From cautious optimism to caution

It is beginning to look like the economy is circling the drain. To be sure, I hate to make too much of one report, but the May employment report comes at the end of a series of bad reports stretching back to nearly the beginning of the year. There looked to be solid hope the recovery was on a better track as 2010 drew to a close, and that momentum appeared to carry through into January. But then we hit a wall.

What wall? Theories abound. Temporary weather and tsnumai induced disruptions for one, but we should be trying to look through such short term events. The crisis in Europe, although to be honest I don’t think this is having much of an impact on the decision making of the average US citizen or firm. I tend to think the rise in commodity prices, particularly oil, was the primary culprit, as consumer spending faltered and businesses struggle to pass increasing costs onto consumers. But what it really comes down to is that we have only had one good quarter in this recovery, and that simply was not enough to provide sufficient resilience to the sheer number of shocks the economy has weathered this year.

Tim Duy, Fed Watch

I agree with this characterization of events. I was cautiously optimistic about 2011 as the year began. But the economic data have been weak. I see a global growth slowdown happening, not just a US slowdown. In China, for example, we could see a hard landing, meaning growth slows considerably as tightening takes a toll on the economy via credit writedowns and non-performing loans.

Now, in April, I was saying this:

This [cautiously optimistic] base case is still operative but many of the downside risks are starting to become evident. When I wrote, "I expect this to continue through at least the first half of 2011, probably through the whole year," what I meant is that the cyclical recovery will see us through at least the first half of the year. However, I felt that starting in the second half, you will see problems from cuts in federal as well as state and local government. Monetary policy will also be less accommodative as well.

The question then was about exogenous shocks. I listed four in addition to the municipal problem:

  • European debt crisis
  • Housing
  • Currency Wars
  • Commodity prices

In Europe, the debt crisis has claimed Portugal as expected. Spain has decoupled thus far. In the U.S., the housing double dip has resumed. On the currency front, the US dollar is falling quite fast right now. Is this a good thing or a bad thing – I don’t know? My sense is that it could precipitate more currency war problems. Finally, there are rising commodity prices. It’s not clear to me that they will continue to rise. But, at a minimum the prospect of demand destruction is there, even without a further rise in prices. The other exogenous events were in Japan and the Middle East. Overall, I would say that the exogenous shocks have added to downside risk. I would expect economic weakness in the second half of 2011.

If economic weakness does materialize in the US, I would expect lower long-term interest rates. Many are predicting QE2 will lead to higher rates. But why would that be the case in an environment of economic weakness in which risk assets could sell off? Watch the ECRI index for signs that the economy is weakening.

Just a few comments on this. I think this analysis was spot on. The ECRI is slumping. Economic weakness is fully manifest in the data. So risk assets are selling off and rates are lower despite the Chinese dumping T-bills. It’s about inflation and rate expectations, folks, not bond vigilantes. Like Tim Duy, I think demand destruction is a key to why thing are going pear-shaped right now. But I also think the policy response will be weak. As I implied in April, QE3 is not on the horizon; Comstock Partners have it right when they say QE3 will only become a reality after the economy deteriorates (not that QE is good policy anyway). More to the point, austerity is more likely than ever in the US.

So tell me why this is the headline from Bloomberg on commodities: Funds Boost Bullish Commodity Bets Amid Improving Global Growth Prospects?

The Standard & Poor’s GSCI Spot Index rose for a fourth straight week as Chinese metal inventories plunged and droughts lingered in the Asian country and Europe, trimming prospects for wheat and cotton crops. The global recovery “is gaining strength,” the Group of Eight leaders said May 27 after a summit in Deauville, France. In the U.S., consumer sentiment rose to a three-month high in May, a private report showed last month.

“We are seeing a reasonable rate of growth in worldwide economic activity,” said Michael Cuggino, who helps manage $12 billion at Permanent Portfolio Funds in San Francisco. “The supply-demand associated with that growth, combined with a weaker dollar, probably explains the move into commodities.

This sounds like pure confabulation. I am more cautious than optimistic on risk assets and the global economy. From where I sit global growth prospects are not improving; they are weakening.

15 Comments
  1. Sharon Choe says

    Agree Ed!

  2. Edward Harrison says

    Sharon, I wish it were otherwise. But the data have been bad. The most worrying thing is the jobs situation.

  3. Sharon Choe says

    Yes, not good. Hence, the silver lining being the ability to hedge. We must therefore EMBRACE THE VOL! :D

  4. Richard Rosso says

    Ed has it correct.

  5. DavidLazarusUK says

    You are far more optimistic than I am. I still think that we are in the initial downswing which has only been extended by all the extend and pretend and QE. The stock markets are still grossly overvalued, as are property and commodities. US property has resumed is collapse as has commodities. 

    I suspect that Australian housing is about to slump and that will devastate the Aussie banks, who have borrowed heavily on the interbank markets. The lingering destruction of Greece by the banks will have repercussions. The banks are still very weak yet politicians have crippled economies to bail out bankers.  With so many governments now planning on austerity to get themselves out of trouble the lunatics are now running the asylums. 

    The depression has not been averted simply delayed with the trillions of dollars squandered to protect the banks. The real lesson of the New Deal has been forgotten and I suspect that there will be a major change in US and european policy before the decade is out. 

    I never thought that this would be a decade of recovery. It was always going to be a stagnant decade as the debt burden held back consumers and small businesses. The decades of de regulation will now mean decades of crises until major reforms are implemented. In fact they are not even being discussed. So I expect a deeper depression because of the lack of a credible policy. 

    There are two plusses though. One is that significantly lower asset prices will lower the costs of new entrants to markets, and that new entrants are generally job creators. Though asset prices are not at a level to stimulate demand. The longer governments intervene to maintain bubbles the longer the pain will be.

    1. Edward Harrison says

      Perhaps I am more optimistic than you here, David. But I have always felt that policy accommodation could attenuate the downturn, without preventing follow-on downturns.  Here’s a blog entry from MarketBeat that gets at the view I hold as well:

      http://blogs.wsj.com/marketbeat/2011/06/06/five-out-of-five-pessimists-agree-qe3-is-coming/

      These guys expect QE3 (only after weakness becomes serious), but they expect it already some time this year. And they anticipate that it will lift asset prices yet again. I am not quite that optimistic yet. First, let’s watch this rough patch and where it heads, in the US and elsewhere.

      1. DavidLazarusUK says

        QE 3 is highly likely. I will agree with you on that. My concerns are where the extra liquidity will flow to? If it flows to commodities again everyone will know what it is doing. Economies are already slowing down from the commodity prices out there before QE3 inflates them further. I am wondering what concerns they have about asset prices? High property prices keep millions in poverty. Lower property prices will force them to default. But it releases their cash flow for consumption. Ultimately all these policies do is delay restructuring. It is Japan all over again. So that is why I think we will have a decade of pain. 

        This only seems to work for a short while. So what will happen in five years time with QE 7? What will the impact be on the Fed’s balance sheet? What is the exit strategy? Ultimately the problem is that assets are overvalued.  

    2. peter says

      David, if you believe that major change in US policy will come in the form of increased police state repression of the populace in response to dire economic conditions resulting in social and political disorder, then I believe you.  However, if you believe that policy change will come in the form of policy choices geared to the economic uplift of main street americans, then I greatly disagree with you for as long as the corporatists have a vulcan death grip on the policy making elites in Washington, this change that we thought we could believe in will never come to pass.

      1. DavidLazarusUK says

        The lesson from the last Depression was that when people have no stake in society they become a threat to society. It was the fear of a marxist uprising that led to the creation of federal housing programs. Now these are being destroyed by the banks, who want those profits. With more people giving up on the idea of home ownership they have a lot less to lose from a revolution. It will not necessarily be marxist or socialist but something new will take its place. It might take many years but I think that an American Spring along the lines of those in north Africa this year is increasingly likely. Though until then how large a share of its population can the US lock up to maintain order is another question. 

  6. Anonymous says

    You are far more optimistic than I am. I still think that we are in the initial downswing which has only been extended by all the extend and pretend and QE. The stock markets are still grossly overvalued, as are property and commodities. US property has resumed is collapse as has commodities. 

    I suspect that Australian housing is about to slump and that will devastate the Aussie banks, who have borrowed heavily on the interbank markets. The lingering destruction of Greece by the banks will have repercussions. The banks are still very weak yet politicians have crippled economies to bail out bankers.  With so many governments now planning on austerity to get themselves out of trouble the lunatics are now running the asylums. 

    The depression has not been averted simply delayed with the trillions of dollars squandered to protect the banks. The real lesson of the New Deal has been forgotten and I suspect that there will be a major change in US and european policy before the decade is out. 

    I never thought that this would be a decade of recovery. It was always going to be a stagnant decade as the debt burden held back consumers and small businesses. The decades of de regulation will now mean decades of crises until major reforms are implemented. In fact they are not even being discussed. So I expect a deeper depression because of the lack of a credible policy. 

    There are two plusses though. One is that significantly lower asset prices will lower the costs of new entrants to markets, and that new entrants are generally job creators. Though asset prices are not at a level to stimulate demand. The longer governments intervene to maintain bubbles the longer the pain will be.

    1. Edward Harrison says

      Perhaps I am more optimistic than you here, David. But I have always felt that policy accommodation could attenuate the downturn, without preventing follow-on downturns.  Here’s a blog entry from MarketBeat that gets at the view I hold as well:

      http://blogs.wsj.com/marketbeat/2011/06/06/five-out-of-five-pessimists-agree-qe3-is-coming/

      These guys expect QE3 (only after weakness becomes serious), but they expect it already some time this year. And they anticipate that it will lift asset prices yet again. I am not quite that optimistic yet. First, let’s watch this rough patch and where it heads, in the US and elsewhere.

      1. Anonymous says

        QE 3 is highly likely. I will agree with you on that. My concerns are where the extra liquidity will flow to? If it flows to commodities again everyone will know what it is doing. Economies are already slowing down from the commodity prices out there before QE3 inflates them further. I am wondering what concerns they have about asset prices? High property prices keep millions in poverty. Lower property prices will force them to default. But it releases their cash flow for consumption. Ultimately all these policies do is delay restructuring. It is Japan all over again. So that is why I think we will have a decade of pain. 

        This only seems to work for a short while. So what will happen in five years time with QE 7? What will the impact be on the Fed’s balance sheet? What is the exit strategy? Ultimately the problem is that assets are overvalued.  

    2. peter says

      David, if you believe that major change in US policy will come in the form of increased police state repression of the populace in response to dire economic conditions resulting in social and political disorder, then I believe you.  However, if you believe that policy change will come in the form of policy choices geared to the economic uplift of main street americans, then I greatly disagree with you for as long as the corporatists have a vulcan death grip on the policy making elites in Washington, this change that we thought we could believe in will never come to pass.

      1. Anonymous says

        The lesson from the last Depression was that when people have no stake in society they become a threat to society. It was the fear of a marxist uprising that led to the creation of federal housing programs. Now these are being destroyed by the banks, who want those profits. With more people giving up on the idea of home ownership they have a lot less to lose from a revolution. It will not necessarily be marxist or socialist but something new will take its place. It might take many years but I think that an American Spring along the lines of those in north Africa this year is increasingly likely. Though until then how large a share of its population can the US lock up to maintain order is another question. The worse thing is that it is completely avoidable.

  7. Positroll says

    “But the economic data have been weak”

    Maybe you are concentrating too much on the US and China?

    Lets start with the biggest economy in the world, Europe (EEA ≈ USA + China)
    – in Q1, the Eurozone grew by 4 % (annualized)
    – Retail sales in the Eurozone rose more than expected in April, despite the debt crisis and an interest rate rise. http://www.bbc.co.uk/news/business-13678453
    – German manufacturing orders grew more than expected in April http://www.bloomberg.com/news/2011-06-07/german-manufacturing-orders-rebound-in-april-on-investment-goods.html

    Then let’s look at the remainder of the BRIC’s:
    – Brazil’s economy continued to expand by 4,2% in Q1 2011, fueled by record-low unemployment and higher wages that allowed families to boost spending. Brazil’s economy should decelerate (slightly) in the last two quarters of the year, ending 2011 with GDP growth of 3.9%,  http://online.wsj.com/article/SB10001424052702303745304576363382440798462.html
    – The EU Commision increased it’s expectations for Russia’s GDP growth for 2011 to 4,5% (from 3,8% earlier) http://de.rian.ru/business/20110513/259113432.html  . The number of new car permissions in Russia climbed by 75% (!!!) in Q1 / 2011 http://bazonline.ch/wirtschaft/agenturen-ticker/VW-setzt-auf-dem-Weg-an-die-Weltspitze-auf-Russland/story/19822189
    – the Indian economy may grow 8.5% in FY12 http://www.indiainfoline.com/Markets/News/Indian-economy-may-grow-8.5-percent-in-FY12-Dr.-C.-Rangarajan/5169434116

    Turkey will slow a little but still grow at a respectable 6,5%. http://www.businessweek.com/news/2011-05-25/turkey-current-account-gap-forecast-at-8-7-percent-of-gdp.html . South Korea grew 1,4 quarter on quarter in Q1 (that’s >5,6% annualized), http://www.businessweek.com/news/2011-06-05/s-korea-to-decide-rates-release-revised-gdp-data-week-ahead.html And Indonesia’s central bank governor Darmin Nasution said on Wednesday that full year economic growth could reach between 6.5 to 7%, that’s up from earlier predictions of 6% http://uk.reuters.com/article/2011/05/11/indonesia-economy-growth-idUKJKF00257620110511  Some observers even think 8% is possible, http://www.indonesianstockmarket.com/idx/indonesia-a-demographic-sweet-spot/
     
    Yes, there are some downers, too (Japan, Mexico come to mind), but it’s not all bad …
     
     

    1. DavidLazarusUK says

      I think that the world economy is fine overall. There may be problems in the west but Latin America, Asia and Africa are still doing well. Though the increase in oil prices might slow the world economy but not enough to cause problems overall. Europe and the US will be derailed by a series of defaults in Greece and Ireland. The only problem is that will our governments be stupid and bail out the banks again?

      1. Edward Harrison says

        Agreed, this is a case of two speeds, the west and everybody else. Remember, even if China slows considerably, it will still be growing faster than Europe or North America. In Europe, the problems in the periphery and the UK will drag down the whole lot and growth will slow even in Germany and Sweden.

        The wild cards for the next three to ix months are China and EM policy response, commodities. Most of the risk right now is to the downside because of inflation in EM and debt in developed economies.

        1. Positroll says

          “the problems in the periphery and the UK will drag down the whole lot and growth will slow even in Germany and Sweden.”
          I tend to disagree. The GDP of Ireland, Portugal and Greece combined is just the size of the Netherlands, which are doing fine. With Spain and Italy more or less flatlining this year, the success of the German economy by and large depends on continued exports to the BRICs + other emerging countries. As I showed above, the picture is far from dark in this respect. The only real danger I can see there is China – but even that has a silver lining: There is a good chance that sooner or later China will have to either increase internal consumption or (/and) let its currency appreciate to avoid commodity induced inflation getting out of hand. Both will be a positive for German exporters: either they get more sales of German cars, household appliances etc in China, or they will pick up market share world wide due to Chinese exports becoming more expensive.
          Good business for German exporters in turn helps the Netherlands, Austria, Czech Republic, Slovakia and Poland who all are part of the German production chain. France + Norway are doing fine on their own. Sweden will profit from the fact that the Baltic countries (finally) have started growing again (and Russia remains growing).
          So yes, there is a faultline, but it’s not as neatly divided by west-east as you make it sound.

          P.S. For a modern social-democratic country with a stable population like Germany, GDP growth of e.g. 2,5% is perfectly fine (I expect 3% + for this year, but that’s just my gut speaking). Of course, if a country chooses to allow immigration at a level that pushes poulation growth to 1% (like the US), you need an additional 1% point of GDP growth to make up for that on a GDP / capita level. And things get worse as 1/4 of this growth is channelled to the wealthiest 1% of the US population – because it means that for the remaining 99% of the population only 3/4 of the increase remain),

          1. Edward Harrison says

            We will have to see. Certainly today’s decline in industrial production in Germany is the sort of weakness I expect to see more of going forward.

    2. Edward Harrison says

      Positroll, you also may want to look at this post:

      https://pro.creditwritedowns.com/2011/05/global-growth-slowdown.html

      It is unlikely that Germany and Sweden will not be affected by a global phenomenon. Austerity in the west, debt overhangs in the periphery and monetary tightening in Emerging markets will act to slow demand globally. And this will certainly impact Germany.

  8. Positroll says

    “But the economic data have been weak”

    Maybe you are concentrating too much on the US and China?

    Lets start with the biggest economy in the world, Europe (EEA ≈ USA + China)
    – in Q1, the Eurozone grew by 4 % (annualized)
    – Retail sales in the Eurozone rose more than expected in April, despite the debt crisis and an interest rate rise. http://www.bbc.co.uk/news/business-13678453
    – German manufacturing orders grew more than expected in April http://www.bloomberg.com/news/2011-06-07/german-manufacturing-orders-rebound-in-april-on-investment-goods.html

    Then let’s look at the remainder of the BRIC’s:
    – Brazil’s economy continued to expand by 4,2% in Q1 2011, fueled by record-low unemployment and higher wages that allowed families to boost spending. Brazil’s economy should decelerate (slightly) in the last two quarters of the year, ending 2011 with GDP growth of 3.9%,  http://online.wsj.com/article/SB10001424052702303745304576363382440798462.html
    – The EU Commision increased it’s expectations for Russia’s GDP growth for 2011 to 4,5% (from 3,8% earlier) http://de.rian.ru/business/20110513/259113432.html  . The number of new car permissions in Russia climbed by 75% (!!!) in Q1 / 2011 http://bazonline.ch/wirtschaft/agenturen-ticker/VW-setzt-auf-dem-Weg-an-die-Weltspitze-auf-Russland/story/19822189
    – the Indian economy may grow 8.5% in FY12 http://www.indiainfoline.com/Markets/News/Indian-economy-may-grow-8.5-percent-in-FY12-Dr.-C.-Rangarajan/5169434116

    Turkey will slow a little but still grow at a respectable 6,5%. http://www.businessweek.com/news/2011-05-25/turkey-current-account-gap-forecast-at-8-7-percent-of-gdp.html . South Korea grew 1,4 quarter on quarter in Q1 (that’s >5,6% annualized), http://www.businessweek.com/news/2011-06-05/s-korea-to-decide-rates-release-revised-gdp-data-week-ahead.html And Indonesia’s central bank governor Darmin Nasution said on Wednesday that full year economic growth could reach between 6.5 to 7%, that’s up from earlier predictions of 6% http://uk.reuters.com/article/2011/05/11/indonesia-economy-growth-idUKJKF00257620110511  Some observers even think 8% is possible, http://www.indonesianstockmarket.com/idx/indonesia-a-demographic-sweet-spot/
     
    Yes, there are some downers, too (Japan, Mexico come to mind), but it’s not all bad …
     
     

    1. Anonymous says

      I think that the world economy is fine overall. There may be problems in the west but Latin America, Asia and Africa are still doing well. Though the increase in oil prices might slow the world economy but not enough to cause problems overall. Europe and the US will be derailed by a series of defaults in Greece and Ireland. The only problem is that will our governments be stupid and bail out the banks again?

      1. Edward Harrison says

        Agreed, this is a case of two speeds, the west and everybody else. Remember, even if China slows considerably, it will still be growing faster than Europe or North America. In Europe, the problems in the periphery and the UK will drag down the whole lot and growth will slow even in Germany and Sweden.

        The wild cards for the next three to ix months are China and EM policy response, commodities. Most of the risk right now is to the downside because of inflation in EM and debt in developed economies.

        1. Positroll says

          “the problems in the periphery and the UK will drag down the whole lot and growth will slow even in Germany and Sweden.”
          I tend to disagree. The GDP of Ireland, Portugal and Greece combined is just the size of the Netherlands, which are doing fine. With Spain and Italy more or less flatlining this year, the success of the German economy by and large depends on continued exports to the BRICs + other emerging countries. As I showed above, the picture is far from dark in this respect. The only real danger I can see there is China – but even that has a silver lining: There is a good chance that sooner or later China will have to either increase internal consumption or (/and) let its currency appreciate to avoid commodity induced inflation getting out of hand. Both will be a positive for German exporters: either they get more sales of German cars, household appliances etc in China, or they will pick up market share world wide due to Chinese exports becoming more expensive.
          Good business for German exporters in turn helps the Netherlands, Austria, Czech Republic, Slovakia and Poland who all are part of the German production chain. France + Norway are doing fine on their own. Sweden will profit from the fact that the Baltic countries (finally) have started growing again (and Russia remains growing).
          So yes, there is a faultline, but it’s not as neatly divided by west-east as you make it sound.

          P.S. For a modern social-democratic country with a stable population like Germany, GDP growth of e.g. 2,5% is perfectly fine (I expect 3% + for this year, but that’s just my gut speaking). Of course, if a country chooses to allow immigration at a level that pushes poulation growth to 1% (like the US), you need an additional 1% point of GDP growth to make up for that on a GDP / capita level. And things get worse as 1/4 of this growth is channelled to the wealthiest 1% of the US population – because it means that for the remaining 99% of the population only 3/4 of the increase remain),

          1. Edward Harrison says

            We will have to see. Certainly today’s decline in industrial production in Germany is the sort of weakness I expect to see more of going forward.

    2. Edward Harrison says

      Positroll, you also may want to look at this post:

      https://pro.creditwritedowns.com/2011/05/global-growth-slowdown.html

      It is unlikely that Germany and Sweden will not be affected by a global phenomenon. Austerity in the west, debt overhangs in the periphery and monetary tightening in Emerging markets will act to slow demand globally. And this will certainly impact Germany.

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