From cautious optimism to caution
It is beginning to look like the economy is circling the drain. To be sure, I hate to make too much of one report, but the May employment report comes at the end of a series of bad reports stretching back to nearly the beginning of the year. There looked to be solid hope the recovery was on a better track as 2010 drew to a close, and that momentum appeared to carry through into January. But then we hit a wall.
What wall? Theories abound. Temporary weather and tsnumai induced disruptions for one, but we should be trying to look through such short term events. The crisis in Europe, although to be honest I don’t think this is having much of an impact on the decision making of the average US citizen or firm. I tend to think the rise in commodity prices, particularly oil, was the primary culprit, as consumer spending faltered and businesses struggle to pass increasing costs onto consumers. But what it really comes down to is that we have only had one good quarter in this recovery, and that simply was not enough to provide sufficient resilience to the sheer number of shocks the economy has weathered this year.
I agree with this characterization of events. I was cautiously optimistic about 2011 as the year began. But the economic data have been weak. I see a global growth slowdown happening, not just a US slowdown. In China, for example, we could see a hard landing, meaning growth slows considerably as tightening takes a toll on the economy via credit writedowns and non-performing loans.
This [cautiously optimistic] 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.
Just a few comments on this. I think this analysis was spot on. The ECRI is slumping. Economic weakness is fully manifest in the data. So risk assets are selling off and rates are lower despite the Chinese dumping T-bills. It’s about inflation and rate expectations, folks, not bond vigilantes. Like Tim Duy, I think demand destruction is a key to why thing are going pear-shaped right now. But I also think the policy response will be weak. As I implied in April, QE3 is not on the horizon; Comstock Partners have it right when they say QE3 will only become a reality after the economy deteriorates (not that QE is good policy anyway). More to the point, austerity is more likely than ever in the US.
So tell me why this is the headline from Bloomberg on commodities: Funds Boost Bullish Commodity Bets Amid Improving Global Growth Prospects?
The Standard & Poor’s GSCI Spot Index rose for a fourth straight week as Chinese metal inventories plunged and droughts lingered in the Asian country and Europe, trimming prospects for wheat and cotton crops. The global recovery “is gaining strength,” the Group of Eight leaders said May 27 after a summit in Deauville, France. In the U.S., consumer sentiment rose to a three-month high in May, a private report showed last month.
“We are seeing a reasonable rate of growth in worldwide economic activity,” said Michael Cuggino, who helps manage $12 billion at Permanent Portfolio Funds in San Francisco. “The supply-demand associated with that growth, combined with a weaker dollar, probably explains the move into commodities.
This sounds like pure confabulation. I am more cautious than optimistic on risk assets and the global economy. From where I sit global growth prospects are not improving; they are weakening.