Cyclical recovery petering out before it hits middle class
Before I get into the details today, I want to note that going forward, I may not have the bandwidth to be able to post on a daily basis. I am going to try. But there are definitely going to be weekdays going forward where I won’t be able to post given other commitments I am making. I don’t want to put sub-standard material out when pressed for time. A few weeks ago, I had noticed a marked increase in typos and garbled sentences that was a bit disconcerting and it said to me that I need to take more time in the editing and review process. I also have a few changes coming up for the website that I will unveil in the coming weeks. Likely, I will separate the Credit Writedowns Pro platform from the blog platform for behind the scenes ease of maintenance. I will let you know as the changes occur. All of them will be positive. Now, on to the note
This is going to be a downbeat note. Let me say from the outset that my bond market/credit mindset makes me naturally attuned to risks more than upside on occasion. Nevertheless, I have been consistently upbeat about the economies in both the U.S. and the Eurozone periphery for the better part of a year. Now, I am becoming worried, the recoveries there are coming unstuck before the heavy lifting of structural adjustment is complete. The result could be a period of turbulence economically, financially and politically. We are not close to there yet in the U.S. but in Europe the signs are more marked. Comments now below
The United States
Let’s start off with the US, where the expansion has been better than in Europe. My baseline narrative here is that the US is in a full-blown sustainable cyclical recovery now. But the recovery is one that is muted because of the lingering effects of the financial crisis and the lack of wage growth to support consumer spending. We are in a 2%ish phase of growth that is above the stall speed that causes economic shocks to create recessions out of the blue. But we are nowhere near the point where the economy can support rate hikes that will give monetary officials policy space to ease in the next cyclical downturn. And this recovery is long in the tooth, making us closer to the next trough than we are to the last one in 2009.
Now, let’s remember that the economic policy paradigm in the US has been tighter fiscal policy and loose monetary policy on the government side combined with a focus on cost cutting and excess capacity reduction on the business side. Coming out of a period of heavy household debt, this has meant deleveraging in the first instance and tepid growth thereafter because of the lack of consumer purchasing power. The focus on deficit reduction effectively means lower net fiscal transfers to the private sector, further diminishing the potential for a consumer boost. And this has been offset by loose monetary policy in the form of zero rates and asset purchases, the result of which is a reduction in discount rates and increased risk appetite, both of which are favourable for asset prices.
None of this is geared to a broad middle class-based recovery. That much has to be said. And in terms of inequality, the numbers are stark. Bloomberg noted recently that:
Households in the top 20 percent of U.S. socioeconomic groups saw their incomes grow by an average of $8,358 a year from 2008 to 2012, compared with a $275 annual decline for the lowest 20 percent, according to data from the Bureau of Labor Statistics.
And they point to wage growth as a key missing link in this recovery with the following graph:
What concerns me for the US is this. If this recovery can last and the labour market can tighten, wage growth might increase enough to underpin the recovery properly. However, if the recovery is snuffed out before this can occur, we will have no policy space monetarily or politically to support robust countercyclical measures when the credit and business cycle turns down.
The labour market is still tightening. Both the U-3 and U-6 unemployment levels are coming down with the U-3 at 6.2% now, well through the Evans Rule threshold of 6.5%. Job openings recently hit a 13-year high of 4.7 million. The number of workers hired inched up to 4.8 million, while more Americans also felt comfortable enough to quit, with 2.53 million doing so in June, the highest level in 6 years. I should also note that the 300,000 average initial jobless claims level is consistent with an average 250 to 350,000 jobs added per month.
But the first sign of economic weakness came via the housing market and the increase in mortgage rates last year after the Taper Tantrum. This sent demand for housing down and cooled that sector of the market, particularly in the previous bubble markets like Phoenix and Las Vegas.
The more worrying sign that is now starting to appear is in retail, where retailers are cutting forecasts everywhere. Walmart was first to show problems after the harsh winter. Macy’s has cut. Lowe’s has cut. Target has cut. These companies represent a wide swathe of different mainstream retail spaces for middle class consumers in the US. And they are all cutting earnings estimates well after the Q1 weather-induced lull is beyond us. To me, this is worrying.
On the other side of this, you see still good earnings in two spaces in particular. First is luxury. Tiffany’s last reported in May and was upbeat. Coach is talking about earnings going up as well. Then there is the auto sector, where the reach down into subprime lending is buoying earnings artificially. While GM has missed because of special problems, Ford’s profits are topping expectations. Firms outside the US are also doing well. Toyota profits were double. VW sales have jumped as Audi and Porsche sales are at record levels. Note, however, even here there is softness because all of the output is driving down used car prices, which will both drive up incentives for new cars and increase loan losses on bad debt for auto repos. Watch the auto space for further confirmation of weakness in retail.
My overall view here is that the US can still power through if wage growth picks up. But if it does not and the Fed is forced to raise rates due to concerns about froth in the credit markets and pockets of the equity markets, this recovery will end. The Fed knows this on some level and that’s why it is doing anything it can to justify continuing its easy money policy as an offset to fiscal policy. But the mix is all wrong for secular sustainability. Wages need to go up more than asset prices at this point in the cycle.
I have less to say about Europe here because I have discussed it in the last two newsletters. But let me give a 40,000 foot view to contextualize.
Europe has many of the same problems as the US regarding private debt, bank undercapitalization and unfavourable demographics – more so, even. To make matters worse, the Euro acts as an impediment to cyclical solutions, adding pro-cyclical volatility to the situation by reducing fiscal policy space, introducing the spectre of sovereign defaults and limiting the lender of last resort role of the monetary authority. The ECB improvised solutions that have worked to help Europe out of the acute phase of crisis but all of the structural problems remain.
What should concern us is that Europe’s economy is decelerating while disinflation is becoming more acute before any of the structural issues have been fixed. The most important structural issue in Europe is the bank – sovereign debt nexus. When the sovereign debt crisis was acute and we saw spread divergence between the core and the periphery, one major culprit was the sovereign debt on bank balance sheets. After the Draghi Put was in place, the bank sovereign debt issue worked in the opposite direction, masking the still fragile capital state of periphery financial institutions. If spreads were to widen appreciably from here, we would see serious turmoil in the periphery financial sector which would amplify the economic deterioration through credit rationing. I do not believe that the TLTRO program can overcome this effect.
And, despite the wholesale drop in yields, we are seeing an incipient flight to quality here, with yields in Germany and Belgium, for example, hitting negative yield territory. If investors are piling into safe assets so aggressively, that speaks to a certain risk off sentiment that could be taking shape as the European recovery falters. The fall in safe asset yield is a first phase result of the risk off behavior. Future phases will include a flight from risk assets like high yield bonds and long-dated periphery sovereign bonds. We are not there yet because the bid for bank debt, high yield debt and periphery sovereign debt is still there. But the high cost of short-dated Greek paper tells you that default risk is still an issue that could increase in importance if the European downturn starts in earnest.
And that’s the question: where is the European economy headed. I have made hay of the fact that Greece and Spain are storming back to growth. but this growth comes from a diminished economic base amid widespread unemployment in depression-like circumstances. If the sanctions against Russia start to bite and the core turns down, then the knock on effects could stall out the recovery in the periphery as well. Even Spain lobbed in an ugly industrial production number in the last round of data flow, with industrial production falling 0.8%. This is why EU unity on Russian sanctions is fraying.
Government policy is key here. On the fiscal side, we have been in the backloaded austerity paradigm for some time now. This move was made out of necessity. But when the economy was on the upswing, the new paradigm worked because targets were met, lessening political pressure. France, which was a laggard, was forced to cut though, showing us that the backloaded austerity paradigm had limits. As the economy slows down across the board, targets will get pushed across the board. And for many, that’s not going to be acceptable. We are going to see conflict. France will actually lead the periphery on this, with Italy in tow. I see deficit targets and the need for stimulus as the next epic battle we will face in the Eurozone shortly.
On the monetary side, it is the same paradigm as in the US, monetary policy as an offset to fiscal tightening, with both monetary and fiscal policy being relatively tighter in Europe than in the US, the UK or Japan. Because of the institutional deficits of Euroland, the ECB has been forced to focus exclusively on bank liquidity to get monetary policy to work. In the US, the Fed did QE via mortgage-backed securities and government bonds. Both of those avenues are out for the ECB because banks have not been disintermediated to the same extent by capital markets in Europe and because the ECB does not want to violate Article 123’s anti-monetary financing of member states rule. If the ECB wanted the best bang for the buck today, the European high yield market presents an opportunity for buying up private sector debt that might help the periphery. This is a solution I have not heard mentioned. In the meantime, the ECB is trying to get consensus on where to proceed next, once TLTRO has taken off. My sense is that their efforts will be too little and too late.
Overall, we see some serious signs of deceleration in Europe and the US. And this is going to be bullish for safe assets but potentially destabilizing for risk assets. The US is better positioned here and therefore, given the lack of fiscal space in Europe, all of the weight now falls on the ECB in terms of this incipient slowdown. I do not think the ECB will be proactive. It will be reactive. German Bunds and other core government bonds will outperform. Long-dated periphery assets will underperform.