January Newsletter: Predicting questions

Posted by Alex Frey (@alexhfrey )

Last month we embarked on our annual tradition of "predicting" the key questions that 2017 might answer (rather than their answers, which are yet to be determined). In part 2 of this series, this month we look back at the questions we "predicted" for 2016 and reflect on which of them were actually answered. 

What’s happening with the Japanese economy?   

Assessment: This question's lack of an answer makes it all the more interesting.   

One of the galling things about macroeconomics is the lack of empirical data about what works and what doesn't. Unlike more scientific disciplines, you can't simply run experiments and get more data. Experiments are rarely controlled to isolate a single variable, and outcomes take years to come in. That's why we were excited to point out starting way back in 2014 that one of the great macroeconomic experiments of our time was underway in Japan.   

Since that date, the Japanese Central Bank has been involved in an unprecedented large and continuing program of quantitative easing (the Bank is buying government bonds to increase the money supply, suppress interest rates, and create a low level of inflation). In addition, the government has been running deficits to provide a fiscal stimulus, and already has a massive amount of debt – far more relative to the size of their economy than even beleaguered countries like Greece and Argentina. The government is purposely trying to print money and ignite inflation in order to stimulate the moribund Japanese economy – but if it goes too far and raises interest rates it risks throwing the country into an unsustainable debt spiral (higher interest rates would increase the cost of debt payments, which would require the country to borrow even more).   

Figure 1 shows the level of central bank assets, which demonstrates the amount of quantitative easing that has occurred, and figure 2 shows the trends in central government debt. Both have increased markedly. 

So what did this unprecedented binge of money printing and debt spending result in? Keynesian paradise or a debt-spiral demise? In many ways to date it has resulted in... a lot of nothing.   

There has certainly been no debt calamity – interest rates remain low and even negative at many maturities. But Japanese economic growth has continued to be anemic, as shown by figure 3. The gross domestic product (GDP) has grown very slowly, averaging less than 1% per year, and the trend in 2016 was not encouraging. The combination of slow growth and fiscal stimulus has taken the debt to GNP ratio to about 229%, a very high level. One might expect that this would reignite inflation, but the inflation rate in the last year has remained quite low, well below the central bank’s target rate of 2%, although it showed signs of increasing late in the year (see figure 4).   

On the face of it, the debt to GNP ratio seems to portend disaster. However, Bloomberg Business Week noted a feature that is often overlooked: the amount of Japanese debt in private hands is actually decreasing. The quantitative easing program is putting the debt in the hands of the central bank, so the government owes this portion of the debt to itself. They could simply cancel it or convert it to long term zero interest bonds, which is the same thing as canceling it. Japan is, in essence, funding their budget deficit by creating money. If they can get away with this without creating significant inflation, it’s a great deal! Unfortunately, if this program is continued, inflation will probably raise its head sooner or later (and if the central bank had to fight inflation it would have to sell back some of the debt it had previously purchased, putting it back out onto the market and raising interest rates at that point).   

The problem with the Japanese economy is at least partly demographic: the population is getting smaller and older. Given the demographic trends, a low growth rate may be inevitable, and the failure of stimulus program to create meaningful growth is understandable. Unfortunately, this bodes ill not just for Japan, but also for Russia and Europe where similar demographic problems exist. China also faces a similar problem, but the Chinese economy continues to grow rapidly as their technology and capital stock catches up to that in the developed countries. It appears that future world growth will have to come primarily from the developing countries.

Img1Figure 1: Assets of the Central Bank of Japan. The data were taken from the Federal Reserve Economic Data, Federal Reserve Bank of St. Louis. 

Img2
Figure 2: Japanese central government debt/GDP. Data were taken from tradingeconomics.com 

Img3Figure 3: Growth rate of the Japanese GDP. Data were taken from trading economics.com

Img4Figure 4: Japanese inflation rate. The data were taken from tradingeconomics.com

Will 2016 be the year we reach long-term equilibrium in the oil market?

Assessment: While it's too early to tell, we think we are closer to being there than at any other points in the last fifteen years. 

We pointed out last year that oil has had quite the roller coaster the last fifteen years, with the notion of "peak oil" (supply) pushing the price all the way to $130 in the first part of the period; then the price of oil collapsed in 2014 and 2015, going from over $100/barrel to under $30/barrel. The fall in price in 2014 and 2015 was a response to a large increase in U.S. production (based on the new fracking technology) and to slower growth in Europe and China. Overnight it seemed as if the world shifted from peak supply and rising demand to peak demand and rising supply.   

The low price was devastating to the U.S. oil industry, and U.S. production fell. Per Bloomberg Markets, Chinese production also fell. Figure 5 shows the price of West Texas Crude oil for the last five years, and figure 6 shows the trends in U.S. production. The price started to increase in 2016. It is currently a little more than $50/barrel, and in response U.S. production has also started to increase. In November, the Organization of Petroleum Exporting Countries (OPEC) announced an agreement among their members to cut production in order to increase the price of oil. The market responded with a bump in the price to about $53/ barrel.   

The fact that U.S. production is increasing again indicates that U.S. producers can make money at $50/barrel. The International Energy Agency (IEA) is predicting that the price of Brent Oil will rise slowly over the next five years to about $60/barrel. They do not see a return to $100/barrel prices. World political events can have a big effect on oil prices, but it’s possible that the price of oil will settle in the $50 to $60/barrel range for the near term, as increases would bring on more supply and decreases might lead to cuts in production again – precisely the conditions that make for a relatively stable equilibrium.   

Img5Figure 5: The price of West Texas crude oil. The data were taken from the Federal Reserve Economic Data, Federal Reserve Bank of St. Louis. 

Img6

Figure 6: U.S. crude oil production. The graph was taken from the Wall Street Journal. 

Will the Fed ever raise interest rates? 

Assessment: At least this question has a definitive answer: yes, and the economy did not fall apart as a result. Those on the fringe predicting "QE infinity" and permanent zero interest rates were quite simply wrong. 

Of course, you are well aware that the Federal Reserve Open Market Committee (FOMC) raised the federal funds rate (fed rate)* by a quarter of a percent at their meeting in December. This was the only move they made in 2016 after raising the fed rate by a quarter of a percent in December 2015. The fed rate and interest rates in general remain at historical lows, and the hiatus between the last two moves indicates that the FOMC had doubts in early 2016 about the strength of the economy. The fact that they raised rates in December indicates that those doubts are disappearing. Unemployment has fallen below the 4.8% level that the Federal Reserve (Fed) defines as full employment. Inflation is still below the Fed’s 2.0% target rate, but it has been increasing, as shown by figure 7. Several FOMC members have indicated that there could be three more quarter point moves in 2017.   

Perhaps more important, longer term interest rates jumped immediately after the election and before the FOMC made its move. Donald Trump has indicated that he wants to cut taxes and increase infrastructure spending. If he succeeds in doing this, it could reignite inflation. The market moves may be pricing in an expectation of faster economic growth and revived inflation. In any case, it is likely that the era of extremely low interest rates is over. The correlation between interest rates and stock prices is very loose, but a significant rise in interest rates could cause a decrease in stock prices. 

Img7
Figure 7: U.S. inflation rate (the rate of change in the consumer price index). Data were taken from the U.S. Bureau of Labor Statistics.   

* The Federal Funds Rate is the rate that the Federal Reserve targets for overnight loans between banks. 

What is going to happen to the Euro and the European Union? 

This turned out to be a prescient question – though not for the reasons we thought it might.   

We thought that the catalyst here might be a "Grexit" (Greek exist from the European Union). In 2015, Greece was going through an economic crisis. They had accumulated too much Euro denominated debt and couldn’t afford to pay the interest. For a time in 2015, it appeared that Greece would have to drop out of the Eurozone (the group of European Union members who use the Euro as their currency). It was feared that this could lead to other countries dropping out and a collapse of the Eurozone.   

Eventually, the Eurozone stabilization fund and the International Monetary Fund (IMF) gave Greece another loan, but the creditors insisted on strict austerity conditions aimed at bring the Greek budget back into balance. Greece dropped out of the news for a while, but the problem wasn’t really solved. Figure 8 shows what has happened to the Greek GDP. It has leveled off but growth has been very weak. The government still has an annual deficit equal to 2.5% of GDP. The deficit is much improved over the past two years, but the total debt is still growing. Greece is still undergoing extreme hardship, as indicated by their unemployment rate which is greater than 23%. It is still very possible that Greece will choose to leave the Eurozone (i.e. abandon the Euro currency) or be forced out sometime in the next few years, and it is still possible that this could lead to further defections and a dissolution of the Eurozone. Some other EU countries also have very high debt to GDP ratios. In addition to Greece, Italy, Portugal, Belgium, and Spain have ratios that are above 100%.   

For 2016 at least though, "Brexit" rather than "Grexit" was the phrase of the day. The greatest threat to the EU came not from depressed Grecians, but from relatively well-off Britons. The United Kingdom voted to withdraw in June in an election that surprised most observers. And it might not be an isolated case as other rich-world countries grapple with nationalist uprisings.   

In France, Marine Le Pen leads a nationalist party which has been surging in popularity. France will hold a presidential election in the spring. Based on current polls, Le Pen probably won’t win, but we have seen polls fail several times in the last year. If she wins, she has said that she would hold a referendum on France’s membership in the EU. She would also reintroduce the French Franc as a parallel currency with the Euro and would redenominate French bonds in Francs. It appears that the only reason to do this is to prepare for a devaluation of the currency and, in essence, a default on the bonds. This would result in a large increase in interest rates on French bonds and probably on other Euro denominated bonds. We suspect that this won’t really happen, but it is troubling that it is even being discussed. Further, a Pew Research study conducted in the spring of 2016 indicates that voters in many EU countries are developing a more negative view of the EU. In Greece, France, the UK, and Spain less than half those surveyed had a positive view of the EU.   

In response to its problems, the value of the Euro has dropped significantly with respect to the U.S. dollar. The trend is shown in Figure 8. This will make it harder for U.S. companies to export to Europe and easier for European countries to sell in the U.S. 

The establishment of the Euro may have been a mistake, but we think the European Union has been highly beneficial to the European countries and to the world. We doubt that it will break up, but if it does, there will be negative effects on the world economy.   

Img8Figure 8: Real (inflation adjusted) GDP for Greece. Data were taken from the Federal Reserve Economic Data, Federal Reserve Bank of St. Louis. 

Img9
Figure 9: The value of the Euro measured in U.S. dollars. Data were taken from the Federal Reserve Economic Data, Federal Reserve Bank of St. Louis.   

What is happening with the Chinese economy?   

Assessment: This was the right question to ask, but we might have been early in asking it as there is still no clear answer.   

For the most of the past 25 years the Chinese economy has been growing very rapidly, averaging more than 10% growth per year. However, since the Great Recession in 2008, growth has slowed a bit, as shown in figure 10. To maintain growth, China has been stimulating its economy by providing easy credit to corporations and households. Although Chinese government debt is low, the total debt (government, corporate, and household) to GDP ratio has been rising rapidly, and this has caused concern in some circles.   

There is an economic metric called the “credit to GDP gap”, which according to some economists is a warning sign of coming financial problems. We aren’t going to explain this metric here, but the current figure for China is very high compared to other countries. On the other hand, although China’s total debt to GNP ratio has been increasing rapidly, this ratio is still a little below the comparable figure for the U.S. or the European Union. In China’s case, the government portion of the debt is very low, and the private portion is high and has been rising rapidly, as shown in figure 11. On the surface, the Chinese total debt does not seem catastrophic, but the rapid increase and the concentration in the private sector is worrisome. Some people think Chinese banks may be holding bad loans and that a financial meltdown could be near. Some people are also skeptical of the quality of the data coming out of China. China has been the main engine of world growth for a number of years, and a serious recession in the Chinese economy would have worldwide impact. We think this is unlikely, but we wouldn’t invest a large portion of a portfolio in China. 

Img10
Figure 10: Chinese GDP growth. Data were taken from the World Bank national accounts data.

Img11
Figure 11: Domestic credit in the private sector in China, stated as a percent of GDP. The data were taken from the Bank for International Settlements. 

What other things should we be watching in 2017?   

Obviously, the biggest new factor is Donald Trump and the Republican Congress. We discussed Trump’s plans in our last newsletter, but we don’t know what he and the new Congress will actually do. If they follow the plan that Trump laid out in the campaign, there will be a large tax cut and an increase in spending on defense and infrastructure. This would give the economy a short term stimulus, but it would increase the federal budget deficit. Conventional economic theory says it will lead to inflation, higher interest rates, and a recession in the longer term.
It is unclear whether Congress will go along with this plan, and the Republicans in Congress spent the last eight years arguing against deficit spending. It will be interesting to watch this develop. We doubt that anyone knows what will really happen at this point.   

On the positive side, we believe that reform of U.S. corporate taxes is desperately needed, and the new government might achieve this. The U.S. currently has one of the highest corporate tax rates in the world, but corporations have various ways of avoiding the tax and generally pay much less that the advertised rate. A lower tax with fewer deductions would be very beneficial to the economy and to stocks.   

Trade policy is another situation that bears careful watching. We don’t think that Trump will start a trade war, but if he does it will be disastrous for both consumers and investors. Consumers have grown accustom to cheap imported goods, and tariffs will push up prices. Other countries will respond with their own tariffs. Companies have built international supply chains where products are designed in one country; parts may be produced in another country; products may be assembled in a third country, and the products are sold around the world. If these relationships are broken, at the very least there will be a long period of adjustment. A drop in profits and stock prices can be expected. Watching what actually happens to fiscal, tax, and trade policy will be very interesting and could have big long term effects on investments.


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By Alex Frey