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What if Wall Street is waiting for the wrong disaster?

May 16,2018 00:14

Slok told clients on Tuesday that he thinks this is because the strong dollar is being driven by the US-EU business cycle and interest rates are still being driven by inflation fears ("higher risks of US inflation because of big fiscal stimulus, tight ...and more »


What if the entire world of money is preparing for the wrong disaster — which would be a disaster in and of itself?
Since the financial crisis, Wall Street, central-bank heads, economists, and policymakers have been waiting for the return of inflation. At the beginning of this year, they thought they had found it. It came, so they thought, in the form of a weak dollar, wage growth, economic stability in China, and steadily rising interest rates.
So here in the US, the Federal Reserve started talking about the importance of preparing to fight runaway inflation. In fact, it's obsessed with the idea. According to Deutsche Bank analyst Torsten Slok, the Federal Reserve is talking more about inflation now (in its minutes and in its reports) than it did in 2006 when the economy was actually overheating, right before the crash.
This, even though personal-consumption expenditures haven't grown by the Federal Reserve's 2% target since the financial crisis.
There's a lot of noise, from data revisions and Trump tweets, trade-war threats and hopes of growth from tax policy, a wobbling stock market, and rising interest rates. But when it comes down to it, the things that everyone is saying will be sources of inflation may not be sources at all.
Meanwhile, the weak dollar, wage growth, and a stable China elixir that got markets high in January have since faded. That should be a warning. If we play our cards wrong and pay attention to all the wrong signs, we may still be in a world tilting dangerously closer to our old enemy, deflation.
If you built yourself a myth
Let's kick this off with a simple "reality check" — US GDP growth. In Q1 2018 GDP (printed last at the end of last month) came in at 2.3%, down from 2.9% the quarter before. It's better than analysts polled by Bloomberg expected (2%), but it's definitely not runaway economic growth.
During this period consumer spending grew by 1.1%, falling from 4% the quarter before.
Now to be fair, Q4 is always a big spending quarter (holidays and whatnot), but spending dropped off at the same time as there was a 3.4% increase in disposable income.
"Momentum from late 2017 led Fed officials and economists to upgrade their 2018 views ... Our 2018 forecast is unchanged, but the confidence and certainty at the Fed and in the markets need a reality check," analysts at Societe Generale wrote in March.
So, PCE inflation is still below target and the US economy is growing, but not as fast as many expected, certainly not at the Trump administration's target 3%-4%.
Plus, after taking a nosedive at the beginning of the year, in part thanks to some boneheaded comments from the Trump administration, the dollar is strengthening. The US dollar index is now up 1.53% from the start of the year. At the same time the world is tightening and interest rates are still rising.
Slok told clients on Tuesday that he thinks this is because the strong dollar is being driven by the US-EU business cycle and interest rates are still being driven by inflation fears ("higher risks of US inflation because of big fiscal stimulus, tight labor market, higher oil prices, higher health care inflation, and tariffs boosting US domestic prices") and US Treasury supply worries.
This is not a combination people expected, and it has set off some wonky activity, especially in emerging markets. EM stocks are seeing their worst outflows since 2016. Argentina, which looked so great last year that investors were actually buying 100 year bonds for a country that has defaulted like clockwork throughout the 20th Century, is on the brink of another disaster. Turkey is looking bad too.
Now, you can argue that these countries have historically been some of the worst houses on the block, but pretending that they aren't telling us anything important is problematic. The music of the market is a symphony, and if even the most minor instruments are out of tune, your ears should tell you something is wrong.
Keep in mind that Wall Street is notorious for waiting until the music stops before it panics.
Look at China. No, really look at it
Now you may be thinking to yourself, but China. It's growing. It is, but it's also slowing.
Used to be (back in March) that the smart guys were saying that China's economy was going strong, and that it could no longer export deflation to the rest of the world.
"We expect China's CPI [consumer price inflation] to maintain this momentum and average 2.7% in 2018, a marked change from 1.6% in 2017," wrote PIMCO analyst Isaac Meng back in March. "Although still below the target of 3% set by the People's Bank of China (PBOC), we expect the central bank to continue normalizing monetary policy this year."
This narrative should sound familiar. It sounds like the US. And like the US China's inflation isn't actually showing signs of nudging toward its CPI target.
"CPI eased further from 2.1% in March to 1.8% in April, with a weaker-than-usual mom rate of -0.2%," Societe Generale wrote in a note to clients on Tuesday. "The main drag remained food inflation, which dropped sharply from 2.1% to 0.7%. Non-food inflation also continued on its moderating trend, despite the uptick in energy prices. Actually, unless oil prices surged further, fuel inflation is unlikely to cause significant inflationary pressure on CPI, due to its small weighting of less than 1.5%."
So no inflation there. Independent China-watchers still insist that the reforms the government promised have yet to come. In March, the data firm China Beige Book reported that deleveraging hadn't started and that corporates were still sucking up credit to survive.
This means that a deflationary event could still be in the works for China. Even back in Q4 noisy data showed that the Chinese economy was being driven by exports, and that domestic consumption couldn't carry growth (which is President Xi Jinping's goal).
This was still the case in China last month (from Societe Generale):
"Despite the strong rebound in industrial production growth, many domestic demand indicators slowed down in April. Credit conditions have continued to tighten and real economic pain is beginning to surface, due to more broad-based and faster increases in the cost of funding ...
"Export growth bounced back from the surprisingly sharp contraction in March, to 3.7% in CNY terms, but this pace was only half of that of 1Q18 and 4Q17. Indeed, it provides an indication of softening momentum in external demand from the very strong performance of 2017, and is consistent with the latest development experienced by other major Asian exporters."
Of course, none of that is deflationary per se; it's just not inflationary or healthy at all. And it could get worse.
Add to that, though, some of the warning shots some Chinese corporates are sending up. For example: Earlier this month a private Chinese manufacturer, DunAn Group, sent a letter begging the Chinese government to help it out with its $7 billion of debt.
"If a credit default happens, it will deliver a serious blow to many financial institutions in Zhejiang and may even cause systemic risks," said DunAn's letter, according to the Financial Times. The letter also blamed the company's troubles on China's tepid effort to tighten credit conditions and rein in corporate debt.
China watchers will tell you that private Chinese companies are supposed to be much healthier than state-owned entities (SOEs). DunAn tells you a different story. It is not the only company between a rock and hard place. This time, the Zhejiang government called DunAn's creditors to rescue the company at the very last minute. It had enough collateral, in the form of shares of a subsidiary listed on the Shenzen stock exchange, to do a deal with its creditors.
Not every Chinese corporate may be so lucky.
The devil's in the demographics
There are still two strong deflationary forces working in the economy that no one in the world can escape — demographics and inequality.
In the US, an aging population has had a hand in suppressing wage growth. More from Deutsche Bank's Torsten Slok:
"Although wage growth is firming, it continues to lag past cycles. The relatively low growth rate of wages has triggered a wide discussion of potential drivers including population aging, low inflation expectations, weak productivity growth and remaining labor market slack.
"We focus on population aging and find that aging has exerted a meaningful drag on wage growth since the crisis. On average, this drag has been 32 bps since 2012, and most recently aging has reduced wage growth by about 20 bps. This effect, while significant, is unable to fully explain why wage growth remains below its pre-crisis level.
"There are two channels through which aging lowers wage growth. First, older workers have slower wage growth. Second, aging has increased the number of older individuals who exit employment, likely due to retirement, and these individuals typically have relatively high wages."
As Slok said, aging can't fully explain why wage growth has been suppressed, but he has other ideas too.
"One important reason why the expansion since 2009 has been so weak is that wealth gains have been unevenly distributed (see chart below). A decline in the homeownership rate and the number of households holding stocks has dampened consumer spending growth for the bottom 90% of households," he wrote in a note to clients back in March.
Yes, this is the chart he was talking about.
Deutche BankThe deflationary impacts of economic inequality and an aging population are not going away with the flick of a wrist or the push of a button. They are long-term challenges that require imaginative, difficult policy solutions. It's hard to see that coming from the Trump administration or an increasingly polarized, uncooperative world.
So we need to ask ourselves: Are we waiting for the wrong disaster?

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