Overcapacity

Another week begins, and it's hard to figure out what the talking points may be for the next few days...err, scratch that.  Focus will clearly be on the twin central bank announcements on Wednesday, with expectations reasonably high that the BOJ will deliver something, be it more negative rates or even a reverse Twist (call it the Electric Slide?)  However, given the BOJ's history of confounding market expectation, it seems reasonable to expect that someone, somewhere will be surprised.

Not so, of course, with the Fed, who have failed to deliver a single rate hike that wasn't mostly expected in the last 22 and a half years.   With the market currently pricing just an 8% chance of a move on Wednesday and recent activity data almost uniformly awful, the question is not whether they hike or not this week, but how much of a hint they give that December is still a possible or even likely option.

There was a lively discussion in the comments section on Friday's post about the impact of ZIRP/NIRP on inflation, with a few commenters seeming to accept the central bank argument about optimal real rates and the beneficent impact of ultra low policy rates at face value.   One commenter, on the other hand, proffered the argument that ultra easy policy permits the ongoing development of businesses/capacity that would be uneconomic at higher hurdle rates, thus permitting a capacity excess that keeps output prices (and thus inflation) low.

Macro Man has a great deal of sympathy for this view, and not just because it corresponds to his own way of thinking.   For one, there appears to be some empirical (or at least anecdotal) evidence to support it; in May, Macro Man linked to a Bloomberg story quoting the head of Maersk, who noted that accommodative policy allowed questionable shippers to remain afloat, thus depressing prices.   It is possibly a coincidence that this has been Japan's modus operandi for the two decades in which the country has been embroiled in deflation...then again, perhaps not.

Another link in this particular chain is that allowing unproductive firms and projects to remain alive would tend to reduce.....productivity.  Macro Man designed a simple indicator to partially test this hypothesis.  Long time readers may recall that one of Macro Man's favourite economic charts is that of US industrial capacity, particularly the large increase in the late 1990's that pushed the level way above trend and has resulted in a secular reduction in capacity utilization ever since.  Not coincidentally, this has also occurred at the same time that inflation has trended substantially lower.

Anyhow, Macro man created a simple indicator where he took the 10 year sum of the difference between monthly manufacturing capacity utilization rates and 80, which historically has been something of a boom/bust line.   He then compared this rolling sum with 5 year average manufacturing productivity growth.  Although the high frequency data is quite jumpy, when smoothed like this there does appear to be a decent relationship between trends in capacity and those in productivity.   Currently there is a large degree of overcapacity, which appears to correspond to the steep decline in productivity.


Now, perhaps this relationship is merely coincidental.  Yet Japan provides a wealth of anecdotal and empirical evidence that the dampening of Schumpeterian creative destruction does little to foster growth or kindle inflation.   Unfortunately, the US and Europe seem to be well on their way down the same path.

Finally, a brief word on risk parity.  It's no wonder that some of the wolves are circling given the performance of the past few months, as exemplified by the AQR risk parity fund:



However, before we worry too much about forced liquidations and the like, shouldn't we maybe wait until these strategies have at least drawn down half of their year's P/Ls (P/Ls, mind you, that crush most of the actively managed strategies out there.)

Macro Man has no great love for many of the largest proprietors of this strategy, but he's pragmatic enough to realize that the chart above hardly screams "the world is coming to an end", now does it?
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Anonymous
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September 19, 2016 at 9:53 AM ×

Different sectors may be at different part of cyclical (secular?) capacity utilization, though. As demand for labor grows in one sector, it should attract workers from declining/stagnant sectors, and eventually feed into higher wage growth and inflation regardless of the amount of excess capacity overall.

Anecdotally there are more than a few men who moved from declining industries (workshop, machinery) into health care where they earn as much when temporary lay offs are taken into account, with just 1-2 years education, with close to 100% employment and 3-5% annual wage increase.

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scepticus
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September 19, 2016 at 9:59 AM ×

Looks like the inflection point in the over-capacity chart is about 2001, which is more or less the same point at which the total energy consumption for the US changes from a rising to flat (https://www.eia.gov/totalenergy/data/annual/pdf/aer.pdf, Fig 1.1 . Its the same story in the UK, no real increases in energy consumption since circa 2000. I imagine there is a good chance the two are related. In fact they must be, because where else does productivity ultimately come from?

Of course given population growth, flat total energy consumption translates to declining per capita energy consumption.

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12yo HFM
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September 19, 2016 at 1:50 PM ×

World's biggest equities bear calls for Dow 100K !!!
http://www.marketwatch.com/story/dow-100000-it-could-happen-says-one-of-the-stock-markets-biggest-bears-2016-09-14

I've always thought of Mr Faber as a pleasant and intelligent fellow. Following his sage advice I will maintain my long US equities position as we head back up to ATH's. I have a feeling this is gonna be a 'mega-trade', so if those betting against me wish to borrow some funds for their margin calls, feel free to DM me. Peace.

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abee crombie
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September 19, 2016 at 2:11 PM ×

Nice post MM, cant agree more with the Maersk situation, though that might be an outlier example of a relatively open industry with big risk takers making long term decisions at the height on China-mania. But it serves the point. My take is that you need to stimulate the Shumpterian creative destructive forces, and you do that by juicing the equity markets, who allocate capital (supposdly) to those who can provide the highest return. For sure there is a little bubble in Silicon Valley, but it is still the envy of the world, and as I pointed out before, Tech has been the main leader in US Equity markets for the past several years.

On the issue of over capacity, Germany running an insane 9% Current account Surplus. If they are going to vote out Merkel and Trump is gonna win (looking likely now) outlook for Global trade cant be good. So at least that might stop some of hte overcapacity.

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wcw
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September 19, 2016 at 2:58 PM ×

@MM, does this mean we've punted on the Neofisherists? Let's hope so.

On capacity, as before I founder on the mooted mechanism and absent supporting data. Raise rates, small transfer to depositors and floating lenders from banks and floating borrowers. Commercial paper and mortgage rates are now up. This reduces credit demand, as would seem a necessary condition for reducing capacity, and that slows economic activity.

The more I think about this, the more it looks like Hayekian liquidationism. We tried that under Hoover and Mellon, you may recall. It did not go well.

Since I know that folks here are too smart to argue in favor of liquidationism, I must have something important wrong here. What am I missing?

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Macro Man
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September 19, 2016 at 3:09 PM ×

Well, I think part of the fallacy is that he current allocation and price of credit reflects supply and demand. There are a number of non price factors that are determining the allocation of credit, most notably regulatory issues. So why yes, I would agree that higher yields might reduce the demand for credit, I don't think it would necessarily significantly impact the allocation of credit, which isn't reflective of demand.

Re liquidationism, I think it's a bit of a straw man to suggest that the only two options are zombification and total liquidation. At extremes, neither work. Given that we are much further towards the zombie extreme at the moment, some movement towards the center is desirable IMO.

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Leftback
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September 19, 2016 at 3:30 PM ×

BoJ show front and centre this week now that the market has decided the FOMC will stand pat.

So many times we say that it is easier to trade the reaction to these events than the event itself. Unless we see outsize moves in something or other we think it wise to hew to the hammock, but with a few OTM puts in case of major CB mis-steps.

The logical move for both the BoJ and FOMC this week would also seem to be: nothing. Another mini-wave of vol selling and squeezing will surely follow, and then we can begin again to assess the "investing" landscape.

We still like the USD going forward, not on the basis of the Fed hiking, but in view of the likelihood of tighter conditions in emerging markets that typically lead to a dollar short squeeze.

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wcw
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September 19, 2016 at 3:32 PM ×

Huh. Let me restate, then please correct what I have wrong:
A credit is insensitive to demand due to regulation, resulting in
1 financial repression of depositors and lenders
2 zombification of uneconomic actors
3 weak aggregate demand, overcapacity, low productivity growth
B raising rates in this environment is beneficial
1 eases financial repression above
2 forced uneconomic actors out
3 aggregate demand improves, capacity shrinks, productivity rises

Did I get this right? What sort of data sets can we examine to test any or all of these?

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Anonymous
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September 19, 2016 at 5:08 PM ×

@anon 9:53 AM

Please let me know what those occupations in the healthcare industry are. I need a backup plan if my bet on market does not pan out this year.

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Mr. T
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September 19, 2016 at 5:16 PM ×

I think the trick of the week for CB's is going to be a walking up of long term inflation targets. A bump from 2% to whatever means the curve gets steeper, financials can maybe make a buck, short end can get more negative without everything going to zero and it sends another strong message of letting things run hot. It's also consistent with the ideas that out-year breakevens are a self-fulfilling prophecy - so you can harness that to create inflation? It also allows the "data dependent" fed to move the goalposts again and get the "have you seen the CPI...?" crowd off their backs.

In a bit of a bookkeeping note, as I at least value the other opinions and stances here, Im out of all of my oil/gas/iron/commodity names. We all have our canaries in the coalmine and at least for me they are pretty much all dead now.

I, for one, cannot follow the majority of the comments lately.

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abee crombie
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September 19, 2016 at 6:46 PM ×

Mr T. I sold my oil stuff, though keeping MLPs for longer term. And a small position in POT.

On Gold, still have a small long term investment. Dont see the need to sell as I keep it for strategic portfolio reasons. Insurance on a bad outcome in monetary policy seems like a decent thing to hold a bit of.

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abee crombie
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September 19, 2016 at 7:15 PM ×

Speaking to active management, I have always found Thomas Lee’s market insights to be net worth-changing; first, as J.P. Morgan’s Chief Investment Strategist, and now at his own firm (Fundstrat.com), where he currently makes a compelling case for buying the recent pullback. He writes, “Has our conviction changed about markets staging gains into yearend (YE)? No. Since 1940, to gauge what stocks do between 9/15 and YE is simply look at YTD performance. When stocks are up 5% or better, they rally into YE 87% of the time (90% when between 5% and 20%). In other words, we believe this 3% pullback NEEDS TO BE BOUGHT aggressively.” -- Jeff Saut

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washedup
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September 19, 2016 at 7:16 PM ×

Mr T - do you really think moving the target higher will actually steepen the curve? Color me skeptical. That idea is based on the ability of Central banks to tolerate inflation with our raising rates as and when that situation arises - however, if they are also simultaneously engaged in QE and lowering long dated yields that way, its efficacy is quite limited. Plus, if low long term yields are bad for financials, they were also great for the rest of the market yes? So now financials will make a buck because they will be served a steep curve on a platter, and so will the rest of the 90% of the market? The correlation between long bonds and risk on is now fairly positive, FYI, but of course that could prove temporary.
Strange times.

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AB
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September 19, 2016 at 7:32 PM ×

WCW/MM

Do we have too much capacity relative to demand or too little demand relative to capacity?

It seems to me that the bottom 90% of households across economies globally have an extraordinary low share of GDP (income). Policies that benefit the lower 90% of households have a chance of helping growth and policies that hurt them do not. We papered over this problem for many years by extending debt to these households. Eventually more debt was extended than these households could service (some time before 2008). Once the demand from the unsustainable debt was removed we noticed how much damage inequality can do to growth rates. (Michael Pettis " Economic Consequences of Inequality").

I think if you can find policies that are progressive in nature and boost NGDP then it would be beneficial to implement them alongside increases in cash rates. For example, helicopter money payments by SSN with a rise in rates to 2%.

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12yo HFM
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September 19, 2016 at 9:12 PM ×

@abee: Thx for the quote. I've always thought of Jeff Saut as an intelligent & pleasant fellow.

"we believe this 3% pullback NEEDS TO BE BOUGHT aggressively" #STUDY

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Leftback
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September 19, 2016 at 9:19 PM ×

Another snoozer. Long end rates are absolutely becalmed for now, their direction this week will determine all else. A collapse in rates and another selloff in vol to the 10-11 range seems like one obvious way this could go. It's an old movie, "Janet Teases the Hawks", you can watch it over and over again and it always ends the same way.

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