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Why Consensus Is Wrong About 2015

By | economics, economy, statistics | No Comments

US GDP Forecasts: Mainstream Economists Will Be Wrong Again

You can’t fault positive thinking, but in economic and investment terms realistic expectations are the most valuable.

Back in January, I estimated that 2014 US GDP would be ~2.2%, far below Consensus which was thinking 3%+. Consensus has caught up and is now predicting 2.2% (down from 2.5% in May).

Turning to 2015, Consensus is again pie-in-the-sky hopeful at 3%.

Sluggish Inflation Today, Sluggish Inflation Tomorrow

The traditional and conventional view is that inflation drives economic growth by forcing producers to buy today before prices get more expensive. Inventory stockpiling boosts the economy.

Looking around, is there inflation and are producers stockpiling? The answer to both is a whopping no.

Some amount of wage inflation is creeping in as minimum wages grow and as labor continues to tighten. Businesses will sometimes bump prices opportunistically. Paul Krugman recently pointed out something that is actually useful and relevant to the 21st century economy. He said businesses that are local and don’t face competitive pressures are raising prices, like airlines and restaurants.

However most producers do face competition and they are not raising prices. Producer Price Inflation (PPI) for goods has been negative two months in a row. On a year-over-year basis, PPI is up a tepid 1.6%. What little inflation we’ve seen comes from food price hikes in the face of drought.

Low inflation has been the trend for over a year, stemming from less pressure to raise prices because margin pressures have eased in the face of low energy prices (thank you cheaper oil) and a stronger dollar. The strong dollar is lowering inflation expectations since the US has emerged at the cleanest shirt in the global economy.

Global Oversupply: The Real Reasons for Low Inflation

Producers are struggling for pricing power. The economy may be on better feet than at any time since the recession ended, but there is still a major supply glut. Chinese supply has overwhelmed demand, leading producers like Alcoa to close factories and steel makers to walk away from purchases. Many commodity prices are in free fall. So much for the super-cycle in commodities.

Manufacturing Capacity Utilization is a great way to evaluate slack on the production side of life. The Federal Reserve Board measures capacity utilization by considering how much production is possible and sustainable and how much is actually being utilized. It considers available labor and equipment, among other things.

Supply constraints point to inflationary pressures as well as demand trends. Buyers bid up prices when supplies are tight.

Capacity Utilization

The good news is that capacity utilization is at a cyclical high, indicating solid demand and some price strength.

The bad news is that capacity utilization remains below the peaks of the previous cycles. We are almost four months into the sixth year of recovery and still lagging the previous cycle.

This business cycle is continuing for a while and with it capacity will get tighter, which is good for producers. Although the primary reason for higher capacity utilization is that producers are expanding slower than the pace of demand growth.

This undermines the entire conventional expectation that inventory stockpiling should be happening – right now – and pulling GDP up with it. Listen to earnings calls and you’ll hear producers in the supply-chain complaining that their customers’ inventories are too lean.

It’s not true that inventories are lean, though. They are leaner than the 1990s but right about where they were in the previous cycle and higher than ever this cycle. Business inventory-to-sales are actually rising.

Business Inventory to Sales

If anything, inventories have grown too much. They have grown while sales have been flat. Some form of inventory cutbacks is likely in the 4Q as businesses right-size their capital.

Business Inventory to Sales Year to Year

The key point in all of this? Producers have sufficient capacity to meet end-user demand, which itself looks likely to soften a bit. Against this background, prices are not likely to rise much and growth will probably weaken a bit.

Semiconductor Sales: The Crystal Ball for 2015 Growth

Consider semiconductor equipment spending. Everything being manufactured either includes semiconductor chips or uses machines that require semiconductor chips. As such, expansion in production of any kind automatically translates into more semiconductor chips.

Semiconductor sales today are tomorrow’s industrial production. Right now, semiconductor producers are looking out and expecting minimal increase in demand.

Look at semiconductor factory expansion. While they are spending more on re-tooling capacity expansion is barely above 0%, about the same as this year.

Fab Equipment Spending vs Change of Installed Capacity

Semiconductor makers are migrating to a new technology and that’s causing massive spending. Despite significant growth in the auto and mobility (smartphone) spaces as well as general global demand for stuff, semiconductor companies see no reason to greatly expand supply.

All that follows other fundamental data points. Consumer spending is steady but relatively mild. Most new jobs in 2013 and 2014 have gone to secretaries and bartenders. Retailers expect organic growth only, and without Y/Y increases.

With demand cruising along at organic levels (low single digits), of course producers will expand cautiously.

Fed Actions Will Slow Growth

Retailers and producers are positioning for low growth in 2015. Earlier this year there was talk about an escape velocity, meaning weather had caused some near-term sluggishness from which the economy was poised to surge and get back to some higher level of growth.

This idea of some mean reversion to higher growth made no sense. Growth is mild because demand is mild. US consumers spend what they earn, and no more. The wage picture doesn’t reflect a surge. Global demand is slowing. Producers expect prolonged subdued demand and are keeping a lid on expansion plans.

Into a low-growth environment, now add in rate hikes. David Shulman, Senior Economist at UCLA’s Anderson School, recently reflected the consensus view when he said that rates will go up for good reasons; because of a strong economy.

That’s not exactly true. One could argue that a stronger economy is what’s enabling both the end of QE and the reduction in treasury borrowing. The absence of pressure to keep rates low is far from being the presence of pressure to boost rates.

It’s an important distinction. If the economy is actually poised to slow and real interest rates rise, GDP will drop fast.

Household Wealth Will be Hit

The first blow will be felt in the housing market. Housing has already entered a slower stage. July home sales fell 4.3% Y/Y. During the most recent earnings calls, homebuilders reported a drop in unit sales and banks aren’t stepping in to chase the marginal buyer and create some type of escape velocity. Wells Fargo CEO John Stumpf recently said, regarding loans to low-income borrowers and poor credit holders, “We’re just not going to make those loans.”

Prices will come under some pressure as inventory grows. More owners are above water and can sell. Into this slower growth market, add higher mortgage rates.

Beyond the housing market, the stock market won’t like the impact of higher rates on leverage. A hit to stock prices is a hit to household wealth, contributing to further slowdown in spending.

We are likely entering a period of disinflation where prices don’t rise. That’s great for consumers; not so great for producers.

Prologue to Recession

Without inflation and pricing power, without growth in demand, companies stop hiring and start firing. A rate hike hastens the advent of a recession.

Right now, jobless claims are at 14-year lows. That’s actually a sign that a recession is coming within 12 months because once claims hit bottom, they can only rise. A rise in claims is the turn in the wheel for the economic cycle as it begins to slow and then contract.

So take economic indicators, conventional wisdom and consensus estimates with a grain of salt. Realistic expectations are far more valuable than overly positive ones.

East Meets West: How the Valley Effects China

By | charts, data, economics, economy, statistics | No Comments

iPhone Sales: Evidence of Online Spending

Moneyball Economics visited a few local stores selling iPhones for the big, long-awaited iPhone 6 release. There were lines but not that deep and none reaching outside the store.  Wait times were no more than two hours. Photos of lines going around the block – like in NYC – reflect unusual circumstances, far from the norm elsewhere.

Apple Store Line

(photo source unknown)

The evidence was certainly not enough to drive the 6.5M figure being whispered for in-store sales. In this case, online sales become much more significant.

Apple hit the whispered 10M unit sales, about $5B worth. It’s hard to find any company that can expect $5B in sales for a week, much less $5B a year, and that’s just a kickoff for the smartphone holiday spending. This promises to be a $60B+ global event over the next few months.

It’s quite possible. A real iPhone release has been two years in the making (the iPhone 5 was a placeholder). A massive and loyal user base is waiting to upgrade.

China’s Struggle for Growth

The Chinese economy is in trouble. The domestic consumer economy is a pale shadow of the export economy, and exports are sluggish and slowing. According to the Port of Hong Kong, total exports grew 2% Y/Y on a rolling average basis, but August contracted (-3%) Y/Y.

Hong Kong Exports

The smartphone will push up the figures in the next few months, but not for long.

It’s hard to be positive about China’s prospects for growth over the next year. As an export-dependent economy, China has no reason to feel positive. The EU is tipping back into Recession. US demand for Chinese goods has matured. None of these things will be countered by growth in the emerging economies.

Surveys of China’s producers (Markit’s Purchasing Managers Index or PMI) indicate production is one cold breeze away from contraction. (Markit surveys 420 manufacturing companies each month.) Production is 50%+ of the economy.

Additionally, new products simply aren’t appearing fast enough. It’s a post-smartphone world. US and EU markets are saturated. The Chinese domestic market has a lot of growth potential, but the total global growth that Chinese manufacturers have been serving is slowing down. Replacing the production is critical to maintaining growth.

The promise of the next high-volume consumer product is centered on connected devices. The idea is that every smartphone owner will want at least two or more peripheral gadgets; glasses and a watch, at the very least.  These devices aren’t taking off though. Instead of a few billion smartphone users and billions of connected devices, we’re seeing a few million connected devices. Apple had to delay the release of their watches into 2015, causing some delay in pick-up. Samsung has theirs ready but sales have been puny at best.

Desperation and Distribution Channels

If Chinese companies can’t grow out of the slowdown, then they can expand out of it. Instead of manufacturing for other companies, many Chinese companies are looking to sell under their own labels and some are looking to move into local markets and participate in the distribution channel. This requires massive infrastructure investment and the payoff is not happening anytime soon.

Chinese manufacturers are starting to seek growth outside of their traditional areas of expertise. High tech companies now entering the ice cream space, for example.

Predicting this slowdown back in 1Q, SouthBay Research said that – despite official Chinese government assertions – some stimulus would be needed by Summer 2015. Indeed, the PBOC just stepped in with some big monetary help and it won’t be the last.

There’s a reason why Caterpillar expects sales to China to collapse (-10%). Global demand is slowing. At the same time, domestic demand has relied on the property bubble, and we all know how spectacularly it burst.

Capital Flight From China to the US

Faced with slowing global demand, a sluggish domestic economy, a collapsing real estate market and a seriously under-performing stock market, Chinese investors are looking for better performance. The US stock market is calling like an oasis in the desert.

While investments in gold have more downside risk and US real estate seems to be peaking, the US equity markets are liquid and seem to have gas left.

Alibaba is a juicy example of capital flight in action. The #1 company in China had the biggest IPO of all time. However Alibaba did not IPO in China and that’s serious loss of face. The likely reason is that important Chinese investors (insiders including government officials) could maximize their returns and, more importantly, keep the money outside of the reach of the Chinese government.

It will be interesting to watch the carrots and sticks the Chinese government puts up to slow capital flight.

Expect Stimulus to Combat Slow Growth

The housing market is crashing, pulling down domestic consumption. Look for some action here in the form of lower down payments or moves to lower interest rates.

Expect monetary stimulus in the form of extra lending.

With slower global demand, China’s consumers are the key going forward. The Chinese government will attempt to keep the yuan flat. A cheaper yuan helps exports but hurts consumers.

This is all good for US equities. A boon in Chinese demand will lead to greater US company sales and a flat yuan keeps the dollar-denominated profits stable (most US companies price in dollars to avoid the yuan trap but there is still exposure to a falling yuan and the erosion of dollar-denominated profits).

Normally a strong dollar is bad for the stock market as it reduces value of offshore profits, slows exports and moves money into alternative investments like bonds. However trends like a Chinese capital flight into the US equity markets will add some tailwind.

This all leads back to our anecdote about iPhone 6 sales. Growth in the mobile phone market is stagnant and other mobile device growth sluggish. The strongest company in China had the largest IPO of all time, but in the US equity market. The Chinese economy is in major need of a kick-start if it wants to keep up with the world.