The global economy appears to be suffering from diminishing returns to stimulus as the response to sustained QE and deficit spending are failing to increase economic growth. Policy makers around the world are unsatisfied with the current economic situation and so keep piling on the stimulus – making it the status quo for business leaders who now spend more time worrying about when it will end. In the US, while the financial markets worry about tapering, the Federal Reserve is actually discussing whether there is a need for even more QE in response to falling inflation. In Europe, the shift away from austerity implies growing demand for more government deficit spending to spark growth somewhere as their ongoing downturn creeps into the core of France and Germany. In Japan, Abenomics call for higher inflation as a spur to higher growth (who knew?) is running into the inevitable result of higher interest rates. And in China, the new leadership’s concern that ever more debt is producing ever smaller gains in GDP has them talking down growth expectations, while playing up prospects for greater income equality and better living standards.
Four years ago, at the bottom of the deep Lehman trough, Government policy makers, investors, business leaders, and labor around the world were in agreement that dramatic measures were needed to restart the cratering global economy. For a year afterward, a rising tide carried all boats. Then, cracks appeared as Europe refused to bailout its periphery – stalling growth momentum globally. A year later, Japan suffered a devastating shock via the tsunami and compounded its problems by shutting off all nuclear power. Japan’s woes actually offered opportunity for others who gained market share while Japanese competitors were side-lined. But this “stimulus” was short lived as Japan rebounded in 2012 and global growth again stalled. Now QE3, Abenomics, reduced European austerity, and Chinese reforms are policy makers’ hopes to generate new growth.
However, global business leaders seem far less likely to use this round of economic aid to invest and hire in anticipation of a profit producing growth rebound. Rather, they are preparing for the possibility that stimulus will end – perhaps permanently – as it did temporarily in the summers of the past three years. Having survived the Lehman crisis, they are cautious, with many accepting that the current muddle through maybe all that can be expected for the foreseeable future. This leaves them in a much different place than politicians worried about upcoming elections; or investors worried about spending power a decade ahead; or labor still struggling for job growth; or consumers still paying down debts; or Keynesians worried about a liquidity trap; or monetarists who fear the loss of anchored inflation expectations. The uneven nature of the recovery four years past the trough is unlike any post-war expansion, and conflicting opinions and interests suggest it is unlikely we will achieve the “rising tides raises all boats” kind of peak seen in those cycles.
The Cart Before the Horse
Nowhere is this more obvious than in the ebbing and flowing of the bond market. Each year during this recovery, long term interest rates have backed up as investors begin to believe a recovery is underway. The latest episode was sparked by the breakdown of the bond market in Japan – as should have been expected when the Government embraces inflation – and from Wall Street (but hardly the Federal Reserve) talking about the imminent tapering of QE3. Investors obviously fear the loss of capital gains that comes from rising interest rates and can quickly move to the exit. However, real economic players move more slowly, as the sharp back up in interest rates will act on the economy with a lag – but they definitely make a significant difference.
Mortgage rates have already risen 50 basis points from their February low, and thirty year fixed rate loans passed 4% for the first time since Lehman. That is roughly a 15% increase in monthly carrying costs – on top of a 10% increase in home prices during the past year. A 25% jump in monthly carry will cripple the two-thirds of the housing market not paying cash. The fact that home prices are rising faster than interest costs has clearly supported housing – but banks are likely to be much more fearful post-Lehman that a sharp rise in mortgage rates could generate a decline in home prices ahead. Lending standards are unlikely to loosen up and keep the housing recovery going. Bottom line, the cure for higher prices is higher prices. Only where capital gains or inflows of foreign money are important will housing whistle past this graveyard. Our concern is not that the shrunken housing market will no longer add fuel to the economic fire. Our concern is that already capital wary banks will become even more wary if the current strong appreciation in home prices falters, undermining the already tepid growth in the economy.
Investors are fearful that a strengthening economy will reduce QE and push rates higher, but we see these fears as unfounded on two fronts. First, the economy is not strengthening. Real GDP in the first quarter was just 2.4%, and second quarter estimates are now below 2% after the weak personal spending report on Friday. Third quarter GDP will be hit by the sequester, which will cut pay for 750,000 workers by 20% — equivalent to laying off 150,000 in June. Only when hours worked rebounds in the fourth quarter will the Fed start the clock running on a sustainable recovery, which puts us well into 2014 before they are likely to be convinced. Investors feared the fiscal cliff and sequester early in the year – but when they had no immediate effect these risk-takers gained confidence in the recovery. However, in the real world, it has been the cumulative effect on wages and salaries from both higher payroll taxes and reduced government spending that has weighed on consumers. First quarter personal spending was buoyed by special dividends and by early bonus payouts made in late 2012, which typically would not have been spent until the second quarter.
Second, interest rates typically rise during the economic cycle when expectations about economic growth are strong enough that competition between risk takers to borrow money outstrips the available supply of savings. This is hardly the case now. Interest rates are rising because investors are rotating away from bonds in anticipation of the Fed doing the same. Some are wary of bonds because of the rise in rates in Japan, but that was entirely due to a well communicated rise in inflation expectations – and has much further to go. US Inflation expectations remain well anchored. In fact, they are so well anchored that they have not fallen despite persistent deflationary pressure since Lehman. Bottom line, we believe higher bond rates will weigh on the economy during the middle of 2013 and eventually retreat back below 2% when investor’s expectations that stronger growth will taper QE wanes. We remain stuck in a muddle through with short bursts of economic optimism causing volatility in relative asset prices – but sustained QE’s most likely course remains an ongoing rise in all asset prices.
The Horse that Won’t Pull the Cart
The disturbing news out of the revised GDP report was the Commerce Departmen’ts first estimate on corporate profits from current production – which fell $44 billion, after rising $45 billion in the fourth quarter. The key leading indicator in a capitalist economy is corporate profits – which are a measure of potential risk-taking and investment in the future. The lack of growth in profits over the past six months brings the annual gain to just 3.6% — in line with nominal GDP growth. Increases in profits have been winding down since 2009, when huge government stimulus pushed money into corporate coffers. With no growth in earning power over the past six months, firms can hardly be expected to increase purchases of plant and equipment or to start hiring. We see no additional policy stimulus which will spur growth, thus a return to cost cutting is likely – threatening the same kind of austerity has throttled Europe. Bottom line, corporations are not preparing a new round of risk-taking which potentially could raise all boats. Rather they are likely to contract investment and hiring in an attempt to protect their still strong balance sheets. The strong will survive, but this process is likely to bleed cash flow away from corporations over the next several quarters leaving them increasingly vulnerable to economic shocks at home and abroad. This appears to us to be the denouement of the economic cycle, as in late 2006, not the start of something new.