Relevant and even prescient commentary on news, politics and the economy.

Stocks have gone from overvalued to fairly valued.

With the market falling like it did over the past week it may prove valuable to look at the PE and some other economic reports.  In my PE model the market became overvalued in December and January.  The last observation is at the market close on Thursday, 8 February 2018. the previous two observation are the end of December and January values.

Notice that the PE did not rise until December . As of November, 2017 the market PE was still below where it was when Trump was elected.  If the market rallied because investors expected higher future earnings because of the tax cut, it did not show up in the PE until the tax bill was actually passed.  The usual rule is to buy the rumor and sell the fact.  But given Trumps record, it was understandable that investors were not willing to pay up for stronger earnings until the legislation was actually signed into law.

Most of the market rally for a year after Trump was elected reflected double digit earnings growth rather than  a higher PE as investors started discounting stronger earnings.  Now, we have a divergence in earnings expectations as the top down strategists and economist expect the tax cut to generate double digit earnings growth in 2018.   But the bottoms-up analysts only expect modest earnings gains. Analysts expectations are driven largely by company guidance. This divergence may suggest that corporate America is not as bullish as Wall Street has been the last few months.

Generally ignored because of the jobs report,  productivity was reported the same day as unemployment, and it was very weak.  As a consequence, the spread between unit labor cost and prices — the nonfarm deflator– narrowed sharply. This spread is the dominate determine of profit margins and is a leading to concurrent  indicator of earnings growth. It implies that earnings growth will be quite weak over the next few months.  Right now there seems to be two views on 2018 profits growth.  Economists and strategist expect the tax cut to lead to double digit earnings growth in 2018 while  analysts expect single digit earnings growth.  Analysts bottoms-up forecast are driven largely by management guidance.  So this divergence between analyst and economists may imply that corporate management may not be as bullish on the economy as Wall Street.

Moreover,my bond model implies that bond yields should be rising.  Rising rates are especially hard on the market when the market is overvalued. So you are faced with an market where rates are rising and earnings expectation are falling.

Finally, the dollar is weak despite the point that interest rate spreads between US and foreign rates are rising. Historically, the combination of rising interest rate spread and a falling dollar is a very bearish development.

The bottom line is that this market fall is being  produced in Washington. Over the last six years under Obama we had a combination of easy money and tight fiscal policy as the Republican Congress implemented restrictive fiscal policy– the deficit fell from near 10% of GDP to about 3%. –and the Fed offset it with  easy money.  But now, Congress is implementing easy fiscal policy when the economy is at or near full employment and the Fed is being  forced to offset it with tight money policy.  The agreement to give the Republicans the expanded military spending and the Democrats the expanded social spending they want is a repeat of the guns and butter policy under President Johnson. But now, the US is dependent on foreign capital inflows to  finance the deficit and the weak dollar implies that the foreign capital is not forthcoming at current interest rate spread.

Comments (8) | |

Trade in the GDP accounts

Trade was a significant factor in the weak GDP report today and as usual when this happens you see many comments that do not understand why imports are a negative in calculating GDP.

We do not directly calculate GDP.  Rather, we calculate consumption and adjust that for trade and inventories to obtain GDP indirectly.  To go from consumption to production in the US we have to subtract imports because they were not produced in the US.  However, imports show up twice in the GDP accounts.  They show up once in final demand –consumer spending, government spending or investments.  So for example if you buy a Volvo, which are not yet built in the US,  it will  be recorded in both personal consumption expenditures as a positive and in trade as an import.  So when you subtract imports all it does is offset the positive contribution recorded  in final demand.   So your buying a Volvo will have a zero impact on GDP, which is the way it should be because GDP is a measure of what is made in the US.  Most people, like Larry Kudlow on CNBC do not seem to understand this and  keep saying this it is a mistake to subtract imports.

 

Their is another big difference in how trade is treated in the GDP accounts.  Final demand –personal consumption expenditure, government spending and investments –is calculated as the average of the three months data that is reported monthly.  But trade is calculated as the difference between what it was in the final month of the previous quarter and the final month of the current quarter– data that is not yet reported when the first estimate of GDP is released.  In the GDP accounts trade and inventories are reported as the change over the quarter rather than the average during the quarter.  This is an adjustment that is necessary to go from the estimate of final demand or consumption to a measure of  production which is what GDP measures.  It is also normally the major reason why the first and second revisions to GDP or so significant.

 

Comments (3) | |

Are wages poised to rise sharply in 2018 ?

For the first time since the Great Recession my wage equation says average hourly earnings growth should be higher than the actual data shows.  Moreover, the fitted value is rising sharply.  Each of the three variables in the equation — the unemployment rate, capacity utilization and inflation expectations — is now pushing the fitted value higher.  This is the first time since that the fitted value is both above the actual growth of average hourly earnings the Great Recession and rising sharply. Rising  wages should contribute to higher nominal income growth and this in turn is a major determinate of bond yields.

Figure 1

Comments (16) | |

SAVINGS, INVESTMENT & THE DEFICITS

Over the past decade, thanks to fracking, the US has approached self-sufficiency in oil. Since 2008 the trade deficit in oil fell from over half of the overall trade deficit to under 10% in 2016.

TRAADE DEFICIT

 

 

 

 

 

 

 

 

 

Surprisingly, however, the massive decline in the oil deficit did not lead to a contraction of the overall trade deficit. Rather, the non-petroleum deficit expanded to offset the improvement in oil.  Actually, it should not be a surprise as this is a beautiful example of the standard economic analysis that the current account balance  (the trade deficit plus certain capital transactions) equals  the gap between domestic savings and investments.

When it first became obvious that the Reagan tax cuts were going to lead to a very large structural federal deficit, main stream economic forecasters started to talk about crowding out.  If you look at the US economy as a closed system, domestic investments must equal domestic savings and  interest rates are the price that changes to ensure that tat identity holds.

FED DEFICIT BY PRESIDENT

 

 

We clearly got a massive increase in the federal deficit as after the Reagan tax cuts the federal deficit exploded from -2% to – 6% of GDP.  Moreover, this occurred during the time of very strong economic growth that should have caused the deficit to contract.  But interest rates did not rise and the crowding out analysis was discredited.  Vice President Cheney even went so far to claim this demonstrated that deficit do not matter.

savings invest gap 2

 

 

 

 

 

 

 

 

 

 

But the view that savings must equal investments only holds in a closed economy. In those days virtually everyone looked at the US economy as a closed system and ignored the international aspects of the economy. In an open economy, however,  savings does not have to equal investments because foreign capital inflows can finance a gap between savings and investments.  In  a closed economy, interest rates adjust to ensure this identity.  But in an open economy both interest rates and the currency can move to ensure that economic identity prevails.

As the chart shows, the US has sustained a large gap between savings and investments since the 1980s.  Initially, the large federal deficit following the Reagan tax cut was accompanied by a massive 50% surge in the dollar.  This was generated by foreign investors bidding up the dollar as the demand for dollars exceed the supply.  But with a lag, the strong deficit lead to an increase in the current account deficit — the supply of dollars–and the supply and demand for dollars balanced without the dollar rising..  But this analysis brings up another identity that hold in an open economy; the domestic savings-investment gap must equal the current account balance.

savings-current account

 

 

 

 

 

 

 

 

 

 

As the chart shows, the identity that the savings-investment gap must equal the current account deficit has clearly held over the years.  We had crowding out after the Reagan tax cuts, it just worked through the dollar to hurt the economic sectors exposed to foreign competition  rather than interest rates to impact the interest sensitive sectors.  Moreover, as this analysis shows that the trade deficit is not a function of NAFTA or the other things that President Trump claims.  If you look at the US as an open economy it is obvious that the large  trade deficit and the loss of many manufacturing jobs has been caused by the Republican tax cuts that produced a structural federal deficit, a large domestic-savings gap and the large current account deficit.  Moreover, if Trump is able to implement another round of large tax cuts it will lead to a widening of the domestic-savings gap and  the current account –trade — deficits.  His tax policies will severely damage the American manufacturing worker that elected him in hopes that he could make America great again.

Comments (14) | |

Employment in coal mining

Trump is claiming he can restore coal mining to its former glory by reversing the new regulations that Obama enacted.

 

Obvious he has no idea what the history of employment in coal mining is.

Just note that it peaked in 1923.

 

Update: Today the NY Times had a very good article on coal and jobs: “Coal Mining Jobs Trump Would Bring Back No Longer Exist

COALMINING

Tags: Comments (8) | |

Trumponomics

Trump’s America First economic strategy looks a lot like the import substitution economic development strategy that was so popular several decades ago—notably in Latin America and South Asia..  But it only had limited success, especially compared to the export led growth strategy followed in East Asia.  Import substitution tended to produce fragmented, inefficient and low productivity industries protected from foreign competition by high tariffs and other trade barriers

Take autos, for example.  It does not take a lot more labor to build a $30,000 or $60,000 car than a $15,000 car.  But no one can profitably manufacture a $15,000 car using expensive American labor.  That is why most auto imports are economy or luxury cars.  But this is exactly what Trump is asking Detroit to do.  SEER suspects that the auto CEOs told Trump what he wanted to hear and went back home and did nothing. If for no other reason, the auto industry is operating at very high capacity utilization and does not have the idle capacity to dedicate to small car and truck production. If questioned, they can say it is more difficult than they thought and they are still working on it. That is probably preferable to  actually building some white elephant. Most manufactured imports are not profitable to make in the US at current prices.

 

The Border Adjustment Tax ( BAT) appears to be dead, but who knows.  SEER does not accept the idea being pushed that the dollar will automatically rise to offset the tariffs. It is an interesting theory, but SEER has not been able to find a single historic example of it ever actually happening.  The trade deficit is driven by the domestic savings-investment gap – including the federal deficit as negative savings.  BAT will be a major source of federal revenues and will dampen the savings- investment gap as well as the trade balance.  The impact of BAT on the dollar appears indeterminate as far as SEER can tell. But the bottom line is that the Republicans have long worked to shift taxes from income to consumption and BAT is just another example of that.

Comments (3) | |

Productivity and Capital Stock Per Employee

Last week Timothy  Taylor at Convertible Economist did a very good post on  gross vs net capital spending. Declining US Investment, Gross and Net

He showed that in recent years the more rapid growth of  high  tech  spending has had an unanticipated impact.  The new high tech equipment has a much shorter life span that more traditional equipment. Consequently, more and more of gross capital spending is just being used to replace old equipment ( depreciation).  Before the 1980s net investment was about 40% of gross investment but now it is only about 20% of gross investment. We are having to run faster and faster just to stay even. As he points out investment in capital is a major driver of productivity growth and is a major factor behind the stagnation in US economic growth.

I’ve taken his analysis one more step to show the relation between productivity growth and the change in real capital stock per employee.

productivity

 

 

As the chart shows, there is a very tight relationship between productivity growth and the growth of the real capital stock per employee.  I am convinced that this is a real and important factor behind the weak productivity and the stagnant economy in recent years. Real GDP growth  is essentially the growth of productivity plus the growth of the labor force. You should be able to tell that the trend growth of both economic series have a significant downward slope.

What I’m showing in this chart is not unusual and would fit in with most versions of mainstream economics.  But I’m going to take the analysis a step further and suggest that the underlying problem is cheap labor.  If labor is cheap, business has little or no incentive to make large scale investments to raise the productivity of labor.  Rather, the two dominant factor explaining much of business investment over the past few decades has been the shift of factories from the north to the south of the US and if this is not enough to shift production abroad.

Comments (4) | |

NAFTA and MANUFACTURING EMPLOYMENT

President Trump is not alone in blaming NAFTA for the decline in US manufacturing employment over the last several decades.  Many people on all sides of the political spectrum believe the same thing.  But as this chart demonstrates the economic data tells a very different story.nafta manuf

 

In the decade after NAFTA came into being, manufacturing output growth actually accelerated  to an average annual growth rate of 3.7% as compared to an average annual growth rate of 2.9%  in the decade before NAFTA was implemented. However, while manufacturing output growth actually  accelerated, the average annual growth rate of manufacturing employment weakened from -0.4% to -1.3%.  This was because the rate of growth in productivity or output per employment jumped about 50% from 3.3% to 5.0%.  The big jump in the growth of output per employee or productivity was the dominant factor in the drop in manufacturing employment.  Automation or  information technology accounted for  virtually all of the weakness in manufacturing employment after NAFTA.    NAFTA was a factor, but it was clearly a relatively minor factor.  The way NAFTA contributed was for low productivity industries like textiles and autos  to move abroad while high productivity industries like semiconductors grew rapidly so that the composition of US manufacturing changed drastically.   Because of this, Trumps policy of bring jobs back from overseas is almost certain to fail.

The important question is not why his policy will fail.  Rather, it is what will Trump do after it becomes obvious to everyone that it has failed.

If you want to blame the trade deficit for the drop in manufacturing employment, it obviously played a role.  But Mexico only accounts for some 5% to 10% of the US trade deficit,  so even on this basis, NAFTA played a very minor role in the drop in US manufacturing employment.

 

Comments (44) | |