Month: July 2018

This bulls/bears chart from Investors Intelligence is very interesting in two aspects. From the 2009 low in equities, sentiment has totally reversed.

(Ed Yardeni)

Now peek at the very left of the II chart above before looking at the next chart which plots inflation and interest rates between January 1, 1987 and October 17, 1987.

With plenty of bulls and virtually no bears around, the year 1987 looked very promising for investors. U.S. GDP was accelerating from +2.7% in Q1 on its way to +4.4% in Q4. The unemployment rate, which had peaked at 10.8% in 1982 and declined slowly during 1985 and 1986, went into a tailspin in 1987, reaching 5.9% in September from 7.2% fifteen months earlier, underscoring the strengthening economy obviously boosted by Reagan’s Tax Reform Act of 1986 which cut the top tax rate from 50% to 28% and set the only other tax rate to 15%.

Wage growth remained subdued, bottoming at +1.6% in December 1986 and reaching +2.8% in September 1987. Given nominal GDP growth accelerating from 4.9% to 7.6% during the same period, corporate profits were booming, rising 38% in Q3 1987. The S&P 500, which had tripled since the 1982 cycle low, was then selling at 18.2x trailing EPS in September, but only 14.2x forward EPS, seemingly quite reasonable in this rather positive environment.

Sure, inflation was accelerating and interest rates rising but these were simply corroborating the strength in the economy.

Sounds familiar? Read on.

Following are excerpts from the FOMC minutes of September 22, 1987 (my emphasis):

(…) In their discussion of specific developments bearing on the outlook for domestic business activity, members observed that key economic indicators provided evidence of appreciable momentum in the business expansion. Individual members also reported that local business conditions appeared to be strengthening in many parts of the country (…). It was suggested that the expansion could be characterized currently as better balanced than earlier, with favorable implications for its sustainability. (…) Some members also noted that increasing domestic demands and the prospects for improvement in the foreign trade balance had greatly reduced the odds of a shortfall in the expansion from current expectations.

The members continued to view the very large deficits in the federal budget and in the foreign trade balance as issues of fundamental concern. (…) The members generally expected at least some progress to be made on the latter basis as foreign trade patterns and prices were adjusted over time to the reduced value of the dollar in foreign exchange markets. However, the timing and extent of such improvement remained subject to considerable uncertainty and differing views were expressed regarding the most likely prospects for net exports and the underlying pressures on the dollar. The members agreed that the vigor of the domestic expansion would depend to a substantial extent on foreign trade developments. (…)

Turning to the outlook for inflation, members commented that the sharp decline in unemployment this year together with anecdotal evidence of labor shortages in many areas of the country had not triggered any general increases in wage rates thus far. Additionally, the members did not see in recent indicators any evidence of an upturn in the general level of prices. (…)

With regard to possible adjustments in policy implementation during the intermeeting period, the members generally felt that there should be no presumptions about the likely direction of such adjustments, if any. A number of members commented that, taking account of earlier policy firming decisions, monetary policy was now appropriately positioned under the circumstances that were most likely to prevail. (…)

Alan Greenspan, who was just appointed Fed chairman on August 11, surprised markets on September 9 with a “pre-emptive discount rate hike” of 50 bps to fight inflation.

Rewind to September 22, 1985 at the N.Y. Plaza Hotel where Treasury Secretary James Baker reached an agreement with the U.K., Germany, Japan and France to “stabilize” the then high flying dollar, seen as the main cause for the exploding U.S. trade deficit. The so-called Plaza Accord effectively engineered a drop in the dollar and with it, lower U.S. interest rates which, it was hoped, would allow for lower interest rates around the globe.

It worked so well that, in February 1987, the G7 agreed that the dollar had sufficiently corrected and that they should “work together to stabilize exchange rates”. In April, the Fed increased the fed funds rate 50 bps.

But in mid-August, the announcement that the June merchandise trade deficit reached a huge $15.7 billion sank the USD. The dollar kept sliding as the U.K., Italy, Japan and Germany hiked their own interest rates to fight perceived inflation pressures.

That went against the strong and repeated U.S. demands that these countries, particularly Japan and West Germany, the main feeders of the U.S. trade deficits, implement expansionist policies in order to stimulate their domestic economy and increase imports of U.S. products. The February 1987 Louvre Accord displayed more coordinated efforts at maintaining world growth through commitments for tax cuts and lower interest rates in G5-ex-U.S. countries while the U.S. monetary authorities would support the dollar.

In August and September, Baker bullied and blackmailed Japanese and German leaders but these countries rather reaffirmed their sovereignty and their respective economic and monetary independence.

By then, financial markets began to understand that the unity and coordination apparent since the Plaza Accord and reaffirmed at the February 1987 Louvre Accord were breaking down.

On Wednesday, October 14, 1987 came the news of another larger than expected trade deficit.

The next day, an angry James Baker implied that the U.S. might let the dollar fall in reaction to higher German interest rates. Saturday, October 17, Baker told the Germans to “either inflate your mark, or we’ll devalue the dollar.” On Sunday, October 18, to make it clear to a wide audience, Baker went on the Sunday morning talk shows and said, in fewer than 280 characters, that Bonn ”should not expect us to sit back here and accept” the recent German interest rate increase.

Moments later, a Treasury official confirmed that the U.S. would “drive the dollar down” if necessary.

The Louvre Accord had effectively crumbled into a free-for-all where each country re-centered towards its own internal economic, monetary and political motivations.

That was enough on Sunday night for foreign investors to conclude that dollar assets had just become very risky and enough for American investors to realize Monday morning that equity valuations may be too high in this new, uncertain and highly confrontational environment.

The S&P 500 cratered until it was 35% below its August peak.

At its August 1987 peak, the S&P 500 index was selling at 18.8x trailing EPS while the Rule of 20 P/E was at 23.1, overvalued by 15.5%. At its trough the following November, the trailing P/E was 12.8 and the Rule of 20 P/E stood at 17.4, a 13% undervaluation that remained until late in 1989 when both earnings and inflation peaked just prior to the Index peak of 353 in December 1989, 7% above the August 1987 top.

This in spite of a pretty good economic background throughout. Such was the economic situation on September 22 per the FOMC:

• Yes, inflation had risen from 3.6% to 4.2% but the Fed was not seeing “any evidence of an upturn in the general level of prices”.
• Yes, unemployment had declined quickly but even “anecdotal evidence of labor shortages in many areas of the country had not triggered any general increases in wage rates thus far.”
• Yes, interest rates, short and long, had gone up but “monetary policy was now appropriately positioned under the circumstances that were most likely to prevail.”
• In all, the U.S. economic “expansion could be characterized currently as better balanced than earlier, with favorable implications for its sustainability.”

Right on the 150th anniversary of Goldilocks!

Jay Powell said something very similar to the Senate Banking Committee on July 17, 2018:

With appropriate monetary policy, the job market will remain strong and inflation will stay near 2 percent over the next several years, (…) Overall the risks to the economy were “roughly balanced,” with the “most likely path for the economy” one of continued job gains, moderate inflation, and steady growth.

The Fed also “agreed that the vigor of the domestic expansion would depend to a substantial extent on foreign trade developments”, a statement from the September 22, 1987 FOMC minutes that could be re-used verbatim today, even though, then and now, this particular outlook was highly uncertain and, to be sure, pretty shaky…

At one point, in August 1987, many investors became uncomfortable with the increasing confrontations. When Baker dropped the gauntlet on dollar support in October, sellers rushed to the exits but the then market logistics turned this into a panic. Today’s ETFs and algo trading were then dubbed program trading and portfolio insurance strategies, all perfectly valid and useful in normal circumstances but all highly challenging when sellers rush for the exits.

S&P 500 companies increased their profits another 43% through mid-1989 but sentiment was crushed enough to prevent valuations to climb back above 13 times for the actual P/E ratio and above 17 for the Rule of 20 P/E. In effect, Baker’s decisions devalued U.S. equities by 30% for a period of 4 years. Investors who hung on in 1987 on the basis of a good, sustainable economy and booming earnings proved right on the background but awfully wrong on values. They had to wait past the 1990 recession before their capital began to sustainably appreciate again.

Baker’s threats proved vain: Germany’s tax reform of 1990 was not significant and did not modify Germans’ high propensity to save. The Japanese economy was already booming in the late 1980’s with strong domestic consumption and rising imports. It peaked out in the early 1990s. The U.S. dollar actually rose a little in 1988-89 before resuming its long tem slide.

  

The Reagan administration’s policies to deal with the newly increasing trade deficit sought to boost exports by bringing the dollar down (1985 Plaza Accord) and increasing global demand by pressuring foreign governments, particularly Germany, to stimulate their domestic economies. Exports, which were on an upswing in 1986 thanks to the sharply lower dollar, took off from 1987 through 1991 owing to increasingly favorable terms of trade.

The Trump administration is trying to tackle the perceived trade deficit problem seeking to reduce imports, coercing manufacturers into producing in the United States or face heavy tariffs. If successful, such policy would likely result in higher prices for American consumers and potentially reduce American exports as U.S. producers could become uncompetitive in world markets.

The laundry appliance industry may be a microcosm of what is likely to happen: according to the BLS, prices of laundry appliances have shot up 20% in the U.S. and both LG and Samsung are building plants in America to avoid the 20-50% import tariffs. We shall see how they will price their U.S. made machines in 2019 against Whirlpool but it would be very surprising to see consumer prices drop meaningfully given the higher costs of producing in the USA and protection against imports.

In fact, there may well be some nasty surprises in store. A recent WSJ analysis revealed that,

Whirlpool’s least-expensive model among a group tracked by Thinknum jumped from an average price of $329 in January to $429 in June [+$100 or +30%]. Samsung’s rose from $494 to $582 [+$88 or +18%], while LG’s rose from $629 to $703 [+$74 or +12%].

Trumpism will have helped Whirlpool and create perhaps 1000 new jobs but will have significantly raised costs for 325 million Americans and potentially stifle competition and innovation for U.S. domiciled manufacturers which no longer need to compete in world markets.

Imports account for 14% of U.S. total personal consumption expenditures (24% for goods) but if American-based manufacturers use the tariffs umbrella to jack their own prices up, much like Whirlpool just did, inflation could jump rapidly and significantly.

At the same time it is seeking to reduce imports through protectionism, the Trump administration has cut personal income taxes which will surely boost imports of goods, potentially making the trade deficit look worse as we approach the mid-term elections, fuelling the President’s protectionist instincts even more. Déjà vu again!

The whole picture could get aggravated if Americans decide to advance purchasing newly tariffed goods such as autos and other higher priced items before they hit U.S. stores. Retail sales jumped at an 11% annualized rate in May and June and imports of nonpetroleum goods are up 7.5% YoY in May.

The hope on trade is that there will be intense and positive negotiations before the end of August when the U.S. threatens to impose 10% tariffs on an additional $200 billion worth of Chinese imports. In truth, nobody really knows what will happen, but if the NAFTA negotiations with friendly countries Canada and Mexico are any guide, politics often trump common sense.

What we know at this point is that the risks of trade wars are real and significant, that importers and consumers may be front-loading and that businesses are in a wait-and-see mode, potentially resulting in a boom-bust economic pattern which could force the Fed to over-react, or otherwise be perceived as totally behind the curve.

There is a possible happy ending if we consider that everybody has too much to lose from things spiralling out of control.

The United States also does not want any major geopolitical headwinds to disrupt its economy and financial markets, especially before the upcoming midterm congressional elections.

As for China, it can ill-afford a full-blown trade war at a time when it is trying to implement major structural reforms. It is also dealing with the challenges of rising wages, high debt levels, a rapidly ageing population, and significant air/water pollution. Complicating matters further is the widely held view among leading nations that China must change its unfair trade practices. (NBF)

Words of wisdom which are evidently keeping hopes alive but which can get lost amid political and/or personal  imperatives. James Baker was a smart and sensible man after all…

In any event, this murky outlook is dangerous for investors, even more so given these facts, present whether or not common sense prevails:

1. Equity markets are clearly in overvalued territory.
2. We are late in the cycle and resources are stretched.
3. Tax cuts and increased government spending are fuelling the economy at a very inopportune time.
4. Inflation is rising.
5. The Fed is decidedly on a hiking path.
6. The Fed is also draining liquidity, to be accelerated in coming months.
7. The ECB, BOJ and BOE are also of that mood.
8. The Fed and the U.S. government have virtually no dry powder to quickly react if needed like in 1987.

Goldilocks is often used in economics to describe stable, “just right” conditions. In reality, it is a rather bearish story…

“Goldilocks and the Three Bears” (originally titled “The Story of the Three Bears“) is a 19th-century fairy tale of which three versions exist. The original version of tale tells of a badly-behaved old woman who enters the forest home of three bachelor bears whilst they are away. She sits in their chairs, eats some of their porridge, and sleeps in one of their beds. When the bears return and discover her, she wakes up, jumps out of the window, and is never seen again.

The second version replaced the old woman with a little girl named Goldilocks, and the third and by far most well-known version replaced the original bear trio with Papa Bear, Mama Bear and Baby Bear.

What was originally a frightening oral tale became a cozy family story with only a hint of menace. (Wikipedia)