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Monday July 27, 2009 - 20:50:56 GMT
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Forex Blog - Read All Abut It, Recovery Here.

Read All Abut It, Recovery Here.


In the last week everyone from Nouriel Roubini, to Paul Krugman, to Alan Blinder, to Newsweek Magazine (Daniel Gross) has concluded the recovery is here and it is real, if tepid.  I only mention these names to drive home the point that these prognosticators were among the most negative on the economy early in the crisis.  Ironically the likes of Roubini were championing a current account-led crisis driving a recession, not a speculative bubble bursting in the credit market as late as the summer of 2007, but who cares if it delivers the same result – a recession.  Even Martin Feldstein said the economy is likely to rebound in the second half of 2009, while doubting the sustainability of a recovery with rising unemployment, ill-conceived fiscal stimulus and debt restructuring by households and firms.


What happened?  Well the Fed and Treasury kept the banking system from financial suicide, albeit at a huge economic and social cost (latter more an opportunity cost assuming there is a net loss at the end of the day…thanks to AIG and Bear Stearns mainly).  With the banking system saved from itself, and the official invitation to return to riskier assets with depressed official rates and reflationary monetary and fiscal policies in place, asset prices (as well as commodity prices) have recovered significantly and impressed upon investors, consumers and firms that holding cash balances is a fools game (not sure the final word on this is written). 


But the closer truth to the “recovery” ahead is probably best captured by Blinder last week in the WSJ op-ed where he explained simply how easy it is for an economy to grow when it has been so beaten down like in the US…if we think of growth off a sharply lower base (q/q and q/q annualized), posting positive GDP in the second half of 2009 is relatively easy, especially if one believes that firms will need to restore some inventories after running them down to very low levels on expectations of weak sales, then an inventory jump in output will lend to some q/q growth in Q3 and Q4 all else being equal.  Also housing investment will be less negative and this will lower the bar for positive growth.  Moreover, consumer spending has seen some additional lift from lower withholding taxes for many Americans, cash for clunker subsidies for auto purchases, home buyer tax incentives and a recovery in sentiment (Yale’s Shiller would call this a necessary and nearly sufficient condition…it is all about the mind and the body will follow…). 


Frankly I have no argument against the 2H GDP turning positive.  But what is still very much in play is the shape of the recovery – here there is little consensus (Feldstein is calling a W-shaped recovery, Krugman a U-shaped recovery with risk of W-recovery and Roubini is in the L-shaped recovery camp).   Even Bernanke is tamping down expectations of a more robust recovery (not ruling out, but not likely). 


So why are so many like me thinking the economy has all the get up and go as a lame race horse?  Well take the recovery in housing.  I believe in the saying all real estate is local…I don’t know anyone who has sold a home much less bought one in the last 18 months.  The home sales data seems to be capturing a market clearing effect for low-end homes not high-end homes as first time buyers and some speculators gobble up foreclosed and short sale properties, especially in May and June when financing costs troughed.  But higher end homes are not moving and there is a heck of a lot of adjustment ahead in this market before I can believe that the housing sector has bottomed.  Rental markets in Manhattan and San Francisco have been through seismic shifts in the last 6 months and can property prices be that far behind?  I think real estate has a large aftershock ahead and it is in high-end markets…will impact banks write downs on non-conforming jumbo (prime) loans. 


Commercial real estate is also under huge downward pressure –much of it is revolving short-term borrowing that drives financing for development and these loans are coming due big time in the next four quarters…will banks roll these lines/loans?  Fed is frantically starting up a CMBS TALF facility to allow banks loans to get securitized and achieve the risk spreading function this market so needs (not sure how much risk is spread if the securities all end up held by the Fed as collateral on loans). 


Consumer credit card losses are running at elevated rates as the unemployment rate keeps rising.  This part of the story is probably best known – most of us know people out of work…and those with savings (unfortunately 401K’s are the new supplementary unemployment insurance fund for many white collar unemployed workers and their families) are at risk of running through the ability to avoid default or bankruptcy if unemployment period is lengthy (something continuing claims says is happening – last few weeks may be too distorted by seasonals to read much into decline in continuing claims).


Frankly I don’t see how banks so needed in credit creation (money multiplier) can really support a higher or even positive growth rate ahead if still risk averse, a number with US government stakes depressing risk taking and facing significant new write downs. 


The one upside for growth ahead is a weak US dollar. But, if trade is declining a record 10% (import plus exports) this year according to WTO estimates, I just don’t see how US exports will fill a massive void left by a sharp rise in domestic savings.  Not even a China on fiscal steroids is going to tap global markets for exports beyond a few quarters before this model breaks down (bubbles forming now in real estate and equity prices in China).  China has not decoupled from an export-led economy and it will take a decade at least to shift to more balanced economy with sustainable domestic consumption.  Is Europe and Japan the ticket to US-export driven growth?  Is Latin America?  Think no and no.


Beyond a few quarters of a base-effect, inventory-led bounce in GDP, I can’t see much upside for growth ahead.  But even more optimistic forecasts are really quite sanguine like Bernanke and the Fed’s. So that brings me back to the notion that stocks reflect some PDV of future earnings and I simply don’t see where earnings come from once the cost cutting-led earnings of Q2 are exhausted. 


If I had to bet on the shape of a recovery it would be a small cap “w” as opposed to a large cap “W” shaped recovery (an end to negative GDP), while feeling like an “L” shaped recovery.  And the longer it feels “l” shaped the longer the economic anemia lasts if Shiller’s behavioral approach holds water which I believe it does, at least in the short- and medium term.


So stocks are closer to a top (see peak in late summer), bond yields have more to worry from supply than the real economy – some upside still, and the dollar is vulnerable as the markets are likely to price in an extended period of malaise for the US economy which leaves a highly indebted US economy more at risk than say an extended period of malaise globally. 


Moreover, markets are likely to face a period in the near-term where recovery bets get more fully priced into asset markets and this means decent near-term upside risk in bond yields and equity prices while the USD is likely to trade inversely to stocks on the risk aversion theme (lower risk aversion lower dollar, higher risk currencies).  And even when the market breaks with risk pricing for FX, I expect to see the race across the rate hike line as a new theme driving FX in the near- to medium-term and this does not favor the USD…recall Bernanke’s pledge to hold rates low for an extended period last week (don’t look to Plosser for a read on when the Fed may hike rates).


David Gilmore




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