Recently, many economic indicators out of the US—housing starts, building permits, pending home sales and vehicle sales—have turned out to be not only worse than expected, but even contracting. The labour market data for June released on 2 July confirmed that the unemployed face the daunting prospect of remaining as such for a very long period of time. The duration of unemployment went up again and sharply in June. The mean duration of unemployment is now 35.2 weeks (nearly nine months). Those who are unemployed for more than six months now constitute around 45% of the overall unemployed.
Further, those who hold jobs are receiving lower wages. The annual wage growth in the US is now 2.3% and declining. The implication of this is that consumer spending is unlikely to support the economic growth forecasts of the market consensus.
For stock market investors, the decline in the Institute for Supply Management Purchasing Managers’ index (ISM index, for short) should be a matter of concern. The ISM index came down from 59 to around 56 in June. According to historical data, the median returns from S&P 500 in the 12 months since the ISM index hits a level of 60 is a paltry 1.1%. The bulk of the stock market returns are made when the ISM travels from below 50 to a level of 50 and not after it reaches 60. Certainly not on its way down either.
In addition to the weak financial market signals emanating from the “peaked and declining” ISM index, the economic portents are not encouraging either. The Weekly Leading Index of the Economic Cycle Research Institute (Ecri) is now contracting. Its annual “growth” rate is now -7.7%. According to a recent post by John Mauldin, the 13-week annualized rate of change of this index is now -23.5% and, in the past, it has always presaged either “recession or pointing to recession in short order”.
By now, it must be apparent that the structural force of the accumulated debt of the last 20 years exerts a powerful drag on the US economy, overwhelming the stimulus measures. The boost provided to economic growth fades after a momentary effect. A similar phenomenon is witnessed in the stock market too. In the aftermath of the Federal Reserve quantitative easing and stimulus announced in mid-March 2009, the S&P 500 stock index staged a powerful rally. It lasted around five months at most. The S&P 500 index has been virtually unchanged from end-August 2009 until end-June 2010.
One way of restoring sustainable growth is to allow the forces of deleveraging to play out until the point when it is safe to releverage the economy. After all, the marginal productivity in terms of generating economic growth of debt has been declining in the US. This is done through inducement to savings and debt reduction with minimum and targeted support from the fiscal authorities to the poor.
Federal Reserve governor Kevin Warsh, in a recent speech, warned of the consequences of throwing more money at the structural problems that bedevil the US economy. He is understandably nervous about bloating the Federal Reserve assets through purchase of government debt with freshly printed dollars. In contrast, some argue that the reason the effect of the stimulus fades after a while is that the stimulus measures so far have been neither big nor long-lasting. I suspect they would prevail in the end.
Anticipating that the US policymakers would resort to the last throw of the dice in terms of further easing of monetary and fiscal policies, the euro has reversed course against the US dollar in recent days. It is also in line with what we have seen for the Japanese yen over the last 20 years. Deflationary and stagnating Japan has seen its currency appreciate as deflation boosts purchasing power. The same thing might be beginning to happen to the euro zone and hence the euro is beginning to trace its bottom versus the US dollar.
The US is still setting public policy to avoid the repeat of the Great Depression of the 1930s that has left such a powerful scar on its psyche. Equally, for Germany, the hyperinflation of the 1920s guides its penchant for deflationary monetary policy and fiscal austerity. Both regions are thus setting policies to correct historical accidents rather than for the present situation. The US can do with less activism and more austerity, whereas Germany need not self-flagellate this much. In their own ways, these two regions are thus set to exacerbate the global imbalances with uncertain and unknown consequences.
This should remind readers of Mark Twain’s quote on statistics: if you have one leg on burning firewood and another on an ice bar, statistics would tell you that on average you are comfortable. The US and the Europe are equivalent to the firewood and ice bar, respectively. Investors are better off jumping off both.
V. Anantha Nageswaran is chief investment officer for an international wealth manager. These are his personal views. Your comments are welcome at firstname.lastname@example.org