When I am asked whether I think this is a rally in a bear market or a new bull market, my answer is “neither”. In my opinion, investors have reacted with relief to the growing sense that we are not headed for a depression. We think we can now plumb the bottom of the economic decline. The result is a modestly higher level of valuation (up 26% from the March 9 low) that is no longer anticipating a trough of unknown dimensions. You can think of it as a higher but still depressed plateau, around which stocks may fluctuate in a fairly wide range for some time ahead.
But, let’s get something straight. The U.S. and global economies are still contracting at an uncomfortably rapid rate. Just not as rapidly as they were. The rate of decline of the rate of decline has declined! My friend and economist Larry Chimerine suggests that whereas we have been experiencing a GDP contraction per month of about 0.5 to 0.6% since last September, the rate of decline may now be “only” 0.2-0.3% per month. The fever gas gone down a bit but the patient is still quite sick.
Importantly, credit market conditions have improved, and Wall Street, obsessed as it is with its own activities and problems, has reacted quite positively. For this, give full credit to the Federal Reserve in helping to satisfy high levels of liquidity preference on the part of market participants. As I have said before, imagine how bad it would have been if investors and business executives had tried to satisfy their preference for liquidity within a static stock of money. Our worst deflationary fears would have been a reality. (Speaking of deflation, see footnote on deflation in China)
But make no mistake. There is plenty of ugly news ahead. The quality of bank assets continues to deteriorate, even as the banks, enjoying extremely low cost funds, are making decent operating profits. The labor market still stinks. April is on course for another 700,000 job loss. And at this rate of job loss don’t try to convince me that labor statistics are a lagging indicator. The negative coincident effects on demand will be palpable.
Housing activity, adjusted for foreclosure sales at very low prices, is bumping along a very deep bottom, and housing prices are still declining at a rapid rate (an annual rate of over 26% for the latest three months). In fact, real estate of all kinds is falling in price pretty much continuously since early 2008. Moody’s Real Commercial Property Price Index (effectively an index of transaction prices, for all commercial properties, declined about 19% during 2008, and was down 5.5% in December (the latest number). Things have almost certainly gotten worse since then. (For more on commercial real estate price changes go to http://web.mit.edu/cre/research/credl/rca.html )
Household net worth continues to fall, and is now down over 30% from late 2007. It seems almost impossible to me that consumer optimism and spending will be anything but anemic and weak for months to come. To be sure, tax refunds are up substantially, and mortgage refinancings have climbed, adding to consumer spending power and softening the decline of retail sales. But a significant and lasting change for the better in consumer spending is simply not in the cards for many months.
Yes, fiscal stimulation will be a plus, particularly as we enter 2010, but a significant piece of federal spending will be offset by an ongoing contraction of state and local government spending. And the time that any sizeable stimulus spending actually begins is probably a year away.
Having been raised as a monetarist, I continue to put as much if not more weight on monetary expansion, which is being relentlessly and aggressively pursued by the Fed. Because of the Fed’s actions, I think we have avoided an even more extended and deeper economic contraction. True, so far the growth of the money supply has been sterilized by declining velocity, a reflection of high liquidity preference. But that will ultimately change, as it always has before, but with a lag.
I think there is a glimmer of light at the end of the tunnel. Policy actions will begin to give the economy some positive traction before the end of the year. But don’t expect much after a nice initial bounce that will come from some inventory building, some recovery in housing based on a large leap in affordability, and an eventual leveling of unemployment.
I have written before and repeat here that this is more than a recession. It is the beginning of a transition to an economy that will be characterized by an extended period of higher private savings rates and lower public savings rates. In other words, higher savings by consumers and businesses and higher dissaving by government. We will see lower consumption and private investment as a share of total domestic demand and a rising share of government consumption and investment. Compared to the years leading up to the current economic illness there will be more reliance on domestic private saving to finance government dissaving, and much less reliance on foreign savings to fill the gap. (see footnote on Savings and Investment)
Incidentally, in the past, periods of declining private savings have coincided with high returns from stocks, and periods of increasing savings rates have been accompanied by low returns.
Just how long this pattern of total demand will stay with us, nobody can say. We also are unable to judge at this point whether or not private savings will be sufficient, so that the Federal Reserve need not resort to monetizing a significant share of the increase of government debt and/or that we once again become uncomfortably dependent on foreign savings.
For those of you who are concerned about ultimate inflation, I refer you to a discussion of that subject in my April Musings.
Footnote on deflation in China: The Wall Street Journal reported China’s growth rate last quarter at 6.1%. But what wasn’t said is that 2.4 percentage points of that growth came from deflation. That’s right. Nominal growth was 3.7%. Just as inflation is a subtraction from nominal growth when calculating real growth, deflation is an addition. Interestingly I’ve seen very little comment on this. I am no expert on China, so I will not speculate on what this means.
Footnote on Saving and Investment: A reminder to those who might have forgotten their college economics: in National Income accounting, saving and investment are an identity, i.e., are equal by definition. Thus, as government dissaving (borrowing) rises, either private saving must rise, and/or private investment must fall, and/or savings must be “imported” from a nation or nations with a savings surplus. Over the past few years we have been big importers of savings to finance an extraordinary climb of domestic consumption to record levels as a share of GDP coincident with a high Federal deficit. China, as a major exporter to satisfy our domestic demand, has been our largest source of foreign savings inflows, resulting in that nation owning a huge piece of our Federal debt.