Cycle Logical Issues?
One of the early year themes we have been discussing on our subscriber site has been our expectation for an increase in market volatility. Probably about three weeks back we wrote, "Unlike the consensus and big Street houses which have been predicting/expecting falling volatility in 2010 after an already accomplished death defying drop in volatility during 2009, we're not so sure shorting volatility is such a wonderful investment idea right here. Although we could be dead wrong, we believe 2010 will present us with a great opportunity to buy volatility. We could be very close right now." We're not reprinting this to proverbially pat ourselves on the back as the year is still very young. Secondly, anyone spending time patting themselves on the back in this business are usually about 15 seconds away from having the proverbial rug pulled out from under them. Anything can happen, so judgment is reserved for now as we'll just have to see what happens on the financial market front as we move forward. We think an increase in volatility is in store not only for the financial markets, but also in a much broader context we'd like to discuss in this missive. We want to quickly talk about another type of volatility - economic volatility. And we want to take a look at the long term in the hope that perhaps we can "see" the future more clearly. Here's the question that may indeed morph into an investment theme for 2010 and beyond that we'd like to pose. Looking ahead, will the US economy be more or less volatile than we have experienced over what is close to the last thirty years? Yes or no? If indeed were are anywhere even close to the mark regarding our thoughts that economic volatility will increase, then that has direct and meaningful implications for equity and broader business valuations. Let's start digging through some facts.
Nothing like starting off with a visual, now is there? In many a case, pictures can help clarify. In the top clip below is an update of a chart we have shown you so many times you know it by heart - total credit market debt as a percentage of GDP. And yes, in 2Q of last year we sat at a high never seen before in US history, about 125% above the ratio seen in December...of 1929. The bottom clip is the very simple year over year rate of change in real GDP updated through 4Q 2009. The issue is that from the early 1950's (the earliest of official Fed data) through to the early 1980's, the US economy was a whole heck of a lot more volatile than has been the case since (until recently, of course). Economic rate of change highs and lows from the fifties through the seventies was a lot broader than has been the case subsequent. We often hear a lot of folks explain this away as the US transforming itself from an industrial to a service based economy. Less manufacturing dependence has meant less overall economic volatility, etc. We've transferred the cyclical inventory and manufacturing swings offshore, right? We're sure you've heard the logic many a time. But is that really the case? Is it really just a function of domestic economic evolution, or is there something else going on here that ties right back into the keynote issue of the current economic and financial market cycle - credit?
Of course in the bottom clip above we are looking at the year over year rate of change in real GDP from 1952-present. Nominal GDP swings were noticeably greater than the last three decades. So from the early 1950's through to the early 1980's we see a top to bottom rate of change range of approximately 10%, from plus eight on the upside to minus two percent in southern trajectory. But as is also clear, that range of top to bottom rate of change swings in real GDP was cut in half from the early 1980's until the current cycle. A compression in economic volatility and an elongation in expansion cycles. And as is all too clear, this period of the early 1980's to the present is the exact period of what we'd term the occurrence of the baby boomer generational credit acceleration cycle. It was an intergenerational change in attitudes toward leverage. You can see the question coming, can't you? Was it the supposed transformation in the US economy from industrial to a service centric model that caused this contraction in economic volatility? Or was it the changed nature of a generational credit cycle that drove this experience? You know that the commonality underlying many government sponsored stimulus initiatives over the last year was an attempt to restart the credit cycle. Cash for clunkers was about sparking auto lending and of course the tax credit for home buying was about reinvigorating mortgage credit growth.
As mentioned, what also accompanied the compression in US domestic economic volatility over close to the last three decades was an elongation in specific economic cycles relative to the experience of the early '50's to early '80's period. The following table quantitatively documents this fact.
|Duration Of Historical US Economic Expansions|
|Expansion Periods||Months of Expansion|
|5/54 - 8/57||39 mos|
|4/58 - 4/60||24|
|2/61 - 12/69||106|
|11/70 - 11/73||36|
|3/75 - 1/80||58|
|7/80 - 7/81||12|
|11/82 - 7/90||92|
|3/91 - 3/01||120|
|11/01 - 12/07||73|
|Average 1954 - 1982||45.8 mos.|
|Average 1982 - 2007||95.0|
|Average Total Period||62.2|
On average, US economic expansions from the early 1980's to the current cycle have been twice as long as what was seen in the prior three decade period. Again, was this due to the ascendance of the service economy, or was this being driven by virtually consistent acceleration in the macro US credit cycle? You'll remember that when we discussed the components of US final demand (a key analytical point for 2010) last year, we told you that the commonality in all economic recoveries/expansions historically has been the expression of pent up demand for housing, auto's and an acceleration in consumer credit. And wouldn't you know it, all three relate to credit expansion in the macro. If the prior cycle of maniacal mortgage credit expansion and it's direct and significant impact on macro economic outcomes does not reinforce this conceptual thinking, we just don't know what will.
So the important thematic question becomes, in the assumed absence of significant acceleration in the US credit cycle ahead as both households and corporations continue to delever, will the forward rhythm of US GDP become more volatile, perhaps as was the case from 1950 through the early 1980's? Will we experience higher rate of change highs and lower lows than has been seen since the early 1980's? Although this is a question no one can answer with any type of certainty at this point, we believe it's very worthy of consideration and benchmarking as we move forward for if we are anywhere even near being on the right track with this thinking then increased economic volatility ahead will absolutely influence future investment outcomes, primarily valuations. Referring back to the bottom clip of the first chart, the depth of the real GDP rate of change low in the current cycle looks much more like experience of the US economy from 1950-82. An early marker of character change? We'll see.
And as crazy as this may sound, we are now on the cusp of upside real GDP rate of change that could easily bring us back toward the top end of the prior range pretty darn fast do to comping against prior year disaster quarters. But very importantly please remember that inventory rebuilds do not economic recoveries make. Sustainable economic recoveries are driven by growth in final demand, and so far any meaningful upturn in final demand remains wildly tepid at best. We suggest you keep an eye on the tone of real final sales. Why? It excludes inventories. As the chart below shows us, as of 4Q 2009, year over year final sales are flat.
But longer term this question of the linkage of the credit cycle to the character, texture and rhythm (volatility) of GDP looms very large as we see it. We have one final table of data for your consideration. As you review the decade by decade trends in the numbers, remember the shape and decade by decade acceleration in the macro US credit cycle we lived through over the last half century. Have a look.
|Historical Economic Character Stats By Decade|
|Annual Employment Growth||2.6||3.2||2.7||2.0||2.0||0|
|Household Net Worth Growth||89.8||93.4||189.7||142.4||112.3||26.3|
|S&P Price Change||251.3||53.7||16.6||220.5||319.3||(24.1)|
|Real GDP Growth||49.9||53.1||38.2||34.9||38.9||17.8|
|Real Personal Consumption Expenditure Growth||42.8||54.0||40.8||38.3||40.4||24.2|
You already know from our longstanding coverage of the issue that the prior decade of the 2000's was the first completely lost decade for job growth in the post Depression US economy. Question - did we experience zero job growth in the last decade due to the nature of the US being a service economy? Did we simply stop creating service industry jobs? Or has it been the credit implosion and now lack of private sector credit creation that has engendered the drop in final demand and the coincident and necessary corporate cost cutting primary expressed in employment stats? Was the implosion in jobs in the 1930's the result of the US "transforming" itself from an agrarian economy to one driven by industrialization? Or was it the aftermath credit bust environment subsequent to the prior 1920's credit cycle of significance that blew apart the labor market? You get the picture and the concept. By the way, you already know manufacturing jobs imploded in the last decade as the government and service sector were the job creators, and that's not saying much at all as per the numbers.
The last decade was certainly the worst for household net worth growth over the last six decades. Why? Because we are a service economy? Or because the credit bust engendered asset deflation of generational proportion on household balance sheets, essentially helping to drive much greater volatility in the rate of change of real US GDP? Did the credit bust primarily influence S&P equity price outcomes, or was it the fact that the character of the service economy drove a worse than lost decade experience for equities?
We could ramble on and on, but the numbers sure seem to be telling us a story. They tell us a story that reflects the law of diminishing returns of credit acceleration over a very long term cycle. They tell us a story that generational credit cycles are initially virtuous until they hit a point where the burden of leverage outweighs it's productive employment in capital allocation and a tipping point is hit where leverage is extended beyond the point at which it can be comfortably serviced. We see it in the stark contrasts of real GDP growth and real personal consumption expenditure growth during the last decade compared to the prior five, despite this period being the final credit cycle blow off. Without trying to reach for melodrama, the table above sure speaks to the secular change engendered by changing credit cycle dynamics and seems to have little to nothing to do with the fact that the US is a service economy.
This is why we are asking the question. This is why we believe that in the absence of a renewed and reinvigorated credit cycle domestically, history suggests economic cycles will become not only shorter in duration, but also more volatile in amplitude. Does that suggest the risk premium theoretically priced into financial assets at any point in time should increase or decrease from here? That's the issue. If our assumption of increasing domestic economic volatility is near the mark, then we suggest this will have very important implications for our investing activities and behavior ahead.
Head East?...Tying in to what we discussed above, let's have a very quick look at the credit bubble and post bubble periods in Japan. Why? Well, we hope we can shed a bit more light on this whole question of economic volatility. Below is the year over year rate of change GDP trend for Japan from 1980 through to the third quarter of last year. We started the numbers in 1980 and the fact is that from '80 to early 1992, Japan experienced quite the elongated economic growth cycle. Very much as was the case in the US during the 1980's. But once the credit and asset bubbles (financial and real estate) popped in Japan in the early 1990's, the elongated economic expansions were no more. Economic volatility increased as is plainly visible in the chart below.
We'll be the first to admit that government/central banking policy making in Japan certainly influenced the economic cycle outcomes you see above. A number of times policy makers backed off on stimulus measures and almost immediately the Japanese economy fell back into official recession. But as we see it, this says something about what the US faces immediately ahead.
It's clear that US government officials have done a darn good job of talking up the economic recovery as of late. In many cases a better job than the carnival barkers on the Street. The downside of talking up the recovery or stretching the headline economic stat numbers a bit is that the markets will expect stimulus to be withdrawn and will begin to price it in. Isn't this the theme of market action over the last few weeks? Although we have written in recent months about our feeling that there is absolutely no way the stimulus will actually be withdrawn anytime soon, investors may demand and price in otherwise if the happy spin continues. This is especially a danger in 2010 given the political aspect of it being a md-term election year. The "lipstick" we expect to be painted on the economy by the political faction prior to this fall should be as thick as anything seen in quite some time. The bottom line is that we personally expect the deleveraging process to last years. But will the markets allow the government to borrow and Fed to continue to print for years to come, all in the spirit of maintaining stimulus, while simultaneously these folks are talking up economic healing? Will politicians and pseudo-politicians at the Fed and Treasury be forced to withdraw some stimulus at some point based on perceptual pressure of the markets themselves? Or will politicians believe their own BS and proactively pull back on the stimulus reigns prior to the private sector again beginning to lever up? If so we will face a situation very similar to what Japan faced in the mid-1990's? Indeed we will. Early withdrawal of stimulus in Japan actually heightened economic volatility. We expect a very similar outcome in the current US cycle if the powers that be are cocky enough to do the same. For now, their rhetoric says they are cocky enough. We simply need to watch their actions as opposed to their comments. And as we wrote about extensively recently, a first test will be the Fed's assumed termination of printing to buy mortgage backed securities that lies immediately ahead.
So as we look forward, whether as a function of lack of credit cycle reacceleration or premature removal of stimulus by the powers that be, we believe the risks of heightened economic volatility are real and meaningful in our present circumstances. And you can clearly see that in the Japanese experience from 1990 onward of private sector deleveraging, rotting bad debt on the books of what were to become Japanese zombie banks, quantitative easing and ZIRP (zero interest rate policy) conducted by the Bank Of Japan, and massive government borrowing and spending, heightened economic cycle volatility was accompanied by heightened cyclical volatility of Japanese equity prices. Notice any parallels? In many senses the US is traveling down a very similar path. Key differences for now being, as Japan entered its period of credit bubble bust and heightened financial market and economic volatility, it did so with an already existing very high internal savings rate. The US savings rate is just starting to increase after decades of compression. Japan had a very large current account surplus while at present the US is still in deficit position that has existed for well over a decade, although it is improving as of late. And lastly, Japan had a viable, competitive and growing export sector. The US certainly is not devoid of export strength, but it has a massive amount of global competition in the current global down cycle. And still Japan exhibited meaningfully increased economic and financial market volatility in the credit bubble aftermath period. Again, Japan and the US are two different economies, social systems, etc. They just happen to have one thing in common, though. Human beings are making the key decisions that will influence economic and financial market outcomes. And of course the US has the same crew aboard who "never saw it coming" in the first place. No worries as we're sure their "vision" has been subsequently corrected to 20/20, hasn't it? Prepare for shorter US economic expansion cycles characterized by heightened volatility in the absence of another maniacal credit cycle. That seems to be the clear message of history speaking quite loudly.