by Asset Allocation Committee

Since the end of WWII, there have generally been three factors that have caused recessions.  The first, and most important, is policy error.  Although fiscal tightening can cause recessions, major tax increases have become less common.  The usual source of policy error comes from the monetary side, where the central bank either raises rates too high or doesn’t move quickly enough to lower rates when business conditions weaken.  The second cause comes from geopolitical events.  The 1973-75 recession was triggered by the Arab Oil Embargo, a direct result of U.S. aid to Israel during the Yom Kippur War.  The 1990-91 recession was due to the Persian Gulf War.  The third cause is due to inventory mismanagement.  The third reason has become rare due to improved logistics technology.  Although inventory issues can affect sectors of the economy, it hasn’t led to a national downturn since the 1950s.

As a result, currently, there are two factors we watch most closely to predict recessions, monetary policy and geopolitical issues.  Although predicting recessions is difficult, at least with monetary policy, there are consistent indicators, such as yield curves, financial stress indexes, volatility indexes, Phillips Curve measures, etc.  Obviously, timing is difficult, even when the indicators flash warning signs, but at least there are fairly consistent indicators one can monitor.

Geopolitical indicators are far more idiosyncratic.  Global tensions are constant.  There are always geopolitical tensions so it is hard to parse the signal from the noise.  To some extent, this is always a problem with geopolitics.  It’s not that there is a lack of situations that could develop into a threat to the business cycle; it’s just that most don’t.

Perhaps a better way to think about geopolitics and theor impact comes from the book, Ubiquity: Why Catastrophes Happen.[1] In this book, Mark Buchanan makes the case that geopolitical events are much like sandpiles where grains rise steadily, making the structure increasingly unstable.  A final grain triggers a collapse and, due to the post hoc, egro propter hoc fallacy, that last “grain” becomes the “cause” of the collapse.  In reality, the structure had been losing stability for some time and the triggering event may not have led to the catastrophe under conditions of stability.

For example, the Persian Gulf War occurred mostly because Saddam Hussein miscalculated the reaction of the world to his invasion of Kuwait.  He probably would not have invaded Kuwait if the Kuwaitis had been willing to reduce production to allow Iraq to have a greater market share of world oil markets, something that Iraq felt it was owed from the Persian Gulf states due to its prosecution of the war against Iran.  In addition, if the Soviet Union hadn’t collapsed, Moscow would have probably not supported the invasion by its client state.  The trigger to the war, the reports that Kuwait was using horizontal drilling to tap Iraq’s oil fields, was the proximate cause of the war.  But, the mere act of taking the oil may not, by itself, have triggered the invasion without the other factors in play.

The current trade conflict with China has similar complicated characteristics.  The U.S. has been struggling to develop a consistent foreign policy since the end of the Cold War.  Policy toward China has mostly been to support its economic development on the idea that the richer it becomes, the more likely that it will democratize, following the path of other Asian nations.  Unlike Japan, South Korea and Taiwan, however, China was not as reliant on American security.  Those nations were directly protected by the U.S., whereas China only relied on America’s sea lane security.  In addition, China viewed its commitment to communism as something to be maintained.  The construct of the Trans-Pacific Partnership, which was designed to isolate China, showed that the U.S. was rethinking its relationship with China by 2008.

Under President Trump, the relationship with China has become increasingly contentious.  The application of tariffs and continued negotiations have caused increasing equity market turmoil.  Nevertheless, so far, the impact on the economy has been less dramatic.  However, we may be reaching the point where the trade conflict will begin to affect the economy.  The most recent decision by the Trump administration to apply 10% tariffs on $300 bn of imports, by itself, is probably not enough to trigger a downturn.  But, the culmination of earlier tariffs and the impact to technology restrictions may be creating conditions that lead to recession.

History suggests that recessions induced by geopolitical events are difficult to avoid even with stimulative economic policies.  The unknown is whether we are near a point where geopolitical risks are great enough to trigger a downturn.   At this point, we are probably not at that level but risks are escalating and the odds of a geopolitical mistake are rising.  Although it is probably too soon to position portfolios in a defensive manner, tactical planning is in order.

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[1] Buchanan, Mark. (2000). Ubiquity: Why Catastrophes Happen. New York, NY: Three Rivers Press.

by Asset Allocation Committee

As wages and other costs rise and pricing power appears constrained, there are reasonable worries about the path of corporate earnings.  We use purely top-down analysis to forecast earnings.  Essentially, we forecast the percentage of total S&P company earnings relative to GDP.  We use the nominal GDP forecast from the Philadelphia FRB’s Survey of Economists along with our earnings as a percentage of GDP forecast to arrive at our estimate; we do note that this estimate is for total earnings for all members of the S&P 500 and not the per share estimate.

We are currently expecting S&P earnings to equal around 6% of GDP.

There are a large number of components in the model but the most statistically significant are net exports as a percentage of GDP, credit spreads, the dollar and oil prices.  The components suggest that margins will likely contract if the U.S. does move to reduce the trade deficit.  A weaker dollar will help lift margins, and higher oil prices will tend to lift margins as well.  Narrow credit spreads tend to support margins.

The process of getting to earnings per share is tied to the divisor of the index.  And, that has been steadily falling, which is lifting earnings per share.

The divisor adjusts the index by accounting for mergers, the exchange of new companies into the index, and share issuance and buybacks.  The persistence of share buybacks is clearly reducing the divisor which acts to boost earnings per share.

Adjusting for all these factors, our current forecast for earnings this year is $157.20, which is down from $160.93 at the beginning of the year.  We do use Standard and Poor’s earnings data, which tends to be less than the more widely reported data from Thomson-Reuters; we use the former because we have a much longer history of that data.  The current difference is significant.  Thomson-Reuters data is about 11% higher than what is reported by Standard and Poor’s.

Our conversion model suggests a Thomson-Reuters earnings number of $168.92, which is well above the current consensus of $165.21.  Given that we are working off a 3.8% nominal GDP growth rate (and so, 2% inflation would lead to a 1.8% GDP growth number), which seems achievable, the financial markets are probably too pessimistic on earnings for the rest of the year.  If we are wrong, it’s probably due to margin contraction.  Although there are worries about future policy causing margins to fall, the policy effect probably occurs next year, not in 2019.

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by Asset Allocation Committee

How much attention is the FOMC paying to international factors?  It appears to be quite a lot.  We have documented that the financial markets are clamoring for a rate cut.  We have seen some of the more popular yield curves invert and the implied LIBOR rate from the Eurodollar futures market, two years deferred, has moved into easing territory.

The chart on the left shows the aforementioned implied LIBOR rate.  In Q3 last year, the implied rate was 3.30%; it has fallen to just above 1.60%, a decline of 170 bps.  The chart on the right compares the implied rate to the fed funds target.  When this implied rate falls below the target, it is a signal to policymakers that monetary policy is too tight.  The Bernanke Fed mostly ignored this indicator, unlike his predecessor, and Bernanke had to deal with the deep 2007-09 recession.  This indicator is giving clear evidence that the Fed should be cutting rates aggressively.

However, the signals from the domestic economy are not supporting a rate cut.  The ISM Manufacturing Index is well above 50; since the Federal Reserve began confirming the policy rate, it is rare to see rate cuts when the index is above 50.

We have indicated when the ISM index falls below the 50-expansion line with vertical lines.  The only time we saw significant rate cuts without the ISM index below 50 was in 2007, when financial markets were under clear stress.  In May 2007, the Chicago FRB National Financial Conditions Index, an index of financial stress, was reading -0.67.[1]  By August, it had risen to -0.13 and turned positive in November.

In this cycle, international pressures seem to be guiding policymakers to act.

This chart shows the fed funds target with the Global Economic Policy Index.  This index measures mentions of economic or policy uncertainty in 20 nations; the index is weighted by GDP, adjusted for purchase power parity.  A rising reading suggests increases in policy uncertainty.  This chart supports Chair Powell’s continued references to overseas issues when calling for easing.

To some extent, there is a worry among market participants that the Fed is simply creating a narrative to allow it to ease, reducing pressure from the White House while maintaining some element of independence.  The third chart suggests the Fed does have good reasons for acting to lower rates.  With trade wars, the immigration crisis in Europe and the U.S., the potential for conflict in the Middle East and worries about a currency war, the level of global policy uncertainty is historically elevated.  This factor, we believe, reflected in the financial markets, is what is prompting the desire to cut rates.  We do expect a significant level of dissent among FOMC voters but, in the end, we look for two rate cuts this year, unless global stress levels unexpectedly diminish.

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[1] A reading under zero suggests low levels of stress.

by Asset Allocation Committee

In his last testimony to Congress, Chair Powell agreed with Representative Ocasio-Cortez (D-NY) that the relationship between unemployment and inflation appears to have been broken.  This relationship, usually referred to as the Phillips Curve, suggests there is an inverse relationship between the two variables.  If one desires low inflation, then the tradeoff is higher unemployment.

The Phillips Curve has a controversial history.  There is nothing in economic theory that necessarily supports the tradeoff.  In fact, in its original construction by the economist A.W.H. Phillips, the relationship was between wages and unemployment and was developed by observation.  On the one hand, the relationship makes intuitive sense.  The unemployment rate should offer some insight into the supply/demand balance for labor and it would be reasonable to expect that the relative scarcity of labor should increase wages.  Economists then took the next step and assumed that rising wages would lead to higher price levels.  There are periods when the relationship between prices and unemployment is stable.  But, history shows the relationship is far from consistent.

Both charts are scatterplots of the unemployment rate and the yearly change in CPI.  The chart on the left shows the relationship from 1960 through 1969.  It exhibits what the theory suggests—declines in unemployment are consistent with higher inflation.  It also suggests a non-linear relationship, in that when the unemployment rate declines below a certain point then inflation tends to rise quickly with little improvement in the labor markets.  This chart was part of the development of the theory of the “natural unemployment rate,” which suggested there was a long-term unemployment rate and falling below that rate would lead to sharply higher prices, thus limiting the impact of policy.

The chart on the right suggests something quite different.  In the data since 2010, the relationship is positive, meaning that higher levels of prices are consistent with high unemployment.  Although that relationship is due, in part, to the distortions caused by the Great Financial Crisis, the fact that the curve slopes upward does suggest the relationship between price levels and unemployment may be sensitive to other factors.

It is no great secret that the relationship between unemployment and price levels is inconsistent.  So, in light of this problem, why has the Federal Reserve clung to the Phillips Curve in policymaking?  As the linked article above notes, Chair Powell appears to have given up on the relationship but others on the FOMC have not.  We suspect the Phillips Curve served an important narrative for the Federal Reserve tied to its dual mandate.  The Fed is expected to execute monetary policy that yields stable prices and full employment.  The Phillips Curve made it clear that this mandate had a tradeoff; if the Fed delivered low unemployment, there was an inherent risk of rising price levels.  The belief in the Phillips Curve allowed the Fed to avoid policies that brought very low unemployment that might risk higher price levels.

For the Federal Reserve, the Phillips Curve was a useful theory even if it wasn’t always consistent.  But, if there is a belief that the Phillips Curve doesn’t work anymore, then one could see Congress demanding ever lower levels of unemployment.  If the theory really doesn’t hold, there is no risk of inflation coming from falling unemployment.  However, there may be other issues.  For example, very low interest rates could distort financial markets.  It could lead to malinvestment in the economy.  Perhaps the most potent problem is that terms such as “stable prices” and “full employment” are not fully defined.  Former Fed Chair Allen Greenspan defined stable prices as inflation that is low enough to where consumers and firms do not take inflation into account when making investment and purchase decisions.  Although workable, Greenspan’s definition is clearly ad hoc.  It is arguable that any level of inflation is inappropriate.  Defining full employment has been difficult as well.  Part of the Phillips Curve theory is the concept of Non-Accelerating Inflation Rate of Unemployment (NAIRU), which suggests there is a minimum rate of unemployment consistent with steady prices.  Policymakers have used NAIRU as a proxy for full employment, even though it changes over time.  Most elected members of Congress would describe full employment as every likely voter in their district or state has a job if they want one.

The problem for the Fed is that if the Phillips Curve is jettisoned, there could be a focus on the unemployment rate of the mandate and the inflation mandate could become secondary.   After all, if inflation isn’t affected by the unemployment rate, the political class would generally want a rate as close to zero as possible.  Since inflation is affected by the degree of deregulation and globalization, it may be possible that inflation will remain low even at historically low levels of unemployment.  Unfortunately, it is also possible that the Phillips Curve relationship has become dormant for a myriad of reasons, including the aforementioned globalization and deregulation policies, demographics, and custom.  One observation we have noted is that the level of service seems to decline when the unemployment rate falls significantly.  Businesses note that they don’t have much pricing power and, in the face of rising wages, firms may opt to simply deliver less in terms of normal service.  In other words, hotel rooms may not be available at check-in time due to the lack of housekeeping staff or tables in restaurants may not be bussed as quickly due to the lack of entry level staff.  Such deterioration is not technically “inflation” but can occur in response to factors that otherwise would trigger rising price levels.

In the end, the Fed may find itself without an adequate response to Congress when it demands ever lower levels of unemployment.  The Phillips Curve was useful for the FOMC to avoid being forced into extreme policy positions.  Without the Phillips Curve, there is the potential that the Fed will be forced to engage in persistently accommodative monetary policy, with outcomes that could either lead to inflation or significantly distorted financial markets.

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