Wednesday, December 11, 2013

Totally unexpected news, all bullish

Five years ago global financial markets were in a shambles, global trade was shutting down, credit spreads had blown out to unbelievable levels, and most people's hopes for the future were going up in smoke as their homes and their investments collapsed in price. Since then we've pulled back from the abyss, financial markets are as calm as they've ever been, the economy is growing, and equity markets are booming. In many important ways, the recovery and the improvements we've seen in recent years have far surpassed even the super-optimists' wildest dreams. Nobody saw this coming, and it's all very good news, even though this is the weakest recovery ever.


Back in July 2008, U.S. crude oil production was just over 5 million barrels per day. At that time, NOBODY would have predicted, even in their wildest dreams, that crude production would increase by 60% (to 8 mbd) by the end of 2013. But it happened, thanks to fracking technology.


Back in July 2008, natural gas prices hit an astounding high of $13.58 per million BTUs. At the time, the talk was of critical and chronic shortages that would push prices still higher and potentially cripple the economy. NOBODY would have predicted, even in their wildest dreams, that natural gas prices would fall by two thirds by the end of 2013, blessing U.S. consumers with some of the lowest energy prices in the world. But it happened, thanks to fracking technology.


Back in the first half of 2003, natural gas prices on average reached their highest level ever relative to crude oil on a sustained basis. NOBODY would have predicted, even in their wildest dreams, that natural gas prices would fall by 75% relative to crude oil prices over the next 10 years, thus conferring a unique advantage to U.S. industrial energy consumers, due to the difficulty of exporting the growing relative abundance of U.S. natural gas supplies. But it happened, thanks to fracking technology.

As Mark Perry notes, "The Great American Energy Boom ... might qualify as the most important economic story of the past decade."


Back in December 2009, the federal deficit was 10.2% of GDP, and we were told that deficits exceeding 9% of GDP were economically debilitating and could spiral out of control. At the time, NOBODY would have predicted, even in their wildest dreams, that the deficit would decline to a mere 3.6% of GDP within the next 4 years, thus eliminating the need for higher tax rates. But it happened, thanks mostly to zero growth in federal government spending and a growing economy.



Back in mid-September 2008, the monetary base totaled $875 billion, and it had grown only 5% per year over the previous decade, and only 2.3% over the previous year. At the time, NOBODY would have predicted, even in their wildest dreams, that the base would more than quadruple over the next five years. And even if you had God's word that you spoke the truth, every living economist at the time would have told you that such an explosive increase in the monetary base would almost certainly lead to an explosion of inflation. NOBODY would have predicted that an explosion of the monetary base would have resulted in a rate of consumer price inflation that would average only 1.5% per year over the next 5 years. But it happened, thanks to the fact that the Fed decided to pay Interest on Reserves, and thanks to banks' almost insatiable demand for safe, risk-free assets.


In late 2008, when we learned that after-tax corporate profits for the third quarter had fallen to 7.1% of GDP, down from an all-time high of 8.6% just two years earlier; when the stock market had lost almost half its value in less than a year; and most chartists were predicting that profits would mean-revert to 6% or less of GDP, NOBODY would have predicted, even in their wildest dreams, that corporate profits would hit an unimaginably high 10% of GDP within the short span of only three years. But it happened, thanks to the Fed's QE efforts, corporations' inherent dynamism and the ability of the U.S. economy in general to cope with adversity, among other things.


Near the end of 2008, as financial markets were imploding and corporate credit spreads had reached previously unimaginable heights—which in effect predicted that 24% of all corporate bonds would be in default within the next 5 years, and the next several years would be the most disastrous in the history of the U.S.—almost nobody would have predicted that it was the buying opportunity of a lifetime. But it was, even though markets didn't hit bottom until a few months later.

Markets move and economies respond when the future turns out to be different than what everyone expected it to be. The past five or so years have been a case study in how this can happen, as we have swung from expecting the end-of-the-world-as-we-know-it to now being in the fifth year of a recovery. The future turned out to be MUCH better than expected in many ways—even though this has been the weakest recovery ever—and that is the main reason that the equity and corporate bond markets have enjoyed their most spectacular rally on record.

7 comments:

randy said...

Your post reminded me of a book review I recently read about The Myth Of Americas Decline.

America’s overblown worries of decline persist, he says, mainly because of “linearity”: the mindless extrapolation of transient trends [..] far into the future.

I fall into the worrier camp, and it would be easy to point out that our busts have largely resulted from linearity of positive trends... but for now I think I'm happy to appreciate the well documented reminder that good surprises in America have over time outweighed the bad ones. Thanks!

Benjamin said...

Interesting post. I am not sure about the Fed's payment of 0.25 interest on reserves. Many say it should be cut. Others say banks are not lending as they are not finding anything to lend to. I assume any loans would generate more than 0.25 percent.

Actually, Milton Friedman might have anticipated that an increase in the monetary base would not lead directly to inflation. In his seminal work, "Reviving Japan," 1998, for the Hoover Institution, he asserted that increases in the monetary base must first, with a lag, lead to higher growth, and then only higher inflation.

He seemed to anticipate that QE would not work right away and told the BoJ to just keep buying bonds until it did.

I have yet to find a situation in which Milton Friedman was fundamentally wrong about something.

As in the USA we have not hit higher inflation, but rather record-low inflation, Milton Friedman would probably say the Fed did not buy enough bonds. They need to pour it on.

Thus the Fed's open-ended QE program may be the right choice, and I think it is, though maybe enlarged. My fear is the Fed will scare too easily, and stop buying bonds. This will replay Japan.

What the Fed is afraid of is not clear. It can't be inflation. There are no bubbles. The Fed seems o be afraid of the unknown. Well, sometimes so am I.

Still, better error on the upside, and have some strong growth and maybe even some demand-pull inflation for a while.

Gee, a robust economy? I pledge to endure that for the good of my nation.

http://www.hoover.org/publications/hoover-digest/article/6549

seekingtraceevidence said...

Most believe inflation comes from excess money supply, but the hoarding of cash shows that there is a psychological component which is stronger than the 'monetary phenomena'.

seekingtraceevidence said...

Most believe inflation comes from excess money supply, but the hoarding of cash shows that there is a psychological component which is stronger than the 'monetary phenomena'.

Hans said...

Will the real Scott Grannis please stand up?

Hans said...

The banking industry is still are badly capitalized and it is the primary reason they are making few loans.

They have billions in loans not marked to market because it would involve huge losses..

This is why QEs will continue into the future...

There remains a massive debt bubble that could explode one day.

This is a phony recovery..

http://www.marketwatch.com/story/global-economys-recovery-is-a-sheep-in-wolfs-clothing-2013-12-12

William said...

Scott wrote: "But it happened, thanks to the fact that the Fed decided to pay Interest on Reserves, and thanks to banks' almost insatiable demand for safe, risk-free assets."

One wonders if the FED was prescient in their decision making or was the fact that banks horded the money as "excess reserves" an unintended consequence of the FED's attempt to head off deflation by creating hoped for inflation.

Perhaps even the economists at the FED wanted to - and expected to -create some inflation with QE1. But learning that the banks weren't loaning as they expected, the FED was confident in pursuing QE2 and eventually QE3.

A FED history of this period will make interesting reading.