Wednesday, 26 August 2009

Out of the woods? Don't bet on it yet

Stock markets around the world have certainly made a fantastic comeback since the lows of early March in anticipation that the worst of the economic crisis is over and that businesses soon will continue to do business and making profits as they did before the economic crisis erupted. Nouriel Roubini, however, is less optimistic and argued in an excellent article appearing in that a second recession is a real possibility:

T he global economy is starting to bottom out from the worst recession and financial crisis since the Great Depression. In the fourth quarter of 2008 and first quarter of 2009 the rate at which most advanced economies were contracting was similar to the gross domestic product free-fall in the early stage of the Depression. Then, late last year, policymakers who had been behind the curve finally started to use most of the weapons in their arsenal.
That effort worked and the free-fall of economic activity eased. There are three open questions now on the outlook. When will the global recession be over? What will be the shape of the economic recovery? Are there risks of a relapse?
On the first question it looks like the global economy will bottom out in the second half of 2009. In many advanced economies (the US, UK, Spain, Italy and other eurozone members) and some emerging market economies (mostly in Europe) the recession will not be formally over before the end of the year, as green shoots are still mixed with weeds. In some other advanced economies (Australia, Germany, France and Japan) and most emerging markets (China, India, Brazil the recovery has already started.

On the second issue the debate is between those – most of the economic consensus – who expect a V-shaped recovery
with a rapid return to growth and those – like myself – who believe it will be U-shaped, anaemic and below trend for at least a couple of years, after a couple of quarters of rapid growth driven by the restocking of inventories and a recovery of production from near Depression levels.
There are several arguments for a weak U-shaped recovery. Employment is still falling sharply in the US and elsewhere – in advanced economies, unemployment will be above 10 per cent by 2010. This is bad news for demand and bank losses, but also for workers’ skills, a key factor behind long-term labour productivity growth.
Second, this is a crisis of solvency, not just liquidity, but true deleveraging has not begun yet because the losses of financial institutions have been socialised and put on government balance sheets. This limits the ability of banks to lend, households to spend and companies to invest.
Third, in countries running current account deficits, consumers need to cut spending and save much more, yet debt-burdened consumers face a wealth shock from falling home prices and stock markets and shrinking incomes and employment.

Fourth, the financial system – despite the policy support – is still severely damaged. Most of the shadow banking system has disappeared, and traditional banks are saddled with trillions of dollars in expected losses on loans and securities while still being seriously undercapitalised.
Fifth, weak profitability – owing to high debts and default risks, low growth and persistent deflationary pressures on corporate margins – will constrain companies’ willingness to produce, hire workers and invest.

Sixth, the releveraging of the public sector through its build-up of large fiscal deficits risks crowding out a recovery in private sector spending. The effects of the policy stimulus, moreover, will fizzle out by early next year, requiring greater private demand to support continued growth.
Seventh, the reduction of global imbalances implies that the current account deficits of profligate economies, such as the US, will narrow the surpluses of countries that over-save (China and other emerging markets, Germany and Japan). But if domestic demand does not grow fast enough in surplus countries, this will lead to a weaker recovery in global growth.

There are also now two reasons why there is a rising risk of a double-dip W-shaped recession. For a start, there are risks associated with exit strategies from the massive monetary and fiscal easing: policymakers are damned if they do and damned if they don’t. If they take large fiscal deficits seriously and raise taxes, cut spending and mop up excess liquidity soon, they would undermine recovery and tip the economy back into stag-deflation (recession and deflation).
But if they maintain large budget deficits, bond market vigilantes will punish policymakers. Then, inflationary expectations will increase, long-term government bond yields would rise and borrowing rates will go up sharply, leading to stagflation.
Another reason to fear a double-dip recession is that oil, energy and food prices are now rising
faster than economic fundamentals warrant, and could be driven higher by excessive liquidity chasing assets and by speculative demand. Last year, oil at $145 a barrel was a tipping point for the global economy, as it created negative terms of trade and a disposable income shock for oil importing economies. The global economy could not withstand another contractionary shock if similar speculation drives oil rapidly towards $100 a barrel.
In summary, the recovery is likely to be anaemic and below trend in advanced economies and there is a big risk of a double-dip recession.

Monday, 24 August 2009

Protecting the dollar's integrity

Warren Buffett recently expressed his views on the US dollar in an op-ed article appearing in The New York Times. While he is supportive of the massive and liberal monetary aid, he is nevertheless concerned what the after-effects will be:

IN nature, every action has consequences, a phenomenon called the butterfly effect. These consequences, moreover, are not necessarily proportional. For example, doubling the carbon dioxide we belch into the atmosphere may far more than double the subsequent problems for society. Realizing this, the world properly worries about greenhouse emissions. The butterfly effect reaches into the financial world as well. Here, the United States is spewing a potentially damaging substance into our economy — greenback emissions.

To be sure, we’ve been doing this for a reason I resoundingly applaud. Last fall, our financial system stood on the brink of a collapse that threatened a depression. The crisis required our government to display wisdom, courage and decisiveness. Fortunately, the Federal Reserve and key economic officials in both the Bush and Obama administrations responded more than ably to the need.
They made mistakes, of course. How could it have been otherwise when supposedly indestructible pillars of our economic structure were tumbling all around them? A meltdown, though, was avoided, with a gusher of federal money playing an essential role in the rescue.

The United States economy is now out of the emergency room and appears to be on a slow path to recovery. But enormous dosages of monetary medicine continue to be administered and, before long, we will need to deal with their side effects. For now, most of those effects are invisible and could indeed remain latent for a long time. Still, their threat may be as ominous as that posed by the financial crisis itself.

This fiscal year, though, the deficit will rise to about 13 percent of G.D.P., more than twice the non-wartime record. In dollars, that equates to a staggering $1.8 trillion. Fiscally, we are in uncharted territory.
Because of this gigantic deficit, our country’s “net debt” (that is, the amount held publicly) is mushrooming. During this fiscal year, it will increase to about 56 percent of G.D.P. from 41 percent. Admittedly, other countries, like Japan and Italy, have far higher ratios and no one can know the precise level of net debt to G.D.P. at which the United States will lose its reputation for financial integrity. But a few more years like this one and we will find out.

An increase in federal debt can be financed in three ways: borrowing from foreigners, borrowing from our own citizens or, through a roundabout process, printing money. Let’s look at the prospects for each individually — and in combination.

The current account deficit will be $400 billion or so this year. Assume, in a relatively benign scenario, that all of this is directed by the recipients — China leads the list — to purchases of United States debt. Then take the second element of the scenario — borrowing from our own citizens. Assume that Americans save $500 billion, far above what they’ve saved recently but perhaps consistent with the changing national mood. Finally, assume that these citizens opt to put all their savings into United States Treasuries (partly through intermediaries like banks).
Even with these heroic assumptions, the Treasury will be obliged to find another $900 billion to finance the remainder of the $1.8 trillion of debt it is issuing. Washington’s printing presses will need to work overtime.

Slowing them down will require extraordinary political will. With government expenditures now running 185 percent of receipts, truly major changes in both taxes and outlays will be required. A revived economy can’t come close to bridging that sort of gap.

Legislators will correctly perceive that either raising taxes or cutting expenditures will threaten their re-election. To avoid this fate, they can opt for high rates of inflation, which never require a recorded vote and cannot be attributed to a specific action that any elected official takes.
In fact, John Maynard Keynes long ago laid out a road map for political survival amid an economic disaster of just this sort: “By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.... The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.”
I want to emphasize that there is nothing evil or destructive in an increase in debt that is proportional to an increase in income or assets. As the resources of individuals, corporations and countries grow, each can handle more debt. The United States remains by far the most prosperous country on earth, and its debt-carrying capacity will grow in the future just as it has in the past.
But it was a wise man who said, “All I want to know is where I’m going to die so I’ll never go there.” We don’t want our country to evolve into the banana-republic economy described by Keynes.
Our immediate problem is to get our country back on its feet and flourishing — “whatever it takes” still makes sense. Once recovery is gained, however, Congress must end the rise in the debt-to-G.D.P. ratio and keep our growth in obligations in line with our growth in resources.
Unchecked carbon emissions will likely cause icebergs to melt. Unchecked greenback emissions will certainly cause the purchasing power of currency to melt. The dollar’s destiny lies with Congress.

Friday, 21 August 2009

Unwinding the global imbalance

Fred Bergstein and Arvind Subramanian of the Peterson Institute for International Economics recently expressed their concerns in an article on how the global imbalances (huge US current account deficits and China's large current account surpluses) will rectify itself over time:
The Obama administration is increasingly signalling that the US will not continue to be the world’s consumer and importer of last resort. Larry Summers recently said: The US must become an export-oriented rather than a consumption-based economy and must rely on real engineering rather than financial wizardry.
The logic of this new US position is not just economic. It is also strategic. Mr Summers has previously remarked on the tension between superpower status and net foreign indebtedness. US influence can be compromised if it is dependent on foreign investors to bail out its financial sector (as in the early part of this crisis) or to finance its fiscal profligacy (as China and other surplus countries have been doing for a long time). The US undoubtedly also recognises that it might not be able to finance large external deficits in the future at an acceptable price so to some extent it is making a virtue of necessity.

This long-run vision for US growth entails greater exports and probably a smaller current account deficit than where it is now (about 3 per cent of gross domestic product). Although Mr Summers did not and could not say so, the vision will require an end to the remaining overvaluation of the dollar.
In the short run, US recovery from the recession requires that the fiscal and monetary stimulus programmes be effective. In turn, that calls for domestic and foreign investors to absorb smoothly and trustingly the voluminous amounts of IOUs being offered by the US government. Hence it is essential to avoid perceptions that the dollar is about to fall, at least by very much, and that the US authorities are pushing it down.
But Mr Summers’ long-run structural targets will come into play once the economy is out of the woods. Redirecting resources away from finance and consumption towards exports and investment will require relative price shifts, for which the dollar has to move down. So a stronger rate for the dollar now and a more sustainable rate once the recovery has taken hold can reconcile the short-run imperative and the medium-term goal.
What are the implications of this vision for America’s trading partners? To the extent it is credible, it is a warning shot to the rest of the world. If the US will not run large and persistent current account deficits, countries such as China, and probably Germany and Japan, will not be able to run large and persistent current account surpluses. They will not be able to rely on export-led growth. They will have to find ways to expand domestic demand on a lasting and substantial basis.
Progress is already being made in reducing global imbalances. The US current account deficit has come down from a peak of more than 6 per cent of GDP to about 3 per cent. China’s current account surplus has declined from 11 per cent of GDP to about 9.8 per cent and is expected to decline much further this year.
Mr Summers has stated that China can no longer behave like China because the US intends to behave much more like China. The world economy cannot have two, or even one-and-a-half, Chinese growth strategies from its two most important economies. Which will prevail?

Tuesday, 18 August 2009

Reflecting on Buffett's advice

Warren Buffett wrote an article - which he seldom does - in the New York Times last year (October 17) advising investors not to turn away from the markets and in fact to share in his optimism going forward. Basically, Buffett's credo is: "Be fearful when others are greedy, and be greedy when others are fearful."

Certainly at that time fear had gripped the markets and investors were fleeing equities into cash. Zacks Investments Research evaluates Buffet's advice against the backdrop what subsequently happened during the past year:

1. The Markets Rebound Long Before the Economy

Buffett believed that equities would far outperform other asset classes, especially cash, over the next 5, 10 or 20 years as the stock market rises in anticipation of an economic recovery, even if we weren't in one yet.
A perfect example is the Dow's behavior during the Great Depression. Buffett wrote that it took several years for the Dow to hit its low of 41 on Jul 8, 1932. But you wouldn't have known that that was "the bottom" based on economic conditions. The economy continued to worsen until March 1933, when Franklin Roosevelt took office.
Meanwhile, from the market lows in July 1932 to March 1933, the Dow rebounded 30%. We've seen a similar rebound in the last 5 months but no one knows how long the rally will last or if it's the start of a new bull market. Still, while your cash is getting virtually no interest in this zero-rate interest environment, equities are paying a dividend yield and have the possibility of more upside. In this kind of environment, cash is not king.
2. Long-Term Outlook For Equities Is Good
The stock markets have been around much longer than any of us. During that time, the world suffered through world wars, influenza outbreaks, terrorist attacks, recessions and one depression but still, businesses created new products and made profit. They will continue to do so in the future.
Consider Apple and the iPhone. Even in the midst of this recession, millions of people bought the iPhone around the world. Investors who understood that Apple was still selling its products at a fast clip were rewarded with a stock that jumped over 90% from the beginning of the year. Apple won't be the last company to cash in on its powerful brand and host of good products. The key for investors is to find other companies that will be next to do the same.
3. Prepare for Inflation
Buffett wrote that greater inflation was a possibility as the government printing presses work overtime to alleviate the recession and liquidity enters the economic system. Cash is where you will NOT want to be. The value of your cash will actually decline under those conditions.
There are now exchange-traded funds (ETFs) and other instruments available to investors to prepare for inflation including owning TIPs, Treasury-Inflation Protected Securities, and the precious metals through the gold or silver ETFs or precious metal mining stocks.
4. Finding Great Stocks
The great thing about being an investor is that there are always hidden gems to be uncovered in any kind of market. Despite the massive rally we've seen on the markets in the past few months, you can still hunt for undervalued stocks that will see a big upside when investors figure out that the fundamentals are great and the stock is cheap.
5. It's Not Too Late to Invest
By March, it seemed that Buffett's advice to buy equities was very, very wrong. But that was his point. You can't time it. He said he had no idea what stocks would do in the short term. But it's not too late.

Wednesday, 5 August 2009

One bleak European economic outlook

RGE Monitor recently published their European outlook:

RGE Monitor expects the cyclical recovery in the eurozone - led by Germany and France- to lag recovery in the U.S., the BRICs and non-Central and Eastern Europe (CEE) emerging markets.
Among the main factors muting Europe’s recovery in 2010 are a permanent decline in potential output; unwinding pressures of large internal imbalances leading to deflationary pressures; a more restricted monetary and fiscal policy response compared to the U.S. and especially to China; a leveraged financial sector with too-big-to-fail institutions and too-big-to-save features; and a strong reliance on bank funding by the corporate sector subject to a larger financing gap than that seen in the U.S.
Lending to the private sector is slowing quickly, and for small and medium sized enterprises with no access to capital markets, bank credit lines represent the only recourse for liquidity. Based on IMF and ECB estimates, total bank losses will amount to between $650 billion and $900 billion, implying substantial additional recapitalization costs.
Germany’s specialization in cyclical industrial goods, and its export-led growth model, have been particularly damaging to growth. Going forward, RGE cautions that given the likely reticence of the U.S. consumer in the medium term future, an exclusive reliance on export-led growth is not advisable. France’s more balanced domestic demand-led growth model has served it relatively better. Italy is grappling with a structural and long-term decline in its relative living standard-a situation that requires a radical overhaul of structural impediments in product and labor markets. Spain’s challenge lies in an expected 20% unemployment rate and deflationary pressures to restore relative price competitiveness. Ireland is among the developed countries hit hardest by the crisis and its large banking sector (relative to GDP) represents a contingent liability despite the country’s commendable bad bank scheme.
The UK's mainstay is its financial sector, which has accordingly received substantial government support. The lending environment is equally important for the housing market, which is fundamental to the British economy.
Among emerging market regions, CEE economies are experiencing the steepest roller-coaster ride in terms of growth. After exceeding global growth averages for the last decade, regional growth is plummeting in 2009 and is expected to underperform both emerging Asia and Latin America. A dangerous combination of falling exports and slowing capital inflows is behind the bleak growth picture. The hardest-hit economies have tended to be very open, with wide current account deficits in recent years and high levels of foreign currency borrowing.
After strong growth earlier this decade, all five Nordic economies are now in the midst of recessions. These are small, open economies that have been hit hard by slumping external demand for their exports. Given their strong public finances, Nordic economies, with the exception of Iceland, have resources available to cushion their contractions. Ultimately, however, economic recovery in the region hinges on a global recovery.

A medium-term interest rate outlook for South Africa: What we know and don't know

Cees Bruggemans, chief economist for FNB - one of the major banking groups in South Africa - recently sketched some of his beliefs where interest rates will go in the next couple of years:

There has been some speculation regarding the likely shape of the next cyclical interest rate upswing. First sideways through 2010, thereafter rising gradually through 2013 before peaking.

Such forecasts have tended to expect a long sojourn at low levels through 2010, followed by a slow ascent and a non-violent peaking.

Though a gentle view, this kind of playout is rarely the reality. Either external shocks force up our inflation, potentially quickly and suddenly, through rising import prices and/or Rand plunging, or domestic overheating or other shortcomings push through the surface, reversing the downward inflation drift.

Either way reality comes calling, forcing the SARB into response mode, raising interest rates in killjoy fashion, fully determined to contain inflation expectations and the reimbursement syndrome, especially among labour.

The global condition is set on recovery, perhaps slow in the West, but probably fast in the East. That suggests at some point the return of commodity bottlenecks and renewed commodity price surging.

Domestically, strained budgets and needed infrastructure point towards greater use of increased pricing to generate extra cash flow, besides greater recourse to capital markets. Politically-controlled, non-tradable sectors hint at outsized price pressures for some years.

These are two badly skewed inflation boosters.

Happily (for non-exporters), the recovering world has excess capital and a restored risk appetite, with emerging markets first choice of destination. Also, we have good quality assets and corporates, and our macro policies are receiving rave reviews, encouraging risk upgrades to A-ratings.

This attracts foreign capital. You can see it in our overfunded current account and firming Rand, nowadays on a good day once again contemplating 7.50:$, a mere nine months after seeing a cyclical low near 12:$.

A firming Rand is an important suppressant of inflation and could be a feature through 2010-2014. It is difficult to tell how much of a Rand undershoot we could get this time, with current account deeper in structural overshoot. Still, don't write off a firm Rand as inflation suppressant just yet.

Labour tends to be backward-looking (when inflation was high, though falling rapidly this year and next), but politically it also tends to be forward-looking (payoffs just where you look).

Though the backward-looking inclination tends to get moderated by falling inflation and job losses as employers square high wage demands with labour layoffs, intense political demands create additional cost-push syndrome.

Nothing new in any of this, but possibly more intense in this particular cycle.

So will labour costs, and especially unit costs after job losses and productivity gains have been taken into account, really be such an inflation threat? Probably not, despite all the upfront noise.

Professional skill scarcity is probably getting a one-off shot in the arm from the global recession and slow Western recovery. Global skills have been coming home in droves, from London, Dubai and elsewhere, or are simply no longer leaving in such a hurry, as per FNB Homeloan Barometer readings.

This may only be a temporary respite, as the medical profession is suggesting daily. Any global recovery and no noticeable change in local conditions could see the emigration of scarce skills start up again.

But for now this salary premium source is probably dormant, but a factor to bear in mind again after 2012.

With CPI inflation this week likely falling to 7%, with 5% still the main expectation for next year, a Taylor-based inflation would currently look for a 13% prime rate.

Bearing in mind that banks have tightened their credit criteria, and increased their average interest rates to new borrowers, some of this probably structurally enduring, new borrowers are experiencing a higher interest rate reality than what the current prime 11% may suggest, indeed closer to 13%.

This alone suggests the present 11% interest rate regime to be strongly disciplinary BEFORE we consider incorporating a real sector output gap into the Taylor estimate.

But then we unexpectedly run into trouble, something our labour unions won't like, as it limits the downside to interest rates.

Overseas output gap estimates have run into a lot of flak lately. Traditional estimating, mostly allowing for a rise in unemployment and idled physical plant, suggest US actual output to be 6% below potential GDP. Something similar applies to Europe.

Such resource slack suggests a long period of intense resource competition, capping cost pressures, yielding low inflation.

But alternative output gap estimates suggest the slack resources won't easily compete with actively employed resources, while idle physical plant tends to be slowly written off. Both reduce potential output, to such a degree that the output gap may only be -1% of GDP.

The South African condition poses similar dilemmas. Taking into account idled skilled labour and plant, our output gap today may be -4% to -6% of GDP. But it could be much less, if overseas reasoning is to be believed.

A Taylor estimate incorporating the traditional view of the output gap may suggest a prime of 10%, against an experienced reality today of 13% as previously estimated.

If, however, the effective output gap is smaller, a prime of 11%-12% looks about right, compared to an experienced effective reality today of about 13%.

So what now? Is our existing prime rate at 11% too high, the National Credit Act too tough and/or banks' credit policies too tight?

Either banks ease their credit policies modestly as the economy turns, in which case currently prevailing prime seems to be appropriate, also bearing in mind risk insurance against the inflation forecast being wrong.

Or the SARB should still lower interest rates, policy being still far too tight, given the lower inflation outlook, the large output gap and the sharpened bank credit policies, and not everyone agreeing about such high forecast risk assurance.

On balance, the SARB is not expected to give way.

But then how do we move forward?

CPI inflation will probably ease towards 5% next year, but may move higher again during 2011-12, say towards 6%.

The recovering economy should start reabsorbing skilled labour from next year, gradually reducing the output gap, which may in any case not be as big as traditionally suggested.

Banks may cyclically lighten their credit policies, but not necessarily to any large degree, at most halving the premium increase new borrowers have experienced of late.

And the risk of higher inflation due to global changes could be that much nearer, increasing any risk premium.

If you add all that together, you get a Taylor estimate for prime in the 12% range, with the banks' credit tightness good for at least 1%, suggesting an actual prime of 11%.

That takes care of 2009-2010. No change to prime 11%. Until things start heating up in the external and/or internal environment.

If during 2011 the CPI inflation were to be 6%, possibly rising to 7% in 2012, with a modest positive output gap and risk of inflation accelerating, what would that do to the Taylor advice?

A 14% estimate would come into view, with the banks' credit tightness good for 1%, yielding a prime of 13%.

Does that mean we face risk during 2011-2012 of prime slowly being raised towards 13% from 11% today? On these assumptions, yes, but that is the $64 000 question.

How will external and internal forces change the inflation outlook, including the condition of the economy, the risk (either way) of the inflation forecast being wrong and the credit policy tightness of banks?

That we don't know at this juncture. It could be far worse, suddenly, than surmised here, as happened during 2008. Or it may remain benign. The set of circumstances will presumably be unique, whatever decides to turn up.

That is why the Monetary Policy Committee meets frequently and is likely to keep doing so under new leadership, given the very challenging nature of what we and the world will be facing and to which the SARB will need to respond, given the task given to it by the government.