I am not bullish but I am not bearish either

Happy Friday. Here’s a quick gold-level note note on what I think is going on in the markets and the economy right now that I am making freely available.

Turning to the paradigm I set out in 2009, the following points frame the secular environment:

  • The household sector in many countries is overly indebted. The natural tendency, therefore, is toward more saving and less spending in the household sector (although asset price appreciation can attenuate this through the Wealth Effect). From a national accounting perspective, this necessarily means the public sector or the nonfinancial business sector must run deficits or the import-export sector must run a surplus.
  • Most countries are still in a state of economic weakness. Even emerging markets like China, India and Brazil are seeing weakening growth. That means consumption demand is constrained globally. Conclusion: There is zero chance the US or the euro zone periphery can export their way to sustained recovery without a collapse in the value of their currencies.
  • State and local governments are still constrained as currency users by the inability to print money and weak tax receipt growth. So from a national accounting perspective, only the Federal Government can run large deficits absent a business sector capital investing binge.
  • Because consumption growth is still uneven, I see the capital investment binge as unlikely and that means increased private savings must be facilitated by government deficits.
  • Politically, expansionary fiscal policy has come under and will continue to come under assault, particularly in the euro zone where national governments are currency users and vulnerable to bond vigilantism.
  • So all major central banks will inflate the currency base as much as they can reasonably get away with. This policy creates currency weakness and a competitive currency devaluation dynamic which has led to the so-called currency wars and the likelihood of sustained capital controls, currency intervention and nationalist economic responses. But these policies will work in creating asset price inflation and temporarily boosting economic growth.
  • I believe this dynamic will induce a Scylla and Charybdis of inflationary and deflationary forces, forcing central bankers to add and withdraw liquidity in a manic way. Financial repression will cause a secular decline in real yields across developed and developing economies. For investors like pension funds with nominal return targets and future payout liabilities, risk seeking return plays have proliferated to create huge shifts in private portfolio preferences. In particular, portfolio preference shifts into commodity assets due to easy money will increase the volatility of inflation and act as a tax on developing economies and the less well-off in developed economies.
  • The likely volatility in government spending and taxation gives you the makings of a depression shaped like a series of W’s consisting of short and uneven business cycles. Consumers will not deleverage in earnest during cyclical upswings but will overcompensate during recession. The secular force, therefore, is the D-process and the deleveraging, so I expect deflation to be the resulting secular trend more than inflation.
  • As we are now realising, this kind of volatility induces a wave of populist sentiment, leading to an unpredictable and violent geopolitical climate and the likelihood of more muscular forms of government.

I will say this: we are in a cyclical bull market right now. Lower jobless claims and higher credit growth despite slow income gains tell me that the cycle is well advanced. Because of household indebtedness, the commodity volatility tax, and fiscal consolidation I expect this cycle to be cut short. The US has resisted the fiscal consolidation, and has, therefore, benefitted from higher growth than Europe. But how much longer will it do so? My initial prediction in 2009 was that the upcycle would last 4 years at most i.e. to 2013. I stick by that. I expect economic weakness to begin in the second half of this year. This will turn into recession unless we see a countervailing effort by business or government. Watch China, India, Brazil and the US in particular because those countries are now leading global growth. For canaries in the coalmine, watch Australian house prices because Australia is commodity-dependent and the overvalued housing sector is coming off the boil. Any slowdown that feeds through into commodity price weakness will exacerbate weakness there and be a harbinger of larger problems.

From an investing standpoint, consider this a secular bear market for stocks then. Play the rallies, but be cognizant that the secular trend for the time being is still down.

  1. David Lazarus says

    I am far more pessimistic than you. All the efforts are to stop people deleveraging and keep spending. That will fail eventually. As soon as economies recover interest rates will have to rise, and anyone suckered into buying a home with interest rates close to zero will find that they are owning a money pit that bleeds them dry as rates rise, unless they are lucky enough to get 2% 30 year mortgages. Assets are still over valued in most countries except the US, where they are probably are much closer to real value, but they probably have another 20% to go which would be close to the lower limit used in the stress test. That would expose the limitations of the stress tests of the losses from second lien mortgages to only $50 billion very rapidly.

    That excludes the massive debts built up in Europe and that are not being written off. In the UK house prices have fallen 15% but still have a long way to fall to sustainable level and yet QE is doing its job keeping prices high, all while the wages that will ultimately support them are falling. Spain’s homes have fallen but the banks are not declaring the losses fully. Ireland will have a serious problem with bankruptcy once interest rates increase. It will be then when its draconian bankruptcy keeps people out of the credit markets for 12 years which will seriously impact any potential growth. Though I do agree with you that people will over compensate with deleveraging when the recession returns.

    Greece will collapse and the fall out will be horrendous, possibly resulting in a coup. Though mass migration will spread across Europe dragging down wages everywhere. The demographics for the periphery and eastern Europe will be disastrous for decades. Ireland will find that the recovery will be very tough because hundreds of thousands will have left, leaving the debt for fewer to repay.

  2. Jack Pollard says

    I find the overwhelming sense of complacency in the markets baffling at the moment…Listening to people cherry-pick macro data is laughable. Until the Eurozone is federalised/ some other form of transfer union then it’s all just can-kicking….

    1. David Lazarus says

      Yes I agree. Markets are looking for the news that shows that the recession is over. The US has done better than most because of the political paralysis that has stopped significant spending cuts. Though they have not followed through with fiscal transfers to the states and counties.

      Yes the Eurozone is can kicking, though how will it end?

      1. stevie b says

        staying long-term bullish…

        1. David Lazarus says

          Are you forgetting the huge private debt burdens in the US Europe and Australia? While corporates are stuffed with cash until households have an increase in disposable income these nations will be stagnant. They do have the rest of the world that that can trade with but that will not make a major impact in their debt burdens. So I can will say that multinationals can be bullish, but not for small domestically centred businesses.

          1. Stevie b. says

            David – you may well be right about some domestic Cos., but otherwise all the old problems are well known and well reflected in current market prices. Give me unknowns and I could worry!


          2. David Lazarus says

            The unknowns within the US is the ability of households to support the debt burden with failing income and whether QE will help them or burden them. Profits are peaking and so I would expect some PE compression as reality kicks in. Deleveraging will take more than a decade with simple repayments, so any bullishness should be concentrated in overseas markets.

            Black swan events are very rare and fat tail outcomes could obliterate any gains if you are not careful. So value investing should really be the name of the game right now. Though I would expect sovereign defaults to sweep across eastern Europe over the next five years, and possible revolutions, that impose losses on banks and expose more systemic failure.

            The problem is that everyone thinks that they have dodged a bullet and can resume the same old business, whereas smart money will have left. The boom over the last few years could turn out to be the biggest suckers trap ever. When it crashes it will expose problems in pension funds and hedge funds.

  3. Stevie b. says

    Well I guess that’s what makes a market! I think extremes have been seen and whatever happens next wont be as bad for market levels as last year’s lows anticipated. Time will tell – and alas, I have been wrong before…

    1. David Lazarus says

      Yes for traders it is probably good, but for most buy and hold investors, I would be cautious. Overall while certain sovereigns might be vulnerable globally the situation is good. So if you are willing to trade in all markets then there will be scope for gains. I am not an active trader so would exercise caution. From my perspective I see a huge fall in stock markets as markets collapse. Banks are probably insolvent and only surviving because of the massive volumes of liquidity created by central banks. So I expect trouble there eventually. Then when you consider that all governments have papered over the cracks a systemic banking crisis is very likely and soon. If the leverage on homes was substantially lower the risks would be much smaller but that is not the case.

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