The sun is shining over the global economy | Martin Wolf

From Martin Wolf at FT.com:

The world economy is enjoying a synchronised recovery. But it will prove unsustainable if investment does not pick up, especially in high-income economies. Debt mountains also threaten the recovery’s sustainability, as the OECD, the Paris-based group of mostly rich nations, argues in its latest Economic Outlook.

…..Low investment and high indebtedness are not the only constraints the world economy faces. Political risks are also high, as are threats to liberal trade. But raising investment and lowering debt are high priorities. As President John F Kennedy said in 1962, “the time to repair the roof is when the sun is shining”. It is essential to hack off the overhangs of unproductive private debt bequeathed by the crisis and its aftermath. The transformation will not happen overnight. But we should eliminate the incentives for such risky behaviour.

An excellent summary of the global economy’s strengths and weaknesses. I agree with Martin that low rates of capital investment (which leads to low productivity growth) and high levels of both private and public debt are the major threats to continued growth. And that the time to address it is now.

Click here to read the full article: The sun is shining over the global economy | Martin Wolf

How Will Tax Cuts Affect the US Economy and Corporate America?

Bob Doll at Nuveen Investments discusses the likely impact of tax cuts in the US:

Is it even a good idea to enact tax cuts at this point in the economic cycle? After all, growth has picked up, unemployment is at a 17-year low and capacity utilization is high. It’s reasonable to wonder whether tax cuts spur inflation higher rather than boost economic growth. We agree that inflation is likely to move modestly higher next year (more so if tax rates are reduced), but lower tax rates will likely improve productivity and benefit the economy.

Tax cuts are unlikely to have a significant impact on inflation or productivity other than through indirect stimulation of new investment and job creation.

…..If the corporate tax rate is reduced from 35% to 20%, we estimate this would increase S&P 500 earnings-per-share between $12 and $15 annually. Companies could also see an additional boost in the form of earnings repatriation. It’s possible (and even likely) that some companies would use these earnings benefits to lower prices to increase market share, so some gains may be “competed away.” But we think an overall boost in profits and earnings is likely.

That would amount to an annual increase of between 10 and 13 percent in S&P 500 earnings per share (based on a forecast $114.45 EPS for calendar 2017). Companies that invest in building market share would expect a return on that investment by way of increased growth which would still benefit future earnings streams.

Furthermore, if U.S. companies finally bring their overseas earnings home in a tax-effective manner, it’s fair to wonder what they would do with their cash windfalls. Should this happen, we expect increases in balance sheet improvements, more hiring, a rise in capital expenditures, dividend increases, higher levels of share buybacks and an increase in merger and acquisition activity. All of these actions would be a positive for corporate health and equity prices.

I would expect a big increase in stock buybacks as that will boost stock prices and have a direct impact on executive bonuses. Mergers and acquisitions have less certain outcomes and are likely to be secondary, while new investment and job creation will most likely get the short straw.

ASX 200 tests support at 5900

Australia is headed for a period of political uncertainty, while tighter Chinese monetary policy and a crackdown on capital outflows will slow the local real estate boom. Employment is strong but low wage growth suggests under-employment.

Reliance on mining and real estate as the backbone of the economy is bound to disappoint. What the economy needs is a vibrant manufacturing and tech sector but this is shrinking rather than growing, with investment in machinery and equipment falling from 8% to almost 4% of GDP over the last decade.

Stocks are rising but we need to temper our enthusiasm with a hint of caution. The ASX 200 is testing medium-term support at 5900. The tall shadow on Friday’s candle indicates continued selling pressure. Breach of 5900 would warn of a strong correction to test primary support at 5650, while respect (indicated by recovery above 6000) would confirm an advance to 6250 (5950 + 300).

* Target calculation: 5950 + ( 5950 – 5650 ) = 6250

I remain wary of the banks because of their low capital base and high mortgage exposure. Reversal below the medium-term trendline warns of a correction to test the band of primary support between 8000 and 8100. Recovery above 8800 is less likely.

Miners are more bullish despite the low iron ore price. The ASX 300 Metals & Mining index is testing medium-term support at 3300. Respect is likely and would signal another advance.

Australia: Housing bubbles and declining business investment

The Australian housing bubble is alive and kicking, with house prices growing at close to 10% per year.

Loan approvals are climbing, especially for owner-occupiers. Fueled by record low interest rates.

Causing household debt to soar relative to disposable income.

Business Investment

Nominal GDP growth of 6.34% for the 2017 FY is a rough measure of the average return on capital investment.

With a mean of close to 5% over the last two decades, it is little wonder that business investment is falling. Not only in mining-related engineering but in machinery and equipment.

Capital Misallocation

More capital is being allocated to housing than to business investment.

Returns on housing are largely speculative, premised on further house price growth, and do little to boost GDP growth and productivity.

The result of soaring house prices and household debt is therefore lower business investment and lower GDP and wages growth.

You don’t have to be the sharpest tool in the shed to recognize that soaring household debt and shrinking wage growth is likely to end badly.

Australia: Housing, Incomes & Growth

A quick snapshot of the Australian economy from the latest RBA chart pack.

Disposable income growth has declined to almost zero and consumption is likely to follow. Else Savings will be depleted.

Residential building approvals are slowing, most noticeably in apartments, reflecting an oversupply.

Housing loan approvals for owner-occupiers are rising, fueled no doubt by State first home-buyer incentives. States do not want the party, especially the flow from stamp duties, to end. But loan approvals for investors are topping after an APRA crackdown on investor mortgages, especially interest-only loans.

The ratio of household debt to disposable income is precarious, and growing worse with each passing year.

House price growth continues at close to 10% a year, fueled by rising debt. When we refer to the “housing bubble” it is really a debt bubble driving housing prices. If debt growth slows so will housing prices.

Declining business investment, as a percentage of GDP, warns of slowing economic growth in the years ahead. It is difficult, if not impossible, to achieve productivity growth without continuous new investment and technology improvement.

Yet declining corporate bond spreads show no sign of increased lending risk.

Declining disposable income and consumption growth mean that voters are unlikely to be happy come next election. With each party trying to ride the populist wave, responsible economic management has taken a back seat. Throw in a housing bubble and declining business investment and the glass looks more than half-empty.

Every great cause begins as a movement, becomes a business, and eventually degenerates into a racket.

~ Eric Hoffer

US Retail & Light Vehicle Sales slow

Retail sales growth (excluding motor vehicles and parts) slowed to 2.4% over the 12 months to June 2017.

Source: St Louis Fed & US Bureau of the Census

Seasonally adjusted light vehicle sales are also slowing.

Source: St Louis Fed & BEA

Seasonally adjusted private housing starts and new building permits are starting to lose momentum.

Source: St Louis Fed & US Bureau of the Census

The good news is that Manufacturer’s Durable Goods Orders (seasonally adjusted and ex Defense & Aircraft) are recovering.

Source: St Louis Fed & US Bureau of the Census

Cement and concrete production continues to trend upwards.

Source: US Fed

And estimated weekly hours worked (total nonfarm payroll * average weekly hours) is growing steadily.

Source: St Louis Fed & BLS

All of which suggest that business confidence is growing and consumer confidence is likely to follow. Bellwether transport stock Fedex advanced to 220, signaling rising economic activity in the broader economy.

Target: 180 + ( 180 – 120 ) = 240

The S&P 500 broke resistance at 2450, making a new high. Narrow consolidations and shallow corrections all signal investor confidence typical of the latter stages of a bull market. The immediate target is 2500* but further gains are likely.

Target: 2400 + ( 2400 – 2300 ) = 2500

The stock market remains an exceptionally efficient mechanism for the transfer of wealth from the impatient to the patient.

~ Warren Buffett

Investment the key to growth

Elliot Clarke at Westpac recently highlighted the importance of investment in sustaining economic growth:

The importance of sustained investment in an economy cannot be understated. Done well, investment in real capacity begets greater production volume and employment as well as a productivity dividend. Its absence in recent years is a key factor behind sustained soft wage inflation and the US economy’s inability to consistently grow at an above-trend pace despite the economy being at full-employment and household balance sheets having more than fully recovered post GFC.

The graph below highlights declining US investment in new equipment post GFC.

source: Westpac

There are three factors that may influence this:

1. Accelerated tax depreciation allowances after the GFC encouraged companies to bring forward capital spending in order to stimulate the recovery. But the 2010 to 2012 surge is followed by a later trough when the intended capital expenditure was originally planned to have taken place.
2. Low growth in personal consumption, especially of non-durable goods and of services, would discourage further capital investment.

3. The level of stock buybacks increased as companies sought alternative measures to sustain earnings (per share) growth. The graph below shows debt issuance has soared while net equity issuance remains consistently negative.

source: Westpac

Net capital formation (the increase in physical assets owned by nonfinancial corporations) declined between 2015 and 2017. While this is partly attributable to the falling oil price curtailing investment in the Energy sector, continuation of the decline would spell long-term trouble for the economy.

The cycle becomes self-reinforcing. Low growth in personal consumption leads to low levels of capital investment ….which in turn leads to low employment growth…..leading to further low growth in personal consumption.

Major infrastructure investment is needed to break the cycle. In effect you need to “prime the pump” in order to create a new virtuous cycle, with higher investment leading to higher growth.

It is obviously important that infrastructure investment target productive assets, that generate income, else taxpayers are left with increased debt and no income to service it. Or assets that can be sold to repay the debt. But the importance of infrastructure investment should be evident to both sides of politics and any attempt to obstruct or delay this would be putting political ahead of national interests.

Australia

Australia is in a worse position, with a dramatic fall in investment following the mining boom.

source: RBA

If we examine the components of business investment, it is not just Engineering that has fallen. Investment in Machinery & Equipment has been declining for the last decade. And now Building Investment is also starting to slow.

source: RBA

You’ve got to prime the pump…. You’ve got to put something in before you can get anything out.

~ Zig Ziglar

Federal budget 2017: The next boom is under way – before another bust

From Michael Pascoe:

A Caterpillar and Komatsu cavalry is arriving just in time to save the next two federal budgets from the effects of slowing residential building approvals, solving one of Treasurer Scott Morrison’s fiscal dilemmas. National spending on transport infrastructure is in the process of soaring 73 per cent from last financial year to 2018-19, according to industry research company Macromonitor.

Spending on road and rail hit a cyclical low of about $19 billion in 2015-16. In constant dollars, the cycle is expected to peak at $33 billion in 2018-19. That spending would more than cover a 10 per cent decline from last year’s $63 billion worth of new residential building….

Increased infrastructure spending is welcome but former RBA governor’s comments on setting up a proper process of infrastructure planning and selection [see link below] highlight the negative boom-bust mentality of government focused on the election cycle.

Source: Federal budget 2017: The next boom is under way – before another bust

Michael Gove on Brexit, productivity and innovation

Interesting viewpoint on Brexit.  How the EU became anti-innovation, erecting barriers to entry which favor incumbents.

Australia: Say goodbye to growth

Business investment in Australia continues its sharp descent since the end of the mining boom, falling below 14% of GDP for the first time since the Dotcom crash.

Source: RBA Chart Pack

Apart from the expected “cliff” in Engineering, investment in Machinery and Equipment has fallen to record lows.

Source: RBA Chart Pack

Without investment, growth is likely to contract. The impact on Australian wages is an ominous warning.

Source: RBA Chart Pack

Priming the Pump

US stocks are buoyant on hopes that a Donald Trump presidency will benefit business, with major indexes flagging a bull market. But promises come first, the costs come later. While I support a broad infrastructure program and the creation of a level playing field in global markets, the actual execution of these ideas is critical and should not be allowed to be hijacked by the establishment for their own ends.

Erection of trade barriers is a useful negotiating position but is unlikely to be achieved without enormous damage to the global economy. As long as your trading partners think you are crazy enough to do it, they may be more amenable to establishing fair ground rules for international trade. If they don’t believe the threat, they will be happy to continue on their present path. So Trump walks a fine line between reassuring his allies and the domestic market, while keeping others guessing about his intentions.

Before we get carried away with hopes and expectations, however, we need to evaluate the current state of the economy in order to assess the current potential for growth.

The Cons

Let’s start with the negatives.

Construction spending is slow, at about three-quarters of pre-GFC (and sub-prime) levels. It will take more than an infrastructure program to restore this (though it is a step in the right direction). What is needed is higher growth expectations for the economy.

Industrial production is close to its pre-GFC peak but has been declining since 2014.

Job growth is slowing. Decline below 1.0 percent would be cause for concern.

Rail and freight activity also reflects a slow-down since 2015.

The Philadelphia Fed’s broad-based Leading Index has also softened since 2014. Decline below 1.0 percent would be cause for concern.

One of my favorite indicators, this graph compares profit margins (per unit of gross value added) to employee costs. There is a clear cycle: employee costs (per unit) fall after a recession while profits rise. As the economy recovers and approaches full capacity, employee costs start to rise and profits fall — which leads to the next recession. At present we can clearly see employee costs are rising and profit margins are falling.

It will be difficult for corporations to continue to grow earnings in this environment. Business investment is falling.

Plowing money into stock buybacks rather than into new investment may shore up corporate performance for a while but hurts construction and industrial production. Turning this around is a major challenge facing the new administration.

The Pros

Retail sales are rising as increased employee compensation costs lift consumer confidence. Solid November sales with strong Black Friday numbers would help lift confidence even further.

Light vehicle sales are also recovering, a key indicator of consumers’ long-term outlook.

Rising sales and infrastructure investment are only part of the solution. What Donald Trump needs to do is prime the pump: introduce a fairer tax system, minimize red tape and reduce political interference in the economy, while enforcing strong regulation of the financial sector. Not an easy task, but achieving these goals would help restore business confidence, revive investment, and set the economy on a sound growth path.

In the short run, the market is a voting machine
but in the long run it is a weighing machine.

~ Benjamin Graham: Security Analysis (1934)

Australia: Infrastructure spending nosedives

From Andrew Hanlan at Westpac:

Total real infrastructure activity contracted by almost 10% in the June quarter 2016, to be 26% below the level of a year ago. That was the fourth year of contraction…..

Infrastructure construction work is declining rapidly. First, we had the end of the mining boom as existing projects reached completion while demand, mainly from China, contracted. This was followed by falling demand in the oil & gas sector, ending the development boom in that sector. If you think the apartment boom — driven by investor demand from China — is going to fill the hole, think again.

US private investment dwindles

Private investment is declining as a percentage of GDP. Not a good sign when you consider that a similar decline preceded previous recessions.

Click graph to view full-size image.

Also a concern, when private credit is rising as a percentage of GDP while investment is falling. Crossover of the two lines would indicate that the private sector is borrowing more than it is investing. That is not likely to end well.

Does Government Spending Create Jobs?

By William Dupor, Assistant Vice President and Economist

The most recent U.S. expansion, however lackluster, entered its eighth year in June.1 In anticipation of the possibility (or perhaps inevitability) of another recession, observers have remarked on how and whether countercyclical fiscal policy should be used to combat an economic downturn….

Gauging Effects through Military Spending
Research Analyst Rodrigo Guerrero and I took up the issue of the efficacy of government spending at increasing employment. We looked specifically at over 120 years of U.S. military spending, which provides a kind of “natural experiment” for our analysis.

Looking at government spending more generally suffers from the problem that the spending may be correlated with economic activity: The government may spend more during a recession (as with ARRA) or more during an expansion (when tax revenues are high). This might bias the results, which economists call “an endogeneity bias.”

Military spending, on the other hand, is likely to be determined primarily by international geopolitical factors rather than the nation’s business cycle.

….We used a similar methodology and found that military spending shocks had a small effect on civilian employment. Following a policy change that began when the unemployment rate was high, if government spending increased by 1 percent of GDP, then total employment increased by between 0 percent and 0.15 percent. Following a policy change that began when the unemployment rate was low, the effect on employment was even smaller.

In the event of another recession, policymakers have a number of stabilization tools at their disposal, including quantitative easing, negative interest rates and tax relief. The research discussed above suggests that one other device, namely countercyclical government spending, may not be very effective, even when the economy is slack.

I think the authors of this research come to the wrong conclusion. Instead they should have concluded that military spending is not very effective in creating jobs.

Military spending provides no lasting benefit to the economy in terms of tax revenue or saleable assets, leaving future taxpayers with public debt and no means of repayment. Other than an austerity budget which would risk another recession.

Whereas infrastructure projects can be selected on their ability to generate market-related returns on investment, providing revenue to service the public debt incurred…..and saleable assets that can be used to repay debt.

But there are two caveats.

First, project selection must not be a political decision. Else projects likely to win votes will be selected ahead of those that generate decent financial returns.

Second, the private sector must have skin in the game to ensure that #1 is adhered to. Also to reduce cost blowouts. Private companies are not immune to blowouts but government projects are in a league of their own.

The added benefit of infrastructure spending is the free lunch government gets from reduced unemployment benefits. Money they would have spent anyway is now put to a more productive use.

Source: Does Government Spending Create Jobs?

The real problem: Private Investment

Want to know the real cause of low GDP growth? Look no further than Private Investment.

Private Investment ran with peaks around 10 percent of GDP and troughs around 4 percent throughout the 1960s, 70s and most of the 80s. Since then Private Investment has declined to the point that the latest peak is close to 4 percent.

It is highly unlikely that the US will be able to sustain GDP growth if the rate of investment continues to decline. GDP growth is a factor of population growth and productivity growth. Productivity growth is not primarily caused by people working harder but by working more efficiently, with better tools and equipment. Using an earthmover rather than a wheelbarrow and shovel for example. Falling investment means fewer new tools and efficiencies.

The second graph plots the annual increase in private debt against GDP. You would think that this figure would fall — in line with falling rates of investment. Quite the opposite. Private debt growth is rising. While annual debt growth is nowhere near the red flag of 5 percent of GDP, if it crosses above the rate of private investment — as in 2006 to 2009 — I would consider that a harbinger of another crash.

Michael Pettis: Brexit could speed breakup of the Euro

On secular stagnation: “I don’t see growth picking up until you either redistribute income downwards — which is politically quite difficult and slow — or developed countries which are credible borrowers engage in massive infrastructure spending — which would be a great idea but politically difficult — so I’m afraid secular stagnation is going to last several more years.”

On BREXIT: “I’m not to optimistic that the Euro will be around in 10 years…BREXIT could speed up the process if England does well.”

On future crises: “It’s always the same thing: a huge switch from New York to Washington (in American terms) where policy begins to dominate the whole process…because the solutions to the problems are political solutions, not really economic or financial solutions…”

Stan Druckenmiller: This Is The Endgame | Zero Hedge

Hedge fund legend Stan Druckenmiller, founder of Duquesne, addressing the Sohn Conference:

….The Fed has no end game. The Fed’s objective seems to be getting by another 6 months without a 20% decline in the S&P and avoiding a recession over the near term. In doing so, they are enabling the opposite of needed reform and increasing, not lowering, the odds of the economic tail risk they are trying to avoid. At the government level, the impeding of market signals has allowed politicians to continue to ignore badly needed entitlement and tax reform.

Look at the slide behind me. The doves keep asking where is the evidence of mal-investment? As you can see, the growth in operating cash flow peaked 5 years ago and turned negative year over year recently even as net debt continues to grow at an incredibly high pace. Never in the post-World War II period has this happened. Until the cycle preceding the great recession, the peaks had been pretty much coincident. Even during that cycle, they only diverged for 2 years, and by the time EBITDA turned negative year over year, as it has today, growth in net debt had been declining for over 2 years. Again, the current 5-year divergence is unprecedented in financial history!

And if this wasn’t disturbing enough, take a look at the use of that debt in this cycle. While the debt in the 1990’s financed the construction of the internet, most of the debt today has been used for financial engineering, not productive investments….

Source: For Stan Druckenmiller This Is “The Endgame” – His Full ‘Apocalyptic’ Presentation | Zero Hedge

Hat tip to Houses & Holes at Macrobusiness.

Can ‘New’ Keynesianism Save the Chinese Economy? | The Diplomat

Excellent summary of China’s growth dilemna by Dr Yanfei Li, Energy Economist at the Economic Research Institute for ASEAN and East Asia (ERIA) [emphasis added]:

To conclude, national capitalism, which aims to help the Chinese economy move up the global value chain through technological catching up, can be considered part of the essence of the “new” Keynesianism – in other words, the Chinese approach to intervention in the current economic downturn. It will certainly continue to make significant progress in certain well-targeted areas, given enough time. However, there are two key dimensions to measuring how successful the strategy will be. One is the timeline: how long it takes for such efforts to be translated into significant productivity gains for the whole economy. Second, whether or not these selected areas, especially AI and robotics, can bring about a major productivity boost as seen with the IT boom in the 1990s and early 2000s.

In addition, national capitalism, a centralized strategy, is an intrinsically high-risk approach to technological development. Even with well-informed decisions, such as the case of Japan in developing HDTV, there are always surprises. The Chinese government can only hope that it has chosen the right technologies to pursue.

Finally, it is worth mentioning that the other part of China’s “New” Keynsianism, namely the One Belt One Road initiative, which is about exporting the products and services of over-capacity, infrastructure-related industries overseas, also seems riskier than usual. Put another way, if these proposed infrastructure projects in targeted developing countries were attractive and low risk, they would have been financed and done. The fact that they are not itself implies higher risks are involved.

At this point, policymakers must look inward: They must identify and implement all necessary reforms to improve the micro-level efficiency of the Chinese economy. And this always implies the importance of truly open, competitive, transparent and fair markets for all industries. That is a vastly superior approach to the Ponzi game of emphasizing ways to manipulate the property market to keep prices climbing ever higher.

Source: Can ‘New’ Keynesianism Save the Chinese Economy? | The Diplomat