Welcome to the Capital Note, a newsletter about business, finance, and economics. On the menu today: inflation fears deflate stocks, from pipeline to railroad, China’s (latest) green-jobs threat, working from the office, and crime and the minimum wage. To sign up for the Capital Note, follow this link.
‘All is Well’
I saved this story as something to write about on another day, but then yesterday happened:
Hedge fund manager Bill Ackman is betting on interest rates rises crashing stock markets, as the American investor eyes a repeat of the trade that netted his funds billions of dollars when stocks plunged last year.
Mr Ackman made $2.6bn (£1.8bn) for his funds, including the £5bn Pershing Square investment trust, last year from a series of trades to protect against a stock market sell-off.
Now the fund manager has identified a surprise rise in interest rates as the next big risk for markets. “We will see a spike in inflation as early as the middle of the year,” Mr Ackman said. “It is already starting to happen. At some point if rates move enough than it becomes a market risk event.”
Mr Ackman said he had bought “instruments that pay off in a large way in the event of a surprising move in rates” . . .
A wave of selling in U.S. government bonds intensified on Thursday, sending yields soaring after new data indicated a strengthening economic recovery and an auction of seven-year Treasurys met with tepid demand from investors.
The yield on the benchmark 10-year Treasury note reached as high as 1.539% before finishing Thursday’s session at 1.513%, according to Tradeweb—its highest level in a year and up from 1.388% at Wednesday’s close.
Moves were also pronounced in shorter-dated bonds. The five-year yield rose to 0.799% Thursday from its previous close of 0.612%—the largest one day gain since December 2010.
Yields, which rise when bond prices fall, climbed after Labor Department data showed that the number of jobless claims fell sharply last week, signaling the job market could be stabilizing after layoffs edged higher earlier in the winter . . .
This is yet another reason to read the pieces by Larry Summers and the Financial Times’ Martin Wolf that I highlighted in a Capital Note earlier this week. Both, on the face of it, supported Biden’s $1.9 trillion stimulus package, but were clearly, however politely, warning that it might be just a bit too much.
I will just requote this passage from Wolf:
The growth of the broad money supply is extraordinary. The IMF forecasts only a modest gap between actual and potential GDP in the US in 2021. It is quite possible that monetary and fiscal expansion on this scale will hugely overheat the US economy.
Wolf went on to suggest that there was too much complacency in the markets about inflation, and then added this:
Some analysts seem to view a big upsurge in inflation as inconceivable, because it has not happened for a long time. This is a bad argument. Many once thought a global financial crisis was inconceivable because it had not happened for a long time. In the 1960s many thought the inflationary upsurge of the 1970s similarly inconceivable.
From the look of yesterday’s trading, some of those “some analysts” may be becoming a little less relaxed, although I was interested in this twist (via the Wall Street Journal):
Markets are signaling that inflation is coming and investors are getting ready. Treasury yields are rising and stock-market investors are starting to shift from high-growth tech companies toward companies like airlines that will benefit from an economic rebound.
But one corner of the Treasury market suggests that a coming bump in U.S. inflation will run out of steam swiftly. This has implications for fans of gold or cryptocurrencies who fret about runaway inflation.
Investors’ inflation expectations can be seen in Treasury markets by looking at the difference between the yields on ordinary Treasurys and the yields on inflation protected Treasurys, known as TIPS. This difference is called the break-even rate.
The difference between five-year Treasury and TIPS yields shows break-even inflation expectations have risen to nearly 2.4% in recent days—the highest level since May 2011, implying inflation is set to pick up.
But there is more going on below the surface. Shorter-term break-even rates are higher than longer-term ones, an extremely rare situation—known as an inversion of the break-even curve. This forecasts a spike in inflation that then falls away.
For instance, longer-term inflation expectations are lower: 10-year break-even rates are 2.15% and 30-year rates are 2.1%.
The five-year rate hasn’t been above the 10-year since July 2008, according to FactSet, and the gap between the two has never been as great as it was on Wednesday.
Interpretations for the anomaly vary. One possibility is that the $1.9 trillion coronavirus-relief package Washington will vote on this week will bring only short-term benefits—and only a short-lived bump to inflation. More than three-quarters of the funds likely to be approved will be spent on stimulus checks and other income support, according to Goldman Sachs estimates.
Another view is that the inversion in break-even rates might signal expectations that the Federal Reserve—contrary to promises—will react swiftly to cap inflation and keep it close to its 2% target . . .
Read the whole thing and judge for yourself, but it seems unlikely to me that the Fed is going to reverse course soon, despite market fears.
Take this (via Bloomberg), for example, from the Atlanta Fed’s Raphael Bostic:
While U.S. growth is recovering quicker than expected amid the Covid-19 pandemic, the Federal Reserve is focused on supporting the labor market that is still in crisis after losing 10 million jobs, Atlanta Fed President Raphael Bostic said.
The remarks, from a voting member of the central bank’s policy setting committee this year, reinforce the message that the Fed is not close to tightening policy even as the economy rebounds.
“Just to remind you, our mandate is full employment,” Bostic said Thursday during a virtual speech to the bank’s banking conference. “It’s not full GDP. It is not the size of GDP. So this disparity is something that is important and something we are going to have to continue to watch closely.”
There is also the fact that with government debt as large as it now is, higher interest rates could be . . . inconvenient. Using inflation to erode a debt burden is not exactly unknown. It is perhaps not entirely surprising that the euro has been creeping up of late against the greenback (one euro now buys around $1.22, up from $1.20 a couple of weeks ago). Meanwhile the British pound has being doing well against the buck (up from $1.37 on February 1 to $1.40 yesterday), although local factors, including a remarkably successful rollout of the U.K.’s vaccine program (my youngest brother — six years younger than me — will get his first shot over there in ten days, whereas I . . .) and a general feeling that Britain has been looking oversold, have probably contributed to the rise in sterling.
On the other hand, the first scenario laid out in that Journal report — a jump in the inflation rate, which then peters out — seems reasonable to me. As we finally emerge from COVID-19 there will be a lot of pent-up demand, but I would guess that the economy will not be as well-placed to meet that demand as it could be. To go back to something that was being said almost a year ago now, economies cannot just be switched off and on. A surge in demand would be one inflationary trigger. If that demand cannot be met, there is another.
Equally, to repeat something that I have written before, I cannot see how, over time, the policies of the Biden administration will do anything other than hold growth back. There is the regulatory onslaught, already under way, and we should not forget taxes that may well be heading corporations’ (and our) way.
Take corporations, for example. From the Tax Foundation:
Lowering the corporate tax rate to 21 percent brought the U.S. closer to the OECD average, reduced the incentive for corporations to invert or shift profits, and increased investment incentives that lead to a higher growth rate.
Increasing the corporate income tax would undermine the progress policymakers made four years ago. An increase in the federal corporate tax rate to 28 percent would raise the U.S. federal-state combined tax rate to 32.34 percent, giving the U.S. the highest combined corporate income tax rate in the OECD, ahead of France at 32.02 percent.
A higher U.S. corporate tax rate would also exacerbate the current double taxation of corporate income. Corporate income faces two layers of tax: once at the entity level through the corporate income tax and another at the individual level when that income is distributed as dividends or capital gains. When accounting for both levels of tax, under current law, corporate income faces a combined top tax rate of 47.47 percent, reduced from a pre-TCJA rate of 56.33 percent.
The top integrated tax rate faced by corporations today puts the United States near the middle of the pack compared to other OECD countries. However, a 28 percent federal corporate income tax rate combined with Biden’s proposal to tax long-term capital gains and qualified dividends at an ordinary income tax rate of 39.6 percent for income earned over $1 million would make the top integrated tax rate on corporate income in the U.S. the highest in the OECD at 62.7 percent.
I have seen better recipes for growth.
One question I have that will not go away — perhaps it is just a legacy of having been brought up in the 1970s — is whether inflation will really subside when the economy slows down again.
But to end on a (sort of) brighter note, on a day when the Dow Industrials (-1.75 percent), S&P 500 (-2.45 percent), and the NASDAQ Composite (-3.52 percent) all sold off, there was one notable ray of light (via the Wall Street Journal):
GameStop Corp. shares skyrocketed for a second day Thursday as momentum surrounding the stock continued to build and derivatives activity heated up. Shares of the videogame retailer surged 47% to $135 after more than doubling in the final minutes of Wednesday’s trading session.
I am sure it was this that drove it (from Tuesday’s Journal):
GameStop Corp.’s finance chief was forced out of his role as activist investor Ryan Cohen pushes for a digital transformation of the ailing videogame retailer, people familiar with the matter said.
Fundamentals, you see.
Around the Web
U.S. President Joe Biden’s decision to cancel the Keystone XL pipeline is sparking renewed interest in shipping Canadian oilsands crude by rail, and that comes with its own environmental risks.
Cenovus Energy Inc. and Imperial Oil Ltd. have increasingly turned to trains to move their crude, with oil exports by rail from Canada more than tripling since July. Now, Gibson Energy Inc. — an oil shipping company that signed a 10-year contract with ConocoPhillips to process oilsands crude before loading it at its train terminal — expects other producers to follow suit.
Without Keystone XL, which was scheduled to enter service in 2023, rail is poised to become a more important way for Canadian oil to reach U.S. Gulf Coast refineries, which need the heavy crude to replace declining supplies from Mexico and Venezuela. That means the risk of derailments may also rise . . .
Tesla, you say? Green jobs, you say?
HEFEI, China — Walk around the sprawling auto factory in central China, and the wealth pouring into the country’s electric car industry quickly becomes clear.
Rows of bright orange, 15-foot-tall robots — 307 of them, mainly from Sweden — whir with activity. They glue lightweight aluminum panels to vehicle frames using aerospace-grade adhesives. In an industry in which speed can mean cost efficiency, the assembly line plods along at half the pace of many lines elsewhere.
Even by the standards of the $1.6 trillion global car industry, an operation like this doesn’t come cheap. In fact, the Chinese operator of the factory, a company called Nio, loses thousands of dollars on every car it makes. State-run companies last year mustered a combined $2.7 billion to bail it out.
But Nio, or Chinese companies like it, could be the future of the global car industry. General Motors and other major names are increasingly betting that the next generation of rides will be powered by batteries alone, without a drop of gasoline or diesel. If so, China has invested so much money in the industry that it could hit the accelerator with ease . . .
Working from the office:
The chief executive of Goldman Sachs has signalled his determination to get his bankers back behind their office desks, calling home working an “aberration” that must be corrected “as soon as possible”.
While the bank operated successfully throughout the Covid crisis with less than 10% of its 34,000 global staff working in the bank’s offices, David Solomon dashed the hopes of any Goldman staff hoping to split their time between their homes and offices in the future, saying it did not represent “a new normal” for the firm.
My best guess: The new normal will, so far as office work is concerned, look a lot like the old normal.
The Minimum Wage and Crime
From City Journal:
Both President Joe Biden’s coronavirus stimulus proposal and a bill recently reintroduced by congressional Democrats propose raising the federal minimum to $15. Such a steep increase would have profound social and economic effects, boosting wages for some while driving others out of the work force. It could also contribute to another, less-expected consequence: a rise in crime.
A surprising body of research links increases in the minimum wage to increases in criminal offending by those most likely to lose jobs as a result of the wage hike. One analysis concluded that raising the federal minimum to $15 could create crime costs of up to $2.5 billion—a bill that would be borne disproportionately by the very people whom the wage hike is meant to help.
The minimum wage’s economic trade-offs are well known. It raises the take-home pay of some, while causing others—particularly teens, young adults, and less-skilled workers—to lose their jobs. The Congressional Budget Office has estimated that a $15 minimum would boost 17 million workers’ earnings by 11.8 percent, on average, but would also cost from 1 million to 3 million jobs.
Higher wages could make working more appealing than illegal activity for some. For others, put out of work by the hike, losing a job heightens the risk that they will go on to commit both property and violent crimes. After all, the people most likely to feel the economic downsides of a minimum-wage hike, in the form of lost jobs—the young—are also among those most likely to commit such crimes. Youths aged 16 to 24 make up just 12 percent of the population but were 23 percent of those arrested as of 2019; they account for a full third of those making less than $15 an hour. The CBO estimated that 16- to 19-year-olds alone would account for half of the job lost if the minimum wage reaches $15.
In one paper from last year, researchers evaluated decades of data to consider the relationship between minimum-wage hikes and crime among 16- to 24-year-olds, finding that the wage hikes tend to correlate with increased property crimes, particularly larcenies—a sign that some unemployed people decide to earn their keep through theft rather than finding another job . . .
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