9 Economic Myths
Really good stuff. Read Cullen Roche's take (the CR responses) on these.
9 ECONOMIC MYTHS
28 March 2012 by Cullen Roche
One of David Rosenberg’s latest notes touched on 9 economic myths. If you’re familiar with his stance you probably know what his position is on each. So, instead of regurgitate them I am going to hijack his myths and insert my own opinions:
1. Bonds are in a bubble
DR: No, bonds are not in a bubble.
CR: No, bonds are not in a bubble. I outlined my position on this in some detail several years ago, but in short – I think the term “bubble” is being abused in reference to bonds. Bonds are a fixed income product, which if held to maturity will return 100 cents on the dollar plus interest. Can you get left holding the bag if you trade bonds? Yes. I’ve pointed out two different occasions over the last 3 years in which bonds were particularly risky – January of 2010 and January of 2012. Both events were followed by substantial declines in bond prices, but not the end of the secular bond bull. But the bigger point here is to understand what it would mean for bonds to be in a bubble. A bubble implies risk of catastrophic loss.
But let’s remember a few things – first of all, if you ladder into a bond portfolio and actually diversify across bonds then you can substantially eliminate this risk. But more importantly, you must understand the potential macro drivers of a bond market collapse. First, the US govt bond market is not susceptible to Greek-like raids by mythical bond vigilantes (see here for more). Second, since inflation and not solvency is the concern for an autonomous currency issuer, then we need to always worry about inflation, right? What are the big inflation risks, right now? Most likely a supply side oil shock generating a 1970′s style environment (which would likely be followed promptly by a recession) or an economic boom. If we’re in for an economic boom (which will likely lead to higher wages, higher prices, etc) then you better also be diversified across other asset classes because bonds should never be your entire portfolio. Bonds serve a specific role in a portfolio – to help hedge and diversify other holdings. If you’re properly diversified then bond declines (even substantial bonds declines) will be more than offset by gains in other assets.
2. The LTRO saved Europe
DR: The LTRO kicked the can.
CR: The LTRO kicked the can really hard.
I’ve laid out my opinion on Europe previously, but it might help to refresh. The problem in Europe is simple. Because none of the countries are autonomous currency issuers they all suffer from solvency constraints. They can’t print Euro without the approval of a foreign central bank in essence. So, unlike the USA, they can “run out of money”. This makes for frightened bond investors. The problems all arise out of the trade imbalance which essentially forces the core to lend to the periphery to maintain growth. This is only sustainable up to a point and that point has been reached. So the issue now is that you must fix the broken currency. You must make these nations autonomous in their currency. The only two ways to do that is to create some sort of US of Europe. Or default, defect and bring back the old currencies. So far they’re trying to keep the ship from sinking, but the water is pouring in faster than it’s getting bailed out (pun very much intended). The LTRO was a powerful tool that helps prolong this process. It’s really just more of the same ponzi backed by the ECB. The private sector lends to the periphery and on we go. It won’t work. They need to do more…..
3. The US fiscal situation is intractable
DR: Washington must tackle the fiscal problem before it gets out of hand.
CR: I had to look up the word “intractable” so let me just start by stating that I feel pretty stupid already. But DR misses the point here. The USA is an autonomous currency issuer. There is no such thing as our financial situation leading to insolvency. The US government is nothing like a household. It cannot “run out of money”. Nor is it like Greece or Spain or Portugal or any of the countries in Europe involved in that mess of a single currency. Remember, the states in the USA are analogous to the countries in Europe – not the US federal government.
So what is sustainable? Well, as mentioned briefly above – we are constrained by inflation. We could spend so much money into the economy that it causes massive inflation and destroys our living standards. I have long argued that inflation and hyperinflation fears are overdone for various reasons (misunderstanding monetary ops primarily). But the bigger point to understand here is that the USA doesn’t have a solvency constraint like you or I do. The nation has an inflation constraint. It’s not a semantic difference. See here for more.
4. It’s clear sailing ahead
DR: No, the economy is still very weak
CR: I’ve been much more optimistic than most others about the economy. I was very vocal last year that I thought there would be no recession and once again believed this to be the case in 2012. But the risks are looming large. The balance sheet recession is waning, but it’s not over. The government has propped up the economy through large budget deficits that helped offset the de-leveraging process. There are signs of healing, but we must not rip the band-aid off. The private sector is still not quite ready to run with the baton. See my full view here.
5. Housing is embarking on a full fledged recovery
DR: No, housing remains and will remain very weak.
CR: As I detailed yesterday, I think the housing market is stabilizing, but I think “bottom” calls are misguided. There will be no event-like bottom in housing. Instead, I think housing will likely flat-line for years. We could see good years and bad years, but I think we’re in the beginning to middle stages of a typical post-bubble workout period. Bubbles rarely bottom and bounce back to highs. Rather, the extremes from the previous cycle get worked off over long periods of time. In this case the high inventories and slowly recovering consumer balance sheets will come together to create a rather mundane housing environment for the next 5 years or so.
6. No hard landing in China
DR: There are enormous downside risks in China
CR: China is a black box. I’d have more luck guessing the velocity and vector of Haley’s Comet at this instant. But yes, I agree that there are enormous risks involved in a country which builds empty cities in the desert and routinely releases economic data that is filled with holes….In short, I just don’t know enough about China to know what’s really going on there. And I would be shocked if anyone outside of their government really knows either….
7. The surge in gas prices doesn’t matter
DR: Gas prices will eat into consumer spending.
CR: Gas prices will eat into consumer spending. We seem to have this debate every year now. And every year people say the same things. The same analysts find a new excuse for why it’s different this time and their opponents say it will cause a slow-down mid year. And we tend to see a slow-down mid year. I see no reason why this year will be different. Goldman’s Jan Hatzius doesn’t disagree. But the more interesting effect might just be abroad where gas prices are ripping the hearts out of already suffering European economies. You think gas prices are high here? Whew. Go over to Europe and fill up….Now that’s pain at the pump.
8. Inflation is coming back
DR: Inflation is the last thing to worry about
CR: I am a bit more concerned about inflation than DR is. But only moderately so. I’ve been pretty consistent over the years that I am not worried about high inflation, but we are now beginning to see real signs of economic recovery and sustainable credit growth. This could all be a recipe for a sustained fight with inflation. Of course, the government could torpedo all of this might cutting the budget deficit massively, but we’ll play that by ear as the year plays out. I still think there’s upside risk in inflation data from here, but I’d be shocked to see high single digit inflation any time soon. It’s not the last thing to worry about, but I generally agree with DR that the risks are overstated here. We need to worry about getting back to full employment and full capacity first….Having an energy plan of some sort would also help.
9. The stock market is cheap
DR: The equity market is not cheap.
CR: I wouldn’t put all your eggs in the valuation metric basket. Most valuation metrics are relatively misleading except at market extremes. Most of them are rear view mirror looking or based on guesses by analysts who have no idea what the future actually holds.