Bubbles and Busts'  Instablog

Over the course of this year, economic growth has been slowing considerably in many countries that were previously considered beacons of strength following the global financial crisis. Among those countries falling on harder times is Canada, eking out growth of 0.1 percent in the third quarter. Canada appears determined not to be outdone by Europe and Australia in reducing its budget deficit at the expense of economic growth. Canadian optimism based on the last round of austerity is badly misplaced for reasons outlined in this fantastic post on Austerity in Canada: Then and Now (at Fictional Reserve Barking). Taking a sectoral balances approach, here are three charts that highlight the differences:

During the 1990's, Canada witnessed a dramatic rise from a ten percent budget deficit to a fiscal surplus. That reduction in aggregate demand was countered by a significant decline in the household financial balance to a net borrowing position and a substantial trade surplus (foreign net borrowing). Keeping with global trends, the massive rise in Canadian household debt was primarily funneled into the domestic housing sector, pushing prices into bubble territory:
Source: Macleans.ca

The Canadian government's hopes of repeating its "success" from over a decade ago will require a renewed surge in demand from one of the other sectors. Weak global growth, especially in China, suggests that commodity-rich Canada will not witness a dramatic reversal in their trade balance anytime soon. That leaves the household (or business) sector to pick up the slack.

As witnessed recently in the US and throughout Europe, there comes a point at which households can no longer credibly be expected to repay outstanding debts. Regardless of what event brings about this realization (possibly declining house prices), the ensuing household deleveraging will be a major headwind to growth.

A global commodity boom and domestic housing bubble bailed out the Canadian government last time it attempted to drastically reduce the budget deficit. This time around, the government's actions may be enough to bust the housing bubble and push Canada into a recession.

Over the past year or so, I've continually made the claim that QE and Operation Twist would have little impact on the broader economy aside from pushing investors further out on the risk curve. Despite being correct in that view, the persistent bullishness within US equity markets has been surprising. Taking a different approach by looking at market internals, Microfundy offers a new perspective on how QE Failed.

Mario Draghi's infamous speech on July 26th hinted at more asset purchasing/easing causing the markets to roar higher. As you can assume, taking a look at the internals of that two day rally, you would see out-performance by the high yielding blue chips. THIS WAS NOT A GOOD RALLY! It's akin to EPS growing via cost cutting. I don't care if the S&P goes to 2,000 by year end, if it is led higher by XLU & XLP, that's telling me that it is a QE fueled rally that is not being sustained by growth or a economic recovery etc. It is being caused by the powerful "hunt for yield", and the unfortunate belief & wager that we are Japan! That is not a rally to be celebrated, because just like cost cutting… it's unsustainable!

The analogy between effects of QE and cost cutting, in particular, caught my attention. Since the market peaked in mid-'07, earnings per share of the S&P 500 (SPY) have grown over 50% despite sales per share only growing by ~3%.

(click to enlarge)

S&P 500 Sales Per Share data by YCharts

While QE has generated a "hunt for yield", cost cutting has also been providing a significant tailwind for stocks over the past few years. Extending the time range a bit further shows that the market has generally been nearing its peak when earnings diverge upwards from sales.

(click to enlarge)

S&P 500 Sales Per Share data by YCharts

Growth from cost cutting and lower yields appear to be reaching their limits just as revenue growth turns south. Without these tailwinds for earnings and multiple expansion continuing, the market is probably much closer to an interim top than bottom. Whether or not earnings will witness a precipitous drop similar to '08 remains to be seen and likely hinges on the future stance of fiscal policy (in the US, Europe and China). Regardless, patience remains warranted as far better entry points to the market will present themselves in the next few years.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Last week, a report from Jon Hilsenrath at the WSJ and comments from ECB President Mario Draghi sent markets screaming higher in expectations of an onslaught of monetary stimulus being announced this week. Following the conclusion of meetings by the FOMC and ECB, those expectations are now delayed. Bernanke was the first to disappoint, announcing no new monetary stimulus and merely repeating the obvious pledge to do more, if necessary. Today, Draghi proved that European policy makers will continue to talk a big game while offering little in terms of details or even a plan of action.

While many reports are focusing on the lack of follow through by Draghi, a strong countervailing opinion is presented at Mosler Economics.

Karim writes:Draghi announced significant philosophical changes today. The key announcements were:

• The ECB was ready to renounce seniority on its bond purchases.

• The size of future purchases was open-ended: 'size adequate to reach its objectives'.

• Future purchases may not be sterilized, as they have been with the SMP so far.

• Purchases would be front-end focused as that 'falls squarely in line with monetary policy instruments'. A key instrument is obviously the LTROs. So would imagine purchases would be 3yrs and in on the curve.

The adherence of governments to their commitments and the fulfilment by the EFSF/ESM of their role are necessary conditions [for some action on the ECB side]. The Governing Council, within its mandate to maintain price stability over the medium term and in observance of its independence in determining monetary policy, may undertake outright open market operations of a size adequate to reach its objective. In this context, the concerns of private investors about seniority will be addressed.Other news was that:

• As in the excerpt above, purchases would be subject to strict conditionality via the EFSF (i.e., Spain has to accept a Memorandum of Understanding). Fiscal consolidation and structural reform were listed as the key conditions.

• He threw cold water on the ESM getting a banking license, saying he was 'surprised by the attention this has received'.

• Logistics and objectives on bond purchases were TBD by a committee.

• Further non-standard measures were forthcoming.

• Rate cuts were discussed but unanimously voted down; as for a negative depo rate he said 'we are in unchartered waters', implying the hurdle may be high.

Relative to levels before Draghi's London speech last week, Spanish 2y yields are 200bps lower, and 10yr yields are 50bps lower.

Whether or not these "philosophical changes" ever become reality remains an open question, but the ideas of renouncing seniority and leaving QE open-ended are clearly a step in the right direction. That being said, Draghi maintains the ECB's position that further action is conditional on fiscal consolidation and structural reform. In this more important sense, the ECB's philosophy has not really shifted at all. Describing that philosophy recently (ECB's Means (Lost Decade With High Unemployment) To An End (Structural Reform)), I concluded:

By working to prevent an all out collapse of the EMU, Draghi is merely taking the necessary actions to maintain his position. If Spain or other European countries must "suffer from a decade of recessions with unemployment over 20%" in order to implement the desired structural reforms than so be it.

As long as this philosophy remains in play, the most likely outcome in Europe will be a sustained period of high unemployment with declining or stagnating growth. Operationally this scenario can go on indefinitely but politically the time may be running out.