Below is my updated thesis as of January 2012. Categories are in order of importance (i.e. the factors that lead the development of my thesis). For example, I believe that the most important factor for the U.S. economy and financial markets in general is what direction our global economy takes; therefore, this topic is first. Government Policy is the second most important factor towards shaping the trajectory of the US economy and financial markets; hence, it’s second on the list… and so on.
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—Main Thesis—: The global economy remains the most important factor in determining the direction of the U.S. economy and financial markets. Currently, Europe and China present the largest risks to its recovery. I believe that global growth will continue to slow with a greater than 70% chance of a double-dip if factoring in a negative turn of events in Europe. If crisis is averted there, I see a 30-50% chance of a double-dip due to China’s ongoing structural overhaul of its economy. There is little doubt that the global economy is in the midst of a historic structural transformation. Unfortunately, this makeover will entail an undeterminable period of increased financial and economic uncertainty.
Europe remains the largest risk for the global economy, with a greater than 50% chance of fragmenting. The region is in the midst of a Currency Crisis, caused by trade and structural budget deficits as well as high levels of un-payable debt among periphery nations. Germany is pursuing a “balance-of-payments (BOP) recalibration” by forcing these nations to become surplus countries. This involves increasing competitiveness via internal wage deflation (i.e. cutting costs), in an effort to drastically reduce or eliminate their trade deficits. It also requires that governments eliminate their budget deficits by raising taxes and undergoing austerity. As long as German-mandated austerity persists, the probability of a Eurozone split up will increase. These policies are resulting in deep recessions and are tearing apart the social fabric of Europe. Resentment towards Germany and the financial elite is becoming engrained in the psyche of regular citizens in the periphery. Remonstrations are progressively intense. Like trends in financial markets, psychological trends aren’t linear. We are currently in a lull and protests are likely to pick up in the coming months, as the effects of austerity harshly bite Main Streets of periphery countries. Unfortunately, these countries are only in the middle innings of this BOP recalibration, at best; more pain lies ahead. Political risk remains extremely elevated. Furthermore, existing government and private debt is so large that debt traps are becoming evident in Greece, Portugal, and Spain. They in turn will lead to further austerity and worsening political and social trends, a nefarious feedback loop. Germany also needs to impose its own set of painful reforms to induce consumption and reduce their strong reliance on exports to become a deficit country. I haven’t heard much on this front. All nations cannot export their way out. My $64,000 question is: Has psyche amongst the periphery citizenry and political spectrum crossed the event horizon into nationalism? The rise of the True Finns in Finland, dwindling political maneuverability for Merkel, and an increasingly dangerous election for Sarkozy in April say that this view is gaining strength.
Given the pitfalls of pursuing this strategy, investors have instead called for the ECB to initiate quantitative easing (QE). This would greatly reduce, if not eliminate, the probability of default and save the region’s banking system. However, pursuing this policy would be against the central bank’s charter and receive vehement opposition from the Bundensbank and Germany’s Constitutional Court. The dilution of the Euro would constitute a stealth transfer of wealth from savers and the financially prudent to spenders and banksters, arguably the causers of the crisis. To pursue this strategy without a referendum would be amoral and likely cause mass resentment in the populations of surplus countries such as Germany, Denmark, and the Netherlands, among others. If officials chose to allow the ECB to print, it would be bullish for global markets. Eurozone economic activity would rebound and China would have improved chances to pull off a soft-landing. However, QE could also set the stage for a dangerous bout of protectionism over the medium to long-term.
Overall, there’s little room for maneuver on all fronts and a comeback for the Peseta, Lira, Franc, Deutsche Mark, etc. is becoming seriously probable. Perhaps the Euro will split into 2 currencies. Continued austerity and bank deleveraging are also hindering the ability of Asian countries to conduct trade.
Since early 2010, I have been bearish on China. However, the outlook is becoming increasingly clouded, with significant downside risks. I’d say that the chances of a hard landing in 2012-2013 range between 40-70%, a large range. On the bullish end we have: falling inflation, leading to loosening monetary policy; and a strong fiscal position, yielding plenty of wiggle room for stimulus should demand falter. On the bearish end, you have: continued austerity and bank deleveraging in Europe affecting Asian export-dependent economies, a possible popped housing bubble triggering unrest from a new cohort of citizens and possibly erupting into a full blown banking or political crisis, and finally, an economy susceptible to high inflation should additional stimulus be passed (stagflation). Overall, these symptoms are of an outdated growth model dependent on fixed-asset investment (ghost cities, malls, Disney) and exports. The country must restructure its economy towards consumption. On the bright side, we are certainly seeing progress toward that end. But, will it be enough to appease U.S. politicians?
The clouds of protectionism are gathering and could pose a large negative risk for global trade in the quarters ahead. Mitt Romney has bluntly stated that China is a currency manipulator. Should he win the presidential election this year, the probability of protectionism would increase markedly. As I mentioned in a prior article more than a year ago (near the bottom of the 3rd paragraph), U.S. politicians need to practice stern patience. It is truly a tightrope they need to walk. China is taking the necessary steps. Give them time. Losing patience and enacting protectionist policy is the last thing the global economy needs right now, contrary to my own protectionist talk a few months ago.
My main point with today’s global economy is that it was personalized to feed the American consumer over a couple of decades. Why would it take only 4 years to materially alter its structure? I believe this transformation will take longer than many investors believe, and present plenty of potential potholes along the way. Signs of an un-balanced recovery can be seen today. A European recession is clearly having an effect on the global economy, with China struggling to pick up the slack. While investors expect further stimulus and loosened monetary policy to help support growth, these interventions only increase the margin for error and are likely to create “unintended” consequences. In China’s case, historically it has been very difficult to engineer a soft-landing. Perhaps communists will succeed where most capitalists have failed ;-).
On the geopolitical front, we have a large negative wildcard in the Middle East, Iran. Oil prices have priced in a geopolitical premium; however, they would increase drastically and cripple the U.S. and global recovery if conflict erupted in the region. Is the U.S. playing the same script it played with Japan to get that country to attack Pearl Harbor? I don’t pretend to know what will happen there, but it is a risk to the global recovery if WTI crude oil makes another run at $120 due to a negative surprise from the region.
Despite gloomy forecasts in the near-term, I’m actually a bullish fellow in the longer-term. The future of the global economy lies in China. The country is in the slow process of preparing for a period of sustainable expansion. If we were faced with a negative market environment in the coming quarters, I’m sure one could find plenty of diamonds in the rough in regards to US manufacturing and transportation companies. I believe that China’s stock market has bottomed and it is currently in the retesting phase. Some caveats to the long-term bullishness though: first, protectionism would nullify my long-term view; second, Japan could be an unexpected negative surprise (inverted head and shoulders on the 5-year chart?) and finally, continued QE from central banks, especially our Fed, could result in high inflation and interest rates at home once the global restructuring achieves escape velocity, crippling the U.S. recovery.
—What’s Happened?—: As I expected in my prior outlook, the Eurozone debt crisis was not a risk to be ignored. Unprecedented volatility in global markets during the second half of 2011 exhausted investor sentiment. Sovereign bond yields in Greece, Spain, Italy, Portugal, Belgium, and even France rose to uncomfortable levels. Technocratic governments were created in Greece and Italy. Greece’s Papandreou almost sank the boat with, gasp!, a referendum. Germany flatly rejected issuing Eurobonds or allowing the ECB to print. Meanwhile, the country’s Constitutional Court ruled that further Eurozone integration without the consent of the governed would be a dangerous subversion of democracy. Plans to leverage the European Financial Stability Fund failed to induce confidence and plans to create the European Stability Mechanism have been accelerated to this year.
Currently, the region, led by Germany and France, has embarked on creating a “fiscal compact,” with a new Eurozone treaty likely to be completed by the end of January. As a requirement for its adoption, participating countries will need to embed a constitutional amendment placing strict controls over their national budgets into their respective constitutions. Official are hoping to have the treaty signed, sealed, and delivered by March. Meanwhile, Greece is in the midst of a bank run and progress towards a voluntary restructuring may have hit a snag. Many countries are in danger of credit downgrades. I’d say my comparison of the region with “a town next to a volcano,” in my prior outlook has been a good one.
In regards to China, my thesis has been mostly in line, though I somewhat underestimated how quickly inflation would come down late last year due to slowing economic growth. I say “somewhat” because Premier Wen recently stated: “We see downside pressure on our economy and elevated inflation at the same time.” So, you see, Mr. Wen is describing a “wage-induced stagflationary scenario” in the months ahead, exactly what I wrote in my prior outlook. Furthermore, Yuan appreciation has recently slowed and supports my view of limited appreciation due to persistent weakness in the country’s export sector. However, I am surprised that appreciation has continued. The U.S. Treasury stated late last year that China isn’t a currency manipulator, to the chagrin of U.S. politicians. Chinese officials worked throughout the second half of 2011 to temper housing prices and they finally succeeded in the tail end of last year. Protests have sprouted due to property issues and souring employment prospects. Progress on the country’s social safety net continues.
From a geopolitical standpoint, the Arab Spring dominated global news as the self-immolation of Mohamed Bouazizi lead to a powerful wave of pro-democratic revolutions, upending Egyptian, Tunisian and Libyan dictators. The effects of this movement remain today with Syrian dictator Bashar al-Assad tenuously in power and an increasing risk of civil war. Meanwhile, tensions between Iran and Israel are dangerously high. Recent financial sanctions against the Iranian regime seem to be resulting in economic collapse, risking continued escalation and a possible shut down of the Straits of Hormuz.
—Keeping An Eye Out—: I’ll be paying most attention to sovereign bond yields in Italy, Spain, Portugal, and Hungary. Increasing yields would put these countries at risk of requesting a bailout from the EU and damage already fragile investor confidence. I’ll also scour news sites for a possible resurgence in nationalistic sentiment and protests. Populations of peripheral countries mired in deep recessions (bordering on depressions) can only stand so much. Moreover, I’ll be on the look out for changes in German strategy to deal with deep recessions in the periphery. Further headway on employing effective growth policies would be a positive. Finally, I’ll be closely following the upcoming French presidential election. The Eurozone crisis would flare up if Francois Hollande won the election, as he would directly challenge what has so far been a German-dominated response to the crisis. Disagreement among the big two would result in increased uncertainty.
In China, I’ll be following up on continuing protests. Will they grow larger? I’ll also be keeping an eye on Chinese property equities for any hint of an improving outlook and a decreasing probability of a banking crisis and protests. Finally, I’ll check out a chart of the Yuan to make sure that appreciation continues. If it stopped, the threat of protectionism would grow. Over the longer term I’ll be periodically checking up on continued progress with regards to social safety nets and continued consumption-based policies. Most of the Chinese population has a very high savings rate. Enacting a program such as Social Security would raise their confidence and result in more spending and less saving.
On the geopolitical front, keep an eye on Iran. While this story is barely mentioned in the mainstream media, it has the potential to significantly affect the investment landscape. So far, the news trend demands caution. Finally, I’ll be following up on the U.S. presidential election. In my view, if the U.S. economy improves, then the risk of protectionism will decline due to increased prospects of a second term for Obama. However, if the economy were to double-dip, then Romney would have a better chance of winning the presidency, which would be a negative for global trade.
US Government Policy:
—Main Thesis—: My theme of “Political Frugality,” which I presented in mid-2010, is likely to remain in place throughout this year. Look for continued political deadlock and a lack of leadership from Washington as both political parties jockey for position leading up to Election Day in November. Consequently, my fear lies in the need for decisive action from government officials to step in with fiscal stimulus in case of a downside surprise from Europe or China.
From a bearish view, the U.S. recovery will be challenged by fiscal contraction, due to the fading effects of the 2009 stimulus, as well as ongoing weakness in the global economy. In addition, continued deleveraging by households throughout 2012 will expose the vulnerability of the private sector to an exogenous shock, such as a Eurozone split up, a Chinese hard landing, or spiking oil prices. FOMC members continue to express their frustrations of the lack of fiscal stimulus to complement their efforts and support the economic recovery.
From a bullish perspective, we haven’t had additional stimulus because economic activity has maintained momentum. Furthermore, I expect another extension of the payroll-tax break and unemployment benefits as well as political debate to reverse automatic spending cuts in 2013, warranted by the super-committee’s failure to cut the government’s budget deficit. This would cushion some of the blow of fiscal contraction, especially in Q2.
Overall, if Europe muddles through, China’s slowdown is transitory, and we don’t have a spike in oil prices, then government policy may prove to be innocuous to the U.S. economic outlook. However, economic contraction in 2012 could set in motion a chain of events that would significantly endanger global trade.
I sense that the tide is slowly turning against continued globalization. While Obama has exercised enormous patience for China’s economic restructuring, political will is clearly decreasing. Mitt Romney looks to be the front-runner for the Republican Party in the presidential elections. It is clear that he has no misgivings on China being a currency manipulator. If the U.S. economy were to go into a double-dip recession, Obama’s chances of reelection would decrease markedly, while Romney’s would increase. The probability of this political outcome can be seen in real time here, here and here (notice the inverse correlation between the final two charts). Should Romney become the Republican front-runner, a double-dip recession could clear the way for his election and dangerously increase the risk of protectionism. Note that this progression of events would increase in likelihood if the US economy fell into a double dip recession.
In the longer term I believe that government officials will eventually address the structural causes of this prolonged period of economic frailty. We may get a giant jobs-based stimulus, packed with a nationwide university system to retool displaced workers as well as large investments in the nation’s infrastructure, alternative energy, and exports. Unfortunately, we may need a period of crisis to get lawmakers to unite as they did in 2008 and pass this type of far-reaching program.
—What’s Happened?—: Business confidence was damaged by the U.S. debt ceiling fiasco, where political bickering amongst Democrats and Republicans ultimately led to a historic credit downgrade of U.S. government debt. Furthermore, our dysfunctional political system was on display in November when the super-committee failed to create a plan to cut $1.2 trillion off the government’s budget deficit, triggering automatic spending cuts to be enforced in 2013. Leaders of both political parties have already begun backtracking on these cuts. Finally, the formation of the Occupy Wall Street Movement in Zucotti Park in New York City metastasized on a global scale and reflects the growing impatience and lack of confidence of ordinary citizens in the government’s ability to resolve the crisis.
Overall, I’d say that my prior two outlooks have been in line with regards to fiscal policy; however, the jury is still out on whether political deadlock and a failure to pass additional stimulus will translate to a key policy error if the U.S. economy ends up contracting.
—Keeping An Eye Out—: Throughout 2012, I’ll be keeping an eye out for a flare-up in the Eurozone debt crisis (French election in April, further downgrades, etc) or an increasing probability of a Chinese hard landing. Negative surprises from these regions would significantly increase the probability of a U.S. recession. Will U.S. politicians ignore the gravity of the consequences until it is too late? Government officials should be hoisting the fiscal gun with their finger on the trigger given this high level of uncertainty; instead, the gun is unloaded and in the woodshed across the farm. I remain confident that my “Political Frugality” theme remains in place.
Finally, I’ll be keeping tabs on the upcoming U.S. elections. A downturn in the U.S. economy would increase Romney’s chances of winning the presidency and likely significantly curtail what patience is left for China to complete its restructuring.
Monetary Policy/U.S. Dollar:
—Main Thesis—: I’d place the probability of further monetary easing between 50-60%, not at the high end of the consensus, but a decent likelihood. Note that a negative surprise in the Eurozone would cause Fed officials to institute QE3 shortly thereafter. I remain adamant that this policy is creating a platform for powerful unintended consequences in the medium to long-term, should the global economy avoid the long-term risk of protectionism.
The case for further QE is gaining strength. Here’s a breakdown of the pertinent factors for my sentiment:
- (QE Bullish): The replacement of Kocherlakota, Fisher, Plosser, and Evans with Pianalto, Lockhart, Williams, and Lacker will further strengthen the dove’s stronghold on the FOMC in 2012. We’ve already seen a slew of speeches from these new officials supporting further easing.
- (QE Bullish): Market expectations of inflation, such as 5 and 10-yr breakevens are nearing mid-2010 levels, when the Fed hinted at Jackson Hole that it would undergo QE2. Also, signs of falling inflation are percolating at the producer level, such as the ISM Manufacturing Survey’s Prices Received subcomponent.
- (QE Slight Bullish): The Conference Board shows consumer inflation expectations are falling, while University of Michigan’s survey shows expectations holding steady.
- (QE Neutral): Comparing the latest FOMC projections, released November 2nd (New), to those released in June 2010 (Old), just before Bernanke embarked on QE2, offers a mixed picture. Though an inexact science, I compared forecasts for 2011 in the Old projections with the 2012 forecasts in the New projections. Forecasts for Real GDP were actually higher in the Old than in the New projections. The Unemployment Rate was roughly the same, while inflation forecasts (PCE and Core PCE inflation) were higher in the New vs. the Old projections. Fed officials see slower growth with slightly higher inflation than they did in 2010.
- (QE Slightly Bearish): The YoY CPI rate has been declining, reflecting falling food and gas prices. However Core-CPI, arguably longer-term in nature has been increasing and is actually just above the Fed’s YoY target rate, @ 2.2% vs. 2.0%. Rising rents, due to a lack of multi-family dwellings, will likely keep Core-CPI sticky to the upside.
- (QE Bearish): While I mentioned that gas prices accounted for a fall in the headline CPI rate, they are still high by historical standards. Furthermore, they recently turned higher, reflecting increased tensions in the Middle East, and stand roughly 20% higher than in mid-2010. I recently categorized conflict in the region as a bearish wildcard in the global outlook. It would be extremely shortsighted if the Fed wasn’t accounting for this major wildcard.
While I personally believe that the risks for QE outweigh the benefits (not sure what those are actually), a dovish FOMC is likely to move forward in the coming months, especially if economic growth ends up weaker than expected.
The long-term implications are turning substantially negative in my view. These policies only serve to distort capital markets and disrupt the process of effectively allocating capital to produce real economic growth. Furthermore, assuming we avoid a bout of protectionism or a Chinese hard landing, the global economic restructuring is slowly opening the Pandora’s Box of these policies. I’ll review these in the “Inflation” section below.
I believe 2012 will see a strengthening dollar (DXY), but with plenty of volatility. I’ve actually been bullish since late-2010. While I arrived to the party a little early, I became increasingly confident as trends progressed. This year may be a tale of two halves, dollar strength in the short-term (0-6 months), followed by dollar weakness in the medium-term (6-12 months). The primary reason for my sentiment is the deteriorating situation in the global economy (see Global Trade/Economy section above). A Eurozone-related wave of risk aversion is an elevated and increasing probability. In fact, one could say that this wave is in progress, after beginning in mid-2011. You also have signs that China’s economic growth is slowing, sparking fears of a hard landing in the short to medium-term (3-12 months). These trends are dollar bullish. On the dollar bearish side, you have the Fed preparing another round of QE. Both competing forces will result in volatility.
Longer-term (1 yr+), I remain uncertain, but I’ve had a constant itch to shade bullish since late 2010 (see first link above). I must stress that I am comparing the greenback against other fiat currencies (DXY). When priced against commodities or precious metals, I am bearish but without conviction.
Focusing on the U.S. dollar versus other fiat currencies, throughout 2010 and 2011, my bullish position was extremely contrarian. I was actually made fun of by commenters. Today, more are becoming bullish, but not over the long-term. I continue to slightly slant to a bullish long-term future for the greenback. Since this is my long-term view there is obviously plenty of room for error. I’m looking at two main scenarios for the longer-term for the time being. The first would be a global double-dip recession, possibly setting the stage for a wave of protectionism (see “U.S. Government” outlook). Declining global trade would result in large waves of risk aversion and would be dollar bullish. Now let’s say that there’s no global double-dip. A continuing trend in rising wages in China may translate to a manufacturing renaissance in the U.S. Investment flows from around the world into our domestic economy due to increased investments in U.S. exports is certainly a compelling bullish argument. This could also mean that the Fed will need to raise rates as well, further helping the greenback. The jury is still out.
—What’s Happened?—: I’ve been consistently correct with this portion of my outlook, while my dollar bullishness has finally paid handsome dividends.
The Fed held back from QE3, despite plenty of sentiment to the contrary. Unless you regard Operation Twist as a QE, my prior outlook was spot on. Fed hawks Fisher, Plosser, and Kocherlakota repeatedly dissented throughout the second half of 2011, worried of the inflationary consequences of loose monetary policy. This resulted in deadlock within the Fed. Chicago Fed President Evans proposed adjusting monetary policy by establishing a target for the unemployment rate. There was also a discussion on targeting the nominal GDP growth rate. Neither of these policies gained favor. Instead, the Fed has prepared a communications strategy based on FOMC members publishing their interest rate projections.
The dollar (DXY) rallied 6.9% since my prior outlook, and 5.5% since my bullish call in October, 2010.
—Keeping An Eye Out—: In the short-term, I’ll be looking at progress out of the Eurozone. In the medium-term, is China’s slowdown more treacherous? Negative surprises would lead to another round of easing as the Fed does all it can to protect the U.S. recovery. I’ll also be keeping an eye on most of the factors I highlighted in my “Main Thesis”: market inflation expectations, consumer confidence surveys, FOMC projections, CPI, and gas prices. I’ll also be following up on the new interest rate projections; although I have mixed feelings on this new communication strategy as they may end up confusing markets. Bernanke said that the housing issues would be contained in 2007 and looked what happened. Are the blind leading the blind? Finally, if QE took place, I’ll be checking out feedback from investors, analysts, and foreign governments. QE2 was largely unpopular, especially among Emerging Market economies. As a quick reference, here’s a list of the 2012 FOMC meeting dates.
On a possible bearish outcome for the dollar, I would turn cautious if a retest of 76.65 failed and would be reducing exposure all the way to 72.75.
—Main Thesis— In the short to medium-term, there are notable harmful risks in the Eurozone and China. Negative developments here would trigger a surprise global deflationary episode due to a turbulent period of selling throughout global risk markets. I still worry about deflation instead of inflation. Longer-term, inflation’s trajectory has become clouded, contrary to my sentiment in my prior outlook, and is dependent on the resolutions to the aforementioned risks. I am considering 3 scenarios.
- Deflation: Eurozone Fragmentation/China Hard landing (Probability = 50-60%): A global double-dip would likely occur. Deflation would make a vicious comeback. Along with falling global growth, a weak U.S. consumer would be unable, or unwilling, to pay higher prices. This scenario could result in the dreaded Japanese mindset of deflationary anticipation. Consumers would begin to hold back, as they currently are with the housing market, only for a wider range of products. Fed would continue QE.
- Disinflation: Eurozone Fragmentation/China Soft landing or Eurozone Fiscal Compact/China Hard landing (Avg. Probability = 35-45%): A disinflationary environment would ensue if one of the two major global risks had a negative resolution. An uneven global recovery would negatively affect commodities and a chronically weak U.S. consumer would translate to a stronger bargaining power of buyers versus suppliers. An example of this environment occurred in 2011. Higher commodity prices led to increasing inflation during the first half of 2011; however, the weak U.S. consumer was unable to shoulder these higher costs and the recovery was in jeopardy by mid-year. Price increases have recently slowed. Fed would continue QE, but have its hands tied during periods of elevated inflation.
- Uncomfortable Inflation: Eurozone Fiscal Compact/China Soft landing (Probability = 40-50%): The U.S. recovery would likely continue. Commodity prices would increase, fueled by a rebound in global growth. Additionally, wage equalization between China and the U.S. would carry on; higher wages in China would see more companies moving operations back to the U.S. or smaller Emerging Markets. Due to the Fed’s myopic policies, these secular trends would result in a period of persistently high inflation, possibly harming the middle class and retiring baby-boomers. The Fed would eventually be forced to raise interest rates, thus semi-capping the recovery’s potential. This sequence of events would be bearish for the U.S. Treasury market (Top?).
—What’s happened?—: It became clear that if the Eurozone were to split up, a wave of deflation would have swept the global economy. Instead, the situation stabilized, China’s economy slowed, and global inflation began cooling off during the second half of the year. Central banks in many Emerging Market economies began focusing on growth versus inflation by lowering interest rates. I was actually surprised at how quickly inflation cooled and how quickly authorities responded to slowing economic growth.
In the U.S., the string of hot inflation releases in the middle of the year finally slowed near year-end due to economic turbulence in the 3rd quarter. At the producer level, pricing pressures in the manufacturing pipeline (crude and intermediate) have fallen and signal further disinflationary trends in the coming months. At the consumer level, headline inflation tempered; however, core-CPI has remained sticky to the upside. One notable metric that still signals strong inflationary pressures is the ISM Service Index’s Prices Paid subcomponent. It has consistently stayed above 60.
I also mentioned how my thesis of disinflation would be put to the test as two powerful forces, inflation at the producer level versus a weak U.S. consumer, would meet in the second half of the year. While we did see higher CPI readings (which I expected), consumer confidence plummeted and the economy came close to contracting. Indeed, many were expecting a recession in the closing months of 2011. I’d say that my thesis of disinflation was correct versus prevalent predictions of high inflation and rising treasury yields.
—Keeping An Eye Out—: In the short-term, I’ll be looking at progress out of the Eurozone. In the medium-term, is China’s slowdown more than transitory? Negative surprises would lead an increasing risk of deflation. Conversely, if Europe and/or China can resolve their issues, then the risk of deflation would decline. I’ll also be looking at the job market as well as wage growth. If real wages continue to decline, then inflation should remain contained. If the job market improves then confidence could improve, the use of credit could increase, and consistent growth in consumption could lead to increased inflation.
—Main Thesis—: I regard consumer confidence as an indicator of the continuing recovery. In the short-term, I expect it to improve as long as the job market makes headway. Any significant deterioration at this point would likely signal a weakening labor market. Risks abound. Confidence would likely plunge if the Eurozone broke up or if China experienced a hard landing due to widespread disruptions in financial markets. Moving into the medium-term, if we don’t have a negative surprise from either of these areas, confidence would continue to improve as the positive feedback loop gains strength.
Looking at the bigger picture, consistently high unemployment and poor job prospects will continue to semi-anchor consumer confidence. Absent any exogenous shock I believe confidence would crawl back with strong risks to the downside if we have a double-dip recession or commodity prices make a comeback.
—What’s Happened?—: After a significant dip mid-year, confidence came roaring back due to improvement in the labor market. In the important “Present Situation” metric, the Conference Board reports that it hit its highest since September 2008. However, the University of Michigan’s Consumer Sentiment survey wasn’t has ebullient. Nevertheless, both indexes point to genuine strength in the economy.
—Keeping An Eye Out—: Recoveries begin with flaring “Animal Spirits.” If consumers become more confident, they’ll spend more. I’ll be looking to see whether a worsening Eurozone or China situation will spook consumers. If confidence continues to rise, the economy is getting better, plain and simple.
—Main Thesis—: Over the short and medium-term, the prospect of further job creation would quickly deteriorate if we had an acute negative event in Europe or China. Absent a negative resolution, I expect a slow but vulnerable recovery in the labor market.
The feasibility of a self-sustaining economic recovery depends on a healthy job market. Substantial and consistent job creation would precipitate rising real wages and solidify consumption growth. However, we remain in a “chicken-or-egg” scenario. Before, the use of credit served as a spark plug for consumption growth, leading to job creation and ultimately a potent positive feedback loop. This dynamic has been severely damaged. To put it mildly, the recovery from the 2001 recession was built on a faulty foundation, no pun intended. Rising home values and careless lending standards increased the supply of credit (home ATM), producing artificial demand. Once the housing bubble popped, credit dried up and construction activity collapsed; we had a semi-permanent reduction in demand growth. As a result, structural unemployment became a stark characteristic of the 2007-2009 recession. I expect this characteristic to linger as a persist headwind to job creation. The housing bubble also exposed the flaws in the underpinnings of our global economy.
As I discussed in my Global Economy/Trade outlook, the main short to medium-term risks lie in Europe and China. Business confidence is unlikely to rebound vigorously as long as these dark clouds overhang the economic outlook. Absent any serious negative exogenous shock, I expect the job market’s recovery to endure, though my cautiousness has grown a bit. Leading indicators, such as the JOLT survey and ISM Non-Manufacturing’s Employment sub-index, are pointing to potential weakness in the months ahead. Compensating for these bearish tidbits though, the Conference Board’s Employment Trends index, recent news reports, and improving consumer confidence surveys point towards improvement. Overall, the short-term outlook remains somewhat clouded but with a constructive shade. A weak positive feedback loop in the U.S. economy may be at work.
Over the long-term, the global economy must rebalance itself. Once China or a group of Emerging Market economies can embark on a sustainable recovery, increased global demand will act as a secular tailwind. I would also like to see some new life-changing technology developed (alternative energy anyone?), or a job-targeted “New Deal” type of legislation. If I had a kid, I’d be guiding him/her towards learning science or engineering.
—What’s Happened?—: The job market continued to improve. Jobless claims dipped under 400K, while the 4-week moving average fell to a 3.5-year low. Furthermore, 2011 ended with the 2nd strongest jobs report since April (establishment survey). Meanwhile, the unemployment rate fell to its lowest reading since February 2009, while the household survey signaled continued job creation. As an offset, the 6-month average of the establishment survey is lower than the first 6 months of the year, signaling a weaker pace of recovery. Furthermore, the fall in the unemployment rate was due to statistical reasons instead of an improving economy.
With respect to my prior outlook, comparing the job market to a pre-born baby in an incubator has been accurate, and I quote: “On the bright side, absent any substantial negative shock to the system, I actually believe that the job market has the ability to heal itself. Think of it as a pre-born baby in an incubator (job market = baby). Lack of a negative shock is like keeping the baby in the incubator so that it may gain strength. You don’t want to take the baby out of its incubator too much.”
—Keeping An Eye Out—: In the short-term, I’ll be keeping an eye on the JOLT survey as well as consumer confidence and real-time polls (Gallup.com, etc.) for signs of accelerating job growth. On this front, we have seen some improvement but it remains tepid. Over the long-term, I’ll be on the look out for progress on the development of new-technology and my long-term thesis of global restructuring. If we were to have economic turbulence, I’d focus on news of a job-focused stimulus.
Consumption (Domestic End-Demand) and Borrowing:
—Main Thesis—: Over the short-term, I expect the consumer to trudge along. Objectively, it is possible that a weak positive feedback loop in the U.S. economy is at work. However, the prospects of sustainable growth can only increase with an improving labor market. However, risks abound, the largest being the Eurozone and China. A negative surprise would send stock prices lower, producing a negative wealth effect. Finally, the Middle East is a wildcard in the outlook with a potential to throw a monkey wrench into everything. A flare-up in that region would result in sharply higher oil prices.
In the medium to long-term, I still expect consumption growth in the US to remain weak due to several reasons:
- US government spending has been paring back, affecting jobs, while the effects of the 2009 stimulus are fading.
- A weak labor market, negative real wage growth, and a moribund housing market will equate to significant long-term headwinds.
- Most baby boomers are still caught flat-footed, as their retirement plans have been turned upside down by two giant bubbles in the past decade. They cannot count on the automatic housing ATM to deliver spending power anymore. Most Retirees won’t be spending what they had planned in the past. The same concept can be applied to many pension plans.
- Furthermore, demographics will be a headwind for years to come.
- With regards to credit, you have the budding psychology of living a healthier financial lifestyle by paying down debt = De-leveraging. This will result in continued weakness in demand for credit over the medium to long-term. While we have seen an increase in credit use, I believe the psychological secular trend of saving more is still intact. The most common sense reason why this long-term trend would change is if job creation staged a furious comeback.
—What’s Happened?—: The consumer staged a remarkable comeback in the second half of the year. Despite the Conference Board’s and University of Michigan’s confidence survey hitting lows last seen in April 2009 and September 2008 respectably, confidence pulled a Tebow 4th quarter comeback and roared higher to finish the year. This was due to an improving labor market and falling gas prices, which triggered a wave of spending during the second half of the year. However, December showed a weaker than expected reading with core retail sales hitting negative territory for the first time since July 2010, despite ballyhooed optimism of a fantastic holiday season.
While I was cognizant that lower gas prices would likely play a positive role for consumer psyche and spending, I overestimated the consequence of a plunge in equities in late July/early August. The negative wealth effect it produced wasn’t strong enough to derail the consumer. I also overestimated the effects of falling home prices. While I stated that they wouldn’t affect consumer psyche like they did in 2007-2009, I haven’t seen any effect whatsoever.
The increased use of credit contradicts my long-term theme of “living a healthier financial lifestyle.” Finally, the savings rate has actually declined. I expected it to continue rising due to higher expected taxes (Ricardo-Barro Effect). Maybe I’m just being impatient.
The consumer is damn resilient!
—Keeping An Eye Out—: In the short-term, I’ll be checking out a few factors. Will the situation in Europe and China improve? These are exogenous risks that can’t be ignored. Any substantial negative event would likely spook consumers and sink the U.S. recovery. Next, will the job market improve? Also as forecasted in my prior outlooks, housing prices are double-dipping. Will they have any effect on consumer spending?
In the medium to long-term, I’ll be periodically checking on the de-leveraging theme. In the past one could rely on credit as a way to jump start consumption. If de-leveraging continues, credit may remain in low demand and consumption growth would in turn be affected. From a deleveraging standpoint I’ll be looking at the Household Debt to Disposable Income Ratio and the Savings Rate.
Service Industry (Non-Manufacturing):
—Main Thesis—: The service sector accounts for 80 to 90% of the U.S. economy. Its future direction remains clouded. In the short to medium-term, it’s all about what happens in Europe and China. There’s a significant likelihood that a negative event from either of these regions would tip this important sector of the economy back into contraction. It remains vulnerable.
In my prior outlook, I had mentioned how absent an exogenous shock, I thought the sector’s growth was sustainable. However, I’ve become more cautious. Leading indicators in the ISM’s Non-Manufacturing survey are cause for concern. Backlogs have been shrinking for 6 out of the last 7 months. Growth in the survey’s New Orders component has also shown some weakness. Growth, solely depending on increasing new orders, may turn inconsistent. Moreover, the dollar has turned higher and will act as a headwind for exporters if it continues.
Lack of substantive end-demand growth will keep hiring activity at a low level, and low job creation will keep end-demand growth tepid; all in all, this sector will be hard-pressed to find any impetus for strong growth.
The longer-run story is similar to manufacturing (secular expansion), though not as magnified.
—What’s Happened?—: The service sector has maintained steady growth, led by business activity. Overall, it has been in line with my outlook of sustainable expansion with little sign of strong growth.
—Keeping An Eye Out—: …for end-demand in the U.S., Europe, and China. I’ll also be keeping an eye on the US dollar compared to the Euro and the Yuan. Continued dollar strength would act as a headwind for exporters. Finally, how does the job market progress? An improving labor market would produce improved consumption trends. Once again it’s all about the positive feedback loops.
Industrial Production (Manufacturing):
—Main Thesis—: Manufacturing continues to support the economic recovery, however the outlook remains clouded with downside risks; I expect a muddle through at best and remain cautiously bearish on the sector over the short to medium-term.
Weakness in the global economy may affect export-oriented industries, while a weak consumer may translate to cautious inventory restocking. Furthermore, business spending is poised to decline during the first half of the year given the expiration of the investment-tax credit. Fiscal contraction from the fading effects of the 2009 stimulus may turn into another headwind. It’s important to note that according to the ISM Manufacturing survey, backlogs have been shrinking for four months in a row. While new orders remain in positive territory, this type of growth is choppy and is not conducive to increased confidence. On the bright side, inventory restocking may lead to continued activity and increased job creation, further strengthening the positive feedback loop in the economy. It comes down to the extent of the inventory restocking as well as whether Europe and China can resolve their issues. This would spark confidence in the recovery.
While industrial production is obviously important to the U.S. economy, I currently do not regard it as an important impetus capable of profoundly altering the bigger macroeconomic picture. I see it more as a coincident indicator; however, this will change in the longer-term, absent a strong wave of protectionism.
Longer-term, emerging markets may provide the secular growth that is needed for the sector to stage a renaissance in the years ahead. While I don’t believe this scenario is knocking at our door, it’s progressively getting closer. Should economic and political trends shift towards a protectionist environment, the outlook for manufacturing would become clouded but with upside risks nonetheless.
—What’s Happened?—: Manufacturing has continued to grow. After slowing somewhat in the 3rd quarter, the final quarter of the year saw the sector’s growth pick up. The business environment in the past 3 months was better than I expected. The U.S. economy has shown continued resilience in the face of numerous headwinds.
—Keeping An Eye Out—: First and foremost and just like my prior outlooks, I’ll be keeping a pulse on end-demand in the US, China, and Europe. If China or Europe experience any negative surprises, demand from those countries will drop and will have a negative effect on manufacturing activity. Given that we are still experiencing a recovery in the US (a weak one in my view), industrial activity may be buoyed by continued demand at home. Finally, I’ll continue to focus on the development of consumption-based policies coming from China. As Chinese officials put these policies into place, the outlook for their consumption will improve. This will in turn improve my outlook for Industrial Production.
—Main Thesis—: Nationally, home prices have not bottomed. We are still faced with a large supply of homes and lukewarm demand. On a positive note, I believe construction has bottomed and will contribute to economic growth in the quarters ahead. Overall, we are approaching a secular low in housing; however, a rebound will take time. A recovery in home prices will increasingly depend on local conditions.
The supply/demand dynamic for the housing market remains in favor of lower prices in the quarters ahead. While property sellers have held back, buyers aren’t willing to chase. Both are amidst a standoff. However, a wave of foreclosures (shadow inventory) will be hitting the market throughout the year, increasing supply. A deflationary mindset among buyers will strengthen as the year wears on. Furthermore, the weak economic recovery risks critical damage if hit by a negative exogenous shock from Europe or China. Property valuation metrics, such as the Price-to-Rent ratio, are more supportive of prices; therefore, I expect this leg lower in home prices to be smaller than the first decline and likely mark a secular low. Regarding home sales, expect stellar percentage numbers during the year to get everyone excited (+15%, +20%, +30%). Just remember that home sales are near all-time lows. 100 to 120 = 20% (+20 units) vs. 1000 to 1020 = 2% (+20 units).
On a positive note, I think the construction sector has bottomed. High demand for rental properties is spurring investment in multi-family real estate. This will act as a steady tailwind for job creation.
Over the long-term, home prices will rebound; but, the veracity of a recovery remains uncertain. I’d be interested in checking out real estate near manufacturing cities (Detroit, Milwaukee, Cleveland, etc.) that have experienced sharp price declines. If the U.S. were to undergo a manufacturing renaissance, it would make sense to make long-term investments in areas that would benefit. Furthermore, the asset class would serve as a good long-term hedge against potential inflation due to the Fed’s shortsighted QE policy.
—What’s Happened?—: Housing prices continued their double-dip as I had forecast in my prior outlooks. Mortgage applications have remained anemic in growth. However, demand has clearly stabilized. Recently, a raft of improving home sales and construction reports has boosted sentiment. Calls for stimulus are picking up steam.
—Keeping An Eye Out—: I’ll be looking at valuation measures such as the Price-to-Rent and Owner’s Equivalent Rent ratios to gauge whether prices have come down to attractive levels. In the short to medium-term, the job market will be a factor to watch as well as the incessantly mentioned Eurozone and China issues. Keeping an eye on the MBA’s mortgage applications metric would also be prudent as it is one of the best short-term leading indicators in the industry.
This completes my macro thesis. My next update will occur around mid-May/early-June.