IN THIS EDITION
A VICIOUS CYCLE
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Economic data the world over indicate that a global economic slowdown is well underway. Central banks have already responded with fresh stimulus, as anticipated by financial markets. But just as the economic recovery of 2009-2011 was largely artificial and, thus, disappointing in key respects, so the unfolding slowdown is going to result in a few nasty surprises. In this Amphora Report I discuss what I believe to be some of the more important implications of the current, ‘vicious’ cycle, in which unseen damage is being done to the global economy. As the damage becomes apparent—perhaps already this year—equity market valuations are going to take a hit.
NOT YOUR PARENTS’ BUSINESS CYCLE
For some months now, leading indicators the world over have been pointing toward slower growth ahead. It’s not just about the euro-area any more. China, India, Brazil, the US, Japan—most economies appear to be slowing. A major recession may not be on the way but below-trend growth has already arrived and looks set to continue into 2013. Business cycles being a fact of economic life, the current slowdown is not surprising in of itself. No, what is surprising is the upturn that preceded it. By various measures, it was deeply disappointing.
First, in the developed economies, the level of real GDP has yet to materially exceed the previous peak reached in 2007. For a downturn to begin without having exceeded a previous output peak is one way to distinguish a ‘depression’ from a ‘recession’, a semantic point discussed in a previous Amphora Report, From Deflation Push to Inflation Shove (June 2012; The link is here.).
Second, while headline growth has been disappointing, the mix of growth has also been poor, that is, it has been driven somewhat less by real fixed investment and final demand, and rather more by stimulus-fueled inventory accumulation. Indeed, in the US, real final demand, considered to be the ‘core’ rate of GDP growth, has struggled to rise above 2% y/y, far below the level seen in past recoveries.
A SUB-PAR RECOVERY: WEAK FINAL DEMAND
Now inventory accumulation is not necessarily a problem. There is nothing wrong in principle with producing today that which will be consumed next year. But businesses must remain confident that the inventory will indeed be consumed at some point and won’t cost too much to finance in the interim. Lose that confidence and businesses will seek to reduce inventory, with all the negative implications for jobs, incomes and growth generally.
Now why might businesses be concerned that inventories are too high? Well, in the US, the inventory to sales ratio has been creeping higher, albeit from a low level. More worrying, personal disposable income growth is weak, in part due to the large decline in the workforce participation rate over the past three years.1 And, notwithstanding a small rise in the household savings rate since 2009, households have yet to meaningfully de-leverage. Indeed, the truth is rather the opposite, as household net worth has plummeted as a result of the housing market crash. There is thus little if any so-called ‘pent-up demand’ to absorb accumulating inventory.
US HOMEOWNERS’ EQUITY HAS YET TO RECOVER MEANINGFULLY FROM THE CRASH
(Equty as % of real estate assets by market value)
Corporations may look in comparably better shape. Profit margins are elevated. They have accumulated much cash on their balance sheets in recent years. But as I have pointed out before, they remain unusually highly leveraged in a historical comparsion.2 The aggregate corporate debt/net worth ratio, at nearly 70%, is much higher than is normally associated with high rates of fixed investment. No, corporate investment is not going to lead the way out from here. As is the case with households, there needs to be an economic de-leveraging first. This is a simple, unavoidable economic fact, policymaker rhetoric to the contrary notwithstanding.
The trick thus becomes how to engineer this de-leveraging. Central banks are resisting a natural, deflationary de-leveraging in which prices decline to levels that clear the excess inventory and excess capacity in various sectors of the economy. (By ‘excess’, I mean that which has run ahead of underlying real income growth and net savings.) This resistance follows directly from their stated aim of rescuing their weak financial systems, still drowning in distressed, illiquid assets.
Preferable from their point of view is to engineer an artificial, policy-driven reflation instead, as this will erode the real debt burden and keep the financial system more or less intact as is. Eventually, so the thinking goes, through inflation, incomes will rise to levels that can service the accumulated debt such that healthy, sustainable growth can resume.
Perhaps central bankers can pull this off, although putting fresh capital in the hands of those who misallocated it in the past doesn’t exactly come across as a compelling long-term growth strategy. It is as if a failing corporation (USA Inc), rather than firing underperforming managers (Wall St), gave them large bonuses instead (TARP). Who in their right mind would invest in such a firm? When it becomes a national policy, who in their right mind would invest in such a country?
In any case, what policymakers won’t tell you is that this sort of artificial reflation is a wealth transfer from the real, productive economy to distressed, in some cases politically-connected firms that receive first access to the new money entering the economy. This is important. While a printing press can’t create wealth, over time it can transfer it from those who don’t have access to the press, to those who do. Indeed, if printing presses actually created wealth and distributed this evenly and fairly throughout society, why on earth would counterfeiting be illegal?
Please see Fighting Solvency Time Bombs with Liquidity Bazookas, Amphora Report Vol. 2 (October 2011). Link here. That new money entering the economy benefits primarily those who first receive it is hardly a novel idea but it is one that neo-Keynesian economics conveniently glosses over. Economist Richard Cantillon recognised the ‘non-neutrality’ of money way back in the 18th century and the way in which new money distorts relative prices is called the ‘Cantillon Effect’. For more on this important concept, please see the Wikipedia article linked here.
FROM QE TO CURRENCY AND TRADE WARS
Regardless of the insidious wealth transfer it engenders, artificial reflation can be difficult to engineer when faced with such a huge accumulated debt, as so-called ‘balance sheet effects’—debt write-downs—can overwhelm ‘income effects’-the rising nominal incomes associated with inflation. There is, however, one method that trumps all others: Currency devaluation.4 Yes, this may clearly and directly rob savers (and importers) to bail-out borrowers (and exporters), but if other methods fail, then devaluation will ensure a de-leveraging of the economy. It will also make it poorer overall, but the borrowers, being bailed-out in the process, avoid bankruptcy and thus are naturally all for it. Who cares if the pie shrinks a bit if your slice increases disproportionately in size? Such is the attitude of an established, self-serving elite.
By announcing QE3 last month, the US Fed is raising the stakes in the reflation game. Asset purchases are now ‘open-ended’; in other words, the Fed will buy up whatever is required to generate what it believes is a sufficiently high rate of inflation. If that sounds radical, it is. This is the greatest economic central-planning experiment of modern times, one that threatens to wreck the US economy via chronic resource misallocation as described above.
Whether or not QE3 results in a material decline in the value of the dollar relative to other currencies is unclear. There are two sides to any exchange rate, and many other economies have issues of their own, including their own versions of QE. Who succeeds in devaluing against whom is one of the great unknowns at present. But be under no illusions: A ‘currency war’ of sorts is already underway. (Brazilian Finance Minister Guido Mantega seems particularly fond of this term, having used it on multiple occasions to criticise US monetary policy. He has also claimed that the current currency war is leading toward a more general global trade war.)
Back in October 2010, in the Amphora Report titled Begun, The Currency Wars Have (The link is here.), I considered the potential implications of a general global currency war:
Currency wars might appear to be zero-sum. But this is true only up to a point. For if all countries intervene to weaken their currencies in equal measure, no country succeeds in devaluing versus the others. As such, they might then resort to raising trade barriers or enacting currency controls which restrict the flow of capital across borders. These sorts of actions cause substantial economic damage however and are thus hugely counterproductive. The 1930s were characterised by, among other things, currency devaluation, capital controls and rising trade barriers such as the infamous “Smoot-Hawley” tariff.
Fed Chairman Bernanke stated as much in a (in)famous 2002 speech in which he discussed how central banks can always prevent deflation and create inflation if desired. The link is here.
While potentially growth negative for the global economy, currency and trade wars can, however, contribute to rising price inflation. Why? Well, the weapons of currency wars are the printing presses. The more you print, the more you can weaken your currency, or at a minimum prevent it from rising. He who prints most, devalues most and “wins”. But if all print in equal measure, exchange rates don’t move, but the global money supply soars. As such, currency wars don’t stimulate real economic growth–indeed they are much more likely to weaken it–they stimulate only nominal growth, that is, inflation. The net result is most likely to be a global “stagflation”.
Now imagine that the current global downturn is met with even more aggressive attempts by various countries to weaken their currencies, increasing uncertainty with respect to currency and trade policies. Tariffs and import quotas for sensitive goods begin to rise from historically low levels. Globalisation, as it were, begins to go into reverse.
While the neo-luddite, anti-globalisation crowd might rejoice at this development, for investors, there will be little to celebrate. Modern corporations are highly leveraged to relatively free trade. They are already facing higher input costs due to the general global commodity price inflation resulting from previous QE. Industries ranging from airlines to mining are facing industrial action as workers push for wage increases. These factors are beginning to place pressure on profit margins.
But now, already facing margin pressure, corporations might need to contend with unforeseen trade barriers springing up right in the middle of their highly specialised, globalised operations. These may have a huge impact on their cost structure and in some cases will render entire divisions uneconomic. Large restructurings may be required, costly as they are. Some corporations may find that they are simply unprofitable absent free trade and will wind down operations or possibly even end up in bankruptcy. Shareholders may be in for a rude shock.
At a minimum, the equity risk premium is likely to rise in the event that it appears that the currency wars are morphing into trade wars. That will depress valuations. At worst, the global equity market might crash. Indeed, some economic historians believe that the proximate trigger for the great stock market crash of October 1929 was news of a major compromise in the US Senate making it highly likely that the proposed Smoot-Hawley Tariff Act would pass.6 Of course, the world was hardly as globalised back then.
Begun, The Currency Wars Have, Amphora Report Vol. 1 (October 2010). The link is here.
The US House of Representatives passed a version of the Smoot-Hawley bill by nearly a 2/3 majority in May 1929. It was assumed at that time, however, that the bill was unlikely to get through the Senate, and the stock market continued to rise. Indeed, even following much debate and compromise, the Senate’s version of the bill passed by only the narrow margin of 44 to 42. Just imagine what effect something along the lines of Smoot-Hawley would have today.
INVESTING FOR THE VICIOUS CYCLE
When economic upturns are disappointing and downturns trigger counterproductive policy responses, equity risk premia naturally adjust higher, implying lower market valuations. When those policy responses escalate into currency and trade wars, the result can be a major correction or even a crash.
Near term, regardless of whether such risks materialise, I would be concerned about the equity markets. QE-euphoria has led to fresh advances but there has been a noticeable lack of participation by transportation stocks. That may be due in part to a handful of profit warnings in prominent firms such as FedEx Corporation (NYSE:FDX), but then global industrial bellwether Caterpillar Inc. (NYSE:CAT) also issued a warning late last month. Meanwhile, the euro-area crisis stubbornly refuses to go away. In Spain, demonstrations have recently turned violent and at least two regions are considering seceding as a way to opt out of further central government attempts to impose ‘austerity’.
While not a prediction, I would not be at all surprised by a 15-25% stock market decline over the next few months. We have now entered a seasonal period which contains a majority of major market declines, including 2008, 1987 and 1929. Just last year, there was a sharp correction in Aug-Sep, immediately prior to the current window.
Cautious investors should consider waiting in cash for a more attractive valuation point at which to re-enter the equity market. But be under no illusions: In a world of QE, cash is not a store of value, rather merely a convenient place to wait out the downside risks associated with the current, ‘vicious’ cycle, artificial reflation and the associated currency and trade wars that may lurk in future. Bonds are an even worse store of value of present, as they represent a leveraged exposure to devaluation risk.
As an alternative to cash, investors may want to consider an allocation to relatively defensive commodities, that is, those with a low correlation to the business cycle. As I pointed out in my September report, Par for the Pathological Course (link here) a handful of these look relatively inexpensive at present, including cotton and sugar. Among industrial commodities, following a recent sharp decline, oil is looking relatively cheap at just over $90/bbl.
Gold may be approaching the previous record high from 2011, but given currency debasement and other, associated risks discussed here, it will probably continue to rise in price, as indeed it did as the US descended into the Great Depression in 1929-1934. Remember, gold is a form of insurance, not a productive asset. As uncertainty rises, so does the demand for insurance. But if the supply of insurance is relatively fixed, then the price must rise.
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