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The US economy suffered continued economic contraction during the 2nd quarter, (April to June), though the gap to growth narrowed, relative to Q1. The fall in output of -1% annualised compared to a consensus forecast of -1.5%. Q1 GDP was revised downwards from -5.5% to -6.4%. 2008 growth was also revised to a weaker 0.4% from 1.1%.
The world’s largest economy has now shrunk for four consecutive quarters, the longest losing sequence since records were formalised in 1947.
A key contributor to the latest decline was the erosion of business inventories which slumped by a record $140bn in the quarter as firms cut production in an effort to reduce stockpiles. The production cut-backs contributed about 80% of the Q2 contraction in economic activity.
Exports, residential and business investment all fell though the rate of decline in each sector slowed compared to the 1st quarter.
The GDP report came at the end of another week of appreciating equity prices, though as predicted in this column last week Monday and Tuesday saw equity markets stutter giving short sellers a small window of opportunity mid-session to prosper before equities resumed their bullish run later in the week.
For four decades the Japanese economy secured more than its fair share of coverage in the financial press. Dominating the economic headlines were the manufacturing and export expansion of the 60’s and 70’s and the phenomenal market rally that took the Nikkei to almost 40,000 during the 80’s. Thereafter commentators focused on the lost decade of the 90’s caused by the property market crash, bank balance sheet shrinkage and the death of Japanese equity wealth by a thousand cuts.
This decade has seen the rise of China’s economic profile, with the PRC now destined to replace Japan as the world’s second largest economy. Such is the dominance of Chinese related articles it’s easy to forget Japan is still an economic goliath, albeit in relative decline. And the cause of that decline can be summed up in one word; deflation.
There’s something deeply embedded in the Japanese economy and psyche of Japanese businesses and consumers that has caused deflation to be a secular and persistent challenge for the Bank of Japan for the past 20 years. The problem with deflation is that it maintains the real value and burden of debt, whereas a healthy rate of inflation, 2-3%, over the years gently erodes the real economic cost of borrowed capital. It is inflation that has given the western economies the luxury of consuming more in the present, with debt in nominal terms eroded by the passage of time. Deflation throws another spanner in the works of economic growth. Why buy a new car, or new machinery, in fact why buy anything today that will be cheaper in a few months? The result is structurally weak demand, an interest rate so low it’s barely visible to the naked eye and a flight of capital to higher yielding currencies (the New Zealand and Australian dollars have been a favoured destination for retail and institutional investors for years). Deflation is a nasty poke in the eye for demand, capital investment and growth.
In fact Japanese interest rates have been so low for so long, the Yen has been systematically sold (shorted) not just by Japanese investors but by a legion of hedge fund managers for years with the proceeds placed just about anywhere that offered a higher return. Admittedly that carry-trade, along with most risk embracing investment strategies, grew to bubble proportions and burst in 2008 but with investors embracing risk again, greed replacing fear, that transaction (short Yen, long anything else that moves) is likely to re-surface.
Investors unsure about the viability of continued Japanese deflation, preferring to focus on the unprecedented global stimulus measures, that should be inflationary, should look closely at the latest Japanese consumer prices data. Prices fell 1.7% in the year to June, prolonging the sequence of deflationary months (year-on-year) to four in row. The main contributor to the decline in prices is energy, with oil settling into $60-$70 channel compared to last years roller-coaster ride to $147.
Investors could suggest that the global economic recovery could re-inflate energy and commodity prices, prompting inflation and thus curing the Japanese “I’ll buy it later when it’s cheaper” philosophy. Unfortunately, higher energy costs are paramount to poking the Japanese economy in the other eye. Japanese energy imports can peak to 97% of its oil and 96% of its gas needs. Japan is similarly deficient in other key energy and mineral related commodities. Higher energy and commodity prices just leave Japanese consumers with less to spend on domestic goods, further hurting demand.
Mid-session Thursday and the equity rally has sparked back to life after 3 days of relative calm. The ‘QQQQ’ NASDAQ Tracker’s relative strength index has progressed deeper into overbought territory and now stands at 75.09, which is unsustainable. Any reading over 70 indicates prices are stretched at least in the short term on the upside.
Surprisingly, considering the rally, there has been an absense of good economic news on the day with the latest jobless claims data coming in slightly worse than expected.
QQQQ to mid session 30th July 2009
Democracy is the system of one person one vote. Business is one dollar one vote. It would take a vivid imagination to think that the perfect scenario for a business; securing abnormal profits or a monopoly, is appropriate in a fair and democratic society. Likewise, the managers and shareholders of corporations need to be offered a reward for their time, skills and investment otherwise there would be no motivation to take risks or to employ workers. A fair equilibrium is the logical aim.
But the two, democracy and business, co-exist uncomfortably as there is a finite amount of wealth in the economy and that wealth needs to be shared equitably between two of the three participants in any economy: individuals, (workers, consumers and taxpayers) and businesses. The third participant is the government which should not pursue wealth or power for its own benefit but should act as the moderator and facilitator creating a scenario which allows the two other parties to prosper fairly, in correct proportion and in line with the law. To achieve this fair scenario key governmental decision makers should not have personal interests more aligned with one group, business, than the other, society.
In periods of economic growth when both the individual and corporations as a whole prosper the division of wealth between the two is naturally a concern. But those concerns are magnified significantly when the economic pool of wealth is contracting. In a recession tensions between the individual (the ‘man on the street’) and companies increase as corporations lay off staff to protect the interests of the firm’s owners. Tensions rise further when certain companies or industries receiving preferential treatment at the expense of industries with less political influence or the collective society.
The onus is on the government to ensure fair allocation of stimulus and support so that both individuals and companies exit the recession together, as far as that is possible. But if the country is still struggling to recover, unemployment is rising and the average individual is still suffering whilst certain corporations are already, again, enjoying abnormal profits then the division of wealth and the legislation that created that scenario is flawed. Also, corporate earnings can only grow quicker than GDP growth if the finite wealth of society is being re-allocated from the individual to corporations.
The past 25 years has seen the economic balance of power shift too far from the fair equilibrium. The few are benefiting at the expense of the many. Goldman Sachs is a beneficiary. Wall Street as a whole is another beneficiary. Main St has suffered. But the individual, the workers, the micro-engines of the economy have suffered most. Unfortunately, one dollar one vote is more popular than ever in Washington.
GS to 29th July 2009
An understanding of economics is greatly enhanced by the study of great economists, men who formed original and ground-breaking theories regarding economic management, foreign exchange mechanisms and monetary and fiscal policy.
If Adam Smith was the founder of economic theory as we understand it today (The Wealth of Nations, 1776) then John Maynard Keynes was the father of modern monetary and fiscal policy. His brilliance, soon to be obvious, went largely unnoticed in his formative years of study and examination. “The examiners presumably knew less than I did”, he famously remarked.
Later, in the years between the two great wars, his work focused on developing theories better able to achieve full employment – in response to the deflation and poverty caused by the global depression. His work relating to interest rate controls and government led stimulus, obvious and accepted now as a cure for recessions, were at the time revolutionary, misunderstood and unproven.
Morally robust, he resigned in protest against the First World War reparations policy, a thorn in the side of Europe for 20 years and a key grievance which led to the rise of militarism across Europe, and the Second World War.
In 1943 Keynes was fundamental to the original proposal for an international monetary authority. In 1944 he led the British delegation in the Bretton Woods Agreement. Late in 1945 he was accredited with almost single-handedly negotiating the American Loan Agreement which helped rebuild Britain, bankrupt in all but name, following six years of war.
The stress and burden of the US loan negotiations contributed to the demise of his health. Americans found Keynes to be “irritatingly brilliant”. But the war, Britain’s earlier guarantee for financial help, was already over. Military cooperation had been replaced with a new economic order. Keynes secured a loan for $3.75bn agreed at a 2% rate of interest. Any other man would have returned to the UK empty-handed. The final loan repayments were made 61 years later by Tony Blair’s government.
Keynes remains famous for his theories tackling monetary deflation and trade depression. His policies embraced the economy as a whole. His understanding of the relationships between money supply, fiscal intervention, investment and job creation were unrivalled. His suggestion that increased economic activity could be best achieved via centralised intervention and sponsorship of capital projects was proved successful during the 1930’s.
During the process of financial market de-regulation from the 1980’s to 2007 the policies of John Maynard Keynes were increasingly viewed as out-dated, too interventionist. Economists cited the modern free market economy to be self-controlling, self-moderating and a capitalistic self-fulfilling prophecy of wealth creation. The past year has seen a return to centralised intervention, all-encompassing economic policies and a return to the theories that were first realised by Keynes 75 years ago.
Born on 5th June 1883, a student of Eton and Cambridge, a renowned teacher committed to helping others learn and a reputation for speed of mind that few could cope with, Keynes’ theories again form the bed-rock of solutions used to resolve recessions and stimulate economic growth.
It’s a rare rally that sees an index make gains in 12 consecutive sessions but that’s what the US technology sector achieved at close of business on Thursday. In fact the index was just minutes away from closing up in the 13th session, as the first chart below highlights though a burst of selling just before close quickly eroded the day’s marginal gains and the NASDAQ 100 Index Tracker (QQQQ) ended 0.76% down (2nd Chart).
Despite the late fall on Friday the index has now significantly out-performed the S&P 500 diversified index in recent weeks. Entering the new week the index offers investors a poor risk-adjusted return scenario in the short term with the sector’s 14-day RSI (Relative Strength Index) a lofty 72.68. An RSI over 70 indicates prices are overbought in the short term irrelevant of fundamentals or valuations. We may see the technology index make further impressive gains between now and the end of the year but those gains are unlikely to receive much of a contribution from the next couple of sessions, such is the rarity of two weeks of near unbroken bullish behaviour. For nimble shorters the prospects are better. A well placed trade, with stop losses of course, could give shorters a quick profit but those positions should be closely monitored as this rally offers investors a bit more meat on the bone in terms of economic fundamentals than March’s gamble.
QQQQ Minutes Before Close on Friday
QQQQ Minutes Before Close on 24th July 2009
QQQQ At Close Friday
QQQQ At Close 24th July 2009
Investor confidence during recessions is hard won, but easily lost. Pessimism is contagious. Selling pressure can intensify, accelerating the downside momentum. Forecasts of new lows become self-fulfilling prophecies as sellers scramble to reduce exposure to risky assets. We saw this scenario late in 2008 and again into March 2009 when equity markets fell repeatedly to new multi-year lows.
Eventually the selling pressure eases. Bargain hunters see once in a decade buying opportunities. Equity markets spike up as bears rush to close short positions and bulls spot value. The question of timing is raised. Is the economic recovery in place? Is this a new dawn for risk appetite or a dead cat bounce, a suckers rally? The temptation for long investors to bank their easy profits grows, as in May and June this year. Bears open new short positions albeit more selectively than previously. Mixed economic data pulls sentiment one way, then the other. It takes a new and prolonged stream of aligned data to set a new trend. This is the phase we are in now.
A batch of economic and corporate earnings data over the past ten days has surprised on the upside and we have commenced a new bullish run in equity prices which has seen investors win back weeks of losses in just a few sessions. Talk of a return to March’s lows has disappeared. Investment banks have revised upwards, their end-of-year targets for the S&P 500, with Goldman Sachs’ revision to 1,060 the most mentioned upgrade.
The rally has substance. GDP forecasts for 2010 have been uniformly raised. US corporate earnings for Q2 have beaten forecasts. China is booming again, reporting growth of 7.9% in the period March to May. Inflationary pressures remain muted allowing monetary policy in the US, UK and Europe to stay accommodative for the rest of 2009. House prices have stabilised and consumer confidence is growing. Merger and acquisition activity is returning further supporting equity prices and risk appetite. Structural problems persist, particularly in the US and UK economies but a return to global economic growth is now certain. Unanswered questions remain. However, “Will the global recession drag into 2010?”, is not one of them. It won’t.
SPY Daily Chart to 20th July 2009
The Reserve Bank of Australia recently held rates at 3.0%. The cost of borrowing compares to 0.5% in the UK. 1.0% in the Euro-Zone and the 0.0% to 0.25% band in the US.
Whilst the RBA’s monetary policy hints at a 2009 recovery their accompanying comments leave no-doubt Australia will be one of the first G20 nations to exit recession and return to growth. The RBA confirmed downside risks have diminished and recent upgrades to Chinese GDP would help the wider region and Australia to enjoy healthy growth in 2010. Interestingly, the RBA took the time to highlight its cautious confidence in a US recovery but suggested the Euro-Zone remained behind the curve. The sentiment mirrors the thoughts of the IMF in their July World Outlook Update.
The Australian Central Bank also cited fast improving domestic consumer confidence and a pick-up in housing with a healthy number of first-time buyers joining the market. Also highlighted is an absence of labour cost inflation further helping the RBA to keep rates on hold for now rather than tightening monetary policy possibly too early and thereby threatening the recovery. On a more cautious note the willingness of companies to borrow remains subdued despite the 3.0% interest rate, low by Australia’s historical standards.
In summary the combination of fast rising consumer confidence, recovering commodity demand from China and continued domestic monetary and fiscal support suggests the pace of the Australian recovery will remain intact. The International Monetary Fund’s recent upgrade to its GDP forecast also reassures with a revised prediction of a modest -0.5% contraction in the current year and growth of 1.5% for 2010.
EWA to 18th July 2009
Risk appetite firmed over the week with equities benefiting from better than expected corporate earnings data, improving investor confidence, technical buying on resistance levels and an International Monetary Fund upgrade to global growth forecasts for 2010. Gold, like equities, also rallied whilst volatility, measured by the VIX index dipped again after temporarily spiking on poor jobless data from the 2nd which sparked last week’s decline.
Oil also stabilised near $60 after a brief sell off but remains rangebound with improving global sentiment offsetting growing US inventories.
Risky asset prices are not yet stretched (RSI) following the week’s progress and with most key corporations surpassing earning predictions further gains can not be ruled out in the short term.
S&P 500 Daily Chart
SPY Daily to 17th July 2009
Gold Weekly Chart
Gold Weekly Chart to 17th July 2009
Crude Oil Weekly Chart
Crude Oil Weekly to 17th July 2009
VIX Weekly Chart
VIX Weekly Chart to 17th July 2009
