September 5, 2011
An Imminent Downturn: Whom Will Our Leaders Defend?
The global economy is at a crossroad that demands a decision - whom will our leaders defend? One choice is to defend bondholders - existing owners of mismanaged banks, unserviceable peripheral European debt, and lenders who misallocated capital by reaching for yield and fees by making mortgage loans to anyone with a pulse. Defending bondholders will require forced austerity in government spending of already depressed economies, continued monetary distortions, and the use of public funds to recapitalize poor stewards of capital. It will do nothing for job creation, foreclosure reduction, or economic recovery.
The alternative is to defend the public by focusing on the reduction of unserviceable debt burdens by restructuring mortgages and peripheral sovereign debt, recognizing that most financial institutions have more than enough shareholder capital and debt to their own bondholders to absorb losses without hurting customers or counterparties - but also recognizing that properly restructuring debt will wipe out many existing holders of mismanaged financials and will require a transfer of ownership and recapitalization by better stewards. That alternative also requires fiscal policy that couples the willingness to accept larger deficits in the near term with significant changes in the trajectory of long-term spending.
In game theory, there is a concept known as "Nash equilibrium" (following the work of John Nash). The key feature is that the strategy of each player is optimal, given the strategy chosen by the other players. For example, "I drive on the right / you drive on the right" is a Nash equilibrium, and so is "I drive on the left / you drive on the left." Other choices are fatal.
Presently, the global economy is in a low-level Nash equilibrium where consumers are reluctant to spend because corporations are reluctant to hire; while corporations are reluctant to hire because consumers are reluctant to spend. Unfortunately, simply offering consumers some tax relief, or trying to create hiring incentives in a vacuum, will not change this equilibrium because it does not address the underlying problem. Consumers are reluctant to spend because they continue to be overburdened by debt, with a significant proportion of mortgages underwater, fiscal policy that leans toward austerity, and monetary policy that distorts financial markets in a way that encourages further misallocation of capital while at the same time starving savers of any interest earnings at all.
We cannot simply shift to a high-level equilibrium (consumers spend because employers hire, employers hire because consumers spend) until the balance sheet problem is addressed. This requires debt restructuring and mortgage restructuring (see Recession Warning and the Proper Policy Response ). While there are certainly strategies (such as property appreciation rights) that can coordinate restructuring without public subsidies, large-scale restructuring will not be painless, and may result in market turbulence and self-serving cries from the financial sector about "global financial meltdown." But keep in mind that the global equity markets can lose $4-8 trillion of market value during a normal bear market. To believe that bondholders simply cannot be allowed to sustain losses is an absurdity. Debt restructuring is the best remaining option to treat a spreading cancer. Other choices are fatal.
Greek debt races toward default
On Friday, the yield on one-year Greek debt soared to 67%. Europe is demanding greater and greater austerity as a condition for additional bailouts, but austerity has already resulted in a depression for the people of Greece, and a loss of tax revenues that has paradoxically but very predictably resulted in even larger budget deficits. As I noted more than a year ago (see Violating the No-Ponzi Condition ), "The basic problem is that Greece has insufficient economic growth, enormous deficits (nearly 14% of GDP), a heavy existing debt burden as a proportion of GDP (over 120%), accruing at high interest rates (about 8%), payable in a currency that it is unable to devalue... I suspect that budget discipline to the extent required will not be easily implemented, and may be so hostile to GDP and tax revenues as to make default inevitable in any event."
Presently, the Greek debt/GDP ratio is 144%, and is likely to reach 180% by year-end. It was only in June that we observed (see Greek Yields - Certain Default But Not Yet ), "At the point that a near-term default becomes likely, we would expect to see one-year yields spiking toward 40% and 3-month yields pushing past 100% at an annual rate (essentially pricing near-term bills toward the anticipated recovery rate)." To see the one-year yield leaping suddenly to 67% is an indication that we should brace for a very serious turn of events almost immediately.
One problem appears to be that European banks are eagerly volunteering for a 21% haircut on the debt (which is trading far less than that on the open market), but only in exchange for shifting the debt covenants from Greek law to more binding international law. This would be a bad deal for Greece, because it would essentially impose further severe austerity on the Greek people in return for a debt reduction that would still leave the debt/GDP ratio well above 100% and growing. Greece should reject this, because a larger default is inevitable, and it would serve the country best to maintain as much control over the size of the default as possible. Ultimately, my impression is that it would serve Greece best to exit the Euro, but it appears too late for this to be graceful.
Undoubtedly, a Greek default comes with a significant risk of contagion to other countries. On that front, the most worrisome targets of contagion - Italy and Spain - both have high debt-to-GDP ratios, but there is really no credible risk of outright default in those countries. As such, the ECB should certainly be willing to extend its purchases of Spanish and Italian debt. But note that the objective would not be "quantitative easing," nor would it represent a subsidy to those countries. Rather, an ECB backstop for larger European countries would represent market stabilization of what are likely to be good credits. And provided that the ECB only purchases the debt at reasonably high interest rates (rather than depressed rates as the Fed seems eager to do here), the intervention would simply be an application of the century-old Bagehot's Rule ("very large loans at very high rates are the best remedy for the worst malady of the money market when a foreign drain is added to a domestic drain.") Importantly, Bagehot also accompanied this rule with an admonition to impose costs, capital requirements, and other safeguards where public funds are concerned. As for any public funds approved for use by various European governments to stabilize the financial system, IMF chief Christine LaGarde is right - those funds would be better used to recapitalize banks (ideally, restructured banks) rather than using those funds as a transfer to Greece in hopes of making bad debt good.
What is particularly unfortunate is that all of this is unfolding in a very predictable way, but the constant attempts to ignore reality and defer the inevitable restructuring is imposing enormous costs on the public. As Ken Rogoff and Carmen Reinhart wrote two years ago in their book This Time It's Different, "As of this writing, it remains to be seen whether the global surge in financial sector turbulence of the late 2000s will lead to a similar outcome in the sovereign debt cycle. The precedent [a close historical overlap between banking crises and external debt crises in data from 1900-2008] however, appears discouraging on that score. A sharp rise in sovereign defaults in the current global financial environment would hardly be surprising."
Measuring the probability of oncoming recession
A wide variety of data continues to corroborate the high risk of an oncoming recession, including plunging consumer confidence, weak payroll employment, and various indices of economic activity. The following chart updates the U.S. economic activity composite that I presented in early August (see More than Meets the Eye ). Note that new orders, in particular, have deteriorated to a point that is rarely observed outside of U.S. recessions. The deterioration is also clearly more severe than we observed in 2010.
In that August 1, 2011 comment, I reviewed the components of our Recession Warning Composite , noting "From the standpoint of this composite, we would require only modest deterioration in stock prices and the ISM index to produce serious recession concerns." Within a few hours of publishing that comment, the August ISM figures were released, coupled with a drop in the S&P 500 sufficient to complete the elements of that recession warning. I should note that while the September ISM figure for manufacturing came in slightly above 50, the primary source of strength was inventory accumulation, while new orders slumped. This is not a favorable profile, and as the graph above indicates, a much broader set of evidence is consistent with economic contraction.
In the same commentary, I noted a number of corroborating indicators (see also the 2007 comment Expecting A Recession ) that are typically also observed near the beginning of oncoming recessions. It is worth noting that few of these were observed during 2010. These additional factors, now in place, include a major, abrupt plunge in consumer confidence, with an even sharper drop in the "future expectations" index, negative real interest rates, an ISM index below 54, a decline in aggregate weekly hours versus a quarter earlier, year-over-year growth in non-farm payrolls less than 1%, and six-month payroll growth less than 0.5%. Though there is some hope that the current downturn is no different than what we saw in 2010 (despite evidence otherwise), it's worth noting that the S&P 500 is below where it was when the Fed initiated QE2, and has made virtually no net progress since March 2010.
I'm not sure how other economists come up with the 10%, or 30%, or even 50% "probability" numbers for recession that are reassuringly quoted by the media. I'm fairly certain they're tossing out numbers from the top of their heads, because statistical methods kick out a very high probability of recession here unless you limit the variables to things that are impossible in the face of zero interest rates, such as an inverted yield curve.
An ensemble of other models also produces a very high probability of recession across a broad set of assumptions - I've charted the data below to give you an idea of what I'm seeing - the heavy black lines show actual recessions. Maybe this time is somehow different. I just think it's a poor idea to ignore the data here.
All of this mirrors what we observe from our Recession Warning Composite. Even with a strong prior belief in a continued recovery, Bayes' Rule still implies a near certainty of recession once you observe the data, because the combination of evidence we currently observe has always been seen in recessions and isn't seen outside of them. So while there are a lot of opinions about the risk of recession, the observable data are challenging to probability estimates much short of certainty. That is, unless you ignore the data entirely on the assumption that Ben has it all under control.
Some may object that the jump in personal consumption expenditures in July somehow rules out a recession, but we can't find a year except 2008 in which we did not see at least a 4% annualized jump in monthly consumption expenditures for either July or August, largely corresponding to back-to-school spending. Moreover, despite widespread misconception on this point, the NBER Recession Dating Committee (headed by one of my former dissertation advisors at Stanford) does not define a recession as two quarters of negative GDP growth. The actual determination captures fluctuations in a much broader set of individual economic measures, and the starting and ending dates use monthly, not quarterly figures.
Still, while the evidence is challenging, we shouldn't entirely rule out the chance that we could avoid recession. It's just that the hope of a recovery rests on the belief that either a turnaround will happen spontaneously despite unusually strong constraints on the flexibility of fiscal policy, or that the Fed will provoke a recovery through additional policy even though none of what the Fed has proposed appears to have any transmission mechanism to the real economy. I continue to believe that the core of our economic problem rests in the need to significantly, and probably painfully, restructure debt burdens on loans that were carelessly made and are no longer serviceable. This will require lenders to accept more significant losses than they have taken to date, but everything else is just can-kicking.
Profit margins, labor income, and the growing cloud over earnings growth
As of the latest GDP report (National Income and Product Accounts - NIPA), U.S. corporate profits are now at the highest ratio to GDP in history. Wall Street is eagerly basing its valuations of stocks not only current earnings, but on forward operating earnings that reflect assumptions even higher profit margins. The resulting P/E ratios are made to look better still by comparing them with historical norms that are based on trailing net earnings (which are typically much lower than forward operating earnings and therefore produce higher P/E "targets"). The resulting valuation estimates are pure noise, and have virtually nothing to do with what counts - the present value of the very long-duration stream of cash flows that will actually be delivered to shareholders. Using normalized measures of valuation, we continue to estimate that the S&P 500 is priced to achieve 10-year total returns of only about 5% annually.
The chart below illustrates the danger is basing valuation estimates on earnings figures that reflect very high profit margins. The blue line presents the ratio of profits/GDP (left scale). The red line presents the annual growth of corporate profits over the following 5-year period, and the right scale is inverted. Higher profit margins are predictably related to weak subsequent earnings growth over time.
Note that in the past few years, the growth of NIPA profits (about 6% annualized) has been above the level that one would have projected on the basis of already high profit margins in 2006-2007. It is tempting to think that this divergence means that somehow profit margins have escaped their historical tendency to mean-revert, so that "this time is different." However, we've seen this sort of divergence before (see the early 1960's). On inspection, it is clear that faster-than-expected profit growth results in a very high level of profit/GDP at the end of the 5-year period (see the late 1960's), which is then followed by dismal 5-year earnings growth.
From that perspective, it is of some concern that we're starting to see analysts quoting the relationship of the S&P 500 to NIPA profits as an indicator of "market valuation." This is problematic because NIPA profits are far from any normalized value upon which long-term valuation conclusions should be based. In fact, the raw ratio of nominal GDP to the S&P 500 is better correlated historically than NIPA profits to the S&P 500, over any reasonably long-term horizon (say 5 years or more).
That said, however, it is also clear that investors seem to take the bait of high profit margins over the shorter run, which can help to prop up overvalued markets, which later retreat. Somehow the very predictable erosion of profit margins still takes investors by surprise. This dynamic is why profit margins have a clear negative correlation with subsequent 5-10 year returns in the S&P 500 itself. So despite the fact that profit margins have a wicked historical tendency to mean-revert, investors seem to ignore this to their misfortune.
To a large extent, the widening of profit margins in recent years reflects two unsustainable dynamics. One is that the increase in profits as a percent of GDP has essentially come at the expense of employees. The spike in corporate profit margins has moved hand-in-hand with the collapse in labor income. As companies cut employment dramatically in recent years, they were able to maintain relatively high levels of output, which was reflected in high productivity growth figures. At this point, however, there is little latitude to expand profit margins through further payroll cuts, and labor tensions are increasing as well. The sequential decline in measured productivity in recent quarters, and the corresponding pickup in unit labor costs, reflects the difficulty in picking much more from the bones of workers.
But if wage income is falling, how is it possible to maintain the sustained (though not growing) level of demand that is responsible for elevated corporate profits? Simple - add in a second unsustainable dynamic. Government transfer payments are now substituting for wage income to the greatest extent ever observed in history. The majority of the recent surge represents unemployment compensation.
In fact, 22 cents of every dollar of U.S. personal consumption is now financed with transfer payments. It would be absurd to imagine that this does not fall to the bottom line of corporations. In effect, the elevated level of profit margins is largely a reflection of government deficits that maintain transfer payments, and by extension, consumption demand - even in the face of wage compensation that has never been lower as a share of GDP. While we are likely to see further deficit spending in the event of a full-blown recession, which will provide at least some buffer for demand, it is doubtful that investors should bake the assumption of sustained record profit margins into their long-term valuation of stocks.
As of last week, the Market Climate for stocks remained hard negative, reflecting the combination of unfavorable valuations, unfavorable market action, and an ensemble of additional conditions that has historically been associated with a poor return/risk tradeoff. Strategic Growth and Strategic International Equity remain well-hedged here. Strategic Total Return continues to have a limited duration of about 1.5 years in Treasury securities, with about 20% of assets in precious metals shares and about 4% in utility shares.
It is clear that investors have pinned a great deal of hope on a third round of quantitative easing, or alternatives such as a "twist" (in which the Fed would extend the maturity of its holdings), or a reduction in the interest rate that the Fed pays banks on reserves. While there is some amount of Pavlovian speculative potential in these prospects, I doubt that we would see a full replay of the advance we saw during QE2 in any event because it is now much clearer that the whole objective of QE is to provoke speculative demand from greater and greater fools. While we don't expect any durable market returns in the event of another round of QE, we'll respond to new data as it emerges, which includes periodically accepting some amount of market risk - even briefly - at points where the market's expected return/risk profile moves above zero on the basis of observable conditions.
The basic problem is that none of the Fed's policy options operate to relieve any economic constraint that is actually binding. Ten year yields are already below 2%. If this is not sufficient to prompt demand for loans (and it is not, because existing debt burdens are already excessive), there is little sense in a policy aimed at further marginal lowering of long-rates. Though Wall Street gurgles an audible "goodie, goodie, goodie" at every prospect of Fed intervention, it would be best for the Street to collectively put its big-boy pants on and realize that economic growth is not something that the Fed can sprinkle out of Ben Bernanke's cans of fairy dust.
At the point our nation recognizes that the pattern of repeated bubbles, crashes, and misallocation of capital is not solved by the Fed but is instead caused by the Fed, it will become clearer that the best path to economic recovery is to shift attention toward debt restructuring, real investment, useful infrastructure, and the creativity and work ethic of real human beings. Until then, we will have an economy built on speculation and paper, stacked into a flimsy house of cards. As James Grant of Grant's Interest Rate Observer noted last week, the Federal Reserve is presently run by "policymakers that seem to have no first, or fixed principles. Current monetary arrangements are defective and are robbing us of the dynamism this country has been known for... Somehow, with QE everything, with a zero percent funds rate, with monetary 'mastery' from the people in Washington, I think the current system is leeching dynamism from this economy and from society, and I think we'll find something better."
Grant accompanied those comments with an exceptional insight about the consequences of Fed actions - "Inflation is more than CPI - it is too much money chasing too few something or others. Inflation takes the form that we will know about later." Speaking of the housing bubble, he observed "so the Fed was targeting inflation, as measured, but neglected to notice that house prices were where they had never been before. So that was inflation as it came to be defined in retrospect."
That is exactly right. The policies that the Fed is pursuing here distort market signals, create speculative incentives, and encourage the misallocation of capital. There should be no doubt that this will damage our economic future over time, but we will only discover exactly the form of that damage later. The best vision for the United States is one where the markets allocate saving toward productive investments that legitimately have the potential to reward that saving, where the banking system finances good ideas and useful economic activity instead of looking for the next profit opportunity from financial engineering, and where government policies promote a flexible and well-trained labor market that is strong and skilled enough to enjoy a reasonable share of the economic fruits. That vision is only corrupted by the Federal Reserve's misguided conceit that prosperity can be dropped from a helicopter, and by policies that avoid debt restructuring on the belief that lenders can never be allowed to suffer losses.
I wish I could be more optimistic here, but we are data driven - the objective evidence looks awful and the likely policy choices seem equally unappealing. Undoubtedly, the data will eventually change, and our outlook will change in response, but the best we can do at present is to estimate the probabilities and return/risk profiles that are consistent with the data we observe, and respond accordingly.
The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse.
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