Half-term ponderings – Random Macro Thoughts

It is a mark of how quickly uncertainty has returned to one’s thoughts that in looking through my notes I was convinced that claims of the economy reaching its fabled ‘escape velocity’ were made last year.  They were, of course, not.  Instead Larry Summers’ April confidence marked the peak of the positive economic data, which has become increasingly questionable over recent months.  The question that thus stands before us today is whether recent weakening data simply illustrates a mere soft patch as the economy (and its participants) digests the sharp changes of recent years before self-sustainable growth is resumed, or if now that the sugar-high of government support is waning we are merely seeing the underlying weakness that was ever present beneath it.

As we are currently in the eye of the storm the data is not conclusive in either direction.  As such, much of the debate raging amongst those in the financial world is more ideological and belief-orientated in nature.  On the one-hand, those who believe that this is a run-of-the mill recession, and can be modeled as such, can point to numerous historical examples of soft patches that have proven non-fatal.  Their point is well-founded; most of us (especially in the US, and Western Europe) have never experienced anything bar a run-of-the mill recession, so why should this time be different?  On the other-hand, for those who see this as a credit crisis, whose primary underlying cause (too much debt) hasn’t been attacked and fear the debt-driven deflation as it is reduced, largely see the current weakness as a come-down from the sugar-high of QE and Stimulus-driven GDP.  Their argument is that no, this time is not different and implementing Japan-esque policies, albeit in much larger size, will not produce a different end result.  Some might even say it is insanity.

However, only data and time will provide the answer to this debate, though as a tangent it seems quite possible that we will fail to draw the right conclusions; when one is only left with bad choices, the temptation is to blame the last of those ill-fated choices rather than appreciating the underlying problem that led us down the path.  This is apparent from the rhymes of history; after all, no lesser lights than Fed Chair Ben Bernanke and Milton Friedman have noted that the Fed’s raising of rates in 1932 was cause for the economy falling back into recession.  Or that the leading expert on Japan’s lost decade(s), Richard Koo, blames Japan’s relapses on the various moments when the government tried fiscal reforms (and reduced Quantitative Easing).  Sadly, I fear both are arguing over the footnotes of history; is the real sin the normalization of policy or the implementation of the “extraordinary” policy in the first place? 
Perhaps the prevalence of economic weakness across many countries means that the modern-day Austerians will have greater luck than those in the past as those countries that stick with the program emerge solvent and in better shape.

The underlying problem is, of course, the level of debt, which is a cultural phenomenon of Anglo-Saxon capitalism (in particular) with debt being something we’ve quite mastered creating and disbursing be it through securitization, collateralization or just your plain old leveraged financing.  For those who balk at the word cultural, consider the following true tale. Mrs OM’s insistence on fulfilling the American dream of homeownership means that we have a nice little mortgage, for which we receive a tax break on the interest payments.  However, our small savings (bar this portfolio) sit in the bank accruing interest but we’re not rewarded by the government for this and instead watch some of the interest generated head over to the taxman.  Given these simple government incentives, is it thus any kind of surprise that Americans (and Brits, amongst others) have a proclivity to take out too much debt and buy shiny new things with it, along with an aversion to saving?  The same incentive structure holds true for corporations, except that their executives have even greater personal incentives to use debt rather than the equity they’re paid in.  What’s more, if it all goes wrong…that’s ok, because you get a bail out (if you have the right friends) or a mortgage modification (meaning you pay less that your neighbor who didn’t show such poor judgment of their finances) or some other juicy offering from the powers that be.  In the absence of a firm willingness to subject debtors to the creative destruction of the bankruptcy process, especially when it’s felt that it may be a systemic issue, shouldn’t the incentive structures be set such that the level of debt is never a structural issue and one is encouraged to save.  But I digress…

Those that venture here often know that my opinion has long-been that this is credit crisis (see Plight of the Consumer and Commercial Lending) and so I fear now for the economy as the sugar-high subsides, with the Fed’s efforts having failed to spur any revival in bank lending.  If one could only pick one graph, to suggest why this is your normal recovery…the weakness of real final sales, as shown compared to the 80’s recovery below, would be it.

Last month’s Chartology showed the signs of the leading indicators (including two of my favourites in ECRI and Consumer Metics) declining along with both M2 and M3 (which is declining at the fastest pace since the Great Depression), and these trends have continued with a number of coincident indicators (including my favourite, the ADS) threatening to roll-over.  The data in the remainder of the year will be important and likely unpredictable on a short-term basis.  While I will touch on the portfolio’s positioning and my thoughts on it in the coming days, it’s fair to say that from a macro perspective I worry about a second pre-emptive QE from the Fed.  Should it happen, it’s likely to be a rough time for the book though perhaps fortune will smile on us and the Fed will buy long-end Treasury bonds…