Welcome to Authers’ Note, in which I will attempt to provide some context and analysis on the world of investment each day, and provide you with a handy guide to the best coverage on offer, both here in the FT and elsewhere. All feedback is welcome, particularly of the constructive variety, as we try to get this right. (Email to firstname.lastname@example.org).
Sign up to receive Authers’ Note daily by email here
If you needed a reason to be cheerful, the latest ISM manufacturing numbers provided it. ISM indices, published on the first of each month, poll supply managers on issues like new orders, inventories and employment, and boil down into one neat number where anything above 50 implies economic expansion, and anything below it means recession. ISMs are closely watched because over time they have been great leading economic indicators, and because they allow direct comparisons between countries.
And today's data, covering the month of September, could scarcely have been better. In the US, the ISM ticked up above 60, for its highest reading since 2004. Indeed, throughout the great economic expansion of the 1990s, the ISM never once exceeded 60:
Even more impressively, the guts of the numbers showed that the optimism was not particularly driven by export orders, and appeared to be domestically driven. This despite the fact that all the world's other leading economies — with the sole significant exception of the UK — also registered growth. None was below 50:
Strong numbers like that helped ensure a good day for stocks, with the S&P 500 setting yet another record. But it does raise a new issue that has not been discussed much before, because it might have seemed like wishful thinking: could there be a risk of overheating?
That was at least the suggestion of Leuthold's Jim Paulsen, who is nervous that a big fiscal stimulus may be about to arrive just at the point when it might do more harm than good. He points out that the US has never cut taxes in the ninth year of a recovery, with the unemployment rate nearing 4 per cent and while the Federal Reserve was already tightening monetary conditions. Jim is known as a bull, but his commentary is negative:
the current US government deficit as a per cent of nominal GDP is already greater (at about 4.4%) relative to the current unemployment rate than at any time in post-war history! While revenue neutrality is the stated goal, most likely any tax cut will result in raising the deficit (at least in the short run). Deficit spending in relation to the unemployment rate is already “out of bounds” by post-war standards. Follow the arrow in the chart. With a tax cut, how would the financial markets feel about 5%+ deficit spending with an unemployment rate slipping to a 3%ish handle? Would commodity prices stay put (remember the US dollar is already declining) and would wage inflation remain dormant? Would bond vigilantes feel okay with the current 2.33% 10-year bond yield? How far would this put the Fed behind the curve? And, while “E” may rise, how much would this out of bounds policy force stock investors to lower the “PE”?
The foundation of this bull market has been a persistent disappointingly slow pace of economic growth. While significant fiscal stimulus could finally help boost economic growth, at this point in the recovery, would it ultimately be good for the bull market?
A further argument on the ISM is simply that when it gets this strong, it tends to usher in higher interest rates, to a point where they crimp stocks. Luca Paolini of Pictet points out that on all the four previous occasions when the US ISM manufacturing index topped 60 (it has happened four times before, in 1984, 1987, 2004 and 2011), stocks have fallen over the following six months.
Against this, however, there is a counter-argument. Steven Blitz, of Lombard Street Research, agrees that strong manufacturing numbers imply a more aggressive Fed. He said:
Using manufacturing as a guide, there is about a 24 month lag between the ISM Manufacturing production index and construction put-in-place to build manufacturing facilities. While there is nothing absolute about this lead/lag relationship, it is nevertheless reasonable to anticipate improved construction activity in the coming months — which would make the Fed’s anticipated three tightenings in 2018 much more likely than not.
This is still not what the market is predicting. But the good news is that strong manufacturing generally leads to increased construction, which is beneficial for many corners of the economy:
But he is less worried that a tax cut could contribute to overheating, as any tax cut will be aimed at attempting to persuade companies to produce domestically. Unlike previous big attempts at tax cuts, this one is aimed more at corporations than at individuals. He also points out that highs in manufacturing sentiment tend to come early in a cycle (as in 2004 and 2011) as businesses begin to perceive a range of new opportunities. As the economy (excluding construction) suffered a minor recession in 2015 and 2016, the strong ISM may reflect a bounceback in sentiment, rather than a frothy top.
This is an issue to watch. It is at the very least fascinating to see how much the conversation has changed.
My cousin Kevin
Possibly the most consequential financial markets decision of this year is coming within two weeks, so President Trump tells us. It could be critical to determining whether the US economy overheats and whether the Fed really raises rates next year. And yet there is still little excitement about it. Who will the president nominate to chair the Federal Reserve once Janet Yellen's term expires early next year?
It is an important decision, and a close-run one. According to the Predictit prediction market, Ms Yellen's chances were almost 50-50 in midsummer to stay on. She is now being quoted at 17 per cent. By the end of July, the frontrunner was Gary Cohn, the president's chief economic adviser and the former president of Goldman Sachs. He is known to covet the job. At one point, his odds also reached 50-50; he is now being quoted at 14 per cent.
The new frontrunner is Kevin Warsh, a Fed governor during the scariest moments of the financial crisis and once the youngest governor in history. He is also known to covet the job, and his odds surged, again to about 50-50, on the news last Thursday that he had had a lengthy conversation with the president, which had gone well. He is still the frontrunner but his odds have now trimmed back to 34 per cent, largely because of the sudden emergence of current governor Jerome Powell, who we subsequently learned had also had a conversation with the president.
Predictit now has it as a close two-horse race between Warsh (34 per cent) and Powell (29 per cent), while neither Yellen nor Cohn can be counted out. That sounds about right, and suggests extreme uncertainty. That uncertainty is only likely to be egged on by the president's penchant to use reality television techniques for important personnel announcements. On Friday, he said he would make his decision within "two to three weeks", so the name will come this month. Whether he goes to the lengths of his Supreme Court nomination earlier this year, when he summoned two candidates to Washington without letting them know who would be the nominee, remains to be seen; markets might not appreciate that level of drama.
For the time being, however, the favourite has a surprising supporter. SocGen's bearish strategist Albert Edwards is a big Warsh fan, and the note he published today was headed: "I have seen the future and his name is Kevin". Albert, who saw Warsh speak at a Bank Credit Analyst conference last week, went on:
Much to my own regret I had never familiarised myself with the views of Governor Warsh, who was at the Fed from 2006-11, and played a key role in navigating the Fed through the crisis. He got a rousing reception from the BCA audience as he talked a lot of sense — in particular on how the Yellen Fed has lost its way and current policy is deeply flawed. He explained that the Fed has been “captured” by a groupthink of academics led by the ‘Secular Stagnation’ ideas of his friend, Larry Summers. Rather than admitting they are wrong, this group, who failed to predict the current economic malaise, have constructed this theory to explain why ever more stimulus is required. In particular Warsh warned that the Fed had become the slave of the S&P. Warsh’s views were indeed a breath of fresh air for someone so close to policy. I have recently seen his name mooted as a future Fed Chair, and should a vacancy (unexpectedly) arise, he would definitely be my choice.
As the president is on record as a critic of the Fed's monetary policy, albeit not as vociferous a one as Albert, a Warsh chairmanship might well make sense to him. Here is an interesting interview on CNBC in which we hear a little of the Warsh philosophy:
Does he have a point that the Fed has been driven by asset prices? Why yes he does. From the time of the LTCM bailout in 1998 until the crisis of 2008, the Fed Funds rate seemed blatantly to follow the S&P 500:
Since the crisis, wobbles for the stock market have generally been greeted with new doses of QE, or at least with relatively dovish rhetoric. Does this mean that Albert believes that a Warsh Fed could prevent the likely disaster of which he has been warning for years?
No, not quite. When I asked him this, he sent me this reply:
I just think Warsh has a very different mindset to the central bank herd. He might not be as hawkish as some of his previous comments have suggested he might be, but his views are definitely not from the Summers Secular Stagnation, central bank group-think. And he is not an idealistic monetarist idealist. He was in the thick of it when he was at the Fed previously.
I don’t think he will be able to avert disaster though. But the sooner this credit and asset bubble is popped the better.
The longer it is left to run, the deeper the ultimate recession will be.
And there should also be at least one word of caution about Warsh's candidacy. He is right that the Fed has in recent years set too much store by the level of the S&P 500. But that is nothing compared to the president himself, who regularly tweets when the S&P hits a new record. A Fed chairman who determinedly pricks the bubble before it gets too large may not be exactly what he wants.
Get alerts on Markets when a new story is published