Understanding the 'Q' Recovery 32 comments
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There’s been an active discussion as to whether we should expect an “L” recovery or a “V” recovery. For those not familiar with these terms, each letter resembles the shape of a GDP graph of the respective scenario. In other words, an “L” recovery represents a sharp economic decline followed by a period of zero growth. The “V” scenario represents a similar drop, but one followed by a robust recovery. Those seeking to fit our current economic environment into one or the other of these categories miss the point — we are in a recovery that has elements of both scenarios. I argue that we are in the early stages of a “Q” recovery. The letter “Q,” after all, is the letter precisely between an “L” and a “V.” But this is more than a mere hybrid or average of these latter two. The “Q” recovery is a distinct animal that must be understood on its own terms.
"V", "L" or "Q"?
History certainly favors the “V” scenario. Most recessions snap back relatively quickly. The pattern is straightforward as businesses cut production in the midst of a downturn, but retain the capacity for greater output while reducing their costs and inventories. When demand improves, the lack of inventory means that demand translates almost immediately into increased production, taking advantage of the excess capacity. With the leaner cost structure and no need for increased capital expenditure to meet the production needs, corporate profits soar (an important GDP component). The higher corporate profits, in turn, both reflect a pickup in existing demand as well as spurring future demand through higher employment and investment. The current aggressive monetary policy and the large fiscal stimulus package all support the case for the traditional V-shaped rebound.
Despite the historical case for the “V,” there’s a compelling, and I think, stronger argument for an “L” recovery. It is increasingly apparent that the fiscal stimulus was poorly constructed, and that we won’t get much bang for the buck. Monetary policy is only effective if it results in the extension of credit and a pickup in consumption. Credit remains constrained by our wounded and undercapitalized financial system — it will take years for earnings to fill in the holes in the balance sheets of some of our largest banks. Even where credit is available, some of the traditional routes by which that was transformed into consumption no longer function as they did in the past. In particular, the inventory overhang in housing means that even low-cost and accessible mortgages won’t necessarily result in new construction.
The most convincing case for the “L” recovery lies with the broader case for weaker consumption. Unlike past recessions, the U.S. consumer will not return to pre-recession spending. The past decade’s wealth effect, whereby higher stock portfolios and higher home prices spurred consumption, now works in reverse. Income once directed to spending will now be diverted to rebuilding shrunken retirement savings. Demographics will be our economic destiny as aging baby boomers have entered the phase of life where acquisition tails off and downsizing begins. Finally, the spirit of the times reflects a certain frugality and seriousness; starting in mid-2008, the number of Google searches for “coupons” exceeded the number of searches for “Paris Hilton,” and the trend continues – these are somber times indeed!
Some Bright Spots
Despite the strong case for a zero-growth environment, there are some bright spots that suggest that things are not as bad as they seem, and this strange “Q” recovery will be our future. Internationally, decades of outsourcing business to India and China can alternatively be viewed as building the future prosperity of those nations. We may soon reap dividends from that investment. The emergence of a middle class in those populous countries brings demand for U.S. exports of technology, agriculture and airplanes, to name but a few. Domestically, productivity continues to improve in defiance of set patterns of earlier recessions. Labor flexibility has clearly played a role here, but this also reflects the fact that internet and telecommunications technology will continue to enhance economic growth. All these positives will not be enough to fully offset the unusal weaknesses of this business cycle, but they argue that proponents of the “L” scenario are overly pessimistic.
For investors, what does the “Q” recovery mean? The equity market rebound since early March has already given us a glimpse of the future. The characteristics of the current rally defy our historical experience, with growth stocks leading the way and large company performance in a dead heat with small-caps, contrary to most early stage moves. Whenever markets move against historic patterns, the best bet is to assume that trend will continue. Certainly fundamentals point to the continued dominance of large companies, with their superior access to credit, global markets and lobbyists who shape new regulations to their advantage. Those companies able to garner growth will gain superior multiples in the slow growth “Q” recovery. Those that do succeed will find their growth may be largely driven by business investment and emerging market demand, rather than domestic consumers, yet another twist in our unusual environment.
For most of this decade, investment advisors “beat the S&P” not only by loading up on U.S. small cap companies, but by benefitting from the superior returns of foreign stocks. Much of the overseas outperformance was due to currency translations; as the greenback fell in value, the price of foreign-denominated securities gained in dollar terms. In the “Q” recovery, the dollar is likely to be range-bound, and that inherent currency advantage will not be present. This doesn’t mean there are no opportunities abroad, particularly in the emerging markets, but it does suggest that investors will no longer “have the wind at their backs” in this asset class. Recent data have suggested that European economies are ahead of the U.S. in recovering from the global recession. This does raise the possibility that investment flows to those economies could boost their currencies, but investor expectations should focus on foreign stocks as a valuable diversification rather than the star of their portfolios. While emerging markets offer far more growth potential for outperformance, the size of those markets relative to global inflows suggests volatile boom/bust cycles ahead for equity investors in that sector; prudent participants would be well advised to be more tactical in approach.
For the first time in years, corporate bonds and select tax-exempt bonds offer the opportunity for competitive investment returns, and will likely outperform cash and money markets. Fears of government deficits and the reliance on global capital for financing that debt could well keep real U.S. Treasury rates high. While the commodity price component of inflation measures may be resilient, slack domestic growth and continued productivity gains will moderate overall inflation. Credit spreads can contract from current levels, but the past year’s interventionist government policies will leave a legacy of uncertainty as to “rules of the road,” preventing a return to the narrow spreads of 2005/2006. Municipal bonds will suffer from credit uncertainty as their issuers struggle to rationalize their commitments with a slow-growth economy. From current levels, munis are best viewed as “coupon-clipping” opportunities, but, on a risk-adjusted basis, not unattractive relative to other capital markets.
The “Q Recovery” will offer investors diverse opportunities, but not broad opportunities. This will be far from the “rising tide” markets of past cyclical upturns. However, within the more narrow circle of winners, we believe returns will more than justify the risks of investment.
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This article has 32 comments:
C + I + G + (X - M)
C = Consumption
I = Investment
G = Gov't spending
X = Exports
M = Imports
One could reply that corporate profits show up in the "I" portion, but that is not the case. All coporate profits occur at the bottom of the income statement, after all investment moneys (e.g., capex) have been spent. You make a strong case, but one that could be strengthened further by being a bit more careful with the terminology. Overall, though, a good piece.
Under a previous article, I commented that the US export policies should be retooled to maximize our chances in international trade. Over the long-run, through ruinous fiscal policies, we will kill the dollar, which should help US exporters. In addition to streamlining a bureaucratic maze that must be pierced before obtaining a license, we should do everything humanly possible, while remaining inside of GATT/WTO guidelines, to fascilitate exports.
In parallel, we should take firm steps to ensure that intellectual property rights are respected across the globe.
Here's an excerpt from a speech given by San Francisco Fed Janet Yellen drawing the same conclusion:
"I don’t like taking the wind out of the sails of our economic expansion, but a few cautionary points should be considered... a massive shift in consumer behavior is under way.. American households entered this recession stretched to the limit with mortgage and other debt. The personal saving rate fell from around 8 percent of disposable income two decades ago to almost zero. Households financed their lifestyles by drawing on increasing stock market and housing wealth, and taking on higher levels of debt. But falling house and stock prices have destroyed trillions of dollars in wealth, cutting off those ready sources of cash. What’s more, the stark realities of this recession have scared many households straight, convincing them that they need to save larger fractions of their incomes.... a rediscovery of thrift means fewer sales at the mall, and fewer jobs on assembly lines and store counters....
This very weak economy is, if anything, putting downward pressure on wages and prices. We have already seen a noticeable slowdown in wage growth and reports of wage cuts have become increasingly prevalent—a sign of the sacrifices that some workers are making to keep their employers afloat and preserve their jobs. Businesses are also cutting prices and profit margins to boost sales..... With unemployment already substantial and likely to rise further, the downward pressure on wages and prices should continue and could intensify....
If the economy fails to recover soon, it is conceivable that this very low inflation could turn into outright deflation. Worse still, if deflation were to intensify, we could find ourselves in a devastating spiral in which prices fall at an ever-faster pace and economic activity sinks more and more."
"Falling prices." "Deflation." "Devastating spiral." That's not the kind of honesty that one expects from a Fed chief. Yellen must not be drinking the lemonade.
An interesting and optimistic take on "outsourcing." Where do I get the dividends from my "investment?" If you ask me, we should invest even more so our future returns will be even bigger.
I continue to call for an ampersand-shaped recovery, &. We start backwards, then we rise a bit and move slightly forwards before starting down and backwards again, then straight down to return to where we started.
On Aug 18 11:29 AM Tony Petroski wrote:
> The author: "Internationally, decades of outsourcing business to
> India and China can alternatively be viewed as building the future
> prosperity of those nations. We may soon reap dividends from that
> investment."
>
> An interesting and optimistic take on "outsourcing." Where do I get
> the dividends from my "investment?" If you ask me, we should invest
> even more so our future returns will be even bigger.
>
> I continue to call for an ampersand-shaped recovery, &. We start
> backwards, then we rise a bit and move slightly forwards before starting
> down and backwards again, then straight down to return to where we
> started.
"Labor flexibility has clearly played a role here, but this also reflects the fact that internet and telecommunications technology will continue to enhance economic growth."
So many macro economic articles act the world hasn't changed since 1920.
At least Regan gave a bone to the public in cutting taxes. So far I see nothing but empty promises the last 10 years.
Profits influence stock price; stock price influences consumer psychology; consumer psychology (the perception of the destruction or creation of wealth based on paper profits or losses in 401K's, etc) influences consumption.
Seems like there is more consumption when corporate profits are higher...
Corporate profits --> Optimistic market perception of company --> Stock rise --> CEO cashs in on options --> CEO buys a yacht, new home, etc. --> Consumption
If so much of our wealth is controlled by the top 1%, let's hope they spend.
To add to Moon's comment, at least with trickle down Reagonomics we had the ability to lower taxes to stimulate consumption and growth. Thanks to the last decade of tax cuts, during our opulant boom years of course, we are about as low as we can go. Don't you see that we will need to raise taxes? Do you all understand what effect that will have?
I do wonder about the "permanency" of this new behaviour by American consumers to one of savings vs buying. The huge loss in savings by those invested in the market, I am sure is having a save and catch up effect among that huge cohort - the Baby Boomers. I am just not sure how long it will last.
And also, it seems to be different from the behavior of other age cohorts. As I look about me in my own town, and friends, I do not see that change among the young, especially young families. Those who have jobs, especially jobs that seem relatively secure, continue to charge and spend, and save little.
Could be my observation is wrong, or just too limited by own location and circle of friends and family, but even if it is not, the question remains how important that is to the consumerism in our country that has reigned for so long.
I do not know, but someone is going to have to do a better job to convince me that nearly 50 years of American behavior from the late 60s till now, is going to radically change for the next decade or even 5 years, because of this near depression.
And by the way, the Q idea is part of the ancient science of mercantilism. One must wonder if the EM states will import and if so what will they use for money? Under the old rules the developed state over changed the client state for its goods, and underpaid for the raw resources it received. The net gains from trade were always in the developed states favor. Caused several wars. Try not to worry this is unlikely to happen anyway.
On Aug 18 09:26 AM Desiderius Erasmus wrote:
> Jeffrey, your thesis is compelling, and one I ascribe to myself.
> A quibble, though: there is an error in the second paragraph of the
> piece. Corporate profits are not "an important GDP component" --
> they are no component of GDP at all. The GDP calculation does not
> include corporate profits. The formula for GDP is:
>
> C + I + G + (X - M)
>
> C = Consumption
> I = Investment
> G = Gov't spending
> X = Exports
> M = Imports
>
> One could reply that corporate profits show up in the "I" portion,
> but that is not the case. All coporate profits occur at the bottom
> of the income statement, after all investment moneys (e.g., capex)
> have been spent. You make a strong case, but one that could be strengthened
> further by being a bit more careful with the terminology. Overall,
> though, a good piece.
Emergency room physicians talk of the "O" sign. It is significant in a patient - not a good sign - with their mouths is open and not very responsive - this is bad. The next step from the "O" sign is the "Q" sign. This is worse as the tail of the "Q" is a the patient's tongue hanging out. This is far worse then the "O" sign. "Q" is a bad development.
Actually - the combination the "V" and the "L" recovery should more properly be called "TV Antenna" recovery. Or maybe the "Inverted Clown hat on a Step" recovery. I crack myself up.
Ok. Read the signs. Last week consumer confidence was down - anyone who makes investment decisions on that data should not be allowed out in public without a guardian. The real way to figuer out waht is going on is to pay attention to Back to School. Everyone expects it to be lousy. If it is just slightly below average the market will blow out the doors. So far retailers are making encouraging noises. That plus initial claims and housong are the key right now.
That's all.
That's the one where our economy is circling the drain.
1. There is very little excess spending or borrowing capacity in the US Consumer - Who comprise 70% of the GDP.
2. We are now a service economy and must sell our services overseas to those economies that are expanding - and those are the NATURAL RESOURCE rich economies: Canada, Saudi Arabia, The Emirates, Brazil, Nigeria, Australia, etc. To do that our cost must drop, and the US government is doing just that, by devaluing the dollar.
When the dollar gets to about $2/Euro, and $1.20/100Yen, we will start to get a recovery.
3. The stock market recovery in the US and Europe is a Bear Market Rally. The PE ratio of about 40 in Europe and 17 in the US needs to drop to about 7 in the US, (the traditional market low PE) and dividend yields of about 4% (versus the current 2%).
4. This drop in the value of the dollar and in the value of stocks will devastate individual's net worth and cause oil and commodity prices to skyrocket. Since we are the world's breadbasket, US farmers and food producers will do well. However, most of us will not. (at least not initially)
5. However I am an OPTIMIST, and am investing in commodity producers outside the US, and holding the MAXIMUM debt I can safely service (at fixed interest rates).
SUMMARY:
Decreasing value of the dollar overseas.
Increasing Commodity prices
Decreasing value of the doller inside the USA
High Inflation (same as above)
One of the best opportunities in the past decade to make tons of money.
There is alot of hard eveidence out there that does not look pretty, but guess what? Let's not go there, after all, it might scare someone.
Just simple economics.
In a perfect world I'd agree with this but as anyone who has read about China and India knows they aren't playing fairly with tariffs and governmental interference on imports to their countries. China's manipulation of its currency puts its products at an advantage and those products made in the USA at a disadvantage. And that's not discussing their prohibitive impost policies and their 'Buy China' policy.
As I see it, all the outsourcing done will continue to be devastating to the USA and to American workers. Until the USA can become an 'exporter' nation, rather than an 'importer' nation our economy cannot really grow and the wealth of the USA will continue to be drained as exemplified by our trade deficits.
In addition, I don't have any faith in Wall Street and its ilk; in the past I did, but a new breed of 'cowboy' has overtaken it. My friend's dad who worked on Wall Street in the 60s - 90s is mystified by what is taking place and the unrelenting greed that has overcome moderation and common sense. They are using our 401K and IRA money as if it was Monopoly money and making wild gambles and assumptions of what will happen in the future - unless they have a crystal ball I don't know about, I can't see how they can make some of the bets they have.
Anyway, one thing I am not so sure is the Euro-USD, because the problems on the other side of the pond are no different from over here, I am from Germany and know things over there aren't good and probably will even go worse , maybe even worse than here in the US. My point, while I agree the USD will get weaker , I don't see the Euro becoming stronger, hence I don't see 2 $ for the Euro, in my humble opinion I guess it will be between 1.25 and 1.50 for quite some time.
Petra
On Aug 19 09:03 AM Jonathan Christopher wrote:
> Recovery? What recovery? We are in the eye of a hurricane, and the
> windwall is heading in our direction. We have the following things
> to consider:
>
> 1. There is very little excess spending or borrowing capacity in
> the US Consumer - Who comprise 70% of the GDP.
> 2. We are now a service economy and must sell our services overseas
> to those economies that are expanding - and those are the NATURAL
> RESOURCE rich economies: Canada, Saudi Arabia, The Emirates, Brazil,
> Nigeria, Australia, etc. To do that our cost must drop, and the US
> government is doing just that, by devaluing the dollar.
> When the dollar gets to about $2/Euro, and $1.20/100Yen, we will
> start to get a recovery.
> 3. The stock market recovery in the US and Europe is a Bear Market
> Rally. The PE ratio of about 40 in Europe and 17 in the US needs
> to drop to about 7 in the US, (the traditional market low PE) and
> dividend yields of about 4% (versus the current 2%).
> 4. This drop in the value of the dollar and in the value of stocks
> will devastate individual's net worth and cause oil and commodity
> prices to skyrocket. Since we are the world's breadbasket, US farmers
> and food producers will do well. However, most of us will not. (at
> least not initially)
> 5. However I am an OPTIMIST, and am investing in commodity producers
> outside the US, and holding the MAXIMUM debt I can safely service
> (at fixed interest rates).
> SUMMARY:
> Decreasing value of the dollar overseas.
> Increasing Commodity prices
> Decreasing value of the doller inside the USA
> High Inflation (same as above)
>
> One of the best opportunities in the past decade to make tons of
> money.
when monetary expansion takes place in an environment where there is little real demand for consumption or investment the money leaks into the financial markets..just look at shanghai..a dramatic rise in financial markets effects the disposable income of those families with large stock portfolios..
it effects their consumption and as small business owners their investment policies..if you are a u.s. investor with $2 million in stocks in March you now have $3 million..if you are in hong kong you have $4 million..this has a dramatic effect on how you use your cash flows..
this is textbook 1975..check out rzv..small cap value..this is why we have v shaped recoveries..
Only when people like this are asking "Would you like fries with that?" will it be time to go long for the long haul. Listen to Richard Russell, he'll tell you.
There is no supply side theory. Capital supplies only to satisfy real demand (read Samuelson if you don't know what that is). There is only consumption to absorb production. There can only be consumption when there is mass income. From 1980 to 2007 the top 1% went from taking 8% of income to 22%. While that change may make the 1% feel much better, even superior, it does mean that the economy and society will remain crippled. Just as it did in the 1930s.
www.filife.com/stories...
Earnings above 106K/y went up 78% and earnings below went up 61% during the decade before 2007. During the five years before 2007, pay of high earners increased 48% and lower earners increased 24%. True, the high earners went from 28% of the total payroll to 33%, but that is a far cry from the figure you cited. America was doing fine in 2007 and 2008 with positive numbers for growth in Q1 and Q2, even though the increase in oil prices and the harsh winter of 2007 caused a slowdown. The big drop began in Q3, after the change in accounting method froze the banks and dropped the GDP severily. So, your statement that only the burning of the home equity kept the crash from occuring in 2002 is without foundation. I put the charts from the Saint Louis Fed on my blog.