John Mauldin points out in his latest newsletter that one of the oldest – and least correct – market assumption is that market conditions have changed permanently from similar conditions in markets past:
“Our immersion in the details of crises that have arisen over the past eight centuries and in data on them has led us to conclude that the most commonly repeated and most expensive investment advice ever given in the boom just before a financial crisis stems from the perception that ‘this time is different.’ That advice, that the old rules of valuation no longer apply, is usually followed up with vigor. Financial professionals and, all too often, government leaders explain that we are doing things better than before, we are smarter, and we have learned from past mistakes. Each time, society convinces itself that the current boom, unlike the many booms that preceded catastrophic collapses in the past, is built on sound fundamentals, structural reforms, technological innovation, and good policy.”
– This Time is Different (Carmen M. Reinhart and Kenneth Rogoff)
Unfortunately for all concerned, this time IS different. Sez Mauldin:
The Statistical Recovery Has Arrived
Before we get into the main discussion point, let me briefly comment on today’s GDP numbers, which came in at an amazingly strong 5.7% growth rate. While that is stronger than I thought it would be (I said 4-5%), there are reasons to be cautious before we sound the “all clear” bell.
First, over 60% (3.7%) of the growth came from inventory rebuilding, as opposed to just 0.7% in the third quarter. If you examine the numbers, you find that inventories had dropped below sales, so a buildup was needed. Increasing inventories add to GDP, while, counterintuitively, sales from inventory decrease GDP. Businesses are just adjusting to the New Normal level of sales. I expect further inventory build-up in the next two quarters, although not at this level, and then we level off the latter half of the year.
While rebuilding inventories is a very good thing, that growth will only continue if sales grow. Otherwise inventories will find the level of the New Normal and stop growing. And if you look at consumer spending in the data, you find that it actually declined in the 4th quarter, both annually and from the previous quarter. “Domestic demand” declined from 2.3% in the third quarter to only 1.7% in the fourth quarter.
The decline in credit multipliers suggests that final sales will continue to shrink which means the inventory buildup is a blind leap of faith. Mauldin:
Second, as my friend David Rosenberg pointed out, imports fell over the 4th quarter. Usually in a heavy inventory-rebuilding cycle, imports rise because a portion of the materials businesses need to build their own products comes from foreign sources. Thus the drop in imports is most unusual. Falling imports, which is a sign of economic retrenching, also increases the statistical GDP number.
The new normal is a continuing drop in imports. The hard dollar – caused by the dollar/crude peg – is a (perverse) incentive to conserve energy and drive less. Less driving means less oil imports. This time IS different! Mauldin:
Fourth (and quoting David): “… if you believe the GDP data – remember, there are more revisions to come – then you de facto must be of the view that productivity growth is soaring at over a 6% annual rate. No doubt productivity is rising – just look at the never-ending slate of layoff announcements. But we came off a cycle with no technological advance and no capital deepening, so it is hard to believe that productivity at this time is growing at a pace that is four times the historical norm. Sorry, but we’re not buyers of that view. In the fourth quarter, aggregate private hours worked contracted at a 0.5% annual rate and what we can tell you is that such a decline in labor input has never before, scanning over 50 years of data, coincided with a GDP headline this good.
This time is REALLY different! The costs of running a global commercial empire have caught up to the West, the greatest cost being our gigantic oil tab. The choice is presented; drive a car … or work for a good wage. So far, the choice has been to drive. Wrong choice! The only ‘technological advance’ that would mean anything is a perpetual motion machine, which is about … 20 years away.
It’s always 20 years away. Twenty years from now it will be 20 more years away, like fusion.
Mauldin points out the the current figures are the result of ‘guesswork’ which is a bureaucratic techno- term for ‘lie’. As befits the ‘New Normal’ what comes out of the US government mirrors what emerges from the Chinese government. Since ‘guesswork’ is the New Normal it will not be surprising if the economy stalls suddenly. Mauldin quotes from the Reinhart- Rogoff study of previous historical money panics:
Economic theory tells us that it is precisely the fickle nature of confidence, including its dependence on the public’s expectation of future events, that makes it so difficult to predict the timing of debt crises. High debt levels lead, in many mathematical economics models, to “multiple equilibria” in which the debt level might be sustained – or might not be. Economists do not have a terribly good idea of what kinds of events shift confidence and of how to concretely assess confidence vulnerability. What one does see, again and again, in the history of financial crises is that when an accident is waiting to happen, it eventually does. When countries become too deeply indebted, they are headed for trouble. When debt-fueled asset price explosions seem too good to be true, they probably are. But the exact timing can be very difficult to guess, and a crisis that seems imminent can sometimes take years to ignite.”
Mauldin examines Greece and comes up with material that is similar to what is found here with one major exception:
“What is the next step? Having lived through the Mexican, Thai, Korean and Argentine crises, it is hard not to distinguish a common pattern. In our view, this means that investors need to confront the fact that we are at an important crossroads for Greece, best symbolized by a simple question: ‘If you were a Greek saver with all of your income in a Greek bank, given what is happening to the debt of your sovereign, would you feel comfortable keeping all of your life savings in your savings institution? Or would you start thinking about opening an account in a foreign bank and/or redeeming your currency in cash?’ The answer to this question will likely direct the next phase of the crisis. If we start to see bank runs in Greece, then investors will have to accept that the crisis has run out of control and that we are facing a far more bearish investment environment. However, if the Greek population does not panic and does not liquefy/transfer its savings, then European policy-makers may still have a chance to find a political solution to this growing problem.
“What could a political solution be? The answer here is simple: there is none. So if Europe wants to save Greece from hitting the wall towards which it is now heading, the European commission, the ECB and/or other institutions (IMF?) will have to bend the rules massively. In turn, this will likely lead to a further collapse in the euro. But for us, an important question is whether it could also lead to a serious political backlash. Indeed, at this stage, elected politicians are likely pondering how much appetite there is amongst their electorate for yet another bailout, and for further expansions in government debt levels. The fact that the intervention would occur on behalf of a foreign country probably makes it all the more unpalatable (it’s one thing to save your domestic banking system … but why save Greece?).”
If Greece is bailed out, Portugal and Ireland will ask “Why not us?” And Spain? Italy? If Greece is allowed to flaunt the rules, what does that say about the future of the euro? Will Germany and France insist on compliance or be willing to kick Greece out?
It’s ‘bailout or die’ time and since the Germans didn’t bail out Greece yesterday, the odds for a more severe dislocation have lengthened just that much more. By this I mean the euro will die. The exception to my own observation is that the key to the Greek situation – and that of the Eurozone as a whole – is petroleum consumption and cost. The cost to Greece for it wasteful petroleum usage does not allow them the flexibility to restructure their (increasing) debt, sovereign and otherwise.
Along with Euro sneering at the USA for its Bernanke- clown show and other follies, is the Euro- sense of superiority for its micro cars and high fuel prices at the gas pump. What the Euros don’t mention is they have a huge number of micro cars and the fuel prices – inflated by taxes – aren’t really all that high. For example: in France the current dollar price per gallon is approximate $7, compared to $2.95 in the US. At the same time, a gallon of hot tea – in 16 oz. increments – at the nearby 7- eleven costs $11.20! A gallon of gasoline that contains over 130,000 btus. of work energy should command a greater price than colored water, don’t you think?
It is this mispricing that is a culprit in the ongoing worldwide deflation. Cheap energy made sense when John D. Rockefeller designed the oil market back at the hind- end of the 19th century, when there were no cars. Now, there are almost a billion motor vehicles. Lacking the common good sense to properly price a valuable resource, the resource is pricing itself and cutting our economic throats in the process. This time IS different!
John Mauldin posts a free weekly macro/trading newsletter that is worth reading. Click here to subscribe: http://www.frontlinethoughts.com/subscribe.asp
Meanwhile, back in China, Andy Xie tells us all this time it’s VERY different. Xie suggests that China inflation is beginning to ramp up.
Being the first to belly up to the bar means I get to drink the lion’s share of the beer. Where were the other finance analysts calling for inflation/hyperinflation in China last year? Where were Roubini, Diamond, Taleb, Krugman, Reich, Pettis, Thoma, Hamilton, Stiglitz … etc. etc?
Where were all the other analysts pointing out the dangers of a dollar/oil peg? Where is Krugman on the new hard dollar? What about Peak Oil having taken place in 1998? Why are economists castigating themselves for missing the Crisis of 2008? What about the crisis that is happening right NOW?
“Who’s buying? Roubini? Where’s my CNBC interview?” Sez Andy Xie @ the New Caixin:
Inflation is playing into the game as well. The 23 percentage point difference between nominal GDP and growth in the money supply M2 last year has stored up a great deal of inflation for the future. The money is temporarily trapped in property and shows up as property inflation, but it is working into inflation through rising distribution costs.
Money supply cannot grow faster than GDP forever. A prolonged gap between the two usually suggests an asset bubble, i.e. excess money supply is piling up in an asset market. But sustained asset inflation inevitably leads to consumer price inflation, either through the wealth effect on consumption or a cost push on the production side.
It’s interesting that made-in-China products are priced higher at Chinese stores than in many other countries. High property costs are probably the most important factor. The same phenomenon occurred in Japan during the 1980s when Japanese goods sold for much more at home than in the United States.
The money supply surge is also working into inflation through expectation. When workers consider wage offers, property prices are probably their most important consideration. Incipient wage inflation could partly be explained by the devaluation effect of property inflation on money.
As far as I can tell, China’s consumer inflation rate is already quite high. India and Russia have stronger currencies than China’s and are experiencing nearly double-digit inflation. However, China’s official statistics still report low inflation. The discrepancy may be due to how inflation is measured.
The monetary surge occurred at a time when the economy is increasingly prone to inflation. Money printing eventually turns into inflation, although the transformation’s speed depends on many factors. The more plentiful the production factors, the longer the lag between money growth and inflation.
Which means the more severe effects of inflation are to come. Keep in mind, the Chinese have a command economy and the government’s prestige is wrapped up in rapid economic growth. A tapering off of growth would probably mean turmoil in the government. The government will both push more stimulus into the body economic but will also push on citizens to buy more stuff. Their GDP figures will look good, but those – like USA GDP figures – are going to be more ‘guesswork’.
Meanwhile, over at Automatic Earth – which is one of those websites listed over on the right – Stoneleigh also tells us how it’s different this time:
Stoneleigh: The headlines will get much worse from here. Negative t-bill rates are coming in a much bigger way, but always less negative than would yield a low real rate of interest, so the liquidity trap persists. Negative t-bill rates will make cash on hand look better than bonds, even of the shortest duration, as cash won’t have a built in depreciation. T-bills will still be a good deal relative to most things, but cash on hand will be better. That will increase the likelihood of cash withdrawals leading to bank runs.
Welcome to the perfect financial stormWhat is coming, I think, is a nominal short term interest rate that is moderately negative – an official Fed rate rather than a market rate as at present (as the Fed follows the market). This means people will be paying to own t-bills, but this will still be one of the best options available for short term capital preservation. The capital will be far less likely to be lost there than in a bank, and the return OF capital is the important thing. Despite a negative nominal rate, the real rate (the nominal rate minus negative inflation) will still be high as deleveraging continues and accelerates.
It won’t be as high as it would have been at a nominal rate of zero, but there would still be a real return on top of greater capital security than most other options. I think a lot of investors will be happy to buy t-bills even where the nominal rate is negative. The US dollar appreciation relative to other currencies will be a significant bonus as well.
Of course cash on hand would be an even better option in terms of return, because that would have a nominal rate higher than zero, and therefore a higher real rate as well. The real rate will apply even outside a bank, reflecting the greater domestic purchasing power of liquidity. It isn’t practical to hold really large sums of money in cash though. The main risk for cash is reissuance of the currency in a different form.
In the US they wouldn’t need to make conversion difficult as they did in Russia, because there’s not that much cash under the nation’s beds (unlike in Russia where there was a chronic mistrust of banks). Requiring people to convert would require them to reveal what they had though, and this would probably result in windfall tax bills (i.e. extortion) for those who had been foresighted.
For T-bills the main risk is that the government could convert short term debt instruments into long term ones, and then default on them later like Argentina did. I think the risk of that for domestic investors is higher than for foreign, as it is foreign bond market participants that the government will not want to rattle, for fear of losing access to international debt financing.
The domestic ones could be strung a line about it being their patriotic duty to invest in their country. I don’t think the risk is high at the moment, which is why I still recommend them for the next couple of years. The risk is non-zero, but lower than for almost anything else in a high risk environment.
Eventually one will want to get into hard assets, even if asset prices still have further to fall. Liquidity can be as hard to hang on to as it sounds, and is therefore not a long term bet. A couple of years should be enough to ride out the worst of an asset price collapse while still being in a relatively low risk position regarding liquidity.
I don’t personally think negative short rates cause problems by themselves – the world as we know it is coming to an end for other reasons than negative rates. The ‘zero bound’ is powerful, not for sentimental reasons. Sweden’s central bank carried a negative rate with no ill effects. Greg Mankiw made a case for negative rates last year. Interpretors of the Taylor Rule suggest a strongly negative rate of perhaps -5%. My own prescription for putting Greece on its feet calls for a local Greek currency based on Euros that is a defacto negative carry currency. Quantitative Easing – which doesn’t work long term – is a form of negative rates. Without QE, Japan would have crashed a decade ago. As the current deleveraging leg takes hold, look for more Fed QE to push rates effectively negative.
Stoneleigh is right about one thing; negative rates are a market phenomenon that reflects the new, super- hard dollar. Liquidity matters and the fact of the rates’ existence right now suggests that the demand for cash dollars is becoming very strong. The ”Niewe Petrodollar’ is the new gold standard! Stoneleigh senses the deflation sure to come.
Considering the increasing real cost of fuel is what is driving the unwinding, paying anything to rent money is a simple tax on productivity: fuel costs being added to money costs. Only ‘super- soft’ money – bearing a negative rate or a cost to hold (hoard) – can make business profitable/competitive as other input costs increase. Since this is not likely to happen – the idea cuts across all that bankers live for – the result is what Stoneleigh describes; a series of outflanking tactics by and between cash arbs.
Cross- trading and speculations between gold and currency traders was a primary propellant of the Great Depression. Maybe it’s different this time …
… or, maybe not.