By Edward Harrison of Credit Writedowns
If you have been wondering whether a statistical recovery is at hand, today’s ISM manufacturing report should be the clincher. The report was definitely bullish with the ISM index rising to 55.7 and sub-components supporting the understanding that the manufacturing sector is expanding. This is quite a contrast to last month’s weak data and demonstrates that last month was a one-month aberration in what should now be seen as a full-blown technical recovery.
I want to talk about this recovery briefly in the context of the signs that came before it, my own forecasting psychology and what the future holds.
The ISM data
The key data points to see as evidence of a fairly broad-based expansion in manufacturing come from new orders, production and inventories. The production number came in at an incredibly bullish 63.3, marking the fifth consecutive month of increase. New orders slipped slightly, but were also in striking distance of the 60 range. (50 represents the demarcation between expansion and contraction).
But, from my perspective, it is inventories which are the most bullish data points. The inventories data show that inventories in the manufacturing sector were still being purged in October even while production is increasing. That means that inventories are likely to make a huge contribution to GDP going forward in Q1 and Q2 of 2010. GDP could again surprise to the upside.
My mea culpa on forecast herding
All of this suggests the economy has been growing since the beginning of Summer. In the early Spring, I indicated that jobless claims were peaking (which added to my stock market bullishness at the time). This call turns out to have been accurate. However, at the time, this post produced very negative sentiments, albeit more from readers on Naked Capitalism than Credit Writedowns – in my opinion because most people erroneously extrapolate a current trend into the future (see my reaction to this from a post weeks later, “Through a glass darkly: the economy and confirmation bias in the econoblogosphere”)
Nevertheless, a piece from NBER guru Robert Gordon that I reported demonstrated to me that I was not alone in seeing the trend reversal in jobless claims. Eventually, in May I indicated that the jobless claims data were pointing to an imminent recovery and remarked that the data had usually been fairly accurate in the past.
And for the record, I have said I see a recovery happening probably in Q4 2009 or Q1 2010 (see my post “The Fake Recovery”).
The real question is how robust a recovery are we going to have and this is directly related to why the jobless claims series has been sending a false signal. Now, initial claims has been sending a recovery signal since January. Yet, continuing claims continued to rise more quickly until last week. In the past, one had seen these two series as harbingers of imminent recovery. But, I am talking Q4 here. Why? Deleveraging.
In the end, consumers are going to be forced to reduce debt and save more in this more cautious financial environment. Team Obama does seem intent on re-kindling animal spirits but the personal savings rate has gone up nonetheless. This will be a drag on GDP growth going forward and means that the economy’s rebound will be more tenuous and slower to develop. In my view, this means recovery will be delayed and once it gets going it will be weak. The potential for a double dip is very high.
So, to be clear, first derivatives are starting to turn up and since recession is a first derivative event, we are probably going to see an end to this recession soon enough. But, with structural problems still remaining, the U.S. economy will be weak for a long time to come.
Why do I bring this up? Because, despite the data pointing to recovery, I decided the start of the recovery process would be delayed until this quarter or Q1 2010 by consumers repairing their balance sheets – and, in retrospect, in part due to a desire to avoid being too far out of step with the consensus.
I must admit to falling prey to forecast herding, something I talked about in June (admittedly without mentioning my own culpability which I should have done). At the time, I said:
No one wants to go out on a limb with a bold call only to see this prediction proved wrong. If one fails, it is better to fail conventionally. The necessary corollary of that statement is this: market forecasters and analysts play it safe by making sure their forecasts are not often far from the consensus forecast. Think of the consensus forecast as an anchor which restricts the outlook of any individual forecaster afraid of failing unconventionally.
In Roubini’s case – and this logic also applies to media darlings like Meredith Whitney – it does NOT pay to up the ante. What Faber is saying is that they have already benefitted from the bold and unconventional contrarian market call they initially made. There is little payoff and much risk from continuing on that path. A bearish analyst who misses the turn gets the stick. Just ask the original Dr. Doom, Henry Kaufman.
Roubini is not running with the herd
The one thing that makes me think about my error in tweaking my bullishness has to do with Nouriel Roubini. In the quote above, I said he has little incentive to double down on a bearish forecast at this point in time. Both he and Meredith Whitney, two voices of caution leading into crisis, have been much more upbeat of late. Are they hedging as I did? Hard to say.
But, with Nouriel Roubini’s recent FT Op-Ed, this is over. Roubini decried the easy money policy he believes is leading to a dollar carry trade and an increase of risk appetite across a wide variety of asset classes. He believes this experiment will not end well. I share his view.
Roubini, in going public in this way, is officially departing from a more hedged nuanced position he has been using over the last few months as the recovery has taken hold. Yves Smith says:
Nouriel Roubini has officially left the “hedging your bets on the economy” camp.
I applaud him for coming out with this piece and suggest you read it because it may come to be seen as the make or break call in determining his reputation as economic soothsayer.
Recovery is happening, but watch asset prices
For my part, I will look to avoid a repeat of the ‘jobless claims incident.’ Hopefully, I have done by writing my depression post at the beginning of last month, which outlines my view that we are in a cyclical recovery in the middle of a longer-term depression.
I would like to make some amendments to my thinking at the time though. First and foremost, I have come to doubt whether we are seeing a balance sheet recession right now. One reason I am writing this post is because the ISM manufacturing data turned up in May at precisely the same time that the credit revulsion-induced savings rate turned down. Translation: there is no balance sheet recession in the U.S., at least not yet. (see my post “Americans are not increasing savings”). This means the recovery could surprise to the upside. Moreover, the ISM data point to potential upside surprises from inventories, leading to an even more robust outlook.
What I believe is happening has much to do with Nouriel Roubini’s comments. U.S. economic policy is geared toward reproducing the status quo ante via reflation of asset prices (something Bill Gross thinks is the right policy and even Dilbert has made fun of). The policy has been wildly successful so far, with asset prices bubbling over globally. I have called this the fake recovery, but as recently as September I was on the fence about how much uptick we were to get. I never dreamed the recovery process could be so robust given the headwinds we faced.
However, reflation has also given investors a license to take risk. Look at the return of John Meriwether as a telltale sign. Reflation policies are inflating assets far and wide: European high yield, American high yield, Swedish house prices, London house prices, Chinese property prices, and inducing reckless lending. The list is endless. Even Bill Gross’ piece pointed to inflated prices, a view shared by Jeremy Grantham.
The long and short is we are seeing another asset bubble inflating courtesy of easy money. While Morgan Stanley worries easy money will lead to inflation, former Morgan Stanley economist Andy Xie fears this will end in a double dip. To make matters worse, there is a dollar carry trade now spreading a liquidity seeking return dynamic abroad. This is the additional risk of which Roubini writes, believing it could precipitate another crunch or crash. Ironically, a strong recovery is not necessarily bullish.
Is a double dip or crash a baseline scenario? No, not necessarily – but it is increasingly likely. So, as bullish as I believe the data are, I am more worried about a bad outcome, not less.