The Case of the Missing Capex

Are Taxes the Problem?

A rather curious event took place in the course of the Republican tax overhaul push last week.  At an event hosted by the Wall Street Journal,  CEOs were asked if passing Republican sponsored tax reform would spur them to increase capital expenditures.  The paltry show of hands raised by the group left little doubt that cutting corporate tax rates would do virtually nothing to raise the level of capital expenditure ( CEOs raise doubts about cutting the corporate tax rate ).  The meager rates of capex since the financial crisis have not been a function of either the level of taxes corporations pay, nor the structure of the tax system in place.  That realization should be a wake up call for Republicans seeking to pass the most ambitious overhaul of the tax system in 30 years, considering it debunks their primary argument for the legislation.  My previous post ( ’80’s Nostalgia: Glue That Binds the GOP  ) already made this case by comparing compound growth rates for U.S. GDP between the ’70s and the ’80s, as well as, deficits.  There is literally no basis for the belief that growth will be spurred by the tax cuts, but there is a basis to predict that deficits will rise. In fact, the house bill that just passed is expected to raise deficits by almost $1.5 Trillion over the next decade.


The irony here is that in recent years Republicans have been held captive by “Tea Party” Republicans pushing for fiscal austerity, rather than largesse. But with the GOP in complete control in D.C., and facing a first year with little to show, Republicans are desperate to achieve a legislative victory.  Unfortunately, with economic growth actually looking quite solid, it looks as though they are prescribing the wrong medicine at the wrong time.


Have We Just Been Depressed?


The most simplistic reason often given for the depressingly low rate of investment in this cycle is a hangover effect from the crisis. Without a doubt, the desire for risk taking after a catastrophic financial crisis is going to be lacking.  To illustrate the damage to “animal spirits” Chart 1 shows the level of U.S. Fixed Investment as a percentage of GDP.


Chart 1

U.S. Fixed Investment as a Percentage of GDP


U.S. Bureau of Economic Analysis


It’s easy to see from Chart 1 that fixed investment in this cycle has peaked well below previous cycles (16.5% of GDP vs. 19-20%), and the average has been substantially lower.  The argument that this lower level of investment is a function of poor sentiment, and risk aversion, isn’t wrong, it’s just incomplete.  Record low interest rates have not raised investment levels because the cost of capital was not the problem.  The issue was, and continues to be, a surplus of capital.  An extraordinary level of fixed investment was accumulated in the years prior to 2008, and nowhere was that more evident than in China.


 The Real Culprit:  Capacity Glut Led by China

The elements of the lead up to the financial crisis of  2008 at this point is well known. Stories of obscene leverage applied through complex derivatives, and the ensuing credit bubble have been catalogued extensively in books and movies.  A lesser known aspect, but a crucial ingredient, was the policy driven expansion of fixed investment in China.  The opening of the Chinese economy from a communist to a more market driven system, which had accelerated in the 1990’s, went into hyperdrive with the acceptance of China into the World Trade Organization in 2001.


Aided by an undervalued exchange rate, the Chinese promoted export growth through a classic mercantilist strategy.  Augmenting China’s advantage further, their currency was pegged to the U.S. dollar, which depreciated massively through the early and mid-2000’s (approximately -40%).  On the monetary side, to hold the peg, China needed to buy enormous amounts of dollars, and invest in U.S. treasuries.  This action acted like a perpetual motion machine for liquidity, keeping rates low, and risk assets buoyant.


In regards to the real economy, China promoted growth in various ways that exacerbated the bubble.  Local officials were given GDP targets to hit without regard for whether the growth was healthy and sustainable.  State-run banks had loan quotas that guaranteed excessive credit growth, and back-stopped reckless investment.  Chart 2 shows the inexorable rise in Chinese investment as a percentage of GDP throughout the 2000’s.


Chart 2

China Gross Fixed Investment as a Percentage of GDP


National Bureau of Statistics of China


What is quite shocking is that the ratio didn’t top out prior to the financial crisis.  That’s because in the immediate aftermath, China issued new directives for banks to increase credit growth, setting off another leg in the fixed investment bubble.  As the chart shows, gross fixed investment topped out in 2014 at a little over 45% of GDP.  For perspective, it’s important to know that this is a level double that of the average economy.  Emerging markets, during periods of rapid expansion, have registered much higher levels than the average,  but prior to China, the highest we had seen was around 35%.  When you take into consideration the size of China, at about 15% of the global economy, it’s easy to understand how such massive investment levels have global implications.  Excess investment in China has been the primary contributor of surplus manufacturing capacity around the world.


If You Build It, Will They Come?


Chart 3 shows Capacity Utilization for the U. S. economy, which indicates the percentage of manufacturing capacity that is in use at any given time.


Chart 3

U.S. Capacity Utilization (Percentage of Available Capacity)



You may notice a positive correlation between Chart 1 and Chart 3 (Fixed Investment/GDP Ratio vs. Capacity Utilization).  That makes perfect sense.  Why build new factories, warehouses, etc. when you’re utilizing a historically low level of existing capacity.  Zero interest rates, negative interest rates, and trillions of dollars in central bank purchases of securities does nothing to change this reality.  Businesses are reacting to real economic fundamentals.  And if we take corporate leaders at their word, lower tax rates will not lead to more capex either.  Nor should it.  Adding to capacity is only likely to lead to more excess capacity, ultimately driving down returns on capital.


Theoretically, if these monumental monetary efforts had stoked demand, capacity utilization would have risen, and new capex may have been justified.  But as we know, demand has been lackluster for most of this cycle.  Sentiment explains much of this, but once again is only half the story.  Consumers and businesses, traumatized by  the crisis, have been reluctant to take risk.  Households in particular had spent well beyond their means, aided by bubble level house prices, and easy credit (particularly home equity loans). In 2008, household debt as a percentage of GDP reached a record high 98%.  In subsequent years, it has dropped to 76.5%.  Bankruptcy, mortgage forgiveness, and somewhat higher savings rates have lowered household debt. That is marginally comforting, until you realize that it has simply been offset by government and corporate debt accumulation, leaving the U.S.  Total Non-financial Debt to GDP ratio close to its record high at roughly 245%!


Political Gamesmanship


So if we buy into the argument for the GOP tax plan, we believe that cutting corporate taxes will unleash growth beyond what we’ve seen in this cycle.  As I have shown, this is in contrast to the evidence I presented in a prior post.  First, the ’80’s tax cuts do not look to have improved growth, but they did raise deficits.  Second, corporate leaders show no desire to use the windfall from tax cuts to increase capex.  Beyond having excess capacity, a look at S & P 500 net profit margins shows they are near record highs.  Corporations are not suffocating under repressive taxation, and they are not capital constrained in any respect.  Furthermore, the economy seems to be on solid ground right now.  The GOP is risking expanding deficits into an economy 8 years into an expansion while the labor market seems to be tightening.  I’m sorry, but that doesn’t seem like smart policy.  Which begs the question:  Why are Republicans really doing this?  Actually, that’s rhetorical.  I think readers know why.  And some members of the GOP have already told us:  it’s to keep donors happy.


The longer-term implications of Republican’s cynical political strategy are not academic.  Corporations have used excess cash flow in this cycle primarily to buy back stock in lieu of expanding capex.  Along with about $4.5 Trillion in balance sheet expansion from the Fed, their actions have helped push equity market valuations to levels similar to prior to the 1929 and 1987 crashes.  Of course, valuations were much higher at the height of the tech bubble.  Continuing QE from Japan and Europe, a global coordinated expansion, and tax cut fever, have people feeling giddy.  If the GOP manages to pass these tax cuts in a form similar to what’s been proposed, I think they will learn two harsh lessons:  one economic; and one political.  I look forward to covering these in the near future.  For now, I’ll leave you with the immortal words of Chuck Prince, Citigroup CEO, circa 2007:

“When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”



’80’s Nostalgia: Glue That Binds the GOP

Extreme Partisan Division

I’d prefer to write about markets instead of politics.  But the tone and pace of political news has become stifling in the last two years, and I believe our present political circumstances warrant some thought as it pertains to markets.  Incidentally, an interest in politics is what led me to study economics, which eventually led to a career on Wall Street.  In subsequent years I grew tired of the mind-numbing trench warfare that takes place between the two major parties.  Studies show that partisan division has never been as extreme as it is now ( Pew Research: Partisanship), and it’s difficult to see it improving soon.  The internet, social media, and the 24-hour news cycle seem to be exacerbating some of the worst instincts we humans possess.  Rather than providing clarity with better information, we are drowning in a sea of data, which is polluted with half-truths and blatant misinformation.  There is little attempt at bipartisanship these days.  Short-term political gain is the primary motivation, and constituents only matter from poll to poll.  In the 1990’s, there was often talk about the prevalence of “gridlock”.  That is, the inability of congress to take any definitive action.  The partisan divide of the 1990’s seems quaint by comparison, as evidenced by 16% approval rating for congress in Gallop polls.


Within the parties, there are various political positions which at times may act as “litmus tests” for party loyalty.  For Republicans, restrictions on abortions (and possibly abolition), the right to bear arms, limited regulation, and adherence to free market principles are core principles all party members are expected to uphold.  For the last few decades, the “Reagan Revolution” of the 1980’s has held a special place in GOP hearts.  A dogmatic belief in the benefits of deregulation, and more importantly, lower tax rates, is paramount in Republican orthodoxy.  Yet, this presents a problem in the Republican party of 2017.  The forces that propelled Donald Trump to the White House have little overlap with the supply-side theory that was a cornerstone of the Reagan era.


Voodoo Economics?

Being a naïve undergrad in the 1990’s, I could not understand how Republicans could view the 1980’s as an economic golden age, while Democrats deplored the ’80s as a new dark age .  As I said, naïve.  The Mark Twain adage, “lies, damn Lies, and statistics”, applies as much to economics as anything else, and cherry-picking statistics to promote a favored view is a time-honored tradition in politics.  The concept of “Supply-Side Economics”, is the epicenter of that debate, and my primary motivation for studying economics was to gain an understanding of why it was so controversial. Supply-side theory promotes the idea of spurring investment (supply) rather than demand through lower taxes and deregulation.   Certainly, it was not a surprise that liberal Democrats disliked economic plans that aimed to give large tax cuts to wealthier people.  However,  what was surprising to me was that there did not seem to be a consensus on whether or not the “Reagan Revolution” had even been beneficial in terms of economic growth.


Why am I bothering to dredge this up now?  In my previous post, Disruptive Donald Balks at the Fed , I invoked the specter of Reaganomics as a burgeoning element in the current political debate. The effort of Republicans to implement a drastic overhaul of the tax system is bringing supply side views to the forefront once again.  The GOP is claiming that large tax cuts will lead to a faster rate of economic growth without expanding the deficit.  From the beginning, this was the promise of supply side economic theory.  Lower tax rates, particularly at higher income levels, promotes higher growth rates. Deregulation also has a role to play, but the focus has usually been on tax rates.  Economists love to represent ideas with charts, and the simplest way to convey the idea behind supply-side economics is with the Laffer Curve (chart 1).


Chart 1:  The Laffer Curve

By Vanessaezekowitz at English Wikipedia, CC BY 3.0,



Chart 1 shows three different Laffer curves each representing a different economy, with dotted vertical lines marking the optimal tax rate for that economy.   Any change up or down from that optimal rate will result in a drop in tax revenue.  If we were to assume our economy has a tax rate denoted by t*, then the red curve is the one promoted by supply-side theorists, where lowering tax rates results in higher revenue, and raising them makes revenue lower.  The blue is a more traditional viewpoint with tax revenues rising and falling with the tax rate.   Two issues should be readily apparent.  First, there is no one tax rate.  There are many different types of taxes, and marginal rates vary with the level of income.  Second, even if we simplify the analysis by using an average tax rate for the whole economy, can we assume that the red curve is reality, and reducing taxes will lead to more revenue?  This second part is the heart of the matter.  Since the 1980’s Republicans have generally worked on the assumption that lowering taxes always boosts economic activity, and therefore, tax cuts can “pay for themselves”.  But is that true?

Using real GDP data from the Bureau of Economic Analysis to compare the two decades is telling.  The compound annual growth rate during the 1970’s comes out at 2.44% versus 2.16% for the 1980’s.  I will admit to being shocked by this realization!  A supply-sider might rightly argue that including the first two years of the 1980’s is not fair.  The Reagan tax cuts had not been enacted, and there were two sharp downturns as Federal Reserve Chairman, Paul Volker, was hiking rates to combat inflation. If we compare the post-recession periods of the two decades, 1975-1979, and 1982-1989, we get CAGRs of 3.95% and 3.94%.  Virtually no difference.  And to drive the point home even harder, federal budget deficits in the ’82-’89 period averaged 3.87% of GDP, versus 2.42% in the ’75-’79 period. So no matter how you want to measure it, there is no evidence that the large tax cuts raised economic growth during the 1980’s.  But federal budget deficits actually averaged an extra 1.5% of GDP.  Bruce Bartlett, domestic policy advisor under Ronald Reagan, recently attested to this in a Washington Post article ( I helped create the GOP tax myth )


As I have illustrated above, the evidence shows that tax cuts do not pay for themselves.  In reality, there are a multitude of elements that affect economic growth, and it is difficult to isolate one driver, since all of the elements are in motion over time.  Personally, I believe that cutting certain taxes at the right time can have a positive effect on growth.  Hence, the structure of the tax system is as important as the total amount of taxes paid.  Incentives should be properly aligned to promote growth.  But that’s not how it is generally presented.  Republicans are selling the idea that tax cuts always accelerate growth.  Much will depend on various alternatives are being discussed at present, and the end result is very much in flux. Regardless of what Republican plan ultimately emerges from the fray, you can bet Democrats will attack the plan as a typical Republican “tax giveaway to the rich”, and will likely oppose it unanimously.  Given the narrow majority Republicans hold in the Senate, there is little room for Republican dissension.


Republican Civil War

This returns us to our fractious political environment.  With Republicans in charge of both houses of congress and the White House, it would seem passage of tax cuts would be a sure bet, despite Democratic opposition.  But today’s GOP is not the party of old.  Donald Trump rode to the White House on a wave of populist anger.  Stephen Bannon, Trump’s former Chief Strategist, promotes the view of what we might call the “Trump Republican”.  These individuals are middle or working class people who feel they have been neglected by Republican leadership over the years.  Paul Ryan, Speaker of the House, embodies the characteristics Trump Republicans hate.  He is attacked for promoting policies that cause jobs to leave the country for cheaper labor destinations.  Former White House strategist Stephen Bannon, now back as the head of Breitbart, the conservative news site, has openly targeted Ryan and other Republican leaders, which they label as “globalists” and “elitists”.  Bannon’s vision is that the Republican Party be transformed into a nationalist workers’ party.  Such a direction would be diametrically opposed to the goals of the Republican party over the last several decades.  Extreme divisions do not just exist between the parties anymore, they exist within the parties.


Certainly, the Democrats are divided between the Democratic establishment and the Bernie Sanders supporters, but Democrats are not in charge now.  Therefore, their divisions will play little part in driving current policies, and playing the opposition party will likely not hurt them.  On the other hand, Republicans have shown themselves woefully inept at governing thus far, despite their advantages. The failure to repeal Obamacare through three separate attempts has been humiliating for the party.  After seven years of promising repeal, they had no ready and viable plan.  Republican leaders pushed to pass a plan that had an abysmal 17% approval rating (vs. 51% for Obamacare), and was widely panned by groups such as the American Medical Association and the American Association of Retired Persons.  They also sought to ram through this legislation in a matter of weeks, with virtually no debate, and before the Congressional Budget Office could properly score it.  It’s difficult to see how these actions can even qualify as good politics, much less good governance.  Stalwart Republican Senator from Arizona, John McCain, said as much when after delivering the deciding vote in the senate he stated, “It’s time Congress returns to regular order.”  Amen!  But I don’t think any of us should hold our breath.


Desperation and Recklessness


Beyond tax cuts, the GOP has pushed the notion that a simplified tax code is in the country’s best interest.  Without a doubt, our roughly 74,000 page tax code is absurd, and any valid effort to simplify it should be embraced.  But this should be a bipartisan undertaking which properly weighs the pros and cons of various elements of the code.  Unfortunately, the Republicans are now desperate to get a legislative victory this year, before the 2018 mid-term election cycle starts.  They have also shown themselves not to be too picky about details, or the optics of how they proceed.  With that in mind, it has seemed to be a good bet that something will get passed this year.  However, in elections held last week, Republicans were beaten badly, which further erodes their rapidly shrinking political capital.


The last time we had a major overhaul of the U.S. tax system was the Tax Reform Act of 1986,  which took two years.  Republicans are attempting to accomplish something similar in a matter of months!  While an array of options have been bandied about, there seems to be little consensus, and the outcome is extremely uncertain.  Despite concerted effort by the GOP, and an admitted sense of desperation, a failure similar to the health care debacle is looking increasingly possible.  Even if they do succeed, it is likely that whatever plan gets implemented would increase federal budget deficits substantially.  Increasing deficits at a time when the economy is already on solid ground, and the labor market is tightening, could cause both inflation and interest rates to spike, as the economy moves toward overheating.


Market is Not Priced for Uncertainty


Market action in the last few months has been relentlessly bullish.  To a great extent, this is likely due to a coordinated acceleration in global growth which began last year, and not coincidentally, continued QE implemented in Japan and Europe.  The third pillar supporting this rally has been the hope of substantial tax cuts enacted in the U.S.  With global central banks beginning to remove stimulus, it remains to be seen how stable the global economy will be without emergency level liquidity provisions (see Are We There Yet?).  A failure of Republicans to get something substantial done on tax cuts would deliver a sharp blow to what is an extraordinary level of optimism.  By the same token, a tax plan that widens deficits, causing inflation and rates to spike would not be a welcome outcome, as it would require the Fed to get more hawkish.  Either way, we have an extremely overbought market, a VIX that has been near record lows for months, and sentiment indicators looking frothy.  Nothing has shaken this market’s resolve for quite some time.  But events are starting to coalesce that could give us our first meaningful correction since before last year’s election.



Disruptive Donald Balks at the Fed

Modus Operandi: Chaos

When Donald Trump descended that golden escalator over two years ago, he began by tossing grenades at every stronghold of the government establishment.  A sizable enough contingent of the Republican party had decided the system was against them, and someone promising to blow it up had to be better than the status quo.  Disruption of the norm has been a constant in the Trump administration.  Unfortunately, rather than leading to creative destruction, which could be beneficial, mostly what we have gotten is chaos.  The constant threat of a Trump “tweet bomb”, combined with the ongoing Russia investigation, has dissolved what little goodwill was left in  D.C. between the major parties.  Despite the Republicans controlling the White House, and both houses of congress, they have been unable to pass any significant legislation.  But along with executive orders, the president has great power to shape the government through appointments.


Until now, many Trump appointments have been so far outside the norm, they have engendered fear and loathing in the political opposition, and in some cases, alarm among the establishment.  With regard to the opposing party, this isn’t completely abnormal.  The opposing party always attacks certain nominees as unqualified, or too extreme.  But as is often the case with any Trump action, the concept of normal has to be adjusted severely.


The recent nomination for the U.S. Department of Agriculture, Sam Clovis, was a conservative radio talk show host that ran Trump’s Iowa campaign.  This position is usually held by someone with a strong scientific background, which is completely lacking with Clovis (although he has been very vocal in expressing skepticism on climate change).  Incidentally, he has had to withdraw his nomination due to being implicated in the Russia investigation, but he is by no means the only example of an controversial nominee.  The current head of the Environmental Protection Agency, Scott Pruitt, spent most of his time as Attorney General of Oklahoma suing the EPA for what he called an “activist agenda”.  Unsurprisingly, he is also a climate change skeptic.  Hatred of Pruitt by environmentalists is so extreme that he is receiving death threats at a rate 4 to 5 times the norm, and his security detail dwarfs his predecessors.  Rick Perry, former governor of Texas, and a former presidential candidate, once recommended dismantling the Department of Energy.  He now heads the agency, and it was readily apparent that he had no idea what the job entailed.  While not exhaustive, these examples are emblematic of the Trump approach to government.  Many of his nominees are either unqualified, or they have a complete disdain for the agency they were picked to lead.  Which is why the nomination of Jerome Powell for Federal Reserve Chair, while seemingly boring, raises some interesting issues.


Don’t Bite the Hand That Feeds You


I’m pretty sure no U.S. president has ever criticized a Federal Reserve Chairman for keeping interest rates too low.  At least not while in office.  However, before taking office, President Trump stated that Fed Chairwoman Janet Yellen should be “ashamed” of what she’s doing to the country ( Trump: CNBC Yellen ), and implied that keeping rates low was a politically motivated decision designed to benefit President Obama.  He also called the stock market a bubble driven by low interest rates  ( Trump: Market is a Bubble ).  Naturally, he is now touting new record highs in the market as indicative of the efficacy  of his proposed economic policies.


Markets have rocketed higher since the election.  Business and consumer surveys have been manic in anticipation of tax cuts and deregulation, although real data has not been exceptional, and a tax overhaul has not been passed.  But I contend the situation would have been the same with any Republican nominee had they been handed a congress completely controlled by the GOP.  The global economic acceleration since 3Q last year had a part to play as well.  What’s notable here is that despite Trump’s penchant for change, and an expressed belief that easy money has caused long-term damage to the economy, he has acquiesced to the status quo.  The nomination of Jerome Powell for Fed Chairman is not materially different to nominating Yellen to a second term.  Powell voted along with Yellen at every turn.  Certainly, it could be argued that he will take a more hawkish view than Yellen would on future monetary policy, but there’s little evidence to support that.


An easy money policy is almost always the preference of leaders in the short-run, regardless of the long-term problems it may pose.  So Trump’s flip-flop on this issue is not at all surprising.  But besides the obvious issue of possibly promoting another market bubble in the long-run, there are implications for the populist movement Trump has spearheaded.  Trump ran on a demagogic platform that targeted certain scapegoats as the source of economic angst.  Immigrants, corrupt politicians, and “stupid” trade deals were all promoted as the root causes for the economic malaise dubbed “the new normal”.  Arguably, the popularity of Trump and Bernie Sanders, in this last election, was primarily driven by the anxiety of the financial crisis which unfolded in 2008-2009, and the lackluster economic growth in it’s wake.  None of the culprits promoted in Trump’s campaign had anything to do with that.  Financial crises are always a function of too much leverage, which is often exacerbated by lax regulation.  With the nomination of Powell, not only has Trump picked a nominee likely to continue easy money policy, but one who has also shown a desire to loosen banking regulations imposed by Dodd-Frank legislation after the crisis.


Lather, Rinse, Repeat


There are certain human errors that will be invariably repeated.  The policy mistakes that precipitate financial crises fall into this category.  Part of this is ignorance, as new policy makers fail to learn the mistakes of their predecessors.  The other part, which may be more prevalent, is a complete lack of courage.  Neither politicians, nor central bankers care to assign  long-term stability the same importance  as short-term gain.  Even if such a remarkable individual should happen to come to power, it’s unlikely the masses would let them.


The aftermath of financial crises often leaves scars which linger for a generation.  Human nature, being what it is, people will often grasp at whatever remedies seem easiest at the time.  History has shown that right-wing populism gains popularity in the decade after a financial crisis, and those at the bottom of the socioeconomic spectrum are easy prey.  The rhetoric employed by Donald Trump during the presidential campaign last year was right out of the demagogue’s playbook.  But what policies are actually being promoted right now?  We just saw that despite the president being on record (see link above) blasting monetary policy for promoting a bubble, he nominates a man for Fed chairman quite likely to continue the same policies.  And despite corporate profit margins being near record highs ( Record Profit Margins ) Republicans are pushing a corporate tax cut as panacea for systemically weak economic growth.  Total debt to GDP remains at a record high, but it doesn’t feel so onerous, because interest rates are barely off record lows.  Don’t be concerned though, the market loves this!  But I’m starting to think I’ve heard this song before.  More accurately, it’s two songs:  “The Supply Side Revolution”;  and “The Great Moderation”.  A mashup of two of our greatest economic hits!  Two songs which both hit the top of the charts, got played to death, and now we’re sick of hearing them.  But what should we expect? Folks are suckers for nostalgia.  And some lessons never get learned.









Are We There Yet?

I would not be surprised if this title has been used repeatedly in the last several years by various commentators on the markets.  But it would be difficult to find a more apt illustration of the state of the global economy over the last few years, or rather, the psychology of investors.  In particular, most Fed watchers can identify with the frustration of a child in the backseat of a car, on a seemingly endless car trip. In September, Janet Yellen signaled that the Federal Reserve will begin reducing its balance sheet next month to the tune $10 Billion.  In yesterday’s Fed statement, they continued to signal they will hike one more time this year, and that reduction of the balance sheet remains on course. Fed Fund futures are signaling a 92% chance of a hike at the December meeting. Certainly, these are hawkish moves at the margin, but the Fed has been signaling these moves for some time, and markets did not seem surprised.  After the Fed announcement in September, the initial knee-jerk reactions in the market were to sell U.S. Treasuries, sell gold, buy the U.S. dollar and sell equities.  None of the asset class moves were extraordinary, and only the downward move in gold has had significant follow through.  The S & P 500 has gone on to new highs, as global economic data has been surprising on the upside. Two year treasury yields have moved out about 24 basis points, and the ten year only about 13 basis points.


Secular Stagnation

Despite what would seem to be a watershed moment in the Federal Reserve’s great “monetary experiment”, there is scope for skepticism.  The Fed has consistently been forced to back off from more hawkish policy as both growth and inflation have repeatedly disappointed.  For now, I want to concentrate on the state of the world, rather than the causes.  Below is a chart I call, “U.S. Organic Growth” (Chart 1).  It shows U.S. Nominal GDP minus the Federal Budget Deficit as a percentage of GDP.  The gist here is that a growth rate in a healthy economy should be substantially above the Federal Budget deficit, since government spending is an inherent component of GDP.  From the late 1960’s to the advent of the financial crisis (end 2007) this measure has averaged approximately +5%.  In the post crisis era, +5% has been the high, and presently, we are hovering just under 2%.  It should be noted that some of this differential is a function of inflation, given that in previous decades nominal economic growth would be higher due to higher inflation, but if you back out inflation, the trend is the same.  I believe the inability of the economy to produce growth above the level of debt-financed government spending is a sign that we have not reached escape velocity at this point, and that aggressive removal of monetary accommodation risks a potential relapse in growth.  The muted response in the market to recent Fed announcements implies that market players do not believe the Fed will move at a rapid pace, and that once again, forecast moves may not actually take place.


Chart 1

U.S. Organic Growth (Nominal GDP minus Federal Budget Deficit)


Source: U.S. Bureau of Economic Analysis and U.S. Treasury


Global Acceleration

The fueling of economic optimism for both the U.S. and the world this year has its origin in a modest synchronized global expansion which began in the 3rd quarter of last year.  We have had two global growth scares in this cycle, 2012 and 2015/16.  In 2012, Chinese growth slowed sharply in concert with the Eurozone, and Eurozone political tensions were high enough to make investors wary of a possible breakup of the European Union.  Once again in 2015, Chinese growth slowed sharply, and global growth skirted with recessionary levels in developed countries. Chart 2 shows the OECD Composite Leading Indicator, which is a good proxy for global growth momentum.  After weakening through much of 2015 into early 2016, global economic momentum has been on a solid uptrend. In the U.S., after reaching a low of 48 at the beginning of last year (marking worsening conditions below 50), the ISM Manufacturing Index printed at 58.7 for October, which is near the highest level since early 2011!  There is little reason to be worried about growth momentum at the moment, and it’s easy to see why the Fed feels confident in beginning the process of reducing its balance sheet.


Chart 2

OECD Composite Leading Indicator


Source:  Organization for Economic Co-operation and Development


A Triumph of Hope

But while these survey based measures are reassuring, some caveats are in order.  The PMIs for example, are diffusion indexes.  Participants are asked whether conditions are better or worse than the previous month, not how much better or worse.  As trend growth has been consistently weaker in this cycle, the typical strength we might expect when the ISM Manufacturing PMI reaches present levels is well below that of the past.  GDP growth year over year for the U.S.  is only running at 2.3%, which remains considerably below historical levels.  A persistent theme for 2017 has been real economic data remaining weak, while survey-based data has rocketed higher.

So far, a substantial amount of hope has been built into U.S. markets.  It seemed quite reasonable after last year’s elections, with Republicans controlling both houses of congress and the oval office, that pro-business policies would be implemented, spurring growth.  After witnessing the chaotic machinations out of Washington this past year, it’s difficult to believe that such optimism could still be prevalent.  Nevertheless, there’s an ebullience emanating from the business sector, and not surprisingly, that has filtered into equity markets.  I’ll discuss equities in later posts.  First, I’d like to address the issue of inflation.


Central Bank Impotence

Along with the consistently mediocre growth since 2008, there has been a surprising lack of inflation.  Given that major central banks have conducted quantitative easing totaling approximately $13 Trillion, many have expected (including the Fed) both higher growth and inflation, only to be invariably wrong.  Companies have been loath to invest in capital expenditures due to their worries about sustainable demand.  Excessive debt and ageing demographics in developed economies is not allowing for robust organic growth.  With capacity utilization running at 76% versus a 50 year average of around 80%, there is no sign of production constraints that should fuel inflation.  Excess labor through much of this cycle has kept wages depressed, which constrains buying power, as well as, inflation.  Technology continues to be implemented in lieu of labor in many areas of the economy, which further dampens wage increases.  Below is a chart of the U.S. PCE (Personal Consumption Expenditure) Price Index YoY (Chart 3).  Despite the recent economic acceleration, the Fed’s favored inflation measure has rolled over hard.  Certainly, it may bottom here, and head back higher, but there seems to be little reason for the Fed to be worried about inflation.


Chart 3

U.S. PCE Core Inflation YoY


Source:  Bureau of Economic Analysis; Federal Reserve


Returning to my initial question posed in the title, “Are We There Yet”?  At the risk of sounding too cute, I’d say that depends on what you mean by “there”.  For the Fed, and for most people, “there” would mean a return to what would be considered normal economic dynamics.  In that vein, my answer is a resounding no. The reasons are legion, and will fill economic journals for decades to come.  I look forward to expounding on the various issues over time. On a more immediate basis, we can say there is a reasonable basis for the Fed to begin reducing its balance sheet, as economic growth is solid.  However, there is little reason to expect the Fed to be particularly aggressive.  In particular, the anchoring of long-term interest rates at lower levels seems right to me.  I believe bond bears will continue to be frustrated with yields having limited upside.  U.S. equities have repeatedly been supported by this disinflationary backdrop, and little has shaken investors’ resolve.  Despite excessive valuations relative to history, equities continue to be supported by the prospect of a continuation of the “Goldilocks” scenario.  This is the status quo.  And despite the historic nature of the Fed’s move to reduce its balance sheet, I don’t believe there will be much change in the short-run.





Almost twenty years ago, fresh out of grad school, I trekked up to Wall Street from my native South Carolina looking to experience the thrill and excitement of the markets.  Having studied economics with an initial interest on the policy side, I had grown weary of the abstraction of mathematical models and longed to be in the midst of the action.  Like many before me, I thought I knew more than I did, and couldn’t wait to make my mark on the financial world.  Most friends and family thought I was nuts!  Why would I want to leave the serenity of my homeland to go to a place where everyone was angry and rude all the time?  One girl asked, “don’t you like trees”?  Once I arrived, I was happy to find that many of the people here were quite considerate, and yes, there are trees.


Twenty years later, having arrived in the heart of the tech bubble, and after successfully navigating through the Great Financial Crisis, there have certainly been times when I wondered if my friends were right.  But these moments have been fleeting.  As much as I’ve missed loved ones from the south through these years, and regardless of the stress inherent in this business, there is nothing I would have rather have been doing.  With this blog, I hope to share insights I’ve gleaned from working as a proprietary trader, hedge fund strategist and portfolio manager during one of the most tumultuous periods in market history. Hopefully, in the next few weeks, I will begin posting commentary that readers will find enlightening, informative and interesting.