Thinking Things Over June 10, 2012
Volume II, Number 23: The Heartburn of the Next Sixty Days Presages Better News This Fall
By John L. Chapman, Ph.D. Washington, D.C.
Fed Chairman Ben Bernanke testified before the Joint Economic Committee this week, and said the Fed was “prepared to take action” to bolster a U.S. economy still facing “significant” risks to its continuing recovery, especially if the general outlook worsens or, specifically, the Eurozone calamity deepens. Sadly, this is exactly what is going to happen in the near term, yet we remain confident of hints at better policy later this year.
The News This Week was “Mixed”, and Will be More So This Summer
Along the way to deepening the entitlement deficit in France this past week, French President François Hollande was overheard complaining that what the Eurozone needs now is economic growth – but growth, in turn, demands “stability”, he opined. Pardonnez-nous, Monsieur le Président, mais chacun à ses gouts, when it comes to your concept of “stabilité.” (That is to say, “To each his own….”).
The new French premier is nothing if not ironic in his intonations about what ails Europe. For indeed, while he campaigned against the failures of the Sarkozy government, blaming the current French torpor on his predecessor’s policies, Mr. Hollande completely missed the naked truth of the matter: French economic policies, and much of Europe’s more broadly, have long been governed with his kind of “stability” in mind. Sadly for the French, however, that is the “stability” of Marx and Rousseau, with supremacy of the state, bureaucratic diktat and the equality of incomes (or, results) foremost in the intentions of policymakers – and not the stability engendered by the market economy, viz., a decentralized societal stability based on property rights, sound money, capital accumulation, and equality of entrepreneurial opportunity. Indeed, only this latter kind of “stability” is truly stable, in the sense that it guarantees real economic growth and human progress, and is thus self-perpetuating.
It is a telling mindset of a leader on the world stage at a moment not unlike that of 1937, when the global economy, having suffered a catastrophic downturn followed by a few years of uneven recovery, was again teetering on a worldwide recession. But unfortunately, it is a mindset which produces all sorts of errant policy ideas, such as punitive taxes on upper-income citizens, a group comprised largely of the job-creating producer class. Or, per this week, policies promoting ever-expanding entitlement obligations that in turn bring with them ever-increasing unfunded liabilities. Such illiteracy of basic economics or of the drivers of sustainable growth based on the true “stability” of the venerable policies of laissez faire is, sadly, not confined to Mr. Hollande. But a repeat of the 1937-38 downturn need not happen, at least globally, and while further gyrations and blasts to global equities are a certainty in the next 60 to 90 days, a rally in the U.S., as a precursor to better policy, is eminently possible this fall.
The continued heartburn in the near-term seems all but assured based on this past week’s headlines:
- Global unemployment figures continued to climb (France to 9.6%, Italy to 10.2%, and Greece to 21.9%, in releases last week, and now 11%+ across all of Europe), while estimates of global and U.S. GDP growth for 2012 were uniformly lowered (and for the world, too; JP Morgan, for example, lowered its global growth estimate for the second half of 2012 to 2.1% from 2.6%, saying the Eurozone will contract, and many emerging markets such as Taiwan, once expected to evince strong GDP gains this year, were also lowered [in that case to 3.3%] – U.S. first half 2013 growth may well now be below 2%, too). Moody’s is now set to cut ratings on many of the world’s top 100 banks, including the “Big 5” here in the U.S., as early as this week; this will further pressure liquidity and credit availability.
- Global rate cutting: China’s central bank (the PBOC) lowered its benchmark one-year rate 25 bps this week to 6.31%, for the first time since last summer after signaling rates would move higher. India and Australia have also cut rates recently, and Mario Draghi hinted last week that the ECB will move soon as well. Meanwhile safe-haven ten-year bonds in Germany and the U.S. have traded – largely on their own of late – down into record territory, below 1.50% in the U.S. and down to 1.30% in Germany. While yield curves have been bastardized globally (the U.S. central bank’s balance sheet assets are up 225% in the last four years while the U.K.’s is up 320% and the ECB’s more than 150%), the marked decline in long yields around the globe in the OECD is an unambiguous signal of slower growth due to, in this case, deadened animal spirits, in the time ahead.
- The pressure on Spanish banks to find sources for recapitalization – read, German-led bail-out with strings, as its 10-year sovereign rate has soared in the last three months (from 4.5% back toward 7%) – has intensified, though published reports of needed funding in the range of $40-100 billion seem low for what is the world’s 12th largest economy now wading through a true depression. ECB and EU summit meetings later this month (as well as Greek elections on June 17) may engender unpleasant surprises – particularly if there is no traction on developing any long term solution, as there likely will not be. European equities, which rose 30% from last fall’s lows on the “hope” of a comprehensive and orderly Eurozone restructuring (that could only be based, in the end, on “austerity” for the public sector and growth incentives for the region’s private sector), have now retreated in their entirety, while global equities are off one-sixth in the same timeframe (though still up 70% from March 2009 lows). The fact that Spain and its possible bail-out partners (EU, IMF, ECB) cannot find common ground for a recapitalization and bank back-stop is the source of renewed global nervousness, above and beyond Greece itself (which, after all, has already seen 75% of its debt written down and is now smaller than the economy of Maryland).
- Oil (and other commodities) have moved sharply lower this year, often a bad indicator of investor sentiment in a macro sense when it is so pervasive (though helpful to global consumers).
Yet in our view there are reasons for a quiet sanguinity about the future, if not outright unbridled optimism, in spite of the sure turbulence to come this summer:
First, U.S. economic data continue to portray a hardy resilience in the people who make up the numbers. The trade figures for April were announced this week: the deficit in goods and services trade came in at $50.1 billion in April, as exports and imports both declined, by $1.5 billion and $4.1 billion, respectively. Heavy capital goods led the decline both ways, continuing recent months’ slowing in manufacturing and trade indicators. But importantly, exports are still up year-on-year by 4.1%, while imports are up 6.3%. As we have repeatedly held, it is the combined totals – showing trade (and hence economic activity) volumes, that are of most interest. The volume totals are just off the record highs (in both real and nominal terms) of recent months, a sign of health in any economy. The stronger dollar in recent months will pressure corporate profits later this year, but seen in a longer run context, the decade decline in the dollar’s trade-weighted value has unambiguously helped some U.S. exporters, particularly those in higher-end value-added goods – and of course professional services as well.
(As an interesting aside, several prior years’ quarterly data were adjusted for both exports and imports, and this is likely to lead to a decrease in 4th quarter 2011 GDP, but an increase in 1st quarter 2012, potentially back up above the psychologically-important 2.0% level.)
Weekly jobless claims for the week ended June 1 were down 12,000, to 377,000 – not good, but not terrible for this highly volatile metric. We expect this figure to rise in the month ahead, but only slightly. (A robust economy would see this trend down to 320,000, and will be a huge foretelling sign when that happens).
Meanwhile non-farm productivity was down -0.9% in the first quarter, revised downward alongside the lowered first quarter GDP estimate, from last month’s initial estimate of -0.5%. However, productivity is still up +0.4% year on year, and 2.5% annually, on average, since the end of the recession. While any productivity gain less than 2% cannot be called robust, and anything less than 1% must indeed be labeled as weak, it is nonetheless true that positive productivity gains, while always uneven, are a strong signal that no recession is imminent.
Within the data on productivity, the manufacturing sector continues to shine. The first quarter’s growth rate for manufacturing productivity was +5.2%, a stellar statistic three years into a recovery, while total output in the sector grew 10% on an annual basis. This is all due to the path-breaking new technologies – primarily of a digital and increasingly wireless nature — coming online throughout the process value chain. Unit labor costs are down sharply as well (nearly -5.0%), good for the sustenance of manufacturing profits and ever leaner production (per capita compensation is down across the board, too, however, -1.5% year on year with a -2.0% decline in the first quarter).
Lastly, the overall ISM non-manufacturing index rose to 53.7 in May, indicating continued expansion in the services sector. Most of the sub-indices (for business activity, new orders, and supplier deliveries) were all higher and into the mid-50s from the prior month, while only employment fell, to 50.8 (from 54.2), along with prices paid.
This month’s report was very encouraging, given the “global gloom” now pervading equity markets around the world. U.S. services are the very leading-edge part of the U.S. economy and always the best class of American exports. To have not only continued positive growth readings here (above 50.0 for the 29th straight month) in spite of an absolute decline in export volume and declining sentiment is a very good sign of the robust durability of the U.S. economy. Indeed, the ISM indices correlate positively with GDP growth over all, and again belie the recession talk in many quarters now.
Summary and Implications
Where does all this leave us? Of course we have our eye on the June 17 elections in Greece, and the Federal Reserve’s Open Market Committee meeting on June 19-20; both events may well move global markets in a big way next week. And later in the month the EU, and likely the ECB and IMF as well, will create “noise” around Spain specifically, and a Eurozone fiscal pact more broadly (though the latter will develop over a period of years, however formal or not, in our view).
Other events in the United States will affect global sentiment and trading as well: in the next three weeks the U.S. Supreme Court will render a verdict on ObamaCare, even the partial negation of which, in our view, would be read as a condign ending to open-ended fiscal irresponsibility. And the U.S. consumer, though somewhat chastened in recent months, still continues to post increasing year-on-year purchase volume totals in nearly all goods categories, especially durables and even housing. While no policy shifts in the U.S. will occur before the November election, it is increasingly possible that even more robust proposals for growth-inducing saving, investment and work output will be forthcoming from Mr. Romney, at least, as he has gained resonating approval when enunciating his determination to pass comprehensive growth measures right away next year. In turn, his traction on this would surely force President Obama to embrace his own Bowles-Simpson reform platform, and all of this would (will?) move U.S. equities this fall.
We also refuse to buy into the panic scenarios now fed and fostered from so many quarters in the professional investment management community – a true herd mentality now, if ever there was one. If Greece leaves the Euro formally, it might happen soon this summer, the finality of which will quickly be fed into market consciousness (and prices), and all this after multiple rounds of discounting of the reality there. Further, there is too big a “zone of agreement” on the Spanish banks’ indebtedness, and too much capital wealth in the rest of Europe, for some accord not to be struck, at the “11th hour” (and after much heartburn, we concede). And countries like Portugal will learn, one way or another, from Greece’s path.
Overall, though, we think the Europeans will muddle through in the next few years. Our study of the Asian crises of the late 1990s reinforces this view. The disasters and contagion that sped through the five countries that broke currency pegs in 1997 (Indonesia, Malaysia, the Philippines, South Korea, and Thailand) were as traumatic then to that region as the Eurozone’s challenges are now. Policy differed by country, but in the latter two countries especially, a few years of negative GDP and declining real per capita incomes were fought through to full recovery. More recently Iceland went through a banking disaster and a steep decline in GDP growth (-6.5% and -4.7% in 2009 and 2010, respectively, before returning to positive growth of nearly 3% in 2011); eventually the necessary restructuring will ensue in the Eurozone. It is important to note that the Asian disasters of the late ’90s had next to zero impact on the United States; while it is true that the Eurozone is much more integral to the U.S. economy today than emerging Asia was then, it is also true the global capital stock and economic flexibility are greater today than they were then.
All of this makes us cautious about European equities as an asset class at the moment, as well as the Euro itself (EUR is down 8% against USD in the last two years), but we have long positions in both. And though we expect the near-term turbulence described above, as stated, longer term there is too much fundamental value still there.
Indeed, there are pockets of good tidings around the world that will help Europe as well. Interest rates are lower in the non-affected parts of Europe now, for example, as well as in the configuration of Asian growth stories. This will all help with both refinancing and recapitalizations in Europe and around the globe, as well as with current consumption now. Further, industrial commodity prices have fallen to such an extent that they are now a de facto tax cut for the world’s consumers.
Second, whether for better or ill, the world’s major central banks all seem set to reinvigorate the discredited Phillips Curve, and this cannot but be ameliorative to short term growth – and asset prices, again in the near near-term. Investors who are out of the market when all this happens in coming months may regret it.
Third, corporate America, and many of their best global brethren, are all cash-rich. Realizing an era of new liquidity will foreordain higher interest rates in the years ahead, coupled with the potentiality of better growth policy out of the United States that much of the world, developed and developing alike, will proceed to emulate, may well lead to at least a steadying of growth next year.
We concede this is an “optimistic” description of how the next several months will play out, and things could go terribly wrong, beginning with the aftermath of the Greek elections and then exacerbated by more troubles in the Eurozone and China, a U.S. fiscal breakdown next year, and so on. None of the above should be construed in any case as an argument for a robust period of growth, such as the multiple quarters of 6-7% growth in the 1980s in the U.S. Nor have we lost our fears of a stagflationary era a few years out, prompted by the higher interest rates and inflation we see as axiomatic. The likeliest scenario now for the United States may well still be GDP growth in the 2% to 2.5% range for the coming decades.
But considering the “correlation of forces” now pressuring the global economy in detail, along with recent history of recovery from debt-burdened breakdowns, does offer hope that macro-catastrophe can not only be avoided, but that there are investment gains to be had in the offing, near-term. This of course is of little consolation to the pathetic and now-benighted Greeks, or their brethren in Portugal and Spain and perhaps France and Italy, too. Living standards must, per force, be lowered in much of Europe (and that is already happening, in fact). To say all this differently, the laws of economics are inexorable, and cannot be annulled.
But thinking dispassionately, as investors, there is much opportunity amidst the ruin, even as there is much ruin in a nation. And for the United States at least, it seems to us as though votes such as that taken last week in Wisconsin show that a population that is (finally) educated about looming fiscal burdens that are either massively inefficient for the economy if not wholly unjust – let alone unfunded – can indeed turn the tide, demanding better policy in the months and years ahead. We will find out soon enough.
For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, John Chapman can be reached at email@example.com. The views expressed here are solely those of the author, and do not necessarily reflect that of colleagues at Alhambra Partners or any of its affiliates.
Click here to sign up for our free weekly e-newsletter.