Being in the Dolomites puts me into a long-term thinking mood. So here we are – a post on some of my long run thinking.
In a recent post I wrote about the probability of the L-shaped recovery now standing at and even 1/3 split with the probability of the recovery being V-shaped or W-shaped. I motivated this estimate by the references to some of the US economy fundamentals.
A different world beacons
Think growth dynamics in the long run. Usually, a recovery is led by a small fiscal stimulus and a moderate easing of the monetary conditions. These come after a number of quarters of tighter fiscal and monetary conditions pre-crisis. And both act to moderate fall-offs in household and business investment, plus arise in unemployment in the environments of relatively unchanged long-term savings/investment ratios and a temporary shock to transient consumption.
We are in a different world today from a ‘normal’ recessionary cycle, and this warrants my concern that the recovery dynamics are likely to be highly uncertain.
Fist, think the investment cycle. Investment – both household and corporate – is down and it is down structurally. The structural nature of this downturn is most likely due to the shifting pattern for investment financing into the years ahead. Gone is the leverage and originate model of lending. We are in the new brave world of deposit and originate model, where capital financing will be held back by the need to generate significant deposits.
Even an era of sustained precautionary savings by the households is not going to change this reality. Why? Because in years before the current crisis, leveraging model meant that a deposit of, say, $100 in a bank translated into the lending out of some $960 or more into the economy. With deposit and originate model, the same deposit is going to see first round lending of no more than $90 out into the economy. Once the hovering of excess liquidity into banks capital is done with, we might move to a lending of slightly above the deposit rate, say $100 plus a wedge between the borrowing rate and deposit rate. But this is hardly going to get us above $110 even in most pessimistic inflationary scenario. In the mean time, the banks are going to beef up their capital reserves by skimming retail clients – so returns to savings will quickly turn negative. Never mind the returns, households will still hoard cash as sticky unemployment will breath fear into their hearts – the new era of the hearts of darkness will set in ushered by the elevated risk aversion.
Second, think precautionary savings. If in traditional recession precautionary savings cycle exhausts itself within a span of 2-3 quarters post recession on-set, in the current one, the savings rates are still climbing up, corporates are still hoarding whatever cash they can generate and the late payments gap is widening, not shrinking. This suggests to me that we might see the US savings rate finally moving in the direction the majority of economists in the 1990s wished it would be heading – into possible high single digits or even double digits. The trade wars of the 1930s might be replaced by a slow decay in world trade due to shrinking US (and also European) consumption expenditure. Not as nasty of a proposition as the Depression era ‘beggar thy neighbour’ policies, but a much longer behavioural shift that is more benign in the short run, but is much more damaging in the long term.
Third, think of the place we came from when we entered this recession. That place was Alice in Wonderland mondo bizarro of excessive liquidity sloshing across global boundaries and asset classes and fiscal policies of prolificacy that made even the US Republicans (traditionally pro-balanced budget conservatives) into the spending-happy traditional Democrat-types. In this environment, lack of global inflation was only sustained through a combination of extreme asset bubbles formation (housing, equities, carry trade-financed speculative real estate allocations, excessively optimistic M&As and commodities bubble that rivalled anything we’ve seen since the Dutch Tulip craze. But looking forward, this environment was ‘corrected’ in the recession through another massive injection of liquidity and another substantial hike in public deficits worldwide. It might be a forced measure for Obama Administration to prop up the entire US economy by pumping more steroids of public spending and running printing presses at the Treasury 24:7, but this activism has to go somewhere real, and it will go into real long term inflation and a new asset bubble generation, along with higher taxation.
Ronald Regan inherited from the Democratic Party’s leading historical disaster (Jimmy ‘The Peanut’ Carter) presidency one of the sickest economies in the US history. But one thing he did not inherit was decades-long appreciation of the US deficits. Subsequently, Regan was able to cut taxes while re-channelling fiscal spending into new programmes. Obama’s successor (who is now increasingly looking set to come in 2013) won’t have this luxury. Neither will Angela Merkel’s successor, or Brian Cowen’s or Gordon Brown’s. High tax era is upon us in the developed world and this means we are going to lose in the economic game. This impending tax regime fiasco will be far more damaging to the West’s economic standing in the world than the oil price inflation can ever be.
Fourth, inflation is coming. I wrote about it before and I keep saying this over and over again: if you think double digit yields on US debt are the stuff of science fiction, think again. Someone will have to pay for the orgy of new fiscal debt creation and that someone will have to borrow hard. The new borrowing – the rollovers of the past, plus the interest rates of the future, compounded by the Obamanomics and the Democrats appeasing their traditional constituencies will be exacerbated by the need to rescue the next wave of ‘economic recession victims’ – the states and municipalities. That these are going to be predominantly amongst the Democratic party strongholds (e.g California) will only make matters worse. So what little liquidity will be added over time will be consumed in an orgy of new debt issuance by the Feds and the states and municipalities. The pyramid scheme whereby Feds-created cash will be rolled into Feds-backed Government borrowings will mean investment slowdown will be deeper and more permanent than the point one above suggests.
Inflating and devaluing out of this mess will set the stage for the graduate de-dollarization of the global economy, further undermining the US.
So high inflation, lower growth, lower real rates of return on deposits, lower lending origination and thus lower investment all form the prospects for L-shaped recovery. At the same time, sheer magnitude of liquidity pumping into the global economy via loose monetary policy on top of the previous decade-long monetary easing might, just might, usher a new age of asset bubbles. From oil and gold to banal fertilizers and regulatory-driven forestry – commodities will reign as perceived, if unreal, inflation hedges. Exotics of risk aversion assets might turn out to be even more exotic, more technical and thus less stable than the securitized and repackaged real estate loans of the Mid-Naughties. If they do, a V-shaped recovery is a possibility, as is a W-shaped one. Both will be short-lived, but at least we will get to enjoy one more run of the madness.
About the only silver lining to this long-term Western Winter will be the fact that Europe will be faring even worse than the US with Italian-style slog contaminating the entire EU, inclusive of the Accession states.
So where do we stand?
An L-shaped recovery offers a period of zero (or near zero) real growth post-recession. The V-shaped one represents a robust recovery post-recession. The W-shaped scenario is the one where recession will be followed by a significant bull run, followed by another collapse before the recover set in.
In my view, however, all those who paint the current economic environment in one of these historically known categories miss the majour point — because of the changed relationship between perceived and real risks and our systemic household, banking and corporate responses to these, we are entering a recovery that has elements of all three scenarios. This is risking to be a PQR recovery – a recovery based on Public and Quoted Risks. Now, it is a handy feature of the alphabet that letter PQR are smack in between letters pairs of K and L (denoting traditionally Capital and L-shaped recovery) and V and W shape of recovery descriptors.
PQR is not a simple average of L and V-shapes, some sort of a root sign-shaped recovery. It is a recovery that starts from the top of the previous cycle, heads for depths severe of a recession, rises in a volatile fashion above the floor and flattening out at an equally volatile new floor of suppressed long term growth. It is the stuff that makes superpowers lose their supremacy positions and that led to disintegration of mighty super states of the old.
Historically, recessions follow a V-shaped scenario. The dynamics are as follows:
First businesses cut production through the downturn: capital investment grounds to a halt, layoffs cut less productive workforce and maintenance and capital replacement drop to below amortization;
Second, businesses stop cutting at the point where their capacity still exceeds demand, and they go for correcting the supply overhang by reducing costs and inventories;
Once demand troughs, the depletion of inventory means that any new demand will translate into increased output, sapping the excess capacity;
Capital expenditure rises on the maintenance and amortization side, but no new capital is added, so profits improve and war chests are replenished by the healthier businesses to take on some of their competitors;
Increased corporate profits support strategic drive in increasing capacity to address future demand – employment and investment rise;
High rates of money creation and fiscal stimuli (with priorities going from tax cuts, to public investment in infrastructure upgrading, to Uncle Sam’s shopping for consumption spending, and not the other way around) help the process of orderly de-leveraging and maintenance of excess capacity by businesses.
We, thus, have Public Risk – the risk of permanent deficit financing and the under-saturation of public debt with liquidity (see below). We have Quoted Risk – the risk of higher equity and commodities volatilities as desperately shallow liquidity pools are chasing higher returns in the new era of diminished tolerance for risk amongst retail investors. We have a PQR recession – an alphabet soup of messy noise along a shallower than before and flat growth rate.
A PQR recession dynamics will be as follows:
First businesses cut production below the point where their capacity is less than the expected medium term demand;
The supply overhang will be short-term managed to a supply undercut by reducing costs and inventories much deeper than before;
Once demand troughs, the depletion of inventory means that any new demand will translate into increased inflation, triggering some monetary tightening that will trigger renewed push for precautionary savings and the W-shape will emerge;
Capital expenditure will have to increase on the maintenance and amortization side as even the minimal levels of capital will begin to fall apart at a rate not seen since the collapse of the USSR, but no new capital will be added, so profits will improve;
The improvement in the profits will drive us up the last leg of W, but there will be no build up in corporate war chests as liquidity will remain tight;
Instead, strategic drive in increasing capacity to address future expected demand will mean that employment and investment will rise faster in the BRICs and the rest of the world than in the OECD;
Fiscal stimuli with priorities of Obama administration implying more spending on immediate Uncle Sam consumption of stuff from the Democratic Party cronies, followed by lower public investment creation and not followed by tax cuts, but by tax increases will mean that no productive capacity will be underpinned in the productive US sectors, yielding their competitive positions globally to newcomers from Asia;
The US economy will settle into a permanently lower rate of growth characterized by relatively frenzied swings from Public Capital Formation schemes to Private Risk Premia increases and back to Public Capital.
A PQR paradigm. QED
How do we know this?
We now are wiser than in October-December 2008 and it is now more than apparent that the US fiscal stimulus misconceived (in a rushed atmosphere of a sever crisis) and misdirected (at the least productive sectors of the US economy where mis-aligned long term incentives will prevent any future productivity growth springing the green shoots). Fiscal stimulus in the US did not help significantly to deleverage households, so monetary easing did not restart demand for borrowing. Fiscal stimulus, in the Obama administration conception, did not prop up capacity preservation in productive sectors of the US economy and was wasted instead on the Big 3 Auto-monsters and the larger, less productive financial institutions. Fiscal stimulus did nothing to get the Americans out of negative equity and thus did absolutely nothing to reduce incentives for precautionary savings. This means that consumption growth is simply not going to happen, folks. Not at the rates pre-crisis and not even at the rates of post IT-bubble recession.
Monetary policy is also going to fail in everything but inflation generation. US private sector credit remains in the doldrums a year after the efforts to repair it began and the US wounded and undercapitalized financial system continues to struggle with the ghosts of looming future losses.
The longer-term theme in the US is the emergence of the two polar opposites as demographic drivers of the economy. On the one hand, ageing assets-holding population will have no access to liquidity as home sales will remain subdued by the massive overhang in unoccupied properties still crowding the market and by the banks unwillingness to lend on real estate assets. On the other hand, high savings –geared younger population will be consuming less and repatriating more. Think of the Latin Americanization of the US population with the resultant outflow of financing from the younger second generation US workers to their first generation American parents who will move back to Latin America to get better quality of life in return for their savings.
So future consumption will be depressed by financial system, demographic changes and the overall change in risk aversion across the US population. As an interesting side-bar, in the mid 2008 the number of Google search hits for ‘Paris Hilton’ – an imperfect signifier of the younger generations presence in the economy – has been overshadowed by the number of search hits for that key word of the Wal-Mart generation of greying retirees: ‘coupons’.
The downsizing of American consumption-driven economy has begun. And this is hardly an encouraging sign for the V-shape theorists.
Europe’s moment of sickness
This leaves us at the point for comparing the US with its today’s competitors. The sick state of the nation on the western shores of the Atlantic will be predictably mirrored with an even deeper decay on the eastern shore of the pond. As US continues to improve productivity – albeit at a much slower pace – European society, geriatrically-challenged, hamstrung by the trade unions, obsessed with preserving the status quo of wealth distribution and increasingly anti-immigrant and anti-innovation will suffer even more. Increased consumer demand from China and India, Brazil and possibly Russia will go some way to prop up German manufacturing, but more and more of those fine BMWs and Mercs will be stamped out in the US, assembled in Free-to-work states of the US South, designed in the Free-to-dream states of the US West and financed from the Free-to-invest states of the US Midwest and Northern Atlantic corridor. German manufacturing will sing the same blues as British manufacturing did before it. What will remain will be a museum trinket shop – a place where Ferraris and Bugattis will still be made backed by subsidies from the US- and elsewhere-based ‘German’ production of actually demanded goods.
Investment themes of a PQR recession
There will be new themes for the investment markets in years ahead. These themes will be about more active management of volatility and use of volatility spells to the same purpose as we used the international ‘growth’ stocks in the past – to get ahead of the benchmarks. Another theme will be maintaining sane returns once the risk of dollar devaluation is taken into account. Third theme will be the rise of global volatility. Displacement of the US and EU from the pedestal of global leaders in future growth (the first one still coming, the latter having already taken hold) is not going to take place because some other power will emerge as being better in absolute terms. Unlike almost all other deaths of the superpowers (with exception of the collapse of Rome), this one will not result in an immediate emergence of a heir apparent to the US dominance. China – the sickly giant that will be seen as having toppled the US – will not be able to bear torch for the rest of the world primarily because it has no model of its own, no engaging or charismatic ideology. And this will mean that the world of investment will be jittery, uncertain, fast changing worldwide.
Prepare for some serious volatility management, folks. PQ to QR to PQ across the horizontal axis, US to BRICs to Asia to US to Latina America to the BRICs across the vertical one, and across all asset classes on the Z-axis. Shall I remind you that complexity of PQR recession is by even alphabetic standards much more significant than that of L, V or W?