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John Mauldin's Weekly E-Letter
Mid-2003 Forecast: Muddle Through*
by John Mauldin
July 4, 2003
2003 Mid-Summer Forecast: Muddle Through*
Why This Doesn't Feel Like a Recovery?
The New Productivity Paradox
The Dark Side of the Productivity Force
What Do You Want The Fed To Do?
Daddy's Home or Daddy's Clueless?
Can You Say Long Term Capital Mortgage?
Transparency at the Fed
I promised in my January 2003 forecast I would re-visit my predictions, giving you a mid-year update. Faster than I can believe, that time is upon us. Once again I dare to venture where wiser minds will not trod: into the territory of economic predictions.
This week's letter is titled "Muddle Through*". That is Muddle Through with an asterisk. I lay out the case for the continuation of The Muddle Through Economy, although one which should be mildly better in the last half of the year than the first six months. But (isn't there always a but?) there is a serious potential problem that must be dealt with: Federal Reserve Bank policy which borders on - what's the word I'm looking for? Opaque? Dangerous? Irresponsible? That is my asterisk. If they do not follow through on their rhetoric - if they do not walk their talk - we will see a recession before the end of the year. We will examine the problem in detail, and I will suggest we will see a significant change in Federal Reserve policy within a very short time. If you are thinking about mortgages, you will want to read this letter.
Going back to my January 2003 forecast, so far we are more or less on track. I called for a Muddle Through, slower growth economy which would avoid recession; a bear market stock rally; a rise in gold to $355 and then to $385 (not yet there); S&P 500 profits growth in high single digits; that if there was any Fed action it would be to cut rates; the passage of a tax cut; a continued fall in the dollar (suggesting a $1.17 euro); a volatile bond market and a falling oil price.
So far, the oil prediction has yet to be manifest. We have certainly seen a significant bear market rally. The normally bullish Ed Yardeni rightly notes in this week's Barrons: "If third-quarter results don't live up to expectations, then we could see a September-October stock-market massacre like that of so many past years." The good news is that earnings will grow. The more important news is that stocks are now richly priced for more than mere growth - the market will not tolerate disappointments. Stay tuned.
The market to watch, however, is the bond market, as that is the key to the rest of the year, for the stock market and the economy. The bond market, and the Fed response to it, is the focus of my asterisk.
First, let's look at some good news. The economy is in a position to grow in the 2-3% range for the last half of the year. That may be below potential, but is still above the anemic annualized probable growth of less than 2% for the first half of the year.
Why should we see a modest improvement in the last half? The tax cut will kick in this week, and whether you like the policy or not, it will put real extra dollars in consumer pockets. Thus we can expect consumer spending to rise modestly. I expect mortgage rates to remain low, thus a continuing boon to the housing market (although I lay out the clear and present danger in mortgage rates below). The delinquency rate for all loans is dropping. The dollar is dropping which is helping US exports. The Fed is pumping the money supply like there is no tomorrow. In fact, tomorrow, as in a few years down the road, is not on their radar screen. They are focused on the here and now. (This will be a problem - a big problem - down the road, but right now we are focused on the next six months.)
Inflation is low and likely to remain so for the near future. The stock market is rallying. The Fed has promised low rates for some time to come. (Question: will they deliver?) Government spending is increasing, which in the odd world of economics is considered a stimulus. Foreign governments, especially Asian, continue to buy American dollars in massive amounts. In short, just about everything that could be done by governments and the Fed is being done to "get the economy back on track." Is Muddle Through being too pessimistic? Both Ned Davis and the Bank Credit Analyst, independent (read non-cheerleader) firms which have excellent track records at forecasting, agree that the economy is likely to grow at 3% rates or higher.
If this is all true, I can hear you asking, then why did unemployment rise to 6.4%? Why are the production numbers so puny? Why is capacity utilization still below an feeble 75%? Where is the rise in business and capital investment? Why is commercial bank lending rising while business loans fall?
Why doesn't this feel like a recovery?
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The New Productivity Paradox
Barry Ritholtz, Market Strategist for the Maxim Group, argues persuasively in a recent essay highly critical of the Fed that the answer lies in the productivity numbers. Quote:
"In 1987, Nobel laureate Robert Solow famously observed: "You can see the computer age everywhere but in the productivity statistics." Despite massive investment in IT infrastructure, productivity growth was nonexistent. At the time, this was known as the "Productivity Paradox."
"It's not too difficult to see why productivity increases remained so elusive during that era. In 1987, PCs were clunky and awkward to use. Command codes via DOS were not the path to improved worker efficiency. As companies struggled to incorporate PCs into their workflow, they upset existing efficient routines. Firms had to create new infrastructures, hire consultants, and add IT staff. The subsequent integration was both painful and costly.
Productivity Spike in late '90s
"Starting in 1995, non-farm worker productivity growth doubled. Looking back from our present vantage point, it's easy to see how a few incremental improvements added up to a massive increase. By 1995, most office applications had become standardized. New hires no longer had to learn a unique set of tools. The learning curve for existing workers dramatically flattened. With the introduction of Windows 95, DOS became buried under a graphical user interface (GUI). The tools themselves were getting better and easier to use.
"Additionally, new workers had grown up using PCs. They required little if any formal training. Using computers was not a learned skill to these new hires. For new employees from the "Class of 1995" onwards, the PC was a tool internalized as much as the telephone or pen and paper. Standardization - plus these new, highly computer literate workers - helped boost productivity dramatically.
"Thus, the Productivity Paradox appeared to have been solved. Growth of U.S. productivity surged on an annual basis. Since 1995, labor force productivity has been increasing at an annual rate double that of the previous two decades. This "productivity feast" (as its been called by Greenspan) is the largest increase in non-farm business output per hour in 30 years.
"Since 1995, productivity has been increasing on an annual basis of about 2.25% per year. At the same time, the labor force itself has been growing at 1% per year.
"That simple math of 1% + 2.25% lies at the heart of the 'new Productivity Paradox': As long as productivity continues to increase year after year at the present rate, the traditional notion of 3% GDP creating jobs no longer applies. Real GDP must increase at the annual rate of at least 3.25% per year just for the economy not to lose any more jobs.
"The conservative American Enterprise Institute (AEI) noted that "right now, we're in a 'jobless recovery' - the economy is growing, but so is unemployment. The reason is that productivity is increasing. If new technologies enable each worker to produce more, the economy can grow without increasing the number of jobs."
"This simple revelation engenders a host of issues not publicly addressed by the Fed Chief. During the boom times, Greenspan lauded productivity as the source of all that was right in the world. Productivity increases got the credit for a myriad of positives: increased living standards, higher corporate profitability, boosted tax revenues, and better funded pension plans. At the time, it seemed that the benefits of technological induced efficiencies knew no bounds."
Like Darth Vader, we are now seeing The Dark Side of the Productivity Force.
Ritholtz summarizes the problem quite well and quite succinctly:
"Since the stock market bubble popped, the markets have been confronting the dark side of productivity: Companies now need less laborers to produce even more goods and services. On a macro-economic level, less workers mean less consumer spending, lowered tax receipts and weaker corporate profitability. Firms have little pricing power. The National Review noted that 'productivity stemming from technology advances and applications also creates inexorably downward price pressures. Technology breakthroughs make it a lot cheaper to produce commodities, finished goods, and all manner of services.' "
"This new Productivity Paradox has the potential to cause significant dislocations in the labor market - one that might not be as easily solved as the last major shift. When the nation changed from a mostly manufacturing to a primarily service economy, it caused similar dislocations. The response by displaced workers was to retrain themselves for employment in other sectors, using the new tools of the trade. That response - learning how to use new technological based productivity tools - will not work at present. Indeed, it's what's to blame for these new productivity issues.
"The jobs being lost presently via enhanced productivity will not be so easily replaced. Unlike the last seismic shift, there is no new "new economy" on the horizon to absorb newly displaced workers.
"In order to stem the tide, one of two things needs to occur: Either GDP must improve dramatically, or productivity gains must tail off, if not outright reverse. Indicators suggest GDP is on the upswing, but if neither of these occur, the U.S. may not start creating jobs for the next few quarters - if not years. Indeed, any backslide in the economy would see job losses resume at a disturbing pace."
And thus the stage is set for the Muddle Through Economy. In order to see any meaningful increase in consumer spending, we are going to have to see a reversal of the unemployment numbers. In order to create more jobs, we are going to need to see a rise in investment spending. And before we see that, we will need to work through the excess capacity built during the boom years of the 90's.
And thus we come to the heart of the matter for this forecast: interest rates. The best way to address my thoughts will be in the context of a discussion of the problems facing the Federal Reserve board of governors. If you were in their shoes, what would you do? Let's start with a quick (and simplistic) review of the economic situation as it looks from the Fed.
Starting with Paul Volcker in the early 80's, the Fed began to fight inflation. Since that time, interest rates have come down, albeit in fits and spurts. The lowering of interest rates and inflation spurred the economy and gave rise (pardon the pun) to a booming stock market which turned into a bubble. (As I will show in a letter later this month, there is a very significant correlation to lowering inflation and a rising stock market.)
During this period, and especially in the later 90's the rest of the world began to depend upon the Untied States for growth. As much as 40% of world economic growth came from countries selling products to the US consumer. This caused a significant rise in the dollar and has now increased our trade deficit to what has historically been an unsustainable level in terms of the percentage of the deficit related to GDP. The over-valuation of the dollar has been corrected somewhat by the rise of the euro (and a few other related currencies) back to the levels at which it was originally introduced. However, the overall correction has been limited due to the competitive currency devaluation in Asia and the fixed exchange rates between the dollar and the Chinese yuan.
The above trend growth in the 90's, plus easy financing, gave momentum to a rather large build-up of manufacturing capacity both in the US and abroad. That growth eventually became excess capacity. Not needing any additional capacity, business investment and capital spending slowed dramatically. This, along with the pricking of the stock market bubble, sent the major world economies into almost simultaneous recessions. The US, which had been the main engine for world growth, was not replaced by Europe or Japan as the driver of growth. Thus the world remained dependent upon the US consumer.
The Fed responded in the only way it could: it began a massive and prolonged series of rate cuts accompanied by significant growth in the money supply. While some maintain it has created two new bubbles in both housing and bonds, it has maintained the strength of the housing market, and with lowering credit costs, rising borrowing and "cash-out" from mortgages, the US consumer market remained resilient. Thus, the recession of 2001 was one of the mildest on record.
Unfortunately, the recovery has also been tepid and jobless. Typically, significant recoveries are made when housing and consumer spending rise dramatically. But since these areas of the economy were already at very high levels, there was no ability for them to rise more than modestly from what were already record levels.
There are three main pillars of the US economy: business spending (capital investment), housing and consumer spending. The current hope by the Fed is that if housing and consumer spending can simply hold there own long enough, that normal (even if below trend) growth will eventually allow for the economy to work through excess capacity and capital spending will again become a source of major economic growth.
The problem is that housing and consumer spending will only thrive in two environments. Either low mortgage and borrowing rates are needed to spur (stimulate) housing and consumer spending, or the economy must be aggressively growing well above trend, adding jobs and increasing personal income so that even in the face of rising rates, these markets will maintain steady growth.
There is pretty much a consensus that if mortgage rates were to rise too much prior to a sustainable increase in business spending, this would be a serious drag upon housing and the economy. This is partly explained by the fact that rising rates mean that fewer people qualify for loans or the loans they do qualify for are less amounts. This would put a damper on the housing market. Since the correlation between consumer confidence (thus consumer spending) and the price of a consumer's home is well established, it is important that housing prices not be seen to be in danger. (The correlation between housing prices and confidence is far more significant than between that of confidence and the stock market.)
>From the point of view of the Fed, this is further complicated by the fact that there is a tide of deflation sweeping through the world. The battle against inflation has largely been successful in the US. If actual deflation were to manifest itself in the US, it could lead to a world-wide recession or worse. The recent (last century) world experience with deflation is not one which has been pleasant, to say the least.
Thus, we see various Fed spokesmen vociferously telling us that deflation will not be allowed to develop in the US. The most famous (and most important) of these was the Bernanke "printing press" speech. Prior to that, the Fed issued a research paper by their economists outlining the causes of deflation in Japan and what we could do to avoid deflation in the US.
The problem is that we are closer to deflation today than many observers realize. Inflation for the first five months of the year (with or without energy) is less than 1% on an annualized basis, and the June numbers due July 16 should see that trend continue. A recent Financial Times article tells us that: "The signs of outright deflation are starting to multiply. The chain consumer price index [another way to measure inflation], introduced to capture substitution effects, shows core inflation is already down to 1%. The US is precariously balanced between price stability and negative inflation. Falling prices started to emerge during the fourth year of Japan's bear market. History is in danger of repeating itself."
We are at what Steve Roach calls "stall speed." If the economy grows any slower, we are in clear danger of "stalling out." If this economy were to slip into recession in today's economic environment, it would almost invariably lead to outright deflation. The consequences for the world economy would be severe. The recent disappointing unemployment numbers would become far more dismal.
Up until last week, the Fed policy of lowering short term rates, plus threatening to work on long term rates if necessary, had been enough to keep interest rates falling and the economy moving forward, albeit in a Muddle Through manner. The concern now is that the traditional lever of lowering short term rates, plus rhetoric, may no longer be enough.
And thus, we come to last week's Fed meeting and the main thrust of this letter.
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What Do You Want The Fed To Do?
Last week, Sue Herera asked me in an interview on CNBC's Business Week, what did I want the Fed to say on the next day? I replied that I wanted the Fed to tell us they were going to work on keeping long interest rates low in order to fight deflation and to maintain the housing market.
The next day they did cut rates 25 basis points (0.25%), but the release that accompanied the announcement was almost identical to earlier meaningless announcements. Art Cashin (UBS head floor trader and of CNBC Fame) wrote:
"It Seems To Me I've Heard This Song Before - Or - Hope Springs Eternal At The Fed - We said on the squawkbox and in these Comments yesterday that traders (stock division) would take their key from the FOMC directive. They did - initially. They looked at it like a monkey looking at a Rubik's Cube. For some time stocks vibrated narrowly in confusion. Then, lacking any new insight they decided that if bonds were weak maybe stocks should be weak.
"Let's talk about the directive and its language to see what we can learn of the Fed's informed view on the current state of the economy and monetary policy. In paragraph two they begin:
" 'The Committee continues to believe that an accommodative stance of monetary policy, coupled with still robust underlying growth in productivity, is providing important ongoing support to economic activity. Recent signs point to a firming in spending, markedly improved financial conditions, and labor and product markets that are stabilizing.'
"That sounded vaguely familiar so we started looking back at directives over the last three years of rate cutting. We found the theme was rather repetitive. Here's what they said, or rather wrote, in early December of 2002.
" 'The Committee continues to believe that this accommodative stance of monetary policy, coupled with still robust underlying growth in productivity, is providing important ongoing support to economic activity. The limited number of incoming economic indicators since the November meeting, taken together, are not inconsistent with the economy working its way through its current soft spot.'
"We did not make this up. You are encouraged to go to the Federal Reserve website and read each of the directives over the last three years.
"Net/net the latest directive is part of a litany of hope. Thirteen rate cuts and the hope that things will improve as they always have (according to the guidebook)."
Daddy's Home or Daddy's Clueless?
After the CNBC interview, Art and I went to dinner, discussing the topic of the day. After 44 years on the floor, Art is as tuned into the sturm and drang of trader psychology as anyone I know. He made the very interesting observation that what the markets wanted to hear fom the Fed the next day was that "Daddy's Home."
Given the violent rise in bonds since that time, that was not what the bond markets heard. Given the significant rise in unemployment only a week after the Fed meeting in which they proclaimed "labor markets....are stabilizing" the concern is that Daddy may be clueless.
It is not that traders have some inherent religious belief in the power of the Fed. "Daddy's Home" in Art's analogy is supposed to represent some sense of stability. Traders simply want to have some reasonable certainty of the future. They have been willing to give the Fed the benefit of the doubt as Fed governor speeches constantly and consistently proclaim their intent to work on keeping long-term rates down.
But the recent Fed statement, with its same song, 30th verse litany of hope, gave no sign of that. Some took it as a hint that the Fed sees a strong recovery and will be raising rates soon. Others thought that this would be the last cut, therefore bonds had nowhere to go but down. Confusion, the enemy of bonds, was evident.
The bond markets threw up. 10 year bond rates, which are the key to mortgage rates, have risen from 3.07% to 3.65% in a week. Longer rates have risen similarly. The yield curve has "steepened" which is precisely the opposite of the results the Fed wants. It is not hard to imagine mortgage rates rising 0.50% fairly rapidly. Given the speed of the recent interest rate move, could another 0.50% be in the future? Is a 1% rise in mortgage rates enough to hurt the housing market? I am not suggesting the housing market implodes, but given the fragility of the economy and a rising unemployment rate, it could slow the growth enough to send us into recession.
If the recent bond market trend stabilizes, then my concerns will evaporate. Long-term rates are still low enough to keep housing and consumer spending from falling out of bed. My concern is that a trend is developing that will arrest the stability of the housing and mortgage markets, pushing us over the edge into a recession and deflation.
The Fed is playing a dangerous game. Bond markets in Japan and Europe are also in wholesale retreat. The carnage in Japanese bond markets makes our markets look calm by comparison. This morning (July 4), the Financial Times tells us that S&P has threatened to downgrade Japanese bonds again in the light of recent bond market turbulence.
Can You Say Long Term Capital Mortgage?
A huge portion of the US bond market has put on a very profitable "carry trade." They borrow at very low short-term rates and buy longer term bonds, thus getting the difference between the two bonds or the "carry." (Don't try this at home, boys and girls.) Since the Fed has implicitly told everyone (wink, wink) that they will keep short-term interest rates low for the near future that trade is quite profitable and was considered to be "risk-free."
Perhaps the recent rise in interest rates was the result of traders taking profits. But it doesn't feel that way. What it feels like is uncertainty, and bond investors hate uncertainty. That is why you buy a bond - for the supposed certainty.
There are massive amounts of this bond "carry trade" in banks, financial institutions and hedge funds. If rates back up, this "risk-free" trade could become unprofitable and force managers to bail out. I am not so much worried about the hedge fund community, which tends to hedge out the interest rate directional risk and use leverage for the profit potential. The concern is the institutional community which does not hedge.
In 1998 we had one fund (Long Term Capital) which had a thousand trades all over the world in a variety of markets which turned out to be fundamentally the same trade. (It was a bet on the convergence of interest rates. They made the same bet, with 80 times leverage, in Norway and Thailand and the rest of the world, thinking they were diversified because they were in different countries. For a great book and a fun read on the subject, see When Genius Failed by Roger Lowenstein.)
Today we have the same trade by thousands of funds and institutions. Yes, it is not as leveraged and no, we are not looking at the precipice, nor are we even as close as we were in 1998. I am not pushing the panic button.
Bond vigilantes, those traders who see inflation lurking behind every statistic, apparently see the recent Fed pronouncements as hinting that deflation is under control, inflation is coming, and the next move in interest rates will be up, possibly as soon as next year. I do not think this is the case, but then I am not a bond vigilante.
The concern is that the bond vigilante crowd becomes the bond mob as institutions start to unwind their carry trade. Everyone cannot get out of the same exit at the same time. Controlling a crowd is one thing. Controlling a mob is another matter entirely. Experience tells us mobs may not be able to be controlled, short of John Wayne staring them down backed up by his deputies. If bond traders sense that there is a rush to "cover" losing trades, it could create just such a mob.
In 1998 there was just one fund. A NY Fed governor could call a meeting and force the major investment banks of the world to cooperate (play nice, boys and girls) and stave off disaster. Today, what would you fix? Who do you call to stop the pain? There are 100,000 bond traders, each looking at their own screen, and not concerned at all about the rest of the world's bottom line.
None of this has to happen. The cure is simple. The Fed simply needs to become transparent. They need to tell investors, from institutions down to Mom and Pop, exactly what to expect, instead of keeping everyone in a guessing game. The market is saying that speeches are no longer enough. Actions speak louder than words. We need to know in an official release whether they intend to keep long rates down, and what they will do to accomplish this.
We all know they will eventually raise rates, so under what circumstances will they do so? Markets and businesses need to be able to plan. If it is the intention of the Fed to hold down long term rates for a period of time until the economy is clearly growing, then say so.
We are in a situation similar to that of Dorothy and the Wizard of Oz. The Professer was behind the curtains, pulling the levers, telling her inscrutable things, pushing her to do unnecessary tasks, all because she did not know the truth. There was no wizard.
Some would say the Fed is a humbug and that revealing what is behind the curtain will simply show they have no real power - that not only are they naked they are also filled with hubris. I rather think that is not the case. These are men who have a difficult job with a tradition and history they have inherited. That tradition is one of a certain mystery and "above it all" attitude that has generated a mindset which is reflective of a long ago era, but which is no longer acceptable in today's world.
We live in a world where it is simply inappropriate that a group of people should operate in such secrecy about matters of such importance. Like Dorothy running off to face the Wicked Witch, forcing the markets to guess about possible directions creates situations inn which some investors go in directions which are not productive. The situation is now possibly moving beyond inappropriate and starting to become dangerous.
This is not to say that the Fed necessarily knows what it will do. But the principles upon which it makes its decisions and the process should be readily transparent, so as to allow investors to make more informed choices,
At least one Fed governor agrees. Dennis Gartman notes: "Finally we note that the President of the Philadelphia Federal Reserve Bank, Mr. Anthony Santomero, made it absolutely clear that the Fed wants to press further ahead with greater transparency. He said in comments made at a meeting there in Philadelphia yesterday that: 'Consumers need and want a better understanding of what the Fed does and why we do it.... As a result, we have implemented greater transparency in monetary policy and we are now trying to extrapolate that transparency to all of our functions.'"
That transparency needs to be translated to full disclosure as to Fed intentions regarding interest rates. It is time for analysts to stop having to read Fed pronouncements, much as fortune tellers read tea leaves, looking for subtle meaning in the nuances of adjectives and subjunctive phrasing. A simple clear sentence or two will create some stability. Just as my children find comfort in knowing the rules, even if they don't like them, the markets will respond with far more orderly behavior from direct policy communications.
Transparency at the Fed
I believe we will see, and rather soon, if rates continue to rise, the Fed respond to the aura of uncertainty they have produced and clearly indicate they will work to lower long rates by moving out the yield curve. Ben Bernanke, who has shown an ability to write clearly, should be in charge of Fed communications.
The Fed has made it clear in speeches that they will work to fight deflation. They know if we slide into recession that deflation will come banging at the door. They should be convinced that a real rise in mortgage rates will almost certainly cause a recession. Thus, they will work to keep long rates down. If they see long rates continue their recent rise, I expect they will begin to walk their talk, and make it clear they are doing so. Being forth-coming will be a great help to that effort.
This accommodative stance will keep the Muddle Through Economy puttering along for the rest of the year, and for some time in the next year as well. With the tax cuts taking effect this week, the additional stimulus will work to increase growth as well.
Will the increase in debt that this policy will encourage, plus the growth in the money supply, eventually have to be reckoned with? Of course. But if you are a voting member of the Fed, will you vote to raise rates, or allow long-term rates to rise, creating a recession and thus see the country slip into deflation? Would you do so without at least trying to hold long-term rates down? Would you rather deal with the possible (not guaranteed) problem of inflation in the future or the highly likely problem of deflation in the here and now?
That vote becomes clearer, especially when no one really knows what to do about deflation once it starts except let it run its course. We have experience with inflation. It might not be fun. It will cause problems. But the speeches that the Fed governors make tell us they believe the devil of inflation we know is better than the devil of deflation we don't know.
(It is not the place of this letter, nor is there the space, to argue for market based reform of the Fed. We are where we are, and we have to deal with reality than with nice theories. Please do not send me long articles about what should be done to replace the Fed. I have read them.)
As a final aside, I would have preferred the Fed not cut rates at all the last meeting and told us they wanted to see continued lowering of long term rates until the economy starts to grow above trend for a reasonable period of time. It was a merely symbolic cut, and is just another 25 basis points they will have to raise in the future. As I noted above, we don't need symbolism, we need clear cut communication as to their direction. Given the fact the market had already priced in a cut, they had no choice, but we still needed clear policy communication. Will somebody please show Daddy the way home?
Happy Fourth of July
It is time to hit the send button and get home to family, friends, fireworks and a picnic dinner. By the way, I am well behind in my correspondence, but hope to get caught up next week.
I still have some openings for meetings in Geneva, Switzerland on the 22-23rd of July. And let's all pause a moment this weekend to remember our men and women in the US and around the world in the armed services, police and fire departments, who put themselves in harm's way so that we can celebrate our independence in safety.
Your enjoying the summer analyst,
Copyright 2003 John Mauldin. All Rights Reserved.
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