Friday, September 2, 2011


Unfortunately, the actions by both the Democrats and Republicans do not suggest a likely coordinated pro-growth fiscal strategy that will address the structural issues facing the domestic economy. And the closer we get to the November 2012 elections, the more difficult it will be to break the current gridlock.

Moreover, balancing near-term fiscal stimulation with intermediate-term austerity is a balancing act that our representatives are unlikely to resolve anytime soon.


We’ve reached a stall speed in the economy, not just in the U.S., but in the euro zone and the UK. We see probably a 60% probability of recession next year and unfortunately we’re running out of policy tools. Every country is doing fiscal austerity and there will be a fiscal drag. The ability to backstop the banks is now impossible because of political constraints and sovereigns cannot bail out their own distressed banks because they are distressed themselves.

Everyone would like a weaker currency, but if the currency's weaker, another has to be stronger. There'll be more monetary easing and quantitative easing done by the Fed and other central banks, but the credit channel is broken. The velocity has collapsed and all the extra money is going into reserves. There was asset deflation, but it occurred because the economic numbers in August started to improve even before QE was done. This time around the macro data is negative, so yes, the market is rallying on the expectation of QE3, but I think it will be a short-lived rally. The macro data, ISM, employment, and housing numbers will come out worse and worse, the market will start to correct again. We're going to a recession, we are at stall speed and we are running out of policy bullets.

On whether there are any monetary policy tools that might be more helpful than others:

The ones that are being discussed by the FOMC will not have much of an effect because if you lengthen the maturities, you are buying long-term Treasuries and selling short-term, you are flattening the yield curve in a way that hurts the banks…This time around we will not have an additional purchase of Treasuries or fiscal stimulus. We will have a fiscal drag and the short-term effect of a rally in the market will fizzle out when the real economy is going in the tank. We are entering a recession based on my numbers.

On what President Obama and Congress could do if Bernanke doesn't have the ammunition:

We certainly need another fiscal stimulus. Much stronger than the one we had before. The one we had before was not enough. Congress is controlled by the Republicans and they're going to vote against Obama in the realm of fiscal austerity. If things get worse, it's only to their political benefit.

[The American Recovery and Reinvestment Act of 2009] was effective in the sense that the recession could have turned into a Great Depression. Things would have been much worse without it, so it was very effective in the sense of preventing a Great Depression, but it was not significant enough. With millions of unemployed construction workers, we need a trillion dollar, five-year program just for infrastructure, but it's not politically feasible and that's why there will be a fiscal drag and we will have a recession.

On the yield curve signaling not signaling a recession and whether there's a distortion with the reporting of the Fed:

Traditionally, you can have inversion of the yield curve. Right now, we have policy rates at 0 and we cannot have this inversion of the curve, but the bond market as opposed to the stock market is expecting a recession. We're having a growth scare in spite of the worries about the credit risk of the sovereign. After the S&P downgrade, bond yields fell from 2.5% to 2% or below. The bond market is telling as a recession is coming and the flattening of the yield curve is telling us that. We cannot have an inversion because you can have negative long-term interest rates. That's the reason we don't see the inversion.

On Europe and what can be done to stop contagion:

Not much is going to be enough. Once the FSF is passed they will run out of money in a matter of months and unless you triple the FSF or have euro bonds, then if Italy and Spain lose market access, there will not be enough money to back stop them…I don't think it is politically feasible to tell the German public they're going to backstop several trillion dollars of debt of that in the periphery. If we will not have a euro bond, what happened in the case of Greece will happen not just in an exceptional way as they said in Greece, but Portugal, Ireland and eventually Italy and Spain.

On whether there's anything to prevent a debt crisis from becoming a true systemic financial crisis:

The banks in Europe are already in trouble. Banking risk has become sovereign risk when the banks were bailed out by the sovereigns, but now the sovereign risk is becoming banking risk because you have a bunch of distressed near insolvent sovereigns who cannot backstop their own banks. There is a good chunk of the government debt held by the banking system. It is a vicious circle between the sovereign risk and the banking risk. You cannot separate them. The current approach of the Europeans is to muddle through and kick the can down the road. Extent and pretend. It is not a stable equilibrium. It's an unstable disequilibrium. Either the Europeans go in the direction of a greater economic monetary fiscal and political union or the only other alternative is a disorderly default or work out and eventually break up of the monetary union.

On China and its growth prospects:

China in the short term can maintain growth because there will be a severe recession and advanced economies will do more monetary and fiscal and credit stimulus. The reality is that their economy is imbalanced. Fixed investment has gone now to 50% of GDP. No country in the world can be so productive and take half of the output to invest into capital stock. You'll have a surge in public debt, it's already 80% of GDP including local government…I see a hard landing in China as the likely event, not this year or next year, but by 2013 when this over investment move will go bust.

Even without the slowdown of the U.S., this over investment boom is going to go into a bust in a hard landing. We're going to have weakness in the U.S., Europe and Japan. That is going to accelerate the climate in which the weakening of China will occur.

On the possible debt exposure for Chinese banks:

If you are looking at the Chinese banks, they have huge exposure to state and local governments and special purpose vehicles that have done the financing of the local investment. There has been at several trillion dollars yuans and we estimate 30% of these loans will go into default and become underperforming. The heat will be on the Chinese banks.

On Brazil:

Brazil has some strong economic fundamentals.... Our forecast that when the recession in advanced economies hits, economic growth in Latin America, including Brazil, is going to slow down as sharply next year compared to this year. Brazil has its own other domestic problems. If they do the structural reform that's needed, it could have high potential growth, but the question is whether the new president will be willing to do those structural reforms to reduce the distortion and increase the potential growth of the country. There may be some political economy constraints to doing that.

The good news is that for the 25th consecutive month, the ISM was in expansionary mode in August. The employment component (51.8), though lower (month over month), was also above 50 and in an expansion phase. Imports (55.5) rose by 2 points, and the prices index improved by almost 4 points (55.5) to the lowest level in 25 months.

The bad news is that the August ISM was the lowest reading in over two years and very near contraction. As well, new orders (49.6), production (48.6) and backlogs (46.0) all were at contraction levels. Exports (50.5) fell by nearly 4 points.

Here is a good rundown of the ISM by Miller Tabak's Peter Boockvar:

The Aug ISM remained surprisingly above 50 at 50.6. It's better than expectations of 48.5 and fears of worse but down a touch from 50.9 in July. The level of 50.6 is still the weakest since July '09. New Orders remained below 50 at 49.6 vs 49.2 in July and Backlogs too at 46 vs 45 in July. Production fell by 3.7 pts to below 50 at 48.6. Employment fell almost 2 pts to 51.8, the lowest since Nov '09. Importantly, Export Orders fell 3.5 pts to 50.5, the lowest since July '09. Inventories at the mfr'g level rose 3 pts to the most since Jan and were up 2.5 pts at the customer level but stayed below 50 at 46.5. Prices Paid fell 3.5 pts to the lowest since Nov '09. Of the 18 industries surveyed, just 10 reported growth. The ISM gave a bottom line, "the overall sentiment is one of concern and caution over the domestic and international economic environment, which is affecting customers' confidence and willingness to place orders, at least in the short term." While the number was better than expected, this quote spells out the economic concerns and the ISM does capture all the new market turmoil experienced in August.

Investors will soon begin to realize that more monetary easing will fail to produce more meaningful economic growth.

Last night, the August Chinese Manufacturing Index was reported at 50.9 compared to 50.7 in July and with expectations of 51.0 In response, S&P futures immediately rose by six handles, though futures began to trend down as the evening matured. Over the course of the past 12 months, this index has slowly dropped from 54.0, and many observers now see a soft landing of about 8% GDP growth for China in 2011 vs. 10% last year.

As a consequence of slowing growth but a soft landing in China, several bullish strategists now envision slowing inflation and the end of tight money in China. Those same bullish strategists have pointed to the eurozone's much weaker economic growth prospects, coupled with austerity and slowing inflation, as an indication that the ECB, similar to China, is likely moving away from tightening policy.

Finally, those same bullish strategists have chimed in that, over here, the Fed may continue to ease.

So, with global monetary policy becoming more accommodative, the argument now being made by bulls is that global easing is a plus for risk assets.

But I would like the bullish cabal to respond to the following concerns:

* Why is the need for global easing (and the need for pro-growth fiscal policies) a good thing only two years into a recovery?
* While the consensus has moved down to looking for a relatively weak worldwide economic recovery, when does a weak worldwide economic recovery dependent on generous policy (with the promise of economic reacceleration) become a bad thing as it underscores (among other things) the long tail of deleveraging and the structural issues that will likely continue to weigh on growth?
* After all, in the past, many optimists have observed that rising interest rates would be healthy for risk assets, as it would be a reflection of improving growth prospects, yet rates have not risen.

Nevertheless most market bulls now cite low interest rates as a valuation positive and contributing to the appeal of risk assets.

There seems to be some hypocrisy in this view.

Some rise in interest rates, owing to better economic growth, is what is now needed to extend the market rally. In its absence, I recognize that the option of easing by the Fed and the ECB can serve to stabilize equity markets from the effect of slow growth, but there comes a point in time when the failure of monetary policy to produce a reacceleration of economic growth will become more worrisome to investors. This is particularly true without any sense that pro-growth fiscal policies will be adopted by the November 2012 elections.

From my perch, that point in time is soon approaching when investors will begin to more seriously struggle with the realization that more monetary easing (and cowbell) will fail to produce more meaningful economic growth prospects around the world.

Perhaps the first shot across the bow and recognition of this risk was already seen in the weakness in equities during the first half of August.