Not as Bad as You Think?

Submitted by Leo Kolivakis, publisher of Pension Pulse.

Alia McMullen of the Financial Post reports that the Fed urged to lift rates -- sooner rather than later:

A
year has passed since the tumult surrounding the collapse of Lehman
Brothers pushed the already sinking global economy into its worst
recession in the post-war period. Much has changed in that year, so
much so that the once doomed U.S. economy -- the epicentre of the
global downfall -- has turned full circle and is now widely projected
to be out of recession. Some even say the country is on the verge of
rapid economic growth.

A few
brave economists believe fiscal and monetary stimulus, as well as
improved productivity, will help the United States bounce back stronger
than anticipated, helping it to leap hurdles such as high unemployment,
a soaring budget deficit and a beleaguered consumer.

One
person not surprised by the recovery taking place south of the border
is Brian Wesbury, chief economist at Illinois-based First Trust
Portfolios L.P. and author of the book It's Not as Bad as You Think.

"We
have said from the beginning that the recession would end quickly and a
V-shaped recovery would follow," he says, describing a situation
characterized by a steep economic decline followed by a rapid recovery.

Past
examples show economies generally power up with annual growth of about
4% in post-recession environments. The bulk of economic forecasters do
not expect the United States to sustain such a rapid growth rate this
time around because of weak consumer spending. However, there is a
school of thought that says it can, and will be done.

Mr.
Wesbury says this recession was different from past recessions because
it was caused by a dramatic slowdown in the speed money circulating
through the economy rather than high interest rates. With the flow of
money improving as a result of government and central bank action, he
says the U.S. economy would likely grow at a 4% annual rate in the
second half of this year, a prediction stronger than most other
forecasts.

Based on this outlook, Mr. Wesbury says inflation
would likely rise 2% in the second half, a sharp turnaround from the
annual drop of 1.5% drop in August. Headline inflation has been kept
low because of last year's rapid drop in oil prices from the record
high of US$147 in July. These price declines would soon work their way
out of the yearly calculations. However, the surge in consumer prices
should not be a problem for the economy provided the central bank acts
soon to unwind quantitative easing and raise interest rates. Mr.
Wesbury says the record low federal funds rate band of 0%-0.25% is too
low and could cause problems in the future.

"The sooner the Fed lifts rates, the less inflation and more economic stability the U.S. will have down the road," he says.

Mr.
Wesbury is not alone in his call for interest rate increases sooner
rather than later. Alan Greenspan, the former chairman of the Federal
Reserve between 1987 and 2006, says the Fed would need to roll back its
monetary stimulus to keep inflation down amid a "fairly robust"
recovery led by productivity and the need to rebuild depleted
inventories. He says if the Fed fails to withdraw stimulus promptly, it
risks fueling double-digit inflation by 2012.

Mr.
Greenspan's advice comes after heavy criticism for keeping interest
rates too low for too long during his chairmanship. Many believe his
decision to cut the benchmark rate to what was then a record low of 1%
in June 2002, and hold it there for a year, was a primary cause of the
house price bubble.

For now, U.S. government efforts to
rescue the economy from the bursting of that bubble, which put it
US$1.4-trillion into the red for the first 11 months of fiscal 2009,
appear to be working. Declines in gross domestic product, employment,
house prices, retail sales and manufacturing, have become steadily
smaller in recent months, beating market expectations.

"Intervention
so far has made things better because it has prevented panic and an
overly dark long-term outlook in consumers and business," says Daniel
Schwanen, deputy executive director, Centre for International
Governance Innovation.

John Irons and Ethan Pollack,
economists at the Washington-based think tank Economic Policy
Institute, say US$62.5-billion in tax relief, as well as unemployment
insurance, food stamps and social security, has helped stop the
economic slide since the American Recovery and Reinvestment Act was
approved in February. However, with just 14% of the US$787-billion
package spent, the lion's share of the spending on infrastructure,
education and research and development, would hit the economy in late
2009 and into 2010. This spending should not only propel economic
growth, but also encourage improved productivity and innovation,
resulting in higher profits.

But economists are divided
about the long-term consequence of high deficits as a result of the
spending. Many say the blowout in public debt will be a thorn in
America's side for years to come, resulting in tax increases and
crimped spending. The more optimistic do not expect debt to be a major
problem for the megalith economy.

In a positive sign, Mr.
Geithner, the Treasury Secretary, said last week that budget deficit
projections had been revised down because of the improving economic
outlook. Furthermore, more than 30 financial firms had repaid
$70-billion in Treasury investments, with taxpayers earning a
double-digit return on these equity investments.

The repayments reduce
the government's investment in the banks to US$180-billion. Mr.

Geithner said a further US$50-billion would likely be repaid in the
next 12-18 months.

Mr. Schwanen says it is possible for
productivity to also help the U.S. emerge from its high-debt position.
He says such a scenario played out in the aftermath of the Second World
War.

Federal debt is predicted to reach 56.6% of GDP in
2009, compared with a record high of 112.7% at the end of the Second
World War in 1945, Congressional Budget Office figures show.
Debt-to-GDP is expected to widen to 61.1% in 2010. In comparison,
Canada's federal debt is projected to increase from 29% of GDP in
2008–200909 -- the lowest debt ratio in 27 years -- to a peak of 35.5%
in 2010 to 2011, the Finance Department recently reported.

Mr.
Schwanen says the restructuring of the economy as a result of the
recession will cause some positive changes. He says capital will be
used more efficiently, government spending in research and development
will drive innovation and productivity and U.S. consumers will likely
take more care not to spend excessively. This last point will play a
vital role in rebalancing the global trade flows and reducing the U.S.
trade deficit with China.

The Chinese government has begun
to encourage its population, notorious for over-saving, to consume,
while in the United States job losses and a high rate of loan defaults
have taught over-spending consumers to save.

"Growth will be better distributed in effect between China, India, the U.S. and other places," Mr. Schwanen says.

There are increasing signs that growth will surprise to the upside. Bloomberg reports that M&A Boom Signaled for S&P 500 Index on Record Cash:

Never
before have U.S. companies piled up cash faster compared with interest
costs than they are now, setting the stage for a surge in mergers and
acquisitions.

As the economy emerges from the worst recession
in 70 years, cash flow may rise from the $1.5 trillion reported by the
Commerce Department for the year ended in June, according to data
compiled by Credit Suisse Group AG and Bloomberg. The amount reached a
record in the past 12 months amid the biggest wave of firings since
World War II and central bank interest rates near zero percent.

Cash
relative to share prices will climb to the highest in at least two
decades next year compared with yields on corporate bonds, the data
show. The previous high in 2005 preceded the two busiest years ever for
takeovers.

“You’ll see a steady return to growth in the
M&A market,” said Michael Boublik, the chairman of mergers and
acquisitions for the Americas at New York-based Morgan Stanley.
“Investors are wanting and demanding that companies start thinking
about M&A to fuel growth, so therefore deals are being well
accepted.”

Takeover bids by companies from Walt Disney
Co. to Kraft Foods Inc. signal increasing confidence among executives
that may extend the 57 percent rally in the Standard & Poor’s 500
Index from a 12-year low on March 9. A record amount of mergers helped
send the benchmark gauge to its October 2007 high.

Reuters reports that this week is slated to be the biggest for IPOs since 2007:

This
week is slated to be the biggest for initial public offerings in the
United States in nearly two years -- and some say the resurgence could
be sustainable.

There are
eight deals on deck and they are expected to raise $3.5 billion, which
would increase 2009's total so far by 66 percent. In an additional sign
of strength, they run the gamut from real estate investment trusts
created to buy toxic assets to a clean tech company that has never made
a profit.

That broadening
of industries shows how much the IPO market has healed since a
six-month virtual drought ended in February, with the recovery in the
IPO market that started in China and Brazil making its way to the
United States.

"It's too
early to say 'everything's fine, everyone come back into the pool,' but
we are seeing signs that more and more types of investors are coming
back to the market and there is robust interest in IPOs," said Mary Ann
Deignan, head of equity capital markets for the Americas at UBS
Investment Bank.

The number
of deals could make it the busiest since the week of December 9, 2007,
when 11 IPOs came to market. So far this year, there have been only 22
IPOs.

LESS RISK AVERSE?

Among the IPOs ready to test investor appetite for risk is Foursquare Capital Corp (FSQR.N), a REIT that will be run by a unit of money manager AllianceBernstein (AB.N) and plans to raise $500 million with which to buy "toxic assets" under a U.S. Treasury program.

Two other REITs, Colony Financial Inc (CLNY.N) and Apollo Commercial Real Estate Finance Inc (ARI.N),
created by Leon Black's private equity firm, are each seeking hundreds
of millions to buy commercial mortgage-backed securities, betting that
their values will rebound.

IPO investors are becoming more adventurous again.

"Investors are looking more broadly across all sectors now. It's not just defensive names that are appealing," Deignan said.

But
a flop or two next week, or a sudden end to the recent stock market
rally, could be enough to send investors running for the doors again,
an analyst said.

People
could be frightened if some of these deals do badly," said Nick
Einhorn, a research analyst at Connecticut-based investment firm
Renaissance Capital.

Despite considerable buzz, A123 Systems Inc (AONE.O),
a promising lithium car battery maker gunning for $225 million, may
give investors pause as it would be the first this year by an
unprofitable company.

Two of the offerings are carve-outs from large companies: Swiss bank Julius Baer's (BAER.VX) U.S. asset management unit Artio Global Investors Inc (ART.N) ($585 million) and Chinese media company Shanda Interactive's (SNDA.O) spin-off of its gaming unit Shanda Games Ltd (GAME.O) in a $725 million IPO.

Investors have been receptive to carve-outs this year. Shanda Games' rival Changyou.com Ltd (CYOU.O) was carved out of Chinese Internet portal Sohu.com (SOHU.O)
and has risen 156 percent since its IPO in April in the best
performance of the year, leading some analysts to say Shanda could see
the strongest first day jump of this week's crop.

Investors
have been rewarded -- 13 of 16 IPOs (excluding REITs) this year have
risen since their debuts and the FTSE Renaissance IPO Index is up 41.3
percent, besting the S&P 500 Index's .SPX 18.4 percent rise.

HAPPY BANKERS

The
spike in IPOs has come as a relief to investment banks that covet
underwriting fees and the prestige of being on the hottest deals.

Of all investment banks, Goldman Sachs, (GS.N) which is co-managing five of the IPOs, stands to gain the most if the coming week's deals all price at expected levels.

Goldman would jump to No. 2 from No. 8 in the league tables for 2009 so far, barely behind rival Morgan Stanley (MS.N), according to projections by Thomson Reuters.

Morgan Stanley would leapfrog over Bank of America Merrill Lynch (BAC.N), which would fall to No. 3 -- though all the top three would be within a hair of each other.

While
IPOs remain inherently risky investments, the slew of IPO filings since
July point to a sustained spike in IPOs through the end of the year,
Deignan said.

Since July 1, 33 companies have filed for IPOs, compared with only 11 in the first half of the year.

Deignan
does not think the market will maintain next week's torrid pace but
expects two to three IPOs per week to be the norm again in the coming
months.

"We could see a good number of those late summer filings come to market this fall," she said.

Given the signs of a stronger than anticipated economic recovery, you might
start to wonder if the Fed is ready to remove liquidity. The answer is
no since there are no signs that pipeline inflation is imminent:

Those
worried about high inflation rates think that once demand starts to
pick up, the large money supply will make it extremely easy for
consumers to obtain funds and thus inflation will rocket upward.

The
odds of this happening are extremely low as the output gap and high
unemployment rate do not correlate well with a spike in either consumer
or investment demand.

However, let's say this does occur. The Fed is not going to sit back and watch inflation take off.

They
can easily pull back large quantities of money by ending their
quantitative easing purchases. This can be done by simply letting the
Asset-backed Commercial Paper Money Market Mutual Fund Facility, the
Commercial Paper Funding Facility, the Primary Dealer Credit Facility,
and the Term Security Lending Facility to end when their mandate is up.
These programs were not instituted indefinitely and are all set to
expire over the next 12 months. The removal of these programs will
reduce "easy" money significantly.

They also can sell assets
back to the marketplace if need be. The Fed has approximately $800
billion dollars in "legacy" Treasury assets composing of TIPS and
nominal bonds and $450 billion in asset backed securities. The
liquidity constraints imposed by the market on these assets should ease
significantly as the economy rebounds. Demand should become more stable
and the Fed can reduce the money supply by selling the securities back
to the investors.

In a worse case scenario, the Fed can also
drastically rein in the money supply by increasing the required reserve
ratios. This tends be thought of as the nuclear option due to the
disastrous effects shown after the Great Depression. However, the Fed
has given every indication that it has learned from that experience and
will make sure that any increase in the reserve requirements will not
cause the lending markets to seize up.

The Fed understands that
high inflation is creeping into consumer inflation expectations. The
Fed has every intention of keeping inflation under control.

As
I stated in the past, the Fed will err on the side of inflation.
Inflation is also what pension plan sponsors want because it will lower
their future liabilities (as rates go up) and increase their assets (as
profits grow). Will inflation eventually seep through? I wouldn't bet
on it just yet, but you can sure bet on on an other asset bubble to
form in the meantime.

Finally, Martin Wolf of the FT thinks the government will have a devil of a time managing this transition smoothly:

Right now, banks are printing money courtesy of subsidized borrowing
rates from the Fed.  They're also dumping their crappy mortgage assets
on the Fed's balance sheet in exchange for fresh cash, thus avoiding
further asset write-downs.  As soon as the Fed begins to reverse these
measures, banks may come under pressure again.

Worse, the Fed is
still buying mortgage securities in the open market, thus helping to
keep mortgage rates low.  If the Fed abandons this crutch, mortgage
rates could rise, putting new pressure on the housing market.

Lastly,
the government's fiscal stimulus, which has driven some of the rebound
in GDP in the last two quarters, will start to peter out in 2010.

Meanwhile,
unemployment is nearly 10% and GDP is nearly 4% below its peak.  Until
hiring resumes in earnest, the government and Fed will likely remain
under intense pressure to keep their foot on the gas--lest they snuff
out the incipient recovery.  On the other hand, if they wait too long,
they'll risk a bout of severe inflation.

Whatever happens, Wolf thinks it is highly unlikely that the Fed and Congress will get it just right.

When did the Fed and Congress ever get it "just right"? Mr. Wolf is correct,
get ready for a bumpy ride ahead, but before the VIX shoots up, it
might first collapse. Stay tuned, things are getting interesting.

***UPDATE: Meredith Whitney: 'Roaring' Recovery? Unlikely***

Prominent banking analyst Meredith Whitney cautions against taking too sunny a view of the economy:

"What
neither of those people are saying is that we come roaring back,"
Whitney, the CEO of the Meredith Whitney Advisory Group, told Diane
Sawyer this morning on "Good Morning America."

There's "a lot
to be optimistic about," Whitney said, including the security of the
banking system and the increase in Federal Deposit Insurance
Corporation's backing of bank deposits.

You can watch Whitney's GMA interview by clicking on the link above or on YouTube below.

Comments

[Leo Kolivakis]

If you really want to hear a bear growl, listen to this Tech Ticker interview with Peter Schiff who thinks Ben Bernanke is wrong, the economy is getting worse, not better.

[Anonymous]

It's not as bad as you think, it's worse!

[Leo Kolivakis]

***UPDATE: Meredith Whitney: 'Roaring' Recovery? Unlikely***

Prominent banking analyst Meredith Whitney cautions against taking too sunny a view of the economy:

"What neither of those people are saying is that we come roaring back," Whitney, the CEO of the Meredith Whitney Advisory Group, told Diane Sawyer this morning on "Good Morning America."

There's "a lot to be optimistic about," Whitney said, including the security of the banking system and the increase in Federal Deposit Insurance Corporation's backing of bank deposits.

You can watch Whitney's GMA interview by clicking on the link above or on YouTube below.

[McGriffen]

Wesbury...I just don't know where to begin.  He fails to mention, without fail, how dysfunctional bank balance sheets are and will continue to be over the next 2-5 years (at a minimum).  He also fails to account for the level of economic stimulation that occurred between 2005-2007 that was largely driven by the beastly Wall Street engine of securitization, LBO, etc...  Systemic financial risk has subsided, but bank failures continue to happen and the excess has to burn off.  Economic growth created from nothing doesn't exactly just come back, or such is my theory anywho...

Wesbury also called for 13,000 on the DOW, for year-end 2008!  Not so much...

Who doesn't like optimistic calls, but realism is what's needed.  1.5 - 2% GDP would be darn-tooting okay, absent US govt intervention / interference.

[Anonymous]

Good catch, Mr. Westbury is not an academically trained economist, he just plays one on TV. He also completely misread the credit bubble and ensuing PANIC, all just a short year ago. I guess it can help sell books though

[steve from virginia]

No mention of oil prices - already too high to support business, certain to go (much) higher if currency is available via increased lending and velocity and increased demand. Not to mention flow out of dollars and debt overhangs.

I hate to say it but Leo, you come across as a nincompoop. You are in denial. The real, physical economy is now a gigantic millstone around the ankle of the speculator. Physical production that depends upon cheap oil is declining resulting in the inability of the physical economy to service accumulated finance/administrative sector debts. The problem is a long- term rise in oil/energy prices that has shifted energy market balance from the consumers to producers. In dollar terms, the oil production 'peak' took place in 1998. Don't believe me, look for yourself in the EIA database!

The US and the rest of the developed world has been on the 'downslope' of peak oil for ten years. No wonder the economy is kaput. Guess what, these are the 'easy times'. Things will be worse next year, and worse than that the following year and so on. The world's economies have been built on a superstructure of extremely cheap petroleum - $20 a barrel or less. It's all over, now!

Returning you to your regularly scheduled Dennis Kneale program.

[Anonymous]

oh horse crap....wherever the price of oil needs
to be the economy will adjust....

our economy has ajusted after major price increases
starting in the 1970s....painful yes but not
impossible...

the oil is still flowing regardless of what nonsense
is in the peak oil thesis....and it will continue
to flow even at 150 per barrel....

energy will remain abundant and sufficient to
support economic activity....

[Ned Zeppelin]

I like Leo's challenge and refusal to dismiss out of hand any opinions or facts that may not fit within an "all is lost" mind set.  I know, because that is my mindset, and it gives me considerable comfort to know that someone, somewhere, believes better times will return. 

However, I read through each of these opinions, and find them wanting;  at the very least, they do not say "how" we are surmounting many obstacles heretofore not encountered in a postwar recession, only that we "will." My impression of the Obama stimulus is not nearly so optimistic as the various authors (productivity increases??), and I see elements of the "things are getting less worse ERGO, robust recovery dead ahead" theory that suffers from a lack of credibility.

None of that "connects" in my book.  BUT, I like the attitude and the openmindedness.

[Anonymous]

one of my biggest points of skepticism is the
rapid rise in debt on the government side
when mpd is less than zero....that cannot do
anything but cause economic contraction....

if a recovery takes off interest rates are sure
to follow....the treasury can't compete with a
growing stock market and economy....but with
real estate in such precarious condition it
will snuff out growth....

i am not sure that the optimists are accounting
for that....maybe they will use their cash
hoard to pay down debt thus mitigating some of
my objections...

[Leo Kolivakis]

Did anyone notice the question mark at the end of my title? Please read the comment carefully before you dismiss it. There is a lot of performance anxiety out there driving equities higher and there are clear signs that we bottomed out and economic activity will pick up (the gap between ISM new orders and inventories widened to its largest margin in 34 years, climbing to 30.5 from 21.8.). The question is will the momentum continue into the first half of next year and further out. That I am not sure about.

Leo

[docj]

Indeed Leo - thanks.  I did indeed read and ponder these, I just find it borderline impossible to jive this with what I pretty much see every day from my perch as a strategy guy for a global hi-tech software company.

But mea culpa for being so evidently out-of-hand dismissive.  Not my intent, honest.

Cheers -

[Anonymous]

this was an interesting collage of opinions....for me it is very difficult to reconcile these views with some of the structural impairments in the economy which look more like the big one waiting along the san adreas fault....

the opinions are consistent with ecri's weekly leading index which shows sharp growth on the horizon....yet how does that jibe with the dismal state of the re market and banks which are insolvent in all but name?

additionally trade is down sharply (though not too great a piece of usa gdp), cre is faced with resets, and impending interest rate increases spell crater....

i can't argue with the wli but at the same time something doesn't feel right...

[docj]

Nothing but rainbows, unicorns and puppy kisses, eh?

Yeah.

[Anonymous]

That means, the next crisis, we'll only have companies that are "TOTO BIG TO FAIL"

You can't go wrong with that view he :)

Soon : S&P 500 = S&P 1

[Anonymous]

"Never before have U.S. companies piled up cash faster compared with interest costs than they are now, setting the stage for a surge in mergers and acquisitions."

Ok, so other than making Goldman very happy with huge fees, just how does that make the economy grow? Especially considering that these mergers almost always result in layoffs, further killing the golden consumer goose.

[snorkeler]

The grand plan - oligarky

Less competition

Less jobs

And Obama wants to put tariffs on Chinese tires! Please!