US Economy: Four Deuces & a Joker. I was in Chicago and Toronto at the end of last week visiting our accounts. Almost all of us were in agreement on the outlook for the US economy, which means that almost all of us are nervous that our consensus outlook is too consensus. So we also talked about alternative scenarios.
The consensus scenario is “what you see is what you’ll get.” It is the Three Deuces scenario.
In our conversations, I raised the ante, adding a couple of scenarios as follows:
(1) Three Deuces. In the consensus view, real GDP should continue to grow at a sluggish pace around 2.0% y/y. Inflation is likely to be no higher than 2.0%. The Fed should gradually raise the federal funds rate to 2.00% by the end of next year (Fig. 1). That’s the Three Deuces scenario.
(2) Four Deuces. I added that if inflation remains subdued and if there is no boom, then there should be no bust for the foreseeable future. In this Four Deuces scenario, the unemployment rate, which is currently 4.4%, could fall below 3.0% toward 2.0%, though the lowest it has ever been in the post-war era was 2.5% during May/June 1953 (Fig. 2).
(3) Four Deuces and a Joker. In one of my meetings, with an account who invests mostly in bonds, one fellow pointed out that the US Treasury 10-year bond yield is another deuce card. When I was at that meeting in Chicago on Thursday, the yield fell down to 2.05%, the lowest reading since November 8, 2016 (Fig. 3). It’s been led back down recently by the comparable TIPS yield, which fell from 0.66% on July 10 to 0.25% on Friday, the lowest since November 9, 2016. Interestingly, the expected inflation rate for the next 10 years implied by the spread between the nominal and TIPS yields has been fairly steady around 1.8% for the past few weeks (consistent with the deuce card for inflation) (Fig. 4). Since there are only four deuces in a pack of playing cards, we agreed to call this the “Four Deuces and a Joker” scenario.
In a breakfast meeting with one of our accounts on Friday in Toronto, my guest suggested that the joke could be on the consensus view. Like most Canadian investors, he is very aware and knowledgeable about commodity markets. He noted that the jump in metals prices over the past year is telling him that a typical late-cycle boom may be underway. So he is on the lookout for big upside surprises in economic growth, inflation, and interest rates. In this scenario, stocks might continue to rise for a while. But this should all end badly by 2019 because booms always set the stage for busts. In his opinion, the business cycle isn’t dead, and is about to make a widely unanticipated comeback.
My response was that I don’t see an inflationary boom coming, but that his scenario is probably the most plausible contrary one out there right now. He asked me to be alert to signs that he might be right. I told him that my contrary instincts were already on high alert, and even more so after our breakfast.
Commodities: The Joker Is Wild. There is only one Joker in a pack. In my Four Deuces and a Joker scenario, the Joker is the bond yield, which has fallen from a high for this year of 2.62% on March 13 to 2.06% on Friday, with the comparable TIPS yield down from 0.61% to 0.25% over this period. My Canadian friend’s Joker is the price of copper, which has soared 19% over this same time period (Fig. 5). There are two alternative Jokers: North Korea’s deranged leader and our kooky president.
In other words, the Joker could be a deuce or a King. Or the Joker might be the Ace pilot leading commodity prices higher. I know: My metaphor just turned into a losing hand. Before I turn into a court jester, let’s have a closer look at the high-stakes poker game underway on the commodity tables:
(1) Copper & other commodities. The price of copper is one of the 13 prices included in the CRB raw industrials spot price index, and the two are highly correlated (Fig. 6). The metals component of this index—which includes scrap copper, lead scrap, steel scrap, tin, and zinc—soared 68% since it bottomed on December 17, 2015 to its recent peak last Tuesday, which was the highest reading since September 10, 2014 (Fig. 7). That’s quite an impressive rebound. It shows that the metals and mining industry restructured remarkably quickly when their prices tanked in 2014 and 2015. Now that the global economy is growing in a synchronized fashion for the first time since the recovery from the 2008 recession, commodity prices are soaring as robust demand is tightening up supplies.
(2) Commodities & the dollar. But there is more going on behind the soaring CRB raw industrials spot price index than just global synchronized economic growth. The inverse of the trade-weighted dollar is highly correlated with the CRB index, its basic metals components, and the price of copper (Fig. 8, Fig. 9, and Fig. 10). The trade-weighted dollar fell nearly 10% since peaking recently on January 11 through Friday to the lowest level since July 14, 2015.
Market Correlations: Lots of Wild Cards. Besides the breakdown of the correlation between the bond yield and the price of copper there have been a few other notable divergences:
(1) Copper and oil. From 2004 through 2016, the price of a barrel of Brent crude oil was highly correlated with the nearby futures price of copper (Fig. 11). So far this year, they’ve diverged significantly as the price of copper has soared while the price of oil has been relatively flat. The same can be said for the relationship of the CRB raw industrials spot price index and the price of oil (Fig. 12).
(2) The dollar and oil. From 2005 through 2016, there was a good correlation between the price of a barrel of Brent crude oil and the inverse of the trade-weighted dollar (Fig. 13). This year, the dollar has dropped 9%. Yet, instead of moving higher as suggested by the past correlation, the price of oil is down 5% since the start of the year.
Then again, some correlations are still working, such as:
(1) EMs and commodities. The CRB raw industrials spot price index bottomed on November 23, 2015 and is up 30% since then. The Emerging Markets MSCI index (in local currencies) bottomed on January 21, 2016, and is up 44.7% since then (Fig. 14). The correlation is even tighter when the stock price index is in dollars (Fig. 15).
(2) EMs and the dollar. There was a tight correlation between the EM stock price index (in local currencies) and the inverse of the dollar from 2001 through 2012 (Fig. 16). Then they diverged for a while, or at least didn’t move in tandem as they had, from 2013 through 2016. However, they’ve found their mutual groove this year as the EM stock price index rose 20.7% ytd, while the trade-weighted dollar fell 9% ytd.
So what’s the story? It looks like a global synchronized boom, according to the prices of basic metals and Emerging Markets stocks. The boom may be attributable to the windfall that users of oil are enjoying, as ample supplies have cut the oil price in half since 2014. The global boom isn’t inflationary so far given the weakness in oil, which has a much bigger weight in the S&P GSCI than other commodities. The weaker dollar is keeping a lid on inflationary pressures overseas. Here in the US, slow growth, political gridlock, geopolitical risks, and overvalued stocks have attracted bond buyers. All the above may continue to be a winning hand for stocks.
Mother Nature: The Wildest Card. On Friday, when I was in Toronto, Jennifer Lawrence was in the UK promoting her new film “Mother!” She suggested the devastating hurricanes in Texas and approaching Florida were signs of “Mother Nature’s rage and wrath” at America for electing Donald Trump and not believing in man-made climate change.
She must know what she is talking about since she is an Oscar-winning actress. In any event, a consequence of these disasters is that lots of homes will have to be repaired or rebuilt. The government is likely to finance some of this reconstruction since so few homeowners had flood insurance. This could boost economic activity in the US. However, there is a serious shortage of construction workers. That could boost wage inflation, though it is likely to be limited to the construction industry. Trump might have to beg Mexican construction workers to come back to the US after an estimated 500,000 of them went back home when the US housing boom turned into a bust in 2008. He may also need them to build the wall on their way back home.
The real problem in Texas and Florida is what they used to say in the TV commercial for Chiffon margarine: “It's not nice to fool Mother Nature.” If you want to live in areas that are prone to flooding, hurricanes, and tornadoes, perhaps you should be required to have insurance for such disasters, especially if you take out a mortgage.
According to a 9/10 article posted on Quartz, “Homeowners’ insurance does not cover damage to a home caused by flooding. A homeowner must have a separate policy to cover flood-related losses, defined as water traveling along or under the ground. Most such policies are underwritten by the National Flood Insurance Program, which is part of the Federal Emergency Management Agency (FEMA). The National Flood Insurance Program was established in 1968 to address the lack of availability of flood insurance in the private market and reduce the demand for federal disaster assistance for uninsured flood losses.”
Now technically, flood insurance is required in high-risk areas. According to an 8/29 Washington Post article: “Legally, homeowners in places that FEMA designates as ‘high-risk’ flood areas are supposed to have the insurance, but the rule isn't tightly enforced.” To us, it seems logical that the enforcement problem probably reflects owners allowing in-place policies to lapse more so than new home owners not getting flood insurance in the first place since many mortgage companies require it to obtain a home loan in risky areas. In any event, “the vast majority of people hit by Harvey weren't even in a high-risk flood zone,” a storm damage estimator was quoted as saying for the Washington Post article.
It’s too bad that homeowners (either in or outside floodplains) don’t see the value in the flood insurance until it’s too late. Usually that’s when a storm is brewing. Last-minute coverage isn’t available because of the 30-day wait period after a National Flood Insurance Program (NFIP) policy is purchased.
Generally, these policies seem relatively cheap for the coverage to protect one of life’s biggest assets, our homes. On average, the cost for a policy in Texas is about $500 per year, though it is higher in areas designated as floodplains. That typically covers around $250,000 for damages and $100,000 for personal property inside the damaged structure. In contrast, those who forgo the insurance might be eligible for aid from FEMA. But that could be just about $33,000 max. That’s all according to the article.
Interestingly, private insurance companies have hesitated to touch flood policies because of the potential for catastrophic losses. Indeed, according to the article, the NFIP is $25 billion in debt after Sandy and Katrina. That’s not even including Harvey, let alone Irma. The program is authorized to borrow only up to $30 billion, so that limit undoubtedly will need to be extended if more aid is to be provided.
Dr. Ed Yardeni is the President of Yardeni Research, Inc., a provider of independent global investment strategy research.
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