Double dip or muddle through? An increasing number of forecasters are calling for the former, but we're now starting to lean towards the latter. The risk of a soft patch or even a period of negative growth has certainly been elevated over the last few months, but may now be receding. As is so often the case, public policymakers are still the actors on the margin, and "muddle through" falls well short of galloping growth. But given the alternative, it should feel just as welcome, and should offer some meaningful opportunities for investment and speculation.
Our take on the positive evidence:
- There are increasingly dovish fiscal signals coming from the Obama administration, including his stand (pdf) against premature fiscal consolidation at the G20 meeting this past weekend, and the resignation of OMB chief Peter Orszag, who like his old colleague William Gale at Brookings, is known to embody a hawkish approach to fiscal policy (as we've pointed out elsewhere, that approach may have been well suited to the Clinton era, but could prove toxic under current conditions). As one FT blogger put it, "Barack Obama's decision to sack General Stanley McChrystal this week drowned out news of the resignation of Peter Orszag, his star budget director, and the first of his cabinet members to step down. But the departure of Mr Orszag, who decided to resign partly in frustration over the absence of a tough plan to address America's mounting national debt, may well come to be seen in retrospect as equally significant." Not too long ago we penned the phrase "Thank God for Christina Romer," which still holds true. A recent op-ed by her lieutenant Jared Bernstein indicates how additional stimulus measures will be sold to Congress, taxpayers, and the rest of the world. From the sounds of it, the days of shock and awe are over, but it's still a better direction than concerted fiscal austerity. If we're wrong, the U.K. should outperform the U.S. over the next several years.
- Voices of fiscal sanity -- most notably Martin Wolf, in our view -- seem to be gaining some traction in the press. Even Forbes made space for an interview with Bob Lenzner, who argues (correctly we think) that Japan is the relevant example for policymakers and investors. And the recent America Speaks conference, which had started looking to us like little more than a Peterson Foundation trojan horse (their accompanying PR blitz became obvious when I awoke to our local NPR editor fawning over David Walker's IQ!), attracted a fair amount of criticism and reportedly produced some surprising results.
- Though still playing its cards close to the chest, the ECB now appears to be supporting sovereign eurozone debt in a sustainable way. As Warren Mosler recently inferred, the ECB is managing the tensions between national finance ministers and eurozone industry on the one hand, and "money interests" on the other. Mosler has also keenly observed that if the ECB does in fact fully backstop eurozone government debt, this could be rather bullish for European equities, given that they appear to have priced in some degree of sovereign default(s). The wild cards at this point appear to be the length of the ECB's commitment, what happens at the end of the stated commitment period, and what it does regarding sterilization. Especially interesting to us is that the countries with the most upside in the coming decade are those on the periphery, including the notorious 'PIIGS'.
- Real time indicators such as rail car loadings and trucking activity are still sending positive signals, and imply that Q2 GDP in the U.S. could surprise to the upside.
- Though the credit crisis (like periodic downgrades of Japan's debt) has plainly revealed that we must take credit rating agencies actions with a large pile of salt, credit rating trends have turned positive for the first time since 2007. In addition, other than still stubborn yields on (and risk aversion to) European sovereigns' debt, credit market indicators have calmed down notably since May and early June. And although we continue to expect the Treasury yield curve to flatten, its current slope still argues strongly against an imminent recession.
And the negative:
- A proprietary Hussman indicator is reportedly set to signal recession. Because it's proprietary, we don't know what factors it includes that might push back on a lower ISM reading. If it accurately signals recession, then we might indeed be heading into a period of negative growth, or at least a notable soft patch.
- Housing stinks of late, and it's possible that the growth rate of rail car loadings and trucking will soon start to roll over; initial claims for unemployment insurance are still consistent with elevated single digit unemployment (i.e., muddle thru territory).
- Bond markets are still signalling growing deflation expectations and/or rising risk aversion. Self fulfilling expectations are possible, if bearish outlooks reach a tipping point that intensifies the demand for savings beyond what the public sectors of the world are currently willing to accomodate.
- There's a widespread belief that the recent recovery is self sustaining and not due primarily to fiscal stimulus. This point of view ignores the essential meaning of fiscal multipliers, and on this point, we agree wholeheartedly with John Hussman, who recently wrote: "Wall Street seems to have no concept at all that every bit of growth we've observed over the past year can be traced to government deficit spending, with zero private sector expansion when those deficits are factored out...In effect, Wall Street's is seeing "legs" where the economy is in fact walking on nothing but crutches...If we fail to recognize that the "good news" reported over the past year is due not to a recovery in intrinsic economic activity, but instead to massive government intervention, we risk being blindsided as those synthetic effects gradually erode."
- There's also a growing movement, primarily on the right, to cut public spending in order to boost growth. Proponents are citing the work of Harvard economist Alberto Alesina. However, as capable a scholar as Alesina is, there are two glaring problems with applying his research findings to today's world. First, it's based on data from OECD countries over the period of the mid-1970s to the early 2000s. This period happens to coincide with the global financial and trade reintegration that followed World War II, and with the rise of the baby boomer generation in most developed nations (note that Japan is roughly ten years ahead on the demographic composition curve -- its 1989 was our 1999). Second, it contains only instances where a single country or at most a handful of countries embarked on fiscal consolidation. Today, fiscal austerity is being pushed on public sectors in a majority of the world's economies. The clear takeaway is that Alesina et al's findings cannot be blindly applied to today; our current situation is far more reminiscent of Japan 1989-2009, and the world in the 1930s.
- A strong Republican showing in the November midterm elections could cause economic policymakers to commit the error outlined in the last two bullet points -- a concerted withdrawal of fiscal support in the belief that the private sector recovery is self sustaining. If that happens, we would expect the Fed to ride to the rescue via quantitative easing and other unconventional measures. Unfortunately, that will make valuation and private sector investment more challenging at the margin. As we've pointed out previously, well designed (as opposed to politically expedient) fiscal stimulus can actually make room for the Fed to normalize monetary policy.
- Who will replace Orszag at OMB? Laura D'Andrea Tyson an interesting choice. Those suffering from blind political allegiance to the right won't care for her (to the left should love her), but we think that her philosophical orientation is appropriate to prevailing conditions, as long as she doesn't become a soak the rich crusader.
- State and local fiscal consolidation in the US continues apace. In fact, it has largely offset the direct contributions of the federal government to GDP in recent quarters. This is an area where Congress should be able to find some common ground on spending. The risk, as always is agency related. Obviously, not all public spending is created equal. Waste must be avoided and fraud must be punished severely. We continue to believe that the sanest way for the federal government to "spend" would be to enact a long term payroll tax holiday and an employer of last resort program. Tax code improvements would be wonderful as well. We can all dream...
- Imminent fiscal tightening in Europe, the U.K., and Japan could have negative spillover effects on financial markets and the global economy.
- Dislocations in non EMU countries of Europe could cause problems, especially given exposures within the eurozone banking system. Obviously the IMF would be on call, but how might that impact European bank capital, and how might the EMU and ECB respond, if at all?
- Low interest rates and, where applicable, continuing fiscal stimulus in developed nations will continue to create problems for faster growing economies. Watch things like food price inflation. This is tough for central banks and treasuries of emerging economies to manage, but they should be better equipped to do so than they were in the 1970s and 80s. This dynamic will also continue to have a push-pull effect on commodity prices.
- Along with the bullish behavior of Treasuries, equity market "technicals" look scary -- lots of dreaded "head and shoulders" patterns, and the possibility of a negative 50-day 200-day cross in the S&P 500:
Lining up the positive against the negative:
- We have pretty clear evidence that fiscal austerity in the U.S. is no longer imminent, which is a bullish development for the U.S. economy, employment, and asset prices. But that could change after midterm elections, and fiscal austerity continues to unfold at the state and local level and is imminent in other developed nations. If voices of fiscal sanity like Wolf's continue to gain prominence, this should help. If the 'cut spending now' crowd carries the day, a double dip would become a virtual guarantee.
- The ECB appears to be capably backstopping eurozone sovereign paper after all, though renewed stresses in the eurozone periphery and core, and/or in non-EMU Europe, could cause trouble. Most intriguing is that many European equities are priced for sovereign default. If that outcome isn't realized, or is credibly postponed for a few years, then Mosler's European equity call could be a good one.
- Real time indicators suggest that 2Q10 GDP in the U.S. could print well, but Hussman reports that his proprietary indicator is precipitously close to signalling recession.
- The Treasury yield curve is not signalling recession, but researchers have noted that yield curves have had little explanatory power in Japan since the BOJ faced the zero bound. Given how emphatic we are regarding the relevance of Japan's experience and the direction of long term U.S. rates, that certainly gives us pause.
- Technical indicators give little comfort. However, an interesting idea among some analysts is to place more value on the KBW Bank Index (^BKX) than the S&P 500. That makes some sense, given that financial systems are at the heart of concerns over defaults and double dips. And that index paints a less dreary picture than the S&P 500. Though it's still a challenging one, it looks more like a muddle through than a breakdown at this point:
Clearly, there are plenty of powerful cross currents at work for investors to mind. Our current investment stance:
- Cash offers no yield, but is the best hedge against deflation. It's also important in volatile markets to keep dry powder on hand.
- We continue to expect yield curve flattening in the U.S. While the ten year may be a bit overbought for now, longer term Treasuries are still attractive, potentially offering a real "risk free" yield of three to four percent.
- We have taken off short gold positions, as (1) despite yesterday's breakdown, the bubble trend still appears to be intact, and (2) both fiscal dovishness in the U.S. and the perceived risk of renewed central bank intervention (QE) should be supportive. We are considering long positions in far out of the money put options on GLD (conspiratorial rumors regarding the ETF's actual physical holdings add an interesting wrinkle). Pair traders might also consider "retrieval" trades like short gold, long silver, although a double dip and/or deflation pose a risk to such strategies, especially if gold continues to be the primary hedge against QE and/or fiscal expansion.
- If our muddle-through-the-soft-patch thesis is correct, selective opportunitites in US cyclicals might be appropriate. Additional fiscal stimulus could conceivably be favorable to industrial services companies, for example. Thermadyne (THMD) continues to be a major holding in our Opportunistic Portfolio, although recent steel data causes some concern. Pike Electric (NYSE:PIKE) is also a significant holding, but their clients' expenditures have been frustrated by head fakes and uncertainty over government policies, including fiscal stimulus. Again, the cross currents are challenging. If we start to question our call against a double dip, we would hold or possibly pare back on these and/or other industrials and cyclicals. Also among cyclicals, it seems that Mr. Market has forgotten how far removed technology stocks now are from their 1999-2000 bubble. We continue to see some interesting values among small cap tech stocks.
- Splicing together the insights of Warren Mosler and Ajay Kapur, we are intrigued by eurozone equities, especially in PIIGS countries and parts of eastern and central Europe, including Russia. Market Vectors Poland ETF (NYSEARCA:PLND) is a core holding in our Opportunistic Portfolio, though we are cognizant of the heavy bank weighting of the index and the ETF, and the resulting risks to the upside and downside. We'll develop this European equity theme in the days and weeks ahead, but with appropriate caution, given the continuing opacity around the ECB's current intentions (as well as the looming ascendance of an even more hawkish successor to Trichet).
- Given how the fiscal outlooks have aligned globally, we're not quite as bullish on the USD as we were early in the year, and now expect forex markets to muddle through for a bit as well. That said, it will be interesting to watch the British Pound and possibly the Euro as austerity measures begin to bite. If markets believe that central banks will stand firm, those currencies could strengthen. But if it looks like central banks will accomodate the anticipated side effects of austerity with lower rates or unconventional easing, then they'd be more likely to fall against the USD in our view.
- The Japanese Yen provides a much more interesting case, and we've taken notice of its recent strengthening. Keep in mind that Japan is in the midst of a favorable turn in demographic composition, and at the end of a long period of private sector balance sheet repair, and both should be supportive of growth. That could pose a risk to the decades long role of the Yen as a funding or 'carry trade' currency. As in the 2008 crisis, renewed strength in the Yen could cause global dislocation. Thus, an ETF like CurrencyShares Japanese Yen Trust (NYSEARCA:FXY) might not be a bad hedge against riskier positions, including gold (though investors should always be aware of the consequences of their actions, even in hedging -- a concerted move into Yen, which seems to be unfolding as I write, could help precipitate renewed market dislocation). And if higher growth and even inflation gradually take hold in Japan, as we expect, then the 'black widow' trade of shorting Japanese government bonds might finally work. Of course, the deficit phobes will then rant and rave about how they were right all along, even as long rates continue to fall in other developed nations with rising debt to GDP levels; but we believe that the balance sheet and demographic recession explanations are a much better fit for the data.
IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC (“SCM”) is a state registered investment adviser in the Commonwealth of Pennsylvania. The views expressed by the author are as of the publication date, and are subject to change based on market and other conditions. The foregoing information is for informational, educational, or entertainment purposes only. It does not constitute an offer to buy or a solicitation to sell any security, or to engage in any investment strategy. Investors should not use this information as a basis for any investment decisions without first consulting their own financial adviser. At the time of writing, clients of the firm owned TLT, THMD, PIKE, PLND, FXY, EWJ, JSC, and/or FXY. The firm is long THMD. PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS.
Disclosure: Some clients own TLT, THMD, PIKE, PLND, FXY, EWJ, JSC, and/or FXY. Firm is long THMD.