Is the ISM index a bubble?

The ISM index for the manufacturing sector is, in August, at its highest since May 2004. It was then at 61.3 versus 61.4 in May 2004.
The reading of this index is puzzling for different reasons
1 – Since 2011, the average growth in the US is 2.2% but the trend was 2.7% between 2000 and 2007. But the ISM index was, on average, higher since 2011 than before the crisis. Its average was 54.1 from January 2011 to August 2018 but only 52.1 from January 2000 to December 2007. A higher ISM index doesn’t not reflect a stronger growth momentum. We can see that also when looking at the manufacturing production index. On the same periods, the annual growth rate was 1.8% from 2000 to 2007 but 1.15% from 2011 to July 2018.
In other words, the index is higher than in the past while growth is lower. 
2 – There is a robust index calculated by the Federal Reserve of Chicago. The CFNAI (Chicago Fed National Activity Index) is the synthesis of 85 indicators (industrial production, employment, personal income,….). It’s reading is easy with an average at zero and a standard deviation of one.
The CFNAI is an accurate measure of the business cycle based on observed variables. Usually the two profiles are consistent as the graph shows.
Recent data show a persistent divergence between the two. The CFNAI is close to 0 while the ISM is at a high historical level. It is probably too high giving a wrong signal of the US growth strength.ismcfnai-summer2018.png

The Fed’s strategy, the dollar and the emerging markets

The Fed’s meeting today is an opportunity to show the dramatic monetary policy divergence between the US central bank and the ECB and the risk for a stronger greenback.
The first graph shows the gap between monetary policies’ expectations in the two countries. The measure here is the 2 year rate in 1 year. The time scale begins with the Euro Area inception in 1999.
The divergence between the two central banks’ strategy has never been so important. It’s a strong support for the US dollar which will continue to appreciate and it’s a source of risks for emerging countries. The strong probability of a US tighter monetary policy in a foreseeable future will support capital outflows reducing liquidity on these markets. MPexpectationsdetail Continue reading

The flattening of the US yield curve is a source of concern – This time is not different

Jerome Powell said that the yield curve flattening was not a source of concern and that it wasn’t showing a risk of recession as the economy is following a strong trajectory.

This point of view can be challenged for at least two reasons

1 – A negative yield curve (10 year rate below 2 year rate on government bonds) has always been a signal of recession with a lead of 18 to 24 months. The following graph is clear. Each negative yield curve is followed by a recession with a lag. The current spread is lower than 30 basis points, almost one increase of the fed funds rate.

We expect this yield curve profile for the end of this year due to the tighter monetary policy and therefore we have a strong probability of recession for 2020.

2 – The yield curve flattening reflects higher short term rates and no strong expectations on the long duration side showing that investors do not forecast a bright and strong future.

The tighter monetary policy means that the funding of the economy will be constrained for consumers and companies. We’ve seen recently that companies’ debt (as % of GDP) is at a record high and that consumer credit is still increasing rapidly. The impact of higher short term rates will be negative for both of them.

On the real estate market, around 50% of the financing is coming from brokers whose funding is linked to short term rates. For them too the situation will dramatically changed.

Moreover, an expected tighter monetary policy has provoked higher mortgage rates which will be damaging for households as real wages are no longer creeping up.

The argument saying that “this time is different” must be related to the discussion Reinhardt et Rogoff had in their famous book “This time is different”. Investors always think that the situation, at the moment they live it, is different from what was observed in the past with same type of signal. Reinhardt and Rogoff just say that it is not different on financial markets. An unbalanced situation must be adjusted. Current sources of “this time is different” argument are based on the neutral and non observable long term rate and also on the Fed’s balance sheet operations that have an impact on long bonds through the Fed’s reinvestment of their portfolio proceeds

In other words, the impact of higher short term rates will be negative on the US private sector and could be the source of the expected lower momentum on the economic activity. It it just the impact of a tighter monetary policy as we’ve always seen it in the past. This time is not different.

A discussion of Jay Powell’s speech at the congress can be read in the following FT article

Corporations Are Investing In Stock Buybacks That Don’t Pay

The Trump tax cuts were supposed to trigger a boom in business investment and wage growth. Instead, corporations are plowing record amounts of money into stock buybacks that don’t even reliably increase their share prices.
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China – US: the battle is just beginning

Donald Trump’s threats to world trade are a desperate attempt from the US to maintain the country’s world economic leadership. The most dramatic shift over the past 20 years has taken place in China, as the country has displayed stellar growth and now accounts for an increasingly large percentage of the world economy.

China has been one of the big winners from globalization, as citizens have enjoyed an impressive surge in income to the detriment of the middle and lower classes in developed markets, as shown by Branko Milanovic’s famous elephant chart. This chart also goes a long way to explaining recent political events in western countries: the middle classes across the board have ended up in a more unstable situation than 10 or 20 years ago, and this has major consequences for the way they vote.

The industrial momentum that very swiftly pushes up income is now the preserve of Asia, and China in particular. Industrial output across the US, Japan and Europe – the three major areas that drove world growth after the Second World War – has stagnated over the past ten years, while figures in Asia (excluding Japan) have doubled. The “Made in China 2015” plan seeks to further accelerate this shift.

This contrasting industrial momentum now comes firmly down on the side of Asia and acts as the focus for Trump’s trade measures against China. Output is no longer increasing in western countries, but rather in Asia, driving the region’s catch-up trend and reducing developed countries’ headway. The US is seeing its leadership diminish, while at the same time the situation also raises major challenges for Europe, although it has not taken the same aggressive course of action as the White House. Furthermore, the industrial revival in developed countries often referred to as “Industry 4.0” only seems to involve the substitution of existing production, rather than a true jump in production volumes. For the moment, this so-called revival is not sufficient to point to a reversal in the aforementioned trend towards the location of production in Asian countries. Continue reading

Fed:+25 bp

The Fed has raised its main rate by a quarter-point. It is now in the range of 1.75-2%. Explanations are the strength of the business cycle and inflation close to the Fed’s target. Projections still suggest two rate increases in 2018, 3 in 2019 and 1 in 2020.

This is consistent with my forecasts but will lead to a flattening of the curve and therefore a higher probability of a recession in 2020.