A few thoughts on economics

Enjoying this? Macro Man is not, particularly, and wishes he were back on holiday. And from what he's hearing, he has plenty of company. One broker he spoke to this morning said that everyone she has spoken to, across asset classes and strategy, lost money yesterday.

That, boys and girls, is called a short squeeze, and looks set to get worse before it gets better. Macro Man was frankly surprised to hear it, as it suggests that many risk takers were quicker than he had assumed in cutting longs and going short whilst he was sunning himself. The 40 day moving average in the SPX (currently at 1492) is as good a target as any for a likely faltering point; in the meantime, get ready for a barrage of commentary today about a break back above the downtrend line and that the worst has passed, etc. Keep your stack of red tickets handy to lighten up and reposition into this low-volume rally.

Macro Man has used the relatively quiet conditions this week to update all of his macroeconomic data spreadsheets and engage in a good old-fhasioned bit of data digging. After all, there was a fair amount of data released in the two weeks he was gone. One thing he saw inspired him to create a little game for his readers. See if you can match the economy below with its non-annualized real economic growth in the first half of 2007:

1) Eurozone a) 0.92%

2) Japan b) 0.99%

3) United States c) 1.04%

Those growth rates look awfully similar, don't they? Maybe global de-coupling (amongst the G3, at least) really is a fairytale! The answers, for what it's worth, are as follows: 1) c 2) a 3) b

Of course, many people will tell you that the US faces substantially greater headwinds moving forwards. While it's true that the mortgage issue isn't going away, which should keep the US at a subtrend growth rate for some time, it's also the case that the future doesn't look quite as bright for the other two, either. Europe can no longer rely on easy monetary policy to help fuel growth, and Japan seems unlikely to enjoy the sort of marginal boost from a weak currency in the future that it's had for the past couple of years.

A number of very smart people with whom Macro Man has spoken this week maintain vigorously that "all of this is bound to impact the real economy." While Macro Man won't dispute that- lending standards seem certain to be tighter moving forwards- it's also the case that Wall Street tends to have an exaggerated view of its place in the world, and thus its impact on Main Street.

The 1987 crash did not cause a recession.
The Asian crisis did not cause a recession.
Russia's default did not cause a recession.
The LTCM crisis did not cause a recession.
The corporate scandals and credit massacre of 2002 did not cause a recession- they occured as the US was coming out of recession!

The chart below shows the 6month change in the SPX, US industrial production, and US real personal consumption growth. While this is admittedly a quick-and-dirty representation of Macro Man's view, he believes it is instructive nonetheless. Observe that over the past fifteen years, the six month change in the S&P 500 has had thirteen seperate episodes where it's been negative.

Industrial production has had eight episodes where it's been negative.

Personal consumption has had one epsisode where it's been negative.
Now it's true that Wall Street has flagged each of the last two recessions; but it's also flagged plenty of recessions that did not occur. And that preponderance of false positives makes Macro Man very leery indeed of extrapolating market prices into real activity.

Of course, there is distress in the housing market, and household wealth is set to take a bit of a hit. And naturally, there remains a coming hit to personal income from the reset of adjustable-rate mortgages over the next couple of years. But income growth is the primary driver of consumption, and in Macro Man's view many market participants grossly overestimate the macroeconomic impact of ARM resets.

The reason is perhaps because it is easy to focus on the gross amount of ARMs resetting rather than the marginal impact. Throwing around numbers like $500 billion or $1 trillion or even $2 trillion makes it sound like a problem that MUST have a huge impact. But remember, those figures represent the nominal size of the debt and not the change in servicing costs, which is what really matters.

And even if we use the aggressive assumption that there is $2 trillion of ARM debt that will all reset 3% higher over the next year, that only represents $60 billion. While that is certainly more than Macro Man has under the sofa cushions, it still only represents 0.5% of US personal income. Personal income growth can and has exceeded that total in a single month, as recently as March of this year. Under less aggressive assumptions, the annual change in debt servicing costs could be in the $15 billion- $35 billion range. To put those numbers in perspective, there have only been two months in the last year when that latter figure has not been exceeded.
Now, Macro Man is not saying this will have no impact- he is happy to concede that consumer spending and thus growth will be below trend for some time. And that should, in and of itself, beget market volatility. But in his view, when markets feel the worst, Wall Street is most likely to overestimate its own impact.

And that is why he wants to clear the decks now so he can buy at lower levels.

EWZ gapped through the offer level yesterday, and Macro Man was filled at 55.55. Premature, in retrospect, but Macro Man would rather be too early than too late. Another trade that Macro Man is looking at, from a pure risk-reward perspective, is to fade the consensus that a Fed easing by next month is a done deal. He will look to buy either the 94.8125 or 94.875 Sep Fed Funds futures puts this morning, spending $200k or so of premium. The potential payoff should be something like 4-1


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"Cassandra"
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August 23, 2007 at 2:16 PM ×

Fmr GS journeyman-analyst Joseph Ellis has his finger on PCE and its economic relationship perhaps better than anyone.

Real Hourly Earnings as best leading indicator of PCE

Combined YoY employ growth and growth in real earns approximates growth in real PCE.

MM. I wonder if this post was answering my discord with you of -3 days. I would suggest to you that some things are better suited to statistical extrapolation and so better at prognosticating. Others are not, just as some things should revert to the mean (tosses of a fair coin), and some not (A growth stock's price where the company continues to grow sales and earnings). The use of the stock market to forecast (or not!) recession is (as you;ve pointed out, limited. This is NOT because the stock market is not for lack of information about the future. But rather because the system is diabolically complex, and the contextual information is not only almost always different, but magnitude of each contextual information varies non-linearly in relative importance (with regards to forecasting recession IN COMBINATION with stock prices. Even stock prices themselves are suspect. For example, while folks point to Mar 2001 as "the market top", ("the average US stock" topped in 1997 and was gripped by bear market for 5 years. Indeed the S&P500 of CY2000 (with o/v tech was demonstrably different from that of today such that making solid inferences are like standing on quicksand with ankle-weights.

From where I sit, I think you are correct in suggesting the impact of ARM resets upon, say, real PCE is on the margins. The real impact and economic danger however - and this is where Ellis's charts are interesting - is understanding why the prior unusually robust behaviour of real PCE has done what its done (llarge refi & large unprecedented persistent equity withdrawal) and therefore, why, given the current backdrop, these props are not only gone, but very likely to begin working in reverse for the numerous reasons that one can conjure. The most important ones are supply and "change-in-price" oriented, the latter which pressures and in many cases eliminates home equity for some 04 and all 05 & 06 equity withdrawal, and the former, which keeps a lid on recovery, and encourages the marginal home to be sold bid-side, further pressuring equity, buy-to-let schemes, and in the end, real PCE. And additionally, all this pressure in real-estate land is having (and will continue to have) marginal impacts upon construction and related employment employment along the whole cascade effect down the chain of dependancies, to go alongside the marginal impacts of ARM resets, and the marginal impacts of high oil prices, the marginal reduction in risk preferences of virtually financial lending institutions, and the marginal impacts of rising food prices, and in 2008, the marginal impact of rising tax rates.

Cheaper money will (I expect) do little to ameliorate any of these events already set in motion, until/unless authorities relent and fast decide to open the spigots wide hoping further inflation will nominally float the housing boat. But is this realistic? The housing bust scenario are playing out as one would have expected (in USA, in Spain), though admittedly at half-speed compared to the same-day resolution market-traders have grown accustomed to and perhaps expect before flip-flopping from bear to bull.

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Anonymous
admin
August 23, 2007 at 2:25 PM ×

Asia's crisis did not cause a recession in the US. it certainly caused a recession in asia -- and a major slump in both global growth and commodity prices.

Russia's default did not cause a recession in the us or Europe and to be honest didn't have a huge impact on russian real growth either -- getting rid of the debt service from gkos and a more competitive exchange rate helped russia in some ways (the recovery in oil helped). but its default followed a very long period of economic decline - which makes the example less than relevant.

the us is so big that you can always argue essentially nothing (barring a huge stock market tank) really matters, b/c it gets dissipated broadly. but nonetheless, recessions happen ..

on this point, i agree the cassandra - if the us consumer suddenly spends only personal income growth, rather than leveraging up/ spending more, us growth would certainly slow ...

on the lack of decoupling, it is worth noting that us consumption growth was very growth in late 06 -- and even q1 if memory serves. it only slowed in q2. the slump was due entirely to a fall in residential investment, which had a bigger impact on canada than asia b/c of the nature of what each exports. Canada's resilience tho has been impressive - but then again canada had a nice little positive commodity shock to offset reduced timber and auto exports ...

bsetser

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Macro Man
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August 23, 2007 at 2:45 PM ×

My own studies suggest that combining real disposable personal income growth and changes in net worth yield a very, very strong correlation with personal consumption. The model residual also has a very strong correlation with the savings rate.

Now, I will concede that the changes in household net worth are likely to show some stagnation and possibly a modest drawdown. My own calculation of mortgage equity withdrawal suggests that it was a non-issue in 2006 and 2007.

However, gas prices are already off more than 10% over the last three months, which should provide a nice boost to disposable income. My belief is that some of the recent deceleration in spending around mid year was caused by the sharp rise in energy bills; as that is at least partially unwound, the model suggests that so, too, should spending.

As always, the savings ratio is the key unknown, and should consumers decide to rebuild savings then spending will remain limp even if income growth is strong.

Again, I am not saying that spending growth is going back to 3.5%. But I can see it muddling along at 1.5 - 2% growth. And that, combined with a corporate sector that has largely obstained from real economy investment excess and a hypercompetitive dollar (against Europe and Canada, at least)shoudl be enough to muddle through.

And given the excesses and imbalancs of the past, is that such a bad thing?

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Macro Man
admin
August 23, 2007 at 2:48 PM ×

Oh, and C: I've had a few people inquire why I am interested in buying the (presumably forthcoming) dip, so the posts of the last couple of days have attempted to set out that stall, as well as offer a bit of justification for my muddle through view for the consumer in our debate.

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Anonymous
admin
August 23, 2007 at 3:05 PM ×

would look to other avenues to fade the rate cuts than sep funds...whats currently priced into the futures is more than just the expected target rate...even if fed doesnt go the miss, ie effective funds rate trading well below 5.25 targer is expected to continue. and b/c of the timing of labor day augy funds is also part of sep...ie where it posts for aug 31st will be where the 1st 4 days of sep trade...get a sub 5% fix and the contract wont trade below 94.79. would be better off in sep eurodollar puts.

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Anonymous
admin
August 23, 2007 at 4:12 PM ×

To Cassandra's excellent comments, I would add that the ARM resets are likely to disproportionately hit homeowners least able to absorb an increase in their mortgage payments (i.e., those who stretched beyond their means to buy their home), leading to an outsized increase in distress sales, foreclosures, "jingle mail," etc. So while the resets may equate to only 0.5% of personal income, the ripple effects on home prices and, in turn, household wealth and, in turn, PCE could easily be much worse.
P. Lumumba

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August 23, 2007 at 4:24 PM ×

Brad,

With all due respect, Canada's the worst example that you can use, there being no economy even remotely similar to it in the world - as far as I know. You've got a country whose population is generally located in a thin east-west strip along several thousand miles of border with the U.S. and comprising zones of very distinct ecomomic bases, but whose economic relations travel north and south. The end result is that different regions avail themselves of, or are crushed by, distinct phases of any economic cycle resulting in a serious distortion of macro stats. The current macro boom is almost exclusively generated in Alberta, despite its relatively small population, and is in few ways beneficial to the real population centres of Southern Ontario and Montreal.

Cass,

Don't write it us off yet. Property prices are still in deceleration mode, aiming for negative in 2008-09. But so far the real estate boom hasn't hit employment and has had the surprising (in a country that typically spends an inordinately large amount of money on having fun) effect of giving a serious bump to the savings rate, which eventually will go to property purchases. Also, foreclosure rates remain negligible - even if we only count you lot up to the teeth in some gleaming architectonic travesty along the Med. Not to say never, but don't mortgage the shanty on an anglo style bust.

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Anonymous
admin
August 23, 2007 at 6:22 PM ×

what abt commercial ppr market ?

its still stuck isnt it ?

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Macro Man
admin
August 23, 2007 at 6:39 PM ×

Yes, the CP market is still dysfunctional. However, I cannot see how the future inability of financial firms to issue CP and buy AAA-rated turds impacts Main Street. Note also that both Citi and Merrill have come to market with 5 to 10 year bond issues this week that have, as far as I am aware, come off without a hitch.

The great uncertainty out there is exactly how much further house prices have to fall. For every anecdote that you hear about collapsing prices in Florida and California, there are many more that you don't hear about stability in Dallas and Atlanta and Milwaukee and Manhattan.

And while Manhattan property is obviously expensive, house prices in the other three cities are not (relative to local incomes.) So it's not clear to me that distressed borrowers in the sunshine states need impact house prices (and by extension, household wealth) in other places.

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Anonymous
admin
August 23, 2007 at 7:12 PM ×

didn't those aaa rated turds fund the ability of at least some americans to consume in excess of their income growth? i am not saying "recession" but i wouldn't discount the impact of 1-2% real consumption growth v 3% plus (haven't checked the #s; am working off memory). the prudent burghers of milwakee haven't contributed as much to the recent boom as their sun-drenched cousins ...

bsetser

Charles. fair points on Canada. Detroit north (southern Ontario) and Texas north (Alberta) are rather different economies. my broader point was that the hard leg of decoupling for most of the world comes with the fall in the pace of real consumption growth, not the fall in residential investment.

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Quarrel
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August 23, 2007 at 9:17 PM ×

Charles,

Australia is the other Canada.. (but your point is well made just the same)


--Q

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