Semi-Annual Review: Disequilibrium and its Discontents
Welcome to the inaugural edition of Promontory’s semi-annual review. We begin with a medicinal dose of perspective for those who insist our generation of political and economic burdens are singularly acute. Divisive politics? In May 1856, pro-slavery Senator Preston Brooks cane-whipped his abolitionist colleague, Charles Sumner, on the chamber floor after the latter demanded that Kansas be admitted into the Union as a free state. Terrorism in America? The number of attacks sustained over the last 16 years is dwarfed by those committed during the ten years ending in 1975. Indolent, thin-skinned Millennials? Five decades ago college students occupied campus offices across the nation, demanded free tuition, condemned the Vietnam war and, upon graduation, produced some of the worst cars and television sit-coms in US history.
However dour things may look in our nation’s capital – or however bright they might seem on Wall Street – events are rarely, if ever, irreparable or irreversible. The trick is to parse the cyclical trends from the secular ones and proceed from there. As Anfield reflects upon the last half-year we believe that one of each – the cyclical Great Liquidity and the secular estrangement between the financial and “real” economies – has defined markets and the global economy and will continue to do so in the coming years.
Late last month, the International Monetary Fund downgraded its US growth forecast in response to President Trump’s failure to deliver a job-friendly fiscal policy.s if on cue, a lackluster auction of 10-year paper signaled inflationary expectations below the Federal Reserve’s 2% trigger for a third round of rate-tightening this year. At the same time, the Fed has made clear its intention to begin disposing of its enormous stock of bonds accumulated since the 2008 financial crisis, an operation that has profound consequences for debt markets.
Still, major stock indices continue to soar. While we forecasted early this year that share prices had room to run we failed to anticipate the political entanglements that have ensnared the President’s fiscal agenda. Nor does investor insouciance in the face of mega-asset valuations, together with the uncertain outcome of the Fed’s high-wire act inspire much confidence. The skeletons of the dotcom and bundled-asset bubbles are fairly rattling in their closets.
Herein lies the disequilibrium of our age: While investors are happy to chase equity prices to vertiginous levels, thanks in part to the Fed’s easy-money program – itself the by-product of an asset bubble’s explosive aftermath – they are less inclined to invest in infrastructure projects and enterprises that could accelerate economic growth. As a result, inflation remains stubbornly slow, which along with a weaker dollar complicates the Fed’s desire to lighten its $4.5 trillion balance sheet. Until this conflict between fiscal and monetary policy is reconciled so too will Wall Street remain the tail that wags the Fed, (more tail risk, as if it were needed), and the economy will continue to underperform.
The tensions between cyclical and secular trends are also evident within the economy itself. Take chronically depressed productivity rates, which Promontory highlighted in January. As the dean of macroeconomic commentary, the Financial Times’ Martin Wolf wrote last month, fifty years of record US productivity gains peaked in 1970 after returns on such transcendent inventions as the light bulb, gas heating systems and home appliances entered their prolonged diminution. The rebound of productivity that coincided with the dawn of the internet lasted little more than a decade, in part because of weak investment following the financial crisis, but mostly because the digital revolution failed to match the hype. As venture capitalist Peter Thiel famously put it: “We wanted flying cars. Instead we got 140 characters.”
High productivity is a vital tonic for long-term growth. If rates are to be restored to pre-1970 levels, capital must be deployed for investment in technologies that promote efficiencies that also create stable jobs and living wages. Sadly, as we have been reporting since April, the rate of new loan growth – in particular the all-important Commercial & Industrial space – has slipped to historically low levels and shows no signs of reversing themselves. A year ago Fed Chair Janet Yellen appealed to federal and state governments to meet the need for capital investment, but they were just as debt-ridden and revenue-challenged then as they are now and the void remains unfilled.
Meanwhile the US ranks second among developed countries that reported flat or falling income levels, another secular trend that gives us pause. Cyclically we hope to see stronger performances on a variety of fronts, including factory orders, inventory rates, household spending and new-home starts. The amalgamation of debt – from the aforementioned public borrowing to auto and student loans – warrant attention.
Overseas, European share prices are riding what appears to be a late-cycle bounce and catch-up rally. However, we are careful not to confuse this with a secular event absent a fundamental overhaul of the European economic model. Brexit fever appears to have broken with the election in May of the reformist Emmanuel Macron as France’s new president and we hope he can redeem his pledge to relieve the economy of an over-weening state and extortionist unions. Emerging markets should continue to benefit from an expanding global economy despite a weak dollar. China remains an unsinkable beach ball despite unplumbable debt levels and we will watch closely for signs of political or labor unrest.
That leads us to geopolitical risk. In our annual outlook this year we cautioned that armed conflict between Washington and its Cold War adversaries was inevitable so long as the US refused to parcel out its hegemony over Asia and Europe to its (now rich) allies. In June, North Korea launched a missile that, if suitably armed, could deliver a nuclear attack on the continental United States. In response, the White House imposed sanctions aimed at disrupting Pyongyang’s commercial relations with China and staged joint US-South Korean military exercises not far from the peninsula’s military demarcation line.
China, which for centuries lorded over the ancient Korean kingdoms as tributaries, regards Pyongyang as a guarantee against further US encroachment on its Northeast doorstop. In that way Beijing’s interests clash with American efforts to topple the North Korean government as a senior Trump official recently suggested was a US objective. Given the failure of previous sanctions to undermine the regime, let alone its nuclear program, and absent support in Washington for a genuine diplomatic solution to the crisis – i.e., negotiating an end to the Korean conflict and establishing formal ties relations with North Korea – the prospect of a second peninsular conflict cannot be overstated. Despite this, investors have all but discounted the attendant risks.
We began the year confident that the White House would by September have redeemed its commitments to entitlement and tax reform, infrastructure spending and deregulation and that the energy of those efforts would power the economy to robust levels. Needless to say, those hopes have fizzled. Unlike some investors we are not inclined to ignore political and geopolitical factors in our projections and we are proceeding with caution.