Skeptical of Recovery

I admit it. My brain hurts. The financial/economic world isn’t making a whole lot of sense to me right now. Current consensus is that the worst is over, “green shoots” are taking root, and that growth is just around the corner. The stock market goes up on news deemed “less bad” and interest rates have also risen based on the idea that inflation will return with growth- how can it not return with all the stimulus and liquidity put into the system? Yet somehow I can’t help but remain skeptical of this growth story.

I’d like to present the facts and my take; then you can draw your own conclusion. In no way do I mean this as a prediction. This is simply an exercise in being skeptical of current market perceptions and expectations.

First, let’s set the stage. Investors in both stock and credit markets have become more sanguine based on something called the “green shoots” theory. In early March, Fed Chairman Bernanke did an interview on 60 Minutes where he said

“we are seeing progress in -- in the money market mutual funds, and in the business lending area. And I think as those green shoots begin to appear in different markets -- and as some confidence begins to come back -- that will begin the positive dynamic that brings our economy back.

I do. I do see green shoots. And -- not everywhere, but certainly in some of the markets that we've been -- functioning in. And -- we've seen some improvement in-- in the banks, as well, certainly in some key cases.”

Ben was saying that after all the efforts the Fed and Treasury undertook, we are actually starting to see a thawing of the credit markets and an improved flow of credit. This means that the seeds sown by a veritable alphabet soup of government programs are starting to sprout results. Programs such as TARP, TALF, CPFF, MMIFF, PDCF, TSLF and even something abbreviated to ABCPMMMF are stabilizing the system. (It does seem like we are facing a bubble in acronyms though- buy some T’s, M’s and F’s before we run out!) Stability in financial markets is a necessary condition for the economy to operate properly.

So far, so good. Since that interview, the credit markets have indeed stabilized and appear to be functioning. Some economic data has indeed come in “less bad”. For example, initial claims for unemployment insurance tapered off to the 500,000s compared to well over 600,000 through April. Sales of homes, in units, has recently ticked up as well (prices continue to fall though). Retail sales appear to have stopped plummeting and many businesses are reporting relative stability in activity. These improvements are desperately needed, but are they enough to declare The Great Recession has been defeated, The Great Recovery is upon us and things will be up from here on out? I think the answer requires a broader perspective than simply extrapolating marginal improvements. Now for some interpretation.

All this news is certainly “less bad”. The last time I checked though, less bad is still bad. We’re not talking about anything that can even remotely be considered good news yet. Sure, it looks unlikely that we’ll come face to face with a total meltdown as we did last autumn, but that doesn’t mean we are prosperous yet. This is a bit like saying the patient’s heart was successfully restarted in the ER but due to the severity of the heart attack, they may be in a coma for some unknown period of time. Mr. Market, however, seems to think the patient is about to start jogging again tomorrow even though they are still hooked up to every machine in the intensive care unit.

Another way to look at this is to say that after a near freefall in economic activity, we are at the “dead cat bounce” stage. Thinks don’t freefall forever, but the rate of fall slows. Take a look at this table.

What you see is the “headline” GDP number as reported in the first row. The BEA annualizes the change from quarter to quarter (“Q/Q AR”). As you can see, the last two quarters were horrific, but the rate seems to have bottomed out. Now look at the second row. This is the actual change in economic activity compared to the same period one year before. This metric actually shows an increase in the rate deterioration. What happens if we project out a little? Take a look:



If we optimistically assume that the 2Q will deteriorate at a slower pace and growth resumes by the Q4 this year, the year over year change in economic activity is still negative! That means the economy will shrink some 2% compared to the atrocious 4Q of 2008. Now, how are jobs going to get created when the economy continues to shrink? Who needs to invest in new capacity? Who will want to borrow or lend given the risks? How will decreased cash flows cover the fixed costs? If cash flows continue shrinking, losses on debt will continue to pile up given the highly leveraged nature of the economy. (By the way, this modest projection above would result in a peak-to-trough contraction of 4.2%. This is FAR less than the Great Depression at -27%, but double the average since.)

Currently the markets fear inflation. The odds of the Fed raising interest rates this year had risen to 58% this year, according to the futures markets. When the economy continues to shrink, debt losses continue to mount, excess capacity of all types abounds. I find it really hard to believe inflation is around the corner, particularly with housing being a key force and housing is highly dependent on rates these days (we’ll revisit the potential for monetary policy to cause inflation in this context another time, but I don’t think it is likely anytime soon).

Examining the situation another way, if stocks are rallying based on expecting growth, they look to be wrong. If the bond market is forecasting inflation, it looks to be wrong. Can both be wrong? They were both wrong last year, though the bond market usually “sees” trouble before stocks do. Consider the possibilities: stock market right/wrong in forecasting growth and the bond market right/wrong in forecasting inflation. Both can be right or wrong. How might the outcomes play out? Well, if the bond market is right, higher interest rates (i.e. higher mortgage rates) will crush any housing recovery and make capital for expansion and investment more expensive. So if the bond market is correct, stocks are most certainly overpriced in an inflationary world.

If the stock market is right, inflation must be around the corner too for the stock market is expecting growth with ample liquidity. This implies the only way for stocks to be right is for there to be inflation, only moderate inflation and not destructive inflation. What are the odds that inflation is just right? The “Goldilocks” scenario where inflation is just right, keeping rates low and growth humming is a rarity. It would be especially impressive under the present circumstances where monetary policy, fiscal policy and economic conditions are at war with each other.

Let’s back up to the cause of this whole mess once again. Beginning in the early 1990’s, Americans began saving less and spending more. To finance this spending, debt was often used as interest rates fell. This party went on a long, long time. It culminated in excessive leverage for not just consumers, but corporations and the financial system as a whole too. In fact, at the height of the housing bubble, the savings rate fell to almost zero, down from a historical average of almost 9%. People simply can’t spend more than they earn indefinitely, but for a while the economy zoomed as people saved less and spent more, financing the spending with debt. As the financial markets melted down in the fall and unemployment climbed rapidly, the realization that people weren’t saving enough began to sink in.



The savings rate has since jumped to over 4% in just a few quarters. This is likely to be a permanent shift in consumer behavior for the foreseeable future, one which will have significant consequences. Consumer spending climbed from 66% of our economy in 1990 to 71% of our economy last year. If consumers are retrenching toward higher savings rates in order to pay down debt and save for retirement, that roughly 5% of spending is likely to disappear, weighing on any economic growth. Once again, I come back to what are the drivers for growth? I find nothing compelling, merely headwinds to growth.

Well, I could go on and on. My brain hurts, so it's time to publish and see what you think. I’d like to hear your thoughts.