The Great Reckoning for policymakers’ failures has begun

Next week, I will publish my annual Budget Outlook, covering the 2018-2020 period. The aim, as always, will be to challenge conventional wisdom when this seems to be heading in the wrong direction.  Before publishing the new Outlook each year, I always like to review my previous forecast. Past performance may not be a perfect guide to the future, but it is the best we have:

The 2007 Outlook ‘Budgeting for a Downturn‘, and 2008′s ‘Budgeting for Survival’ meant I was one of the few to forecast the 2008 Crisis
2009′s ‘Budgeting for a New Normal’ was then more positive than the consensus, suggesting “2010 should be a better year, as demand grows in line with a recovery in global GDP
The 2010 Outlook was ‘Budgeting for Uncertainty’. This introduced the concept of Scenario planning, to help deal with “today’s increasingly uncertain New Normal environment.”
2011 was ‘Budgeting for Austerity’. It anticipated weak growth across Europe as a result of the austerity measures being introduced, and disappointing global growth, whilst arguing that major new opportunities were opening up as a result of changing demographic trends
2012 was ‘Budgeting for an L-shaped recovery’, arguing that recovery was unlikely to meet expectations
2013 was ‘Budgeting for a VUCA world‘ where Volatility, Uncertainty, Complexity and Ambiguity would dominate
2014 was ‘Budgeting for the Cycle of Deflation‘, 2015 was ’Budgeting for the Great Unwinding of policymaker stimulus’, 2016 was ‘Budgeting for the Great Reckoning’

Please click here if you would like to download a free copy of all the Budget Outlooks.

My argument last year was that companies and investors would begin to run up against the reality of the impact of today’s “demographic deficit”.  They would find demand had fallen far short of policymakers’ promises.  As the chart shows, the IMF had forecast in 2011 that 2016 growth would be 4.7%, but in reality it was a third lower at just 3.2%.   I therefore argued:

“This false optimism has now created some very negative consequences:

 Companies committed to major capacity expansions during the 2011 – 2013 period, assuming demand growth would return to “normal” levels
 Policymakers committed to vast stimulus programmes, assuming that the debt would be paid off by a mixture of “normal” growth and rising inflation
 Today, this means that companies are losing pricing power as this new capacity comes online, whilst governments have found their debt is still rising in real terms

“This is the Great Reckoning that now faces investors and companies as they plan their Budgets for 2017 – 2019.”

Oil markets are just one example of what has happened.  A year ago, OPEC had forecast its new quotas would “rebalance the oil market” in H1 this year. When this proved over-optimistic, they had to be extended for a further 9 months into March 2018. Now, it expects to have to extend them through the whole of 2018.  And even today’s fragile supply/demand balance is only due to China’s massive purchases to fill its Strategic Reserve.

Policymakers’ unrealistic view of the world has also had political and social consequences, as I noted in the Outlook:

“The problem, of course, is that it will take years to undo the damage that has been done. Stimulus policies have created highly dangerous bubbles in many financial markets, which may well burst before too long. They have also meant it is most unlikely that governments will be able to keep their pension promises, as I warned a year ago.

Of course, it is still possible to hope that “something may turn up” to support “business as usual” Budgets. But hope is not a strategy. Today’s economic problems are already creating political and social unrest. And unfortunately, the outlook for 2017 – 2019 is that the economic, political and social landscape will become ever more uncertain.”

As the second chart confirms from Ipsos MORI, most people in the world’s major countries feel things are going in the wrong direction.  Voters have lost confidence in the political elite’s ability to deliver on its promises.  Almost everywhere one looks today, one now sees potential “accidents waiting to happen”.

Understandably, Populism gains support in such circumstances as people feel they and their children are losing out.

The last 10 years have proved that stimulus programmes cannot substitute for a lack of babies.  They generate debt mountains instead of sustainable demand, and so make the problems worse, not better.

Next week, I will look at what may happen in the 2018 – 2020 period, and the key risks that have developed as a result of the policy failures of the past decade.

 

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Baby boomers’ spending decline has hit demand and inflation

FTThe Financial Times has kindly printed my letter below, wondering why the US Federal Reserve still fails to appreciate the impact of the ageing BabyBoomers on the economy

Sir, It was surprising to read that the US Federal Reserve is still puzzled by today’s persistently low levels of inflation, given that the impact of the ageing baby boomers on the economy is now becoming well understood (“An inflation enigma”, Big Read, September 19).

As the article notes, factors such as globalisation and technological advances have all helped to moderate price increases for more than two decades. But the real paradigm shift began in 2001, when the oldest boomers began to join the lower-spending, lower-earning over-55 generation. As the excellent Consumer Expenditure Survey from the Bureau of Labor Statistics (BLS) confirms, Americans’ household spending is dominated by people in the wealth creating 25-54 age cohort. Spending then begins to decline quite dramatically, with latest data showing a near 50 per cent fall from peak levels after the age of 74.

This decline was less important when the boomers were all in the younger cohort. BLS data show it contained 65m households in 2000, with only 36m in the older cohort. But today, lower fertility rates have effectively capped the younger generation at 66m, while the size of the boomer generation, combined with their increased life expectancy, means there are now 56m older households.

Consumer spending is around 70 per cent of the US economy. Thus the post-2001 period has inevitably seen a major shift in supply/demand balances and therefore the inflation outlook. So it is disappointing that the Fed has failed to go up the learning curve in this area. Demographics are not the only factor driving today’s New Normal economy, but central bankers should surely have led the way in recognising their impact.

Paul Hodges
Chairman,
International eChem

Oil price weakness will unmask reflation and recovery myth

Brent Jun17Oil markets have been at the centre of the recent myth that economic recovery was finally underway.  The theory was that rising inflation, caused by rising oil prices, meant consumer demand was increasing.  In turn, this meant that the central banks had finally achieved their aim of restoring economic growth via their zero interest rate policy.

This theory was first undermined in 2014, when oil prices began their fall.  There had never been a shortage of oil. Prices rose to $125/bbl simply because the hedge funds saw commodities like oil as a ‘store of value’ against the Federal Reserve’s policy of weakening the dollar.

The theory sounded attractive and plenty of people had initially made a lot of money from believing it.  But it didn’t mean that the global economy had recovered.  And by August 2014, as I highlighted at the time, oil prices were starting to collapse under the weight of excess supply.  As I also suggested in the same post, this meant “major oil price volatility is now likely”.  By luck or judgement, this has indeed since occurred, as the chart shows:

□  The 2009 – 2014 rally was dominated by “technical trading”, as oil markets lost their role of “price discovery”
□  August – December 2014 then saw prices crash to $45/bbl
□  Prices rose nearly 50% in early 2015 in a “failed rally”, as hedge funds assumed prices would quickly recover
□  Prices then halved to $27/bbl in January 2016 as the reality of over-supply swamped the market
□  Since then prices have doubled as OPEC combined with the hedge funds to try and push prices higher
□  This rally now seems to have failed, as US shale supply continues to increase

In reality, as I discussed last month, this final rally merely enabled new US production to be financed.  The US oil rig count has doubled over the past year, and each rig is now 3x more productive than in 2014.  At the same time, the medium-term outlook for oil demand in the key transport sector is becoming more doubtful, with China and India both now moving towards Electric Vehicles as a way of reducing their high levels of air pollution.

A measure of how far the market has moved was seen at last week’s Clean Energy Ministerial meeting, which:

“Set a collective aspirational goal for all EVI members of a 30% market share for electric vehicles (EVs) by 2030. It does so with the aim of taking advantage of the multiple benefits offered by electric mobility for innovation, economic and industrial development, energy security, and reduction of local air pollution.”

Already oil price targets, even amongst the optimists, are now being revised downwards.  Nobody now talks about a “quick return” to $100/bbl, or even to $70/bbl.  Instead the hope is that possibly they might return to $60/bbl at some point in the future – others merely hope that today’s $50/bbl level can be maintained.

Inflation Jun17Hope, however, is not a strategy.  And in the absence of major geopolitical disruption, it seems likely that the hedge funds will continue to withdraw from the market and leave supply/demand fundamentals to once again set the price. In turn, this will challenge the reflation and recovery myth that grew up whilst the funds were boosting their bets on the oil and commodity markets.

As the second chart shows, inflation has already begun to weaken in China as well as in the US and Eurozone economies.  China’s move away from stimulus will help to accelerate this move in H2, In turn, markets will likely return to worrying about deflation once more.

Japan is an excellent indicator of this development.  Its inflation rate completely failed to take off despite the major rise in oil and other commodity prices. As I have long argued, Japan’s ageing population means that its previous demographic dividend has now been replaced by a demographic and demand deficit.

The US and Eurozone economies are both going through the same process.  10k Americans and 18k Europeans have been retiring every day since 2011 as the BabyBoomer generation reaches the age of 65.  They already own most of what they need, and their incomes generally suffer a major hit as they leave the workforce.

Companies and investors therefore need to prepare for a difficult H2.  The failure of the latest oil price rally, and the return of deflation worries, will puncture the myth that reflation and economic recovery are finally underway.  Political stalemate will increase, until policymakers finally accept that demographics, not central banks, drive demand.

“Demographics in mainstream economics has been under-emphasized for too long” – Andy Haldane, Chief Economist, Bank of England

Haldane Jan17“Will economists start to consider demographics when making their forecasts and developing government policies?”

This was the question on my mind at a recent discussion on the topic of “An economy that works for everyone” at the UK’s Institute for Government.  The speaker was the Chief Economist of the Bank of England, Andy Haldane, and the Institute’s Director, Bronwen Maddox kindly invited me to ask my question as part of the discussion.  You can watch the Q&A by clicking here.  The transcript is below.

Critically, Haldane acknowledges that economists need to rethink their approach.  Until now, they have focused on developing policies that impact “the average person”.  Instead, he agrees that they now “need to be super-granular, household by household”, in terms of demographics and other relevant detail.

Andy Haldane is a leading central banker.  His statement that “we shouldn’t have fixed views on how monetary policy works” is therefore very important.  New ideas are urgently needed, and his comment opens the door for debate.    As I have discussed here in earlier posts (Policymakers’ out-of-date economic models fail to create growth, againAge range and income level key to future corporate profits), I believe there is an urgent need to develop an alternative economic model based on the ”competing populations” concept developed by the biologists.

Paul Hodges
Andy. Thank you very much indeed for the stimulating talk. You made a comment just now about “is it something else” (that is causing the post-2008 recovery to be so slow and uncertain), and at the start you talked about the need perhaps to reinvent or rethink economics. You also made a point about the failure of conventional economics to explain this difference between the frontier companies (who are leading in their fields) and the others.

Just before Christmas the bank put out a survey of spending with relation to interest rates and monetary policy which suggested that again and I quote almost exactly “conventional economics would have said that if you pass on lower interest rates, people will spend more. “But in fact only 10% of people did. So what I wanted to ask you was,

“Is this something else” to do with really significant demographic changes in the economy – that we now have a group of BabyBoomers, the largest-ever group of people in the population, who are refusing to die at 65 as they would have done in the past. In fact they are living now for another 20 years, and we have around one in five of the population in that age group.”

My question really is therefore “do you think that investigating this demographic impact, which has never happened before in the world, could be useful”? Because I think that it might provide the key (a) to the new type of economics and also (b) to the question of how we raise UK productivity.

Andy Haldane
“Paul, your work on this is a very good example of how demographics in mainstream economics has been under-emphasized for too long.

That I think is changing by the way – that I think is changing and we are seeing for example when people tell the story that I mentioned earlier on about secular stagnation – the kind of Bob Gordon, Larry Summers-type hypothesis – one of the facts that is pointed towards would be demographic factors nudging us in that direction.

When we’re trying to make sense of why it is that interest rates globally – not ones set by central banks, ones set by financial markets – why they are so low, for as far as the eye can see, part of the explanation, I think, lies in evolving demographics and the implications that has about saving and for investment. 

The study you mention, I think of households, which we conduct a regular basis to try and understand their patterns of spending and saving is, in some ways, a brief example of all we discussed today. It’s a vertical distribution. It’s saying we can’t take the average person, the so-called representative agent and hope that by studying them we can make sense of what’s going on. We need to be super-granular, household by household:

 Conditioning on whether they are a borrower or a saver, whether they are young or whether they are old, whether they live in the North East or whether they live in the South West
 And using that to condition our policy responses including our monetary policy responses

It could be the case we reach the point where interest rates are a bit less potent in stimulating spending than was the case in the past. We shouldn’t have fixed views or fixed multipliers about how monetary policy works.

It can change as the economy can change and by looking at this more granular data, like Michael Fish* did after 1987, we can perhaps tomorrow, or failing that the day after tomorrow, do a somewhat better job of making sense of what happens next in the economy.”

 

* Michael Fish was the BBC weather forecaster who famously denied on-air in October 1987 that a hurricane was about to hit the UK. Haldane had earlier noted that this failure had prompted a complete rethink of weather forecasting, which was now much better as a result. He hoped that economists’ failure to forecast the 2008 Crisis might end up causing a similar process of rethinking and reinvention to take place.

Interest rate and US$ surge mark start of the Great Reckoning

Right direction Nov16

The bond market vigilantes are back.  And they clearly don’t like what they are seeing.  That is the clear message from the charts above, showing movements in 10 year government bond interest rates for the major economies, plus their exchange rate against the US$ and the value of the US$ Index:

  As I warned in the Financial Times in August, You’ve seen the Great Unwinding; get ready for the Great Reckoning
  The financial world has completely changed since the Brexit vote in June, and then Donald Trump’s election
  The Brexit vote saw rates begin to surge and the US$ to rise; these moves have accelerated since Trump’s win
  Since the Brexit vote, US rates have risen by more than a half from 1.4% to 2.3%
  UK rates have trebled from 0.5% to 1.5%
  Chinese rates have risen by more than a tenth from 2.6% to 2.9%; Japanese rates have risen from -0.3% to zero
  German rates have risen from -0.2% to a positive 0.3%; Italian rates have doubled from 1% to 2%

At the same time, the value of the US$ has been surging against all these currencies, as the black line in each chart confirms.  And the value of the US$ Index against the world’s major currencies has risen by 8% to $101.

These are quite extraordinary moves, and it is most unlikely they will be quickly reversed.  They mark the start of the Great Reckoning for the failure of the stimulus packages introduced on an ever-larger scale over the past 15 years.

Now investors are going to find out the hard way that return on capital is not the same as return of capital, due to the return of the bond market vigilantes.  As James Carville, an adviser to President Bill Clinton once warned:

I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.

The key issue is that the demographic dividend of the BabyBoomer-led SuperCycle is now creating a demand deficit.  The 50% rise in global life expectancy since 1950, combined with the 50% decline in fertility rates, means that we have effectively traded 10 years of increased life expectancy for economic growth.  That’s not a bad trade, and I have yet to meet anyone who would volunteer to die early, in order to allow growth to return.

The problem is that in recent years, policymakers have chosen to ignore these demographic realities.  They have instead assumed they can always create growth via stimulus programmes based on ever-increasing amounts of debt.

Today, we therefore now face the problem of high debt ($199tn according to McKinsey. and 3x global GDP, last year), and no growth.  So as I warned in January (“World faces wave of epic debt defaults” – central bank veteran), investors are now beginning to realise all this debt can never be repaid.

These developments also highlight how central banks are now starting to lose control of interest rates.  Instead, markets are beginning to rediscover their real role of price discovery based on supply/demand fundamentals.  They are no longer being overwhelmed by central bank liquidity:

   The interest rate rises will have major impact on individuals and companies, as prices realign with fundamentals
   A rising dollar is also deflationary for the global economy, as it further reduces growth levels outside the USA
   In addition, it is bad news for anyone who borrowed in dollars, thinking they would benefit from a lower interest rate from that available in their own country, as their capital repayments increase

As I warned last month in Budgeting for the Great Reckoning:

“The problem, of course, is that it will take years to undo the damage that has been done. Stimulus policies have created highly dangerous bubbles in many financial markets, which may well burst before too long. They have also meant it is most unlikely that governments will be able to keep their pension promises, as I warned a year ago. .

“It is still possible to hope that “something may turn up” to support “business as usual” Budgets. But hope is not a strategy. Today’s economic problems are already creating political and social unrest. And unfortunately, the outlook for 2017 – 2019 is that the economic, political and social landscape will become ever more uncertain.

“I always prefer to be optimistic. But I fear that this is one of those occasions when it is better to plan for the worst, even whilst hoping that it might not happen. Those who took this advice in October 2007, when I suggested Budgeting for a Downturn, will not need reminding of its potential value.”

US 10-Year interest rates suggest Great Reckoning may be near

10yr Treasury Sept16

 ”History doesn’t repeat itself, but it often rhymes“, Mark Twain

Bob Farrell of Merrill Lynch was rightly considered one of the leading Wall Street analysts in his day.  His 10 Rules are still an excellent guide for any investor.  Equally helpful is the simple checklist he developed, echoing Mark Twain’s insight, to help investors avoid following the crowd:

  He worried that emotion often caused investors to buy at peaks or sell at lows, due to following the herd
  He identified how most equity market downturns ended with a 10% annual fall, and major downturns with a 20% fall
  He also found that most rallies ended with a 20% gain, and major speculative blowoffs ended after a 40% gain

The above chart applies Farrell’s insight to the US 10-Year Treasury bond market, using Federal Reserve data for the monthly interest rate (NB rates move inversely to the price, so a higher yield means a lower price, and vice versa). We only have to adjust the downside levels, as most downturns end with a 20% fall, and major downturns with a 40% fall.

It is hard to overstate the importance of the 10-Year Bond.  It is the benchmark interest rate for the global economy, and so should not suffer speculative blowoffs. In fact, it has only seen 2 blowoffs since 1973 – and both were due to the US Federal Reserve’s recent attempts to manipulate the market:

  The first was during the 2008 Financial Crisis, when investors rushed for a “safe haven” after the subprime collapse
  The second was after 2011, when the major central banks pushed rates lower during the Eurozone debt crisis
  Both were followed by 20%+ falls, confirming Farrell’s Rule 1 – that “markets tend to return to the mean over time”

This suggests that Farrell’s simple checklist is a very powerful tool for an investor who wants to avoid being driven by market fear or greed.   It also shows that today’s market is close to blowoff levels, with July seeing a peak after a 35% gain.  Another warning of potential stress is that this rally ended with the interest rate at 1.5% – the lowest ever recorded by the Fed (the series goes back to 1953).  Is this level really sustainable for a 10-year bond?

If not, the recent rally in the Treasury bond market could have been the last in the series.  We may learn more from market reaction to the Fed and Bank of Japan’s meetings this week.  Any change in sentiment could have important consequences for Emerging Markets and those in the developed world, as the Financial Times warned recently:

“Institutional investors across the developed world have been pouring money into emerging market assets at a rate of more than $20bn a month since the middle of this year — quite a turnround after the outflows that dominated much of the previous 12 months….the big imperative driving the flows comes from the more than $13tn of bonds in developed markets that now charge investors for the privilege of owning them”.

Investors are so desperate for yield, due to central bank interest rate policy, that they have abandoned their normal caution.  Many have invested in countries which they would be hard-pressed to find on a map.  Others have bought developed country bonds at higher and higher prices – assuming that interest rates will never, ever, rise again.

Of course, markets can always go higher temporarily.  But the logic of Farrell’s Rule 1 suggests that developments in the US 10-Year bond market are warning us that the start of the Great Reckoning is not far away.  As the Bank for International Settlements (the central bankers’ bank) warned yesterday:

“Developments in the period under review have highlighted once more just how dependent on central banks markets have become”

 

WEEKLY MARKET ROUND-UP
My weekly round-up of Benchmark prices since the Great Unwinding began is below, with ICIS pricing comments:
Brent crude oil, down 55%
Naphtha Europe, down 56%. “A build up in products supply has punctured refiners’ margin”
Benzene Europe, down 53%. “Pricing and consumption was expected to see an upturn this month following the lull in activity over the summer holiday period, but this has yet to materialise.”
PTA China, down 41%. “Lack of demand for spot cargoes”
HDPE US export, down 27%. “Exports in July accounted for roughly 23% of PE sales.”
S&P 500 stock market index, up 9%
US$ Index, up 18%