I had the great honour and privilege to speak at the 20th anniversary of the Seoul International Finance Forum last week. In a nutshell, I said what I had been saying in this space for the past years, namely that US economy and labour market aren’t as strong as everybody would love to believe, and that the Fed would eventually come around and change their monetary policy course as it did in December. I didn’t get the sense that people were outright opposing my thesis.
I did however also suggest that Q1 growth numbers might come in disappointing before their release on Friday night. Boy, did I step into it, or at least it seems like that… The headline GDP growth figure measured up to 3.2% annualised, a bombastically strong number despite seasonal effects and the government shut-down earlier in the year. Wall Street celebrated and pushed the equity indices to new all-time highs yet again.
Was I dead-wrong, and do I finally need to go back to the drawing board and rethink my proposition? Well, as I pointed out at the conference, you have to look behind the curtain before doubting yourself and throw in kitchen sink. The truth, as it can be revealed to all of us, is a little more complicated. When checking on the most important aspects of the GDP composition, as in fixed asset investments and consumption, you will find that they were the weakest in years.
The stock market may have jubilated, but don’t bet on share prices to tell you the whole story. Rather, you should mind what the Treasury curve is doing to get the essence of the message. And bond yields fell on the news, quite hard for that matter. In other words, there is a contingent of investors out there who wouldn’t touch the Q1 numbers with a stick. They remain on the track of caution, and their scenario is that the Fed will more likely than not lower interest rates later on in the year.
Like me, they forecast a weaker growth scenario moving further into 2019 and 2020. Who is to blame them, really? Retail sales have been clocking up ever weaker numbers month by month. How is this possible if the labour market is allegedly on fire and wage growth is intact? Well, it should not be. Low-skilled and low-wage job creation has limits in an economy that prides itself to be geared toward intellectual property, and so have the moderate gains in wages.
If you excluded intellectual property, business investments would actually be flat. It is a clear response to the Trump trade war, as in companies are not taking the risk of going all-in on global supply chains. And no, that trade war will not be resolved in one statement. It is likely to be here to stay. So, there is a shortage of investments in hard assets that seems to be overcompensated by a splurge of funds flowing into software and related services.
You see the contradiction here? Didn’t Donald Trump pledge the revival of the industrial base in America? This is becoming a lop-sided result and not a healthy one to begin with. As I suggested at the conference, the only way for the administration to get on course is a massive infrastructure program, something that had been promised during the first campaign but can now only be delivered on experimenting even further with the money printing machine, as all the fiscal room has been taken by the tax cut.
Residential investment has been negative for over a year, and there is no impetus on the horizon that could change that. This is particularly remarkable in light of the continuing low mortgage rates. There is more research to be done with regards to what the detailed numbers are telling us, as in single- versus multi-family homes, and whether the phenomenon of changing demographics is giving us further heads-up. In any case, those numbers have been disappointing and aren’t reflecting nominal Q1 growth.
But then, where is the expansion coming from? Well, we mentioned intellectual property which admittedly is a key driver but had not fully been counted as GDP until recently. Apart from that, net exports were strong, but against the background of Trump pushing China and the rest of the world on their trade balances with America, this could easily be a temporary phenomenon whereby leaders of export-heavy economies will tweak everything to make the numbers work for the sake of closing new trade deals.
Inventories made up a large chunk, but is this a good thing? One, they are traditionally very volatile readings and can hardly be relied on as the pillar of a great year. And two, a rise in inventories in a weakening economy may just make up for and reflect falling sales. The rest emanated from state and local government investments which, in the financial state that most of them are in, is likely to be temporary yet again. And that’s it. That’s what the nominal 3.2% is composed of.
It should therefore not be seen as a surprise that the bond market visibly errs on the side of caution and prices in downside risk. I raised the issue of the yield curve in Seoul, something that had not even been talked about when I started pointing the finger earlier last year but is now dismissed by the punditry and the Fed itself as hardly relevant. History tells us it is very relevant though, has in fact been telling us six times in modern history when a flat or inverted curve heralded economic stagnation or a recession.
In summary, if you want to get this picture right, I can only advise not to run with the stock market crowd. Stick to the bond market, and you are in good hands. It will tell you with a lot more precision where that economic journey will take us.
