Below is a round-up of Longview related views/research & trade ideas – the intention is to publish this most Fridays, updating key themes and highlighting key pieces of (often contrarian) research. Feedback, as always, is appreciated. Equally just ‘unsubscribe’ at the bottom if you don’t want to receive the email.
The Structural State of the US Economy
From a structural perspective, the state of health of the government’s finances is a focal point in the media and for many economists. On one side of the argument, Trump is denounced for implementing a fiscal package late into an economic cycle. From the other end of the political spectrum, reflecting the new fashionable left wing ‘MMT’ thinking, he should be doing more (as the state of health of the government’s balance sheet, under MMT theory, is purported to be irrelevant – see bottom of email for detail).
From the perspective of assessing the likely longevity of this cycle, though, the best sectoral balance dynamics to watch is that of the corporate sector. Ultimately the corporate sector creates jobs, pays taxes and, in the long run, creates the wealth (i.e. as it drives productivity growth – which is the only real, enduring form of wealth creation).
As such we closely monitor and analyse each quarter’s update from the Federal Reserve on the structural state of health of the US corporate sector (and household sector). This comes with the publication of the Federal Reserve’s quarterly ‘Financial Accounts’ release (previously known as the ‘Flow of Funds’). Last week, the Fed published its Q4 2018 update.
Below we assess the overall state of health of the corporate sector, and then the state of health of the household sector (from a balance sheet perspective).
The State of Health of the US Corporate Sector
Overall, whilst there are some troubling factors (see below), the position of the US corporate sector is reasonably robust. Productivity, margins and profitability have all been improving. Importantly, that is profitability measured using the more reliable national accounts data, as well as stock market earnings. With that improving profitability, corporate sector cashflow remains healthy (i.e. before buybacks). The traditional measure of the US corporate sector financing gap shows that the gap is still negative (i.e. there is no gap – the corporate sector is cashflow positive on this measure). Critically in that respect, recessions typically occur once the corporate sector financing gap has become significant (i.e. a deficit of 2% of GDP, or greater) – i.e. once corporate sector excess is in place.
As such from a profitability, margins and cashflow perspective, the US corporate sector is structurally strong. That therefore implies that US recession risks are low (and a US recession isn’t likely in the near future).
FIG 1: US national accounts corporate sector margins model
FIG 2: US labour productivity and NIPA corporate profits (Y-o-Y %*)
* NB productivity is smoothed by 4 quarters
FIG 3: US corporate sector financing gap (as % of GDP)**
** defined as internal funds less capex less dividends
Troubling factors: The troubling aspects of the US corporate sector relate to the ‘financialisation’ of the sector. Whilst traditional free cashflow measures show that the sector is throwing off spare cash, this is not the case after deducting for buybacks. Pure buybacks (i.e. see S&P data below) have been steadily growing throughout this cycle. Net of M&A activity, equity issuance has been more volatile (although it was significant in Q4, while it has also deteriorated, on a trend basis, in this cycle - see black line in FIG 4).
FIG 4: US corporate sector equity retirement3 (through buybacks and/or M&A)
*** NB the Standard & Poor’s data isn’t yet updated for Q4 2018. The flow of funds data is updated for Q4 2018 but includes net equity issuance due to M&A activity as well as share buybacks.
FIG 5 shows the impact of that financialisation effect, by adjusting the corporate financing gap for share buybacks. Thus ‘all-in’ cashflow has deteriorated in the past few quarters (i.e. after the initial cash infusion from Trump’s tax and repatriation legislation at the start of 2018). As such, if buybacks are deducted and included in the calculation, then the US corporate sector’s cashflow swings from positive to negative (by 2.8% of US nominal GDP). As we illustrate on the chart, at around the 4% deficit level this metric enters risky territory. Given the current speed of deterioration, that level could be reached in the next few quarters (and therefore needs to be watched closely).
FIG 5: US corporate sector financing gap (as % of GDP) – shown after accounting for buybacks
With that high spending on buybacks, net debt to GDP (i.e. net of cash and cash equivalents) is also close to prior peak levels (although on its own that doesn’t preclude the ratio from going to new highs).
FIG 6: US non financial corporate sector NET4 debt as a % of GDP
**** that is net of ‘cash and cash equivalents’
Overall, whilst there are troubling developments and factors that need to be watched closely, at this juncture the structural state of the corporate sector is good.
The Household Balance Sheet
The risk in the household sector, at this juncture, is very different from the risk at the end of the last cycle. Ahead of the GFC, households had engaged in a credit boom, they were overstretched from a cashflow perspective (as shown by their record low savings ratios in the time), while house prices (the most widely held major asset) had been booming for several years, creating a perception of wealth (and an associated consumption boom in 2004/05).
In this cycle, in contrast, households have strengthened their balance sheets, in particular by reducing mortgage debt (relative to GDP – FIG 7). They have also remained conservative with their cashflows (retaining a reasonably high savings ratio – FIG 8), and have not engaged in a consumption boom (other than briefly in late 2014/early 2015). Added to which, house price strength has stalled (as shown in our latest US cyclical analysis – shown HERE).
In addition to those structural points, from a cyclical perspective employment growth has been strong (albeit with a currently slowing growth rate), job vacancies are at record high levels, while wage inflation is picking up and household confidence about the current situation remains high.
As such, and given the lack of excess in the household sector, the next US recession (when it eventually happens – see above for thoughts on timing) is likely to be a shallow one with only small adjustments in the unemployment rate and for the household sector overall. In that context it’s likely to be closer to the shape/type of US recession in 2001, than the 2007-09 GFC.
FIG 7: US Household debt – split between consumer credit and mortgage debt (as % GDP)
FIG 8: US household personal savings rate (%)
Interestingly, that 2001 recession was linked to a negative wealth effect from a ‘financial asset’ bear market, as well as the reversal of a capex boom. Given the re-rating of US financial assets relative to the size of the US economy, in the past decade, the household sector exhibits risks similar to those during the build-up to the stock market bubble (i.e. late 90s).
US net financial assets peaked in Q3 last year at 353% of nominal GDP. This is an all-time record (and significantly above other end of cycle peaks). Current market rationale given for this anomaly is that US financial assets generate much more profit overseas than previously. While this is probably true, it seems unlikely to justify the latest peak a full 73pp of GDP higher than the last peak just ahead of the GFC (as well as the 2000 stock market bubble peak) – FIG 9. Standing back from the noise, and applying Kindleberger’s bubble thesis (along with Ockham’s Razor), the record high ratio likely reflects highly unusual global monetary policy in this cycle (i.e. widespread negative rates and central bank money creation).
As such, a bursting of this household ‘financial assets’ bubble is a key risk to the US economy. Q4’s data was, of course, weak. For now, it appears that the Fed has caught the unwind before it’s too late. This, though, bears watching closely. It’s difficult to recognise the bursting of a bubble at its start.
Importantly, though, that ‘financial asset’ wealth is narrowly held by US households (while the household asset which is widely owned, i.e. housing, is not the key driver of high valuations). In 2007 – 09 it was (widely held) housing wealth and associated mortgage debt which were one of the key reasons for such a major recession.
On this occasion, therefore, there are more parallels (i.e. similar risks) with the 2000 – 2002 period and 2001 recession.
FIG 9: US household financial asset wealth to GDP (%)
A quick aside on the latest fashion in economics: MMT (modern monetary theory)
As evidence that MMT is another theory with limited merit and no broad substance, it’s worth recalling Charles Kindelberger’s analysis of why reserve currencies lose their ‘reserve currency’ status. In 2009, we distilled Kindleberger’s thinking on the end of world economic primacy (from his book: “World Economic Primacy: 1500 -1990”) into 7 preconditions - see HERE (our 2009 analysis: “Will the USD Reserve Currency Status Persist?”). Critically, many of those 7 preconditions relate to the financialisation of an economy (i.e. build-up of indebtedness) and the debasement of the currency which often accompanies it. Of note in that respect, MMT effectively promotes currency debasement as central to its theory (i.e. the government should print as much money as it wants in order to achieve full employment and until inflation becomes a problem). In other words, MMT is a historically proven path to accelerating the loss of leadership of the global economy, and with that the country’s reserve currency status, and the associated benefits of holding that status. Over and above that, it fails to address the causes of the productivity shortfall (and therefore true wealth creation), which we would argue is the result of too much money creation (i.e. and the zombies that cheap money leaves in the economy). That lack of productivity and financialisation of the system, coupled with the global debt super cycle, are the key drivers of income and wealth inequality (and therefore the key drivers of populism/populist politics). As such MMT won’t solve the problems it sets out to cure – it will simply add to them.
Instead of recommending more government money creation, largely based on the observation that there hasn’t been any inflation to date, MMT proponents would be better advised (in our view) to investigate why there hasn’t been any significant inflation to date (despite a decade of global QE). The answer lies, we think, in the points mentioned above, i.e. the global debt super cycle and the deflationary forces that the popping of that bubble creates. More money creation and more financialisation is not going to solve those structural problems.
For further insight on MMT pls see HERE, HERE and HERE. Of note, sadly the UK’s current labour government will no doubt adopt/pick up on this theory in coming months (especially given Bernie Sanders adoption of it, and its promotion by his prior economic adviser, Stephanie Kelton, who is its current main proponent).
Have a great weekend.
Kind regards,
Longview
Longview Research Recently Published
This week:
Extract from Quarterly Asset Allocation No. 37, 15th Mar ’19:
"US Growth Soft Patch Ongoing in 2019" – see HERE
Extract from Quarterly Asset Allocation No. 37, 14th Mar ’19:
"Eurozone: The new Japan" – see HERE
Extract from Quarterly Asset Allocation No. 37, 13th Mar ’19:
"Chinese Growth: Set to Re-accelerate" – see HERE
Weekly Market Positioning Update, 11th Mar 2019:
"How much are portfolios positioned for rate cuts?"
Last week:
Longview on Friday, 8th Mar 2019:
"Is the Risk Appetite Regime Shifting?; The Attractiveness of Bonds; & Chinese Growth Question Marks" – see HERE
Tactical Equity Outlook, 5th Mar 2019:
"Caution Advised - Some Giveback Likely" – see HERE
Weekly Market Positioning Update, 4th Mar 2019:
"Sharp shift in copper positioning"