Wednesday, July 09, 2014 - Waiting for Liftoff

Waiting for Liftoff
by Sinclair Noe

DOW + 78 = 16,985

SPX + 9 = 1972
NAS + 27 = 4419
10 YR YLD - .02 = 2.54%
OIL – 1.46 = 101.94
GOLD + 7.00 = 1327.60
SILV + .08 = 21.10

The Federal Reserve released the minutes of the most recent FOMC policy meeting from June 17-18.

The Fed is going to take away the punchbowl. As of October, no more punchbowl. That’s it, QE is drying up. I think we all knew that was coming. And then after the Fed stops buying Treasuries and mortgage backed securities, they will get around to probably raising their target on interest rates, but rates would remain near zero for a “considerable time” (probably the spring of 2015) after the Fed halts its program of bond purchases.

According to the minutes, there continues to be division over when the Fed should stop reinvesting proceeds of the $4.2 trillion in assets it purchased to support financial markets. Ending reinvestment will put the central bank's balance sheet on a declining path, and some members argue that should not take place until interest rates have been increased. Fed officials also agreed that the rate of interest on excess reserves would play a “central role” in moving rates higher when the time comes.

And this is a fluid timeline for all this; it is partly dependent on “liftoff”; that’s the new word from the Fed – liftoff. At some point, the economy will slip the surly bonds of earth and wheel, soar, and swing high in the sunlit silence, and do a hundred things we haven’t dreamed of for such a long, long time. Someday, we’ll have liftoff.

The market players looked at the minutes and pulling away the punchbowl, while painful, was an indication of economic strength. Fed officials expressed overall confidence that moderate economic growth will continue and unemployment and inflation will gradually move towards the central bank's targets. A couple of participants noted that consumer spending had been supported importantly by gains in household net worth while income gains had been held back by only modest increases in wages. So, an important element in the economic outlook was a pickup in income, from higher wages as well as ongoing employment gains that would be expected to support a sustained rise in consumer spending. Which is correct in theory; we just haven’t seen the pickup in income.

At the press conference after the June meeting, Fed Chairwoman Janet Yellen said that recent inflation readings were “noisy.” According to the minutes, the Fed staff was not concerned with inflation despite some recent higher readings. Although the Fed staff revised its inflation forecast up “a little” in the near term, the medium term projection was revised down slightly.

Yesterday I talked about an anomaly in the jobs number from Thursday. How could we have negative 2.9% GDP in the first quarter while we were adding all those jobs? I concluded that the problem was that productivity was declining.

New data was released this morning showing US productivity growth was the worst since the recession. The data from the Labor Department looks at multifactor productivity, and it includes the impact of capital, new machines, investment in technology, and such. The measure of capital services input grew 1.9%, which is the best showing since 2008, but that is more a reflection of the bounce from the 1st quarter, and still far from the pre-recession levels that were consistently above 3%. So, the data in this morning’s report is consistent with an economy coming out of a recession but nowhere near its pre-recession rate of growth. Bottom line is that productivity needs to increase if the economy is going to get better.

One of the concerns for Fed monetary policy is inflation, which isn’t a problem right now and when we have seen a problem in the past 20 years of so, the Fed has been able to tamp it down. The problems with inflation right now are tied to energy and food prices. Food prices are largely tied to weather, and we have seen some nasty weather, and the Fed can’t control the weather. Extreme weather will be an ongoing problem, and rising food prices will be an ongoing challenge, but for now, it’s a short term inflation problem.

Energy prices are largely tied to geopolitical problems in the Middle East. Iraq, Israel, Syria, and other problems could explode out of control at any given moment, but we’ve seen crude oil prices dropping for 9 sessions. The problem in Iraq may very well result in the country splitting apart, but the southern regions, which produce and export the most oil, will likely continue exporting oil. So, the oil traders don’t seem concerned about Iraq divided in 3 parts. Meanwhile, Ukraine hasn’t unfolded as Putin planned. Kiev did not roll over. Sanctions are painful. Putin doesn’t look like he wants to escalate the fight; at least not today.

Meanwhile, the US is more or less on track to pass Russia and Saudi Arabia as the world’s largest producer of crude oil within the next 5 years. Domestic crude output is increasing but the increase is coming from shale and shale is notoriously tricky and expensive to extract. The US will continue to extract more shale oil but certain projects, even mega-projects, have been abandoned because of the expense. We know that there are huge reserves in the US, but it doesn’t always pay to pump it; so the increase in output may not be as strong as hoped. For now, prices are high and oil extraction is soaring at shale formations from Texas to North Dakota as companies split apart rocks using high-pressure liquid, or fracking. The result is that now Oklahoma has more earthquakes than California, and we are less dependent on foreign oil.

The United States has just become the world’s biggest oil producer, at least when you consider crude oil plus natural gas together. The US has been the top global nat gas producer for the past 4 years, but a new report from Bank of America says that in the first six months of this year the US overtook Saudi Arabia and Russia to become the top producer of petroleum product, that is oil and natural gas and the liquids that are separated from nat gas.

Annual investment in oil and gas in the US is at a record $200 billion, reaching 20% of the country’s total private fixed-structure spending for the first time, but it will take some time for that investment to work its way through the rest of the economy. We now produce about 11 million barrels a day of crude oil and we consume about 18.5 million barrels a day. So despite the boom, we still import oil and we are still dependent on OPEC. If we converted from oil and gasoline to nat gas, starting running more cars on compressed natural gas, we could become energy independent in short order.

The other side of the equation remains conservation and not just a switch to nat gas but a switch to renewable energy. You think green energy is too expensive? Tosh; tosh and falderal. Global energy markets are reaching a tipping point. For the first time, a large fraction of the world's fossil fuels could be replaced at a lower cost by clean energy, with today's renewable technologies and prices. And virtually no further investments in fossil fuels make long-term economic sense because higher fossil fuel prices over their useful life will be exorbitant.

Barclay's Bank recently downgraded the entire US utility sector in fear that it would not respond to the disruptive challenge of distributed solar. The Barclays credit team believes that, over the next few years, the “confluence of declining cost trends in distributed solar photovoltaic (PV) power generation and residential-scale power storage is likely to disrupt the status quo.” The new government in India is cutting fossil fuel subsidies and promising to provide rooftop solar for 400 million homes. Conservation is another important element. Profitable building retrofits would cut fossil fuel used for heating and cooling by 20%, and displace another 15% of fossil fuel electricity demand.

International oil companies are hitting the wall on the price they will pay for big new oil projects. There is plenty of oil in Ohio but BP, in its last quarterly report, announced it would halt development of the Utica shale fields. Along with BP, Chevron, Shell, Total, Statoil, and Exxon have all cancelled or delayed mega projects or even sold off major investments in US oil projects

The latest Bloomberg New Energy Finance projection suggests that 2/3 of incremental global power generation over the next fifteen years will come from renewables. Declines in coal use in developed economies will be sharp enough to cut the global share of fossil fuels from 64% today to only 44% in 2030.

Electricity currently provides only 1% of global transportation energy; EV's and rail could today replace the first 15% of the oil used by cars and trucks at with an internal rate of return higher than 15%. Fossil fuels generate 63% of the world's power, renewables less than 5%, but 1/3 of fossil electricity now costs more than competing wind and solar. And that doesn’t even begin to factor in the externalities associated with fossil fuels.

A couple of quick notes as we wrap up. Citigroup is reportedly close to paying about $7 billion to resolve a probe into whether it defrauded investors on billions of dollars’ worth of mortgage securities in the run-up to the financial crisis. A majority of the settlement is expected to be in cash, but the figure also includes several billion dollars in help to struggling borrowers. An announcement of the settlement between the bank and the Department of Justice could come as early as next week.

This bit of economic data came in late this afternoon. The Arizona Regional Multiple Listing Service shows the Phoenix market saw overall sales in June drop 11% year over year; now back to the lowest sales since 2008. Non-cash sales were up 6% year over year, but cash sales were down 40%; so it looks like investors are moving on. Active inventory is up 43% year over year and at the highest level for June since 2011. So, sales are down, inventory is very high, and cash is scarce.

When do we start QE4?