This is the first part of a brief series which will cover the relationship between economic forecasts, GDP growth, valuations and expected returns. As self-nominated “Investment Myth Busters,” we hope this series helps to clarify a few common misperceptions.
In recent months, we have noticed an increasing divergence in the economic forecasts of market participants (none of which are accompanied by any decrease in confidence). From our perspective, we are approaching a critical point in today’s economic adventure with the plot divided along two distinct branches leading to very different conclusions. Similar to the popular children’s books, Choose Your Own Adventure, after a brief introduction (driven by unprecedented injections of monetary and fiscal stimulus), the reader (global policy makers) is asked to determine the next course of action.
Today, we are confronted by two possible adventures. One is a world where the economy’s problems are largely behind us, profits are on the upswing and things will soon return to the comfortable old “normal.” An increasing number of economists and analysts point to the past sixty years of post-war recessions and recoveries to show that the Great Recession is now over (we might warn that most “analysts” in this camp failed to see the truck that hit them barreling down the road uncontrollably in the first place). Unfortunately, they are now looking at the wrong sixty years of data! As John Hussman vividly explained:
We have seen a great number of research reports with the basic thesis of “The recession is over. Here is how the market (or the economy, or employment, etc) has performed after a recession is over.” The difficulty is that these are basically attempts to say “here is an elephant” and then immediately move to describing elephants in general, when in fact, this particular elephant is very likely to be pink, or white. If we want to see things as they truly are, we have to look both at the elephant, and at anything that might set this particular elephant apart. With regard to the investment markets, if we suspect that the particular features of the present situation make things “different” than they have been historically, then it is best to look closely and get more data.
When we look at the current market environment today, it is clear that the enthusiasm about the market here is largely based on the idea that the recent recession is over, and that the economy will form a “V” shaped recovery similar, but much stronger quantitatively, to standard post-war recoveries. This is a very difficult argument to make, because the drivers of economic growth that existed in typical economic recoveries – particularly debt origination and consumption growth – are very compromised at present.
The reader’s who choose the second path, see an alternative adventure best described by economists Kenneth Rogoff and Carmen Reinhart, who actually foresaw the recent financial crisis, and are far less sanguine about the prospects for sustained recovery. Rogoff and Reinhart first presented their views in a NBER Working Paper and in their recent book, This Time It’s Different – Eight Centuries of Financial Folly. A few excerpts follow:
The aftermath of systemic banking crises involves a protracted and pronounced contraction in economic activity and puts significant strains on government resources. On average, government debt rises by 86 percent during the three years following a banking crisis . . . Broadly speaking, financial crises are protracted affairs. More often than not, the aftermath of financial crises share three characteristics:
First, asset market collapses are deep and prolonged . . . Reports of nonperforming loans are often wildly inaccurate, for banks try to hide their problems as long as possible and supervisory agencies often look the other way . . . Second, the aftermath of banking crises is associated with profound declines in output and employment . . . Third, the value of government debt tends to explode. The main cause of debt explosions is not the widely cited costs of bailing out and recapitalizing the banking system . . . the biggest driver of debt increases is the inevitable collapse in tax revenues that governments suffer in the wake of deep and prolonged output contractions.
Yet, in many ways, this ‘Second Great Contraction’ is a far deeper crisis than others in the comparison set, because it is global in scope, whereas other severe post-World War II crises were either country-specific or at worst regional.
Stated more simply, this is not your grandfather’s recession! Standard post-WWII recessions have been the only cycles experienced by investors in the market today, which explains why most expect more of the same and point to the past sixty years as “proof” of a v-shaped recovery. But, these recessions were merely hiccups in an extended cycle of expanding credit. We suggest investors take a close look at the graph below, and ask themselves if this latest contraction in credit is best described as a “hiccup.” History suggests it is not. The Aftermath of Financial Crisis suggests we are just beginning a prolonged period of credit contraction. In other words, thrifty is the new trendy.
Even more disturbing than Wall Street’s hope for a quick return to record profit margins, is the recent admission by Donald Kohn, the Vice Chairman of the Federal Reserve that, “the core macroeconomic modeling framework used in the Federal Reserve and other central banks around the world has included, at best, only a limited role for the balance sheets of household and firms.” If that statement does not send chills down your spine, it should!! Someone should advise Mr. Kohn (and many of his closest friends) that the demand for credit is the single most important component of the macroeconomic outlook today given the deleveraging process currently underway.
It will take time to turn this credit battleship around, which has been gaining speed for a generation. With the recent drop, total outstanding debt has fallen from nosebleed levels to levels more accurately described as extremely elevated, and not recommended for those afraid of heights. As a percentage of disposable income, consumer credit remains well above pre-bubble levels (see below). Maybe the reason that balance sheets are ignored is that they are not important most of the time. But once every generation or so, they become critical. Odds are that this is just one of those times. Fundamentally strong economic growth is not sustainable until balance sheets are further improved. We’d like to see this ratio at least fall toward the long term average of 12% before talking about a sustainable recovery.
What does this mean for investors? The answer will likely be even more of a surprise! We’ll discuss the possible outcomes of these two adventures in part two of our series. Stay tuned.
Disclosure: No Positions mentioned