On Friday, the ECRI publicized their call that the U.S. economy was headed for a recession (here). This firm has a respectable track record of forecasting turns in the business cycle, so this is a particularly noteworthy call.
Most of the financial commentary I have read so far has been forecasting a garden-variety recession (should one even occur), with corporate earnings falling 10-15%. While I have yet to be able to quantify the effect on corporate earnings, I take issue with comparisons to historical recessions for a number of reasons.
Starting with the C in Y = C + I + G + X, the consumer is still balance-sheet constrained. Historically, when consumer income fell, consumers would borrow money to smooth their consumption. With the American consumer leverage sitting as high as it is, it is likely that consumer spending will fall more than in historical recessions (higher flow through from falling consumer income).
Moving on to investment, while I am not expecting a total credit market freeze for highly-rated corporates, the high-yield primary market has been effectively closed for nearly three months. Historically, high-yield names have not been a meaningful proportion of total corporate issuance, but in the last two years, we have seen $600B in high-yield issuance, which I suspect has significantly inflated business capital expenditures (admittedly some of this issuance was debt-for-loan swaps). With this group of firms locked out of the primary market (and higher-rated firms behaving in line with historical experience) I expect there to be a larger decline in business investment than has been seen in historical recessions.
Government. Given the hysterical obsession with cutting spending (and taxes) in the House, I cannot see the U.S. passing any marginal stimulus until after the 2012 elections. If this is the case, government expenditures will actually contract relative to 2011. This is in direct contrast to historical recessions, wherein the government traditionally inflates expenditure in an attempt to stimulate the economy.
I do not have any strong feelings on net exports and feel that it is probably a wash.
Throw in European and Chinese tail risks, and the risks to the consensus recession forecast are clearly overweighted on the downside.
I should clarify that I am not saying with 100% certainty that teh U.S. is headed for a recession (although I do believe that a recession is more probable than not), but rather detailing my thoughts on the nature of the recession, should it occur. I will flesh out these thoughts in upcoming posts.
Showing posts with label Forecasts. Show all posts
Showing posts with label Forecasts. Show all posts
Saturday, October 1, 2011
Friday, June 17, 2011
Working Assumptions and Predictions
Well at long last, it is time to get this blog started up again. Third time the charm?
I suppose the best (and easiest) way to go about this is to articulate the assumptions which impact my worldview and expectations of how the global economy will evolve moving forward:
1) Greece and Ireland are insolvent. The only way out of their current situation will be debt restructuring. The current policy is quite clearly to roll maturing privately-held debt onto the books of the solvent core EU members, in anticipation of a restructuring at a later date. It is unfortunate that the precarious state of the European banking sector does not allow policy makers to force a restructuring of privately held debt (and let the cards fall where they may) but that is the status quo, and the current policy strikes me as the least-bad of policy makers' options. Domestic politics in both the core and periphery nations are the biggest threat to the current policy prescription, but I am guardedly optimistic that it will be sustained until a restructuring is a containable event. I think it is incredibly unfair that German taxpayers will have to shoulder a considerable amount of this burden, but it is a necessary evil.
Once the EU emerges from the slow burn of the peripheral debt crisis (if it does at all), there will have to be a dramatic move towards fiscal union in order for the common currency to be tenable. However, I fear that the electorate in member countries will be unwilling to accept this and therefore am not confident in the long-term sustainability of the Euro as a currency. That being said, I do understand the significant benefits of regional integration and expect regional currencies to be a more common phenomenon moving forward (say on a 50-year time frame)
2) The emergence of the Tea Party in the United States has made a responsible discussion of the U.S. budget deficit a near-impossibility before the next presidential election. Any Republican presidential hopeful must pander to the hard right's overzealous anything-but-tax-to-fix-the-deficit dogmatism and cannot be seen as cooperating with Obama on anything if they are to succeed in the Republican primaries. Diddo for any Republican who will be seeking re-election in the near term. Fortunately, I don't see this as cataclysmic for the Treasury market. Perhaps some risk premium will be priced in (and rightly so), but I do not foresee a Greece-like spike in yields anytime soon (sorry Gross et al).
3) I don't believe the hype about China. Yes they have grown 10% annually for 30 odd years. No, it cannot be sustained for the next 30. Anyone who tells you otherwise is either a fool, or has an ulterior motive for doing so. Over the last 3 years, there has been an unprecedented surge in lending without enough/any analysis of borrowers' credit worthiness. The result has been massive investment in what will turn out to be overcapacity and totally unproductive infrastructure. We are already witnessing the first ramifications of this in the form of spiking non-performing loan ratios, and it is going to get much worse before it gets better.
That being said, I am a long-term China bull - a chart of fixed capital per capita in China vs the West is all I need - but there are going to be some pretty nasty surprises in the short term, which will shift long-term output projections downward. Trend growth will also prove to be closer to 7% than 10%.
4) There has been an accelerating shift over the last 150 years from a world where capital was very scarce and real interest rates were high, to a world where capital is abundant and real interest rates on high quality investments are much lower. This is the necessary by-product of enormous gains in economic efficiency, which has lead to higher aggregate savings as an ever-expanding proportion of the population produces more than they consume and are thereby able to save for the future. While the implications of this shift are surely enormous, they are also not immediately apparent to me. If financial markets manage to allocate this capital more efficiently, it should allow for more entrepreneurial ventures and positively impact total factor productivity. Holding inflation constant, this will allow for more leverage across the economy, from the consumer through to the government, as the cost of debt service declines. This final dynamic strikes me as one of the most under appreciated dynamics at play in the global economy and warrants significant analysis by both private and public decision makers.
5) Finally, over the long term, as there is a transition to a more multi-polar world, I expect a re-emergence of realpolitik and a shift to the right across the Western world as a number of liberal ideals which (while both admirable and generally desirable) will lose priority in a more adversarial global community.
I suppose the best (and easiest) way to go about this is to articulate the assumptions which impact my worldview and expectations of how the global economy will evolve moving forward:
1) Greece and Ireland are insolvent. The only way out of their current situation will be debt restructuring. The current policy is quite clearly to roll maturing privately-held debt onto the books of the solvent core EU members, in anticipation of a restructuring at a later date. It is unfortunate that the precarious state of the European banking sector does not allow policy makers to force a restructuring of privately held debt (and let the cards fall where they may) but that is the status quo, and the current policy strikes me as the least-bad of policy makers' options. Domestic politics in both the core and periphery nations are the biggest threat to the current policy prescription, but I am guardedly optimistic that it will be sustained until a restructuring is a containable event. I think it is incredibly unfair that German taxpayers will have to shoulder a considerable amount of this burden, but it is a necessary evil.
Once the EU emerges from the slow burn of the peripheral debt crisis (if it does at all), there will have to be a dramatic move towards fiscal union in order for the common currency to be tenable. However, I fear that the electorate in member countries will be unwilling to accept this and therefore am not confident in the long-term sustainability of the Euro as a currency. That being said, I do understand the significant benefits of regional integration and expect regional currencies to be a more common phenomenon moving forward (say on a 50-year time frame)
2) The emergence of the Tea Party in the United States has made a responsible discussion of the U.S. budget deficit a near-impossibility before the next presidential election. Any Republican presidential hopeful must pander to the hard right's overzealous anything-but-tax-to-fix-the-deficit dogmatism and cannot be seen as cooperating with Obama on anything if they are to succeed in the Republican primaries. Diddo for any Republican who will be seeking re-election in the near term. Fortunately, I don't see this as cataclysmic for the Treasury market. Perhaps some risk premium will be priced in (and rightly so), but I do not foresee a Greece-like spike in yields anytime soon (sorry Gross et al).
3) I don't believe the hype about China. Yes they have grown 10% annually for 30 odd years. No, it cannot be sustained for the next 30. Anyone who tells you otherwise is either a fool, or has an ulterior motive for doing so. Over the last 3 years, there has been an unprecedented surge in lending without enough/any analysis of borrowers' credit worthiness. The result has been massive investment in what will turn out to be overcapacity and totally unproductive infrastructure. We are already witnessing the first ramifications of this in the form of spiking non-performing loan ratios, and it is going to get much worse before it gets better.
That being said, I am a long-term China bull - a chart of fixed capital per capita in China vs the West is all I need - but there are going to be some pretty nasty surprises in the short term, which will shift long-term output projections downward. Trend growth will also prove to be closer to 7% than 10%.
4) There has been an accelerating shift over the last 150 years from a world where capital was very scarce and real interest rates were high, to a world where capital is abundant and real interest rates on high quality investments are much lower. This is the necessary by-product of enormous gains in economic efficiency, which has lead to higher aggregate savings as an ever-expanding proportion of the population produces more than they consume and are thereby able to save for the future. While the implications of this shift are surely enormous, they are also not immediately apparent to me. If financial markets manage to allocate this capital more efficiently, it should allow for more entrepreneurial ventures and positively impact total factor productivity. Holding inflation constant, this will allow for more leverage across the economy, from the consumer through to the government, as the cost of debt service declines. This final dynamic strikes me as one of the most under appreciated dynamics at play in the global economy and warrants significant analysis by both private and public decision makers.
5) Finally, over the long term, as there is a transition to a more multi-polar world, I expect a re-emergence of realpolitik and a shift to the right across the Western world as a number of liberal ideals which (while both admirable and generally desirable) will lose priority in a more adversarial global community.
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