Thursday, December 06, 2018

The Albatross and the Canary

By Steve Stapleton

Economic predictions are generally a fool’s errand.  That is especially true when such predictions are dependent on events yet to unfold, such as whether the pause apparently negotiated by the US and China at the G-20 meeting will yield any substance in their continuing trade war.  Nevertheless, trends can be identified and, while they may not dictate a particular outcome, they can lead to verifiable suppositions.

So putting the issue aside as to whether there will be any substantive improvement in the trade war, there are some trends to be aware of.

A Long Way from … Neutral
First, Fed Chairman Jerome H. Powell said last Wednesday that the Fed’s rate hikes are approaching an important level, the so-called “neutral” level, meaning a rate that neither stimulates nor discourages borrowing.  Thus, investors rewarded the comment by sending the stock market up, an assumption that the current benchmark rate, which is at a range of between 2.00 and 2.25 percent, will not be propelled substantially upward any time soon.  The comment of the Fed Chair is somewhat at odds however with his comments in October when he said the benchmark rate was still “a long way” from neutral. Indeed, Richard Clarida, the Fed’s Vice Chairman, said on Tuesday that the economy remained “robust” and that the Fed planned to keep raising rates, but would do so with “judgment and humility,” whatever that means.  It may imply that the Fed will go slow, as earlier this month Powell said the Fed would proceed like a man in a dark room, “feel[ing] your way” around the room.  What could be more comforting?

GM as Bellweather or Outlier
Second, GM recently decided to shut down (“unallocate” in GM’s parlance) five of its plants in both the US and Canada.   Closing the plants will idle 15% of GM’s workforce, fully 8,100 people, and in the process will save GM about $6 billion.  The closure can arguably be attributable to the many challenges facing the auto industry rather than to the prospects of a downturn in the economy.  There is a well-recognized, nascent shift toward electric and self-driving vehicles, and that point was underscored by GM’s decision to eliminate some mechanical engineering positions in favor of software engineers. 

Others will point to the fact that GM, after being the beneficiary of a bailout that cost the American taxpayer more than $11 billion, has spent almost that amount ($10.6 billion) in buying back its own shares.  While such buybacks often spur stock gains, in GM’s case the stock declined 10% since the stock buyback began.  That money could have been used in other ways, such as investing in older plants.  Nevertheless it should be noted that GM, and the auto industry as a whole, must fund its significant up-coming expenditures to accommodate the changing consumer landscape at a time when costs are rising – in part due to the tariffs in steel and aluminum – and sales are declining in major markets such as the US and China.  GM’s sales in the last quarter fell 11% while its sales for the year slipped 1.2% overall. And, while the 2017 tax cut was intended to spur investment in new factories, new equipment and new products – GM, for one, has said that the cost of the tariffs exceed the benefits of the tax cuts. 

My Appreciation (for you) is Flattening
Third, while home prices were 5.5% higher this past September than the previous year, according to the Case-Shiller Home Price Index, this is the eighth month of declining home appreciation.  Part of this can be attributable to the current mortgage rates, currently at 4.9 percent for a 30-year fixed; a rate that is 100 basis points higher than a year ago.  While a few markets are still seeing home appreciation, such as Las Vegas, San Francisco and Seattle, home prices for pre-owned properties in Dallas are flat from 2017.  This is notable considering the North Texas region enjoyed a housing boom with the influx of transplants from other states – for the past 10 years.

A Worsening Economic Outlook
Fourth, on Wednesday the Fed issued a report assessing the stability of the US financial system, and pointed to excessive borrowing by both banks and households.  Debt owed by businesses is at a historic high, currently running at $2 trillion.  Although the credit quality of bank lending is generally strong, the debt held by some companies in relationship to their assets is the highest it has been in two decades. 

Robert Kaplan, the Dallas Fed Chair, in a recent interview on CNBC, noted that input costs are rising generally, only a portion of which is attributable to the recently-imposed tariffs and companies are struggling to pass these costs on to their consumers. As a result, margin erosion is accelerating along with a deceleration of expectation and global growth generally.  Reacting to the 76% market expectation that the Fed will raise rates again in December, he noted that the Fed has raised rates eight times in the last two and a half years and the fiscal stimulus is waning.  While he wouldn’t comment on the accuracy of the rate rise expectation, he did say that the first quarter of 2019 will look substantially different (worse?) than the last quarter of 2018.

International Contraction
Fifth, in Greece, Spain and Italy, the youth unemployment rate remains above 30%.  South Africa’s economy is smaller today than it was in 2010.  Great Britain’s exit from the EU, no matter what form it takes, will result in a substantially smaller economy.  The rate of growth in China is slowing faster than experts anticipated.  The economies of both Germany and Japan have contracted in recent months.  And, once the effects of the $1.5 trillion stimulus winds its way through the economy, the US will be left with a public debt that dwarfs the historical record.

Flat Math
Finally, some math:  I’ve mentioned the yield curve in a prior newsletter article.  The yield curve is fundamentally the difference between interest rates on short-term government bonds and long-term government bonds. Since 1960, every time the yield curve has inverted — when long-term rates were lower than short-term rates — a recession followed.  And we’ve already experienced just such an inversion.  The spread between 3- and 5-year yields fell to negative 1.4 basis points on Monday, dropping below zero for the first time since 2007.  While the 2- to 10-year gap is more closely watched as a potential indicator of a recession, other parts of the yield curve are also beginning to flatten.  Indeed, the spread between 2- and 10-year rates – arguably the most closely watched section of the curve – went below 16 basis points, which is again, the flattest since 2007 and could signal a coming recession.

We will likely see the economy expanding by 3.5% annually through the remainder of this year – down from 3.7 percent last year – and perhaps, for a time, into the next.  But,

  • the auto sales cycle has peaked,
  • as has the housing cycle,
  • the fiscal stimulus has had its day,
  • lending rates for mortgages and auto loans are steadily rising, and
  • a with heartfelt apologies to Samuel Taylor Coleridge, a global economic albatross seems to be settling in around our necks. 

While consumer confidence remains strong – consumer spending accounts for two-thirds of economic activity – declines or warning signs in areas such as housing and autos, a slowing of the global economy, and the economic indices trending lower – most of the canaries, one by one, are becoming mute, with only the consumer spending canary still singing. 

The economically-interdependent coal mine we find ourselves in is beginning to seem like an awfully quiet place.



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