The Twilight Zone

Written by Stephen Swanson

The world economy is sliding into a “twilight zone,” trapped between mixed valuations, feeble growth and recession on the horizon but with coordinated central bank intervention promising expansion and escape from contraction. In truth, fiscal authorities and central banks have steered us from recession, but we seem incapable of generating self sustaining growth and central banks on their own can not close the gap and bring about a lasting and durable recovery. Most equities have fallen into an eerie calm.

Twilight Comes Just Before Nightfall

In the twilight, central bank euphoria will find itself intermittently challenged by macro economic worries and the harsh realities of monetary policy. Last week flash PMI’s confirmed the US is functioning slightly above the expansion-contraction divide while most of Europe and China remain mired in contraction, with some of Europe in recession as well, and Japan appearing to be on the brink of recession.  Bonddad published an excellent piece on central bank perspectives on the sagging global economy and the WTO, in similar fashion, downgraded their 2012 forecast for world trade expansion to 2.5% from 3.7% and scaled back their 2013 estimate to 4.5% from 5.6%. They also note:

“In an increasingly interdependent world, economic shocks in one region can quickly spread to others.”

As to the realities of quantitative easing, the US recently embarked upon its fourth round of unconventional policy by announcing a program of open ended purchases of MBS. Such unconventional measures are believed to work through raising inflation expectation levels, increasing excess reserves, lowering real interest rates, portfolio rebalancing, shifting risk appetites, dollar depreciation and wealth effects.

Rising Sea of Liquidity, But Not All Boats are Rising

Greenspan, Volcker and Stiglitz and others hold doubts about the efficacy of further easing in a sea of liquidity and believe past QE programs have simply stimulated risk appetites, boosted equities, encouraged various carry trades and supported commodity prices. Real interest rates may have declined but there is little evidence to suggest that the transmission mechanism actually links and acts upon on the real economy as most are still mired in a liquidity trap. Loans expand the broader money supply, not excess reserves.

Apres Moi ….

Outside the bubble of the twilight we find ourselves in very fragile economic circumstances with central bankers containing conditions which could easily spread recession beyond the UK and most of Europe. Warnings from Morgan Stanley, Citigroup and Pimco is that even with central bank support, the recent slowdown means growth is around the level at which it could suddenly lapse into recession. That leaves economies increasingly vulnerable to a slump-inducing shock as Europe’s debt crisis festers, the U.S. nears its fiscal cliff, China continues to melt and the balance of the global economy continues to slow.

Confirmation of slowing global growth is beginning to manifest itself outside of PMI’s in different corporate surveys and statements of forward guidance. Just over half of managers at North American companies now expect production levels to increase in the next 12 months, down from 64 percent in the second quarter, according to a survey by CEB, a member-based advisory firm. In the same survey, the percentage of executives who expect to hire more workers fell to 34 percent from 41 percent last quarter.

… Le Deluge?

With potential revenue streams shrinking and fewer opportunities to cut costs, the outlook for third-quarter earnings is looking somewhat grim. So far, 103 companies in the S&P 500 index have provided guidance for the third quarter. Of those, 80% have guided below consensus estimates according to FactSet. That’s the most negative outlook since FactSet began tracking the figures in the first quarter of 2006.

Adding insult to injury, S&P 500 companies are projected to see earnings drop year-over-year for the first time in 12 quarters. Third-quarter earnings are currently estimated to drop by 2.7% for the S&P 500 as a whole, the worst forecast growth rate over the past 12 quarters. At the beginning of the quarter, analysts had been forecasting earnings growth of 1.9%. Revenues are expected to be flat and profit margins for the S&P 500, after rising steadily in the wake of the recession, profit margins for S&P 500 companies are believed to have peaked at 8.9% in late 2011 according to Goldman Sachs. Margins are expected to fall to 8.7 percent in 2012.

While profit margins have plateaued, productivity gains in the overall economy have ebbed as well. After rising at an annual rate of 2.9 percent in 2009, and a 3.1 percent pace in 2010, productivity inched up 0.7 percent in 2011, according to the Bureau of Labor Statistics.

More Than Eight Years of Monetary Stimulus?

Were this not troubling enough, Tim Duy observes:

“under the Fed’s extended guidance they do not see the need to raise short term interest rates until mid-2015. June 2015 would mark 90 months since the peak of the last business cycle in December 2007. The average peak-to-peak cycle of the last three recessions has been 96 months; the average since 1945 is 66 months. Now, I don’t think you can say that the probability of recession in the next month is a factor of the time since the last recession. But you can say that given past business cycle timing, it is perfectly reasonable to believe that the next recession will hit before we lift off the zero bound. Moreover, it would be relatively uncommon for the peak-to-peak cycle to last more than 90 months as only 4 of the last 11 cycles have exceeded this length of time.”

Conclusion (Looking for the Night Vision Googles)

With global economy deteriorating, monetary policy simply containing the inevitable and possibly accelerating a synchronized global slowdown through effects of higher energy prices, continued growth in thinly capitalized, opaque financial systems, corporate sales stagnating, margins contracting and the calendar likelihood of recession waxing, it would seem very opportune to put in place tight stops and exercise greater than usual risk controls. We’re running out of time and if we do slide into recession I don’t think there is a policy response beyond exhortations at conferences as all tools are deployed and the much vaunted policy kit is empty.

* Some data cut and pasted from various sources

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About the Author

Stephen Swanson has a degree in economics and an MBA. His corporate experience includes several executive positions including a divisional VP assignment. More recently he has left the corporate world and has been investing in financial instruments and real estate, with interests expanding into S&P futures and commodities. Stephen is known on the internet under the pseudo nom CautiousInvestor and is a frequent commentator at Seeking Alpha where he also posts blogs.