US: Low CPI and soft Treasury Yields

The Consumer Price Index (CPI) and Core CPI (excluding food and energy) both came in at a low 1.7% p.a. for the 12 months ended July 2017.

Consumer Price Index (CPI) and Core CPI

Source: St Louis Fed, BLS

Long-term interest rates are trending lower as CPI moderates. Breach of support at 2.10% by 10-Year Treasury Yields would signal another primary decline with a target of 1.80%*.

10-Year Treasury Yields

Target: 2.10% – (2.40% – 2.10%) = 1.80%

Bank credit growth is slowing, to the level where it is tracking nominal GDP growth, avoiding some of the excesses of previous cycles. But if bank credit falls below GDP growth that would warn of tighter monetary conditions and the economy is likely to slow.

Bank Credit and GDP growth

Source: St Louis Fed, FRB, BEA

The S&P 500 is testing its long-term rising trendline, while bearish divergence on Twiggs Money Flow warns of selling pressure. But the market appears to have shrugged off Donald Trump’s promises of North Korean “fire and fury” and both of these movements seem secondary in nature. A correction is likely but the primary trend remains on track for further gains.

S&P 500

Target 2400 + ( 2400 – 2300 ) = 2500

Why is it so hard to forecast interest rates? | San Francisco Fed

Interesting paper by Michael Bauer at the San Francisco Fed:

….The difficulty of predicting changes in interest rates mainly arises from two features that characterize their evolution over time. First, like other financial variables, interest rates vary widely from day to day, which makes them difficult to link to economic fundamentals such as monetary or fiscal policy. This well-documented “excess volatility,” was first pointed out in Shiller (1979), and it reflects the importance of frequent changes in investor sentiment due to a never-ending stream of economic data releases and other news.

Second, as evident from 10-year Treasury yields since 1971, seen in Figure 1, interest rates have not fluctuated around a stable average level over this period. Instead of “mean reversion” around a constant average, they exhibit slow-moving trends, such as the rise during the “Great Inflation” period of the 1970s, and the long-lasting decline since then.

….the gap model does not assume that the level of the series will revert to some constant mean, but instead that the gap between the series and its trend component will revert to zero. Estimating trend components and gaps underlies most macroeconomic forecasting, and Faust and Wright (2013) recently demonstrated the gap model’s excellent performance for inflation forecasting.

….Since inflation is ultimately determined by monetary policy, the long-run inflation trend corresponds to the perceived inflation target of the central bank. This can be estimated reasonably well from surveys. Figure 1 plots the publicly available and mostly survey-based inflation trend estimate (red line) that underlies the Federal Reserve Board’s structural model of the U.S. economy, FRB/US. For the trend in the real interest rate, also called the natural or equilibrium real interest rate, Laubach and Williams (2003) suggested a way to estimate it from macroeconomic data and popularized its use in policy analysis (see also Williams 2016). Figure 1 includes an estimate of the equilibrium real interest rate (green line) taken as the average of several popular estimates, as discussed in Bauer and Rudebusch (2017).

Figure 1 also plots the sum of these two trends (red line); this estimate of the trend component in interest rates has exhibited a very pronounced decline since the 1980s. The 10-year yield generally fluctuated near this trend, and both are currently very low in historical comparison, with important consequences for policymaking (Williams 2016). Figure 1 suggests that it may be useful to take into account the level of the trend when forecasting interest rates.

….the final piece required for a practical forecast rule is an assumption about the transition of interest rates to their trend. Based on how quickly interest rates have historically reverted back to the trend, a reasonable assumption to make for this forecasting exercise is that 20% of the remaining gap is closed each quarter. But the precise speed of reversion to the trend is typically not crucial for forecasting performance (Faust and Wright 2013). Furthermore, it becomes essentially irrelevant for long-horizon forecasts, since forecasts are approximately equal to the estimated trend…..

Source: Federal Reserve Bank of San Francisco |

Bob Doll: Lack of  infrastructure stimulus might benefit stocks

Bob Doll at Nuveen makes a good point about Trump’s failure to get infrastructure spending through the House.

Washington, D.C. seems mired in gridlock, despite the fact that Republicans control the House, Senate and White House. No significant economic legislation has been passed, and the optimism from January about health care reform, infrastructure spending and tax cuts has all but vanished. Political attention will soon be focused on the 2018 midterm elections, and the window for pro-growth policy action is closing.

The lack of fiscal stimulus is disappointing, but it comes with a silver lining: We are unlikely to see the significant and sharp advance in interest rates or in the U.S. dollar that would probably result from such stimulus. The lost opportunity on the political front might therefore have the ironic effect of prolonging the bull market in stocks.

It seems crazy when you consider that both Clinton and Trump campaigned on a platform of major infrastructure programs to boost the economy. Just shows how dysfunctional Washington has become.

But I agree with the silver lining. Infrastructure spending would have boosted employment — the US is already below its long-term natural rate of unemployment — and upward pressure on wage rates. Which would have drawn a sharp increase in interest rates from the Fed, to combat inflation. Populist policies often ignore the hidden/unforeseen consequences and can produce the opposite result to that intended.

Unemployment v. LT Natural Rate

Source: Weekly Investment Commentary from Bob Doll | Nuveen

Stronger dollar, weaker inflation could check rate hawks

Jens Meyer at the AFR says that a stronger Dollar and low inflation are likely to prevent the RBA from raising interest rates for some time:

Inflation is expected to remain below the Reserve Bank’s comfort zone when second-quarter CPI data is unveiled on Wednesday. Despite a jump in vegetable prices due to damage caused by Cyclone Debbie, economists predict consumer prices rose just 0.4 per cent over the second quarter and 2.2 per cent over the year.

More importantly for the central bank, ongoing softness in wages growth is tipped to have kept a cap on the less volatile core inflation, coming in at 0.5 per cent over the quarter and 1.8 per cent over the year, below the Reserve Bank’s target band of 2 to 3 per cent.

Rising iron ore prices helped the Aussie Dollar break long-term resistance at 78 cents, testing 80 against the greenback. This goes against the wishes of the RBA who need a weaker Dollar to assist exports and boost import substitution.

Aussie Dollar

But the RBA is in a cleft stick. It cannot lower rates in order to weaken the Dollar as this would encourage speculative borrowing and aggravate the property bubble. It also can’t raise rates when inflation is low, the Aussie Dollar is strong and the economy is weak. Like Mister Micawber in Charles Dickens’ David Copperfield, the RBA has to sit and wait in the hope that something turns up.

Source: Stronger dollar, weaker inflation could check rate hawks

Australia: Job gains

ABS June figures reflect solid gains for the labor market. Justin Smirk at Westpac writes:

“….The annual pace of employment growth has lifted from 0.9%yr in February to 2.0%yr in May and it held that pace in June. In the year to Feb there was a 106.9k gain in employment; in the year to June this has lifted to 240.2k. The Australian labour market went through a soft patch in 2016 that was particularly pronounced through August to November when the average gain in employment per month was a paltry 2.2k. We have clearly bounced out of this soft patch and now holding a firmer trend.”

My favorite measure, monthly hours worked, jumped (year-on-year) by 3.1%.

Monthly Hours Worked

Infrastructure spending, particularly in NSW and Victoria, is doing its best to offset weakness in other areas.

Wage rate growth remains subdued, indicating little pressure on the RBA to lift rates.

Monthly Hours Worked

Weekly Top Themes from Bob Doll | Nuveen

  1. U.S. monetary policy should remain equity-market friendly. In her comments last week, Janet Yellen stated that the neutral rate for the fed funds rate is “currently quite low,” and rates would not have to rise much more to become neutral. In our view, a neutral fed funds rate is closer to 2% than the 3% currently implied by the fed funds futures market. If this is accurate, it would likely be good news for economic growth, corporate earnings and the stock market.
  2. Global monetary policy is starting to normalize, but still supports stocks. The Bank of China raised rates by 25 basis points last week and other central banks are becoming less dovish. We think this is good news since it reflects improving global economic growth, while overall policy remains easy. Central banks are still promoting liquidity, which should support equities and other risk assets.
  3. Inflation remains surprisingly low. Although economic growth is improving and the Fed is normalizing, inflation has not increased similarly. Inflation should eventually react to tightening labor markets, but the process is taking a long time.
  4. If the “Goldilocks” environment persists, we think equities can continue to make all-time highs. Low inflation, slow-but-positive economic growth, climbing earnings and a cautious Fed have contributed to record-high stock prices. We think these conditions should remain in place for at least the next 6 to 12 months.
  5. Active fund manager performance has improved. According to Merrill Lynch, 54% of active large cap U.S. equity managers outperformed their benchmarks for the first half of the year and more than half also outperformed for the last four months. This is the longest such streak since Merrill Lynch began tracking this data in 2009, and it marks the first time a majority of managers outperformed for the first half of a year.

Global monetary policy supportive of stocks, low inflation and slow-but-stable earnings growth. Nothing much wrong here. Inflation is the one to watch though. A surge in wage rates as the labor market tightens would tighten monetary policy, with a domino effect on earnings and stock performance.

Source: Weekly Investment Commentary from Bob Doll | Nuveen

Australia faces headwinds

Australian wage rate growth, on the other hand, is declining. is in a worse position, with a dramatic fall in investment following the mining boom.

Australia: Wage Price Index

Source: RBA & ABS

As is inflation.

Australia: Inflation

Source: RBA & ABS

Growth in Household Disposable Income and Consumption.

Australia: Household Income and Consumption

Source: RBA & ABS

And Banks return on shareholders equity.

Australia: Banks Return on Equity

Source: RBA & APRA

But not Housing.

Australia: Banks Return on Equity

Source: RBA, ABS, APM, CoreLogic & Residex

At least not yet.

Falling house prices would complete the feedback loop, shrinking household incomes, consumption and banks ROE.

US adds 222 thousand jobs

From the Wall Street Journal:

U.S. employers picked up their pace of hiring in June. Nonfarm payrolls rose by a seasonally adjusted 222,000 from the prior month, the Labor Department said. The unemployment rate ticked up to 4.4% from 4.3% the prior month as more people joined the workforce…..

Job Gains

Source: St Louis Fed & BLS

Forecast GDP for the current quarter — total payrolls * hours worked — is rising, showing an improving economy.

Real GDP Forecast

Source: St Louis Fed, BLS & BEA

Declining corporate profits as a percentage of net value added (RHS) is typical of mid-cycle growth, while employee compensation (% of net value added) is rising at a modest pace. Peaks in employee compensation are normally accompanied by troughs in corporate profits…..and followed by a recession.

US Corporate Profits and Employee Compensation as percentage of Value Added

Source: St Louis Fed & BEA

Average wage rate growth, both for production/non-supervisory and all employees, remains below 2.5% per year. Absence of wage rate pressure suggests that the Fed will be in no hurry to hike interest rates to curb inflationary pressure.

Hourly Wage Rate Growth

Source: St Louis Fed & BLS

Which should mean further growth ahead.

Gold-Oil ratio warns of further easing

I don’t attach much significance to the Gold-Oil ratio on its own but it’s back in overbought territory, above 25.

Spot Gold/Light Crude

The chart below — plotting inflation-adjusted prices (over CPI) — far better depicts the relationship between gold and crude oil. Each major spike in crude prices over the last 50 years has been followed by a rising gold price.

Spot Gold/Brent Crude

Falling crude prices are likely to weaken demand for gold over the next few years, both through lower inflation and declining foreign reserves of major oil producing nations.

Gold finds support at $1250

The Dollar Index continues to test support at 96.50. The primary trend is down and breach of support is likely, signaling a decline to test the 2016 low at 92/93.

Dollar Index

Spot Gold found support at $1250. A weaker Dollar and rising political uncertainty both favor an up-trend but rising interest rates are expected to weaken demand. Respect of support at $1250 would confirm the up-trend, while breach of $1200 would warn of another decline.

Spot Gold

Australia: Warning signs of a contraction

Australia faces shrinking inflationary pressures.

Inflation

Wage growth is falling.

Wage Price Index

Credit growth is shrinking.

Inflation

Growth of currency in circulation is also slowing. The fall below 5% warns of a contraction.

Currency in Circulation: Growth

One piece of good news is that Chinese monetary policy seems to be easing. After a sharp contraction of M1 money stock growth in January, February shows a partial recovery. Collapse of the Chinese property bubble may be deferred a while longer.

China M1 Money Stock

Which is good news for iron ore exporters. At least in the short-term.

Inflation surges

Inflation is rising, with CPI climbing steeply above the Fed’s 2% target. But core CPI excluding energy and food remains stable.

Consumer Price Index

Job gains were the lowest since May 2016.

Job Gains

But the unemployment rate fell to a low 4.5%.

Unemployment

Hourly wage rate growth has eased below 2.5%, suggesting that underlying inflationary pressures are contained.

Average Hourly Earnings Growth

The Fed is unlikely to accelerate its normalization of interest rates unless we see a surge in core inflation and/or hourly earnings growth.

Jobs, Inflation & the Fed | ECRI

From Lakshman Achuthan at ECRI:

Headline jobs growth came in well below expectations, and weather played some part in suppressing job growth, both in construction and retail.

But the jobless rate dropped to 4.5%, its lowest reading since 2007, so the Fed’s “full-employment” mandate has been met.

Their other mandate is on inflation, and over the past year I’ve discussed our U.S. Future Inflation Gauge, which anticipated the inflation cycle upturn shown by the chart. Today the forward looking USFIG remains near an 8¾ -year high.

The chart shows the year-over-year PCE inflation rising sharply to a 5-year high, and breaching the Fed’s 2% inflation target which is defined by this inflation measure.

For those who might think this is just about oil prices, please note that core PCE inflation, ex-food and energy, has also been rising, and now above 1¾%, the highest reading in over 2½ years.

This is what a cyclical upswing in inflation looks like.

Moreover, the U.S. economy has a good tailwind from rising global growth.

All of this helps explain why the Fed is finally able to implement a full-fledged rate hike cycle.

Source: Jobs, Inflation & the Fed | News | News and Events | ECRI

Robert Shiller: Is he right that stocks are overpriced?

I frequently come across stocks such as Netflix [NFLX], trading on a forward PE of 137 (Morningstar), or even Coca Cola [KO] and Procter & Gamble [PG] that leave me muttering about unrealistic valuations.

Nobel laureate Robert Shiller this week commented that he was no longer buying stocks as he believed they were overvalued. His justification is the CAPE index which compares current stock prices to the 10-year average of inflation-adjusted earnings.

Shiller CAPE Index

The index is below its Dotcom high but is approaching the same level that it peaked at in 1929. Is the CAPE index flawed or does this portend disaster?

Bear in mind that Shiller is not selling all his existing stocks — he has merely stopped buying — and is the first to point out that the CAPE index is a poor tool for timing market tops and bottoms.

Before we make any rash decisions let us compare Shiller’s index to a few other handy measures of market valuation.

Warren Buffett’s favorite

Warren Buffett’s favorite measure of market value is to compare total stock market capitalization to GDP. The higher the ratio, the more the stock market is overvalued.

US Market Cap to GDP

This looks even worse than the CAPE index, with market cap to GDP well above its 2007 high and well on its way to Dotcom levels.

Adapting the ratio to include offshore earnings of multinational companies makes very little difference to the results. Here I compare market cap to GNP as well as GDP. GNP, or gross national product, includes offshore earnings of domestioc companies rather than just domestic earnings as with GDP. The end result is much the same.

US Market Cap to GNP

Market Cap to Corporate Profits

When we compare market capitalization to current profits after tax, however, valuations are still high but nowhere near the irrational exuberance of the Dotcom era.

US Market Cap to Profits after Tax

The current peak resembles earlier peaks in the 1980s and 1960s.

What this tells us is that corporate profits are rising faster than GDP. And that a 10-year average may be a poor reflection of future sustainable earnings.

Sustainable Earnings

Are current earnings sustainable? There is no clear answer to this. But there are some key criteria if earnings are to remain at current levels of GDP.

First, wage rate growth remains low. The graph below illustrates how profits fall when employee compensation rises (per unit of value added).

Wage Rates

Second, that interest rates stay low. The Fed is doing its best to normalize interest rates but monetary tightening would spoil the party. That is, deliberate tightening by the Fed to subdue rising inflationary pressures.

A third element is corporate taxes but there seems little risk of rising taxes in the current climate.

The key variable for both #1 and #2 is wage rates. At present these are subdued, so no cause for alarm.

Wage Rates

….yet.

Australia’s economic growth is slowing.

Employment and Participation rates are falling.

Australia Employment & Participation Rates

Wage rate growth is slowing.

Australia Wage Rates

Slowing wage rate growth and inflation confirm that the economy is faltering.

Australia Underlying Inflation

The RBA, with one eye on the housing bubble, has indicated its reluctance to cut rates further. Increased infrastructure spending by Federal and State governments seems the only viable alternative.

With the motor industry winding down and apartment construction headed for a cliff, this is becoming increasingly urgent.

US Job Growth, Wage Rates & Inflation

Payrolls jumped by a seasonally adjusted 235,000 jobs in February, setting the Fed on track for another rate rise next week.

US Job Growth

GDP growth is projected to lift in line with employment, wage rates and hours worked. At this stage, the Fed is still attempting to normalize interest rates rather than slow the economy to cool inflationary pressures.

Projected GDP

Wage rate growth remains muted, at close to 2.5 percent, so rate hikes are likely to proceed at a gradual pace.

Hourly Wage Rates and Money Supply

The need to tighten monetary policy is only likely to be seriously considered when wage rate growth [light green] exceeds 3.0 percent [dark green line]. Then you are likely to witness a dip in money supply growth [blue], as in 2000 and 2006, with bearish consequences for stocks.

*The dip in 2010 was a mistake by the Fed, taking its foot off the gas pedal too soon after the 2008 crash.

The key component driving inflation

Two interesting graphs on inflation from Niels Jensen at Absolute Return Partners:

….similarities between the story unfolding in the UK and the one in the US. Core inflation in both countries is significantly higher than it is in the Eurozone – just above 2% in the US and just below 2% in the UK whereas, in the Eurozone, it is only 0.9%. Furthermore, services are very much the engine that drives core inflation in both the UK and the US (exhibit 6).

Exhibit 6: The drivers of core inflation (US only)Source: The Daily Shot, BEA, Bureau of Labor Statistics, Haver Analytics, February 2017. Data as of December 2016

To a very significant degree that is down to rising medical care costs (exhibit 7). As the populace ages, this can only get worse – at least in the US, where almost all healthcare is provided privately and paid for by insurance companies.

Exhibit 7: US personal consumption expenditures by component (%)
Source: The Daily Shot, BEA, Haver Analytics, February 2017

Source: A Note on Inflation: Is it here or isn’t it? – The Absolute Return Letter

Australia & Canada in 4 charts

RBA governor Phil Lowe recently made a speech comparing the experiences of Australia and Canada over the last decade. Both have undergone a resources and housing boom. Four charts highlight the differences and similarities between the two countries.

Australia’s spike in mining investment during the resources boom did serious damage to non-mining investment while Canada’s smaller boom had no impact.

Australia & Canada: Mining v. Non-Mining Investment

Immigration fueled a spike in population growth in Australia, adding pressure on infrastructure and housing.

Australia & Canada: Population Growth

Both countries are experiencing a housing bubble, fueled by low interest rates and lately by export of China’s property bubble, with capital fleeing China and driving up house prices in the two countries.

Australia & Canada: Housing

Record levels of household debt make the situation more precarious and vulnerable to a correction.

Australia & Canada: Household Debt

Hat tip to David Llewellyn-Smith at Macrobusiness