Think Piece: Economic Disjuncture

Much of the commentary in the financial media is focusing on the Euro region, and the dire prospects for a sustainable solution to deal with Greek sovereign debts that avoids contagion to countries such as Spain, Portugal and even Italy, and at the same time avoids consigning a large portion of the populace to penury. External balances indicate that under normal circumstances Italy in particular would be unlikely to be vulnerable.

 Meanwhile, the equity markets have in reality exhibited impressive buoyancy. They appear to have been sensing developments that are somewhat removed from mainstream concerns, not immediately relevant to the economic consensus, or the analytical community generally.  Gloom about economic prospects is deepening, but key Wall Street indices closed last week at a 2 ½ month high. 

In the UK, the respected Item Club (which deploys the HMT economic model to generate forecasts), has just shaved its forecast for growth in the UK economy in 2011 from 1.4 percent three months ago to 0.9 percent. Even more strikingly, the most recent minutes of the Bank of England meeting reveal that the BOE has trimmed its forecast growth rate for the remainder of the year to almost zero.      

 Some of this will be down to the incorporation into the Item club model of new data reflecting existing conditions. The more fundamental dynamic responsible for the economy treading water to my way of thinking is the erosion of household incomes and purchasing power consequent on persistent inflation and weak sterling, all aligned to an excessively accommodative monetary policy.  Such monetary policy for instance contributes to higher energy prices through fostering currency weakness, while at the same time awarding pricing power to the major energy suppliers.

These forecast revisions, though, are curiously at odds with the September retail sales statistics, which were 0.6 percent up on the month in the context of a 15.5 percent rise in the category that includes internet purchases.  This number, released a few days after news of a horrible inflation statistic – CPI up 5.2 percent year-over-year – suggests that had the BOE delayed until next month it would have found it difficult to justify the £75bn expansion of the quantitative easing programme announced on 6 October.        

Perhaps the focus all round is on the wrong dynamic?  This idea will be risible to some, but, just possibly, Europe and the Euro is not the main issue right now? If some important cataclysm in Europe does unfold it will surely be one of the most widely anticipated crises in economic history.  Typically though, past crises tend to suggest that it is most often the unanticipated shocks that occur; if it were possible to anticipate shocks they would not occur because appropriate evasive action would be taken.  Known unknowns and unknown unknowns spring to mind.  Those who do think that Europe and the Euro deserves to be centre stage contend that this is precisely the problem; that EU leaders are in denial about the scale of the response required.    

But what has always exerted a powerful tow on stock markets has been prospects for the US economy.   When the US sneezes, the rest of the world catches a cold.  During times of recovery, the US economy has often acted as the locomotive to pull the rest of the world along. Frequently, global stock markets dance to a US-conducted beat. 

Indeed, when the purchasing managers reports’ for September on the state of manufacturing worldwide were reported on 4 October,  my first thought was that the spin being placed on these reports was too gloomy, that they could easily have been reported as depicting glimmerings of cheer.  True, the indices were at a level at which they were flirting on the borderline between expansion and contraction. But both in the US and the UK the indices displayed a slight uptick on the margin, although that for the Euro zone continued to plough a deeper furrow into the zone of contraction.  Why I refrained from writing a quick note to the effect that the purchasing managers’ data are indicative of somewhat better circumstances than were widely acknowledged, is that while current conditions can arguably be portrayed in a better light than they have been, future prospects remain unpromising, as reflected in weak order books. In the US, these are just slightly below the breakeven point. 

What is crucial is the interplay between expectations and data releases.  Gloomy prognostications abound; perhaps these are by now fully discounted by markets.  The purchasing managers reports portray the manufacturing sector toying with outright contraction in the context of weak order books but the flow of statistics denote some signs of improvement, or at very least continued growth, albeit uninspiring growth.

Post the release of these data some investors or perhaps computer models designed to detect changing trends with alacrity, have pushed equity markets materially higher, albeit on light volumes. Since then there have been quite a few moderately encouraging data releases, at least for the US.  Durable goods were moderately upbeat, the jobs data came in a little higher than expected and importantly too, the infamous “zero” jobs number was revised upwards. Retail sales confounded gloomy readings of consumer confidence. The key here is the discrepancy between expectations – what the market was expecting and was priced in – and the outcome.  Against a consensus forecast of 0.7 percent, retail sales in September gained 1.1 percent over the previous month, a rate which, if sustained over the course of a year would translate into a hefty gain of 14 percent.  The previous month’s figure was also revised upwards.  And auto sales increased an even more impressive 10 percent, fuelled by pent-up demand and the introduction of new models.  And – don’t laugh – fashion industry insiders expect the sector to remain “hot”.  In the UK the fashion industry accounts for a more substantial share of GDP than the auto industry.   

To be sure, we are far from out of the woods economically speaking.  The Ceridian-UCLA Pulse of Commerce Index, which monitors trucking activity in the US (in other words the extent to which goods are trucked across the country), fell at an annualised rate of 10 percent in August. Falls of this magnitude tend only to be observed during recessionary periods.  However, the economists who compile the index, while concerned at the development, are themselves not convinced of the double-dip scenario.  Likewise, Germany has to be at the heart of any successful efforts to resolve the Euro-zone worries.  But the reliable ZEW index of sentiment has plummeted to -48.3, worse than expected, and the lowest level since November 2008.  It does seem to be the case that the forecasts that the German economy will slip into contraction in the final quarter of the year and into the start of next year may well be proven right. 

This apparent disjuncture between the drift of economic statistics and how they are being interpreted and commented on could be an example of what psychologists call “mental set”.  The observer is predisposed to see something, so does, and any ambiguous information is interpreted as confirmation of the pre-existing idea.  This is one reason why economists need econometric models – to prevent us from falling foul of our existing prejudices.   Reporters know about current economic travails, and expect to see confirmation of same in current data releases.   Hence gloom currently pervades the financial media.  Of course, the media will always have a predilection for bad news since of one thing there is no doubt: bad news sells.  The subjective side to this is that the financial media seems to have fallen into “mental set”.  Some important data releases just before the equity markets began to bounce were interpreted negatively, but could in fact have been reported with a rather different spin.

However, even if the economy does remain as lacklustre as everybody seems to think it will, it is important to remember that economic weakness is not necessarily detrimental to stock market performance.  When the real economy tumbles, this lowers interest rates and frees up available money from the real economy to flow into financial markets instead, propelling valuations and share prices higher. Even under normal circumstances, this is a powerful dynamic.  But it is being turbo charged by Quantitative Easing (QE), and other unconventional policy measures.  QE1 fuelled the impressive bounce from the trough of 2009, which elevated the S&P500 more than 70 percent from its lows. QE2 counteracted the unfolding correction by ushering in gain of more than 30 percent from mid-2010 through to early May 2011.  And now the elixir of operation twist, a watered-down kind of QE, seems to have worked its not unexpected effect as it has infused its way into financial markets, even though it is widely held that the economic effects are likely to be negligible. 

An essay in Buttonwood ,The Economist , May 19 2011, http://www.economist.com/node/18713528 drew to the attention of readers the controversy over the link between GDP growth and stockmarket returns. The thrust of the essay is that there is a surprisingly weak correlation between the two, and even the advocates of investing in emerging markets on the basis of superior secular growth rates find it hard to muster much empirical evidence in support of their view that this will be matched by outperformance of investment returns. Indeed, there is no evidence that economic growth in any one year is correlated with equity market performance in the same year.  A strategy of investing in the stockmarkets of the economies with the highest (known) growth rates and avoiding those with the lowest (known) rates of growth does not reliably deliver consistent outperformance.

Our guess is that what may be happening in the US at least is a fairly typical driver:  the availability of money is expanding in relation to real economic activity.  This money is finding its way into financial markets, in the process lowering bond yields and giving a fillip to equity markets.  This is part of the monetary transmission mechanism that eventually leads to more vigorous real economic activity as well.

I also have a sense that some market participants may have been “gaming” central banks to an extent by invoking the spectre of deflation.  As I pointed out previously, deflation is an ill-defined concept.  Falling prices are not harmful in an off themselves.  What matters for the real burden of debt is the price level.  In the UK for instance inflation has overshot the 2 percent target for 22 consecutive months now, with the result that prices could fall for a time and still leave the price level above that it would have reached had inflation remained on target.

But market participants appear to have learned that if they raise the “terrifying” prospect of deflation enough times, central banks will eventually respond by infusing the system with almost free money, driving stockmarkets higher again.  One flavour of economic model posits that agents figure out policy rules and adjust their behaviour accordingly.  This would seem to be an example of such:  If there is a policy rule that fears of deflation lead central banks to engage in measures to expand the money stock, agents will learn the rule and adapt their behaviour so as to exploit it.               

Overlaid against this is the normal seasonal behaviour of equity markets as well. September tends to be the worst month for stockmarket performance.  During October the markets grope to establish some kind of bottom.  Then the strongest period for market returns unfolds through to the early months of the new year. In this context, this would be the markets anticipating an improvement in economic conditions in the US and possibly globally in the latter stages of next year. Indeed, 2011 is the year prior to a US presidential election; it has rarely been right to be overly cautious about equities in the year prior to an election, as it is virtually impossible for the Fed to pursue a contractionary monetary policy in the months preceding an election. 

In my post of September 27, I argued that the runes did not point convincingly towards recession in the US.  The flow of data releases since then has tended to strengthen rather than weaken my position.  At the same time, if the stockmarket does enter a stronger phase, as I am suggesting here, this is not necessarily at odds with the idea that the longer-run stockmarket valuation charts indicate that further equity market de-rating over time is likely.