The Transitional Year: Bullish cyclical and bearish secular forces

I was just reviewing some of the commentary from this January’s Barron’s Roundtable. I thought Felix Zulauf’s take on macro trends for investors was spot on.  His comments on currencies in particular inspired this post.

Zulauf sees 2010 as a transitional year in which the global economy will benefit from the cyclical agents of recovery and lingering monetary and fiscal stimulus in the first half of the year. However, eventually these bullish forces will give way and the more bearish secular forces will re-assert themselves.

Zulauf also mentions competitive currency devaluations, which I believe have already begun. This means that trade and currency tension will mount as 2010 continues.

Let’s start with bullish factors.

Felix, let’s hear from you.

Zulauf: This will be a transitional year. I am not sure how it will end for the markets. Cyclical forces are bullish. Governments and central banks have poured money into the global economy. We don’t know what the true condition of the economy would be without all that help.

Edward here. I agree with this. However, I believe we do know the true condition of the economy without the monetary and fiscal stimulus is weak as evidenced by poor credit growth, deleveraging, high unemployment and on down the line. He gets to some of this in the next part.

Are there any comparable periods in history?

Zulauf: The only comparable in modern times is Japan, although Japan’s financial and economic crisis was worse. Japan lost three times the value of its gross domestic product as asset values deflated, while the U.S. lost only one times GDP.

On the negative side, we are in the early stages of a deleveraging process, which is marked by a shift from maximizing profits to minimizing debt. It is a multiyear process. The U.S. consumer is in bad shape, and the U.K. consumer is even worse. So are consumers in parts of southern and eastern Europe. If the consumer saves 5% and invests it in stocks or bonds, the savings remain in circulation. However, if he pays down debt with that 5%, the money comes out of the economic system. That is what is happening, and it will be a drag on growth. This structural setup could last another five years. The U.S. consumer has to lower his debt by at least $4 trillion. But fiscal stimulus is ongoing. Central banks have spent trillions of dollars to manipulate asset prices higher, and that’s a positive in the near term.

This next part regarding when all the stimulus is going to be withdrawn is the crucial part to get right. When I characterized the nascent recovery in October I said:

So what’s next?  A lot of the economic cycle is self-reinforcing (the change in inventories is one example). So it is not completely out of the question that we see a multi-year economic boom.  Higher asset prices, lower inventories, fewer writedowns all lead to higher lending capacity, higher cyclical output, more employment opportunities and greater business and consumer confidence. If employment turns up appreciably before these cyclical agents lose steam, you have the makings of a multi-year recovery. This is how every economic cycle develops. This one is no different in this regard.

However, longer-term things depend entirely on government because we are in a balance sheet recession.

The recession is over but the depression has just begun, Oct 2009

My calculus is that the secular forces cannot be overwhelmed by cyclical agents and that the withdrawal of stimulus will see a lapse into recession. Moreover, the more robust the cyclical rebound is, the greater the political pressure to withdraw stimulus will become.

Isn’t the stimulus slated to end this year?

Zulauf: That’s the big question. Central bankers themselves are somewhat afraid of what they have been doing. Politicians are worried about public-sector debt. Therefore, the authorities will try to step away slowly from their stimulation efforts, because this policy isn’t sustainable. That’s the risk for the markets. The U.S. stock market has enough momentum to rise another 10% or so. But the authorities will start leaning the other way as they see signs of economic growth in the first two quarters, and possibly a jump in inflation. That could push the market down.

Schafer: How can you have deleveraging and better growth?

Zulauf: Inventories fell to about 9% of GDP in the recession. Just replenishing inventories gets you better growth. Then you have government spending on the order of $400 billion. The funny thing is, whenever the consumer wants to save and tries to do the right thing, the government and central bank come in and encourage spending. For a while they will succeed, but then structural forces will take over. The Federal Reserve has said it will stop buying mortgage-backed securities by the end of March.

Faber: But that might not happen.

Hickey: The Bank of England kept buying after the date at which it pledged to stop, because the alternative would have been a downturn.

Zulauf: If economic growth proves disappointing, the Fed will continue its stimulative policies. But if GDP grows at a better-than-expected rate in the first half of the year — say, at 4% or 4.5% — the Fed will try to stop its programs completely. No new liquidity will enter the system, and the market will be on its own. If it loses momentum and isn’t priced cheaply, it will correct. That’s what I expect.

So, Zulauf’s point is exactly mine: stimulus will continue only if the economic rebound is weak. If we see decent growth, both fiscal and monetary stimulus will be withdrawn. I don’t believe the cyclical agents can overcome the secular weakness (structurally high unemployment, debt, deleveraging, and deflation). This means another dip is likely.

One other point that Zulauf made which bears noting has to do with currencies. The sovereign debt crisis in the eurozone means that the Euro will be relatively weak. Zulauf believes that the ECB could even try and depreciate the currency’s value to help the fiscally constrained Eurozone economies.

Here is the exchange:

Zulauf: I also see opportunities in the foreign-exchange market. I have described the de-leveraging process in many industrialized countries. It is a deflationary process, and central banks are using inflationary policies to offset or fight it. Competitive currency devaluation is one of their tools. We saw a big devaluation of the dollar last year, and next in line are the yen and euro. The euro is about 20% overvalued relative to the U.S. dollar. It could trade down to $1.25, from $1.45. You can see how the weaker members of the European Union are getting squeezed…

Gross: So you see a stronger dollar.

Zulauf: The dollar should bounce against these currencies this year, but I see a competitive devaluation of currencies generally. First the dollar fell, and now it is the turn of the euro and yen. When this round is over, it’s back to the dollar. It goes in circles until all the currencies are debased.

Think about this in the context of the recent China – US currency spat. China had a crawling peg up until 2008. It had been appreciating its currency by 20%. And then it froze the currency.

Meanwhile, several countries have been engaging in credit and/or quantitative easing in order to provide liquidity. Switzerland, the UK, the US, and Japan are notable QE adherents. This increases the money supply and lowers the currency’s value.

Then, you have record low interest rates across the developed world, with some countries (Sweden, the United States, Canada, Japan and Switzerland) at the zero bound (see chart below from the Economist). This also lowers a currency’s relative value as global carry trade investors bid up currencies where local interest rates are higher as they are in Australia.


Are these not forms of competitive currency devaluations? I see them as such. This puts the U.S. – China debate and the protectionist rhetoric in a very 1930s-style context.

So, while Zulauf points to Japan for historical parallels for the U.S., the synchronicity of economic downturns globally, makes the 1930s a good parallel as well.  In my view, we are still not out of the woods yet. If economies return to growth slowly, the pressure to end policy accommodation will be less severe. This might bode well for both a multi-year recovery and equities.

On the other hand, if growth proceeds slightly more robustly, the pressure to normalize fiscal and monetary policy will be too great to bear. In such a scenario, the downside risk is much greater.


New Strategies for a New Era – Barron’s

  1. Greg says

    Zalauf estimates consumers need to delever by at least $4T. My back of the envelope estimate for overall private sector deleveraging (which of course is more than just consumers) is much higher.

    Have you tried to estimate how much deleveraging is needed?

    1. Edward Harrison says

      I haven’t done that yet. How are you running the numbers?

      1. Greg says

        I haven’t done much work either, but just looking at historical charts, total private sector debt was near 300% of GDP at the start of the financial crisis. It appears to me that a long term historical norm would be well under 200%. Even if we just went back to where we were in the mid 90’s where debt to GDP was a little over 200%, that looks like well over $10T of total deleveraging to me. I would love to have your view on whether this is a reasonable ballpark.

        1. Edward Harrison says

          Greg, that’s too high because the U.S. household sector has debts of 100% of GDP. The large debt increases over the past generation have come most in the financial services sector.

          See this post below:

          So, using this back of the envelop analysis with GDP at $14 trillion, a come down to say 75% in the household sector is 25% of $14 trillion or $3.5 trillion.

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