Economic happiness in 2014? - Unlikely

I want to be an optimist for 2014 but it is hard to think that way when you look at the facts of the current US economy. There are positive signs in the current economic environment, but how much of this is truth or just the desire to feel better as we start the year. 

To provide context for 2014, we have to start with the major theme that is overhanging the global economy, deleveraging. We were and are still in a balance sheet recession adjustment process. The data that we have on balance sheet recessions is that it may take more than five years to fix the system. A balance sheet recession needs to work through the excesses in the economy. We are doing it at a rate that is consistent with history. We may not like this but it is reality.

We have followed a growth path of around 2.3% since the beginning of the recovery. We are below the long-term growth path and continue to have a large output gap. This is unlikely to be closed in 2014. Global GDP has been revised down by the IMF to 2.9% in 2013 and 3.6% in 2014. This is not a launch pad for a stronger recovery. 

The labor markets are not in good shape and household income is 9.1% below the highs set in 1999 and still over 8% below pre-recession levels. People are not in better income shape, so the driver of consumer spending is not present. Yes, balance sheets have improved, but this is through belt tightening, lower rates, and bankruptcies which wipeout debt. 

Interest rates are being kept low, but there is a fiscal drag in the US economy. The deficit has moved from over $1 trillion to a level that will be closer to just under $700 billion. Fed employment is declining. State and local job growth is still below past highs. It does not seem likely that we will get any fiscal help over the next year. Regulation uncertainty will provide a drag on growth. 

The forward guidance from the Fed is that rates will be kept low even if we move through the 6.5% unemployment rate. We will see low rates even if we go to 6% unemployment, but that does not mean that monetary policy will help with job creation. 

Inflation is below the 2% target for the Fed. The benchmark PCE is at 1.2% and does not show signs of moving higher in the near-term. Labor cost are low, commodity prices are low, and firms have little pricing power in this economy. The Fed wants inflation but has been unable to create it. 

The stock market does not seem to have the environment necessary for significant increases in 2014. Profits for the third quarter are above 9.5% but revenue ha sonly increased by 2.7% YOY. Net income is at the high end of ranges at 14.9% but sales are only increasing 5% YOY. This means that gains are coming from cost containment and lower interest expenses. This cannot continue forever. The gains in stocks are coming form jumps in the P/E ration not earnings. Risk is at low levels as measure by the VIXX index, but given the level of uncertainty in the markets, it is unclear that this also can continue. 

This is gloomy but it is the reality of what we are dealing with. We can have some good news that will create optimism in markets, but we want to be more careful concerning any view of growth opportunities. 

Tett and conventional wisdom

 A very insightful article from Gillian Tett in the FT on unconventional wisdom since the financial crisis. I will not present all of the arguments but will say that it is a good road map on what are the key take-aways from the Great Recession.

1. Bigger in banking is not better. We do not need institutions that are too big to fail.
2. Finance is self-stabilizing. Yes, and speculators will always drive markets to equilibrium.
3. Taxpayers are on the hook. Always. We cannot take pain in the modern capitalist economy
4. Leverage matters. Leverage kills financial businesses
5. Liquidity matters. You never have it when you need it.
6. Bubbles must be popped early. Yes, bubbles do exist.
7. Structural solutions are not taboo. But that does not mean we will get it right.
8. Shadows should not stay shadowy. There are shadows because markets will try and avoid regulation.

So now we have this information, but that does not mean we will know how to use it.

Larry Summers and lower real rates

There is a growing consensus that the US and the world needs more stimulus for longer. Certainly, this should not be surprising given the size of the output gap that has not been closed almost five years since the bottom of the recession. This is also not surprising given the forecasts provided by those who have looked at past balance sheet recessions.

Forget about tapering, the view from the leading monetary economists is that we have to keep real rates even lower for more years to solve the great potential growth gap. The new theme in macroeconomics going back in time to the work of Alvin Hansen is secular stagnation and the Larry Summers is at the vanguard for stating that more has to be done.

The action which is being called for by Summers is a combination of more classic Keynesian economics. Fiscal policy will be more effective at low interest rates, and monetary policy is needed to keep real rates negative. what is startling about the Summers proposal is that it is very clear on the impact for savers - they should be penalized. Rates should be held down in a manner that would be consistent with the Keynesian view of "euthanizing the rentier class". The only way to close the output gap is make money as cheap as possible to push activity forward. Additionally, Summers is willing to accept the risk of a bubbles as simple cost to get the output gap closed. How can we obtain a wealth effect if there will be maker bubbles that will burst.

I am not sure how this is going to help investment and savings if we accept bubble risk and drive down real rates to unacceptable levels. This is truly unchartered territory that could spell disaster for those who are savers but do not have the skill or funds to adapt to this risky environment. 

Morgan Stanley commodity sale to Rosneft

Morgan Stanley will sell its oil merchanting unit to Russia's Rosneft. Rosneft is the largest oil company in Russia, but is not an independent company in the traditional sense, but one that works for the interests of the Russian state. It would be hard pressed to say that it would make corporate decisions that were in conflict with state policy.

This sale is interesting for two reasons. First, it shows the growing commitment of Wall Street firms to get out of the commodity business. Usually a good sign that we are getting close to the commodity bottom when profit maximizing businesses are throwing in the towel. Clearly, the commodity business has not been generating the returns demanded by share-holders. Second, it is interesting that the sale is to a foreign company that is tied closely to the government. This places key logistical assets and information in the hands of a company that may not be profit-maximizing and that may have goals that are conflict with the US. In fact, it could be argued that this sale will reduce the level of competition in the markets and could lead to actions that will place a squeeze on prices at key market choke points. 

Given all of the actions taken by the CFTC to increase market transparency and competition, it is not clear that this sale will be in the bets interests of the market. It is an alarming trend to see more commodity assets in the hands of state owned companies. Is someone watching the competitive store?