In Europe, equity markets worry that there is no growth – fear of inflation has disappeared. In the US, equity investors are uncertain whether the problem ahead is slowing growth or rising inflation. I reckon growth won’t be a problem in the US this year. But, ironically, that will be a big problem for investors since it will deflate asset and debt bubbles as interest rates move much higher than expected.
Why will rapid growth be bad news for investors? First, higher inflation in the US will raise the nominal and real cost of capital, making the cost of servicing debt mountains unbearable. Second, that will promote a further precipitous fall in the dollar that would have much the same effect. Third, rising debt costs could cause an exogenous shock to the financial system, such as a major bankruptcy.
Dog dollar
Higher inflation would have several impacts on financial markets. It would suppress risk appetite and increase volatility. US and European financial asset performance would decouple (as inflation became a mainly US trend). Equities would suffer from rising capital costs, disappointing profits and reduced risk appetite. Bonds would be hit by higher inflation and, in many categories, reduced risk appetite. The dollar would be a dog.
Inflation in the US is not yet that high, at about 2.5%. However, it is rising. I reckon it will go well over 4% in the next 12 months. Even if the yield gap between US treasury 10-year bonds and three-month rates flattens, bond yields will still go over 5%. That will cause the credit bubbles in US consumer borrowing and mortgages to contract.
Just at the moment, when many are talking of a ‘soft patch’ in the US economy and very weak expansion in Europe and Japan, do I think economic growth will continue at a healthy pace?
It will, not least because the doughty US consumer is not yet dead. The American shopper has contributed the lion’s share of world growth over the past 10 years and there is no sign that US households are finished yet. Even after the May interest rate rise the Federal Reserve has not really tightened much. The real Fed funds rate is, at 1%, still well below its historical average of 2.5%. So mortgages and borrowing are still very cheap. And US taxes are still not a major burden on household income. So the US consumer is not feeling a squeeze from any of those quarters.
Second, household income from work is rising strongly, with the job market buoyant, as the recent monthly payroll figures indicated. Finally, the housing market remains strong, with prices and transactions at record highs.
But more growth means more inflation. And that’s why things will start to go wrong. First, US labour productivity gains are declining and unit labour costs are rising. The decline in productivity is being caused by two factors: the advanced state of the US economic cycle compared with Europe’s and Japan’s and the waning of New Economy productivity benefits. The tightness of the US labour market should ensure that unit labour costs continue to rise faster in the future – and certainly faster in the US than in Europe or Japan.
Second, US commodity and oil inflation is 40% to 60% worse than in Europe and Japan because of the weak dollar and energy waste. With high oil and commodity prices here to stay, inflationary expectations will be raised.
Corporate pricing power
Third, capacity utilization in the OECD has now risen to levels that demonstrate that the excess investment of the dot com bubble has been worked off. Capacity utilization is now at a level that must restore pricing power to corporations. All the evidence is that US corporations are now maintaining profits and profit margins by charging their customers more.
Both slowing productivity and rising costs are working to generate inflation. And corporate pricing power is capable of making it happen. So the fatal inflationary mechanism is in place in the US.
What if I’m wrong and the US consumer stops spending and starts saving? In that case, US inflation will probably still rise some more, but growth will be low and equities will still have big problems maintaining earnings in a rising interest-rate, weak consumption environment. The bubbles (household debt, housing and bonds) will still deflate, but more slowly. The dollar might benefit from a shrinking current account deficit, but it would be tough for the US to provide the investment returns that would attract much foreign capital.
But fast-rising inflation driven by American non-stop spenders looks more likely to me. And it will all end in tears, as the huge US (and global) debt bubbles burst under the weight of the cost of servicing them. The US is certainly not the place for investors to be this year. Europe and Japan would be better. Even better will be non-dollar cash and gold.
