Business Cycle, Debt Cycle... And Now Printing Cycle
Submitted by Nic Lenoir of ICAP
Today's PMI data was very strong. There are experts in econometrics much more knowledgeable than I will ever be calling for further strength in production numbers that will lead to a turn in unemployment into Q1 2010. I don't dispute their models or the indicators they look at. However I can't come to terms with it. I think this is in great part because the business cycle which is supposed to lead us out of this recession is at odds with a much longer and bigger cycle: the debt cycle. I know this flies in the face of 50 years of econometrics that has made people a lot of money trading, but this is mainly due to the fact that the debt cycle is so long and stretched over time that we don't really have data to measure its impact on previous cycles. It coincides in a sense with the Kondratieff cycle, but transposed into today's financial markets, the burst of the debt bubble is a lot more pronounced. Basically modern technology and financial engineering has made it very easy to securitize credit and source funding or financing globally, so that the extent of the debt bubble has been allowed to grow far beyond what could have happened 50 years ago. There is also obviously the global aspect of it. Because financial markets are more and more global, so is the crisis.
Albert Edwards had a great piece the other day discussing the renewed importance in a post-bubble environment of the business cycle. This line of thought has also been outlined by the Global Macro Investor in the past. It relies a lot on the example given by Japan, or the 70s. One could argue that unlike the case of Japan which benefitted of the strong economy of the 90s to have a more robust business cycle due to exports, our current global economy will lack an engine to drive the cycle. The risk is that the consumer has retrenched enough in the US and in Europe that the business cycles becomes a restocking of shelves carrying products there is not necessarily much demand for. I will not even entertain the argument regarding China and the rest of Asia becoming the leading engine of growth for the rest of the world. China has about 40% over-capacity. While there is no doubt that most of the growth in this "new world" will come from emerging markets, and especially Asia, production capacity is already far above demand so growth there can be digested without employment. That's especially bad since we have to turn around tax receipts and deficits, and many assets that have been re-inflated via excessive liquidity need a strong underlying economy to justify current valuations.
That leaves only two choices for governments: let the debt cycle take its course. Bankruptcies will rise further, real estate will devalue another 30%, equities will lose 65%, and we will start with a clean sheet. That will wipe out the baby-boomers who are the main asset holders. Note by the way that the correlation between the number of 45/55 year-olds in our society and equities is historically positive. The other solution is to print as much as needed to prevent that from happening. It will be very difficult because leverage will only find people with sound balance sheets who will pour the resources into assets, driving asset inflation at the expense of sound economic recovery. Also despite what politicians may think asset inflation is a lot worse for the lower and middle class than is the debt cycle, or maybe they are just cynical. In the end, there is little chance that governments will be able to coordinate their actions like they did last fall, because fear then was a lot greater than now, when consequences of today's actions can in fact be more dramatic than they were then... In the end I think we will experience cycles of injection and draining of liquidity trying to dance between the two evils.
That bring us to today's markets. Part of what has driven the sell-off recently is the fear of a pull-back in liquidity. China is trying to move away from excessive lending which has been out of control in the first half of the year, Brazil is talking about taxing foreign investments, Europe is oscillating between hawkish rhetoric and the fear of a strong Euro, and we have the FOMC next week, though I think it's a non-issue for now. We are obviously in a phase were authorities try to give the impression that liquidity will be controlled or pulled. More important than liquidity, it's the sentiment of infinite liquidity they are trying to squander. After testing the resistance on the Dax yesterday we had the follow through sell-off expected. The AUDUSD is very similar which is why I have added the chart today. S&P is back close to the bottom of the short-term bearish channel is breaking the key 1,032 support. After such a powerful move, I think we finally bottom between 1,025 and 1,012 in the S&P future for the short-term, before consolidating between 1,025 and 1,065. During that consolidation one would observe subdued strength on the upside compared to the recent sell-offs, and momentum indicators retracing around 60 for RSIs, before we accelerate and go test the main intermediate support highlighted on the daily chart around 942.
Good luck trading,