Global Economy Probably Weakening

A downward trend in leading global indicators, manufacturing, and trade has many central banks and political leaders concerned, and they are collectively doing a number of things to try to keep growth on track.  Quantitative Easing (money printing) is very widespread, as are currency interventions and stimulus spending.  By some measures the world has recently fallen into a global recession, with 45% of the OECD’s 41 countries already having recorded two consecutive quarters of negative GDP growth.[i]  Even the economists at Goldman Sachs say they think a global slowdown phase lies just ahead.[ii]  In the USA, preliminary GDP growth was reported as +0.1% for 4Q/2012,[iii] YOY growth in durable goods orders has fallen to zero,[iv] and the Chicago Fed’s National Activity Index for January was -0.32, indicating US economic activity remains sluggish.  The Philadelphia Fed’s January Business Outlook for manufacturing recorded a -12.5 reading, the second in a row, but recent national housing data have been much better (at least on on paper), with monthly new home sales soaring over 15% (annualized) in January.[v]  (However, note that this increase was based on a calculated 437,000 home annualized rate of sales, which was adjusted for seasonal effects off a mere 31,000 raw, or unadjusted actual sales.  Thus 406,000 or 93% of the total reported sales are tenuously supported adjustments to the raw data).[vi] 

Durable goods orders excluding transportation equipment climbed in January the most in a year, suggesting growing demand and a continued recovery.[vii]  So the signals are still mixed in the US, and hope remains that somehow we will avoid the global trend.  However, the debt ceiling/sequester crisis in March will probably hurt both the US economy and the markets to some degree, perhaps causing a 0.5% reduction in GDP.  When this reduction to already sluggish GDP is combined with rising fuel prices and higher payroll taxes, which will be  cutting a wide gash in consumer spending in the months ahead, it would not be much of a stretch to end up with stagnant growth or even a mild recession.  This certainly indicates downside risk to Wall Street’s projections of continued economic growth.

Debt, the Credit Cycle, and Economic Growth

Many countries are simultaneously deleveraging their private sectors while boosting overall debt, due to government deficit spending.  Enormous central bank asset purchases (QE, or money printing) have kept the bond vigilantes at bay so far in most countries (except in Europe), but one aspect of this deserves more attention than it gets: the fact that these spending patterns and excessive debt are slowly killing economic growth.[viii]  Carmen Reinhart and Kenneth Rogoff have shown that once a country has exceeded a 90% debt/GDP ratio, economic growth has historically been reduced by 2% per year for a period of about one decade, on average.[ix]  By their metrics, the US already has a debt/GDP ratio of 100%, which may explain the really sluggish growth we’ve observed in the last two years. 

Why does a high level of debt tend to dramatically slow down growth?  Because when debt is high, capital is being misallocated to non-productive purposes, such as financial engineering, market speculation, corporate rent-seeking behavior, debt service, and unfunded government handouts. [x]   Over time, less and less is invested in income generating assets such as capital equipment, buildings, toll roads, etc., and so future GDP growth and national net worth suffer.  By not investing for the future, corporations and governments are simply hoping for a future rather than planning on one.  History shows that this doesn’t work in the long run, and since we started down this path many decades ago, we are now facing the long run’s consequences.  Jeremy Grantham of GMO thinks that as a result, we are now facing decades of low GDP growth (averaging around 1.4% annually, or half the normal rate).  Grantham also believes that there is a low or negative correlation between stocks and GDP, so it is unnecessary for investors to worry about some kind of permanent decline in stocks, and indeed plenty of money can be made in the markets.[xi] 

Rather, investors should worry about what various interventionist governments will do to try to boost GDP growth.  For example, look at all the wasted stimulus spending in Japan, China, the US and Europe over the last five years – it’s measured in trillions of dollars.  Except for an increase in Chinese infrastructure, much of which still lays idle, little has actually been achieved, and most of the money was misallocated to non-productive purposes.  Continued heroic efforts by government planners will ignore all these past failures and keep government spending elevated, with all of the money borrowed from the future.  This aspect of the problem is not yet fully discounted by the markets.

Currency War, or Just Re-Balancing?

Recently there has been much talk of the possible currency war we may have begun, with some observers suggesting that the mistakes of the 1930s could be repeated.[xii]  Countries in the 1930s attempted to boost trade, which had declined, by engaging in competitive devaluations, in effect making their products cheaper to consumers in other countries.  Unfortunately, we can’t all devalue our currencies at once, but still they tried back then, and as a result of this “beggar your neighbor” policy, trade completely collapsed. This made the Great Depression much more damaging than it otherwise would have been.  Other workers have compared the current situation to that of the Asian Financial Crisis of 1998, which was triggered by a rapidly rising US dollar.  This rising dollar trend caused liquidity in developing Asian countries to practically disappear (that is, hot money flows into Asia when the US dollar is declining, and flows back out again when the US dollar is rising).  Eventually the loss of liquidity took down the entire financial system in the region.[xiii]  A criticism of the Asian Crisis analogy might be that the US is printing money, which should tend to drive the dollar’s value down, not up, but that is an assumption that does not appear to be supported by the facts. 

Even though theory suggests that the dollar should have fallen under QE, that’s not really what has happened.  What we have actually observed is a rise in the dollar under the QE1 program, a subsequent decline in the dollar during the QE2 program, and another rise in the dollar under QE3 and QE4.[xiv]  In fact, the US dollar index (DXY) now stands at about 82, which is almost exactly what it was in August of 2007, when the Fed announced its first rate cut heading into the financial crisis.  One reason there has been no decline in the dollar in spite of $2.5 trillion of money printing is that other major countries were also printing money.  For example, the balance sheet of the U.K. has now reached about $608 billion, the Bank of Japan has about $1.73 trillion on its books, the US Federal Reserve has about $3.15 trillion on its books, and the ECB has about $3.60 trillion on its books.  Almost all this grand total of $9.09 trillion was added over just the five years since the financial crisis began.[xv]  Another explanation for the unexpected strength of the dollar may be that since core inflation rates have been benign, and inflation expectations are still low, there has been no driver for pushing the currency down.  Core inflation has in part been held in check by the fact that the assets purchased by the Fed are still on the Fed’s balance sheet, i.e., banks have not deployed the money out into the economy, thus keeping money supply subdued and preventing a major rise in core inflation.  Also working against inflation has been the high unemployment rate, which has kept real wages, which can be major drivers of inflation, in a downward trend.[xvi]      

The latest round of media speculation about a new currency war started when incoming Japanese Prime Minister Shinzo Abe vowed to end Japan’s deflation and liquidity trap by immediately devaluing the yen and raising interest rates.[xvii] Since the election in late 2012 the yen has fallen from 80 to 95 per dollar (about 19%), but has recently gained back about 3%.  This fall in the yen sounds like a lot, but in fairness we should consider the fact that the yen rose from about 150 per dollar in 1999 to about 76 per dollar a year ago, for a total increase in value of about 49%.[xviii]  In fact, the yen has risen about 70% over the last three decades.  Against that gain a fall of 16% is hardly excessive.  The idea behind the falling yen is to end the steep decline in Japan’s export market share they’ve experienced over the last 20 years as the yen rose, and reinvigorate Japanese competitiveness versus other Asian countries.  At the same time the new, perpetual round of QE undertaken by the Federal Reserve recently could exert some downward pressure on the dollar over time, assuming (per discussion above) that inflation rises a bit.  This declining dollar trend, if it happens, might help the competitiveness of the US manufacturing and export sectors, but it could also potentially cause troubles for some other countries. 

Niels Jensen[xix] has pointed out that there are really two mechanisms for adjustment when central banks print huge volumes of money.  Foreign investors who demand compensation for super low bond yields and/or lagging equities can be appeased by either an increase in sovereign bond yields, or by a devaluation of the currency.  Increased bond yields have indeed been a major adjustment mechanism in Europe, which in turn has greatly increased the risk of a banking collapse.  This was especially true when Spanish, Portuguese, Italian and Greek yields soared in 2011, for example.  Alternatively, the mechanism of a falling currency should make local stock markets soar and thus adequately compensate foreign investors who move their assets from bonds to stocks to get away from QE-induced low yields.  Jensen suggests that the preferred adjustment mechanism is going to be currencies rather than bonds in many countries, since many over-indebted nations have major portions of their sovereign debt parked in their banking systems, and they simply cannot risk another financial crisis.  So we should expect most advanced economy sovereign bond yields to stay low much longer than the consensus expects, and their currencies to gradually devalue as the adjustment mechanism for foreign investors. 

The main currencies rising against the US dollar (USD) and the other major currencies should be those in developing Asia.  The world’s primary reserve currency (USD) itself may eventually rise a bit, since it serves as a safe haven and will be in demand as the global debt crisis reaches its endgame.  Indeed, any sustained drop in the USD would be a disaster for many other countries, since it would cost them some export volume at a time when they need more trade to survive.  The US economy has done well with a strong dollar in the past, so there shouldn’t be much impact on US manufacturers, especially given their new cost advantages derived from abundant, cheap natural gas.  But if the US currency doesn’t adjust for foreign investors seeking compensation for low bond yields, it may be that US bond yields will have to rise instead.  That would make the US the one major exception to the idea of currency adjustments.  However, to the extent that European bond yields continue to rise whenever an adjustment is needed, perhaps the euro (EUR) will not be used as an adjustment mechanism and will fall again.  It appears now that the yen (JPY) will continue to fall as well, both because of the new monetary policy stance, and because of the huge holdings of government debt parked on the balance sheets of Japanese banks.  The British pound (GBP) is more of a problem, and it could go either way, although right now the direction is down.  It is expected that the Chinese yuan (CNY) will continue to rise as it has for many years now, since it is still considered undervalued; bonds would not be used as an adjustment mechanism in a centrally planned economy anyway.  Thus, it would appear that since several of the major currencies will rise, and others will fall in the next two years, an outright global currency war is not yet occurring.  However, the need for export-driven economies to grow their international trade volumes in order to keep GDP growing and unemployment under control, at least in the near term, poses a serious risk going forward.       

[i] D. Van Vuuren, http://advisorperspectives.com, 2/15/2013

[ii] G. Cole et al., Goldman Sachs, https://360.gs.com/research, 2/21/2013

[iii] J. Mitchell, The Wall Street Journal, 1/31/2013

[iv] D. Rosenberg, “Breakfast with Dave” column, www.gluskinsheff.com, 2/06/2013

[v] S. Chandra & J. Smialek, Bloomberg, www.bloomberg.com, 2/26/2013

[vi] D. Rosenberg, “Breakfast with Dave” column, www.gluskinsheff.com, 2/27/2013

[vii] A. Kowalski, Bloomberg, www.bloomberg.com, 2/27/2013

[viii] Bill Gross, reprinted by John Mauldin, www.mauldineconomics.com, 12/15/2012

[ix] C. Reinhart & K. Rogoff, American Economic Review: Papers & Proceedings 100 (May, 2010), 573-578.

[x] S. Minerd, Guggenheim Funds, reprinted by John Mauldin, www.mauldineconomics.com, 2/22/2013; J. Grantham, “GMO Quarterly Letter,”  www.gmo.com, 11/02/2012; N. Jensen, “The Absolute Return Letter,” www.arpllp.com, 9/02/2012

[xi] J. Grantham, “GMO Quarterly Letter,”  www.gmo.com, 2/02/2013

[xii] H. Kalirai, “Weekly Report,” BCA Research, www.bcaresearch.com, 1/18/2013

[xiii] M. Kling, quoting Andy Xie, www.moneynews.com, 2/08/2013

[xiv] T. Lauricella, The Wall Street Journal, 1/23/2013

[xv] D. Kotok, “Total Assets of Major Central Banks,” www.cumber.com, 12/31/2012

[xvi] G. Shilling, “Insight,” www.agaryshilling.com, 2/02/2013

[xvii] A. Nathan et al., “Top of Mind” monthly, https://360.gs.com/research, 1/17/2013

[xviii] N. Jensen, “The Absolute Return Letter,” www.arpllp.com, 2/02/2013

[xix] N. Jensen, Op.Cit.