Monday, January 6, 2014

2014 and the Business Cycle: Continuing Recovery and Another Year of Opportunity in the Stockmarkets?


First off, Happy New Year to all my Econoblog readers.  If you want a review of 2013, rather than rabbittng on here, I thought I would just point you to a wonderful article in The Atlantic on the Most Important Economic Trends in 2013 which you can find here. In this Econoblog I want to look ahead to what might happen in 2014, as some eminent economists have been doing at the most recent American Economics Association meeting..

As the business cycle is now in heading into the later part of the cycle, with the danger of recession and deflation receding, most countries will experience accelerating growth this year.  Although markets are jittery about the Fed’s signal to taper monetary policy, this is long overdue in my view, and will only have a marginal effect on economic growth in the US and other developing countries.  The economic process of re-invigorating the economy through stimulus has now done its magic, and in North America, Europe and now Japan, the growth dynamic has started to take on a life of its own, so that the agents of stimulus can now withdraw their assistance as a catalyst for economic growth.

So there are 2 further issues here – first, how will economic growth be distributed among the developed countries, and second, given what is going on in the developed world, what are the prospects for the developing countries.

Although the consensus is almost uniformally positive for the US for 2014, it is still probably the most uncertain country in the developing world to forecast for 2014, as there are so many factors that might impinge upon economic growth rates. The most notable are fiscal matters and the political problems in Congress, the ongoing taper, and when the actual tightening of monetary policy will begin, how movements in long term interest rates will impact the housing market and also lastly, how the dollar will behave during the upcoming year.  If the current truce in Congress yields more bi-partisan consensus on how to move ahead in other contentious areas (such as immigration reform, for example), then this could boost growth as confidence is at least partially restored in the US political process.  Given a brighter fiscal outlook, this would mean that Fed purchases of government bonds could be slowed much more quickly than Mortgage backed securities (MBS), which would allow a residual boost to the housing market rather than propping up a shaky Federal government credit rating. Longer term interest rates are key in determining the course of mortgage rates, and if the Fed keeps these low enough for long enough, the housing market could really boom, setting off a real investment boom in the rest of the economy.  Of course everything could go the other way as well, leading to a further downgrade in the credit rating of US debt, a Fed that ends up having to reverse the taper because of a sagging labor market, and a housing market that experiences a bubble because of prices rising too far too fast. 
In my view, the history of economic cycles points to a positive future though for the US, and although some of the shorter term cyclical effects will be present, the dominant longer term cyclical features will push the US forward without any major internal economic dislocations, leading to another good year for both the housing and stock markets.  This of course implies another bad year for the bond market with yields moving upwards to levels more typically associated with this stage of the business cycle.

But perhaps the best opportunities in North America lie not in the US, but in Canada.  The Canadian market has been extremely stable through the recent turmoil and the Canadian stockmarket has really not shown much of a return compared with its US counterpart, which in my opinion is almost counter-intuitive, but is probably based on the perception that Canada has an economy based much more on commodities than the US does.  Nevertheless, in my view the Canadian market still has much less downside risk that the US market does, and much more upside.

Japan and the EU have less potential for growth as demographic factors restrain both entities. The fact that Abenomics seems to continue to deliver the goods will push Japanese markets higher and lead to the deflationary threat receding.  In the EU the resurgence of the northern member states will continue and the Southern member states will start to emerge from the difficult deflationary period they have been in. 

The biggest risks, but also the biggest rewards in 2014, lie in the developing world.  Developing country markets were rocked by the initial announcement of a taper, but now that the ongoing taper and then tightening has been priced into the markets the real effects on the developing markets should be apparent. As monetary tightening occurs in the US, so the liquidity glut will start to disappear, putting some pressure on developing countries.  Now the big question is, how big will the impact be on countries like the BRICSA countries.  Brazil should be cushioned by the massive infrastructure spending going on there for the Olympics and the World Cup, while Russia really is not dependent on the stimulus as it is natural resource prices that really drive the Russian market.  South Africa is certainly not a large holder of US bonds so the taper will likely have minimal effects on that country.  No, the biggest risk is in both China and India, where both countries have a significant interest in holdings of US debt. 


Given the negative announcement effect of the Fed’s taper, I believe that possibly the best performing markets will be in Canada, parts of Latin America, Africa and parts of Europe next year. Now I have put my neck on the line, let's see what happens!

Sunday, November 17, 2013

Secular Stagnation and the Yellen Put

An interesting discourse about "Secular Stagnation" has broken out in the economics profession, and this seems to be quite appropriate given the replacement of Ben Bernanke by Janet Yellen as the Chairperson of the Fed, and her reputedly dovish stance on monetary policy. "Secular stagnation" is really a forgotten relic of 1930s macroeconomics (by Alvin Hansen), and has fed into similar thinking in the current state of both the US and EU economies.

So first, what is "secular stagnation"?  As Gavyn Davies points out in his excellent FT piece, it is a situation where after a financial crisis, as nominal interest rates remain close to zero, deflation causes real interest rates to go negative ( - recall that real interest rates are nominal interest rates minus inflation).  In other words, if you borrow money, the gain in its value due to deflation outstrips the low nominal interest rate, meaning in real terms it's actually costing you quite a bit. The problem originates from the fact that although inflation can be negative ( - and is termed deflation), nominal interest rates cannot (under normal circumstances) go negative. This means that real interest interest rates remain above where they should be ( - the equilibrium rate being the Wicksellian "natural" interest rate), so that chronic underinvestment occurs and the economy crawls along at much lower growth rate than it should do, with in fact a widening of the output gap even though the economy is no longer in recession.  

Source: Board of Governors: Federal Reserve System

But Paul Krugman in his commentary (see here) on Larry Summer's comments at an IMF conference, takes this one step further. He says that in fact bubbles in the economy are a good thing, as they keep the economy moving along, rather than sinking into stagflation and deflation as they have in Japan.  But as Krugman points out, this might be due to the slowing growth in population and in the labor force participation rate in particular. This in turn reduces the equilibrium natural real rate of interest, and so current real rates are above this level and this consequently fosters below average growth. The further corrollory is that stricter financial regulation might be bad for growth as irresponsible lending is actually good for the economy and also presumably creating housing bubbles by QE is actually a good thing as it presumably puts money in people's pockets. The chart above shows that less food and energy, inflation is around 1.7 percent currently.

My problem with this entire thesis is that it is predicated on QE not being in place.  QE is in place and by keeping short term interest rates near to zero, it does create negative real rates on these government rates as long as inflation is positive, which it now is. The 90 day non-financial commercial paper rate is currently 0.25 percent, which means that the core real rate calculates to around -1.5%. Obviously the danger is deflation, as this pushes real rates up creating a disincentive to invest. But in fact right now companies have a great incentive to invest, as money is still cheap and likely to become more expensive once the Fed tapers. No, the real problem is that companies and banks are sitting on a huge pile of cash - lending standards are extremely strict and so the stimulus that is supposed to be funding house purchases and small business expansion is just not at the level it should be.

No the best way to get the world economy moving forward is not really in the hands of the Fed anymore - it is in the hands of the politicians - so in my view completion of the Transatlantic Free Trade Area (TFTA), the Trans-Pacific Partnership (TPP) and also perhaps the re-starting of the Doha Round of the GATT/WTO talks will lead to an upswing in growth in 2015 and beyond if these agreements are concluded.  These agreements will boost world trade and although yes, they are likely to depress prices for traded goods, they will lead to greater quantities of goods being traded between the major trading blocs leading to a one-time stimulus for all economies.  Plus the wealth effect from the US stockmarket right now will hopefully continue as more bystanders are convinced that the return on stocks far exceeds that of interest bearing deposits, so this should support US consumption and investment going forward.

And this brings us round to the Yellen Put.  Yellen clearly is going to follow in the footsteps of Bernanke, so the support underlying the stockmarket and the financial sector should continue into 2014, but as long as no further government shutdowns are likely, the taper should start in 2014. As I have stated in previous blog postings the taper will likely start on just the purchases of government paper, given that government really doesn't need this support anymore and continue to stimulate the housing recovery.

As I believe in the persistence of economic cycles, it is not unlikely that we will have a downturn anytime from 2015 onwards, so getting the Fed to move away from an extremely expansionary stance is now taking on some urgency, otherwise it will have limited ammunition to fend off another economic downturn.  But this is also where the completion of these Free Trade deals is extremely important, as their completion should delay any future downturn beyond 2015 through to 2016 or beyond.

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