Thursday, December 1, 2016

Manufacturing and inflation get a lift

Both inflation and real growth are getting a modest lift these days. Recent economic data continue to support the notion that economic activity has firmed a bit in the second half of the year, after being weak in the first half. The improvement is modest, but nevertheless encouraging, especially since there are signs that overseas activity is picking up as well. The market is also pricing in a modest pickup in inflation, with expectations now centering around 2% over the next 5 and 10 years.


As the chart above suggests, he November ISM manufacturing report is consistent with an economy that is growing at a modest 2-3% pace.


It's encouraging that Eurozone manufacturing surveys point to some improvement in the second half there as well.


Industrial metals prices have surged almost 45% year to date, and that is very impressive. Some of the upward impetus could be speculative in nature, a bet that a Trump administration ramp up infrastructure spending in a big way. The hoopla surrounding the ARRA infrastructure spending bonanza was way overblown, but this time could be different. Instead of relying on local governments to identify "shovel-ready" projects, Trump may instead rely more on tax incentives and private sector funding, and that could mean an infrastructure push that could be more efficient and more productive. Caterpillar stock, up 60% since January, is sending the same message. However, I note that prices have been increasing all year, well in advance of any expectation that Trump might win.


This year has seen a remarkable divergence between the value of the dollar and industrial commodity prices. They normally move inversely (e.g., a stronger dollar coinciding with weaker commodity prices), but this year both the dollar and commodity prices have moved up (resulting in the divergence shown in the chart above). When prices move inversely it is a sign that the change in commodity prices has a monetary component (e.g., tight money is pushing the dollar up and deflating commodity prices). Now that they are moving together it could be that the rise in commodity prices is mostly being driven by improving economic fundamentals both here and abroad: prices are rising because demand is outstripping supply. The dollar has its own reasons for rising: the Fed is clearly in a mood to raise rates, while most other central banks are still on the sidelines. More recently, the dollar has gotten a boost from speculation that a Trump administration will be more growth-friendly.

Traditionally, a stronger dollar has spelled bad news for emerging market economies. That's because a stronger dollar has usually coincided with weaker commodity prices, and commodities are very important to emerging market economies. But this time emerging market economies have been taking a beating of late, even though commodity prices have been rising. Perhaps there is too much pessimism? Might it be the case that a stronger dollar and an improving U.S. economy and rising commodities will act like a rising tide that lifts all economies, particular those in the Western hemisphere?


The yen has fallen almost 13% against the dollar in just the past 3 months, and Japanese stocks have reversed to the upside. The strong inverse correlation between the value of the yen and the stock market is still in place. It's unusual for a weaker currency to be good for a country's stocks, but the case of Japan looks different from that of most countries. A weaker yen may be a sign that deflationary pressures—which have weighed heavily and uniquely on Japan's economy for many years—are being replaced by some much-needed reflation.


The U.S. stock market has outperformed the Eurozone stock market for many years now, and nothing seems to have changed of late. The outlook for the U.S. economy is still brighter than it is for the Eurozone economy.


Inflation expectations, as derived from the prices of TIPS and Treasuries, have moved meaningfully higher in the past three months. The chart above shows how this has played out with 5-yr TIPS and 5-yr Treasuries. Nominal yields have risen much more than real yields, with the breakeven spread (equivalent to the expected average annual rise in the CPI over the next 5 years) rising from a low of 1.3% in early August to now 1.9%. 10-yr inflation expectations are now 2.0%. At the very least this means that deflation worries are a thing of the past.

Caution: if this process continues (i.e., if inflation expectations continue to rise), it will mean that the Fed is falling behind the inflation curve and will therefore need to speed up its normalization of short-term interest rates. As I've warned for years, the Fed's biggest nightmare is the return of confidence, and confidence is definitely picking up these days. With rising confidence and less risk aversion, the pubic's demand for all the money that has been created in the past 8 years will begin to decline, unless the Fed takes offsetting measures to boost money demand by raising short-term interest rates.

UPDATE: As seen in the chart below, the Chemical Activity Barometer is still rising impressively, up 4% in the year ending November. Such a move has tended to foreshadow a pickup in industrial production, which has been flat for quite awhile.


18 comments:

Benjamin Cole said...

China is by far the biggest consumer of industrial commodities, and much of the metals-price action rests to the improving China industrial outlook. Their PMIs are above 50 now.

China real GDP has more than doubled in the last 10 years, despite sluggish global growth, and it was and is an exporting nation. China is slightly less than one-fifth of global GDP, and much larger than when the topic is anything industrial.

I am no fan of the China economic system, though its central bank may be better-operated than our own. Every year people say China will collapse, but instead its economy doubled in the last 10 years.

On the US dollar, I sometimes read emerging nations fear a stronger dollar and higher interest rates in the US, as "hot money" will flow out of emerging markets to the US. Evidently, the world has several trillion dollars of capital that very fluidly searches the globe for best yields. If heavily leveraged borrowers are exposed to hot money, they could see escalating interest costs.

Heavily leveraged borrowers--let us hope there are no Long-Term Capital Management bombs out there.

An interesting year ahead. If China and the US grow, two such large locomotives may pull the world economy. There is plenty of excess capacity in the world (excluding certain zoned-property types), so any increases in aggregate demand will likely not be inflationary.

steve said...

It will be interesting indeed to watch the economic progress under a DT presidency. I for one do not believe that hampering free trade and strong arming US companies to stay home is "progress" and make no mistake that is exacting what the DT admin will do.

steve said...

I hardly EVER agree with Bernie Sanders but he brings up a damn good point here:

http://www.huffingtonpost.com/entry/bernie-sanders-donald-trump-has-endangered-american-jobs_us_58402e52e4b09e21702cdedc

Scott Grannis said...

I'm torn on this issue. I hate to see Trump strong-arming companies and threatening to punish them if they take jobs overseas. But I like the fact that Trump realizes that companies respond to incentives, and that regulatory burdens and a high corporate tax rate are big problems that must be fixed. We'll have to see how he evolves on this. If he goes long on strong-arming and short on cutting taxes and regulatory burdens, that will be very disappointing.

Johnny Bee Dawg said...

We don't have "free trade" so this Trump stuff is just a different form manipulation. But this time it favors the America worker's paycheck for a change. Remains to be seen if it harms the American worker's spending.

I don't think it will be harmful. I don't think it costs that much more to run robots in the US than it does in Mexico, and am not convinced that inflation will be harmful for a long time. And incentives and deals like Carrier means that tariffs stay off the table.

This move also wakes up Mexico, and starts hurting Mexico directly, and gives Trump a great starting point for negotiating immigration reform with them....whether that involves Mexico paying for a wall, or negotiating a better NAFTA deal. There are a lot of good outcomes available with this strategy toward growth and prosperity.

Inner cities getting cleaned up and rebuilt will be the icing on the cake. America should have great cities...not a bunch of crime ridden hell holes. Trump will be the first POTUS to make a positive difference there. Watch and see.


Benjamin Cole said...

Carrier: maybe good maybe not---but isn't nice to have a US president talking about business! Visiting a factory and talking about jobs?

Is drone-bombing taxi-drivers in Eatcrapistan really more important than bolstering US enterprises?

Recent US presidents evidently thought so....



Benjamin Cole said...

Add on re income taxes:

Forgotten today that Reagan's Tax Reform Act of 1986 resulted in all income being treated equally, whether from capital gains, dividends, wages or salaries.

One might say all income was still not treated equally even under Reagan, as Social Security taxes still applied to wages and salaries, but not to capital gains or dividends. But then the Social Security Trust is sort of an oddball outlay, and was not considered part of the federal budget until 1968. .

Over at American Enterprise Institute, they point out that having a lower corporate income tax rate than personal income tax rate will result in artificial shifting of income from "personal" to "corporate" as people naturally evade taxes.

Maybe Reagan had it right: lower tax rates, but treat all income the same.

As usual, I will posit we really need to move away from income taxes, and towards consumption, fuels and "Pigou" taxes and yes, perhaps imports. I would like to eliminate all income taxes.



steve said...

I completely agree benjamin. Eliminate income and replace with consumption tax with exemption for food/clothing. Ain't gonna happen of course but then again I NEVER thought DT had a chance-not from begining until end and while I'm on it, the left is gonna try and steal this thing and if there's even a smidgen of a chance-anarchy and civil war II in the US.

Johnny Bee Dawg said...

The Left isnt gonna steal anything else for a while.

William said...

Ed Yardini: We Are All Populists Now

"(1) Exhibit A China. In researching the causes of the productivity slowdown during the current economic expansion, I ran a chart of the Fed’s indexes for manufacturing industrial production and capacity. They both are available monthly since the late 1940s. Both have been on uptrends since the start of the data until about 2001, when both started moving sideways. China entered the World Trade Organization (WTO) on December 11, 2001.

While manufacturing production reflects the ups and downs of the business cycle, manufacturing capacity has a long history of relatively stable growth. In fact, on a year-over-year basis, the former tends to turn negative, while the latter had remained positive until it turned slightly negative for the first time from September 2003 to October 2004, and again from August 2008 to November 2011. Capacity growth averaged 3.9% from 1949 through 2001. From 2002 through 2015, it averaged just 0.4%.

If we were all populists now, I would argue that this is Exhibit A confirming that US companies stopped expanding their capacity in America ever since China entered the WTO. Instead, they invested in factories in China or outsourced to Chinese factories to produce goods that now are imported into the US rather than made here by American workers.

(2) Smacking productivity. If we were all populists now, I would challenge the argument made by Globalists that Americans have lost jobs as a result of labor-saving technological innovations, rather than the migration of jobs to Chinese workers. I would counter that this notion isn’t supported by the flat trends in manufacturing production and capacity since 2001. Technological innovation should expand manufacturing capacity and boost labor productivity. Yet nonfarm business productivity growth has been extremely weak during the current economic expansion. Over the past 20 quarters (five years), it is up only 0.7% per year on average. It has never been this weak during an economic expansion!

Not surprisingly, there does seem to be a good correlation between the growth in manufacturing capacity on a y/y basis and the five-year growth trend in productivity. The latter tends to grow fastest during or soon after a period of fast growth in capacity. This makes sense to us. If companies aren’t expanding capacity at home, then domestic productivity is likely to suffer.

http://blog.yardeni.com/2016/11/we-are-all-populists-now.html

Hans said...

What a shame, Scott Grannis has
joined the Censorship League.

steve said...

This was exactly as I expected. benefit the few and hurt the many. STUPID.

https://www.bloomberg.com/news/articles/2016-12-05/carrier-raises-prices-after-trump-talks-alter-plant-closure-plan

William McKibbin said...

Too many economic challenges to resolve in 2017 -- Trump's economic reforms will need 3-5 years to settle in -- dollar index likely to rise to record levels in coming next few years -- watch out for 75% declines in DJIA, real estate, oil, and gold -- nothing will be spared -- eliminate debts, start a garden, and prepare to fend off economic refugees from your property -- recovery will not begin before 2023.

Benjamin Cole said...

I hate to sound like a Neanderthal protectionist…but.

Ed Yardeni, cited above, does make some points.

In theory, free trade is best, not only in goods and services, but capital and labor (free migration).

But, in the real world, there is no free trade, only negotiated trade, and there are huge structural impediments, and the value of nation and culture.

The globalists say global homogenization is the answer. True, a world without nations or real borders may be a world without nationalist wars and higher material prosperity.

But are the citizens of France or Italy wrong to try to preserve their culture and way of life? Must all nations and cultures be ground under the hoof of global commercialization?

I say nothing against any group, nor do I want to. I like people. Anybody with an work ethic, or who is merely pleasant. America, in fact, is an immigrant nation, and should be open to legal immigration.

But I can see why many populations are turning against globalism. Not only are middle-class living standards not really rising in developed nations (due largely to property zoning, yet demand for housing from migration and foreign capital) but middle-class people are told they are xenophobic if they prefer their culture to others.

In fact, multinational corporations have fiduciary responsibilities to an international role call of shareholders. They do not, and should not, be patriotic in any way. Add that to more than $21 trillion being stored in largely untraceable Cayman Islands, Cook Islands type bank accounts.

Interesting topic.



Medguy said...

Scott-would be interested at some point in your current thoughts on REITS and MLPs given pending and long telegraphed rate increases on Dec 14.

steve said...

From John tamny:

http://www.realclearmarkets.com/articles/2016/12/06/to_save_800_jobs_donald_trump_destroys_exponentially_more_102449.html

bob wright said...

Scott,

In your 2nd chart comparing U.S. and Eurozone Manufacturing Indices, you use a "Diffusion Index."

What is this diffusion index?

Thank you very much.
Love the blog.

Scott Grannis said...

A diffusion index tries to show how widespread a certain condition is. In this particular case, respondents in the manufacturing sector of the economy are asked to report whether they see purchasing activity expanding or not. A 55 on a diffusion index would thus mean that 55% of those reponding reported expansion.