Volume 63, Number 5
The economy and financial markets look like it is Déjà vu all over again. After a strong rally early in the year, the markets and economy faded as it entered the critical spring ramp up –just as it did a year ago, and two years ago. Last year, it was the Japanese Tsunami. The year before, it was the first round of Greek angst. This year, we are dealing with a payback for warm winter weather and renewed concern about Greece – oh, and the loss of China as the global engine of growth. The good news is that gasoline prices have stopped going up and that interest rates are at record lows in the US, as low as – well, as low as Japan in 1995. Yet, with the fiscal cliff still looming, we do not see the accelerating expansion promised in strong January and February data. Rather, a retreat from risk taking is under way as the one really big positive for the US economy – robust gains in the equities markets – has disappeared; putting consumer spending and the expansion back at risk.
The US has been muddling along flirting with stall speed, and now the world economy is threatening to cool the strong export growth that has been the backbone of the expansion. The bond market has been an excellent –and widely disregarded – harbinger of low inflation, both actual and expected. If the signal is accurate again, there is a possibility that the Fed is back to quantitative easing in order to forestall Japanese style deflation, especially as commodities prices come off the boil. With two new Federal Reserve Governors to bolster Bernanke’s position, QE3 can’t be dismissed if slow growth is accompanied by the threat of inflation under 1%. Bottom line, sub 3% nominal growth simply cannot be tolerated as it results in a downward spiral from private sector austerity at a time when the public sector is already overextended. Avoiding the fiscal cliff may be the least of the economies worries as it increasingly looks like fresh stimulus may be needed. The Federal Reserve is pushing for long term tax reform accompanied by short stimulus. This is a formula that is becoming increasingly mainstream in Europe, despite the resistance of Angela Merkel. Unfortunately for the monetary authorities here and in Europe, politicians do not act quickly without a clear mandate, so quantitative easing is far easier to bring to bear on the problem.
The first and foremost problem for financial markets and CEOs alike is that the Greeks will not have a resolution to their problem until June 17th. After strong indications that the left would gain further momentum immediately after the May 6th election, the failure of all parties to play nice and form a new government has erased that advantage. The desire of most Greeks, including those who support Syriza, to stay within the Euro is being threatened by rhetoric from both the conservatives in Germany and the radicals in Greece. What happens after June 17th is now a crap shoot, and as investors one must worry that we are crossing over from informed speculation to gambling. Hence, the run on non-German banks continues. We are not much worried about a run on Greek banks as that process has been underway for months. However, the threat of contagion could drag down Spain and Italy as deposits are exiting those regions – and should continue to until a Greek resolution is reached. As the US found during the Lehman crisis, bank runs don’t wait for elections.
While Europe continues to talk confidently about their ability to survive a Greek default, we are less certain. The essential problem for the continental banks is that still have not made sufficient allowances for bad debts. True, 90% of the Greek debts have been written off – or more accurately transferred to stronger government hands — but the losses in the rest of Europe remained buried on the banks’ books. By comparison, US banks have been clearing bad debts for many quarters, resulting in consumers financial obligation ratios returning to pre-crisis levels. Most of the reduction in consumer and mortgage debt in the US has been from write-offs. True, more consumers are paying on time and credit growth has been moderate by historical standards. However, principal repayments are still a slow painful way to reduce debt. Read the fine print on most credit card statements and you will find making the minimum payments results in years of future payments. Even at record low interest rates, principal repayments on 30 year fixed rate mortgages are less than 2% a year – and refinancing is reducing principal repayments by stretching loan maturities. For better or worse, the reality is that debt forgiveness is the primary source of improvement in consumers’ balance sheets. This process has not even begun for most European banks who are still counting on governments to shoulder the burden of losses. Bottom line, no matter how Europe solves their short term problems, the repairing of bank balance sheets promises an extended period of low growth and limited lending – for an economic region whose demographics already limit the potential upside. A weaker Euro seems the clearest path to recovery – just as a weaker dollar helped spark the export led recovery (tepid as it has been) in the US.
Although many analysts will argue for a weaker currency as the cure to economic ills, we have always found that a strong currency is a better long term policy. A currency weakens as investors leave for greener pastures, helping increase liquidity, lower interest rates and raise asset values in the beneficiary nations. While a weaker currency temporarily helps a countries existing exporters, it is a sugar high not a correction of the underlying problems. Temporarily gaining a price advantage over your competitor is only a benefit if you use the profits generated by the currency shift to solve the fundamental problem that caused investors to abandon your nation. Meanwhile, the stronger currency forces the stronger competitor to up their game – while at the same time providing them with the lower borrowing costs to do so. As we saw in Europe over the past year, a flood of money into Germany only exacerbated their structural advantages over the rest of Europe. They did not face a strengthening currency; rather they have seen higher inflation. In any fixed currency block, the stronger regions of the economy will always see prices rise as demand outstrips supply. This is the invisible hands signal to attract more investment. A stronger currency (or price inflation in a fixed currency block) only enhances the more successful countries advantage by allowing them to acquire the best practices and brightest employees of the weaker nations at a discount. Contrary to the widely held European myth that there is no worker mobility, Greeks, Irish and other young workers are moving out in droves as they seek work – and they don’t move to Italy.
The reality of a weak currency is that it cannot save a nation’s weaker industries; rather it forces capital toward its comparative advantages. Similarly, a strong currency forces a nation up the value added chain, and into greater innovation if they are already at the top. Take a simple example where a nation produces only two goods, movies that are 100% domestic content and cars which are 50% imported, and the country devalues by 50% in order to boost their auto sector’s competitiveness. Its films are now 50% cheaper and will see strong global demand. Its cars are just 25% cheaper (only the domestic portion sees a price decline) so while they will see stronger global demand, it will not be as great as for film. From the investors viewpoint (both foreign and domestic) it is better to invest in film, since it will see both a fatter profit margin and a better growth rate. Over time, the car industry will fair somewhat better – but film will grow faster. By devaluation, you have opened your strong film industry to foreign investment and control, basically selling a strong stream of future profits to shore up a weaker industry. Competitive devaluation is not good long term economic policy – but it is often seen as good politics. Bottom line, the US can only hope that its competitors – in both Europe and Asia – will follow bad long term economic policy. It will preserve the US as the world’s reserve currency (a significant comparative advantage) and force a focus on longer term issues – which are the dominant challenge in our economy.
It is still far from clear if the US will be able to avoid a recession in early 2013 as we deal with our fiscal cliff. As we look at the economic data, the US economy appears to be late in the economic cycle – after all the recession ended almost three years ago – rather than at the start. This month’s weakness in the Philadelphia Fed and the index of leading indicators may be part of the payback for warm weather. However, the correction in equities shows that investor confidence is far from where it was just weeks ago, and it has been high end spending and investment (particularly in real estate) that has sparked the recent revival in economic growth. The problem is narrowing (and perhaps now negative) profit margins as firms are fighting the reverse of the social safety net. Compensation costs are going up as fast as corporate revenues – but the low end spending has been restrained by higher taxes, especially at the state and local level, and reduced transfer payments. It was increased spending from investor households, who breathed a sigh of relief as equity markets rallied after the European LTRO, that carried the economy lately. Now, that confidence has been deflated. If firms turn to private sector austerity to reestablish margins at a time when no new government stimulus is available, a recession – like those now underway in the UK and Europe – is likely. Indeed, a fresh downturn, far less violent than post-Lehman, may be inevitable at this late date in the cycle given the best that can be expected is an avoidance of the worst of the fiscal cliff. One can only hope that the threat of a deeper debacle will force political adversaries into compromise. Europe is about to give us some insight as to whether that is possible.
Next week we will be traveling in Poland to get a close up view of the potential in Emerging Europe. The newsletter may be delayed due to travel.