Rebel Traders – Analysis Without The Hype

Bearish commentators have been insisting heavily on the lack of resumption in consumer spending to justify doubts on a US recovery, or even the possibility of a double-dip recession by 2010 (other commentators have ascribed a possible double-dip to hyper-inflation, so you can make your choice in the matters of bearish scenarios).

However, an important factor that might be missed is the increase in US savings. In a recent interview,  Jim McCaughan, a representative of Principal Global Investors, pointed out some elements to give a more nuanced image of the US economic situation.

Whereas he believes that a number of smaller banks shall not be able to survive the losses on RE loans, he points out that the larger banks have been adequately immunized by their capital raise. While a lot of reservation can be expressed as to his assessment that US large banks are “transparent”, it remains that the logic of “too big to fail” holds true.

However, McCaughan also points out that the short-term perspectives might be bleak for the economy, considering that the high savings rate also means less consumer spending. But and that’s a point worth noticing, he also points out what I’ve been considering as a “paradigm change”. The high rate of savings is a negative aspect if you take a keynesian perspective; in a monetary perspective, a high rate of savings means more money available for investment.

The danger in considering only the negative side of the hike in savings is of missing the formidable paradigm change and the chance for the US economy if no other issue adds up on to the current predicament.

The reduction in spending means of course a reorganization of the economy and an evolution of the various sectors in order to adapt to more frugal consumers and to use to the best the cash made available by the savings. For one thing, this cash could help to absorb a part of the US debt nationally, and it might be invested into the development of new technologies or sciences. On the whole, once the necessary adjustments done, the economy could emerge stronger, with a strong investment arm (provided that the banking culture is reordered towards longer-term objectives rather than high short-term returns), and provided the necessary steps are taken, with a new industrial sector.

However, precisely because the recession has been accompanied by enormous productivity gains, it should not be expected that personnel is going to be hired in droves any time soon. These same productivity gains and cost-cutting could give some additional surprises in the upcoming earnings season, despite the more or less tepid recovery seen so far.

But the mix of high productivity, the high level of savings and the painful social differences between the “have” and the “have-nots” will make it imperative for the US to develop a social policy at the government level to handle a social rift that might become only more pronounced.

The U.S. economy’s recovery from its worst recession since the 1930s will be helped as savings climb to the highest level in 24 years, according to Jim McCaughan, the chief executive officer of Principal Global Investors.

Americans will keep up to 9 percent of their disposable income in the bank, the most since 1985, said McCaughan, who oversees $201 billion, in an Oct. 2 interview. While less spending will cut U.S. growth and profits at retailers, it will make the expansion last longer by reducing household debt and the nation’s trade deficit, he said.

“You’re going to see a pretty tepid recovery,” McCaughan said in New York. “You’ll have a less leveraged personal sector and financial sector. You’ll get growth. It won’t be 5 percent, it will be 2 percent. That isn’t so bad.”

The outlook echoes predictions from Richard Clarida of Newport Beach, California-based Pacific Investment Management Co. and Gary Shilling, president of A. Gary Shilling & Co. in Springfield, New Jersey. Clarida, whose firm runs the world’s largest bond fund, estimated the savings rate may exceed 8 percent. Shilling said Americans are on a decade-long “savings spree” that will restrain the economy. Both spoke in Bloomberg Radio interviews last month.

Consumers lost $9.67 trillion of wealth last year as the housing bubble burst and the Standard & Poor’s 500 Index fell 38 percent, the most since 1937. The declines spurred them to push savings up to 5.9 percent in May, the highest since 1998. The rate slid to 3 percent in August, above the three-year low of 0.8 percent in April 2008, Commerce Department data show.

Belt Tightening

Only 8 percent of U.S. adults plan to increase household spending, almost one-third will spend less, and 58 percent expect to “stay the course,” according to a Bloomberg News poll from Sept. 17. More than three in four adults said they reduced spending in the past year, the survey showed.

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“You need a more balanced economy,” McCaughan said. “Consumer spending got to 70 percent of the U.S. economy. That’s actually unsustainable.”

The median economist surveyed last month by Bloomberg forecast U.S. growth of 2.4 percent next year and 2.9 percent in 2011. That compares with the gross domestic product expansion that exceeded 3 percent in 2004 and 2005 as consumers used cash extracted from their real-estate holdings to fuel spending.

More Failures

McCaughan predicted more failures at smaller banks as they struggle with mounting losses on real-estate loans. Larger lenders have been strengthened by government cash infusions, he added. Almost 100 U.S. banks have collapsed this year, the most since the savings-and-loans crisis of the early 1990s.

“There will be more land mines” in regional lenders, McCaughan said. “The large U.S. banks have been very good at being transparent. They’ve raised a lot of capital, so I think they’re in fundamentally quite a strong position.” (…)

We pointed out a previous economic analysis by Andy Xie on the subject of a crash predicted for 2010 by the Chinese economist… Back in June 2009.

However, as economy is a living human science, economists are bound to adapt their analysis with the evolution of the economy.  However, Andy Xie confirms his outlook of a second dip by 2010, taking into account the new bubble created by the assets.

Short-term however, Andy Xie points out that the markets should do well for the coming two months. He also reaffirms his belief in an inflationary scenario, which, for me, is somewhat questionable. True enough, expectations and market games can push assets prices upwards (the “self-realizing” prediction to which Andy Xie is affectionate). But in the end, the realization that the economy is moving slower than expected should just kill that inflationary play, lowering assets prices and at that point the question would be whether the dip in assets prices would kill the economy or give it the oxygen it needs to continue recovering.

Needless to say, Andy Xie finds that a keynesian policy will not work in the US, for the simple reason that the US consumers have been shocked into saving. Recreating another bubble seems the policy being effected right now and whereas it will be effective for a while, it may (and probably will) backfire on the long run. In short, a worthwhile analysis to read by anyone who has the desire to go look behind the media coverage and look at the workings of the economy. Also, it brings some much needed discussion of Keynesian theses vs the governments’ policies.

In a normal economic cycle, an inventory-led recovery would be followed by corporate capital expenditure, leading to employment expansion. Rising employment leads to consumption growth, which expands profitability and more capex. Why won’t it work this time? The reason, as I have argued before, is that a big bubble distorted the global economic structure. Re-matching supply and demand will take a long time.

The process is called Schumpeterian creative destruction. Keynesian thinking ignores structural imbalance and focuses only on aggregate demand. In normal situations, Keynesian thinking is fine. However, when a recession is caused by the bursting of a big bubble, Keynesian thinking no longer works.

Many policymakers actually don’t think along the line of Keynes versus Schumpeter. They think in terms of creating another bubble to fight the recessionary impact of a bubble burst. This type of thinking is especially popular in China and on Wall Street. Central banks around the world, although they haven’t done so deliberately, have created another liquidity bubble. It manifested itself first in surging commodity prices, next in stock markets, and lately in some property markets. Will this strategy succeed? I don’t think so.

The lifespan of a bubble depends on how it affects demand. The longest-lasting are property and technology bubbles. The multiplier effect of a property bubble is multifaceted, stimulating investment and consumption in the short term. The supply chain it impacts is very long. From commodity producers to real estate agents, it could stimulate more than one-fifth of an economy on the supply side. On the demand side, it stimulates credit growth and financial sector earnings, and often boosts consumption through the wealth effect. Because a property bubble is so powerful, the negative effects of a bursting are great. Excess supply created during a bubble’s lifespan takes time to consume. And a bust destroys the credit system.

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A pure bubble tied to excess liquidity that affects one or many financial assets cannot last long. Its multiplier effect on the broad economy is limited. It could have a limited impact on consumption due to the wealth effect. As it neither stimulates the supply side nor boosts productivity, whatever story it is based on will have holes that become apparent to speculators. It doesn’t take long for them to flee. Furthermore, a pure liquidity bubble without support from productivity can easily lead to inflation, which causes tightening expectations that trigger a bubble’s burst.

What we are seeing now in the global economy is a pure liquidity bubble. It’s been manifested in several asset classes. The most prominent are commodities, stocks and government bonds. The story that supports this bubble is that fiscal stimulus would lead to quick economic recovery, and the output gap could keep inflation down. Hence, central banks can keep interest rates low for a couple more years. And following this story line, investors can look forward to strong corporate earnings and low interest rates at the same time, a sort of a goldilocks scenario for the stock market.

What occurred in China in the second quarter and started happening in the United States in the third quarter seems to lend support to this view. I think the market is being misled. The driving forces for the current bounce are inventory cycle and government stimulus. The follow-through from corporate capex and consumption are severely constrained by structural challenges. These challenges have origins in the bubble that led to a misallocation of resources. After the bubble burst, a mismatch of supply and demand limited the effectiveness of either stimulus or a bubble in creating demand.

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Recent data point to a sharp increase in the household savings rate in the United States. Over two years, it rose above 5 percent from minus 2 percent. The current level is still below the historical average 8 percent. If normalization remains on track, it should rise above 8 percent, and probably reach above 10 percent, to bring debt levels down to the historical average.

Some argue that, if low interest rates revive the property market, American households may be willing to borrow and spend again. This scenario is possible but not likely. The United States has not experienced serious property bubbles in the past because land is privately owned and plentiful. A supply overhang from one bubble takes a long time to digest. And American culture tends to swing to frugality after a bubble. One’s outlook either for a normal recovery or a bubble-inspired boom depends on the outlook for the U.S. household savings rate. Unless the U.S. household sector is willing to borrow and spend again, emerging economies will not be able to revive the export-led growth model.

If one accepts that the U.S. household savings rate will continue to rise, emerging economies must decrease their savings rates, increase investment, or decrease production. The best choice is to decrease savings rates. But savings rates are hard to change. They depend mainly on demographics and wealth levels. The quickest possible way out would involve creating an asset bubble that inflates household wealth and decreases savings. Many advocates of inflated property and stock markets in China have this effect in mind. Japan’s bubble after the Plaza Accord in 1985 had its origin in the same dilemma. This approach, if it works, has catastrophic long-term consequences. Japan remains mired in stagnation two decades after its bubble began to burst.

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Conventional wisdom says inflation will not occur in a weak economy: The capacity utilization rate is low in a weak economy and, hence, businesses cannot raise prices. This one-dimensional thinking does not apply when there are structural imbalances. Bottlenecks could first appear in a few areas. Excess liquidity tends to flow toward shortages, and prices in those target areas could surge, raising inflation expectations and triggering general inflation. Another possibility is that expectations alone would be sufficient to bring about general inflation.

Oil is the most likely commodity to lead an inflationary trend. Its price has doubled from a March low, despite declining demand. The driving force behind higher oil prices is liquidity. Financial markets are so developed now that retail investors can respond to inflation fears by buying exchange traded funds individually or in baskets of commodities.

Oil is uniquely suited as an inflation hedging device. Its supply response is very low. More than 80 percent of global oil reserves are held by sovereign governments that don’t respond to rising prices by producing more. Indeed, once their budgetary needs are met, high prices may decrease their desire to increase production. Neither does demand fall quickly against rising prices. Oil is essential for routine economic activities, and its reduced consumption has a large multiplier effect. As its price sensitivities are low on demand and supply sides, it is uniquely suited to absorb excess liquidity and reflect inflation expectations ahead of other commodities.

If central banks continue refusing to raise interest rates during these weak economic times, oil prices may double from their current levels. So I think central banks, especially the Fed, will begin raising interest rates early next year or even late this year. I don’t think it would raise rates willingly but wants to cool inflation expectations by showing an interest in inflation. Hence, the Fed will raise interest rates slowly, deliberately behind the curve. As a consequence, inflation could rise faster than interest rates, which is what the indebted U.S. household sector needs.

This fool-the-market strategy may work temporarily. Its effectiveness must be reflected in oil prices; the Fed needs to target oil prices in its interest rate policy. If oil prices run from current levels, it means the market doesn’t believe the Fed. That would force the Fed to raise interest rates quickly which, unfortunately, would trigger another deep recession.

Instead of a V-shaped recovery, we may instead get a W curve. A dip next year, although perhaps not statistically deep, could deliver a profound psychological shock. Financial markets are buoyant now because they believe in the government. The second dip would demonstrate the limits of government power. The second dip could send asset prices down — and keep them down for a long time.