1/4/19: Hollowing out of the American Middle Class: the High Earners, and the 1-percenters

An interesting and insightful 2016 paper from John Komlos of CESIfo, titled "Growth of Income and Welfare in the U.S. 1979-2011" (CESifo Working Paper No. 5880), paints the pretty dire picture of the post-1980s dynamics in the U.S. labor markets, that laid the foundations of the current acceleration and deepening of political populism and opportunism not only in the U.S., but also in Western Europe.

Kolmos estimated growth rates in real incomes in the U.S. from the Congressional Budget Office’s (CBO) post-tax, post-transfer data. Kolmos also adjusts the real income data to improve the accuracy of the measures. The result is striking: "... the major consistent findings include what in the colloquial is referred to as the “hollowing out” of the middle class. According to these estimates, the income of the middle class 2nd and 3rd quintiles increased at a rate of between 0.1% and 0.7% per annum, i.e., barely distinguishable from zero. Even that meager rate was achieved only through substantial transfer payments." Of course, given that we have experienced positive growth in the aggregate economy in excess of these figures and well above the demographic change, this "hollowing out" of the middle class had to be accompanied by the "fattening up" of some other income classes, either the rich or the poor or both. Per Kolmos, it was the former one: "the income of the top 1% grew at an astronomical rate of between 3.4% and 3.9% per annum during the 32-year period, reaching an average annual value of $918,000, up from $281,000 in 1979 (in 2011 dollars)." Predictably, "...the post-tax, post-transfer income of the 1% relative to the 1st quintile increased from a factor of 21 in 1979 to a factor of 51 in 2011."

But what about the poor? Again, per Kolmos, "...income of no other group increased substantially relative to that of the lowest quintile. Oddly, the income of even those in the 96-99 percentiles increased only from a multiple of 8.1 to a multiple of 11.3."

Kolmos id this exercise for 'high' and 'low' ranges of income (depending on specific assumptions that were less and more conservative ratline to the CBO's raw data.

The results of the two calculations are shown in the chart below

Source: Kolmos (2016: 14)

In simple terms, this chart shows two interesting things:
1) The dramatic growth differential between income estimates for all quintiles compared to the top quintile is fully accounted for by the massive growth in income of the top 5% of the populations and especially by the growth in income of the top 1%.
2) The gap between high and low estimates for income growth are massive for the second and third quintiles (the middle class), and are relatively comparable for the first (low income earners) and 4th quintile (upper middle class). The gap becomes much smaller for the 5th quintile (high earners) and turns negligible for top 1%.

Kolmos attempts to convert income into more meaningful 9albeit harder to pin down) measure of well-being. To do this, he estimates the logarithmic utility function for the quintiles (logarithmic utility function preserves the property of the diminishing marginal utility - the idea that as our incomes continue to increase, each percent increase in our income results in progressively smaller gains in satisfaction/utility). Here is what he finds: "A logarithmic utility function yields a growth in welfare for the middle class of roughly 0.01% to 0.07% per annum, which is indistinguishable from zero. With interdependent utility functions only the welfare of the 5th quintile experienced meaningful growth while those of the first four quintiles tend to be either negligible or even negative." Chart below shows these estimates.

Source: Kolmos (2016: 15)

Focusing on the Percentiles section, markers 6-9 disaggregate the last 5th quintile into the ranges of top 81-90%, 91-95%, 96-99% and top 1%. It is quite evident that only top 5% (segments 8 and 9) experienced welfare gains of more than the 4th quantile cohorts.

This strongly implies that, contrary to some left-leaning policymakers' proposals and preferences, the problem of 'hollowing out' of the American middle class is not driven by the incomes of the top 81-90th percentiles, nor even by those in 91st-95th percentiles. The real source of the problem starts somewhere within the 96-99th percentile and most certainly extends to the top 1%.

The same is confirmed by looking at each cohort income relative to that of the top quintile, shown in the chart below

Source: Kolmos (2016:27)

In summary, thus, the problem with the 'hollowing out' of the middle class is not within theta 20% earners, nor within the top 10% earners. It starts much higher than that.

30/3/19: The Art of Trade Fudge: USMCA

Much-lauded Trump's Nafta 2.0, officially known as the United States – Mexico – Canada Agreement (USMCA) came to being on November 30, 2018. In his State of the Union speech on February 5, 2019, President Donald Trump claimed that the USMCA will replace “the catastrophe known as NAFTA” and “deliver for American workers like they have not had delivered to for a long time.” In a brief summary of the USMCA, Vox (see https://www.vox.com/2018/10/3/17930092/usmca-nafta-trump-trade-deal-explained) has effectively argued that the new Agreement is largely a rehashing of the original Nafta - a step in no new direction, with only minor modifications of the Trump-hated agreement.

Last week, the IMF piped in with its own analysis of the Agreement. The new IMF paper (see: https://www.imf.org/en/Publications/WP/Issues/2019/03/26/NAFTA-to-USMCA-What-is-Gained-46680) provides "an analytical assessment of five key provisions in the new agreement, including:

• tighter rules of origin in the automotive, textiles and apparel sectors, 
• more liberalized agricultural trade, and 
• other trade facilitation measures." 

So how good is the USMCA in driving forward trade and investment flows between the three economies? Per IMF, the "results show that together these provisions would adversely affect trade in the automotive, textiles and apparel sectors, while generating modest aggregate gains in terms of welfare, mostly driven by improved goods market access, with a negligible effect on real GDP. The welfare benefits from USMCA would be greatly enhanced with the elimination of U.S. tariffs on steel and aluminum imports from Canada and Mexico and the elimination of the Canadian and Mexican import surtaxes imposed after the U.S. tariffs were put in place."

So, repealing the problem created by Mr. Trump - steel and aluminum tariffs - has more potential for welfare gains for Mr. Trump's electorate, than the new Nafta agreement that Mr. Trump claims to be one of his Administration's major achievements.

Mr. Trump has referenced, on many occasions, the need for reducing U.S. trade deficits with Mexico and Canada as the core justification for altering Nafta. IMF analysis of the USMCA shows that under the most welfare-enhancing scenario of USMCA introduction, accompanied by normalization of trade in steel and aluminum, U.S. trade deficit with Mexico can be expected to improve by only USD576 million per annum (0.58%), and with Canada by USD 1,781 million (4.31% improvement). However, U.S. trade balance with the rest of the world is expected to worsen by USD 2,698 million (a deterioration of 0.375%), more than offsetting the gains from Canada and Mexico trade.

Worse, U.S. workers will see no material gains from USMCA, as the IMF estimates presented in Table 9 (below) show:

As noted above, IMF projects no material growth boost from USMCA. More detailed analysis - by sector - shows that under the scenario involving repeal of Trump tariffs (the only scenario with positive welfare impact of USMCA), only two non-agricultural sectors of the U.S. economy can expect gains in output: food manufacturing and Other Manufacturing. In contrast, six sectors are likely to see their output decline:

All in, the IMF research shows the extent of economic fudge that is the current Administration's trade and investment policy. The art of the deal seems to be the art of faking soundbites and slogans, while delivering nothing new.

12/3/19: S&P500 Concentration Risk over 10 years

More on increasing concentration risks in the U.S. equity markets: Goldman Sachs estimates that almost 1/4 of total return to S&P500 over the last 10 years came from just 10 stocks:

Of these, Apple alone accounted for almost 1/5th of total return to S&P500. 22% of total return was accounted for by ICT sector.

10/3/19: Irish Residential Construction Sector 2018: A New 'Recovery' Low

It has been an ugly decade for Ireland's building and construction industry. especially for housing. Following a historically massive bust in 2009-2012, indices of total production in the housing sub-sector fell from the pre-crisis high of 751.7 for value and 820 for volume, attained in 2006, to their lowest cyclical points of 57.9 and 59.5, respectively, in 2012. In other words, from 2006 through 2012, Irish residential building and construction production fell a massive, gargantuan, non-Solar-System-like 92.3% in value terms and 92.74% in volume terms. That was bad.

The recovery has not been any better. Since the lowest point of the cycle in 2012, through 2018, based on the latest figures from CSO, value of production in residential construction sector rose to 186.6, an uplift of 222.3% and volume rose to 176.9 (a rise of 197.3%). Still, compared to pre-crisis peak, current value of production in Ireland's residential building and construction sub-sector is down 75.2%, still, and in volume terms it is down 78.4%.

Of course, comparatives to the peak production year would be subject to criticism that things should be benchmarked by something 'other' than the levels of activity achieved during the bubble. I disagree. Back in the days of the bubble, Ireland experienced rampant house price inflation, as demand was still lagging behind supply. But, let me entertain, as in the above chart, an argument about averages over two periods: the period of the pre-bust activity and the period of the recovery activity.

Ireland today has an acute crisis in the supply of homes. There is no question about that. What 2018 figure shows, however, is far worse. In 2018, value of production in residential construction sector in Ireland grew by only 6.88% y/y - the slowest pace of growth since the recovery started in 2013. By volume, activity grew only 3.75% y/y in 2018 - also the slowest pace for the recovery period. As the crisis in supply of homes get worse, the rates of growth in the 'recovering' sector get shallower. This suggests that Irish residential construction is nowhere near the trajectory needed to achieve the rates of growth required to fill the gap in the housing supply.

In all 12 years of positive growth (between 2000 and 2018), last year marked the worst rate of growth in Value and the second worst year of growth in Volume terms. To put things into perspective: under 2018 growth rates, Irish residential building and construction production won't reach its 2000-2007 average levels until mid-2033 in value terms and mid-2052 in volume terms.

6/3/19: Expectations Sand Castles and Investors

As raging buybacks of shares and M&As have dropped the free float available in the markets over the recent years, Earnings per Share (EPS) continued to tank. Yet, S&P 500 valuations kept climbing:

Source: Factset 

As noted by the Factset: 1Q 2019 "marked the largest percentage decline in the bottom-up EPS estimate over the first two months of a quarter since Q1 2016 (-8.4%). At the sector level, all 11 sectors recorded a decline in their bottom-up EPS estimate during the first two months of the quarter... Overall, nine sectors recorded a larger decrease in their bottom-up EPS estimate relative to their five-year average, eight sectors recorded a larger decrease in their bottom-up EPS estimate relative to their 10-year average, and seven sectors recorded a larger decrease in their bottom-up EPS estimate relative to their 15-year average."

Bad stuff. Yet, "as the bottom-up EPS estimate for the index declined during the first two months of the quarter, the value of the S&P 500 increased during this same period. From December 31 through February 28, the value of the index increased by 11.1% (to 2784.49 from 2506.85). The first quarter marked the 15th time in the past 20 quarters in which the bottom-up EPS estimate decreased while the value of the index increased during the first two months of the quarter."

The disconnect between investors' valuations and risk pricing, and the reality of tangible estimations for current conditions is getting progressively worse. The markets remain a spring, loaded with the deadweight of expectations sand castles.

4/3/19: BRIC Manufacturing PMI: January-February Trend

In January-February 2019, Global manufacturing PMI sunk to its lowest reading since 2Q 2016 averaging 50.7 over the first two months of the year. With it, the slowdown has also been impacting the BRIC economies, overall BRIC Manufacturing PMIs average 41.2 in 4Q 2018 based on each country share of the global GDP for 2018, below 51.83 average for Global Manufacturing PMI over the same period. In the first two months of 2019, BRIC Manufacturing PMI was around 50.8, statistically indistinguishable from the 50.7 Global PMI average.

As the chart above clearly indicates, poor BRIC performance was driven by a contraction-territory reading for China (49.1 in January-February 2019 as opposed to stagnation-signalling 50.0 in 4Q 2018), and Russia (50.5 for the first two months of 2019, against 4Q 2018 average of 51.9). In contrast, both Brazil and India outperformed BRIC and Global PMI readings. Brazil's Manufacturing PMI averaged 53.1 in the first two months of 2019 against 52.1 in 4Q 2018, while India's PMI rose to 54.1 in January-February this year against 53.4 in 4Q 2018.

All in, Manufacturing sector leading indicator suggests a major slowdown in the Global growth momentum, and some spillover of this slowdown to Russia and China.  Brazil's robust reading so far marks the fastest pace of expansion since 1Q 2010, on foot of a recovery from a very long and painful recession. India's reading is the highest since 2Q 2012. If confirmed over March and over Services PMI, this implies a major diversion of growth momentum within the BRIC group.

4/3/19: S&P 500 Share Price Support Scams are a Raging Trend

Having posted a record-breaking USD939 billion of shares repurchases in 2018, Corporate America is on track to set a new record-wrecking year of buybacks in 2019. per latest data from JPM (via @zerohedge), January-February 2019 saw USD187 billion worth of shares repurchases in S&P 500 index constituent companies.

This is a notch higher than in 2018 and almost 90 percent above 2017 period.

1/3/19: U.S. PMI is not at a Crisis levels

My take on today's ISM for Manufacturing data here: https://twitter.com/GTCost/status/1101512164584546304, with charts:

Chill-ax everyone… #ISM is not even close to signalling a serious trouble ahead… Not that it is a measure I would even consider for troubleshooting.

— Constantin Gurdgiev (@GTCost) March 1, 2019

1/3/19: Australia is the New Ireland: How Property Hype Inflates Financial Bubbles

Australia - a country with the biggest property bubble of all times and of all countries - is retracing the exact mis-governance steps as its predecessor claimant of the title, Ireland. Just as in Ireland pre-2008 bust, Australian central and regional Government figures are adding to the hype of 'real estate investment', whipping up households' enthusiasm for property spending, just as the market is starting to crate:

Source: https://wolfstreet.com/2019/02/28/home-prices-sydney-melbourne-australia-spiral-down-bust-spreads-imf-to-regulators-reinforce-financial-crisis-management/.

While Australian property investors should be heading for the hills, Australian voters should consider actively advocating that the country (regional, etc) Government should adopt a more responsible approach to managing the risks of a massive bubble collapse. One suggestion - suitable not only to Australia, but to all economies around the world - would be to force politicians to be legally liable for what amounts to selling pitches and investment advice they so eagerly dish out.

How about a new way of thinking about accountability in politics? Your politician says 'A' and 'B' happens, you charge your politician for any damages that their call to action on the claim 'A' has produced. At least with such a system of 'incentives' in place, we might see politicians taking some time to reflect on the opportunistic garbage they push into public domain before speaking.

25/2/19: Europe's TBTF Banks are only Bigger-to-Fail...

Since the start of the Global Financial Crisis (GFC) and through subsequent Euro area crises, the EU frameworks for reforming financial services have invariably been anchored to the need for reducing the extent of systemic risks in European banking. While it is patently clear that Euro area's participation in the GFC has been based on the same meme of 'too big to fail' TBTF banks creating a toxic contagion channel from banks balance sheets to the real economy and the sovereigns, what has been less discussed in the context of the subsequent reforms is the degree of competition within European banking sector. So much so, that the Euro area statistical boffins even stopped reporting banking sector concentration indices for the entire Euro area (although they did continue reporting the same for individual member states).

Chart below plots weighted average Herfindahl Index for the EA12 original Euro area states, with each country nominal GDP being used as a weight.

The picture presents a dire state of the Euro area reforms aimed at derisking the bank channel within the Eurozone's capital markets:

• In terms of total assets, concentration of market power within the hands of larger TBFT banks has stayed virtually unchanged across the EA12 between 2009 and 2017. Herfindahl Index for total assets was 0.3249 in 2009 and it is was at 0.3239 in 2017. Statistically-speaking, there has been no meaningful changes in assets concentration in TBTF banks across the EA12 since 2003. 
• In terms of total credit issued within the EA12, Herfindahl Index shows a rather pronounced trend up. In 2010 (the first year for which consistent data is provided), Herfindahl Index for total credit shows 0.0602 reading, which rose to 0.0662 in 2017.

Put simply, TBTF banks are getting ever bigger. With them, the risks of contagion from the banking sector to the real economy and the sovereigns remain unabated, no matter how many 'green papers' on reforms the EU issues, and no matter how many systemic risk agencies Brussels creates.

24/2/19: Eurozone's Corporate Yields are not quite in a crisis territory... yet...

Euro area high yield corporate credit rates are under pressure to continue moving:

But they are far from being dramatic, even though banking sector margins have now surpassed ex-crises averages:

The problem, however, is what awaits on the horizon. So far, the ECB is planning on hiking rates in the second half of 2019. If it does, with one 25 bps hikes to the end of 2019, we are looking at high yield rates jumping close to a 7 percent mark:

That is a bit more testing than the current above-the-average yields.

24/2/19: Europe of Divergence: Euro and the Crisis Aftermath

A promise of economic convergence was one of the core reasons behind the creation of the Euro. At no time in the Euro area history has this promise been more important than in the years following the series of the 2008-2013 crises, primarily because the crisis has significantly adversely impacted not only the 'new member states' (who may or may not have been on the 'convergence path' prior to the crisis onset), but also the 'old member states' (who were supposed to have been on the convergence path prior to the crisis). The latter group of states is the so-called Euro periphery: Greece, Italy, Spain and Portugal.

So have the Euro delivered convergence for these states since the end of the Euro area crises, starting with 2014? The answer is firmly 'No'.

 The chart above clearly shows that since the onset of the 'recovery', Euro area 8 states (EA12 ex-periphery) averaged a growth rate of just under 2.075 percent per annum. The 'peripheral' states growth rate averaged just 1.623 percent per annum. In simple terms, recovery in the Euro area between 2014 and 2018 has been associated with continued divergence in the EA4 states.

This is hardly surprising, as shown in the chart above. Even during the so-called 'boom' period, peripheral states average growth rates were statistically indistinguishable from those of the EA8. Which implies no meaningful evidence of convergence during the 'good times'. The picture dramatically changed starting with 2009, starting the period of severe divergence between the EA8 and EA4.

In simple terms, the idea that the common currency has been delivering on its core promise of facilitating economic convergence between the rich Euro area states and the less prosperous ones holds no water.