Double Dip?

A review of the macro-economic scenarios for 2011
Brait Multi Strategy Fund – Macro Economic Research
Risk asset prices anticipating a strong recovery
Global risk assets appear to have priced in a typical economic recovery. The chart below, from Contrary Investor, compares the year on year change of the S&P500 Index and US payroll employment. Is a strong recovery in employment already in the price? (Ref.1) It certainly looks that way. However, I believe the probability of a different economic outcome is significant. This paper aims to explore a variety of possible economic scenarios, the evidence for and against each, and crucially their asset price implications, for both developed and emerging markets.

May 2010

contrary evidence. I will use a tool that helps minimize these biases, the Analysis of Competing Hypothesis (“ACH”) process. The ACH process focuses on reviewing evidence against each scenario, noting that evidence may be consistent with more than one scenario, but in particular, documenting evidence that contradicts a scenario. Scenarios can then be ranked or assigned a probability on a more impartial basis. (Ref.3) The table below lists key items of evidence and their scenario consistencies. Summary of Evidence
C = Consistent with Scenario X = Contradicts Scenario Leading Indicators show very strong YoY growth universally e.g. OECD G7 LI +10.2% in Feb 2010 GDP growth QoQ growing at a very rapid annual rate e.g. Q4 2009 at 5.7% in the USA Global growth in recent quarters is also strong and synchronized, with forecasts for 2010 and 2011 being revised up Impact of household and CRE sector deleveraging in the US, UK and parts of Euroland Inappropriate policy response to attempt to lower deficits despite private sector deleveraging planned from 2011 Secular trend towards of the Global economy leaves the Local economy as highly credit dependent and deeply cyclical. Local growth potential poor.
Typical New Double ReNormal Dip covery







Economic scenarios for 2011
I will focus on the US economy initially, given its crucial role in asset prices globally. While it is possible to develop many alternative scenarios, I believe the key outcomes can be adequately covered in just three.
2011 Scenario Characterization

The items of evidence that are shaded are, I believe, nonconsensual and are reviewed in detail in this report. While the table above is of course fairly stylized, I believe it makes a crucial point. The probability of a Double Dip scenario in 2011 is significant.

Asset price implications of each scenario
The Typical Recovery appears consistent with current earnings forecasts, although of course forecast upgrades would also be likely. Rapid growth in tax revenues would enable governments to improve finances reasonably quickly. The challenge for equity and bond markets would quickly become inflationary pressures and the normalization of monetary policy. We would expect reasonable performance of risk assets generally in this scenario, especially the commodity complex. The New Normal is a less favourable scenario for risk assets, in particular the financial sector (most impacted by regulation). Global economy exposed companies may benefit from consistently low interest rates, and I believe there is a significant chance of price bubbles in Asian and other EM equities, in other words “decoupling”. The Double Dip will result in a dramatic risk aversion event similar to 2008. I doubt EM assets can successfully decouple in this scenario. Safe haven assets (US treasuries and Bunds) do well.

Typical Recovery Above trend GDP growth Big reduction in unemployment Issue in due course becomes fully-utilised resources and inflation New Normal Weaker recovery Trend growth lower in future due to higher taxes, less available and more costly leverage, back-tracking on globalization and increased regulation (Ref.2) Issue likely to be budget deficits Growth collapses once the fiscal stimulus ends Deleveraging by household and Commercial Real Estate sectors continues for an extended period impacting consumer spending Issue is deflation and the ineffectiveness of monetary policy

Double Dip

We have a behavioral tendency to put greater weight on evidence that supports a favoured scenario, and to exclude or downplay

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Double Dip? A review of the macro-economic scenarios for 2011
Brait Multi Strategy Fund – Macro Economic Research May 2010

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.

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 exportorientated 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
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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

Double Dip? A review of the macro-economic scenarios for 2011
Brait Multi Strategy Fund – Macro Economic Research May 2010

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 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”.

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. 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.

1. Contrary Investor, “The Room to Consume?”, Contrary, 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, 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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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.

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