Strategy

Economy: Climbing a wall of worry

The economy turned around faster than expected, but we are far from in the clear.

Call it the Great Recovery, but don’t bet the bank on it lasting.

Remember the mood a year ago, back when billionaire fund manager Eric Sprott hosted his Night with the Bears in Toronto? Institutional investors gathered to meet the financial world’s most negative Nellies. Canada’s Ian Gordon, who believes we face a prolonged economic version of nuclear winter, warned the Dow Jones industrial average was destined to drop to 1,000. But anyone who heeded Sprott’s bearfest missed out on a spectacular bull run.

The S&P/TSX composite index jumped 31% last year, posting its biggest annual advance since 1979. In April, the Dow topped 11,000 for the first time in 18 months.

Canadians can clearly stop wondering if the recovery is real. According to Statistics Canada, our recession ended in the third-quarter, with real gross domestic product down just 3.3% from Q3, 2008, a less severe contraction than during downturns in the early ’80s and ’90s. Unemployment peaked last summer at 8.7%, but consumer spending actually rose during the recession — which is why average household debt is now a record 146% of disposable income. And despite the soaring loonie, our trade surplus widened to $1.4 billion in February, thanks to global demand for energy products and a jump in auto shipments to the United States.

The Organization for Economic Co-operation and Development says Canada’s economy is heating up faster than any other in the G7 and will probably post a 6.2% growth rate for the first quarter. And that makes Fraser Institute economists Niels Veldhuis and Charles Lammam appear credible when they argue Ottawa should never have borrowed a dime to juice economic activity. Veldhuis says government projects compete with private-sector projects, driving up costs. “The sooner the stimulus stops,” he says, “the better.”

The real issue, of course, is whether the global economy is healthy enough to support itself after interest rates rise and stimulus spending by our trading partners stops.

After world output dipped 0.8% in 2009, the IMF estimates it will rise by 3.9% this year and 4.3% in 2011. And those numbers are considered low since economists around the world have been adjusting growth estimates upward. But projections are never written in stone.

While a few smart folks predicted the financial crisis, nobody saw how quickly global production and trade would bounce back, transforming the so-called Great Recession into the mother of all V-shaped economic recoveries, at least in Canada. But nobody knows what is going to happen next. When it comes to the global economy today, the only certainties are that monetary policy can’t get any looser and governments must now deal with the aftermath of record stimulus spending, not to mention the massive new liabilities on their balance sheets.

As Carmen Reinhart and Kenneth Rogoff point out in their book This Time is Different, maintaining confidence in credit markets is critical in highly leveraged economies that must continually roll over short-term debt to keep chugging along. And today, threats to confidence abound.

For example, after bailing out everything from U.S. automakers and homeowners to international financial institutions and national governments, the world is now awash with moral hazard. The European Union keeps promising to contain its sovereign debt crisis, but there is no good reason to expect it will be contained any better than the sub-prime fiasco that U.S. Federal Reserve chairman Ben Bernanke once insisted would not engulf the world. Greek financial woes are about five times larger than the Russian debt obligations that sank the global economy in 1998. And Spain — where unemployment sits around 20% — potentially poses an even bigger problem.

Back on this side of the pond, Uncle Sam’s federal financial problems are well known. But state-level finances are just as serious. The embattled treasurer of California recently expressed outrage at Goldman Sachs and other banks for marketing credit default swaps on the debt issued by America’s largest state.

The instruments, he complained, “wrongly brand our bonds as a greater risk than those issued by such nations as Kazakhstan.”

But as Financial Times columnist Spencer Jakab points out, Kazakhstan’s unemployment of just 6.7% looks positively stellar next to the Golden State’s joblessness rate of 12.4%, and its modest budget deficit makes it a paragon of fiscal virtue compared to a state that pays bills with IOUs.

And despite all that has happened in the past few years, Wall Street is still playing balance sheet games. According to the Federal Reserve Bank of New York, 18 major U.S. banks have used temporary transactions just before issuing the last five quarterly reports to understate debt levels by 42%, on loans used to roll the dice on securities trading.

Meanwhile, Japan, the world’s second-largest economy, remains lost in the woods.

The good news, according to David Rosenberg, Gluskin Sheff’s chief economist, is that 2010 started off with a pretty solid consensus view that there will be “a muted economic recovery” this year, with no risk of a “double-dip” recession. Equity markets are expected to continue to perform well with limited volatility. And although U.S. monetary policy will begin to tighten, there will be no negative impact “since interest rates will still be low.”

Then again, Gluskin Sheff also pointed out that market watchers are typically wrong when they all agree.

According to Rosenberg’s firm, a sustainable global economic recovery will not get underway until the ratio of household credit to personal disposable income in the U.S. dramatically improves. And recent data indicate the money supply in the world’s largest economy is shrinking, leading Gordon, Canada’s über-bear, to confidently predict serious deflation is rearing its ugly head.

With the U.S. consumer treading water, Gluskin Sheff thinks U.S. equity markets are now overvalued by somewhere between 20% and 30%, and suggests global investors should “maintain defensive strategies.”

But that’s not happening. Markets around the world have experienced a buying spree fuelled by punters who are wilfully ignoring the not-so-great big picture.

In early April, American equities rose on the U.S. employment report for March, which showed the biggest increase in non-farm payrolls since the Great Recession began. Nobody seemed to care that temporary census workers accounted for nearly a third of the gains. Shortly after, a stronger-than-expected earnings report at JPMorgan Chase helped push major U.S. stock indexes to fresh 52-week highs.

“There’s a growing risk that we’re underestimating the strength of the recovery,” Stephen Stanley, chief economist at Pierpont Securities, announced on April 14.

The next day, a fresh reminder of problems in the U.S. housing market was issued by California’s RealtyTrac, which reported residential bank foreclosures in the first quarter jumped 35% from the same period in 2009.

There was also a wake-up call from an unexpected 24,000 increase (and second consecutive rise) in the weekly number of Americans filing for unemployment benefits.

Since December 2007, the U.S. economy has lost 8.4 million jobs and failed to create the 2.7 million required to keep pace with new entrants into the job market. To simply return to pre-recession levels of employment, it must generate 300,000 net new jobs per month for years.

The world can pin its hopes on China all it wants, but its economic growth is also a house of cards supported by bad debt, with other problems looming. As pointed out last year by Minxin Pei, senior associate at the Carnegie Endowment for International Peace, Asia as a whole produces roughly 30% of global economic output. But because of its huge population, its per capita GDP is only US$5,800, compared with US$48,000 in the States.

The Chinese population is not expected to reach mean American income levels for half a century. And that’s assuming all goes well with China’s bubbling assets, industrial overcapacity, export dependency and an aging population that will have a higher percentage of elderly than the United States by 2040. So like it or not, the world needs American consumers to support the recovery. And as economist Robert Reich recently noted, U.S. household debt sits around 122% of annual disposable income, and “most economic analysts think a sustainable debt load is around 100% of disposable income, assuming a normal level of employment and normal access to credit.”

Wall Street economist Robert Brusca has been dismissing any and all negativity for a long time. “Pessimists repent,” he playfully commanded in a market commentary last summer. “You have nothing to lose but your short-selling losses.”

Today, Brusca likes what he sees in U.S. retail numbers and manufacturing, but the unemployment picture hashim nervous. He notes small businesses do most of the hiring in America, and they are simply not beefing up staff. “We need jobs to make the recovery sustainable,” he says, “and sharply rising claims is not getting that job done.”