Thursday, March 15, 2018

In the Wall Street Journal (online) on Fed Tightening, March 15

David Shulman, senior economist at UCLA Anderson Forecast, said investors are “underestimating the tightening cycle.”

Monday, March 12, 2018

My Amazon Review of Jason Matthews' "The Kremlin's Candidate: A Novel"

Spy Hunters

Former CIA operations officer Jason Matthews has offered up his third and likely final book in his “Red Sparrow” series of novels on Dominika Egorova, a CIA spy operating in the heart of the Kremlin. To get a sense of whom Egorova is I would note that Jennifer Lawrence is playing her in the newly released “Red Sparrow” movie.

Although not quite as good as the first two, “The Kremlin’s Candidate” packs quite a punch. In Moscow Egorova is well on her way to becoming the head of the SVR (Russian Foreign Intelligence Service) wining, dining and bedding Putin all the while the Kremlin is running an agent in the United States destined to become the CIA Director. It is Erogova’s and her CIA handler and lover, Nathaniel Nash, role to foil the Kremlin’s plot. Similarly the Russians are searching for a mole in their security services with Erogova in and out of the cross hairs.

Along the way we visit Khartoum, Hong Kong and yes, Staten Island, New York. We learn much of the tradecraft used by the CIA and the Russians and of how the Russians use “illegals” in the United States. (Shades of the TV series “The Americans”) We also get a very real sense that Matthews doesn’t like the wimpy politicians who ran America’s foreign policy under the Obama Administration. My guess is that he will like the current crop of politicians even less. As with his prior two books Matthews ends each chapter with a recipe for a menu item that was eaten in the chapter. Trust me; there are some real good ones here.

Although the reader doesn’t have to read the earlier novels first, it certainly helps. You won’t be wasting your time. Enjoy.

Thursday, March 8, 2018

"Regime Change," UCLA Anderson Forecast, March 2018

Regime Change

David Shulman
Senior Economist
UCLA Anderson Forecast
March 2018

The sudden 10% decline in stock prices (see Table) and the rise in long-term interest rates in early February signaled what economists call a “regime change.” (See Figures 1 and 2) The economic environment is changing from one of sluggish growth and low inflation to one of accelerating growth and moderate inflation. Moreover, monetary policy is transitioning from one of accommodation to one of normalization and fiscal policy is moving from a moderate deficit to a high deficit regime with trillion dollar deficits in the on deck circle. (See Figure 3) The $300 billion budget compromise (2 years) combined with the recently enacted $1.5 trillion dollar tax cuts (10 years) highlighted the demise of the so called deficit hawks. Included in the budget compromise was a substantial increase in defense spending which ratified our long held belief that the era of contraction in that sector is over. (See Figure 4)

Figure 1. S&P 500 Index , 24Feb17 – 23Feb18
Sources: Standard and Poor’s via

Figure 2. 10-Year  U.S. Treasury Bond Yields, 24Feb17 – 23Feb18

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                          Will the 2018 Stock Market Be a Rerun of 1987?
The quick run-up in stock prices in January took place under a backdrop very reminiscent of the boom and crash in stock prices that took place in 1987. Recall that the S&P 500 advanced 33% from January-August 1987, only to decline by 39% by October. Further, like 1987 there was a Fed transition from Volcker to Greenspan in August of that year while Powell replaced Yellen in January of this year. However, unlike 1987, stocks dropped 10% in January, while in 1987 a similar drop took place in April. The Table below highlights the similarities and a few differences between 2018 and 1987.


Indicator                                     January 1987                     January 2018

S&P 500                                       +13.2%                               +7.5%*
Extended Bull Market                Started 8/82                     Started 3/09
Computer Trading                      Portfolio Insurance         Algo Trading
Economy                                    Strengthening                      Strengthening
Profit Growth                             Accelerating                         Accelerating
Dollar                                         Weakening                           Weakening
Oil Prices                                    Up from lows                     Up from lows
Inflation Rate                             Increasing                            Increasing
Fed                                             Tightening                             Tightening
10-Year Treasury Yields         Bottoming, about to rise   Rising     
Pro-Growth Tax Reform            1986 Tax Act                     2017 Tax Act
Trade Tensions                           Japan/Germany             China/NAFTA
White House Scandal                Iran/Contra                     Russian Interference


Europe                                        Uniting                                   Dividing
Big Power Rivalry                      Declining                               Increasing
Shiller CAPE                               14X                                        35X

*-As of January 26.


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Figure 3. Federal Deficit, FY 2010 -FY2020
Sources: Office of Management and Budget and UCLA Anderson Forecast

Figure 4. Real Defense Purchases, 2010 – 2020
Sources: U.S. Department of Commerce and UCLA Anderson Forecast

Growth Driven by Business Investment

Spurred by rising business fixed investment, real GDP growth is on track to continue its 3% pace established in the second quarter of 2017. (See Figure 5) For all of 2018 we forecast a growth rate of 2.9%, but that will slow to 2.6% in 2019 and a sluggish 1.6% in 2020. Why the slowdown? Simply put, the economy is already operating at full employment and it is bound by slow labor force growth and sluggish productivity. Nevertheless, job growth will continue, albeit at a slower clip than in recent years and the unemployment rate will hit 3.5% in early 2019. (See Figures 6 and 7)

Figure 5. Real GDP Growth, 2010Q1 – 20120Q4F
Sources: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 6. Payroll Employment, 2010Q1 -2020Q4F
Sources U.S. Bureau of Labor Statistics and UCLA Anderson Forecast

Figure 7. Unemployment Rate, 2010Q1 – 2020Q4
Sources: U.S. Bureau of Labor Statistics and UCLA Anderson Forecast

As we mentioned above, the key driver of the economy will be business fixed investment. All three categories of business fixed investment (equipment, intellectual property and structures) will be expanding robustly in 2018 with real equipment spending leading the way with a gain of 8.4%. (See Figures 8, 9, and 10) Business investment is responding to pent-up demand, the near moratorium on new regulations by the Trump Administration as well as the reduction in business taxation and the new 100% expensing rules for the depreciation of capital equipment. Nevertheless, growth here will slow as the economy begins to operate at its full potential.

Figure 8. Real Equipment Spending, 2010Q1 -20120Q4F
Sources: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 9. Real Intellectual Property Spending, 2010Q1 – 2020Q4F
Sources: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 10. Real Business Investment in Structures, 2010Q1 -2020Q4F
Sources: U.S. Department of Commerce and UCLA Anderson Forecast

No Boom for Housing

Although housing activity will continue to expand through 2019, it will be far from a boom. Higher interest rates (discussed below) and higher home prices will take their toll on housing starts. (See Figure 11) Simply put, if we didn’t have a housing boom with mortgage rates below 4%, how will we have one when mortgage rates exceed 5%? Thus, after recording 1.2 million housing starts in 2017, we are forecasting 1.3 million units in 2018 and 1.38 million and 1.36 million units in 2019 and 2020, respectively.

Figure 11. Housing Starts, 2010Q1 – 2020Q4
Sources: U.S. bureau of the Census and UCLA Anderson Forecast

A Blow Out in the Trade Deficit

Although President Trump has railed against the trade deficit, the stepped up pace of economic activity along with increase in the federal deficit will cause the trade deficit, as measured by real net exports, to increase from $620 billion in 2017 to nearly $800 billion in 2020. (See Figure 12) Because the United States is consuming more than it is producing it has to make up the difference through imports. As a result, the Trump fiscal policy will be playing a major role in increasing the trade deficit. Moreover, instead of improving the situation, the Trump Administration proposals to increase tariffs on steel and aluminum will actually make things worse as domestic costs rise and foreign producers retaliate.

Figure 12. Real Net Exports, 2010 -2020
Sources: U.S. Department of Commerce and UCLA Anderson Forecast

Higher Wages, Inflation and Interest Rates Ahead

One of the triggers of the stock market sell-off in early February was a reported increase in average hourly earnings of 0.3% in January over December. Instead of using hourly earnings we prefer to use the employee compensation index as a better measure of the strength of the labor market largely because that index includes bonuses and benefits. In 2017 that index increased at a very modest rate of 1.4% over 2016, but the quarterly run rate for 2018 will likely be above 4% and approach 4.5% by 2020. (See Figure 13) This is how a fully employed economy is supposed to behave.

Figure 13. Employee Compensation per Hour, 2010Q1 – 2020Q4F
Sources: Bureau of Labor Statistics and UCLA Anderson Forecast

Inflation is not as quiescent as it was earlier in the decade. The fears of deflation have abated and for the first time since 2012, the consumer price index increased by over 2%. Going forward, with the end of the oil price rout and rising wages coming from an increasingly tight labor market, inflation as measured by both the headline and core consumer price indices will exceed 2% over the forecast horizon and likely reach 3% in 2020. (See Figure 14) Indeed, the month-over-month increases reported for January in the headline and core consumer price indices of 0.5% and 0.3%, respectively, is supportive of our view. Moreover, the price cuts for cellular services will anniversary this spring and that will trigger a near automatic increase in year-over-year inflation.

Figure 14. Headline vs. Core Consumer Price Index, 2010Q1 -2020Q,
Sources: U.S. Bureau of Labor Statistics and UCLA Anderson Forecast

In a fully employed economy, with rising inflation and an exploding federal deficit, what is a central bank supposed to do? The answer is obvious. The Fed will become more aggressive in raising interest rates. We are forecasting four quarter point hikes in the federal funds rate this year and continued increases throughout the forecast horizon to a target of 3.25% - 3.5% in 2020. (See Figure 15) We are aware that this looks very aggressive, but we would surmise that former Fed Chair Janet Yellen would be on board with this. Why? She, as an adherent of the Phillips Curve, would be troubled by our and other forecasts of a 3.5% unemployment rate which would signal oncoming inflation and as a neo-Keynesian economist she would be horrified at trillion dollar federal deficits being overlaid on a fully employed economy. We would expect no less from Jay Powell, the new Fed chair.

Given the prospect of rising inflation and a substantial increase in Treasury issuance arising from the deficit, long-term interest rates will likely surprise on the upside. Further, with the Fed shrinking its balance sheet, which in effect works as a net issuance of government securities, the long shortage of “safe assets” is about to come to an end with a vengeance. Further, with both Europe and Japan now firmly in recovery modes, their periods of unusually low interest rates are also about to come to an end. Thus, we would not be surprised to see the 10-Year Treasury yields exceeding 3.5% this year and cross 4% in 2019.

Figure 15. Federal Funds vs.10-Year U.S. Treasury Yields, 2010Q1 -2020Q4
Sources: Federal Reserve Board and UCLA Anderson Forecast


The title for the report is “Regime Change.” We mean it. The Trump Administration has put in place an all-out stimulus policy on top of a fully employed economy. As with an automobile, when an economy runs hot, sometimes a few gaskets break. Near-term, spurred by strong business fixed investment, the outlook is for continued 3% growth, but as we enter 2019 the economy could very well begin to sputter under the strains of higher inflation and interest rates and by 2020 it could very well stall out.

Thursday, March 1, 2018

Will Trump Tariffs Force Gary Cohn Out?

As I write this stocks are in free fall after President Trump announced that he will impose a 25% tariff on steel and a 10% tariff on aluminum. It signals the opening salvo in a trade war that will raise prices domestically, harm export industries and weaken alliances abroad.

However the knock-on effect could trigger the resignation of National Economic Council Director, Gary Cohn. Cohn clearly lost a very public internal fight against the protectionist wing in the White House, namely Peter Navarro, Wilbur Ross and Robert Lighthizer. Because the financial markets have been reassured by the presence of Cohn, a former Goldman Sachs executive, his leaving of the White House would trigger further selling. Given the wholesale resignations from the Trump White House, why should Cohn's leaving be any different.

Friday, February 23, 2018

My Amazon Review of Benn Steil's "The Marshal Plan: Dawn of the Cold War"

The Cold War through the Lens of the Marshall Plan

Benn Steil, a senior fellow at the Council on Foreign Relations has written a very well researched history on the role of the Marshall Plan as the fulcrum of the Cold War. He previously wrote a history of the 1944 Bretton Woods monetary conference and that certainly prepared him to deal with the economic and geopolitical issues facing Europe at the beginning of the postwar era. He chronicles how the U.S. attitude changed from plans to deindustrialize Germany and to make the U.N. central to foreign policy toward rebuilding Germany and making NATO the focus of U.S. policy in Europe.

The very fact that the U.S. would take part in both the rebuilding of Europe and entering into peacetime multi-lateral alliance represented a revolution in U.S. foreign policy. Steil highlights the role of such key figures as Marshall himself, Harry Truman and George Kennan. More importantly he brings to light the roles of Republican Senator Arthur Vandenberg moved the necessary legislation through Congress and Under-Secretary of State Will Clayton, a former cotton baron, who first articulated the strategic vision of a united Europe.  We also witness the work of former car executive Paul Hoffman running the day-to-day operations of the plan along with General Lucius Clay who acted as America’s proconsul in Germany.  He also noted the important role played by Massachusetts Congressman Christian Herter who led a congressional fact finding delegation to Europe that was influential in generating the political support for the plan.

The Marshall Plan was enabled in Europe by the far sighted leadership of British foreign minister Ernest Bevin and his French counterpart George Bidault. Here we had a socialist politician working hand in glove with a center-right one. Most interesting was the fact that Stalin understood the implications of the Marshall Plan far better than his western counterpart. He knew that it would divide Europe and that in turn would make it impossible for him to neutralize a united Germany. Thus it was the Russian backed coup in Czechoslovakia to prevent that government from participating in the plan that sealed the fate of Europe. From there it was quickly realized that aside from economic support, Europe would need military support. That realization was crystalized by the Berlin Airlift where a logistics wizard, General William Tunner did the nearly impossible task of supplying Berlin by air. NATO would come soon thereafter.

Steil does a service in describing the role of British spies (The Cambridge Five) of informing Stalin of western plans and the role Soviet mole Henry Dexter White in Treasury in his continued support of keeping Germany down. We also see Henry Wallace following Stalin’s line in opposing the Marshall plan in the 1948 presidential race. Although it is not clear the full role Russia played in the 2016 election, it certainly had a candidate in Henry Wallace.

Steil goes on to present his views on the NATO expansion after the Cold War ended in 1991. His take is that the U.S. was far from being clear-eyed in the 1990s of the implications of moving NATO east and the effect it would have on the Russians. I don’t think that was necessary in this book. This topic should be taken up in a future book.

I read Steil’s book with a great deal of sadness. In the 1940s we had brilliant statesmen who rose to the occasion.  Unfortunately our statesman of the past twenty years or so have been found wanting and this is especially true of the current administration.

Sunday, February 11, 2018

My Amazon Review of Andrew Lo's "Adaptive Markets: Financial Evolution at the Speed of Thought"

Biological Finance

I am a sucker for kids from middle-class Queens who become great successes. (I am one, without the success part.) Andrew Lo, a M.I.T. finance professor and hedge fund manager is one of the more notable ones. Aside from being a finance super-star, Andrew Lo is a great story teller. I wish I could take his class. However at times he tells too much and as result his 504 page book in the print edition is too long.

Lo’s thesis, building on the work of Kahneman, Tversky, Thaler and Haidt argues rather convincingly that the home economicus model that modern day financial economics relies on is a special case and shouldn’t be generalized for all markets in all seasons. Thus the physics math that finance uses, while it creates reasonably good heuristics, is not complete. Simply put the efficient market hypothesis works most of the time, but not all of time.  

Lo is an expert on modern finance and he presents a well-documented history as to how it came into being starting with an obscure mathematics dissertation written in French by Louis Bachelier which ultimately became the foundation for options pricing models. He makes one mistake here by noting that Paul Samuelson received his Ph.D. in 1947. It was 1941 while his Ph.D. was formally published in 1947.

Be that as it may Lo brings to the table of modern finance neuroscience, evolutionary biology and behavioral economics. When doing this much of the rigor of physics math goes away but it makes his adaptive markets far more relevant to the real world. After all, despite the rise of the machines, markets are made by human beings who have a multitude of motives many of which are not “rational” and many of which are unconscious. Instead of thinking about the day-to-day chaos that appears on the stock exchanges, think of traders fighting for survival on the African Savannah. This would certainly put the concept of seeking alpha in a different light.

Professor Lo also comes up with a neat idea for mass funding of cancer research through the creation of a $30 billion biotech fund that is following the science rather than the near term dictates of the venture capital market place.

In sum, Andrew Lo has written an important book and it should be part of the curriculum in all serious finance departments.

Tuesday, January 30, 2018

My Amazon Review of Robert Harris' "Munich: A Novel"

Two Flies on the Diplomatic Wall

Author Robert Harris has given us a well-researched fast paced novel on the 1938 Munich Conference where Britain and France surrendered the Sudetenland portion of Czechoslovakia to Nazi Germany to avoid a war that was surely coming. His two protagonists Hugh Legat, a junior secretary at 10 Downing Street, and Paul von Hartmann, an official in the German Foreign Office, act as flies on the wall as Hitler and Chamberlain meet at the Regina Palast Hotel in Munich to settle the crisis. Legat and von Hartmann are linked by their past connections at Oxford.

The book opens with Hitler’s September 27th ultimatum to Czechoslovakia to surrender the Sudetenland or face an invasion. It is here where Legat and von Hartmann watch as events transpire and we hear conversations of the very real historical figures on both sides. We see Chamberlain scrambling to get Mussolini to act as a mediator which quickly brings about the conference. Both Legat and von Hartman end up at the conference as interpreters through the manipulation of the intelligence services of both countries. In von Hartmann’s case, he is a member of the Oster conspiracy to bring Hitler down. It failed in 1938 and failed spectacularly in 1944. Von Hartmann is bringing to Munich the minutes of a 1937 meeting which Hitler announced his plans for a general European war to his senior military and foreign policy officials. Von Hartmann naively believes that if Chamberlain had that information he wouldn’t yield to Hitler forcing a war that the German military would rebel against Hitler.

Through the very anti-Nazi Legat Harris paints a sympathetic picture of Chamberlain trying to avoid the second Great War in 20 years. He has Chamberlain understanding that Britain was both militarily and psychologically unprepared for war and his appeasement policy was buying time to strengthen the country. However he avoids bringing up the facts that it was the Baldwin-Chamberlain policies that put Britain in the position of weakness.

Along the way we get a sense of what life was like in 10 Downing Street, the precariousness of air travel and the general yearning for peace in both Britain and Germany. Chamberlain was hailed as a hero in both countries, much to the chagrin of Hitler. I found the book to be a great read and it was hard to put down.