The Two Utes

“The Two Utes … Oh, excuse me, your honor, the Two Youths”
-Joe Pesci, My Cousin Vinny 

The Devil, recall, used to be an Angel. 

Anyone long the Two Utes (Utilities and its defensive yield brother, XLP) into and now out of peak all-time valuation, all-time lows in volatility, the 2017 low in rates and an @Hedgeye overbought signal the last two weeks acutely understands the investment relevance of that Biblical reality.  

Anyway, ready the grains of salt, rally the caveats and redux your favorite rationalization, boys ... it's distortion season & the lowly plebes need the high conviction pablum. 

Markets, thankfully, only go up, which is great. 

What is also great is that interminable one way equity benchmark parades leave the collective ‘strategist’ community free to pursue its inveterate infatuation with superfluous analysis  … 

In its latest iteration we’ve been treated to the now ubiquitous generation of convicted point estimates forecasts around the inherently unforecastable impact of multiple hurricanes on high frequency macro data.  

Let’s quickly check in on how those hundreds of man hours are paying off in research alpha terms:   

Builder Confidence:  Consensus was for an index reading of +67, essentially flat sequentially and just off cycle highs. 

We rhetorically contextualized the setup as follows: 

Suppose your largest market was facing an acute and potentially protracted crisis. One that could potentially curtail activity for an uncertain period of time and significantly drag on margins as cost growth (in your largest expense line) step functions 2-3X.   Further suppose that this negative externality coincides with lot and labor shortage concerns sitting at 17 year highs.  Would thou Confidence Cup runneth over?

Builder Confidence Printed -3 pts to an 11-month low at 64.  0 for 1. 

Existing Home Sales:  Consensus was looking for a sequential increase in sales.  This was difficult to understand on almost every front:

Mortgage Purchase Applications and Pending Home Sales (signed contract activity & lead indicator for closed transaction volume) were both signaling modest-to-moderate sequential softness.  And The Houston Association of Realtors had already reported that home sales in Houston were down -24.2% Y/Y in August.  Houston area sales have accounted for roughly 1.8% of total existing sales on an NSA basis over the last two quarters so the August decline for Houston alone would be a >-40bps headwind to growth.   

EHS fell -1.7% M/M in August while decelerating to +0.2% Y/Y.  0 for 2. 

Initial Jobless claims: Consensus was looking for a +18K increase to +302K

Hmmm … ~6% of the population impacted by natural disasters … higher would seem like a reasonable directional expectation.  It would also seem incorrect. The immediate -23.5K decline in initial claims in Texas more than offset the +5.1K increase in Florida, taking Headline Claims -25K sequentially and back to multi-decade lows at 259K. 

0 for 3.  

The point is that the distortions will continue to pervade the data through October and we can continue to look forward to looking past more superfluous analytical activity.

Besides, the near-term policy path now looks pre-determined and largely insensitive to noisy macro, at least according to Janet’s latest humpday exploits. 

Back to the Global Macro Grind…

It’s Friday and the domestic eco calendar is pretty light so what I’d like to attempt is a little didactic digression.

Below I’m going to try to explain the crux of growth accounting for the non-institutional macro crowd in under a minute. 

Reviewing exponent properties is, of course, everyone’s favorite Friday morning fun so I’ll pause briefly while you caffeinate accordingly ….  

Now, the conceptual crux underpinning the majority of endogenous growth theories is that ideas combine with labor and capital in such a way that continual, near exponential growth becomes achievable.

That may sound jargon’y and complicated but, intuitively, it’s pretty straightforward. 

Let’s quickly break it down:

1. First, “endogenous” simply means it’s determined by or inside the model itself …. It’s not just manna from heaven or somehow assumed or pulled from elsewhere.

The simplest and most common form of the growth accounting equation is:  Y = AK^1/3L^2/3 where Y = output, A = our productivity parameter, K = Capital and L = Labor

There are 3 practically important things to understand about that equation:

1. The exponents on Capital (K) and Labor (L) are less than one which means, individually, they are subject to diminishing returns.  If you double the amount of capital per worker, output will less than double.  This is intuitive – give a person 1 machine and she will be very productive.  Give her 10 machines and her marginal productivity (increase in output per unit increase in machines) will invariably decline.
2. Together, the exponents on Capital (K) and Labor (L) sum to 1.  In other words, there are constant returns to labor and capital taken together. So…
3. If you double capital and labor, you will double output.  That is also simple and intuitive.  If you want to double the output of a McDonald’s, you could just replicate the setup exactly (build the same building, same equipment, same # of workers, etc) in a different location … which is pretty much what McDonald’s does

Now, the key to the model is the idea parameter (A), most often referred to as Total Factor Productivity (TFP).  Here, there are two important things:

1. NonRivalry:  Ideas are nonrivalrous in the sense that anyone can use them and without limitation.  Every worker can’t use the same fry machine at McDonald’s but everyone can use the “idea” of addition or multiplication without limiting someone else’s use of it.    
2. Increasing Returns:  As we said, capital & labor are subject to constant returns (the exponents sum to 1).  Ideas + Capital + Labor, however, provide for increasing returns.  It doesn’t matter what the exponent is on “ideas” as long as its non-zero, which it is not.  So the exponents on Capital + Labor + Ideas is more than 1, which provides for increasing returns.  In other words if you double the amount of capital, labor and ideas …. output will more than double. 

To make it tangible let’s suppose the exponent on ideas is 0.66.  Our equation looks like this:

Y = A^2/3K^1/3L^2/3.

Now, let’s double the amount of ideas, Capital and labor:

Y = (2A)^2/3(2K)^1/3(2L)^2/3  => 2^2/3 *2^1/3 *2^2/3 *A^1/2 *K^1/3 *L^2/3 

Y = 2^5/3 *A^2/3 *K^1/3 *L^2/3  = 3.2 * (A^2/3 *K^1/3 *L^2/3)

See that “3.2”? ….  Voila, increasing returns …. doubling inputs more than doubles output.   

And there you go, 3 weeks of Intermediate Macro in 1 minute, hopefully that was digestible.

I bring up the growth accounting discussion for 3 reasons:

1. I get that question in varying forms not infrequently so I wanted to put it on paper.
2. Recent Research has pointed to rapidly declining research productivity and increasing difficulty in “Finding New Ideas”.  The authors of the linked paper highlight Moore’s Law as an example.  The number of researchers required today to achieve the famous doubling every two years of the density of computer chips is more than 18 times larger than the number required in the early 1970s.  Expect more research on this topic.
3. Despite the ever expanding body of analytical underlings at the Federal Reserve and increasingly sophisticated theoretical econometric modeling, policy – in practice – remains quite simple.    

The Chart of the Day below is from our 3Q17 Macro themes call.  It’s titled “Kindergarten Macro” and you can take the 5 seconds to review it.  But with the Fed reducing its inflation forecast and commensurately increasing its growth forecast by the same amount that effectively represents what the Fed actually did …. on a 6-month lag. 

Let’s see, what else:

• Capex:  The Capex Plans component of the Philly Fed Survey printed just south of cycle highs in September.  The corresponding measure in the Empire Survey did the same and our composite index of Capex Expectations remains elevated.
• VIX/SPX/10Y: All-time lows in realized and implied volatility continue to perpetuate a narrow S&P500 Trading Range (2, Bullish Trend) and after the UST 10yr Yield @Hedgeye Risk Range was widening for all of SEP into the Fed meeting, this morning it’s narrowed to 2.12-2.30%; not only does the low-end of the range register as a higher-low vs. the YTD low of 2.02%, but it starts to build the case for a 2017 bottoming process in long-term yields.
• 1 Meeelion:  If you can hold out until 2117, the Dow should be over 1 Million … as Buffett goes Dr. Evil WSJ
• TIPS Yields: Real Yields are back to positive and rising which remains decidedly negative for Gold.  If it weren’t for that pesky geopolitical bid ….

And lastly, of course, in everyone’s new favorite pastime of rhetorical nuclear balderdash oneupsmanship chicken, Kim saw Trumps unprecedented U.N. Rocket Man Speech and raised him a Dotard.  

“I will surely and definitely tame the mentally deranged U.S. dotard with fire.”

The Two Utes …

Our immediate-term Global Macro Risk Ranges (with intermediate-term TREND views in brackets) are now:

UST 10yr Yield 2.12-2.30% (bullish)
SPX 2 (bullish)
NASDAQ 6 (bullish)
DAX 121 (neutral)
VIX 9.47-11.15 (bearish)
USD 91.20-92.60 (bearish)
EUR/USD 1.18-1.20 (neutral)
Oil (WTI) 47.88-51.46 (bearish)
Gold 1 (neutral) 

Christian B. Drake
U.S. Macro analyst