In Part I of this report, we looked at current key global population trends. The report showed how plunging birth rates have been weighing on population growth and boosting average ages all over the world, potentially having a huge impact on the distribution of geopolitical power, economic prospects and future investment returns. An important countertrend is that urbanization is accelerating, with city populations growing relatively faster while rural populations stagnate or decline. Part I noted that stronger innovation and productivity could help offset the negative impact of slowing population growth and population aging, but the world’s education systems are not rising to the occasion so far.
This week, in Part II, we will show how these demographic trends are playing out for the world’s sole superpower and most important economy: the United States. Part III will dive deeper into the economic impact of slowing population growth and population aging, and, as always, conclude with a discussion of the ramifications for investors.
by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA
[Posted: 9:30 AM EST]
It’s “red Monday” – global equities are taking a hit as the COVID-19 virus is starting to look like a global pandemic. Risk assets are down around the world while most risk-off assets, gold and Treasuries, are rallying. We cover three elections – Iran, Germany and Nevada. The president is in India. Here are the details:
We would have to say that the perception of the virus has changed. Financial markets have been looking through the initial wave of infections and expecting conditions to improve by the end of March. If the virus prompted policy stimulus, risk-on assets would do even better. That attitude appears to have changed over the weekend, although signs of caution were emerging last week. As the virus spreads, it does appear that the global economic impact will be larger than first thought. Clearly, China will be hurt but it does have policy space to react to the problem. Unfortunately, most policy measures boost demand, but if the problem is supply, the impact of lowering interest rates or distributing cash will merely bring higher prices. Reports suggest that Chinese firms are facing severe liquidity constraints and supplying credit will raise already elevated debt levels. Low levels of global inventories are intensifying the impact of outages. Further disruptions of global supply chains appear inevitable. The G-20 warns that COVID-19 will threaten global growth. At the same time, U.S. officials continue to believe that the virus will not be an impediment to China’s purchases as mandated by the Phase One agreement. We suspect that position will change.
Our overall view of the virus remains the same; we expect it to be mostly a three-month event and look for the virus to dissipate. However, this is a probabilistic statement; there is a chance that COVID-19 becomes a global pandemic that becomes impossible to control and has an impact similar to influenza pandemics of the past. We continue to think the odds of this outcome are rather low but the spread we are observing is a concern. But, for now, we still see this problem mostly over by spring.
Odds and ends: A rising CHF versus the EUR is causing problems for the Swiss National Bank. In the past, the SNB has aggressively intervened to fix the CHF/EUR rate. However, intervention to prevent the rise of the CHF would likely anger the U.S. and is complicating policy. The booming tech sector in northern California is starting to look like a bust. The impact on the broader economy might be next.
In 2017, we introduced an indicator of the basic health of the economy and added it to the many charts we monitor to gauge market conditions. The indicator is constructed using commodity prices, initial claims and consumer confidence. The thesis behind this indicator is that these three components should offer a simple and clear picture of the economy; in other words, rising initial claims coupled with falling commodity prices and consumer confidence is a warning that a downturn may be imminent. The opposite condition should support further economic recovery. In this report, we will update the indicator with January data.
This chart shows the results of the indicator and the S&P 500 since 1995. The updated chart shows that the upward momentum in the economy has slowed but remains well above zero. We have placed gray bars to indicate recessions. The indicator was coincident with the 2001 recession but didn’t turn negative until June 2008, when the recession was well underway. Unfortunately, in its raw form, it signals trouble when the equity markets are already well into their decline.
To make the indicator more sensitive, we took the 18-month change and put the signal threshold at minus 1.0. This provides an earlier bearish signal and also eliminates the false positives that the zero threshold generates. Nevertheless, the fact that this variation of the indicator is below zero raises caution.
What does the indicator say now? The economy has been decelerating but conditions have improved over the past three months, lifting this indicator back to near-zero. Thus, the improvement does suggest that investors should remain in equities based on the idea that economic conditions remain supportive. In past updates, we have expressed caution that at least rebalancing of portfolios was in order. This update would indicate that further defensive action should be put on hold for now.
by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA
[Posted: 9:30 AM EST]
It’s Friday! Virus worries lead to mixed equity markets but a distinct element of worry—gold—continues to move higher despite dollar strength. Treasury yields continue to fall. However, the other flight-to-safety asset, the JPY, has failed to rally this time on fears of recession in Japan. We update the virus news. There are reports of a peace deal with the Taliban. Iranians go to the polls today. The EU is struggling with budget negotiations. Japan restricts foreign investment. We recap the DOE report. Here are the details:
Meanwhile, the economic impact of the virus is becoming clear. Airlines have been hurt. Energy demand has declined. There are increasing reports of manufacturing disruptions. Although today’s PMI data shows improvement, the virus may be distorting the reports. One element of the report, supply deliveries, may be giving a false reading. In the construction of PMIs, slower deliveries are considered bullish because they signal rising demand. However, in this case, slower deliveries caused by COVID-19 are actually a reflection of weakness. It appears that equity markets are taking a more cautious reading on the impact of the virus.
Iranian elections: Iranians go to the polls today to vote on a reduced slate of parliamentary candidates. The choice in most districts is either a hardliner or an extreme hardliner. The Council of Guardians, who decides which candidates can run, has severely restricted choices. The vote will generate a conservative parliament; however, the legitimacy of the vote is clearly weakened. In other Iranian news, the Financial Action Task Force, a Paris-based organization that monitors terrorist financing, is planning to put Iran on its blacklist. This action will further isolate Iran and undermine relations with Europe.
The EU budget: The EU is in the process of creating a seven-year budget. One of the major parts of this process is the transfer payments that move from the wealthy EU nations to the poorer ones. The latter want a bigger budget with high transfers; the former want less spending. A rebellion of sorts from Germany and the “frugal four,” trying to contain spending, is making it very difficult for negotiators to make a deal. Overhanging the problem is Brexit. The U.K. leaving the EU has left a €60 to €75 billion “hole” in available funds; the northern European nations are loath to fill that gap. In effect, the southern nations want the northern nations to offset the loss of Britain, while the northern nations want to offset the loss by reducing available funds.
Japan: The government is finalizing a plan to tighten scrutiny of foreign investment in 12 economic sectors, including defense, nuclear power, aerospace, telecom, utilities and others. Signaling a further rollback of globalization, the plan says any foreign investor buying 1% or more of certain firms in those sectors would be subject to prescreening, up from 10% currently.
Odds and ends: Despite the Phase One trade deal, financial conditions in the farm belt continue to deteriorate. Farm bankruptcies are forecast to remain high this year. The poor financial situation for farmers may be behind a shift in recommendations by Agriculture Secretary Perdue. He has come out in favor of a carbon tax, a significant break from the stance of the administration. It appears he is angling for farmers to receive payments for carbon sequestering. When farmers plant corn or soybeans, carbon is pulled from the atmosphere into the soil. After harvest, if the silage rots, some of this carbon is released back into the atmosphere. However, various techniques may prevent this from occurring and, if so, we suspect Perdue would push for farmers to receive payments for containing the carbon that was captured in the growing process.
Energy update: Crude oil inventories rose 0.4 mb compared to the forecast rise of 3.2 mb.
In the details, U.S. crude oil production was unchanged at 13.0 mbpd. Exports rose 0.4 mbpd, while imports fell 0.2 mbpd. The inventory build was less than forecast due to rising exports, falling imports and a rise in refining activity.
(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 remains narrow between the normal pace of inventory accumulation and the actual. Seasonally, next week should be steady too, but further builds would be expected into May.
Based on our oil inventory/price model, fair value is $59.59; using the euro/price model, fair value is $46.28. The combined model, a broader analysis of the oil price, generates a fair value of $50.13. The wide deviation in model forecasts is due to the weakness in the dollar. Although we have seen a rebound in oil prices on hopes that the COVID-19 virus will be contained soon, dollar strength remains a bearish risk factor for oil prices.
by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA
[Posted: 9:30 AM EST]
Global equities are mixed this morning with U.S. equity futures taking a breather. We update the COVID-19 news. The Fed is warming up to the economy. U.K. changes immigration rules. A new DNI. The president is off to India. Trouble in Argentina. Here are the details:
However, it is not clear whether the decline is anything more than another change in reporting standards. One of the problems with analyzing China is that there is clear manipulation of data in normal circumstances. Thus, the temptation is strong to jigger the numbers to make it appear that the virus is under control. We aren’t saying the data is necessarily tainted but simply unreliable. However, that doesn’t stop researchers from trying to capture what is really happening.
Overall, our stance remains the same; the COVID-19 virus will most likely be a one- to two-quarter event with a recovery fueled by global fiscal and monetary stimulus.
Fed minutes: There were no surprises in the report (there seldom are). Although the tone was a bit more upbeat on the economy than what we have seen previously, there was nothing in the content to suggest the FOMC is thinking about raising rates. Worries about the fallout from COVID-19 are probably going to keep the Fed on hold; recent dollar strength should also give policymakers pause.
Off to India: President Trump will visit India next week and there are hopes that a mini-trade deal might be in the offing. India tends to be protectionist and this has caught the ire of U.S. trade negotiators. However, India has strategic value as a foil for China, so we may see an attempt by the president to improve relations.
Germany: A right-wing extremist killed nearly a dozen people near Frankfurt before apparently killing himself. Many of the victims were ethnic Kurds, and the killer left behind a letter calling for the extermination of “certain peoples” that could no longer be expelled from Germany. The killings highlight the ongoing ethnic tensions and right-wing pushback against immigrants at the center of Europe.
Argentina: The IMF said Argentina’s public debt position has become so precarious that a restructuring is necessary, including a “meaningful contribution” from private creditors. With Argentina continuing to struggle with ballooning debt, falling international reserves, and a weakening peso, the outlook for the country’s stocks and bonds is deteriorating rapidly.
by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA
[Posted: 9:30 AM EST]
World equity markets have mostly shrugged off yesterday’s weakness and continue to focus on the post COVID-19 world; doses of additional stimulus aren’t hurting either. The Fed releases its minutes from the last meeting today. Here are the details:
COVID-19: The number of reported cases are 75,317 with 2,012 fatalities. Although there is growing evidence of economic disruption, so far, this has been met with additional stimulus. Due to expectations that the virus will be a one quarter event, the stimulus is enough to support risk markets. On that note, we do find it interesting that gold prices are higher this morning despite the recovery in equity markets. On the negative side of the ledger, there are reports of shortages and Chinese companies are warning that they are struggling to meet payrolls. If the payroll problem spreads, the impact on the Chinese economy will be much more serious. The Chinese real estate market is a special concern due to high leverage. The drop in air traffic to China is also starting to have an impact. On the positive side, Chinese policymakers are moving quickly to aid the economy. To reiterate, the most likely outcome is a one to two quarter slump in growth that will be partly offset by stimulus and that same stimulus will set the stage for a stronger economy by H2. That doesn’t mean that tail risks don’t exist and could make this event much worse. But, for now, financial markets are assuming the worst won’t occur.
China: There were a number of cross currents in the news. First, President Trump personally took steps to cool trade tensions with China. Hawks in Congress and the administration were pushing to prevent the sale of jet engines to China and have been pushing for other restrictions as well. The president rebuked these officials, suggesting that he does not want to close off China but only wants them to change their behavior. The president does not want to put U.S. businesses at a disadvantage and thus is trying to find a middle ground between no restrictions and isolation. However, the U.S. has also designated five Chinese media firms as “foreign government functionaries” which will reduce the abilities of these firms’ reporters to operate in the U.S. Meanwhile, China has expelled three journalists from the WSJ. But China has also taken steps to reduce tariffs on U.S. products, preparing to meet its obligations in the Phase One part of the recent trade agreement. We see these crosscurrents as evidence both nations are trying to figure out what relations are going to look like in the coming years. What existed before, where China was given great latitude to exploit U.S. hegemonic public goods, is over. What replaces it isn’t clear.
MMT rises: In response to a February survey, global investors stated that fiscal policy was likely better positioned to solve the persistently low inflation than monetary policy. The sentiment reflects growing clout of modern monetary theory in economic circles. That said, there are critics who believe that increased fiscal spending could be detrimental to price stability, which in turn could be harmful to equities. Furthermore, it appears that the Federal Reserve may also welcome fiscal stimulus in the economy. In a testimony to Congress, Federal Reserve Chairman Jerome Powell hinted that the Federal Reserve may not have the tools needed to combat the next recession.
by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA
[Posted: 9:30 AM EST]
Welcome back! Equities are under pressure due to Apple (APPL, 324.95) news. The U.K. rejects the EU trade agreement proposals as it appears Britain is ramping up fiscal spending. The Netherlands threatens the EU/Canada trade deal. We’re seeing rising tensions over the U.S/China technology war. Here are the details:
Of course, we offer our usual caveats; we suspect the actual number of infections is much higher, but the lethality is much lower than the official data suggests. Although nothing we have seen convinces us that our take on the disease is wrong (we expect one weak quarter from the event), we remain vigilant for the unexpected. We do note that China’s equities have recovered their losses since the return from the New Year holiday, supported by fiscal and monetary stimulus from Beijing.
Brexit: The EU is offering a trade deal with the U.K. in exchange for a “level playing field” on rules and regulations. Westminster is outright rejecting such an arrangement, which it should; there is no point to Brexit if the country leaves only to follow rules that it no longer has input in setting. Meanwhile, PM Johnson appears to be ramping up a fiscal splurge. If it occurs and the BOE turns more hawkish as a consequence, it should be bullish for the GBP.
EU: There are two items of note. The Netherlands, normally a supporter of free trade within the EU, may reject the recent free trade deal with Canada. Under EU rules, all the members must approve a free trade arrangement, which explains why getting anything approved is really hard. Under normal circumstances, we expect the smaller states or France to be leery of free trade deals, but if the Dutch are done with free trade then there is little hope that any new treaties are possible (take note, Brits!). Why the trouble? Agriculture. Farmers in the Netherlands are afraid of the agricultural power of the central North American plains; however, as usual, the worries are couched in safety terms.[1] Second, despite recent visits by Facebook (FB, 214.18) CEO Mark Zuckerberg, the EU is still giving the company the cold shoulder and pressing for more extensive regulation.
Russia-Turkey: The Turkish government yesterday sent a delegation to Russia in an effort to forge a ceasefire agreement for northwestern Syria. Nevertheless, Turkey continues to pour troops and equipment into the area and has threatened to attack Syrian forces there if they don’t stop targeting Turkish-backed rebels. Such a Turkey-Syria conflict would raise a serious risk that Russia would be drawn in.
The data on U.S. residential real estate has been improving in recent months. Housing tends to have an outsized effect on the economy. Not only do housing purchases trigger follow-on buying of consumer durable goods (e.g., furniture and furnishings, etc.) but non-durables as well (e.g., basic household items). A house is an asset and there is a wealth effect that affects future spending as well. The direct impact on GDP is rather modest; the average contribution to GDP from residential real estate is only 0.08% per quarter. However, there is evidence that a weak housing market has been a precursor to recession.
This chart shows the four-quarter rolling contribution to GDP from residential real estate. We have applied a Hodrick-Prescott Filter to the data to establish the underlying trend. Since 1980, with one exception, a negative reading on the trend has been a warning of eventual recession. The only exception was the 2001 recession which was an unusually mild downturn. In Q1 of last year, the trend indicator turned negative. Although it can take a long time from signal to recession (it turned negative in Q1 2005, for example), it has been a reliable signal of economic weakness. However, some housing indicators have shown notable improvement recently, which may lead to the trend rising later this year. Here are a couple indicators we are watching.
Home ownership rates have been rising rapidly.
In 1995, the government began to aggressively support home ownership. Credit restrictions were eased, and refinancing was encouraged. The home ownership rate peaked at 69.3% of occupied homes in 2004. The housing crisis led to a collapse in this metric, reaching a trough of 63.1% in 2015. As the chart shows, the homeownership rate has been rising rapidly since, reaching a new cycle high of 64.9%. The rise in home ownership rates has increased the most among households earning less than median family income.
Although there is a potential credit quality issue with less affluent home buyers, the rise should be supportive for economic growth.
The only “fly in the ointment” has been that home prices have been rising rapidly. Although it hasn’t adversely affected affordability due to low mortgage rates, it will make the housing market increasingly sensitive to interest rates.
Ideally, rising prices for existing homes should spur new building. Housing starts are beginning to accelerate, which is a good sign. If housing continues to accelerate, our estimates for GDP this year may be overly conservative.
by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA
[Posted: 9:30 AM EST]
Happy Friday and St. Valentines Day! It’s rather quiet in the financial markets, with bonds doing well and equities grinding higher. We update news on COVID-19. There is unrest in Colombia, and more legal action on Huawei (002502, CNY 2.61). We have additional color on Johnson’s cabinet shakeup. Judy Shelton is under fire. Canada faces a rail strike. Here are the details:
Is Shelton in trouble? Although President Trump initially selected conventional figures for Fed governor positions, in the past couple of years he has offered more radical candidates, all of whom have failed to get nominated. The latest in this group is Judy Shelton, who in the past has argued for a gold standard, deliberate monetary policy to trigger a weaker dollar and reduced independence of the central bank. Surprisingly, senators are pushing back much harder than we expected and it is possible that Shelton will join Herman Cain and Stephen Moore on the list of candidates that couldn’t get confirmed. If she fails, we would view it as a win for the establishment. However, we would not be surprised to see other governor candidates in the future suggest policies to reduce independence or intervene in exchange rates. If the U.S. is going to reflate, such policies are probably necessary. Nevertheless, Shelton’s positions do seem muddled. On the one hand, she calls for a return to the gold standard and appears reluctant to deploy unconventional policies such as QE but has little problem with overtly engaging in currency depreciation. Our suspicion is that she is really a political candidate who wants policies designed to keep her favored party in power. In our reading of Fed history, this type of appointment would be a first for the Fed and perhaps such an appointment is a bridge too far for the Senate to cross. So, we will see if these “misgivings” evolve into rejection.
Canada: The country’s biggest railroad said it has shut down operations in eastern Canada because of widespread rail blockades set up by activists protesting the construction of a major natural gas pipeline. Since the shutdown is likely to result in layoffs and significant disruption to Canada’s economy, we expect it to be a near-term headwind for Canadian stocks.
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