Housing is one of the few weak spots in the US economy

Outlook:

We have a ton of data today, the first of which is housing starts, although it’s not a market-mover. As we have been warning, housing is one of the few weak spots in the US economy. New houses are a small number compared to existing, but can serve as a proxy for everything from affordability to builder confidence. In Aug, starts rose a giant 9.2%, but Sept is forecast to slip downward, although permits might be up. At 2 pm we get the Fed minutes, with nothing new expected.

As usual, the TICS report got no coverage, which is very odd considering all the pundits opining about the demise of the dollar and the multi-cycle crash about to hit us. Or maybe not so odd, considering the Treasury presents the data in an unreadable table format that takes hours to decipher. Both China and Japan, the two big holders of Treasuries, reduced their stash by a little, but it would be a stretch to say it’s meaningful. China’s cut its holdings by $6 billion to $1.165 trillion, possibly using some dollars to support the yuan. Nobody knows. This is a piddly amount, anyway.

From Chandler at BBH we read that demand for long-term US assets is high, $131.8 billion in August, the most since September 2014. The average this year to July was $49.3 B and $44.4 B in 2017.  Chandler cleverly adds that the capital inflow is vastly higher than the current account deficit.

If the Trump whining about the Fed is just noise, and assuming the Saudi situation goes away, that leaves us with the stock market recovery and whatever is going on in Europe about Brexit and Italy. EU heads of state hold a dinner tonight, with reporters swarming like flies to get an off-the-cuff comment, but we pretty much know the outcome—both Brexit and Italy pose an existential threat to the EU and the EMU in their own way, and whatever the failings of those treaties and their institutions, they represent an end to European wars and a path forward. The implication is that Europe has to hold the fort.

Well, no. The UK can leave the EU with or without a trade deal and with or without an acceptable Irish border deal, and WW III will not break out. The mismanagement of the Brexit talks is breath-taking. As analysts have been saying ever since the UK referendum, Europe has a lot to lose on a hard Brexit, too. A hard Brexit is damaging to the UK economy, but until all the cows come home, there have been real advantages to devaluation—including the lowest unemployment rates in decades.

Merkel is one of the few to see that the UK can gain a competitive advantage with a continuation of a customs deal like Turkey’s, in which there is no tariff on goods but a single external tariff against outsiders. Note that agricultural products are excluded, something the UK excels at. Merkel says, according to the Guardian, that the single market is Europe’s one big competitive advantage. Giving it away to Britain is not acceptable. She doesn’t say so, but the Irish border impasse can be viewed as a ruse to get extra advantages from Europe. Merkel favors hard talks for the next 21 months after the actual exit in March.

One EU source said “To negotiate [a Turkey-like deal with the UK], we need more time than we have until March, since the UK is such a major economic power.” Golly, we haven’t heard that one before—Europe is afraid of Britain. The UK press always positions May as the beggar at the gate. Evidently the Europeans see Britain as more like a ravening horde at the gate.

Italy is another story. The FT again has a long story with many charts showing that Italy has an unsustainable debt problem only if you are making the worst-case case.

First, the 2.4% deficit embedded in the Italian budget is lower than “the deficits of France,  Spain, Japan or the US. It is also about half of what economists said the original cost of the government’s spending promises would be.” The problem lies in assuming growth will be boosted enough to make debt payments realistic. We tend to side with Italy on this one. Italians are the only ones in Europe capable of American-style animal spirits. Free them from the Brussels strait-jacket, and innovation/growth might come from it. You can’t say that abut (say) Germany. Now to get them to pay taxes. Well, lower them enough and they might.

The FT notes that Italian spending has not been irresponsible. In fact, the primary fiscal balance (tax revenues minus spending ex-interest costs) has been in surplus since 1992. “That is not the case for most advanced countries. Indeed, Italy’s fiscal primary balance has been healthier than the average of the OECD in the past 26 years and in 2012 Italy was one of nine countries running a primary fiscal surplus — the third-largest among the 35 OECD countries.”

Alas, you do have to consider the cost of servicing debt. The overall balance, that does include debt service, is not so hot. “The overall budget balance has not been positive since the 1960s, despite steady improvements since 2009. On the back of a debt-to-GDP ratio that doubled in a decade to 117 per cent in 1994, and worsened after the economic crisis To become the second largest in the EU after Greece, Italy’s payments for interests on public debt are among the highest in the OECD. The result is that Italy’s debt sustainability is strictly linked to interest payments.”

This is precisely what the northern tier (aka German voters) are afraid of—another bailout.

The FT goes on to discuss various adjustments to the Italian budget that might be useful, but “The bottom line is that if the expansionary measures fail to deliver the projected growth, and interest rates payments rise, economists calculate that Italy’s debt-to-GDP would rise again — in contrast with the official budget expectation of a slow downward trend.” Everyone agrees that the risk of an unsustainable amount of debt is very high.

Here’s the problem: conventional wisdom from economists and Brussels bureaucrats has it that the probability of Italy pulling off this stunt is very low. Is that external interference in sovereign decision-making? You bet. That Italy agreed to this interference in the form of the various treaties is a weak leg for the EC to stand on. Treaties get dumped all the time over the course of history. This is not to say Italy should dump the treaties. It is to say that Italy has a case for making its own decisions and policy choices, and unless and until it violates the rules in some egregious way, Europe’s role is to warn and to guide but not to demand and insist. After all, nobody can forecast GDP. Nobody can even forecast when the ECB will be raising rates, not even Mr. Draghi. The ECB has a plan, but it’s not written in stone. All this ruckus is being caused by expectations, forecasts and conventional wisdom guidance.

In both instances, Brexit and the Italian budget, the European Commission reveals itself as holding a weak hand. It would appear stronger if it were more willing to compromise and be more open-minded about experimentation instead of so uptight and strait-laced. We think the EC knows it, too.  Most observers expect blow-up crises. If so, neither Britain nor Italy will be a loser. And the EC knows that, too. The first sign of tractability by the EC will be wildly euro-favorable.

Fun Tidbit: Remember when folks thought the dollar index was a decent substitute for VIX in determining risk appetite or total fear? That was around 2010 or so. We haven’t shown the two together on the same chart in a long while, so thought we would take a look. The VIX is dark yellow and the dollar index is green. The chart is weekly and not adjusted for scale. We might say that we see some positive correlation between the two, especially during the period of the 2008-2009 crisis and also during the long rangey period from 2010 to 2013. But the VIX spikes are not obviously related to the dollar index and almost surely a function of organic developments in equities alone. Can we make any deductions? Not safely. VIX spikes whether the dollar is going up or down, and the dollar goes up and down seemingly independently of VIX. Right after a VIX spike in 2011, the dollsr started to rise, but that was two years later. So, some correlation since both are measuring risk appetite/risk aversion, but attributing causation is probably not a good idea.

 

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