Friday, November 21, 2014

Why the global gloom?

One popular meme these days is "the global economy is slowing down." China's economy has slowed from double digit growth rates to 7%, Japan has suffered two quarters of negative GDP growth, and the Eurozone economy has grown by less than 1% in the past year. The U.S. economy has barely managed to exceed 2% annual growth for the past five years, and people worry about the future since the Fed seems almost certain to begin raising interest rates within the next 3-6 months. Industrial commodity prices are down almost 10% in the past six months, and oil prices have plunged almost 30% since last June—all (supposedly) signs of weaker demand. Moreover, high-yield credit spreads have risen over 140 bps since June, reflecting a loss of confidence in the future of corporate profits. 

To make matters worse, policymakers seem to have run out of options. Short-term interest rates are near the zero bound in Europe, Japan, and the U.S. Quantitative easing hasn't done much at all to stimulate the U.S. economy, and it's unlikely to be a miracle cure for the Eurozone economy. The Bank of Japan has managed to ease by enough to push the yen down by almost one-third against the dollar, but a hike in Japan's sales tax seems to have swamped any stimulus from stronger exports. Genuine stimulus (e.g., tax reform, tax cuts, and reduced regulatory burdens) is being discussed almost everywhere, but it's not likely to happen any time soon.

A lot of people are probably thinking "If policy can't stimulate, and demand is weakening on the margin, it's time to really start worrying."

I'm not so sure it's time to run for cover. 

One of the most remarkable turnarounds in the global economy in recent years is shown in the chart above. In the past two years, the yen has plunged against the dollar, and the value of Japanese equities has doubled, both in seeming lockstep. Even in dollar terms, the Nikkei 225 is up over 30% in the past two years. It's hard to deny that something big is going on here, even though the Japanese economy shrunk in the six months ending September.

Have you noticed that no one seems to be talking about the "wealth effect" anymore? That's the theory that says an increase in stock prices and/or housing prices can induce consumers to spend more because they have become wealthier. That increased spending has the effect of strengthening the economy, or so the theory goes. That's never made much sense to supply-siders, however. You can't spend your way to prosperity. Prosperity only comes as a result of more work, more investment, and/or more risk taking. The "wealth effect" theory assumes that stock prices just happen, or that they can be pushed up by easy money. In turn, higher stock prices cause more spending, which grows the economy and validates the higher stock prices.

Not so, in supply side theory. The stock market, like the bond market, is difficult to fool. Easy money doesn't just magically raise stock prices, and higher stock prices don't then stimulate the economy. More likely, stock prices rise as a result of improving economic and financial market fundamentals. Higher stock prices discount rising future earnings. Stock prices are the barometer of the economy's future health, not a by-product of easy money.

So consider the implications of the chart above. It shows that the market capitalization of the world's equity markets has increased over $40 trillion dollars since March 2009, and in the past two years the value of global equities is up about 30%. That's a huge, and welcome increase. Does it mean that consumers are going to be spending double and triple as much because stock prices have almost tripled? No. It means that the expected future cash flows of corporations all over the globe have increased significantly. Consumers likely will be spending more in the future, but only because corporations will be making more and better stuff, hiring more workers, building new plant and equipment, and booking rising profits. The stock market is often able to look across the valley of despair and see a better future on the other side. It's likely that that's the case today.

As the chart above shows, U.S. equities have greatly outpaced their Eurozone counterparts in the past four years. Well, yes, we know that the U.S. economy has been much stronger and more dynamic than the Eurozone economy—that's not a surprise. But conditions in the Eurozone have nevertheless improved. In the two years since Japan's equity market suddenly came to life, U.S. equities are up almost 50%, and Eurozone stocks are up a little over 30%. In dollar terms, Eurozone equities are up about 20%. That's not chickenfeed.

It's hard to get pessimistic about the future when the world's stock markets are becoming more and more optimistic. Of course, it's hard to see significant improvements anywhere right now, but in my experience it sometimes takes awhile before the average person realizes the extent to which economic conditions have actually improved. For now, the world's stock markets are seeing better times ahead, and investors seem to be getting the message.

Despite all the gloom out there, and despite all the disappointment, there is reason to be optimistic. If we've learned anything in the current recovery it's that 1) fiscal stimulus (e.g., the ARRA) doesn't work and 2) monetary stimulus (e.g., QE and zero interest rates) don't work either. Government policymakers cannot conjure up prosperity by spending more money or cutting interest rates. What's needed is for government to get out of the way and boost incentives for the private sector to jump-start the economy. That means lowering marginal tax rates, simplifying tax codes, eliminating subsidies, and reducing regulatory burdens.

This is not rocket science. The entire world has witnessed massive, almost laboratory-type experiments in fiscal and monetary stimulus fail to deliver the promised results. There's nothing left to try except what is most likely to work. Politicians need to hand the reins over to the private sector and market forces and step aside. The world's stock markets seem to be saying that this is a real possibility that may come to fruition within the foreseeable future.


Benjamin Cole said...
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Benjamin Cole said...

Egads, Scott Grannis, you have blown a fuse on this one.

You cite the rise in Japanese equities - - but you do not credit the concurrent use of QE by the Bank of Japan!

You note the yen's decline in exchange rate against the dollar. That has to be QE in action.

Then you say the market cannot be fooled.

 The rise in the Nikkei 225 is based on fact.

One might assume that the Bank of Japan QE program is working!

And that the only problem with the American QE program is that it was half hearted, faltering, dithering. The Fed lacked the resolve that the Bank of Japan is showing. I agree the tax increase in Japan is a terrible idea, and I think Shinzo Abe is going to scuttle it.

If QE does not work, I do not know why such monetary titans as Milton Friedman, John Taylor and Ben Bernanke advocated the use of QE in Japan. John Taylor wrote a paper in 2006 declaring the use of QE back then was a success. That's on his website but it is not link-able.

A second issue is whether demand creates supply. I think this is historical fact, yes, demand creates supply, and obviously so.

What should we conclude by the boom of WWII industries? The Long Beach shipyards employing tens of thousands and pumping out the Liberty ships? They built the ships, and then supply emerged? The WWII economic boom?

Of course, fédéral demand created supply.

Again, what created the huge China export industry? It was demand from Western consumers. China did not build out its export industry, hoping demand would emerge.

In fact, the vast bulk of business is only supplying demand. Those who build supply before demand are called venture capitalists, and they are a very brave and admirable lot. They are hoping demand will emerge for their new good or service.

This is not to say I believe in federal deficits. Far from it. I would raise the retirement age for Social Security, advocate euthanasia in Medicare, and cut "national defense" spending in half.

I think we could bring federal outlays down to 15% of GDP from 20%, and be a safer nation in the mix.

However, part and parcel of the WWII boom, and the wonderful 1950s and 1960s economic expansion was a pro-business, growth-oriented Fed.

The Fed may have drawn out its game plan a little too long by the late 1970s, and we fleetingly reached double-digit inflation (although it is well to remember that from 1976 through 1979, real US GDP rose by 20%. So if inflation hurts growth, it is hard to verify that in the real GDP figs. in contrast today we have record-low inflation, and real growth is pitiful).

Since the early 1980s, the Fed has been in inflation-fighting mode, and US growth has never been the same. We have reached the end of this Fed game plan, with inflation dead and growth weaker than Bill Cosby's ethics.

You cannot have a robust modern growing free market and dead prices.

The price signal attracts new resources to emerging bottlenecks. That is a good sign.

That is how the oil industry boomed.

Of course we would all like to see decreases in unnecessary regulations and taxes. I would make deep cuts in the federal government.

But one cannot monetarily asphyxiate an economy into having less structural impediments.

William said...
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NormanB said...

Exactly. If flooding a system with money helped an economy we would have done it eons ago. Only the possibility of a better life through work and creativeness spur increases in living standards.

Also, the Japanese StockMarket-Currency lockstep is exactly what happened in hyper inflation Germany. To maintain buying power then you could do it through holding stocks. The real economy, though, did not do well just like now.

Benjamin Cole said...

NormanB--explain the WW2 boom in the US economy or the boom in the China economy, spurred by exports.

Unknown said...

Ben, was there really a WW2 boom? I thought a large number of items were rationed? Yes, everyone was employed, but did living standards increase? Wasn't the boom after WW2? Now we can debate why we had a boom after WW2, but let's get when the boom was. WW2 was the classic dig holes and fill them up (i.,e., go fight a war and build stuff to fight the war). I think living standards declined during WW2, and the rationing of goods was an example.
Though I agree Scott has blown a fuse here, as the main reasons stocks are up is because interest rates are low and the fed does set short term interest rates.

Benjamin Cole said...

Sarah--yes, per capita incomes in the United States rose sharply through the World War II years, they also rose nicely through the 1950 and 1960s. Those were great times.

moneytalk88 said...

Tks Scott to share your food of thoughts with us on this thanksgiving day indeed! Regarding the global gloom, a recent article on Economist offer a very good explanation on how demographic slow the growth and press down interest rates. Looks like aging population is attributed the major cause to the secular stagnation. If u got chance would u pls offer your thoughts? Happy Thanksgiving!