Red Flags

Just around the Corner? Maybe Not.

A very smart analyst joked yesterday that the Consumer Price Index is the new Nonfarm Payroll. Since the FOMC has made it clear that they are waiting for 2% inflationor perhaps Godotall eyes are searching for signs we might be getting there, so all price indexes are good fodder, especially the PCE, the Fed’s favored index.

The FOMC’s models have continually demonstrated a “just around the corner,” feature where, despite currently weak PCE measures, the expectation is that higher inflation would occur in the near future.
Unfortunately, a historical look at the broad components of this inflation measure belies their optimistic projections:

pce-log

Above is a logarithmic graph of the three components of the PCE price index: durable goods prices (in blue), non-durable goods prices (in red) and service prices (in green). Two key visual elements are apparent: durable goods prices have been consistently declining since the mid-1990s. Non-durable goods prices have been stagnant to slightly lower for the last 5 years. That leaves services as the only PCE price index component that can exert upward pressure.

Let’s look at the same data from a Y/Y percentage change perspective:

pc-yy

Durable goods prices (in blue) have been subtracting from price growth for the last 20 years. Non-durable goods prices (in read) have been declining since 2011-2012; they subtracted from PCE price growth for most of 2015 and only recently turned positive. Only service prices (in green) have increased PCE price pressures on a consistent basis.

There are several important lessons to draw from this data. First, the PCE price index looks at prices from a business perspective. According to the Cleveland Fed, “the PCE is based on surveys of what businesses are selling.” The above charts indicate that neither durable goods nor non-durable goods companies have any pricing power. Second, the Y/Y percentage change in service prices has been declining. Third, price growth for 31% of PCEs are either negative or very weak. That means the remaining 70% of prices would have to increase at a faster Y/Y rate to hit the Fed’s 2% PCE Y/Y inflation target. This runs counter to the second conclusion regarding service prices, that the y/y rate of change is narrowing.

Those trends mean the Fed cannot hit its 2% y/y target under the current circumstances.

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Risky Balance Sheets: IMF Confirms TLR Worries

For some time now, TLR has been pointing to risks in rising nonfinancial corporate debt levels – a sharp contrast with the deleveraging that has been going on in the household and financial sectors. In its latest Global Financial Stability Report, out this morning, the IMF confirms our worries, offering considerable detail on the nature and risks of increasing corporate leverage.

The IMF makes several points, among them:

• Even with a cut in corporate tax rates, many firms would be too cash-constrained to increase capital spending – which is the economic rationale for such a policy change. Three sectors in particular – energy, utilities, and real estate – which together have contributed almost half the capital spending among S&P 500 firms in recent years, would find it difficult to boost investment. “Perhaps more important,” writes the IMF, “cash flow from tax reforms may accrue mainly to sectors that have engaged in substantial financial risk taking,” like purchases of financial assets, M&A, and dividends/buybacks. Such spending, the Fund notes, has accounted for more than half of free corporate cash flow since 2012 (another risky practice we’ve been highlighting in our quarterly reviews of the Fed’s financial accounts).

• Despite high equity valuations, firms have chosen to buy their own stock rather than floating fresh shares, and have often been using debt to finance the buybacks.

• Corporate credit quality, as measured by weakening covenants and rating downgrades, has been deteriorating – and not just in the energy sector. Capital goods and health care are looking dodgier as well.

• Leverage ratios are rising as credit quality deteriorates. (See graph below. All graphs from the IMF report.) Median debt of S&P 500 companies is close to a historic high of over 1.5 times earnings – and it’s not just energy. A broader universe of 4,000 companies, accounting for about half of all U.S. corporate assets, is approaching levels last seen just before the global financial crisis.

screenshot-2017-04-19-1

• Despite low interest rates, debt service ratios have fallen dramatically, as shown on graph below. Interest coverage is less than six times earnings, a ratio below what we saw before the financial crisis, and on a par with what we saw in 1999, just before the dot.com bust. Should tax cuts lead to wider budget deficits (which are not terribly high right now) and higher interest rates, interest coverage ratios could decline further.

screenshot-2017-04-19-2

• You might think that a cut in corporate taxes and moves that would allow the repatriation of funds stashed in tax havens abroad might ease the situation, but the IMF warns against those comforting thoughts. As shown on the final graph, the 1986 corporate tax cut and the 2004 repatriation led not to a reduction in debt or an increase in capital spending, but an increase in financial adventuring. Were such measures accompanied by a weakening of financial regulation and oversight, things could get very bumpy.

screenshot-2017-04-19-11-57-52

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Revenue Reality Check

As we noted above, the yearly change in sales tax receipts in our survey is down to +1.1%, and the three-month moving average is running at +1.6%. Both are quite weak. The average since the series began in 2001 is +2.2%—and that includes the Great Recession. Take that out, and the average rises to 2.9%. Take out the months of the feeble recovery of late 2009 and early 2010, and it’s 3.3%.

The yearly change in revenue tracks well with the yearly change in core retail sales (that is, less autos, gas, and building materials). So far retail sales are holding up but will this continue? Maybe not: note how revenues appear to lag retail sales in the periods just before and after recessions. The pattern is especially striking in late 2006 and early 2007, as shown here:

TLR core

And it may be happening again, as the two series parted ways in early 2016. It’s certainly far from conclusive, but it’s one of several possible recessionary signs that struck us as we prepared a recent issue.

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Real Estate Headwinds

As we’ve noted before, the end of QE is taking its toll on a variety of frothy markets—not just the unicorns in the Silicon Valley. The high-end condo market in Manhattan is cooling substantially; sales at the 1,004-foot tower known as One57 have stalled, with 20 of the 94 of the units still unsold, according to the Wall Street Journal. And One57 was a pioneer of the super-high-end segment; newcomers are finding it a rougher go. There’s no evidence—yet—that this slowdown is trickling down to more modest dwellings. There’s a massive construction boom underway in downtown Brooklyn and the neighboring “cultural district” around the Brooklyn Academy of Music, and a lesser one underway in Long Island City, Queens, both areas that were never known for luxury in the past. The transformation of both neighborhoods have been dreams of city planners since the late 1980s; it’s taken a few real estate cycles to get there. So far, demand has met supply, but if you walk around either area, you have to wonder how long their developers’ luck can hold out. During the mid-2000s housing boom, people seemed to forget that rising prices calls forth rising supply, which eventually puts an end to a bubble; will New Yorkers soon find out that the rules of the heartland apply to them as well?

But it’s not just the end of QE—there’s also the cooling in China and the end of the commodity boom, which is reducing the supply of restless capital looking for a home. A friend of TLR who does real estate banking in South Florida reports: “Construction lending is getting very tight, even for luxury condos in glamor markets. Russian, Latin and Mideast oligarch demand has evaporated, and the Chinese flight capital ain’t enough to bridge the gap. Likewise with hotels. Next shoe to drop is luxury rental market.”

In the Fed’s most recent survey of bank loan officers, there was a modest tightening of standards on commercial and industrial and commercial real estate loans—not as harsh as our Florida correspondent reports, but still a headwind for those sectors, though more a breeze than a gale. Standards on loans to households, by contrast, were modestly eased.

 

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Manufacturing Taxes in the MIdwest

One of our state revenue contacts in a classic midwestern manufacturing state–cars!-tracks withheld receipts flowing in from the manufacturing sector in his large state. He, and we, use withheld receipts because they are tied to ordinary wages, and bonuses, not to non-wage income, which is so noisy that we once heard an official at the Congressional Budget Office (CBO) remark that it’s a waste of time and tax dollars to try to project that stream out more than a year. Manufacturing is an important part of the current expansion, and we’re watching this stream carefully.

Of course, these receipts are reported as growth over the year and so are facing a tougher bar because of the recent recovery, but this is one of the reasons he describes his current outlook as “cautious.”

man empl

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