November 5th, 2007 - Third-quarter GDP growth in the United States was strong, as expected. But this is a look at what happened in the past that is already receding in the rear-view mirror. The forward outlook is of greater import, and more recent data indicate a softer economy in the fourth and first quarters.
The labour market is holding up well. Jobs are still being created, but at a below-average pace. One must note, with caution, the high level of inventory build-up evident in the Q3 report. If this represents unanticipated accumulation, then we should expect liquidation in the current quarter, dragging down growth.
Consumer confidence is wobbly and surveys indicate a rise in pessimism. However, thus far, this has not translated into a drop in consumption, even though the overall situation in the housing market is deteriorating rather than improving. Foreclosures are rising and prices are falling. If history is any guide, the adjustment process will be long, especially after the bubbly rise in prices that we have witnessed in the past few years.
It is odd how some Wall-Street commentators still talk of the housing sector as though it has been ring-fenced. "The economy is doing fine, other than the housing sector" is a typical comment. Even Bernanke used to speak in these terms before the facts hit him on the head.
Rising house prices and blue skies as far as the eye can see, used to be the mantra on Wall Street and Main Street. It is not surprising that people wanted to borrow and buy. The low interest rates, courtesy of Mr. Greenspan, made it look like a no-brainer. But the situation has changed dramatically. Now, instead of bidding up prices, buyers can afford to wait and speculate on falling prices. The market has a marvellously effective way of adjusting supply and demand imbalances. In most cases any malfunction in the market is caused by authorities meddling with the process.
Bernanke and his FOMC crew at the Fed are meddlers par excellence. They have effectively thrown a lifeline to Wall-Street speculators and distressed homeowners, rather than let the market sort out clearing prices and the price of risk. But one has to be a naive indeed not to recognise the political and sectional pressures that the Fed is under, bending to the demand for lower interest rates.
Over at the Treasury, Hank Paulson has been busy trying to bypass market solutions for the pricing of the toxic debt that the banks had accumulated in their Special Investment Vehicles. The so-called superfund has been put together by three large US banks under the aegis of the Treasury.
Patently, it is a smoke-and-mirrors attempt to prevent a proper pricing of risk. It has been roundly criticised by a number of commentators, including European banks that also hold chunks of toxic debt. The folks in Europe weren’t particularly keen on a full market solution. It is just that they were peeved at not being included in the plan. All the banks are eager to avoid marking the securities to market, which would mean recognising substantial losses.
Apparently, no government money is to be involved in the superfund. But, the question remains. Why is a Republican administration, ostensibly committed to free-market principles, meddling in this whole thing? It has raised a few eyebrows, as well as charges of crony capitalism from some of the Asians who remember well the moralistic American lecturing on these principles during the late nineties.
Bernanke and his FOMC colleagues came through with the expected 25 basis-point cut at the recent meeting. The market expected it and they delivered. This is not an environment in which the Fed wants to upset the market. For good measure, they lowered the discount rate by an equivalent amount.
The statement accompanying the release of their decision made mention of the balanced risks to growth and inflation. Some commentators took this to mean that the Fed is just as worried about inflation as it is concerned about a growth slowdown. However, the actual statement was meant for immediate consumption and is not a good indication of policymakers’ future action. More than ever, they are focussed on the tone of near-term data releases and market conditions. Their bias is likely to be in the direction of preventing a recession rather than worrying about inflation.
Bernanke has made the FOMC into a more collegial entity with shared decision-making, whereas Greenspan preferred a firmer hand. There is little indication that the changes are going to produce better decisions. A more important factor is the pressure they are under from politicians, Wall Street and industry groups such as automakers and those related to housing.
In recent comments, Greenspan has correctly identified a troubling trend, namely that the Fed will come under increasing political pressure to conduct an easy monetary policy and alleviate the pain of normal market corrections. It does not require much analysis to see that this is likely to increase upside risks of inflationary pressure. A fiat currency is fundamentally based on confidence that the issuer is going to act responsibly and refrain from debasement. Once credibility is lost it is difficult for it to be regained.
It is hard not to be in full agreement with Greenspan on two other issues: a rising inflation trend and lower US productivity growth. As far as inflation is concerned, there are a number of factors involved. They range from rising food prices to the limits of substantial cost savings, resulting from globalisation. These factors are likely to boost inflationary pressures. It must be noted that we are not about to witness a breakout in inflation. The thrust of the argument is that upside risks are high over the next year or two.
Earlier in the year, we discussed, at length, the reasons why US productivity growth will slow down. The evidence, since then, appears to confirm that such a trend is underway. Under these circumstances if the central bank tries to boost growth beyond the economy’s trend rate, higher inflationary pressures will be the outcome.
Initially, people’s inflation expectations may be slow to react and central banks may overestimate their skill in being able to reverse the course. In recent years, a benign global environment has been kind to policymakers. There was leeway for making mistakes, with the unfortunate consequence of giving central banks a false sense of their capabilities in a more challenging environment.
One way of gauging inflation expectations is to compare the spread between inflation-indexed government bonds, such as TIPS, and their un-indexed equivalents. Currently, the spread indicates a fairly benign expectation of future inflation. However, this indicator is not forward-looking and tends to lag actual inflation. In addition, many analysts are sceptical about the accuracy of government statistics regarding inflation.
Credit market conditions have not returned to normal and it may take a long time before they do so. Opacity in the sub-prime securities sector generates a good deal of mistrust among financial firms. Many of them are holding tranches, even the previously AAA-rated stuff, that have collapsed in value. As for lenders, they have to worry about their capital base, and are tightening lending standards and charging more for loans.
The trade-weighted dollar index has plumbed to new lows. Little was expected to be done at the G-7 meeting on currency issues and that’s how it turned out to be. Of course, there was the usual talk about the need for the renminbi to be re-valued, but there is no indication that the Chinese are willing to bend under pressure and accelerate its revaluation. As for Japan, which has been running a ridiculously expansionary monetary policy that invites depreciation, it was
let off the hook again.
The dollar’s decline has been quite orderly, and this appears to be acceptable to the US Treasury. There is, of course, the risk of a feed-through to inflation via imported prices. But there is also an underlying hope that foreign exporters will take part of the hit to their profit margins rather than raise prices in the US and lose market share.
We are not there yet, but at some point the dollar’s devaluation will prompt intervention by the authorities to prevent further appreciation of their own currencies. In a slow-growth world, if exporters are penalised because of an expensive currency, there is likely to be an increase in protectionist sentiment. Hopefully, politicians will resist any move towards protectionism because the consequences are bad for growth, employment, inflation and profits. Crude prices have reached new highs. Most recently, the price increase resulted from a concern about the low level of US inventories, relative to expectations. More generally, global growth is still strong and demand for oil is high. Of course, there is also a speculative element in the recent run-up in prices. Traders have a few concerns about a broader conflict between Turkey and the Kurds in northern Iraq.
Iraqi Kurdistan is the only part of Iraq that is stable. A conflict that destabilises Kurdistan may have spill-over effects into surrounding countries with large Kurdish populations, namely Iran and Syria. As for Iran, there are renewed worries about a military attack by the United States. The Russians are expressing some anxiety and the Saudis are distancing themselves from the Americans, as well as becoming more vociferous.
After the debacle in Iraq, where the US engaged against Saudi advice, the royals lost much of their confidence in America’s ability and willingness to protect them. As a result, they are looking after their own interests. Part of the strategy involves moving closer to Russia and China. Meanwhile, among the beneficiaries of the economic sanctions against Iran have been the Chinese who have extended their interests considerably. Overall, in terms of geopolitical strategy and influence, the US is losing ground in the Middle East.
After a period of calm weather, volatility is up again. However, risk appetite hasn’t dissipated. Emerging market equities have been rerated and are roundly outperforming developed-market indices. The longer-run structural story about developing countries is good. But the decoupling thesis is not entirely convincing and has yet to be put to the test. If the US undergoes only a mild slowdown then the decoupling argument may turn out to be valid. However, a more severe deceleration of the American economy will also be felt in the emerging world.
Third-quarter earnings reports in the US presented a mixed picture. The technology sector was expected to do well and the results broadly met expectations. Big names such as Intel, Microsoft and Apple beat consensus forecasts. The financial sector was already marked down by analysts. Even so, there were negative surprises. One major theme was the positive impact of overseas growth and the low dollar on earnings. But the market had already discounted this. As for the forward outlook for profits, it remains somewhat cloudy.