Chips for the Holidays

December 19 (Thursday)

Strategy: A Strong Year for Almost Everyone. For a year that started on a sour note, 2019 sure looks about to end fabulously. Despite the December 2018 correction, the market rallied this year, helped by the Federal Reserve’s midyear about-face and the recent cooling in the US trade war with China. The S&P 500 is up 27.4% ytd through Tuesday’s close, and many sectors and industries boast even stronger results.

Here’s the performance derby for the S&P 500 sectors ytd through Tuesday’s close: Information Technology (45.0%), Communication Services (29.8), Financials (29.4), S&P 500 (27.4), Industrials (26.4), Consumer Discretionary (24.5), Consumer Staples (23.2), Utilities (20.8), Real Estate (20.0), Materials (20.0), Health Care (17.4), and Energy (5.5) (Fig. 1).

Recent headlines have been filled with tales of woe from two large US companies: FedEx and Boeing. Fortunately, neither is big enough to have a large impact on the S&P 500. And neither FedEx’s nor Boeing’s ills reflect a weak US economy. New competition from Amazon and a troubled European merger are primarily what has hurt FedEx. Meanwhile, Boeing’s shares have risen only 1.4% ytd due to engineering problems with the 737 Max.

FedEx is down 8.6% ytd after selling off on Wednesday in the wake of its poor earnings report and after lowering its earnings estimate for this fiscal year (ending May). The company does make up 7% of the S&P 500 Transportation index’s market capitalization. While the Transports have risen 19.1% ytd through Tuesday’s close, they’re still 3.8% below their 9/21/18 record high (Fig. 2).

In addition to dragging down the S&P 500, Boeing’s shares also have weighed down the Dow Jones Industrial Average, which is up 21.2% ytd (Fig. 3). The Nasdaq, however, has neither Boeing nor FedEx as constituents, and thanks to the strong returns of tech shares, Nasdaq has had the strongest returns ytd of the three major indexes. It’s up 33.0%, a gift for which we can all be thankful (Fig. 4).

Technology: Semi Equipment Wins the Day. The S&P 500’s top-performing industry so far this year is Semiconductor Equipment, up 96.5%, followed by Technology Hardware, Storage & Peripherals (71.4%), Diversified Support Services (69.0), Computer & Electronics Retail (63.1), and Personal Products (58.4) (Fig. 5). The Semiconductors industry was just a bit further down the performance line, up 40.6% ytd (Fig. 6). Here’s Jackie’s look at some of the news driving semis to the front of the pack:

(1) A bottom has arrived. The notoriously cyclical semiconductor industry started this year in a freefall, but a bottom appears to have been made this summer. Worldwide sales of semiconductors rose 2.9% in October m/m, but sales remains down 13.1% y/y, according to a Semiconductor Industry Association 12/3 press release. The improvement in the three-month moving average of semi sales is impressive, up 9.3% (Fig. 7). The World Semiconductor Trade Statistics organization projects sales will increase by 5.9% in 2020 and 6.3% in 2021, after falling 12.8% this year.

Micron Technology confirmed our optimism last night when in its earnings report, its CEO said he was optimistic that the company’s current quarter will be the cyclical bottom for its financial performance.

A bottom would be good news for the industry’s earnings, which after falling sharply this year are expected to recover in 2020. The Semiconductor Equipment industry’s earnings are expected to surge 15.7% in 2020 and 17.1% in 2021 after falling 21.5% this year (Fig. 8). And net earnings revisions in November were positive for the first time in 17 months.

Wall Street analysts aren’t expecting the earnings recovery in the Semiconductors industry to arrive until 2021, when earnings are forecast to jump 16.5% compared to a 12.4% decline this year and a 1.5% decline in 2020 (Fig. 9).

(2) 5G drives recovery. Some of the excitement around Semis and Semiconductor Equipment centers on the buildout of 5G telecom services. After being discussed for years, the 5G rollout is expected to accelerate next year. Semiconductor chips will be needed in the new equipment used to send and receive 5G signals as well as the new phones and Internet-connected devices.

(3) Analysts getting excited. A number of analysts have started upgrading stocks based on the 5G buildout next year. Susquehanna upgraded Western Digital and Micron Technologies to Positive from Neutral on Monday, according to a 12/16 CNBC article. The analyst anticipates improvements in the selling price of DRAM and NAND chips in the May quarter and through H2-2020. A Wedbush analyst raised Micron’s rating to Outperform from Neutral due to an “improving memory cycle,” a 12/17 Seeking Alpha article reported.

Bank of America’s analyst Vivek Arya upgraded Skyworks Solutions and Qorvo to Buy from Underperform, a 12/9 Barron’s article reported. “In our view, 5G could prove to be one of the more compelling and investible themes in semis, driven by the exponential growth in components required to upgrade ~1.4 billion 4G smartphones and several hundred million IoT [Internet of Things] devices,” his report stated.

(4) Industry players optimistic too. Applied Materials CEO Gary Dickerson sounded upbeat in the company’s 11/14 earnings conference call. “Looking beyond the cycle at the broader context for the electronics industry, it's important to recognize that we are in a period of transition as major new growth drivers emerge in the form of IoT, Big Data, and Artificial Intelligence. Over the next decade, we expect hundreds of billions of edge devices to be deployed, an explosion of data generation, and new approaches to computing to sustainably process and create value from all the data that's available.”

And Taiwan Semiconductor Manufacturing, the world’s largest contract chip maker, added to the industry’s cheer in October when it upped its capital expenditure forecast by almost 40%, a 10/18 WSJ article reported. Taiwan Semi manufactures chips designed by others, including Apple, Huawei, AMD, and Qualcomm. So when it’s doing well, that means many other industry players are too.

“The Taiwanese bellwether cited 5G, the next-generation wireless network, as the main reason for its confidence in the industry. It expects the penetration rate of 5G smartphones globally to reach midteens next year—more optimistic than its single-digit forecast six months ago,” the article stated. 5G phones are expected to have more chips in them than older phones. While the stock market has clearly sniffed out the industry’s bounce in advance, these stocks should continue to improve in 2020, as the cycle should last for a year or two before the inevitable next downturn arrives.

Disruptive Technology: All Things AI. Perhaps it’s just a coincidence, but the number of companies with AI announcements seems to be multiplying. AI is becoming as buzzy as the Internet was in 1999. Here’s a rundown of some of the recent AI news making headlines:

(1) AI in healthcare. Cigna is rolling out Health Connect 360 to help patients control chronic conditions like diabetes, heart disease, and pain. “The system aggregates medical, pharmacy, lab and biometric data—such as information from glucometers, which measure blood-sugar levels—into a dashboard that is accessible through an online interface,” a 12/12 WSJ article reported. The information can be accessed by patients, Express Scripts case managers, nurses, and physicians with access rights. The system’s algorithms will analyze the data to make recommendations on ways to improve patient care and ideally prevent costly problems from arising.

(2) AI in chips. Intel announced the $2 billion acquisition of Habana Labs, a startup that makes AI chips used in data centers to help customers analyze data. AI is one of Intel’s investing priorities, and the Habana deal follows Intel’s 2016 acquisition of Nervana Systems, which specializes in machine learning systems, and its purchase of Movidius in 2016. Movidius specializes in AI and computer vision processors that power the cameras in devices that need to understand what they are seeing, like drones and thermal cameras.

“Intel said it expects the market for chips to power AI to grow to $25 billion by 2024. Almost half that revenue, it said, would be generated from selling chips to be used in big data centers,” a 12/16 WSJ article noted.

(3) AI to boost savings. JPMorgan Chase hopes to use artificial intelligence to tap the data it has about its customers to create new products and services for them. “The bank ‘stores about 390 petabytes—or 390 million gigabytes—of data, ranging from information about its customers to data about credit-card transactions,’ [CIO Lori] Beer said. The bank also integrates details from about 7,500 alternative data sources, such as public financial statements, census data, social media, satellite images, news sources and market data,” a 12/11 WSJ article reported.

With that trove of data, JPM could use AI-based virtual assistants to help consumers save money for retirement. It’s already using AI to help tailor its marketing messages to customers and to audit the company’s employees’ travel and expense data.

(4) AI in 2020. IBM made five predictions about how AI will advance in 2020, according to a 12/17 Inside HPC article. The company expects more AI systems to use neuro-symbolic technology, which combines learning and logic but requires less data. That should lead to technological breakthroughs that help computers better understand human conversations and allow companies to deploy more conversational automated customer care and technical support tools.

Workers will start feeling the impact of AI more directly in their jobs, and employees should focus on expanding their skills. We’ll see the rise of AI to govern AI—to ensure that it’s reliable, fair, and accountable. IBM has developed an AI tool to predict the result of millions of chemical reactions, and it can synthesize molecules in the cloud. IBM expects the system will discover and develop new materials next year.

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2020 Vision

December 18 (Wednesday)

US Economy: More of the Same in 2020? Next year’s number includes two “2”s and two “0”s. Could there be a message in that unusual coincidence? As an amateur numerologist who also happens to be an economist, I’m thinking that the number “2020” strongly implies zero chance of a recession, with real GDP growing around 2.0% while inflation remains just below 2.0%. That just happens to be our outlook for next year, though we would never say “never” when it comes to predicting recessions. They are always possible.

But Debbie and I don’t see a recession in next year’s economy. That’s because credit crunches invariably cause recessions. With the major central banks on course to increase the sizes of their balance sheets in 2020, a credit crunch seems very unlikely. (See our “More Easy Money in 2020” in the 12/11 Morning Briefing.)

Will 2020 turn out to be much like 2019 for the economy and financial markets? Consider the following:

(1) Political assumptions. Our outlook assumes that geopolitical tensions abate next year from this year’s concerns about US trade relations with the rest of the world, the upheaval in Hong Kong, and Brexit. Then again, they could all get worse in the coming year. Furthermore, the Middle East is always primed for yet another crisis. Iran is particularly hard-pressed by US sanctions and could instigate a war with either Saudi Arabia or Israel, or both.

Here at home, 2020 is likely to be just as acrimonious in the political arena as was 2019. Nevertheless, the US economy continues to perform well despite all the noise coming out of Washington. Our working assumption is that there won’t be a radical regime change in the White House at the beginning of 2021, i.e., Trump will get a second term as POTUS. No matter who wins, the checks-and-balances system of government invented by our Founders continues to work relatively well.

(2) Real GDP. On a y/y basis, real GDP growth in the US has been hovering around 2.0% since Q1-2010 (Fig. 1). Since then through Q3-2019, it has ranged between a low of 0.9% and a high of 4.0% (Fig. 2). In our forecast table, we are projecting that real GDP will increase 2.5% next year, a bit better than this year’s 2.3%. (See YRI Economic Forecasts.)

We expect that real consumer spending will increase 2.5% next year, the same as this year. A slowdown in hiring as a result of a tight supply of workers should be offset by better growth in real wages, if productivity growth rebounds, as we discuss below. We are expecting that the pace of growth in real capital spending will double from 2.0% this year to 4.0% next year as trade uncertainties and recession fears diminish. There is also likely to be a significant swing in residential fixed investment in real GDP from -1.3% this year to 4.3% next year.

(3) Productivity. The surprise next year is likely to be that a tightening labor market boosts productivity, which would allow nominal wages to continue increasing faster than consumer prices. The resulting increase in real wages should bolster consumers’ purchasing power and fuel consumer spending growth. We are projecting an increase in nonfarm business (NFB) productivity growth from 1.7% this year to 1.9% next year.

The growth in inflation-adjusted NFB output closely tracks the growth in real GDP (Fig. 3). Actually, the former has been slightly outpacing the latter since mid-2010. NFB productivity growth has been fluctuating between 1.0% and 1.8% y/y since the start of 2017. It was 1.5% during Q3.

Productivity is one of the two variables that determines real output growth. The other is NFB hours worked, which rose just 0.9% y/y during Q3, little changed from Q2’s 0.8%, which was the weakest pace since Q2-2010. The tightening labor market is weighing on the supply of labor.

In other words, real GDP growth might be about the same in 2020 as in 2019, but more of it is likely to be based on productivity than labor input. That would be a positive development for keeping inflation down, while boosting real wage growth and the profit margin. It would be a win-win-win situation for sure.

(4) Inflation. In our 2020 outlook, inflation remains dead or at least in a coma for another year. We are predicting a core PCED inflation rate of 1.8% next year, the same as this year (Fig. 4). The major central banks are likely to persist in trying to offset the four deflationary forces (i.e., the “4Ds”) with ultra-easy monetary policies. They should continue to avert deflation but be frustrated by their inability to achieve their 2.0% inflation target.

(5) The Fed and interest rates. In our scenario, the Fed is likely to remain on hold through next year’s 11/3 presidential and congressional elections. In his 10/30 press conference, Fed Chair Jerome Powell said, “So I think we would need to see a really significant move up in inflation that’s persistent before we would consider raising rates to address inflation concerns.”

So the federal funds target range should remain 1.50%-1.75% through the end of next year (Fig. 5). In our outlook, the 10-year US Treasury bond yield should range between 1.50% and 2.00%.

(6) Rest of the world. We are expecting somewhat better growth overseas during 2020 than in 2019. The “peace dividend” from the de-escalation of Trump’s trade wars should benefit global growth. So should yet another round of ultra-easy monetary policies from the major central banks.

The latest data aren’t there yet. As Debbie reported yesterday, the Eurozone’s flash M-PMI remained weak at 45.9 during December (Fig. 6). On the other hand, the NM-PMI remained above 50.0 at 52.4.

The good news is that passenger car registrations in the European Union (EU) have been ticking up over the past three months through November, based on the 12-month sum of unit sales (Fig. 7). However, on the same basis, automobile sales in both the US and China continued to weaken during November to the lowest since July 2015 in the US and the lowest since June 2016 in China. Auto sales in China, the EU, and the US combined totaled 56.4 million units over the 12 months through November, down 7.7% from a record high of 61.1 million units during August 2018 (Fig. 8).

US Economy II: Curve Balls in 2020? For contrarians, the problem with our outlook for 2020 is that it is probably close to the consensus outlook. The big surprises this year have been mostly bullish for the stock market. The Fed pivoted from warning us during the fall of 2018 about the prospect of three or four rate hikes in 2019 to actually cutting the federal funds rate three times this year. Trump escalated his trade wars earlier this year, but has been deescalating them in recent months. Also earlier this year, widespread fears that the inverted yield curve was signaling an imminent recession have abated as the yield curve spread turned positive as a result of the Fed’s third rate cut this year at the end of October.

The two biggest surprises this year would be a rebound in inflation and/or a recession:

(1) Inflation risk. A rebound in price inflation is long overdue according to the Phillips curve model. Perhaps the model will finally work in 2020 as a very tight labor market boosts wage inflation, which then boosts price inflation.

Actually, the Phillips curve model is finally working to explain rising wage gains, as the jobless rate has been below 4.0% for the past 10 months and for 16 of the past 17 months (Fig. 9). Average hourly earnings for production and nonsupervisory workers rose 3.7% y/y during November, the most since February 2009.

However, there’s no sign that rising labor costs are boosting the core PCED inflation rate so far (Fig. 10). That’s because productivity growth is offsetting much of the increase in the Employment Cost Index, which is keeping a lid on the core PCED inflation rate (Fig. 11). As we’ve previously noted, the happy outcome is that real wages are growing without putting any upward pressure on prices or downward pressure on profit margins.

(2) Recession risk. The other surprise relative to the current consensus outlook would be a recession in 2020. Melissa and I have been writing about the zombie apocalypse. We’ve argued that the ultra-easy monetary policies of the major central banks are deflationary because they are enabling supply-side companies that should be out of business to stay in business, while two to three consecutive decades of easy money have dulled the stimulative impact of those policies on demand-side borrowers.

Historically low interest rates are causing investors to reach for yield, while paying less attention to credit quality. The result has been that of the $7.1 trillion in US nonfinancial corporate debt (including bonds, loans, and revolving credit) at the start of this year, $2.9 trillion was rated BBB (i.e., only one grade above junk) while $2.4 trillion was rated as junk, according to S&P Global’s 5/17 report, “U.S. Corporate Debt Market: The State Of Play In 2019.”

It's not too hard to imagine that this pile up of dodgy debt could set the stage for a credit crunch, which would bury the walkng-dead zombies, forcing them to shut down their capacity and to let go of their workers. The good news is that unlike 2008, the banks are in great shape. Furthermore, rising defaults by nonfinancial corporations may not cause a credit crunch if distressed assets funds act as a shock absorber in the capital markets as they did during the 2015 crunch.

In any event, for now, zombies are safe. The central banks continue to pump lots of liquidity into the global financial markets stimulating lots of reach-for-yield demand for the dodgy credits. It could all end badly, but not likely to do so in 2020.

Stocks: Meltup in 2020? Another risk is that investors could conclude that there is nothing to fear but fear itself. That could lead to a meltup. When the S&P 500 rose to our 3100 target for this year on 11/15, we started to consider the possibility of a meltup scenario involving an advance to our 3500 year-end 2020 target well ahead of schedule in early 2020. We may be experiencing that meltup now given that the S&P 500 is getting close to 3200 already!

As you know, Joe and I have been keeping a diary of panic attacks since the start of the current bull market. By our count, there have been 65 of them so far, followed by 65 relief rallies (Table of S&P 500 Panic Attacks Since 2009). The latest one occurred in August. The S&P 500 has been making new record highs in recent weeks as investors have been relieved by the de-escalation of Trump’s trade wars, the diminishing risks of a global recession, and the prospect of more easy central bank policies in 2020.

Bonds: Lower Longer in 2020? Given our outlook above, we believe that the 10-year US Treasury bond yield will remain subdued between 1.50% and 2.00% through the end of next year. Credit quality spreads should remain tight as long as recession fears don’t make a comeback next year. Helping to keep US yields low are the slightly negative yields on comparable German and Japanese bonds. We don’t expect that real growth and inflation will surprise to the upside and push yields higher in Germany and Japan.

Currencies: Less Mighty Dollar in 2020? The US trade-weighted dollar has had a great run since the summer of 2011. It is up 33% since then. It may not have much more upside, but we don’t see much downside either. Usually, the dollar is strongest when investors overweight US investments in a global portfolio (i.e., they “Stay Home” in the US). It is weakest when investors underweight US investments (i.e., they “Go Global”).

As we started to observe in early October, stocks are cheap overseas compared to the US, and the outlook for the global economy is improving in 2020. However, the US still looks like the best environment for long-term investors seeking a diversity of major world-class industries with lots of market cap.

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Slicing & Dicing Pork & Profits

December 17 (Tuesday)

China: Pork Prices Boost Retail Sales. Yesterday, the financial press touted November’s 8.0% y/y increase in Chinese retail sales as a harbinger of better things to come for China’s economy in 2020. Trump’s willingness to deescalate his trade war with China following the Phase 1 trade deal announced at the end of last week also should boost China’s economy.Melissa and I agree that reduced trade tensions with the US should benefit China, the US, and the rest of the world’s economy next year. However, we weren’t impressed by November’s retail sales report out of China. As we observed just yesterday, the swine flu epidemic is decimating China’s pig population. Pork prices are soaring. That’s boosting nominal retail sales growth but depressing real growth in retail sales. Pork represents a big share of many Chinese consumers’ household budgets. Consider the following: (1) Nominal vs real retail sales growth. While retail sales rose 8.0% y/y in nominal terms, China’s CPI rose 4.5% y/y. As a result, inflation-adjusted retail sales rose just 3.5%, the weakest pace since December 1997 (Fig. 1). (2) Lots of food inflation. The CPI for meat, poultry, and related products soared 74.5% y/y through November (Fig. 2). The CPI excluding food was up just 1.0% over this same period (Fig. 3). (3) Production growing. There was better news in November’s industrial production, which rose 6.2% y/y (Fig. 4). That’s better than the month before, but this growth rate has been hovering around 5.0% since the start of this year—near some of the lowest readings during the Global Financial Crisis. (4) Less bang per yuan. According to the People’s Bank of China (PBOC), the outstanding amount of bank loans in China has increased six-fold, from $3.6 trillion at the start of 2008 to $21.7 trillion through November 2019 (Fig. 5). The PBOC has fueled this credit binge by lowering the reserve requirement ratios for large banks (as well as small/medium-sized ones) from a record high of 21.5% (19.5%) during H2-2011 to 13.0% (11.0%) during late September of this year (Fig. 6). We like to monitor the ratio of industrial production to bank loans in China. It has dropped from a record high of 106.6 during December 2007 to only 50.7 last month (Fig. 7). The PBOC is getting less and less bang per yuan of bank lending! (5) Looking forward. Joe and I track the forward revenues and forward earnings of the China MSCI stock price index (Fig. 8 and Fig. 9). Both are uninspiring, having been on slight downward trends since early last year. The question is whether the easing of trade tensions with the US will revive these two sensitive economic indicators. We suspect that homegrown problems may also be weighing on China’s economy. These include too much debt and too many seniors. Nevertheless, the consensus of industry analysts is that the revenues of the China MSCI will grow 8.9% this year, 8.9% next year, and 8.1% in 2021 (Fig. 10). They are expecting earnings to grow 22.1% this year, 12.3% next year, and 13.9% in 2021. (6) Consolidating to go higher. The China MSCI stock price index (in both yuan and US dollars) has traced a volatile triangular consolidation pattern since Trump started the trade war with China last spring (Fig. 11). They’re both up 21% since this year’s low on 1/3 through Friday’s close. Our hunch is that the index goes higher in 2020 now that trade tensions are easing. Another positive is that the stock index is selling at a relatively cheap 11.3 forward P/E. (See our Global Index Briefing China MSCI.) Corporate Profits: Dividends Confirming Profit’s Uptrend. Joe and I are seeing more and more articles on the discrepancy between the growth in after-tax corporate profits as stated in the National Income & Product Accounts (NIPA) and the growth in S&P 500 reported net income, which tends to account for about half of NIPA profits. The NIPA measure has been stalled at a record high around $1.9 trillion since Q1-2012 (Fig. 12). Meanwhile, S&P 500 reported net income remains in an uptrend in record-high territory. The spread between these two measures has been on a downward trend since Q1-2012 (Fig. 13). The question is: What’s in the spread that has weighed on corporate profits, offsetting the uptrend in the S&P 500 net income? Consider the following: (1) What’s in NIPA profits? According to the NIPA Handbook, corporate profits includes all US public, private, and “S” corporations. It also includes other organizations that do not file federal corporate tax returns—such as certain mutual financial institutions and cooperatives, nonprofits that primarily serve business, Federal Reserve banks, and federally sponsored credit agencies. (2) What are S corporations? On its website, the IRS explains the difference between C and S corporations: “A C corporation is taxed on its earnings, and then the shareholder is taxed when earnings are distributed as dividends. S corporations elect to pass corporate income, losses, deductions and credits through to their shareholders for federal tax purposes. Shareholders of S corporations report the pass-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. This allows S corporations to avoid double taxation on the corporate income.” As a result, most of the income of S corporations is paid out as dividends. So their profits are taxed once as personal dividend income rather than as corporate profits. On a pre-tax basis, their profits are included in NIPA corporate profits. We are reaching out to the NIPA folks to determine whether after-tax NIPA profits excludes S corporation profits because they are mostly paid out as dividends to individuals. If so, as we suspect, then perhaps more C corporations have elected to be S corporations, which might misleadingly depress NIPA after-tax profits. (3) Accounting for dividends. Obviously, we’re still gathering up the pieces to this puzzle. There may be some clues in the data available for dividends. The Fed compiles a quarterly series for dividends paid by all corporations (Fig. 14). It closely tracks the monthly series for personal dividend income that is included in personal income. We can subtract the dividends paid by S&P 500 corporations from the Fed’s series on dividends paid by all corporations to derive a series that should be composed mostly of S corporation profits that are paid out as dividends (Fig. 15). The important point is that dividends are at a record high for all three series. Since Q1-2012, when NIPA after-tax corporate profits first began to stall, total dividends are up 65%, S&P 500 dividends are up 92%, and the residual (which may include dividends paid mostly by S corporations) is up 54%. These figures suggest that the underlying profits must also have improved over this period. (4) National Income shares must add up. The NIPA accounts distribute pre-tax National Income to the following categories: Compensation of Employees, Proprietors' Income with inventory valuation and capital consumption adjustments (IVA and CCAdj), Rental Income of persons with CCAdj, Corporate Profits with IVA and CCAdj, Net Interest and miscellaneous payments, and three other minor categories. The adjustments are necessary because National Income shares, which sum to 100%, are based on income from current production. Earlier this year, NIPA revisions contributed to the flattening of pre-tax profits from current production. The Q1-2019 level was cut by $245 billion to $2.0 trillion (saar) (Fig. 16). Offsetting this downward revision for Q1 were upward revisions for Compensation of Employees ($241 billion), Proprietor’s Income ($17 billion), and Net Interest ($103 billion) (Fig. 17). So some of the recent flattening of NIPA profits reflects the upward revisions in compensation and interest expenses for corporate America. Labor’s share of Q1 National Income was revised up from 62.2% to 63.1%, while profits share was revised down from 12.6% to 11.2% (Fig. 18 and Fig. 19). (5) Bottom line. Our latest slice and dice of the NIPA profits data suggests that it’s a confusing measure of profits. What we do know is that S&P 500 net income continues to grow and so do dividends. The bull market’s fundamentals remain bullish, in our opinion.

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Peace in Our Time

December 16 (Monday)

Global Economy I: Peace Dividend? “Suppose They Gave a War and No One Came” was the title of a 1966 McCall’s magazine article by Charlotte E. Keyes. She helped to popularize the American antiwar slogan from the hippie subculture during the Vietnam War era. Now suppose that Trump’s trade wars end; will the global economy get a boost from the resulting peace dividend? We might get an answer in 2020 now that the US and China have agreed on a Phase 1 trade deal. Of course, the trade war between the two countries isn’t over, but it has been significantly deescalated. There is at least one more phase to negotiate, if not many more. While Trump agreed to postpone the 12/15 round of tariffs on imports from China, plenty of others, imposed over the past two years, are still in place. Furthermore, he might be emboldened by his apparent success in using tariffs as an economic weapon to attack unfair European trade practices. He might even escalate the trade war with the Chinese next year to secure a better Phase 2 deal than possible unless he gets tougher with them. Debbie and I expect that the global economy will benefit if Trump deescalates his trade wars next year as he focuses on winning the November 2020 presidential election for a second term. However, global economic growth might disappoint if it turns out that something more than just Trump’s trade wars has been slowing the global economy since early 2018, especially in the manufacturing sector. Specifically, manufacturers around the world may be hamstrung by operating in a global economy that is stuffed with too much stuff. That’s because ultra-easy credit conditions over the past 10-plus years have financed lots of capacity expansion, particularly by zombie factories that would be shut down but for the availability of easy credit. At the same time, geriatric demographic profiles are getting more geriatric around the world, as people aren’t having enough kids to replace themselves and are living longer. As a result, we expect somewhat better global economic growth next year, but no boom. That’s a good thing given our mantra: “No boom, no bust.” A related concept of ours: “No credit crunch, no recession.” As we observed in our 12/11Morning Briefing titled “More Easy Money in 2020,” the total assets of the world’s three major central banks is on track to make new record highs next year. So credit conditions should remain easy. The problem is that easy money allows the zombie companies to multiply, exacerbating excess capacity in manufacturing and resulting in deflation for goods prices. We discussed this development in our 11/13 Morning Briefing titled “Zombies In the Fed’s Soup.” Here was the crux of our argument: “Meanwhile, supply-side borrowers, who produce the goods and services purchased by demand-side borrowers, can take advantage of easy money to refinance their debts at lower rates. Producers may also borrow more to keep their businesses going. The ones who are most likely to do so are the ones who would be out of business if they couldn’t borrow money. In other words, they are zombie businesses, i.e., the living-dead companies that won’t die because they are resuscitated by the cash infusions provided by their lenders. As long as they stay alive, they create deflationary pressures by producing more goods and services than the market needs. “And why are lenders willing to lend to the zombies? Instead of stimulating demand, historically low interest rates incite a reach-for-yield frenzy among lenders. They are willing to accept more credit risk for the higher returns offered by the zombies. Besides, if enough zombies fail, then surely the central banks will come up with some sort of rescue plan.” In any event, it was good to see that commodity prices rose sharply on Thursday and Friday in reaction to the announced US-China trade deal. The CRB raw industrials spot price index is showing signs of bottoming (Fig. 1). The same can be said of its copper price component (Fig. 2). The price of crude oil also firmed up last week (Fig. 3). Global Economy II: More of the Same. While last week’s bullish reaction in the commodity pits to the trade news is a happy development, other recent global economic indicators continued to show US growth remaining slow and steady, European growth still weakening, and Chinese growth continuing to slow. Consider the following: (1) US economy moseying along. Notwithstanding November’s weaker-than-expected retail sales reported on Friday, the Atlanta Fed’s GDPNow estimate for Q4 GDP growth remained at 2.0%, the same as it was on 12/6. According to the GDPNow website, the “increases in the nowcasts of fourth-quarter real government spending growth, real private inventory investment, and real net exports were offset by a decline in the nowcast of fourth-quarter real personal consumption expenditures growth.” In current dollars, the monthly series on total federal government spending excluding the major entitlement programs (which redistribute income) closely tracks federal government outlays on goods and services in nominal GDP (Fig. 4). The former was up 8.6% y/y through November to a new record high of $1.68 trillion, while the latter was up 5.4% y/y through Q3. There was a small uptick of 0.2% m/m in current-dollar business inventories during October (Fig. 5). Nevertheless, the series has stalled out at a record high around $2.0 trillion since the start of this year. The real merchandise trade deficit did narrow in October, which should boost real GDP (Fig. 6). Current-dollar retail sales rose 3.1% y/y during November, but the available October data show that manufacturing shipments were down 1.5% y/y and wholesale sales were down 1.4% y/y (Fig. 7). (2) European production struggling. Is it possible that young adults around the world don’t aspire to own a Benz or a Bimmer, even if they could afford to do so? That’s hard for Baby Boomers to wrap their minds around, we know! But that might explain some of the weakness in German auto production. Many young people today don’t aspire to own any car at all. They prefer ride-sharing services and scooters. Many also worry about climate-change issues and may be waiting for electric vehicles to become a practical alternative to gasoline-powered cars. Compounding the woes of European automakers were stringent emission-control standards imposed during September 2018. The result is that German auto production, based on the 12-month sum, plunged 14% since then through November of this year (Fig. 8). German manufacturing output is down 6.1% y/y through October (Fig. 9). That has weighed on the Eurozone manufacturing index, which is down 2.3% over the same period. (3) China running out of pigs and shoppers. The swine flu is devastating China’s supply of pigs. That’s ironic given that 2019 is the Year of the Pig according to the Chinese Zodiac. The CPI for meat, poultry & related products jumped 74.5% y/y through November (Fig. 10). The overall CPI rose 4.5% over this period, but only 1.0% excluding food (Fig. 11). The y/y growth rate in inflation-adjusted retail sales dropped to 3.4% during October, the lowest reading since December 1997 (Fig. 12). Pork is a significant portion of the budgets of lots of low-income Chinese families. So it’s not surprising that the growth rate of retail sales has been falling sharply recently. However, real retail sales growth has been on a significant downward trend since late 2009. We believe that the combination of urbanization and the one-child policy from 1979 to 2015 is weighing heavily on Chinese consumers. Just think about all those young adults who are the only children of their two elderly parents. In China, children have a social responsibility to take care of their aging parents. That’s a heavy burden. Now imagine the burden of a married couple composed of two only children: They have four older parents to support. China’s fertility rate has been falling since the mid-1950s in part because of urbanization (Fig. 13). The one-child policy pushed the fertility rate below the replacement rate of 2.1 children per woman during 1994. The UN projects that it will remain below the replacement rate through the end of the current century.

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Pedal to the Light-Truck Metal

December 12 (Thursday)

Auto Makers & Retailers: In the Slow & Fast Lanes. Companies that make cars are having a tough year, but companies that sell new and used cars are doing just fine. Those two ideas seem contradictory, but they are not. The shares of GM and Ford Motor are trailing the broader market, up 5.0% and 18.6% ytd through Tuesday’s close, while the shares of AutoNation, CarMax, and Group 1 Automotive are trouncing the market, up 42.7%, 54.5%, and 95.7%! I asked Jackie to take a look at what’s driving the disparate experiences:

(1) A world of hurt. US new motor vehicle sales, at 17.2 million saar in November, were down 1.3% y/y, driven by a 12.5% plunge in auto sales; light-truck sales were up 3.6% y/y—climbing to record highs (Fig. 1). However, GM and Ford sales span the world, making their results more than just a reflection of what’s occurring in the US.

GM’s North American operating profit rose 7.0% y/y to $3.0 billion in Q3, while its International business dropped to a $65 million loss, down from a $139 million profit a year ago, according to the company’s 10/29 press release. The company’s autonomous division, Cruise, also lost money to the tune of $251 million last quarter. Were it not for an increase in the profit kicked in by GM Financial, the drag from the International and Cruise divisions would have been even more evident. GM Financial’s Q3 operating profit rose to $711 million from $498 million a year earlier.

It’s a similar scenario at Ford, where US revenue rose 5% in Q3 y/y; but this company presented a much darker picture of international operations. Ford’s Q3 revenue fell in South America (-19% y/y), Europe (-14), Middle East and Africa (-2), China (-27), and Asia Pacific (-12), according to its 10/23 press release.

(2) Hot used wheels. Unlike the auto manufacturers, auto retailers are largely domestic operations, selling both new and used autos and light trucks. While sales of new vehicles have been stagnant, the sale of used vehicles has risen sharply in recent years. Real personal consumption expenditures on used autos and light trucks is near record levels, having risen 98% since its January 2014 bottom. Real sales of used light trucks have raced ahead, soaring 150% over the period to new record highs, while used auto sales advanced a more subdued 38% (Fig. 2).

With operations across 16 states, AutoNation calls itself the nation’s largest auto retailer. AutoNation’s Q3 sales of new vehicles fell 2.0% y/y, but its Q3 sales of used vehicles rose 9.5%. Add in sales of financial and insurance services, car parts, and repair services, and the company’s total revenue increased 2.1% y/y last quarter, a 10/29 press release reported.

CarMax, the nation’s largest retailer of used cars, reported that its fiscal Q2 sales rose 9.1% y/y and its net earnings increased 5.8% y/y. Its smaller competitor, Group 1 Automotive, posted a 7.9% y/y jump in total revenue and a 6.5% y/y increase in income from operations in Q3, according to its 10/24 press release. The company, which sells both new and used cars and operates collision centers, generates roughly two-thirds of its revenue in the US, with most of the remainder coming from the UK except for a sliver (i.e., 3.6%) from Brazil.

(3) Ugly numbers. The S&P 500 Automobile Manufacturers stock price index has gained 10.5% ytd through Tuesday’s close, but trails the S&P 500’s 25.0% jump (Fig. 3). The industry is expected to post a 4.9% drop in revenue this year, followed by a 2.3% increase in 2020 (Fig. 4). Likewise, two years of earnings declines (-14.5% in 2018 and an expected -18.2% this year) are forecast to be followed by a jump of 20.8% in 2020 (Fig. 5). Investors appear to be in show-me mode, as the industry’s forward P/E is a lowly 6.2 (Fig. 6).

Disruptive Technology I: Brokers Battle Back. Fin Tech companies have been biting at the ankles of their larger brokerage trading counterparts for a few years. Upstarts like Robinhood, Betterment, and Wealthfront have entered the investing scene with free online trades and very inexpensive computer-generated advice. But Charles Schwab’s moves this fall seem to have given investors confidence that the old dog’s new tricks just might be what’s needed to fend off the competition. Let’s take a look at what Chuck’s shop has done and how Schwab shares have reacted:

(1) Slashed to zero. The earth shook on 9/26 when Interactive Brokers announced it would offer commission-free, unlimited online trades on stocks and ETFs through a new account dubbed “IBKR Lite.” Schwab responded quickly. On 10/1, the firm revealed that it too would offer free trades on stocks, ETFs, and options listed in the US and Canada through online accounts. Later the same day, TD Ameritrade followed suit with a zero-trading commission announcement.

The fall to zero continued this week: On Tuesday, Wells Fargo announced free online stock and ETF trades, and on Monday Bank of America’s Merrill Edge broadened free trading beyond customers of a loyalty program to all of its self-directed brokerage customers. Said differently, the disrupted struck back at the disruptors. But that doesn’t mean that the move won’t be painful. Trading commissions made up about 7% of Schwab’s revenue, a quarter of TD Ameritrade’s revenue, and a fifth of E*TRADE Financial’s revenue, a 10/1 WSJ article noted.

(2) The threat continues. Despite recent moves, the online brokerage industry remains under fire from the disruptors. Competition to lure assets is fierce. Betterment is offering up to 1.78% on cash reserves, Robinhood 1.80%, and Wealthfront 1.82%, according to their respective websites. That’s much higher than the 0.06%-0.30% Schwab offers on uninvested cash in brokerage accounts or even the 0.18% yield on a Schwab Bank high-yield investor saving account.

The fees charged for giving advice are also under pressure. Wealthfront, a robo advisor with $22 billion under management, uses index funds to construct recommended portfolios. It charges a 0.25% advisory fee on assets under management; the ETFs it recommends charge fees between 0.06% and 0.13%, according to its website. Traditional financial advisors typically charge 1% to 2% of a client’s assets annually, the WSJ article noted. At Schwab, investors who invest their cash in Schwab’s bank can use the firm’s portfolio-management algorithms for free.

(3) Investors approve. Schwab followed its earth-shaking zero-fee announcement with the $26 billion acquisition of TD Ameritrade Holding announced on 11/25. The market has given its seal of approval to the company’s bold moves. Schwab’s shares are up 18.4% ytd, compared to TD Ameritrade share’s 4.8% ytd return and E*TRADE’s 3.4% return. Schwab’s performance is even more impressive if you consider that the shares fell 20.5% from the start of the year through 10/3 and then gained 34.7% from 10/3 through Tuesday’s close.

(4) Brokers hold their own. Schwab’s trials and tribulations are lost when looking at the S&P 500 Investment Banking & Brokerage stock price index, which includes Schwab, Goldman Sachs, Morgan Stanley, E*TRADE, and Raymond James Financial. The index is up 24.3% ytd through Tuesday’s close, having recently broken out of a year-long trading range, and it’s keeping pace with the S&P 500, up 25.0% ytd (Fig. 7). The industry’s revenue growth is expected to decline 0.6% this year and increase 1.3% in 2020 (Fig. 8). Likewise, earnings are forecast to fall 2.2% this year and increase 3.1% in 2020 (Fig. 9). Analysts have cut earnings estimates sharply over the past three months, and the industry’s forward P/E stands at 11.4 (Fig. 10).

Disruptive Technology II: Smart Roofs. Tesla CEO Elon Musk unveiled the latest version of Tesla’s solar roof in late October, and there have been some very important developments that might finally take solar energy mainstream. Most importantly: The price of the newly dubbed “Solarglass” is competitive, and its aesthetics have improved. It’s the latest step toward Musk’s belief that in time Tesla Energy (home to the solar roofs) will approximate the size of Tesla’s auto business. Let’s take a look at the progress:

(1) Price. The price of Tesla’s Solarglass has come down sharply, 40% by one estimate. The overall cost has fallen to $33,950 after incentives for a 2,000-square-foot home with 10 kW of solar tiles installed, less than the $43,790 for a new roof with solar panels on it.

The individual roof tiles are much bigger than their predecessors, 45 inches long by 15 inches wide, which reduces the cost of production, increases the power density, and facilitates installation, a 10/28 Teslarati article reported. It’s expected to take just as long as a traditional roof to install, roughly one day, down from the five to seven days needed to install earlier versions of Tesla solar roofs.

(2) Appearance. Just as important, Tesla solar panels now look sleek. Gone are the clunky eyesores of years past sticking up above the roofline. The company is currently producing tiles that look like dark traditional asphalt roof shingles. Eventually, the company plans to have the Solarglass in roofs that look like clay tile and French slate.

The roof has a 25-year warranty and is suggested for newly constructed homes or replacement of existing roofs with less than 10 years of life left. The solar roof tiles aren’t as efficient at converting sun to electric as a traditional solar panel, but they can cover more of a roof’s area, so they end up being more efficient as a whole, a 10/25 CNET article noted.

(3) Good timing. The timing of Tesla’s Solarglass is fortuitous. California is making solar roofs mandatory for newly constructed homes in 2020. The state’s Energy Commission estimates the new rule will add $8,000-$10,000 to the cost of a new home, increasing a monthly mortgage payment by $40 but reducing homeowners’ utility bills by an average of $80 a month, a 2/17 CNBC article reported. Tesla’s Solarglass looks like it will be competitive on its own merits. But a little kick from the Golden State couldn’t hurt.

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More Easy Money in 2020

December 11 (Wednesday)

Central Banks: Lots of Santas. Former Fed Chair Paul Volcker passed away on 12/8. Below, I briefly discuss his great achievement: He broke the back of inflation. Unfortunately, he had to cause a recession to do so, which broke the backs of lots of good hard-working people. He was widely viewed by them as the Grinch Who Stole Christmas. All of the Fed chairs who came after have preferred playing the role of Santa Claus, showering us all with lots of easy money. They were able to do so mostly because inflation has remained subdued ever since Volcker subdued it.

Actually, at the end of last year, Fed Chair Jerome Powell seemed more like a Grinch than a Santa. He roiled the financial markets by suggesting that the Fed would continue to raise the federal funds rate three or four times during 2019. He started to change his mind just around Christmas of last year and signaled that the Fed would halt rate hikes for a while. He completed his pivot by lowering the federal funds rate three times this year, on 7/31, 9/18, and 10/30 (Fig. 1).

As a result, the S&P 500 stock price index bottomed on Christmas Eve last year at 2351.10 (Fig. 2). It was up 33.2% to 3132.52 on Tuesday (Fig. 3). That’s a very long Santa Claus rally.

At the 7/31 meeting of the FOMC, the committee decided not only to lower the federal funds rate, for the first rate cut since 2008, but also to terminate quantitative tightening (QT) ahead of schedule: “The Committee will conclude the reduction of its aggregate securities holdings in the System Open Market Account in August, two months earlier than previously indicated.” From 10/1/17 through 7/31/19, the Fed’s balance sheet was pared from $4.4 trillion to $3.7 trillion (Fig. 4).
The Fed and the other major central banks are all playing Santa during this holiday season and are on track to continue doing so in the new year:

(1) Fed. In a 10/11 press release, the Fed announced that beginning on 10/15 it “will purchase Treasury bills at least into the second quarter of next year in order to maintain over time ample reserve balances at or above the level that prevailed in early September 2019.” More details were released in a separate New York Fed statement (and accompanying FAQs).

The initial pace of these “reserve management” (RM) purchases will be approximately $60 billion per month and will be in addition to ongoing purchases of Treasuries related to the reinvestment of principal payments from the Fed’s maturing holdings of agency debt and agency mortgage-backed securities. As the new holdings mature, the principal payments will be reinvested again into T-bills.

Many have commented that these actions look a lot like quantitative easing (QE). After all, the Fed is expanding its balance sheet sizably, possibly by up to $300 billion or more assuming $60 billion a month through March as a ballpark figure. The Fed’s balance sheet totaled $4.0 trillion during the 12/4 week, including $2.3 trillion in US Treasury securities, of which $420 billion are Treasuries maturing in one year or less (Fig. 5). This portfolio of Treasuries maturing in under a year is up $71 billion since the end of September.

(2) ECB. Mario Draghi’s term as president of the European Central Bank (ECB) ended on 10/31. Before leaving, Draghi put together a monetary stimulus package. It is designed to induce Eurozone governments to borrow at zero or negative interest rates to spend on stimulating their economies.

The package includes an open-ended commitment to buy as much as €240 billion per year of bonds issued by Eurozone governments. In other words, Draghi set the stage for the implementation of Modern Monetary Theory (MMT) in the Eurozone. According to MMT, governments should borrow as much as possible as long as inflation doesn’t heat up. All the better if the central bank enables such borrowing by lowering interest rates and purchasing government bonds—again, as long as inflation doesn’t heat up. Now it is up to the various Eurozone governments to take the bait.

The ECB terminated its QE1 program at the end of 2018. Under the program, which started 1/22/15, the ECB’s “securities held for monetary policy purposes” increased by €2.4 trillion to €2.7 trillion (Fig. 6). Draghi’s QE2 program will once again expand the ECB’s balance sheet to new record highs.

(3) BOJ. In an 11/18 Reuters interview, Bank of Japan (BOJ) Governor Haruhiko Kuroda said the BOJ has room to deepen negative interest rates, but he signaled there were limits to how far it can cut rates or ramp up stimulus.

According to Reuters, “Kuroda also said there was still enough Japanese government bonds (JGB) left in the market for the BOJ to buy, playing down concerns its huge purchases have drained market liquidity. After years of heavy purchases to flood markets with cash, the BOJ now owns nearly half of the JGB market.”

The BOJ’s QE program started in April 2013 and has yet to be terminated. This can be seen in bank reserve balances at the BOJ. They rose to a record high of ¥352 trillion during November, up 740% since the start of the program (Fig. 7).

(4) All together now. The total assets of the Fed, ECB, and BOJ rose $264 billion y/y during November to $14.5 trillion (Fig. 8). On this basis, they had been falling from December 2018 through September 2019. This total is on track now to rise to record highs in 2020.

That should be good for the stock market, which has been tracking the total assets of the three major central banks since the start of the current bull market (Fig. 9). Don’t fight the three major central banks.

Paul Volcker: The Great Disinflator. The following is an excerpt about Volcker from my forthcoming book, Fed Watching for Fun and Profit.

When Volcker took the helm at the Fed, the Great Inflation was well underway. During the summer of 1979, oil prices were soaring again because of the second oil crisis, which started at the beginning of the year when the Shah of Iran was overthrown. Seven months later, in March 1980, the CPI inflation rate peaked at its record high of 14.8%. When Volcker left the Fed during August 1987, he had gotten it back down to 4.3%.

How did he do that?

Volcker didn’t waste any time attacking inflation. Eight days after starting his new job, he had the FOMC raise the federal funds rate on 8/14/79, by 50 basis points to 11.00%. Two days later, on 8/16/79, he called a meeting of the seven members of the Federal Reserve Board to increase the discount rate by half a percentage point to 10.50%. This confirmed that the federal funds rate had been raised by the same amount. Back then, as I previously noted, FOMC decisions weren’t announced. The markets had to guess.

On 9/19/79, Volcker pushed for another discount-rate hike of 50 basis points to 11.00%. However, this time, the vote wasn’t unanimous; the Board was split four to three. In his memoir, Volcker wrote that market participants concluded that “the Fed was losing its nerve and would fail to maintain a disciplined stance against inflation.” The dollar fell and the price of gold hit a new record high.

Volcker, recognizing that the Fed’s credibility along with his own were on the line, came up with a simple, though radical, solution that would take the economy’s intractable inflation problem right out of the hands of the indecisive FOMC and the Board: The Fed’s monetary policy committee would establish growth targets for the money supply and no longer target the federal funds rate.

This new procedure would leave it up to the market to determine the federal funds rate; the FOMC no longer would vote to determine it! This so-called “monetarist” approach to managing monetary policy had a longtime champion in Milton Friedman, who advocated that the Fed should target a fixed growth rate in the money supply and stick to it. Under the circumstances, Volcker was intent on slowing it down, knowing this would push interest rates up sharply.

On 10/4/79, Volcker discussed his plan with the Board. In his memoir, he noted, “Even the ‘doves’ who had opposed our last discount-rate increase were broadly supportive, having been taken aback by the market’s violent reaction to the split vote.” A special meeting of the FOMC was scheduled for Saturday, 10/6/79. Holding an unprecedented Saturday night press conference after the special meeting, Volcker unleashed his own version of the Saturday Night Massacre. He announced that the FOMC had adopted monetarist operating procedures effective immediately. He said, “Business data has been good and better than expected. Inflation data has been bad and perhaps worse than expected.” He also stated that the discount rate, which remained under the Fed’s control, was being increased a full percentage point to a record 12.00%. In addition, banks were required to set aside more of their deposits as reserves.

The Carter administration immediately endorsed Volcker’s 10/6/79 package. Press secretary Jody Powell said that the Fed’s moves should “help reduce inflationary expectations, contribute to a stronger US dollar abroad, and curb unhealthy speculation in commodity markets.” He added, “The Administration believes that success in reducing inflationary pressures will lead in due course both to lower rates of price increases and to lower interest rates.”

The notion that the Fed would no longer target the federal funds rate but instead target growth rates for the major money supply measures came as a shock to the financial community. It meant that interest rates could swing widely and wildly. And they did. The economy fell into a deep recession at the start of 1980, as the prime rate soared to an all-time record high of 21.50% during December 1980. The federal funds rate rose to an all-time record high of 20.00% at the start of 1981. During 1980, the discount rate was raised to 13.00% on 2/15/80, then lowered three times to 10.00%, then raised again two times back to 13.00%, on the way to the all-time record high of 14.00% during May 1981. The trade-weighted dollar index increased dramatically by 56% from 95 on 8/6/79, when Volcker became Fed chair, to a record high of 148 on 2/25/85.

The public reaction to Volcker’s policy move was mostly hostile. Farmers surrounded the Fed’s headquarters building in Washington with tractors. Homebuilders sent Volcker sawed-off two-by-fours with angry messages. Community groups staged protests around the Fed’s building. Volcker was assigned a bodyguard at the end of 1980. One year later, an armed man entered the building, apparently intent on taking the Board hostage.

At my first job on Wall Street as the chief economist at EF Hutton, I was an early believer in “disinflation.” I first used that word, which means falling inflation, in my June 1981 commentary, “Well on the Road to Disinflation.” The CPI inflation rate was 9.6% that month. I predicted that Volcker would succeed in breaking the inflationary uptrend of the 1960s and 1970s. I certainly wasn’t a monetarist, given my Keynesian training at Yale. I knew that my former boss [at the Federal Reserve Bank of New York] wasn’t a monetarist either. But I expected that Volcker would use this radical approach to push interest rates up as high as necessary to break the back of inflation.

Volcker must have known that would cause a severe recession. I did too. Back then, I called Volcker’s approach “macho monetarism.” I figured that a severe recession would bring inflation down, which in turn would force the Fed to reverse its monetary course by easing. That would trigger a big drop in bond yields. Arguably, the great bull market in stocks started on 8/12/82, when the Dow Jones Industrial Average dropped to 776.92. On 12/6/19, it was 27,677.79.

Thank you, Paul Volcker.

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What’s in Style?

December 10 (Tuesday)

Strategy I: Small, Medium, and Large. The S&P 500 LargeCap stock price index has outperformed the S&P 400 MidCaps and S&P 600 SmallCaps since 12/24/18 (Fig. 1). The former peaked last year at 2930.75 on 9/20 (Fig. 2). On Friday, it was up 7.3% from that peak and close to its 11/27 record high. Both the S&P 400/600 (i.e., the “SMidCaps”) are still below their 2018 highs.

The SMidCaps may be starting to outperform the LargeCaps. The Fed’s third rate cut this year seems to have reduced fears of a US and global recession, as evidenced by the yield-curve spread, which bottomed on 8/30 at -62bps and was back up above zero at 23bps on Friday (Fig. 3). Generally speaking, smaller companies are viewed as riskier during recessions than are large companies.

The problem is that it is getting harder to find workers, which may be harder for small companies to do than for large ones. That makes it tougher for the smaller ones to grow since they tend to do so by expanding their payrolls more so than larger companies. The larger ones may be better at using technology to boost the productivity of their workers. This would explain why the aggregate profit margin of the LargeCaps is higher than the profit margin of the SMidCaps, and also why the former has held near its record high this year while the SMidCap margin has been squeezed significantly (Fig. 4).

Last Wednesday, I visited one of our NYC accounts, who manages a portfolio of SmallCaps. She invests in the growthier names in her universe and is especially keen on companies that either provide productivity-enhancing technological tools or use them to boost productivity. Among her recent homeruns are SmallCap software companies.

Let’s have a closer look at the relevant data:

(1) S/M/L employers. The unemployment rate has been below 4.0% for the past 10 consecutive months and for 16 of the past 17 months (Fig. 5). It is highly inversely correlated with the percentage of small business owners who say that they have job openings. This year, more than a third of them have been saying so, which has been a record high since the start of the data in 1974.

ADP payroll data show that small companies with 1-49 workers employ more workers (52.8 million during November), than either medium-sized companies with 50-499 workers (47.0 million) or large companies with over 500 workers (29.7 million) (Fig. 6). Since January 2011, the S/M/Ls have increased their payrolls by 7.4 million, 8.1 million, and 5.4 million.

(2) S/M/L profit margins. Joe and I derive weekly profit margin series for the S&P 500/400/600 by dividing the forward earnings of each by their respective forward revenues (Fig. 7 and Fig. 8). All three weekly series track their respective actual quarterly profit margins very closely (Fig. 9).

The weekly forward profit margin of the S&P 500 has been holding up near last year’s record high of 12.4% during the 9/13/18 week. It was 12.0% during the last week of November, well above the 11.1% reading at the end of 2017, just before Trump’s corporate tax cut pushed it higher. On the other hand, the forward profit margin for MidCaps has given up about half of the boost from the tax cut. It was down to 7.0% during the 11/28 week, the lowest since the 6.9% before the tax cut. The forward profit margin for SmallCaps peaked at 5.8% in October of last year, falling to 4.9% at the end of November and now matches the reading just before the tax cut.

(3) S/M/L sectors. Joe and I monitor the forward profit margins of the S&P 500/400/600 sectors (Fig. 10). The data are available weekly since 2006. The LargeCap’s margin has almost always exceeded those of the SMidCaps. Interestingly, this year in the Financials sector, the SmallCaps have exceeded the margins of the LargeCap and MidCap Financials.

We also notice that the profit margin of the S&P 500 Industrials sector is on an uptrend in record territory. The same can be said of the Utilities sector’s margin. Not surprising is that margins have been getting squeezed especially hard this year in Energy and Materials.

Strategy II: Growth vs Value Market-Cap Shares. Joe and I aren’t big fans of the Growth-vs-Value style distinction. We prefer focusing on sectors and industries. The Fed’s third rate cut this year and the reversal in the yield curve noted above seem to explain why S&P 500 Value has outperformed S&P 500 Growth since 8/27 (Fig. 11). However, it makes more sense to us that both of these developments explain why the S&P 500 Banks industry has outperformed recently, given that many of the companies within it tend to be classified as “Value.”

By the way, the average of the M-PMI and NM-PMI has been a good leading indicator for the spread between the yearly percent changes in S&P 500 Growth versus Value during the current bull market (Fig. 12). The weakness in this average PMI since early last year set the stage for the recent outperformance of Value relative to Growth.

I asked Joe to determine the market-cap shares of Growth versus Value for the S&P 500/400/600 sectors. Here are his major findings as of Friday’s close (also see Table):

(1) Financials. The Financials sector has the highest market-cap shares in the S&P 500/400/600 Value indexes at 18.6%, 20.9, and 19.2. These compare to the following shares in the S&P 500 Growth index: 6.9, 11.8, and 13.7.

(2) Information Technology. The Information Technology sector is the biggest market-cap sector in the S&P 500 Growth index (at 22.7) and in the S&P 400 Growth index (at 17.0).

It is in fourth place in the S&P 600 Growth behind Health Care (18.9), Industrials (17.3), and Financials (13.7).

(3) Communication Services. The Communication Services sector is the second largest one in the S&P 500 at 17.9. It’s relatively small in the Value index at 6.5, and even smaller in both S&P 400/600 Growth and Value.

(4) Industrials. The Industrials sector tends to have a higher market-cap share in the Value indexes than in the Growth indexes of the S&P 500/400/600: S&P 500 (8.8 Growth, 10.3 Value), S&P 400 (14.9, 19.4), and S&P 600 (17.3, 17.5).

Strategy III: Stay Home vs Go Global. In early October, Joe and I figured that with a third rate cut for this year likely by the end of the month and the reversal of the yield curve, it might be time to look for some Go Global opportunities as an alternative to our long-held Stay Home recommendation. In particular, emerging economy stocks, bonds, and currencies tend to do better when the Fed is easing than when it is tightening credit conditions in the US. European companies that do significant business in emerging economies also would benefit in this scenario. However, Friday’s big jobs report favored Stay Home, which continues to outperform.

What is Go Global waiting for? Perhaps a significant de-escalation of Trump’s various trade wars. That could happen soon with China. However, just last week, Trump slapped tariffs on steel imports from Argentina and Brazil, and may soon do so on French wine.

More signs of life from the global economy would also benefit Go Global. The problem is that the slide in the CRB raw industrials spot price index, which started last summer, continued through the end of last week (Fig. 13). The good news is that the Emerging Markets MSCI stock price index (in dollars), which in the past has been highly correlated with the commodity index, has been holding up very well so far this year. But it isn’t outperforming the US MSCI.

Let’s review the latest batch of global economic indicators:

(1) German orders and output. The news out of Europe, particularly Germany, remains depressing. Yesterday, Debbie discussed German factory orders and production. The former edged down 0.4% during October, following a gain of 1.5% the month before, but it is down 5.5% y/y (Fig. 14). The weakness has been in both domestic orders (down 7.5% y/y) and foreign ones (down 4.1% y/y) (Fig. 15).

Really ugly is the 1.5% m/m and 6.3% y/y freefalls in production (excluding construction) during October. The small uptick in the 12-month sum of German passenger car production during October has been followed by a new low during November, down 9.3% y/y (Fig. 16).

(2) Leading indicators. The composite leading indicator for the OECD countries has stopped falling, holding steady at 99.1 in October, the same reading as for August and September. The OECD-Europe index posted 99.2 for the seventh month in a row, with indexes in the UK, Italy, and Spain falling over the period, while France’s has held steady in recent months and Germany’s ticked up in October for the first time in two years.

The US index also showed improvement in October, edging up to 98.9 from 98.8 the month before. The rest of the world trended downward or held steady. Japan’s index fell for the 12th consecutive month to 99.2, the lowest since December 2009.

Among the four BRICs, three are below 100.0: China (99.2), India (99.3), and Russia (99.5). Brazil (102.2), on the other hand, has been strong for a while, registering readings above 100.0 since June 2017. (See our Global Leading Indicators.)

(3) China trade. Debbie and I track Chinese merchandise exports and imports on a seasonally adjusted basis. Both edged down during November. Both have stalled at record highs over the past year, with exports up only 1.1% y/y and imports up 2.4%.

We also track the 12-month sum of Chinese exports by destination. The data through October show the following y/y growth rates: Emerging economies (5.4% to a record high), advanced economies (1.2), Eurozone (7.9 to a record high), South Korea (7.8 to a record high), Australia (3.9 to a record high), Japan (1.7), and US (-8.1). (See our China Trade.)

(4) Forward revenues. We also track forward revenues for the major MSCI indexes around the world in our MSCI Metrics Comparisons. They are showing that the forward revenues of the All Country World MSCI remains on a very gradual upward trend since early 2018, weighed down by the EMU, UK, and Japan. On the other hand, the US remains on a solid uptrend, and Emerging Markets may have bottomed during the summer.

Here are y/y growth rates in forward revenues through the 11/28 week for selected MSCIs: All Country World (4.3%), Emerging Markets (7.0), EMU (3.4), UK (1.2), Japan (1.4), US (4.9), China (8.7), India (7.3), and Brazil (4.4).

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Purchasing Power

December 09 (Monday)

US Labor Market I: The Fed Is Listening. Over the past year, the Fed has been conducting a first-ever public review of monetary policy. As part of that review, Fed officials have been meeting with representatives from a wide range of groups around the country. During these so-called Fed Listens events, the locals have been telling Fed officials how the economy is working for them and the people they represent. In an 11/25 speech, Fed Chair Jerome Powell said that his big takeaway is that the longest economic expansion on record is only now starting to have a very positive impact on lots of people who have been down and out for a very long time:

“Many people at our Fed Listens events have told us that this long expansion is now benefiting low- and middle-income communities to a degree that has not been felt for many years. We have heard about companies, communities, and schools working together to help employees build skills—and of employers working creatively to structure jobs so that employees can do their jobs while coping with the demands of family and life beyond the workplace. We have heard that many people who in the past struggled to stay in the workforce are now working and adding new and better chapters to their lives. These stories show clearly in the job market data. Employment gains have been broad based across all racial and ethnic groups and all levels of educational attainment as well as among people with disabilities.”

Sure enough, here are the November unemployment rates by race and ethnicity: African-American (5.5%, a tick above October’s record low of 5.4%), Hispanic (4.2%, not far above September’s 3.9% record low), White (3.2%, around 50-year low), and Asian (2.6%, close June’s 2.1% record low) (Fig. 1).

Here are November’s jobless rates by education for people aged 25 and over: less than a high-school degree (5.3%, in the neighborhood of September’s 4.8% record low), a high-school degree (3.7%, within close range of its lowest rate since 2000), some college (2.9%, around its lowest readings since 2001), and a Bachelor’s degree (2.0%, bouncing around its lowest readings since 2008) (Fig. 2).

US Labor Market II: Gainfully Employed. There was plenty of other good news in November’s employment report that was released on Friday, as Debbie discusses below. On balance, the report confirms that the purchasing power of consumers continues to rise in record-high territory. Consider the following:

(1) Earned income. Our Earned Income Proxy (EIP) for private-sector wages and salaries rose 0.4% m/m as both aggregate hours worked and average hourly earnings (AHE) increased 0.2%. All these series are at record highs. The EIP is up 4.8% y/y (Fig. 3). Debbie estimates that consumer prices rose just 1.3% y/y through November based on the headline personal consumption expenditures deflator (PCED). (That’s unchanged from October’s rate.) That means that aggregate real earned income is up 3.5% y/y, a very solid increase indeed.

(2) Wages. AHE for all workers rose 3.1% y/y during November, which also well exceeds consumer price inflation. It was even better for production and nonsupervisory workers, at 3.7%. Dividing this series by the PCED shows that real AHE for these workers, who currently account for 70% of total payrolls and 82% of private payrolls, is up 1.7% y/y through November.

This measure of the real wage has been moving higher since 1995 along a growth path of 1.2% per year (Fig. 4). It is up 34% from December 1994 through November. In other words, it belies the widespread myth that real wages have stagnated for the past two to three decades, with all the economic gains going to the rich. In fact, most Americans have never been better off. Period.

Could it be that the real AHE—which is an average, not a median measure—has been driven up by the rich? Nope. The series we are using is just for production and nonsupervisory workers. They would have to win the lottery to be rich.

(3) Employment. Friday’s employment release was widely described as a “blowout jobs report.” November’s 266,000 gain in payrolls, which counts the number of both full-time and part-time jobs, was the most since the start of the year. However, this has been a volatile series. The latest 12-month average gain was 183,700 (Fig. 5).

Similarly, household employment, which counts the number of people with jobs, increased by 149,200 per month on average during the 12 months through November, while the labor force has increased by 131,900 per month on average.

The really good news is that full-time jobs edged up to another record high during November, accounting for 83% of household employment. That was the highest percentage since 2008 (Fig. 6).

(4) Weekly earnings. Buttressing our upbeat story about real pay is a monthly series that comes out with the employment report called “median usual weekly earnings for full-time wage and salary workers.” It excludes self-employed persons.

Dividing it by the PCED shows that the series rose 1.9% y/y to a record high during Q3 (Fig. 7). This quarterly median series is highly correlated with monthly mean weekly earnings, which we derive by multiplying AHE by the average workweek for all workers as well as for production and nonsupervisory workers. The resulting derived series are up 1.8% y/y and 1.7% through November, respectively, both to record highs. They’ve both been especially strong in recent months, suggesting that productivity growth may be making a comeback.

US Consumers I: Saving a Bundle. Many consumers spend 100% of what they earn, or more than 100% by borrowing money. Yet collectively, consumers have turned into big savers, especially after the Great Financial Crisis. That’s not surprising since it was such a traumatic experience for so many people.Consumers on fixed incomes might also be investing more in interest-bearing securities to boost the income they live on given that interest rates are so low.

We wonder if anyone explained this difficult problem caused by the Fed’s low interest-rate policy to the listening Fed officials. Furthermore, lots of people who shouldn’t be reaching for yield by purchasing risky securities are being forced to do just that. In any event, consumers are saving a bundle:

(1) Personal saving trend. The 12-month moving sum of personal saving was relatively flat around $400 billion from 1990 through 2008 (Fig. 8). Since the Great Financial Crisis, it has been on a strong uptrend to a record $1.3 trillion through October of this year. The annual average from 2009 through 2018 was $983 billion, more than double the prior average from 1990-2008. The 12-month average of the personal saving rate was 8.1% through October, the highest since April 2013 (Fig. 9).

(2) Personal investing trends. The Bureau of Economic Analysis defines personal saving as a residual derived by subtracting personal consumption expenditures from disposable personal income. It can also be defined as the change in assets minus the change in liabilities of households, but the Fed’s data can be misleading because the household sector includes domestic hedge funds, private equity funds, and personal trusts.

The available monthly data of net inflows into various asset categories is just as messy because they include the activity of all investors including individuals and institutions, both domestic and foreign. Nevertheless, we track the following under the assumption that they mostly reflect the investment behavior of individuals in the US:

(1) Money market mutual funds attracted $194 billion over the 12 months through October (Fig. 10). That’s the most since April 2008.

(2) Saving deposits are up $449 billion over the past 12 months through October, up from a recent low of $153 billion last December, following a big drop in these net inflows from a December 2016 peak of $649 billion. It’s conceivable that many individual investors jumped into the stock market in 2017, regretted doing so in 2018, and have missed the rally in stock prices to record highs this year.

(3) Equity and bond mutual funds attracted only $35 billion over the 12 months through October, with a $236 billion outflow from equity funds and a $271 billion inflow into bond funds. That sum is down from a recent high of $343 billion during January 2018, after a previous 12 months in which there was a $39 billion outflow from equity funds and a $382 billion inflow into bond funds.

(4) The grand total of all the above net inflows was $679 billion over the 12 months through October, up from a recent low of $257 billion last December. Actually, this total isn’t so grand because we left out ETFs on purpose since institutional investors may be more active in this asset class than individuals.

In any event, the grand total of liquid assets—specifically, savings deposits (including money market deposit accounts), small time deposits, and total money market mutual funds held by individuals and institutions—rose to a record high of $13.6 trillion during the 11/25 week, up $1.2 trillion y/y (Fig. 11).

(5) Bottom line: There is plenty of cash available to drive equity prices higher, possibly even in a meltup fashion if stragglers decide that now is the time to jump into the stock market with both feet.

US Consumer II: Other Side of the Ledger. What about the right side of households’ balance sheets? On balance, they have a record amount of debt, but the debt-servicing burden is the lowest on record thanks to record-low interest rates.

According to the Quarterly Report on Household Debt and Credit compiled by the Federal Reserve Bank of New York, household debt totaled a record $14 trillion during Q3-2019 (Fig. 12). It is up $2.8 trillion since it bottomed during Q2-2013. The household debt-service ratio (i.e., debt-service payments to disposable personal income), which peaked at a record high of 13.2% during Q4-2007, was down to 9.7% during Q2 (Fig. 13). That’s the lowest on the record starting in 1980.

On the other hand, lots of young adults coming out of college are burdened with large student loans, which in aggregate rose to a record $1.6 trillion during Q3, up $1.0 trillion since Q1-2008! The latest total exceeds the record amount of auto loans, which was $1.2 trillion during Q3 (Fig. 14).

US Consumer III: The Inequality Debate. In my 2018 book Predicting the Markets and on numerous occasions since its publication, I have questioned the widespread notion that income inequality has worsened over the past two to three decades as the incomes of 99% of Americans stagnated. As discussed above, real wages actually have been rising along a 1.2% annual growth trendline since the start of 1995.

So I am pleased to see that I am not the only one claiming that the data don’t support the interrelated myths of income stagnation and worsening income inequality. The 11/28 issue of The Economist features a cover story titled “Inequality illusions: Why wealth and income gaps are not what they appear.” The article itself is titled “Economists are rethinking the numbers on inequality.”

On the progressive side of the debate have been Thomas Piketty and Emmanuel Saez. Together, they “pioneered the use of tax data over survey data, thereby doing a better job of capturing the incomes of the richest.” Their work revealed that “the 1%” had made out like robber barons at the expense of “the 99%.” Their research gave Occupy Wall Street its vocabulary.

The article counters: “It is fiendishly complicated to calculate how much people earn in a year or the value of the assets under their control, and thus a country’s level of income or wealth inequality. Some people fail to complete government surveys; others undercount income on their tax returns. And defining what counts as ‘income’ is surprisingly difficult, as is valuing assets such as unquoted shares or artwork.”

Here are a few more key points from The Economist piece:

(1) “[A] recent working paper by Gerald Auten and David Splinter, economists at the Treasury and Congress’s Joint Committee on Taxation, respectively, reaches a striking new conclusion. It finds that, after adjusting for taxes and transfers, the income share of America’s top 1% has barely changed since the 1960s.”

(2) “Marriage rates have declined disproportionately among poorer Americans. That increases top-income shares by spreading the incomes of poorer workers over more households, even as the incomes of the top 1% of households remain pooled.”

(3) “Reagan’s tax reform created strong incentives for firms to operate as ‘pass-through’ entities, where owners register profits as income on their tax returns, rather than sheltering this income inside corporations. Since these incentives did not exist before then, top-income shares before 1987 are liable to be understated.”

(4) “But it is inequality in incomes after taxes and benefits that really conveys differences in living standards, and in which Messrs Auten and Splinter find little change. Some economists argue these figures are distorted by the inclusion of Medicaid. But it is hard to deny that the provision of free health care reduces inequality. The question is whether ‘non-cash benefits’ should properly count as income.”

In my book, I came to the same conclusion:

“I’m not saying there’s no income inequality. There is and always will be in a competitive economy. I am saying that it probably hasn’t gotten any worse since 1999, based on the fact that most Americans have enjoyed solid gains in their standard of living as measured by both average personal income and personal consumption per household. Furthermore, I submit that it’s incumbent upon progressives who claim income inequality has worsened to prove that this is so after taxes and after government support payments have been considered, not before. If they’re still right, then their calls for more income redistribution are more justified. However, before pressing for even more income distribution, they also should prove that the existing redistribution programs are not the cause of worsening pretax and pre-benefits income inequality. Conservatives argue that government benefits erode the work ethic and thereby exacerbate income inequality. I generally agree with that view. The debate rages on.”

Movie. “The Irishman” (+) (link) is another Mafia movie directed and produced by Martin Scorsese. It’s a very long movie. The first hour was very slow and boring, but it did get better during the remaining two and a half hours. The movie alleges that hitman Frank Sheeran, played by Robert De Niro, was the killer of Joey Gallo and Jimmy Hoffa, played by Al Pacino. Joe Pesci plays mob boss Russell Bufalino. All three actors look their age and give the movie a nursing-home quality. The movie also implies that John F. Kennedy won the presidential election thanks to the mob in Chicago. The mob expected reciprocation via the Bay of Pigs invasion of Cuba, which would have liberated the Cubans from Castro and returned the island’s casinos to the mob. However, it failed, and insult was added to injury as Kennedy’s brother Bobby, appointed Attorney General, insisted on going after the mob and jailing Hoffa. The movie implies that JFK was assassinated by the Mafia for double-crossing them. Needless to say, much of the story is Hollywood folklore. Sheeran most likely didn’t kill either Gallo or Hoffa, and the Kennedy assassination remains a hot topic for conspiracy buffs.

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’Tis the Season for Shopping

December 05 (Thursday)

Consumer Discretionary: They Shopped ’til They Dropped. Santa came early to the retailers, as consumers do what they do best when they have jobs and cash-lined pockets: They shopped.

On Cyber Monday, shoppers increased spending 19.7% y/y to a record $9.4 billion, according to an Adobe Analytics report, which tracks 80 of the top 100 US web retailers. And the National Retail Federation (NRF) and Prosper Insights & Analytics reported that the number of consumers shopping online and in stores over the five days through Cyber Monday jumped 14% y/y to 189.6 million, and the average amount each spent increased by 16% y/y to $361.90.

Yesterday, in a Bloomberg Opinion column, our friend Barry Ritholtz warned about the NRF’s tendency to hype up the holiday selling season with guesstimates rather than hard data: “They are based on sentiment surveys, not real spending. The NRF conducted its Annual Thanksgiving Weekend Consumer Survey by asking 6,746 adult consumers how much they expected to spend. It then presents this as if its actual money that consumers parted with. … The trade organization has no interest in being accurate; instead, its goal is to promote a sense of excitement to the benefit of the shopping malls and retailers who are members of the NRF.”

The double-digit y/y gains reported by the NRF are based on survey respondents’ recollection of how much they spent during last year’s holiday shopping season. Do you recall how much you spent?

In any event, holiday shoppers may be more hyper because there are six fewer days between Thanksgiving and Christmas this year. On average, 52% of consumers had completed their shopping by the end of the weekend, up from 44% last year, reported the NRF, which forecasts a 3.8%-4.2% y/y spending jump in November and December. While these numbers may or may not be hyped up, consumers’ purchasing power is at a record high, and is likely to make for a record holiday selling season for most, but not all, retailers.

Let’s take a quick look at why consumers are comfortable opening their wallets more this year than last year:

(1) Jobs are plentiful. Total US unemployment remains near record lows, and a number of other indicators continue to show that the extra slack is slowly coming out of the labor market. The latest data point from ADP was less than inspiring, with private payrolls only adding 67,000 jobs compared to the 150,000 expected. We’re not convinced the job market is rolling over, however; we look forward to Friday’s Labor Department report on November payrolls, which should include the return of striking GM workers.

When last reported for October, unemployment stood at 3.6%, little changed from September’s 3.5%, which was the lowest since December 1969 (Fig. 1). The number of people in part-time jobs for economic reasons has fallen to 4.4 million, down from the September 2010 peak of 9.2 million (Fig. 2). The number of workers who’ve been unemployed for 27 weeks or longer has fallen to 1.3 million, down from 6.8 million in April 2010 (Fig. 3). Even the U-6 unemployment rate—which includes those who are unemployed, plus all who are marginally attached to the labor force and those who work part-time for economic reasons—has fallen to 7.0% down from the record high of 17.1% in spring 2010 (Fig. 4).

(2) Pockets are full. Those who are working are also benefitting from rising wages. The real Employment Cost Index rose 1.6% y/y in Q3 and has gained 1.5% annually since 2015. Real average hourly earnings rose 2.2% y/y in October, and has risen 1.3% annually since 2012 (Fig. 5).

(3) Confident consumers shop. Consumers are optimistic about their ability to land a new job and confident in general. Almost 45% of respondents said jobs are plentiful, according to The Conference Board (Fig. 6). And while consumer confidence has come off its peak, it remains near the highs. The Conference Board’s consumer confidence index came in at 125.5 in November, down a bit from the high of 137.9 last year (Fig. 7).

(4) Winners and losers. More jobs, higher wages, and confident consumers have led to strong gains in retail sales, particularly online. Retail sales excluding gasoline increased 3.9% y/y in October (Fig. 8). The S&P 500 Consumer Discretionary sector’s revenues are expected to climb 4.0% this year and 6.1% next year, while its earnings are forecast to inch up 0.9% this year and 12.9% next year (Fig. 9 and Fig. 10).

Despite the uptick in spending, not all retailers will benefit as consumers continue to change where and how they shop. The resulting rash of retail bankruptcies continues, with A.C. Moore closing 145 craft stores and retailers like Payless, Gymboree, and Forever 21 filing for bankruptcy protection earlier this year. Survivors, like Target and Walmart, are left to take market share. So while earnings are expected to drop this year in the S&P 500 Department Stores industry and Apparel, Accessories & Luxury Goods industry, falling by 24.1% and 1.2%, respectively, they’re expected to jump 9.4% in the General Merchandise Stores industry and 10.6% in the Consumer & Electronics Retail industry. It pays to shop carefully.

Information Technology: Flying Too Close to the Sun? The S&P 500 Technology sector is up 39.8% ytd, and while that’s awfully impressive it understates how well certain segments of the sector have performed this year. The S&P 500 Semiconductor Equipment industry has climbed 80.7%, and the S&P 500 Technology Hardware, Storage & Peripherals industry is 61.7% higher ytd, thanks in large part to Apple.

Software stocks, however, have had mixed performance. Shares of two of the fastest growing software companies, Salesforce.com and Workday, have had a lackluster year. They both reported earnings Tuesday evening, and, despite turning in pretty stellar results, their shares sold off, leaving ytd returns through Wednesday’s close at 14.2% for Salesforce and 3.6% for Workday. I asked Jackie to take a look at why these previous high-fliers have fallen to Earth. Here is what she found:

(1) Forecasts not quite good enough. Salesforce, which provides customer relationship management software in the cloud, reported fiscal Q3 (ended October) revenues that climbed 34% in constant currency and adjusted earnings of 75 cents a share, above analysts’ forecast of 67 cents a share.

It was Salesforce’s financial forecasts that disappointed investors. The company’s fiscal Q4 (ending January) adjusted earnings target of 54 to 55 cents a share was below analysts’ estimate of 61 cents a share, a 12/4 MarketWatch article reported. Salesforce’s forecast for next year’s fiscal Q1 (April) revenue was also light: $4.80 billion to $4.84 billion compared to analysts’ forecast of $4.85 billion. And the software company’s fiscal 2021 revenue target is $20.80 billion to $20.90 billion, below analysts’ $20.95 billion forecast.

The modest difference between the company’s and analysts’ forecasts might not seem worthy of a selloff. However, Salesforce’s stock sports a lofty multiple that doesn’t leave room for disappointment. At a recent $155.35, the shares trade at 53.9 times next year’s adjusted EPS consensus.

(2) The growth story. Salesforce has historically sold customers software that manages sales contacts in the cloud. The company expanded through two recent acquisitions. In 2018, Salesforce purchased MuleSoft, which connects companies’ apps, data, and devices whether they be legacy systems on terra firma or software in the cloud. It broadened Salesforce well beyond its customer-relationship software base.

Then this August, Salesforce purchased Tableau, an analytics platform, for $15.7 billion in stock. In the press release for the deal Salesforce’s co-CEO Marc Benioff said, “Together we can transform the way people understand not only their customers, but their whole world—delivering powerful AI-driven insights across all types of data and use cases for people of every skill level.” Again, the goal appears to be moving beyond the company’s traditional customer-relationship software base.

In Salesforce’s fiscal Q3 earnings conference call transcript, Benioff noted that Salesforce’s software now can connect a company’s data from across sales, service, marketing, and commerce to give companies better information while also removing any obstacles from accessing that data in legacy systems. And if the economy does slow, Benioff noted that “digital transformation” was the last thing that companies would stop investing in. “[D]igital transformation is number one on everybody’s list and everybody wants a trusted digital advisor.”

Salesforce wants to be its customers’ digital advisor and software provider. If the cloud’s leading software provider sees itself branching into other areas, it could mean greater competition for other cloud software providers.

(3) Industry still on a roll. Salesforce is a member of the S&P 500 Application Software industry, which is up 30.9% ytd through Tuesday’s close to its high for the year (Fig. 11). The industry is forecast to grow revenue 20.6% this year and 17.0% in 2020 (Fig. 12). Earnings growth is expected to rise 23.5% this year and another 16.7% in 2020 (Fig. 13). That growth doesn’t come cheap: The industry’s forward P/E is 36.5 (Fig. 14).

Some of the top performers in the industry have had performances that left Salesforce and Workday in the dust. The shares of Ansys, an engineering simulation software and services company, have climbed 75.2% ytd. Not far behind are Synopsys shares, up 60.5% ytd; that company provides software to companies developing semiconductor chips. Cadence Design Systems, with shares are up 50.0% ytd, makes electronic devices and software.

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What’s New? Not Much!

December 04 (Wednesday)

Strategy I: High Hopes. Debbie and I had some high hopes Monday morning. We were hoping that November’s global M-PMIs would show a clear improvement. They showed some improvement, but not a clear improvement.

In addition, on Monday, President Trump threw a wet rag on the stock market when he announced that he was slapping steel tariffs on Brazil and Argentina. Also on Monday, at the NATO meeting in London, Trump threatened more tariffs on France. Yesterday morning, Trump tweeted that he is in no rush to do a trade deal with China. He is willing to wait until after next year’s US presidential election. That increases the odds that the administration will impose the additional tariffs on $250 billion of Chinese imports that Trump said would kick in on 12/15 if there’s no deal by then.

This could all be “the art of the deal,” as practiced by our fearless leader. The problem is that Chinese President Xi has his own approach to the art of the deal. Then again, you never know when it comes to the eventual outcome of deal-making. It’s like watching sausage-making, not very pretty. The question is whether there will be any meat in an eventual deal, assuming there is one. Meanwhile, Trump’s latest escalation of his trade wars is likely to continue to weigh on global manufacturing. Let’s have a closer look at the M-PMI data:

(1) The good, the bad, and the mediocre. On the M-PMI front, as we noted yesterday, China’s official data were better than expected, while the US ISM manufacturing survey was worse than expected. The Eurozone was less bad, but still bad.

Here is a performance derby for a selection of November’s M-PMIs, from highest to lowest: Greece (54.1), Hungary (53.0), Colombia (52.9), Brazil (52.9), France (51.7), Canada (51.4), Philippines (51.4), India (51.2), Vietnam (51.0), World (50.3), China (50.2), Australia (49.9), Taiwan (49.8), Ireland (49.7), the Netherlands (49.6), Turkey (49.5), Malaysia (49.5), South Korea (49.4), Thailand (49.3), Japan (48.9), UK (48.9), Indonesia (48.2), US (48.1), Mexico (48.0), Italy (47.6), Spain (47.5), Eurozone (46.9), Poland (46.7), Austria (46.0), Russia (45.6), Germany (44.1), and Czech Republic (43.5).

(2) Developed vs emerging economies. On balance, they all added up to a continuation of the recovery in the global M-PMI since July, when it bottomed at 49.3 (Fig. 1). It was up to 50.3 last month, back near where it was during April 2019. Most of the improvement from July to November reflects a rebound in the M-PMI for emerging market economies (Fig. 2). It has been above 50.0 for most of this year and was at 51.0 last month. The M-PMI for developed market economies has been below 50.0 since May of this year. It rebounded from a recent low of 48.6 in both September and October to 49.6 in November. The US, UK, Eurozone, and Japan were all below 50.0 last month (Fig. 3). Three of the four BRICs were above 50.0 (Fig. 4).

(3) Revenues matter. Investors care about the M-PMIs because they have always been useful economic indicators. Perhaps we should care less for them because the nonmanufacturing economy has been growing faster than the manufacturing one around the world. On the other hand, for stock investors, it matters that manufacturing is a very cyclical component of corporate profits. That explains why the y/y growth in S&P 500 aggregate revenues is highly correlated with the US M-PMI (Fig. 5). The former was down to 2.2% y/y during Q3-2019 from a recent peak of 10.0% during Q2-2018.

Joe and I expect revenues growth to rebound to 4%-5% next year. So we would like to see a V-shaped recovery in the US M-PMI. Could that happen even if there’s no trade deal between the US and China until 2021? We think so given the strength in consumer spending and housing activity in the US. Real wages and salaries rose solidly during October by 3.5% y/y, while real consumer spending rose 2.3% (Fig. 6). Anecdotal evidence suggests this year’s holiday shopping season is going gangbusters. Mortgage applications for new purchases remains on an upward trend, auguring well for the sum of new plus existing single-family home sales (Fig. 7).

What about business spending in the US? It still looks weak. The y/y growth rate in nondefense capital goods orders ex-aircraft is highly correlated with the US M-PMI (Fig. 8). The former was down 0.8% during October, hovering around its weakest yearly growth rate since November 2016. Ongoing trade uncertainty may continue to weigh on business spending.

(4) Can stocks rally while the M-PMI is below 50.0? The short answer is “yes,” since that’s what they’ve been doing all year. The S&P 500 rose to yet another record high of 3153.63 on 11/27. However, the y/y percentage change in the S&P 500 has been very highly correlated with the M-PMI (Fig. 9). Year-over-year losses in the stock market typically have occurred when the M-PMI was below 50.0.

Then again, the Fed pivoted from projecting three hikes in the federal funds rate this year to actually cutting it three times so far. Fed officials attributed their reversal mostly to “uncertainties” created by Trump’s trade wars. Another round of uncertainty might convince the Fed to cut some more. Last Tuesday, we wrote: “If there is no deal, stock prices could crater. However, Trump views the DJIA as his most important poll. So he would likely respond to a market selloff with some encouraging words. More importantly, Fed officials would most likely signal a willingness to ease some more if trade headwinds threaten to depress the US economy.”

Strategy II: Forward Looking. Meanwhile, S&P 500 forward revenues per share remained on an uptrend in record-high territory during the 11/21 week (Fig. 10). That augurs well for actual revenues during the final quarter of this year. It also augurs well for earnings. However, there is clearly lots of air (i.e., higher forward P/E) between the S&P 500 stock price index and earnings.

Forward earnings per share for the S&P 500 rose to $177 during the 11/28 week (Fig. 11). This weekly series tends to be a very good year-ahead indicator of actual earnings on a four-quarter trailing basis. The latter was $164 through Q3.

In other words, forward earnings is implying a 7.9% increase in earnings through late 2020. That may be too optimistic, though the weekly series tends to be mostly dead-on right with only one significant exception: Industry analysts don’t see recessions coming. If you agree with us that a recession is unlikely through the end of next year, then there is a good chance earnings could be up solidly in 2020 as industry analysts expect, based on forward earnings.

Bonds: Home on the Range. Melissa and I are still thinking that the Fed is done finetuning monetary policy for the year and maybe for next year too. We are expecting that the Fed’s target range for the federal funds rate will stay at 1.50%-1.75% through the November 2020 elections. We expect that the 10-year US Treasury bond yield will range between 1.50% and 2.00% through the end of next year.

However, the news on Monday and Tuesday slightly increases the odds of a one-and-done rate cut early next year. Nevertheless, we are sticking with our range for the bond yield, for now.

The 10-year US Treasury bond yield rose from this year’s low of 1.47% on 9/4 to a recent high of 1.94%, mostly on news that Trump was deescalating his trade war and that the prospects for the global economy are improving. Over the past two days, this bond-bearish scenario looks a bit shaky, which is why the yield was back down to 1.72% yesterday.

Some of the indicators we track for insights into the bond market actually remain bond-friendly. Consider the following:

(1) Inflation. As we observed yesterday, the core PCED inflation rate remains subdued. It was only 1.6% y/y during October (Fig. 12). The spread between the nominal bond yield, and the core inflation rate has been fluctuating between zero and 1.0ppt since 2011 (Fig. 13). It’s been highly correlated with the 10-year TIPS yield since the start of the data in 2003.

Helping to hold the nominal bond yield down is that the TIPS yield was only 0.09% yesterday, while the spread between the nominal and TIPS yield was only 1.63% (Fig. 14). The spread is widely deemed to be a proxy for the annual expected inflation over the next 10 years.

(2) Commodity prices. We’ve observed a tight correlation between the bond yield and the ratio of the CRB raw industrials spot price index to the gold price (Fig. 15). The ratio remains near this year’s low.

(3) Economic surprise index. The 13-week change in the bond yield tends to be highly correlated with the Citigroup Economic Surprise Index. This index was weak during the first half of this year, bottoming at a low of -68.8 on 4/25. It rebounded to the year’s high of 45.7 on 9/25. On Monday, it was back down to 8.7. (See our Citigroup Economic Surprise Index.)

(4) M-PMI. Last but not least, the bond yield has been highly correlated with the M-PMI in recent years (Fig. 16). The surprising weakness in November’s M-PMI along with Trump’s renewed trade confrontations have brought risk-averse investors back into the bond market.

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Signs of Life & Death

December 03 (Tuesday)

Global Inflation: Still in a Coma. I’ve been a disinflationist since the early 1980s. I first used that word, which means falling inflation, in my June 1981 commentary, “Well on the Road to Disinflation.” The Consumer Price Index (CPI) inflation rate was 9.6% y/y that month (Fig. 1). I predicted that Fed Chair Paul Volcker would succeed in breaking the inflationary uptrend of the 1960s and 1970s when he adopted a monetarist approach during October 1979. I certainly wasn’t a monetarist, given my Keynesian training at Yale. I knew that my former boss at the Federal Reserve Bank of New York wasn’t a monetarist either. But I expected that Volcker would use this radical approach to push interest rates up as high as necessary to break the back of inflation. Which is exactly what happened.

Ever since then, reflationists have been predicting, without any success, that inflation is bound to make a comeback. They’ve been wrong for so long because inflation is so yesterday. The Great Inflation was basically a 1970s phenomenon attributable to the two oil price shocks of 1973 and 1979 (Fig. 2). Thanks to cost-of-living clauses in private-sector union contracts back then, those price shocks were passed directly to wages, causing a wage-price spiral (Fig. 3).

The CPI isn’t the best measure of price inflation because it has a significant upward bias. The Fed prefers the core personal consumption expenditures deflator (PCED), which better reflects the prices of the goods and services that consumers are actually buying. According to this measure, inflation has ranged between a low of 0.9% and a high of 2.6% since 1995 (Fig. 4).

In recent years, I’ve often declared: “Inflation is dead.” I’ve frequently discussed the four deflationary forces (which I call the “4Ds”) that have killed it. They are détente, disruption, demography, and debt. The data show that at best inflation is in a coma, especially in the major industrial economies. Here is an update on the latest inflation readings:

(1) US CPI and PCED. In the US, the headline and core CPI were up 1.8% and 2.3% y/y, respectively, in October. However, the comparable readings for the PCED were only 1.3% and 1.6% (Fig. 5).

Now sit down for this one: The Fed is seriously considering a “make-up” strategy for targeting inflation. That’s according to yesterday’s FT article “US Federal Reserve considers letting inflation run above target.” Here is the gist of the plan: “The Fed’s year-long review of its monetary policy tools is due to conclude next year and, according to interviews with current and former policymakers, the central bank is considering a promise that when it misses its inflation target, it will then temporarily raise that target, to make up for lost inflation.”

With all due respect, that’s hilarious! Why do Fed officials want to embarrass themselves by targeting inflation over 2.0% when they haven’t been able to move it up to 2.0% since officially targeting that level in January 2012? Fed Governor Lael Brainard, speaking to reporters last week, said that a strict make-up rule would be too hard to explain to the public. I think she is right.

Since January 2012, the headline PCED has been tracking a 1.3% annual trendline (Fig. 6). In other words, October’s PCED was 4.7% below where it should have been if it had been tracking 2.0%. To get back to the steeper trendline by the end of 2022, the PCED would have to increase by about 12.0%, or 4.0% per year! Try explaining that to the public.

By the way, the big divergence between the CPI and PCED inflation rates during October was mostly attributable to consumer durables (up 0.5% in the CPI and down 1.0% in the PCED) (Fig. 7). In addition, medical care services was up much more in the CPI (5.1%) than in the PCED (2.1%) (Fig. 8). These divergences are par for the course—they are not unusual. Rent inflation tends to be almost identical in the CPI and the PCED, but it has a much higher weight in the former than the latter, and it has been running hotter (at 3.7%) than the overall inflation rate (Fig. 9).

(2) Eurozone CPI. An 11/28 Bloomberg article reported that the European Central Bank (ECB) is expected to “tweak” its inflation target in an upcoming review of monetary policymaking: “The institution’s first fundamental assessment in 16 years might conclude with a goal of 2%—instead of the current ‘below, but close to, 2%’ which some governors worry risks leaving inflation too weak.” One word comes to mind: “Lame.”

During November, the Eurozone’s CPI inflation rate picked up to 1.0% from a three-year low of 0.7% in October (Fig. 10). The core rate was 1.3%, the highest in seven months.

On 11/22/19, Christine Lagarde delivered her first speech as ECB president, “The future of the euro area economy.” Remarkably, she spoke about monetary policy almost in passing, in just one paragraph in fact. Instead, she presented a case for fiscal policy to focus on more public investments in infrastructure, R&D, and education. She also said she wants to see more economic integration in the EMU. She is one of the few central bankers who seems inclined to acknowledge that monetary policy may have lost its effectiveness.

(3) Japan CPI. An 11/18 Bloomberg article reported that the Bank of Japan (BOJ) may be running out of ammo to boost inflation in Japan: “Speaking in parliament on Tuesday, [Bank of Japan Governor Haruhiko] Kuroda said there was still room to lower interest rates further, but added that he had never claimed the BOJ’s easing ammunition was endless or that there was no limit on how low rates could go.”

In fact, he is running out of support for additional monetary stimulus measures.
The article observed: “Such low yields have gradually pushed institutional investors and regional banks out of the JGB market and into riskier assets. Many analysts see bankruptcies looming among beleaguered regional banks, where the old model of borrowing short and lending long has been upended both by a flat yield curve and a diminished demand for credit.”

The BOJ has been reluctant to follow its peers around the world in easing policy this year, suggesting that the days of shock and awe from Kuroda’s BOJ are over. There is more talk about doing more to stimulate the economy with fiscal policy, but it’s all talk so far.

Meanwhile, Japan’s CPI inflation rate is on life support. The headline rate was up just 0.2% during October (Fig. 11). The core rate, which includes oil costs but excludes volatile fresh food prices, rose 0.4% y/y in October. Excluding the impact of the sales tax hike rolled out in October and the introduction of free childcare, annual core consumer inflation was 0.2% in October, slowing from 0.3% in September.

(4) China CPI. China’s headline CPI inflation rate jumped to 3.8% during October (Fig. 12). That was the highest since January 2012. However, it was boosted by soaring pork prices, which lifted overall food-price inflation to a more-than-11-year high, as consumer demand drove up prices for pork alternatives including eggs and other meat products. Hog prices have soared this year at the fastest pace on record as a result of the deadly African swine flu. Excluding food, the CPI was up just 0.9% during October!

Global Economy: A Faint Pulse. While inflation in the major economies remains comatose, the global economic slowdown may be coming to an end, as more global economic indicators are showing some signs of life. However, post-bottom growth appears so far to be tracing an L-shaped recovery rather than either a U-shaped or V-shaped one. This is consistent with our view that global growth is being weighed down by aging demographic trends and too much debt.

Much of the weakness since early last year has been in global manufacturing, which may also be bottoming. Trump’s trade wars have been blamed for the global factory recession. Debbie and I suspect that there may also be a more structural problem: The global economy is stuffed with too much stuff. Both young adults and seniors are becoming minimalists, so they’re buying less stuff (like autos), leaving too much manufacturing capacity relative to the slowing demand.

Let’s review the latest global indicators:

(1) China. When we stir-fry China’s latest batch of PMIs for November, it’s a slightly warmer mix than October’s. The official M-PMI rose to 50.2 last month, the first reading above 50.0 since April (Fig. 13). The NM-PMI rose to 54.4, the best reading since March.

Two of the components of the M-PMI were solidly above 50.0, with output at 52.6 and new orders at 51.3 (Fig. 14). On the other hand, the employment component was only 47.3.

Now the bad news: Profits at China’s industrial firms continued to fall in October, posting their steepest decline since 2011 as producer prices remained weak and trade tensions with the US weighed on China’s economy. Industrial profits plummeted 9.9% y/y during October. It was the third straight monthly decline. The PPI was down 1.6% y/y during October, the weakest since July 2016.

(2) Eurozone. Whoopie: The Eurozone’s Economic Sentiment Indicator (ESI) ticked up during November (Fig. 15). You need a magnifying glass to see it, and there have been similar upticks along the way down from the ESI’s peak of 114.5 at the end of 2017 to November’s 101.3. The ESI is highly correlated with the y/y growth in the region’s real GDP, which slowed to 1.2% during Q3.

The good news is that the Eurozone’s M-PMI stopped falling during September, when it bottomed at 45.7. It rose to 46.9 during November. The bad news is that it has been below 50.0 since February. Germany’s M-PMI has recovered from a low of 41.7 during September to 44.1 last month. France’s rose to 51.7 and has managed to stay mostly above 50.0 since the start of this year (Fig. 16).

Oops: At the end of last month, Audi announced a cut of 9,500 of its 61,000 jobs in Germany. Daimler said it would shed at least 10,000 jobs of nearly 300,000 worldwide. Both claimed they were reducing payrolls to fund the switch to electric cars.

(3) US. US consumers have started the holiday shopping season by spending like they all have jobs and record real pay (which they do). New home sales in October (733,000 units) barely budged from September’s 738,000 units (saar), which was the best pace since July 2007.

Yet the US M-PMI edged down from 48.3 in October to 48.1 during November, the fourth consecutive monthly reading below 50.0 (Fig. 17). Weakness was widespread. Of the 18 manufacturing industries, only five reported growth in November. The New Orders Index fell from 49.1 to 47.2. The Employment Index declined from 47.7 to 46.6. The New Exports Index (47.9) and Imports Index (48.3) remained below 50.0 (Fig. 18).

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What’s the Matter with Profits, Again?

December 02 (Monday)

Profits I: Big Divergence Between S&P 500 & NIPA Profits. Something is very wrong with the profits data. Consider the following oddities:

(1) NIPA profits flatlining since 2012. Last week, we learned that after-tax book corporate profits (as reported to the IRS) edged down 0.6% q/q and 0.5% y/y during Q3 to $1.85 trillion (saar). Remarkably, it’s been stalled around this level since Q1-2012 (Fig. 1). This measure of profits is reported along with GDP in the National Income & Product Accounts (NIPA).

The bears love this measure of profits because it confirms their view that the bull market is, well, full of bull. How can the S&P 500 be up 123% over the same period that profits have been stalled? The divergence can only be explained as a sugar high provided by the ultra-easy policies of the central banks, they figure, so it must be a stock market bubble that is bound to burst.

(2) S&P 500 profits still on uptrend. However, another interesting divergence is between NIPA profits and S&P 500 after-tax aggregate reported net income, using GAAP data. While the former has stalled since Q1-2012, the latter is up 38%. That’s an odd divergence given that S&P 500 net income tends to account for about 50% of NIPA profits, and over 60% since Q3-2018 (Fig. 2).

Something in the NIPA profits measure must be negatively offsetting the uptrend in S&P 500 earnings.

(3) Diverging profit margins. Joe and I often compare the S&P 500 reported profit margin to the one we derive from the NIPA data, dividing NIPA after-tax book profits by nominal GDP (Fig. 3). The latter peaked at a record high of 11.7% during Q1-2012 and was down to 8.6% during Q3 of this year. Over the same period, the S&P 500 margin rose from 8.6% to 9.8%.

That’s mighty peculiar. A similar though starker divergence is apparent when we compare the S&P 500 profit margin based on operating earnings and the NIPA margin (Fig. 4). The former is up from 9.6% during Q1-2012 to 12.0% during Q3-2019. It has been fluctuating around 12% since early last year, when the Trump corporate tax cut boosted the profit margins of S&P 500 corporations. However, there is absolutely no sign of the tax cut in either NIPA aggregate profits or the derived NIPA profit margin. Mighty peculiar, don’t you think?

(4) Reverting to the mean, or not? Joe and I believe the story being told by the S&P 500 margin data rather than the comparable but diverging NIPA data. However, the former starts during Q1-1992—which is why we constructed the NIPA margin: It starts during Q1-1947. The more historical data series shows that the margin has tended to peak during booms and to revert to its mean, and fall below it, during recessions. The booms forced the Fed to tighten credit conditions, which caused recessions. Margins start dropping when businesses’ outlays on labor and capacity start to rise faster than their revenues during booms prior to busts.

Our thesis since 2009 has been that the Great Recession and the Great Financial Crisis caused corporate managers to focus primarily on boosting and maintaining high profit margins. They’ve resisted the spending excesses that typically occurred several years after the previous recessions were forgotten. So as a result of the Trauma of 2008, we figured margins would stay high because there was no boom in business spending, which reduced the odds of a bust. So far, so good.

However, while the S&P 500 profit margin completely supports our thesis, the NIPA margin does not. Once again, we advise you: Pay no attention to any data that don’t support our story. Actually, we can explain why the NIPA profits data are very misleading. Before we go there, let’s review the latest S&P 500 data that came out late last week for Q3 and continues to support our story.

Profits II: S&P 500 Earnings Outlook Looking Good. S&P 500 earnings growth slowed dramatically this year because revenues growth slowed significantly, and the profit margin edged down following the boost it got from Trump’s tax cut at the start of 2018. Last year was a hard one to beat in terms of earnings, resulting in an earnings growth recession this year. The stock market, which tends to discount the future, fell 6.2% last year based on the S&P 500 stock price index. But it is up 25.3% ytd, suggesting that investors expect better earnings growth next year.

Let’s review the latest data and its implications for the 2020 outlook:

(1) Last year. From Q2-2017 through Q2-2018, S&P 500 revenues rose 11.2% on a per-share basis (Fig. 5). Operating earnings per share rose 26.7% over the same period. Most of that 15.5ppt spread between earnings and revenues growth must have been attributable to the tax cut.

The S&P 500 operating profit margin rose to a record high of 10.9% during Q4-2017, just before the tax cut. In 2018, after the tax cut, it peaked at 12.5% during Q3-2018. Since then, it has remained around 12.0%, with a reading of 11.9% during Q3-2019 (Fig. 6).

(2) This year. On a y/y basis, S&P 500 revenues rose 3.9% and 2.2% in aggregate and per share, respectively, during Q3-2019. That’s a significant slowdown from last year, with some of it attributable to the Energy sector subtracting from this year’s overall revenues growth, while adding to revenues growth last year (Fig. 7).

S&P 500 operating earnings growth per share fell 0.7% y/y during Q3 of this year, a significant drop from the Q3-2018 growth rate of 27.5% (Fig. 8).

(3) Next two years. As of the 11/21 week, industry analysts were projecting earnings growth of 1.1% in 2019, 9.1% in 2020, and 10.7% in 2021 (Fig. 9).

Joe and I believe that the analysts are too optimistic about earnings growth over the next two years. However, we think their numbers for revenues growth are realistic at 3.9% this year, 5.0% in 2020, and 4.7% in 2021 (Fig. 10). Earnings should grow in line with revenues, assuming, as we do, that the profit margin will remain around 12.0% through 2021.

(4) The rest of this year. Once again, there has been a significant earnings hook during the just completed earnings season (Fig. 11 and Fig. 12). S&P 500 operating earnings per share for Q3 turned out to be 2.6% better than expected by industry analysts at the start of the latest earnings season. They may be setting up the Q4 earnings season for yet another earnings hook. Their estimate for earnings growth during the final quarter of this year is -0.4%, a big drop from plus 3.5% when the Q3 season just started and an even bigger drop from plus 11.7% at the beginning of this year.

Profits III: NIPA Profits Looking Bad. Debbie and I addressed the misleading nature of NIPA profits in our 8/12 Morning Briefing, “What’s the Matter With Profits?” We were inspired to do so by several requests from our accounts to explain the significant downward revision in NIPA profits from mid-2016 through Q1-2019. That revision accentuated the puzzling flattening of NIPA profits in recent years. Here is a brief review of our analysis:

(1) S corporations distorting the profits picture. “According to the NIPA Handbook, corporate profits includes all US public, private, and ‘S’ corporations. It also includes other organizations that do not file federal corporate tax returns—such as certain mutual financial institutions and cooperatives, nonprofits that primarily serve business, Federal Reserve banks, and federally sponsored credit agencies.”

“Most of the difference between the NIPA measure of profits and the S&P measure is attributable to sub-chapter S corporations and private corporations. So most of the downward revision in NIPA profits must have been attributable to them.”

(2) Ignore NIPA profits. Go with S&P 500 earnings. “The conclusion is that comparing NIPA profits and S&P 500 earnings is like comparing apples and oranges. Actually, the NIPA measure is more like a fruit cocktail with lots of different fruit juices. That makes it hard to explain the latest NIPA revisions, especially since the S corp data are only available through 2015. For those of us in the stock market, what matters—and remains bullish—is the trend in the S&P 500 earnings.”

(3) NIPA profits should come with warning label. “The key takeaway is that NIPA data are complicated and can be misleading if not properly understood and interpreted. The revisions in the data can occasionally paint a significantly different picture of the economy than the preliminary data. The NIPAs should come with a warning label: ‘The following data are prone to misinterpretation if not carefully analyzed, and may be revised significantly from time to time.’”

Profits IV: National Income Shares Distorted Too. Our analysis suggests that S corporations have also had a significant impact on distorting the National Income shares of profits and labor compensation. Consider the following:

(1) Definition. On its website, the IRS explains the difference between C and S corporations: “A C corporation is taxed on its earnings, and then the shareholder is taxed when earnings are distributed as dividends. S corporations elect to pass corporate income, losses, deductions and credits through to their shareholders for federal tax purposes. Shareholders of S corporations report the pass-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. This allows S corporations to avoid double taxation on the corporate income.”

(2) Lots of them. The IRS estimates that there were 4.6 million S corporation owners in the US in 2014—over twice the number of C corporations. The IRS data on S corporation dividends and the BEA data on pre-tax corporate profits show that the ratio of the two has increased from 8%-9% during 1992 to about 20% from 2000-2015 (Fig. 13).

(3) Are S corp dividends labor income? The National Income shares of labor compensation and profits are measured on a pre-tax and pre-dividends basis. The latter includes the Inventory Valuation Adjustment (IVA) and the Capital Consumption Adjustment (CCAdj), which restate the historical-cost basis used in profits tax accounting for inventory withdrawals and depreciation to the current-cost measures used in GDP.

Debbie and I think that S corp dividends (distributed from their profits) are more like labor compensation than profits. Excluding these dividends from profits and adding them to labor compensation shows that the latter has done much better than widely recognized, especially by income-inequality zealots (Fig. 14, Fig. 15, and Fig. 16).

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Some More Thanks Giving

November 26 (Tuesday)

Strategy I: The Bull Is No Turkey. While we are on the subject of Thanksgiving, my team and I would like to thank you for your interest in, and support of, our research service. Yesterday, I compared the holiday to Mr. Rogers, who always had kind words to say to everyone he knew or met for the first time, especially if they were children. I intend to take my lead from Mr. Rogers during our family gathering. I’ll wear a cardigan sweater and say only nice things to all my relatives.

According to the weather forecasters, most of us won’t be thankful for the weather on Thursday, when we gather for Thanksgiving. It’s going to be stormy around the country. Depending on the winds, the organizers of the Macy’s Thanksgiving Day Parade might have to ground their balloons.

For those of us in the stock market, the questions are whether there will be a Santa Claus rally this year, and whether it will inflate stock prices with too much hot air. Joe and I are predicting that the S&P 500 will reach 3500 by the end of next year. That’s an increase of 12.5% over Friday’s close, which itself represents a year-to-date gain of 24.1%.

Our main worry currently is that the S&P 500 will get to 3500 well ahead of schedule in a meltup scenario. Our 3100 target for this year was surpassed on 11/15. However, that was actually well behind schedule, since 3100 had been our target for the end of last year. Everything was working out fine for our forecast through 9/20/18, when the S&P 500 peaked at 2930.75. But then recession fears emerged as investors fretted that the Fed was set on an overly restrictive monetary policy course and that the trade war with China was escalating. The S&P 500 proceeded to plunge by 19.8% through the day before Christmas (Fig. 1).

The day after Christmas, investors came to their senses, betting that Fed officials would do the same and that the US and China would eventually work out a trade deal. As a result, there has been a meltup of sorts in the S&P 500 and its 11 sectors since the day before last Christmas through Friday’s close, as follows: Information Technology (50.0%), Industrials (35.3), Communication Services (35.2), Financials (33.7), S&P 500 (32.3), Consumer Discretionary (30.5), Real Estate (26.9), Consumer Staples (25.4), Materials (25.4), Utilities (21.7), Health Care (21.6), and Energy (10.0) (Fig. 2).

However, it doesn’t look like a meltup when we compare the market’s performance since last year’s 9/20 peak: Utilities (18.8%), Information Technology (15.3), Real Estate (14.4), Communication Services (12.5), Consumer Staples (11.0), S&P 500 (6.1), Health Care (4.2), Financials (3.4), Industrials (2.7), Consumer Discretionary (1.0), Materials (-2.4), and Energy (-20.7) (Fig. 3).

When we look at fluctuations in the S&P 500’s valuation multiple, however, the picture does look like a meltdown during 2018 followed by a meltup this year (Fig. 4). The forward P/E of the S&P 500 peaked at 18.6 on 1/23/2018, the highest reading during the current bull market. It crashed 28% to 13.5 on 12/24/2018. It soared back up to 17.5 last week.

Strategy II: Yearend Meltup or Another Panic Attack? Let’s consider some of the possible events during the holiday season that might fuel the meltup or trigger panic attack #66. (See our table of the 65 panic attacks since the start of the current bull market.)

Let’s start with the meltup scenario:

(1) Growth. On the meltup side, investors are starting to anticipate better global economic growth next year, while inflation is expected to remain subdued. This year’s earnings growth slowdown to near zero was mostly attributable to tough y/y comparisons because last year’s growth rate was boosted by Trump’s tax cut and higher Energy earnings. Earnings comps should be easier next year, with industry analysts currently projecting gains for S&P 500 operating earnings of 9.1% in 2020 and 10.8% in 2021 (Fig. 5). Joe and I think the analysts are too optimistic, as they often have been in the past. Earnings should grow in line with revenues growth, which is currently expected to be 5.2% in 2020 and 4.7% in 2021 (Fig. 6). Analysts tend to be more realistic about revenues growth than earnings growth.

(2) Monetary policy. The major central banks are likely to persist with their ultra-easy monetary policies. The Fed probably will keep the federal funds rate unchanged through next year’s election. However, the Fed started buying $60 billion per month in Treasury bills during mid-October and will continue doing so through mid-2020 (Fig. 7). On the other hand, the Fed’s holdings of mortgage-backed securities continue to decline (Fig. 8).

Now let’s consider some of the possible triggers of yet another panic attack and why the next one should be followed by yet another relief rally rather than a bear market:

(3) Trade war. Both China and the US have a clear interest in getting a phase-one trade deal completed relatively soon to calm financial markets and reduce the drag on their economies from the uncertainty attributable to the trade war. However, it won’t be a done deal until the deal is done.

Trump wants to secure a big phase-one announcement. He is expecting that the Chinese will commit to purchases of US agricultural goods that he can tout as an important win during his re-election campaign. The signing of a phase-one deal could slide into next year as the two countries tussle over Beijing’s demand for more extensive tariff rollbacks.

In any event, Beijing trade officials aren’t likely to sit down to discuss a phase-two deal before the US election, in part because they want to wait to see if Trump wins a second term.

If there is no deal, stock prices could crater. However, Trump views the DJIA as his most important poll. So he would likely respond to a market selloff with some encouraging words. More importantly, Fed officials would most likely signal a willingness to ease some more if trade headwinds threaten to depress the US economy.

(4) Impeachment. The impeachment hearings seem to be over at the House, where the Democrats have majority control of that body. Now it’s up to Nancy Pelosi, the speaker of the House, to decide whether to proceed with a vote to impeach the President, so that the actual trial can start in the Senate. She knows that there is no way that there will be enough votes in the Senate to impeach Trump. If she hands the process over to the Senate, where the Republicans have the majority, the Republicans will have the opportunity to stick it to the Democrats the way that the House Democrats stuck it to their Republican colleagues. That means calling witnesses who could discredit the House investigation and open up cans of worms for the Democrats.

Pelosi is under pressure from the far-left wing of her party to proceed with the impeachment vote in the House, where she probably will have the votes to impeach the President. However, there is some chatter that she might opt out of an impeachment vote in favor of a vote to censure the President instead—and magnanimously claim that for the good of the country, the Democrats are willing to let the voters decide in the next election. The problem for Pelosi is that anything short of a vote to impeach would be seen as an embarrassing failure.

Stocks could melt up if Pelosi caves, because investors probably perceive more uncertainty if a Democrat wins the White House than if Trump gets a second term. In my meetings two weeks ago in London, I was asked whether Trump could be even more disruptive to world trade if he gets a second term. It’s possible. It’s also possible that he’ll get faster and better deals once the other sides realize that he won’t go away.

(5) Budget deficit. Congress passed a massive budget deal earlier this year, but lawmakers still need to pass individual spending bills to divvy up the money. An 11/25 Politico article reported: “In one sign of progress over the weekend, negotiators announced they had agreed on overall spending levels for each of the dozen bills that fund the government—which means the measures can now be written and then start coming to the floor.”

“But lawmakers also acknowledge there’s a very real possibility Congress falls flat on its face despite securing a breakthrough agreement in August that increased federal spending by $320 billion over two years and raised the debt ceiling.”

Trump signed a short-term spending bill into law last Thursday averting a government shutdown. The measure funds the government at current levels through 12/20, setting up another potential showdown over spending next month.

(6) Hong Kong. An 11/25 NBC News article reported: “Pro-democracy forces swept Hong Kong district council elections over the weekend, boosting pressure on the city’s Beijing-backed government to listen to protesters’ demands for greater freedoms.

“China responded sternly to the landslide in the vote widely seen as a referendum on public support for the anti-government movement. Foreign Minister Wang Yi said that no matter how the situation in Hong Kong changes, the semiautonomous region is part of China.”

Beijing has avoided directly intervening so far, preferring to let Hong Kong’s embattled leader Carrie Lam handle the situation. In this age of smartphones, Beijing has been deterred from cracking heads and having the carnage live-streamed around the world.

(7) Middle East. Yesterday, Brig.-Gen. Zvika Haimovich, former commander of the Israel Defense Forces’ Aerial Defense Division, warned that Iran is planning a “multi-directional” attack against the state of Israel together with its proxies, and that the Jewish state needed to prepare for it now.

Iran has been gripped by an economic crisis since the US restored painful sanctions on 5/8/18 after withdrawing from the 2015 nuclear deal. Last week, there were widespread riots in Iran following a fuel price hike by the government. During the violence, dozens of banks, gas pumps, and police stations were torched across the Islamic republic.

Iranian officials accused the US, Britain, Israel, and Saudi Arabia of stoking the unrest. Yesterday, the head of Iran’s Islamic Revolutionary Guard Force threatened to destroy Israel, the US, and other countries as he addressed a pro-government demonstration.

Disruptive Technologies: Recycling CO2. Let’s not forget Thursday to be thankful for all the scientists toiling to improve our lives, including those working to reduce the amount of carbon dioxide (CO2) in our air. The concentration of CO2 in the atmosphere reached another record high in 2018, according to a report released Monday by the World Meteorological Organization. Scientists envision building synthetic forests that suction CO2 out of the air to be sold to companies that use it as a raw material. In a perfect world, costs will fall, and revenues will rise enough to make carbon-capture companies self-sustaining and profitable. Let’s take a look at some recent developments in this quickly evolving field:

(1) MIT scientists at the fore. The brains at MIT claim to have developed the holy grail: a device that can take carbon out of the air inexpensively.

“The device is essentially a large, specialized battery that absorbs CO2 from the air (or other gas stream) passing over its electrodes as it is being charged up, and then releases the gas as it is being discharged,” a 10/24 MIT press release states. The MIT method eliminates an intermediate step that requires significant heat or pressure required by competitors’ methods. It can take the carbon out of the CO2-rich air spewed by power plants or “regular” air, which contains far fewer CO2 particles.

In a power-plant setting, the MIT scientists envision two separate stacks of electrochemical cells operating next to a plant’s flue. The plant’s emissions would be directed at the first stack, which would capture CO2 until it’s full. Then the flue’s emission would be directed at the second stack, which would start capturing the CO2 while the first stack discharges concentrated CO2. The researchers have set up a company, Verdox, to commercialize the process.

(2) Oil giants jumping in too. This summer, ExxonMobil announced a joint development agreement to advance Global Thermostat’s technology to capture CO2 from the air. It follows news earlier this year that the venture arms of Occidental Petroleum and Chevron jointly invested in Carbon Engineering, a Global Thermostat competitor.

“Global Thermostat already has built two pilot facilities, each with the capacity to remove 3,000 to 4,000 metric tons of CO2 per year. ExxonMobil aims to help the company build bigger facilities in more places, until they’re removing a gigaton (1 billion tons) of CO2 every year,” an 8/29 article in GreenBiz reported. Exxon has reportedly provided Global Thermostat with millions of dollars and a team of 10 ExxonMobil employees. The companies will also try to find markets for the captured CO2.

Global Thermostat was started by Graciela Chichilnisky and Peter Eisenberger. Chichilnisky is a development economist and a member of the Intergovernmental Panel on Climate Change, which shared the 2007 Nobel Prize with Al Gore. She wrote the section of the Kyoto Protocol dealing with carbon markets. Eisenberger, a materials scientist, was the founding director of Columbia’s Earth Institute, an interdisciplinary environmental research center, who early in his career worked in R&D at ExxonMobil.

(3) CO2 for sale. The hope is that these CO2-removing plants become profitable by selling the CO2 they capture to companies that use the gas in their businesses. One potential customer: soft-drink-bottling plants that currently burn fossil fuels to generate the CO2 that gives sodas their bubbles. Farmers who burn natural gas to produce CO2 to feed their plants in greenhouses are also potential clients.

Scrubbed CO2 is also used by the fracking industry. NRG’s electric plant outside of Houston runs on coal, and it uses equipment to capture more than 1.4 million tons of CO2 gas each year. The CO2 is piped 80 miles to an oil field, West Ranch, where it’s injected into the spaces between underground rocks where oil used to be. The CO2 forces any remaining oil up to the surface, making older oil wells profitable again.

“Before using carbon capture technology, West Ranch produced about 300 barrels of oil daily. Now, NRG is recovering 4,000 barrels per day,” reported a 6/28 article on Now, a website “powered” by Northrop Grumman.

Carbon Engineering aims to combine the CO2 its plants capture with hydrogen to create a new “clean” fuel it calls “Air to Fuels” (A2F), a 2/4/18 article in The Guardian reported. The company was founded by Harvard physicist David Keith and initially funded by Bill Gates and oil sands executive Norman Murray Edwards. They hope the cost of direct air capture and producing A2F will fall to “little more than” the price of fossil fuels today.

(4) A future solution? Scientists at RMIT University in Australia are turning CO2 back into coal, in a laboratory anyway. When electricity and pure CO2 gas are pushed into a glass tube holding liquid composed of an alloy of gallium, indium, cerium, water and tin, flakes of solid carbon form on the surface, according to a 2/26 article in Science magazine, quoting the scientists’ report in Nature Communications.

After the reaction, the carbon flakes can be separated off, allowing the reaction to continue with additional CO2. The carbon produced by the reaction could be used in battery electrodes, tennis rackets, golf clubs, and airplane wings, observed a scientist from Utrecht University in The Netherlands. The trick will be scaling the experiment up from something done in a laboratory to something that can work beside a power plant.

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Thanksgiving

November 25 (Monday)

US Economy I: Counting Our Blessings. Thanksgiving is my favorite holiday. It’s great getting together with family and friends. We always take turns—going around the dinner table—sharing what we are most thankful for. The comments tend to focus on health and supportive family members.

Uniquely devoted to counting blessings and setting troubles aside, Thanksgiving is the “Mr. Rogers” of the holidays. Mr. Rogers always accentuated the positives and used them to overcome the negatives. (See my movie review below.) So let’s count our economic and financial blessings:

(1) Stocks and bonds. It’s been a very good year for stocks and bonds so far, particularly in the US. Here is the performance derby for the major MSCI indexes ytd through Friday’s close, in dollars: US (24.4%), AC World (19.2), EMU (16.3), Japan (15.1), UK (8.6), and Emerging Markets (8.6) (Fig. 1).

With the exception of Energy, the S&P 500 sectors have had double-digit gains so far this year through Friday’s close, as follows: Information Technology (39.4%), Communication Services (27.5), Industrials (26.7), Financials (25.2), Real Estate (22.3), Consumer Discretionary (20.8), Consumer Staples (20.3), Utilities (18.6), Materials (17.5), Health Care (13.5), and Energy (3.3) (Fig. 2).

It’s also been a good year for the bond market so far. The 10-year US Treasury bond yield is down from 2.69% at the end of 2018 to 1.77% on Friday. So investors earned their coupons and enjoyed another year of capital gains, despite the recent uptick in yields (Fig. 3).

(2) S&P 500 revenues. There’s no sign of a recession in S&P 500 revenues. Q3 data, released last week, show that revenues in aggregate and per-share rose 2.2% y/y and 3.9% (Fig. 4). Joe and I expect a modest rebound in revenues per share growth to 4%-5% in 2020 and 2021. We are impressed that revenues per share rose to yet another record high during Q3. We aren’t surprised, though, because our weekly proxy for revenues per share, i.e., forward revenues per share, continues to make new highs (Fig. 5).

(3) Misery Index and jobs. As Joe and I observed last week, the Misery Index—which is the sum of the unemployment rate and the inflation rate—was down to only 5.4% during October (Fig. 6). It’s down from the current expansion’s peak of 12.9% during September 2011. The S&P 500 forward P/E is highly inversely correlated with the Misery Index. The current low readings of the index are supporting relatively high valuation multiples in the stock market.

The unemployment rate was down to only 3.6% during October (Fig. 7). Here are the latest unemployment rates for teenagers (12.3%, among the lowest readings since 1969), African Americans (5.4%, record low), Latinos (4.1%, near September’s 3.9% record low), college educated (2.1%, bouncing around its lowest readings since 2008), and high-school educated (3.7%, around its lowest rate since 2000).

The number of full-time jobs (based on the household survey) rose 1.6 million during the first 10 months of this year to an all-time high of 131.5 million (Fig. 8). Full-time employment increased 21.0 million since it bottomed at the end of 2009. Over the same period, part-time employment was virtually flat at around 27 million.

(4) Real pay and confidence. Another blessing for workers is that real wages are at a record high. Average hourly earnings for production and nonsupervisory employees divided by the nonfarm business price deflator has been rising at a 1.4% compounded annual rate since Q4-1994 through Q3-2019 (Fig. 9). That could not have happened if real wages weren’t supported by productivity gains. Sure enough, nonfarm business productivity is up at a 2.0% compounded annual rate over the same period. All this belies the urban legend that real wages have been stagnating for the past two to four decades!

No wonder that the Consumer Optimism Index—which is the average of the Consumer Confidence Index and the Consumer Sentiment Index—remains at a cyclical high, with the present situation component near its record highs during the late 1990s (Fig. 10).

(5) Capital spending. Let’s continue to accentuate the positives, turning now to business capital spending in real GDP. It rose just 1.3% y/y during Q3. But as we reviewed in our 11/4 Morning Briefing, most of the weakness was in structures (down 8.1% y/y) and transportation equipment (-1.2). Meanwhile, the following components of real capital spending rose to new record highs during Q3: software (up 9.8% y/y), R&D (7.7), and industrial equipment (2.8), with information processing equipment (1.5) just below Q2’s record high. Intellectual property products in real capital spending rose 8.1% y/y, also to a record high during Q3.

(6) Government spending. State and local government spending in real GDP is also in record-high territory, with a gain of 1.5% y/y during Q3 (Fig. 11). Federal government spending in real GDP was up 3.7% y/y during Q3.

US Economy II: Missing Vitality. Meanwhile, the latest Atlanta Fed’s GDPNow shows Q4 real GDP tracking at just 0.4%. But don’t let that spoil your Thanksgiving holiday. At YRI, we’ve been thankful that the US economy continues to grow without booming. Booms lead to busts. The current economic expansion is the longest on record, having lasted 125 months through November—confirming our mantra: “No boom, no bust.” We expect that real GDP growth will be close to 2.0% during Q4. Nevertheless, we are continuing to monitor the economy’s weakest links:

(1) Exports and imports. Trump’s trade wars have weighed on both US exports and imports in real GDP, with both basically flat y/y (Fig. 12).

(2) Railcar loadings. The y/y growth rate in real GDP of goods is highly correlated with the y/y growth in railcar loadings (using the 26-week average) (Fig. 13). However, they’ve diverged significantly recently, with the former up 4.7% through Q3 and the latter down 6.4% through the 11/16 week.

(3) Manufacturing. As Debbie reports below, the three available regional business surveys conducted by the Federal Reserve Banks of New York, Philadelphia, and Kansas City for November are lackluster. The average composite index (up from 2.2 to 3.4) showed very little growth again in November, while the average new orders index (down from 5.6 to 3.6) expanded at the weakest pace since June; the average employment index (down from 11.5 to 7.6) showed hirings increasing at half the pace of December 2018.

(4) Leading indicators. The Index of Leading Economic Indicators (LEI) has declined for the past three months through October, while the Index of Coincident Indicators flattened out at a record high during the month (Fig. 14). The LEI is down only 0.4% over the past three months, and still up 0.3% y/y.

Financial Stability: Worrying About the Zombie Apocalypse. Last week, I visited some of our accounts in the Mid-Atlantic states. My basic message during my meetings was that inflation is dead. It’s been killed by the 4Ds, the four forces of deflation: Détente, Disruption, Demography, and Debt. The major central bankers are likely to continue to provide ultra-easy monetary conditions in their futile efforts to boost inflation to their 2.0% targets, I opined. By doing so, they are contributing to deflation by keeping zombie companies alive, thanks to the easy credit conditions resulting from the reach-for-yield behavior of lenders.

In my meetings, I detected concern that the proliferation of zombies could worsen the next recession. The risk is that something will cause lenders to panic over all the low-quality credit they accrued on their balance sheets as they reached for yield. That could trigger a credit crunch, which would cause a recession. I share this concern. However, the Fed still has 163bps between the federal funds rate and zero. Furthermore, the new shock absorbers in the credit markets are distressed asset funds.

The Fed issued its third Financial Stability Report, dated November 2019, last week. The first one was released a year ago, and the second one in May of this year. It boggles the mind to know that it took the Fed 10 years since the Great Financial Crisis to formally start monitoring financial stability. Better late than never, I suppose. All three reports were relatively sanguine, but all three flagged warnings about the potential for financial instability attributable to the mounting debts of nonfinancial corporations.

The latest report raised several warning flags:

(1) Risky business. “Business debt levels are high compared with either business assets or GDP, with the riskiest firms accounting for most of the increase in debt in recent years.”

(2) On the verge of turning into junk. The report observed: “In addition, about half of investment-grade debt outstanding is currently rated in the lowest category of the investment-grade range (triple-B)—near an all-time high. The volume of debt downgraded from investment grade to speculative grade in 2019 has been close to the average over the past five years. However, in an economic downturn, widespread downgrades of bonds to speculative-grade ratings could lead investors to sell the downgraded bonds rapidly, increasing market illiquidity and downward price pressures in a segment of the corporate bond market known already to exhibit relatively low liquidity.”

(3) Strong demand for weak credits. Demand for leverage loans remained strong, according to the report, while “credit standards have remained weak. … However, the credit performance of leveraged loans has been solid so far, with low default rates.”

(4) Reaching for yield. The Fed’s report acknowledged that historically low interest rates could cause financial instability: “If interest rates were to remain low for a prolonged period, the profitability of banks, insurers, and other financial intermediaries could come under stress and spur reach-for-yield behavior, thereby increasing the vulnerability of the financial sector to subsequent shocks.”

(5) Distorting the price mechanism. “Low interest rates may also increase risk-taking among some financial institutions. In addition to the pressures on banks and insurance companies, low interest rates could affect pension funds and other institutional investors pre-specified returns for policyholders that are significantly higher than the general level of interest rates. In order to meet the specified yield, these asset managers may hold riskier investment portfolios, which are expected to generate higher returns. Furthermore, this decision could artificially increase the price of risky assets.”

(6) Don’t worry, be happy. So what does the Fed intend to do about the potential for financial instability? Nada! Not a thing beyond monitoring the situation: “While vulnerabilities related to low interest rates have the potential to grow, thus calling for caution and continued monitoring, so far, the financial system appears resilient.”

Movie. “A Beautiful Day in the Neighborhood” (+ +) (link) stars Tom Hanks as Fred Rogers. The film is also about Tom Junod, a journalist who wrote an Esquire profile of the television celebrity. Junod said Rogers changed his perspective on life. Hanks was born to play Rogers, who was born to help kids feel better about themselves and manage their fears. He was also a big promoter of kindness. He had an amazingly calming demeanor about him, reflecting his own inner peace, which he shared with others. He taught that everyone is special. His critics claim that his popular TV show for kids turned Baby Boomers into self-centered brats, perversely setting the stage for today’s widespread incivility. We have only ourselves to blame for today’s bitter partisan divide. Mr. Rogers did all he could to promote kindness. Perhaps, we all need to sit down and watch the reruns.

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Consumers Are Consuming

November 21 (Thursday)

Holiday Gift Suggestion. Why not give the gift that will keep on giving during the coming holiday season? Why not give all your colleagues and your accounts my book Predicting the Markets? Of the 76 reviews on Amazon, 81% have been five stars. You can order five or more copies at a steep discount for the holidays at our online shop.

Europe: Signs of Life! Debbie, Joe, and I have been on the lookout for signs of life in the global economy since early October, when we decided it might be time to venture out of our Stay Home cabin and take a Go Global cruise for a while. We didn’t have to wait long to get a batch of better-than-expected economic indicators for Europe. Consider the following:

(1) Auto sales and production. On Tuesday, Reuters reported that passenger car registrations in Europe rose 8.6% y/y in October, to their highest October level since 2009 (Fig. 1). Demand is robust in Germany and France. The gain was led by a 29% gain for Volkswagen. A year ago, registrations were depressed as carmakers struggled to certify new vehicles to meet the Worldwide Harmonised Light Vehicle Test Procedure.

(2) German output and sentiment. This augurs well for German auto production, which plummeted 10.7% y/y during October but has stopped falling over the past three months, based on the 12-month sum (Fig. 2). The German Ifo business confidence index also stopped falling in October (Fig. 3).

(3) Retail sales. Despite the slowdown in Eurozone economic growth since early last year, the volume of non-auto retail sales in the region has continued to trend higher in record-high territory (Fig. 4). During September, it was up by a very solid 2.7% y/y.

China: Debts Coming Due. The People’s Bank of China lowered the loan prime rate yesterday, the third such cut since the benchmark was introduced in August. The move was telegraphed by a governor of the central bank, Yi Gang, who said on Tuesday that China would increase credit support to the economy and push lending rates lower to prop up slowing growth.

China’s economic growth is certainly slowing. GDP expanded 6.0% y/y during Q3, its weakest rate in the history of the series going back to 1992 (Fig. 5). Slowing economic growth is a major problem because China has $21.3 trillion of bank loan debt outstanding (Fig. 6). Bank debt has increased $16.7 trillion, or 375%, during the last decade, not plateauing until the spring of this year. China’s bank loans as a percentage of GDP surged to 152% during 2018 from 94% a decade ago (Fig. 7).

In addition to piling up bank loans, there’s lots of money being loaned outside of traditional banking channels, through other “social financing.” That’s an additional roughly $4 trillion. All told, China’s corporate, household, and government debt totals roughly $40 trillion, more than 300% of GDP. Companies and municipalities that assumed China’s economy would grow 7%-8% a year may have difficulty repaying their debt in a 6% (or less) annual-GDP-growth environment.

There is a growing number of articles about defaults by Chinese companies and municipalities, which may imply a problem brewing. Here’s Jackie’s look at some of the recent tales of woe from China’s credit market:

(1) Defaults low, but on the rise. China had its first bond default in 2014, when the government decided to end the perception that it would always bail out businesses. Then in 2016, the government cracked down on the shadow banking market and credit tightened. With the US-China trade war and a slowing economy pressuring issuers too, it’s no surprise that record bond defaults ensued.

In the first three quarters of 2019, issuers defaulted on 100 billion yuan ($14 billion) of debt. That’s on pace to approximate the full-year defaults of 2018, when 135 billion yuan of bonds defaulted, according to a 10/19 article in the South China Morning Post. Granted, the default rate is still low, at 1.03% of all issuers.

(2) Private companies squeezed. Chinese lenders are getting more conservative. Money is flowing into state-owned companies, which are considered safer than their private counterparts. Private companies are being asked to provide a large amount of collateral or credit guarantee to secure financing. “[M]any private firms have to issue short-term bonds to support their long-term investments,” Moody’s Ivan Chung said in a 10/23 South China Morning Post article. “When the companies encounter refinancing troubles, they run into liquidity problems.”

Tunghsu Optoelectronic Technology, an electronics manufacturer, ran into problems this week. It failed to repay principal and interest worth more than 2 billion yuan ($285 million) on two domestic bonds due Monday. “The delinquency came as a shock to the market because Tunghsu had reported holdings of cash or cash equivalent worth over 18 billion yuan as of the end of September in its latest quarterly report, more than enough to meet the bond repayments,” an 11/19 South China Morning Post article reported.

In September, Qinghai Salt Lake Industry Group (QSLIC) filed bankruptcy with a Chinese court, and it too is working on a restructuring. QSLIC has about 6.2 billion yuan of bonds outstanding and owns Qinghai Salt Lake Magnesium, which had 42.3 billion yuan ($5.94 billion) of debt and lost 7.9 billion yuan in 2017 and 2018 combined, a 10/11 Caixin Global article stated.

Even dollar-denominated debt has been hit. China Minsheng Investment Group Corp., a conglomerate with $34 billion of debt, missed principal and accrued interest payments on a 3.8% $500 million bond due in August. Creditors agreed to a one-year extension, and now questions are being raised about the company’s ability to repay its yuan-denominated debt, a 9/27 Nikkei article reported.

(3) States to the rescue. Sometimes, local governments jump in to prevent defaults. Two investment funds of the Heilongjiang provincial government raised their combined stake in Harbin Bank, a lender in northeastern China, to 48% from 20% according to a 11/19 article in the South China Morning Post. It’s unclear why the rescue was necessary.

In Shandong, three city governments set up a 3 billion yuan fund to support Xiwang Group, a steel and corn processing company struggling to pay debt. And in October, a local state-owned investment firm bought a 26% stake in Shandong Ruyi Technology Group, a fashion group, for 3.5 billion yuan and provided credit guarantees for the company’s bonds.

(4) Local governments need life preserver ring too. “Lower-tier” governments are under financial stress because their revenue is falling short of their obligations, like paying for education and healthcare. Spending on education jumped to Rmb3.9 trillion in 2017 from Rmb1.1 trillion a decade ago, reported an 11/10 FT article.

Chinese courts have listed 831 local governments as being in default for the first 10 months of this year compared to just 100 for all of 2018, the FT article noted. The amount owed grew by more than 50% to Rmb6.9 billion ($984 million) from Rmb4.1 billion ($585 million). These defaults don’t include any debt owed by local government finance vehicles or companies operated by local governments.

Jilin Transportation Investment Group is one such local government financial vehicle (LGFV). Jilin said in September that it plans to skip the call option on a 1.5 billion yuan 4.64% perpetual note. Instead, it will pay an increased coupon in the 8.00% vicinity, according to a 9/13 article in the South China Morning Post.

“If defaults or bankruptcies among high-profile LGFVs become epidemic, it would erode market confidence, tarnish government reputations, and destabilize the financial system,” Gloria Lu, an S&P infrastructure analyst said in the 9/13 article in the South China Morning Post. “It could also shut down financing to other local state-owned enterprises, at least initially. This would be highly disruptive at a time when China is counting on infrastructure development, along with other fiscal stimuli, to sustain economic growth and social stability.”

(5) Banks are debt heavy. In May, Chinese regulators seized a bank for the first time in 20 years. Baoshang Bank in northern China was placed in receivership. “The bank was once part of a network of investments controlled by Xiao Jianhua, a tycoon who was ensnared in an anticorruption campaign. Baoshang made several large loans to other companies within Mr. Xiao’s financial empire that were never paid back. Still, it remained open for depositors,” an 11/7 NYT article noted.

Last summer, Bank of Jinzhou received a 3 billion yuan equity infusion from China’s biggest bank, Industrial & Commercial Bank of China, and two investment firms, China Great Wall Asset Management and China Cinda Asset Management. And China’s sovereign wealth fund made an equity investment into Hengfeng Bank. Two of the bank’s former chairmen are under investigation for corruption. Given the amount of debt outstanding and the economic pressures on China, these rolling restructurings may roll on for quite a while.

Consumer Discretionary: Two Sides of the Coin. The S&P 500 General Merchandise Stores industry and the Department Stores industry might both be in the S&P 500 Consumer Discretionary sector, but they are having very different years.

The stocks in the General Merchandise industry are having a banner 2019, led by Target (67.7%) and followed by Dollar General (46.6) and Dollar Tree (18.3). The General Merchandise Stores industry has been the eighth-best-performing industry we track this year, up 47.9% ytd (Fig. 8).

Meanwhile, shareholders of stocks in the S&P 500 Department Stores industry may wish the year never started. The shares of Macy’s have fallen 49.5%, followed by those of Kohl’s (-29.1%) and Nordstrom (-23.8). Altogether, that means the S&P 500 Department Store stock price index has fallen 35.6%, making it the worst-performing index we track (Fig. 9).

To understand why the two similar industries are having such different performance, look no further than the Q3 earnings results of Target and Kohl’s. Target’s Q3 same-store sales rose 4.5%, beating expectations, while Kohl’s same-store sales rose only 0.4%, missing Wall Street analysts’ target.

Target’s total revenues increased 4.7% y/y to $18.7 billion, while Kohl’s sales were essentially flat at $4.4 billion. Kohl’s blamed a 1% decline in women’s clothing sales and warm weather. Target didn’t mention either as a problem.

Target’s net income from continuing operations jumped 14.5% to $706 million. The results, which beat Wall Street’s expectations, helped the company raise its full-year EPS forecast to $6.25-$6.45, up from the prior $5.90-$6.20 range. Conversely, Kohl’s operating income was $116 million for the quarter, or 74 cents a share, compared to 98 cents a share a year ago. Kohl’s cut its full-year EPS target to $4.75-$4.95, down from the prior range of $5.15-$5.45.

Target believes it’s taking market share in apparel and boasted a 31% jump in online sales compared to Kohl’s “mid-teens” increase in online sales. Kohl’s, which recently introduced a number of new apparel brands and expanded its athletic wear offering, said it remains hopeful that its sales will improve during the holidays.

Both companies have been investing in their stores, renovating, and updating their systems to allow customers to buy online and pick up in the store. They each have certain advantages. Kohl’s is accepting Amazon’s merchandise returns, which brings new customers into the stores. Target offers groceries, which gives customers a reason to return frequently. Customers may be indicating their preference for stores that offer one-stop shopping for anything from office supplies to food and clothing.

The good news for the economy is that consumers are still shopping.

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Global Capital Flows & the Dollar

November 20 (Wednesday)

Global Economy I: Downshift for Dollar Drivers. In my discussions with our accounts in London last week, I was often asked about the outlook for the US dollar. Since the beginning of the current bull market, Joe and I promoted a Stay Home investment strategy rather than a Go Global one. We figured that the US stock market would outperform most of the other ones around the world and that the dollar would be strong.

So far so good, but in early October, we expected that the Fed would cut the federal funds rate for a third time this year, providing a lift to emerging market economies and weighing on the dollar. So far, the jury is out on whether Go Global is set to outperform Stay Home over the next 6-12 months as we expect.

After the Great Financial Crisis, we believed that the US economy and financial system would be restructured much faster and much better than overseas ones. The US banking system is certainly in much better shape now than most other ones around the world. The American capital markets are more fully developed than most others overseas. The private equity market continues to provide lots of financing for new ventures.

American consumers remain among the most dependable ones around the world. The inflation-adjusted wage of production and nonsupervisory workers has been increasing 1.0% per year on average since the mid-1990s (Fig. 1). Full-time employment is at a record high of 131.5 million (Fig. 2).

The US industrial base is much more diversified than most others. As we observed yesterday, the sum of the market caps of the S&P 500 Information Technology plus Communications Services sectors currently accounts for 33.1% of the total market cap of the S&P 500 (Fig. 3). The sum of the Consumer Discretionary, Consumer Staples, plus Health Care sectors’ market caps accounts for 31.0% of the total market cap (Fig. 4). The aggregate market cap of Materials, Energy, and Industrials represents 16.5% of the S&P 500’s total market cap (Fig. 5). Financials, Real Estate, and Utilities combined account for 19.4% of the S&P 500 total (Fig. 6).

The high-tech revolution continues to flourish in the US. Capital spending on information processing equipment, software, and R&D rose to yet another record high of $1.34 trillion (saar) during Q3 in current dollars (Fig. 7). Together, these three categories account for 46.6% of capital spending, up from less than 20% in the early 1960s (Fig. 8).

In recent weeks, we’ve been discussing the attractiveness of Go Global on a valuation basis relative to Stay Home. Yesterday, we drilled down and compared the valuations and market-cap shares of the 11 sectors of various MSCI stock price indexes for selected countries and regions. Today, let’s discuss the outlook for the dollar:

(1) Commodity prices and the dollar. Our basic model of the foreign-exchange value of the US trade-weighted dollar (TWD) is very simple. Debbie and I have observed that the dollar tends to be strong (weak) when the global economy is relatively weak (strong), as evidenced by weak (strong) commodity prices. Indeed, there is a very discernible inverse correlation between the TWD and the Goldman Sachs Commodity Index (GSCI) (Fig. 9).

There’s no clear buy or sell signal for the dollar coming from the commodity pits currently since the GSCI has been moving mostly sideways this year. We are expecting the index to firm up in 2020 on better global economic growth. If that happens, then it would suggest dollar weakness ahead.

(2) Capital flows and the dollar. A less ambiguous sell signal for the dollar may be our World Capital Flows Proxy (WCFP), which is a monthly capital-flows series for the world excluding the US. On a 12-month basis, the US has been running widening trade deficits for many years (Fig. 10). The US trade deficit must equal the trade surplus of the rest of the world. So the 12-month change of non-gold international reserves held by all central banks (with the notable exception of the Fed, thanks to the dollar standard) minus the trade surplus of the rest of the world should be a proxy for capital inflows (outflows) to the rest of the world from (to) the US (Fig. 11). The WCFP starts in 1995.

The credibility of our proxy for international capital flows between the US and the rest of the world is confirmed by its high inverse correlation with the yearly percent change in the trade-weighted dollar (Fig. 12). This makes a great deal of sense. It suggests that the dollar is much more sensitive to capital flows than to trade. When the rest of the world is experiencing capital inflows, the dollar tends to be weak. When capital is pouring out of the rest of the world and into the US, the dollar tends to be strong.

The non-gold international reserves component of our proxy tends to be much more volatile than the trade component, reflecting the greater volatility of capital flows than of merchandise trade. Therefore, it isn’t surprising to see that the inverse of the yearly percent change in the TWD is also highly correlated with both the 12-month absolute change and the 12-month percent change in non-gold international reserves (Fig. 13 and Fig. 14).

The latest WCFP data showed capital outflows from the rest of the world to the US of $608 billion during the 12 months through September. That’s bearish, but the TWD was fractionally higher y/y through early November. Nongold international reserves were up slightly during September, by $246 billion y/y, or 2.3%.

(3) Emerging markets and the dollar. Our bet is that the Fed’s pivot from signaling three rate hikes this year to actually cutting rates three times will reverse capital flows away from the US back to the rest of the world, especially emerging economies. That reversal should put some downward pressure on the dollar. It’s interesting to note that the Emerging Markets MSCI stock price index has held up remarkably well this year (Fig. 15).

(4) The world’s reserve currency. Of course, the dollar’s ace-in-the-hole is that it remains the world’s #1 reserve currency. Data compiled by the International Monetary Fund show that nongold international reserves totaled $12 trillion during September. Allocated reserves totaled $11 trillion during Q2, with 62% in dollars (Fig. 16).

Global Economy II: Deflating PPIs. Debbie and I continue to search for signs of life in the global economy, but aren’t finding much to get excited about. In the US, it’s still early, but the Atlanta Fed’s GDPNow is tracking at only 0.4% for Q4’s real GDP. The Citigroup Economic Surprise Index (CESI) has been surprisingly weak recently, dropping from the year’s high of 45.7 on 9/25 to -5.7 on Monday (Fig. 17). Then again, as Debbie reports below, October’s housing starts and building permits were both very strong.

Over in Asia, we are paying more attention to PPI inflation rates because they are mostly deflating as follows: Singapore (-6.9% y/y, September), Taiwan (-6.2, October), Thailand (-2.5, October), Malaysia (-2.4, September), China (-1.6, October), South Korea (-0.8, September), and Indonesia (-0.8, September) (Fig. 18).

Deflating PPIs tend to signal weakness in profits. The forward earnings of the Emerging Markets Asia MSCI was falling from the spring of 2018 through the summer of 2019. In recent weeks, it has been firming, suggesting that the worst might be over. (See our Global Index Briefing: Emerging Markets Asia MSCI.)

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P/E Primer

November 19 (Tuesday)

Valuation I: Everyone is asking us: Is the market overvalued? Yesterday, Joe and I compared valuation to a beauty contest, noting that beauty is in the eye of the beholder. A talent show might be more apt an analogy during today’s divisive times. Like any objective judge at a talent show, we want to see the contestants compete before we pick the winner. That’s what we at YRI do on a regular basis when we assess the various valuation models.

In recent years, we’ve given more of our votes to the contestants that incorporate inflation and interest rates into their acts. That’s led us to a more sanguine opinion about stock valuation than suggested by the more traditional reversion-to-the-mean P/E models, especially the ones based on trailing earnings.

As we observed yesterday, there are lots of models for assessing valuation in the stock market. We follow three of them that account for inflation in determining valuation. We discussed the Real Earnings Yield and the Rule of 20 yesterday. Both deliver sanguine assessments, suggesting that stocks are not overvalued. The third one sends the happiest signal right now. We call it the Misery-Adjusted P/E (MAPE). Consider the following:

(1) The Misery Index. The Misery Index is the sum of the unemployment rate and the yearly percent change in the CPI inflation rate (Fig. 1 and Fig. 2). The Misery Index tends to fall during bull markets and to bottom before bear markets. It was down to 5.4% during October, almost matching the most recent low of 5.0% during September 2015, which was the lowest reading since April 1956. What you’re about to hear may be hard to believe, we know, amid all the naysaying by all the naysayers, but the truth is: Most Americans have never been less miserable, at least in terms of how they’re affected by the performance of the macro-economy.

(2) MAPE. We’ve found that there is a reasonably good inverse correlation between the forward P/E of the S&P 500 and the Misery Index (Fig. 3). That makes sense to us. When we are miserable, we aren’t in the mood to drive up the valuation multiple. When we are happy, we tend to become exuberant, driving up the P/E. However, a high P/E, by historical standards, may not necessarily reflect irrational exuberance if interest rates are historically low because inflation is subdued. In other words, the current readings of the Misery Index are historically low and may justify P/Es that exceed the historical average.

Our homebrewed MAPE is the sum of the S&P 500 forward P/E and the Misery Index (Fig. 4). It averaged 23.8 from September 1978 through October 2019. Readings above (below) the average suggest stocks are overvalued (undervalued). It was 22.6 during October, i.e., below average. MAPE correctly warned that stocks were overvalued prior to the bear markets of the early 1980s and 2000s. It did not anticipate the last bear market, but that’s because the problem back then was the overvaluation of real estate, not stocks.

Valuation II: How Is P/E Measured? We’ve received requests to drill deeper into the S&P 500 forward P/E by individual companies and by the sectors. First, to be clear, I asked Joe to review how these valuation multiples are calculated. Here is his primer, which applies to both S&P and MSCI data:

(1) Companies. We use I/B/E/S data provided by Refinitiv (formerly Thomson Reuters) for the weekly forward operating earnings of each S&P 500 company (Fig. 5). These are the time-weighted averages of industry analysts’ consensus earnings expectations, which change weekly, for the current and coming years. For each of the S&P 500 companies, the forward P/E is simply the company’s stock price divided by the latest weekly reading of its forward earnings (Fig. 6). (The two linked charts show the forward earnings and forward P/E for Nike, the only component of the S&P 500 Footwear industry.)

(2) Broad indexes and sectors. The forward P/E of the overall S&P 500 stock price index is measured by dividing the total market capitalization of all the companies in the index (derived by adding up each company’s market cap, i.e., the number of its shares outstanding multiplied by its share price) by aggregate forward earnings (derived by adding up each company’s forward earnings, i.e., its number of shares outstanding multiplied by its forward earnings per share) (Fig. 7). The same methodology is used to calculate the forward P/Es of all the S&P 500 industries and sectors.

(3) Mean vs median. So the forward P/Es of the industries, sectors, and broad indexes are not market-cap weighted and are not averages of the P/Es of individual companies that they include. For example, during the week of 11/15, Joe calculated the forward P/Es of each of the 505 issues in the S&P 500 (Table 1). The average was 22.3, with a low of 3.8 and a high of 301.2. This average is heavily impacted by the high outliers.

The median P/E was 17.7, which was close to the actual forward P/E of the S&P 500, at 17.1. Joe calculates the median P/E for the S&P 500 once a month. Not surprisingly, it tends to closely track the actual forward P/E (Fig. 8).

Valuation III: 505 P/Es. As noted above, there are 505 issues in the S&P 500. Also noted was that the average P/E is inflated by the high outliers. During the 11/15 week, there were 37 companies with a forward P/E exceeding 40.0, including four that are in the S&P 500 Energy sector and 22 that are in the Real Estate sector. There were 169 companies with forward P/Es between 20.0 and 40.0, including 35 that are in the Information Technology sector. There were 118 companies with forward P/Es of 15.0-20.0 and 181 companies with forward P/Es within the 3.8-15.0 range.

Valuation IV: US Sectors. When we drill down to the sector level, we see that seven of the 11 S&P 500 sectors have forward P/Es exceeding that of the overall index’s 17.7 reading through the 11/14 week: Real Estate (42.4), Consumer Discretionary (21.5), Information Technology (20.6), Consumer Staples (19.8), Utilities (19.2), Communication Services (18.3), and Materials (17.8) (Fig. 9). If you are looking for value, i.e., low P/Es, they are in Financials (12.8) and Health Care (15.0).

In the 11/7 Morning Briefing, we suggested that Energy is relatively cheap and might be a good hedge against higher oil prices caused by supply concerns, should a conflict between Israel and Iran occur, and/or by stronger-than-expected demand if world economic growth improves next year, as we expect. Financials also look cheap and more attractive now that the yield curve is no longer inverted. Health Care has been held back by fears that if a Democrat beats Trump during the presidential election at the end of next year, there will be more political pressure for a one-payor healthcare system run by the federal government. Our current assumption is that Trump will win a second term, which would provide a boost to health care stocks.

For additional insights into the sectors’ valuations, we also like to compare the market-cap shares to the earnings shares of the sectors. We generally become concerned if any sector’s market-cap share rises to 30% without support from a comparable reading for its earnings share. We don’t see much to worry about on this score. Consider the following:

(1) Consumer Discretionary and Consumer Staples currently account for 9.8% and 7.3% of the S&P 500’s market-cap share, or 17.1% combined (Fig. 10). Their earnings shares are 8.0% and 6.5%, or 14.6% combined. So they are both a bit pricey.

(2) Information Technology and Communication Services currently account for 22.7% and 10.4% of the S&P 500’s market-cap share, or 33.1% combined (Fig. 11). Their earnings shares are 19.4% and 10.1%, or 29.5% combined. They are both fairly valued, in our opinion.

(3) Materials, Energy, and Industrials currently have market-cap shares of 2.7%, 4.4%, and 9.4%, or 16.5% combined (Fig. 12). Their earnings shares are 2.7%, 4.6%, and 9.9%, or 17.2% combined. They seem relatively cheap to us.

Valuation V: Overseas Sectors. Since early October, Joe and I have been studying and discussing the record-wide divergence between the forward P/E of the US MSCI and the All Country World ex-US MSCI. To get a better handle on this subject, Joe ran a table showing the 10/31 values of both the forward P/Es and the market-cap shares of the 11 sectors of selected MSCI countries and regions (Table 2). Here are a few of our conclusions:

(1) Information Technology and Communication Services. One of the main reasons why the US valuation multiple is higher than that of the ACW ex-US is that the Information Technology sector has the highest market-cap share in the US, currently at 22.6%, and the sector’s P/E, at 20.3, is among the highest in the world for this sector.

China’s IT sector is cheaper, with its P/E at 17.8, but it has a market-cap weight of just 3.6%. IT is relatively cheaper in emerging market economies, with a forward P/E of 15.6 and a market-cap share of 15.8%.

Interestingly, the market-cap share of Communication Services is higher in China (at 21.7%) than in the US (at 10.2%).

(2) Energy. If you decide to increase your weight in Energy, it might make more sense to do so with the overseas rather than the domestic sector. The sector’s forward P/E is 10.6 over there, but 16.2 over here. There’s a bit more market-cap share over there, at 6.6%, than over here, at 4.3%.

(3) Consumer Discretionary and Consumer Staples. The combined market-cap share of the two major consumer sectors is bigger in China (at 28.9) than in the US (at 17.5). Consumer Discretionary is cheaper abroad (at 14.8) than in the US (at 22.3), mostly because of Amazon and Netflix, as we discussed last Thursday. Consumer Staples are equally valued in the US and abroad, both between 19.0-20.0.

(4) Financials. The Financials sector is relatively cheap around the world. Here is the latest performance derby showing the market-cap shares and forward P/Es across the major MSCI indexes for the sector: Canada (39.7, 10.9), EM (24.6, 8.8), China (22.2, 6.4), ACW ex-US (21.4, 10.0), UK (20.2, 9.7), EMU (16.5, 9.6), US (12.9, 12.3), and Japan (10.7, 8.7).

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Revisiting Earnings & Valuation

November 18 (Monday)

Strategy I: Back Home with a Worry List. I’m back in the USA after spending a week visiting our accounts in London, which is a wonderful city with lots of history, shopping, and great restaurants. It’s truly multicultural and probably the most cosmopolitan and globalized city in the world.

My usual taxi driver, Brian, drove me from meeting to meeting. Getting around London’s streets is a big challenge since many of them are very narrow, partly because of the many bike lanes around town. There aren’t too many bikes in the bike lanes, which really annoys Brian. So does all the road and building construction. Brian is all for Brexit. He wants out of the EU. Of course, the long, drawn-out Brexit melodrama is still playing out and creating a great deal of anxiety and uncertainty among Brits and lots of other people around the world. Still, you would never guess it by the number of cranes at numerous office-building construction sites all over London.

During my meetings, I did ask for some feedback on the likely course of Brexit. Most of the conversations about it were short because I could tell that these Londoners are thoroughly sick of the whole mess. They are also sick over the bitter partisan divide between the Tories and the Labour Party, which is very similar to what we are seeing between the Republicans and the Democrats in the US.

When I got back to my hotel room on Wednesday evening, I turned on the television, and there was Hillary Clinton being interviewed on the BBC. She must have timed her visit to London to coincide with mine. She remains obsessed by certain things: It is “inexplicable and shameful” that the UK government has not yet published a report on alleged Russian interference in British politics, she said during her interview. The former Democratic presidential nominee didn’t rule out entering the 2020 race, telling the BBC: “Never say ‘never.’” She said she thinks “all the time” about what kind of president she would have been had she beaten Trump in 2016.

In my meetings, it seemed that everyone is happy about the bull market in stocks, but nervous about how much longer it might last. Valuations are high, especially in the US. They are lower in Europe, Japan, and emerging market economies. But based on my meetings, London’s investors aren’t jumping to reduce their US stock allocations to move funds elsewhere.

Of course, last week came news that the “Phase 1” trade deal between the US and China isn’t a done deal. The Chinese want Trump to phase out his tariffs on their goods sold in the US, while he wants to keep the pressure on so they will move on to the next phase of talks. It is in Trump’s interest to de-escalate his trade war as the 2020 election approaches. But he insists he won’t do any deal that’s not a good one for the US.

Also last week, the clash between pro-democracy protestors and the local police in Hong Kong escalated. The mainland government is warning that it will send troops to quash the demonstrations. If Chinese President Xi decides to send in his troops, resulting in many more casualties among the protestors, thousands of cell phones will be filming it and countless more around the world live-streaming it. Trump then might have no choice but to suspend trade talks with China and impose a bigger and across-the-board tariff on Chinese imports.

In other words, just because the stock market is at a record high doesn’t mean there’s nothing to worry about. From a contrarian perspective, new highs can be associated with too much complacency. Consider the following:

(1) Bull-bear ratio. Investor Intelligence’s bull-to-bear ratio (BBR) has been above 3.0 for the past three weeks through the 11/12 week (Fig. 1). That’s up from a recent low of 0.86 during the 1/1 week. The BBR historically has provided a very good buy signal whenever it has fallen to 1.00 or less, as Debbie and I discussed in our 1/14 Morning Briefing (Fig. 2). However, readings of 3.00 or higher aren’t as good sell signals (Fig. 3).

(2) Margin debt. Somewhat more unsettling is the divergence between the S&P 500 and margin debt. In the past, the two were very highly correlated. They’ve diverged significantly recently, with margin debt down 17% from a record $669 billion during May 2018 to $556 billion during September (Fig. 4). Over the same period, the S&P 500 is up 10%. Margin debt took a dive at the end of last year along with the stock market, but never recovered.

Then again, maybe that’s bullish, if the stock market can advance without more leverage!

(3) Boom-Bust Barometer. Another possibly worrisome divergence is the one between the S&P 500 and our Boom-Bust Barometer (BBB), which has been trending down since it rose to a record high during the 4/13 week (Fig. 5). The BBB is the ratio of the CRB raw industrials spot price index and jobless claims.

The BBB may be losing its ability to rise much because jobless claims can’t fall much from their recent historical lows. That’s confirmed by the close fit in the past between the BBB and S&P 500 forward earnings, which have continued to crank out new highs this year (Fig. 6).

(4) Dividend yield. Again from a contrarian perspective, the new mantra for the bullish camp is that “stocks are the new bonds.” Then again, the bulls (including yours truly) have chanted “TINA” (“there is no alternative”) and “FOMO” (“fear of missing out”) during our pep rallies. Joe and I added “FONIR” (“fear of negative interest rates”) to the mix of bullish acronyms.

The fact is that the S&P 500’s dividend yield, at 1.9% during Q3, about matches the 10-year Treasury bond yield (Fig. 7). As long as there is no recession, there’s probably more upside in dividend-yielding stocks than in bonds.

Strategy II: Updating Our Earnings Outlook. Joe and I are updating our outlook for S&P 500 operating earnings per share. We now expect earnings will edge up just 0.7% this year to $163 per share, then rise 5.5% in 2020 to $172 and rise 5.2% in 2021 to $181 per share (Fig. 8). (See Table 1 in YRI S&P 500 Earnings Forecast.)

During the 10/31 week, industry analysts were forecasting $163, $179, and $198, or gains of 0.5%, 10.2%, and 10.3% (Fig. 9). Industry analysts tend to be overly optimistic about earnings in the distant future, so they end up revising their estimates downward over the course of most years as the corresponding reporting seasons approach (Fig. 10).

To offset this bias, we use forward earnings, which is the time-weighted average of consensus earnings-per-share estimates for the current year and the coming year (Fig. 11). It rose to $177.20 during the 11/7 week. We reckon that it could rise to $190 by the end of next year, which will be the same as the consensus estimate for 2021 and down from the current estimate of $198.

Now that our year-end target of 3100 for 2019 has been achieved, we feel more confident in our 3500 target for the end of next year. We derive it by multiplying our forecast of forward earnings at the end of next year ($190) by a forward P/E of 18.4.

Strategy III: The Outlook for Revenues. Actual earnings growth over the coming two years will be determined by revenues growth, since we expect that the S&P 500 profit margin will remain flat near its record high around 12.0% through 2021 (Fig. 12). The growth rate in S&P 500 revenues is highly correlated with the growth rate in business sales, which was up only 0.5% y/y through September (Fig. 13).

That’s not much, and a long way from the 5% annual growth rates we need to boost earnings by the same amount over the next two years. But we think that a pickup in the global economy will be sufficient to revive revenues and earnings growth back into the mid-single digits.

Strategy IV: Valuation & Beauty Contests. As noted above, we see some issues that could trip up the bull market. However, our biggest concern right now is the market itself—i.e., if it gets to 3500 well ahead of our schedule. Such a melt-up could push the forward P/E of the S&P 500 up toward 20.0 from 17.5 currently (Fig. 14). It’s easy to justify such a high multiple by observing that inflation remains subdued and interest rates are historically low. But then again, it is human nature to find justification for high multiples at the top of bull markets.

If the market moves higher on advances by some of the cheaper S&P 500 sectors—such as Energy, Financials, and Health Care—we would be more relaxed about its elevation. Here are the latest S&P 500 sector forward P/Es as of the 10/31 week, from lowest to highest: Financials (12.6), Health Care (15.0), Energy (16.1), Industrials (16.5), Materials (17.5), Communication Services (17.9), Utilities (19.8), Consumer Staples (19.8), Information Technology (20.1), and Consumer Discretionary (21.8).

In my book Predicting the Markets (2018), I introduced a review of various valuation models that stock investors follow by recalling what an elusive, subjective thing valuation really is: “Judging valuation in the stock market is akin to judging a beauty contest. … Not only is beauty subjective, Hollywood tells us—it can be dangerous. At the end of the original version of the movie King Kong (1933), the big ape’s death is blamed by his handler on Ann Darrow, Kong’s blonde love interest, played by Fay Wray: ‘It was beauty that killed the beast.’ Valuation is in the eye of the beholder too. And buying stocks when they are most loved and very highly valued can also be deadly.”

Here’s an update of three of the valuation models that I reviewed:

(1) Buffett ratio. Warren Buffett has said he favors the ratio of the value of all stocks traded in the US to nominal GNP, which is nominal GDP plus net income receipts from the rest of the world (Fig. 15). The data for the numerator are included in the Fed’s quarterly Financial Accounts of the United States and lag the GNP report, which is available on a preliminary basis a few weeks after the end of a quarter. Needless to say, they aren’t exactly timely data. However, the forward price-to-sales ratio of the S&P 500, which is available weekly, has been tracking Buffett’s ratio very closely. The quarterly series is back at the 1.90 peak just before the bear market of 2000-2002. The weekly series was 2.07 at the end of October. Buffett has remained bullish, observing that historically low inflation and interest rates justify these high ratios.

(2) Rule of 20. The “Rule of 20” was devised by Jim Moltz, my mentor at CJ Lawrence. It simply compares the S&P 500 forward P/E to the difference between 20 and the inflation rate, using the y/y percent change in the CPI. When the sum of the forward P/E and the inflation rate is above (below) 20, stocks are deemed to be overvalued (undervalued) (Fig. 16). It was slightly below 20.0 during October. This rule of thumb has had a few hits and misses, as have more sophisticated models.

(3) Real earnings yield. The earnings yield of the S&P 500, which is simply the reciprocal of the P/E based on reported earnings, is highly correlated with the CPI inflation rate on a y/y basis. The real earnings yield (REY) of the S&P 500 is the difference between the nominal yield and the inflation rate (Fig. 17). The result is a mean-reversion valuation model that logically includes inflation.

The average of the real yield since 1952 through Q3-2019 is 3.19%. The model tends to anticipate bear markets when the yield falls close to zero. Our friend John Apruzzese, the Chief Investment Officer of Evercore Wealth Management, examined this model in a November 2017 paper titled “A Reality Check for Stock Valuations.” Based on the REY model, he found that “stocks appear more reasonably priced than the conventional P/E ratio suggests during periods of low inflation and rising markets, and more expensive during periods of high inflation and falling markets when they otherwise might seem cheap.”

According to the model, stocks remained reasonably priced during Q3, with the REY at 2.92%.

Movie. “Ford v Ferrari” (+) (link) is a film about American car designer Carroll Shelby and driver Ken Miles, who build a race car for Ford and challenged Ferrari at the 24 Hours of Le Mans race in 1966. It’s about American ingenuity that triumphs despite the obstacles imposed by corporate honchos at Ford. Matt Damon plays Shelby, and Christian Bale plays Miles. Both performances are solid. Breaking land speed records can be fatal. In late August, Jessi Combs died attempting to do that in the Alvord Desert when the front wheel of her jet-powered car malfunctioned after hitting something, causing the front-wheel assembly to collapse. The crash happened at speeds near 550 mph.

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A Couple of Consumer Discretionary Industries

November 14 (Thursday)

Consumer Discretionary I: Has Housing Had Its Heyday? Everyone loves a bargain. It’s the reason shoppers stand in line for hours after Thanksgiving dinner and risk their bosses’ ire by trolling the Internet on Cyber Monday. Homebuyers are no different. When the 30-year mortgage interest rate began to fall late last year, prospective home buyers saw their opportunities and pounced (Fig. 1). The 2018 slump in existing home sales quickly reversed and has remained near the highest levels of the past four years.

But after five months of strong sales, homebuilding stocks face two problems. First, there’s a lot of good news baked into their stock prices; the stocks trade near all-time highs and have been among the best performers in the S&P 500 over the past year. Second, interest rates may have hit their nadir. If so, they won’t likely provide any additional help to the industry and might become a hindrance. Here’s Jackie’s look at some of the industry’s fundamentals:

(1) Low rates have improved affordability. Late last year, the Federal Reserve was expected to continue raising the federal funds rate into 2019. When the reverse became reality, the interest rate on the 30-year fixed-rate mortgage fell to a low of 3.60% on 9/5, down from a high of 4.99% in early November 2018 (Fig. 2). The lower cost of borrowing helped make buying a home much more affordable (Fig. 3).

In Q3-2018, the median price of a single-family home peaked at $266,500, and the average mortgage rate hit 4.77%. Homeowners’ average monthly principal and interest payment rose to $1,115, representing 17.4% of the average homeowner’s income (up from 15.8% in 2017 and 15.0% in 2016), according to data from the National Association of Realtors (NAR). Fast-forward to Q3-2019: According to NAR’s preliminary data, the mortgage rate fell to 3.71% in Q3-2019, the monthly principal and interest payment dropped to $1,033, and that payment as a percentage of income slid to 15.6%.

So why worry? Because the interest rate on the 30-year mortgage has started to creep higher. Currently at 3.96%, the rate might head higher still if the US and China ever strike a trade deal. And Fed Chair Jerome Powell indicated on Wednesday that the Fed is back in pause mode. We expect that the Fed will leave interest rates unchanged through next year’s elections. The events of 2018 made it clear that very small increases in mortgage rates have an outsized impact on the housing market in today’s low-interest-rate world.

(2) Home prices keep rising. After bottoming in February 2012, the average and median prices of existing single-family homes have crept higher every year (Fig. 4). And in some of the hottest real estate markets, home prices are rising by percentages in the double digits. Ogden, Utah has been dubbed the “hottest” real estate market, as it’s attracting buyers from other nearby expensive states. The one-year change in list price was 13.5%, and the projected one-year change is 7.8%, according to a 9/26 article in Construction Coverage.

In order to ensure its homes are affordable, DR Horton started building smaller homes. “[W]e continue to see our average square footage come down slightly. It was down about 3% on a year over year basis again. And we’ve proactively gotten the houses out there that we believe are affordable in today’s market,” said Jessica Hansen, vice president, Investor Relations on the company’s fiscal Q4 conference call.

(3) Stock prices keep rising. With interest rates low and sales humming, the S&P 500 Homebuilding industry has been one of the top-performing industries we cover. It’s up 50.8% ytd, making it the sixth-best-performing industry in the S&P 500 on a ytd basis, and up 52.2% y/y, making it the fourth-best-performing industry on that basis (Fig. 5).

The Homebuilding industry is expected to produce respectable results this year and next, with revenue forecast to rise 5.3% in 2019 and 5.4% in 2020 (Fig. 6). Earnings are expected to jump 7.5% this year and 8.6% next year (Fig. 7). The S&P 500 Homebuilding industry’s forward P/E has rebounded to 11.4, leaving it somewhat elevated (Fig. 8).

(4) Inventories still low. The best things the housing market has going for it now are low inventories and a strong job market. At 1.61 million units, the existing single-family homes available for sale are fewer than half that in 2006 and on par with the lows of 2000 despite the population growth since then (Fig. 9). Strong employment levels and wage gains also help buyers keep up with home price increases. Unemployment remains near an all-time low of 3.6%, and real wages are edging higher (Fig. 10 and Fig. 11).

But those job market dynamics were also true in 2018, and it wasn’t enough to offset the downward pull that higher interest rates had on housing sales. If interest rates head much higher, bargain shoppers will likely walk away and wait for a better deal.

Consumer Discretionary II: Internet Retail Falling Behind. The S&P 500 Internet & Direct Marketing Retail industry—home to powerhouses Amazon, Expedia Group, and Ebay—is conspicuously absent from this year’s stock price leader board. The industry’s stock price index rose at a compounded annual growth rate (CAGR) of 28.4% during 2003-18, trouncing the S&P’s 6.8% CAGR over that period. But this year, the industry’s stock price index has sputtered (Fig. 12).

The S&P 500 Internet Retail stock price index has gained 16.9% ytd through Tuesday’s close, lagging behind the S&P 500’s 23.3% ytd appreciation. Likewise, the Internet Retail index has climbed 7.3% y/y, almost half the S&P 500’s 13.4% y/y return. Let’s take a look at what knocked the Internet Retail industry off its leadership perch:

(1) Earnings and P/E tumbling. The S&P 500 Internet Retail industry’s forward earnings forecasts have fallen 14% since mid-July (Fig. 13). Once expected to grow by more than 40%, the industry’s 2019 earnings are now expected to gain only 7.5% (Fig. 14). Next year, the above-market earnings growth rate returns: 22.4%.

The Internet Retail industry’s forward earnings multiple has shrunk as well. Last year, its forward P/E was north of 80. Today, it’s only 45.8 (Fig. 15). The Internet Retail sector has the biggest impact on the S&P 500 Consumer Discretionary industry. Joe reports that Internet Retail earnings represent 16% of the S&P 500 Consumer Discretionary sector’s forward earnings, ahead of Home Improvement Retail’s 14%. And the sector’s 21.8 forward P/E shrinks to 17.1 if the Internet Retail industry is excluded (Fig. 16).

(2) A trip to nowhere. The Internet Retail industry was grounded last week when Internet travel companies Expedia and TripAdvisor reported disappointing earnings. They blamed changes in Google’s search algorithm, which they say began to display their websites further down the list of search results, an 11/7 WSJ article reported. The Internet travel companies are expected to respond by spending more on digital and TV advertising, which could hurt earnings.

Expedia shares have been the worst performers in the S&P 500 Internet Retail index, falling 15.1% ytd and 21.8% y/y. Booking Holdings—which owns online reservation companies Kayak.com, Booking.com, and OpenTable—beat earnings estimates, and its shares haven’t fallen as sharply, less than 10% ytd.

(3) Not so amazing. Amazon stock is doing better than the Internet travel retailers, but it’s still lagging behind the S&P 500. Up 18.4% ytd and 8.6% y/y, the company’s performance is trumped by that of the S&P 500 (23.3% ytd and 13.4% y/y).

Amazon has come under attack from various angles. On the retail front, the WSJ discovered that 10,870 items Amazon has come under attack from various angles. On the retail front, the WSJ discovered that 10,870 items being sold by other retailers through Amazon’s website between May and August lacked required warnings or were deemed unsafe, deceptive, or banned by federal agencies, an 8/23 article reported. Of the 1,934 sellers whose addresses could be determined, 54% were based in China.

Amazon has recruited Chinese manufacturers and merchants to sell their products on Amazon, an 11/11 WSJ article reported. The paper discovered Chinese sellers marketing products deceptively. Amazon’s response: “Bad actors make up a tiny fraction of activity in our store and, like honest sellers, can come from every corner of the world. Regardless of where they are based, we work hard to stop bad actors before they can impact the shopping or selling experience in our store.”

The latest retail black eye comes from Nike, which this week said it would stop selling its products directly to Amazon. “Nike executives were unhappy with how unauthorized sellers continued to be widely available on Amazon, according to people familiar with the matter,” an 11/12 WSJ article reported.

Amazon’s cash cow is its fast-growing, high-margin web services business. But it too received a black eye when it lost a head-to-head bakeoff against Microsoft’s cloud business, Azure, for a $10 billion Defense Department contract. Microsoft’s Azure has less market share than Amazon, but the government contract win may cause corporate IT decisionmakers to give Azure a second look, an 11/2 MarketWatch article noted.

Lastly, Amazon is spending with abandon. It’s building a one-day package-delivery system. It continues to build out its cloud. And the company is taking on Hollywood, producing movies and TV series to show over its streaming service. Amazon’s profit fell y/y in Q3 for the first time in more than two years. It’s expected to decline again in Q4. It may take a while for the Internet Retail industry to return to the market-beating powerhouse it was in the past.

Disruptive Technology: 3-D Printing Update. 3-D printing is progressing slowly, but it is progressing. We recently came across two features. One looked at how it’s being used to build homes. The other discussed the various ways manufacturers are employing the technology. Here are some of the highlights:

(1) 3-D printing at work. Manufacturers are increasingly using 3-D printed items to cut costs and save time. 3-D printing is being adopted first by companies that manufacture or need low-volume, high-value parts, an 11/9 CNBC article reported. IDTechEx estimates in the article that the market for 3-D printing should grow 13% annually, from $10 billion today to $31 billion by 2029.

A diverse group of companies uses the technology. Workers on a North Sea oil rig use a 3-D printer to make replacement parts on the spot instead of waiting days for a delivery by air or sea. L’Oreal is using 3-D technology to print prototypes of its projects, and now it’s using the technology to create human skin. With bioprinting, layers of living cells are used to create human skin on which L’Oreal can test its products instead of using animals. And in the dental community, 3-D printers are creating more precise crowns and dentures.

(2) 3-D printing at home. Want to vacation in a 3-D printed home? You might be able to as soon as this spring in Garrison, New York on the Hudson River. The TERA project is building two-story structures using 3-D printing technology, according to an 11/8 NYT article. It’s just one of the 3-D printed neighborhoods cropping up.

ICON is building small 3-D printed homes for the homeless. It built a 350-square-foot house that was printed with a machine in just 47 hours over several days at a cost of $10,000 for the printed elements. ICON has plans to print 50 houses for a poor community in an undisclosed location in Latin America. It’s also working on a 51-acre development for the homeless outside Austin, Texas.

In the Netherlands, Project Milestone is building five 3-D printed homes that will use various materials and designs. Expected to be completed in early 2020, the homes will be sold to a real estate company and leased out. In Italy, WASP built a 323-square-foot house from local soil and rice-cultivation waste. WASP aims to use materials sourced near where the home is built to reduce the energy and waste involved with current homebuilding techniques.

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Zombies in the Fed’s Soup

November 13 (Wednesday)

Central Banks: Demand-Side Obsession. I’ve been finishing up the writing of my next book, Fed Watching for Fun and Profit: A Primer for Investors. I’ve had a lot of fun writing it, and it has allowed me to see more clearly the Fed in particular and central bankers in general.

In my opinion, they all suffer from group-think.

They all use the same or similar models of the economy. Some are empirical models, but most are theoretical. The empirical ones create the illusion of a precise scientific analysis of how the economy works. The theoretical ones tend to be, well, too theoretical. Both can be quite misleading, especially if they are based on faulty assumptions and logic. Put simply, most of the models reflect thinking that bears little resemblance to reality and lacks plain old common sense.

When reality conflicts with what their models suggest to be the case, the central bankers—rather than questioning their models and learning from their mistakes—resolve the cognitive dissonance by doubling down on their commitment to their models. In other words, they do more of the same, expecting that the result will eventually coincide with their models’ predictions.

A case in point is their determination to provide ultra-easy monetary policies to boost inflation to their target of 2.0%. The major central bankers have been trying to do so for over 10 years without success. They seem totally befuddled. Fed officials have recently been talking about their “symmetrical target” of 2.0%, implying that they are willing to let the economy run hot, with inflation exceeding 2.0% for a while, since it has been running below that pace for so long. That’s an interesting idea, but they can’t even get inflation up to 2.0%—why embarrass themselves further by shooting for an even higher target?

Outgoing European Central Bank (ECB) President Mario Draghi loaded up his bank’s bazookas yet again as he was walking out the door. On 9/12, the ECB’s Governing Council voted to lower the bank’s deposit facility rate from -0.40% to -0.50% and to restart the asset purchase program at the pace of €20 billion per month with no set end date. The Bank of Japan never let up on its ultra-easy policies, but it did stop projecting when inflation might get up to 2.0%. The inflation rates in the US, Eurozone, and Japan are currently 1.7% (core US PCED), 0.7% (Eurozone CPI), and 0.3% (core Japan CPI) (Fig. 1, Fig. 2, and Fig. 3).

The major central banks all are run by PhD macroeconomists as well as people like Jerome Powell at the Fed and Christine Lagarde at the ECB who have been surrounded by macroeconomists their entire careers. Most of the macroeconomists working at the central banks were trained as demand-side Keynesians. They believe that easy money should stimulate demand, which should revive inflation. That’s their core belief, in fact.

More specifically, easy money should boost consumer spending on durables and housing. It should stimulate capital spending by businesses. When the economy runs out of slack, that’s when it will run hot enough to heat up inflation. The central bankers admit that there has been more slack than they expected, but once the economy runs out of workers, wage inflation will rise, pushing price inflation higher, especially once capacity utilization gets to be tight enough. The Phillips Curve and output-gap models are variations of this demand-side view of the world.

There are two major flaws in this model: It fails to recognize that there are limits to how much debt demand-side borrowers can carry to keep buying stuff. And it completely ignores the impact of easy money on supply-side borrowers. Consider the following:

(1) Too much debt on the demand side. In the past, when demand-side borrowers had plenty of capacity to take on more debt, easy money effectively stimulated demand. It seems to have lost its effectiveness because monetary policy has been easy for so long, resulting in high debt-to-income ratios. Even historically low interest rates, which reduce the cost of servicing debt, don’t seem to be stimulating demand, which might explain why interest rates are historically low, of course.

(2) Too many zombies on the supply side. Meanwhile, supply-side borrowers, who produce the goods and services purchased by demand-side borrowers, can take advantage of easy money to refinance their debts at lower rates. Producers may also borrow more to keep their businesses going. The ones who are most likely to do so are the ones who would be out of business if they couldn’t borrow money. In other words, they are zombie businesses, i.e., the living-dead companies that won’t die because they are resuscitated by the cash infusions provided by their lenders. As long as they stay alive, they create deflationary pressures by producing more goods and services than the market needs.

And why are lenders willing to lend to the zombies? Instead of stimulating demand, historically low interest rates incite a reach-for-yield frenzy among lenders. They are willing to accept more credit risk for the higher returns offered by the zombies. Besides, if enough zombies fail, then surely the central banks will come up with some sort of rescue plan.

(3) Debt binges, now and then. It’s interesting to compare the borrowing binge in home mortgages that led to the Great Financial Crisis and the current borrowing binge in nonfinancial corporate (NFC) debt, including bonds and loans. At the start of 1990, the amount outstanding of both equaled around $2.4 trillion each (Fig. 4). Home mortgages then soared by 378%, or $9.0 trillion, to a record $11.3 trillion during H1-2008. Over the same period, NFC debt rose 162%, or $4.0 trillion to $6.4 trillion.

After peaking, home mortgages outstanding fell $1.4 trillion through Q1-2015, and then increased by $1.1 trillion to $11.0 trillion by Q2-2019. That was still slightly below the record high. Over the same period, NFC debt rose 55%, or $3.5 trillion, to a record $10.0 trillion.

During Q2-2019, NFC corporate bonds outstanding rose to a record $5.7 trillion (Fig. 5). NFC loans held by banks rose to a record $1.1 trillion, while “other loans” (which are mostly leveraged loans) rose to a record $1.8 trillion (Fig. 6).

(4) Central banks fueling deflation by feeding zombies. Our interpretation of the data is that excessively easing credit conditions fueled the mortgage borrowing binge and housing boom that ended with the Great Financial Crisis. The strong debt-financed demand for homes stimulated economic activity and caused home prices to soar.

Since the Great Financial Crisis, the borrowing binge in NFC debt hasn’t contributed much to economic growth, and consumer price inflation has remained subdued. Apparently, a significant percentage of NFC debt is attributable to zombie companies using most of the proceeds from their borrowing to stay in business. The Fed’s May 2019 Financial Stability Report nailed it, as follows:

“[T]he distribution of ratings among nonfinancial investment-grade corporate bonds has deteriorated. The share of bonds rated at the lowest investment-grade level (for example, an S&P rating of triple-B) has reached near-record levels. As of the first quarter of 2019, a little more than 50 percent of investment-grade bonds outstanding were rated triple-B, amounting to about $1.9 trillion.”

The report also warned about leveraged loans as follows:

“The risks associated with leveraged loans have also intensified, as a greater proportion are to borrowers with lower credit ratings and already high levels of debt. In addition, loan agreements contain fewer financial maintenance covenants, which effectively reduce the incentive to monitor obligors and the ability to influence their behavior. The Moody’s Loan Covenant Quality Indicator suggests that the overall strictness of loan covenants is near its weakest level since the index began in 2012, and the fraction of so-called cov-lite leveraged loans (leveraged loans with no financial maintenance covenants) has risen substantially since the crisis.”

During his 10/30 press conference, Fed Chair Jerome Powell was asked about financial stability. He responded: “Obviously, plenty of households are not in great shape financially, but in the aggregate, the household sector’s in a very good place. That leaves businesses which is where the issue has been. Leverage among corporations and other forms of business, private businesses, is historically high. We’ve been monitoring it carefully and taking appropriate steps.”

He didn’t specify those steps. However, the Fed’s three interest-rate cuts are likely to feed the zombies’ appetite for more debt. In other words, the easy money provided by the Fed and the other central banks may be contributing to deflationary pressures attributable to supply-side borrowers. This would certainly explain why easy money has failed to boost inflation as expected by the proponents of demand-side models.

(5) Is a zombie apocalypse inevitable? If you want to read a very frightening script of how this horror movie plays out, see the October 2019 Global Financial Stability Report prepared by the International Monetary Fund. Melissa and I reviewed it in the 10/30 Morning Briefing. Here is the punchline: “In a material economic slowdown scenario, half as severe as the global financial crisis, corporate debt-at-risk (debt owed by firms that cannot cover their interest expenses with their earnings) could rise to $19 trillion—or nearly 40 percent of total corporate debt in major economies, and above post-crisis levels.”

We concluded: “There’s certainly lots to digest and think about in this unsettling report as the S&P 500 climbs to another record high. Apparently, investors expect that before doomsday arrives, even the Fed will lower interest rates close to zero again, allowing all the zombie borrowers to refinance their debts, thus postponing the zombie apocalypse.”

The NFC data discussed above is less alarming when scaled by nominal GDP (Fig. 7 and Fig. 8). Home mortgages outstanding peaked at a record 77% of GDP during Q1-2009. NFC debt rose to a record high of 47% of GDP during Q2-2019.

Strategy: More on Global Valuation by Sectors. Joe and I continue to do our homework on global forward P/E comparisons between the US and the rest of the world. Yesterday, we compared the 10 major MSCI sectors (excluding the Real Estate sector, which can be funky) in the US MSCI vs those in the All Country World ex-US MSCI. Joe expanded this work to compare the sectors in the US vs those in the MSCI indexes for the EMU, Japan, Emerging Markets, and China. (See our Forward P/Es: US MSCI Sectors vs Rest of World.) Here are some of our findings, with numbers in parentheses showing first the latest US forward P/Es then the same for comparable forward P/Es abroad:

(1) US vs EMU (Fig. 9). Consumer Staples (19.8, 19.2) have been remarkably close since 2006. The same can be said about Health Care (15.5, 13.9), Industrials (17.4, 15.9), and Materials (17.3, 15.8). They all currently are cheaper in the EMU, with the exception of IT.

Surprisingly, IT (20.3, 21.0) tends to have a higher P/E in the EMU. Financials (12.3, 9.6) and Utilities (19.6, 14.7) tend to be cheaper in the EMU. The same goes for Consumer Discretionary (22.3, 13.4), but the spread is the widest ever thanks to Amazon’s forward P/E of 67.0.

(2) US vs Japan (Fig. 10). Consumer Discretionary (22.3, 12.5) also tends to be much cheaper in Japan than in the US. IT (20.3,18.0) valuations tend to be similar. Since the start of the current bull market, the following sectors have tended to be cheaper than in the US: Financials (12.3, 8.7), Industrials (17.4, 13.5), Materials (17.3,12.6), and Utilities (19.6, 9.0). They are all relatively cheaper now in Japan than they have been since the start of the bull market.

The valuation outliers since 2006 are Consumer Staples (19.8, 21.1) and Health Care (15.5, 30.2).

(3) US vs EMs (Fig. 11). Consumer Staples (19.8, 21.9) and Health Care (15.5, 24.5) have been more expensive in EMs than in the US during the current bull market. The same can be said about Communication Services (18.5, 19.1) over the past three years. The other sectors have tended to be cheaper in the EMs, and increasingly so recently: Consumer Discretionary (22.3, 18.8), Energy (16.2, 8.4), Financials (12.3, 8.8), Industrials (17.4, 11.6), IT (20.3, 15.6), Materials (17.3, 9.1), and Utilities (19.6, 11.7).

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Going Global

November 12 (Tuesday)

Global Strategy I: Greetings from London! I’ve gone global. I’m not staying home this week. Instead, I am visiting our accounts in London. I’m sure to get lots of questions about the possible impeachment of President Trump, as well as the status of his trade war and/or peace with China. I’ll be asking lots of questions about Brexit. A hard version of Brexit is still possible, and it would certainly initially hit the UK economy hard. However, it now seems that a soft Brexit is more likely. In any event, it’s hard to imagine London’s globalized financial community picking up and moving to Frankfurt, or even Paris. Then again, there is always Dublin, which has plenty of pubs.

As you might recall, in our 10/8 Morning Briefing, Joe and I wrote that we are getting cabin fever: “Cabin fever is a popular term for a relatively common reaction to being isolated in a building for a period of time. In our case, we have been isolated in the US, promoting a Stay Home investment strategy during most of the current bull market. It may be time to venture outside of our home market and Go Global for a while.”

That was a relatively contrarian call at the time. However, in yesterday’s What I Am Reading email, I provided links to four of the many articles written in recent days about the attraction of investing globally. Their headlines say it all:

“Investors looking beyond U.S. equity market for 2020” (11/8 Reuters)
“Is It Time to Shop for Stocks in Europe and Japan?” (11/8 Barron’s)
“Global investors flock to China, undeterred by trade war” (11/8 Reuters)
“Unloved Assets Join Market Rally in Latest Sign of Optimism” (11/10 WSJ)

The most recent article in this list observed: “Investors are piling into beaten-up assets from commodities to emerging-market stocks, powering a broad rally that reflects a brightening outlook for the global economy.” The article also noted the reasons for this development: “Driving the gains are signs of better-than-expected outcomes to several issues that have weighed on markets for most of the year. The U.S. and China are approaching an initial accord on trade; the world’s biggest central banks have slashed interest rates to curtail a manufacturing slowdown; and the odds of a disorderly U.K. exit from the European Union are declining.”

We’ve observed the same since early October. Most importantly, in our opinion, the Fed’s third cut in the federal funds rate this year, at the end of that month, was widely expected. We observed that emerging market economies (EMEs)—along with their bonds, stocks, and currencies—do well when the Fed is lowering interest rates. We also observed that their Purchasing Managers Indexes were outperforming those of the advanced economies this year (Fig. 1). European companies tend to benefit more than American ones from better growth in EMEs.

The forward P/E spread between the US MSCI, currently at 17.7, and the All Country World ex-US MSCI, at 13.6, has been widening since the beginning of the bull market, making Go Global increasingly attractive on a valuation basis (Fig. 2 and Fig. 3). Investors were held back by fears that the rest of the world was more at risk of falling into a recession than the US. Let’s not forget that the Fed was normalizing monetary policy last year, which did weigh on global economic growth, especially overseas. Trump’s escalating trade wars also weighed on foreign economies more than ours.

By the way, it’s important to note that the valuation spread between us and them has stalled with some volatility around a record high of 4.0ppts since 2018. There is certainly room for an increase in the forward P/E of the ACW ex-US MSCI.

Now investors around the world are much more relaxed about the Fed. New York Federal Reserve President John Williams said on Friday that the US economy is in a good place, reiterating his view that the interest-rate cuts made this year should appropriately address the potential risks of the trade war with China and a global economic slowdown. The Fed’s pivot from signaling three to four rate hikes for 2019 late last year to actually cutting the federal funds rate three times so far this year has been a great relief for investors. The global economy may benefit from that pivot more than the US economy does given the dire circumstances that might have befallen the global economy had the Fed persisted on its tightening course. Now Melissa and I expect that the Fed will press the pause button again and keep it pressed through next year’s election.

On the other hand, with Trump, you never know: It’s hard to make predictions since he never stops negotiating, even when deals are done. At the end of last week, it seemed like the Phase 1 agreement with China isn’t a done deal yet because the Chinese want Trump to also phase out his tariffs on China. On Saturday, he said trade talks with China are moving along “very nicely,” and said the leaders in Beijing wanted a deal “much more than I do.” Trump also described as “incorrect” reports about how much the US was ready to roll back tariffs on China. “If we don’t make that right deal, we’re not going to make a deal.”

Then again, the President views the Dow as his most reliable poll. He can see that it is at a record high mostly on news suggesting that he has at least stopped escalating his trade wars and may be de-escalating them. Since he clearly wants to win a second term, Trump will have to focus more on defending himself from the Democrats’ moves to impeach him and on campaigning for a second term as the November 2020 presidential election approaches.

Global Strategy II: Risk-On Hurts Bonds. Joe and I have counted 65 panic attacks since the start of the current bull market in stocks. All were followed by relief rallies. While we count three minor panic attacks this year, the latest big one occurred late last year from 9/20 through 12/24, when the S&P 500 plunged 19.8% (Fig. 4). The relief rally since then in the S&P 500 has been extraordinary (Fig. 5). Here is the performance derby of the S&P 500 and its 11 sectors since the Christmas Eve low through Friday’s close: Information Technology (49.3%), Industrials (35.6), Communication Services (33.9), Financials (33.5), Consumer Discretionary (31.9), S&P 500 (31.6), Materials (27.3), Real Estate (26.0), Consumer Staples (24.6), Utilities (19.6), Health Care (17.8), and Energy (12.0).

There have also been significant mood swings in the bond market. The one over the past 12 months has been especially intense. The 10-year US Treasury bond yield peaked last year at 3.24% on 11/8. It dropped to a recent low of 1.47% on 9/4 as investors fretted about a recession (Fig. 6). Those fears were heightened when the yield curve inverted during the late summer (Fig. 7).

Those concerns have clearly diminished since. The bond yield was back up to 1.94% on Friday, or 39bps above the federal funds rate. It was 62bps below the federal funds rate at the end of August.

Apparently, the recent inversion of the yield curve was a false alarm, as Melissa and I argued in our 4/7 Topical Study, “The Yield Curve: What is it Really Predicting?” It didn’t lead to a recession this time because Fed officials recognized they were on the wrong course and changed it at the beginning of this year. Now both the bond yield and the yield curve confirm that the economy is likely to continue to grow. So the stock market is reading the signals from the credit markets as bullish ones.

Since last year’s peak in the US bond yield, it seemed that it was getting dragged down by negative government bond yields in Germany and Japan. Now it seems that the backup in the US bond yield is putting some upward pressure on comparable German and Japanese yields (Fig. 8). Both still are slightly negative, but the German yield is up from a record low of -0.72% on 8/15 to -0.25% yesterday. The Japanese yield is up from a record low of -0.29% on 9/4 to -0.07% yesterday.

Global Strategy III: Still No Oomph in Germany. It’s unlikely that the latest batch of German economic indicators caused the backup in the German bond yield. At best, the latest numbers suggest that the German economy may be finding a bottom, but there’s no sign of a V-shaped recovery. An L-shaped outlook is more consistent with the latest stats:

(1) Production and orders. German manufacturing output, excluding construction, fell 0.6% m/m and 4.3% y/y during September to the lowest reading since December 2016 (Fig. 9). The sort-of good news was that new factory orders rose 1.3% m/m during September, but it was still down 5.4% y/y.

(2) Exports. The widespread view is that Germany’s weakness reflects the weakness in the global economy. The data show that the country’s exports actually rose to a record high during March 2019 (Fig. 10). They have stalled since then, though in record-high territory.

(3) Auto output. Debbie and I have been closely monitoring the 12-month moving sum of German auto production. The good news is that it seems to have found a bottom around 4.7 million units over the three months through October (Fig. 11). But that’s the lowest since February 1998.

Global Strategy IV: Into the Weeds of Valuation. They say that the devil is in the details. That seems to be the case when Joe and I compare the forward P/Es of the major sectors of the US MSCI and the ACW ex-US MSCI.

Here are the latest readings as of the 10/31 week, first for the US followed by the rest of the world: MSCI Composite (17.7, 13.6), Communication Services (18.5, 15.9), Consumer Discretionary (22.3, 14.8), Consumer Staples (19.8, 19.0), Energy (16.2, 10.6), Financials (12.3, 10.0), Health Care (15.5, 19.2), Industrials (17.4, 14.9), Information Technology (20.3, 17.7), Materials (17.3, 12.5), and Utilities (19.6, 13.9) (Fig. 12).

Strictly on a valuation basis, if you plan on going global, the following sectors are relatively cheaper over there than over here, starting with the best to the worst values: Energy (35% cheaper), Consumer Discretionary (34), Utilities (29), Materials (28), Financials (19), Communication Services (14), Industrials (14), Information Technology (13), Consumer Staples (4), and Health Care (24% more expensive).

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Productivity Is Rebounding

November 11 (Monday)

US Productivity I: Nostalgia. Did our rebounding-productivity-growth story fall apart last Wednesday when the Bureau of Labor Statistics (BLS) reported that nonfarm business productivity fell 0.3% q/q (saar) during Q3? Recall Yardeni’s Rule #1 for Forecasters: “When the data support my story, they are good data. When they don’t do so, they must be wrong and are bound to be revised to show I was right after all.”

The rule worked very well for me in the second half of the 1990s when I argued that productivity must be better than the official numbers indicated. Back then, Fed Chair Alan Greenspan was also convinced that productivity growth must be better than shown by the BLS stats. Lo and behold, during November 1999 the BLS revised annual productivity growth rates upward for the 1990-98 period from 1.4% to 2.0%. The revised annual rate was even higher for the three years spanning 1995-98: 2.6% instead of the previous 1.9%. These revisions put to rest the apparent disparity between the data and Greenspan’s view as well as mine.

These revisions converted the “productivity paradox” into a “productivity miracle,” as productivity’s growth rate jumped during the second half of the 1990s. That helped to explain why inflation remained subdued and why inflation-adjusted wages rebounded during this period after declining during most of the 1970s through mid-1990.

Back then, I observed that productivity and real incomes stagnated as the Baby Boomers entered the labor force, when they turned 16 years old between 1962 and 1980. In an October 1991 Topical Study, I wrote: “Now that most of them have been employed for several years, odds are that the standard of living for most families will improve along with productivity.”

It was easy to predict that during the 1990s, older workers increasingly would outnumber younger ones, which is what happened. I wrote: “Assuming that older workers are more experienced and efficient than younger ones, productivity should grow at a faster pace in the years ahead. There is a very strong correlation between productivity and incomes. As productivity growth rebounds, so should real incomes. Because older workers are more productive than younger ones, they earn more than do younger ones.”

US Productivity II: The Here & Now. Could it happen again? Could the BLS revise the weak productivity growth rates during the current expansion higher? Sure, that’s possible, but Debbie and I aren’t making that argument. Instead, we are arguing that productivity growth as officially measured has been rebounding since 2015 and should continue to do so for the next several years. Let’s have a close look at the official data:

(1) Year-over-year growth. We prefer to track productivity growth on a y/y basis rather than on the more volatile q/q basis. It was up 1.4% y/y during Q3, as nonfarm business output rose 2.3%, while hours worked increased 0.9% (Fig. 1).

(2) Five-year trend growth. For a longer-term perspective, we like to track the five-year moving average of annual productivity growth. It bottomed most recently during Q4-2015 at 0.5% (Fig. 2). It rebounded to a recent high of 1.3% during Q1-2019, but it edged back down to 1.0% during Q3.

We believe that this recent rebound could be the beginning of a longer-term rebound similar to those seen in the first half of the 1960s, first half of the 1980s, and second half of the 1990s through the early 2000s.

(3) Real income growth. Confirming our working hypothesis on the outlook for productivity growth is the five-year cycle in inflation-adjusted hourly compensation growth in the nonfarm business sector (Fig. 3). During the current economic expansion, the annual average bottomed at 0.3% during Q3-2014. It was up to 1.8% during Q3 of this year, the best reading since Q1-2008.

Hourly compensation includes wages, salaries, and benefits and is available quarterly along with the productivity data. We divide this series by the nonfarm business price deflator (NFBD). That’s because microeconomic theory posits that in competitive markets productivity determines real labor compensation and that the relevant price index is the one reflecting the prices received by employers, not the prices paid by consumers as reflected in either the Consumer Price Index (CPI) or the Personal Consumption Expenditures Deflator (PCED).

That makes sense, and is corroborated by the very close correlation between real hourly compensation growth (on a five-year basis and using the NFBD), and the comparable growth for productivity.

Historically, the NFBD has been inflating at a slower pace than either the CPI or the PCED. The CPI has been outpacing both the PCED and NFBD (Fig. 4).

(4) S&P 500 profit margin. More evidence of rebounding productivity is implicit in the S&P 500 quarterly operating profit margin. It rose to a record high of 10.9% during Q4-2017, i.e., just before President Trump cut the corporate tax rate (Fig. 5). After the tax cut, it rose to a record high of 12.5% during Q3-2018. It has remained near that record since then, with a reading of 11.7% during Q2-2019.

Meanwhile, the weekly series we construct for the S&P 500 forward profit margin, which tracks the quarterly series of the actual profit margin very closely, has been hovering around 12.0% all year through the 10/31 week. As we’ve noted before, that’s impressive given that the headline news suggests that tariff and labor costs have been rising all year. If so, then rebounding productivity growth must be offsetting those cost increases.

(5) S&P 500 profit margins for sectors and industries. I asked Joe to drill down to the profit margins of the 11 sectors of the S&P 500 as well as of most of the major S&P 500 industries. He compiled a handy collection of them in our S&P 500 Sectors & Industries Profit Margins.

To smooth out the volatility in the data, Joe constructed the following quarterly profit margins based on four-quarter trailing operating earnings from S&P. On this basis, the S&P 500 operating profit margin was 11.2% during Q2, just a touch below the record high of 11.3% during Q3-2018 (Fig. 6).

All but two of the 11 sectors were either at record highs or very close to their recent record highs: Real Estate (20.9%), IT (20.6), Financials (15.8), Communication Services (15.3), Utilities (12.1), S&P 500 (11.2), Industrials (9.7), Materials (9.1), Health Care (8.7), Consumer Staples (7.4), Consumer Discretionary (7.1), and Energy (6.7). The laggards are Energy and Health Care.

Here is a selection of industries with record, or near-record, profit margins that have been on uptrends for a while, in the order that they appear in Joe’s chart book: Hotels, Resorts & Cruise Lines (11.5%), Restaurants (17.0), Specialty Stores (8.9), Home Improvement Retail (8.5), Household Products (15.9), Tobacco (31.5), Soft Drinks (15.8), Biotechnology (31.7), Pharmaceuticals (22.6), Aerospace & Defense (9.6), Electrical Components & Equipment (12.8), Construction Machinery & Heavy Trucks (10.4), Industrial Machinery (11.3), Railroads (26.5), Data Processing & Outsourcing (26.6), Communications Equipment (21.9), Semiconductors (25.9), and Broadcasting (11.5).

That’s a long list, covering a broad assortment of industries. Its length and breadth confirm our view that businesses across-the-board are using technology to boost their productivity and profit margins. We believe that the managers of the S&P 500 companies responded to the Trauma of 2008 by focusing on boosting their profit margins. They can do so by using the tools provided by the ongoing high-tech revolution, particularly now that labor is becoming increasingly scarce and expensive.

US Productivity III: Underestimated? There’s a case to be made that upward revisions in the official productivity data—like those made in the late 1990s—are warranted again now.

Back then, I argued that in addition to demographic factors, the high-tech revolution, which started in the mid-1990s, must be boosting productivity. The official bean-counters at the BLS certainly were aware of the structural changes impacting the economy, but I observed that it can take them 5-10 years to change their output-measuring methodology to reflect structural changes in the economy.

The high-tech revolution is ongoing and going stronger than ever. Consider the following:

(1) The cloud. In the past, companies used their own software that was purchased and loaded onto their mainframes, minicomputers, PCs, and laptops. They networked their systems through in-house or outsourced “server farms.” All this required large IT departments to maintain the systems and to upload software updates—a challenging job as PCs and laptops proliferated. Much of this IT infrastructure operated well below capacity.

The cloud changed all that. Now companies can use the servers of cloud vendors such as Amazon, IBM, and Microsoft for their data-processing and storage needs. In effect, this is reminiscent of my days at the Federal Reserve Bank of New York in the late 1970s, when we used remote computer terminals to access the fire power of the organization’s mainframe computers, kept in a large, air-conditioned room on another floor.

Any computer hardware connected to the cloud is analogous to a remote terminal, and the mainframe is now all the servers operated by the cloud companies. This greatly reduced the need for large in-house IT departments, especially since software companies rent their latest products so that there is no need to update them on individual computers anymore. In 2011, Microsoft started to rent Office 365, which is on the cloud and automatically updated there, for an annual subscription fee.

The cloud also reduced the need for buying as much hardware and software, since it provides a much more efficient way to process and store data. The servers of the cloud companies are operating much closer to full capacity than those at server farms and on site at company locations. This could well explain why real capital spending on computers was flat from 2008 through 2016.

(2) Free stuff. It is possible that technological innovation is outpacing the ability of the government’s statisticians to measure output, so they are underestimating productivity. Hal Varian, the chief economist of Google, rightly observed that the digital revolution happening doesn’t show up anywhere in the economic numbers, as GDP doesn’t include all the free stuff we’re getting with the Internet. For example, WhatsApp meets the telecommunications needs of billions of people, but it isn’t in GDP and productivity because it is free. The relatively small cost of producing such apps is measured in GDP, but the huge benefits are not.

(3) Brave New World. In a March 2017 study, “The Coming Productivity Boom,” Michael Mandel and Bret Swanson explained why they see lots of productivity upside for “physical industries,” which represent 75% of private-sector employment and 70% of private-sector GDP but make up just 30% of the investments in information technology. Their analysis makes good sense to me:

“The 10-year productivity drought is almost over. The next waves of the information revolution—where we connect the physical world and infuse it with intelligence—are beginning to emerge. Increased use of mobile technologies, cloud services, AI, big data, inexpensive and ubiquitous sensors, computer vision, virtual reality, robotics, 3D additive manufacturing, and a new generation of 5G wireless are on the verge of transforming the traditional physical industries—health care, transportation, energy, education, manufacturing, agriculture, retail, and urban travel services.”

US Productivity IV: YRI Is Virtual. At Yardeni Research, we’ve been big fans of the high-tech revolution, writing about it frequently since the early 1990s. We’ve also been enthusiastic users of the tools provided by the high-tech revolution to increase our productivity.

Since 2007, when I formed my own company, we have been virtual. We don’t have a central office. Everyone works from wherever they like. We replaced a couple of servers we had at a server farm with a virtual server on the cloud at Amazon Web Services (AWS) in 2012. We subscribe to Microsoft’s Office 365. Our Morning Briefing is delivered to all our accounts by email and posted on the website. It is a collaborative undertaking, with all of the YRI team contributing to its production; that often entails a daily flood of 300 emails among us to get the job done.

Our charting system detects when the thousands of data series provided by our data vendors are updated. The charts that use those series are automatically revised with the updates on our server, which is on AWS. The charts are refreshed in their appropriate locations in the hundreds of chart publications we’ve created over the years. So, for example, when the employment report is posted at 8:30 am during the first Friday of every month, all of the employment publications we keep on the website are automatically updated within a few seconds of the information’s release.

Movie. “Midway” (+ +) (link) is an action-packed movie about the action that was packed into the major battles in the Pacific between the US and Japan from Pearl Harbor at the end of 1941 to Midway during June 1942. The acting and dialogue are uniformly lame. However, the true story about so many American heroes is awe inspiring. It certainly puts us to shame today for all our petty domestic political intrigues and conflicts. The heroes of World War II selflessly and courageously defended and spread our democracy, while they tear it apart in a selfish and cowardly manner. In today’s bitterly divided political circus, partisans on the left and on the right claim that their goal is to save our democracy, while they selfishly and cowardly tear it apart. Fortunately, there are still plenty of heroes in our military, as evidenced by their effectiveness in crushing ISIS.

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Energy Getting Re-Energized?

November 07 (Thursday)

Energy I: From Worst to First. There are few times in life when problems can be boiled down to something simple. For the market in crude oil, the current problem is simply too much supply and not enough demand. US crude production has soared, and a sluggish world economy has led to punk consumption.

If the US and China can strike a trade deal, there’s a chance that the worst has passed for the energy markets for a while. A deal should cause consumers and businesses to use more oil, at the same time as US fracking production growth may be slowing down. With those feathers of hope in the air for long-only investors, the S&P 500 Energy sector became the best-performing of the 11 S&P 500 sectors over the past week. It’s a nice change of pace given that the Energy sector is also the worst-performing sector ytd and over the past year.

Over the past week through Tuesday’s close, the Energy sector has risen 3.5%, besting the S&P 500’s 1.2% gain, and the price of Brent crude oil futures has risen 2.2% (Fig. 1 and Fig. 2). For the energy industry, this move is a step in the right direction after many weeks of subpar performance. The S&P 500 Energy sector is up by only 6.9% ytd, while the S&P 500 has gained 22.6% over the same period (Fig. 3). The sector gave back some of its recent gains on Wednesday, when the meeting between Presidents Trump and Xi was reportedly postponed until December.

The consensus of industry analysts is optimistic that the Energy business has solid fundamentals ahead. The Energy sector’s earnings, which are expected to drop 25.7% this year, are also expected to have a solid rebound next year, 24.7% (Fig. 4). Likewise, revenues flip from a drop of 3.1% this year to an increase of 4.0% in 2020 (Fig. 5). That said, analysts’ forecasts are notoriously slippery in the Energy sector and can change quickly along with the price of crude.

The sector has been struggling ever since peaking in 2014, and at long last it may be washed out. Its forward P/E has declined to 16.1, and it represents only 4.3% of the S&P 500’s market capitalization, down from a peak of 16.1% in July 2008 (Fig. 6 and Fig. 7).

Let’s take a look at the supply and demand fundamentals that are giving investors hope for the first time in a long while:

(1) US production forces OPEC and Russia to cut output. US oil and gas production has continued to surge this year even as the rig count has fallen. US oil rigs have fallen by 22% to 691 since mid-November 2018; yet over that time, crude production has jumped 8% (Fig. 8). Crude production has surged to 12.9 mbd this year from 8.7 mbd in 2016 (Fig. 9).

The US oil production miracle means the country no longer depends on imported oil to meet its needs (Fig. 10). OPEC and Russia have responded by cutting production to deal with the global oil glut and falling prices (Fig. 11 and Fig. 12). Their production cuts helped keep world oil production flat this year, but supply is set to rise again next year, according to the Energy Information Administration’s (EIA’s) 10/8 Short-Term Energy Outlook.

(2) Dwindling demand. OPEC’s and Russia’s efforts to support the market have been thwarted by the global economic slowdown in the wake of the trade war between the US and China. The world produced more oil in 2018 (100.81 mbd) than it consumed (99.98 mbd). This year, the market was more balanced, with production (100.80 mbd) roughly equal to consumption (100.82 mbd). Next year, the EIA forecasts production (102.44 mbd) will again be more than world consumption (102.12).

The agency assumes world real GDP (weighted by oil consumption) picks up to 2.4% growth in 2020 compared to 2.0% this year. However, it continues to see the price of Brent crude oil per barrel declining to $59.93 from $63.37 this year.

(3) What could go wrong? If the US and China manage to repair their trade relationship—something that’s in both parties’ interests—it’s possible that global economic growth will rebound more than the EIA expects. Global growth was 3.0% in 2018 down from 3.2% in 2017. It should be at least as good as 2017 if a deal is struck, in which case energy demand might surpass the forecast.

There’s also some concern that US oil production growth could slow more than expected as fracking wells age and as the price of oil remains subdued. US oil production increased by less than 1% during the first six months of 2019, down from the 7% growth in the same period of 2018, a 9/29 WSJ article reported.

Well productivity may be falling off more quickly than expected. Again from the WSJ article: “In December, drilling rigs helped extract 25% more oil than they had a year prior. In August, they were producing about 14% more than last year, according to the [EIA]. Meanwhile, production in the first 90 days of an average shale well, its most productive period, declined by 10% in the first half of the year compared to the 2018 average, according to research by Raymond James.”

A better supply/demand balance could support the energy market over the next 12 months, and the price of crude oil could rise modestly. A longer recovery or major spike in the price of oil is unlikely, however. There’s just too much oil available at the right price. If oil prices spiked to $70 or $80 a barrel, OPEC and Russia would probably reverse their production cuts and US companies would find a way to pump more oil out of existing wells or find more wells to drill. Oil prices then would fall back down. Likewise, technological developments in renewable energy and batteries are coming along rapidly and may dampen crude oil consumption within the next few years.

But over the next 12 months or so, oil production and consumption appear to be more in balance than they have for a while, and that could help the downtrodden sector. Drill, Baby, drill.

Energy II: Another Middle East War Soon? If you want to get really bullish on oil, and more depressed about geopolitical developments in the Middle East, then read the 5/4 article in The Atlantic titled, “The Coming Middle East Conflagration.” It is written by Michael Oren who is very well informed about the region given that he served as Israel’s ambassador to the US from 2009-2013. He was a member of Knesset and deputy minister in the Prime Minister’s Office from 2015-2019.

The article starts off ominously enough, and doesn’t provide much relief to its bitter end:

“The senior ministers of the Israeli government met twice last week to discuss the possibility of open war with Iran. They were mindful of the Iranian plan for a drone attack from Syria in August, aborted at the last minute by an Israeli air strike, as well as Iran’s need to deflect attention from the mass protests against Hezbollah’s rule in Lebanon. The ministers also reviewed the recent attack by Iranian drones and cruise missiles on two Saudi oil installations, reportedly concluding that a similar assault could be mounted against Israel from Iraq.

“The Israel Defense Forces, meanwhile, announced the adoption of an emergency plan, code-named Momentum, to significantly expand Israel’s missile defense capacity, its ability to gather intelligence on embedded enemy targets, and its soldiers’ preparation for urban warfare. Israeli troops, especially in the north, have been placed on war footing. Israel is girding for the worst and acting on the assumption that fighting could break out at any time.”

Here is how Oren concludes his dire warning:

“But I also remember that, back in 1973, Egypt and Syria saw a president preoccupied with an impeachment procedure, and concluded that Israel was vulnerable. In the subsequent war, Israel prevailed—but at an excruciating price. The next war could prove even costlier.”

Energy III: Disruptive Technology. We’ve been a bit obsessed with the technological advances in batteries because they may be the key to making solar power, wind power, and electric cars widely economical. If the cost of energy storage drops enough, then all of the above becomes economical for the masses.

China too has been focused on batteries. An 11/3 WSJ article laid out the lengths to which the country nurtured and protected CATL so it could grow from an also-ran to the world’s biggest maker of electric vehicle batteries. But there are others who believe the key to energy storage lies beyond the battery.

Researchers at Sweden’s Chalmers University of Technology have harnessed a molecule made of carbon, hydrogen, and nitrogen to absorb sunlight. It can then hold the energy for days or decades “until a catalyst triggers its release as heat,” an 11/4 Bloomberg article reports. It’s called “MOST,” or “molecular solar thermal storage.”

Using this molecule, the scientists developed a storage unit that they claim can outlast the 10-year span of a lithium-ion battery. They’ve also created a transparent coating that uses the energy-trapping molecules. It can be applied to home windows, vehicles, and clothing. It absorbs the daytime sun’s heat, keeping rooms cool during daylight hours, and when the sun sets, it releases heat and keeps rooms warm.

The coating doesn’t require the silicon used in solar panels or the rare metals used in lithium-ion batteries. Up next: determining whether the molecules can produce electricity.

Technology: Uncle Sam on Alert. The US government is objecting to how Chinese technology companies are conducting business in the US. TikTok, the social media website, and DJI, a Chinese drone maker, are the latest to come under scrutiny. Here’s a look at some of the concerns:

(1) Singing off-key? TikTok is a popular social media site where people make 15-second videos to trendy music. Jackie is sad to say her daughter spends far too much time on the app.

The Committee on Foreign Investment in the United States (CFIUS) has reportedly inquired about TikTok’s Chinese parent ByteDance’s purchase of US social media app Musical.ly. CFIUS fears that the November 2017 acquisition poses a national security risk because it gives the Chinese company access to millions of Americans’ personal data, according to an 11/4 CNBC article.

At first glance, it’s hard to see how TikTok is a national security risk. For every entertaining clip, at least 20 seem little more than a waste of time and a few offensive. The fact that this website is draining the brainpower of America’s youth seems, on the surface, to be its most egregious offense.

But how much is TikTok content being censored? The Chinese parent company easily could prevent any videos from showing on TikTok that criticize the Chinese government or support the Hong Kong protestors or Taiwan; that flies in the face of American freedom-of-speech values but is common practice in China.

And what sort of data collection and data retention is going on? The site could allow the Chinese government to collect US citizens’ faces, emails, phone numbers, and locations to some privacy-invasive end or even rights-abusing end if today’s US users travel to China in the future. These are questions the CFIUS will likely delve into. Separately, one could argue that the US should not allow China to own a social media offering in the US when Facebook is blocked from entering China’s market.

(2) Not CFIUS’s first rodeo. Earlier this year, CFIUS told Chinese gaming company Beijing Kunlun Tech that its ownership of Grindr, a popular gay dating app, posed a national security risk, a 3/27 Reuters article noted. CFIUS never explained why it arrived at that conclusion. The US agency also blocked Alibaba’s Ant Financial from purchasing MoneyGram International in 2018 for $1.2 billion.

(3) Grounding drones. The most popular drone being used by US government agencies is made by a Chinese company, DJI. There’s concern that these drones could send back to China whatever they “see.” There’s also concern that DJI has captured so much of the drone market—more than 70%—that the US government and companies have few good alternatives, an 11/5 FT article reports.

“There are people within the administration who want to hit DJI with a hammer right now,” said one senior government official quoted in the FT article. “But there are plenty of others who are warning that if you do, there are not many alternatives.”

Last week, the US Department of the Interior grounded its fleet of 810 drones, because 121 of them are made by DJI and the remainder contain parts made in China. The agency aims to determine whether the drones can send data they’ve collected back to China, posing a threat to national security.

This wouldn’t be the first time that the US government got involved in commerce. National security concerns were also invoked when the Trump administration and the US Department of Commerce effectively banned Huawei from selling telecom equipment into the US market.

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What’s Up?

November 06 (Wednesday)

Global Economy: Manufacturing Remains Limp. Joe and I are looking for opportunities to spend some time investing abroad. There are certainly compelling valuations out there, with MSCI forward P/Es in emerging markets (12.1 currently), the UK (12.4), Japan (13.5), and the EMU (13.7) well below that of the US (17.4) (Fig. 1). The problem is that the fundamentals overseas aren’t compellingly upbeat. Actually, they remain mostly downbeat.

To be fair, we only started to take an interest in the rest of the world around mid-October after the Governing Council of the European Central Bank (ECB) voted to provide another round of significant monetary stimulus at their 9/12 meeting, including restarting the ECB’s asset purchase program. That should provide some lift to Eurozone economies, especially if fiscal authorities take advantage of the ECB’s renewed bond buying.

Furthermore, the Fed was widely expected to cut the federal funds rate for a third time this year at the end of October—and didn’t disappoint. As a general rule, Fed easing (tightening) tends to be good (bad) for the stocks, bonds, and currencies of emerging market economies (EMEs). Improving economic activity in the EMEs would benefit European companies. In addition, Trump only recently started to de-escalate his trade wars.

In other words, all the good news on the policy front is recent and may take a few months to boost the global economy. On the other hand, as we discussed yesterday and numerous times before, there are structural problems weighing on global growth, especially in the manufacturing sector, including aging demographic profiles in many countries around the world and too much debt.

Let’s have a closer look at the latest batch of global economic indicators, hoping to find some signs of better growth, particularly overseas:

(1) Bad sentiment in Eurozone. The Economic Sentiment Indicator (ESI) for the Eurozone dropped sharply again during October (Fig. 2). It is down from last year’s peak of 114.5 during December 2017 to just 100.8 last month, the lowest reading since January 2015. This doesn’t augur well for the region’s real GDP growth, which was only 1.1% y/y during Q3.

Leading the way down was the industrial component of the ESI (Fig. 3). Germany’s industrial ESI remained weak during October at the lowest reading since October 2012 (Fig. 4).

Not surprisingly, October’s M-PMIs were also weak in most of the major Eurozone economies, with three out of four below 50.0 as follows: Germany (42.1), Spain (46.8), Italy (47.7), and France (50.7). The region’s M-PMI was 45.9 last month (Fig. 5).

(2) Bad economic surprises in Eurozone. The Citigroup Economic Surprise Index was mostly above zero during H2-2016 through 2017. It’s been mostly negative since the start of 2018, suggesting that Trump’s escalating trade wars weighed on the region’s economies (Fig. 6). The latest reading we have is 5.0 for Monday.

(3) Mostly weak M-PMIs elsewhere. Japan’s M-PMI fell to 48.4 during October, the lowest reading since June 2016 (Fig. 7). The UK M-PMI rebounded from a recent low of 49.4 during May to 49.6 during October, probably as companies scrambled to stockpile inventories in case Brexit causes trade disruptions. But it is still below 50.0. So is the US M-PMI, at 48.3 during October, up slightly from September’s 47.8. The GM strike may have weighed on this index over the past two months.

Meanwhile, China’s M-PMIs are giving mixed signals, with the official one edging down to 49.3 last month, the sixth consecutive reading below 50.0, and the Caixin Markit M-PMI rising to 51.7, the third consecutive reading above 50.0 (Fig. 8). Here are October M-PMIs for a few other selected economies: Poland (45.6), Russia (47.2), Indonesia (47.7), Korea (48.4), Turkey (49.0), Malaysia (49.3), Vietnam (50.0), Mexico (50.4), India (50.6), Australia (51.6), and Brazil (52.2).

Altogether now: The JP Morgan Global M-PMI edged up to 49.8 during October, the sixth consecutive reading below 50.0 (Fig. 9). Interestingly, this index’s component for developed economies was flat at 48.6 last month, the sixth consecutive reading below 50.0, while the one for EMEs was 51.0 during October, making this reading the eighth of the past nine months above 50.0 (Fig. 10). (See our automatically updated chart book, Global Manufacturing PMIs.)

Strategy I: Wish List for the Bull. Now that the S&P 500 is within shouting distance of our 3100 year-end target, we’re feeling more comfortable with our 3500 target for the end of next year. Given that the forward P/E of the S&P 500 was 17.4 on Monday, we hope that the market moves to our next target in a leisurely fashion, allowing time for earnings growth, rather than valuation, to drive stock prices higher.

Stocks aren’t cheap in the US given that only four of the 11 S&P 500 sectors are trading below the market’s forward P/E multiple: Real Estate (43.0), Consumer Discretionary (21.4), Information Technology (20.5), Consumer Staples (19.6), Utilities (19.6), Communication Services (18.0), Materials (17.6), S&P 500 (17.4), Energy (16.9), Industrials (16.8), Health Care (14.9), and Financials (12.8).

We also would like to see the rally broaden out in 2020. Both the Dow Jones Transportation Average and the S&P 500 Transportation composite are slightly below their respective record highs in September last year. The S&P 400 MidCaps and S&P 600 SmallCaps are also still below their August 2018 highs, while the ratios of the equal-weighted to the market-cap-weight S&P500/400/600 indexes have been declining for about the past three years (Fig. 11).

The year-end 2020 S&P 500 will be determined by forward earnings at that time, which will be identical to analysts’ consensus expectations for 2021 earnings. (Time certainly flies when you are having fun in a bull market.) We wouldn’t be surprised if that number is $190 per share. To get to 3500 would require a forward P/E of 18.4. Stay tuned.

Strategy II: Value Takes the Lead. I asked Joe to continue our Growth versus Value discussion from last week. Recall that in the 10/29 Morning Briefing, we wrote: “S&P 500 Value has been outperforming S&P 500 Growth since 8/27. That has coincided with the backup in the bond yield and the reversal in the yield-curve spread from slightly negative to slightly positive … Financials, which tend to be classified as Value stocks, do better when the yield curve is ascending rather than inverting. The current mix of interest-rate trends—with short-term rates falling while long-term rates are rising—is especially good for Financials.”

Value stocks and deep cyclicals typically have performed better when the Fed was starting an accommodative monetary policy, and their recent outperformance seems to confirm that. As we noted last week, the ratio of the price indexes for S&P 500 Growth and S&P 500 Value peaked on 8/27 (Fig. 12). Since then, Value has done Roadrunner’s beep-beep and left Growth choking on its dust like Wile E. Coyote (Fig. 13). The Value index has risen a whopping 11.0% since 8/27 through Monday’s close, 6.8ppts better than the 4.2% gain for Growth. While Value may have arrived late to the party, its participation bodes well for a continuation of the bull market.

Let’s have a closer look at their performances:

(1) Value’s ytd performance ahead of Growth now. After lagging the Growth price index on a ytd basis for much of 2019, Value has also taken the lead again. The index had been beating Growth ytd through the end of February, but underperformed considerably over the next six months. By 8/27, the index was up only 11.0% ytd, 6.6ppts behind the 17.6% gain for Growth. Now, Value’s 23.2% gain ytd through Monday’s close has moved 0.7ppt ahead of Growth’s 22.5% rise (Fig. 14).

(2) Value finally at new highs again after a long absence. The S&P 500 Value index hit its first recent record high back on 10/22. Prior to that, the index had not been at a record high for nearly 21 months! Monday’s latest record high for the index was only its sixth since 1/26/18. For the sake of comparison, the Growth index has recorded 31 new record highs since then, just 13 of which occurred during 2019. However, the Growth index was just 0.4% below its 7/26 record high on Monday. With Value’s investment style coming into favor again, that bodes well for a continuation of the bull market, which has had few new highs this year.

(3) Relative P/E meltup averted? On 8/27, the forward P/Es for Growth and Value were 20.7 and 13.3, respectively. That put their relative P/E ratio at 1.56, which happened to be about the highest level since January 2002.

Based on Monday’s close, Value’s forward P/E was at a 20-month high of 14.7 compared to Growth’s three-month-high P/E of 21.3 (Fig. 15). The relative P/E ratio was down to a 10-month low of 1.45 (Fig. 16).

Strategy III: Value vs Growth by LargeCaps vs SMidCaps. The Value-outperforming-Growth theme is also apparent within the MidCap and SmallCap indexes. Here’s how all six of the indexes have performed since 8/27 through Monday’s close: SmallCap Value vs Growth (13.9%, 6.8%), MidCap Value vs Growth (12.3, 5.7), LargeCap Value vs Growth (11.0, 4.2).

I also asked Joe to dig deeper—into the sector levels for the S&P 500 Growth and Value indexes and to compare how they have performed since 8/27. Here’s what he found.

With the exception of Communication Services, ten of the 11 Value sectors have outperformed their Growth counterparts.

Here’s how the Value and Growth components of each sector has performed since 8/27 through Monday’s close, in descending order by their performance spreads: Information Technology (17.3% for Value, 4.8% for Growth), Materials (11.1, 5.0), Financials (12.9, 7.4), Consumer Discretionary (7.3, 2.7), Industrials (12.9, 8.6), Real Estate (2.8, -1.5), Consumer Staples (1.5, -0.9), Health Care (7.5, 5.3), Energy (10.0, 7.9), Utilities (1.9, 1.5), and Communication Services (5.4, 7.1).

Digging down deeper, it becomes apparent that Apple’s 26% gain has played a big part in Value Tech’s outperformance, but the sector’s Value-versus-Growth outperformance has been broad. Double-digit percentage gains have been recorded for many of the companies in the Technology Hardware, Semiconductor, and Semiconductor Equipment industries in the Value index, while the Growth-heavy Data Processing industry has lagged considerably. Within the Financials sector, companies in Value’s Asset Management & Custody Banks and the Regional Bank industries have registered double-digit percentage gains of 20% on average, while firms in Growth’s Financial Exchanges & Data industry are down slightly.

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It’s an Old World After All

November 05 (Tuesday)

Global Economy I: EDR Dysfunction. Trump’s escalating trade wars have been blamed for the global manufacturing recession. That makes sense since the sputtering of global industrial production began in early 2018 when Trump started his trade tiffs with almost all of America’s major trading partners. If that blame is well placed, then Trump’s apparent moves to de-escalate trade tensions as the November 2020 presidential election approaches should revive the global economy.

Global industrial production growth peaked at 4.1% y/y at the start of last year. It was down to 0.4% during August (Fig. 1). Production in the economies of the Organisation for Economic Co-operation and Development’s 36 member countries peaked at 4.1% during December 2017 and fell to -0.4% during July. During August, industrial output was down 0.7% y/y among advanced economies (the slowest since July 2016) and up only 1.4% among emerging economies (the lowest since July 2009) (Fig. 2).

Confirming this weakness are producer price indexes (PPI) around the world, particularly in the US (-0.2% y/y through September for the finished goods PPI) and China (-1.2% y/y through September for the total industrial products PPI) (Fig. 3). The same conclusion applies to the weakness in the CRB raw industrials spot price index (Fig. 4).

Then again, could it be that the world may simply be stuffed with too much stuff? More specifically, the world may be experiencing peaks in the demand for autos, consumer electronics, and oil. These developments may be structural rather than cyclical. We attribute these peaks to the ongoing decline in the global elderly dependency ratio (EDR), i.e., the working-age population divided by the elderly population 65 years old or older.

Yes, the world may be suffering from EDR dysfunction! Unfortunately, there are no blue pills that can cure this disorder.

EDRs are falling around the world because fertility rates are falling below the replacement rate of 2.1 children per woman as a result of urbanization. Kids have an economic value in rural agrarian communities but represent all cost in urban settings. In addition, people are living longer beyond their retirement, increasing the tax burden on the working-age population that isn’t being replenished sufficiently. That all adds up to slower consumer spending on lots of stuff, resulting in excess capacity to produce said stuff. Excessive amounts of debt are financing the excess capacity, resulting in deflationary forces that have been offset, but not vanquished, by the ultra-easy monetary policies of the major central banks.

Older folks tend to be more frugal than younger ones because they don’t know how long they will live. So they have to ration whatever income and assets they have. The result is peak gadgets. Older folks are less likely to own a car, and if they do own one, they are aren’t likely to drive very far from their homes. The result is peak autos and peak oil. These days, younger folks tend to be minimalists for various reasons.

Let’s have a closer look at EDRs around the world:

(1) Fertility. According to data compiled by the United Nations (UN), the global fertility rate has dropped from 5.0 children per woman during 1955 to 2.5 during 2019 (Fig. 5). It is actually below the 2.1 replacement rate almost everywhere with the exception of Africa and India. Here are the 2019 fertility rates for selected regions and countries: Japan (1.4), Europe (1.6), China (1.7), US (1.8), Latin America (2.1), Asia (2.2), India (2.3), and Africa (4.5). (See our Global Fertility Rates.)

(2) World EDRs. The UN estimates that the EDR for the world fell from 11.8 during 1955 to 10.1 during 1985 to 7.2 during 2019 (Fig. 6). Over the past 30 years, the EDR for developed economies is down from 5.4 to 3.4 (Fig. 7). The EDR for emerging economies is down from 13.5 to 9.1 over this same period (Fig. 8).

(3) Country EDRs. Here are the 2019 EDRs for Japan (2.1), Europe (3.5), the US (4.0), China (6.2), Latin America (7.7), India (10.5), and Africa (16.1). They are all down significantly since the 1950s. We reckon that they weigh on growth once the number of workers per senior falls below 4.0. (See our Global Elderly Dependency Ratios chart book.)

Global Economy II: Peak Autos. Jackie and I started writing about peak autos in our 4/11 Morning Briefing. We identified several developments suggesting that there isn’t much, if any, upside to global sales of passenger motor vehicles. We also started to surmise that the global manufacturing recession may be partly attributable to the structural weakness in car sales. Here are a few of our updated thoughts on this important subject:

(1) Ridesharing is a big negative for car sales. An HSBC survey found that 18% of frequent Uber and Lyft users say they are less likely to buy or lease a car in the future, a 1/23 Barron’s article reported. These killer apps and increasing urbanization led Bloomberg Businessweek to question in a 2/28 article whether the world has reached “peak car.” The tipping point, the article contends, will occur around 2030 when automated cars hit the road, cutting 60% from the cost of taking a taxi and making car-sharing much cheaper than owning a car.

(2) Fewer teens getting driver’s licenses. According to the Bloomberg story: “Young people continue to turn away from cars, with only 26 percent of U.S. 16-year-olds earning a driver’s license in 2017, a rite of passage that almost half that cohort would have obtained just 36 years ago, according to Sivak Applied Research. Likewise, the annual number of 17-year-olds taking driving tests in the U.K. has fallen 28 percent in the past decade.”

(3) Depressing global manufacturing and trade. A 10/29 WSJ article by Greg Ip is titled “‘Peak Car’ Is Holding Back the Global Economy.” He observed: “Given the industry’s outsize influence, an enfeebled auto industry poses a little-realized risk to the world. In its latest World Economic Outlook, the International Monetary Fund estimates the sector accounts for 5.7% of global economic output and 8% of world trade. The IMF thinks autos contributed a fifth of last year’s slowing in global gross domestic product and a third of the slowdown in trade.”

(4) A green bad deal for autos. Regulators in Western Europe are imposing significant emission control standards that will increase the cost of cars. If the auto makers raise their prices to cover their costs, more would-be buyers will opt for ridesharing apps. India is also mandating tougher pollution standards.

(5) Sales are stalling and sputtering. China is the biggest auto market in the world. The 12-month sum of auto sales peaked at a record 29.6 million during June 2018 (Fig. 9). It was down 12.2% to 26.0 million during September.

New passenger car registrations in Europe peaked at 15.8 million units over the 12 months through August 2018. They were down 5.1% to 15.0 million through September. US motor vehicle sales have been stalled around 17.0 million (on a 12-month-run basis) since December 2017.

US Economy I: Consumers Are ‘in a Good Place.’ As we noted in yesterday’s Morning Briefing, Fed Chair Jerome Powell observed in his press conference last Wednesday that “the household sector’s in a very good place.” His upbeat assessment certainly was confirmed by Friday’s employment report. Consider the following happy developments:

(1) Earned income proxy flying high. As Debbie observed yesterday, our Earned Income Proxy for private-sector wages and salaries rose 0.3% m/m and 4.3% y/y during October. Average hourly earnings (AHE) for all workers rose 3.0% y/y, while aggregate weekly hours rose 1.3% y/y. These are all solid readings.

(2) Full-time employment soaring. Although 50,000 GM workers were on strike last month, durable goods manufacturing employment declined less than that, by 41,000. Total payrolls rose 128,000. October jobs growth would likely have been closer to 200,000 if not for the strike and the end of temporary Census jobs last month. The strike ended late last month, so November’s payroll employment will be boosted by returning GM workers.

Meanwhile, September’s increase was revised upward from 136,000 initially to 180,000, and the August gain was revised higher from 168,000 to 219,000. We pay more attention to the revisions of the previous two months than to the initial estimate for the current month, as we’ve often mentioned.

The payroll survey counts the number of jobs, while the household survey counts the number of workers regardless of whether they have one job or more. The latter showed a gain of 241,000 during October. The number of those workers with full-time jobs rose 451,000 last month to a record 131.5 million, or 83% of total household employment (Fig. 10).

(3) Wages outpacing price inflation. The widespread belief that real wages have been stagnating for decades is absurd and dead wrong. As we observed yesterday, they did decline during the 1970s as a result of the two oil price shocks and during the 1980s as a result of deindustrialization. However, they’ve been on a solid uptrend since 1995. That’s based on AHE for production and nonsupervisory workers, who account for 70% of payroll employment currently.

Another measure of real wages is the wage and salary component of the Employment Cost Index for private-sector workers divided by the personal consumption expenditures deflator (Fig. 11). It’s been trending higher since 1991. It’s up 28.5% (1.0% per year, on average) since then to a new record high.

US Economy II: What’s in Capital Spending? There is a widespread view that capital spending is weak. Yesterday, we observed that the recent weakness isn’t widespread but concentrated in structures and transportation equipment. On the other hand, spending on industrial equipment rose to a record high during Q3. Furthermore, spending on information processing equipment, software, and R&D remains very strong and accounts for an increasing share of nominal capital spending budgets.

I started writing about the High-Tech Revolution in 1993 and have been following the GDP stats on high-tech capital spending since then. During 1993, capital spending on IT equipment, software, and R&D totaled 39% of capital spending in nominal GDP (Fig. 12). It was up from 15% during 1959. It is now up to 47% of nominal GDP. Excluding R&D, spending on IT equipment and software is up from only 7% in 1959 to 29% of capital spending in nominal GDP currently.

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‘In a Good Place’

November 04 (Monday)

US Economy I: Warm & Fuzzy. One of Fed Chair Jerome Powell’s favorite expressions is “in a good place,” as in: “We believe that monetary policy is in a good place.” He said that in his press conference last Wednesday, along with: “We believe that monetary policy is in a good place to achieve these outcomes [i.e., moderate economic growth, a strong labor market, and inflation near our symmetric 2 percent objective],” and “the household sector’s in a very good place.”

Debbie and I agree, but our contrary instincts go on full alert anytime that a key policymaker says something to the effect of “mission accomplished.” So we are paying extra close attention for any signs of economic weakness that might turn into a recession, any signs that inflation is heating up (which could force the Fed to raise interest rates and trigger a recession), and any signs of stress in the debt markets that might lead to a credit crunch. We are also trying to assess whether President Trump will be re-elected for a second term during the November 2020 presidential election.

The latest GDP and employment numbers suggest that the economy is in no imminent danger of stalling and falling into a recession. The latest inflation indicators remain subdued. Credit quality remains relatively high at this point in the business cycle, with the notable exception of nonfinancial corporate debt. However, the Fed’s three rate cuts and the drop in bond yields this year allow lots of junky companies to refinance their debts, many with investment-grade ratings albeit BBB, the lowest such rating.

In other words, aside from some credit market excesses building, the US is in a good place economically. Politically, not so much. Consider the following:

(1) Lock him up? During Game 5 of the World Series, an eerily familiar chant arose from the chorus of boos that erupted when President Trump was shown on a giant screen at Nationals Park in Washington: “Lock him up! Lock him up!” The Washington Post observed: “The phrase was no doubt delivered with some irony, as a largely elite crowd in the heart of a heavily liberal city offered its own spin on the anti-Hillary Clinton slogan that has become a staple of Trump’s raucous rallies.”

Washington’s Democrats want to impeach Trump because they believe he committed an impeachable offense during his phone call with Ukrainian President Volodymyr Zelensky on 7/25. In response to allegations by an anonymous whistle-blower, Trump released the transcript of that call on 9/4. One important issue is whether significant portions of the conversations were deleted. Administration officials said the ellipses in the transcript represent words that trailed off or were inaudible. The 11/2 WSJ reported: “It was mostly accurate, but with caveats.”

If the transcript is the whole story, then it’s up to all the members of the House and the Senate to read it and decide whether an impeachable offense was committed. Witnesses who testify that they heard the conversation as it appears in the transcript and believe that a crime was committed are expressing their own opinion. It’s that simple, unless the transcript is not the whole story.

According to the transcript, Trump did ask for a favor as follows: “I would like you to do us a favor though because our country has been through a lot and Ukraine knows a lot about it. I would like you to find out what happened with this whole situation with Ukraine, they say Crowdstrike.”

According to a 9/25 NYT article, “In asking Mr. Zelensky for a ’favor’ in the July 25 call, Mr. Trump appeared to be referencing an unfounded conspiracy theory that Ukrainians, not Russians, were behind the D.N.C. [Democratic National Committee] hacking, and the Ukrainians framed the Russian government to make it look like that country was working with Mr. Trump’s presidential campaign. Rudolph W. Giuliani, Mr. Trump’s personal attorney, has been among those pushing this theory.”

Zelensky responded as follows: “I guarantee as the President of Ukraine that all the investigations will be done openly and candidly. That I can assure you.” Then Trump followed up with: “The other thing, there’s a lot of talk about Biden’s son, that Biden stopped the prosecution and a lot of people want to find out about that so whatever you can do with the Attorney General would be great. Biden went around bragging that he stopped the prosecution so if you can look into it. … It sounds horrible to me.”

I’m not convinced the transcript contains enough to impeach Trump.

The Democrats, who have a majority in the House, may have enough votes to pass articles of impeachment (i.e., the formal list of allegations) against Trump because it requires only a majority vote in the House. But the Senate, where the Republicans have a majority, probably won’t have the votes of two-thirds of the members required to remove him from office.

Will Trump strike out before 11/3/20, or will he remain in the game and hit a home run on that date? Given what I know today, my hunch is that he will win another term.

(2) Zombie apocalypse. Perhaps the greatest threat to the longest expansion on record is the amount of debt building up, with more of it of low quality. Furthermore, most of the dodgy credits are priced for perfection, or at least a continuation of the expansion with no recession for as far as the eye can see. That typically happens as memories of the previous recession recede, causing borrowers and lenders to downplay the mounting risks of the next widespread economic downturn.

Powell was asked at his presser about the International Monetary Fund’s recently released Global Financial Stability Report, which Melissa and I reviewed in the 10/30 Morning Briefing, the day before Halloween. It was quite spooky. After stating that everything is mostly hunky-dory, Powell stated: “That leaves businesses which is where the issue has been. Leverage among corporations and other forms of business, private businesses, is historically high. We’;ve been monitoring it carefully and taking appropriate steps.”

Was that Powell’s trick or treat? He didn’t say what steps have been taken, unless he means the three cuts in the federal funds rate this year, which are stoking a reach-for-yield frenzy by investors. This means that zombie companies can continue to borrow and to refinance at attractive rates. So the Fed is extending their lives and increasing their numbers, postponing the zombie apocalypse rather than taking any steps to keep it from happening.

In the 11/1 Barron’s, Randy Forsyth reviewed the latest development the “attack of the killer BBBs.” Randy soothingly observed:

“The swarm of corporate bonds with the lowest investment-grade rating supposedly were on the precipice of a descent into the high-yield level—the polite term for junk—as soon as the inevitable economic slowdown hit. In that event, these erstwhile members of the respectable investment-grade world would be punished with a major decline in their securities prices and a concomitant rise in their yields.

“But that was so last year. What’s happened in 2019 has been a big rally in BBB corporates, resulting in falling yields and strong total returns. Indeed, BBB bonds comprise the biggest portion of the corporate bond market, accounting for 58.2% of the $4 trillion of investment-grade debt outstanding as of Sept. 30, according to a report from Fitch Ratings. That’s actually down a touch from its peak of 58.8% in 2018.

“The dire forecasts of chaos in this sector of the corporate bond market haven’t been borne out.”

US Economy II: GDP Growth Slow, But Steady. The US economy continues to grow at a slow but steady pace, notwithstanding the Circus Maximus in Washington. Consumer spending continues to be the main driver of growth, especially over the past two quarters, when capital spending was weak. However, the weakness in capital spending was not across the board. There have been important pockets of strength in capital spending. More uniform weakness is visible in US exports and imports. Trump’s escalating trade wars have been blamed for the soft patches in both US business spending and exports. That makes sense, but a closer inspection of the data suggests that other factors have also weighed on business spending and exports. Consider the following:

(1) Stall speed: NOT! Prior to the current economic expansion and since 1948, the economy always fell into a recession soon after real GPD growth fell to 2.0% y/y (Fig. 1). It did so during each of the 11 recessions over this period. Real GDP rose 2.0% y/y during Q3, and it has been hovering around this growth rate since 2010 without falling into a recession.

(2) Consumers consuming: as usual. Consumer spending accounts for 68.0% of nominal GDP (Fig. 2). Interestingly, consumer spending on just health care alone has grown from 3.5% during 1960 to 14.5% currently.

Meanwhile, the nominal GDP share of consumer spending on motor vehicles plus residential fixed investment was only 6.2% during Q3, down from a record high of 12.4% during Q3-1950 and a more recent peak of 9.9% during Q3-2005 (Fig. 3). As the Baby Boomers age and Millennials postpone having babies, the increasingly geriatric demographic profile of the US suggests that health care’s share of nominal GDP will continue to rise while the shares of autos and housing fall.

(3) Capital spending: weak structures. Much of the recent weakness in capital spending in real GDP has been in structures. This category is down 8.1% y/y to $502 billion (saar) (Fig. 4). Over this same period, real spending on capital equipment and intellectual property rose 1.0% (to $1.3 trillion) and 8.1% (to $980 billion).

The recent weakness in real spending on structures is broad based, with y/y declines in commercial and health care (-7.5%), manufacturing (-2.1), power and communications (-6.1), mining and wells (-15.0), and other structures (-6.6) (Fig. 5).

(4) Capital spending on industrial & transportation equipment: up & down. Real spending on capital equipment shows some recent weakness in transportation equipment (-1.2% during Q3 to $273 billion), while industrial equipment rose 2.8% during Q3 to a record high of $246 billion (Fig. 6).

(5) Capital spending on technology hardware and software: in the cloud. Information processing equipment was down -7.3% (saar) during Q3, but up 1.5% y/y to $514 billion (Fig. 7). Software is included in the intellectual property category of capital spending. In real terms, it remains strong, rising 9.8% y/y to a record high of $458 billion.

Within information processing equipment, spending on computers and peripherals (-1.4% y/y) seems to be slowing down faster than on other information processing equipment (2.6% y/y).

The cloud is really part of the so-called “gig economy,” allowing users to rent both hardware computing power and software. Debbie and I surmise that it may be weighing on business spending on hardware but boosting business spending on software.

Also included in the intellectual property category of business capital spending is R&D outlays. In real terms, it rose 7.7% y/y to $441 billion during Q3, which was yet another record high. (See our Capital Spending in Real GDP.)

(6) Trade: a world of woes. The slowdown in overseas economic growth is apparent in the weakness in real US exports of goods and services (0.1% y/y during Q3) (Fig. 8). Some of the slowdown can be blamed on Trump’s trade wars, but homegrown problems are also weighing on the various economies around the world, as we’ve frequently discussed. Meanwhile, US imports growth is also relatively weak at 0.8% y/y.

US Economy III: Inflation Remains MIA. In his press conference last Wednesday, Fed Chair Jerome Powell said that the Fed isn’t likely to raise interest rates until inflation makes a comeback.

The latest price and wage data show that inflationary pressures remain subdued despite rising tariff costs, a tight labor market, and lots of liquidity provided by the Fed and the other major central banks. Here’s a quick rundown of the latest developments on the inflation front:

(1) PCED. Powell must have been referring to the core personal consumption expenditures deflator (PCED) inflation rate. On a y/y basis, it dipped to 1.7% during September after rising to 1.8% during August (Fig. 9). The headline PCED inflation rate has been hovering around 1.3% all year right through September.

By the way, through thick and thin, since 1997, the core PCED inflation rate has hovered between 0.9% and 2.6% (Fig. 10).

(2) CPI. There is a wide discrepancy between the core CPI inflation rate at 2.4% during September and the core PCED inflation rate at 1.7% (Fig. 11). It is a fairly widespread divergence among many of the major components of the CPI and PCED as follows, in no particular order: used cars (2.6%, -1.6%), furniture & bedding (2.3, 1.8), airfares (1.9, 0.9), medical care services (4.4, 2.1), and wireless telephone services (-2.9, -7.4).

One of the major sources of the discrepancy is that rent-of-shelter inflation, at 3.5% for both the CPI and PCED, exceeds the overall inflation rate measured with either measure and has a much higher weight in the core CPI (at 42% currently) than in the core PCED (at 18%).

(3) Hourly wages. Average hourly earnings (AHE) for all workers rose 3.0% y/y during October, as Debbie discusses below (Fig. 12). They were up 3.5% for production and nonsupervisory workers (P&NSW), who accounted for 70% of employment during October. Both increases well exceed the 1.3% increase in the headline PCED through September.

(4) A really ‘good place.’ As a result, the inflation-adjusted AHE of P&NSW rose 2.1% y/y through September to yet another record high (Fig. 13). It is up 32.2% since September 1995, or 1.3% per year on average over those 24 years.

Now get this: The bottom line is that real wages should be driven by productivity, in theory. In practice, this relationship broke down during the 1970s as a result of the two oil price shocks and during the 1980s as a result of deindustrialization (Fig. 14). The relationship has been making a comeback since the mid-1990s as a result of the High-Tech Revolution, which I started to write about in the early 1990s. The relationship has gotten tighter during the current economic expansion as both growth rates have been moving higher together, particularly since 2015.

Movie. “Parasite” (-) (link) got very good reviews for no good reason, in my opinion. It’s a Korean movie about a family of four grifters that takes advantage of a family of four that’s well off. It’s certainly offbeat. Like Quentin Tarantino movies, it’s a dark comedy mixing slapstick and violence. Unlike Tarantino movies, there are no likable characters. I suppose that in some ways it might be a commentary on income inequality and the social divide between the rich and the poor. If so, it might get lost in the translation between the English subtitles and the Korean dialogue on the screen. My hunch is that the movie’s producer picked the title to make the audience question who the real parasites are. The answer might very well be “all of the above” after watching this pointless film. Then again, this film may be yet another sign of our uncivil times.

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As Goes Tech, So Goes the Market

October 31 (Thursday)

Tech I: Back on Top. The new highs that the S&P 500 eked out this week owe much to the revival of the S&P 500 Information Technology sector, which likewise hit a new high, on Monday. That brings its ytd return to a lofty 34.2% through Tuesday’s close (Fig. 1). The importance of Tech to the broader market can’t be overstated. Consider the following:

(1) A fine performance. The Tech sector has outperformed the next-best-performing sector, Real Estate, by a whopping 8.1ppts ytd. Here’s the performance derby for the S&P 500 sectors ytd through Tuesday’s close: Information Technology (34.2%), Real Estate (26.1), Communication Services (23.2), Industrials (23.0), Consumer Discretionary (21.4), Financials (21.1), S&P 500 (21.1), Consumer Staples (19.9), Utilities (19.7), Materials (16.5), Health Care (8.7), and Energy (3.3) (Fig. 2).

Trump has been good for Tech, despite his complaints about some of Tech’s giants. Here is the performance derby since Trump was elected president on 11/8/16: Information Technology (82.6%), Consumer Discretionary (51.6), Financials (44.5), S&P 500 (41.9), Health Care (37.9), Industrials (32.6), Real Estate (29.2), Utilities (29.0), Materials (24.5), Consumer Staples (15.7), Communication Services (9.2), and Energy (-14.2).

(2) Land of the Giants. The Tech sector’s market cap is almost twice that of the next largest sector. Fortunately, its earnings contribution is outsized as well. Here are the capitalization and earnings contributions of the 11 S&P 500 sectors: Information Technology (21.8%, 19.2%), Health Care (13.8, 16.3), Financials (13.0, 18.1), Communication Services (10.4, 10.1), Consumer Discretionary (10.1, 8.2), Industrials (9.3, 9.9), Consumer Staples (7.5, 6.5), Energy (4.5, 4.7), Utilities (3.5, 3.0), Real Estate (3.3, 1.3), and Materials (2.7, 2.7) (Fig. 3).

With giants like Apple and Microsoft as members, the S&P 500 Information Technology sector’s market capitalization is 21.8% of the S&P 500’s total market cap, and its earnings share 19.2%. The S&P 500 Communication Services sector—home of Facebook, Netflix, and Alphabet—has market-cap and earnings shares of 10.4% and 10.1%.

Add them together, and you’ve got nearly a third of the S&P 500’s market capitalization covered, or 32.2%, with a combined earnings share of 29.3%!

Tech II: FAANGM Fandango. The stock market continues to be heavily influenced by just six technology stocks that represent 18.3% of the S&P 500’s market cap: FAANGM (Facebook, Apple, Amazon, Netflix, Google [or rather its parent company Alphabet], and Microsoft) (Fig. 4). FAANGM bounced sharply from the December selloff and rallied 39% to a new high on 7/26, according to Joe’s calculations. After that, FAANGM traded in a sideways range for the next few months before returning to a new high last week (Fig. 5).

So if you’d like to know who deserves credit for this week’s first record high in the S&P 500 since 7/26, look no further. Google, Apple, and Microsoft have kept marching higher to new record or near-record highs. Facebook, Amazon, and Netflix each stopped falling and rose modestly, but they all remain at least 10% below their record highs in mid-2018. Here’s how each of the stocks have performed ytd through Tuesday’s close: Apple (54.2%), Facebook (44.4), Microsoft (40.6), Google (20.6), Amazon (17.4), and Netflix (5.1). Altogether, the FAANGM index is up about 33% ytd.

FAANGM’s gains relative to the broader market have slowed this year. From 2013 through its 2018 peak, FAANGM outperformed the S&P 500 by 290 percentage points. But since the 2018 peak, the tech giants have gained only 3.2% while the S&P 500 has risen 4.7% (Fig. 6). FAANGM’s earnings have grown far faster over the past five years (83.6%) than the S&P 500’s ex-FAANGM earnings (25.8%) (Fig. 7). And the faster growth has commanded a much higher forward price/earnings multiple, of 30.3, for the FAANGM stocks than the market has granted the S&P 500 (17.2) and the S&P 500 ex-FAANGM (15.7) (Fig. 8 and Fig. 9).

Many of the tech giants were among the parade of companies reporting earnings this week. Let’s take a look at Google and Netflix:

(1) Alphabet. The parent of Google showed amazing growth in Q3 for a company of its size. Revenue jumped 20.0% to $40.5 billion, and the company is sitting on a $121.2 billion mountain of cash, equivalents, and marketable securities. Alphabet upped its stock buyback program last quarter, repurchasing $5.7 billion of shares, and still its cash pile edged higher q/q!

However, money is going out the door almost as fast as it’s coming in. Operating expenses rose 24.7% y/y in the quarter, so operating income rose only 6.4% y/y. A $1.5 billion unrealized loss on an equity investment contributed to the 23.1% y/y drop in the company’s net income to $7.1 billion. The shares fell only modestly as adjusted earnings per share of $12.32 beat analysts’ consensus expectation of $10.12.

This company has so many irons in the fire that its stock can be viewed as one giant option. The Alphabet family includes Waymo’s driverless cars and Wing’s drones, which recently started making deliveries. Alphabet is also a big quantum-computing player, last week announcing its 53-qubit quantum computer performed a computation faster than a traditional supercomputer.

No longer is Alphabet content to rely on other companies to make advancements in computing power, explained CEO Sundar Pichai. It’s prioritizing advancing computer power itself to ensure that it has the power it needs for its own business goals. In addition, Alphabet wants to offer quantum computing via the Google Cloud, which it believes will be a competitive advantage. Finally, Alphabet plans to move beyond the Internet of Things, where individual devices communicate via the Internet, to “ambient computing.” Many of its offerings will work together for customers in ways that are more intuitive. “[C]omputing should adapt to users, not the other way around,” explained Pichai. A 10/16 Stratechery article describes the seamless-across-devices user experience achievable with ambient computing and how it will leverage multiple Alphabet offerings and AI research.

Little was said on the call about criticisms the company has faced related to user privacy. And the company continues to provide little financial transparency (it doesn’t break out the results of YouTube, Google Cloud, or Waymo). Given how quickly the company is growing, though, we’re sure Alphabet soon will have to pull back the curtain.

(2) Netflix. The streaming company’s stock has fallen by roughly a third since July 2018 as the entertainment industry’s largest players have evolved from partners to competitors. AT&T announced its streaming pricing earlier this week: HBO Max will charge $14.99 for its service to launch in May. This follows announcements earlier this year from Disney, which will have a $6.99 streaming service live on 11/12, and Apple TV+, which on 11/1 will launch a streaming service for $4.99 a month.

When Netflix reported Q3 earnings, it missed its own q/q US and international subscriber-growth targets. The company attributed the lower-than-expected subscriber count to the price increase it took earlier this year.

Nonetheless, Netflix’s Q3 revenue jumped 31% to $5.2 billion, and net income rose 65% to $665.2 million. The concern: The company’s operating cash flow was a negative $501.8 million, hurt by the mounting expenses of paying for new content. The cost to execute competitive projects has jumped 30% y/y because of all the competition entering the streaming market, the company stated. Netflix indicated it would fund more of its content expenses with internally generated cash flows as its revenue continues to increase.

Disruptive Technology: Ultracapacitors. We’ve been tracking developments in the battery market for some time now because the company that develops the smallest battery that can hold the most power for the longest time will be integral in advancing the broad adoption of electric cars and solar-powered homes.

A reader recently brought ultracapacitors to our attention. Sometimes called “supercapacitors,” they’re an alternative to lithium ion batteries and have some positives and some negatives. Ultracapacitors don’t catch fire like lithium ion batteries can, but they can’t hold as much energy as lithium ion batteries either.

Companies are developing various ways to improve the performance of ultracapacitors. And ultracapacitors are slowly being tested in the real world. Tesla recently acquired a company that makes both ultracapacitors and traditional batteries, and ultracapacitors are being used in buses in London and China. Here’s Jackie’s look into this electrifying subject:

(1) Pluses and minuses. Batteries and ultracapacitors, as currently constructed, have dissimilar strengths and weaknesses that make them ideal for different functions.

Traditional lithium ion batteries use a chemical reaction to generate electricity, whereas ultracapacitors, made of carbon, use an electric field. A lithium ion battery holds 20 times more energy than an ultracapacitor, so its energy density is greater. However, an ultracapacitor is 100 times more powerful, but only for a very short time. Finally, ultracapacitors have a longer life, roughly 1 million cycles (from fully charged to empty) versus 3,000-5,000 for a lithium ion battery.

(2) Skeleton Technologies. To increase ultracapacitors’ energy density, industry players are experimenting with various materials. Skeleton Technologies has developed an ultracapacitor using curved graphene, cutting the cost of an ultracapacitor by 40%.

Skeleton sees ultracapacitors being used in conjunction with traditional batteries. Ultracapacitors are terrific at starting and accelerating a car because they provide a burst of energy. That burst creates a lot of heat and drains a traditional lithium ion battery. In addition, ultracapacitors fully charge in only a few seconds, which makes them good for absorbing the energy generated when drivers hit the brakes.

By using the two different types of batteries in combination, there’s a 10% reduction in overall cost, the battery’s efficiency is increased, the size of the lithium battery is decreased, and the lithium battery’s life is increased by a factor of two, according to Taavi Madiberk, Skelton’s CEO, in this 7/23/18 InsideEVs video. He predicted that in five to seven years almost all new vehicles will have both an ultracapacitor and a battery.

Last year, the company signed a contract to supply ultracapacitors in 1,000 London double-decker hybrid buses that use diesel and electricity for fuel—tripling the buses’ battery lifetime to an estimated 12-15 years compared to a lithium ion-powered bus.

(3) Seeing the future. Superdielectrics is working with the material used in contact lenses to increase the energy density of a supercapacitor. Superdielectrics claims its supercapacitor has 26 watt-hours/kilogram (Wh/kg), while a traditional supercapacitor has 4 Wh/kg. The company hopes Moore’s Law will apply to supercapacitors, driving the cost down and doubling the energy density every 18 months, ultimately to 250 Wh/kg, according to CEO Jim Heathcote in a 2/13 presentation. A lithium ion battery has energy density of about 100-120 Wh/kg.

The material in a Superdielectrics ultracapacitor has advantages over traditional batteries including recyclability, sustainability (they don’t contain rare earth metals, which require a lot of energy to be mined and manufactured), and operability in a wide variety of temperatures.

Heathcote believes large supercapacitors will be used to store wind and solar energy and will be used in charging stations. If Superdielectrics succeeds at increasing energy density to 250 Wh/kg, its supercapacitor could be used in aircraft. He also believes that cars will have batteries and supercapacitors working together.

That said, the company is still in its infancy. Superdielectrics is looking to commercialize its technology with a large multinational partner.

(4) Musk enters the field. Last May, Tesla acquired Maxwell Technologies, an ultracapacitor and lithium ion battery company, for $235 million in stock. The unanswered question: Why?

Tesla could be looking to use Maxwell’s dry, lithium ion battery technology, which could allow Tesla to produce its own batteries without relying on Panasonic. Most lithium ion batteries are “wet” and use a liquid. “Maxwell claims that its dry electrode tech enables an energy density of over 300 Wh/kg in current demonstration cells and they see a path to over 500 Wh/kg. That’s believed to be about 15 to 100 percent better than Tesla’s current technology,” a 5/16 Electrek article reported.

Tesla might also be interested in Maxwell’s ultracapacitors. When Musk first moved to California in the 1990s, it was to get a PhD in ultracapacitors, but he stopped those studies to start an internet company. Maxwell’s ultracapacitors are typically used in plug-in hybrid vehicles, Electrek notes. Tesla could consider adding ultracapacitors to its electric vehicles to increase the range and life of its cars’ lithium ion batteries. We’ll be watching.

(5) China’s one step ahead. China has a line of buses in Shanghai that run solely on ultracapacitors, per a 9/27 Shine article. Since ultracapacitors quickly run out of charge, charging stations were installed at bus stops to give the buses a quick hit of energy when needed. Regenerative braking on the buses, manufactured by Shanghai Sunwin Bus Corp., further boosts the batteries’ charge.

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Style Guide

October 30 (Wednesday)

Strategy I: Stay Home vs Go Global. Joe and I have been getting requests to focus more on investment styles. The idea is to monitor the relative performances of the major investment styles and provide some analysis to explain why one style is either outperforming or underperforming its alternative style. Your wish is our command. So let’s start with Go Global versus Stay Home.

The bottom line is that Stay Home has outperformed Go Global during most of the current bull market, but it could lag over the next 6-12 months. That’s because Go Global is so cheap relative to Stay Home and may have some catching up to do now that there are fewer headwinds.

The problem is that the fundamentals of Stay Home are better than those of Go Global. However, emerging markets might emerge as winners for a while now that the Fed has been easing again this year. And while European fundamentals remain more challenging, it’s a positive that the European Central Bank (ECB) launched another massive round of QE at the end of October and has invited fiscal authorities in the region to issue bonds to finance stimulative government spending. Also, Go Global may get a reprieve if Trump continues to de-escalate his trade wars as the presidential election in November 2020 approaches. Additionally, Brexit may be on a path toward a soft rather than a hard version of the UKs divorce from the EU.

Consider the following:

(1) Relative stock price performance. Since the beginning of the current bull market through Monday’s close, the US MSCI stock price index is up 348%. Over the same period, the All Country World ex-US MSCI is up 113% in dollars and 123% in local currency. As a result, the ratio of the two in dollars has soared from 4.80 to 10.10 over this period (Fig. 1). This year, the ratio (in dollars) peaked at a record 10.35 on 8/13, falling to 10.10 on Monday (Fig. 2). By the way, since the presidential election during November 2016, the US index is up 42.0%, while the ACW ex-US is up 16.9% in dollars and 18.9% in local currency.

The folks who construct the MSCI stock price indexes also construct a currency ratio, which is highly correlated with the JP Morgan nominal broad effective exchange rate (Fig. 3). The former is up 3.0% ytd through Monday to 1.168. We doubt that it will exceed its 2017 peak of 1.191 on 1/3 now that the Fed is back to lowering the federal funds rate and may not resume raising it over the foreseeable future. The currency ratio is down 0.9% from this year’s peak on 10/1.

(2) Relative forward earnings and revenues. Stay Home has outperformed Go Global during the current bull market mostly because the forward earnings of the former has outpaced that of the latter. The ratio of the two (with the US in dollars and the ACW ex-US in local currency) rose from a low of 3.59 at the beginning of March 2009 to 6.03 during the 10/18 week of this year (Fig. 4). Over this period, the former is up 166%, while the latter is up 50% (Fig. 5).

Interestingly, since the start of the bull market, the forward revenues of the US MSCI has outperformed those of most of the rest of the world (Fig. 6). The forward revenues of the Emerging Markets MSCI has also performed well, but it has had some big swings.

(3) Relative profit margins. The spread between the forward profit margin of the US MSCI and that of the rest of the world has been widening since the start of the current bull market (Fig. 7). Here is the performance derby for the major MSCI profit margins during the 10/17 week: US (12.0), Canada (11.3), India (9.4), UK (8.8), All Country World ex-US (7.8), EMU (7.8), Emerging Markets (6.6), Japan (6.1), and China (4.4). (See our MSCI Forward Profit Margins.)

(4) Relative valuation. The major attraction of Go Global over Stay Home is valuation. The forward P/E of the US MSCI during the 10/17 week was 17.3, while the ACW ex-US was 13.4 (Fig. 8). It’s among the biggest divergence between the two since 2001. Here are the forward P/Es of some of the major MSCI indexes: India (17.8), US (17.3), Canada (13.9), EMU (13.7), Japan (13.4), UK (12.3), Emerging Markets (12.0), and China (11.2). (See our MSCI Forward P/Es.)

Strategy II: LargeCaps vs SMidCaps. Yesterday, Joe and I suggested that LargeCaps have been outperforming SMidCaps because the profit margins of the latter are getting squeezed harder by rising labor costs and widespread labor shortages, while the LargeCaps may have more access to state-of-the-art technologies to boost their productivity.

September’s survey of small business owners, conducted by the National Federation of Independent Business, found that “50 percent (88 percent of those hiring or trying to hire) reported few or no ‘qualified’ applicants for the positions they were trying to fill.”

On the other hand, technology is very user friendly and relatively cheap so that any size business should be able to harness it to boost productivity. A 10/22 Reuters article titled “U.S. companies facing worker shortage race to automate” discussed this but mentioned only large companies, namely Citigroup, UnitedHealth Group, Constellation Brands, and FedEx. The article observed:

“Overall, companies have discussed automation on quarterly earnings calls more than 1,110 times since the beginning of the year, a 15% increase from this time last year and nearly double the mentions by this time in October 2016, according to Refinitiv data. Corporate orders of robotics alone rose 7.2% over the first half of this year compared with 2018, totaling $869 million in spending, according to the Association for Advancing Automation.”

(1) Relative stock price performance. Since the start of the current bull market through Monday’s close, the S&P 500/400/600 are up 349%, 387%, and 437%. Since Trump was elected president, the S&P 500/400/600 are up 42.9%, 30.5%, and 35.0% (Fig. 9). It’s possible that Trump’s policies of deregulation and tax cuts have benefitted larger companies more than smaller ones. However, the SmallCaps significantly outperformed until they were crushed by the selloff during the second half of last year; they’ve recovered this year, but have lagged behind the LargeCaps. (See our Stock Prices Since November 8, 2016.)

(2) Relative forward earnings and profit margins. The SMidcaps have mostly outperformed the LargeCaps during the current bull market until mid-2018 because their forward earnings have outpaced those of the LargeCaps. Since the start of March 2009 through the 10/24 week of this year, S&P 500/400/600 forward earnings are up 169%, 196%, and 238% (Fig. 10). This year, the forward earnings of the S&P 500 has been making new highs, while the those of the SMidCaps are back down to their mid-2018 levels.

As we observed yesterday, the forward profit margin of the S&P 500 has remained relatively stable around 12.0% since it was boosted to this record high by Trump’s corporate tax cut at the start of 2018 (Fig. 11). Not so for the forward profit margins of the SmallCaps and MidCaps: The former is back down to its pre-tax-cut level, and the latter has given back about half of its tax-cut boost.

(3) Relative valuation. The SMidCaps has sold mostly at a valuation premium to the LargeCaps since the start of the bull market until the selloff of late 2018 wiped the premium out. On 10/29, the S&P 500/400/600 forward P/Es were relatively close at 17.1, 16.5, and 17.4 (Fig. 12).

Strategy III: Value vs Growth. As we observed yesterday: “S&P 500 Value has been outperforming S&P 500 Growth since 8/27. That has coincided with the backup in the bond yield and the reversal in the yield-curve spread from slightly negative to slightly positive. Financials, which tend to be classified as Value stocks, do better when the yield curve is ascending rather than inverting. The current mix of interest-rate trends—with short-term rates falling while long-term rates are rising—is especially good for Financials.”

Let’s take a closer look:

(1) Relative stock price performance. The ratio of the S&P 500 Growth to the S&P 500 Value stock price indexes looks very similar to the ratio we use to monitor the Stay Home versus Go Global (Fig. 13). Since the beginning of the bull market, Growth is up 404%, while Value is up 294%.

(2) Relative forward earnings. Much to our surprise, the forward earnings of Growth hasn’t exceeded that of Value during the current bull market (Fig. 14). Since the first week of March 2009 through the 10/17 week, the forward earnings of Growth is up 162%, while Value is up 157%.

(3) Relative valuation. So the outperformance of Growth relative to Value is largely attributable to the widening spread between the forward P/Es of the former relative to the latter (Fig. 15 and Fig. 16). With the exception of the tech bubble of the late 1990s, Growth is selling at a historically high premium relative to Value. Yesterday, on 10/29, the forward P/E of Growth was 21.1, while Value’s was at 14.4, or 50% more than Growth’s.

Global Credit: Mind the Debt. The International Monetary Fund (IMF) discusses a bleak scenario for global credit in its October 2019 Global Financial Stability Report: “In a material economic slowdown scenario, half as severe as the global financial crisis, corporate debt-at-risk (debt owed by firms that cannot cover their interest expenses with their earnings) could rise to $19 trillion—or nearly 40 percent of total corporate debt in major economies, and above postcrisis levels.”

The report warns that easy monetary policy may fuel a further buildup of systemic vulnerabilities. Another concern is riskier debt. As Melissa and I have discussed in the past, riskier debt is just a small piece of total corporate debt in the US and globally. Nevertheless, we acknowledge that danger may lurk in the less visible corners of the US leveraged lending markets and in China’s opaque credit markets.

Let’s examine the IMF’s doomsday scenario outlined in Chapter 2 of the report:

(1) Major economies vulnerable. In the next recession, debt-at-risk and speculative-grade debt could approach or exceed crisis levels in several major economies, concluded the IMF staff. The shock could be amplified if susceptible banks and nonfinancial lending institutions incur losses and restrict credit to the larger economy.

Those major economies include: China, France, Germany, Italy, Japan, Spain, the United Kingdom, and the US. Corporate earnings forecasts in these regions have fallen while the risk appetite for bonds has risen, observed the IMF. Global bond spreads are narrower than they should be relative to the known risks in the global economy and financial markets.

(2) Risky private business. M&A activity has surged in the US. Nonbanks have been providing more of the credit to finance M&A, especially to risky firms. “The share of highly leveraged deals has grown and now surpasses precrisis highs,” according to the report.

In the US, the nonbank private lending market has reached nearly $1 trillion. Private lenders that have scooped up risky distressed assets are particularly vulnerable. Earnings add-backs, or positive adjustments to earnings related to expenses that are expected to be eliminated after an M&A or LBO deal are often used to determine purchase valuations. These artificial add-backs have recently risen to record highs, according to the IMF.

(3) Not a big piece of the pie. While private and institutional leveraged loans have gained prominence in the US, the two together represent only about 14% of corporate credit in the US, whereas bank loans and corporate bonds compose 76% of the market (see the IMF report’s figure 2.9). Included in that 76% are at-risk segments of corporate bonds like BBBs (28%) and high yield (11%).

In the Eurozone and China, bank loans still compose the majority share of the corporate credit markets at 80% and 72%, respectively. In China, “overall corporate debt is very high, and the size of speculative-grade debt is economically significant,” mainly because of large state-owned enterprises. As the IMF points out, however, the “potential systemic impact of corporate vulnerabilities is complicated by the implicit government guarantees and the lack of granular data.”

In Europe, significant progress has been made in corporate deleveraging since the crisis. However, sales and profits at large firms in the Eurozone have weakened, and the levels of speculative-grade debt and debt-at-risk are already high in several countries.

(4) Zombie apocalypse. In the IMF’s adverse scenario, a GDP growth shock is applied to all countries “at half the average severity of the global financial crisis growth” and “interest rates paid by firms rise to half the level in the global financial crisis.” What would happen based on IMF staff projections?

Corporate bond spreads would widen significantly, firms would face lower profits and difficulty deleveraging quickly, and debt-at-risk would rise (as speculative-grade debt moved into that less stable category). The IMF concluded: “On aggregate, in these eight economies, the debt-at-risk would amount to $19 trillion, or nearly 40 percent of total corporate debt, in the adverse scenario in 2021.”

There’s certainly lots to digest and think about in this unsettling report as the S&P 500 climbs to another record high. Apparently, investors expect that before doomsday arrives, even the Fed will lower interest rates close to zero again, allowing all the zombie borrowers to refinance their debts, thus postponing the zombie apocalypse.

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Bottom Fishing

October 29 (Tuesday)

Bottoming I: US Interest Rates. The 10-year US Treasury bond yield bottomed this year at 1.47% on 9/4 (Fig. 1). It rose to 1.85% yesterday. That’s despite widespread expectations that the Fed will cut the federal funds rate a third time this year at the FOMC meeting today and tomorrow. If that happens, the federal funds rate range would be lowered to 1.50%-1.75% with a midpoint of 1.63%. That would put the yield-curve spread between the 10-year bond and the overnight rate at plus 22bps, up from minus 62bps at the end of August (Fig. 2).

The S&P 500 rose to a new record high yesterday partly on expectations of a Fed rate cut. Just as important is that the inversion of the yield curve may be over, reducing the fears of an imminent recession. Importantly, the backup in the bond yield is viewed as a healthy sign for the economic outlook. It is also widely expected that if the Fed cuts the federal funds rate for a third time, then the FOMC statement is likely to emphasize that the committee’s next decision will be data dependent.

In our 4/7 study titled The Yield Curve: What Is It Really Predicting?, Melissa and I concluded that the Fed should use the shape of the yield curve to set monetary policy. When it is ascending, the Fed should be raising interest rates. When it is inverted, the Fed should be lowering interest rates. When it is flat, the Fed should do nothing, i.e., pause. In effect, that’s what the Fed has been doing since last year. The current flattening of the yield curve suggests that the Fed should pause after this week’s rate cut.

Here in brief is why the bond yield has been rising lately:

(1) Reversing the self-fulfilling prophecy. The US bond yield fell to this year’s low and inverted the yield curve on recession fears that were heightened by the inversion of the yield curve. The flattening of the yield curve in recent days has reduced recession fears.

(2) De-escalating the trade war. Also stoking recession fears was Trump’s escalating trade war with China. It has been deescalated in recent days as trade negotiators work on completing a Phase One deal.

(3) Postponing Brexit. The possibility of a hard Brexit also raised fears of a global recession. The deadline has been postponed until 1/31/20, providing time to complete a soft Brexit.

(4) Showing better survey data. As we discussed yesterday, the business surveys conducted by four Fed district banks (NY, Philly, Richmond, and KC) show that new orders and employment improved during October, suggesting that the national PMIs might have bottomed during September. Yesterday, we learned that the Dallas Fed survey was disappointing (Fig. 3). However, the averages of the five surveys still suggest that economic activity bottomed during the summer (Fig. 4). (See our Regional Business Surveys chart publication.)

(5) Surprising the pessimists. Previously, we have shown the strong correlation between the Citibank Economic Surprise Index (CESI) and the 13-week changes in both the nominal and TIPS 10-year US Treasury bonds (Fig. 5 and Fig. 6). The CESI has dropped from a recent high of 45.7 on 9/25 to 4.9 on Friday, but it is still up from this year’s low of -68.8 on 4/25.

(6) Heating up CPI inflation. In recent meetings with our accounts, a few have noted that the core CPI inflation rate jumped to 2.4% y/y during September (Fig. 7). It was 2.7% at an annual rate during the three months through September (Fig. 8). Debbie and I aren’t concerned because the core PCED inflation rate remained subdued at 1.8% y/y during August. However, we are adding this CPI inflation concern to this bearish list for bonds because we are hearing more about it in our meetings with our accounts.

Bottoming II: German Bond Yield. Interestingly, the German 10-year government bond yield seems to have bottomed at a record low of -0.75% on 9/3. It was up to -0.36% yesterday (Fig. 9). At their 10/24 meeting, the European Central Bank’s (ECB) Governing Council implemented a package of stimulative initiatives, including reviving its asset purchase program (APP), committing to buy €20 billion per month in bonds. So why might the German bond yield be bottoming?

Incoming ECB President Christine Lagarde agrees with outgoing President Mario Draghi that the fiscal authorities in the Eurozone, and especially in Germany, should take advantage of the ECB’s offer to purchase €240 billion per year in bonds to finance fiscal stimulus programs.

For now, the German authorities aren’t embracing the idea. In a 10/15 CNBC interview, German Finance Minister Olaf Scholz made it clear that Germany is “not willing to have extra debts.” German officials believe that world trade conflicts are weighing on the German economy. Scholz said, “The economic situation in Germany is still stable, we have lower growth, but we will [have] better growth in the next year.” He added that the country’s labor market is robust.

Nevertheless, Germany has been running large budget surpluses for years and is now under pressure from other Eurozone countries, the ECB, and the International Monetary Fund to spend more to help prevent an economic slowdown in the region. Germany’s seasonally adjusted budget surplus was 1.7% of the country’s GDP in Q2, down from 2.0% in Q1, according to Eurostat.

Meanwhile, a few important data series suggest that the German economy may be starting to bottom:

(1) Ifo business confidence index. Debbie and I may be seeing things, but we think that the Ifo business confidence index is bottoming. It held at 94.6 in October after climbing in September for the first time in six months, from August’s 94.3 (Fig. 10). It’s down from last year’s record high of 105.2 during January. Granted, it has upticked before on the way down since then, but we are encouraged to see that the Ifo diffusion index for motor vehicles bottomed during May at -11.9 and was up to 3.8 during October (Fig. 11).

(2) Auto production. We may also be seeing a bottom in the 12-month sum of German passenger car production. It plunged from 5.8 million units through March 2017 to 4.8 million units last month, which was a small uptick from the low of 4.7 million units during July and August (Fig. 12).

Bottoming III: Commodity Prices & Emerging Markets. Central banks around the world have been lowering their interest rates this year, which should revive global economic growth. Joining the Fed has been the ECB, which cut its official deposit rate from -0.40% to -0.50% at the 10/24 meeting of the Governing Council. The central banks of Brazil, India, and Russia have been lowering their rates this year too.

We may be starting to see a bottom in the CRB spot commodity price index for 23 industrial and agricultural commodities in recent days (Fig. 13). We would be more confident of that if we saw a bottom in the CRB raw industrials spot price index of 13 raw industrial commodities (Fig. 14). (Both indexes exclude energy and wood commodities.)

We are encouraged to see that the Emerging Markets MSCI stock price index (in dollars) has been relatively stable this year after weakening last year. That’s because this stock price index has been highly correlated with the CRB raw industrials spot price index. So the stock price index has been holding up much better than the CRB index so far this year.

In the past, emerging market economies along with their stock, bond, and currency markets fared badly when the Fed was tightening monetary policy. The Fed’s easing this year should benefit these economies and their financial markets. As noted above, it has allowed their central banks to lower interest rates without unsettling their financial markets, as it might if the Fed were moving rates the other way.

Bottoming IV: S&P 500 Earnings Growth. Also bottoming should be the growth in S&P 500 operating earnings per share, assuming, as we do, that there won’t be a recession next year. Industry analysts’ consensus earnings estimates imply they’ve lowered their expectations for 2019 growth to 1.4% this year over last year (Fig. 15).

Meanwhile, their estimates for 2020 and 2021 undoubtedly are too optimistic, at 9.8% and 10.6%, respectively. Joe and I reckon that with the profit margin at an all-time high, earnings aren’t likely to grow faster than revenues; we see both rising around 5% per year over the next two years. That outlook for revenues growth coincides with that implied by the consensus estimates of industry analysts, at 5.3% next year and 4.6% in 2021 (Fig. 16).

Bottoming V: Value & SmallCaps. In my meetings in Texas last week, I was asked about Value versus Growth and SmallCaps versus LargeCaps. S&P 500 Value has been outperforming S&P 500 Growth since 8/27 (Fig. 17). That has coincided with the backup in the bond yield and the reversal in the yield-curve spread from slightly negative to slightly positive. Financials, which tend to be classified as Value stocks, do better when the yield curve is ascending rather than inverting. The current mix of interest-rate trends—with short-term rates falling while long-term rates are rising—is especially good for Financials.

The outlook for SmallCaps relative to LargeCaps is less clear. The former has underperformed the latter since early July (Fig. 18). It’s possible that SmallCaps will outperform for a while if risk-on makes a comeback as the S&P 500 moves to new record highs.

On the other hand, the fundamentals of forward earnings and forward profit margins have been looking better for LargeCaps than for MidCaps and SmallCaps since the beginning of the year (Fig. 19 and Fig. 20). We’re thinking that labor costs and shortages may be squeezing the profit margins of smaller firms more than of larger ones.

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Good News & Bad News

October 28 (Monday)

US Economy I: Good News. First, the good news. Last week, I visited our accounts in Ft Worth, Dallas, and Austin. I could see that the economy is booming in Texas. That was most evident in Austin, where new construction is occurring literally everywhere. The taxi driver who took me from the city’s airport to my hotel downtown told me that people are pouring into Austin from California. Given the widespread wildfires, rolling blackouts, high taxes, and the homelessness epidemic in California, Texas could get overrun by Californians.

The bad news is that Austin may not have the water supply needed to support a much bigger population. Austin is also starting to have a problem with homeless people camping out on the streets, and traffic is getting really bad. Texans may have to build a wall to keep Californians out.

Here is more good news for the rest of the country: There are signs of life in the Fed’s regional surveys of business activity. Four of the five surveys conducted by the Fed’s district banks are available for October: New York, Philly, Richmond, and Kansas City. The Dallas Fed district survey will be available this morning. Here is the good news from the four available surveys:

(1) Regional business composite. The average of the four composite business indexes edged up from 0.8 during September to 3.7 during October (Fig. 1). The most recent low was -1.6 during June.

(2) Regional orders and employment composites. Similarly, the average of the four new orders indexes rose from a recent low of -0.7 during July to 5.9 during October. Really good news is that the average employment index jumped from a recent low of -2.8 during August to 11.9 during October, the best reading since March.

(3) Regional composite and national PMIs. The Fed’s regional business surveys seem to be heavily weighted toward manufacturing, as evidenced by the closer correlation of the average regional composite business index with the national manufacturing PMI (M-PMI) than the national non-manufacturing PMI (NM-PMI) (Fig. 2). So the recent rebound in the average business index suggests that October’s M-PMI should be up from September’s 47.8 reading, which was the lowest since June 2009.

(4) Regional and national orders indexes. The regional average of new orders for the four surveys suggests that the new orders component of M-PMI should improve soon (Fig. 3). The same can be said for the growth rate of total factory orders, which were down 1.8% y/y through August, the weakest reading since August 2016 (Fig. 4).

(5) Regional and average employment indexes. The most striking development among the four regional surveys is the rebound in the September and October employment indexes, especially in the New York, Philly, and Richmond districts (Fig. 5). That augurs well for the employment indexes of both the M-PMI and NM-PMI (Fig. 6 and Fig. 7).

(6) Flash PMIs. Also showing signs of life are Markit’s flash M-PMI and NM-PMI (Fig. 8). Both bottomed during August, with the M-PMI rising from 50.3 back then to 51.5 this month and the NM-PMI edging up from 50.7 to 51.0 over this two-month period. Admittedly, those are lackluster readings, but they are up and are above 50.0.

US Economy II: Bad News. The bad news last week was that durable goods orders fell 5.4% y/y through September (Fig. 9). That makes the recent uptick in the regional average for the four available new orders indexes all the more encouraging. Now consider the following related bad news, some of which has been offset by mitigating good news:

(1) Auto strike. Some of the recent weakness in durable goods orders may be attributable to the strike by the United Auto Workers union against GM. It started on 9/16. Union and company negotiators reached a deal on 10/16, but strikers remained on the picket lines until it was ratified. The rank-and-file members voted 57% in favor of the deal, according to the union. They will be returning to work on Monday. This strike, by nearly 50,000 GM workers, was the longest auto industry work stoppage in more than 20 years and the longest nationwide auto strike in 50 years.

According to a 10/25 CNN Business article, the new contract will pay the hourly workers an $11,000 signing bonus. Wages for most veteran workers will rise by 6% during the four-year life of the contract to $32.32 an hour. The union also won a way for many temporary workers to be hired as permanent employees as well as a quicker end to the two-tier wage system instituted after the 2009 bankruptcy than was in the previous contract language. The union also got the company to drop its demand that workers pay a larger percentage of their own healthcare costs. But the union failed in its efforts to save three plants—an assembly line in Lordstown, Ohio and transmission plants in Warren, Michigan and Baltimore, Maryland, where GM halted operations earlier this year.

Factory orders and shipments of motor vehicles and parts rose just 0.1% and 0.9% y/y, respectively, through September (Fig. 10). The growth rate should move higher now that the GM strike is over.

(2) Boeing’s woes. Nondefense aircraft & parts shipments edged up 1.8% last month after a two-month plunge of 17.1%; they were down 35.5% y/y through September (Fig. 11). After two fatal crashes of Boeing 737 MAX 8 aircraft in October 2018 and March 2019, regulatory authorities around the world grounded the 737 MAX series until further notice.

According to a 10/23 USA Today article, “Boeing reiterated its hope Wednesday that the 737 Max jetliner, grounded after two crashes, will be back in the air by the end of the year. But Boeing was less definitive than three months ago, when it told analysts it hoped the plane would be recertified as soon as this month. That would have made it available to airlines during the holiday travel period, a time critical to profits.”

(3) Trade war and peace. The weakness in the growth rate of nondefense capital goods orders excluding aircraft started toward the end of 2017, when it peaked at 13.2% y/y; the rate fell to -0.8% y/y during September (Fig. 12). So it coincided with the escalation of Trump’s trade wars. That’s the bad news.

The good news is that the US and China may be de-escalating their conflict over trade issues. A 10/25 CNBC article reported: “The U.S. and China have made progress in trade discussions and have come close to finalizing parts of a phase one deal, the Office of the U.S. Trade Representative said Friday. … Earlier this month, Trump announced the sides reached a ‘very substantial phase one deal’ to be finalized over three weeks. He said the agreement would address issues such as intellectual property and financial services and include a pledge for China to buy $40 billion to $50 billion in American agricultural products. Trump called it a ‘tremendous deal for the farmers’ as he tries to contain damage from Beijing’s retaliatory tariffs on U.S. crops.

“The Trump administration also ditched a planned tariff hike on $250 billion in Chinese goods that was set to take effect Oct. 15. Reports suggested Beijing also wanted the U.S. to abandon another tariff increase set for December.”

Melissa and I have been arguing since last year that both President Trump and China’s President Xi need a deal. Trump needs to de-escalate the trade war with China so that it won’t weigh on the US economy as he focuses on the 2020 presidential election. Xi needs to do the same so that China’s economy won’t be harmed by more and higher US tariffs. Apparently, they’ve agreed on a partial “Phase One” deal, which should reduce trade tensions for a while.

US Economy III: Trillion-Dollar Government Deficits. Nobody seems to care about the US federal budget deficit. So there wasn’t much (if any) reaction from either the bond market or the stock market to Friday’s news that the US Treasury said that the federal deficit for fiscal 2019 was $984 billion, a 26% increase from 2018 but still short of the $1 trillion mark previously forecast by the administration.

Now let’s play the good-bad-and-ugly game with the latest federal budget data news:

(1) Ugly: HUGE deficit. The gap between revenues and spending was the widest it’s been in seven years, as expenditures on defense, Medicare, and interest payments on the national debt ballooned the shortfall.

The jump in the deficit over last year’s level is a harbinger of things to come, according the Congressional Budget Office (CBO). In August, the CBO estimated that the budget deal reached between Trump and Congress would help push the shortfall over $1 trillion in fiscal 2020. The deficit will exceed $1 trillion each year over the subsequent decade, the agency projected (Fig. 13). Federal debt held by the public is projected to rise to $29.3 trillion, or 95.1% of nominal GDP, by 2029 (Fig. 14).

(2) Good: tax receipts. The 12-month sum of tax receipts rose 4.0% during fiscal 2019 to a record high of $3.5 trillion through September (Fig. 15). Also at record highs were individual tax receipts at $1.7 trillion (and up 2.0%) and payroll tax receipts at $1.2 trillion (up 6.2%) (Fig. 16). Even corporate income tax receipts rose 12.5% to $230 billion. In other words, there was no recession in the tax receipts data.

(3) Bad: net interest paid. The 12-month sum of net interest paid soared 15.7% y/y to $376 billion through September (Fig. 17). The $51 billion increase last year accounted for 33% of the increase in the fiscal 2019 budget deficit.

(4) Bad: outlays on income redistribution. The 12-month sum of federal outlays on redistributing income rose 5.0% y/y to a record $2.9 trillion through June (Fig. 18).

Movie. “The Current War” (+ + +) (link) is a docudrama about the AC/DC war during the late 1800s between Nikola Tesla and George Westinghouse—who championed alternating current (AC)—and Thomas Edison and JP Morgan, who pushed for direct current (DC). AC electricity won because it was more reliable and much cheaper to produce and distribute. The movie should be required in every school to demonstrate how capitalism benefits us all by providing the capital to fund great innovations that improve everyone’s lives at the lowest cost. Progressives long have impugned the achievements of the great capitalists of the so-called “Gilded Age” by calling them “Robber Barons.” They’ve failed to appreciate that these capitalists financed the invention and widespread use of kerosene and gasoline (Rockefeller), steel (Carnegie), and electric power and lights (Westinghouse and JP Morgan).

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Some Well-Performing Cyclicals

October 24 (Thursday)

Strategy: The Outstanding Standouts. Despite all the handwringing and unsettling political headlines, this has been a relatively spectacular year for the S&P 500. It’s up 19.5% ytd through Tuesday’s close (Fig. 1). Of course, some of that above-par performance is thanks to the market’s December selloff, which meant the S&P 500 began 2019 at a depressed level. But even if the clock starts on December 29, 2017, the S&P 500 rose a moderate 12.1%, and since December 30, 2016 it has returned 33.8%.

The last three months haven’t been quite so spectacular. As we’ve discussed previously, since peaking this summer, the S&P 500 has dipped 1.0% and defensive sectors enjoyed the top returns. Here’s the S&P 500 sectors’ performance derby from 7/26 through Tuesday’s close: Real Estate (8.0%), Utilities (7.3), Consumer Staples (0.8), Health Care (-0.2), Industrials (-0.5), Financials (-0.9), S&P 500 (-1.0), Communication Services (-2.0), Consumer Discretionary (-2.2), Information Technology (-2.3), Materials (-3.3), and Energy (-5.9).

While defensive sectors have led the way since July, a number of very economically sensitive industries have turned in remarkably strong performances over the same time period. Here they are: S&P 500 Homebuilding industry is (up 24.0%), General Merchandise Stores (22.3), Trucking (14.0), Construction Materials (12.2), Electronic Equipment & Instruments (10.2), Home Improvement Retail (9.2), Construction & Engineering (9.1), Industrial REITS (8.9), and Semiconductor Equipment (8.4).

Let’s look at what’s driving some of these economically sensitive industries.

(1) Lower rates lend a hand. The drop in interest rates has helped some of the best performing industries. The 10-year Treasury yield has fallen from 3.24% on 11/8/18 to 1.78% (Fig. 2). The drop in mortgage rates makes residential and commercial real estate more affordable for those who need financing. The interest rate on fixed-rate home mortgages has fallen to 4.00% from a peak of 5.00% in November 2018 (Fig. 3). Lower rates helped new home sales rebound from a slump earlier this year (Fig. 4).

The S&P 500 Homebuilding industry is the second-best performing industry since July 26, and it has been in rally mode since 12/24/2018 rising 61.1% (Fig. 5). The industry is expected to post earnings growth of 6.1% this year and 8.0% in 2020 (Fig. 6).

Meanwhile, the Federal Reserve has lowered the federal funds rate two times this year—in July and September. The yield curve, as measured by the 10-year Treasury and the 3-month Treasury bill, hit its most negative level on 8/28 (at 48bps) and has since turned slightly positivity (Fig. 7). A positively sloped yield curve was good news for the S&P 500 Diversified Banks industry, which has climbed 3.2% since July 26, but not as helpful to Regional Banks (-0.3). (Fig. 8).

(2) Semis take two steps forward, one step back. There are other economically sensitive industries, like S&P 500 Trucking and S&P 500 Semiconductor Equipment, that are less directly impacted by interest rates, but have also had a great few weeks. The Semiconductor Equipment industry has gained 8.4% since July 26, while Semiconductors industry has outperformed the S&P 500, but not by much (-0.4%). (both are through Tuesday’s close.) On a ytd basis, Semiconductor Equipment and Semiconductors have both led the market. Semi Equipment is the top performing industry ytd (68.0%) and Semiconductors (26.0%) has beaten the market by a nice margin.

Worldwide semiconductor sales had been falling from their October 2018 peak through June, when they appear to have bottomed because sales have climbed in July and August (Fig. 9). Despite the uptick in sales, concerns have lingered about the impact of the US-China trade war, which played a starring role in Texas Instruments’ earnings report Tuesday after the close. The company’s Q4 earnings forecast missed analysts’ estimates by a mile. The company projects a range of 91 cents to $1.09 a share for earnings, far below analysts’ forecast of $1.28 a share.

Texas Instruments blamed the US-China trade war for causing customers to pull back. “It is due to macro events, and specifically, the trade tensions. [I]f you think about when there’s tensions in trade and obstacles to trade, what do businesses do? They become more cautious and they pull back. And we are at the very end of a long supply chain,” TI CFO Rafael Lizardi told analysts, according to 10/22 MarketWatch article. Shares of TI fell 10% in aftermarket trading Tuesday and dragged down other semiconductor stocks as well.

(3) Trucking on. With earnings declining this year, it’s somewhat surprising that the stock of the S&P 500 Trucking industry’s one constituent, J.B. Hunt Transport Services, has risen 14.0% since July 26 and 38.3% since bottoming on 5/29 (Fig. 10). Earnings are expected to decline 4.7% this year, but investors may be focused instead on 2020, when earnings are forecast to climb 9.8% (Fig. 11).

The ATA Truck Tonnage index has been volatile but remains in record high territory. At 117.6 in September, the index is down 3.8% from its July peak, but still up 3.5% y/y (Fig. 12). On the other hand, after rising sharply in 2018, prices for truck freight transportation fell 0.2% in the September PPI (Fig. 13). Of course, that’s good news for the customers of the trucking industry.

(4) Industrials moving forward despite headwinds. In addition to Trucking, there are a number of other industries in the Industrials sector that have outperformed the S&P 500 since July 26. Their outperformance is notable given the trade dispute, the slow European economy, Boeing’s problems with the 737 Max, and the strike at General Motors. The standouts since July 26 are Trading Companies & Distributors (10.9%), Construction & Engineering (9.1), Building Products (4.9), Electrical Components & Equipment (3.5), Agricultural & Farm Machinery (2.8), Construction Machinery & Heavy Trucks (1.3), Railroads (0.8), Aerospace & Defense (0.6), and Industrial Machinery (0.1).

Yesterday Boeing reported huge earnings miss, but the company’s shares rallied anyway because it continued to forecast the Max 737 would return to the skies in the fourth quarter and maintained a production rate of 42 planes per month. The company posted earnings of $1.45 a share, compared to $2.09 a share that analysts expected.

Honeywell International CEO Darius Adamzyk sounded extremely optimistic in a CNBC article yesterday, which follows modestly disappointing earnings report last week. Honeywell reported Q3 adjusted earnings per share of $2.08, seven cents higher than analysts’ forecast, but it also gave Q4 earnings per share guidance of $2.00-$2.05, below analysts’ target of $2.06. Companies that manufacture airline replacement parts, like Honeywell, have benefitted from the Boeing 737 Max grounding because it has meant the airlines fly older planes, which require more maintenance and repairs.

Despite the light Q4 forecast, Adamzyk remained confident. “Overall we’re actually not seeing the softening of this environment, and actually I was very pleased with the bookings, which is really a predictor of our future,” he said Wednesday on CNBC. “Our backlog was up high single digits for the quarter, and we had double-digit booking gains in places like China and the Middle East, Latin America and so on. A lot of markets that really aren’t doing well. Even Europe was up nearly double-digits for us as well,” he said. The company’s shares are up 27.9% ytd.

Disruptive Technologies: Gene Fixing. The world of gene editing is growing more sophisticated by the day. Scientists are developing new, more accurate techniques and applying existing methods to new diseases. It all leads to very exciting medical trials that give hope to millions of patients. I asked Jackie to review the latest developments.

(1) Tackling blood diseases. Sickle cell disease is caused by a genetic defect that turns red blood cells into hard, sticky, misshapen cells. These cells don’t carry oxygen well and clot the bloodstream, damaging organs, causing pain, and potentially resulting in stroke or heart attack. ARK Investment’s newsletter highlights a study underway that hopes to cure this disease using gene editing. Doctors are taking out patients’ bone marrow cells, editing the cell’s genes with CRISPR, and putting them back into the patients’ bodies.

“Scientists used CRISPR to modify a gene in the cells to make them produce fetal hemoglobin, a protein that babies usually stop making shortly after birth. The hope is that the protein produced through the gene-editing treatment will give sickle cell patients like Gray healthy red blood cells,” a 10/10 NPR article reported.

Crisper Therapeutics and Vertex Pharmaceuticals, which are sponsoring the sickle cell study, also used CRISPR earlier this year to treat a German patient with beta thalassemia, a similar blood disorder. In July they reported that the patient’s edited cells started functioning in the bone marrow.

(2) Other CRISPR trials underway. Scientists at the University of Pennsylvania are running trials to see if CRISPR can cure relapsed cancers, like multiple myeloma or melanoma. The scientists modify patients’ T cells, an immune cell that circulates in the blood, to make them more efficient at fighting cancer, a 9/3 Smithsonian.com article reported.

Crisper and Vertex are conducting another trial using CRISPR to treat non-responsive or relapsed non-Hodgkin’s lymphoma. And lastly Editas Medicine and Allergan began a trial using CRISPR to treat inherited childhood blindness. It will be the first CRISPR trial where the cells are edited while still in the patients’ bodies.

(3) New and improved gene editing.Harvard University and MIT researchers think they have improved upon CRISPR gene editing, by making the process more accurate. Prime editing, they claim, edits DNA with “incredible” precision and introduces fewer errors than previous gene-editing techniques.

CRISPR makes cuts across both strands of double-stranded DNA and either deletes genes or pastes new genes in the gap. CRISPR can make errors when the cuts are made at the wrong place or errors are introduced into the genes. Prime editing cuts just one strand of the DNA and inserts base letters into the strand. The Prime editor then nicks the other DNA strand and the cell copies what’s in the first edited strand.

The researchers edited human cells to fix sickle cell and Tay-Sachs disease and they believe Prime editing can be used to treat about 89% of the 75,112 human genetic mutations that cause disease, a 10/21 CNET article reported.

Both techniques have pros and cons. Prime editing works best when only a single base needs to be changed on a DNA, as with Tay-Sachs disease. But when larger sections of DNA need to be altered, as would be necessary to affect the genes involved with hereditary heart disease, CRISPR would be the better vehicle, a 10/21 Smithsonian.com article explained. Also, the Prime editor is larger than CASPR, so scientists have to figure out how it could be put into living cells in living organisms.

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A World of Lowflation

October 23 (Wednesday)

Global Inflation I: Central Banks Agonistes. Like the Fed, the other major central banks responded to the Great Financial Crisis by adopting unconventional monetary policies that have become all too conventional. They’ve all flooded the global economy with lots of liquidity in efforts to avoid another financial crisis and to avert deflation. They’ve succeeded so far. They also deserve some credit for the significant improvements in their labor markets since the Great Recession.

However, inflation remains below their 2.0% targets notwithstanding all the liquidity that they provided. Moreover, their unconventional policies seem to be losing their effectiveness, which raises the question of whether they will have enough ammo left to fight the next recession.

Another concern is that their untested policies may have unintended adverse consequences, including undermining financial stability in unexpected ways. Their near-zero interest-rate policies (NZIRP), zero interest-rate policies (ZIRP), and negative interest-rate policies (NIRP) have resulted in a worldwide “reach for yield.”

Then-Fed-Governor Jerome Powell warned about this problem in a 6/27/13 speech titled “Thoughts on Unconventional Monetary Policy”: “Demand for higher-yielding fixed-income securities has outstripped new supply. The result has been very low rates, declining spreads, increasing leverage, and pressure on non-price terms such as covenants. These concerns have diminished somewhat as rates have risen since mid-May. Nonetheless, since it is likely that asset purchases will continue for some time, markets will need careful monitoring.”

When Powell became chair of the Fed’s Board of Governors early last year, he seemed determined to normalize monetary policy. But he changed his mind at the beginning of this year. So the Fed raised the federal funds rate four times during 2018, but lowered it two times so far during 2019 back down to 1.75%-2.00% (Fig. 1). More rate cuts are widely expected, as can be seen from Monday’s federal funds futures contracts: nearby (1.63), 3-month (1.58), 6-month (1.45), and 12-month (1.34) (Fig. 2).

So the reach for yield continues. In the US, this is evident in the record forward P/E of the S&P 500 Utilities sector at 19.7 (Fig. 3). It can also be seen in the narrow yield spread between junk bonds and Treasury bonds (Fig. 4).

In Europe, the European Central Bank (ECB) first adopted NIRP on 6/5/14. Since then, it lowered the interest rate on its deposit facility for bank reserves five times, from zero to -0.50% most recently. As a result, government bond yields are close to zero in France (0.19%), Germany (-0.52), Italy (0.68), and Spain (0.31) (Fig. 5).

In early October, Greece sold 13-week bills at a yield of -0.02%. It also recently sold 10-year bonds at a yield of just 1.50%. In 2012, yields on similar bonds were closer to 24%.

Global Inflation II: Comparing CPIs. In addition to lowering their interest rates toward zero, the major central banks have purchased lots of bonds through quantitative easing programs. The central banks of the US, the Eurozone, Japan, and China collectively have expanded their combined balance sheet from $5 trillion at the start of 2007 to over $19 trillion currently (Fig. 6).

In my opinion, the central bankers are trying to fix problems that can’t be fixed with ultra-easy monetary policies. They are trying to fight the four powerful forces of deflation: Détente, Disruption, Debt, and Demographics. I call them the deflationary “4Ds,” and have examined them on several occasions in the past.

For now, let’s review the latest CPI inflation rates in the Eurozone, Japan, and the US, and examine how they differ:

(1) CPI headline and core inflation rates. The latest stats show headline CPI inflation of 0.8% in the Eurozone, 0.2% in Japan, and 1.7% in the US (Fig. 7). The comparable core rates are 1.0%, 0.3%, and 2.4% (Fig. 8). Since 1996, Japan has experienced prolonged periods of core deflation (i.e., falling prices), while core CPI inflation has hovered around 1.5% in the Eurozone and 2.0% in the US.

(2) CPI durable and nondurable goods inflation rates. Since 1996, the durable goods CPI often has deflated, particularly in Japan, but also in the Eurozone (Fig. 9). On a y/y basis, it has fluctuated around zero in the US, with moderate bouts of deflation followed by equally moderate bouts of inflation.

The nondurable goods CPI inflation rates are currently closer together than usual in the Eurozone (0.2%), Japan (0.1), and US (-0.4) (Fig. 10). They all fluctuate quite a bit, though mostly around zero.

(3) CPI services inflation rates. The big difference among the three CPIs, since 1996, is that the services price inflation rate runs hotter in the US than in the Eurozone (Fig. 11). The comparable series for Japan fluctuates around zero. This is mostly because rent inflation runs hotter in the US (3.5% currently) than in the Eurozone (1.5) and Japan (0.0) (Fig. 12). It also has a much higher CPI weight in the US (33.1%) than in the Eurozone (6.5) and in Japan (17.8).

I asked Melissa to dig deeper into the statistical similarities and differences among the three CPIs. Her report follows.

Global Inflation III: Different Strokes for Different Folks. Inflation around the globe has been persistently low, bordering on too low, for over a decade now. In some countries (e.g., Europe and Japan), prices are rising at a slower pace than in others (e.g., the US). But are their respective central banks’ preferred inflation measures comparable? Not entirely.

Let’s have a closer look at these measures for the ECB, Bank of Japan (BOJ), and the Fed and how they differ (major differences are underlined):

(1) ECB’s HICP. Price stability is the ECB’s primary objective, as set by the Treaty on the Functioning of the European Union. The Treaty does not define price stability, but the ECB adopted a formal definition in 1998. The ECB’s price stability target is close to, but below, a 2.0% y/y increase in the Harmonised Index of Consumer Prices (HICP) for the euro area over the medium term.

Why a 2% goal rather than 0% or 1%? Three reasons: “To account for the fact that inflation figures can be slightly overstated, to have a safety margin against the potential risks of deflation, and to leave room for differences in inflation across euro area countries.”

The HICP measures the change over time in the prices of consumer goods and services acquired, used, or paid for by euro area households. To ensure that the data are comparable across the euro area, the term “harmonised” denotes that all EU member countries follow the same methodology. Eurostat compiles the HICP.

(2) ECB’s scope. Within the scope of the HICP are most consumer goods and services purchased via monetary transactions. That includes purchases by all types of households (e.g., those headed by foreigners) in all EU geographic areas. One major exclusion is expenditure on housing by homeowners. That’s not because the ECB thinks housing shouldn’t be included but rather because the statistics needed for doing so consistently across all EU countries aren’t available. Also excluded: price changes for state-funded purchases (e.g., state-funded education).

(3) ECB’s methodology. The HICP is a Laspeyres-type price index as opposed to a cost-of-living index. The former defines a basket of goods and services in the base period that is priced in each subsequent period; the goods and services are weighted according to their share in overall consumption in the base period. The latter “measures the change in expenditure necessary to maintain the utility of the base period.”

The HICP is not based on a fixed basket, as it measures the “development of prices over time for fixed ‘consumption segments’—sets of consumer expenditures that serve a common purpose.” However, specific items may enter and exit a basket over time as they become relevant or irrelevant.

The HICP aims to measure “pure” price changes over time. To that end, prices are adjusted for changes in specifications or quality.

(4) ECB’s weights. The HICP weighs product groups by survey-based measures of “the share of each group in the total expenditure of all households for the goods and services covered by the index.” Most countries update these weights annually, though law requires they do so only every seven years.

For the entire euro area, the HICP is calculated as an average of the national HICPs for each country “weighted by the countries’ relative household consumption expenditure shares in the euro area total.”

(5) BOJ’s CPI ex food. The BOJ set its price stability target at 2% y/y for the CPI in January 2013. The CPI is affected by short-term factors, while the bank is primarily interested in the underlying trend of inflation. Therefore, the BOJ’s preferred measure of inflation is the CPI for all items less fresh food. A CPI for all items less fresh food and energy is also released but isn’t the favored measure because Japan’s energy prices don’t fluctuate significantly, as the bank pointed out in a 2013 Background Note. Both measures are released by the Statistics Bureau of the Ministry of Internal Affairs and Communications. The bank excludes the direct effects of changes in the consumption tax rate on prices when it makes sense to do so.

(6) BOJ’s methodology & weights. Japan’s CPI is compiled based on the fixed-weight Laspeyres formula described above, but with the consumption basket of goods and services in the base year fixed for five years. To calculate the CPI, goods and services that are important components of household spending are chosen and weighted based on their rates of consumption. The shares are survey based. At every five-year revision interval, the weights are recalculated.

The BOJ acknowledges that Japan’s CPI has both upward and downward biases. It’s biased upward because the weights of cheaper goods and services in the whole consumption basket are not reflected on a real-time basis. It’s biased downward for two reasons: survey respondents are mainly large-scale stores and housing rents aren’t quality adjusted over time (e.g., to account for units deteriorating with age). “The weight of housing rents in the CPI (all items excluding fresh food) is small (i.e., 2.8 percent), but this applies to imputed rents as well, whose weight is 16.2 percent,” according to the 2013 note.

(7) BOJ’s micro notes. In its note, the BOJ explains a couple of important micro fluctuations in prices that impact the overall measure.

For one, the decline in durable goods prices is particularly pronounced in Japan. Since the same durable goods products are sold in Japan and the US, “the difference in the declining pace of durable goods between the two countries is likely due to different statistical compilation methods (i.e., sampling method of survey items and quality adjustment method) and the difference in the competitive environment in the retail sectors.”

For two, there is a significant gap in the rates of increase in services prices between Japan and the US because Japanese firms tend to adjust wages rather than lay off employees when faced with a decline in demand.

(8) BOJ’s imputed rent. Unlike the ECB but similar to the US CPI, Japan’s CPI accounts for a proxy of owner-occupied household living expenses. While “buying a house or a piece of land is a form of property acquisition and not consumption expenditure,” the Statistics Bureau reasons, “a household living in a house it owns receives some service from the house.” Imputed rent of an owner-occupied house “refers to the rent paid to owner-occupied houses assuming that owned houses were rented,” as a proxy for the benefit the household receives from living in an owner-occupied house. These “rents” are included in the CPI calculation.

(9) Fed’s PCE vs CPI. In the US, there are two primary measures of inflation: the Personal Consumption Expenditures Deflator (PCED) produced by the Bureau of Economic Analysis and the CPI released by the Bureau of Labor Statistics. In 2012, the Fed set an inflation target of 2.0% as measured by the annual change in the PCED. The CPI and the PCED are similar but not exactly the same. The CPI tends to run higher than the PCE. The Fed’s 2.0% goal is primarily based on the headline PCED as opposed to the alternative core measure (excluding food and energy).

“Both indexes calculate the price level by pricing a basket of goods. If the price of the basket goes up, the price index goes up. But the baskets aren’t the same, and it turns out that the biggest differences between the CPI and PCE arise from the differences in their baskets,” according to a 2014 note from the Cleveland Fed. The CPI is based on surveys of what households are buying; the PCE is based on surveys of what businesses are selling.

Another major difference is that the CPI covers only out-of-pocket expenditures on goods and services purchased and excludes other expenditures that are not paid for directly (not unlike the ECB’s exclusion for state-funded purchases)—for example, medical care paid for by employer-provided insurance, Medicare, and Medicaid. These are, however, included in the PCED.

Last, the PCED aims to account for substitution of goods when one becomes more expensive, while the CPI uses the same basket as before.

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Shiller’s Bullish Trump Scenario

October 22 (Tuesday)

US Economy I: Lifestyle of the Rich & Famous President. The US economy continues to grow despite recurring recession scares. By our count, they’ve triggered 65 panic attacks in the stock market since the start of the bull market during March 2009. (See our S&P 500 Panic Attacks Since 2009 chart book and table.) The panic attacks—which include both corrections and mini-selloffs—have been followed by relief rallies. As a result, on Friday, the S&P 500 was only 1.3% below its record high of 3025.86 on 7/26 (Fig. 1).

The current economic expansion became the longest one on record during July of this year. It has now lasted 124 months. Debbie and I expect it will continue through 2020. The main risk might be a radical regime change if President Donald Trump is defeated by one of the Democratic socialist candidates come the November 2020 election. Then again, our Founders reduced the chances that a radical president could be too radical by designing a constitutional system based on checks and balances.

We were intrigued and puzzled by the strange interview on CNBC with Nobel Prize-winning economist Robert Shiller on Friday. He said a recession may be years away due to Trump’s bullish impact on the economy. Shiller is a behavioral finance expert who apparently believes that consumers are following the President’s lead: “I think that [strong consumer spending] has to do with the inspiration for many people provided by our motivational speaker president who models luxurious living.” That’s certainly a different spin on the Trump presidency than we’ve heard before.

Shiller also said that the next recession may not hit for another three years, and it could be mild. If the economy remains strong, Shiller expects Trump to be re-elected.

Shiller coined the phrase “irrational exuberance” and correctly anticipated the bear market of 2000 because his CAPE valuation ratio was too high. He also correctly predicted the bear market in home prices that led to the Great Financial Crisis. His CAPE ratio is bearish again, yet he is bullish on the economy and the stock market.

In our opinion, consumers are doing what they do best because their real disposable incomes are growing along with employment and real wages. Consider the following:

(1) Growing wages driving consumer spending. Our Earned Income Proxy for private-sector wages and salaries rose 4.2% y/y to a new record high during September, while retail sales rose 4.1% (Fig. 2). Trump’s policies of deregulation and tax cuts undoubtedly contributed to the strength in personal income.

(2) Trade wars and impeachment hearing causing uncertainty. On the other hand, Trump’s trade wars have created lots of economic uncertainty. So has his eccentric style of governing, which has led the House Democrats to start an impeachment hearing. The Democratic candidates all seem to favor higher taxes, including taxes on wealth.

(3) Consumers saving more. As a result, personal saving has soared. The 12-month sum of personal saving jumped by $335 billion from $969 billion during November 2017, when Trump was elected, to a record $1.3 trillion during August (Fig. 3). Over that same period, the personal saving rate rose from 6.5% to 8.1% (Fig. 4).

(4) Income growing faster than spending. Real disposable personal income has been growing faster than real personal consumption expenditures since May 2017 (Fig. 5). Since then through August, the former is up 7.8%, while the latter is up 6.6%.

We don’t disagree with Shiller on the longevity of the current economic expansion. However, we doubt that Trump’s lavish lifestyle is the role model for 99% of American consumers. The wealthiest 1% may be cutting back on their extravagant lifestyles and doing most of the saving, figuring that if Trump loses, they will be paying lots more in taxes.

US Economy II: No Big Surprises. If consumers were emulating Trump’s lifestyle, the US economy would be booming, which would set the stage for a bust. Our mantra remains the same when it comes to the economic outlook: “No boom, no bust.” The Atlanta Fed’s 10/17 GDPNow model is currently estimating a 1.8% (saar) growth rate for Q3’s real GDP, with real residential investment up 6.2% and business fixed investment down 1.2%. Here’s some more on the performance of the economy:

(1) Leading indicators. September’s Index of Leading Economic Indicators (LEI) fell for the second consecutive month since reaching a new record high in July. It slipped 0.1% last month following a 0.2% downtick in August. The LEI was up only 0.4% y/y, slowing steadily since peaking at 6.6% a year ago (Fig. 6 and Fig. 7).

Last month, five components of the LEI contributed positively and four negatively, with the average workweek unchanged. The ISM new orders index (-0.17ppt) recorded the biggest negative contribution, followed by building permits (-0.08), the interest rate spread (-0.04), and consumer expectations (-0.01). Stock prices (0.11), the leading credit index (0.09), and jobless claims (0.06) were the biggest positive contributors.

During September, the Index of Coincident Economic Indicators held steady at August’s record level. It was up 1.5% y/y, suggesting that real GDP continues to grow around 2.0% y/y (Fig. 8).

Should we worry about the stall in the LEI over the past 12 months? Debbie and I have some misgivings about this index. Many of its components are cyclical. That makes sense in the context of forecasting the business cycle. However, some may have run out of room to improve given that this has turned out to be the longest economic expansion on record. For example, jobless claims are so low that they probably can’t go much lower. Building permits have been moving sideways at their cyclical high since 2017.

(2) Economic surprise. The good news is that the Citigroup Economic Surprise Index (CESI) soared from this year’s low of -68.8 on 4/25 to this year’s high (so far) of 45.7 on 9/25 (Fig. 9). That’s not as exciting as it sounds because, since 2009, the CESI has had a funky tendency to be weak during the first half of the year and strong during the second half. Furthermore, it is volatile, and it dropped back down to 8.0 at the end of last week.

By the way, we found that the 13-week change in the 10-year TIPS yield is highly correlated with the CESI (Fig. 10). That helps to explain the upward pressure on the yields of both the 10-year TIPS and comparable Treasury bond since mid-year.

Global Strategy: US vs Them. Over the past couple of weeks, Joe and I having been paying closer attention to the Go Global alternative to the Stay Home investment strategy. We are suffering from cabin fever and looking for opportunities to venture out into the world.

The main attraction abroad is lower valuation multiples than in the US. On the other hand, it’s hard to get excited about the fundamentals over there versus over here:

(1) Comparing CESIs. While the CESI for the US has recovered nicely since mid-year, the comparable measure for the Eurozone remains solidly in negative territory, as it has all year (Fig. 11). The spread between the two was 75 on Friday (Fig. 12).

(2) Comparing the Blue Angels. The forward earnings of the S&P 500 has been rising into record-high territory since early this year through the 10/10 week. When we multiply this series by forward P/Es of 10.0 to 19.0, the resulting Blue Angels framework shows that the S&P 500 has been trading between 16.0 and 17.0 most of this year (Fig. 13).

The comparable Blue Angels chart for the All Country World ex-US MSCI stock price index shows that forward earnings abroad has been heading lower this year, but may possibly be starting to bottom (Fig. 14). This index’s forward P/E has been trading around 13.0 in recent weeks.

(3) Missing ingredient. We would get much more excited about taking a portfolio trip abroad if commodity prices firmed and the dollar weakened. Historically, there has been a good inverse correlation between these two variables (Fig. 15). That’s because broad-based global economic growth would push up commodity prices, while weakening the dollar. When the global economy is relatively weak, commodity prices tend to fall while the dollar strengthens.

Previously, we’ve often observed the close correlation between the CRB raw industrials spot price index and the Emerging Markets MSCI stock price index (in dollars) (Fig. 16). Again, we would be more gung-ho about Go Global if we saw an upturn in the commodity index, which remains MIA for now.

(4) China still slowing. Weighing on commodity prices is the economic slowdown in China. The country’s real GDP growth rate fell to 6.0% y/y during Q3-2019 (Fig. 17). The quarterly rate was 5.2% (saar), down from 5.4% during Q2. The y/y growth rates of both industrial production and real retail sales remain on downward trends, with the former at 5.8% and the latter at 4.8% during September (Fig. 18).

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Global Soft Patch

October 21 (Monday)

S&P 500 Revenues: Still Growing But Slowing. During 2015, the US and global economies hit a soft patch as a recession rolled through the global energy and commodities industries. This year, the US and global economies hit a soft patch partly attributable to Trump’s escalating trade wars. This is plain to see in the growth rate of aggregate S&P 500 revenues back then and now (Fig. 1). During 2015, it turned negative. However, excluding the aggregate revenues of the S&P 500 Energy sector, which dropped by roughly 40% at the time,it remained around zero (Fig. 2).

During Q2-2019, aggregate Energy revenues fell 4.3% y/y, but S&P 500 aggregate revenues rose 3.0% and 3.8% with and without the Energy sector. Nevertheless, either way, S&P 500 revenues growth has slowed from last year’s peaks of 10.0% and 8.0% with and without Energy during Q2-2018. Energy revenues were growing at double-digit rates above 20% for much of last year.

Now consider the following:

(1) Weak business sales growth. It will be interesting to see how Q3-2019 revenues growth comes in during the current earnings season. On Wednesday last week, we learned that manufacturing and trade sales (a.k.a. business sales of goods) rose just 1.1% y/y during August, down from a recent peak of 8.3% during May 2018 (Fig. 3). This series is highly correlated with the quarterly series for aggregate S&P 500 revenues growth. So the latest data suggest that Q3’s aggregate revenues growth results could be closer to zero.

(2) Forward revenues going strong. The good news, as Joe and I have been observing recently, is that S&P 500 forward revenues per share has been rising into record territory all year, auguring well for actual quarterly S&P 500 revenues per share (Fig. 4). Forward revenues per share rose 4.2% y/y through the 10/10 week (Fig. 5).

(3) Analysts tend to be optimistic, but realistic, about revenues. Industry analysts remain optimistic about S&P 500 revenues growth. They are projecting gains of 4.2% this year, 5.5% next year, and 4.4% in 2021 (Fig. 6). Their estimates for this year and next year have been holding up well all year (Fig. 7).

Last week, we observed that industry analysts tend to be too optimistic about future earnings results and have to cut their annual estimates when visibility into actual results improves as earnings seasons approach(Fig. 8). The same generalization does not apply to revenues. The analysts seem to have a more realistic handle on the outlook for revenues. We aren’t sure why there’s this discrepancy, but it is a fascinating dichotomy.

(4) Better global growth ahead? Of course, the key assumption for the optimists, including the YRI team, is that global growth picks up in 2020. That’s consistent with the latest IMF World Economic Outlook released last week. It is subtitled “Global Manufacturing Downturn, Rising Trade Barriers.” Here is the key excerpt from the report:

“The global economy is in a synchronized slowdown, with growth for 2019 downgraded again—to 3 percent—its slowest pace since the global financial crisis. This is a serious climbdown from 3.8 percent in 2017, when the world was in a synchronized upswing. This subdued growth is a consequence of rising trade barriers; elevated uncertainty surrounding trade and geopolitics; idiosyncratic factors causing macroeconomic strain in several emerging market economies; and structural factors, such as low productivity growth and aging demographics in advanced economies.

Global growth in 2020 is projected to improve modestly to 3.4 percent, a downward revision of 0.2 percent from our April projections. However, unlike the synchronized slowdown, this recovery is not broad based and is precarious. Growth for advanced economies is projected to slow to 1.7 percent in 2019 and 2020, while emerging market and developing economies are projected to experience a growth pickup from 3.9 percent in 2019 to 4.6 percent in 2020.”

That doesn’t sound very cheery, but we agree with the IMF projection that global growth should pick up next year. We expect that Trump will continue to deescalate America’s trade tensions with the rest of the world as the 2020 presidential election approaches. We’ve been expecting a soft Brexit deal, which seems to have been accomplished in recent days, though another postponement is also possible. We believe that Germany’s manufacturing output is bottoming along with the country’s car production. Recent Chinese data including the M-PMI, rail freight traffic, and bank loans are all improving. The latest rounds of easing by the Fed and ECB should provide some policy stimulus for the global economy.

Strategy: Time To Go Global? All the above suggests that a Go Global investment strategy could outperform Stay Home over the rest of this year through the first half of next year. We first raised this possibility in our 10/8 Morning Briefing titled, “Cabin Fever.” Here again are a few key points:

(1) More attractive valuations abroad. Stocks in the rest of the world look cheap compared to those in the US. At the end of September, the US MSCI had a forward P/E of 17.3, while the All-Country World ex-US had a 13.3 valuation multiple. Keep in mind that the US has tended historically to command a premium P/E compared to the rest of the world, but the recent spread of 4.0 P/E points is among the widest since the start of the data in May 2001.

(2) More resilient PMIs in emerging economies. The PMIs of the emerging economies have been holding up better than those of the advanced economies so far this year. Here are September’s M-PMIs for a few of the major emerging economies: Brazil (53.4), China (51.4), India (51.4), Thailand (50.6), and Vietnam (50.5) (Fig. 10). Some of those in Southeast Asia may be benefitting from manufacturers’ moving their supply chains out of China.

(3) Further easing in Europe. The European Central Bank (ECB) last month cut its key deposit facility rate further into negative territory, from –0.40% to –0.50%, and relaunched a €20 billion per month bond-buying program without setting a termination date. Outgoing ECB President Mario Draghi said, in effect, that the ECB would be delighted to purchase €240 billion per year in Eurozone government bonds to finance stimulative fiscal policy in the region.

US Consumers: E Pluribus Unum & Dopamine. The key question for the global economy is whether US consumers will continue to do what they do best. A big concern is that jobs growth may be slowing. Debbie and I think it has more to do with labor shortages than with weakening demand for workers. We also believe that more and more companies will react to the shortage of workers by boosting their productivity, which should allow wages to grow faster than prices. Real wage gains should continue to drive consumer spending in the US, along with a slower, but steady, pace of hiring.

Might the deep divide over politics depress American consumers? Debbie and I don’t think so. Might the deep divide over politics depress American consumers and their spending? Debbie and I don’t think so. When Americans are happy, we go shopping. When Americans are depressed by the news, we do even more shopping, because it releases dopamine in our brains. And online shopping gives us an even stronger dopamine fix than going to the mall, reported Psychology Today, citing a Razorfish report, Digital Dopamine. High percentages of shoppers from the US, UK, Brazil, and China in 2014 reported getting more excited to receive online purchases than to buy things in a store.

As Debbie reported last Thursday, September retail sales fell 0.3% m/m. However, August retail sales was revised up from 0.4% to 0.6%. The latest report is titled “Advance Monthly Sales for Retail and Food Services.” It shows that the “nonstore retailers” category was down 0.3% during September (the first decline this year), which is a rough estimate. This item consists mostly of “Electronic shopping & mail-order houses,” which won’t be available for September until next month. Numerous other items also won’t be available until next month, including new car dealers, furniture stores, pharmacies & drug stores, and warehouse clubs & supercenters. We expect an upward revision next month in September’s preliminary estimate.

In any case, retail sales remained strong during Q3. On an inflation-adjusted basis and at an annual rate, they rose 5.9% last quarter (Fig. 9). In current dollars, retail sales are up 4.1% y/y, matching the comparable growth in our Earned Income Proxy for private-sector wages and salaries (Fig. 10).

The Fed: Repo Man. In an unscheduled 10/11 press release, the Fed announced that beginning on 10/15 it “will purchase Treasury bills at least into the second quarter of next year in order to maintain over time ample reserve balances at or above the level that prevailed in early September 2019.”

More details were released in a separate New York Fed statement (and accompanying FAQs). The initial pace of these “reserve management” (RM, our acronym) purchases will be approximately $60 billion per month and will be in addition to ongoing purchases of Treasuries related to the reinvestment of principal payments from the Fed’s maturing holdings of agency debt and agency mortgage-backed securities. As the new holdings mature, the principal payments will be reinvested again into T-bills.

Many have commented that these actions look a lot like quantitative easing (QE). After all, the Fed is expanding its balance sheet sizably, possibly by up to $300 billion or more assuming $60 billion a month through March as a ballpark. The Fed’s balance sheet currently totals $3.9 trillion, including $2.1 trillion in US Treasury securities, of which $345 billion are T-bills maturing in one year or less.

However, in a 10/8 speech, Fed Chair Jerome Powell insisted that this operation is not the same as QE: “I want to emphasize that growth of our balance sheet for reserve management purposes should in no way be confused with the large-scale asset purchase programs that we deployed after the financial crisis,” he said. We agree they are RM, not QE. Whatever you call the Fed’s latest balance-sheet expansion plan, here’s more information on it:

(1) The backstory. In October 2017, the Fed began reducing its massive $4.4 trillion post-crisis balance sheet by allowing up to $50 billion in maturing securities to roll off the balance sheet per month. On 3/20, the Fed announced that it would end this practice by September, leaving the balance sheet sized appropriately, though still significantly bigger than pre-crisis. By September’s end, total assets on the Fed’s balance sheet had been reduced to $3.8 trillion.

(2) The crunch. The fed funds rate is mainly controlled by paying banks interest on the reserves they hold at the Fed. Reserve balances increased after the crisis when the Fed flooded the debt markets with cash by purchasing bonds. But now, the Fed seems to have allowed bank reserves to shrink too much, creating a crunch in the overnight repurchase, or “repo,” market. Reserves declined to less than $1.4 trillion last month, the lowest since 2011 and down from $2.8 trillion in 2014, with most of that decrease in the last two years.

Limited access to cash on reserve in overnight lending markets caused such a significant squeeze on 9/16 and 9/17 that short-term rates surged as high as 10%. Meanwhile, the federal funds rate rose 5 basis points above the Fed’s target range. That’s a problem: Since the federal funds rate is the Fed’s primary monetary policy lever, it needs to be controllable. So the Fed was forced to intervene with emergency repo operations.

(3) The solution. To provide an “ample” supply of reserves without regular interventions in the short-term markets, the Fed will buy T-bills that mature in one year or less. Holding a portfolio of shorter-term assets should not create any monetary stimulus, officials maintain, but rather is a technical necessity to properly control short-term rates. Under QE, in contrast, the Fed aimed to lower long-term rates to stimulate the purchase of risker assets, sending those asset prices higher.

(4) The warning. Market participants chided the Fed for not averting the September disfunction. But FRB-NY President John Williams defended the Fed’s actions as appropriate in terms of both preparation and response. Recall that Powell had warned about possible funding issues in a 3/8 speech: “In January, the Committee stated its intention to continue [to hold] our main policy rate, the federal funds rate or possibly some successor … within its target range by the interest rates we set on reserves and on the overnight reverse repo facility. In this system, active management of the supply of reserves is not required.”

Powell continued: “Thus, the supply of reserves must be ‘ample’ … to satisfy reserve demands even in the face of volatility in factors affecting the reserve market. Put another way, the quantity of reserves will equal the typical reserve demands of depositories plus a buffer to allow for reserve market fluctuations. … The precise level of reserves that will prove ample is uncertain.”

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Happy Bankers. Brawling Brokers.

October 17 (Thursday)

Financials: Beating a Low Bar. A slew of earnings out of the S&P 500 Financials sector confirmed that the economy continues to perform well. Loans are up, the consumer is healthy, and the stock market is near a record. Despite lower interest rates, banks have managed to increase their returns on equity to respectable levels. As always, there are clouds to watch closely, including loan losses, which may have bottomed. Also, Wall Street’s brokers and asset managers are in a bit of a dog fight, as disruption roils those industries and may dent results over the next year. Here’s Jackie’s look at highlights from some of the latest earnings reports.

(1) Banks overcome flat yield curve. JPMorgan and Bank of America Q3 earnings laid to rest fears that they couldn’t perform well in a flat yield curve environment. Net interest margin is under pressure, but the country’s two largest banks still managed to grow adjusted profits and beat expectations (Fig. 1). JPMorgan’s stock even managed to make a new high this week.

Bank of America’s Q3 net interest margin fell to 2.41% from 2.45% a year ago, but net interest income still rose slightly to $12.3 billion, up from $12.2 billion a year earlier. Despite the flat yield curve, the bank’s businesses performed well. Net income rose in Consumer Banking (5%), Global Wealth and Investment Management (8%), and Global Banking (3%). The bottom line declined 8% in Global Markets due in part to a gain on the sale of an equity investment in Q3 2018, according to the company’s press release. Otherwise, sales and trading revenue and investment banking fees rose.

Likewise, JPMorgan’s net interest yield on average net interest earning assets declined to 2.41% from 2.53% a year earlier, but net interest income rose 2%. The bank also managed to grow the bottom line by 8% y/y. Net income rose 5% at Consumer & Community Banking and 7% in the Corporate & Investment Bank, but results declined 14% in Commercial Banking and 8% in Asset & Wealth Management.

Bank of America’s consumer and commercial loans were each up 6%, while JPMorgan’s average total loans were up 3% excluding the impact of loan sales. Commercial and industrial loans at all banks have fallen in four of the last six weeks and are down 1.6% from their peak at the start of May (Fig. 2). Loans are still up y/y by 5.1%, but given the uncertainty about trade wars, this is certainly a data point to watch (Fig. 3).

Credit quality remains strong at two of the nation’s largest banks, but it’s no longer improving as it has been in recent years. Instead of benefiting from reserve releases, the banks are modestly increasing loan reserves. Bank of America’s provision for credit losses was $779 million, up $63 million y/y. In the 2018 quarter, the bank had enjoyed a $70 million reserve release, primarily from energy exposures in its Global Banking division. JPM’s provision for credit losses jumped to $1.5 billion, up 60% y/y, which it attributed to “reserve releases and net recoveries” in 2018.

Most importantly, the large banks are proving they can post decent returns on capital, something that was questioned in the days after massive regulation was imposed on the industry in the wake of the Great Recession. Recent moves by the Trump administration to loosen regulations and capital requirements have helped. Bank of America’s return on average common shareholders’ equity was 11.2%, excluding a charge, and at JPMorgan it was 15%.

Bank of America and JPMorgan are both members of the S&P 500 Diversified Banks stock price index, which has climbed 21.0% ytd, but remains 8.5% below its 1/26/18 record high (Fig. 4). The industry’s revenue and earnings growth rate have peaked and net earnings estimate revisions are decidedly negative, but earnings are still growing. The Diversified Bank industry’s revenue is forecast to grow 0.5% this year and decline 0.1% in 2020 (Fig. 5). And after growing earnings by 25.6% in 2018, earnings growth is forecast to slow to 10.1% this year and 4.0% next year (Fig. 6). Not much good news is expected, as the Diversified Banks’ forward P/E is 10.1, slightly below its average over the last 25 years.

(2) Battling brokers. Disruption is battering asset managers and brokers from all angles. Assets in low-cost index funds recently topped the assets in higher-cost, actively managed funds. The robo-advice market is growing, with Vanguard as the most recent entrant. Companies like Zoom and Crowdstrike, are opting to directly list their shares instead of paying Wall Street to underwrite an IPO. And new players like KKR want to get a piece of the IPO business that’s left.

The most recent disruption comes from the brokers themselves. In quick succession, Fidelity, Schwab, TD Ameritrade, E*Trade Financial, and Interactive Brokers Group each eliminated the fees they once charged to trade US stocks, ETFs and options. At Schwab that will mean the loss of about $100 million in revenue. The company is betting that the loss of trading revenue will be more than offset by an increase in assets under management, a 10/15 CNBC article reported.

Schwab’s client assets reached a record high of $3.8 trillion in Q3 and earnings per share of 70 cents were up from 65 cents last year and above the 64 cents that Wall Street analysts expected. Schwab shares, now around $39, have gotten crushed since last May when they almost hit $60. But it’s not alone. The S&P 500 Investment Banking & Brokerage stock price index has fallen 27.2% from its 3/12/18 peak (Fig. 7).

Wall Street analysts have very modest growth expectations for the industry, which also includes Wall Street firms Goldman Sachs and Morgan Stanley. Revenue growth is expected to decline this year by 0.8% and nudge higher by 1.6% in 2020 (Fig. 8). Earnings growth estimates follow the same path, down 2.7% this year and up 4.9% next year (Fig. 9). The industry’s forward P/E has come down sharply to 9.2, from 14.9 on 12/14/17 (Fig. 10). Low expectations often make for interesting investment opportunities.

Disruptive Technologies: Science Takes Flight. In the 10/10 Morning Briefing we discussed the advent of Flight Shaming and highlighted the numerous players introducing electronic aircraft. It quickly became apparent that to make an electronic aircraft commercially viable, companies will need to develop new lightweight materials to reduce the weight of the plane and develop more powerful batteries. Innovations will undoubtedly benefit the electric vehicle market as well. Large organizations like NASA and Boeing are working with and competing against small startups in a race that would make the Wright brothers proud.

Here’s a look at what some of the biggest brains in science are working on.

(1) Stronger, lighter materials. Lighter planes need less energy to get off the ground. For years, engineers have been working to lighten the load in order to improve traditional planes’ fuel efficiency. For a large electric plane to work, materials will need to continue to get lighter and stronger.

One material under development is graphene. It’s a version of carbon that’s only one atom thick, but many times stronger than a carbon fiber. While some scientists doubt the ability to use graphene on a large scale, Sir Richard Branson hopes the material can be used in planes 10 years from now, according to a 4/6/17 article in The Telegraph.

MIT researchers fused flakes of graphene to create a 3-D, sponge-like material with a density of 5%, but with the strength 10 times that of steel, according to 3/1/17 item in TechBriefs.com. The new material was made using a high-resolution, multimaterial 3-D printer.

Boeing scientists have been working on the microlattice, which it calls “The Lightest Metal Ever.” Work on the material dates back to 2007, but the company recently put out this video in 2015. Described as a 3-D, open cellular structure, microlattice is made of 99.99% air. It’s both lightweight and excellent at absorbing forces. Boeing has been looking to use microlattice in items in the cabin, like overhead bins or in the floor to make them lighter.

A 10/15/15 article in Phys.org explained how Boeing made the microlattice: In a 2011 research paper “the researchers described making the material first by creating a template and then by coating it with electroless nickel plating—afterwards the template was removed via etching. The result was a material that got its strength from the lattice, similar to the way bones grow to be strong despite being light, though with the lattice it is taken down to the micro scale—the lattice was a network of extremely tiny tubes with walls that had a thickness of just 100 nanometers, all made of a nickel-phosphorus alloy, though it is still not clear if the same materials were used in the newly updated microlattice.”

NASA and General Electric are partnering to develop a new inverter that uses GE’s silicon Carbide, which works at high temperatures and is lightweight. Inverters change the direct current of batteries into the alternating current for a plane’s propulsion system. Existing inverters are big and heavy. The new NASA/GE inverter will have more power density and is small enough to work on an electric plane.

“We're essentially packing 1 MW of power into the size of a compact suitcase that will convert enough electric power to enable hybrid-electric propulsion architectures for commercial airplanes," said Konrad Weeber, Chief Engineer of Electric Power at GE Research in a 9/25 ZDNet article. “The next step is to build and demonstrate one that is altitude ready."

(2) Better batteries. Developing batteries powerful enough but light enough to be used in an aircraft will be key if large electric planes are to takeoff. Boeing and Safran announced a joint investment in Electric Power Systems (EPS), a private company that’s developing aviation-grade energy storage systems, according to a 9/18 press release. EPS developed an 850-pound lithium-ion battery pack used on NASA’s X-57 Maxwell, an electric plane with many engines on its wings, according Spinoff 2019, a NASA publication. The X-57 is expected to make its first electric flight this year.

Boeing also invested in Cuberg, an advanced lithium metal battery technology company in 2018. Cuberg claims to have invented a battery that’s less flammable and can produce roughly twice as much energy as a lithium battery that weighs roughly the same amount.

Rolls-Royce says it has built the most powerful battery ever for an electric plane. It’s hoping to use that battery in a plane that can break the current speed record of 210 miles per hour, set by an electric Siemens plane in 2017. A B787 Dreamliner with a traditional combustion engine travels about 560 mph and the Rolls-Royce plane dubbed ACCEL (Accelerating the Electrification of Flight) aims to travel 300 mph next year, a 9/7 article in Globtrender reported.

“We believe that pure electric, or all-electric, propulsion will power smaller aircraft in the foreseeable future, while larger aircraft will rely upon hybrid electric solutions that combine electrification with evolutions of the gas turbine,” Paul Stein CTO at Rolls-Royce, according to a 6/19 article in The Manufacturer. The company agreed to acquire Siemens’ eAircraft business, where employees are developing all-electric and hybrid propulsion systems.

Before electric planes become widely deployed, manufacturers will have to overcome the long time it takes to charge a battery. Zap&Go is working on a battery made of materials other than lithium and cobalt, to reduce the flammability of the battery, while increasing how quickly it can be charged. Its electric battery has Carbon-Ion (or C-ion) cells. The battery charges up in roughly five minutes and has 20-30 years of operational life, so the total cost of ownership is far lower than lithium batteries. The battery can also be recycled, the company’s website explains.

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Lead Weights

October 16 (Wednesday)

US Economy: GM & Boeing. We’ve been asked a few times recently whether the strike at GM and the strike-out of Boeing’s 737 MAX jet are weighing on the economy. In March 2019, aviation authorities and airlines around the world grounded the Boeing 737 MAX passenger airliner after a second MAX 8 aircraft crashed, killing everyone on board. Boeing hasn’t shipped any since then and may not start doing so until early next year.

GM’s strike began on 9/15 with the walkout of 48,000 United Automobile Workers from some 50 plants in the US. Demands by workers include better pay, better healthcare benefits, and increased job security.

US manufacturing indicators have been weakening since early last year, suggesting that most of the sector’s woes are attributable to Trump’s escalating trade wars since then. Nevertheless, it’s very likely that the strike and strike-out also have been weighing down manufacturing—both directly, as output from both companies has been depressed, and indirectly, as vendors to both have seen their business drop too.

Estimating the total impact of the two lead weights is hard to do, especially since GM’s strike is too recent to show up in the data. Let’s have a closer look at the relevant and available stats:

(1) Industrial production. Manufacturing output in industrial production fell 0.5% y/y during August (Fig. 1). It’s down from a recent peak of 3.5% during last September. This series tends to be highly correlated with the comparable growth rate in the goods component of real GDP, which was up 4.8% y/y during Q2-2019.

On a three-month annualized basis, manufacturing output actually rose 1.2% through August (Fig. 2). That followed five consecutive negative readings for this series from March-July. So it’s possible that Boeing’s troubles contributed to a one-shot drop in factory production over that five-month period.

In the Fed’s industrial production report, there is a category for “Aerospace and miscellaneous transportation equipment.” It shows little change from March through August, slipping just 0.5% over the period (Fig. 3).

In the Fed’s report, there is also a series for assemblies of autos and light trucks (Fig. 4). However, the data is only through August.

(2) Shipments. Another source on manufacturing is the Census Bureau’s Monthly Advance Report on Manufacturers’ Shipments, Inventories and Orders. It is limited to durable goods orders and shipments. It has a category for nondefense aircraft and parts shipments. It is a volatile series. It was down 30.2% y/y during August (Fig. 5). From March through August, it fell 29.7%. It’s actually relatively small, currently accounting for 4% of total durable goods shipments (Fig. 6).

The report also has an item for motor vehicles and parts, which accounts for 24% of durable goods shipments. It was up 3.9% y/y through August, just before the GM strike (Fig. 7).

It’s likely that Boeing’s production problem with the MAX spilled over to shipments of primary metals and fabricated metal products. The former was down 6.8% y/y, while the latter was up 2.4% during August (Fig. 8). GM’s strike should weigh on both up ahead, depending on how long it lasts.

(3) Purchasing managers. The manufacturing sector’s PMI has also been weakening since late last year. It was down to 47.8 during September from a recent high of 60.8 during August 2018 (Fig. 9). This series tends to be a very good leading indicator for the growth rate of nondefense capital goods shipments excluding aircraft (which was up only 1.4% y/y during August).

The new orders component of the M-PMI was down to 47.3 during September from a recent peak of 67.3 at the end of 2017. It is a good leading indicator for the growth rate in durable goods orders (which was down 3.0% y/y during August) (Fig. 10).

In September’s M-PMI report, neither Boeing nor GM was mentioned as trouble spots. Instead, of the 18 manufacturing industries, only three reported growth in September.

(4) Bottom line. The available data through August and September suggest that US manufacturing is in a fairly widespread growth recession. The slowdown in global economic growth is probably the main cause of this soft patch, as evidenced by weak manufacturing data around the world. The recent truce in the US-China trade war could help to revive growth, as could the latest rounds of stimulus from the ECB and the Fed.

China: Inflation, Deflation & Freight. Trump’s trade war has been weighing on China’s economy. That’s on top of homegrown problems that are depressing the nation’s economic growth, specifically an increasingly geriatric demographic profile and too much debt.

The latest weak indicator was September’s PPI, which was down 1.2% y/y (Fig. 11). Trump’s tariffs may be forcing China’s exporters to lower their prices on goods shipped to the US to stay competitive. The US import price index for China (which does not include tariffs) fell 1.8% y/y during September. China’s deflating PPI spells trouble for the profitability of Chinese manufacturers.

There’s more trouble for consumers evident in China’s CPI, which was up 3.0% y/y during September. That’s the highest consumer inflation rate since November 2013. It’s been moving higher on soaring pork prices resulting from the swine flu epidemic. The CPI for meat, poultry, and related products is up 46.9% y/y (Fig. 12). The good news is that excluding food, the CPI was up only 1.0% y/y during September, the lowest pace since March 2016 (Fig. 13).

Also good news for China is that the 12-month average of railways freight traffic rose to yet another record high during August, even though the sum of exports plus imports has stalled at a record high since late last year (Fig. 14).

The Fed: Keeping the Boat Afloat. The Minutes of the Federal Open Market Committee (FOMC), released last Wednesday and covering the 9/17-18 meeting, seemed a bit more stale than usual, especially given how quickly geopolitical events are moving these days. Participants focused mostly on the reasons for the decision to cut rates another 25bps during September to a range of 1.75%-2.00%.

Not much of a sense of where rates are headed was discussed. Several participants suggested that more clarity should be provided to the markets about “when the recalibration of the level of the policy rate in response to trade uncertainty would likely come to an end.” What’s more, a “few” participants thought that financial markets’ expectations for the path of the federal funds rate “were currently suggesting greater provision of accommodation at coming meetings than they saw as appropriate.”

From what Melissa and I can gather, the Fed may have less reason and less room to cut rates again in the near term. The FOMC meets again two more times this year, on 10/29-30 and 12/10-11. Officials may be able to justify one more cut in October along with a signal that there won’t be any more cuts for now unless incoming US economic data markedly sours.

In fresh remarks last week, Fed Chair Powell said that the expansion feels “very sustainable.” He added: “Clearly things are slowing a bit,” but US economic growth “may just be gathering itself.”

Consider the following:

(1) Geopolitics. The Fed may have less reason to cut rates further on the basis of geopolitical uncertainties at the next meeting than they did at the previous one. Global risk factors that could impact the path of policy noted in the Minutes included trade tensions between the US and China, political tensions in Hong Kong, uncertainties related to Brexit, and escalating tensions related to the attacks on Saudi oil facilities.

Not all these hot issues have been fully resolved over the month since the meeting, but they have cooled some. The US and China seem to have reached a trade truce. Intense talks between the EU and the UK regarding a possible Brexit deal are happening now. If no deal materializes soon, then the Brexit deadline may be extended. Tensions remain in the Middle East, but at least Saudi Arabia’s full oil production capacity should be recovered soon.

But global uncertainties seem to change by the day. If they escalate again, weighing on domestic business investment and manufacturing output, the Fed might see cause to more aggressively cut rates.

(2) Inflation. Persistently low inflation despite historically low interest rates continues to be one of the biggest challenges for FOMC officials. However, in the Minutes, meeting participants noted a recent firming in the incoming data. To describe the low state of inflation, some participants used the word “transitory,” a word that received a lot of attention after Fed Chair Powell used it during his 5/1 press conference.

From then until now, it seemed that officials had backed away from suggesting that below 2.0% target PCED inflation might be temporary. But the September meeting Minutes stated that participants agreed that inflation would move up to the Committee’s objective over the medium term under the appropriate policy.

(3) ELB. There really is not much room to cut rates from here. The federal funds rate is about eight 25bps rate cuts away from zero even though the US economy is in a generally stable growth environment. The first section of the Minutes indicated a concern among members about what could be done in the event of a downturn with perpetually low inflation despite a near zero-policy rate, also referred to as the “effective lower bound” (ELB).

The Fed’s policy-setting committee discussed going to a more aggressive balance-sheet policy, allowing the balance sheet to expand, in the event of a downturn. That suggests to us that the Fed may not be so keen on turning to negative interest rates in hard times, favoring instead a return to quantitative easing (QE) to stimulate the economy, especially at the point of the ELB.

Officials also discussed using inflation “makeup” strategies, which would keep rates accommodative for longer, allowing inflation to temporarily overshoot the target. The Fed has been debating this for some time now without any signs of implementing it. Some officials see these strategies as difficult to commit to and communicate, presenting a credibility challenge. Some also see possible financial stability risks as an outcome.

(4) SEP. The Summary of Economic Projections (SEP) accompanying the Minutes did not provide much in the way of forward-looking clues. Projections did not change much from the June meeting except for the federal funds rate. It was lowered to 1.9% from 2.4% for 2019, reflecting the latest rate adjustment. While the projection for 2020 was lowered from 2.1%, it was held at the same rate as projected for 2019, or 1.9%, indicating no further rate moves into next year. Further out, rates are projected to increase to 2.1%, 2.4%, and 2.5% in 2021, 2022, and over the longer run, respectively.

Looking at the Fed’s dot plot, most Fed forecasters expect rates either to stay put or be hiked. We don’t know which dots belong to whom nor which represent voters on the FOMC this year. But it’s notable that of the 17 forecasting officials, five project keeping rates as is and five project a rate increase (for a total of ten that prefer not to cut) while seven project a cut by the end of the year.

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Earnings Season’s Greetings

October 15 (Tuesday)

Strategy I: The Squiggles Story. The Q3 earnings reporting season has started. Industry analysts’ estimates for the S&P 500 operating earnings per share plunged 8.7% from $44.85 at the end of last year to $40.93 during the 10/10 week (Fig. 1). As a result, the y/y growth rate in the consensus estimate for Q3 plummeted from 5.1% at the end of last year to -4.1% (Fig. 2).

It’s not unusual to see such downward revisions since industry analysts tend to be too optimistic about the future and become more realistic as the actual results approach during earnings-reporting seasons. Oddly, they tend to overshoot on the pessimistic side in the weeks before earnings seasons. That, in turn, means that there is often an earnings “hook” to the upside as actual results beat expectations.

Joe and I have weekly “earnings squiggles” data going back to Q1-1994. Of the 98 quarters since then through Q2-2019, there have been 77 such hooks by our count. (See S&P 500 Earnings Squiggles Annual & Quarterly.)

In addition to tracking the consensus earnings “squiggles” for each quarter, Joe and I do the same for the annual consensus earnings squiggles on a monthly basis (Fig. 3 and Fig. 4). They rarely show hooks, but they do confirm that analysts have an optimistic bias that gradually diminishes as each year progresses until their estimates converge with the actual annual results for S&P 500 companies.

Our monthly data for the annual squiggles start in 1980, spanning 25 months from February to February. Of the 39 years since then through 2018, we count 30 years with descending squiggles averaging -17.8%. The 9 ascending ones, averaging 7.0%, tended to occur following recessions. Even optimistically inclined analysts tend to turn pessimistic during recessions. That sets the squiggles up for upside surprises during recoveries (Fig. 5).

Now let’s focus on the weekly data for the annual squiggles (Fig. 6). For the 10/10 week, they show that industry analysts expect that earnings per share will be up 0.8% y/y to $163.27 this year, up 11.2% to $181.53 next year, and up 9.2% to $198.23 in 2021. That puts S&P 500 forward earnings at a record high of $177.67 during the 10/10 week.

Strategy II: Mixed Fundamentals. An earnings hook could turn the actual Q3 earnings growth rate positive but not by much, since the underlying economic fundamentals are mixed for the major S&P 500 sectors. Consider the following fundamentals that should be relevant to the Q3 earnings-reporting season:

(1) Global revenues. By some estimates, about 30%-40% of S&P 500 revenues come from overseas. During their upcoming conference calls, the managements of companies that report disappointing results are likely to blame slower global growth, the tariff wars, and the strong dollar.

The y/y growth rate of S&P 500 revenues per share is highly correlated with the comparable growth rates in world industrial production (excluding construction) and in the volume of world exports (Fig. 7 and Fig. 8). July data show that the former was up just 0.8%, while the latter was down 0.4%.

Keep in mind that both the production and exports series are “real” variables, while revenues are in nominal dollars. In any event, revenues per share rose 5.2% during Q2 even as global growth was slowing. Furthermore, as we observed yesterday, the weekly S&P 500 forward revenues series, which is a great coincident indicator of the actual quarterly revenues, rose to a record high during the 10/3 week.

Trump’s trade wars, particularly with China, have weighed on the global economy. For example, the y/y growth rate in the sum of the 12-month moving averages of Chinese exports (in yuan) to the US, Eurozone, UK, Japan, South Korea, and Australia was -0.2% during July (Fig. 9). Slower global growth and the trade wars have depressed the growth rate of US merchandise exports as well (down 0.1% during August), which are highly correlated with the growth rate in S&P 500 revenues per share (Fig. 10).

Also, revenues from abroad are getting clipped a bit by the strength of the trade-weighted dollar. It is up 2.3% y/y through early October (Fig. 11).

(2) Consumers. The good news for consumer-related stocks is that Americans are still doing what they do best; they are going shopping. Their purchasing power continues to rise along with payroll employment and inflation-adjusted wages.

Our Earned Income proxy for private-sector wages and salaries was up 4.2% y/y through September (Fig. 12). Retail sales rose 4.1% through August. The problem is that retailing is very competitive with narrow profit margins, especially as online shopping has become so popular. Online sales accounted for a record 35.0% of GAFO sales during July, up from 31.7% a year ago and 23.8% five years ago (Fig. 13).

On our website, we automatically update Industry Indicators: Retail. It shows forward earnings and forward revenues rising to record highs in the following S&P 500 retailing industries: General Merchandise Stores, Home Improvement, Motor Vehicle Parts & Dealers, Electronic Shopping & Mail Order Houses, and Restaurants. The same can be said for the Consumer Discretionary sector.

Also showing strength has been the S&P 500 Homebuilding Index (up 47.4% ytd), which is highly correlated with the National Association of Homebuilders Index (Fig. 14). The latter is up from a recent low of 56 at the end of last year to 68 in September.

(3) Industrials & Technology. It’s a mixed picture for the S&P 500 Industrials and Information Technology sectors. Shipments of durable goods slipped below zero (-0.3%) on a y/y basis for the first time since November 2016 during August (Fig. 15). Here is the performance derby for some of the major shipments categories through August: communications equipment & related parts (9.8%), defense (6.7), motor vehicles & parts (3.7), fabricated metals (2.4), electrical equipment, appliances & components (2.4), computers and related parts (2.1), machinery (1.6), nondefense capital goods excluding aircraft (1.4), primary metals (-6.9), and nondefense aircraft and parts (-30.2).

Worldwide semiconductor sales were down 16% y/y during August, though they have edged up over the past two months (Fig. 16). The forward earnings of the S&P 500 Semiconductors industry has been falling since early this year.

US industrial production rose just 0.4% y/y through August. Here is the performance derby for some of the major industries included in business equipment: communications equipment (8.1%), information processing (5.0), semiconductors & other electronics (0.7), industrial & other equipment (-0.4), transit (-2.1), and computer & peripherals (-2.5).

(4) Railroads & Trucking. Here is some bad news for S&P 500 Railroads: Not a pretty picture is the y/y growth rate in railcar loadings of intermodal containers (using the 26-week moving average) (Fig. 17). It is down 4.7% through the 10/5 week. This series is highly correlated with the growth rate of the sum of inflation-adjusted US exports and imports. Total rail car loadings are down 5.1% y/y and are also highly correlated with S&P 500 revenues (Fig. 18).

On the other hand, the news is mixed for S&P 500 Trucking. The ATA truck tonnage index remained in record-high territory during August. The three-month average is up 3.8% y/y. Then again, the PPI for truck transportation of freight was down to -0.2% y/y from a recent high of 8.2% last October.

(5) Financials. First, the good news for S&P 500 Diversified Banks: Commercial and industrial loans at commercial banks rose 5.1% y/y through the 10/2 week. In addition, mortgage applications to purchase a home increased 11.8% y/y through the 10/4 week. On the other hand, the yield curve remains flat, which may be putting some downward pressure on net interest margins.

The S&P 500 Brokerage and Investment Banking industry is facing some challenges up ahead. In addition, the IPO market has recently turned less welcoming to companies with no earnings, and a price war has broken out among discount brokers. These last two developments may be issues for Q4 earnings rather than Q3.

(6) Energy & Materials. Upside surprises among commodity producers in the S&P 500 Energy and Materials sectors are unlikely for Q3. The price of a barrel of Brent crude oil is down 27.0% on a y/y basis. The CRB raw industrials spot price index is down 9.5% y/y.

Strategy III: Q3 Sectors Estimates. I asked Joe for the latest Q3 earnings and revenues consensus estimates for the 11 sectors of the S&P 500. Here they are: S&P 500 (3.5%, -4.1%), Communication Services (9.8, -1.0), Consumer Discretionary (5.4, 0.7), Consumer Staples (3.4, 0.1), Energy (-6.1, -34.3), Financials (-1.0, 1.2), Health Care (12.8, 2.5), Industrials (0.3, 1.0), Information Technology (-0.4, -7.6), Materials (3.7, -11.2), Real Estate (3.7, 2.7), and Utilities (6.6, 2.2).

It’s a mixed picture, for sure, with revenues growth ranging between 9.8% and -6.1% for the 11 sectors. The range for earnings is 2.7% to -34.3%.

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Below the Headlines

October 14 (Monday)

Strategy I: Head-Spinning Headlines. The stock market has been spinning its wheels since early 2018 when the S&P 500 rose to a record high of 2872.87 on 1/26/18 (Fig. 1 and Fig. 2). That has been the view of the bears. During the summer of this year, they observed that this stock price index had fallen back below that high.

Along the way, though, it made new record highs of 2930.75 on 9/20/18 and 2945.83 on 4/30/19. The most recent record high at 3025.86 was achieved on 7/26/19. On Friday, the S&P 500 closed at 2970.27, just 1.8% below that high. It still looks like a classic bull market to Joe and me, with higher highs since early 2018 and higher lows since the panic selloff late last year.

Much of the wheel-spinning since early 2018 is attributable to head-spinning headlines, mostly related to President Donald Trump. For investors, the question isn’t whether he is a good man or a bad man, which has preoccupied the media on the Right and the Left. For investors, the question is whether he is bullish or bearish for the stock market.

The answer is “YES”: Trump has been simultaneously the most bullish and the most bearish president of all times. His policies of deregulation and tax cuts have been bullish and drove the S&P 500 to its high early last year. Since then, his escalating trade wars have been bearish at times when progress toward resolution has seemed to be floundering and bullish when progress seemed to be advancing—i.e., when Trump responded to market selloffs by tweeting that progress is being made in the various trade negotiations. The result has been lots of wheel-spinning action.

On balance, Trump has been bullish for stocks since the day he was elected. Here is the performance derby of the S&P 500 and its 11 sectors since 11/8/16 through Friday’s close: Information Technology (79.1%), Consumer Discretionary (51.2), S&P 500 (38.8), Financials (38.5), Utilities (30.1), Health Care (31.8), Real Estate (29.2), Industrials (28.8), Materials (21.3), Consumer Staples (15.5), Communication Services (7.5), and Energy (-16.2) (Fig. 3).

US stocks have also done well on a global basis as Trump’s trade wars weighed more on overseas stock markets in economies that depend more on exporting to the US than the US depends on exporting to them. Here is the performance derby of the major MSCI stock price indexes since Election Day in dollars and in local currencies: US (38.8%), EMU (18.2, 18.3), Japan (13.7, 17.8), Emerging Markets (12.1, 16.5), and UK (6.9, 4.6) (Fig. 4). Our Stay Home investment strategy (as opposed to Go Global) has worked well so far under Trump.

Contributing to the market’s wheel-spinning has been the escalating political wars in Washington, DC as Democrats have been aiming to impeach Trump. He dodged the Mueller Report bullet: He didn’t collude with the Russians to win the election. Now the question is whether he committed an impeachable offense when he asked the Ukrainian president to investigate his political rival, former Vice President Joe Biden. Friday morning, former Trump adviser Steve Bannon opined on CNBC that Biden would self-destruct anyway, and that former presidential contender Hillary Clinton or former NYC mayor Michael Bloomberg might jump into the race, countering Senator Elizabeth Warren’s (D, MA) presidential bid and possibly defeat Trump.

Meanwhile, in the UK, Prime Minister Boris Johnson seemed to be making some progress in negotiating a soft Brexit with the European Union at the end of last week. The S&P 500 fell 1.6% last Tuesday as the headlines suggested that Trump was expanding his trade war with China. It has risen 2.7% since then on his tweets that a partial deal might be imminent. Sure enough, an outline of the deal emerged before Friday’s close:

(1) The Dow gave up 200 of its 500-point gain in the final half hour as investors realized that it was more of a truce than a peace treaty. There was a cessation of tariff hikes but no clear timeline for removal of the existing tariffs. The US won’t increase tariffs on $250 billion in annual Chinese imports from 25% to 30% that had been scheduled for this week.

(2) China agreed to buy $40 billion to $50 billion in American farm products, though the timeframe wasn’t specified. Trump touted it as a “substantial phase one deal,” but the details still need to be ironed out over the next few weeks. Chinese state media said the two sides made “substantive progress” on a range of issues including agriculture but didn’t mention potential Chinese purchases.

(3) So it is more of a mini-deal than a big deal. However, investors are relieved that Trump isn’t likely to escalate America’s trade war with China for now. The WSJ reported: “The planned tariff increases in December on electronics, apparel and other imported consumer goods—a big uncertainty for many U.S. firms—haven’t been shelved so far, Mr. Trump’s trade adviser, Robert Lighthizer, said in the Oval Office.”

Strategy II: The Earnings Story. This is all head-spinning stuff, for sure. Yet here we are within sight of yet another new record high for the S&P 500. Why?

Well, below the manic-depressive headlines, industry analysts are remaining calm and continue to report that S&P 500 companies are doing well. S&P 500 forward revenues per share rose to yet another record high during the 10/3 week (Fig. 5). As we have often observed, this weekly series is highly correlated with the actual quarterly revenues of the S&P 500, which also rose to a fresh record high during Q2. The weekly series suggests that the quarterly series may have hit a new record high again during Q3.

Forward earnings also has been edging higher in record territory in recent weeks, and the forward profit margin has been flat nearly all year at around 12.0%. Forward revenues are trending higher among of the 11 sectors of the S&P 500, with the laggards being Materials and Utilities (Fig. 6).

So despite the depressing headline news about the slowing global economy, S&P 500 companies still are finding more revenues. Despite the headlines warning about rising labor and tariff costs, the forward profit margin implied by analysts’ forward revenues and earnings estimates remains flat in record-high territory. It has yet to revert to the mean as the bears have been forecasting it would for many years now. Now let’s have a closer look at the profit margins of the S&P 500 sectors.

Strategy III: The Margins Story. In the decade since the Great Recession, S&P 500’s profits and margins have more than recovered—they’ve displayed impressive resilience in the face of slowing global growth, rising tariffs, and a tightening labor market. The S&P 500 forward profit margin based on forward earnings and forward revenues estimates is 12.0%, close to its record high of 12.4% hit on 9/13/18 (Fig. 7).

It got a nice boost of about 1.1ppts in the first half of 2018 from the Trump administration’s tax cuts. But even before those cuts, the profit margin had been moving higher. It climbed past its 2007 peak of 10.5% by May 2014 and kept improving. The margin went sideways during the energy-related economic slowdown of 2015 and 2016, then climbed to another record high of 10.9% during Q4-2017, just before the tax cuts boosted it again.

Let’s take a closer look at the margin story:

(1) Information Technology. Information Technology is the S&P 500 sector with the highest forward profit margin, at 21.5%—wide relative to both the S&P 500 broadly and the sector’s own history (Fig. 8). The Tech sector’s forward margin was only 13.8% in 2007 before it collapsed in the recession. The Tech sector is chock full of industries with wide forward profit margins including Systems Software (29.2%), Data Processing & Outsourcing (28.5), Semiconductors (27.7), Communications Equipment (25.0), and Application Software (23.5) (Fig. 9 and Fig. 10).

Notably, Systems Software, the Tech industry with the widest margin, has traditionally had margins ranging between 25%-30%. Data Processing & Outsourcing, however, has seen its operating margin almost triple in the past decade. And the Communications Equipment industry’s profit margin has jumped to 25% from 15% in 2006.

(2) Communication Services. The S&P 500 Communication Services sector, after being reconfigured in September 2018 with growthy stocks from the Internet and media industries, saw its forward profit margin jump. In 2012 its forward profit margin was 6.4%, 3.6ppts below the S&P 500’s profit margin. Now the margin has widened to 15.1%, 3.1ppts above the S&P 500’s profit margin (Fig. 11).

(3) Financials. Despite the low-interest-rate environment, the S&P 500 Financials sector’s forward profit margin has returned to heights last seen before the Great Recession. Imagine what the sector’s margins and shares could do if the yield curve ever steepened. At 18.3%, the industry’s profit margin has had a resurgence from 2009, when it wallowed in the single digits during the recession (Fig. 12). Among the Financials industries with the highest profit margins are: Financial Exchanges & Data (39.8%), Diversified Banks (27.4) and Regional Banks (26.1), Asset Management & Custody Banks (24.6), and Investment Banking & Brokerage (23.3) (Fig. 13 and Fig. 14).

(4) Energy and Health Care. The S&P 500 Energy and Health Care sectors at one time traded with a forward profit margin approximating the S&P 500’s. But in recent years, the sectors’ forward profit margins have shrunk relative to the broader index. The S&P 500 Energy sector has a forward profit margin of 6.8%, almost half that of the broader index (Fig. 15). The Health Care sector has a forward profit margin of 10.6%, well below the S&P 500’s; that’s quite a reversal from the higher margin relative to the S&P 500’s that Health Care maintained from 2006 through 2011 (Fig. 16).

(5) Consumer Discretionary and Consumer Staples. For a number of sectors, profit margins haven’t expanded sharply through this bull market. The Consumer Discretionary sector has a forward profit margin of 7.5%, below that of the S&P 500 and not far from where it stood when the stock market began to recover in 2011 (Fig. 17). The same goes for Consumer Staples, which has had a similar forward profit margin (7.4%) for the past decade (Fig. 18).

(6) Industrials and Materials. Given the US-China trade war, it’s surprising that the Industrials and Materials sectors’ forward profit margins have held up as well as they have. The Industrials’ profit margin, at 10.4%, is right near its high of the last decade (Fig. 19). The one industry within Industrials that has seen its profit margin surge over the last decade is Railroads, which has a profit margin of 28.3%, almost triple its 2006 level (Fig. 20).

The Materials sector’s forward profit margin has fallen from a high of 11.6% in 2018 to a recent 10.2%, but that’s still not far from the highest levels of the past decade (Fig. 21).

Movie. “Joker” (+ + +) (link) is a very disturbing movie about a very disturbed man, Arthur Fleck, played brilliantly by Joaquin Phoenix. It is about the formative years of Batman’s arch enemy. But it’s really much more than that. Like “Natural Born Killers” and “Network,” it is a searing examination of numerous destructive forces in our society including the arrogance of the ruling class, the decline of civility, and the media’s obsession with ratings at any price. Mostly though, it is about the awful consequences of mental illness when it isn’t properly diagnosed and treated. Fleck is on several drugs for his psychiatric disorder. His psychiatrist tells him that because of budget cuts in public assistance, she can no longer see him, leading him to ask how he will continue to get his medications. Early in the movie, he asks her: “Is it me, or is it getting crazier out there?” The movie leaves it up to us to decide. Hint: It’s easy to feel sorry for this Joker.

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Flygskam

October 10 (Thursday)

Airlines and Hospitality: Flying into Headwinds. Is flying becoming as shameful as wearing a fur coat? Environmentalists want us to think good and hard before booking a flight and supporting its emissions into the atmosphere. Flight-shaming is a change in attitude that’s much more prevalent in Europe than the US. Not even Prince Harry is spared; he faced critical headlines after flying in a private jet.

We’re not here to debate flight-shaming but to look at its potential effects on the airlines and the travel industry. Unfortunately, the travel industry is facing other headwinds concurrently. Hotels and resorts are absorbing added labor expense owing to many states’ minimum wage hikes. And tourism to the US is down because of the strong dollar and the US/China trade war.

The shares of many travel-related stocks have tumbled from their highs this summer. The S&P 500 Hotels, Resorts & Cruise Lines stock price index rose 27.4% from 12/31 through its peak on 5/3. Since then, the index has fallen 16.7%, leaving it up just 6.2% ytd through Tuesday’s close. If the three negative trends continue to batter the industry, there certainly could be more downside because the industry’s stock price index is up 67.5% since its low in 2016 (Fig. 1). Meanwhile, the S&P 500 Airlines stock price index has been trading in a sideways channel for much of the past three years (Fig. 2).

I asked Jackie to look at whether the airlines and hospitality industry will be grounded by these diverse headwinds or can still take flight. Buckle up:

(1) The shame of flying. Prince Harry is about as environmentally woke as they come. But the British royal was dubbed a hypocrite for decrying the ills of climate change yet also taking a private plane to Ibiza for his wife’s birthday and another to Google’s climate change summit in Sicily. The backlash was surprising to this American reader. But in Europe, the environmental impact of flying gets far more attention than in the US—not just from environmentalists but lawmakers and corporations too.

A 9/26 Bloomberg Businessweek article reported: “[C]ompanies across Europe are reconsidering travel policies, and individuals are asking whether jetting off to sunny spots for holidays is worth the environmental cost. The Swedes even have a name for it: flygskam, or flight shame, and it’s a growing threat to airlines in Europe and beyond. SAS AB says its traffic fell 2% in the nine months ended July 30 from the year-earlier period, and Sweden’s airport operator has handled 9% fewer passengers for domestic flights this year than last. Both say flygskam has played a role in declining traffic.”

Beyond Sweden, there’s a proposed ban on intra-country flights in France and revived interest in rail travel, which is environmentally more benign than flying, throughout Europe. Austria’s state railway has seen increased demand for its overnight trains, and Germany aims to cut taxes on train travel and boost them on air travel. European companies are cutting their use of plane travel to meet their carbon-reduction goals as well.

Again from the Bloomberg Businessweek article: “Finland’s Nordea Bank Oyj aims to trim flights 7% this year and plans internal carbon fees to meet that goal. German broadcaster Tele 5 in June said it will no longer pay for domestic flights for its 60 employees. Consulting company PwC and Switzerland’s Zurich Insurance Group AG say they want to reduce carbon emissions per employee by a third or more from 2007 levels, mostly by cutting back on flights.”

Americans don’t have a strong rail alternative as the Europeans do, so encouraging our behaviors to change will be difficult. However, businesses can conduct more meetings via video-conferencing.

(2) Paying up. Hospitality employs many entry-level workers, so it may be disproportionately affected by increases to the minimum wage. The minimum wage was increased in 21 states and Washington DC over the past year, according to a nifty graphic on the Economic Policy Institute’s website.

Some of the country’s largest states have been wage-hiking. In New York, the minimum has been increased to $11.10 an hour from $10.40 and is going to $11.80 at year-end 2019 and $12.50 at year-end 2020. At the start of this year, Florida’s minimum wage was upped to $8.46 from $8.25 and California’s popped to $12.00 from $11.00; it will be raised by another $1.00 in each of the next three years. Conversely, Texas and Pennsylvania laws set the states’ minimum wages to equal the federal minimum wage of $7.25. However, actual wages paid are typically far higher and set by market forces in today’s tight job market.

Rising wages may help explain why the S&P 500 Hotels, Resorts & Cruise Lines’ projected profit margin has fallen this year to 12.9% from its peak of 13.5% on 3/7 (Fig. 3). The S&P 500 Airlines’ projected profit margin has remained relatively steady in recent years and is currently 8.0% (Fig. 4).

(3) International travelers go elsewhere. The US/China trade war and the strong dollar together have dented demand for travel to the US. While domestic travel rose 3.8% in July and 3.4% in August, international travel to the US contracted in July by 1.2% and was flat in August. The Leading Travel Index projects international inbound travel “vulnerability is likely to continue and may worsen,” according to the US Travel Association’s August report.

The industry association predicts that the US’s share of global long-haul travel will fall from its current 11.7% to below 10.9% in 2022. It attributes the decline to the strong dollar, trade tensions, and competition from other countries for tourism business.

The weakness is confirmed by Las Vegas’s flight statistics. In August, arriving and departing passengers at Las Vegas’s McCarran airport were up for domestic travelers by 3.7% but down 3.1% for international travelers, according to a 9/25 press release.

(4) Optimism still flying high. Despite these headwinds, analysts remain relatively optimistic about the fortunes of travel-related companies. The S&P 500 Airlines industry is expected to grow revenue by 4.3% this year and 5.2% in 2020 (Fig. 5). Net earnings revisions for the industry have been positive, leaving estimates for earnings growth at 17.9% this year and 10.4% in 2020 (Fig. 6). The cyclical industry’s forward P/E is 8.0, close to the industry’s historical lows (Fig. 7).

On Tuesday, investors were cheered by news that American Airlines Group expects Q3 total revenue per available seat mile to increase 1.5%-2.5% despite the impact of Hurricane Dorian. The prior range was 1.0%-3.0%. In addition, Goldman Sachs upped its price target on United Continental to $128 from $114.

Meanwhile, the S&P 500 Hotels, Resorts & Cruise Lines industry’s revenue growth is forecast at 6.3% this year and 6.3% again in 2020 (Fig. 8). Net earnings revisions have been negative over the past three months, leaving this year’s earnings growth at 6.8% and 2020’s at 10.5% (Fig. 9). The industry’s forward P/E has fallen to 14.0, down from 19.6 in January 2018 (Fig. 10).

(5) Can flight be electrified? A handful of companies is working on electrifying planes to make flying greener and less shameful. About 45% of global flights are under 500 miles, which is within the range of an electric plane, according to a 8/20 article on GreenBiz. The article highlights six companies developing electric planes.

Eviation has a nine-seat, battery-powered, electric aircraft dubbed “Alice,” which can fly 650 miles at 276 miles per hour at an operating cost of $165 per hour. One potential hurdle: The battery takes two to three hours to charge, far longer than it takes to fill a tank with liquid fuel. The company is aiming for Federal Aviation Administration certification by late 2021.

Pipstrel, a light aircraft manufacturer in Slovenia, introduced its first electric plane in 2007 and more recently designed the ALPHA Electro, an electric, two-passenger plane that it claims is more affordable to maintain than a traditional plane. It’s targeting the flight-training industry, as the plane can take off and land in short distances and has “endurance of one hour plus reserve,” according to the company’s website. The battery charges fully in an hour, and it costs only roughly $5 to operate the plane for an hour.

Bye Aerospace is an American company that’s also developing a plane for the training market. And Ampaire has retrofitted a six-seat Cessna 337 Skymaster with one conventional combustion engine and one electric motor powered by a battery; its range is approximately 200 miles.

NASA is testing the X-57 Maxwell, an electric aircraft with 12 small motors on its wing. The smaller engines provide additional lift for takeoff and landing, and their propellers fold away during flight to reduce drag. The hope is to improve the plane’s fuel efficiency by 500%, a 10/9 Vox article reported.

Disruptive Technologies: Machines’ Best Friend. The interaction between man and machine is reaching new heights. Handicapped humans are learning to use their minds to manipulate exoskeletons to give them mobility. The US Army is looking into using exoskeletons to enhance the power of soldiers. And our favorite example is the individual flying suit that Gravity Industries is developing. Machines are letting man achieve what was not previously possible. Let’s take a look:

(1) Brain power. In a breakthrough study, a 28-year-old who was paralyzed from the shoulders down, with only some movement in his biceps and left wrist, was able to use his thoughts to control an exoskeleton that moved all four of his limbs.

“Two recording devices were implanted on either side of his head between the brain and the skin, to span the sensorimotor cortex (the area of the brain that controls sensation and motor function),” according to a 10/3 press release about the two-year study. (In previous studies, the recording devises were implanted further in the brain, where they were connected with wires and would eventually stop working. Previous studies were also limited to single-limb movement.)

Each recording device has 64 electrodes collecting brain signals, which are transmitted to a decoding algorithm. The algorithm translates the brain signals and sends the commands to the exoskeleton. The patient first trained with a virtual avatar and played video games. He was then able to walk while wearing the exoskeleton, which was tethered to the ceiling for balance (see video). Researchers are attempting to determine how the exoskeleton can be used without the ceiling tether.

“Our findings could move us a step closer to helping tetraplegic patients to drive computers using brain signals alone, perhaps starting with driving wheelchairs using brain activity instead of joysticks and progressing to developing an exoskeleton for increased mobility,” said Professor Stephan Chabardes, a neurosurgeon from the CHU of Grenoble-Alpes, France, according to the press release.

(2) Army’s super soldiers. The US Army is evaluating exoskeleton technologies available commercially for their potential use in the military to “support strength and endurance and protect soldiers from strain injury,” according to a 5/15 article in Army Technology.

One of the systems being evaluated is Lockheed Martin’s Onyx, which straps around a soldier’s legs. “ONYX is a powered, lower-body exoskeleton with artificial intelligence (AI) technology that augments human strength and endurance. It counteracts overstress on the lower back and legs. Using electro-mechanical knee actuators, a suite of sensors and an AI computer, ONYX learns user movements and delivers torque to assist with walking up steep inclines, lifting or dragging heavy load,” according to a 11/30/18 article in Defense World.

(3) Hello, Iron Man. Our favorite contraption is Gravity Industries’ flying suit (discussed in our 9/20/18 Morning Briefing). Wearable jet packs can propel an airborne person at 55 miles per hour. Here’s a cool demonstration video. The ability to soar like a bird costs $440,000, and, for those with a real adventurous streak, Gravity Industries is hoping flying competitions will begin in 2020.

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Helicopter Money

October 09 (Wednesday)

Small Business Survey: Less Gusto. Uncertainty is weighing on small business owners, according to September’s survey conducted by the National Federation of Independent Business (NFIB). “The tariff wars are adversely impacting many small firms, about 30 percent recently reported negative impacts,” according to the NFIB. Yet most of the survey’s business indicators remain relatively high, though below last year’s peaks. More specifically:

(1) The Small Business Optimism Index was 101.8 during September, down from a record high of 108.8 during August 2018. It’s up from 94.9 during October 2016, the month before Trump was elected president with promises of tax cuts and deregulation (Fig. 1).

(2) The labor market remains strong as 35.0% of respondents reported job openings. This response has been fluctuating in a 35%-40% range for the past 16 months (Fig. 2). The net percentage of them reporting plans to increase hiring over the next three months was 17.0%, down from a record 26.0% during August 2018, but still around the past two cyclical peaks. Fifty percent said that there are few or no qualified applicants for job openings.

The percentage planning to raise worker compensation over the next three months was 18.0% (Fig. 3). This series tends to be a leading indicator for average hourly earnings growth on a y/y basis. It suggests that wage inflation may remain around 3.0%, as it has for the past 14 months.

(3) Pricing pressures seem to be easing. The percentage of respondents planning to raise average selling prices fell to 15.0% from a recent high of 29.0% during November 2018 (Fig. 4). The percentage actually doing so was down to only 8.0%. Inflationary price pressures are dissipating despite concerns about rising labor costs and tariffs.

(4) Capital-spending plans remain solid. During September, 27% of small business owners were planning capital expenditures over the next three to six months (Fig. 5). It’s down from last year’s peak of 33% during August. According to the NFIB, “Plans to invest were strong in manufacturing (34%), professional services (33%), wholesale trades (32%).”

(5) Earnings continue to drive employment and capital spending, with all three on solid uptrends (Fig. 6 and Fig. 7). The NFIB survey includes a series for the net percentage of firms with higher versus lower earnings over the past three months. This series has always been negative since it started in 1974. It came close to turning positive last year for the first time ever. This series is very highly correlated with the percentage of firms expecting to hire over the next three months. The same can be said about the relationship between the earnings series and capital-spending plans over the next three to six months.

(6) The most important problems facing small business owners are less troublesome since Trump won the election. The percentage of firms complaining about poor sales dropped from 12.0% during October 2016 to 8.2% currently, using the six-month average of this series. On the same basis and over the same period, companies complaining about taxes fell from 21.7% to 15.8%, while complaints about government regulation fell from 19.5% to 13.0% (Fig. 8).

Central Banks: The Outer Limits. The Outer Limits was a show on TV from 1963-65. The series is often compared to The Twilight Zone, but with more of a sci-fi bent. Some of the episodes were scary, especially for young kids. Today, some of those first young viewers are fearing that the outer limits of monetary policy will soon be tested.

The world’s major central banks are scaring us with their out-of-this-world monetary policies. They’ve tried numerous unconventional policies to boost inflation and stimulate faster economic growth, including zero interest rates, ultra-easy forward guidance, quantitative easing, and negative interest rates. These unconventional tools have become very conventional since the Great Financial Crisis. Now there is chatter about the central banks considering “helicopter money” and embracing Modern Monetary Theory. These are the outer limits of monetary policy, for sure.

“Monetary policy is almost exhausted as global interest rates plunge towards zero or below,” wrote three executives from BlackRock along with former Fed official and BlackRock Senior Advisor Stanley Fischer in an 8/15 BlackRock Investment Institute report titled Dealing with the next downturn: From unconventional monetary policy to unprecedented policy coordination.” The authors say that “[u]nprecedented policies will be needed to respond to the next economic downturn.”

Recall that Fischer was the Fed vice chair when Janet Yellen was the chair. When he taught at MIT, his students included Ben Bernanke and Mario Draghi. The man is influential!

According to the Blackrock study, fiscal policy will struggle to deliver stimulus in a “timely fashion” on its own. So some fiscal and monetary policy coordination will be necessary. The four propose a framework for an ultra-unconventional monetary policy: helicopter money. Ray Dalio endorsed a similar idea in a 5/1 LinkedIn post titled “It’s Time to Look More Carefully at ‘Monetary Policy 3 (MP3)’ and ‘Modern Monetary Theory (MMT).”

Of course, helicopter money isn’t a new concept. Back in 1969, economist Milton Friedman coined the term “helicopter drop” in his book The Optimum Quantity of Money. The term gained currency in 2002 after then Fed Governor Ben Bernanke referenced it in a 11/21/02 speech, earning him the nickname “Helicopter Ben.”

Helicopter Ben revisited the subject in detail in an April 2016 Brooking’s series of posts titled: “What tools does the Fed have left?” Bernanke lamented: “[S]o long as people have the option of holding currency, there are limits to how far the Fed or any central bank can depress interest rates. Moreover, the benefits of low rates may erode over time, while the costs are likely to increase.” He explained that when monetary policy is inadequate, especially when interest rates are “stuck” near zero, fiscal policy could be a “powerful alternative.”

During a 3/21 interview with Erik Townsend’s MACRO Voices, David Rosenberg of Gluskin Sheff noted that Bernanke laid out the “whole menu of options for what the Fed would do to fight a deflationary recession with interest rates at zero” in his 2002 speech. Rosenberg added that the Fed “did everything in that playbook except” monetizing fiscal policy, which is the “big bazooka.” Rosenberg “firmly expects” to see helicopter money in the next few years.

My view is that fiscal stimulus programs facilitated by monetary policy are likely when the next downturn occurs. Central banks indeed are running out of both conventional and unconventional monetary policy tools. Going deeper into negative rates or asset purchases already has proven to have diminishing returns.

My main concern is that fiscal-like programs financed by central banks remain largely untested. It’s possible that inflation could get too hot if fiscal and monetary policymakers in coordination become too aggressive with their free-money meddling. And with many complex implementation issues that could blur the lines between monetary and fiscal policy, things could get dicey. Let’s drop down for a closer look:

(1) What is helicopter money? “[Suppose] one day a helicopter flies over this community and drops an additional $1,000 in bills from the sky, which is, of course, hastily collected by members of the community. Let us suppose further that everyone is convinced that this is a unique event which will never be repeated,” wrote Milton Friedman in his 1969 book.

The analogy is an apt one: Helicopter money is money that’s added to the money supply by putting it directly in the hands of the people rather than indirectly by lowering interest rates to stimulate lending or buying bonds to increase bond investors’ capital. Central bankers like to talk about the effectiveness of the “transmission mechanism” of monetary policy to the overall economy. Infusing an economy with “free” money is the most direct transmission mechanism there could be—and an effective one, assuming that it works to generate spending and demand among the recipients.

In his 2002 speech, Bernanke explained: “A money-financed tax cut is essentially equivalent to Milton Friedman's famous ‘helicopter drop’ of money.” In a footnote, he elaborated: “A tax cut financed by money creation is the equivalent of a bond-financed tax cut plus an open-market operation in bonds by the Fed, and so arguably no explicit coordination is needed. However, a pledge by the Fed to keep the Treasury's borrowing costs low, as would be the case under my preferred alternative of fixing portions of the Treasury yield curve, might increase the willingness of the fiscal authorities to cut taxes.”

Rosenberg agreed with Townsend during his March interview when he suggested that if the Fed proposes another round of QE, “the political left is going to say ‘no way.’ There’s going to be a huge revolt and people are going to say, look, if you’re going to create money out of thin air, it needs to be helicopter money. Give it to the people, not to Wall Street.”

(2) Forms of helicopter money. Dalio framed the subject well when he said that helicopter money is a form of MP3. To borrow from Dalio’s terms, MP1 is conventional interest-rate-setting monetary policy that works to stimulate bank lending, MP2 is unconventional bond-buying quantitative easing (QE) type monetary policy that injects money into the investment markets, and MP3 covers last-resort monetary policies that are more direct, like helicopter money and Modern Monetary Theory (MMT). (For more on MMT, see our 4/19/18 Morning Briefing.)

MMT and helicopter money both fall under the umbrella of a monetary-financed fiscal operation, which could come in many different flavors. (See for example, Dalio’s helpful chart titled “Flavors of Monetary Policy 3” in his LinkedIn post.) There are two primary variants of this: one targets the private sector and the other the public sector.

In the private-sector approach, the central bank could provide printed cash directly to households (i.e., true helicopter money) or finance a direct tax cut with printed money. The public-sector approach involves a central bank distributing interest-free funds to the government for the specific purpose of spending on fiscal projects like infrastructure.

Such financing arrangements should positively “influence the economy through a number of channels,” namely by boosting GDP, jobs, household income and consumer spending as well as inflation, Bernanke explained. Debt-financed fiscal programs work similarly; however, they increase future debt service costs and future tax burdens, which could offset “some of the program’s expansionary effect.”

The folks at BlackRock note that, unlike monetary-financed programs, deficit-financed programs raise the question of debt sustainability and could force interest rates to rise. Helicopter drops could be perceived as relatively permanent by the public, an important aspect of the effectiveness of fiscal programs.

(3) Problems with helicopter money. Helicopter money is not without potential problems. What’s to ensure that the recipients will spend the cash or otherwise put it to uses that stimulate broader economic demand? Who should get the “free” money and how much? Should it be equally distributed to all citizens? Those are fiscal questions, outside of central banks’ purview. So some level of fiscal and monetary policy coordination would be required.

Similarly, if central banks were to hand interest-free money over to the Treasury, fiscal policymakers would need to decide what to do with it. Ideally, those decisions would be based on the best ways to stimulate the economy, but it would be hard to believe that they wouldn’t also be politically motivated.

You can see how easily the lines between fiscal and monetary policy could become blurred in these cases, potentially compromising monetary policy’s vitally important independence from politics.

Bernanke proposed a solution to the independence issue in his 2016 note, which happens to be the same solution later proposed by the group at BlackRock: Congress could create a special Treasury account at the central bank, giving the bank the sole authority to “fill” the account. The central bank would add funds to the account only when a specified amount of funding was needed to achieve the bank’s employment and inflation goals.

Alternatively, the Treasury could issue debt, which the central bank would agree “to purchase and hold indefinitely, rebating any interest received to the Treasury.”

(4) Who could be the next helicopter pilot? At his last press conference, outgoing European Central Bank (ECB) President Mario Draghi spearheaded his last-ditch effort to “do whatever it takes” to stimulate the eurozone with yet another stimulus package, including a further negative deposit rate and a revived QE program without an end date. Nevertheless, he said that fiscal policymakers too must step up and do their part.

Draghi has recently come out in support of MMT; however, he said during his last press conference that helicopter money is not something that the ECB has seriously considered. Incoming ECB President Christine Lagarde has publicly agreed with Draghi on fiscal spending and committed to review the ECB’s unconventional policies.

Fed Chair Jerome Powell seems to prefer to stay on the ground. While his Fed recently has lowered interest rates, Powell has yet to restart QE and has said that he thinks policies like MMT are “just wrong.” But Powell has been known to change his mind. Maybe someday, facing the next downturn coupled with perpetually low inflation and near-zero interest rates, we’ll hear him exclaim: “Get to the chopper!”

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Cabin Fever

October 08 (Tuesday)

Strategy: Time to Go Global? Joe and I are getting cabin fever. Cabin fever is a popular term for a relatively common reaction to being isolated in a building for a period of time. In our case, we have been isolated in the US, promoting a Stay Home investment strategy during most of the current bull market. It may be time to venture outside of our home market and Go Global for a while.

A smart fellow at one of our accounts in Austin, Texas told me that he is considering overweighting Europe. Our friends at Capital Group are leaning in the same direction. In a 10/2 post titled “Life after Brexit: Will the European economy rebound?,” they conclude: “Despite economic headwinds, company-specific investment opportunities remain” in the region. Emerging market economies are also showing some signs of life. Debbie and I see this in their improving PMIs.

Our bottom line is that there may very well be some tactical opportunities to Go Global over the next 6-12 months. If the opportunities do pan out over this period, we will most likely come back home. Furthermore, we may not venture away from home for very long if the opportunities don’t pan out in a short period of time. Consider the following:

(1) Performance. Here is the relevant performance derby for the two approaches: The US MSCI stock price index is up 335% since the start of the current bull market on 3/9/09 through Friday’s close. The All-Country World ex-US MSCI is up 104% in dollars and 115% in local currency over this same time. It has been no contest, as the other major stock market indexes have lagged miserably both in dollars and in local currencies: Emerging Markets (105%, 123%), Japan (102, 118), EMU (91, 120), and UK (75, 96) (Fig. 1 and Fig. 2).

(2) Valuation. Stocks in the rest of the world look cheap compared to those in the US. At the end of September, the US MSCI had a forward P/E of 17.3, while the All-Country World ex-US had a 13.3 valuation multiple (Fig. 3). Keep in mind that the US has tended historically to command a premium P/E compared to the rest of the world, but the recent spread of 4.0 P/E points is among the widest since the start of the data in May 2001 (Fig. 4).

Here is a collection of the latest forward P/Es for the advanced economies: Italy (11.1), Spain (11.3), UK (12.2), Germany (12.9), Japan (13.4), EMU (13.5), France (14.0), and Canada (14.1) (Fig. 5).

Emerging markets are also cheap, with a forward P/E of 12.0 at the end of September. Here are the major regional EM valuation multiples: Asia (12.7), Latin America (12.5), Eastern Europe (6.5) (Fig. 6).

(3) Forward revenues & earnings. Also keep in mind that the underlying fundamentals are looking better in the US than elsewhere. The forward revenues per share of the US MSCI stock price index remains on an uptrend in record-high territory and is outpacing the comparable metric for Developed World ex-US. For example, since the start of 2016 through the 9/26 week, the former is up 22.5% while the latter is up 8.1% (Fig. 7). Over this same period, the forward revenues of the Emerging Markets MSCI is up 11.5%, but has been looking toppy since the summer.

The forward earnings per share of the US MSCI has stalled at a record high this year, while the comparable metrics for Developed World ex-US and Emerging Markets have been trending lower so far this year (Fig. 8).

(4) Profit margin. The forward profit margin of the US MSCI is the highest in the world (Fig. 9). At the end of September, it was 11.7% in the US, 8.4% in the Developed World ex-US, and 6.6% among Emerging Markets.

Emerging Market Economies: Emerging Again? As we noted yesterday, the PMIs of the emerging economies have been holding up better than those of the advanced economies so far this year. Here are September’s M-PMIs for a few of the major emerging economies: Brazil (53.4), China (51.4), India (51.4), Thailand (50.6), and Vietnam (50.5) (Fig. 10). Some of those in Southeast Asia may be benefitting from manufacturers’ moving their supply chains out of China.

Nevertheless, it’s hard for us to pound the table on a strategy of overweighting the EM MSCI (in dollars) while the CRB raw industrials spot price index is falling (Fig. 11). The two series have been very highly correlated since the mid-1990s. That’s because the forward earnings of the EM MSCI has also been highly correlated with the CRB index (Fig. 12).

This suggests that while many emerging economies are benefiting from consumers’ rising standards of living, the MSCI index must still be heavily weighted with commodity-producing companies. In other words, the EM MSCI may not be reflecting all the progress and prosperity going on in many of the emerging economies. That dynamic suggests opportunities to invest in undervalued companies that are prospering by catering to consumers but aren’t included in the stock index.

Europe I: First, the Bad News. In their 10/2 post cited above, our friends at Capital Group observed: “The United Kingdom is beset with Brexit uncertainty. Germany is teetering on the verge of recession. Protests in the streets of Paris until recently threatened to destabilize the French government. On top of all that, global disruption from the U.S.-China trade war has weighed heavily on Europe’s export-dependent economy.”

Then last Wednesday, the US escalated its trade war with Europe after the World Trade Organization gave President Donald Trump the go-ahead to impose tariffs on as much as $7.5 billion worth of European exports annually in retaliation for illegal government aid to Airbus SE.

The 10/2 Bloomberg reported: “The Trump administration is considering a particularly damaging trade weapon known as ‘carousel’ retaliation, which would enable the U.S. to regularly shift around the targeted goods, people familiar with the deliberations said last month. That would increase trade uncertainty and pain for European businesses.”

The latest batch of European economic indicators is also depressing:

(1) Economic sentiment. The economic sentiment index for Europe fell to 100.0 during September, the lowest reading since November 2013 (Fig. 13). It was down to 101.7 in the Eurozone, the lowest since February 2015, signaling that real GDP growth in the region is heading toward zero from only 1.2% y/y during Q2 (Fig. 14).

Leading the recent decline in Europe has been the sentiment index for the UK. It fell to 88.0 last month to the lowest reading since May 2012 (Fig. 15). Leading the rout in the industrial components of the sentiment indicator is Germany with a reading of -15.6 during September, the weakest since October 2012 (Fig. 16).

(2) Factory orders. Yesterday, we learned that German manufacturing orders fell during August, as Debbie discusses below. They were down 6.7% y/y. They are down 4.8% y/y in the Eurozone through July (Fig. 17).

Europe II: Now, the Good News. The good news is that the volume of retail sales remains on an uptrend in the Eurozone, rising 2.1% y/y during August, in record territory (Fig. 18). The 12-month sum of German auto production may have bottomed during September, a year after tougher auto emission standards were imposed (Fig. 19). The value of German exports is up 2.0% over the three months through July.

Interestingly, while European equities have lagged those of the US this year, they are up solidly. The region’s MSCI is up 7.8% ytd in dollars and 11.7% in local currency through Friday (Fig. 20). The euro is down 4.7% y/y through Friday’s close, which should help exporters in the Eurozone. While the bad news currently outweighs the good news, that’s all the more reason to expect a stimulative policy response, especially from German fiscal authorities.

The European Central Bank (ECB) last month cut its key deposit facility rate further into negative territory, from –0.40% to –0.50%, and relaunched a €20 billion per month bond-buying program without setting a termination date. Outgoing ECB President Mario Draghi promoted Modern Monetary Theory in a recent speech.

In effect, he said that the ECB would be delighted to finance €240 billion per year in Eurozone government bonds for the purpose of stimulating economic growth in the region. “When you look at them closely, you realize the task of distributing money to one subject or the other subject, that’s typically a fiscal task,” he said. “It’s a government decision, not the central bank ... It’s the political governance of these ideas that needs to be addressed.” Incoming ECB chief Christine Lagarde intends to keep pushing fiscal authorities to take advantage of the ECB’s largesse.

The Capital Group post concludes: “Although European economic growth has been disappointing so far in 2019, investment returns have charted a decidedly different course—which serves as a timely reminder that the economy and the stock market aren’t always on the same page.”

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Depressed Purchasing Managers

October 07 (Monday)

Purchasing Managers I: Impact on the Economy. The Institute for Supply Management (ISM) released September’s M-PMI last Tuesday. It was depressing. On Thursday, ISM released September’s NM-PMI; it was less depressing, but disconcerting because it was weaker than widely expected. It also suggested that the weakness in the manufacturing sector may be starting to spread to the non-manufacturing sector of the US economy.

The S&P 500 sold off sharply on Tuesday and Wednesday by 3.0% following the release of the M-PMI. Wednesday’s selloff was exacerbated by the release of September’s ADP private payrolls, which rose only 135,000 after August’s number was revised downward by 38,000 to 157,000.

Then, Thursday’s weak NM-PMI led to a 0.8% increase in the stock index as investors concluded that the weak PMI stats set the stage for another cut in the federal funds rate at the next FOMC meeting, on 10/29-30. Friday’s report that nonfarm private payrolls rose only 136,000 during September also increased the likelihood of more Fed easing, pushing the S&P 500 up another 1.4%, which put it only 2.4% below its record high (Fig. 1).

To examine the relationships among the two PMIs, the financial markets, and the economy, let’s start with a simple average of the M-PMI and the NM-PMI (Fig. 2 and Fig. 3). During September, the former was 47.8, while the latter was 52.6, putting the average at 50.2, the lowest reading since July 2009.

Why not give the NM-PMI more weight since it reflects activity in a much larger portion of the economy than manufacturing? That fact should be roughly balanced out by the fact that manufacturing tends to be more cyclical than services, thus accounting for more of the ups and downs of the business cycle. So a simple average should be fine for our purposes. Now consider the following:

(1) No recession in PMIs is evident. According to the ISM press release on the M-PMI, when readings are above 42.9 over a period of time, that generally indicates that the economy is growing. In fact, September’s reading of 47.8 corresponds to real GDP growth of 1.5%.

According to the ISM press release on the NM-PMI, readings above 48.6 suggest the economy is growing; September’s 52.6 corresponds to 1.4% growth in real GDP.

Averaging the two September readings gives us 50.2, solidly above the 45.8 ISM-provided average recession marker for the average.

(2) Orders & production are weak. That’s all fine, except the average PMI has been going in the wrong direction since late last year, falling from a recent peak of 60.2 during September 2018 to 50.2 last month. Both the production and orders indexes are down comparably with their averages, at 51.3 and 50.5 during September (Fig. 4 and Fig. 5).

Confirming the weakness in the PMIs, manufacturing production was down 0.5% y/y during August, while factory orders were down 1.9% (Fig. 6).

(3) Employment signals are mixed. On the other hand, last week’s employment data showed gains even though the average of the employment indexes of the M-PMI and NM-PMI was under 50.0, at 48.4 (Fig. 7). ISM doesn’t provide a recession marker for employment, but if they did, it likely would be below 50.0 as well.

Let’s compare September’s ADP versus BLS reports: private payrolls up 135,000 vs 136,000, with goods-producing up 8,000 vs 5,000 and service-producing up 127,000 vs 109,000. Here are manufacturing (2,000 vs -2,000), construction (9,000 vs. 7,000), professional & business services (20,000 vs 34,000), education & health (42,000 vs 40,000), leisure & hospitality (18,000 vs 21,000), financial services (8,000 vs 3,000), and trade, transportation & utilities (28,000 vs 5,000).

In other words, the economy is still creating plenty of jobs despite the weakness in the PMI employment components. Then again, our Earned Income Proxy (EIP) rose just 0.1% m/m during September, as Debbie discusses below. Contributing to the weakness in our EIP was that average hourly earnings for all workers was unchanged during the month and up 2.9% y/y, falling below 3.0% for the first time since last July (Fig. 8).

Purchasing Managers II: Impact on Interest Rates. Also boosting stock prices on Friday afternoon was a speech by Fed Chair Jerome Powell at a “Fed Listens” event. He reassuringly said: “While not everyone fully shares economic opportunities and the economy faces some risks, overall it is—as I like to say—in a good place. Our job is to keep it there as long as possible.”

The latest batch of PMIs and employment reports suggested to many investors that the Fed may need to cut the federal funds rate for a third time this year at the next FOMC meeting to keep the economy in a good place. Those expectations were clearly reflected in interest rates last week:

(1) Federal funds rate futures fell sharply last week. The federal funds rate range is currently 1.75%-2.00%. On Friday, the futures rates fell to 1.64% for the nearby contract, 1.56% for the 3-month, 1.30% for the 6-month, and 1.06% for the 12-month (Fig. 9). That implies three to four rate cuts of 25bps over the next 12 months, starting with another cut at the end of this month.

That seems more likely now after the latest weak PMIs, and Powell’s commitment to keep the economy in a good place. The only question is whether the next rate cut might be 50bps? FRBNY President John Williams believes that the Fed needs to act more aggressively to lower the federal funds rate when it is so close to zero, to get ahead of deflationary pressures. He said so in a 7/16 speech: “When you only have so much stimulus at your disposal, it pays to act quickly to lower rates at the first sign of economic distress.”

(2) The 2-year US Treasury yield fell 23bps last week to 1.40%. Debbie and I view the two-year US Treasury yield as another indicator of the market’s expectation for the federal funds rate a year from now since it closely tracks the 12-month federal funds rate futures (Fig. 10).

Interestingly, there has been a reasonably good correlation between the average PMI, discussed above, and the y/y change in the 2-year yield (Fig. 11). The exception was 2010-2015, when the Fed was targeting the federal funds rate at zero.

(3) The 10-year US Treasury yield fell 17bps last week to 1.52%. Not surprisingly, there is also a reasonably good correlation between the average PMI and the y/y change in the 10-year US Treasury yield (Fig. 12).

The Fed may be giving more weight to the yield curve in managing monetary policy, as Melissa and I suggested in our 4/7 study titled “The Yield Curve: What Is It Really Predicting?” We argued that the Fed should be easing when the yield curve inverts until it stops inverting. That may be the Fed’s game plan now. From 8/27 through 8/29, the 10-year versus 2-year yield spread turned slightly negative. On Friday, it was up 12bps on expectations of further Fed easing ahead following the disappointing PMI and employment reports (Fig. 13).

(4) Credit-quality spreads remained tight. The good news is that despite the weakness in those reports, credit-quality spreads remain low. If a recession were coming soon, those spreads would widen significantly.

Purchasing Managers III: Impact on Stock Prices. As we noted last week, the y/y growth rate of S&P 500 aggregate revenues is highly correlated with the average PMI series (Fig. 14). That explains why the S&P 500 stock price index, also on a y/y percent change basis, is highly correlated with the average PMI (Fig. 15).

While the sharp drop in the average PMI over the past 12 months is bearish news for revenues growth and thus the stock market, it is bullish for the stocks if it prompts the Fed to continue lowering interest rates. It is especially bullish if those lower rates boost economic growth.

Purchasing Managers IV: Impact on Growth vs Value. Yet another interesting correlation is between the average PMI and the relative performance of the S&P 500 Growth stock price index to the S&P 500 Value stock price index (Fig. 16). The former has been a relatively good leading indicator of the latter during the current economic expansion.

Purchasing Managers V: Around the World. The global composite C-PMI, along with its two components tracking global manufacturing and non-manufacturing activity, has been following the same path as the comparable US indexes (Fig. 17). That’s even truer for the indexes covering advanced economies.

Interestingly, the C-PMI, M-PMI, and NM-PMI for emerging economies have been showing more signs of life recently. September’s M-PMI rose for the third month, from 49.9 in June to a six-month high of 51.0 last month. September data for both the C-PMI and NM-PMI are due out this morning; the former rose from 50.9 in June to 51.8 in August, while the latter rose from 51.5 to 52.3 over the comparable period.

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No Recession in Analysts’ Forecasts

October 03 (Thursday)

Strategy: No 2020 Earnings Dip Yet. US manufacturing activity may be slowing and investors may be selling, but analysts have yet to throw in the towel on next year’s earnings estimates. The Institute for Supply Management’s (ISM) manufacturing index fell to 47.8 in September, the second consecutive reading below the all-important 50.0 that’s widely considered to be the line between economic growth and contraction (Fig. 1). (As we observed yesterday, the make-or-break level is actually 42.9 according to the ISM.)

The reading spooked investors so much on Tuesday that S&P 500 safety sectors sold off along with their growth counterparts, though admittedly to a lesser extent. Here’s the performance derby for the S&P 500 sectors’ price performance on Tuesday: Consumer Staples (-0.3%), Utilities (-0.3), Consumer Discretionary (-0.8), Information Technology (-0.9), Health Care (-1.0), Communications Services (-1.0), Real Estate (-1.0), S&P 500 (-1.2), Financials (-2.1), Materials (-2.3), Energy (-2.3), and Industrials (-2.4). The rout continued on Wednesday.

Despite the doom and gloom, analysts continue to expect the S&P 500 Industrials and Materials sectors to have the second- and third-best earnings growth in 2020. Here are the S&P 500 sectors’ 2020 earnings-growth estimates: Energy (29.7%), Industrials (17.4), Materials (15.4), Communications Services (12.4), Consumer Discretionary (12.0), S&P 500 (10.1), Health Care (9.7), Information Technology (8.0), Consumer Staples (7.1), Financials (5.2), Utilities (5.1), and Real Estate (-10.2) (Table 1).

Let’s take a look at how some of the S&P 500 industries are expected to perform next year:

(1) The last shall be first. Many of the industries with the fastest expected earnings growth in 2020 are forecast to have some of the worst results this year. Copper’s earnings are expected to rebound 350.2% next year after declining 90.6% this year (Fig. 2). Oil & Gas Refining & Marketing’s earnings are forecast to jump 60.1% next year after tumbling an expected 33.2% this year (Fig. 3). Rounding out the top three industries with the best earnings growth in 2020 is Casinos & Gaming, with 58.1% growth, a marked improvement from the 10.4% decline forecast for this year (Fig. 4).

(2) Boeing needs to fly. The primary reason Industrials earnings are forecast to rebound in 2020 is that analysts have high hopes for Boeing and its ability to put the 737 Max back in the air. The S&P 500 Aerospace & Defense industry is forecast to grow earnings 47.1% next year, up from the 15.1% decline forecast for this year. Boeing is the primary reason behind the drop (Fig. 5). The plane manufacturer earned $17.85 a share in 2018; its results are forecast to fall to $3.64 this year and are expected to surge to $22.50 in 2020.

(3) Autos in neutral. So far, the GM auto strike isn’t dragging down the S&P 500 Consumer Discretionary sector, primarily because not much has been expected from the Automobile Manufacturers industry for quite a while. The industry’s earnings fell 14.5% in 2018 and is expected only to inch higher this year (1.5%) and next year (1.0%) (Fig. 6). Analysts have trimmed their GM EPS estimates for 2019 by eight cents over the past month to $6.63, but 2020 EPS consensus hasn’t budged from $6.61, where it stood a month ago.

There’s a bit more optimism about earnings in the Auto Parts & Equipment industry, which may need estimate-trimming. Analysts forecast the industry’s earnings will rise 10.7% next year after falling 7.2% this year (Fig. 7).

(4) Looking at the unloved. Perusing the list of industries with the lowest earnings-growth forecasts can be fruitful if those industries manage to beat low expectations. Many of the industries are facing structural issues. For example, competition from Amazon and the Internet has decimated business in the Department Stores industry (-20.1% in 2019 and -1.9% in 2020) and encroached on the Drug Retail industry (-0.7% in 2019 and 0.4% in 2020) (Fig. 8 and Fig. 9).

Tariffs from the US/China trade war are hurting the Construction Machinery & Heavy Trucks industry (8.6% in 2019 and -2.4% in 2020) and Steel (-40.3% in 2019 and -7.7% in 2020) (Fig. 10 and Fig. 11). The trade war has also brought us low interest rates and a flat yield curve, which have taken a toll on Financials. Consider that the Regional Banks industry’s earnings are expected to inch up 4.8% in 2019 and 4.3% in 2020; these rates compare with Diversified Banks’ 12.0% and 3.4%, Reinsurance’s 446.9% and -5.0%, and Multi-Line Insurance’s 136.7% and 1.8%.

Real Estate: Postmortem on WeWork’s IPO. Much handwringing has occurred since WeWork pulled the plug on its IPO and sent its CEO packing. Some are worried it’s a sign that the IPO market has shut down forever. Others fear the company will drag down US real estate markets.

The demise of the shared office space provider’s IPO doesn’t make us shudder. We think the market, by rejecting a company with poor governance that’s hemorrhaging money, behaved rationally and has yet to enter the always dangerous bubble stage. WeWork’s fail doesn’t mean the IPO market is closed to profitable companies or those with a plan for reaching profitability in the near term.

Likewise, we’re less concerned about WeWork’s impact on the real estate market than we would be if its clients were going out of business. Yes, the company is NYC’s biggest landlord, with about 7 million square feet of office space. But the Big Apple is a big place. WeWork represents less than 2% of the city’s 450 million square feet of commercial space, and its customers will keep renting from WeWork or from another lessor. Let’s take a deeper look:

(1) Tapping into the zeitgeist. WeWork’s arguably kooky—and greedy—CEO notwithstanding, the company did tap into a niche that other landlords had largely ignored, the office-less self-employed. The romance of starting a business sitting alone at a kitchen table grows old fast. WeWork offers a cool place to be social while working. If the company stopped its frivolous spending and improved its governance, it might make for an interesting investment.

“Flexible workplace now accounts for 1.2% of all U.S. office inventory, and is expected to grow to 30% in the next 10 years,” according to a Cushman & Wakefield 8/16 report. “Driving this shift is technology advancement and companies needing to provide work settings that include access to technology culture, community, hospitality and wellness capabilities to help them stay competitive in the war for talent.”

(2) Alternatives abound. We’d be a lot more concerned about the commercial real estate market if WeWork’s customers couldn’t access capital and were going bust. Then demand from self-employed renters would disappear, as it did when the tech bubble burst. We’d also be concerned if the tech market took a dive. Roughly a quarter of the top leases in US markets as of mid-2019 are to companies in the tech sector, according to Cushman & Wakefield.

However, the environment for small businesses remains healthy, and the self-employed no doubt will continue to seek out social workplaces, whether provided by WeWork or not.

Long before WeWork’s IPO was DOA, we noted in the 5/9 Morning Briefing that traditional competitors were upping their game to compete with WeWork and entering the short-term leasing market. CBRE Group launched Hana, a business to help landlords create their own flexible offices. Tishman Speyer started Studio, a coworking business. Blackstone and Brookfield Property Partners have partnered with coworking companies Industrious and Convene to manage flexible space in their buildings, according to a 12/19/18 Finance & Commerce article.

(3) Not so mismatched. We noted two major problems with WeWork. First it was losing tons of money, and on that front nothing has changed. Last week Standard & Poor’s downgraded WeWork’s debt one notch to B- and after the IPO was pulled this week, Fitch Ratings downgraded WeWork’s credit rating two notches to CCC+.

Fitch warned that the company doesn’t “have sufficient funding to meet its growth plan” now that it won’t be raising $3 billion from the IPO and $6 billion from a bank loan that was contingent on the IPO, a 10/1 Reuters article reported. The company is discussing alternative funding sources with its banks and SoftBank, its largest investor. Fitch warned that customers, particularly big companies, might “hesitate” before becoming WeWork members given the company’s turmoil.

Our second concern was the funding mismatch between the company’s long-term leases with landlords and short-term memberships with customers. When a recession comes along, members can drop their memberships, but WeWork will still have to make lease payments. WeWork has $47.2 billion of future undiscounted fixed minimum-lease-cost payment obligations.

However, this concern may have been misplaced. WeWork, in its IPO filing, noted that a majority of its leases are held by individual special-purpose entities (SPEs). Presumably, this means that if WeWork has a problem making lease payments at a specific building, it can stop making payments and walk away. The landlord’s only recourse might be to get what is owed to it from the SPE—not WeWork.

Boston Fed President Eric Rosengren noted this structure in his 9/20 speech at a conference on credit markets, which Melissa dissected in the 9/24 Morning Briefing. Rosengren worried not about WeWork but about the banks lending to the building owners that lease space to WeWork and others like it.

(4) Risks still exist. Despite our general optimism about the IPO and real estate markets, we’re well aware of the potential risks. For example, it’s unclear just how much of WeWork’s real estate is leased. If the company has gobs of unleased real estate to return to the market, the real estate market may take a bigger hit than we’re anticipating.

It’s tough to calculate how much of the company’s real estate is occupied. According to WeWork’s 8/14 IPO filing: “As of June 1, 2019, our occupancy stabilized at an average of approximately 89% after 18 months and generally remained at that level after 24 months.” Because the company is growing so fast, only 30% of its locations have been open for 24 months or more. The company had 528 locations in 111 cities in Q2-19, up from 425 locations in 100 cities in 2018 and 111 locations in 34 cities in 2016.

The bigger problem the real estate market has faced over the past few years is the disappearance of Chinese buyers. They’ve gone from big buyers to net sellers of US real estate. Chinese investment in US property fell to $336 million in 2018 from $8.8 billion in 2016. The Chinese government imposed capital controls to end “splashy overseas property deals,” and a crackdown on shadow banking led to tighter credit conditions, a 6/24 FT article reported. But as 2020 quickly approaches, that problem should be fully priced into the market.

Disruptive Technologies: Chemically Recycling Plastic. Once created, plastic can stick around forever. So more than a century after it was invented, we’re realizing that something needs to be done with all the plastic that’s in our landfills and oceans. About 35% of plastics can be mechanically recycled, i.e., picked out of trash and recycled by cutting the bottles into small pieces, melting them, and forming new plastic items. But 65% can’t be. It typically ends up in landfills—in the best-case scenario. Plastic Energy, a private company founded in 2011, believes it has come up with the answer:

(1) A chemical solution. According to its website, Plastic Energy heats used plastic without using oxygen until it melts and the molecules break down to form a saturated hydrocarbon vapor. The condensable gasses are converted to hydrocarbon products, like raw diesel, light oil, and synthetic gas components. These can be sold back to the petrochemical industry to make new plastic, fuel oil, or transportation fuels. For every ton of used plastic it gathers, the company generates about 700 liters of oil. The non-condensable gases are collected and can be burned to generate energy and run the plant.

(2) Two plants running, two on the way. The company has two plants in Spain and sells what it produces to SABIC’s petrochemical plant in the Netherlands, which makes packaging for consumer products. While still in the pilot stage, the materials produced are being supplied to Unilever, Tupperware, and Vinventions to develop high-quality packaging for foodstuff, personal care, and homecare products, according to an 8/28 article in New Food. Plastic Energy and SABIC have also agreed to build a recycling plant in the Netherlands that could begin commercial production in 2021.

Plastic Energy also has an agreement with the Indonesian province of West Java to build five recycling plants. In addition, Petronas Chemicals Group is working with Plastic Energy to evaluate building a commercial plant in Malaysia.

(3) Better alternatives? Not everyone is convinced that chemical recycling of plastic is the answer. Jan Dell is a chemical engineer whose organization, the Last Beach Cleanup, works with investors and environmental groups on projects to reduce plastic pollution. “The economic realities of cheap new plastic production and low-cost oil and gas production make chemical recycling processes economically uncompetitive and impractical at commercial scale,” she said in a 4/11 article in Chemical & Engineering News. “Labor, transport, and processing costs for collecting, sorting, and recycling plastic make it more costly than new plastic or new oil.” Her preference: reducing the consumption of single-use plastics.

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Looking Forward to 2021

October 02 (Wednesday)

Strategy I: Cause for Concern? One of my favorite songs is “We Didn’t Start the Fire” (1989), by Billy Joel, who is one year older than I am. The lyrics are simply a long list of major personalities and issues that have pleased, pained, and plagued my generation—the Baby Boomers—since our parents started to have children during the late 1940s. The lyrics include brief, rapid-fire allusions to more than 100 domestic and global headlines during the Cold War, from 1949 through 1989. Many of them refer to troublesome events during that period.

Today, Billy Joel would have no trouble updating his list of troublesome events: Red China, North Korea, South Korea, vaccine, Ayatollah’s in Iran, foreign debts, homeless vets, China’s under martial law, impeachment, MMT, negative rates, deflation, inverted yield curve, M-PMI, and many more. Actually, the first eight items were in Joel’s original lyrics.

Yesterday’s cause for concern was the release of September’s M-PMI report. It wasn’t pretty. It was weak across the board (Fig. 1). Consider the following:

(1) Weak, but still no recession. The overall index fell to 47.8 from 49.1 during August. These are the first readings below 50.0 since 2016. There was no recession back then. The latest readings don’t signal a recession now according to the Institute for Supply Management (ISM), which conducts the PMI survey:

“A PMI® above 42.9 percent, over a period of time, generally indicates an expansion of the overall economy. Therefore, the September PMI® indicates growth for the 125th consecutive month in the overall economy, and the second month of contraction following 35 straight months of growth in the manufacturing sector. The past relationship between the PMI® and the overall economy indicates that the PMI® for September (47.8 percent) corresponds to a 1.5-percent increase in real gross domestic product (GDP) on an annualized basis.”

(2) Regional surveys also mostly down and out. The three major components of the M-PMI were all below 50.0 during September: new orders (47.3), production (47.3), and employment (46.3), as Debbie reviews below. The weakness in the M-PMI was confirmed by the composite and orders averages for the regional business surveys conducted by five Federal Reserve district banks (Fig. 2). However, the regional average employment index rebounded during September, while the employment component of the M-PMI fell to the lowest reading since January 2016 (Fig. 3).

(3) Trade war hits exports index. Also standing out on the weak side was the M-PMI’s new exports component, which plunged from last year’s peak of 62.8 during February to 41.0 during September (Fig. 4). That was the lowest reading since March 2009. Trump’s escalating trade war has depressed US exports, according to the latest ISM survey. The imports index, however, edged up from 46.0 during August to 48.1 last month.

(4) Bad news for S&P 500 revenues. The growth rate in S&P 500 aggregate revenues, on a y/y basis, is highly correlated with the M-PMI (Fig. 5). September’s reading for the latter suggests that the former could turn negative. That would imply negative earnings growth too. Aggregate revenues were up 3.0% during Q2.

The good news is that aggregate revenues growth is also highly correlated with the NM-PMI, which probably remained well above 50.0 during September (Fig. 6). It edged up to 56.4 during August. September’s number will be out tomorrow.

Strategy II: No Cause for Concern? Industry analysts aren’t singing Billy Joel’s song. They may be reading the headline news about the slowdown in the global economy, but it isn’t showing up in their upbeat expectations for S&P 500 revenues and earnings:

(1) Revenues. S&P 500 forward revenues rose to yet another record high during the 9/19 week (Fig. 7). This time-weighted measure of expectations for the current year and the coming year is rapidly converging to the 2020 consensus estimate. Joe has updated our forward revenues (and earnings) charts with consensus 2021 expectations. Industry analysts are expecting S&P 500 revenues to grow 4.3% this year, 5.5% next year, and 4.5% in 2021 (Fig. 8).

Joe and I are big fans of the forward revenues series because it is available weekly and it is a great coincident indicator of the trend in actual quarterly revenues (Fig. 9).

(2) Earnings. Also impressive, given the depressing headline news, is the fact that S&P 500 forward earnings has been inching upward in record-high territory in recent weeks through the 9/26 week (Fig. 10). This series tends to be a good leading indicator of the trend in actual S&P 500 operating earnings.

Undoubtedly, industry analysts are too optimistic about the outlook for earnings, as they often have been in the past. They are currently forecasting earnings growth of 2.0% this year, 10.1% next year, and 10.3% in 2021 (Fig. 11). That implies that the profit margin, which is at a record high, will continue to move higher.

(3) Profit margin. Meanwhile, the forward profit margin, which is a coincident indicator of the actual quarterly profit margin, has stabilized just below its record high late last year around 12.0% (Fig. 12). That’s impressive given the news about shortages of workers driving up labor costs and tariffs driving up prices paid for imports.

(4) Earnings season ahead. On a quarterly basis, S&P 500 earnings rose 2.8% during Q1 and 0.8% during Q2. Prior to their earnings seasons, both quarters were expected to show slight declines in earnings. Now, Q3 is expected to be down 3.2% y/y (Fig. 13 and Fig. 14). Another “earnings hook” could turn that number slightly positive, as occurred during the first two quarters of this year.

That would still leave earnings growth in the very low single digits and the weakest since 2016, when it was only 0.5%. Industry analysts are currently projecting it will be just 1.1% this year, while we are at 3.1%. Next year, they are at 11.2%, while we are at 5.4%. (See YRI S&P 500 Earnings Forecasts.)

Politics: Warren Has a Plan for That. As President Donald Trump sinks in the Beltway swamp, Elizabeth Warren’s chances of becoming the Democratic Party’s presidential nominee are rising. If she continues to advance and Trump continues to sink, taking current Democratic frontrunner Joe Biden down with him, she could be the president in 2021.

That would mean yet another radical regime change, from community organizers and lawyers under Obama, to deal-makers under Trump, to central planners under Warren.

“Elizabeth has a lot of plans, but they’re really one simple plan: We need to tackle the corruption in Washington that makes our government work for the wealthy and well-connected, but kicks dirt on everyone else, and put economic and political power back in the hands of the people,” according to her website.

By our count, 11 of her 45 campaign-platform “plans” would dramatically impact the US economy and financial markets. Here are our short, factual summaries of those 11, scrubbed of her anecdotes and biases:

(1) Imposing an ultra-millionaire tax. Warren would tax the wealth of households with a net worth of $50 million or more, or the top 0.1%. They’d pay an annual 2% tax on every dollar of net worth above $50 million and a 3% tax on every dollar of net worth above $1 billion. This would bring in an estimated $2.75 trillion in revenue over 10 years, based on research by University of California, Berkeley Professors Emmanuel Saez and Gabriel Zucman noted on Warren’s website.

(2) Making higher ed affordable for all. Warren would cancel student-loan debt for more than 95% of the nearly 45 million Americans with such debt; more than 75% would see theirs eliminated entirely. This is intended to “provide an enormous middle-class stimulus that will boost economic growth, increase home purchases, and fuel a new wave of small business formation.” She also plans to create “universal free college.” The entire cost of the plan, $1.25 trillion over ten years, would be paid for by the ultra-millionaire tax. The debt cancellation has a phase-out feature and wouldn’t be offered for people with household income above $250,000. Funding would also be made available to cover non-tuition-related expenses such as books and boarding.

(3) Stopping the “coming” economic crash. This “plan” is a catch-all for several plans. Warren is worried about household and corporate debt, a manufacturing slowdown, and the inverted yield curve. She cites a survey that projects the next recession will come by the end of 2021. To “stop” it, she says we need to reduce household debt by increasing the minimum wage and canceling student-loan debt, lowering the cost of rent, providing universal affordable childcare, and instituting universal free college. To tackle corporate debt, Warren plans to monitor corporate lending, especially leveraged lending, upon which she’d enforce new guidance. Her Green Manufacturing Plan will make “a $2 trillion investment in American green research, manufacturing, and exporting over the next decade.”

(4) Reducing corporate influence over the Pentagon. Warren dislikes the “coziness” of corporate defense contractors and lobbyists with the Pentagon. She would cut the US defense budget—but doesn’t say by how much—and sever connections between “giant corporate contractors” (like Lockheed Martin) and the Pentagon.

(5) Empowering workers via “accountable capitalism.” Warren aims to change what she sees as the primary aim of corporations: “maximizing shareholder value.” Her plan requires US corporations with more than $1 billion in revenue to obtain a federal charter as a “United States corporation,” which would obligate directors to consider the interests of all corporate stakeholders, not just shareholders, and mandate that employees elect at least 40% of the company’s board members. To keep execs focused on the long term, directors and officers at large US companies would be prohibited from selling company shares within five years of receiving them or within three years of a stock-buyback program. Finally, before large companies could engage in political funding, they’d need to undergo an approval process.

(6) Ending Wall Street’s “stranglehold” on the economy. Warren’s Wall Street focus targets private equity. To transform the industry, she plans to make private-equity firms responsible for the debt and pension obligations of companies they buy, limit these private-equity firms’ fees and dividends, raise the tax rates on their deals, and close the carried-interest loophole. To reduce speculative excesses on Wall Street, she would enact her 21st Century Glass-Steagall Act, rebuilding the wall between commercial banks and investment banks; institute new executive compensation rules for bankers; and strengthen rules on big banks’ capital, liquidity, leverage, and resolution-planning. (These plans are tied into her plan for “Holding Wall Street Accountable.”)

(7) Implementing new trade approaches. Warren is not for free trade that supports only corporations but for trade that benefits “the people.” In a Warren administration, trade agreements would be negotiated and approved via a transparent process with public disclosures and commentary. Countries would have to meet a set of standards as a precondition for trading with the US. She’d also strengthen trade-rule enforcement and end “Investor-State Dispute Settlement,” the “favorable enforcement approach we offer corporations.”

(8) Breaking up Big Tech. Warren wants to break up market-dominating tech companies like Amazon, Facebook, and Google. To start, she’d require “large tech platforms to be designated as ‘Platform Utilities’ and broken apart from any participant on that platform.” Regulators would be appointed to revise illegal and anti-competitive tech mergers. (These “plans” are tied into her plan to promote competitive markets.)

(9) Defending & creating American jobs. Warren plans to “pursue an agenda of economic patriotism, using new and existing tools to defend and create quality American jobs and promote American industry” through “fundamental, structural changes in our government’s approach to the economy” that put “American workers and middle-class prosperity ahead of multinational profits and Wall Street bonuses.” To do so, she plans to mirror other countries’ plans like “Made in China 2025.” Warren says it’s not globalization, automation, and the skills gap that are to blame for American job losses and flat wages but Washington’s trade and tax policies. Some of her “more aggressive tactics” include: “[m]ore actively managing our currency value to promote exports and domestic manufacturing,” leveraging federal R&D, and instituting a new agency focused on growing well-paying jobs.

(10) Providing health care as a human right. Warren supports “Medicare for All.” She also plans to institute the Affordable Drug Manufacturing Act to “allow the Department of Health and Human Services to step in where the market has failed.” Warren’s Behavioral Health Coverage Transparency Act “would hold insurers accountable for providing adequate mental health benefits.” Warren’s CARE Act with Rep. Elijah Cummings (D-MD) “would invest $100 billion in federal funding over the next ten years” to fight the Opioid Crisis.

(11) Implementing a new tax law: Real Corporate Profits Tax. This new tax would apply to companies that report more than $100 million in profits. For every dollar of profit above $100 million, corporations would pay a 7% tax (with no “loopholes,” deductions, or exemptions) to ensure that no major corporations have a zero tax liability. “Any company profitable enough to hit the Real Corporate Profits Tax will pay that tax in addition to whatever its liability might be under our current corporate tax rules.” According to an estimate from Saez and Zucman noted on Warren’s website, the tax would bring in $1 trillion in revenue over the next 10 years.

To limit potential shocks to the markets, Warren also plans not to tweet as much as Trump does. Her plans would be shocks enough.

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Inflation Roundup

October 01 (Tuesday)

Inflation I: Still Subdued in US. The headline and core PCED inflation rates, on a y/y basis, remained subdued during August at 1.4% and 1.8%, respectively (Fig. 1). Both are lower than the comparable inflation rates for the CPI at 1.7% and 2.4% (Fig. 2).

The Fed puts more weight on the PCED than on the CPI when determining monetary policy. Furthermore, the Fed gives more weight to the core PCED inflation rate, which has been targeted at 2.0% since January 2012. Since May 2012, it has been below that target during all but nine months. That’s been one of the main rationales for the Fed’s ultra-easy monetary policies from 2012-14, its gradual normalization of monetary policies from 2015-18, and its two rate cuts so far this year.

The CPI inflation rate tends to exceed the PCED inflation rate both on a headline and core basis (Fig. 3 and Fig. 4). The inflation rates of both the goods and the services components of the CPI exceed those of the PCED (Fig. 5 and Fig. 6). Let’s see why:

(1) Nondurable goods. There isn’t much divergence between the inflation rates for nondurable goods in the CPI and the PCED (Fig. 7). In fact, they’ve been nearly identical over time. During August, the former was 0.0%, while the latter was -0.2%. In the CPI, nondurable goods has a weight of 26.9%. It has a weight of 20.6% in the PCED. Nondurable goods includes energy and food.

(2) Durable goods. Over time, the inflation rates of durable goods in the CPI and PCED have diverged significantly (Fig. 8). Since 1990, the spread between the two has been 1.2 percentage points. During August, the former was up 0.6% y/y, while the latter was down 1.1%. In the CPI, durable goods has a weight of 9.9%. It has a weight of 10.6% in the PCED.

Drilling down, we find that the divergence in the durable goods category is fairly widespread. In recent years, the inflation rates for new vehicles, used vehicles, and furniture have tended to be higher in the CPI than in the PCED.

(3) Medical care services. Among services, medical care shows the biggest divergence between the CPI and PCED measures (Fig. 9). Since 1990, the gap has been 1.3 percentage points. During August, the former was up 4.3% y/y, while the latter was up 1.8%. This ongoing divergence is somewhat muted by the lower weight of medical care services in the CPI (at 7.0%) than in the PCED (at 16.9%). The former includes only out-of-pocket expenses, while the latter includes the cost of all such outlays, including those paid for by public and private insurance plans.

(4) Rent of shelter. There’s almost no divergence between the rent-of-shelter inflation rate in the CPI and PCED (Fig. 10). They’ve both been hovering around 3.5% over the past few years, making rent one of the most rapidly inflating components of consumer prices. Indeed, inflation in rent of shelter has exceeded the inflation rates of both the headline CPI and PCED much more often than not. However, rent of shelter has a much higher weight in the former, of 33.4%, than in the latter, at 15.9%. It accounts for a whopping 41.7% of the core CPI and 17.9% of the core PCED. So rent inflation has been one of the major reasons why the CPI inflation rate has been exceeding the PCED inflation rate on both a headline and core basis.

Rent of shelter includes tenant rent (with weights of 8.0% and 4.2% in the headline CPI and PCED), and owners’ equivalent rent (at 24.1% and 11.6%). The latter reflects an odd concept: how much homeowners would have to pay to rent their home from themselves.

Inflation II: Still DOA in Eurozone and Japan. The US headline CPI inflation rate has been running hotter than the comparable rates in the Eurozone and Japan for quite some time. The goods components of the three measures tend to be volatile and diverge from time to time (Fig. 11). They’ve converged recently, with the US at 0.2% during August and the Eurozone and Japan at 0.8% and 0.3%, respectively, during August.

In the US, the services inflation rate (2.7% in August) remains much higher than in the Eurozone (1.3% in August) and Japan (0.2% in August) (Fig. 12). We suspect that the discrepancies are mostly attributable to a higher weight for rent inflation in the US than in the Eurozone and Japan.

Inflation III: Wages Still Outpacing Prices. As I discussed yesterday, the key to a happy economic outlook and a continuation of the bull market in stocks is productivity growth. I think productivity growth is starting to make a comeback as the labor market gets tighter. If so, then wages—which have been rising faster than prices since the mid-1990s—would rise at a faster clip. Faster growth of real wages likely would more than offset the supply-side slowdown in payroll employment growth. A quicker pace of productivity growth would keep a lid on inflation. Profit margins would remain at recent historical highs or even go higher. The bull market in stocks would continue as earnings moved higher.

At a meeting last week in San Francisco with one of our accounts, I was asked to explain why an 8/7/18 Pew Research Center study disputed my claim that real wages have been rising for many years. The fellow came prepared with a copy of the piece, titled “For most U.S. workers, real wages have barely budged in decades.”

Right at the top is a chart showing that the purchasing power of average hourly earnings has been flat for 40 years! Can that possibly be right? Nope, it cannot be right. It makes absolutely no sense. In fact, it’s total nonsense. Consider the following:

(1) Agreeing on wage measure. The author of the study and I both focus on the average hourly earnings (AHE) of production and nonsupervisory workers. The series starts in January 1964, while the series for all workers is available only since March 2006. But the less comprehensive series has covered around 80%-84% of all workers and isn’t as skewed by the wages of top earners.

(2) Disagreeing on price measure. The Pew study divided AHE by the CPI indexed to 2018 dollars. It is well known that the CPI is upwardly biased, especially compared to the PCED (Fig. 13). Since January 1964 through August of this year, the CPI is up 728% while the PCED is up 539%, both indexed to 2018.

Over this same period, AHE is up 844%. Adjusted by the CPI, AHE was $22.90 during August, no higher than it was during late 1973, confirming Pew’s alarming and depressing headline (Fig. 14). Adjusted by the PCED, the AHE was the same, but up 48% over the same period!

(3) Making sense. The PCED-adjusted measure of the real wage makes much more sense. It rose during the second half of the 1960s before stagnating during the 1970s as a result of two oil price shocks and during the 1980s as a result of deindustrialization. It rebounded, along with productivity growth, during the second half of the 1990s in an uptrend into record-high territory since the late 1990s that persists to this very day.

BREXIT: Update. When we last covered Brexit in detail, in our 8/29 and 8/28 Morning Briefings, Melissa and I noted that a no-deal Brexit could be the worst-case scenario for markets upon the UK’s official separation from the EU. Some have said that the country’s currency could crash, inflation could soar, London equities could suffer, and/or a recession in the region could ensue.

While the UK’s conservative leaders are crafting a fiscal and economic policy response to prepare for a hard Brexit, the UK’s leadership has said that they really don’t know what the short-term impact could be to the UK’s economy, wrote BBC News yesterday. While a hard Brexit remains possible, a lot of obstacles would have to be overcome first. Consider the following:

(1) Humbug. In a turn of the Brexit drama, Prime Minister Boris Johnson’s call to suspend the UK’s parliament for weeks leading up to the Brexit deadline on 10/31 was deemed unlawful by the Supreme Court over there. A hostile Parliament was ordered to get back to work last Wednesday, as National Review detailed. (See this short video from The Guardian for an idea of the mood in the room.)

Prior to the suspension, Parliament passed a measure that requires a deal to be reached during the 10/17-18 EU summit or else Brexit must be further extended until at least 1/31, reported The Guardian. We highly doubt a deal will be reached by 10/18, as too many internal and external parties are involved for such a controversial deal to come together in short order.

(2) Surrender act. Johnson has mocked the UK opposition party’s extension bill by coining it the “Surrender Act” or “Capitulation Act.” Despite the Act, Johnson and his conservative supporters in Parliament have refused to back down from the 10/31 deadline date. Supposedly, the PM is for leaving with or without a deal at the end of next month without breaking the law.

Johnson’s main prospect for Brexiting with or without a deal seems to be to call for a snap election with the aim of gaining a stronger conservative backing in Parliament to support what he wants to do. Johnson came out fighting, calling for a snap election last Wednesday. However, a two-thirds vote of Parliament is required to hold a snap election and has yet to be agreed upon, reported CNN. The opposition has said that it would happily hold one, but only after a no-deal Brexit is ruled out, as documented in a CNN video.

Calling for a snap election is a risky move for Johnson because he could lose his seat altogether in the crossfire. In any event, Johnson may have run out of time for calling a snap election ahead of his 10/31 deadline. Parliament must be dissolved 25 days before an election, according to the CNN article. In an alternative scenario, Johnson could resign as a “Brexit martyr” and run again in the next election.

(3) 3-D chess. “[T]o understand Boris Johnson’s predicament, you need to grasp the complex and contradictory trade-offs inherent in keeping power at home while managing international negotiations abroad,” The Guardian smartly observed. The article added that for Johnson to “secure a deal,” he must do so in a way that will be approved by the EU, survive parliamentary scrutiny, and gain him a majority in the next general election.

Johnson’s time as PM could be cut short for other reasons too, as he faces recent allegations for improper actions that took place decades ago reminiscent of the recent “Me Too” movement in the US. Only a master at British political chess could possibly guess what happens next. Our best guess is that the Brexit deadline is extended yet again.

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California Dreamin’

September 30 (Monday)

California I: The Other Coast. I visited with our accounts in California last week. I was in San Francisco, Pasadena, Los Angeles, Newport Beach, and San Diego. According to the 1972 song: “It never rains in Southern California.” It did on Thursday and Friday when I was in LA and San Diego. In other words, never say never. Never say Trump won’t be impeached. Never say “Never Trump,” which actually has a Wikipedia page.

While I was meeting with our accounts out West, the West Wing at the White House faced an impeachment hearing as a result of the President of the United States’ asking the President of Ukraine for a favor. Everyone else outside of the Beltway went about their business. The financial markets remained relatively calm. The S&P 500 edged down 1.0% last week (Fig. 1). The 10-year US Treasury bond yield edged down last week to 1.69% (Fig. 2).

Some of the weakness in the stock market last week was attributable to President Trump’s speech at the UN on Tuesday. He berated China as follows: “In 2001, China was admitted to the WTO. Our leaders then argued that this decision would compel China to liberalize its economy and strengthen protections to provide things that were unacceptable to us, and for private property and for the rule of law. Two decades later, this theory has been tested and proven completely wrong. Not only has China declined to adopt promised reforms, it has embraced an economic model dependent on massive market barriers, heavy state subsidies, currency manipulation, product dumping, forced technology transfers, and the theft of intellectual property and also trade secrets on a grand scale.”

Nevertheless, he expressed hope that an agreement that’s beneficial for both countries still can be negotiated. But, he said, “I will not accept a bad deal for the American people.”

On Friday, the market was weak on news that the Trump administration is considering curbs on US investments in China. In his Barron’s column, Randy Forsyth explained, “What’s actually being discussed would plug a loophole exempting Chinese companies from the same disclosure requirements that other foreign and U.S. concerns face.”

Also jarring investor confidence last week were signs that the IPO market is getting tougher for new offerings, especially if they have questionable earnings prospects. As Randy concluded, “[i]f the equity market is showing rational reluctance to provide profitable exits for private investors in profitless unicorns, that’s all good.”

Meanwhile, in California, while there wasn’t much immediate concern about these recent events, I was surprised by the uniformity of the fatalistic narrative about the long-term outlook that seemed to prevail during several of my meetings. The basic premise is that whether Trump does or does not weather the latest impeachment storm, socialism is coming. Consider the following:

(1) Socialism. Sooner or later, there will be a wealth tax, according to this narrative, and the wealthy will willingly pay it for the sake of social stability. It will happen sooner if Warren is in the White House in 2021.

In this scenario, the wealthy are getting wealthier thanks to technological innovation. That allows them to make more of the goods and services we all consume with less and less labor. That means that more and more people will be forced out or leave the labor force if they can’t adapt to the brave new world.

(2) UBI. To maintain social stability, the government will have to provide a Universal Basic Income (UBI) that would allow people to pursue whatever path they find rewarding in life, whether it be working for a living, writing poetry, or mastering miniature golf.

(3) Taxes and MMT. To pay for all this, income taxes on the rich will have to be raised and supplemented with taxes on their wealth. Furthermore, just as Modern Monetary Theory predicted, the Fed will keep interest rates near zero and buy lots of Treasury bonds, enabling the fiscal authorities to run larger and larger deficits to fund their socialist schemes and green new deals.

(4) Democrats’ agenda. Of course, none of the above is theoretical. Several of the contenders to be the next Democratic nominee for president are running on minor variations of this socialist agenda.

Some of my friends in California, who tend to be conservative, aren’t endorsing this agenda. Rather, they seem resigned to it. They figure that following the next financial crisis, the socialists will have all the plans to make life better for all who have been on the losing side in the brave old world. In the brave new world, health care will be free, and so will all education. This may require some of us to be less free to pursue our selfish interests such as building a business, earning more money, and accumulating wealth.

(5) Next crisis. According to a few of the accounts I met, the next financial crisis is coming sooner rather than later. These folks tend to be involved in commercial real estate as well as private equity and debt. They told me that they are seeing “crazy stuff” happening in these markets that is very reminiscent of the excesses that led to the Great Financial Crisis. Commercial real estate values are soaring, as investors are coming to believe that their financing rates will remain near historical lows forever. Credit quality is rapidly deteriorating, as bonds and leveraged loans are issued with fewer, if any, covenants.

One fellow in Newport Beach, who has 30 years of experience as a derivatives trader, believes that bonds with negative yields may be symptomatic of the proliferation of new derivatives that convert them into positive returns. Such alchemy is reminiscent of how derivatives transformed subprime mortgages into triple-A CDOs and CDSs.

(6) Happier story. In several of my meetings, I offered a more optimistic alternative scenario to the one outlined above. The key is productivity growth.

I think productivity growth is starting to make a comeback as the labor market gets tighter. If so, then wages—which have been rising faster than prices since the mid-1990s—would rise at a faster clip. Faster growth of real wages likely would more than offset the supply-side slowdown in payroll employment growth. A quicker pace of productivity growth would keep a lid on inflation. Profit margins would remain at recent historical highs or even go higher. The bull market in stocks would continue as earnings moved higher.

(7) Bottom line. Needless to say, my trip to California was an eye opener. So with my eyes wide open, I’m going to remain bullish on stocks for now, but will work with my team to more fully assess some of the risks that were discussed at my meetings in California.

California II: Politics Matters. In the past, politics didn’t seem to matter much to the stock market. We’ve had bull markets when the White House had both Democratic and Republican presidents (Fig. 3). The same can be said about the relationship of the stock market to the balance of power in Congress (Fig. 4). Yet prior to every presidential election, we all seem to agree that it will be more consequential than ever for the economy and the stock market.

That’s especially true now as we approach the next election. This time, the election might actually be more consequential than previous ones because the agenda of the Democrats has turned increasingly to the Left, while the Republican agenda (at least under Trump) has gone in the other direction. If Trump doesn’t get impeached and wins another term, that would be a radically different scenario than a victory by Elizabeth Warren, who is passing Bernie Sanders as the standard-bearer for the socialists in the Democratic Party.

Joe Biden is still in the race, but he could be the only casualty of the move by the Democrats to impeach Trump. After all, while Trump’s request of the Ukrainians only implied a quid pro quo—military aid in exchange for the favor Trump requested—Biden is on tape saying that military aid was contingent on the country’s delivering on the favor Biden requested. Some Democrats may very well be hoping that they knock both Trump and Biden out of the presidential race!

Politics matters, and we will be spending more time assessing it, not as partisans, but as investment strategists trying to determine whether the latest developments are bullish or bearish for stocks and bonds. Given last week’s events, I asked Melissa to research the impeachment process. Here are a few of her preliminary findings on this topic that came up often in my discussions in California:

(1) The case for and against. Did Trump abuse his executive power to withhold US aid when he asked the Ukraine to “look into” Biden, who may have abused his power as vice president to stop a Ukrainian prosecutor’s inquiry into his son? That’s the central question in the impeachment inquiry. The President’s defenders claim that evidence suggesting Trump abused his power is lacking and question whether he broke any laws.

But an impeachment may proceed regardless. Under the framework of the Constitution, according to the Washington Post, the House can vote to impeach a president for “high crimes and misdemeanors,” meaning whatever the House wants it to mean. Impeachment alone wouldn’t remove Trump from office, however; for that, the Senate must convict the impeached.

(2) Alternative scenarios. The Week helpfully outlined four impeachment scenarios: impeachment inquiry only, House impeachment and Trump resignation, House impeachment and Senate acquittal, impeachment and conviction (i.e., removal from office). But under which of these scenarios could, or would, Trump run for reelection? Currently, the most likely scenarios are an impeachment inquiry only or an impeachment and acquittal. In either case, Trump could run for reelection.

In the House, a simple majority of 218 votes is needed for impeachment, which would seem an easy bet, as there are 235 House Democrats. But gaining all the necessary votes may not be so simple, as a 9/25 MSNBC article discussed. Even harder would be the Senate’s removing Trump from office, for which a two-thirds majority is needed; that would require “20 Republicans to join 45 Democrats and both of the Senate’s independents.”

(3) Memorandum. Exhibit A in the impeachment hearing is the memorandum of Trump’s 7/25 telephone conversation with Ukrainian President Volodymyr Zelensky. While Trump did not explicitly request favors in exchange for US aid on this call, evidence external to the call may implicate the President.

(4) Conspiracy theories. By the way, Trump also asked the Ukrainian President on the phone call to investigate Crowdstrike, the cybersecurity company involved in the Democratic National Committee’s (DNC) allegations that Trump colluded with the Russians to hack the 2016 election database. Trump reportedly believes that a server held in the Ukraine by Crowdstrike may carry evidence that the DNC framed him, as discussed in a 9/26 Forbes article.

California III: Homeless. The weather will always be better on the West Coast than the East Coast. It’s been that way at least since The Mamas & The Papas sang “California Dreamin’,” released in 1965. The lyrics say that “On a winter’s day / I’d be safe and warm / If I was in L.A.”

On the other hand, California isn’t as carefree as it once was, when it was officially nicknamed “The Golden State” in 1968. A 9/28 article in MarketWatch reported: “More than half a million people are homeless each night in the United States, a new White House report has found. And nearly half of them are concentrated in one state: California.”

Why has this happened? Weather-wise, it’s less challenging to be homeless in warm and sunny California than other states that have inclement weather. Furthermore, many of California’s homeless simply can’t afford to rent, let alone own a home. Rents and home prices are too high.

The article cited above is based on a September 2019 White House report, The State of Homelessness in America by the Council of Economic Advisers. The article notes:

(1) “At the city level, four of the five cities with the highest rate of unsheltered homelessness are in California: San Francisco, Los Angeles, Santa Rosa and San Jose. Seattle joins the California municipalities in the top five.”

(2) “As for state homelessness rates, the District of Columbia has the highest in the country, at 5.8 times the U.S. rate. New York is next, followed by Hawaii, Oregon and California. These five states together [represent] 20% of the overall U.S. population but 45% of the country’s homeless population.”

A 9/10 Washington Post article reported: “President Trump has ordered White House officials to launch a sweeping effort to address homelessness in California, citing the state’s growing crisis, according to four government officials aware of the effort.”

Movie. “Downton Abbey” (+ +) (link) is a feel-good movie about the good old days in Britain, when people were more civil to one another than they are today. Everyone knew their place in society and was comfortable with it. Everyone did their job with pride, even those who were the downstairs servants of the upstairs aristocrats. That’s a rather simplistic portrait since there are always tensions that keep societies perpetually in flux. The movie is basically a sappy reunion of the British television show’s cast of mostly likable characters.

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The Utility of Utilities

September 26 (Thursday)

Strategy: Lots of Winners. After days like Tuesday, it’s easy to understand why “safety sectors”—perceived as less risky than average—have been in vogue. President Trump’s speech to the UN dashed investors’ hopes for a quick trade agreement. He bluntly described how the Chinese steal US technology and benefit from unfair trade practices, and later in the speech painted US tech companies as enemies of democracy. The day ended with House Speaker Nancy Pelosi (D-CA) announcing that the House of Representatives is beginning a formal impeachment inquiry into President Trump. Another banner day in US politics.

Safety sectors ruled the day on Tuesday, continuing the outperformance that has accelerated since late summer. Here’s the performance derby for the S&P 500 sectors from 8/1 through Tuesday’s close: Utilities (7.5%), Real Estate (4.7), Consumer Staples (2.4), Industrials (1.3), Financials (1.0), S&P 500 (0.4), Consumer Discretionary (-0.3), Communication Services (-0.4), Health Care (-0.5), Materials (-0.5), Information Technology (-0.8), and Energy (-1.4) (Table 1). Let’s dive deeper into the market’s movements:

(1) Utilities stocks hitting records. Ironically, the S&P 500 Utilities stock price index is at a record high even though its market-capitalization share of the S&P 500 is at an all-time low (Fig. 1 and Fig. 2). The industry’s stock performance has been helped by P/E multiple expansion. The S&P 500 Utilities trade at a forward multiple of 19.8, 3.4pts higher than one year ago (Fig. 3). But that’s far below the 55.6 “P/E” of the 10-year Treasury note (Fig. 4).

(2) Utilities’ dividends attractive. Utilities also offer a nice dividend yield, relative to other S&P 500 sectors’. A sluggish global economy combined with low inflation could make dividend payers attractive for some time. Here’s are the dividend yields offered by the various S&P 500 sectors: Energy (3.47%), Real Estate (3.16), Utilities (3.11), Consumer Staples (2.87), Communication Services (2.32), Financials (2.11), Materials (1.98), Industrials (1.94), S&P 500 (1.92). Health Care (1.71), Information Technology (1.38), and Consumer Discretionary (1.30) (Fig. 5).

(3) Utilities seeing strong relative earnings this year… Investors’ love affair with Utilities has some foundation in fundamentals this year. Analysts are expecting the sector to grow earnings moderately, by 4.2%, in 2019. That makes Utilities the fourth-fastest-growing among the S&P 500’s 11 sectors. Here are the S&P 500 sectors’ expected 2019 earnings growth rates: Financials (9.2%), Health Care (7.4), Consumer Discretionary (5.2), Utilities (4.2), Communications Services (2.6), S&P 500 (2.0), Consumer Staples (1.1), Information Technology (0.5), Industrials (0.4), Real Estate (-0.1), Energy (-20.0), and Materials (-21.8) (Fig. 6).

(4) …But there’s more earnings growth elsewhere in 2020. However, investors buying Utilities today may be fighting yesterday’s war. Looking forward to 2020, traditional growth sectors are forecast to have much faster earnings growth than Utilities and other safety sectors. Here are the S&P 500’s sectors’ expected earnings growth rates in 2020: Energy (28.8%), Industrials (17.2), Materials (15.6), Communications Services (12.4), Consumer Discretionary (12.0), S&P 500 (10.1), Health Care (9.7), Information Technology (8.0), Consumer Staples (7.1), Financials (5.2), Utilities (5.1), and Real Estate (-10.9).

Perhaps that explains why both high-growth and defensive names are having a banner year. Investors willing to look ahead can justify buying S&P 500 Tech, Communications, and Consumer Discretionary sectors because of their faster earnings growth, while defensive investors or those looking for income can turn to Utilities, Real Estate, and Staples.

For a change, almost every sector is a winner on a ytd performance basis through Tuesday’s close: Information Technology (28.6%), Real Estate (26.4), Utilities (22.1), Communication Services (20.8), Consumer Discretionary (20.2), Industrials (20.1), Consumer Staples (19.3), S&P 500 (18.3), Financials (17.0), Materials (14.2), Energy (5.0), and Health Care (4.9) (Fig. 7).

Disruptive Technologies: Updates. Technology stands still for no one. Here are some of the latest developments in four areas we’ve touched on in the past: quantum computing, robots, drones, and high-tech tunneling. I asked Jackie for a quick update:

(1) Google claims quantum supremacy. Google claims that its quantum computer is more powerful than the most powerful classical computer. This claim of “quantum supremacy” was made in a research paper temporarily posted on a NASA website, a 9/20 FT article stated.

The paper claimed that the Google quantum computer could perform a calculation in three minutes and 20 seconds, beating the 10,000 years that the same calculation would take the fastest classical computer, dubbed “Summit.” Google’s 53-qubit computer was asked to prove “that a random-number generator was truly random. Though that job has little practical application, the Google researchers said that ‘other initial uses for this computational capability’ included machine learning, materials science and chemistry,” the FT reported.

Google, which declined to comment in the FT’s story, predicted in the report that the power of quantum computers would increase at a “double exponential rate” compared to the exponential rate laid out in Moore’s Law, which has described the rate of improvement in silicon chips and classical computers. For a primer on quantum computing, check out our 7/11/18 Morning Briefing.

(2) More on high-tech deliveries. On its earnings conference call last week, FedEx mentioned that Roxo, its delivery robot, is being tested in three markets: Memphis, Tennessee; Plano, Texas; and Manchester, New Hampshire. “Roxo preparing to change the way on-demand e-commerce shipments make it to customers’ doorsteps,” said Brie Carere, FedEx’s chief marketing and communications officer.

Roxo has conquered the challenges of stoops and curbs because its power base “is modeled after the standing, stair-climbing wheelchair invented by Dean Kamen of DEKA Development and Research, more than 20 years ago. Now, higher volume production of the base could help lower the cost and make the wheelchair more accessible for the disabled,” an 8/7 MSN article reported. Here’s a promotional FedEx video of Roxo.

Roxo faces competition from drones. FedEx, Walgreens, and Sugar Magnolia are working with Wing, the drone delivery service company that began life at Alphabet. Starting next month, they plan to use Wing’s drones to deliver health care products, food, and other items in Christiansburg, Virginia, according to a 9/19 article on The Verge. Wing has been certified as a commercial air carrier by the Federal Aviation Administration, which allows its drones to make deliveries even when they are not within the drone operator’s line of sight.

Here are the details, courtesy of a 9/19 CNET article: “The drones will take off from and land at a nearby service center. They'll fly about 100 to 200 feet in the air. When the drone is ready to drop off a package, it'll hover at about 23 feet and lower the box with a tether to a backyard or doorstep. Wing's drones weigh about 10 pounds and will be able to carry packages that weigh about 2 to 3 pounds, Burgess said. The aircraft will fly 60 to 70mph and can travel about 6 miles one way. The company said items will be delivered within 5 to 10 minutes of ordering.”

(3) Dig, Baby, dig. Elon Musk’s Boring Company is preparing to dig its first commercial tunnel in Sin City. A Twitter user posted pics of large equipment being positioned to start construction of three Las Vegas tunnels, according to a 9/24 Teslarati article. Boring won the $48.6 million project last spring, and Musk has said it could be completed by the end of this year even though the project’s official due date is 2021.

The project involves one pedestrian tunnel and two vehicle tunnels that connect two Las Vegas Convention Center buildings about a mile apart. But make no mistake: This is no hyperloop. Modified Tesla EVs that can carry up to 16 passengers are expected to shuttle people between the two buildings at high speeds. Initially, they will be manned by humans, but the hope is that they will work autonomously in the future.

Consumer Discretionary: Used Autos Cruising. We’ve penned quite a bit about the woes of the auto industry both at home and abroad. However, if CarMax’s results are any indication, the ills of the new car industry are benefitting sellers of used cars. Let’s take a drive-by:

(1) Car sales go omnichannel. CarMax, a used car dealer, reported that its revenue rose 9.1% in its fiscal Q2 ended 8/31, with sales in stores open more than a year increasing 3.2% and total used car sales rising 6.2%. The company is in expansion mode both online and on land. CarMax opened 18 stores over the past year and plans to open another 13 stores over the next 12 months. In addition, it’s rolling out omnichannel shopping, where consumers can shop online and purchase online or in a showroom. In some markets, consumers can find a car they like online and CarMax will bring it to their home for a test drive.

(2) Pricier autos. Both used and new car prices are increasing, but new car prices are increasing faster, with the price gap between new and three-year-old vehicles widening to $14,443. according to a Q2 report from Edmund’s. That explains why the 12-month moving average of new car dealers retail sales hit a new high of $78.5 billion in July, even as the number of new cars sold has stalled (Fig. 8 and Fig. 9).

(3) Tech pumps up the prices. A big reason that new cars are rising in price is all the new tech bells and whistles consumers can opt for today. As for used car prices, Edmund’s explains that they are rising because there are more SUVs in the mix, there are more younger cars coming off leases, and the increased technology hiking new car prices boosts used car prices too. The average price of a used car has jumped to $20,700 in Q2 from $17,900 in 2014.

“[A]s equipment becomes more tech-focused, shoppers face the prospect of purchasing a vehicle that quickly becomes out-of-date. But for those who aren’t in need of the latest and greatest, there will be even more value in buying used,” the report concludes.

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Flow of Funds (FOF)

September 25 (Wednesday)

FOF I: Households. Americans collectively have never been wealthier. This statement doesn’t come with a money-back guarantee, nor does it take a stance on income and wealth inequality. It is a simple observation based on the latest data, for Q2, published in the Fed’s September 2019 Financial Accounts of the United States.

US household wealth rose to a record $113.5 trillion during the quarter (Fig. 1). That’s up 88% from its cyclical low during Q1-2009. Even compared to the previous cyclical peak, during Q3-2007, household wealth is up 59%. The ratio of household net worth to disposable personal income was 6.9 during Q2, continuing to hover near the record high of 7.0 recorded during Q4-2017 (Fig. 2). Let’s have a closer look:

(1) Assets. A big contributor to the rebound in household net worth since the Great Recession has been equities directly held by households as well as indirectly held by them in mutual funds and other accounts (Fig. 3). Equities directly held totaled $18.3 trillion during Q2, while mutual fund holdings (which include equity and bond funds) totaled $9.1 trillion. Both were just shy of their record highs during Q3-2018.

The stock-market rally has worsened wealth inequality, since the wealthiest households own the most equities. Life isn’t fair. However, lots of households have pension entitlements, which jumped to a record $27.1 trillion during Q2.

Also at a record high, of $18.7 trillion during Q2, was owners’ equity in household real estate, which tends to be more equitably distributed than stock-market wealth. Small business owners are also prospering, as evidenced by the record high of $13.2 trillion in equity in noncorporate business.

The downside to this litany of prosperity is that of the $27.1 trillion in pension entitlements, a whopping $6.2 trillion is unfunded (Fig. 4). However, thanks to the dramatic rally in stocks and bonds, the unfunded portion of pension entitlements was 22.8% during Q2, down from a recent high of 34.2% during Q1-2009 (Fig. 5).

The good news is that private pensions, with $10.4 trillion in liabilities, are close to 100% funded (Fig. 6). The bad news is that state & local pensions, with $8.8 trillion in liabilities, are only 52% funded (Fig. 7). Also for the good-news column: Americans have a record $9.4 trillion in Individual Retirement Accounts (Fig. 8).

(2) Liabilities. From Q1-2009 through Q2-2019, household assets are up 71%, while household liabilities are up only 13% (Fig. 9). Home mortgage debt, currently at $10.4 trillion, has been essentially unchanged over this entire period (Fig. 10). As a result, household liabilities as a percentage of household assets was 12.5% during Q2, down from a record 19.2% during Q1-2009 (Fig. 11).

FOF II: Nonfinancial Corporations. While it is widely recognized that the household sector is in good shape, there is a great deal of controversy about nonfinancial corporations (NFCs). The litany of concerns includes that they aren’t investing enough, that they are borrowing excessively, and that they are spending too much on buybacks. Yet, the latest data from the Fed’s Financial Accounts of the United States show that nonfinancial corporations also are doing well, overall. Consider the following:

(1) Cash flow and capital spending. The four-quarter sum of NFC cash flow and of capital expenditures both rose to record highs of $2.1 trillion through Q2 (Fig. 12). Contrary to the popular myth, net fixed investment during the current economic expansion has been comparable to that of the previous two economic expansions (Fig. 13).

(2) Bonds and loans. As we’ve noted before, the record amount of NFC debt has been of widespread concern for a while. It rose to $10.0 trillion during Q2, with outstanding bonds at $5.7 trillion and loans at $3.5 trillion (Fig. 14).

Of course, most of the bonds were either issued or refinanced at record-low interest rates, reducing the burden of servicing all that debt. That means that the upward trend in the ratio of NFC debt to internal cash flow exaggerates the burden (and risk) of the debt (Fig. 15).

(3) Buybacks. As for buybacks, Joe and I wrote a detailed study titled “Stock Buybacks: The True Story,” during May of this year. Our basic finding was that since the start of 2011, roughly two-thirds of S&P 500 buybacks were done to offset dilution from employee stock compensation, with the remainder to boost earnings per share. In other words, the widespread view that corporations have been borrowing in the bond market to boost their earnings per share is mostly wrong.

The Fed’s Financial Accounts of the United States has contributed to the confusion by showing only the net issuance of equities, which has been significantly negative for many years, without also accounting for the offsetting purchases of equities by employee stock compensation plans. I brought this issue to the attention of the Fed’s staff. One fellow acknowledged the problem and told me it will be investigated.

Draghi: Give MMT A Chance. Outgoing ECB President Mario Draghi told European lawmakers that Modern Monetary Theory (MMT) should be considered to stimulate the slowing economy of the Eurozone. “It’s a government decision, not [that of] the central bank,” he said. During his tenure, Draghi’s monetary policy commitment to “do whatever it takes” to save the Eurozone economy hasn’t been enough, so Melissa and I aren’t surprised that before his 10/31 departure he is calling on fiscal policy to save the day.

The basic tenet of MMT is that a government may borrow and spend to infinity and beyond because it controls the creation of money. Under MMT, governments can never run out of money to pay their debts, say MMT advocates. Draghi has set the stage for MMT in Europe by setting the bank’s interest rates at ultra-low levels (i.e., negative on the key policy rate) and restarting the asset-purchase program to encourage not only private, but public borrowing and spending.

The problem is that German leaders won’t readily succumb to pressure from the ECB, let alone its outgoing president, to consider an idea like MMT. Officials of the EU’s largest economy deeply value fiscal discipline. They undoubtedly will protest that MMT violates the principles of the Maastricht Treaty, the official treaty on the European Union signed in 1992, which emphasizes sound fiscal policies and limits on debt.

Some German officials have publicly opposed Draghi and his unconventional policies. They are particularly upset by the impact on German savers. Eventually, they may not have much of a choice but to consider fiscal options, especially if the ECB’s latest stimulus package fails to jumpstart the Eurozone’s manufacturing sector and broader economy, as we discussed in our 9/16 Morning Briefing.

The only real limit on MMT kicks in if and when running government deficits begins to cause inflation to overheat. That doesn’t seem like it will be a problem in Europe anytime soon, because even highly aggressive monetary policy has failed to stimulate inflation toward the central bank’s 2.0% target. (For more on MMT, see our 4/19/18 Morning Briefing.)

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The Dissenters

September 24 (Tuesday)

Global Economy I: Germany Still Sinking. IHS Markit has released its flash estimates for September’s Purchasing Managers’ Indexes (PMIs) in the Eurozone along with those for France and Germany. The German data were downright ugly. There’s no oomph or oompah in Germany. Instead, manufacturing has fallen into a recession and is dragging down the rest of the economy. Real GDP edged down 0.3% (saar) during Q2 and is up just 0.4% y/y (Fig. 1). Another q/q decline is likely during Q3.

In the Eurozone, Markit estimates that the Composite PMI (C-PMI) fell from 51.9 during August to 50.4 this month (Fig. 2). The drop was led by the Manufacturing PMI (M-PMI), which is down from a recent peak of 60.6 during December 2017 to 45.6 this month. However, the Nonmanufacturing (NM-PMI) also contributed to the month’s decline, falling from 53.5 to 52.0. Germany stands out with an M-PMI that is now down to 41.4 compared to 50.3 in France (Fig. 3). Also weakening in Germany is the NM-PMI, which is down from this year’s high of 55.8 during June to 52.5 in September (Fig. 4).

We’ve previously observed that there is something wrong with Germany’s economy. Trump’s trade wars may be part of the problem, but Germany—along with most of the rest of the world—has a serious homegrown problem: not enough babies and too many seniors. Babies tend to stimulate consumption as they grow older. It’s hard to stimulate people who are already old to do much of anything.

That may explain the weakness in global auto sales in recent years (Fig. 5). Germany’s manufacturing economy is particularly dependent on the auto industry. Let’s have a closer look at Germany’s economy:

(1) Tougher emission standards. In the Eurozone, regulators made things worse for the industry with new emission standards imposed a year ago. The new EU-wide test procedure was the authorities’ reaction to VW’s 2015 admission to widescale cheating on diesel vehicles, with suspicions since spreading to other manufacturers.

(2) Losing cache. Germany’s high-performance and high-priced Bimmers and Benzes may not be as popular with Millennials around the world as they were with the Baby Boomers. Millennials tend to be minimalists. They are more concerned about fuel economy and are likely to favor electric vehicles once EVs become cheaper and have more range.

(3) Competing with Chinese EVs. A 9/20 Bloomberg article titled “China Is Winning the Race to Dominate Electric Cars” hits on several of the issues plaguing Germany’s automakers. For starters: “The global auto market is not only not growing, but it is also shrinking. Sales peaked in 2017 at nearly 86 million on a trailing-12-months basis; right now in 2019, sales are closer to 76 million.”

The future for the auto industry is electric vehicles, which are mostly made in China: “There is only one company in the top 10 by percent of electric passenger vehicle revenue that isn’t Chinese: Japan’s Mitsubishi Corp. Two Chinese automakers get more than 40% of revenue from electric vehicle sales; a third gets nearly a quarter of its revenue from EVs.”

(4) Fiscal stimulus coming? In August, German Chancellor Angela Merkel said she sees no need for a stimulus package “so far” but added that “we will react according to the situation.” She pointed to plans to remove the so-called solidarity tax, an added income tax aimed at covering costs associated with rebuilding the former East Germany, for most taxpayers.

(5) Green new deal. The problem is that the government plans to spend $60 billion through 2030 on green new deals, which are more likely to weigh on the economy than to stimulate it. According to the 9/20 WSJ article on this subject:

“The measures, including subsidies for green power generation, will be financed by revenues from higher taxes on polluting activities, such as air travel and car fuel, as well as a new carbon emission certificate trading scheme to be launched in 2021. The package won’t affect Germany’s balanced budget. Despite international pressure on Berlin to loosen the purse strings and revive a slowing economy, the country’s budget surplus is projected to stand at over €40 billion in 2019.”

The government will help to finance more than a million charging stations for EVs by 2030. Owners and buyers of EV cars will get government subsidies, which might further depress gasoline-powered auto sales.

Global Economy II: S&P 500 Revenues Still Growing. The weakness in global manufacturing activity is confirmed by the 17% drop in the CRB raw industrials spot price index since mid-2018 (Fig. 6). The price of copper, which is especially sensitive to global factory demand, actually peaked in 2011. It has been weakening since mid-2018 following a modest rebound during 2016-17 (Fig. 7).

Notwithstanding the litany of global economic woes, S&P 500 revenues per share continued to trend higher, into record territory, through Q2, rising 5.2% y/y (Fig. 8). Weekly forward revenues per share, which is a good coincident indicator of the quarterly series, has done the same through mid-September. And the same can be said for S&P 500 forward earnings, which is a good leading indicator of actual earnings. Earnings seem to be growing in line with revenues given that the forward profit margin has been flat at around 12.0% since the start of this year.

Fed I: Better than Groupthink? Dissension among FOMC voters isn’t unusual from a historical perspective, but the last FOMC meeting—on 9/17-9/18—saw three dissenters, the first time there were that many since 2016, and opposing views among them, a first in recent memory. Boston Fed President Eric Rosengren and Kansas City Fed President Esther George opposed rate-cutting, as they did in July, while the third dissenter, St. Louis Fed President James Bullard, favored an even bigger rate cut.

One measure of success for a Fed chair is the ability to unite colleagues with differing opinions. This level of dissension represents a clear challenge for Powell. Nevertheless, the 9/18 WSJ observed that “Powell has taken the variety of arguments in stride.” Earlier this month in Zurich, he said that the current FOMC doesn’t submit to “groupthink,” and that he “wouldn’t have it any other way.” We would: The problem with too many opinions, in our view, is that lack of unanimity among officials can unsettle financial markets.

In any event, here’s more on the dissenters’ views:

(1) Cut poses risks to financial stability. In a 9/20 statement, Rosengren said: “The stance of monetary policy is accommodative.” Additional stimulus “risks further inflating the prices of risky assets” and encourages too much leverage. “While risks clearly exist related to trade and geopolitical concerns, lowering rates to address uncertainty is not costless.” He elaborated on these thoughts in a 12-page speech.

(2) Cut not warranted based on incoming data. George last explained her dissenting view with a brief follow-up statement on 8/2: “In my view, incoming economic data and the outlook for economic activity over the medium term warranted no change in the policy rate.”

(3) Cut should have been bigger to stimulate inflation. Bullard is for “lowering the target range for the federal funds rate by 50 basis points” to ward off further declines in expected inflation and a slowing economy with downside risks. In his view, it is prudent “to cut the policy rate aggressively now and then later increase it should the downside risks not materialize.”

Fed II: Rosengren’s Dissent. Speaking on 9/20 at a conference on credit markets, Rosengren gave a 12-page speech titled “Assessing Economic Conditions and Risks to Financial Stability” addressing his concerns about cutting rates at this time—the main one being a “potential buildup” in the credit markets as a result of too-low interest rates. Here are the key points (see also his supporting figures):

(1) Already accommodative. Rosengren thinks that monetary policy is already accommodative enough. Two factors indicate so, in his mind. For one, the rate on unsecured overnight credit is near the rate of inflation, so the return on federal funds just about compensates for inflation. Secondly, the current federal funds rate, set at 1.75%-2.00%, is below the estimated longer-run rate of 2.50%.

(2) Expansion continues. Further, “[t]he data we have in hand suggest instead that the recovery would continue apace even with little monetary policy accommodation,” he said. Rosengren cited the unemployment rate at 3.7% and the 12-month change in the core CPI, which stood at 2.4% in August, as well as the fact that the trimmed mean PCE and core PCE have been near the Fed’s 2.0% target rate (see Rosengren’s Figures 4 and 5).

The data do not indicate a forthcoming recession, Rosengren explained, showing charts of building permits (his Figure 6) and initial unemployment claims (his Figure 7). Non-manufacturing indicators of recession are not a concern, nor is any recession signal in the yield curve.

(3) Unmaterialized risks. Rosengren admitted that there are “elevated risks” to the outlook, especially the uncertainty surrounding the US-China trade dispute, that could cause a further slowdown in manufacturing growth and business investment. Nevertheless, real GDP grew by 2.0% in Q2, close to GDP’s sustainable rate (see Rosengren’s Figure 1).

Rationalizing his views on trade, he said: “Most of the U.S. trade dispute is currently with one country. And while the trade dispute has the potential for painful impacts on some industries in the U.S., in total the estimated direct impacts for the U.S. macroeconomy to date are not particularly large—perhaps several 10ths of a percentage point on GDP (in part because exports are only 12 percent of U.S. GDP and tariffs are not on all goods from all countries).”

(4) Financial stability cost. The costs outweigh the benefits of lowering rates further, the Boston Fed president believes. Too much stimulus “entails costs, and thus introduces risks of its own,” he said, adding that very low rates may cause households and firms to take on “excessive risks” in the form of increased leverage and asset inflation that becomes unsustainable.

This might not cause, but could “amplify,” a downturn, should one occur, in his view. Rosengren is worried about commercial real estate leverage, especially the fast-growing market for shared office spaces (see his Figures 9 and 10). Highly leveraged loans’ rising debt-to-EBITDA levels don’t sit well with him either (see his Figure 8).

Fed III: Financial Instability? We agree with Rosengren that monetary policy is accommodative enough to sustain the expansion and that cutting rates further is not necessary right now. However, we don’t see financial stability risk as a pressing reason.

We had a look at the Fed’s flow-of-funds data through Q2, released last week, and its May 2019 Financial Stability Report (FSR). Both suggest that household debt isn’t a problem given its size relative to GDP. The buildup of corporate debt relative to GDP is of greater concern. Consider the following:

(1) Debt to GDP. The debt of the nonfinancial domestic sectors including households and nonfinancial corporations (NFCs) as a ratio of nominal GDP has been stable at about 1.5 from early 2013 through Q2-2019, well below the nearly 1.8 it reached at the height of the financial crisis.

(2) Leveraged loans. Rosengren mentioned specific concern about leveraged loans, but he didn’t put them into a macro perspective. According to the Fed’s most recent FSR, NFC credit ($9.8 trillion) is composed of bonds and commercial paper ($6.2 trillion), bank lending ($1.5 trillion), and leveraged loans ($1.1 trillion). Per the report, leveraged loan growth for 2018 was the highest of all categories, but it remains the smallest share of total NFC credit.

Additionally, these days most leveraged loans are structured in a much simpler, more transparent, “plain-vanilla” way than was typical before the crisis, as we have mentioned before. It is also notable that the big banks are significantly better capitalized than before the crisis, the FSR pointed out.

(3) CRE and co-working. Rosengren detailed the model for co-working spaces in his figure 10. Without getting into the details, we understand his concern that this growing trend could bode ill for the commercial real estate (CRE) market in the event of an economic downturn. However, the effects should be isolated to that market, in our opinion.

For a sense of scale, CRE loans ($2.4 trillion) were about a quarter the size of the mortgage market ($10.3 trillion) as of the latest FSR. How much CRE debt is related to co-working is unknown, but co-working is a rapidly growing subset of the CRE market. By 2028, flexible workspaces are expected to account for about 10% of Class A (i.e., newest and highest-quality) buildings, according to a July 2019 Allwork Space post. And co-working spaces made up about 18.0% of new leasing activity in Manhattan during 2018.

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Powell’s Latest Mid-Cycle Adjustment

September 23 (Monday)

The Fed I: Powell’s Crib Notes. On Thursday, the FOMC lowered the federal funds rate by 25bps to 1.75%-2.00% (Fig. 1). The cut was widely expected. Melissa and I think the FOMC can take the rest of the year off.

We noticed that during his press conference after the committee’s meeting, Fed Chair Jerome Powell responded to several of the questions from the assembled reporters by reading from prepared statements. He has learned that he can get into trouble by speaking off-the-cuff. So he came prepared with scripted answers to the questions he anticipated would be asked at the presser. He did his best to say nothing that would upset the markets. He succeeded.

On Thursday, the S&P 500 rose just 0.06% while the 10-year US Treasury bond yield remained around 1.80% (Fig. 2 and Fig. 3). On Friday, the former fell 0.50% while the latter edged down to 1.74%. Friday’s moves occurred late in the day and mostly reflected disappointing news about the latest meeting of US and Chinese trade negotiators.

The bond yield is up 25bps from its recent low of 1.47% on 9/4 on better-than-expected US economic numbers and chatter about fiscal stimulus in Germany. Nevertheless, the financial markets are still expecting more rate cuts according to the 12-month federal funds rate futures, which was 1.39%, and the 2-year Treasury yield, which was 1.69%, on Friday (Fig. 4).

While Powell didn’t say anything that riled the financial markets, he did have a lot to say about numerous issues that are important for monetary policy and therefore for investors to consider:

(1) Data dependent and uncertain. Melissa and I believe that Powell should keep his press conferences short. In his preliminary prepared remarks, he should review what the FOMC had decided to do at the latest meeting of the committee and why. Then, he should say: “As always, the future course of monetary policy will remain data dependent.” During the Q&A, he should respond by repeating this mantra when asked about the future course of monetary policy.

In his latest presser, Powell seemed to be taking our advice. The word “data” was mentioned 17 times in the context of messaging that the Fed is data dependent, 11 times by him and 6 by reporters. During his prior presser, in July, Powell used the word in that context 5 times, fewer than reporters’ 6 times. So in the latest presser, Powell accounted for the majority of the mentions, or 65% of them, up from 45% at July’s presser.

His emphasis on the Fed’s data dependence reflects the Fed’s greater uncertainty about the future. The words “uncertain” or “uncertainty” appeared 21 times, with 13 times by Powell in last week’s presser, up from 9 times in July, when all mentions were Powell’s. In both pressers, he mentioned the words 4 times during his prepared preliminary remarks.

So the Fed is uncertain about the future course of the economy—all the more reason to be data dependent. That was the gist of his latest press conference. No wonder the financial markets didn’t move in response to Powell’s post-meeting comments.

(2) The yield curve. Powell briefly spoke about the inversion of the yield curve and also about the long end of the curve, i.e., the bond yield. It was music to our ears, because his views happen to coincide with ours on both subjects. He opined, as we have, that an inverted yield curve may not be as good a predictor of recessions as in the past because the long bond yield has been pulled down by negative bond yields in Europe and Japan, which have been brought down by the negative interest-rate policies (NIRPs) of the ECB and BOJ.

Meanwhile, the yield curve based on the spread between the 10-year and 2-year Treasury bond yields (the 10-2 yield curve) hasn’t really inverted; it remains flat. The recent backup in the bond yield along with the Fed’s latest rate cut reversed the recent inversion of the yield curve based on the spread between the 10-year Treasury yield and the federal funds rate (Fig. 5).

Powell said that the “yield curve is something that we follow carefully.” He observed that “there’s this large quantity of negative yielding and very low yielding sovereign debt around the world, and inevitably, that’s exerting downward pressure on U.S. sovereign rates without really necessarily having an independent signal.” That neatly describes our “Modern Tether Theory” of the bond market. As we have observed since last year, US bond yields have been tethered to German and Japanese bond yields (Fig. 6).

By the way, in our 4/7 study “The Yield Curve: What Is It Really Predicting?,” we argued that the Fed should pay more attention to the curve—raising interest rates when it is ascending, pausing when it is flat, and cutting rates when it is inverted. In other words, the 10-2 yield curve supported the Fed’s decision to pause rate-hiking earlier this year but did not support the easing decisions made at the last two meetings.

In our study, we also observed that the yield curve has a very good track record of calling recessions because it has often accurately anticipated the credit crunches that have caused recessions. There are no signs of that now. Indeed, during August, a mere net 1% of small business owners reported that their last loan was harder to get than the previous one (Fig. 7).

(3) Negative interest rates. At his press conference last week, Powell declared that NIRP won’t happen on his watch. During the Q&A, he said: “I do not think we’d be looking at using negative rates, I just don’t think those will be at the top of our list.” Does that mean it was still on the list, but at the bottom?

Powell added: “If we were to find ourselves at some future date again at the effective lower bound, again not something we are expecting, then I think we would look at using large scale asset purchases and forward guidance.” He stated that “[w]e feel that they worked fairly well” and concluded that “[w]e did not use negative rates.” In other words, Powell isn’t ready to satisfy Trump’s NIRP envy.

(4) Trade uncertainty. The word “trade” was mentioned 31 times in the latest presser versus 30 times at the July presser, which also followed a 25bps rate cut. Powell mentioned the word 7 times in his preliminary prepared remarks, up from 6 times in July. In both pressers, trade was referred to as a cause of the economic uncertainty that is depressing business spending and justified this year’s two rate cuts so far.

Recall that our 7/11 Morning Briefing was titled “Powell Gets Trumped!” We wrote: “President Donald Trump wants the Fed to lower interest rates. Fed Chair Jerome Powell claims that the Fed is independent and won’t bow to political pressure. Yet Trump has figured out the perfect way to force the Fed to lower interest rates. All he has to do is keep creating uncertainty about US trade policy.”

(5) Done? So what’s next? At his previous presser, Powell characterized July’s 25bps rate cut as a “mid-cycle adjustment.” When asked whether the latest cut was more of the same, he seemed to agree that it was, noting that similar adjustments during 1995 and 1998 kept the economy growing.

Late last year, we called for the Fed to stop hiking for a while. So we were all for the Fed’s pause at the start of this year. We haven’t been as gung-ho about the past two rate cuts. We like even less the thought of another cut anytime soon given the recent surge in retail sales and rebound in industrial production, which led to an upward revision in the 9/18 GDPNow forecast for Q3 to 1.9%. The Citigroup Economic Surprise Index has rebounded since mid-year, much as it did during 2017, which was a good year for the economy (Fig. 8). The data that the Fed depends on doesn’t justify another rate cut.

By the way, did you notice? Powell didn’t dwell on inflation in his latest presser. He didn’t say that the recent dip in the core PCED inflation rate might be “transient,” as he did during his May presser; in fact, he hasn’t mentioned that word since then. To be fair, Powell didn’t entirely ignore the topic of inflation in the recent press conference; he said that the FOMC expects inflation to rise back to 2.0% (yada, yada, yada). But he made no mention of the higher-than-expected core CPI inflation data, which we thoroughly discussed last week.

The Fed II: Concerns About Business Spending. Many businesses’ spending plans have been put on hold lately as a result of Trump’s trade policies, as Powell observed during his latest presser: “Our business contacts around the country have been telling us that uncertainty about trade policy has discouraged them from investing in their businesses. Business fixed investment posted a modest decline in the second quarter and recent indicators point to continued softness.”

Indeed, in the Fed’s September Beige Book, which qualitatively surveys business sentiment, the word “uncertainty” was used 29 times (up from 21 in the previous Beige Book), most often related to tariffs and trade tensions. Powell’s statement was also supported by a 9/4 FEDS Notes titled “Does Trade Policy Uncertainty Affect Global Economic Activity?” Here’s the conclusion:

“We find that the rise in TPU [trade policy uncertainty] in the first half of 2018 accounts for a decline in the level of global GDP of about 0.8 percent by the first half of 2019. Had trade tensions not escalated again in May and June 2019, the drag on GDP would have subsequently started to ease. However, renewed uncertainty since May of 2019 points to additional knock-on effects that may push down GDP further in the second half of 2019 and in 2020.”

Let’s review the latest batch of mixed capital-spending indicators:

(1) CEO survey. The Business Roundtable CEO Economic Outlook Index decreased during Q3 to 79.2, down from a record high of 118.6 during Q1-2018 and the lowest reading since Q4-2016 (Fig. 9). The CEO sentiment index is highly correlated with the growth rate of capital spending in real GDP, which was down to 2.7% y/y from a recent high of 6.9% during Q2-2018. CEOs’ plans for capital investment decreased 14.7 points to 73.4, which is lower than the capital investment sub‑index’s historical average of 76.7.

The latest quarterly survey (conducted from 8/23-9/9) asked 138 CEOs about their forward-looking expectations for sales, hiring, and capital investment. According to the report: “This quarter, CEO plans waned likely due in part to growing geopolitical uncertainty, including U.S. trade policy and foreign retaliation, and slowing global economic growth.”

(2) Small business survey. August’s NFIB survey of small business owners found that their capital-spending plans remain surprisingly firm: “Twenty-eight percent plan capital outlays in the next few months, up 1 point. Plans to invest were strong in manufacturing, 35 percent and agriculture and the wholesale trades each at 30 percent. The effects of the new tariff wars remain uncertain. Owners are more reluctant to make major spending commitments when the future becomes less certain so the increase is not supportive of future capital investment.”

(3) Industrial production. The Fed study cited above notes that a rise in trade-policy uncertainty in 2018 and 2019 has coincided with a slowdown in world industrial production and global trade. Domestically, industrial production of business equipment has stalled over that timeframe (Fig. 10). Of the three components in the series, transit equipment has lost the most ground, falling 2.1% y/y through August. That makes sense, since it is the component most sensitive to trade. Industrial equipment is down too, by 0.4%, while IT equipment is up 5.0%.

(4) Durable goods orders. Nondefense capital goods shipments excluding aircraft has stalled for the past two years around the current expansion’s cyclical peak, so far (Fig. 11). However, orders for these goods remains on an uptrend and in record-high territory so far this year. Then again, a broad range of machinery orders has been flat to down since mid-2018 (Fig. 12).

The Fed III: The Dot Plot Thickens. The “dot plot” of the latest FOMC meeting participants’ economic outlook shows median expectations for the federal funds rate at 1.90% in 2020, unchanged from this year. (See our FOMC Summary of Economic Projections.) At their meeting a year ago, they were projecting 3.4% for next year and 3.1% for this year. Their estimate for the longer-run federal funds rate (deemed to be the unmeasurable “neutral interest rate”) has dropped from 3.0% to 2.5% over this period.

The range of rate forecasts for this year is 1.6%-2.4%, with five expecting no change over the rest of this year, seven participants expecting the FOMC to lower the federal funds rate further, and five participants expecting the Fed to be hiking over the rest of this year. Indeed, at the latest meeting, there were three dissenters, with two preferring no change and one calling for a half-point cut in the federal funds rate.

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From Downhill to Uphill

September 19 (Thursday)

Railroads: Profit-Margin Ride Over? After chugging along nicely for the better part of the past three years, railroad stocks are facing multiple challenges that could stop them in their tracks.

First and foremost, the US-China trade war is hurting the industry. The high-level spat has sent sales of US agricultural products and other items to China tumbling. Less trade and a US manufacturing slowdown have hurt the rails both directly (reducing business) and indirectly (making truckers, who are facing slower growth, tougher competitors). In addition, the industry may have squeezed all the savings possible out of an efficiency program rolled out in recent years, according to a well-thought-out article in Barron’s last weekend.

The S&P 500 Railroad stock price index has climbed 1,736% since bottoming in 2000, outperforming the S&P 500’s 121% gain, but it has been idling since its peak in May (Fig. 1). A resolution to the trade war would go far in getting the industry’s stock price index back on track.

Here’s what Jackie has discovered about the issues rails are facing:

(1) Trade woes. Transporting goods from the Heartland to the coasts for export is big business for railroad operators, so the US-China tariff spat is bad news for rail business. The tariffs also have hurt the industrial customers of railroad operators.

Railcar loadings have fallen 5.8% from the peak in early November 2018, based on the 26-week moving average to smooth out some of the seasonality in the data (Fig. 2). The tariff’s impact is even more directly felt by the rails’ intermodal traffic (transport of containers that fit on trains, trucks, and ships, and are often used to ship items abroad). Intermodal traffic, which represents 51% of railroads’ business, is down 7.0% from its late December peak (Fig. 3).

On a y/y basis, intermodal railcar loadings have dropped 4.1% (Fig. 4). Over the past 19 years, that figure has been negative only twice, in 2009 and 2016.

According to the Association of American Railroads, the carloads that have fallen the most ytd through the week of 9/7 include coal (-6.6%), grain (-5.1), metallic ores and metals (-5.0), nonmetallic minerals (-4.7), and forest products (-4.2). Shipments of coal have been in long-term decline, as more utilities have been opting to use low-cost, cleaner-burning natural gas.

(2) More competition from truckers. The trucking industry has also felt the pain of the US-China trade war and the resulting decline of international trade. The timing of the slowdown is unfortunate because many new medium- and heavy-weight trucks were delivered at the end of last year and early in 2019 (Fig. 5).

Total truck-hauling volumes remain at record absolute levels, but their growth slowed to a 3.8% y/y increase in July, based on the three-month average, compared to the peak growth of 8.4% last year (Fig. 6 and Fig. 7). The softness in the trucking market is apparent in hauling prices, which aren’t rising as sharply as last year. Prices for truck transportation of freight in the Producer Price Index rose only 1.2% y/y in August, compared to the peak of 8.2% y/y last October (Fig. 8).

(3) End of efficiency gains? In a 9/13 Barron’s article, Bill Alpert questioned whether the railroads would be able to continue improving efficiency and lowering costs by using precision scheduled railroading, or PSR. He wrote: “Precision railroading involves replacing a rail network’s traditional hub-and-spoke routes with straight runs, while keeping trains to strict schedules. By pulling longer trains using fewer locomotives, workers, and switch yards, CSX expanded its operating profit margin to 40% in 2018 from 30% in 2016.”

The implied profit margin suggested by analysts’ consensus revenue and earnings estimates for S&P 500 Railroads stands at 28.4%, a record high. About 4ppts of the 7ppt improvement since the beginning of 2018 reflects President Trump’s tax cut for corporations, but the industry’s margins had been gradually improving from a low of 8.5% in 2004 (Fig. 9).

Improving margins undoubtably have boosted earnings over the past three years. That’s why it’s notable that the industry suffered two back-to-back months of negative net earnings estimate revisions in July (-17.4%) and August (-32.0) (Fig. 10). Yet despite the downward revisions, analysts continue to call for the industry’s earnings to rise by 11.2% this year and 12.1% in 2020 (Fig. 11). Stock investors are clearly more concerned about the Railroad industry, as its forward P/E has fallen to 16.5 from a post-tax cut peak of 18.7 in September 2018 (Fig. 12).

(4) Tech-disruption watch. Traditional players in the transportation industry should keep an eye on the moves tech giants are making. Amazon now delivers almost 50% of its own packages (accounting for 20% of all e-commerce shipments), up from about 15% two years ago, per a 6/27 Axios article. And Amazon’s delivery speed averages 3.2 days versus six days for all other e-commerce companies.

Earlier this year, FedEx exited its contracts with Amazon and upped its own shipping game. FedEx aims to double its e-commerce package capacity, and to that end it’s striking deals with retailers for new package drop-off points and increasing delivery hours. These new investments combined with slowing global trade and global economic growth triggered more than a10% share-price drop in FedEx shares on Wednesday after management warned that it expects EPS to fall 16%-29% this fiscal year.

Uber Technologies also has jumped into the transportation business, with Uber Freight. The company’s mobile app lets truckers book multiple loads at one time, allowing them to plan better and keep their trailers full, a 9/17 WSJ article reported. Truckers rate pick-up and drop-off facilities on the app, helping other truckers decide which loads they’d like to take on. Sound familiar?

While Amazon and Uber aren’t planning to build their own railroads, their entry into the trucking market could pressure the railroad business, given—as we mentioned above—that the two markets compete in certain areas. Maybe railroad CEOs should go talk with their retailer CEO counterparts.

Valuation: Lots of Rotation. The S&P 500’s forward P/E is an unsensational 17.1, only 0.3ppt higher than it was one year ago and around where it has stayed for much of the past four to five years. At the sector level, however, valuations have moved sharply this year. Consider the following:

(1) Two interest-rate-sensitive and defensive sectors have seen their forward P/Es increase sharply. The S&P 500 Real Estate sector’s P/E, at 43.9, is 5.1 points higher than it was this time last year, and the S&P 500’s Utilities sector’s forward P/E is almost 3.0 points higher at 19.6—a record high dating back nearly 25 years (Fig. 13). Another defensive sector, S&P 500 Consumer Staples, has a forward P/E that’s 1.7ppts higher today than at this time last year.

(2) Two Growth sectors have enjoyed multiple expansion too: The S&P 500 Communications Services sector’s forward P/E has increased to 17.9, up from 10.5 last year (when it was composed primarily of telecom companies), and the Information Technology sector’s P/E at 19.7, is up 1.1 points.

(3) A few sectors have lower P/Es today than a year ago. The S&P 500 Health Care sector’s forward P/E has dropped to 14.6, down from 16.2 a year ago, as the presidential election season has taken its toll. The S&P 500’s Industrials and Energy sectors’ earnings multiples are fractionally (0.4 point) lower than last year. Lastly, the beleaguered S&P 500 Financials sector earnings multiple is 0.2ppt lower today than a year ago.

(4) Here are the 11 S&P 500 sectors’ forward P/Es today and one year ago: Real Estate (43.9, 38.8), Consumer Discretionary (21.6, 21.4), Consumer Staples (19.8, 18.1), Information Technology (19.7, 18.6), Utilities (19.6, 16.7), Communications Services (17.9, 10.5), S&P 500 (17.1, 16.8), Materials (17.0, 15.2), Industrials Sector (16.0, 16.4), Energy (15.5, 15.9), Health Care (14.6, 16.2), and Financials (12.1, 12.3) (Fig. 14, Fig. 15, Fig. 16, and Fig. 17).

(5) After underperforming Growth stocks for most of the past eight years, Value stocks have outperformed in recent days. The outperformance Growth stocks have enjoyed over the past eight years has been diminishing since mid-2018 (Fig. 18 and Fig. 19).

The S&P 500 Citigroup Growth index trades with a forward P/E of 21.0, near recent peaks and close to where it has been for much of this year. The S&P 500 Citigroup Value index has a much lower forward P/E of 14.1, also near where it has been for much of this year (Fig. 20). The gap between the forward P/Es of Growth and Value stocks hasn’t been this wide since the go-go days of the tech bubble and its aftermath.

Crypto Update: Blockchain In, Libra Out. Getting Libra approved by financial regulators around the world will be a tough slog. Questions and concerns about Facebook’s proposed stablecoin came from finance officials in the US, France, Germany, and European Union (EU) in recent days. Meanwhile, stablecoins being proposed for internal use by some of the country’s largest banks seems to be gaining traction. Let’s take a look:

(1) No love from the EU. European Central Bank board member Benoit Coeure, who also chairs the Bank of International Settlements’ committee on payments and market infrastructures, made his doubts about Libra clear. “Stablecoins are largely untested, especially on the scale required to run a global payment system,” he said according to a 9/16 Reuters article. “They give rise to a number of serious risks related to public policy priorities. The bar for regulatory approval will be high.”

The EU is considering a common set of rules for virtual currencies and has developed its own project for real-time payments in the Eurozone, known as “TIPS.” It’s also evaluating a central-bank digital currency, which would let consumers use electronic cash that’s directly deposited at the ECB. The system would eliminate the need for bank accounts, financial intermediaries, and clearing counterparties, thereby reducing transaction costs. The project began before Libra’s launch, and development could take years.

(2) France and Germany aren’t fans. Virtual currencies pose risks to consumers, financial stability, and the monetary sovereignty of European states, said the finance ministers of France and Germany in a joint statement, a 9/13 Reuters article reported. So far, Facebook has not convinced them that the Libra project “properly” addresses those concerns.

Instead, France’s Finance Minister Bruno Le Maire and Germany’s Finance Minister Olaf Scholz threw their support behind public digital currencies issued by central banks. In a joint statement, they said: “We encourage European central banks to accelerate work on issues around possible public digital currency solutions.”

(3) US raises concerns. Under the existing proposal, Libra would be based and governed in Switzerland. US and Swiss officials met last week to discuss regulatory controls, including the need to ensure that regulations are strong enough to dissuade “bad actors,” a 9/10 WSJ article reported. Switzerland has already agreed to the stronger cryptocurrency standards adopted this summer by the Financial Action Task Force to combat terror financing and money-laundering.

(4) Marcus defends Libra. Libra’s co-creator David Marcus defended his cryptocurrency via Twitter, pledging to continue to engage with central banks, regulators, and lawmakers: “Libra is designed to be a better payment network and system running on top of existing currencies, and delivering meaningful value to all consumers all around the world. Libra will be backed 1:1 by a basket of strong currencies. This means that for any unit of Libra to exist, there must be the equivalent value in its reserve. As such there’s no new money creation, which will strictly remain the province of sovereign Nations.”

(5) Wells jumps into stablecoins. Wells Fargo is developing its own version of JPM Coin. Wells Fargo Digital Cash, linked to the US dollar, will be used initially for transactions between the bank’s businesses, including cross-border payments. The platform will be able to move money in close to real time, outside of regular operating hours, and will “remove the need for third-party payment intermediaries, and cut time and costs associated with such transactions,” a 9/16 CoinDesk article stated. The pilot is expected to kick off next year.

One looming problem: Wells Fargo Digital Cash and JPM Coin operate on different networks that don’t communicate. Looks like the race to become the largest network, with the most members, has begun.

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China’s Hurting

September 18 (Wednesday)

China I: Needing a Trade Deal. China’s economy is faltering, as the latest data continue to show. Numerous attempts by Chinese government and central bank officials to stimulate the economy are simply slowing the inexorable downward trend in economic growth.

Melissa and I have previously analyzed the strong secular forces driving the downtrend, including the country’s aging population and its increasingly burdensome public and household debt load. They may prove to be too powerful to overcome. Officials already have attempted—and dialed back attempts—to deleverage, have buried their one-child limits, and have unleashed massive amounts of fiscal and monetary stimulus to little avail. China’s economic growth has slowed to a relatively lackluster pace and continues to head lower.

The US-China trade dispute is only worsening China’s homegrown economic challenges. Perhaps that’s why Chinese officials recently seem more open to making a trade deal with the US sooner rather than later. After weeks of heightened tensions and an apparent hold on talks, China’s Ministry of Commerce announced on 9/5 that the two countries agreed to conduct high-level trade talks in Washington, DC early next month.

To prepare for these talks, both countries will begin consultations this week. Following that, US Trade Representative Robert Lighthizer and US Treasury Secretary Steven Mnuchin are expected to meet with China’s top negotiator, Vice Premier Liu He, reported Reuters. By sending Liu He to the US table, it signals that China may be serious about deal-making. Another such signal came on 9/11, when China’s Tariff Commission of the State Council announced that it will exempt certain types of US imports from additional tariffs, effective for a year from 9/17.

Providing the US with plenty of negotiating leverage, China’s recent economic data have taken a hit on several fronts as a result of its domestic and geopolitical problems. There may be more woes to come, as more multinational companies are moving previously planned investments away from China, according to CNBC.

Perhaps complicating Chinese officials’ readiness to deal, however, is the fact that the US in trade talks has raised issues that threaten China’s ascendance as a superpower. Their stated plan to realize global dominance hinges on practices that the US won’t tolerate. For China, the trade talks aren’t about “trade or the economy, stupid,” but rather the politics of nationalism and global power. One need not look much further than China’s militarism in the South China Sea for evidence of this dynamic.

For the US, we know for sure that the negotiations are not just about trade but also about unfair business practices and national security concerns, as we have discussed on numerous previous occasions. Important components of this are international property theft and forced technology transfer. Before the talks broke down in early May, China apparently acknowledged these concerns for the first time, after having previously denied and dismissed them, reported Reuters.

China II: Hard Data. In any event, here is a roundup of some of China’s latest disappointing data:

(1) Industrial production & real GDP. China’s industrial production growth peaked at more than 20.0% y/y during 2010, then fell into the teens during 2011. It continued a steep decline to about 6.0% in 2015, about where it stayed until early 2018, right before the US-China trade dispute started and escalated. The series rebounded to about 9.0% early this year, likely due to some front-loading ahead of anticipated tariffs, or perhaps just a statistical anomaly. In any case, it has since dipped to only 4.4% y/y during August, the slowest growth seen since the Great Recession. China’s real GDP growth fell to 6.2% y/y in Q2, down from 6.7% a year ago (Fig. 1).

(2) Industrial profits. In the first two months of this year, Chinese industrial firms’ profits fell 14.0% y/y, according to an 8/22 South China Post (SCMP) article citing the latest data from the National Bureau of Statistics. That was the sharpest contraction since 2009. Manufacturing profits fell by 15.7% y/y, with profits from oil-processing companies dropping 70.4%.

(3) Manufacturing Purchasing Manager’s Index (M-PMI). China’s official M-PMI dropped to a seasonally adjusted 49.5 during August. Two out of the three components of the composite index fell further below 50.0. Employment and new orders fell to 46.9 and 49.7, respectively. Output remained above 50.0 but decreased in the month to 51.9 (Fig. 2).

(4) Exports. China’s merchandise exports fell 1.0% y/y during August (Fig. 3). One of the larger contributors to the decline was exports to the US, which dropped 16.0% y/y. China’s merchandise exports to the US as a share of its total exports has fallen to 16.6% from 19.6% a year ago.

Slowdowns in exports have become apparent in tariff-sensitive industries. For example, according to the SCMP, over 500 companies in an eastern Chinese city known for its textile production exported 28% less in the first four months of 2019 versus the comparable period last year. Woven fabric is included on the list of $200 billion Chinese goods covered by the 25% tariffs imposed by the US.

(5) Retail sales. Domestically, Chinese consumer spending growth is slowing. Chinese retail sales growth slowed to 7.5% y/y in August from a recent high of 9.8% in June. Inflation-adjusted retail sales growth is down to 4.7%, trending lower along with the growth of industrial production.

If slowing consumer purchases are tied to the country’s growing household debt burden (as discussed below), then more stimulus from the government may do little to solve the problem. The aging of China’s population, another not easily solved structural issue, is likely showing in these data too (Fig. 4 and Fig. 5).

China III: Litany of Woes. Those are some of the structural problems weighing on China’s economic growth along with corroborating data. Here are excerpts from recent articles Melissa and I have found that drill more deeply into these challenges:

(1) Demographics. “Burying ‘One Child’ Limits, China Pushes Women to Have More Babies,” appeared in the 11/11/18 NYT. “Almost three years after easing its ‘one child’ policy and allowing couples to have two children, the government has begun to acknowledge that its efforts to raise the country’s birthrate are faltering because parents are deciding against having more children. Officials are now scrambling to devise ways to stimulate a baby boom, worried that a looming demographic crisis could imperil economic growth—and undercut the ruling Communist Party and its leader, Xi Jinping. ... The new campaign has raised fear that China may go from one invasive extreme to another in getting women to have more children. Some provinces are already tightening access to abortion or making it more difficult to get divorced.”

According to the article, the government is considering replacing the two-child limit with no limit. “The proposal is politically fraught” because it reminds people of the disastrous one-child policy imposed by the government. One of the terrible consequences of that policy is that there aren’t enough women to have babies because it caused far more boys than girls to be raised, resulting in a gender-imbalanced society: “The number of women between the ages of 20 and 39 is expected to drop by more than 39 million over the next decade, to 163 million from 202 million …” (For an even deeper dive into the social havoc wreaked by this policy, read Wanting a Daughter, Needing a Son.)

(2) Fiscal & monetary policies. “China’s Stimulus Muddle Deepens” appeared in the 3/5 WSJ. “Li Keqiang, China’s premier, has a few ideas for 2019: keep overall debt growth in check, cut taxes, accelerate government bond issuance, and boost lending to small businesses. If that sounds like a lot to ask—and contradictory—it is.

“Some of these goals will fall by the wayside. Getting banks to lend more to small businesses without overall credit growth accelerating will be near impossible. And significantly higher government debt sales will require more banking system liquidity to keep rates from rising and further damaging growth. That means more monetary easing: probably not a 2015-like flood, but definitely a rising tide. Beijing rightly recognizes that its two previous rounds of stimulus in the past decade, funded largely off the government’s books through state bank loans to state-owned enterprises, created a lot of bad debt for the buck.”

(3) Total debt. “China’s total debt rises to over 300 per cent of GDP as Beijing loosens borrowing curbs to boost growth” appeared in the 7/17 SCMP. “China’s total debt burden rose strongly in the first quarter of 2019 as Beijing allowed more loans and local government bond issuance to help shore up the slowing economy, according to estimates by the Institute of International Finance. The figure stood at nearly 304 per cent of its gross domestic product (GDP) in the first three months of the year, up from 297 per cent a year earlier, the US-based trade association said.”

“China launched a deleveraging campaign more than two years ago aimed at reducing debt and reining in risky lending, but as its economy has slowed due to the impact of the trade war with the United States, the government has eased credit conditions and posted fiscal spending on infrastructure projects to support economic growth.”

(4) Household debt. “China’s household debt has grown so much that trade war stimulus is largely ineffective, study shows” appeared in the 8/7 SCMP. “China’s household debt has risen to a such a high level that government stimulus designed to boost consumer spending would likely be ineffective, an international research group said. The country’s household debt-to-income ratio rose to 92 per cent at the end of last year, a sharp increase from only 30 per cent in 2008, the Washington-based Institute of International Finance (IIF) wrote in a research note. The ratio is higher than the 86 per cent in Germany and close to the levels of 97 per cent in the United States and 100 per cent in Japan.”

(5) Depressed banks. “World’s Biggest Banks Sink to Record Lows as China Pain Spreads,” appeared on the 8/4 Bloomberg. The article observed that investors recently dragged down valuations of China’s largest banks because they expect that the large banks will be forced by the state to bail out smaller peers. That’s just one indication that it’s not only China’s economy that’s in trouble but the global financial system as well.

The plight of the banks “has been a major focus of investors since May, when Beijing surprised markets by seizing control of Baoshang Bank Co. in the first government takeover of a Chinese lender in two decades. That was followed two months later by a capital injection into Bank of Jinzhou Co. by ICBC and two other state-owned financial firms.”

The Fed: The Cases for Zero, 25, and 50. The Federal Open Market Committee (FOMC) is widely expected to lower the federal funds rate range this week by 25bps to 1.75%-2.00%. We agree with that consensus view, seeing greater chance of a 25bps cut than the alternatives of no cut or a bigger, 50bps one. Here’s our thinking:

(1) The case for zip. The global “crosscurrents” behind the last rate cut, of 25bps on 7/31, have dissipated. Fed officials worried that these issues would have a depressing spillover effect on US consumer confidence as well as business confidence and investment. In recent weeks, US-China trade negotiations are back on track, China hasn’t resorted to military force in Hong Kong, and a no-deal Brexit may yet be avoided. In the US, CPI inflation has warmed up, while retail sales and industrial production figures have been strong.

In other words, without these crosscurrents, it’s not clear that another rate cut this soon is appropriate.

(2) The case for 25bps. The financial markets are expecting a 25bps cut. If it doesn’t happen, the credibility of the Fed’s messaging could be impaired. Fed officials can still justify a small cut by observing that business spending remains weak and the PCED inflation rate is still below their 2.0% target. They could also indicate that they are doing it to stop the inversion of the yield curve.

(3) The case for 50bps. In the old days, a crisis in the Middle East, especially one that hit Saudi oil output, would have sent oil prices soaring—boosting global inflation and depressing global economies. Now global-oil-demand growth is slow, while there is relatively ample capacity for the US and Russia to increase supplies to offset the loss of Saudi oil until it is restored, which may happen fairly soon in any case. The FOMC would be hard-pressed to justify a 50bps rate hike on “uncertainties” created by the attack on Saudi oil output. In other words, there really isn’t a case for a 50bps cut, as was thought possible during the late summer.

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More on Inflation

September 17 (Tuesday)

Geopolitics: Iran vs Saudi Arabia. Anything is possible in the Middle East, where truth or dare is played with weapons. There is already some chatter suggesting that Iran didn’t attack Saudi Arabia over the weekend. Rather, some third party in the neighborhood with an interest in a full-out war between the two sent the drones that badly damaged the Saudi’s oil infrastructure. The truly frightening development is that hard-to-detect and hard-to-stop drones rigged with explosives can be deadly.

The truly ironic development is that Israel has developed anti-drone technology that could protect Saudi Arabia from more drone attacks. An 8/20 article in US News & World Report observed that Israel has numerous companies making technology to detect drones. For example: “Vorpal [Ltd. In Israel] has built a system that uses sensors to identify drones in a specific geographic area, then sends a live feed of a map with the locations to a customer’s phone or computer screen, Raz said. The company has partnerships with Microsoft and AT&T, and its global customers include law enforcement and intelligence agencies, militaries and civilian companies.”

While I’ve learned a lot about the Middle East over the years, I often turn to Robert Hardy, the proprietor of The Geostrat, for deeper insights into the latest geopolitical developments in the region and around the world. Robert kindly agreed to let me excerpt some of his comments from a special report he issued yesterday:

(1) Location of attack. “[Abqaiq] is located in Saudi Arabia's Eastern Province, which has the Kingdom's largest Shia [minority] population. [It] is the most important facility for the Kingdom’s oil sector; more important than its Gulf export terminals at Ju’aymah and Ras Tanura. For that matter, it is more important that the Strait of Hormuz or the Bab el-Mandeb Strait at the southern entrance to the Red Sea. Oil can be diverted away from the above choke points by pumping it across the county via the East-West pipeline to the Yanbu or Yenbo export terminal on the Red Sea, but it cannot bypass Abqaiq because the East-West pipeline begins at Abqaiq, and all the production from the three [main oil] fields ... is processed there.”

(2) False claims? “There were…glaring anomalies about the Houthi claim [that they launched the attack]. The Houthis [who are Iran’s allies in the war in Yemen] have always rushed out claims before the Saudis; this time they waited almost two hours after the official Saudi report. Unlike prior attacks, the screen did not show anything about the drones’ path or the targets.”

(4) Damage. “The processing facility contains very advanced distilling columns packed with ‘spiroids.’ If the distilling chamber was destroyed—worse case up to two years to rebuild. If not, the Saudis will have dodged a bullet.” It all adds up to a carefully crafted professional hit job.

(5) Defenseless. “Most of the Saudi’s billions of dollars air defenses are designed to intercept traditional ballistic missiles. They will have to acquire a low-level air defense system, but the best one the Israeli Iron Dome system is probably politically off limits. The next best choice is the Russian Pantsir S1M, a point defense anti-aircraft, anti-rocket anti-missile combined artillery and missile system.”

(6) Oil supply. “IEA members are required to have a 90-day stockpile of crude. Japan and South Korea are members, China and India are not. The latter two are estimated to have between 30 and 40-days of supply. The world is awash in potential supply, while the global slowdown had reduced demand, seen in OPEC and Russia’s agreement to reduce supplies.”

Credit: Loans Expand When Yield Curve Inverts! Last week’s backup in bond yields was partly attributable to abating recession fears on news of better-than-expected retail sales and higher-than-expected core CPI inflation both for August. The former continues to outpace the increase in the goods component of CPI inflation. So inflation-adjusted core retail sales (excluding autos, gasoline, building materials, and food services) rose at a solid 7.5% (saar) over the three months through August (Fig. 1). Consumers are in great shape and continue to drive the economic expansion.

What about the widely held notion that the slight inversion of the yield curve during the late summer might depress bank lending and push the economy into a recession? As Melissa and I explained in our 4/7 study “The Yield Curve: What Is It Really Predicting?,” inverted yield curves don’t cause recessions. Rather, they predict that if monetary policy remains tight or continues to tighten, a financial crisis is likely to happen. That event tends to morph into an economywide credit crunch and a recession. Financial crises cause credit crunches, not inverted yield curves.

We can see this by tracking the relationship of the yield-curve spread between the federal funds rate and the 10-year US Treasury bond (which is a component of the Index of Leading Indicators) and the growth rate of commercial and industrial (C&I) bank loans (Fig. 2). It shows that these bank loans tend to grow when the yield curve is flattening and inverting. When the yield-curve spread is widening, bank loans tend to be falling. That’s exactly the opposite of the popular notion that inverted yield curves are associated with declining bank lending!

Recent developments bear this out. The yield-curve spread turned slightly negative in late June. Meanwhile, C&I bank loans are up 6.2% y/y through 9/4.

In our study, we wrote: “The widely held notion that a flat or an inverted yield curve causes banks to stop lending doesn’t make much sense. The net interest margin, which is reported quarterly by the Federal Deposit Insurance Corporation (FDIC), has been solidly positive for banks since the start of the data in 1984” (Fig. 3). The net interest income of FDIC-insured institutions rose to a record $140.2 billion during Q4-2018 and remained near that figure, at $139.0 billion, during Q2-2019 (Fig. 4).

US Inflation: More or Less? Debbie, Melissa, and I are spending more of our research efforts on inflation these days. In recent years, we’ve stuck our necks out by declaring that inflation is dead, or at least in a coma. So we are scrutinizing any signs of life on the inflation front.

August’s core CPI data showed the index rose 2.4% y/y and 3.4% (saar) over the past three months. As we noted yesterday, while we are not alarmed, we are on alert. In the 9/11 Morning Briefing, we reviewed alternative measures of CPI inflation, which are mostly showing more of it. Yesterday, we sliced and diced the CPI and compared it to the PCED, which is the Fed’s preferred measure of headline and core inflation. The latter remained subdued at 1.4% y/y and 1.6%, respectively, during July. August data for the PCED will be out on 9/27 in the personal income press release.

Today, let’s examine more measures of inflationary pressures:

(1) Rent in CPI, again. First, let’s have another look at the exaggerated impact that rent has on the CPI. A few of our readers were surprised by the following observation in our commentary yesterday on this subject: “Rent of shelter accounts for 33% of the CPI and only 16% of the PCED, with comparable weight discrepancies for tenant rent (8% vs 4%) and owner-occupied rent (24% vs 12%). Since rent has been rising relatively faster than most other components of inflation, its bigger weight in the CPI gives the CPI another upward bias compared to the PCED.”

The bias is even worse for the core CPI. Debbie reports that rent of shelter accounts for 42% of the core CPI and only 18% of the core PCED, with comparable weight discrepancies for tenant rent (10% vs 5%) and owner-occupied rent (30% vs 13%).

Rent of shelter in the CPI rose 3.4% y/y during August. It has consistently exceeded 3.0% since July 2015 (Fig. 5). So rent inflation biases the CPI inflation rate higher relative to the PCED measure. We suspect it is doing so for the alternative CPI measures as well.

(2) CPI and PPI. Goods inflation remained subdued during August, with the CPI up just 0.2% y/y and PPI (final demand for goods) down 0.1% y/y (Fig. 6). Services inflation was higher for both, with the CPI and PPI (final demand for services) up 2.7% y/y (Fig. 7).

(3) PPI and import prices. Notwithstanding the US-China trade war’s result of higher tariffs on US goods imported from China, import-price inflation remains subdued, which is keeping a lid on PPI goods inflation. During August, import prices fell 2.0% y/y (Fig. 8). Excluding petroleum, they were down by 1.0%, the eighth consecutive decline on this basis.

During August, import prices from China fell 1.6% y/y (Fig. 9). That might seem surprising given that tariffs have been increased on some of those goods. However, keep in mind that China’s PPI inflation rate has been falling from a recent peak of 7.8% during February 2017 to -0.8% during August.

(4) Surveys of pricing. The prices-paid index in the US M-PMI survey has tumbled from a recent peak of 79.5 during May 2018 to 46.0 during August (Fig. 10). It has been below 50.0 for three consecutive months. The similar index in the NM-PMI survey has been hovering around 57.0 since the start of this year, after hovering around 62.0 most of last year.

Significantly, the percentage of small business owners planning to raise their average selling prices dropped from a recent peak of 29% last November to 17% during August, according to the latest survey conducted by the National Federation of Independent Business (Fig. 11).

Debbie and I average the survey results of the five Federal Reserve banks that conduct these surveys monthly. The average prices-paid index, which tends to track the comparable M-PMI index, fell from a recent peak of 47.7 during July 2018 to 14.1 during August, the lowest since October 2016 (Fig. 12). The average prices-received index for the five districts surveyed by the Fed banks fell from a recent peak of 25.4 to 5.7 during August.

(5) Truck transportation. Last year, there was some angst concerning a shortage of truck drivers pushing up labor costs and prices in the trucking industry, which would push up retail prices. Wage inflation remains relatively high in the industry, at 5.6% y/y through July (Fig. 13). But the PPI for truck transportation of freight was up only 1.2% y/y during August, down from a recent peak of 8.2% (Fig. 14).

(6) Bottom line on inflation. We continue to believe that powerful forces of deflation (a.k.a. the 4Ds—détente, disruption, demographics, and debt) are keeping a tight lid on inflation, frustrating the efforts of the major central banks to push it higher with their ultra-easy, unconventional monetary policies.

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Inflation Warming Up?

September 16 (Monday)

Geopolitics: Iran Attacks Saudi Arabia. We may be about to experience Panic Attack #65 after Iran attacked Saudi Arabia’s oil fields over the weekend. Iran denies it did so, but US Secretary of State Mike Pompeo immediately blamed Iran. The already hot proxy war between Iran and Saudi Arabia in Yemen could be about to turn into a direct confrontation between the two. The latest attacks show that Saudi Arabia is defenseless against drones. Senator Lindsey Graham (R-SC) says direct attacks on Iranian oil production should be considered.

While investors have been focusing on the escalation of the trade war between the US and China, an escalation of the war between Saudi Arabia and Iran is potentially more dangerous and damaging to the global economy if it cuts off oil supplies and boosts prices. However, the latest oil price shock may be minimized by the release of strategic petroleum reserves around the world. On Sunday, President Donald Trump authorized such a release from the US reserve.

If oil prices spike significantly nonetheless, the result is more likely to be weaker global growth than a significant increase in inflation. Could it cause a recession? The latest escalation does increase the risk of that happening. That means that Fed officials might consider a 50bps cut at this week’s meeting of the Federal Open Market Committee rather than the widely expected 25bps cut. Never a dull moment in our world.

ECB I: Draghi Sets Stage for MMT? Mario Draghi’s term as president of the European Central Bank (ECB) ends on 10/31. So Thursday’s meeting of the ECB’s Governing Council was his last. He has headed the ECB since 11/1/2011. His ultra-easy monetary policies haven’t worked as well as he expected in boosting economic growth and inflation in the Eurozone. He has called for more fiscal stimulus, particularly from Germany, to help, as Melissa and I discussed in last Wednesday’s Morning Briefing.

Before leaving, Draghi put together a monetary stimulus package, which we review in the next section. But first, here is our spin: It is designed to induce Eurozone governments to borrow at zero or negative interest rates to spend on stimulating their economies. The package includes an open-ended commitment to buy as much as €240 billion per year of bonds issued by Eurozone governments. In other words, Draghi set the stage for the implementation of Modern Monetary Theory (MMT) in the Eurozone. According to MMT, governments should borrow as much as possible as long as inflation doesn’t heat up. All the better if the central bank enables such borrowing by lowering interest rates and purchasing government bonds—again, as long as inflation doesn’t heat up. Now it is up to the governments to take the bait.

That might explain why the German bond yield is up from -0.70% at the start of this month to -0.45% as of Friday’s close, which in turn explains last week’s backup in US bond yields (Fig. 1). In the US, bond yields were also boosted by higher-than-expected core CPI inflation and better-than-expected retail sales, which helped to alleviate recession fears. As a result, the S&P 500 is only 0.6% away from its record high.

ECB II: Quantitative Easing Forever? Last Tuesday, we wrote the following about the ECB’s forthcoming meeting: “During his 7/25 press conference, Draghi suggested that more stimulus is coming. Minutes from the 7/25 meeting of the ECB’s Governing Council backed up this message. … The ECB’s official deposit rate on bank reserves is currently -0.40%. It is expected to be cut by 10-20bps at the next meeting. The APP program, which was terminated on 12/31/18, is expected to be restarted at the next meeting as well.” We also noted that aid for banks was likely, to offset negative interest rates. The departing head of the ECB delivered the whole enchilada:

(1) Releasing all the doves. During his 9/12 press conference following the release of the ECB’s monetary policy decision, Draghi announced his extremely dovish final actions, solidifying his legacy as the ECB president who did “whatever it takes” to support the Eurozone economy. “You remember me saying … that all instruments were on the table … ready to be used, well today we did it,” Draghi proclaimed.

The key interest rate was lowered further into negative territory, the asset purchase program (APP) was reintroduced, and banks were provided with support to sustain the transmission of monetary policy to the real economy. The ECB’s latest APP will add to the €4.7 trillion already carried on the central bank’s massive balance sheet, which increased by €2.3 trillion since Draghi presided over the ECB in late 2011 (Fig. 2).

During his press conference Q&A, Draghi outlined three reasons for the ECB’s actions: (1) persistent risks from trade and geopolitics; (2) lowered ECB inflation projections given a continued muted underlying trend; and (3) slightly increased risk of a broader Eurozone recession given a greater-than-expected slowdown in the Eurozone economy. Indeed, during July, industrial production (excluding construction) in the Eurozone contracted 2.0% y/y to its lowest level since April 2017 (Fig. 3).

(2) Going deeper into negative territory. Specifically, the ECB lowered its deposit facility rate 10 basis points to -0.50%. The interest rate on the main refinancing operations and the rate on the marginal lending facility were kept at 0.00% and 0.25%, respectively. Draghi explained the central bank should hold these rates “at their present or lower levels until we have seen the inflation outlook robustly converge to a level sufficiently close to, but below, 2% within our projection horizon, and such convergence has been consistently reflected in underlying inflation dynamics.” Headline CPI inflation has remained well below the ECB’s 2.0% target since early 2013, while core CPI inflation has persisted significantly below target since around 2009 (Fig. 4).

(3) Bringing back APP, forever. The APP was reintroduced at €20 billion per month starting on 11/1. The projected amount of monthly purchases is sizable, but not as great as it was at the height of its quantitative easing (QE) from April 2016 to March 2017, when the bank was purchasing €80 billion per month. To keep up a more substantial pace, the ECB likely would have to significantly broaden its scope of assets eligible for purchase. Draghi said during his press conference that at the newly introduced pace there is “headroom to go on for quite a long time.”

Surprisingly, no estimated calendar end date was provided for the APP. Forward guidance for rates instead has been tied to inflation, as noted above. The asset purchases will continue for “as long as necessary” up until “shortly before” the ECB starts raising its key interest rates—meaning that the APP too is tied to inflation. So if inflation remains stubbornly low, the ECB’s ultra-easy policy could go on forever, or at least for a very long time. If it all goes into Eurozone government bonds, the APP will monetize €240 billion of that debt every year for the foreseeable future!

(4) Lending a hand to the lenders. To help banks’ profitability, the ECB implemented a two-tiered system that exempts a portion of banks’ holdings of excess liquidity from the negative deposit facility rate.

For the new series of quarterly targeted longer-term refinancing operations (TLTRO III; the TLTROs provide long-term funding to financing institutions), banks whose eligible net lending exceeds a benchmark will enjoy a lower interest rate than otherwise set and extended maturities, from two years to three years.

(5) Passing the wand to Lagarde. As we discussed last week, Christine Lagarde will succeed Draghi and is likely to continue his program—set to begin on her first day as ECB president—but for how long is anyone’s guess. Lagarde has suggested that there are limits to what the ECB can effectively do to stimulate the economy, calling on Eurozone governments to step up structural reforms and fiscal spending. “I’m not a fairy,” she told European Parliament during her 9/4 nomination hearing. Lagarde also said she hopes she will never have to say something like “whatever it takes” because it would mean “the other economic policy makers are not doing what they had to do.” In other words, she’ll take Draghi’s wand, but it might not work.

Lagarde will immediately face powerful forces opposed to the ECB’s course. According to unnamed sources mentioned in the 9/12 WSJ, “at least five officials on the ECB’s 25-member rate-setting committee opposed the decision to restart QE, including the governors of the Dutch, French and German central banks. … Two members of the ECB’s executive board—Sabine Lautenschlaeger and Benoit Coeure—also opposed the move.”

Lagarde may not be Tinker Bell, but she might have to be Houdini. One possible exit plan from Draghi’s policy is to lower the inflation target. Draghi objected to changing the target during his tenure. But it will be one of the topics of the strategic review under Lagarde, Draghi said at his press conference. Magically, by moving the inflation target, the end date for Draghi’s policies could be whenever Lagarde’s ECB wants it to be.

US Inflation: Warm CPI, Cool PCED. Despite the ECB’s widely expected easing last week and expectations that the Fed will cut the federal funds rate by 25bps this week, the 10-year US Treasury bond yield jumped 35bps from 1.55% on Friday 9/6 to 1.90% on Friday 9/13 (Fig. 5). The increase was attributable to a 22bps increase in the comparable TIPS yield to 0.23% and a 13bps increase in the spread between the two to 1.67%, which is commonly perceived to be a measure of the annual inflation rate expected over the next 10 years (Fig. 6).

Last Wednesday, we observed that the backup in US yields might be related to the backup in German yields on news that the German government is considering fiscal measures to stimulate their economy. We also noted that recession fears are abating in the US. In addition, we suggested that the bond market might be starting to discern that inflationary pressures are mounting.

On Thursday, August’s CPI confirmed that inflation may be warming up. While the headline rate was up only 1.7% y/y, the core rate rose to 2.4%, returning to last July’s rate—which was the fastest since September 2008 (Fig. 7). Even more alarming was that while the three-month annualized change was only 1.8%, the comparable core rate was 3.4% (Fig. 8).

Debbie and I aren’t alarmed, yet. Here’s why:

(1) CPI vs PCED. The Fed’s preferred measure of inflation remained subdued through the latest available data for July. The headline and core PCED inflation rates were 1.4% and 1.6%, respectively, that month (Fig. 9).

(2) Goods inflation. If we compare the CPI and PCED goods versus services components, we see that the two measures for goods inflation continue to track one another closely, though the PCED goods inflation rate tends to be a bit lower than the CPI rate. During August, the CPI goods index rose 0.2% y/y, while the PCED measure for goods fell 0.5% during July (Fig. 10).

(3) Durable goods. Within the goods category, the CPI measure of inflation almost always exceeds the PCED measure (Fig. 11). The latter has been in negative territory every month since October 1995 with only one exception, during July 2011 when it was zero. Over this same period, the CPI measure of durable goods inflation has been positive a few times including the present time since the start of this year. During August, it was up 0.6%, while the PCED measure was down 1.2% in July.

(4) Nondurable goods. There is rarely much, if any, difference between the CPI and PCED measures on nondurable goods inflation (Fig. 12). Both were close to zero during the summer months.

(5) Services inflation. The big discrepancy in the past often has been in the services measures of inflation in the CPI and the PCED, with the former often running hotter than the latter (Fig. 13). It’s happening again, as the gap has been widening—with the CPI services index up 2.7% y/y through August and the comparable PCED measure up 2.2% during July.

(6) Medical care services. Consistently among the biggest discrepancies between the CPI and PCED measures is seen in medical care services (Fig. 14). The former typically well exceeds the latter because the CPI covers out-of-pocket medical services costs while the latter reflects all such costs including those paid for by private and public insurance programs. During August, the CPI measure jumped to 4.3%, while the PCED measure rose only 1.7% during July.

(7) Rent. There is rarely much, if any, difference in the CPI and PCED measures of rent inflation. The rent-of-shelter component of the CPI consists of a measure that tracks tenant rent (up 3.7% during August) and another that tracks owners’ equivalent rent (3.3%), which is an odd concept purporting to measure what homeowners would have to pay in rent to themselves.

The big discrepancy between the CPI and the PCED in the case of rent is that the CPI gives rent a much bigger weight in the overall index than does the PCED. Rent of shelter accounts for 33% of the CPI and only 16% of the PCED, with comparable weight discrepancies for tenant rent (8% vs 4%) and owner-occupied rent (24% vs 12%). Since rent has been rising relatively faster than most other components of inflation, its bigger weight in the CPI gives the CPI another upward bias compared to the PCED.

(8) US vs them. The US headline CPI inflation rate has been running hotter than the comparable rates in the Eurozone and Japan for quite some time. The goods components of the three measures tend to be volatile and diverge from time to time (Fig. 15). They’ve converged recently, with the US at 0.2% during August and the Eurozone and Japan at 0.9% and 0.8%, respectively, during July.

In the US, the services inflation rate (2.7% in August) remains much higher than in the Eurozone (1.3% in August) and Japan (0.3% in July) (Fig. 16). We suspect that the discrepancies are mostly attributable to a higher weight for rent inflation in the US than in the Eurozone and Japan.

Movie. “Luce” (+ +) (link) is an intense mind-game thriller about a white couple who adopted a young boy from war-torn Eritrea. At first, he had lots of issues adjusting to his new home, but 10 years later he turned out to be an all-star high school student. His African-American history teacher promotes him as a great role model for other black kids in the school. However, she comes to suspect that he might be capable of turning violent given his past. The acting by Kelvin Harrison Jr. in the lead role is superb, as is that by Octavia Spencer as his teacher.

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No Shortage of Gluts

September 12 (Thursday)

Autos and Hollywood: Too Much Stuff. It’s not often that we can compare the entertainment industry with the auto industry. But this week, it’s possible because of Apple’s presentation of its new offerings and the Frankfurt Auto Show. Both events made it clear that these industries are suffering from too much stuff.

Hollywood has too many hours of entertainment, and the auto industry has too many manufacturers selling too many cars. In addition, technology is roiling both industries: Streaming has forever changed the entertainment industry, and electric and autonomous vehicles are forcing auto-manufacturing incumbents to spend a lot of money to compete with the industry’s upstarts. Altogether, these forceful trends are leading to deflationary pricing pressures. Below is Jackie’s look at the industries’ big events this week and what they tell us about Tinsel Town and Motor City:

(1) Not enough hours in a day. Jackie’s daughter spent the second half of the summer binge-watching “Grey’s Anatomy” on Netflix. Despite logging far too many hours of TV time, Cate only managed to watch five seasons of the medical drama. There are still 10 more seasons available for viewing! The experience made it abundantly clear that there are not enough hours in the day to watch even a small fraction of the video entertainment available for streaming. In addition to each season’s new show offerings, incalculable hours of “reruns” are always just a click away.

(2) Spending big bucks to compete. All this content costs a lot to produce. Disney is expected to spend $16.4 billion on entertainment programming in 2019, a figure that excludes its budget for sports programing, a 1/29 article in Variety reported. Not far behind is Netflix’s 2019 budget, forecast to be $15 billion on 301 original productions currently planned or in the works worldwide. Apple recently upped its production budget for 2019 to $6 billion from $1 billion, noted an 8/19 article on the Verge. And a 4/26 CNBC article estimated that Amazon is on pace to spend $7 billion this year. HBO Max is expected to reveal more about its offerings and spending at an October presentation.

The big dollars involved lead to questions about what kind of return these companies can earn on their investment. So perhaps it should be no surprise that activist investor Elliott Management Corp. revealed it took an equity stake in AT&T, noting the company’s lack of focus in its entertainment division.

As a 9/10 WSJ article reported: Elliott “said in a letter to the company that it has ‘failed to articulate a clear strategic rationale’ for the $80 billion-plus Time Warner acquisition ... when it comes to direct-to-consumer streaming, there is a ‘growing sense that AT&T doesn’t have a plan,’ given recent shifts in strategy. And it said the departure of top Time Warner executives leaves the company without necessary media expertise at a critical moment in the industry.”

(3) Let the pricing wars begin. Despite a crowded field, Apple announced its entrance into the streaming wars with Apple TV+ and priced its service below everyone else’s: $4.99 a month. The service is free for a year to those who buy certain Apple devices. Apple, which admittedly has less content today than the competition, undercut the pricing of Disney+ ($6.99 a month starting in December), Netflix’s standard plan ($12.99), and AT&T’s HBO Max (presumed to be slightly more than $14.99 when it launches later this year or early in 2020). Amazon’s Prime Video is included in the Prime membership ($12.99 per month).

We’ve said it before (see our 3/28 Morning Briefing), and we’ll say it again: There’s a glut in TV programming and at some point subscription fatigue will set in.

(4) Too many cars. The auto industry also has tons of options from which consumers can pick. There are sedans, minivans, crossovers, and trucks. There are new manufacturers on the scene from South Korea and China. And now, thanks to the latest in technology, new manufacturers, including Tesla and Rivian, are offering up electric cars as an alternative to cars powered by the traditional combustion engine.

Traditional manufacturers are racing to catch up to their electric counterparts. At the Frankfurt Auto Show, Volkswagen is displaying its ID 3 electric vehicle, Porsche its Taycan electric sports car, and Mercedes-Benz its fully electric van. The Volkswagen ID 3’s lowest end car will be priced at roughly $33,000, but it will only have 205 miles of range, a 9/9 article on The Verge reported. More expensive versions will be able to travel for up to 340 miles. The Porsche Taycan starts closer to $150,000, and the Mercedes van’s price isn’t yet available.

Despite his many crazy antics, Elon Musk has brought to market an affordable electric car that people want to drive. Tesla’s Model 3 starts at $36,000, but typically costs more. And so far, it has proven itself a worthy new competitor in an already crowded field.

(5) Gloom in Frankfurt. The latest signs of the global auto industry’s malaise are on display at the Frankfurt Auto Show, which has fewer exhibitors and less exhibition space. “[E]xhibition space had been cut from around 200,000 square meters in 2017, to around 168,000 this year…The number of exhibitors has shrunk to around 800 this year, from 994 in 2017. Fiat, Volvo, Mitsubishi, Nissan, Subaru, Chevrolet, Cadillac, and Aston Martin will skip the show and only five exhibition halls will have new cars, instead of eight,” according to a 9/2 Reuters article.

Back in the US, Moody’s Investors Service on Tuesday cut Ford Motor’s bond rating to Ba1 (making it a “junk” bond), down from Baa3 (investment grade). The agency noted the company’s “weak cash generation and a years-long restructuring plan that the auto maker is undertaking just as the car market softens globally,” a 9/9 WSJ article reported. However, it added that the company has a “sound balance sheet and liquidity position.”

Both S&P Global Ratings and Fitch Ratings still consider Ford debt two notches higher than junk, so Ford’s debt will remain in the Bloomberg Barclays investment-grade corporate bond index.

(6) Prices only inching higher. According to government data, new vehicle prices are climbing much slower than prices in the overall economy. New vehicles prices (which includes both cars and trucks) in the Consumer Price Index (CPI) rose 0.3% y/y in July, which is far below the overall CPI’s 1.8% y/y increase in July (Fig. 1).

(7) Data dump. The S&P 500 Automobile Manufacturing index is up a surprisingly strong 20.3% ytd through Tuesday’s close (Fig. 2). The industry has rallied even though its revenue is expected to fall 1.6% this year and 0.5% in 2020 (Fig. 3). Expected earnings growth doesn’t look much better, but it is positive for now: 1.5% in 2019 and 1.0% in 2020 (Fig. 4). The industry’s forward P/E, at a recent 6.2, has been extremely low for the past four years, which often means a cyclical industry is at its earnings peak (Fig. 5).

Disney and Netflix are members of the S&P 500 Movies & Entertainment stock price index, which has risen 16.3% ytd through Tuesday’s close (Fig. 6). The industry’s revenue is expected to grow a robust 16.5% this year and 18.0% in 2020 (Fig. 7). Earnings, however, are forecast to fall sharply in 2019 (-14.0%), only to rebound sharply and grow 10.4% in 2020 (Fig. 8). Despite the earnings volatility, the industry’s forward P/E has held near its recent highs at 27.0 (Fig. 9).

Strategy: Looking for Bubbles. In theory, a sector’s market capitalization as a percentage of the S&P 500’s should be close to the percentage of earnings that sector kicks into the broader index. When market-cap and earnings contributions differ dramatically, it’s often the sign of a valuation-based buying—or selling—opportunity. Perhaps the most famous example of this was the 2000 tech bubble, when the S&P 500 Information Technology sector represented 33.7% of the S&P 500’s market cap but only 16.3% of its earnings.

Today’s divergences are much smaller than that extreme case, but they’re interesting, nonetheless. Information Technology is still the S&P 500 sector with the market capitalization that most exceeds its earnings. The sector contributes 22.1% of the S&P 500’s market capitalization, but its earnings represent only 19.1% of the S&P 500’s earnings (Fig. 10). Not far behind are the Consumer Discretionary sector, which contributes 10.2% of the S&P 500’s market cap but only 8.1% of its earnings, and Real Estate with a 3.3% capitalization and a 1.2% earnings share (Fig. 11 and Fig. 12).

On the other side of the coin are the sectors with higher earnings shares than market-cap shares. Financials is the most undervalued sector by this metric, with a market cap that contributes 12.7% of the S&P 500’s but earnings that represent 18.5% of the broader index’s (Fig. 13). Looking back over the last 25 years or so, financials have typically contributed more in earnings than capitalization. More unusual is the Industrials sector, with a 9.2% market-cap share and a 10.1% earnings share (Fig. 14). The Health Care sector has a 13.8% market-cap and a 15.9% earnings contribution. Before 2009, that sector’s market-cap share typically exceeded its earnings contribution.

The differences between the market-cap and earnings shares in the remaining S&P 500 sectors are minimal. Here’s the full list of the sectors’ market-cap and earnings shares: Information Technology (22.1, 19.1), Health Care (13.8, 15.9), Financials (12.7, 18.5), Communication Services (10.5, 10.0), Consumer Discretionary (10.2, 8.1), Industrials (9.2, 10.1), Consumer Staples (7.7, 6.4), Energy (4.4, 5.1), Utilities (3.5, 3.0), Real Estate (3.3, 1.2), and Materials (2.7, 2.7) (Fig. 15).

Disruptive Technologies: Robots Attending College. Looks like the younger set is quickly embracing robot delivery. Starship Technologies, which just raised $40 million, plans to roll out its delivery robots to 100 universities within the next two years. Each university will have 25-50 robots making deliveries. The company already has robots rolling along the sidewalks of University of Pittsburgh, Purdue University, Northern Arizona University, and George Mason University.

Starship deploys an app that customers can use to order food from meal plan service providers and restaurants. Deliveries are made anywhere on campus and cost $1.99 (less than most tips!). When the robot arrives at the delivery location, it sends a text message to the recipient that it has arrived along with a link that will unlock the robot. The robot can carry up to 20 pounds, or about three shopping bags filled with food, and it can cross the street, maneuver curbs, and operate in the dark, rain and snow, according to a 1/22 article in Mashable. The robot looks a lot like Scout, Amazon’s sidewalk-driving delivery robot that we discussed in the 8/8 Morning Briefing.

The Starship robot does have an Achilles’ Heel: It can’t climb stairs. ANYbotics, a Swiss company, has conquered that mountain with a dog-like delivery robot. It has four “legs,” weighs about 80 pounds, and climbs stairs and other obstacles. It can even reach up to ring a doorbell or an elevator button. It can drop your parcel at a doorstep or place it in a parcel box.

For CES earlier this year, ANYbotics and Continental partnered up to create a vision of a driverless shuttle that carries many robot dogs that are set loose to deliver packages. Take a look at this cool video on Mashable. It gives a whole new meaning to the phrase: “Drop it.” The company also has developed a four-legged robot that can carry out inspections in industrial settings and other areas where humans don’t want to go, like sewers and offshore drilling platforms.

Here’s the company’s promotional video showing how the robot operates in an industrial setting. An 8/22 IEEE Spectrum article describes ANYbotics’ robot: “It can move at 1 meter per second, manage 20-degree slopes and 45-degree stairs, cross 25-centimeter gaps, and squeeze through passages just 60 centimeters wide. It’s packed with cameras and 3D sensors, including a lidar for 3D mapping and simultaneous localization and mapping (SLAM). All these sensors (along with the vast volume of gait research that’s been done with ANYmal) make this one of the most reliably autonomous quadrupeds out there, with real-time motion planning and obstacle avoidance.” Wonder if our pooches should get nervous about being replaced?

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Yields Backing Up

September 11 (Wednesday)

Credit I: US Bond Yields Made in Germany. Yesterday, Melissa and I wrote that another round of central bank easing is underway. So why are bond yields rising?

The 10-year US Treasury bond yield rose from a recent low of 1.47% on 9/4 to 1.72% yesterday (Fig. 1). The record low was 1.37%, hit on 7/8/16 just after the Brits voted to leave the European Union (EU). The risks of a no-deal Brexit have eased in recent days, though it still could happen next month. A hard Brexit could cause the bond yield to retest its recent low.

In any event, the main reason that the US bond yield has moved higher in recent days has more to do with Germany than the UK. The 10-year German government bond yield has risen from a recent record low of -0.71% on 8/30 to -0.54% yesterday. Reuter’s reported: “Germany’s 30-year government bond yield briefly rose into positive territory on Tuesday for the first time in over a month, lifted by expectations for fiscal stimulus and caution over the scale of stimulus the European Central Bank might deliver this week.”

During a parliamentary budget debate on Tuesday, Germany’s Finance Minister Olaf Scholz said that Germany can counter a possible recession with a big stimulus package. On Monday, Reuters reported that Germany was considering creating a “shadow budget” to boost public investment above and beyond limits set by its national debt rules, sparking a bond sell-off.

European Central Bank (ECB) President Mario Draghi has been lobbying for fiscal policy to turn more stimulative to support the ECB’s ultra-easy monetary policies. Germany has resisted doing so and even questioned whether the ECB’s asset purchase program could legally buy sovereign bonds, as we discussed yesterday. We also observed yesterday that Germany’s fiscal and monetary conservatives might be starting to waver as a result of Germany’s intensifying manufacturing recession, with factory orders and production down 5.6% and 4.8% y/y through July (Fig. 2).

Last year, when there was widespread bearishness in the bond market, with some predicting that the US yield would rise from 3% to 4%-5%, we observed that the US bond yield might be “tethered” to the comparable German and Japanese yields, which were barely above zero. This year, both have dropped solidly below zero.

During the Q&A portion of his 7/25 press conference, Draghi pleaded for more fiscal stimulus, especially from Germany:

“What’s hitting the manufacturing sector in Germany and [elsewhere in Europe is] an idiosyncratic shock. Here what becomes really very important is fiscal policy. [T]he mildly expansionary fiscal policy is supporting activity in the euro area. But if there were to be a significant worsening in the Eurozone economy, it’s unquestionable that fiscal policy … becomes of the essence. … I started making this point way back in 2014 in a Jackson Hole speech: monetary policy has done a lot to support the euro area … but if we continue with this deteriorating outlook, fiscal policy will become of the essence.”

Credit II: Recession Scare Blowing Away. Meanwhile, back in the USA, fears of a recession have been receding, although the yield-curve spread between the 10-year Treasury and the federal funds rate remains negative (Fig. 3). On the other hand, the comparable spread based on the 2-year Treasury yield rather than the federal funds rate remains around zero.

More importantly, there is still no sign of a credit crunch in the US. In our study titled “The Yield Curve: What Is It Really Predicting,” Melissa and I observed that in the past an inverted yield curve didn’t cause recessions. Rather, it often correctly anticipated that monetary policy was too tight and might trigger a financial crisis, which would turn into an economy-wide credit crunch and cause a recession.

The credit-quality yield spread between high-yield corporate bonds and the 10-year US Treasury bond remains low around 400bps (Fig. 4). Commercial and industrial loans have stalled in recent weeks but are at a record high and are up 6.4% y/y (Fig. 5 and Fig. 6).

Meanwhile, lots of US economic indicators continue to show an expanding economy:

(1) Citigroup Economic Surprise Index. The Citigroup Economic Surprise Index (CESI) has rebounded smartly from a recent low of -68.3% on 6/28 to 7.0% yesterday (Fig. 7). While it is based on seasonally adjusted indicators, it continues to show a seasonal pattern of weakness during the first half of the year followed by strength during the second half. Indeed, looking at the past 11 years, we can pick six years where the index bottomed almost exactly midway through the year.

There is a very good correlation between the CESI and the 13-week change in the 10-year US Treasury bond yield (Fig. 8). The CESI is clearly seasonally bearish for bonds.

(Then again, let’s not get too bearish on bonds. The yield is also highly correlated with the nearby futures price of copper (Fig. 9). The latter remains relatively weak, though not so much as suggested it might be by the 131bps drop in the bond yield over the past year. In other words, the bond yield might have gone down too far relative to the weakness in the global economy, as signaled by Professor Copper, the metal with a PhD in economics.)

(2) JOLTS. Friday’s weak payroll employment gain of 130,000 for August remains an outlier. Most other labor market indicators remain very strong. For example, yesterday’s JOLTS report for July showed that quits rose to a record high of 3.6 million (Fig. 10). That’s confirmed by the jump during August in the “jobs plentiful” response of the survey used to construct the Consumer Confidence Index. When workers perceive that there are lots of job openings, they are more likely to quit to change jobs. While these openings are actually down 3.0% y/y through July, at 7.2 million they remain above the number of unemployed workers for 17 months in a row (Fig. 11).

By the way, the JOLTS data also show more employment than does the official payrolls series. We regularly compare the 12-month change in payrolls to the 12-month sum of total hires minus total separations in the JOLTS report (Fig. 12). The former is up 2.2 million through July, or 185,500 per month on average, while the latter is up 2.6 million (also through July), or 213,000 per month on average!

In any case, on Monday, Debbie and I blamed the weakness in payroll employment on a shortage of workers rather than weakening demand for them. Yesterday, the National Federation of Independent Business’s survey of small business owners reported that a record 57% of them said that there are few or no qualified applicants for their job openings during August (Fig. 13).

Credit III: Inflation Scare Ahead? Low inflation is “the problem of this era,” said New York Federal Reserve Bank (FRB) President John Williams in a 9/4 speech. Melissa and I agree that low inflation is a real challenge for the major central banks of the world. They have been trying to revive inflation to 2% with their ultra-easy monetary policies for the past 10 years without any success.

But what if inflation makes a surprising rebound? That would certainly shock markets into fearing that the low-interest-rate era might be over. In fact, several funky measures of inflation suggest that inflationary pressures may be mounting in the US already. Might that be what the bond market is starting to discern?

We tend to be traditionalists when it comes to inflation measures, preferring the headline and core readings of the personal consumption expenditures deflator (PCED) rather than alternative indicators—not only because that’s what the Fed most often relies on but also because the alternatives tend to exclude too many price categories that are important to consumers, in our opinion. Let’s dig into the numbers:

(1) Mind the headline & the core PCED. During July, the headline and core PCED inflation rates were only 1.4% and 1.6% y/y, respectively (Fig. 14). The Federal Open Market Committee announced its 2.0% inflation target for the first time in January 2012. The core PCED has achieved that during just six months, from mid-2012 through July of this year. The three-month annualized percent change in the core PCED was 2.2% through July (Fig. 15). It tends to be much more volatile than the y/y measure. The headline PCED was up 1.7% on the same basis.

(2) Don’t mind the alternatives. The Atlanta FRB’s sticky-price CPI is an alternative inflation measure based on a weighted basket of items that change price relatively slowly. It rose 2.5% y/y in July, while the actual CPI rose 1.8%. However, the core sticky (excluding food and energy) increased just 1.6%, while the core CPI rose 2.2%. The headline sticky has not been above 2.5% since June 2018, while the core sticky has remained below 2.0% since September 2016 (Fig. 16).

The Cleveland FRB tracks two of its own alternative inflation measures: median CPI and trimmed mean CPI. These measures exclude the items that change the most in price on a monthly basis. The median CPI excludes all price changes except for the ones in the center of the distribution of price changes. The trimmed mean CPI excludes price changes on the highest and lowest sides of the distribution.

The Cleveland FRB’s median CPI has been on an upward trend since early last year, rising well above 2.0% during that time to 2.9% during July. Its trimmed mean CPI has remained above 2.0% since May 2018, registering a reading of 2.2% during July (Fig. 17).

During his 5/1 press conference, Fed Chair Jerome Powell focused on the Dallas FRB’s trimmed mean PCE inflation rate, which is calculated similar to the Cleveland FRB’s trimmed CPI version, noting that it has been consistently at or above 2.0% since May 2018 (Fig. 18). But Powell’s enthusiasm for the measure seems to have been short-lived. The Fed has since dropped its focus on that figure, obviously crafting its recent monetary policy decisions based on the more traditional measures.

Williams closed his speech by saying that “stubbornly low inflation is a reflection of the broader economic picture—the July rate adjustment [was] an appropriate response to ease financial conditions and support the economy.”

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More Easing

September 10 (Tuesday)

Central Banks I: More of the Same. The major central banks are providing yet another round of monetary easing. They are doing their best to stimulate their economies and boost inflation closer to their 2.0% targets. However, their ultra-easy monetary policies haven’t worked as expected, so they keep doing more of the same. Let’s start with the central banks of China, Japan, and the US before moving on to the Eurozone’s central bank:

(1) PBOC. Last Friday, the People’s Bank of China (PBOC) said it was lowering bank reserve requirement ratios (RRR) for the third time this year, freeing up $126 billion in liquidity. This follows an announcement in early June by China’s central bank that it will use various policy tools to keep liquidity in the market reasonably ample and to provide targeted liquidity support to small and mid-sized banks. Chinese markets were rattled in late May after the government took over troubled regional lender Baoshang Bank.

The PBOC said it will cut RRR on 9/16 by 50bps for all banks, with an additional 100bps cut for qualified city commercial banks. The RRR for large banks will be lowered to 13.0% (Fig. 1). This makes seven times that the PBOC has slashed the ratio since early 2018.

The central bank is widely expected to cut the loan prime rate as well in mid-September, for the first time in four years, in an effort to reduce corporate funding costs (Fig. 2).

(2) BOJ. Also on Friday, according to an interview with the Nikkei newspaper, Bank of Japan (BOJ) Governor Haruhiko Kuroda said cutting interest rates further into negative territory is among the bank’s policy options. The official deposit rate for bank reserves was cut to -0.10% on 1/29/16 and remains there for now (Fig. 3). But Kurado stressed that if the BOJ were to ease, the central bank would take into account the impact such a move could have on Japan’s banking system and financial market functions.

There’s lots of market chatter suggesting that the BOJ could ease policy this month to take pressure off the yen, which has been trending higher recently as a result of the expected monetary easing steps by the Fed and the European Central Bank (ECB) (Fig. 4).

(3) The Fed. Also on Friday, just before the FOMC’s pre-meeting blackout for Fed officials, Fed Chair Jerome Powell spoke at a forum in Zurich. He claimed that the Fed’s pivot this year to lower interest rates has helped sustain US economic growth. He noted that there are multiple challenges for sustaining growth, including weakness in Europe and elsewhere, as well as the tariff war between the US and China. He said that trade uncertainty is weighing on US capital spending.

The FOMC lowered the federal funds rate range on 7/31 from 2.25%-2.50% to 2.00%-2.25%. It is widely expected to do so again at the 9/16-17 meeting next week. Powell bolstered those expectations by pledging once again that the Fed will “continue to act as appropriate to sustain this expansion,” a phrase he has used before that the market has taken to mean that the Fed is likely to cut interest rates.

On Friday, the 12-month futures federal funds rate was down to just 1.11% (Fig. 5). The 2-year US Treasury note yield was down to 1.53% (Fig. 6).

Central Banks II: Draghi’s Swan Song. ECB President Mario Draghi will leave the ECB on 10/31 when his term expires. He will be replaced by Christine Lagarde. Before passing the baton, Draghi is expected to stay true to his dovish 2012 words to “do whatever it takes” to support the eurozone economy. The bank’s next meeting, scheduled for 9/12, could be one of the most interesting since the ECB decided to delve into negative-interest-rate policy during June 2014. Discordant political and economic factors are converging at this meeting just as Draghi sings his swan song. Consider the following:

(1) A spoon full of sugar. During his 7/25 press conference, Draghi suggested that more stimulus is coming. Minutes from the 7/25 meeting of the ECB’s Governing Council backed up this message. Officials discussed that a broad stimulus “package” would be more effective than a series of actions, observed the 8/22 WSJ. Sources told Reuters last week that the ECB is leaning toward a rate cut, reinforcement of the bank’s pledge to keep rates low for longer, and aid for banks to compensate for negative rates. It is also possible that the bank will revisit its asset purchase program (APP).

The ECB’s official deposit rate on bank reserves is currently -0.40% (Fig. 7). It is expected to be cut by 10-20bps at the next meeting. The APP program, which was terminated on 12/31/18, is expected to be restarted at the next meeting as well (Fig. 8).

(2) Germany’s vocal chorus. However, some hawkish ECB officials have downplayed the possibility of further stimulus, reported CNBC yesterday. Some hope, as Draghi has previously discussed, that fiscal stimulus will save the day. But in the absence of that, the ECB may need to step in. Yesterday, Bloomberg observed: “It’s notable that the hawks’ complaints have been about restarting QE only, with barely a squeak against cutting rates. This is no doubt an acknowledgement that something has to be done to stop the euro from rising.”

The central bank’s APP is a controversial issue in Germany, where “the country’s constitutional court is embroiled in an ongoing case centering on whether the ECB’s bond-buying constitutes so-called ‘monetary financing,’ which is prohibited under EU law,” the CNBC article recalled. Critics have long claimed that the bank’s policies have led to low returns for savers and reduced the incentive for political reforms throughout the euro region. However, especially weak German manufacturing data may drown out the chorus of critics.

(3) Lagarde singing Draghi’s song. As she prepares to take the reins, Christine Lagarde sided with the central bank’s unconventional policies, defending low rates and supporting the APP, during her nomination hearing in the European Parliament last week, reported Time. Without such measures, “the crisis would have been a lot worse,” she said. Lagarde also said that she agrees with the bank’s perspective that accommodation will be necessary “for an extended period of time.”

(4) La commedia è finite. Draghi noted during his prior presser that, despite further employment gains and increasing wages, softening global growth dynamics and weak international trade weigh on the eurozone’s outlook. Uncertainties related to geopolitical factors, including the rising threat of protectionism, particularly the threat of a hard Brexit, and vulnerabilities in emerging markets, have dampened economic sentiment, especially in the manufacturing sector. With inflationary pressures remaining muted, “a significant degree of monetary stimulus continues to be necessary to ensure that financial conditions remain very favourable and support the euro area expansion” as well as prices. Nevertheless, he reassured the public that the risk of a recession in the broader eurozone remains “pretty low.” Let’s hope Draghi’s swan song isn’t off key.

Global Economy: Low-Octane Fuel. As the major central banks have been pumping fuel—i.e., liquidity—into the global economy’s tank, we can’t help remembering how lower-octane fuels can damage a car’s engine.

Where has all the liquidity been going? Lots of it seems to be offsetting deflationary pressures resulting from the four forces of deflation, or what we call the “4Ds”: détente, disruption, demography, and debt. Lots of it also has been boosting asset prices in stock, bond, and real estate markets. Neither effect represents high-octane economic stimulus.

Now consider the following economic developments:

(1) Commodity prices. The forces of deflation are so powerful that all the central bank liquidity has failed to boost commodity prices and inflation. The CRB raw industrials spot price index is down 16% from last year’s peak on 6/12 (Fig. 9). The CPI inflation rate among the G7 economies remained subdued during July, at 1.6% on a headline basis and 1.8% on a core basis (Fig. 10).

(2) OECD leading indicators. As Debbie discusses below, the OECD leading indicators composite fell from the most recent peak of 100.7 during February 2018 to 99.0 during July, the lowest reading since September 2009. Weakness is widespread, with Japan (99.3), the Eurozone (99.0), and US (98.7) all below 100.0 (Fig. 11).

(3) German orders and production. During July, German manufacturing orders and output were down 5.6% and 4.8% y/y (Fig. 12). On the other hand, merchandise exports were up 0.7% in July and 2.0% the past three months. This suggests to us that Germany’s economic problems may be largely homegrown, contrary to the popular tale that the country is facing weak demand for its exports.

(4) US durable goods orders. Powell is half right about US capital spending being depressed by uncertainty. The full story is that nondefense capital goods orders excluding aircraft has stalled for the past year, but at a cyclical high that matches previous cyclical and record highs (Fig. 13).

(5) China trade. Also stalling at record highs for the past year have been both Chinese exports and imports (on a seasonally adjusted annual rate basis) (Fig. 14).

US Economy: Beige Beige Book. Beige is dull; so was the Fed’s September Beige Book economic survey, showing the economy nationwide growing at a modest pace. The publication captures qualitative business commentary on issues pertinent to the US economy through the end of August for the 12 Federal Reserve districts. Seven Federal Reserve districts reported modest or moderate growth, two reported steady growth, two said growth picked up slightly, and one reported that growth was unchanged.

Business commentary was mixed. On the plus side, employment, wage growth, and prices grew modestly, and real estate activity held steady. Concerns about tariffs and trade notwithstanding, generally optimistic outlooks nationwide were reported across many industries. Some districts anticipated that the actual effects of the recent tariff hikes would not be felt for a few months. However, the uncertainty related to international trade disputes already has showed up in manufacturing activity, as discussed below. Consumer-spending reports were mixed. Among the negatives, home sales were reported as restrained by low inventory.

The biggest challenges identified in the report were soft manufacturing activity and the labor shortage. Let’s focus on these areas of weakness:

(1) Soft manufacturing activity. Manufacturing showed signs of slowing or softening among most districts but not across all industries. Bright spots included semiconductors and metals production in the San Francisco area.

Nevertheless, as new orders have declined, manufacturers in several districts noted rising finished inventories despite decreased capacity utilization and production levels. The St. Louis Fed observed that slowing growth in manufacturing has been reported for the past few quarters, “but this is the first time that [respondents] have reported declines for all three of these measures [new orders, production, and capacity utilization] since 2016.”

Many manufacturing contacts expressed concern about geopolitical and international trade uncertainties going forward. The word “uncertainty” was used 29 times (up from 21 in the previous Beige Book), most often related to trade or implied trade tensions. For example, Philadelphia district manufacturing contacts “noted a slightly more cautious outlook given trade and market uncertainty.”

Cleveland manufacturers attributed weak demand to customers delaying capital spending as a result of stiff international competition. Richmond contacts had similar complaints. The 9/8 WSJ ran an insightful article on this phenomenon titled “Manufacturers Cut Spending as Trade War Dents Confidence” after surveying their own manufacturing contacts.

(2) Labor shortage. Yesterday, Debbie and I discussed the recent weak employment data, attributing it to tight labor supply, not weak labor demand. The latest Beige Book confirmed our thinking: Labor shortages, reported in nearly all districts, are continuing to constrain growth. Only Cleveland’s labor pool was characterized in mixed to upbeat terms. In most districts, finding qualified applicants topped employers’ challenges.

In the Boston district, labor supply was reported as scarce and matching skill sets to open positions as difficult—requiring less-than-ideally qualified workers to be hired at higher pay. In New York, “trouble finding qualified workers in a variety of roles” and a wide gap between salary demands and employment offers were reported, slowing hiring.

Richmond, Chicago, St. Louis, Kansas City, Dallas, and San Francisco firms similarly reported difficulty finding qualified workers across job categories and experience levels. Sought-after workers spanned from retail and food-service clerks, truck drivers, construction workers, auto technicians, and production workers to teachers, financial services and IT professionals, engineers, pilots, and physicians.

A few Minneapolis employers said they will have to close or move if workers cannot be found. In Atlanta’s district, the “inability to secure labor was holding back growth, encouraging investments in automation and pushing a few firms to acquire competitors as a means of gaining labor resources.” Philadelphia district contacts said that the labor pool was nearly “nonexistent.”

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Bottom Line on Top Line

September 09 (Monday)

Strategy: Down & Up. Last week started out as a good one for the bears on news that shouldn’t have been a surprise: The US slapped some more tariffs on goods imported from China. Later in the week came news that the US and China will meet again in October for another round of trade negotiations. More importantly, China wants a deal, according to credible Chinese sources (rather than Trump tweets). In a related development, the Chinese government moved to deescalate tensions in Hong Kong. A 9/5 CNBC story reported:

“‘There’s more possibility of a breakthrough between the two sides,’” said Hu Xijin in a tweet Thursday. Hu is editor-in-chief of the Global Times, a tabloid under the People’s Daily, which is the official newspaper of the Communist Party of China. His Twitter account has been followed by many Wall Street traders and market participants for insight on the trade war.”

In the 8/14 Morning Briefing, we introduced you to Mr. Hu: “In a 7/31 article, the NYT said that Hu is sometimes called a ‘frisbee fetcher’ by critics, i.e., a party loyalist who retrieves whatever is thrown at him by the party. The article reports that Hu acknowledges that he has ‘special access’ to party officials.” (We follow his tweets.)

Also last week, the financial markets seemed to be relieved that the odds of a no-deal Brexit declined as Britain’s Parliament countered Prime Minister Boris Johnson’s threat to use that option to either get a better deal from the European Union or actually walk away with no deal.

The S&P 500 ended up 1.8% last week, and only needs to rise 1.6% to match its previous record high on July 26. As we have frequently observed, geopolitical crises in the past more often than not have created buying opportunities.

Meanwhile, the US economic backdrop remains positive on balance. The Citigroup Economic Surprise Index has rebounded sharply from a recent low of -68.3 on 6/28 to 5.4 on Friday (Fig. 1). In the face of mounting trade tensions with China, the Consumer Confidence Index held up better than did the Consumer Sentiment Index during August, resulting in a still-solid reading of 112.5 for our Consumer Optimism Index, which is the average of the two (Fig. 2). Now let’s turn to the latest purchasing managers and employment data, which on balance were also upbeat, in our opinion.

Purchasing Managers Indexes: Mixed Picture for S&P 500 Revenues. Last week, we got some bad news from August’s M-PMI and some good news from the month’s NM-PMI. Both are highly correlated with the growth rate of S&P 500 aggregate revenues. In the US, the services sector is much bigger than the manufacturing sector, but the manufacturing sector is much more cyclical. So it’s a mixed picture for revenues growth: not great, but not as bad as suggested by the M-PMI alone. Let’s have a closer look:

(1) M-PMI. Last week on Wednesday, Joe and I observed that the drop in the US M-PMI below 50.0 during August was bad news for S&P 500 aggregate revenues growth since the two series are highly correlated (Fig. 3). The growth rate of these revenues has declined from a recent peak of 10.0% y/y during Q2-2018 to 3.0% during Q2. That’s still relatively good considering all the negative headlines about the global economy this year.

However, the drop in the M-PMI from a recent peak of 60.8 a year ago to 49.1 this August is a downer for revenues growth. All three of the major components of August’s M-PMI were below 50.0: new orders (47.2), production (49.5), and employment (47.4) (Fig. 4).

(2) NM-PMI. Last Thursday, we learned that the NM-PMI rose from 53.7 during July to a solid reading of 56.4, with all three of its major components solidly above 50.0: new orders (60.3), production (61.5), and employment (53.1) (Fig. 5). This series is also highly correlated with the growth rate in S&P 500 revenues, though not as highly as is the M-PMI (Fig. 6).

(3) Average PMI. It makes sense to use the simple unweighted average of the M-PMI and NM-PMI as an indicator of S&P 500 revenues growth. Again, while the services sector is much bigger than the manufacturing sector, the latter is more volatile. During August, this average was 52.8—still above 50.0, not as bad as the M-PMI nor as good as the NM-PMI, and consistent with the current low-but-positive growth rate in revenues (Fig. 7 and Fig. 8).

(4) Global PMIs. Of course, S&P 500 revenues are derived not just from US markets but also overseas. By some estimates, foreign revenues account for 30%-40% of the total. So the global PMIs matter as well. They tell the same story as the domestic ones. The global composite PMI along with its components for advanced economies and emerging economies have weakened since early last year but remained above 50.0 during August, at 51.3, 51.0, and 51.8, respectively (Fig. 9).

In manufacturing, the global M-PMI was 49.5 during August, weighed down by advanced economies (48.7) and boosted by emerging economies (50.4). The global NM-PMI was solid at 51.8 during August, with good readings among advanced economies (51.5) and emerging ones (52.3).

(5) Aging populations. Debbie and I aren’t convinced that the weakness in global manufacturing is all about Trump’s trade war with China. However, a resolution of this issue should provide a peace dividend for global manufacturers. The secular problem for them is that populations are aging around the world as people live longer and have fewer babies. This demographic trend favors consumption of services over consumption of manufactured goods.

Furthermore, one of the weakest segments of global manufacturing has been the auto industry, especially in Europe and China (Fig. 10). In the US, auto sales have been high but flat around 17.0 million for the past year. The aging of populations is weighing on auto sales. So is ridesharing.

(6) Bottom line. The bottom line on the top line for the S&P 500 is that revenues are still growing, though slowly as weakness in manufacturing is being offset by strength in services.

US Labor Market: Weakening Demand or Limited Supply? Connecting the dots among US employment indicators in the latest batch reveals an abstract expressionist painting in which reality is in the eyes of the beholder. Those looking for signs of a weakening economy can see it in the picture. Those looking for signs of strength can see that too.

Debbie and I see a labor market where the supply of labor is getting increasingly tight rather than one where demand is weakening. We see inflation-adjusted wages rising to new record highs. We believe that the scarcity of workers combined with the rising purchasing power of consumers will boost productivity growth, which in turn will boost real pay gains. In this scenario, price inflation remains subdued, corporate profits grow, and the economic expansion can continue. Consider the following:

(1) BLS private payrolls. According to the Bureau of Labor Statistics (BLS), private payrolls rose just 96,000 during August. The average monthly increase during the first eight months of this year was 145,000, down from 215,250 during all of 2018. Total payroll employment gains during the previous two months was revised down by a total of 20,000, bringing the 12-month sum of revisions to -72,000 through July (based on first-reported data) (Fig. 11). In the past, when this series turned negative, it foreshadowed the recessions of 2001 and 2008.

Speaking of revisions, the BLS recently released a preliminary estimate of annual benchmark revisions—which are benchmarked to comprehensive counts of employment for the month of March. They show a downward adjustment to March 2019 total nonfarm employment of -501,000. The final benchmark revision will be released in February 2020, with the release of January payroll data.

Then again, Friday’s employment report also showed that based on the household survey, the number of jobs soared 590,000 during August, fully absorbing the 571,000 increase in the labor force! According to this survey, full-time employment jumped 360,000 to another record high last month.

Adding to the abstract painting of the employment situation is the latest ADP private payroll gain of 195,000 during August. There’s no shortage of workers in that number.

Also on the strong side is our Earned Income Proxy for private-sector wages and salaries, as Debbie reviews below. It rose 0.8% m/m during August (its strongest gain this year!) despite the paltry 0.1% gain in private payrolls as hours worked rose 0.3% and average hourly earnings rose 0.4%. The latter component continues to well outpace price inflation, thus boosting real take-home pay.

(2) PMI & regional employment indexes. As noted above, the M-PMI employment figure was weak in August, at 47.4, while the NM-PMI was relatively strong at 53.1 (Fig. 12). The weakness in the national M-PMI employment index was confirmed by similar weakness in the average of the employment indexes compiled in the monthly business surveys of five of the Federal Reserve districts, which seem to be over-weighted with manufacturing respondents (Fig. 13).

(3) CCI & NFIB employment indicators. Most impressive, in our opinion, was last week’s report that the “jobs plentiful” response in August’s consumer confidence survey. It jumped to a new cyclical high of 51.2% up from 45.6% during July. That’s the highest since September 2000. It is highly correlated with the 12-month average of the percent of small business owners in the NFIB survey reporting that they have one or more job openings. In August, this series was up to 37.2%, near recent record highs (Fig. 14).

(4) Bottom line. The bottom line is that consumers’ incomes remain in very good shape. So the economy should continue to grow led by consumer spending.

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Winners & Losers

September 05 (Thursday)

Strategy: Keeping Score. Perspective is a funny thing. Much of what you see depends on where you stand, to take liberties with an old saying. One’s opinion about the stock market’s performance depends on when scorekeeping begins. Despite all the negative headlines, the S&P 500 is up 15.9% ytd through Tuesday’s close, making this an above-average year. However, if the starting point is one year ago, the S&P 500’s performance is a paltry 0.4%.

Consider the two performance derbies with different starting points:

(1) Looking at the rosier ytd returns, all but one of the S&P 500’s sectors are in positive territory: Real Estate (27.7%), Information Technology (26.4), Consumer Discretionary (19.9), Utilities (19.7), Communication Services (18.8), S&P 500 (15.9), Industrials (15.7), Financials (11.3), Materials (10.9), Health Care (3.9), and Energy (-1.0) (Fig. 1).

(2) Conversely, the sectors’ one-year returns aren’t pretty, with conservative, interest-sensitive sectors performing the best and cyclical sectors taking it on the chin: Real Estate (20.1%), Utilities (18.2), Consumer Staples (12.0), Information Technology (5.4), Communication Services (3.8), S&P 500 (0.4), Consumer Discretionary (0.2), Materials (-2.4), Financials (-2.7), Industrials (-3.5), Health Care (-5.0), Energy (-24.7) (Table 1).

Since financial markets discount the future, perhaps the S&P 500’s poor one-year returns anticipated the gloomy headlines we’re seeing now, while the market’s strength this year forecasts a brighter future. There’s no way around it: The headlines about manufacturing, trucking, autos, farming, aerospace, and energy are gloomy. I asked Jackie to look at some of the news flow and see how related industries have reacted. Here’s what she found:

(1) Truckers hitting speed bumps. The trucking market has loosened up after being extremely tight in recent years. The ATA Truck Tonnage Index rose to a new, record monthly high in July (Fig. 2). However, new trucks in the market, combined with less demand for transportation of goods to the ports for trade with China, have led to sharp price declines in the spot market, where last-minute transportation is booked. According to ISM’s August M-PMI report, the new export orders sub-index fell further below 50.0, contracting at its steepest pace since April 2009, falling to 43.3 from 48.1. The imports sub-index posted the biggest decline since December 2015, declining to 46.0 from 47.0 (Fig. 3).

In this weaker environment, trucking rates fell 0.1% y/y in July after a 27-month run of annual increases, according to an 8/29 WSJ article, and prices on trucking’s spot market dropped nearly 19% last month y/y. The PPI for trucking transportation of freight rose only 1.6% y/y during July, down from a recent peak of 8.2% during October 2018 (Fig. 4). The change in the business environment has pushed about 640 truckers out of business in H1-2019, up from 175 during the same period in 2018.

Given the trucking market’s reversal, it’s not surprising that new orders for some trucks have declined sharply. While median-weight and heavy truck sales rose to a cyclical high of 567,000 units (saar) during July, “[o]rders for heavy-duty models from the four largest truck makers in North America—Daimler Trucks North America LLC, Paccar Inc., Volvo Trucks USA and Navistar International Corp.—fell 80% in July from a year earlier,” reported a 9/1 WSJ article quoting data from ACT Research (Fig. 5). June orders declined 69% y/y.

Despite the change in fortune, the S&P 500 Trucking stock price index is up 14.6% ytd (Fig. 6). Analysts forecast a deceleration in revenue growth from 19.8% last year to a still respectable 6.3% this year and 6.5% in 2020 (Fig. 7). Earnings this year are expected to fall 3.2%, but the comparison is a tough one given 2018’s extremely strong 58.9% jump in earnings, which was boosted by Trump’s corporate tax cut. In 2020, earnings are expected to grow a respectable 10.1% (Fig. 8). The industry’s forward P/E has returned to a more normal 17.7, down from a peak of 25.5 in December 2017, but it’s far from the recessionary levels of 6.5 and 8.2 seen in 2008 and 2012 (Fig. 9).

Because of the gloomy backdrop, the slightest sign of good news has the potential to send trucking shares higher. Navistar International reported on Wednesday fiscal Q3 earnings of $1.56 a share, which soundly beat Wall Street’s expectations for $1.17 a share. Navistar stock, which was down 15.8% ytd through Tuesday’s close, popped roughly 10% in trading Wednesday.

(2) Autos coasting. US auto sales peaked in September 2017 at 18.0mu (saar), and they’ve declined slightly ever since, with July’s at 16.9mu (Fig. 10). Automakers are also being buffeted by slower auto sales in China, higher research costs to develop electric and self-driving cars, and new competition coming from electric cars and Chinese manufacturers. The latest in this tale of woe: The United Auto Workers (UAW) union said Tuesday that its members authorized UAW leaders to call a strike if a new labor deal with the manufacturers can’t be reached. The current deal expires on 9/14.

Despite the industry’s problems, the S&P 500 Automobile Manufacturing stock price index is up 13.8% ytd, the S&P 500 Automotive Retail stock price index has climbed 16.9%, and the S&P 500 Auto Parts & Equipment index tops them all with a 20.2% gain (Fig. 11, Fig. 12, and Fig. 13). Of the three industries, the stock price performance of the S&P 500 Automobile Manufacturers index is the most baffling because revenue is expected to decline 1.5% this year and 0.5% in 2020 (Fig. 14). Earnings growth also is scant, with analysts forecasting a 1.8% increase this year and a 0.3% increase next year (Fig. 15).

Earnings in the S&P 500 Automotive Retail industry are expected to decelerate from 2018’s banner result of 25.3% growth to still-strong rates of 14.9% in 2019 and 8.7% in 2020 (Fig. 16). While earnings in the Auto Parts & Equipment industry are forecast to drop 7.0% this year, they’re expected to grow again in 2020 by 11.0% (Fig. 17). None of the three industries’ 2020 earnings forecasts appear to anticipate a recession.

(3) Tech marching on. If a recession were imminent, you’d expect CIOs to be slashing their tech budgets. If they are, you’d never know it by looking at the ytd returns in the S&P 500 Information Technology sector. It’s up 26.4% ytd, with the most impressive returns coming from Semiconductor Equipment (53.6%), Systems Software (30.2), and Technology Hardware, Storage & Peripherals (27.6) (Fig. 18).

Analysts are expecting the S&P 500 Information Technology sector’s earnings growth to stall this year (0.5%) after a banner 2018 (26.3%). They’re also calling for a return to more moderate earnings growth of 8.2% next year. Meanwhile, the Information Technology industry’s forward P/E of 19.1 is expensive compared to where it’s been during the recessionary years in the past two decades, but it’s right on par with the P/E the sector has sported during the good times of the past 20 years (Fig. 19).

Two of the tech sector’s top performers are the S&P 500 Semiconductors stock price index (up 16.7% ytd) and the Semiconductor Equipment index (53.6%). They both started to rally far before there was any good news in the headlines or in their earnings estimates. After many rounds of estimate cuts, the Semiconductors industry’s earnings are expected to decline 13.9% in 2019 and increase only 0.7% next year (Fig. 20). Likewise, the Semiconductor Equipment industry’s earnings, after many rounds of cuts, are expected to plummet 21.9% this year and gain only 4.8% in 2020 (Fig. 21).

Instead of earnings, investors may be pouncing on the positive inflection of the three-month moving average of worldwide semiconductor sales, which occurred in July for the second time in three months after falling for six consecutive months (Fig. 22). On a y/y basis, semi sales are still negative (-15.5%), but investors focused on the m/m data are looking at a half-full glass. As we said, it’s all a matter of perspective.

Strategy II: Capital Markets Looking Healthy Too. Despite the stock market’s volatility, companies are issuing bonds and stocks at a robust pace. While that can change at a moment’s notice, for now the capital markets are open for business—yet another optimistic sign for the future. Let’s take a look:

(1) IPOs surging y/y. In Q2, $28.3 billion of US IPOs came to market, bringing the ytd total to $42.5 billion, a 32% surge compared to last year, according to Dealogic data in the WSJ. And if the market continues to cooperate, the US IPO market may have its biggest year since 2014.

“As of August 29, there were 68 US IPOs publicly on file, 38 of which have submitted a new or updated filing since June 1. Based on historical trends and both public and confidential IPO filings, we believe that 50-70 US IPOs could raise over $15 billion between now and year end,” reported Renaissance Capital in its fall IPO report. One thing slowing the market down: the disappearance of Chinese IPO filings. Last year in August, there were eight US IPOs filed by Chinese issuers.

(2) Bond sales booming. The market for high-yield bonds is open as well, with $126.1 billion sold in Q2, bringing the ytd total up to $200.3 billion, up 24% y/y. While the spread between the yield on high-yield corporate debt and 10-year Treasury notes has widened a bit, to 417bps from 353bps in mid-April, the absolute yield has fallen to 5.64%, near its lowest levels since November 2017 (Fig. 23 and Fig. 24).

Investment-grade debt issuance is down slightly, 7%. But that is changing as corporate treasurers take advantage of the 10-year Treasury note’s recent rally. On Tuesday alone, US companies sold almost $28 billion of bonds, the 9/3 FT reported. Among the issuers was Deere, which sold 30-year bonds with a 2.877% yield, a record-low 30-year corporate bond yield. The previous record was a 3.197% 30-year bond sold by Walt Disney in 2016, a 9/3 WSJ article reported.

(3) Big IPOs on the way. IPOs have turned in a banner performance so far this year. The Renaissance IPO ETF is up 30.0% through Tuesday’s close, down from its 44% ytd performance in July but still sharply outperforming the broader stock markets. Those returns are even more impressive given the sharp ytd declines in two of its holdings: Uber Technologies and Lyft.

The strong IPO returns are good news for the deals waiting in the wings, including SmileDirect Club, which sells clear aligners directly to consumers. They eliminate the need to go to an orthodontist and reduce the cost of straightening one’s teeth by 60%, SmileDirect says. The company, which is unprofitable, plans to raise up to $1.3 billion in its IPO.

SmileDirect and WeWork—which has a $3 billion IPO pending—both will use an umbrella partnership corporation, or an “up-C,” when they go public. “The structure allows companies to sell shares through a public holding company that owns a stake in an underlying limited liability company, where certain company executives and early investors continue to hold their economic interests. Unlike WeWork, SmileDirectClub also said it would use a so-called tax receivable agreement granting LLC members 85% of the savings generated by an increase in the company’s tax basis,” an 8/16 FT article stated. Stay tuned to see whether investors push back against the deals’ added complexity.

Also expected to hit the market in September are Cloudflare, 10X Genomics, and Peloton Interactive. Cloudfare provides cloud-based networking and cybersecurity services. With plans to sell 35 million shares at $10-$12 each, it could raise north of $400 million. 10X Genomics, which develops systems to analyze biological systems at the cellular level, plans to sell 9 million shares at $31-$35 each for proceeds that could top $300 million. And Peloton Interactive has an IPO on deck that could raise $500 million.

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Industry Analysts’ World Tour

September 04 (Wednesday)

Strategy I: Global Revenues Remain on Uptrends. Previously, we’ve observed that global economic headlines have been increasingly depressing since early last year. We’ve also observed that notwithstanding the headlines, S&P 500 forward revenues—which is the time-weighted average of industry analysts’ revenues estimates for the current and coming years—has remained on a solid uptrend in record-high territory (with some downside volatility late last year) (Fig. 1). It continued to set record highs during August.

The weekly S&P 500 forward revenues series tends to be a very good coincident indicator of the composite’s actual quarterly revenues (Fig. 2). During the 8/22 week, industry analysts projected that S&P 500 revenues will grow 4.4% this year and 5.3% next year (Fig. 3). Those are upbeat estimates considering the headline news.

Now let’s see whether the picture changes much when we go abroad. Are the industry analysts who are following companies outside the US more upbeat or less so about those companies’ prospects? Here’s the good news first, followed by the not-so-good:

(1) US vs them. When we compare the forward revenues of the US MSCI stock price index to that of the comparable All Country World Ex US index (in local currency), we see that both remain on uptrends that started in early 2016 following the 2015 downdraft resulting from the bursting of the commodity super-cycle bubble (Fig. 4). Astonishingly, both are in record-high territory, though the consensus expectations for revenues growth abroad are a bit lower than for the US, at 3.2% this year and 4.4% next year (Fig. 5).

(2) Developed vs emerging. Let’s drill down some more. The forward revenues of the Developed Countries Ex-US MSCI (in local currency) isn’t at a record high, but it has been making new cyclical highs since early last year (Fig. 6). The forward revenues of the Emerging Markets MSCI (also in local currency) has stalled at a record high since early 2018 (Fig. 7).

(3) Comparative growth rates. Here are the consensus revenues growth rates expected this year and next for the major Developed Countries MSCI indexes around the world: Emerging Markets (5.1%, 7.3%), US (4.4, 5.4), EMU (2.4, 3.9), UK (1.6, 2.5), and Japan (1.7, 1.9). (See our Annual Consensus MSCI Revenues & Earnings Growth.)

(4) US M-PMIs. Now for the bad news: S&P 500 aggregate revenues growth is highly correlated with the US M-PMI, which fell below 50.0 during August for the first time since August 2016 (Fig. 8). It dropped to 49.1 from 51.2 during July and a recent peak of 60.8 during August 2018. Revenues rose 2.9% y/y during Q2-2019 and could weaken more based on the latest reading of the US M-PMI.

A silver lining is that the Institute for Supply Management, which compiles the M-PMI, reports that the US economy still isn’t in a recession and is growing around 1.8% based on the past relationship of their index with real GDP.

Then again, the S&P 500 stock price index tends to stall on a y/y basis when the M-PMI is around 50.0 (Fig. 9). In any event, all of us recession-watchers now have another weak indicator to add to our worry list, including the yield curve, which inverted during the summer and is also highly correlated with the M-PMI (Fig. 10). Nevertheless, we still aren’t in the recession camp.

Almost all the components of August’s M-PMI were weaker than during July: M-PMI (49.1, down from 51.2), new orders (47.2, 50.8), production (49.5, 50.8), employment (47.4, 51.7), supplier deliveries (51.4, 53.3), inventories (49.9, 49.5). prices (46.0, 45.1), backlog of orders (46.3, 43.1), new export orders (43.3, 48.1), and imports (46.0, 47.0).

(5) Overseas M-PMIs. More bad news: The M-PMIs of the other major industrial economies have already been below 50.0 for several months (Fig. 11). Here are their August readings: China (49.5), Japan (49.3), US (49.1), Canada (49.1), UK (47.4), and Eurozone (47.0). Australia (50.9) is an exception.

Here are the M-PMIs for the Eurozone economies: France (51.1), Spain (48.8), Italy (48.7), Germany (43.5) (Fig. 12).

Among the emerging economies, we found only three with M-PMI readings above 50.0 during August: Brazil (52.5), India (51.4), and Vietnam (51.4).

Strategy II: Global Earnings Stalling or Weakening. The global forward earnings picture isn’t as bright as the forward revenues based on the major MSCIs. Forward earnings for the US MSCI has stalled at a record high since mid-2018, while the series for the All Country World Ex US (in local currency) has been on a downward path over the same period (Fig. 13). The weakness overseas is visible in both Developed Countries Ex US and Emerging Economies. (See our Global MSCI Comparisons of Forward Earnings.)

Strategy III: Global Profit Margins. As we observed on Tuesday, earnings are weak relative to revenues around the world because profit margins are getting squeezed (Fig. 14). However, the US forward profit margin is near its 2018 record high of around 12.0% and holding up better than overseas margins, which on average have dropped from last year’s peak of 8.3% during the 10/11 week to 7.8% currently.

Central Banks: Negative Consequences of Negative Rates. In late August, I discussed that the Minutes of the 7/30-31 FOMC meeting suggested that Fed policymakers might consider negative interest rates if and when the federal funds rate was lowered to the so-called “zero lower bound” (ELB). (See our 8/27 Morning Briefing titled “Fed’s New Obsession with ELB.”) Previously, Melissa and I made the case that such policies can have negative unintended effects on the economy. In our 2/24/16 Morning Briefing, we wrote:

“Negative interest rates are intended to stimulate the economy. But they might actually do the opposite ... Ultra-easy monetary policy ‘could be the greatest failure of modern central banking’ … economist Stephen Roach wrote in a 2/18 op-ed. He might be right. In any case, it’s very hard to find the positives of negative rates. There’s certainly lots of potential danger in these uncharted and troubled waters.”

Negative policy rates already have been implemented in Japan (on 1/29/16) and in the Eurozone (on 6/5/14). Yet those policies have backfired, according to recent research. Nevertheless, there is no end in sight for the Bank of Japan’s (BOJ) negative-rate policy, and the European Central Bank (ECB) stands ready to push rates further into negative territory at its next policy meeting this month (on 9/12).Consider the following:

(1) The ECB’s experience. Central bankers believe that by lowering interest rates, they will stimulate economic growth and inflation. However, when interest rates go below zero, the opposite might happen. A 5/20 WSJ article titled “Negative Rates, Designed as a Short-Term Jolt, Have Become an Addiction” focused on the failure of negative interest rates to revive European economies:

“The negative-rate policy’s ineffectualness is a sign of just how weak Europe’s economic engines are, and how vulnerable. The policy threatens pensions, creates the risk of real-estate bubbles and doesn’t fully quell the specter of deflation. European banks struggle with weak interest income and thin margins on loans, putting them behind American peers in profitability and making it harder for them to finance the economy.”

During his 7/25 press conference, ECB President Mario Draghi was asked if businesses “might no longer invest or hurry up investing because” they anticipate “rates staying low” basically “forever.” Draghi shrugged off the comment, responding that construction spending has been up. Draghi did not mention weakness in capital spending but did admit: “Certainly we have to ask ourselves: are all these instruments going to be effective forever? I think that's a legitimate question to ask.” The latest batch of M-PMIs for the Eurozone suggests that negative interest rates have lost their effectiveness rather quickly.

(2) The BOJ’s experience. Two Fed economists at the Federal Reserve Bank of San Francisco reviewed Japan’s experience with negative interest rates in an 8/26 article titled “Negative Interest Rates and Inflation Expectations in Japan.” They examined movements in yields on inflation-indexed and deflation-protected Japanese government bonds “to gauge changes in the market’s inflation expectations from the BOJ moving to negative policy rates.” They found that “this movement resulted in decreased, rather than increased, immediate and medium-term expected inflation.” Their conclusion: “This therefore suggests using caution when considering the efficacy of negative rates as expansionary policy tools under well-anchored inflation expectations.”

Examined in the paper is an adjusted breakeven inflation rate (BEI). The adjusted measure accounts not only for nominal versus real Japanese government bond yields but also the value of deflation protection for Japanese inflation-index bonds. With deflation protection, bonds pay off their nominal principal at maturity even if there is price deflation. This protection has been highly valued by Japanese investors for extended periods. The authors noted: “This enhancement raises the value of inflation-indexed bonds, and hence pushes down real yields. This creates an upward bias in the measurement of inflation expectations from BEI rates.”

On the BOJ’s announcement day, the Japanese 10-year BEI (not accounting for deflation protection) rate increased 1bp. After accounting for deflation protection, the 10-year adjusted BEI rate declined an estimated 8bps, the researchers found. The paper noted: “Essentially, the market appeared to treat negative rates as bad news, perhaps because investors were concerned that the BOJ’s unprecedented move meant that economic conditions were worse than they thought.”

After its foray into negative rates, the BOJ was warned by lawmakers: “You have sent a message to the people that they had better watch out because Japan’s economy is in trouble.” Sure enough, the growth rates of private consumption and business investment in Japan have remained weak despite negative interest rates.

(3) Bank-lending studies. Negative interest rates on banks’ excess reserves are supposed to encourage the banks to lend more. A 7/30 study based on data for 6558 banks from 33 OECD countries over 2012 through 2016 found that bank lending was weaker in countries that had adopted negative interest rates. A forthcoming follow-up study by the same researchers found that bank margins and profits fall in countries with negative interest rates compared to countries that did not adopt this policy.

A summary of the research titled “Negative interest rate policies are backfiring—new research,” explained: “Negative interest rates are supposed to stimulate the domestic economy by facilitating an increase in the demand for bank loans. In theory this could increase new capital investment by firms and domestic consumption, via credit creation. But the research showed bank margins were being squeezed, curbing loan growth and damaging banking profits.” Furthermore, negative interest rates seem to have negated the stimulative impact of other forms of unconventional monetary policy like quantitative easing.

(4) Currency wars. “In theory, negative rates discourage capital inflows and should depreciate the home currency, which should stimulate exports. In practice, devaluation is futile. There’s only so far that currencies can weaken against others before they trigger competitive devaluations. Such ‘currency wars’ won’t revive overall global economic growth. On the contrary, they might weigh on it instead. Negative interest rates and currency depreciation are signs that monetary policy can’t solve the world’s economic problems,” as we wrote in our 2/24/16 Morning Briefing. Yesterday, the euro slid to its lowest since 2017 as investors anticipated ECB rate cuts. Currencies around the globe are falling as the dollar strengthens, for now.

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FONIR Down South

September 03 (Tuesday)

Strategy: Negative Thoughts. I visited with our accounts in Atlanta and Chattanooga at the beginning of last week. They seemed relatively calm. Most of them believe that the US economy can continue to grow for the foreseeable future. So they aren’t freaking out about the recent inversion of the yield curve. However, they are somewhat anxious about the prospect of negative interest rates in the US, though they think it is a remote possibility. Consider the following:

(1) US bond yields stand out. We discussed in our meetings the expectation that the Bank of Japan (BOJ) is likely to keep its official policy interest rate at -0.10% for the foreseeable future, as it has since 1/29/16, while the Governing Council of the European Central Bank (ECB) is likely to lower its official deposit rate, currently -0.40%, deeper into negative territory at its 9/12 meeting (Fig. 1). The ECB is widely expected to resume quantitative easing at that meeting as well (Fig. 2).

Such expectations have driven the 10-year German government bond yield down to -0.70% on Monday from 0.24% at the start of this year. At 1.50% on Friday, the 10-year US Treasury bond yield is literally outstanding compared to the comparable yields available overseas: UK (0.34%), Japan (-0.27), Sweden (-0.34), France (-0.40), Germany (-0.70) (Fig. 3). The negative-interest-rate policies (NIRPs) of the ECB and BOJ are increasing the amount of negative-interest-rate bonds (NIRBs) around the world.

(2) Dividend & earnings yields stand out. The rationale for remaining bullish on US stocks seems to be shifting from TINA (there is no alternative) and FOMO (fear of missing out) to FONIR (fear of negative interest rates). These fears are inherently bullish for stocks and continue to overcome the bearish fear that an inverted yield curve is predicting an impending recession.

A few of the accounts with whom I met last week noted that the 10-year US Treasury bond yield at 1.50% is below the S&P 500 dividend yield, at 1.90% during Q2-2019 (Fig. 4). That is one very good reason why they remain mostly fully invested in the stock market. I observed that the forward earnings yield of the S&P 500, at 6.06% during August, is even more outstanding compared to the bond yield (Fig. 5).

(3) Performance derby. The 119bps drop in the US bond yield since the beginning of the year certainly has benefitted dividend-yielding stocks. The S&P 500 sectors that tend to have lots of dividend-paying companies have outperformed those that tend to have fewer of them: Information Technology (28.0% ytd), Real Estate (26.0), Consumer Discretionary (20.3), Communication Services (20.0), Consumer Staples (19.0), Utilities (17.6), Industrials (17.4), S&P 500 (16.7), Financials (12.6), Materials (11.9), Health Care (4.6), and Energy (-0.5) (Fig. 6).

FONIR should continue to benefit dividend-yielding stocks. Their high valuation multiples reflect investors’ willingness to pay up for these stocks, as evidenced by the relatively high forward P/Es of the S&P 500 sectors with lots of dividend payers: Real Estate (44.0), Consumer Discretionary (21.2), Information Technology (19.6), Consumer Staples (19.6), Utilities (19.4), Communication Services (17.4), Materials (16.9), S&P 500 (16.8), Industrials (15.4), Health Care (14.8), Energy (14.7), and Financials (11.4) (Fig. 7).

(4) Real yields. During July, the US bond yield averaged 2.05%, while the CPI inflation rate was 1.80%. So the inflation-adjusted bond yield was close to zero, at 0.25% (Fig. 8). During August, the bond yield fell below the inflation rate. In other words, in real terms, bond yields are entering negative territory. Meanwhile, the real earnings yield of the S&P 500, using reported earnings, remained solidly in positive territory during Q2-2019, at 3.02% (Fig. 9). The real forward earnings yield of the S&P 500 was 4.03% during July (Fig. 10).

US vs Them: Outstanding. The US economy has recovered from the Great Recession of 2008-2009 much better than most other economies around the world. The American banking system is very well capitalized. The nonbank credit markets have been revitalized. Private equity markets are funding lots of startups. Corporate profit margins are at record highs. The US has numerous world-class companies in technology, industrials, health care, media, communications, and finance. The labor market is booming, with inflation-adjusted wages rising to record highs. The US faces plenty of challenges to the good times, with trade uncertainty currently paramount; however, the US economy and stock markets continue to outperform on a global basis. Consider the following:

(1) Real GDP. Among the industrial economies, US real GDP rose 2.3% y/y during Q2, outpacing Australia (1.8%, during Q1), Canada (1.6), the Eurozone (1.3), the UK (1.2), and Japan (1.1). A few of the big emerging economies are growing faster than the US, while a few are growing slower: China (6.2), India (5.0), Indonesia (5.0), South Korea (2.1), Brazil (1.0), and Mexico (0.3) (Fig. 11).

(2) Industrial and energy production. US manufacturing is in a growth recession along with manufacturing in the rest of the world. Manufacturing output growth in the US slipped by -0.5% y/y during July (Fig. 12). It’s the same story in the Eurozone (-2.8% y/y through June), UK (-1.3), and Sweden (-0.2), while growth in Japan (0.7) and South Korea (0.8) were just above zero. China’s industrial production was still up 4.8% y/y during July, but this growth rate has remained on a downtrend since 2011.

One of the brighter spots in the US is energy production. US crude oil production rose to another record high of 12.6mbd during the 8/23 week (Fig. 13). Over the past 12 months through April, US natural gas production rose to another record high of 34.0 trillion cubic feet, more than enough to meet growing domestic demand, making the US a net exporter of natural gas (Fig. 14).

(3) Inflation. Interest rates shouldn’t go negative in the US as they have done in the Eurozone and Japan. That’s because inflation remains higher in the US, at 2.2% y/y on the core CPI versus 0.9% in the Eurozone and 0.4% in Japan (Fig. 15).

(4) Profit margins, valuation, and stock prices. The US MSCI stock price index continues to outperform the All-Country World ex-US (ACWX) MSCI stock price index in both dollar and local-currency terms (Fig. 16). The former is up 17.0% ytd, while the latter is up 6.4% in dollars and 8.2% in local currencies over the same period.

Contributing to the outperformance of our Stay Home investment thesis relative to the Go Global alternative is the widening spread between the profit margins of the US MSCI and the ACWX during the current bull market (Fig. 17).

The outperformance of the US is reflected in relative forward P/Es. Here are the latest readings for the major MSCI stock price indexes around the world: US (17.1), EMU (12.8), Japan (12.4), UK (11.7), and Emerging Markets (11.7) (Fig. 18).

Movie. “Blinded by the Light” (+ +) (link) is yet another very entertaining movie about rock stars. This year, movies about the Beatles (“Yesterday”) and Elton John (“Rocketman”) came out. Last year, there was one about Freddie Mercury and Queen (“Bohemian Rhapsody”). The latest movie in this genre is about Javed, a teenage boy whose parents moved from Pakistan to Luton, England for a better life. The film is set in the 1980s, when unemployment was high. Javed’s father loses his job, stressing the entire family, which also faces anti-Pakistani harassment. Javed takes joyous refuge from his bleak environment in the music of Bruce Springsteen, which inspires him to write lyrics for a local band. He struggles to resolve the tension between his father’s very close-minded traditional values and the mind-opening poetry of the music he loves. I wonder when they will start making movies about economists.

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Running Out of Gas

August 29 (Thursday)

Stock Buybacks: Fed Seeking Missing Data. Joe and I have been working hard to set the record straight on buybacks. We wrote a 5/20 Topical Study titled “Stock Buybacks: The True Story.” We summarized our findings in an 8/23 Barron’s op-ed titled “Don’t Blame Buybacks for Boosting Stock Prices—Or Promoting Inequality.” Paperback and Kindle versions of our study are now also available on Amazon.

In our original study, we wrote: “We suspect that the Fed’s accounts might not be accounting for the value of stocks issued by corporations to their employee stock compensation plans. We have reached out to the Fed and are awaiting guidance on this matter. Stay tuned.” Well, sure enough, they recently sent us an email acknowledging that we might be right and are working to correct the problem!

Let’s see if their fix corroborates our conclusion: “Hence, we again conclude that the impact of buybacks on earnings per share has been greatly exaggerated. That’s because we found that roughly two-thirds of buybacks may be mostly offsetting stocks issued as labor compensation. Rather than boosting earnings per share, most buybacks are aimed at reducing the share-count dilution that results from compensating employees with stock.”

Germany: Autobad. Labor Day typically means time with friends and family at the pool or beach, end-of-season barbeques, and of course traffic. Despite concerns that Americans are falling out of love with their cars, US vehicle miles traveled continued to climb in June, by 1.0% y/y, to new record highs, based on the 12-month sum (Fig. 1). And over the holiday weekend, driving times could spike by 85%-115% in metro areas, according to INRIX data quoted in an 8/17 USA Today article.

Despite the traffic, car sales in the US and in most major countries around the world have been declining for the past year. According to data from VDA reprinted by bestseillingcars.com, here’s how some of the world’s largest markets fared in terms of 1H-2019 sales growth (or rather, lack thereof for most): China (-14.0% y/y), India (-10.3), Europe (-3.1), Russia (-2.4), US (-1.9), Japan (-0.3), and Brazil (10.9).

The reasons behind the declines vary. US tariffs typically are blamed for China’s slowing economy and car sales. Europeans, too, are slogging through a slowing economy as they face Brexit, new car emissions rules, and potential US tariffs. The trade war is dampening US economic growth. Higher car prices have made car ownership more expensive, and ridesharing via Uber and Lyft has made it less hip worldwide. After multiple years of record or near-record car sales, it just may be time for the car market to take a breather now that many driveways have shiny, moderately new vehicles.

The economy of Germany, the world’s Detroit, is among the most directly impacted by the global decline in the auto industry. German car manufacturers produced about one-fifth of cars sold globally last year and two-thirds of higher-margin premium cars, a 10/23 Financial Times article reported. Eight hundred auto suppliers operate in Germany, and a third of auto research occurs there. As a result, Germany’s auto industry employs 834,000 and directly contributes around 5% to the country’s GDP.

As you’d expect, the German auto market—and economy broadly—have felt the global auto industry’s slowdown. Germany’s passenger car production has been falling sharply since July 2018 and in July dropped to 4.7 million units (12-month sum), far below the 2016 peak of 5.8 million units and even below the 2009 Great Recession nadir of 4.8 million units (Fig. 2). The drop in production weighed on the country’s GDP, which in Q2 fell 0.3% (saar) (Fig. 3). Q2 GDP was hurt most notably by a deterioration in net trade, as exports (-5.3% saar) fell more than imports (-1.1). Capital investment (-0.5) was also a drag on growth, with a drop in construction spending (-4.0) more than offsetting an increase in machinery & equipment investment (2.5) (Fig. 4).

Given these developments, I asked Jackie to take a closer look at Germany’s economy in general and its auto industry in particular. Here are her findings:

(1) Competition racing ahead. While the global auto market has always been a tough competitive space, two new entrants have been disrupting it lately: electric car manufacturers and Chinese manufacturers seeking international growth.

Electric car sales have taken off as many countries have slapped the industry with tougher emissions rules, consumers have grown more environmentally aware, and price points have come down. Global electric vehicle sales reached 2.1 million units last year, up 64% y/y, according to an EVvolumes.com article. Some of the most aggressive electric car adopters include Norway, where 40% of new car sales were electric last year; Iceland (17.5%); and Sweden (7.2). In Asia, China leads the way (4.3). The country accounts for 56% of all electric cars sold last year.

German companies are aggressively rolling out their own electrified models, but others have a large head start. Tesla’s Model 3 was the best-selling electric car worldwide last year, with a 7% market share, a 1/31 InsideEVs article reported. The Model 3 was followed by China’s BAIC EC-Series (4% market share), Nissan Leaf (4), the Tesla Model S (2), and Model X (2). Granted, these are early days, and as more German manufacturers roll out their offerings, the leader board could certainly change.

Meanwhile, Chinese auto manufacturers are looking abroad for growth as their domestic economy slows. Right now, their focus is primarily on emerging markets, but it’s likely they’ll continue to expand, targeting developed markets in the future, according to an 8/11 WSJ article.

“China’s car manufacturers once struggled to sell their cars at home, let alone abroad. Now, the cars they are producing are much improved, analysts say, matching foreign rivals on quality and outflanking them on price,” the article explained.

SAIC Motor is selling its sport-utility vehicle in India and has opened plants in Indonesia and Thailand to sell into Southeast Asia. Great Wall Motors opened its first overseas plant in Russia in June. And BAIC Motor started production in South Africa last year. Zhejiang Geely Holding Group opened a plant in Belarus in 2017 to serve Russia and Eastern Europe and entered the Southeast Asian Market in December.

(2) China’s slowing. About a third of all vehicles sold globally are sold in China, and about a quarter of all cars sold in China are sold by German manufacturers, according to a 8/22 WSJ article. So when China’s economy slows, it’s likely that Germany’s auto industry will catch a cold. Right now, it looks like it’s time to buy some tissues.

Auto sales in China fell 9.6% y/y in June and 12.0% y/y during 1H-2019 to 12.3 million, the weakest result in four years. On a 12-month sum basis, the country sold 26.2 million automobiles, down from a peak of 29.6 million during June 2018 (Fig. 5).

(3) Europe making life difficult. In Europe, the auto industry is facing the double whammy of Brexit uncertainty and tougher auto emissions rules. Add to that a potential tariff war with the US, and you have numerous reasons for the economy to slow and consumers to postpone car purchases.

Brexit heated up Wednesday after UK Prime Minister Boris Johnson attempted to shut down Parliament temporarily to block lawmakers from voting against a no-deal Brexit. Melissa provides details on the Brexit drama below. The upshot is that UK real GDP fell 0.2% in Q2, hurt by sharp declines in manufacturing (-2.3%)—which is included in industrial output (-1.4)—and construction (-1.3); services showed no growth, its weakest performance since Q1-2010 (Fig. 6 and Fig. 7).

In addition to Brexit, European car companies face the burden of reducing their vehicles’ CO2 emissions. The EU has set initial targets for 2021 that get progressively tougher. For companies, that means more R&D spending to develop cars that can meet those standards.

The need to meet emissions standards was one of the reasons why Ford and Volkswagen expanded their global alliance last month. The companies agreed to collaborate on the development of self-driving technology and electric vehicles, a 7/12 Financial Times article explained. VW will invest $2.6 billion in Ford’s driverless technology startup company, and Ford will build an electric car in Europe using VW’s manufacturing systems.

Brexit Update: Johnson’s Prorogation. Members of Parliament (MPs) had their summer holiday recess rudely interrupted yesterday when PM Johnson invoked a procedure called “prorogation” to suspend parliamentary sessions for five weeks prior to the 10/31 Brexit deadline. His critics call it “a dirty trick.” Next week, anti-no-deal Brexiters and Conservative rebel MPs will have to get their acts together quickly to stop Johnson from potentially allowing the UK to leave the EU without a deal.

In yesterday’s Morning Briefing, we detailed the three different Brexit scenarios: deal, no-deal, or delay. Most MPs oppose a no-deal Brexit because it would impose a hard border between Northern Ireland (part of the UK) and the Republic of Ireland (an EU member state) overnight. That could send the UK’s economy into a recession, with negative spillover effects to other countries.

What is prorogation, and can it be stopped? Prorogation ends a session of Parliament for a short time, so legislative discussions are halted and Parliament doesn’t even sit. After the forced break, Parliament reopens with the Queen’s speech. The process cannot be stopped by MPs, as they do not get to vote on it. (For more, see The Guardian’s article titled “What is prorogation and why is Boris Johnson using it?”)

Yesterday, Johnson said that he requested and gained approval from the Queen for a 10/14 speech to help focus on the public’s priorities, including “helping the NHS, fighting violent crime, investing in infrastructure and science and cutting the cost of living,” according to an article in the UK publication Independent.

Critics call the PM’s act a deliberate move to shorten Parliament’s Brexit debate time.

Johnson claims that there will be “ample” time for these discussions despite the prorogation. In fairness, the suspension curtails debate time by just over a week’s worth of days given that Parliament has a three-week recess scheduled during the five-week suspension and doesn’t sit on Fridays. The media hasn’t focused on that fact.

The PM says that a debate over Northern Ireland would be held on 9/9. Further Brexit discussions would be held in the days before the European Council Summit on 10/17-18, leaving plenty of time for MPs to consider any breakthroughs with the EU on a withdrawal deal before vote in Parliament on 10/21-22.

Nevertheless, some say that shortening the discussion timeline gives the PM leverage to leave without a deal. Critics didn’t look kindly on his move and may push anti-no-deal parties and Conservative rebels more quickly toward either a vote of no-confidence or the passing of legislation to delay the Brexit deadline date, both of which we covered yesterday.

Conservative rebel Dominic Grieve called the move in the “middle of a national crisis” “outrageous” and “unprecedented.” It will “cause MPs to move very quickly to a vote of no-confidence in the government,” Independent reported he said. Our hunch is that there will indeed be a countermove by anti-no-dealers next week.

Crypto Update: Carney’s Currency. It’s one thing for Chinese officials to try to dethrone the dollar as the world’s reserve currency. It’s quite another thing for the head of the Bank of England (BOE) to suggest that the world’s financial system would be sounder without dollar dominance.

BOE Governor Mark Carney in his 8/23 speech at the Jackson Hole Symposium laid out such a case. The dollar, he argued, has an outsized impact on the global economy relative to the US economy’s size. The dollar is used in at least half of international trade invoices—representing value of about five times the US’s share of world goods imports and three times its share of world exports. The large amount of trade done in dollars encourages companies to use the dollar when issuing global securities and central banks to use the dollar in their foreign exchange reserves.

That forces foreign countries to focus monetary policy on stabilizing capital flows instead of using it to achieve domestic priorities related to output and inflation, Carney noted. To ensure stable capital flows, countries accumulate dollar-denominated reserves, creating the “global savings glut” that former Fed Chairman Ben Bernanke has pointed out can lead to extremely low global interest rates.

Because the dollar is dominant, every time the Fed acts to strengthen or weaken the US economy, the rest of the world’s economies feel it. In the current environment, that means the strong US economy and the strong dollar have muted the impact of loose monetary policy in countries with weak economies, making it difficult for their economies to revive.

Carney’s solution: Central banks around the world could join forces to create a virtual currency based on a basket of currencies. Trade could occur in that virtual currency. The private sector could also develop a virtual currency, along the lines of what Facebook’s doing with LIBRA. Either way, moving away from the dollar would give countries more control over their economies and perhaps mean that interest rates could rise from their basement levels.

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Abnormal Times

August 28 (Wednesday)

The Fed: Dudley Joins the Resistance. What a surprise! Bill Dudley is a Never-Trumper, and he wants the Fed to join the resistance. He served as president of the Federal Reserve Bank of New York and as vice chairman of the Federal Open Market Committee from 2009 to 2018. He revealed his antipathy for the President in a 8/27 Bloomberg View op-ed titled “The Fed Shouldn’t Enable Donald Trump.”

He wants the Fed to fight fire with fire: “I understand and support Fed officials’ desire to remain apolitical. But Trump’s ongoing attacks on Powell and on the institution have made that untenable. Central bank officials face a choice: enable the Trump administration to continue down a disastrous path of trade war escalation, or send a clear signal that if the administration does so, the president, not the Fed, will bear the risks—including the risk of losing the next election.”

In other words, the Fed shouldn’t offset the uncertainties caused by Trump’s trade policies with lower interest rates, even if that leads to a recession. The Fed should refuse to meet its legal mandate to maintain full employment and price stability rather than enable Trump.

Dudley is essentially calling for the Fed to overthrow the President in the coming election: “There’s even an argument that the election itself falls within the Fed’s purview. After all, Trump’s reelection arguably presents a threat to the U.S. and global economy, to the Fed’s independence and its ability to achieve its employment and inflation objectives. If the goal of monetary policy is to achieve the best long-term economic outcome, then Fed officials should consider how their decisions will affect the political outcome in 2020.”

I am almost speechless. Dudley may be calling on the Fed to join the resistance and to fight fire with fire, but that would be playing with fire for the Fed. Welcome to the New Abnormal, where everyone loses their minds! Trump has the amazing ability to make sane people go insane. (For more on this, Google search “Trump Derangement Syndrome.”)

Strategy: Industry Analysts Remain Bullish. The headlines about the global economy remain depressing, yet industry analysts who cover the S&P 500 corporations remain upbeat. That’s impressive considering that 30%-40% of S&P 500 revenues and earnings comes from overseas. Not only are overseas economies weak, but the dollar remains strong, which reduces the dollar value of earnings from abroad.

In our opinion, the economic weakness overseas isn’t attributable solely to Trump’s trade skirmishes. Debbie and I believe that aging demographic profiles and piles of burdensome debt are weighing on economic growth around the world. Not even ultra-easy monetary conditions in Europe and Japan or plentiful bank loans in China are rousing the global economy out of its funk.

In the US, real GDP has resumed growing at around a 2% annual rate after receiving a short-lived boost from Trump’s tax cuts last year. The President is clearly disappointed and upset that his supply-side tax cuts have yet to sustainably boost economic growth. That’s evident in his railings about the Fed as he calls for more interest-rate cuts. Let’s have a closer look at some recent developments:

(1) US real GDP growth back to 2%. On a y/y basis, US real GDP rose 2.0% during Q4-2016, just before Trump moved into the White House (Fig. 1). His tax cuts boosted that growth rate to 3.2% during Q2-2018. But it was back down to 2.3% during Q2-2019. Economic uncertainty attributable to Trump’s helter-skelter trade policies undoubtedly are weighing on the economy. And so might be the prospects of huge federal deficits over the next 10 years, as Melissa and I discuss below.

The good news is that the Index of Leading Economic Indicators (LEI) jumped 0.5% during July after two straight months of decline (Fig. 2). Keep in mind that one of the 10 components of the LEI is the yield-curve spread, which was negative for the second month in July, after turning negative in June for the first time since January 2008 (Fig. 3).

The Index of Coincident Economic Indicators rose 0.2% during July to yet another record high. It is up 1.8% y/y, consistent with real GDP growth of around 2% (Fig. 4).

(2) Something is wrong with Germany. German real GDP fell 0.3% (saar) during Q2 after rising 1.5% during Q1 (Fig. 5). It is up just 0.4% y/y (Fig. 6).

Germany relies heavily on exporters that sell a large amount of goods to China and the US, which are locked in a trade war. The country’s carmakers are facing weak global auto demand, and fears of a disorderly Brexit remain a drag. The outlook remains grim for Q3, as Germany’s IFO business confidence index plummeted from 99.8 during January to 94.3 during August, the lowest since November 2012 (Fig. 7).

(3) Industrial commodity prices remain weak. Confirming the weakness in the global economy, especially in global manufacturing, is the CRB raw industrials spot price index (Fig. 8). It is down 7.5% ytd. Weak commodity prices tend to be associated with a strong trade-weighted dollar, which is up 4.0% y/y.

(4) S&P 500 forward revenues and earnings are at record highs. Notwithstanding all of the above, Joe reports that S&P 500 forward revenues rose once again to a new record high during the 8/15 week (Fig. 9). As we have often observed in the past, this weekly series is a very good coincident indicator of actual quarterly S&P 500 revenues, which rose to a record high during Q2. Also near recent record highs are S&P 500 forward earnings and the forward profit margin.

US Budget Deficits: A Trillion Here, a Trillion There. Here is some grim reading: Last week, the Congressional Budget Office (CBO) released its August 2019 The Budget and Economic Outlook: 2019 to 2029. It projects that the federal budget deficit will be $960 billion in FY2019 and average $1.2 trillion between 2020 and 2029 (Fig. 10).

Treasury debt held by the public is projected to nearly double from $16.6 trillion this year to $29.3 trillion in 2029. Over this same period, the ratio of this debt to GDP should rise from 78.9% to 95.1%, according to the CBO (Fig. 11). Many investors are concerned that the government is quickly running out of room for more fiscal stimulus, should it be needed, at a time when the Fed is running out of ammo to fight off the next recession.

Here are some of the key underlying assumptions behind the CBO’s projections and our spin:

(1) GDP. The CBO expects real GDP to grow by 2.3% in 2019. From 2020-2023, annual output growth is projected to slow to an average of 1.8%. From 2024-2029, growth is expected to stay at that rate, which is lower than the long-term historical average.

(2) Productivity. Approximately 40% of that slowdown is a result of slower growth of the potential labor force, with the remaining 60% from lower potential labor productivity growth, according to CBO. Labor productivity growth is expected to slow from an annual average of 1.6% from 2019-2023 to 1.4% from 2024-2029 (see CBO’s Figure 2-1).

We think productivity could grow faster and may be starting to do so already, as we discussed in our 8/19 Morning Briefing. CBO acknowledges that there is a high degree of uncertainty in these projections.

(3) Inflation. When GDP is higher than its potential (as it is now, according to the CBO), it means that the demand for goods and services is higher than the economy’s maximum sustainable level of production. That leads to increased demand for labor and puts upward pressure on inflation and interest rates, observed the CBO.

After 2019, the CBO expects inflation, as measured by the core PCED, to rise above 2.0%, which is the Fed’s target for inflation. Specifically, the CBO sees core PCED inflation increasing to 2.2% in 2020 from 1.9% in 2019. From 2024-2029, when actual and potential GDP are expected to be about the same, the CBO projects inflation to average 2.0%.

We expect lower inflation than that, as the powerful deflationary forces we call the “4Ds” (détente, disruption, demographics, and debt) continue to contain it below 2.0% for the foreseeable future.

(4) Interest rates. The estimates for inflation impact the assumptions for interest costs to the government. From 2020-2029, primary deficits, excluding net interest outlays, are projected to be $1.9 trillion higher than they were in the CBO’s previous baseline projections. That increase is partially offset by a reduction of $1.1 trillion in interest costs.

The CBO stated: “The largest factor contributing to that change is that CBO revised its forecast of interest rates downward, which lowered its projections of net interest outlays by $1.4 trillion (including interest savings from the resulting reductions in deficits and debt).” No wonder President Trump keeps beating up the Fed to lower rates!

If we’re right that productivity growth could be faster than the CBO projects, that could promote higher output while keeping a lid on inflation. That in turn could cause interest rates—and thereby the interest cost associated with the federal debt—to fall short of CBO estimates.

(5) Trade. Among the many uncertainties included in the CBO’s projections, US and foreign trade policies are paramount. That’s especially so in the near term because businesses are expected to adjust supply chains to mitigate these effects over the longer term. For its baseline projection, the CBO expects that changes in these policies, particularly tariffs put in place since January 2018, will reduce the level of real US GDP by 0.3% by 2020.

These changes reflect the policies in force as of 7/25, when the CBO’s economic projections were compiled, and assume that they remain in force through 2029. Accordingly, “if trade disputes were resolved such that trade barriers were lowered or removed, economic growth would be faster than CBO projects” and vice-versa.

For now, we remain optimistic on the trade front for the longer term; but, as we have discussed in recent days and months, there are a lot of moving parts on trade.

Brexit: Deal, No Deal, or Delay? The latest Brexit deadline, 10/31, is fast approaching. That’s the hard date by which the UK must leave the European Union (EU), deal or no deal, says UK Prime Minister Boris Johnson. Leaving without a deal could have dire consequences for the UK economy, with “sizeable negative spillovers on growth in other countries,” says the OECD. That’s why Melissa and I expect either a deal by the deadline or a delay in Brexit. Consider the following:

(1) Deal. On 6/23/16, 52% of voters in a UK referendum voted to leave the EU. The separation was slated to occur during March 2019. That was two years after former Prime Minister Teresa May triggered Article 50 of the EU treaty, which specified the formal process for a state to leave the union. UK leadership and the EU agreed on a deal during November 2018. Its three main clauses cover the rights of EU citizens in the UK and British citizens in the EU, the UK’s exit fee to be paid to the EU, and the “backstop.” (For more, see the BBC’s primer titled “Brexit: All you need to know about the UK leaving the EU.”)

(2) No deal. The UK Parliament has rejected the deal on three occasions. Many Members of Parliament (MPs) disapprove of the backstop. It dictates that if the UK and the EU do not reach a satisfactory trade deal soon after Brexit is finalized, Northern Ireland would stay within the EU’s customs union and be subject to the rules of the EU single market. That means it would have to allow the free and untaxed movement of goods, capital, services, and labor from EU member states across its borders and not strike trade deals with countries outside the EU. Critics of the backstop worry that it could become permanent, which effectively would sign away the UK’s economic independence.

If the UK leaves the EU on 10/31 without a deal, then the EU would call for a hard border between Northern Ireland, which is part of the UK, and the Republic of Ireland, a separate member state of the EU. Physical check points would inspect British goods, causing potential supply delays and damaging the UK economy. UK PM Boris Johnson has promised funding reserves to avoid these outcomes.

(3) Alternative deal or delay. Nevertheless, most MPs don’t want a no-deal Brexit. UK PM Johnson prefers an alternative agreement whereby technology would replace the need for a hard border. Customs checks would be done at warehouses rather than points of entry, via mobile phone or microchip technology. But EU officials say proper controls would be impossible without physical checks.

Regarding the backstop, Tusk and Johnson have a major rift. Both have referred to the other as “Mr. No Deal.” Both hardliners have argued that a no-deal result would be the fault of the other. Johnson is all for leaving the EU on the 10/31 deadline with or without a deal. Tusk says he is open to hearing “realistic” alternatives to the backstop, but presumably he has doubts about Johnson’s technology solution.

One way to prevent a no-deal scenario is for the MPs to vote down Johnson with a vote of no confidence, replacing the government with an alternative one that’s willing to further delay a Brexit until an amicable deal is reached, a 7/29 Business Insider article observed.

“If a majority in the Commons threatens to topple the government rather than contemplate ‘no deal,’ it would force Johnson into a compromise, either proposing his own deal or by extending the Article 50 period, perhaps for a general election that might … give him the majority he needs,” according to the article based on an analysis by Pantheon Macroeconomics’ Samuel Tombs.

Yet before pursuing a no-confidence vote, considered to be a last-resort option, MPs who oppose a no-deal Brexit could feasibly change UK law to delay the deadline, as they have done once before. Taking the first steps toward this, MPs plan to apply for an emergency debate as early as next week, according to BBC sources.

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Fed’s New Obsession with ELB

August 27 (Tuesday)

The Fed I: Turning Negative? The minutes of the 7/30-31 FOMC meeting mentions the acronym “ELB” 15 times, up from none in the June meeting’s minutes. That stands for “effective lower bound,” which is Fedspeak—presumably for “ZERO” or conceivably for even less. The presumption is that the federal funds rate can’t fall below zero. Yet the minutes hinted that Fed officials might be thinking that if they have to lower the federal funds rate to zero, it’s a slippery slope from there to considering going negative.

All the ELB references were in a special section at the beginning of the July minutes titled “Review of Monetary Policy Strategy, Tools, and Communication Practices.” The Fed initiated this review about a year ago, and we expect ongoing discussion of the ELB and other monetary policy issues in future FOMC meetings.

There were lots of high-fives in the review section, as committee participants congratulated one another for supplementing the ELB with forward guidance and quantitative easing (QE) programs. The conventional response to weak economic activity with low inflation is to lower the federal funds rate. It was dropped to a range of 0.00%-0.25% on 12/16/08 in response to the Great Recession and the Great Financial Crisis. The Fed then resorted to unconventional policies including forward guidance and QE.

The only regret that Fed officials expressed during their discussion of this subject is that they hadn’t implemented more unconventional policy measures after they hit the ELB: “In particular, a number of participants commented that, as many of the potential costs of the Committee’s asset purchases had failed to materialize, the Federal Reserve might have been able to make use of balance sheet tools even more aggressively over the past decade in providing appropriate levels of accommodation.”

Here’s what might happen the next time the federal funds rate falls to the ELB, which Fed officials apparently believe is a distinct possibility: “If policymakers are not able to provide sufficient accommodation at the ELB through the use of forward guidance or balance sheet actions, the constraints posed by the ELB could be an impediment to the attainment of the Federal Reserve’s dual-mandate objectives over time and put at risk the anchoring of inflation expectations at the Committee’s longer-run inflation objective. Participants looked forward to a detailed discussion over coming meetings of alternative strategies for monetary policy.”

The minutes did not mention the possibility of pushing the federal funds rate below the ELB into negative territory, as happened in the Eurozone (on 6/5/2014) and Japan (on 1/29/16) (Fig. 1). Instead, the remainder of the section reviewing monetary policy focused on communicating the Fed’s intention to increase the inflation rate. How or why such an approach would work to boost inflation isn’t clear at all.

Powell was even more obsessed with ELB in a 6/4 speech that mentioned it 26 times, as Melissa and I have observed previously. Powell never defined what he meant by ELB in the speech. He didn’t say it means zero. So he didn’t explicitly rule out the possibility of negative interest rates. He did seem very concerned that the federal funds rate is too close to the ELB and worried about what the Fed can do when the federal funds rate falls to the ELB:

“The next time policy rates hit the ELB—and there will be a next time—it will not be a surprise. We are now well aware of the challenges the ELB presents, and we have the painful experience of the Global Financial Crisis and its aftermath to guide us. Our obligation to the public we serve is to take those measures now that will put us in the best position to deal with our next encounter with the ELB.”

Leaving no doubt about his concern, Powell said: “In short, the proximity of interest rates to the ELB has become the preeminent monetary policy challenge of our time, tainting all manner of issues with ELB risk and imbuing many old challenges with greater significance.”

The Fed II: The World’s Central Bank of Last Resort? The latest minutes provided more detail than usual explaining the decision to lower the federal funds rate range from 2.25%-2.50% to 2.00%-2.25% (Fig. 2). There were three main reasons:

(1) Trade-related pressures. In the US, capital-spending growth has been weakening and manufacturing activity has slowed significantly. Overseas, “uncertainties surrounding international trade” have been weighing on global economic growth. The word “trade” was mentioned 32 times in the minutes (compared to 19 times in the previous minutes). The phrase “trade tensions” was mentioned eight times (versus seven times in the previous minutes).

(2) Uncertain world. Lowering the federal funds rate was justified “from a risk-management perspective.” The minutes mentioned the word “uncertainties” 14 times (versus 16 times in the previous minutes). The source of these uncertainties is deemed to be mostly in the global economy.

Ominously, a number of participants warned that “policy authorities in many foreign countries had only limited policy space to support aggregate demand should the downside risks to global economic growth be realized.” Wow! Does that mean that the Fed is the central bank of last resort for the entire world?

(3) Anemic inflation. “A number of participants” are worried that actual and expected inflation rates are too low. Over the past 12 months through June, the headline and core PCED inflation rates were 1.4% and 1.6% (Fig. 3). They noted that wage inflation remains subdued despite the low unemployment rate, suggesting that “the longer run normal level of the unemployment rate is appreciably lower than often assumed.” Most participants agreed that long-term inflation expectations are below the Fed’s 2.0% target and would stay there unless actual inflation moved higher.

By the way, since the Fed first officially targeted inflation at 2.0% during January 2012, the PCED headline inflation rate has been tracking a 1.3% trendline rather than a 2.0% one (Fig. 4). In the monetary policy review section of the latest minutes mentioned above, there was a discussion of alternative strategies for boosting inflation, including convincing the markets that the Fed would “make up” the shortfall of below-target inflation readings by allowing inflation to run above 2.0% for a while.

A couple of other reasons got only glancing mention: Concern about the inversion of the yield curve was mentioned just once. Also mentioned was that “the longer-horizon real forward rate implied by TIPS had also declined, suggesting that the longer-run normal level of the real federal funds rate implicit in market prices was lower.”

The Fed III: Financial Stability Is an Issue. There was some discussion about financial stability at the latest FOMC meeting, more so than at June’s meeting. The points were a rehash of the ones reviewed in the Fed’s May 2019 Financial Stability Report (FSR) as follow:

(1) Corporate debt and leveraged lending reflect “high levels of corporate indebtedness” (Fig. 5, Fig. 6, Fig. 7, and Fig. 8). May’s FSR observed: “[T]he distribution of ratings among nonfinancial investment-grade corporate bonds has deteriorated. The share of bonds rated at the lowest investment-grade level (for example, an S&P rating of triple-B) has reached near-record levels. As of the first quarter of 2019, a little more than 50 percent of investment-grade bonds outstanding were rated triple-B, amounting to about $1.9 trillion.”

And here was the alarming news about leveraged loans: “The risks associated with leveraged loans have also intensified, as a greater proportion are to borrowers with lower credit ratings and already high levels of debt. In addition, loan agreements contain fewer financial maintenance covenants, which effectively reduce the incentive to monitor obligors and the ability to influence their behavior. The Moody’s Loan Covenant Quality Indicator suggests that the overall strictness of loan covenants is near its weakest level since the index began in 2012, and the fraction of so-called cov-lite leveraged loans (leveraged loans with no financial maintenance covenants) has risen substantially since the crisis.”

The good news is that the junk bond default rate remained very low during the first half of 2019. The renewed decline in bond yields at that time certainly helped to ease financial conditions in the corporate debt markets.

(2) Private credit markets aren’t regulated and should be monitored, according to the minutes. There wasn’t much said about this issue in May’s FSR, suggesting that private credit markets need much more monitoring!

(3) Valuations in both the stock and bond markets are near all-time highs. The same can be said about commercial real estate valuations. May’s FSR expressed some concern about elevated asset valuations reflecting higher risk tolerance by investors. Credit-quality yield spreads became very narrow as investors reached for yield in the corporate bond market, buying bonds with lower credit ratings to get more yield. The forward P/E of the S&P 500 was above its historical mean, though still well below the bubble of the late 1990s.

May’s FSR noted that in a recession there would be widespread downgrades of near-junk bonds to junk bonds. Institutional investors who are restricted from holding noninvestment-grade bonds would be forced to sell into an illiquid market at distressed prices. The situation would be exacerbated if corporate bond mutual funds were forced to sell their holdings as a result of panic redemptions by individual investors. The resulting credit crunch for corporate borrowers would then exacerbate the recession.

Our good friend Mike O’Rourke, the chief market strategist of Jones Trading, opined that the Fed’s section reviewing its monetary framework was a bit “alarming.” As noted above, Fed officials bragged that their unconventional policies didn’t have “adverse implications for financial stability” and suggested that maybe next time they should be even more aggressive with their ultra-easy policies. Mike observed: “It appears as though the way the FOMC defines ‘success’ is by not imploding the financial system with its policies.”

Needless to say, Fed officials have yet to review why their attempts to normalize monetary policy failed so badly. They were on that course through the end of last year, but reversed course back to easing this year. They are mostly blaming uncertainties about trade. So now instead of talking about whether the federal funds rate should be at 3.00% or a bit higher, as they did last year, Fed officials are stressing out about the dreaded ELB. That’s quite a reversal.

The Fed IV: History Lesson. Former Fed Chair Ben Bernanke first suggested the need for more quantitative easing (i.e., QE2) in his Jackson Hole speech on 8/27/10. He viewed that as an alternative to dropping the ELB below zero. William Dudley, the president of the Federal Reserve Bank of New York, gave a speech on 10/1/10 favoring another round of QE, offering specific numbers: “[S]ome simple calculations based on recent experience suggest that $500 billion of purchases would provide about as much stimulus as a reduction in the federal funds rate of between half a point and three quarters of a point.” His basic argument was that despite the downside of additional QE, it was the only tool the Fed had left to meet its congressional mandate to lower the unemployment rate.

At the time, I argued that if the Fed’s econometric model was calling for a negative official policy rate, then either there was something wrong with the model or the Fed was trying to fix economic problems that could not be fixed with monetary policy. In my opinion, when the federal funds rate was lowered to zero, Fed officials should have said that that was all they could do. While I expected and endorsed QE1, I am not convinced that QE2 and then QE3 were necessary.

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Trump’s Game of Chicken

August 26 (Monday)

Trump vs Trump: Is He Jimmy or Buzz? President Donald Trump seems to be playing simultaneous games of chicken with Fed Chair Jerome Powell and Chinese President Xi Jinping. On Friday, he raised tariffs again on US imports from China and ordered US companies to leave China. He also said that Powell is a greater enemy than Xi. Trump’s game plan is to create more uncertainty about trade, thus increasing the risks for US economic growth so that the Fed will have to respond with more interest-rate cuts. At the same time, he hopes that Xi will also relent by agreeing to a trade deal that is good for the US economy.

Games of chicken are often reckless and dangerous, with dire consequences. The S&P 500 tumbled 2.6% on Friday and is down 5.9% from its record high on 7/26. Like everyone else, Joe and I are reassessing our outlook for the US economy and the financial markets in light of Friday’s potentially significant developments. Trump’s game of chicken seems to be turning more reckless and dangerous. If so, it may be time to turn more defensive. That doesn’t necessarily mean turning bearish but rather staying even more over-weighted in our Stay Home investment strategy than in the past. After all, increasing trade uncertainties do in fact increase the likelihood that the Fed will continue to lower interest rates.

In the classic movie “Rebel Without a Cause,” (1955) Jimmy (played by James Dean) agrees to a “chickie-run” to settle a dispute with Buzz, the leader of a local gang. Both race stolen cars toward the edge of a cliff. The first to jump out of his car is branded a “chicken.” Jimmy flings himself out an instant before the cars reach the edge of the cliff. Seconds into the race, Buzz discovers that his jacket is stuck on the door handle. So he goes over the cliff and dies.

The question for all of us is whether Trump is Jimmy or Buzz. Is Trump trumping Powell and Xi or is Trump trumping Trump?

Our 7/11 Morning Briefing was titled “Powell Gets Trumped!” I wrote: “President Donald Trump wants the Fed to lower interest rates. Fed Chair Jerome Powell claims that the Fed is independent and won’t bow to political pressure. Yet Trump has figured out the perfect way to force the Fed to lower interest rates. All he has to do is keep creating uncertainty about US trade policy. In his congressional testimony yesterday on monetary policy, Powell mentioned the trade issue eight times in his prepared remarks.”

Sure enough, the Fed lowered the federal funds rate by 25bps on 7/31. However, that afternoon, Trump said that it wasn’t enough and that he wants more easing right away. Trump was quick to attack the Fed’s decision. He tweeted: “What the Market wanted to hear from Jay Powell and the Federal Reserve was that this was the beginning of a lengthy and aggressive rate-cutting cycle which would keep pace with China, The European Union and other countries around the world. … As usual, Powell let us down, but at least he is ending quantitative tightening, which shouldn’t have started in the first place—no inflation. We are winning anyway, but I am certainly not getting much help from the Federal Reserve!”

The very next day, Trump trumped Powell again by creating more uncertainty about trade when he said that the US will impose a 10% tariff on an additional $300 billion worth of Chinese imports next month. The new tariff comes on top of the 25% levy that Trump already has imposed on $250 billion worth of Chinese imports—so the US will be taxing nearly everything China sends to the US. Trump added that the tariffs could be raised to 25% or higher if the talks drag on further without any significant progress, but he allowed that alternatively they could be removed if a deal is struck.

Then on 8/14, stocks rebounded after the Trump administration de-escalated its trade war with China. The 10% tariff would be delayed until 12/15 on imports from China of cellphones, laptop computers, toys, and other items. No reason was given. Trump trumped Trump.

In our 8/7 Morning Briefing, I wrote: “What does Trump want? He wants to win another term on 11/3/20. What does Xi want? He wants Trump to lose. They both know that. Xi is president for life, so he figures he can easily outlast Trump, though having to deal with Trump through 2024 would be more challenging than through 2020. Trump must know that even if he gets a deal with China before the election, that won’t mean much if he loses. He seems to be talking up the scenario of a post-election deal, perhaps believing that timing will yield a better deal from the Chinese, assuming he wins a second term.”

I also concluded in that commentary: “Trump must figure that he needs the Fed to lower interest rates while he waits for the Chinese to come around on trade, hoping to strike a deal after the elections.” Trump’s game is to trump Powell before he trumps Xi.

Trump vs Powell: A Less ‘Favorable Place.’ Last year and until recently, Fed Chair Jerome Powell often said that the US economy is in “a good place.” On Friday, in his speech at Jackson Hole on “Challenges for Monetary Policy,” he said that “our economy is now in a favorable place.” Melissa and I aren’t sure if “favorable” is better, the same, or worse than “good.”

The biggest challenge facing the Fed according to Powell is “fitting trade policy uncertainty” into decision-making for monetary policy. He observed: “Trade policy uncertainty seems to be playing a role in the global slowdown and in weak manufacturing and capital spending in the United States.”

He suggested that recent events may be making his head spin: “The three weeks since our July FOMC meeting have been eventful, beginning with the announcement of new tariffs on imports from China. We have seen further evidence of a global slowdown, notably in Germany and China. Geopolitical events have been much in the news, including the growing possibility of a hard Brexit, rising tensions in Hong Kong, and the dissolution of the Italian government. Financial markets have reacted strongly to this complex, turbulent picture. Equity markets have been volatile.”

Nevertheless, he pledged to keep calm and carry on: “I will conclude by saying that we are deeply committed to fulfilling our mandate in this challenging era.” Melissa and I wish him luck.

Meanwhile, President Donald Trump went off the rails on Friday when he implied in a tweet that Powell is a bigger enemy than Chairman Xi. In addition, there was a report that the White House is discussing a rotation of Fed governors that would make it easier to check Powell’s power.

Trump vs Xi: Exit Order. Trump’s pronouncements came immediately after Powell delivered his speech at Jackson Hole and after the Chinese imposed tariffs on US goods in retaliation over previously imposed US tariffs. Trump clearly provided Powell and the rest of us with much more uncertainty about trade. He also stepped harder on the accelerator in his game of chicken with Xi, as follows:

(1) More tariffs. Trump boosted by 5 percentage points the 25% tariffs already in place on nearly $250 billion of Chinese imports, including raw materials, machinery, and finished goods, with the new higher 30% rate to take effect on 10/1.

He said planned 10% tariffs on about $300 billion worth of additional Chinese-made consumer goods would be raised to 15%, with those measures set to take effect on 9/1 and 12/15.

(2) Exit order. Hours after China announced retaliatory tariffs on US goods on Friday, Trump ordered US companies to “start looking for an alternative to China, including bringing your companies HOME and making your products in the USA.”

According to a 8/24 CNBC report, Trump has some policy options to force American companies to quit China:

“Trump could treat China more like Iran and order sanctions, which would involve declaring a national emergency under a 1977 law called the International Emergency Economic Powers Act, or IEEPA. Once an emergency is declared, the law gives Trump broad authority to block the activities of individual companies or even entire economic sectors, former federal officials and legal experts said. …

“Another option that would not require congressional action would be to ban U.S. companies from competing for federal contracts if they also have operations in China …

“A far more dramatic measure, albeit highly unlikely, would be to invoke the Trading with the Enemy Act, which was passed by Congress during World War One. The law allows the U.S. president to regulate and punish trade with a country with whom the United States is at war. Trump is unlikely to invoke this law because it would sharply escalate tensions with China ...”

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Consumers Still Consuming

August 22 (Thursday)

Consumer Discretionary: Shoppers Still Shopping. It’s hard to read that Macy’s Q2 profits fell 48.2% y/y and not worry about consumer spending. Macy’s has 870 department and specialty stores in 43 states and had $25.0 billion of sales last year. But the slow, painful decline of department stores does seem to be isolated from the rest of retailing. It doesn’t appear to reflect the health of the consumer but rather the consumer’s changing tastes.

Consumer spending, looked at from many different angles, still looks healthy. Consumers are spending at Walmart and at Target. They’re spending at restaurants and hotels. And they may have room to spend more, as the saving rate was relatively high at 8.1% during June and personal savings rose to a record $1.3 trillion over the past 12 months through June (Fig. 1 and Fig. 2). Over that same period, real disposable income is up solidly, with a gain of 3.3% (Fig. 3). Here’s a look at some more consumer-spending metrics and this week’s earnings reports from retailers confirming that consumer wallets are open—just not at department stores:

(1) Broad indicators are positive. Nominal US retail sales rose 0.7% m/m in July. Adjusted for inflation, they rose 5.4% on a three-month, seasonally adjusted moving average (Fig. 4). Growth rates differ dramatically by category. Shoppers are spending more online (14.7% y/y), at health & personal care stores (4.3), at warehouse clubs & super stores (3.8), on food either at stores or in restaurants (3.6), and at general merchandise stores (2.1). Consumers are shopping less at department stores (-4.7) and electronics & appliances stores (-3.5).

Online sales rose to a record $694 billion (saar) during June, well exceeding department stores sales ($138 billion) and sales at warehouse clubs and superstores ($496 billion) (Fig. 5). Online shopping now accounts for a record 35% of GAFO (general merchandise, apparel and accessories, furniture, and other sales), which includes retailers that specialize in department-store types of merchandise such as furniture & home furnishings, electronics & appliances, clothing & accessories, sporting goods, hobby, book, and music, general merchandise, office supply, stationery, and gift stores (Fig. 6).

Bank of America often has a good, early read on consumer spending because it boasts 66 million consumer and small business clients. The bank’s CEO Brian Moynihan told CNBC yesterday that its consumer base spent $2 trillion ytd, a 5.9% increase y/y. “The U.S. consumer continues to spend and that will keep the U.S. economy in good shape,” he said.

(2) Plenty of dry powder. Consumers are benefiting from more jobs and higher wages. The unemployment rate was 3.7% in July, a tick above the 3.6% rate during April and May—which was the lowest rate since December 1969 (Fig. 7). Real average hourly earnings of production and nonsupervisory workers continued to climb in June, up 1.9% y/y, marking its 80th month of gains (Fig. 8).

While consumers are spending some of their newfound dough, they’re saving lots too. The US personal saving rate is in an uptrend, as the absolute amount saved has climbed to new highs, as noted above. Typically, saving rates fall during economic booms as consumers get more optimistic and spend excessively. Saving rates often rise during recessions, when consumers turn more cautious. The saving-rate jump may mean consumers will be able to keep spending more, longer.

(3) Target hits the bullseye. Target showed that if you build it right, shoppers will come. The company is remodeling stores, introducing new brands, and expanding online purchase delivery options. Last quarter saw a 1.5% y/y increase in comparable-store sales, a 34% y/y jump in comparable digital sales, a 2.4% y/y increase in traffic, and a 0.9% y/y increase in average ticket prices.

The company’s operating margins expanded, and its Q2 EPS rose 20% y/y. The strong performance allowed Target to increase its full-year EPS estimate by 15 cents to $5.90-$6.20—with the midpoint implying a 12% y/y jump. The shares soared 20.4% on Wednesday.

Target and two dollar-store companies are members of the S&P 500 General Merchandise Stores stock price index, which is up 22.0% ytd through Tuesday’s close (Fig. 9). The industry is expected to grow revenue 4.5% in 2019 and 4.2% in 2020 (Fig. 10). Bottom lines are expected to grow sharply as well: 6.0% in 2019 and 9.8% in 2020 (Fig. 11). Despite that strong growth, the industry’s forward P/E is 15.7, in the middle of its P/E range over the past 15 years (Fig. 12).

(4) Lowe’s beats Q2 estimates. The home improvement industry is doing fine, Q2 reports show, but fine is much better than expected, so shares of Home Depot and Lowe’s rallied on the news. Lowe’s total revenue was basically flat y/y, at $21.0 billion, but US same-store-sales were up 3.2% y/y. At Home Depot, comparable-store sales rose 3.1%. Lowe’s adjusted EPS of $2.15 increased 3.9% y/y, beating analysts’ average estimate by 14 cents and sending the shares up 10.4% on Wednesday.

"We capitalized on spring demand, strong holiday event execution and growth in Paint and our Pro business to deliver strong second quarter results. Despite lumber deflation and difficult weather, we are pleased that we delivered positive comparable sales in all 15 geographic regions of the U.S. This is a reflection of a solid macroeconomic backdrop and continued momentum executing our retail fundamentals framework," said Lowe’s CEO Marvin R. Ellison in the company earnings press release.

Home Depot and Lowe’s are members of the S&P 500 Home Improvement Retail stock price index, which is up 20.7% ytd (Fig. 13). Analysts are forecasting the industry will grow revenue by 2.4% this year and 4.1% in 2020 (Fig. 14). Analysts have been trimming their earnings estimates for this industry. As a result, earnings growth is expected to slow this year to 4.3% and accelerate in 2020 to 11.3% (Fig. 15). At 17.8, the industry’s forward P/E is toward the top end of its range over the past 10 years (Fig. 16).

Disruptive Technology: Transforming Transactions. When it comes to the financial transactions of global trade, there’s no doubt that the dollar and the use of the SWIFT (Society for Worldwide Interbank Financial Telecommunication) system dominate. Roughly 39% of international transactions occur in dollars, and 63% of foreign currency reserves are in dollars.

But at the margins, the advent of cryptocurrencies is changing the status quo. The massive market’s evolution will determine whether the dollar will continue to dominate global transactions and allow the US to impose its will through sanctions on other countries. New cryptocurrencies could also reduce the time and fees involved with transactions between companies and institutions.

Earlier this summer, Facebook made waves with the introduction of Libra, a cryptocurrency backed by a basket of established currencies, which we discussed in the 6/20 Morning Briefing. Others are interested in getting into the crypto transaction business as well, including China, which is working on a digital yuan, and JPMorgan, which is testing JPM Coin backed by the dollar.

Here’s Jackie’s news roundup on recently introduced forms of digital currency:

(1) Yuan going digital. China is developing the systems needed to offer a digital yuan, according to an 8/12 Bloomberg article, citing a speech given by Mu Changchun, deputy director of the payments unit at the People’s Bank of China (PBOC). He noted that the digital yuan is “close to being out.”

The advent of a digital yuan is ironic given that China had banned the trading of digital currencies and initial coin offerings early in the development of cryptocurrencies because of the wild price swings that occurred. It’s also the latest indication that the nation is paying close attention to Facebook’s Libra project.

Libra shows there could be a new, global “strong international currency,” which could challenge cross-border payments and weaken the role of sovereign currencies that don’t have a stable value, said Zhou Xiaochuan, former governor of the PBOC, according to a 7/11 South China Morning Post article. China should learn from Facebook’s white paper, he said.

China is concerned that Libra could reinforce the dollar’s dominance. “If the digital currency is closely associated with the US dollar, it could create a scenario under which sovereign currencies would coexist with US dollar-centric digital currencies,” said Wang Xin, the PBOC’s research chief according to the South China Morning Post article.

China has hoped to expand the use of the yuan in global transactions, in part through the country’s Belt and Road Initiative. It aims to reduce the transaction costs of international trade, reduce exchange-rate risks, and increase the number of financial transactions in yuan. The Chinese currency is used in only about 2% of global transactions. The broad adoption of a digital yuan may be limited by fears of China’s state surveillance of transactions.

(2) The JPM Coin arrives. JPMorgan is expected to start trials of the JPM Coin with several of its corporate customers as early as this year, according to a 6/25 Bloomberg article. The coin is initially exchangeable one-for-one with the US dollar, but in the future the company believes it could be used with other major currencies as well.

JPM Coin will be used only by JPMorgan institutional clients over a blockchain-based system. “When one client sends money to another over the blockchain, JPM Coins are transferred and instantaneously redeemed for the equivalent amount of U.S. dollars, reducing the typical settlement time,” the bank explained in this primer. The currency initially will be used for international payments between large corporate clients, but in the future it might also be used in the issuance of debt securities and in Treasury services, a 2/14 CNBC article explained.

Because the coins are essentially backed by whatever currency they purchase, they’re considered “stablecoins.” And that’s what makes them very different from cryptocurrencies like bitcoin, which JPMorgan’s CEO Jamie Dimon famously has bashed in the past. Bitcoins don’t have the backing of any currency or any country.

The bank believes JPM Coin will reduce clients’ counterparty and settlement risk, decrease capital requirements, and enable instant value transfer. However, it theoretically would increase client’s exposure to JPMorgan, which is probably why the bank highlights in the primer its “strong” $2.6 trillion balance sheet, the trillions it spends on cybersecurity, and the regulatory oversight with which it complies.

(3) Other stablecoins arriving too. UBS Group and 13 other big banks in the US, Europe, and Japan have created a new company, Fnality International, to develop the utility settlement coin, or USC. The USC token will carry information and act as a payment device for trades over a blockchain system. It will be backed by “bank-owned currency held at central banks,” a 6/3 WSJ article reported. The token still needs regulatory approval, but it’s expected to be operational within a year.

Mitsubishi UFJ Financial Group, the world’s fifth-largest bank, plans to issue J-Coin, a blockchain-based stablecoin pegged 1-for-1 to the Japanese yen. The bank will make J-Coin available to retail customers for use in paying restaurants, convenience stores, and shops as well as transferring currency to other participants’ accounts, according to a 4/9 article on Cointelegraph.

The world’s third-largest cryptocurrency exchange, Binance, is developing stablecoins pegged to currencies around the world. The exchange already has three stablecoins pegged to bitcoin, the British pound, and the dollar, USD Coin.

(4) Fed’s Bullard adds his two cents. James Bullard, President of the Federal Reserve Bank of St. Louis, seemed skeptical about the flurry of cryptocurrencies hitting the market in a 7/19 speech. According to the press release and a power point presentation, Bullard suggested that the US appears to be “drifting” toward a system of multiple currencies, which he believes can compete and coexist. But he warned that systems with multiple currencies are typically volatile and historically have been disliked (e.g., in 1830s America).

Competing currencies currently exist in the global market, but they can be volatile and attempts at trying to fix exchange rates “as suggested by ‘stablecoins,’” often have failed, he said. “Currencies have to be reliable and hold their value … This is probably why government backing has been important historically, combined with a stable monetary policy that promotes stability of the currency.”

Stable currencies impart certainty about future issuance, so they can be appropriately valued. “With cryptocurrencies, there is a monetary policy encoded in the system, perhaps a fixed volume of ‘coins.’ But the system can also bifurcate, creating two fixed volumes of coins—a process that can happen multiple times.” And fixed exchange rates tend eventually to collapse.

Bullard concluded: “Cryptocurrencies may unwittingly be pushing in the wrong direction in trying to solve an important social problem, which is how best to facilitate market-based exchange.”

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Bonds in Neverland

August 21 (Wednesday)

Credit I: Monetary Policies for the New Abnormal. The major central banks adopted unconventional monetary policies following the Great Recession and the Great Financial Crisis. They were supposed to be temporary responses to the “New Normal,” i.e., slower global growth with subdued inflation. These ultra-easy policies have become conventional and permanent. They increasingly seem like abnormal reactions by the central banks to problems that can’t be fixed with monetary policy. Instead of boosting economic growth and lifting inflation rates closer to zero, they are inflating asset prices. Here is a brief update of the latest developments:

(1) Fed. The Federal Reserve started down the path to normalizing US monetary policy on 10/1/14, when it terminated QE3 (Fig. 1). The Fed started raising the federal funds rate at the end of 2015, moving it that first time from 0.00%-0.25% to 0.25%-0.50% (Fig. 2). The rate was subsequently raised to 2.25%-2.50% at the end of 2018.

But the Fed was back in easing mode by last month, when it lowered the fed funds rate to 2.00%-2.25% on 7/31 (Fig. 3). More rate cuts are widely expected. In the federal funds futures market, the 12-month forward yield fell to 1.19% on Monday (Fig. 4). QT (i.e., quantitative tightening), which began on 10/1/17, was terminated on 7/31/19.

(2) ECB. Meanwhile, the European Central Bank (ECB) never got started on the path to monetary normalization. Instead, the ECB adopted its negative interest-rate policy (NIRP) on 6/11/14, when its official deposit rate was lowered to -0.10%; three months later, the rate was dropped again, to -0.20% on 9/10/14 (Fig. 5). There were two more cuts in this rate at the end of 2015 and during early 2016, to -0.40%.

Last year, ECB officials suggested that the process of normalizing this rate would start sometime in 2019; but in recent months, they’ve reversed course and prepared the financial markets for another cut at the 9/12 meeting of the ECB’s Governing Council. They’ve also suggested that they will resume their QE program, which had been terminated at the end of 2018 (Fig. 6).

(3) BOJ. The Bank of Japan (BOJ) never even considered leaving Neverland. In his opening remarks at a conference in Tokyo on 6/4/15, BOJ Governor Haruhiko Kuroda said: “I trust that many of you are familiar with the story of Peter Pan, in which it says, ‘The moment you doubt whether you can fly, you cease forever to be able to do it.’” The Wall Street Journal (6/4/15) observed: “Japan’s central bank chief invoked the boy who can fly to emphasize the need for global central bankers to believe in their ability to solve a range of vexing issues, whether stubbornly sluggish growth or entrenched expectations of price declines.” Kuroda added, “Yes, what we need is a positive attitude and conviction.”

On 1/29/16, the BOJ surprised everyone by adopting NIRP, lowering its official rate on new bank reserve deposits to -0.10%. It remains at that level. The BOJ’s QE program, which started during April 2013, continues with no end in sight. As a result, bank reserve balances at the BOJ have increased 738% from 42 trillion yen to 352 trillion yen during July (Fig. 7).

(4) PBOC. The People’s Bank of China (PBOC) seems like an outlier. It still has normal interest rates. The prime lending rate in China was set slightly lower yesterday to 4.25%. However, China’s central bank has fueled the greatest credit binge in world history over the past 10 years. Since late 2008, bank loans have soared 386%, from $4.4 trillion during December 2008 to $21.4 trillion during July of this year (Fig. 8). They are up a staggering $2.4 trillion in just the past 12 months.

CNN reported on Monday: “On Saturday, the People’s Bank of China launched a long-awaited reform to the way it manages money in the world’s second biggest economy to support growth and employment. Its aim is to make it cheaper and easier for companies to borrow. The central bank is gradually replacing its existing fixed benchmark lending rate, with a new Loan Prime Rate, starting Tuesday. ... The PBOC’s benchmark one-year lending rate stands at 4.35%, and it hasn’t changed since October 2015. The new LPR will be set Tuesday, and subsequently on the 20th of each month. It will become the benchmark for banks to price new loans.” This amounts to a rate cut.

(5) The Magnificent Four. Here are the growth rates of the assets of the four major central banks since the start of 2008 through July of this year in their local currencies: Fed (338%), ECB (234), BOJ (411), and PBOC (112) (Fig. 9). Here are the values of their assets in dollars at the end of July: Fed ($3.7 trillion), ECB ($5.3 trillion), BOJ ($5.2 trillion), and PBOC ($5.2 trillion) (Fig. 10). The sum of their assets rose 208% from $6.3 trillion at the start of 2008 to $19.4 trillion during July (Fig. 11). Here are the latest quarterly data on the assets of each of the four central banks as a percentage of their respective country’s nominal GDP: BOJ (101%), ECB (40), PBOC (37), and Fed (18) (Fig. 12).

Credit II: Unreal Bond Yields. The NIRPs of the ECB and BOJ have created a Neverland in the global fixed-income markets. An 8/18 Bloomberg story reported: “The world’s headlong dash to zero or negative interest rates just passed another milestone: Homebuyers in Denmark effectively are being paid to take out 10-year mortgages. Jyske Bank A/S, Denmark’s third-largest lender, announced in early August a mortgage rate of -0.5%, before fees. Nordea Bank Abp, meanwhile, is offering 30-year mortgages at annual interest of 0.5%, and 20-year loans at zero.”

A 7/29 story in The Washington Times reported: “The latest estimates are that approximately 30 percent of the global government bond issues are now trading in negative territory. Last week, Swiss 50-year borrowing costs fell below zero percent, which means that Switzerland’s entire government bond market now trades with negative yields. Earlier in the month, Denmark became the country to have its entire yield curve turn negative.”

During 2018, when the 10-year US Treasury bond yield was rising toward last year’s high of 3.24% on 11/8, there was much chatter about its going to 4%-5%. For example, on 8/4 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.”

At the time, the bears worried about mounting federal deficits, resulting from the tax cuts at the beginning of the year, at the same time that the Fed was on track for more QT. In addition, there was mounting evidence that inflationary pressures were building, with some related to Trump’s tariffs.

In the 8/8/18 Morning Briefing, I wrote: “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.”

The tether has gotten tighter since last year’s peak in the US bond yield on 11/8. Since then, the US bond yield has dropped 164bps to 1.60% on Monday, while the comparable German and Japanese yields are down 111bps to -0.65% and 36bps to -0.23%, respectively (Fig. 13).

Now consider the following related developments in the US bond market:

(1) Tipping into negative territory. The 10-year TIPS yield dropped to zero on Monday, suggesting that the nominal yield reflects only inflation expectations with no real yield (Fig. 14 and Fig. 15). The TIPS yield could be about to turn negative, as it did in 2012.

(2) Real rates and productivity. Why should the real bond yield be negative or even zero? The most widely accepted notion is that the real bond yield should be related to the growth rate in productivity, which is the economy’s real return, arguably. The correlation between the two—using averages over five-year time periods—is not compelling, though (Fig. 16).

In any event, as we showed in yesterday’s Morning Briefing, productivity growth has been turning up over the past few years. Productivity has been growing faster in the US than in the other G7 economies (Fig. 17).

(3) Demography is destiny. The geriatric trend in global demographic profiles does support a case for negative nominal and real interest rates if the trend leads to a combination of slow growth and deflation. That’s if deflation reduces the value of assets purchased today with debt. Negative interest rates on that debt might reflect the voluntary self-extinction of the human race attributable to the collapse of fertility rates around the world. Dwindling populations, particularly of younger people, will put downward pressure on real asset prices, because there will be less demand for the goods and services they provide in the future.

Credit III: Jackson Hole. Central bankers, policymakers, and academics will head to Jackson Hole, Wyoming from 8/22 to 8/24 for the annual economic policy symposium hosted by the Federal Reserve Bank of Kansas City (FRB-KC). According to the FRB-KC’s website, the central topic this year is appropriately “Challenges for Monetary Policy.” Investors will be scrutinizing the speeches and discussions for clues on the direction of monetary policy. So will Melissa and I.

While former Fed Chair Janet Yellen geared her Jackson Hole speeches toward an audience with advanced degrees in economics, that’s not current Chair Jerome Powell’s style. We expect from Powell a speech that’s easier to decode but light on specifics. We’ll be listening for terms—such as “cross currents” and “uncertainties,” especially related to trade—that underpinned the Fed’s decision to reverse course and cut interest rates 25 bps at its 7/30-31 meeting. With the Federal Open Market Committee (FOMC) not meeting next until 9/17-18, Powell’s Jackson Hole speech will be important for feeling out the Fed’s policy leanings—especially since President Trump’s announcement of new tariffs to be imposed on China came on 8/1, a day after the last FOMC meeting.

The question is: How much more of a “midcycle adjustment,” as Powell put it during his last press conference, is expected? Markets did not react kindly to that phrase, as it suggested a possible one-and-done rate adjustment. Our hunch is that the Fed chair will leave the door open for maybe one more 25bps rate cut at the next FOMC meeting. We don’t expect a big rate cut signaled, like the 100bps cut Trump wants. Nor do we expect any hints about a renewed QE, as Trump also has called for.

When we last did a roundup of FOMC voters ahead of the July meeting in our 7/29 Morning Briefing, we noted that “the doves clearly outweigh the hawks at the Fed.” The two officials we expected to dissent—FRB-KC’s President Esther George and FRB-Boston President Eric Rosengren—indeed did so.

Lately, Rosengren has become more vocal on his position. Following his July dissent, he issued a statement saying that he did not see a “compelling case” to cut rates and cited concerns that further cuts could compromise financial stability. On Monday, he told Bloomberg Television: “We’re likely to have a second half of the year that’s much closer to 2% growth … I just want to see evidence we are going into something that is more [of] a slowdown.’’

Nevertheless, Rosengren noted that he is mindful of global risks including the situation in Hong Kong. As we’ve discussed previously, the outcome in Hong Kong has implications for the US-China trade deal. We will be interested to see if Powell adds Hong Kong to his list of global “cross currents.”

Interestingly, Rosengren also said: “Just because other countries are weak, if we’re strong, it doesn’t necessarily mean we should be easing as well … It’s much more efficient for China and Europe to expand their own economies” through their own policy actions. He added that he isn’t focused on the recent inversion in the yield curve as the Fed’s goal is to get inflation and employment right.

Whether Rosengren’s arguments sway other Fed officials remains to be seen. But regardless, we expect Powell’s monetary policy stance to remain on the easing side for now.

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Searching for Growth

August 20 (Tuesday)

Strategy I: S&P 500 Delivers Record Revenues. Both last year and this year, Joe and I have been impressed by S&P 500 forward revenues. The weekly series, which is a time-weighted average of analysts’ consensus expectations for S&P 500 actual revenues this year and next year, has been rising to record highs (Fig. 1). It dipped at the end of last year but has bounced back smartly this year. We’ve been impressed because it has contradicted the grim headline news about the sorry state of the global economy, which is still growing but at a very slow pace.

Just as impressive is that the weekly series continues to be a very good coincident indicator of the actual quarterly data for revenues, as evidenced by the S&P 500’s Q2 results released by Standard & Poor’s at the end of last week. Revenues rose 5.0% y/y to a new record high (Fig. 2). There’s no recession in the quarterly revenues data. There was a brief recession from Q1-2015 through Q1-2016 when plunging commodity prices caused a global growth recession. But it has been solid growth since then.

This suggests to us that as long as US real GDP continues to grow around 2.0% and global growth remains subpar, but positive, the folks who manage America’s biggest companies will continue to manage to achieve positive low-single-digits revenues growth. If they can maintain their historically high profit margins, which we expect they will, then earnings growth should be close to revenues growth. Of course, if a recession unfolds, revenues growth will be negative no matter how good S&P 500 managers might be at running their businesses in a slow-growing world.

The spread between the growth rates of revenues on an aggregate and a per-share basis has been relatively small considering all the hype about the big positive impact of stock buybacks on per-share results. During Q2, the former was up 2.9% while the latter was up 5.0% (Fig. 3). That’s a relatively small spread despite record S&P 500 buybacks of $823 billion over the four quarters ended Q1 (Fig. 4). (See our Topical Study #84 titled “Stock Buybacks: The True Story.”)

With the exception of forward revenues, many of the economic indicators that we use to forecast S&P 500 aggregate revenues growth have been weak. Let’s review the relevant data:

(1) Business sales. The growth rate in the Census Bureau’s measure of manufacturing and trade sales tends to be highly correlated with the growth rate of S&P 500 aggregate revenues. The fit between the two is remarkably good given that the former includes only goods and not services. The former increased just 1.3% y/y through June, while the latter increased 2.9% during Q2 (Fig. 5). Both saw growth in the high single digits during 2017 and the first half of 2018, when the global economy recovered from its 2015-16 growth recession. So comps have been trougher in recent quarters. They should get easier over the rest of this year and into next. We expect both sales measures to grow at around a 5% clip over the next year and a half.

(2) Factory orders. New factory orders have been especially weak, at -1.2% y/y through June (Fig. 6). Growth in these orders has been deteriorating since early this year, dipping into negative territory during May for the first time since November 2016. Since S&P 500 aggregate revenues tends to trail factory orders (both on a y/y basis), the recent weakness in orders may weigh on revenues over the rest of the year.

(3) Merchandise exports. Trump’s escalating trade war with China has depressed the growth in US merchandise exports so far this year. These exports fell -3.6% y/y during June (Fig. 7). US merchandise exports account for only 8% of nominal GDP. The good news is that domestic demand for goods and services remains strong, led by consumer spending.

(4) Purchasing Managers Index and industrial production. The US M-PMI has been weakening all year but has remained north of 50.0, at 51.2 in July (Fig. 8). It is down from a recent peak of 60.8 last August, which was near previous cyclical highs for this series. Corresponding with the weakening in the US-PMI, the growth in US industrial production has run out of steam, with a gain of just 0.5% y/y during July (Fig. 9).

(5) Railcar traffic. Intermodal railcar loadings have been very weak this year so far. To smooth out this volatile series, Debbie and I use its 26-week average, which was down -3.9% through the 8/10 week (Fig. 10). We think that reflects the weakness in exports and imports resulting from US-China trade tensions. This is the weakest indicator of the ones we are highlighting today. The good news is that this series isn’t as highly correlated with S&P 500 aggregate revenues as the other indicators discussed above.

Earnings growth trailed revenues growth during Q2-2019 for a second straight quarter, and for the first time since Q2-2016. Counting Q2-2019, earnings growth has trailed revenue growth just six times in the 42 quarters since the bull market started more than 10 years ago. It also happened during Q1- and Q2-2016 and Q1- and Q2-2009.

Strategy II: Soft Patch for Earnings or Tough Comps? The S&P 500 profit margin upticked to 11.8% during Q2, but it was down from 12.3% a year ago (Fig. 11). As a result, S&P 500 operating earnings rose just 0.7% y/y during the quarter (Fig. 12 and Fig. 13). That followed a small increase of 2.8% during Q1.

This is the weakest performance since 2015 and 2016, when comparisons turned slightly negative during four consecutive quarters. The current earnings growth recession is less severe and is partially attributable to tough comps as a result of the corporate tax cut that boosted earnings last year. So we view it more as a soft patch than as a growth recession.

Now let’s review the analysts’ earnings expectations for the rest of this year and all of next year, and compare them to our forecasts:

(1) Quarterly outlook. Consensus analysts’ earnings estimates for the 8/15 week show a -2.2% y/y decline for Q3 followed by a 4.8% increase during Q4 (Fig. 14). That is well below where analysts had pegged both growth rates last fall, at over 10%. Q3 results should beat expectations, as results for Q1 and Q2 did.

Upside “earnings hooks” are the norm during earnings seasons because analysts experience mood swings from excessive optimism about distant earnings prospects, which tend to turn excessively pessimistic as earnings seasons approach for any particular quarter. Analysts forecasted negative y/y earnings growth for Q1 and Q2 just before each respective quarter, but neither quarter’s results actually fell below zero. We anticipate a similar “hook” for the Q3 based on recent history. Past history also shows that analysts tend to base their estimates on management guidance—which tends to be overly conservative heading into earnings season, making managements’ forecasts easier to beat.

(2) 2019 and 2020 outlook. For the full year of 2019, analysts expect S&P 500 operating annual earnings to grow a meager 2.1% while 2020 growth is expected to pick up to 10.4%. Keep in mind that 2020 growth comparisons will be easier than those of 2019, which followed 2018’s tax-cut-boosted 23.8% growth (Fig. 15). Operating earnings growth expectations for 2020 have dropped some since earlier this year but remain in record-high territory (Fig. 16).

(3) Forward earnings. Forward earnings, the time-weighted average of consensus operating earnings estimates for the current and next year, rose to a new record high of $176.69 per share during the 8/15 week. It is converging toward the 2020 consensus estimate, which is currently $183.61 (Fig. 17 and Fig. 18).

Strategy III: Doing the Math on S&P 500 Targets. Our targets for the S&P 500 remain at 3100 for this year and 3500 for next year. We can reverse-engineer them to determine the path for earnings required to hit bullseyes. Joe and I believe that given that both inflation and interest rates are below 2.0%, a forward P/E of 18.0 is doable and reasonable.

That means that 3100 by year-end would require the market to discount 2020 earnings per share of $172. That’s very reasonable given that we are projecting 2020 earnings at $176, while the consensus of industry analysts is currently at $184! There is plenty of margin for downside earnings revisions in this scenario, with 3100 still working out by the end of this year.

Getting to 3500 by the end of 2020 with an 18.0 forward P/E would require that the consensus earnings-per-share estimate for 2021 be $194. Joe and I are currently projecting that it will be $185, or 5% above our $176 estimate for next year, which is 5% above our 2019 estimate.

So while 3100 looks reasonable for this year, 3500 seems to be a stretch. However, keep in mind that the market discounts analysts’ consensus expectations for the coming 12 months, and they tend to be too optimistic. That consensus could very easily be $194 for 2021 by the end of next year. If analysts are forced to lower their estimates during 2021, as is likely, the market could still move higher as 2022 approaches.

Of course, this all assumes, as we do, that there will be no recession through at least the end of next year.

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Productivity Could Frustrate Endgamers

August 19 (Monday)

US Economy I: The Short Story. The stock market tanked on Wednesday, 8/14 because the yield spread between the 10-year US Treasury bond and the 2-year Treasury note turned negative (Fig. 1). Such an inversion of the yield curve is widely viewed as a reliable leading indicator of economic recessions. Indeed, the spread between the 10-year Treasury bond yield and the federal funds rate is one of the 10 components of the Index of Leading Economic Indicators (Fig. 2).

The S&P 500 is also one of the components of the LEI. It remains just 4.5% below its July 26 record high but would fall sharply if stock investors become convinced that a recession is imminent (Fig. 3). We are adding last week’s selloff to our list of panic attacks, making it #65 (Table and Fig. 4).

Not only did the stock market react badly to the latest yield-curve inversion but so did President Donald Trump, who tweeted: “CRAZY INVERTED YIELD CURVE! We should easily be reaping big Rewards & Gains, but the Fed is holding us back.”

While this was all happening, I was visiting with our accounts in Kansas City at the end of last week. Of course, we discussed the recent inversion of the yield curve and the possibility that it is once again predicting an impending recession. There was certainly no sign of an imminent recession in Thursday’s July retail sales press release. It jumped 0.7% m/m. Debbie reports that real retail sales rose 5.4% (saar) during the three months through July, based on the three-month average, matching its fastest pace since the end of 2017 (Fig. 5). As a result, the Atlanta Fed’s GDPNow estimate for Q2 real GDP was raised from 1.8% to 2.2%.

In my meetings, I noted that an inverted yield curve has predicted 10 of the last 7 recessions. In other words, it isn’t as accurate a predictor of economic downturns as widely believed. It can be misleading, having given three false signals of a recession. I also observed that inverted yield curves don’t cause recessions. They’ve tended to predict financial crises, which morphed into economy-wide credit crunches and recessions (Fig. 6). There is certainly no sign of a credit crunch in the yield spread between high-yield corporate bonds and the 10-year Treasury bond (Fig. 7).

The S&P 500 Diversified Banks stock price index dropped 3.2% last week on fears that an inverted yield curve would narrow the net interest margin of financial intermediaries (Fig. 8). This margin has remained between 2.8% and 4.3% since 1984 (Fig. 9). So in the past, it never inverted along with the yield curve! Financial crises that morphed into widespread credit crunches caused banks to cut their lending, not negative net interest margins.

US Economy II: The Long Story. The most widely hated bull market in history has been associated with the most widely anticipated recession of all times. In our opinion, the odds of a recession are reduced when so many people in business and finance are worrying about an impending recession. That fear of falling reduces excessive speculative behavior, which has typically set the stage for a recession. Join in with us to repeat our mantra: “No boom, no bust.” A corollary is our mantra: “No credit crunch, no recession.”

Nevertheless, as we saw once again last week, it doesn’t take much to cause panic attacks about recessions. The endgame doomsters have been predicting that “this will all end badly” ever since it ended badly in 2008. So they get very excited each time that something happens that might finally cause the next endgame.

Undoubtedly, one day in the future, there will be a recession, and it could be worse than the Great Recession. However, Debbie and I are thinking that the endgame scenario might be delayed, if not averted, by a secular rebound in productivity growth. Such a development would allow the economy to grow despite labor shortages.

In our opinion, a shortage of labor is the reason why productivity should rebound. If it does so, then real wages should rise along with productivity, which will give consumers more purchasing power to do what they do best, namely, go shopping. A productivity rebound would also keep a lid on inflation, which would reduce the risk of a recession caused by Fed tightening and a credit crunch. Let’s have a look at the latest data:

(1) The long view. Over the past 20 quarters (i.e., five years) through Q2-2019, nonfarm business productivity has increased by an average annual rate of 1.2% (Fig. 10). That’s up from a cyclical low of 0.5% during Q4-2015. That’s a good gain, but still well below previous cyclical peaks of 4.0% during Q4-2003, 2.5% during Q2-1987, 2.8% during Q1-1973, and 4.6% during Q1-1966.

(2) The current view. We are already getting closer to our happy scenario. Q2-2019 productivity data were released last Thursday. They show that productivity rose 1.8% y/y during the quarter, with real nonfarm business output up 2.6% and real GDP up 2.3% (Fig. 11). The increase in productivity was the best reading since Q1-2015. As Debbie reports below: “Nonfarm productivity for Q2 expanded 2.3% (saar) following an upwardly revised 3.5% (from 3.4%) advance during Q1.”

(3) Compensation. For the nonfarm business sector, the 20-quarter cycle in inflation-adjusted hourly compensation is highly correlated with the comparable cycle in productivity (Fig. 12). During Q2-2019, the former was up at an average annual rate of 1.7%, the fastest pace since Q1-2008. As per microeconomic theory, we are using the nonfarm business price deflator rather than the CPI or personal consumption deflator to calculate real hourly compensation (Fig. 13).

(4) Inflation. In current dollars, nonfarm business hourly compensation is very volatile, even on a y/y basis and especially compared to average hourly earnings and the Employment Cost Index (ECI) (Fig. 14). During Q2-2019, hourly compensation rose 4.3% y/y, while the ECI rose 2.6%.

A good measure of unit labor costs can be derived by dividing the ECI (rather than hourly compensation) by nonfarm business productivity (Fig. 15). The yearly percent change in this measure tends to be in the same neighborhood as the inflation rate using the y/y percent change in the core PCE deflator. Our unit labor costs proxy rose just 0.8% during Q2, which is why price inflation remains so low.

(5) Revisions. The Bureau of Labor Statistics released its latest Productivity and Costs report last Thursday. It included revisions from Q1-2014 to Q1-2019. The revised data for productivity showed more of it from 2016-2018, but by Q1-2019, the revised level was identical to the preliminary estimate (Fig. 16).

Movie. “One Child Nation” (+ + +) (link) is an extremely disturbing documentary about China’s horrible one-child policy from 1979 to 2015. It resulted in the mass forced sterilization of women and involuntary late-term abortions. It led to human trafficking in babies, who were placed in overseas homes, many under the false pretense that they were orphans. The Orwellian government campaign to control the population’s growth rate was deemed necessary to avoid nationwide starvation. It included incessant propaganda, a widespread network of informants, and the conscription of medical professionals to execute the government’s dirty deeds. Among the people interviewed in the documentary, a few condoned it, but most did not and seemed to have been deeply traumatized by it. Everyone said they had no choice. The legacy of that policy is that China is rapidly turning into the world’s largest nursing home as the population ages without enough young adults to support the elderly. See the UN-compiled data in charts of China’s fertility rate (Fig. 17), elderly dependency ratio (Fig. 18), and young-vs-old population shares (Fig. 19).

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Another Curve Ball

August 15 (Thursday)

Strategy: Blaming Algos. The 10-year US Treasury yield fell below the two-year yield on Wednesday. That triggered a stock-market stampede for the exits in fear that the inverted yield curve signals an impending recession. The S&P 500 fell nearly 86 points yesterday, bringing the market’s decline to 6.1% since its peak of 3025.86 on 7/26.

We aren’t joining the hysteria, which we blame mostly on computer-driven algorithms programmed to sell stocks on bearish headlines such as those about the inversion of the yield curve. Our research has shown that inverted yield curves do not cause recessions. In the past, they’ve predicted credit crunches caused by Fed tightening. So investors on the lookout for a recession should instead pay attention to credit availability. We laid out our case in the 4/7 Topical Study #83: “The Yield Curve: What Is It Really Predicting?”

Credit remains amply available. The Fed has been back in easing mode since the end of July, when the federal funds rate was cut by 25bps. Fed officials are likely to respond to the inversion with more rate cuts.

Recession-watchers should keep an eye on bank credit metrics—specifically, net interest margin, charge-offs and dividends, and business loans. Right now, those metrics aren’t signaling a credit crunch (Fig. 1, Fig. 2, and Fig. 3). In our study, we observed:

“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. …The widely held notion that a flat or an inverted yield curve causes banks to stop lending doesn’t make much sense. The net interest margin, which is reported quarterly by the Federal Deposit Insurance Corporation (FDIC), has been solidly positive for banks since the start of the data in 1984.”

Nonetheless, the S&P 500 Financials sector has been the second-worst-performing S&P 500 sector since the broad index peaked. Here’s the performance derby from 7/26 through Wednesday’s close: Real Estate (2.1%), Utilities (0.2), Consumer Staples (-2.9), Health Care (-3.3), Materials (-5.9), S&P 500 (-6.1), Communication Services (-6.6), Information Technology (-7.0), Industrials (-7.1), Consumer Discretionary (-7.3), Financials (-9.5), and Energy (-9.8).

China: Consumers Spending at JD. In addition to an inverted yield curve, investors were spooked by the latest data out of China, which shows the country’s economic growth continues to slow. China’s industrial production grew 4.8% in July y/y, the slowest pace since February 2009. That’s below China’s industrial production growth in June (6.3%) and in May (5.0) (Fig. 4). Chinese retail sales growth also slowed, to 7.6% y/y in July, down from June’s 9.8% growth rate (Fig. 5).

Despite the latest dour news, the Q2 earnings of JD.com—widely considered to be China’s Amazon.com—soundly beat expectations. Revenue jumped 23% y/y, active customers increased 3.5% in the 12 months through June, and adjusted, diluted earnings per share of 2.30 yuan beat analysts’ expectations. JD.com upped its guidance for 2019 adjusted net income to between 8.0-9.6 billion yuan. Better-than-expected results, combined with postponed US tariffs on certain Chinese goods, helped JD shares jump 12.9% on Tuesday to $30.66.

JD’s earnings report doesn’t signal “all clear” for the Chinese consumer, however. The Internet retailer cited several factors that had nothing to do with the economy when explaining how it turned in such a strong report:

(1) Logistics pulling its weight. The company credited the maturity and profitability of its logistics business, which after years of investment has finally reached the break-even point. JD delivers its own packages to customers’ front doors.

(2) Market share expanding. JD is expanding its customer base and isn’t solely dependent on its existing customers spending more. The company noted it has moved beyond large markets and into third- to sixth-tier cities. It’s also growing faster than its market because it continues to take market share. “We remain optimistic about the Chinese consumer market and JD.com’s competitive market position despite uncertainties with the macro environment,” said JD’s CFO Sidney Xuande Huang during the Q2 earnings call.

(3) VAT-cut benefit domino-ing. Also mentioned as a sales propellant was China’s Value Added Tax (VAT) cut, though JD couldn’t quantify the benefit. China cut the VAT rate for manufacturers to 13% from 16% effective 4/1, representing an estimated 2 trillion yuan in 2019 and benefiting the manufacturing, transportation, and construction sectors. Many of JD’s suppliers and clients responded by lowering their prices—Apple and luxury brands such as Gucci among them, according to a 4/1 Reuters article. JD’s Chinese consumers likely were enticed to snap up products at lower prices, boosting JD’s sales.

(4) Combining bricks and clicks. Lei Xu, CEO of JD Retail, sounded one positive and one negative note: First, he said that because of the “overall macro environment,” China’s advertising market is “under great pressure.” More optimistically, he said China’s real estate market is “recovering, especially, in the third to fourth tier cities.” Like US Internet retailers, JD has expanded into brick-and-mortar stores. In 2018, it opened its first 7Fresh Supermarket, with plans to have 1,000 stores in the next three to five years. The stores both sell food and act as a showcase for other items that customers can order online from JD.com.

While JD’s results were a pleasant surprise, their strength appears to have more to do with company-specific issues and less to do with a resurgent Chinese consumer.

Semiconductors: Fried Chips. The S&P 500 Semiconductor and Semiconductor Equipment stock price indexes were battered Wednesday on renewed fears of a global economic slowdown. They dropped 3.0% and 3.1%, respectively. Their drubbing wiped out the gains they enjoyed the previous day on news that some of the US tariffs on Chinese goods would be postponed until December.

Semiconductor sales worldwide have been tumbling all year. The Semiconductor Industry Association reports that worldwide semiconductor sales in June were down 0.9% m/m and down 16.8% y/y (Fig. 6). Using a three-month moving average, the drop in industry sales measures 22.3% from the $42.1 billion peak last October.

Until recently, investors seemed to be anticipating the end of the downturn. The S&P 500 Semiconductor Equipment industry index is up 44.4% ytd through Wednesday’s close (Fig. 7). A bit further behind is the S&P 500 Semiconductors stock price index, up 13.5% ytd and narrowly beating the S&P 500 over the same period (Fig. 8).

Until the recent selloff, perhaps investors were focusing on the improved earnings analysts are forecasting for both industries next year. Analysts expect the Semiconductor Equipment industry’s revenue to drop 11.3% this year and rise 6.3% in 2020 (Fig. 9). Likewise, earnings are forecast to drop 22.2% this year and to bounce by 9.8% next year (Fig. 10).

The revenue and earnings rebounds aren’t nearly as strong in the S&P 500 Semiconductors industry. Analysts call for the industry’s revenue to fall 6.3% this year and increase 3.9% in 2020 (Fig. 11). Earnings are expected to drop 14.0% this year before improving by 1.0% in 2020 (Fig. 12).

Disruptive Technology: Tesla Still a Leader. Investors in Tesla want to have their cake and eat it too. They want Tesla to be both successful and profitable, and that’s not what’s happening—not yet anyway. Tesla reported a $1.12 adjusted loss per share in Q2, even as revenue climbed more than 50% to $6.4 billion.

While Ford Motor shares have climbed 17.7% ytd and GMs shares are up 11.2% ytd, Tesla’s stock has fallen 34.0% so far this year. That painful decline may mean that investors’ high expectations haven’t been met, but it doesn’t mean Tesla’s business isn’t making progress.

Tesla remains a market-share leader in the electric car industry. Utilities are experimenting with how they can use Tesla’s batteries and solar panels to provide electricity. And the cost of batteries is tumbling, which should make further adoption of Tesla’s products easier. Here’s Jackie’s look at some of the progress Tesla is making, even if that progress isn’t fast enough or producing enough profits to appease investors:

(1) Plummeting prices. The economics of renewable energy are moving in the right direction, thanks in part to the declining cost of batteries. The price of large-storage batteries—those used to store large amounts of energy for utilities—has dropped nearly 40% since 2015, according to Wood Mackenzie data quoted in an 8/11 WSJ article. Getting battery prices down is key to the broad adoption of solar and wind energy because of the need to store energy that can be used when the wind isn’t blowing and the sun isn’t shining. Wood Mackenzie expects spending on high-capacity batteries to grow six-fold to $71 billion by 2024.

(2) Utilities going virtual. The idea of having solar panels on, and batteries in, homes is powerful; but if the utility can link all those homes, the idea becomes exponentially powerful. The idea of linking them is being tested in South Australia, where solar panels and Tesla’s Powerwall 2 battery storage units have been installed in 1,100 low-income households.

“The homes are linked together to form a virtual grid which can both ease power demands from the main grid during peak consumption times and act as a backup power source during blackouts,” an 8/12 article on Teslarati.com explained. The project’s next phase will give another 50,000 households solar panels and batteries, creating a 250 MW virtual power plant. After solar energy fills the battery, the electricity can then be sent back to the utility. Customers are offered a 20% discount on their electric bills.

In the US, a VPP (virtual power plant) is being proposed for the Los Angeles Department of Water and Power (LADWP). LA Mayor Eric Garcetti’s Green New Deal wants LADWP to close its three remaining natural gas plants and get 80% of its power from renewables by 2036, according to an 8/13 article in Utility Dive. Sunrun, a residential solar provider, has proposed replacing one of the plants with a VPP. Doing so will be a big push, because only 2.5% of homes in the utility’s coverage area have solar panels generating 182 MW. To replace the plant, 862 MW of energy would need to be generated by solar panels on homes and the utility would need to modernize its distribution grid.

In Massachusetts and Rhode Island, National Grid allows homeowners with a Tesla Powerwall home battery to sell their energy back to the grid at peak demand times, a 6/21 article on Inverse.com reported.

(3) Europe getting greener. Electric vehicle (EV) sales are staying hot even as combustion engine car sales are cooling off. Battery EV sales in Europe were up 98%, or 34,000 units, y/y in June, according to a 7/29 InsideEVs article. Europe’s sales of battery and hybrid cars have topped US sales for each month this year.

Tesla, which has a 17% share of the European EV market, had the best-selling model, the Model 3. The Model 3 sold 37,780 cars in Europe in the first half of the year, with the Renault Zoe (24,288), the Mitsubishi Outlander hybrid (18,982), BMW’s i3 (16,370), and the Nissan Leaf (16,348) trailing behind.

Car manufacturers will need to offer more EVs over the next year if they hope to comply with Europe’s new emissions. Only 95% of an EU car company’s fleet on average must emit 95 grams of carbon dioxide per kilometer driven, down from 120.5 g/km last year. And by 2021, the entire car fleet must meet that standard. Those who don’t meet the standard will have to pay fines, which a 6/26 Bloomberg article reports could hit 34 billion euros through 2021, citing a projection by Jato Dynamics. Based on its 2018 reported emissions, Volkswagen AG could face the largest fine, of about 9 billion euros, followed by Peugeot, 5.4 billion euros.

In the past, car makers were able to meet lower emissions standards by adding new technology to small cars with combustion engines. But companies may not be able to make that work this time around while also keeping small car models profitable. Many car companies likely will stop selling small internal combustion cars as a result, instead selling small EVs to offset the CO2 spewed by internal combustion SUVs. The problem is that small electric cars, at 18,000-20,000 euros, cost more than mini combustion engine cars, at 12,000-14,000 euros, a 6/22 Automotive News article states. The higher price of an EV could dent consumer demand, and the slimmer margins on EVs could dent manufacturers’ bottom lines.

The good news for Tesla is electric cars will become even more accepted in Europe. The bad news is that every car maker is coming out with new EVs, so EV competition is only just starting to heat up.

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China, China, China

August 14 (Wednesday)

China I: Speeding Toward Slower Growth. In recent years, China watchers have been debating the following question: Will China grow old before it grows rich? The current snapshot of China compared to snapshots taken 10, 20, and 30 years ago shows that it has gotten much richer. Standards of living have certainly improved for most people in China. China’s infrastructural achievements—the highways, railways, ports, and cities—all are dazzling.

On the other hand, the following negative spin appeared in a 5/23/17 opinion piece in the South China Morning Post: “The underlying reality is of a fundamentally indebted, extremely unequal and vastly over-built society that is going to be knocked sideways by its own demographic earthquake—as decades of the one child policy come home to roost—and China’s population growth starts to falter.”

One salient example of the yin-and-yang dynamics of China’s economy is the country’s high-speed rail system, the longest in the world. It’s extremely impressive, with 29,000 kilometers (18,000 miles) of rail operating as of year-end 2018. One critic, however, Zhao Jian—director of the China Urbanization Research Center at Beijing Jiaotong University—says the rail network is fraught with problems, which he reviewed in a 1/29 Caixan article titled “What’s Not Great About China’s High-Speed Rail? The Debt.”

The problems Zhao sees include the system’s high cost, inefficiency as measured by “transportation density,” massive debt financing (with total liabilities of 5.28 trillion yuan as of September), and the fact that investing in this system, which carries only people, has meant less construction of regular railways, which has led to a serious imbalance in China’s transportation infrastructure.

My take is that China runs the risk of having lots of state-of-the-art “ghost” infrastructure. We’ve all seen YouTube videos of China’s ghost cities. They are a bit of an urban legend in which the government built vast, sprawling, futuristic metropolises in the middle of nowhere that nobody actually lives in. While most have failed to live up to their original promise, few have failed completely. Their populations are growing.

Nevertheless, China’s rapidly aging demographic profile does increase the risk that China has built too much ghost infrastructure that will be plagued by excess capacity and burdensome debt.

China II: Managing Slower Growth. The Chinese government has provided lots of fiscal and monetary stimulus to manage the slowdown in China’s economy. It is slowing partly because that’s what emerging economies do as they mature into developed economies. But the slowdown has been greatly exacerbated by the one-child policy from 1980 to 2015. China’s fiscal policy has focused on building infrastructure, which has been creating excess capacity, as discussed above. Monetary policy has enabled too much debt expansion, which is weighing on China’s economy rather than stimulating it. Let’s review the recently released data on China’s economy:

(1) Inflation. China’s CPI rose 2.8% y/y during July, boosted by food prices—particularly pork prices, which have soared as a result of the swine flu epidemic (Fig. 1). Higher food prices reduce the purchasing power of Chinese consumers. The PPI fell 0.3% y/y in July, which suggests that China’s manufacturing sector is weakening, with industrial profits under pressure. That is likely to put financial stress on many of China’s manufacturers, who already face challenges from Trump’s escalating trade war.

(2) Money supply. M2 rose 8.1% y/y during July (Fig. 2). This growth rate has declined from 14.0% at the beginning of 2016. This may be yet another indicator of China’s economic slowdown. Since early 2016, it has diverged from the growth rate in bank loans, which has been relatively steady around 13.0%. In the past, M2 growth tracked bank loans growth closely. The recent divergence confirms our view that easy credit policy isn’t stimulating the economy as much as it might have in the past.

M1 growth remains low around 3.1% (Fig. 3). It tended to grow much faster during periods of monetary stimulus. It’s not doing so even though the People’s Bank of China (PBOC) lowered the reserve requirement ratio for large banks from 17.0% at the start of 2017 to 13.5% currently (Fig. 4).

(3) Real retail sales. The growth rate in inflation-adjusted M2 is highly correlated with the growth rate in inflation-adjusted retail sales (Fig. 5). Both have been on downward trends since 2013. Again, in our opinion, these downtrends reflect the increasingly geriatric demographic profile of China.

(4) Bank loans. The cuts in the reserve requirements ratio by the PBOC have kept bank loans growing at a fast pace, as noted above. The PBOC has been filling up the punch bowl regularly ever since the Great Financial Crisis. As a result, bank loans have soared by $17.0 trillion from $4.4 trillion at the start of 2009 to $21.4 trillion during July of this year (Fig. 6). Over the same period, US bank loans rose only $2.9 trillion to $9.8 trillion.

Over the past 12 months through July, Chinese bank loans rose $2.4 trillion (Fig. 7). Total “social financing,” which includes bank loans, rose $3.3 trillion over the same period (Fig. 8).

All that lending seems to be delivering less and less bang per yuan. The ratio of M2 to bank loans (both in yuan) was relatively flat from 2006 to 2014, but has been falling ever since (Fig. 9). The ratio of industrial production to bank loans has been on a steep downtrend from record high of 107 during December 2007 to 52 during June of this year (Fig. 10).

China III: Hong Kong Coming to a Boil. Stocks rebounded yesterday after the Trump administration de-escalated its trade war with China. Tariffs will be delayed until 12/15 on imports from China of cellphones, laptop computers, toys, and other items. No reason was given, but US importers must have put lots of pressure on the administration to back off. Or perhaps President Trump doesn’t want to force American consumers to pay more for many of their made-in-China Christmas presents this year before the November presidential election next year.

Now what if China uses lethal force to end the pro-democracy protests in Hong Kong? Obviously, the US can’t respond militarily to any carnage that might ensue. The only viable option might be to reverse course again and impose a tariff on the remaining $300 billion of Chinese goods imported into the US. Instead of the 10% tariff that was just delayed, a much more punishing rate might be necessary in response to an attack by Chinese military forces on Hong Kong’s civilians.

One of the biggest differences between current events in Hong Kong and the massacre at Tiananmen Square during June of 1989 is the proliferation of smartphones and social media. That could cause the Chinese government either to back off or to create a global firestorm for the regime if it proceeds with a bloody crackdown. The question is: What will President Xi Jinping do?

China IV: Meet Xi Jinping. Communism is in Chinese President Xi Jinping’s blood. His father, Xi Zhongxun, was an original communist revolutionary who worked his way up to become vice premier of the PBOC in the first generation of Chinese communist party leadership. Like his father, Xi Jinping spent several decades climbing political ranks in various roles serving the agenda of the Chinese communist party. Though a communist at heart, Xi, the son, projects a more liberalized persona as a voice of globalization and international cooperation. But don’t doubt his commitment to communist ideals: Xi initially applied to join the Chinese Communist Party nine times before being accepted on the tenth during 1974. Let’s further explore Xi’s dual personality:

(1) Supreme leader vs president. Many US news journalists, politicians, and analysts (including ourselves) often refer to Xi Jinping as “President Xi.” Technically, this is wrong, but China sees symbolic advantage internationally in not correcting it, according to an 8/8 Slate article.

The article points out that calling Xi “president” makes it sound like China goes through some of the motions of democracy. Hardly: During his reign, Xi successfully has abolished term limits, granting him leadership over China for an unlimited amount of time.

Xi actually has three titles: “General Secretary of the Central Committee of the Chinese Communist Party,” a.k.a. “General Secretary,” most used for domestic purposes; “Chairman of the Central Military Commission;” and “Head of the People’s Republic of China,” the one often mistranslated as “president.” This misnomer helps to support Xi’s diplomacy on a global basis, surmises Slate. Xi also holds a seat on China’s top policy-making body, the Politburo Standing Committee. Internally, General Secretary Xi runs a tightly controlled state. Internationally, President Xi promotes globalization and free trade.

But make no mistake: Xi is anything but a democratic leader. China is fully a one-party system that forcibly squelches any opposition. Since taking on the role of General Secretary in 2012, Xi has led a signature internal anticorruption campaign, cracking down hard on dissenters and, of course, political opponents, even wiping out some long-standing members of the Politburo. Xi has usurped centralized control over the nation, taking on a variety of party leadership positions. His political philosophies, termed “Xi Jinping Thought,” has been made a permanent part of the Communist Party constitution.

(2) Global liberalizer vs domestic controller. It was in December of 1978 that Xi’s predecessor, Deng Xiaoping, brought China out of Maoist communism into “socialism with Chinese characteristics.” When Xi came to power, it was hoped that he would walk in Deng’s footsteps, further democratizing markets. But in reality—as Xi has faced slowing domestic growth, the US trade dispute, human-rights violations, loads of debt, and lagging consumption—the state sector has grown while the private sector has shrunk as credit conditions have tightened, observed an article in The Guardian covering China’s 40^th anniversary of its initial economic transition.

Xi gave a speech that day capturing the essence of his duality—both painting China as a paragon of global cooperation and asserting that no one tells the party how to control China. On one hand, he said: “China will never seek global hegemony. … China is approaching the center of the World Stage and has become a recognized builder of world peace, a contributor to global development, and a defender of the international order.” On the other hand, he said: “No one is in a position to dictate to the Chinese people what should or should not be done. … Whether it’s the party, the government, the army, ordinary people, or students, the east, the west, the south, the north or the middle, the party leads everything.”

Chinese leadership has always been “absolutely correct,” he noted, pointing out China’s accomplishments over the past decades in abolishing hunger and hardship that “plagued our people for thousands of years.”

(3) Opposing initiatives. At the World Economic Forum in Davos in January, Xi said that “protectionism is like locking oneself in a dark room. Wind and rain may be kept outside, but so are light and air,” according to an 8/12 article in Worth magazine on Xi’s rise to power. As an active participant in globalization, Xi has promoted foreign infrastructure projects and collaborated on global trade deals.

Worth observed: “Within months of President Trump’s withdrawal from the Trans-Pacific Partnership trade deal, China initiated trade talks with the other member nations as well as South Korea. Similarly, when Trump withdrew the U.S. from the Paris Agreement, Xi raised a potent call for global cooperation on climate change, warning about a risk to the global economy.” Separately, China’s Belt and Road project aims to build infrastructure by land and sea to connect Asia, Europe, the Middle East, and Africa.

However, these seemingly innocuous activities seem to be priming for the exact positioning that Xi has promised not to pursue—global dominance, particularly over and above the US. Counter to the idea of China’s friendly global involvement, Xi’s deputy, Chinese Premier Li Keqiang, issued the “Made in China 2025” strategic plan to dominate the high-tech industry. The US has identified this strategy as a major threat to US intellectual property as China seeks to steal US technologies, an injustice that sits at the core of the US-China trade dispute.

Amid Xi’s friendlier global initiatives, China has been quietly expanding its military capacity in the disputed islands of the South China Sea. The country has also been policy-meddling in the semi-autonomous region of Hong Kong, sparking the recent unprecedented riots there. Moreover, the country’ has long come under international criticism for its human rights violations, including atrocities related to its only recently abolished one-child policy and, recently, the detainment of a large population of Chinese Muslims.

The bottom line is that the undercurrent of China’s actions beneath Xi’s promises make it hard to trust that his motives are pure and that he is not seeking global hegemony as he claims. The next litmus test for Xi may be how he chooses to handle the situation in Hong Kong. If he reacts with force, it would be a major line in the sand, revealing his true nature as an authoritarian communist.

China V: Meet Hu Xijin. On a 2016 visit to the People’s Daily—a primary domestic news source controlled by the Chinese communist party—Xi said that his office subscribes to the Global Times, according to an article in the Lowy Institute’s The Interpreter. The tabloid-like Global Times is a subsidiary of the People’s Daily, and its editorials are often characterized as outlandish and lacking in substance. But the media outlet sometimes dubbed “China’s Fox News” echoes the views of the communist party and its loyal supporters.

One of those loyalists is the Global Times’ own deputy editor, Hu Xijin. In a 7/31 article, the NYT said that Hu is sometimes called a “frisbee fetcher” by critics, i.e., a party loyalist who retrieves whatever is thrown at him by the party. The article reports that Hu acknowledges that he has “special access” to party officials. Strangely, Hu was one of the student marchers for democracy at Tiananmen Square but left just before the horrific attacks on protestors.

Hu claims to have been deceived back then by pro-democracy intellectuals who were impulsive and childish, according to the NYT. Hu has not been shy about tweeting messages calling for today’s protestors in Hong Kong to stand down. Hu also has publicly supported the Muslim “reeducation” camps in Xinjiang.

There is no shortage of entertainment on social media, but it is not all fun and games. Often, the Chinese media maven stays up late into the night in Beijing, standing at the ready to tweet back at anything President Trump comes online to say. The editor views the west as “demonizing” China and has said that military conflict with the US cannot be ruled out, reported the NYT.

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Less Than Zero: From FOMO to FONIR

August 13 (Tuesday)

Equities: Stocks in Beantown. I visited some of our accounts in Boston last week. The weather kept thwarting my travel arrangements. My morning flight on the way up was cancelled, as thunderstorms kept the plane from reaching LaGuardia (LGA) the night before. All other flights to Boston were either cancelled or full. I managed to get on the 7:00 a.m. Acela train from Stamford, Connecticut, which required taking a car service from my Long Island home. A drawbridge stuck in the open position delayed the train ride; I just barely made it to my first meeting. On the way back, I had to scramble to catch a 4:00 p.m. flight from Logan to LGA. While waiting on the tarmac, the pilot announced that we had to return to the terminal and disembark—more thunderstorms! Five hours later, the flight was cancelled. I made it home the next morning.

Such volatility is typical of what summer travelers face, I suppose. There’s also been quite a bit of volatility in the stock market this summer—typical of what investors have faced throughout the current bull market. By our count, there have been 64 panic attacks followed by 63 relief rallies in the S&P 500 since early 2009. Joe and I expect that the current panic attack will also pass. So we are still predicting that this index will continue to rise into record-high territory, with our targets of 3100 before the end of this year and 3500 sometime next year.

In Boston, I sensed that our accounts are turning more cautious and defensive, with a few expecting a recession before the end of the year. I acknowledged their main concern, i.e., about the escalating trade war with China. However, US nominal GDP is around $21 trillion, while US exports to China totaled just $108 billion over the past 12 months through June, and imports from China totaled $509 billion over the same period.

My mantra continues to be: “No boom, no bust.” Another way to put it is: “No credit crunch, no recession.” Booms lead to speculative excesses financed by debt binges; the resulting inflation in consumer and/or asset prices forces the Fed to raise interest rates. In the past, such scenarios have triggered a financial crisis for a few borrowers and lenders, which rapidly has morphed into a widespread credit crunch, which caused a recession (Fig. 1).

The inverted yield is also a nagging concern among many of our accounts (Fig. 2). It has been a very good predictor of previous recessions. Our 4/7 study titled “The Yield Curve: What Is It Really Predicting?” addressed this question as follows: “More specifically, inverted yield curves don’t cause recessions. Instead, they provide a useful market signal that monetary policy is too tight and risks triggering a financial crisis, which can quickly turn into a credit crunch causing a recession. If so, then the Fed’s recent decision to be patient and pause its rate-hiking may reduce the chances of a recession.”

Of course, since we wrote that, the Fed decided to cut the federal funds rate range from 2.25%-2.50% to 2.00%-2.25% on 7/31 (Fig. 3). The 12-month federal funds futures yield was down to 1.25% at the end of last week (Fig. 4). That implies three or four 25bps cuts in the federal funds rate by next summer.

The Fed seems to have gotten the message from the yield curve: Ease up or risk a credit crunch and a recession.

Equities: Stocks in Wonderland. One day after the Fed cut the federal funds rate, President Donald Trump escalated the US-China trade war on 8/1 when he announced that a 10% tariff will be slapped on $300 billion of China’s exports to the US at the beginning of September. That’s in addition to the 25% tariff that had already been imposed on another $250 billion of such goods.

The latest escalation caused the Bull-Bear Ratio compiled by Investors Intelligence to decline from 3.35 during the 7/30 week to 2.69 during the 8/6 week (Fig. 5). That isn’t much of a drop, actually. Most of it is attributable to the percentage of survey participants expecting a market correction, i.e., up from 25.7% to 34.0%. Bearish sentiment upticked from 17.1% to 17.9%.

It’s widely known that August can be a turbulent month for stocks. So can September and October. So can all the months of the year. In any event, this coming September and October, investors can look forward to another rollercoaster ride. The 10% tariff on China hits on 9/1. The European Central Bank (ECB) is likely to lower its official interest rate further into negative territory and restart QE on 9/12. The FOMC meets on 9/17-9/18 with the possibility of another rate-cut decision. On 10/15, the Q3 earnings reporting season gets going. The Brexit deadline is 10/31.

Given all this commotion, why is the S&P 500 down only 4.7% from its record high on 7/26 as of yesterday’s close? While I am getting the impression from my meetings with accounts recently that fears of an impending recession are mounting, it’s hard to see that in the stock market’s performance or in sentiment indicators so far.

Some investment strategists explain the ongoing bull market with the notion that There Is No Alternative to Stocks, or TINA. Last week, I argued that bonds have been a great alternative, with both bonds and stocks beating cash, for sure. Other strategists have attributed the bull market to Fear of Missing Out, or FOMO.

I propose an alternative acronym: FONIR, or Fear of Negative Interest Rates. Investors continue to scramble into both bonds and stocks, fearing that the ECB will go more negative with its official rate, which is currently -0.40% (Fig. 6). The Bank of Japan (BOJ) is at -0.03% and might also go lower. In the US, the federal funds rate was cut at the end of July. It remains well above zero but is widely expected to be heading closer to zero through next year, as evidenced in the federal funds futures market.

Putting lots of pressure on the Fed to lower interest rates is President Trump, who has a severe case of NIRP (Negative Interest Rate Policy) envy. He keeps wondering out loud why interest rates in the US are so much higher than they are in the Eurozone and Japan. He has figured out that by escalating his trade war with China, he puts pressure on the Fed to cut interest rates. He believes he needs the Fed to do so to support the economy to win his trade war with China.

NIRP in the Eurozone and Japan and NZIRP (near-zero interest rate policy) in the US are fueling a global-reach-for-any-yield-north-of-zero panic. So this is bullish for bonds and also bullish for stocks, especially those with a dividend yield. Fear is a powerful emotion. FONIR should continue to be a powerful driver of the bull markets in bonds and stocks.

Credit: Bonds in Neverland. The 8/11 WSJ included an article titled “Investors Ponder Negative Bond Yields in the U.S.” As a result of the negative interest rate polices of the ECB and BOJ, “there is more than $15 trillion in government debt around the world with negative yields.” In other words: “That means, essentially, that savers holding these bonds are paying the government to store their money.”

So far, NIRP isn’t doing much to revive the economies of the Eurozone and Japan. It may actually be doing more harm than good: “In Europe and Japan, subzero yields were brought about by slow growth, low inflation and aggressive central-bank stimulus, including negative interest rates and extensive asset purchases. That has helped alleviate economic pain. But the subzero yields haven’t led to a true revival in those economies. They have also hurt savers and threatened the financial system by curtailing the ability of banks to generate profits.”

Consider the following related developments:

(1) Bond yields here and there. On Friday, the 10-year government bond yields in Germany and Japan were down to -0.57% and -0.19%, respectively (Fig. 7). The comparable US yield was down to 1.74%; it dropped again, to 1.65%, yesterday.

Since the start of this year, here are the declines in these yields through Friday: US (-95bps), Germany (-82), and Japan (-20). Since last year, my Modern Tethered Theory (MTT) of the US bond yield has been that it is falling in response to the gravitational pull of negative yields in the Eurozone and Japan.

(2) US TIPS yield almost negative. The 10-year US Treasury TIPS yield is down 90bps over the same period, from 0.98% at the start of this year to just 0.08% on Friday (Fig. 8). It may be on the verge of turning negative, which is what it did during 2012.

(3) Inflationary expectations subdued. A widely followed proxy of the expected annual US inflation rate over the next 10 years is the yield spread between the 10-year US Treasury bond and the comparable TIPS (Fig. 9). On Friday, it was back down to the year’s low of 1.66%.

(4) Unreal real rates. In the US, the core CPI y/y inflation rate was 2.1% during June (Fig. 10). It was 0.9% through July in the Eurozone and 0.3% through June in Japan.

That means that both the inflation-adjusted federal funds rate and 10-year US Treasury bond yield are around zero (Fig. 11).

In the Eurozone, the inflation-adjusted official deposit rate of the ECB and the German 10-year government bond yield were -1.3% and -1.2%, respectively, in July (Fig. 12).

In Japan, the BOJ’s inflation-adjusted official rate and the 10-year government bond yield both were at -0.4% in June (Fig. 13).

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What’s the Matter With Profits?

August 12 (Monday)

Global Economy: Hitting Bottom? Just after the gloom about the gloomy global economic outlook got gloomier at the beginning of last week, it got less gloomy later in the week. Last Thursday, we learned that China’s merchandise exports rose 10.4% y/y to a record high in yuan, based on seasonally adjusted data (Fig. 1 and Fig. 2).

Also on Thursday, the OECD reported a better-than-expected reading for the composite leading indicator for the 36 member countries of this organization. It held steady at 99.1 in June, beating expectations of another decline (Fig. 3). Our friends at Moody’s Analytics’ website Economy.com reported: “The headline suggests that growth momentum should remain stable in the OECD area as a whole, but the geographical breakdown was less upbeat, showing that growth is expected to slow further in the U.S., Germany and the euro zone as a whole. For most of the other major economies—such as France, Italy, Canada, Japan, and Brazil—the CLI pointed towards a steady pace of expansion. The only standouts were China and the U.K., whose indexes rose slightly over the month. We caution that Brexit means there is huge uncertainty over the U.K. forecasts, especially as a no-deal exit on October 31 is still on the table.”

Last Thursday as well, Japan’s real GDP was reported showing an increase of 1.8% (saar) during Q2. That was a solid showing, though it was lower than the 2.8% gain in the previous quarter. However, boosting Japan’s economy is consumer spending in advance of a consumption tax hike scheduled for October. That suggests that consumer spending could weigh on economic growth during Q4 and next year.

Also on Thursday, in the US, initial unemployment claims was reported at 209,000 during the 8/3 week, near recent historical lows. On Tuesday, June’s JOLTS report showed job openings (at 7.35 million) exceeding the number of unemployed workers (at 5.98 million during June) for the 16th month in a row (Fig. 4). There’s no gloom in the US labor market.

Profits I: Big Downward Revision in NIPA. At the end of July, the Bureau of Economic Analysis released its 2019 Annual Update of the National Income and Product Accounts (NIPAs). Updated estimates of the NIPAs are usually released in July. They incorporate newly available and more comprehensive source data, as well as improved estimation methodologies. The timespan of this year's update is Q1-2014 through Q1-2019.

The report states: “The picture of the economy presented in the updated estimates is very similar to the picture presented in the previously published estimates.” That’s true for real GDP. That’s not the case for corporate profits.

The key takeaway is that NIPA data are complicated and can be misleading if not properly understood and interpreted. The revisions in the data can occasionally paint a significantly different picture of the economy than the preliminary data.

First, here’s real GDP: “From 2013 to 2018, real GDP increased at an average annual rate of 2.5 percent; in the previously published estimates, real GDP had increased at an average annual rate of 2.4 percent. When measured from the fourth quarter of 2013 to the fourth quarter of 2018, real GDP increased at an average annual rate of 2.4 percent, the same as previously estimated.” Now for the profits shocker:

(1) Pre-tax book profits. The revisions reduced corporate profits before taxes as reported to the IRS, especially since mid-2016 (Fig. 5). Q1-2019 was revised down by $165 billion from $2.2 trillion (saar) to $2.0 trillion, and is now down 1.4% y/y rather than up 3.3%, as previously reported (Fig. 6).

(2) After-tax book profits. On an after-tax basis, book profits (i.e., as reported to the IRS) was revised down most sharply since early 2018, when it was slashed by $413 billion for the year (Fig. 7). For Q1-2019, profits was cut by $142 billion at an annual rate. Before the revision, Trump’s corporate tax cut had boosted after-tax book profits to new highs last year. That’s no longer the case, as the new estimates for Q1-2018 through Q1-2019 are all below 2017’s readings.

(3) Profits from current production. Another measure of corporate profits is used in calculating National Income as well as corporate cash flow. It is called “profits from current production,” and it adjusts book profits by including the Inventory Valuation Adjustment (IVA) and Capital Consumption Adjustment (CCAdj). These two adjustments restate the historical cost basis used in profits tax accounting for inventory withdrawals and depreciation to the current cost measures used in GDP.

During Q1, on an after-tax basis, the cash-flow measure of profits was revised down by $221 billion to $1,791 billion (saar) during Q1-2019, a decline of 2.9% y/y rather than an increase of 2.4% (Fig. 8). It remained in record-high territory last year thanks to Trump’s tax cut, but less so after the revisions.

National Income showed little revision until Q1-2019, when it was revised higher by only $110 billion (saar) to $17.9 trillion. So the downward revisions in profits were mostly offset by upward revisions in some of the other components of National Income. Here are their upward revisions just during Q1-2019: compensation ($237 billion), net interest ($103 billion), and proprietors’ income ($17 billion) (Fig. 9).

Profits II: S&P 500 Earnings Still Strong. Debbie and I regularly compare NIPA’s after-tax book profits measure to aggregate S&P 500 reported net income, which is based on GAAP and never gets revised (Fig. 10). As a result of the revisions, the former has now been flat around $1.8 trillion since Q1-2012 through Q1-2019. On the other hand, the S&P 500 measure of aggregate profits is up 40% over this same period.

The S&P 500 measure has tended to account for roughly 50% of the NIPA measure (Fig. 11). It accounted for 63.3% during Q1.

Since most of our efforts in forecasting the stock market are focused on the S&P 500 stock price index, we pay more attention to the S&P 500 data on earnings than on NIPA profits. We can add the earnings of the S&P 400 MidCaps and the S&P 600 SmallCaps to the earnings of the S&P 500 LargeCaps to get closer to the all-encompassing NIPA measure. However, they don’t add much to earnings. The S&P 500 tends to account for about 91% of S&P 1500 aggregate earnings (Fig. 12).

Profits III: The Impact of S Corporations. So what gives? If S&P 500 aggregate earnings remains strong, why the downward revision in NIPA profits?

According to the NIPA Handbook, corporate profits includes all US public, private, and “S” corporations. It also includes other organizations that do not file federal
corporate tax returns—such as certain mutual financial institutions and cooperatives, nonprofits that primarily serve business, Federal Reserve banks, and federally sponsored credit agencies.

Most of the difference between the NIPA measure of profits and the S&P measure is attributable to sub-chapter S corporations and private corporations. So most of the downward revision in NIPA profits must be attributable to them. We don’t have the data on private corporations that is included in profits. We do have some data for S corporations, though the available series is only through 2015, which means it isn’t relevant to the latest revisions for 2016-2018. Nevertheless, consider the following:

(1) Definition. On its website, the IRS explains the difference between C and S corporations: “A C corporation is taxed on its earnings, and then the shareholder is taxed when earnings are distributed as dividends. S corporations elect to pass corporate income, losses, deductions and credits through to their shareholders for federal tax purposes. Shareholders of S corporations report the pass-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. This allows S corporations to avoid double taxation on the corporate income.”

As a result, most of the income of S corporations is paid out as dividends.

(2) Impact on National Income shares. The IRS estimates that there were 4.6 million S corporation owners in the US in 2014—over twice the number of C corporations. The IRS data on S corporation dividends and the BEA data on pre-tax corporate profits show that the ratio of the two has increased from 8%-9% during 1992 to about 20% from 2000-2015 (Fig. 13).

This suggests that S corporations have had a significant impact on exaggerating the increase in corporate profit’s share of National Income over this period. Obviously, I am assuming that S corporation dividends are more like labor compensation than profits. Excluding these dividends from profits shows that this adjusted measure’s share of National Income has been relatively flat around 9%, while the all-inclusive measure has been trending higher from 1992 to 2015, which is the latest available data for S corp dividends (Fig. 14 and Fig. 15).

(3) Impact on effective corporate tax rate. Since S corporations tend to distribute most of their earnings to their limited number of shareholders as dividends, which are then taxed as personal income, they boost corporate profits even though they actually directly benefit the employees of the S corporations. This also explains why NIPA’s effective corporate tax rate has been well below the statutory rate.

Profits IV: Tale of Two Margins. The downward revision in NIPA profits obviously lowered both the profits share of National Income as well as profit margin measures based on the NIPA data. Consider the following:

(1) National Income shares. The revised NIPA data now show that the share of pre-tax profits from current production in National Income has declined from a cyclical high of 14.5% during Q1-2012 to 11.2% (down from the preliminary 12.6%) during Q1-2019 (Fig. 16). That’s the lowest share since Q2-2009.

On the other hand, over the same period, the labor compensation share has increased from 60.4% to 63.1% (up from the preliminary 62.2%), the highest since Q4-2009 (Fig. 17).

(2) Profit margins. Data on the S&P 500 profit margin is available since Q1-1992 (Fig. 18). We found that it has been correlated with a NIPA proxy for the profit margin, i.e., after-tax corporate book profits divided by nominal GDP, most of the time. That has not been the case in recent years, as the former has been moving higher while the latter has been moving lower.

During Q1-2019, the S&P 500 profit margin was 10.3% using reported earnings and 11.6% using operating earnings (Fig. 19). Both are near last year’s record highs.

(3) Bottom line. The conclusion is that comparing NIPA profits and S&P 500 earnings is like comparing apples and oranges. Actually, the NIPA measure is more like a fruit cocktail with lots of different fruit juices. That makes it hard to explain the latest NIPA revisions, especially since the S corp data are only available through 2015. For those of us in the stock market, what matters—and remains bullish—is the trend in the S&P 500 earnings.

(4) Warning label. The above analysis of the relationship of NIPA and S&P profits was inspired by several recent email queries about their divergence from our accounts. To repeat: The key takeaway is that NIPA data are complicated and can be misleading if not properly understood and interpreted. The revisions in the data can occasionally paint a significantly different picture of the economy than the preliminary data. The NIPAs should come with a warning label: “The following data are prone to misinterpretation if not carefully analyzed, and may be revised significantly from time to time.”

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World Woe I

August 08 (Thursday)

Global Economy: Will Trump Trump Trump? According to his many detractors, President Donald Trump is the cause of all the world’s woes. I’ve had a more balanced view. The world has lots of problems that aren’t attributable to Trump. I’ve discussed the homegrown problems in China, Europe, and Japan. They all have too many old people, not enough young people, too much debt, and out-of-control central banks. However, Trump’s escalating trade wars since early 2018 have exacerbated the world’s woes. That’s most apparent in global manufacturing indicators, which have been weakening since early last year, as we reviewed in Tuesday’s Morning Briefing.

Trump is a disruptor, for sure. He has upended the post-WWII multilateral world order. His goal is a more bilateral world where the US can use its economic clout for the benefit of the US economy. As I discussed yesterday, his endgame with China may be more about forcing companies to move their supply chains out of China than to get a trade deal.

In any event, he now doesn’t see a deal with China until after he wins next year’s presidential election. But he won’t win if all of his huffing and puffing (H&P) over trade continues to weaken global growth and harms the US economy. So he is doing more and more H&P about the need for the Fed to lower interest rates more aggressively. Since late last week, the stock market’s reaction to his latest round of H&P has been decidedly negative. The mounting risk is that Trump may trump Trump as he unleashes his deal-making skills on the world.

The world’s woes are easy to monitor via the CRB raw industrials spot price index, which is down 14% since the start of last year through Monday to the lowest level since 4/6/16 (Fig. 1). That has leveled out our Boom-Bust Barometer (which is the ratio of the CRB index to initial unemployment claims) since early last year (Fig. 2). This indicator tends to be highly correlated with the S&P 500, which nevertheless managed to rise to a new record high on 7/26 as S&P 500 forward earnings rose to a record high in early August (Fig. 3).

Another recent example of the world’s woes is Germany’s industrial production (excluding construction). It plunged 1.8% m/m during June and is down 6.2% y/y, to the lowest level since December 2016 (Fig. 4). Auto production on a 12-month sum basis fell again during July, to 4.7 million units, slightly below the 2009 trough (Fig. 5). I seriously doubt that Germany’s woes all are attributable to Trump, though his policies clearly are weighing on China’s economy, which means fewer Chinese imports of German cars.

Energy: For Whom the Tariffs Toll. To see the impact of Trump’s tariffs on the S&P 500, we measured performance from 4/3/18, the day the Trump administration released its $50 billion list of 1,333 Chinese products under consideration for 25% tariffs.

As you’d expect, S&P 500 Industrials, Materials, and Energy sectors were hit hardest. A bit more surprising was the Financials sector’s appearance near the bottom of the list and Real Estate’s location at the top. Here’s the performance derby for the S&P 500 sectors from 4/3/18 through Tuesday’s close: Real Estate (22.4%), Information Technology (21.4), Utilities (19.4), Consumer Discretionary (17.5), Consumer Staples (13.2), Health Care (13.0), S&P 500 (11.6), Communication Services (9.9), Industrials (2.9), Materials (1.2), Financials (0.3), and Energy (-11.5) (Table 1).

The Energy sector has been hurt by the drop in demand growth from a slowing global economy. The price of Brent crude oil per barrel has fallen 17% since 4/3/18 (Fig. 6).

The Energy Information Administration trimmed its forecast for the growth in global oil consumption during 2019 to 1.0% as of 8/6 from 1.1% on 7/9, making August the seventh consecutive month the estimate was reduced. World consumption, at 100.91mbd, is projected to be slightly below global production of 101.02mbd—an estimate that also was trimmed slightly this month, to 0.3% growth from 0.4%.

The US fracking miracle continues to change the industry’s dynamics (Fig. 7). And others are looking to emulate our success. Vista Oil & Gas is tapping into Argentina’s shale oil and gas basin, Vaca Murta, which is estimated to have about 27 billion barrels of potential resources, an 8/6 FT article reported. Argentina hopes to double its oil production to 1mbd by 2023, and some of the major oil companies have announced plans to boost production in the area.

The S&P 500 Energy sector’s 11.5% decline since the trade war began fails to reflect the deeper damage borne by some of its component industries: Oil & Gas Equipment & Services (-42.2%), Oil & Gas Drilling (-32.1), Oil & Gas Exploration & Production (-19.8), and Oil & Gas Refining & Marketing (-13.1).

China: A Fist Full of Dollar-Denominated Debt. There’s an old saying in the world of bankruptcy workouts that’s attributed to JP Getty: “If you owe the bank $100, that’s your problem. If you owe the bank $100 million, that’s the bank’s problem.” We’re not quite sure who owns the debt that China’s corporations and state-run companies have outstanding (stay tuned!). But there’s certainly an awful lot of it.

Jackie took a look at China’s $4 trillion corporate bond market and $21 trillion bank loan market in the 7/25 Morning Briefing. Her focus was some of the issuers who were defaulting on their obligations. China’s weakening of the yuan, presumably in retaliation for President Trump’s tariffs, made us explore another avenue: the amount of dollar-denominated debt Chinese organizations have outstanding.

The Bank of International Settlements’ Q1 report breaks Chinese dollar-denominated debt down among resident issuers (those that are incorporated in China) and national issuers (those who have a Chinese parent company). Here’s Q1 debt among the former: banks ($68.6 billion), other financial corporations ($71.0 billion), non-financial corporations ($27.4 billion), and general government ($5.2 billion). Among national issuers, the figures are: banks ($272.3 billion), other financial corporations ($149.4 billion), and non-financial corporations ($444.0 billion).

Together, that equates to $1.0 trillion of dollar-denominated debt, though it’s unclear whether there’s overlap among the two categories. It’s also unclear whether the data being reported is accurate. “According to analysts at Nomura, the amount of offshore dollar bonds issued by Chinese corporations was $841.6 billion at the end of June,” an 8/7 WSJ article reported. That’s almost twice the BIS figure.

President Donald Trump should be eternally grateful to those who lent to Chinese entities in dollars because the burden of repaying that debt may prevent the Chinese government from sharply devaluing its currency. The country has been manipulating the yuan around the edges, letting it settle slightly above 7 yuan per US dollar this week (Fig. 8). But it’s unlikely the country can seriously devalue its debt because doing so would put more pressure on the issuers of dollar-denominated paper.

Here’s some more news on dollar-denominated Chinese debt:

(1) New issue market has been on fire. Asian dollar-denominated, high-yield debt issuance has been at a record pace this year, with Chinese issuers leading the way. Of the $59 billion of dollar-denominated Asian debt sold ytd through 7/26, Chinese companies represented about $38 billion, according to a 7/28 WSJ article. Higher yields helped sell the debt. On average, Chinese junk issues were yielding 7.9% by the end of July, compared to 6.0% for US junk bonds and 3.1% for euro-denominated, high-yield debt.

(2) Developers were big borrowers. Chinese real estate developers were the largest issuers of dollar-denominated debt. They have $114 billion of offshore high-yield bonds outstanding, up from $8.9 billion in 2010. About $21 billion of that debt will be due in 2020 and $29 billion in 2021, the 7/28 WSJ article stated, crediting Fitch.

An 8/5 WSJ article citing Moody’s said $33.8 billion of onshore and $19.3 billion in offshore bonds issued by developers either mature or are subject to put options in the next year. The article continued: “Several hundred minor players have already been bankrupted this year: wider failures could have a knock-on impact through an already fragile financial system, parts of which are short of dollars already. Last month, the government restrained the ability of developers to issue offshore bonds for anything other than refinancing maturing dollar debt, perhaps in anticipation of currency weakness. All of that suggests that even if seven is no longer the magic number for the PBOC, policy makers will want to prevent the yuan from weakening too far.”

(3) Running short on dollars? The Chinese dollar issue may be bigger than just the need to meet dollar-debt maturities. Kyle Bass, CEO of Hayman Capital Management, who’s known for betting against subprime mortgages during the financial crisis, told CNBC on 8/5 that the Chinese need dollars to buy oil, food, and basic materials. The country is running both a current account and a fiscal deficit. And while China says it is 15% of the world’s economy, less than 1% of global transactions settle in yuan.

Kevin Lai, chief economist for Asia excluding Japan at Daiwa Capital Markets, is also on alert. He believes that China’s growing external US dollar leverage is being underestimated, and it could possibly trigger a major financial crisis, according to a 11/16/18 South China Morning Post article. Lai noted that China’s dollar debt makes it vulnerable because of tightening US dollar liquidity, a weakening yuan, and the US-China trade war. Stay tuned.

Disruptive Technology Review. It may be the hazy, lazy days of summer, but disruptive technology is moving faster than ever. Here’s an update looking at new delivery methods, robots in stores, and tech firms invading the world of finance:

(1) Delivery without the guy. Meet Scout, Amazon’s six-wheeled, sidewalk-driving delivery robot. Looking a bit like a beach cooler on wheels, Scout has begun making deliveries in the Irvine, California area. It’ll work during daylight hours, accompanied by an “Amazon Scout Ambassador”—a.k.a. a human making sure it doesn’t get lost and answering questions from people in the neighborhood, according to an 8/6 Techcrunch article.

Scout has been operating in the Seattle area “over the past few months” and has navigated both rain and snow. In a video about Scout on Amazon, Scout rolls up the sidewalk and stops in front of a house. The homeowner then comes out to Scout to retrieve the package.

At first glance, Scout doesn’t seem able to climb front steps or ring a doorbell. It’s unclear what it would do if the homeowner wasn’t home. Wouldn’t it be great if they could teach Scout to walk our dogs?

(2) Marty arrives at Stop & Shop. Imagine our surprise as we were racing through Stop & Shop and saw in the distance a beeping, moving object with large eyes. Could it be one of the robots we’ve been writing about all these many months?

Yes! Marty has arrived on Long Island! He’s 6 feet, 8 inches tall and goofy enough looking to make you smile. The Marty we saw did cause some congestion in the aisles (he moves very slowly), but most people who encountered Marty chuckled and moved on.

Marty’s job is to monitor the aisles for any spills or items that could harm customers. When he spots something amiss, he sends a message over the public address system asking for an employee’s help. Five-hundred Martys are being put to work this year at Stop & Shops in New York, Massachusetts, Connecticut, Rhode Island, and New Jersey, a 8/6 Newsday article reported.

(3) Banks under siege. Banks are facing competition from two very large entities: Apple and the Federal Reserve.

Apple has started rolling out its new consumer credit card with Goldman Sachs. Here are some of the details from an 8/7 MarketWatch article: “People will be able to sign up for the card direct from their iPhone—to do so, they will need to have the latest version of the iOS software. They will be prompted to provide personal information including age, address and the latest four digits of the Social Security number. That information will be then sent to Goldman Sachs for approval, which should take less than a minute. If approved, people will be able to start using their card almost immediately with the Wallet app and Apple Pay. A physical card will also be mailed to these customers.” This is great news for Apple and Goldman and bad news for any other credit card issuer.

Were that not enough, the Federal Reserve has announced plans to develop a faster payment system for banks to exchange money. The catch: There’s another real-time money exchange network set up by big banks. “The new [Federal Reserve] system would allow bill payments, paychecks and other common consumer or business transfers to be available instantly and round-the-clock, a change from the government’s current system that is closed on weekends and can at times take days to settle a transaction. The Fed said it anticipates that the new service will be available in 2023 or 2024, and will support payments of up to $25,000,” the 8/5 WSJ article reported.

Big banks—including Citigroup, US Bancorp, and JPMorgan Chase—already have invested about $1 billion in their own clearing system. The Fed has decided to build a second system because it believes the competition would lower costs, improve efficiency, and reduce the vulnerability of the financial system while creating redundancy.

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Tariff Man vs Mao Man

August 07 (Wednesday)

Trade War I: Chinese Checkers. President Donald Trump started the trade war with China on 4/3/18, when his administration released its $50 billion list of 1,333 Chinese products under consideration for 25% tariffs. The month before, on 3/2/18, Trump famously pushed back against a wave of criticism about steel tariffs that he had imposed in February of last year, saying “trade wars are good, and easy to win.”

He would have been right if the Chinese had concluded a deal in early May, as was widely expected thanks to Trump’s cheerleading. Most of the details had been worked out. However, the remaining big issue was the enforcement mechanism. Trump wanted the Chinese to change their laws to reflect the agreement, particularly on intellectual property rights. The Chinese balked at going that far.

Chinese President Xi Jinping’s hardliners on trade apparently convinced him that no deal is better than the deal that had been negotiated. Trump has his hardliners on trade too, including trade adviser Peter Navarro and US Trade Representative (USTR) Robert Lighthizer.

So on Sunday 5/5 of this year, Trump announced that the 10% tariff on $200 billion of imports from China, which had been imposed on 9/24/18, would be raised to 25%. He also threatened to impose the 25% tariff on the rest of US imports from China. On Thursday 8/1, immediately following another round of talks, Trump slapped a 10% levy on $300 billion of those goods and threatened to up it to 25%. All US imports from China now face a tariff of 10% for $300 billion of imports and 25% for $250 billion of imports.

China retaliated on Monday 8/5 by freezing all agricultural imports from the US and by devaluing its currency below 7.00 yuan per dollar. The prospect of a currency war along with a trade war sent stock prices reeling, with the S&P 500 falling 6.0% from its record high on 7/27 through Monday’s close.

In fact, it may be that the two hardest of the hardliners are none other than Xi and Trump. The two leaders are playing a dangerous game of Chinese checkers. Chinese checkers isn’t a variation of checkers, nor is it originally Chinese in origin. However, the object of the game is to win by moving all one’s pieces into the star corner on the opposite side of the board before your opponent does the same.

Trade isn’t a game, of course. When it is done right, both trading partners should benefit from the relationship. If it devolves into a trade war, there can be no winners no matter who claims that title.

Nevertheless, back on 5/28, I wrote that if the trade war escalates, “I expect it will do more damage to China’s economy than to the US economy. As Debbie and I observed last week, nominal GDP in the US was up to a record $21 trillion (saar) during Q1-2019. Over the past 12 months through March, US merchandise exports to China totaled $114 billion while US imports from China totaled $522 billion. Both are small relative to the size of our economy” (Fig. 1). Chinese exports to the US, in yuan, account for 18.4% of total Chinese exports, based on the 12-month average (Fig. 2).

Regarding a possible currency war, I wrote: “If push does come to shove and Trump slaps a 25% tariff on all Chinese goods imported by the US, the inflationary shock could be offset by a weaker yuan.” The drop in the Chinese currency below the key psychological level of 7.00 yuan per dollar on Monday certainly unnerved stock investors (Fig. 3).

Stocks recovered some of their losses yesterday because the exchange rate stabilized after the Chinese central bank indicated that it isn’t intent on starting a currency war. The Chinese already have a problem with capital outflows, which would worsen if they significantly devalued their currency. Our monthly proxy for implied capital outflows shows that they totaled about $400 billion over the 12 months through June (Fig. 4). (We derive this proxy as the 12-month change in China’s non-gold international reserves minus the 12-month sum of China’s merchandise trade surplus.)

Trade War II: Trump’s Game. What does Trump want? He wants to win another term on 11/3/20. What does Xi want? He wants Trump to lose. They both know that. Xi is president for life, so he figures he can easily outlast Trump, though having to deal with Trump through 2024 would be more challenging than through 2020. Trump must know that even if he gets a deal with China before the election, that won’t mean much if he loses. He seems to be talking up the scenario of a post-election deal, perhaps believing that timing will yield a better deal from the Chinese, assuming he wins a second term.

The following is from a Friday 7/26 Bloomberg article titled “Trump Says China May Delay Trade Deal Until After 2020 Elections”:

“President Donald Trump said China may wait until after the 2020 U.S. presidential election to sign a trade agreement because Beijing would prefer to reach a deal with a Democrat. ‘I think that China will probably say, ‘let’s wait,’ Trump told reporters in the Oval Office on Friday. ‘When I win, like almost immediately, they’re all going to sign deals.’”

In other words, Trump may have decided that he will get a better deal once he wins next year’s election (if he wins). On Monday 7/29, USTR Lighthizer and Treasury Secretary Steven Mnuchin went to China for the first high-level, face-to-face trade negotiations since talks broke down in early May. The talks lasted just two days, with no progress, and on Thursday 8/1, Trump escalated the trade wars, as noted above.

Meanwhile, Trump is also playing Chinese checkers with Fed Chair Jerome Powell. So far, it’s no contest: Trump is winning the game. Trump must figure that he needs the Fed to lower interest rates while he waits for the Chinese to come around on trade, hoping to strike a deal after the elections.

In the 7/11 Morning Briefing, we predicted that Trump would force the Fed to lower interest rates by creating uncertainty about US trade policy. We noted that in his 7/10 congressional testimony on monetary policy, Powell mentioned the trade issue eight times. So Powell had been trumped by Trump, as evidenced by the Fed’s decision to cut the federal funds rate by 25bps on 7/31 (Fig. 5). The very next day, Trump upped the tariff ante.

In response to Monday’s stock market rout, Fed Governor Lael Brainard said at a forum at the Kansas City Fed, “I am certainly monitoring developments for their implications for the outlook and I will continue to be very attentive to them.” The 12-month federal funds rate futures plunged to 1.17% on Monday (Fig. 6). That implies four 25bps cuts in the federal funds rate by August of next year.

Trade War III: Xi’s Game. In addition to the trade war with the US, President Xi has plenty of homegrown problems. The country’s economic growth is slowing. There is too much debt, and more zombie companies that can’t service their debts. Large capital outflows have been a problem in recent years.

Xi’s biggest immediate challenge is the unprecedented pro-democracy protests in the self-governing region of Hong Kong. How to respond is a test for Xi’s leadership and has the potential to worsen US relations if he opts for a violent solution. The unrest in Hong Kong has become intertwined with US and China trade relations as Chinese officials have blamed the US for the protests, though there is no evidence to support it, observed the 8/2 NYT.

China certainly has taken unfair advantages of the US when it comes to trade. The problem now is that attempting to work out a win-win “free and fair” trade deal with a society that is not free or fair may prove futile. Consider the following:

(1) The life of the party. Xi is a communist. In many ways, he is Mao in a business suit. Since assuming power during 2013, Xi has ended term limits, securing his power as leader for life of the Communist Party of China (CPC). Nevertheless, “Xi has a legion of internal critics, including over his handling of relations with Washington,” said Richard McGregor, an expert on the CPC and the author of a new book about Xi’s leadership, according to an 8/3 article in the Washington Post. The internal critics may be getting more vocal, especially as China experienced its slowest annual growth in nearly three decades during Q2.

Long-time China scholars say that Xi’s efforts to bolster the party and his leadership over it are rooted in insecurity. Taking an admission oath at the site of the first CPC National Congress during 2017, CPC leaders chanted: “It is my will to … strictly observe party disciple, guard party secrets, be loyal to the party, work hard, fight for communism throughout all my life, be ready at all times to sacrifice my all for the party and the people and never betray the party.” Xi’s values are heavily promoted throughout the country and taught to young children in schools.

Xi believes that the risk to his authority is within his own country. “No exterior forces are able to take us down, as we are the world’s largest political party; the only one who can defeat us is ourselves,” Xi wrote on 7/31 for a CPC publication, according to the Washington Post article.

(2) Hong Kong boiling over. Xi has faced more and louder criticism from the semiautonomous region of Hong Kong, where pro-democratic tensions are growing. A proposed extradition bill allowing the detainment and transfer of wanted persons to the Chinese mainland has sparked an unprecedented level of protests, noted the 6/10 NYT; protesters fear the law would extend not just to criminals but to political activists too.

Hong Kong is out of control and may not be restored without a show of force by Beijing. On Tuesday, according to NPR, more than 12,000 police officers conducted anti-riot drills in the southern city of Shenzhen, adjacent to Hong Kong—ostensibly to prepare for the 10/1 70th anniversary of the founding of the People’s Republic of China, but the intimidation factor likely wasn’t lost on anyone.

Trade War IV: The Endgame. An 8/2 post on Foreign Policy’s website is titled “Trump Hired Robert Lighthizer to Win a Trade War. He Lost.” The conclusion that Trump has lost the trade war is based on the pain inflicted by the tariffs: “The entire theory that had anchored the Trump trade policy turns out to have been wrong; it may live on zombielike, but the already minimal returns will diminish more. The United States will hurt itself and others with tariffs without even the prospect of meaningful trade deals.”

But missing in the analysis is that the ultimate endgame for the Trump administration is to force manufacturers around the world to move their supply chains out of China. In that, it is succeeding. Consider the following:

(1) A 7/16 Forbes article is titled “Europe Joins U.S. Companies Moving Out Of China.” It reported: “Make no mistake about it, the trade war is absolutely remapping global supply chains ... to the detriment of Chinese manufacturing. The percentage of China-leaving businesses surveyed by quality control and supply chain auditor QIMA was 80% for American companies and 67% for those based in the European Union.”

While European companies are less affected by the trade war, they have their own reasons to reduce their dependence on China manufacturing. Most are diversifying throughout Southeast Asia and moving closer to home.

(2) A 7/18 Nikkei Asian Review story is titled “China scrambles to stem manufacturing exodus as 50 companies leave.” It reported: “China is racing to keep foreign enterprises in-country, dangling special benefits so that the advantages of staying outweigh the heavy tariffs imposed by the U.S. A year into the trade war with Washington, more than 50 global companies, including Apple and Nintendo, have announced or are considering plans to move production out of China, Nikkei research has found. And not just foreign companies. Chinese manufacturers, as well as those from the U.S., Japan and Taiwan, are part of the drain, including makers of personal computers, smartphones and other electronics.”

(3) The 7/14 WSJ includes an article titled “Manufacturers Move Supply Chains Out of China.” It reported: “The moves by U.S. companies add up to a reordering of global manufacturing supply chains as they prepare for an extended period of uneven trade relations. Executives at companies that are moving operations outside China said they expect to keep them that way because of the time and money invested in setting up new facilities and shifting shipping arrangements. Companies said the shifts accelerated after the tariff on many Chinese imports rose to 25% from 10% in May.”

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TINA Versus TIAA

August 06 (Tuesday)

Strategy I: Panic Attack #64? Randy Forsyth’s 8/2 Barron’s column is provocatively titled “The Case for Going Into Cash Now.” That seems like a timely call. The S&P 500 peaked at a record 3025.86 on July 27 (Fig. 1). It is down 6.0% since then through yesterday’s close. Joe and I are tentatively numbering this selloff as Panic Attack #64. (See our Table of S&P 500 Panic Attacks Since 2009.)

Yesterday, the escalating trade war between the US and China became a currency war as the Chinese let the yuan depreciate above 7.00 yuan per dollar (Fig. 2). They also hit back by halting crop imports from the US.

We expect that the latest escalation will hurt the Chinese economy more than the American economy. By the way, the Chinese Communist government has another major problem brewing in Hong Kong. Pro-democracy demonstrators have staged huge rallies in Hong Kong protesting the authoritarian practices of the regime in Beijing, which is threatening to use military forces to quash the protests. It has the potential for turning very ugly very quickly.

We don’t expect that rising trade tensions with China will push the US economy into a recession. The devaluation of the yuan means that some of the tariff costs to US consumers will be offset by the weaker Chinese currency. So Chinese exporters will get lower revenues in their local currency for their dollar sales in the US. In other words, Trump is partly right when he says that the Chinese will absorb some of his tariffs. But they will do so by manipulating their currency to remain competitive in the US.

Strategy II: Is Cash Still Trash? In his aforementioned column, Randy observes that the bull market in stocks has been driven by TINA, which is the acronym for “There Is No Alternative.” He reports that the JPMorgan’s Global Markets Strategy team is touting TIAA, which stands for “There Is An Alternative,” specifically US-dollar cash equivalents.

Joe and I have been bullish on stocks during the current bull market because we have been bullish on earnings. We still are. A certain contingent of bullish strategists hasn’t been as enthused about the bull market in stocks. Their mantra has been “There Is No Alternative.”

It’s hard to get enthusiastic about investing in stocks just because the alternatives aren’t compelling. The most obvious alternative asset class is the one for bonds. The flow-of-funds data clearly show that lots of investors continue to buy bonds, which have done well since early 2009 along with stocks. Since the start of 2009, bond mutual funds have attracted $2.4 trillion through June of this year (Fig. 3). ETF bond index funds have attracted $667 billion over this same period (Fig. 4).

The most obvious alternative to both stocks and bonds is cash, which has been widely viewed as “trash” because the major central banks have kept their official interest rates near zero since 2009. They’ve actually been slightly negative in the Eurozone and Japan for the past few years. At the end of July, the Fed stopped normalizing the federal funds rate and lowered it for the first time since 2008 (Fig. 5).

Nevertheless, as Randy reports, cash is an alternative to stocks, especially if the latest panic attack is actually the start of the long awaited and widely anticipated bear market, which we don’t believe it is.

Over the weekend, just by coincidence, we learned that Warren Buffett is sitting on a ton of trash—that is, cash. In quarterly earnings reported on Saturday, Berkshire Hathaway announced it has a staggering $122 billion in cash and equivalents. That’s a record amount for the investment firm and up from $112 billion during Q1. According to the 8/3 Bloomberg story on Buffett, the “growing cash pile is a reflection of the strength of the operating businesses that Buffett has assembled under one roof, and allows the billionaire investor flexibility to move quickly when big deals emerge.” The problem is that he can’t find any stocks to buy that aren’t overvalued. Another panic attack might give him the opportunity to do so.

Strategy III: Are Earnings Still Bullish? Now let’s revisit the most important driver of stock prices. That would be earnings. An 8/4 Bloomberg story on this subject is titled “It's Not Just the Fed and Trump That Trouble the Stock Market.” Last week’s selloff in stock prices was not all about Jerome Powell and Donald Trump. During the current earnings season, misses have been punished by more than hits have been rewarded. The article observed:

“Among S&P 500 companies that have reported second-quarter results, those whose trailed analyst estimates saw their stock lagging behind the market by 3 percentage points the day after, data compiled by Goldman Sachs showed. Meanwhile, beats were rewarded by gains of 1.43 percentage points. The spread, more than 4 points, was the third biggest since 2012.

“The divergence in performance shows that even in an environment where macro concerns seem to dominate, getting stock selection right still has consequences. Earnings haven’t lost their ability to move markets—something else to worry about as companies slash their forecasts at the fastest rate in four years.”

Without any further ado, let’s look at the latest stats on S&P 500 revenues and earnings:

(1) Earnings season. We are well into the Q2 earnings season. The typical upward “earnings hook” was Missing in Action (MIA—since acronyms are in fashion) until the 8/1 week. The actual/estimate blend for Q2 earnings jumped that week so that the y/y growth rate is now 0.4%, up from -2.0% the prior week (Fig. 6 and Fig. 7). The prospects for Q3 have turned a bit more negative, with a 1.1% drop now expected by industry analysts. The projected growth rate for Q4 is still solid at 5.7%, but that’s down from 11.7% at the beginning of the year.

(2) Forward revenues. The good news is that S&P 500 forward revenues rose to a record high during the 7/25 week (Fig. 8). That augurs well for actual quarterly results for both Q2 and Q3. On the other hand, revenues growth is expected to fall from 8.9% last year to 4.2% this year. However, that’s still reasonably good growth in the face of lots of gloomy headlines about global economic growth. And next year, revenues are expected to be up 5.3%. There’s no recession in any of these projections.

(3) Forward earnings. The forward profit margin has been holding up remarkably well around 12.0% since the start of the year. So the record high in forward revenues is mirrored in the record high in forward earnings during the 8/1 week (Fig. 9). Although industry analysts currently expect that earnings will grow just 2.0% this year, they remain upbeat about next year, with a 10.8% growth estimate (Fig. 10).

Strategy IV: Global Manufacturing Recession? The global manufacturing sector has been slowing since early last year. Now the situation is starting to look like a growth recession. It could turn into an outright recession for the sector. The weakness has been mostly blamed on Trump’s escalating trade war. Debbie and I think it might also have a lot to do with the slowing in the economies of the Eurozone, China, and Japan as a result of homegrown problems.

The biggest domestic problem for all of them is demographic profiles that are rapidly turning geriatric, as we’ve discussed numerous times before. All these economies are also drowning in debt, so adding more debt only makes it harder for them to stay afloat! Both fiscal and monetary policies have lost their abilities to stimulate growth. Other than that, everything is hunky-dory, particularly in the global services economy. Let’s review the latest relevant data:

(1) Commodity prices. The CRB raw industrials spot price index is down 8% ytd through last Friday, and down 14% since the start of 2018, when Trump started his trade wars (Fig. 11). The index is the lowest since 4/6/16, when the US and global economies were starting to recover from the 2015-2016 growth recession that was triggered by the plunge in commodity prices back then.

(2) M-PMIs. The JP Morgan Global M-PMI edged down to 49.3 during July from 49.4 during June (Fig. 12). It has been below 50.0 since May. The M-PMI for developed markets fell to 48.6 last month, while the M-PMI for emerging markets was 50.1 (Fig. 13).

Among the major industrial economies, the M-PMI for the US fell to 51.2 last month, down from an August 2018 high of 60.8 (Fig. 14). It is the lowest since August 2016. Below 50.0 are the M-PMIs for the Eurozone (46.5), the UK (48.0), and Japan (49.4).

All the BRICs’ M-PMIs are below 50.0 except for India’s. The latest readings: Russia (49.3), China (49.7), Brazil (49.9), and India (52.5).

(3) Economic sentiment. The Economic Sentiment Indicator for the Eurozone fell to 102.7 during July, the lowest reading since March 2016 (Fig. 15). It is highly correlated with the y/y growth rate of the region’s real GDP, which was up only 1.1% during Q2, according to the flash estimate. Leading the weakness in the indicator is the industrial component; here are the data: industrial (-7.4), consumer (-6.6), retail trade (-0.7), construction (5.0), and services (10.6) (Fig. 16).

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Trump’s Trump

August 05 (Monday)

The Fed: Bad Trade. Our 7/11 Morning Briefing was titled “Powell Gets Trumped!” We wrote: “President Donald Trump wants the Fed to lower interest rates. Fed Chair Jerome Powell claims that the Fed is independent and won’t bow to political pressure. Yet Trump has figured out the perfect way to force the Fed to lower interest rates. All he has to do is keep creating uncertainty about US trade policy. In his congressional testimony yesterday on monetary policy, Powell mentioned the trade issue eight times in his prepared remarks.”

Consider the following related developments last week:

(1) FOMC decision. Sure enough, last Wednesday, the FOMC voted to lower the federal funds rate’s target range from 2.25%-2.50% to 2.00%-2.25% (Fig. 1). That was the first rate cut since 2008. In addition, the FOMC decided to terminate quantitative tightening (QT) ahead of schedule: “The Committee will conclude the reduction of its aggregate securities holdings in the System Open Market Account in August, two months earlier than previously indicated” (Fig. 2). From 10/1/17 through 7/31/19, the Fed’s balance sheet was pared from $4.4 trillion to $3.7 trillion.

The 7/31 FOMC statement attributed this decision to “the implications of global developments for the economic outlook as well as muted inflation pressures.” Also, the word “uncertainties” was used regarding the economic outlook—the first time this word has appeared in an FOMC meeting statement since 3/18/03. Back then, the concern was about “geopolitical uncertainties,” specifically the imminent war with Iraq. Today’s uncertainties are similarly geopolitical, centering around Trump’s escalating trade wars.

(2) Stock market reaction. Despite the rate cut, the S&P 500 fell 1.1% last Wednesday (Fig. 3). That’s because in his press conference following the FOMC meeting, Powell characterized the move as a “midcycle adjustment.” He mentioned the phrase three times in his Q&A with reporters, implying that another rate cut at the September meeting is not a foregone conclusion (italics ours):

“So we do think it [i.e., the rate cut] will serve all of those goals, but again, we’re thinking of it as essentially in the nature of a midcycle adjustment to policy.”

“What I said was it’s not a long cutting cycle, in other words referring to what we do when there’s a recession or a very severe downturn. That’s really what I was ruling out. I think if you look back at other midcycle adjustments you’ll see, you know, I don’t know that they’ll be in the end comparable or not, but you’ll see examples of these.”

“But in other cycles the Fed wound up raising rates again after a midcycle adjustment. Again, I’m not predicting that, but I don’t think that we know that we won’t have—that we’ll have less ammo because of these things.”

(3) Trump’s tweet. On Wednesday afternoon, Trump was quick to attack the Fed’s decision. He tweeted: “What the Market wanted to hear from Jay Powell and the Federal Reserve was that this was the beginning of a lengthy and aggressive rate-cutting cycle which would keep pace with China, The European Union and other countries around the world. … As usual, Powell let us down, but at least he is ending quantitative tightening, which shouldn’t have started in the first place—no inflation. We are winning anyway, but I am certainly not getting much help from the Federal Reserve!” (A 7/30 Bloomberg post provides a handy timeline of Trump’s key quotes on Powell and the Fed.)

(4) Trump escalates trade war with China. The S&P 500 recovered some of its losses on Thursday morning of last week. However, it closed down 0.9% that day after Trump said that the US will impose a 10% tariff on an additional $300 billion worth of Chinese imports next month. The new tariff comes on top of the 25% levy that Trump has already imposed on $250 billion worth of Chinese imports—so the US will be taxing nearly everything China sends to the US. Trump added that the tariffs could be raised to 25% or higher if the talks continue to drag on without any significant progress, but he allowed that alternatively they could be removed if a deal is struck

Trump’s announcement came one day after his top trade negotiators returned from two days of fruitless trade talks with their Chinese counterparts in Shanghai. Both sides said that there would be more discussions in Washington next month.

The 8/1 NYT reported: “Talks have been complicated by the recent emergence of Zhong Shan, China’s commerce minister, as a lead negotiator for the Chinese, according to a person familiar with the discussions. Mr. Zhong’s role has signaled to some in the Trump administration that the hard-liners in China are winning the debate over the reformers, such as Vice Premier Liu He, who are more open to making structural economic changes that the United States wants.”

An 8/1 Bloomberg post observed that Trump’s escalation of the trade war with China the very day after he was disappointed by the Fed’s lame decision was not coincidental: “[A]fter the Fed chairman said his rate cut was justified by trade tensions, it makes sense the president would be tempted to create more of them.” (You read it here first in our 7/11 commentary.)

An 8/1 Reuters story came to the same conclusion about how Trump has trumped the Fed into cutting interest rates by escalating the trade war with China. It was titled “Trump's new tariffs may set stage for more Fed rate cuts.” It noted: “The president’s mid-afternoon bombshell [on Thursday] sent stock markets tumbling and Treasury bond yields plunging to their lowest levels in nearly three years. It unleashed frantic buying in interest rate futures markets that 24 hours earlier had been scarred by Fed Chair Jerome Powell’s indication that Wednesday’s quarter percentage point interest rate cut—the first since the financial crisis—was not intended as the start of a lengthy easing cycle. By the close of trading on Thursday, however, markets had restored full expectations that the Fed indeed would need to ease policy substantially more from here.”

The yields in the federal funds futures market, which jumped higher on Wednesday, fell to new 2019 lows on Thursday, with the nearby rate dropping to 1.91%. Friday data are available for the 3-month (1.86%), 6-month (1.62), and 12-month (1.38) yields, which continued to set new lows for this year (Fig. 4). These futures yields suggest that the Fed will cut the federal funds rate two or three more times by next summer. That’s certainly possible if Trump continues to trump the Fed by stirring up uncertainty about trade.

(5) Still appropriate. While Powell’s “midcycle adjustment” comment threw a damp rag on hopes of a series of rate cuts, the FOMC statement still promised that the Fed “will act as appropriate to sustain the expansion.” That became the new boilerplate clause in the 6/19 statement, implying that the Fed is ready to lower interest rates (Fig. 5).

In the first three statements of this year (1/30, 3/20, and 5/1), the key boilerplate clause had been: “[T]he 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.” That implied that the Fed wasn’t rushing to raise or to lower interest rates.

Powell has pivoted from calling for more rate hikes last October to waiting and seeing patiently whether incoming data warranted hikes early this year, to possibly cutting the federal funds rate if that was deemed appropriate, to actually cutting it, to suggesting that the cut might be a one-and-done adjustment. In this uncertain world, Powell is certainly a perplexing pivoter.

US Trade: Not So Bad. In his recent congressional testimony and press conference, Powell attributed the Fed’s rate cut mostly to uncertainty about the outlook for trade. The latest US merchandise trade data—for June, released on Friday—weren’t so bad. They weren’t good either; but notably, they weren’t bad enough to justify the latest rate cut, let alone a series of rate cuts. Consider the following:

(1) Inflation-adjusted US merchandise exports fell 1.3% y/y during June, while imports on the same basis rose 1.8% (Fig. 6). Both are the weakest growth rates since the midcycle slowdown during 2015 and 2016. Back then, the Fed slowed the pace of rate hikes. There were no rate cuts.

(2) US trade with China is showing some weakness, resulting from mounting trade tensions and tariffs. Over the past 12 months through June, US merchandise imports from China fell to $509 billion from a record $540 billion during December (Fig. 7). US exports to China over the past 12 months through June are down to $108 billion from a record high of $135 billion last July.

(3) The US trade deficit remains large, confirming that the world’s largest economy continues to stimulate the global economy by importing much more than it exports. On a 12-month basis, the US merchandise trade deficit widened to a record $886 billion in June, with the following breakdown: China ($401 billion), Eurozone ($156 billion), Mexico ($93 billion), Japan ($69 billion), Canada ($21 billion), and the rest of the world ($146 billion) (Fig. 8).

(4) US petroleum trade data confirm that US is energy independent. The 12-month sum of the US trade deficit in crude oil and petroleum products narrowed to just $32 billion during June (Fig. 9). This series is down from a record high of $409 billion during October 2008. That’s a significant windfall for the US economy.

US Employment: Still Good. The US labor market certainly doesn’t justify rate-cutting by the Fed. The data that make the headlines continue to be robust. Consider the following:

(1) Household survey. During July, the labor force rose 370,000 following a gain of 335,000 during June, suggesting that we haven’t run out of workers. The household measure of employment rose 283,000 last month following a gain of 247,000 the month before. The unemployment rate was 3.7% during July, the sixth consecutive reading below 4.0% and the twelfth in 13 months. Full-time employment (in the household survey) rose to a record 130.4 million during July.

(2) Payroll survey. The payroll employment survey (which counts the number of jobs rather than the number of workers) is showing slower growth, but that may reflect skills and geographical mismatches as the labor market tightens. Over the past three months through July, payrolls are up 139,700 per month on average versus 184,250 per month during the first four months of this year.

The weakest headline stat in July’s employment report was average weekly hours in private industries (Fig. 10). It fell 0.3% m/m and 0.6% y/y (led by drops of 0.7% m/m and 1.5% y/y in manufacturing hours). The weakness in the total hours worked offset all of the 0.3% m/m and some of the 3.2% y/y increases in average hourly earnings, weighing on the month’s Earned Income Proxy for private-sector wages and salaries, as Debbie discusses below.

Movie. “The Farewell” (+ +) (link) is a heart-warming film about love, family, life, and death. So it covers lots of ground and also provides some great insights into the cultural similarities and differences between Americans and the Chinese. Billi, a young independent woman, emigrated with her parents to the US from China more than 25 years ago. They return to China under the guise of a fake wedding to stealthily say goodbye to Billi’s beloved grandmother, who has only a few weeks to live but doesn’t know it—and is the only person in the film who doesn't.

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Cleaning Up

August 01 (Thursday)

Consumer Staples: Doing Fine. Fed Chairman Jerome Powell was panned by the markets yesterday after signaling that Wednesday’s rate cut may not be the first in a series of rate cuts. His description of the Fed’s move as a “mid-course correction” sent the Dow Jones Industrial Average down 333.75 by the close. Supporting Powell’s take-it-slow position were recent earnings results out of the S&P 500 Consumer Staples sector confirming that consumers are still spending. The sector, which rose 4.4% in July, reported results that were better than expected because of product innovations, strength in the emerging markets, healthy consumers, and the ability to raise prices around the world.

Here’s the performance derby for the S&P 500 sectors for the month of July through Tuesday’s close: Information Technology (4.8%), Consumer Staples (4.4), Communication Services (4.2), Financials (2.7), S&P 500 (2.4), Consumer Discretionary (2.1), Real Estate (2.0), Industrials (1.7), Materials (1.1), Utilities (0.1), Health Care (-0.7), and Energy (-1.3) (Fig. 1).

Despite July’s strong results, Consumer Staples continues to lag behind the S&P 500’s ytd performance through Tuesday’s close: Information Technology (32.2%), Consumer Discretionary (23.5), Communication Services (23.3), Industrials (22.2), Real Estate (20.8), S&P 500 (20.2), Consumer Staples (19.5), Financials (19.1), Materials (17.2), Utilities (13.0), Energy (9.6), and Health Care (6.3) (Fig. 2).

Analysts have recently grown more optimistic about the sector. The S&P 500 Consumer Staples sector’s net earnings revisions have been positive in June and July for the first time since April 2018 (Fig. 3). The industry’s revenue and earnings are expected to grow by only 3.4% and 1.2% this year, improving to 3.6% and 6.8% in 2020 (Fig. 4 and Fig. 5). Yet the industry’s forward P/E multiple is 19.6 as of 7/25, a premium to the S&P 500’s and 2.3ppts higher than it was a year earlier (Fig. 6). I asked Jackie to take a look at some of the recent earnings that have helped the sector catch fire of late. Here’s her report:

(1) P&G performs. Procter & Gamble turned in fiscal Q4 results that grew awfully fast for such a large company. The company reported a 4% increase in sales, and if you exclude the impact of foreign exchange, acquisitions, and sales, the figure jumps to 7%. Sales benefitted both from price increases of 2%-4% across its business lines and unit-volume increases in all but one segment (grooming, where it declined by 1%). Excluding the company’s one-time, non-cash write-down of its Gillette Shave Care business, EPS jumped 17% to $1.10, beating analysts’ estimates by five cents.

P&G also forecast for fiscal 2020 3%-4% organic sales growth and adjusted EPS growth of 4%-9%. Wall Street analysts were expecting a 3.5% jump in sales and a 5.1% earnings increase, according to a 7/30 CNBC article. The company has been simplifying its portfolio into 10 categories of products that people use every day. All 10 categories grew sales last quarter, and the company gained market share in eight of the 10 categories, CFO Jon Moeller told CNBC.

P&G shares jumped 3.9% after its earnings report, and they’re up 31.0% ytd. Procter is a member of the S&P 500 Household Products industry, which has climbed 27.2% ytd (Fig. 7). The industry is forecast to grow revenue and earnings by 1.0% and 3.9% this year, followed by a 3.1% and 6.1% improvement in 2020 (Fig. 8 and Fig. 9). Household Products’ forward P/E has climbed sharply, to a 19-year high of 23.3 from 16.5 in May 2018 (Fig. 10).

(2) Estee puts on a good face. The S&P 500 Personal Products industry is the top performer in the Consumer Staples sector, having risen 48.6% ytd (Fig. 11). It’s composed of Estee Lauder shares, up 45.3% ytd, and Coty, up 70.6%. Estee Lauder credited strength among Chinese consumers, travel sales, and its skincare lines when reporting stronger-than-expected fiscal Q3 earnings. Net sales rose 11% in the quarter to $3.74 billion, above expectations for $3.57 billion. Adjusted EPS was $1.55, above the $1.30 analysts’ forecast, according to a 5/1 Reuters article. The company also increased its fiscal 2019 net sales forecast to 7%-8% from 5%-6%. Sales in Asia-Pacific, which includes sales in China, grew 25%.

In a 6/24 Barron’s article, Estee Lauder’s CEO Fabrizio Freda discussed the differences between the company’s US and Chinese consumers. The most powerful consumer in the US and Europe tends to be around 38-42 years old. In China, the average is 25. The Chinese “millennials tend to be only children, and get more attention and access to family wealth. Not only that, they have better jobs than their parents and are more educated, and because of this, their initial compensation is much higher than previous generations.”

He continued: “And while in the U.S. millennials are much more dedicated to being cool and trying new things, the power of their spending is lower and less concentrated. Our statistics show that the most independent millennial women globally are in China and this makes them the best consumers in the world. The other big difference is attitude. When we interview people in Europe and the U.S., the reaction today is that the outlook is not as good as yesterday and I’m worried about my future. When you pose the same question in China or India, the answer is that today is better than yesterday and I’m excited about my future.”

The S&P 500 Personal Products industry is expected to grow sales and earnings by 4.7% and 12.1%, respectively, in 2019 and 5.3% and 10.3% next year (Fig. 12 and Fig. 13). Investors already have rewarded this industry, too, with a generous forward P/E of 30.1, which is higher than the industry’s forward P/E has been since 1999 (Fig. 14).

(3) Sweet results from Mondelez. The chocolatier is another company that recently has upped expectations for future financial results. Mondelez said Tuesday that its organic revenue would rise more than 3% this year, more than the 2%-3% it has previously signaled, and its 2019 EPS now is expected to rise 5% compared to the prior forecast of 3%-5%. Q2 organic sales jumped 4.6%, and adjusted EPS climbed to 57 cents from 21 cents a year ago, meeting analysts’ estimates, a 7/30 Reuters article reported. Mondelez benefitted from a 7.6% surge in organic sales in emerging markets, with notable strength in China, India, Southeast Asia, Russia, and Mexico. The company did warn that a hard Brexit could hurt consumer spending in the UK.

Mondelez is a member of the S&P 500 Packaged Foods & Meats industry, which has gained 21.5% so far this year (Fig. 15). The industry is forecast to grow revenue by 3.3% this year and 2.2% in 2020 (Fig. 16). Earnings growth is expected to improve from a 2.6% decline this year to a 6.4% gain in 2020 (Fig. 17). With a forward P/E of 17.0, the industry is still moderately valued relative to the past two decades (Fig. 18).

(4) Bubbly results. Coca-Cola and PepsiCo both produced better-than-expected Q2 results by creating new, innovative products and shrinking portion sizes, helping to more than offset slack demand for sugary and sports drinks. Coke shares have climbed 13.5% ytd through Tuesday’s close, and Pepsi’s shares are up 18.1%, both trailing the S&P 500’s 20.2% return.

At Coca-Cola, organic revenue climbed 6%, operating income adjusted for currency climbed 14%, and operating EPS climbed 4% to 63 cents—beating estimates by two cents. Results benefitted from double-digit volume growth globally in Coca-Cola Zero Sugar and new offerings like Coca-Cola Plus Coffee and Orange Vanilla Coca-Cola. The company jumped into the coffee business with its $5.1 billion acquisition of Costa Coffee earlier this year. It introduced a Costa Coffee ready-to-drink chilled product in Great Britain and its first energy drink, Coca-Cola Energy.

The company raised its forecast for full-year organic revenue to 5%, up from about 4%, and operating income adjusted for currency is now forecast to rise 11%-12%, up from an earlier forecast of 10%-11%, a 7/23 WSJ article reported.

Meanwhile at PepsiCo, last quarter’s results benefitted from the company’s shift to using smaller can sizes with better margins. The company offered new flavors earlier this year, including berry-, lime-, and mango-flavored soda. To appeal to the health conscious, PepsiCo will also be offering Bubly sparkling waters in new fruity flavors. Organic revenue for the quarter rose 4.5%, and excluding one-time items, EPS came in at $1.54, four cents higher than expectations, a 7/9 Reuters article reported.

The S&P 500 Soft Drinks stock price index has climbed 16.6% ytd (Fig. 19). The industry’s revenue is expected to expand nicely this year and in 2020, by 7.2% and 4.5% (Fig. 20). Earnings growth is set to improve from 0.1% this year to 8.4% in 2020 (Fig. 21). Net earnings revisions have just turned positive in the last two months, and the industry’s forward P/E, at 23.6, is high relative to those in recent years, but far below the late 1990s when the industry’s P/E was a bubbly 41.3 (Fig. 22).

Disruptive Technology: Hot Topic. Nuclear fusion has long been the Holy Grail of energy. It’s not the method used in traditional nuclear plants. That’s nuclear fission, where atoms are split in order to generate energy, and the resulting waste remains radioactive for thousands of years. Nuclear fusion is the process that powers the sun and the stars. Atoms are fused together to release energy, and it generates no nuclear waste.

The problem with fusion is that it requires insanely hot temperatures for a reaction to happen. So scientists around the world are working on how to generate more energy from nuclear fusion than a reaction requires, so that additional energy can be harnessed. Let’s take a look at some recent developments in this electrifying subject:

(1) ITER unites the world. The International Thermonuclear Experimental Reactor (ITER) is developing the first industrial nuclear fusion reactor, which will maintain fusion for long periods of time and produce “net energy,” i.e., more than is needed to trigger a reaction. It’s expected to generate 500 megawatts of fusion power from the 50 megawatts needed for a reaction.

ITER took a large step toward its goal when major parts were delivered to the reactor construction site, according to a 7/24 article in ClimateWire. Now the project is 65% complete, and the organization aims to launch operations by 2025.

Started in 1985, ITER members include China, the European Union, Japan, Korea, Russia, and the US. Each member contributes funding and structures for the reactor’s construction.

(2) Bezos jumps in too. Amazon’s Jeff Bezos is one of many investors who collectively have put up $127 million in funding for General Fusion, a British Columbia company that has built all the components for a reactor. Next comes a prototype, to be built over the next five years, followed by a full-scale reactor capable of powering a small city.

General Fusion “injects plasma (or ionized gas), which is surrounded by liquid metal, into a compression chamber where magnets help contain the gas. Then, pistons put pressure on the chamber to compress the plasma to fusion conditions. The now heated liquid metal gets turned into heat, which then gets turned into electricity,” explained a 3/6 CNBC article.

(3) MIT brains at work. Commonwealth Fusion Systems, which was spun out of MIT, is working in partnership with MIT to create its own reactor. The partnership is creating magnets out of rare-Earth barium copper oxide, the CNBC article stated.

Meanwhile, Lockheed Martin is working on a compact fusion reactor that’s 10 times smaller than existing reactors and would fit on the back of a truck. Earlier this week, the US Department of Energy announced $14 million in funding for 10 university-led research projects using the DIII-D National Fusion Facility. Scientists hope that one of these methods will work to replace fossil fuels and reverse the ills of climate change.

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Dividing Up Wealth

July 31 (Wednesday)

Inequality I: The Wealth Divide. Wealth inequality, like income inequality, is a controversial subject. Contributing to the controversy is that both sides in the debate tend to make assertions without providing much, if any, data to support their vociferously held views. The good news is that we now have more data on wealth distribution; the bad news is that this development probably won’t resolve the debate.

In March, the Fed released its new database on the distribution of wealth in the US since 1989, the Distributional Financial Accounts (DFAs). The DFA integrates data from two sources of household net worth: the Survey of Consumer Finances (SCF) sampling of household balance sheets, compiled every three years, and the Financial Accounts (FAs), reflecting the aggregate assets and liabilities of US sectors including households, compiled quarterly. More specifically, the DFA applies the distributions available from the SCF to the more timely FAs. The result, according to the DFA’s introduction, is “the most rigorous reconciliation to date [of these two] concepts of household net worth.”

Wealth inequality is important to study, Fed staff assert in the DFA introduction, because it significantly affects economic outcomes such as economic growth, monetary policy transmission, and aggregate savings rates. Melissa and I are skeptical that wealth inequality has been as important a driver of the US economy as the introduction suggests. True, more wealth has accrued to those at the top of the wealth distribution than to those at the bottom. However, total net worth has substantially increased over the past three decades such that most Americans are better off financially.

One finding of the Fed staff’s preliminary analysis of the DFAs that caught our attention is that corporate equity (excluding pensions) has been the primary driver of household net worth over the past 30 years, accruing mostly to the wealthiest Americans. This is not new news but rather confirmation of a common observation from many previous wealth inequality studies, including ones referenced in the Fed’s DFA introduction.

Some are bothered by this. But it is logical—and inevitable—in a capitalist system that those who undertake more risk are likely to benefit more from stocks during economic expansions, which tend to last much longer than recessions. Not surprisingly, the analysis of the DFAs finds that in the top percentiles, wealth is highly pro-cyclical, while in the bottom percentiles it is less prone to cyclicality. Given that unemployment is at historically low levels and we are in the longest bull market on record, it makes sense that the wealth inequality gap has been widening.

But again, all wealth distribution cohorts have benefited in recent decades. Importantly, wealth held in some asset classes, including real estate and pensions, is more equitably distributed than in others, like corporate equity. Consider the following:

(1) Wealth has become more concentrated at the top. Total US household nominal net worth has quadrupled since 1989 from near $20 trillion to about $100 trillion at the end of 2018, according to the Fed’s report (see Figure 2 on page 26). The Fed’s analysis discusses the percent of the aggregate wealth held by the top 10%, next 40%, and bottom 50% over that time period. For the top 10%, the share of aggregate wealth has increased from 60% to 70%. For the next 40%, the share decreased from 36% to 29%. The bottom 50% share fell from 4% to 1%.

(2) But the pie has grown. Undeniably, the wealthy have gotten wealthier. But focusing narrowly on that fact obscures the broader context: So has everyone else, to some extent. And the overall pie has grown significantly over the period. For the top 10% of US households, net worth has increased from about $12 trillion (60% x $20 trillion) to about $70 trillion (70% x $100 trillion). Net worth for the next 40% is up from about $7 trillion (36% x $20 trillion) to $29 trillion (29% x $100 trillion). For the bottom 50%, the increase in net worth admittedly is insignificant, from just under $1 trillion—i.e., $0.8 trillion (4% x $20 trillion)—to $1 trillion (1% x $100 trillion).

With more “skin in the game,” via their investments, it stands to reason that the wealthy will benefit more than others when the overall pie expands. Their leverage also means that they would take bigger hits were the pie to shrink. Indeed, looking at the distribution of wealth in various asset classes bears out that the riskier assets are concentrated in wealthier hands. Read on.

(3) Corporate equity is a big driver of uneven wealth distribution. Corporate equities and mutual funds (excluding pensions discussed below), which represent about 22% of total US household net worth as of 2018, have long been large drivers of wealth concentration to the top of the distribution. From 1989 through the end of 2018, the share of corporate equities has increased for the top wealthiest 10% of households from 80% to 87%, according to the Fed’s analysis. Total corporate equity has increased from about $3 trillion to about $22 trillion over the timeframe (see Figure 1, panel [a] on page 24 of the report). That means that the top 10% amassed about $17 trillion of the roughly $19 trillion increase in this one asset category.

By the way, noncorporate business equity has also driven the increase in wealth concentration among the wealthiest percentiles. However, it is a smaller asset class, representing about 13% of total assets, or around half of the value of corporate equity.

(4) Real estate and pension wealth are more equitably distributed. Real estate and pensions each separately account for about 25% of total net worth as of 2018. Looking across the four panels of Figure 5 on page 29 of the Fed’s study, one sees that real estate and pensions are more equally distributed than total net worth (i.e., the share of these assets held by the lower two percentile groups are much larger). Meanwhile, noncorporate and corporate business equity are the most concentrated among the top 1%. Nevertheless, the Fed observes that the share of real estate and pension assets has become somewhat more concentrated among the wealthy over the time period studied.

(Technical note: The DFAs reconcile the most recent SCF from 2016 to the Q3-2016 FAs, then apply SCF distributions with imputations and forecasts to the latest available FAs. For example, see that in FA table B.101.H, Line 27 equates to the total net worth level shown in the first chart on page 26.)

Inequality II: Lots of Retired Public Employees Are Millionaires. The massive underfunding of federal, state, and local retirement funds increasingly reflects some inconvenient truths about the public employee retirement system.

Most public-sector employees are hard-working and dedicated workers, who are permitted to retire in their 40s and 50s because they have had tough jobs as cops, firefighters, and teachers. The problem is that contractually they are entitled to start receiving their retirement benefits right away rather than at age 65, as typical in the private sector. As longevity has increased, many of these beneficiaries have been living longer, a main reason that the public employee retirement plans are increasingly underfunded.

Measures of income inequality never consider the fact that a growing number of retired public employees effectively are millionaires when the present discounted value of their contractually guaranteed retirement benefits is taken into account. At current interest rates, the rest of us working stiffs would have to amass a few million dollars in savings to match the retirement income received by the many public pensioners living 20-40 years past their first month of retirement.

Now here are the disturbing data on underfunded public pensions from the Fed’s Financial Accounts of the United States, which is available through Q1-2019:

(1) State and local government employee retirement funds. The retirement funds for state and local employees are woefully underfunded. The problem is with defined benefit plans, which totaled $8.7 trillion during Q1-2019, accounting for almost all of the $9.1 trillion in state and local government retirement funds. Of this total, a whopping $4.2 trillion (or 46%) was unfunded! In the Fed’s accounts, the unfunded item is described as “claims of pension fund on sponsor” (Fig. 1). (See Table L.120.)

Who owes all this money to the funds? Taxpayers, of course, many of whom helped to elect politicians who made contractual retirement promises to their municipal employees that far exceeded the assets available to meet these obligations. So the unfunded amount is in effect financed by the IOUs of taxpayers.

The result has been rising tax rates to meet these retirement liabilities on a pay-as-you-go basis. In many states, cities, and towns, the politicians face resistance to higher taxes and have been forced to reduce spending on public services and infrastructure.

(2) Federal government employee retirement funds. Federal employees’ retirement funds have the same problem, but to less of an extent. They had liabilities totaling $4.1 trillion during Q1, with $1.7 trillion of them unfunded (Fig. 2). (See Table L.119.)

(3) Social Security. Social Security is not included in the Fed’s accounts as an asset of the household sector. However, the recipients of this program are receiving support payments equivalent to the return on a $1 million retirement nest egg at current historically low interest rates. Specifically, the average monthly Social Security payment to retired workers in 2019 is $1,461, or $17,532 a year. A million dollars would generate only $20,000 per year at today’s 2% interest rate. A million dollars isn’t what it used to be!

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The World According to Garp

July 30 (Tuesday)

Global Economy I: Dysfunctional Demographic Destiny. There is something wrong with the global economy. It’s not functioning as it “should,” or traditionally has. Actually, the world economy seems downright dysfunctional. This distortion relative to past norms reminds me of the skewed, tragicomedic worldview of Garp in John Irving’s best-selling novel The World According to Garp (1978), about a man born out of wedlock to a feminist icon.

The US economy is showing some signs of similarly unusual behavior, but it doesn’t appear as abnormal as the rest of the global economy, so far. I am using the objective meaning of the word “abnormal” without drawing any subjective implications just yet. In other words, for us investors, the world is what it is—and our investment conclusions must be derived based on how it is, not on how it ought to be.

It’s possible that many of the abnormalities are related to Trump’s escalating trade wars with the rest of the world since early last year. The rest of the world is more dependent on exports, particularly to the US, than the US is on exports to the rest of the world. By disrupting US trade relations with the rest of the world, Trump does more economic damage over there than over here.

Nevertheless, I’m not convinced that it’s all about Trump. Many overseas economies seem to have lost their dynamism in recent years. One possible explanation is that demographic profiles have turned increasingly geriatric around the world, led by Europe, Japan, and China (Fig. 1, Fig. 2, Fig. 3, and Fig. 4). As I’ve discussed on numerous occasions, fertility rates have fallen below population replacement rates around the world, particularly in these three important regional and national economies (Fig. 5, Fig. 6, Fig. 7, and Fig. 8). China’s government exacerbated the situation with its one-child policy from 1979 through 2015.

Furthermore, almost everywhere, people are living longer. That is also making demographic profiles more geriatric around the world, which is putting pressure on governments to borrow more and accumulate more debt to provide retirement support programs for their rapidly increasing cohort of senior citizens. Such government borrowing and mounting government debt are weighing on economic growth. In the past, debt financed government spending and tax cuts stimulated economic growth. That no longer seems to be the case.

The major central banks have joined in to help by providing ultra-easy monetary policies. They claim that their mandate is to avert deflation and to maintain inflation at around 2.0%. In addition, they are hoping that their policies will stimulate more economic growth. They’ve been struggling to do so for more than 10 years. Yet inflation remains mostly below their 2.0% target and economic growth remains lackluster at best. Actually, over the past year and a half or so, economic growth has been slowing around the world despite monetary and fiscal stimulus.

The result has been a mix of monetary and fiscal policies designed for geriatric economies. These polices have been offsetting the deflationary consequences of the voluntary self-extinction of the human race, which is the inevitable consequence of below-replacement fertility rates. Japan has been on this course for some time, which is why since 2011, more people died in Japan than were born. China is on course to displace Japan as the world’s largest nursing home. Europe isn’t that far behind. The US is in better demographic shape since the fertility rate remains around the population replacement rate.

The only areas where the prospects for population growth remain positive are Africa and India. But that could change for the worse as they continue to urbanize. In my opinion, it is urbanization that explains why fertility rates have fallen below replacement in much of the world. Children have an economic value in rural agricultural communities, but not in cities. Technological innovation has been boosting productivity in agriculture significantly in recent decades. The result has been migration from rural to urban areas, where children are all cost and no benefit in economic terms. Some may represent economic benefit to their parents in an urban setting, those that get jobs and support their parents in their old age. However, young adult children are less prone to do so the more that the elder care of their parents is outsourced to the government.

In Garp’s world, Garp’s mother had only one child. That’s half as many as required for population replacement. In our similarly demographically dysfunctional world, fiscal and monetary authorities are deploying their policy tools on a whatever-it-takes basis to offset the consequences of the one-child or no-child policies that more and more couples (or single moms) are deploying in their personal lives. Some governments are starting to provide incentive for couples to have more babies, but without much success so far.

By the way, in our world, Modern Monetary Theory (MMT) isn’t a theory. Instead, it is a description of the monetary and fiscal policies that governments increasingly have adopted to manage the voluntary self-extinction of the human race. MMT amounts to large government deficits enabled by a combination of near-zero interest rates and debt monetization provided by the central banks.

The proponents of MMT claim that it works very well as long as consumer price inflation remains subdued, as it has been for well over a decade. In theory, the flaw in the theory is that MMT is fueling asset price inflation as a result of widespread reaching for yield by investors. That increases the risk of financial instability, with meltups in asset prices followed by meltdowns.

Global Economy II: Dysfunctional Manufacturing Data. Now let’s turn to more mundane matters like assessing whether the latest batch of economic indicators confirms that something isn’t quite right with the global economy. It’s been easy to see in Japan for many years. Now it is becoming increasingly apparent in Europe. Consider the following latest developments:

(1) Eurozone M-PMI. The good news is that the NM-PMI remained solidly above 50.0 during July at 53.3, according to the flash estimate (Fig. 9). The really bad news is that the region’s M-PMI fell to 46.4 during July, well below 55.1 a year ago.

(2) Germany’s Ifo. The really bad news is that Germany’s M-PMI fell to 43.1 during the month from 56.9 a year ago (Fig. 10). That weakness was confirmed by Germany’s Ifo business confidence index, which fell to 95.7 during July, the lowest reading since April 2013, with the expectations component (92.2) the lowest since July 2009 (Fig. 11).

(3) Japan’s M-PMI. During the first seven months of this year, Japan’s M-PMI has been below 50.0 during five of those months (Fig. 12). It was 49.6 during July.

US Economy: Functioning More Normally. In the US, the growth rate of real GDP has been around 2.0% on a y/y basis since 2010. That once was considered to be the economy’s stall speed. Whenever it fell to that rate on a y/y basis, it wasn’t too long before it turned negative in a recession. Now since 2010, the 2.0% area has been the new normal for real economic growth in the US. Sure enough, the latest data for Q2 real GDP show that it was up 2.1% q/q (saar) and 2.3% y/y (Fig. 13). Let’s examine the data more closely:

(1) Real final sales and inventories. Q2’s 2.1% (saar) q/q increase in real GDP followed a gain of 3.1% during Q1. Inventories boosted Q1 and depressed Q2. Excluding inventory investment, real final sales rose 2.6% (saar) during Q1 and 3.0% during Q2 (Fig. 14).

(2) Real consumption and capital spending. Leading the gain in Q2’s real final sales was a solid gain of 4.3% (saar) q/q in personal consumption expenditures, with spending on goods up 8.3% while services increased 2.5%.

Lagging was capital spending, with a decline of 0.6% (saar) during the quarter. Spending on structures declined 10.6% (saar), while intellectual property products rose 4.7%. Spending on capital equipment was up only 0.7% (saar), with transportation equipment down 9.2% while information technology equipment jumped 6.7% to a new record high.

Nondefense capital goods orders excluding civilian aircraft rose 1.9% m/m in June and 3.2% ytd, suggesting that spending on capital equipment may be starting to improve.

(3) Trade. Trump’s trade wars may be weighing on both US exports and imports of goods and services in real GDP. The former fell 5.2% (saar) during Q2, while the latter was flat.

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The Fed Ahead

July 29 (Monday)

The Fed I: Wasting Ammo. The FOMC meets on Tuesday and Wednesday. Everyone is expecting the Fed’s policy-setting committee to reset the federal funds rate range at 2.00%-2.25%, down from 2.25%-2.50% (Fig. 1). Here are Thursday’s closing prices of the federal funds rate futures: nearby (2.12%), three-month (2.05), six-month (1.77), and 12-month (1.52) (Fig. 2). Not too long ago, the 12-month futures peaked at 2.88% on 11/8/18. The current 12-month federal funds futures yield implies three rate cuts through July of next year.

Our 11/19/18 Morning Briefing was titled “On Your Mark, Get Set, Pause.” Melissa and I argued that the Fed was setting an overly aggressive course of “gradually” raising interest rates for 2019. The FOMC came around to our position early this year. But since May, several Fed officials have completely reversed course and raised expectations of rate cuts ahead.

There isn’t much risk in this change of course other than perhaps triggering a meltup in asset prices. Our main objection is that the economy is doing well enough that a rate cut isn’t really justified, especially since there is so little ammo left for the Fed to use the next time rate cuts are really needed. However, Fed officials seem to have persuaded themselves that at least one rate cut this week is a good insurance policy against weaker economic growth.

The Fed II: Alternative View on Inflation. Some of the Fed officials who are leaning toward a rate cut at this week’s FOMC meeting have expressed their concern that inflation remains below their 2.0% target. Atlanta Fed President Raphael Bostic is not one of them. In a 7/11 speech titled “Ruminations on Inflation,” he argued that the rate of inflation is close to the Fed’s target and not materially trending away from it. Bostic, however, won’t be a voting member of the Federal Open Market Committee (FOMC) until 2021 but does weigh in on monetary policy decisions as a meeting participant.

His well-thought-out case showing that inflation is on target argues against the prospective interest-rate cut this week that many Fed officials favor. Let’s consider Bostic’s side of the argument:

(1) Noisy headline & core. Traditionally, the Fed has relied on the personal consumption expenditures deflator (PCED) as the primary measure for the inflation rate. The FOMC’s latest “Statement on Longer-Run Goals and Monetary Policy Strategy” states: “[I]nflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve’s statutory mandate. The Committee would be concerned if inflation were running persistently above or below this objective.”

Both the headline and core PCED measures of inflation have been running mostly below the Fed’s 2.0% target since the goal was established during January 2012 (Fig. 3). However, Bostic argued that the PCED measure may not be a reliable indicator of trend inflation because it includes lots of goods and services prices that are volatile on both m/m and y/y bases.

The core PCED excludes food and energy prices that are deemed to be especially volatile. But Bostic notes that food prices are not as volatile as in the past. And “by excluding only food and energy prices from the underlying inflation measure, you are treating every other price change in the consumer market basket, regardless of its source, as a signal of underlying inflation.” That means that the core measure can still be “noisy.”

(2) Trendy trimmed measures. To separate the signal from the noise, Fed economists have developed several alternative measures of inflation, Bostic noted. One is the Dallas Fed’s trimmed-mean PCED (Fig. 4).

The 5/1 FOMC Minutes mentioned the Dallas trimmed mean measure for the first time that we can recall, noting that it “removes the influence of unusually large changes in the prices of individual items in either direction.” (See technical note below.) A number of participants “observed that the trimmed mean measure had been stable at or close to 2 percent over recent months” and therefore viewed the recent decline in PCED inflation as transitory. Others believed that the downside risks to inflation have increased. Bostic said he puts more weight on what the Dallas measure indicates now—that “we are very close to our 2 percent price stability mandate.”

(By the way, Fed Chair Jerome Powell mentioned the trimmed mean measure of PCED price inflation for the first time during his 5/1 press conference, calling low headline inflation “transitory.” But he didn’t mention this notion again during his 7/10-7/11 semi-annual testimony to Congress.)

(3) Mixed inflation expectations. Besides hard data on inflation, Fed rate-setters also take into consideration survey-based measures of inflation expectations. The public’s perception of future inflation matters because it affects purchasing and investing decisions.

Bostic reviewed the four key measures of inflation expectations by the four key US economy stakeholder groups: professionals (FRB-PHL’s Survey of Professional Forecasters), households (University of Michigan’s Surveys of Consumers), businesses (FRB-ATL’s Business Inflation Expectation’s Survey), and financial markets (TIPS-based ten-year/ten-year forward breakeven inflation rate). The professional and business surveys tend to be the most reliable indicators, he said, because professionals are trained at forecasting and businesses set future prices (Fig. 5 and Fig. 6). They are currently expecting that inflation will be 2.2% and 1.9%, respectively.

Bostic is skeptical of market-based measures, which have recently declined, because they are highly correlated with changes in the price of oil, a poor long-run indicator of inflation. Furthermore, they reflect factors unrelated to forward expectations of inflation.

(4) Our view. We don’t have a problem with using the headline and core PCED inflation rates. We expect inflation to remain low but stable between 1.5%-2.0% for the foreseeable future. We remain generally optimistic about the labor market and the US economy overall and agree with the Fed’s previously stated patient, wait-and-see stance.

(Technical note: To calculate the trimmed mean PCED inflation rate for a given month, the Dallas Fed sorts the price changes for each of the individual components of personal consumption expenditures into ascending order, then “trims” the most extreme observations on both ends of the distribution. Then, the trimmed mean inflation rate is calculated as a weighted average of the remaining components, according to a 2005 Dallas Fed working paper. The Dallas Fed website publishes a listing of all of the included and excluded components each month. This month’s listing can be viewed at the following link. As you can see, there are numerous categories of all kinds cut from the bottom and the top.)

The Fed III: Doves vs Hawks. Far more important than what we think about the outlooks for inflation and the US economy is what the majority of FOMC voters think—and will do as a result. For now, the doves clearly outweigh the hawks at the Fed.

Again, to state the obvious: When we say “dove” in the present context, we mean to say that the Fed official either has advocated for, or seems open to, a rate cut in the near term. We will qualify that by saying that most of the Fed officials that hold a dovish view seem to think that just one or two 25bps rate cuts are appropriate. The officials we classify as “hawks” have advocated for more of a wait-and-see approach before taking any action.

By our count, at least two Fed officials could dissent at this week’s meeting if the consensus of doves votes for a rate cut. Here’s a rundown on where the current-year FOMC voters stand based on our assessment of their comments heading into the blackout period (where no comments are allowed from officials) prior to the meeting:

(1) Jerome H. Powell, Fed Chair (dove). Powell has morphed from a hawk last year to a dove this year. In his 7/11 congressional testimony, he told the senators that the so-called “neutral rate,” or policy rate that keeps the economy on an even keel, is lower than past estimates have put it—meaning that monetary policy has been too restrictive. “We’re learning that interest rates—that the neutral interest rate—is lower than we had thought, and I think we’re learning that the natural rate of unemployment is lower than we thought,” he said. “So monetary policy hasn’t been as accommodative as we had thought.”

(2) John C. Williams, FRBNY President (dove). On 7/18, Williams gave a speech titled “Living Life Near the ZLB.” “ZLB” stands for “zero lower bound.” The FOMC’s second in command seemed to endorse a significant rate cut, ending his speech by saying that the actions he recommended “should vaccinate the economy and protect it from the more insidious disease of too low inflation.” The S&P 500 climbed on those comments that day.

(3) Michelle W. Bowman, Fed Governor (dove). Bowman began her term on the Board on 11/26/18. She is the first governor to fill the role Congress designated for someone with community banking experience; her primary role is representing community banks. Since the start of her term, she hasn’t had much to say publicly about monetary policy, focusing her speeches on more localized community issues. We expect her to vote with the consensus, as she has done since the start of her term.

(4) Lael Brainard, Fed Governor (dove). Brainard takes a cautious approach to monetary policy, arguing for some time that the relationship between inflation and unemployment has flattened. During a 7/11 speech, she said: “While the modal outlook is solid, the downside risks, if they materialize, could weigh on economic activity. Taking into account the downside risks at a time when inflation is on the soft side would argue for softening the expected path of monetary policy according to basic principles of risk management.”

(5) James Bullard, FRBSL President (dove). The most obvious of all the doves is Bullard, the only FOMC member to vote on 6/19 against the FOMC’s decision to leave rates as is; he preferred to lower the target range for the federal funds rate by 25bps. Speaking with reporters on 7/19, Bullard confirmed that he wants to see the Fed lower its target interest rate by 25bps at the FOMC’s 7/30-7/31 meeting. The WSJ noted that Bullard “believes that will help lift what have been low levels of inflation to move back to the central bank’s 2% target.” However, Bullard said he isn’t yet ready to call for a string of rate cuts.

(6) Richard H. Clarida, Fed Governor (dove). In a Fox Business Network interview on 7/18, the same day that Williams made his let’s-ease-before-we-have-to message, Clarida said: “You don’t need to wait until things get so bad to have a dramatic series of rate cuts.” He added: “We need to make a decision based on where we think the economy may be heading and, importantly, where the risks to the economy are lined up.”

(7) Charles L. Evans, FRB-Chicago President (dove). Evans long has leaned dovish, so we aren’t surprised that he is one of the few Fed officials who’s officially calling for multiple rate cuts. In a 7/16 interview, Evans said: “In order to get inflation up to two-and-a-quarter percent over the next three years I need 50 basis points more of accommodation. And in fact, maybe that’s not quite enough,” reported the WSJ.

(8) Esther L. George, FRB-Kansas City President (hawk). On 7/17, George suggested she isn’t ready to see rates cut: “When I look at the current settings for monetary policy, my own outlook suggests we will continue to see growth in the economy around or slightly above the trend rate of growth, we see an unemployment rate at a 50-year low and continued job gains as recently as the most recent employment numbers,” with positive wage growth for workers, as reported the WSJ. She added: “Across all of these parameters, inflation has remained low and stable,” concluding that “suggests we are in a good range in terms of thinking about monetary policy.”

(9) Randal K. Quarles, Fed Governor (hawk). Quarles has not voiced his specific views on the outlook for interest rates since March, focusing recent speeches on financial stability. However, during a 5/30 speech on the relationship between monetary policy and financial stability, he said: “Monetary policy … if too accommodative, may lead to a buildup of financial vulnerabilities.” During a 3/29 speech, he opined that rate hikes would become appropriate at some point: “In regard to policy, I am very comfortable remaining patient at this point and monitoring the incoming data. … [F]urther increases in the policy rate may be necessary at some point, a stance I believe is consistent with my optimistic view of the economy's growth potential and momentum. … [M]y estimate of the neutral policy rate remains somewhat north of where we are now.”

(10) Eric Rosengren, FRB-Boston President (hawk). Rosengren suggested to CNBC in a 7/19 interview that he is not on board with a rate cut right now: “[G]iven that the economy is quite strong, given that I do think that inflation is going to be very close to 2%, and given that the growth in the economy is satisfactory, I think … you don’t have to take a lot of action.” He added: “[S]hould the economy change, if the trade situation changes dramatically, if we start getting surprised by how slow China or Europe are, then [we should react]. But I think we should wait until we actually see the evidence that that’s happening.”

Movie. “Once Upon a Time … in Hollywood” (- -) (link) is a weird film directed and written by Quentin Tarantino, who has a knack for directing and writing weird films. I enjoyed some of them (“Kill Bill,” “Inglourious Basterds,” and “Pulp Fiction”), but not this one. The performances of Leonard DiCaprio, Brad Pitt, and Margot Robbie all were top notch, but the script is just odd. It’s a retrospective on Hollywood’s film and television industry during the late 1960s. The tragic murder of actor Sharon Tate by Charlie Manson’s cult of crazed hippies plays a strangely prominent role in the film. One of the hippies observes that they grew up on shows mostly about murder, so why not kill the people who turned murder into an entertainment industry?

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Targeting Big Tech

July 25 (Thursday)

Technology: Harming Consumers? When Google went public in 2004, its corporate motto was “Don’t be evil.” That’s a bit creepy, and quite ironic since the US government has decided to investigate whether Google and fellow FANGs (Facebook, Amazon, and Netflix) are evil after all.

The Department of Justice (DOJ) announced on Tuesday that it’s taking a crack at investigating the Internet Giants. Specifically, the DOJ said it’s “reviewing whether and how market-leading online platforms have achieved market power and are engaging in practices that have reduced competition, stifled innovation, or otherwise harmed consumers.” Much attention has been paid to the “reduced competition” element of the above statement. But making an antitrust case seems awfully difficult. Facebook can argue that there are myriad ways to communicate. Google can swear it just built a better mousetrap than Microsoft. And there are tons of places to shop online and off; no one forces consumers to buy from Amazon.

The government might focus instead on the last item, “otherwise harmed consumers.” It’s a much broader, catch-all category. Proving harm could be a much easier case to make. Facebook allowed Russia to manipulate our elections and misused consumers’ data. Amazon generated $232.9 billion of revenue last year and paid only $1.2 billion of taxes. And Google’s YouTube allowed the New Zealand mass murder video to air over the Internet site for more than an hour. None of these actions are anticompetitive, but they arguably did harm, so they could lead to more fines and perhaps behavioral remedies, which could impact the businesses of the giants.

Investors haven’t seemed overly concerned about antitrust cases. News that the DOJ and the Federal Trade Commission (FTC) were looking into anticompetitive behavior broke on 6/3, and the shares of these companies fell. But from 6/4 through Monday’s close, each of the companies’ stocks shook off their antitrust fears and outperformed the S&P 500 as follows: Facebook (up 23.3%), Apple (19.6), Amazon (17.3), Google (9.8), and S&P 500 (8.8).

If the DOJ arrives at settlements like the one the FTC reached with Facebook, then the shares shouldn’t have a problem. Facebook will pay a fine of roughly $5 billion to the FTC, and CEO Mark Zuckerberg personally will certify that the company is taking steps to protect consumer privacy, a 7/23 WSJ article reported. Despite the regulatory distractions, Facebook reported on Wednesday Q2 revenue and earnings growth that beat analysts’ forecasts, with $48.6 billion of cash and short-term investments, making a $5 billion bill no sweat.

But if the DOJ gets a bit more creative—and “otherwise harmed consumers” implies that it might—the shares might face a tougher road. What would happen if the DOJ forced Facebook to know and disclose its advertisers, as television companies are required to do with political ads? Or worse: What if Facebook had to ensure the items it publishes are true, as a newspaper does? Could the DOJ require a five-minute delay before video is streamed over the Internet to millions? Could the government change the tax laws so companies such as Amazon pay more? And could the DOJ force Apple to let consumers buy apps for the iPhone outside of the Apple app store? Those actions might make investors sweat a little more.

Industrials: Defying Trade Slowdown. It may not have the dazzling returns of the S&P 500 Tech sector, but the S&P 500 Industrials sector has turned in an above-average performance this year despite the drag from US and Chinese tariffs and the escalating trade war between the two nations.

Here’s the performance derby ytd through Tuesday’s close: Technology (32.4%), Consumer Discretionary (25.0), Industrials (21.9), S&P 500 (19.9), Communication Services (19.8), Real Estate (19.5), Financials (18.7), Consumer Staples (18.4), Materials (17.8), Utilities (13.1), Energy (10.2), and Health Care (6.5) (Fig. 1).

One of the industries boosting the sector’s performance is Aerospace & Defense, up 24.9% ytd. Here are the others: Diversified Support Services (59.5%), Research & Consulting Services (34.5), Building Products (33.6), Environmental & Facilities Services (26.2), Construction & Engineering (25.5), Industrial Machinery (24.5), Railroads (23.6), and Industrial Conglomerates (21.7) (Table).

US defense spending has been bolstered by a world of seemingly rising danger and a Congress that’s willing to open the federal wallet despite already huge deficits. The two-year budget agreement reached by White House and congressional leaders this week will lift defense spending by 3% to $738 billion in 2020 and leave it basically flat in 2021 at $741 billion. With Iran raising the ante in the Strait of Hormuz and North Korea showing off a nuclear submarine, we’d bet the 2021 budget will be revised north before that fiscal year begins.

Lockheed Martin, a beneficiary of the Department of Defense’s largess, reported earnings on Tuesday that exceeded expectations, and the company raised its forecast for this year. Lockheed reported Q2 revenue jumped 7.7% to $14.4 billion, operating profit increased by 6.0% to $1.6 billion, and adjusted EPS gained 16.0% to $5.00. EPS beat analysts’ $4.77 consensus and the company raised its full-year guidance to $20.85-$21.15, up from a prior forecast of $20.05-$20.35.

The S&P 500 Aerospace & Defense sector stock price index has plateaued at a very high level over the past two years (Fig. 2). However, its forward operating EPS has continued to climb over that period, which has brought down the index’s valuation (Fig. 3 and Fig. 4). The industry is expected to grow earnings by 5.5% this year and 11.2% in 2020 (Fig. 5). Meanwhile, its forward P/E has fallen to 16.6, down from 22.7 in January 2018 (Fig. 6).

Investors should note that Boeing has weighed heavily on the S&P 500 Aerospace & Defense sector. Since Boeing’s stock price peaked on 3/1, it has fallen 15.6% through Tuesday’s close. Excluding Boeing, the industry’s stock price index would be up 9.3% instead of 0.9%, Joe calculates.

China: The Art of Credit Analysis. Lots of debt and a slowing economy aren’t a good combination. But that’s exactly what China is facing. They may be big enough problems that US Trade Representative Robert Lighthizer and Treasury Secretary Steven Mnuchin can use them as leverage during their face-to-face trade meetings next week with China’s Vice Premier Liu He. The number of bankruptcies and defaults in China has jumped over the past year, a trend that bears watching because the country has a $4 trillion corporate bond market and $21 trillion of bank loans outstanding, which has doubled since January 2013 (Fig. 7).

China’s debt may get more difficult to service if the Chinese economy continues to slow. China’s real GDP fell to 6.2% y/y in Q2, down from 6.7% a year ago (Fig. 8). Likewise, its Manufacturing Purchasing Managers Index fell to 49.4 in June, with new orders falling below the 50 marker as well (Fig. 9 and Fig. 10).

“This year, 35 Chinese onshore corporate issuers have defaulted on interest or principal payments on 58 bonds with a total principal value of 54.31 billion yuan ($7.90 billion),” a 7/19 Reuters article stated. “That is 60% more than the value of defaulted bonds in the first seven months of 2018, and more than half of the total for all of 2018, the highest on record.” S&P Global expects the number of Chinese corporate defaults will rise in the back half of the year as the slowing Chinese economy and the Chinese/US trade war weigh on credit.

“Last year, 165 bonds worth 157.2 billion yuan ($23.3 billion) defaulted, according to data provider Wind. That was just 0.6% of the entire corporate bond market—but it was more in both volume and value than all such debt in the four years starting 2014, when China saw its first onshore default by a private company,” a 1/11 WSJ article reported.

The latest defaults were reported in a Caixin article on Tuesday. Shanghai-listed retailer and electronics manufacturer Jiangsu Hongtu High Technology didn’t make interest and principal payments due Monday on 700 million yuan ($101.8 million) of medium-term notes issued in 2016. Likewise, Nanjing Construction Industrial Group Co. Ltd. didn’t pay interest and principal due Friday on 2 billion yuan of privately placed green bonds issued in 2017.

Here are some other headlines that caught Jackie’s eye:

(1) Fraud comes to the fore. Some companies are defaulting because the cash that they say is in the bank isn’t. Beijing’s Kangde Xin Composite Material Group (KDX) is a high-tech materials firm that supplies optical film products to Apple and carbon fiber materials to Mercedes-Benz. It reported 12.2 billion yuan of cash on its balance sheet last fall but defaulted on 1.5 billion yuan of short-term debt in January. That triggered defaults on another 6.3 billion of other debt the company has outstanding.

In May, the company’s bank told its auditor that it had no funds in its deposit account, a 5/8 Reuters article reported. Founder Zhong Yu reportedly misappropriated around 10 billion yuan in company funds, supposedly for a carbon-fiber project being done by Kangde Investment Group, which owns a 24.04% stake in KDX. He resigned as chairman in March. KDX shares were used to back more than 8 billion yuan in loans for Kangde Investment.

(2) Cross defaults a concern. China Minsheng Investment Group won’t repay the principal or interest on $500 million of bonds due in August. The unrated bonds carried a coupon of only 3.8% and were issued by an offshore subsidiary called “Boom Up Investments,” a 7/19 WSJ article reported. China Minsheng is a conglomerate that “has focused on investments related to China’s economic development as well as the country’s Belt and Road infrastructure initiative.”

The conglomerate also defaulted on 2.35 billion yuan in onshore debt earlier this year. A definitive reason for the defaults wasn’t given, but the WSJ article noted an anonymous employee who blamed the company’s use of short-term debt to fund some of its long-term assets.

The default triggered another $800 million in “cross defaults,” which has raised concerns. “Chinese companies in recent years have included cross default clauses in debt agreements for their subsidiaries and affiliates as a means to secure easier funding,” a 4/25 article in the South China Morning Post reported. “Essentially, the clauses allow less creditworthy companies to borrow on the strength of their parent company. The practice is especially common in industries with overcapacity issues, such as coal and steel, among lower quality private companies, as well as local government-linked companies.”

Total bond issuance containing cross default covenants due in 2018 was $80.2 billion, up from $446 million in 2016, the article stated, citing Wind Financial. The number of cross defaults actually triggered rose to $3 billion last year from $187 million in 2017.

(3) Chinese government gets involved. China’s central bank and the banking regulatory commission took over Baoshang Bank, a small bank in Inner Mongolia. The government takeover was unusual because it was done so publicly. It raised concerns about the financial health of small banks in China’s rural areas and small cities.

Baoshang Bank was under an umbrella company, Tomorrow Holding Ltd., which was owned by Xiao Jianhua, who left Hong Kong, entered mainland China, and disappeared in 2017. Later that year, the bank reported a capital shortage. A 5/24 WSJ article reported on the trend of the missing corrupt tycoon: “The seizing of Baoshang is another coda on an era in which a clutch of tycoons disappeared, some resurfacing later, as Chinese authorities pressed a crackdown on corruption and a cleanup of the financial sector following a stock-market meltdown. Some were formally detained and investigated while others saw their businesses come under pressure.” Another example: the state’s seizure last year of Anbang Insurance Group. Its chairman was convicted of fraud and abuse of power and sentenced to 18 years in prison.

(4) Foreign bonds not immune. Qinghai Provincial Investment Group, which is two-thirds owned by the provincial government, defaulted in February on a $300 million Hong Kong note and a 20 million yuan ($3 million) onshore note. Five days later, the company—whose main businesses are aluminium, coal, and hydroelectric power—paid what it owed.

The brief defaults came as a surprise because the local municipality allowed them to occur. Investors typically believe that companies like Qinghai Provincial Investment Group will receive financial support from the municipality. The price of the dollar-denominated bonds dropped from 93 cents on the dollar to about 70 after the defaults. The bond price rebounded to 88 after the defaults were cleared, a 3/12 Bloomberg article reported.

(5) Reading the tea leaves. Earlier this month, China’s central bank released draft rules on trading defaulted bonds in the interbank market, according to a 7/1 Caixin article. A sign, perhaps, that the Chinese bond market is maturing and more defaults should be expected?

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Mark to Market

July 24 (Wednesday)

Strategy I: Limits of the Boom-Bust Barometer. In the past, Joe and I have often observed the strong correlation between the S&P 500 and our Boom-Bust Barometer (BBB), which is the ratio of the CRB raw industrials spot price index to initial unemployment claims (Fig. 1). They’ve diverged lately, as the S&P 500 is at yet another record high while the BBB has been fluctuating widely and wildly since late last year, though also in record-high territory. It’s been near the bottom of this range recently.

The CRB component of the BBB has been mostly falling since mid-2018 (Fig. 2). It is down 15% from the 6/12/18 week through the 7/13 week of this year, hovering around its lowest readings since early April 2016. That reflects the weakness in the global economy.

On the other hand, jobless claims remain historically low, with the four-week average at 218,750 during the 7/13 week. The problem is that they probably can’t go much lower, while commodity prices could do so if the global economy continues to weaken. Boosting commodity prices undoubtedly would require an amicable resolution of Trump’s trade war with China.

Then again, there is nothing set in stone about the importance of the BBB to the S&P 500. Consider the following:

(1) Forward earnings matter more. In fact, the BBB has also been highly correlated with S&P 500 forward earnings, which clearly has a more direct impact on stock prices than our jerry-rigged ratio (Fig. 3). These two series also have diverged since late last year, with forward earnings climbing to a new record high in early July.

The strength in forward earnings suggests that industry analysts believe that their companies can continue to grow earnings despite the headline news about weaker global economic activity. Forward earnings tends to be an excellent year-ahead leading indicator of actual earnings with one important exception: Industry analysts never see recessions coming (Fig. 4). If you agree with us that a recession is unlikely over the next 12 months, then forward earnings are bullish for actual earnings and for stock prices.

(2) Forward revenues at another record high. Confirming the analysts’ bullishness on earnings is their S&P 500 forward revenues estimate, which also rose to a record high during the 7/18 week (Fig. 5). Weekly forward revenues is a very good coincident indicator of actual quarterly S&P 500 revenues (Fig. 6).

(3) Waiting for another hook up. Meanwhile, the stock market continues to perform well. That’s despite the fact that earnings growth was weak during Q1 and likely remained weak during Q2. There’s no relief in sight until Q4 and next year. That confirms what we all should know: The stock market discounts the future, not the past or the present, except to the extent that they influence the future.

S&P 500 earnings rose just 2.8% y/y during Q1 (Fig. 7). The earnings blend of estimates/actuals for Q2 was expected to be -1.5% during the 7/18 week, up slightly from -2.0% during the previous week. We still expect a small positive growth rate for Q2 similar to Q1’s result. Q3 may also be getting set up by the analysts for the typical upward earnings hook, as the latest estimated growth rate was cut to -0.2%.

Meanwhile, Q4 is expected to be up 6.6%, while all of 2020 is projected to show earnings growth of 10.5%, up from 2.5% this year (Fig. 8).

Strategy II: Valuation & the Blue Angels. Joe and I like to monitor the flight of the S&P 500 with our Blue Angels radar tracking system (Fig. 9). It shows S&P 500 forward earnings multiplied by forward P/Es of 10.0-19.0 in increments of 1.0. These 10 series fly in parallel formation, never colliding, just as the Blue Angels pilots of the US Navy do.

Then we show the S&P 500 as the stunt plane, flying in the vapor trail of the Blue Angels. So in one chart, we can see all three variables in the stock market identity P = P/E x E, where “P” is the daily S&P 500 closing price, “P/E” is the forward valuation multiple, and “E” is forward earnings per share.

The current readings as of Friday’s close were P = 2976.61, P/E = 16.9, and E = $176.27. As long as there is no recession, earnings should continue to climb higher, continuing to lift “P” to new highs. Every now and then, the market may hit a P/E air pocket, as it has numerous times during the current bull market. We’ve counted 63 such air pockets and associated “panic attacks,” which is a normal reaction when flying on a plane that suddenly and unexpectedly loses altitude.

The combined panic attacks at the start and end of 2018 caused the forward P/E to fall from a high of 18.6 on 1/23/18 to a low of 13.5 on 12/24/18 (Fig. 10). It was back to 16.9 at the end of last week.

It is widely known that the historical average P/E of the stock market tends to be around 15.0. Let’s use that to simplify the Blue Angels analysis. We can compare the actual S&P 500 to its Blue Angel series based on forward earnings times 15.0 (Fig. 11). We can then calculate percentage difference between the two. When the divergence is positive (with the S&P 500 exceeding its implied value based on a 15.0 P/E), stocks presumably are overvalued. A negative reading suggests stock are undervalued (Fig. 12).

Based on this simple model, the S&P 500 is currently overvalued by 12.9%—not by much. However, 15.0 is just the average P/E. As we’ve discussed over the past few days, the P/E should be above average in an economic environment like the current one, where inflation and interest rates are well below average. Granted, economic growth is also below average. But having all those variables at moderate levels simply increases the likelihood that the economic expansion will be sustained, which would also argue for a higher-than-average P/E.

Strategy III: Retail Forward Revenues & Earnings on Moon Shots. One of our lazy-days-of-summer projects has been to track the relationship between the forward revenues and earnings of various S&P 500 industries and the relevant economic variables that pertain to those industries. So far, among the most remarkable charts are those reminiscent of the Apollo 11 moon shot, which occurred 50 years ago. Let’s focus on what we have found out so far for retailers:

(1) Internet retail (Amazon, Booking Holdings, eBay, and Expedia). Needless to say, the Internet & Direct Marketing Retail industry index has gone beyond the moon and seems to be heading to Mars or beyond. The forward revenues of the industry has doubled since August 2015, while forward earnings has doubled since April 2018 (Fig. 13 and Fig. 14). Online retail sales has doubled since October 2012 from $335 billion (saar) to $678 billion currently.

(2) Home Improvement (Home Depot and Lowe’s). The forward revenues of the Home Improvement industry has doubled since February 2013 (Fig. 15). Over that same period, retail sales of building materials and garden equipment rose 26%. The forward earnings of the industry has doubled since December 2014 (Fig. 16).

(3) Restaurants (Chipotle, Darden, McDonald’s, Starbucks, and Yum!). After stalling from mid-2014 through late 2017, forward revenues of the Restaurants industry is up 19% since the start of 2018 (Fig. 17). Retail sales of food services and drinking places is up 9% from January 2018 through June 2019. The industry’s forward earnings has been on a tear since the start of 2015, rising 61% since then (Fig. 18).

We automatically update these charts and other retail-related ones in our Industry Indicators: Retail publication.

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Valuation Here & There

July 23 (Tuesday)

Valuation I: The Growth Question. The US economy is rolling triple deuces. Real GDP continues to grow around 2% on a y/y basis. Inflation is around 2%, and the 10-year US Treasury bond yield is also around 2%. This seems to be a very lucky combination for the US stock market.

In yesterday’s Morning Briefing, Joe and I wrote: “Should investors be willing to pay high P/Es when inflation and interest rates are low, but growth is weak? That doesn’t seem like a good deal. Then again, the combination of low inflation and interest rates with slow growth may result in a longer-than-usual economic expansion. The current one became the longest one on record just this month. If it keeps going, even at a slow pace, maybe it makes sense to pay relatively high P/Es.”

We concluded that the current mix of inflation and interest rates and economic growth merits relatively high, above-average valuations, especially for stocks of companies that can generate consistently above-average earnings growth.

Today, let’s have a closer look at analysts’ consensus expectations for long-term earnings growth (LTEG) before turning to a comparison of valuation multiples in the US versus overseas. We track LTEG for the S&P 500 and its sectors on a weekly basis. While the headline news clearly suggests that powerful secular forces are weighing on global economic growth, they don’t seem to be weighing on LTEG. Consider the following:

(1) LTEG is remarkably high. Perhaps industry analysts haven’t received the global-growth-slowdown memo yet. I/BE/S calculates LTEG as the consensus median five-year expected earnings growth rate. For the S&P 500, it was 14.4% during the 7/11 week (Fig. 1). The weekly data start during January 2006. Monthly data are available from 1985. The latest weekly reading is down from a recent peak of 17.5% during the 10/18/18 week. The latest weekly reading and the latest cyclical peak aren’t that much lower than the record high of 18.7% during August 2000, when the Tech bubble was about to burst.

The latest weekly LTEG, at 14.4%, is well above the latest readings for both STEG (i.e., consensus expected short-term earnings growth), at 7.9%, and STRG (i.e., consensus expected short-term revenues growth), at 5.3% (Fig. 2).

(2) Don’t blame Tech this time. During the bull market of the 1990s, Tech led the dramatic ascent in LTEG to its record high (Fig. 3). The S&P 500 LTEG rose from 11.5% at the start of 1995 to peak at 18.7% in August 2000. Over that same period, the Tech sector’s LTEG soared from 15.7% to peak at 28.7% during October 2000. Interestingly, Tech’s LTEG always exceeded the S&P 500’s LTEG until February of last year. The former has continued to be slightly below the latter since then. During the 7/11 week, Tech’s LTEG, STEG, and STRG were 13.6%, 7.0%, and 4.4%, respectively (Fig. 4).

(3) Blame Amazon. This time, the outlier is the Consumer Discretionary sector, led by the Internet & Direct Marketing Retail industry, which includes Amazon. Here is the performance derby for the S&P 500 LTEGs as of the 7/11 week: Consumer Discretionary (38.3%), Energy (15.2), Communication Services (13.9), Materials (12.1), Financials (11.7), Industrials (10.0), Health Care (9.8), Consumer Staples (5.7), and Utilities (5.0) (Fig. 5).

The Internet & Direct Marketing Retail industry (Amazon, Booking Holdings, eBay, and Expedia) had LTEG, STEG, and STRG rates of 83.0%, 28.0%, and 16.4%, respectively, during the 7/11 week (Fig. 6).

(4) PEGs are relatively cheap if LTEGs are relatively accurate. The S&P 500 forward P/E divided by LTEG (a.k.a. the “PEG ratio”) was 1.19 during the 7/11 week (Fig. 7). That’s relatively low. During the current bull market, PEG peaked at a record 1.68 during the 1/28/16 week. It was still high at 1.44 during the 12/14/17 week.

Here is the performance derby for the S&P 500 sectors’ PEGs as of the 7/11 week: Utilities (3.8), Consumer Staples (3.4), Health Care (1.6), Industrials (1.5), Information Technology (1.4), Materials (1.4), Communication Services (1.3), Energy (1.0), Financials (1.0), and Consumer Discretionary (0.6) (Fig. 8). Utilities and Consumer Staples stand out as particularly expensive on a PEG basis.

(5) Bottom line. Surely, investors aren’t buying what the analysts are selling about the heady outlook for LTEG. Then again, while everyone is aware of the secular-slowdown story for the global economy, some investors may be purchasing stocks that they believe will outperform the more realistic, weaker top-down (headline) outlook. If so, then they are likely to buy the bottom-up optimism of industry analysts for the stocks that they are buying. In other words, they are willing to pay a relatively high valuation multiple for their favorite companies that are expected to grow their earnings faster than other companies. Collectively, this all may add up to lots of companies’ stocks selling at valuation multiples not justified by the companies’ actual long-term earnings growth.

Investors who don’t buy analysts’ LTEG mostly believe that subpar economic growth is here to stay. That’s not great for actual long-term earnings growth. But it might still justify relative high P/Es, as we wrote yesterday: “Then again, the combination of low inflation and interest rates with slow growth may result in a longer-than-usual economic expansion. The current one became the longest one on record just this month. If it keeps going, even at a slow pace, maybe it makes sense to pay relatively high P/Es.”

Valuation II: A World of Cheap For a Reason. LTEG, STEG, and STRG outlooks for the All Country World ex-US MSCI were more subdued during the 7/11 week—at 9.6%, 7.5%, and 4.2%, respectively—than the comparable figures for the S&P 500 were (Fig. 9). That helps to explain why the forward P/E of this composite of overseas stocks was relatively cheap, at 13.2 during the 7/11 week (Fig. 10). Here is the performance derby of the forward P/Es of the major MSCI composites during the 7/11 week: US (17.4), EMU (13.3), Japan (12.8), UK (12.4), and Emerging Markets (12.0) (Fig. 11).

Stocks in the rest of the world are cheap compared to those in the US. However, keep in mind that this has been so most of the time since the start of the current bull market. As we’ve often observed, our Stay Home investment strategy has outperformed the Go Global alternative since the start of the current bull market (Fig. 12). Here is the performance derby, showing the percent gains in the major stock market MSCIs since 3/9/09 in US dollars: US (340%), Emerging Markets (118), Japan (99), EMU (97), and UK (88) (Fig. 13 and Fig. 14).

The US economy has weathered the Great Financial Crisis better than have the other major economies. The US economy and stock market are also more diversified than elsewhere. The US economy is less dependent on exports than are other countries. The US capital market is the biggest in the world and provides ample financing of economic activity through the banking system as well as through lots of other financial intermediaries. The US has the largest private equity market in the world. In the US, distressed asset funds continue to attract lots of money and collectively act as a very good shock absorber in the credit markets.

Valuation III: Global Sectors Rankings. I asked Joe to compare the forward P/Es of the 10 sectors of the major MSCI stock market composites around the world (Fig. 15). Here are a couple of his key findings:

(1) The forward P/Es of the US MSCI exceed those of all the other major markets for Consumer Discretionary, Energy, Financials, Materials, and Utilities sectors.

(2) Here is how the other US sectors currently rank around the world: Consumer Staples (fourth place), Industrials (second), Information Technology (second), and Communication Services (second).

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Mixed Signals

July 22 (Monday)

Strategy I: Earnings Are In Season. It is too early in the earnings reporting season to draw any firm conclusions. So far, we have mixed readings from transportation companies’ revenues and earnings during Q2. Trucking companies are doing well, while railroads are more challenged. Jackie and I aren’t surprised, since just last Tuesday we noted that truck freight tonnage has cruised to record highs in recent months, while railcar loadings are actually down on a y/y basis. (See “Truck & Train Spotting,” in the 7/16 Morning Briefing.)

Also mixed were the earnings reports from the major banks. The ones that are most exposed to consumer lending did best. That’s no surprise either, since both income and spending data for consumers have been very strong in recent months. (See “Consumers Unchained,” in the 7/18 Morning Briefing.)

Now let’s review the latest weekly stats on overall S&P 500 revenues and earnings:

(1) Revenues. Again, it’s early in the earnings reporting season, but Joe is detecting that revenues might be stronger than some industry analysts expected for their S&P 500 companies that have reported so far. We won’t be surprised if this continues to be the trend. That’s because weekly S&P 500 forward revenues recovered nicely earlier this year from its swoon late last year, and has continued to rise in record-high territory during Q2 (Fig. 1). Consensus expected revenues estimates are holding up very well despite all the weak headline news about the global economy (Fig. 2). During the 7/11 week, industry analysts estimated that S&P 500 revenues will increase 4.3% this year and 5.3% next year (Fig. 3).

Joe and I have often observed that the weekly S&P 500 forward revenues per share is a very good coincident indicator of actual quarterly S&P 500 revenues per share (Fig. 4).

(2) Earnings. The consensus expected growth rate for S&P 500 earnings during Q2 continued to fall during the 7/11 week to -2.0% y/y from 4.9% at the beginning of the year (Fig. 5 and Fig. 6). That’s exactly the same downward revision as occurred for Q1, which turned out to be up 2.8%. We expect a similar earnings “hook” will evolve as the current earnings reporting season unfolds.

Meanwhile, S&P 500 forward earnings per share rose to a new record high of $176.00 during the 7/11 week as it converges toward the 2020 estimate, which is currently at $184.87 (Fig. 7). This series tends to be a good leading indicator for actual earnings a year from now (Fig. 8).

(3) Profit margin. Remarkably, the forward profit margin has been holding steady around 12.1% since the start of this year (Fig. 9). That’s despite higher labor costs, higher tariffs, and a strong dollar. This suggests to us that companies may be succeeding in boosting their productivity to offset the pressure on margins.

Strategy II: Everyone Is Asking About Valuation. In recent weeks, as the S&P 500 has climbed to yet another record high, we have been getting more requests to discuss valuation. Chapter 14 of my book, Predicting the Markets (2018), examines the various models that are widely followed by investors to gauge valuation.

I concluded in the book that valuation, like beauty, is in the eyes of the beholder. In other words, it is more art than science. It is more subjective than objective. Nevertheless, Joe and I continue to monitor all the major valuation models, especially those that include the influence of inflation and interest rates. History shows that when both are high (low), valuation multiples tend to be low (high).

The conundrum is that in the current environment, we have historically low inflation and interest rates, but they are attributable to subpar domestic and global economic growth. Should investors be willing to pay high P/Es when inflation and interest rates are low, but growth is weak? That doesn’t seem like a good deal. Then again, the combination of low inflation and interest rates with slow growth may result in a longer-than-usual economic expansion. The current one became the longest one on record just this month. If it keeps going, even at a slow pace, maybe it makes sense to pay relatively high P/Es.

On balance, Joe and I believe that the current mix of inflation and interest rates and economic growth merits relatively high, above-average valuations, especially for stocks of companies that can generate consistently above-average earnings growth. Let’s have a look at some of the relevant valuation models:

(1) Misery Index. The simplest model incorporating inflation is the one showing the strong inverse correlation between the S&P 500 forward P/E and the Misery Index, which is the sum of the unemployment rate and the CPI inflation rate (Fig. 10). The Misery Index was very low at just 5.3% during June, justifying the month’s forward P/E of 16.8, which is above the historical average reading of roughly 15.0.

(2) Fed’s Stock Valuation Model. There was a relatively good fit between the S&P 500 forward earnings yield and the 10-year US Treasury bond yield from 1979 to 2001 (Fig. 11). Since then, they have diverged, suggesting either that stocks are a screaming buy relative to bonds or that bonds are grossly overvalued. At 2%, the bond yield matches the dividend yield of the S&P 500, making dividend-yielding stocks with growing dividends very attractive, in our opinion (Fig. 12).

(3) Real Earnings Yield Model. A valuation model that explicitly incorporates inflation is the one tracking the spread between the S&P 500 reported earnings yield and the CPI inflation rate (Fig. 13). Since 1952, the quarterly spread has averaged 3.3%. Bear markets were preceded by declines in the real earnings yield toward zero. During Q1, it rose back to the average, registering 3.5%.

(4) Buffett Ratio. If you are looking for overvaluation, you’ll find it in the so-called Buffett Ratio, which is the market capitalization of all US equites (excluding foreign issues) divided by nominal GNP (Fig. 14). During Q1, it stood at 1.85, only a bit below its record high at the end of the bull market of the 1990s.

However, even Warren Buffett has cautioned that this valuation metric doesn’t reflect that both inflation and interest rates are at record lows. So he is ignoring it. In a 5/6 CNBC interview, Buffett said stocks are a huge bargain if interest rates remain at their low levels. “I think stocks are ridiculously cheap if you believe ... that 3% on the 30-year bonds makes sense,” Buffett said.

US Economy: Mixed Readings. Economists like rules of thumb. One of them is that when the Index of Leading Economic Indicators (LEI) falls three months in a row, a recession is likely to follow in short order. That hasn’t happened yet. The LEI did drop 0.3% m/m during June, but that’s after no change in May and a 0.1% uptick in April. It is down 0.2% over the past three months (Fig. 15). It has turned slightly negative before on this basis a few times during the current expansion without leading to a recession.

Nevertheless, economic growth seems to be slowing based on the Index of Coincident Economic Indicators (CEI), which is up only 1.6% y/y in June, the weakest since February 2017 (Fig. 16). This growth rate is highly correlated with the comparable growth rate for real GDP. By the way, the latest Atlanta Fed GDPNow estimate for Q2’s real GDP is 1.6% (saar).

Debbie and I have some misgivings about the LEI. Its components are all very cyclical (Fig. 17). That makes sense in the context of forecasting the business cycle. However, many have run out of room to improve given that this has turned out to be the longest economic expansion on record.

For example, the average workweek has been fluctuating around its cyclical high since 2014. Jobless claims are so low that they probably can’t go much lower. Building permits also have been moving sideways at their cyclical high since 2017. This might explain why the LEI has stalled at a record high over the past nine months through June, while the CEI has continued to make record highs.

By the way, as we have noted in the past, the yield-curve-spread component of the LEI is just one of the 10 components of the LEI. It has been getting lots of attention because it seems to be signaling a recession. Indeed, it turned negative in June for the first time since January 2008. The S&P 500 is another component of the LEI. We are siding with the stock market’s upbeat message rather than the downbeat one from the credit market.

Another upbeat signal is coming from July’s business surveys conducted by the Federal Reserve Banks of New York and Philadelphia (Fig. 18). The average of the general business indexes rebounded from -4.2 during June to 13.1 during July, led by very strong growth in the Philly region. The orders and employment sub-indexes also rose smartly this month. That augurs well for the national M-PMI for this month.

The Fed: Mixed Up. Say what? Last Thursday, FRBNY President John Williams gave a speech titled “Living Life Near the ZLB.” “ZLB” stands for “zero lower bound.” Apparently, for Williams, life near the ZLB is a bit discombobulating. In the speech, he said that based on simulation models, “monetary policy can mitigate the effects of the ZLB.” He mentioned three ways:

(1) “The first: don’t keep your powder dry—that is, move more quickly to add monetary stimulus than you otherwise might. When the ZLB is nowhere in view, one can afford to move slowly and take a “wait and see” approach to gain additional clarity about potentially adverse economic developments. But not when interest rates are in the vicinity of the ZLB. In that case, you want to do the opposite, and vaccinate against further ills. When you only have so much stimulus at your disposal, it pays to act quickly to lower rates at the first sign of economic distress.”

(2) “This brings me to my second conclusion, which is to keep interest rates lower for longer. The expectation of lower interest rates in the future lowers yields on bonds and thereby fosters more favorable financial conditions overall. This will allow the stimulus to pick up steam, support economic growth over the medium term, and allow inflation to rise.”

(3) “Finally, policies that promise temporarily higher inflation following ZLB episodes can help generate a faster recovery and better sustain price stability over the longer run. In model simulations, these ‘make-up’ strategies can mitigate nearly all of the adverse effects of the ZLB.”

William’s PR department rushed to set the record straight with the WSJ, which reported after the market close: “New York Fed President John Williams didn’t intend to suggest Thursday that the central bank might make a large interest rate cut this month, a spokesman said Thursday. In the speech, presented at an academic conference in New York, Mr. Williams said policy makers needed to confront potential weaknesses more quickly given the prospect that a historically low interest rate could fall to zero sooner, leaving less room to stimulate growth in a downturn.”

Williams ended his speech by saying that the actions he recommended “should vaccinate the economy and protect it from the more insidious disease of too low inflation.” Raise your hands if you agree that “too low inflation” is an “insidious disease.”

Also weighing in a Fox Business Network interview on Thursday with a similar let’s-ease-before-we-have-to message was Fed Vice Chair Richard Clarida: “You don’t need to wait until things get so bad to have a dramatic series of rate cuts,” he said. “We need to make a decision based on where we think the economy may be heading and, importantly, where the risks to the economy are lined up.”

Let the easing begin!

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Consumers Unchained

July 18 (Thursday)

US Consumer: Spending Everywhere. The US consumer continues to keep the bull market moving forward. This week saw bank earnings bolstered by consumer lending, retail sales up strongly, and airline earnings kept aloft by travelers willing to spend.

As we mentioned in last Thursday’s Morning Briefing, all of the S&P 500 Consumer Discretionary industries’ stock price indexes—with the notable exceptions of Department Stores and Housewares & Specialties—are up strongly ytd. Joe notes that of the 22 Consumer Discretionary industries with gains, 21 are up by double digits. This week’s news reports have confirmed investors’ bullish expectations for consumer-related stocks.

Here’s the performance derby for the S&P 500’s sectors ytd through Tuesday’s close: Technology (30.1%), Consumer Discretionary (26.3), Communication Services (23.0), Industrials (22.1), Real Estate (21.1), S&P 500 (19.8), Consumer Staples (18.3), Financials (17.8), Materials (16.0), Utilities (14.3), Energy (10.2), and Health Care (6.5) (Fig. 1).

Let’s take a look at how consumer spending continues to keep the earnings parade rolling along:

(1) Remarkable retail sales. Consumer spending drove retail sales to the latest record high in June, Debbie reports (Fig. 2). Total real retail sales climbed 3.9% (saar) during Q2. Excluding building materials, the figure is even higher, at 5.4%; when autos, gasoline, building materials, and food services are excluded, it’s still higher than the total, at 4.0% (Fig. 3).

Consumers continue to shop ’til they drop online and shun department stores (Fig. 4 and Fig. 5). They’re also spending mightily in warehouse clubs and eating and drinking establishments (Fig. 6 and Fig. 7). Even spending on motor vehicles and at parts dealers hit a new high last month (Fig. 8).

(2) Consumers in the air. Strong demand for travel helped United Airlines Holdings post Q2 profit growth of 54% y/y, to $1.1 billion. To meet future demand, United signed an agreement to buy 19 used Boeing 737-700 planes. It has grounded 14 737 Max 9 jets through the start of November. The 737 groundings mean that the airline’s capacity will only grow by 3%-4%, less than 4%-5% before the groundings.

United’s shares are up 5.1% over the past five trading sessions, helping boost the Dow Jones Transportation Average (DJTA) by 4.9% since last Wednesday (Fig. 9). Another member of that index, J.B. Hunt Transport Services, gave investors a “relatively upbeat outlook for the months ahead,” a 7/16 WSJ article reported.

The paper quoted Shelley Simpson, Hunt’s CFO, on the earnings call saying: “From a demand perspective, our customers are optimistic. They did recognize the level of inventory that they brought in [was] incremental to avoid what was happening around tariffs, but they’re starting to work through that inventory and feel better about the back half of the year.” That helped lift the company’s stock by 5.6% in the aftermarket on Tuesday.

By the way, after having the strongest performance among the Transports, up almost 30% ytd, the S&P 500 Railroad industry is showing some signs of running out of steam. CSX told investors in its conference call to expect a 2% drop in revenue this year, instead of its earlier forecast for a 1%-2% increase. The rail operator’s CEO Jim Foote blamed the reduced forecast on lower coal deliveries in the wake of low natural gas prices, lower volumes in intermodal traffic, and weakness in demand from the company’s industrial customers. In addition, CSX was affected by the shutdown of a refinery, to which it had delivered crude oil. The earnings report once again highlights the difference between the industrial economy, hurt by US/Chinese trade negotiations, and the consumer economy that so far has been left unscathed by trade tensions.

The Dow Transports are now 6.7% off their 9/14 high, edging closer to confirming the latest new high the Dow Jones Industrial Average made this week. As we noted in Tuesday’s Morning Briefing, the DJTA has been held back by the companies in the Air Freight & Logistics industry, including FedEx, which have been hampered by the slowdown in international trade as well as the threat that Amazon will continue to build out its own delivery network. The S&P 500 Air Freight & Logistics remains 24.1% below its record high on 1/12/2018.

(3) Consumers boost banks. With trading in the doldrums and net interest margins under pressure, consumer lending saved the day at many of the banks that reported earnings this week (Fig. 10).

Bank of America reported yesterday that its net interest income rose 3% y/y but fell 1.5% q/q. Net income jumped 13% in the consumer banking segment and 11% in the global wealth management division, but fell 9% in global banking. Adjusted global sales and trading revenue slid 10%.

CEO Brian Moynihan highlighted the consumer’s strength: “Our view of the economy reflects the activity by the one-in-two American households we serve, which points to a steadily growing economy. We see solid consumer activity across the board, with spending by Bank of America consumers up five percent this quarter over the second quarter of last year.”

At Bank of America’s consumer banking unit, average loans and leases grew 5.6% y/y, while credit card balances were flat. US consumer credit outstanding has been growing steadily since 2010, with auto and student loans growing sharply (Fig. 11 and Fig. 12). But consumers’ debt-service ratio—the ratio of debt-service payments to disposable personal income—remains near 30-year lows (Fig. 13).

PNC’s Q2 earnings also benefitted from its consumer business. The bank’s net interest margin shrank 0.05ppts y/y to 2.91%, but income rose in retail banking by 18.6% y/y while falling in corporate & institutional banking by 8.3%. Average loans outstanding increased y/y in both areas: 4% in retail and 7% in commercial & institutional, according to the company’s press release.

However, the commercial business was hurt by a jump in the provision for credit losses to $100 million in Q2 from $15 million a year earlier. In the retail business, the y/y increase in the provision for credit losses was only $9 million, to $81 million.

Finance: Libra Grilling. Facebook’s past actions have angered both Democrats and Republicans, so Facebook’s David Marcus, vice president of Messaging Products, faced a tough audience when he testified Tuesday in front of the Senate Banking Committee. Senators repeatedly noted their distrust of Facebook and the company’s need to resolve the problems in its existing businesses. However, some senators did express appreciation for the company’s technological innovation and voiced a desire for the US to lead in the era of digital currency.

The senators’ questions and diatribes were the latest pushback that Facebook and its Libra digital currency have faced. Here are some of the takeaways from the Senate hearing and recent news reports:

(1) Really for the unbanked? Facebook has made much ado about how Libra will help bring the 1.7 billion people without access to the banking system into the financial fold by providing financial services to those without bank accounts at much lower costs than anyone offers currently. Broadening access to the banking system is a common discussion theme in Congress. Who wouldn’t like to reduce financial costs to consumers and increase the number of banking clients?

However, Facebook did little to explain how hard currency would actually be turned into Libra by people without a bank account. Facebook’s white paper says the firm is in discussions with “principal cryptocurrency trading firms and top banking institutions as authorized resellers to allow people the opportunity to exchange their local currencies for Libra as easily as possible.” But currency exchanges exist today, and they charge a lot. Why will Libra’s currency exchanges charge less?

(2) Identity verification. Facebook’s Marcus continually noted that fraud would be avoided because customers would need to enter their government identification in order to open a Libra account. But we wonder just how many of the unbanked have government IDs and how Facebook intends to ensure that the ID is valid and not a fake.

(3) Who’s responsible? Many questions centered around who would be responsible if a customer’s account was hacked or if the customer fell victim to fraud. Is it the wallet provider? What happens if the wallet provider is an overseas company? US banking customers are used to being made whole if their banking account is hacked, and credit card customers are made whole when defrauded.

Another line of inquiry targeted Libra’s unwieldy structure, with its headquarters in Switzerland and 100 founding members who elect a board of 5-19 people, who in turn elect a managing director. One senator went as far as to jokingly compare it to SPECTRE, the fictional, evil organization in the James Bond films that isn’t allied with any government.

(4) Mnuchin, Trump, Powell are doubtful. The three most powerful folks in government have expressed reservations about Libra. Treasury Secretary Steven Mnuchin in a press conference Monday said that Libra “could be misused by money launderers and terrorist financiers.” He compared it to cryptocurrencies, which have been used in illicit activities like drug and human trafficking.

Mnuchin’s comments came a few days after President Donald Trump tweeted that he was “not a fan” of cryptocurrencies like bitcoin. He added: “If Facebook and other companies want to become a bank, they must seek a new Banking Charter and become subject to all Banking Regulations, just like other Banks, both National and International.”

Fed Chair Jerome Powell added his voice to the mix when testifying before the Senate Banking Committee last week: “I think we agree that Libra raises a lot of serious concerns, and those would include around privacy, money laundering, consumer protection, financial stability,” he said. “Those are going to need to be thoroughly and publicly assessed and evaluated before this proceeds,” a 7/11 WSJ article reported.

(5) Objections from abroad. France’s Finance Minister Bruno Le Maire also raised objections to Libra. Countries have strong rules and commitments regarding their currencies. “We cannot accept a new currency having the exact same kind of power, without the same kind of rules, without the same kind of commitments, and without the same kind of obligations,” he said according to a 7/17 CNBC article. In addition, he raised concerns about the potential for money laundering and the funding of terrorism using Libra. Marcus is facing an uphill battle.

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Central Bankers’ Ballet

July 17 (Wednesday)

Central Banks I: Pirouette Lessons. Fed Chair Jerome Powell and European Central Bank (ECB) President Mario Draghi have been taking ballet lessons. They’ve both mastered the pirouette. They might have learned to do so from a YouTube video titled “How to Pirouette” with Alexandra MacDonald, the first soloist of the National Ballet of Canada. The problem with this maneuver is that after all that effort to execute a perfect turn, you remain exactly where you were before! Let’s review the recent performances of these two remarkably agile central bankers.

Central Banks II: Draghi’s Dance. Last Thursday (7/11), the ECB released the minutes of the 6/5-6/6 meeting of the central bank’s Governing Council. ECB officials were in “broad agreement” at their June meeting that the bank should “be ready and prepared to ease the monetary policy stance further by adjusting all of its instruments,” according to the minutes. The 7/11 WSJ explained:

“While the exact timing of any ECB action remains unclear, analysts said the bank could cut its key interest rate, currently set at minus 0.4%, as soon as its next policy meeting on July 25. More likely, the ECB could clearly signal a rate cut at its July meeting, and follow through on Sept. 12, when policy makers will have fresh economic forecasts for growth and inflation.”

This wasn’t a big surprise since ECB President Mario Draghi in a 6/18 speech in Sintra, Portugal refreshed his “whatever-it-takes” approach to central banking by saying: “In the absence of improvement, such that the sustained return of inflation to our aim is threatened, additional stimulus will be required.”

In his speech, as reported by CNBC, Draghi declared: “The (European) Treaty requires that our actions are both necessary and proportionate to fulfil our mandate and achieve our objective, which implies that the limits we establish on our tools are specific to the contingencies we face. If the crisis has shown anything, it is that we will use all the flexibility within our mandate to fulfil our mandate—and we will do so again to answer any challenges to price stability in the future.”

He also said: “We remain able to enhance our forward guidance by adjusting its bias and its conditionality to account for variations in the adjustment path of inflation. This applies to all instruments of our monetary policy stance.” He added: “Further cuts in policy interest rates and mitigating measures to contain any side effects remain part of our tools. And the APP [Asset Purchase Program] still has considerable headroom.”

The ECB has had a negative deposit facility rate since 6/11/14 (Fig. 1). The central bank started its APP on 1/22/15 and terminated it at the end of 2018 (Fig. 2).

The surprise is that the minutes showed broad support at the June meeting for an aggressive approach. Officials noted that they should be ready to use all policy tools, including interest-rate cuts and fresh bond purchases, “in the light of the heightened uncertainty which was likely to extend further into the future.”

This was all quite a reversal from the ECB’s plans to start normalizing its monetary policy, as expected earlier this year. The ECB had previously been moving to phase out its extraordinary policy tools, including negative interest rates, and had been guiding investors to expect a future interest-rate hike. The central bank phased out its €2.6 trillion bond-buying program, a.k.a. quantitative easing, at the end of 2018.

But then the ECB rolled out fresh stimulus in March, pushing back the timing of an interest-rate rise—which was further extended on 6/6—and unveiling a new batch of cheap long-term loans for banks. At his post-meeting 6/6 press conference, Draghi announced that in response to rapidly deteriorating inflation expectations, the ECB would keep interest rates at their current, record-low level at least through the first half of 2020, instead of the end of this year as stated in March. Also, he said banks would be allowed to borrow from the ECB at a rate just 10 basis points above its minus 0.4% deposit rate provided that they beat the ECB’s lending benchmarks in a new targeted longer-term refinancing operation, or TLTRO.

In the Q&A session after that 6/6 press conference, Draghi said several members of the Governing Council raised the possibility of rate cuts in the meeting, while others mentioned restarting asset purchases. The minutes confirmed that there actually was broad support for these actions, as noted above. Here’s a quick review of Draghi’s pirouette based on his press conferences since the spring of 2018:

(1) 4/26/18 presser. Draghi confirmed that APP would continue at a pace of €30 billion until the end of September 2018, “or beyond, if necessary.”

(2) 6/14/18 presser. Draghi announced that the pace of APP purchases would be cut to €15 billion per month from October to December 2018, and then purchases would stop.

(3) 12/13/18 presser. Draghi confirmed that APP will be terminated by the end of the year and reiterated that “we intend to continue reinvesting, in full, the principal payments from maturing securities purchased under the APP for an extended period of time past the date when we start raising the key ECB interest rates…”

(4) 3/7/19 presser. Draghi said that interest rates would remain unchanged “at least through the end of 2019.”

(5) 6/6/19 presser. Draghi said that interest rates now would remain unchanged “at least though the first half of 2020.” He also strongly suggested that the next rate move would be a cut rather than a hike, and that APP might be reactivated.

It’s not so obvious why ECB officials are freaking out about the need for another round of easing. Granted: The headline and core CPI rose just 1.2% and 1.1%, respectively, over the past year through June, based on the flash estimates (Fig. 3). But both rates, particularly the core rate, have been mostly below the ECB’s 2.0% target since the Great Recession, notwithstanding ultra-easy monetary policy. Why would another round of it work any better?

Granted: The Eurozone’s economic indicators have been weak, especially the ones for manufacturing. But the region’s industrial production (excluding construction) rose 0.9% m/m during May, suggesting that the sector may be bottoming (Fig. 4).

Central Banks III: Powell’s Turn. Fed Chair Powell has also been working on his pirouette since the start of this year. Last year, his hawkish off-the-cuff comments in an interview on 10/3/18 sent stock prices reeling, resulting in a 19.8% plunge in the S&P 500 from 9/20/18 through 12/24/18 (Fig. 5 and Fig. 6). Then in a 1/4/19 panel discussion, he walked back his hawkish talk with dovish comments. This time, he read from a script to avoid making another bearish gaff. He said that the Fed would be “patient,” implying a long pause in rate-hiking. Melissa and I dubbed it “Patient Powell’s Put” in our 1/7/19 Morning Briefing.

Sure enough, the stock market loved what has also widely been called “Powell’s Pivot,” sending the S&P 500 soaring 25.3% from the 12/24/18 low to a new record high on 4/30/19. Like the three Fed chairs before him, Powell was stress-tested by the stock market and delivered the obligatory put, just as Greenspan, Bernanke, and Yellen had done.

The escalation of the US-China trade war in early May sent stock prices down sharply again, by 6.8% through 6/3/19. Once again, the Fed chair revived the market with even more dovish talk in the second paragraph of his prepared 6/4/19 remarks. He said that monetary policy would “act as appropriate to sustain the expansion, with a strong labor market and inflation near our symmetric 2 percent objective,” implying rate-cutting ahead. The S&P 500 soared 9.2% to yet another new record high on 7/3 thanks to “Powell’s Pirouette.”

Last Thursday (7/11), Powell told the Senate Banking Committee: “The relationship between unemployment and inflation became weak” about 20 years ago “It’s become weaker and weaker and weaker.” He also told the senators that the so-called “neutral rate,” or policy rate that keeps the economy on an even keel, is lower than past estimates have put it—meaning monetary policy has been too restrictive. “We’re learning that interest rates—that the neutral interest rate—is lower than we had thought, and I think we’re learning that the natural rate of unemployment is lower than we thought,” he said. “So monetary policy hasn’t been as accommodative as we had thought.”

It’s also not obvious why Fed officials are freaking out over the need to lower interest rates after spending so much time and effort getting us acclimated to normalizing monetary policy in the US. Granted: The latest Atlanta Fed’s GDPNow is showing real GDP rising just 1.6% during Q2. But yesterday’s reading for real consumer spending in real GDP was raised to 4.2% from 3.8% following the release of June’s solid retail sales report (Fig. 7)! Manufacturing output rose 0.4% during June, following a 0.2% gain in May, the first back-to-back monthly increases since the end of last year (Fig. 8).

Granted: The headline and core PCE deflator rose just 1.5% and 1.6% y/y through May (Fig. 9). But didn’t Powell say at his 5/1 presser that some of the recent weakness was likely transitory?

In his testimony last Thursday, Powell left no doubt that he is ready to cut the federal funds rate at the end of this month to boost the economy. He implied as much in his congressional testimony on Wednesday before a House committee. He was more emphatic about it on Thursday during his Q&A before a Senate committee.

Yesterday, Powell showed off his pirouette in Paris. He gave a speech titled “Monetary Policy in the Post-Crisis Era” at a conference organized by the Banque de France. He pulled back a bit from the ready-to-ease tone of his Thursday testimony, saying:

“In our baseline outlook, we expect growth in the United States to remain solid, labor markets to stay strong, and inflation to move back up and run near 2 percent. Uncertainties about this outlook have increased, however, particularly regarding trade developments and global growth. In addition, issues such as the U.S. federal debt ceiling and Brexit remain unresolved. FOMC participants have also raised concerns about a more prolonged shortfall in inflation below our 2 percent target. Market-based measures of inflation compensation have shifted down, and some survey-based expectations measures are near the bottom of their historical ranges.

“Many FOMC participants judged at the time of our most recent meeting in June that the combination of these factors strengthens the case for a somewhat more accommodative stance of policy. We are carefully monitoring these developments and assessing their implications for the U.S economic outlook and inflation, and will act as appropriate to sustain the expansion, with a strong labor market and inflation near its symmetric 2 percent objective.”

Central Banks IV: The Great Delusion. Central bankers tend to be macroeconomists who were taught in graduate school that inflation is a monetary phenomenon. They were also taught to hate deflation as much as inflation. That’s why the major central banks have all pegged 2.0% as their Goldilocks inflation target, not too hotly inflationary or frigidly deflationary.

But surely, they must have learned over the past 11 years that inflation isn’t a monetary phenomenon after all. They must realize that there are four powerful forces of deflation that are microeconomic in nature. I’ve dubbed them the “4Ds,” Détente, Demographics, Disruption, and Debt.

In his speech in Paris yesterday, Powell (sort of) mentioned them in passing: “Many factors are contributing to these changes—well-anchored inflation expectations in the context of improved monetary policy, demographics, globalization, slower productivity growth, greater demand for safe assets, and weaker links between unemployment and inflation. And these factors seem likely to persist.”

He has been worrying a great deal recently that these factors collectively may continue to keep the “neutral rate of interest low,” i.e., too close to zero, which is the dreaded “effective lower bound.” He concluded: “This proximity to the lower bound poses new complications for central banks and calls for new ideas.”

The problem is that the central bankers have run out of new ideas (and policy tools), so they keep trying the same old ones. Their delusion is that doing more of the same (i.e., ultra-easy monetary policy) should boost inflation to 2.0%. Maybe they should just give up on the notion that deflation is a bad outcome of the 4Ds and admit that they are trying to fix a problem that monetary policy cannot fix.

If they persist in their delusion and their ultra-easy monetary policies, the outcome will continue to be asset price inflation, especially in global equity markets. That’s fine, until it isn’t.

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Truck & Train Spotting

July 16 (Tuesday)

US Transportation: Mixed Signals. While the Dow Jones Industrials Average (DJIA) rose to a record high on Friday, the Dow Jones Transportation Average (DJTA) remained 8.1% below its record high set on 9/14/18 (Fig. 1). In other words, the record-setting strength of the DJIA has yet to be confirmed by the DJTA, according to proponents of Dow Theory, who would be more bullish if the DJTA also crossed into record territory.

The S&P 500 Railroads industry accounts for 50% of the market capitalization of the S&P 500 Transportation composite and is within a short station stop away from the record high hit on 5/3 (Fig. 2). Weighing most heavily on the S&P 500 Transportation composite is the Air Freight & Logistics industry, which accounts for 28% of the composite’s market cap and, on Friday, was still 24.4% below its record peak on 1/12/18 (Fig. 3).

All of the above suggests that the global economy is weaker than the US domestic economy. Debbie and I can see this divergence in the US transportation indicators that we follow:

(1) Trucking tonnage and employment. The US trucking industry just keeps truckin’ on. In June, payroll employment in truck transportation rose 4,300 m/m and 36,800 y/y to another record high (Fig. 4). This series is highly correlated with the ATA truck tonnage index, which rose to a record high in May based on the three-month moving average of the series. We’ve found that the trucking payrolls series is actually a very good leading indicator of the economy (Fig. 5).

Confirming the strength of the trucking industry is that average hourly earnings in trucking rose 5.9% y/y through May (Fig. 6). Rapidly rising wages seem to be attracting more truck drivers. Yet the Producer Price Index (PPI) inflation rate for truck transportation is down from a recent peak of 8.2% y/y during October 2018 to 2.8% during June.

(2) Railcar loadings. Now for the bad news: Railcar loadings (including both carloads and intermodal container units) are very weak. We track the y/y growth rate in the 26-week moving average to reduce the volatility in this series. It was down 3.4% during the 7/6 week (Fig. 7). It is highly correlated with the y/y growth rate in manufacturing output, which has been slowing all year but remained positive during May, though at a meager 0.7%.

(3) West Coast ports activity. The growth rate in railcar loadings of intermodal containers is highly correlated with the growth rate in the sum of US real exports and real imports of merchandise (Fig. 8). The former was down 3.0% y/y through the 7/6 week, while the latter has been fluctuating around zero over the past couple of months through May. The West Coast ports data show that the 12-month sum of their exports has been slipping all year, while the 12-month sum of their imports has been basically flat (Fig. 9 and Fig. 10).

(4) Vehicle miles traveled. Meanwhile, Americans continue to drive, pushing the 12-month sum of vehicle miles traveled up 0.7% y/y in April to another record high (Fig. 11). By the way, gasoline usage has been relatively flat over the past couple of years, implying that gasoline fuel efficiency is still improving in the US (Fig. 12).

China Transportation: Moving Forward. We don’t have as much data on transportation in China as we have for the US. We do have monthly data on railways traffic in China. Consider the following:

(1) Railways traffic. We track the 12-month average of railway freight traffic because the monthly series is quite volatile (Fig. 13). It rose 8.2% y/y during May to a record high. It is somewhat correlated with the sum of Chinese imports plus exports, also on a 12-month basis and in yuan. The latter has been relatively flat since late last year, rising 8.6% y/y through June, having slowed from October’s recent peak of 11.3%.

(2) Exports and imports. The implication of China’s transportation and trade data—like that of the US data—is that the domestic economy is stronger than the global economy. By the way, China’s monthly trade data, as reported widely in the press, are not seasonally adjusted. Our data vendor, Haver Analytics, provides seasonally adjusted data in yuan. They show that both Chinese exports and imports have stalled at record highs since mid-2018 (Fig. 14).

(3) PPI. There’s a surprisingly good correlation between the y/y growth rate in railways freight traffic and China’s PPI, which was unchanged from a year ago during June (Fig. 15). That’s the lowest such inflation rate since late 2016 and implies that industrial profits are also weakening.

(4) GDP. The financial press reports China’s real GDP growth rate on a y/y basis. Our friends at Haver also calculate the comparable quarterly data at a seasonally adjusted annual rate (saar). Yesterday’s headlines reported that the y/y growth rate slowed to 6.2% through Q2, the weakest in the history of the series, which goes back to Q2-1992 (Fig. 16). The quarterly number was even weaker at 5.5% (saar).

US Economy: Is the Labor Market as Tight as It Gets? “How Have Lower-Educated Workers Fared since the Great Recession?” is the title of an expository box in the Fed’s 7/5 Monetary Policy Report (MPR). It helps to explain why Fed Chair Jerome Powell said during his semi-annual testimony to Congress last week that monetary policy may need to be more accommodative. The labor market may not be as tight as it seems based on the unemployment rate. More importantly, it continues to improve, especially for lower-educated workers. The Fed should accommodate that healthy trend, according to the Fed chair.

Powell feels that there may be even more room to run in the labor market, particularly for wage growth. During his testimony, Powell said: “We don't have any basis or any evidence for calling this a hot labor market.” He observed: “While we hear reports of companies finding it hard to find qualified labor, we don't see wages responding.”

Our key takeaway from Powell’s comments and the MPR box is that a case can be made to run accommodative policy for longer to benefit lower-skilled workers. Let’s further explore the MPR box and connect these thoughts:

(1) Employment-to-population ratio. Since the end of the Great Recession, the unemployment rate has dropped about 6ppts, and the employment-to-population ratio (EPOP) for prime-aged persons (i.e., between 24 and 54 years old) has risen about 4.5ppts. However, lower- and higher-educated people have fared quite differently in the labor market over that time period, the MPR observed.

The EPOP for prime-aged college graduates declined about 2.5ppts during the recession, then steadily recovered from 2010 to nearly its pre-recession level by 2018. For prime-aged persons with a high-school degree or less, the EPOP declined much more dramatically during the recession and did not begin to recover until 2014. It continued to remain below its pre-recession level in 2018, according to staff calculations using the Current Population Survey. (See chart A on page 8 of the MPR.)

(2) Real wages. Following the recession, the percentage change in inflation-adjusted hourly wages declined more for prime-aged lower-educated workers than it did for prime-aged college graduates. Real wages since have recovered on a percentage basis for both groups, but only recently for lower-educated workers. (See chart B on page 8 of the MPR).

(3) Reasons for relative unemployment. Evidence suggests that the less educated may benefit less than the highly educated when unemployment is sustained below its natural rate. Lower-educated workers’ underperformance relative to higher-educated ones is a trend apparent in business cycles going back to at least 1980, the report observed.

It may take at least eight years following a recession for the EPOP for lower-educated workers to recover, the report found. One reason may be that employers require higher standards for new hires during a recession, only lowering these restrictions later, during the subsequent recovery. Another reason is that during recessions higher-skilled workers tend to accept jobs requiring lower skills than they would otherwise.

Globalization and technology may also influence labor-market outcomes for lower-skilled versus higher-skilled workers, noted the report.

Owing to these trends, in our view, the employment prospects for lower-skilled workers may deteriorate over time irrespective of the business cycle. However, given that employment trends have continued to improve for lower-skilled workers following the recession up until now, we can see why Powell may be looking for more out of the labor market.

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Wuthering Heights

July 15 (Monday)

Strategy I: New Stormy Highs. In her novel Wuthering Heights, Emily Brontë explained the origin of the word “wuthering”: “Wuthering Heights is the name of Mr. Heathcliffe’s dwelling. ‘Wuthering’ being a significant provincial adjective, descriptive of the atmospheric tumult to which its station is exposed, in stormy weather.”

Now that the S&P 500 is once again climbing to record heights, can investors expect that it will get stormier? That will depend on whether investors will continue to suffer recurring bouts of anxiety. Joe and I have dubbed such events “Panic Attacks.” By our count, there have been 63 since the start of the current bull market. (See the table and the charts.)

Some have been more intense than others. Following Panic Attack #25, which was associated with fears of a “fiscal cliff” at the end of 2012, we noted that most of our accounts were fully invested bears (a.k.a. “FIBERs”) and experiencing anxiety fatigue. They were tired of being anxious about the bull market. If that description fit investors generally, it should have led to fewer and less severe panic attacks.

But that’s not what happened. There have been another 38 panic attacks by our count since early 2013, including four outright corrections (Fig. 1). The latest one saw the S&P 500 plunge 19.8% from 9/20/2018-12/24/2018. Since then, the index is up 28.2% through Friday’s close. Along the way, the market has climbed to new heights, but the weather has remained stormy.

That’s partly because the new heights have been mostly achieved with rising forward P/Es. That makes the market vulnerable to valuation multiple contractions when investors turn jittery (Fig. 2). Here are the past four P/E corrections: down 7.6% from 16.9 to 15.6 (4/30/19-6/3/19), down 19.8% from 16.8 to 13.5 (9/20/18-12/24/18), down 9.1% from 18.6 to 16.9 (1/26/18-2/5/18), and down 11.1% from 16.6 to 14.8 (11/3/15-2/11/16).

On Friday, the 17.1 forward P/E of the S&P 500 was 8% below its bull-market peak of 18.6 on 1/26/2018. So how did the S&P 500 manage to reach new highs last week? Consider the following:

(1) Revenues. The forward revenues per share of the S&P 500 rose to a record high during the 7/4 week (Fig. 3). So did forward earnings. As a result, the forward profit margin leveled out in recent weeks around 12.1%. That’s all very impressive.

It’s impressive that analysts’ consensus expectation for revenues over the next 52 weeks is so strong despite all the depressing headline news about weakness in the global economy. As we have noted previously, S&P 500 weekly forward revenues is a very good coincident indicator of the trend in the actual quarterly series.

On the other hand, numerous other economic indicators that correlate closely with S&P 500 revenues suggest that the analysts may be too optimistic. For example, the y/y growth rate in S&P 500 revenues per share tracks the US M-PMI very closely. The former was 5.8% during Q1. The latter was 51.7 during June, the weakest since October 2016, when the former was only 3.0% (Fig. 4). Here are the latest (May) y/y growth rates of other indicators that also correlate well with S&P 500 revenues-per-share growth: US business sales (1.5%), factory orders (-1.2), and US merchandise exports (-2.6) (Fig. 5, Fig. 6, and Fig. 7).

(2) Earnings. Bearishly inclined strategists have been inclined to observe that earnings are in a growth recession. They are right about the earnings growth recession, but wrong about that being bearish for stocks. How can that be?

The market discounts the future, not the past—or even the present unless it has bearish or bullish implications for the future. The market is at record highs because investors mostly expect that today’s earnings growth recession will be followed not by an outright earnings recession but by improving earnings growth. We agree. Furthermore, record-low interest rates in Europe and Japan, and historically low interest rates in the US all are boosting valuation multiples.

S&P 500 earnings per share rose just 2.8% y/y during Q1. Industry analysts currently expect them to fall 1.6% during Q2 and edge up just 0.4% during Q3 (Fig. 8). That’s certainly an earnings growth recession, reminiscent of a similar experience during 2015 and 2016.

Back then, the S&P 500 was volatile and relatively flat from the start of 2015 through mid-2016. Then it wuthered to new heights over the rest of 2016 through early 2018 as earnings growth was revived by a rebound in the global economy (Fig. 9).

Currently, industry analysts are projecting that earnings growth should improve to 7.1% during Q4-2019. It is expected to be 10.8% in 2020 following only 2.6% this year. Joe and I are a bit less upbeat than the analysts, who must have had even happier childhoods than we did. We expect earnings per share to rise 3.1% this year, 5.4% next year, and 8.0% in 2021 (Fig. 10).

(3) S&P 500 targets. We are still projecting that the S&P 500 will climb to 3100 before the end of this year. That wouldn’t take much effort, since it is only 2.8% higher than Friday’s close. We are projecting 3500 for next year. We are thinking ahead, figuring that next year the market will increasingly be discounting earnings of $190 per share for 2021 (an 8% increase over 2020). To get to 3500, we’ll need to see the forward P/E at 18.4—which we think is doable.

This is certainly a happier tale than the one in Wuthering Heights.

Strategy II: Active Managers Getting FAANGM’d. We received the following email message from one of our accounts in response to our recent analysis of the FANGs:

“If you include AAPL and MSFT in FANG you’re looking at 17% of the S&P 500 and a 30% average ROR this year. This has been a killer for active management. For instance, we run a 50-stock portfolio with 2% ‘full’ positions. To match that exposure, we’d have to buy all six of the names (in spite of stretched valuations) and target each at 3% (i.e. ‘full and a half’).”

I asked Joe to broaden our analysis from the FANGs to the FAANGMs by including Apple and Microsoft. Here is what he found:

(1) Market-cap share. Sure enough, as of 7/12, they accounted for 18.1% of the S&P 500 market capitalization (Fig. 11). That’s up from 9.0% at the start of 2013. They did get whacked during the correction at the end of last year, but their market-cap share rebounded from a low of 15.8% on 1/4 of this year to 18.1% currently.

Since the start of 2013, the FAANGMs’ market cap is up 298%. Over that same period, the market cap of the S&P 500 with and without these stocks rose 100% and 80% (Fig. 12). Since the beginning of this year, the FAANGMs’ market cap is up 31%, while the S&P 500 excluding this group is up just 19%.

(2) Forward earnings. The aggregate forward earnings of the FAANGMs is up 78% since the start of 2015, while it is up 39% and 26% for the S&P 500 with and without the FAANGMs (Fig. 13).

(3) Valuation. The forward P/E of the FAANGMs is currently 30.8 versus 17.2 for the overall S&P 500 and 15.7 excluding them from the index (Fig. 14 and Fig. 15).

(4) Share count. While the FAANGMs have been buying back their shares, the per-share impact has been relatively small compared to the organic growth in their earnings. Joe calculates that from Q3-2012 through Q1-2019, basic shares outstanding of the FAANGMs has declined 10.9%, or at an average annual rate of 1.7% (Fig. 16). He found that over the same period the share count of the S&P 500 excluding the FAANGMs fell 6.4%, or 1.0% annualized. Both stats belie the widespread notion that buybacks have significantly fueled the bull market by boosting earnings per share. (For more on this, see our Topical Study #84, “Stock Buybacks The True Story.”)

(5) Growth vs Value. Growth has been mostly outperforming Value during the current bull market (Fig. 17 and Fig. 18). Obviously, the outperformance of the FAANGMs has been a major contributor to that divergence.

Above-average growth is scarce in our world of subpar growth. Companies that can deliver above-average growth get higher P/Es and higher market capitalizations, which make them even more influential in a market-cap-weighted index like the S&P 500.

It’s also worth noting that market concentration has increased while competition has decreased across lots of industries. That’s easily demonstrated in technology by the FAANGMs. According to a 4/23 Oxford Academic paper, discussed in a 7/12 The Nation article: “[F]irms in industries with the largest increases in product market concentration show higher profit margins.” Fair or not, big companies that hold market power are today’s top performers. It is what it is.

The Fed: Where Is the Storm? While we are on the subject of stormy weather, last Thursday, Atlanta Federal Reserve Bank President Raphael Bostic said: “I am not seeing the storm clouds actually generate a storm yet.” He said he is skeptical of the need to cut interest rates right now. “With very few exceptions businesses are telling me the economy is performing as strong as it was. They are not seeing weaknesses in consumer engagement. And they are not materially changing their plans.” These remarks followed a speech in which Bostic concluded that neither inflation nor inflation expectations are materially off target or trending that way. Bostic is a non-voter on the Federal Open Market Committee (FOMC) this year, so his opinion may not matter as much as the views of those who do get a vote.

That same day, Richmond Federal Reserve Bank President Thomas Barkin, also a non-voter on the FOMC this year, said that the economy is still humming and he sees no clear need for the Fed to ease monetary policy. Highlights of his comments on the bank’s website included this observation: “I don’t see the current levels of inflation or inflation expectations as a trigger for additional accommodation. The potential to use rate changes to alter firms’ settled routines is small, and the potential cost of overreaching feels real. It’s also hard to make a case for stepping on the gas with unemployment so low and consumer spending so healthy.”

That was the very same day that Fed Chair Jerome Powell left no doubt that he is ready to cut the federal funds rate at the end of this month to boost the economy. He implied as much in his congressional testimony on Wednesday before a House committee. He was more emphatic about it on Thursday during his Q&A before a Senate committee, as evidenced by these excerpts:

(1) The US economy is “in a very good place. The Fed wants “to use our tools to keep it there.”

(2) “We’re learning that interest rates—that the neutral interest rate—is lower than we had thought and I think we’re learning that the natural rate of unemployment is lower than we thought. … So monetary policy hasn’t been as accommodative as we had thought.”

(3) “The relationship between unemployment and inflation became weak” about 20 years ago. “It’s become weaker and weaker and weaker.”

Also on Thursday, two Fed governors (who get a permanent vote on the FOMC) seconded Powell’s dovish talk. New York Fed President John Williams, speaking later in the day than Powell, said that the argument to ease had strengthened and the central bank wants to “extend this expansion, and have monetary policy in the right place to do that.” At another event the same day, Fed Governor Lael Brainard said: “Taking into account the downside risks at a time when inflation is on the soft side would argue for softening the expected path of monetary policy according to basic principles of risk management.”

On Friday, Chicago Fed President Charles Evans, a current FOMC voter who has a history of leaning dovish, said that “a couple of rate cuts” could help push the PCE inflation rate above 2.0% by 2021, which would be “a perfectly acceptable, good outcome,” reported Bloomberg. Echoing Powell, Evans said: “Because inflation expectations seem to me to be anchored a little bit below a level consistent with our 2% objective, and it’s been stubborn like that, I think that tells me that our current setting for policy is a little bit on the restrictive side.”

Movie. “Maiden” (+ + +) (link) is an outstanding documentary about Tracy Edwards, a 24-year-old cook on a sailing ship who aspired to enter the 1989 Whitbread Round the World sailing competition with the first-ever all-female crew. She had no problem putting together a crew of 10 first-rate female sailors. But getting a boat and financial backing were huge struggles, since sponsors feared that an all-female crew would die at sea and generate bad publicity. She and her crew reconditioned a used boat and received some financial backing from Jordan’s King Hussein. The sheer guts of these remarkable women is awe-inspiring. The movie is a reminder that everyone is capable of great things even if the stupid biases of others stand in their way.

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Powell Gets Trumped!

July 11 (Thursday)

The Fed: Trump’s Powell Play. President Donald Trump wants the Fed to lower interest rates. Fed Chair Jerome Powell claims that the Fed is independent and won’t bow to political pressure. Yet Trump has figured out the perfect way to force the Fed to lower interest rates. All he has to do is keep creating uncertainty about US trade policy. In his congressional testimony yesterday on monetary policy, Powell mentioned the trade issue eight times in his prepared remarks:

(1) “However, inflation has been running below the Federal Open Market Committee's (FOMC) symmetric 2 percent objective, and crosscurrents, such as trade tensions and concerns about global growth, have been weighing on economic activity and the outlook.”

(2) “The slowdown in business fixed investment may reflect concerns about trade tensions and slower growth in the global economy.”

(3) “Moreover, a number of government policy issues have yet to be resolved, including trade developments, the federal debt ceiling, and Brexit.”

(4) “At the time of our May meeting, we were mindful of the ongoing crosscurrents from global growth and trade, but there was tentative evidence that these crosscurrents were moderating.”

(5) “The latest data from China and Europe were encouraging, and there were reports of progress in trade negotiations with China.”

(6 & 7) “Apparent progress on trade turned to greater uncertainty, and our contacts in business and agriculture report heightened concerns over trade developments.”

(8) “Since then, based on incoming data and other developments, it appears that uncertainties around trade tensions and concerns about the strength of the global economy continue to weigh on the U.S. economic outlook.”

The message to Trump is clear: Keep trade negotiations ongoing and alternate your messaging about how they are going between well and not so well. The more uncertainty the better to get the Fed to lower interest rates. Then later this year or early next year, declare victory in the trade wars with China, India, Japan, Europe, and the rest of the world. It’s all about winning a second term and playing Powell to do so.

In this scenario, the S&P 500 gets to our year-end target of 3100 ahead of schedule, and to 3500 by the end of next year, or sooner.

After listening to Powell’s testimony yesterday, Melissa and I are joining the consensus expecting a 25bps rate cut at the July 30-31 FOMC meeting. We still think it would be a mistake (though not a tragic one), since we don’t see the need to use some of the Fed’s scarce ammo at this time.

By the way, in the Q&A session of his testimony, Powell inadvertently suggested that the Fed is facing an existential crisis, and we don’t mean Trump’s threats to limit the Fed’s independence. Rather, Powell expressed concern that if inflation gets too close to zero, the federal funds rate will also be too close to zero, not leaving the Fed much room to ease during the next recession.

That existential threat helps to explain why Fed officials continue to believe (hope) that their easing policies will boost inflation. We think that by now they should have realized that inflation may not be a macroeconomic phenomenon that can be fine-tuned with monetary policy. Instead, it might be driven by the “4Ds” (Détente, Demographics, Disruption, and Debt), which we discussed in the 3/26 Morning Briefing.

Sector Roundup: Revisiting Old Friends. There were lots of headlines in recent days that hit upon many of the themes we’ve highlighted this year. Some themes were notable because of their broad impact, and others we called out because they weren’t getting enough attention. So here’s a quick update from Jackie that takes a look, both forward and backward:

(1) Tech: FANG bites. We’ve spilt considerable ink on how the Internet giants have come under attack from politicians at home and abroad for their business practices and their overwhelming size, including in the 6/6 Morning Briefing. The frenzy will certainly continue next week when executives from Alphabet, Amazon, Apple, and Facebook testify at a US House of Representatives hearing on online platforms and market power.

Their appearances follow a new probe launched on Monday by the House Energy and Commerce Committee into fake reviews on Amazon. Fake reviews can put honest sellers at a disadvantage, and their writers may have learned how to trick Amazon’s algorithms that highlight certain products. “In March, ReviewMeta, an American data company, released a report that found nearly 60% of the reviews they analyzed on Amazon within the first three months of 2019 were from unverified buyers. That was up from 9% in the same period in 2018,” a 7/9 article in The Washington Times reported.

Amazon also got bad news from a US federal appeals court that ruled the company could be held liable for defective items sold by third parties over Amazon’s website. The decision goes against two earlier court cases ruling that Amazon was not liable because it wasn’t the seller of the products. We’ll keep an eye on the appeals process, as third-party sales represented 18.5% of the company’s total revenue.

In this case, Heather Oberdorf bought a dog collar from “The Furry Gang,” a third-party retailer on Amazon, according to the decision by the 3^rd US Circuit Court of Appeals in Philadelphia in Oberdorf vs. Amazon. When her dog lunged, the ring on the collar broke, and the leash recoiled. It hit Oberdorf’s face and eyeglasses, leaving her blind in the left eye. She tried to sue Furry Gang, but neither she nor Amazon has been able to locate a representative of the company.

The court decision notes that Amazon does more than just list the products third-party companies are selling. Amazon also collects order information from the consumer, processes payments, and formats the product’s listing information. Amazon and third-party sellers have an agreement that gives Amazon a “royalty-free, non-exclusive, worldwide, perpetual, irrevocable right and license to commercially or non-commercially exploit in any manner the information provided by third-party vendor.” In addition, vendors agree to not charge more on Amazon than they charge for the product in any other sales channel and to communicate with customers only over the Amazon platform.

FANG—the acronym for the stocks of four tech giants, i.e., Facebook, Amazon, Netflix, and Google’s parent Alphabet—hasn’t outperformed the S&P 500 since early 2018 (Fig. 1). At its peak last year, FANG represented 10.5% of the S&P 500’s market capitalization. That percentage has contracted only slightly since then, to 9.9%, so FANG is still an important component of the broader index (Fig. 2). The S&P 500’s forward P/E is 17.2, but without the FANG gang it’s only 16.0 (Fig. 3).

(2) Materials & Energy: Dirty business. In the 7/3 Morning Briefing, we discussed how the surge in fracking and low gas prices have led to a boom in plants that produce the feedstocks for plastic—and, conversely, how a move to recycle more could threaten that boom.

Some eagle-eyed readers noted that the world’s oceans would still be polluted even if US residents became hyper-conscious recyclers, because 90% of the plastic found in the world’s oceans is traced to eight rivers in Asia and two in India, according to a 2017 study in Environmental Science & Technology.

Fortunately, the US isn’t alone in its recycling efforts. The 7/5 WSJ ran an excellent article about India’s efforts to reduce single-use plastics. Many of India’s products are sold in single-use containers to keep the price low. By the end of next year, India will require consumer goods companies to collect and find alternative uses for multilayer plastic packaging equal to the amount of plastic packaging that’s used in the new products they sell. Doing so will require consumers to clean out and sort their garbage, and companies may employ a bevy of pickers to find and sort the material.

London might not be a huge source of plastic pollution in the oceans, but two girls with help from their mother launched a petition asking McDonald’s to stop putting plastic toys in Happy Meals, according to a 7/8 WSJ article. The petition has attracted 325,000 signatures since launching late last year, and it follows calls by the UK Environment Minister Thérèse Coffey for McDonald’s to end plastic toys in Happy Meals.

The WSJ article noted that a McDonald’s working group is looking into the environmental issues related to Happy Meal packaging and toys. The group is exploring ways to make the toys from plastic that is more readily recyclable and from renewable materials.

(3) Hyper for hyperloops. While it was Elon Musk who wrote a famous white paper outlining the ideas behind hyperloops, three other companies are turning those ideas into a reality. The 3/7 Morning Briefing took a look at Virgin Hyperloop One, which created a test track in Las Vegas; Hyperloop Transportation Technologies (HTT), which is building a test track in Toulouse; and TransPod, a Canadian company with plans to start building a test track in Canada and France. The wheels of hyperloop progress are moving slowly, with technological issues still to solve, major government red tape involved, and billions in funding still to be raised. Here’s a look at some of the current projects under consideration:

Hyperloops at home. A proposed hyperloop from Kansas City to Saint Louis would shrink the 250-mile trip to 30 minutes and cost an estimated $7 billion to $10 billion, a 5/23 WSJ article stated. A theoretical Great Lakes Hyperloop would get you from Cleveland to Chicago in under 30 minutes. Another hyperloop under consideration would run from Pittsburgh to Chicago via Columbus. And lastly, Colorado and Virgin Hyperloop One are conducting a feasibility study for a 215-mile hyperloop from Cheyenne, Wyoming through Denver (with a line to Vail), to Colorado Springs, noted an article in Travel Weekly.

Hyperloops abroad: Virgin Hyperloop One has a “framework” agreement with India’s state of Maharashtra for a 100-mile hyperloop between Mumbai and Pune. HTT is hoping to build another hyperloop between Dubai and Abu Dhabi and expects the first portion of the line will be operating by the October 2020 World Expo, the Travel Weekly article stated. In Europe, Hardt Hyperloop dreams of a system connecting the European continent’s major cities, extending over 10,000 kilometers, a 7/1 article in The Brussels Times reported.

Consumer Discretionary: Getting Some Respect. Fourth of July festivities may be over, but the market saw fireworks yesterday as the S&P 500 briefly passed 3,000 for the first time on rate-cut optimism. Here’s the performance derby for the S&P 500’s sectors ytd through Tuesday’s close: Technology (28.4%), Consumer Discretionary (24.1), Real Estate (22.5), Communication Services (20.8), Industrials (19.2), S&P 500 (18.9), Financials (17.8), Consumer Staples (16.5), Utilities (14.8), Materials (14.2), Energy (10.3), and Health Care (7.7) (Fig. 4).

The S&P 500 Consumer Discretionary sector has been an unsung hero of this market. But as business spending has slowed in recent months, the consumer is getting some respect. Both PepsiCo CEO Ramon Laguarta and Fed Chair Powell called out the strength of the US consumer in comments this week.

From PepsiCo’s Laguarta: “We see a healthy consumer. A consumer where price statistics are good and so we cannot see any signals that tells us that consumer is slowing down, at least in our categories.” And from Fed Chair Powell: “While growth in consumer spending was weak in the first quarter, incoming data show that it has bounced back and is now running at a solid pace.”

So while department stores and malls continue to struggle, consumers keep spending in other areas. The stock price indexes of fun-related industries are having a great year, as these ytd gains attest: Casinos & Gaming (27.0%), Restaurants (26.6), and Hotels, Resorts & Cruise lines (20.0) (Fig. 5).

Meanwhile, lower interest rates have reignited investors’ enthusiasm for housing-related industries, which have surged higher ytd: Household Appliances (33.6%), Homebuilding (23.8), and Home Improvement Retail (20.7). All things auto have rallied too, even as auto sales have plateaued: Automobile Manufacturing (21.4), Automotive Retail (21.3), and Auto Parts & Equipment (20.4) (Fig. 6).

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Fedspeak

July 10 (Wednesday)

The Fed I: Words Have Meanings. Fed Chair Jerome Powell has been head of the Fed for a year and a half. He had been a plain-vanilla Fed governor from 5/25/12 through 2/5/18, when his four-year term as chair started. Notwithstanding his experience prior to assuming the Numero Uno role on the Federal Open Market Committee (FOMC), Powell has had lots of learning-by-doing since early last year. First and foremost, he learned that his words have meanings that can move financial markets significantly around the world:

(1) Yesterday. Powell’s hawkish off-the-cuff comments in an interview on 10/3/18 sent stock prices reeling, resulting in a 19.8% plunge in the S&P 500 from 9/20/18 through 12/24/18 (Fig. 1 and Fig. 2). Then in a 1/4/19 panel discussion, he walked back his hawkish talk with dovish comments. This time, he read from a script to avoid making another bearish gaff. He said that the Fed would be “patient,” implying a long pause in rate-hiking. Melissa and I dubbed it “Patient Powell’s Put” in our 1/7/19 Morning Briefing.

Sure enough, the stock market loved what has also been widely called “Powell’s Pivot,” sending the S&P 500 soaring 25.3% from the 12/24/18 low to a new record high on 4/30/19. Like the three Fed chairs before him, Powell was stress-tested by the stock market and delivered the obligatory put, just as Greenspan, Bernanke, and Yellen had done.

The escalation of the US-China trade war in early May sent stock prices down sharply again by 6.8% through 6/3/19. Once again, the Fed chair revived the market with even more dovish talk in the second paragraph of his prepared 6/4/19 remarks. He said that monetary policy would “act as appropriate to sustain the expansion, with a strong labor market and inflation near our symmetric 2 percent objective,” implying rate-cutting ahead. The S&P 500 soared 9.2% to yet another new record high on 7/3 thanks to “Powell’s Pirouette.”

(2) Today and tomorrow. All eyes and ears will be on Powell today and tomorrow when he testifies on monetary policy before two congressional committees. Will he pivot again back to a patient monetary policy stance following June’s strong employment report? Will he reiterate that inflation is possibly being pulled down by “transitory” forces, as he said at his 5/1 presser? He hasn’t mentioned that point again since. Will he walk back that notion by hinting that a rate cut might be justified by low inflation? Words certainly do have meanings. The question is what does Powell mean to do next?

As we wrote yesterday, “We wouldn’t be surprised if he made another pirouette back to a no-change stance for monetary policy. We wouldn’t be surprised if he proceeded with a 25bps cut either, but we would view it as a mistake.”

The Fed II: Word Games. Melissa and I suspect that the Fed has a wordsmith on staff. This position was most likely created by Fed Chair Alan Greenspan. The role of the wordsmith is to come up with one word or a short phrase that best describes and communicates the current monetary stance of the FOMC. That word or phrase is then repeated in the FOMC statements and minutes, and by the Fed chair and other Fed officials over and over again in their speeches and interviews. It is the monetary mantra that everyone in financial markets is expected to repeat at least on a daily basis. Below, we recap how some of the FOMC’s mantra words and phrases have been used over the years:

(1) “Measured.” Beginning with the 5/4/04 FOMC statement under Fed Chair Alan Greenspan, the FOMC used the following phrase: “[T]he Committee believes that policy accommodation can be removed at a pace that is likely to be measured.” Those exact words remained in the statements through 11/1/05. Over this 18-month period, the federal funds rate was raised from 1.00% to 4.00% in “measured” increments of 25bps, with the first on 6/30/04 (Fig. 3).

The language around the key word was tweaked in the 12/13/05 statement as follows: “The Committee judges that some further measured policy firming is likely to be needed to keep the risks to the attainment of both sustainable economic growth and price stability roughly in balance.”

(2) “Firming may be needed.” The word “measured” was eliminated from the FOMC’s vocabulary after that statement, but nearly the exact language around it was maintained for an additional two statements (i.e., the 1/31/06 statement and 3/28/06 statement): “The Committee judges that some further policy firming may be needed to keep the risks to the attainment of both sustainable economic growth and price stability roughly in balance.” By then, the federal funds rate had been raised to 4.50%. That also happened to be the first FOMC decision under Fed Chairman Ben Bernanke.

Under Bernanke’s FOMC, the 5/10/06 statement similarly noted: “The Committee judges that some further policy firming may yet be needed to address inflation risks but emphasizes that the extent and timing of any such firming will depend importantly on the evolution of the economic outlook as implied by incoming information.” On the same day, the FOMC voted to raise the federal funds rate from 4.50% to 5.00%. It did so again on 8/8/06 to a peak of 5.25%, where it remained until the 9/18/07 meeting, when it was lowered to 4.75%.

The FOMC included variations of the same wording in the 6/29/06 statement through the 1/31/07 statement: “The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.”

From the 3/21/07 to the 8/7/07 meetings, the Fed was no longer in firming mode but more balanced, as suggested by the following phrase used: “Future policy adjustments will depend on the evolution of the outlook for both inflation and economic growth.” The federal funds rate remained at 5.25%.

(3) “Will act as needed.” There were two unscheduled statements during August 2007, in which the Fed expressed concern about the disorderly functioning of financial markets. On 9/18/07, the FOMC voted to cut the federal funds rate by 50bps, from 5.25% to 4.75%. The statement noted: “The Committee will continue to assess the effects of [financial markets] and other developments on economic prospects and will act as needed to foster price stability and sustainable economic growth.” The federal funds rate was cut again to 4.50% on 10/31/07. That language remained in the statements through 12/11/07, when the committee announced that it was lowering the federal funds rate from 4.50% to 4.25%.

On 1/21/08, a sense of urgency to ease policy was added to the statement: “Appreciable downside risks to growth remain. The Committee will continue to assess the effects of financial and other developments on economic prospects and will act in a timely manner as needed to address those risks.” With Bernanke still at the helm, growth concerns led the Fed to reduce the federal funds rate by 75bps from 4.25% to 3.50% in one shot. “Timely manner” made it into a total of three FOMC statements through 3/18/08.

“Timely manner” was dropped, and “will act as needed” remained in the 4/30/08 statement. By then, the Fed had lowered the federal funds rate from 3.50% to 2.00%. The FOMC took rates down further, to 1.00% on 10/29/08, just before the Fed changed its phrasing again.

(4) “Exceptionally low levels.” In the 12/16/08 statement, the Fed had established a historically low target range for the federal funds rate of 0.00%-0.25%. The economic situation had turned more desperate, as evidenced by: “The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.”

“[A]ll available tools” was changed to “a wide range of tools” in the 9/23/09 statement and dropped in the 12/16/09 statement.

The “exceptionally low levels” phrase was attached to timeframes of “for an extended period” in the 6/22/11 statement, “at least through mid-2013” in the 8/9/11 statement, “at least through late 2014” in the 1/25/12 statement, and “at least through mid-2015” in the 9/13/12 statement. The timeframe then was extended to “as long as the unemployment rate remains above 6-1/2 percent” in the 12/12/12 statement.

In the 1/25/12 statement, the phrase “highly accommodative” joined “exceptionally low levels” to describe the policy stance. The committee stated: “To support a stronger economic recovery and to help ensure that inflation, over time, is at levels consistent with the dual mandate, the Committee expects to maintain a highly accommodative stance for monetary policy.” In other words, the Fed saw the US economy as improving but still fragile. The new phrase appeared 34 times in the statements over roughly 32 months through 9/17/14.

(5) “Balanced approach.” In the 1/30/13 statement, the Fed eliminated the use of “exceptionally low levels.” In the 12/12/12 statement just before that, “balanced approach” was added to go along with “highly accommodative.” The use of “balanced” was intended to communicate that the committee at some point would consider slowly removing policy accommodation. The statement noted: “When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.”

The Fed abandoned “highly accommodative” in the 10/29/14 statement. It was axed under Fed Chair Janet Yellen, whose first FOMC decision as Fed chair had been several months earlier on 3/19/14. However, “balanced approach” hung around through the 10/28/15 statement.

(6) “Gradual.” In the 12/16/15 statement, the FOMC lifted the federal funds rate to a range of 0.25%-0.50% after nearly seven years near zero. At the same time, the FOMC adopted “gradual” to describe the likely path of future policy moves, specifically: “The Committee currently expects that, with gradual adjustments in the stance of monetary policy, economic activity will continue to expand at a moderate pace and labor market indicators will continue to strengthen.”

“Gradual” was Yellen’s last key word as Fed chair. It was passed on to Powell, who voted for the first time in his new position on 3/21/18. By then, the Fed had gradually lifted the federal funds rate to a range of 1.50%-1.75%.

(7) “Patient.” In early 2019, “patient” became the FOMC’s new key word in the 1/30/19 statement. At that point, the FOMC had raised the federal funds rate range to 2.25%-2.50% (Fig. 4). The FOMC had become increasingly concerned about persistently low inflation as well as possible further slack in the labor market and geopolitical risks, especially the US-China trade dispute. Considering this, the FOMC opted for a wait-and-see approach before making future adjustments to rates up or down. The statement noted: “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.” Ironically, the word “patient” didn’t last long.

(8) “Appropriate.” Most recently, in the 6/19/19 statement, the FOMC deleted the word “patient” and emphasized “appropriate.” The statement noted: “In light of these uncertainties [to the outlook] and muted inflation pressures, the Committee will closely monitor the implications of incoming information for the economic outlook and will act as appropriate to sustain the expansion, with a strong labor market and inflation near its symmetric 2 percent objective.”

(9) The word game. On occasions when the Fed’s primary economic concerns, inflation and unemployment, have been tracing predictable patterns, the FOMC statement has been template-like and predictable. But when economic uncertainty has heightened or unforeseen crises like the housing collapse have hit, FOMC communication, understandably, has been less clearly focused and more haphazard.

In terms of policy today, global uncertainties like trade and its possible effects on the US economy are wildcards. So it seems that the Fed has opted for the word “appropriate” because it provides more latitude to move (or not to move) than “patient” did. But what the FOMC will do remains unpredictable in this uncertain environment.

The Fed’s word game is intended to communicate its monetary policy stance to the financial markets as simply as possible. Yet it can also create more confusion and uncertainty. In the current situation, clarity would be aided if the FOMC would simply translate “appropriate” for us: Does it mean a cut is more likely than a hike? Or does it mean the FOMC members themselves don’t have a good idea of what will happen next until the incoming data clarifies the picture?

Even better would be if the FOMC would just avoid ambiguous one-word characterizations of its stance altogether, and save markets the head-scratching. Instead, statements could just repeat this mantra—suitable for every occasion—over and over: “Monetary policy will continue to be data dependent.”

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Global Economy: More Slow-Mo

July 09 (Tuesday)

Global Economy I: Staying Home. The good news: The global economy isn’t in a freefall. The bad news: The global economy is in a free-slowdown. So why have the major world stock markets been performing so well, with the US leading the way so far this year? Is it all about Powell’s Pivot at the beginning of the year to a “patient” monetary stance, followed by Powell’s Pirouette to an “appropriate” stance in early June? Yes, probably. If Powell pivots back to a patient stance when he testifies before Congress on monetary policy on Wednesday and Thursday, will that crush stock markets? Not necessarily, as Melissa and I discuss in the next section.

In any event, Joe and I continue to be homebodies. We continue to recommend a Stay Home investment strategy rather than a Go Global one. We’ve been doing so during most of the current bull market, and that strategy has worked very well. Consider the following:

(1) Since the beginning. Here is the performance derby of the major MSCI stock price indexes (in dollars) since 3/9/09 through Friday’s close: US (342%), Emerging Markets (118), Japan (101), EMU (100), and UK (89) (Fig. 1). No contest: USA All the Way (even in women’s soccer)! Over this same period, the All Country World MSCI is up 209%, but only 113% excluding the US.

The trade-weighted dollar is up 8.3% over this same period. More relevant is that the All Country World currency ratio is up 0.8% since 3/9/09 (Fig. 2).

(2) So far this year. Here's the same performance derby ytd in dollars: US (19.6%), All Country World (16.2), EMU (13.7), Emerging Markets (9.7), UK (9.7), and Japan (8.4) (Fig. 3). And here it is again ytd in local currencies: US (19.6), All Country World (16.3), EMU (15.8), UK (11.7), Emerging Markets (9.3), and Japan (7.1) (Fig. 4).

(3) Leading the way higher. The ratio of the US MSCI to the All Country World MSCI ex-US rose to record highs in both dollars and in local-currency terms at the end of last week (Fig. 5). This is especially impressive given that the forward P/E of the US MSCI has consistently exceeded the comparable valuation multiple of the All Country World ex-US since the second half of 2010 (Fig. 6).

That’s mostly because the S&P 500 has relatively more market capitalization in the Information Technology sector (currently at 21.6%), which has a relatively high earnings growth rate and P/E (Fig. 7). The sector’s stock price index is up 603% since 3/9/09, lagging only the 668% increase in the S&P 500 Consumer Discretionary sector (Fig. 8).

Global Economy II: Does the Fed Really Matter? All eyes will be on Fed Chair Jerome Powell on Wednesday and Thursday when he testifies before Congress on the outlook for monetary policy. By law, the Fed chair does this twice a year, usually during February and July.

Following the release of May’s weaker-than-expected employment report early last month, the widespread expectation was that the FOMC will cut the federal funds rate by 50bps from a range of 2.25%-2.50% down to 1.75%-2.00% at the 7/30-31 meeting of the committee.

Melissa and I view the 2-year US Treasury note yield as the market’s forecast for the federal funds rate a year ahead (Fig. 9). This yield plunged from 1.95% at the beginning of June to 1.77% last Wednesday. It jumped to 1.87% on Friday following the release of June’s better-than-expected employment report.

Now the widespread consensus is that the FOMC will still lower the federal funds rate at the July meeting but by 25bps rather than 50bps. After May’s report, we doubted that the FOMC would cut the rate at the 6/18-19 meeting, and we also doubted a rate cut at the July meeting. Especially after June’s employment data, we don’t see a good justification for a rate cut right now. Indeed, the Fed doesn’t have much ammo left and should save it for when it is really necessary to use it.

The debate on what the Fed will do next will be resolved shortly. Indeed, Powell is likely to give the markets a big heads-up when he testifies this week. We wouldn’t be surprised if he made another pirouette back to a no-change stance for monetary policy. We wouldn’t be surprised if he proceeded with a 25bps cut either, but we would view it as a mistake.

In any event, does it really matter what the FOMC does at the next meeting? If they cut rates by 25bps, the committee is likely to indicate that another rate cut may not be forthcoming over the rest of this year.

More importantly, the 10-year US Treasury bond yield is down from 2.69% at the end of last year to 2.05% yesterday (Fig. 10). That probably has more to do with our “Modern Tether Theory” (MTT) of the bond yield than Fed policy. Since last year, we have argued that the US bond yield must be tethered to comparable bond yields in Japan and Germany, which fell to -0.16% and -0.37% at the end of last week.

The Fed may not matter as much as the European Central Bank (ECB) and the Bank of Japan (BOJ). While the Fed had been on course to normalize monetary policy from late 2015 through the end of 2018, the ECB and BOJ remained in ultra-easing mode. Their negative interest-rate policies made US bond yields at 3.00% look awfully attractive to foreign investors even on an unhedged basis. Around 2.00%, the US yield still looks mighty attractive.

Falling bond yields around the world have boosted valuation multiples for stocks around the world.

Global Economy III: A World of Hurt. The bottom line is that the ECB and the BOJ matter as much as the Fed to global financial markets. That means that these markets aren’t dependent just on the data that the Fed depends on but also on the data driving the monetary policies of the ECB and BOJ. For now, let’s focus on the latest batch of really awful European economic indicators as well as some of the global ones that are being weighed down by Europe:

(1) Germany. “Das ist nicht gut!” That’s the only suitable reaction to May’s data for German manufacturing orders and production (Fig. 11). Orders dropped 2.2% m/m and 8.6% y/y to the lowest since February 2016. Factory output, excluding construction, rose 0.7% m/m, but was down 4.3% y/y. Meanwhile, the 12-month sum of German passenger car production plunged to only 4.8 million units during June, the lowest since September 2009 (Fig. 12). That’s down 14.5% y/y. What is the opposite of “wunderbar”?

(2) Eurozone PMIs. The good news: The Eurozone’s NM-PMI was solidly above 50.0, at 53.6, during June, with Germany at 55.8 (Fig. 13). The bad news: The Eurozone’s M-PMI was solidly below 50.0, at 47.6, with Germany at 45.0 (Fig. 14).

(3) Global PMIs. The global M-PMI fell to 49.4 during June (Fig. 15). In addition to Germany’s poor contribution, there was manufacturing weakness in the UK (48.0), China (49.4), and Japan (49.3). While the US remained above 50.0, at 50.6, it was the second weakest since September 2009. On the other hand, the global NM-PMI held up reasonably well, at 51.9 during June.

(4) OECD leading indicators. More troubling, perhaps, is that May’s batch of OECD leading indicators (OLI) continued to signal economic weakness ahead for the 36 member countries of the organization. The overall OLI fell to 99.0 in May, the lowest since September 2009 (Fig. 16). Showing similar weakness were the OLIs for the US (98.8), Europe (99.0), and Japan (99.3). These aren’t terrible readings, but they all are on the wrong side of 100.0.

Global Economy IV: World Revenues Stalling. Joe and I have been monitoring weekly S&P 500 forward revenues to see if it is starting to reflect the weakness in the global economy. We remain impressed by its resilience. It has been hovering in record-high territory throughout June (Fig. 17). This weekly series, reflecting the time-weighted consensus estimates for this year and next year, tends to be an excellent coincident indicator of actual quarterly revenues.

During the 6/27 week, industry analysts were expecting that S&P 500 revenues will grow 4.4% this year and 5.3% next year (Fig. 18). Those are solid growth expectations, and certainly don’t reflect much of a slowdown in global business for the S&P 500.

For the All Country World ex-US MSCI, revenues are expected to grow 3.6% this year and 4.5% next year. Again, those are relatively good growth rates (Fig. 19). Like the S&P 500 forward revenues, the US MSCI component of global forward revenues has stalled at a record high in recent weeks (Fig. 20). The Developed World ex-US MSCI forward revenues has stalled in recent weeks at a cyclical high, while the Emerging Markets forward revenues has dropped slightly from its record high during the 5/3 week.

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Another Powell Pivot Ahead?

July 08 (Monday)

US Labor Market: Will Productivity Offset Labor Shortages? Last month, Debbie and I argued that May’s weak payroll gain of 75,000 was likely an aberration. We certainly didn’t believe that labor demand is weakening given that so many other labor-market indicators remained robust. If the weak number reflected anything fundamental in nature, it might have been a sign that a shortage of workers might be the problem. Friday’s employment report, showing a solid payroll gain of 224,000 during June, put both the weak-demand and worker-shortage theses on ice. It probably froze monetary policy in place as well, for now, as discussed in the next section.

Then again, a closer look at the latest data in the context of the past 12 months shows some signs of labor-market fatigue on both the demand side and the supply side. Of course, the two sides of this market are not independent. It’s conceivable that after struggling to find the right workers with the right skills in the right geographical locations, some employers are giving up.

That could be bad news for economic growth. Or it could be good news if employers are finding ways to increase the productivity of their current workforce. A secular upturn in productivity remains our working hypothesis to explain how the longest expansion in US economic history might continue apace despite labor shortages.

In our best-case scenario for the economy, the slowing pace of labor-force growth should be offset by a pickup in productivity growth. Since productivity growth drives the growth in the inflation-adjusted wage rate, consumer spending should be bolstered by real wage gains, offsetting the slowdown in supply-constrained payrolls. Let’s have a closer look at the data that we will be monitoring to track whether our upbeat outlook is panning out:

(1) 12-month trends. Over the past 12 months through June, payroll employment rose 191,800 on average (Fig. 1). That’s certainly a solid performance, though it is the slowest pace since last April. The average for the last three months was weaker at 170,700. The supply constraints may be showing up in the 12-month average increase in the labor force, which was only 71,000 through June, near the bottom of the range since 2017 (Fig. 2).

(2) 10-year trends. The constraint on economic growth attributable to labor shortages can be seen more clearly by tracking the average 10-year annualized growth rates of both the working population aged 16-64 years old and the labor force (Fig. 3 and Fig. 4). The former was just 0.4% through June, the lowest on record, while the latter was only 0.3%, near the record lows of the past couple of years.

(3) Productivity & real GDP. It is instructive to compare the average annualized growth rate of the labor force over the past 10 years to real GDP’s comparable growth rate (Fig. 5). The secular growth rate of the labor force certainly has an influence on the trend growth in real GDP. The former fell from a record high of 3.1% during the 10-year period through January 1979 to only 0.5% through June of this year. That has weighed on the growth rate of real GDP, but productivity growth allowed the economy to more than offset the slowdown in the supply of labor over this period (Fig. 6).

Productivity growth collapsed during the Great Inflation of the 1970s and during the Great Recession of 2008 and for several years after this event. The productivity growth cycle may be turning. Productivity hit a low of 1.2% during the 10-year period through Q4-2017. It was up to 1.4% during Q1-2019. Using the five-year growth rate puts the bottom at only 0.5% during Q4-2015, with an increase to 1.3% by Q1-2019.

(4) Better growth in real wages ahead. Our upbeat outlook for productivity should boost the growth rate of real hourly compensation (RHC). Naysayers have observed that since the mid-1970s there has been a growing divergence between productivity and RHC (Fig. 7). That divergence is mostly attributable to the fact that for some bizarre reason the Bureau of Labor Statistics still uses the CPI to deflate the hourly compensation series, which is released along with productivity.

Much of the divergence disappears when RHC is calculated using the personal consumption expenditures deflator (RHC-PCED). Almost all of the gap between productivity and RHC is eliminated using the nonfarm business deflator (RHC-NFBD). That makes sense since microeconomic theory says that employers pay their workers the real value of their marginal product based on the prices that employers receive for the goods and services that they produce rather than on prices that consumers pay!

The 10-year growth rates of both the RHC-PCED and RHC-NFBD continue to be highly correlated with the comparable growth rate in productivity (Fig. 8). If productivity growth has started to rebound over the past few years and continues to do so, then so should the growth rate in RHC-PCED!

(5) Signs of strength. For the here and now, our Earned Income Proxy (EIP) for private-sector wages and salaries rose 0.4% m/m and 4.6% y/y during June (Fig. 9). Over this period, aggregate weekly hours worked is up 1.5%, while average hourly earnings is up 3.1%. Both components of the EIP are at record highs. Also looking upbeat are the latest surveys of job openings, showing plenty of them.

(6) Signs of weakness. If you are looking for trouble, the four-week average of initial unemployment claims rose to 222,300 through the 6/29 week, up from a recent low of 201,500 during the 4/13 week (Fig. 10). However, you really need to use a magnifying glass to see trouble in this important labor-market indicator. Last week, we noted that the jobs-hard-to-get response in June’s survey of consumer confidence rose to 16.4% from a recent low of 11.8% during May. That may be a sign that labor demand is weakening, or (more likely, in our opinion) that the remaining supply of workers isn’t qualified for the available jobs.

Somewhat more worrisome, in our opinion, is that ADP’s count of private-sector payrolls rose only 102,000 during June following a gain of just 41,000 during May (Fig. 11). Goods-producing payrolls dropped slightly during the past two months. The same can be said for small companies with 1-49 employees (Fig. 12).

The Fed: What’s ‘Appropriate’ Now? In our 6/24 Morning Briefing, Melissa and I wrote: “We aren’t convinced that a rate cut at the July FOMC meeting is as likely as many traders believe.” After Friday’s stronger-than-expected jobs report, we are surprised that a rate cut is still widely expected, though instead of a 50bps cut, now 25bps is the consensus. Stock prices fell modestly on Friday on that revised outlook for the federal funds rate.

We still expect no rate cut. If we are right, that could put more downward pressure on stock prices this month, especially since this month’s corporate earnings reporting season is likely to show that earnings were basically flat on a y/y basis during Q2-2019, as they were during Q1.

Given June’s solid employment gain, the indefinite truce in the US-China trade war, and the record high in the S&P 500, we don’t see that a rate cut is necessary or justifiable. Fed Chair Jerome Powell seems to be pivoting more often these days. We expect he will do so again when he testifies before Congress on monetary policy this week on Wednesday and Thursday.

The Fed’s latest Monetary Policy Report to Congress was released on Friday. It noted that during most of the first half of 2019, the FOMC “indicated that, in light of global economic and financial developments and muted inflation pressures, it would be patient as it determines what future adjustments to the target range for the federal funds rate may be appropriate. At the June FOMC meeting, however, the Committee noted that uncertainties about the global and domestic economic outlook had increased. In light of these uncertainties and muted inflation pressures, the Committee indicated that it will act as appropriate to sustain the expansion, with a strong labor market and inflation near its symmetric 2 percent objective.”

We will soon find out from Powell how he and his colleagues currently define “appropriate.” Tomorrow, we will turn to a retrospective of the Fed’s word games.

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Plastic: The Last Straw

July 03 (Wednesday)

Beach Reading List: Forbes Picks Dr. Ed’s Book. It’s time again for backyard barbecues, beach chairs, and summer reading. At the end of June, Forbes picked six of The Best Investing Books. It said this about mine, third on the list:

“One way to invest is to look at megatrends. Often these are about technology transformations, such as the internet, cloud computing and social networking. To help analyze trends, Edward Yardeni’s Predicting the Markets is a great resource. Keep in mind that—during the past four decades—he has a solid track record of anticipating waves. Just some include globalization and disinflation. He also has a knack for predicting bull-bear turns in the markets.”

Energy & Materials: Peak Plastic? The US fracking boom led to low-cost natural gas and natural gas liquids, like ethane. Low-cost ethane prompted many large corporations to invest billions of dollars in US plants that turn ethane into the raw material used to make plastic. That’s brought jobs and economic growth to areas hard hit by the decline of US industry.

What could go wrong? Well, recent months have seen a groundswell of support for the elimination of single-use plastics and for plastic recycling. Stories of dead whales with bellies full of plastic products and pictures of litter in the deepest depths of the ocean have flooded the Internet. Municipalities and corporate America have jumped on the bandwagon, making pronouncements aplenty.

Could tree-hugging Millennials (and their “woke” elders) throw cold water on industry’s plans to boost plastic production? Would Mr. Robinson be wrong if the 1967 movie “The Graduate” was shot today? Is the future not plastic? I asked Jackie to take a look. Here is her report:

(1) Cheap feedstock. The US fracking miracle has led to a 38% increase in natural gas gross withdrawals in 2018 compared to 2010, according to a 6/4 US Energy Information Administration report. Remarkably, natural gas production has continued to increase over those years, even though the number of rigs being used tumbled and remains low (Fig. 1). This bounty has led to an extremely low price for natural gas futures, between $2 and $3 for much of the past four years (Fig. 2).

The record amounts of natural gas go to processing plants, where about 90% of hydrocarbon gas liquids (HGLs) are produced. The remainder is produced at petroleum refineries. Ethane is one of the HGLs, and it’s used in the production of plastics, resins, and fibers in many consumer goods. Ethane accounted for 1.7 million barrels a day (mbd) of the 5.0 mbd of HGLs produced last year. Ethane production has more than doubled from 0.88 in 2010, and it’s up 20% from 2017.

As we noted in the 6/20 Morning Briefing, BP’s 2019 Energy Outlook puts forward two scenarios about future energy consumption by 2040. If governments ban single-use plastics, the amount of liquid feedstocks used would grow only 4 mbd instead of growing by 10 mbd under the assumption that regulations tighten only modestly.

(2) Producers produce. Manufacturers have been quick to build new plants that can turn ethane and other gases into ethylene and other plastic feedstocks. The American Chemistry Council estimates that since 2010 the chemical industry has announced 333 new projects valued at $202 billion. About half are near or at completion, and the rest are still in the planning stage.

US manufacturers have added 6.5 million metric tons of polyethylene production capacity since 2017, according to ICIS data quoted in Petrochemical Update’s 2/26 article. US producers are expected to add another 12.1 million metric tons of production before 2022. About 25% of polyethylene production is currently exported, and as production expands exports could rise to 90%.

The Gulf Coast has long been a center for ethylene production. Planned projects in Texas include new plants by LyondellBasell and ExxonMobil, and Taiwanese producer Formosa Plastic recently received a permit for a new plant in Louisiana. A second production hub is developing in the Appalachian region (Ohio, Pennsylvania, and West Virginia). Among the largest projects there is Royal Dutch Shell’s plant being built outside Pittsburgh; it could cost up to $10 billion and be completed in the early 2020s, a 3/26 NYT article stated. Projects in development include an Ohio polyethylene plant owned by PTT Global Chemical of Thailand and South Korea’s Daelim Industrial.

These plants will have direct and indirect economic benefits. “More than 6,000 tradespeople and laborers will be on the site during the peak summer construction period (of the Shell plant). Some 600 full-time workers will manage automated technology to operate the completed plant. A 97-mile pipeline from gas separation installations in Ohio and West Virginia will supply ethane; a 250-megawatt gas-fired electrical generating station will power the plant,” the NYT article states. And then there are the indirect benefits that will go to businesses serving the folks working at the plants, the local housing industry, and those who are transporting the products being produced for export.

(3) Not everyone is happy. The chemical plants presumably will bring pollution and continue to supply the world’s plastics habit. “If [the planned projects] succeed in attracting investment to build all these new facilities, a new generation of cheap plastics will flood markets around the world, exposing frontline communities to toxic risks and the world’s rivers and oceans to an endless stream of plastic waste,” said Steven Feit, staff attorney at the Center for International Environmental Law in a 9/21/17 press release.

(4) Could the recycling movement take hold? The only thing standing between these plants and lots of profits is the growing push against the use of single-use plastics and a push to increase recycling. National Geographic published a 6/10 list of recently announced recycling efforts. Most recently, Canadian Prime Minister Justin Trudeau announced plans to ban single-use plastics by 2021. He’ll also make plastic manufacturers and companies that use plastic packaging responsible for the collection and recycling of the materials.

The European Union’s Parliament voted to ban the top 10 single-use plastic items found on European beaches by 2021 and to shoot for the recycling of 90% of plastic bottles by 2025. Single-use plastics are banned from Peru’s natural and cultural protected areas, including Machu Picchu, the country announced in January. Washington, DC banned the use of plastic straws at the start of this year, following the lead of Seattle, which banned them last year. And India’s Prime Minister Narendra Modi said last year that India would eliminate single-use plastics by 2022.

Vermont and Maine are among the many US states that have banned plastic bags and other single-use plastics this year. “State lawmakers have introduced at least 95 bills in 2019 related to plastic bags, according to the National Conference of State Legislatures (NCSL). Most of these bills would ban or place a fee on plastic bags. Others would preempt local government action or improve bag-recycling programs. Plastic bags have been taxed or banned in 127 nations, according to a United Nations count,” a 6/24 Recycling Today article stated.

Even corporate America is going green. Pepsi will begin packaging in aluminum cans its Aquafina water sold in US food service outlets and its Bubly seltzers next year. More than half of aluminum soda and beer cans are recycled in the US, and 70% of the aluminum used in cans is recycled, according to a 7/1 MarketWatch article. That’s far better than plastic beverage containers: just 31.2% of them are recycled, and only 3% are made of recycled plastic. In addition, Pepsi’s LIFEWTR will be sold in 100% recycled plastic bottles.

“Tackling plastic waste is one of my top priorities and I take this challenge personally,” PepsiCo Chairman and CEO Ramon Laguarta said in a press release.

Coca-Cola Great Britain announced that Sprite bottles will switch from green plastic to clear plastic to enable recycling starting in September. Sprite will also increase the recycled material used in bottles by 50% in 2020, according to a 6/27 post on Recycling Today. In addition, GLACEAU Smartwater bottles will be made from 100% recycled materials by the end of this year.

(5) Disruptive development? The Lawrence Berkeley National Laboratory has developed a new plastic material that can be more easily recycled. It’s difficult to separate current plastic objects from additives that might give the plastic color, flexibility, or toughness, explained a 5/8 Smithsonian article. This new polymer—called “polydiketoenamine,” or “PDK”—can be separated from additives after being dunked in an acidic solution. Colorado State University is developing another recyclable polymer. We’ll be watching to see if the world can kick its plastic addiction.

(6) The numbers. The S&P 500 Energy sector is the second-worst-performing sector in the S&P 500 so far this year (Fig. 3). Fears of a global economic slowdown have overshadowed news of OPEC’s agreement to extend its output cuts into Q1-2020. Here’s the S&P 500 performance derby ytd through Tuesday’s close: Information Technology (27.9%), Consumer Discretionary (22.1), Industrials (20.5), Communication Services (19.2), S&P 500 (18.2), Real Estate (18.1), Financials (17.2), Materials (16.8), Consumer Staples (15.0), Utilities (12.5), Energy (11.2), and Health Care (7.7) (Fig. 4).

Analysts appear optimistic that the Energy sector’s fortunes will improve next year. The Energy sector is expected to have a slight drop in revenue this year and a 6.8% increase in revenue in 2020 (Fig. 5). Likewise, earnings are forecast to decline 10.1% this year and rebound 29.8% in 2020 (Fig. 6). Net earnings revisions have just turned positive in the past few months, and the Energy sector’s forward P/E is 15.2, in line with levels during previous periods of neither boom nor bust (Fig. 7).

Disruption: The Robots Arrive. The right technology at the right time can be magical. That magic alignment may be about to push the mass adoption of industrial robots. ARK Investment Management forecasts a sharp decline in the price of industrial robots just as some manufacturers are looking to move manufacturing outside of China because of existing and threatened tariffs and keep costs low in the process. Robots may be the answer. Let’s take a look:

(1) Cheaper by the day. Industrial robot costs will drop by 50%-60% by 2025, and that should prompt an uptick in robot adoption, according to a 4/17 ARK report. ARK forecasts robot unit sales will hit 3.4 million in 2025, up from about 380,000 in 2017. Its unit cost estimate of $10,856 is far below Boston Consulting Group’s estimate of $23,831.

“Fundamental to our analysis is Wright’s Law: that is, for every cumulative doubling in number of units produced, costs will decline by a consistent percentage,” the ARK report states. Boston Consulting Group, conversely, sees the price improvements stalling, as the underlying material costs can’t continue to fall. But ARK believes manufacturing innovations like 3D printing will reduce the use and weight of materials, prolonging the cost saving.

(2) History plays a role. President Trump’s existing and threatened tariffs on goods produced in China and imported into the US give manufacturers a renewed appreciation for a geographically diversified manufacturing base that potentially includes the US. To exit China and keep costs down, manufacturers could look toward robots. Even before the tariffs hit, the market for all robots was expected to more than double from $103.1 billion in 2018 to $214.4 billion by 2021, according to data from International Data Corp. cited in a 1/8 article on ManufacturingAutomation.com.

(3) Tech advancing in leaps and bounds. Manufacturing robots need a lesson in sensitivity. So one South Korean team is using light to measure pressure. The researchers are hoping the technology could be wrapped around robots, making the sensors like a skin. Collaborative robots are learning how to work with humans. Using them is attractive because it doesn’t require entirely changing the manufacturing line and, since humans would remain on the job, consistency can be improved.

Boston Dynamics has created a robot that can pick, move, and stack boxes, skills that are useful in a warehouse. Suction cups allow for lifting, and an “on-board vision system” permits the robot to see what it’s doing, according to this 3/28 writeup in Popular Mechanics.

(4) Marty goes shopping. Grocers, renowned for slim margins, are embracing robots. Marty, the Robot is coming soon to 500 Giant Food Stores, Stop & Shop, and Martin’s locations. The googly-eyed robot built by Brain Corp. will be on the lookout for problems, like spills or trip hazards. Upon identifying a hazard, Marty will call for help over the store’s public announcement system. Marty also will keep an eye out for out-of-stock and incorrectly priced items, according to a 1/14 Popular Mechanics article.

Walmart uses Brain robots to clean aisles. Brain announced on 4/10 that Walmart will add another 1,500 robot floor cleaners to its stores by year-end, bringing its total robot fleet to 1,860.

Amazon long has had robots that picked items off of shelves and brought them to workers to pack. Joining them, Reuters reported on 5/13, will be machines that box and label ordered items at four to five times humans’ rate.

Now if only Amazon would deliver a robot to man our Fourth of July barbecue.

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The Rodney Dangerfield of Economic Expansions

July 02 (Tuesday)

US Economy I: Happy 10^th and 243^rd Birthdays! It’s July, and it’s official: The current US economic expansion is the longest on record. It turned 10 years old this month, a month that happens to include the 243rd birthday of the United States of America. Let’s have a look at some of the underlying economic achievements of the current expansion:

(1) For the record books. Appendix 5.1 in my book, Predicting the Markets (2018), is titled “US Business Cycle Expansions and Contractions: 1854-Present.” An updated version of this table shows that the current expansion has lasted 121 months so far. According to the National Bureau of Economic Analysis, it started in June 2009 and now exceeds the previous longest expansion from March 1991 through March 2001.

Debbie and I aren’t surprised. As far back as 2014, we predicted that the expansion might last well into 2019 and maybe beyond. We still believe that “beyond” is likely now that we are well into 2019. Our basic thesis has been “no boom, no bust.” That’s one of the major lessons I learned during the first 40 years of my career on Wall Street, as I discuss in my book.

The Trauma of 2018 was extremely traumatic. The widespread fear that it could happen again anytime soon has kept a lid on speculative excesses. So there hasn’t been a boom to set the stage for a bust.

The current bull market in stocks has frequently been described in the financial press as the most widely hated bull market of all time. It certainly has been hated by the bears. Similarly, in our opinion, the next recession has been the most widely anticipated of all time. That might explain why it hasn’t happened so far, frustrating the pessimists. The current economic expansion has been the most hated one of all time, as the pessimists claimed that it has been associated with the most inequality in both incomes and wealth. According to the naysayers, only the rich have gotten richer, while the standard of living has been stagnating for everyone else.

In other words, this has been the Rodney Dangerfield of economic expansions—getting no respect. Yet here we are, celebrating its 10^th birthday!

(2) Longest, but among the laggards. Reflecting the absence of a boom, the economic expansion has been among the laggards compared to previous expansion. So, for example, industrial production is up 25.8% since June 2009 through May of this year (Fig. 1). The post-WWII record increase so far was 74.9% from February 1961 to December 1969. The average increase during the previous 11 expansions since the end of WWII was 32.4%.

Real GDP is up 25.0% from Q2-2009 through Q1-2019 (Fig. 2). That’s the second-weakest 10-year economic performance compared to the previous six 10-year periods that started with expansions and might have had some downturns along the way. (Keep in mind that five of the previous six expansions were shorter than 10 years old.) The same can be said about the 25.4% increase in real personal consumption expenditures (Fig. 3). On the other hand, the 65.0% increase in real capital spending so far beats two of the previous 10-year periods (Fig. 4). That demolishes the myth promoted by the naysayers that capital spending has been the worst ever.

(3) Recoveries and expansions. Back in 2014, Debbie and I compared the current economic expansion to the previous five using the Index of Coincident Economic Indicators (CEI). The CEI includes four components: payroll employment, real personal income (less transfer payments), real manufacturing & trade sales, and industrial production (Fig. 5).

We divided the business-cycle upturns into their recovery and expansion phases (Fig. 6). On average, the previous five recoveries, measured back to their pre-recession peaks, lasted 26.4 months. We observed that the latest recovery took 68 months from January 2008 through October 2013. We reckoned that since the recovery took so long, so might the expansion into record-high territory.

The previous five expansion phases averaged 65.4 months. Adding that average to the end date of the latest recovery phase puts the next business-cycle peak in July 2019. Here we are, though we don’t believe that the current expansion is over.

US Economy II: The Secret to Old Age. The secret to the longevity of the current expansion isn’t a mystery, in our opinion. In the past, booms set the stage for busts by generating lots of speculative excesses that were financed by too much debt. Those excesses caused either price inflation or asset inflation, or both, to soar.

The Fed responded by raising interest rates. Somewhere along the way, interest rates rose to levels that triggered a financial crisis when one or a few significant borrowers couldn’t service, refinance, or roll over their debts. The crisis turned into a widespread credit crunch when even good borrowers couldn’t get credit as their lenders struggled to stem the damage to their capital from mounting bad loans. That would quickly turn the boom into a bust.

So far, there has been no serious credit crunch during the current expansion. The yield curve has inverted, which in the past has signaled a recession. However, in the past, inversions also have coincided with credit crises (Fig. 7). So why haven’t we had a credit crunch so far? Consider the following:

(1) The doom view. The doomsayers have been saying that there are plenty of excesses in the credit markets. They are particularly alarmed by the record amount of nonfinancial corporate debt outstanding ($5.6 trillion during Q1-2019) as well as the record amount of leveraged loans ($1.8 trillion) (Fig. 8 and Fig. 9). The bears have been ringing the alarm bell for some time, yet here we are in the longest expansion of all time with the S&P 500 at a record high.

They’ve been wrong partly because record-low interest rates have fueled reach-for-yield demand for credit instruments. So it has been easy for borrowers to refinance their debts, often at lower yields.

(2) The new shock absorber. In addition, there is a relatively new shock absorber in the credit markets, which we first discussed in 2016. Distressed asset funds (DAFs) have been attracting lots of investors. They have SWAT teams of professionals who are adept at restructuring broken balance sheets and income statements. They love doing so when they can buy distressed assets at a huge discount and restructure them to be sold at much higher prices.

I believe that’s what happened during 2015. Back then, credit-quality spreads soared, particularly for debt held by commodity-related businesses when the price of oil collapsed (Fig. 10). Before the financial crisis among commodity-related firms could spread, the DAFs restructured all the bad stuff.

The DAFs are similar to the government’s Resolution Trust Corporation (RTC), which restructured the S&L crisis from 1989-1995. The RTC became a massive property-management company, cleaning up what at the time was the largest collapse of US financial institutions since the Great Depression.

(3) Dearth of distress. I first got wind of the DAF shock absorber during the spring of 2016 from one of our accounts in NYC who happens to manage DAFs. He was bemoaning the dearth of distressed assets. The ones from 2015 had already been snapped up by the DAF industry, but new money was still pouring into the funds. In a meeting with the same account last week, he told me that finding distressed assets is still tough and that they are getting snapped up at lower discounts.

(4) Powell’s credit crunch. There actually might have been a mini credit crunch in the nonfinancial commercial paper market late last year in response to the plunge in stock prices, which had been triggered by hawkish comments by Fed Chairman Jerome Powell in early October. The outstanding amount of paper dropped 29%, or $104 billion, from a 2018 peak of $355 billion during the 6/20 week to a $251 billion trough during the 1/2 week of this year (Fig. 11). That might have contributed to Powell’s pivot to dovish comments at the beginning of this year.

Buybacks: Negligible Impact. Joe reports that Q1-2019 stock buybacks data are now available for the S&P 500. They totaled $206 billion, the second-highest quarter since the final quarter of 2018, when they totaled $223 billion (Fig. 12). Previously, Joe and I have observed a high correlation between the S&P 500 stock price index and the sum of S&P 500 buybacks and dividends (Fig. 13).

We had assumed that causality ran from the cash flows to the stock market’s performance. We changed our minds when preparing our May Topical Study #84: “Stock Buybacks: The True Story.” We wrote:

“With the benefit of hindsight and additional research, Joe and I are amending our interpretation of this chart. The bull market in stocks has been driven by solid earnings delivered by a global economy that continues to grow. The coincident relationship between the S&P 500 and buybacks reflects that compensation—with some percentage paid in stock—rises in a growing economy. If compensation rises, buybacks tend to. If the economy grows, bull markets thrive. So economic growth drives both buybacks and the stock market. That’s why they move in sync. It’s not that buybacks drive the stock market, as widely believed.”

We concluded that the impact of buybacks on earnings per share has been greatly exaggerated. On balance, buybacks reduced the share count of the S&P 500 by only 8.0% over the period from the Q1-2011 through Q1-2019, or an average of 1.0% per year. That’s because we found that roughly two-thirds of buybacks may be mostly offsetting stocks issued as labor compensation. Rather than boosting earnings per share, most buybacks are aimed at reducing the share-count dilution that results from compensating employees with stock. Limiting them or banning them by law, as suggested by a few Progressive politicians, would deprive lots of employees, not just top managements, from an equity stake in their companies and from benefitting from their companies’ success.

I asked Joe to update his analysis of the relationship between the changes in the share count of the S&P 500 companies and the changes in their stock prices since Q1-2011 through Q1-2019. Plenty of these companies have had aggressive buyback programs, aimed not only at offsetting dilution from stock compensation but also at boosting earnings per share. However, as demonstrated in our Topical Study, the overall impact of buybacks on S&P 500 earnings per share has been relatively small.

Joe didn’t find a noticeable performance difference between companies that had increased and those that had decreased their share counts. But among those companies that had share-count reductions, there was slight outperformance correlating with how much a company’s share count was reduced. Here is a summary of his findings, based on the share-count data shown in S&P 500 Share Count Update:

(1) Joe looked at 458 of the 505 issues in the S&P 500 with price performance data from Q1-2011 through their calendar Q1-2019. The 47 issues not included in his study went public after Q1-2011.

(2) Joe found that the stock prices of all companies rose an average of 165%. The 175 issues with increased share counts had a slightly higher gain of 170%, while the 281 issues with decreased share counts rose a slightly lower 163%. (Two companies’ share counts were unchanged.)

That was a little surprising, but not unexpected. Joe surmises that companies with higher share counts after the past eight years issued additional shares primarily to finance M&A activity. These companies outperformed because the M&A activity presented them with better opportunities for cost reductions and growth of their revenues and earnings.

(3) Looking at the companies with share-count decreases and grouping them in tranches by degree of decrease, Joe noted that their average price change improved negligibly the more shares were removed. Among the 149 companies that reduced shares by more than 15%, the average price gain was 163%, slightly worse than the all-company average of 165%. The 100 firms with at least a 20% decrease in their share counts rose 174%; the 41 companies with more than a 30% drop rose 175%; and the 16 companies with at least a 35% decrease rose an average of 185%.

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Glittering Gold, Soaring Bitcoin

JuLy 01 (Monday)

Geopolitics: He Said, Xi Said. So what did we learn from the G20 meeting over the weekend? President Donald Trump wants to be reelected next year for a second term. Chinese President Xi Jinping may be president for life, but he realizes he might have to deal with Trump through 2024. Xi said: “Forty years on, enormous change has taken place in the international situation and China-U.S. relations, but one basic fact remains unchanged: China and the United States both benefit from cooperation and lose in confrontation.”

To get reelected, Trump needs the US economy to continue growing and creating more jobs. Escalating the US-China trade war now risks hurting the US economy as next year’s presidential election approaches. What’s the point of doing that and losing the election? Better to win another term first, then get tougher on China.

So the two leaders agreed to resume trade negotiations and declared a ceasefire on any additional tariffs. Trump suggested that he will allow US companies to sell some components to Huawei, but not those that involve national security issues. He claimed that the Chinese will soon be purchasing more US agricultural products.

All this should be positive for the stock market. Indeed, despite trade tensions, the S&P 500 gained 6.9% last month, its best June since 1955, on its way to a 17.3% rise during the first six months of 2019, its best first half since 1997. On the other hand, the G20 news suggests that the Fed might hold off on lowering the federal funds rate at the 7/30-31 meeting of the FOMC.

Gold I: Mixed Message. June was a good month for gold, which made this year’s first half a good one for gold. The price of the precious metal rose 10% from $1,280.30 per ounce at the end of last year to $1,409.00 at the end of last week. It jumped 9% during June (Fig. 1). It’s now at its second-highest level since 5/14/13, but is still 26% below its record high of $1,895.00 on 9/6/11. It has also rallied strongly so far this year relative to the euro (10%), pound (9), and yen (8). So not surprisingly, gold is up 9% ytd relative to the trade-weighted dollar (Fig. 2). On the other hand, it hasn’t outperformed the S&P 500, which is up 17.3% ytd and 6.9% during June (Fig. 3).

Why this year? And why particularly in June? The solid performances of both gold and the S&P 500 during June and so far this year probably reflect the pivots by both Fed Chairman Jerome Powell and European Central Bank (ECB) President Mario Draghi away from monetary normalization, with recent hints that they are considering going back to ultra-easy monetary policies.

The Fed chairman moved in that direction in a 6/4 speech, while the ECB president did the same on 6/18. Their comments drove interest rates down, with 10-year government bond yields falling around the world. In the US, the 10-year Treasury bond yield fell to 2.00% at the end of last week, the lowest since 11/8/16, while the comparable German and Japanese yields fell deeper into record-low negative territory at -0.33% and -0.13%, respectively (Fig. 4). (See our 6/25 Morning Briefing titled “Lots of Central Bank Liquidity.”)

The lower bond yield in the US is bullish for gold, particularly since it has been led lower by a significant drop in the 10-year US Treasury TIPS yield. Lower bond yields are also bullish for the stock market as they boost valuation multiples, provided that they don’t foreshadow a recession. Consider the following:

(1) There’s no inflation to hedge against with gold. The 10-year US Treasury bond yield has dropped 124bps from 3.24% on 11/8/18 to 2.00% on Friday (Fig. 5). Over this same period, the comparable TIPS yield is down 86bps to only 0.31%, one of the lowest rates since 9/11/17.

The spread between these two yields over that period is down 38bps to 1.69% (Fig. 6). This spread is widely considered to be a proxy for the fixed-income market’s outlook for the annual inflation rate over the next 10 years, so its narrowness suggests inflationary expectations remain low. If that’s the case, then why would the gold price be as strong as it is? After all, gold is widely viewed as a hedge against inflation.

But there is no inflation to worry about. Indeed, on Friday, we learned that the headline and core PCED inflation rates were just 1.5% and 1.6% y/y through May (Fig. 7). The core rate hit the Fed’s 2.0% target only six times since it was publicly set by the Fed at the start of 2012!

(2) Gold is getting TIPsy. The answer to why gold is rallying can be found in the fact that the gold price tends to be highly correlated with the inverse of the 10-year TIPS yield (Fig. 8). In other words, gold does best when the TIPS yield is falling. That makes sense, since both speculators and investors in gold have to pay for storing the metal somewhere. If the inflation-adjusted financing cost is going down, gold is cheaper to store.

(3) Gold diverging from other commodities. In the past, I have often observed that the price of gold seems to confirm the underlying trend in the CRB raw industrials spot price index as well as its basic metals component (Fig. 9 and Fig. 10). However, the price of gold has been diverging from both of these indexes so far this year.

That’s an odd divergence. Is gold signaling that other commodity prices will soon be heading higher? That seems unlikely given the persistent weakness of the global economy. On the other hand, if the US and China strike a trade deal, there could be a “peace dividend” for the global economy, which would boost global growth. However, in this scenario, the price of gold is likely to move lower again.

(4) Copper-to-gold ratio coincides with bond yield. While the TIPS yield seems to drive the price of gold, it is interesting to see that the ratio of the price of copper to the price of gold has been highly correlated with the nominal 10-year US Treasury bond yield (Fig. 11). The same can be said about the ratio of the CRB raw industrials spot price index to the price of gold versus the bond yield (Fig. 12).

This makes lots of sense, though causality runs both ways: A weaker (stronger) copper price signals a bullish (bearish) environment for the bond price leading to lower yields. A lower (higher) bond yield, led by the TIPS yield, tends to be bullish (bearish) for the gold price.

Gold II: Reversal of Fortune. Gold is no longer an inflation hedge because inflation is no longer a problem thanks to the four secular forces of deflation (i.e., the 4Ds: Détente, Demography, Disruption, and Debt), which we discussed most recently in the Morning Briefing cited above. Instead, gold might be a hedge against weak economic growth. Why would weak growth be bullish for gold? Economic weakness tends to inflame destabilizing anti-globalization nationalistic political forces around the world; gold is a refuge from economic and political instability.

The latest batch of global economic indicators shows widespread economic deterioration:

(1) Eurozone sentiment eroding. Especially troubling is the drop in the Eurozone Economic Sentiment Indicator from a recent high of 114.5 during December 2017 to only 103.3 during June, the lowest since August 2016 (Fig. 13). This series is highly correlated with the y/y growth rate of the region’s real GDP growth rate, which was just 1.2% y/y during Q1.

(2) US Q2 real GDP growth estimate lowered. The FRB Atlanta GDPNow model estimate for real GDP growth during Q2 was lowered to only 1.5% (saar) on Friday, as real consumer spending was lowered slightly from 3.9% to 3.7%. That’s still a solid number for consumer spending.

On the other hand, the Citigroup Economic Surprise Index plunged from a recent high of 27.3 on 2/1 to -68.3 during 6/28, virtually matching the year’s low of -68.8 on 4/25 (Fig. 14).

(3) US regional surveys depressed by escalating trade war. Also of concern is the plunge during June of the average business conditions index of the five regional surveys conducted by the FRBs of Dallas, Kansas City, New York, Philly, and Richmond (Fig. 15). This does not augur well for this morning’s national M-PMI release, or for manufacturing in general during June. Debbie and I believe that the weakness was exacerbated by the escalation of the US-China trade war in early May. The ceasefire announced at the G20 meeting could provide at least a temporary boost to the US and global economies, as discussed in the first section.

Bitcoin: Embezzelcoin. In late 2017, when bitcoin was soaring toward a record-high price of $18,961 on 12/18/17, a distant relative asked me what I thought about the cryptocurrency (Fig. 16). He had bought one bitcoin when it was around $4,000 in mid-2017. I said it reminds me of digital tulips. “What do you mean?,” he responded. He is a Millennial who had never heard of the Dutch Tulip Bubble from 1634-38. I explained what happened back then and noted that the bubble was mostly confined to Amsterdam, whereas the bitcoin bubble is global.

Of course, some bitcoin fans believe that bitcoin has a legitimate role in a portfolio as a hedge against the madness of central banks. I concede that point. However, as we saw last year, it can crash, which is what it did on its way back down by a gut-wrenching 83% from the high of $18,962 on 12/18/17 to a low of $3,224 on 12/14/18. But now, it’s back up to $12,356. It certainly is volatile and hardly a stable store of value, which makes it a very poor candidate to replace more stable forms of money.

Some of this volatility may be attributable to the illegitimate uses of bitcoin. I’ve noticed more news stories this year about hackers planting ransomware on the computer systems of small city governments in the US. They successfully extort tens of thousands of dollars in exchange for the software key to unlock the frozen computer systems. Payment has to be made in bitcoin.

In June, Riviera Beach, a city in Florida, paid hackers $600,000 in bitcoin with the hope of having its systems restored. Also during the month, Lake City, Florida facing a ransomware demand, authorized the payment of $490,000 in bitcoin to a hacker in order to regain access to its phone and email systems. At the end of the month, the village of Key Biscayne confirmed it had been hit by a cyberattack, though it wasn't clear if it was related to ransomware.

Cities and small businesses are becoming more popular targets for hackers, who recognize frequently unsophisticated systems. According to FBI estimates, there were 1,493 ransomware attacks in 2018, with victims paying a total of $3.6 million.

In my book Predicting the Markets (2018), I wrote:

“I’m particularly intrigued by the impact of bitcoin and other cryptocurrencies on our monetary system. Blockchain, the software that runs these digital currencies, is allowing banks to eliminate clearinghouse intermediaries in their transactions and to clear them much more rapidly. Smartphone apps allow consumers to use these digital devices to deposit checks and make payments. These innovations could reduce employment and bank branches in the financial sector, much as Amazon is doing in the retail space. Central bankers are scrambling to understand the implications of bitcoin and blockchain. In time, central banks likely will incorporate these technologies into their operations, perhaps spawning bitdollars, biteuros, bityen, etc.”

I concluded:

“Libertarians might long for a day when central banks are replaced by a monetary system based on a digitized currency that is unregulated by governments. I doubt that the central monetary planners will allow that to happen. But who knows? Technology has disrupted major industries. Maybe it will disrupt central banking!”

The International Monetary Fund (IMF) is studying cryptocurrencies. The 6/27 IMFBlog is titled “Five Facts on Fintech.” It reviews the findings of a report titled “Fintech: The Experience So Far.” Based on the IMF’s research, countries generally foresee the emergence of crypto assets backed by central banks. The study surveyed central banks, finance ministries, and other government agencies in 189 countries. More specifically:

“The survey reveals wide-ranging views of countries on central bank digital currencies. About 20 percent of respondents said they are exploring the possibility of issuing such currencies. But even then, work is in early stages; only four pilots were reported. The main reasons cited in favor of issuing digital currencies are lowering costs, increasing efficiency of monetary policy implementation, countering competition from cryptocurrencies, ensuring contestability of the payment market, and offering a risk-free payment instrument to the public.”

Increasingly, at the top of the list for the central bankers is the need to improve cybersecurity in the payments system. Banning cryptocurrencies that are not officially backed by central banks undoubtedly will be considered. Whether this is even feasible is a matter for future discussion.

Movie. “Yesterday” (+ +) (link) is a feel-good movie about The Beatles. The rock group doesn’t exist in the movie. After a brief global power outage, only one person ever heard of The Beatles, and he happens to be a wannabe rock singer. He starts singing their catchy tunes (like “Hey Dude”) to bigger and bigger audiences on his way to becoming a global phenom with the help of Ed Sheeran. It’s nice to recall a time when we all enjoyed singing the same Beatles songs together and feeling good about one another. Actually, even their happy lyrics didn’t do much to bring us quarrelsome lot together during the 1960s and 1970s, which were just as divisive as current times in many ways. By the way, Coke doesn’t exist in the movie either, so no one heard of “I’d Like To Teach The World To Sing (In Perfect Harmony).”

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