After having suffered the worst May since 1940 (Dow), equities have continued their sell-off into early June, amidst concerns about spreading European debt crisis, Chinese tightening and fading US recovery. The rally off the March 2009 lows was driven by liquidity, stimulus and improving economic and earnings data, particularly in the US. Now that government stimulus starts to taper off the question is whether economic growth has become self sustaining or not.

A natural slowing in the second half of the year has been expected. However, concerns about a double dip recession now appear to be growing, given the sovereign debt crisis and contagion risks in the eurozone and Europe’s impact on the global economy as countries start implementing austerity measures. Add concerns about Chinese tightening to cool an overheating economy and rampant real estate speculation, plus a weakening recovery in the US… the picture is not pretty.

In the US leading economic indicators have started turning over. The Economic Cycle Research Institute’s (ECRI) Weekly Leading Index has gone negative for the first time in over a year, falling to 123.2 from 124 the week before – the lowest level since July 2009. The ECRI WLI has historically been a good predictor of US economic activity, so its downturn is pointing toward a significant slowing in economic growth in the coming months. The Conference Board’s LEI for the US peaked in March.

China has taken steps to cool growth. China’s LEI (leading economic index) peaked last fall, Chinese PMIs are weakening and property market activity has been declining in response to the authorities’ measures to curb speculation. The worry is how much the world’s growth engine will now slow down; so far the economy remains very resilient (exports jumped 48.5% in May). However, the Shanghai Composite index is off nearly 30%, indicating weaker global growth prospects.

May saw the largest slump in commodity prices since Lehman’s collapse, pointing to potentially disappointing global economic growth. The Journal of Commerce Industrial Price Commodity Smoothed Price Index plunged 57% last month, the most since October 2008. Copper price broke down to a new 7-month low, before a bounce this week.

For now the global business cycle expansion appears intact but growth is starting to soften. A mid-cycle slowdown is not so unusual; however, it’s not immediately clear whether we should expect a normal moderation or indeed a double dip recession.

According to the yield curve a recession is not likely. Having correctly called past recessions when it inverted (short rates higher than long rates), the yield curve presently sees the risk of a recession in the next 12 months or so as near zero.

Buy on dips? Maybe not this time …

So, has the recent panic in the financial markets been overdone? The global economy and financial system are still fragile and vulnerable to further shocks, and confidence is fast evaporating. This is no time for complacency – things could get very ugly very fast.

On top of everything else, policy shock (including US financial regulatory reform outcome) is an additional risk investors have to consider. As is often the case, the authorities have been adding to the uncertainty by increasingly erratic moves (chaotic ECB actions, Germany’s ban of naked short selling of some financial stocks and eurozone sovereign bonds and CDS – likely to be further extended, etc). Such actions are counterproductive; they only heighten volatility, increasing the cost of capital and reducing liquidity.

May proved catastrophic for most assets, including equities, commodities (except gold), the euro. The winners have been the US dollar and Treasuries, reflecting a flight to safety as well as a symptom of a deflationary trend. (Money supply is falling at a pace not seen since the early 1930s!)

Markets went into June very oversold, so the relief rally currently underway was expected, and indeed could last a little longer. However it is unlikely to be more than a short term bounce. The S&P has now closed below its 200 day moving average for 16 consecutive sessions – a clear sign of trend change. Although we can’t yet be 100% certain that this is indeed something far more worrisome than a standard correction, there are signs that the trend has turned negative. Until there is more clarity it may be wise not to buy this market – you will likely be able to pick up most assets at much lower valuations late in the year.

It is true that the market has already priced in plenty of bad news – assuming the global recovery remains intact and there is no contagion from Europe; however, that scenario is increasingly looking too optimistic. Considered there is still a great deal of complacency, the bulls could be in for a nasty shock in the coming weeks and months.

Credit crunch is back!

Furthermore, there is good reason to believe this sell-off is different from the previous ones we have seen since March 2009 – the action in the credit markets. We have not witnessed significant deterioration and widening of credit spreads since the start of the rally – until several weeks ago. This is a fundamental change and a sign that the credit crisis is returning.

Credit is the early warning sign; equities lag deterioration in credit conditions. Decline in commodity and equity prices, and ultimately in economic growth, are a result of weakness in the credit markets. It would be foolish to overlook that the current correction has indeed a differentiating characteristics to it; do pay attention to the funding markets.

The European sovereign debt crisis is not going anywhere, and global credit conditions have been worsening. Cost of credit is rising and credit availability declining, which is affecting the funding needs of corporations worldwide. The economic fallout is only just starting to become apparent.

And it’s not only Europe. Higher cost of capital is also noticeable in the US and emerging markets where corporate debt spreads have been rising and debt issuance slowing. Funding markets are seizing up and capital is becoming more expensive, a consequence of which will be a squeeze in profits and slowdown in global growth.

Credit clearly continues to point to further stress ahead. Some disturbing signs that we may be witnessing the beginning of credit crisis 2.0:

Widening eurozone government bond spreads: yield spreads between German bunds and Club Med bonds have resumed their widening trend in recent weeks and in some cases became wider than before Europe’s mega bailout package was announced (although they tightened somewhat this week). And it’s not just the PIGS’s creditworthiness that has been deteriorating; we have seen huge spikes in CDS spreads on Eastern European sovereign debt and even that of France, Austria, UK and Germany over the last month.

European bank CDS have surged, indicating rising stress in the banking system, loss of confidence and growing risk aversion. It means sharply higher borrowing costs for banks. (European banks have raised less from the capital markets in the past six weeks than in any year since 1995.) Some smaller banks have been reported to be completely shut out of the credit markets. Even more troubling is that some of the world’s largest banks in Spain, Germany and France are now becoming infected. The Markit iTraxx Financial Index of CDS on 25 European banks and insurers soared to the highest level since March 2009 (before improving somewhat this week).

The LIBOR-OIS spread has widened significantly in recent weeks (now standing at 32.4bps). Equally, the TED spread has been deteriorating and is now at 47, up more than 300% in the last three months.

LIBOR-OIS and TED reflect the health of (and perceived credit risk in) the interbank lending markets. They are gauges of financial strength or weakness of banks. A rising spread shows that banks are unsure of the creditworthiness of other banks, hence charging higher interest rates to compensate for greater risk. Due to the European debt crisis counterparty risk is increasing and banks are reluctant to lend to each other once again.

Eurozone banks have been parking record sums in the European Central Bank’s deposit facility. Use of the facility, which pays an interest rate of just 0.25%, reached a new high of 364.6 billion euros (higher level than after the Lehman collapse) – a further sign that banks don’t trust each other’s creditworthiness, opting to instead deposit funds with the ECB.

The uncertainty is also rocking the corporate debt markets. May was the worst month for corporate bond sales for over a decade. Issuance of high-yield company debt nearly halted amid new signs that Europe’s sovereign debt crisis may be spreading; investment grade companies are also finding it more difficult to issue bonds. Both High Yield and Investment Grade spreads have soared in recent weeks.

There has also been substantial deterioration in the US Commercial Paper market (short-term IOUs), which contracted to its lowest level since 1999. Debt outstanding dropped, after six straight weeks of decline, to the lowest level on record as companies pared back on tapping short-term funding.

The European contagion impact and lack of liquidity is being felt in the emerging markets as well. New bond issuance of Brazilian companies halted for a sixth straight week, the longest stretch in 14 months, as Europe’s debt crisis drove up borrowing costs and caused a surge in volatility.

This worrying credit contraction is eerily reminiscent of the situation in summer 2007. Investors are fleeing all but the safest government securities. Poor liquidity and vanishing risk tolerance could see consumers contract, businesses stop hiring and investing and economic activity coming to a halt.

The prospects aren’t so good. A recent ECB forecast (Financial Stability Review, May 2010) that eurozone’s financial institutions may have to write off 195 billion euros of bad debts by 2011 – on top of the 238 billion already accounted for – confirmed fears about the fragility of the financial system.

Deflation and double-dip recession?

Meanwhile, the economic picture in Europe is not encouraging.

On the positive side, European core has been surprising with strong economic data; German manufacturing and exports are booming – exports to non-euro area have now surpassed the pre-Lehman bankruptcy peak (a weaker euro will only supercharge this growth), Germany’s PMIs are at a four year high; IFO Expectations Index is at its highest level since mid 2007.

On the other hand, Greece is insolvent and will unlikely avoid debt restructuring/default, which poses a massive risk for the European banking system. (Could Spain and Portugal also turn out to be insolvent in the end?) The hope is that Europe has bought sufficient time to stabilize the rest of the eurozone before a Greek debt restructuring.

The question is whether the European sovereign debt crisis could bring down Europe’s banking system, causing a collapse in confidence and economic activity similar to the fallout of Lehman in September 2008. It’s too early to tell, but a bank run (and a capital strike against eurozone investments) is looking increasingly more plausible.

(Of course European banks are already in a precarious shape, having made much less progress on writedowns and rebuilding of equity than US banks. They will also have to refinance some 800 billion euros in long-term debt by the end of 2012, and bank borrowing has already suffered a major blow because of sovereign risks – see notes above on deterioration in the credit markets.)

It’s not just the ultimate value of their government bond holdings the banks have to worry about. The deficit reduction and austerity programs much of Europe is embarking on are a step in the right direction but will inevitably kill consumption, investment and growth in the short to medium term. A long and painful deflation and severe recession in the periphery would appear unavoidable. (Defaults down the road are still a likely scenario.)

The fiscal retrenchment under way will see incomes in a number of eurozone countries beginning to fall in nominal terms; this will undermine the ability of households and businesses to service their debts, leading to a surge in private sector loan losses at European banks. Credit growth will also further contract as banks – already burdened with the until recently thought safe government bond holdings – will become even more reluctant to lend to riskier private sector borrowers.

Lack of credit will further reduce investment, job creation and economic growth. Slower growth and lower tax receipts will make it even more difficult for the periphery to get their debts under control. And, slower economic growth will create further problems for the banks, causing higher loan losses as highly indebted eurozone households and companies default on their loans. A vicious feedback loop.

A double dip recession in parts of the eurozone should, on itself, not have a disastrous impact on US and Asian economies, although some industries are companies will be more heavily exposed to diminishing European revenues (Europe is China’s largest export market). However, a potential collapse of the European banking system would undoubtedly have catastrophic consequences for the global financial markets, plunging the world back into recession.

And this time policy makers and central bankers would have little ammunition left to support the economy; interest rates are already at or near zero and there is (for now) little appetite for several more trillions worth of stimuli. That might change, of course, after a severe deflationary period, financial collapse, recession/depression; the Fed, ECB and other central banks and governments would then undoubtedly embark on quantitative easing and stimuli on a never before seen scale.

Deflation followed by hyperinflation, anyone?

Over the past weeks we’ve been digging down into what might, or might not be the real story. Everybody seems to have an opinion or three, from world class money managers to yowling cretins, and none of them seem to fully add up. Whither the economy?

There is a bewildering array of evidence pointing to global inflation, except that it also indicates overcapacity, a la Hyman Minsky, which instead means it should be deflationary, except that supply is creating its own demand, hypothetically, in China at least, which should be inflationary, except that world shipping fell precipitously and is staying down, which means deflation, except that foodstuffs are gaining, inflationary, but Prechter says deflation, which Arun Motianey claims is the precondition for inflation, but consumer confidence plunged and the Politburo hates inflation and the Brits are certainly on the brink of a national collapse because they have collectively drunk themselves to terminal cirrhosis, credit card companies have run amok, people are cutting back like mad and saving every dime, in total contradistinction to the prior era where easy credit proliferated like rats in the New York subway system, which should be deflationary, except flooding the system with liquidity should be inflationary, except the banks won’t lend it to the  businesses that really need it which is deflationary, and China is running an annualized GDP growth of 10.5% which is just nuts…

Baffling…infuriating…the truth is nobody has a firm idea… even Soros has gotten it wrong, way wrong, on occasion. What’s up?

On one level we believe that we are beholden to mental models, or framing mechanisms, that no longer suffice to describe the complexity, nor the potential instability of this new economic condition; we’re tweaking prisoner’s dilemma models when the global economy is beginning to look like a  3D Julia Set in a sped up animation. Could be our metaphors and mental constructs no longer cut it. This baby has plain run off the known map. Some of those mathematical curiosities that we loved to play with more than a decade ago may be getting closer to necessary descriptors of the real world than we realized.

Which leaves us where? The Chicago Fed’s favorite all purpose indicator, the CFNAI, is flashing recovery. And we admit, the CFNAI is probably as good of an all purpose economic indicator as we know of, being a diffusion index of 85 indicators run through a principle components analysis.

The question then becomes, what kind of recovery is this actually? Optimally one recovers into a state of mild inflation, which encourages borrowing and sets into motion a virtuous cycle of credit expansion, hiring, equipment purchasing, product line upgrades, and so on. However, as Richard Koo of Nomura will cheerfully remind his readers, there is another potential scenario, the not so salubrious debt deflation. In this circumstance, even a subtle tilt towards deflation can induce large borrowers to use their profits to first pare down their existing debt load rather than invest in expansion and upgrading. Which, of course, leads to the unhelpful lost decade syndrome. Aided and abetted by a period of low interest rates. Like we have now.

Practically speaking, there is no way policymakers can entertain the idea of a prophylactic increase in interest rates without risking mini-depressions at the state level. But the problem is hardly restricted to the nitty gritty of keeping the street lights on at night in Colorado Springs. Japan too is facing a potential double dip back into grinding deflationary territory which in turn further deflects borrowing behavior into saving behavior (as deflations reward savers and punish borrowers)… only now it seems that the US consumer is finally learning the same lessons that the Japanese consumer learned 20 years ago.

We are of the opinion that economic phenomena often appear as social phenomena, at the level of shared values, ideals, behaviors, and shifts therein before they can be captured and quantified as numerical  sort-of facts that make it to the public by way of the media blatheroons. We look for trends that are slowly working their pernicious ways to the surface. Such as…..

We must admit we find that disturbing on a multitude of levels. We recall that deflations have strong historical connections with phases of breakdown and decay. In the late 19th century nearly the entire agricultural sector was driven to bankruptcy by an extended deflation era. Deflations can be insidiously corrosive, slow moving glaciers that crush everything before them, unlike the swifter moving tsunami of hyperinflation. Each is coupled with a powerful social mood.

We take the prospect of deflation with great seriousness and no small degree of angst. We have noted as well that the Baltic Dry index, which reflects worldwide shipping of dry bulk goods such as ores, cement, grains, and the like, has remained at a surprisingly low level since the great breakdown, in spite of a couple of recovery bumps. Simply judging by the BDI, world trade is not recovering to anywhere near even the 2007 LOW, not the high.

On the other hand, there is China, which seems to be living in an economic universe so disconnected from our own it solicits disbelief. Is this in fact some form of massive decoupling that no one can adequately explain? Is this sustainable, a true breakthrough, a new epoch that makes fools of the naysayers, the great engine that will pull us out of what would have been a deep, cold worldwide depression?

China, India, and the Asian Tigers are, to put it mildly, on some kind of roll. As one writer put it, hot enough to make the devil sweat. But, my friend, when you go from 400 billion Yuan of bank lending to 1.4 Trillion Yuan in 2 quarters, you either really know what you’re doing or you’re about to burn the house down.

China promoters, Dr. Megatrends himself, John Naisbitt, included, seem to have bought the Unstoppable Giant Awakens scenario wholesale and retail. And for all we know he could be completely correct, or not. We have a few statistics that might help us appreciate the impact of China, more of an importer than many realize. Sure, they export manufactured stuff, but they still have a ravenous appetite for raw materials. Which they must buy on world markets. Which explains the extraordinary efforts they go to to insure uninterrupted flows of the elements of manufacture.

Thus we think it is fair to say that the Chinese relationship with the global economy is far more complex that the simplistic model that they sell us stuff and buy our treasury debt with the profits. A lot of that economic activity is leaking back out into the primary producer world, places like Africa. So the model of capital and material flows is
necessarily a more nuanced process of transforming economies they encounter and being transformed themselves by those contacts. China, for all of its legalistic and authoritarian rigidities, may be a novel form of a complex adaptive system that the American founders could not have imagined.

But complex adaptive systems can fall victim to their own contradictions and instabilities as well, and as far as we know, no imperial administrators for the entire duration of history have escaped an encounter with such systems suddenly taking on an unpredictable and frustrating life of their own. No rider has fully mastered the beast, although many have tried, and many have been seduced into the illusion that this time we have finally mastered it. We should be so lucky. And we never will be. Great Moderation, anyone?

With growth come growing pains. With hyper-growth come hyper-growing pains. Lao Tzu warned of this 2,500 years ago. Sudden wealth breeds envy, unfathomable greed, lust for power, ruthlessness, and often, terrible errors of hubris. We have noticed many reports of criminality, of the organized entity sort, and abuses of power.

Does this become a long running institutional struggle between power bases or will a central authority be able to impose a stable, uniform standard and rule of law across the extremely diverse population?

We cannot help but notice that the Western structure, as relatively wealthy as it is, with its excellent university system, with a long history of economic booms and busts, could have gone from the most overweening arrogance and sense of historical imperative to one of confusion and despair in less time than it takes to grow a fairly impressive plant behind one’s house or to put a child through one stage of education. Didn’t we also think that we had conquered risk and parked our vehicle at the end of history ?

Granted,  this World Bank study of per capita electricity consumption is 4 years out of date, however, it is suggestive of how great the development gap actually may be between the USA and China/India. We tend to see this as an indication of the degree of “standard of living arbitrage” that exists between cultures.  Our energy hogging ways speak to an outsized standard of living, just as the Chinese and Indian levels of electrical energy consumption point to the degree to which they are positioned to catch up to our levels of usage, which would be correlated with square footage of living space, the use of heating and air conditioning, lighting, entertainment systems and so on.

Given this metric we would infer that there remains an enormous upside potential for their consumer economies, and perhaps a degree of downside potential for ours as more and more highly skilled, highly educated work migrates East. One might infer as well that we have lifestyle addiction issues that will only be reframed by significant changes in flows of capital, goods, raw materials, and knowledge.

Paul Krugman is clearly concerned about the deflation scenario as well, but perhaps he does not see how intimately this dynamic is tied to the almost steroid driven drive for an improved standard of living in Asia.

We wanted to double check Krugman’s  source of concern, so we composed the following two charts. In the first case, we compared the Dallas Fed’s trimmed mean deflator (the blue line) with the CPI–minus-energy chart for the same period (the red line). In both cases these do show, expressed in % change YoY, what might be taken for the beginnings of a deflationary process.

On the other hand, there is energy, our national equivalent of pure glucose intravenous drip. Here we see an entirely different process unfolding. If everything else is a reasonably steady process slowly trending, energy pricing and energy’s effects on our economy are downright manic-depressive.

We see the deflation conversation in areas like the convenience store industry, where the vice-chairman of Wal-Mart hopes to see deflationary pressures ending soon in his industry.

Hopefully, yes, we’ll be seeing that.

The recovery we are embarked on has a schizophrenic quality about it; it is typical and it is anything but typical, the diseased roots have been cleaned out and the diseased roots remain very much in place, central bankers have matters in hand and central bankers are clueless, economics offers sufficient explanations and economics is in crisis.

We believe that the distinction between normal cyclic processes and deeper level long term processes will offer clarification. The hidden layers, one might say, are generally obscured from view behind (an often politically convenient) smokescreen of day to day and week to week noise processes which drive the media cartoons that pass for informed discussion.

To begin with, we must look at Total Public Debt, which unfolds in three acts. The first shows a rising debt through the eighties until the late nineties, until it began to slow and level off going into the 21st century. This was a period when the world was expecting a reduction in military expenditures and a globalized neoliberal trade arrangement.

When the attacks of 9/11 occurred, and the American project was suddenly recalibrated as the GWOT, the Global War On Terror, the public debt surged at about a fifty degree angle between 2001 and 2008. During this phase, the equity value of the defense sector increased fourfold, by 400%. There was a phenomenal boom in real estate. Credit became absurdly convenient and absurdly lax.

Oddly, very oddly, the entire credit for this seismic shift was given to innovations in the lending and loan securitization markets. No mention was made of the stimulative effects of ramping up a militarized economy which was, in effect, shifting future growth into present hot expenditure. We would argue that it was a combination of massive public borrowing during a low interest rate boom that produced the extreme overshoot in multiple asset classes in the late 2000s.

Then, with the collapse of the private sector in 2008 the Total Public Debt exploded by about 3 trillion dollars in one final vertical surge. With very little clear idea as to how this debt will be paid down, or even how the annual interest on this debt will be paid off.

Even at 3% per annum for the aggregate debt, we’ve got to come up with a 360,000,000,000, that’s three hundred sixty billion dollars per year in interest, for a very long time.  We’re basically sticking future American generations with a long term multiple hundred billion debt obligation to pay for the current generation’s missteps.

A phenomenal, unsustainable debt obligation that will hit us hardest precisely as the baby boom generation becomes most dependent on public solutions to long term health care problems. As it stands, the Congressional Budget Office has calculated that the United States will experience a significant output gap (enforcing deflationary pressures) between now and 2015. We believe that this problem has been greatly understated.

One critical factor not to be overlooked is the progression of the American demographic. In 1956 the future of the country was literally in its infancy, and following a long decline in the birth rate during the Great Depression and WWII, there was a massive population surge. This baby boom would define many of the dominant characteristics of both our economic operation and our cultural and political tastes throughout its life cycle.

As the Baby Boom outgrew its’ younger, more radical student phase in the Viet Nam era, with drugs, lifestyle experimentation and protest, and then embarked on adult concerns and a rightward drift in their political tastes, the financial culture of the United States also morphed from a Great Depression inspired risk averse way of thinking into the New Thing, which fetishised theories like the Efficient Market Hypothesis, Neo-Classical economics, Monte-Carlo simulations, Gaussian probability distributions, and the salutary effects of unrestricted capital flows.

The Baby Boom had grown into financial power and drifted away from its youthful political radicalism, slowly but surely into an airlessly dogmatic sense of the revealed truth, while retaining its elemental characteristics, what Freud referred to as Die Anlage, the “essential blueprint”, the idea that reality could be remade by the imposition of a theory. One could say that the fate of Cuba and the fate of a business school worldview had a common spiritual ancestor.

This generation would exchange radical theories of society for radical, very typically for that generation, academic ideas that were prized more for their elegance than their practical conformation with reality. This avaricious, indulged, entitled, theory and model loving generation would, combined with global changes in finance and technology, unleash the long wave that ran from 1982 until 2007.

The final denouement coincided with the beginning of the end of the Baby Boom driven cultural cycle and the  ascendancy of Generation X, the air pocket behind the Baby Boom, whose first major representative is Barack Obama. We feel that whatever his imperfections, far too much has been imputed to the person of President Obama, and far too little to the mass dynamics of one asymmetrical generation leaving the stage, with all of their self serving narcissism, with all of their sense of being owed, with their irresponsibility and shallow thinking, and being replaced by another generation whose worldview is based in a very different relationship to advantage and opportunity.

As of this writing, year 2010, the US population is yet again 10 years older, with the maximum age cohort from 45 years to 54, now in their positions of senior management and positions to direct policy. The absolutely essential point to grasp is that this generation will be in their last stages of public involvement within the coming decade and there will be a wholesale shift from the Baby Boom mode to the Generation X mode, of whom Barack Obama is but a stylistic harbinger.

There will be an accelerating shift toward health and medical expenditure, a much lowered interest in foreign involvements, and a phenomenal amount of debt outstanding.

We note with some alarm that the Dallas Fed’s in house measure of inflation and deflation pressures, the Trimmed Mean CPE inflation rate, which we take as a more reliable indicator as to what the Fed really thinks versus the popular CPI numbers that are sops thrown out to give talking heads something to mumble about, is diving quite nicely into deflationary territory.

Deflation implies staying put, real estate sells with less vigor when inflation isn’t there to justify price increases, the arguments for wage increases are less convincing, and yes, we’re stuck with an awful lot of debt to service. Inflation may ultimately reduce debt service real costs, but the path there as rates increase can get painfully expensive, painfully quickly.

The Fed, the Treasury, Congress and the President must feel as if they’re walking on a razor’s edge. Maintaining a slow, steady, low growth posture risks plunging into a deflation spiral and attempting to use inflation as a way of ultimately evaporating the debt risks a hyperinflation spiral. It will be exceedingly hard to find the Goldilocks wonderland that gave the late 1990’s their “end of history” quality. The 2010s are sure to be a “history is back, with a vengeance” epoch.

As we can see from the Rectified Unemployment chart (total unemployment minus five week and less), serious unemployment has just barely turned the corner, but we feel that this unprecedented destruction of work opportunity has been so cauterizing that it will leave scars on the public psyche long into the future.