Economy Evidence File

Nov18: New Economic Information: Indicators and Surprises
Why Is This Information Valuable?
Fragile New Economy: The Rise of Intangible Capital and Financial Instability” by Ye Li
The rising amount of intangible assets on corporate balance sheets that can’t be pledged as loan collateral has led to higher corporate prudential savings. However, this has also caused banks to bid up the prices of (and lower the yields on) risky assets in which they invest these funds (e.g., BB rated bonds). This is creating a hidden source of rising risk in the global financial system.
The Secular Decline in US Employment Over the Past Two Decades” by Abraham and Kearney
“Labor demand factors – notably import competition from China and the rise of industrial robots – emerge as the key drivers of employment decline. Some labor supply and institutional factors (increased disability benefits, higher state minimum wages, and increased incarceration rates) also have contributed to the decline, but to a lesser extent.”

The first conclusion echoes one reached by David Autor and his colleagues in their 2016 paper, “The China Shock: Learning from Labor Market Adjustment to Large Changes in Trade.”

These are significant findings that will further reinforce both rising conflict between China and western nations, as well as debates over appropriate domestic policies to address employment declines.
Superstars: The Dynamics of Firms, Sectors, and Cities Leading the Global Economy” by Manyika et al, McKinsey Global Institute
“We define superstar to mean a firm, sector, or city that has a substantially greater share of income than peers and is pulling away from those peers over time… Superstars exist not only among firms but among sectors and cities as well, although we find the trend most evident among cities and firms…

“Relative to their peers, superstars share several common characteristics. In addition to capturing a greater share of income and pulling away from their peers, superstars exhibit relatively higher levels of digitization… For firms, we analyze nearly 6,000 of the world’s largest public and private firms, each with annual revenues greater than $1 billion, that together make up 65 percent of global corporate pretax earnings. In this group, economic profit is distributed along a power curve, with the top 10 percent of firms capturing 80 percent of economic profit among companies with annual revenues greater than $1 billion.

“We label companies in this top 10 percent as superstar firms. The middle 80 percent of firms record near-zero economic profit in aggregate, while the bottom 10 percent destroys as much value as the top 10 percent creates. The top 1 percent by economic profit, the highest economic-value creating firms in our sample, account for 36 percent of all economic profit for companies with annual revenues greater than $1 billion…

“Over the past 20 years, the gap has widened between superstar firms and median firms, and also between the bottom 10 percent and median firms. Today’s superstar firms have 1.6 times more economic profit on average than superstar firms 20 years ago…Today’s bottom-decile firms have 1.5 times more economic loss on average than their counterparts 20 years ago, with one-fifth of them (a growing share) unable to generate enough pretax earnings to sustain interest payments on their debt.”

This analysis shows the extreme economic pressures on many business models today, which has implications for both future income inequality (which is exacerbated by the gap between superstar and other firms) and future growth in the real median wage. Both of these have additional implications for potentially intensifying social and political conflict.
In its latest extended Z.1 Release – Financial Accounts of the United States – the US Federal Reserve has substantially revised upward its estimate of the size of US public sector pension deficits, based on the use of an estimate of pension funds’ future retirement benefit obligations and the use of an appropriate discount rate, which is much lower than that used by most public sector (but not private sector) defined benefit pension funds.
Unfunded public sector pension liabilities are a major source of “hidden” public sector debt. Ultimately, they can only be reduced through either much higher investment earnings (which are unlikely in a highly indebted global economy characterized by declining birthrates and stagnant productivity growth), or increased employer pension contributions (which means either cuts in other program spending and/or higher taxes to support retirement benefits for public sector employees which are often much better than those realized by their private sector peers).

This is a highly significant move, as it signals that the Fed will no longer silently conspire with state and local politicians to, in effect, hide the true size of public pension debt, that will likely one day force either significant benefit cuts for public employees, and/or significant spending cuts and/or tax increases.

This will have further implications for the future ability of state and local borrowers in the United States to access credit markets to fund infrastructure investments.
IMF World Economic Outlook, October 2018 edition
The latest WEO’s conclusions are in line with our forecast conclusions.

“Growing debt is creating increased financial vulnerabilities in world economy…the possibility of unpleasant surprises outweighs the likelihood of unforeseen good news… With shrinking excess capacity and mounting downside risks, many countries need to rebuild fiscal buffers and strengthen their resilience to an environment in which financial conditions could tighten suddenly and sharply.”

“Beyond the next couple of years, as output gaps close and monetary policy settings continue to normalize, growth in most advanced economies is expected to decline to potential rates—well below the averages reached before the global financial crisis of a decade ago. Slower expansion in working-age populations and projected lackluster productivity gains are the prime drivers of lower medium-term growth rates.”
Special Report on World Economy” in The Economist
The Economist’s conclusions are consistent with our own and those in the WEO.

The world is “woefully unprepared” for the next recession…” Handling a bout of economic weakness used to be simple: the central bank would cut short-term interest rates until conditions improved. But in the aftermath of the global financial crisis rates around the world fell to zero, and the weak recovery that followed kept them pinned there.”

“Even the Fed, which has chalked up the most post-crisis rate increases, will almost certainly enter the next recession with a historically small amount of room to cut rates. In a downturn, central banks are likely to turn almost immediately to other tools used after the 2007-08 crisis, such as [quantitative easing]. But such tools are politically harder to deploy, and their stimulative effects are less certain…”

“Fiscal stimulus could pick up the slack, but mobilising government budgets to aid the economy will also prove a tall order. Across advanced economies the average government debt load has risen above 100% of GDP, up more than 30 percentage points from 2007. Debt in emerging markets has risen as well, from an average of roughly 35% of GDP to over 50%. Plans for large-scale fiscal stimulus were politically difficult to enact during the financial crisis, and will be harder still the next time around.”

“In Europe, any debate about government borrowing threatens to revive the disastrous political showdowns of the euro-area debt crisis. In the end politics may prove the greatest stumbling block to managing a new global downturn…Most advanced economies now have viable populist or nationalist parties, waiting to capitalise on the first sign of renewed economic distress. Many emerging markets have regressed as well. Nationalism and strongman tactics are in the ascendant.”

“Power in China is worryingly concentrated in the hands of one man, Xi Jinping. Thanks to Mr. Trump’s trade war, relations between America and China have become openly hostile.”

“In 2007 financial markets were primed for a massive crisis, but governments were able to draw heavily on their monetary, fiscal and diplomatic resources to prevent that crisis from destroying the global economy. Today the financial dominoes are not set up quite so precariously, but in many ways the broader economic and political environment is far more forbidding.”
Italy’s new leaders and budget could be setting up a renewed Eurozone crisis.
Because of its size, Italy potentially represents a much bigger problem for the Eurozone than previous crises in Greece, Ireland, and Portugal. Politically, Germany is also less willing to support Eurozone today than it was in previous crises. A crisis in Italy could thus could lead to a significant restructuring of the Eurozone – for example, the departure from the Euro of northern European nations with stronger currencies, which would allow the Euro to significantly depreciate, and thus restore the competitiveness of southern tier economies without forcing even more painful austerity and domestic restructuring of labor and produce markets.
Global Trends in Interest Rates” by Del Negro et al from the Federal Reserve Bank of NY

“Four main results emerge from our empirical analysis. First, the estimated trend in the world real interest rate is stable around values a bit below 2 percent through the 1940s. It rises gradually after World War II, to a peak close to 2.5 percent around 1980, but it has been declining ever since, dipping to about 0.5 percent in 2016, the last available year of data” …

“The exact level of this trend is surrounded by substantial uncertainty, but the drop over the last few decades is precisely estimated. A decline of this magnitude is unprecedented in our sample. It did not even occur during the Great Depression in the 1930s.

“Second, the trend in the world interest rate since the late 1970s essentially coincides with that of the U.S. In other words, the U.S. trend is the global trend over the past four decades. In fact, this has been increasingly the case for almost all other countries in our sample: idiosyncratic trends have been vanishing since the late 1970s. This convergence in cross-country interest rates is arguably the result of growing integration in international asset markets.”

“Third, the trend decline in the world real interest rate over the last few decades is driven to a significant extent by a growing imbalance between the global demand for safety and liquidity and its supply. This contribution is especially concentrated in the period since the mid-1990s, supporting the view that the Asian financial crisis of 1997 and the Russian default in 1998, with the ensuing collapse of LTCM, were key turning points in the emergence of global imbalances.”

“Fourth, a global decline in the growth rate of per-capita consumption, possibly linked to demographic shifts, is a further notable factor pushing global real rates lower.”

An important implication of these findings is that the persistent macroeconomic headwinds emanating from the financial crisis, including the effects of the extraordinary policies that were put in place to combat it, are far from being the only cause of the low-interest-rate environment.

Longer-standing secular forces connected with a decline in economic growth since the early 1980s also appear to be crucial culprits, even though these trends might have been exacerbated by the crisis.

The global nature of the drivers of low interest rates limits the extent to which national policies can address the problem.”
The Rise of Corporate Debt Must Be Managed” FT Editorial 31Oct18
A substantial amount of BB and BBB rated debt is now held in short-term vehicles (mutual and exchange traded funds) with high redemptions likely in the next economic downturn, which in turn would force fire sales and a sharp increase in rates. This would cause financial distress for many borrowers. As the FT’s Robin Wigglesworth wrote back in December 2017, “The Corporate Debt Boom Will Come to a Nasty End
The Student Loan Debt Crisis is About to Get Worse” by Griffin et al, Bloomberg 17Oct18
“Student loans have seen almost 157 percent in cumulative growth over the last 11 years. By comparison, auto loan debt has grown 52 percent while mortgage and credit-card debt actually fell by about 1 percent…there’s a whopping $1.5 trillion in student loans out there (through the second quarter of 2018), marking the second-largest consumer debt segment in the country after mortgages…More than 1 in 10 borrowers is at least 90 days delinquent, while mortgages and auto loans have a 1.1 percent and 4 percent delinquency rate, respectively…

Student debt has delayed household formation and led to a decline in homeownership. Sixteen percent of young workers aged 25 to 35 lived with their parents in 2017, up 4 percent from 10 years prior.”

The growing and as yet unresolved student loan problem in the US reminds us of Herbert Stein’s famous quote: “If something cannot go on forever, it will stop.”
Oct18: New Economic Information: Indicators and Surprises
Why Is This Information Valuable?

A Template for Understanding Big Debt Crises” by Ray Dalio.

Following Bridgewater’s deep dive into “Populism: The Phenomenon”, it’s Chair has published this equally exhaustive guide to debt crises. As a veteran of many of the ones described (e.g., the LDC crisis in the 1980s), I found it a very impressive work.

Dalio is clearly trying to prepare policymakers and investors for when the stock of outstanding debt reaches a critical “Minsky” threshold.
Claudio Borio is the head of the Monetary and Economic Department at the Bank for International Settlements. For years, he worked there with Bill White, who presciently anticipated the crisis of 2008.

In a 23Sep18 speech, Borio said that, “On the financial side, things look rather fragile. Markets in advanced economies are still overstretched and financial conditions still too easy. Above all, there is too much debt around: in relation to GDP, globally, overall (private and public) debt is now considerably higher than pre-crisis. Ironically, too much debt was at the heart of the crisis, and now we have more of it - although, fortunately, banks have reduced their leverage thanks to financial reform. With interest rates still unusually low and central banks' balance sheets still bloated as never before, there is little left in the medicine chest to nurse the patient back to health or care for him in case of a relapse. Moreover, the political and social backlash against globalisation and multilateralism adds to the fever. Policymakers and market participants should brace themselves…”
Indicator that, like Dalio, Borio and the BIS believe that the global macro system is approaching a critical debt accumulation threshold.
Federal Reserve Bank of Boston Conference on “The Consequences of Long Spells of Low Interest Rates”. Presentations highlighted the continuing reach for higher yields; increased defined benefit pension plan underfunding due to low liability discount rates and investment earnings; and changing institutional structure in financial markets (e.g., growth of credit hedge funds) have created new sources of system risk. Do we have sufficient policy tools to buffer impact of next crisis? Greater likelihood that zero lower interest rate bound will be reached in future, and limit effectiveness of monetary policy (like Abe’s experience in Japan). Also highlighted limited state/local fiscal policy buffers. Final observatioin was impact of low rates on the ability of retirees to obtain sufficient income (e.g., via annuities).
Clearly, the US Federal Reserve system is concerned about the accumulation of negative consequences of the extreme monetary stimulation that avoided a severe downturn after 2008. Perhaps more important is their worries about the lack of sufficient monetary and fiscal policy “firepower” when the next downturn (which could be accompanied by a severe debt crisis) occurs. As in Japan, that places more emphasis than ever on structural policy reforms, which are too often blocked by political gridlock.
A Failure of Responsibility” by Levin and Capretta (AEI)

As Debt Rises, the Government Will Soon Spend More on Interest Than on the Military”, by Nelson Schwartz, NYT

Avoiding [Sovereign] Debt Traps”, by Padoan et all, OECD Journal

Paying Off Government Debt” by Bryan Taylor (the options are austerity, growth, inflation, and/or default)
All of these highlight growing concern with ballooning US federal deficits and the underlying growth of entitlement spending (e.g., Medicare, Medicaid, Social Security) which is being financed via debt issuance, which, even with a relatively strong economy, is still causing a rise in the ratio of government debt to GDP.
New Federal Reserve Board research paper: “Measuring Aggregate Housing Wealth: New Insights From an Automated Valuation Model” by Gallin et al. Housing recovery hasn’t been as strong as repeat sales indexes suggest; also, metrics based on owner valuation estimates understate extent of housing value destruction.
Combine this with IMF research finding common monetary policies by leading central banks have led to a sharp increase in global synchronization of housing prices, which has exacerbated the potential negative impact of a global fall in housing prices.
Crashed: How a Decade of Financial Crises Changed the World” by Adam Tooze, and his Foreign Affairs arcticle, “The Forgotten History of the Financial Crisis” , “Ten years later, there is little consensus about the meaning of 2008
and its aftermath”… “How will a multipolar world that has moved beyond the transatlantic cooperation structures of the last century cope with the next crisis?”
Will wholesale funding markets hold up in the next crisis? The US Dollar has become an even more dominant currency since 2008, while foreign borrowing in USD has sharply risen. Fed swap lines could again be critical to prevent implosion of banking system in the next crisis – but with frayed political relations, will they work? E.g., At peak of Eurozone crisis, the Fed reopened swap lines. While European banks have disengaged from global financial system, emerging markets have increased theirs – including China’s shadow banking system.
The China - US trade war intensified in September. So far this only involves tariffs, but the potential for China retaliating by disrupting US companies’ supply chains remains.
Such a move could quickly trigger a financial panic in anticipation of a global recession of unknown severity. The US reaction to this is also another area of critical uncertainty.
In France, President Macron’s proposed structural reforms are running into growing political opposition. But they are key to increased growth in France and, through the power of example, across the Eurozone. In turn, higher growth creates the possibility for reducing class conflict and the attraction of extreme political views, as well as relaxing the currently difficult tradeoff between social and defence spending.
As noted above, given the limited monetary and fiscal “firepower” that will be available to policymakers in the next economic downturn (and financial crisis), structural reform will be a far more important policy lever than in the past for restoring economic growth. Yet there is great uncertainty about the willingness and ability of political systems in many countries to enact it
New Pew analysis shows US public pension fund’s shift to alternatives (hedge funds and private equity) is not paying off in higher net returns and improving funding ratios (pension assets as a percent of the present value of liabilities).

Also, “Lehman’s Legacy is a Global Pensions Mess” by John Authers in the Financial Times
The building public pension fund crisis, not just in the US but in other countries as well, is a classic “grey swan” – a future crisis that everyone can see, but nobody does anything about until it explodes. The essential problem is that due to a combination of higher promised benefits and longer lifetimes, public pension fund liabilities have continued to grow. To some extent, their true size has been disguised by the use of higher discount rates than private sector companies are allowed to use. Plan sponsors had hoped that shifting assets into risker investments would offset a significant percentage of this liability growth. As Pew found, this generally hasn’t worked. This leaves public sector plan sponsors and governments with an unpalatable choice between cutting government spending in other areas, raising taxes, or cutting retiree benefits. This choice will become exponentially harder in the context of a protracted economic downturn and extended low investment returns.