Daily Comment (October 19, 2017)
by Bill O’Grady and Thomas Wash
[Posted: 9:30 AM EDT] Something unusual is happening this morning…equity futures are pointing to a lower opening. At the time of this writing, S&P futures are indicating about a 0.5% decline. In the sea of calm we have been operating in, such a modest decline does look rather different. We also note that other flight to safety assets are rising this morning—the JPY and EUR are higher, and Treasuries and gold are rising, too. Here is what we are watching today:
What’s behind this morning’s weakness? Although the proximate cause is the rising threat of state action by Spain against Catalonia, this probably isn’t it. The Catalonian government refuses to back down from independence and PM Rajoy appears ready to take steps to remove the provincial government from power and take control of the region. However, this isn’t really news as this action has been expected for some time. A good part of today’s weakness is probably just simply that we are due for some profit-taking. However, there are a few items that are worrying enough to remove some of the confidence in equities. Here is our list:
China and debt: Although Xi Jinping gave a long speech yesterday outlining his view of China as a rising power (long enough that a tea break was necessary), the other news out of China was far more sobering. The People’s Bank of China (PBOC) Governor, Zhou Xiaochuan, said in a talk today that excessive debt growth is raising the risk of a “Minsky moment” in China. Zhou may be replaced at the current party congress; if not, his term will end a year from December, so he is probably in the last 15 months of his career. He has been running China’s central bank since 2002, the longest serving governor of the PBOC in China’s history. So, what’s his concern about a “Minsky moment”? Hyman Minsky, who spent most of his career in St. Louis at Washington University, theorized that stability breeds instability, a condition known as the “financial instability hypothesis.” In other words, the longer an economy is stable, the more confident investors, firms and households become and the more likely they are to take on more risk and leverage. Zhou indicated this morning that, in his opinion, corporate debt is too high and household debt is rising rapidly. His worry is that leverage will magnify the cyclical variations in China’s economy in a pro-cyclical fashion, meaning that it will lead to stronger growth in expansions and deeper recessions in downturns. In a nation run by a communist authoritarian regime that desires stability, Zhou’s concerns are a significant concern. China needs to lower its debt; although it promises it can, history shows countries that have recently achieved development through debt investment have two paths to adjustment. They can either follow the U.S. depression model, which rapidly lowered U.S. private debt during the Great Depression through liquidation and foreclosure, or the Japanese model, which reduces private sector debt slowly by cutting growth to a sustainable level. Neither is pleasant but we don’t see a way for China to maintain stability, cut debt growth and maintain 6.5% GDP growth (as noted below, China grew 6.8% in Q3). We expect China to take the Japan option but try to get a bit better growth at 2.5% to 3.0% growth. That wasn’t the tenor of President Xi’’s speech. Thus, talking about China’s debt introduces a new risk to the global economy.
North Korea: The U.S.S. Ronald Reagan carrier group has moved to the Sea of Japan off Korea’s northeastern coast. According to reports, ships in this group have been given a warning order and prepared Tomahawk cruise missiles to fire on North Korean targets. There has been growing speculation that North Korea may either launch missile tests or detonate another nuclear device (or even both—an airborne test of a nuclear warhead over the open sea) during China’s 19th Party Congress. The U.S. is apparently prepared to retaliate if a test or a North Korean attack on American military assets in Japan, Guam or South Korea are part of North Korea’s actions to spoil Chairman Xi’s “party.” We note that the U.S.S. Theodore Roosevelt carrier group is near Hawaii and could move toward Korea, giving the U.S. two carrier groups if hostilities escalate. Although we don’t expect a conflict, tensions are high and the potential for a mishap is elevated.
Yellen and Trump today: Chair Yellen will meet with President Trump today. Although the president has indicated he likes Yellen’s low interest rate policy, he does favor looser regulation. Given the desire for less regulation and opposition to Yellen from Congressional Republicans, we doubt she will get another term. The best combination of easy policy and deregulation is probably Jerome Powell, who is favored for the chair position by Treasury Secretary Mnuchin. However, Trump may want a “name” and John Taylor would be the highest profile candidate among those mentioned. Taylor would probably be more hawkish on policy, which the president wouldn’t necessarily like, but he would also favor less regulation. We will be watching for post-meeting comments from the White House.
[Ed. note: we will update the energy recap in tomorrow’s report.]