Things Will Get Much Worse Before They Get Better

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Way back in May 2012 before a press conference announcing the ECB's decision to hold rates steady, Mario Draghi, European Central Bank (ECB) President, speculated that the Eurozone economy showed "tentative stabilization". This was two months after he commented to a German newspaper that "the worst was over".

Yesterday the ECB relented on interest rates, reducing both its benchmark rate and its deposit rate (to 0.00%), bowing to the reality that Europe's hoped-for economic progress is now firmly in reverse. In addition to the ECB's action, the Bank of England increased its quantitative easing program by £50 billion in an effort to pull the UK out of its own sharp and persistent re-recession. Even the People's Bank of China got into the monetary act by reducing its benchmark bank lending rate (the 7-day repo rate on reserve payments, the RRR) and continuing its reverse repo operations.

These measures follow closely the intentional reductions in collateral acceptance parameters at the ECB and the Bank of England from just a few weeks ago. And just before that, the Federal Reserve pledged to keep its Operation Twist program going, extending the maturity of its US treasury portfolio still further. Most significant, however, may have been the first officially sanctioned instance of negative interest rates. The Danish central bank reduced the certificate of deposit rate to -0.20%, commenting that this was a "good problem" to have. In doing so, the Danes have confirmed that money continues to flow out of the European periphery and into the so-called "core" that apparently includes Denmark.

Central banks continue to employ "monetary stimulus" in unconventional ways, through unprecedented means and taken to unbelievable levels. And the arc of re-recession continues and spreads unimpeded.

Here in the US, economic data continues to disappoint now at a near-universal pace. Economic measures may not be showing contraction yet (though the manufacturing ISM sunk below 50 for the first time since 2009), but there is little doubt as to the deceleration - a dangerous condition for even an economy growing at a moderate pace, let alone one barely in the plus column. This is a stark contrast to just a few months ago when the US economy was almost uniformly believed to be in the full bloom of recovery. That celebration itself was only a few months removed from last summer/autumn's slowdown and gloom.

In the post-2008 crisis period, the US and global economies seem to have compressed the course of their "normal" cycles. A typical "boom" period would/should last several years before exhaustion and malinvestment turn into a slowdown. Now, it seems, "boom" phases last only months before souring. More than that, though, the nagging inability to grow at anything more than a trivial pace seems to be giving rise to outsized expectations, perhaps due to nothing more than frustration or exhaustion. Whatever may be causing this growing dichotomy between actual output and expectations, emotions are playing a larger role in charting perceptions of reality, and therefore transferring into the volatility of the real economy itself.

There are several factors that may account for this economic compression, economic and accounting aspects I covered back in February when the world was still enraptured by both liquidity measures and seasonal adjustments. At that time I wrote:

"This third iteration of this pattern strikes me more as the last legs of the recovery, rather than the foundation of a new growth phase. The savings rate can fall only so far, there is only so much room for spending absent full employment and robust wages."

Yet for all that optimism, the same problem remains essentially untouched. Despite the unending parade of "monetary" policies and stimulus, there is nothing monetary about said policies. Every means of stimulus enacted by central banks or central governments amounts to a version of borrowing to create growth. Central governments aim to borrow money to increase government spending and "investment", ending up in the pockets of the unfortunate as transfer payments or the temporary reprieve from pink slips. On the other end, central banks reduce interest rates and provide bank "liquidity" to get the private sector to increase its propensity to borrow for economic activity. Economic policies are totally and completely captured by credit and debt - there is nothing else to them.

The economic theories that guide these credit-focused responses are ill-equipped for the structural problems that exist today because those structural problems are themselves artifacts of previous versions of credit-focused policies. The Federal Reserve created a housing bubble to "save" the economy from the potential deflation of the dot-com bubble, creating an incentive structure that led to $7 trillion in mortgage debt and countless trillions in debt in other sectors (including the generous portions of debt accumulated in the public or official sector). However, the fact that central banks accomplished the trick once is enough to give credence to expectations of replication. Thus the mini-cycles. The backdrop of structural imbalances remain unresolved, but certain economic actors respond to their own expectations (which have proven to be unfounded) and interpretations of just how effective "monetary" policies can and will be. The focus seems to have shifted away from the real problem of economic potential toward policy potential.

For example, most businesses conduct planning based on a number of factors in their own industry and within their own interpretations of parameters like market share and innovation. But they also incorporate macro economic "research" into those plans, forming a top-down forecast of the larger economic picture to give the firm what they hope is a deeper, more robust expectation for profitably committing scarce resources. Among the tools available for this kind of macro forecasting is the Blue Chip Economic survey (a poll of expectations from mainstream economists).

Back in mid-April 2011, the Blue Chip Economic Indicators predicted that:

"...the consensus continues to believe the recovery remains self-sustaining and that above-trend growth will resume in short order."

At that time, for full-year 2011, the survey of economists led to a consensus forecast of 2.9% growth, with high expectations of a second half rebound after a weak start. The key point is the combination of expectations for not just a second half rebound, but that the economy itself would take that rebound and shift into the "above-trend growth" of a real recovery. How many businesses based their operational decisions, in part, to such surveys and mainstream economic expectations, including expectations of central banks themselves?

Based on those expectations of "above-trend growth" in the near future, certainly some manufacturing firms increased production levels and inventory in anticipation. If those expectations were matched by additional monetary measures that also conformed to the survey expectations, and appeared to be confirmed by coincident financial indications (like stock prices), then some businesses will have not just followed these expectations, they might have done so robustly. As long as enough marginal actors participated in this over-exuberance, it would make a marginal difference in economic volatility.

After an initial misstep in the third quarter of 2011, the Bureau of Economic Analysis estimates that private inventories in the next two quarters (Q4 2011 & Q1 2012) expanded at the fastest pace since the middle of 2010 (when GDP was actually growing at a rate better than 3.5%). Though inventory levels are still somewhat depressed compared to levels of the middle of the last decade (during the housing bubble), they have revived significantly in the wake of their collapse during the Great Recession. It would make sense that businesses would be very cautious about adding inventory at a pace that corresponded to that last robust period, artificial as it may have been. In pure dollar terms, however, the pace of sustained inventory expansion in Q4 2011 and Q1 2012 matches the best days of the artificial recovery of the housing bubble (equaling the pace of expansion in the last half of 2004).

If these forecasts and operational paces turn out to be overly optimistic, then we would expect a rather sharp reversal as production schedules and inventory levels have to be curtailed to match real conditions. What was once a marginal spurt of optimistic activity becomes a marginal source of economic dead weight, pulling overall activity lower as these businesses attempt to learn from their mistake of putting too much stock in mainstream economics. The June contraction indicated by the ISM's manufacturing index seems to add weight to this idea. Even the ADP employment report from Wednesday showed unambiguous weakness in manufacturing-related employment.

The "pillars" of this post-recovery period (I continue to maintain that whatever recovery we were going to have ended in mid-2010, and that economic growth has been decelerating ever since) have been inventory restocking after the 2008/09 wipeout, the resumption of business investment that was suspended due to financial and liquidity problems in 2008/09, and consumers attempting to recreate the best days of the housing bubble by spending money they really don't have (the personal savings rate was nearly 6% in mid-2010, having fallen all the way to 3.4% by the end of 2011, before reverting back to 3.9% recently). Now that the savings rate is trending higher, matching this recent bout of "unexpected" weakness, a follow-through diminishment of the inventory restocking trend would both confirm the mini-boom/bust cycle and the obtuse optimism of conventional economics. We have already seen a significant deceleration in business investment (especially in computers), not surprising since restarting suspended activity is a finite process, so a slowdown in all three "pillars" pushes the economy into dangerous territory; a place that is completely unexpected by mainstream economics practitioners, and therefore a marginal proportion of businesses.

There does seem to be a definitive pattern emerging in the real economy as it lurches from the euphoria of monetary stimulus to near-panic and back again. However, what is more troubling is that the volatility of sentiment is occurring against a real backdrop of a downward trend that began with the end of recovery in mid-2010. The euphoria and overwrought optimism of monetary "easing" does not erase that trend, merely engages volatility that serves to cloak that trend in the temporary relief of asset prices and the ephemeral emotions that come with them. But stock prices and the real economy are not synonymous - stock prices do not create wage income.

For their part, mainstream economists and policymakers continue to be surprised by all this "unexpected" weakness simply because they are still captured by their outdated framework of economic relationships and expectations. It is still largely assumed that monetary and fiscal policies, both conventional and emergency, are effective because they have been at specific times in the past - and many do actually believe that stock prices are a definitive measure of the real economy. The economics profession has extrapolated these individual circumstances of efficacy into hard and universal rules and laws. For Mario Draghi, it really is as simple as doing X and expecting Y. Where X is an LTRO, Y is expected to be "the worst is over". The monetary paradigm under which that simple relationship previously held no longer exists.

The same is true for Blue Chip economists - they still expect that the X of low interest rates (or negative real interest rates, as the case may be) will yield to the Y of an "above-trend" growth trajectory. In April 2011 when that forecast was released, it was during the height of expectations for QE 2.0 in the US. There had already been a slowdown concurrent with the monetary program, but it was simply expected that QE would eventually work without fail given enough time (the expected lag between policy execution and policy results).

For the global banking system and the global real economy, however, the simple rules and laws of conventional economics are now largely unrelated to the structural deficiencies and conditions in which we now find ourselves. Central banks can push real interest rates as negative as they want and it will not move the needle of economic activity one bit. There is no functioning pathway for financial largesse to move from central banks to banks to real economy actors - debt as an economic plug factor is dead. As is the "wealth effect" of asset inflation. Central banks can create trillions of new currency units and then punish the holders and "hoarders" of those units, but all that new currency still cannot be forced to circulate within the real economy as long as they are required to be borrowed or lent into circulation.

Economists will continue to expect results that conform to their subsets of the real economy, and will continue to be confounded by the "unexpected" weakness that persists. What they, and any businesses that rely on them, should be working toward is an understanding of the economy free from the paradigm of historical relationships. Growing the economy through artificial means is no longer an answer to the difficult questions of global trade and monetary imbalances. Sure the Fed "engineered" a recovery from the dot-com bust with a $7 trillion housing and multi-trillion dollar government debt bubble, but what bubble can they pull out of their hat to replicate that neat trick now? The flow of productive capacity overseas was papered over for nearly twenty years, now there is nothing left to make up for that lost wage potential.

The fact that there has been no repeat of the 2003-2007 artificial "boom" in the three years since the end of the Great Recession more than suggests that waiting for delivery of such a boom is a fool's errand; albeit one that is aided in every way by the continued re-assurance of authorities and the rapidly diminishing sway they have on asset prices. I find it unlikely that conventional economists and monetary practitioners will see it that way, so the volatility of the mini-boom/bust cycle is likely to be with us awhile longer. But even that has a potential end once people stop listening to these old and outdated conventions and begin to step outside the narrow confines of historical extrapolations. The marginal number of businesses and investors that end up making decisions based on the predictions of conventional economists and their optimism for outmoded policies is dwindling with the lack of true success and the rapid pace at which pronouncements are proven ill-conceived. One of these days when an authority figure once again pronounces the "worst is behind us", or some variant of that sentiment, no one will even notice. That will mean, however, that it will get worse before it gets better, and that day may not be that far off.

 

Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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