December 30, 2013
The holiday season is the traditional time of year to prognosticate about the upcoming year. But, before I start, I want to make a distinction between short-term and long-term forecasts.
Long-term trends are just that, and they unfold slowly. And, while I have great concerns about the long-term consequences of inflation, the dollar’s role as the world’s reserve currency, the bloated Fed balance sheet and resulting excess bank reserves, and the freight train of unfunded liabilities which will impact the debt and deficit, because these are long-term issues and simply don’t appear overnight, I do not believe there is anything contradictory about being optimistic about the short-term.
With that caveat, here are my predictions for 2014:
1. Real GDP will grow faster in 2014 (3.5%): The “fiscal drag” that caused headwinds for the economy has now passed with the signing of the first budget in four years in mid-December. Since 2009, governments at all levels have been shedding jobs. But, that has now all changed. The November jobs reports show that employment at all levels of government has turned positive.
No matter your view of the desirability of this for the long-term, in the short-term, those employees receive paychecks and consume goods and services. I predict the real gross domestic product growth rate will be more than 3.5 percent in 2014.
2. Manufacturing and trade are healthy and will get better in 2014: The Institute for Supply Management’s indexes, both manufacturing and non-manufacturing, are as high or higher than they were in the ’05-’06 boom. In November, industrial production finally exceeded its ’07 prior peak level.
Auto sales today are as frothy as they were in the pre-recession boom, and auto sales in the holiday buying period are destined to surprise to the upside. Online sales in the weekend before Christmas overwhelmed both UPS and FedEx, causing many gifts to be delivered on the 26th.
3. Housing, while not near its old bubble peak, has turned the corner: Part of the reason the economy is not overheating is housing. While November’s housing starts surprised to the upside, they still only represent 53 percent of their bubble peak. Nevertheless, because new home construction has been in the doldrums for the past six years, the resurgence evident in the economy has pushed the median price of homes to the point where many homeowners, who were underwater just a couple of years ago, can now show positive home equity on their balance sheets
While interest rates have risen and may be a cause for concern for housing, they are still very low by historic standards, and we have a Fed that, on Dec. 18, recommitted to keeping them down for a period much longer than the market ever anticipated.
4. The unemployment rate will end 2014 somewhere near 6%: Because the popular unemployment index is a lot higher today than it was in the ’05-’06 boom (7 percent vs. 5 percent), the popular media assumes that the labor markets are still loose. But, demographics and incentives to work have changed over the past seven years.
The labor sub-indicators imply much tighter labor conditions than the traditional unemployment index would lead one to believe. Recent data for nonfarm payrolls are equivalent to their monthly numbers in ’05-’06. Weekly new jobless claims are in a steep downtrend. The sub-indexes for layoffs and discharges are lower than they were in ’05-’06. And hard-to-fill-position and job-opening subindexes are in definite uptrends and are approaching ’05-’06 levels. As a result, expect a steady decline in the unemployment rate in 2014.
5. Investment in new plant & equipment will rise in 2014: For the past 5 years, large-cap corporations have hoarded cash and have not reinvested in their businesses. As a result, because equipment and technology is older, labor productivity has stagnated. This is one reason for the strong labor market. In 2014, I predict there will be an upturn in the reinvestment cycle. Beneficiaries will be technology companies and banks.
6. Inflation will be higher in 2014, both “officially” and in reality: While every individual player in the financial markets knows that everyday prices are rising, each espouses the Fed’s deflation theme, perhaps only to play along hoping the Fed will continue printing money.
Are we to believe that the jump of retail sales in October of 0.6 percent followed by 0.7 percent in November were all without price increases as the Bureau of Labor Statistics says? The “official” consumer price index says that airline fares have not increased despite the 18 percent growth of airline revenues in 2013 (bag check fees, etc.)? Should we believe that double-digit revenue growth rates at restaurants are volume-only and we are just eating more? I don’t know what the actual rate of inflation is, but it sure feels like it is higher than 5 percent. In 2014, it will be even higher than that.
7. Equity markets will rise in 2014: The fiscal headwinds are behind us; industrial production and sales are strong; housing is healing, the rise in home prices have generally raised consumer confidence; there appears to be the beginning of an upturn in the capital investment cycle; and, most important, the labor markets are strong. Any equity market corrections should be bought. Meanwhile, longer-duration bonds should be avoided unless there is an accompanying hedge instrument.
8. Gold — it should rise in 2014, but this is a tricky market: Every indicator points to a rise in the price of gold, especially since all of the world’s major central banks are printing money at record rates. But, contrary to logic, the price of gold has fallen in 2013 by nearly 30 percent.
The reason behind this lies with leverage and hypothecation — getting a loan using collateral — in the gold market. Once again, Wall Street has discovered that money could be made by leveraging; and the paper gold market is about 100 times larger than the physical market. When you have that kind of leverage, collusion, price fixing, or just plain panic can quickly move markets.
As inflation is recognized, the price of gold (both physical and paper) should rise. In a healthy economic year, as I predict for 2014, a collapse in the paper gold market is unlikely, and perhaps the price of gold will rise in response to rapidly expanding fiat money. But beware. The only safe gold is what you can hold in your hand.
December 27, 2013
If you’ve read Part I of this year end outlook, you know that it is our view that the underlying private sector is healthy and, except for the fact that the real rate of inflation is much faster than the ‘official’ rate, we could well have a short period of prosperity.
Unfortunately, our long-term outlook is not as sanguine as our short-term view. The eventual recognition of the inflation issue, the dollar’s role as the world’s reserve currency, the bloated Fed balance sheet and the resulting excess bank reserves, and the freight train of unfunded liabilities and its impact on the debt and deficit are issues that have large negative long-term consequences. Remember, the long-term unfolds slowly, and we don’t expect that we will wake up one day to find that all has changed. Still, the changes discussed below could very well take place over the next decade, and investors need to be prepared.
The Dollar as the Reserve Currency
The dollar is currently the world’s reserve currency. Most world trade takes place in dollars, even if no American entity is involved. Because world trade has rapidly expanded over the past 20 years, more dollars have been needed than those required for the U.S. economy alone. As a result, the U.S. has been able to run large deficits without any apparent significant impact on the dollar’s value relative to other major currencies. Any other country that runs a large deficit relative to their GDP suffers significant currency devaluation. Current policy in Japan is a prime example. A weakening dollar has implications for the prices of hard assets.
In addition, the Fed’s policy of Quantitative Easing (essentially money printing) has disrupted emerging market economies. Zero rates and money creation caused hedge fund managers to leverage at low rates and move large volumes of money offshore to emerging nations where interest rates were higher. The initial fear of “taper” in May and June caused huge and sudden capital outflows from those countries resulting in massive economic dislocation in those markets. In India, for example, the Rupee was pummeled as the hedge fund investors, fearing that interest rates were about to suddenly rise, all tried to unwind their Rupee investments at the same time. And now that ‘taper’ has officially started and longer-term rates are expected to rise, these issues will continue. Those countries have all taken defensive measures. India, for example, imposed taxes on gold imports, which has impacted the gold markets but has reduced India’s balance of payments deficit.
As a result of such tone deafness on the part of the Fed, and because there now appears to be enough dollars in the world for the current level of trade, the international appetite for U.S. dollars is clearly on the wane. Japan and China, the two largest holders of Treasury debt, have recently reduced purchases. Most emerging market nations and large players like Russia and China have vocally called for an alternative to the dollar as the world’s reserve currency. This movement is alive and well.
The Fed’s Balance Sheet
As the economy expands, the size of the Fed’s balance sheet and the level of excess bank reserves will become a problem. There are $2.3 trillion of bank reserves in excess of what are ‘required’ under the law and regulations. (Required reserves for the U.S. banking system are $.067 trillion; so, the system has 34x more reserves than it needs.) Under ‘normal’ conditions, and the way the system was designed to work, if the economy got too hot, the Fed could sell a small amount of securities out of its portfolio which would reduce bank reserves to the point where banks would have to ‘borrow’ from the Fed. Because bankers are hesitant to do that, and because the Fed could raise the ‘discount’ rate, the rate charged for the borrowings, the Fed could control new lending and thus the economic expansion. This isn’t possible today as the Fed would have to sell $2.2 trillion to cause banks to have to borrow. Such a volume of sales would likely cause a crisis in the financial system, or even collapse. Today, the only way the Fed has to stop the banks from lending is to pay them not to lend – this is exactly the opposite of the intent of the original legislation and the opposite of how the Fed has worked for most of its 100 year history.
Furthermore, given the growing lack of confidence in the dollar as the world’s reserve currency, if fiscal budget deficits grow in the future, the Fed may end up as the major lender (i.e., lender of last resort) for the U.S. Treasury. That simply means more money creation.
The U.S. Treasury officially recognizes $85 trillion as the amount of unfunded liabilities of the Federal Government. Other professionals set this number near $120 trillion. For comparison, the annual U.S. GDP is about $16 trillion. The budget deficit reported in the media is a cash flow deficit (tax collections minus expenditures). The budget deficit doesn’t include promises made for future payments (Medicare, Medicaid, Social Security, government pensions) which have been running between $4 and $5 trillion annually for the past few years. These amounts simply get added to the ‘unfunded’ liability number.
As the population ages, these payments will have to be made, and the budget may become overwhelmed. (You see the relevance of the remark made above about the Fed being the lender of last resort for the Treasury.) This is the heart of the debate about ‘entitlements’ that has been front and center for the past decade.
Solutions (none of which you will like)
Philipp Bagus is a fellow at the Ludwig von Mises Institute in Europe. He is well known in Europe for his work on financial issues there. In a recent paper, Bagus says that there are several possible ways out of the current money printing predicament. Any one or a combination is possible. We have put them in an order of most likely to least likely to be used:
- Inflation – this is the natural outcome of printing money;
- Financial Repression – this is current Fed policy; savers and retirees bear a disproportionately large burden as inflation eats at their principle but there is no safe way to earn a positive real rate of return;
- Pay Off Debt – this means much higher levels of taxation, and is definitely a real possibility. In Europe, the International Monetary Fund (IMF) has proposed a one-time 10% wealth tax. As the unfunded liabilities push up the federal deficit, expect such proposals in the U.S.;
- Bail-In – In ’08-’09 we saw ‘bail-outs’ where the government saved GM, Chrysler, AIG and the Too Big to Fail banks by buying stock or otherwise recapitalizing them. A ‘bail-in’ refers to the financial system. Banks and other depositories have liabilities called deposits. The depositors do not consider themselves ‘lenders.’ But, in a ‘bail-in,’ it is the depositors who lose. Their deposits are ‘converted’ to equity in the bank. When they try to sell their bank shares, they find that it will fetch only a fraction of the value of their deposits. A variant of this is what happened in Cyprus in the spring of 2013. Because of the distaste the public now has for ‘bail-outs,’ if there is another financial crisis, this is likely to be the method used;
- Default on Entitlements – when we talk about ‘entitlement reform’ in the U.S., we really mean at least a partial default. It is likely that some people simply won’t get what they were promised. We put this low on the list because we have witnessed a political process that won’t deal with the issue;
- Repudiate Debt – Because the government can simply print money to pay it debts, this is the least likely of all of the possibilities in the U.S.
The long-term issues are serious. And not addressing them simply means a higher level of pain when addressing them is required. Remember, these are long-term issues. They are all not likely to occur at the same time, nor will they simply appear overnight. The first signs of trouble will occur when markets begin to recognize that the ‘official’ inflation rate significantly understates reality, or that the inflation data become so overwhelming that they can no longer be masked. Even then, markets may come to tolerate higher inflation, as after 100 years of fighting inflation, the Fed and the world’s major central banks have embraced it as a good thing.
Meanwhile, as set forth in Part I of this paper, the immediate outlook for the economy is upbeat. Enjoy it while it lasts.
December 20, 2013
Robert Barone, Ph.D.
Andrea Knapp Nolan
Those who read our blogs know that over the past 6 months or so, we have turned positive on the underlying private sector of the U.S. economy. We have had comments from several readers about this apparent change of heart, some of them almost in disbelief. So, let us dispel any doubts. There is a huge difference between the short-term and the long-term outlooks. Let’s realize that long-term trends are just that, long-term, and that they take a long time to play out. As you will see if you read through both parts of this year end outlook, our long-term views haven’t changed. But, since the long-term doesn’t just suddenly appear, there really isn’t anything contradictory in being optimistic about the short-term. As a result, we have divided this outlook up into its two logical parts, the short-term and the long-term.
Let’s start with the short-term. First, at least through 2014 and probably 2015, the ‘fiscal drag’ that caused headwinds for the economy has now passed with the signing of the budget deal in mid-December. In his December 18th press conference, Fed Chairman Bernanke indicated that four years after the trough of the ’01 recession, employees at all levels of government had grown by 400,000; but at the same point today, that number is -600,000, i.e., a difference of a million jobs. Think of that when you think about ‘fiscal drag.’ The November jobs data shows that jobs at all levels of government have now turned positive. No matter your view of the desirability of this, those employees receive paychecks and can consume goods and services. So, from a short-term point of view, the ‘fiscal drag’ has ended, and, all other things being equal, this will actually spur the growth rate of real GDP.
Manufacturing and Trade
The institute for Supply Management’s (ISM) indexes, both manufacturing and non-manufacturing, are as high or higher than they were in the ’05-’06 boom period. This is shown in the chart immediately below.
Shown in the next chart is industrial production, which in November, finally exceeded its ’07 peak.
Now look below at the auto chart. Sales are as frothy today as they were in the pre-recession boom. Sales for the holiday buying period are destined to surprise to the upside.
Part of the reason that the economy is not overheating is housing. The chart clearly shows that housing starts are significantly lagging their ’05-’06 levels. But, recognize that ’05-’06 was the height of the housing bubble.
November’s housing starts surprised to the upside. But, they are still only 53% of their bubble peak. Nevertheless, because new home construction has been in the doldrums for the past six years, the resurgence evident in the economy has pushed the median price of a new home north of what it was then. In addition, the lack of construction has put the months’ supply of new homes at less than 3. In the housing bubble, when everyone was in the market, the average level of supply was 4 months. So, in some respects, the current housing market is hotter than it was at the height of the bubble. And, while interest rates have risen and are a cause for concern, they are still very low by historic standards, and we have a Fed that on December 18th recommitted to keeping them down for a period much longer than the market had anticipated.
Because the popular unemployment index is a lot higher today than it was in the ’05-’06 boom (7% vs. 5%), the popular media assumes that the labor markets are still loose. But, demographics and incentives to work have changed over the past seven years. The labor sub-indicators imply a much tighter labor market than the traditional unemployment index would lead one to believe. Recent new nonfarm payrolls are equivalent to their monthly gains of ’05-’06. The weekly Initial Jobless Claims number for the week ending 11/30 was 298,000. Except for one week this past September, you have to go all the way back to May ’07 to find a number that low. The first chart below shows the definite downtrend in new and continuing jobless claims.
The next chart shows that layoffs and discharges are lower than they were in ’05-’06 and that both the “Job Openings” and “Jobs Hard to Fill” sub-indexes are in up trends and are approaching ’05-’06 levels.
So, while auto sales are booming, the labor markets are tight, and manufacturing and services are expanding at or near boom levels, why do the aggregates (Real GDP, for example) appear so depressed? One explanation that we think has some credibility, is that there has been an expansion in the underground economy (barter; working for cash, etc.). The ‘fiscal drag’ headwinds discussed earlier, have, no doubt, had a large impact on the sluggish growth in the aggregates. On a positive note, the latest revisions to Q3 ’13 Real GDP show a growth rate of 4.1%, which, on its face, supports our short-term optimism. And until mid-December, the markets had discounted this as resulting mainly from growth in unwanted inventories. But Black Friday and Cyber Monday sales along with upbeat ongoing retail reports tell us something different, i.e., the inventory growth was not unwanted at all. While the markets expect a 2% Real GDP growth for Q4 ’13, don’t be surprised if it is much higher.
The underlying data, at least for the next 6 to 12 months, point to a strengthening economy. Certainly, a stock market correction is possible. We haven’t had one for more than 2 years. But, while possible, a significant downdraft like those of ’01 or ’09, don’t typically occur when the economy is accelerating (1987 is an exception) without an extraneous and unanticipated shock. With the signing of the first budget deal in four years, and with the Fed clearing the air about tapering and actually extending its announced period of zero interest rates, almost all of the short-term worries appear to be behind us, except one.
Inflation – The Potential Fly in the Ointment
The ‘official’ Consumer Price index (CPI) was flat in November, dominated, as it has been all autumn, by the fall back in gasoline prices. Somehow, while we all know that everyday prices are rising at a significant pace, the markets have bought into the deflation theme. Perhaps the belief is that if the markets play along with the Fed’s low inflation theme, the Fed will remain easier for longer.
In his December 16th blog, David Rosenberg (Gluskin-Sheff) has the following to say about inflation:
I have a tough time reconciling the ‘official’ inflation data with what’s happening in the real world… the .7% jump in retail sales in November on top of +.6% in October – these gains were all in volume terms? No price increases at all? Restaurants are now registering sales at a double-digit annual rate… No price increases here? The BLS tells us in the CPI data that there is no pricing power in the airline industry and yet the sector is the best performing YTD within the equity markets… global airline service fees have soared 18% in 2013… these [fees] are becoming an ever-greater share of the revenue pie and one must wonder if they are getting adequately captured in the CPI data.
Inflation could be the fly in the ointment for 2014. As long as the markets play along with the Fed’s deflation theme, as we expect they will as long as they can, the economy and markets will do just fine (this doesn’t mean there won’t be a correction in the equity markets, as we haven’t had a meaningful one for two years). But sooner, or later, something will have to be done about inflation. We will close this Part I with a quote from Jim Rogers, the commodity guru (Barron’s, October 12, 2013):
The price of nearly everything is going up. We have inflation in India, China, Norway, Australia – everywhere but the U.S. Bureau of Labor Statistics. I’m telling you, they’re lying.
December 20, 2013
Robert Barone, Ph.D.
Andrea Knapp Nolan
December 10, 2013
The mainstream business media continue to worry about a faltering economy, most notably of late, a fixation on the fear of a poor retail holiday shopping season. This makes one yearn for those good old days of a vibrant economy, like what we had in 2005-06. But wait! Except for the construction of new housing units and some problems measuring aggregate demand, the underlying data indicate that the good old days are back.
The top portion of the accompanying table shows various economic indicators for the three months ending in November, and it shows the average values of those same indicators during the 18 months of the pre-recession boom period ending June 30, 2006. The bottom part of the table is similar, but shows quarterly data.