Woody Brock: why economic growth will be lower, unintended consequenses of QE and 30 year decline of labour income quote

Why growth in the world will not be as high as in the past

It is not necessary for economic growth to be so low in the coming years, but there are several factors why growth will be lower in the coming years than in the last decades.

In the US good government investing could produce more growth, in Europe and Japan it is labour reform and in Emerging Markets it is less corruption/ a better judicial system that should provide much better economic growth. Woody is losing confidence in Abenomics because Abe is saying that labour reforms are too difficult.

For the US: productivity growth has been high (1.5-4%) after WWII and this is not easy to repeat after a period with low investments. Demographics are hurting now but have helped last decades (low birth rate 1930-1946, baby boom until 1965). This also caused house prices to go up tremendously with big net wealth effects. The big consumer financing burden was created after the real incomes didn’t rise anymore. Two incomes per family was the biggest contributor to income growth.

All these factors go into reverse now.

Government debt will become a disaster when the labour force is shrinking and nominal GDP is not growing enough.

 

For the Emerging Markets: the big ones are leaving stage 1 of development (Rostow) where a command economy can force high economic growth. In stage 3 a good judicial system is necessary and less corruption. Innovation, ideas have to trigger growth and that will not happen in China with the vested interests only interested in the government companies they own/ get their money from. The current politicians have to give away their privileges and that will not happen easily. The BRIC’s don’t have the right structure with a balanced system of fairness (judicial system), care (social security so they don’t have to save half of their income) and freedom (competition, drive for innovations). India is best positioned but with its too much red tape it will not be good enough.

 

(Of course I see things more positively: demographics are not that bad in the US, very favourable in many Emerging Markets (ex China and Russia) and corruption is going down because internet exposes it much more than in the past. The good example of Singapore, Hong Kong and South Korea is giving a clear road map how to get rich for the Emerging Markets. But the most positive is the knowledge explosion since internet that will drive the innovation cycle, human capital is up and that will compensate for the low physical capex of the last years and capex will grow in the coming years from very low levels in the West)

All important will be if productivity growth will go down because there are no new all purpose innovations like internet, computers, steam machine, cars etc. Gordon thinks all communication innovations are not all purpose and will not contribute to productivity growth. Woody and I are more optimistic. Networks are bigger than in past, there was a knowledge explosion. But Woody thinks the innovation cycle will not lead to fast improving productivity soon.

 

QE will end badly: the unintended consequences

 Woody thinks a bit like William White/ FED governor Stein have written about the dangers of QE.

As told before by Woody monetary and macro policy could not succeed after 2008 because there are too many targets and not enough instruments (the failure against the Tinbergen axiom).

Since the credit crisis macro policy has to solve many new problems (system crisis, deleveraging of private sector, retiring baby boomers) while they initially didn’t had new instruments (QE is a new instrument, reforms another)

Monetary policy is now excessively overused.

We have seen the benefits now of QE, but the costs are not yet visible.

QE1 was necessary to rescue the system, but the QE after 2009 was dangerous, not necessary in the eyes of Woody (and maybe also of Stein).

The interest rates are extremely low, even the long dated yields. Artificial low interest rates cause wrong investments, can cause higher risk premiums (Stein arguments). Getting rid of QE can cause higher interest rates than the natural interest rate over some time (Koo argument, he thinks that is already happening now)

In normal times low interest rates will trigger more investments and consumer spending, less saving.

But the very low rates now are creating uncertainty about the long run. Business is now not investing more when interest rates are going down. People are now saving more with lower interest rates because they can’t leverage up and need to save more for their pensions at current low interest rates (PV: you also hear that QE hurts the private sector with the difference between the coupon yield of the bought bonds and the deposit rate).

Zero interest rates are not necessary thinks Woody. Other government policy is necessary: in the US productive government spending in infrastructure, R&D, in Europe/Japan labour reforms.

Woody agrees with McKinnon, stick with the devil you know: hike interest rates but buy more mortgages etc. when you want to stimulate the housing market

 

It was stunning that when the FED only talked about taper of QE but didn’t do it you got already such a big market reaction. When it really will take place markets could move more, but maybe not, see the UK.

 

In the UK they suddenly tapered QE and nothing happened. In Germany long bond yields went down more than in the US without QE. So other factors than QE are having big influences on bond yields, changing beliefs determine the yields. When safe haven is important, credit risk is seen as high, yields decline.(also central banks in Asia buying Treasuries or selling when their currency is involuntarily weak is important).

It looks like only the shadow banking system is getting all the advantages of QE

 

The 30-Year Decline in Labor’s Share of Income

Why important: woody:

•       It deepens the “inequality” and the “hollowing out of the middle class” stories

•       Political unrest can and will result

•       The decline logically implies a hefty rise in corporate profits, just as we have seen

•       The story is global

Of course for an investor the importance is: it is the main reason why equities are doing so well, why profit growth can be higher than GDP growth (or growth of business sales)

 

Reasons Why Labor’s Share Has Declined

•       Decline in the relative price of Investment Goods

•       Loss of bargaining power by labor unions

•       Impact of the rise of China and of its illegitimate trade policies

•       De-skilling of the workforce due to deteriorating educational performance

•       Low interest rates

•       “Ludditism” and new technologies (robots will do all the work cheaply)

But these factors will go into reverse in the coming years. The prices of investment goods, chips are declining slower, the bargaining power of individuals will go up, China is no longer cheap and is seeing high wage rises and the yuan is no longer very undervalued. The low interest rates will become less low. Ludditism was always exaggerated.

four year cycle: have we seen the top?

Ter Veer and I always judged in which phase we were in the cycle. The current cycle is lasting too long as happens often when you have had a very severe downturn with a long and this time slow recovery.

The prices of the S&P are compared with (red line) what the fundamental value seems to be: 14 times trailing earnings corrected for the cycle (with ISM/50). This shows the S&P went up about 200 points too much probably because of QE.

It could have been that we have seen the highest point at May 22 when the taper discussion of QE started in earnest.

The phases of the cycle

L=defeated=A

Cautious, not brave enough to buy= AB

Hopeful, should I buy?= BC

Encouraged, start buying=CD

Positive, forgot to buy the dip=DE

 Confident, let us buy=EF

 Thrilled, buy the dip=FG

 Euphoric, buying as much as possible=GH

 Surprised, in denial of the decline=HI

 Worried, but relieved the decline is not getting worse=IJ

 Panic Stricken, everything must be sold=JL

S&P to go to 1620-1650 in 2013

Business Insider had some nice slides where several gurus showed their chart of the year. The above of Matt King shows how the S&P500 marched up with the balance sheet of the FED. A $1000 billion QE was enough to get the S&P500 320 points higher.

It is not at all clear how much Money the FED will throw to the markets in 2013. they promised $85B each month for the time being, less is not possible with current fiscal spending cliff uncertainties. But what to do when the economy recovers in H2, or worse when the confidence in the FED to prevent inflation will go down? Then QE will stop. For the time being it is estimated that the FED will buy between $500B and $1000B. Let us say $750B, then the S&P could rise 240 points to about 1650.

This chart of Kleintop showed how well the S&P tracked the average presidential cycle of the last 28 years. This could continue and should mean about 15% for the S&P in 2013, or about 1620 for the S&P500.


15% in the first year of a president is more than average since WWII (there were several nasty bear markets in the first six/seven quarters of a president cycle) , but maybe it is possible with the of Bernanke. Profit growth will be much lower in 2013 but expectations for 2014 could improve.

So 1620-1650 is an educated guess according to the president and monetary cycle.

10 forecasts for 2013

The intention is to give forecasts for possible trends that are underestimated by the market according to us.




1. After a weak H1 US economic growth will surprise to the upside (3%+). 3.5-4% growth in 2014 very well possible.

2. According to expected QE and the president cycle of the last three decades the S&P500 should rise to 1620-1650. This could very well be the case even while the market will be more volatile than in 2012 with the possibility of a nasty shock that could bring a correction of more than 10-15%.

3. Spain could surprise to the upside later in 2013. France not becoming the disaster as many are saying. Portugal could very well be a big new worry in Europe.

4. Fight the FED. After some time the FED could very well become under pressure because of too much QE without (horrible) exit scenario. After H1 core inflation could start to rise because of higher unit labour costs and higher rents. The market will fear that inflation will be earlier than 2015 above 2.5% and earlier than unemployment below 6.5%.

5. Japan will see its reverse Volcker moment: deflation will turn into inflation and after 2014 in too much inflation. Initially this will be seen as good news for Japanese equities and bad news for the yen.

6. Emerging Markets the place to be for equities in 2013. Confidence is returning in China. Brazil and India will surprise to the upside. Inflation will not be a problem in most countries causing more monetary easing by central banks.

7. UK credit rating to be downgraded. AAA rated government bonds to become more scarce (less AAA rated governments and declining deficits of AAA countries).

8. Credits will suffer from more downgrades and defaults than in 2012. Inflows from investors will go down and demand from borrowers up. This contrasts with 7.

9. The deflationary thinking since the credit crisis will move to inflationary thinking. This means the correlation between equities and government bonds will become clearly less negative, maybe about zero. (=The FED model could come back as good indicator for equities in 2014).

10. The Great Transition from lower and lower long term bond yields (1981-2012) to decade(s) of higher and higher bond yields will start. 30 year euro zone swap yield to go up above 2.7%, maybe above 3%. 30 year bond yields in US to go to 4%.