THE INCOMPARABLE STEPHANIE POMBOY, no stranger to this space, week in week out spices her intriguing insights with sprightly irreverence. But she was really in top form in the latest edition of her worthy MacroMavens commentary. So we thought we might pass along some of her bon thoughts and bon mots that enlightened and tickled us.
Under the elegant title "Burping Out Loud," Stephanie stands the conventional wisdom on its head on corporate profits and the stock market. We should warn you that recovery isn't currently a prominent part of her lexicon.
For openers, she doesn't buy the growing conviction that what we've been witnessing is more than a bear-market rally.
And her Exhibit A is the amount of financial pain being priced into the credit markets. She readily grants that spreads have narrowed, but notes that they remain "far, far wider than they were at the 2003 cycle lows."
The complacent reaction among the investment cognoscenti is that the credit markets are wildly oversold. More likely, she sniffs, it has something to do with the fact that "an overwhelming portion of some $8 trillion in mortgage debt (or 80% of the total) is teetering on the edge of, or in some state of, negative equity."
As to the Fed's claim that the equity of homeowners as a group stands at 43%, she points out that what the Fed neglects to tell you is that roughly a third of them have their houses free and clear. Lo and behold, some basic arithmetic reveals that 67% of homeowners with mortgages have equity of less than 15%. That, Stephanie comments drily, suggests the "destruction priced into the credit markets hardly seems out of whack with potential reality."
And while, thanks to "the transfer of toxic assets to taxpayers" and the magic of accounting legerdemain, the scarred financials to some significant extent may be spared further pain, the same, alas, can't be said for the nonfinancial sector. Little recognized, she insists, is how much the extraordinary gains in domestic nonfinancial profits from the low in 2001 to the peak in 2006 -- a stunning rise of 388% -- owed to the housing bubble.
"Who in his right mind," she asks, "would believe that explosion in profits during the housing-bubble stretch a mere coincidence and, therefore, in no way subject to the same inexorable decline?" Since we delight in answering rhetorical questions, we'd reckon not more than 95% of the folks who contend we're in a new bull market.
Absent the powerful stimulus provided by the unprecedented boom in housing, she sees a huge hit still in the offing for nonfinancial corporate profits. A worst-case analysis is that such profits would sink to 2003 levels, a further decline of $450 billion, or 54%. Under a less exacting (and frightening) estimate, using their relationship to GDP, they would return to their pre-bubble percentage of 3.5%, which translates into a drop from here of $340 billion, or 41%.
At the end of the day, earnings, to state the obvious, are what makes the stock market go up -- and down. The prospect that they are in for a fresh drubbing is all the more ominous because it's unexpected. As Stephanie reflects, "bear-market rallies come and go, but what makes this one so noteworthy is just how far removed perception is from reality."
Second, from Jim Welsh of Welsh Money Management, courtesy of Barry Ritholtz's blog, The Big Picture:
Investment letter – April 23, 2009
ECONOMY
Perspective – A way of regarding facts and judging their relative importance.
There are a number of data series that evaluate economic conditions using a diffusion index. A diffusion index will have a value above 50, when a plurality of respondents are positive, and below 50 when a majority are negative. If a diffusion index increases from 35 to 38, it represents a gain of 8.6%, while a rise to 46 from 45 is only a gain of 2.2%. It is natural to think of the larger percentage gain to be more noteworthy. However, the smaller gain is actually more significant, since it will only require a small further improvement, before actual economic growth is achieved. In recent weeks, many economists and market strategists have heralded the end of the recession and the arrival of spring, after spotting a few ‘green shoots’ of improvement. In most cases, the ‘green shoot’ was a modest up tick, from a multi-decade low! For instance, the Conference Board’s Consumer Confidence Index edged up to 26.0 in March, from 25.3 in February, the lowest reading since records began in 1967.
In February, new home sales were up 4.7% to 337,000, and after that robust increase, were only down 75.7% from their July 2005 peak. In the last three years, housing starts have plunged from 1,823,000 to 358,000, or 80.4%. At the February sales rate, it will take 12.2 months to clear the inventory of new homes for sale, versus 5 months in a healthy market. In the past year, the median price of a new home has fallen from $251,000 to $200,900, a drop of 20%. After retail sales collapsed in the fourth quarter, the inventory-to-sales ratio soared from 1.25 to 1.45, or 16%. Companies were forced to cut production drastically in the first quarter, so bloated inventories could be whittled down. Although the ratio dipped to 1.43 in February, production levels will remain low, until the ratio falls further. The large decline in production will contribute to a fairly weak first quarter, and depress second quarter GDP too.
As noted last month, there is a good chance that GDP will post a positive print in the fourth quarter of this year, and maybe in the third quarter. Most of the ‘gain’ will be statistical nonsense, but that won’t deter most economists from getting excited. In the last 2 years, the 80% plunge in housing starts has subtracted about .9% from GDP each quarter. If housing starts stabilize near February’s level in coming months, the .9% hit to GDP will become 0%. If inventories are brought down by the fourth quarter and are in line with sales, the decline of 1% to 2% to GDP from production cuts in the first and second quarter could also improve to 0%. In the fourth quarter last year, personal consumption fell an extraordinary -2.99%, as consumers turned into Grinches.
But consumer spending improved in the first quarter, as government income transfers of $127 billion offset the decline in wages and salaries of $89 billion. In the second quarter, social security recipients will receive a onetime $250 payment in May. Tax refunds are up 11% from last year, and the decline in gasoline prices is also providing a boost to incomes. Consumers will use the extra disposable income to pay down debt, and increase savings and spending. All of these factors should help swing personal consumption to a positive for GDP in coming quarters.
In the second quarter of 2008, GDP grew 2.8%, which is a respectable number. Despite this growth, job losses continued each month, and a self sustaining economic expansion failed to take hold. The most important issue in the next 12 to 15 months is whether the rebound in the second half of 2009 and first half of 2010 will gain enough traction to launch a self sustaining economic recovery. There are many reasons why I remain skeptical.
In the first three months of 2009, more than 2 million jobs were lost, causing the unemployment rate to jump from 7.6% to 8.5%, the highest since November 1983. The unemployment rate increased in March in 46 states, with California, the world’s eighth largest economy, hitting 11.2%, the highest since January 1941.
Underemployment, which combines the unemployed, with involuntary part time workers and discouraged workers, reached 15.6%. As noted in recent months, post World War II recessions have on average caused personal income to fall between 4% and 7%, and this one has further to go. Wages and salaries shrank at a 4% annual rate in the first quarter, and according to Deutsche Bank, payroll-tax withholding receipts collected by the Treasury Department are down 8.2% from a year ago. This suggests that personal income growth will remain weak in coming months, and shave more than $250 billion from total income and future demand. Changes in temporary jobs lead reversals in the overall labor market by 6 to 10 months. In 2007, a continuous decline in temporary jobs and hours worked led me to forecast a decline in jobs in 2008. When non-farm jobs fell in January 2008, most economists were shocked, and the stock market sold off sharply. In March, employers cut 71,700 temporary workers, so any real improvement in job growth is many months away.
Most economists are quick to note that unemployment is a lagging indicator, and they’re right. But the magnitude of the job losses shouldn’t be dismissed so glibly, given the impact they are having on the banking system. The American Bankers Association reported that 3.22% of consumer loans were delinquent at the end of 2008. That is the highest level since the ABA began tracking overall loan delinquency rates in the mid 1970’s. And that was before 2 million jobs were lost in the first quarter.
An average of 5,945 bankruptcy petitions were filed each day in March, up 9% from February and 38% from a year ago. The soaring job losses since last September are certainly behind the increase in bankruptcies.
The surge in job losses are working their way up the income ladder, with an increasing number of middle income and upper middle income workers being affected. This is pushing many of those who previously were considered prime credit risks over the edge. Two-thirds of mortgages in the U.S. are held by the best credit risk, prime borrowers. According to the American Bankers Association, 5.06% of prime borrowers have missed at least one mortgage payment. Since prime borrowers are such a large group, this represents 1.8 million mortgages. Although the delinquency rate for sub prime mortgages is up to 21.9%, it only accounts for 1.2 million mortgages.
In the fourth quarter, a number of states mandated a freeze on foreclosures, and a number of banks, not wanting to be a modern day Mr. Potter during the holidays, voluntarily suspended foreclosures. According to RealtyTrac, foreclosure filings increased to 341,180 in March, up 17% from February, and up 46% from a year ago. After the foreclosure moratorium expired in California, notices of trustee sales, which precede foreclosure sales, climbed more than 80% to 33,178 in March from February. Moody’s Economy.com estimates more than 2.1 million homes will be lost this year, up from 1.7 in 2008.
Existing home sales have declined 33.3% since peaking in September 2005. The median price has dropped 28.7%, after peaking in July 2006 at $230,900. In February, existing homes sales increased 4.4%, and the median home price advanced 2.4%. The ratio of monthly sales to the inventory of homes for sale was 9.5 months, versus 5 months in a healthy market. However, 45% of the sales in February were foreclosures, and that proportion will remain high in coming months. Since foreclosed sales represent forced selling, the persistently high level of foreclosures will continue to push home prices lower. As home prices fall another 5% to 10% or more, more home owners will realize that their mortgage exceeds the value of their home. An increasing number are simply choosing to walk away, since they have nothing to lose.
According to RealtyTrac, job losses result in a home foreclosure 10% to 15% of the time. If job losses narrow from the monthly average of 670,000 in the first quarter to 325,000, almost 3 million more jobs will be lost before year end. That will translate into another 300,000-450,000 foreclosures, and an unemployment rate of almost 11%. But what if that estimate of job losses is too optimistic?
New research by the Federal Reserve and Boston University of credit spreads of 900 non-financial companies from 1990-2008 predicted changes in the economy ‘phenomenally’ well. Based on their initial research on low to medium risk corporate bonds with more than 15 years to maturity, the researchers went back to 1973 and found the analysis still worked well. With the massive widening of corporate bond spreads last fall, the researcher’s model predicts the economy will lose another 7.8 million jobs by the end of 2009, and industrial production will fall another 17%. In the spirit of optimism, let’s assume this ‘phenomenal’ model is off by 35%, due to the extreme nature of this credit crisis. That still results in another 5.1 million lost jobs, and an 11% drop in industrial production. In that scenario, the unemployment rate climbs to near 12.5%, the underemployment rate breaches 20%, and another 500,000-750,000 foreclosures result.
The International Monetary Fund (IMF) now estimates the U.S., European, and Japanese financial sectors face losses of $4.1 trillion. Banks are confronting losses of $2.5 trillion, insurers $300 billion, and other financial institutions $1.3 trillion. To date, the banking sector has written down $1 trillion of expected losses. The IMF estimates that U.S. and European banks need to raise $875 billion in equity by next year to return to pre-crisis levels.Over the last week a number of banks have reported first quarter earnings, which was a pleasant surprise. Citigroup said it made $1.6 billion. One of the ways Citigroup achieved this gain was booking a profit of $2.7 billion on the decline in Citi’s own debt. Say what? Under accounting rules, Citi was allowed to book a one-time gain equivalent to the decline in its bonds because, in theory, it could buy back its debt cheaply and save $2.7 billion over time. Of course, Citi didn’t actually do that. Even though more consumer loans went bad in the first quarter, Citi reduced its loan loss reserve from $3.4 billion in the fourth quarter to $2.1 billion in the first quarter, thereby picking up another $1.3 billion of ‘earnings’. And the recent change in mark to market accounting enabled Citi to book an additional $413 million in ‘profit’ on impaired assets. Without theses one-time adjustments, Citi’s $1.6 billion in first quarter profit becomes a $2.8 billion loss.
According to a Wall Street Journal analysis of Treasury Department data, the 19 banks that received tax payer funds made or refinanced 23% less in new loans in February versus last October. Why lend money when all you’ve got to do is make a few adjustments and make even more money.
Between 2000 and 2008, the major credit card companies increased the number of credit cards issued to small businesses from 5 million to 29 million. During that period, many small business owners increasingly relied on their cards to provide short term financing for their business. Spending on small business credit cards increased from $70.4 billion in 2000, to $296.3 billion, according to the Nilson Report. Over the last 15 months, business bankruptcy filings have risen faster than consumer bankruptcies, with the average charge-off rising to $11,000 from $7,000, according to Equifax, Inc. In response, the card issuers have been aggressively scaling back, and have reduced available credit lines by almost $500 billion. Just another example of how the availability of credit to the economy is evaporating, despite all the Fed’s efforts.
Industrial production fell 1.5% in March, and is down 12.8% from a year ago. Capacity utilization fell to 69.3%, the lowest since records began in 1967. As I discussed in detail in January, excess capacity is a powerful dynamic. Companies are forced to reduce or eliminate budgeted investments in new equipment, compete for every dollar of revenue, even if it means accepting thinner profit margins, and reduce costs through job cuts. The amount of excess capacity that has been created by the depth of this economic contraction is unprecedented. What most inflation bugs and investors fail to understand is how long it will take to work off the current over hang of excess capacity. If the output gap grows from the current 7% to 10% next year, Goldman Sachs estimates it could be 2015 before all the excess capacity is used up, and that’s if GDP grows 4.75% per year! Ironically, one of the reasons the economy is not likely to grow that fast is that business investment will be weaker than in prior business cycles. With so much excess capacity, businesses won’t need to materially increase business investment for the next 2 or 3 years.
The economy needs to create 125,000 jobs each month, just to absorb the number of new entrants into the labor market. If job growth were to average 325,000 per month in coming years, it would still take four years to replace all the jobs lost in this recession. With so much excess labor capacity, wage growth will be weak for the next few years, which will make it harder for consumers to increase savings and spending. The combination of less credit availability, weaker business investment and consumer spending will be headwinds whenever the economy emerges from this recession.
The Untied States is mired in the deepest cyclical contraction since at least World War II, and arguably the depression. Falling home prices led us into this crisis, and home prices are still falling. The financial crisis in 2008 has become the economic crisis in 2009, as more than 2 million jobs were lost in just the first quarter, with another 3 to 5 million likely before year end. With the unemployment rate headed over 10%, and maybe up to 12% next year, the default rate on every type of consumer credit – (prime mortgages, Alt-A mortgages, Option Arm mortgages, sub-prime mortgages, home equity lines, credit cards, auto loans, student loans) – is headed much higher. Commercial real estate values are plunging, and corporate default rates are set to soar. Although every bank will ‘pass’ the government’s stress test, some banks will fail the real world stress test, and need billions more in capital. Sooner or later, the Treasury Department will likely have to go hat in hand asking for more money from Congress for some of the banks. For the first time since World War II, the global economy will contract in 2009, so there aren’t many places to hide. Although it is welcome to see a few ‘green shoots’, in this case, those green shoots are unlikely to yield a bountiful harvest in 2010.
In addition to the daunting cyclical problems challenging the economy, there are a number of significant secular issues I’ve discussed before that will make it even more difficult for a self sustaining recovery to develop in 2010. Between 1982 and 2007, the amount of Total debt grew from $1.60 to $3.53 for each $1.00 of GDP. This was made possible as the cost of money fell from 15% to 20% in 1982 to the generational lows of the last few years. As interest rates fell, consumers were able to take on more debt, without their monthly payments increasing very much.
Household debt has increased from $.44 in 1982 to $.98 for each dollar of GDP in 2007. However, there is no more relief coming from lower rates, so consumers are going to have to pay for their debt from income. From the mid 1990’s until 2007, most consumers had the luxury of believing that their homes and 401Ks would provide most of what they would need for their retirement. The saving rate fell from over 8% 15 years ago to near 0% in 2007. The last 18 months has convinced them they need to increase their savings. The saving rate has rebounded to near 4% in the last six months, which is one reason why the economy has been so weak. As debt levels increased over the last 25 years, GDP was boosted as consumer’s bought cars, bigger homes, second homes, went on nice vacations, and basically lived the good life. However, since 1966, each dollar of additional debt has given the economy less of a boost. In 1966, $1 dollar of debt boosted GDP by $.93. But by 2007, $1 dollar of debt lifted GDP by less than $.20.
The message from these facts is fairly clear. Debt levels are high, and any increase in interest rates will impose a bigger burden on the economy and quickly stunt growth. Consumer debt is already so high and interest rates are so low that it will be difficult for consumers to add debt. This means economic growth will be far weaker than the debt induced growth of the last 25 years. As consumers increase their savings, GDP will be lowered by .70% for each 1% consumers increase their saving, since consumer spending represents almost 70% of GDP. In addition, the banking system remains crippled. Lending standards are high and are not coming down with the economy remaining weak. The need for additional capital will lower future lending by several trillion dollars, as banks work to repair their balance sheets and lower their leverage ratios from 30 to the low teens. The securitization markets provide more credit than the banking system, but they remain on life support. Credit availability will remain constrained well into 2010, which represents a headwind than will mute some of the lift from fiscal stimulus.
The diminishing boost given to GDP from each additional $1.00 of debt since 1966 strongly suggests that adding more debt will not return the economy to prosperity. I am reminded of a movie from the 1950’s, ‘The High and the Mighty’. It starred John Wayne and Robert Stack and was about an airline flight from Honolulu to San Francisco. During the flight, one of the engines fails, but they are past the point of no return, so they must try to make it to San Francisco. Over the last 60 years, the United States has used a combination of fiscal stimulus and monetary policy to soften each recession and spur the subsequent recovery, with a fair amount of apparent success. From 1982 until 2007, the U.S. only experienced two shallow recessions that each lasted just 8 months. This stretch of 25 years may be the best 25 years in our economic history. But much of this prosperity was bought with debt, as the ratio of debt to GDP rose from $1.60 to $3.50 for each $1.00 of GDP. Sometime in the last 25 years, we passed the point of no return. Unfortunately, Hollywood won’t get to write the script on how this ends.
STOCKS
The stock market has been rallying because investors believe there will be a recovery in the economy before the end of 2009. This leads them to ignore any bad news now, since better news is just around the corner. If I’m right, there will be GDP growth by the fourth quarter, if not in the third quarter. This suggests that the market can make further upside progress in coming months. The market fell for 17 months, between October 2007 and March 2009. This suggests the market should work its way higher for at least 5 months or so, maybe longer. My expectation has been that this rally should take the form of an up phase, a pullback, and then another up phase. As noted last month, I didn’t expect the initial rally phase to exceed 878 on the S&P. So far, the high has been 875.63. I also expected the S&P to pullback to 760-780, which it did for literally a few minutes on March 30.
Although I think the S&P will exceed 878 in coming months, the economic fundamentals are far worse than most investors realize. Of course, this has been the case since this crisis began in August 2007. From an investment point of view it means this is no time to let one’s guard down. If you buy something, use stops. If I’m right, and the rebound in the economy does not launch a self sustaining recovery, there is a moment of realization coming for most investors. That’s what happened after the market rallied in April and May of last year in anticipation of a second rebound in the economy. When it failed to show up, the market reversed lower, after peaking in late May. Markets experience their largest moves when expectations are not met.
The S&P reached 845.61 on April 2 and closed at 843.55 on April 22. It’s been 3 weeks, and the market hasn’t made much progress, but it hasn’t given any ground either. Investor’s willingness to buy each dip has been in over drive, so each attempt at a sell off has lasted no more than 2 days. That’s impressive, even if it’s reflective of a herd mentality driven by misplaced optimism. The choppiness of the past 3 weeks is likely to continue, as sideline money uses any dip to buy. Eventually, the S&P should drop below 800, but hold above 760. Investors can buy in this range, using a decline below 740 as a stop. Conversely, investors can buy, if the S&P climbs above 872, using a decline below 825 as a stop. If the S&P closes above 878, a quick rally to 940 should follow. The high yield bond funds recommended last month (FAGIX, NNHIX, VAGIX) are up 4% to 6%. Use a trailing 1.5% stop.
BONDS
In a very real sense, the decision by the Federal Reserve to buy longer term Treasury bonds means this market will remain distorted for an extended period. My guess is that the Fed will intervene if and when the 10-year Treasury yield approaches 3.1%. But bonds will also be supported by weak economic data, and the lack of inflation.
DOLLAR
Since the bottoming last July, the Dollar cash index has made a series of higher lows and higher highs. That is the definition of an up trend. After making a new recovery high in early March, the pullback in the Dollar was given a shove, when the Federal Reserve announced its decision to employ quantitative easing on March 18. The Dollar then rebounded an almost perfect .618% of its 6.99 point decline to 86.94 on April 20. Since the rebound looks ‘corrective’, it implies that the dollar will fall to at least 82.50. As long as it holds above 80.30, the longer term trend is still up.
GOLD
Over time inflation has been defined as too much money chasing too few goods. Our problem now is that there is too little money chasing too many goods everywhere in the world, and that dynamic isn’t likely to change anytime soon. The Federal Reserve has committed to quantitative easing and many investors have assumed the expansion of the Fed’s balance sheet from $900 billion to almost $3.5 trillion has to be inflationary. But the massive levels of excess capacity throughout the global economy are going to keep a lid on price increases and wages for a long time. Japan is the second largest economy in the world, and their experience with quantitative easing for more than a decade has not led to inflation, as they are still battling deflation. And, if the U.S. stock market has another leg up in its bear market rally, gold will lose some of its financial instability luster.
I still think gold has the potential to drop below $700 in coming months. Investors can short Gold in a number of ways, depending on risk tolerances. The most conservative way would be to short GLD, which is the ETF tied to gold, or by buying DZZ, which is the 2 to 1 short gold ETF, or by shorting Gold futures, which is the most aggressive. Irrespective of the route, use a print of $1004.50 on June Gold as a stop. Short GLD above $94.00, buy DZZ below $20.70, and short Gold above $960.00.
E. James Welsh
And, last but not least, Willem Buiter's post at his FT blog, Maverecon, entitled Green shoots, grounds for cautious pessimism:
I am not going to use this opportunity to deepen the gloom by exploring at length the possible consequences of a worldwide pandemic of a virulent form of swine flu. Just a few depressing words will have to suffice. From an economic perspective, a flu pandemic amounts to at least a temporary reduction in the effective supply of labour. If flu-related mortality is high, there will be a permanent reduction in labour supply. The dependency ratio rises (temporarily or permanently, depending on whether mortality increases). Trade and travel are interrupted. A flu pandemic therefore represents an adverse supply shock. Notional consumption demand need not decline materially, but effective consumption demand may well be depressed if many would-be shoppers cannot reach the sellers of goods and services or arrange for delivery. Investment is bound to suffer.
A flu pandemic therefore also represents an adverse shock to aggregate demand. It is bad news on both the demand and supply side. It will however, impact favourably on global warming. Now you know. In what follows I will analyse global economic prospects on the assumption that there will not be a global swine flu pandemic.
The real economy downturn in the US is about 1½ years old; the UK recession has been with us for at least three quarters; the rest of Europe, Japan and most emerging markets and developing countries have juvenile recessions, barely a couple of quarters old.
As regards the overdeveloped world, or at least the North Atlantic part of it, the odds are that this contraction of real economic activity will be deeper and last longer than other post-war recessions. The reason is that other post-war recessions were either the results of central banks murdering a boom that threatened price stability or of an exogenous oil price increase (Opec I and II). Following both types of downturns, the financial system (markets, banks and other systemically important institutions) were, on balance, in good shape (cyclically adjusted!). Banks suffered as a result of the decline in demand for external financing by households and non-financial enterprises caused by the recession, and from the increase in arrears, defaults and other delinquencies that come with an economy-wide slowdown. But the capacity of the system for providing intermediation services and external financing for households and non-financial enterprises was typically in reasonable shape.
Not so today. The crossborder North-Atlantic financial system had collapsed before the downturn in the real economy got going in earnest. Indeed, the financial collapse was the primary cause of the recession in the USA, the UK, Iceland and most of the rest of Western Europe. We know from the studies of Reinhart and Rogoff and of Laeven and Valencia that real economy contractions that follow a financial crisis tend to be both longer and deeper than those that don’t. Specifically, following deep financial crises, the unemployment rate rises an average of 7 percentage points over the down phase of cycle, which lasts on average over four years. Output falls (from peak to trough) an average of over 9 percent, and the duration of the GDP downturn averages around 2 years.
US real GDP growth was -0.2 percent in 2007, Q4 (on the previous quarter), but became positive again the next two quarters (0.9 percent growth in 2008Q1 and 2.8 percent in 2008 Q2). Since then, growth has been negative, with -0.5 percent in 2008Q3 and -6.3% in 2008Q4. The Reinhart-Rogoff downturns are measured from previous peak GDP, which was 2008Q2. If the US conforms to the average of the post-World War II serious financial crisis countries studied by Reinhart and Rogoff, negative GDP growth would persist until 2010Q2. Growth after that would be slow and hesitant. The 2008Q2 level of GDP would be regained at the earliest around the middle of 2012. Unemployment would still be far above the 2008Q2 level at that time.
There is little reason to assume the US will do better than the average achieved post-world war II. Its room for discretionary fiscal stimuli has been more than exhausted. Almost two years have been wasted since the beginning of the financial crisis as regards getting past toxic assets off the balance sheets of the banks. The US regulators and Treasury have put the interests of the unsecured creditors of the banking system ahead of those of current and future tax payers and beneficiaries of public spending. Worse than that, by failing to come up with the required amount of up-front fiscal resources to clean the balance sheets of the zombie banks, recapitalise the banks and, where necessary, guarantee new lending and borrowing, the US authorities have relegated most of the banking system to a state of limbo in which far too little new lending to the real economy is undertaken. The sloth-like speed of the stress tests and the six months grace period granted banks deemed short of capital to come up with new capital on their own, contribute further to my sense that the authorities in the US are doing everything they can to make sure that the US gets as close as possible to emulating Japan’s lost decade.
Bank profitability
What limited bank lending takes place is often at high interest rates, and is funded at government-subsidised rates (about $340bn worth of borrowing by banks has so far been guaranteed by the state). These tax-payer-engineered high spreads on limited new lending, plus the welcome transfusion of taxpayers’ money through AIG paying off its counterparties at 100 cents on the dollar gave a useful boost to many banks’ Q1 profits. Add to that the under-provisioning by many banks for new loan losses, plus the new latitude granted by the FASB to banks wishing to window-dress the depressed mark-to-market value of some of their securities, plus the wonderful accounting convention that permits banks to count as revenue reductions in the market value of their traded debt caused by a loss of market confidence in their creditworthiness, and the banking profitability green shoot is visibly wilting on the vine.
Disguising the new damage done to the banks’ loan book by the contraction of the real economy will become harder as time passes. By the end of the year, I expect that the combination of the stress tests and the reluctant revelation of new bad loans may bring us to the point that even the authorities can no longer shrink from restructuring the insolvent components of the banking system by forcing the unsecured creditors to swap their debt and other claims for equity. Only then can the banking system as a whole begin to function normally again - one hopes under very different rules of the regulatory game.
The inventory cycle
The inventory cycle is short and sharp. Statistically, inventory accumulation and decumulation often account for more than 100 percent of the business cycle. This is unlikely to be the case in the current cycle. Final demand (private consumption, private fixed investment, exports and government spending on goods and services) is contributing to the downturn and will have to turn around to achieve a sustained recovery.
With financial intermediation in tatters, external finance for would-be financial deficit units, households or firms, will be hard to find and expensive. Most households have suffered massive losses of financial wealth and will want to restore their financial health by saving more. Other final demand components are also unlikely to become buoyant in a sustained manner anytime soon. Private fixed investment is likely to be week for the next couple of years because of prevailing excess capacity and limited availability and high cost of external funds. US export growth inn unlikely to be a major source of demand.
Government spending will grow quite rapidly, but the dire fiscal condition of the Federal government effectively precludes further discretionary expansionary fiscal measures. Federal government deficits significantly larger than those envisaged here would unnerve the financial markets and trigger a buyers’ strike in the US Treasury debt markets, either because of a fear of default (quite unlikely) or because of a fear of large-scale irreversible future monetisation and inflation (quite likely). I know it’s not priced in the long-term US government bond yields yet, but this would not be the first time financial markets have been wildly irrational in recent years - so just you wait.
Asset price stabilisation
House prices continue to fall. While house price changes don’t have an aggregate wealth effect, they do affect the capacity of households to borrow, because property, unlike human capital, makes rather good collateral. Until house prices stabilise, it is hard to see consumption reviving. Even with the recent (in my view premature) recovery in the US equity markets, stock market wealth in the US has come down spectacularly from its previous peak, and is now, in real terms, at about its 1996/1997 level. Talk of a lost decade…
Europe
In Europe, the UK is in many ways the US with a half-year lag. The size of its banking sector relative to the economy and to the fiscal capacity of the government and the absence of global reserve currency status for sterling makes the UK more vulnerable than the US to a triple crisis - banking, exchange rate and sovereign debt. The ability of the UK authorities to raise future taxes or slash public spending is, however, likely to be greater than that of the US, whose political system is polarised to the point of paralysis. The US, like the UK, is therefore at risk of a ‘sudden stop’ (an unwillingness of anyone to fund the sovereign and an unwillingness of the rest of the world to fund either the private or public sectors of the US), as long as US political infantilism, especially in the US Congress, guarantees a veto for any sensible (or even just arithmetically feasible) proposal for solving the scary fiscal unsustainability problem of the US.
The rest of Western Europe is dead in the water. The ECB is paralysed, partly by fear of the zero lower bound on interest rates among some of its Governing Council, partly because of the absence of a ‘fiscal Europe’, capable of recapitalising the ECB/Eurosystem should it suffer a serious capital loss as a result of private sector credit exposure incurred as a result of its monetary, liquidity enhancing and credit enhancing operations. Countries that have fiscal credibility and could do more as regards Keynesian fiscal stimuli, like Germany and France, refuse to do so. The recession in Western Europe started about a year after that in the US. It will last at least as much longer. The banking system of Western Europe (ex-UK) has been even more reluctant than that of the US and the UK in owning up to the disastrous state of its balance sheet. At least €500bn additional capital will be required to keep the continental West-European banking system on its feet. More will be required if it is to actually start lending in earnest again.
Japan
I don’t understand the Japanese economy. Never have. Probably never will. Will they be a locomotive for the rest of the world? Everything’s possible but not everything’s likely.
Japan’s public debt to GDP ratio is 180% of GDP and rising. Yet even long-term rates on nominal public debt remain very low. The main reason is, I believe, that while the Japanese state runs a massive financial deficit, the Japanese private sector runs an even more massive financial surplus. The consolidated financial position of the country has been one of persistent current account surpluses. Private financial wealth is huge and the net international investment position of the country is a large positive number. (Italy has a milder version of the same configuration of private and public saving and borrowing propensities).
So if the markets believe that the Japanese political system is and will be capable of achieving, sooner or later, the large resource transfer from the private sector to the public sector that is required to make the public finances sustainable, the overall financial position (flows and stocks) of the country is what matters. And these consolidated national flows and stocks still look pretty good. This in contrast to the US and the UK, where looming fiscal deficits combine with low private saving propensities to create enduring doubt about fiscal sustainability. As regards Italy, I am less than fully confident that the Italian tax payer/beneficiary of public spending will do as (s)he is told by the nation’s fiscal authorities, now or in the future.
Emerging markets
The prospects of the emerging markets depend, first, on their dependence on external demand, second, on their dependence on external finance and, third, on the scope for expansionary domestic demand management and the ability of the authorities to use it intelligently and flexibly.
No emerging markets suffered the destruction of their banking systems prior to going into recession. Their contractions are the result of the external transmission of the north-Atlantic financial crisis and contraction, through trade linkages, through deteriorating terms of trade (especially for commodity producers), through falling remittances, through the financial markets and through the parent banks of foreign-owned local subsidiaries and branches restricting the availability of re-financing and new funding to their local subsidiaries and branches.
The emerging markets that are best poised to enjoy a speedy recovery (following a V-shaped recession) are those that do not depend excessively on external finance and on external demand.
China certainly fits the bill as regards lack of dependence on external finance. Like many other emerging markets that suffered through the Asian and Russian crises of 1997-1998 or observed it closely, China self-insured against an interruption of external financing flows by building up massive liquid foreign exchange reserves. Chinese reserves today even exceed those of Japan. India, Brazil, Korea, Malaysia, Singapore and Taiwan also built up large foreign exchange reserves.
China does not fit the bill, however, as a candidate for a sustained early recovery because of its external trade dependency. Growth in demand for its exports will not revive anytime soon. The country is not large enough to pull itself up by its own boot straps, unless it achieves a radical restructuring of its production and a shift in the composition of final demand away from exports and towards domestic final demand.
China recognises this and has thrown the kitchen sink at the problem. Although it is hard to understand the exact size of the fiscal stimulus it has provided, there is no doubt that this stimulus was large. Interest rates have been cut. Credit growth, including bank lending to state enterprises and to construction has exploded. The problem with this approach is that the composition of the demand stimulus and production boost is completely wrong. The government has simply done more of whatever it was doing in the past: increased investment in the production of exportable goods and heavy industry (metals and chemicals), increased production of semi-finished manufactured goods and increased investment in infrastructure. The inevitable result of this investment boom will be increased excess capacity in exportables and unprecedented environmental destruction.
China is missing a huge opportunity. Its short-run imperative (boost demand through a fiscal stimulus) coincide with its long-run imperative (reduce the national saving rate and the external current account surplus). This stands in sharp contrast to the US and the UK, where the short-run imperative (boost demand through a fiscal stimulus) conflicts 180 degrees with its long-run imperative (save more and reduce the external current account deficit). China saves too much in the household sector, the corporate sector (especially the state enterprises) and the public sector. It badly needs an unfunded pay-as-you go social security retirement scheme to boost consumption by the old. China’s fiscal position is such that the country could introduce the benefit (pension) part of the social security scheme for a number of years without having the social security tax in place!
China’s rapidly greying population and the one-child policy mean that, without a credible, universal, publicly funded social security retirement scheme, it is individually rational to save like crazy, because neither the state nor your children will be able to look after you in old age.
Another way to boost public consumption (and reduce household saving), is to guarantee decent quality medical care for all regardless of ability to pay. Saving to pay for private tuition for one’s (only) child is another important driver of private saving in China. Providing better quality public education could free private resources for consumption.
But a boost to consumption demand (private and public) of this nature requires a matching change in the structure of production towards consumer goods and services and away from heavy industry. China hasn’t even begun to address this shift of demand towards non-traded goods and imports and of production towards consumer goods and services. Even if its ultra-old-school demand stimulus does not get killed (yet) by environmental constraints (clean fresh water, clean air, clean soil etc.), it will certainly be killed by mismatch constraints as the country adds massively to its capacity to supply goods nobody wants.
The green shoots we may be seeing in China will therefore not endure unless the country manages, very rapidly, a radical change in the composition of its production and consumption. That is possible, but not likely.
A country like India - much less dependent than China on external demand but rather more dependent on external finance - could also recover rather soon, and in a more sustainable way, especially if it finds a way to further stimulate domestic saving. But its weight in the world economy is slight - not enough to be a locomotive, not even the little engine that could.
Other emerging markets, like Brazil, have been hit hard by the global downturn and by the freezing up of key financial markets despite being net foreign creditors and running external surpluses prior to the crisis. Brazilian corporates were heavily exposed to the international financial markets, often at short maturities. While the central bank, thanks to its large foreign exchange reserves, was capable of preventing large-scale defaults, the financial squeeze on Brazil’s corporations, plus the terms of trade shock and the decline in export demand has caused the country’s industrial production to fall off a cliff. One would expect it to be able to recover sooner than the US or Western Europe, if it can direct demand towards domestic sources.
Eastern Europe (including the CIS) is the most dramatic victim of the made-in-Wall-Street/City-of-London/Zurich crisis. Virtually all countries in the region were heavily dependent on external financing and on foreign trade. Some, especially in the CIS, are major commodity exporters. Western banks are often the parent banks of the local branches and subsidiaries. As the barbarians threatened Rome, headquarters withdrew the Legions from the provinces. Parent banks are ruthlessly cutting the access to funds of their subsidiaries and branches in CEE. No help will come anytime soon, with the members of the old EU barely capable of keeping their own trousers up.
Conclusion
The only reasonably convincing evidence of ‘green shoots’ comes from China. That, however, is unlikely to be sustainable, as it is very much the result of a ‘same-as-it-ever-was’ package of fiscal, monetary and credit policy measures by the Chinese authorities. The export- and heavy-industry led expansion they have successfully engineered is the way of the past. It will go nowhere, unless China transforms the composition of both production and demand in the directions that are unavoidable (and also desirable) for a country at its level of economic development. Apart from China, the only green shoots I have seen were in the salad bar of the hotel I am staying at.
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