Recession Knocking at the Door: Part 2

On September 26, 2011, in Economic Commentary, by admin

Nothing has happened to change my mind that “recession is knocking at our door.” While we could say that the directions of the market is path dependent, there is little to suggest that political leaders are prepared to face the tough decisions until we face crisis conditions (at which time they hopefully won’t “let a good crisis go to waste”). Note based on the ECRI Weekly Leading Index that the current negative reading is still above the level it reached during the Double Dip Recession Scare in 2010.

While we averted a Double Dip Recession in 2010 with our remaining fiscal stimulus and the Fed’s Q/E-2, we now have a Fed that is out of major policy bullets, only limited room for fiscal stimulus and Gathering Storms on the International Stage. Crises affecting both European Banks and Sovereign Credits threatens a disorderly crisis in the Euro that makes it much more difficult to accelerate the economy out of its present “stall speed.” To add to the challenges, we now find that China’s attempt to contain their property bubble is beginning to take hold. “Dr. Copper” is warning of a serious Asian slowdown that is further confirmed by collapsing prices for cement and other commodities. Domestic Metallurgical Coal producers are further confirming a softness in steel, another telltale sign of a soft patch that will prove to be the start of a new recession UNLESS policy makers can pull some kind of rabbit out of the proverbial hat!

Real GDP apparently fell in January and February, followed by a weak bounce and renewed weakness this summer. While it has not yet persisted long enough to qualify as a recession, any bounce this quarter will need to be followed by additional growth to avoid the next leg down. The sad thing is that this next recession, whenever it starts, will start from a high level of unemployment that will seriously challenge our own deficit and make it difficult to stimulate out of. An economy that does not respond to 0 to 1% interest rates and does not respond to multi-trillion dollar deficit spending in the face of deflationary excess capacity is an economy that is in a Depression. The exact start of the next recession is academic. Unless the word “depression” is purged from our vocabulary, a three year liquidity trap is depression. Even if we get by with another near miss, the fact that we’ve had two near misses in two years after what is called the Great Recession tells me we are in a Depression, albeit still a Contained Depression. (As in all depressions, some segments of the economy are still doing fine. For example, retail technology as exemplified by Apple Computer which is in the process of trading places with Exxon as the most valuable company in the world). I do find it interesting that fewer people get mad at me when I say we are in a depression than when I said we were entering a depression three to four years ago! This tells me that a psychological depression is beginning to set in which gives me hope that we are moving from the 2nd to the 3rd inning of this slump. Attitudes toward debt will eventually change as it did after the Great Depression***.

While Q/E-1 led to a massive bounce comparable to the recovery in late 1929 to 1930 and Q/E-2 at least helped forestall a Double Dip Recession, Operation Twist may actually do more harm than good as it dampens the rebuilding of bank capital by pressuring banks’ Net Interest Margins while further depletes the income of savers. Meanwhile, reducing mortgage rates by 15 to 25 basis points will do little or nothing to stimulate housing demand that was not already stimulated by 30 year interest rates around 4%. In the words of David Rosenberg, “ the Fed has moved from cannons to shotguns to water pistols.” It will be very interesting to see the next data point on the ECRI Weekly Leading Index tomorrow.

Facing a crisis, the World is retreating to the US Dollar, a store of value that still retains a lingering reputation as a risk free asset. This temporarily stronger dollar will exacerbate weakness in commodities and even exacerbate a temporary weakness in precious metals. But in the end, I’ll bet that the temptation to depress interest rates will lead to further purchases of overvalued bonds and further debase currencies in a worldwide competitive devaluation (i.e. a race to the bottom). To make matters worse, Brazil has just imposed a 30% Tariff on China, a move reminiscent of the infamous Smoot-Hawley tariff imposed by the Emerging USA in 1930. Meanwhile, Europe’s decision to tighten monetary policy as it did just before the 2008 recession has dried up demand for European Sovereign Debt and forced the U.S. Fed to swap Dollars for Euros so that the European Central Bank can funnel dollars to insolvent European Banks and Governments.

From what I can see, this does not end well.****

For now, look at the message from “Dr. Copper” as seen in the stock price of Freeport McMoran (the largest copper producer). In many ways, it looks very much like the ECRI Leading Index. We may bounce here in the short term, but we’ll punch through to new lows UNLESS POLICY MAKERS CAN BREAK THE VICIOUS CYCLE. So far, I don’t see the political will in either Europe or the U.S. “Everyone” says that this is “no Lehman.” My only questions are: what is bigger Greece or Lehman Brothers?…Portugal or Lehman Brothers?…. Spain or Lehman Brothers? …Italy or Lehman Brothers? …European Money Center Banks or Lehman Brothers? …Bank of America or Lehman Brothers?

Just thinking about these rhetorical questions tells me that policy makers will be forced to act; otherwise our post-Lehman Brothers panic will look like a walk in the park. We know the identity of the 2011-vintage Lehman Brothers. We don’t know who the AIG-like counterparties are.

Governments will not allow a cataclysm until all other options have been exhausted. So Germany and the U.S. will eventually have to do the right thing….but not until they’ve exhausted every other alternative (to again use this overused Churchillian phrase)

 

*** A similar phenomenon also occurred after the Panics of 1837, 1873, and 1893. This may have been especially evident after 1893 when inflation brought by the mass coinage of silver (i.e. 19th Century Money Printing) turned the 1870′s deflation to inflation in the 1880′s and eventual crash in 1893 which President Cleveland blamed on the money printing of silver. The Deflation of the 1870s arose out of the post Civil War Railroad build out and Excess Capacity analogous to the Worldwide Excess Capacity we face today. While the frontier opened up by the railroads brought surpluses of goods in the 1800′s, trade, emerging markets and technology provide the transmission of Excess Capacity today.

 

****But I of course want to pay heed to Art Cashin’s famous advice to be careful about predicting the end of the world since the end of the world only happens once! In the end, policy makers will be forced to make tough decisions or at least “kick the can down the road” to buy time to get our fiscal houses in order. Debt can grow a few percentage points a year if GDP eventually grows by a few percentage points plus 1%! What can’t continue won’t. I just don’t believe it’s going to stop before we slip into another recession! This Contained Depression will include at least two (and I’ll bet at least three) recessions punctuated by short recoveries. But in the end, new technologies will lead to the dawn of a New Era, again proving Malthus wrong and proving Schumpeter right! So I remain a long term optimist…


 

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