Head Fake?
January 29, 2009
By Richard Berner | New York
The global economy fell off a cliff in the fourth quarter of 2008. Official data from countries as diverse as Great Britain and Korea indicate that output collapsed in the final three months of last year at the fastest pace on record. In those two economies, output plunged by 6% and 20.8% annualized.
A fierce debate is now unfolding over the economic prognosis: Many hope that these shocking declines in global output represent a massive destocking of the global supply chain that has gone so far, it has to snap back. Coupled with scattered signs of stability in business surveys and the fact that policy stimulus is coming, this belief has spurred hopes that the worst is over or even that a rebound is coming. Such an inflection point – famously identified by its mathematical label of a positive second derivative – would be critical not just for the economic prognosis, but also for markets. Negative market sentiment is intensely pervasive, so any less-bad news could promote a rally in risky assets. Would that it were true. In our view, recovery is coming eventually, thanks to efforts to repair the financial system, massive stimulus, and the ebbing of recessionary forces. But a sustainable economic rebound is unlikely soon. The fundamentals behind demand are still negative, inventories are excessive, and the lags between coming policy changes and their economic impact may be longer than hoped. Indeed, barring significant changes in the pending US fiscal stimulus plan, its timing and thrust seem likely to disappoint. We think the upside and downside risks now seem more evenly balanced than a month ago, and the freefall in economic activity will turn less intense in the next couple of months. But in our view the improvements in recent data are for now more noise than signal, and likely represent a transitory deviation from the fundamental weakness of the overall economy. Investors beware: The road through this recession to recovery will turn more bumpy and treacherous, marked by dead ends, false dawns, head fakes and other dangerous critters. A clear implication is that it is likely too soon to embrace risky assets. There’s no mistaking recent weakness, even in economies for which official 4Q output figures haven’t been published. We estimate that, courtesy of sharp declines in consumer spending, business investment, housing and exports, US output tumbled at a 6.5% annual rate in 4Q. In the Eurozone, we think real GDP contracted by about 4%, and in Germany by more than 6%. In other economies and regions where the data on output are published with a longer lag, indicators ranging from industrial production to exports are declining at a double-digit pace. While the experience is diverse, that’s largely true for Japan, Asia excluding Japan, some countries in Latin America, and many in Central and Eastern Europe. For example, our team reports that in Brazil, one of the last economies to see the downturn, many indicators for 4Q08 show the sharpest decline on record – from car production and paperboard sales to heavy vehicles traffic and business confidence. These sharp declines in production seemingly make the logic for a rebound straightforward: Production cuts have gone well beyond the declines in demand, so inventories are thought to be razor-thin. Interest rates and energy prices are down, frozen markets are thawing, and fiscal stimulus is coming. Other scraps of evidence support this thesis: Mortgage applications have spiked, funding and credit markets are active, and the University of Michigan index of consumer sentiment has bounced off its November trough. Early-January production indicators have turned less negative. In the US, for example, the January Empire and Philadelphia Business Outlook Surveys rose by 6 and 11 points, respectively. Our own Business Conditions Index jumped by 11 points in early January. US leading indicators rose by 0.3% in December, reflecting a steeper yield curve and growth in the M2 monetary aggregate, and existing home sales jumped as foreclosure sales rose. In Europe, production seems aligned with plans, and improvements in the Eurozone flash manufacturing PMI and the Belgian BNB survey and a stabilization in the French INSEE survey hint at an eventual recovery. Big increases in Ukrainian and Russian steel exports in December and January probably reflect the impact of devaluation and a correction after large-scale shutdowns in October-November. Industry analysts cite anecdotes of improvement as well. For example, Equistar, one of the largest producers of ethylene, propylene and polyethylene in North America, says demand for petrochemical derivatives is showing signs of improvement in 1Q. This is the first chemical company to make a positive noise for several quarters. We see three problems with this thesis. First, the crisis hit when inventories were excessive. Despite five straight quarters of inventory liquidation, equaling the records for duration from 1981-82 and 2001-02, stocks are not especially lean. On the contrary, judging by inventory-sales ratios and purchasing managers’ surveys, inventories are more out of line with sales than at any time in nearly a decade. We estimate that the real inventory-sales ratio in manufacturing and trade jumped to 1.42 in November – up 10 points off its 2007 lows – as real sales plunged nearly 6% from a year earlier but real inventories fell by only one-third as much. While purchasing managers have slashed their stocks, the ISM customer inventories index jumped to 57 in December, the second-highest reading ever. So even if demand stabilizes quickly, which is in doubt, more production cuts lie ahead. In Japan, automakers are cutting production in order to trim bloated inventories. The second problem is that head fakes and false dawns are common in recessions. The intensity of contractions is never uniform, and changes in business behavior can cluster or move in waves. Quirks in the weather or other factors can create deviations in business surveys and economic data that are inherently volatile. Classic examples of US head fakes are the double-dip recessions in 2001 and 2007-9 (yes, the current recession began in December 2007). In fact, history shows that such ups and downs within recessions are common. In the 1957-58 recession, the economy rebounded sharply after contracting in the spring of 1957, but relapsed into two quarters of steep declines. In 1960, a 3Q increase in activity separated contractions in 2Q and 4Q. Two quarters of contraction kicked off the 1969-70 recession, followed by two quarters of growth and a final setback in 4Q70. In the long 1973-75 recession, two separate quarters of growth (4Q73 and 2Q74) interrupted a long downturn. And the six-quarter downturn in 1981-82 encompassed two separate quarters of economic growth. Most important, the fundamentals are still negative, although the positive factors cited above mean that the risks to US and global growth are now more balanced around a weaker baseline than a month ago (see Global Forecast Snapshots, January 2009). The full impact of the tightening in credit is still playing out, so it’s too soon to expect a reversal. Indeed, the adverse feedback loop from the credit crunch to a deteriorating economy and balance sheets prompted our colleague Betsy Graseck to increase her estimates of cumulative losses in the US financial system to US$1.5 trillion, and this will feed back to a further tightening of lending standards. Global economic activity has just begun to fall, and this will feed back to weaker US exports (see Global Recession Aggravates the US Downturn, January 12, 2009). Moreover, a deep US and global capital-spending recession is now underway, one that may rival the bust of 2001-2. The economic ‘accelerator’ is working in reverse, and slumping operating rates, sinking profitability and tighter financial conditions are all dragging down investment outlays. They will suffer early in 2009 as the expiration of investment tax incentives on December 31, 2008 will accentuate the downturn (see The Capex Recession Goes Global, December 1, 2008). Policy implications: For the Fed, with interest rates now effectively at zero, these developments mean that it is important to continue to expand its menu of financing facilities and purchases of long-term securities in order to ease the credit crunch. The Term Asset-Backed Securities Lending Facility (TALF) will go into operation next month and could be a template for helping other markets, like those for commercial MBS and municipal bonds. The Fed will also continue its aggressive purchases of residential MBS and agency debt through the spring, which should support those markets until the Obama Administration can begin to use the housing GSEs’ balance sheets to support housing finance. While the Fed is unlikely to take the option of purchasing longer-term Treasuries off the table, such outright purchases seem less likely than buying other assets, unless rates back up significantly under the weight of heavy Treasury supply. And Fed officials likely will collaborate with the incoming Treasury team to explore options for cleaning up bank balance sheets and mitigating mortgage foreclosures.
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Could Hyperinflation Happen Again?
January 29, 2009
By Joachim Fels & Spyros Andreopoulos | London
According to Philip Cagan’s (1956) classical definition, hyperinflation is an episode where the inflation rate exceeds 50% per month. The historical examples of hyperinflation mostly occurred in the 1920s, when Austria, Germany, Hungary, Poland and Russia experienced galloping price increases. For example, Germany in 1923 recorded an astronomical inflation rate of 3.25 million percent in a single month. Since the 1950s, hyperinflations have been confined to developing and transition economies. Some recent examples include Argentina (1989-90), Bolivia (1984-85), Brazil (1989-90), Peru (1990), Ukraine (1991-94) and Zimbabwe in the past several years. The root cause of hyperinflation is excessive money supply growth, usually caused by governments instructing their central banks to help finance expenditures through rapid money creation. Hyperinflations have mostly occurred in a context of political instability, adverse economic shocks and chronically high fiscal deficits. Hyperinflationary episodes are characterised by a general loss of confidence in the value of money, a flight into real assets and hard currencies, a surge in barter trade, and a shrinkage of financial intermediation and thus of the banking system. An important empirical feature of hyperinflations is the high correlation of money supply growth and inflation rates. Money growth and inflation rates are also highly correlated in milder versions of high inflation episodes. Past bouts of high inflation in the UK, Italy, New Zealand and Mexico were preceded and accompanied by high growth rates of the money supply. It is important to note that in low-inflation and low-monetary growth environments, the relationship between money growth and prices is much weaker or altogether non-existent. Average money growth rates have varied substantially between countries that have experienced relatively low (single-digit) inflation rates. However, countries with sustained high money growth rates have also experienced sustained high inflation. Against this backdrop, could hyperinflation or high inflation happen again? Possibly yes, under certain circumstances. First, the rapid expansion of the monetary base that the Fed, the ECB, the Bank of England and others have engineered in the last several months would have to continue and, importantly, would have to feed into a more rapid and sustained expansion of money in the hands of the general public. Money supply M1 (consisting of currency in circulation and sight/checking deposits by non-banks) has gained momentum recently, especially in the US. We will be watching closely how this measure of money will evolve in the coming months. Second, governments would have to face difficulties in financing rapidly rising expenditures on the various stimulus and bailout packages through taxes and selling bonds to the general public. In such circumstances, political pressures on central banks to monetise government spending would probably rise. This could be done through central bank loans to the government, central bank buying of government bonds at auction, outright unsterilised purchases of government bonds in the open market or additional lending to banks against government collateral. Last, but not least, a combination of sustained monetary growth and high fiscal deficits would have to undermine the general public’s confidence in both the government’s ability to service the debt without taking resort to the printing press, and in the central bank’s ability or willingness to resist such pressures. A sudden surge in inflation expectations on the back of such a loss in confidence would induce people to reduce their deposits and cash holdings and pile into real assets. The velocity of money and inflation would rise, and the government/central bank would have to keep printing ever more money to finance government spending. Clearly, this is an extreme scenario. Governments and central banks would have to jettison their commitment to long-term fiscal sustainability and keeping inflation low, and the public would have to lose confidence in their credibility. Given the reputation that central banks have built up, and given the commitment of central bankers to maintaining low inflation, a return to high inflation or even hyperinflation would seem to us to be no more than a distant possibility. However, given the size of the current and prospective economic and financial problems, and given the size of the monetary and fiscal stimulus that central banks and governments are throwing at these problems, investors would be well advised not to ignore this tail risk, especially as markets are priced for the opposite outcome of lasting deflation in the next several years. Put differently, we believe that buying some insurance against the black swan event of high inflation or even hyperinflation makes sense and is relatively cheap currently.
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