“It’s the level, stupid – it’s not the growth rates, it’s the levels that matter “– said governor of Bank of England Mr. Mervyn King. Mr. King expressed serious concerns about where we are in recovery, especially because of the fact that people had no patience in declaring victory. As Paul McCulley from PIMCO said ‘boldness in execution is not a vice but patience in declaring victory is indeed a virtue’. Mr. King is reminding us of that virtue. When we look at the absolute value of key drivers of economy such as wealth, debt, unemployment, consumption and investment, we are far from what would be a desired and required level to put us on the track of robust recovery. This brings us to the question: Going forward, what shape of recovery would we see?
Most of the optimism is coming from the recent rally in stock markets. I did a simple analysis by looking at the revenue of top 25 performers of S&P and as is widely being talked about, and noticed that these firms didn’t show much increase in revenue. In fact, in 9 cases, revenue went down but the firm improved its net income and the stock price. Moreover, when I look at the valuations of a lot of companies, a growth rate of 4-5% has been priced into the equity value. So the current valuation is not realistic because 1) A growth rate of 4-5% in the US economy is not achievable anywhere in the near future and 2) When the firms are increasing their free cash flows by cutting cost and not increasing revenues, I don’t see how consumption and employment are going to increase. In my opinion, the US is going to see 2-3% of growth in 3-years timeframe.
So far, the growth in the economy has been driven by government support. Government took exceptional measures, rightly so, to avoid another great depression, and in the process, injected lot of money. This has created huge deficit, a level that is unprecedented, and in order to cover the deficit, US will have to increase taxes. If we look at the value created by corporate America, there are three pieces in it: 1) corporate profit 2) Return on Investments in the US and 3) Taxes. As the tax will increase, corporate profit will reduce. People are wounded after the collapse of US investments and have are not inclined to put the money back here. Secondly, a weak US Dollar will make the absolute return on investments less valuable than they would have been otherwise. Together, it would mean that either firms employ less people or they move outside of the US in order to save taxes. We already witnessed an unprecedented event in 2nd quarter when the US firms filed higher taxes abroad than they did in the US for the first time in history. I cannot stress the point enough that the current unemployment levels would persist. Going forward, I believe the dominating theme would be deleveraging (in the financial sector), reregulation and conservative spending. Deleveraging and reregulation would increase government’s intervention and reduce private firms’ ability to take risk and hence will suppress innovation. Spending cuts would mean lesser cash flows to scientific institutions, research and development and academia, all of which are the lifeline of this country and have ensured this country’s lead over the rest of the world. This lead would be in serious jeopardy and will seriously undermine the key strength of Corporate America.
70% of US GDP comes from consumer spending. With increase in private savings rate (not to be confused with national savings rate) and the destruction of household wealth, it is easy see that consumption will go down, shrinking the US GDP and bringing it down to much lower levels from what we saw in 2006. In addition, credit is not going to be easily available (another pre-requisite for the entrepreneurial spirit of this country). Looking at outstanding commercial and industrial loans, we see that credit has been continuously shrinking from October’08 to September’ 09. Cash assets in all commercial banks have gone up. Banks are still sitting on cash and not providing money to consumers. Cash reserves are still in the range of 800B-1150B USD, compared to 370B USD which we saw between 2004 and 2008. Consumption will continue to be low and credit availability stringent. This will put us into a New Normal – a term coined by Mohammed El-Erian at PIMCO. (This is in sharp contrast to China where consumer behaviors are already changing and with one of the fastest recoveries of any country, it is poised to overtake Japan as the second largest economy three years sooner than had been forecasted for a long time).
The broader point I am trying to make is that the fundamental problem with the US economy hasn’t been solved. Recovery has been made possible by government spending and the spending needs to be continued. I definitely see that Ben Bernanke is willing to do so but will the politics let him do that? This poses a big policy risk. Policymakers in the US will support a weaker USD in the short term in order to reduce debt by promoting export but how will that impact the global economy? In a recent interview the French Finance minister said- “no one likes weak US Dollar”. China definitely doesn’t (being the largest external holder of US treasury) and since US imports the most amount of oil from Canada, Canadians don’t like it either.
I believe that no letter in English alphabet can define the shape of recovery but if you force me, I say it would be the combination of L and V with few dips on the way. The path to recovery will depend not only on the decisions made by policy makers in the US but also how cooperative the global leaders are. If all countries are committed to ‘no matter what it takes to get back to normal’, I will be more optimistic. In between, not only fiscal and monetary policies but also the foreign policy will be critical. The political risk of a policy implementation is high, what with recent developments in Afghanistan, Iran and Russia’s ever so non committal stance to solving the Iranian crisis. Any non action can change L+V to W.
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