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Kass: An Open Letter To Larry Kudlow

By Guest Author | October 22, 2018

, Kass: An Open Letter To Larry Kudlow

“We believe that free market capitalism is the best path to prosperity!” – The Kudlow Creed

Dear Larry,

You and I go way back – we have been friends for many years.

I deliver this letter to you out of respect and in recognition of that friendship. It is being submitted and is intended to be respectful, courteous, analytical and forward thinking.

This letter is being offered in several parts:

  • Our strong friendship
  • Why domestic economic growth is weaker than is apparent and the White House believes
  • Risks associated with the delivery and substance of the Administration’s current policy towards China 
  • Suggestions

The Current Trajectory of Domestic Economic Growth is Weaker Than It Appears

* Look bottom up and not top down to decipher U.S. growth trends and risks

All this said, I respectfully disagree with you on a number of statements you made recently in an interview with Scott Wapner on CNBC in which you said:

“Our economy and the people and the workers and entrepeneurs, they’re killing it. We’re the hottest in the world. We’re crushing it right now, and I think that’s going to continue regardless of China… I don’t think this is anything resembling a sugar high… America is on a tear… It has strong legs”

To begin with, the jobs market is not as strong as it is being heralded – this is not “the greatest jobs market in history.” Indeed, the Obama Administration created, on average, 211k non farm payroll jobs/month in its last 20 months compared to 190k jobs/month in the first twenty months of the Trump Administration. And since the total US population climbs every year (+250% in the last seven decades), the percentage improvement, on a per capita base, is not that impressive in 2017-18. The same observation applies to wages – they are not simply anywhere as grand as currently advertised by the White House.

There is now ample ‘bottoms up’ evidence (discussed in the next section) that the domestic economy is much weaker than you suggested last week as numerous companies are missing the consensus expectations. More importantly, as reported by Schwab’s Liz Ann Sonders, we are now experiencing the highest percentage of S&P 500 companies issuing negative earnings guidance since the first quarter of 2016. Highest percentage of S&P 500 companies issuing negative earnings guidance.

Overall, the underlying economic growth story, outside of one-time events and natural disasters, isn’t nearly as strong as reported. My pal and former advisor to Dallas Federal Reserve President Richard Fisher, Danielle Dimartino Booth, concurs with my assessment:

“Against that backdrop, it’s becoming clear that many companies are rushing to secure products and materials before prices rise regardless of current demand. You could say they are in panic-buying mode. The upside is that this behavior bolsters economic growth in the short term. The downside is that there is likely to be a nasty hangover. The noise in the economic data will be amplified by the rebuilding from Hurricane Florence. The estimates of the storm’s damage span from $20 billion to $50 billion.”

Given the size of the tax cuts and the increase in government spending it should not be surprising that Real U.S. GDP has risen from about +2.5% to more than +3.75%. But this boost is a “sugar high” and not sustainable. Tax cuts and relentless government spending only serves to push forward and borrow from future economic growth. And so has the financial repression (zero interest rate policy) of the last nine years served to pull forward domestic economic growth.

Considering the age and strength of our economy we should be achieving a surplus – instead the deficit is expanding. Economic growth is greatly debt dependent and is therefore unsustainable in a very real sense. Fiscal 2017 GDP rose by $1.3 trillion but the federal deficit rose by exactly the same amount – $1.3 trillion. Tax cut based and increased spending help to explain why confidence is so high, but the delta (rate of change) in these two factors will not exist in perpetuity.

Rising government debt, sanctioned in the U.S. by both parties, is fiscally irresponsible and, with rising interest rates, growth will be sapped. This imprudence is not restricted to the U.S. as, if we look at the 180 most important economies of the world, only seven have in their estimates an improvement in commercial and fiscal imbalances – so almost no government in the world plans to reduce the rate of debt increases.

Over the last decade, the tools of monetary ease, (providing more and more liquidity) and rising government spending have been increasing less productive – for every $3 in debt created has only resulted in $1 of GDP in the U.S. We are now at a point of diminishing returns of policy and potentially even at a point of saturation.

Since The Great Recession in 2007-08, the accumulation of large debt loads in the private and public/sovereign sectors are now being adversely impacted by rising interest rates and, when combined with harsh trade rhetoric (with China) is serving to jeopardize economic growth.

Already the auto industry is foundering and housing has stalled. These are two industries, as our mutual friend Jim Cramer says, that punch above their weight in terms of aggregate impact on the US economy.

Globally, in a flatter and more interconnected world (reflected by a record share of non U.S. sales/profits of S&P 500 companies), we are impacted by first and second order consequences of our policy and rhetoric – with risks to higher costs and disruption in important supply chains.

Risks Associated with the Delivery and Substance of the Administration’s Current Trade Policy

Though the headline (and lagging) high frequency economic data may appear promising we are already seeing rising cost and supply chain problems in the current third quarter earnings reporting period – much of which is in the province of and directly derived from the trade disputes with China.

Recent warnings have been communicated by cyclically sensitive companies like Fastenal (FAST) , Ford (F) , General Motors (GM) , Lennar (LEN) , Trinseo (TSE) (a Dow Company spin out), United Rentals (URI) , Textron (TXT) , W.W. Granger (GWW) , Sealed Air (SEE) and PPG (PPG) as well as by more stable companies like Kimberly-Clark (KMB) , Kraft Heinz (KHC) , Campbell Soup (CPB) and many others.

The prices of Drs. Copper and Linerboard are telling a story of weakening economic activity. And so are numerous other commodities prices.
According to JP Morgan, the U.S. economy has a roughly 28% chance of falling into a recession in the next 12 months. The recession probability surges to 60% if the forecast period is extended to two years.

The bankruptcy of Sears (SHLD) and K Mart could add 75k-100k in layoffs as Joseph Schumpeter’s creative destruction and the Amazoning (AMZN) of our economy continues apace – providing a further and secular headwind to growth.

The world is flat and global growth is slowing. The Fed is now on autopilot (and is jacking up interest rates) and the world’s global bankers are also making a monetary pivot.

Tariffs are a tax on the U.S. consumer and trade talk is now impairing global trade and the IMF has, once again (last week), downgraded worldwide growth projections for 2018 and 2019.

Our largest S&P companies have successfully penetrated overseas markets and have steadily expanded their non U.S. exposure (in sales/profits) over the last several decades. Our country’s largest companies are called “multi nationals” for a reason – and their future prospects are increasingly tied to the health (of non-disruptive) world trade and sound trade policies.

The global stock markets are a leading economic indicator. For some time non U.S. markets (led by Europe and China) have been dropping, in recent weeks the U.S. stock market has followed suit. Markets are not coincident indicators, not lagging indicators – they are leading indicators. And in the last few weeks (and particularly in the tantrum since Wednesday) the markets are telling a story – and, based on price action, it’s not a fairy tale.

Finally, the President’s open and harsh trade dispute with China and our country’s renewed isolationist policies may threaten China’s willingness to finance our deficits (anywhere near the current level of interest rates) by offering up their excess savings. With over $10 trillion of global corporate bonds maturing over in the next five years (from a recent McKinsey Global Institute study , $7 trillion of Treasuries (currently paying on average a coupon of only 2%) rolling over, near all-time debt/GDP ratios and central banks’ quantitative tightening around the world – unlike “The Street Car Named Desire’s” Blanche DuBois – we may no longer be able to rely on “the kindness of strangers.”

From a forward looking economic standpoint, this compounding curve of debt is quite worrisome.

Bottom Line Observations and Suggestions

“We should be slow to speak and patient in listening to all…Our ears should be wide open to our neighbor until he seems to have said all that is in his mind – St. Ignatius

First, we should be cognizant of the fragile state of the U.S. economy and that there are already signposts of a weakening in the rate of growth, rising cost pressures, and developing supply chain disruptions – which, if it continues, will lead to lower business activity and deterioration in U.S. corporate profits. These perceptible warning signs should not be ignored.

Second, the U.S. stock market’s recent tantrum and the continued, steady weakness in overseas markets are likely a warning signpost of “Peak Global Growth.”

Third, policy rhetoric should be more subdued and conflated less with politics – behaving less like singer Meghan Trainor who (to paraphrase) famously sang that “it was all about the base, the base, the base” and more like St. Ingatius.

Fourth, the global economy is flat and interconnected. There are more dominoes today than yesterday and more yesterday than there were the day before. Again, our policies need to follow the path of St. Ignatius who wrote that “nations should be linked for good.”

In order to avoid a policy mistake and to hold off a deterioration in consumer and business confidence that leads to a quick downturn in our economy, the current President must begin to act more like President Teddy Roosevelt who carried a big stick but talked softly. As it relates to our current trade dispute with China (and others), President Trump might consider taking the advice from St. Ignatius who advised that if one must correct another, it ought to be done “without hard words or contempt for people’s error.” And so might Vice President Pence tone it down, who, in a recent speech at the Hudson Institute strongly suggested that the dispute with China goes far beyond the realm of trade.
“America had hoped that economic liberalization would bring China into a greater partnership with us and with the world. Instead, China has chosen economic aggression, which has in turn emboldened its growing military. As history attests though, a country that oppresses its own people rarely stops there. And Beijing also aims to extend its reach across the wider world.

The American people deserve to know: in response to the strong stand that President Trump has taken, Beijing is pursuing a comprehensive and coordinated campaign to undermine support for the President, our agenda, and our nation’s most cherished ideals.

China is also applying this power in more proactive ways than ever before, to exert influence and interfere in the domestic policy and politics of this country. And worst of all, China has initiated an unprecedented effort to influence American public opinion, the 2018 elections, and the environment leading into the 2020 presidential elections. To put it bluntly, President Trump’s leadership is working; and China wants a different American President.

There can be no doubt: China is “meddling in America’s democracy.”

To paraphrase President Lincoln’s “A House Divided Against Itself Cannot Stand” speech in June, 1858, I do not expect the U.S. economic recovery to be dissolved and I do not expect our economic house to fall anytime soon.

But I do expect that the economic recovery will cease and corporate profits will fall from current levels if we continue to be divided and engaged in harsh rhetoric and trade battles with our neighbors that will, in the fullness of time, bring on multiplying and adverse first and second order consequences.

Doug Kass

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