Issues, News and Views
SEMI-ANNUAL FORECAST OF ECONOMICS, MARKETS, AND INTERNATIONAL AFFAIRS
2017/12/20 - Happy New Year. As is our wont, we herewith provide our semi-annual update on the economy and markets. For years now we have been correct, and we again predict that our predictions will come about as predicted.
Let's begin by talking about the black swan risk factors, and topping the list is Korea. We continue to believe that a Korean war, while not probable, is far more likely than commentators and pundits predict. We do not believe the probability is as high as one in two (50%), but no less than one in five (20%) and possibly as high as one in four (25%) or even one in three (33%).
It is hard to game out what would happen in a Korean conflict. For example, in a best-case scenario, a successful decapitation strike combined with a pre-emptive nuclear-threat elimination strike could cause a collapse and surrender by the NK's, ending the war almost before it starts. Such an immediate, desirable and definitive outcome would prompt a short term euphoria initiating another leg up for optimism, sentiment, markets and the economy.
But that's not going to happen. More likely a conflict will include several weeks of very ugly ground war with many casualties in the South, and this will hit markets hard. Stay hedged in case there's a war, stay fully invested in case there isn't.
And the world will be on edge as it watches and waits to see what, if anything, China can or will do. Ultimately we believe China can do nothing. The North is the worst regime on the planet. China is hardly better, a wolf in sheep's clothing for whom Kim a useful pawn, but this is not the time or place for China to undress and expose their geopolitical ambitions of regional domination.
Aside from Korea there are the usual concerns, including massive global debt, especially among governments. The US government has a spending problem (not a revenue problem). At some point our $20+ Trillion debt will catch up with us, but that day is not today. Soon, perhaps, but not now. The party is not over quite yet.
United States equity markets continue in a "buy-the-dip" environment which serves to prevent small dips from becoming huge crashes. Which keeps buyers poised at the edge, ready to jump. If there is a major correction it would come from a geopolitical shock like Korea, or a change in economic outlook like a bad read on inflation, but not an "air pocket", not some kind of random imbalance of supply and demand contained wholly within capital markets.
We continue to hold a constructive view of the United States economy with a number of factors contributing to the favorable environment. However, we do see risks of a downturn developing. We are not saying that a recession is inevitable or even likely any time soon; but there exists a significant possibility that recession pressures may develop as the year unfolds.
The first and most important factor presently in play, as always, is the cost of energy. And yes you can thank fracking for these favorable energy supply fundamentals. The price of oil and especially natural gas remain at levels conducive to economic growth. That being said, the price of oil continues to climb. Heretofore we had expected oil prices would hit a ceiling before approaching their current levels, but that doesn't seem to happening quite yet, which is a concern.
Theoretically a domestic price of $60 should be triggering a response of increased production that should keep near-term prices in check. In addition, these prices should serve to stimulate investment in exploration, development and related technologies that should keep the longer term price trajectory at sustainable levels as well. But no one seems to be opening the spigots.
The second most important factor in our positive economic view is the continuing roll back of regulation by Republican administrations at both the federal and state levels. This is the big mystery that economists, journalists and bureaucrats never seem to understand. Unless you are a business owner you will never grasp how oppressive a regulation can be, and how suppressive it is to economic activity.
Economists don't know how to quantify regulation and therefore do not model it. Thus there is index, no data release, no time series, no news for journalists to report on. And in quite retrograde fashion, legislators and burrocrats (yes, they are asses) point to the growing number of laws they have passed, and regulations they have implemented, as metrics of their success, while in fact they suffocate the economy.
The deregulation wave sweeping across America will continue to fuel economic growth, growth unexpected and unpredicted by the Media-Academia-Government Complex. And of course President Trump will get no credit for the growth and opportunity he is spurring in America. Deregulation is low-hanging fruit. It is free money. It is like how good you feel when you stop banging your head against the wall.
The third reason for continued US economic growth is the new tax cut. The cut in business taxes will switch the US from being one of the most punitive tax nations to one of the most accommodative tax nations. Not only does this serve our economic interests directly, it also forces other jurisdictions to respond, fostering organic economic growth in their countries, causing them to buy more US goods and services. It's very good.
There will also be an impact by foreign companies. For an example, consider BMW, which builds its entire global production of SUVs in upstate South Carolina. Energy is cheaper, land is cheaper, and regulation less frustrating, than any other potential alternative on the face of the planet that BMW originally considered.
Now you can add lower taxes to that list. Not only will the US maintain its hold on BMW production and not need to worry about seeing it clawed away by Mexico or China, BMW might decide to allocate an even higher proprotion of their global vehicle production to the US.
But every firm around the globe with international operations faces the same considerations - some of whom will maintain production here, production that might otherwise have been vulnerable to relocation; or other businesses who might now decide to expand operations here; or still other companies who will be attracted to America who might otherwise have proceeded with other alternatives.
A fourth reason for continued US economic growth is global economic growth. For some years the US economy has been hampered by sluggish growth elsewhere, but now global economies are showing signs of growth. There had been worries about China but those seem to have dissipated (for the time being). Brazil had seven months of positive employment growth (before dropping back a tick in November). Eurozone factories are registering production levels that are at all-time highs.
A fifth reason for economic optimism is the current low levels of interest rates. Yes, rates are rising, but at a very slow pace, and from historically low levels. Rates are still very low, but the expectation of rising rates should entice businesses and households to invest now and lock in low financing costs while they still can. You can expect homebuilders in particular to do well in this environment.
With these factors in play we see continued favorable economic prospects. Whether or not growth will continue its string of >3% growth quarter after quarter remains to be seen, but it is not unrealistic. It stands to reason that the stock market should continue moving northward as corporate revenues increase, margins expand and profits proliferate.
But synchronized global growth is a two-edged sword. Too many economies doing too well all at the same time creates demand pressures and price bubbles. Bubbles take many forms - an oil bubble, a housing bubble, a dot-com bubble, a tulip bubble, a bitcoin bubble, a copper bubble, or perhaps this time it will be an Amazon bubble.
Consider China, to the extent you can. China is opaque, and everyone knows it has its issues. Just because China fakes its numbers doesn't mean things are going badly. The China-bears have been wrong for a long, long time. But even a broken clock is right twice a day.
One good China indicator is the price of copper. Copper supply is relatively stable, and copper demand is mostly a China story. If the price of copper goes down, that would indicate trouble in China. Copper has been on a roll since the summer, currently sitting at 4-year highs. This indicates strong copper demand from China, which in turn is indicative of robust global economic activity.
However, we may already be in a copper bubble. Copper rose above $3/pound in August and now sits around $3.25-$3.30. Since hitting $3.15 in September, it has twice dropped to about $2.90 but the second dip was of shorter duration. Fluctuations are normal, but it should keep hitting higher highs and higher lows.
But, excessive demand combined with a supply shock could be problematic for the global economy. Freeport-McMoRan, the world's largest corporate copper miner, has been in sometimes acrimonious negotiations with the government of Indonesia about its mining activities there, and there is always the possibility that it could end badly with a strike, lock-out or some other production disruption.
A significant contraction of copper supply could cause an economic face plant in China. Not enough raw material available, and too high a price for what is available, could drastically slow their economy, in turn triggering a melt-down in their debt-laden real estate market. Eerily similar to our economic meltdown in 2008 triggered by the oil bubble.
And then there is oil. Our economic optimism over the past few years has been founded partly on low oil prices, but $60 oil is not stimulative. It is a good price, a fair price, but hardly the windfall that consumers – both businesses and individuals – have enjoyed the past few years. We may see an oil price bubble develop if US production does not soon increase beyond levels that are currently approaching all-time highs set in the early 1970's.
We will not avert a spike in oil prices if US producers get greedy and do not ramp up production soon. Just like the copper scenario we outlined, inadequate petroleum production combined with a supply shock – Iran looks at-risk at the moment – could cause a face plant in the global economy.
There is also a question of how much slack there is in the US labor market. The how-and-why of the low US labor participation rate is a very relevant question but well beyond the scope of this article, nonetheless, the economy - employers - may soon run out of workers even while many prospective workers choose instead to sit around smoking pot and collecting government hand-outs. (Hey Washington, now would be a great time for welfare reform).
Just like the oil and copper markets, we may soon see a price spike in wages, perhaps a drastic one. As companies have to pay incrementally more for each marginal worker they add, they become somewhat obligated to pay all their workers on the same scale, thus rapidly increasing their payrolls and creating consumer price pressures.
Price pressures on inputs such as labor and commodities tend to find their way into consumer prices, which means inflation. And if the Fed sees inflationary pressures developing, then interest rate hikes will surely follow – larger rate hikes at a faster pace than the stock market has priced in. Right now most pundits are expecting two to three hikes this year, but more than that could cause markets to tumble. And that wakeup call would cause consumers to pull back their spending.
Many left wings pundits are arguing that now is not the right time for the recently enacted tax cuts and they are right, at least in economic terms. They may very well contribute to a recession in the short term. But they will also contribute to a robust recovery and are vital in the long term. And now is the only time it could happen politically, thanks to those very same liberals. The time for the tax cuts was eight years ago. Better late than never.
The bottom line is that recessions are caused by insufficient supply of production inputs - if a business can't get their hands on sufficient raw materials, they have no choice but to curtail production, and at the same time, increase prices charged to customers to maximize the revenue on what they are able to produce. Central bank see rising prices and raise interest rates. At the same time the economy is lowing down. And as this reverberates throughout the business sector, prices continue go up while employment continues to decline, and the economy falls into recession.
Again, we are not saying that a recession is imminent, or even likely. What we are saying is that the pieces are starting to come together, and that is not something we have said over the past few years. We see storm clouds on the horizon, but that does not mean it's going to rain. We are still positive on the economy. For now. Check back in July.
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