Optimism is breaking out all over. The stock market is up 50% since early march, and pundits are discussing how long it will take to get back to the levels of 2007. The economy appears to be recovering nicely, and the Obama administration is attempting to claim credit for causing it to do so through its “stimulus.” Housing has bottomed out, and in Britain is even showing something of a bounce. Was it all a terrible dream, after all?
No, it wasn’t. And the worst is yet to come.
I have written in the past about my view that this recession would take a W shape. Even among pessimists, this has been a somewhat unfashionable view; the normal pessimistic outlook was for a simple U, with recovery being very slow. At the beginning of this year, a number of commentators speculated whether the recession could worsen until it matched the Great Depression, with a 25% drop in Gross Domestic Product. I always thought this very unlikely, if only because the Great Depression was the result of a staggering chain of politician incompetence, unlikely to be repeated. I thus forecast a 5% drop in GDP, top to bottom, worse than other post-war recessions but nothing like the Great Depression. In the event, the drop in GDP has so far been just under 4%, still the worst since World War II, but only by a whisker.
My modest forecasting error may have been due to the beginning effects of President Obama’s $779bn stimulus plan, passed in February and partially coming into effect in late spring. Certainly the Obama administration would like everybody to think so. However the benefits of spraying public spending around the economy appear more quickly than its costs, so their rejoicing may be premature.
When you look at the current picture, a number of anomalies become apparent. For one thing, energy, commodity and precious metals prices have been rising consistently, as if we were in the middle of a raging boom, or galloping inflation. Bond yields, after rising somewhat as one would have expected, have backed down again and are extraordinarily low in relation to current inflation of around 2% or a reasonable inflation forecast significantly higher than that.
Then the stock market’s rise has been altogether too vigorous. One would have expected some kind of bounce off the early March low as the economy bottomed out, but the 50% rise we have seen is abnormal, and has put stocks well into overvalued territory again. This is not 1933, and at the bottom the stock market was not at 1932 levels, merely at a somewhat conservative estimate of its fair value.
Based on the stock market prices of early 1995, when the economy was in approximately in equilibrium, one could have expected the Dow Jones Index to have risen from its 4,000 at that point to around 7,800 — in line with nominal GDP. At that point the market would have been equivalently valued, in terms of the economy, to its level in early 1995. However early 1995 was already four years into the long 1990s boom, and the market was almost 50% above what had seemed an unsustainable peak in 1987. Thus at over 9,500 on the Dow Jones index the market looks distinctly overvalued, in relation to today’s questionable prospects for the US economy.
With commodities prices behaving as if it was still 2007, the stock market overvalued and bond yields extraordinary low, it should be clear that the poison of the 1995-2007 monetary excess has not been eradicated, far from it. When you add to that the record federal deficits, whose long-term effect we really do not know, it becomes clear that we will need to go through another credit crunch, with financing availability tight and interest rates much higher than at present, before the economy can enter healthy recovery. Without such a crunch, oil prices will continue rising inexorably, and will reach $200 a barrel within a year, which will certainly have a most unpleasant economic effect, simultaneously deflationary to economic activity and inflationary to the cost of living. (The theory that you cannot have both recession and inflation simultaneously is mad, and disproved by experience for anybody in Britain or the US over the age of about 45.)
Paradoxically therefore, the longer the current bounce lasts and the more vigorous it is, the more unpleasant will be the ensuing downturn. As the middle spike in the W grows — even if it involves little revival in US consumer spending — the imbalances of excessive monetary and fiscal expansion become more extreme and the resulting crunch nastier. If the stock market, bond market and commodities bounce end within the next month or so, then the W may be only mildly “lazy” with output falling only slightly below the false bottom established in late spring. However since the Fed and the administration are both determined to continue “stimulus” policies it is more likely that the bounce will continue for another 6-12 months, with the stock market getting back towards 2007 levels, removing the effect of the credit crunch, oil prices heading above $100, and gold passing $1,500 per ounce.
In that case, by next spring inflation will be running around 5%. Bulls will chortle that the recession is over, and will attempt to ignore the excessive prices of stocks, commodities and bonds (with real yields on 10-year bonds being by then negative) but the market will not allow them to do so for long.
The rebound will end in one of three ways. The least likely is that Ben Bernanke and the administration will come to their senses and begin to withdraw the excessive fiscal and monetary stimulus. They won’t dare withdraw much, but even the beginning of withdrawal will cause panic in overextended financial markets. Since politicians generally and Bernanke in particular are above all determined to avoid blame, it’s unlikely they will choose this course, which would leave their fingerprints too clearly on the subsequent unpleasantness.
The second possibility, as I discussed last week, is a bond market strike, in which yields shoot upwards and the market refuses to absorb the ever increasing amounts of Treasury confetti Tim Geithner attempts to offload. In that event, the Fed would almost certainly step in to buy Treasuries, intensifying the monetary stimulus.
That would then bring about the third possible denouement, in which rapidly accelerating inflation and rapidly accelerating commodity prices cause a collapse in real demand, plunging the US into renewed recession. That process is likely to take longer than the others, perhaps a year. At that point, the Fed will also be forced to stop buying Treasury bonds, or watch the US slide into the situation of 1923 Weimar, with wheelbarrows needed for daily cash.
Since the choice of triggers is at present uncertain, the precise shape of the second leg of the W is also unclear. We can be sure however that it will involve a deeper trough than we have so far seen, so that the W’s shape is thoroughly “lazy” – or as I have heard expressed elsewhere, it becomes a square-root sign. It will also be accompanied by a burst of inflation and much higher interest rates. The latter however should be welcomed, as they will at least provide the real returns for saving that in a civilized economy would never have been allowed to disappear as they have over the last decade.
The above analysis has treated the US economy as an isolated entity, but of course it is nothing of the kind. Internationally, the future economic track will vary. Some countries, such as Germany Brazil and Chile, avoided excessive fiscal or monetary stimulus and so will see quite vigorous bounces out of a relatively short recession, with little resurgence in inflation. (Brazil will suffer over the longer term from its misguided new oil policy, which provides a huge new slush fund for politicians to waste, but that is another story.) Japan’s trajectory will depend on whether the new DPJ government is decently fiscally disciplined; its approach of shifting resources from infrastructure to middle-income consumers makes sense, but it needs to withdraw more resources than it injects, since Japan’s fiscal position is teetering on the edge of disaster.
At the opposite extreme, Britain’s economy is more distorted than the US one, because both fiscal and monetary stimuli are more extreme, with the Bank of England buying enormous amounts of government debt. Housing has already bounced, up 8% in London in the last few months, which makes no sense economically since London housing is wildly overpriced. This almost certainly means a square root sign of considerable severity, with the second downturn much worse than the first, and accompanied by rapid inflation, while the remnants of the City of London decamp overseas to avoid soaring local taxes.
India is obvious; the country is already running into the balance of payments crisis that will mark the end of economic growth for a while. China is extremely obscure; one cannot believe that there won’t be a banking crash of huge magnitude, but the country has managed to avoid one for the last 30 years and may somehow be able to do so again.
There may well be further profits to be made in stocks and commodities in the next few months. Enjoy them, because the second downward leg will be truly unpleasant.
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)