Tim Duy wrote a post on his blog on Sunday about his optimism about the US economy that got me thinking and I want to use it as a launching pad for a discussion about baseline economic scenarios. My baseline is positive, optimistic if you will. And in view of Tim’s post, I think this bears pointing out because a lot of us are looking for crises everywhere. While there are risks, and I like to concentrate on those risks, and I will point some out in this post, I also realize that the base case right now is positive, even in the eurozone. I’ll explain below.
First, let’s look at what Tim is saying:
The lesson no one wants to draw from this recovery is that the US economy is both stronger and more resilient than commonly believed. Everyone, it would seem, is in the pessimism business – and such pessimism seems endemic throughout the US public. Perhaps only pessimism scores political points. Or perhaps that is only human nature.
My take here: Tim is right. I’m sure a lot of the pessimism is a recency effect. People have been beat up by crises in the US, Europe and Japan to the point where we have a bit of economic PTSD. But, the US economy is and has been more resilient than commonly believed. I certainly pegged the US economy as likely falling back into recession within four years of the last recession in 2009. That has not happened, despite a record fiscal tightening and very anemic wage growth. So rather than expecting recession at any turn, we should understand that the baseline for the US economy is up. I don’t think it is up robustly, but it is still beyond stall speed, meaning the US will be hard-pressed to fall into recession any time soon due to exogenous shocks. Tim pegs the chances of recession in 2015 at 0% and says 2016 is close to that mark as well. I wouldn’t make that claim. But I would say that, for now, I don’t see a recession in the cards.
What about the oil shock? Just today, Reuters reported that shale oil permits were down 15% in October. That’s a pretty substantial decline, one that is also backward looking since we are into December and oil has dropped in price since October. I expect these numbers to get worse before they get better. There is going to be serious bloodletting in the fracking community. And that means lower capex. But from a national economic perspective, how much will this shave off GDP? Goldman sees a marginal 0.1% decline from the capex and employment hit, with a 0.3 to 0.4% add from the disposable income shift. So, on the whole, we should expect a growth increase from the decline in oil prices.
Let’s also remember that the decline in oil prices is, on net just a shift from oil producers to oil consumers. From a global perspective, we will see the uptick in consumption associated with that shift first. Only later will do we see the full downshift in consumption amongst producers. For example, the Saudis are still well above production cost at these levels. That means their only constraint is macro and fiscal. To the degree they are willing to tough this period out and dip into foreign reserves, we may see negligible cutback in demand from Saudi Arabia or Russia, which is in a similar position. Mexico says it has hedged a huge slug of its production. So there again, we cannot expect immediate cutbacks. It’s with the states in more precarious fiscal and external balance positions like Venezuela or Libya that we have to worry. And there the concern is more geopolitical than economic because these countries make up so little of the global economy. What I am saying is that high oil prices are like a regressive tax that hurts those with the greatest marginal propensity to spend the most while it hurts those with the lowest consumption demand elasticity the least. On net, lower oil prices are positive for growth.
The concern that I have with oil is more market related. High yield has beeen one of the best performing market sectors. But with oil prices down, energy HY issues are getting killed and this “puts U.S. corporate junk bond funds on track for their worst performance in six years”, according to Reuters. My baseline scenario here is for there to be defaults, a winnowing out of higher cost and over-leveraged producers over the next 12-18 months. And this will lead to high yield under-performing. But my worry is that the probability of a market crisis and contagion are much higher than zero. So, going back to Tim’s comments about pessimism, I am not pessimistic but I am concerned. And this is largely because I believe the shale boom is in part an artefact of excessively easy monetary policy as an offset to tight fiscal policy that has skewed resource allocation in a way that will produce crisis when that allocation adjusts. Right now we are seeing the adjustment. But because resource allocation has been so skewed toward risk and long-lived assets like shale, the adjustment process will be more extreme, more volatile, and therefore something that could create the next financial crisis. I am not saying this will happen, more that it could and that the likelihood is much greater than a Gaussian distribution of outcomes would have us believe.
David Merkel makes some good points here though:
Often the rate of change in a price can tell you something, particularly if the good in question is widely traded/held by a wide number of parties with different interests. In this case, I am talking about crude oil prices, and the related set of prices that are cousins.
Overall demand for crude hasn’t shifted, and neither has supply. Yes, there has been some buildup of inventories, and some key global players refuse to cut production in response to lower prices. But the sharpness of the price move feels more like some large player(s) who were relying on a higher oil price finally hit their “stop loss” point, and their risk control desk is closing out the trade.
I could be wrong here, but paper barrels of oil trade more rapidly than physical shifts in net demand, and risk control and margin desks will force moves that are non-economic. Wait. Surviving is economic, even at the cost of forgoing potential profits.
We’ll see how this shakes out over the next few months. There’s a lot of pain for pure play producers, and those that aid them. I particularly wonder at governments that rely on crude exports to support their budgets… they may not cut, but what will they do, if they don’t have reserves? Cuts will have to come from economic players initially. It make take a revolt to affect non-economic governmental entities.
All that said, sharp price moves tend to mean-revert, slow moves tend to persist, so be wary of too much bearishness here.
The question I have is when the mean reversion occurs. Right now, after oil went to deeply oversold levels on Thursday and Friday, we have temporary bounce back to less oversold levels. But my sense is that we will need to see a shakeout in the real economy of oil for the price decline to end. So mean reversion will occur but I don’t think we are there yet by a long shot. Now, remember, we’ve seen this kind of volatility before, with emerging markets in January and February. And that looked to be the real thing. But it turned into a mini-crisis, a harbinger of imbalances that presage something to come later or an opportunity for EM to get back into line with fundamentals. Since that time, emerging markets have been less bad and the talk of crisis has receded. We could witness the same in oil. We just don’t know.
This situation reminds me of how market outcomes and power laws come together at outlier events. Let me repeat something from May on how volatility plays out and add a few comments. In May, I wrote: “What Buchanan says is that many events in nature and the financial markets have event patterns defined more by power law probability distributions than by standard Gaussian bell curve distributions. This is what produces so-called fat tails. The way he describes it in the book is that fingers of instability build that individually could end in a market dislocation. If you think of a forest of trees, then the instability could lead to a forest fire. In markets, it leads to a market hiccup or melt-up. Now, when enough fingers of instability build up in nature, what happens is a catastrophe of unpredictable size and scope, an earthquake of 5.0 or 6.0 or 7.0 on the Richter scale or a forest fire of 100 acres or 1000 acres or 10,000 acres. The key here is that the fingers of instability come together to form a potentially catastrophic outcome that cannot be predicted in time or size but that varies in an exponential magnitude that is not consistent with a Gaussian distribution.”
Basically, new and future prices are never entirely independent of previous prices. And while this doesn’t matter in normal markets because the ‘error term’ is small, it matters greatly in extreme cases – like the fracking and energy high yield ones – when the error term from non-independent path movements is large. Read the whole May post because it talks about Jeremy Grantham’s Presidential cycle as well and the analysis is holding up well. The point I want to make here, however, is that power laws take over at market extremes and this reduces predictability around likely outcomes both in time and volatility. Recognizing we are in an outlier position in the energy sector, however, means adjusting risk appetite downward to take account of the volatility that we should expect.
Going back to the real economy and baseline cases for a second here, I caught something Ryan Avent wrote at the Free Exchange blog n reply to Tim Duy today that I agree with (emphasis added):
An historical comparison, by contrast, leads to a much bleaker assessment of the current recovery. The employment recovery since June of 2009 is the worst of any American rebound in the postwar period, and the GDP recovery is the second worst, outdone only by the performance after the 2001 recession. America remains well below the levels of output and employment one might reasonably have expected it to attain both before the Great Recession and in its immediate aftermath. It is true that growth in GDP and employment has been surprisingly—even shockingly—steady and resilient. But that makes it all the more remarkable that America has made up so little of the ground lost since 2007.
That brings us to another case for pessimism: the limited nature of the recovery. GDP is growing, but you can’t eat GDP. You can’t even eat employment. Incomes you can eat, if you spend them. Real GDP per capita is only a shade above its level of seven years ago: $50,675 now to $49,455 in the third quarter of 2007. At the median the performance has been much worse; real median household income tumbled from 2007 and has barely recovered.
For me, this is the second real reason people are glum, as Ryan puts it. The first was the recency effect. But policies to create recovery have entrenched a skew that has left the middle class wanting more. Look at what Laura Tyson says about outcomes in the US at Project Syndicate: “Since the recession ended in 2009, real consumption spending by the top 5% has increased by 17%, compared to just 1% for the bottom 95%.” That’s secular stagnation in action. And the reason is, as Harry Sender makes plain at the FT regarding Abenomics, is that the policy mix doesn’t address stagnant real wages. Japanese workers are reported today to have seen the 16th consecutive month of real wage declines due to Abenomics and rising inflation. To me, that’s policy failure.
What’s the outcome then? The currency wars of course. Beggar thy neighbour, with Japan leading the charge, drawing increasing retaliation from Asian neighbours along the way. China’s unexpected rate cut was not just the result of poor economic performance as signalled by declining rolling 4-month M2 money growth for the first time in recorded history. It was also the result of a need to compete in export markets with Japan that is trying to win through currency changes. Eventually, the Chinese will have to let their currency depreciate. And that’s when the U.S. Federal Reserve will be forced to make a policy response.
Right now, the U.S. economy is doing well. It will continue to do well for the foreseeable future under any reasonable baseline scenario. The strength of the economy is attenuated by slow real wage growth and increasing distress in the oil industry. To me, that still spells 2%+ growth at a minimum. Only if we see a major crisis in high yield bonds and leveraged loans should we call this prognosis into question, irrespective of how Japan and Europe are doing.
But Europe should be doing relatively better. In Greece, Q3 GDP was up 0.7% q-o-q, Greek retail sales were up for a fourth month in a row, the external balance is positive. And this is not all a basing effect. Portugal’s yields are at a record low 2.86% for 10-year borrowing, Spain’s unemployment is coming down fast and credit to households is increasing. Ireland is poised to grow 4.6%. The entire periphery outside of Italy and France is doing well. And what’s more, Europe will gain a lot from the decline in oil prices without much in the way of oil industry drags on growth. My baseline for Europe is now increasing. Absent exogenous shocks for a stall-speed Europe, watch for growth above expectations in Q4 and Q1 2015.
The bottom line here is that the baseline is positive, not just in the US but globally. The drop in oil prices will help a lot here. I have my eye on potential destabilizing events, but I don’t expect them to derail us at this point. Let’s see how low oil falls before we start changing our baseline.