Today, San Francisco Fed president, Janet Yellen stated in a speech in Coeur D'Alene, Idaho that she sees the "first solid signs of recovery. However, she also said: "That recovery is likely to be painfully slow." "A gradual recovery means that things won't feel very good for some time to come." So are we recovering or not? Yes, but it will not feel or look like the recoveries of the past 25 or so years.
The U.S. economy can be compared with a person that has taken a stimulant to reinvigorate himself or herself. The 1970s were a time of economic malaise. Former Fed Chairman, Paul Volcker's raising of interest rates to defeat inflation was a slap in the face for the U.S. economy. Lower taxes under President Reagan and a policy of lowering rates to make borrowing more affordable and to promote home ownership and business expansion was an economic amphetamine.
The problem wit taking amphetamines is that when it wears off one usually feels worse than before. There is no free energy. At sometime one must rest. One can keep taking amphetamines, but that just makes it worse in the end. The same is true of the U.S. economy. The Fed's speed induced economic recovery which began in the 80s would sputter from time to time. However, instead of permitting the economy to correct, the Fed would ease monetary policy to the point that recessions were mild and short-lived. This was known as "The Great Moderation". It became accepted that the Fed had found away to limit economic discomfort by prudent and creative interest rate policies. In actuality all the Fed did was give the patient more "speed" every time he was about to crash. As we have recently witnessed, when the patient is cut off from his supply he crashes hard. The U.S. economy was on a two and one half decade high. The financial crisis was the crash.
It is the prospect of an economic recovery without economic amphetamines which is leading level-headed financial experts to manage their expectations. The cheerleaders don't get it or don't want to get it. Investors have become accustomed to repeat performances of rapid and sharp recoveries without really understanding why. Many market participants have become lazy. They look at charts of previous economic cycles and assume that it all has to happen the same way once again. The problem is that the recovery has to happen with reduced leverage.
If the economic recovery will be gradual, why the strength in the stock market. The fact is that the market is not as efficient as seminar lecturers and mutual fund wholesalers would have us believe. Markets reflect more than fundamentals. They reflect fear and greed. When the equity markets plummeted to their lows last March, that reflected fear more than fundamentals. The rally since then reflects greed more than fundamentals. Sure, we will see improved earnings and possibly, positive GDP for the second or third quarter of 2009, but that will be more because business reduced unnecessary activities during 2008. Manufacturers stopped producing, choosing instead to let inventories decline. Businesses stopped placing orders for equipment choosing to make do with what they had. Now, businesses are spending, as are consumers, to a point. What we are seeing is, mostly, replacement spending with some opportunistic discretionary spending.
Who is spending? Those who can borrow. This means very-well-qualified consumers and businesses, especially businesses. Due to low interest rates and fairly tight credit spreads within the industrial sector, corporate borrowing can be attractive for some companies, but as with consumers, it is high-quality businesses which are able to borrow. Lower-rated corporations have not been able to borrow. Instead, corporate defaults are rising and are currently approaching 11%. This makes the high-yield bond arena a very dangerous place, in spite of the its rise due to greed-induced speculation.
It is who is able to obtain credit and who isn't which will shape the coming economic recovery. Unlike during the past decade, both individuals and corporations will have to prove their abilities to repay debt. Weak companies will no longer be able to tap the corporate bond market at low rates or obtain sweetheart covenant-light loans from banks. The same is true for individuals. One will now actually have to prove their abilities to pay.
Why is it so different now? In the past, banks and investment banks could slice and dice pools of glow-in-the dark loans and create AAA-rated securities. Investors (even alleged professionals such as municipalities and pensions) looked no further than the credit rating. No one knew or wanted to know what kind of radioactive collateral was residing within these structures.
The banks were all to happy to write these loans, so long as they could securitize them and get the toxic waste off of their balance sheets. The prospects of not being able to securitize and sell lead as gold is putting a damper on Wall Street alchemy. It is the prospect of investors and (saints preserve us) credit ratings agencies actually basing their decisions on the quality of the underlying assets is causing some pundits, such as economist Brian Wesbury to renew calls to suspend mark-to-market accounting.
The argument is that if banks have to value assets at prevailing market prices, it may cause banks to appear under capitalized when compared to the so-called hold-to-maturity value. Problems abound with this thinking.
1) Do you know what the hold to maturity value is of a pool of loans? Of course not, neither do the banks. Yes, they have sophisticated models which give banks estimates, but all models are backward looking. They cannot account for unknown unknowns.
2) Would you trust banks to properly and fairly value asset-backed securities without the market to voice its opinions? I wouldn't
3) This may be the most important,. Loans held on bank balance sheets ARE NOT SUBJECT TO MARK TO MARKET! This is why the PPIP is stalled. Banks have not marked their toxic loans much and do not wish to sell them at markets prices. Heck, they don't want to sell them at models derived prices as that would lead billions of dollars of realized losses. Levering up is not going to happen.
Where does this leave us? We could see fairly string growth later in 2009 and in early 2010 as businesses replenish inventories and replace equipment, but then it is back to slow progress as Americans live within their means, almost. This will be a very jobless recovery, but a recovery nonetheless.
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