Albert Edwards On The Upcoming Economic "Abyss"
As always, Albert Edwards provides a solid dose of economic observations based on facts, not hope. And, as always, he is one of the few in his attempts at deductive logic: why bother with causal relationships when there is a scent of "change you can (almost) believe in" permeating the airwaves. Never mind that the next administration will have to deal with the massive fallout of this "change" once it realizes America is bankrupt: we hope they have their catchy slogan writers already on damage control. After all "debt repudiation you can really believe in" just lacks that certain pizzazz that may prevent the next president from being on TV 24/7.
Back to Albert, who shares his thoughts on the liquidity driven asset bubble:
Many clients believe it is inevitable that "excess" liquidity will continue to drive risk assets higher. The broken nature of the banking intermediation means that surplus reserves are not being funnelled into the real economy and therefore must, it is believed, inevitably cascade foaming and invigorating over risk assets. And all the while interest rates remain close to zero this process is expected by many to continue apace, driving risk assets higher.
This is wrong. It is the cyclical upturn that is sucking money into risk assets. This is exactly what happened in Japan in the 1990's. Japan enjoyed many decent economic and profit recoveries which regularly pushed equities and other risk assets substantially higher. But the underlying fragility of any cyclical recovery amid a secular balance sheet recession meant there were frequent lapses back into recession. This eventually drained hope away from zombie investors who then became sellers-on-rallies, rather than buyers-on-dips.
Additionally, Edwards presents the case for balance sheet-based deflation. In essence, even as the government tries to inflate its way out of all its problems, it is, even by printing trillion in new treasuries, unable to catch up with the non-governmental balance sheet collapse.
The US Federal Reserve recently published their comprehensive flow of funds data for the US. This showed that the household sector continued to pay down debt for the fourth consecutive quarter. Corporates also started to pay down debt sharply in Q2 at a similar $200bn pace. The non-financial private sector paid down debt at a $435bn pace in Q2. This compares to a $2,116bn pace of expansion in 2007 (see chart below). Add to that the financial sector unwind and the total private sector is unwinding debt faster than the government is able to pile it up (hence the red line is still negative)! The lesson from the balance sheet recession in Japan is that the massive private sector headwind to growth has a long, long way to run.
If that is the case, we can expect, just like Japan, frequent relapses back into recession. The market now understands how an end of inventory de-stocking can boost GDP, i.e. it is the change in the change that matters. Similarly as Dylan Grice points out - link, it is the change in the fiscal deficit that is a net stimulus or drag to GDP. A massive 6pp stimulus last year is likely to turn into a 2pp drag on growth next year (see chart below). With continued private sector de-leveraging likely next year and beyond, how can one seriously not expect the global economy to relapse back into recession next year taking nominal GDP deep into an abyss?
Most notably, Edwards discusses the red herrings of systematically focusing on the wrong economic indicators, whose recurring spin by the media exaggerates the scope of any nascent recovery:
Amid the excitement of this cyclical recovery, equity investors continue to focus on entirely the wrong thing. It is cash revenue growth that is relevant for profits, not volumes. Hence when we see that Japanese core CPI inflation suffered a record 2.4% decline in August, it emphasizes that we should forget volumes and look at values. Volumes are a red herring that are misleading investors into a frenzy of excess optimism. One of the reddest of red herrings was the recent Australian GDP data. Real GDP rose a surprisingly robust 0.6% QoQ in Q2 after a rise of 0.4% in Q1 and a single quarter decline of 0.7% in Q4 2008. Unsurprisingly equity investors liked this data. Yet less attention was paid to the fact that nominal GDP declined 1.5% in Q2 after a decline of 0.6% in Q1 and a decline of 0.1% in Q4 2008 (see chart below)!
In cash terms, Australian GDP is getting worse sequentially, not getting better. One last comparison worth considering: in Q3 2008 Australian nominal GDP peaked out at a 11% yoy rate and on the most recent data that had slowed to 0.9% yoy - a heady slide indeed (by way of comparison real GDP slowed from 2.4% yoy in Q3 2008 to 0.6% in Q2 this year). Investors should not be reassured by the minor 1.8 percentage point (pp) slowdown in yoy volume growth over this period. Instead, they should panic at the 10pp loss in cash GDP growth.
At this point it is passe to discuss green shoots. An early term coined to fantasize about a quick V-shaped recovery, has since been eradicated due to the ongoing concurrent data presentations that highlight on one hand an employment picture that keeps getting worse (over and above expectations, see today's number) and on the other hand stimulus funding trickling down into the economy. In a sense, Obama has bet the house, farm, and generations of unmanageable interest payments, that the second will overtake the first eventually, and that consumers will look beyond the fact that tomorrow they may be out of a job and get back to using their credit cards as the only real driver of the U.S. economy.
Yet all factual signs point to a continued divergence between cash in (government) and cash out (everyone else) in the US, and by implication, global economy. Layer on top the fact that global trade has been decimated and that currency imbalances will make it prohibitive for natural flows to resume (US core importer, everyone else exporters), courtesy of a worthless dollar, and if you were to remove your rose-colored glasses for a second, you will see why even in the face of a 55% rally in the stock market, strategists and economists (not David Bianco mind you, we mean objective, unconflicted ones) continue their bearish stance on the economy. Because unless you truly believe that the stock market is its own isolated bubble, which many do, at some point cash from assets will have to support equity and debt valuations. And once the government cash funding vacuum pops, the market-economy divergence will also collapse. At that point, every dollar used by the government via stimulus and Federal Reserve pumps will have an equal and opposite effect on stocks, thereby throwing America not just into a debt funding crisis, but a complete economic and capital market tailspin. Alas, it appears impossible to prevent this, as the administration and the Federal Reserve Chairman are dead set on executing their inherently flawed experiment...and the American middle class.