Misadventures of the Real Economy in Central Banks' Neoclassical Wonderland
Sebastião Buck Tocalino, February 5 2016
Before I get started, I want to explain that the term wonderland I used in the title above is much more in the sense of incongruous and defying common sense, than in some cynical reference to the splendid sense of the word.
In a nutshell, the real economy consists of services and industries making, selling and shipping things for people who need or want and pay for them. It is not the somewhat inconsonant world of Central Banks and Wall Street, which we have been trying so hard to understand in recent years.
Central Banks may adopt some politburo-style central planning, such as printing money at their will and judgment, while Wall Street finds ways to rake it in. But it is the people and the businesses on the streets of the real world who suffer for real!
The middle-class is in dire straits. Industries are struggling and life is getting harder even for big multinational corporations. We can see commodity prices collapsing and currency adjustments happening all over the world.
The ongoing downfall of Caterpillar is an alarming omen of this challenging scenario. Goldman Sachs reported that its analysts see 35% downside to consensus 2017 earnings per share. This will be driven by structurally lower global infrastructure investment still in the early stages of what may be an extended commodity deflation cycle. It is a challenge for future producer returns and balance sheets. It looks like there will be a lasting lower demand for machinery utilization.
A grisly backdrop for CAT, whose global machinery sales have already declined for several months since mid-2012.
This discouraging perspective for infrastructure investments seems to agree with what I am seeing in cargo transport industries.
If transportation is a good barometer for the economy, the Baltic Dry Index, currently at an all time low of 298 points (at the time of this writing), also paints a picture of despair! This Baltic Dry Index was first published on January 4, 1985, at 1,000 points. It was formulated as an economic indicator and is issued daily by the London-based Baltic Exchange. Not restricted to Baltic Sea region, the index assesses the cost of moving major raw materials by sea. It covers dozens of shipping routes on a time charter basis, monitoring Handysize, Supramax, Panamax, and Capesize dry bulk carriers transporting a range of commodities like coal, iron ore, cement and grains.
Despite the peaks we saw in the past, BDI shows a huge drop from its early values. From the index's 1,000 points at inception in 1985 to the actual quote of 298 points (on Feb 4 2016), it dropped 70%. Though it is true that most of these lower costs of shipping are the reflex of numerous new ships recently built, it is also true that the expected demand for them just isn't there. I believe the chart above captures the wretched perspective for global economics. Apparently, this glut story is happening in many industries. And its implications are deflationary.
But if freight costs are sinking at sea, raising your eyes to the skies won't make you less blue!
In January, to match changing demand in the cargo market, Boeing announced that it would lower its production rate on 747-8 jet. It doesn't want to overproduce, since the market is not demanding a lot right now. The air transport industry numbers for November 2015 showed air freight volumes contracted 1.2 percent compared to November 2014. The company said low-trade growth and the decelerating global economy affects air-cargo traffic.
Okay, so freight traffic is wobbly by sea and by air, but firm land is not holding so solid and stable for the cargo industry either!
It has been said that watching railroads is a good way to check if the U.S. economy is on its right track. But the view suggests some derailment!
Erwin's 175-acre rail yard in Tennessee, a rail terminal that had been continuously operating for 135 years, was permanently shut down a few days ago, abruptly ending the employment of the facility's 300 workers. And in Grand Junction, Colorado, slow rail traffic left literally hundreds of engines sidelined on the tracks. According to Wolf Richter, "Union Pacific, the largest US railroad, reported awful fourth-quarter earnings Thursday evening. Operating revenues plummeted 15% year over year, and net income dropped 22%. It was broad-based: The only category where revenues rose was automotive (+1%). Otherwise, revenues fell: Chemicals (-7%), Agricultural Products (-12%), Intermodal containers (-14%), Industrial Products (-23%), and Coal (-31%). Shipment of crude plunged 42%. So Union Pacific did what American companies do best: it laid off 3,900 people last year."
A load of worries! But otherwise, not much load growth for trucking either... FTR, the industry source for transportation intelligence, has released preliminary data showing that in January 2016 North American Class 8 truck net orders slipped down 35% month over month, and 48% year over year. These are the huge trucks that haul freight on North American highways.
As the going gets tough, the tough gets going. Tough Wal-Mart announced the closure of 269 stores. GoPro's own snapshot snapped 7 percent of the company's workforce. Ain't that a tough picture! Sprint also made a tough call: to lay off 8 percent of its workers. Even the big banks are withdrawing people from their staff. According to fourth-quarter earnings reports from Bank of America and Citigroup, these two banks together now have 20 thousand fewer people working for them. Too-big-to-fail (but not too big to reduce its headcount) JPMorgan Chase also has 6,700 fewer workers than in the previous year.
Not too shabby? Apparently not! At least not in the curious view of Central Bank's breastfed Wall Street. For these QE-fed bankers, recent years have shown that bad news is good news. So I wonder: could the merry-go-round in the stock market just regain momentum with a perhaps more dovish reconsideration from the FED? Goldman Sachs seems to believe so. Either that or it is a bluff to gather buyers for Lloyd Blankfein's selling... The fact is that Goldman's analysts are forecasting the S&P 500 rebounding to 2,100 until the end of this year.
But behold! Too much of a bad thing... (wait! Am I getting confused here between Main Street and Wall Street diverging realms? Pardon me!)... Too much of a good thing may become a bad thing at one point or another. And complacency is a dangerous attitude! Not so much for the giants of the financial system, since in the end these too-big-to-fail institutions always seem to hold the right end of the stick no matter what! But common folks with their own hard-earned money invested in stocks must be careful. Against all recent odds, bad news may turn out to be indeed hazardous to stock prices...
Different industries have built up their capacity in the past. They acted on expectations of some greater global demand that just did not materialize! Transportation equipment and oil production are some of the most conspicuous examples of the current supply glut. But even money has been printed to overcapacity! It would have caused hyperinflation by now, if not for the diminished need for new investment in many sectors of the economy. Not just that, but the trauma of numerous debt-burdened consumers is still very fresh in people's memories. Consumers are getting older, and hopefully wiser too!
Credit does not depend on the money-to-lend side of the scale alone. There must be a money-demand side to offset the scale! That should be further productive investments. But there is not enough demand for them to counterbalance the freakish glut of newly printed money held by the banks.
Credit for consumption, in the long run, is a non performing loan. Definitely a BAD LOAN! Even if Central Banks succeed in pushing this kind of credit to consumers, it just delays the disaster. Face it: consumer credit growth in a troubled economic environment like ours only steals purchasing power and economic growth from the future to appease any present anxiety! Credit-based consumption can only grow while this pyramid scheme does not fall apart. Pushing consumer credit right now is a short-sighted measure, to say the least, or, more likely, a very irresponsible policy!
Credit is only promising and healthy when directed towards potentially productive investments that may generate the cashflow necessary to repay it later. But right now, in many industries, there is not much need for that. (The health sector is an exception, not only in the developed world of aging populations, but also in the emerging countries that suffer with less sanitary and medical infrastructure. Investment in good education is also badly needed in a country like Brazil!)
In the aging societies of developed countries, which constitute the lion's share of our global economy, traditional pyramid schemes start to falter. That can be seen not only in the already flimsy shape of welfare programs (like Social Security, Medicare and Medicaid), but also in the shortcomings of the inflationary fiduciary-money models and credit-dependent consumption growth. Neither welfare, nor fiduciary money and credit are necessarily bad, but they can only stretch to a sensible point! Promises of ever greater economic growth may not be supported by the profile changes of population.
Demographic pyramids are a souvenir of the past. Those once-common charts have changed. Important economies like Germany, Italy and other countries show a diamond-shaped population chart. I suggest that the obsolete term demographic pyramids at some point must be replaced by demographic diamonds, with the largest number of people already in their middle-age zone. With fewer young consumers, replenishing the demand side of the market gets tough.
But while the number of active people in the workforce will also diminish, the supply side will suffer less. Industries can still count on technology for mass production in much of the manufacture sector. Information technology will also help to hold up the supply side of the service sector: hardware and software together can book flights; check in luggage; chemically test soils; plow, seed and harvest crops; milk cows; answer calls; take orders; sell products online; monitor businesses; perform troubleshooting routines; do the accounting and perform a growing variety of tasks with increasingly lower costs, greater reliability and longer non-stop work shifts than before.
This trend of supply overwhelming demand means that capital consumption by the private sector tends to decelerate or even stall, with less need to invest in the formation of fixed capital, human capital, and productive capacity.
This overcapacity phenomenon may also be seen in financial services, since credit concession itself gets diminished and people's portfolio allocations stalls with their aging.
Amidst excessive QE dollars and fewer investment needs, the cost-of-credit scale gets tilted towards very low (but still positive) nominal interest rates. While negative nominal rates are not natural and truly an arbitrary aberration, low nominal interest rates are neither intrinsically a problem nor always an arbitrary imposition from Central Banks. Like everything else in the market, money should be priced in terms of supply versus demand. Therefore, low international rates are natural in the current environment, and I expect they will stay low for much longer.
An arbitrary measure indeed was the quantitative easing program aimed to push deflation back up to the inflation side (and rescue banks much more than their account holders). Despite low, this inflation annihilated the real gains that could still be generated by some understandably low interest rates. In a deflationary scenario, even 0% is lucrative! But QE induced inflation is a tax arbitrarily imposed on people's cautiousness. Japan not only resorted to arbitrary QE, but now has also imposed an arbitrary negative nominal rate. This trend of Central Banks denying the evident limitations and errors of the neoclassical economic models and academic theory is creating a Frankenstein economy. If it punishes prudence, it rewards risk. But we haven't seen much productive risk-taking in the shape of job creation and infrastructure investment. What we did see was a frenzy of stock buybacks to prop up share prices as well as earnings per share. Not only that, but also some undesirable leveraged speculation that inflated commodity prices, such as gold and oil (check this out). And that is not productive in the long run. The unrealistic Fed-induced high prices of oil have generated a destabilizing supply glut that finally burst the self-inflicted bubble. Investment was misdirected! Machineries, equipment, infrastructure and environmental damage that proved not necessary after all!
Acts have consequences! But not always the deferred consequences prey on those who acted in bold or reckless manners. The subprime crisis was a good example of that. Harsh consequences are usually a heavier burden on the meek and average man.
The blood-spattered ascension of ISIS was financed by oil prices propped up by QE. The FED may have raised rates in December 2015 just to try to remediate some of that. I know this may sound farfetched to some readers, but why raise rates with: (1) lowering infrastructure demand; (2) freight industry's overcapacity; (3) lower-demand demographic trends; (4) low CPI inflation; (5) low participation in the work force; and (6) fewer new orders for durable goods?
These are misadventures of the real economy in Central Banks' neoclassical wonderland!
Copyright © Sebastião Buck Tocalino
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