Slowdown in Economic Deterioration: Hardly a Recovery

Suppose they threw an Economic Recovery but nobody came? The last few weeks have seen all kinds of motley rent-a-quotes pontificating about green shoots, or rather a slowing down in the rate of economic deterioration, but a slowdown in the rate of something worsening is hardly the same as a recovery, not least because all economic data are inevitably subject to subsequent revision. And if existing data are unreliable, how to describe the accuracy of economic forecasts?

The Bank of England, for example, in its quarterly inflation reports uses "fan charts" that reflect various probability distributions. The problem with their latest projections for UK GDP is that they are all over the place; forecast output growth for 2011-2012 is seen at anything from +6% to -2%. Well, thanks for that.

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As the Bank admittedly concedes, "There are considerable uncertainties surrounding the projections of GDP growth and CPI inflation published in the Inflation Report." But one is entitled to ask whether forecasts that embrace such a wide variation in outcome should even be issued in the first place, except to underline just how ineffectual economic forecasting is.

Uberinvestor George Soros has noted that the "economic freefall" has stopped. Indeed. So has the trajectory of a person chucked off a tall building when he reaches the ground. ECB President Jean-Claude Trichet has seen sporadic evidence of "a picking up". So have spokespeople for fund managers Fidelity (Anthony "Bull Market" Bolton and Trevor Greetham) and numerous other long-biased firms. So, for that matter, has much of the financial media, no doubt mindful of who their advertising paymasters are. The problem in investment markets as in property markets is that it's extremely difficult to get truly impartial advice. Virtually everybody in the game has a vested interest in talking up the market, and- indirectly- their own funds.

The economy might be okay... Well, probably not now.

We see, intuitively, more reason to favour the views expressed by Merrill Lynch's outgoing economist David Rosenberg:

...the risk in the market... is much higher than it was the last time we were close to current market prices back in early January, for the simple reason that we believe professional investors have covered their shorts, lifted their hedges and lowered their cash positions in favour of being long the market..¡°While it may be the case that the pace of economic decline is no longer as negative as it was at the peak of the post-Lehman credit contraction, the reality is that employment, output, organic personal income and retail sales are still in a fundamental downtrend.

The proximate cause for all the 'green shoots' guff was almost certainly the straightforward bounce in the stock market off its March lows. This was admittedly impressive, taking the FTSE 100 from roughly 3,500 to roughly 4,500 in the space of just over a month. But as we indicated last week, the rising tide ('storm surge' may be a fairer coinage) did not lift all boats. Fundamentally oversold mining and engineering companies did well, but the lunatic fringe that is banks and financials did best of all, with the likes of Barclays (BCS) rallying by over 300% over the period. At the time of writing, Barclays was still widely reported to be considering selling off its crown jewels, in the form of fund management subsidiary BGI. So, innumerable banks will probably make it through the crisis, but they will have gone ex-growth in the process.

Under the circumstances, one might be tempted to conclude that the worst has passed. In terms of the 'armageddon' risk of systemic banking failures, that may well be the case: administrations around the world have raided a) taxpayers and b) the future in order to lay down a protective moat of liquidity around the ailing banking sector. But before we all go skipping over the sunlit uplands hand-in-hand chasing unicorns toward a rosier tomorrow, it should be borne in mind that the banks, like many inhabitants of the now shattered economic landscape, are in no position to regain their former profit-generative heights any time soon.

Pimco's Mohamed El-Erian refers to the current environment (in which we are likely to be becalmed for some considerable time) as one of DDR: De-leveraging, De-globalization and Re-regulation. The puppy of the state (what Ronald Reagan called an alimentary canal with a big appetite at one end and no sense of responsibility at the other) is now running uncontrollably around the living room, leaving messes here and there and trashing the economic furniture. As Luke Johnson put it in the FT last Wednesday,

The backlash against free market economics is growing. From the demented new laws surrounding hedge funds and private equity proposed by the European Union, to the 50%-plus income tax rates introduced in the UK, to the nationalisation of Chrysler, socialism is in the ascendance.

And his military metaphor is bang on. When the government parks its tanks on capitalism's lawns, that spells trouble for those who invest, add value and create jobs. Trillion dollar bailouts do not only leave massive public sector deficits in their wake (so the outlook for government bonds is less promising than the economic textbooks on deflation would have us believe), they also leave the presence of the heavy hand of government "all over industry and markets".

Philosopher Alain de Botton advised us at the end of April to shake off our misplaced optimism. There is good reason to believe that the only thing we really have to fear is not fear, but hope. It is hope that is luring investors back into the stock market, also known as the fear of missing out. But two sunny days do not constitute a new environment of global warming. And the meteorological
analogy is probably fair: we may be able to forecast one or two days ahead with reasonable accuracy, but try a month. The same holds for the stock market. A surge in liquidity has temporarily buoyed stocks, but the economic future remains fraught. Investors will be well served by holding to a plan, rather than allowing their investment strategy to be dictated by the random oscillations of a febrile market desperate for good news.

Among Pimco's conclusions are that it makes sense to favour "credit spreads higher up in the economic and capital structure and, increasingly, on an even more international basis".

We couldn't agree more. There has been a giant sucking sound in the markets over recent months as investors have stampeded, not just into oversold equities of uncertain value, but into corporate bonds. On a selective basis that makes sense, but in the aggregate, the corporate bond market, we would argue, is now overvalued. And the trend is dangerous, because corporate default rates are almost certain to rise further as the slowdown (illusory green shoots withstanding) winds on and consumers rebuild their balance sheets as opposed to resume their previous spending habits. The stand-out value, we would suggest, is in debt issued by highly creditworthy sovereign issuers (versus both corporates and fundamentally indebted G7 sovereign issuers) . More on this theme in due course.

Comments

[Alan von Al...:]

Thank you, Tim. Low volume hijinks and euphoria are noise. Looking forward to your next piece on sovereign debt.

May 19 06:53 AM

[market ace:]

Excellent article and your statement about we have nothing to fear today except (false) "hope" is right on.

The stock markets are aglow and financial stocks soaring on lies and phony stress tests. The WSJ reported today that their review of smaller banks showed 600 did not pass their test. The big banks that do survive (floating on tax payer life boats) will only be a shell of their former selves and not the financial giants they once were. If everything is so rosey in the banking sector why did congress just approve another $500 bbl for the FDIC?

Soon even Wall Street and the clueless media will realize that "less bad" is not good and "recovery" will mean muddling along with a sick economy for many, many years.

May 19 11:45 AM

[conceptwizard:]

Its not so much when the bottom hits or if we have stopped falling. Its the pace of recovery which will be very slow. Jobs dropping at even 400,000 to 500,000 per month will mean 11% unemployment. When the markets realize that the corporations valuations are to high to maintain shareholder value there will be a correction.

May 19 12:49 PM

[Fighting Yoda:]

Yes less bad is never good, 500K+ job losses a complete disaster, with GM Chrysler mega bankruptcies – 500K+ job losses are certain for a long time (American Express threw in an additional 4K unexpected today).

Price action in the stock market is the most cited green shoot. Despite the myth and hype Wall Street creates for itself - stock markets are always wrong - else you will not have these massive bubbles and busts. The current market has predicted six of the none recoveries. These economists turned botanists are all clueless - these are the same people who saw nothing coming - have been predicting no recession, recovery in the second half of last year.

Some green shoots did die with: Housing starts 'unexpectedly' slid 13 percent to an annual rate of 458,000, led by a 46 percent tumble in multifamily starts.
Medtronic’s - maker of must have medical devices reporting downturn in sales - earnings dropped 69%, and plans to cut as many as 1,800 jobs.

This is structural downturn, no easy quick fix here. The stimulus and bailouts will cushion the pain but there is the inevitable hell to pay down the line - severe tax hikes are in the cards.

May 19 01:59 PM