6836 Bee Caves Rd.

B2 S100, Austin, TX 78746 (512) 327-7200

www.Hoisington.com

Quarterly Review and Outlook

Fourth Quarter 2015

A Weak Finish to a Disappointing Year

The economy was supposed to fire on all
cylinders in 2015. Sufficient time had passed
for the often-mentioned lags in monetary and
fiscal policy to finally work their way through
the system according to many pundits inside
and outside the Fed. Surely the economy would
be kick-started by: three rounds of quantitative
easing and forward guidance; a record Federal
Reserve balance sheet; and an unprecedented
increase in federal debt from $9.99 trillion in
2008 to $18.63 trillion in 2015, a jump of 86%.
Further, stock prices had gained sufficiently over
the past several years, thus the so-called wealth
effect would boost consumer spending.
The economic facts of 2015 displayed
no impact from these massive government
experiments. The broadest and most reliable
measure of economic performance nominal
GDP decelerated. The 3% estimated gain
registered in 2015, measured by the year
ending quarter, was down from 3.9% and 4.1%,
respectively, in 2014 and 2013. In fact the gain in
nominal GDP in 2015 was less than the gain for
any year since the recession. The two components
of nominal GDP also decelerated in 2015. Real
GDP slowed to 2%, down from 2.5% in the prior
two years, and the implicit price deflator rose by
1% compared with a 1.4% and 1.6% rise in 2014
and 2013, respectively. All of the above economic
measures were expanding at, or near, their weakest
yearly growth rates in the final quarter of 2015,
indicating that the economy possessed little
forward momentum moving into 2016.

Personal consumption, the largest category

of nominal GDP, decelerated to an estimated 3%
rise in the latest twelve months, down from 4%
at year-end 2014, the smallest year end annual
increase since immediately after the 2008-09
recession. The faltering consumer pattern
occurred despite a significant lowering of credit
standards that accelerated automotive lending.
The percentage of total auto loans in the subprime
category hit a ten-year pre-crisis high in the
third quarter, according to the New York Fed.
In addition, the Affordable Care Act has caused
health outlays to surge. Excluding these two
special circumstances, consumer spending was
notably weak, providing additional confirmation
that the so-called wealth effect remains elusive.
Other important economic indicators
reported outright contractions last year. Industrial
production slumped 1.4% over the first eleven
months of 2015, with a drop of 2% outside of the
automotive sector. Only about 10% of private
Corporate Profits: After Tax with IVA & CCAdj
$1,700

billions

billions

$1,700

$1,600

$1,600

$1,500

$1,500

$1,400

$1,400

$1,300

$1,300

$1,200

$1,200
'10

'11

'12

'13

'14

Source: Bureau of Economic Analysis. Through Q3 2015.

'15

Chart 1
Page 1

Quarterly Review and Outlook

payroll employment is accounted for in the

manufacturing sector. This fact distorts the true
impact of this critical part on GDP. According
to the Federal Reserve Statistical Release on
Industrial Production, the industrial sector
accounts for about one quarter of real GDP on a
value added basis. The importance of this sector
to corporate profits is considerably greater. Not
surprisingly, corporate profits registered yearover-year declines in the latest two quarters
available. According to the BEA, corporate profits
in the latest quarter were below the level reached
in the fourth quarter of 2011 (Chart 1). The profits
picture is a worrisome portent for 2016 since it has
fallen prior to all the economic contractions since
1929, albeit it has also had a few false signals.
The 2015 global picture was just as
disappointing. By some measures, worldwide
economic growth was the poorest since the
last recession. Reflecting the depth of the
underperformance, world trade was essentially
flat for the first time since 2009. Commodity
prices, a sensitive and impartial barometer of
global final demand, dropped sharply. At the
December lows, the S&P GSCI Commodity
Index was 59% below the April 2011 peak and
at the lowest point since December 2004. The
alternative Bloomberg Commodity Price Index,
which is reweighted largely based on futures
contract volume and includes gold, slumped to
the worst level since 1999 (Chart 2). As in the

United States, economic growth was ebbing in

Japan, China, Canada, Australia, Europe and
virtually all of Latin America as the books closed
on 2015. As an indication of the Chinese problem,
the Yuan has recently dropped to the lowest level
since 2011. Thus, the global economy confirms
that the entry point for 2016 is fragile.

Empirical Evidence on the

Counter-productiveness of
QE and Forward Guidance
Since the introduction of unconventional
and untested monetary policy operations like
quantitative easing (QE) and forward guidance,
an impressive amount of empirical evidence has
emerged that casts considerable doubt on their
efficacy. The historical facts regarding the grand
experiment by the Federal Reserve Open Market
Committee (Fed) are worth considering.
The trend in economic growth in this
expansion has been undeniably weak and perhaps
unprecedentedly so. Real per capita GDP grew
only 1.3% in the current expansion that began in
mid-2009; this is less than one half the growth rate
in the expansions since 1790 (Chart 3).
Based on their theoretical expectations of
QE, the Fed and multilateral economic agencies
(such as the International Monetary Fund)
constantly projected that economic growth would
Real Per Capita GDP Growth,
Current Expansion vs. Prior Expansions

S&P GSCI vs. Bloomberg Commodity Index

monthly level

240

1000
900
800

200

S&P GSCI

700
600

160

500

3.0%

average annual growth

3.0%

2.7%

2.5%

2.5%

2.0%

2.0%

1.5%

400

1.5%

1.3%

120
1.0%

1.0%

80

0.5%

0.5%

40

0.0%

300
200
Bloomberg

100
0

Fourth Quarter 2015

91

95

99

'03

'07

'11

Source: Standard and Poors, Haver Analytics. Through December 2015.

'15

Chart 2

1790-2008

2009-2015

0.0%

Sources: Bureau of Economic Analysis, Congressional Budget Office, Office of Management and Budget,
N.S. Balke & R.J. Gordon, C.D. Romer, Measuring Worth. Through Q3 2015.

Chart 3
Page 2

Quarterly Review and Outlook

accelerate significantly and that inflation would

return to the 2% level targeted in the Feds dual
mandate. These forecasts widely and consistently
over-estimated both real growth and inflation.
The study Persistent Overoptimism
About Economic Growth by Kevin J. Lansing
and Benjamin Pyle and published in the Federal
Reserve Bank of San Francisco Economic Letter
of February 2, 2015 systematically examined the
Feds forecasting record. Specifically, Lansing
and Pyle examined the real GDP projections
made four times per year by the Fed that began in
November 2007. Their overall conclusion reads:
Since 2007, Federal Open Market Committee
participants have been persistently too optimistic
about future U.S. economic growth. Real GDP
growth forecasts have typically started high, but
then are revised down over time as the incoming
data continue to disappoint. Even Mrs. Yellen
in her December press conference admitted the
Feds models were not working.
Central banks in Japan, the U.S. and
Europe tried multiple rounds of QE. That none
of these programs were any more successful
than their predecessors also points to empirical
evidenced failure. The pattern is shown in yearover-year growth in U.S. nominal GDP (Chart
4). Three weak transitory mini growth spurts all
reversed, and the best rate of growth in the current
expansion was weaker than the peak levels in all
Nominal GDP

year over year % change, quarterly

25%

25%

20%

20%

15%

15%

10%

10%

5%

5%

0%

0%

-5%

-5%

-10%

48

55

62

69

76

83

90

97

'04

Source: Bureau of Economic Analysis. Through 2015. (Q4 GDP est. 2%)

'11

-10%

Chart 4

Fourth Quarter 2015

of the post 1948 expansions.

Several academicians have found that
the data does not validate the efficacy of QE and
forward guidance. In a paper presented at the
Feds 2013 Jackson Hole Conference, Robert Hall
of Stanford University and Chair of the National
Bureau of Economic Research Cycle Dating
Committee wrote an expansion of reserves
contracts the economy.
Negative interest rates would have the
same non-productive characteristics as QE and
forward guidance.

A Causal Mechanism Explaining the

Counter-Productiveness of
QE and Forward Guidance
This empirical data notwithstanding,
a causal explanation of why QE and forward
guidance should have had negative consequences
was lacking. This void has now been addressed by
Where Did the Growth Go? by Michael Spence
(2001 recipient of the Nobel Prize in economics)
and Kevin M. Warsh (former Governor of the
Federal Reserve), a chapter in a new book
Growing Global: Lessons for the New Enterprise,
published in November 2015 by The Center for
Global Enterprise.
The Spence and Warsh point is that the
post-crisis policy response contributed to and
helps to explain the slower economic growth
during the past several years. Their line of
reasoning is that the adverse impact of monetary
policy on economic growth resulted from the
impact on business investment in plant and
equipment. Here is their causal argument: QE
is unlike the normal conduct of monetary policy.
It appears to be qualitatively and quantitatively
different. In our judgment, QE may well redirect
flows from the real economy to financial assets
differently than the normal conduct of monetary
policy. In particular, they state: We believe the
novel, long-term use of extraordinary monetary
Page 3

Quarterly Review and Outlook

policy systematically biases decision-makers

toward financial assets and away from real assets.
Quantitative easing and zero interest rates
shifted capital from the real domestic economy to
financial assets at home and abroad due to four
considerations:
First, financial assets can be short-lived,
in the sense that share buybacks and other
financial transactions can be curtailed easily
and at any time. CEOs cannot be certain about
the consequences of unwinding QE on the real
economy. The resulting risk aversion translates to
a preference for shorter-term commitments, such
as financial assets.
Second, financial assets are more liquid.
In a financial crisis, capital equipment and other
real assets are extremely illiquid. Financial assets
can be sold if survivability is at stake, and as is
often said, illiquidity can be fatal.
Third, QE in effect if not by design
reduces volatility of financial markets but not
the volatility of real asset prices. Like 2007,
actual macro risk may be the highest when
market measures of volatility are the lowest.
Thus financial assets tend to outperform real
assets because market volatility is lower than real
economic volatility.
Fourth, QE works by a signaling effect
rather than by any actual policy operations. Event
studies show QE is viewed positively, while the
removal of QE is viewed negatively. Thus, market
participants believe QE puts a floor under financial
asset prices. Central bankers might not intend to
be providing downside insurance to the securities
markets, but that is the widely held judgment of
market participants. But, No such protection
is offered for real assets, never mind the real
economy. Thus, the central bank operations boost
financial asset returns relative to real asset returns
and induce the shift away from real investment.

Fourth Quarter 2015

Additional empirical evidence, cited by

Spence and Warsh, supports these fundamental
arguments. From 2007 to 2014 gross private
investment registered extremely substandard
growth. Growth in nonresidential fixed investment
fell substantially below the last six post-recession
expansions. Spence and Warsh calculate that S&P
500 companies spent considerably more of their
operating cash flow on financially engineered
buybacks than on real capital expenditures in 2014;
this has not happened since 2007. According to
them, during the past five years, earnings of the
S&P 500 have grown about 6.9% annually, versus
12.9% and 11.0%, respectively, from 2003-2007
and 1995-1999. Inadequate real investment
means demand for labor is weak. Productivity is
poor, which in turn, diminishes returns to labor.
According to a Spence and Warsh op-ed article in
the Wall Street Journal (Oct. 26, 2015), ... only
about half of the profit improvement in the current
period is from business operation; the balance of
earnings-per-share gains arose from record levels
of share buybacks. So the quality of earnings is
as deficient as its quantity.

Do Decision Makers Need to Understand

the Transmission Mechanism?
It is quite possible that corporate decision
makers do not understand the relationships that
cause QE and forward guidance to redirect
resources from real investment to financial
investment. It is also equally likely these
executives do not understand that this process
reduces economic growth, impairs productivity
and hurts the rise in wage and salary income. But,
does a lack of understanding of economic theory
by key market participants render the causal
relationships invalid?
Spence and Warsh elegantly argue
corporate executives do not need to know these
fundamental relationships. Here is their key
passage: Market participants may not be expert
on the transmission mechanism of monetary
policy, but they can deduce that the central bank is
Page 4

Quarterly Review and Outlook

trying to support financial asset prices. The signal

provided by central banks might be the essential
design element. Real assets market participants
simply need to know that the central bank does
not offer such protection. In other words, the
corporate managers merely need to realize that
one asset group is protected and the other is not.

The Asymmetric State of Monetary Policy

Our assessment is that monetary policy
has no viable policy options that are capable of
boosting economic activity should support be
needed. In fact, the options available to the central
bank, at this stage, are likely to be a net negative.
This, however, does not mean that conventional
and tested monetary operations that are designed
to restrict economic activity and inflation are
ineffectual. In fact, standard restraining operations
remain effective. Monetary restraint may even be
more effective than historically because of the
extreme debt overhang of the U.S. economy.
The increase in short-term interest rates that the
Fed has thus far achieved is small, but public and
private debt stands at 375% of GDP, far above the
historical average of 189.4% from 1870 to 2014.
Thus, the higher cost reverberates much more
significantly through the U.S. economy.
The extremely high level of debt suggests
that the debt is skewed to unproductive and
counterproductive uses. Debt is only good if the
project it finances generates a stream of income to
repay principal and interest. There are two types
of bad debt: (1) debt that does not generate income
to repay interest and principal (Hyman Minsky,
The Financial Instability Hypothesis); and (2)
debt that pushes stock prices higher without a
commensurate rise in corporate profits (Charles
P. Kindleberger, Manias, Panics and Crashes).
When the composition of debt is adverse, less
flexibility exists for the end users of the debt to
absorb the higher costs engineered by the Fed.
Even if this is not the case, the small increase in
the federal funds rate serves to shift both money
growth and velocity downward, which has the

Fourth Quarter 2015

effect of weakening nominal GDP at a time when

it is already slow and decelerating.
Prior to the Feds December rate hike
M2 grew at annual rates of 5.3% and 5.6%, for
the three and six month periods, respectively.
Subsequent to the Feds change in policy, three
conventional monetary influences have turned
more restrictive. First, in the reserve maintenance
period ending January 6, the monetary base, as
measured by the Federal Reserve Bank of St.
Louis, dropped $258 billion, versus the reserve
period immediately prior to the Fed rate hike.
Consequently, the base was at the lowest level
since October 2013, when the Fed was still
executing QE3. The base, as measured by the
Federal Reserve Board, registered a slightly larger
contraction of $294 billion. Second, the Federal
funds rate rose by about 0.25%, from roughly
0.125 to 0.375%. Third, the short to intermediate
Treasury note yields rose relative to the ten-year
and thirty-year Treasury security yields. Thus,
the yield curve between the two-year and ten-year
Treasury notes as well as the between the twoyear note and thirty-year treasury bond flattened
considerably.
All three of these actions will, in time,
serve to lower M2 growth and reduce the velocity
of money. The absorption of reserves places
downward pressure on M2 growth, while the
higher short-term rates encourages households
and businesses to minimize transactions balances.
The higher short- and intermediate-term yields
encourage households to save a little more by
spending less. The flatter yield curve reduces the
earnings potential of the depository institutions,
which, in turn, reduces the lending directly and
M2 indirectly. Thus, the Fed tightening could
serve to push M2 annual growth toward 5% or
below. If velocity continues to remain in the
persistent 3% downward trend, nominal GDPs
growth rate could fall to 2%, a third lower than
in 2015. This leaves little room for a sustained
acceleration in either real growth or inflation.
Page 5

Quarterly Review and Outlook

The flatter yield curve is also a reliable

leading indicator of economic activity, as well as
the above-mentioned source of monetary restraint.
A rise in short-term rates relative to the long ones
is an indication that investors expect economic
activity and/or inflation to fall in the future. Such
an expectation is consistent with the likely trends
in M2, velocity and nominal GDP.

Treasury Bond Yields

With the trajectory in the nominal growth
rate moving down, U.S. Treasury bond yields
should work lower, thus reversing the pattern of
2015 and returning to the strong downtrend in
place since 1990. In the United States, ten- and
thirty-year yields are considerably more attractive
than in virtually all of the major industrialized
countries (Table 1). At year end 2015, the U.S.
thirty-year Treasury bond yield was 154, 176
and 240 basis points higher, respectively, than
in Germany, Japan and Switzerland. The U.S.
thirty-year Treasury yield was even 88 basis points
higher than in Canada. These wide differentials
indicate that ample downside still exists for longterm U.S. Treasury bond yields to decline since
the attractive U.S. yields should incent global
investors to continue to move funds into the
United States.
A firm dollar should serve to depress
price levels in the United States and restrain
Global Interest Rates
10 Year Yields

Spread from U.S.

10 Year Yields

30 Year Yields

Spread from U.S.

30 Year Yields

1.

U.S.

2.27%

2.

Canada

1.38%

0.89%

2.14%

3.

Sweden

0.97%

1.30%

2.27%

0.75%

4.

Netherlands

0.79%

1.48%

1.58%

1.44%

Fourth Quarter 2015

the already low pace of domestic inflation. A

stabilization of the oil price around current levels
could cause the year-over-year increase in the
consumer price index (the base effect) to move up
from 0.4% currently to around 1.2% this winter,
since oil prices will not be as much of an offset
to government controlled prices such as medical
care, utility bills, taxes or artificially calculated
prices captured by home owners equivalent
rent. This base effect of oil on the CPI, however,
will reverse in the late spring and summer and
be reinforced by a firm dollar that will have a
much more lasting effect on domestic inflation.
Moreover, the 34% rise in the dollar from May
2011 has not been fully captured in the imported
non-oil prices which have only declined by a mere
3.4%. The pipeline of foreign goods for the U.S.
is likely to be filled with lower priced goods for
a considerable time. The minimal adjustment of
non-oil import prices relative to the higher dollar
indicates that the damage to the trade balance
and corporate profits is far from complete. Thus,
poor foreign business conditions will continue to
be a drag on domestic economic activity while
depressing inflation.
The firm dollar will remain a restraining
force on economic activity and should cause the
year-over-year increase in the CPI to reverse later
in the year. Under such circumstances, lower,
rather than higher, inflation remains the greater
risk. Such conditions are ultimately consistent
with an environment conducive to declining
long-term U.S. Treasury bond yields. In short,
we believe that the long awaited secular low in
long-term Treasury bond yields remains ahead.

3.02%
0.88%

5.

France

0.98%

1.29%

2.00%

1.02%

6.

Austria

0.89%

1.38%

1.75%

1.27%

7.

Germany

0.62%

1.65%

1.48%

1.54%
1.29%

8.

Taiwan

1.01%

1.26%

1.73%

9.

Switzerland

-0.12%

2.39%

0.62%

2.40%

10.

Japan

0.25%

2.02%

1.26%

1.76%

Through December 2015. Source: Bloomberg.

Van R. Hoisington
Lacy H. Hunt, Ph.D.

Table 1
Page 6