How does one of the best strategists view the world as we close the page on 2012, and look toward 2013? Find out with the help of these 35 charts.
What causes hyperinflations? The answer is: Quasi-fiscal deficits (A quasi-fiscal deficit is the deficit of a central bank)! Why have we not seen hyperinflation yet? Because we have not had quasi-fiscal deficits! Essentially, hyperinflation is the ultimate and most expensive bailout of a broken banking system, which every holder of the currency is forced to pay for in a losing proposition, for it inevitably ends in its final destruction. Hyperinflation is the vomit of economic systems: Just like any other vomit, it’s a very good thing, because we can all finally feel better. We have puked the rotten stuff out of the system.
While many believe that with the output gap so wide that inflation is not an immediate threat, longer-term, as UBS notes, excessive money printing could indeed generate inflation and that inflation expectations are unusually volatile and could quickly be dislodged. This inflation hedges are a very valid concern. An oft-cited reason for owning stocks is that they have an implicit inflation hedge, however, just as with many market myths, UBS finds that, in fact, equities do not look like a compelling hedge against rising inflation. Indeed, they provide an appropriate hedge to rising inflation only in a limited number of cases. In short, equities provide only a partial hedge – one which works only for small positive inflation shocks.
N as in "Nominal". Nominal GDP targeting, the latest burlesque of monetary fiction. But first things first. There is a land, where people calculate a "potential GDP". How do they do that? By simply extrapolating trends. Potential GDP is "the level of economic activity achievable with a high rate of use of its capital and labor resources". In the past, the differences from observed GDP were not very large, though now we are growing "below trend". But what if that trend has changed? With a flawed measurement of economic activity, leading to an imaginary output gap, what else might our economic elite come up with? Stagnating real GDP and high unemployment are no fun. After exhausting every traditional and non-traditional tool of monetary and fiscal policy, what else could be done to make that GDP grow? Nominal GDP equals real GDP plus inflation. So if real GDP doesn't want to grow... Eureka! you just have to cause more inflation, and nominal GDP will obediently join its potential GDP. Except for one little error of judgment: if elevated inflation led to wealth creation and jobs, Zimbabwe would be the richest country on earth. As real incomes of US employees have stagnated for more than a decade, rising prices would either lead to falling volumes, or force households further into debt. Also, how would this be different from a communist command-style economy?
The good news this morning is that the 2nd estimate of the third quarter (3Q) GDP was revised up from 2.0% initially to 2.7%. This is up sharply from the 2Q print of 1.3%. However, the combination of rising levels of unsold goods (inventory), slowing sales growth and declining incomes all point to weaker GDP growth in Q4 and into the early quarters of 2013. Look for GDP growth in the 4Q to decelerate to 1.5% to 1.7%. While there is currently not an official recession in the U.S. economy, as of yet, the details of the current economic growth are not ones of robust strength. If we are correct in my assumptions the economic underpinnings will continue to negatively impact fundamental valuations as profit margins continue to be compressed. While most of the media, and mainstream analysts, continue to focus on the state of the economy from one quarter to the next - the trend of the data clearly shows the need for concern. Of course, this also why Bernanke is already considering QE4. As we stated previously, while economic growth did pick up this quarter it is the makeup, and more importantly the sustainability, of that growth is what we need to continue to focus on.
We remain in the throes of a secular era of disinflation. We also are in a long-term period of sub-par economic growth and below-average returns. This has become so well entrenched that U.S. pension plans now have more exposure to bonds than to stocks, as we highlighted two weeks ago. Look, this is not about being bearish, bullish or agnostic. It's about being realistic and understanding that in our role as market economists, it is necessary to provide our clients with information and analysis that will help them to navigate the portfolio through these stressful times. Our crystal ball says to stick with what works in an uncertain financial and economic climate — in other words, maintain a defensive and income-oriented investment strategy.
It is not going to be a new government that necessarily ushers in a whole new era of growth, prosperity and confidence. Even under the revered Ronald Reagan, the period of secular growth and bull market activity took two years to unfold — it didn't happen right away. It took the inflationary excesses to be wrung out of the system and concrete signs that the executive and legislative branches could work together to usher in true fiscal reform — and to get blue Democrats on board with reduced top marginal tax rates. Hope isn't generally a very useful strategy, but there is reason to be hopeful nonetheless. The critical issue is going to be how we get Washington to move back to the middle where it belongs. This requires bipartisanship which in turn requires leadership. Reagan's whole eight-year tenure in the 1980s occurred with the House being in Democrat hands the whole way through. Bill Clinton's second term coincided with both the House and Senate controlled by the Republicans.
It can be done!
With this in mind, the best that can happen is a Reaganesque and Clintonesque return to compromise on the road to fiscal reform. It will be painful. We all know it will be painful.
With Greece and Spain (and arguably Portugal and a few others) stuck in dramatic debt-deflation spirals, the political need for maintaining these nations in the euro far outweigh the economic 'benefits'. As UBS notes, looking at the euro area today, one cannot help but notice the parallels to Japan of the early 1990s. Europe today, as with Japan a generation ago, is an aging society with structural rigidities, pockets of corporate excellence, but wide swathes of inefficiency; but the two most striking similarities (and not in a good way) lie in the banking system (bloated from over-leveraging, under-capitalization, and bad loans); and fiscal policy (which is inherently pro-cyclical - as the politics of monetary union preclude national level stimulus - leaving ineffective monetary transmission channels unable to help fiscal failure). As UBS concludes, the current euro's similarities to Japan are key impediments to growth - and as such we should expect sclerotic economic activity for a five-year period.
With the entire world engaged in global coordinated easing, slashing, burning, and overall lowering rates and printing money by the wheelbarrow, the Bank of Canada just fired a shot across the bow. Here is the kicker: "Reflecting all of these factors, the Bank has decided to maintain the target for the overnight rate at 1 per cent. Over time, some modest withdrawal of monetary policy stimulus will likely be required." Surely they must be punished for this blasphemy in the holy church of Saint John Maynard and the apostles of collapsing fiat.
The recent release of the final estimate of Q2 GDP, and the September's Durable Goods Report, confirmed that indeed the economy was far weaker than the headline releases, and media spin, suggested. While the media quickly glossed over the surface of the report there were very important underlying variables that tell us much about the economy ahead. The problem is that there is little historical precedent in the U.S. as to whether maintaining ultra-low interest rate policies, and inducing liquidity, during a balance sheet deleveraging cycle, actually leads to an economic recovery. This is particularly troublesome when looking at a large portion of the population rapidly heading towards retirement whom will become net drawers versus net contributors to the economic system. The important point for investors, who have a limited amount of time to plan and save for retirement, is that "hope" and "getting back to even" are not successful investment strategies.
With Draghi stepping aside, the headliner can shine and while Goldman does not expect Chairman Bernanke's speech on Friday morning, entitled "Monetary Policy Since the Crisis", to shed much additional light on the near-term tactics of monetary policy beyond last week's FOMC minutes; their main question is whether he breaks new ground regarding the Fed's longer-term strategy. An aggressive approach would be to signal that the committee is moving closer to the "unconventional unconventional" easing options that Goldman has been ever-so-generously advocating for months, although even they have to admit that expectations are that any moves in this direction will be gingerly.
The first estimate of the 2nd Quarter GDP was released at a 1.5% annualized growth rate which was just a smidgen better than the 1.4% general consensus. There has been a rising chorus of calls as of late that the economy is already in a recession. For all intents and purposes that may well be the case but the GDP numbers do not currently reveal that. What we are fairly confident of is that with the weakness that we have seen in the recent swath of economic reports is that the 2nd quarter GDP will likely be weaker than reported in the first estimate. It is this environment, combined with the continued Euro Zone crisis and weaker stock markets, as the recent rumor induced bump fades, that will give the Federal Reserve the latitude to launch a third round of bond buying later this year. While the impact of such a program is likely to be muted - it will likely push off an outright recession into next year.
This has been the recovery of downward revisions - each annual revision to payrolls and GDP since the recovery started in 2009 revealed an even sharper contraction and weaker recovery. BofAML believes this year’s revision, which is released with the Q2 GDP report on Friday, will once again show an even slower start to the recovery with growth revised lower in 2009 and 2010, and modestly higher in 2011. While it is good news that growth could be revised higher in 2011, it appears that it will only be marginal. The downward revisions to growth in 2009 and 2010 will still leave the level of GDP lower and, hence, the output gap larger. This shows that the economy has made even less progress in healing from the deep recession. The severity and duration of the recession was understated in real time and the recovery was overstated. This suggests that monetary policy may not have been easy enough over the past several years - and therefore the current slowdown is even more significant.
The euro has depreciated to its lowest level in nearly nine years when measured in trade-weighted terms. Common wisdom is to assume that this might trigger a GDP forecast upgrade for the common currency area. UBS says "no", while at first sight, this 'devaluation' should boost output, the exchange rate response is simply part of the bigger, well-known picture of economic stress in the common currency region. Simply put, the currency has depreciated on fear and risk aversion - and economic growth tends to suffer rather than flourish in that environment - and furthermore, the two structural measures that help determine the outlook for the currency - the internal balance (output gap) and the external balance (current account) - point to further weakness.
Some time ago we said that in a world in which virtually every risk and liquidity benchmark is manipulated by either private banks (thank your Liebor) or central banks, if one needs to know the true state of events in Europe, the only real remaining, unmanipulated benchmark remain Swiss nominal bond yields. And at -23.5 bps for the 2 Year it is telling us that nothing is fixed. As usual. Also judging by the SNB's new head Jordan statements which just hit the tape, in which he says that he would not rule out capital controls or negative rates if the crisis worsens, the SNB gets it. Or does it? Jordan also said that the SNB is ready to defend the FX market with unlimited market purchases if necessary. However, as the note below from JPM shows, the SNB may simply be faking it, hoping it too can get away with simple jawboning, instead of actually putting its money where its mouth is. As it turns out the SNB has indeed been intervening in huge size in the month of May to keep the EURCHF peg. The previously undisclosed news is that it has also been sterilizing its purchases. As JPM further notes: "This is highly significant and undermines the credibility of the SNB’s claim that it is willing to do whatever it takes to hold EUR/CHF 1.20. For the floor to be credible the SNB needs to surrender control over the Swiss monetary based, i.e. it has to be willing to deliver both unlimited and unsterilised FX intervention. The intervention in May was certainly unlimited; it most definitely was not unsterilised." How long until the FX vigilantes decide to test just how far the SNB is truly willing to go in defending the peg? And what happens when Swiss nominal yields hit record negative numbers once again?