Economic View: No ice age for perma-bears

The idea that this isn't a proper recovery is misconceived. It wasn't a proper recession, either
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The Independent Online

With US economic growth being revised up again, and now assumed to be running at 3.1 per cent in real terms, those who boldly declared a new ice age and a return of deflation as little as two months ago are feeling slightly awkward. Not to be deterred, however, many of them are seizing on the evidence of growth - higher interest rates, higher oil prices and a stronger dollar - as a reason why the recovery will "fail".

With US economic growth being revised up again, and now assumed to be running at 3.1 per cent in real terms, those who boldly declared a new ice age and a return of deflation as little as two months ago are feeling slightly awkward. Not to be deterred, however, many of them are seizing on the evidence of growth - higher interest rates, higher oil prices and a stronger dollar - as a reason why the recovery will "fail".

The dismal science, which, as somebody once put it, draws a crooked line from an unproved assumption to a foregone conclusion, is thus looking more than unusually muddled. While some are prepared to execute (another) adept U-turn, the really dismal scientists are muttering about how the recovery (which they never predicted) will soon be killed off. By interest rates, oil prices, the US budget deficit, whatever. In fact, by all the things that were going to cause the recession we never had.

Part of the problem lies in the traditional model. It failed to predict the downturn, yet continues to be used to predict the timing and pattern of the upturn. To explain, there is a model that basically works as follows: interest rates rise, which chokes off demand, leaving excess stock. As this inventory is run down, output is cut, prices are cut, profits fall, capacity is scrapped and unemployment rises. Wages fall and interest rates are left high to "squeeze excesses out of the system". And then the process reverses. Rates are lowered, which stimulates investment, which boosts demand, which leads to job creation, which leads to higher prices, and off we go again.

The process is shown in the chart on the left, above. It's simple, it's logical and it's appealing. Unfortunately it's flawed.

The chart on the right adapts this traditional model, contrasting what was supposed to have happened with what actually did. We can see that rates didn't go up, demand didn't collapse and spending didn't fall. So far, so wrong. However, inventory was too high, output was cut and profits and prices did fall.

So how did we get to the second leg of the downturn without the first? In effect, this was a supply problem not a demand problem, as a combination of cheap capital and over-optimistic forecasts led to too much production in 1999-2000. However, because this was (correctly) seen as cyclical, corporates did not cut capacity or employment. So employment remained high and capacity utilisation rates dropped sharply as production fell while inventories were run down.

This analysis, then, gives us a different-shaped up-wave. Demand doesn't rise significantly, because it never fell much in the first place, and inventory clears at the bottom of a shallower cycle. In other words, a clearing of inventory, not a rise in investment, signals the bottom. More importantly, as the lines show, profits rise earlier, and investment and unemployment later, than in a "traditional cycle", meaning the equity markets discount it earlier. Indeed, by the time employment and investment reach "normal levels", interest rates should also be back to normal and the cyclical boost to profits and cyclical rally in equities will probably both be over. The idea that this isn't a proper recovery is thus misconceived. It wasn't a proper recession, either.

This sort of framework also lies behind theories as to the investment cycle, selling equities and buying bonds on the down-wave and vice versa on the up-wave. This leads us to the second problem in understanding what is going on. The model was being used backwards - bonds were going up, so we must be in the down leg, and if we were in the down leg then equities had to go down. The problem was that the selling of equities was largely complete by the summer of 2001. The bear market of 2001-02 was more about 9/11 and lower risk tolerance from pension funds. The fact that bonds rallied and equities were sold off for non-economic reasons helped maintain the fiction of the traditional economic cycle. It also helped to build a reputation for the perma-bears, many of who were, in effect, right for the wrong reasons.

Output and profitability have been rising, putting the turning point sometime in 2002, but a bond rally needed us to still be in the down-wave, and the absence of so-called early indicators on investment, demand and employment allowed the "traditional model" to be maintained. The crack in the bond market has helped focus on the cyclical recovery story already in place. However, while recent data showing signs of investment and higher employment have compelled traditional cycle theorists to give up on the obsession that we are still in the down-wave, they have not given up on the model itself.

This, then, is the second part of the problem: the role the markets play in forecasters' minds. Financial markets can move for reasons other than the economy; this is more common than not. In particular, the bond markets are interested in monetary policy rather than economics per se. You didn't have to believe in deflation to buy bonds yielding 3.2 per cent when US interest rates were a fraction of that. You only had to believe the Fed did, and more importantly, that it would shape policy in such a way that it would be beneficial to you. Thus, while deflation is theoretically good for bonds, what is really good is if the Fed is willing to buy them off you at any price, which was the chief delusion in the US bond markets in June and July. The real change in recent weeks has not been in the economy, but in the markets.

It is this analysis that makes me comfortable with the prospects for both bonds and equities. Equities are correct to be pricing in a cyclical recovery in profits, while bonds do not need to worry about cyclical inflation because there are sufficiently low levels of capacity utilisation. However, bonds are not driven by inflation at the best of times (despite what they may tell you) and certainly not now.

Mark Tinker is a director of Execution Stockbrokers. Mark.Tinker@Letsxstock.com

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