The “Brexit” caused market swoon on Wall Street turned out to be a nasty 5.3% two day dive (S&P 500) that was all but reversed in the next 4 trading sessions. The reason was clear early on – despite forecasts of immediate worldwide economic doom and gloom, the non-binding referendum was mostly a political statement about bureaucratic government, and the referendum split along demographic lines (older vs. younger, and rural vs. urban), much like what is being played out in the U.S. election cycle. This is not to say that “Brexit” doesn’t have significant economic consequences. But those consequences primarily impact the U.K., not the U.S. that has a fairly closed economy where international trade accounts for only a small portion of GDP.
- The FTSE 100, which is composed mainly of U.K. multinational corporations, stands 3.7% higher (as of close of business July 7) than it did the day before the market dive. The FTSE 250, which encompasses domestic U.K. market participants, fell 13.6% in the two days subsequent to the referendum, but its recovery has been quite shallow only retracing about a third of its losses (July 7). It is clear that U.K investors expect significant psychologically induced negative economic consequences;
- The European banks have lost significant market value since the “Brexit” vote. It’s as if the market has finally awakened to the bad loan, balance sheet, and capital issues of Europe’s major banks;
- To show stresses now emerging in the U.K. economy, some U.K. commercial real estate funds have now closed themselves to withdrawals.
We must acknowledge that Britain’s actual exit from the E.U. takes a political act (invoking Article 50), and it remains uncertain as to when or even if such an act will occur, as there appears to be little will among the U.K. political class to pursue such a course. Finally, even if Article 50 is invoked, it will be at least 2 years from such invocation before Britain actually leaves the E.U. In market terms, that is like a lifetime. (As an appendix, we have listed the upcoming political events and emerging political dissatisfaction now coming to the forefront in Europe.)
The U.S. and other major markets outside of the U.K. have thus turned their attention to the more mundane – in the U.S., to the current and near term performance of the economy and its various sectors, and internationally, to the brewing crisis in Italy’s banking sector.
Potential Economic Growth
While shock factors such as the unexpected results of “Brexit” cause significant market volatility, at its mid-June meetings, the Fed took an unexpected step toward market volatility reduction. To understand why, one must look at how econometrics (i.e., economic modeling) works, and how the economy organically grows.
Economists use historical patterns when analyzing data or making forecasts. But, since the recession, there have been epic changes in the way people move around, spend money, borrow, get married, buy homes, have children, etc. This, together with the aging population, has played havoc with economic modeling, expectations, and market volatility, as the historical patterns no longer hold.
The growth rate of the economy is primarily due to two factors: working aged population growth, and productivity growth. Currently, the working aged population is growing at a rate of 0.6% per year, while productivity (which has been struggling of late showing negative growth in 4 of the last 6 quarters – see below) has grown at a rate of 1.3% since mid-’09. If 1.3% is now the long-term growth rate (now questionable given its recent performance), then the potential growth of the economy is less than 2% (0.6% + 1.3%).
Since the recession, using models based on historical data, the Fed, via the “dot plots” of the FOMC members (their forecasts of future interest rates) has been consistently overly optimistic about the growth rate of the economy. As a result, they frequently have threatened to raise interest rates, as their history based forecasting models projected a near-term return to pre-recession growth rates. Suddenly, at their June meetings, after 7+ years of basing their economic forecasts on their erroneous models, they have finally concluded that future economic growth will be slower than their previous forecasts, and, therefore, interest rates will be “Lower for Longer.” We know this from the significantly lower set of “dots” in the most recent “dot plot.” The end result is likely to be a reduction in market volatility around Fed meetings, as the markets’ view of the economy, already built into market pricing, and the Fed’s view are now more likely to converge. Thus, because there may be little or no need for market prices to change based on Fed policy, market volatility will be reduced.
As indicated above, the biggest issue now facing the markets and the economy is the low potential rate of economic growth (both for the U.S. and for the world’s economies). While it can be impacted by other social policies, there isn’t much that can be done from an economic policy point of view regarding the growth of the working aged population. And this is a huge problem in the industrialized world (Japan, Europe, China, the U.S.). However, there are economic policy choices that can enhance productivity.
- The slow growth world has seen trade wars emerge (via product dumping in contravention of free trade agreements, and via managed currency depreciation) as countries with excess capacity, like China, vie for the world’s now limited demand;
- It has become clear that unconventional monetary policy has lost its effectiveness at raising demand, and therefore, at enhancing growth;
- Unfortunately, fiscal policy, which traditionally had been used as a counter-cyclical tool, has now become an engine for income redistribution. Unlike in the past, today’s huge deficits produce little economic growth, and they have become a significant issue on the political scene;
- Yet deficits, if properly used in a counter-cyclical manner, could actually spur economic growth;
- The poor use of tax policy has also discouraged organic investment in new plant and equipment – profits earned and taxed in other countries by U.S. multinationals cannot be brought home to be used in new organic investments without a 35% tax penalty – a factor that is partially responsible for low/negative productivity growth.
We have remarked in several blogs about the high fiscal deficits and the concomitant deterioration of the social infrastructure in the U.S. while its citizens and businesses pay some of the highest tax rates in the modern world. One tried and proven tactic for economic growth is social infrastructure spending. Bridges, highways, high-speed trains, etc. are sponsored by government but built by the private sector. Private sector jobs are created in the process, and there is an income multiplier effect. Look at the prosperity that arose from the building of the interstate highways in the 50s, 60s, 70s and 80s.
For the first time since the recession, we see some western governments adopting pro-cyclical macroeconomic fiscal policies. The first government to do so was Canada. They are now being followed by Korea and Japan – and just in time for Japan, as increased use of unconventional monetary policies (negative interest rates) are having the opposite market and economic impacts than textbook theory predicts. Even Italy now wants to use fiscal policy to inject capital into its banks. (Unfortunately, the E.U. bureaucracy has the final say, and that bureaucracy appears to have a different view of how the problem should be handled. This issues continues to simmer and has the makings of the next international monetary crisis.) Unfortunately for the U.S. citizenry, any change in fiscal policy must await the result of the November elections. So, the earliest possible use of pro-cyclical fiscal policy is the 2018 budget.
The Foreseeable Future
The data have been mixed of late – not unusual in a slow growth economy. There is no recession in sight, but when traveling at stall speed, it doesn’t take much to disrupt the flight path.
- As a sign of market concern over growth, the 10 year Treasury yield sat at a record low of 1.37% on July 5th, a big slide from 1.74% on June 23rd (the “Brexit” referendum date). Falling bond yields, especially to lows never seen before, send the opposite message from that sent by rising equity prices. The bond market is more often correct. Perhaps rising equity prices are a function of TINA (There Is No Alternative).
- Jobs bounced back in June to 287,000 from a revised paltry 11,000 in May; June’s growth far surpassed market expectations for 175,000. For all of 2015, job growth averaged 229,000 per month. The average for 2016 is 171,500. So, what should we make of June’s number? Looking at both May and June as aberrations and using an average for the two months, we would get 149,000 for each month, still good, but definitely decelerating – something we should expect as the economy approaches a point where unemployment is structural (job seekers don’t have the skills for the jobs that are available).
- GDP: The third and final estimate of Q1 GDP raised the real growth rate to 1.1% from 0.8%, and the Atlanta Fed’s GDP Now model is forecasting Q2 growth at 2.7%. But, that is the extent of the good news. Real private sector domestic demand was revised lower, from 2.0% to 1.1%. The pattern of slower growth over the past year is unnerving. In Q2/15, such growth was 3.9%. In the ensuing 3 quarters it has fallen as follows: Q3/15 = 3.2%; Q4/15 = 2.2%; Q1/16 = 1.1%. Income growth has a similar pattern (5.3%, 4.4%, 4.2%, 3.7% respectively).
- Housing: The sales of new and existing homes have simply not taken off as one would have expected, based on history, in a world where interest rates are at the lowest level on record. Once again, economic history just isn’t repeating itself. Don’t forget, it is the younger generations who are now stuck with significant student debt and, as a result, these generations have postponed marriage and child rearing. First time home buyers, usually composed of younger families, now comprise 30% of home sales, whereas the pre-recession norm was 40%. In addition, the housing crisis decimated the ranks of the small local land/home developers. Many of these small business people no longer have the credit rating, or the desire, to return to such risky ventures, while, at the same time, community banks, the traditional lender to such ventures, have been dis-incented from such lending by their regulators. Furthermore, it now often takes years to get raw land through the local government entitlement process (in some places longer than others). The result has been a lack of supply, especially in the affordable price ranges. We now see most urban markets with robust economies pricing younger buyers out. Conclusion: while housing isn’t leading the economy into recession, neither is it leading the charge toward more rapid growth.
- Industrial Production: IP declined in May, and has actually fallen in every month but one since the turn of the year. In addition, the production index has been buoyed by the high sales levels in the auto industry, much of which have been due to the emergence, and general availability, of sub-prime auto loans. (Don’t worry, this isn’t like housing. Delinquencies are resolved rapidly via repossessions; so far, there are no laws slowing this process.) The growth of sub-prime lending, however, has peaked, so it is likely that auto sales, in general, have also peaked. (This was confirmed by June’s data, as the rate of sales for the month fell to 16.7 million units, a 13 month low.) But, like housing, as long as monthly sales remain above the 16 million annual rate, this sector is not likely to lead the economy into recession. On the other hand, again like housing, IP isn’t likely to spur more rapid growth
- Manufacturing: The manufacturing portion of production, as measured by the ISM Manufacturing index, was tentatively in expansion territory in May (51.3), and unexpectedly rose to 53.2 in June. As long as the dollar doesn’t strengthen, manufacturing will remain in its slow growth mode. However, a possible fallout is that China uses “Brexit” as an excuse to devalue their currency and start another round of trade wars. The jury is still out on this file. In addition core capital goods orders remain a concern, as they have been negative in 4 of the past 6 quarters, down at a rate of more than 6% in Q2. Orders for heavy duty trucks sank to their lowest level in 6 years and are down 30% over the past year.
- Non-Manufacturing: The ISM Non-Manufacturing Index delivered in June rising to a solid 56.5 from 52.9 in May. Of great importance, the employment index rose to 52.7 from its contractionary 49.7 reading in May.
- Confidence: Consumer Confidence (the Conference Board’s measure) jumped to 98.0 in June from 92.4 in May, a unusual and unexpected jump. But, once again, that was the extent of the good news as appliance, auto buying, and home buying plans fell. So did plans to take a vacation.
- In Q1, hourly compensation grew at a 3.0% annual rate, and unit labor costs rose at a 4.1% rate. Given the growth in jobs and rising hourly compensation, one would normally expect consumption to follow closely. The surprise is that overall consumption was soft while the savings rate rose. As explained in previous blogs, it appears that this phenomenon is demographic in nature, as the baby boomer cohort, the one with the largest share of the nation’s wealth, reduces consumption at retirement, or saves more as retirement rapidly approaches.
- Inflation is another unique issue. Core goods CPI (excludes food and fuel) fell -0.1% year over year in May. Here are some annual changes in goods pricing:
- Furniture: -2.5%
- Used Cars: -2.3%
- Video Equipment: -9.6%
- Toys: -7.9%
- Computer Products: -8.2%
Such deflation has occurred because of excess production capacity worldwide, and, of course, because of the precipitous fall in the price of oil. But, as you undoubtedly already know, the U.S. is primarily a services economy. Services costs in May were 3.2% higher than a year earlier. This explains why most readers don’t believe the “deflation” story – because services are a large part of family budgets.
- Banking: The best news of late for the economy was that 20 of the 22 SIFI (Systemically Important Financial Institutions) passed the Fed’s stress tests, indicating that they could survive an event or events substantially worse than the ’08-’09 financial crisis. Only the U.S subsidiaries of Deutsche Bank, and Bank Santander did not pass (Morgan Stanley was given a conditional pass with plan revisions due in December). Until they passed such stress tests, the banks were constrained as to what they could do with their capital, i.e., buy back shares or pay dividends. Within a few hours of the announcement, the major banks had authorized $45 billion of stock buybacks and significant dividend increases. The table shows some of the buyback and dividend announcements.
|Bank Announced Stock Buybacks and Dividend Increases|
|$ Value of||Value of|
|Bank of America||$5.0 billion||$.075/share|
|American Express||$3.3 billion||$.03/share|
|US Bancorp||$2.6 billion||$.025/share|
|Ally Financial||$.70 billion||$.08/share|
|M&T Bank||$1.15 billion||$.05/share|
|PNC Bank||$2.0 billion||$.04/share|
|BNY Mellon||$2.7 billion||Yes-undisclosed|
|Northern Trust||$0.275 billion||$.02/share|
|State Street||$1.4 billion||$.04/share|
|Discover Financial||$0.95 billion||$.02/share|
“Lower for Longer” has been the millstone for the bank stocks in the U.S. for the past year or so. (Note: European banks suffer from a different malady –because of how they account for their assets and take bad debt write-offs, the value of the equity portion of their balance sheets is highly questionable. Thus, the impending crisis in the Italian banking system where questionable debts average 18% of loans – compare that to U.S. banks where there is concern if this ratio is 2%.) For U.S. banks, the markets have concentrated on net interest margin (NIM), as if that is their only source of earnings. But these banks, especially the big ones, have many diverse sources of non-interest income (consumer and business bank charges, investment income, investment banking income, etc.), many of which have been growing. The huge outpouring of dividends and buybacks (from the build-up of excess capital during the last few years) indicate that U.S. bank shares have been significantly undervalued.
- “Brexit” was an expression of political dissatisfaction; there are few real economic consequences from it in the near term. Thus, the short-lived market swoon;
- The “New Normal,” “Lower for Longer” and slower economic growth are realities in today’s economies and markets;
- Beginning in June, Fed policy has likely come to be more in sync with what the market views as economic conditions. This will cause less market volatility when the Fed meets and announces policy decisions;
- Slow growth is the result of a slowdown in the growth of the working aged population, and poor fiscal policies are partially responsible for low organic investment and low/negative productivity;
- The appropriate use of fiscal policy can spur economic growth. For the U.S., this isn’t a possibility until at least the 2018 fiscal budget as a result of the election cycle;
- The data from the economy is mixed. Job growth has taken some wild swings, but is definitely decelerating from that of 2015. And there is growing concern around capital investment and labor productivity. While no recession is in sight, an economy operating at stall speed can easily be knocked off of its flight path;
- The best economic news of late is that U.S. banks are rich in capital, that they are paying out their excess capital, that the capital that remains is more than enough to withstand stress worse than the financial crisis of ’08-’09, and that their earnings potential is higher than previously ascribed to them by U.S. bank analysts.
Robert Barone, Ph.D.
Andrea Knapp Nolan
Appendix: Political Issues in Europe as a Result of “Brexit”
- “Frexit” – The National Front is proposing a French referendum on E.U. membership;
- Italy – will hold a vote on Constitutional reforms in October;
- Hungary – will hold a referendum in October on the refugee issue;
- Austria – is going to re-run its Presidential election in October with Hofer, who favors an Austrian exit from the E.U., as a viable candidate.