Looking ahead into the second half of 2012, the one conclusion that stands out is that nothing is going to be easy.
The economy is slowing - the year-on-year change in inventories (not seasonally adjusted) has now fallen for eleven months in a row (March-April was a tie). Alan Greenspan appeared on CNBC Wednesday night and made the comment that the level of fixed residential investment to cash flow is the lowest it's been since 1935. That decade gave rise to the phrases "liquidity trap" and "pushing on a string" in the same context: despite flooding the economy with liquidity, a lack of demand leaves the money sitting idle. Those notions seemed far away to me when I read them long ago in Samuelson's economics text, but of course he had lived through them. Now it seems to be our turn.
Perhaps the largest similarity between recent times and the Depression era was the sudden and dramatic destruction of household wealth. Household net worth fell about 20% in the 2008 crash, and some have estimated that the typical household has seen that grow to around 35% when taking into account further home price declines. Estimates of how much net worth fell in the Depression vary widely, due to a number of factors including a lack of comparable data; the stock market crash was larger and home prices also fell, but the rate of home ownership was much lower.
There are many excellent books recently written on the Great Recession, with no doubt more to come. We will not be so presumptuous as to present an answer here in twenty-five words or less; Rogoff and Reinhart's assertion that recoveries from credit bubbles take longer certainly seems to be borne out by the economic events of recent years. The point is how it all hangs together - Greenspan's observation about the low level of fixed investment, the credit collapse, and decline in household worth - to create a significant drag on demand.
However, the drag on demand is not insurmountable, and we aren't in the Depression. Unemployment is relatively high at around 8%, but it has never approached the 20%+ rates of the 1930s. GDP is growing, albeit at a modest pace. If you will forgive for us for being bold, we will quickly summarize the situation in a paragraph or three.
We'll start with the obstacles, so as to finish on a positive note. The two largest ones reside outside the U.S: the EU recession, and the bubble deflation in China. Regarding Europe, we observe that the U.S. House of Representatives yesterday voted to repeal President Obama's health care law. While the vote was largely a symbolic one to establish bona fides with Republican party voters, we bring it up to illustrate the difficulty Europe's far looser and more diverse confederation is going to have in keeping its union together in the face of its recession.
Here in Massachusetts, for example, the statewide medical insurance system that Obamacare was based on is widely popular, yet there are several state legislatures that regard it with utter horror. We would suggest that debt mutualization in Europe is going to be at least as contentious an issue if not more, and would bet that any attempt to effect it today in the EU would fail. The markets might leap at any hint of softening by German Chancellor Angela Merkel or ECB President Mario Draghi, but the concept is deeply unpopular in several EU countries, above all its largest member Germany, and that would not change if Merkel were to retire to Greece tomorrow. We see no reason to deviate from our long-standing assertion that only a crisis will force the EU into making difficult choices.
The recession in Europe should therefore drag on, partly because the governments are largely continuing to pursue austerity, partly because of the inability of banks and governments to face down remaining losses (the most outstanding example being Spain), and partly because the weaker countries have no currency of their own with which to reset their balance sheets.
That will continue to affect the country that counts Europe as its biggest customer, China. We see the Middle Kingdom as being beset by one of the same problems that dropped Japan into its lost decades, which is to say a structural reluctance to acknowledge the scale of debt and overinvestment. Its bubble wasn't nearly as large, but it's still a problem that the state is ill-equipped to deal with, especially when its biggest customer is tanking and the world's largest economy is running at slow speed.
The pluses are that U.S. is in pretty good shape. Despite all the whinging over the Fed's failure to produce robust growth, we would say that avoiding the deflation that plagued the Great Depression has to be counted as a very significant achievement. Not having deflation is perhaps similar to not having a terminal disease - difficult to appreciate in its absence, but having a malice unmistakable to anyone unfortunate enough to be touched by it.
In addition, we are probably without equal in the developed world when it comes to speedy restructuring. Corporate balance sheets are in very good shape, unemployment amongst the educated is low, and housing is recovering - not as fast as the stock market wants or thinks, but it will improve. Personal savings and net worth have suffered, though, and these will take time to repair for the 99%.
The unfortunate aspect of Europe - much more important to the developed world than China, regardless of what a few mining company executives might think - is that had the euro not existed, the EU's weaker countries would be on the mend, global trade would be better and U.S. GDP would probably be running in the 2.5%-3.0% range. We are not tilting against the common currency, but against the EU's current structure as ill-equipped for the present situation of recession and debt.
We do have the fiscal cliff to deal with here in the U.S. That should begin to trouble markets in the fall, but the most likely result of the next deadline will be to postpone the visit.
Those are the broader issues, but it must be admitted that the equity markets rarely concern themselves with such matters, frequent pretensions to the contrary notwithstanding. Right now, the markets survive mostly on hopes of more central bank easing and a lack of convincing alternatives. The very short term is oversold and sentiment is sufficiently negative enough to support an upside bounce, despite the weak earnings season. Without a genuine policy change from the US or EU, though, such a move is unlikely to endure downbeat company guidance.
The bull strategists are still bullish, the bears are still bears, but traders are cautious. That should mean more bad news for hedge funds, beset by a range-bound market (the S&P 500 (SPY) is at about the same level as a year ago) and the price of insuring against (or betting on) disasters that the air is heavy with, yet remain stuck on the horizon. It also favors equities to fade for a few more weeks, barring a visit from a European angel, then rally again the last couple days of the month, in anticipation of the next Fed announcement on August 1st.
We close on that note with the observation that the Federal Reserve Bank of New York announced Wednesday morning a study showing that since 1994, all of the stock market's return can be attributed to the rises in the three days leading up to FOMC announcements. All of it. Somehow, that doesn't surprise.