“The Silly Things Investment Bankers Write”

The Financial Times published on July 29^th an op-ed written by the Head of Asset Allocation for Barclays Capital, one of the world’s largest investment houses, entitled “Learn to love the recovery.”  While we try to read and appreciate various points of view, and in fact attempt to study those that disagree with our own in order to test our theses, to say that we disagree with the author of this article dramatically understates our feeling.  Because of his role as an ostensible leader in the investment community and the appearance of the article in a highly regarded publication, we’re concerned that his misstatements, logical errors and erroneous conclusions will be taken for gospel.

I’ve taken the liberty of copying the article below and adding our comments (in parentheses and italicized.)

For an even more scathing rebuttal of the FT op-ed, see the link below.

http://www.forexhound.com/article/Blogs/Michael_J_Panzner/Dont_Be_Fooled/149058

Insight: Learn to love the recovery

By Tim Bond

Published: July 29 2009 16:13 | Last updated: July 29 2009 16:13

Never has a bull market climbed a steeper wall of worry. In spite of a proliferation of positive economic indicators, the consensus remains gloomy. Bullish economists are [scarcer] than hens’ teeth.

The average forecast for third-quarter US gross domestic product growth is a weak 0.8 per cent, which would be by far the slowest first quarter of any recovery on record. Since 1945, the average annualised real US growth rate in the first two quarters of recovery is 7 per cent. History provides abundant evidence that the deeper the recession, the stronger the bounce. Even the recovery from the Great Depression conformed to this rule, real US GDP grew 10.8 per cent in 1934 and 8.9 per cent in 1935.

(Firstly, it seems dangerous logic to extrapolate one quarter forecasted meager positive growth into an argument for a sharp economic rebound.  Such a conclusion simply can’t be drawn.  Further, most reasonable observers would agree that this downturn is anything but standard. According to Dr. Nouriel Roubini of NYU, the current recession is three times longer and five times deeper than the previous two.)

Yet today’s consensus assumes this time things will be different. The persistence of such pessimism is striking given a strong Asian recovery is visible, with output, employment and demand all following V-shaped trajectories, and regional industrial production rapidly bouncing back above the previous peak. Yet this recovery is dismissed by western analysts, who appear unable or unwilling to believe the region is capable of endogenous growth. That 2009 will be the second year in a row in which the increase in Chinese domestic demand exceeds that of the US is a point roundly ignored.

(As has been suggested in prior HIA missives, Chinese demand has been fueled in 2009 by a nearly $600B stimulus package that has artificially inflated the Chinese economy and markets.)

The fate of the Chinese economy is supposedly in thrall to the US consumer, in spite of clear and persistent evidence to the contrary. The US economy, which provides a home to 17 per cent of China’s exports, is still seen as the arbiter of growth in Asia. This obstinate adherence to an outdated assessment of economic dependence is not the only gaping intellectual flaw.

(According to The Economist “Pocket World In Figures” 2008 Edition, exports represented 36.7% of China’s GDP. The author ignores the fact that virtually the entire world, not just the US, is in recession. A gaping intellectual flaw indeed.)

The 9.5 per cent US unemployment rate is also viewed as an obstacle to recovery. This objection ignores the many contrary examples of high unemployment rates and subsequent recoveries, not least in the US. Thus in 1982, US unemployment hit 10.8 per cent, yet GDP soared at an average annual pace of 7.7 per cent over the next six quarters.

(Economic recoveries have typically occurred because the Fed lowered interest rates enough to spur lending, which began while unemployment continued to rise. Unemployment is a lagging indicator as businesses are generally reluctant both to fire and then rehire employees. With Fed-controlled short-term rates effectively at 0.0% and the transmission mechanism for monetary policy, the banking system, hobbled if not broken, the spur for the “typical” recovery is simply unavailable.)

Similarly, few commentators consider the possibility that the large post-Lehman rise in US unemployment was a mistake on the part of panicky managements. Yet this is precisely what trends in labour productivity growth, not to mention common sense, tell us occurred. In the first half of 2008, labour productivity growth averaged 3.3 per cent, while the unemployment rate rose to 5.6 per cent. At that point, there was no evidence US companies were overstaffed. Thereafter, output collapsed, yet business productivity growth remained positive, registering an average yearly pace of over 2 per cent, as companies shed labour at a faster pace than they reduced output. Businesses, like markets, panicked after Lehman went under. Employment and output were both reduced far more than it turned out to be necessary, as businesses temporarily and understandably assumed a worst case scenario.

(His assertion that businesses panicked appears to be pure conjecture. In our research we’ve not heard from a single company management suggesting that this might’ve been the case.)

Just as global output is performing a V-shaped recovery, there is a big risk US employment will do the same, with monthly payrolls showing surprising growth by the end of 2009.

(The idea that employment will come “roaring back” seems far-fetched to say the least. With the headline unemployment rate at 9.5% and the U6 rate, which includes those who are “under-employed”, at 16.5%, and consumer demand likely to remain weak for the foreseeable future, we believe companies will be very measured in how quickly they increase their headcount. We expect they’ll prefer to use technology to maintain productivity at high levels, then reinstate part-time workers before adding full-time ones.)

If unemployment is one half of the bearish consensus, de-leveraging is seen as the other main obstacle to recovery. Yet increases in private leverage never play a significant role in recoveries. Indeed, since 1950, US private sector borrowing ex-mortgages has declined an average 0.1 per cent of GDP in the first year of recovery, with non-financial business borrowing declining 0.6 per cent of GDP.

(An increase in private leverage is precisely the genesis of the current economic slump. The US economy never saw the degree of leverage it had before this economic debacle. According to The Conference Board, private debt as a percentage of GDP rose from 123% in 1981 to 350% in 2008. Also, Harmonic believes that a secular shift towards frugality is underway, making it unlikely that private leverage will increase for a number of years, much less in the first year of the recovery.  It’s simply irrational to believe that this economic downturn bears a resemblance to any since the 1930s.)

A regression of the household savings rate on the wealth-to-income ratio tells us the former has made the appropriate adjustment to declines in the latter. In fact, the rally in the stock market, the low level of interest rates and the stabilisation in house prices all tend to limit the risk of a further sizeable increase in the savings rate. So over the rest of this year, the standard cyclical timing of a US economic turning point tells us pessimistic expectations are likely to collide with the economic reality of a strong recovery. The net result is almost inevitable, in the shape of an inexorable continuation of the equity rally.

(The rally in the stock market is simply not an “all’s-well” signal; the move upward from the March low can be argued to be a rebound from an oversold condition or the recognition that economic Armageddon was averted. The author’s statement that house prices are stabilizing, which apparently is based on a couple of months seasonally-adjusted data, is alarming. His circular logic – stocks should go up because the economy’s improving because stocks are going up – is baffling.  Finally, his reference to “standard cyclical timing” is equally confusing – as noted above this downturn is anything but standard.)