Tag: USA

Real US GDP Drops in 4Q – Initial Estimate

US Real gross domestic product (GDP) increased at an annual rate of 1.9 percent in the fourth quarter of 2016 (table 1), according to the “advance” estimate released by the Bureau of Economic Analysis. In the third quarter, real GDP increased 3.5 percent.

The Bureau emphasized that the fourth-quarter advance estimate released today is based on source data that are incomplete or subject to further revision by the source agency. The “second” estimate for the fourth quarter, based on more complete data, will be released on February 28, 2017.

Real GDP: Percent Change from Preceding Quarter

The increase in real GDP in the fourth quarter reflected positive contributions from personal consumption expenditures (PCE), private inventory investment, residential fixed investment, nonresidential fixed investment, and state and local government spending that were partly offset by negative contributions from exports and federal government spending. Imports, which are a subtraction in the calculation of GDP, increased.

The deceleration in real GDP in the fourth quarter reflected a downturn in exports, an acceleration in imports, a deceleration in PCE, and a downturn in federal government spending that were partly offset by an upturn in residential fixed investment, an acceleration in private inventory investment, an upturn in state and local government spending, and an acceleration in nonresidential fixed investment.

Current-dollar GDP increased 4.0 percent, or $185.5 billion, in the fourth quarter to a level of $18,860.8 billion. In the third quarter, current dollar GDP increased 5.0 percent, or $225.2 billion.

The price index for gross domestic purchases increased 2.0 percent in the fourth quarter, compared with an increase of 1.5 percent in the third quarter (table 4). The PCE price index increased 2.2 percent, compared with an increase of 1.5 percent. Excluding food and energy prices, the PCE price index increased 1.3 percent, compared with an increase of 1.7 percent.

Personal Income

Current-dollar personal income increased $152.0 billion in the fourth quarter, compared with an increase of $172.3 billion in the third. The deceleration in personal income primarily reflected a deceleration in wages and salaries.

Disposable personal income increased $130.2 billion, or 3.7 percent, in the fourth quarter, compared with an increase of $141.5 billion, or 4.1 percent, in the third. Real disposable personal income increased 1.5 percent, compared with an increase of 2.6 percent.

Personal saving was $791.2 billion in the fourth quarter, compared with $818.1 billion in the third. The personal saving rate — personal saving as a percentage of disposable personal income — was 5.6 percent in the fourth quarter, compared with 5.8 percent in the third.

2016 GDP

Real GDP increased 1.6 percent in 2016 (that is, from the 2015 annual level to the 2016 annual level), compared with an increase of 2.6 percent in 2015.

The increase in real GDP in 2016 reflected positive contributions from PCE, residential fixed investment, state and local government spending, exports, and federal government spending that were partly offset by negative contributions from private inventory investment and nonresidential fixed investment. Imports, which are a subtraction in the calculation of GDP, increased.

The deceleration in real GDP from 2015 to 2016 reflected a downturn in private inventory investment, a deceleration in PCE, a downturn in nonresidential fixed investment, and decelerations in residential fixed investment and in state and local government spending that were offset by a deceleration in imports and accelerations in federal government spending and in exports.

Current-dollar GDP increased 2.9 percent, or $530.3 billion, in 2016 to a level of $18,566.9 billion, compared with an increase of 3.7 percent, or $643.5 billion, in 2015.

The price index for gross domestic purchases increased 1.0 percent in 2016, compared with an increase of 0.4 percent in 2015.

During 2016 (that is, measured from the fourth quarter of 2015 to the fourth quarter of 2016), real GDP increased 1.9 percent, the same rate as during 2015. The price index for gross domestic purchases increased 1.5 percent during 2016, compared with an increase of 0.4 percent during 2015.

Is Overvaluation Risk Real?

From Moody’s.

VIX Is Low, Overvaluation Risk Is Not

Overvaluation does not preclude an even higher market value of common stock relative to current and expected corporate earnings. Moreover, provided that the now extraordinarily low VIX index stays under 11.8, a further narrowing by corporate bond yield spreads is likely. However, an increasingly overvalued equity market favors a higher VIX index.

A convincing explanatory model for the high-yield bond spread employs measures of default risk and business activity, in addition to the VIX index. This model recently predicted a 411 bp midpoint for the high-yield spread, which eclipses its recent actual gap of 394 bp. By the way, the latter is the thinnest high-yield spread since September 2014.

What is now the lowest predicted midpoint since April 2015 owes much to an ultra-low VIX index. After removing the VIX index from the explanatory model, the predicted midpoint for the high-yield spread widens to 456 bp. (Figure 1.)

Record highs for stocks, not so for profits

For the first time ever, the blue-chip Dow Jones Industrial average broke above 20,000. Meanwhile, the market value of all US common stock as measured by the Wilshire Index set a new record high.

Nevertheless a popular measure of core profits, though improving, remains well under its apex. Since the moving yearlong estimate of pretax profits from current production peaked at the end of March 2015, the market value of US common stock has climbed higher by 10%. By contrast, the consensus estimates that for the year-ended March 2017, core pretax profits will still trail March 2015’s zenith by -5%. Moreover, the consensus does not expect yearlong profits to eclipse its record high until 2018’s second quarter.

As inferred from the different directions taken by share prices and profits since March 2015, the US equity market is richly priced, if not significantly overvalued. However, overvaluation does not promise impending doom for share prices.

For example, during 1998-2000’s stock market frenzy, though overvaluation first resembled today’s excesses in 1998’s second quarter, the market value of US common stock continued its ascent until March 2000 despite becoming increasingly overvalued. Amazingly, notwithstanding the accompanying -7% drop by yearlong profits from December 1997’s peak, the market value of US common stock managed to soar by a cumulative 49.5% from 1997’s final quarter through the first quarter of 2000.

Not surprisingly, March 2000’s unprecedented overvaluation of equities set the stage for a cumulative -43% plunge to October 2002’s bottom. Granted that today’s overvaluation falls considerably short of the excesses of late 1998 through early 2000, buying into an overvalued market necessarily entails above-average risk.

Based on the historical record, the current rally may not expire soon. Absent another extended bout of profits deflation, the US equity market is likely to set new records regardless of today’s overvaluation. For now, the consensus expects pretax operating profits to grow through 2018.
Interest rate risk now poses the biggest danger to stocks.

Nevertheless, substantially higher interest rates could temporarily drive the market value of US common stock down by at least -5%. Sharply higher interest rates previously outweighed the positive effect of profits growth and temporarily sank share prices in 1994 and late 1987. In both instances, deep declines by interest rates allowed profits to re-assume its leading role as the primary driver of equity valuation.

Incredibly, 1987’s outsized 19% annual advance by core profits was not enough to prevent a stock market crash of frightening severity. In late 1987, the market value of US common stock plunged by as much as -27% from its then record high largely because of a lift-off by the 10-year Treasury yield from a January 1987 average of 7.08% to the 10.36% of October 17, 1987.

In fact, it was at the morning of October 19, 1987’s infamous -18% daily plummet by the market value of US common stock that the benchmark Treasury yield was last above 10%. Who would have thought back then that 30 years later markets would fret over the possibility of a 3% benchmark Treasury yield?

Regarding 1994’s far less dramatic episode, a climb by the 10-year Treasury yield’s month-long average from October 1993’s 5.3% to April 1994’s 7.0% helped to sink the market value of common stock by -5.3% from its then record high despite an accompanying 19% annual advance by profits.

Do not underestimate the power of sharply higher benchmark interest rates to pummel share prices. The equity market sell-offs of both 1994 and 1987 occurred despite significant narrowings by medium- and low-grade bond yield spreads. Nor did the declining trends of high-yield defaults offset the selling pressure arising from fast rising Treasury yields.

As inferred from what occurred in 1987 and 1994, the 10-year Treasury yield may need to approach 3% for there to be at least a 50% likelihood of a 5% drop by equities amid profits growth. However, the record also makes clear that an especially disruptive ascent by benchmark yields is likely to be reversed. In order to stabilize share prices, the 10-year Treasury yield’s month-long average fell to 8.21% by February 1988 and to 5.65% by January 1996.

VIX Index stays low despite risks surrounding overvalued equities

Overvaluation warns of a painful correction in the event market sentiment worsens considerably. In recognition of ample downside risk, the VIX index has tended to be greater in richly priced equity markets, where above-trend VIX indexes have typically been joined by above-average corporate bond yield spreads. (Figure 2.)

In the current market, however, the VIX index has broken from the norm and remained unexpectedly low amid elevated ratios of equity’s market value to core profits. The market value of US common stock recently approximated 11.2-times the yearlong estimate for pretax profits from current production for the highest such ratio since the 11.5:1 of 2002’s second quarter. It was in 1998’s first quarter that common equity’s market value last climbed up to 11.2-times core profits. At that time, the VIX index averaged 21.3, which was far above its recent 10.8. Similarly, when the ratio of common equity’s market value to profits rose to Q4-2007’s previous cycle high of 10.3:1, the VIX index averaged a well above-trend 22.1. Thus, the longer elevated price-to-earnings ratios persist, the more likely is a climb by the VIX index that ordinarily is accompanied by wider corporate yield spreads.

On January 24, 2007 the VIX index closed at a record low 9.89. Ten years later the VIX index closed at the 10.83 of January 25, 2017. The latter was its lowest finish since the 10.32 of July 3, 2014, or when the high-yield bond spread was an exceptionally thin 322 bp. However, even that gap was wider than the 276 bp of January 24, 2007. Do not be surprised if an ultra-low VIX continues to lead the high-yield bond spread lower.

According to the historical statistical relationship, by itself, the recent VIX index of 10.9 predicts a 326 bp midpoint for the high-yield bond spread, which is much thinner than the recent 394 bp. As shown in Figure 3, exceptionally low readings for the VIX index have tended to prompt narrowings by the high-yield spread throughout the current business cycle upturn. (Figure 3.)

 

US Mortgage Rates Move Higher, Again

From Mortgage Rate Newsletter.

Mortgage rates moved higher for the 5th time in the past 6 business days.  The past 2 days have combined to bring rates a full .125% higher.  That’s the increment by which rates are most commonly divided (i.e. 4.0, 4.125%, 4.25%, etc.).  Under normal circumstances rates might move that much over 2 weeks as opposed to 2 days.  In fact, it happened twice in this most recent cycle (Jan 18/19, and Jan 24/25).  The only time we see rates moving any faster is during major blowouts like the weeks following the election or the 2013 taper tantrum.

The average lender is once-again quoting 4.25% on top tier conventional 30yr fixed scenarios.  This isn’t the first time we’ve seen 4.25% this year, but closing costs are slightly higher today.  That means effective rates are at 2017 highs.  Several lenders are already up to 4.375% and a scant few remain at 4.125%.

In the bigger picture, the recent weakness suggests a trend toward higher rates is taking shape after markets paused and corrected heading into mid-January.  This trend would have its most severe implications if rates break above mid-December’s highs, and it’s safest to assume that’s where we’re headed until/unless we see a big shift in the other direction.  Bottom line: early January was a nice break in the storm.  We knew the move toward lower rates would run out of steam at some point before retracing too many of the steps taken in late 2016.  The past few days increasingly confirm that break is over.

The Dow Crosses The 20,000 Rubicon

The Dow has now hit, and passed the 20,000 barrier.

It was supported by the lowest trading range in US history over the last month, and as a result the volatility index is also down.

Major shares, such as Goldman Sachs, JP Morgan, IBM and Boeing provided much of the action. The expectation of new business friendly policies, rising interest rates, and renewed economic activity are behind the moves. Not least traders hope the banks’ regulatory frameworks will be loosened.

Has so much really changed in the past couple of months, or will the US debt overhang bite back?

A $90 Billion Debt Wave Shows Cracks in U.S. Property Boom

From Bloomberg.

A $90 billion wave of maturing commercial mortgages, leftover debt from the 2007 lending boom, is laying bare the weak links in the U.S. real estate market.

It’s getting harder for landlords who rely on borrowed cash to find new loans to pay off the old ones, leading to forecasts for higher delinquencies. Lenders have gotten choosier about which buildings they’ll fund, concerned about overheated prices for properties from hotels to shopping malls, and record values for office buildings in cities such as New York. Rising interest rates and regulatory constraints for banks also are increasing the odds that borrowers will come up short when it’s time to refinance.

“There are a lot more problem loans out there than people think,” said Ray Potter, founder of R3 Funding, a New York-based firm that arranges financing for landlords and investors. “We’re not going to see a huge crash, but there will be more losses than people are expecting.”

The winners and losers of a lopsided real estate recovery will be cemented as the last vestiges of pre-crisis debt clear the system. While Manhattan skyscraper values have surged 50 percent above the 2008 peak, prices for suburban office buildings still languish 4.8 percent below, according to an index from Moody’s Investors Service and Real Capital Analytics Inc. Borrowers holding commercial real estate outside of major metropolitan areas are now feeling the pinch as they attempt to secure fresh financing, Potter said.

 

The delinquency rate for commercial mortgages that have been packaged into bonds is forecast to climb by as much as 2.4 percentage points to 5.75 percent in 2017, reversing several years of declines, as property owners struggle with maturing loans, according to Fitch Ratings. That sets the stage for bondholder losses.

CMBS Record

Banks sold a record $250 billion of commercial mortgage-backed securities to institutional investors in 2007, and lax lending standards enabled landlords across the U.S. to saddle buildings with large piles of debt. When credit markets froze the following year, Wall Street analysts warned of a cataclysm, with $700 billion of commercial mortgages set to mature over the next decade.

“At the depths of the panic, it was just that: panic,” said Manus Clancy, a managing director at Trepp LLC, a firm that tracks commercial-mortgage debt. “That made people’s future expectations extremely bearish. Extremely low interest rates over the last four or five years have forgiven a lot of sins.”

The CMBS market roared back after an 16-month shutdown, and lenders plowed into real estate as an antidote to skimpy returns for other investments. The cheap loans helped propel property values to record highs in big cities such as New York and San Francisco, alleviating concerns about the mountain of debt coming due.

Credit for property owners has once again become scarce in some pockets. Borrowing costs jumped following the surprise election of President Donald Trump, and Wall Street firms are being more cautious as new regulations kick in requiring them to hold a stake in the mortgages they sell off. Other lenders are scaling back on commitments to property types and locations where problems have gotten harder to ignore.

Struggling Malls

Lenders are taking an increasingly dim view of retail properties — especially malls — as the growth of e-commerce eats into sales at brick-and-mortar stores. Malls tend to have higher loss rates than other property types after a default, increasing the stigma for lenders, according to Lea Overby, an analyst at Morningstar Credit Ratings LLC.

When malls “start to go downhill, if nothing is done to turn the ship around, they plummet,” Overby said. “The fate of some of these malls is very, very uncertain.”

The Sunset Mall in San Angelo, Texas, added a glow-in-the-dark mini golf course in June, part of a nationwide trend of retailers trying to lure customers with experiences they can’t find online. Yet when a $28 million mortgage came due in December, the borrower couldn’t refinance it, according to data compiled by Bloomberg. The debt, part of a bond deal sold by Citigroup Inc. and Deutsche Bank AG in March 2007, was handed off to a firm specializing in troubled loans.

A similar storyline is playing out at a 82,000-square-foot (7,600-square-meter) suburban office complex in Norfolk, Virginia, whose tenants include health-care services firms. The borrower stopped making payments on a $20 million loan that comes due next month and can’t refinance the debt, Bloomberg data show.

Representatives for the owners of the properties didn’t respond to phone calls seeking comment on the loans.

Manhattan Tower

Landlords that own high-profile buildings in big cities are faring better. At 5 Times Square, the Manhattan headquarters for Ernst & Young LLP, the owners are close to securing a five-year loan to pay off $1 billion in debt that comes due in March, according to Scott Rechler, chief executive officer of RXR Realty, which owns 49 percent of the building. RXR acquired its stake in the 39-story tower shortly after the building was sold to real estate investor David Werner for $1.5 billion in 2014.

“We are currently reviewing term sheets from a number of institutions and expect to settle on a lender within a week or so,” Rechler said.

Some borrowers chipped away at the maturity wall by retiring their mortgages early in order to take advantage of ultra-low interest rates. At the same time, landlords with the weakest properties have already defaulted, further reducing the pool of loans that need to be refinanced. The maturity wall has been whittled down to about $90 billion from $250 billion in 2008, according to data from Morningstar. The firm estimates that roughly half of the remaining loans will have difficulty refinancing.

S&P analysts are predicting that about 13 percent of real estate loans coming due will ultimately default, up from 8 percent over the past two years, according to Dennis Sim, a researcher at the firm. That’s their base case, but the default rate could be higher, he said.

“There are a lot of headwinds currently — with the interest-rate increase, with the new administration coming in, and also risk retention,” Sim said. “Those three wild-card factors could also play a role in how some of the better-performing loans are able to refinance or not.”

Trump Revamps U.S. Trade Focus by Pulling Out of Pacific Deal

From Bloomberg.

With the stroke of a pen, President Donald Trump abruptly ended the decades-old U.S. tilt toward free trade by signing an executive order to withdraw from an Asia-Pacific accord that had been promoted by companies including Nike Inc. and Wal-Mart Stores Inc. as well as family farmers and ranchers.

“Great thing for the American worker, what we just did,” Trump said on Monday after signing an order withdrawing the U.S. from the Trans-Pacific Partnership accord with 11 other nations. He didn’t take any step to initiate a renegotiation of the Nafta deal with Mexico and Canada, but an aide, who spoke on condition of anonymity, said action on the accord is still in the works.

“We’ve been talking about this a long time,” Trump said.

While Trump’s order doesn’t come as a surprise — he campaigned against the TPP and other trade deals during his campaign for the White House — the action rattled some Republicans and company executives who’ve built their businesses around decades of U.S. policy geared toward more open trade. Its unclear whether Trump will replace TPP with other, narrower trade deals. There also is concern about what more protectionist policies will mean for the modern economy, where goods can travel across more than a dozen borders before making their way to the consumer.

Turnabout

“Never has the president been the one to initiate protectionism or been so vocal about turning inward,” Dan Ikenson, the director of the Cato institute’s Herbert A. Stiefel Center for Trade Policy Studies. “U.S. Trade policy on a bipartisan basis since 1934 has been geared toward liberalization and accommodation and internationalism.”

An unlikely group of bedfellows supported and opposed the announcement. Among the supporters were labor groups, Democrats such as Ohio Senator Sherrod Brown and U.S. tobacco companies, which opposed the deal over a provision that would have prevented them from suing to challenge anti-smoking measures.

Expressing disappointment with the move were farm interests and some members of Trump’s own party, including Senator John McCain, who warned it would mean abandoning the U.S. strategic position in Asia, where China is ready to step into to any vacuum left by the American withdrawal.

“Abandoning TPP is the wrong decision,” said McCain, an Arizona Republican in a statement. “Moving forward, it is imperative that America advances a positive trade agenda in the Asia-Pacific that will keep American workers and companies competitive in one of the most economically vibrant and fastest-growing regions in the world.”

Beef Sales

The National Cattlemen’s Beef Association, a trade group representing 230,000 cattle ranchers and feeders, said not having a trade deal like TPP costs the industry $400,000 in sales a day and that Nafta has driven up U.S. beef exports to Mexico more than seven-fold. Without those deals in place, the price of U.S. beef would cost more oversees, putting them at a disadvantage.

“TPP and Nafta have long been convenient political punching bags, but the reality is that foreign trade has been one of the greatest success stories in the long history of the U.S. beef industry,” the group said in a statement.

U.S. agriculture exports have doubled since Nafta was signed by then-President Bill Clinton in 1993.

Trump’s decision to pull out of TPP eliminates potential savings on import tariffs for retailers like Foot Locker Inc. and Wal-Mart, and brands such as Nike, Adidas AG and Puma SE, according to data from Bloomberg Intelligence. The cut in import costs would have been $450 million a year, according to the Footwear Distributors and Retailers of America.

Company Support

The death of TPP is an especially bitter pill for Mark Parker, Nike’s chief executive officer. He has said TPP would help it add jobs in the U.S. because Nike would be able to use the savings from the deal to invest in the U.S. As the world’s largest sports brand, Nike sources about 40 percent of its shoes from Vietnam, a TPP member nation, and was very public supporter of the trade pact. Representatives from Nike didn’t respond to requests for comment.

Aldo Group, a Canadian footwear maker with a third of sales in the U.S., has been shifting production from China into Vietnam in anticipation of TPP being implemented in the hope of being able to take advantage of lower tariffs, said Bryan Eshelman, chief operating officer.

“TPP would have been fantastic’’ as the footwear industry pays on average as much as 18 percent of duty for imports to enter the U.S., Eshelman said in an interview before the executive order was signed. “In the short term, we are slightly disappointed that we can’t expect the duty relief that we were hoping for out of Vietnam.’’

Taxes, Regulation

But he said if the U.S. economy would grow faster because of some of Trump’s other policies such as regulation reduction and lower tax rates, that would be beneficial for the company.

“If that happens, forget tariffs reduction, our business will grow because the economy will grow and that would be a better outcome for us than lower duty imports into the U.S.,’’ Eshelman said.

The TPP, a 12-country deal that sought to liberalize trade between the U.S. and Pacific Rim nations including Japan, Mexico and Singapore, was a signature piece of former President Barack Obama’s attempt to pivot U.S. global strategy to focus on the fast-growing economies of Asia. The group that was part of the accord represents about 40 percent of the world economy. However, given rising opposition among Democrats and some Republican, it was never submitted for ratification.

The future of the TPP is now in flux. Japanese Prime Minister Shinzo Abe said in November that TPP without the U.S. would be “meaningless.” Still, multiple signatory countries including Vietnam and Australia have said they would stick to the deal even without the leading party of the agreement.

‘Good Result’

On Nafta, Trump said Sunday that he’ll meet with Canadian Prime Minister Justin Trudeau and Mexican President Enrique Pena Nieto to begin discussing the deal, which he has routinely blamed for the loss of U.S. jobs although there was little change to employment in the U.S. in several years after it went into effect. Trump signaled that he’s willing to work with the U.S.’s closest neighbors.

“We’re going to start renegotiating on Nafta, on immigration, and on security at the border,” Trump said at the start of a swearing-in ceremony for top White House staff. “I think we’re going to have a very good result for Mexico, for the United States, for everybody involved. It’s really very important.”

Officials in Canada, which is the biggest buyer of U.S. exports, have indicated they want to avoid getting entangled with the Trump administration’s targeting of imports from Mexico and China. The three countries are the biggest trading partners of the U.S.

David MacNaughton, Canada’s ambassador to the U.S., told reporters his focus is on avoiding Canada being “collateral damage” in trade talks.

Trump inauguration marks ‘whole new world’

From InvestorDaily.

Investors should prepare for more volatility and political uncertainty as the new President of the United States commences in his role, says Eaton Vance.

Equity markets enjoyed a rally following Donald Trump’s successful campaign for the presidency, benefitting from the then president-elect’s pro-growth policy proposals, but Eaton Vance co-director of global income Eric Stein notes this has recently paused.

“Equity markets have been in a bit of holding pattern recently after their post-election rally, while Treasury yields and the US dollar have fallen somewhat from post-election highs,” he said.

“Yet the big question is how markets will react after Trump takes the Oath of Office as the 45th US president, and investors start to get more details on his administration’s policies and agenda.”

Mr Stein cautioned investors not to discount the potential downside risks that may appear should Mr Trump focus on his more protectionist policies than his pro-growth reforms, but equally that they should not “underestimate the chance for a transformational positive economic environment” his proposed fiscal and regulatory reforms could create.

“Both outcomes are very possible, but I think it’s almost as important to watch tone and messaging as it is to watch the specifics of policy proposals,” he said.

“The inauguration speech is obviously an opportunity for Trump to act more presidential, and investors will be watching and listening closely. They will also focus on the communication style after the inauguration, and any details on what Trump plans to tackle first and how.”

Some of Mr Trump’s policy goals however could take longer to implement than many expect, said Pimco head of public policy Libby Cantrill.

“Many of the items that President-elect Trump and congressional Republicans are looking to tackle in 2017 – a healthcare overhaul, tax reform, infrastructure – are inherently complex and time-consuming, even with Republican majorities in both chambers of Congress,” she said.

Ms Cantrill said Mr Trump’s stance on Obamacare was one such example of this, noting that the Republicans controlling the house are split on whether to repeal and replace the legislation, or repeal and delay it.

“Healthcare policymaking is notoriously complex and time-consuming; it took Congress 14 months to pass Obamacare after holding more than 100 hearings in the Senate and 80 in the House,” she said.

Infrastructure spending, trade negotiations, and whether to cut or reform taxes were other policy decisions likely to be met with difficulty, Ms Cantrill said, noting that many of these may not be completed or implemented prior to 2018.

“The bottom line is that governing is harder than campaigning,” she cautioned.

“While we expect policymakers to focus on advancing the Trump agenda, there is a good chance that some of these agenda items slip into 2018 given the realities of Washington.”

‘Threat of protectionism’ poses serious risks

From InvestorDaily.

The global economy is improving, but investors must avoid complacency as the risks associated with US trade policy and its effects on emerging markets increase, according to Standard Life Investments.

Global activity is picking up and supporting corporate earnings growth, the company said, and fears of deflation are beginning to subside due to improving headline inflation rates and commodity prices.

“Meanwhile, other than the attack on the Mexican peso, market participants have so far shrugged off the potential for the trade policies of the incoming Trump administration to weigh on global growth, instead choosing to focus on the benefits of possible corporate tax reform and broader US fiscal easing,” the company said.

Despite the improved economic conditions, Standard Life Investments cautioned that “investors need to be wary of complacency”, noting that the current global manufacturing cycle was being led by emerging markets off the back of China’s stimulus efforts, and that President-elect Donald Trump’s proposed policies could undermine productivity and corporate margins, putting investors in “an unusual position”.

“On the one hand, the recent run of strong data suggests that there are upside risks to our global growth forecasts for 2017,” the company said.

“On the other, left-hand tail risks are also clearly higher. Trump’s first 100 days in office, together with the early year Chinese credit figures, will tell us more about which force will win out.”

Investors should also watch for developments in US-China relations, the company said, as “tensions are running high” in several areas, including trade.

“Investors would be wise to take the threat of protectionism seriously,” the company said.

“While it is unclear how far Trump’s team will go in changing trade policy, it is also unclear how other countries would react, particularly an emboldened China. Chinese official press have denounced the threats of across-the-board tariff increases and indicated their intention to retaliate.”

US Deregulation Seen to Spur to Growth, Trim Risk

Moody’s says Washington’s transfer of power is complete. Very high probabilities can now be assigned to lowering the 35% corporate income tax rate, easing federal business regulations, and a major overhaul of the US government’s role in health insurance.

Deregulation will supply stimulus at no immediate cost to the taxpayer. Nevertheless, deregulation reintroduces systemic risks that could prove costly over time.

A relaxation of federal business regulations and changes in government-mandated health care programs may supply an unexpectedly large lift to business activity. Not only will overhead costs decline, but businesses will be able to allocate a greater portion of their scarce resources to an enhancement of their product offerings. Success at the latter will expand attractive job opportunities.

Regarding a possible reformulation of Dodd-Frank, diminished regulatory burden will increase the supply of mortgage credit and business credit. Mortgage yields and business borrowing costs may be lower than otherwise, helping to offset the upward pressure put on private-sector borrowing costs by a higher fed funds rate and higher Treasury bond yields.

In addition, a softening of Dodd-Frank would enhance the ability of banks to make markets in corporate bonds and leveraged loans, where the availability of buyers for riskier debt is of critical importance during episodes of systemic financial stress. Corporate credit spreads have been wider than otherwise because of worry surrounding market depth in a time of stress.

Paradoxically, despite fears that a relaxation of regulations will add to systemic risk, a widely followed measure of business credit risk — the high-yield bond spread — has narrowed considerably from an election day, or November 8, close of 515 bp to a recent 409 bp. Indeed, high-yield bonds have far outperformed higher-quality bonds since Election Day. Unlike the 10-year Treasury yield’s jump from November 8’s 1.86% to a recent 2.43% and the rise by an investment-grade corporate bond yield from 3.00% to 3.34%, a composite speculative-grade bond yield sank from November 8’s 6.53% to a recent 5.96%.

As inferred from the high-yield bond market’s upbeat response to the Republican sweep, the outgoing administration’s efforts to reduce systemic financial risk may have weighed so heavily on business activity and the efficient functioning of financial markets that they increased perceived default risk on a company by company basis. How ironic that an anticipated relaxation of financial and other business regulations has lessened perceived default risk considerably.

Room for growth may still go unfilled

And there is plenty of room to expand business activity without the risk of a potentially destabilizing upturn by price inflation. Rates of resource utilization are now exceptionally low for the seventh year of an economic recovery. If demand materializes, the Trump administration’s goal of 3% to 4% real growth for the US economy may at least be temporarily achievable.

However, given the financially stressed condition of many households both at home and abroad, as well as the diminished spending proclivities of the aging populations of advanced economies, spending may fall short of what is needed to sustain 3% to 4% growth over a yearlong span.

Moreover, real GDP growth of at least 3% may not be a recurring phenomenon. Long-term economic growth may be constrained to a pace closer to 2% if both the labor force and productivity continue to rise at rates that are well below their respective long-term trends.

Consensus outlook for profits requires faster than forecast GDP growth

Early January’s Blue Chip consensus projection of a 5.0% annual increase for 2017’s pre-tax profits from current production may be incompatible with the accompanying forecast of a 4.4% annual increase by 2017’s nominal GDP. Only if employment costs slow from their 4.7% annual climb of the year-ended September 2016 might nominal GDP growth of 4.4% deliver profits growth of 5.0%. However, if the recent 4.7% unemployment rate correctly indicates rising wage pressures, a deceleration by employment costs seems unlikely.

As inferred from the strong 0.87 correlation between the annual yearlong growth rates of corporate gross value added and nominal GDP, the consensus prediction of 4.4% nominal GDP growth favors a 4.1% annual gain for 2017’s corporate gross-value-added, where the latter is a proxy for corporate revenues.

In terms of moving yearlong averages, the percentage point difference between the annual growth rates of gross value added less corporate employment costs generates a strong correlation of 0.86 with the annual growth rate of pretax profits from current production.
Combining 2017’s prospective annual increase of 4.1% for gross value added with 4.7% employment cost growth predicts a 2.5% midpoint for the annual increase of 2017’s pretax operating profits. To the contrary, the equity and high-yield bond markets may be pricing in faster growth rates of 4.9% for gross-value-added and 5% for employment costs, where such assumptions support a predicted midpoint of 5% for core profits growth. However, 4.9% growth by gross-value-added may require faster-than-forecast nominal GDP growth of 5%.

Profits growth is likely if capacity use rises

Fourth-quarter 2016’s comparatively low industrial capacity utilization rate of 75.3% amplifies 2017’s upside potential for earnings growth. After declining from a year earlier in each of the last seven quarters including Q4-2016, the capacity utilization rate is expected to increase annually in each quarter of 2017. If true, the return of profits growth in 2017 is practically assured.

The yearly percent change by pretax profits from current production shows a highly asymmetrical response to the capacity utilization rate’s yearly percentage point change. Since early 1979, 68, or 85%, of the year-to-year increases by the capacity utilization rate have been joined by a year-to-year increase for profits. In stark contrast, only 32, or 46%, of the span’s 70 yearly declines by the capacity utilization rate were accompanied by lower profits.

The fuller use of production capacity also bodes well for corporate credit. In terms of yearly changes, the high-yield bond spread narrowed for 63% of the months since mid-1987 showing an increase by the capacity utilization rate, while the spread widened for 66% of the months showing a decline by capacity utilization.
Still low rates of resource utilization suggest that the current recovery may prove to be a late bloomer in terms of realizing its full potential.

Does a Strong Dollar Slow the Growth Rate of GDP?

From The St. Louis Fed Blog.

Over the past several months, a new episode of appreciation of the dollar began. The dollar spiked noticeably Nov. 9 and 10 (the two days following the U.S. presidential election) and again on Dec. 15 (the day after the Federal Reserve announced its most recent rate hike).

This appreciation has renewed concern of a slowdown in U.S. economic growth through the channel of international trade. The appreciation of the dollar implies that U.S. goods become more expensive abroad, and hence tends to reduce U.S. exports.

Meanwhile, a strong dollar makes foreign goods cheaper to U.S. consumers, which tends to increase imports. The forces of increasing imports and decreasing exports both deteriorate the trade balance and could slow down the growth rate of the U.S. economy. This article reviews the impact a stronger dollar had on gross domestic product (GDP) growth from 2014 to the beginning of 2016, the previous significant episode of appreciation.

Previous Dollar Strengthening Episode

How much does international trade, in conjunction with such a sharp appreciation of the dollar, slow down the GDP growth rate? The Bureau of Economic Analysis reports international trade’s contribution to the GDP growth rate each quarter. The figure below plots the GDP growth rate, the trade component’s contribution to GDP growth and the appreciation of the dollar from the second quarter of 2014 to the first quarter of 2016.1

TradeGDPGrowth

It is clear that a strong dollar is associated with net exports contributing negatively to GDP growth. During the sample period’s two-year span, trade contributed positively to GDP growth in only one quarter.

The negative impact was particularly strong over the first half of the appreciation period. For example, during the fourth quarter of 2014 and the first quarter of 2015, the contributions to the GDP growth rate from net exports were -1.14 percent and -1.65 percent, respectively. The negative effects diminished by the end of 2015, standing at -0.5 percent despite the dollar’s increase in value of another 10 percent.

Imports and Exports

The next figure further decomposes international trade’s contribution to GDP growth into exports and imports.

ExpImpGDPGrowth

In response to the strength of the dollar, the contributions from imports played a much more significant role than that of exports. The cumulative contribution of imports to GDP growth was -4.6 percent, while the cumulative contribution of exports was slightly positive at 0.85 percent. This suggests an asymmetric reaction between exports and imports in response to increases in the dollar’s exchange rate. Thus, it is reasonable to conclude that the slowdown in GDP growth was associated more with the growth of imports rather than the reduction in exports.

In sum, the new episode of appreciation of the dollar that began over the past several months is likely to hurt the current growth rate of GDP through an increase in imports rather than a decrease in exports if the trend from the previous period of appreciation holds.

Notes and References

1 We used the real broad trade weighted U.S. dollar index, indexed to its average over the sample period.