Green shoots: is an economic recovery ahead?

There are two sides to the ‘green shoots’ debate and both share a fundamental flaw.

The optimists argue that the green shoots foreshadow economic recovery and that this sets the stage for strong stock market returns.

The pessimists believe the green shoots will wither in the arid soil of underlying economic conditions, delaying any recovery in equities.

Both sides agree that the health of stock markets will largely depend on economic recovery.

The fact is that there is no meaningful relationship between economic conditions and equity returns.

Table 1 and graph 1 demonstrate this over 10-year periods. Note the contrast between the 1970s and the 1990s, gross domestic product (GDP) in both was similar, however, the S&P 500 averaged a total real return of almost 15 per cent per annum in the 1990s but produced a negative return through the 1970s.

The best decade for real growth was the 1940s, but the market only managed a little above 3 per cent per annum. (Note: GDP is a real figure, hence real returns are quoted.)

Over one-year periods the correlation between GDP and real returns is a negligible 8.7 per cent.

There is a view that markets predict economic conditions. If true, there would be a relationship between equity returns and future GDP.

Yet the correlation between the S&P 500 and growth one and two years later is -2.8 per cent and 5.2 per cent respectively. Statistically, the market has no predictive ability.

As there is no reliable short or long-term relationship between the stock market and current or future rates of growth, we need to recognise that the green shoots debate is about economic conditions but does not necessarily tell us much about the prospects for stock markets.

Looking with a selective eye

There is a tendency for the human eye to seek out evidence that supports the views of whoever is looking. Thus, proponents of every view can always point to supporting evidence.

As an example, the US Conference Board’s Consumer Confidence Index rose from 25.3 in February to 26.0 in March.

The February reading was the lowest ever. One could report March as an increase in confidence or describe it as evidence that confidence remains staggeringly low. Both views would be true. This illustrates the green shoots debate today.

Any endeavour to understand the state of the world is always profoundly difficult.

The International Monetary Fund (IMF) has provided a stark example of the difficulty of accurate predicting. In April it forecast global growth in 2009 to shrink by 1.3 per cent.

A quarter earlier its forecast was slightly positive growth. Clearly, the earlier forecast was inaccurate, but will the current forecast prove any better?

Finally, all economic data is out of date. It takes time to collect data, analyse and report it. Data is usually one to three months out of date when it hits the headlines.

Its interpretation is also made complex by the inventory cycle (eg, if sales fall sharply, production will be cut by more than the fall in sales, until inventories reduce to reflect prevailing levels of demand.

Thus production data can substantially exaggerate changes in demand.)

It is worth remembering that the aggregate wealth of the whole planet is estimated to be US$100 trillion, so a trillion dollars is 1 per cent of the total wealth of the human race.

Black holes

Green shoots need to grow from profoundly black holes. World trade is plummeting, unemployment is soaring, credit defaults are expanding and the toxic debt pandemic remains.

Early in the crisis the primary uncertainty was the value of securitised assets on the books of banks. How has that since resolved? It hasn’t.

The IMF estimates that the losses of institutions on financial assets will total US$4 trillion, a sharp increase over the preceding quarter (perhaps a red shoot?).

It estimates that between US$0.9 and US$1.3 trillion will be required to recapitalise US, UK and European banks.

The Federal Deposit Insurance Corporation has “postponed indefinitely” its plan to assist banks to sell troubled assets, acknowledging many are refusing to sell for the prices buyers are willing to pay.

Some suggest this shows that banks’ financial strength have improved, others claim banks simply want to avoid governmental interference. The question of whether the US will be forced to nationalise a portion of its banks has not died.

Yet banks are raising much-needed funds from capital markets and reporting increased profits.

American banks made a US$7.6 billion profit in the March quarter, a stunning turnaround from the US$36.9 billion loss in the previous quarter.

How did they do it? Let’s take the example of Citigroup, which made US$1.6 billion.

According to Welsh Money Management, the market price of bonds Citi had issued fell by US$2.7 billion. On the grounds that, theoretically, Citi could buy back its own debt more cheaply, it booked this amount as a profit.

Further, despite increasing credit losses, Citi reduced its loss reserves by US$1.3 billion. These adjustments alone would turn an otherwise US$2.4 billion loss into its reported profit.

Have US banks turned the corner — and not met an oncoming bus — as the stock market suggests? It’s too early to know.

The fact remains that banks continue to overvalue assets on their books. Ultimately, this must be resolved. The IMF believes this is critical for recovery.

The big issue

The rapidity and co-ordinated nature of the economic slump was unprecedented, as was the speed and scale of the regulators’ stimulatory response. Governments have stepped in as the stabilising agent.

Simultaneous to the explosion in government expenditure, taxation revenue is declining, resulting in huge deficits.

These are being funded by gargantuan government borrowings. The critical question for the long term is the consequences of these debts.

Many nations are seeking to borrow greatly increased sums. Who will lend all this money? What impact will it have on bond interest rates?

How will the scale of funds flowing into bonds affect other markets? And how will they all be repaid?

Normally the currency of a heavily indebted country might weaken. Currently, many nations are borrowing more, but all of their currencies cannot weaken together as they are priced against each other.

Sovereign credit ratings will come under pressure, as the UK’s has already.

Stanford professor John Taylor notes that the US Government’s tax revenue is projected to be $2 trillion, leaving a deficit of US$1.2 trillion.

A 60 per cent increase in tax would be required to eliminate the shortfall, which simply can’t happen.

Over time, it is a reasonable working assumption that a government’s capacity to collect tax revenue will parallel GDP growth.

If a government consistently spends more than it earns, its debts will compound, causing the interest on that debt to consume an ever-larger proportion of government revenues, further compounding the deficit.

A critical ratio to watch will be the trajectory of the growth of debt and GDP.

How can the debt problem of governments be resolved?

The options broadly include increasing taxes, default, monetisation and another speculative boom deferring but compounding the whole problem.

Tax increases are inevitable but hamper recovery, so they cannot be introduced rapidly. Every year at least one country defaults on its sovereign debt, so we can confidently expect some to adopt this ‘solution’. The other option is monetisation (ie, ‘printing’ money).

One view is that inflation is the only solution to the deleveraging problem. To date, central banks have been printing money at an extraordinary rate, although US Federal Chairman Ben Bernanke states the Federal Reserve will not monetise the US Government’s debt. We shall see.

There is also a contrasting view: we will follow the precedent of Japan and struggle with deflation.

The fourth option noted above is another speculative boom driving asset prices to unsustainable levels once again, temporarily papering over the economic cracks.

Unthinkable? The recent bubble began less than three years after the dot.com mania collapsed.

Already we have seen some of the very people who forgot all risk in the latest boom begin again to speak as if the recent jump in stock markets must, no question, roll on. Surely another bubble will not inflate so fast — but it is not impossible.

Only when artificial stimuli ceases will we discover the sustainable level of underlying demand. From then on, the most challenging question will be how governments deal with their debt.

Yet markets ascend

Meanwhile, the behaviour of markets suggests none of the above matters. Some economic data has blipped up, share prices are rising strongly, credit spreads are narrowing, interbank lending rates are moderating, banks and corporations are raising capital and commodity prices have turned up.

Markets remain far below previous peaks, credit spreads and interbank rates remain well above average.

There is no evidence that conditions have returned to normal, but as far as markets are concerned, things have turned.

No-one would deny that after large losses it is wonderful to see a reversal. One cannot help wondering if, perhaps, it is just the beginning.

The most personally felt symptom of the collapse was its direct impact on portfolios. There has been definite improvement here, even though only in the short term.

So, to the extent that we can credit markets with thinking (a dangerously anthropomorphic habit), they ‘think’ the worst is past.

In any case, markets fell so heavily that it is argued all the difficulties besetting the world are fully priced in.

Moreover, as noted above, markets are not meaningfully correlated with GDP, so an economic recovery is not necessarily required for equities to rise.

This brings us to the question of market valuation. According to most long-term, trend-reverting models (eg, Schiller’s PE method), the US and Australia are now in the broad fair value range.

This gives us no hint about future direction, though it does caution against any temptation to believe ‘the market fell heavily so it must rise commensurately’.

The non-conclusion

Many commentators, pointing to markets as evidence, are certain that the world is recovering.

Others are certain that this is false optimism and point out that the fundamental problems have not evaporated.

Neither is justified in their certainty.

Neither case can be dismissed entirely, so the only attitude that is consistent with all the evidence is to recognise the uncertainty of the situation.

From here, anything could happen: the world may stumble around, gradually regaining its balance and moving back to a growth footing; or we could find ourselves facing another shock that shatters the fragile confidence of the past couple of months.

One fact seems unchallenged to date: Australia is coming through the crisis less damaged than most other developed nations, although we will have to navigate our dependence on international capital at a time when it is less readily available.

Robert Keavney is an independent spirit, of no fixed industry address, who believes financial planning is an honourable profession.