The Road to Reform
(May 22, 2009)
Dear Subscribers and Readers,
As mentioned in my email yesterday, Rick Konrad – our regular guest commentator – had a medical procedure done his arm on Wednesday and is still recuperating. Rick is still not at “100%” so I will pen tonight's mid-week commentary instead. We wish you a speedy recovery, Rick!
Before we go ahead and discuss the latest signals of our U.S. liquidity indicators, let's take a step back and think about the road forward for both the financial markets and the our society in general. As we have mentioned in our commentaries over the last few weeks, our global liquidity indicators have been signaling an upturn in both the financial markets and the global economy. ECRI, in particular, has gone on the record asserting that an economy recovery in the US is “imminent” sometime this summer. What this means is that in the short to intermediate term (6 to 12 months), the economy is showing signs of stabilization and renewed growth. What this does not mean, as we have also pointed out, is an imminent return to 3%+ real GDP growth in the long run. With the US consumer and corporations still actively deleveraging – and with no way to export our way out of a slowdown (unlike the “Asian Tigers” in 1998, Germany, and Japan over the last decade), US real GDP growth would most likely see-saw around 2% for the next 3 to 5 years. There are always exceptions to this scenario, of course:
- If the Chinese consumer unexpectedly picks up “the slack” of the US consumer sometime in the next few years. While China's purchasing power is formidable, it still pales compared to that of the US consumer. Given the current lack of social safety nets, savings rates in China will remain high. As a result, there is also not much will to utilize much of that spending power. By the years 2013 to 2015, I expect the Chinese consumer to play a significant role in the global economy – but not before.
- Many US and global secular bull markets were driven by certain world-changing events or technologies that captured our collective imagination. Every bull market – no matter how crazy it gets towards the end – has a solid grounding based on fundamentals. Most recently, this came in the form of productivity growth driven by the advent of the PC and internet, and the “opening up” of the formerly communist countries in the 1990s. Unless we could commercialize “cheap” (i.e. lower than grid parity) alternative forms of energy or carbon nanotubes to replace our most common building materials in the next few years, I expect both US and global real GDP growth to remain “challenged” in the next 3 to 5 years.
While global regulators are currently doing everything they could to revive economic growth, there is no doubt the many upcoming financial reforms and regulations will turn out to be significant headwinds over the longer run. For example, current legislation in Congress to prevent consumer abuse by the credit card industry is estimated to curb annual consumer spending by $90 billion once the legislation is signed. Other regulatory moves – such as curtailing the amount of leverage in banks, regulating hedge funds, or reforming the securitization markets – should also limit the growth of consumer spending for years to come. This is not necessarily a bad development. For example, while limiting interest rates and financial fees that credit cards can charge will limit overall credit growth, this will also curb lending to our most overextended and the most financially-vulnerable US consumer. Over the long run, making loans to overextended or high credit risk consumer does not make business sense, and in extreme cases (such as the period 2005 to 2007), could be a source of systemic risk. More importantly, consuming for the sake of simply having more material things or for “status” has been shown not to increase long-term happiness. I, for one, has never bought a flashy car, a home entertainment system, or the latest cell phone.
That said, global policy makers realize the economic dangers of financial and general reforms – so they will tread carefully. That said, this is always a very tricky process. On one hand, now is the best time to implement reforms, as there is significant political will to do so. As the economy recovers later this year, populist backing for financial reforms will no doubt wane. Coupled with strong resistance by the “Old Guard” to reforms, policymakers will find it increasingly difficult to implement them as time passes by. But with the global economy still hanging in the balance, policymakers must be doubly careful not to “rock the apple cart.” Sure, we could deal with a $90 billion decrease in US consumer spending, but other ideas, such as requiring banks to keep a significant amount of mortgages they originate on their balance sheets (i.e. similar to the “covered bonds” structure in Europe) will have to wait. I will discuss the upcoming trend of financial reforms in more detail in this weekend's commentary.
In the meantime, both US and global liquidity is still conducive for a further rally in financial assets over the next several months. For one, bank lending has continued to improve, as loans and leases in bank credit by US commercial banks, at $7.13 trillion, is now at its highest level since February. Secondly, the U.S. monetary base has continued to make new highs, rising from $1.71 trillion to $1.80 trillion in the last two weeks. In the meantime, the size of the Federal Reserve's balance sheet is holding steady at $2.17 trillion, or its highest level since December 31st of last year. More importantly, the latest minutes from the last monetary policy meetings from the Federal Reserve and the European Central Bank suggest that both central banks will continue to ease monetary policy through unconventional means to support global liquidity and the global economy. Specifically, the Federal Reserve most recently signaled that it will start accepting AAA-rated “legacy” CMBSs under the TALF in order to help improve liquidity in the commercial real estate market. As of yesterday, CMBS prices (as shown by the following chart showing the CMBX.NA.AAA.1 index courtesy of Markit.com) rose to their highest levels in over six months:
This narrowing of credit spreads across the board – along with the collapse and stabilization of the VIX – suggests that investors are starting to take more risk and redeploy their assets back into the equity and credit markets again (e.g. net redemptions from hedge funds in April sunk to their lowest levels in six months, and all signs point to a positive inflow into hedge funds for May). GaveKal's velocity indicator – which is a leading indicator of investors' risk appetite – just rose to its highest level in over four years. All signs continue to post to a further rally in the equity and credit markets for the next several months.
Henry To, CFA