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Weekly Economic Update by Michael Drury

July 15, 2019

We were out west most of this week, attending the Global Interdependence Center’s 11th annual Rocky Mountain Economic Summit in Victor, Idaho, across the Teton pass from Jackson Hole, Wyoming. This is one of our favorite events all year, as it brings together an interesting and varied audience of economists, financiers, and entrepreneurs. Discussions focus primarily on government policy, but the insights come from both theory and application. Unlike last year, when optimistic discussions about tax cuts dominated the room, a more muted tone was apparent as the consequences of the trade war entered every conversation. Last year, the question was how the tax cut and repatriation would be spent – on capital gains, financial engineering or distributed to workers via wages in a tightening labor market. This year, in addition to trade, key issues were the ongoing absence of capital spending, productivity, wage pressure, and inflation despite recent robust growth — and how much and how soon the Federal Reserve would ease to preserve the fully employed economy. There was concern that the Fed might not have enough ammunition on its own and that, given the current political situation, fiscal stimulus was unlikely. Political debate was Soto voce as opinions in a heavily Republican audience differed on who might represent the Democrats in 2020 and which issues would come to the fore. We heard no proponents for rapidly accelerating growth – but some for equity markets – due to an easing Fed. Worry about recession was common – specially with the expansion so long in the tooth — but most felt a muddle through and return to trend, with still low inflation, was the most likely path. No excesses were seen in the real economy, and those recognized on the financial side were still considered contained.

One thing that was very clear from the discussions is that pressure makes diamonds. Faced with a trade war that was raising prices for imported parts and materials, a tight labor market that was making new hires tougher, and a lack of inflation that made it impossible to pass along costs – firms were relying on innovation to stay profitable. Consequently, in addition to rising costs, technology was making a wide array of goods and services more like commodities with steadily declining prices and profits due to ruthless competition. Some of the innovation was via entering new markets; some by substituting capital for labor; some used financial engineering to increase leverage; others used mergers, acquisition or partnerships to achieve scale; some were shifting to faster growing fields, like medical or defense – but the most universal strategy appeared to be the development of new products with more proprietary control, and thus wider margins.

As an economist it was glorious to listen to practitioners commiserate about inputs from other economic agents becoming more expensive – and then relying on a wide range of tactics and strategies to survive. Bottom line, market forces were at work everywhere – yet no one was exuberantly optimistic that they were a sure thing and few were concerned that they held a losing hand. Yes, every firm there expressed an interest in a different (and for them more profitable) economic setting and many analysts expressed support for a wide variety of opposing solutions. No one was happy – which means Mr. Market acting as the invisible negotiator was doing its job. In a fully employed economy with still above trend growth and slightly less than target inflation, everyone in the room was pressing for more. No one seemed complacent and willing to just ride along at trend growth. That sounds like a pretty good economic environment to me – with virtually all of the risks on the downside. Like the referee said, fight hard – and protect yourself in the clinches.

One topic that got far less debate than usual was the level of debt, both in the public and private sector. Perhaps with interest rates so low, even those with a pathological aversion to borrowing were less motivated to argue the issue. We in no way suggest debt was viewed as less of a problem – it’s just not on the front burner with the Fed easing and the trade war at center stage.  Inflation hawks, the boy who keeps crying wolf, when no one else can see a wolf, are losing credibility. The argument that eventually a wolf will come – even if absolutely correct – falls more on deaf ears, like the idea that there will be a big one on the San Andreas fault (Ooops, maybe that is true!!!)

This is important because as one political commentator illuminated, the US is rapidly nearing its debt ceiling, with little time for Congress to act given the August holidays. As with other looming problems, like Brexit and the trade war, most investors are assuming either a certain resolution (because not doing so would be folly) or a kick the can solution that simply buys more time. Few are prepared for the debt ceiling deadline to become a line in the sand for either political party or the Administration – which in our view means that the risk is being underestimated and underpriced by markets. A disaster does not have to happen, just rising uncertainty about a default, shutdown or return to sequester level spending. All would result in more risk being priced in from current low levels.

As similar attitude seemed to prevail on the concept of the Fed easing as aggressively as the markets currently believes. The probability of a July easing remains at 100%. As our good friend Jim Bianco’s research indicates, the Fed never has failed to satisfy the market when the odds were this high (the exception to prove the rule was after Lehman when they disappointed, but moved two weeks later between meetings). The market continues to expect additional moves by year end and into 2020. However, as GIC’s keynote speaker at the Rocky Mountain Economic Summit, Thomas Barkin, President of the Richmond Fed, indicated the conditions in his view argued neither for a tightening or an ease. This speech came just as Chairman Powell was warming up the crowd in DC with a suggestion that the FOMC would ease. Barkin is not a current voter, but clearly not everyone is as convinced as the Street that imminent and repeated action is coming.

Perhaps it is the 240,000 new jobs in June. Perhaps it was the 17.3-million-unit sales pace for motor vehicles in June. Maybe it was the 0.3% rise in the June CPI – bringing the yearly gain to 2.1%. That is above the 2% target as are some other inflation measures (like the Dallas trimmed mean reading) – but still suggests a headline PCE, the Fed’s preferred target, at an annual 1.5%-1.6% gain. Barkin noted that the precision of decimal points on a figure that many governments have never been able to manage by even integers is perhaps a bridge too far. Many commentators have noted through the years that decimal points are to show that economists have a sense of humor.

Our own question during the Chatham House rules, gloves off roundtable on day two of the conference was: has there ever been a time when inflation flared without aid from government policy? We cannot think of one. Inflation is historically associated with wars, as sovereigns clipped coins, or forced banks to lend, in order that desperately needed supplies could be purchased or troops paid. The Weimar hyperinflation, and other episodes like Argentina, were sparked by governments that had been excluded from international lending markets and inflated domestically to continue government payments, rather than tax. The US inflation of the 1970s started with LBJ’s dual commitment to the Vietnam War and the Great Society. Nixon aggravated the trend with the end of the Bretton Woods commitment (a dollar pegged to gold) which weakened the dollar and imported inflation. Moreover, wage and price controls only temporarily capped inflation, which exploded on their demise. The 1973 Yom Kippur War resulted in the Arab states oil embargo against the US – and easy US monetary policy to dull the blow of skyrocketing gas prices.

When governments ramp up demand for funding, whether through bonds or directly from banks, they typically come with enough scale that all market driven interest rates will rise unless the central bank is accommodative. The only event we can think off where enough businesses simultaneously borrowed (achieving government like scale) without government influence was Y2K. That is the only time in post-war measured US history that corporate borrowing actually exceeded corporate savings. However, because the boom in capital spending ultimately sparked an explosion in productivity, the temporary inflationary pressure was quickly offset by deflationary forces – soon augmented by the entry of China’s into the WTO in 2001.

Recent experience has shown that government leniency is a necessary, but not sufficient condition for inflation to rise. The Trump tax cut was the largest in US history, and it generated faster growth in a fully employed US economy – but it did not lift inflation despite widespread fear. Japan has been in a thirty-year experiment to see how even the most profligate government cannot raise inflation or inflation expectations. With the highest debt to GDP in the world it also has about the lowest interest rates – which are, in fact, negative. One presenter pointed out a Japanese firm had just floated a junk bond at 99 basis points. Another noted Austria just sold 100-year bonds at 1%.

Paul McCulley reiterated his observation that central banks left on their own with no help from fiscal authorities have indeed solved the debt problem – by driving real interest rates so low at both the short and long end of the curve that asset values have soared relative to debt. Thus, both debt to assets and debt service to income are declining, leaving room for greater private sector economic activity. The byproduct is wealth concentration. Indeed, we would emphasize that within wealth holders the benefits to risk takers have been disproportionately raised, as falling real yields have narrowed the field who will compete for positive returns when losses in nominal terms are more likely.

In our view, wealth concentration has had two profound and divergent effects. On the one hand it has narrowed influence into fewer hands – particularly of multi-national companies who can move capital rapidly around the world in search of the lowest costs for doing business independent of where they sell. These firms are able to game competing government rules and regulations, reducing the power of even national politicians, in much the same way Amazon pitted US cities against each other for its new headquarters. This is why we no longer believe there is a US economy or a European economy or a Chinese economy. Rather they are all cogs with specific roles in a global economy – the US as the suburbs, Europe and Japan as the rustbelt, and China (plus the ASEAN & India) as the new factory floor in the Sunbelt. Investors should fade the rustbelt and go long the sunbelt and suburbs.

Meanwhile, as wealth concentration resulted in existing politicians losing lost control of the business elites, a new breed has turned to the populous with nationalistic appeals to limit the import of goods, services, labor and influence. Centrists have been assaulted on the right and left – restrict immigration and raise tariffs vs. tax the rich to redistribute income. Theory tells us that any interference with market forces is likely to reduce economic activity. Both the new right and left argue that their government solution will improve society enough to offset the economic costs.

Thus, the global economy is pitting ever fewer and more dominant firms against weaker, but more nationalistic governments. Historically, the battle between the economic forces of greater scale and local control has favored the capitalist. Size allows firms to walk down the cost curve increasing profit margins and enhancing the next round of investment for even greater scale. Many dominant global firms have succeeded by following the strategy of plowing all available funds – especially borrowed funds — back into the company to scale up first. Entrepreneurs in new fields are focused on raising enough funds via venture capital, borrowing or IPOs to out-subsidize others on the way dominance. As noted earlier, many firms now find being an innovator with a monopolistic edge as more important than producing at the lowest cost. In a world with free flow of capital, local rules are simply seen as higher costs. To be successful with national politics, one must have either a desirable scale in the domestic market or effective capital controls to keep the reinvestment of profits earned by entrepreneurs at home.

The US is obviously at the top of the scale chart with a $20 trillion economy. It also has adopted far more capital friendly rules, encouraging investors to profit more regardless of where they participate in the global economy. Its protection of proprietary information is also best in class. China and India also offer massive markets – and through effective capital controls have keep entrepreneurs at home. With these countries so still so far behind the developed world, entrepreneurs trade off strong productivity — and thus profits for advantageous reinvestment – for limits on control. Europe offers a huge market, and free capital flow – but stiffer regulations than in the US and less growth than Asia. The UK, in particular, appears to be a poster child for ignoring both the advantages of scale and the cost of local restrictions. Many nations are trying to boost scale through trade pacts at the same time their populous is less interested in trade. Those that achieve the best balance will reward investors most. Historically, one advantage to the US was that 50 states offered variations on a theme – and best practices won out. Today, the global economy offers even more petri dishes, with more varied starting points – and results. Let the world be your oyster, even if you invest from an armchair and never leave home.

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