When Money Slows Down
…Nasdaq up for 8. Wholesale prices flatline. Why worry about overshooting inflation targets. Money velocity at near record lows. Fed mops up surplus cash. Markets don’t reinvest for future growth.
Financial Review by Sinclair Noe for 08-09-2018
DOW – 74 = 25,509
SPX – 4 =2853
NAS + 3 = 7891
RUT + 4 = 1690
10 Y – .04 = 2.93%
OIL – 0.23 – 66.71
GOLD – 1.40 = 1213.10
The Nasdaq Composite posted a gain for the eighth consecutive session, logging its best winning streak since October. The Dow and the S&P slipped. The S&P 500 is near record levels but can’t seem to muster steam for a breakout move. Earnings and data look good but earnings season is winding down and it will be tough to top the second quarter results. Global economies probably can’t provide a synchronized lift. Trade wars could blow up fast. But for now, the markets are on cruise control. The VIX, or volatility index is just slightly above 11, which is another way of saying we are in the Dog Days of summer, and most traders are on vacation.
Bloomberg reports that the U.S. Securities and Exchange Commission is intensifying its scrutiny of Tesla’s public statements in the wake of Elon Musk’s tweet Tuesday about taking the electric-car company private. “funding secured.”
Vice President Pence laid out a plan that would begin creating a military command dedicated to space and establish a “Space Force” as the sixth branch of the U.S. military as soon as 2020, the first since the Air Force was formed shortly after World War II.
Rite Aid and Albertson’s announced that their planned $24 billion merger had been scrapped, with Rite Aid saying that it didn’t have shareholder support. Rite Aid shares dropped 11%.
U.S. government debt yields fell the most in weeks, reversing course after a reading on inflation came in weaker than expected; that in turn helped support buying of Treasuries and pushed yields sharply lower. The producer-price index was unchanged in July. The 10-year Treasury note had pushed yields right up to 3%, but today’s rally was the biggest one session move since July 3. The flat PPI reading pulled the 12-month rate of wholesale inflation down to 3.3%. The 12-month rate of core PPI advanced 2.8% in July, just below the record high of 2.9% reached in March. Wholesale prices were held down by lower prices for food, energy and trade. The electrical power index fell 1.6% and meat prices also fell. The index for pharmaceutical preparations rose 0.7%. The index for final demand for services fell 0.1%, the first decline since December. Both the headline and core indexes were constrained by a 0.8% drop in the volatile ‘trade services’ component, which measures profit margins for retailers and wholesalers. Tomorrow the government releases the consumer price index, or CPI, which measures price sat the retail level.
Inflation is likely to rise above 2% given the strong economy, but Charles Evans, the president of the Chicago Fed said today that price pressures are “not a problem” that would require the Fed to accelerate the gradual pace of interest-rate hikes. Evans says that inflation above 2% is nothing to be worried about. Evans said he is open minded to risks that the economy could overheat but added that his judgement at the moment is that those fears are “not quite what is relevant.” Evans forecast GDP growth of 3% this year and 2.5% in 2019. This should bring the unemployment rate down to 3.5% from 3.9% in July. Given this forecast, Evans said he saw the need to keep gradually raising interest rates towards a neutral level, in other words, a rate neither stimulating or restricting growth. Evans said his bank’s economic team puts that neutral rate around 2.75%. This is above the current level of rates. In June, the Fed hiked interest rates to a range between 1.75% and 2%.
Rate hikes are not the only monetary policy tool. The Fed built up a massive $4-trillion-plus balance sheet of Treasuries and mortgage-related assets in the wake of the financial crisis. Buying the assets, or quantitative easing, helped keep a lid on long-term interest rates after the Fed’s traditional short-term rate tool had hit the zero lower bound. Reversing these purchase has always stressed Wall Street. The Fed has ruled out outright asset sales. Instead, the Fed began to allow assets to slowly roll off its balance sheet at a pace of $10 billion per month. These roll-offs are not set to reach the peak pace of $50 billion per month until October. One result is that the money velocity has dried up. M1 is considered a measure of the velocity of money. Low inflation increases demand for money because higher prices requires more money for a given amount of goods and services. Higher inflation rates increase the velocity of money, which increases inflation even more. As with inflation, higher price levels will also increase the demand for money. The velocity of money was designed to give an indication of how fast money is exchanging hands in the economy. Generically defined, it’s the frequency at which one currency unit is used to purchase goods and services within a given period of time, or nominal GDP divided by the money stock. The idea the money has a “velocity” or speed at which it circulates in the economy is a bit of a spurious concept. Velocity more closely resembles the rate at which credit is formed in an economy. Money velocity points to the notion that the US Federal Reserve will have trouble increasing interest rates to its 2.75%-3.00% expected target this cycle.
The velocity of money in the United States is at its lowest level in recent history. M1 money velocity is currently at 5.48, almost the lowest on record. M2 money velocity is currently at 1.44, almost the lowest on record. MZM money velocity is currently at 1.31, almost the lowest on record. Money velocity has declined due to a massive increase in money supply. More money supply is required to fuel GDP growth with low levels of money velocity. [That equation: Money Supply * Money Velocity = Nominal GDP]. So, maybe Evans is right, maybe a little inflation is not a problem, maybe it is needed to get money moving again. Inflation is not a problem as long as the velocity of money is declining, or hovering near these record low levels. The dangerous part of the equation is Money Supply. After 2008, the Fed printed large amounts of cash supply because US cash demand shot up. Today, the Fed is destroying about $30 billion of cash supply every month because US cash demand is falling. Cash demand drops when credit or risk appetite grows. If US cash demand is falling $30 billion every month, then the Fed’s cash supply cut is matching the demand drop. The Fed is mopping up surplus cash. No more, no less. The mopping up process is like walking a razor’s edge. Directional changes to the velocity of money take place at a glacial pace, meaning the possibility of overshooting the target is real and will only be realized once money “spills” out of capital markets and into the broader economy; provided some other force doesn’t turn off the money spigot in the meantime.
That might all sound a bit strange at a time when Apple tops $1 trillion in market cap, and buybacks and dividends are on the rise. What does a higher market cap or a higher valuation do to improve the operation and long-term success of the business? Historically market cap was a representation of operational performance and expected future growth, but it has now become the objective. Market cap can actually hurt a firm’s capacity for productive investment as capital is eaten up paying out against an asset that hasn’t generated any return. The destructive force of this connect is exacerbated by the stock buy backs whose sole purpose is to drive market cap higher. Case in point, Apple versus Amazon. Apple’s numbers are mediocre. But they are distributing $110 billion in cash this year so it doesn’t matter. They hit a trillion dollar market cap. That puts its price-to-sales in line with Amazon, which has a 3 year revenue growth rate 7x higher than Apple’s (32% vs. 4.5%). Amazon’s growth rate continues to accelerate while Apple actually lost overall market share dropping from second largest to the third largest seller of smartphones. Amazon doesn’t distribute cash to speculators. It attracts speculators by driving expected future growth. The rest of the market is attracting speculators by paying them cash. In effect, CEO’s are investing in market cap today rather than growth tomorrow. When market cap is being driven by something other than expected future growth derived from productive investment it is coming at the cost of expected future growth due to lack of productive investment. At this point financial markets require perpetual money injections to prevent market cap from collapsing. The economy simply cannot compete with financial markets for available capital. Enter the Fed with rate hikes and the end of the bubble cycle. A market cap reset is required for future growth.