Time to Change Strategy

By John Mauldin

My recent letters described what I think the future will look like. I hasten to add, it isn’t what I think the future should look like or what I want to see. Almost the entire developed world has painted itself into a corner.

It won’t necessarily be terrible. I don’t expect another Great Depression or economic upheaval, but we will have to adapt our portfolios and lifestyles to this new reality. The good news is the changes will happen relatively slowly. We have time to adapt.

In war movies, it’s common for the dashing leader to make bold promises like, “We will never retreat!” ahead of a glorious victory. The assumption is that retreat is bad. But real-life military strategists say retreat can be the right move. When the odds are against you, better to save your ammunition for another time. Better yet, adopt a new strategy that gives you a better chance.

My last few letters may look like retreat, but I’m just recognizing reality. There is no plausible path to stopping the world’s debt overload, much less paying it off, without a serious and painful purge. If you know of such a path, please share it with me, but I haven’t seen one. So I foresee a tough decade ahead.

Summing up:

1.   Entitlement spending, interest on the debt, defense spending, and so forth will continue to produce trillion-dollar-plus deficits.

2.   No constituency is arguing to reform the entitlement system by reducing benefits. By the middle of the next decade, deficits will be in the $1.5 trillion range even under the CBO’s optimistic assumptions. While the numbers look marginally different elsewhere, the developed countries are all going the same direction: toward higher deficits.

3.   Following the next recession (and there is always one coming), the US deficit will be well north of $2 trillion and the total debt will quickly rise to $30 trillion. It will almost certainly be in the $40 trillion range before 2030. Unless interest rates drop significantly, simply paying the interest will consume much of the tax revenue. (Fortunately, I expect interest rates to drop significantly. Think Japan.)

4.   A growing body of academic literature and real-world experience suggests there is a point beyond which debt becomes a drag on growth. That means that the recovery after the next recession will be even slower than the last one. If, as I expect, the Federal Reserve and other central banks react with massive quantitative easing, it is entirely possible that the whole developed world will begin to look like Japan: slow nominal GDP growth, low interest rates that penalize savers, low inflation or even deflation, etc.

5.   In such an environment, normal equity index funds won’t produce the returns many have grown to expect.

6.   Public pension funds will get hammered in the bear market and many will have difficulty meeting their obligations. Governments will be forced to either cut benefits, raise taxes, or both. That is not going to make for a happy citizenry. It will play out in different manners all across the world, but the resulting frustration will be the same. And to put it very bluntly, “frustration” is inadequate to describe the result of underfunded pensions. Retirees made plans for their futures based upon receiving those pensions. And taxpayers likewise make plans.

7.   All of this will have significant investment implications, which we will visit below and in great detail in the coming weeks and months. But Japanification, to use a word, is going to make income and wealth inequality worse, not better.
This all being the case, the priority now isn’t whether to “retreat,” in the sense of changing your investment strategies, but how and to where, so you can pick up the fight later. Developing a strategy requires us to understand exactly what is happening and why. So I’m looking at the situation from different angles.

We Have a Problem

You have likely heard of “income inequality”—that wealthy people are making a larger share of our collective income. In one sense, it’s nothing new. Of course, the people with the highest incomes have more of the total. Math guarantees it.

But it is true that the top’s share has grown in recent decades, as has the share of assets owned by the wealthiest. Ray Dalio of Bridgewater Associates has been writing about this for a few years now. Here’s a chart and quote from his latest article.

As shown below, the income gap is about as high as ever and the wealth gap is the highest since the late 1930s. Today, the wealth of the top 1% of the population is more than that of the bottom 90% of the population combined, which is the same sort of wealth gap that existed during the 1935-40 period (a period that brought in an era of great internal and external conflicts for most countries). Those in the top 40% now have on average more than 10 times as much wealth as those in the bottom 60%. That is up from six times in 1980.

Source: Ray Dalio

Dalio thinks it is significant that inequality, at least by these measures, is now in the same area it was in the Great Depression. It plunged in the postwar years and began rising again in the 1980s.

I suspect, if we had data going back a few centuries, we would see that those 30 or so years between 1950 and 1980 were actually the statistical aberration. Mass prosperity hasn’t been the historic norm. It certainly wasn’t that in the 1800s and the Gilded Age. Nor was it so in Europe.

Some people see this inequality as somehow unfair. I think it is more complex than that. It depends on how those with wealth became so. There’s a big difference between (a) despots who use political authority to enrich themselves and their friends, (b) monopolists who thrive by taking choice away from consumers instead of adding to it, and (c) entrepreneurs who grow wealthy by selling useful products to willing consumers.

(Incidentally, Dalio does a good job describing the problem, but I think he lays the blame at the wrong doorstep. His proposed solutions leave a lot to be desired. I will discuss this at length in a forthcoming letter.)

The problems begin when people perceive the wealthy are getting rich at the expense of others. And, it’s hard to escape that conclusion when the data say the top tier is keeping a bigger share of the pie, even if the pie is growing. Especially when your piece of the pie is not growing nearly as fast as those of the top. The relative distance becomes even more stark.

Let’s review some charts from my friend Bruce Mehlman’s latest fascinating slide deck. (He has much more that you can and definitely should view here.)

Source: Bruce Mehlman

If you take GDP as a proxy for national income, it’s been growing far faster than median family income, even adjusted for inflation. The wider that gap gets, the more people feel like they are being left behind.

Here’s another one comparing stock market growth with family net worth. This isn’t really surprising since we know the top quintile owns most of the stocks. The lower 80% see little direct benefit. But the magnitude of the disparity is still remarkable.

Source: Bruce Mehlman

One reason income may be unequal is that talent is increasingly unequal, too. Or at least, the willingness of businesses to buy talent. Here’s a chart showing the most valuable companies have been getting that way with a smaller headcount.

Source: Bruce Mehlman

Mehlman cites technology as the explanation for this, and I agree that’s a significant part of it. But so are other things, like the increasing number of sectors where a small number of companies, whose existence is enabled by financial engineering and monetary policy, dominate their respective markets.

My good friend Ben Hunt of Epsilon Theory notes that the S&P 500 companies have the highest earnings relative to sales in history.

Source: Ben Hunt

Quoting Ben:

This is a 30-year chart of total S&P 500 earnings divided by total S&P 500 sales. It’s how many pennies of earnings S&P 500 companies get from a dollar of sales… earnings margin, essentially, at a high level of aggregation. So at the lows of 1991, $1 in sales generated a bit more than $0.03 in earnings for the S&P 500. Today in 2019, we are at an all-time high of a bit more than $0.11 in earnings from $1 in sales.

It’s a marvelously steady progression up and to the right, temporarily marred by a recession here and there, but really quite awe-inspiring in its consistency. Yay, capitalism!

Ben goes on to say many people think that is because of technology. He argues it is the financialization of our economy and the Fed’s loose policies. I agree 100%. If you think they haven’t changed the rules since the 1980s and 1990s, you aren’t paying attention, boys and girls!

Work-saving technology isn’t bad. In the past, it freed our bodies from dangerous, exhausting toil, and now it’s freeing our minds from mental drudgery. We can adjust. The problem is that it is hitting us so fast. Farming went from manual labor to automation over several generations. Now we’re traveling an equal distance in only a few years, resulting in millions of unemployed humans.

As unhappy as all this is making people now, imagine how it will be when recession hits. And then couple that with an ever-increasing explosion of new technologies that reduce demand for many types of labor (like automated driving).

No Solutions

Some degree of unhappiness and discontent is part of the human condition. It’s what drives us to improve our lives. We accept challenges as long as we think we have a fair chance at overcoming them.

Many Americans no longer believe they have that chance. That’s partly because they have higher expectations—possibly too high. But right or wrong, the perception is there. It affects behavior and, more to the point, it affects what people expect from the government. When they perceive less ability to reach the next level on their own, they look to Washington for help.

I noted last week that almost no one really wants to cut government spending. Even the so-called fiscal conservatives mostly nibble around the edges, reducing budget growth here and there. Bill Clinton was wrong when he said “the era of big government is over” in 1996. It’s bigger than ever and growing faster than ever. Whether you like it or not, that is a fact.

Government revenue is not growing faster than ever, which means rising debt even in today’s relative prosperity.

Again, whether you like this or not is irrelevant. It’s happening. I see no way out. Raising taxes on the wealthy won’t get us even close to a balanced budget, even at confiscatory levels. Raising taxes on the middle class won’t happen in a recession. The only tax system with a shot at actually paying for current spending (even without adding the new programs some Democrats want) is a “VAT” or value-added tax, and it is anathema in both parties.

No matter how I look at this, I keep coming back to gigantic deficits that the Federal Reserve will have to monetize in some fashion—probably something like the previous QE rounds but on a vastly larger scale. And thus my belief it will launch an era of Japan-like deflation and economic doldrums.

If you think this is impossible or I’m being too pessimistic, please, please tell me why I’m wrong. Show me where we can get the necessary tax revenue without severely impacting the economy. Show me how we can cut benefits without getting massive pushback from politicians. And please, show me how we get off the path we are on. And tell me what scenario you think is more plausible. I don’t see one. I really don’t.

Friends Don’t Let Friends Buy and Hold

You probably read my letters because they help inform your investing strategy. If so, then let me say this loud and clear: your strategy probably needs to change. The methods that worked well recently won’t cut it in the new era I think we will enter soon.

At the risk of repeating myself for the 20th time, bear markets like last December that are not accompanied by recessions have V-shaped recoveries. Bear markets that happen in the context of a recession have long recoveries. The next one, because of the massive debt that will be increasing at an astounding rate, is likely to see an even slower recovery.

Friends don’t let friends buy and hold. At a minimum, you need some type of hedging program on your equity portfolios. Using a simple 200-day moving average to signal the time for going to cash, while not the best, will help protect you from the worst of a massive bear market.

The recent flurry of IPO filings by “unicorn” companies like WeWork ought to be ringing alarm bells. The venture capital investors who financed these businesses thus far are ready to exit. They’re doing so because they think the risk-reward equation is as favorable as it will ever be. Possibly they’re wrong, but I don’t think so.

We have reached the “distribution” stage, when insiders and professional investors become net sellers while the small investors who missed most of the bull market finally jump in. History says it won’t end well for the latter group.

As the economy weakens into recession and public markets retreat, I think we’ll see two strategic trends.

First, active management will return to prominence as investors realize prices can move in both directions. The RIAs, mutual funds managers, and hedge funds that have managed to hold on through the lean years (and many didn’t) will draw assets once again. That doesn’t mean they will succeed, performance-wise, but they’ll get a chance to try.

Second, and possibly more important, the best opportunities will leave the public markets entirely. We already see this unfolding as the number of listed companies declines, mainly at the expense of small caps. There is just no reason for most successful companies to accept the hassles and expense of an exchange listing. They can raise all the capital they need from that small number of investors in whom most of the wealth is now concentrated.

This will, unfortunately, aggravate the inequality frustrations. Our regulatory structure keeps most private investments off limits to the average investor, or even above-average net worth investors. So even if you manage to accumulate some capital, you may not have the much better options for investing it than those with a few million dollars and more. The government has rigged the markets against small investors in the name of protecting them.

That doesn’t mean investment success will be impossible. You’ll have opportunities, but you may have to hunt for them and act quickly when you find them. That’s what active managers do, and not just in stocks and bonds. I foresee many opportunities in real estate as well. There are going to be amazing opportunities in new technologies. Like smart generals, sometimes we have to retreat from the unwinnable battle and develop a different plan. That’s what I am doing.

We’ll go deeper into this subject at my conference in Dallas, which is now less than two weeks away. I can’t wait. You can hear and/or see most of it with a Virtual Pass. I truly don’t know of a better educational opportunity for investors than either directly attending the Strategic Investment Conference or getting your Virtual Pass. Please note that for people like me, who prefer to learn by reading and not listening, all of the speeches will be transcribed for the Virtual Pass. And attendees automatically get them. The conference is May 13–16 and there are usually a few spots that open from people having to cancel at the last minute. If you can make it, you probably should. I look forward to seeing you there.

Dallas, SIC, and Conversations

Shane and I will head for Dallas next Wednesday, taking care of some local business and meeting friends (and hopefully getting to watch the new Avengers movie) and then turn our complete focus to the conference. Surprisingly, my travel calendar after that is fairly sparse for the early summer, with a few potential spots here and there.

I was in Washington, DC this week where I did a video interview with my friend Neil Howe. We discussed a wide variety of subjects, including what the last half of the Fourth Turning will look like. He foresees a great deal of political angst. There is the real potential for the same kind of political stresses that gave us Franklin Roosevelt almost 90 years ago. For some of you, that is a scary thought, and others will say “about time.”

I then had the privilege of spending some time with good friend Newt Gingrich and some of his staff. We drove to a bookstore in Virginia for a book signing and then he took two of us to a hole-in-the-wall Italian restaurant near his home. He quizzed me for some time on my view of the economy and its interplay with society, and in return, I got to ask a few questions as well. Newt has some of the best stories. As does Neil Howe. I have been with them together, and it is a priceless moment. Just for the record, I also met with those of a different political and economic philosophy. I do so all the time.

One of the greatest investment risks is a lack of imagination, in that we can’t imagine what could actually go wrong with our main investment thesis. As Mark Twain supposedly said, “It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so.”

Michael Lewis’s book The Big Short opens with this similar quote, from Leo Tolstoy: 

The most difficult subjects can be explained to the most slow-witted man if he has not formed any idea of them already; but the simplest thing cannot be made clear to the most intelligent man if he is firmly persuaded that he knows already, without a shadow of a doubt, what is laid before him.

I spend a great deal of time trying to determine if what I already “know for a fact” is actually the case. That is especially true when I’m developing a new thesis that makes me uncomfortable. But if the facts change, what else can we do but evolve with them?

And on that note, let me wish you a great week! Find a friend or two and swap a few stories. It will make your life better.

Your trying to see the way forward analyst,


John Mauldin
Chairman, Mauldin Economics

Redesigning life

The promise and perils of synthetic biology

To understand them well, look to the past

FOR THE past four billion years or so the only way for life on Earth to produce a sequence of DNA—a gene—was by copying a sequence it already had to hand. Sometimes the gene would be damaged or scrambled, the copying imperfect or undertaken repeatedly. From that raw material arose the glories of natural selection. But beneath it all, gene begat gene.

That is no longer true. Now genes can be written from scratch and edited repeatedly, like text in a word processor. The ability to engineer living things which this provides represents a fundamental change in the way humans interact with the planet’s life. It permits the manufacture of all manner of things which used to be hard, even impossible, to make: pharmaceuticals, fuels, fabrics, foods and fragrances can all be built molecule by molecule.

What cells do and what they can become is engineerable, too. Immune cells can be told to follow doctors’ orders; stem cells better coaxed to turn into new tissues; fertilised eggs programmed to grow into creatures quite unlike their parents.

The earliest stages of such “synthetic biology” are already changing many industrial processes, transforming medicine and beginning to reach into the consumer world (see Technology Quarterly). Progress may be slow, but with the help of new tools and a big dollop of machine learning, biological manufacturing could eventually yield truly cornucopian technologies.

Buildings may be grown from synthetic wood or coral. Mammoths produced from engineered elephant cells may yet stride across Siberia.

The scale of the potential changes seems hard to imagine. But look back through history, and humanity’s relations with the living world have seen three great transformations: the exploitation of fossil fuels, the globalisation of the world’s ecosystems after the European conquest of the Americas, and the domestication of crops and animals at the dawn of agriculture. All brought prosperity and progress, but with damaging side-effects. Synthetic biology promises similar transformation. To harness the promise and minimise the peril, it pays to learn the lessons of the past.

The new biology calls all in doubt

Start with the most recent of these previous shifts. Fossil fuels have enabled humans to drive remarkable economic expansion in the present using biological productivity from ages past, stored away in coal and oil. But much wilderness has been lost, and carbon atoms which last saw the atmosphere hundreds of millions of years ago have strengthened the planet’s greenhouse effect to a degree that may prove catastrophic. Here, synthetic biology can do good.

It is already being used to replace some products made from petrochemicals; in time it could replace some fuels, too. This week Burger King introduced into some of its restaurants a beefless Whopper that gets its meatiness from an engineered plant protein; such innovations could greatly ease a shift to less environmentally taxing diets. They could also be used to do more with less. Plants and their soil microbes could produce their own fertilisers and pesticides, ruminants less greenhouse gas—though to ensure that synthetic biology yields such laudable environmental goals will take public policy as well as the cues of the market.

The second example of biological change sweeping the world is the Columbian exchange, in which the 16th century’s newly global network of trade shuffled together the creatures of the New World and the Old. Horses, cattle and cotton were introduced to the Americas; maize, potatoes, chilli and tobacco to Europe, Africa and Asia. The ecosystems in which humans live became globalised as never before, providing more productive agriculture all round, richer diets for many. But there were also disastrous consequences. Measles, smallpox and other pathogens ran through the New World like a forest fire, claiming tens of millions of lives. The Europeans weaponised this catastrophe, conquering lands depleted and disordered by disease.

Synthetic biology could create such weapons by design: pathogens designed to weaken, to incapacitate or to kill, and perhaps also to limit themselves to particular types of target. There is real cause for concern here—but not for immediate alarm. For such weaponisation would, like the rest of cutting-edge synthetic biology, take highly skilled teams with significant resources. And armies already have lots of ways to flatten cities and kill people in large numbers. When it comes to mass destruction, a disease is a poor substitute for a nuke. What’s more, today’s synthetic-biology community lives up to ideals of openness and public service better than many older fields. Maintained and nurtured, that culture should serve as a powerful immune system against rogue elements.

The earliest biological transformation—domestication—produced what was hitherto the biggest change in how humans lived their lives. Haphazardly, then purposefully, humans bred cereals to be more bountiful, livestock to be more docile, dogs more obedient and cats more companionable (the last a partial success, at best). This allowed new densities of settlement and new forms of social organisation: the market, the city, the state. Humans domesticated themselves as well as their crops and animals, creating space for the drudgery of subsistence agriculture and oppressive political hierarchies.

Synthetic biology will have a similar cascading effect, transforming humans’ relationships with each other and, potentially, their own biological nature. The ability to reprogram the embryo is, rightly, the site of most of today’s ethical concerns. In future, they may extend further; what should one make of people with the upper-body strength of gorillas, or minds impervious to sorrow? How humans may choose to change themselves biologically is hard to say; that some choices will be controversial is not.

Which leads to the main way in which this transformation differs from the three that came before. Their significance was discovered only in retrospect. This time, there will be foresight.

It will not be perfect: there will certainly be unanticipated effects. But synthetic biology will be driven by the pursuit of goals, both anticipated and desired. It will challenge the human capacity for wisdom and foresight. It might defeat it. But carefully nurtured, it might also help expand it.

China stimulus efforts show signs of stabilising economy

Concerns remain that recovery is fragile with trade war and weak credit supply curbing growth

Don Weinland and Sherry Fei Ju in Beijing

A section of the Hong Kong-Zhuhai-Macau bridge, one of the key infrastructure projects in southern China © Bloomberg

Beijing had a clear message to local authorities at the end of last year: hurry up and build.

The flurry of government debt issuance and a boom in infrastructure projects that followed in early 2019 have started to deliver a boost to the economy, lifting sentiment after months of gloomy economic data.

But it is unclear how far the uplift will carry through this year. The flow of credit to businesses in China remains weak and demand for exports feeble even as a trade war with the US inches closer to resolution.

Some economists worry that positive signals from March are a seasonal fluke, and that China’s frothy stock market will eventually experience a deep correction as economic growth slows to a three-decade low.

In its strongest reading since June, China’s official manufacturing purchasing managers’ index on Sunday marked a return to growth: it rose to 50.5 in March from 49.2 in February, outpacing even the highest expectations for the index.

A PMI reading above 50 signals expansion while a reading below 50 indicates contraction.

The survey results offer an early peek at the activity at the heart of the economy — such as factory output and demand for raw materials — but are considered less robust indicators compared with industrial profits, which a week earlier notched the fastest rate of decline in almost a decade.

The leading source of fresh growth for March was manufacturing production, a sign that government spending on infrastructure projects was having a noticeable impact on the economy, according to Robin Xing, chief China economist at Morgan Stanley.

“This is a policy-driven rebound,” he said. “It’s better than in previous easing cycles because it’s not relying on shadow banking. They are more focused on fiscal policy easing.”

The impact has been felt in infrastructure spending, with the number of power plants under construction increasing according to Global Energy Monitor, a non-governmental organisation that tracks fossil-fuel use.

Approvals for local debt issuance usually come after the week-long lunar new year holiday that lands between late January and late February. But this year, facing a serious economic slowdown, regulators front-loaded those approvals to expedite the building of infrastructure.

In the first two months of the year, gross local bond issuance hit Rmb782.1bn ($116.5bn), up from just Rmb28.5bn for the first two months of last year. Several other new fiscal policies are coming down the line, Mr Xing said. A value added tax relief programme came into effect on Monday, with the potential to deliver Rmb2tn in tax cuts this year.

The fiscal spur represents a change in approach for China.

Policymakers have often attacked economic problems with a flood of credit and a command to banks to lend more, often leading to a spurt of growth but high leverage for companies. Regulators this year are still pushing for more lending but they have not fully opened the credit taps and are focused on helping smaller companies borrow.

“The previous one-size-fits-all deleveraging has now become structural deleveraging and stable leveraging,” said Zhao Xijun, head of the Financial and Securities Institute at Renmin University of China.

Some economists worry the credit supply could still be growing too slowly to support a continued turnround in other areas of the economy. Total social financing, China’s broadest measure of credit growth, increased by just 10.6 per cent year on year in February, down from 13.3 per cent a year ago.

Conditions in March for small and medium-sized companies improved from a month earlier but were still contracting, according to the PMI data. Conditions worsened for large enterprises last month.

“We’re a bit cautious about calling this the bottom [for credit growth],” said Julian Evans-Pritchard, senior China economist at Capital Economics. “This still points to a further slowdown.”

But challenges to growth remain beyond China’s borders.

While Beijing and Washington are closer to an agreement in their trade war the PMI survey has showed export demand remains weak.

“I don’t think there is any clear sign of external demand stabilising yet,” said Charles Yuan, a China economist at CICC, the Beijing-based investment bank. “The market was expecting a temporary trade resolution at the end of March but we didn’t get that.”

Many economists, including Mr Yuan, have warned that the lunar new year gave March a seasonal boost. By landing in early February, the holiday pushed some economic activity into the third month of the year.

China’s stock market has traditionally been sensitive to signs of an economic slowdown. However, a barrage of gloomy data in January and February did not discourage investors from moving into equities. Chinese stocks have rallied during that time and climbed to their highest level in a year on Monday following the positive PMI news.

Part of the rally has been driven by margin lending, where large shareholders pledge stock for loans and often reinvest. The government is likely to crack down on the activity in the hope of bringing back healthy investment to the market, said Chi Lo, senior strategist for greater China at BNP Paribas Asset Management.

“Froth has come back to the market and that has caught Beijing’s eye because they want to keep it stable,” said Mr Lo. “A lot of investors are waiting for that correction to get back into the market.”

Additional reporting by Lucy Hornby in Beijing

Failure To Communicate

by: The Heisenberg
- Jerome Powell's post-FOMC press conference on Wednesday ended up shifting the narrative materially.

- It's not entirely clear whether the Fed chair meant to come across as "hawkish", per se, and therein lies the danger of holding press conferences after each meeting.

- Here's a comprehensive, in-depth take on this week's most important event.

It took roughly six months for me to feel vindicated regarding my long-held contention that Fed Chair Jerome Powell's "plain English" (as he famously called it) approach to communicating with markets would end in tears.
Right up until October 3, pundits and analysts celebrated Powell's "non-academic" approach. But cheers turned to jeers when the Fed chair's tone-deaf characterization of policy as "a long way from neutral" came across as unnecessarily aggressive under the circumstances and set the stage for what would eventually morph into a horrendous quarter for risk assets of all stripes.
Powell's December press conference was, by most accounts, disastrous. Minutes from the December meeting would later reveal that Powell arguably failed to convey the tone of the actual policy discussions taking place at the time, to the detriment of fragile market sentiment.
A related argument of mine from last year was that Powell's decision to hold press conferences after every meeting was a bad idea. It would, I suggested on too many occasions to count, have the opposite of its intended effect. Specifically, I argued that more frequent press conferences had the potential to create confusion, especially if Powell proved to be less-than-adept at communicating.
Wednesday's proceedings were an example of why less is often more when it comes to post-FOMC press conferences. The market went into the May Fed decision expecting a "dovish hold" and that's precisely what the FOMC delivered. The statement effectively downgraded the inflation outlook and referenced the Fed's "patient" approach. The committee also delivered the IOER cut that everyone knew was coming at some point.
Obviously, the Fed has come under immense political pressure to cut rates, despite the US economy expanding at a 3.2% annualized pace in Q1 (the internals from the GDP report weren't great, but the headline print certainly doesn't scream "time to cut rates") and despite unemployment sitting at a five-decade nadir. Over the past two months, Fed officials, White House aides and President Trump himself have gone out of their way to debate whether subdued inflation theoretically provides a justification for what, in market circles, is known as an "insurance" cut. Calls for such a move come as the Fed is set to reconsider its inflation framework and there are rumors that policymakers could eventually opt for a strategy that involves letting the labor market run "super-hot" (think: a 2-handle on unemployment) on the excuse that that's what's necessary to get inflation sustainably to target.
If you go back and read the transcript of the October 23-24, 2012, FOMC meeting, you'll find Powell delivering the following remarks (he was referring to the balance sheet, but the sentiment is applicable in a general sense):
The market in most cases will cheer us for doing more. It will never be enough for the market.
At the beginning of this year, markets were clamoring for clarity on the balance sheet. All anyone wanted was a hint that the Fed would at least consider altering the pace of runoff to account for the possibility that at some point last year, QT ceased to be "like watching paint dry" (as Janet Yellen put it) and began to negatively affect risk assets. Bear in mind that there is scant evidence to support the contention that we crossed some kind of magical threshold in the second half of last year beyond which runoff was having a direct, mechanical impact. The psychological effect was likely far more important in explaining the apparent connection between the selloff in risk assets and QT. That said, there is a link between MBS runoff and stocks/volatility, and it is true that if you add the current Fed rate to the 300bp rise in the shadow rate from the lows in 2014 (attributable to the wind down of QE), you end up around 5.5% worth of tightening, so it's at least plausible to suggest that things finally "snapped" in Q4.
In any event, fast forward from the first three days of January (i.e., before Powell's remarks in Atlanta on January 4 which set the dovish pivot in motion) to this week's FOMC meeting, and the Fed has given the market everything and more.
There is now an end-date for runoff, the beginnings of a plan on what will happen after runoff ceases, a commitment to being on hold ("patient") enshrined in the dots, and regularly-floated trial balloons, which all generally seem to suggest that at some point, subdued inflation could warrant a preemptive rate cut, even if the economy is doing well.
The market has responded by pricing in easing and risk assets have levitated. Cross-asset volatility has concurrently collapsed. Stocks are at all-time highs, high yield spreads have tightened dramatically off the Q4 wides, BBB credit (last year's boogeyman) had its best first quarter to a year since 1995, and on and on. Here's an updated cross-asset performance chart (current through Monday):
But, as Powell put it more than six years ago, "it will never be enough for the market", and now that "the market" includes the President of the United States, it's little wonder that the Fed chair was subjected to questions on Wednesday about the threshold for a rate cut.
Here is where I get to remind you that Wednesday's press conference was entirely unnecessary. It was Powell's decision to hold press conferences after every meeting, and had he not presided over one this week, he would have been spared a series of questions about inflation and whether subdued price pressures could conceivably be used as an excuse to cut rates. The Fed could have easily worked into the statement language which communicated the idea that factors weighing on inflation are seen as transitory. Further, if someone can explain to me why Powell needed a press conference this week to reiterate that the Fed currently sees no strong case for moving either way on rates, I'd love to hear it, considering that when you've just kept rates on hold it pretty much by definition means you didn't see a strong enough case for adjusting them.
Long-time followers of mine might well be tempted to respond with "What about Mario Draghi's press conferences?" To that I would simply reiterate that Jerome Powell is not Mario Draghi who, in addition to being famously adept at communicating, generally has more to talk about given that he's conducting monetary policy for a disparate collection of economies, all with their own unique fiscal and political situations.
In any event, the dovish market reaction to the Fed statement and the IOER cut was promptly erased when Powell discussed the reasons why he believes the factors weighing on inflation are likely to prove transitory. His reiteration that the committee didn't see a strong case for moving either way on rates only magnified the hawkish character of the presser.
You might well argue that Powell felt it was incumbent upon him to push back against the notion that a rate cut is imminent and to (implicitly) defend the Fed's independence amid withering political pressure to ease. You could also plausibly argue that Powell knew the IOER cut had the potential to be interpreted as something other than a technical adjustment (i.e., as conveying something about policy) and therefore thought he needed to clarify.
But, again, all of that could have been worked into the statement and, in the case of the clarification on the IOER tweak, into the implementation note.
Instead, it was delivered in "plain English," and while I don't pretend to know how policymakers felt about the U-turn in rates on Wednesday, I can confidently say that what you see in the following chart isn't desirable from a policymaker perspective:
If you're wondering whether that ~10bps swing in 2-year yields from the initial knee-jerk to where things stood an hour later is "normal", the answer is no. Here's a chart from Goldman:
Again, this was avoidable. Everything Powell said in the press conference could have easily been incorporated into the statement, and markets would have latched onto the "dovish hold" and gone about their business. Instead, there was confusion.
You can read a summary of Wall Street's reactions here, but suffice to say analysts are willing to give Powell the benefit of the doubt regarding the relative wisdom of expounding on the "transient" factors pushing down inflation. As I argued on Thursday morning, though, that generous assessment could well be explained by the fact that so many desks were caught completely wrong-footed with their Fed calls for 2019 and are now hoping against hope that a cut doesn't in fact materialize and make those calls seem even more off the mark in hindsight.
For my money, I'm inclined to agree with Nomura's Charlie McElligott, who expressed more than a little skepticism about the whole situation on Thursday morning. "I remain completely convinced that the bar to cut rates is infinitely lower than the bar to hike again", he wrote, after noting that "Powell's messaging on 'transitory' factors behind inflation weakness was met with a collective eye-roll and broad investor cynicism."
The follow-through on Thursday was less than inspiring, as both stocks (SPY) and bonds (TLT) fell in tandem in what was pretty clearly a post-Fed positioning adjustment. Sharply higher real yields certainly didn't help stocks' cause.
In case you were wondering whether you can blame risk parity (a frequent scapegoat whenever bonds and equities fall/rise simultaneously), the answer is probably not. Rather, this was just an example of what happens when the narrative suddenly shifts. Here's what McElligott had to say in an afternoon client note:
We simply had a lot of people on the same side of the same trades with the same view-and it was working fine; stability breeds instability however, and all it takes sometimes is a modest tweak to a narrative which then "tilts" excess positioning / leverage into a correction with occasional "cleanses".
Goldman of course had a lot to say in the aftermath of the press conference, but midway through Thursday, the bank weighed in with a little ad hoc color as follows:
We didn't think the Fed was contemplating a cut, but we acknowledge that markets did, and markets have had to unwind some of this expectation over the last few trading hours. Interesting to consider: you can't have it both ways. The reason why the Fed is not factoring in a cut is because it thinks growth remains "moderate or perhaps modest" - also consistent with the absolute levels of the ISM Manufacturing Index (if not the second derivative inflection).
The point being, you might well think Powell said all the right things during the press conference (and, for what it's worth, Goldman's other two Fed postmortems suggest the bank thinks he in fact did get it right), but in my view, everything that needed communicating could have been channeled through the statement. You are not going to convince me that whatever position adjustments have been made over the past 24 hours would have looked the same way had the message been delivered more subtly via the statement as opposed to Powell standing at the podium and pounding the table on "transitory". It is my opinion that Wednesday's press conference created unnecessary confusion.
Perhaps the riskiest thing about Wednesday was that the perception of a hawkish turn from Powell helped put the brakes on a much needed pullback in the dollar, which recently summitted new YTD highs. At a certain point, dollar strength is going to weigh on risk assets and, indeed, it's already starting to impact emerging markets at a time when idiosyncratic turmoil is picking up again in Argentina and Turkey.
As you're probably aware, the Fed's dovish turn in 2019 has not translated into dollar weakness, primarily because the FOMC's global counterparts leaned dovish in tandem and also because relatively speaking, the US economy continues to hold up well. Have a look at the following chart:
I used a red line to show Thursday's rise in real yields. The question you should ask yourself when you ponder that visual is this: If the dollar has been as resilient as it has in the face of sharply lower real yields, what will the greenback do if, suddenly, real rates start to rise again on the back of more hawkish Fed expectations?
If your answer is that the dollar will probably strengthen even more, then think about the implications of that for EM.
In that context, consider this brief color from a BofA note dated Thursday:
While China is doing an impressive job at stimulating (note the jump in Total Social Financing), export dataflow for other EM economies remains disappointing (South Korea and Taiwan exports are still very weak). China's stimulus may be less effective this time around (vis-à-vis '15/'16) given the rebalancing of the Chinese economy more towards domestic consumption and away from investment. EM has been a winner in 2019 amid central banks' dovish pivot. YTD inflows into global EM debt funds have amounted to an impressive $25bn (close to surpassing the pace of inflows in '17). But US Dollar strength may be a harbinger of a rise in EM FX volatility. Chart 6 shows that the ratio of EM FX vol to G7 FX vol has risen again since the end of March.
On the bright side, EM country correlations (stock markets) are near record lows, which suggests any spillover from dollar strength into vulnerable locales with idiosyncratic issues should remain contained. Here's JPMorgan's Marko Kolanovic on the correlations point:
Country correlations near all-time lows indicate there is little risk of a systemic EM crisis, e.g. driven by the strong USD. Record low correlations indicate that recent EM troubles are more of a collection of country-specific developments (e.g. Turkey, Brazil, Argentina, etc.) rather than a systemic EM crisis in the making.
The point in all of the above is to illustrate and otherwise underscore how sensitive the narrative is to any turn of phrase from the Fed.
Wednesday's post-FOMC press conference might fairly be described as an admirable effort on the part of Powell to recalibrate market expectations vis-à-vis a cut and to reassert the Fed's independence from politics. That's all fine and good, but I would argue that markets could have done without the extended discussion, especially when it comes from someone who isn't known for his ability to strategically employ academic doublespeak in the service of making it difficult for market participants to confidently categorize a given utterance as "hawkish".
The punchline to this whole discussion is that everyone will have a chance to effectively re-trade the Fed on Friday as April payrolls will now be viewed through the lens of Powell's presser.

The End Of The Bull Market, In Three Charts

Stocks have completely recovered from their flash bear market of late 2018.

But now they face a hard question: Can already record high prices continue to rise in the face of falling corporate profits?

Let’s start with the “falling corporate profits” part:

A business generates improving profits when the things it sells rise in price faster than the cost of production. So on the following chart you want labor costs to be flat or falling, and the other line – a measure of inflation – to be rising. But lately the opposite is true.

A big part of the past decade’s spike in corporate profits came at the expense of workers, who saw real wages stagnate while the cost of living rose. Now, with labor markets tightening and minimum wages rising, workers are getting a bigger slice of their employers’ revenues. That means shrinking corporate margins and, other things being equal, slower to negative earnings growth.

Now let’s look directly at corporate profit margins. Note that they stopped widening in 2015 as wage inflation began to bite. Then they spiked in 2018 when the Trump corporate tax cuts provided a one-time windfall. But that windfall is over and future comparisons will be with last year’s unbeatable earnings. As a result, public companies are going to report lower year-over-year profits going forward.

Why does that imply falling stock prices, especially when corporate profits stagnated between 2015 and 2018 while share prices kept rising? Because of what those rising share prices did to valuations. Stocks are now a lot more expensive both nominally and compared to earnings than they were in 2015, which means the air pockets under them are much bigger. They’re priced for perfection, and falling earnings per share is the definition of imperfect for the stock market.

Based on history, the next few years look brutal for the US stock market. Which raises yet another question: Is history still worth anything in a world of out-of-control central banks and hyper-profligate governments?

Australia’s Geopolitics 

By George Friedman


In the past two fragments in this series, I began to lay out the interaction between geography and the development of the United States. I want to continue with some other examples. This week, I will focus on the geopolitics of a country that, like the U.S., is fairly young, but that has developed very differently: Australia. Next week, I want to write about a very small country that has existed for a millennium: Hungary. Apart from the fact that my wife was born in Australia and I was born in Hungary, my goal here is to create a small baseline in reality, before returning to theory.

Australia, like the United States, was born in the course of the British Empire’s creation. Both were occupied by indigenous peoples when the English arrived. In each, the English settlers created states that were eventually united into a single nation. The two countries share significant cultural similarities, not least their common language. But there are dramatic differences in how Australia and the U.S. behave within the international system.

Let’s begin with the obvious: Australia appears bigger than it actually is. Much of the country cannot be inhabited. Its populated areas run along the coast in a strip no wider than a few hundred miles. This strip wraps around much of Australia, but the population is unevenly distributed. The historic heartland of Australian ran from Sydney to Melbourne. Over time, outposts like Adelaide and Brisbane were drawn into this crescent of urbanization, though Perth on the Indian Ocean, Darwin in the far northeast and Hobart in Tasmania remain distinct.
Beyond its population distribution, Australia differed from the United States in two profound ways. First, the distance between Australia and Britain made extensive contact impossible. Second, Australia’s center was unproductive, and the country had few exports that interested Britain. It was therefore generally self-sufficient and far more isolated from the international system than the United States was. It also suffered internal isolation: While transport routes developed in the southeastern coastal strip, much of the rest of Australia’s settlements were isolated from the main corridor and from one another. The American colonies developed in a degree of isolation, but Australia’s was so intense that the various states did not form a single federated country until 1901. The distance made conflict between Australia’s states impossible, but it also meant that Australia did not need the kind of heterogeneous immigration that the U.S. needed to exploit the country. Therefore, in spite of isolation and differences in how they lived, Australia’s population did not differentiate itself linguistically or culturally. Geography did not create multiple, incompatible political centers.

But that virtue became a vice; Australia needed to grow its population to cement the nation. To attract immigrants, it needed to create economic opportunities and luxuries, which it could not do through its domestic economy alone. Australia had to import not only many luxuries but many of the necessities, too, and as a result, it needed to have products it could export and trade. Much later in the 20th century, those products were industrial minerals, but until then Australia had a range of agricultural products available.

Australia’s strategic priority became the need to maintain access to sea lanes, particularly in the western Pacific Ocean. But that became a problem. Think of Australia as a creature whose circulatory system is outside of its body. That circulatory system – maritime trade – is essential to both its regular functions and its ability to grow. Obviously, having a circulatory system outside the body is enormously dangerous. Someone could easily cut off that circulation, leaving Australia in a desperate condition.
There is a massive imbalance between Australia’s dependence on trade and its ability to protect that trade. Given the size of Australia’s economy and population, it cannot build and operate a naval force large enough to protect the circulatory system. Its only advantage is that invading Australia is both difficult and yields relatively little value for the effort. The size of the land and narrow lines of attack make Australia an unlikely choice for an invasion and impossible to occupy as a whole.

Its urgent requirement is, therefore, to establish and maintain an alliance with a major naval power, which, in the course of pursuing its own ends, can secure Australia’s sea lanes without any interest in cutting them. Australia’s strategic history, then, can be divided into two. During the first phase, from when it was first settled in the 18th century until the fall of Singapore in 1942, Australia depended on the Royal Navy – a natural relationship that grew out of Australia’s colonial history – to guarantee its maritime access. But the relationship also carried with it a price: Australia had to fight in British wars. There is a photo of my wife Meredith’s maternal grandfather heading out to the Boer War; another of her paternal grandfather going to fight in the trenches of France; and another of her mother’s cousin in uniform, who would die in the downing of a de Havilland Mosquito over Austria in World War II. This was the price Australians paid for protection of the trade that was their lifeblood.

The second phase began with the fall of Singapore and the Royal Navy’s departure from the Western Pacific. Australia pivoted quickly to dependence on the new global naval power, the United States. The U.S. needed Australia as a forward base to fight the Japanese, and Australia needed the reassurance that it would not be isolated by Japan. The relationship has been maintained since then with the same quid pro quo as with the British: The Australians contribute their limited ground forces, and the U.S. guarantees the sea lanes Australia uses. (Our daughter, when serving in Iraq, visited Australian troops regularly for tea, Vegemite and whiskey.)

What makes the Australian geopolitical situation so interesting is that it appears on the surface that Australia is too far, too big, and too rugged to be attacked, and therefore not in need of a defense policy. But given its dependence on maritime trade and inability to afford a navy, Australia is actually an extremely vulnerable country, especially because its most important sea lanes run through the Western Pacific, the very focus of World War II.

This all raises a theoretical question: Can cultural affinity transcend geopolitical divergences? The U.S. and Australia have a common cultural base. But Australia and the United States (like Australia and Britain) have potentially different strategic needs. Could their potential divergences break the alliance?

The United States and Australia are a laboratory for geopolitical theory. They have common cultural roots but widely different geographies and histories. They are bound together in a common interest. The cultural and the strategic reinforce each other. But can strategic interests diverge while cultural affinity is maintained? Can cultural similarities diverge while strategic interests remain? The question of culture’s relationship to geopolitics is tested here.

It is also tested in Hungary, a country utterly different from Australia and the United States. But that’s a topic for next week.