Fears of a relapse in economic activity are stalking professional investors, judging by the fall in Treasury bond yields, the sagging equity indexes and the softening of commodity prices over the past month or so. Our stated position has been that investors got ahead of themselves with all the “green shoots” rhetoric. This is clearly not your garden-variety recession, so operating from the typical playbook is not advisable. Sifting through the volumes of macro statistics, our assessment has been that the economy is still struggling with a severe recession complicated by balance sheet issues, and, at best, we could find some signs of stabilization in spending and activity starting to shape up in recent months.
To our mind, the twin head winds of private sector deleveraging and impaired financial institutions with unusually high-risk aversion are the larger issue. If the business and household sectors seek to maintain a high net saving position (that is, saving from income flows minus tangible investment expenditures), as was the case in Japan, then barring the political willingness to allow debt defaults and rapid relative price changes to rip through the economy, only a rising trade surplus plus an increasing fiscal budget deficit can deliver US economic growth. As we will show you in a moment, though, we are detecting for the first time some signs of life in business investment.
Most investors, policymakers and economists appear to be either ignoring the implications of private sector deleveraging or have implicitly assumed any such deleveraging will prove short-lived. The latter is, of course, more consistent with their experience, but as many professional risk managers at hedge funds and other institutions recently learned the hard way, the past is at best an imperfect guide to the future – especially if you do not stop to consider why the past developed the way it did.
We have expressed the challenges of private sector deleveraging in our work on US financial balances.
In simplest terms, the challenge of a balance sheet recession is this: In the face of a large drop in asset prices, the private sector reduces spending on goods and services in order to save enough money out of income flow to reduce balance sheet leverage. Unless the trade balance improves and fiscal stimulus is ramped up in a large enough fashion, private income flows will tend to fall as households and firms spend less money to try to reduce debt loads. Realizing that one man’s outlays are another man’s income, the end result of this process is much like a dog chasing its tail: Private sector income deflation arises as spending is curtailed, and falling income aggravates attempts to reduce debt burdens.
In a world where Austrian School precepts held sway, the dog would be allowed to exhaust itself and start out fresh, facing less-distorted relative price signals that eventually would lead to a more productive set of behaviors. Debts that could not be supported would be allowed to disappear in default, creditors would gain ownership of any remaining tangible productive assets and prices for products and labor would adjust until growth returned to the trend path dictated by the available supply of productive resources and the willingness of entrepreneurs to search for profitable production opportunities.
Few nations appeared prepared to take the pain of such unfettered adjustments. Instead of allowing a debt deflation to rip and eventually burn itself out, contemporary policymakers aim to reduce debt-servicing costs, socialize losses and buttress private sector money income flows. Two routes to buttress private sector money flows are available: first, by an improved trade balance (so more domestic and foreign spending is received as income by domestic producers) and, second, by an increased fiscal deficit (so more income is received by the private sector from government expenditures than is removed by taxation). At a global level, until we discover life on another planet, the first exit strategy is, of course, unavailable.
Balance sheet recessions have distinct characteristics from normal garden-variety recessions, and so it is no surprise that recoveries from balance sheet recessions will tend to have different profiles as well. Consumer durable and home sales usually, along with an abatement in the pace of inventory reductions, lead the charge in garden-variety recessions. Not so this time – or, at least, less so. We anticipate recoveries in these areas are likely to prove shallower than usual, but judging from the move in the S&P 500 consumer discretionary stocks year to date, most investors have been positioning as if we were working with a more garden-variety recession. We suspect this will prove to be a mistake, especially as more of the infrastructure-related components of the fiscal policy come into view as 2010 approaches.
For example, consumer expectations, as measured by surveys performed by the University of Michigan, have tended to offer a reasonably good guide to the year-over-year growth rate in consumer spending, adjusted for inflation. July results so far display a 9-point decline in expectations, back below the April readings, but still above the recent February lows. The latest reading on inflation-adjusted consumer spending growth is still as bad as it was during the depths of the 1973-5 recession, which we know was the deepest recession of the post- World War II period. While consumer expectations are consistent with real consumer spending growth migrating back to flat year-over-year gains, this is not the usual liftoff that is typical of garden-variety recessions.
However, Dr. Richebächer worked with a model of economic growth driven by business capital spending, not by consumer spending. This approach was consistent with much of the emphasis of the classical economists, who emphasized the importance of capital accumulation to growth. It was also consistent with Austrian School insights and the work of J.M. Keynes (although subsequently forgotten by some Keynesian followers).
In this regard, the collapse of US business investment spending as a share of GDP over the last two quarters is most striking, and no doubt this is in part testimony to the “lockdown” mentality that spread among corporate CFOs after the Lehman Bros. debacle and the subsequent freeze in credit markets. CFOs went into cash conservation mode and, of course, not just inventories and payrolls got the axe, but capital spending plans were put on ice.
In a smoothly growing economy, households do not consume all that they produce. They save out of income flows, and businesses mobilize the associated unconsumed output as working capital or in the production of new plant and equipment. With the sharp revival in the personal saving rate in the wake of plummeting asset prices and extremely weak job prospects, it is no wonder that US nominal GDP has tracked a deflationary path in recent quarters. Higher household saving, with no mobilization of that saving into reinvestment in plant and equipment, is bound to short-circuit any economy.
We believe the extremely sharp retrenchment in business capital spending is important because the gross spending flows are nearly down to estimated levels of depreciation. That is to say net investment is fast approaching zero. If this is correct, replacement demand for capital equipment is likely to arise in some industries, and therefore could play a larger role in any economic recovery than usual.
We cannot ignore that some industries will be shrinking their available capital stock as the economy adjusts to a reduced private debt growth path. Autos are an obvious case in point. Nor are we ignorant of the extremely low reading on capacity utilization in the manufacturing sector. But we suspect investors and economists may be missing the fact that gross capital spending has dropped so dramatically that replacement demand for capital equipment is likely to kick in sooner than usual. Indeed, perhaps this recognition of the onset of replacement demand is part of the relative performance in tech stocks year to date, as the tech capital stock tends to depreciate quicker than other forms of capital equipment.
We have previously noted the Institute for Supply Management (ISM) new orders series has been signaling a revival in order flows, and with the usual three-four month lag, Commerce Department orders are, in fact, confirming the ISM improvements. Dollar levels of manufacturing orders are starting to make the turn, and capital goods orders are already showing improvement off levels that marked the end of the last recession. By composition, the order improvement is reported in the industrial machinery, materials handling machinery and nondefense aircraft and parts segments. Recent Boeing announcements call the improvement in the last category into question, but the key point here is that even at historically low rates of capacity utilization in the manufacturing sector, there are signs of life in new orders for capital goods. The initiation of replacement demand for some types of capital equipment may have begun given the sharp plunge in gross business investment to levels close to estimated depreciation.
We are quite certain Dr. Richebächer would have recognized this is no garden-variety recession, and so we believe he would agree that positioning investment portfolios as if it were, green shoots in the consumer area and all, is unlikely to prove very satisfying. We are also quite certain Dr. Richebächer would have argued any sound and sustainable recovery requires an improvement in business investment. Business investment is the route to lower cost production and product innovation, as well. In the absence of any such improvement, higher household saving rates will simply tend to show up as shortfalls in the revenues of consumer-oriented firms and a weak, if not falling, nominal GDP. What we wish to share with you is that we are finding evidence that business capital spending has been cut so sharply over the prior three quarters that it is reasonable to expect some replacement demand to begin showing up – and indeed, for the first time in months, we can find evidence of higher new orders for capital goods. While fears of a relapse are still building, that is one green shoot we believe Dr. Richebächer would deem worth applauding.
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