Do you remember those wonderful cartoons featuring the Roadrunner being chased by the Coyote? In particular, the bits that made me laugh inevitably featured the coyote running off a cliff or over a valley, realizing about a few feet into the peril that terra firma wasn’t in evidence anymore. Cue that wonderfully resigned expression on the coyote’s face before it plummeted to the usual crash.
I saw that look last week not once but many times as various “analysts” and “strategists” went blue in the face during their regular appearances on financial media (television as well as video interviews on newspaper websites) about how their assumptions about such things as “earnings recoveries” and “economic revival” would soon be proved correct, even if things looked a little hairy at the moment.
A consistent point I have made in these columns for the past three months or so has been that the only reason for risk assets to rise since the beginning of the third quarter (July) has been the notion of ample liquidity being pushed through to virtually create the next asset bubble. In other words, the last party trick of the Keynesians unable to hoist the global economy is to try ushering in an asset bubble that would rescue the global economy in much the same way that the US housing boom helped in the aftermath of the collapse in global stocks after the dotcom bubble burst.
A wonderful irony is that the Keynesians are using the same formula as one used by the person they apparently detest the most, former US Federal Reserve chairman Alan Greenspan, but then we shouldn’t get too bothered about things like principles at this stage of the global game. (See also Principal over principle, Asia Times Online, June 6, 2009.)
All bubbles depend on the notion that a marginal buyer of a pricey asset can be found at any point in time – that is, irrespective of the price and the time, the asset in your hand will always find a buyer. Assuming that you subscribe to this theory of making wealth, you would be called the “Fool” and the person(s) who is expected to buy the asset from you will be called the “Greater Fool”.
If you exclude the notion of a Greater Fool lurking behind the next curtain who will purchase your loftily purchased assets, the world suddenly looks bereft of any support for asset valuations. It isn’t so much a function of a minor adjustment being called in for risk assets over the near term as perhaps a wholesale re-evaluation of this year’s stunning performance in equity and credit markets.
Look in this article at some disturbing new facts that have emerged with many commonly held assumptions. The base case for me remains the same – major stock indices are likely to retreat to levels some 25-30% below today’s levels before the second quarter of next year; usually we should expect any correction to be sharp and very painful.
Firstly, that economic data point to an improvement.
The favorite point made by the equity market bulls globally is that economic data already highlight a bounce; with the global economy likely to emerge from recession early next year. It may, but then it is also possible that pigs will fly (no, not swine flu). This commonly made assertion rests on two connected sub-theories, neither of which stands up to scrutiny.
The first sub-theory involves the actual calculation of “real” gross domestic product (GDP) growth; trained economists will tell you quickly that virtually no other economic indicator can be as manipulated because it is easy to overstate nominal GDP changes just as it is to understate the “price deflator” element. Combine the two and you can make “real GDP” do pretty much anything you want it to do. Yes, even that.
The second sub-theory is that economies “always” bounce back from recessions. This is patently untrue with respect to the experience of Japan since 1989; but even ignoring that little factoid there are many other countries where despite positive demographics, the underlying economy hasn’t bounced back after many years of contraction (for example, Zimbabwe). So many otherwise wonderful economists quote this particular “bounce-back” theory that I am left pondering about how to beat all of them on the head with the voluminous data from Japan and the World Bank over the past few years.
Then there are the inconvenient details with regards to GDP numbers; such as what is happening to consumption data, investment and so on. Last Friday’s durable goods orders in the US for example showed a worse-than-expected decline in orders for durables, excluding aircraft orders. This suggests both that businesses do not expect a quick turnaround for the US economy and that removal of public-spending initiatives inevitably changes the picture back towards a new normal. (See also Clunkers for cash, Asia Times Online, August 8, 2009.)
As for consumption, anyone following economic statistics in the United States and Western Europe should know by now that retail sales, home purchases and durables (as above) all point to a consistently downward-looking picture. Just because you happened to see a brand new Ferrari on your last visit to Los Angeles doesn’t mean that the American consumer is back. In any event, the idea is to reconcile the volume of sales with the prior availability of credit: this is simply impossible under any circumstances; which means all these economies will have to settle at a lower level of consumption in their GDP figures, and permanently so.
Secondly, that employment is a backward-looking indicator.
A common refrain on financial talk shows to the question “if the economy is bouncing back, how come there aren’t more jobs” is the notion that employment is a backward-looking indicator. This is the case for the part of the economy focused on production – as typically order volumes rise, prices of certain goods rise, investments in capital expenditure rise before finally factories start employing more people; but it is incorrect for the consumption part of the economy.
For the US and certain countries in Western Europe (Britain, France, Spain and so on), consumption is typically over half to three-quarters of total GDP; and to the extent that jobless people don’t tend to spend a lot of money on new cars and houses or indeed even purchase new handbags, employment suddenly looms as a forward-looking indicator for economic growth.
People likely to default on mortgages or credit cards will not get any credit at all in the current climate where banks are already hiding billions in losses. Without employment, there will be no credit provided to these people.
This is the most inconvenient bit about the current asset bubble in stocks and bonds: such assets aren’t usually leveraged at the individual level. In other words, not a lot of people borrow money against stocks and bonds (unlike banks and companies, which do borrow a lot of money against them), and even when they can do so, the amount provided is a fraction of the current value of these investments. This is very different from leverage provided against home ownership, for example.
The last point about employment is that “liar loans” and the like are now impossible to get, thanks to the meltdown in mortgage-backed securities; and because of that, any credit will depend on your job as well as earnings (as well as other measures, including income stability). All of which means that without employment generation, there will be no consumption growth.
Now, that doesn’t look like a backward-looking economic indicator, does it?
Thirdly, that fast-growing countries cannot have asset bubbles.
Another item of faith in global markets now is the notion that accelerating economic growth washes away all sins, including those of asset bubbles. This percept lulls many investors into a false sense of security with respect to their investments, with many choosing to buy assets despite recognizing the valuation risks and bubble indicators.
How many times have you heard the phrase “well, it seemed like a good idea at the time” or its more verbose equivalent, “I knew the risks, but thought implicitly that macro growth would paper over the cracks”?
While it is possible that lofty valuations can be justified by growth that meets or beats previous expectations, the risks are almost inevitably slanted towards disappointment rather than elation. That is because most asset bubbles are monetary creations, rather than economic ones. In other words, the excess availability of credit or money almost without exception explains asset bubbles.
Barely two weeks ago, an open warning was issued from a rather unlikely source, from a bank in China, the world’s fastest-growing major economy. I reproduce part of the Bloomberg article that appeared on September 10:
Bank of China Ltd, which led the nation’s $1.1 trillion lending spree in the first half, said ample liquidity has caused “bubbles” in stocks, commodities and real estate. “The potential risk is that a lot of liquidity goes to the asset market,” Vice President Zhu Min said in an interview in Dalian today. “So you see asset bubbles in commodities, stocks and real estate, not only in China, but everywhere.”
China’s record credit expansion, which helped the country’s economy expand 7.9% in the second quarter, has raised concerns that bank loans have been diverted and used to buy stocks and real estate, fueling unsustainable gains in equity and property markets.
“There’s no way for the real economy to absorb so much liquidity,” said Liu Yuhui, a Beijing-based economist at Chinese Academy of Social Science. “Policymakers in China and around the world are well aware of the harm that could do, but they are unwilling to sacrifice short-term growth and wean the economy from addiction to the stimulus policies.”
… Bank of China advanced 1 trillion yuan [US$146 billion] of new loans in the first six months, more than any other Chinese lender and the gross domestic product of New Zealand. The Beijing-based bank, the nation’s third-largest, said last month it plans to slow credit growth in the rest of the year and improve loan quality.
The point is that China has the least to worry about in terms of asset bubbles, not because they don’t exist (they very much do) but because surpluses in fiscal and current account terms can be re-circulated to absorb banks’ losses at a future stage.
If there isn’t a prospect of avoiding asset bubbles in a fast-growing economy like China with the current levels of stimulus, imagine what is happening in countries with lower structural growth opportunities such as the US and Western Europe. More to the point, think of what kind of an economic miracle would be needed to justify today’s asset prices in these countries.
Lastly, that Europe is bouncing back.
The last battleground of the Keynesians is the supposed recovery in Western Europe that “justifies” the same course of action (strong government intervention, higher social welfare, rising taxes and so forth) in the Anglo-Saxon orbit. This notion would be fully supported if there were any quick bounce in European economies.
Certain economic indicators of late have been “massaged” to produce the illusion that some European economies are doing a lot better than they actually have been – car sales in Europe supported by a “cash for clunkers” scheme similar to the one in the US is a frequent example. Another is the stability (but not the trend) in retail sales – no big surprise really; the level of government welfare payments against high tax rates implies that gross disposable income in the economy doesn’t change dramatically over the short term.
Now we have cracks showing on the periphery of Europe, in particular in Portugal, Italy, Greece and Spain. Correspondent Ambrose Evans-Pritchard, in a September 24 Daily Telegraph article, “Spain tips into Depression”, makes the following points:
The Madrid research group RR de Acuna & Asociados said the collapse of Spain’s building industry will cause the economy to contract for the next three years, with a peak to trough loss of over 11% of GDP. The grim forecast is starkly at odds with claims by Premier Jose Luis Zapatero, who still says Spain’s recession will be milder than elsewhere in Europe.
RR de Acuna said the overhang of unsold properties on the market, or still being built, has reached 1,623,000. This dwarfs annual demand of 218,000, and will take six or seven years to clear. The group said Spain’s unemployment will peak at around 25%, comparable to the worst chapter of the Great Depression.
Spanish workers typically receive 50% to 60% of their former pay for 18 months after losing their job. Then the guillotine falls. Spain’s parliament has rushed through a law guaranteeing 420 euros [US$612] a month for long-term unemployed, but this will not prevent a social crisis if the slump drags on.
Separately, UBS said unemployment will reach 4.8 million and may go as high as 5.4 million if the job purge in the service sector gathers pace. There is the growing risk of a “Lost Decade” akin to Japan’s malaise after the Nikkei bubble.
Roberto Ruiz, the bank’s Spain strategist, said salaries must fall by 10% in real terms to regain lost competitiveness, replicating the sort of wage squeeze seen in Germany after reunification …
Spain has been in sharp focus of late, ever since a series of unflattering portraits of the country’s banks was made public. Research produced by a group called Variant Perception was widely circulated in the investment community; it makes the fairly significant point of calling the bluff from Spanish banks on their true level of capital.
As goes Spain, so shall other European economies, including but not limited to Portugal, Italy, Greece, France and Belgium. That’s another case where the collective look on the faces of Keynesians will resemble that of the proverbial coyote in the Roadrunner cartoons.
Disclaimer: As with all my analyses of stock and bond market movements, this one too comes with a health warnings namely to highlight the not insignificant peril associated with readers attempting to follow the advice of a pseudonymous writer such as myself without taking adequate precautions such as consulting with an appropriate adviser who understands your circumstances; or failing to find any such adviser to use your common sense.