Monday, February 4, 2019

Why Healthcare

Previously I discussed why I think bubbles occur in the US but I left out why I took the position I did, and I was asked so the answer is:

I asked the market.  Starting from the assumptions that I layed out the conclusion is fairly straightforward.  The bubble sector* would be one that has grown much faster than the surrounding economy and then showed strong signs of a peak just as the yield curve started to invert.  There were a few other check marks that it would need to have, such as increased demand or government meddling recently to explain why they were the sector that the money flowed into, but those were obvious for healthcare once I found that the other two patterns fit. 

As for individual companies I went through and chose one whose growth appeared to have benefited the most from this situation (stock price wise). 

*There doesn't have to be just one.


Monday, January 28, 2019

First Move

I posted my first trade based on the ideas that I have been (slowly outlining above), I am listing my general positions here (but not the specifics) for tracking purposes (yours and mine).  Today I went short (via puts) on United Health Groups stock (UNH ticker).  This is not financial advice, this is simply my position and my reasoning.  My actual advice is don't take financial advice from random people on the internet.  A little bit of my positional reasoning to follow.

My current thoughts on how bubbles are created in the US is functionally a Cantillon feedback loop (for lack of a better term).  As the Fed expands the money supply in the aftermath of a recession there will be some sector of the economy that is situated to benefit from this more than the others.  One possible reason for why an industry would have greater profit potential would be a recent shifting of regulations meaning there is a new profit space to be explored and the means to do it.  Three factors then compliment each other to push up the desirability of investing in the sector.  First is the higher profit potential, the second is that there are underused resources in the economy as it comes out of recession, and third you have the Cantillon effects.  Money naturally flows faster towards areas where there is more profit potential and so any new money* that enters the system is more beneficial to these sectors than other ones, and the sector gets first crack at the unused resources.

This gives you the initial growth period, but it also allows you to overshoot the "natural" total growth that an industry would see.  Each new dollar that is created disproportionately benefits the particular sector and so the sector has an outside boost for as long as the Fed is loosening.  From my point of view the Fed is functionally loosening until the Yield Curve starts to invert.  The curve inversion strongly coincides with the early signs of issues within the bubble.  The 2006 inversion was just before the sudden decline in new housing starts and the 2000 inversion was just before the sudden decline in the NASDAQ.

This general explanation has two advantages over other discussions of the Yield Curve that I have seen.  It can be used to explain why the recession typically starts 6-8 quarters after the inversion and it can explain why the bubble does not reflate when rates are cut.  The latter point is often ignored, as the Fed was cutting interest rates in July of 2007 and in November of 2000, both ahead of the beginning of the recession.  


*using the term loosely here


Monday, December 3, 2018

More on debt

In my previous posts I have frequently discussed government debt and the dangers it causes, but with fairly vague notions of where it becomes dangerous.  Looking further into this I have sketched out a basic outline for myself, and it follows.

1.  To steal from Adam Smith, there is an awful lot of ruin in a nation.   A country can absorb a tremendous amount of debt and spending without a collapse, and even in some cases with continued growth.  Greece hit 100% debt to gdp levels in 1994, but didn't have (perhaps thanks to some fraud) major issues until the world started shaking in 2008, and I discussed Japan as an example in my most recent post.   This is not to say that these countries were trouble free, only that the high debt loads looked more like a hindrance than a potentially fatal flaw.

2.  High debt levels can exist for long periods of time, and so are "slow moving" crisis in that sense, but the end is very fast.  The indicators that a country is approaching a crisis appear to likewise be slow moving for long stretches.

One rule of thumb that looks solid is a lack of improvement in debt to gdp levels during good times.  Greece had decent growth from 1994 through 2008, but debt to GDP levels stuck at between 98% and 110% of GDP during that time.  Think of it this way, if you left college with $50,000 in unsecured debt and started out making $50,000 a year and 10 years later you were making $100,000 a year but your unsecured (ie no mortgages) debt had also increased to $100,000 that would be a pretty bad sign for your finances, right?  What are the odds you are going to on net be paying down debt in the future if you can't even maintain a level of debt while doubling your income?  What are the odds you would be able to handle a major life crisis if your baseline is increasing debt?  Japan also had some significant warning signs during the 80s.  Their debt to GDP levels rose from 50% in 1980 to 70% in 1992 despite GDP tripling in that time.  

This is very worrying for the near future as the US has been following this pattern.  Debt to GDP was fairly stable at around 60% for the 90s and 2000s until 2008, during a period of relatively strong growth and then saw a large burst during and immediately following the crisis.  While the expansion has slowed it has not reversed with a return to full employment, debt to GDP was higher in 2017 than any year prior to 2016.  

This is a pattern not isolated to the US, I looked at 19 countries (why not 20?  because that would have been more) including most of the top 20 world economies in terms of GDP and 16 of the 19 had increased their debt to GDP levels from 2008 to 2017 and 14 of them from 2012 to 2017.  10 countries had increased debt by 20 percent of GDP or more and 5 by 30 percent or more since 2008.

This is also not a series of small economies along with the US, 6 countries from that sample now have debt to GDP ratios of 85% or more and they are the UK, Canada, France, the US, Italy and Japan.  

Saturday, December 1, 2018

Concepts From Japan

Government debt to GDP is a tricky subject to discuss these days, largely because Japan with its extreme, and growing, debt loads kind of broke a lot of people's (including mine) intuitions about debt.  The lunatic fringe of economics (MMT) likes to nod toward Japan as an example of how debt doesn't matter as long as you can print your own currency, but they don't want to nod to much as it brings up the obvious questions about their growth and how, just perhaps, avoiding collapse isn't a good enough metric on its own.  Monetarists were really excited about Japan for about a quarter or two when they promised really hard to raise inflation, and managed to do it (with a large tax increase) for brief period, and Keynesians had to repeat the adage of "they didn't stimulate enough" so many times even they appear tired of it. 

Japan is a great example of one major impact of high debt loads, you get boxed in on one path, or boxed out of others.  The old debt concept that since a government liability is someone else's asset they must cancel out only works on the balance sheet.  With a debt to GDP ratio of 250% these days and government spending at around 40% of GDP interest rates of 16% would engulf the entire budget.  This is an extreme and ultimately meaningless example in a lot of ways, interest rates are no where near 16%, Japan doesn't roll over its bonds annually, etc.  The idea is not to note THE point where their government would 100% go bankrupt, but to note how much lower the point is now than it was 10, 20 and 25 years ago.  In 2008 debt to GDP was around 190%, and a (potential) budget of 40% of GDP meant that Japan could not pay more than a 21% interest rate, and in 1996/97 when it was 100% it was a 40% rate, and their pre debt explosion levels it would have been between 55 and 60%. 

In less than 30 years Japan has gone from definite ruin at levels rarely seen (only under hyperinflation) only under to levels seen in the 1970s into the early 1980s in many countries.   It is of course unlikely that they would stave off ruin until these levels were hit, interest rates of even 5 percent now across all of their debt would be very difficult to handle and would mean effectively shifting about 10% of GDP worth of spending away from current programs to interest payments, which would have a lot of impact across the economy. 

So does high debt cause low growth or does low growth cause the high debt?  The obvious answer is yes.  Both occur.  Once high debt is in place it is very difficult to get high growth, even if you have long dated bonds where the government will have years of cushion to reduce debt levels before the payments become a problem the bondholders will be taking real losses.  If those bonds are held by citizens and corporations then those losses should be a real drag on the economy.  If interest rates tracked growth perfectly (they don't, but its a starting point) then debt levels 100% of GDP would mean functionally all increases in growth would be offset by decreases in wealth held by the public.  The reverse, perversely, might be true as well.  Declining growth would mean declining interest rates, which would push the value of debt up as long as it wasn't perceived to increase the likelihood of default. 

Why do I say perversely above?  Aren't these stabilizing forces?  I don't think that they are, I see them as channeling forces, as the economy can't handle anything outside the norm well, be it growth or contraction, and so the potential pathway of the economy narrows effectively removing the dynamic segments of the markets. 

Some countries have managed to reduce large debt loads while breaking out of a potential channel, the US after WW2 is one good example, but if you look at what it took overall it is daunting.  Federal spending was slashed by 40% in year 1 after the war, then another 40% in year 2 and another 10% in year 3, the economy was effectively heavily liberalized as inhibiting regulations (price controls and the like) were removed and perpetual destruction of capital in the form of war losses were cut out, and the Federal Reserve did its bit to, keeping rates low for years after the war (and possibly causing the stagflation of the 70s along the way... possibly).

Greece is a good (as in terrible) example of how badly this type of channeling can go, the government got to a point where outside funding was necessary very early on which allowed the scenario where those outside forces could dictate Greek policy.  Now the Greeks weren't doing a bang up job managing themselves but this functionally cut out some of the possible routes out of the crisis.  A dedicated public servant pitching a plan to restore economic growth had a double hurdle to overcome, convincing both the public of his plan and external lenders.  There is a general truism here, the fewer options you have the more likely that all of them are going to be bad. 

Thursday, November 29, 2018

Slow growth

Several accounts off the Great Recession talk about higher demand for money being a driving force, I don't see it.  I see it as reactionary to another force.




Sure you can make a case that the recession drove up the demand for more savings, but coincidence doesn't work so well when there are potential causal factors shifting a quarter or two prior.


In my previous post I noted that sales declined first, with layoffs not starting at unusual rates until late 2008, with the implication being that the rise in UE rate in late 2007 through mid 2008 was primarily caused by a lack of new job creation, not layoffs.   

The Federal debt ramp up has been stunning and barely commented on for its magnitude, it has risen by a larger share of GDP in the years after the end of the recession that it did during the recession.  We have not seen a sustained decline since the end of the 1990s, and there is only one sustained decline in Federal debt as a share of gdp sine 1980, making 33 of the past 38 years either flat or increasing debt to GDP.  The most worrying is the past decade plus now where the deficit has exceeded GDP growth every single year.  This is a large phase shift from the post WW2 economy where such years were rare, occurring only 3 times from 1948 through 1970, with each one being only a small net deficit.  

This is obviously something that cannot continue indefinitely (although Japan shows that it can continue for long stretches), but more worrying is that the typical path out of high debt levels has been robust growth and that is less and less possible.  I don't just mean because we appear to be in a low growth era, but that with debt levels this high more growth, which ought to lead to higher interest rates, will mean more debt payments.  Debt levels of over 100% of GDP make it very difficult to grow out of debt when starting with an annual deficit, and when you are starting with a budget deficit during growth years?  Yikes.

One might argue that a government can borrow long, locking in interest rates, and then absorb growth because it wouldn't increase its deficit.  This is true on one side of the ledger only, as it would only be transferring losses to the holders of that debt.  To make it work you need to have those losses not end up as a drag, preventing the very growth that you need to get the debt/GDP ratio back under control.

*************************

I don't have a good segue here, so I will just plow on ahead.  There is an idea in economics called monetary offset, basically it is that the impact of fiscal decisions (ie spending decisions made in Washington DC) can't be determined without looking at what the Federal Reserve does in response.  A fiscal 'stimulus' program that expands the deficit would only be expansionary if the Fed doesn't tighten in response.  The failure of this mode of thinking is the assumption that there is a bright line between Federal spending actions and Federal Reserve actions, there doesn't truly appear to be.  One example:  If the composition of Federal spending has an impact on the economy, that spending $100 billion on defense is different from $100 billion in tax cuts which is different from $100 billion in Medicare expansion  which is different from $100 billion in interest payments, then Federal Reserve policy that effects the interest payments of a government is functionally fiscal policy.  A shift in interest costs would shift money either away from or toward other programs which would have a different 'multiplier'.  Most Keynesian models assume that there are at least some differences, with different multipliers for tax cuts vs spending increases during a recession, and most argue that 'productive' uses of money will have higher multipliers than non productive ones (Keynes himself made that argument as well).  On the flip side of this the Federal Reserve has a dual mandate to manage inflation and unemployment, and therefore any Federal spending that impacts either of these two will in fact be influencing monetary policy.

Monetary offset relies on the idea that the Fed moves last, and that after noticing the fiscal actions they will 'correct' the economic course.  It also implicitly relies on the Phillips Curve being real, or that 'stimulus' attempts can't cause UE (which are similar ideas).  If those don't hold then the Fed doesn't have the power to offset in all situations, it only has the power to choose a path and take a bad outcome either way.

I can't help but noting here that the largest recession in my lifetime came in concordance with the Federal Government and the Federal Reserve acting in combination early on (and even prior to) what was at the time a relatively mild recession.  Lost to the collective memory hole is the fact that the Federal Government passed a 100 billion dollar+ stimulus package in early 2008, before the recession was even officially a recession.  The Federal Reserve was even faster on the stimulus train having started interest rate cuts in July of 2007, going from a FFR of 5.25% then to 2% in August 2008.  

Wednesday, November 21, 2018

Cause of Unemployment

What were the causes of high UE during the Great Recession?  Well, it isn't getting fired.



The red line here is layoffs times 4 to rescale and make it clear that total unemployment increases first and then layoffs follow.  Here it is again with the UE rate instead of total unemployed.



Layoffs are a normal part of a healthy economy, some people are bad fits for their jobs, some jobs are bad fits for the economy or company and some companies are badly run, shifting people into more productive roles is crucial for economic growth.  Layoffs during the great recession lagged, they took longer to move out of their prior range than most other indicators.  You might think that such a relationship was obvious (employers aren't prescient and generally don't like to fire people in general) but most theories off the GR require the opposite, and so the opposite is believed.  For example 

The economy surely saw what was, fundamentally, just a reshuffling of financial players and asset ownership as a sure sign (a very bright sunspot, if you will) that bad times were here again. The reaction was shift. Employers laid off their workers in droves to lower their payrolls before their customers stopped arriving. This was the worst of the many types of multiple equilibria associated with the GR.  


New home sales had been falling for 3 years before layoffs spiked and auto sales had been falling for a year+.  Other sectors differed, restaurants saw an end to a long growth in terms of total receipts in late 2007/early 2008.  They did see a decline after September 2008, but the break from trend occurred well before that.

All retail sales minus food service saw a break from trend prior to 2008, and saw early declines before the masses of layoffs in late 2008.






Monday, October 22, 2018

"Real" Interest Rates



We are diving right into this one, no words to start, just a graph! 

Red line = Federal Funds rate, blue line = Federal funds rate minus 5 year expected inflation.

From July 2003 to June 2004 the Effective Funds rate is essentially flat at 1%, during this time inflation expectations increase by about 1 percentage point.  This represents roughly a 67% increase in the expected inflation rate, from around 1.5% to 2.5%.



What is the Fed to do?  Well, start raising rates of course.  The Fed raises rates over 4 percentage points from June 2004 to July 2006 while 5 year inflation expectations move up another 15-20% to their peak at just under 3% in early 2005.  Meanwhile at the 10 year break even rate


So 10 year inflation expectations peaks right before the Fed starts raising the funds rate, and then is in the 2.2 to 2.8 range right up until August 2008 (not shown here).  Another look



The spreads here are small, but functionally doubled.  Early in the graph 10 year inflation expectations are basically 0.35% per year more than 5 year at the widest points, given that 10 year inflation includes the next 5 years as well this implies that years 6-10 should have around 0.70% higher inflation than years 1-5.  That isn't a huge deal but it is notable when rates are in the 1.5-2% range.

What is a huge deal is that the Federal Reserve raise interest rates by 4 percentage points and inflation expectations are virtually identical after the last increase to what they were at the first increase and were slightly higher for good portions of the rate increases.

If you are of the opinion that the Federal Reserve can control inflation (expectations) with the funds rate then you are looking at a 400% increase over 2 years to stop inflation expectations from rising.  And don't give me "long and variable lags", these rates include the 10 year break even rate which stops rising BEFORE the 5 year rate does.

There is a sentiment to be found that the Fed was to tight during this period, that they either raised rates to far or held them up there for to long.  This is awkward to argue as the lower of the 5 and 10 year break even rates stays above 2.15% and they were both right around 2.35% when the Fed starts easing in 2007.  Then the Fed lowers rates by 3+ percentage points from July 2007 to May 2008 and inflation expectations stay in the range the Fed wants them to.

All of this is just a set up for




This is about as close to a smoking gun as you can have against monetarism or Keynesian economics, both of which rely on using real interest rates as a mechanism for driving down the savings rate and driving up the consumption rate to combat a recession.  First I will zoom out as far as the Fed data goes to show how poorly correlated real interest rates are with the savings rate


Now a zoomed in section from the financial crisis


The savings rate fell and held steady while real interest rates climbed.  There are multiple measures here of what a "real" interest rate should be, the 10 year bond rate minus 10 year expected inflation, the same for 5 and 5, 2 year bond minus 5 year inflation, 2 year treasury minus the current inflation rate, the federal funds rate minus 5 year inflation and they all show the same pattern.  Real interest rates climbed and the savings rate ignored them, then rates fell and the savings rate ignore them and then the early stages of the financial crisis started and the savings rate moved higher and quickly.  I'm not going to discuss the spikes here, just the trend, the savings rate went from around 4% in the early stages of the recession to above 5% in about 6 months and up to the 6-7% range with peaks above 7.5%. 

If you read my previous posts on the yield curve you would note that the stock markets started rising more rapidly right around the same time that real interest rates started rising during the above period, and not long before housing starts fell off a cliff.

I am going to return to my explanation of a bifurcated market, that there exists two (or several) different sets of participants with little cross venturing.  Low, and especially negative, real interest rates should benefit borrowers at a cost to lenders.  Higher rates should benefit lenders at a cost to borrowers, and lower rates vice versa but how many would be borrowers can benefit by switching to being lenders?  If you have a cash reserve and are thinking of borrowing because real rates are low then your cash reserves are going to suffer poor growth roughly equal to the gains you get by borrowing the money for a project rather than using your own.  Moving towards equilibrium is difficult in this way, which is why the channel of rising real rates encouraging savings and decreasing real rates reducing them is central to modern macro theories and why the above graphs are so devastating to them.