January 16th, 2011
in Op Ed
Guest Author: Edward Harrison is the founder of Credit Writedowns and a former strategy and finance executive with twenty years of business experience. A more complete bio is available at a recent Analysis Blog article.
I am cautiously optimistic on the U.S. and global economy for 2011. Let me explain both pieces of the puzzle - the cautious part and the optimistic part – below. I'll start with the positive first. Follow up:
Double-dip recessions are not the norm; they are the exception. Why? Here's how I put it in September:
Recoveries by definition start from a point of diminished output because recessions are periods of diminishing output. So output in the initial period of any recovery is always lower. That’s how the math works – and also why I continue to stress that this is a technical recovery.
But, the important part to remember is how the business cycle works and how the recency effect creates self-reinforcing declines or recoveries in output.
Increases in income lead to increases in retail sales which lead to increases in output and inventories which lead to more jobs and thus a further increase in income. This is a virtuous circle that defines the upward path of a business cycle.
So, you really need to see powerful secular forces to overcome this self-reinforcing dynamic. Once a technical recovery begins, we should expect it to continue and blossom into a full-blown cyclical recovery. Obviously, I am talking about the medium-term, not the long-term here. But the point is that we have been in recovery for over one-and-a-half years in the U.S. Odds are that this will continue for some time to come (through 2011 at least).
I see the jobs picture as encouraging. Employment is lagging as it has in the last two recoveries. So the recovery looks particularly weak. Moreover, there seems to be a skew toward the upper income strata. This makes the technical recovery appear even more sluggish. But clearly, the jobs picture is improving.
What are U.S. jobless claims telling us about recovery? They are averaging about 415,000, down from almost 470,000 a year ago. And since employment is a lagging indicator, we should expect claims to drop even further as GDP has been growing. Why are jobless claims so high this week; is the government data fudging? No. This is one week's data skewed by seasonality.
Across the board, the economic indicators show a modest but improving economic picture: industrial production, capacity utilization, personal income, retail sales. And I expect this to continue through at least the first half of 2011, probably through the whole year.
I am cautious about this outlook because I still believe the U.S. is in a cyclical upturn within a larger depression. The concept that the structural problems of excessive household indebtedness and an over-reliance on financial services and housing can be solved by money printing and fiscal stimulus leaves me cold. My thesis is that these remedies mask problems only due to the cyclical upturn. If the recovery is not used to whittle the problem away, the next recession will be as bad or worse than the last.
That said, policy makers have done a pretty good job of avoiding egregious errors so far. I think that gives us enough oomph to get over the hump so the cyclical agents like inventories and cyclical hiring can do their magic. But, here are my lingering concerns.
- Europe: the sovereign debt crisis refuses to go away. The European periphery is hurting but the crisis has infected the core via Belgium and Italy. I expect the crisis to get worse before decisive action is taken because that's how politicians usually respond. There are three options for the euro zone: monetisation, default or break-up. The question is whether this – in and of itself - deals a fatal blow to recovery in Europe, infecting the global economy. If you had asked me this question early last year, I would have said yes. Today, one year more into a cyclical recovery, it is less clear.
- U.S. States and Municipalities: Meredith Whitney has put this crisis top of mind. My take is similar to the one on Europe: The question is whether this – in and of itself - deals a fatal blow to recovery in the U.S., infecting the global economy. Here, I have always felt that the budget issues would only become dire in a cyclical downturn as declining asset prices created public sector pension losses. In an upturn, tax revenue increases as do accounting gains from asset prices. Costs for supporting the unemployed decrease. To the degree there are budget problems, the situation is very pro-cyclical – meaning you have what MBA's call a high degree of operating leverage on municipal and state income statements. Leverage works to magnify cyclical ups and downs. That means that, while I agree with Whitney's alarm on munis and expect some defaults, I do not think this gets critical in 2011. I expect the next recession to bring this issue to a head.
- Housing: House price declines have resumed in the UK and the U.S. They never stopped in Ireland and Spain. The housing double dip is in progress. Complicating matters, clearly, fraud was a big issue not only in the origination of mortgage loans in the U.S. but also in packaging and foreclosure. There is a real possibility that a systemic legal problem develops on that front in 2011. I don't know how this problem will be resolved. At this point, I see it as the biggest near-term risk for the U.S. in 2011.
- Currency Wars: a lot of good is done simply by having economic growth. It takes a lot of political heat off politicians. The currency wars are really a political event because they are caused by a lack of aggregate demand. When the pie shrinks, individual countries feel obliged to implement beggar-thy-neighbour policies to maintain their standards of living by taking a larger share of the pie. The developed economies have felt this pie shrinkage most acutely. So it is they who are driving the so-called currency wars forward. The emerging markets are merely reacting in kind. I say "First the rate reductions, then money printing, then the currency war, then the tariffs, then ... hopefully economic recovery. But, as with the other problems, unless recovery is used to solve the issue of external imbalances created by our jury-rigged monetary system, the so-called Bretton Woods II, then tensions will return worse than before when recession hits. Only after a full-blown crisis will the underlying issues be addressed. So, wait for the next crisis for reform of the monetary system.
- Commodity Price Inflation: There is a real threat to recovery from commodity price inflation. We have already begun to see signs of food price riots, food price controls and the like in emerging markets. Additionally, Brent crude is at 27-month highs, closing in on $100 a barrel. Just think back to 2008; this type of commodity price inflation was toxic and sowed the seeds of its on demand destruction.
I may write what I think this means for stocks or bonds in another post. But the quick data dump is that profit margins are cyclically high while P/E ratios are above their long-term levels. If firms staff up, we could see a modest rise in stocks due to an increase in aggregate demand despite these two factors. Personally, I tend to like large cap value and I think that's the right call for this environment because, while I am optimistic, I am cautious. On bonds, I have been saying for four months that they showed a poor risk/reward skew at these levels. Moreover, duration changes are pretty large when yields are low. That means you can sustain heavy losses if yields tick up. There is no reason to be a hero by moving out the curve and getting long duration. Nor is there any reason to load up on risk, especially in munis and sovereign debt. That is still my view. But U.S. sovereign debt is a lot more attractive today than it was four months ago.
On the economic front, I moved away from a multi-year recovery baseline because of the prospect of policy errors. We avoided those errors in 2010. With the technical recovery poised to become a full-blown cyclical recovery, I think it's time to move back to the multi-year recovery baseline. Let me repeat my oft quoted phrase about the secular leveraging in the developed economies:
The problem I have with the recent history of growth in the United States, the United Kingdom, Spain and Ireland in particular is that the growth was underpinned by high debt accumulation and low savings. As debt is a mechanism through which we pull demand forward, the debt and consumption has meant we have been growing today at the expense of future growth.
Low quality growth can go on for a long time
This dynamic can continue for a very, very long time. In the United States, by virtue of America’s possession of the world’s reserve currency, an increase in aggregate debt levels has been successfully financed for well over twenty-five years. Mind you, there have been a number of landmines along the way. But, time and again, these pitfalls have been avoided through asymmetric monetary policy and counter-cyclical fiscal expansion.
So, poor quality growth can continue for very long indeed. And it is this fact which allows the narrative of easy money and overconsumption to gain sway.
The boy who cried wolf
A soothsayer who counsels against this type of economic policy, but who warns of impending collapse will surely be seen as the boy who cries wolf. Think back to 2001 or 2002. Did we not witness then the same spectacle whereby the bears and doomsayers were let out of their holes to warn of impending doom from reckless economic policy? By 2004, unless these individuals changed their tune, they were long forgotten or even laughed at – only to resurface in 2007 and 2008 with their new tales of woe. Knowing this shapes the psychology of economic forecasting and is why missing the turn is disastrous for one’s career. Efforts to avoid missing the turn are also part of a very large pro-cyclical psychological force underpinning a cyclical bull market.
The fact is: low quality growth does not lead to immediate economic calamity. It can continue through many business cycles. Even today, it is wholly conceivable that we could experience a multi-year economic expansion on the back of renewed monetary and fiscal expansion.
Marc Faber: “Don’t underestimate the power of printing money”
You will recall that I wrote a post at the depths of the market implosion highlighting a phrase by Marc Faber, “Don’t underestimate the power of printing money.” This quote has stuck with me as asset markets have soared in the intervening time. What Faber was alluding to was the fact that printing money works. It does goose the economy as intended and it can induce a cyclical recovery.
Nevertheless, the recovery is likely to be of poor quality due to significant malinvestment. Debt levels will rise and capital investment will be directed toward riskier enterprises. Look at what’s happening in China. Are you telling me stimulus is not working? It most certainly is.
In the west, stimulus is also working. It is designed to stop people from hoarding cash and to consume. It is also designed to get people out of savings accounts and into riskier asset classes. It is doing just that.
However, remember, the developed world has a lot of problems to work through. The origins of the next crisis are already apparent – and they have nothing to do with cyclical upturns and everything to do with a secular trend of rising indebtedness, now in both the public and private sectors in developed economies. If the developed economies use this cyclical upturn wisely to reduce household debt levels, to increase private sector savings, to clean up the balance sheets of weak banks, and to cautiously normalize fiscal and monetary policy, we will be in a much better position to counteract economic weakness when the next downturn hits.