FYI | Jun 18 2009
By Greg Peel
We have all by now become familiar with the “alphabet soup” argument. If one was to predict just what shape the global economic recovery from the GFC would take, we have heard support for the L, the U, the V and the W.
Let’s assume the US S&P 500 index to be a forward proxy for the global economy.
An L-shape “recovery” is not really a recovery at all, just a stabilisation at the bottom. Japan over the 1990s proved that the L-shape is quite achievable, but given we’ve already bounced 40% the L has been eliminated.
Indeed, the sharpness of the bounce already suggests a V-shape is the answer, particularly if one notes the six-month chart of the S&P:
But obviously this is not the end of the story. On the sixth month chart there is a nice symmetry from the 900-950 level to the bottom and back again. But if one recalls that the S&P reached over 1500 before the start of the crash in October 2007, we haven’t yet completed a true V. Indeed, a true V implies we go straight back to the highs without barely a correction on the way, and quite frankly no one is silly enough to suggests that’s possible.
More likely is a U. Obviously a U is not unlike a V, except that the turnaround is more graceful and less abrupt, with more time spent tracing out a slow turnaround. The chart above already suggests a U has also been eliminated, unless you take a wider perspective, such as in this one-year chart:
This chart still shows a distinct V at the base, but it doesn’t take much to see that a further recovery to around the 1300 level would trace out a more U-like shape. A popular prediction, on the wider scale of things, is that the U will be elongated so as to more resemble a soup bowl than the letter U. This is very much a distinct possibility – more so than a complete V – if one is pondering the longer term horizon.
But there are others who ardently support the W. A W would imply we go back down from here to retest the low and then make a second rebound. Perhaps we won’t go all the way back to the low and simply trace out a wonky sort of W. If one believes the rally to over 900 has been too fast and built on too much premature euphoria, then a W is definitely on the cards. Maybe we will see a W in the shorter term within the bigger-picture, elongated U.
But a more recent school of thought has suggested we won’t see any of these letter shapes, but instead will see a square root sign:
The square root sign implies a V bounce of sorts but with a flat tail, or something a bit like an L with a bit of a V in it. The implication here is that the market will recover from its panic lows and embrace the “green shoots” of a stalling downturn to make a V bounce – which it has done – but then simply drift sideways for a while as the global economic recovery struggles to overcome the lingering forces of the great debt unwinding.
Actually, if you spin the square root sign around…
…you end up with a more likely prediction. We have dropped from the highs, bounced off the bottom to a degree, but now we will drift. Take a look at a three-year chart:
Okay, a bit of imagination is required, but can you see the backwards square root sign in there from October 2007?
To sum up, we’ve eliminated the L and we’ve formed a V, but the V could yet become either a W or a square root sign (backwards). This could all still happen within the context of a wider, stretched U. Really this is all just a way of saying: We’ve bounced, we’ve stalled, do we now go back down, back up, or sideways for a while?
Global research house GaveKal weighed into the argument this week.
GaveKal argues that the “green shoots” of global economic data which are now leading to slightly less dire forecasts (the IMF, for example, has made some upward revisions) have been supported by two key factors: The collapse in interest rates and the collapse in the oil price. Those green shoots have given us our V bounce to date, but support has begun to wobble given US mortgage rates have now climbed back some 150 basis points (1.5%) and the oil price has bounced from under US$40 to over US$70/bbl. Two of the rally’s important “tailwinds” are now turning into “headwinds”.
Accordingly, the rally has stalled and is currently looking tenuous. However, GaveKal also notes conditions are still much better than they were a few months ago. The velocity of money (the speed of money moving around in the economy rather than sitting idle in safe-keeping) has come back to life somewhat and total Armageddon has been avoided. But for your average business, any pick-up from the depths has still been slow and uncertain, unlike the more optimistic share market.
A trucking company, for example, might find business is now a bit healthier again, but now it’s again facing rising oil prices. A retailer might be seeing a little more traffic, but rising oil prices and rising interest rates are eating away at consumer spending capacity. Commodity prices in general have risen, which should lead to a rise in the price of finished goods. Commodity price have become there own worst enemy again, GaveKal suggests, given if they kill off economic growth they must fall once more.
The result is the equity market may need to take a breather. Stocks have been overbought anyway, GaveKal believes, and a pause would provide the opportunity for the market to ultimately stabilise and strengthen. GaveKal remains medium term bullish of equities, but a bit of short term weakness would not surprise.
Now that America’s creditor nations, such as Japan and the BRICs, have rallied to support the US dollar (they still would like to see diversification down the track, but they hold too many US bonds to risk a dollar collapse), it has now found a better level of stability. Bond yields are drifting back again. The Fed has indicated it has no intention of monetizing the US deficit forever (buying US bonds with printed money – the source of dollar collapse fears) and is under no pressure from the Obama Administration to do so. Commodity prices need not continue to surge from here.
As to the bigger picture, GaveKal notes that this recession is a little unusual given the economies of most major OECD countries (including the US, Japan, France and others) spent 2004-2007 growing at below trend. (This was clearly not the case for Australia, as it is more directly linked to the China story). Normally a recession is simply an inevitable hangover after several years of excess. Therefore, given these economies did not reach dizzy heights, is it too much to suggest they won’t have too much trouble returning to where they were in growth terms?
Many say of course they will – this recession is all about repairing balance sheets and that will take time. GaveKal argues, however, that this recession is actually about a lot of things – global trade, inventories, consumption, credit, trust… And right now all of these things seem to be on the mend. Inventories are a case in point.
Inventory liquidation in 2008 in the face of the GFC wiped 1% off the US GDP. This is a level which has seldom been reached before, but when it has, the following year has nearly always seen an equivalent 1% bounce. The only time this hasn’t happened was in 2002. The reason it didn’t, GaveKal argues, is that the twenty-first century saw OECD countries offloading their inventory risks onto developing economies as they shifted the manufacturing processes offshore to China et al.
As it likely remains easier for OECD companies to finance their inventories in China and elsewhere right now, GaveKal believes the same result may occur again. In other words, inventories will be rebuilt but not necessarily show up in the numbers at home.
Another point to consider is that recessions can be an extremely “creative” period for businesses. They force once complacent businesses to cut excess costs, improve efficiencies, seek new markets and generally become more productive. Many businesses won’t survive however, but that means the ones that do can increase market share and thus profitability, giving them scope to grow once more in a less crowded space. Money is more productively exploited when it passes “from weak hands to strong”.
Thus GaveKal can see a breather in equity markets ahead, which will be a negative force, but at the same time the analysts can see fundamental positive developments underpinning the market. Hence they suggest the outcome from here might be more of a sideways one, and therefore, the shorter term shape of the recovery will trace out something akin to our backwards square root sign.
