Tuesday, October 21, 2014
Key themes for fourth quarter
Legacy of the Great Recession - It will not go away
Output gaps are not closing, get used to it. Growth is slower around the world and there is no catalyst to get growth to increase above the pre-recession levels in order to close the gap. There has been no rubber band effect usually seen in post WWII recessions. Those who were more highly levered, the non-wealthy class, has not been able in increase consumption. They have also not participated in the wealth effect. Hence, we have growing income inequality and no increase in aggregate demand. The aggregates do not tell us about the wealth problem which exist for certain income groups and regions.
The thesis that financial or balance sheet recessions take longer to unwind has proven to be true regardless of monetary stimulus. The average rebound is about 10 years. The priors tell us that we will still have to wait as balance sheet get repaired.
In this period while balance sheet are repaired, we can still have "normal" business cycles and a recession. We have to accept that cyclical behavior continues even if there is a long-term balance sheet adjustment.
We have inflation - It is in the asset markets not real markets
We are in an inflationary environment. This is what many economists expected, except it is focused in the asset markets and not the real good markets. This is what many did not fully predict. This view on bubbles is now changing. There is an excess supply of good but a shortage of financial assets to meet the excess money in the economy and the high level of savings. Inflationary expectations are still tamed but financial asset expectations are running wild.
Money growth has declined in the US with the ending of QE, but there is a need for unconventional monetary policy in the EU and continued money growth in Japan. There will not be any return to the old normal anytime soon.
The three speed economy continues - Just at a lower speed
The global growth rates are coming down. we have a three speed world economy, but all of those speed are slower. There is the US which is doing better than the rest of the developed world. There is the slow speed of the EU and Japan. and then there is the other speed of emerging markets which is slowing but still higher than the developed world. This tiered growth world is not changing, but the absolute growth will slow with less money and credit in the global system.
Emerging markets are still tied to the money creation by the US. Things have not changed now that commodity prices have come slowed. Emerging markets are in better financial shape but they need outside liquidity for strong growth.
Volatility rise - RO/RO trading is back
The low volatility environment has existed for too long. A growing level of economic fear exists as normal business cycle dynamic suggest a potential slowdown from the trough of 2009. Normal business cycle dynamics can still exist even if we are still working though the balance sheet adjustment. The US economy is improving on a number of fronts, but the dynamics do not suggest strong above trend growth. We are lucky that lower energy costs may provide a boost for the economy.
The risk-on/risk-off environment of 2009-2011 may be back. Asset class switching will dominate market specific opportunities. Investors will have to get the asset allocation right.
The search for yield - Created the credit bubble, but in transition
The search of yield has not stopped. We are not in an equity bubble but a credit bubble, but this yield search is in transition with the increase in overall market volatility. Credit conditions will tighten and spreads will have a harder time tightening in a world with higher volatility. Zero cash rates are more attractive versus negative asset returns.