:

(1) Here is the ytd performance derby of the major MSCI stock price indexes in local currencies: US (8.7%), All Country World (3.5), EMU (-1.8), Emerging Markets (-3.5), UK (-3.6), and Japan (-4.0) (Fig. 9).

(2) Here is the ytd performance derby of the major European MSCI stock price indexes in local currencies: Sweden (6.2), France (2.8), Switzerland (-3.2), UK (-3.6), Ireland (-4.0), Germany (-5.4), Spain (-7.0), Italy (-8.1), and Greece (-16.3) (Fig. 10 and Fig. 11).

(3) Here is the ytd performance derby of the major Asian Tigers and Emerging Markets MSCI stock price indexes in local currencies: Russia (9.9), India (9.2), Taiwan (5.2), Brazil (-0.6), Mexico (-1.4), Singapore (-6.1), South Korea (-6.4), Chile (-7.0), China (-9.0), and Argentina (-53.0) (Fig. 12, Fig. 13, and Fig. 14).

Strategy IV: Mr. Wonderful’s Meltup. On Friday, Kevin O’Leary (a.k.a. “Mr. Wonderful” and one of the sharks on Shark Tank) appeared on CNBC’s Halftime Report. He said that if Trump wins his trade war with China, the stock market could experience a meltup. I agree with that.

Joe and I have kept count of the number of panic attacks followed by relief rallies since the start of the bull market in early 2009. (See our S&P 500 Panic Attacks Since 2009.) Including the 13-day correction at the beginning of the year, we are up to 61. A resolution of Trump’s trade war resulting in fairer trade and less protectionism could trigger the “MAMU,” i.e., “the mother of all meltups.”

Last Thursday, the EU’s trade chief, Cecilia Malmström, said Brussels is willing to scrap tariffs on all industrial products, including cars, in its trade talks with the US! “We said that we are ready from the EU side to go to zero tariffs on all industrial goods, of course if the U.S. does the same, so it would be on a reciprocal basis,” Malmström told the European Parliament’s trade committee. “We are willing to bring down even our car tariffs down to zero … if the U.S. does the same,” she said, adding that “it would be good for us economically, and for them.”

Malmström’s comment goes beyond what was agreed to in July: The joint statement between European Commission President Jean-Claude Juncker and President Trump mentioned eliminating tariffs, non-tariff barriers, and subsidies only for “non-auto industrial goods.”

Movie. “Operation Finale” (+ +) (link) depicts the true saga of how Israeli intelligence officers captured former SS officer Adolf Eichmann in 1960 and brought him to trial in Israel. He claimed to be a patriot and overworked accountant for the Nazi regime rather than the architect of the Final Solution. He was hanged for his crimes against humanity. In 1963, Hannah Arendt published a book about the trial, Eichmann in Jerusalem: A Report on the Banality of Evil. She wrote that Eichmann declared “with great emphasis that he had lived his whole life ... according to a Kantian definition of duty.” Arendt considered this so “incomprehensible on the face of it” that it confirmed her belief that he wasn't thinking at all, just mindlessly following orders, thereby establishing his banality. She argued that moral choice remains even in a totalitarian regime.

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Full Pipelines & Killer Robots

August 30, 2018 (Thursday)

Energy: Gushers Seeking Pipelines. There can be too much of a good thing. Too much sun causes sunburn. Too many hot dogs result in a stomach ache. And too much oil production in the Permian Basin in Texas and New Mexico is overwhelming the capacity of pipelines that transport oil. The supply crush means shipping costs are rising, and that’s depressing the spot price of Permian Basin oil. It’s also leading oil companies to question the wisdom of expanding their production capacity any further until pipeline capacity catches up with supply, which could take roughly a year.

The abundance of oil does have an upside: Pipeline companies can charge higher prices to oil companies that don’t have long-term contracts. Pipelines are also scrambling to expand capacity, and that’s giving the local economy a boost beyond the region’s already robust activity. Let’s drill down into this “good” problem:

(1) Pumping all out. US oil production has soared for over a year to 10.9 million barrels/day (mbd) in June and July from 8.5 mbd in September 2016 (Fig. 1). Much of the added supply has come from oil fields in Texas and New Mexico where the technological miracle of hydraulic fracking has been extracting oil that was once trapped in the earth (Fig. 2).

Over the past two years, as companies lowered costs and figured out how to operate in a $40- to $60-a-barrel oil environment, they’ve aggressively increased the number of rigs in use. The number of US oil rigs jumped to 860 units during the week ended August 24, up from a low of 316 units in 2016 when oil prices cratered (Fig. 3 and Fig. 4).

Given this positive environment, the stalling of the rig count in recent weeks was notable. The number of US oil rigs has bounced between 858 and 869 for the last 13 weeks, according to Baker Hughes data. While that’s not catastrophic, it’s unusual given the recent strength in oil prices.

The number of oil rigs being used in the Permian Basin followed a similar pattern. The Permian, which contains the nation’s largest concentration of oil rigs, saw its rig count hit 485 last week, unchanged from earlier in the month and up only slightly from 480 in early June.

(2) Maxed out. The number of rigs may be plateauing because the pipelines that carry crude oil away from the Permian Basin are near capacity. “Nearly all crude pipes leaving the Permian were operating at full capacity last quarter, up from an average 94% capacity during the previous three months, according to East Daley Capital Advisors. The congestion is expected to worsen over the next year and a half, further depressing local crude prices,” a 7/30 WSJ article reported.

Producers selling oil in Midland, TX fetch about $16 less per barrel for their oil than West Texas Intermediate gets, according to CME Group data. Those selling in Midland receive less because of the higher oil transportation costs to ports and refiners.

As you might expect, pipeline companies are pouncing on the opportunity that bountiful oil presents, and have many projects in various stages of development. The problem: Getting the approvals to build a pipeline and then building it all takes time. In addition, President Trump’s tariffs on steel could drive up the cost of these projects.

‘“We can drill a well anywhere in the Permian in less than 30 days. … We can bring that well online within a couple of months. It takes 18 months to bring on a new pipeline. ... It’s not a quick fix,” Bernadette Johnson, vice president of market intelligence at Drillinginfo, told The Dallas Morning News, according to a 6/1 article.

Late next year, upward of 1.8 million barrels of capacity on oil pipelines running from the Permian to Corpus Christi, TX is expected to hit the market as pipelines built by Epic Midstream Holdings, Plains All American Pipeline, and a Phillips 66 and Andeavor joint venture come online, the above-mentioned WSJ article added.

“Permian oil production, according to EIA data, hit 3.2 million bbl/d in early May. Current projections call for output to continue to rise to 3.6 million bbl/d by the end of 2018, and to reach as high as 5.3 million bbl/d in 2020. On the takeaway side, current pipeline capacity available for Permian producers to transport oil out of the basin equaled 2.8 million bbl/d in 1Q 2018. Several major projects are planned and being put in service … If all of these are successfully funded and accomplished, total transportation capacity should rise to as high as 5.8 million bbl/d by the end of 2020. That will balance the supply/takeaway equation,” explained a 6/7 article on Drillinginfo.com.

Indeed, those betting on the future price of oil sold in Midland do expect capacity to come online because the discount slowly shrinks over the next year to only $4.62 by next August. Expect this good problem to crop up again, as pipeline capacity increases may be met with production increases, which will then create new capacity issues on pipelines. This cycle will undoubtedly make for a rich trading environment.

(3) A Band-Aid. In the meantime, producers have been shipping a small, but increasing, portion of oil by truck and train. The amount of chemical and petroleum products shipped by rail has jumped to 43,300 units during the final week of August from its recent low of 39,800 units during the week of November 25, 2017 (Fig. 5). (We are using a 26-week moving average of the data, which are very volatile on a weekly basis.)

However, shipping capacity via rail and truck are also strained and more costly. Increasing the amount of oil shipped by rail further would be tough because the rails are needed to bring fracking materials to the oil well sites.

“Many of the rail terminals in the Permian have in recent years been converted to supplier terminals, mostly for production materials like frac sand, and using them to transport crude would involve retrofitting and readjustments, which have yet to happen. In response to current constraints, Murex, a distribution company operating one of the few rail terminals in the Permian, has announced its plans to double its’ crude takeaway capacity to 75 thousand barrels per day starting in Q3 2018,” according to a July report by McKinsey.

The constraints in the trucking industry—primarily a lack of drivers—are being felt by many industries, not just those in the oil patch, so pipelines remain the most effective mode of transport for oil.

(4) Industry stats. The S&P 500 Oil & Gas Exploration & Production industry contains companies with operations far beyond the fields of Texas, but we thought we’d take a look nonetheless. The industry’s stock price index is up 36.3% y/y (Fig. 6). Its revenue is expected to grow 16.0% this year and 6.6% in 2019, while earnings are forecast to climb tremendously this year, as they’re coming off a small base, and 29.2% in 2019 (Fig. 7 and Fig. 8). As earnings have improved, the industry’s forward P/E has fallen to 17.5 (Fig. 9).

Meanwhile, the S&P 500 Oil & Gas Storage & Transportation stock price index has risen only 4.7% y/y (Fig. 10). The industry’s revenues are targeted to grow 5.5% this year and 8.3% in 2019, while its earnings are expected to increase 22.8% this year and 13.2% in 2019 (Fig. 11 and Fig. 12). Its forward P/E has also improved with earnings, to a recent 23.3 (Fig. 13).

Defense: Debating Killer AI Robots. A UN committee is meeting this week to discuss how to deal with autonomous weapons. Whether or not they should be allowed is a topic with strong opinions on both sides. If you want a good scare, watch this video dubbed “Slaughterbots” by Stop Autonomous Weapons, a group that—as you might have guessed—wants to ban autonomous weapons. The video portrays a world where small autonomous, flying drones easily evade capture, have cameras for facial recognition, and deploy explosives. In other words, the drones can fly, identify targeted humans, and kill their targets.

Even more disconcerting is how small armies of those drones could be harnessed. In the video, a swarm of drones is unleashed to target people in a city based on age, sex, uniform, or ethnicity. Another set of drones is unleased to attack congressmen, but on only one side of the aisle (which side, it doesn’t say). Drones attack students at a college, presumably based upon their social media posts.

A number of prominent scientists are warning about the threat of AI weapons, including Tesla CEO Elon Musk and now-deceased Stephen Hawking. “Unless we learn how to prepare for, and avoid, the potential risks, AI could be the worst event in the history of our civilization. It brings dangers, like powerful autonomous weapons, or new ways for the few to oppress the many,” said Hawking in 2017 at the Web Summit technology conference in Lisbon, CNBC reported on 11/8/17.

However, the decision to ban autonomous weapons may not be as cut and dried as the video implies. A 7/10 WSJ essay by Erik Schechter, a writer on defense and security issues, laid out the other side of the argument:

“[L]et's assume for the moment that warbots, unhampered by feelings of fear, anger or revenge, can outperform human soldiers in keeping the rate of civilian casualties low. (We'll know for sure only if such a system is developed and tested.) If the goal of international humanitarian law is to reduce noncombatant suffering in wartime, then using sharpshooting robots would be more than appropriate, it would be a moral imperative.”

Along those lines, Jeremy Rabkin and John Yoo, scholars at the American Enterprise Institute, argue in a 9/1/17 WSJ essay: “Robots won’t bring perfection to the use of force, but they can reduce mistakes, increase precision and lower overall destruction compared with their human counterparts.”

Beyond the dilemma of whether AI weapons are moral, there’s the practical problem of enforcing such a ban. Enforcement would be next to impossible because there’s no way to discern whether a shot was fired by a traditional weapon or an AI-enhanced weapon. Determining whether the shooter was a human-controlled drone or an AI-controlled drone would require capturing the drone and looking at its internal software.

“Countries already hide their nuclear-weapons programs behind claims of scientific research or energy production. The technology involved in autonomous weapons is a classic instance of ‘dual use,’ with obvious peaceful applications. The same technology that can produce a self-driving car can also drive an autonomous tank. A drone can just as easily deliver a bomb as a box from Amazon,” argue Rabkin and Yoo.

Likewise, the jump to AI weapons isn’t that much of a stretch from the capabilities that already exist in today’s weapons. Schechter notes that combat pilots currently rely on machines when they have to hit a target beyond visual range, the Captor sea mine hunts submarines on its own, and the Phalanx gun automatically shoots water-skimming missiles.

So perhaps instead of debating whether or not to ban AI weapons, we should be acknowledging that the cat already has one paw out of the bag.

By the way, do you recall the wonderful drone-based light show staged by Intel at the February 2018 Winter Olympics Opening Ceremony in PyeongChang, South Korea? Here is a video of the beautiful event. Intel set a Guinness World Record for most simultaneous airborne drones: 1,218 in total. Now imagine if the remarkable swarm were weaponized and programmed to execute a malevolent deed.

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Dancing with the Stars

August 29, 2018 (Wednesday)

The Fed I: The Yield Curve Conundrum. Fed Chairman Jerome Powell didn’t mention the flattening of the yield curve in his opening remarks at the Kansas City Fed’s annual economic symposium, held in Jackson Hole, WY last Thursday through Saturday. He has addressed this recent development before, and seems to lean toward benign neglect on the subject. Not so for others at the conference: James Bullard, president of the St. Louis Fed, said that signals such as a flattening yield curve signal should be taken “seriously,” adding that there’s no reason to challenge them now. He is not a voter on the FOMC this year, however. Cleveland Fed President Loretta Mester, who is a 2018 voter, said the indicator is “different than it has been in the past.” Consider the following:

(1) It isn’t different this time. A new Economic Letter published Monday by the Federal Reserve Bank of San Francisco (FRB-SF) warns that the flattening of the yield curve may still be a good recession indicator if it leads to an inversion of the curve (Fig. 1). In other words, this time is no different than in the past in that respect. However, the article also notes that “it is still a comfortable distance from a yield curve inversion.” The yield curve spread is commonly measured as the difference between the 10-year US Treasury bond yield and the federal funds rate. It was still well above zero at 97 bps on Monday, hovering around its lowest readings since March 17, 2008 (Fig. 2).

Bearishly inclined prognosticators are always looking for trouble, and have found more to worry about in the spread between the 10-year and 2-year Treasury yields. It was down to 18 bps on Monday, the lowest since August 2, 2007 and awfully close to zero. The 2-year yield tends to be identical to the 12-month forward federal funds future, and both currently imply that the Fed is expected to raise the federal funds rate to around 2.60% from the current 1.88% (Fig. 3).

(2) It is different this time. One obvious explanation for the flattening of the yield curve is that the Fed’s QE bond-purchasing programs reduced the supply of Treasury bonds. However, the Fed’s QE program was terminated during October 2014, and the Fed started reducing its holdings during October 2017 (Fig. 4).

As Debbie and I have observed in the past, a more likely explanation for why the 10-year US Treasury bond yield has been remarkably subdued just below 3.00% for most of this year is that comparable yields in Germany and Japan remain near zero (Fig. 5). That’s because both the ECB and BOJ continue to peg their official rates just below zero (Fig. 6).

The BOJ continues to be frustrated in its quixotic campaign of ultra-easy monetary policy, aiming to boost inflation to 2.0%. During July, the Japanese headline CPI was up only 1.0% y/y, while the core rate came in at a big fat ZERO (Fig. 7). The ECB has achieved its inflation goal with the CPI up 2.1% y/y during July, but the core rate was still only 1.1% (Fig. 8).

The ECB has a new problem that may frustrate the bank’s desire to follow the Fed’s lead in gradually normalizing monetary policy. The Italians elected yet another new government on March 4. This one has a strong anti-EU bias. Yesterday, TheStreet reported:

“Italy’s benchmark borrowing costs hit a four-and-a-half year high Tuesday as investors continued to trim government bond holdings amid concern that the country’s populist administration is on a collision course with EU officials in Brussels that echoes the worst of the region’s 2012 debt crisis.

“Italy’s Deputy Prime Minister Luigi Di Maio told the Il Fatto Quotidiano newspaper Tuesday that his government could breach the EU’s 3% deficit target next year as it spends billions more than anticipated in order to meet various election commitments. The outlay is also expected to include billions more for improvements in Italy’s road and transport infrastructure following the deadly collapse of a busy commuter bridge earlier this month that killed 43 people in the northern city of Genoa.”

As a result, the 10-year Italian government bond yield has soared from this year’s low of 1.63% on April 19 to 3.11% on Monday (Fig. 9). The spread between this yield and the comparable German one has blown out from 116 bps to 289 bps over this same period (Fig. 10). How do you say “bond vigilantes” in Italian?

The Fed II: Powell’s Path. Melissa and I spent the weekend reviewing the speeches, papers, and commentary presented at Jackson Hole. Going into the event, we had a good sense of what topics would be covered, as discussed in our 8/22 Morning Briefing.

Most widely anticipated was Jerome Powell’s first Jackson Hole speech as Fed chairman, given on 8/24 and titled “Monetary Policy in a Changing Economy.” We didn’t expect the speech to indicate any major change in his policy guidance as we had outlined it based on his 7/17 Semiannual Monetary Policy Report to the Congress. (See the C-SPAN broadcast here, including the Q&A.)

Indeed, Powell’s overriding message didn’t change much. However, there were a few subtle differences in the subtext. It seems to us that Powell has gradually become more concerned about upside risks to the US economy than the downside ones. He struck a slightly more confident tone, defending his position that gradual interest-rate increases remain appropriate. Speaking to a mostly academic audience, Powell also brought more of the technical reasoning behind his stance on monetary policy to light than before.

Let’s compare more closely what Powell has said before to points made in his latest speech:

(1) Continuing on the slow, but steady path. Once again, Powell reiterated the Committee’s consensus view that the “gradual process of normalization remains appropriate.” He said: “As the economy has strengthened, the FOMC has gradually raised the federal funds rate from its crisis-era low near zero toward more normal levels. We are also allowing our securities holdings—assets acquired to support the economy during the deep recession and the long recovery—to decline gradually as these securities are paid off.”

(2) Conservative approach is best in uncertain times. This time, however, Powell went into more depth about the conservative philosophy behind the gradual approach. Powell explained that it is especially appropriate given the uncertainty around the direction of the US economy, particularly related to longer-term structural forces “beyond the reach of monetary policy.” Powell began and ended his speech with two quotes on uncertainty. He quoted former Fed Chairman Alan Greenspan: “Uncertainty is not just an important feature of the monetary policy landscape; it is the defining characteristic of that landscape.”

Near the end of his speech, Powell referred to the literature on uncertainty, which “started with the work of William Brainard and the well-known Brainard principle, which recommends that when you are uncertain about the effects of your actions, you should move conservatively. In other words, when unsure of the potency of a medicine, start with a somewhat smaller dose.” The word “uncertainty” appeared 15 times in Powell’s speech and footnotes.

Powell explained that there are two exceptions to this rule. One is when “attempting to avoid severely adverse events.” The other is when “inflation expectations threaten to become unanchored.” Neither scenario is probable right now, according to Powell.

(3) Avoiding two major errors. On numerous previous occasions, Powell has repeated the mantra that the risks to the outlook are balanced. This time, we noticed that Powell dropped the word “balanced” when discussing the risks. However, he did continue to touch on the risks to the outlook on both sides. He stated: “[T]he two errors that the Committee is always seeking to avoid” are “moving too fast and needlessly shortening the expansion, versus moving too slowly and risking a destabilizing overheating.” He added: “Readers of the minutes of FOMC meetings and other communications will know that our discussions focus keenly on the relative salience of these risks.” Powell sees the “current path of gradually raising interest rates as the FOMC’s approach to taking seriously” both risks.

Previously, Powell has said that the Fed would accept deviations above or below the Fed’s 2.0% inflation objective if these weren’t significant or persistent. This time, we observe that Powell gave slightly more weight to the upside risk to inflation: “While inflation has recently moved up near 2 percent, we have seen no clear sign of an acceleration above 2 percent, and there does not seem to be an elevated risk of overheating.”

(4) Labor market is strong. Similarly, Powell previously focused on the improvement in labor force participation, suggesting that there may be room for the labor force to run. While he noted that the Fed continues to monitor lots of different labor force metrics in his Jackson Hole speech, he didn’t specifically mention labor force participation. Rather, Powell said: “The unemployment rate has declined steadily for almost nine years and, at 3.9 percent, is now near a 20-year low. Most people who want jobs can find them.” In context, that statement indicates to us that he thinks the labor market is pretty tight.

(5) One area of weakness. Powell’s stance on wages, however, didn’t change much. He said: “[R]eal wages, particularly for medium- and low-income workers, have grown quite slowly in recent decades.” He explained, as he has before, that “if incomes are to rise meaningfully over time,” then the economy must “break out of its low-productivity mode of the past decade or more.” In the past, Powell indicated that education and investment might solve the productivity problem. While he didn’t go there this time, he did note that monetary policy has little control over this issue.

(6) Staying in his lane. Powell hasn’t said much on fiscal or trade policy in the past, preferring to “stay in his lane.” Previously, he has said that the outcome of the recent tax changes and trade spats are difficult to predict. However, he has previously indicated that the recent tax cuts will likely be simulative; meanwhile, protectionist trade policies may not be so good for the economy.

Powell continued to say very little on either matter. He opened by saying: “As always, there are risk factors abroad and at home that, in time, could demand a different policy response, but today I will step back from these.” We translate this to mean that Powell doesn’t feel the need to change his course of action based on these outside forces right now. He did say that with “fiscal stimulus arriving, there is good reason to expect” that “strong performance will continue.”

By the way, once again, two additional important developments that Powell did not address are the yield curve, as discussed above, and the turmoil in a few emerging market economies.

The Fed III: Stargazing with Jay. During his tenure as a Fed governor, Powell seems to have become increasingly disenchanted with the ability of economic models to guide monetary policy “because the economy has been changing in ways that are difficult to detect and measure in real time.” One finding from recent Fed research that Powell highlighted during his Jackson Hole speech was that “no single, simple approach to monetary policy is likely to be appropriate across a broad range of plausible scenarios.”

Powell explained that, according to conventional thinking, “policymakers should navigate by” the following stars: u* (the natural rate of unemployment), r* (the neutral real rate of interest), and Π* (the inflation objective). For example, “the famous Taylor rule calls for setting the federal funds rate based on where inflation and unemployment stand in relation to the stars.” That is, interest rates should be set higher when inflation and unemployment are above and below their natural rates, respectively, and vice versa.

“Guiding policy by the stars in practice, however, has been quite challenging of late because our best assessments of the location of the stars have been changing significantly,” he said. Returning to the “nautical metaphor,” he said that “the FOMC has been navigating between the shoals of overheating and premature tightening with only a hazy view of what seem to be shifting navigational guides.”

In addition to the Taylor rule, Powell suggested that the Phillips curve (which posits an inverse relationship between inflation and unemployment) has flattened and that Okun’s law (the “well-known relationship between output and unemployment”) has broken down.

The Fed IV: Jackson Hole Teach-In. Leading up to Jackson Hole, Melissa and I reviewed the symposium’s key topic: market concentration—that is, the rise of so-called “superstar” firms that are dominating certain industries, which may or may not be leading to a reduction in competition. The topic is relevant for monetary policy because such market dynamics influence US macroeconomic variables including productivity, growth and inflation.

Reviewing relevant Fed research ahead of Jackson Hole, we wrote that there are two important questions to consider: First, have markets become more concentrated because of uncompetitive practices or have firms just become more efficient? Second, what are the economic ramifications of the increased market concentration? Studies conflict on the answers to both questions. We believe there’s a bit of truth in the various viewpoints, with their applicability differing by industry and company. (For more, see our 8/22 Morning Briefing linked above.)

We don’t have much more to add to our previous conclusion after reviewing all the symposium documents posted to the Kansas City Fed’s website. Nevertheless, the latest research is at the top of the minds of central bankers who attended Jackson Hole. So, let’s quickly review the bottom line of three of the relevant academic papers presented and their implications for monetary policy:

(1) “Increasing Differences between firms: Market Power and the Macro-Economy.” In his 7/29 paper, John Van Reenen of MIT’s Department of Economics and Sloan School of Management concluded that superstars in many industries have become “winner take most/all” because of efficiencies gained from technology and globalization rather than overly relaxed regulations or anti-competitive practices.

Implication for monetary policy: “[I]f the trends of increased concentration and [prices] reflect technological and globalization changes … we may expect to eventually observe higher productivity, lower prices and higher real wages.”

(2) “Understanding Weak Capital Investment: the Role of Market Concentration and Intangibles.” In their 8/10 paper, Nicolas Crouzet of Northwestern University and Janice Eberly of Northwestern University and the National Bureau of Economic Research (NBER) determined that the rise in intangible capital explains the fall in physical capital investment since 2000. Also, intangibles are associated with two of the drivers of rising market concentration: market power and productivity gains.

Implications for monetary policy: “[I]ntangible capital is less interest-sensitive and less collateralizable than physical capital, potentially weakening traditional transmission mechanisms.”

(3) “More Amazon Effects: Online Competition and Pricing Behaviors.” In his 8/10 paper, Alberto Cavallo of Harvard Business School and NBER found that because of Amazon and its influence on increases in online competition, prices change more frequently and uniformly across locations than they did a decade ago.

Implications for monetary policy: “[R]etail prices are becoming less ‘insulated’ from” nationwide shocks.”

Our takeaway: Powell’s introductory remarks were the high point of the conference.

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What If . . . ?

August 28, 2018 (Tuesday)

Video Podcast. Does the stock market have a breadth problem? The stock market rose to new record highs at the end of last week. There is some concern about the narrow breadth of the recent advance. I'm not concerned. Instead, I'm encouraged by the broad rally in Small Caps. Click here to view my short podcast.

Strategy: The Difference This Time. What if Trump’s trade war leads to less protectionism and more global prosperity? What if Trump’s deregulation of business unchains the animal spirits of businesses, especially smaller ones that arguably have been more stymied by regulations than large ones? What if jobs actually do come back to the US?

What if the pace of technological innovation is increasing, disrupting business models in ways that keep a lid on inflation and finally boost productivity? What if the growth of distressed asset funds has created a shock absorber in the capital markets, reducing the severity of credit crunches? What if Baby Boomers downsize, while Millennials remain minimalists?

I can go on, but we have enough to work with in this list of “what ifs.” So let’s explore the implications of these mostly bullish possibilities:

(1) What if Trump’s trade war leads to less protectionism and more global prosperity? I wrote about this scenario again last week in the 8/21 Morning Briefing titled “Superpower.” I observed: “Before launching his economic wars, Trump bolstered the home front’s economy with deregulation and tax cuts. He figures that strength will allow the US to win his wars without much, if any, pain at home. So far, the US stock market seems to be siding with Trump’s approach. The message from the markets seems to be: ‘What if Trump wins his trade wars and if his sanctions work?’ Investors are giving quite a bit of weight to the possibility that this all will lead to less protectionism and greater global prosperity. I agree with this prognosis.”

I observed that Trump could just as quickly deescalate as escalate his trade skirmishes with our major trading partners, depending on the progress made in negotiations. I’m convinced that our side is pushing for fairer trade with fewer trade barriers, not higher tariffs, which Trump is using as a tactical negotiating tool. I reviewed the latest developments last week, but there have been more since then.

Two days of low-level negotiations between the US and China in Washington concluded last Thursday with no concrete steps toward ending the bilateral trade war that started last month. The trade war continued its escalation on Thursday, as the US enacted punitive tariffs of 25% on $16 billion of Chinese imports (following a similar move a few weeks ago on $34 billion of such imports, to total $50 billion), an action that was immediately mirrored by China. Last week, the USTR held an unprecedented six-day public hearing ahead of further tariffs on $200 billion of Chinese goods, expected to go into effect in September. Initially proposed at 10%, the duties could be raised to as much as 25%, at Trump’s direction. The additional tariffs effectively would slap levies on half of all Chinese exports to the US, or roughly double what China imports from the US (Fig. 1).

The US and Mexico reached an agreement on Monday to enter a new trade deal, ending months of talks on a replacement for the North American Free Trade Agreement. The talks with Mexico have been focused on creating new rules for the auto industry. Details remain scant. The new trade pact will be called “The United States Mexico Trade Agreement,” Trump said when announcing the deal from the Oval Office, adding that the previous name would be scrapped. The US imported $329 billion from Mexico over the past 12 months through June (Fig. 2).

(2) What if Trump’s deregulation of business unchains the animal spirits of businesses, especially smaller ones that arguably have been more stymied by regulations than large ones? It’s impossible to measure the impact of Trump’s deregulation of business on S&P 500 earnings. Yesterday, Joe and I raised both our 2018 and 2019 S&P 500 earnings estimates by $4 per share (Fig. 3). We’ve been bullish on earnings, but they’ve been stronger than the impact implied by the cut in the corporate tax rate at the end of last year. Our guess is that deregulation, which started early last year, might very well amount to $4 per share in additional earnings.

We’ve noted that the stock prices of small corporations have been outperforming the larger ones since Trump was elected on November 8, 2016. Since then through Friday, the S&P 600 SmallCaps stock price index is up 50.3%, outpacing the 34.4% of the S&P 500 LargeCaps and 34.5% of the S&P400 MidCaps (Fig. 4). Many observers have attributed this to the fact that smaller companies are less exposed to damage from a trade war than larger ones.

Joe and I have suggested that there might be another important reason why SmallCaps are doing so well: Small companies may be getting a bigger after-tax earnings boost from Trump’s tax cuts than larger corporations that have had the means to dodge taxes better (Fig. 5).

That still begs the question of why small companies’ revenues are so strong on a relative basis, as we have noted previously (Fig. 6). Perhaps Trump’s deregulation policies benefit smaller companies more than larger ones. After all, regulations are often promoted by large companies to keep small competitors at bay. The monthly survey conducted by the National Federation of Independent Business (NFIB) shows that significantly fewer small business owners have been reporting concern about government regulation and taxes since Trump was elected (Fig. 7 and Fig. 8).

No wonder the earnings component of the NFIB survey is the highest on record since the start of the data during 1974 (Fig. 9). This series is highly correlated with the NFIB “expecting to increase employment” series, which is also at a record high.

(3) What if jobs actually do come back to the US? Since November 2016, payroll employment is up 3.9 million, including 412,000 manufacturing jobs. The unemployment rate has dropped from 4.6% back then to 3.9% during July. Trump obviously relishes taking credit for all this. It has long been my view that Washington doesn’t create jobs; companies do that, especially small ones. Washington’s policies can make it easier or harder for companies to hire. Trump’s policies are certainly helping.

In any event, the ADP payroll employment data show that small, medium, and large companies have increased their head counts by 1.0 million, 1.6 million, and 1.2 million since November 2016 (Fig. 10). The smaller ones represented in the NFIB survey are running into staffing problems. During July, a record 37% of small business owners reported having job openings (Fig. 11). At the same time, 52% reported few or no qualified applicants for their job openings.

To relieve this pressure, the best solution would be for a bipartisan congressional agreement on migration that would allow more legal immigrants to enter the US to fill job openings. Of course, of all the “what ifs,” this one is the most farfetched given the political divide in Washington. More likely is that companies will continue to reach out to able-bodied workers who have dropped out of the labor force. Even more likely is that companies will accelerate their use of technology to boost productivity.

(4) What if the pace of technological innovation is increasing, disrupting business models in ways that keep a lid on inflation and finally boosts productivity? The rebound in manufacturing employment mentioned above augurs well for manufacturing production, and possibly for productivity (Fig. 12).

Not widely recognized is that since China entered the World Trade Organization at the end of 2001, both manufacturing production and capacity in the US have been flat (Fig. 13). Obviously, lots of manufacturers moved their operations to China, and didn’t spend much on enhancing their productivity in the US. So while it is widely believed that the slow pace of productivity growth in the US is mostly attributable to the services sector, the fact is that the five-year annualized growth rate of manufacturing productivity peaked at 6.0% during Q3-2003 and plunged to zero in recent years (Fig. 14).

If Trump succeeds in bringing production back to the US, then manufacturers might be hard pressed to find enough workers and turn to boosting their productivity instead of raising their wages.

Meanwhile, the rapid pace of technological innovation continues to disrupt business models in both the manufacturing and services sectors. This is forcing all businesses to focus on innovations to remain competitive. Raising wages and prices in this highly competitive technology-driven business environment may be a sure way to fall behind.

(5) What if the growth of distressed asset funds has created a shock absorber in the capital markets, reducing the severity of credit crunches? If you blinked, you might have missed the mini-recession of 2015. It was more of a growth recession than an actual drop in business activity. The credit markets saw it coming as the credit quality yield spreads between corporate high-yield bonds and the 10-year Treasury bond soared from a low of 253 bps on June 23, 2014 to a high of 844 bps on February 11, 2016 (Fig. 15). That was attributable to the collapse in commodity prices, led by a 76% plunge in the price of a barrel of Brent.

There was an immediate credit crunch for commodity producers. But it ended remarkably quickly without turning into a contagion. The credit quality spread dropped back down to 362 bps by the end of 2016 and has fluctuated around there since then. That’s because distressed asset funds jumped in and restructured the balance sheets of distressed commodity producers by converting debt into equity. Joe calculates that just in the S&P 500 Energy sector, the share count rose from 17.2 billion during Q4-2015 to 18.3 billion during Q4-2017 (Fig. 16).

Distressed asset funds certainly acted as an important shock absorber for the credit markets during 2015. They are likely to do so again during the next credit shock.

(6) What if Baby Boomers downsize, while Millennials remain minimalists? The current economic expansion will be the longest on record next year during July. It is likely to achieve that milestone and exceed it partly as a result of demographic trends. This year, the number of singles outnumbered the number of married people for the population aged 16 years or older. The percentage of singles has risen from 37.7% during 1977 to 50.8% last month (Fig. 17).

This trend has been mostly driven by “never married” singles (Fig. 18). Many of them are Millennials who are postponing getting married if they ever do so at all. They are minimalists who aren’t big earners or spenders because they need only support themselves. The Baby Boomers were big spenders when they were getting married and having kids. They too are turning into minimalists as they trade down to smaller houses and apartments now that they are empty nesters.

These demographic trends suggest that the pace of consumer spending growth will remain lower than during the heydays of the Baby Boomers. If so, this may keep a lid on economic growth and reduce the likelihood of a boom. If there is no boom, there is less likelihood of a bust.

(7) Conclusion. Why not . . . ?

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Teamsters & the Stock Market

August 27, 2018 (Monday)

Strategy I: Record Highs for Stock Prices. I’ve posted a few short bullish articles on social media recently. The editor of MarketWatch warned me not to read the comments that are posted below my articles. So of course, that’s what I did. Some border on uncivil and even deranged, though there are also plenty of civil and thoughtful comments.

Scanning other social media discussions of the bull market, I see that there’s often a similar barrage of hostility from the bull-market haters. One of their major gripes is that the bull market has been making record highs on the backs of a few stocks. The haters also complain that the bull market isn’t based on fundamentals, but rather on too much fiscal debt and too much monetary easing.

Time for an old joke: “How many Teamsters does it take to change a light bulb?” Time’s up. The answer is: “Ten. You gotta problem with that?”

Let’s say that the bears have been right all along: The bull market has been rigged by fiscal and monetary policies. “You gotta problem with that?” If so, then you’ve been missing the greatest bull market in history or the second greatest so far, depending on how you measure it. Whether a bull market ought to have been going on, and for so long, is moot; the fact is, it has been. Investing isn’t a moral pursuit. It isn’t about good-vs-bad, but rather about bullish-vs-bearish.

Joe and I have been arguing since the beginning of the bull market that corporate earnings were driving the bull market. No one should have a problem with that. In addition, we’ve observed that corporate share buybacks also have fueled the bull’s run. That has led some bears, especially those on the political left, to complain that corporations have been spending all of their after-tax profits on buybacks and dividends. As a result, they haven’t been investing enough in their capital and labor, which has got to be bearish in the long run!

Now consider the following:

(1) Breadth. On Friday, the S&P 500/400/600 all rose to record highs, with y/y gains of 17.7%, 19.1%, and 31.9% (Fig. 1). So did the Russell 1000/2000/3000, with y/y gains of 17.9%, 25.3%, and 18.5% (Fig. 2).

As we noted last Thursday, Charles Dow must be resting in peace. While the Dow Jones Industrial Average is just 3.1% below its record high of January 26, the Dow Jones Transportation Average was at a new record high last week (Fig. 3). On the other hand, the S&P 500 Industrials Composite—which excludes Financials, Transports, and Utilities—has been rising to new record highs since July 25 and the S&P 500 Transportation Composite since last week (Fig. 4).

Meanwhile, joining the S&P 500 in record-high territory are the following three big sectors of the composite: Consumer Discretionary, Health Care, and Information Technology (Fig. 5). Among the S&P 400 sectors, Health Care, Information Technology, and Utilities have been leading the way to record highs this year (Fig. 6). The breadth among the S&P 600 sectors really stands out, with new record highs for Consumer Discretionary, Consumer Staples, Financials, Health Care, Industrials, Information Technology, Telecom Services, and Utilities all leading the way to higher ground (Fig. 7).

(2) Liquidity. The bears have been arguing since the beginning of the bull market that the bull was on a “sugar high” and “running on fumes.” Their favorite chart showed a close correlation between the S&P 500 and the Fed’s rising holdings of Treasury and mortgage securities as a result of the QE programs (Fig. 8). Sure enough, the stock index flattened out during 2015 and 2016 after the Fed terminated QE at the end of October 2014. However, even though the Fed started to taper its balance sheet last October, here we are at new record highs for the major US stock market benchmarks (Fig. 9)!

I suppose that the bears still can growl that the ECB and BOJ continue to pump liquidity into financial markets (Fig. 10). My response: “You gotta a problem with the resultant record highs we’re now making yet again?”

(3) Buybacks. Since the start of the current bull market during Q1-2009 through Q1-2018, S&P 500 corporations repurchased $4.1 trillion of their shares (Fig. 11). Over the same period, they paid $2.9 trillion in dividends. During Q1-2018, the sum of the two was a record $1.2 trillion at an annual rate, undoubtedly boosted by the repatriation of profits earned abroad. No wonder the market is at a record high.

It is true that buybacks and dividends have been about the same as after-tax operating profits for the S&P 500 in recent years (Fig. 12). However, focusing on this fact overlooks the record amount of corporate cash flow provided by depreciation allowances, which has been fueling corporate capital spending.

In any event, Joe reports that the number of S&P 500 shares outstanding is down 3.3% since Q2-2006 through Q4-2017, and down 7.7% from its post-financial crisis peak in Q1-2011 (Fig. 13).

Strategy II: Record Highs for Earnings. Of course, the major drivers of the bull market have been forward revenues and earnings, which are at record highs for the S&P 500/400/600 (Fig. 14 and Fig. 15). Weekly forward revenues tend to be coincident indicators of actual quarterly data, while weekly forward earnings tend to lead the actual results (Fig. 16).

For the S&P 500, forward earnings per share rose to record $172.95 during the 8/23 week (Fig. 17). Industry analysts are expecting a record $178.68 next year. Of course, Trump’s tax cuts at the end of last year provided a HUGE boost to earnings this year, which are on track to soar by 23% this year (Fig. 18).

Joe and I don’t have a problem with any of that. The S&P 500 only needs to rise by 7.8% over the rest of the year to get to our 3100 target (Fig. 19). A forward P/E multiple of 18.0 times the latest reading for forward earnings would get us there; so would a 17.4 P/E on next year’s consensus expected earnings.

Strategy III: Raising Earnings Forecasts. In appreciation of the bull market’s latest achievement, Joe and I are raising our S&P 500 earnings-per-share forecasts for this year by $4 from $158 to $162, and for next year by $4 from $169 to $173 (Fig. 20).

This move reflects the strong results during the first half of this year, which certainly were bolstered by the cut in the corporate tax rate at the end of last year. However, something is also boosting organic earnings growth. It might be Trump’s business deregulation. It might also be that the tax cuts for consumers are boosting business revenues. Moreover, there’s not much evidence, so far, that the strong dollar and the escalating trade war are weighing on profits. (See YRI S&P 500 Earnings Forecasts.)

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Trucks & Batteries

August 23, 2018 (Thursday)

Transportation: Flying Higher. Investors who are getting jittery about the S&P 500’s record levels on Tuesday can take some solace in the strong performance of the Dow Jones Transportation Average (DJTA), which also hit a new high on Tuesday. When the companies that are moving stuff are doing well, it’s often a confirming signal of health for the broader economy. Now if the Dow Jones Industrial Average (DJIA) would just rise another 3.1% and take out the 26616.71 high it hit on January 26, even the spirit of Charles Dow would rejoice (Fig. 1).

Over the past year through Tuesday’s close, the DJTA has risen 24.3%, outperforming both the DJIA, up 17.9%, and the S&P 500, up 16.7%. Much of the credit goes to the railroads, which have had stellar results. Railcar loadings excluding coal are at record highs (Fig. 2). And the shares of CSX, Norfolk Southern, and Union Pacific have each appreciated more than 40% over the past year.

The volume of goods being moved around by trucks is also off the charts, thanks to the strong economy and the continued move toward Internet shopping (Fig. 3). This multi-year surge in activity has led to capacity constraints in rails and trucking, which have boosted cargo rates in land-based shipping. The PPI for truck transportation of freight is up 8.2% y/y through July (Fig. 4).

“Freight rates have been climbing in recent months, making it harder and more costly for shippers to book transportation at a time of year when demand is typically lighter. U.S. trucking and rail-freight spending rose 17.3% in May compared with the same month in 2017, according to the Cass Information Systems Inc.,” a 6/17 WSJ article reported. Companies have complained about the jump in shipping rates in their conference calls, and they’re looking for ways to ameliorate the situation.

Conversely, there’s still overcapacity in the market for shipping products via sea. Excess shipping capacity has pushed down freight rates, encouraged mergers, and caused ship owners to scrap vessels. A global trade war would only add to the shipping industry’s list of woes. Economically, however, all looks well, as the activity at US West Coast ports remains at all-time highs (Fig. 5).

In a nod to Charles Dow, let’s take a look at some of the fundamentals in the largest transportation industries:

(1) Riding the rails. The S&P 500 Railroad industry is expected to increase revenue by 6.9% this year and 4.4% in 2019. Strong revenue growth plus corporate tax-rate cuts are expected to result in 38.9% earnings growth this year and 12.2% earnings growth in 2019 (Fig. 6 and Fig. 7). The Railroad industry’s forward P/E, at 17.9 as of August 16, is at the high end of the range in which it has traded since 1995 (Fig. 8).

(2) Trucking along. The S&P 500 Trucking industry stock price index has gained 27.3% y/y, a move that appears to be supported by fundamentals (Fig. 9). Revenue in the S&P 500 Trucking industry is expected to jump 19.5% this year and 10.6% in 2019 (Fig. 10). Earnings are expected to soar 51.3% this year and 18.0% next year (Fig. 11). Here too, the industry’s forward P/E appears to be stretched at 20.0 (Fig. 12).

(3) Recovering from turbulence. Airline industry stocks haven’t fared quite as well, tethered by investor concern about added capacity and high oil prices. But they have rallied in recent weeks as the price of oil has backed off, leaving the S&P 500 Airline industry stock price index up 11.3% y/y (Fig. 13).

Analysts are forecasting good, but more subdued, results out of the S&P 500 Airline industry, with revenue expected to increase 6.4% this year and 5.2% in 2019 (Fig. 14). The industry’s earnings are forecast to grow 7.4% in 2018 and 21.4% next year (Fig. 15). Airlines have among the more reasonable forward P/Es among the transport industries, at 9.5 (Fig. 16).

Technology: Building Better Batteries. Speculation surrounding Tesla and Elon Musk has filled newspaper headlines for days. Will the company go private or will it stay public? Did Musk’s tweets break SEC rules? Will he give up his tweeting habit? Unfortunately, this is all a distraction for what’s arguably one of the country’s most important companies.

Tesla’s ability to produce industry-leading batteries for both automobiles and electricity storage is important if the US hopes to maintain its auto industry market share. China and a number of other countries are aggressively pushing consumers toward the use of electric vehicles (EVs) and away from the gas-powered cars. And the companies or countries that develop the best batteries are going to win the race.

“China is developing its own plan to eventually ban sales of new combustion-engine vehicles; it’s already established ambitious quotas for the production of electric vehicles and hybrids. BNEF forecasts that these and other policies will push electric-vehicle sales in China to 2.5 million in 2020, up from nearly 800,000 last year, quadrupling battery demand,” according to a 6/13 article in MIT Review.

Other countries already have taken that major step. Norway will ban the sale of new gas- and diesel-powered cars by 2025, India by 2030, Scotland by 2032, and France and the UK by 2040. Last year, roughly a third of Norway’s cars were either electric or plug-in models, followed by Hong Kong’s just over 20%.

US electric vehicle sales last year were well below 5% of new car sales, or almost 200,000 cars. That said, EV sales are growing fast, up 25% y/y last year, when overall auto sales were down, according to a 1/4 article in ARS Technica.

The key to dominating the electronic vehicle market is coming up with the most powerful, safest, least expensive battery. Let’s take a look at some of the recent advancements in the battery industry:

(1) Battery 101. A battery has an anode, or a negative electrode, made out of graphite, which stores lithium ions when a battery is charged. As the ions move to the cathode, the battery’s energy gets used. In between the anode and cathode is an electrolyte solution.

To increase the power of lithium-ion batteries, scientists have experimented with the materials used. “Most of the improvements in battery life so far have been made by manufacturers creating cathodes out of some combination of nickel, manganese, and cobalt. The crystal structures of these metals, when combined together, store lithium ions more efficiently. They also make the ions’ movement through the cathode to the anode easier than other materials. All the while, however, anodes have basically all been made with the same material: graphite, a form of carbon,” explains an 8/16 article in Quartz.

(2) Enter silicon. Sila Nanotechnologies is a private company with a CEO, Gene Berdichevsky, who hails from Tesla. Sila aims to use silicon as an anode material because “it can bond with 25 times more lithium ions than graphite,” a 4/11 article in MIT Technology Review explained.

Silicon hasn’t been used in the past because the lithium ions make it swell and “crumble during charging.” But Sila believes it has come up with a rigid silicon that overcomes that problem. Sila believes its battery can improve upon the energy density of current batteries by 20% and will ultimately produce a 40% improvement.

Sila expects to see its battery materials in consumer products next year and to be in some of BMW’s electric cars by 2023. Companies including Enovix and Enevate are also developing batteries that use silicon in anodes.

(2) The Holy Grail. Another way to increase the power of the battery is to replace the liquid electrolyte inside a battery with solids. Henrik Fisker, founder of an electric car startup that went bankrupt, claims to have created a solid-state battery.

Fisker says his battery uses thin-film technology used in making solar cells inside of each solid-state battery, according to an 8/19 article in CleanTechnica. As a result, the battery has 27 times more surface area than conventional cells, twice as much energy density as a conventional battery, and is much longer lasting. He has put this battery in his new car, the Fisker Emotion, which he claims can recharge in just nine minutes.

Another company, Ionic Materials, has created a polymer to replace the electrolyte, according to a 5/29 article in IEEE Spectrum. The polymer can conduct lithium ions at room temperature, and the material is low cost, flexible, and durable. It’s hoped that the new material will make batteries less prone to fires and more powerful. It’s also hoped that it will enable batteries to be made of materials besides cobalt.

The US government is pushing scientists to develop batteries that use little or no cobalt, which is an increasingly expensive metal mostly found in the Democratic Republic of the Congo, where activists say workers often “toil in inhumane conditions,” an 8/19 article in Axios explains.

The Department of Energy is funding three-year research efforts to reduce the use of cobalt in batteries at Argonne National Laboratory and Lawrence Berkeley National Laboratory. Argonne scientists are attempting to swap cobalt with nickel or manganese, and at Berkeley scientists are experimenting with using disordered rock salt.

(3) Chinese look to grow. According to many accounts, China aims to be the Detroit of the electric vehicle industry. China’s financial incentives to buyers of electric vehicles in 2016 and 2017 may have totaled 83 billion yuan, according to a 2/1 article in Bloomberg Businessweek. But there’s a catch: “Carmakers seeking to qualify (for subsidies) choose domestic battery suppliers because of concerns that models built with foreign brands will be ineligible, even thought there isn’t a written rule banning non-Chinese suppliers,” the article states.

Earlier this year, China announced plans to refocus its subsidies. It raised the minimum distance that a car must run on a single charge in order to qualify for a subsidy to 150 kilometers, up from 100 kilometers. Those cars that can run for more than 400 km saw their subsidies increased. BYD Co. warned investors to expect a drop in Q1 profit, which it attributed to the reduction in subsidies.

The country long has said that its subsidies will decrease each year until they end in 2020. China will introduce a quota program next year that “will mandate that all automakers will have to ensure that a certain percentage of their output is composed of new-energy vehicles,” a 7/12 Caixin article reported.

China also has been ensuring that it has access to the materials needed to make batteries. The above Bloomberg Businessweek article continued: “China is securing supplies of key materials such as lithium, nickel and rare earths, and its mining companies are estimated to be responsible for 62 percent of the global supply of cobalt, the Cleveland-based Institute for Energy Economics and Financial Analysis said in a January report.”

Amid this supportive government backdrop, Chinese companies are rapidly expanding battery production. Chinese company Contemporary Amperex Technology (CATL) did an $850.6 million IPO in June that soared 44% on its debut, making it one of the highest-valued companies on the ChiNex stock exchange. CATL was expected to use the proceeds to help fund its 24 gigawatt-hour capacity increase, bringing the company’s total capacity to 88 gigawatt hours by 2020.

That will make it larger than Tesla’s US Gigafactory, which has capacity for 35 GWh. However, Tesla is also planning to build a plant in China. Chinese company BYD, in which Berkshire Hathaway is an investor, is also planning to build a battery factory next year, with annual capacity of 24 gigawatt-hours by 2019. That would bring the company’s total battery-making capacity to 48 GWh in 2019 and 60 GWh in 2020.

“Lithium battery production in China rose 31 percent last year to hit 1.18 billion units. However, experts have warned of the risks of overcapacity, with 102 firms now producing as many as 335 types of electric, hybrid and fuel cell vehicles throughout the country,” a 6/10 Reuters article reported.

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Superstars

August 22, 2018 (Wednesday)

Fed I: Jackson Hole. On Thursday and Friday, prominent central bankers, finance ministers, academics, and members of the media will gather in Jackson Hole, WY for the 2018 Economic Symposium—a.k.a. simply “Jackson Hole.” The annual event, hosted by the Kansas City Fed since 1978, focuses on a single economic issue with significant importance to the US and global economies. Jackson Hole is close to Grand Teton National Park and Yellowstone National Park.

Despite the resort-like atmosphere, the Jackson Hole topics of focus are heavily academic and comprehensively examined via papers, panel discussions, and presentations. This year’s topic is “Changing Market Structure and Implications for Monetary Policy.” A News Release issued by the Kansas Fed last Friday provided this high-level overview: “This year’s symposium topic will explore dynamics that have contributed to shifts in productivity, growth and inflation that are of concern to central bankers.” It added that understanding the market dynamics behind these shifts is “vital for policymakers as they seek to promote conditions that can best foster long-run sustainable growth with stable prices.”

We won’t know the specific talking points to be covered until the 2018 program is available on the Kansas City Fed’s website when the event opens on Thursday at 6:00 p.m. MT (8:00 p.m. EST). Papers presented will be posted to the website as delivered, and a list of attendees will be available after the event. (Here’s last year’s participant roster.) Meanwhile, it’s worth reading the Kansas City Fed’s depiction of the three key areas in focus from the News Release:

(1) Multinationals & market concentration. “Within product markets, there has been a notable increase in economic activity associated with large multinational corporations along with increased market concentration in many industries. These developments suggest that large firms today may have greater market power than in the past, and this shift may result in a decrease in competition within many industries. These shifts should concern central bankers since they likely have important linkages to observed structural changes in the global economy, including lower capital investment, a declining labor share, slow productivity growth, slow wage growth and declining dynamism.”

(2) Online retailers & technology. “The marketplace for consumers also has seen rapid changes due to advances in technology along with changes in consumer behavior. New markets are emerging online as traditional retailers struggle to adapt. This shift may be altering pricing behavior of firms in an increasingly global marketplace. In particular, it may limit the ability of firms to raise prices in response to rising demand which may affect deviations from the law of one price. As pricing behavior evolves, inflation dynamics will also evolve, suggesting that the monetary policy transmission mechanism within and between countries may change as well.”

(3) Banking markets & bank regulation. “Finally, the marketplace for the banking industry has also changed, leading to an increased focus on financial stability in the aftermath of the financial crisis that has raised questions about potentially competing trade-offs between competition, efficiency and stability. Disentangling these potential tradeoffs requires an improved understanding of the relationship between competition and bank risk. Analysis of changes in banking markets and bank regulation across countries before and after the financial crisis can provide valuable insights for regulatory policy makers and central bankers concerned about the monetary transmission mechanism.”

Fed II: Markets Too Concentrated? Rising market concentration may help explain the recent productivity slowdown and slow wage growth, observed the cover story of the Richmond Fed’s Q1 Econ Focus publication. The article—titled “Are Markets Too Concentrated?,” by Tim Sablik—reviews the relevant literature without offering a concrete answer or solutions. Melissa and I wouldn’t be surprised to find this article and its references vetted at Jackson Hole given the symposium’s focus on market dynamics, which the News Release emphasized as important to understand.

The article centers primary around two questions: 1) Have markets become more concentrated because of uncompetitive practices or have firms just become more efficient? 2) What are the economic ramifications of the increased market concentration? Studies conflict on the answers to both questions, the article suggests; we suspect there’s a bit of truth in the various viewpoints, with their applicability differing by industry and company. With market concentration on the minds of central bankers right now, let’s review the main points of the Richmond Fed story:

(1) Efficiency or market power? There are two schools of thought on market concentration. One originated in the 1950s from University of California, Berkeley economist Joe Bain. Bain reasoned that as market concentration rises, surviving firms would collude to reduce competition and increase prices. On the other hand, during the 1970s, economists from the University of Chicago noted that concentration might rise simply as more efficient firms outperform their rivals, increasing their market shares.

(2) Superstar firms. A 2017 study published in the American Economic Review found that the industries that have become the most concentrated in recent decades have also been the most productive. “Superstar firms,” more efficient than their competitors, are behind the increase in market concentration.

Sablik notes that 90% of all search traffic is sourced from Google. And Google and Apple produce the operating systems that run on nearly 99% of all smartphones. Four companies—Verizon, AT&T, Sprint, and T-Mobile—provide 94% of U.S. wireless services. And the five largest banks in the US control nearly half of all bank assets in the country.

The tech sector is a prime example of where “superstar” firms have gained market share. Some economists worry that the rise in “one-stop shops” may “limit the ability of new firms to contest the market share of incumbents.” Exhibiting this trend, market entry rates for new firms have fallen in recent years.

(3) Market power & wages. Academics seem to agree that rising market power has probably suppressed wages. The question is whether that’s a result of collusion or not. On the one hand, “firms might collude to reduce competition for workers and thus pay lower wages.” In 2010, for example, “the Department of Justice investigated claims that Apple, Google, Intel, Intuit, Pixar, and Adobe had entered into agreements not to poach each other’s employees, suppressing competition for tech workers. The firms agreed to end the practice as part of a settlement.” On the other hand, “superstar” firms may rely on fewer workers due to the firms’ higher productivity.

(4) Market power & innovation. “Policymakers at the Fed are also interested in the long-term growth potential of the economy, and some economists have argued that rising concentration may have a negative effect on innovation.” One school of thought suggests that “creative destruction” drives productivity growth via competition from innovative new entrants. Another suggests that innovation and productivity gains largely come from incumbent firms that are improving themselves rather than from startups.

(5) No easy solutions. If indeed rising market concentration is having such negative effects, what to do about it? The story concludes with a quote from MIT economist Richard Schmalensee, an expert on the industrial organization of platforms: “You worry about a firm that has market power, ceases to innovate, and just charges high prices. But competition sometimes has winners, and one of the worst things you can do as a policymaker is pick on the winners.”

Fed III: Powell’s Upcoming Speech—Déjà Vu? Jackson Hole presenters tend not to give tactical guidance on the outlook for monetary policy. No major announcements have come out of the event since Bernanke’s speech at Jackson Hole in 2010. That won’t stop investors from tuning in for clues on where Fed policy is headed next. In particular, Jerome Powell will be widely watched on Friday at 10:00 a.m. EST as he delivers his first Jackson Hole speech as Fed chairman, which will be about “monetary policy in a changing economy.”

Melissa and I suspect that Powell will be singing the same song that he has been singing since he became Fed chairman in February, but we’ll be listening closely for any changes in his tune and lyrics. As a baseline for Powell’s perspective, let’s revisit his 7/17 Semiannual Monetary Policy Report to the Congress. As we discussed in our 7/19 Morning Briefing, Powell continued to characterize the risks to the economic outlook as remaining balanced on the upside and downside—suggesting that the Fed will continue to gradually raise interest rates “for now.”

Recently, the phrase “for now” has received lots of attention in media reports speculating about Powell’s likely messaging at Jackson Hole. Their consensus seems to be that “for now” means that the Fed isn’t on autopilot and may move to tighten monetary policy faster (or slower) than gradual if necessary.

We don’t think “for now” is worth harping on because the point isn’t anything new. Since the Fed started to normalize monetary policy under Janet Yellen, Powell’s predecessor, Fed officials have emphasized that they will set policy based on incoming data. That’s a longer way of saying that they’ll stay the course “for now.” Investors will also be listening for clues on possible changes to the timing and scope of the Fed’s balance-sheet reduction, which Powell has previously suggested won’t be of any consequence for markets.

In any event, below we repeat 10 quotes from Powell’s testimony, which represent points he’s made before:

(1) Continuing to gradually increase rates. “With a strong job market, inflation close to our objective, and the risks to the outlook roughly balanced, the FOMC believes that—for now—the best way forward is to keep gradually raising the federal funds rate.”

(2) Risks to the outlook are balanced. “Overall, we see the risk of the economy unexpectedly weakening as roughly balanced with the possibility of the economy growing faster than we currently anticipate” (Fig. 1 and Fig. 2).

(3) Inflation objective is symmetric. “Many factors affect inflation—some temporary and others longer lasting. Inflation will at times be above 2 percent and at other times below. We say that the 2 percent objective is ‘symmetric’ because the FOMC would be concerned if inflation were running persistently above or below our 2 percent objective” (Fig. 3).

(4) Low productivity explains low wage growth. “Over a long period of time, wages can’t go up sustainably without productivity also increasing. It’s a different thing to say that higher productivity guarantees our wages. … I don’t think that’s true” (Fig. 4).

(5) Education & investment may solve low productivity. “Part of [the productivity problem] is … stagnation of educational achievement. … It’s also partly evolution of technology and investment. I think … we had a number of years of very weak investment after the crisis because there was no need to invest.”

(6) Labor force participation is improving. “So prime age labor force participation … has been climbing here in the last couple of years. That’s a very healthy sign. Because prime age labor force participation [has] been weak in the United States compared to other countries. So it’s very troubling, and the fact that that’s coming back up … is a very positive thing” (Fig. 5).

(7) Staying in his lane. “I’m firmly committed to staying in our lane, and our lane is the economy. Trade is really the business of Congress. And Congress has delegated some of that to the Executive Branch.”

(8) Tax & trade difficult to predict. “It is difficult to predict the ultimate outcome of current discussions over trade policy as well as the size and timing of the economic effects of the recent changes in fiscal policy.”

(9) Open trade policy is good. “[C]ountries that have remained open to trade—that haven’t erected barriers, including tariffs—have grown faster, had higher incomes, higher productivity, and countries that have … gone in a more protectionist direction have done worse. I think that’s the empirical result.”

(10) Fiscal policy outcome in a range. “[L]ate in the cycle near full employment, the effects may be less. They may or may not be. There’s a lot of uncertainty. One of the great things about the Fed is we get a healthy range of things, which is a healthy thing.”

See the C-SPAN link here for the full transcript of Powell’s 7/17 testimony.

By the way, two important developments that Powell didn’t focus on during his testimony are the potential for yield curve inversion and emerging markets turmoil. That may be because he isn’t too concerned about either of them “for now.” The Fed’s policies may play a hand in the outcome of both of these potentially troubling issues.

If the Fed raises rates too quickly, then the yield curve may invert with short-term interest rates rising above long-term interest rates, which has historically signaled a recession (Fig. 6). Powell isn’t too worried about that, he said in his 6/13 press conference, because that’s what happens when the Fed raises the short end of the curve. However, he’s unsure about what’s keeping a lid on longer-term yields.

Separately, the IMF has been warning for a while that if the Fed raises rates too quickly, emerging market economies (EMEs) may suffer mainly because they carry a lot of dollar-denominated debt, which could become more difficult to service. Further, as US interest rates rise, there could be greater demand for US fixed-income assets and a flow away from EMEs, all else being equal. Some observers say that, on balance, EMEs will be able to handle a gradual rise in US interest rates; others disagree. Powell shares the view of those who believe the concern over EMEs is probably overstated, as he discussed in a 5/8 speech.

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Superpower

August 21, 2018 (Tuesday)

Geopolitics I: Trump’s World Order. President Donald Trump is great for the news business. His daily firestorms of Tweets immediately generate firestorms of news reports, which are overwhelmingly editorial in nature. On a regular basis, I drive from my home office on Long Island to visit our accounts in NYC. Along the way, while grinning and bearing the traffic on the Long Island Expressway, I listen to the news on SiriusXM. I flip between CNBC, Bloomberg, CNN, and Fox. The latter two seem to reside on different planets when it comes to reporting about Trump, which they do on a 24x7 basis these days.

The cacophony is so bad that I’ve started to watch Blue Planet after the evening news for a little bit of rest from the noise. It’s a wonderful series of BBC nature documentaries narrated by David Attenborough.

There is nothing natural in the political world these days. Trump is the Great Disruptor when it comes to the business-as-usual approach in Washington, DC. He has single-handedly upended the old order, not only at home but also on a geopolitical basis.

I have often observed that there is method in Trump’s madness. He clearly believes strongly in his “America First” campaign. The flip side of that view is that Trump sees global governmental organizations as threats to America First. These include NATO, the UN, and the World Trade Organization. He prefers bilateral deals to multilateral ones.

Trump firmly ascribes to the old British adage: “Nations have no permanent friends and no permanent enemies, only permanent interests.” In pursuit of those interests, as he perceives them, Trump is flexing America’s economic power all over the world. He has done so at an accelerating pace so far this year. First came threats to impose tariffs on imports, which were implemented. They have been followed by numerous more threats. More recently, Trump’s might-is-right approach has led to sanctions against North Korea, Iran, Turkey, and Russia.

Before launching his economic wars, Trump bolstered the home front’s economy with deregulation and tax cuts. He figures that strength will allow the US to win his wars without much, if any, pain at home.

So far, the US stock market seems to be siding with Trump’s approach. The message from the markets seems to be: “What if Trump wins his trade wars and if his sanctions work?” Investors are giving quite a bit of weight to the possibility that this all will lead to less protectionism and greater global prosperity. I agree with this prognosis.

Geopolitics II: Free & Fair Trade. One of the main themes of my book, Predicting the Markets: A Professional Autobiography, is that I am an investment strategist, not a preacher. I don’t do good or bad. I do bullish or bearish. As a conservative-leaning fellow, that approach helped me to stay bullish during the bull market under the Obama administration from 2009-2016 (Fig. 1 and Fig. 2). During those eight years, the Fed’s ultra-easy monetary policies were much more important and bullish for stocks than were the policies coming out of the White House (Fig. 3 and Fig. 4).

When Donald Trump won the presidential race on November 8, 2016, I remained bullish. Prior to his surprise win, Joe and I argued that the global economy was showing signs of recovering from the 2015 energy-led mini-recession. We figured that no matter who won, the strong recovery in earnings would push stock prices higher. After Trump won, I began to monitor the remarkable rebound in animal spirits, as evidenced by numerous surveys of business and consumer confidence. I argued that Trump’s pledge to deregulate business and cut taxes would be bullish for stocks.

Everything remained on that bullish track as Trump followed through with deregulation and a package of tax cuts, which was enacted late last year. Stocks soared to new record highs through January 26 of this year, when the S&P 500 peaked at 2872.87. Then Trump started a trade war with our major trading partners. In my book, I opined:

“Donald Trump’s election as the 45th President of the United States on November 8, 2016 posed potential new challenges to globalization, given his campaign promises suggesting a more anti-trade stance for the incoming administration. While it is too soon to tell, Trump seems to be advocating free-trade agreements on a more bilateral basis than the multilateral approach that emerged after World War II. If so, that alternative approach might actually blunt the forces of protectionism.”

I noted that a similar outbreak of protectionist sentiments occurred under President Ronald Reagan. The Reagan administration imposed “voluntary restraints” on Japanese exports of autos to the US. During April 1987, Reagan placated the chorus of protectionists with a 100% tariff placed on selected Japanese electronics products. I reiterated:

“[Trump’s] policies could pose a threat to global trade. However, the threat level seems more like what it was during the Reagan years than the debacle of the Hoover administration. Reagan succeeded in promoting fairer trade and bringing back lots of jobs in the auto industry as foreign manufacturers moved some of their production facilities to the United States. Trump might also succeed in forcing some of America’s trading partners to eliminate unfair trade practices. His approach is bilateral rather than multilateral, which is a different approach to negotiating free trade deals than the one that has prevailed since World War II. That’s alright by me as long as the result is free trade. All the better if it is also fair trade.”

Here is a brief review of the status of Trump’s trade war:

(1) China. The resumption of trade talks between Beijing and Washington begins sometime before the end of this month. It will be the first meeting between the two sides since June 3. So far, the US has slapped a 10% tariff on $34 billion of Chinese imports, and threatened to slap a 25% tariff on all Chinese imports. China is not winning the trade war according to the China MSCI stock price index, which is down 11.9% ytd in yuan (12.2% in US dollars) through Friday (Fig. 5). Over this same period, the US MSCI is up 6.8%. The Chinese index is highly correlated with the price of copper, which is down 20.3% since June 8. (For more, see our 8/15 Morning Briefing titled “Trump vs Xi: Tiger vs Dragon?”)

(2) NAFTA. Yesterday, CNBC reported: “Trump economic advisor Kevin Hassett told CNBC on Monday that Canada is going to want in on the trade deal that U.S. negotiators are on the verge of crafting with Mexico. ‘We're even closer’ to reaching a trade deal with Mexico after Mexican negotiators were in Washington for most of last week, the chairman of the Council of Economic Advisors said. Canada has not been part of the most recent talks to rework the 24-year-old North American Free Trade Agreement, which were expected to continue this week. … On Friday, Mexico's economic minister said outstanding bilateral issues with the U.S. could be resolved midweek, adding that Canada could then rejoin negotiations.”

The Mexican peso has been holding up remarkably well all year despite concerns that a new government would be more left-leaning and less likely to work out a deal with Trump (Fig. 6). We covered this subject in a story titled “Mexico: Let’s Be Neighborly” in the 7/23 Morning Briefing. Andres Manuel Lopez Obrador’s (a.k.a. “AMLO”) won a landslide victory in Mexico’s July 1 presidential election. We wrote:

“So far, President-elect AMLO is proving to be more conciliatory than candidate AMLO. Since the election, AMLO and his cabinet members have sought to reassure financial markets that his administration will exercise fiscal discipline, maintain the autonomy of the central bank, and honor government contracts. Also, his administration will support continued talks to renegotiate the North American Free Trade Agreement (NAFTA).”

(3) Europe. The 7/25 NYT reported: “The United States and the European Union stepped back from the brink of a trade war on Wednesday, after President Trump said the Europeans agreed to work toward lower tariffs and other trade barriers, and to buy billions of dollars of American soybeans and natural gas.” The two sides agreed to hold off on further tariffs, and to work toward dropping the existing ones on steel and aluminum, while hammering out a deal to eliminate tariffs, nontariff barriers, and subsidies on industrial goods excluding autos.

Geopolitics III: The Big Stick. The 8/18 New York Post included an interesting column by Michael Walsh titled “Trump is proving America’s power through economic warfare.” Walsh does a very good job of showing how Trump is using tariffs and sanctions to reorder the world order. He is using US economic strength to pursue not only America’s economic interests but also our geopolitical interests. Here are a few key excerpts:

(1) Iran. “In Iran, the rial is down 40 percent in the wake of Trump’s canceling of Obama’s nuclear agreement in May. America has been hindering Iran’s ability to conduct financial transactions in dollars and gold, and has hit its automotive and commercial airline sectors hard. Still to come in November: more punishing sanctions on oil and banking. As a result of the cratering of the Iranian economy, the country’s huge cohort of restive young people has been launching widespread protests that may yet bring down the regime, and Trump’s actions could accelerate that.”

(2) China. “In China, America’s foremost geopolitical challenger, Trump’s approach has been more stick than carrot lately, imposing tariffs and threatening a major trade war, unnerving the Chinese communist leadership, which is beginning to think he may just be crazy enough to do it. The Chinese yuan is down 9 percent against the dollar since April and its stock market is slumping. For all their defiant talk, however, the prospect of an economic war with the US is not something the Chinese leaders want right now, since they can’t afford to have access to the lucrative American market restricted. But both growth and consumer spending have slowed, and even ordinary Chinese are now publicly criticizing president-for-life Xi Jinping.”

(3) Turkey. “Meanwhile, in Turkey, where the tinpot dictator Recep Erdogan is trying to revive the lost glory of the Ottoman Empire, the country’s currency, the lira, has lost 45 percent of its value this year. This is a direct result of American-imposed tariffs and sanctions against the Islamic regime, in part over the continued imprisonment of American evangelical pastor Andrew Brunson, whom Turkey has accused of spying. In ‘retaliation,’ Erdogan has announced a boycott of US electronics. Good luck with that.”

(4) North Korea. Walsh didn’t mention economic sanctions imposed on North Korea by the United Nations Security Council at the end of last year. They were proposed by the US and adopted by a vote of 15 to 0 in an escalating effort to force the North to reverse course on its nuclear weapons program. North Korea has made some moves to placate Washington, including suspending its nuclear and missile tests, demolishing its underground nuclear test site, and tearing down a missile engine test site.

(5) Russia. Also not mentioned by Walsh: On August 9, the Trump administration announced new sanctions on Russia in retaliation for the nerve-agent attack on a former Russian spy and his daughter in March. Russia is already under US sanctions for its 2014 invasion of Crimea, and the Trump administration has expelled 60 Russians from the US and shuttered the Russian consulate in Seattle in response to the failed assassination attempt. Under the new sanctions, which will take effect in two weeks, requests by American companies to sell to Russia items with a potential national-security purpose will be automatically denied, with few exceptions.

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The Long Good Buy

August 20, 2018 (Monday)

US Stocks I: Bull for the Ages. All together now: “Bull markets don’t die of old age. They are usually killed by recessions” (Fig. 1 and Fig. 2).

It was back in October 2014 that Debbie and I projected that the current economic expansion could last through March 2019. We noted that the expansion phases of the business cycle—which follow the recovery phases back to the previous peak—historically have lasted 65 months, on average (that’s based on the past five cycles of the Index of Coincident Economic Indicators). Applying that average duration to this cycle would put its peak in March 2019. Notably, this isn’t a model but rather a benchmark based on recent history (Fig. 3).

However, given what we know today, we believe that the current expansion could continue past next March, well into next year and beyond. There is a very good chance that the expansion will continue through July 2019, which would make it the longest one on record.

If so, then it’s no wonder that the current bull market in stocks is on track to be the longest one on record. There is some controversy about whether that milestone is about to be reached this week on Wednesday, August 22. Consider the following:

(1) Still second longest. The S&P 500 will exceed that previous longest bull market on that day assuming that the previous one lasted from October 11, 1990 through March 24, 2000. The problem is that the “bear market” from July 16, 1990 through October 11, 1990 was actually a correction, with the S&P 500 down 19.9% rather than by the 20.0% or more that’s widely accepted as the definition of a bear market.

Joe and I start the clock on the previous longest bull market (and still the reigning champ) not on October 11, 1990 but on December 4, 1987, following the 33.5% plunge in the S&P 500 since August 25, 1987. So the longest bull market lasted 4,494 days. The current one has lasted 3,448 days through Friday, and thus isn’t about to overtake the champ on Wednesday. It will in time, assuming of course that the record high set on January 26 will be surpassed without an intervening bear market!

(On the website of my book, see Appendix 15.3 S&P 500 Bull Markets Since 1928 and Appendix 15.4 S&P 500 Bear Markets and Corrections Since 1928. I also discuss this subject in a short video podcast: “The longest bull market in history? Sure, why not?: It is discounting what may soon be the longest economic expansion in history.”)

(2) Feeding on earnings. Bull markets are driven by rising earnings (E). Along the way, corrections can occur often because of drops in the earnings valuation multiple (P/E) triggered by fears that a recession may be imminent. When these panic attacks pass, investors regain confidence in the earnings uptrend as the P/E rebounds. Of course, when recessions do occur, the E drops and the P/E takes a dive, resulting in a bear market. This simple narrative is handily demonstrated with our Blue Angels charts.

Quarterly data available since 1935 show that reported S&P 500 earnings are very procyclical (Fig. 4). During the current economic expansion, this series has increased 369% since Q1-2009.

(3) No predictive value. Ben Levisohn included some of my views on this subject in his 8/16 Barron’s column:

“But even if this really was about to become the longest bull market on record, there’s another reason to ignore the milestone: It has no predictive value. That’s why it’s important to focus not on the length of the bull market, but on the length of the economic expansion instead, says Ed Yardeni, chief investment strategist at Yardeni Research.

“‘All I’m interested in is how long the expansion lasts,’ Yardeni says. ‘Because the longer it lasts, the longer the bull market lasts.’ This economic expansion will become the longest on record in July 2019.

“If anything, the obsession about the length of the bull says more about investor psychology than about the market. This bull has been described as the most hated one in history, and investors have found reason after reason not to buy in, even as the S&P 500 has quadrupled. It’s not too difficult to see the same dynamic in play. ‘Lurking behind the argument that this is about to be the longest bull is a bearish notion that it could drop dead at any time,’ Yardeni says.

“And that’s just bull.”

US Stocks II: Another Great Earnings Season. Joe reports that S&P 500 revenues and earnings are out for Q2-2018. It’s all good news across the board. No wonder the S&P 500 is just 0.8% below its record high set on January 26. Let’s review:

(1) Revenues at all-time high. Most extraordinary is that S&P 500 revenues jumped 10.3% y/y last quarter to a new record high (Fig. 5 and Fig. 6). Normally this far into an economic expansion, revenues growth tends to be around 4%-6%.

(2) Earnings at all-time high. S&P 500 earnings as measured by Thomson Reuters I/B/E/S soared 25.6% y/y last quarter, reflecting the strength in revenues as well as the cut in the corporate tax rate (Fig. 7 and Fig. 8).

(3) Profit margin at all-time high. Notwithstanding all the chatter about rising costs, the S&P 500 corporate profit margin rose once again to a record high of 10.9%. It was at a record 10.1% during Q4-2017 before the tax cut. It jumped to 10.5% during Q1-2018 thanks to the tax cut. Yet here it is at yet another record high. The bears (remember them?) have been growling during most of the current bull market that the margin is about to revert to the mean.

(4) Lots of happy sectors. I asked Joe to drill down into the 11 sectors of the S&P 500. He reports the following y/y growth rates for revenues: Energy (33.6%), Materials (17.8), Health Care (15.4), Information Technology (14.9), S&P 500 (10.4), Industrials (9.7), Financials (9.3), Consumer Discretionary (8.5), Real Estate (6.1), Consumer Staples (-1.6), Utilities (-3.0), and Telecommunication Services (-6.4) (Fig. 9).

Here is the comparable performance derby for operating earnings as compiled by S&P: Energy (142.2%), Telecommunication Services (39.3), Information Technology (36.9), Materials (35.6), Financials (30.5), S&P 500 (26.8), Industrials (21.0), Consumer Discretionary (16.7), Consumer Staples (13.0), Utilities (12.4), Real Estate (12.4), and Health Care (7.2) (Fig. 10).

And here are the latest trailing four-quarter profit margins based on S&P’s operating earnings data: Information Technology (22.1%), Real Estate (18.9), Financials (14.7), Utilities (12.0), Telecommunication Services (11.5), S&P 500 (10.9), Materials (10.1), Industrials (9.7), Health Care (8.7), Consumer Discretionary (7.8), Consumer Staples (7.0), and Energy (5.2) (Fig. 11).

US Economy: Extended Expansion. The bears have been warning all year that the flattening of the yield curve increases the risk of a recession. They’ve cautioned that the escalating trade war could trigger the expansion’s downfall. They’ve been expecting rising labor costs and commodity prices to squeeze profit margins. Nonetheless, they’ve been sounding the alarm that rising costs will boost inflation, which would send bond yields higher. They’ve touted the worrisome notion of “peak earnings,” which really means that the growth rate of earnings is bound to slow next year. And of course, the bull could drop dead at any time, they say, simply because it is so old. Consider the following counter-arguments:

(1) Leading higher. The yield curve is just one of the 10 components of the Index of Leading Economic Indicators, which has been setting fresh record highs for the past 17 months through July (Fig. 12).

That augurs well for the Index of Coincident Economic Indicators, which is also at a record high. This index’s y/y growth rate is highly correlated with the comparable growth rate for real GDP (Fig. 13). The former was 2.4% through July, confirming that the underlying growth of the economy continues to fluctuate between roughly 2%-3%, i.e., at a sustainable pace. The latest GDPNow estimate shows real GDP growing 4.3% (saar) during Q3. That translates into a 3.2% y/y growth rate.

(2) Trade war. President Trump unilaterally has called a ceasefire in his trade war with Europe. Progress is reportedly being made in negotiations with Mexico. Talks will resume with China later this month. Perhaps it’s time to stop using the adjective “escalating” to describe the trade war? What if this all leads to less protectionism once the fog of war clears? This possibility sure helps explain why the US stock market has performed so well so far this year, with the S&P 500 up 6.6% ytd!

(3) Inflation. It’s true that there are more signs of mounting inflationary pressures. They just aren’t bubbling up into the CPI, PPI, and wages. To have cost pressures rising even as profit margins likewise are rising without discernably higher price inflation is a curious set of circumstances. Could it be that productivity is finally making a comeback? That certainly would explain things well. Also, the strong dollar is helping to keep a lid on inflation. Recently, commodity prices have been falling, not rising.

(4) Earnings. There’s no doubt that earnings growth will fall from over 20% this year to under 10% next year. So what? Earnings should still be growing in record-high territory in 2019. Stock prices should follow suit.

Movie. “BlacKkKlansman” (+ + +) (link) is Spike Lee’s disturbing movie about a black undercover cop who infiltrated a local chapter of the Ku Klux Klan in Colorado Springs during the early 1970s—a true story. He did so with the help of a white surrogate, who eventually became head of the local branch. He has several phone conversations with the KKK leader, David Duke, and acts as Duke’s bodyguard at one event. Lee makes a compelling case along the way, especially at the end of the film, that race relations in America haven’t improved much, if at all, over the past half century. That’s very sad and reflects that all too often race issues have been politicized with the aim of exacerbating rather than ameliorating the problem.

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Consumers Unchained

August 16, 2018 (Thursday)

Consumers: Spending Up a Storm. Consumers are employed, paying lower taxes, and feeling good, so of course they’re spending more. It’s the American way. The pickup in spending boosted July’s retail sales report, which rose a larger-than-expected 0.5%, its sixth consecutive gain in sales, as Debbie discusses below (Fig. 1). Core retail sales—which excludes autos, gasoline, building materials, and food services—also rose 0.5% last month.

The report continued the drumbeat of positive news surrounding the consumer. The National Retail Federation (NRF) said retail sales rose 4.8% y/y in the first half of 2018, and it expects continued strength in the back half of the year. So the NRF has increased its 2018 sales growth forecast to 4.5%, up from 3.8%-4.4% in February, the industry association’s 8/13 press release noted.

Investors appear to have anticipated the improved spending environment, as the S&P 500 Consumer Discretionary stock price index is the second-best performer ytd of the 11 sectors in the S&P 500. Here’s where the sectors’ ytd performances stood through Tuesday’s close: Tech (16.4%), Consumer Discretionary (14.7), Health Care (8.9), S&P 500 (6.2), Energy (2.9), Utilities (0.6), Real Estate (0.0), Financials (-0.2), Industrials (-1.0), Materials (-3.2), Consumer Staples (-6.4), and Telecom Service (-7.9) (Fig. 2).

Last year’s concern that Amazon was going to put bricks-and-mortar retailers out of business was quickly replaced at the start of 2018 by strains of “Happy days are here again!” Looking at the retailing industries within the Consumer Discretionary sector, the S&P 500 Department Stores industry’s stock price index is up 45.2% ytd. The S&P 500 Apparel Accessories & Luxury Goods industry’s index has added 20.4% so far this year, while the Apparel Retail index has gained 12.7% ytd. Not far behind ytd are General Merchandise Stores (11.3%) and Specialty Stores (10.5) (Fig. 3).

Stronger consumer spending combined with lower corporate tax rates have improved retailers’ top and bottom lines. The S&P 500 Consumer Discretionary sector is forecast to grow revenue by 7.3% this year and 5.9% in 2019 (Fig. 4). Even more impressively, the sector’s earnings per share are expected to soar 18.7% this year and 12.1% in 2019 after decidedly positive net earnings revisions for the past seven months (Fig. 5 and Fig. 6).

All of this positive news has boosted the sector’s forward P/E to 20.9 as of August 9, at the high end of where it has been over the past 20 or so years (Fig. 7). Without Amazon and Netflix, that forward P/E would decline to 14.6 (Fig. 8).

However, the market may have moved a bit too far too fast. On Wednesday, a number of retailers’ stocks sold off despite a continuation of strong earnings reports. Let’s take a look at recent earnings out of Home Depot and Macy’s:

(1) Enjoying the bounce-back. Sometimes, you really can blame the weather. Home Depot’s Q2 sales came springing back when gardeners and do-it-yourselfers got back to work after poor weather in Q1. The retailer’s total sales rose 8.4% in Q2, and earnings per share jumped 35.6%, helped by a tax rate that fell to 24.7% from 36.6% a year ago.

Home Depot’s comparable-stores sales rose 8%, boosted by a 4.9% increase in the average ticket price and a 2.9% increase in the number of transactions. The average ticket price was boosted by 1.19ppts by the uptick in prices for lumber, building materials, and copper.

“In addition to core commodity inflation, we are now experiencing inflation in other areas. These inflationary pressures come in many forms, including rising raw material costs and transportation costs along with recently enacted tariffs; however, as the customer’s advocate for value, it is our job to work with our partners throughout the value chain to manage these pressures,” said Ted Decker, Home Depot’s executive vice president, merchandising on the earnings conference call.

There are a number of reasons to expect inflationary pressure could abate in upcoming months. For example, tariffs on washing machines were felt in Q2, but “as the Korean manufacturers get their facilities up and running in Tennessee and South Carolina respectively, that tariff pressure will mitigate because they will be producing all their machines here domestically,” said CEO Craig Menear. In addition, lumber and copper prices have dropped in recent weeks (Fig. 9 and Fig. 10). Framing lumber is now just 4% higher than it was last year vs 40% higher y/y at the peak.

Home Depot continued to benefit from growth in its online operation, up 26% y/y, and its new small-parcel express delivery service, which makes deliveries from stores to locations in all major US markets.

Consumers on average shop at just 9 different retailers, CEO Menear said on the call, which has dropped over the past four years from 13. So why shouldn’t they buy more of their home goods through Home Depot? That was part of the thinking behind buying The Company Store at the end of last year.

Reflecting the strong first-half results, Home Depot boosted its fiscal-year 2018 diluted earnings per share estimate to $9.42 from $9.31.

(2) Buy the rumor, sell the news. It’s one of Wall Street’s wisest adages, and it certainly came to mind when Macy’s shares fell roughly 16% Wednesday in the wake of an earnings report that beat analysts’ forecasts.

Q2 same-store sales, on an owned and licensed basis, rose 0.5% y/y, compared to expectations that sales would drop 0.9%, a 8/15 WSJ article reported. Excluding the shift of a promotional event to Q1, same-store sales would have risen 2.9% including licensed departments.

Total sales fell 1.1% to $5.6 billion, hurt by the closure of stores last year. However, the company’s adjusted earnings per share came in at 70 cents, above the 51 cents analysts expected and the year-earlier 46 cents. The company raised its 2018 earnings forecast by 20 cents a share.

While warnings about the risk of Macy’s demise may have been wildly exaggerated last year, it’s still tough to see how the company grows as a department store. Department store retail sales have stopped falling, but they don’t seem to be rising, either (Fig. 11). And that won’t appease investors anymore.

Telecom: Race to 5G. There’s a lot of breathlessness in the telecom world as speculation grows about which countries will be first to host 5G services and which equipment companies will have the first 5G phones. The 3/1 Morning Briefing had a primer on 5G, but things are moving so quickly that it’s already time for an update:

(1) Fears of falling behind. Deloitte captured headlines recently with a report warning that the US lagged China in preparing for a 5G rollout: “Since 2015, China outspent the United States by approximately $24 billion in wireless communications infrastructure and built 350,000 new sites, while the United States built fewer than 30,000. Looking forward, China’s five-year economic plan specifies $400 billion in 5G-related investment. Consequently, China and other countries may be creating a 5G tsunami, making it near impossible to catch up.”

Other researchers have arrived at a similar conclusion. “David Abecassis, Partner in Analysys Mason said, ‘Our research shows China with a slight lead in 5G readiness, with South Korea and the U.S. close behind. The U.S. led the world in 4G, and the U.S. wireless industry is leading global 5G research and development with aggressive commercial 5G deployment plans that will benefit U.S. consumers,’” according to a 4/16 CTIA press release.

If the US loses the 5G race, it could also fall behind on developing other related technologies that depend on access to a 5G telecommunications network. Being first in 4G added nearly $100 billion to US GDP and led to an 84% increase in wireless-related jobs. It meant the US had a leading position in the global wireless ecosystem, including the app economy. Conversely, when Japan and Europe lost their leadership positions in wireless, they experienced job losses and contraction in their domestic wireless industries, the CTIA piece stated.

(2) Not everyone agrees. That said, some think concerns about who comes in first are overhyped. “Telecommunications industry analyst Jeff Kagan says the competition between the US and China keeps the US motivated to push 5G forward, but he doesn’t believe that it will make a big difference to the US economy in the long term if the US is second or third. ‘I don’t think it’s ever been more than a battle over the ego over which country is first,’” he told Wired Magazine in a 6/6 article.

The periodical goes on to note that the US doesn’t have the fastest home broadband speeds today, nor does it have the most widely available 4G networks. Finland, Japan, and South Korea often best the US in those metrics. “Europe was quicker to roll out 2G, and Japan was the first with 3G, but that hardly deterred Apple and Google from dominating the smartphone market,” the article notes.

But if China beats the US by a couple of years, that could trigger a bigger problem, as the country’s massive population will generate tons of data that then can be used by corporations to develop applications and services. Just as Apple, Google, and Facebook benefited from US access to 4G, “[t]he concern is that if China delivers widespread access to 5G first, its companies will get a head start on creating the next generation of high-tech products and services,” Wired explains.

(3) The standings. So who’s in the lead, and who’s behind? Qatar’s telecom carrier, Ooredoo, announced in May that it launched a commercial 5G service, but hardware wasn’t available until June, and mobile hardware is not available until 2019. In June, Finnish carrier Elisa said it too had launched commercial 5G. Elisa does have terminal devices and is selling subscriptions.

The US still needs to get the proper wireless spectrum into the hands of its carriers. It’s holding auctions of its 28 GHz millimeter wave band in November, followed by auction of the 24 GHz band. More auctions are expected next year.

The US also needs the creation of many small cell spots for 5G to work. “While there are currently some 300,000 cell towers operating in the U.S., 5G is likely to involve a vastly larger number of much smaller cells. Since there may well be multiple 5G cells within a single building (or even within a single room) in areas with high demand for service, installing these cells will involve getting permission from not only thousands of municipal governments but potentially from millions of individual landlords. Cooperation among all the parties involved will be essential, but new regulation may be needed to ensure that these gatekeepers don’t become bottlenecks,” a 7/13 Recode article noted.

The Chinese government doesn’t have to worry about cantankerous local governments. According to the Deloitte report, “China Tower is the leading provider of sites and owns approximately 96 percent of macro towers, small cells and DAS sites that serve China’s wireless carriers. China Tower has invested $17.7 billion in capital and added more than 350,000 sites since 2015.” The country has 14.1 wireless sites per 10,000 people compared to 4.7 in the US.

A successful 5G rollout also requires the development of new cell phones, which is underway. “Hardware is a problem for all prospective 5G carriers: Apart from early and arguably prototype devices made by Huawei and Samsung, actual 5G smartphones aren’t expected to be available in large quantities until early next year. However, Samsung has produced 5G broadband modems for home use, which Verizon plans to sell in several U.S. markets later this year. Rival AT&T says it will offer 5G mobile hotspots from an unnamed supplier in a dozen markets,” a 6/28 article on VentureBeat reported.

In the US, Verizon is rolling out 5G residential broadband in Houston, Los Angeles, Sacramento, and Indianapolis later this year. It plans to roll out 5G mobile services next year. Motorola released the Moto Z3, a phone that has an accessory, the 5G Moto Mod, to tap into Verizon’s 5G network.

Sprint is partnering with LG to deliver a 5G smartphone in the first half of 2019. “While details remain a mystery, Sprint promised its 5G network will be capable of full-length HD movie downloads in ‘seconds instead of minutes’ and the ability to play games without any ‘delays, hiccups or lag-time. Sprint will launch its 5G network in Atlanta, Chicago, Dallas, Houston, Kansas City, Los Angeles, New York City, and Washington next year before expanding into other parts of the county,” reported an 8/14 USA Today article.

Sprint is also in the midst of attempting to merge with T-Mobile. Part of the rationale behind the deal, which combines the country’s third- and fourth-largest telecom companies, is that together they’ll be better positioned to fund the 5G rollout than they’d be separately. They plan to invest $40 billion in network improvements that would help Sprint and T-Mobile become a leader in 5G. The deal is still awaiting FCC approval.

Lastly, AT&T has announced plans to roll out 5G in six cities shortly—Oklahoma City, Charlotte, Raleigh, Atlanta, Dallas, and Waco, Texas—and a dozen by year-end. AT&T’s initial offering will involve 5G service aimed at hot-spot devices, but not phones, that deliver 5G broadband wirelessly into homes. The race is on.

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Trump vs Xi: Tiger vs Dragon?

August 15, 2018 (Wednesday)

China I: Will Xi or Won’t Xi? Blink, that is. No one really can hope to win a trade war, but in this game of tit-for-tat tariffs being played by the US and China, China is emerging as the more vulnerable.

The trade conflict has exacerbated an already slowing economy, a weakening currency, and a plunging stock market in China. It is eroding the notion of China’s invincibility just five months after President Xi Jinping consolidated his hold on power by becoming leader for life and outlining a grandiose vision for China’s global ambitions. That move followed Xi’s elevation last October to a status on a par with the founder of the People’s Republic of China, Mao Zedong, and the inclusion of Xi’s “new era” political ideas and philosophy in the party constitution.

Xi has suffered numerous humiliations at the hands of Trump, most recently when Xi’s top economic adviser, Liu He, declared there would be no trade war upon returning from negotiations in Washington in May. Trump immediately imposed $34 billion in tariffs on China, with $16 billion more in the works.

With President Trump ratcheting up the pressure and after missteps and miscalculations by China, China’s new goal—as voiced at the summer meeting of the Politburo on July 31—is to maintain stability in the economy and the financial markets, noted an 8/12 FT piece.

Will Xi (the dragon) be forced to blink by Trump (the tiger)? I asked Sandra Ward, our contributing editor, to examine recent developments. Here’s her report:

(1) Tariffs, tariffs, and more tariffs. The second round of Trump’s tariffs is scheduled to take effect August 23 on $16 billion in Chinese exports. Beijing will match the move by slapping duties on an equivalent amount of US goods. This follows July’s opening salvo when the two placed duties on $34 billion of each other’s bilateral exports.

More recently, Trump threatened to tax an additional $200 billion of Chinese exports at 25%. That could lead to nearly half the $505 billion China exports to the US, about 19% of its total exports, being taxed at 25%, according to the FT article cited above. China has already taxed $110 billion in US exports of a total $130 billion (Fig. 1).

Should the additional tariffs go through, the impact would shave 1% from China’s GDP, according to Gavekal Dragonomics, an 8/9 CNBC story noted.

(2) Faster pace on economic reforms. One possible outcome of US trade pressure: Beijing could pick up the pace on enacting economic reforms, noted the CNBC story. Among the reforms: allowing private investment into state-owned firms, transferring 10% of state-owned shares into pension funds, and reducing taxes for corporations and individuals.

China has made significant progress in moving to a consumer-led economy, and domestic consumption has become a more important driver of growth than investment and exports combined, according to a 6/5 analysis by Stratfor Worldview. Stratfor notes China’s services industry—including finance, e-commerce, and logistics—is booming and represents about 45% of total employment compared with 23% a decade ago. Export-related employment has dropped from 9% of total employment in 2008 to an estimated 6% today. Still, China has little room to maneuver in the event of a more significant trade blow, as high debt levels and diminishing investment returns will limit its ability to stimulate the economy.

(3) Daring to dissent. The fallout from the escalating trade war has led to rare public displays of sniping in the ranks of the Communist Party, with a central bank official sharply criticizing the Ministry of Finance’s fiscal policy for not being more stimulative, according to a 7/26 report in the WSJ. And a prominent academic wrote a widely circulated essay critical of the direction in which Xi is taking the country and called for reinstating term limits, a 7/31 NYT article reported.

(4) Yearning for Deng. Other academics are urging Xi to soften his rhetoric and adopt a leadership approach similar to that of Deng Xiaoping, paramount leader of China from 1978 through 1989. Deng was a reformer who modernized China by introducing free-enterprise principles to the economy and followed the maxim: ‘Hide your strength, bide your time.”

One example of that line of thinking was quoted in the NYT story: “China should adopt a lower profile in dealing with international issues,” Jia Qingguo, a professor of international relations at Peking University, said at a recent forum in Beijing. “Don’t create this atmosphere that we’re about to supplant the American model.”

An 8/7 Bloomberg Businessweek piece also discussed the reappraisal of Xi that’s occurring in China as a result of the trade war, noting a “newfound sense of self-doubt.” It quoted Wang Yiwei, a professor of international affairs at Renmin University in Beijing and deputy director of the school’s Xi Jinping Thought Center, saying “The trade war has made China more humble. We should keep a low-profile.” He noted, too, that this might mean rethinking Xi’s audacious One Belt, One Road infrastructure project, modeled on the ancient Silk Road, that would link China with trading partners throughout Asia and Europe.

(5) Made in China 2025. Officials appear to be heeding some of the criticism. State media outlets were told to downplay “Made in China 2025,” China’s bold industrial initiative to become a dominant force in 10 advanced and strategically important sectors, including robotics, semiconductors, and aerospace, according to a 6/26 Politico story. The US has identified Made in China 2025 as a major threat, and is seeking to block Chinese-owned companies from buying tech-rich US companies.

(6) Summer of discontent. Exacerbating what the Businessweek article dubbed Xi’s “summer of discontent” is a public health scandal that erupted in July. A vaccine maker was found to have faked reports and skirted regulations, producing ineffective vaccinations for rabies, diphtheria, pertussis, and tetanus that were administered to 250,000 children. The public outcry has been enormous and proven difficult to control by censors, according to a 7/24 piece by The Guardian. It has also led to a sell-off in Chinese drug stocks.

China II: Stress Fractures. China's economy has been slowed by the escalating trade war with the US. Here's a rundown of some of the evidence:

(1) Currency weakness. The yuan is Asia’s worst-performing currency over the past three months, down 8% against the dollar. To blame, according to an 8/13 Bloomberg report, are trade tensions and the People’s Bank of China’s (PBOC) moves to support the economy by devaluing the currency, making Chinese goods more affordable (Fig. 2). On the other hand, China’s central bank recently made it more expensive to short the yuan, which served to stabilize it.

(2) Manufacturing trends. China’s official M-PMI fell for the second straight month in July, to 51.2, after climbing from 50.3 in February to an eight-month high of 51.9 in May. Both the output (to 53.0 from 54.1) and new orders (52.3 from 53.8) measures showed growth eased over the two-month period, while new exports orders (49.8) contracted slightly for the second month, at the same pace as June. Meanwhile, factory employment continues to decline, though at a slower pace, edging up from 49.0 to 49.2 last month; it has averaged 49.1 the past five months (Fig. 3).

(3) Bank reserve requirements. The PBOC cut the amount of cash banks must hold in reserve for the third time this year to encourage debt-for-equity swaps, which ease debt burdens, and to boost lending to small firms (Fig. 4).

(4) Dr. Copper. Copper prices fell to a 13-month low Tuesday, down 19% from four-year highs in June, as investors worry about the trade war’s impact on demand from China, which represents about half of global copper demand (Fig. 5).

On the other hand, China’s producer price index jumped 4.6% y/y in July, and the consumer price index rose 2.1%—both strong showings in light of the trade wars (Fig. 6).

(5) China stock markets. The Shanghai Stock Exchange Composite Index and the Shanghai Shenzhen 300 both are down more than 16% ytd, and down 22% from their 52-week intraday highs, bringing the indexes into bear-market territory (Fig. 7).

China III: Ticking Time Bombs. Some threats to China’s long-term growth prospects have no easy fixes. China’s longtime one-child policy has birthed a demographic time bomb—i.e., an aging population and shrinking workforce that will hinder economic growth. And China is one of the countries most at risk for a banking crisis, according to the Bank of International Settlements, because of its massive debt load. Let’s look more closely at these areas:

(1) Baby bust. After 35 years of strictly enforcing a one-child-per-family policy to address an overpopulation problem, China now faces the opposite problem: not enough workers to support an aging population (Fig. 8). Despite easing the restrictive policy in 2016 and encouraging women to have two children, many are sticking with one or none. And there are fewer women to bear children as a result of the one-child policy. The government is now trying frantically to create a baby boom, an 8/11 NYT article reports, by providing incentives such as tax breaks and housing and education subsidies and by limiting abortions and divorces.

(2) Bank bust? Chinese banks issued 1.45 trillion yuan ($211 billion) in net new loans in July, as the government increased its support for banks and encouraged lending to small businesses and infrastructure projects, according to an 8/13 report on Reuters. Outstanding yuan loans grew a larger-than-expected 13.2% y/y (vs a 12.8% consensus estimate)—faster than June’s 12.7%.

While monetary policy has been stimulative, fiscal policymakers may be stepping on the brakes. Fixed-asset spending on items such as factory machinery and public works projects fell to the lowest level since 1999, an 8/14 WSJ article pointed out. Fixed-asset investment in nonrural areas grew at a 5.5% y/y pace in the seven-month period from January to July compared to 8.3% growth in the year-earlier period. Shuang Ding, an economist with Standard Chartered Bank in Hong Kong, told the WSJ this was evidence that “China can't go toe-to-toe in retaliating” against the US.

China is faced with the delicate balancing act of trying to reduce its massive debt load—estimated at about 270% of GDP—while staving off a sharp slowdown from the effects of the trade war.

Will Xi blink?

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Big Revisions, Small Net-Net

August 14, 2018 (Tuesday)

US Economy I: Same Old Real GDP Story. An accountant, an engineer, and an economist apply for the same job. The employer asks all three the same question in their respective interviews: “What does two plus two equal?” The accountant replies: “Four.” The engineer says: “On average, four—give or take 10%.” The economist gets up, locks the door, closes the shade, sits down next to the interviewer, and says: “What do you want it to equal?”

Reviewing the Bureau of Economic Analysis’ (BEA) 7/27 “2018 Comprehensive Update” of the National Income and Product Accounts (NIPAs)—the 15^th such NIPA revision—reminded us of that old joke. Remarkably, the macro narrative for real GDP didn’t change much despite dramatic, albeit mostly offsetting, changes in the underlying components. Although real GDP on an annualized basis was basically unaffected, the quarterly flow of output shifted toward the first half of the years revised, on average. And while the annual real GDP growth trajectory didn’t change much, the tone of the revisions was mostly positive. Technology investment and personal saving were revised higher, as we discuss below. But first, let’s review some of the underlying changes to the top line of nominal and real GDP:

(1) Level of GDP in the same ballpark. The level of nominal GDP hasn’t changed much at all (Fig. 1). It was revised from $19.4 trillion during 2017 to $19.5 trillion. Real GDP is now reported in 2012 dollars rather than 2009 dollars (Fig. 2). It rose to a record $18.1 trillion last year.

(2) Real GDP annual growth tweaked. Along with the update, the BEA published a chart titled “Real GDP average growth rates” covering the “before” and “after” versions of real GDP over various economic cycles. For older decades, real GDP average annual growth rates stayed mostly the same as follows: from 1929-1944 at 5.1%, 1944-1973 at 3.1%, and 1973-1990 at 3.0% (Fig. 3). For the more recent periods, real GDP was revised slightly up to 3.1% from 3.0% for 1990-2007 and up to 1.5% from 1.4% for 2007-2017. The BEA also provided a chart titled: “Revisions to recent contractions and expansions.” None of the contractions or expansions looked much different before and after the revisions. However, the contraction from Q4-2007 to Q2-2009 was a tad less bad than previously estimated. (See also the charts on page 2 and page 5 of the BEA’s “Results of the 2018 Comprehensive Update of the National Income and Product Accounts.”)

(3) Quarterly contours adjusted. The revisions also show that output growth during the first half of the year tends to be a bit faster than initially estimated (Fig. 4). That’s because the BEA made improvements to its seasonal adjustment (SA) methodology. Aware of the challenges of accurate SA, the BEA announced that it would publish the raw non-seasonally adjusted real GDP data so that seasoned folks could apply their own methodology to adjust it. Reading between the lines, the quarterly SA data may not be so precise, which gives more weight to the y/y growth rates of real GDP. That’s a point Debbie and I have been making for a while.

Nevertheless, the BEA’s statisticians revised the quarterly real GDP growth rates (saar) going back to 2002. On average, the rates for 2002-2017 moved up for Q1s to 1.6% from 1.2%, and down for Q3s to 2.2% from 2.4%, while the average rates for Q2 and Q4 didn’t change. Over 2012-2017, the average rates were revised up for Q1s by 0.5 percentage point (ppt) and Q2s by 0.1ppt, while Q3s and Q4s were revised down by 0.3ppt and 0.2ppt, respectively. (See the charts on pages 12 and 13 of the BEA’s 2018 Comprehensive Update Results.)

(4) Tech investment gains offset by higher trade deficit. For 2007-2017, real GDP was revised up by only 0.05ppt, consisting of several offsetting adjustments: +0.12ppt for investment, +0.01ppt for exports, +0.01ppt for government spending, -0.02ppt for personal consumption expenditures, and -0.08ppt for imports. (See the chart on page 4 of the BEA’s 2018 Comprehensive Update Results). Most of the revisions to investment and imports stemmed from improved technology deflation measures.

The BEA explained the reason for these revisions in its “2018 Preview of the Comprehensive Update”: “Software, medical equipment, and communications equipment typically experience rapid innovation and are associated with state-of-the-art technologies. Such products present challenges when using standard matched-model techniques to construct quality-adjusted price indexes.” Notably, communications equipment includes cell phones, a key driver of the import revisions.

By the way, the revisions noted above were just a selection of important ones from the BEA’s 2018 Comprehensive Update. See the Preview section for more details if you don’t mind lots of statistical jargon. More explanations of the revisions, hopefully in plain English, will be available in mid-September, in the BEA’s “September Survey of Current Business.”

US Economy II: Personal Saving at Record Low. Not! The 1/29 WSJ included a sobering article titled: “With Stocks Surging, Americans Are Saving at 12-Year Low.” The article’s subtitle read: “Shift away from saving could leave consumers exposed if stocks or other assets take a sudden turn for the worse.” But don’t worry, be happy: After the BEA’s July revisions, a more appropriate subtitle for the article would be “Never Mind! Personal Saving Has Been Much Greater Than Previously Estimated.”

Included within the BEA’s comprehensive update were revisions to “Personal Income and Outlays: June 2018.” The new data revealed an eye-popping upward revision to the personal savings rate (personal saving as a percentage of personal disposable income) for 2017 of 3.3ppts to 6.7% (Fig. 5)! That’s a big deal because the initially published rate implied that consumers are saving at a lower rate today than just before the 2008 recession. As initially published, the rate averaged 3.0% in 2007; it peaked at 11.0% during 2012 before decreasing to 2.4% by the end of 2017. With that data now debunked, so is the previous storyline about consumers saving at historically low rates.

Before the revisions, consumers seemed to be banking personal savings faster than prior to the recession (Fig. 6). The average of the 12-month sum of personal saving from 2009 to 2018, at $714.0 billion, was double the average from 2000 to 2008 at $357.0 billion (Fig. 7) The latest pace of personal saving fell sharply along with the rate during 2016 and 2017. It seemed as if a new era of substantially lower average personal saving were beginning. But, never mind! The recent drop was revised away. And the average of the 12-month sum of personal saving increased to $882.0 billion from 2009 to 2018 and to $408.5 billion from 2000 to 2008.

Some media reports covering the 2017 personal saving revisions suggested that small business owners had contributed to the increase in saving rather than workers. The implication was that the revisions were not widespread, but isolated among wealthier individuals. I asked Melissa to dig into the numbers to verify that conclusion.

Looking at the revisions as a percentage of the previously published figures for each of the major components of personal income, the obvious standout is indeed proprietors’ income, which is included in personal income rather than corporate income in the NIPAs. Proprietors’ income was revised 8.3% higher than initially published for 2017. Another major component of personal income, personal income receipts on assets, was also revised up by 7.7%. Like proprietors’ income, that category tends to reflect the income of wealthier individuals as well. Meanwhile, the compensation of employees was revised just 0.9% higher. (See Table 1A within the “Tables Only” download available on the right of the BEA’s Q2-2018 webpage.)

Melissa also observed that the upward revisions were broad based in dollar terms. Contributing to the $499.4 billion increase in personal saving for 2017 were increases in personal income totaling $401.9 billion as follows: personal income receipts on assets (up $189.2 billion), proprietors’ income (up $114.9 billion), and compensation of employees (up $97.9 billion), along with other less significant offsetting revisions. Most of the revisions to these components of personal income data resulted from adjustments to the underlying source data. Here are a few more details:

(1) Personal income receipts on assets (up $189.2 billion) consists of personal dividend income and personal interest income, according to the BEA’s “A Guide to the National Income and Product Accounts of the United States.” For 2017, personal dividend income and personal interest income were revised up by $143.3 billion and $45.9 billion, respectively. The revisions to personal dividend income primarily reflect the incorporation of newly available IRS Statistics of Income data, according to the BEA (Fig. 8).

(2) Proprietors’ income (up $114.9 billion) is essentially the current production income of sole proprietorships and partnerships and of tax-exempt cooperatives, according to the BEA’s guide. Table 1A from the BEA’s Q2-2018 GDP release breaks down proprietors’ income into two categories: farm and nonfarm. Most of the revision to proprietors’ income was in nonfarm (up $111.2 billion). BEA’s Personal Income and Outlays update explained that these revisions primarily reflect adjustments to estimates of underreported income based on newly available IRS data (Fig. 9).

(3) Compensation of employees (up $97.9 billion) includes wages and salaries (up $100.6 billion) in addition to supplements to wages and salaries (down $2.7 billion). The BEA sources the wages and salaries data from the Bureau of Labor Statistics Quarterly Census of Employment and Wages, which was revised and incorporated into the BEA’s update (Fig. 10 and Fig. 11).

(4) Personal outlays (down $83.6 billion) captures personal consumption expenditures, personal interest payments, and personal current transfer payments. The series is deducted from disposable personal income to derive personal saving. Consumers spent slightly less than was previously thought, according to the BEA’s revisions. But that didn’t move the personal saving rate nearly as much as the increases in personal income we discussed above (Fig. 12).

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Trump’s World

August 13, 2018 (Monday)

Stocks I: America First. US stocks have been outperforming other major overseas stock price indexes since early February. That’s when President Donald Trump started his “America First” protectionist campaign aimed at making free trade fairer trade with America’s major trading partners. During the current bull market, Joe and I had been recommending a Stay Home investment strategy until the fall of 2016. On November 8, 2016, we switched to a Go Global strategy on mounting evidence that the global economy was rebounding from the worldwide energy-led mini-recession of 2015. We switched back to Stay Home in early June of this year in response to the escalating trade war.

US stocks have outperformed the major overseas stock indexes priced in local currencies so far this year. They’ve done even better when foreign indexes are priced in local currencies because the dollar has soared in response to Trump’s escalating trade war. Meanwhile, the 10-year US Treasury bond yield has remained below 3.00% since May 24. All this suggests that the greenback and US financial assets are viewed as the winners in a trade war.

However, Stay Home isn’t all about a risk-off approach to overseas economies. In fact, Joe and I believe that the outperformance of Stay Home so far this year also owes a lot to Trump’s stimulative tax cuts at the end of last year. Consider the following:

(1) The dollar. The preceding statement doesn’t seem to apply to the trade-weighted dollar, which jumped 7.4% since the year’s low on February 1 (Fig. 1). That coincides with the implementation of Trump’s America First trade campaign.

Debbie and I have often observed that the dollar tends to be strong (or weak) when the rest of the world is looking relatively weak (strong). That explains why the dollar tends to be inversely correlated with commodity prices, as measured by the Goldman Sachs Commodity Index (GSCI) (Fig. 2). So far this year, the GSCI is holding up reasonably well. However, it is heavily weighted with the prices of petroleum products, which have been propped up by looming US sanctions on Iranian crude oil.

Looking somewhat weaker is the CRB raw industrials spot price index, which has been weighed down by a significant drop in the price of copper in recent weeks (Fig. 3). The price of copper remains highly and inversely correlated with the value of the dollar (Fig. 4).

Of course, some of the relative weakness in the rest of the world reflects the relative strength provided the US economy by Trump’s tax cuts. In other words, the dollar’s strength isn’t all about the trade war. Fed officials continue to say that while the trade war may be a threat to US economic growth, they believe the economy will remain strong enough to justify further hikes in the federal funds rate from 1.75%-2.00% currently to possibly 2.75%-3.00% next year. Meanwhile, both the ECB and BOJ show no signs of normalizing their official interest rates, which remain abnormally low just below zero (Fig. 5).

(2) Relative forward earnings. The main reason why Stay Home has been outperforming Go Global since the start of the bull market is that the forward earnings of the US MSCI has outpaced the forward earnings of the All Country World ex-US MSCI (in local currencies) (Fig. 6). The former is up 172.4% since it bottomed during the 4/30 week of 2009 through the 8/2 week this year, while the latter is up 78.2% over the same period (Fig. 7).

(3) S&P 500 sectors. As Joe and I have previously observed, the ytd relative performance of the S&P 500 sectors’ stock indexes suggests that concerns about ongoing Fed rate hikes are having a more pronounced impact on stock prices than worries about the trade war. Here is the ytd derby for the 11 sectors: Information Technology (15.8%), Consumer Discretionary (14.2), Health Care (8.4), S&P 500 (6.0), Energy (3.9), Utilities (0.4), Financials (0.0), Real Estate (-0.4), Industrials (-1.1), Materials (-2.9), Consumer Staples (-7.0), and Telecommunication Services (-8.3) (Fig. 8). The leaders are mostly cyclicals, while the laggards are mostly interest-rate-sensitive sectors.

Drilling down some more, we can see that the ytd relative performance of the S&P 500 sectors’ forward earnings can explain some of the price action: Energy (56.3%), Telecommunication Services (20.9), Industrials (20.2), Financials (18.2), Materials (17.8), S&P 500 (17.4), Consumer Discretionary (16.3), Information Technology (15.8), Health Care (14.0), Utilities (5.6), Consumer Staples (5.1), and Real Estate (3.1). (See Table 2E in Performance Derby: S&P 500 Sectors & Industries Forward Earnings & Revenues.)

Stocks II: SmallCaps First. The widely held view is that SmallCaps have outperformed in the US because they are less exposed to the escalating trade and currency wars. That does make sense. However, their underlying fundamentals are improving faster on a relative basis as well. Consider the following:

(1) Forward revenues. Here are the ytd performances of forward revenues for the S&P 500/400/600: 6.2%, 6.0%, and 14.4% (Fig. 9).

(2) Forward earnings. Here are the ytd performances of the forward earnings of the three: 16.7%, 16.1%, and 27.9% (Fig. 10).

(3) Stock price indexes. Here are the ytd performances of the S&P 500/400/600 stock price indexes: 6.0%, 5.0%, and 13.4% (Fig. 11).

SmallCaps may be getting a bigger after-tax earnings boost from Trump’s tax cuts than larger corporations that have had the means to dodge taxes better than smaller ones.

That still begs the question of why small companies’ revenues are so strong on a relative basis. Perhaps Trump’s deregulation policies benefit smaller companies more than larger ones. After all, regulations are often promoted by large companies to keep small competitors at bay. The monthly survey conducted by the National Federation of Independent Business shows that significantly fewer small business owners have been reporting concern about government regulation and taxes since Trump was elected (Fig. 12).

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Robot Advisors & the Magic Kingdom

August 09, 2018 (Thursday)

Financials: AI-Powered Robo-Advisors. As in most industries, technological innovation is disrupting the money management business. That’s most visible in the remarkable growth of exchange-traded funds (ETFs), which were enabled by the revolution in high-speed data processing and telecommunication.

Since the start of 2001, cumulative inflows into equity ETFs totaled $2.0 trillion through June of this year (Fig. 1). From 1990 through the end of 2000, equity mutual funds attracted $1.8 trillion net inflows (Fig. 2). Since the start of 2001, they’ve attracted only $885 billion. Since the start of the current bull market during March 2009, ETFs attracted $1.5 trillion, while equity mutual funds attracted only $149 billion. In other words, so-called “passive” asset managers have clearly benefitted from the tech revolution at the expense of “active” managers.

ETFs provided low-cost investment alternatives and pushed existing players to lower their fees on products new and old to remain competitive. Most recently, Fidelity introduced two fee-free index funds. The Fidelity Zero Total Market Index Fund and the Fidelity Zero International Index Fund won’t charge investors any fees regardless of the amount they invest. Zero. Zip. Zilch.

Nevertheless, thanks to the recent bull market, equity mutual funds racked up capital gains totaling $7.5 trillion through June. Now there is another challenge for traditional active managers. Around 2008 to 2010, a group of upstarts began offering active money management services that used computer programs to decide what and when to buy or sell. Computer programs allocate the funds, rebalance them, and sometimes take tax losses. Human assistance is often available via the phone.

Better known as robo-advisors, firms like Betterment, Wealthfront, and Personal Capital have clients fill out a questionnaire online about their financial status and goals; using that information, a computer places customers’ money in ETFs. Clients benefit from low minimum investments and low fees—often just a quarter or half of a percentage point.

In short order, the big, traditional players took notice and either bought robo-advisors or developed their own AI-empowered offerings. Vanguard, Schwab, Merrill, and other large established companies now offer their own AI-managed funds, often in conjunction with advice from their own financial advisors. I asked Jackie Doherty, our contributing editor, to have a look at recent developments in this growing corner of money management. Here’s her report:

(1) Numbers getting bigger. Robo-advisors may have started small, but their assets under management are growing fast. According to estimates in a Juniper Research study published earlier this year, revenue from robo-advisor technology was about $1.7 billion in 2017, but it will grow to $25 billion by 2022 as assets under management expands from about $330 billion last year to $4.1 trillion in 2022.

“Juniper found that robo-advisors are broadening the appeal of the wealth management market, with their delivery method via intuitive smartphone apps making the investment process far more convenient, offering a compelling reason for millennials to invest,” a company press release stated.

(2) Big fish buying minnows. Large money managers have two choices: build or buy. Among those in the buy camp is BlackRock, which purchased a large minority stake in the UK’s Scalable Capital; founded in 2014, the firm has clients in the UK, Germany, and Austria. That followed BlackRock’s 2015 acquisition of US robo-advisor FutureAdvisor.

Now small financial companies are partnering with FutureAdvisor to offer their own robo-products. US Bancorp has partnered with FutureAdvisor to offer a product called “Automated Investor” that rolled out in June. “The investment portfolios have been created by U.S. Bank wealth management professionals and will have access to ‘the same investment content from our investment team’ that all wealth management clients receive,” Mark Jordahl, president of US Bank Wealth Management, said in a 6/19 American Banker article. “The technology seeks to optimize returns and help minimize risk, and automatically rebalances investments as the markets change, he said. Users can receive a free analysis of their investments to see how they are performing and how they can potentially improve.” The fee: 50 basis points.

Along the same line, Fifth Third has partnered with Fidelity’s digital platform, Automated Managed Platform, to develop a Fifth Third digital wealth management offering. “Fidelity’s automated advice platform launched later than offerings from competing firms such as Schwab and BlackRock. However, the firm has more than a dozen clients already live and using Fidelity AMP, with more than 150 firms in the pipeline, including a mix of banks, RIAs and broker-dealers,” a 6/5 American Banker article reported.

Meanwhile, some of the minnows have started to offer banking products. In Q2, robo-advisors Acorns and Stash launched checking account and debit card options, according to the Q2 Robo Report by BackendBenchmarking. SoFi, a fintech lender with a robo-advice product, now offers checking accounts and credit cards. Wealthfront is exploring offering checking and savings accounts.

(3) Scale matters. Those robo-advisors who have failed to gain scale or attract a deep-pocketed buyer are closing up shop. Hedgeable, a robo-advisor launched in 2010, announced in July its plans to close. The firm had almost 1,700 clients and $79.9 million in assets. The news follows the December closing of WorthFM, a robo-advisor focused on female clients.

Hedgeable’s “demise indicates that the ‘market of independent automated investment services is saturated and the players need either hundreds of thousands of accounts or millions of dollars in order to succeed.’ Small digital advisory firms can’t afford to survive against the big legacy institutions or Betterment or Wealthfront,” said Bill Winterberg, founder of FPPad.com, a technology consulting firm, in a 7/13 Thinkadvisor.com article.

Betterment has $14.1 billion of assets under management, and Wealthfront has $10.2 billion. But even those levels are dwarfed by the robo assets that the large money management firms hold. Vanguard Personal Advisor Services has $101.0 billion of assets under management in its robo arm, and Schwab Intelligent Portfolio Products has $33.3 billion, according to the Robo Report.

(4) The report card. The Robo Report has a quarterly ranking of how various robo-advisors fare. The firm opens up and funds accounts at various robo-advisors. In taxable accounts, it seeks a moderate allocation of 60% stocks and 40% bonds for an investor in a high tax bracket.

No one robo-advisor providing equity advice attained a top-three performance position over more than one of the three time periods measured—ytd, one year trailing, and two years trailing—as of Q2’s end. Vanguard’s Total Portfolio, which can include stocks and bonds, was in third place for the one-year-trailing ranking and in first place for the two-year-trailing ranking. SoFi’s fixed-income portfolio was the top performer ytd and in third place for one-year-trailing performance.

None of their blended portfolios matched the returns of the S&P 500 because the portfolios typically include allocations to bonds, foreign equities, and value stocks. Even their equity portfolios, which may include international or value stocks, failed to match the 14.0% one-year-trailing S&P 500 return as of 7/31. Two of the highest one-year-trailing results came from Fidelity Go, 12.2%, and Wealthfront, 12.4%. Fidelity charges 0.35% annually and has no minimum investment, while Wealthfront charges 0.25% and has a $500 minimum. On the other end of the spectrum, FutureAdvisor and Betterment’s equity portfolios had among the lowest one-year returns, 7.8% and 8.0%, respectively.

(5) Note of caution. Robo-advisors are undoubtedly the flavor of the month on Wall Street; however, investors should be certain to understand exactly how the robos’ algorithms work. Dr. Ed’s book Predicting the Markets illustrates why it’s important to do so.

He writes: “Gary Smith, a professor of economics at Pomona College, wrote an August 31, 2017 opinion piece for MarketWatch titled ‘This Experiment Shows the Danger in Black-Box Investment Algorithms.’ Gary was an assistant professor at Yale when I attended the graduate program in economics, and I learned much from him. We remain good professional friends and like-minded about the cluelessness and irrelevance of most macroeconomic research.

“In the article, Gary reported running big-data, black-box investment algorithms to explain the S&P 500 daily for 2015. He let data-mining software loose on 100 variables that might be correlated with the S&P 500 stock price index. His experiment considered all possible combinations of one to five variables, including all 75,287,520 possible combinations of five variables. Several of them worked great but then failed miserably in 2016. He wisely concluded: ‘We should not be intimidated into thinking that computers are infallible, that data-mining is knowledge discovery, that black boxes should be trusted. Let’s trust ourselves to judge whether statistical patterns make sense and are therefore potentially useful, or are merely coincidental and therefore fleeting and useless.’”

Algorithm suspicion will be important to develop for years to come.

Consumers: Hitting the Road. The Dog Days of Summer have arrived in New York, leaving residents with two options: find air conditioning or travel somewhere with cooler temps. The travel industry has been on strong footing in recent years as the unemployment rate has declined and Boomers and Millennials have shown a proclivity to see the world. Let’s take a look at some of the industry’s stats and the earnings of industry leaders Marriott International and Walt Disney:

(1) Not much room at the inn. The hotel industry is enjoying a strong vacation season. During the week ending 7/28, hotel occupancy rose 1.3% y/y to 78.5%, the average daily rate of hotel rooms increased 2.9% to $135.94, and RevPAR (revenue per available room) jumped 4.2% y/y to $106.66, according to a press release from STR.

That strength fed into a healthy Q2 for Marriott International, which completed its acquisition of Starwood Hotels in 2016. Marriott’s RevPAR increased 3.1% y/y in North America and 3.8% worldwide. Exceedingly strong growth occurred in Asia Pacific, where RevPAR jumped 9% in Q2, including a 10% jump in China. That strength is expected to continue for the remainder of the year, with Marriott forecasting worldwide RevPAR increases of 2.5%-3.0% for both Q3 and Q4.

Overall, the company reported adjusted Q2 earnings per share of $1.73, above analysts’ consensus estimate of $1.38 a share. Disney raised its 2018 adjusted profit estimate to $5.81-$5.91 a share, up from $5.43-$5.55.

Some interesting notes from the company’s Q2 conference call included CEO Arne Sorenson’s take on trade wars and the company’s push into home rentals. So far, he said, there’s no indication that the trade spat between the US and China has affected the company’s occupancy in China or its ability to develop new hotels in that country.

“Personally, my larger fear about the trade war potential is what it could do to GDP growth in the United States and to some extent what it could do to the cost for construction materials in the United States and in other markets around the world,” Sorenson said on the call. The trade war “certainly has not seemed to manifest itself yet in US GDP numbers. It probably is starting to manifest itself in terms of some materials that are used for construction, but it's early on in that process; we'll have to see how it evolves.”

Marriott also discussed its new pilot program Tribute Homes, which seems aimed directly at pushing back against Airbnb and other home rental operations. Launched roughly three months ago, Tribute Homes is a program in London where about 200 homeowners have connected their homes to the Marriott system. Those who book a home get the ability to tap into the Marriott loyalty programs, and Marriott provides services, like key delivery and housekeeping, that make the stay more predictable and consistent with the Marriott brand, said Sorenson. He didn’t say whether the program would be rolled out to other cities.

(2) Still the happiest place on Earth. Results out of Disney’s Park and Resorts division are still indicating that consumers are ready and able to spend. The division’s fiscal Q3 revenue increased 6%, and operating income jumped 15%, due to growth at domestic and international parks and Disney Cruise Line. Both metrics hit new records.

Attendance at domestic parks rose 1% last quarter, a figure that would have been 2% were it not for the timing of Easter. Nonetheless, park guests opened their wallets. Who can resist a set of Mickey ears? “Per-capita spending at our domestic parks was up 5% on higher admissions, food and beverage, and merchandise spending. Per-room spending at our domestic hotels was up 8%,” said Disney CFO Christine McCarthy during the company’s conference call. So far in the current quarter, reservations are down 2% y/y, but rates are up 7%.

Despite the strong business environment, the S&P 500 Hotel, Resorts & Cruise Lines stock price index has fallen 7.8% ytd (Fig. 3). The industry’s revenue is forecast to grow 3.0% this year and 7.3% in 2019 (Fig. 4). That’s expected to translate into earnings growth of 20.0% this year and 13.8% next year (Fig. 5). Despite that strong growth, the industry’s forward P/E multiple is a reasonable 15.6 (Fig. 6).

(3) Up, up, and away. The airline industry’s strength continued in April, the most recent month for which data is reported. US airlines carried in April 73.8 million domestic and international passengers, a new high for the seasonally adjusted figure, according to a 7/13 press release from the US Department of Transportation. The April result is up 0.9% m/m and up 5.0% y/y.

The industry’s load factor declined slightly, as the number of new planes coming online grew faster than the number of passengers. April’s system-wide load factor, at 83.8%, was down from March’s 84.2% and below the all-time seasonally adjusted high of 84.8% reached in October 2015.

The high volume of air travelers hasn’t been enough to offset the recent spike in the price of oil. The S&P 500 Airlines stock price index has dropped 6.9% ytd compared to the S&P 500’s 6.9% climb (Fig. 7). The industry is expected to see revenue climb 6.4% this year and 5.2% in 2019, but earnings are estimated to rise 7.4% this year and a much improved 21.2% in 2019 (Fig. 8 and Fig. 9).

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Tuning Out the Noise

August 08, 2018 (Wednesday)

Stocks: Strong Earnings Signal. The Q2 earnings season, which is nearly over, has been almost as remarkable as the Q1 earnings season, when industry analysts scrambled again to raise their 2018 and 2019 earnings estimates to reflect the passage of the Tax Cuts and Jobs Act (TCJA) at the end of last year. Such Q2 strength on the heels of such Q1 strength suggests that earnings have been boosted by more than just the slashing of the corporate tax rate under the TCJA.

US economic growth has also been strong during the first half of this year. That too might be attributable to the stimulative impact of the TCJA, as well as to the ongoing lift to earnings from the Trump administration’s business deregulation. So far, neither the rise in short-term interest rates nor the increase in the trade-weighted dollar nor the escalating trade war has weighed on earnings. Joe and I think that earnings will remain strong over the rest of this year. Our year-end target of 3100 for the S&P 500 is only 8.5% above yesterday’s close. Consider the following:

(1) Happy earnings hooks. Q1 earnings for the S&P 500 turned out to be 5.3% better than expected by industry analysts at the start of that earnings season (Fig. 1). So far, the earnings surprise for Q2 is 3.7%. Similar ascending hooks are visible for S&P 400/600 Q2 earnings following Q1’s happy hooks. Q2’s y/y growth rates were as awesome as Q1’s were: S&P 500 (24.8% following 23.2%), S&P 400 (22.2, 26.8), and S&P 600 (36.5, 34.8) (Fig. 2).

(2) Forward earnings at fresh record highs. While 2018 and 2019 earnings estimates may be starting to level out at their latest record highs for the rest of the year, forward earnings continue to rise to new record highs for the S&P 500/400/600 as they converge toward the elevated 2019 estimates by the end of this year (Fig. 3).

For the S&P 500, forward earnings rose to $171.93 per share during the 8/2 week. At the beginning of the year, when it was $147.23, we thought we were optimistic carrying a year-end target of $170.00. Forward earnings by definition will equal the 2019 consensus estimate at the end of this year. Currently, the 2019 consensus is at $178.64! That number is more likely to come down than go up from here. But for now, it is pulling forward earnings higher.

(3) Many happy sector returns. The forward earnings of the S&P 500 is up 16.9% since the passage of TCJA through the 7/26 week (Fig. 4). Here is the comparable performance derby for the S&P 500 sectors: Energy (58.8), Telecom (21.2), Financials (18.9), Industrials (18.8), Materials (17.4), S&P 500 (16.9), Tech (15.4), Consumer Discretionary (14.1), Health Care (12.6), Utilities (5.0), Consumer Staples (5.0), and Real Estate (2.7). All are at or near recent new record highs except Energy and Financials.

So far this year through July, the Net Earnings Revision Index readings have been solidly positive for Consumer Discretionary, Energy, Financials, Health Care, Industrials, Information Technology, Materials, and Utilities (Fig. 5).

Bonds: Noise-Canceling Headphones. On Saturday at the Aspen Institute's 25th Annual Summer Celebration Gala, JP Morgan Chase Chief Jamie Dimon warned that the 10-year US Treasury bond yield could go much higher: “I think rates should be 4% today. You better be prepared to deal with rates 5% or higher—it's a higher probability than most people think.”

He should know. Then again, the yield isn’t “4% today.” Rather, it has been eerily stable around 3.00% since the beginning of the year, even though the Fed raised the federal funds rate twice so far this year, and is expected to do so two more times by the end of this year (Fig. 6 and Fig. 7). The 12-month forward fed funds rate futures was at 2.61% Monday. The 2-year US Treasury note yield has closely tracked that futures yield, and is up 75bps ytd to 2.64% through Monday.

I’ve spilled some ink of late about the tug of war in the bond market between the bears and the bulls. Here is some more on the subject:

(1) The bears. Dimon is clearly bearish, and the Bond Vigilantes Model confirms his view that the bond yield should be closer to the growth rate of nominal GDP, which was 5.4% y/y during Q2.

The bears rightly observe that the TCJA and additional fiscal spending approved by Congress at the beginning of the year will significantly boost the federal deficit in coming years. Since last October, the Fed has been on course to slash its holdings of Treasuries and MBSs through 2024. And Fed officials have strongly signaled more rate hikes next year, aiming to raise the federal funds rate to 3.00%.

The bears observe that demand for US Treasuries has been temporarily bolstered this year by impending tax reform, which has spurred US companies to shift billions into corporate pension plans, increasing demand for longer-dated maturities. By doing so, the companies qualify for tax deductions before the new lower rate of 21% takes effect in mid-September.

Meanwhile, some countries, most notably Russia, may be responding to Trump’s sanctions and tariffs by reducing their holdings of US Treasuries.

In addition, there is mounting anecdotal evidence that inflationary pressures are building. Some are doing so in the labor market, which is very tight. Some are related to Trump’s tariffs. The national M-PMI’s prices-paid index dipped in July to 73.2 from a recent high of 79.5 during May (Fig. 8). That index was mostly well below 50.0 during 2015 and early 2016. The national NM-PMI prices-paid index remained relatively high at 64.5 last month. (Prices-received indexes are not available for the national surveys of purchasing managers.)

Debbie and I calculate similar averages for the five Fed districts that survey business conditions each month. The regional prices-paid index rose to 48.3 during July, the highest reading since May 2011 (Fig. 9). It was just below zero in early 2016. The regional prices-received index rose to 26.2 last month, the highest since August 2008.

(2) The bulls. So why isn’t the US bond yield soaring? The bulls respond that trying to forecast the bond market using flow-of-funds supply-vs-demand analysis has never worked. It’s fairly obvious that US bond yields are tethered to comparable German and Japanese yields, which are near zero, and are likely to remain there given the stated policies of both the ECB and BOJ to keep their official rates near zero for the foreseeable future.

Inflationary pressures may appear anecdotally to be building, but July’s average hourly earnings measure of wages remained subdued at 2.7% y/y. June’s headline PCED was up 2.2% y/y and 1.9% on a core basis (Fig. 10). Inflationary expectations as reflected in the yield spread between the 10-year bond and its comparable TIPS remains subdued around 2.1% (Fig. 11). Companies’ record profit margins are likely to absorb some of the cost pressures before they show up in prices.

All that may be so, but what about the record amount of debt worldwide that continues to accumulate? One person’s debt is someone else’s asset. Debt may be at a record high, but so is wealth, which is also growing. Some of that wealth will always be invested on a risk-off basis. Some investors are worrying that all that debt will eventually lead to yet another financial calamity. Ironically, many are buying government bonds because they are deemed to be safe assets!

Then again, September is coming. The kids will be going back to school. The question is: Will the bond yield rise back above 3.00% on the way to Dimon’s 4%-then-5% target? I don’t think so. I’m playing on both sides of the tug of war in the bond market until I see a clear winner.

Global Economy: Tinnitus. While US stock and bond investors are doing a great job of tuning out the noise coming out of Washington, the global economy may be starting to get disorienting tinnitus, i.e., a ringing in the ears, from all the noise about an escalating trade war.

This is most evident in the global M-PMI, which has dropped from a recent high of 54.5 at the end of last year to 52.7 during July (Fig. 12). The global NM-PMI is holding up better around 54.0, as it has been since early 2017 (Fig. 13). That’s not surprising since manufacturing industries are much more vulnerable to an escalating trade war than services industries.

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Slowing? Not So Fast!

August 07, 2018 (Tuesday)

New! YRI Video Podcasts. Full-time employment continues to rise to new record highs (link).

US Economy I: Slowing? Real GDP rose 4.1% (saar) during Q2 (Fig. 1). That was good, but not surprisingly good. Actually, given that taxes were cut at the end of last year, it’s surprising that it wasn’t better. In fact, GDP growth was temporarily boosted by exports as US exporters scrambled to beat Trump’s tariffs. Exports of goods and services contributed 1.12 percentage points to Q2’s real GDP growth, the most since Q4-2013 (Fig. 2).

Debbie and I like to look at the y/y growth rate of real GDP to assess whether the trend growth rate of the economy is changing (Fig. 3). It was up 2.8% y/y during Q2. That’s not a new high for the current expansion, and remains in the 1.0%-3.8% range it has spanned since 2010. In other words, real GDP growth still may be fluctuating around 2.0%, as it has been doing since 2010.

Consumer spending in real GDP rose 4.0% (saar) during Q2, the best since the end of 2014. Again, on a y/y basis, the growth rate for the monthly series was 2.8% during June, just about where it has been since late 2015 (Fig. 4). Real capital spending rose solidly by 7.3% (saar) during Q2, but the 6.7% y/y growth rate was nothing out of the ordinary (Fig. 5).

Could the US economy actually be slowing already despite the fiscal stimulus provided by the tax cuts enacted at the end of last year and the fiscal spending increases passed at the start of this year? If it is, we can blame it on the Fed for raising interest rates and on the Trump administration for imposing tariffs. Both developments have also contributed to a stronger dollar, which may also start to weigh on exports and profits.

Debbie and I don’t see a recession coming, but we are looking out for signs of weakness. There have been more of them recently, with the obvious exception of the all-important and booming labor market. Now consider the following:

(1) Economic surprises downbeat. The big surprise is that the Citigroup Economic Surprise Index (CESI) has dropped from a recent high of 84.5 on December 22, 2017 to -13.9 yesterday (Fig. 6). That doesn’t jibe with the strength in real GDP, particularly during Q2. Then again, the CESI tends to be weak during Q1 and sometimes during Q2, before rebounding during the second half of the year. In any event, it is a trendless cyclical indicator, which means that after it goes down for a while, it goes up for a while.

Notice that the CESI dropped sharply on the weaker-than-expected payroll employment gain of 157,000 during July, reported on Friday. However, it obviously didn’t reflect the significant upward revisions in May (24,000 to 268,000) and June (35,000 to 248,000), as Debbie and I discussed yesterday! Nor did it capture the 389,000 jump in the household measure of employment, led by a whopping 453,000 in full-time jobs!

(2) NM-PMI drops. The NM-PMI fell from 59.1 during June to 55.7 last month (Fig. 7). That’s the lowest since last August. The new orders component plunged from 63.2 to 57.0. We aren’t alarmed, because the series is very volatile and the latest readings remain relatively high. Keep in mind that this is another trendless cyclical indicator. It was so good earlier this year that it couldn’t get much better. Instead, it got a little worse, but still remains upbeat!

(3) Residential construction flattening. Private residential investment in real GDP fell 1.1% (saar) during Q2, and was up only 1.4% y/y (Fig. 8). The weakness has been concentrated in multi-family housing construction, which is down 4.9% y/y (Fig. 9).

Yesterday, we observed that household formation among homeowners has been increasing in recent quarters, while the number of households who rent has been falling. That should be good for single-family residential investment, though it fell 4.7% (saar) during Q2 (but was up 3.5% y/y), as rising mortgage rates may be starting to curb some enthusiasm for buying a home. That’s not confirmed by mortgage applications for new purchases, which remain near recent cyclical highs (Fig. 10).

(4) Auto sales looking toppy. The 12-month sum of US motor vehicle sales peaked at 17.7 million units during February 2016, falling to 17.3 million units last month (Fig. 11). While both domestic light truck and imported auto sales remain on uptrends, domestic car sales have crashed to the lowest since November 2010 (Fig. 12).

Melissa and I suspect that the Millennials may be causing home and auto sales to top out. They are mostly minimalists. Many are single and city dwellers, renting apartments, which are no longer in short supply after the multifamily housing boom of the last few years. They don’t have much use for a car, let alone a light truck. Instead, they rely on Uber and Lyft or rent bicycles.

US Economy II: Not So Fast! The bottom line on all the above is that the US economy isn’t as weak as it seems according to the recent signs of slowing. On the other hand, it isn’t as strong as supply-siders had hoped it would be in response to their tax cut, but the jury may still be out on that score.

Meanwhile, the labor market indicators show an economy that continues to create plenty of jobs. The risk may be that we run out of able-bodied men and women to keep the economy growing, but that hasn’t happened yet, and may not happen at all. Consider the following:

(1) Plenty of people filling jobs. Here are the ytd and monthly average employment gains over the past seven months through July for the following three surveys: payrolls (1.50 million, 215,000 per month), household (1.94 million, 278,000), and ADP (1.45 million, 207,000). Here are the monthly averages for the past three months through July: payrolls (224,000), household (261,000), and ADP (199,000). These numbers suggest that while it may be taking longer to fill job openings, there are still plenty of people to fill the jobs.

(2) Payrolls rising in construction and trucking industries. Notwithstanding lots of anecdotal evidence that construction workers and truck drivers are hard to find, the payroll survey shows that both job series are still rising. Construction employment is up 170,000 ytd through July (Fig. 13). Employment in the truck transportation industry is up 20,600 over the same period (Fig. 14). Furthermore, wage inflation in the industry remained subdued at 2.7% y/y during June (Fig. 15).

(3) Rent a robot. An 8/4 NBC News report explained how a Michigan factory facing a labor shortage as a result of booming demand for its seat belt parts rented two robots from Hirebotics. The company pays each of the robots $15 an hour when they are working. The robots are 30% more productive than their human colleagues.

No wonder wage inflation remains subdued despite the tight labor market. More of us humans may face competition from robots that are paid less, and are more productive, than us!

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Babies & Help Wanted

August 06, 2018 (Monday)

US Demography: Generation Zero. I am among the older Baby Boomers (i.e., those born 1946-1964), having been born in 1950. My colleague Melissa is among the most senior members of the Millennials (1981-1996), having been born in 1981 (Fig. 1). We are both married. I have five kids; she has one. I enjoy collaborating with Melissa, especially on demographic trends.

Unlike Melissa, most of the Millennials are postponing getting married and having kids. At the rate that they are not reproducing, the next age group after Generation Z (1997-2014) might be called “Generation Zero.”

Friday’s employment report included data on the marital status of the adult population, i.e., everyone who is 16 years or older. Marriage continues to lose market share. Consider the following:

(1) Singles outnumbering married couples. The number of single persons equaled the number of married couples for the first time ever during July 2017 (Fig. 2). During July of this year, the former exceeded the latter by 4.1 million. The percentage of the population that is single rose to a record 50.8% during July (Fig. 3). It has been rising steadily from about 38.0% during 1977.

(2) More never-married “selfies.” Among the population of singles, the number of never-married ones (or “selfies”) rose to a record 80.6 million persons during July, as did the number of either divorced, separated, or widowed singles, to 50.4 million persons (Fig. 4). However, the percentage of the former rose to a record 31.3% during July, while the percentage of the latter has been range-bound between roughly 19% and 20% since the mid-1990s (Fig. 5).

(3) Not rushing to get married. The increase in never-married selfies is reflected in the median age at first marriage. It has increased significantly over the past 20 years (1997-2017) from 26.8 to 29.5 years for men and from 25.0 to 27.4 for women (Fig. 6). The marriage rate per 1,000 people in the population dropped from a record high of 16.4 during 1946, when the soldiers came home after World War II, to a record low of 6.8 during 2009 (Fig. 7). It has been basically flat since then through 2016.

(4) Birth dearth. The bottom line is that during 2017, the general fertility rate (i.e., live births per 1,000 women aged 15-44) dropped to a record low of 60 (Fig. 8). That’s half the post-WWII peak during 1957, when the Baby Boom boomed.

(5) Forming households and buying houses. There is some evidence that the Millennials, who are turning 22-37 this year, may be starting to form households and to buy houses. Over the past 12 months through June, household formation totaled 2.3 million (Fig. 9). The number of households representing home owners, which mostly fell following the housing debacle of 2007-2008, has been rising since 2016 (Fig. 10). The number of renting households has been declining slightly since late 2017.

US Labor Market: Full Time. For the here and now, Friday’s employment report was a bit weaker than widely expected. However, a deeper analysis shows that the labor market remains tight. Consider the following:

(1) Payroll vs household employment. The labor force increased by only 105,000 during July, though that followed a gain of 601,000 during June. Payroll employment rose 157,000 during July (Fig. 11). The consensus was 190,000. On the other hand, the more volatile household employment series jumped 389,000 last month, as full-time employment rose 453,000 to another record high of 129.0 million (Fig. 12).

(2) Bullish revisions. Debbie and I tend to give more weight to the revisions in the prior two months of the payroll employment series than to the latest preliminary number. May’s result was revised up by 24,000 to 268,000, and June’s was raised by 35,000 to 248,000. Those are very solid numbers, and suggest that July’s figure might also be revised higher.

We have previously observed that the 12-month sum of the revisions of the payroll employment series is actually a very useful business-cycle-timing tool (Fig. 13). It tends to turn less positive approaching recessions and less negative prior to recoveries. Sure enough, it fell close to zero during the energy-sector-led mini-growth recession of 2015. It started to turn more positive during 2016. In June, it was 305,000, the highest reading for this 12-month moving sum of revisions since the end of 2014, suggesting that all is well with the economy.

(3) Lots of quitters. Separately, the latest JOLTS report shows that the number of job quitters jumped to a record 3.6 million during May (Fig. 14). That’s not surprising, since job openings are plentiful. The ratio of the number of unemployed workers to job openings fell just below 1.0 during both April and May for the first time on record since 2001 (Fig. 15).

What is surprising, though not to us, is that wage inflation remained subdued at 2.7% y/y during July. We’ve argued that demographic factors may be keeping a lid on average hourly earnings. Many Baby Boomers aren’t retiring, and aren’t demanding or getting any meaningful pay gains since they are already well paid. Many Millennials prefer having a minimalist and free lifestyle rather than climbing the corporate ladder of success and pay.

In the past, job quitters did so for better pay, which put upward pressure on wages when the labor market was tight. This time, among the quitters may be Millennials who see the tight labor market as an opportunity to drop out for a while to see the world, figuring that there will be a job available when they come back. They might decide to extend their travels if they can find enough Wi-Fi hot spots to work as freelancers!

Movie. “Three Identical Strangers” (+ + +) (link) is a truly remarkable documentary about triplet boys who were separated at birth. The true story is as suspenseful as any fictional tale. It should be at the top of the list labeled “You Can’t Make This Up.” It delves into the nature-versus-nurture debate among psychologist and psychiatrists. The ethical and moral questions raised are truly profound. I don’t want to spoil it for you. See it to believe it.

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Artificial vs Material Worlds

August 02, 2018 (Thursday)

AI: SciFi or Reality? Artificial intelligence, a.k.a. AI, has the potential to do amazing things. It should spur the development of new drugs. It may power robots that can serve as helping hands and drive autonomous cars. AI stands to be as transformative as the Industrial Revolution and the advent of the Internet.

But there’s also a darker side to AI. Those who think deeply about the ethics of technology warn that we need to be prepared for robots that are smarter than humans, weaponized drones, fake news/videos, and algorithms with undisclosed biases. It’s the stuff of science fiction, akin to the 1927 film “Metropolis,” where a robot is given the identity of a woman programmed to start a rebellion. Science fiction is becoming a reality faster than we might expect or be prepared for. I asked Jackie Doherty, our contributing editor, to shine a little light on the dark side of AI:

(1) Unintended results. Robots equipped with AI are still very literal and can make unintended mistakes. For example, Tay was a system built about two years ago by Microsoft to chat with digital hipsters. However, users were appalled to find Tay spewing hateful speech because she’d repeat whatever was said to her. Tay was shut down.

New and improved systems have been developed to learn to converse instead of just respond with canned answers. But if a chat bot is learning language from those who are prejudiced or offensive, it’s liable to say incorrect or offensive things. “If you mention your company’s C.E.O., it may assume you are talking about a man—unaware that women are chief executives, too. If you ask a simple question, you may get a cheeky reply,” according to a 2/21 New York Times article. AI mistakes in a chat bot may be annoying or embarrassing; AI mistakes in weapons systems may be lethal.

(2) Mysterious black box. Zeynep Tufeki is a techno-sociologist known for her research on the social implications of emerging technology. A Fellow at the Berkman Center for Internet and Society at Harvard University and a 2015 Andrew Carnegie Fellow in the Social Sciences and Humanities, Tufeki gave a 2016 TedTalk discussing the problems involved with relying on AI. Machine learning tells companies whom they should hire, which news item should be recommended, whether to grant parole, and, more shockingly, whom should be hit by an autonomous car. The problem: We don’t know what drives the algorithms in the “black box” and are essentially abdicating our decision-making to these machines.

For example, Facebook’s algorithm decides what you see on your news feed. Tufeki notes that when news reports about the Ferguson, Missouri protests broke out, they didn’t appear on her Facebook feed. It turns out the Ferguson story wasn’t “algo” friendly. It wasn’t liked. It had few comments. Instead, Instead, many Facebook news feeds showed a story on the ALS ice-bucket challenge, which was liked, commented on, and passed on.

“We cannot outsource our moral responsibilities to machines,” Tufeki implored the TedTalk audience. “We need to cultivate algorithm suspicion, scrutiny, and investigation. We need to make sure we have algorithmic accountability, auditing, and meaningful transparency.”

(3) Security threats. As AI gets smarter, its potential threat to our security grows. Some of these threats are laid out in an aptly named report: “The Malicious Use of Artificial Intelligence: Forecasting, Prevention and Mitigation.” Published in February, the report notes that AI systems can now categorize pictures better than humans and can generate an image that’s almost indistinguishable from a photograph. As a result, the “ability to recognize a target’s face and to navigate through space can be applied in autonomous weapon systems. Similarly, the ability to generate synthetic images, text, and audio could be used to impersonate others online, or to sway public opinion by distributing AI-generated content through social media channels.”

Because they can be employed from afar, AI systems can increase anonymity and psychological distance between victim and perpetrator. Someone using an autonomous weapons system to carry out an assassination need not be at the scene of the crime or look the target in the eyes. And if perpetrators know the crime is untraceable, they may feel less empathy and be more willing to carry out the attack.

The report notes that in addition to advancements in AI, the “Progress in robotics and the declining cost of hardware, including both computing power and robots are important too … For example the proliferation of cheap hobbyist drones, which can easily be loaded with explosives, has only recently made it possible for non-state groups such as the Islamic State to launch aerial attacks.” The same may also soon be true for autonomous cars.

In general, the report warns that attackers will “conduct more effective attacks with greater frequency and at a larger scale.” In addition, the improved technology will allow one person to launch an attack remotely using many weaponized autonomous drones.

AI can be (and is being) used in various ways to control dissent and affect political outcomes. States can use automated surveillance to suppress protests, for example. Fake news reports with fabricated video and audio can make leaders seem to say or do things they never have said or done. Automated, disinformation campaigns can target voters in swing districts with personalized messages or manipulate media platforms’ content curation algorithms.

(4) World domination. Though it may sound grandiose, the country or countries that develop and harness AI may also be the countries that dominate the world’s future economic and military power. Just as oil became a key to national power in a world dominated by the combustion engine, there will be certain “raw materials” that make countries powerful in a world dominated by AI.

One key ingredient: access to data. “AI will augment the national power of those countries that are able to identify, acquire, and apply large datasets of high economic and military importance in order to develop high-performance AI systems,” concludes a 7/25 report from the Center for a New American Security. In this respect, China benefits from its willingness to make data available to promote the development of AI. Conversely, doing so in the US could elicit complaints that the government is trampling on privacy rights.

The report also noted that AI-dominating countries will need scientists, mathematicians, and engineers—i.e., humans sophisticated enough to develop advanced AI systems. They’ll also require massive computing resources to train machines. And finally, successful countries will have cooperation between their public and private institutions. This, too, gives China an edge over the US government, which often clashes with the titans of Silicon Valley.

Henry Kissinger, former national-security adviser and secretary of state to Presidents Richard Nixon and Gerald Ford, recommended in the June issue of The Atlantic that the US government consider assembling a “presidential commission of eminent thinkers to help develop a national vision” for AI.

“The Enlightenment started with essentially philosophical insights spread by a new technology. Our period is moving in the opposite direction. It has generated a potentially dominating technology in search of a guiding philosophy,” Kissinger warned. “Other countries have made AI a major national project. The United States has not yet, as a nation, systematically explored its full scope, studied its implications, or begun the process of ultimate learning. This should be given a high national priority, above all, from the point of view of relating AI to humanistic traditions.”

(5) Employees revolt. Those in the trenches writing the code that empowers AI at Microsoft, Google, and Amazon recently have stood up to protest what their companies are doing with their AI services—specifically, to whom the AI is being sold.

At Google, employees protested and some quit over concerns that the company’s contract with the Pentagon meant Google was sharing technology that the Pentagon could use to kill people. Google Cloud won “Project Maven to develop AI that can recognize people and objects captured in drone footage,” reported a 6/4 article in ZDNet. “While Google claimed only to be providing its open-source TensorFlow APIs to the Pentagon, emails seen by Gizmodo show that Google was planning to build a ‘Google Earth-like’ surveillance system for Pentagon analysts, enabling highly-accurate real-time views over people, vehicles, crowds, and land features of an entire city,” the article stated.

Google won’t be bidding to renew the contract that expires in 2019. Bet relinquishing potential business like that wouldn’t have happened in China.

Microsoft employees became upset in June when they realized the company’s Azure Government cloud-computing arm had entered a partnership with the US Immigration and Customs Enforcement (ICE). “Microsoft condemned family separation by ICE in a statement to Gizmodo but declined to specify if specific tools within Azure Government, like Face API—facial recognition software—were in use by the agency. The company also did not comment on whether it had assisted in building artificial intelligence tools for ICE, something the agency has been seeking (and courting Microsoft over) for some time,” reported a 6/18 Gizmodo article.

Finally, Amazon employees have asked their company to discontinue any work with ICE and to end the sale of the facial recognition technology Rekognition to law enforcement agencies. “We don’t have to wait to find out how these technologies will be used. We already know that in the midst of historic militarization of police, renewed targeting of Black activists, and the growth of a federal deportation force currently engaged in human rights abuses—this will be another powerful tool for the surveillance state, and ultimately serve to harm the most marginalized,” an employee letter states, according to a 6/23 Seattle Times article.

No doubt Chinese leaders are overjoyed and doing high fives.

Materials: Trade Wars Winners & Losers. President Trump’s trade war with the world has helped some of the industries in the S&P 500 Materials sector and hurt others. The Steel industry is decidedly in the former camp, as the tariffs have helped US manufacturers compete against foreign players. However, the price of copper has fallen sharply during the tariff wars on fears that a slowdown in global commerce will depress economic growth (Fig. 1 and Fig. 2).

So far, the benefit from the winners is outpacing the drag from the losers. Wall Street’s analysts expect the S&P 500 Materials sector will deliver some of the fastest earnings growth over the next 12 months when compared to the other S&P 500 sectors. Here’s how the S&P 500 sectors’ forward earnings growth stacks up: Energy (40.3%), Financials (17.4), Materials (15.2), Industrials (14.9), Consumer Discretionary (14.3), S&P 500 (14.1), Tech (12.9), Health Care (10.5), Telecom Services (8.0), Consumer Staples (7.9), Utilities (5.6), and Real Estate (-3.6) (Fig. 3).

The recent strength in the S&P 500 Materials sector’s forward earnings is a striking departure from the lack of growth the sector exhibited between its 2011 peak in forward earnings and its 2016 trough. The sector’s forward earnings broke through the 2011 peak in December and has moved steadily higher (Fig. 4).

Growth among the sector’s industries is far from uniform, ranging from a 50.7% jump in the Fertilizers & Agricultural Chemicals industry’s forward earnings to a 7.7% decline in the Copper industry’s forward earnings. Here’s what’s expected for the forward earnings of all the industries in the S&P 500 Materials sector: Fertilizers & Agricultural Chemicals (50.7%), Construction Materials (27.9), Paper Packaging (20.2), Diversified Chemicals (19.0), Steel (18.4), Metal & Glass Containers (15.3), Materials sector (15.2), Specialty Chemicals (13.5), Industrial Gasses (11.6), Gold (7.2), Commodity Chemicals (2.2), and Copper (-7.7) (Fig. 5 and Fig. 6).

Despite the rosy perspective on upcoming earnings from the sector, the S&P 500 Materials stock index is among the worst performing of the S&P 500’s 11 sectors ytd. Here’s how the ytd sector returns stack up: Consumer Discretionary (12.7%), Tech (12.4), Health Care (7.5), Energy (6.7), S&P 500 (5.3), Industrials (1.2), Utilities (0.3), Financials (0.0), Real Estate (0.0), Materials (-1.2), Consumer Staples (-6.4), and Telecom Services (-9.9) (Fig. 7).

Labor Force: PWAM-NILF Vets & Ex-Offenders. In Monday’s Morning Briefing, Melissa and I explored the depressing several-decades-long decline in the labor force participation rate of prime-working-age males (PWAMs). Today, we’re following up on a related lingering question: Do increased numbers of veterans or ex-offenders explain the rise in PWAM-NILFs? “NILF” (which stands for “not in the labor force”) denotes working-age people who neither have a job nor are actively looking for one. NILFs are not factored into the unemployment rate.

It wasn’t hard to find lots of articles, studies, and statistics on the challenges of reentering the workforce after serving active military duty or being charged with a crime. But those challenges don’t provide a neat explanation for the rise in PWAM-NILFs; the data don’t support a correlation. We can comfortably say that veterans are not a contributing factor to the rise in PWAM-NILFs. The data on ex-offenders isn’t as clear cut, but they probably have not significantly contributed to the rise in PWAM-NILFs either. Further, neither veterans nor ex-offenders independently represent the majority of NILFs. Let’s have a look at the available data:

(1) Share of vets on the decline. Alan B. Krueger’s 2017 paper titled “Where Have All the Workers Gone? An Inquiry into the Decline of the U.S. Labor Force Participation Rate” answered our question on veterans in a footnote: “A natural question is whether an increase in the number of disabled military veterans returning to civilian life has contributed to the decline in the participation rate. The short answer is that this does not appear to be the case. The share of out-of-the-labor-force prime-age men who are veterans has declined, from 11.4 percent in 2008 to 9.7 percent in 2016.”

A 2016 Obama administration analysis corroborated that: “[A]lthough veteran participation has fallen by more than for the overall prime-age male population, the share of nonparticipating prime-age men who are veterans has declined, suggesting that this is not a key factor in the overall decline.”

(2) Ex-offenders only a fraction. According to a study cited in the Obama analysis, approximately 6.0% to 7.0% of the entire PWAM population has a criminal record, but how many PWAMs with a criminal record are also NILFs is unknown. We do know that about 12.0% of the entire PWAM population is also NILF. So if all of the roughly 6.0% of PWAMs with a criminal record were also NILFs, they would make up about half of the PWAM-NILF cohort.

But we can safely assume that at least some PWAMs with a criminal record are working or looking for work. That means that ex-offenders likely make up less than half of the PWAM-NILF cohort. Further, some fraction of PWAM-NILFs with a criminal record may have opted out of work even before committing an offense—so their NILF status would not be a result of having a criminal record.

Nicholas Eberstadt, in his book Men Without Work: America’s Invisible Crisis, observed that PWAMs with a criminal record are more likely to be NILFs than those without one. However, he also notes: “[T]he great male flight from work had already been under way for more than a decade and a half before the U.S. male population of ex-prisoners and at-large felons began to soar in the early 1980s and … curiously enough, the explosive growth of that ‘criminal class’ after 1980 seemingly did little or nothing to speed the pace of decline for prime-age male [labor force participation rates] over the following three-plus decades.”

If vets and ex-offenders do not explain the decline in PWAM labor force participation, then there must be other reasons for it. Perhaps that gives more weight to the argument that government support may have something to do with the increase in PWAM-NILFs. That is, unless the nearly half of them who report they are too disabled or ill to work truly are so.

(3) Second-chancers. Data aside, we don’t mean to minimize the problem that many individuals face in rejoining the workforce after a trying time. We think lending a hand to ex-offenders may help to resolve a separate, but related, labor force problem: The number of job openings currently exceeds the number of job seekers, as our friend Jeffery Korzenik, chief investment strategist at Fifth Third Bank, has observed. In a 6/29 article for Barron’s, he wrote: “Our best opportunity is for businesses to make better use of our most underappreciated labor resource: ‘second-chancers.’ This population—those who have paid for mistakes through incarceration or other forms of supervision—offers a path to expand and extend our economic expansion.”

By the way, prisoners are not counted in the labor force participation rate because the denominator for the rate excludes working-age adults who are incarcerated. According to the Obama analysis, if the 1.1 million PWAMs in federal or state penitentiaries were included in the labor force participation rate, the rate would be about 1.5 percentage points lower.

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New York, Tokyo, and Mumbai

August 01, 2018 (Wednesday)

US Stocks: Earnings on a Hot Tin Roof. The Q2 earnings season is coming to a close. Remarkably, the result for the S&P 500 once again is turning out better than industry analysts had expected at the start of the season (Fig. 1). That happens regularly, but it’s surprising so soon after industry analysts scrambled to raise their Q2 earnings estimates at the beginning of this year to reflect the slashing of corporate taxes by the Tax Cuts and Jobs Act (TCJA) late last year. It suggests either that they underestimated the impact of the TCJA or that earnings are getting a bigger boost than expected from the strong US economy. Consider the following:

(1) Earnings. The earnings season has also brought some upside surprises for the S&P 400 and S&P 600. Interestingly, industry analysts have continued to increase their Q4 estimates for all three stock price composites, as they have been doing since the beginning of the year. The result is that the 2018 estimates for all three continue to rise, as do the comparable estimates for 2019 (Fig. 2). Consequently, the forward earnings of the S&P 500/400/600 all rose to record highs at the end of July.

(2) Revenues. Just as impressive is that the 2018, 2019, and forward revenues estimates of the S&P 500/400/600 also all have continued rising in record-high territory (Fig. 3). That’s truly remarkable, since by all accounts the global economy is slowing, partly in response to Trump’s escalating trade war. Then again, his tax cuts have boosted the US economy.

(3) Valuation. Despite the recent rally in stock prices, valuation multiples remain in fair-value territory for the S&P 500/400/600, as rising earnings have offset rising stock prices. The forward P/Es of the S&P 500/400/600 at the end of July were 16.4, 16.3, and 17.4 (Fig. 4).

US Bonds: Yields Made in Japan. Helping stocks to recover from the year’s lows in early February is the eerie calm in the US bond market. The Bond Vigilante Model suggests that the 10-year Treasury bond yield tends to trade around the growth rate in nominal GDP on a y/y basis (Fig. 5). It has been trading consistently below nominal GDP growth since mid-2010. The current spread is among the widest since then, with nominal GDP growing 5.4% while the bond yield is just below 3.00% (Fig. 6).

Why isn’t the bond yield closer to 4.00% or even 5.00%? After all, the TCJA and additional fiscal spending passed by Congress earlier this year are projected by the Congressional Budget Office to result in federal budget deficits averaging about $1 trillion per year for the next 10 years (Fig. 7). Furthermore, the FOMC commenced tapering its balance sheet last October and plans to continue doing so through the end of 2024 (Fig. 8). The Fed is on track to slash its holdings of Treasuries and MBSs by $2.5 trillion and $1.7 trillion, respectively, over the next seven years! Oh and by the way, the FOMC is on track to raising the federal funds rate to 3.00% by the end of next year from 1.75%-2.00% currently.

Let’s review some possible explanations for the nonchalant performance of the bond market. Is it the calm before the storm or the calm that calmly continues? Consider the following bullish offsets to the bearish factors just mentioned above:

(1) Near-zero yields in Germany and Japan. The 10-year German government bond yield has dropped from this year’s high of 0.77% on February 2 to 0.44% yesterday (Fig. 9). Germany may have been hit by uncertainty created by Trump’s trade war. The IFO Business Confidence Index has been falling all year, with its expectations component the lowest since March 2016 (Fig. 10). In any event, the ECB has indicated that the bank’s key interest rates will remain at historical lows at least through the summer of next year!

Meanwhile, there was some anxiety last week about a rumored change of course by the BOJ. The 10-year Japanese bond yield jumped from 0.035% on Friday, July 20, to 0.104% on Monday of this week. It was back down to 0.048% yesterday after the BOJ kept its policy steady. It maintained its target for the 10-year government bond yield at around 0.00% and the short-term interest rate target at minus 0.1%. The bank announced one minor tweak: In a statement, it explained that the yields may move up or down “to some extent mainly depending on developments in economic activity and prices.”

Wow, lots of agita about nothing! The BOJ also acknowledged that it will take “more time than expected” to achieve its inflation target of 2%. You think? The BOJ’s monetary base has more than quadrupled since April 2013, when Haruhiko Kuroda, the new head of the bank back then, slammed on the monetary accelerator and never took his foot off of it (Fig. 11). Most of the time since then, through June of this year, Japan’s CPI inflation rate has remained closer to zero than 2.0% (with the exception of 2014, when the sales tax was raised significantly) (Fig. 12).

(2) Subdued inflation. Back in the USA, the latest inflation figures remain relatively benign: Not too hot, not too cold, just warm enough to allow the Fed to proceed with the gradual normalization of monetary policy. The headline PCED rose 2.2% y/y through June, while the core increased 1.9% over the same period (Fig. 13).

The wage component of the Employment Cost Index held at 2.9% y/y during Q2 (Fig. 14). That’s the highest pace since Q3-2008, but still relatively low given the tightness of the labor market.

(3) Record wealth, with lots set on risk off. That still leaves an important question: Why aren’t bond yields rising in anticipation of all the debt that will need to be financed? There is already a record amount of debt everywhere, and more coming can’t be good for bonds. There is also a record amount of wealth in the world. Some of it tends to be managed with a risk-off bent. Ironically, people who expect that “this will all end badly” tend to buy government bonds because they are deemed to be among the safest assets.

India I: Hotter and Hotter. India boasts the hottest big economy in the world at the moment, and its stock market is hitting record highs. In some ways, it’s the financial equivalent of a Bollywood movie, exuberant and over the top, minus the music and dancing. One thing that’s different: Investors aren’t assured of the happy ending that movie goers can expect. A weak rupee and rising oil prices are seen as threats. I asked Sandra Ward, our contributing editor, to look behind the scenes, to see what’s been driving the growth in the economy and the stock market and whether it’s sustainable. Here’s what she found:

(1) Shaking off demons. India’s GDP grew at a 7.7% y/y clip during Q1, compared with 7.2% growth the prior quarter and 6.1% in Q1-2017 (Fig. 15). It was the highest rate of growth in seven quarters. The Reserve Bank of India expects full-year growth of 7.4%, a 4/28 piece on Reuters reported. The International Monetary Fund concurred until a few weeks ago, when it cut its growth outlook for India in 2018 by 0.10% to 7.3%, citing higher oil costs and higher interest rates, according to a 7/16 article in The Hindu. Significantly, India’s Q1 economic growth eclipsed that of China’s 6.8% by nearly a full percentage point. China’s growth came in slightly ahead of expectations but was flat with the previous two quarters.

All core segments of India’s economy contributed to growth, and the construction sector showed exceptionally strong performance, according to a 5/31 article in The Hindu. One concern: Government spending is still the biggest driver of GDP at 16.8% growth, but that figure is down significantly from the 31.9% contribution posted in Q1-2017 when we wrote about India in the 7/20/17 Morning Briefing (Fig. 16).

India is recovering, at last, from the initial negative effects of economic reforms enacted by Prime Minister Narendra Modi. First, common bank notes in circulation were eliminated in a demonetization process in 2016, creating a lot of uncertainty and subsequent disruption to the economy. Then in 2017, a goods and services tax designed to simplify the tax code, boost efficiencies, and increase the competitiveness of Indian goods was imposed, and the confusion that resulted also interfered with business activity.

(2) Manufacturing PMI. India’s manufacturing improved in June at the fastest rate since December, extending the period of expansion to 11 months, according to the 7/2 Nikkei India Manufacturing PMI report. The M-PMI index rose to 53.1 in June from 51.2 in May (Fig. 17). July’s M-PMI is being released this morning.

Input costs rose at the fastest rate since July 2014 on higher steel and oil prices. Growth in output charges exceeded that pace as firms raised their prices at the fastest rate since February. New orders from overseas posted the eighth straight month of gains, with the rate of expansion the fastest since February.

(3) Services PMI. After contracting slightly in May, the Indian service sector returned to a growth trajectory in June. The strongest rise in new business in a year led to the fastest rate of expansion since June 2017, according to the 7/4 Nikkei India Services PMI report. The Nikkei Business Service Activity Index rose to 52.6 in June from 49.6 in May. Service providers weren’t able to fully pass on their higher input costs to India’s famously price-sensitive consumers.

(4) Inflation. Wholesale prices rose by 5.8% in June, accelerating at the fastest pace in four and a half years on surging food and fuel prices, according to a story in the 7/16 Economic Times. Consumer prices rose 5.0% on higher fuel and housing costs (Fig. 18).

(5) Rate hike. In a surprise move, the Reserve Bank of India raised its benchmark interest rate by 0.25% in June for the first time since 2014, citing the pressures from higher oil prices and the weakening rupee, a 6/6 article in the FT pointed out (Fig. 19). India relies on foreign sources for 80% of its oil.

India II: Higher and Higher. India is the best performing of the emerging markets and Asian countries so far this year. The MSCI India Share Price Index is up 4.4% ytd (in rupees) compared with a loss of 2.5% in the MSCI Emerging Market Share Index (local currency), while the MSCI Emerging Asia Share Index (local currency) is down 3.1% ytd (Fig. 20).

(1) Higher earnings. The MSCI India index companies are projected to increase earnings this year at a 28.0% rate, compared with 15.7% for the MSCI Emerging Market index companies and 14.9% for the companies in the MSCI Emerging Asia index. Yet the MSCI India index is trading at a forward P/E of 18.1 (Fig. 21).

Investors are betting that stronger economic growth will lead to higher profits. They also see India somewhat as a safe haven in the tit-for-tat trade war between the US and China. In addition, more and more domestic investors have been drawn to the equities market by the strong performance of Indian equities over the past few years. Many, too, have turned increasingly to mutual funds and insurance products as demonetization discouraged folks from investing in physical assets such as gold and real estate, according to a 6/27/17 piece on LiveMint.com.

Other emerging markets have sold off as higher interest rates in the US have driven the US dollar higher, but the S&P BSE Sensex has bucked the trend, rising 10.1% ytd through Monday. The Sensex set a new high on Tuesday, closing at 37,606.58. Still, comparatively few companies are driving the benchmark higher. The WSJ reports that the bulk of the gains can be credited to outsourcing companies and banks, with Tata Consultancy Services and Infosys advancing the most, according to a 7/26 piece.

(2) Bad loan resolution. Financial companies make up 41% of the Sensex. Kotak Mahindra Bank and Yes Bank are among the top five performers so far this year, as investors expect the new bankruptcy code will help break up the logjam of bad loans on bank balance sheets and free up lending. State Bank of India, the largest by assets of the state-owned banks, reported a $1.1 billion loss in the quarter ended March. Yet the bank also signaled that the worst of its non-performing loan problem was behind it and that it is on track for recovery, according to a 5/22 article on Reuters. More recently, more than 20 Indian banks signed an agreement aimed at speeding up bad-loan resolution, according to a 7/23 Reuters story.

(3) Foreign direct investment. A spate of high-profile deals could mark a new spurt of growth for foreign inflows into India, which grew at a rate of 3% last year, a five-year low.

In May, Walmart announced a $16 billion investment in Flipkart, giving it a 77% stake in India’s largest online retailer, which was started by two former Amazon employees, according to a 5/9 FT piece.

Sweden’s home-furnishing giant Ikea is preparing to open its first megastore in India, after more than a decade of delays and setbacks and an estimated $750 million to acquire land and permissions for four stores. It plans to spend about the same over the next few years, says a 6/10 FT article.

The entertainment company and streaming service Netflix just launched its first Indian-produced series, Sacred Games, lured by the country’s 500 million Internet users. Netflix views India as its next major source of revenue growth and expects to add 100 million Indian subscribers to its existing base of 125 million global subscribers, according to a 7/16 report in the FT.

And French industrial group Schneider Electric agreed to buy India’s Larsen & Toubro for $2.1 billion, which will make India the third-largest market for Schneider. “It’s a bet on India and a growing economy with favorable government policies,” a Schneider spokesperson told the FT for a 5/1 piece.

(4) Demographic dividend. On track to become the world’s most populous country by 2024, India has a highly desirable demographic profile. More than 50% of its population is below the age of 25, and more than 65% is under 35. A growing workforce population should help drive economic growth (Fig. 22). Of course, all those folks are going to need jobs, and that will be Modi’s next challenge, especially as he faces reelection in 2019.

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