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%.

Update Kondratieff Wave

Optimistic chart of the S&P500 corrected for inflation on a logarithmic scale (as above in the blog). Since December 2009 (publication of the book with current chart and red arrows) the S&P has followed the trend of the red arrow pretty well, even while the S&P was more often below the red arrow than above (explanation with the four year cycle: until the last upward phase GH arrives the S&P ought to remain a bit below or at the red arrow).

Pessimistic chart of S&P500, with other time scale for the six scenario’s. This is the explanation of the believers in the winter of the Kondratieff wave.

We are pretty near the point where you have to change to a less pessimistic version of the pessimistic chart of the Kondratieff winter.
Even when the optimistic chart should prove to be right it still can last some time before the winter will be expelled. A new correction (the last years happening so often) will revive the belief in the winter.

 

Above JP Morgans ‘thoughts about the long wave (logarithmic scale but not corrected for inflation). Every 15 to 20 years a new bull market started. The next chart can be some time away because we are now only at the line through the highs of 1906 and 1965.

They give three periods in which equity markets didn’t rise for a long period. What were the main reasons for the bad performance of equities?

1906-1924 correction of high valuations, war, Spanish flu, stagnation of profit growth

1937-1949 austerity government spending/ extreme expansion of government, war, inflation

1966-1982 correction of high valuations, wages rising faster than productivity, inflation, oil crises

2000-2009/12 correction of high valuations, debt crisis, extreme expansion government spending


More in general:

• In every case there was a correction of the valuation of equities (after they had become too expensive)

• There was disappointment that things were not going as good as thought

• There were severe shocks that caused a crash of confidence for a sustained period

• Government took too much of the GDP and the forced austerity afterwards caused slow growth before and after austerity

There is a lot of doubt about the growth of the structural trend. According to most commentators of JPM’s chart the slope should be slower, around zero for the future. Ter Veer and I see the opposite: the trend is going up faster because of high growth in the world (Emerging Markets grow very fast and dominate growth in the world, China alone will soon be bigger than Western Europe in total) and because of structurally higher productivity growth (especially in Emerging Markets and the US) since 1995 because of the ICT Revolution (current application phase shows highest productivity growth). Profit growth will be good in the coming decade because business is more powerful than employees.

Good news of the last week

1. The hope rally of surplus liquidity

The most important last week was the analysis that with some patience one should have to get more glad and hopeful with the plans of central banks in the world.

The FED and ECB didn’t give instant gratification last week, but the analysises afterwards and afterwards became more positive by the day. In September it will be very likely that the FED will act. At the end of August on the congress of the central banks in Jackson Hole Bernanke and Draghi will compete who will give the most and best unconventional new means to battle pessimism and provide more liquidity (e.g. with the British Funding for Lending System). Something else is also allowed to get lower interest rates in Southern Europe without Germany becoming too angry.

The ECB opened the discussion for quantitative easing/ buying PIGS bonds in the future and only Germany objected.

[ “Over the coming weeks, we will design the appropriate modalities for such policy measures”. According to the head of the Bank of Finland (who made remarks Friday), the ECB will take control and cool market turmoil once preparations are over. “Once preparations are over, we are ready to act” (Bloomberg).]

The market seems to believe in the plans of Draghi, because the yield curve steepened considerably.

2. Economic Surprises less disappointing

Almost as much hope produced the further recovery of the Citigroup Economic Surprise Index. Some analysts even produced a buy advice for cyclicals base don this (and for the ones with a strong heart: in the previous rounds of QE automobiles & parts went up the most). Quantitative Easing is only amplifying economic trends, without those going up QE is not enough to push up markets.

3. China wants higher equity markets

In China they are following the strategy of the FED to talk up the markets when they declined too much. Lowering interest rates is not enoug. The Chinese government suddenly communicated that Chinese equities were too cheap. It was a shame they have declined 52% from top while in the same period nominal GDP almost doubled. So they lowered transaction caists and suggested business to give equities to their workers.

4. better real personal income growth and so soon also retail sales
In the US not only the housing market is improving, the mini cycle also seems to have troughed (that is why economic surprises became less negative)

Pessimism about growth extrapolated: age of diminished expectations (Minack, Strategas, Pimco)

George Minack of Morgan Stanley as usual had nice charts with the accompanying gloomy and dreary analysis. How things are going in the US is just disappointing, see chart above.

Economists usually start forecasting something like trend growth, but nowadays that seems more 2% than 3% (=law of Okun). In the last months the expectations for 2013 got down seriously (because of bad recent numbers and fiscal cliff) and also 2014 starts to deviate from Okun’s 3%. Austerity will bring down growth to below potential in the US like in 2011 and 2012 and fiscal austerity will be the New Normal.


Accordingly the expected profits for the coming years are going down seriously. That revision still has more to go according to Minack. In the US the PE is still about the same as in last year (mainly because of miraculously good macro expectations), while in other countries the PE has gone down materially already. So American equities are very expensive, way overvalued for believers in Shillers (Graham)s PE.


So forget about good returns of equities: profits are gong down and PE’s also = bear market.

Then the growth in the Euro-Zone, that is not disappointing, but very, very disappointing. It is a miracle European equities still have some value.

Strategas had the chart above as proof that PE’s have to go down in the coming years.


I have to say that this analysis is believed by many more people than my analyses about a brighter future ahead, mainly for not that important (in western eyes) countries like China and India. People like to extrapolate trends. The charts above are pre-eminently suited for this. I think that has happened in the heads of most investors and so it should be discounted now in the prices.


Even as people have seen in Australia interest rates in the Netherlands are at their lowest levels in 500 years. Ineterst rates are becoming negative in more and more countries for longer and longer durations. But maybe it is no longer that safe to extrapolate the trend.


Pimco mentions now the end of the cult of equities. People have to become sensible and forget about equities (and in the future they should only invest in bond funds of Pimco).


You never know but maybe in the next years equity markets and bond yields will rise materially. Maybe they continue the path of the Kondratiev wave as lined out above in my blog.

Is it like 1937 or like 1949? The time of diminished expectations

Many people fear that after the fiscal cliff of 2013 the US is in the same situation as in 1937. After the tremendous Roosevelt government stimulus from 1933-1936 came the bill and that austerity caused below trend growth from 1937-1942 including a big recession. Also it originated inflation after the deflation period. World War II made an end to the bad period, but only after 1949 growth really came back.


It is at least as likely that you can compare the current situation 2000-2012 with 1937-1949.

In 2000 it was not government spending that had to go back, but business spending that had been way too high from 1996-2000. After 2000 you got artificial economic growth, not from a world war, but from the housing market used as ATM. The bill came in 2007 and the damage was big but unlike 1937 there were some positive developments in the world: the emerging markets, especially China, helping the world economy and the ICT Revolution helping productivity growth. Also monetary policy was better than after 1929.

In 2010 new problems arose in Europe. This was a bit comparable with 1946 when many of those no longer necessary soldiers didn’t do productive work as was hoped for. Europe was weak and its currencies were not trustworthy, only the US Dollar was a safe investment (like 2012). Interest rates in the US set a record low in 1946 and remained very low until c. 1953.

In 1949 people looked back and concluded a man sound of soul and mind should no longer invest in equities. Since 1929 dividends had not been rising and prices and dividends were very volatile, so safe US government bonds delivering 1-2% were the preferred investments. The Fed had promised to keep the FED rate very low for an extended period. US government debt was far above 100% of GDP. German bonds and equities were of course way too dangerous and interest rates were rightfully much higher than in the US.

So this all sound familiar. The case for 1949 is equally interesting as the case it is now 1937.

In 1953 suddenly all the pessimism was thrown away: a strong belief arose that dividends were structurally growing and that dividend yields should be below the government bond yield. This belief continued until 2008, then the opposite was thought again like in 1949. Like in 1949 people think now that it is unclear that dividends will grow and looking back… one should better not do so…

To keep it comparable with 1949 there must arrive something that causes higher economic growth than in the previous decades and uncertainty has to go down.

That something ought to be: things have to be better than thought now and for in a few year believable reasons. It is not so difficult to see what that should be: continuing growth in Emerging Markets making them an excellent market for exports and cheap imports (like after 1949 Europe was the Emerging Market from the ashes of WWII), a believable plan to get growth back in Europe (ECB/ESM financing enough, infrastructure building etc), like the Marshal Plan and a wave of innovations like after 1949 (because of WWII a lot of innovations were stalled and they exploded after 1949). That wave of innovations is already visible in the growing force of the ICT Revolution with its internet networks of tremendous force and knowledge (never in history grew Knowledge so fast as in the past decade).


All in all, I think it is more like 1949 than 1937 now.

Some charts for optimists

1. Economic Surprise Induces are troughing

Source: Credit Suisse

2. Earnings pessimism is extreme

(Socgen chart)

(Credit Suisse): after trough normally equities rise on average 4% in the following month when earnings pessimism is as extreme as now..

Earnings pessimism often troughs when it is as negative as now.

Slowing of growth in UK, Germany and US

A very bad number for UK growth in Q2, -0.8% because of the diamond jubilee of Elizabeth and the lower amount of days worked. The consensus hoped for -0.2%.

In Germany the IFO declined and then it is clear that GDP growth is slowing too.

The eurocoin indicator and many other indicators already signalled that economic growth in Europe was worse in Q2 than in Q1. Base effects for Q3 are bad too.

In the US it was not so much different this time. The Phillyfed coincident indicator by state showed there are now many more states with negative growth than in Q1. This means about 1% economic growth. We hope that things will go better from August on, but it looks like Q3 will be disappointing too, 2% or lower (we are near the point people are saying that 2% growth is not all something disappointing, but really quite nice)

High taxes like new Dutch Disease bad for equities (JP Morgan)

JP Morgan had a report (Impact of Tax Rates on Stock Market Returns) how bad it is when you raise taxes. So Obama remaining in power should mean S&P 500 -7 to -14% and Romney +7 to +14%. [PV: history learns that when a democratic president is re-elected that lead to a rise of 20% of the S&P on average] The authors of JP Morgan doesn’t seem to be friends of Obama.

There are reasonably strong relations between higher taxes and more progressive taxing and bad equity returns according to JPM .

If you hike taxes on incomes and makes the system more progressive you could end up like the Netherlands: -5% each year for the S&P.

The returns of the Netherlands could have been worse when the Dutch didn’t had such a favourable treatment of taxes for business (chart below).

At the moment the US scores average for income tax and bad for business taxes.

The results are not that convincing: one could say that the bad results are caused by geography: maybe the Euro crisis produces all the bad returns, not the tax system.
Still, the tax influence seems to be pretty big and then one could better invest in Chile and Poland

some good news of the last days

After all these disaster stories about Spain it is good to see that not everything is going in the wrong direction for  Spain: the big problem that Southern Europe is not competitive, is according this export and import chart of Spain diminishing.  

In more and more Chinese cities the house prices are rising again, in Bejing the fastest. The problems are far form over, houses are unaffordable for the average Chinese and inventories of unsold houses are still way too high. But still, the situation seems to be improving and that is logic when wages are rising 10% or more.

The US is becoming a bigger and bigger energy producer. Not only because of fracking of natural gas, but also because of refinery production.

The German housing market is becoming stronger and stronger. After the decline until 2006 you had a pretty normal four years of stabilisation and since 2010 prices are rising. That can last for a decade or more.


Central banks are going on with their attack on interest rates: South Africa -0.5% is the most recent lowering of interest rates. The FED wants to copy the Funding for Lending system of the Bank of England to get more credit growth.




On medical discoveries they are making progress. Gammagard of Baxter International, is showing to retard the Alzheimer process with three years in a small trial. There are new pills against obesitas that will reduce weight 7% pretty easily.









There are now too many bears according to AAII. In the past years a rise of the S&P was then not far away. There will be hope the pain of Spain will diminish when Mario will be in a good mood.

Seasonals and calendar effects: Swinkels and van Vliet

A nice, thorough study by Laurens Swinkels and Pim van Vliet (July 2011): An anatomy of calendar effects (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1593770) (hat tip Lukas Daalder) shows there are only two effects really important:


1. Halloween effect (sell in May and go away but remember to come back in September (a bit adjusted): be invested only in the after Halloween period from November 1 to the witches sabbath of April 30 and

2. the end of the month effect TOM (at the last and first day of the month returns are higher).

All other calendar effects studied like several holidays, the January- effect, weekends etc were not strong enough to get really significant results.

Of course they could have studied a lot more things, like St. Patricks Day and especially FOMC days (these are the true holidays for investors). Also the first week of a quarter is often favourable for equities.


When you try to measure those effects you must correct for a lot of double counting, many holidays are in the Halloween zone, also January and when you correct for Halloween+ end of month nothing significant remains.

Trading at the end/ first day of the month that is not something that will make administrators happy and they will prevent institutional investors to exploit TOM, especially around January 1. That could be a reason for the surprisingly strong results of TOM.

When you are in the market outside the Halloween and TOM periods it seems you cannot expect positive returns for equities when you extrapolates the results from 1963-2011. Even when you try to be clever by investing in value stocks or small caps that will not help to get positive results in those disaster periods (large caps are safer, but still not winning). 

Warning: the studied effects are anomalies and these have often the bad property to vanish suddenly because they are arbitraged away. Not that long ago the January-effect was documented to be by far the strongest positive calendar effect and now it is only believed a bit for small stocks: the now profitable strategies are anomalies and they can suddenly stop to occur. Not that long ago the January effect was seen as the strongest calendar effect, especially for small caps (that small cap thing seems to be still all right).

American dream (2): belief in free markets succumbs to bad times

The American Dream is the belief you can become rich when you work hard enough and that is mainly because the free market economy enables that. Pictures at night of North and South Korea show a big difference in wealth: without free markets it is difficult to get rich. In our theory of long waves the spirit of the age has to enable that the most important domains of freedom, care and justice are up to date good enough to cause better times. In some periods freedom is more important (like we saw in the past two decades), in some others justice and care (1965-1980 for example).


According to the table of PEW Center (via NYT: http://economix.blogs.nytimes.com/2012/07/13/chinese-love-free-markets-as-much-as-americans-do/ by Catherine Rampell) the Chinese and Brazilians are now the strongest believers in free markets, even more than Americans. The Ameriican Dream is exported to the BRIC’s, but Russia is moving away from it, just like in most other western countries where things are not going well. The belief in free market tanks when confidence in growth succumbs. Only Mexico is an exception, drug violence is asking for more justice, law and order and so free markets are not that popular even while economic growth is quite good