Economic Direction as Seen Below the Radar

The financial press’s take on the economy and financial markets has lately been cloudy. The growth rate has indeed been drifting and the economy is being subjected to adverse shocks. But let me suggest there is good reason to believe there is a positive direction emerging below the radar of the cross-currents.

One way to reveal patterns of growth is to break down or decompose economic time series into long-term secular trends, cycles and shocks, which take on a pattern of random noise. Since the noise sells newspapers, it receives the lion’s share of daily attention, and it can also cloud the economy’s overall sense of direction. Certainly, the recent plethora of shocks — whether tapering and then more tapering, the emerging market sell-off, Obamacare’s attendant ripples, or adverse winter weather — can create a sense of economic drift or even contraction.

But it seems to me that more important cyclical forces are unfolding below the radar, moving the economy so slowly that its movement is barely detectable.

When I say cyclical forces are moving the economy, I mean that they have a life and momentum of their own apart from the shocks and the secular influences. That is, economies slipping downward don’t go to zero, and economies moving upwards don’t go to infinity. Growth sets in constraints — which typically are overinvestment in durables and plant and equipment — indeed leading to an absence of investment in the recession that follows.

Similarly, during times of recession, a backlog of deferred replacement for capital goods occurs and is ultimately fulfilled. This is true whether the capital goods or durables are those of the consumer, business or even the government.

The below graph depicts the duration and amplitude of U.S. employment cycles during the last 70 years or so. The graph reveals that when the economy goes down, so does peak employment from the previous cyclical high. The depiction of cycles is centered on the cyclical employment bottom, which is measured relative to the number of months since the beginning of the recession.

As you can see, most of the post-WWII cycles were relatively short and mild compared to our current episode (shown in red), which is still struggling to return to peak employment six years later. The current recession is a long-bottoming-out saucer that stands out from the much shorter and shallower post-WWII business cycles. The graph shows how the current “recovery” has been slow-moving but nonetheless persistent.

Easier and cheaper money has been the usual driving force that lifts the economy out from a cyclical bottom. In the first wave, it stimulates consumer durable spending, including housing after an absence of durable replacement. This revival has already occurred in the U.S., causing a bottoming out of our current great saucer.

The typical second wave of a cyclical recovery is business investment spending on plant and equipment, which kicks in after demand rises faster than the supply side is expanding. The usual pattern is that business meets higher demand levels first by adding labor, which becomes more expensive as it becomes scarce.

The availability of skilled cheap labor in the U.S. is becoming constrained due not just to rising employment levels but also to an unprecedented drop-out factor in labor participation. Furthermore, much of the globalism movement of the past 30 years (i.e., moving production to countries with large pools of cheap labor) has pretty much run its course.

In that situation, the recessionary lag in business investment spending tends to kick in, driving the next phase of a cyclical expansion.

The usual benchmark for this to occur is when industry capacity utilization reaches 80 percent — and U.S. total industry utilization is now knocking on that door at the 79.2 percent level.

capacityFurthermore, most of our emerging market competitors’ utilization rates are above those of the U.S., so the expansion of the capital goods industries is likely to be a global phenomenon.

Basically, there has not been a capital expenditure boom since the tech go-go years in the late 1990s, and the capital equipment we do have is aging, with an estimated life of 22 years (up from a more usual 19 years.

Much like my 1999 Pathfinder of the tech year vintage, it has physically worn out, and the usual capital goods replacement phenomenon has me reaching for my wallet. But in that regard the business sector is cash-rich like never before, so the usual obsessing over interest rate elasticity of investment spending is less relevant. If it were relevant, rates are low enough.

Indeed on the financing front, a great deal of financing occurred last year via the non-bank banking sector on top of retaining earnings for years during the recession. To the extent that the Ma and Pa shops did not get in on last year’s financing bonanza, the commercial banking system is showing signs of loosening up credit six years after the shockwaves of 2008, and banks should again become relevant for them.

So basically we are at the point where the baton to keep this race moving forward is in the hands of business cap spending, as consumers are showing signs of constraints in paying for more expensive health care.

The other missing sector that has not been heard from (or at least is not making a lot of noise) is the gradual removal of the net export drag. Available domestic energy is a very positive and long term “shock” to the system.

So cap goods spending, which disappears in recession, reappears at about this juncture of the business cycle, fortified by physical obsolesce, a shortage of skilled labor, and ample cash on hand.

Will this be a typical business cycle recovery? Well, there is nothing about this recovery that is totally classical, as it’s been a classic all to its own. But this fundamental impetus from deferred demand for capital goods stands a high probability of being realized to keep the ball rolling forward.

Moreover, despite governments at all levels attempting to get their fiscal houses in order, there is also a deferred infrastructure demand that will pressure the replacement if not the expansion of the existing roadways across America that are in critical neglect.

While there is good reason to believe that the current cyclical movement will continue into its next phase, one must realize that as employment grows and labor markets become tighter — especially for the skills needed for today’s plant and equipment — labor costs tend to rise as a percentage of the corporate top-line revenue leaves a thinner margin of corporate profits.

So we get into the anomalous territory where growth continues but profit margins and total profit growth decline. So the growth of the economy and the growth of profit diverge at this juncture as an aggregate number, but the focus on the growth industries in this environment makes this a stock-pickers market — unlike last year, when the broad indices outperformed the economy.

As a last note: Cost-push inflation often creeps into this second stage of a cyclical recovery,  which causes fixed-income prices to decline in the later portions of cyclical patterns. We should anticipate much the same to happen again, which makes inflation-sensitive income streams more valuable at this juncture.

 

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The Stock Market, QE3 and Voodoo Finance

As we look across the economic landscape there is an abundance of reason to anticipate a global economic slowdown. It is already well in the works as reflected in anticipatory data. It would not be a garden-variety recession emanating from some lull in spending but rather the grinding process of over-indebtedness and uncertainty due to tax and health care issues.

At the same time, over-indebtedness also creates a withering of financial valuations, which sets off another chain reaction called systemic financial meltdown.  This reduces the value of assets held by individuals and institutions such as banks, which in turn further dissolves financial wealth when assets are dumped in order to pay off fleeing depositors.

As a result, financial intermediation withers so that the process of matching of savers, if there are any, with investments is impeded. This in turn negates future growth. For example, systemic financial forces causing a recession visited the U.S.  in the late 1980s. At that time large commercial banks were overburdened with Latin American loan defaults and simultaneously savings and loan associations (remember them?) were decimated when inflation depreciated their book of long-term mortgages.  This limited systemic financial event resulted in a prolonged 1990 recession.

Hence whether the over-indebtedness first strikes spending or financial intermediation, it is difficult to discern as they interact and both income flows and financial valuations suffer, whichever occurs first.

Today, the developed world’s over-indebtedness reactions of the combined recessionary forces and bank runs are emanating from Europe’s southern tier. Unemployment numbers in Greece and Spain rival those of the Great Depression.

But the question on the table is the ability of Northern Europe and the U.S. (and, for that matter, the rest of the world) to escape at least temporarily the ill effects of the above degenerative process.

To gauge that, the market looks to the ability of monetary and fiscal policy to come to the rescue, and if the rescue is attempted will it work? Given the succession of bailout funds established but without the means to fund them, it is not a realistic option. To the extent country debt has been carried by other contributing countries, it is extremely limited and if, indeed, the Spanish bank bailout takes place, it exhausts all bailout funds from the Eurozone’s willing contributing countries.

Nonetheless, the contributing countries keep promising more and more, with the latest being a bank deposit insurance fund — and the market somehow believes it.

If fiscal resources from other contributing countries are extraordinary limited, what is the extent of monetary funding to aid both a recession and systemic financial meltdown? Well, there is some defense to the systemic financial event as long as the Fed and the ECB and other central banks are willing to keep expanding their balance sheets. There is no theoretical or legal limit to how much can be purchased to keep financial asset valuations afloat in order to prevent imminent financial meltdown, but to go overboard they are willing to give up all discipline of monetary control, and with it, holders of the currency go elsewhere.

Given the vulnerabilities present, how then can one explain stock price buoyancy? Since the beginning of the year the S&P 500 index is up approximately 6% and FTSE 100 index is up 2 percent despite the onset of recession and bank runs.

If there is any logic to it, it seems to be resting on less than a firm foundation. While equity investors rely on current known information such as earnings, they also project forward the value of the claims they are purchasing, hence making financial pricing a mixture of facts and a learned history to project forward.

What you often hear these days is a general awareness of the economic and debt problems but a faith that the bigger the problem, the bigger the government response will be. That is to say, any investor citing “in my 25 years’ experience” is a candidate to be projecting a future based on the Great Moderation Period of Greenspan Puts and currency solidarity in Europe.

Financial prices are inherently an extrapolation of a history, but it’s certainly not the Great Moderation, though that was the dominant influence in the thinking of the 25-year U.S. veteran stock market investor.

But then there is a newer history called the Bernanke Put, best characterized as a succession of QEs or other outside-the-box monetary stimulus, the latest of which is operation twist.

It’s now a common attitude that if the situation becomes bad enough there will be a response equal to the task needed to keep financial values afloat. Now being cited is the above chart showing how equity markets respond to QEs. It seems that the Fed has well trained stock market investors in Voodoo financial logic. The worse the economic problem, the better it is for stocks despite declines in earnings.

As a side note, QE faith stock valuations are throwing noise into the long term relationship of stock prices to earnings and as an early indicator of a recession. This is one of many structural changes that are occuring which implies that one must be careful of which history is chosen to extrapolate.

Before one relies on Voodoo finance and a faith-based QE3, one should note that additional Fed stimulus is almost certain in the face of a systemic financial institution collapse but is less certain and will be less dramatic due to a softening economy. Systemic financial defense was the raison d’etre for the Fed and remains its number one policy objective, but some token form of monetary aid has now become necessary to prevent a collapse of the Voodoo expectations the Fed has created. If that occurs, expectations have become self-fulfilling.

 

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VIDEO – Texas Financial Market Roundtable 2012

The economic, financial and public policy issues associated with debt overload and bank runs is discussed by Dave Rosenberg, John Mauldin and Rich Yamarone. Professor Lew Spellman of the McCombs School of Business moderates.

 

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The Great Recession

The Elements of the Perfect Storm
The Great Recession: Why the Great Recession is Different
The Great Recession: Ineffective Fiscal and Monetary Policy in the Great Recession and Fed Exit
The Great Recession: The Carry Trade and Asset Bubbles
The Great Recession: The Threat to the Carry Trade