In Part I of this report, we looked at current key global population trends. The report discussed how plunging birth rates have been weighing on population growth and boosting average ages all over the world, with a potentially huge impact on the distribution of geopolitical power, economic prospects and future investment returns. In Part II, we showed how these demographic trends are playing out for the world’s sole superpower and most important economy: the United States.
This week, in the final segment of this report, we’ll dive deeper into the economic implications of slowing population growth and an aging population. Our analysis will show that these demographic trends are likely to weigh heavily on future economic growth and inflation. The trends may well impact standards of living and constrain monetary and fiscal policy in important ways. We’ll conclude with a discussion of the long-term ramifications for investors, although it’s important to remember that many other forces can have a greater impact on investment returns in the short term.
by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA
[Posted: 9:30 AM EST]
It’s March! February seemed unusually long this year. There is lots of news this morning. We are seeing some signs of equity market stabilization, but risk-off markets are also doing really well. We update the COVID-19, including China’s PMI data (quick update—it was historically bad). One war is starting; it looks like Syria and Turkey are going at it. Another war may be winding down as the U.S. and the Taliban have agreed to a deal. North Korea fires a couple missiles. Here are the details:
The details offered little in the way of silver linings. New orders fell to 29.3; new export orders plunged to similar levels. Given this data, it will be very difficult for China to avoid a negative quarter for GDP.
The OECD came out today and warned that global economic growth is at risk from COVID-19. In response, central banks and fiscal authorities are rolling out support packages. The Fed and the BOJ both offered support, with the latter giving the most details. There are also proposals to ease liquidity issues for the financial system with a temporary relaxation of banking regulations. Commentators have noted that cutting the policy rate target won’t stem infections, but they would help to reduce the demand side aftereffects of the virus. As we noted last week, the financial markets are signaling that the Fed needs to cut at least 50 bps and is leaning toward 75. We also note that the 10-year Treasury yield flirted with 1% overnight.
Has anything changed in our outlook? Not much in terms of timing but some in terms of impact. We still expect this event to be 3-4 months in duration but the economic impact is probably going to be bigger than we initially thought. In other words, the economic impact will probably be short but deep. Essentially, the problem comes down to the quarantine issue. If policymakers fear the disease is a “killer” then they should engage in aggressive quarantine policies which will hurt growth. That is the lesson from China’s PMI data. If, on the other hand, policymakers conclude that this virus is more of a nuisance and that most people will get through it just fine then quarantine measures should be modest and the economic impact will be less pronounced. Of course, the risk of implementing less aggressive quarantine policies is that if COVID-19 turns more lethal, the impact would be grave. At this point it is almost impossible to tell what the U.S. will do. The administration is giving local governments the power to close schools, which would have a negative impact on the economy. We do note that in the Spanish flu pandemic (a “big one,” BTW) local governments essentially dictated the response. St. Louis was rather draconian in its response and suffered fewer fatalities. But, the overall economic impact will be greatly affected by the degree of panic among households and businesses and the response of government. At the same time, there is evidence from China that the worst may be over and recovery may be starting, albeit from a deep hole.
Since the end of the Financial Crisis, there has been a steady deterioration in investment-grade credit quality.
This chart shows the percentage of investment-grade bonds rated at BBB. Since late 2018, this portion has represented half of outstanding investment-grade credit. This rating is the lowest end of investment-grade credit, so the dominance of this segment raises questions about the stability of these corporate bonds under deteriorating financial conditions.
History tends to show that monetary policy has the most significant impact on the percentage of BBB debt.
A rising policy rate between 2004 into 2006 coincided with a sizeable decline in the percentage of BBB-rated debt in the investment-grade category. Low rates since 2008 led to a steady rise in the percentage of BBB-rated debt. Most notably, the policy tightening from 2016 into last year did not slow the rise, suggesting investors did not believe that monetary policy would lead to concerns about credit quality.
This data suggests a couple of issues. First, the current high level of low-rated debt in investment-grade is a concern if the economy weakens or policymakers overtighten. Second, investors appear confident that neither outcome is likely in the short run and, if anything, the FOMC will react quickly to protect the economy from trouble. The risk, of course, is that either this confidence is misplaced or a circumstance will develop to which no amount of policy stimulus can prevent credit deterioration.
In response to this deterioration of credit quality, we have reduced our overall exposure to investment-grade credit in our allocations to fixed income. However, we remain overweight to investment-grade, in part, due to expectations that a recession or a credit event isn’t imminent.
by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA
[Posted: 9:30 AM EST]
Equity markets around the world continue to spiral lower. Turkey and Syria are on the brink of war and Europe may face another refugee crisis in the midst of COVID-19. U.K. talks tough on trade. Here are the details:
Meanwhile, the U.S. is struggling to develop a response to the virus. It appears that U.S. health workers did not follow infection disease protocols in treating those evacuated from Wuhan, raising the possibility that these workers could become disease vectors if they contracted the illness. The White House is insisting on vetting all public comments on the virus; although that does allow for consistent messaging, as we saw in China, it can also delay bad news and facilitate wider infection rates. At the same time, the vice president has selected Debbie Birx to act as “coordinator” on combating the virus, which sounds like a “czar.” One of the problems of selecting Pence to oversee the role is that a president can’t fire a vice president—if the vice president’s performance is poor, he would remain in office. By creating a coordinator position, that person could be fired if she doesn’t meet up to the job. Another worry—the fractured insurance system may prompt some Americans from seeking treatment for fear of inability to pay. A report from Florida serves as a cautionary tale.
As a reminder, all the research we have analyzed suggests that 80% of those infected report mild or nearly no symptoms. This is good and bad news. The good news is that, unless this virus mutates into a more virulent form, most victims will think they had a cold. The bad news is that it will be nearly impossible to prevent its spread. In fact, the measures taken to thwart the spread may cause more economic damage than the disease itself.
On that topic, U.S. equity markets have fallen into correction territory in record fashion.
(Source: Deutsche Bank)
The S&P is falling much faster than seen in corrections or bear markets.
(Source: Deutsche Bank)
This sort of decline suggests equity markets are anticipating recession. Is this reasonable? The key, from where we sit, is the reaction of consumers. As we have noted before, U.S. GDP has become unusually reliant on consumption.
The four-quarter average of the contribution to GDP from consumption is below 2%, which in the past has often led to recessions. The other components—net exports, investment and government—are not contributing enough to offset a serious decline in consumption. The worry is that if consumer confidence is rattled and households rein in spending, it will be difficult to avoid at least a mild recession. Should a virus that will affect a supermajority with a cold be enough to bring down consumption? If humans were rational, it shouldn’t; but, there is ample evidence to show that humans are anything but rational.
Meanwhile, we are seeing some rather odd actions in other financial markets as well. Gold is not acting like a safety asset today, suggesting that investors only have eyes for Treasuries. The EUR has been surging as carry trades unwind; the EUR has been a funding currency and as borrowers retreat the EUR is being bought back. Financial markets expect the FOMC to cut next month (we would be surprised), while Lagarde says the ECB probably won’t move.
Turkey and Syria:Syrian (or Russian) attacks on Turkish positions in Idlib province have killed 33 Turkish soldiers. Turkey, a member of NATO, should be able to request “Article 5” support, which details that an attack on one member is an attack on all. So far, NATO has been reluctant to support Turkey. President Erdogan is preparing a military response but one of the factors he is facing is a wave of new refugees from the embattled province who are fleeing the war. Turkey does not want to deal with the influx and is threatening to “open the borders” to refugees so they can flee to Europe. This is the last thing Europe needs right now. It still hasn’t resolved the last inflow of refugees and a new inflow when some European nations are closing borders due to COVID-19 could lead to yet another political and economic crisis for Europe.
Shelton update: It appears that Judy Shelton may be confirmed after all. She has turned two GOP senators who were skeptics and only needs one more to get approved. She would be a reliable dove as long as a Republican is in the White House, but we would expect her to develop talons if a Democrat wins in November.
OPEC: Separately, as the virus panic disrupts economic activity and pushes down oil demand, Saudi Arabia is pushing OPEC and its partners, including Russia, to cut oil output by a collective 1.0 mbpd when they meet next week in order to shore up prices. That compares with a proposal earlier this month to cut output by 600,000 barrels per day, which Russia strongly resisted.
Israel: By the time we publish our Monday morning Daily Comment, Israelis will be voting in their third parliamentary election in a year. In recent polls, Prime Minister Netanyahu and his conservative Likud Party have been pulling away from challenger Benny Gantz and his Blue and White coalition. However, even if Likud beats the coalition by one or two seats as expected, Netanyahu would still not have enough seats to govern on his own and would have to form an alliance with smaller parties.
The business cycle has a major impact on financial markets; recessions usually accompany bear markets in equities. We have created this report to keep our readers apprised of the potential for recession, which we plan to update on a monthly basis. Although it isn’t the final word on our views about recession, it is part of our process in signaling the potential for a downturn.
January saw broad improvement in the economic data. The signing of the “Phase One” trade deal offered reassurance that the impact of the trade war would be limited in 2020. Several sentiment indicators surged, likely in response to the development. The NFIB Small Business Optimism Index, Chicago National Activity Index, Philly Manufacturing Outlook and Consumer Confidence, which is featured in the diffusion index, all improved during the month. In addition, financial markets offered mixed signals about the resiliency of the economic expansion due to growing uncertainty about the global economy. Conflict between the U.S. and Iran following the death of Qassem Soleimani and the COVID-19 outbreak in China reignited fears of the U.S. economy’s exposure to geopolitical risks. As a result, there was a slight deterioration in the gains made in equities and flattening along certain areas of the yield curve. Nevertheless, positive gains in employment and improvement in manufacturing activity suggests the economy remains strong. Our diffusion index has improved from the previous month with nine out of 11 indicators in expansion territory. The reading for January rose to +0.636 from +0.576.
The chart above shows the Confluence Diffusion Index. It uses a three-month moving average of 11 leading indicators to track the state of the business cycle. The red line signals when the business cycle is headed toward a contraction, while the blue line signals when the business cycle is headed toward a recovery. On average, the diffusion index is currently providing about six months of lead time for a contraction and five months of lead time for a recovery. Continue reading for a more in-depth understanding of how the indicators are performing and refer to our Glossary of Charts at the back of this report for a description of each chart and what it measures. A chart title listed in red indicates that indicator is signaling recession.
by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA
[Posted: 9:30 AM EST]
Global equity markets are down again due to the continued spread of COVID-19. U.S. futures are down this morning. We update the latest on the virus, including some thoughts about the Fed’s reaction function. Despite everything, U.S. housing data is looking remarkably robust. There is our usual recap of the weekly energy report. Here are the details:
President Trump held a news conference on COVID-19 yesterday evening. He tried to strike an upbeat tone but acknowledged the virus is going to be with us. He appointed VP Pence to coordinate the response. These sorts of events are risky for elected officials. Many a mayor has been ousted for failing to respond to weather events; the unpredictable is risky. So, the president was trying to thread the needle between showing enough caution to be seen as taking the event seriously, but not act so concerned as to prompt a panic. That is a hard line to weave. We could see some officials ousted in this process. As we saw in China, the usual political response is to underreact and underreport on hopes the event doesn’t worsen. At the same time, overdoing it is risky too. President Ford’s reaction to the 1976 Swine Flu outbreak was so strong that the action to counter the outbreak (that really never happened) caused more problems than the flu itself.
As we have been saying ad nauseam, our central case is that this will be a three- to four-month event that will pull some nations into recession. We doubt the U.S. will go into recession, but the event will leave a mark, especially around the world. We would expect a negative impact on earnings. The key issue to watch is whether the supply crunch that will come from COVID-19 becomes a demand event. In other words, as the virus spreads in the U.S., watch household consumption and consumer confidence. If stores empty out and Opening Day has few attendees, the follow-on effects on demand could bring the economy into a downturn. At the same time, our view on equities is that this decline, which is into correction areas in the U.S., is probably short-lived. That doesn’t mean we are out of the woods yet in the near term. As the bull market has extended, all sorts of schemes to enhance performance using option strategies have become imbedded into equities. How these tactics are affected by the recent weakness is anyone’s guess, but our expectation is that they will increase volatility.
The Fed is under pressure to cut rates. Partly that is coming from public pressure. The financial markets are another area of pressure. The implied LIBOR rate from the two-year deferred Eurodollar futures is down to 100 bps, signaling that the Fed needs to cut rates by at least 50 bps.
So, what about timing? Since 2000, the FOMC has tended to lower rates when the 12-week average of the VIX rises above 20. Since the VIX has just started rising, we may need to see more equity weakness before the Fed decides to move. It might move before then, but the combination of a falling implied LIBOR rate and higher equity market volatility would make a strong case for the central bank to act.
We do expect the Fed to cut rates, probably in the summer. FOMC members are still signaling “wait and see.” But, the bank’s reaction function to financial signals is making a clear case that further rate reductions are warranted.
Housing: Recent housing data has been remarkably robust. Yesterday, new home sales data was very strong.
This chart shows new single-family home sales compared to the National Association of Home Builders’ forecast for sales. As the chart shows, current sales are very strong. Before 1995, sales tended to range between 400k to 800k. We are approaching the high end of that range, and with current low rates there is no reason not to expect that we will move above 800. And, it is perhaps not a moment too soon as we have been observing reports of homelessness and substandard housing.
Energy update: Crude oil inventories rose 0.5 mb compared to the forecast rise of 1.8 mb.
In the details, U.S. crude oil production was unchanged at 13.0 mbpd. Exports rose 0.1 mbpd, while imports fell 0.3 mbpd. The inventory build was less than forecast due to rising exports and falling imports.
(Sources: DOE, CIM)
This chart shows the annual seasonal pattern for crude oil inventories. This week’s report was consistent with seasonal patterns and the gap between the normal pace of inventory accumulation and the actual remains narrow. Seasonally, next week should see a notable rise; if stocks fail to rise around 3.0 mb next week, it would be considered somewhat bullish.
Based on our oil inventory/price model, fair value is $59.43; using the euro/price model, fair value is $46.12. The combined model, a broader analysis of the oil price, generates a fair value of $49.96. The COVID-19 continues to play havoc on the oil markets, but the strong dollar and seasonal pressures are not helping either.
In China, there are increasing worries that agriculture continues to be disrupted which could create food shortages later this year. Of course, this also may make it easier for China to achieve its Phase One purchase agreements. One of our China sources suggests there are two items to watch that will signal that the CPC thinks it has COVID-19 under control: (a) Xi personally visits Wuhan, and (b) dates for the National Party Congress are announced.
Brexit: Next week, EU and U.K. negotiators open formal talks on a trade deal. Comments from both sides suggest that talks will be difficult. This news may be behind today’s weakness in the GBP.
Odds and ends: There will be new local elections in Catalonia to try to break the separatist movement. Khalid al-Falih, the former energy minister who was fired last September and stripped of his chairmanship of Saudi Aramco (2222, Tadawul, SAR 33.45), has been tapped to rejoin the government as investment minister, a newly created cabinet position. It is generally believed that al-Falih was fired for slow walking the Aramco IPO; bringing him back could mean a number of things. One is that the crown prince believes he will be better in this role. The other could be that the king realizes his son made a mistake in firing al-Falih and wants an older hand in the government. Axios reports that small business growth has mostly been centered in cities and suburbs and rural America has been losing small businesses. In repo, one of the problems for this market is that banks have the desire to hold much more reserves than the Fed expected. At the same time, there is a facility available for immediate liquidity needs, the discount window. Unfortunately, borrowing through the discount window carries a negative stigma, suggesting a bank is in trouble. And so, instead of risk being seen in a bad light, banks refused to lend at 10% overnight rates last September. A recommended solution would be a standing repo facility, which would be like the discount window but with a different name. This may or may not solve the problem because analysts may view the standing repo facility as equal to the discount window and view borrowing there as a sign that a bank is in trouble. In an interesting development, JP Morgan (JPM, 126.26) has indicated it will begin tapping the discount window on occasion; since the bank is considered the gold standard for U.S. banking, its borrowing at the window won’t carry a stigma. The belief is that if JP Morgan borrows there, other banks can too and the discount window can become the resolution for the repo problem and allow the Fed to reduce its balance sheet.
by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA
[Posted: 9:30 AM EST]
After a deep selloff yesterday, equity markets around the world are mixed. We are seeing some retreat in the flight-to-safety assets after a massive rally yesterday in gold and Treasuries. As usual, we update news on the COVID-19. The president wraps up his India trip. Germany is preparing for a new leader for the CDU. Here are the details:
COVID-19: The number of reported cases is 80,289 with 2,704 fatalities. South Korea is now reporting 977 cases. As an undergrad, I took a course on organizational behavior.[1] In that course, we discussed conditions that tended to undermine organizations. The three most common were dissonant objectives, information overload and information depravation. To some extent, we are seeing all three exhibited in the reaction to the COVID-19. In terms of dissonant objectives, nations are trying to prevent the spread of the disease and avoid recession. These objectives are mostly exclusive—ensuring that the virus doesn’t spread requires actions that will undoubtably lead to an economic downturn. The second method is being seen in the West. The media is putting so much information out there that it is difficult to ascertain what people should do. Outside the developed world, we are seeing just the opposite; propaganda and the lack of information is leading to unfounded rumors being spread, some of which work against containing the virus.[2]
Here is the problem for policymakers. If the virus is really the “big one” then taking aggressive steps to enforce quarantines is necessary and an economic downturn is a reasonable price to pay. But, if the virus is mild, these aggressive steps are unnecessary and the cost of a recession is excessive. So, where does COVID-19 fall? Early evidence leans toward this being a mild virus. A report from China’s CDC did a study on the virus using data through February 11. It looked at 72,314 cases and it found a fatality rate of 2.3% for the confirmed cases and 1.4% for confirmed and suspected cases. The fatalities were concentrated among the elderly (>60 years old,[3] 829 of the 1,023) and most of those who died also had chronic conditions (heart disease, diabetes). Mild cases were reported in 81% of the cases. Overall, the data likely confirms that this respiratory virus is similar to influenza; it does kill, but most who are infected survive and older people are at greatest risk due to other health complications.
In general, fear of this being a bigger deal will probably have a greater impact than the virus itself. Of course, that assumes it remains mild. In the history of the Spanish influenza of 1918, the virus seemed to mutate at least once into a much more virulent form, so the world isn’t out of the woods yet. Nevertheless, our base case remains that this will be a three- to four-month event.
Germany: The CDU will hold a special congress on April 25 to select a new party leader. We are in the twilight of Chancellor Merkel’s reign; depending on who replaces AKK, that ending may come before her term ends in 2021.
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