More cautious optimism?
[Y]ou 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 US. 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 US jobless claims telling us about recovery? They are averaging about 410,000, 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.
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.
We’re three months on since I wrote that. Here’s what I see now: This base case is still operative but many of the downside risks are starting to become evident. When I wrote, "I expect this to continue through at least the first half of 2011, probably through the whole year," what I meant is that the cyclical recovery will see us through at least the first half of the year. However, I felt that starting in the second half, you will see problems from cuts in federal as well as state and local government. Monetary policy will also be less accommodative as well. The question then was about exogenous shocks. I listed four in addition to the municipal problem:
- European debt crisis
- Currency Wars
- Commodity prices
In Europe, the debt crisis has claimed Portugal as expected. Spain has decoupled thus far. In the U.S., the housing double dip has resumed. On the currency front, the US dollar is falling quite fast right now. Is this a good thing or a bad thing – I don’t know? My sense is that it could precipitate more currency war problems. Finally, there are rising commodity prices. It’s not clear to me that they will continue to rise. But, at a minimum the prospect of demand destruction is there, even without a further rise in prices. The other exogenous events were in Japan and the Middle East. Overall, I would say that the exogenous shocks have added to downside risk. I would expect economic weakness in the second half of 2011.
If economic weakness does materialize in the US, I would expect lower long-term interest rates. Many are predicting QE2 will lead to higher rates. But why would that be the case in an environment of economic weakness in which risk assets could sell off? Watch the ECRI index for signs that the economy is weakening.