The OPECoronacession is here

In an attempt to respond to the requests for my views on what is going on with the US  macroeconomy in particular right now, but also in general for the world economy, I have decided to come out of enforced hibernation and put fingertip to keyboard. We certainly live in interesting times, and although we were definitely due a recession, as usual the source of the recession was somewhat of a surprise.

To preview what the basic message is in this blog posting, if anyone is in any doubt that a global recession is occurring, I think you have to study the rather disconcerting facts about the economic impact of both OPEC and this virus, and then even without any statistics it becomes quite obvious that for both the US and UK, and many other parts of the world, a deep recession is now underway.  Quite why the US Treasury Secretary, Steven Mnuchin (see here), thought that the US would avoid a recession, is beyond me.  Some think his forecast was made to keep up morale, but I think that in fact it undermines the credibility of the position of the Treasury Secretary.  I would also note here that soon afterwards, the Treasury Secretary appears to have reversed his views, noting that the US economy could very soon experience an unemployment rate of 20%.

The Corona virus along side human cells

In this blog post, therefore, I want to review what I think could be the economic impacts, and then give my take on what should be done from an economic perspective.

Before we start though, let's get some definitional things sorted out.  First, this is a real "shock" in the proper sense of the word.  Economists use this word "shock" to mean any development or change in conditions that impacts the economy, but it is usually from some kind of change in human behavior or asset bubble.  To be honest I don't think of these changes as "shocks" per se, as they are not really sudden changes that are impacting the economic system, but are rather what I would call a "development" or change in the economic environment.  The OPEC change in policy with regards to oil quotas is a good example of this - there is a change in one sector which ricochets through the economy.  The corona virus, however, is not like just a change in the behavior of certain market participants or an industry with knock on effects; this is a real "shock" in the sense of a wholesale change in economic circumstances with everyone having to adapt to a sudden new environment, with some sectors of the economy closing down entirely, and others seeing booming conditions.

Secondly, the question as to whether this is a supply shock or a demand shock - our macroeconomics is really inadequate in describing what is going on right now, as clearly we have both supply and demand side effects happening, so although I see economists arguing that this is a supply shock rather than a demand shock, this distinction is irrelevant as what we have is a contractionary economic event, both on the supply and demand sides of the economy.  And this also means that the usual textbook monetary policy channel responses are unlikely to help much in stimulating the economy, as both investment and consumer spending is really not dependent on interest rates, and spending opportunities are now quite limited.

Next we need to think about the steps with which this recession is being brought on, and in my own opinion how it might play out.  So first the corona virus rears it's ugly head in China and causes supply problems for US firms due to the fallout in the Chinese economy - oh and incidentally the Chinese economic numbers released last night ( - see here) showed factory output falling by 13.5% during January and February compared with the previous year.  And in addition to statistics on factory output the retail sales figures were down 20% and investment figures were down 25% compared with a year ago.  Now remember here too, that China, as it is a communist country, had a centralized response to the virus, and only locked down one Chinese province (Hubei Province), and so contained the spread.  So just imagine if the virus had caused a complete lockdown of the entire country - and yes, that means that these figures would have been even worse.  Indeed although the Chinese claim to be over the virus and almost fully recovered, this seems quite suspicious to me, and I understand from my contacts in that country that there are still cases arising, but everyone now takes appropriate precautions.

The virus has spread to Europe next, with whole countries on lockdown, with whole swathes of their economies' ground to a halt.  That will surely mean even steeper falls in output in countries like Italy and now France and Germany.  The virus is now definitely spreading in North America too, and that has caused some draconian measures which (as it is now doing in Europe) will cause a collapse in output in certain industries ( - think cruises, tourism and the travel industry, consumer discretionary spending, entertainment and the housing industry). 

The second catalyst for recession in the case of the US is the collapse of the OPEC meeting on March 8th (see here), which caused Saudi Arabia to increase output massively, prompting oil prices to collapse to roughly half of where they were before the OPEC meeting.  This collapse in oil prices, while being good for consumers ( - the US President referred to it as having the same effect as a tax cut), is a real blow to the US fracking industry if these low oil prices persist for any period of time.  Why is this?  Well most fracking wells are not profitable at prices below roughly $40 a barrel, so with prices now down at $22.63, nearly all of the US fracking oil companies will be losing money.  What's more, many of them had bought substantial tracts of land in the heady days when oil was over $100 a barrel, and had borrowed heavily to do so.  So many of these companies are heavily indebted and are unlikely to be able to survive long at these current oil prices - in fact recent reports show that they are already laying off thousands of workers (see here).

The Corona Virus exiting a human cell

So what is happening now with the spread of the virus in North America is that the workers in the oil, transportation, entertainment, tourism and consumer discretionary are being laid off, and hence unemployment is undoubtedly rising, and probably much faster than we realize.  In most locations in the US all bars, clubs, cinemas and restaurants are closed, and in other cities measures are even more draconian.

To gauge the percentage of US GDP that we are talking about here, let us look at US output by sector for 2018 ( - this still hasn't been completed for 2019). For all industries we saw an increase of 6.1% in 2018 over 2017, but of course this is in nominal amounts, so adjusting for inflation, we have to subtract inflation which in 2018 was about 2.3%, which gives us a real output increase of roughly 3.8%, which is obviously a little higher than the 3% real GDP estimate from the BEA due to the fact that GDP subtracts out the items that are intermediate goods ( - goods which are used in the production of something else).
So running down this table we can see that the industries that are at risk are on lines 4, 11, 12, 16 and 24. Now let's make some back of the envelope assumptions and say that we have a similar situation as in 2018 in terms of output amounts.  Let's also assume that we are looking at the first quarter of 2020, so we are only talking about one month out of the whole quarter being subject to this shock.  So let's do some very rough and approximate calculations for the last month (March).

First, mining (which is mostly oil and gas) gets cut in half (-$250m in 2018), retail trade slows by about 25% (-$465.73), transportation and warehousing falls by 25% (-$316.50m), real estate also takes a hit of around 25% (-$1000m) and lastly arts and entertainment and accommodation get cut in half (-$750m).  Note that this does not include any multiplier effects or "knock-on" effects (to other industries) and nor does it include the likely increase in the output of the healthcare sector due to hospital stays.

https://www.bea.gov/system/files/2020-01/gdpind319.pdf Table 8

So when looking at the change in output from 2017 to 2018 this went up by 6.01% in nominal terms. Now if we take off the conservative estimates of the fall in output that would have occurred if the Corona virus had hit the US during that year, we get $2,781m which when subtracted from the 2018 total would give us $33,812.3.  But recall in the first quarter that only the month of March would likely see this fall, so then that gives us about a fall of around $930m.  When you do the calculations as to the nominal growth rate you get about 3.4% which when adjusted for inflation comes out to be roughly 1%, but then taking out the intermediate goods this will bring us down to roughly a stagnant economy with real growth of around 0% in the first quarter.  So my forecast for GDP growth in Q1 is 0% or somewhere close to this.

The 2nd quarter will likely be much worse than the 1st quarter though, and while I don't wish to speculate how bad it will be ( - Goldman Sachs already is forecasting a 24% fall in real GDP), it will definitely put us in recession territory given that it goes on beyond 2 weeks.  But once again let's do a "back of the envelope" extremely rough calculation.  One of the reasons I did not include the multiplier effects for Q1 is that they take time to filter through.  If we assume that this corona virus and OPEC situation persists for the whole of Q2 and that we have a 1.4 multiplier effect on the fall in output then we get approximately $4,000m which then make our change in nominal output -5.5%, but then taking off the inflation rate to get a real rate of growth we end up with -8%, which then taking off roughly another 1% to adjust for intermediate goods gets us to roughly a -10% year over year growth rate.  I would also add that this is also a conservative estimate as it assumes no "knock on" effects so only a limited impact on the sectors of the economy not accounted for above.

Exactly what might be the impact on unemployment of this fall in real GDP growth?  Just to illustrate, according to Okun's law (which is the relationship between unemployment and economic growth, if we see economic growth fall by a total of 13% (the difference between 3% (for last year) and an estimate of Q2 growth of say -10%, that means that (if Okun's law prevails) the unemployment rate would increase by 6.5% from its current level of around 3.5% to 10%, which is the level it reached during the great recession.

Obviously you can do further math which could show things deteriorating much further, but I think you get the picture - at the minimum we are looking at a really sharp recession that, macroeconomically speaking, is at least as bad as the "great recession" of 2008 to 2009, with the likelihood that it could be much worse if this worsens throughout Q2.  Of course if things improve and the viral spread is brought under control quickly as it appears to have been the case in China, then these scenarios brighten considerably. 

Now let's look at the policy responses.

On the monetary side, the Fed has been busy pumping money into the economy by resurrecting some of the tools that it used during the "great recession".  These are summed up here, and they should have the desired effect of safeguarding solvent financial institutions from the negative impact of the corona virus and the fallout from the latest OPEC meeting.  This is important as it provides for lines of credit by financial institutions (such as banks) to their clients, and makes sure that the banks have virtually unlimited funding (from the Fed) to supply this assistance.  Obviously this applies to solvent companies, as even with unlimited backing, few banks are going to want to provide credit to technically insolvent companies. 

Given that both the OPEC and corona virus impacts are not really financial in nature though, but rather are a matter of providing funds to provide a social safety net and to assist industries that are heavily impacted, the burden of response must fall on fiscal policy.  So, on the fiscal side, it is clear that both individuals that are impacted need assistance, and also industries that are impacted might also need and request some kind of government support.  As of writing, the proposals coming out of Congress are essentially "helicopter money", with checks for households, and loans and grants to various industries.  But what is apparent to me is that the government has not seemed to grasp the impact of the quarantining and closing up of businesses that necessitate social interaction, not only on the workers, but also on the firms within the industries.  At the same time, it does seem to me to be incumbent upon the government to learn lessons both from previous recessions and from, for example, the Japanese experience with deflation.  I understand that it is extremely difficult to design a fiscal stimulus package that will address an evolving situation, and obviously anything that Congress passes and which the President signs may have to be tweaked later.  Nevertheless it seems to me that fiscal policy should:

a) provide immediate relief to those suffering hardship from being laid off or from lack of business if self-employed; and
b) provide support for industries that are incapacitated or have severe falloff in customers due to social distancing.

Although the current thinking for a) is that unemployment insurance and 2 checks, proposed by the current Treasury Secretary should be the first step, this is perhaps not the best way to provide assistance, as certainly the checks will not be targeted and will just be presumably to all taxpayers, regardless of income or job security.  Plus one of the problems in just writing a check to citizens is that presumably a secondary important reason for doing so is to stimulate the macroeconomy.  I would suggest that probably a better way of doing this is to provide a debit card to all citizens which would also have an expiration date - that way there would be more certainty that the money is injected into the economy through new spending.  This money could be paid back through paying higher taxes for up to 5 years. Of course some individuals might still claim a debit card only to substitute that debit card spending for their own spending, but I would suggest that this is a better way than just giving individuals a check.

As for support for industries, I would not favor grants, which are one of the current preferred methods of support by the administration.  I would favor small companies receiving loans with low interest rates, and larger companies that are in financial trouble having the ability to issue shares which the government would then purchase (as a secondary issuance).  The cash that companies raise from selling partial ownership to the government would not be permitted to be spent on either share purchases from private citizens or on dividends or increased remuneration of  management.  The idea here is to give support where needed, but at the same time for the taxpayers money to be used in ways such that there is a return on the investment that the government makes in these struggling companies.  And these facilities should not carry a fixed sum, but rather, should be a facility that any company in trouble can tap if required. Of course some of these companies will fail, but at least the government would not be supporting one industry at the expense of another, and would also have a broad portfolio of loans and shares which if properly diversified should yield a decent return for the taxpayer and not end up costing the government a dime.

As Winston Churchill once said: "Never let a good crisis go to waste" and what I fear right now is that our policymakers just do not seem to have the imagination to come up with some new ways of thinking about how to support the macroeconomy without increasing the national debt by an extremely large amount in the long run. 

 
       



 

Happy New Year for 2018!! Economic outlook and investment strategy

Happy New Year to all my Econoblog readers, and readers through the syndication to Seeking Alpha. As usual, I will try and distill my "top down" macro views for prospects for 2018 in terms of economic growth, the stockmarket, and interest rates.

Backdrop

As we enter the 10th year since the last downturn, the global economy is living on borrowed time - and I mean that literally!  As I explored in my last Econoblog posting (see here), the business cycle is elongating, for either temporary or permanent reasons.  My own predilection is for a permanent elongation (mostly due to the findings from my own academic research agenda), but either way, an elongation is now occurring for this phase of the business cycle as we move into 2018.

So the real question is what will perform best as we move into the late stages of the business cycle expansion, and how to hedge the uncertainty of the coming downturn whenever it is. Well there are several different approaches one can take to answering this question, so I will first do a review of what I see are the prospects for the different regions of the world, and then focus in on what I think makes sense for my own investment strategy.

A quick aside. 2017 has been an exceptional year in the stockmarkets, and the performance of the major stockmarkets in the world has been positive almost everywhere. In the US, the S&P 500 was up 19.4%, the DJIA up 25.1% and the Nasdaq up an astounding 28.2%, while the 10 year US government bond yield is still under 3%.  But although the US performed well, many other countries outperformed the US.  The chart below shows the return of different stockmarkets (in US$ terms), and if we use the S&P 500 as probably the best overall barometer for the entire US stockmarkets, then the US is near the bottom of the list in terms of performance for 2017.


Source: Novel Investor

But this also doesn't consider other classes of assets, and the website Novel Investor once again has this covered with a chart that shows that emerging market stockmarkets outperformed all other classes of stocks.  This is due to the fact that emerging market stockmarkets have had a fairly tepid performance throughout this business cycle upswing, so in the late stages of the upswing in growth, obviously this will boost commodity prices for many things, which will allow emerging market stockmarkets to outperform.

Source: Novel Investor

But what of individual emerging markets?  Where performed the best?  Well once again, Novel investor has us covered here too.

Source: NovelInvestor.com

So Poland, China, South Korea and Hungary were the big winners for 2017.  And Pakistan, which several commentators said would perform very well in 2017, was the big loser.  And that really highlights a problem with emerging market economies and individual emerging markets - they are very volatile and it is really a fools game trying to pick which market will be the winner in any particular year.  But there again, that's why anyone interested in investing in emerging markets would be wise to buy an emerging market mutual fund rather than stocks in any individual country.

Back to my thoughts about 2018.  So with the backdrop of the current phase of the business cycle and the fact that US interest rates are likely to rise in 2018, let's look at each region in turn and then devise an economic outlook and investment position for 2018.

North America

The US has had a great run in 2017, but with rising rates, and an erratic President, with the good news for US corporations now delivered in terms of the tax reform, further progress with President Trump's agenda will be difficult.  The President will need cooperation from democrats if he is to pursue his plans to pass an infrastructure spending package, and the impasse on immigration doesn't seem to bode well for cooperation in that or in any other area for that matter.  So I can only conclude that most of the good news for stocks has already now been achieved, and there will be little more coming down the pipeline.  If there is more and I am wrong, then clearly the infrastructure and construction companies will do well.  Given the political uncertainty in the US surrounding the mid-term elections and the ongoing investigations together with rising interest rates and withdrawal of QE, I think the US will underperform compared to other parts of the developed world and certainly with respect to the emerging markets.

I think NAFTA will likely collapse in 2018, which will mean that Mexico is probably not a stable place to invest, but Canada will likely outperform both the US and Mexico, given that the US has made it clear that if NAFTA is terminated, then the US would still be open to falling back to the original CUFTA trade deal that was the precursor to NAFTA.  So in general, I think that Canadian stocks are a safer bet than US stocks for 2018 and should be bought on any signs of weakness.

The other factor that has had very little press so far this year is that yes, we have a new Chair of the Fed, Jay Powell.  As with all Fed Chairs, Jay is likely to have an early stumble or mishap in the job as he finds his feet.  That may unnerve the markets as well.  I would expect that maybe the FOMC might act too aggressively to increase rates than is necessary, or may "fall behind the curve" at some point.  Either way, there are clearly consequences for the stockmarkets here.

The US dollar is also a bit of a conundrum for 2018.  Rising interest rates usually portend a stronger currency, and that's what we have seen so far but with the protectionism proposed by the Trump administration and the possibility that the Chinese may no longer buy so many bonds, that in turn will have an uncertain effect on the currency.  As can be seen from the plot of the trade weighted US dollar, despite the recent depreciation, we are close to all time highs already.  Obviously from international economics that means that the markets have already discounted further rate rises, and are perhaps now looking for reasons not to push the US currency any higher.

Europe

European stockmarkets generally had a great year in 2017, and as QE continues in 2018, it is likely that this will continue at least until the second half of the year.  If you look at the performance of the European stockmarkets in recent years, they nearly all had downturns in 2014 and/or 2015, so they are basically still catching up with the US, and of course the banking sectors in the EU are still fragile but improving as time goes on.  The Mifid2 directive, which was supposed to come into force at the beginning of this year will likely (when implemented in March) increase transparency and efficiency in EU stockmarkets which will tend to increase confidence and spur greater stockmarket returns.

The two areas where there are significant risks are Brexit and Greece.  With Brexit, there is no certainty yet that a trade deal between the UK and the EU will be achieved before the exit date of March 2019.  Although Prime Minister Theresa May has successfully concluded the conditions of the breakup by agreeing to a hefty payment to the EU and safeguarding the right of EU nationals to remain in the UK after March 2019, this does not ensure that a trade deal will be struck in time.  The current policy of "gradual divergence" (see here) does not bode well for a consensus on any new trade deal as the EU does not see this as consistent with having a trade deal that would create a level playing field between the UK and the EU - it is seen as cherry-picking the areas where the UK would not want to diverge for fear of losing business, while having the right to diverge in other areas.  Also the Chancellor, Philip Hammond, who is much more in favor of a "soft" Brexit, has broached the idea of a new customs union with the EU (see here), but this would not allow the UK much independence when negotiating trade deals with other countries as the UK's hands would already be tied in relation to trade policy because of the EU customs union.   The second area of risk remains Greece.  Greece is now experiencing growth again, but the political situation is still not completely stable, as an elections must be called by October 2019, and the current government is unlikely to want to wait that long, so a general election is likely to be called in the second quarter of 2018.  The outcome of the election is likely to determine whether Greece continues to follow the path of fiscal consolidation insisted upon the rest of the EU, or a new government pushes the country in a different direction.

From an investment standpoint probably the Nordic countries are most insulated from these risks, although probably Central and Eastern Europe stockmarkets are still likely to be the most volatile and may yet again outperform the Western and Southern European member states.

Japan

The news from Japan has basically been good in 2017.  The efforts to stimulate the economy using QE appear to be now paying off, with economic growth now positive for the 7th consecutive quarter (see here), but mostly due to external factors rather than domestic growth ( - consumption was still in decline in the last quarter reported).  Nevertheless recent revisions to 3rd quarter GDP suggest that the economy was growing faster than previously thought, which allowed the stockmarket to remain buoyant, but it does mean that without the external demand stimulus and the continuing QE, the economy would likely have experienced only tepid growth.

The Japanese economy therefore does appear to have achieved "escape velocity" which means that deflation is now in the rear view mirror, despite the fact that inflation is still falling short of the Bank of Japan's inflation targets.  This should allow the Japanese stockmarket to make further gains in 2018.  In fact, if correct, a recent FT article (see here) suggests that the labor market is now in a state of severe shortage, which should allow wages to start to rise in a more sustained.  That, in turn, will boost the stockmarket.

Rest of Asia

My views on China are relatively well known after my recent presentation on OBOR (One Belt One Road).  But to recap, I think that China will grow in 2018, but substantially less rapidly than it did in 2017 as OBOR projects take production out of the country ( - remember that GDP only includes production within the borders of a country).  OBOR is clearly long term geopolitical and economic investment project, so it is expected that GDP would slow...GNP, on the other hand, will stay relatively robust.  Anyone who has been to China can attest to the fact that although investment is still high, it is clearly slowing as there is now a substantial amount of "infrastructure slack" in the economy ( - visible in terms of "ghost" trade and logistics inland ports, empty buildings and relatively empty new highways and fast speed trains out in the rural west).  And although consumption is now clearly on display in the major cities, I think that China's next push must be to modernize it's agricultural sector based in the rural areas, and that will not be easy.

As for India, 2017 was quite rocky (what with the monetary reforms and the unpopular new VAT tax), but as long as tinkering with major part of the macroeconomy do not continue under the Modi government, the prospects for an uptick in growth appear quite good.

Africa

The election of Cyril Ramaphosa as ANC Chair and therefore leader of the party, caused a relief rally
in late 2017, and I believe this will continue through 2018, with much more business friendly approaches making an appearance in South Africa and hopefully a more pragmatic approach to achieving the lifting of all boats through more sensible economic policies for the whole economy will start to bear fruit.

Investment Strategy

So given my macroeconomic views detailed above, what does this imply about investment strategy?  I have produced the cyclically adjusted price to earnings ratios (CAPE ratio) for all the countries discussed above in the figure below.  The data ends in November of 2017, so although we are missing one datapoint it is clear that the US has, since early 2016, had the highest CAPE.  That means that the US firms' stockmarket prices were highest compared to their earnings at this stage of the business cycle.  Then comes Japan, which is not far behind.  At the bottom of the CAPE rankings are UK and China, while the countries sandwiched in the middle are India and collectively the European countries. 

Source: http://shiller.barclays.com/SM/12/en/indices/static/historic-ratios.app

But what does that mean then?  I think what it means is that stocks in both China and the UK are valued at roughly half the amount that US and Japanese stocks are.  That in turn tends to suggest that i) if stockmarkets globally continue to climb, it is likely that those with lower CAPEs will grow faster than those with higher CAPEs; and ii) that if there were to be a pullback, the amount of the pullback is likely to be less in both the UK and China simply because those two markets have not climbed to nearly the same levels as have both the US and Japan.

So for an investment strategy based around the viewpoint expressed here, I would suggest:
i) underweight on US and Japanese stocks
ii) overweight on UK and Chinese stocks
iii) some weight in India and European stocks
iv) underweight on US government bond holdings
v) overweight on foreign bonds, particularly of those countries where China might want to substitute  holdings.
vi) overweight on other EM stocks, as these countries try to catch up with the phenomenal pick up in the US stockmarket.

And yes, I have already rearranged my own portfolio to put my proverbial money where my mouth is!

Who will be the next Fed chair?

On the campaign trail, now President Donald Trump made it pretty clear that he wanted Janet Yellen gone as the Chairperson of the Federal Reserve.  Now in a televised speech on Instagram last week (see here), President Trump offered the biggest clue to his intentions by dropping in the word "hopefully" in his wish that "they will do a fantastic job".  That "hopefully" is, in my view, a definite hint that change is on the way, as if he really had another Yellen term in mind he wouldn't have needed that "hopefully" word. As in so many areas with President Trump, he will break precedence if he doesn't reappoint Chairwoman Yellen, as every Fed chair in modern history who has completed a first term has been nominated for a second term.

So now that I believe it is fairly clear that he has signaled that he will replace her, the media has been looking at the candidates that the President has in mind, and focusing on the daily rumors that appear to emanate from the White House about who is in favor.  But the decision is not as easy as you might think, and for two reasons: i) the President has economic growth objectives that many conservative central bankers might see as unlikely and therefore may try and be more hawkish on monetary policy than otherwise would be the case; and ii) the end of the business cycle expansion is approaching, so the President would likely not want a Fed Chair that is inexperienced in the art of central banking.

This is probably the most important appointment that the President will make in his current term of office, as the likelihood of an economic downturn is extremely high, given that we are coming towards the end of the expansionary phase of the business cycle.  Whoever the next Fed chair is will very likely have to cope with a recession, and will have to position the Fed accordingly.

Therefore, in my view, given that Yellen has effectively dropped out of the race, there are really only 3 candidates left in the running. I will deal with each one separately below:

i) Jerome Powell.  Powell is currently on the Fed Board of Governors, so is no stranger to the Fed.  He was appointed to the Board in 2012 and is a card-carrying Republican as well as a multimillionaire having worked at the Carlyle Group.  He is moderate when it comes to monetary policy views but is not an economist, which may be seen by some as a weakness.  Nevertheless he clearly understands monetary policy well, but may not be the right guy for the job if the economy has another severe recession in the next 4 years.

ii) Kevin Warsh.  Warsh was first appointed an economic advisor at the White House in 2002, and then from 2006 to 2011 Warsh served as a Fed governor, but then resigned to join the Hoover Institution where he is currently employed.  He has been a frequent critic of the Fed, and there are already a website that has been established to lobby against his appointment (see here).  He is definitely seen as more of a hawk, and the consensus is that monetary policy would likely be on a tighter trajectory. He was trained as an economist, so that is a plus, but on the other hand many of his predictions when he was previously employed at the Fed (such as higher inflation if the Fed maintained QE) have not transpired, which doesn't give the markets much confidence in his judgment.

iii) Professor John Taylor, is the only distinguished economics professor among the  candidates. He is the author of the so-called "Taylor rule" which was an effort to use a rule-based setting of monetary policy for modelling purposes.  Taylor was at the US Treasury during the George W. Bush administration and served at the White House under Presidents Carter and Ford.  Through his comments on the maintenance of QE, the markets view him as somewhat hawkish, and the media believes that a Taylor appointment would "spook" the markets.

So what is the perception of the odds for each of these candidates?  The website "Predictit" (see here), has odds based on actual bets, and as of Nov 1st at 11.30am, the odds currently are:

So what is my assessment?  For me this comes in 3 parts - i) who will Trump choose and ii) who would be the best choice in my assessment; and iii) who would actually be best for stockmarket gains?  Let's deal with each in turn.

First, who do I think Trump will choose?  It seems that the President has changed his mind almost daily, so although the latest anonymous leak from the White House stating that Powell is the favorite (see here), I doubt this will be sustained until the announcement.  My belief is that Trump will want to go with an economist and someone who will shake things up at the Fed, as he will want to please his base and also impress other Republicans on Capitol Hill.  So my guess is that Trump will go with Taylor as long as he has Taylor's assurances that he will not enact a rules based policy as this would tend to raise rates faster than would be the case with the other candidates and might then derail the so-called "Trump rally" and spook the markets.  Of course if a Taylor appointment is made, then the markets might still be temporarily spooked until they can get reassurance during the Senate confirmation process.

Second, who do I think would be the best choice for the top job at the Fed?  I believe that continuity is important here, and that likely another Yellen term would actually be best for the country as a whole, as Yellen is already acting on "normalizing" Fed policy, but is doing so at a cautious rate that allows for economic growth to be sustained going forward.

Third, who would be the best choice for the markets?  I think the markets, as the polls show, would prefer Powell, as he possesses the element of continuity, but at the same time is a little more "light touch" on financial regulation than Yellen.

What is almost certain though is that whoever takes over at the Fed (unless it is a Yellen reappointment) will change Fed policy going forward, and that will undoubtedly impact the bond markets and perhaps the pace of interest rate hikes and the withdrawal of the QE stimulus, with its attendant effects on economic growth.  

Lions who have lost their roar? The Fed's monetary policy "normalization"

Anyone watching Janet Yellen's announcement back in September (see the statement here) that US interest rates were going to remain on hold (0-0.25% target range for the Fed funds rate back then) could have been mistaken that they were living in some kind of parallel universe.  Why would the Fed be concerned about “international developments” as a reason to hold off hiking rates?  Why did the Fed appear not to be worried about the possibility of not having any ammunition to fight future economic downturns, despite the fact that it is fairly well recognized that these downturns happen every 8-12 years?  Monetary policy has been in emergency mode for 9 years, and the Fed has refused to start to properly "normalize" monetary policy, despite the fact that the US is likely entering the late stages of the business cycle, and despite the fact that most of the US economic indicators had been showing fairly robust growth for quite a while.

Despite the fact that the US economy has been on a decent economic growth trajectory for several years now, the Fed appears to have been incredibly reluctant to raise rates, as though interest rate hikes would somehow cause a dramatic weakening of economic growth.  As one market commentator put it (and I paraphrase here), "the patient is still in the intensive care unit, although he's smiling, eating candies and watching TV".  In other words, by now, the patient should no longer be in intensive care, and perhaps not even hospitalized! 

So there was little economic justification then for the December rate hike announced last Wednesday (Dec 16^th) – the economic data releases are signaling an even weaker US manufacturing sector than we had in September, corporate profit growth has turned negative, and the housing sector has not taken off as might have been expected in such a low interest rate environment, particularly when the expectation of higher rates was fairly widespread.  So although most market commentators focused on the mechanics of the hike, and the new monetary policy tools that have been put in place, I really don’t think that that was the point of the hike – the Fed had signaled that it wanted a hike in 2015 and after delaying for all sorts of (what turned out to be spurious) reasons, it would have taken some pretty tortured reasoning not to raise rates in December after such a hike had been telegraphed for so long.

But that is the problem with the Fed policy right now – they have fallen behind the curve in terms of the normalization of monetary policy, and they do not appear to know how best to normalize policy in a world where monetary policy is now diverging (ECB and Bank of Japan loosening, Fed tightening) with the consequent negative effects on economic growth from deteriorating exports as the US dollar appreciates, and lackluster US economic growth. 

One aspect of the normalization is not being talked about much in the media – the fact that when loosening monetary policy the Fed lowered rates first and then enacted QE – but very little QE withdrawal has occurred and yet the Fed has raised rates again. Clearly the Fed has decided that interest rates are a better signal to markets in the event that there is a future economic downturn, but nevertheless the withdrawal of QE needs to occur before we have policy normalization.  I think it is fairly clear that full normalization will therefore not be achieved before the next economic downturn, given that the business cycle has a periodicity of about 8-10 years. 

In terms of the yield curve then, we are seeing flattening in the curve, as short rates have moved up, but long rates have moved up much less in the wake of the rate hike.  Any further rate hikes will further flatten the yield curve and may even invert it, which of course the Fed would likely want to avoid.  So there clearly is an expectation by the Fed that recent wage pressures will feed into higher levels of inflation – something that we have yet to observe.

In a way, the December rate hike publicly acknowledged that the Fed should have raised rates earlier, and that the Fed now realizes it needs to play “catch up” if certain sectors in the economy are not going to overheat, and to ensure that there is some ammunition available if we have an economic downturn in the next couple of years.  If anyone had any doubts about this, it could be deduced from the press release – the “dot plots” showing Fed expectations that rates will be raised four times in 2016 – this is clearly way out of line with Wall Street analyst expectations that only 2 rate hikes would occur.  Some analysts were puzzled that this was “hawkish” and not consistent with the “dovish” nature of Yellen’s announcement, but I think they missed the point here.

In an opinion piece published some time ago in the FT, Andrew Sentance (see here) made the point that the Fed was "falling behind the curve" in raising rates so as to return to a more normal monetary stance.  I would take that one step further - the Fed is now still seriously behind the curve in terms of rate normalization, as it should have started raising rates back in 2014 – we should be at around the 3rd rate hike in my opinion.

One interesting thing that I did hear last week was a comment by Jean-Claude Trichet that the US is in the late stage of its business cycle, but that the euro area and Japan are still mid-way through their business cycle.  But that implies that there is now not just divergence in terms of central bank monetary policy, but also “de-coupling” of business cycles between the US, Europe and Japan. This is an interesting conjecture, and I am now working on a future blog which explores this idea.

Next blog though will be my annual look at investment ideas for 2016!


Happy Christmas to all my blog readers!

Fed Policy: Do Two Wrongs Make A Right?

Deciding on monetary policy is not an easy task.  It requires an acute sense of economic wisdom in reading the signs that the economic data throws out, and also an actor's skill and sense of timing to ensure that the words are delivered in exactly the right form at the right time. The Fed has a monumental decision to take this week - whether to raise rates for the first time since July of 2006. That is over 9 years ago, and reflects how serious the last recession (or "great recession" as it's now called) was, not only in terms of it's initial depth, but also because of the way the recession was initiated (through the housing and financial sectors), through the consequent sluggish recovery.

But I think some in the media are under certain misconceptions about monetary policy.  Monetary policy is undoubtedly "abnormal" at the moment, with no real ability to lower rates if we go into another recession, and righting this "abnormality" is probably the strongest argument for lifting rates right now, as there doesn't appear to be any inflationary pressures on the horizon.  At least that is the official line I hear in the media, but more on this later.

Source: New York Times

The two strongest reasons I hear that the Fed shouldn't raise rates (see Larry Summers's FT blog outlining why he thinks the Fed should not raise rates now) are that US inflation rate (measured by CPI or PCE measures) is still under the Fed's 2% target, and that although the US labour market has recovered, the lower participation rate and stagnant wages still point to persistent weakness.  Add to this the new "emerging markets" Quantitative tightening argument made yesterday quite forcibly by Gavyn Davies in the FT (see here)

But when I read both Larry Summers's and Gavyn Davies's arguments, they seem rather weak to me, and for the following reasons:

i) "Normalization" is important.  As a central bank, the main instrument that the Fed has is interest rates. Using QE was an experiment, an experiment that other central banks are now using, but where there is considerable and continuing discussion regarding the effectiveness of this relatively new policy.  As we are now nearing the end of the current business cycle ( - business cycles typically have length of 4 to 10 years), the Fed needs to put some real teeth back into it's monetary policy instruments so that it has the ability to effectively ease if and when another sizable downturn occurs.

ii) Inflation.  Inflation is currently low basically because of the role of lower oil prices in bringing down input prices throughout most of the economy.  But once crude oil prices begin to rise again, which they inevitably will, the distortion of such a large fall in oil prices will work in the opposite direction - it will tend to bias inflation upwards rather than downwards.  Now although we do not know the full effect of lower oil prices on inflation, the Fed is using the measure of prices minus food and energy, which only takes out the direct effect of volatile energy prices, and not the further effect of energy prices as an input into the production of other goods and services.  So my point here is that inflation, even measured without food and energy prices, is still downwardly biased. A better indicator is probably wages, and they are increasing now at a 2.5% year over year rate (average weekly earnings on private nonfarm payrolls).  That implies that indeed we now are looking at some inflation in the system with the likelihood that even if current inflation levels are subdued, the actual future inflation rate is likely to incorporate these cost increases, and so inflation should be on an upward medium term trajectory.

Source: http://blogs.ft.com/gavyndavies/2015/09/13/will-emerging-economies-cause-global-quantitative-tightening/

iii) External factors.  The Fed does not set monetary policy on the basis of economic conditions external to the US.  Nevertheless, that has not stopped institutions like the IMF, the central bank of India, and other central banks from weighing in to urge the Fed not to raise rates in September.  Indeed, the sales of dollar reserves in the form of US government bonds has led to a tightening of interest rates which, as Gavyn Davies has pointed out in the FT, is an implicit tightening of policy in the medium term bond yields (around 10 years).  The figure on the right shows this trend, and indeed from a global perspective this trend is sufficiently large as to potentially swamp injections of liguidity through QE from both the ECB and the Bank of Japan. But I would argue that this is not relevant to the US - the US has to set monetary policy according to the economic and financial conditions in the US, and not elsewhere.  If the Fed starts to take these kinds of factors into account, then the Fed will no longer be setting US monetary policy - instead it will be setting global monetary policy, and this is not in it's mandate.

So to end this blog posting I want to make the case that 2 "wrongs" don't make a "right".  The Fed was wrong not to go in 2014 when it clearly had the chance to start the "normalization" process earlier in the growth phase of the business cycle.  For the reasons I have outlined above it would also be wrong not to increase rates now at the September meeting as well.  And yet there are still some commentators who suggest that it would be right not to raise rates this week.  My own assessment of the situation would be that the Fed would be falling seriously "behind the curve" on normalization of monetary policy, which could have extremely negative effects in 2016 or 2017 if and when the next recession arrives. Now the response to the points outlined here would undoubtedly be "but we could always do a QE4" - but no central bank really wants to extend the exceptional circumstances further unless absolutely necessary, and it would be a massive mistake if the Fed were to assume that the US economy could be effectively protected solely by a QE4. That would be like waging a battle with only air cover, and no infantry!

The US economy in 2015: Punch drunk, great DJ, but where is the Exit?

Fed Chairman William McChesney Martin once said  ( - apparently in a speech in 1955, and I paraphrase here), that that whole point of monetary policy should be to remove the punch bowl just as the party gets started". In the spirit of Christmas panto, and to continue the analogy, the drinks are now pretty strong (maybe shots?), and what's more, a talented DJ has just arrived and (s)he seems to really be dropping some great tunes and the party is beginning to look like it will roar!

The really interesting part to this story though, is what happens next? Does the host suddenly decide to hide the punch bowl and threaten to call the police to really put the dampers on things; or does the DJ run out of interesting tunes to drop because (s)he only brought a limited number of tunes; or is the DJ so good that it gets the neighbors involved to really spread the joy and make the whole party rock, with the distinct possibility that the police will show up in force, but only much later?

Those of you who know some economics will recognize the characters here: the DJ is the price of oil, the police represent inflation and the host is the central bank, with the punch bowl being accommodative monetary policy.  We all know that all 3 ingredients make the best parties - good drinks, often supplied by the host, no likelihood of police presence (perhaps because the neighbors are compliant and/or fun loving people) and a good selection of music to really get people in the right mood.

Now the economics.  OK, the precipitous fall in oil prices is good for most countries, and is even moderately good for the US, although it will definitely deliver some pain in some regions (like my own - South Texas).  But after watching an interview by the illustrious Simon Hobbs on CNBC, where he talked about signals that we are approaching the “end of the cycle” I got to thinking about whether Simon was correct, and whether the current oil price decline might soon sow the seeds of the end of the growth phase of the current business cycle.

So let’s look at some stylized facts:

i)   Business cycles typically last between 4 and 10 years;

ii) When the previous recession had, as it’s proximate cause the banking sector, research (by Reinhart and Rogoff) shows that the recovery is anemic;

iii) Central banks are pretty much exclusively focused on inflation and inflation targeting plus slack in the labor market these days; and

iv) Oil price rises tend to slow economies down.
So let’s see where we are on each of these stylized facts. 

First, given that these 4-10 year periodicities are roughly right, and I see no reason to believe that they are not, then as we recently passed the 5 year mark of the emergence from recession, we are definitely in the mid-stage if not heading into the late stage of the business cycle.

Second, the recovery from the previous downturn has been anemic, as anticipated, but this is partly due to the very tight restrictions on bank lending – these are now being relaxed, plus although the housing sector has not been wonderful of late, there are now signs that people are trying to move before the Fed increases rates sometime in 2015. Fanny Mae and Freddie Mac just announced a loosening of these lending standards, and the banks are already beginning to try to get better returns on their balance sheets.  

Third, central banks are expected to keep interest rates low for an extended period of time, principally because with falling oil prices inflation is not perceived to be a threat, at least if measured by core inflation, which excludes the effects of the volatile food and energy components of the CPI.  But in the US, the focus has been on the labor market and unemployment in particular.  So this points to a lagged reaction to accelerating economic growth by the Federal Reserve, and in other countries such as the UK and Canada as well.  Put another way, it means that the punch bowl might have been emptied but it has still not been removed, now that the party has got going.   Articles in the FT such as this obviously support this idea, and will likely bring forward some house purchases, while at the same time gearing investors up for a rapid rise in rates..

The figure below shows the current dislocation very clearly.  3 month T-bill yields are still almost zero, and yet growth is now above 2 percent. To state the obvious: in every business cycle except the current one, by this stage of the cycle interest rates have been higher.  

Fourth, when oil prices finally go up, they could rise just as fast as they have declined – and the fall in oil prices over the last few months has been dramatic (and the fall is likely not over yet). So if one believes that oil prices will first fall, because of lack of agreement on a coherent strategy in OPEC, then it stands to reason that at some point shale oil projects in the US will get taken offline as they will not be profitable at these low prices, and therefore supply will shrink to meet demand.  But at the same time, and no one really is talking about this aspect of things, lower oil prices mean greater demand for oil.  So in fact, although I would be surprised to see oil prices fall below $45, it would not be completely out of the question, as supply needs to shrink at the same time as plans in other industries reacts to the lower oil prices, stimulating demand. 

The point here is that at some point oil prices could suddenly start to rise again, if for example OPEC suddenly agreed on a strategy to restrict output or if oil prices fell so low that they “overshoot” their new equilibrium value. In a way, this isn’t a bad thing, as the shale oil boom in the US has really gone too far, with drillers just everywhere in my part of the world – airborne pollution now a problem as well, and very little infrastructure to deal with the shipping and refining of these natural resource products.  So, as Schumpeter would say, some “creative destruction” is probably in order here, and lower prices will begin to better align oil demand with supply.  As of Friday, WTI oil closed at just about $63, so if this fall continues, some oil companies will soon definitely be cancelling future projects.

The chart below from BP shows some analysis of what we can expect in terms of the continuing fall in the oil price and how this will translate into lower upstream costs (the cost of oil exploration) down the road. The left panel shows where we are in terms of the fall in oil prices compared to previous rapid oil price declines. Previous declines have settled at anywhere between 50 and 70% declines, so we likely have further to fall yet until some kind of equilibrium is reached.  The period for oil prices to start rising again ranges from 5 months to 16 months, so we could be looking at lower oil prices persisting for a considerable amount of time. The right panel shows that in terms of costs, there appears to be a one year lag before costs fully reflect the fall in the oil price, as projects are cancelled and oil exploration is focuses on more certain and cheaper sources of oil.

How does this situation then potentially set us up for the next recession?  The problem here is that the fall in oil prices effectively stimulates the economy (like a good DJ can stimulate a party), by giving people more disposable income to spend, as filling their fuel tanks becomes a lot less expensive. At the same time, this accelerating growth will not show up as a problem at the Fed and at other central banks, as it gets excluded from their core measures of inflation, and they are still focused on labor market indicators (which are lagging indicators of economic growth).  So the Fed will likely be “behind the curve” when it comes to raising rates, something I believe we are already seeing, as they keep on pushing higher rates further into 2015.  

Moreover, given where government bond yields are, the Fed also appears to be very slow off the mark in terms of reversing QE – yields went up slightly when the bumper labor market statistics were released on  Friday Dec 5th, but came down again very quickly with a few other lackluster economic releases.  Market participants appeared somewhat surprised that bond yields had reacted so little – that in turn tells me that the Fed isn’t selling its bond holdings in any significant numbers, which is something I find quite alarming.

So that sets the stage for a medium term “foot on the accelerator pedal” to really boost growth in the oil dependent countries – notably the North American and European economies. The real problem occurs though when oil prices go back up. This will immediately slow growth, presumably when interest rates are higher, and the central bank meanwhile will be in no mood to be accommodative, as they will be busy trying to “normalize” monetary policy so as to fight any upcoming recession.  This situation though could be the trigger which causes the next economic downturn to occur.  To use the punch bowl analogy once again, this could create a great party, but the hangover could be serious, particularly if the party gets out of hand! 

March Madness, then April Fools, and they didn't go away in May!!

So spring is now over in South Texas as temperatures head back into the 90s and 100s after a colder than usual winter.  But of course the transition from winter to summer is punctuated with March Madness and then the foolishness of April, before the academics and market participants traditionally "go away in May".  This March and April have been particularly crazy, what with more cold weather in March and April, and some really eye popping things going on in the real economy as well as the financial markets.  With bond yields heading lower for no apparent sane reason, I was thinking that this must be an extended bout of March madness and April fools, and that things will correct themselves in May, but alas things have now started to get completely out of hand.

US PPI food (mom): Source BLS

US PPI (yoy): Source BLS

Any economist looking at the PPI numbers released last week for April (see http://www.bls.gov/ppi/ for a breakdown) would interpret this as an uptick in inflation.  The chart taken directly from the BLS website below for year over year producer price inflation shows this.  But what is more surprising is that the food component of the index appears to be definitely showing a spike upwards.  The next chart shows this for the food component of PPI on a month over month basis (2.1%), which comes in at a 5.2% year over year rate.  Now I don't know about you, but I tend to have to eat food, and so this will likely feed through (sorry about the pun) into the CPI pretty quickly, and will affect a whole bunch of things, including supermarket prices, eating out, cruise prices, and anything where food is involved.  

Source: US Treasury website

Now given this, I would have thought that bond yields would have "popped" as a signal (albeit not completely confirmed) that the PPI increases would be a pre-cursor to higher inflation and therefore a quicker move to monetary policy tightening.  But no, bond yields didn't increase, or stay constant, they moved sharply lower. The figure below shows how at the longer end bond yields definitely moved in a downwards direction, while short rates still appear to be anchored at almost zero by Fed monetary policy. This is fast becoming unsustainable as we shift gears to a more growth-inflationary environment. Anyone who has booked an airline ticket, bought a vehicle or been to a supermarket lately knows that prices are definitely moving up as the economy firms.

Now there are some economists who seem to think that the negative Q1 US GDP figures (-1% quarter over quarter at an annual rate) point to an economy teetering on recession or at least in a slowdown or holding pattern.  I think they are dead wrong.  Why?  Well first the way in which the US measures it's economic growth is strange to say the least. I know that -1% shrinkage in the US economy sounds bad, but this is simply due to the compounding of what was a bad weather related quarter.  A more sensible way (which most other countries use) to measure economic growth is to use the year over year change in real GDP.  If we do this, we find that real GDP increased by 2.05 percent - which is not exactly a roaring economy, but it is not bad at all.  Second, with strange weather patterns, it becomes really hard to work out the seasonal adjustments that should be done on the data.  If you use a quarter on quarter measure to assess economic growth, then you have to do seasonal adjustment and any errors are then compounded when you multiply up the figure to an annualized rate.  Using a year over year rate obviates all those problems as you don't have to worry about seasonal adjustment as you are comparing figures from the same season of the year.  

So to the left I have plotted the log change in real US GDP ( - this is just the same as doing a % yoy change calculation).  It is clear that even with the really bad weather that the US economy experienced in the 1st quarter, that the economy is humming along, and in year over year terms, the rate is roughly in line with what we've been seeing for the past couple of years.  

But of course, this means that without the bad weather, the year over year rate might have been significantly higher, perhaps a full 0.5% higher, in which case the economy in fact would have been expanding at it's fastest rate since the last recession ended.  

Now if my view is right, the Fed must be starting to get worried that what it is (not) doing is being misinterpreted as a signal to the markets that it will not move if inflation really does start to move higher as it looks to be doing right now.  When I hear Janet Yellen stating that interest rates will remain low for the next 5 to 8 years, I think some in the market interpret this as easy money for the next 5 years at least, but what they don't seem to understand is that the economy is cyclical. 5 years have now passed since the end of the last recession, so that as we move forward over the next 3 years another downturn becomes more and more likely. In other words, given the history of business cycles we are likely already more than half way through the current growth phase of the business cycle. The Fed therefore will likely have to move fast in order to "normalize" monetary policy so it can be prepared for the next economic downturn.  And in that last sentence you notice that I am not saying "if" it comes - no, it will come alright, and in my next econoblog I will show how some of the research that I am doing looks at these cycles in growth highlights the continuing fluctuations in growth patterns and how they can be interpreted as following a cyclical pattern.

Why is the Fed ignoring a "differentiated taper"?

“I believe I am a sensible central banker and these are unusual times” - Janet Yellen, Testimony before Congress, February 11th, 2014.

In watching Janet Yellen's Testimony before Congress in February, and in reading Edward Luce's excellent commentary on the Fed in the FT (see here), it struck me that although Janet Yellen appears to be boxed in in terms of having an appropriate policy tool to get us out of the apparent slow growth US economy we now find ourselves in (see here for the latest Larry Summers opine about secular deflation), she is not.  And I'm not referring to "forward guidance" as the appropriate policy tool ( - a tool which I think has been ridiculous and based on flawed thinking).

As usual with these things, the answer is staring her right in the face.  Yes, the taper itself offers up the solution.  How?  Well in one of my previous blogs I outlined one exit strategy (see here) that I thought might be appropriate for the Fed to adopt. Although the Fed is currently reducing the purchases of both T Bills and mortgage backed securities (MBSs) at equal rates by $5bn each to $35bn of Treasuries and $30bn of MBSs (as most recently announced by the Fed on March 19th in the Fed's press release), this doesn't make too much sense to me in the current climate.

Why is this?  First, the Federal government Treasury interest rates really need to rise, and to be honest the Fed should be selling Treasuries right now, and certainly not buying anymore, given their recent (unwarranted) rally.

Second, the Federal government purchases were a way of stimulating the economy in two ways during the Federal government's economic stimulus a couple of years back - that is now not necessary as the stimulus is over and if anything the government deficit is rapidly shrinking. The chart below shows the US government budget deficit over the last decade, and we are now below the levels of deficits in terms of % of GDP that we experienced in the last major recessions, and more to the point, the trend line looks promising in terms of where we are going.

Third, with enough geopolitical risks in the rest of the world, I think it is safe to say that US Treasuries have enough demand support to weather a withdrawal of Fed support, so these purchases are really not optimal in terms of the objectives of monetary policy.

So I would argue that the Fed should heavily cut back on its purchases of US Treasuries while at the same time continuing to stimulate the housing market through purchases of MBSs.  I am calling this a "differentiated taper" as instead of just cutting purchases of both US Treasuries and MBSs, we can lower the overall amount of purchases while at the same time having a differential effect on the markets for each type of security.

Why is the concept of a "differentiated taper" important?  The reason why is that purchases of MBSs have an indirect impact on the housing market, as it lowers mortgage rates, thereby stimulating the construction of new housing.  Specifically, it should stimulate the employment of both blue and white collar workers in the construction industry, as more housing construction equals more hiring of architects, builders, contractors and subcontractors. What does purchases of government Treasury securities get us?  Lower borrowing rates for government, that's for sure, but not much else. Certainly there is no stimulus to the job market there right now as the government is cutting back on spending to move towards a balanced budget.

So if I were working at the Fed right now I would at the least be recommending a "differential taper" with an increase in purchases of MBSs of around $10bn, and a reduction in purchases of Treasuries by the Fed of around $20bn. This still balances out to a "taper" of $10bn, but it is differentiated, by stimulating the housing market, while allowing a longer term correction to the yield curve, a correction in my view that is now sorely needed.  

2014 and the Business Cycle: Continuing Recovery and Another Year of Opportunity in the Stockmarkets?

First off, Happy New Year to all my Econoblog readers.  If you want a review of 2013, rather than rabbittng on here, I thought I would just point you to a wonderful article in The Atlantic on the Most Important Economic Trends in 2013 which you can find here. In this Econoblog I want to look ahead to what might happen in 2014, as some eminent economists have been doing at the most recent American Economics Association meeting..

As the business cycle is now in heading into the later part of the cycle, with the danger of recession and deflation receding, most countries will experience accelerating growth this year.  Although markets are jittery about the Fed’s signal to taper monetary policy, this is long overdue in my view, and will only have a marginal effect on economic growth in the US and other developing countries.  The economic process of re-invigorating the economy through stimulus has now done its magic, and in North America, Europe and now Japan, the growth dynamic has started to take on a life of its own, so that the agents of stimulus can now withdraw their assistance as a catalyst for economic growth.

So there are 2 further issues here – first, how will economic growth be distributed among the developed countries, and second, given what is going on in the developed world, what are the prospects for the developing countries.

Although the consensus is almost uniformally positive for the US for 2014, it is still probably the most uncertain country in the developing world to forecast for 2014, as there are so many factors that might impinge upon economic growth rates. The most notable are fiscal matters and the political problems in Congress, the ongoing taper, and when the actual tightening of monetary policy will begin, how movements in long term interest rates will impact the housing market and also lastly, how the dollar will behave during the upcoming year.  If the current truce in Congress yields more bi-partisan consensus on how to move ahead in other contentious areas (such as immigration reform, for example), then this could boost growth as confidence is at least partially restored in the US political process.  Given a brighter fiscal outlook, this would mean that Fed purchases of government bonds could be slowed much more quickly than Mortgage backed securities (MBS), which would allow a residual boost to the housing market rather than propping up a shaky Federal government credit rating. Longer term interest rates are key in determining the course of mortgage rates, and if the Fed keeps these low enough for long enough, the housing market could really boom, setting off a real investment boom in the rest of the economy.  Of course everything could go the other way as well, leading to a further downgrade in the credit rating of US debt, a Fed that ends up having to reverse the taper because of a sagging labor market, and a housing market that experiences a bubble because of prices rising too far too fast. 

In my view, the history of economic cycles points to a positive future though for the US, and although some of the shorter term cyclical effects will be present, the dominant longer term cyclical features will push the US forward without any major internal economic dislocations, leading to another good year for both the housing and stock markets.  This of course implies another bad year for the bond market with yields moving upwards to levels more typically associated with this stage of the business cycle.

But perhaps the best opportunities in North America lie not in the US, but in Canada.  The Canadian market has been extremely stable through the recent turmoil and the Canadian stockmarket has really not shown much of a return compared with its US counterpart, which in my opinion is almost counter-intuitive, but is probably based on the perception that Canada has an economy based much more on commodities than the US does.  Nevertheless, in my view the Canadian market still has much less downside risk that the US market does, and much more upside.

Japan and the EU have less potential for growth as demographic factors restrain both entities. The fact that Abenomics seems to continue to deliver the goods will push Japanese markets higher and lead to the deflationary threat receding.  In the EU the resurgence of the northern member states will continue and the Southern member states will start to emerge from the difficult deflationary period they have been in. 

The biggest risks, but also the biggest rewards in 2014, lie in the developing world.  Developing country markets were rocked by the initial announcement of a taper, but now that the ongoing taper and then tightening has been priced into the markets the real effects on the developing markets should be apparent. As monetary tightening occurs in the US, so the liquidity glut will start to disappear, putting some pressure on developing countries.  Now the big question is, how big will the impact be on countries like the BRICSA countries.  Brazil should be cushioned by the massive infrastructure spending going on there for the Olympics and the World Cup, while Russia really is not dependent on the stimulus as it is natural resource prices that really drive the Russian market.  South Africa is certainly not a large holder of US bonds so the taper will likely have minimal effects on that country.  No, the biggest risk is in both China and India, where both countries have a significant interest in holdings of US debt. 

Given the negative announcement effect of the Fed’s taper, I believe that possibly the best performing markets will be in Canada, parts of Latin America, Africa and parts of Europe next year. Now I have put my neck on the line, let's see what happens!