Stocks fell on Friday as bad company-specific news hit bellwethers Boeing# and Johnson & Johnson#. In addition, many of tech high flyers that show great promise, but little or no earnings, lost ground as investors increasingly show concern about the valuation of those stocks.
Over the past many months you have read of my concerns related to overcapacity. At the depths of the Great Recession, capacity utilization in this country dipped below 67%. In the 1970s, it was not uncommon for readings approaching 88%. At such high rates, demand exceeds supply and inflation occurs. Tight capacity wasn’t the only reason for the hyperinflation we saw in the 1970s, but it was an important contributing factor. By the 1990s, the rate was down to the 80-85% range. Most economists suggest that is an ideal range, one that balances supply and demand without putting undue pressure on prices in either direction.
Today, however, capacity utilization in about 77.5%, and that is trending lower. At that rate, there is clear excess supply. The rate is certainly higher than it was at the depths of the Great Recession, but what is most disturbing is that the recent trend is lower, i.e. capacity is now growing faster than demand. While tight labor markets put some upward pressure on inflation, the growing overcapacity has the opposite impact, helping to push prices lower, raising the specter of deflation.
It takes about a decade for the damage of a real financial crisis, as we saw in 2007-2009, to heal. Indeed, by November 2014, the rate was back to 79.24%, very close to the balancing point I talked about above. But over the past five years, two factors unique to this recovery occurred. First, China, which had become a major contract manufacturer to the rest of the world, continued to rapidly expand capacity. That includes both manufacturing capacity as well as residential and commercial real estate. Second, central banks around the world worked to keep key interest rates as close to zero as possible in an effort to sustain what they collectively felt to be fragile economies.
But, as almost always is the case, when one tampers with normal forces to achieve one’s objective, there are unintended consequences. Low rates foster bad investment decisions. Investments that one wouldn’t make in a rate environment where there was a real cost to borrow, are executed when “free” money is available. As a result, capacity started to rise faster than demand, and corporations piled up record amounts of debt in the process. Collectively, governments and central banks adopted policies that, to date, have perpetuated that process. The Fed has begun to cut rates again with growth hovering around 2% and inflation just a bit below. Such moves may stabilize or even push those rates higher in the short run, but they will also serve to keep pushing capacity utilization lower if the continuation of free money stimulates more investment than necessary.
So, what might be a solution? The obvious one would be for central banks to stop trying to artificially move an economy that is pretty close to what most economists would deem to be long term sustainable growth and inflation rates. Perhaps the Fed was spooked by an inverted yield curve. But that has now reversed itself. One more rate cut at the end of this month should be more than sufficient to keep the economy on course. President Trump and others of like mind want to see rates materially lower. But, in real terms, money is already free. Any rate-dependent investment that can’t pass muster today likely won’t pass it if rates are another percentage point lower. The President has the mind of a real estate investor. For them, rates can never be too low. But rates that, in fact, are too low finance projects that shouldn’t be built. In New York, the median sale price of a condominium in August of this year was 12% lower than it was last year. The last thing New York needs is more supply of condos for sale. That is just one for instance.
Oversupply won’t disappear overnight. If demand grows by 2% and supply remains flat for a year, capacity utilization still wouldn’t reach 80%. If demand would grow 2%, new investments were limited to projects that were truly needed, and cost inefficient supply were removed from the market, balance could be restored sooner than later.
The problem isn’t lack of demand; it’s too much supply.
When government policy finally understands this point, central banks and collective fiscal policy would be altered and balance could return. Once balance is restored, investment will resume, inflation will stabilize, and growth can continue along its long term glidepath. Simply said, if market forces were allowed to do the heavy lifting, markets and the economy would operate more efficiently. Central bank intervention is necessary in times of stress. It is not necessary each time GDP growth waivers half a percentage point off trend. Between, 2008 and 2015, the Fed left interest rates alone and the economy did just fine. Perhaps it could have grown slightly faster without some of the post-recession regulations, but it was essentially OK. Stock and bond markets were relatively stable except for brief periods when Europe went through sovereign debt stress (and their central banks intervened as they should have). Note that when Europe was in stress and we escaped most damage, our Federal Reserve held rates steady. Instead, it pumped liquidity into the system until world markets stabilized.
If the Fed persists in employing easy monetary policy at a time of modest stress, it runs the risk of magnifying the unintended consequences and leading to more problems ahead.
Today, Kim Kardashian is 39. Judge Judy Sheindlin is 77.
James M. Meyer, CFA 610-260-2220