Daily Comment (July 21, 2017)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Happy Friday!  Here are the items we are following this morning:

Pardon me:  Numerous media reports indicate that the Trump administration is exploring pardoning options and ways to ring fence Special Counsel Mueller’s investigation.  There are overtones of Nixon in these comments.  First, seeking pardons when no one has reportedly done anything wrong suggests that there is fear that something illegal will be found.  Second, Special Investigators have wide latitude once an investigation gets underway.  Trying to restrict an investigation (or for that matter, pardoning protocol) gets into legal gray areas over the boundaries of presidential powers.  Of course, our concern remains focused on financial markets.  One of the patterns we have seen recently is that equities tend to maintain strength while other financial areas seem to be reacting to these issues.  For example, we have seen Treasuries strengthen in recent sessions after yields had backed up earlier in the month.  Our position on the dollar is that the greenback is overvalued because the forex markets rapidly discounted tightening Fed policy (see the Asset Allocation Weekly below for details).  However, it is possible that recent dollar weakness is also a reaction to the growing turmoil in Washington. The fact that the dollar appreciated yesterday despite a rather dovish press conference and statement from ECB’s Draghi suggests that factors other than monetary policy are underpinning dollar weakness.  Simply put, the political issues in Washington are not adversely affecting equities yet, but that doesn’t mean that other financial markets are not reacting to these events.

Brexit concerns:  The May government appears deeply divided over how to execute Brexit, reflecting Tory divisions that are similar to issues within the GOP here.  The populists want a “hard” Brexit that will restrict the ability of foreigners to work in the U.K. and loath to pay the EU “exit fee” for leaving.  The business wing of the Tories wants a “soft” Brexit that will maintain London’s financial pre-eminence which means that Brexit really isn’t much of a break with the EU.  Unfortunately for Britain, there are elements within the EU that see opportunity from Brexit and are goading the Tory negotiators toward a hard Brexit so as to bring much of London’s financial business to the continent.  Given PM May’s poor election performance, we suspect that her government is likely to face a no confidence vote at some point; the confusion we are seeing in negotiations may simply reflect the lack of an electoral mandate.

China v. India:  China and India fought over disputed parts of their border in the Himalayas in 1962.  Currently, the two states are facing off in the Doklam plateau, which is at the trisection of India, China and Bhutan.  China is building a road in an area claimed by Bhutan and the latter is asking for Indian assistance in enforcing its claim.  This border dispute is part of rising tensions between the two countries.  India has quietly opposed China’s “one belt, one road” initiative and has recently joined naval exercises with Japan and the U.S.  As the U.S. profile declines in the region, tensions between India and China are likely to increase as both powers jockey for regional influence.

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Asset Allocation Weekly (July 21, 2017)

by Asset Allocation Committee

In the past few years, we have generally avoided allocations to non-U.S. markets for our asset allocation portfolios due to two primary concerns.  First, the dollar was rising as a result of an improving U.S. economy and policy divergences between the U.S. and the rest of the world.  The Federal Reserve was raising rates and tapering its balance sheet while the majority of the other nations were still adding monetary stimulus.  Second, we have had secular concerns about the stability and attractiveness of foreign investing in a world where the U.S. is seemingly reducing its hegemonic role.

This quarter we have added foreign allocations into our portfolios.  The primary reason is that we believe the dollar’s bull market is probably coming to a close.  On a relative valuation basis, the dollar has become rather expensive.

This chart shows four purchasing power parity models for the euro, yen, British pound and Canadian dollar.  In all four cases, the dollar is trading “rich” by more than one standard error, and in two cases, nearly two standard errors from parity.  Purchasing power parity uses relative inflation to value currencies.  As the models show, currencies are rarely at parity.   Although purchasing power parity is the oldest way to value currencies, it isn’t the most accurate.  However, it tends to be useful at extremes, and exchange rates tend to move around the parity measure.  In other words, parity is something of an anchor around which the actual exchange rate vacillates.

History also suggests that exchange rates can diverge from parity for long periods of time, which usually means that a catalyst is required to move currencies from extremes of under-and over-valuation.  For example, in the above euro and pound models, the deep undervaluation in the mid-1980s ended with the Plaza Accord.  Yen overvaluation in the early 1990s was ended by the Halifax Accord.  Changes in policy or governments can trigger an end to valuation extremes as well.

This leads us to two additional reasons for this repositioning.  We believe there are two catalysts which will pressure the dollar in the coming quarters.  First, the Federal Reserve appears to be hedging on future tightening.  Although the dots charts still indicate rising rates, a number of FOMC members have raised worries about raising rates while inflation remains depressed.  Chair Yellen appears to be offering a trade to the hawks on the committee; instead of raising rates, balance sheet reductions can act as policy tightening.  It is possible reducing the balance sheet will be dollar bullish.  However, that isn’t supported by the data.

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Asset Allocation Quarterly (Third Quarter 2017)

  • Economic data remain supportive and the inflation outlook is currently benign.
  • Though the economic expansion is elongated, we do not anticipate a near-term recession.
  • Fed policy is expected to tighten in terms of rising short-term rates and the reduction in the size of the Fed’s balance sheet.
  • We expect the Fed to commence the reduction of its $4.5 trillion balance sheet with a $10 billion monthly run-off by the end of this year.
  • Expectations for a softer U.S. dollar combined with attractive valuations overseas have encouraged us to include non-U.S developed and emerging market equity exposure, the former with a tilt toward Europe.
  • Overall allocations to bonds are intact, though with a heavier presence in intermediate-term bonds. Speculative grade bonds remain supportive for income objectives.
  • Our growth/value even weight of 50/50 remains unchanged from last quarter.


The themes present at the start of the year continue unabated, with inflation and unemployment at low levels and both consumer and business sentiment remaining elevated. Although the U.S. is now 97 months into an expansion, closing in on the second longest on record, there are pockets of softness. For example, consumption is slower than historical experience as measured by PCE, investment is muted and capacity utilization is running at 75%, as evidenced in the accompanying chart. In addition, government spending, inclusive of the contributions of states and municipalities, is very low as a percentage of real (inflation-adjusted) GDP. These measures all factor into our belief that a recession is not on the near-term horizon and the economy holds solid potential for continued expansion despite its current length.

Although members of the FOMC are signaling further monetary tightening through an increase in the fed funds rate as well as a reduction in the reinvestment of balance sheet proceeds, markets anticipate that the Fed won’t be as hawkish as the current trajectory implies. For example, the Fed’s much-publicized dot plots indicate a fed funds rate of 2.25% by this time next year, while the markets, as measured by LIBOR, provide an implied rate of 1.61%, as exhibited in the below chart.

The Fed appears mollified by the improvement in unemployment figures and the lack of deflationary pressure, providing the latitude to move rates higher and commence some withdrawal of stimulus by reducing the reinvestment of proceeds from its $4.5 trillion balance sheet. However, uncertainties abound regarding not only the path of balance sheet reduction and its concomitant effect on the U.S. banking system and the availability of credit, but also the complexion of the Fed’s Board of Governors with its three vacancies and the prospect of a new Fed Chair. As mentioned in our last quarter’s report, it remains unclear as to whether the Trump administration will be appointing members who are hawkish or populist. While the issues surrounding the complexion of the Fed and its amount of monetary accommodation remain unresolved, the pace of tightening thus far has been appropriate and there are no indications that they have raised the prospect of thrusting the economy into a recession

Our view is that the issues that create headlines, such as current Congressional activity surrounding healthcare and the potential modifications to the tax code, are more distracting than influential at this juncture. Until, or unless, legislation is advanced or the Fed missteps, we retain the perspective that equity markets carry fair value on the traditional metric of Price/Earnings with a benign level of inflation. In addition, the intermediate and long portions of the bond market provide positive inflation-adjusted returns.  The greater near-term investment significance for U.S.-based investors include expectations that nascent U.S. dollar weakness relative to foreign currencies will continue, particularly versus the euro and the basket of emerging market currencies. The Trump administration’s encouragement of a weaker dollar is a marked departure from the policies of prior administrations and consistent with our belief that U.S. economic hegemony is waning.


The economic landscape has proven favorable for U.S. equities and we find that the current economic environment remains healthy. However, signals of policy tightening from the Fed advise a degree of caution and bear continued scrutiny. In addition, recent readings of small business optimism exhibit softness compared to earlier in the year. Nevertheless, factors that are typical of elevated downside risk are noticeably absent, as shown on the accompanying chart. This graph depicts the monthly average for the S&P 500 Index versus our conflation of initial jobless claims, the Conference Board’s Consumer Confidence data and the CRB commodity index using adjusted standardized data.1 Though this shows that the U.S. economy is well advanced in the economic cycle, near-term concerns are not evident. Valuations have certainly advanced over the past year, but we believe that they can be persistent and are not untenable at this stage. Large cap, mid-cap and small cap equities have all enjoyed solid returns and traditional valuation metrics of Price/Earnings, Price/Book, and Price/Cash Flow have advanced accordingly. In contrast, non-U.S. equities, while enjoying positive returns this year, are generally priced below U.S. counterparts on traditional valuation metrics. Furthermore, given our views of a softer U.S. dollar environment, we are shifting some U.S. exposure to foreign equities. Much of this shift is being pulled from U.S. mid-cap exposure as pricing is more elevated and therefore expected returns are more muted. Among foreign domiciles, we tilt toward Europe in developed countries and also introduce exposure to emerging markets for more growth-oriented strategies.

1 For a full description of the standardization of data, please refer to our Asset Allocation Weekly, 6/30/17.

Among U.S. large cap sectors, we favor healthcare and industrials and continue to underweight telecom and consumer staples. We reduce our previous overweight of financials and utilities to even-weight. REITs continue to be positioned in two strategies for their diversification benefits and potential for modest appreciation. Our growth/value style bias remains evenly balanced at 50/50, reflecting our views toward sectors and industries.


The Treasury yield curve has flattened over the course of this year, reflecting tighter monetary conditions at the Fed. Though the duration of the bond exposure in the more income-oriented strategies remains consistent with our prior exposures, it is now attained through a greater allocation to the intermediate segment as opposed to the former bar-belled overweights to short- and long-term bonds.

The exposure to long-term bonds has proven beneficial, but the current outlook has encouraged a more cautious positioning for the months ahead, especially as the Fed begins to engage in some normalization of its balance sheet. We maintain our favor to investment grade corporate bonds over Treasuries and mortgage-backed securities as the spreads continue to be attractive and supported. We also retain exposure to speculative grade bonds given our outlook for contained default and recovery rates.


Despite a more favorable outlook for commodities, we have concluded that introducing exposure at this time may be premature. In an environment of faster economic growth and/or a surge in inflation expectations, commodities would prove helpful to a diversified portfolio. However, we harbor no expectations of either environment over the near term. Accordingly, there remain no allocations to commodities in the strategies.

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Daily Comment (July 20, 2017)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Equity markets continue their quiet rise to new records.  Here are the items we are watching this morning.

ECB, BOJ lean dovish:  The BOJ came out overnight with nothing that wasn’t unexpected.  It is clear the bank won’t reach its inflation targets anytime soon, so it extended its deadline, making it the sixth time this has occurred under Abe.  The JPY weakened a bit on the news but since it was mostly anticipated, the forex move was modest.  The ECB has released its statement, which is almost identical to its last one.  The statement was taken as dovish by the markets.  In the press conference, Draghi remained dovish, suggesting that the ECB hasn’t laid out any plans for QE tapering.  Even though his opening comments and answers to questions were clearly dovish, the EUR rallied, European stocks fell and European sovereign yields rose.  However, we have seen a reversal in these prices after Draghi reiterated that tapering hasn’t been discussed.  Market behavior suggests that traders are focused on ECB balance sheet management.  Draghi is clearly keeping his “cards close to the vest” on revealing when tapering will begin.  Our view on market action suggests that it might be impossible for the ECB to avoid a “taper tantrum” once ECB QE ends.  Perhaps the most interesting market action is the EUR; the currency weakened after the statement then rallied during the presser.  It appears to us that the currency markets have concluded the dollar is going down, most likely because the ECB will eventually act to reduce stimulus.

U.S./China trade talks stall:  Negotiators for both nations quickly reached an impasse at trade talks.  The Trump administration is taking the position that the bilateral trade deficit with China is a serious problem that can only occur due to unfair Chinese policies.  Commerce Secretary Ross said, “If this were just the natural product of free-market forces, we could understand it, but it’s not.  So, it’s time to rebalance in our trade…”  Evidence of the differences between the two parties emerged when the U.S. canceled a scheduled news conference which was set for the two parties to reveal concrete proposals on trade.  It appears to us that China has no intention of changing its trade policies and its plan to deal with this trade spat is endless negotiations.  That would have worked before; although previous administrations clearly didn’t like the bilateral trade deficit, they understood that the superpower role necessitated a U.S. trade deficit.  The Trump administration, in our analysis, is preparing to withdraw from that role which ends the need for persistent U.S. trade deficits.  Thus, implementing trade barriers and ignoring the WTO are consistent with this position.  America’s more isolationist trade policy is a significant threat to the Chinese economy. 

Poland’s judicial crisis:  The Polish government has already increased control over the media, restricted public meetings and taken other steps.  Now, it is taking direct aim against the independent judiciary.  The populist Law and Justice Party has introduced bills that would force all the judges to resign, save those appointed by the aforementioned party.  Other bills would give the government greater control in appointing judges.  The EU has indicated that the actions against the judiciary, coupled with other moves, may mean Poland would no longer be considered a “democracy” by Brussels.  If this determination were to be made, it could lead to Poland losing its vote in the EU Parliament.  In one sense, this isn’t a big deal; it isn’t clear how much sovereign impact the EU Parliament has anyway.  However, calling Poland a non-democracy might trigger the decision to leave the EU, leading to Polexit.  Although there isn’t much discussion of Poland leaving the EU, the party in power will strongly oppose outside pressures and may conclude that being outside the EU will strengthen Poland’s sovereignty.  Another nation leaving the EU would seriously undermine the union.

The naming of a new Saudi Crown Prince looks like a coup:  Major U.S. media[1] are publishing reports that detail how the former Crown Prince Nayef resigned from the post and was replaced by his cousin, the former Deputy Crown Prince Salman.  We will have much more to say on this in future WGRs but we mention it here because it shows that the potential for leadership instability is rising in Saudi Arabia.  If instability rises, we would expect oil prices to rise.


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[1] https://www.nytimes.com/2017/07/18/world/middleeast/saudi-arabia-mohammed-bin-nayef-mohammed-bin-salman.html?hp&action=click&pgtype=Homepage&clickSource=story-heading&module=first-column-region&region=top-news&WT.nav=top-news&_r=1

Daily Comment (July 19, 2017)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT]The summer doldrums are upon us.  Financial markets are very quiet this morning in front of tomorrow’s ECB meeting and press conference.  Here is what we are watching this morning:

The ECB:  The EUR has been rising recently, in part due to expectations the ECB will begin the process of withdrawing stimulus.  We expect Draghi to offer a very slow path of tapering with lots of comments suggesting that the Eurozone recovery remains fragile and that policymakers must be careful to avoid tightening too quickly.  We do expect signaling that a plan for tapering QE and the eventual path of ending balance sheet expansion will be detailed in September.  Overall, the EUR has been strengthening and the risk is that traders have overestimated the pace of stimulus withdrawal.  However, if our read for tomorrow’s meeting is accurate, the EUR should maintain recent gains.  Anything that signals faster withdrawal of stimulus will lead to further currency strength.

Sanctions on Venezuela:  The Trump administration is reportedly considering sanctions on Venezuela if the Maduro regime decides to rewrite the country’s constitution.  The fear is that a new constitution would move Venezuela to a Cuban-style government, dispensing of contested elections and ensuring that Maduro and the Chavistas will be permanently in power.  The key threat is the U.S. will ban Venezuelan oil exports to the U.S.  Venezuela generally provides around 0.6 mbpd, or about 8% of U.S. gross oil imports.  Although we expect the U.S. oil market to be able to handle the loss of this oil, it may cause some short-term disruptions.  Venezuela mostly sells heavy, sour oil to the U.S. because American refineries have the ability to refine such crude oil.  If Venezuelan imports are disrupted, some refineries may scramble to find heavy, sour oil and we may see a temporary decline in refinery operations.  The sanctions will hurt Venezuela more than the U.S. but our oil infrastructure won’t be completely unscathed if sanctions are introduced.

GCC backs off:  The WSJ[1] is reporting that the GCC has revised its demands that Qatar must meet to see the current blockade lifted.  Specifically, it looks like Al Jazeera will not be forced to close and some clerics sympathetic to the Muslim Brotherhood will be allowed to remain in Qatar.  Although Qatar has not reacted warmly to this overture so far, we suspect that pressure from Turkey and the U.S. led the GCC to ease its demands.  We would not expect the same parties to lean on Qatar to accept the new “principles” as opposed to demands, from the GCC.  The U.S. does need the GCC to work together to combat Iranian designs for the region and this recent dispute between the GCC and Qatar doesn’t support U.S. policy.

Off to taxes:  After the legislative failure to deal with the ACA, the party is mostly moving on to taxes, primarily corporate taxes.  The first issue will be whether we simply see cuts in rates or if broader reform is enacted.  We suspect the president, who would like to see some major legislation signed before year’s end, will opt for simple cuts which could be done faster.  However, it’s likely such cuts, which will probably increase the deficit, won’t be given permanent status.  The House GOP would prefer broader reform which could then yield permanent tax cuts.  However, broader reform will require spending cuts or reduction in tax expenditures to make the tax rate declines revenue neutral and negotiating such changes will slow the process down.  We are leaning toward reductions in the tax rate and higher deficits.


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[1] https://www.wsj.com/articles/qatars-critics-scale-back-demands-in-diplomatic-bid-1500441047

Quarterly Energy Comment (July 18, 2017)

by Bill O’Grady

The Market

Oil prices peaked in March around $55 per barrel.  There have been a series of lower highs and lower lows, as shown by the lines on the chart.

(Source: Barchart.com)


This obvious downtrend has led to a general bearish tone to the market.  We don’t necessarily share that level of pessimism; as we will show below, dollar weakness and falling inventories are supportive for oil prices.  On the other hand, there are legitimate concerns that Saudis may reverse production restrictions after next year’s initial public offering for Saudi Aramco.

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Daily Comment (July 18, 2017)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Although global equity markets are steady to lower this morning, there is a lot of action in the forex markets.  The dollar is sliding on a combination of lower expectations for Fed policy tightening and the lack of policy progress from the Trump administration.  Here are the news items we are tracking this morning:

GOP Senate healthcare dies:  Senate Majority Leader McConnell’s efforts to craft a replacement bill for the ACA fell apart overnight as he could not round up 50 GOP votes to pass a bill.  This is a deep blow to McConnell’s leadership.  There are reports he will now move to a straight ACA repeal, but our sources indicate this vote can’t occur as part of the reconciliation process and thus needs 60 votes, ensuring defeat.  If this is true, all the GOP senators would vote for it but the repeal will never reach the floor because the Democrats can filibuster it.  Why is this important?  It suggests the GOP can’t govern.  This is actually a characteristic we are seeing across the U.S. political landscape.  Two-party systems are forced coalitions.  There are wide divergences in the positions among various groups within parties (we believe these divergences will eventually lead to a realignment of the parties in the coming years).  When a party is out of power, these divergences tend to be papered over in the interests of returning to power.  However, once in power, these different groups believe they are the “real Democrats” or the “real Republicans” and they push a narrow agenda that, shockingly, fails to gain a majority.  The GOP is clearly divided and these divisions killed the healthcare effort.  Now the worry is that these divisions will not only prevent tax reform and infrastructure spending, they may not even get the debt ceiling increase accomplished without drama.   If the GOP can’t get legislation passed, it weakens the outlook for change.  We believe that is showing up today in dollar weakness; after all, if fiscal spending isn’t coming and investor sentiment weakens, the Fed won’t raise rates as much as expected.  On Friday, we will release our new Asset Allocation Weekly; its focus is on the dollar.

OPEC drama:  Oil prices have jumped this morning on rumors the Saudis are planning to cut oil exports.  We may actually see reductions but only because air conditioning demand in the Saudi summer is driving up consumption.  On the downside, Ecuador announced it will no longer comply with its 26 kbpd pledged cut in output because is simply can’t afford the loss of revenue.  Although Ecuador’s defection, by itself, won’t be a major factor in weakening prices, it may encourage other defections which would be a problem for the cartel.  We still expect the Saudis to make strenuous efforts to prop up oil prices into next year’s Saudi Aramco IPO (expected now in Q4 2018) which should prevent a sustained price decline.  In addition, dollar weakness is a major supporting factor for oil prices.

China crackdown continues:  Chinese banking regulators have instructed some lenders to lower the rates they offer on wealth-management products (WMP), which have become alternative investment products due to low deposit rates  As the PBOC tightened the money supply, lenders have raised the rates on WMP to a 17-month high in a scramble to acquire lendable funds.  The PBOC tightened the money supply to support deleveraging.  The banks are trying to offset the PBOC’s efforts via WMP funds.  The risk for the banks is that lowering rates on WMP will deprive them of lendable funds which will slow lending and economic growth.  And, households may again increase their attempts to move funds offshore in search of higher returns.  For years, China has abused the household sector through financial repression; this has led to rising real estate prices and the search for higher returns in overseas markets.  China has been trying to stem the currency outflow through a number of regulatory tactics but the best way to keep the money at home would be to offer higher domestic financial returns to the household sector.  Unfortunately, the more the household sector earns, the less the banking and business sector earns.  Policymakers have generally been captured by the business sector and thus have based their economy on household financial repression.

The RBA turns hawkish:  Although the Reserve Bank of Australia didn’t move on rates, in the minutes from its July 4th policy meeting, the bankers suggested a policy goal of a “nominal neutral cash rate” of 3.5%, which would imply a 200 bps rise in rates is in the offing.  It is unclear if policymakers are really intending to lift rates this aggressively, but in an environment of increasing dollar disappointment, even offhand comments that suggest potential tightening lead to currency strength. The AUD has jumped to its highest levels since May 2015 on this news.

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Weekly Geopolitical Report – A Productivity Boom: A Response to Robert Gordon, Part I (July 17, 2017)

by Bill O’Grady

Robert J. Gordon is a well-known economist and a professor at Northwestern University. A member of the National Bureau of Economic Research, his most notable work is in the area of productivity.  His 2016 book[1] argued that the best years of American productivity are behind us—highlighted by the introduction of steam power to industry, the mechanization and biological revolution in agriculture, the electrification of the country, the communications revolution of telegraph, telephone and television, and the transportation revolution of automobiles and airplanes.  He suggests that the technology revolution would never be able to replicate the growth spawned from these events.  Sadly, ecological damage, rapidly aging populations and the peaking of educational attainment mean that economic stagnation would be the order of the day for the Developed World economies.

We examined the geopolitical ramifications of Gordon’s position in an earlier report.[2]  Stagnation could easily lead to geopolitical problems.  For example, industrialization and the spread of democracy occurred at nearly the same time; it is generally believed that democracy supports economic development but it is possible the direction of causality occurs in the opposite direction.  If so, it may mean that a certain degree of economic growth is necessary to maintain democracy. If growth stagnates, it may become difficult to maintain societal order.  In addition, it is intuitive that an expanding economy makes distribution issues easier; it’s a lot more difficult to determine distribution if it appears to be a zero-sum environment.  In such a world, one group improves only at the expense of others.  That scenario creates conditions of conflict.

Michael Mandel and Bret Swanson recently published a paper[3] rebutting Gordon’s position, suggesting that productivity is poised to expand and support stronger economic growth.  In Part I of this report, we will examine the productivity issue, discuss Mandel and Swanson’s analysis of the situation, and focus on their specific division of industries.  Next week, we will look at six sectors of the economy that appear poised to digitize and how that could change the economy.  We will also discuss the hurdles to Mandel and Swanson’s projection.  As always, we will conclude with market ramifications.

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[1] Gordon, R. (2016). The Rise and Fall of American Growth: The U.S. Standard of Living Since the Civil War. Princeton, NJ: Princeton University Press.

[2] See WGR, The Gordon Dilemma, 8/12/13.


Daily Comment (July 17, 2017)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It was another quiet weekend.  Here are the news items we are tracking this morning:

China economy:  GDP, somewhat predictably, came in a bit stronger than expected, at 6.9% (y/y%).   It’s important to remember that China can generate any growth number it wants as long as it has debt capacity.  Total social financing, the broadest measure of lending, rose 14.7% in June (y/y%).  Recent media reports indicate that the housing boom is exhibiting signs of overheating;[1] we noted that property investment rose 8.5% in H1, above last year’s 6.9% rise over the same period.  Orders from Chairman Xi to the State Owed Enterprises (SOE) to reduce their debt levels does suggest that the Chinese leadership is aware it is creating a debt problem.  The tradeoff, however, is daunting; it’s about impossible for China to grow at the above rate and simultaneously deleverage.

Xi prepares for October:  The PRC holds its annual leadership meetings in late October and this is a special one because it will announce Chairman Xi’s nomination for a second term.  Over the weekend, the party announced that Sun Zhengcai was being replaced as Party Secretary of Chongqing.  Sun was considered a possible successor to Chairman Xi in five years so removing him from power and indicating he is under investigation (effectively ending his political career) at least allows Xi more power in building his own Standing Committee of the Politburo and may be an early ploy to give Xi a third term which would be the first chairman to have more than two terms since Mao.  In the Chinese political system, the second term is usually the most important for a leader because in the first term, his rivals usually pick some of the members of the Standing Committee to maintain their influence.  In the second term, the chairman gets more leeway in building his own Standing Committee.

ECB, BOJ meet this week:  We don’t expect any surprises from the BOJ.  Market speculation suggests that ECB President Draghi will try to ease expectations of policy tightening by signaling the pace of balance sheet reduction will be very slow.  Although we don’t disagree with this goal, we do have doubts that Draghi can pull it off.  As former Fed Chair Bernanke discovered, once markets become fixated on easy policy forever, even the most modest of stimulus withdrawal can have surprising effects.  With Eurozone interest rates still negative in some countries, any hint of tapering will likely be a factor; we believe the most sensitive asset class will likely be forex, meaning any signal of tightening will appreciate the EUR.

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[1] https://www.nytimes.com/2017/06/15/opinion/chinas-real-estate-mirage.html

Asset Allocation Weekly (July 14, 2017)

by Asset Allocation Committee

One of the mysteries of this expansion has been the slow pace of wage growth.  Despite the plethora of evidence that labor markets are tight, including hires-to-openings ratio below one, low unemployment, low initial claims and a low unemployment rate, wage growth has remained stunted.   The chart below is one we have used often in the past; it suggests with unemployment at current levels, previous episodes would have brought wage growth closer to 4% compared to the current growth of 2.3%.

One of our thoughts was that, perhaps, the national unemployment rate was masking pockets of high regional unemployment.  In other words, if there was a wide dispersion of labor market activity, the weak regions of the country could be holding down wage growth.

To test this, we looked at the level of state unemployment relative to the Congressional Budget Office’s calculation of the natural rate of unemployment.[1]  We calculated the number of states with unemployment below the natural rate.  What we found is consistent with the above graph.  In other words, it doesn’t appear that regional issues were holding down wages.

Since 1987, average wage growth is 2.98%; in the periods where the percentage of state unemployment rates below the natural rate exceeds 65%, wage growth was 3.89%.  The current combination is unusually low.

However, as part of this research, we did find another interesting factor.  There has been speculation that low inflation rates may be affecting wage growth.  To test that thesis, we subtracted annual wage growth for non-supervisory workers against the three-year average of the yearly change in CPI.  Our reason for using the average is that businesses and workers tend to react to the recent trend in inflation and not necessarily the most current number.  We found results that were more consistent with this theory.

Over the same time frame, real wage growth was 0.26%, but when the percentage of states with unemployment below the natural rate exceeds 65%, real wage growth is 1.04%.  As the chart shows, real wage growth is consistent with tight labor markets as defined by the percentage of state unemployment rates below the national natural rate.

So, the puzzle of why wage growth is slow may simply be due to low inflation.  The three-year average of inflation may act as an anchor in the wage bargaining process and wage growth will probably remain stalled without rising inflation.   A cursory glance at the annual rate of inflation relative to the three-year average suggests that the average rate will likely remain stable for the foreseeable future.  Thus, wage growth will probably remain stable, increasing the risk that tightening monetary policy will have an adverse impact on the economy and markets.  Of course, the wage issue is a matter of debate within the FOMC which could mean that the path of tightening is slow and measured, more in line with the financial market’s expectations surrounding future policy.

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[1] This rate is sometimes called the Non-Accelerating Inflation Rate of Unemployment, or NAIRU.  The idea is to determine what level of unemployment is the lowest rate attainable before higher inflation is triggered.