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Wednesday, December 1, 2010

Transcript: 415 The Greenspan put expires with the economy out on a limb

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We were somewhat taken aback this week when Calculated Risk, one of the people we rely on most for data and analysis -- find him at CalculatedRisk.com -- opined that things were getting better. Our view at Demand Side, as you know, is and has been that things are bouncing along the bottom with significant downside risks for another crisis.

We'll look today at what CR sees, and then we'll offer a little pushback from an important piece from an another anonymous but very influential analyst. We'll also get to the economic models that worked, from a paper by Dirk J. Bezemer, Groningen University, and get some audio from the always pungent and perspicatious Steve Keen, whose accounting framework modeling is the cutting edge.

Sunday, November 28, 2010
The recent improvement in economic news
by CalculatedRisk

It is worth noting the recent improvement in economic news:

• The October employment report showed a gain of 151,000 nonfarm payroll jobs, the most since April ex-Census. Expectations are for a similar gain in November, although probably not enough jobs added to push down the unemployment rate.

• The BEA estimated real GDP grew at a 2.5% annual rate in Q3. This is still sluggish, but an improvement from the 1.7% growth rate in Q2.

• The Personal Income and Outlays report for October indicated incomes grew at a 0.5% rate (month-to-month), and it appears PCE has grown at about a 3% annualized rate over the last three months. The personal saving rate was 5.7% in October, and although I expect the rate to increase a little more - it appears a majority of the adjustment is behind us (a rising saving rate is a drag on personal consumption).

• The 4-week average of initial weekly unemployment claims has declined to 436,000 last week from over 480,000 at the end of August. The weekly reading was 407,000 last week; the lowest since July 2008.

• Most regional manufacturing surveys, with the exception of the NY Fed survey (empire state), has shown a pickup in manufacturing. This suggests the manufacturing sector is still improving (the ISM manufacturing index for November will be released on Wednesday).

• Trucking and rail traffic improved in October, although the Ceridian diesel fuel index was weak.

• The Architecture Billings Index (a leading indicator for commercial real estate) is near flat - suggesting investment in commercial structures such as hotels, offices and malls will stop contracting next year. (addition by subtraction!)

• Even small business optimism has improved slightly.

Most of the reasons for the recent slowdown are still with us - less stimulus spending, the end of the inventory adjustment, problems in Europe and a slowdown in China, and cutbacks at the state and local level - but it appears Residential investment (RI) has bottomed and will most likely add to GDP growth in 2011. I believe the RI drag is now behind us, and RI is usually the best leading indicator for the economy.

The data is still mixed and fits with my general view of a sluggish and choppy recovery (my view since the spring of 2009). Although I don't see a sharp increase in growth, I think the pace of recovery will probably pick up a little bit in 2011, and I'll take the over on the consensus view of 2.5% GDP growth in 2011. My guess is 3%+ GDP growth in 2011 - still not a strong recovery given the amount of slack in the economy, but an improvement over 2010.

Unfortunately there probably will not be enough growth to significantly reduce the unemployment rate in 2011.

Note: I'll add more before the end of the year, but I've been sharing my thoughts with a few analysts and economic commentators and I try to post my views whenever they change - even a little. Right now it looks like the "slowdown, but no double dip call" was correct (it is still early), and now I'm becoming a little more optimistic and taking the "over" on 2011 GDP growth (still no v-shape recovery though).

That from the mysterious Calculated Risk. Not so different from our bouncing along the bottom with downside risks, except CR seems very willing to extrapolate the bump in good news. We are not. And for some of the reasons why, we yield to another anonymous voice:

Ananomen Analyst is a wealth manager associated with a major Wall Street investment bank who uses a pseudonym to avoid any incorrect implication that his views might reflect those of his firm.

Writing under the head "The Greenspan Put Expires Worthless in the Eye of the Hurricane" courtesy of EconIntersect.com

The Fed Used to be Important: The Greenspan Put

For many years our writing has been focused on the Federal Reserve, since monetary policy easily has the largest influence on the economy and financial markets. Since World War II, every recession was preceded by a tightening of monetary policy and higher interest rates, and every recovery spurred by lower rates and an easing of monetary policy. Every cyclical bear market and bull market was also strongly influenced by changes in monetary policy. Since the stock market crash in 1987 and the 1998 collapse of Long Term Capital Management, investors have believed the Federal Reserve also possessed the capacity to manage every crisis. Since those two crises occurred when Alan Greenspan was Chairman and Maestro of the Federal Reserve, it became known as the ‘Greenspan Put’. This reference to the value of a put option during a market decline, increased investors bravado that they needn’t worry about a negative Macro event, since the Fed would simply exercise ‘Greenspan’s Put’ and restore order.

The current financial crisis has exposed numerous fissures in the U.S. economic foundation, which will be addressed later. More importantly, it has shown that the Federal Reserve no longer possesses the capacity to manipulate economic activity, as they did during the last 60 years. The balance of power has shifted from the Federal Reserve being proactive and exerting a strong controlling influence on the economy, to one of being reactive. The Fed can now only indirectly affect the numerous drags on economic growth, despite an unprecedented level of monetary accommodation. This change in the balance of power, from the Federal Reserve being proactive to reactive is significant, since it means ‘Greenspan’s Put’ has expired.

The majority of mutual fund managers, market strategists, economists, and investors have not yet realized that this shift in control and power has occurred. Their continued faith in ‘Greenspan’s Put’ may cost them dearly in the next few years, as the Federal Reserve struggles to keep the credit bubble from deflating.

The Eye of the Hurricane

The financial crisis that kicked off in August 2007 has never really ended. Much like a Category 5 hurricane, the global economy was battered by the outer wall as it came ashore in 2008 and early 2009. The eye was created, as every central bank adopted an extraordinary level of monetary accommodation. Governments around the world launched massive fiscal stimulus programs that resulted in historic budget deficits in almost all of the developed countries. In the United States, the eye of the hurricane allowed GDP to grow, but at a sub-par pace. Compared to the recession of 1973-1974, the first five quarters of GDP growth since the summer of 2009 have averaged 2.8, half as fast as the first five quarters after the 1973-1974 recession. The first five quarters after the deep 1981-1982 recession averaged GDP growth of 8.4%, three times the strength of this recovery.

There are a number of indications that suggest we will be moving out of the hurricane’s eye sometime in the next six months. Most of the Federal fiscal stimulus has been spent, without launching a self-sustaining recovery. Job growth has been exceptionally weak when compared to other post World War II recoveries. Without a healthy increase in disposable income, consumer spending will not elevate GDP growth above 3% on a sustainable basis. The only way that will occur is if solid job growth of 300,000 jobs per month kicks in, and that’s not likely anytime soon. Spending may marginally pick up during the holidays. Keeping a rein on spending gets old after a while and the holidays are a good reason to loosen up a bit. Unfortunately, millions of unemployed workers will see their unemployment benefits expire, unless Congress extends them, which we expect. However, that will only make cutting the Federal budget deficit more of a challenge.

State legislators do have to balance their budgets and they will be raising taxes and fees, and laying off more state workers. Housing prices are set to fall further, as more than 70% of homes in foreclosure have yet to hit the market.

In Europe, the eye of the hurricane resulted in a very uneven pick-up in economic growth. Although Germany has done well, actually recovering all of the ground lost during 2008, many other countries have not fared well. Ireland and Greece are still contracting, while unemployment in Spain is almost 20%. European banks are in worse shape than their U.S. counterparts. Although we expect the European Union to bail out Ireland’s banks, the credit crisis is likely to eventually engulf Spain. This will prove significant since Ireland and Greece combined represents just 5% of total E.U. GDP, while Spain represents 10%.

In response to the global slowdown in 2008, China initiated a $570 billion stimulus package, and ordered state run banks to lend aggressively. In 2009, Chinese banks increased lending by $1 trillion, an enormous amount given the size of China’s economy, $4.5 trillion. The combination of fiscal and monetary stimulus had the desired effect of boosting China’s economy, but has also resulted in a burst of inflation in 2010. In October, official consumer prices were up 4.4% from year ago levels. The real inflation rate in China could be at least twice as high. China has not revised its CPI since 1993, and the weighting of many food components are not realistic. According to official government data, food prices have risen just 19% over the last three years, but over that period, rice was up 38%, wheat up 35%, and beef and milk prices rose 44%. In contrast, two major supermarkets reported that rice prices had soared by 132% and 190% over the last three years.

In response, China’s central bank has raised its lending rate and bank reserve requirements. Rising inflation isn’t just limited to China, but to most of the Asian countries, which have been enjoying solid growth. South Korea had increased rates once, but Australia has boosted its bank cash-rate seven times from its 2009 low of 3.0% to 4.75%. India has hiked its repo rate six times to 6.25% from 4.75% in early 2010. Inflationary pressures are likely to intensify, since the output gap between capacity and production have disappeared in India, South Korea, China and Indonesia, according to the Royal Bank of Scotland. This makes it easier for companies to raise their prices. These are the countries with the strongest growth, but the gradual tightening of monetary policy will likely result in a slow down during 2011.

As the back wall of the hurricane approaches the global economy with its Category 5 winds, investors will realize that most of the problems that emerged in 2008 were not solved or fully addressed. The macro tides which lifted the global economy for decades have shifted. Investors will have to focus on preservation of capital in 2011, and batten down the hatches.

Components of the Macro Tides

The following is a list of individual headwinds. Each will weigh on growth in the U.S., keep GDP growth from reaching a self-sustaining level, and cause GDP growth to average under +2.0% in coming quarters. This list will provide a worksheet that will allow us to monitor which headwinds are deteriorating or improving. At some point in the future, the majority of these headwinds will begin to improve and help identify when another eye in this extended hurricane is approaching. Many are interconnected and there is some overlap. The most important common denominator is that solid economic growth will address most of these issues. Adopting policies that will strengthen economic growth is imperative. However, there are no easy choices since there are potential negative outcomes associated with every option. We’re in quite a fix. One, even Houdini would struggle with:

¦ The ratio of total debt to total GDP in the U.S.
¦Monetary policy impotence
¦Finding a short and long term solution for the federal budget deficit
¦Recapitalizing the US banking system, so lending broadly resumes
¦Weak job and disposable income growth
¦The change in middle class spending psychology toward less is more
¦Stabilizing housing despite the large overhang of foreclosed homes
¦Commercial property rents and values
¦Dealing with state budget deficits
¦The demographic shift of baby boomers into retirement
¦Social security
¦Addressing the income inequality gap between the top 1% and average worker’s pay
¦The lack of true leadership from either political party
¦The cost of health care rising faster than personal income
¦The unintended fallout from financial regulatory reform
¦The European sovereign debt problems
¦Recapitalizing European banks
¦The global economic drag from closing fiscal budget deficits in developed countries
¦Keeping Israel and other middle eastern countries from starting another war
¦China and its currency and trade policies
¦China’s potential bank loan defaults from excess export capacity
¦The Basil increased requirements for international bank capital by 2020
¦The unanticipated

We can add our own:

Deteriorating infrastructure
Failing educational system
Climate change

Well, that was so much fun we didn't get to the important analysis on why the mainstream economists missed the biggest economic event in half a century. The Queen had the right question, "If this was so big, why did nobody see it coming?" We'll answer that question on our next podcast.

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