NEW$ & VIEW$ (1 FEBRUARY 2016):

‘Consumer Spending and Housing Remain Solid’

Various quotes on the Q4 GDP report:

• The sluggish headline GDP reading masks the fact that consumer spending held up better than expected in the fourth quarter.
• Growth in consumer spending for all of 2015: +3.1%. Consumers carried the economy last year, boosting spending at the quickest pace since 2005.
• (…) robust growth in durable goods purchases bolsters our confidence that the US consumer sector remains solid. Furthermore, residential investment growth surprised to the upside at 8.1%, well above our forecast. Together, better-than-expected growth in big-ticket purchases should allay concerns of a retrenchment in US consumer spending.

The other way of looking at things:

• Consumers during the all-important holiday season cut their spending from what it was even mid-2015
• One of the largest drags on the economy was consumer spending which accounts for about 70% of gross domestic product. They had every reason to spend including healthy employment gains, cheaper gasoline and lower import prices. Instead, consumers remained cautious about spending, boosting the savings rate instead. The unseasonably warm weather contributed to the softness, especially for apparel and utilities…
• To weakness in energy, exports, and too much inventory we can now add to the softer side of GDP data the auto sector—motor vehicle output took 58 basis points away from overall growth.

Real world stuff: credit card companies are doing quite well:

• Visa CEO: “Macro weakness not evident in U.S. Consumer Spending.”
• Mastercard US processed volumes up 13% (versus 9% last quarter) including 100bps from lower gasoline prices (200bps last quarter).

Moreover: retail gasoline prices are now down to $1.81, and mortgage rates are 3.73%.

Tale of Two Economies as Americans Thrive, Companies Dive

Consumer spending grew last year by the most since 2005, in spite of a slight slackening in the fourth quarter. Nonresidential business investment, meanwhile, rose at its slowest pace since 2010 as oil and gas companies sharply curtailed spending. (…)

That same dichotomy was evident in the fourth quarter, as personal consumption expenditures rose while business investment in equipment and structures dropped for the first time since the third quarter of 2012. (…)

Will the strength in consumer outlays encourage companies to step up spending and keep on hiring? Or will businesses, battered by slow global growth and a rising dollar, turn more risk averse and start to prune payrolls, undermining household spending in the process? (…)

The economy is growing, albeit below par. Viewed through the prism of employment, the economy looks surprisingly strong. Yet, it looks weak because the nature of the economy is changing. The GDP numbers are modest because productivity is in trouble. The crucial cause is that nowadays, manufacturing and energy sectors have been hard hit, where productivity is often found. A vast array of service industries, which are labor intensive, are doing most of the employing. It’s pretty hard to get productivity increases out of restaurants, healthcare, accountants, bankers and lawyers. What you get there are price increases! (H. Marleau, Palos Management)

FYI: U.S. vehicle production trends (annualized rates): Q4’15: –19.3%, Q1’16e: –6.0%.

Fed accused of not seeing danger coming

(…) The US has turned out to be vulnerable to the fall in crude prices. The boost from cheap energy to consumer spending has not met expectations while the associated drop in investment in the sector hurts growth. (…)

Confirming concerns about the impact of the high dollar and oil price plunge on US industry, the first reading for fourth-quarter US gross domestic product yesterday showed a slowdown in growth to an annualised pace of 0.7 per cent, compared with an expansion of 2 per cent in the previous three months.

As growth in the US economy slows, inflation has stuck below the Fed target of 2 per cent. Narayana Kocherlakota, who was president of the Minneapolis Fed until December, is calling for a “hard U-turn” in monetary policy. He thinks the central bank is underestimating the risks of sinking inflation expectations and says the credibility of its target is under threat.

The dovish former policymaker says the world faces a “global demand shortfall” and tighter US monetary policy could exacerbate uncertainties outside the country.

“It is hard to know how much feedback from international weakness there will be to the US economy; as the Fed tightens, that tightens economic conditions throughout the world,” Mr Kocherlakota says. (…)

The main reason for optimism is the labour market. In the face of chatter among analysts about the risk of a US recession, job growth has exceeded expectations, with payrolls growing by nearly 300,000 in December.

Ms Yellen placed the employment trend — which has seen 13.2m jobs added over 67 straight months — at the heart of her case for raising rates, arguing that it would be unwise to wait too long before responding to the erosion of spare capacity. (…)

Tim Duy, a professor at the University of Oregon and close Fed watcher, says that December’s rise was not of the magnitude to “make or break the economy” and that talk in markets of a policy mistake was unhelpful.

He says the important aim now was for the Fed to avoid sending signals that it was hell-bent on tightening policy further. That meant downplaying last month’s forecasts from policymakers suggesting that there will be four rate increases in 2016, a bullish outlook that traders now see as divorced from reality.

The Fed has insisted it will be guided by the data and has made no commitment to tighten. Ms Yellen will give further clues in February when she addresses Congress in testimony on Capitol Hill. (…)

U.S. Recession Risk Is Low But Rising: Morgan Stanley

The Morgan Stanley analysts argue that the industrial side, which constitutes about 10% of the U.S. economy, is in recession. They point out that growth in some service-side indicators has slowed. Citing their own proprietary risk model – the MSRISK — the analysts point out that though the recession risk is low currently, there is a rising risk broadly within the next six months:

BCA Research has another view on recession risks:

For now, the FOMC seems content to ignore the lengthening list of economic red flags, including deflation, profit contraction, trade contraction, ISM manufacturing contraction etc. In fact, BCA’s Recession Warning Indicator is now at levels that preceded the Great Recession. (…) 32 out of 60 industries we track are cutting selling prices. Six other industries can’t raise prices by more than 0.5% per annum, while another seven are stuck below 2%, which is near the rate of overall core consumer price inflation. In other words, 2/3 of the industries cannot keep pace with core inflation rates.

So does J.P. Morgan:

 

One Positive Signal Amid A Growing Recessionary Storm

Going back to 1954, we have had nine circumstances when the spread between 10-year treasury yields and 3-month treasury yields goes negative (i.e. yield curve inverts). Only once, in 1967, did the US not fall into a recession within the next 12 months. Fortunately today, the 10-year – 3-month spread sits at a very healthy 175 basis points. As the chart below shows, the yield curve tends to flatten right before a recession occurs and then it actually steepens during the recession. For example, the 30-year to 3-month spread went from 313 basis points in 1972 to -186 basis points in 1973 and then the economy fell into a recession from 12/1973 to 4/1975. In 5/2004, the 30-year to 3-month spread was at 382 basis points. By 3/2007, it had fallen to -66 basis points and then the US fell into a recession officially starting in 1/2008. Granted, we have seen the 30-year to 3-month spread flatten over the past several years as the current level of 175 basis is 122 basis points from the 2013 high and 208 basis points off the 2011 high. However, as long as this spread remains well above the zero line, a US recession will hopefully not be on the immediate horizon.

The problem with the above is that interest rates are currently managed throughout the curve…

It doesn’t take a genius to know we are at the late stages of the cycle. Moody’s adds some credit cycle evidence:

Special Events Are in Late-Cycle Mode

During the early stages of an upturn by M&A, M&A-linked credit rating revisions show more upgrades than downgrades. For example, M&A-linked rating changes showed more upgrades than downgrades during 2010 through 2012, or after M&A activity had bottomed in 2009. However, M&A figured in more downgrades than upgrades once new record highs were set for M&A in 2000, 2007 and 2014.

Net downgrades linked to M&A rose from 2014’s 33 to 2015’s 36 as the increase in the number of relevant downgrades (from 89 to 114) eclipsed the rise in the number of related upgrades (from 56 to 78). In 2016, upgrades stemming from M&A are likely to decline, while downgrades hold steady or rise. A further decline by upgrades relative to downgrades for M&A-linked rating revisions would be consistent with an aging business cycle upturn.

M&A’s record pace for 2015 stemmed from comparatively low borrowing costs, a relatively stable equity market and diminished prospects for organic revenue growth. The importance of the latter helps to explain why record highs for M&A tend to occur close to the end of a business cycle upturn. The urge to merge will be greater the more convinced corporations are of the imperative to meet long-term earnings targets via mergers, acquisitions or divestitures. (…)

Sometimes, efforts to enhance shareholder returns trigger credit rating downgrades. Typically, strategies which benefit shareholders at the expense of creditors employ cash- or debt-funded equity buybacks and dividends. The number of US credit rating downgrades stemming from shareholder compensation increased for 2014’s 40 to 2015’s 48. However, the latter was less than 2013’s current cycle high of 59 and was well under 2007’s record high of 78. (…)

• Experts see 20% chance of US recession FT survey shows lessening expectations of Fed rate rises

 What Happens When Rates Go Negative

The BOJ says it will cut the interest rate, set at minus 0.1%, further into negative territory if necessary. That compares with minus 0.75% in Switzerland, minus 1.1% in Sweden and minus 0.65% in Denmark.

(…) In theory, negative rates at a central bank trickle down to consumers or businesses by encouraging lending. That makes cash a sort of stimulative hot potato: Everyone should want to use it, not hold it.
So far, the record has been patchy. Bank lending has risen modestly in the eurozone, aiding a slow and steady economic recovery. But inflation hasn’t returned. Prices rose just 0.1% in November. Sweden, too, has been stuck with inflation close to zero since 2013, despite joining the negative-rate club in February. The ECB has an inflation target of just under 2%.

In Switzerland, the central bank had long tried to keep the Swiss franc from rising too much against the euro by creating new francs and using them to buy the common currency. But early this year [2015], uneasy with the volume of foreign assets it had acquired, it stopped.
To help soften the blow of a stronger franc, which stifles Swiss exporters, the central bank turned to negative rates, which typically would make a currency less attractive to hold. But the franc surged against the euro and has since settled into a steady range about 11% stronger than where it was.

Denmark, by contrast, has had better success using negative rates to stabilize its currency. The rates helped beat back a flurry of speculative bets on an appreciating Danish krone, themselves spurred by the ECB’s rate-cutting moves. Growth in Denmark is comparatively robust. The economy is expected to expand 1.6% this year.

Still, subzero rates in Denmark and Sweden have helped fuel a surge in house prices, prompting fears of a bubble in major cities. The average price of a Danish apartment climbed 8% in the first half of 2015. The cost of Swedish apartments is 16% higher than a year ago.

And the negative rates come with a cost: Since it is difficult for banks to pass negative rates on to many of their customers, the margin between what they earn from lending and what they pay to depositors gets shrunk. To be sure, Japan has introduced a tiered system so that only a part of the banking system’s huge central-bank reserves will be subject to negative rates. Denmark, too, exempts some of its banks’ deposits from its minus 0.65% rate, and its banks are still hurting.

Negative rates have cost Danish banks more than 1 billion kroner ($145 million) this year, according to a lobbying group for Denmark’s banking sector.
“It’s the banks that are paying for this,” said Erik Gadeberg, managing director for capital markets at Jyske Bank JYSK.KO +3.33%. If it worsens, Jyske might charge smaller corporate depositors, he said, then maybe ordinary customers. “One way or another, we would have to pass it on to the market,” Mr. Gadeberg said.

These economies have seen a range of other odd consequences, from Danish companies paying taxes early to rid themselves of cash, to one Swiss bank charging its customers to hold their deposits. Still, the experiment with negative rates hasn’t spawned more drastic consequences—like mass hoarding of cash or runaway inflation—in Europe, so far at least. (…)

• More on that on Bloomberg.
• Gavekal warns on currency wars (via John Mauldin)

(…) Our view is that the decision was mostly driven by a desire to weaken the currency in an attempt to offset renewed weakness in oil prices and their consequent negative impact on inflation. The BoJ’s December decision to mildly expand ETF purchases was largely ignored by investors who until recent days had bid up the yen on a flight to quality. It is questionable whether the BoJ will be successful in this effort given market positioning and the yen’s undervaluation (see Don’t Buy The BoJ Bluster).

But to the extent that the BoJ can weaken the yen, such a move will hurt other trading economies, exacerbating disinflationary forces. It seems reasonably likely that European central banks will respond to further yen weakness, causing a growing perception that a cycle of competitive devaluations is under way. In such an environment the US dollar seems sure to take another leg upward. (…)

One day’s price action is insufficient to determine a trend, but we tend to see further easing as a rather desperate roll of the dice that risks destabilizing the still weak Japanese economy (see The Dangers Of Further BoJ Easing). The bigger concern is that BoJ has sounded the bugle on an escalated currency war that could yet come back to bite Japan.