An ancient but appropriate Asian tale has it that a fox foraging for food once found itself far from the jungle and in the middle of a town. Spotted by a pack of dogs, the fox ran for its life, and in its hurry ended up in the coloring vat of a textile weaver. It emerged from the vat resplendent in blue; a color that instantly scared off the dogs. The blue fox went back to the forest, where it duly proclaimed itself king by virtue of its unique color among all the mammals living there.
A few months later, the monsoon arrived and with the rains, out came the blue color from the fox; leaving in its place an ordinary brown and red animal. With the color transformation, the fox’s reign also ended, and it soon rushed back to the depths of the jungle never to be heard from again.
The story resonated with the markets on Thursday, after the preliminary estimates of US non-farm payroll (NFP) for June showed a decline of 467,000 jobs, a number that was some 100,000 worse than the market expectations as surveyed by Bloomberg. With it, hopes that had been building up in the global markets over the past few months that further improvements in US employment would help spell the end of the current recession were dented, if not completely destroyed.
Now, I would be the first to caution everyone about extrapolating from a single number, and in particular a noisy estimate that was hurriedly cobbled by people in the US Labor Department ahead of a long weekend to celebrate the country’s Independence Day. Bloomberg reported as following:
The jobless rate jumped to 9.5%, the highest since August 1983, from 9.4%. Unemployment is projected to keep rising for the rest of the year just as the income boost from the stimulus package fades, undermining prospects for a sustained rebound in household purchases, analysts said. As companies from General Motors Corp to Kimberly-Clark Corp cut costs, the lack of jobs will restrain growth.
“This will be another jobless recovery,” said John Silvia, chief economist at Wachovia Corp in Charlotte, North Carolina. “We may get positive economic growth driven largely by federal spending, but people on the street will say, “Where are the jobs?”
Still, going back to the story of the blue fox, it is tempting to note that a number of data points of late haven’t quite backed up the notion of green shoots being visible in the US or European economies. After that observation, it is relatively simple to point out that the rally in various really risky assets would likely end rather quickly if the notion of an incipient economic recovery were disproved.
Why is jobs data so important? In pure economic terms, it is fair to suggest that US monthly jobs attract more than their fair share of market interest, as many believe that the number helps to validate short-term observations for the economy, such as sales growth, production increases, exports and so forth, all of which help to boost the case for overall economic growth and from it, the picture for stock market growth.
The second reason why jobs data is important is their implication for consumer spending, credit quality and other indicators of interest to credit markets (as well as stocks). In the event, the decline in working hours for the second consecutive month points to growing under-employment (that is, people getting work for fewer hours than they want to actually) in the US.
This is an important indicator because if people get less work than they want, it also means that they are getting paid less than they usually receive, or indeed than they would like to get paid. That could well be the function of two different things: employers want to pay them less on an hourly basis (disastrous deflation) or eventually will want to cut the number of workers once they can justify it – because you cannot fire a third of a person.
From there, we can gather that people are more likely to save rather than spend; that the increase in government debt is offset by personal savings; another indicator of really lousy economic conditions (think Japan, but multiplied a few times).
That means retail sales with and without durable goods will continue to drag along while the inventory build-up over the second quarter that helped to spark all kinds of optimism in the stock markets will quickly be replaced by de-stocking. All of that is bad, really bad, for economic numbers in coming months.
There are two major problems with global stock markets today. The first is that the idea of permanently lower corporate earnings hasn’t quite sunk into equity investors in either the US or Europe. Why permanent? Because the very structure of the US and European economies will have to be overhauled in reaction to the current credit crisis. That’s a pretty fancy way of saying that basically, the US and Europe simply cannot consume as much as they did previously and will have to focus more on production for Asian and emerging markets.
This in turn implies that the earnings of Asian exporters will need to implode as their ability to turn profits from the sales of minor widgets to the US and Europe will have to disappear over the near term (one to two years), to be replaced by gigantic profits of goods to their own consumers over the medium-long term (anywhere from three to 10 years).
The second point is that today’s earnings multiple that are arrived at by dividing stock prices by average earnings are totally incorrect in this era of wholesale change. In other words, any double-digit price earnings ratio (PER) is essentially a triumph of hope over (most likely) experience, with almost no chance that the expected growth in dividends will ever take place or at least not quickly enough to justify such lofty multiples.
Thus, equity investors will have to contend with the specter of both lower earnings and smaller earnings multiples – the perfect double whammy on their current positions. Suppose you currently own a stock at $150 per share, which is explained to you as $10 of earnings per share annually, and a multiple of 15 times that earning (in other words, your claim on the company’s earnings for the next 15 years must be paid upfront).
Based on the above correction, lets say we can suggest new earnings of $7.5 per share – a decline of 25% – but also a lower multiple of say 10 times that earning, which is more appropriate given the risks of that basic earning. So your stock price is now $75, which is exactly half the $150 you were asked to pay previously. In effect, that means it would take a pretty large decline in current stock prices for any meaningful bargain-hunting opportunities to be presented.
It is a truism that while debt markets fear inflation, they absolutely detest deflation; especially when one looks past the absolutely safe end of the fixed income spectrum (that is, the government debt of some countries).
In other words, any debt issued by entities that have no ability to print their own currencies – in which hopefully the debt is also denominated – will have to confront lower revenues entailed by deflation, which is only partially offset by lower borrowing costs.
I wrote in various columns previously (see, for example, Easy bets with other people’s cash, Asia Times Online, May 23, 2009) that the game of investors purchasing risky debt – such as that issued by companies rated below investment grade – cannot be explained by economic fundamentals. Such companies have a high dependence on cashflow growth in order to sustain their debt loads; when economies collapse they will inevitably run out of cash faster than they will run out of debt, that is, they will have to default on their obligations.
A scarier version of this problem is represented in the position of various US states, ranging from California to Florida. As state governments issue their own debt that is expected to be repaid by their revenues from taxes and services locally, a deep recession is more likely to hurt these governments than the federal government, especially as the latter can print its own currency.
A report on Yahoo! Finance summarizes as follows:
An across-the-board drop in tax collections, coupled with a prolonged recession, has states facing their worst fiscal crisis in decades. Several states are entering the first weekend of the fiscal year and July Fourth holiday without a budget in place and facing the prospect of government shutdowns and program cuts. California is ready to start issuing IOUs to vendors because the state is out of money.
The sputtering economy has ravaged all forms of tax collections. Taxes ranging from sales to personal income to property are all down, said Brian Sigritz, a staff associate with the National Association of State Budget Officers in Washington, DC.
The problem for debt markets is that the so-called municipal market in the United States runs into hundreds of billions of dollars. With financing down, and various states running the danger of essentially issuing IOUs rather than hard cold cash (Republican-run California has already gotten there), there is a real possibility that the entire market could shut down over summer.
In turn, that would mean the opening of a new front in the financial crisis, as millions of investors lose their investments in such bonds, or at least have to stomach huge losses over the near term. The scale suggests something similar to two years ago when the market for auction rate securities completely froze up, sending many states, cities and other government-linked borrowers to emergency programs.
That crisis could overturn the sunny news from credit markets for much of this year, as shown by new bond issues and generally tighter credit spreads.
It is fair to say that over the past 15 weeks or so, the notion of incipient market recovery has aided emerging markets by providing greater investor interest and allowing for contiguous if not spectacular stock market rises along with slightly better currency values and decent trade numbers.
Step back from the brink though, and as I pointed out in the previous article (see The Jackson Factor, Asia Times Online, June 30, 2009), actual gains from consumption have been minimal, with government spending programs doing much of the heavy lifting. This is indeed appropriate for various Asian governments, including China’s, to indulge in, but not for countries with current account and fiscal deficits such as India.
Even for countries like China, I fear that much of today’s efforts are being misplaced in production infrastructure for non-existent export markets. It almost doesn’t matter that goods can get from the Chinese hinterland to ports on the southeast coast; as the ships docked there aren’t going anywhere soon.
Much of the blame for this situation lies with Asian central banks that insist on a gradual approach to the current crisis, when clearly more radical and forceful steps are warranted. At the very least, a few need to be immediately undertaken including:
1. Cut the currency umbilical cord with the US dollar and allow a free float;
2. Reduce holdings of US and European government debt, instead using the money to upgrade infrastructure and deliver better services to their own citizens;
3. Strictly police the loan growth at domestic banks, much of it being misapplied to risky speculative ventures rather than the credit creation intended by the government;
Health warning: As with any of my commentaries on stock and other asset markets, readers must not depend on the words of a pseudonymous commentator in making their decisions. You should instead consult proper experts that can advise on your specific situation and if no such experts can be found use your common sense.