US business cycles:
For more than two decades the US business cycles have been giving the pulse to the global economy. Business cycles were as accurate as a Swiss timepiece with strong upswings lasting 6 to 7 years. Downswings were short lived with a 2-3 year duration on average. These downswings had the particularity of being extremely violent.
I've encountered quite a number of investors here in Asia who think the situation will be no different today than in the past: to them, we have witnessed a trough in March 09, the equity market bottomed-out at that time and the turnaround in stock prices (the powerful rally we have seen so far which seems unstoppable...) means that the US (real) economy is recovering and that we'll soon see another 6 to 7 years of strong growth. I have to disagree, the reason being that the growth in the US has been fueled by Debt and that we are unlikely to see lending reaching pre-crisis levels anytime soon.
Anatomy of a Cycle:
To better understand where we stand we need to take a quick look at what defines a business cycle. A cycle consists of 4+1 phases.
- First, Companies realize that there is an opportunity on the market. In order to take advantage of it they need to modernize and replace their capital stock. They start spending more on their Capex but are still reluctant to borrow.
- Then, as the positive outlook for growth becomes more entrenched and consumer spending improves, companies realize they need to modernize and expand their capacity more than expected. They turn to banks for loans and their balance sheets start to be leveraged.
- The turning point in the upturn is when an overleveraged private sector fails to turn a profit. In our case the trigger event was an imploding credit market in the US. Production costs are then spiraling out of control and companies start to miss analysts’ estimates.
- Finally, banks start tightening their lending policies, triggering a domino effect: more companies are failing to pays their loans, layoff plans start to appear. NPLs become more prominent and start threatening the banks themselves. Demand for Capital and Labour falls, modernization plans are shelved and unemployment is on the rise. Consumers are spending less.
(+1) Eventually, a falling cost of Labour makes production factors less expensive and companies more competitive. Cost reduction allows profits to grow again and a new cycle can begin.
Where do we stand now?
2010 looks very different from March 2009 when we thought we were witnessing the world coming to its end. I believe the worst is behind us. At the macro level, we can now see leading indicators turning positive on the US economy. At the corporate level, we have seen an astonishing earnings season in 2Q10 with 85% of the companies reporting earnings 35% above expectations. Stock markets worldwide have rallied, allowing the Dow Jones to close above the 11,000 mark. Considering that the crisis has started in mid-2008 and given the “tenets” mentioned previously, it is quite tempting to say that the recovery has finally happened and that now it is “business as usual”. Companies will start to hire more, borrow more, export more…and we’ll reach a new peak in 6 to 7 years.
When “Past history is no indication of future performance”
This innocent sentence that one can find on banks’ termsheets seem to best fit my view of what may happen next. I believe we are witnessing a phase 1 of a recovery where companies start to replenish their inventories, and modernize their production capacity and IT infrastructure. After all, one of the big losers in this crisis was the IT industry as companies have shelved their IT investments for the past 18 months or so. This phase 1 is the shot in the arm the US economy needed to start recovering and the catalyst for the world economy to get better.
Do we get into “Phase 2” in 2010?
In my opinion, it is going to be difficult to reach a “Phase 2” stage where the banks start lending to companies and we see a new “virtuous cycle” of credit. The reason is two-fold: First, the joint operation of the US Central Bank and the US Treasury has allowed the printing of an unprecedented amount of dollars, extending the debt levels to unseen levels and fueling the recovery on the back of the taxpayer’s money. This may require the next administration to run into an austerity plan in order to clear up the country off its excess of leverage as it will weigh on the future of the US economy. Second, this crisis has left the US financial system damaged to the point that regulatory change, weak bank capital and broken securitization has impaired the ability to substitute the government subsidized recovery for private lending in the foreseeable future.
I believe the current situation has at least 5 direct implications for our near future:
- As inventories building and IT investment wane as we go deeper into 2010 I expect the reality of a ballooning public debt burden to become more evident in the US when we enter into 2011. A possible scenario would be an austerity plan that may force unemployment to stay high for an extended period of time while making a phase 2 difficult to get started.
- Cycles will become shorter and sharper as a more stringent regulatory framework for banks in addition to their damaged balance sheets will prevent them from lending money to companies willing to expand.
- “Weak countries” would become weaker as it will take time to recover from such a deeply rooted crisis. (US as it is at the epicenter, Europe because of failed European countries –look at the PIGS- and 3rd world countries with no reserves). Strong countries with little to no debt and/or growth opportunities (e.g China/Hong Kong, India, Singapore) would outperform the rest of the world. Emerging markets may finally “emerge” with Asia at the center of the stage.
- Under the assumption that the shot in the arm of the US economy lasts until the end of the year, the fear of inflation will become increasingly important in third world countries with limited to no reserves. We are already witnessing some commodity prices skyrocketing to pre-crisis level when inflation and food security were two major concerns in some emerging countries (eg: Vietnam : “the Pho Crisis” of 2008 seems to stage a comeback as Hsbc and Citigroup's analysts agree on the worryingly high level of inflation in the country with a 9.2% jump YoY in April).
- The current state of events has bought time to US trade partners to rebalance their trade activities with the US. I would expect these countries to look for more stable markets for their products: if one cannot discount the importance of the American consumer’s spending power, it is still noticeable how Asean countries are busy strengthening their bonds and developing trade friendly policies with one another.
I may have painted a dark picture of the future. It looks like economic model that has pulled so many out of misery and allowed for so much wealth to be created over the past 50 years is now broken. Indeed, this is the case; In the US. My view is that it will take a long time for the US to digest this crisis and that the business cycles will be affected. Moreover, lending will be made more difficult for US banks as the Obama administration is trying to make sure banks can no longer pose a threat to the whole American economy. But if the model is broken in the US it is remarkable to see how well it is working in Asia. Some countries have strong balance sheets, a booming corporate sector, people and skills which makes me believe that the growth will be thought and manufactured in Asia.
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