United States: The $16 trillion Colossus
US growth likely to be circa 3% for 2014
Unemployment rate to hit 6.5% before the summer
Federal Reserve will keep short end low
Bond yields to go higher – 10 Year bond yields could hit 4% at some point
USD to strengthen in 2014 particularly against the Euro and the Yen
Increased equity market volatility expected, but long term trend still up
You are very welcome to the launch note of my new daily Global Macro 360 °. I am delighted that you are choosing to spend some time reading here.
Global Macro 360 ° is a daily product which brings you bang up to speed with what is going on in the global economy and markets and how it all affects you. This launch note focuses almost exclusively on the US, however the daily notes cover news and topics from all over our increasingly intertwined world. I hope you find the ideas, analysis and angles useful. For more information click here. All the best and thanks again, David
I have spent a lot of time in the US in the past month or so. As a European, used to seeing the melancholic side of things, the ability of our American cousins to believe that tomorrow will be better than today is truly uplifting.
I kicked off my American tour in the baking heat of Arizona where I spoke to the tech industry.
I use Google’s Zeitgeist conference (where they are clearly intent on debasing their currency by having me as a guest speaker for the past three years) to gauge the tech industry – not only for signs of great innovation, but for the tell-tale signs of a massive tech bubble.
In terms of business ideas, as well as the truly remarkable, Zeitgeist produces the clearly stupid. Each time I hear a tech head being elevated to deity status or listen to a geek-cool coder in hoodie and faded T-shirt chic, with whispy facial hair and ironic glasses telling me how he is going to change the world, I shudder.
When I see the amount of capital being funnelled into “weird” hipster projects, I am reminded of that great quote from the Victorian English economist John Mills when he spoke of market crashes in the wake of the great British & Irish railway crash of the 1850s:
“Panics do not destroy capital; they merely reveal the extent to which it has been destroyed by its betrayal into hopelessly unproductive works.”
– John Mills, “On Credit Cycles and the Origin of Commercial Panics,” 1867
Don’t get me wrong, I am not against tech or the huge improvements in our lives enabled by technology and neither was Mills. In fact, I am writing from Railway Road in the small town of Dalkey just outside Dublin and the railway line beside me is the one built in the 1840s – one of the first commuter lines ever in the world – between Dublin and our little town of Dalkey.
The issue is not about technology, the issue is that lots and lots of money is lost as well as made in these ventures. When I see companies with no revenues – let alone profits – changing hands for billions, I am reminded of Mills’ quotation and it seems to me that Google’s Zeitgeist is the marketplace for both great deals and even greater follies.
But this is human nature and one great IPO success opens the door for the next and the next until we get one that the world sees through, money is lost and we start again. On that IPO note, I should remind you that this week there were more new issuses than any other week in the year, which usually means the equity market will weaken in the particular bumper issue week.
As the great economist Hyman Minskey opined “Success breeds a disregard of the possibility of failure”. This applies to tech investors as well as Irish housewives buying second homes in the real estate boom in Connemara.
Speaking of Irish mothers, leaving Arizona, the parched land, the canyons and the tech heads, I made for another America. I touch down in South Bend, home to one of the least known Amish communities and one of the best known Irish communities in America.
For a Dubliner, South Bend Indiana on the weekend of a college game, is like a flat version of home. When the “Fighting Irish” take to the field, I sense the power of the great Irish Tribe with quiet pride at how our Irish-American cousins have made such a success of themselves in the USA. I was here at Notre Dame to give a series of lectures at the University of Notre Dame.
After all the academic stuff, where better to gauge the pulse of middle America than in the jammed Linebacker just outside the stadium after the game?
For the first time in a few years of travelling to the Mid West, middle America seems more confident, a bit more upbeat. It is still incredibly politically divided but, at least economically, there is a feeling that the worst of the deleveraging is past and that things are looking up.
Remember in economics, it’s not the level of things that matters; it is the marginal change that dictates the future, and each time a 50/50 decision turns positive, the more likely the economy will surprise on the upside.
Finally, a trip to Manhattan before Christmas is a must if you are on the other side of the pond. Last week, the tills were rattling, taxis hard to hail and after a terrifying experience at Abercrombie and Fitch on 5th Avenue where my teenage daughter was texting shopping orders from 4,000 miles away in Ireland (is it any wonder we perrenially run a current account deficit?), I sense that things on main street are maybe even better that the data suggest. I realise 5th Avenue is 5th Avenue, but we are talking about marginal change here and as almost all of QE is going to rich people via inflated asset prices, why wouldn’t Midtown be buzzing?
No research trip to the US is complete without a visit to an old mate’s bar in the East Village for my own mini non-farm payroll figure. This is the entirely ancedotal and unscientific index of New York bartenders, their pay and conditions constructed on the back of an envelope by the proprietor of the Dorian Gray , Mr Peter Kavanagh. (If you fancy watching rugby, there are few better places to catch a game in the US with the essential post-mortem from knowledgable barmen.) Peter tells me the demand for bartenders is decent with no real wage pressures emerging yet. As soon as I see wage pressures emerging in the Dorian Gray, I will be back to you because wage pressures in services are one of my key metrics..
Taken together, whether it is the tech gizillionaires of the West Coast, the Mid-West Linebackers of South Bend or the East Coast bartenders of East Fourth Street, the American street, plus everything in the official data, tells me that we are in for a surprise on the upside in the US in 2014.
One aspect of the post-crisis world is that the very people who were unambiguously positive up to the 2008 crash, are now uniformly negative or at least not prepared to be surprised on the upside. Consequently, consensus in the boom was always too postive and consensus in the recovery is always too negative.
And this is where we find opportunity. Speaking now as a ex-central banker, having seen how these institutions work on the inside, I am pretty sure the central bankers – the Fed – will get this wrong.
Hostage to fortune
The world’s central banks, and particularly the Fed, are caught in something like a hostage situation. This implies that we may get a both recovery in the US and extended QE at the same time which has serious ramifications for bonds, stocks and currencies.
When we were kids in Ireland, kidnapping and hostage taking were quite a regular occurence in the ongoing war between the terrorists and the authorities in Northern Ireland which often spilled over here in Dublin.
The deal was always the same, the kidnappers demanded a ramson in cash or they would kill the hostage. The government had to negotiate, knowing that the hostage’s safety was the primary concern.
The financial markets are now in a new hostage drama. The kidnappers these days are the big investment banks and Wall Street (the terrorists) , the hostage is the US recovery (the victim), the ransom is more and more QE (the money) and the negotiator is the Fed.
Have a look at the following Punk Economics animation to see the big picture:
So what is the implication?
The implication is that the pressure to maintain QE or some other type of unorthodox monetary expansion will continue for a long while because without it the threat that assets prices will fall back to earth is very real. This would obviously risk derailing the recovery and this fear will keep the monetary spigots open in some shape or form.
Open monetary spigots is the “new normal” and various iterations of it may come in the guise of reducing the target unemployment to 6% or some form of hi-falutin’ forward guidance – as long as inflation remains low.
As an investor, I think that it’s important to understand that the wedge between the asset prices and underlying value is being maintained by QE. The stimulus can’t be withdrawn too hastily or the hostage – the US recovery – will be harmed.
I term this new normal of inflated asset values the “Salvatore Ferragamo” equilibrium. You may have heard of Ferragamo? In fact, coming up to Christmas, you, yourself (for our female readers), your wife, lover, girlfiend or if you are partial to a little festive cross-dressing (you never know these days) may well want a pair of Salvatore’s finest heels. Ferragamo invented a certain type of heel, driving a wedge between actual and desired height, creating one of the most inventive shoes in history.
Central bankers are driving a similar wedge between desired asset prices and actual equilibrium values. In the following cartoon, I am looking at this global monetary dilemma from a European perspective, but the story holds for US assets too. Have a quick gander.
The Bird’s Eye View
This week will be about whether the Fed tapers or not, but if we take a bit of altitude, we see that even if it starts to taper, the stimulus to the US economy is already huge and will continue to be for a long, long time. We are looking at a stimulus of close to $ I trillion per year. Just to give you a sense of how big a number $1 trillion is, if you were to spend $1 million a day, it would take you 2740 years to spend $1 trillion. 2740 years is a long time ago, we are talking Babylon and pre sacking of the 1st Temple .
So even if the Fedheads start tapering, they’ll still be adding $800 billion to the economy or a figure in that region for a long time yet.
Remember the Fed has added buoyant stock prices to its own policy targets – that’s as well as low inflation and low unemployment, so by extension the Fed is now in the business of pushing up stocks in order to push up consumer spending, house prices, bond markets and indeed the whole shebang.
And only the truly jaundiced would claim that that the economy isn’t responding in some shape or form.
From Hannah to Miley, from crisis to calm
In the same time it took smiling Hannah Montana to morph into twerking Miley Cyrus, the last four years have seen a dramatic make over in the US economy. Back when Miley was wholesome Hannah in 2010, the US unemployment rate was 10% and the budget deficit was a whopping 10%. Now, unemployment is at 7%, the deficit is just 4% and soon to be 3% of GDP and a tentative peace process has broken out in the on-going fiscal civil war on Capitol Hill.
Also, despite fiscal tightening in 2013 – which cut a decent chunk of about 1.25 to 1.5 percentage points off nominal GDP – the US didn’t even flirt with recession this year. Given that much of that fiscal drag will lift next year, we are highly likely to start seeing higher GDP growth in 2014 than the mainstream is predicting.
A Marxist view of the future
The other week I was in Trier in the very western part of Germany. Trier happens to have been the second city in western Europe after Rome in the 1st century, being the garrison town at the very edge of the northern Roman Empire.
It is also home to a very fine and underestimated export of Germany. The wines from this Mosel region are of exceptional quality and more importantly they are cheap. And one of the finest drinkers that this part of the world produced was one Karl Marx who was born here in 1818.
As I sat in the living room where young Marx read the giants of German literature I was taken by how the man who set himself so against our capitalist system might be one of the first to recognise what is about to happen in corporate America given the split between capital and labour in American output. After all, that’s what the game is about. It’s all about the split between capital and labour. In this observation Marx was right. Indeed, Marx is a perfectly legitimate place to start your economics analysis so long as you don’t end up with him too!
In all booms, the split between wages and profits favours wages, unemployment falls, wages rise, people take out credit, banks facilitate this, housing prices rise, pushing up compensatory wage demands and corporate profits get squeezed as the return to labour rises and the return to capital falls.
Then in a bust the opposite occurs. Wages fall and unemployment rises, cost cutting lowers wage costs and profits rise quite rapidly. Because capital expenditure is also put on hold, the bottom line of corporations tends to swell as the hole in the average worker’s pocket expands too. So profitability is normally best in post recession, recovery times.
This is what we are seeing now exemplified by share buy backs – the most conspicuous sign of too much profit today but still uncertainty about tomorrow. We know that corporate balance sheets are now in great shape.
Corporate profit margins are at all time highs (11%), but this cost cutting stage is at an end and what we will see before we ultimately see the pendulum swing back towards labour and wages will be a strong resumption of capital expenditure . This will also boost growth in the US near term.
How am I positioned?
Let’s forget Marx and go back to an earlier hell raiser, Saint Augustin. If you were educated by the Jesuits, you will be aware of St Augustin’s truism : “Please oh Lord, make me virtuous but just not yet”. I feel that the financial markets are in a Jesuitical mood, which is kind of hip these days as the new Pope, a Jesuit, is being lauded all over the place , for sneaking out of the Vatican at night giving alms to the poor of Rome .
It is not that markets are giving things away for free, they are being Augustinian in their pricing of bonds.
My Augustinian leading indicator of growth is the spread between US 2 year and 10 year government bond yields.
The longer end is pricing in strong growth and a bit of price frothiness for the next few years, while the short end is saying, like a true Jesuit, yes we like all that good stuff but just not yet and is remaining firmly anchored to the floor.
As the spread between 2 year and 10 year paper increases, we are seeing a build up of the ammunition for future growth. The difference between these two is normally a good leading indicator of growth in the future. The chart below looks at the relationship between these two rates and lagged GDP. We see that the widening of the spread is a good leading indicator for where the economy is going.
However, the short-term, like St Augustine, doesn’t want to pay for the growth just yet. It wants to be virtuous in the years ahead but wants to play a bit here at low rates. I expect the spread to narrow as the real economy’s increased vigour becomes apparent.
As long as long rates move upwards, which I think they will, in tandem with growth, I don’t see any reason why slightly higher rates at the long end will choke off growth. Higher long rates are the consequence of stronger growth and are thus the natural result of the stronger economy I expect to see.
Assuming the move higher in bond rates is not disorderly, I am less concerned about the impact on the economy than some analysts. As noted above, higher rates are the consequence of stronger growth and a normalisation of bond yields can actually be a positive for an economy as money moves from safe haven bonds into more growth friendly assets.
We don’t want to see what we saw last year, where bond yields doubled in a few short months. In the year ahead, it’s more likey that long rates will move towards 4% in a reasonably orderly fashion, but the risk is that rates overshoot 4% quicker.
How I am trading it?
I am bearish on US fixed income for 2014.
A number of secondary investment ideas flow from this idea but one of my core investments will be short US fixed income (5 Year note) looking for better growth in the US, leading to higher inflation expectations.
While I expect a broad move higher in yields, I suggest that there is an opportunity in the 5 Year point of the curve. Inflation expectations are rising, yet yields haven’t come up to meet them. If this happens, and it normally does, there will be quite a bit of carnage at this point in the curve. This is likely to happen even if the Fedheads wait to reduce QE until the moment they see the white in the eyes of the recovery. At this point the Fed will already be behind events and the move upwards in yields will be quicker.
At the moment, this is where a number of large fixed income portfolio managers have concentrated their holdings. If yields move higher, this is the point on the curve that will cause current holders of bonds the most pain.
Have a look at the chart. It shows you the widening of the spread between where 5 years inflation expectations have been going: broadly upwards with views of the robustness of the recovery and five year yields, moving broadly downwards as the market bets on more QE.
One of these is bound to be wrong, maybe not straight away but over time and here is where I believe you could play the Fed’s likely continuation of QE for too long . Remember to protect the “hostage” as in our example above; there is a nice trade.
I will at some point in the New Year look to enter the investment at favourable risk reward levels.
What about the dollar?
Better growth and higher rate environment implies that the USD should strengthen. The chart below is the weighted dollar index and you can see what’s been happening.
Our three favourite currencies at the moment to take our long USD investment up against are the Euro, the Yen and the AUD. But more of that in the coming weeks.
Finally today we take a step back and look at the US equity market. With the S&P 500 up over 20% so far YTD many players are taking their profits pre end year. Market participants question the logic of being aggressively long in 2014.
We expect some form of equity market correction in the coming weeks. Fundamental valuations of stocks are stretched, even taking into account our more positive outlook on growth. Remember the Salvatore Ferragamo Heels Index?
But ultimately I expect the better economic outlook to win the day and for US equity to make modest gains in 2014. The important thing to understand about 2014 is that while the direction will be broadly positive, I expect a pick up in volatility (see chart below).
Volatility has been abnormally low this year as the S&P has been abnormally high; this is likely to change next year, as wobbles on the S&P will prompt mini-panics.
I will share with you some long & short investment ideas, which I am considering in the months ahead, with valuation as the primary driver.
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