Double Dip?

A review of the macro-economic scenarios for 2011

Brait Multi Strategy Fund – Macro Economic Research May 2010

Risk asset prices anticipating a strong recovery contrary evidence. I will use a tool that helps minimize these
biases, the Analysis of Competing Hypothesis (“ACH”) process.
Global risk assets appear to have priced in a typical economic The ACH process focuses on reviewing evidence against each
recovery. The chart below, from Contrary Investor, compares the scenario, noting that evidence may be consistent with more than
year on year change of the S&P500 Index and US payroll one scenario, but in particular, documenting evidence that
employment. Is a strong recovery in employment already in the contradicts a scenario. Scenarios can then be ranked or assigned
price? (Ref.1) It certainly looks that way. However, I believe the a probability on a more impartial basis. (Ref.3) The table below lists
probability of a different economic outcome is significant. This key items of evidence and their scenario consistencies.
paper aims to explore a variety of possible economic scenarios, the
evidence for and against each, and crucially their asset price Summary of Evidence Typical
implications, for both developed and emerging markets. New Double
C = Consistent with Scenario Re-
Normal Dip
covery
X = Contradicts Scenario

Leading Indicators show very strong YoY growth

universally e.g. OECD G7 LI +10.2% in Feb 2010
C C X

GDP growth QoQ growing at a very rapid annual

rate e.g. Q4 2009 at 5.7% in the USA C C X

Global growth in recent quarters is also strong

and synchronized, with forecasts for 2010 and C C X
2011 being revised up

Impact of household and CRE sector

deleveraging in the US, UK and parts of Euroland X C C

Inappropriate policy response to attempt to lower

deficits despite private sector deleveraging X C C
planned from 2011

Secular trend towards of the Global economy

leaves the Local economy as highly credit
dependent and deeply cyclical. Local growth X C C
potential poor.

Economic scenarios for 2011

The items of evidence that are shaded are, I believe, non-
I will focus on the US economy initially, given its crucial role in consensual and are reviewed in detail in this report. While the table
asset prices globally. While it is possible to develop many above is of course fairly stylized, I believe it makes a crucial point.
alternative scenarios, I believe the key outcomes can be The probability of a Double Dip scenario in 2011 is significant.
adequately covered in just three.
Asset price implications of each scenario
2011 Scenario Characterization
The Typical Recovery appears consistent with current earnings
Typical Recovery Above trend GDP growth
forecasts, although of course forecast upgrades would also be
likely. Rapid growth in tax revenues would enable governments to
Big reduction in unemployment
improve finances reasonably quickly. The challenge for equity and
Issue in due course becomes fully-utilised resources
bond markets would quickly become inflationary pressures and the
and inflation
normalization of monetary policy. We would expect reasonable
New Normal Weaker recovery performance of risk assets generally in this scenario, especially the
Trend growth lower in future due to higher taxes, less commodity complex.
available and more costly leverage, back-tracking on
globalization and increased regulation (Ref.2)
Issue likely to be budget deficits
The New Normal is a less favourable scenario for risk assets, in
particular the financial sector (most impacted by regulation). Global
Double Dip Growth collapses once the fiscal stimulus ends economy exposed companies may benefit from consistently low
Deleveraging by household and Commercial Real interest rates, and I believe there is a significant chance of price
Estate sectors continues for an extended period bubbles in Asian and other EM equities, in other words
impacting consumer spending “decoupling”.
Issue is deflation and the ineffectiveness of monetary
policy
The Double Dip will result in a dramatic risk aversion event similar
to 2008. I doubt EM assets can successfully decouple in this
We have a behavioral tendency to put greater weight on evidence scenario. Safe haven assets (US treasuries and Bunds) do well.
that supports a favoured scenario, and to exclude or downplay

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page 1 of 3
 Double Dip?
A review of the macro-economic scenarios for 2011
Brait Multi Strategy Fund – Macro Economic Research
Review of Key Non-Consensual Evidence
1 Deleveraging and GDP impact
Consumer spending has risen to more than 70% of US GDP. Any
secular change in consumer spending habits is hugely relevant
when forecasting future GDP growth. The decade of the US
housing boom was characterized by households spending more
than their income (i.e. borrowing to consume). The Federal
Reserve Feb 2010 report of monthly consumer credit outstanding
shows the biggest year on year decline in sixty years (chart below).
Households are clearly still deleveraging.
In fact US households (together with those in the UK, Spain, South
Korea and Canada) were specifically identified in a recent
McKinsey report on the credit bubble and its economic
consequences (Ref.5) as having a high likelihood of deleveraging.
Also singled out were the commercial real estate (CRE) sectors in
the US, UK and Spain. McKinsey studied 45 episodes of
deleveraging since the Great Depression, 32 of which followed a
financial crisis. Their conclusions were sobering. Deleveraging
episodes average 6 – 7 years after the end of the initial economic
downturn. They also have a significant cost to GDP growth. This is
surely consistent with a “New Normal” scenario, and in addition
raises the risk of the “Double Dip”.
2 Richard Koo and the Balance Sheet Recession
So why have we not seen the impact of this household
deleveraging on the current GDP growth numbers? In short, the
shortfall in economic activity caused by the household and CRE
sectors’ new found thrift has been more than compensated for by
the government’s fiscal spending programmes. Corporate inventory
rebuilding has also provided a sharp, although unfortunately
temporary, boost to growth.
Richard Koo, the Chief Economist at the Nomura Research
Institute in Tokyo, has extensively studied periods of private sector
deleveraging (Ref.6). During these periods monetary policy
becomes ineffective and the only effective tool for governments is
fiscal policy. Despite near zero interest rates demand for loans
collapses and the private sector strives to repay debt. In his view
the greatest risk faced by an economy undergoing what he
describes as a “balance sheet recession”, is the premature
curtailment of fiscal spending programmes before the private sector
deleveraging process has run its course. This has historically
May 2010
happened when a recovery appears to have gathered momentum,
and political pressure mounts to reduce the budget deficit. I believe
that moment is fast approaching in the US, UK and Euroland.
Ironically, Koo demonstrates that spending curbs during
deleveraging episodes actually increase the deficit as tax revenues
fall even faster than the spending cuts themselves.
It is clear, and unsurprising, that high budget deficits are the current
political obsession. The current 2010 estimates are as follows:
US -11.1%, UK -12.8%, Euro area -7.2%, Spain -11.5%. Grim
numbers indeed. I fear that well-founded attempts to reduce the
deficits in the US, UK and Eurozone will have severe unintended
consequences. While Richard Koo’s work is increasingly gaining
credibility (for example he was invited to testify together with the
Federal Reserve Chairman to the House Financial Services
Committee in February) it is still not widely followed.
In fact there appears to be widespread political consensus on the
need for fiscal tightening, with only the means differing between left
and right wing (the left will primarily increase taxes and the right will
primarily slash spending). In a recent debate in the UK between the
Chancellor of the Exchequer and the two shadow chancellors from
the Conservatives and Liberal Democrats, all three were
unanimous that a fiscal adjustment greater than that executed by
the Thatcher government in the 1980’s was necessary. The
Conservatives say that should they win the UK election next month
they will hold an emergency budget review within 60 days of taking
office. Obama has frozen spending for most non-defense items,
and the massive Bush era tax cuts are not to be renewed when
they expire at the end of 2010. At a state level in the US sharp
spending cuts and tax rate increases are the current norm. Overall
forecasts expect fiscal spending to migrate from a substantial boost
to US GDP in Q2 and Q3 2010 to a substantial headwind by Q4
2010 and throughout 2011.
Reducing spending or increasing taxes will have disastrous
consequences on the fragile, deleveraging economies like the UK,
US and much of the Euro area over the medium term. As these
nations attempt to improve government finances I perversely
expect budget deficits to actually widen, as their economies slip
back into recession in 2011 and tax revenues evaporate.
3 The two-tier economy
I believe that the most important distinction for countries, sectors
and even individual firms is how they are positioned in the two-tier
economy. Are they global or are they local? “Global” implies the
ability to benefit from globalization – for example moving
manufacturing plants or service centres to lower cost jurisdictions
(e.g. China and India respectively), selling product globally where
ever there is growing demand and raising capital from global
financial markets rather than being beholden to the banking
system. Sectors that benefit from the “Global” economy also
include basic materials, which has benefited from huge increases in
Emerging Market demand given the resource-intensive nature of
China’s GDP growth in particular. The “Global” economy has strong
secular support and has thrived under the cheap and abundant
liquidity regime brought about by the global financial crisis.
The “Local” economy is generally in far worse shape. Firstly “Local”
economies have lost much of their diversification brought by export-
orientated manufacturing. The migration of manufacturing to
cheaper locations (perhaps cynically described as a labour
legislation and environmental regulation arbitrage) has hollowed
out economies as diverse as the US and SA. Local is more and
page 2 of 3
 Double Dip?
A review of the macro-economic scenarios for 2011
Brait Multi Strategy Fund – Macro Economic Research
more dominated by the credit cycle – consumer spending and
related import, distribution and retailing, construction and property
development and of course financial services such as mortgage
origination. Smaller businesses are invariably “Local”. In the US
small businesses employ 60% of the work force. The difference in
health between “Global” and “Local” is well illustrated by the chart
below (Ref.4).
The ISM surveys larger companies, the majority of which are
benefiting from the “Global” economy. The ISM diffusion index
above is close to its all time high. In contrast, the National
Federation of Independent Business (NFIB), Small Business
Survey is, while slightly above the lows of a year ago, is still
substantially below recession-era levels in 1991.
In addition, the US household and Commercial Real Estate sectors
have huge debt burdens. Large corporates that access markets
directly for funding have benefited from a normalization in
borrowing availability and cost. For example the HSBC AAA
Corporate 5 Year Spread Index (HS3ASP5) is currently back to 117
basis points from a crisis peak of 850 (chart below). In fact given
the level of treasury yields, large corporates have been borrowing
at or near all-time low rates. The recovery in equity markets has
enabled many large companies, most notably in the financial
sector, to raise additional capital at reasonable prices.
Contrast this with the borrowing climate for small businesses. The
NFIB Small Business Survey index of credit availability, illustrated
in the chart below (Ref. 4), is back to the all time low in the March
2010 number.
May 2010
The Local economy in the US is under immense secular pressure,
and, as is shown by the afore-going charts, is still under cyclical
pressure. This is evidence in conflict with the “Normal Recovery”.
Conclusion
I believe there is a significant chance of a Double Dip in 2011. This
is a non-consensual view and hence should this scenario eventuate
it has dramatic asset price implications. Markets most effected will
be the UK, US and parts of Europe (e.g. Spain). SA will also be
severely effected, but has two key differentiating factors. Firstly our
significant exposure to the Global economy via basic material
exports gives positive exposure to any decoupling of EM growth.
Secondly the substantial “cash economy” or informal sector, is
relatively isolated from the credit cycle and global bouts of risk
aversion.
I am not saying the Double Dip is the most likely scenario, rather,
as the ACH process showed, it has a significant likelihood and
given the severe asset price implications that is sufficient. My
strategy will be to isolate sectors and companies fundamentally
most exposed to the double dip and the resulting bout of risk
aversion. To that end I will also examine performances through the
2008 downturn. Trade timing will most likely be only in Q4 2010
and Q1 2011, however this could be accelerated by events in
Europe and China.
References
1. Contrary Investor, “The Room to Consume?”, Contrary
Investor.com, 15 April 2010
2. Bill Gross, “On the course to a new normal”, PIMCO
Investment Outlook, September 2009.
3. Richard J. Heuer, “Psychology of Intelligence Analysis”,
Centre for the Study of Intelligence, Central Intelligence Agency,
1999.
4. Contrary Investor, “One Pill Makes You Larger And One
Pill Makes You Small”, Contrary Investor.com, 20 April 2010
5. McKinsey Global Institute, “Debt and deleveraging: The
global credit bubble and its economic consequences”, January
2010.
6. Richard Koo, “The Holy Grail of Macroeconomics:
Lessons from Japan’s great recession” John Wiley and Sons, 2009.
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