Maybe we need the Star Trek crew in the US Treasury (certainly some of the recent hires look and talk like alien life forms). I've never been in the deflation/depression camp, and have consistently argued that the scale of monetary and fiscal stimulus, particularly in the US and UK, allied to the windfall real income gains from falling prices, would generate an economic rebound in 2010. In particular, I considered the speculative spike in energy costs last Summer as the critical tipping point that pushed a teetering US economy firmly into recession; at the time most economists recognized neither the nature of the mania in the oil market nor its destructive economic consequences.
In 2009, oil importing nations will collectively save about $1.7trn on energy costs if oil averages the YTD $47 (from a $90 average in 2008), and that will do as much as all the official stimulus plans to create a platform for recovery. The inflationary versus deflationary tipping point has consistently been the key factor at the bottom of the cycle in previous bear markets, which is logical. Deflation kills equity value as the risk premium soars, as it had done from the Lehman collapse to the March reversal. All the great bear market bottoms have coincided with the reversal of deflation expectations, and looking at the Tips market (one of my favourite plays), pro cyclical equity sector rotation, and industrial commodity prices such as copper and platinum, for the US the overhyped deflation scare looks over (although globally pockets of deflation will occur in the worst impacted economies such as Ireland).
Recent leading indicator data is indicating that the pace of decline is abating, although no more than that. We are still probably 6-9 months from any broad economic upturn in the US on the best case scenario. Financial market indicators of risk appetite such as the EUR/JPY cross rate are all reflecting growing expectations of an imminent bottom and subsequent upturn, but it will be a very different one to historical precedent. For anybody seeking to understand the constraints on a US economic recovery, I recommend reading Richard Koo's The Holy Grail of Macroeconomics: Lessons from Japan's Great Recession. Koo, global strategist at Nomura Research Institute, is an expert on the balance sheet recessions resulting from the bursting of a huge asset bubble, which leaves widespread private-sector insolvency in its wake and debt minimization as the new priority of consumers and corporates.
This is a theme I've discussed many times; the focus of comment and policy is on credit availability, but the real issue going forward will be demand as the private sector deleverages. Until balance sheets are repaired, which will take at least 3-5 years, growth cannot regain sustainable momentum. US consumer spending and credit growth will be severely constrained in this scenario, as household net assets have collapsed from $64.5trn to about $47trn since mid 2007. Two key questions face equity investors: Have we seen the bottom for this bear market? And what will be the scale and sustainability of the rebound, given the unique economic backdrop we face? It's likely that a US recovery will be a very muted and erratic 'washboard' affair by historical standards, not dissimilar in many ways to the frustrating Japanese experience in the1990's, and certainly nothing remotely approaching the 4% annualized growth forecasts in the recent Obama budget, for a number of reasons:
1. Aggregate debt in the US economy is already about 400% of GDP with public sector leverage growth outpacing private sector decline; to reach 2003-7 growth rates of 3%, over $5 of leverage was added for each increment of income. That credit doped, illusory growth simply cannot be resuscitated. There is still no credible attempt to tackle the dysfunctional and insolvent US banking system, with radical reform stymied so far by the vested interests of bondholders and management. A dysfunctional banking system with excess capacity and an overhang of distressed assets will hinder a classic recovery.
2. Any rebound will take place in the context of declining labor force entrants (and declining participation rates) as discussed at length in previous commentaries on demographic decline. Added to rising taxation across the developed world to bridge unsustainable deficit spending, both factors will crimp aggregate discretionary income and productivity growth.
3. Inflationary resource scarcity hasn't gone away as a key constraint. Last Summer, commodity markets declared a 'speed limit' on global growth, which had been running at 5% since mid-decade, and an incipient inflation crisis across the developing world was only averted by the Autumn's financial crisis. Given structural supply constraints, exacerbated by the shortage of risk funding, even a muted global recovery will create spiking prices in many resource markets, particularly as China is pursuing an aggressive strategic stockpiling program from oil to copper. The respite afforded Western consumers in recent months as food and energy prices reversed is likely to be temporary, and rising commodity prices will again squeeze discretionary income into a recovery.
4. Key to any sustainable US recovery will be the housing market, which has already adjusted considerably. Housing starts which were running at more than two million a month at their height in 2006, are now running at about 500k, their lowest since records began in 1959. Mortgage refinancing activity has soared in recent months as Fed policy has managed mortgage rates under 5%, and probably to sub 4.5% by year-end (cue Wells Fargo etc making windfall operating earnings) and there are pockets of regional recovery already. However, there are maybe 600k foreclosed but unsold properties on bank's books currently, while 1 in 9 properties nationwide remains empty (albeit concentrated in the areas worst afflicted by economic decline like Michigan). Normal cyclical factors will generate a degree of natural recovery, as with auto demand, but it will be restrained both by more conservative lender and consumer behaviour.
5. While the non-financial corporate sector has been busy putting its own house in order eg inventories have been cut aggressively, cashflows have been bolstered, while productivity has accelerated in this recession in contrast to the deep recessions of the Seventies and early Eighties, non-financials earnings have been remarkably resilient overall thus far and profit margins are still near 2007 highs; financial sector reported earnings may be bottoming (pre-exceptionals of course), but non-financials still have substantial downside as structural overcapacity bites in many industries.
6. Even a muted recovery will lead to greater competition for a much shrunken pool of risk capital, leading to rising long-term rates in capital markets. In particular, current Treasury yields, which underpin recovery hopes for the US housing market, will inexorably trending up over the next 12-24 months as official foreign demand wanes and inflation expectations adjust. The Fed's ability to simply monetize the debt burden will be severely tested sooner or later by those dormant but still potent bond vigilantes.
As for markets, I don't believe we saw the despairing revulsion that marks true bear market lows even in early March, and the quality of the rally since, with an instant appetite for the most bombed-out pro-cyclical sectors, suggests the bear to bull switch was flipped prematurely. As ever, all we can do is invest on the balance of probabilities. Perhaps we have seen the absolute bottom in major equity indices and investor behaviour is different this time for a host of structural reasons; even then, the 'V' shaped economic and market recovery being touted by the usual suspects is a low probability outcome. More likely is that a bottoming process has begun, but it will be very extended and volatile, and we range trade between the recent lows and the January highs for several months, pivoting around 800 on the S&P. However, there is a very significant risk that the concerted policy effort to paper over the underlying structural faults in the credit system will ultimately fail even in its own distorted terms, and precipitate a renewed crisis of confidence later in 2009 or early in 2010, pushing equities to a climactic cyclical low.
In the interim, there is a strong case for expecting this bear rally to at least test the January highs in US and European equities; technical, fundamental and valuation factors all suggest that this equity rally will be sufficiently strong to suck in much of the 'sidelined' retail cash currently in money-market funds over the next few months and generate euphoric pronouncements by financial pundits that the secular bear market in place since 2000 is finally over. We have seen these 'false dawn' recovery rallies in the 1930's as well as in Japan in the 1990's, and they can stretch to 40-50% trough to peak. If the bear market lows do lie ahead of us at something like 400-500 on the S&P, it will be a tragic finale for many unsuspecting investors prodded along the risk curve by Fed policy. While I have serious reservations about the long term implications of the policy response and expect inflation to become an issue on a 2/3 year horizon as money velocity rises, equity markets, which are a discounting mechanism as well as a barometer of investor sentiment should perform well over the next few months, regardless of whether this is just a major bear rally, or a genuine turning point. On that basis, the pullback I expect imminently should provide another tradable opportunity to accumulate capital.
