The Big Picture
John Mauldin
I’ve been a bit slow in bringing good friend Neil Howe’s predictions for 2016 to your attention, but over the last couple weeks I have turned back to them more than once as Neil’s take on the year ahead has begun to look very prescient indeed.
In this New Year’s interview that Neil did with his firm, Saeculum Research, he wastes no time in telling us that he thinks expectations of several more Fed rate raises this year are “delusional,” because “The global economy is in no condition to take this medicine. My very safe prediction is that the Fed will either stall or back down.”
Bingo: after scaring the pants off everybody in the world last year with their hawkish talk of a persistently isolationist monetary policy, the Big Dogs of the FOMC have been yapping like toy fox terriers the past couple weeks, making sure everybody hears the message that “… we are closely monitoring global economic and financial developments and assessing their implications for the labor market and inflation, and for the balance of risks to the outlook” (Board of Governors Vice-Chairman Stanley Fischer, Feb. 1, 2016).
Neil doesn’t stop there. He reminds us that the world geopolitical situation is deteriorating, particularly in the Middle East, and that the US presidential race is a complete crapshoot. At this point, the interviewer chirps in with “You sound a bit more downbeat than most.” Well, says Neil,
If I’m coming in beneath the consensus forecast, it’s because – over the last decade – reality has been coming in beneath the consensus forecast….
[T]here do arise periods lasting ten years or more when the consensus forecast can veer consistently too high or too low. And over the last decade, it has veered too high. Each year since about 2005, forecasters have been predicting a rise in corporate earnings, in GDP, in inflation, in interest rates—in basically all of the vital growth metrics – that is substantially higher than what subsequently occurred. And I’m talking about every forecaster: the IMF, World Bank, Fed, ECB, OECD, and CBO, along with surveys of business economists….
Systematic overshooting by international institutions is leading some observers to talk about “an in-built ‘optimism bias.’”
Which leads the interviewer to quip, “I guess we can’t call it the dismal science anymore,” and to wonder at the reasons for the chronic boosterism.
“Oh, I know why it’s happening, says Neil,
The world has fundamentally shifted over the last decade, especially since we’ve emerged from the Great Recession. We are seeing slower demographic growth, overleveraging, a productivity slowdown, institutional distrust, policy gridlock, and geopolitical drift. But the professional class has been very slow to understand what is going on, not just quantitatively but qualitatively in a new generational configuration that I call the Fourth Turning. They don’t accept the new normal. They keep insisting, just two or three years out there on the horizon, that the old normal will return – in GDP growth, in housing starts, in global trade.
But it doesn’t return.
And with that, I think I’d better turn you over to Neil for the straight scoop on what is shaping up to be a watershed year. His message here is a very fundamental, very important one. I should also mention that in addition to his newsletters and research at his website, he is now available on the larger services at Hedgeye.com. He recently joined them as managing director to lead the investing research firm’s work in the demography sector. If you’d like to know how to access Neil and Hedgeye’s institutional research, you can email them at sales@hedgeye.com.
Oh, and for those of you who have registered for the upcoming Strategic Investment Conference, don’t forget that Neil will be with us. For the first time ever, he’ll be previewing his upcoming work, The First Turning. His book The Fourth Turning, published back in 1997, is familiar to many of my readers as one of the most significant books written in the past 25 years.
I was actually somewhat surprised that the conference sold out almost four months before it opens. I’ve never had that happen before. For those who didn’t jump on the registration bandwagon in time, we may possibly have a few slots open up, as there are always a few people who have to cancel at the last minute. You can go to the SIC 2016 website and register to be placed on our waiting list.)
Now, let’s take a look at Neil’s “Big Picture.”
Your thinking about fundamental shifts analyst,
John Mauldin, Editor
Outside the Box
The Big Picture
January 2016
Report
All signs point to 2016 being a momentous year on
every front, from the shuddering global economy to the stormy upcoming election
season. How will the world look by year’s end? BP interviewed Saeculum Research
Founder and President Neil Howe to get his take on what’s ahead. (This is an
expanded version of the interview we published as a Social Intelligence report
on January 6, 2016.)
BP: Neil, 2016 sure began with some big
headlines, didn’t it?
NH: Yes, the year began with a bang—and not in
a good way. Both the Dow and the S&P 500 suffered their worst 5-day and
10-day start to a year in history.
With the market down roughly 8%, we are
suddenly back to the “correction” lows of late last summer. China’s Shanghai
market entered free fall, with circuit breakers stopping trading on January 6
after only 29 minutes. Beijing had to intervene massively to keep the CNY from
following suit. Meanwhile, most of the Sunni Arab nations abruptly broke off
diplomatic relations with Iran. And North Korea successfully tested an H bomb,
which—Dear Leader Kim Jong Un helpfully, if not quite accurately, reminded the media—“is capable of wiping out the whole
territory of the U.S. all at once.”
BP: Wow. “Bang” may be just the right word.
Neil, could you give us a sense of what everybody is going to be talking about
in 2016?
NH: In January, analysts always predict how the
economy will perform over the coming year. Now is no different, especially with
the big December announcement that the Federal Reserve is raising short-term
interest rates by 25 basis points to between 0.25 and 0.5%. The Fed boldly
suggests that interest rates may close in on 1.4% by the end of 2016 and 2.4%
by the end of 2017.
Spoiler alert: I think this is delusional. The global
economy is in no condition to take this medicine. My very safe prediction is that
the Fed will either stall or back down. And the risk of U.S. recession by the
end of the year? It’s higher than most are estimating: I’d say roughly 50-50.
Abroad, there are signs of progress in
international relations, but the overall geopolitical outlook is dangerous. The
Middle East has become a maelstrom. Europeans are voting for leaders who want
to dismantle Europe. Putin seems to enjoy doing whatever he damn well wants
to—while boasting off-the-chart popularity ratings at home. Meanwhile,
Americans are left wondering why their country no longer plays a leadership
role in world affairs.
These issues only raise the stakes for the
upcoming elections. Not that Americans needed more reason to pay attention:
Ever since the first slate of primary debates last summer, we haven’t been able
to take our eyeballs off this race. We have the prospect of seeing another
Clinton in the White House, a highly polarized presidential campaign season,
and—oh yeah—Donald Trump endlessly in the headlines.
BP: OK, let’s focus on the economy. You
sound a bit more downbeat than most.
NH: If I’m coming in beneath the consensus
forecast, it’s because—over the last decade—reality has been coming in beneath
the consensus forecast. And this is a new development. Much has been written
about the abysmal track record of expert forecasters, whose performance is hard
to distinguish statistically from a “blind” forecaster who simply chooses the historical
average growth for each indicator. As the late economist Ezra Solomon once
remarked, “The only function of economic forecasting is to make astrology look
respectable.” But even if most forecasts are pretty random, they are generally
unbiased, meaning that they do not systematically err too high or too low over
a long time span.
The CBO recently confirmed this for its own forecasts going
back to the 1970s.
That being said, there do arise periods lasting
ten years or more when the consensus forecast can veer consistently too high to
too low. And over the last decade, it has veered too high. Each year since
about 2005, forecasters have been predicting a rise in corporate earnings, in
GDP, in inflation, in interest rates—in basically all of the vital growth
metrics—that is substantially higher than what subsequently occurred. And I’m
talking about every forecaster: the IMF, World Bank, Fed, ECB, OECD, and CBO,
along with surveys of business economists.
Does anyone recall that the IMF’s first estimate (in 2010) for global growth by 2015
(+4.6%) was roughly double
the likely final print for 2015. Or that the initial look-ahead Fed forecasts for U.S. GDP growth in 2011, 2012, and 2013 were at or
over +4.0%? 4.0%! The actual average value over those years for the U.S. was
+1.8%. For the EU and Japan, it was +0.6%. I mean, how wrong can you be?
Even if you look at GDP growth predictions made in
January of the year in question, the Fed has been too high on average by well
over one percentage point since 2005. The Wall
Street Journal’s survey of economists has erred in the same
direction by exactly one percent. In 10 of the last 12 years, they
overestimated, sometimes wildly. In 2 of the 10, they nailed it. In no year did
they significantly underestimate.
Systematic overshooting by international
institutions is leading some observers to talk about “an inbuilt ‘optimism bias.’”
The OECD, chastened by its overcarbonated numbers, is soul-searching for solutions. The Fed’s new chronic boosterism is also coming under intense fire,
with critics charging (accurately, I think) that the Fed is wagering its
credibility on a high-risk expectation game: Forecast it, and they will come.
Look, I get that a few institutions—corporations fore casting earnings or the White House
forecasting employment, for example—will always initially overshoot. We all
understand their incentives. But the economics profession as a whole?
BP: I guess we can’t call it the dismal
science anymore. Why do you think this is happening?
NH: Oh, I know why it’s happening. The world
has fundamentally shifted over the last decade, especially since we’ve emerged
from the Great Recession. We are seeing slower demographic growth,
overleveraging, a productivity slowdown, institutional distrust, policy
gridlock, and geopolitical drift. But the professional class has been very slow
to understand what is going on, not just quantitatively but qualitatively in a
new generational configuration that I call the Fourth Turning. They don’t
accept the new normal. They keep insisting, just two or three years out there
on the horizon, that the old normal will return—in GDP growth, in housing
starts, in global trade.
But it doesn’t return. So even while they
grudgingly downgrade their near-term forecasts, they keep reassuring us that a
better future is still out there if we just wait another year. Like a receding
mirage, the good news always keeps glimmering on the horizon.
BP: It’s been a decade now. Are these guys
finally waking up?
NH: Interesting you asked. For the most part,
I see most forecasters trying to stay on script. Once again, both here and
abroad, they are predicting a “rebound” from 2015: Faster real growth, rising
inflation, higher interest rates, and so on. Both Kiplinger and the IMF, for
example, predict U.S. GDP growth will hit 2.8% in 2016—up from perhaps only 2.4% in the year
that just ended.
But I also notice that the mood is a lot less
giddy than it was at the end of 2013 and 2014. There’s a new sobriety. Fewer
forecasters are entering 2016 expecting any robust acceleration. Indeed, many
have been busy downgrading their estimates. Most remarkable are the
increasingly gloomy—indeed, dirge-like—2016 market forecasts issued by big
banks like GS and by big asset managers like Morgan Stanley both before and
after the holidays. Citibank has downgraded the U.S. stock market to
“underweight.” Credit Suisse says “rotate out of stocks.” JP Morgan has shifted from b uy on the dips to sell on the
rallies. RBS is bluntly telling clients to “sell everything.” We
haven’t witnessed this degree of institutional bearishness since the Crash of
’08-09.
Now you could say these are signs that forecasters
are waking up. Or that the forecasters are still too sanguine and that you
should continue to discount accordingly. Which is a scary thought. But it seems
to resonate well in a scary January.
BP: OK, so much for the other forecasters.
I’d like you to explain why you think 2016 will be a dangerous year for the
economy.
NH: It’s because of what I would call a
“quadruple whammy” of economic bad news.
Let me start with whammy number one: the clear
deceleration over CY2015 in U.S. economic growth. We see this in GDP. Over the
last three quarters, GDP growth has slowed from a healthy 3.9% in the spring,
to 2.0% in the summer, to perhaps a mere 0.7% in the fall. This last estimate (from the Atlanta Fed’s GDPNow, a cutting-edge Big Data algorithm whose star is clearly rising) itself shows a stunning
deterioration in forward-looking evidence. On November 5, the GDPNow estimate
for Q4 was +2.9%—and ever since, with almost all the new information negative,
that estimate has been declining at about 3 bps per day.
We also see the deceleration in consumer spending.
According to GDPNow, Q4 PCE spending grew at only 1.8%, slower (even) than it
did in the “frozen” Q1. Just look at nominal retail sales, which barely budged
(0.6% CAGR) over the last five months of 2015. For the entire year, they grew at the lowest rate (2.1%) since 2009. These
figures combine both brick-and-mortar (which continues to struggle mightily, showing its embarrassment on Black Friday) with on-line
(which continues to grow strongly and above trend).
Walmart just announced it is closing 269 stores globally
(154 in the United States) to adjust to this shift and focus more resources on
online retailing.
What’s still hot in retail? Travel and hotels
(thanks, king dollar!); low-budget “experiences” like games and media;
furnishings and home remodeling (a big bull trend we spotlighted two years
ago); and health services, full stop. What’s suffering in retail? Everything
else, including autos, which has been on a great run but is now exhausted.
The problem is not that households don’t have
income to spend. They do. Slowing inflation plus unchanged pay growth has
translated into a nice real income boost in 2015. The problem is that
households are taking that extra income, due largely to falling energy prices,
and they are saving it. Maybe they feel the bonanza will be short-lived. Maybe
they are uncertain about the future. If Larry Summers were our economic czar
(well, he nearly became our monetary czar), no doubt he would implement negative interest rates and try prying
those extra dollars out of people’s pockets. But he’s not, and so here we are.
The cooling consumer would not be worrisome if
industry and agriculture were picking up the slack. But that’s clearly not
happening. The Industrial Production Index has fallen 2% over the last 12
months, with especially steep drops in November and December. Energy has been
hit the hardest: The same oil price decline that delights commuters in New York
has slammed drillers in North Dakota and Texas. If the price stays in the $30
neighborhood, we can count on a dramatic growth in energy bankruptcies. Keep in mind:
Many of these companies will see their forward hedge contracts expire in the
spring.
Since the global crash in raw materials prices is
across the board, U.S. revenue from all forms of mining has shrunk to about
two-thirds of what it was 18 months ago. Falling prices are also hitting U.S.
farmers: 2015 net income is down 50% from the glorious bounty
harvests of 2013 and 2011. In 2016, we can expect a further drop. There’s lots
of hardship here.
Meanwhile, the U.S. manufacturing sector is
wheezing. Its biggest single complaint is the high dollar, which chokes exports
and devalues income from foreign subsidiaries. It’s also suffering from a
decline, both at home and abroad, in capex spending. According to the ISM PMI, U.S. manufacturers’ new orders
and production stopped growing since July and have been contracting since
October. Census reports and Fed regional indexes tell basically the same story.
In short, the U.S. economy has experienced a
dramatic deceleration since last spring. While it is still growing—and is in no
immediate danger of recession—it may not be moving much above stall speed. More
than all of its current growth is now fueled by modest growth in U.S. consumer
spending. If personal savings rates fall and if no other dangers arise (a big
“if,” which I hope to come back to in a bit), GDP growth may pick up speed and
the economy may have another mediocre year in 2016. If savings rates go up,
perhaps in the presence of other dangers, my outlook is a lot less happy.
BP: What are the odds that oil could
rebound to say $50 in 2016 and at least take the heat off U.S. producers?
NH: I see very low odds that will happen. As I
explained in my Big Picture essay last year (see BP: “January 2015 Report”), the global demand and supply shifts
that triggered the recent price decline cannot easily be reversed in a year or
two. They will take many years to reverse, which is why we often talk about a
long “supercycle” in energy prices. In 2016, the consumer behaviors leading to
lower demand will be reinforced by dismal growth in global GDP. On the supply
side, most producing nations (I’ll throw in Texas here) have no choice but to
max out on output even at basement prices—to pay creditors, quell political
unrest, or shore up FX rates and FX reserves. Those who do have a choice (like
Saudi Arabia and its Persian Gulf allies) have chosen for long-term strategic
reasons to turn the valves all the way up and weld them there. Then there are
the massive deep-water production sites in the Gulf of Mexico and Brazil just now coming on line for which the capex is
already a sunk cost. And I haven’t even mentioned the new supply from Iran or the Caspian Sea.
Let me cut to the chase: I don’t think we’ll see a
reprieve. More likely, we may see oil coming down to $20 or lower for a
while—which may actually help in the long run by forcing some producers to
close down.
BP: You talk about faltering growth in
farms and factories. But don’t services now constitute the vast majority of
U.S. value added? So long as services are strong, do we really need to worry
about the thing-producers?
NH: Good question. I’d say first that the data
are often misconstrued. According to the BEA, “goods production” (agriculture
and industry) today comprise only 21% of GDP value added. But if we look only
at the private sector, that share rises to 24%. What’s more, a rising share of
the other 76%—“services”—in effect comprise intermediate inputs to industrial
companies. Just think of all the professional functions, from IT to legal to
finance to PR, which used to be handled in-house by the industrials but are now
outsourced. Estimates vary, but some believe a full adjustment for this “contracting-out”
could push goods production up to about 33% of GDP value added.
And that’s not all. These goods-producing
industrials comprise an even greater share of large-scale marketplace
transactions. They make up the majority of exports and imports between nations.
They make up roughly half of the market cap of the DJIA or S&P 500, which
means they dominate fixed-income and equity markets. And because so much of
their output goes into capital goods, their health is a superb forward-looking
indicator of where the economy is going. Five of the Conference Board’s ten
leading economic indicators specifically refer to manufacturing or
construction.
A lot of services, especially personal services
like cleaning and home care, are just this side of informal “household
production,” which has never been included in GDP. Largescale goods production
stands at the other extreme. Its performance can make or break nations.
So let’s lighten up here and give the industrials
a little love.
BP: They certainly have my love. I’m
thrilled I can buy gas extracted from preCambrian shale for the same price as
bottled water. So you expect them to rebound quickly?
NH: Well, not exactly. I just wanted to stress
that the industrials’ current size and importance is larger than many seem to
think. Over the long run, there’s no question that their share in GDP is
declining over time—and that they are now entering what could be a very
difficult decade or two. Keep in mind that the bust in commodity prices,
mining, energy, and manufacturing are not just U.S. trends. They are global
trends; they’re hurting Manchuria and Malaysia as much as Manitoba and
Michigan. Many thing-making industries are going to require a serious
structural reduction in global capacity in the years to come.
We recently published a report (see SI: “The Immaterial World”) outlining the drivers behind this
trend. They include the rise of the “sharing economy”—everything from Uber to
Rent the Runway—which enables durables to be used much more intensively.
There’s the spread of urban living, which requires less personal housing and
transportation per person.
Ditto for the spread of extended family living
(rising in both America and Europe). And then think about the ubiquitous
presence of social media, enabling Millennials to define their social status by
purchasing and showing off experiences rather than things. We’re seeing a lot
of changes, many of them generational.
Finally, don’t forget demography. Aging societies
with slow-growing workforces no longer require much capital-widening
investment. After all, the existing plant and equipment can already handle all
the new workers and the existing homes can already house all the new families.
Getting local permits to build a new home is Italy is tough—but that’s OK
because Italy really doesn’t need
any new homes. Over time, the impact on durable goods and construction is
massive. Consider further that in most high-income aging societies, working
adults are taxed to support the consumption of the retired elderly, who in
every society are the least likely to spend on things and the most likely to
spend on services (starting with health care and personal care).
Let me stop there. Suffice it to say that
increasingly we’re all living in an immaterial world. And our economy will have
to adjust.
BP: Fascinating. But let’s return to 2016.
What’s the next whammy?
NH: The second bad sign is on the financial
side. For the first time since the Great Recession, we are experiencing a
substantial “earnings recession.” We’ve had two consecutive quarters, Q2 and
Q3, in which S&P 500 earnings have declined year over year. Q4 growth will
almost certainly be negative as well—and, according to FactSet, company guidance suggests that even
Q1 of 2016 will be negative. The BEA data for all corporate earnings show the
same narrowing trend.
Profit margins are shrinking in part because of
the high dollar and in part because of rising real worker compensation. CEOs
would love to raise prices to keep their margins fat, but in today’s
deflationary environment they cannot. Naturally energy is showing the biggest profit
squeeze, but over half of the other S&P 500 sectors are also showing
negatives.
Earnings recessions are a classic late-stage
indicator of an “aging” recovery. They are often (though not always) a prequel
to the next full-blown recession. Their impact on the real economy is very
direct. As a rule, companies handle declining profits by cutting back—on
hiring, on R&D, on capex—anything at the margin no longer expected to add
value. This pullback ultimately feeds forward into declining consumer demand. Arguably,
we’ve already seen this dynamic underway during the second half of 2015.
Yet this time around, there’s another reason to
regard this earnings recession as especially dangerous. For the last few years,
we have been looking at very high valuations in U.S. equity markets. I don’t want
to go into all the different measures people use to measure equity valuations—
like Shiller’s CAPE, Tobin’s Q, and so on. I just want to point out that most of
them focus on three overlapping concepts: a smoothed ratio of price to
earnings; a smoothed ratio of earnings to GDP; and the expected future of
growth rate of GDP. Now here’s my point. The two ratios are both far above their historical
averages, and the low expected GDP growth rate (due to demographics) suggests,
if anything, that the ratios should be beneath their historical averages. It’s
a sobering triad, pointing to nothing pleasant.
I don’t want to get wonky or wade beyond my depth
here. Let me just mention two analysts whose work on valuations I greatly
admire, John Hussman and Ed Easterling. Their reports give me cover by allowing me
to come across as an optimist.
So what do all these measures have to do with the
earnings recession? It’s this. Just knowing that the market is overvalued is of
limited practical significance if the market can sometimes stay overvalued for
years on end. What you really want is a leading indicator that tells when the
market will break to the downside and correct. I think profit margins are such
an indicator—not 100% foolproof, but highly suggestive. In every major postwar
bear market, profit margins have declined together with P/E ratios and have typically shown a clear declining
trend before it became apparent in the noisy P/E ups and downs.
BP: So does the current market downdraft
marks the beginning of secular valuation correction?
NH: It may. Look, for example, at the ratio of
S&P market cap to GDP, a very familiar valuation indicator. You can see
that it plateaued at a lofty level throughout 2014 and started falling swiftly
after Q1 of 2015. Today, I reckon it has already dropped by around 20% from its
peak. The problem is it still has to drop another 30% just to reach its recent
historical average. And of course it may in time overshoot.
Warren Buffett once described this indicator as “the best single measure
of where valuations stand at any given moment.” But there are obviously many
others, and most of these are situated at roughly the same distance above their
historical average.
BP: What’s your prognosis for the market in
2016? And what impact will the market have on the real economy?
NH: I think 2016 will be a very dangerous year
for equities. And I think the big banks already suspect as much, which is why
they are doing something they hardly ever do: Warning their investors to cut
their exposure. For several years, analysts have been puzzling over what Mohamed El-Erian calls the “decoupling” of market returns
(which have been splendid) from real economic growth (which has repeatedly
stumbled). In 2015, market returns ran out of steam. In 2016 and beyond, there
is a growing fear that decoupling may turn around and rush back toward “recoupling”—implying
large negative market returns.
In retrospect, we may put the turning point at the
brief S&P 500 swoon of last August. Though prices recovered late in the
year, other indicators showed the market turning steadily against risk—with the
bond spread widening, the VIX rising, and the IPO count falling. By year’s end,
tech startups were struggling with downrounds and new “unicorns” were deemed an endangered species.
The forward link to the real economy is harder to
assess. Though it is said that market crashes often do not cause
recessions—those that don’t are often fast crashes (like 1987) with no triggers
in business income statements. What concerns me in 2016 is something a lot
bigger than a flash crash. So yes, I think it could participate in a negative
feedback loop with an economy that is already starting out the year in low
gear.
BP: With so much up for grabs in our
domestic economy, I guess the deciding factor may be what happens abroad.
NH: Wonderful segue. You’ve taken me straight
to my third whammy, the global economy, which is slowing down on a massive
scale.
If you look at 2016 from a comprehensive
geographic perspective (“from China to Peru,” to borrow from Samuel Johnson),
you see a clear separation. There are few dire threats in the high-income
world. None of the major affluent players are growing very fast, but then again
neither are they expected to slow down much. Let’s say Japan continues to eke
along at 0.75%, the EU at 1.5%, and the U.S. at 2.5%. That’s a good status quo
ante for roughly half of global GDP. But now let’s look at the other half, the
developing half. Here we see ongoing deceleration. In 2015, the IMF estimates that the developing economies grew at
4.0%—the slowest since the Great Recession year of 2009 and less than half the
rate they enjoyed in 2007, just before that downturn. In 2016, I think their
performance will deteriorate further.
At the epicenter of this slowdown is China, whose
high growth rate only a few years ago (running over 10% per year) enabled it to
generate, singlehandedly, perhaps a quarter of the annual growth in global
production. Everyone agrees that China’s growth rate is now falling, but no one
can agree on how much. While the official numbers put Chinese GDP growth last
year at just under 7%, most outside analysts are frustrated by the regime’s
irregular accounting methods and figure it’s doctoring the numbers to hit
official targets.
Leland Miller at China Beige Book says the real growth rate may be around 4.5%. Citigroup
chief economist Willem Buiter suggests the true growth rate is probably closer to 4.0% and could be as low as 2.2%. Imports and exports (in USD) declined every month last
year. The Caixin Manufacturing PMI shows contraction in 6 of the last
7 months, while producer prices have been tumbling for over three years.
There are many reasons why China is now in
trouble. Its industrial and real estate sectors racked up vast amounts of debt
over the past decade, leading to excess production and capacity that is hard to
unwind. Its overvalued currency is squeezing its export businesses, but any
deliberate attempt to devalue would be like disarming a bomb, incurring the
risk of sudden capital flight. Meanwhile, just as rural areas are running dry
on new young adults to send to the cities, China is undergoing rapid
demographic aging. Just this year and next, its working-age population has
stopped growing and has now started a gradual decline. Basically, China has
outgrown one growth paradigm and hasn’t yet figured out how to move to another.
So much for the causes of China’s woes. Let’s look
at the effects. Most importantly, China’s slowdown shrinks an important source
of rising demand that has helped keep global economies running over the past
decade. Europe, for example, exports furs, fashions, and sport cars to feed
China’s insatiable demand for brand-name luxuries. That is taking a hit. The
U.S. and South Korea export films and smartphones to feed China’s mania for
media and cool IT. That is also taking a hit.
The collapse of China’s infrastructure boom is a
significant driver of falling global energy demand and a huge driver of falling
global commodities demand. In 2014, incredibly, China constituted roughly half
of the global demand for most major metals, from iron, copper, and nickel to
all those once-treasured “rare earth metals” whose prices have since tanked.
China has been an economic juggernaut over the
past quarter century. It has lifted more people out of utter destitution into
at least modest affluence than any nation in history. But now its boom is
coming to an end, after producing “ghost cities” without residents and “ghost bullet trains” without riders. As China changes its
course, so must much of the rest of the world.
BP: Which countries are getting hit
hardest?
NH: Here’s how to think of it: If your country
is dependent on exporting oil or commodities, or if you are close to China
(which presumably means you trade a lot with China), it is likely you are
feeling pain. Sadly, this rule of thumb covers the great majority of the
developing economies.
The energy price collapse has obviously slashed
income to most of the Middle East and to Russia and its Central Asian CIS
allies. The energy and commodity declines together are dragging down nearly
every nation in sub-Saharan Africa, many of which export little other than oil,
gems, precious metals, and base metal ores. Ironically, most of the vast mining
operations in Angola, Zambia, and the Congo were originally funded by China.
The price declines are also a hardship for Latin America, a region already
reeling from a catastrophic failure of political leadership (in Venezuela,
Brazil, and Argentina). The IMF estimates the Latin American GDP, as a whole,
actually shrank last year.
Among the regional Asian economies suffering from
falling trade with China, let me mention Indonesia, Malaysia, and Mongolia.
There are even some regional high-income economies who are struggling to
adjust: Taiwan, Singapore, South Korea, and (to a lesser degree) Australia and
New Zealand.
BP: This sounds uniformly bleak. There must
be some blue sky out there.
NH: Yes, there are important exceptions. Look
for economies that aren’t blessed with energy and commodities and aren’t hugely
dependent on China. Check out India and the Philippines, two large economies
which (using unbiased national accounting) are probably growing faster than
China right now. They hardly skipped a beat last year. Vietnam and Thailand are
also doing well, largely because they are not affluent enough to have been
swept into China’s industrial supply chain yet.
Canada and Mexico, both significant energy and
commodity exporters, are both doing better than they deserve. And for one
reason: Their border with the United States, an economy whose relative strength
thus far keeps them moving forward.
BP: OK, I understand that 2015 was a tough
year for the developing world. But aren’t all the plunging raw material prices
past us now? Shouldn’t these economies begin growing again this year?
NH: I’m afraid not. Adjusting to the new
export prices faced by most of these countries—and to the large deterioration
in the terms of trade they imply—takes time. It’s not something business and
political leaders like to do before they really have to. So they usually find
ways to delay. It’s human nature.
They buy forward contracts to hedge against the
price decline, and then pray the price goes back up again (when they know it
probably won’t). They wait until they need to roll over their loans and hope
the bank or foreign fund will want to reinvest (when they knew they will probably
be refused). They spend down from FX reserves to keep their currency from
falling. They beg for international agency loans. They ask for delays on
stateto-state payments. They ask domestic banks not to act on nonperforming
loans. There are so many ways to put off the day of reckoning.
Some leaders do act with resolution to get through
the adjustment right away. This usually means a large and sudden currency
depreciation—and brutal hardships for most citizens. Russian President Vladimir
Putin chose this path about a year ago when most analysts figured his economy
faced almost certain ruin in the wake of plunging oil prices and Western trade
and investment sanctions. Real wages in Russia have fallen by 11%. Retirees are demonstrating in city squares. But remarkably,
Putin’s fast action worked. He may have saved his economy in the near term,
even if he still faces intractable dilemmas in the longer term.
But the typical course of action is to delay and
defer. As a result, the inevitable decisions around the world to defund
companies, lay off workers, cut back production, pull out investments, and
devalue currencies are made piecemeal over many months. It’s like watching snow
settle.
What’s more, adjustment moves in one country are likely to trigger
further moves in another. One devaluation causes another “competitive”
devaluation; one spooked foreign investor may persuade others to follow suit.
Over time, these small movements may ultimately build up to a crisis point,
when suddenly everyone sees where things are heading and everyone wants to get
out the door first. Then it’s like watching an avalanche fall.
We saw this happen in 1997. It could easily happen
again in 2016.
BP: The financial media have been dumping
on the ’97 parallel. They say today is different.
NH: Yes, today is different. Today is worse.
Look, I’ve heard their arguments: They say that East Asia today is more
committed to floating exchange rates, has more FX reserves, and has a smaller
share of dollar-denominated debt. But everyone goes off the float in a crisis,
no one ever has enough FX reserves, and the dollar-denominated share is almost
impossible to measure. What we do know is that total debt is higher (per GDP).
Here’s why the situation is worse today than it
was just before 1997. Back then, both the world and emerging markets were
growing considerably faster than they are today— which means that most
countries were one or two or even three percentage points of growth further
from recession that they are today. The outlook was glorious. Today, not. Back
then, major central banks around the world still had plenty of room to lower
rates, which many of them used. Today, not. Back then, U.S. equity markets
overall were fairly valued, which reduced the possibility of contagion. Today,
not. Back then, the vulnerability was limited to one region. Today, it is
spread among emerging markets all over the world. Indeed, the first big sovereign
debt default this time could be Brazil or South Africa or Venezuela or Ukraine
or Egypt or wherever. (I’m just reading off some of today’s higher CDS spreads.)
Back then, our main concern was foreign investors
withdrawing their assets from emerging markets. Today, precisely because the IMF persuaded so many countries to get rid of capital
controls, a new concern is outflows triggered by domestic residents pushing their
funds abroad.
The IMF has since backtracked on its earlier disapproval (it now soothingly
refers to “capital flow management”), and over the last year a growing number
of emerging markets are reimposing capital controls as inflows dwindle and
outflows speed up. We may be nearer to the tipping point than many t hink: In
2015, there was a net-net capital outflow from all emerging markets for the first time since 1998.
And then there’s China. In 1997, China was an
inert bystander, with few financial ties to the rest of the world. Today, China
is a slowly collapsing supernova, with such massive external trade and
financial activity that even a slight change in its rate of decline will have
large repercussions both regionally and globally. Without a doubt, China is the
single biggest reason why what goes down for emerging markets in 2016 could be
worse than in 1997.
BP: I should have known: Once again, it’s
all up to China! So what will happen in China in 2016?
NH: Here’s the problem China faces. Because of
the CNY’s de-facto peg to the USD, the dollar’s rapid rise—by about 25%
(trade-weighted average) over the last two years— has dragged China’s currency
up with it. What’s more, two years ago many analysts already believed that the CNY
was overvalued. And now that China’s economy is slowing down and the PBOC is
reluctantly allowing to CNY to ratchet down, the pushing and shoving to get to
the exit is beginning to overwhelm the authorities’ power to control capital outflows.
We’re not just talking about carry traders wanting
out. We’re talking about the Chinese people wanting out. The elite have already
dug their own exit tunnels—a fact attested to by the huge recent influx of Chinese cash into European businesses
and into Canadian and Californian real estate. More will follow. Since last
summer, the PBOC has spent roughly $100 billion in FX reserves each month trying to
keep the CNY up. But the hemorrhage is slowly widening even as the CNY slowly
falls.
Clearly the dam will burst open long before the
PBOC gets to the bottom of its $3.3 trillion war chest, which really isn’t that
large relative to potential investor flow. Consider that each adult Chinese
citizen can legally
send $50,000 per year abroad. If just one Chinese household in twenty were to
exchange the legal maximum from CNY to USD today, PBOC’s entire kitty would be empty by
sundown. China’s government itself is to blame to setting up this situation. In
recent years they’ve helped keep the CNY up by running the perfect roach motel:
Investment can get in, but can’t get out (except with special permission). As a
result, most Chinese families and firms have never been able to diversify their
portfolios by investing abroad, creating an enormous pent-up demand for foreign assets.
Xi Jinping and the PBOC don’t have many good
options, and they don’t have much time to choose from among them.
BP: What are their options?
NH: Their first (and worst) option would be to
stay the current course, losing reserves and credibility at a growing rate
while failing to stop the currency decline. Before the year is out, they will
have to enact a major devaluation anyway and do it from a position of weakness.
Their second option would be a resolute defense of the CNY near its current
level with much stricter capital controls and jacked-up interest rates. But
capital will still seep out—and to prevent higher interest rates from killing
the economy, they would have to switch entirely to fiscal stimulus. I just
think it’s too late for this. Their third option would be to bite the bullet up
front and enact a large devaluation (40% or more) that the PBOC is certain it
could defend and then accompany that by further relaxing of capital controls.
It is the best option, but since it requires boldness and political courage it
is probably not the one Beijing will choose.
In a brilliant interview I highly recommend, strategic trader
Mark Hart summarizes both the problem and the options. His bottom line is this:
We are very likely to see a large CNY devaluation in 2016—regardless of whether
China’s leadership does this preemptively or whether they are dragged to it
unwillingly. And that devaluation will come with real risks.
Global markets may
sink and cause investors to flee other emerging markets. Other economies
(especially in Southeast Asia) may retaliate with their own devaluations,
threatening “currency wars.” Global leaders will react with heated and
nationalist finger pointing. To avoid losing face, leaders in Beijing may blame
others (the Fed, the EU, Shinzo Abe) for forcing them into this decision. It
won’t be a pretty picture.
BP: OK, I think I get your global take. I
recall you saying earlier that the economy faces a quadruple whammy. What’s the
fourth?
NH: It’s the Fed—or, more specifically, the FOMC’s 12-member “dot plot” intention to hike interest
rates. If the Fed goes ahead as planned, it will exacerbate nearly every
problem I’ve mentioned. Domestically, it will raise hurdle rates and dampen
borrowing and investment activity. Globally, it will accelerate the carry-trade
reversal, suck domestic savings out of emerging markets, and put added stress
on the developing economies at a moment of vulnerability.
BP: Wow. So why is the Fed doing this?
NH: Some in the Fed say it’s hiking rates
because the U.S. employment situation is basically fixed. But if we look at the
working-age employment-to-population ratio, we are clearly
a long way from a hot labor market—so that reason seems, at the very least,
incomplete. Others say it’s hiking rates because market valuations are
excessive (“bubbly,” as the Brits might say). I agree, but are they willing to
slow down the global economy to correct these valuations? I haven’t heard
anyone gutsy enough to say that.
Still others say that a “small” hike won’t hurt
much. Sure, but by the same token it won’t help much either. The whole point of
the Fed’s “forward guidance” in its December hike was to put a stake in the
ground and commit itself to a “half-throttle” plan of future hikes, amounting
to nearly 30 bps per quarter over the next three years. That’s pretty big. I
don’t think the Fed intended to make much ado about nothing.
In truth, I don’t think it’s entirely clear why
the Fed is doing this. Most likely, it’s playing an expectations game—hoping
that its plans will make the consumers and businesses believe the economy is speeding
up and thus be more willing to buy and invest. The Fed also feels powerless
with ZIRP and is terrified that it may eventually hit the next recession with
interest rates still stuck at zero. And then there’s the fact that the Fed
tends to echo the opinions of bankers, and bankers (perhaps irrationally) really don’t like low interest
rates.
The fact remains, however, that the only
legitimate reason to embark on such a major shift in monetary policy is to ward
off the threat of inflation.
Only no such threat exists. Look at the CPI, PCE
deflator, M2, and price of gold—nothing there. Look ahead at market
expectations for inflation five and ten years into the future—nothing there
either. I cannot recall another episode in history (except maybe back during
the gold-standard Coolidge and Hoover presidencies) in which the Fed has hiked
interest rates in the face of decelerating GDP growth, falling inflation
expectations, and a global slowdown. I don’t think it will turn out well.
BP: So what’s going to happen?
NH: One thing I can say with confidence is
that this full string of rate hikes will never happen. The Fed will postpone,
cancel, or reverse them—in all likelihood, well before the end of 2016. And it
will do so in a belated response to global market declines, disappointing
economic news, or an emerging markets crisis, possibly involving China. After
just the first two weeks of January, the Fed Funds futures market is already signaling a rapid decline in the share of
traders who believe the FOMC will go ahead as planned. Some are talking about a perverse “Yellen call.” Rather
than support you if the price drops, this Fed will hold you down if the price
goes up.
If for whatever reason the Fed does not back down
early in 2016, we are likely to see tell-tale signs of the inevitable in a
flattening yield curve. The Fed may already be concerned about the failure of
its December announcement to push up long-term interest rates. And if it’s not,
it soon will be. One thing is for sure: A narrowing NIM will get all those
gung-ho bankers to scratch their heads and say, what the hell were we thinking?
Investment analyst (and prolific author) John
Mauldin recently offered an open bet with any takers—that the Fed Funds rate will go back to zero before it ever reaches two percent.
His open bet understandably went viral. A stronger version of the bet would be
that we will see QE4 before the rate ever goes above one percent.
BP: How will the Fed’s rate-hike effort
affect the global economy?
NH: The Fed hike is predicated on the
assumption that the United States can prosper and accelerate while the rest of
the world slows down. The more the Fed hikes, the more it drives a wedge
between our prospects and theirs. While in theory you can say this ought to be
possible, given the relatively modest impact of trade on the U.S. economy,
history says it rarely happens. Most of the time, the U.S. and the rest of the
world expand and contract together—probably because of linkages through
financial markets, geopolitical events, and just contagious animal spirits.
In recent years the Fed has become more
isolationist in its outlook, perhaps following the White House, Congress, and
the American public in a retreat from globalism. Back in 2014, Raghuram Rajan,
Bank of India Governor (and former University of Chicago professor), told the Fed that it ought to take the world more into
consideration when making policy decisions. His outburst wasn’t kindly received
by Chairman Ben Bernanke.
Late last year, both the IMF and the World Bank
suggested to the Fed that now is probably not
a good time to hike rates. The Fed did not respond. I have no problem with the
Fed saying, hey, our first responsibility is to serve the U.S. economy. But
what the Fed fails to understand is the message that your economy and our
economies are connected. We all tend to rise or fall together. At least keep us
in mind.
So that’s my fourth whammy. It’s obvious to most
Americans that rising interest rates and a rising dollar will force our own
economy to swim upstream. What’s less obvious is that these same trends—when
global demand is weak—are painful for the rest of the world as well. And sooner
or later that rebounds on us. Fun fact: From 2014 to 2015, the dollar value of
global GDP actually declined. Historically, this doesn’t happen often. But when
it does, it typically sets up a global recession year—like 1983 and 2009. If
you’re a poor country, it means that hard-currency liquidity is disappearing.
If you’re American, it means no one else can afford what we sell. Either way,
it’s not a good sign.
BP: So of course I have to ask you: Does
all this add up to a U.S. recession in 2016 or not?
NH: As Yoda would say, “The dark side clouds
everything. Impossible to see the future is.” If you ask The Wall Street Journal’s panel of
60 economists, their current answer (taking the average) is that the
probability of a recession in the next year is 17%. This is the highest average
they’ve given since the question was first asked two years ago. But clearly it
suggests a possibility, not a probability.
Now if I were just looking at the U.S. economy in
isolation, I would probably offer a similar figure, maybe 25%. While the momentum
going into Q1 is weak, there’s still enough growth in core employment, income,
and sales (especially in services) to safely bet against a serious downturn
starting before the end of the year. But if I look more broadly at the economy,
and take into account the impact of financial markets, the global economy, and
the Fed, then my outlook darkens. I’d say the probability is more like 50%. And
if we look forward through 2017, then I’d choose a higher number still.
BP: I’ll take that as a qualified yes. Will
we see an inverted yield curve before the next recession?
NH: Unlikely. People sometimes clutch at
straws and say we can’t have a recession without an inverted yield curve. But
of course we can. We had many of them before World War II, and Japan has had
several recessions over the past twenty years even while its short-term rate
has been stuck around zero.
Is it possible? Well, I do see one scenario where
it could happen. Let’s say the hawks prevail in the FOMC and the Fed goes ahead
with some of its hikes in 2016, pushing the Fed Funds to, say, 0.75% by August.
Soon after the last hike, a global currency and financial crisis hits at just
the moment when sovereign wealth funds around the world (think: Saudis,
Chinese, Nigerians, Singaporeans, and so on) stop selling their assets, largely
Treasuries. Let’s imagine that they are running dry—and maybe that their abrupt
illiquidity helps trigger the crisis.
So suddenly a massive tide of assets sales—which
up until then was helping to boost long-term yields—comes to an end. Meanwhile,
of course, every global trader looking for a safe haven is trying to buy them.
We could easily see 10-year yield fall to 0.6% or 0.5%, basically to rates we
associate with the German 10-year Bund. (Recall that in late 2008 we saw the
10-year fall 190 bps in 7 weeks.) Bam, there’s your inverted yield curve.
I’m not saying it’s likely, mainly because I think
the Fed will back down. But it’s possible.
BP: This seems like a good jumping-off
point for geopolitics. What are the major global themes going into 2016?
NH: It’s easy to look around the world and see
signs of promise. In East Asia, China is trying to wage a peace offensive with
its neighbors. All told, we’re like to hear fewer alarm bells going off around
the South China Sea. In the Middle East, the big news is that IBPS is on the
retreat. They’re losing territorial control in the north and east to the
Kurds and Iraqis. After vicious back-and-forth fighting in recent weeks, ISIS
appears to be losing the key city of Ramadi. In Russia, Putin’s efforts to turn
Ukraine into “new Russia” have
stalled, and the regional conflict has reached a stalemate—which itself is
cause for celebration.
So examining the three big trouble spots around
the globe, yes, we see some good signs. Our biggest concerns a year ago seem a
bit less urgent now.
BP: That’s certainly good news. What, if
anything, should we be worrying about?
NH: Well, first you worry that you may be
wrong. ISIS, for example, remains a real threat. They continue to gain territory in the west against the Assad
loyalists. They’re gaining strength in Libya. And Europol says they’re actively planning larger Paris-scale attacks in
2016. And though we usually talk about a geopolitical crisis causing an
economic crisis, you also worry about the reverse. What would happen, for example,
if China underwent a major devaluation? No doubt nationalist passions would
heat up in that region. Wha t if Russia faces further privations due to falling
oil prices? Would that make Putin friendlier? To quote John Wayne, “not
hardly.”
But let me point quickly to two particular threats
in the Mideast which have grown more serious in the past couple of months. They
are long-term threats which may or may not cause us problems in 2016. But they
are big.
The first threat is clear evidence from Iran that Khamenei’s
regime has not the slightest intention of liberalizing or turning westward
now that its $100+ billion is officially being “unfrozen” as we speak. Of
course, many in the West hoped otherwise.
But now the regime is testing ballistic missiles, jailing dissenters, disallowing nearly all the reform candidates in the
upcoming (February) parliamentary election, and cozying up to Russia and China.
Speaking to Chairman Xi last week during his visit to Tehran, Khamenei
announced that he “never trusted the West” and wants to strengthen ties with
Beijing. Iran is spending blood and treasure on several fronts—in Syria, Iraq,
Yemen, and terrorist networks throughout the Mideast. It’s no mystery
where much of that new money is going.
The second threat is the mirror image of the
first: Saudi Arabia, under the untested leadership of King Salman and son, is burning its bridges with Iran and galvanizing a new sense
of unity among Sunni Arab nations. The Saudis recently organized a 34-nation “anti-terror” coalition to which Iran was
pointedly not invited. A couple of weeks ago, they found a convenient pretext
to lead all the Arab Gulf states to break diplomatic relations with Tehran. Military ties with Egypt< /a> are strengthening, and the
Saudis are eagerly trying to pull Turkey into their alliance. They are doubling down on their costly war in Yemen. They feel let
down and left on their own by President Obama on the Iran deal, and now they’re
trying to take history back into their own hands.
In short, threats are escalating and sides are
polarizing around an ancient sectarian divide, while the world’s
referee-superpower remains largely AWOL. Sure, there are other powers in play
here—Turkey, Kurdistan, Russia, Israel—but they just make the whole situation
more fluid and unpredictable. So if you want to know what the biggest new
geopolitical danger is going into 2016, this is it. We’re not just talking
about terrorism. We’re talking about the no-longer-remote possibility of
state-versus-state conflict.
BP: OK, I guess we have something to worry
about here, after all. Let’s move across the pond. What about Europe?
NH: I think this could be relatively
prosperous year for the EU. Yes, it remains economically troubled, with EZ
unemployment still above 10 percent. And yes, Europe still faces stubborn
deflationary pressure and can’t seem to get its banks to start lending again.
But the Eurozone now boasts a favorable combination of extremely low (indeed,
negative) interest rates, a cheap currency, and growing fiscal stimulus. Its
major worry is falling import demand in East Asia. Barring really bad news
there, the EU may do better in 2016 than it did in 2015.
If I were investing in equities in 2016, this
would be my global region of choice. The valuations are favorable. So is the
near-term outlook.
My big concern about Europe is political. The
ongoing migrant crisis is causing walls and fences to go up all over Central Europe. The
popularity of nationalist slogans and direct-action plebiscites is rising.
Support is growing for extreme right-wing and left-wing Eurosceptic parties who
threaten to break up the Union—or who are at least indifferent to its fate. In
France, Marine Le Pen’s National Front party led the pack in December’s first round of national
elections. In Poland, right-wing Law and Justice Party candidate Beata Szydlo was
swept into office in November. Even young voters are
climbing on board. (See CW: “A Rising Generation of Eurosceptics.”) Whether in Hungary,
Poland, France, or Scandinavia, you see rising attraction to these leaders and
to these parties.
Although David Cameron can wait until the end of
2017 to stage his Brexit referendum, he apparently wants to do it this summer. If he goes ahead, it will be a
great opportunity to take the pulse of European public opinion.
BP: Let’s move to the upcoming elections
here at home. Just how do Americans feel about government and politics in
general?
NH: Not good at all. In fact, we may be
reaching a breaking point. American citizens so distrust the establishment that
a growing number want to take a wrecking ball of the whole thing. Even many Democrats admit a fondness for the Donald’s careless nihilism.
According to a November Pew report, more than half of Americans think that
“ordinary people” would do a better job than elected officials at solving the
country’s problems. And fully 59 percent of the public believes that government
needs sweeping reform—a jump up from just 39 percent in 1997.
Not only that, but America has grown more
polarized than ever. People are more ensconced in their partisan views today
than in years past. I even get the sense that, increasingly, the losing side of
a national election regards itself as an oppressed people having no recourse
aside from obstruction, emigration, or rebellion. That really worries me,
because it’s only going to get worse—to the point that it not only impedes our
ability to govern and formulate policy, but could trigger some sort of active
resistance or succession movement. The historical precedent is there.
BP: That sounds serious.
NH: Indeed. But the show must go on, and we
can only hope that a candidate will emerge out of a process that no one likes
who can galvanize a clear majority of voters, not just those on one side of the
aisle.
BP: Who do you see getting the nomination
from each party?
NH: On the Democratic side, I think it’s
clear: It’s going to be Hillary Clinton.
I agree the popularity of Bernie Sanders has been
a real surprise. Here’s this littleknown, self-proclaimed “socialist” drawing
enormous crowds and stirring great excitement on the left-wing “single payer”
side of the party. And especially among Millennial Democrats. According to a
McClatchy-Marist poll, left-leaning 18to 29-year-olds would prefer to see
Sanders in office over Clinton by a margin of 23 percentage points. Like Trump on the other
side, Sanders illustrates the highly polarized mood of today’s electorate.
But Clinton possesses a simply insuperable lead
among rural, blue-collar, and minority Democrats. If she gets into trouble in
Iowa and New Hampshire, her Southern “firewall” will save her. What’s more, she
can count on the overwhelming support of the superdelegates (basically,
establishment politicians) at the convention. They constitute 15% of the
delegates. They are her ace in the hole.
BP: OK, what about the GOP side?
NH: I really don’t have a clue. Like many
other onlookers, I find it humbling how often I have to change my opinion.
Right now, for what it’s worth, I see two
scenarios.
The first is that Trump starts to broaden his
voter base beyond his core supporters —older, less affluent, non-college
Americans. Let’s imagine also that he gathers further (grudging) support from
the GOP establishment. Maybe, like Bob Dole, the old pols soften and come to regard him
as a “deal maker.” Others may invoke the memory of Ronald Reagan, another “amateur”
with a gift for politically incorrect hyperbole and for connecting with
working-class Democrats. In this scenario, Trump wins on the first ballot.
The second is that we reach the convention and
find that no candidate has an absolute majority. So no one wins on the first
ballot. That’s when the fun begins and all hell breaks loose. The only
consensus likely to emerge will be around the candidate who is most likely to
win in November—and this will suddenly thrust the moderates back into center
stage. If Rubio is second to Trump in delegates, he will be the
obvious choice. Others like Christie, Kasich, and Fiorina are possible, but
Rubio will beat them out as both the most electable and most “conservative”
option.
If I had to guess, I would put my bet on the
second scenario. I think the establishment has been warming to Trump only
because they detested Ted Cruz more. With Cruz in decline, the GOP movers and
shakers will start lending their support for electable alternatives to Trump.
Anyway, that’s my thinking today. Tomorrow I may change my mind.
BP: So who’s going to win the general
election?
NH: All depends on who’s running.
If for some reason Sanders is the Dems’ choice and
he goes head to head against Trump, the passion and vitriol will be off the
charts. With a quasi-socialist battling a quasifascist, we will truly be able
to relive the mood of the 1930s. I have no idea who would win that—probably
Trump, so help us God.
If it’s Clinton against Trump, Clinton will
win—but perhaps by a surprisingly narrow margin. She will be the candidate that
no one really likes but feels they have to vote for anyway. Either outcome,
especially a Trump loss, will be socially and politically damaging for the
country. It is likely that post-election rancor could build into active
resistance networks, possibly along class lines. I’m not at all happy about
this prospect. If Rubio is nominated, it will also be a close election—but here
I think the GOP has a realistic shot at winning.
Right now, the futures markets are giving the
election to Clinton: A $100 share of the winner-take-all action costs $60 to $65
for those betting on the Democrats, compared to less than $40 for those picking
the Republicans.
BP: Are these expectations having an impact
on financial markets?
NH: Not much right now, because everyone
assumes government will still be divided under any scenario. Therefore policy
will remain in gridlock. What’s scary is a possible replay of the 2008
election, when Obama and McCain debated each other just as global markets were
plummeting and fear was spreading. Only this time let’s imagine it’s Sanders
versus Trump, each one essentially asking voters to give them a sweeping
mandate to move the nation in radically different directions while the fate of
the economy, like a loaded gun, lies on the table. The heart races just to
imagine the prospect.
BP: Finally, let’s turn to generations. If
you had to choose one noteworthy transition facing each generation in 2016,
what would that be?
NH: I’ll start with Boomers. It will be a
landmark year for them in the economy: With the large 1946-born cohort hitting
age 70 this year, we should finally see Boomers beginning to retire in force.
Though most people retire well before then, Boomers have thus far surprised
everyone by working longer than their parents. But due to heavy tax and benefit
penalties on workers starting at age 70, even these workaholics will make their
final exit from the workforce. And in each future year, another large cohort
will follow. Up until now, America has been delaying the economic and fiscal
burden of a slower-growing workforce.
No more delays. Now it hits.
BP: What about Generation X?
NH: One need only look onstage during the GOP
debates to see the major storyline for Xers in 2016: This generation is finally
rising to political prominence—and they are doing so almost entirely on the
Republican side. Rubio, Cruz, Paul, and Christie are all Xers, all vying for
the Republican nomination. And then there are those who never declared or
dropped out, like Governor Scott Walker, Governor Nikki Haley, Governor Bobby
Jindal, Senator Joni Ernst, House Speaker Paul Ryan...the list of rising Xers
goes on and on. Many have immigrant backgrounds. Then look across the aisle to
the Democrats, and you hear a lot more about candidates too old to be Boomers
(Sanders, Biden, Brown) than too young. Only one Democratic Xer, Martin O’Malley,
with precisely zero chance of winning the candidacy, has even mild name
recognition.
Really, this wave of relative youth is an
extension of a broader political trend. Whether in Congress or in state
legislatures, Xers nationwide—especially first-wavers who were born in the
1960s and came of age with Reagan—are storming into GOP leadership positions.
This generation almost single-handedly catapulted the GOP to its momentous
takeover of Congress in 2014 and of many statehouses in recent years. (See CW:
“Incoming Gen Xers Carry the Midterms.”)
This could be the year that Xers finally take
charge of the White House.
Sure, President Obama is an Xer, but he’s a fringe
Xer, born in 1961. He digs hip-hop, came from a broken family, thinks of
himself as a “post-Boomer” fixer. But when he moralizes to the American public,
you sense the Boomer gene. Unlike Obama, the current crop of GOP candidates
truly embodies the classic Xer temperament: survivalist, pragmatic, distrustful
of large institutions, very pro-family, ready to tear down the system to build
a better one, and basically libertarian in outlook.
Interestingly, this GOP “youth” movement could
lead to a precise reversal of the age gap we saw in 2008. Back then, the GOP
candidate (John McCain) was 25 years older than the Democratic candidate
(Barack Obama). Now let’s imagine that Marco Rubio (born in 1971) wins the
nomination. That means that in 2016 the Democratic candidate (Hillary Clinton,
born in 1947) will be 24 years older than the GOP candidate. So the tables are
turned. I’m not sure what the GOP theme song would be, but I’m pretty sure it
won’t be Fleetwood Mac.
BP: And what about Millennials in 2016?
NH: I’m wondering—and I know I’m not
alone—whether 2016 will be the year when Millennials finally show up in the economy.
Up until now, most Millennials have kept their lives on hold, waiting for
better economic prospects before checking the box on life’s major
milestones—settling on a career, buying a home, and starting a family.
But 2016 could be when we start seeing the tide
turn. The gigantic 1990 birth cohort will reach 26 this year, precisely the age
when young adults start becoming firsttime homeowners and impactful consumers.
Yet this prediction is not a foregone conclusion.
Depressed household formation among Millennials, once thought to be a temporary
effect of the Great Recession, has persisted years after young adults were
supposed to start buying homes. Despite soaring rental prices and record-low
interest rates, Millennials have opted to stay put where they are, either at
home with Mom and Dad or in a shared apartment. In fact, the share of
Millennials living independently today is even smaller than it was in 2010. (See SI: “Did You Know? Millennials Keep It in the Family.”)
Another question is where Millennials will go—if
anywhere—once they buy a home. This generation is unlikely to migrate out to
the suburbs to one of the 40 million McMansions sitting vacant. They’ll likely opt
for something in the inner suburbs that affords them more space than an urban
apartment without losing the distinct flair of city life. (See II: “The Housing Market’s Slow Train to Recovery.”)
BP: Anything else you’d like to mention?
NH: I’ll close with this: Whatever happens,
all eyes will be on Millennials in 2016. This could be a difficult year
economically and a critical year politically. Whether as consumers or investors
or voters, Millennials may have the power to determine where the nation is
heading by the beginning of 2017.
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