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?