The Outlook for Macroeconomics

Editor's Note: This article was written by Damien Cleusix (damien (at) www.clue6.com). It is the third piece of a five-part series on Global Tactical Asset Allocation. To read the first part, click here; the second part, click here; the fourth part, click here; and the fifth part, click here.


“It’s frightening to think that you might not know something, but more frightening to think that, by and large, the world is run by people who have faith that they know exactly what’s going on.”
-- A. Tversky

“The best investors do not target return; they focus first on risk, and only then decide whether the projected return justifies taking each particular risk.”
-- S. Klarman

“Risk means that more things can happen than will happen."
-- E. Dimson

“The more you bet, the more you win…when you win.”
-- Las Vegas expression


The Causes of the Current Crisis -- Another Repeat

We need to put the rest of the macro analysis into perspective.

The New York Times recently published an article by R.Shiller titled "An echo Chamber of Boom and Bust." He wrote:
 

What happened? Economic analysts often turn to indicators like employment, housing starts or retail sales as causes of a recovery, when in fact they are merely symptoms. For a fuller explanation, look beyond the traditional economic links and think of the world economy as driven by social epidemics, contagion of ideas and huge feedback loops that gradually change world views. These social epidemics can travel as swiftly as swine flu both spread from person to person and can reach every corner of the world in short order.

That's it: At turning points, market trends change as the investors universal beliefs are proven wrong while during trends, the markets make the opinion. At turning points, the triggers are often hard to identify (in hindsight it always seems evident). It is thus important to try, as much as possible, to identify the potential triggers before they occur. One of the keys is to see how the markets react when they occur to see if they really are the “turning point." Market perception is of utmost importance, and the less it can discount the consequences, the larger the volatility.

What did cause the current crisis?

Since the spring of 2006, I've been warning that the credit build-up the world economy (mainly US and Europe) was experiencing would lead to a major shift in governments, banks, investors, and consumer perceptions and behaviors; a shift that would be a generational event (so it should last for approximately a generation). Regulators would wake up, banks behave like banks, investors rebalance -- by reason or constraint -- their portfolio toward less risky assets, and consumers spend less than what they earn.

The chain of events have unraveled as expected and should continue to do so. As with every trend, this development won't be linear and we'll have phases when investors will believe that the sky's the limit, but they'll be proved wrong. We'll surely see some bubbles develop and pop along the way, but the wash out will take much more time than one thinks. (Some emerging economies will be able to do quite well if they have the courage to make the necessary domestic reform and let Bretton Woods 2 die away).

This credit bubble was a bad bubble. It was mainly financed by banks and impacted unproductive assets, houses. The end result is that banks can't lend while there hasn't been any addition to the productive capacity. This bubble will also generate new regulations which will imperil financial innovations in the future (some will be good and necessary, some bad) and lower banks' capacity to lend. Money velocity will decline.

The bubble was born out of the belief that central banks had tamed the business cycle and that they'd use any means to prove it. Yes, technological advances, the imagination of the investment banks and hedge fund quant desks, or the semi-coma in which regulators seemed to have fallen allowed it to reach unheard-of proportions, but without this deification of central banks, it wouldn't have reached such a monstrous size. Apparent, believed stability, led to too much risk being taken and instability. Greenspan called it the "Paradox of Credibility."

The confidence in the system has now been eroded, but not as much as one would have expected. Indeed, many believe that the Fed has saved the day, once more.

The bubble also submerged a high number of countries, enterprises, and individuals with debt obligations that can't be paid or can be but only by living frugally, and probably killed the “consume now save later or never" mentality which was prevalent in many developed economies. Borrowing will be a dirty word and consumers will retrench to build up their savings.

Finally it led, by artificially lowering the cost of capital, to a global expansion of capacity which is going to haunt us for some time. Overcapacity will dramatically reduce the “earning power" of the global economy, especially where the operating leverage is high. This will, in all likelihood, encourage new protectionist measures around the world (not to be compared with the '30s, but...)

The consequence will be what Pimco’s B.Gross calls the “New Normal," i.e., de-leveraging (both financial and operating), de-globalization, and re-regulation.

But now for the present and near future.

We continue to see the current phase as simple normalization from the panic experienced at the end of last year and earlier this year on the back of an aggressive rise in excess money (monetary expansion over GDP growth or industrial production) and huge fiscal stimuli (even if besides China, a big chunk of the announced stimuli is yet to be spent). The impact has been much stronger on non-financial leveraged economy where the multiplication effect was in full swing (and was also helped by some government directives in less democratic countries like China). Trade was frozen as letters of credits couldn't be emitted, companies panicked slashing down production (with industrial production falling much more rapidly than sales) and laying off workers en masse. The latter point applies especially to the US.

So now let's look at the various elements in more details.

Leading Indicators

We are starting to see some divergences appear in leading indicators (Chart 1). The Chicago Fed National Activity Index YoY momentum has turned down. The same is true for the NFIB Index (and I'll have more to say on small companies later). The NFIB current level is consistent with an ISM manufacturing Index of 44 -- almost 10 points below current levels.



The non-manufacturing ISM is continuing to print significantly lower readings than the manufacturing survey. This is an excellent leading indicator of the ISM manufacturing survey as noted last September and imply a continuing deterioration here.

The Conference Board leading indicator monetary and financial indicators remain strong while the real economy indicators are rising much less vigorously.

The Japan Economy Watchers Expectation survey has continued to deteriorate (Chart 2). Remember that Japan is leveraged to the global cycle and has tended to lead other countries (note that the Yen strength should also be taken into account, so maybe not as bearish as otherwise). As an aside, the Topix correlation with this survey is extremely high, so use it when looking at your Japanese market exposure.





All in all, growth expectation could be too low for the fourth quarter of 2009 and the first quarter of 2010 while the expectation for the third quarter of 2010 and forward are probably too high. But a lot depends on the evolution of the fiscal stimuli, the Central Banks stance, and partly as a consequence, when the next shoe (probably Europe) drops.

Let's call them the swing factors. They're inventories, residential investments, and autos. They might represent a low percentage of the overall GDP, but believe it or not, they've contributed to all of the GDP decline in previous recessions before the current one (without them we wouldn't have had recessions). They also contributed to a big part of the initial rebounds (Chart 4).



Inventories have less influence as they represent a smaller share of GDP and they remain high (Chart 5). But one has to remember that it's the inventories quarterly rate of change that counts, so even if inventories continue to decline in the fourth quarter, they'll only have to decline less than in the third quarter to have a positive contribution to GDP. They'll add up to 4.5% to the growth announced for the fourth quarter of 2009 and the first quarter of 2010. Note that ISM inventories indices are falling again (to eight months' low) despite the fact that the supplier deliveries is above 50. Inventories are hard to finance, which leads to potential sales lost.