Brace for an era of crisis aftershocks

By David Rosenberg, Financial Times

Here is the reality. We have intense uncertainty on US fiscal, energy and health policies. Nobody knows what their effective tax rate is going to be next year so they cannot plan.

When you model that uncertainty in economic terms, you end up with higher liquidity ratios in business and rising savings rates in the personal sector. This damps spending growth and spending is what gross domestic product is all about.

Now, if the baseline growth trend in the US economy was in the old paradigm range of 4-6 per cent for this stage of the cycle, we could certainly absorb these negative shocks.On top of that, we have an export shock from the spreading European recession that is only now starting to show through in the data, such as the plunge in US purchasing managers’ orders.

But the underlying trend in the pace of economic activity is somewhere between 1 and 2 per cent, so there is little margin for error: the cushion is razor-thin.

After almost four years of $1tn-plus fiscal deficits, near-zero policy rates, and a Fed balance sheet that is pregnant with triplets, how can we not have some growth, any growth?

The government spigots have been turned on to such an extent that if this were a normal plain-vanilla cycle, the economy would have ballooned at an 8 per cent average annual rate since the “great recession” ended three years ago.

The fact that it has expanded at barely more than a 2 per cent pace – the weakest recovery ever – speaks to the secular headwinds from debt-burdened households, structural unemployment and retrenchment at state and local government level.

Indeed, the recession may well have ended in June 2009, but the problem is that there was no recovery to speak of. Lingering excess supply in the labour market has led to a 5 per cent decline in real median incomes over the past three years.

The necessity of crawling out of excess indebtedness has led to the mother of all deleveraging cycles: the aggregate household debt/income ratio has contracted from the bubble-high 134 per cent in 2007 to a nine-year low of 114 per cent. That is an unprecedented 20 percentage point decline in five years.

And what makes this cycle a totally different animal to anything we have seen in the past is the destruction of wealth.

The Fed told us recently that median household net worth collapsed an epic 39 per cent from 2007 to 2010. That is a depression statistic.

And this is what, shamefully, the economics community has totally missed: the effects, the scars if you like, will linger for a long time.

This wealth collapse was the equivalent of an earthquake measuring 7 or 8 on the Richter scale, and earthquakes are followed by aftershocks, which is exactly what has provided the biggest hurdle for the post-recession healing phase we have been in for the past three years.

It takes time for a slump in household net worth to register fully. As such, there are lags between the event and the drawn-out but profound impact on consumer spending patterns, as frugality emerges as the new and lasting fashion.

The baby boomers, who are now entering their mid-60s and the group that was at the epicentre of this tragic collapse in net worth, are still in the process of recalculating their ability to retire when they thought they could at the bubble highs. They have lowered their expectations of what their living standards will look like when they do stop work.

So the era of the aftershock is what we are in and what we will probably stay in for years to come.

That means consumer behaviour and patterns will undergo profound and enduring changes that will prove to be intensely disinflationary and foster a prolonged period of ultra-low interest rates, bond yields and expected returns in the public capital markets.

I remain of the view that the secular bull market in Treasuries does not come to a complete end until the long bond goes all the way back to its early 1940s low of 2 per cent, so there is still a hefty 65 basis points of rally left in this monster.

This will make spread product an attractive way to pick up a yield premium at the lows and mean dividend themes stay prevalent in the equity market.

The scars from the detonation of the housing and credit bubble-bust have yet to heal.

Household net worth per capita is still 15 per cent or $100,000 shy of where it was five years ago and ultra-low interest rates are punishing those who save in bank deposits or money market funds.

The median age of the boomer is 55 going on 56 and retirement is the darkness at the end of the tunnel.

The trend towards second jobs, do-it-yourself, private labels, dollar stores, maintaining your existing vehicle, downsizing property needs, cocooning and frugality will continue unabated.

The boomer age of narcissism is over, but look at the bright side: I’ve never met a Buddhist who wasn’t completely tranquil and ... happy.

David Rosenberg is chief economist and strategist of Gluskin Sheff