In today’s Wall Street Journal, columnist, Justin Lahart writes: “So this truly is a low inflation world. A big reason why: There is too much capacity relative to demand. Many companies appear to have been geared up for rapid Chinese growth only to be caught wrong-footed as that economy slowed. Growth in China itself has relied heavily on fixed-asset investment, adding to global capacity. Meanwhile, Europe’s ability to cut unneeded capacity—witness its auto industry—has been limited, in part by political considerations.”
Let’s put China (which reported disappointing Retail Sales and Industrial Production last night) aside and discuss capacity. We have opined for several years that there is not only excess capacity in the global economy, there is probably much superfluous capacity (readers undoubtedly remember our clever “wish I could fly like Superfluousman captions). Not only has slower-than-expected growth in China led to excess (superfluous) capacity, but technology has increased the capacity of existing facilities.
As businesses had already invested in this capacity, they are loathe to let it whither. Instead, they engage in competition for a smaller-than-anticipated consumer demand. Economists have pondered when businesses will invest in technology to improve productivity. It appears as though insufficient productivity is not what vexes many businesses, it is surplus (superfluous) capacity.
So all we need is for China (and other emerging economies) to solve structural issues and the global economy will be off to the races. Right? There are two problems with that strategy.
- It assumes that foreign leaders will “solve” what is “broken” (see Japan for 25 years and South America forever).
- Technology could easily keep pace with increased demand if foreign economies are restructured.
Investors and economists and strategists have waited (and waited) for productivity to increase and for increases in capital expenditures. However, with an excess of capacity, there is little desire to increase capacity further. Instead, businesses are trying to become more efficient. This (counterintuitively) points to more hiring as lower energy prices (particularly natural gas prices) has resulted in the on-shoring of some jobs and has created others. Yes, the on-shoring of jobs might replace hundreds of the thousands of jobs lost in the outsourcing boom of the 1990s and early 2000s, but jobs are being created nonetheless. However, capacity is greater, even with fewer workers. Robots and computers have taken the place of many occupations once staffed by people.
This brings us to another over-capacity situation. This is the over-capacity of workers. As technology has hollowed out many mid-level and semi-skilled occupations, workers formerly engaged in these occupations have been pushed to the wings. The more capable and ambitious displaced workers acquired new skills or refined skills they already had and moved into upper-tier jobs. The rest moved down the job scale and added to the competition for lower paying jobs. Hence, wage growth has been moderately lackluster. We describe wage growth as “moderately lackluster” because, when viewed versus today’s low inflation, wage growth versus inflation is close to “normal” during an economic expansion.
In the end, the health of the global economy depends on U.S. consumers. They need to purchase foreign goods. The problem is, consumers are spending less on physical widgets (no matter where they are produced) and more on electronic applications, video and internet connectivity. Bond Squad believes that if there is a major increase to foreign exports it will probably be in the area of tourism. Remember, tourism can be considered an export as foreign spending flows into an economy. Thus, the benefits of a weaker euro could benefit the tourism sector more than the manufacturing sector. Something to think about.
What we have just described are economic conditions and trends which are very different than post-WWII historical norms. This is not purely opinion, much of what we said is already happening. If these trends continue, it will drive algorithms absolutely mad. We doubt many have been structured to account for the economy we are experiencing now or we are likely to experience in the future. This should not be surprising as algorithms and models can only be backward looking.
When Janet Yellen became Fed Chair, just over a year ago, critics painted her as an absolute dove, someone who might find it difficult to raise interest rates when it was necessary to do so. Oh how times have changed. Recent comments by pundits and market participants ask Ms. Yellen to be more “patient.” There is a fear that the markets are not ready for a tightening. Really, are they ever ready? Should we expect Ms. Yellen to wait until the markets are “ready” before tightening? Maybe it is the markets which should adapt to what the Fed is going to do rather than asking the Fed to keep the punch bowl full?
However, there are legitimate reasons for the Fed to put off tightening. The main reason is the disinflationary impacts of a stronger USD. As the dollar strengthens, inflation pressures abate. As one of the Fed’s dual mandates is prices stability, allowing prices to drop precipitously is just as bad as letting them rise too far and too quickly. However, the Fed would like some interest rate breathing room to be able to address the next crisis without having to use QE as the starting point for monetary policy accommodation.
The Fed is truly between a rock and a hard place. Next week, the FOMC statement might be absent the word “patience,” but global economic and interest rate realities could put off Fed tightening until later in 2015 (or even beyond). Bond Squad’s base case forecast is for the first Fed Funds Rate hike to occur in September 2015, with the Fed moving the Fed Funds Rate to 0.25%. We then think the Fed could raise the Fed Funds Rate to 0.5% by the March 2016 meeting and (possibly) to 1.0% by December 2016. We stand by our belief that the Fed Funds Rate will peak in the mid-2.0% area and that the yield curve could flatten with all rates below 3.00%.
If our interest rate forecast is correct, it should make life interesting for investors of floating rate securities. First, interest rates might not rise enough to push coupons off of stated floors. Fixed-to-float securities could see coupons float lower, if they have narrow coupon floating spreads. However, low absolute interest rates could keep defaults of floating-rate junk debt (bond and loans) fairly low. In other words, if our forecast is correct, floating-rate investors might not receive as much income as they had hoped, but might not experience the kind of principal haircuts (corporate defaults and debt re-structurings) among their junk debt holdings if interest rates spiked higher.