Medical Bulletin on Mr. Market and Mr. Economy
By Satyajit Das
The condition of the conjoined twins Mr. Market and Mr. Economy remains uncertain.
Mr. Economy has spent much of the last 7 years in an induced coma, with only a modest recovery from the Great Recession. The root causes of the life threatening 2008/ 2009 episode remain unaddressed. Debt levels are higher now. Global imbalances remain. The financialisation virus has proved resistant to available medicines. Structural changes have proved difficult.
Growth, a vital sign, remains below trend. The IMF has slashed global growth forecasts four times in the last year. A medical board inquiry to investigate their fitness to forecast has commenced.Trade growth, another key indicator, is weak. In recent history, trade growth has averaged double economic growth rates. But now trade growth is now below economic growth rates, suggesting further falls in activity. It may also signal a slowdown in cross border financing of trade and a shift towards autarky or closed economies as the benefits of globalisation diminish.
Businesses are experiencing activity levels lower than official forecasts, suggesting that the later reflects an optimistic bias designed to maintain confidence. Ultimately, Mr. Economy’s condition will depend on fact rather than forecasts. As Aldous Huxley observed: “facts do not cease to exist because they are ignored”.
Disinflation or deflation remains a concern. Normally, stable or falling prices would not be problematic. However, Mr. Economy’s high debt levels would become unmanageable under such conditions.
Efforts to boost inflation have failed. With oil prices around $40 per barrel, sharply lower commodity prices and over-capacity in many industries, the chances of improvement are low. Low or negative interest rates, in part engineered to manage Mr. Economy’s elevated debt levels, signal that higher inflation is unlikely.
Consulting physicians are disappointed that lower oil prices did not provide the expected increase in activity. The damage to exporters like OPEC members, Russia and Brazil appears to have been greater than the benefit to oil importers.
Over-production, an unprecedented amount of stored crude, some afloat on tankers, looking for buyers and a fight to the death for market share led by Saudi Arabia suggest prices will remain under pressure. Even the occasional threat of disruption to supplies due to conflict and increasing military consumption as Western powers intervene in the Middle East seem unlikely to reverse the situation.
Mr. Economy’s various parts are performing unevenly.
US growth, at around 2%, remains below par. Producing things which end up in inventory does not seem viable in the long run. America’s improvement was driven by a lower dollar, growth in emerging markets and a revitalised energy sector, which is now reversing.
The extent of long term damage to the energy industry from lower prices remains unclear. Profits and cash flows have fallen especially for shale oil and gas firms. Frantic restructuring, cost cutting (read over 250,000 jobs lost globally) and suspending investment have bought time. But if prices remain low, more problems are expected.
The misery index (inflation rate plus unemployment rate) remains at its lowest level since the 1950s. But faith in statistics is flagging.
Everything you buy increases in price but everything you don’t buy is falling in price. Employment gains are overstated by falls in the participation rate and part time jobs. Employment as a percentage of population has not recovered. The bulk of new jobs are poorly paid, lack job security and progression. Hours worked and wage growth is weak. As a consequence, consumption and investment remain fragile.
The expectation was that in 2015 America would be able to be taken off its low interest rate medication. This remains the plan. But higher rates may curtail progress. Investment, already slow, may fall. A stronger dollar, already up over 20% will affect corporate profits and export competitiveness. It may trigger financial market instability.
The condition of Europe and Japan are more desperate. Europe’s tentative recovery was driven by negative short term rates, massive QE, a weaker Euro (driven in part by these policies) and low oil prices. But the continent has a deteriorating outlook with economists hunting for second decimal points of improvement with microscopes.
German exports to emerging markets are slowing. The Volkswagen emissions scandal has brought into question much vaunted European technical prowess. European debt problems remain unresolved. In the aftermath of the attacks in Paris, the French government have announced that they will not abide by deficit and debt limits. Italy refuses to bring public finances under control, despite a worsening debt-to-GDP ratio.
Greece is likely to be in spotlight, with a relapse probable. The government will find it difficult to meet bailout conditions raising the issue of default, Grexit or both amidst growing reluctance for further support. Portugal’s new government, an uneasy coalition between foes, has sworn allegiance to the EU and the Euro but is seeking major concessions. With the highest total debt-to-GDP in the EU, a Portuguese debt restructuring, explicit or de facto, is not unimaginable.
Despite positive talk, Spain’s public finances remain poor and unemployment unsustainably high. The recovery remains uneven with excessive reliance on domestic consumption and exports, primarily automobiles, to other European countries. With no clear winner emerging in the 2015 election, Spain remains vulnerable to political instability.
Europe’s refugee crisis may boost economic activity but is expensive, at around
€10,000 per refugee per year initially, pressuring weak finances. It has also highlighted deep divisions within the EU and a rancorous decision making process. Serious opposition to immigration and free movement of people required by the Schengen treaty has emerged.
Questions about the EU and Euro continue. Once the poster child of European integration, Finland is in recession, unable to respond by adjusting its currency or interest rates. The Finnish parliament is to hold ‘Fixit’ hearings next year, debating an exit from monetary union and a return to the Markka. Britain will vote in a referendum about their participation in the EU.
Japan has entered its fifth technical recession in 7 years, casting doubts on the ability of Abe-nomics to arrest its two decades of economic stagnation.
No one believes that China is growing at around 6-7% pa. Official growth does not reconcile to underlying individual statistics such as trade, investment, consumption or real production. It is incompatible with policy actions, which include 6 interest rate cuts since November 2014 to record lows, steps to increase bank lending and devaluation of the Yuan.
A massive credit expansion, mal-investment, overcapacity in many industries and property and stock market bubbles are proving increasingly difficult to contain. Chinese economic managers are also finding it difficult to shift towards domestic consumption as a new source of growth. The only debate is whether the adjustment will be a soft or a hard landing.
With it contributing around 1/3 to half of global growth, a deceleration in China will set off negative feedback loops in the global economy. Other countries are reliant on China as source of demand, with around 40 countries having her as their largest export destination.
Like China once a bright beacon of hope for Mr. Economy, emerging markets face several headwinds. Sub-par growth in developed markets and China combined with low commodity prices are key sources of weakness. Deep seated structural problems, including inadequate infrastructure, lack of institutions, corruption and environmental degradation, are now impinging on activity.
Mr. Economy also faces one of the three strongest El Niños since 1950 which will create severe weather conditions which will reduce economic activity.
Mr. Market has regained his irrational exuberance. He has bounced back from the depressive episode of August 2015, though more on short covering than fundamentals.
Mr. Market’s continued health requires improvement in Mr. Economy’s condition, as the twins share vital organs. But Mr. Market insists that he doesn’t need growth or inflation to prosper. He told his psychiatrist that financial instruments are not merely claims on real assets and cash flows but represent a separate reality.
Mr. Market’s elevated valuation levels are of concern.
The S&P500 trades at 17-18 times earnings, inconsistent with stagnant revenues and slowing earning momentum. Small capitalisation stocks trade at higher valuation; the Russel 2000 is at PE multiples of 20-22 times. Weak commodity prices weigh heavily on resource companies. Share buybacks, capital returns, unsustainable dividend payouts and debt financed mega-mergers cannot continue to hold up values forever.
Unicorns (start-ups with valuations greater than US$1 billion) in technology and bio-technology sectors reflect the desperate search for growth and dangerous optimism about prospects. Valuations, such as Uber’s private market valuation of US$50+ billion, are not supported by economics but rely on promotion by shrewd principals, venture capitalists and investment bankers.
With negative yields, investing in government bonds requires ever larger negative rates to provide capital gains. Investors who chased higher returns in corporate and emerging market debt face problems. Credit spreads have increased especially in high yield bonds. They still do not provide adequate compensation for potential future rises in default rates. Feted earlier as astute investors, holders of debt of frontier countries, like Ukraine, Zambia, Rwanda and Sri Lanka, now face losses on their investment as booms turn to bust in a familiar cycle.
Real estate prices have risen sharply, driven in some by the sharps falls in the last crisis. Disillusion with other asset classes, cultural biases which favour property and the inexorable flow of capital fleeing unrest or risk has boosted values, especially in desirable world cities.
Mr. Market’s dysfunction is evident in analyst David Rosenberg’s sardonic observation that today investors purchase bonds for capital gains and shares for income.
Mr. Economy’s stresses are increasingly being seen in volatile currency values. Countries use a mixture of low interest rates, QE and direct intervention to manage the exchange rate. It is designed to reduce the value of outstanding debt held by foreigners. It also increases competitiveness and a nation’s share of global exports and growth. Mr. Market’s ability to withstand the fluctuations and pressures of such currency wars is questionable.
A stronger dollar will pressure US corporate earnings and competitiveness, in turn affecting equity values and economic activity. A higher US dollar, higher interest rates and tightening global liquidity conditions represent a major challenge for emerging markets. Capital outflows have weakened emerging market currencies. It has reduced the availability of and increased the cost of finance. Weak export revenues, falling currency reserves and unhedged US dollar currency combined with around US$9 trillion of debt will squeeze these economies and drive instability.
Confident in their ability to juggle grenades with their pins pulled out, analysts are trying to pick bottoms in weak emerging markets. They ignore the fact that the recent rise in the US dollar may be part of a longer term trend, which parallels a similar trajectory in the late 1990s which triggered the Asian monetary crisis, Russia’s default, and a plunge in crude oil plunge to $10.
Much of the improvement in the condition of Mr. Economy and Mr. Market, especially the later, is due to the administration of ample amounts of vital liquids. The treatment addressed symptoms rather than the underlying disease.
While doctors have not lost hope, they fear that the therapies have reached a point of diminishing returns. More of the same -QE, negative interest rates, additional fiscal stimulus- are increasingly difficult. There are technical challenges as central banks reach operational limits, without a significant change in their rules of engagement, such as the types of assets they are able to buy, and increasing the level of intervention in the functioning of markets. Quantitative easing has morphed into quantitative exhaustion.
The ability to withdraw support already resembles the game of Jenga. Policy makers fight gravity as they seek to withdraw each block one by one without causing the entire structure to crash. If further actions are undertaken and do not succeed, then the ability to normalise becomes even more difficult, with unknown consequences
Austrian economist Ludwig von Mises may have been right when he concluded that: “There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”
As a precaution, we are trying to establish whether Mr. Economy and Mr. Market’s medical cover is fully paid up, and whether he will be able to continue to pay us for the current lavish level of support indefinitely in something more valuable than money.
© 2016 Satyajit Das
Satyajit Das is a former banker. His latest book is Age of Stagnation (published as A Banquet of Consequences in UK, Europe, Australia and NZ). His previous books include: Extreme Money and Traders, Guns and Money.
Satyajit Das is an Exclusive Speaker with Saxton. His profile can be viewed here.
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