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Saturday, April 3, 2010

John Mauldin says, "This is a recovery?"

The top of John Mauldin's weekly letter hits some of the high points on the low economy. Mauldin subsequently, not included here, makes some odd and wrong points about taxes (that a tax increase results in triple damages to the economy), and he is still wading around in the illusion that the economy going forward must be a version of what went on in the past, but the first part here is along the lines we have been promoting.

We are still not calling it a recovery. Absent investment there is no business cycle. Like expecting your garden to grow without sun.

Is This a Recovery?
by John Mauldin
April 2, 2010

Last week I wrote a letter to my kids trying to explain what Greece meant to them. Reader Ken V wrote: "Great letter, John. Now you should write one for the adults who are retired and don't have the long future your kids do. If the US becomes Greece, things won't recover in time for much of the rest of my life to be more than one grim, dreary period. What is your investment advice for those with roughly a 10-year horizon, not 30-40-50 years?"

A very good question Ken, and one that was asked more than a few times. So today I will touch on that thorny issue, as well as look at the employment numbers for what we see about the potential for an actual recovery.
First, let me say that what I am not doing here is giving you, gentle reader, specific advice. To be able to do that I would need to have specific knowledge of your situation, assets, location, needs, health, etc. But what I will try to do is give you a general assessment of what I see for the economy over the next few years and what the investment climate might look like. I am also going to refer to a lot of previous letters I have written, for those of you who want to do further research.
Is This a Recovery?

First, we are in a nascent recovery from the depths of the Great Recession, but the question is "what kind of recovery?" Many suggest that we will see a typical recovery, like we have seen with every recession since World War II. As regular readers know, I don't think we've gone through a typical, garden-variety recession, and to expect a typical recovery is more faith-based than factual. We had a deleveraging recession and we are still deleveraging. The process, as shown in studies I have written about, takes years to conclude.

When I started talking in 2002 about a Muddle Through Economy for the rest of the decade, I had a lot of people giving me a hard time by 2005-6. But as we closed out the decade, average growth of US GDP for the entire decade was less than 2% annualized, which by my definition is Muddle Through. For the US economic machine, that was pretty anemic growth. It resulted in a lost decade for stocks, except for the NASDAQ, for which it was merely a dismal decade. Traditional 60-40 (stocks to bonds) portfolios did not fare well, coming nowhere close to the projections of standard-issue money managers.

I think we are in for yet another Muddle Through period, at least for 5-7 years and maybe for the decade, depending on a few scenarios I will come to in a minute. As my friend Prieur du Plessis outlined for us in last Monday's Outside the Box, if we measure the stock market by either earnings or dividend yields, valuations are in the top 10% historically. Average (!) returns, going out for ten years, are 2.6% real, with some historical 10-year periods being negative. Below is the range of returns, based on dividend yields. It does not look much different from the chart based on earnings. We are currently at the far right-hand bar.

This does not suggest a happy outcome for those who espouse buy-and-hope portfolios, at least not if you have expectations or needs of 7-8% or more.
This Time is Different

If you are a new reader, I suggest going to the archives at http://www.2000wave.com/archive.asp and searching on the name "Rogoff," to read the letters I have written on his and Carmen Reinhart's must-read book, This Time is Different, which shows us that it is never different this time. They looked at 266 financial crises in over 60 countries across a span of 200 years.

Debt crises have sadly similar conclusions: they always end in pain and tears. And although we have stopped, as private citizens, from accumulating debt (or in some cases, such as mortgages, have just walked away from the debt), our national government has stepped into the breach and is borrowing at mind-boggling levels.

Below is a chart that is a wonderful illustration of an economic truth: if something can't happen then it won't happen. We cannot borrow $15 trillion in the next ten years. Not at anywhere near the low interest rates we enjoy today, and probably not even at nosebleed rates. (Note that the chart was created before the health-care reform bill. Add at least another trillion to the total. Anyone who thinks that bill was revenue neutral is kidding themselves.)

The End Game

Something has to change. We have two paths to choose from. We can either slowly bring the US budget deficit back into balance (or at least to a level less than the growth in nominal GDP) or we can continue on the current path and become Greece or Japan. (Again, go the archives and search for "Japanese Disease".)

The first choice is a bad one, but the latter choice would be disastrous. If we take the first choice, which I call the Glide Path Option, a meaningful reduction would have to be on the order of $200-250 billion a year. That, along with reduced spending by state and local governments could (and probably will) amount to reducing spending by a little more than 2% of GDP.

I have written several letters on the equation GDP = C (consumer and business consumption) + I (investments) + G (government spending) + E (net exports) (again, searchable). The Keynesians point out that when "C" is reduced in a recession, "G" should be increased to offset the effects of reduced consumption. And they are correct that a deficit will help overall GDP in the short run.

But we are coming to the end of the Debt Supercycle. There are limits to what even the US government can borrow, and the sooner we recognize that as a nation the better off we will be in the long run.

But if we start to reduce our deficits (the "G"), it will be a short-term drag on GDP. There is no way around it. That means that if inflation is 2% and we have a reduction in "G" of 2% of GDP, then the nominal growth in GDP will have to be 6% in order to achieve after-inflation growth of 2%. Two percent as in Muddle Through.

But wait, John, didn't we just grow at 5.6% last quarter? Why are you being so gloomy? For several reasons. First, the growth was largely statistical. Part of it came from inventory accounting, as inventories had got as low as they could go. Note that an increase in inventories will increase GDP but possibly result in a lower future GDP as the excess inventory is depleted. And inventories are still rising, but not by as much.

Secondly, a significant portion of the increase in GDP came from the stimulus. As noted above, an increase in "G" will be reflected in current GDP. This stimulus begins to go away in the second half of the year, and I think there is little reason to believe there will be anything other than an extension of unemployment benefits past two years, by way of "stimulus" this year.

I rather think the last half of the year will show a slowing (though still positive) economy. Unemployment will be closer to 10% than 9% at the end of the year, as the large number of temporary census workers will no longer be employed by the government.

1 comment:

  1. I am in favour of higher interest rates but not because of inflation. My reasons are as follows. Low interest rates encourage bad investments, because so many more marginal investment projects become viable. It was this that encouraged the property bubbles. With low interest rates any investment that had a return greater than the cost of funds was made. That encourages bubbles because low returns need leverage to boost returns overall.

    Also a higher level of interest will push dividend rates up. This is because stocks are inherently risker than bank deposits. This means that companies will have to offer higher dividends to support their prices. These higher returns will be going to institutional investors who pay pensions.

    For businesses they need stable long term rates to help them make investment decisions. If that choice is between a fixed 4% or variable between 0% to 15% the business will opt for stable rates. The same for consumers. Also the current near zero rates are not encouraging investment as they would under normal situations they are only acting as a reduction in the cost of funds to banks. They are still lending to those that want to borrow but at considerably higher rates. They have widening their margins considerably. Long term that harms investment, as it drains money from the real economy to support the financial sector.

    Overall interest rates are not that precise to stop bubbles, because the Fed will not be looking for them. What might be better is the use of capped leverage rates for banks and then if the Fed think that the housing market is frothy they can demand that the banks deposit reserves with the Fed. This could be targeted at specific lending groups to stop any market getting over heated. If done well it would stop bubbles without the need to raise interest rates at all. If targeted at segments it could be used to stifle mortgage lending without pricing out business loans though higher interest rates. It could also stop excessive lending by one institution. You could demand a deposit at the Fed of say $1 billion and that would reduce lending by $15 billion assuming that there are hard leverage caps, and from institutions that are lending recklessly, without impacting on those that are careful with whom they lend to. If consumer credit card lending was excessive they could again drain banks of capital to cut the amounts owed on credit cards, without raising interest rates or harming other investments.

    It could also be used as a deterrent to hot money. If the banks were flooded by cheap funds from abroad the fed could simply demand all of those funds in non interest bearing deposits and the banks would not accept funds because they cannot lend them out. This would have stopped the problems at Northern Rock in the UK, because its business model was based on cheap wholesale interbank funding. Stamp on that and you can still have interbank lending for short terms but discourage it for longer loans.

    Also US domestic inflation has not been demand pull for years. The US consumer is too financially stretched to drive up inflation. It has been cost pull for years. With Asia now growing fast the demand for oil is greater and the supply has barely coped, the price of oil is lead by demand pull but external to the US, and so not within US control.

    The objective should be stable interest rates, and by using control over the banks capital and hence its ability to lend to one sector over another may be better for all. Than a blunt weapon such as interest rates.