Geld Zug: THE US NAIRU BASE IN MACRO-NESIA

Don’t economists just love acronyms? The usual suspects incorporate GDP and CPI, which everybody recognises – or should – instantly. Moving up the economists’ food chain, we can find other delectables such as PCE, RFR & ERP. Once you enter the realm of the macro economists, the populist pinnacle (because what this class of economists talk about actually sometimes is of relevance to the man on the street), we are blessed with exposure to a whole new universe. The one that currently appears in the media with increasing frequency, for very good reason so the Fed tells us, is one of my personal favourites, “NAIRU”.

 

Not to be phonetically confused with the island nation Republic of “Nauru” in Micronesia, NAIRU is located very much in the realms of macro policy. NAIRU, in English, is the non-accelerating inflation rate of unemployment. The FOMC (Federal Open Market Committee – sorry, this acronym is not technically the domain of economists) periodically releases projections or estimates (CY, CY+1, CY+2 years and a “long run”) of a number of metrics pertinent to their determination of monetary policy settings. These include GDP, the unemployment rate, PCE (personal consumption expenditure) inflation and Core PCE inflation measures. Given that the inflation rate has largely remained static in recent times (even reacting only mildly to the materially significant deterioration in energy prices of ~55% in the last 12 months), the Fed is increasingly focussed on the speed of the rate of change of the unemployment rate.

 

NAIRU is effectively therefore often viewed as a direct representation of the FOMC’s view of its own estimates of the unemployment rate being consistent with “full employment”. The “high” band of the FOMC’s central tendency projections is approximately 5.2%. Headline unemployment is currently 5.3%. The “low” band of the FOMC’s central tendency forecasts is approximately 5.0%.

 

Where NAIRU sits is of importance given that we know that monetary policy often will, empirically, direct inflation and unemployment in opposing ways. Given that the overnight Fed Funds rate (monetary policy) has been at the zero bound now for years and that the Fed is internally debating whether to raise interest rates either this year or the next for the first time since 2004, the efficacy of monetary policy has never before in history been so studiously observed.

 

The Federal Reserve’s dual mandate causes them to pay incredible heed to where levels of inflation and unemployment are. The economic theory attempts to draw a link between the short term effects of monetary policy being that inflation and unemployment are pushed in opposite directions. Other schools of economics believe that NAIRU is also affected by changes in productivity, not just inflation and unemployment. As far back as 1752 in economic literature, linkages were formed between the supply of money upon inflation & unemployment. The Fed is today, in 2015, attempting to ascertain where NAIRU should sit, given the impact that their abnormal policy settings since the GFC have had on the two variables that they say determines, more than anything else, whether or not they raise rates.

 

The Fed has been understandably surprised that keeping rates at an effective overnight rate of approximately 0.14% since the GFC and then additionally increasing the circulation of non-gold-backed currency has not contributed more to inflation. Indeed, QE was introduced to attempt to revive some semblance of inflationary expectations into the economy by attempting to influence the long end of the yield curve. That is to say, to attempt to increase 10 year bond yields. Core Personal Consumption Expenditure Inflation in the US for 2015 remains in the 1.3 – 1.4% range. This only “improves” towards where the Fed would like it to sit, by 2016, in the 1.6 – 1.9% range. Only by 2017 do the FOMC members believe that core inflation (which does not take into account the volatility that energy and food price fluctuations introduce to the inflation basket) will begin to approach the desired 2.0% level.

 

The employment data in some regard contributes an even murkier sense of how to dictate monetary policy than the inflation rate, which has not reacted as many market participants initially suspected – remember gold at USD$1800 just a mere few years ago? The vacuum of demand for physical gold now that inflation doesn’t appear to have panned out to be a global problem, is these days filled almost solely by Indian jewellers and former Chinese equities market investors. Employment has been steadily increasing since the nadir of the GFC, however it has only been in the past 12 months that the nominal number of people employed in the US workforce has returned to the previous high of employment levels pre-GFC. Additionally worrying is that the participation rate in the US labor market is now on par with levels last seen in the 1970s. However, even from 2016, the FOMC members expect that headline unemployment will range from 4.9% to 5.1%.

 

The notion that the Fed presents to us is that by next year (2016) unemployment (headline, and not taking into account participation rates) will have recovered to be in fact below the NAIRU rate, whilst inflation will still not have returned to the Fed’s targeted long run rate of 2.0%. The expected trajectory of inflationary expectations gives weight to the doves at the Fed who do not favour an early rate rise. However, the Fed’s own central tendency forecasts (taken from all 17 Governors of the Federal Reserve system) indicate that by the end of calendar 2016, US interest rates will be approximately 1.5%.

 

15 out of those 17 Governors believe that the appropriate time for monetary policy to be “firmed” (as the Fed words it) is calendar 2015. Only 2 of the 17 dissent, and believe that said “firming” should not take place until 2016.

 

How does this affect the outlook of the US economy and US capital markets given that the Fed demonstrably expects and estimates that NAIRU will be between 4.9% and 5.1% next year? The Fed patently thinks that if they raise interest rates this year, 2015, then that will contribute ever-so-slightly to improving inflationary expectations, yet will actually drive the unemployment rate lower? Our view from NAIRU is that the 2 dissenting Governors may well be correct in their wish to allow further productivity gains associated with current extraordinarily low base rates persist for a few more quarters yet.

 

Given the amount of global dislocation evidenced by the taper tantrum event in 2013 when Bernanke’s words were misinterpreted by the market that QE was going to be concluded earlier than the market had previously expected, we shudder to think what one short sharp rate rise will do to US debt markets, emerging market economies with material USD bonds outstanding and then of course the US equities market. As we know, the US has one of the most liquid labor markets in the world. When distress affects the real economy (transmitted in most cases via the financial markets, notably the GFC in recent times) the US is able to shed jobs at a rapid pace to offset “business risk”. The converse of this is that US companies (as evidenced by the upturn out of the GFC) can also re-hire those previously fired employees, very quickly.

 

We would like to see the headline unemployment rate go some distance between the mid point and the low range of NAIRU before Dr Janet Yellen at the Federal Reserve raises rates. This may occur naturally some time in early to mid 2016, but is unlikely to occur by September 2015. So, delay a little longer, dear Chairman. If the Fed does raise rates, then the outcome to debt markets, equity markets and the real economy is not quantifiable. It is not quantifiable because the US has never had to raise rates from zero to “something” ever before in history. When it inevitably does this (hopefully once unemployment is 5.0% or lower) then it would be comforting to know that investors’ funds are held within hedge funds that are capable of providing downside protection. The Fed will not raise rates until it thinks the real economy can sustain a rate rise, but the manner in which the Fed removes the band-aid will still cause the 7-years-now suffering US patient some degree of discomfort.

Sources:

Ball, Laurence. Professor of Economics, John Hopkins University

The Financial Times

Mankiw, N. Gregory. Professor of Economics, Harvard University

FRED Database from the Federal Reserve Bank of St Louis

The US Federal Reserve

 

Marcel von Pfyffer

Q.E.D.

Slide – 1

 

 

Geld Zug: HELLENIC HADES APPROACHES

As we approach the June Solstice in the northern hemisphere, we would do well to remember that in Greece and North America at this time of year it is known as the longest day of the year. The Latin from which the name is derived is “Solstitium” which means nothing less than “sun-stopping”. So, as we approach the final chapter in a farcical end game between Greece and the IMF/EU/ECB/EFSM/EC/European-taxpayers/(insert acronym beginning with “E”), we truly are about to finally watch the sun stop shining on Greece’s financial credibility. Again.

 

Angela Merkel, the Chancellor of Germany, now finds herself pulled into political discourse due to her to date unbridled support of expending all possible efforts to extend to Greece the means to avoid default. The way political parties have to share power to govern in Germany is in fact quite similar to in Greece. Merkel’s Christian Democratic Union party (centre-right) could not hold power in its own right. Neither can Tsipras’ communist-principled party, Syriza. Merkel shares, indeed owes, her power with the Christian Social Union party (centre-left). In this party coalition, Wolfgang Schauble ranks second only to Merkel and in return for his allegiance and willingness to work with a coalition, holds the post of Minister for Finance in “Merkel’s” government. In recent weeks there have been noticeable fractures between both Merkel and Schauble, with Merkel wanting to be more lenient towards Greece in order to reach a deal, and Schauble wanting Greece to pay what owes or leave the EU. In Greece, the other parties Syriza shares power with in order to govern have approached Tsipras’ tin ear, begging him to not risk Greece’s inclusion in the EU and the Euro currency.

 

Tsipras’ own political judgement is observably sub-optimal. This is a man who joined the Stalinist Greek Communist Party in 1991. That year, he would have received his membership card just in time to watch the Soviet Union finally come to the conclusion that after around 50 years of communism, it didn’t really seem to be working for the people. The government’s fiscal affairs were poorly run and essentially broke, so they discarded the communist model and became the Russian Federation. At Tsipras’ right hand as Finance Minister sits another self-avowed communist who, despite being an academic and having authored a book on game-theory, doesn’t seem to have made the transition to the big leagues known as “the real world” particularly well at all.

 

The IMF will come calling by June 30 for EUR1.5 billion. Then, in a mere matter of weeks, the total bill owed to creditors will reach EUR7.2 billion. Should Greece even miss the EUR1.5 billion payment to the IMF (which they will) then they will find themselves in the esteemed “ZZZ” rated class of Zaire, Zambia and Zimbabwe. You couldn’t make this stuff up even if you tried to. No “developed” country has ever before in history missed a repayment to the IMF. This of course speaks to the heart of the matter. Why was Greece ever allowed to rank as AAA rated (their debt was as good as German debt) when they, now proven to be fraudulently, entered the EU? As Wolfgang Schauble said in 2012, when the Europeans were asked to provide another EUR130 billion, “Why do they deserve another 130 when 100 two years earlier [sic.] had proved insufficient”. Wolfgang’s comments embody the argument that you simply cannot have a political union without fiscal union within the European Union.

 

So what happens next globally after Greek defaults? Do we get to see a repeat of 2011 when other nations in the periphery fall under the same spell of sovereign contagion as Greece’s debt markets? Do we get a return to the blowout in sovereign spreads for Spain, Italy and Portugal in the region of 640 bps over German Bunds? Bunds have, at certain maturities, only just re-entered positive yield territory again in the past 4 weeks.

 

Materially speaking, Greece is of course immaterial. This is applicable to both the operations of the EU should Greece depart and also global financial markets. Apologies to those of Hellenic descent, but Greece’s USD$241 billion GDP contribution per annum to EU’s USD$17.3 Trillion GDP is only 1.3%, which therefore represents 0.047% of the USD$509 Trillion of global GDP. To put this in perspective though, as the World Bank tells us, Greece’s economy is still larger than Kazakhstan, Azerbiajan or Uzbekistan. The Greece FTSE Large Cap index has lost 50.8% in the last 12 months since June 2014. The FTSE/AThex Large Cap index had a combined value at time of writing of USD$38.1 billion as at 19 June 2015. To put this in perspective, the single stock Australian and New Zealand Bank has a market cap of (in comparable USD terms) of USD$70.2 billion.

 

Greece will, as sure the sun sets, default on its debt. This will hardly be a trailblazing event when it comes to Greek financial history. The current Greek administration needs to cease and desist pursuing academic games and embrace mathematical reality. The question that Tsipras and his comrades should start devoting their time and attention to is whether, once the default occurs, do they choose to remain in the EU, and if so, on which currency. After they have made this decision (if they stay, they should no longer expect any sweetheart funding subsidy deals from the Germans, Scandinavian states or any other member state of the EU whose population pay taxes) then they need to decide if they stay on the Euro currency, or revert to the Drachma. Again.

 

The smart play here would be to promptly default, put global financial markets out of their misery and beg humbly to stay in the European Union, whilst exiting the European Area (countries in the EU that trade on the Euro) and revert to the Drachma.

 

The summer solstice marks the start of summer. This may bring short-lived joy because only a few months later this means that winter will follow. With the European grand project called the “EU”, we are concerned that a “successful” resolution to a Greek default may disprove the old notion that it is darkest before the dawn.

 

The largest stock by market cap on the Greek exchange is “Coca-Cola” and its weighting constitutes 54% of the entire index (ref. Athens Exchange Group). The sixth largest stock by market cap is the “Greek Organisation of Football Prognostics”. Syriza’s leader, Alex Tsipras rides a motorbike with a symbol that shares the colours of the Greek flag, but is made by a Motor Works company in Bavaria. This is and always has been (since 2011) an issue of political ideology vs material impact. Everyone wants the finer things in life, but if you buy them with borrowed money, one day you must pay the piper.

 

References:

The Athex Exchange Group

Factset

The Financial Times

The World Bank

 

Marcel von Pfyffer

Q.E.D.

Slide – 1

Geld Zug: CAPTAIN AMERICA AND THE WINTER GDP

Winter has come. A bitter winter can bring with it devastating effects and not just for Al Gore. Winter will kill crops, defeat armies and in some countries where snow falls, it will hide the green grass under a blanket of white for an entire season. Only when the season changes and the snow melts away will the grass appear greener than ever to those who look upon it.

 

Winter in the US this year (2015) has affected US first quarter GDP numbers in a very similar fashion as to what they did to first quarter GDP numbers last year (2014). Alongside this, we see many market participants voice continued concern over the level of valuation for US equities. Another distraction coming to market is that some market participants are questioning whether the equities market’s ascent is due to earnings growth or simply share buy backs. There is a veritable buffet of reasons, were one that way inclined, to believe that US equities have hit their peak.

 

The first quarter GDP numbers in 2014 painted a dismal picture for calendar 2014 in the US. Remember that in 2013, the US economy delivered a below trend annual GDP rate of 2.2%, so the Fed expectations going into 2014 were markedly higher, given the expected uplift that the pledged continuation of QE was supposed to contribute. The winter of Christmas 2013 going into January 2014 was particularly bitter across the US leading to an advanced estimate of first quarter GDP being a barely positive +0.1% (% change from 1st quarter 2013 to 1st quarter 2014). This “advanced estimate” which is allegedly seasonally adjusted was revised further downwards on May 29th 2014 to -1.0%. By the year’s end however, US annual GDP was found to have grown +2.4% through calendar 2014.

 

Come Christmas 2014 and going into January 2015, the US was again beset by yet another bitter winter and on top of this was forced to endure severe labour market “action”, which saw many East Coast ports shut down due to strike action. As the data would show, this would eventually blow the trade deficit out by a massive 8% change at the end of the first quarter. In regards to GDP, clearly when ports are shut down if not by winter, by strikes, then it is quite difficult to export goods which would have otherwise contributed to GDP numbers. Hence, when presented with 2015’s 1st quarter GDP number being +0.2% (a very similar number to 2014’s) some market participants are concerned that this will herald a slower 2015 than the US Federal Reserve forward projections would otherwise have us believe.

 

The problem here with the inaccuracy of the 1st quarter GDP numbers’ bearing on actual economic activity for the other 3 quarters of the year have been cause of much debate. “Seasonal adjustment” of the numbers is supposed to remove noise or volatility from the data due to holidays, weather and lost productivity often associated with Christmas and the winter period. However, 1st quarter GDP has been shown to average 1.6% lower than other quarters across the last 20 years. If this can be observed with regular effect, then theoretically seasonal adjustment should be “taking care of” what the human eye can do to a column of quarterly spreadsheet data.

 

The US Federal Reserve Bank of San Francisco by its own admission states that, “Of course, seasonal adjustment is an imprecise and uncertain statistical exercise”. This should make hedge fund managers throw their toys out of the sandpit in pure exasperation when they are using such data to attempt to make multi-billion dollar investment decisions based on the direction that the nation’s statistical body, the Bureau of Economic Analysis, is leading them.

 

 

Why is all of this so important? Without a clear read on “proper” US GDP, the market will not be able to accurately forecast (yes, an oxymoron!) what Dr Janet Yellen’s decision may be regarding the timing of a rate rise. The market has moved earlier this year from an almost unanimous decision that the Fed would raise rates in June 2015 to a possible rate rise by the end of 2015. Despite continual performance of US corporate debt markets (or perhaps because of them), investors are even more so concerned about the timing and pace of US interest rate rises. If the economy is not recovering, then the Fed will not raise rates quickly or possibly at all. If it does raise rates, what effect will that have on the wider economy? If the wider economy suffers due to an interest burden imposed by an impatient (or overly patient) Fed, then will there be any corporate profits to distribute?

 

People suggesting that relying on revised US GDP estimates this time round (2015) to be different may want to take a look at the data set. Although it is almost taken as gospel that the most amazing growth period the US ever experienced was through the Great Moderation of the last 30 years, this is simply not the case. Since 1930, average annual US GDP has been 3.4% (all data presented here is in chained 2009 dollars). Since 1964, the average annual GDP number in the US has been 3.0%. In the Great Moderation of the last 30 years, it has been 2.8%. This gives pause to the thought that the US economy may not be able to deal with an environment of rising interest rates. To be sure, a heightened interest rate environment will affect some industries and companies within the US economy, but if their business is only sustainable in a near-zero interest rate environment, then the question must be asked, was their business model ever really sustainable?

 

During the tenure of Paul Volcker at the Head of the US Federal Reserve (1979-1987) and across the Regan administration which saw off stagflation, US GDP annually averaged…wait for it…3.0%. This was at a time when Volcker raised the US Federal Funds rate from low double digits (!!) in the late 1970s to a monthly peak of 19.1% in June 1981 (US Federal Reserve FRB_H15).

 

Mark Twain once said that “History does not repeat itself, but it does rhyme”. Well, during Volcker’s reign from 1979 to 1987, the stock market only had 2 years where it finished in negative territory. Clearly 1987 was one of those two years. So, a return of 147% in US equities across 9 years implies an average annual (but not compounded) return of 16.3%. Not bad for a period where interest rates averaged double digits. However, for the stock market to be firing, so too must the broader economy.

 

By the end of May (29th), time – or the Bureau of Economic Analysis – will have told.

Marcel von Pfyffer

Q.E.D.

 

Slide – 1