Is it Over Yet?

By Claus Vistesen

It was telling that, just as the ECRI and other notable research outfits decided to push the recession button on the US economy, the data flow became notably more positive. This could be a sign of the times, that the cycle is just too volatile for even capable analysts to call or it could simply be a blip in otherwise fundamental economic weakness that is here to stay for now. I for one do not share the opinion of those who believe that, if ECRI gets this one wrong, their reputation will be permanently damaged [1].

I have been working with and building economic models for a while and all I can say is that they are seldom 100% right and the margin of error is always there when analysts make calls. The key is your ability to make calls which are transparent and add value for decision makers when they are made.

Risk asset markets made no mince of the recent stabilisation of the euro land crisis as well as the better news flow from the US economy. Just take the following headlines from Bloomberg and you know exactly what kind of sentiment I am talking about.

Quote Bloomberg

U.S. stocks advanced, giving the Standard & Poor’s 500 Index its biggest weekly gain since July 2009, as retail sales beat economists’ estimates and the Group of 20 nations began discussions on Europe’s debt crisis.

(…)

U.S. 30-year bonds capped the longest weekly losing streak since January as concern eased that Europe is unable to curb its debt crisis and U.S. retail sales climbed, damping bets the country will fall into a recession.

The question is then whether it signals a decisive and lasting breakout or whether it was simply a rally to the top of a choppy range before we start another descend to test the lows. Recent weeks’ market movement suggest that you sell the current levels as the top of a post-crash range and I, for one, do not think we are out of the woods yet. It is important to emphasize two issues on the US economy when it comes to the likelihood of a recession.

First, the US housing market has never recovered and inventories remain low. This means that there is not much room for the economy to slump even if it does enter a recession. Any recession is then likely to be relatively short. Second, all liquidity gauges we are watching are pointing strongly upwards which is likely to provide strong tailwinds for risky assets 9-12 months out. Excess global liquidity and broad and narrow measures of money in the US are all shooting up.

In addition, we should consider the slow but sure movements by all four major central banks to increase either the short term liquidity or simply re-starting QE.

The BOE put itself at the front of the pack with the recent addition of another bn 75 GBP worth of QE, but likewise at the ECB it was interesting to see that long term liquidity operations were re-instated together with an expansion of the covered bond purchasing programme. Additionally, the ECB has been and will continue to be more or less forced to support bonds in the periphery, particularly in Spain and Italy, in order to ring fence the periphery from the coming Greek default. In comparison, the Fed’s latest much debated Operation Twist looks almost modest since it is, by the letter of the theory, not quantitative easing but rather qualitative easing [2]. Of course, the market is fully expecting the Fed to act aggressively should the economy falter further with a joint financing programme with the Treasury for long duration mortgage products as the most likely initiative alongside the more technical move in the form of reducing interest rates on excess bank reserves to negative.

I think it is important to realise that the Fed, with its latest actions, has its gaze firmly fixed on stimulating a recovery in the US housing market which is seen as the most important missing leg in an already faltering US recovery.

In Japan, the BOJ’s situation is different in the sense that economic has been distorted by first the devastation of the earthquake and then obviously the technical recovery as supply side disruptions have eased off. I take note of the fact that the BOJ has verbally put a lot of promises on the table in terms of stimulating the economy, not least, one would imagine, in relation to the ongoing strength of the JPY. Finally, it is worth pointing out that the BOJ’s balance sheet has actually expanded briskly in the past two months.

The main conclusion to draw here I think is that, while it is certainly not over yet, developed market policy makers are starting to open the floodgates. The euro zone crisis will remain a severe drag and like an almost chronic illness will continue to flare up. A disorderly Greek default can still not be ruled out and as the euro zone policy makers seem to take comfort on even a second of calm it seems to me that the market will have to push harder before we get a realistic proposal for a Greek default.

The recovery in the periphery (or obvious lack thereof) is still not working. The internal devaluation in the European periphery is alive and well when it comes to nominal wage increases which is getting a beating but in the context of lingering inflation in core and headline it leads to a squeeze in real wages and further depresses the recovery. The problem is that a sharp reduction in living standards through a decline in real wages to restore competitiveness is needed but if it occurs without any form of nominal currency depreciation not to mention in the context of very sticky core inflation, it just becomes counterproductive. Absent a fiscal union to socialise the risks it is difficult to see how the euro zone policy makers will be able to come with a fudge that will satisfy markets. In that regard I agree with Chris Wood here.

Ultimately, GREED & fear’s view on all of the above remain the same. This is that the only coherent end game for Euroland remains a formal move towards collective fiscal responsibility, which would ultimately address the fundamental cause of the present crisis. This is the financial fault line represented by monetary union without fiscal union. Euroland either has to go down this path or it has to confront all the problems associated with a break up since in GREED & fear’s view there is no “middle way”

One positive development on Greece is that the private sector involvement (PSI) proposal originally envisioned seems to have been abandoned for a much more realistic haircut.

But more challenging issues remain.

It was hardly surprising that the S&P downgraded Spain last week which only serves to underline the issue that while Greece may be the imminent worry the real problem lies in Spain and quite possibly Italy. There is a limit to the amount of Italian and Spanish bonds that the ECB can buy as long as it is evidently clear that growth prospects continue to remain difficult.

In emerging markets and touching on the theme I dealt with in my last instalment the recent inflation data from India indicate why I continue to think that investors may hold too high expectations for easing in big emerging markets.

Quote Bloomberg

India’s inflation exceeded 9 percent for a 10th straight month in September, maintaining pressure on the central bank to extend its record interest-rate increases.The benchmark wholesale-price index rose 9.72 percent from a year earlier after a 9.78 percent jump in August, the commerce ministry said in New Delhi today. The median of 21 estimates in a Bloomberg News survey was for a 9.75 percent increase.

Elevated inflation in India and China are crimping room for policy makers to ease monetary policy and support global growth amid Europe’s debt crisis and a faltering U.S. recovery. India’s central bank Governor Duvvuri Subbarao said yesterday that a more than 9 percent inflation is above “comfort level.”

Of course, the picture is not uniform here with notable economies such as Brazil and Indonesia already lowering interest rates but all eyes are currently on China (and secondarily India) and here I think that we will have to see stronger signs of a hard landing or a relapse into a more severe global slowdown we can expect policy makers to actively stimulate.

In summary, I think that we are indeed nearing an inflection point at which money printing in the developed world will once again provide relief to risky asset markets but the problem is that the underlying economic backdrop has not improved much. In particular, the ongoing lack of resolution in the euro zone represents an issue but Eastern Europe as well as a housing bubble in Australia (and perhaps even in Denmark) are also potential sources of uncertainty not to mention the unravelling of credit excess in China. As such, "it" is far from over but a tradable bounce in risky assets which goes beyond the current choppy range may soon present itself. 

—

[1] – I have been working with and building economic models for a while and all I can say is that they are seldom 100% right and the margin of error is always there when analysts make calls. The key is your ability to make calls which are transparent and add value to decision makers’ thought processes when they are made and not whether they were right in hindsight. This is not to say that it is unimportant to be right more times than you are wrong, but the future is awfully difficult to predict. If ever an analyst/advisor had a fiduciary role it is, in my opinion, to provide data and information which help investors making necessary decisions in the present not to make sure that the calls she made always come out right in hindsight.

[2] – The distinction between quantitative and qualitative easing is simple. The former refers to an expansion of the balance sheet through the central bank increasing its liabilities and adding a corresponding amount of assets. The latter refers to changing the composition of the asset side of the central bank’s balance sheet and as I am reading the gist of OT the Fed has committed to keep its balance sheet unchanged by selling short term bonds and buying long term bonds. Try this one for a good recap of what QE is and isn’t.