Weekly Special: Dark thoughts for the beach ...

07-04-2017

Before heading out for vacay this week, I gathered some reading material that I thought I would share. I hope it doesn’t scare you or bring you down. Me? I’m down at the beach, where I always sleep just fine.

Geopolitical uncertainty grows A Barclays survey finds a growing number of global investors view geopolitics as the greatest market risk. Within Europe, Italian political uncertainty and Brexit negotiations are viewed as the biggest threats over the next 6 months, with Brexit negotiations unlikely to be orderly and U.K. assets—sterling in particular—likely to underperform. In the U.S., there is increasing doubt tax cuts and other fiscal stimulus will be implemented before the 2018 midterm elections. A majority of investors now view equities as overvalued and inflationary risks as diminished, bringing the “Trump trade” full circle and back to pre-U.S. election levels.

Oil’s trends point lower Oil’s 50-day moving average (MA) fell below the 200-day MA last month for the first time in a year. This “Death Cross” added to technical evidence pointing to caution, as oil’s 10-day MA remains below its 50-day MA, which is below the 200-day MA. At this point, it is difficult to construct a bullish argument for crude. Following 6 months of under­performance, energy equities now make up only 5.4% of all public equity market capitalization—lower than the depths of 2016’s sell-off and the lowest percentage since early 2001. Gasoline demand also appears to be weakening. With sentiment in the dumps, technicians are watching for support at $42-43 barrel, where West Texas Intermediate formed a double bottom last year.

One reason price stability is proving elusive Even as the jobless rate keeps falling, wages aren’t moving all that much. True, demand for labor remains robust, but there’s a supply shortfall among many skilled occupations that is stunting overall employment and wage growth. Annual growth in nonfarm private payrolls already has slowed from a cycle peak of 2.6% in February 2015 to 1.7% in May, Leuthold Group notes. While wages in the undersupplied areas are heating up, the lack of supply means many openings will go unfilled—a “fact on the ground” unrelated to Fed moves. And jobs that are being created elsewhere continue to confront disinflationary forces.

Another reason—Jeff Bezos The Amazon titan with a killer instinct continues to slaughter his competitors, killing inflation along the way. He has brought deflation to the book industry, mall retailers and the cloud. Now he is doing the same to grocery stores, with the biggest losers likely to be their vendors, i.e., manufacturers of consumer brands, particularly staples, Yardeni Research says. Bezos is not alone in unleashing deflationary forces as he disrupts and destroys business models. Elon Musk intends to harvest solar energy on the roofs of our homes, storing the electricity in large batteries while also charging up our electric cars. Frackers are reducing the cost of pumping more crude. Pharmaceutical companies are under pressure to stop hyper-inflating drug prices. Telecom services prices are falling under intense competition, a key reason of late that headline and core inflation has fallen back below the Fed’s 2% target, but there has been softness in apparel, medical care and autos, too. Over the last 3 months, the annualized core CPI inflation has been a startling low 0.048%. There have been only two other occasions since 1965 when it’s been lower: December 2009-February 2010 and October-December 1982.

Automation is playing a role, too Add repetitious elements of construction such as bricklaying and concrete paving to the growing automated wave. Construction Robotics, a New York-based startup, has developed a bricklaying robot that is able to lay 2,000 bricks per day—5 times the 400 bricks per day the average mason can lay. The Swiss Federal Institute of Technology also is developing autonomous drones to quickly string cable bridges. The market for using drones in construction is a $45+ billion opportunity, concludes a recent PricewaterhouseCoopers study.

The Fed’s dilemma The flattening of the yield curve is read by many market participants as signaling the Fed is in danger of tightening too much and pushing the economy into recession. But rather than crash the economy, Evercore ISI says the policy error may be the failure to arrest deterioration in various indicators of inflation expectations, which may in turn ensure that inflation stalls out modestly below target. The market detects that the joint path for rates and the balance sheet proposed by the Fed is too fast and sticky relative to the outlook, with a roll-off beginning a 5-year autopilot tightening that could have material cumulative effects even if it has only trivial impact at the outset. The Fed appears to have a strong preference to start the roll-off before Yellen steps down. 

Globally synchronized tightening? The European Central Bank has removed the rate bias of even lower rates, claiming that deflation risks were no longer present. Two additional members of the Bank of England’s Monetary Policy Committee want to hike rates, bringing total dissents to 3 of 8 members. Bank of Canada Governor Poloz and Deputy Governor Wilkins both indicated rate hikes would be coming sooner than the market expected. And the Bank of Japan has been buying fewer bonds amid increasing calls for how it will handle an exit. By themselves, none of these was a major event. But with all major central banks moving toward reducing accommodation, policy risks could be additive or even multiplicative, keeping upward pressure on the short end of the curve.

Where are the recession signals? Household and nonfarm employment surveys have been growing at below-average rates for 6 months—1.23% vs. a long-term average of 1.51% for the former, and 1.58% vs 1.78% for the latter. Whenever the year-over-year rate falls below 1%, it has been a warning—and usually a good predictor—of a pending recession, Dudack Research says. Both the manufacturing and services ISM indices also have been slowing, a sign of decelerating activity. And the growth rate of retail sales has been declining, with autos rising at nearly half their year-end 2016 pace and overall retail sales up at just a 1% real rate of late.

Autos no longer a catalyst Speaking of autos, a Morgan Stanley report recently noted that deep subprime participation in the auto lending space is near a record. Last year, 32% of subprime auto asset-backed securitizations carried a weighted-average FICO score below 550 (the least creditworthy customers), up substantially from 5% in 2010. Auto loan delinquencies are rising from trough levels and lending standards are tightening. And, continuing a trend in place for several months, the growth rate of U.S. auto and light truck sales is getting more negative and not just plateauing off last year’s cycle highs.

A growing societal divide The latest income distribution data show 23 million Americans—the top 10%—make $300K per year on average and account for nearly half of national income, while 117 million—the bottom 50%—earn $16K per year on average. In their 2012 study, “Why Nations Fail,’’ economist Daron Acemoglu and political scientist James A. Robinson said societies with politically and economically inclusive institutions are rare due largely to “elite overproduction” as elites seek to perpetuate and pass on their political and economic privileges to their children. BCA Research notes that Peter Turchin, a scientist who studies human conflict, says elite overproduction—and its counterpart, low societal well-being—tends to spawn societal conflicts every 40 to 60-years and that Americans today are living in a second Gilded Age, with elite overproduction at its highest and population well-being at its lowest since the early 20th century. Extreme polarization between elite prosperity and general well-being is empirically associated with political polarization, social unrest and war.

A growing political divide BCA Research also notes that a 2012 Pew Research study found the difference between Americans on a list of 48 values is the greatest between Republicans and Democrats, as opposed to other elements of identity. Americans’ values are now determined more by party identification than race, education, income, religiosity or gender. This has not always been the case. The democratic process, which is supposed to adjudicate between interest groups and regulate elite economic and political privileges, has been drawn to a halt by polarization, the political influence of big money (more than 40% of campaign donations used in all 2012 federal elections was contributed by 0.01% of the voting-age population) and emerging tribalism between non-elites. It is extremely difficult to see how these hurdles can be overcome via America’s regular political process. As such, they will be resolved only after some kind of crisis, whether endogenous or exogenous.