It's a Recovery, But Not as We Know It

Capt. Kirk: What would you say the odds are on our getting out of here?

Mr. Spock: It is difficult to be precise, Captain. I should say approximately 7824.7 to one.

Maybe we need the Star Trek crew in the US Treasury (certainly some of the recent hires look and talk like alien life forms). I've never been in the deflation/depression camp, and have consistently argued that the scale of monetary and fiscal stimulus, particularly in the US and UK, allied to the windfall real income gains from falling prices, would generate an economic rebound in 2010. In particular, I considered the speculative spike in energy costs last summer as the critical tipping point that pushed a teetering US economy firmly into recession; at the time most economists recognized neither the nature of the mania in the oil market (which I shorted very profitably) nor its destructive economic consequences.

In 2009, oil importing nations will collectively save about $1.7trn on energy costs if oil averages the YTD $47 (from a $90 average in 2008), and that will do as much as all the official stimulus plans to create a platform for recovery. The inflationary versus deflationary tipping point has consistently been the key factor at the bottom of the cycle in previous bear markets, which is logical. Deflation kills equity value as the risk premium soars, as it had done from the Lehman collapse to the March reversal. All the great bear market bottoms have coincided with the reversal of deflation expectations, and looking at the Tips market (one of my favourite plays), pro cyclical equity sector rotation, and industrial commodity prices such as copper and platinum, for the US the overhyped deflation scare looks over (although globally pockets of deflation will occur in the worst impacted economies such as Ireland).

Recent leading indicator data is indicating that the pace of decline is abating, although no more than that. We are still probably 6-9 months from any broad economic upturn in the US on the best case scenario. Financial market indicators of risk appetite such as the EUR/JPY cross rate are all reflecting growing expectations of an imminent bottom and subsequent upturn, but it will be a very different one to historical precedent. For anybody seeking to understand the constraints on a US economic recovery, I recommend reading Richard Koo's The Holy Grail of Macroeconomics: Lessons from Japan's Great Recession. Koo, global strategist at Nomura Research Institute, is an expert on the balance sheet recessions resulting from the bursting of a huge asset bubble, which leaves widespread private-sector insolvency in its wake and debt minimization as the new priority of consumers and corporates.

This is a theme I've discussed many times; the focus of comment and policy is on credit availability, but the real issue going forward will be demand as the private sector deleverages. Until balance sheets are repaired, which will take at least 3-5 years, growth cannot regain sustainable momentum. US consumer spending and credit growth will be severely constrained in this scenario, as household net assets have collapsed from $64.5trn to about $47trn since mid 2007. Two key questions face equity investors: Have we seen the bottom for this bear market? And what will be the scale and sustainability of the rebound, given the unique economic backdrop we face? It's likely that a US recovery will be a very muted and erratic 'washboard' affair by historical standards, not dissimilar in many ways to the frustrating Japanese experience in the1990's, and certainly nothing remotely approaching the 4% annualized growth forecasts in the recent Obama budget, for a number of reasons:

1. Aggregate debt in the US economy is already about 400% of GDP with public sector leverage growth outpacing private sector decline; to reach 2003-7 growth rates of 3%, over $5 of leverage was added for each increment of income. That credit doped, illusory growth simply cannot be resuscitated. There is still no credible attempt to tackle the dysfunctional and insolvent US banking system, with radical reform stymied so far by the vested interests of bondholders and management. A dysfunctional banking system with excess capacity and an overhang of distressed assets will hinder a classic recovery.
2. Any rebound will take place in the context of declining labor force entrants (and declining participation rates) as discussed at length in previous commentaries on demographic decline. Added to rising taxation across the developed world to bridge unsustainable deficit spending, both factors will crimp aggregate discretionary income and productivity growth.
3. Inflationary resource scarcity hasn't gone away as a key constraint. Last summer, commodity markets declared a 'speed limit' on global growth, which had been running at 5% since mid-decade, and an incipient inflation crisis across the developing world was only averted by the autumn's financial crisis. Given structural supply constraints, exacerbated by the shortage of risk funding, even a muted global recovery will create spiking prices in many resource markets, particularly as China is pursuing an aggressive strategic stockpiling program from oil to copper. The respite afforded Western consumers in recent months as food and energy prices reversed is likely to be temporary, and rising commodity prices will again squeeze discretionary income into a recovery.
4. Key to any sustainable US recovery will be the housing market, which has already adjusted considerably. Housing starts which were running at more than two million a month at their height in 2006, are now running at about 500k, their lowest since records began in 1959. Mortgage refinancing activity has soared in recent months as Fed policy has managed mortgage rates under 5%, and probably to sub 4.5% by year-end (cue Wells Fargo (WFC) etc making windfall operating earnings) and there are pockets of regional recovery already. However, there are maybe 600k foreclosed but unsold properties on bank's books currently, while 1 in 9 properties nationwide remains empty (albeit concentrated in the areas worst afflicted by economic decline like Michigan). Normal cyclical factors will generate a degree of natural recovery, as with auto demand, but it will be restrained both by more conservative lender and consumer behaviour.
5. While the non-financial corporate sector has been busy putting its own house in order eg inventories have been cut aggressively, cashflows have been bolstered, while productivity has accelerated in this recession in contrast to the deep recessions of the Seventies and early Eighties, non-financials earnings have been remarkably resilient overall thus far and profit margins are still near 2007 highs; financial sector reported earnings may be bottoming (pre-exceptionals of course), but non-financials still have substantial downside as structural overcapacity bites in many industries.
6. Even a muted recovery will lead to greater competition for a much shrunken pool of risk capital, leading to rising long-term rates in capital markets. In particular, current Treasury yields, which underpin recovery hopes for the US housing market, will inexorably trending up over the next 12-24 months as official foreign demand wanes and inflation expectations adjust. The Fed's ability to simply monetize the debt burden will be severely tested sooner or later by those dormant but still potent bond vigilantes.

As for markets, although I alerted subscribers to a high probability trading opportunity in early March and was long S&P calls until last week, I don't believe we saw the despairing revulsion that marks true bear market lows, and the quality of the rally since, with an instant appetite for the most bombed-out pro-cyclical sectors, suggests the bear to bull switch was flipped prematurely. As ever, all we can do is invest on the balance of probabilities. Perhaps we have seen the absolute bottom in major equity indices and investor behaviour is different this time for a host of structural reasons; even then, the 'V' shaped economic and market recovery being touted by the usual suspects is a low probability outcome. More likely is that a bottoming process has begun, but it will be very extended and volatile, and we range trade between the recent lows and the January highs for several months, pivoting around 800 on the S&P.

However, there is a very significant risk that the concerted policy effort to paper over the underlying structural faults in the credit system will ultimately fail even in its own distorted terms, and precipitate a renewed crisis of confidence later in 2009 or early in 2010, pushing equities to a climactic cyclical low.

Disclosure: none

Comments

[themackattack:]

Excellent article Sean -- its this type of insight and analysis that helps me keep my senses when the world around us is filled with short term illusions.

Personally, I think we could see a crazy run up as far as 9k or an outside chance at 10k before reality sets in. However, the underlying facts you've pointed out are critical to keep in mind, and while its great to take advantage of senseless rallies, market volatility and downside risk are as present and likely as ever.

Apr 15 05:59 PM

[HardwoodFlo...:]

It's going to be up and down and sideways with a bit of an up trend.

Apr 15 06:20 PM

[The Geoffster:]

Stardate early 2010. These are the voyages of the Starship Dollar which left the Gold Standard planetary system 40 years ago to seek out and find new markets for derivatives and other complicated financial instruments where no man had gone before.Powered by a limitless drive system, the Starship Dollar has experienced critical mass that was thought to be impossible by its creators. Now marooned in a rapidly failing orbit, The Starship Dollar has run out of options to save itself before crashing down on Planet Commodity, leaving a crater the size of the Universal deficit.

Apr 15 07:03 PM

[THofler:]

A terrific article, even if I think you are overstating the negative.

I have a couple bones to pick:

Excess banking capacity a problem? The mergers of Bear, WaMu, Wachovia, and Merrill, and the collapse of Lehman constitute a huge decline in banking capacity. That's what they do in a merger; collapse down the redundancies. Unless they are misjudging the likely level of future needs right now.

A more conservative lender and consumer? Lender, yes. But the consumer will only be as conservative as the government and lender demand.

Apr 16 12:22 AM

[MGA_1:]

We have two more rounds of an economic beating coming our way: commercial real estate & alt-a/option arm resets. If there is any wonder what these will be like I'd say look what subprime has done to our economy so far. Once these two work their way through the system (ending around 2012 or so for alt-a/option arm) there is one more problem with the US - what the hell do we produce that other people want to buy (besides bad financial products)? This is a long downtrend.

The only thing that is difficult to predict is govt intervention - most recently 800 billion or so to fannie/freddie and 300 billion direct tbill purchases. This type of intervention will cause inflationary bumps, but it's not true recovery.

Apr 16 10:15 AM

[kelm:]

A very good article. I completely agree that we have structural issues and that they will likely manifest themselves later this year or next. That is likely what will put an end to the current rally. We are perhaps starting to see the first real failures in commercial Re. That ARM re-adjustments have yet to come. Personally, I think we things are strangely quiet on the pension side of things. Pensions have taken huge hits and that funding need will impact corporate earnings and state governments at some point. One wonders if pension funds are aggressively playing the current market rise in an attempt to get whole.

Apr 16 11:31 AM

[Allan Frain:]

While the number of dollars that must be introduced to create an additional dollar in economic activity has increased exponentially, the economic drag of increased debt has not decreased proportionately. Only a reduction of real debt levels can bring the system back to where traditional monetary and fiscal policies are effective. Reduction of real debt levels can happen through savings or hyperinflation. With a federal deficit at over 12% of GDP the course has been plotted. Personal savings and improved trade cannot make up the difference.

Apr 16 01:30 PM

[jclarke32:]

Very good read, covers the entire spectrum. Not doomsday nor wishful thinking. Thanks

Apr 16 04:17 PM