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QE Not Preventing Slowest Growth Since 2009 Recession

 October 11, 2012 10:47 AM
 


Slowest Global Economic Growth Since the 2009 Recession 

(By Darrel Whitten) Five years have passed since the S&P 500 peaked at 1,526.75 in July 2007 and BNP Paribas suspended conversion of three subprime-invested funds in August 2007; i.e., the U.S. subprime-triggered global financial crisis. The S&P 500 is back to 1,441.48, having recovered some 98% of the market cap lost during the financial crisis. Just judging from the level of the U.S. stock market, one would assume that the global financial system is largely repaired and the global economy is back to normal.
Source: Yahoo.com

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Nothing could be further from the truth. In Southern Europe, the poster child of the Euro's structural malaise, Spain, stocks are still nearly 60% below its 2007 peak. In high growth Asia, China's Shanghai Composite is still some 65% below its peak and Japan's Nikkei 225 is still 51% below its 2007, even though the 2007 peak was already 53% lower than the all-time 1989 high. 

IMF Slashes Global Growth Forecast 

The IMF now sees an "alarmingly high risk" of a serious global slump, with the world economy growing at 3.3% in 2012, or at the slowest rate since the 2009 recession, and 3.6% growth next year. Further, the downward revision already incorporates a more optimistic take on the looming U.S. fiscal cliff and the Eurozone debt problem—assuming both will be dealt with without serious negative consequences to economic growth.

Sources: Markit, JP Morgan

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The JP Morgan global PMI indices have been showing continued deterioration since peaking in early 2010, and while the services component has recently up-ticked, the manufacturing sector has again dipped below the 50 make-or-break line. Thus the global economy is still sick, despite three rounds of QE by the Fed, two LTRO by the ECB and a new sovereign bond purchase program, an expanding asset purchase program by the BoJ, QE by the BoE and a massive stimulus program by the Bank of China—i.e., unprecedented fiscal and particularly monetary stimulus,

For the IMF, the key issue is whether the global economy is just hitting another bout of turbulence in what was always expected to be a slow and bumpy recovery, or whether the current slowdown has a more lasting component. Their warning suggests a bigger weight being given to the more lasting component. Further, the IMF could be behind the curve in waving the yellow flag on global growth, as a) the global PMI numbers have been pointing in that direction for some time, and b) the positive effects of the latest round of monetary stimulus have yet to kick in.

Despite the hope for a monetary policy backstop by the ECB, the Euro economic weakness is spreading from the periphery to the whole of the euro area", with even Germany buckling. Even if Mr. Draghi and the Eurozone can deliver on a string of promises made over recent months, the IMF sees the Eurozone only eking out growth of 0.2% in 2013. Failure to act in time or a failure in the policies could lead to a full-blown crash, with contraction near 7% next year in Southern Europe and a deep recession in the North.

Drug down by a China slowdown, a credit cycle downturn is developing in Asia and Latin America. Growth this year has been cut to 1.5% in Brazil and 5.4% in India, or much nearer a hard landing scenario than China.

Like the consensus of most private sector economists, the IMF expects the US to muddle through with growth of 2.2% this year and 2.1% in 2013, while the U.S. economy has come uncomfortably close to stall speed over recent months. Congress dropping the ball on the fiscal cliff issues could easily tip the S&P 500 into a temporary nosedive and the economy into recession.

Japan's domestic reconstruction-led recovery is sputtering as exports slump, particularly to China. The slump has been exacerbated by the political tiff between China and Japan over the Senkaku/Diaoyu islands.

QE Ad Infinitum: Why QE is Not Reviving Growth 

In a speech in November of 2002, Fed chairman Ben Bernanke made the now infamous statement, "the U.S. government has a technology, called the printing press, that allows it to produce as many U.S. dollars as it wishes essentially at no cost," thus earning the nickname "Helicopter Ben". Then, he was "confident that the Fed would take whatever means necessary to prevent significant deflation", while admitting that "the effectiveness of anti-deflation policy would be significantly enhanced by cooperation between the monetary AND fiscal authorities."

Five years after the 2008 financial crisis, Helicopter Ben undoubtedly has a greater appreciation for the issues the BoJ faced in the 1990s. The US 10-year treasury bond (as well as global bond) yields have been in a secular decline since 1980 and hit new historical lows after the crisis. What the bond market has been telling us even before the QE era is that bond investors expect even lower sustainable growth as well as ongoing disinflation/deflation, something that Helicopter Ben has been unable to eradicate despite unprecedented Fed balance sheet deployment.

A Broken Monetary Transfer Mechanism 

Effective monetary policy is dependent on the function of what central bankers call the Monetary Transmission Mechanism, where "central bank policy-induced changes in the nominal money stock or the short-term nominal interest rate impact real economy variables such as aggregate output and employment, through the effects this monetary policy has on interest rates, exchange rates, equity and real estate prices, bank lending, and corporate balance sheets." 

Yet two monetary indicators, i.e., the money multiplier and the velocity of money clearly demonstrate that the plumbing of this monetary transmission mechanism is dysfunctional. In reality, the modern economy is driven by demand-determined credit, where money supply (M1, M2, M3) is just an arbitrary reflection of the credit circuit. As long as expectations in the real economy are not affected, increases in Fed-supplied money will simply be a swap of one zero-interest asset for another, no matter how much the monetary base increases. Thus the volume of credit is the real variable, not the size of QE or the monetary base. 

Prior to 2001, the Bank of Japan repeatedly argued against quantitative easing, arguing that it would be ineffective in that the excess liquidity would simply be held by banks as excess reserves. They were forced into adopting QE between 2001 and 2006 through the greater expedient of ensuring the stability of the Japanese banking system. Japan's QE did function to stabilize the banking system, but did not have any visible favorable impact on the real economy in terms of demand for credit. Despite a massive increase in bank reserves at the BoJ and a corresponding increase in base money, lending in the Japanese banking system did not increase because. a) Japanese banks were using the excess liquidity to repair their balance sheets and b) because both the banks and their corporate clients were trying to de-lever their balance sheets. 

Further, instead of creating inflation, Japan experienced deflation, and these deflationary pressures continue today amidst tepid economic growth. This process of debt de-leveraging morphing into tepid long-term, deflationary growth with rapidly rising government debt is now referred to as "Japanification". 

Two Measures of Monetary Policy Effectiveness 

(1) The Money Multiplier. The money multiplier is a measure of the maximum amount of commercial bank money (money in the economy) that can be created by a given unit of central bank money, i.e., the total amount of loans that commercial banks extend/create. Theoretically, it is the reciprocal of the reserve ratio, or the amount of total funds the banks are required to keep on hand to provide for possible deposit withdrawals. 

Since September 2008, the quantity of reserves in the U.S. banking system has grown dramatically. Prior to the onset of the financial crisis, required reserves were about $40 billion and excess reserves were roughly $1.5 billion. Following the collapse of Lehman Brothers, excess reserves exploded, climbing to $1.6 trillion, or over 10X "normal" levels. While required reserves also over this period, this change was dwarfed by the large and unprecedented rise in excess reserves. In other words, because the monetary transfer mechanism plumbing is stopped-up, monetary stimulus merely results in a huge build-up of bank reserves held at the central bank.



If banks lend out close to the maximum allowed by their reserves, then the amount of commercial bank money equals the amount of central bank money provided times the money multiplier. However, if banks lend less than the maximum allowable according to their reserve ratio, they accumulate "excess" reserves, meaning the amount of commercial bank money being created is less than the central bank money being created. As is shown in the following FRED chart, the money multiplier collapsed during the 2008 financial crisis, plunging from from 1.5 to less than 0.8.

Further, there has been a consistent decline in the money multiplier from the mid-1980s prior to its collapse in 2008, which is similar to what happened in Japan. In Japan, this long-term decline in the money multiplier was attributable to a) deflationary expectations, and b) a rise in the ratio of cash in the non-financial sector. The gradual downtrend of the multiplier since 1980 has been a one-way street, reflecting a 20+ year dis-inflationary trend in the U.S. that turned into outright deflation in 2008.


(2) The Velocity of Money. The velocity of money is a measurement of the amount of economic activity associated with a given money supply, i.e., total Gross Domestic Product (GDP) divided by the Money Supply. This measurement also shows a marked slowdown in the amount of activity in the U.S. economy for the given amount of M2 money supply, i.e., increasingly more money is chasing the same level of output. During times of high inflation and prosperity, the velocity of money is high as the money supply is recycled from savings to loans to capital investment and consumption.

During periods of recession, the velocity of money falls as people and companies start saving and conserving. The FRED chart below also shows that the velocity of money in the U.S. has been consistently declining since before the IT bubble burst in January 2000—i.e., all the liquidity pumped into the system by the Fed from Y2K scare onward has basically been chasing its tail, leaving banks and corporates with more and more excess, unused cash that was not being re-cycled into the real economy.

 Monetary Base Explosion Not Offsetting Collapsing Money Multiplier and Velocity 

The wonkish explanation is BmV = PY, (where B = the monetary base, m = the money multiplier, V = velocity of money), PY is nominal GDP. In other words, the massive amounts of central bank monetary stimulus provided by the Fed and other central banks since the 2008 financial crisis have merely worked to offset the deflationary/recessionary impact of a collapsing money multiplier and velocity of money, but have not had a significant, lasting impact on nominal GDP or unemployment. 

The only verifiable beneficial impact of QE, as in the case of Japan over a decade ago and the U.S. today is the stabilization of the banking system. But it is clear from the above measures and overall economic activity that monetary policy actions have been far less effective, and may even have been detrimental in terms of deflationary pressures by encouraging excess bank reserves. Until the money multiplier and velocity of money begin to re-expand, there will be no sustainable growth of credit, jobs, consumption, housing; i.e., real economic activity. By the same token, the speed of the recovery is dependent upon how rapidly the private sector cleanses their balance sheets of toxic assets. 

The Modern Economy Runs on Credit, Not Fiat Money Supply 

The volume of fiat money (money supply) is actually insignificant compared to the gross quantity of credit, the net value of which has to equal zero because every asset is someone else's liability. In other words, when one group (households, mortgage banks or corporations) tries to reduce its liabilities, the only way to maintain a given level of spending is if another group compensates by increasing its liabilities. Since before 2008, this has been governments.


 Role of the Shadow Banking System in Credit Creation 

One of the biggest failures leading up to the crisis was the inability of regulators to understand the scale of the shadow banking system or its interconnectedness with the overall financial system. A research paper by New York Fed as shown in the graph below shows the volume of credit (in trillions of USD) intermediated by the shadow banking system, which is larger than that of the regular banks. Prior to the crisis, shadow banks had liabilities of $20 trillion compared with $11 trillion for regular banks. Today, the figures are $16 and $13 trillion, respectively, meaning the shadow banking system remains a bigger factor in total credit creation even after the crisis.

Further, the 2008 financial crisis was precipitated by a run on shadow banks, and there remains an inherent weakness in the shadow banking system that makes it vulnerable to future bank runs. Following the crisis, the New York Fed paper estimates the shadow banking system (shadow banking credit) shrunk about 20% to 2010, while credit in the formal banking system increased about 18%.

Source: Shadow Banking, July 2010, Number 458

Balance Sheet Recession versus Total Credit Creation  The good news is that total credit market debt in the U.S. is again expanding. With flat or declining credit market debt, the economy would again fall into recession or even depression. The bad news is that the sole source of this credit growth is the government, while private sector credit is declining.

As long as private sector credit is restricted, there is no improvement in the money multiplier or the velocity of money. Worse, already high government debt continues to accumulate.  A prime example of the problem is the U.S. housing market, where the stock of mortgage debt continues to shrink despite all efforts to reduce borrowing costs to record lows. This is not only happening in the U.S. The Financial Times also describes the failure of the U.K. "Funding for Lending Scheme" to actually accomplish much. Despite the launch of the funding for lending scheme in July, the quantity of new loans to businesses and households in the U.K. has not improved, and the price of mortgage money is actually rising, not falling.


After financial crises such as seen in 2008 and during Japan's financial crisis, over-indebted sectors in the economy, and their bankers, see noticeable balance sheet restructuring that, absence of any offsetting factors, would result in a deep recession or depression. This is the so-called balance sheet recession. As was seen in Japan and is being seen in the U.S. and Euroland, liabilities in the private sector tend to end up as a dramatic increase in government and central bank liabilities as governments try to offset the deflationary/recessionary impact of private sector balance sheet de-leveraging. As the chart by Bianco Research shows, the decline in private sector credit since 2009 has been offset by a greater increase in government sector credit, thereby allowing the U.S. economy to continue expanding, albeit at a sub-standard pace.

Thus in retrospect, a temporary bailing out of the shadow banking system, however distasteful, was the right call in that it was in the interest of a heavily leveraged "real" economy, at least until credit in the real banking system expanded enough to offset the drag from shadow banking system de-leveraging. If the treasury and the Fed would have heeded calls to "stick it to the bankers", the U.S. economy would be in a lot worse shape than it is today. By the same token, forcing federal budget austerity on an economy being propped up by government credit creation only exacerbates an already dicey situation. 

Until credit in the private sector begins to re-expand (bringing up the money multiplier and the velocity of money with it), the sustainability of the recovery is entirely dependent on government/central bank intervention. Thus financial markets sell off as government programs wind down, and rally with each new round of intervention (i.e., QE1, QE2, LTRO + Twist, QE3, etc.),  

Source: Bianco Research
Meanwhile, government debt continues to soar. The IMF reckons that that developed economy debt-to-GDP has soared from around 30% in the late ‘70s to 105%, and is still climbing. The IMF warned the U.S. and Japan in particular that their current safe-haven status is not a given, considering the sharp deterioration in debt dynamics.

In the U.S., the Financial and State/Local Government Sectors are Still De-leveraging 

The graph above shows that total credit market debt in the U.S. has been re-expanding since mid 2010 as government credit creation began to overtake the shrinkage in private sector credit.. Looking further into the breakdown of total credit creation in the U.S., the household sector as a whole has stopped de-leveraging and debt is beginning to uptick, Non-financial corporate debt is now growing about 7% PA, while federal government debt is growing some 11% PA, albeit down from 35% PA growth rates. The financial sector however is still reducing its collective balance sheet versus a prior 10% PA expansion, state and local balance sheets are still de-leveraging, even though the balance sheet of GSEs/mortgage-backed pools is basically flat. 

How Long Can this Continue? 

The simple answer is, "until private sector credit creation recovers". Ben Bernanke himself has made it clear that the Fed's tools were limited and that the Fed could not fix the economy by itself. Thus it is far from clear how the U.S. economy gets off the QE merry-go-round. Goldman Sach's U.S. strategist is predicting an additional USD2 trillion of asset purchases by 2015; the Fed's own published economic forecasts suggest QE3 would run through mid-2014 and total $1.2trn. What is implied is a long period of sub-standard (1%~2%) growth insufficient to maintain "full" employment and growing wages.

The Need for Currency Diversification

If Goldman Sachs and people like Marc Faber are right about the prospect of virtually endless QE in the developed nations for the foreseeable future, the first thing investors still need to do is offset the ongoing debasement of fiat currencies such as USD, EUR and JPY with virtually the only alternative currency that can hold value in these times, i.e., gold. The following chart by Kitco shows which of the major currencies have been the most vulnerable to debasement, i.e., weakness vis-à-vis gold. Over the past five years, GBP has been the weakest, with gold rising 197.2% in GBP terms, which is worse even than EUR, where gold has risen 157%. Ironically, CAN$ has been even weaker than USD (with gold rising 134% versus 133% in USD). While the most debt-ridden, JPY has held up the best among the major currencies, but gold is still up 55% in JPY terms.

Source: Kitco.com

The Need to Balance Asset Risk 

According to JP Morgan, teh typical long-term asset allocation for public pension funds in the U.S. and other developed nations is now something like 52% stocks, 28% bonds, 5% real estate, 14% alternative assets (hedge funds) and 1% cash. Corporate pension fund exposure to equities is actually smaller, at something more like 40%. Institutional investor asset allocation is designed to maximize returns while minimizing risk, as outlined in Modern Portfolio Theory, or "MPT." But the recent credit crisis has exposed the flaws of MPT and institutional investors are questioning their ability to avoid downside risk using the old tried and true methods. 

The Biggest Long-Term Risk to Conservative Individual Portfolios is Rising Interest Rates 

For individual investors, the largest asset class is more likely to be real estate, including the value of one's house. The American Association of Individual Investors' suggested conservative portfolio of financial assets is 50% stocks (with only 5% in international stocks), 50% bonds (with 40% in longer-term bonds). The risk here of course is of a significant rise in interest rates somewhere over the horizon, which could cause significant losses in the bond portion of the portfolio, whereas fund flows of individual investors burned by the volatility in stocks has been into bonds—a move that so far has proved more right than wrong. Here again, having a significant exposure to gold helps to mitigate this risk, because gold actually does well in both deflationary and inflationary scenarios, which a typical alternative investment such as a hedge fund cannot do. 

The Biggest Risk to Stocks is Corporate Profits Reverting to the Historical Link to Tepid Economic Growth 

Despite tepid top-down economic growth, U.S. corporate profits at least have been surging. As measured by the U.S. Department of Commerce, corporate profits have never been higher, and are recently growing 20% YoY. Further, profits as a percentage of GDP have also never been higher. However, this profit growth has come at a cost. To maintain profitability, corporations have been restructuring, laying off workers, delaying capital expenditures and de-leveraging their balance sheets, which depresses overall economic growth.  The argument that stock prices lead real GDP is well-established, meaning the simple explanation for the current rally is that stocks are "reading" an economic recovery. There are however notable historical exceptions to this rule of thumb. Stock prices continued to rise despite falling output until the fateful 1987 crash, and they also continued rising right up to the 1990 recession.


Further, the following chart shows that the stock market has historically peaked after a peak in corporate profit margins has been confirmed. Simple math tells you that corporate profits can't grow faster than the economy over the long term, or else they'd be bigger than the economy itself.

Thus aggregate profit growth tends to mean revert relative to nominal growth. Currently, U.S. corporate profits are significantly above trend (by that record 30% level relative to nominal growth and an off the charts 200% relative to the PIMCO formula), meaning they have significantly overshot underlying economic growth and thus are very susceptible to a reversion to the long-term mean or below, simply because corporate revenues at the macroeconomic level are simply Gross Domestic Product. Thus without significant improvement in margins from restructuring, cost-cutting and rationalization, corporate profit growth equals GDP growth over the long haul. 


Asia Growth Has Weakened Appreciably, and Poorer Performing Stock Markets Reflect This 

For years, U.S. and European investors have been lured to Asian stocks and markets by tales of high economic growth, such as the BRICs (Brazil, Russia, India and China) story. While still showing relatively higher GDP growth, the BRICs story has significantly changed since the 2008 financial crisis. Indeed, the go-go years for China, India and even Brazil may be behind them as they evolve into "developed" economies. Further, high economic growth is no guarantee of surging stock prices, as was made abundantly clear by falling stock prices in China.

The IMF notes that growth in Asia has weakened appreciably in developing Asia, to less than 7% in FH2012, as activity in China slowed sharply owing to a tightening in credit conditions, a return to a more sustainable pace of public investment, and weaker external demand. India is suffering from waning business confidence amid slow approvals for new projects, sluggish structural reforms, policy rate hikes designed to rein in inflation, and flagging external demand.

The IMF forecast indicates only a modest re-acceleration of economic activity in the region, which would be helped along by some reduction in uncertainty related to assumed policy reactions in the Euro area and the United States, continued monetary accommodation, and gradually easier financial conditions.  Consequently, Asia stocks vis-à-vis the U.S. will still lag, given the relatively better "muddle through" scenario for the U.S. economy. The following graph comparing the S&P 500, MSCI Asia ex-Japan (EPP) and MSCI Japan (EWJ) clearly show U.S. stock gains are twice as high as Asia ex-Japan, and nearly three times as high as Japan since June 2012.

Source: BigCharts.com
While the China slowdown is the economic focal point of Asia, Japanese equities have performed even worse than China since mid-2012, buffeted by a) a high dependency on China for slowing export demand, b) a political fight with China over islands both claim has exacerbated the trade situation at least in the short-term and possibly longer, c) the JPY exchange rate remains too high for Japanese companies to restore export competitiveness. ry has O i i ?N ? anged since the 2008 financial crisis. Indeed, the go-go years for China, India and even Brazil may be behind them as they evolve into "developed" economies. Further, high economic growth is no guarantee of surging stock prices, as was made abundantly clear by falling stock prices in China.

The IMF notes that growth in Asia has weakened appreciably in developing Asia, to less than 7% in FH2012, as activity in China slowed sharply owing to a tightening in credit conditions, a return to a more sustainable pace of public investment, and weaker external demand. India is suffering from waning business confidence amid slow approvals for new projects, sluggish structural reforms, policy rate hikes designed to rein in inflation, and flagging external demand. The IMF forecast indicates only a modest re-acceleration of economic activity in the region, which would be helped along by some reduction in uncertainty related to assumed policy reactions in the Euro area and the United States, continued monetary accommodation, and gradually easier financial conditions. 

Consequently, Asia stocks vis-à-vis the U.S. will still lag, given the relatively better "muddle through" scenario for the U.S. economy. The following graph comparing the S&P 500, MSCI Asia ex-Japan (EPP) and MSCI Japan (EWJ) clearly show U.S. stock gains are twice as high as Asia ex-Japan, and nearly three times as high as Japan since June 2012.

Source: BigCharts.com

Japan Remains the Laggard to Avoid 

Already underweight Japan in global and international portfolios, global investors are now trying to gage the damage to the earnings of one of the most widely held Japanese stocks, i.e., Toyota (7203), from a sharp drop-off in Japanese auto sales in China, and yet another round of recalls.

Nomura's Japanese strategist notes that, since 2005, the regression sensitivity of Japan's real GDP growth rate to China's real GDP growth rate has been 1.4 and the sensitivity of recurring profit growth to Japan's real GDP growth rate has been 8. Using these figures, a 1 percentage point slowing in China's economic growth would weigh down Japanese recurring profits by around 10%. Thus the slowdown China's GDP growth has an incomparably larger impact than a Chinese boycott of Japanese goods, the combination of both is definitely not good for Japan's GDP or corporate profits.

Given that Japan's stock market continues to lag both the U.S., the stronger Euro markets and most of its neighbors in Asia, we see no reason to have significant exposure, even though JPY remains one of the strongest of the developed economy currencies. If you want hard currency exposure, just buy the FXY JPY currency trust. The apparent cheapness of Japanese equity valuations are justified by deep structural issues and the lack of any real movement to unlock unproductive assets, i.e., the cheapness of the market is merely a value trap without a major catalyst for change.

Source: Yahoo.com
Tokyo Takes provides free commentary on global investments from a Japan perspective. To contact the author, please email darrel@japaninvestor.com.

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