FYI | Oct 09 2007
By Greg Peel
World focus is currently turned to whether or not the US economy will enter recession. As the US economy remains, today, far and away the world’s largest, the ramifications of a US recession should be felt across the globe. The Fed has come in to rescue the credit markets and attempt to head off a recession brought about by the domestic housing slump. It has also indicated it stands ready to act again if economic data begin suggesting it should.
While there are those that argue the cutting of rates could well expedite a recession anyway, or at the least put one off until a later date, the flipside of the argument is that the US is not about to enter recession at all, hence there’s nothing to worry about. Ever since the Fed stated it would watch timely economic data closely, successive data have either proven woeful (such as housing, durable goods orders) or surprisingly good (such as the recent jobs revisions). How this data should thus be correlated is a tough one, except when you consider that good news means no recession and bad news means a rate cut. That’s why the Dow’s at new highs again – what can go wrong?
Since the CEO of mortgage lender Countrywide came out and said it in August, anecdotal suggestions have been that a recession is a very real threat. They have come from CEOs in the lending, building, automotive, transport and retail industries. Impassioned pleas. While the Federal Reserve may work closely with crunched numbers, it also looks at anecdotal evidence and talks to industry leaders. Many an industry leader called for a rate cut in September, and it worked. Now they’re calling for another one.
Well – why wouldn’t they?
At the end of the day it will be the hard numbers that drive Fed thinking. At the moment those numbers are sending mixed signals. While nobody denies there is a “recession” in housing, has this spilt over into consumer spending? That’s the key. So far earnings reports and guidance in the retail industry have been mixed. But we can spend all day talking about what the next set of numbers might bring. The analysts at GaveKal have drawn on their own experience and numbers to arrive at their own conclusion, which is: The US economy will slow, but not recede.
In recent quarters, notes GaveKal, the Fed has been aggressively withdrawing liquidity from the system by tightening monetary policy (raising interest rates). The growth rate of the US monetary base is now much weaker than the growth rate of the US GDP. Such low levels of money supply growth have, in the past, led to financial accidents and, well, whaddya know? After all, it makes sense: If the Fed is pushing less and less money into the system, then those who depend on the easy money start to struggle. Nowhere has easy money been depended on so much as in the dodgy mortgage game.
There is no doubt the housing slump is going to cause heartache for the US economy, but there is more to the US economy than just housing.
For one thing, notes GaveKal, the overall income growth of the US consumer remains “decent”. A growing income means the greater capacity to handle increased mortgage payments. One third of American homeowners do not even have a mortgage. Of the other two thirds, only a small percentage of those are in real trouble.
The US leading economic indicators and the Institute of Supply Management surveys of the manufacturing and non-manufacturing sectors tend to “announce” a recession by turning down in the months preceding. So far this hasn’t happened. If we had a recession today, say the analysts, it would be the first since the 1974 oil shock when the cost of capital has been below nominal GDP growth. Usually, long bond yields need to move above 3% “real” before the US economy enters into a recession. The nominal ten-year bond yield is currently at 4.65%. Inflation is running at 2-3% (depending on how you measure it) meaning the “real” bond rate is some 1.65-2.65%.
Like any market bubble, a recession (which is simply a reversal of economic growth) most often occurs following a period of strong, above trend economic growth. What goes up invariably must come down. But US economic growth has been easing off for a while now. Had the economy been booming, then suddenly there would be warehouses full of inventory that would have to be dumped on an unwilling market. Apart from housing, this is not the case.
It is clearly true that employment growth in the US is slowing. This is hardly a surprise given historically low levels of unemployment. Employment growth will slow, consumer spending will slow, and the overall economy will slow in the last quarter, GaveKal believes. But the emphasis is on “slow”, not “recede”.
The same is not necessarily true for Europe, however.
GaveKal scoffs at the US “perma-bears” – those who have been predicting US economic calamity for 25 years and have been wrong in every one of them. On the other hand, when it comes to Europe GaveKal is a perma-bear. Over the same period, European economic growth has exceeded consensus expectation only once.
Because that year happened to be 2006, GaveKal concedes Europe has given the appearance of finally emerging from a long hibernation. Funnily enough the same was said of Japan in 1995. Europe is only now beginning to feel the effects of raised taxes, raised interest rates and a higher exchange rate. Just like Japan did. Japan duly crawled straight back into the cave.
Indeed, Europe is already exhibiting signs of slowing, GaveKal suggests, but the ECB is in denial. Moreover, whenever there is a global financial crisis Europe always seems to come off worse. It happened in 1985 after the Brazilian default, 1992-3 following the junk bond disaster, 1998 after the Asian crisis and LTCM, and 2002-03 following 9/11. It looks like it’s happened yet again. With no holds barred, GaveKal puts the boot into the ECB:
“Europe’s vulnerability is partly due to lax management in state-run or -protected financial institutions, but mainly to the monetary policies of the ECB (and the Bundesbank before it). Europe’s central bankers have never believed in pre-emptive responses to crises, instead waiting for the real economy to collapse before cutting interest rates. Unfortunately, we expect the same pattern to be repeated this time.”
And the big story in 2006 was not the weakness of the US dollar, but the strength of the euro (against Asian currencies as well). European exporters are just about to start feeling the pinch, GaveKal suggests.
So with Japan still stagnant, Europe on the verge, and the US slowing, how does this affect China? (And thus commodity prices and thus Australia?)
With low short rates and rising inflation, notes GaveKal, Chinese real interest rates are now deeply negative. In turn, this boosts the appetite for risk and should help keep growth booming. After all, why keep money in a Chinese bank to capture negative real rates? The average Chinese is now increasingly employed in the industrial sector. As such, he can now afford to spend more, since his income is much more reliable than when he was a farmer. And as GaveKal sees it, this is just the beginning of the emergence of the Asian consumer, particularly given the nascent Chinese consumer debt market.
As far as GaveKal is concerned, the Asian bubble has not even started yet. While China remains the major re-exporter in the world, it has also aggressively opened new markets and thereby reduced its dependence on the growth of its exports to the US. The majority of these new markets are capital-surplus countries such as the Middle East and Russia, which are currently benefiting from an oil-revenue bonanza. China remains the largest growth story around, but the ASEAN countries are also starting to carry a lot of weight as well.
All this helps underpin commodity prices, says GaveKal.
