• "Kee" Points with Jim Kee, Ph.D.

    • Oil Tanker Attacks
    • Unrest in Hong Kong


    Oil Tanker Attacks

    There continues to be a series of sabotage attacks (involving planted bombs or mines) on oil tankers in the Gulf of Oman, allegedly perpetrated by Iran. The Gulf of Oman is near the Strait of Hormuz, through which one fifth of the world’s oil travels. It is considered a “strategic choke-point” or water passage from the Persian Gulf region to the Indian Ocean (via the Gulf of Oman and the Arabian Sea). Iran, Iraq, Saudi Arabia, Qatar, Kuwait, United Arab Emirates, etc., are all in close proximity. Two tankers were attacked on Thursday (One Norwegian-owned, the other Japanese-owned), which follows four attacks that occurred in May. The incidents occurred in international waters, and the US military ship the USS Bainbridge is in the region (evidently with the blessing of the international community) to defend interests including the freedom of navigation. Oil prices jumped a bit but overall are fairly restrained, with WTI trading at $52 and Brent Crude trading at $62. Think of WTI (West Texas Intermediate) as the price of US oil, and Brent Crude the price of global oil. The difference between the two largely reflects the cost of moving US oil to ports and then on to international markets (WSJ). Pipeline capacity is the limiting factor, and while international shocks should increase the price of Brent and widen that spread, new pipeline capacity being built in the US should work in the opposite direction towards lowering it. As for the price of oil in general (both WTI and Brent), this and other (e.g. Venezuela) supply constraints should put upward pressure on prices. But working to offset that is weaker global demand, particularly in China-led emerging markets, where most of the growth in oil demand has taken place during the last 20 years. Developed economies like Europe, Japan and the US are growing more slowly, and their output is increasingly less oil intensive (using less oil per unit of output). They’ve added really no growth in global oil demand over the past ten years (Federal Reserve Bank of Dallas).   


    Unrest in Hong Kong

    Markets at this point seem pretty unperturbed, and I think that’s because strife in the major oil producing regions of the world is nothing new. I put it in the category of “expected, but not predictable in its specifics.” Another recent headline event that I put in the same category is the current political turmoil in Hong Kong. Hong Kong is a fascinating case study in economics, about as close to a laboratory experiment as you can get. Hong Kong became a colony of the British Empire in 1842, and in 1898 Britain obtained a 99-year lease after which control would transfer to China, which occurred in 1997. In the 1980 television series Free to Choose, economist Milton Friedman described Hong Kong at the time as “the freest market in the world…no natural resources outside of a great harbor, no duties or tariffs on imports or exports, a low flat tax and a stable currency” (the Hong Kong dollar is still fixed to the US dollar, not the Chinese Renminbi). It had over 4.5 million people (7.3 million today), and yet wages had quadrupled since World War II, when Hong Kong was occupied by the Japanese. In 1997, when sovereignty was returned to communist China, I expected tremendous upheaval, i.e. “the world’s freest economy being handed over to communist China”, but that hasn’t really occurred, and it is because China has followed a ‘one country, two systems’ framework that has more or less left Hong Kong alone. There have been protests since (most notably in 2003 and 2012), over things like China-forced “patriotic education” in Hong Kong schools, and the Chinese government has largely backed away. But recently the Chinese government issued a hugely unpopular “extradition bill” that would allow extradition (seizure) of criminals to the China mainland (WSJ). Critics in Hong Kong feel that this is an obvious power grab on the part of the communist officials in China. They fear that it will be used for political purposes to silence dissenters regarding China’s growing encroachment over the city’s autonomy. Massive demonstrations followed, and it looks like the Chinese government is backing away again — for now. To be honest, what has perplexed me has been the relative calm between China and Hong Kong, not the recent unrest.

  • "Kee" Points with Jim Kee, Ph.D.

    • Current State of the World
    • Monetary Mystery

    Current State of the World

    When I look at the world’s economies and stock markets today, it all more-or-less makes sense. Going back to Fed Chair Ben Bernanke, the government had done what it could do on the monetary policy side, essentially acting as a lender of last resort (asset purchases) and keeping rates low. It was fiscal policy that needed attention, because tax and regulatory burdens were grinding higher. I believe we have seen tax cuts and deregulation lifting growth, only to be cancelled out somewhat by tariffs and tariff threats. Markets seem to reflect this, falling and rising as President Trump’s tariff threats rise and fall. Anecdotally, I have friends who are global supply-chain specialists that have little interest in politics, but each describes the reality of how difficult the trade war has been for day-to-day sourcing and planning. But, good news may be likely to happen soon. According to political strategist Greg Valliere, this weekend’s truce between Trump and Mexico (Trump was going to raise tariffs on Mexican imports this week) could presage a positive meeting with Trump and China’s Xi at the G20 summit this month, as well as with Canada and Europe. However, Valliere also points out that the odds of an unclear trade outlook between now and year’s end are not exactly low, either. Last year (2018), trade angst accelerated, producing “volatility to the downside.” I’d like to see 2019’s trade angst decelerating, producing “volatility to the upside.” I think that is a pretty good description of what we’ve seen so far, with a deviation during the month of May.

    Monetary Mystery

    There is an inconsistency to the above narrative that bothers me: If monetary policy has not really been a factor for some time, then why is the market so sensitive to Fed policy? Admittedly, a great spectacle of our time is how the media has managed to make routine Fed meetings into major events, and perhaps there is a short-term overreaction (i.e. temporary and soon-to-reverse) phenomenon occurring. But when the market really jumps on a weak payroll number (like we saw last week) because it increases the chances of a Fed rate cut, it makes me look for a more valid reason than that of short-term swings in sentiment. In a recent Bloomberg interview, former Treasury secretary (and President Obama advisor) Larry Summers asserted that when it comes to the Fed, what is really important is the Fed’s perceived operating strategy. If the Fed is raising rates because of a “Phillips curve” assumption that growth (or really low unemployment) causes inflation – and it wants to get ahead of that by raising rates and slowing growth – that’s one thing. I find that framework wanting as guide to Fed policy, and so does Summers. For a given quantity of money, more output should produce disinflation as each dollar would be worth more in terms of goods and services, which means lower prices. Also, and again for a given quantity of money, more spent on wages leaves less money to be spent in other areas, which puts off-setting downward pressure on those prices. So, low unemployment and higher wages don’t cause inflation. Anyone with a computer and access to Federal Reserve data can graph inflation and unemployment over time and see this in about two minutes. Believing that higher wages (or oil prices, or steel prices, etc.) dolead to inflation (i.e. a rise in ALL prices) is known as the cost-push fallacy. I think that when markets believe that the Fed is operating according to Phillips curve thinking, they believe that the Fed is unnecessarily slowing the economy and threating future profits. That is why markets sell off when the Fed raises rates even though inflation is in check. According to Summers, and I agree with this, the Fed should wait for legitimate inflation signals, which in my opinion would be a consistent (i.e. multi-quarter) rise in its core inflation measure, before it raises rates. It should not raise rates based upon a preemptive Phillips curve-based strategy.

  • "Kee" Points with Jim Kee, Ph.D.

    • What is Capital Structure?
    • Current Corporate Debt Concerns


    Markets sold off last week on aggressive comments from President Trump regarding trade with China and Mexico, then bounced back (apparently) as those countries issued more conciliatory statements towards trade (WSJ). We will see how it goes this week. Today I want to address the issue of increasing corporate debt, which has been vying for media headlines with the ongoing trade-war.

    What is Capital Structure?

    Capital structure refers to the amount of debt (borrowing money) and or/equity (selling ownership shares) a firm employs to finance its operations. For example, if a company had no debt and only issued stock, it would be 100% equity financed. If it then issued debt (i.e. borrowed money) and bought back all of the outstanding shares of stock it had issued, it would be 100% debt financed. Usually firms lie somewhere in between, with some debt and some equity financing. That’s called a firm’s “capital structure.” Firms with assets that are “plastic” (i.e. fungible) and hard to monitor tend to be financed more by equity, because lenders (debt-holders) to such firms would have a hard time figuring out, on an ongoing basis, whether or not their money was being spent wisely. Companies with a lot of research and development (R&D) tend to fit this description. On the other hand, companies with very specific (and easy to monitor) assets, like oil refineries, tend to have more debt. Debt is also seen as a disciplining device for firms generating more cash than they have reinvestment opportunities, as it forces management to pay out surplus cash flow in the way of interest payments. However, this also makes firms riskier during business downturns, as they have less cash on hand to use for a cushion. Because of this, it is often asserted that highly levered firms make economic downturns worse because they are forced to fire workers and liquidate assets in order to make their interest payments. You can see that the question of what a company’s capital structure should be involves a lot of trade-offs. The real point I want to make here is that financial economists have not worked out a final theory of what the “optimal capital structure” of a firm should be.

    Current Corporate Debt Concerns

    But any model of optimal capital structure would surely have corporate debt increasing as its price – the interest rate it has to pay – decreases, and indeed in the past several years we have seen historically low interest rates coincide with increases in corporate debt. Is this cause for alarm? Probably not, according to a recent paper published by the Federal Reserve Bank of New York titled, “Is There Too Much Business Debt?” Corporate debt-to-GDP ratios are near 50-year highs (as interest rates are near fifty-year lows), and debt-to-profits have increased since 2012 (though declining since 2016). But the authors make a case, close to my heart on debt discussions (!), that outstanding debt has to be compared to assets, and that the annual interest payments that companies have to pay to service their debt (i.e. the service cost) have to be compared to annual income or profits (i.e. their ability to pay). On the first measure, the authors look at corporate debt-to-book assets and find that it is within historical norms, as is a similar measure, debt-to-market cap. As an aside, the authors point out that the former may overstateleverage if book values are less than market values, while the latter may understate leverage if market values are stretched. On the second measure, service cost, they look at cash earnings or profits (EBITDA) relative to interest expense, which is known as “interest coverage” (i.e. can you cover your interest payments with your earnings?). Because of strong earnings, this measure remains above its historical median, which means interest coverage (or safety, if you will) is above average. So it too is not a big concern. To sum it all up, I think this paper gives a more intelligent and balanced view of the current corporate debt environment than what is found in the media. Corporate debt levels are not without concern, but they are certainly not the end of the world either, nor a precursor to financial Armageddon.

  • "Kee" Points with Jim Kee, Ph.D.

    • Multi-Year Trade Negations
    • Modern Monetary Theory

    Multi-Year Trade Negotiations

    You are probably as glad as I am that the market was closed on Memorial Day, given what Barron’s described as the Dow’s recent “five weeks of futility.” And recent economic data releases (housing, retail sales, industrial production etc.) haven’t been very encouraging. A good question to ask is whether or not there is a case for optimism regarding the ongoing US-China trade conflict. I think there is, and you hear it particularly among economists who are starting to view trade negotiations as a long-term, multi-step and multi-year process. This might involve an agreement this year on tariffs, for example, with subsequent agreements on items like national security or intellectual property down the road. Economist Scott Powell points out that the General Agreement on Tariffs and Trade (GATT), which preceded the World Trade Organization (WTO), took nine rounds and 60 years of on-and-off negotiations to bring international tariff levels down following the Great Depression. That’s an interesting way to look at it, but given the level of global integration today (discussed in prior Kee Points), some reduction in the current high level of uncertainty regarding trade policy is needed, and fast. I would characterize the current environment of global trade restrictions as relatively moderate and threading to ratchet up, which is a growth and market killer. I think a multi-year series of negotiations would only be successful (as measured by global growth and stock market returns) if they were perceived as a ratcheting down (or at least clarification) of current trade tensions. And in my opinion, that requires a tangible agreement on some aspect of trade with China (tariffs, intellectual property, security) in the next few months.

    Modern Monetary Theory

    “Just wrong” is how Federal Reserve Chair Jerome Powell describes so-called Modern Monetary Theory, or MMT. Since I am hearing this term a lot lately, I am guessing that Kee Points readers are too. The gist of MMT is that a country that issues its own currency, and also borrows in its own currency, can spend more money than it receives in tax revenues without increasing budget deficits by just printing money to pay for the difference. Conventional economists would argue that this would just lead to inflation, or each unit of currency being worth less in terms of the goods and services it can buy. MMT also argues that said government need never default on its debt because it can just print money to pay debt-holders. But conventional economics would argue that lenders, upon seeing this, would not buy new debt (lend money) or roll over existing debt without demanding higher rates. In fact, the University of Chicago polled its panel of experts from top economics programs around the country (Harvard, Stanford, etc.) and found no real supporters of MMT. But then, conventional economists haven’t exactly had a stellar record of anticipating interest rates, inflation, etc., under the current, unconventional monetary policy period! My sense is that anything that promises more spending without raising taxes will always find some political support, but I would be wary of things like MMT that emote more from newsletters than peer-reviewed research. If anything, and like most things monetary, there is probably a case to be made for individuals to be fooled in the short term by some monetary expansion scheme (known as “money illusion”); that is, it might not immediately result in higher inflation and interest rates, but it probably would in the long run.

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