Some thoughts, with references

I share the views of the world of:

Richard Koo, Paul Krugman, Mark Thoma, etc., w.r.t.:
the unique, persistent nature of balance sheet recessions, as distinct from normal cyclical recessions; the need for more government intervention to get unemployment down; the liquidity trap, which causes normal transmission channels of monetary easing, which normally induce housing-led recoveries, to be no better than pushing on a string; and, therefore, the primacy of fiscal policy to fill the gap in aggregate demand in order to achieve the objectives of reducing unemployment and increasing inflation; but, in the absence of sufficient fiscal policy, the necessity for further monetary policy easing, however non-traditional and (in-)effective that may be;

Irving Fisher, Steve Keen, Gary Shilling, Van Hoisington and Lacy Hunt, David Rosenberg, Felix Zulauf, Ray Dalio, Albert Edwards, etc., w.r.t.:
the huge excess of unsustainable debt growth built up over two decades, and the concomitant excessive spending, represented enormous pulling-forward of aggregate demand, which ultimately must be paid for with future savings from income and therefore lower future demand in the same scale as past excess consumption; that that process of debt accumulation appeared to be sustainable not due to income growth but due to the chimera of wealth enhancement due to elusive/temporary asset-price appreciation in the housing market; the credit expansion created excess claims to underlying real wealth; once the asset-price bubble burst, i.e. the Minksy moment, the resultant debt-deflation dynamics, including the paradox of thrift, deleveraging, declining money multipliers and monetary velocity, deflation of broadest measures of effective money supply, which, contrary to the views of many traditional economists, critically includes credit (which dwarves traditional measures of money supply, like M2) (i.e. deflation is a decrease in money and credit relative to available goods and services); and resultant disinflation of wage and price levels; in this deleveraging, disinflationary, low-growth environment, there's no evidence that the secular bull market in bonds has expired, as the phenomenon of lower yields for the last 25 years has been consistent with declining rates of nominal GDP growth, which persists --- i.e. yields have yet to see their lows

Kenneth Rogoff and Carmen Reinhart, et al, w.r.t.:
the costliness of economic recessions that are coupled with financial crises, both in terms of share of GDP and recovery time, particularly given the hits to the consumer due to the debt burden mentioned above and the housing recession; that recovery is extended until the debt overhang is absolved or resolved

Chris Whalen, Josh Rosner, Janet Tavakoli, William Black, John Hussman, etc., w.r.t:
the disastrous policy of rescuing the banks rather than rescuing the banking system, i.e. following the failed Japanese model rather than the successful Nordic model of responding to a financial crisis; that fundamentally nothing that caused the credit crisis has gone away or improved (and in fact have gotten worse when it comes to commercial real estate), only that the inherent problems on bank balance sheets have been glossed over or hidden from public view but remain there (e.g. all of the nation's banks jointly earned $22billion in Q2, thanks largely to reducing reserves against losses by $27billion compared to a year earlier), making the banks into zombie banks and effectively nationalizing the whole mortgage market, but without having done anything to help homeowners with mortgages, the root of the problem; and that without proper debt restructuring (haircuts, debt-for-equity swaps, etc.), the problem will persist and fester; the government's notion that re-capitalizing the banks would result in a multiplier effect (each dollar of capital injected into banks by the government would result in $8 of new lending to families!) proclaimed by Obama was either naive idiocy or duplicitous crony capitalism; that extend-and-pretend merely postpones the necessary adjustments and extends the adjustment period

Joseph Stiglitz, Paul Krugman, Simon Johnson, Paul Volcker, Robert Reich, Mervyn King, William Black, Dean Baker, etc etc etc, w.r.t:
the TBTF banks are not TBTF; until they are broken up and until the paper-ponzi-pushing egomaniac CEOs of those TBTFs lose their sway over policy via their lapdogs, policy-makers will stick with their failed strategies, to the detriment of the economy; the financial sector of the economy is a tax on the productive sectors of the economy

Meredith Whitney and Chris Whalen w.r.t:
the likelihood of states and municipalities defaulting on their debt

Gary Shilling w.r.t.:
the housing recession is not over; house prices remain too high based on price-to-income and price-to-rent metrics, and will fall further thanks to high vacancy rates, tight credit, nonexistent income growth, high unemployment, poor supply-demand dynamics, fraud-closure problems, shadow inventory; reduced housing construction has not yet compensated for too-long a period of over-building, etc.

Warren Mosler, Marshall Auerback and Randall Wray w.r.t.:
on the fiscal side, that, operationally, government spending is not constrained by revenues, there is no solvency problem for the federal government, or any government that issues its own currency; on the monetary side, that QE is not money printing, it is an asset swap (though the monetary base will increase, and, in this very limited sense QE could be construed as money printing, the monetary base does not constitute a full measure of money, which in aggregate will be unaffected); QE is thus not inflationary; it is functionally equivalent to the government issuing T-bills rather than long bonds; excess reserves do not get lent out; expansion of the monetary base is a result of increased lending, not a cause of increased lending; unintended consequences of monetary ease include that ZIRP reduces income for savers, and QE pulls yet more interest income out of the private sector of the economy, neither of which helps the situation; therefore, as per above, I disagree vehemently with the likes of Alan Meltzer who complain that the "enormous increase in bank reserves [caused by QE] will surely bring on severe inflation if allowed to remain" --- though I also disagree with the Fed's notion that it is the paying of interest on reserves that "breaks the link between the quantity of reserves and banks' willingness to lend"

Michael Pettis, w.r.t.:
China's huge trade surplus means that although it accounts for a significant share of global growth, it does not actually contribute significantly to global growth; i.e. its trade surplus means that it absorbs much more demand than it supplies; in fact, China's policy of perpetuating both existing global imbalances and also internal imbalances will make the inevitable adjustment processes that much more difficult and painful; China has been able to maintain high rates of growth by mercantilist export-led growth strategies, which parasitically rely on consumption growth in OECD countries, thereby making the trading partners that China relies on that much weaker (i.e. by appropriating other countries’ demand), and also by continually investing in excess productive capacity (65% of GDP accounted for by fixed-asset investment), which is already well out of line with global demand (akin to the significant over-building in U.S. residential and non-residential construction); massive overinvestment and misallocation of capital seldom ends well; that China is fundamentally not all that dissimilar in nature to Japan circa-1980s (when Japan was considered a miraculous economic success story, and keiretsu were all the rage, as was Japanese innovation and work ethic and MITI-central planning, etc., and when its share of global GDP went from 7% in 1970 to 18% in 1990 --- but has subsequently fallen back to 8%); Chinese consumption growth has been far short of its GDP growth, such that consumption has fallen to just 36% of GDP in 2009, from an already low 46% in 2000, an unhealthily small share of GDP, and is reflective of household income growth, which, while robust by developed country standards, has trailed GDP growth; this internal imbalance will require a period of difficult re-balancing, which, though not necessarily imminent, is inevitable; the question is whether income and consumption growth can exceed GDP growth with that latter being sustained in the prevailing range of 8-10%, which would be inconsistent with historical precedents, or the rebalancing would require GDP growth to fall below household income and consumption growth

Jim Chanos, w.r.t.:
China = Dubai times 1000; China = Enron; China's lending bubble, real estate bubble, stock market bubble, aura bubble

Chanos, Dylan Grice and Peter Gibson, w.r.t.:
every single financial crisis in the last 150 years has been preceded by rampant credit growth; there is a Chinese financial crisis in the making

Marshall Auerback and Albert Edwards w.r.t.:
that beggar-thy-neighbour geopolitics has become the norm, and portend the a potential nasty trade war, particularly given domestic U.S. political considerations and also given China's consistent policy of always doing what's in its own best mercantilist interest; that "Chimerica" has been a chimera; the Fed's attempt to trash the dollar may be motivated by a desire to force the Chinese, who have no wish to revisit the inflation-induced social unrest of 1989, to revalue the yuan sooner rather than later if QE causes commodity and food-price inflation to get out of hand (its unlikely that the Chinese are unaware that food price inflation was a primary contributor to social unrest at the start of the Iranian, Russian and French Revolutions)

Ambrose Evans-Pritchard, w.r.t.:
Europe's "gamble of launching a premature and dysfunctional currency without a central treasury, or debt union, or economic government to back it up, and before the economies, legal systems, wage bargaining practices, productivity growth and interest rate sensitivity, of [the Teutonic] north and [Club Med] south Europe had come anywhere near sustainable convergence, may now backfire horribly" due to its one-size-fits-none arrangements; problems in Ireland and Greece and Portugal cannot be ring-fenced, because Spain will be next in line and it is big enough to bring the whole house of cards down

Dean Baker, Jeremy Grantham, etc., w.r.t.:
the precariousness of the housing market in Canada; that it is naive to believe that "conservative" Canadians could not have bid house prices up much too high just because subprime lending is not endemic here as it was in the U.S., or because mortgages are non non-recourse and mortgage interest payments are not tax-deductible; none of these things changes the fact that most people now own too much home, evidenced by price-to-income, price-to-rent and debt-to-income ratios well above historic norms

John Hussman, etc., w.r.t.:
the over-valued, over-bought, over-bullish stock market, which is discounting far better results than the economy can produce; that market participants were apparently making the assumption in early 2010 that the economy would return to normal as per typical post-war recoveries, implying that profits would return to 2007-"normal" and earnings growth would continue at 1990-2006 rates, allowing for aggressive valuation metrics; that their expectations were quite validly shaken by the Euro debt crisis in the spring and the economic evidence that this recovery would not follow the path of typical recoveries; that the recent bounce back is a sugar-high, under-pinned only by psychology and not fundamentals; and, given prevailing economic and market conditions, is susceptible to a steep drop with little warning



without reference, in my own view:

contrary to popular opinion, stocks do NOT generally earn 10% over the long-run; the historical average has been half that

Earnings growth is typically lower than nominal GDP growth; earnings are currently elevated relative to economic growth; analysts are extrapolating historically high profit margins indefinitely into the future

Modest nominal GDP growth prospects (IMHO) portend modest prospective earnings growth

Stock-holders do not ultimately get paid with “operating” earnings, they get paid with total (reported) earnings; the recent convention of focusing on operating earnings is a perversion of proper valuation analysis; furthermore, forward earnings estimates are unreliable indicators of even future operating earnings, much less reported earnings

Forward P/Es are therefore irrelevant; stocks always look cheap on forward P/E basis, and do nothing to forecast returns on a trailing P/E basis, stocks are moderately expensive (P/E of 16.5 vs long-term median of 14.3), but this assumes the last year’s earnings are representative, and it too has been a very unreliable indicator of future returns On a normalized P/E basis, stocks are 40% overvalued (P/E of 23.7 vs historical median of 16.9) Historically, when normalized P/E ratios were as rich as they are currently, 10-year forward price returns have been not much above zero, with significant volatility in the interim


Other thoughts:

the U.S. economy has received the biggest peacetime stimulus it has received in 75 years but it has resulted in nothing more than lacklustre growth; with final sales so weak, even without a further drop in the cyclical sectors of housing or consumer durables, even a modest dip in inventories could be sufficient to send the economy into a double dip; the usual catalysts for self-sustaining growth have been absent in this recovery; debt deleveraging, with no end in sight, has offset fiscal and monetary stimulus, the former of which does have an end in sight, and the latter of which is pushing on a string, while inventory-led growth, which surprised me by persisting in Q3, is nonetheless not sustainable;

C + I + G + X - M
absent income growth or credit growth, consumption growth will be absent;absent signs of demand growth, and with prevailing excess capacity, investment growth will be absent;the waning of fiscal stimulus by itself detracts from growth, and, with political gridlock, the prospect of further stimulus, with the exception of the likely extension of the Bush tax cuts, which are unlikely to have much impact on aggregate demand, is remote;net exports, particularly if the greenback's depreciation persists, is the one component of GDP that seemingly offers much prospect for growth, though to some degree will be provided by lacklustre import growth, which, though a mathematical contributor to growth, would be reflective of weak growth of the first three components (C, I and G); meanwhile, if the European situation worsens, not only will the weaken, but the impact on risk appetites generally would likely cause general US$ appreciation, and, in any case, there’s not much prospect of significant revaluation of the yuan, implying that the largest component of the U.S. trade deficit will be relatively immune to currency impacts

though both the ECRI WLI and Consumer Metrics Institute gauge are not as negative as they were two months ago, they both herald a double dip

ISM new orders minus inventories foreshadows a decline in ISM to well below 50

inflation expectations have historically been highly correlated with the ISM, so when the ISM falls to 45, that would be consistent with inflation expectations falling from 2% to 1%, which would be positive for bond prices

Ben B does not heed own advice -- says Fed does NOT seek inflation above 2%; didn’t he tell Japan to target high inflation in order to convince the public the BoJ really meant to reflate?

Ben Bernanke said to Milton Friedman "you're right, we did it; we won't let it happen again"; but, ironically, it could very well be that QE is the destabilizing force that causes the next crash; if QE-induced commodity and food price inflation force China's hand, prompting it to break its unbridled expansion of credit, which could cause, given that the market's broad-based resurgence of confidence is seemingly predicated on the emerging markets and commodity prices themes, a re-evaluation of global risk appetite, and if higher food and oil and gas prices in the U.S. impose a tax on the consumer that further slows discretionary spending

Fed needs negative real interest rates to reflate --- but with Fed funds constant and inflation falling (particularly the type of inflation that matters from a debt deleveraging perspective, wage inflation), real interest rates are getting less negative over time

state and local governments will continue to act like 50 little Hoovers; is California (or Illinois or New Jersey) any different than Ireland?

inordinately high corporate cash balances exemplify the type of cash hoarding that goes on when monetary velocity declines

to stimulate the economy, the government could increase aid to the unemployed, reduce employers' payroll taxes, allow expensing of investment costs, provide further state aid, invest in infrastructure, or offer income tax cuts; this list of options is in descending order of effectiveness according to the CBO; and yet the first option has already been kaiboshed, and the only option that is politically feasible in the near future, the extension of the Bush tax cuts, will be least effective option

there are falling pressures on each component of M*V = P*Q

the credit crisis was not an issue of liquidity, but one of solvency; liquidity issues have been temporarily "solved" by glossing over the solvency issues, which have not been alleviated (debtors have too much debt relative to the means to repay it; creditors at risk);

the Fed estimates that the shadow banking system was $20 trillion in size at the start of the crisis, relative to the $11 trillion size of the traditional banking system, and has now fallen to $16 trillion, still in excess of the now $13 trillion size of traditional banking



US = Japan2

The Bank of Canada's revised forecasts

The Bank of Canada's Monetary Policy Report (MPR) released last week laid out its latest views on the economy, which substantiated why it left rates unchanged at 1%.

For starters, after trekking along from 2000-2007, the economy suffered a severe drop-off in 2008/09 which hasn't even come close to being re-couped.

Through June 2010, real GDP remains 4.9% below trend growth, which is up from the 6.6% gap as of June 2009.

And though the economy has turned up since troughing in May 2009, the continuation of that rebound isn't turning out to be as robust as the Bank had hoped and thought.

After growing at an annualized rate of 4.9% during the fourth quarter of 2009, the economy expanded 5.8% in the first quarter of this year, which trailed the Bank's forecast of 6.1%; and then growth decelerated in the second quarter to just 2%, lagging the Bank's forecast of 3%.

The Bank has now revised its growth forecasts down for each of the next five quarters, though it increased its forecasts for the five quarters after that. (This, by the way, is par for the course for the Bank ---- every time it revises its forecasts for growth in the near-term, it must, by the necessity of its mandate, revise its forecasts for later-term growth commensurately in the opposite direction. More on this later.)

Just for point of comparison, I think its worth noting how this forecasted growth, if it materializes as now expected, would compare to trend growth.



Though it does show how underwhelming this recovery has been and is projected to be, obviously trend growth from last decade doesn't hold much relevance as far as the Bank is concerned.

What the Bank is concerned with is how actual economic activity compares to what the Bank views as potential output. And growth of potential output these days is much lower than trend growth of the economy was for the last 5-10 years, because of a slowdown in the growth of the economy's rate of labour utilization, and, more particularly, of labour force productivity.




Canada entered the recession with the economy in a situation of excess demand (actual GDP above potential), but is now experiencing excess supply (actual GDP below potential).

As of July, the Bank believed that the output gap would be eliminated (actual GDP would converge on potential) by the end of 2011. Despite lowering its estimates for the growth of potential output (1.6% in 2010, 1.8% in 2011 and 2.0% in 2012), the Bank now forecasts that the output gap won't be eliminated until the end of 2012.

Here's why this is telling.

The Bank's job is to try to get CPI on target by the end of its forecast horizon, which in this case is to the end of 2012. It therefore needs to eliminate the output gap during that time period.

It previously had thought that it would have CPI on target by early 2012, by virtue of having eliminated the output gap by the end of 2011.

As of July, the Bank was forecasting that growth in 2012 would be 2% because (a) it believed that the output gap would be eliminated by then, (b) it wanted to keep CPI on target, and (c) it believes that the growth rate of potential output would be about 2% in 2012.

Therefore, to keep inflation on track, it would need to keep actual economic activity consistent with the economy's potential growth. Presumably, in order to do that, it would have needed to return to neutral monetary policy in 2011.

But by downgrading its views on economic growth for the last two quarters plus the next four quarters, the Bank is faced with the situation of having to engineer more growth nearer to the end of its forecast horizon in order to meet its objective.

In other words, because monetary policy works with a lag of at least 12 months, its economic growth forecasts for the next four quarters must be based in part on where it has its overnight rate set right now. So, despite remaining extraordinarily accomodative, the Bank doesn't think economic growth will be either (a) as strong as it had previously thought, or (b) strong enough to close the output gap.

Though year-over-year growth of 3.8% in 2010 followed by 2.7% in 2011, which were its forecasts as of the July MPR, would have done the job, growth of 3.0% this year (compared to 1.6% potential growth) followed by 2.4% next year (compared to 1.8% potential growth), which are its current forecasts, won't.

Therefore, the Bank will be required to enhance growth opportunities in 2012 in order to achieve the growth rate of 2.8% (compared to 2.0% potential growth) required to close the output gap.




Given that the Bank forecasts the output gap will not be closed until a year later than earlier projected, it seems safe to assume that the Bank will not return to neutral monetary policy until a year later than it earlier would have assumed.

As such, if its base case scenario had been that once it started hiking its overnight interest rate in July it would do so in sequential meetings until rates had been normalized, it seems that, based on currently available information, a resumption of that projected path of interest rates will likely wait a year.

Personally, given my expectations for deterioration in the U.S. economy (due to continued household deleveraging, continued reluctance on the part of banks to increase lending, fiscal spending headwinds rather than tailwinds, the end of the inventory bounce, spending cutbacks at the state and local levels, reluctance on the part of the business sector to make capital expenditure investments given its overcapacity, and no imminent rebound in the housing market or in the labour market), plus concerns about the unsustainability of household spending in Canada, as well as the prospect of global forces of competitive currency devaluation impairing Canadian trade balances, I am reluctant to believe that the Bank will be successful at closing the output gap over its forecast horizon.

In any case, on a breakeven basis, the current 2-year yield of 1.43% would be consistent with a time-path of overnight rates that involved the Bank staying on hold at 1% until October 2011, at which time rates would be hiked in four consecutive meetings to get to 2%.

Rates

Why should rates rise?

- because they seem really low, don't they?


Why should rates stay low?

- bonds remain in a secular bull market

- there's no evidence of any catalysts that would prompt higher rates (the theory that there will be a flight away from bonds due to fears about the Fed running its printing press remains in the same category as the theory early in the year that huge budget deficits would cause rates to sky-rocket)

- though nominal rates are low relative to historic norms, real rates are very much consistent with historic averages (and, if anything, long Treasuries look cheap)

- the swamp of new Treasury issuance was early this year, and the market digested that, and now there will be less prospective new issuance of longer-dated Treasuries;

- plus there's a new buyer, the Fed, which, if it intends to expand its balance sheet by $1 trillion, could digest virtually all new supply

- as long as the Chinese and OPEC need to recycle the dollars they get from their bilateral trade surpluses with the U.S., there will be foreign buyers of bonds

- easy monetary policy is here to stay as long as unemployment remains high and inflation remains low

- unemployment will remain high and inflation will remain low as long as economic growth remains below potential growth (and even for a not insignificant period of time after growth exceeds potential, as it will take a long time for the output gap to close)

- other asset markets are much riskier than bond markets, so, despite all the talk of a bond bubble, bonds as an asset class, with a guaranteed rate of return if held to maturity, will remain in demand, particularly with LDI, etc.

- the fixed income portion of household balance sheets remains low, and aging boomers will continue to need income-producing assets and more stable portfolios

- the banks have been big buyers of bonds, and as long as they're reluctant to increase their lending to households, they'll continue to be motivated to make money off the yield curve




what have I missed (for either argument)?

WTF!

How the hell does one make sense of the world now?

How does one predict where the markets will next head?

To figure that out, not only do you have to figure out the trajectory of the economy --- strengthening, though soft? or softening, though positive? or softening into contraction? --- and to do that you need to (a) figure out the underlying trend of private domestic demand, (b) determine the impact of inventory adjustments, (c) evaluate the incremental impact of changes in fiscal spending, (d) ascertain the contribution of net exports given differing behaviour of regional growth (e.g. is a strong China good for U.S. net exports? slowing Europe?)

But then you have to throw in the wildcards of:

the election and the prospective outlook for the extension of the Bush tax cuts

QE2 --- what impact it will have on the economy (+ve? none? -ve?), and what first-order impacts it will have on the markets (baked in the cake? lagged?), plus the second-order feedback loop effects between the markets and the economy and vice versa

the mortgage foreclosure mess

beggar-thy-neighbour geopolitical/economic policies, including currency wars and potential for trade wars

The current period seems all too familiar: a period of the market's stubborn refusal to acknowledge the writing on the wall. That the economy is weak, there is no question. If that were not the case, then QE2 would not even be in the discussion. But it seems many view this as a win-win environment: either the economy turns and all is well with the world so asset prices (except bonds) go up; or QE2 is necessary and asset prices (including bonds) go up! Hallelujah!
Such people never learn.

In 2000, in the face of crumbling fundamentals, the market stubbornly ignored valuations, treating valuation analysis as a quaint historic notion of no current relevance. Then the market fell over 50%.

In 2007, in the face of a monstrous debt bubble and housing market crash, the market decided to keep dancing rather than face the music; and then, once it did realize that subprime really might not be contained, it somehow imagined that the Fed could somehow solve all the world's problems with lower rates (the distinction between illiquidity and insolvency never having really been appreciated). Then the market fell over 50%.

Today, the problems seem worse, and the potential for solutions more remote.

Take just the mortgage situation alone:

Banks are still insolvent: their balance sheets and their earnings statements have been goosed by accounting gimmickry, including mark-to-model and off-balance-sheet legerdemain, as well as reducing loan-loss provisions even as non-performing loans continue to escalate, i.e. all the same sort of zombie-bank stuff used in Japan.

Okay, well, I'm quite willing to acknowledge the obvious: the U.S. government has been bailing out the banks for the last 3 years, injecting capital without taking charge, not only letting the banks continue with their standard operating procedures, but changing FASB rules to boot --- and they're NOT about to abandon that strategy now!

So perhaps the fact that the banks are insolvent is irrelevant --- there will be no second shoe to drop in the credit crisis, the next wave of mortgage resets and the CRE situation notwithstanding.

And surely the Feds would not let foreclosure-gate put at risk their grand master plan! How could they possibly do that? What would be the point of QE2 if Obama et al had any thoughts of actually going after the banks for foreclosure fraudulence? The former would have no chance of success if the latter were happening, so, clearly, the latter won't happen.

But but but

But foreclosures in the U.S. are not a federal matter, they're governed by state law. Hmmm.

And...

But BoA, JPM and Citi are each down 5-9% this week. Meanwhile, 5yr CDS on BoA have shot out to 193 from 152. Could this be the tip of the iceberg?

In 2007, when the ABX started falling, most of the Street remained in the "contained" camp --- losses would be minor; there was no need to over-react --- but it didn't take too many months for the ABX to drop 60% and for the S&P 500 Financials index to drop from a 2007 high of 510 to a 2009 trough of 78. Ay, carumba!

Have the problems from that period actually been fixed? Are the underlying cashflows to support all that debt that still remains actually there? Have either employment or housing prices rebounded to give support to mortgage-based valuations? Or, perhaps is there just a lot of smoke and mirrors? And not only that but now actual malfeasance. (If you don't know who owns the loans or who has the right to foreclose, can a raft of lawsuits investor losses and bank writedowns be all that far behind?)

Count me as a skeptic.

But even if the skeptic in me is right, what about QE2? Perhaps the banks could be as messed up as possible, but if the Fed still gives them free use of the printing press (even a badly-managed bank can make money by borrowing at 0% and investing at 3 or 4%), especially if the Fed telegraphs that it will buy whatever the banks have already bought, and will do so at higher prices. How easy is that!

So even if QE2 can't do much for Main Street, surely it can do something for Wall Street. What could possibly go wrong?

Lots, that's what. How about a full-fledged currency war-morphed-trade war?

Too many known unknowns, never mind unknown unknowns.

All I know is, whenever people think about the market being in a win-win situation, they've got their head stuck u-no-where.

Stock prices and bond yields certainly could go up from here. I just don't think that's the way the odds are tilted. Not will all those wildcards.

All in all, I think the market's interpretation (the stock market's, that is; the bond market is always right! well, maybe not always --- like early 2010, when Treasury issuance, inflation and bond vigilantes prevailed --- but at least the bond market is always right before the stock market!) of current events is no more correct today than it was in either 2000 or 2007. Just another flight of fantasy.

Are you ready for some football?

with Vikings at Saints playing tonight to kick-off the season, I thought I'd put down some forecasts to come back to and laugh at come January; we'll see how little I know:

barring major injuries (like star quarterbacks needing to be pried out of a car at 5:30 a.m. by the jaws-of-life), my playoff team predictions:

NFC
1-Falcons (12-4)
2-Packers (12-4)
3-Cowboys (10-6)
4-49ers (8-8)
5-Saints (12-4)
6-Vikings (10-6)

AFC
1-Ravens (12-4)
2-Chargers (12-4)
3-Patriots (11-5)
4-Bengals (10-6)
5-Colts (10-6)
6-Steelers (9-7)

playoffs

round 1:
Saints over 9ers; Cowboys over Vikings
Steelers over Patriots; Colts over Bengals

round 2:
Falcons over Saints; Packers over Cowboys
Chargers over Colts; Ravens over Steelers

conference championships:
Falcons over Packers
Ravens over Chargers

Superbowl:
Ravens over Falcons

Predictions (in prep for next forecast meeting)

"Low-probability" events that I currently predict:

- U.S. is experiencing a balance sheet recession, much like the Japanese did, which leads to very different outcomes than do typical inventory-led recessions, meaning that this will be a bump-along, virtually no-growth era, albeit with lots of volatility

- the wide output gap will persist; economic slack will continue to be disinflationary

- U.S. housing STILL has not bottomed; houses remain overvalued and with the excess supply of homes, even ignoring shadow inventory, (months supply of existing homes now at 12.5 months), pressure on prices will resume

- the U.S. household balance sheet continues to have very much more debt than can be serviced given incomes and nonexistent income growth (median household income adjusted for inflation has not grown since 1997); there will be many more write-offs, loan loss provisions need to increase, which will hit earnings, and deleveraging will persist for a LONG time

- as households delever, deflation picks up (deflation is the contraction of money and credit; though prices as calculated in the CPI are not yet falling, M3 IS, thus deflation)

- with excess capacity and no demand growth, there's no impetus for production growth (other than very short-term inventory cycles), so there is no impetus for employment growth

- waning of inventory rebound and of federal fiscal stimulus will not just no longer add to growth, but will detract from growth, as will the state & local budget cut-backs

- if the U.S. does not double-dip, it will only be because the NBER decides the recession starting December 2007 hasn't actually ended yet (a mid-recession bounce off the lows that does not reclaim the old peak before the down-trend resumes may not justify an end-of-recession call)

- Canada will not decouple from the U.S. going forward any more than it did in 2008/09

- Canada has its own internal imbalances (consumer credit, household debt, housing activity & prices) which makes it not just vulnerable via external shocks, but vulnerable too to unsustainable domestic demand

- China does not just contribute to global imbalances, but has its own severe internal imbalances, which are unsustainable and thus won't be sustained, and China will suffer the same fate as Japan in the 1990s and the U.S. now in the aftermath of the crash of an asset bubble (though many believe the Chinese government has plenty of ability to fine-tune the economy and keep growth near double-digit range, there is not much precedent for successful central planning economies)

- stocks remain in a secular bear market, despite the cyclical swings; stocks will fall below 800 as current very rich valuations (based on cyclically-adjusted P/E ratio and Q-ratio, as opposed to forward P/E) are predicated on robust earnings growth due to robust economic growth, neither of which will materialize; in fact, if fair value is 850ish, and given that stock markets always over-react in each direction, a revisiting of the 600s is not out of the question

- investors will shun stocks and continue to restock the fixed income holdings on their balance sheets, which, for households, remain very low, particulary given the aging baby boomer demographic situation

- Fed will be on hold at least until 2014, likely longer

- BoC will get its overnight rate no higher than 1% while Fed remains at 0%, and I believe it will cut rates again once the shxt hxts the fan again (i.e. once the fact that there's no recovery to speak of becomes obvious)

- the secular bull market in bonds that began in the 1980s has not been broken yet and will not be in the next few years; bond yields will break through the 2009 lows, getting closer to Japanese levels in 2011; US10s will get below 2%, Canada 10s under 2.5% and long bonds to 3%







Context: "Low probability" events that I have previously predicted:

- in late 2006, anticipated not just U.S. housing stalling, but crashing; a recession in 2007; an S&L-type financial crisis

- in Q1/2007, I thought the economy would be in recession in Q2, if it was not already (wrong; but it was by the end of the year)

- in Q2/2007, I predicted a Minsky moment, that the debt bubble would burst (and though I sold most of my non-bank ABCP, I foolishly rationalized not selling my one last piece as it was just a 2-month maturity)

- and that the S&P would fall below 1000 (I was the only in-house predictor of negative stock returns in 2008; however, I was also the only predictor of negative stock returns for the rest of 2007, which was incorrect; early again, like with the recession)

- it was in Q3/2007 that I first started predicting that the U.S. would likely, due to a cratering asset bubble and large private sector debt burden, have an outlook similar to Japan in the 1990s
- in late 2007/early 2008, I predicted that the Fed would drop rates to the old low of 1%

- and, at that time, I believed it was too early to be buying credit (but I did not advocate for selling credit, and I certainly did not foresee spreads widening anywhere near as much as they ultimately did)

- in early 2008 I noted that economic growth since the 1980s had been driven by debt growth, with more and more debt required over time to buy each unit of GDP growth, and therefore that in the absence of debt growth there would be no economic growth; and that though the government could fill the void for awhile and offset private sector deleveraging for a time, it could not do so indefinitely, so economy-wide deleveraging would happen

- in 2008 I agreed that subprime was contained --- to planet Earth

- and I predicted, when losses so far were under $400 billion, that credit writedowns would easily exceed $1 trillion

- I also suggested in mid-2008 that the Fed was in a liquidity trap and that monetary policy, though easy, would not be effective (pushing on a string)

- in Sept 2008, when the S&P was at 1200, I expected stocks to go down a further 14% in 2008 and be down 8% in 2009 (down to 800 then up to 1000) (wrong -- they went lower than I anticipated (to 666), then recovered much more than I anticipated (to 1150))

- in late 2008 I predicted that global decoupling was an optimistic myth, that the global economy relied on the U.S. consumer and would be dragged down by it

- in 2008 and 2009 (and still in 2010) I believed that U.S. housing was not yet in a sustainable recovery

- in early 2009 I predicted that unemployment, then at 8.1%, would exceed 10%; I predicted that the Fed would be on hold for quite some time as, though an overnight rate of 0% seemed very accomodative, relative to a Taylor Rule approximation, it wasn't easy enough, and, because it NEEDED to be very easy, it would STAY very easy; I remained in the deflationary camp; that Fed's so-called printing of money through QE was ineffective as it wasn't a helicopter drop into the hands of consumers, but was instead sitting in banks' excess reserves (effectively just an asset swap), so though the Fed could expand the monetary base, as the money multiplier and velocity fell, monetary base expansion would have no effect on P*Q

- in spring 2009, I removed my hedges, assuming stocks would get back to 900 (at which point I started hedging part of my equity exposure again) or 1000 (at which point I became fully hedged); I did not expect the S&P to get above 1000, and did actually expect much lower stock prices in H2/2009 (below the March low --- wrong) (so I became net short equities as stocks got to 1100 and further at 1200)

- in Sept 2009 I predicted that the Universe bond index would return over 6% and the long index around 10% in 2010

- in late 2009, I predicted that bond yields would head higher in the first half of 2010, along with stock prices, as investors assumed the recovery was underway and entrenched, but that yields and stocks would fall in the second half of 2010 as it became obvious that the stimulus-induced and inventory-led recovery was temporary and not sustainable and that underlying demand remained anaemic and the recovery was really no recovery at all


in other words, just b/c a type of event in a normal economic environment might be of "low probability", in a different type of environment, all bets are off, and probabilities need to be significantly re-appraised

Q2 Forecast

US unemployment is high (near 10%) and core inflation is low (near 1%) so Fed needs to remain very accomodative; in fact, a Taylor Rule prescription suggests FOMC s/b at -5% or so right now, so, relative to where they should be, the Fed is as TIGHT as it ever has been in the AG/BB era

---> Fed on hold through 2012, likely longer, as per Japan


BoC caught between rock and hard place: doesn't want frothy domestic housing and household debt markets to turn into dangerous bubbles, so would like to be more restrictive, but knows external demand will highly influence economy, and risks there growing significantly

---> BoC will hike in July and likely again in September, getting to 1%, by which time the U.S. and global economic outlooks will have deteriorated sufficiently to keep BoC on hold indefinitely


U.S. economic outlook is gloomy for a number of reasons (with or without the European problem); paraphrasing from Andy Harless:

1. quantitative easing, which was temporarily buttressing demand, is over (for now) imparting a downward bias to growth in the coming quarters (before QE gets revived again)

2. fiscal stimulus has been largely exhausted (see recent post) so that its impact will be declining in the coming quarters, imparting a downward bias to growth; even if additional stimulus funds are come up with, they are likely to be modest given the political climate and the paranoia about fiscal deficits (legitimate concern for Mediterranean countries in Euro, but for US, like Japan before it, not yet a legitimate concern), such that any future stimulus will be less than past stimulus, so will have declining impact on GDP growth regardless


3. pent-up demand from consumers (many of whom were worried about the losing their jobs last year but no longer are) has been largely exhausted, and its impact will likely decline over time, imparting a downward bias to growth in the coming quarters.

4. inventory adjustment process has run its course (manufacturing inventories are actually quite elevated relative to shipments/sales); significant increases in production are no longer necessary to maintain inventories, so while inventories added significantly to Q4/09 and Q1/10 growth, may detract, and certainly not add, to H2 growth.

5. recent dollar strength and weak external demand (particularly Europe, but anticipate slowing elsewhere as well, including BRICs) mean export growth will not drive robust recovery.

6. normally, the surge in productivity at the beginning of a recovery is followed by a surge in employment, with a lag of about two quarters; there has been no employment increase following last year’s surge in productivity (exempting census jobs, which, added in spring, will be lost by autumn); meanwhile, productivity growth has settled back into the normal range, which dampens hope for a future surge in employment.

7. Bush tax cuts expire at the end of 2010, which will be drag on income growth and thus on economic growth starting six months out

8. a housing double dip is soon arriving, as government stimulus for housing market, which temporarily supported house sales data, has been lost, and banks will need to increase the pace of foreclosure activity, and there is substantial shadow inventory already; and prices, though they have fallen substantially, remain above their long-term norms in terms of price-to-income and price-to-rent ratios, and can be expected to revert below their means given supply overhang, high unemployment, flat income growth, etc. (see T2 Partners' presentation)

9. the next wave of the credit crisis is ramping up right now; the first wave was subprime, whereas this wave is option ARM
10. consumer balance sheets remain extremely stretched; the process of deleveraging has just begun, and will take many many years to be complete

11. state and local government budgets are severely impaired; these governments, some of which are already in crisis mode, will act like 50 little Hoovers going forward; state and local government spending is 50% larger than federal government spending; has acted as drag on growth in recent quarters, at an escalating pace, and given that fiscal year ends are June 30 and new budgets need to be pared back, the pace of contraction will escalate further

x. there is no evidence of any positive stimulus to growth that would offset all these negatives; in fact, the Consumer Metrics and ECRI leading indicators are already flagging potential of double-dip, and those indicators have been steadily deteriorating over recent weeks/months, with no signs of turning around; even the Conference Board's LEI, once you extract stock prices, yield curve and money supply growth, were negative in 2 of last 3 months





xi. as per Hussman, when you have had credit spreads widening over 6 months, in conjuction with stock prices down over 6 months, in conjunction with a moderate or flat yield curve, in conjunction with an ISM of 54 or below and moderate or declining employment growth, a current or imminent recession has been flagged without error in every instance (i.e. each those criteria is not particularly notable by itself, but in conjunction they are very notable); all the conditions are met with the exception of the ISM


---> U.S. double-dip


Canada is the tail that gets wagged by the U.S. dog; as goes their economy, so goes ours, although with more volatility; for more on Canada, see past post.


as per the Edward Chancellor piece (or brief summary here), I believe China is a bubble waiting to pop, a la Japan 1989 or US 1999; its growth has not just been supported by government stimulus, which, arguably, could continue indefinitely, but also by extraordinary and unhealthy credit growth, by a housing bubble, and by over-investing in yet more excess capacity (malinvestment), none of which are sustainable; its just a matter of (indeterminate) time before they pop and cause major headaches


I have long anticipated, and continue to anticipate the Japan scenario, or one much like it, to play out in the U.S.: i.e. once the BoJ was under 1%, it stayed there; and 10-year bond yields have been at or under 2% for over a decade; there has been deflation for 15 years; the Nikkei is at a quarter the level of its peak, and half the level it was at 10 years ago; money multiplier and velocity contraction have more than offset any money supply growth; real estate prices have been trending down persistently since the peak; consumption has been flat for over a decade; nominal GDP is at the same level it was at 18 years ago



even in the absence of a double-dip in the U.S. (which i DO expect), unemployment resolutely above its normal rate (NAIRU) is disinflationary, and we already have core CPI at 1%, which, i believe, posits strongly for deflation; even if one took the Fed's central tendency forecasts of unemployment and inflation for 2010/11/12, as per the SF Fed, the Fed should be on hold into 2012 (taking account of QE) or through 2012 (assuming no QE)
none of this is good for stocks; all is good for bonds (and gold!)

stocks remain overvalued; forward P/E ratios are worse than useless; on a forward P/E basis, stocks are fairly valued, at just under 15 ---- but fwd P/E has been between 14 and 15 non-stop for the last 5 years!!!

forward earnings estimates are pricing in huge advances in E, not at all consistent with a modest GDP growth environment, much less a double-dip or Japan scenario

longer-term measures of valuation more clearly show how overvalued the stock market is; the Q-ratio, relative to its long term average, shows the S&P about 35% overvalues; the cyclically-adjusted P/E ratio (using 10-year average earnings) shows similarly (CAPE is north of 20, relative to long-term average of 16ish)

based on E of 60 and P/E of 15, fair value of S&P is 900ish

given that I predict another downleg for the economy, I anticipate that analysts will again overreact on the downside (as they did when S&P hit 666), and S&P will trade in 800s again in next 9 months

S&P/TSX will trade in kind

GoC 10years will trade south of 3% and long bonds will approach 3% (while US 10s will once again approach 2%)




p.s. bonus forecast item: Netherlands wins World Cup -- go Orange!

June or July?

Will the BoC hike on June 1, as had been widely expected as of a few weeks ago?

Or will they wait for the July meeting, given they had previously "committed", and reiterated that commitment numerous times, contingent on their inflation projections, to be on hold until the end of the second quarter... and given that economic and market uncertainty --- b/c of the situation in Europe, as well as FinReg in the U.S. --- prevails?

I tend to think that if the Bank was meeting today, given what the ECB is doing, and given what currencies are doing, and given that concerns about the possibility of a global economic double-dip may have mounted in the last couple of weeks, that it would be relatively costless for the BoC to take a wait-and-see approach for another month, whereas it would potentially look odd to hike in two weeks and then perhaps regret it.

That is, of course, if the decision were made today, in the midst of this recent turmoil. But the decision is not today. So that raises the question of what is the likelihood that some meaningful resolution of the European debt crisis is made in the next couple of weeks? In my estimation, this is a problem that is not going away; there is no short-term fix.

That said, there may be band-aids that could be applied that satisfy the market for a while, leading to a bounce-back from the currently oversold condition in stock markets and overbought condition in bond markets. In which case, that raises the question of what is the likelihood that the ECB and European politicians --- who have gotten the market so rattled in recent days and weeks --- actually come to an adequate resolution to satisfy the markets for awhile. Once again, in my estimation, the odds aren't that good; why would they change their stripes over the next week or two?

But let's leave the Euro situation off the table for now. What are the reasons the BoC might hike despite the Euro, and what are the reasons the BoC might hold off?

Hike now:
- by hiking, the Bank would not be tightening so much as starting the process of normalizing rates, and, even with a few hikes, could remain relatively accomodative for some time
- Taylor Rule estimates, based on current levels of CPI and employment, finally suggest that a rate north of 50bp is appropriate
- Q1 GDP is projected to come in up nearly 6% on an annualized basis, following Q4's rise of 1.2% (or 5% annualized)
- Canadian leading economic indicators are up 3% in the 3mths through April and 11% over the last year
- according to the Labour Force Survey, employment has climbed a whopping 148k over the last 3 mths (through April), and even the less volatile Survey of Employment Payrolls and Hours suggests employment has climbed 44k in the 3mths through Februay (pretty consistent with what the LFS said through Feb.)
- retail sales are up 9% YoY through Q1, including up 5.5% ex-autos & gas; retail sales are not just climbing strongly off trough levels, but have surged past the pre-recession peaks
- housing starts and building permits are up significantly off their 2009 lows, and basically back to 2007-type levels
- the Senior Loan Officer Survey says that banks have been easing lending conditions over the last couple of quarters (after a couple years of tightening)
- the Business Outlook Survey suggest future expectations are as positive as they've been over the last decade

Wait and see:
- as of the end of Q4, real and nominal GDP remain 2.5% and 4.4%, respectively, below the peak levels attained in 2008, so even with recent strong growth, the output gap remains substantial
- recent strong growth may be illusory and unsustainable, given that personal consumption accounts for 58% of GDP while personal income accounts for 53% of GDP, so consumption continues to be driven by debt growth;
- similarly, residential investment accounted for 6.9% of GDP at the end of Q4, presumably higher in Q1, and historically has always peaked right around that 7% level, which may portend a housing market due for some cooling
- C$, trading at 94 cents now, is below the BoC's forecasted level of 96-98 cents --- admittedly, it has only been below the Bank's forecast level for a few days, and, admittedly, a lower C$ should actually be stimulative for the economy, giving more reason for the Bank to remove accomodation, but the fact remains that a sharp fall in currency levels could be a telling indicator for the Bank
- further to last, for instance, oil prices have retreated to $70, the lowest level since last July --- which is good for the domestic demand side of the economy, but is a net negative for a net- exporter of oil, and is reflective of commodity prices more generally
- though merchandise trade exports are, through Q1, up 19% from the 2009 trough, they remain 24% below the 2008 peak --- and are sensitive to commodity prices, which have recently been heading down, as noted, and global economic activity, which is at risk
- similarly, wholesale trade is up 9% from the trough, but still down 5% from the previous peak
- though there has been recent job growth, and the number of unempoyed people, at 1.5 million, is down 6% from the worst point in 2009, there are still 42% more unemployed than at the start of the recession; and the unemployment rate, though down to 8.1% from the peak of 8.7%, remains well above the 5.8% pre-recession rate
- both core and headline CPI in Canada are below the Bank's target of 2%, and with the prevailing output gap and the other trends already mentioned, and with U.S. CPI below 1%, there's no clear reason to believe CPI would be escalating rather than be tame or even falling
- that is especially so given that though monetary reserves are up 30% YoY, M1 is up less than half that, at 13.5% YoY, M2 is up about half that, at 6.7% YoY, and M3 is up less than half that, at 2.9% YoY --- so the money multiplier and monetary velocity continue to decline
- indications of a consumer debt bubble in Canada include the facts that mortgage debt as a % of personal income has surged through the 100% level to 116% (vs. a 1990s peak of 84%) and household debt to 170% of GDP, up from 115% in 2000 (apparently Canadians learned nothing from the U.S.)
- the Fed has reiterated that it "continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period", and it is an open question as to how much the BoC can hike without the Fed hiking without currency movements adversely affecting the domestic economy (more than the Bank would be comfortable with)


Really, what it comes down to is how sure is the Bank that recent strong economic trends off recession lows are likely to be sustained?

Personally, I don't buy into the back-to-normal theory, continue to believe that:
- further leveraging (debt growth) in the Canadian economy will make the fall all the worse when it comes
- the U.S. economy has been living off of federal government stimulus for the last year and will soon fall back when (a) that stimulus wanes, and (b) the next round of credit strains (Alt-A and Prime mortgage delinquencies, defaults and related foreclosures) ramps up, and (c) the crisis at the state and municipal levels becomes impossible to ignore
- China is a bubble waiting to burst (details in earlier posts) --- and the recent stock market moves in China may be suggesting that process is underway
- even if Canada, the U.S. and China didn't have their own inherent risks, the linkages in the global economy are too significant for European retrenching not to become problematic for the global economy at large, and European retrenchment will be not just necessary in the PIIGS, but, because of the prevailing bailout mentality, will bring down the European core countries as well (though German exporters will certainly benefit from a weaker Euro, that won't help Canadian or Chinese exporters, so there will be feedback loop impacts)

So, at the end of the day, what do I forecast?

- the Bank does nothing June 1 other than change its commentary to indicate its intention to hike
- the Bank hikes 50bp in July
- the Bank hikes by 25bp once more in early September
- by autumn, things will be visibly messy again
- there will be a European recession, and a double-dip U.S. recession, a significant China slowdown, and, consequently, another Canadian recession
- though domestic demand in Canada will not lead, it will follow; Canadian domestic demand will be the tail, not the dog --- the Canadian recession will not be driven solely by external demand, but the housing and debt bubble in Canada will be pricked by the next global recession
- further BoC hikes will be off the table for a long while, not until the Fed hikes
- the Fed won't hike until perhaps 2014 (yes, Dorothy is not in Kansas anymore; like The Vapors, she, and the FOMC, are Turning Japanese)


p.s. see Canadian Economic Review

Yawn! Yuan.

Amidst all the speculation that China would have to let its currency appreciate, I predicted at our year-end forecast meeting back in December that China had enough problems of its own (too much productive overcapacity, a real estate bubble waiting to burst, under-stated unemployment), and that it was an export-dependent mercantilist, long accustomed to beggar-thy-neighbour policies, and though the U.S. might like it, I couldn't see how yuan appreciation would further China's own aims; so that China would do whatever it took to keep that export engine of its economy running when the other engines, i.e. credit-fueled unsustainable building bubbles (housing, production capacity and infrastructure), spluttered; so that protectionism and yuan devaluation were much more likely than yuan appreciation.

well, perhaps its already started. Guess the Chinese don't like the fall of the Euro, so are trying to prop it up as best they can ---- and, of course, trying to make the Euro appreciate is no different than trying to make the yuan depreciate.

Rumors That China Is Now DEVALUING The Yuan

Global Economic Outlooks

The Bank of Canada released its MPR today, which, among other things (more later), lays out its projections for economic growth.

I thought it might be interesting to compare what the Bank is expecting relative to the recently released projections offered by the OECD and by the IMF.

Here are the BoC's forecasts for 2009 and 2010 real GDP growth:

Canada: -3.0; +2.5
U.S.: -2.4; +1.2
E.U.: -3.6; -0.2
World: -0.8; +2.2

Here are those from the OECD:

Canada: -3.0; +0.3
U.S.: -4.0; 0.0
E.U.: -4.1; -0.3
OECD: -4.3; -0.1
OECD+BRIC: -2.7; +1.2

And those from the IMF:

Canada: -2.5; +1.2
U.S.: -2.8; 0.0
E.U.: -4.2; -0.4
World: -1.3; +1.9

a few observations:

the OECD is the most pessimistic, both for 2009, but particularly regarding prospects for 2010 (basically bigger fall in '09 and then no bounceback in '10)

the BoC is more optimistic than either the OECD or IMF not just on how much the U.S. declines this year, but its prospects for next year; neither the OECD nor IMF have projected any 2010 growth for the U.S.

all three sets of forecasts are reasonably bearish on Europe (from -3.6 to -4.2 this year, and more slippage next year)

all three groups of forecasters predict Canada outperforms other advanced economies in 2010, presumably due to its linkages to developing economies

the BoC's forecasts aren't that far off from those of the IMF, but are definitely more optimistic (or, perhaps more accurately, less pessimistic), and the BoC, though it has pencilled in a more gradual recovery than it was previously forecasting, is definitely looking for more of a V-shape than either the OECD or IMF



UPDATE:
the OECD's more pessimistic outlook may be due to its assessment that it takes 4 to 6 quarters for changes in financial conditions to have their full impact on GDP, so the full effect of past tightening in conditions since Sept/08 has not yet been felt; also, it is expecting further large prospective declines in world trade, based on advance indicators; further, it notes that housing recessions are worsening almost everywhere other than the U.S.; it is also concerned that large cyclical increased in unemployment have a tendency to become structural in part, reducing productive potential

notably, the OECD's foresees:
- the U.S. output gap reaching 10% and therefore inflation, after going negative for much of 2009, only stabilizing near 0% at the end of 2010
- strong BRIC rebound in 2010 driving robust rebound in world trade
- the OECD's report noted that it is important to commit to low levels of monetary policy rates for a sufficient period of time, as studies have shown such a commitment to have an effect on lowering the yield curve

Roubini Global Economics Forecast

from RGE:

Today we present some of the main conclusions of the recently released update to the RGE 2009 Global Economic Outlook.

The global economy is in the middle of a synchronized contraction that will push global growth into negative territory in 2009 for the first time in decades. . This will be the worst financial crisis since the Great Depression and the worst global economic downturn in decades. Global trade volumes face their sharpest contractions of the postwar era – trade is expected to contract 12% in 2009 due to the severe and prolonged global demand slump, excess capacity across supply chains and the continued crunch in trade finance.

Many analysts and commentators are pointing out that the second derivative of economic activity is turning positive (i.e. economies are still contracting but a slower rather than accelerated rate) and that green shoots of an economic recovery are blossoming. RGE Monitor’s analysis of the data suggests that the global economic contraction is still in full swing with a very severe, a deep and protracted U-shaped recession. Last year’s economic consensus forecast of a V-shaped short and shallow recession has vanished. While the rate of economic contraction is slowing compared to the free fall rates of Q4 of 2008 and Q1 of 2009, we are still a long way away from the economic bottom and from a sustained recovery of growth. In particular, in Europe and Japan there is little evidence of a positive second derivative of economic activity.

However by the end of Q1 2009, there were some signs that the pace of contraction had slowed in many economies especially in the U.S. and China, where policy responses have been more significant and leading indicators in the manufacturing sector may have bottomed before they did in Europe and Japan. However, major economies including all of the G7 will continue to contract throughout 2009, albeit at a slower pace than at the beginning of the year.

Moreover the global recovery might be sluggish at best in 2010 given the overhang of credit losses of financial institutions, lingering credit crunch, need for retrenchment by overstretched and over-indebted households in current account deficit countries and a slow resumption of demand prompted by extensive government stimulus.

Some key elements of RGE Monitor’s outlook include:

Global economic activity is expected to contract by 1.9% in 2009. Advanced economies are expected to contract 4% in 2009. Japan and the eurozone will suffer the sharpest downturns. U.S. GDP will continue to contract, albeit at a slower pace throughout 2009, with negative growth in every quarter.

Emerging markets will slow down sharply from the stellar growth rates of the past few years, with the BRIC economies growing at half their 2008 pace.

Deteriorated terms of trade, slower capital flows and tighter credit will push Latin America into recession from the 4.1% growth of 2008. Argentina, Brazil, Chile, Colombia, Mexico, and Venezuela will all shift to negative territory on a year-over-year basis while smaller countries, like Peru, will experience a significant slowdown.

Countries in Eastern Europe and the CIS will experience some of the sharpest contractions given the withdrawal of foreign credit and the risk of a severe financial crisis. The reduction in oil revenues and financial stress will contribute to a 5% yoy contraction in Russia and some countries - especially in the Baltics – are at risk of double-digit contractions.

Export-dependent Asia's growth will slow significantly to less than 3% in 2009. China will have a hard landing with GDP growth falling to 5.5% while India will slow sharply to 4.3%. All four Asian Tigers (Singapore, Taiwan, South Korea and Hong Kong) as well as Malaysia and Thailand will experience recessions.

The Middle East and Africa will mark much slower growth, half of their 2008 pace, given the reduction in capital inflows, reduced demand from the U.S. and EU and decline in commodity prices and output. Israel and South Africa will suffer slight contractions.

The unprecedented fiscal and monetary stimulus may help alleviate the substantial contraction in private demand and reduce the risk of a global L-shaped near-depression. Debt financing may be a challenge for many countries though, especially emerging markets or the most vulnerable Western European economies.

Job losses during the current global recession might exceed those in recent recession, contributing to increases in defaults and posing additional risks to banks. The unemployment rate in developed countries will reach double-digits by 2010 (as early as mid-2009 in the U.S.) and push more people in developing countries into poverty. Moreover, despite new funding from multilateral institutions, severe contractions will raise the risk of social and political unrest.

Commodities as a class are likely to come under renewed pressure in 2009 despite some support from production cuts. RGE expects the WTI oil price to average about $40 a barrel in 2009 as demand destruction continues to outweigh crude supply destruction.

The entire RGE 2009 Global Economic Outlook is available to RGE subscribers.

Forecast Notes

Underlying thesis: the problem of too much debt has not gone away and in fact has gotten worse as the ability to service it has deteriorated, not improved; housing values, the original foundation for all that debt, is still overvalued relative to historic norms and due to fall further; these factors have to be normalized before we will have any sustainable recovery; government interventions are intended to restart the credit cycle and as such are self-defeating

The bursting of the debt bubble is deflationary; the policy response is intended to offset this, and the market is worried that it will be excessive and prove inflationary

Reasonable people can disagree, each with their own good reasons, on this debate; I, for one, remain firmly in the deflationary camp; I believe that government is too small relative to the size of the private economy to offset the downside forces in the broader economy; further, the regular channels of policy traction do not work in a deeply-entrenched credit crunch that is accompanied by serious asset devaluation

For example, the Fed has doubled the monetary base to $1.7T, and may increase it further to $2T or $3T; but that’s still small relative to the $14T of household debt outstanding or the $52.6T of total credit market debt outstanding

furthermore, the monetary base has expanded but has been achieved just by doubling excess reserves at depository institutions to $0.77T, and the banks are just sitting on that; normally, increasing excess reserves would motivate banks to increase lending, because sitting on the money has an opportunity cost, and there would be a significant money multiplier effect due to the nature of the fractional reserve lending system; however, no matter how much reserves are increased now, there is no incentive to increase lending to an already overly-debt burdened and contracting private economy, and every incentive not to given the credit risks involved, and also given that due to the risk of deflation, a dollar tomorrow will be worth more than a dollar today

The Fed’s “printing of money” has not been anything like a helicopter drop; if I were a master counterfeiter and were to fly a helicopter over Toronto and drop millions of perfect hundred dollar bills down all over the city to the public below, it would be like everyone won the lottery, and would certainly lead to incremental spending and economic activity as everyone spent the bulk of their windfall; but that’s not what the Fed has done; what it has done is more akin to me printing a trillion dollars of fake dough then taking it all to my bank and locking it in a safety deposit box; the printing itself does nothing, it’s the dissemination of it that is inflationary

PPIP/TALF/etc useful for solvent banks facing some illiquidity constraints but no panacea for insolvency

Govt still refuses to acknowledge that saving the banks is different than saving the banking system; and whereas the latter is essential, the former is counterproductive; they're using the red herring of the 'no more Lehmans' line as the public justification for their actions when it has a lot more to do with regulatory capture and friends in high places

Despite govt hesitancy to admit and do something about it so far, insolvency, not illiquidity, remains the problem, so there will be more bank failures - big ones; nationalization may be a dirty word for some but bailout has become an even dirtier word so we will, if not soon then ultimately, learn to love the word preprivatization

The writedowns that were never supposed to approach $1T are now well over that ($1.25T) and will exceed $2T if not $3T

It’s not clear that writedowns of mortgages have even peaked yet, given that foreclosures and delinquencies were 11.2% at end of 2008 and still climbing rapidly and home prices are still falling; also, there are many more shoes to drop, particularly credit cards, commercial real estate loans, leveraged loans and, for European banks, Eastern European loans; for instance, the commercial banks are holding their commercial mortgages on their books at average carrying values of 95 cents on the dollar, with many still holding them at 100 cents; construction and industrial loans being carried at 96, construction loans at 90, home equity at 91, etc.; they also have a lot of off-balance sheet stuff still

Leading economic indicators have stabilized but at very low levels, indicating further deterioration though at a slower pace; and LEIs seem to be supported primarily by inclusion of monetary growth, which, given the dropoff in monetary velocity, is not likely to have a stable relationship to how it impacted the economy in normal times

The output gap is wide and getting wider; even if government actions somehow managed to get the economy back to the 2.5% potential real growth rate of the economy (labour force growth of 1.5% and productivity growth of 1%), that would not close the output gap and would not alleviate the deflationary forces; they need to get the economy above potential growth rates to eliminate the deflationary output gap

Nonetheless, nothing goes in a straight line: the U.S. recession may in fact end this year – but, if so, it would then resume early next year before coming even close to regaining the 2007 peak - nasty double dip

Housing may have more false dawns and activity can't fall forever; but crux of the matter is that in environment of worst recession in 75 years with climbing unemployment, falling incomes and a credit crunch, home prices will continue to fall PAST the mean, not just revert to it, which means there is much more home price depreciation to come, so collateral underpinning financial assets will continue to fall in value as will household wealth

U3, now 8.1% but 8.9% NSA, will exceed 10% and U6, now 14.8%, will likely hit 20%; employment-population ratio now under 60% for first time since mid-1980s, despite structural changes in workforce (ie. working females)

Real debt burdens get worse and worse as ability to service debts gets harder and harder - particularly once deflation becomes entrenched - ie not just a commodity phenomenon but a core goods and services one, a la Japan, as excess capacity is rampant throughout the global economy

Vicious circle as aggregate demand is less than aggregate supply --> production cuts --> layoffs and falling incomes --> falling aggregate demand --> rinse and repeat, vicious circle

Europe is a mess; too many countries have too much exposure to loans (banking assets a multiple of gdp) - EUR will fall back to under $1 and may disintegrate altogether as coalition is too fractious

UK is a bigger version of iceland; the $4.4T of foreign liabilities its banks have accumulated are twice the size of the whole economy; there will be a run on the pound as the ability of her majesty's govt to repay all the financial obligations it has taken on will be seriously doubted

Asia's export-dependent economy is a mess; emerging economies were most vulnerable to reversal of the global liquidity pump

Chinese estimates of unemployed migrants (heading back to rural homes or otherwise migrating looking for work) is now over 23 million

social unrest we've seen in Athens and Riga and London and Paris and Kiev will go global and will be particularly worrisome in China

China is the world’s largest surplus country just as the US was in 1930 and is at as much risk as anyone because it doesn't have internal demand to support the jobs, much less the job growth, its vast population has become accustomed to and is losing access to much of the external demand that was the raison d'etre for much of its economy; Chinese leadership may get desperate if conditions continue to deteriorate, and the only potentially effective measure it could conceivably resort to would be massive devaluation of the yuan (like it did in 1993, by 33%), which would be akin to Smoot-Hawley II

Baltic dry falling again, 27% down from March 10 and 85% down from 2008 peak --> oil will fall back to $40 if not $30

Nominal GDP will fall – everywhere; increases in GDP have been fueled by increases in debt, with the marginal efficiency of that debt increase falling over time so that more and more dollars of debt were required to fuel a single dollar of GDP growth (the ratio was about 2:1 from the 50s to the 80s but climbed to 6:1 in the last decade); in other words, the economy has been leveraged; now in deleveraging, the economy will be lucky not to shrink persistently as debt is repaid

Corporate profit impairment is not just a financial phenomenon - Q4/08 was supposed to be a great quarter for earnings due to easy YoY comps but instead had negative earnings, the worst quarter ever on record; now the non-financials will increasingly have their turn

profits are cyclically much more volatile than the economy (b/c they're basically leveraged off economic growth), but much more volatile than stock prices; earnings will fall as much as to 1999 levels

normalized earnings (accounting for the trumped-up nature of earnings and abnormal profit margins from the last decade due to excessive financialization and leverage) seem to be about $40-$50; peak earnings were a fantasy and may not be revisited for decades; assigning an average multiple of 15 would imply fair value in range of 600-750; but in this environment of deleveraging and huge uncertainty, it seems reasonable to demand a greater risk premium now than in a normal environment; in past periods of economic distress, single digit multiples have been common; assuming a multiple of 10, fair value would be 400-500

S&P has not yet bottomed - will fall below 600 in H2; Dow 5000 would not surprise me; TSX 6660 as lows

Fed BoC BoE BoJ SNB BoI will be joined by ECB with a 0 handle and in QE; no hikes until late 2010 and no normalization of rates before 2011 at earliest

Competitive currency devaluation will lead to more obvious beggar-thy-neighbour strategies than those already in play; global trade, already getting slaughtered, will be more at risk as protectionism is already on the rise

It took WWII to pull the world finally out of depression - chinese military aggression, perhaps in siberia, would not surprise me as china clearly even in a slow economy has a large appetite for real assets, and will have the opportunity to take advantage of a very economically-weak but resource-rich neighbour while giving its unstable civilian population something to think about other than overthrowing the govt

FORECAST - year-end 2009:
Universe Bond index: 8%
Long Bond index: 14%
S&P/TSX: 6500 (-28%)
S&P 500: 600 (-33%)
BoC & Fed: 0%
C$: 0.79 USD/CAD
oil: US$35
U.S. recession duration: 72 months before GDP returns to previous peak
(may include double-, triple-dips; Japan-like)
In one word, what will turn U.S. economy around? Normalization (of debt-to-income, home prices (price-to-rent, price-to-income), banking as proportion of economy, global imbalances, income inequality)

Updated Interest Rate Forecast

At the beginning of the year, I had penciled ranges of:

US10s 1.5-3.0
US30s 2.0-3.5

Can10s 2.25-3.35
Can30s 2.95-3.95

With the high yields in Q1 and the low yields in H2

My low yields were framed in the context of the Japanese experience under ZIRP and QE and deflation, whereby the whole Japanese curve traded under 1% in 2003, and even before that in 1998 their 10s got to 0.8% and their 20s to 1.3%

Obviously I didn’t foresee US longs backing up 130 bps from their December low of 2.50 (I thought up to 100)

I’m sticking with my US 10s forecasted range, though my US longs ceiling needs raising to 3.70

And I’d stick with my low yields for Canada (though I think there’s a risk we go even lower --- US10s went to 2.05 in December; now that Canada is likely to also go to ZIRP and to QE, and given that I think Canadian GDP and other economic data will be at least as horrid as the US), but would drop my highs to 2.95 on 10s and 3.70 on longs (given that economic data has deteriorated even faster in Canada than I would have anticipated, increasingly the likelihood of Canadian QE)

As such, the relative duration bets I’d advocate, pending further consideration and debate, would be:

2.25 – 0.2 short
2.35 – 0.1
2.45 - neutral
2.55 +0.10
2.65 +0.20
2.75 +0.30
2.85 +0.40
2.95 +0.50 long