THE BEAR'S LAIR Which green shoots will wilt first? By Martin Hutchinson
Stock markets have shown clear signs of irrational exuberance in recent weeks,
on evidence that the US and global economy is exhibiting "green shoots" of
impending recovery. While I have said several times that the US economy appears
to be approaching a near-term bottom, I don't expect recovery to impend any
time soon, so I thought it worth examining these green shoots to determine
which were most likely to wilt first.
Let's start with one that looks pretty robust. Global trade, particularly in
the Asian supply chain to the United States, dropped a frightening amount in
the first couple of months of 2009. This was very worrying; it appeared
possible that we would see a repeat of the Great Depression's trade madness,
when trade
declined by 65% in four years. That reduced a lot of the "comparative
advantage" efficiencies in the world economy, whereby goods are manufactured in
those countries with the best relative costs - thus a repeat of it would have
had truly dire implications for global economic prospects, effectively
reversing globalization in one bound.
There was however another possibility, which was that US consumption declines
caused an inventory backup in the Asian supply chain that, combined with the
inevitable difficulties for exporters getting financing, sharply reduced trade
for a short period. More recent figures have shown a considerable trade
recovery, indicating this to be the most likely explanation. Thus, while trade
will not recover completely since the US savings rate has increased and
consumption declined, this partial trade recovery is indeed a genuine green
shoot that will not reverse.
A second green shoot that looks likely to persist, although not entirely, is
the increased solidity of the US banking system. Back in February, Treasury
Secretary Tim Geithner was wailing that the US banking system needed another
US$1.5 trillion to fix it. Given the relatively robust state of most regional
banks, that always looked unlikely, and I said so at the time. Now the "stress
tests" have found that a mere $80 billion of new capital, most of it raised
freely in the market, will fix the problem. Geithner's panic in February, which
may have been assumed in order to generate support for the bloated and damaging
"stimulus plan", has thus proved wide of the mark.
Having said that, this green shoot is by no means assured of growing into a
healthy tree. Unemployment figures released on Friday showed a continued
increase in the unemployment rate more rapid than in past post-war recessions -
up by 4.5% in only two years, faster than in 1979-82, when it took 3ฝ
years to rise 5.2%. The Treasury's "stress test" assumptions were based on data
from past recessions; if unemployment continues to rise at a rate with no past
parallel since the Great Depression, or continues to rise to a level above the
postwar record (10.8% in November/December 1982), then we will be economically
"off the map" and it is entirely possible that bank loss rates will rise far
above the stress test predictions.
After all, there can be no certainty that the relationship between unemployment
and either credit-card or mortgage losses is linear; it is possible that there
is a "tipping point" as unemployment continues to rise, at which foreclosures
or credit-card losses increase to such a point that they become
self-reinforcing, escalating uncontrollably with only a modest further
deterioration in economic conditions.
The principal cold gale causing green shoots to wither will probably be the
inexorable rise in long-term interest rates. This has already begun; the
10-year Treasury yield is up from its low of 2.07% in December to around 3.3%.
However, the enormous Treasury financing requirement and the increasing
visibility of inflationary signals will cause yields to go much higher.
In the 1990s, when average inflation was 2.9%, the same level as the recently
announced first-quarter gross domestic product (GDP) deflator, and the federal
budget deficit averaged a mere 2.3% of GDP, the 10-year Treasury yield averaged
6.67%. That level may seem very high at present, but it is likely to be passed
fairly rapidly, on the way to Treasury bond yields of 10% or more as deficits
and inflation provide a howling adverse gale for the T-bond market. The rise in
interest rates will be prolonged and initially quite slow, but we can probably
expect 10-year Treasuries to yield more than 6% a year from now.
If rising interest rates are the gale causing green shoots to wither, inflation
will be the frost causing them to die. Federal Reserve chairman Ben Bernanke
has enjoyed a period in the public eye, even before his January 2006 ascension
as Fed chairman, largely punctuated by self-delusion on an extraordinary scale.
It began with his discovery of a hitherto undetected dire deflationary threat
in 2002, continued with his announcement of the "Great Moderation" in February
2004, just as his lax monetary policy was sending housing policies into orbit.
It continued with his accusation that evil Asian savers had caused the 2007-08
explosion in commodity prices, and it has now settled into an indelible
conviction that, however "unorthodox" and Weimarite his monetary policies may
be, inflation is far less of a danger than deflation.
It will be a race between soaring interest rates and grimly rising inflation to
kill the green shoots of recovery and plunge the US economy into renewed
downturn. Both factors will reinforce each other as buyers of Treasury bonds,
appalled by the price declines in their holdings, will come to realize that
inflation as well as soaring interest rates has made long-term Treasuries the
ultimate sucker's bet. Zhou Xiaochuan, governor of the People's Bank of China,
will no doubt be especially withering in his condemnation, discovering a
hitherto little-known treatise on sound monetary policy in his copy of the Thoughts
of Mao Zedong.
The housing market and its corollaries, the housing finance market and the
construction market, will recover or wilt further, depending on which -
interest rate rises and inflation - proves predominant. Here my crystal ball is
a little cloudy. House prices are now around their long-term average in terms
of median income, but on the other hand there is a huge overhang of unsold
housing inventory and foreclosures or potential foreclosures, which would
normally depress prices further.
Nevertheless, very rapid inflation without a concomitant rise in interest rates
might cause the housing market to find its feet quickly. Had Bernanke been
allowed to wreak his inflationary-producing magic unaccompanied by the
deficit-producing efforts of his partner in congressional obfuscation,
Geithner, that might have happened. However, in the short term, Geithner's
operations pushing up the federal deficit and interest rates should win out
over Bernanke's attempts to push up inflation by lowering interest rates. In
that event, further green-shoot wilting and chaos in the housing market is
likely, producing knock-on negative effects on construction, mortgage finance
and the US banking system.
With higher interest rates, higher inflation, a wobbling housing market and a
wobbling banking system, the stock market's recent exuberance is most unlikely
to continue for long. Currently, particularly in the financial sector, the
riskiest and most damaged stocks are showing greatest strength, which is always
a worrying sign. At some point, investors will note that the old problems
haven't fully gone away, while new problems have appeared. Then a rapid stock
market decline below the March lows will probably occur, although there will be
heavy buying at March's levels by investors who have noticed that in March,
stocks at those levels proved to be bargains. This time around, the bargains
will be false ones, as further earnings damage is in store through the rising
cost of debt in an overleveraged economy.
Consumer spending has shown signs of strength recently, as consumer confidence
has risen from its low and retail sales have edged upwards. However, the
consumer savings rate, at around 4% to 5% of disposable income, is still too
low to balance the US economic system, while consumers' asset holdings are
depleted far below their levels of a couple of years ago. Hence consumer
savings will rise further, probably as interest rates firm, which will in turn
depress retail sales and consumer-oriented activity generally. The green shoot
of consumer confidence will survive only until inflation is seen to have
regained a firm grip on the US economy and the stock market has relapsed into
its currently natural bearish state.
On the corporate side, the Institute of Supply Management indices for April
rebounded somewhat, suggesting that recession is drawing to an end. Inventories
also have begun to rebound after their exceptional weakness in the first
quarter. Like consumer confidence, the modest impending rebound in production
may survive for some months, until it becomes clear that higher interest rates
must be factored into all cost calculations and that consumer spending is not
about to revert to its robust recent trend. Nevertheless, the US corporate
sector will be buoyed by an improving trade position, and will be distinctly
stronger than the consumer sector. Capital spending, which has been weak since
the tech bubble burst in 2000, is likely to remain so as capital costs rise.
The productivity miracle of the late 1990s was always a mirage, caused partly
by record levels of capital spending and partly by statistical jiggery-pokery
in price index figures. Going forward, with capital spending low and inflation
rampant, productivity growth is likely to be exceptionally low, as it was in
the 1970s. This will speed the economic transition from a US-dominated world
economy to the new domination by east Asia. On the other hand, it might slow
the otherwise inevitable decline in US living standards, as labor-saving
technologies prove unattractive capital investments while outsourcing falls
victim to protectionism, expensive emerging market capital costs and slower
trade growth.
Finally, back to unemployment, which on current figures seems sure to exceed
10%, and may well pass 1982's record of 10.8%. Should it move significantly
past previous post-war records into new territory, the effect on consumer costs
and bank loan portfolios will be literally un-calculable, as it will have moved
beyond the data on which previous regressions have been based. Beyond
deficits/interest rates and inflation, this is the third potential adverse
"climate" factor that could cause green shoots to wither for several years to
come. For this reason, unemployment data should be watched closely; if the
unemployment rate steams through 10% in the next few months with some apparent
momentum behind it, watch out.
Economically, it is now spring, with green shoots apparently indicating
recovery, burgeoning in the most unexpected places. The economic climate,
however, is that of early February rather than mid-April. True recovery is
nowhere near imminent, and economic conditions should get considerably worse
before it arrives.
Martin Hutchinson is the author of Great Conservatives (Academica
Press, 2005) - details can be found at www.greatconservatives.com.
(Republished with permission from PrudentBear.com.
Copyright 2005-2009 David W Tice & Associates.)
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