Words ought to be a little wild, for they are the assault of thoughts on the unthinking
- J.M. Keynes

Friday, 18 January 2013

New York Detox: Hopium Shots and Kool-Aid (Part-II - USA)

US’s long term problem and the myth of Bernanke’s invincibility
After the depressing picture in Europe at least there is a glimmer of hope when one looks at the US economy even though politicians and policymakers are doing their utmost to dispel it. Thanks to its flexibility and resilience, the US economy is on the mend. However there are two main problems facing the US. The first is the political impasse about which reams have already been written. A quasi-civil war based on uncompromising policy positions dictated by vested interests and senseless ideological purity is never good. Add a moribund economy and a desperate, reckless gamble by monetary authorities and the die is cast for long-term decline.

The second problem is one of overconfidence in the inherent strength of the economy. Although more flexible and resilient compared to Europe the US economy’s arteries have been hardening of late. Over time as industries consolidate and oligopolies emerge, free movement of capital and labour, an economy’s blood supply, is impeded. Companies use their clout to defend their position and eliminate competition. Creative destruction, so necessary for capitalism, is minimised. Graph-6 shows the increasing domination of established businesses over newer ones.

Graph-6: No country for young businessmen

Source: Source: Haltiwanger. J, Jarmin. R, Miranda. J; Where have all the young firms gone?

More evidence of this unhealthy shift in the structure of the economy comes from two issues garnering attention currently. The first is the much talked about increasing cash piles of big business. Capital lies idle with firms interested in maintaining current margins while entrepreneurs with new ideas are throttled. Firm start-up rate is at a 30-year low as Graph-7 makes clear. Even if somehow threatening new firms emerge then the incumbents remove them through buyouts.

Graph-7: Capitalist arteriosclerosis

Source: Haltiwanger. J, Jarmin. R, Miranda. J; Where have all the young firms gone?

The second is the issue of a patent system run amuck (rounded corners are a technological innovation apparently). It raises barriers to entry and helps sustain oligopolistic domination. In addition it retards real innovation as firms focus on patenting for competitive advantage rather than genuine research.

As economic arteries clog up, it takes longer to recover from each successive shock. The current recovery is symptomatic of this. True, recovery is slow after a housing bust but the present weak recovery has to be seen in context of an unusually supportive monetary policy. Even fiscal policy, despite all the talk of austerity, has not been contractionary as it has in Europe. Therefore the US economy’s long-term prognosis is not optimistic unless the doctors stop quibbling amongst themselves on pointless matters such as the debt ceiling.

However, this is all too long-term and boring for myopic Mr. Market. As long as the good doctor Bernanke keeps pumping the patient full of hopium and steroids it’s all good. It is ironic that disgraced doctor Greenspan prescribed similar easy money policies which are now blamed for the patient’s cardiac arrest in 2007.

Mr. Market’s love of Bernanke is easy to understand if one looks at the two graphs below (Graph-8 & 9).

Graph-8: The Bernanke put

Source: Federal Reserve, Yahoo Finance

Graph-9: Cry ‘QE’ and let loose the yield hunters
Source: Federal Reserve, FRED database

Unfortunately the good doctor is not achieving the same effect on the signs which really matter. Unemployment is still high with the apparent decline in the rate being mainly due to a sharp drop in participation rate. This is unique amongst post-war recoveries (Graph-10). Adjusted for participation rate, unemployment hasn’t budged much and the ratio of part-time to full-time workers (a measure of underemployment) is still elevated. Moreover, per capita personal disposable income (PDI) has only recovered marginally and is well below its peak (Graph-11).

Graph-10: "Jobless" recovery?

Source: US Bureau of Labor Statistics

Graph-11: Fed's impotence
Source: US Bureau of Labor Statistics

Even though the medicine has failed, the good doctor argues that more of it is required (I wrote on this earlier: Why more QE isn’t going to help). One of the arguments made by QE proponents is the recovery in consumer spending (Personal Consumption Expenditures (PCE)) showing that the economy is slowly limping back on track. It would be great were it true. As Graph-12 shows, the increase in PCE is largely because of the increase in the absolute number of employed people which has increased total disposable income. Recovery in per capita disposable income is more muted and has been accompanied by a decline in the savings rate (Graph-13).

Graph-12: Greater number of employed will obviously earn and spend more

Source: US Bureau of Economic Analysis, Author's calculations 

Graph-13: No raise, can’t save but hope the Fed makes us all rich

Source: US Bureau of Economic Analysis

Therefore the real economy seems to be ‘fighting’ the Fed even if the markets won’t. It is courageous of Mr. Market to blindly trust the Fed as it embarks on a grand experiment in monetary policy whose results even it does not know. In addition, the various markets are sending contradictory signals. Equity market expects recovery and strong profit margins. The corporate bond market has imbibed more hopium and not only expects recovery but expects it to be associated with low interest rates. The Treasury market on the other hand is signalling the onset of Japanese disease but without factoring in ‘Helicopter’ Ben.

It’s all very confusing. However equity markets are better placed to handle the eventual outcome than bond markets. If recovery strengthens and sustains then profit margins should stay robust validating the P/E multiple expansion taking place currently. On the other hand if the experiment spirals out of control then equities afford at least some protection from inflation. Ever optimistic, equity holders are not factoring in a margin compression in a demand-destructive double-dip recession. The probability for this is reasonably high given the muted recovery and the current political shenanigans.

If equity market is optimistic then the bond market has drunk industrial quantities of Kool-Aid. A recovery will be negative as rates will rise. An inflationary environment will be negative as bonds lose value even if the Fed stubbornly sticks to an easy monetary policy. Finally a double-dip with consequent corporate distress will give a fresh perspective to current buyers of high-yield at sub-6%. The last case might be expected to favour Treasuries but in such an event the Fed will throw everything and the kitchen printer in desperation. Treasury holders will suffer the consequent loss of confidence in the USA and US Dollar.

The music at Ben’s party is too catchy not to dance but when the morning comes bondholders will wish they hadn’t drunk so much Kool-Aid.

Part-III to follow in due course.

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