Planet Yelnick

Leading Indicators Support the Slow Growth Scenario

The trend is your friend until it meets the bend - Albert Edwards, SocGen

More indicators are coming in besides GDP that we are not in a V-Shaped Recovery. It appears that the economy is in an "L-Shaped" slow growth mode (2% annual growth outside of gimmicks and stimulus) with heightened risk of a W-Shaped double dip.   

PragCap reports: "ECRI confirmed what yesterday’s GDP report is telling us – the economy remains in recovery, however, is beginning to slow." The ECRI index continued to grow, reaching the highest level in two years, but the rate of growth slowed to a 38-week low (see chart). Laksham Achuthan, managing director of ECRI, concludes: "overall U.S. economic growth will soon begin to ease, in line with the downshift in GDP growth shown in this morning’s data.”

 

The Consumer Metrics Institute's Daily Growth Index, which measures consumer demand, is a leading indicator of GDP, and has rolled over to negative. The CEA commentary notes that the index points to where GDP will be 17-18 weeks later. In Nov09 the demand side began to contract, and predicted the lower 3.2% GDP result. It dropped so rapidly that a two week swing would have changed the GDP: two weeks earlier, at 4.4%, and two weeks later, at 2%. "This is the sign of an economy in rapid transition." The index is now projecting that Q2 will come in as a -1.5% contraction. They caveat that factories often are reluctant to shut down that rapidly, so the drop may slip out - inventory rebuilding in Q1 may result in days-inventory increasing at retail in Q2, which would cause a factory pullback over the summer and into Q3. Result: a double-dip sooner than expected:

 

The Big Picture reports on Bob Bronson's latest prediction, of a double-dip. Bronson focuses on the Core Business Cycle, which is the Final Private Product part of GDP (GDP less inventories and government spending). He takes Final Private Product and maps it in the next chart. It shows how the private sector has fallen - a lot farther than GDP itself indicates:

 

An interesting companion analysis on SeekingApha looks at "True GDP", or what GDP would have been without massive borrowing. Over the past three years, real GDP grew a cumulative 1.5%, or $200B. Unfortunately, the government borrowed an astounding $4T to gain that mere $200B of GDP improvement. It simply disguises a drop in True GDP of around 30%, and will slow future growth by having to be repaid. Simply put, we did not get enough bang for the borrowed bucks.

 

This line of reasoning is another exemplar of the Diminishing Productivity of Debt, that as we use debt like a drug to continue a faux economy, it has less and less value. Eventually more debt has no impact at all on GDP, a position Japan may have reached. Recent data from the Great Recession supports that thesis. If the government could borrow our way to prosperity, Greece would be China. While that isn't disputed, the argument for Stimulus is that borrowing and spending is required in a downturn, evan if it should not be used as medicine in an upturn. The True GDP argument is that it isn't working in a downturn, either, because each Dollar of debt results in less than a Dollar of real productivity. It gets slowly wasted in upturns, and rapidly wasted in downturns, as now. 

The Big Picture adds another analysis, that the Conference Board also sees gloom, with the majority of people (60%) surveyed still expecting family income to go down. Only 10% expect it to go up. 

The implications of slow-growth mode are rolling in:

• Double-dip is more likely: the slow-growth mode is an "L" shaped recovery, but it raises the risk of a double-dip W. SocGen believes we rollover in six to nine months. 
• Unemployment should now get worse. It has been flat since Oct and may be slightly worsening already. An L-Shaped 2% growth (which is also being called a "square root sign" shape), is too slow to improve employment, and once the temporary census workers leave the rolls in a few months, the unemployment rate should rise.
• Trade deficit is widening. Trade is now a drag on GDP, as imports are rising faster than exports. This may be a consequence of the commodities bubble echo, and could flip the other way if the bubble bursts, but that may not occur until the Dollar Carry Trade fades, since it is arguably fueling the bubble echo. The carry trade should last as long as the Fed keeps short term rates low. 
• Interest rates should rise. The deficit is deteriorating, with BofA projecting it it at 9% of GDP in 2010 and 7.5% in 2011, up from 5.2% (projected), pointing to higher long-term interest rates, further dampening business recovery.
• PE Ratios may normalize. At 22 they remain at high levels, in part due to low interest rates (the PE in approximation is the inverse of bond rates) but also due to expectations of "rebound" growth (in effect buying forward today into year-end levels). Slow rebound means a more rapid normalization of rates to 15, which points to a 25-30% drop in equities. 

Ambiguity in the ISM Report

The ISM hit 60 in April, indicating a continuing V-Shaped Recovery in manufacturing. Despite the modest GDP report, is ISM signaling the V? 

At best, the ISM report is ambiguous as to the shape of the recovery. The ISM is a backwards-looking indicator. According to some commentators, the ISM came in a bit below expectations, but to others it was above. That expectations game shows up here!

Looking beneath the spin, here are the pros and cons of an ISM recovery:

1. that Q1 GDP was a bit depressed due to harsh weather, and we will spring back in Q2. One damper on that is that we already rebounded in March in good weather, and the effect may be over. Car sales in April came in down from March, and while they are up from the depressed 2009 levels, are still below the bottom in the 1991 recession
2. that inventory levels remain low, so there is upside in building inventory - if the consumer keeps dipping into savings to spend. Spending rose in March as savings dipped to the low level of Sep2008. Disposable income dipped as well, meaning this spending spree should be temporary
3. that this spending blip may be simply fueled by tax refunds, meaning it should stay in May but swoon by June 

The key, then, is consumer spending. John Hussman takes the view that this is not just a normal recovery, and in particular personal income less transfer payments is not following the prior path, but is in a "stark contrast" to other post-war recoveries:

 

The ISM is said to be priced in the market already. David Rosenberg nots that traders follow an "ISM aphorism" that says the positive report is sending a sell signal:

Buy the recovery story when ISM is at 30 and policy stimulus in full swing (13 months ago); fade it when ISM approaches 60 and stimulus subsides [which is where we are now]

Housing Jitters

The economic data today that got the market in a lather was an increase in new home sales. The financial press picked up on an increase in seasonal adjusted numbers. This report should be taken with caution by investors. New home sales drives new construction, and normally lifts the economy out of a recession. We are not seeing such a recovery, putting in doubt any claims of a sustainable recovery.

The non-seasonally adjusted new home sales was only 38K. The lowest March on record is last year at 31K, only 7K different - and this year's increase was boosted by yet another Cash4GDP program, in this case a second run of the first time homebuyers tax credit, this time no longer limited to first-time homebuyers. All can play!  

Before the credit was reinstated in March, new home sales had been below last year. Compare the yellow bars with the bright red ones in the chart below. (Data and charts from CalculatedRisk.) The risk is when the program ends in April we fall below the 2009 level by more than the prior shortfall, as demand would have been pulled forward into March and April from sales that might have occurred anyway in May and June. 

 

The seasonally-adjusted number is 411Km - quite a difference, 10x higher, because it is annualized. (March usually is the best sales month, so the adjustment is less than a simple 12x.) Due to annualizing plus normalizing to prior years, a small increase in the non-adjusted numbers causes a large swing in the seasonal adjusted number. 

We see a jitter of a possible bottom in this next chart - or is it a mere sideways stall before a further decline, a triangle forming? Hard to generalize from this jitter to pronounce a housing recovery. You can see, however, how new home sales drove rapidly up even before the end of the prior recessions. Not this time. 

The seasonal adjustments add noise to the reports, and new home sales themselves are noisy numbers with lots of fluctuations that disguise the trend. Yesterday the S&P warned that the non-seasonally adjusted numbers were more informative. This chart shows how the seasonal adjustments (purple) are swinging wider and irregular changes (green) are becoming a bigger part of the S&P's Case-Shiller Index. The S&P believes that the increase in irregular changes is driving wilder seasonal adjustments, making them unreliable.

 

The bottom line is we cannot yet claim a recovery to the housing market. 

This next chart and accompanying analysis (from CalculatedRisk) shows a gap between the trends in new home sales vs existing homes. The initial gap was likely due to a flood of distressed sales. New homes could not compete. The big spike in existing home sales (blue line) was caused by the first homebuyer tax credit. 

 

The spike in new home sales (red line) was much smaller, and also came earlier. (New home data comes in when the contract is signed, while existing home data comes when the transaction is closed.) The second little red spike is happening now, ahead of a bigger blue spike. 

When the second homebuyer credit program expires in April, expect the new home sales to drop in May, and existing home sales to drop in July. The seasonally-adjusted numbers should exaggerate the drop, just as they exaggerated the impact of a slight rise. The timing will coincide with what I expect to be the Summer of Disillusionment with the economic recovery, after a pretty good reports of GDP growth in Q1 and Q2.  

Did FDR End the Great Depression?

My prediction is that politicians will eventually be tempted to resolve the [fiscal] crisis the way irresponsible governments usually do: by printing money, both to pay current bills and to inflate away debt. And as that temptation becomes obvious, interest rates will soar. - Paul Krugman, 2003

Funny how the worm turns: now Krugman is cheerleading for inflation. Our economic leadership seems to have no way out of chronic budget deficits other living with them and turning Japanese, or inflating the burden away.

The huge ramp of spending gets the US to 6% (of GDP) chronic deficits by 2020 and after. Anything over 5% is considered unsustainable.

It is too large to be eliminated with income tax increases. Brookings estimates the top rate would have to go to 91% to get to a 2% chronic shortfall. At 77%, it would leave a 3% shortfall.

Both of these estimates assume the huge tax hike does not hammer future GDP growth, and that higher rates can increase the Federal tax take from 18% to 22% of GDP. History of rate changes, however, has has shown that changing rates does not modify appreciably the income tax take of around 18% of GDP. Instead, it slows or speeds up GDP growth. Higher rates, slower growth - and the gap does not close even to 2-3%.

Inflate or confiscate - which poor choice is it to be?

There is an alternative which has been tried three times in dire situations and worked each time. It is a sad commentary on the sorry state of our political discourse that the party in power will not even countenance the debate over the alternative, so in thrall they seem to be to a long-dead economist (Keynes). We may end up where we were in 1920 and 1980: having to finally apply the alternative after the inflation remedy gets out of control.

We know what happened in 1980: a tough Fed chair combined with tax cuts ended the Great Inflation that started with LBJ and spiraled out of control under Jimmy Carter. The Great Moderation followed for 25 years.

Less is remembered about 1920, when we had double-digit inflation and high interest rates coming after WWI and Wilson's Democratic Party interregnum between many years of Republican rule with sound money policies. Harding took power amidst 15% unemployment and GDP falling off a cliff worse than we saw in 2008. Harding's Commerce Secy, Herbert Hoover, coming off a government position managing part of the recent war effort, tugged at the new President's sleeve urging Intervention! Spending! Harding wisely ignored him, cut taxes, cut spending, tightened money, and ended his Great Recession in ten months. The Roaring Twenties followed.

Even less remembered is what happened in 1945, at the end of WWII. The WSJ revitalized the history of the end of the New Deal in a recent op-ed, Did FDR End the Great Depression?  FDR was convinced the only way to employ the 12 million returning soldiers was another New Deal program, but he died before he could impose his plan. The new President, Truman, proposed it (and note, this is when Truman is said to have pushed for national healthcare), but as the article explains, it was soundly rebuffed:

Congress—both chambers with Democratic majorities—responded by just saying "no." No to the whole New Deal revival: no federal program for health care, no full-employment act, only limited federal housing, and no increase in minimum wage or Social Security benefits.

Instead, Congress reduced taxes. Income tax rates were cut across the board. ... [T]op marginal corporate tax rates effectively went to 38% from 90% after 1945.  ...

By the late 1940s, a revived economy was generating more annual federal revenue than the U.S. had received during the war years, when tax rates were higher. Price controls from the war were also eliminated by the end of 1946. The U.S. began running budget surpluses.

Unemployment had remained double-digit throughout the whole New Deal. One year after the end of New Deal policies and the return of economic freedom, it was under 4% despite the huge return of soldiers.

As with FDR then, we have Krugman now, pushing a new New Deal. Peter Shiff takes Krugman's arguments head on and shreds them. Here is the key argument on both sides:

In simple terms, Krugman believes that inflation is the best cure for burdensome debt problems. To prove his arguments, he points to the course followed by the United States in the decade after the Second World War. In 1946, due to unprecedented military spending during the war, U.S. public debt as a percentage of GDP came in at a staggering 122 percent – which is even higher than the 113 percent currently weighing on Greece.

Krugman endorses U.S. policy at the time which, he claims, concentrated on fostering growth instead of taking measures to drastically cut the post-war debt. He notes that by the end of 1956, the federal debt had not diminished in nominal terms, but had become much easier to bear because of the decade of GDP growth that inflationary policies had created.

He neglects to mention that during the five years from 1945 to 1949, federal spending dropped by 58% and taxes fell by 12%. Meanwhile, the budget deficit fell by 66% in 1946 and was in surplus from 1947 to 1949. In other words, although we did not pay down our nominal debt in the decade after the war, we did succeed in massively shrinking government and the burden that it places on society. Could it be that this had something to do with the post-war boom, or should we give all the credit to the monetary policy? (It is important to point out that our national debt did initially decline from 1945 to 1949,but the extra spending necessary to finance the Korean War reversed that trend.)

Inside the March Unemployment Report

The March unemployment report was a bit of a disappointment, and shows the job market skipping like a stone across the bottom. Since October we have been popping just above or just below new job creation. 

The report claims 162k new jobs, seasonally adjusted. Without the seasonal adjustment, only 136k new jobs were created. Without 81k statistically-generated jobs from the birth/death model, only 55k jobs were actually counted. Without the 48k census jobs, only 7k jobs were created. Or so it could be argued. 

More hopeful is the alternative method of counting, the BLS Household Survey, which says over a million jobs were added by small business in Q1. That survey is often volatile, and is considered less reliable, but it seems to be pointing to an underlying strength belied by all the negativity surrounding the main survey. As I have said, every W starts as a V, and we may have upside surprise in employment over the next quarter. 

GS thought BLS would report 275k jobs (revised down to 200k the night before), and TrimTabs, which seems to be able to track better than the BLS, expected 280k. The "consensus" had been 184k. Much of the shortfall was due to fewer census workers (48k) than expected (100k). It may be the census hires have been grossly undercounted (irony abounds). Most likely the 162k gets adjusted upwards later. Again, I expect a positive surprise in the next few months. 

The rate stayed at 9.7%, although it would have been 9.8% without the census workers, and a good argument can be made that they should have been skipped from the seasonally-adjusted number since they go away in a few months. (The BLS subtracts them from the non-seasonally adjusted number before applying the seasonal adjustment, then adds them back.) Inside the 9.7% number, rounding masks an increase of 0.5% (9.69% to 9.75%). 

We need around 200k new jobs to employ all the net new workers coming in (eg college grads). Lower than that and the rate still falls, or should fall, except that the BLS has been dropping the total workforce fairly steeply through this period. I discussed this in some detail in Feb. 

The way to avoid the noise is to look at the totals not the rates. We have lost 2.3M jobs in the past 12 months, and 8.2M since the start of the Great Recession. It had been 8.4M. We are skimming the bottom (see chart from Calculated Risk), and the critical question is whether we bend up rapidly as in prior recessions or stay down in the U shaped bottom for an extended period. Ominously, the most recent recession in 2001 and the prior one in 1991 both are the U shaped curves in this compendium chart, and suggest a similar valley of death awaits us this time:

Tragically, the stats underneath the numbers are not promising. An astounding 44% of unemployed are long-term, and the number of these chronic unemployed (meaning unemployed for more than 26 weeks, or half a year) is at record levels (6.5M). The number of part-time workers (9.1M) is also at record levels, and after a few good months has has gone back up from 8.3M in Jan and 8.8M in Feb to the horrendous level of last Oct (9.2M).

Weather effects in Feb may account for about 100k of the total. Weather adjustment plus census workers add to 148k, very close to the total. Temp help rose 40k, healthcare 27k, state & local govt held constant; with the census (48k), a major part of the increase was of the wrong sort of workers (115k) instead of productive private sector positions (41k), such as manufacturing (17k). If you expect the private sector temp positions to roll into permanent, the report suggests 123k growth in private sector jobs, albeit 81k of them are statistical, meaning created by the BLS's questionable birth/death model for small businesses. 

Analyst reactions were mixed. 

Looking forward, the blogosphere reports that job postings are increasing, but a new survey by the BLS says the opposite: the number of unemployed per opening has trended up to 5.5, and the total number of job openings has dropped a bit. This chart is a bit complex, but compares the unemployment rate to the job opening rate. As you can see, it ticked down a bit in Feb, but this might be due to weather effects. Hence the blogosphere may be a better leading indicator than the backwards-looking BLS survey.

 

As we bounce off the bottom, we might see several months of a real uptick, partly driven by census workers and also driven by good private sector hiring. Then the Summer of Disappointment could hit: census jobs go away, and a huge wave of state & local layoffs are expected to commence this summer. Whether the net increase of real private sector jobs will exceed the drag of govt jobs is unclear. 

The Onion had the last word: it reported that the Dept of Labor had created one special new job for $40B of stimulus. The position would be based in the US Virgin Islands and be paid $500k salary plus multi-million bonuses to study multiple orgasms in a hot-tub environment. (Kudos to Mish for finding the cartoon above and this Onion story.) 

Give Credit to the Fed

Amidst all the Fed bashing and Bernanke trashing, we should give the Fed a lot of credit for doing what Congress and the President fumbled badly: bailing out the banks. TARP was urged as the only way to stop a meltdown, but by the time it got approved, the crisis had passed, and it was used for other purposes. 

Instead, the Fed provided a huge dollop of liquidity, to prevent runs on the banks, and then began buying up their toxic assets using swaps via their Maiden Lane facility. (For those not of NYC, Maiden Lane is a cute little street down by Wall Street.) The Fed abated the immediate crisis. 

TARP was badly designed, and inexplicably so, unless you join Martin Armstrong in the bank-robbery conspiracy theory that TARP was one of several mechanisms used to bail out Goldman Sachs. 

TARP looks a lot like a failed Hoover effort called the National Credit Corporation rather than the more successful Reconstruction Finance Corporation that was replicated in the 1980s as the Resolution Trust Corporation to take care of the S&L crisis. Give Hoover credit for quickly abandoning the NCC and pushing for the FRC. Later FDR improved the FRC to allow it to buy bank stock, and eventually the FRC merged into the new FDIC. 

The lesson learned was to use a resolution process as an alternative to bankruptcy or a slow zombie-like state for troubled banks. The resolution process is essentially a rapid and forced recapitalization of a failed bank, done swiftly enough to avoid defaults and the domino effect of defaults. As the 2008 crisis peaked, Kenneth Rogoff of Harvard had just finished his study of recent financial crises, and had lauded Sweden for using a rapid resolution process. Having learned this during the Great Depression, and applied it successfully during the S&L crisis, and just relearned, how did we overlook it this time around? 

Think about this: we could have used the rapid resolution process to avoid the Lehman bankruptcy, and possibly avoid a 500 pt meltdown in the S&P: between that fateful Friday night and the disatrous Monday morning, Lehman could have been completely recapitalized by eradicating equity, forcing unsecured creditors to become new equity, decreasing the value of the secured creditors to the impaired value of their security, and issuing new options to new management. A lot of work, sure, but by Monday morning, Lehman stays in business, and the complex counter-party risk would have stayed in place.  

Unemployment, Stocks, and the Fed's Emergency Meeting

The unemployment numbers continue to suggest a peak in unemployment last Oct/Nov (see chart, from a veritable unemployment chartfest at The Big Picture). This points to the Fed raising rates in Q4. (History says the Fed tends to raise a year after unemployment peaks, or three years after a recession starts, which both put it in Q4. 

This timing for a rate increase should be bullish for stocks, in a Goldilock's sense: it seems good enough to support he 2010 earnings expectations but not so strong as to pull forward a Fed rate increase. While markets were closed Friday, futures markets had a short opening, and stock futures went up a bit. The financial press pointed towards this and the unemployment report as signaling a recovery ahead. I will comment later this week on that, but for now I wouldn't make too much of this report, since stocks seem to be fully-valued against expected 2010 earnings, and the small futures pop was largely technical (specifically, the S&P seems to have completed a triangle, which is typically followed by a sharp thrust, which we might see continue Monday morning). 

The Fed called for an emergency meeting Monday morning, which likely means they will raise the Discount Rate a second time. They raised it on Feb 18, and the USD strengthened. Monday is a bank holiday in Europe. so reaction may be muted until they Euro banks wake up Tuesday am. (Also, the recent pattern of a Monday Pump up may be delayed to Tuesday, due to this holiday.) 

I have seen it mentioned in the blogosphere that the Fed typically waits until the Discount Rate is 1% higher than the Fed Funds rate, or at 1.25%, before raising the Fed Funds rate. I expect a rise to 1% tomorrow, meaning more time until we hit 1.25%. Question is whether the rapidity of the recent rise of the Discount Rate suggests an earlier end than Q4 to holding the Fed Funds rate low?  At six weeks betwixt & between raises, the next window is end of May for 1.25%, followed by mid-July for over 1.25% - both well before Q4.

Or is something else going on? After ObamaCare passed, the Fed had a hard time with auctioning off Treasuries, and has more to offload this week. Perhaps this emergency meeting will reconsider ending QE so the Fed can prop up the auctions.  

Also, last week the Fed revealed that its Maiden Lane program (where it bought mortgage backed securities - the toxic waste of the housing bubble) has left it holding well over $100B of assets of questionable value. The Maiden Lane III portfolio is only worth 39c on the Dollar. Maiden Lane II is 44c on the Dollar. This means the Fed has assumed an impaired balance sheet, and needs to fix it. It also holds over $1T of mortgage-backed securities (MBS) soaked up in the past year, which include a lot of poor mortgages. One way to fix its balance sheet is to sell off or swap out the toxic debt and MBS, and buy Treasuries to slowly return to its historical quality of reserve assets. Thus rather than explicitly continue QE, it may begin a swap program - but notably at a discount (ie a loss) to what it paid. 

Whichever, the Fed is in a bit of a pickle: it needs to successfully fund the huge deficits, and at the same time exit from extraordinary measures. In effect, the Fed rushed in where a resolution process would have treaded, to shore up the bank balance sheets by swapping out some of their toxic debt and buying the MBS that they would have been loathe to pick up this past year. Now in unloading this stuff it will take the loss the banks would have had to - and given the Fed's ownership, the loss would be spread back onto the major banks. A neat trick, that, if it works. More after the Fed's meeting. 

China and the New American Manufacturing Paradigm

"Mercantilism works" - Paul Krugman

Krugman's call for 25% tariffs on China are based on a profound misunderstanding of how the Great Recession will transform US manufacturing. The US is rapidly moving to a higher-value and sustainable position in global production from an older model of unskilled labor gaining a middle class salary on the assembly line. The greatest threat to this repositioning comes not from China but from within, from policies that hinder innovation and burden production. 

I have written how the Great Recession will transform the West by accelerating a drop in core manufacturing and replacing it with high-value jobs in the layer of design, software and services that I call the IP layer (for Intellectual Property). A simple look at how value flows to Apple for the iPhone should convince you. Click on the sidebar thumbnail of a chart of value in the iPhone (courtesy GigaOm, sourced from Column Five Media). In sum:

• Apple gets $579 from the mobile operator
• Apple pays $179 to build it
• China gets $6.50 for core manufacturing

The assembly line manufacturing component is about 1c on the $. Apple gets about 70c, and that does not include the service income from downloadable apps and music. Most the rest of the cost to build it is IP frozen into chips and software. The mobile operator subsidizes the purchase by $351 and gets about twice that in data fees, even before including voice minutes and sms fees. A similar model applies to the new iPad. 

The IP and Services layer is where the value is. Traditional manufacturing of the sort Krugman wrings his hands over is no longer what "manufacturing" is all about.

You could argue that Apple is an outlier, but there are a myriad of similar companies in Silicon Valley, Redmond, San Diego, and elsewhere across the US. The web industry is largely centered in the US. The smartphone industry is almost wholly in Silicon Valley (Apple, Android, Microsoft's Danger division, Palm). The social networking winners are largely here as well. And of course the US and Europe have huge bio-tech and pharma industries.

It is passing strange indeed, then, that what passes for industrial policy in the US is to bailout car companies, enable huge profits in financial services, empower increased public sector union jobs, jawbone about green jobs - and continue to pluck the golden goose of innovation with:

• Sarbanes-Oxley, which has quadrupled the price of going public and at least doubled the cost of staying public
• Demonization of stock options
• Imposition (potentially) of more expensive health benefits
• Imposition (likely) of increased taxation on small business
• Increase (likely) of capital gains tax rates
• Worsening (possibly) the tax treatment of venture capital

Certainly China is catching up, but a look at history shows that China is still a paper dragon. When the US went through its period of remarkable growth to become the China of its day back in 1900, US companies were the world innovators in both technology (telegraph, telephone, lightbulb, electric generation and transmission) and process (ruthless efficiency in oil, steel, transportation and retail). When Japan emerged as a world power, it too showed innovation, particularly in commercialization (VCR, walkman) and process (just-in time manufacturing, quality). As China has emerged, it shows neither. Instead, it is a story of cheap labor and rapid flow of capital. 

This is all too apparent looking at Chinese profitability. The Chinese exporters are hanging on by a thread,with a profit margin of less than 2%. They are at huge risk of failure if the Chinsese currency rises. As an equity analyst noted:

2% margins on export-oriented businesses is not representative of any sort of real competitive advantage. A real competitive advantage when it comes to exporting would show double-digits profit margins.

If Krugman gets his way, the sort of assembly line manufacturing of China would not come back to the US. If the Chinese currency goes up 25%, or we throw on a tariff, the rise is from $6.50 on an iPhone to $8. Instead, it would go to Vietnam or other low cost areas. 

The bigger threat to the US is a continuation of bad industrial policy that hinders US innovation, while China makes great strides to move beyond cheap manufacturing to the IP layer. Already we see R&D moving to China out of the US. Several Chinese companies are gaining world scale and competitiveness with Western companies, such as ZTE in cellphones, Haier in telecom infrastructure, Lenovo in computers, and Baidu in search. 

An encapsulation of the problem with the path we are on is that government workers now surpass goods-producing workers in the US. 

 

The last time a transformation of this magnitude occurred in the 1930s when workers left the farms and went to the assembly lines. Farming dropped from 40% of the workforce to a few percent, and yet farm production kept increasing. We had huge gains in productivity, and after WWII were able to absorb those new workers into manufacturing. 

We have gotten to the point where the number of public employees in the Agriculture Dept is said to rival the number of core farmer workers. I don't know if this is quite accurate, but the joke is, why was the Agriculture employee crying? His farmer had died. 

Yet that old saw misses a deeper and more important observation: while the number of core farmers has decreased, the workforce in the layer above farming - call it Food Processing - has grown dramatically, and adds a lot more value than farming itself. Food processing and the food service industry to deliver it to supermarkets and restaurants has proliferated an incredible assortment of food products. In many respects this is equivalent to the IP layer above the assembly line, and has its own intellectual property in genetic engineering, flavor enhancement, organic products, preservation, packaging and distribution. Sadly, it too is being starved of innovation, and hampered by fears of genetic modification of seeds, while China is moving ahead. 

Similar to what happened in the '30s, as core manufacturing has declined, manufacturing output has not, and the jobs have shifted to the "manufacturing processing" layer above, the IP layer: 

 

As with farming, we can promote innovation, or starve it. Right now the punditry seems intent on starving it. The most astounding fount of bad policy is the Economist Who Wants To Be Taken Seriously but says really dumb things - Paul Krugman. In a recent post in his NYT blog, he actually said that "mercantilism works". Adam Smith wrote Wealth of Nations to show the mercantilist fallacy, that the "beggar thy neighbor" policy lowers overall trade and hurts the mercantilists' citizens. The victory of Capitalism over Mercantilism was decisive, to say the least. The errors in Krugman's argument are dissected here and here. He wants us to become China. He says things this dumb:

• Virtue becomes vice: attempts to save more actually make us poorer [comment: tell that to the Japanese and Chinese, who force their citizens to save at high rates]
• Prudence becomes folly: a stern determination to balance budgets and avoid any risk of inflation is the road to disaster [comment: tell that to the Chinese, who are now deathly afraid of inflation scuttling their miracle]
• Mercantilism works: countries that subsidize exports and restrict imports actually do gain at their trading partners’ expense [comment: really? we grew a whole China in GDP from 2004-7]
• For the moment — or more likely for the next several years — we’re living in a world in which none of what you learned in Econ 101 applies [comment: only in an academic fantasyland]

A much more sophisticated discussion of the topic comes from Professor McKinnon of Stanford, who points out that as long as the Chinese currency is not accepted as a widely-tradeable reserve currency (like the Yen, Dollar or Euro), it cannot be floated without severe internal consequences to China. Simply put, it would rise without much to limit it, as the Chinese themselves would be loathe to recycle their savings by investing in Dollar assets since the rising RMB means their Dollar investments drop. It should come as no surprise then that mercantilist economies tend to force their citizens into huge savings while restricting their ability to spend outside the home market, since that spending would unwind the beggar-thy-neighbor cheap currency. All of this means that the clumsy Krugmanian solution (of the US becoming a mercantilist like China) would fail to change China and would lower global trade whole hurting the US consumer. 

In spite of poor US policies, I see a tremendously exciting and lucrative future for the US in remaining the leader in the IP layer above manufacturing. We have already vastly increased the size and scope of our college-educated workforce, and the IP layer can absorb college graduates just as the assembly line absorbed unskilled labor off the farms. The speed of change and innovation in engineering, design and marketing mean that training for specific jobs is less valuable than being broadly skilled in learning, creativity and adaptation, all areas in which the US culturally excels. 

We need the patience to ride out the Great Recession, the forebearance to let the transformation work its way across industry, and the wisdom to accept the Creative Destruction of Capitalism, rather than fall into the politically expedient trap of intervening to forestall the change. 

Double Dip Watch: Brown Shoots?

We are beginning to see some "brown shoots", early signs of a coming double dip:

1. CA real estate is double dipping
2. ECRI indicator is turning over, although they insist this doesn't (yet) mean double dip
3. Philly Fed's ADS leading indicator is trending down
4. New financial conditions index (FCI) shows a renewed deterioration
5. Morgan Stanley's Roach says 40% chance of double dip
6. Prescient UCLA economist Thornberg sees double dip in 2011
7. China may lead us into double dip - see chart
8. Chinese premier worried over global double dip
9. Congress may be about to derail the economy by tariffing China
10. Krugman wants 25%(!) tariff on China. Oh my!

Thornberg should be listened to: he predicted the real estate bubble, the disastrous downturn in California and the high probability of recession in 200. You can download his presentation here. He says the economic recovery is mostly government induced and could lead to a double dip as the government steps aside and attempts to hand over the baton to the private sector. 

Here is the China leading indicators chart heading south:

 

The Stimulus Has Stalled

When even that great Keynesian pumper Paul Krugman concedes defeat, you know something fundamental has changed - and that is a belief in continued Keynesian stimulus. He used to preach a multiplier effect, which I have dissected in earlier posts, but no more; and without it, we would have to keep increasing stimulus to keep the economy alive until we cannot fathom funding it anymore. He now is urging the Fed to engineer inflation. 

Think about this: we would have to keep increasing stimulus to keep the economy afloat. Krugman posted a table to explain how a lot of Stimulus might remain to be spent, but have no future impact on GDP growth. The table can be used to substantiate the point about increasing stimulus just to stay afloat. (Running harder and harder to stay in the same place - Alice's Red Queen indeed!). His key metrics are the quarterly rate of spending and the quarterly change in spending, not cumulative spending. The rate adds to GDP (+/- any multiplier), but the most important metric is the quarterly change, since that adds to (or subtracts from) the reported GDP growth rate, the measure we all watch. As you can see, even with substantial Stimulus left to be spent, the Change in spending has already peaked and is going to go negative:

 

"Change" peaked in Q3 (see also my post Peak Stimulus), the quarter that has now been revised down to a 2.2% growth. A bit of inventory rebalancing in Q4 plus decent retail results may pop Q4 up above 3% (some predictions, such as from JP Morgan, have been for as much as 4.5%), but it is downhill from there. The quick additional "midnight" stimulus passed right before Congress rushed off to Christmas break is unlikely to have much impact, since it is poorly designed, as were the last two (this is the third stimulus, after W's tax rebate in 2008 and the Porkulus).  

The dynamic of GDP level vs. GDP growth is well captured in this chart from Deutsche Bank:

 

The level of GDP is higher than it would have been absent stimulus, but is peaking in Q2 and rolling over, as growth slows and then goes negative in Q3 next year. Now, inventory restocking and private spending can change this dynamic, if they come back, at least to push off for a quarter or two that roll-over towards down again. 

Until we actually have a recovery of the private economy, we remain on government life support, and will see the economy come crashing down in the W-Shaped recession as the Stimulus abates in the second half of next year. 

So how well is the private economy doing? Inventory rebalancing can help, but the help is transitory. This chart from CalculatedRisk suggests that historically inventories increase in the first two quarters coming out of a recession, adding about 2% per quarter to GDP growth, and then flatline:

 

Let's walk through the primary components of Q4 GDP, beginning with inventories:

• Inventories: If we bottomed in Q2, we should have seen a 2% bump of inventories in Q3; we actually saw only 0.7%, after all the revisions to the Q3 number. We might see 2% in Q4, although retailers kept inventories a bit lean this year. Let's say between 1.5 and 2%.  
• Personal consumption (PCE): Given the late Xmas retail save, PCE should be pretty good in Q4; Calculated Risk estimates 1.7% growth, for a 1.2% contribution to GDP (calculated based on consumption being 70% of the economy).  
• Investment: new housing dropped hard in Nov, and the tax credit for existing home sales is ending, but overall a slight positive from real estate in Q4. Business investment is moribund. Exports are increasing relatively to imports. Overall impact may be scratch. 
• Stimulus: The following chart would estimate a 2% contribution to GDP in Q4.

Put it together and we have GDP for Q4 = 1.8% from inventories + 1.2% from Personal spending + 2% from Stimulus + about scratch from everything else (investment, exports over imports) = 5%. Looks pretty good! Goldman Sachs sees 4% GDP, and we have noted above that JP Morgan sees 4.5%, so this back-of-the-envelope is probably too high. The last two GDP revisions suggest that it is too optimistic to assume investment and net exports to be scratch; they are likely to be negative again and lower the GDP number. This is especially so since the revisions to Q3 were much more than normal; usually the third revision is slight, whereas this one was major. As Goldman Sachs commented:

This was a much larger than normal revision for the third pass on a given quarter, knocking what once was a fairly robust 3.5% bounce down to a mediocre 2.2% (from 2.8% prior to this revision). All sectors except the trade balance -- a focal point of last month's  downgrade -- saw some downward revision. Revisions were particularly deep in business investment -- to -5.9% from -4.1%, worth two tenths of the revision --  and in inventories (also worth nearly two tenths).

What about 2010? The charts above paint a W shape hitting next Fall. The consensus projection is for 2.5% overall growth; a good example of it is here. The consensus says the recession is behind us, as is the meltdown of financial markets, but serious headwinds limit growth. This growth is below the level needed to turn unemployment around, since we need around 3% to employ new workers (net of retirees) to the workforce. This growth is also much less than typical coming out of a recession. The Reagan bounce out of the Carter recession had 6% growth, and the FDR bounce out of the Hoover depression had double-digit growth. 

This consensus growth also implicitly assumes a W shape within it. Here is a set of scenarios by Dr Conerly shows his prediction quarter by quarter, and two scenarios of how inventories can ratchet the numbers: the red line is rapid inventory rebalancing, followed by a drop that turns GDP negative, and the green line is more modest swings in inventory:

 

He sees 2010 peaking in the first half and then softening. The 2.5% consensus scenario contains within it the same assumption: more rapid recovery in the first two quarters, and then a drop in the end of the year that makes the overall rate a modest 2.5%. We may not go negative, but seem at the moment to be destined to go to near flat GDP in the second half of 2010. The projections for a rebound in 2011 are so speculative they should be ignored. 

Whether it actually goes negative depends on the private economy. Some early indicators in freight give concern. Think of them as the fundamental underpinnings of the Transports in Dow theory: if the Industrials are up but Transports soften, it indicates excess inventory and a drop to come. We saw FedEx do well recently, probably driven by bouyant online sales that should drop after the holiday sales season. We still have "ghost ships" globally, idled oil tankers with floating inventory, and empty container ships. The RR bought by Buffett, Burlington Northern, has estimated tepid results next year. Its shipments are down 14% in Q4, and other RRs have also announced drops, such as Union Pacific at -7%. While RR traffic blipped up just last week, it is still down vs 2007, and this the first and only week in 2009 above negative YoY growth:

 

The next big concern is Obama suddenly becoming concerned over the deficit. Well, it is an election year in 2010 and the Demo's are facing a debacle. He is expected to raise taxes and cut some spending, but balance it with more bailouts and stimulii. Ed Harrison asks "how [can] the Administration believe it can cut the deficitand add stimulus?" He answers, by raising taxes and by continuing the "bailout culture" of keeping the private economy on the string of government handouts and regulations to direct activity in favored directions. Think of the just-passed Senate healthcare bill - it turns private insurance companies into regulated utilities, with their profits capped and their services determined by bureaucrats. So far around 46% of the US economy has been so captured by Obama's policies (banking, autos, mortgages, and now potentially healthcare). Ed Harrison concludes that Obama's policies in 2010 are likely to drive the double-dip recession. 

The final drag comes from the excessive debt in USD, which has only now begun to be written down. It first of all means further attempts to stimulate private borrowing are doomed. Defaults are increasing, and will soon accelerate, and bring with them deflation. This chart shows it has started, and has a long ways to go:

 

This excessive debt also emasculates the effects of Keynesian stimulus based on deficits. I will repeat a chart I have published before, on the marginal productivity of debt. It says we have borrowed too much (private and public) and need to write down a lot of debt to fix the economy. Every additional $ borrowed contributes less and less to GDP, and soon we will hit a point where every $ of new debt destroys GDP. That is the point of no return, since if the increase in debt is not stopped, we would be unable to earn enough from our economy to pay it off. Japan may be at that point right now, and many pundits have noted how we are following the Japanese path of the '90s. They already are heading into their double-dip recession. 

If something cannot happen, it won't, so as we get close to that point everything will begin to go nonlinear. Fortunately we still have a few years to get serious about this problem instead of continuing to pour Stimulus and Liquidity into the economy, as Krugman keeps imploring us to do. 

An example of the alternative is this Pro-Free-Market Program for Economic Recovery from the Austrians, who see the primary problem is the terrible difficulty for businesses to get capital today given the problems with the banking sector. Until that is fixed, the economy remains on life support, and the longer it continues, the longer the private sector stays stuck. Ironically, Bernanke's great flood of liquidity is not going where it is needed, to businesses for working capital and growth. Fixing that requires a whole different approach than government programs and the bailout culture, and has three planks:

1. Require 100% reserves against demand deposits (checking accounts) which removes the need for an FDIC and restores integrity to banks that businesses rely on to hold their working capital. This does not restrict growth capital since longer-term deposits (eg. CDs) can be lent out at multiples of reserves. This does force banks to properly recapitalize, giving them the base to lend again.
2. Return to a global currency, probably based on gold, to remove the discretion of the reserve currency central bank (ie. the Fed) to debase the currency and drive inflation to serve domestic policies and politics.
3. Allow wages and prices to fall to clear the markets. One of the lessons of the Great Depression was that extensive wage and price controls created the high unemployment, and kept it high. Wages are held up today with a web of laws and actions, such as bailing out the auto unions in the guise of bailing out GM.

Sadly, such an approach is so outside the mainstream of thinking that we probably have to go through the Day of Reckoning of too much debt first, before we take a different path. Rather than war bailing us out of the bad policies of FDR and Hoover, we will need this debt debacle to bail us out of the equally bad policies of Bush and Obama.  

There are glimmers of hope, however, as if various points of leadership are slowly rousing themselves out of a slumber. Barron's ran a piece on the Fed stopping its easy-money madness. They correctly identify the cause of the current crisis as excessive credit driven by the Fed, not run-amok capitalism or evil bankers. They also establish that Krugman's call for the Fed to reflate with even more liquidity is as wrong-headed as his prior calls for massive Stimulus:

When the Fed tries to induce business activity in this manner, it never lasts. This is because the central bank always has to cut off the flow of easy money, in fear of causing further damage in the form of rising consumer prices. When the Fed removes this artificial stimulus, business activity dependent on it grinds to a halt, asset prices plunge, and recession sets in. In some ways, the process is analogous to a doctor administering adrenalin to a patient. Remove the stimulus and the patient collapses.

The authors conclude that "lurching from crisis to crisis in a boom-bust fashion is unacceptable and unnecessary." They recommend plank 2 above, removing the our currency from the discretionary vissitudes of politicians and the Fed, and backing it with something else, like gold.  

Bolster the Buck!

I have been saying watch the US Dollar for clues as to equities. In a liquidity-driven market (aka a Bubble Echo market) the huge global monetary stimulus is popping up as rising equities and dropping Dollar.

Today the effort to bolster the buck has accelerated. Wave Theory noted 74.50 in the Dollar Index as a key level; apparently the break below 75 and the run down to 74.77, too close to 74.50 for comfort, has spurred a heightened effort by central banks to strengthen the Dollar so as to keep their currencies from rising too much. China sits fat and happy since they dropped their policy of a slow rise in the RMB and went back to a link to the Dollar last summer (2008), and it has kept them competitive with the emerging economies around them. Those economies - and some of the older Asian Tigers - have seen their currencies rise against the RMB as the Dollar drops.

It is an odd global economy when everyone is in a race to the bottom, including the US. Yet that is what all this monetary stimulus means. The US needs China to buy Treasuries, so has backed off putting pressure on them to let their RMB rise against the USD. In that dynamic someone gets hurt. Not everyone can race to the bottom! In the West it is Europe whose Euro is hovering at the $1.50 level; in the East it is the emerging economies who were taking manufacturing share away from China. 

The many emerging Asian countries (ie. other than Japan & China) lack the scale to truly move the USD; so it is the intervention of the European ECB that is critical. News on this is mixed; an sketchy goldbug site claims a "secret plan" by the ECB to intervene. Geitner made the obligatory remarks supporting the USD in Singapore yesterday, and may have encouraged a coordinated effort by Asian central banks to intervene, but he lacks credibility. Perhaps the most telling snippet is the ECB indicating it is preparing to exit the heavy monetary stimulus. In any event, if the ECB is intervening they will try to keep it secret as long as they can. 

If the US Peso has truly bottomed, it signals not the end of global monetary stimulus, nor end of the beginning, but the beginning of the end. Now the ball will go back to the court of fiscal stimulus: if the Fed begins to exit gracefully, with global coordination, but the US economy is still on government life support, Obama will have to come up with yet another Porkulus Stimulus in the new year.

The Fed is Causing a Continuing Credit Crunch

There can be no real recovery without the private sector, and credit is collapsing for consumers and business. These two charts show the businesses are not able to borrow and consumers are not able to get credit. On the consumer side, overall credit is declining at 5%/yr and revolving credit (credit cards) is declining even faster at 8%.  Business loans are down 12% yearly, and in the last three months a frightening drop of 19% annualized for total loans and a 28% annualized in commercial loans. This means the credit crunch is accelerating. 

One of my investments is living this nightmare. Their sales will triple this year in a bad market for retail products, but they have a difficult time getting a line of credit even when backed by real assets - receivables - and have to pay an effective rate of 15%. 

The public looks at the extremely low Treasury interest rates & deposit interest rates, and presumes that businesses can borrow close to them. Instead, normal everyday commercial credit is run up to usurious levels. And almost everyone knows someone who has faced seemingly rapid and arbitrary increases in credit card rates to a stunning 28%. New accounting rules which are supposed to enhance transparency may make consumer credit even harder to get. 

The reason for the worsening crisis is the way the Fed has handled the situation, as described the Run on the Dollar post: by burying the toxic debt inside the Fed, they have postponed the day of reckoning for the banks but have not cured it. 

You can see in the chart how much the Fed has buried, inside their Maiden Lane vehicle and using the TALF program. Total bank reserves have hit an all time high.A huge chunk of it (70%) are "non borrowed reserves" which as best as I can figure from the Fed's gobbleygook are the reserves burined int he Fed. They are not being used for active lending. 

This postponement has consequence. The banks have apparently taken their reprieve and used it to speculate in bonds and equities - the current Obama Hope Rally. Yet they are still tightening credit and pulling back on lending because the buried reserves lock up lending capacity. After all, at some point the Fed will swap them back! And then the banks will have a much harder time avoiding insolvency, since these assets will have to be marked down due to their lack of liquidity and the underlying distress of the assets lent against (primarily real estate). 

So far the Fed has postponed the necessary write-downs of the first phase of the crisis - primarily subprime and alt A mortgages to people of questionable credit who have since defaulted at very high rates. 

In the next two years the second phase will hit: optionARMs, HELOCs (home equity lines of credit) and commercial REITS, mortgages to borrowers of decent credit. The optionARMs and HELOCs are destined to reset to much higher rates. They were typically designed as a five-year balloon, with the expectation that they would get refinanced within that period. Since real estate values have dropped, this is now a fantasy, since many of these homes are underwater - the mortgage is more than the equity value. 

The expectation of course had been for continuing appreciation. HELOCs in particular are distressing, since they were taken out by people of good credit as second or sometimes third mortgages with every intent and capability of covering the payments and repaying the loans. Yet all around them the subprime and no-money-down mortgages drove up the price of housing, both inflating the size of the optionARMs and seducing homeowners into HELOCs. 

In effect we began using our homes as ATM machines, withdrawing to buy SUVs, HDTVs and vacation property. The MEWs or mortgage equity withdrawals drove the rising GDP during the Greenspan Bubble. This chart shows how different GDP would have looked without MEWs. 

The chart below it shows how the home ATM has run dry. 

With MEWs we borrowed beyond our means and spent it on stuff that pulled in future GDP to the present, meaning GDP that would have happened anyway after we earned more to afford it was pulled forward by a debt binge. Just as the mortgages that funded the MEWs have to be repaid or written off, the unearned GDP will have to be given back in the form of lower GDP or actual drops in GDP over the next five years. 

The piper has to be paid. 

This is what makes this situation so different from a normal recession. Normally when we get ahead of ourselves we have borrowed too much but did it against earnings power (or expected future earnings). In this case we borrowed too much based on asset (home) appreciation, and got way ahead of earnings power. As houses fall, the mortgages get written off, and consumer credit will have to wait until our earnings again catch up. 

The debt write-offs cause deflation, and as this chart shows we have been in a deflationary period for the past year. But we have had a relatively mild deflation compared with the scale of the excess debt. That is due of course to the Fed hiding the problem. When the second wave of the crisis rolls over, the Fed will be sorely stressed to continue to hide the hot potato. 

The Fed has an inordinate fear of deflation. So did Hoover in the 1930s, and his attempts to prop up wages and prices helped turn a bad recession into a long depression. 

Ironically they see the situation backwards. As the economy adjusts to excess debt and the pulling forward of GDP, debt write-downs reduce income and layoffs lower wages. With deflation, prices also drop, and less income goes a longer ways. It softens the blow.

Worse, the low interest rates devastate the return on capital. This gives capital an incentive to invest outside the US for higher returns - China? Australia? With a Dollar depreciation risk on top, it pushes investment away even faster. Deflation at least gives protection to the Dollar; but the deeper risk is as the Fed exits a round of deflation then gives way to inflation given the huge overhang of Fed liquidity created to bury the toxic debt. 

When might the chickens come home to roost? 

The second wave of mortgage problems crests in 2011, and can be postponed a bit. 

Fiscal policy in 2010, however, may create an additional set of stresses. The Bush tax cuts are set to expire, causing a huge tax increase in the face of a recession. The Stimulus will be past peak in 2010, and decreasing. The net impact will be a huge negative stimulus in 2010. This chart shows the Federal deficit in red and the change in it in grey; and the year after a stimulus it acts as a brake on the economy. 

Obama has room for a second stimulus. The deleveraging of total debt has been postponed by the Fed, but not avoided entirely. Private debt is still be written down faster than the increase in the Federal deficit. This gives room for a tax cut in 2010 to counter the expiration of the Bush cuts, and room for a second stimulus. 

We can debate the value of stimulus but it would have some short-term impact to at least ameliorate the potentially large negative stimulus next year. And maybe this time they can do a Stimulus bill that acts faster. 

The wildcard for the day of reckoning is a series of defaults come out of Europe. The mainline European banks are more over-leveraged than US banks, especially in Eastern Europe. Latvia just had a failed bond auction, and it is ratcheting Sweden. Other countries may follow. including Ireland. 

The bottom line remains: a continued if not accelerating decline in commercial and consumer credit. 

The longer the Fed tries to postpone the inevitable, the deeper the hole for the private economy to climb out of. All that is left is to try keeping the zombie banks at bay and the economy on some form of government life support until the US creditworthiness begins to seriously weaken. 

Flattening Yield Curve Points to Double-Dip Recession

Bob Pisani of CNBC (who I find their best source for real info) commented at the close today that the flattening yield curve is signaling a lack of belief in the recovery. Normally the yield curve steepens as a recovery gains strength; so a flattening curve indicates weakness. I commented on this several weeks ago and noted:

I would urge caution with the flattening yield curve. The learning from the Yield Curve really comes post WWII, in a period after the Great Depression when the propensity to save was giving way to an avarice for consuming. This has wholly flipped. Consumers are saving, not spending, and private business is still not borrowing to invest. The propensity to save lowers yields and flattens the curve.

  While I expect a W-Shaped recession, a double-dip, I would urge you to look through the pithy one-liners learned during the Great Moderation and double-click below the surface.

First, the Stimulus ain't working. Disappointing employment news today (see chart) and Mish thinks a revision of past periods is coming, indicating things are much worse than the government has been reporting. (I am shocked, shocked! they are dressing up the numbers.) Today the Big Gaffer, Joe Biden, spilled the truth as he is wont to do: the administration will not try for a new Stimulus but will try to fix the one they have - implying that they too admit it is not working.

Second, we are facing deflation not inflation. Yves' wave count for bonds (see prior post) suggests a pretty serious drop in the long bond yield, which rather than indicating a flight to quality like last year indicates deflationary expectations.

If you double-click below the surface of government CPI and PPI estimates, it is clear we have been in a deflationary period for over a year. Mish gave his take on Bill Gross's switch to deflationary investing (more on this in Yves bond post) and also has been arguing that the CPI number is misleading since years ago the govt swapped out housing prices for an imputed rental. Well, oddly enough, as housing collapses rents can actual go up! Hence the whole housing debacle is misrepresented in the CPI. Here is a chart from Mish with the CPI recalculated based on housing not rental. Mish argues for deflation over inflation based on the real stats.

Put this together: if deflation is worse than reported, the real yield on the long bond is quite high. if we actually have the -6% deflation of this revised chart, the long bond at 3.5% yield is at a horrific real rate of 9.5%. Time to buy! Deflation will drive that rate much lower to try to align real rates to a long-term 6% for the long bond. This supports Yves call to buy bonds, and PIMCO's big move back into govt bonds (but not mortgage backed agency paper). 

Third, the economy may be worse than reported. The Big Picture shows this depressing chart of unemployment compared with all other post Depression recessions. Trending out, it may not turn until 2011 and may not get back until 201.

More comments on this by Karl Denniger, including an analysis that actual losses were closer to 1M jobs, not the reported 263K, due to people dropping out of the labor force (giving up looking for a job).

Peak Stimulus

Peak Oil refers to the peak of production of oil (getting it out of the ground), not the peak of oil (in the ground). "Peak Stimulus" refers to the peak of stimulus spending, not the peak of total stimulus.  On that basis, we appear to be at Peak Stimulus.  This is a good as it gets.  This chart courtesy Zerohedge shows this quarter is the peak of stimulus spending.  The analysis from Sprott goes on to outline how this quarter is also the peak of Chinese stimulus; two Chinese banks announcing on July 29 that they would limit loans in the second half of the year was the proximate cause to break the China Bubble.  

The purpose of stimulus is not to put the economy on life support, but to jumpstart the private sector. On this score the worldwide stimulus appears to have failed.  Any slight green shoots are due to seasonal factors (housing) or government life support.  

I have written on this here about the US and here about China.  The amount of US stimulus should have given us a 3% boost to GDP last quarter (see chart): instead it was a bare 0.2%, less than 10% of what was expected.  (The math is that in a $13T economy, a 1% increase is $130B, or $33B on a quarterly basis; hence the $100B of stimulus in Q2 should have caused a 3% rise annualized, just as this chart shows.) Similarly, the Sprott report says that China has injected a whopping 64% of their first-half GDP in 2008 in the first half of 2009.  Instead of showing up in the Chinese economy, even given how China counts GDP more favorably than the West does, it has instead spilled over into stock and commodities speculation, or simply been mal-invested and lost.  

We should be seeing a 4% pop this quarter, and it seems possible that GDP will be slightly positive when the Q3 numbers come out - but nowhere close to the expected impact of stimulus.  We seem to be hitting the point of diminishing returns of stimulus via debt.  This is a known problem; see chart.  It comes from a number of factors, including banks not lending and people/business not borrowing; using the tax rebates for paying down debt; and poorly spending the shovel of sudden money.  

We end up with gimmicks like Cash For Clunkers, a classic example of the Broken Window Fallacy. And gimmicks like C4C fizzle into confusion and political spin.  The reality of that program is "eight of the ten top-selling vehicles are foreign-made cars, while U.S. cars occupied all top 10 spots on the trade-in list." It put people into debt who could have used the money or credit on better decisions.  

BTW the Clunker program created a controversy when DOT put out a chart of the top 10 cars - almost all Japanese and small.  Turns out they may have not properly counted US cars with same design but different models, such as Ford Escape two-wheel drive vs. four-wheel drive.  It may be the most bought car was a truck - the large Ford Escape SUV! Also high on the list would be other SUVs (the small Jeep Patriot and the huge Chevy Silverado).  This is what happens with government gimmicks: they are followed by government spin to attempt to "prove" that the purported purpose was achieved.  

What was accomplished?  If the purpose was global warming, why was the top car (in the real list, not the DOT spin) an SUV and why were two other SUVs in the top 10?  If the purpose was helping American car makers, why were most cars Japanese?  If the purpose was to jumpstart the economy, why are dealers expecting a sharp drop in sales?  Most likely the purpose was desperation - anything to get a green shoot.  I think what was accomplished was to make the W-Shaped Recession more likely.  

In the Greenspan Indian Summer from 2002-2007, we only got 40c on the Dollar: $10T cumulative GDP growth for $24T of new debt. Now it appears that the Stimulus is getting less than 10c per Dollar.  We are rapidly approaching a point of disaster where every new attempt to stimulate simple destroys GDP. See chart.

W-Shaped Recession Coming UPDATED

Today's GDP report makes it more likely that we are headed to a W-shaped "double-dip" recession, somewhat like 1980 and 1982: GDP for the second quarter is estimated at -1%, less bad than the expected -1.5%. At the same time, the prior four quarters were all reduced to twice as bad as previously reported, a huge revision down.  Now, you conspiracy theorists should not jump to conclusions - the NBER appears to be an agency which has retained its integrity when so many others have become hopelessly politicized.  Revisions like this are common.  This Q2 report is likely to be revised downward with more information, but will still show a positive trend off the prior quarter. 

Consumer spending was down in Q2, despite having been up in Q1; the GDP uplift came from massive increase in government spending (up 11%).  This has caused the USD to plummet and bonds to skyrocket (yields collapsing) - see chart, courtesy of Market Ticker.  The FX market expects the government to trash the USD via a continuation of QE (Fed buying bonds to helicopter money into the economy).  The US economy is now on life support, but at least the patient is still breathing. 

Part of the less-bad news was statistical: imports fell more than exports, which added 1.4% to the estimate.  Barry Ritholz notes how odd this is, since we sold less overseas, but bought more less, and so it made our GDP look better! 

UPDATE: another good analysis of these numbers at Economic Edge.  Take a look, and be sure to click on the video (Chris Mortenson's Crash Course on GDP follies and cheats).  Cliff Notes version:

Inventories were cut MORE in Q2 by businesses than in Q1, $141.1 vs. $113.9. No green shoots there.

GDP has now *officially* been negative for five of the past six quarters. And Q1 was revised waaaaay lower, even lower than the *advance* estimate we received in late April, -6.4 vs. -6.3, making Q1 of 2009 WORSE than Q4 of 2008 (at -5.4), the opposite of what had been previously assumed. No green shoots there.

For 2008: Q1 was revised sharply lower, to -.7 from .9; Q2 to 1.5 from 2.8, and Q3 to -2.7 from -.5. No green shoots there.

Gross private domestic investment fell for the seventh quarter in a row, the past three quarters seeing declines of 24.2, 50.5 and 20.4 respectively. Residential fixed investments have now been negative for a stunning 14 consecutive quarters, with the past 13 showing double-digit declines. The past three have shown retrenchments of 23.2, 38.2 and 29.3 respectively. No green shoots there.

What has picked up the slack? Why government spending, of course. This was most pronounced in Q2 2009. Gov't consumption and expenditures rose 5.6. At the Federal level, spending rose a whopping 10.9 in Q2, national defense jumped 13.3 (more wars anyone?), nondefense jumped 6.0 while state and local government spending climbed 2.4. Yes, bankrupt governments across the land INCREASED spending in the prior quarter. That's smart. You can call these numbers green shoots if you are a corporate-fascist-state admirer; that's your prerogative, Bobby Brown.

So there you have it. Once again, down is the new up.

Why China Cannot Lead Us Out of the Great Recession

John Mauldin picks up on the China Bubble thread that I have been on for the past two weeks. He quickly dismisses China as being able to drive the West out of our Greater Recession Depression, since "China is just 7% of global GDP. Even if they grow at 8%, that only adds 0.5% to global growth, and it is likely that we will see global GDP shrink by 2.7% in 2009."  See chart.  He adds: "China is roughly as big as the other three of the BRICs (Brazil, Russia, and India) combined. Russia and Brazil are in recessions. Also, note that it will be decades before China's economy is as big as that of the US, even with growth of 5-6% a year more than that of the US." 

He notes that China's stimulus is 1/3 of GDP, equivalent to a new Porkulus bill of $4.5T by the US.  (This is still paltry compared with Japan's stimulus in the '90s, of $6.5T, more than their GDP; it did not work but saddled Japan with stifling levels of debt.)  The Chinese stimulus is going out as bank debt.  Mauldin quotes from Vitaliy Katsenelson's recent Foreign Policy magazine essay:

"This growth will result in a huge pile of bad debt -- as forced lending is bad lending. The list of negative consequences is very long, but the bottom line is simple: There is no miracle in the Chinese miracle growth, and China will pay a price. The only question is when and how much."

Simon Hunt adds that:

"Money is cheap with loans and credit freely available, so much so that China risks developing new bubbles in the stock and commodity markets and real estate. Speculation is based on the simple premise that prices must rise. Foreigners as well as domestic participants are feeding this frenzy, especially in metal markets.

"The frenzied loan and credit growth is unlikely to be cut back until the fourth quarter at the earliest. It is not this year or next which worries us, but post 2010. What will China do when the world economy gets hit with its next big leg down?"

He sees a staggering amount of copper (as one example) being stockpiled.  Mauldin describes it as China engaged in hiding the Old Maid (the USD) by stockpiling and dumping their USD reserves on other countries, Australia in particular.  In the card game, whoever ends up with it loses.