The Worldwide Slowdown
An image of some red risk dice
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The world’s slowdown continues. China’s growth rate is the slowest in years. Exports there are down as are imports, and pork prices (their protein staple) are up 40% due to swine flu. India, formerly the fastest growing economy in the world, had their manufacturing sector grow +0.6% (stagnation for them and the slowest growth since 2012), and auto sales there are down 41% from year ago levels (hard to believe!). In the world’s third largest economy, Japan, exports are down -8.2% Y/Y in August (negative for nine months in a row) and down -12.1% to China. We see similar data out of So. Korea.
In addition, to make uncertainty worse, Japan and Korea are at each other’s throats over World War II issues (is anyone still alive from that conflict?)! On a year over year comparative basis, Korea’s exports have fallen -13.5%, with exports to China down -21.3%. Data from South/Latin America are no better. Venezuela is a basket case, and Argentina technically defaulted on its sovereign debt in August. The central bank there just raised its short-term rate to 78% (from 58%)! Brazil’s economy is still near recession, and Mexico’s is flat as a pancake in 2019. Australia’s latest jobs numbers are worrisome (job growth was all part-timers), and New Zealand’s Q2 GDP (+2.1%) is a six-year low. Europe is certainly already in recession, with German industrial production and sentiment contracting, and the European Central Bank now embarking on a new Quantitative Easing (QE) program.
Oh, did I mention Brexit and the failure of Boris Johnson to get any movement toward a negotiated withdrawal? And, what about the drone strike on Saudi’s oil production facilities. Think higher oil prices will impact consumers (worldwide)? And, now that it is known that the Saudi oil facilities are vulnerable to further attacks, how does this calm uncertainty? Then, the Chinese negotiating team walked away from their visit to U.S. Ag territory and the equity markets tanked on Friday with interest rates diving 5 basis points (.05 percentage points). The trade war story simply won’t quit and adds to uncertainty and market volatility every time the hoped-for trade resolution is dashed.
The U.S. Is Not An Island
So, even though the U.S. economy appears to be the strongest of all in the first world, the U.S. isn’t an isolated island. Even Jay Powell (Fed Chairman) admitted this in his press conference last week. Worldwide weakness, to date, has already impacted U.S. exports and the manufacturing sector. I’ve commented in earlier writings about how uncertainty has a large negative impact on capex spending and on business optimism. A recent Fed paper (“Does Trade Policy Uncertainty Affect Global Economic Activity?”) found that GDP has been impacted, so far, by -0.8% and capex by -2.0%. In another recent survey, the Atlanta Fed found that due to uncertainty, 67% of the firms surveyed put their capex budgets “under review,” 22% of them actually postponed their capex spending, and 9% had dropped their capex projects altogether. That’s quite a response!
The N.Y. Fed’s Empire State Manufacturing Survey for September showed up as +2.0 vs. +4.8 last month. This survey averages +11.3 during economic expansions. All the following sub-indexes were significantly lower: New Orders, Unfilled Orders (in contraction now for four months in a row); Capex Plans, Hiring Plans, Shipments, and the Outlook for Business Six Months Hence (this one registered the third lowest reading since the recession). The Business Roundtable’s (200 CEOs) Business Confidence Index fell to 79.2 in Q3 from 89.5 in Q2. Plans for sales, capex and employment all fell.
Earnings
Fed Ex, which has historically been a bell-weather for U.S. economic activity, missed badly on both the top and bottom lines (partly due to the loss of the Amazon contract). The company reported that world trade volumes in 2019 had contracted for the first time in 10 years. As mentioned in past writings, Q3 S&P 500 earnings are expected to be -3.6% Y/Y, the third quarter in a row of lower earnings. Some call that an earnings recession. I’ve also mentioned in the past that the transportation indexes have turned down dramatically. Need I say more?
Something Positive (Sort-Of)
Of course, there is always some positive data. Housing starts rose a huge +12.3% in August, most of it in multi-family (there was some increase in single-family, too). It appears that lower interest rates have finally had a positive impact in this sector which has been sinking all year. Building permits were also up substantially. Not to throw cold water on this, but the question is, since home (and auto) buying intentions in both the University of Michigan’s and The Conference Board’s sentiment surveys have turned dramatically lower of late, who will be buying those new homes once they are produced and ready for sale a year from now?
Other positive data included a rise in U.S. industrial production in August (+0.65%) from July and an increase in capacity utilization to 77.88% from 77.51%.
The Fed Lowers
This past week, the markets got hit with more uncertainty. It was Fed week, and the Fed’s interest rate decision was exactly as expected, a 25-basis point (0.25 percentage points) reduction in the Fed Fund’s rate, with Powell dubbing the reduction as a “mid-course correction.” There were three dissenting votes on the Federal Open Market Committee (FOMC), the Fed’s rate setting arm. Two of them wanted to stand pat and not lower (George of the KC Fed and Rosengren of Boston who worries about asset price bubbles caused by sinking interest rates), and one (Bullard of St. Louis) to lower 50 basis points instead of 25 (Bullard is worried about a recession). The markets, for a time, sold-off dramatically when the “dot plots” were released. The dot-plots are the individual FOMC member interest rate forecasts. This set of data implied that the FOMC members aren’t pricing in any additional rate cuts this year. Powell, however, tried to alleviate any anxiety over the dot-plots by indicating that the Fed would closely monitor the situation and act as appropriate to any developing trends.
Developing Liquidity Issues
Still, at the end of the day, the markets ended on a positive note, not because of Fed action, but because of a remark Powell made about the liquidity issues that had surfaced early in the week in the overnight repo market. This is the market where banks trade their excess reserves. On Monday and Tuesday, it appears that there weren’t enough reserves to go around, and, at one point on Monday, the overnight rate climbed to 10%, way above the Fed’s target (2.00%-2.25% – prior to Wednesday’s 25 basis point reduction). The Fed was forced to inject $128 billion of reserves on Monday and Tuesday, and, while they indicated that they didn’t really know why there was such a shortage, they speculated that the liquidity issues were the result of a) corporate needs for cash for tax payments, and b) significant “Treasury settlements.” It was noted by some that the Treasury is trying to build its cash balance by $100 billion as a hedge against any Congressional delay in raising the debt ceiling. So that clearly was having an impact. Also remember that there was record issuance in the corporate market the prior week ($70+ billion in the U.S. and $140 billion worldwide) which likely reduced the available pool of bank reserves and other liquid assets. In addition, let’s not forget that the Fed’s Quantitative Tightening (QT) program has also been withdrawing liquidity that would otherwise have been available.
Likely Villains
We haven’t really seen anything like this liquidity squeeze since the ’08-’09 financial crisis. One thing that has gone undiscussed regarding this issue is the fact that Dodd-Frank (2012) and Basel III have required banks to keep large levels of liquid assets (30-days-worth of net total cash outflows), which, in effect, significantly increases the level of “required reserves” banks must keep. Bond guru Gundlach observed that bank reserves are at an eight-year low. Given the discussion above, it is clear that past Fed tightening, QT, and new regulations, along with significant demand from the U.S. Treasury and from the corporate sector (both for taxes and new issues) have drained bank liquidity. Remember, without excess reserves, banks can’t lend. In past blogs I’ve noted the slowdown in bank lending over the past few months. What happens to an economy when banks can’t/don’t lend?
The Return of QE
When asked about the liquidity issues at the post-Fed meeting press conference, Powell indicated that the Fed might have to resort, once again, to balance sheet expansion. While he said that the addition of the reserves was “temporary,” that really makes no sense. Why would the Fed be tightening bank reserves when they are clearly trying to ease monetary policy? And while he didn’t use the term “QE,” that’s exactly what the addition of liquidity is. The markets interpreted it correctly, i.e., as QE. And, you know, markets love QE!
The Stealth Policy Objective
This is just another example of the Fed’s stealth third policy objective, i.e., to use the “wealth effect” to stimulate the economy by keeping asset prices high. The other two policy objectives are legislatively codified: low unemployment and low inflation. The Fed often refers to the two codified objectives, but it has never acknowledged, orally or in writing, this stealth objective. In truth, the protection of asset prices (equities and real estate) was begun in the Greenspan era, enhanced by Bernanke, and continued by both Yellen and now Powell.
The Widening Wealth/Income Gap
It is well recognized that the gap between the wealthy and the middle class has widened significantly over the past 20 years. People wonder why! A major cause of these widening gaps has to be Fed policy. Who benefits when asset prices rise? Clearly, those who own significant levels of assets (i.e., the wealthy). Since, for the past 20 + years, the Fed has been reliant on the wealth effect to implement monetary policy, then it has clearly been Fed policy that has caused the wealth and income gaps to widen. Worse yet, such unconventional techniques are now being used as the main engine of monetary policy in every major central bank in the world, now even to the point of seemingly irrational negative interest rates. My gut tells me that this can’t end well!