The New Century Weekly
Double dipping again
Andy Xie
May 30, 2011
Summary
The double dip scare has begun earlier this year than in 2010. High oil prices, falling property market in the US, sovereign debt crisis in Europe, recession in Japan, and inflation-induced tightening in the emerging economies are exerting downward pressure on the global economy. The growth data will surprise on the downside, inflation data on the upside. Risk assets like stocks and commodities will come under pressure in the summer.
The bearish sentiment will reverse when (1) the Fed eases again, which is possible after a major drop in oil price, or (2) Europe solves its debt crisis with a credible plan. Neither is likely in the summer. The earliest possible time is probably September.
When the market sentiment turns positive again, it would last for a few months only. The 'risk on' and 'risk off' herd mentality is dominating the market, causing the ups and downs. Stock markets are essentially range bound, supported by low interest rate but held back by economic difficulties. Energy, agriculture, and gold are still on a bullish path due to negative real interest rate around the world.
Risk off
The current round of selloff began in silver. When some exchanges increased margin requirement, some speculators had to sell. Others had to sell other assets to cover their silver positions. Global financial markets are still highly levered in some corners. Silver, internet and alternative energy stocks are in this bucket. When one falls, the others follow, as the same speculators need to liquidate in other markets to meet margin calls in silver.
The global economy has been weak this year. The sentiment wasn't so until recently. I suspect that the market drop is causing people to look at the weak economic data. The US's economic growth rate in the first quarter was halved from the previous quarter. Japan has obviously been in recession. Europe's sovereign debt crisis was never solved. The market just chooses to think about it or ignore it.
Low interest rate and a large speculative community are the upward force for financial markets. Weak growth in the developed economies and tightening fear in the emerging economies keep a lid on the bullish sentiment. This is why stock markets have been range bound for two years. The situation isn't likely to change over the next twelve months.
Serial bubble blowing
A generation of policymakers has grown in a bubbly environment. It has affected their thinking on the tradeoff between bubble and economic growth. Because they were able to rescue the economy after each bubble burst, by inflating another bubble, they don't fear bubble. Hence, while low interest rate is fueling bubbles in some corners, they are not concerned.
One major policy figure from the US recently commented that the worries over an internet bubble showed the confidence in the US economy was back. This statement shows the distorted view common among policymakers. All surveys show that American people are very worried. The internet bubble just demonstrates how sick the financial system is. The bubble doesn't have anything to do with the confidence at large.
When a major bubble bursts, it usually washes out a generation of speculators. Another bubble needs to wait for a new generation who has no such memory. The serial bubbles in the past two decades are due to policymakers bailing out speculators with low interest rate. The policymakers seem to believe in growing out of economic problems. Hence, inflating another bubble, while there is downside from another burst, offers the hope for growing out of the problems again. Beside, politicians have short tenure and have strong incentive to embrace measures that kick the problems down the road.
If one can always blow another bubble to deal with the consequences of a bubble bursting, the world would be a paradise. Everyone would be rich and don't have to work. Such a world isn't possible by definition. There is an absolute end to the serial bubble making. Inflation marks the end.
Inflation is a monetary phenomenon. Bubble is also a monetary phenomenon. While one can have fascinating stories on the details in a bubble, without loose monetary policy, it isn't possible. Inflation and bubble compete for money. When some factors keep inflation down, for example, outsourcing in the past two decades, monetary excesses can support bubbles. When the temporary factors that keep inflation down are exhausted, bubbles cannot be sustained, as money is diverted.
Even though real interest rate is negative everywhere, risk assets are not seeing across-the-board bubble. It is happening only in some corners. Internet is the most obvious one. Because people can imagine the unlimited potential of internet, speculative money is more likely to pile up there than anywhere else.
The biggest bubble this round is in government bonds. It's considered the safest asset. As the global economy remains in trouble, money has been flowing into this asset class. This bubble is inherently unstable. Inflation is picking up everywhere. Panic over bonds losing real value will surface at some point. I suspect that the bond bubble would burst in the last quarter of 2012.
Double dipping
The global economy is turning down again. It did so last summer. The Fed's QE 2 reversed the trend by inflating stock markets around the world. The wealth effect proved short-lived, as oil price surge imposed a heavy tax on the consumer. The end of this tail wind, so soon after QE 2 was introduced, makes structural problems exposed again.
The US housing market is diving again. One fourth of the US's homeowners have negative equity. Without hope of a quick recovery, they are incentivized to give the properties to their mortgage banks and walk away from the debt. As bank repossessed housing stock rises, the market is turning down, fearing banks liquidating their inventory. The adjustment isn't entirely technical. The US's home property value is still at 110% of GDP, even after dropping by 30% from the peak. In the previous cycles it usually bottomed way below 100%.
In some tier II US cities residential land is down 90% from the peak. The price level is only 1% of China's for comparable cities. The US's land price may have fully adjusted already.
Europe's sovereign debt crisis is flaring up again. It was never fully resolved. The EU aid for Greece and others was just enough to solve their immediate liquidity problem without addressing their ability to pay off debts over time. The only way out is for Greece to default. The EU fears the contagion effect on other countries and is stalling for a miracle. This is why the EU debt crisis feels like a chronicle disease. The current flareup isn't the last.
Japan is in deep recession. The 9.0 earthquake has destroyed a significant chunk of its productive capacity. It would take a long time to repair the damages. The hope for a quick turnaround is likely to be dashed. This hope is keeping the yen value up. The reality is that Japan's trade balance will deteriorate further, as it imports more for reconstruction. A big devaluation of yen is quite possible in the second half of the year.
Emerging economies are all tightening in response to surging inflation. It seems inflation isn't being tamed. There are two complications to the inflation battle. First, the Fed is keeping a very loose policy. It is fueling commodity inflation. Emerging economies cannot deal with it effectively. Second, the emerging economies have been slow in raising interest rates, less fast than inflation picking up. Hence, their real interest rate is still negative, which fuels inflation. The need for more tightening is increasing market anxiety about economic growth.
It seems that the global economy is turning down in a synchronized fashion. The economic data are likely to surprise on the downside in the summer. Fear will dominate financial markets.
Who can rescue the market?
I wrote about the possibility of QE 3 in this page a month ago. The feedbacks were not supportive. Almost everyone told me it wouldn't be possible. After the market turns down, they think differently. Suddenly, QE 3 becomes possible. I believe that oil price has to drop another 25% for QE 3 to be possible. As the growth data surprise on the downside, it is possible. When the oil price is down enough, the Fed has an excuse on the inflation front and can stimulate again.
Inflation is eating away income growth in the US, like everywhere else. The Fed still doesn't believe that its policy is counterproductive in almost every way. It inspires bubbles, slows structural reforms, and now depresses consumption. But, it won't change its ways. It believes in the magic of monetary stimulus in reviving the economy. Hence, as the US economy turns down, it isn't likely to sit on the side. It will do something. Would it be a full-blown QE 3 or something else? Hard to tell.
When the Fed does make a move, stock markets will rise. People will feel better. But, the feeling would be temporary. The Fed stimulus would cause oil price to surge, offsetting whatever benefits the rising stock markets would bring. THE FED IS RIDING A TIGER. It is catastrophe either way.
If Europe deals with its debt crisis decisively, it could revive confidence again. There is little doubt that Greece will default. Dragging it out is a big overhang on the financial markets. When a plan is introduced on how much the Greek bondholders will lose and how the affected European banks would recapitalize, financial markets would price in the negative news and move on from there.
There is a lot of hope in the financial markets for China to loosen up again. Almost every month the market talks about China's inflation peaking and the possibility of easing again. While we cannot rule out this possibility, its chance is quite slim. China's inflation is in an unstable phase. The statistics are not as important as what people see and feel. In a normal inflation environment, prices may rise by a few percentage points for goods and services that people consume frequently. In today's China, when the price of a product or service moves, it often goes up by 10-30%. It shows how serious the inflation problem is.
As I wrote in this page two weeks ago, China's economy is slowing. It is good news. China's growth has depended too much on property bubble. The longer such growth lasts, the bigger the adjustment pain down the road.
Further, the bottlenecks in China's growth are becoming too hard to overcome. Energy shortage, for example, is likely to be severe this year. If China abandons the fight against inflation and tries to stimulate growth again, energy shortage will likely become a major crisis.
The Fed or Europe may support the financial markets again. China isn't likely to do so. When the market does revive, it would be temporary anyway.
The path to the next crisis
The global economy is on course to another crisis that centers around government debt. After the 2008 financial crisis no major government restructured sufficiently to cope with the structural reasons for the bubble and its bursting. Instead, major economies resorted to stimulus to revive growth, hoping to grow out of their problems. This is why the world is unstable two years after the crisis.
In the developed world the fundamental problem is high cost of social welfare. Unless it is cut dramatically, their fiscal deficits will remain large. After the World War II the developed countries set up welfare state to buy social peace. As their populations age, the cost is becoming unbearable. At the same time they have lost competitiveness to the developing world and cannot grow out of their problems anymore. Their short-term solution is to run fiscal deficits to keep the system afloat. Greece's fate awaits others. The United States is especially at risk. While it can print money to pay back the debts, the expectation of inflation would cause the treasury investors to flee one day. The resulting high bond yield will force the Fed to tighten to avoid hyperinflation.
The developing world should stop asset bubbles to enrich the ruling class and impoverish workers and industrialists. Developing countries like China or Vietnam have done well on cost competitiveness, i.e., the low wage is their source of wealth creation. But, they have been redistributing wealth through asset bubbles. Workers and industrialists have been devalued. The consequences are that businesses and workers have all embraced speculation. As fewer and fewer businesses and workers are willing to produce, inflation becomes rampant. Unless the basic governing philosophy changes, the inflation crisis in the emerging economies will worsen.
The world is unstable because policymakers are still unwilling to deal with the structural problems. The short-term measures could only revive confidence temporarily. When the temporary measures are exhausted, the world will face another major crisis.
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