Once a technical recovery begins, we should expect it to continue and blossom into a full-blown cyclical recovery. Obviously, I am talking about the medium-term, not the long-term here. But the point is that we have been in recovery for over one-and-a-half years in the US. Odds are that this will continue for some time to come (through 2011 at least)…
Across the board, the economic indicators show a modest but improving economic picture: industrial production, capacity utilization, personal income, retail sales. And I expect this to continue through at least the first half of 2011, probably through the whole year. [emphasis added]
-Cautiously Optimistic Into 2011, Jan 2011
This was my thinking in January. I reckon this view was a bit more downbeat than the average prognosticator. For example, Byron Wien’s ten surprises for 2011 were predicated on 5% growth in the US; he was a lot more bullish than I was to be sure. Call me mildly bullish on the first half of the year, but less sure of the second half.
Economic data are weak
Here’s what I left out between those two paragraphs though:
I see the jobs picture as encouraging. Employment is lagging as it has in the last two recoveries. So the recovery looks particularly weak. Moreover, there seems to be a skew toward the upper income strata. This makes the technical recovery appear even more sluggish. But clearly, the jobs picture is improving.
What are US jobless claims telling us about recovery? They are averaging about 410,000, down from almost 470,000 a year ago. And since employment is a lagging indicator, we should expect claims to drop even further as GDP has been growing.
We have just about made it through the first half in the mildly bullish pattern I indicated we would. But now that the second half of 2011 is upon us, things do not look nearly as positive. The reality since then has been a rise in average jobless claims to 430,000. The pace of expansion in the service sector has slackened. Manufacturing data are weakening. And real GDP has also moved into stall speed. So clearly something has gone seriously off the rails with this cyclical recovery. Moreover many of the risks I noted in January, Europe, housing, commodities, have become more problematic. That leaves the currency wars and government debt as two critical risks I outlined which have yet to derail growth. With state cuts looming and the debt ceiling breached at the national level, I expect economic weakness in the second half of 2011 in the US.
I would argue that the underlying fundamentals have always been weak. Pump priming and quantitative easing have led to animal spirits and speculative excess, giving us the illusion of sustained recovery. As I said in the ‘cautiously optimistic’ piece:
poor quality growth can continue for very long indeed. And it is this fact which allows the narrative of easy money and overconsumption to gain sway.
The boy who cried wolf
A soothsayer who counsels against this type of economic policy, but who warns of impending collapse will surely be seen as the boy who cries wolf. Think back to 2001 or 2002. Did we not witness then the same spectacle whereby the bears and doomsayers were let out of their holes to warn of impending doom from reckless economic policy? By 2004, unless these individuals changed their tune, they were long forgotten or even laughed at – only to resurface in 2007 and 2008 with their new tales of woe.
And indeed, this is exactly how things have played out.
What about the effect on markets?
Without the palliative of quantitative easing, we could see a flight to quality and a shunning of risk. The market has got way ahead of itself. My argument was as follows:
profit margins are cyclically high while P/E ratios are above their long-term levels. If firms staff up, we could see a modest rise in stocks due to an increase in aggregate demand, despite these two factors. Personally, I tend to like large cap value and I think that’s the right call for this environment because, while I am optimistic, I am cautious. On bonds, I have been saying for four months that they showed a poor risk/reward skew at these levels.
Firms really have not staffed up a lot. And so downside economic risk is greater. What’s more, the QE2 trade is now officially over. I flagged this back in March, speculating that the poor risk/reward of Treasuries could turn into a better bet because of a weak underlying US economy. I got into a bit of this in the last post on Richard Koo. My reasoning was that inflation expectations would start to dwindle as the fundamentals turned sour. Pointer to Mark Perry for this chart confirming just that.
The commodities crash was a shot across the bow for all risk asset classes. Equity investors are now getting nervous. Jeremy Grantham reckons the S&P is 40% overvalued and recommends a defensive posture. Felix Zulauf expects a major correction within months.
A weak second half means reduce risk
So, the data are weakening. What does that portend for the rest of the year? Lakshman Achuthan of the ECRI thinks it means a serious global slowdown. Below is a recent interview he did on Yahoo’s Tech Ticker explaining why.
He is concentrated on long-term global leading indicators, not just US indicators and not just short-term leading indicators. I think Achuthan makes a lot of sense. But, more importantly for US investors, there will be no Bernanke Put to counteract this. US interest rates are already at zero percent. QE2 is over and there is immense pressure on the Fed from within as well as politically to refrain from more unconventional policy. My sense is that the economy will weaken significantly before the Fed moves against it – and only then because of vocal outcries for more policy stimulus. At the same time, we should remember, the new fiscal year for states in 2011 and the debt ceiling debates will loom large as fiscal contractions at the same time.
In sum, you have a weakening recovery, uneven job growth, less accommodative monetary policy, tightening fiscal policy at the federal and local levels, austerity in Europe and tightening in emerging markets coupled with secularly high profit margins and above long-term trend price-earnings ratios. In my view, all of this will come to bear in a negative way this summer on risk assets: commodities, equities, and high yield bonds. Treasuries are the mystery. Economic weakness should support them but the debt ceiling debate is an overhang that makes Treasuries unattractive. High quality, high dividend, lower risk equities and high grade corporates outperform in such an environment.