Pivot – To What?

It seems as if every financial writer has no more important subject to opine upon than the exact date of the Fed “pivot,” when the Fed will be “forced to” resume supporting wild speculation.

Such opinions may be successful clickbait, but any such pivot is economically meaningless. Just look at the last employment report. The number of jobs increased significantly, but the number of employed persons hardly moved. People are taking on more jobs in order to, as President Bush put it, “put food on their family.” This can only go so far, for obvious reasons, and it means there are insurmountable limits on the economy’s ability to grow. Production equals labor hours times productivity. Productivity is slow and hard to improve, so not any help. Labor hours are pretty close to the wall, as shown by the average workweek which has flatlined at 34.6 (FRED). This all means that the economy cannot grow in response to stimulus. Easy money and/or a return to QE will simply result in more inflation, which will do as much or more damage to the economy and corporate profitability than higher interest rates. I cannot believe that the Fed is unaware of this reality. There is no free lunch. Pain is coming, regardless of what the Fed may or may not do. Look back at the Great Depression when the Fed thrashed around, trying everything because nothing “worked.”

Just One Chart

When you buy shares in a company, you are really buying a share of the stream of profits yet to come. This chart from John Hussman shows what is going to happen as labor reclaims its share of company income.

The extra profits in the early 2000s were financed by the housing bubble, while the recent spike is mostly the result of massive government deficit spending on subsidies and handouts of various kinds. These are coming to an end despite the best efforts of the Dems to blow up inflation.

Rate Shock

The median price of a new home has fallen by -11.9% over the last 2-month period,

Thanks to Liz Ann Sonders.

Debt

According to the St Louis Fed, from Q1 2000 to Q1 2022, federal debt has expanded from $5.77 trillion or 58% of GDP to $30.4 trillion or 125% of GDP. And the deficit spending continues unchecked. History says that government debt of over 80% of GDP inhibits economic growth.

The interest rate on the debt is currently about 1.5%, but 70% of the debt is due at various dates within 5 years, and will be rolled-over and re-priced at whatever rates are current at its maturity. However, the following chart shows that the highly negative real rates currently in effect do not persist for very long. The red line is the inflation rate, the black line is the Fed funds rate and the blue line is the “real” rate – the nominal Fed rate minus inflation. It seems likely that the Federal budget and interest expense will have a nasty collision in the next few years unless inflation falls rapidly.

The Digital Economy

Zuckerberg said that Meta (Facebook) will make significant losses in coming years as it invests heavily to build “the digital economy”. He implied that the excess expense would include subsidizing the virtual reality headgear needed to experience Meta’s virtual world(s).

We have something of a digital economy today. Crypto tokens, NFTs that include digital avatars and clothing for them, digital real estate and even digital yachts presumably navigating digital seas. Most of what you need in a digital world. Fortunately mundane things like food and water or fuel are not required, just a lot of imagination.

Will it make the kind of huge business needed to pay out those billions to be invested? I don’t know, I like my life real. Even it is dangerous and challenging. Zuck’s vision seems to me to be a sad imitation of reality.

 

Wishful Thinking

Financial advisers are falling over themselves to roll out the bullish case for the stock market. Perhaps the Fed will get scared and resume pumping the stock market. Perhaps the Fed will engineer a “soft landing”. Perhaps the economy will grow fast enough to avoid a recession. Perhaps a recession will abolish inflation. The first is possible. The others are not.

Perhaps the reality is that we are facing a perfect storm. I’ve written about some of the issues here and specifically about energy policy here. 

Perhaps most important but unmentioned is the impact of the Biden administration’s spendthrift and socialist policies. This is an administration that is completely dominated by wishful thinking. That it can print and spend money without concern for the effects of excessive debt on growth, or the impact of inflation on households with little margin for error. That it can grow an economy already short of labor by spending money. That the US can support a level of military spending which exceeds the total military spend of the rest of the world. That pandering to racial and transgender political correctness is more important than taking care of basic necessities such as food and energy. That opening the borders to crowds of uneducated and unskilled refugees fleeing socialist regimes will not overload the US social safety net.  That the US can afford to export democracy when there is precious little left at home.

Reality Check

Everywhere I read the pontifications of eager interpreters of yield inversions, and other signs and portents, predicting smooth sailing for the economy until a possible recession in 2023.

All I can say is you have to be kidding me. First of all, markets are still at unprecedented and artificial extremes. It seems to me to be a trifle naive to assume that scenarios from the past apply here. Markets have never been here before and hopefully will never return again. Secondly, there are major and poorly understood economic disruptions underway:

China: The world’s largest asset class, real estate in China, is in trouble. March sales of new homes are down 29% y-o-y. Lockdowns in Shanghai and other large cities in China are stalling production and shipments of many goods.

Ukraine: The Russian invasion and its corollary sanctions are negatively impacting agricultural and commodity exports. Restricted supply and high prices of fertilizer will reduce agricultural production around the world.

United States: Historically high consumer price increases have resulted from years of low interest rates and massive expansion of the money supply. Measures announced so far to deal with this issue are unlikely to have much effect. The 10-year Treasury yield has doubled since the beginning of 2022, with direct impact on mortgage rates and thence real estate prices. “Green” policies have driven up energy prices by restricting supply.

EU: “Green” policies have left the EU (and the UK) without reliable domestic sources of energy, leaving the group dependent on imports from the rest of the world, but without adequate LNG terminals to replace Russian pipelines. The EU is expected to announce an embargo on Russian oil immediately after the French election, which will drive prices higher.

Japan: The third most traded currency, JPY, the Japanese yen, is falling rapidly, now down more than 10% since the beginning of 2022 against the US dollar. The Bloomberg Commodity Spot Index rose 8.2% in JPY terms over just the past week. It’s up 29% since end of Feb., more than 48% ytd and 177% over the past two years (all in JPY terms). The possibility of intervention is being bruited about. Currency wars are the nuclear option for financial markets.

Look out below.

Deadly Embrace

In a computer system where multiple programs are running at the same time, updating shared data can be a serious problem. A program can lock a chunk of data while it is modifying it so that no other program can inadvertently update it at the same time, which would lead to bad data. But then the situation can arise where program A locks chunk 1 and then needs to lock chunk 2 to proceed, except that program B holds the lock on chunk 2 and needs chunk 1 to proceed. Clearly neither A nor B can proceed. This situation is called a deadly embrace.

The escalating sanctions remind me of this. Both sides are trying to hurt the other but it seems that there is no way that either side can emerge victorious. Mutually Assured Destruction (MAD) may be achievable without any nuclear missiles leaving their silos.

Typically in a computer system the supervisory software will step in and pick a winner, forcing the other program to start over. Unfortunately there doesn’t seem to be a candidate for that task in the geopolitical system.

The Largest Asset Class In The World

Little, if any, attention is being paid to the slow-motion collapse of the largest asset class in the world, Chinese real estate. Property sales in China (100 largest developers) were down 53% in March and 47% in Q1 on a year-over-year basis. Here is an excellent video from the Financial Times which provides perspective on this key driver of global growth.

How To Stop Inflation

It’s not complicated. To stop inflation, you need to stop feeding it. It is fed by adding credit, that is, increasing debt. Doesn’t matter whether in the private or public sectors. The usual ways to discourage additional debt are to increase its price, i.e. interest rates, and reduce or eliminate public deficit spending.

If you don’t do any of these things, inflation spirals and eventually becomes hyperinflation when the public realizes that the government is unable to control its spending. The economy and the currency collapse.

If you do both these things, the economy shrinks. Recession. Inflation eventually responds and interest rates can be reduced. Economic growth is resumed.

If the government doesn’t do its part, then the private sector must do more, usually by massive defaults. Depression. Long and painful, usually ending in war.

The so-called soft landing where inflation falls without recession only occurs when the inflation was exogenous. This is not the case today. This inflation is the result of years of bad policy and over-spending. There will be exogenous effects from the Russia sanctions, but so far they have had little or no impact.