a dose of reality

Armies of bulls and bears are camped out on either side of the great debate over the future of the global economy. Armed with the latest statistics and plenty of financial incentive, both sides are engaged in massive media campaigns to rally anyone left on the fence — principally retail investors who were either burned in the great collapse of 2008-09 or sat out the fast and furious rally over the past 14 months. As the rhetoric heats up, it becomes increasingly difficult to choose sides. A careful examination of these competing wagers provides a more holistic perspective for anyone brave enough to join the fight.

Victory lap

Having survived the worst correction in generations, major indices are now back to levels not seen since the near simultaneous collapse of Lehman Brothers, Merrill Lynch, AIG, Fannie Mae and Freddie Mac. Most stocks are discounting any possibility of a prolonged recession, and in many ways they may be right:

• Home prices are stabilizing
• Manufacturing production is on the rise
• Consumers are out buying again
• Productivity is the highest it has been in decades
• The labor market is coming into balance
• Corporate earnings are blasting through expectations
• Bullish investor sentiment is nearly at all-time highs
• The banking sector is fortifying their balance sheets (with capital)
• Corporate sector is fortifying their balance sheets (with cheap debt)
• Inflation is nowhere in sight
• Low rates are making home and business investment more affordable
• Greece was bailed out by its closest neighbors
• The European Central Bank announced an unprecedented $1 trillion stabilization fund
• Asian economies are growing by double-digits (particularly China, South Korea, and India)
• Latin American countries are following close behind (particularly Brazil)

With all this good news, the casual observer may wonder why so many commentators are making increasingly bearish calls on the global economy. Some of the reasons are technical (i.e. growth comparisons to last year’s apocalyptic performance can be misleading), some are conspiratorial (e.g. the “Plunge Protection Team“) but many are rooted in the simple and often dysfunctional relationship between the non-financial community and the mainstream media.

In that context, this dose of reality isn’t meant to take sides. It simply reminds the casual reader of economic news that what they don’t hear, don’t follow, or don’t understand could have significant consequences on everything from the salary in their next job to the size of their retirement pension to the price of a loaf of bread.

A spoon full of sugar

Despite a few fits and starts, an eerie calm has settled over most of the American economy. The delusional panic of late 2008 and early 2009 has given way to supreme confidence about the prospects of a healthy recovery, much of which is supported by hard data and careful analysis. Moreover, the media has made positive sentiment feel completely natural, with reports that home sales are “surging” or production is “accelerating” or job losses are “stabilizing“. A closer look at the data underlying these three common themes reveals a vastly different economic outlook.

For example, distilling something as complex as real estate demand and supply dynamics into a single growth statistic is not only misleading but potentially dangerous. Home sales may appear to be surging compared to last year’s depressed levels, but prices are well off their highs in late 2007 and still above their long-term average, volumes are the lowest they’ve been in over half a century, and vacancy rates remain elevated.

Similarly, production is definitely up, but off such depressed levels that comparing it growth over the last five years is far less helpful than comparing it to the last time factory orders plummeted as they did in 2008-09 — namely during the Volcker-inspired recession of 1981-82. A look back at that particular episode suggests that recent signs of growth are consistent with the first leg up in manufacturing activity, though it also suggests that production may double-dip before recovering sometime in 2012-13.

Finally, any suggestion by financial commentators that the labor market is improving potentially masks the underlying structural issues facing the U.S. and many of its Western peers. Four simple statistics help put the current situation in context:

1. The unemployment and underemployment rates have only been this high once before since the Great Depression;
2. The duration of unemployment is higher than it has ever been since records were first kept back in 1948;
3. Wage growth hasn’t been this low (i.e. negative) since the 1950s; and
4. Estimates suggest that it will take 18 million new jobs (or roughly 300,000 a month for the next five years) to return to full employment.

Counterfactuals?

There are countless examples of both data and anecdote being used by sophisticated bulls, bears, and even market innocents to try to make sense of all the chaos in modern global capital markets. Rather than point out each individual misrepresentation or dubious causal chain, what follows is a few brief counterpoints to the anthem of bullish sentiment outlined above:

Home prices are stabilizing

• Shares in home builders have more than doubled since the market touched bottom in March 2009, out-pacing the broader market despite any real recovery in sales or prices. Reports of “surging” sales in March are still some of the worst levels in three decades. More worrisome is that no real stability has been achieved despite trillions of dollars in public support and mortgage rates at all-time lows. In fact, the same index that has provided so much support to the bullish case is now signalling a dreaded “double dip“. Add in stubbornly high unemployment and massive shadow inventory and it is tough to see why investors are still so enthusiastic about the sector.

Manufacturing production is on the rise

• Marginal increases in production are certainly a good sign, but record-breaking growth off such depressed levels is hardly the convincing sign of V-shaped recovery that some commentators and bullish investors have been hoping for.  Moreover, with record low rates making investment in capital goods more affordable and government stimulus spending increasing demand for goods and services, manufacturing output is still lower than it was in 2004. The final element in the mix is reflected in statistics on capacity utilization, which has only been this low on one other occasion: during the 1982 recession when interest rates were still in the double digits. With rates hovering near zero and government debt spiraling, there’s little room left to help manufacturers build and — more importantly — hire.

Consumers are out buying again

• Retail sales are definitely rebounding off 2009 lows, and part of any sustainable recovery begins with a resumption of household buying. That said, the debt-fueled consumption over the last half-decade that brought savings rates well-below historical levels. After a brief return to fiscal sobriety, it appears that consumers are once again spending down their savings, a particularly surprising development given that personal income growth is well-below trend and unemployment is still painfully high. Then again, consumer confidence is starting to send pessimistic signals about future income expectations so perhaps people have simply come out of their shells for one last rush through the box store before hunkering down for the next leg of the crisis.

Productivity is the highest it has been in decades

• Defined as output per unit of input, productivity gains can be achieved by either increasing output, decreasing inputs, or both. For example, gains during the 1990s were likely impacted by the mass introduction of the personal computer and the proliferation of leaner supply chains in post-Cold War trade, increasing output without a major shock to the labor force. In contrast, it has been speculated that recent gains are largely due to headcount reductions, lower wages, and lower interest expense, leaving far fewer employed consumers to purchase the same amount of output.

The labor market is coming into balance

• Not to beat a dead horse, but there are still 15 million unemployed Americans, and more than 6 million of them have been looking for work for more than 6 months. The share of the population currently working hasn’t been this low since the early 1980s — just after the mass entrance of women into the labor force.

Corporate earnings are blasting through expectations

• Two major factors are affecting lofty expectations of corporate earnings growth: 1) easy year-over-year comparisons; and 2) chronically low-ball estimates. Moreover, most productivity gains have already been squeezed out of operations so maintaining this pace will become increasingly difficult going forward, particularly as interest rates start to climb and resources prices once again put pressure on key input costs. Only time will tell whether these structural factors will affect market valuations, but there is certainly a clear and present risk.

Bullish investor sentiment is nearly at all-time highs

• Excessive bullish sentiment is a surprisingly accurate contrarian indicator. History suggests that the proportion of optimistic stock pickers increases just as the market begins to turn. Basically, investor psychology tends to lag major inflections, and analysts haven’t been this bullish since the market peaked in late-2007.

The banking sector is fortifying their balance sheets (with capital)

• Banks might need all the help they can get if “strategic defaults” catch on and traditional defaults resume their upward climb. Estimates have suggested that some of America’s largest banks will need to set aside billions over the next year to cover their exposure to increasing delinquency on residential mortgages, commercial mortgages, student loans, credit cards, etc. Equally concerning is the rising failure rate of smaller regional banks, whose traditional role is to provide much-needed credit to small communities.

Corporate sector is fortifying their balance sheets (with cheap debt)

• While credit remains tight for small- and medium-sized businesses as banks remain reluctant to lend, high yield (i.e. “junk bond”) issuers are filling their boots with cheap debt as investors flock to their higher rates of return. Easy access to credit has certainly helped lower the rate of default for this riskier class of issuers, but with credit conditions tightening and risk aversion returning, this abundant source of capital could quickly dry up just when companies need it the most.

Inflation is nowhere in sight

• The economy seems to be sitting in a sweet spot, just slow enough not to trigger inflation and interest rate hikes, and just fast enough to avoid the dangerous downward spiral of deflation. However, both history and recent evidence suggests that the markets will not remain in purgatory for long, and either path is fraught with substantial risk. If the nascent recovery sputters as recent GDP and price data suggest, the American economy could dip further into recession and the Fed would be virtually powerless to support prices with rates already so low. Alternatively, if the recovery takes hold (or commodities prices continue to climb) inflation could force the Fed to raise rates, strangling what little organic growth is left out of the economy. Obviously this leaves out the specter of inflation in China, India, Australia, and Brazil, but we’ll save potentially overheating emerging markets for later…

Low rates are making home and business investment more affordable

• Low rates are artificially inflating asset prices in a risky search for yield. When the Fed eventually begins to tighten monetary policy it may stamp out any artificial/speculative growth and potentially plunge the economy back into chaos, or at the very least lead investors to swap riskier equities and real assets for relatively relatively safer government and high-rated debt. Without an influx of cheap capital, investment will likely slow and asset prices will likely fall, putting subsequent pressure on both the real economy and a highly-leveraged banking sector.

Greece was bailed out by its closest neighbors

• Greece’s biggest issues lie ahead, and its current woes may simply be a symptom of greater fiscal challenges ahead throughout the Eurozone after decades of profligate spending and biased statistical reporting. One important consideration that both politicians and analysts seem to forget is that all the agreements and treaties in the world are meaningless if public opinion leans against the wind. Protests have been flaring up for months and have only worsened since the formal bailout was announced. It will take a true political master-stroke for Greece to implement its harsh but necessary austerity plan without an outright public revolt. Markets are also now aware of the incestuous web of debt that connects Europe’s PIIGS to large financial institutions throughout the region, stoking fears of another cascading credit crisis. Bear Stearns is to Lehman as Greece is to ?

The European Central Bank announced an unprecedented $1 trillion stabilization fund

 

 

• With confidence already shattered in the wake of the Greek drama, European leaders organized a massive campaign of “shock and awe” that buoyed global markets and frightened bond vigilantes (for a day). Unfortunately, the plan still leaves plenty of questions about the wisdom of a common currency and the tenuous relationship between regional haves and have-nots. Moreover, as with TARP in America, the bailout is also likely to unleash another round of moral hazard among the world’s banking giants, with minimal impact on unemployment and retail demand in countries that need it most. Finally, there is still considerable uncertainty about whether legislatures within the Eurozone’s 27 member nations will ratify the program as it is currently conceived. The UK has already refused to participate, German voters and academics continue to challenge their country’s role in leading the rescue, and currency markets remain unconvinced.

Asian economies are growing by double-digits, Latin American countries are close behind

• With growth rates in the low double-digits and pressure from around the world to keep the engines of Western capitalism greased with reinvested dollars and euros, emerging economies (in particular China, India, and Brazil) are starting to see the effects of simultaneous fiscal and monetary stimulus. Only time will tell if politicians are willing to trade lower growth and employment for more stable, sustainable development.

Outside of these traditional indicators, there are other geopolitical factors at play that could disrupt even the most thoughtful analysis. Speculation is mounting that the recent Gulf oil spill could be worse that the Exxon Valdez catastrophe more than 20 years ago, Icelandic volcanoes showed how Mother Nature can wreak havoc on global supply chains, the attempted-bombing in Times Square reminds us that (in)security is still a major global issue, firefights in Korean waters remind us that the Cold War is still alive and well, and Mexican drug-related murders are peaking at 20 per day at the business end of the global criminal supply chain. On the flip side, advancements in health sciences and technology continue to marvel and provide a great vision for a prosperous future, not to mention the hundreds of millions of people lifted out of poverty over the last two decades who are now looking to produce and consume in an increasingly integrated global economy.

Headwinds or tailwinds?

With earnings blasting through expectations and the so-called “fear index” approaching 2010 highs, the battle between bulls and bears seems destined to continue. That said, the quickening pace and feverish rhetoric now suggests a major inflection one way or the other. One simple rule can help draw important insights out of this complex financial, political and economic narrative: stay informed.

You can trust the mainstream media to be too bullish when markets are rising and too bearish when they are falling, but that still leaves a giant swath of data and perspective at the fringes of the public debate. The prudent investor and citizen can learn a lot from these observers regardless of how the wind blows.

When markets are marching euphorically higher, doomsayers like Nouriel Roubini and David Rosenberg provide interesting counterpoints to the market’s hopeful optimism. Highly respected commentators like Barry Ritholtz and Simon Johnson round out the blogosphere with helpful financial and economic insights. In Asia, Stephen Roach at Morgan Stanley and his former colleague Andy Xie are a great source of insight on faraway markets and the political economy that drives them. And against all odds, Twitter has proven to be a powerful tool for following market-making news in real time.

In the end, understanding the totality of our complex global economy is an impossible task. But with every incremental piece of information we can make more informed decisions about our own path through the crisis. With prudence, attention, and a little bit of luck, it may be possible to emerge unscathed — even better off — regardless of what lies ahead.

As the old saying goes, in the land of the blind, the one-eyed man is king.