Macroeconomics Finally Gets Interesting
By John Mauldin
Dec 07, 2014
- The United States seems to be doing relatively well. Employment continues to improve at a 2% pace, more or less; GDP growth is more stable; and interest rates are likely to be low for some time. The equity markets are shrugging off anything negative. You can make a very reasonable case that this climate will continue for another year, so you have to start asking yourself, “What could go wrong?” On my short list is a potentially sharp reduction in capital expenditures in the oil extraction industry. Then US exports are hit by the rising dollar, which also hurts corporate profits of large internationals, which impacts stock market valuations – developments that have historically signaled a major short-term top. And we really need to think through the deflation equation, as energy prices will lower the inflation indexes.
- On the global level, there is the real possibility of a significant US dollar breakout and the unwinding of the US-dollar-funded carry trade. The policy divergence among the major central banks is on the verge of being very pronounced. That will have a far bigger impact on global markets than most of us understand. Such a divergence has traditionally not been good for emerging markets. Ironically, we also have to look at the possibility that the increased funding of global trade in Chinese renminbi may offset some of the impact. But will it be enough?
- We have to pay significant attention to the number-one macroeconomic driving force in the world: Japan. The rapid fall of the yen in recent months has been the topic of numerous conversations I’ve had in the past few weeks. Longtime readers know I fully expect the yen to go to 120, on its way toward 200; but this recent move seems too far, too fast, when accompanied by no correction or even a modest pullback. We have to ask ourselves what is causing this. Have the Japanese lost control of their currency? It’s way too early in the process for that to happen. That is a HUGE potential tail risk that must be analyzed.
- Europe is working its way into an outright deflationary recession. Draghi keeps talking a good fight but never seems to deliver. Will he be able to garner enough support to override German objections to quantitative easing? And even if he can, is €1 trillion really enough to drive a stake through the heart of deflation? Will QE somehow increase monetary velocity and the money multiplier in a system that is basically still dysfunctional? And what happens when Greece defaults again this year? Europe is a big question mark. Can Europe continue to muddle through for another year, or will the structural crisis they have been holding at bay finally force them to deal with the real problems?
- China is clearly slowing down, but by how much? How will slower growth impact its trade partners, especially those who have been providing basic commodities? China is also clearly overleveraged, with a monster shadow banking system that seemingly grew up overnight. Will they be able to manage the transition to a consumption-oriented economy rather than one dependent upon ever-increasing debt and foreign direct investment? How do they actually accomplish that? Does the Chinese desire to make the renminbi an international currency in conflict with the economic reforms that need to happen very soon?
- Emerging markets are now 50% of world GDP. They too have become overleveraged and generally dependent upon carry-trade currencies. The average emerging-market currency is back down to a level (against the US dollar) last seen in 2002, with many of them showing signs of even greater weakness. We’ve seen this cycle before, and the end result won’t be pretty.
- Energy prices are down, and that’s good for the energy consumers of the world; but low prices are going to create problems for various countries, including Russia and Iran. How will they react?
- The widening policy divergence among major central banks, noted above, is going to have a major impact on currencies and create the real potential for a currency war. We have to get our heads around whether the Fed will actually raise rates as currently advertised, and if so, at what pace?
- We need to pay attention to the significant and rising risk that a falling oil price poses for high-yield bonds. Depending on which side of the trade you’re on, this can either generate real profits or big losses.
If the proper stance really is cautious optimism, how does one consciously allocate capital today?
What questions are on your radar screen? I would love to hear what parts of the big picture may be missing, and please feel free to suggest reading and research. I actually do read all the replies in response to each week’s letter. Now, all of the above is going to be more than we can cover in this letter, but let’s get started.
- Energy prices are likely to go even lower for a period of time. This week, one gas station in Oklahoma started selling gas for two dollars a gallon. Others will soon follow. What price your state will see depends a great deal upon how much gas tax your state collects. This significant a drop in the price of energy acts in much the same way as a tax cut. It can only be good for consumers. I know that all my kids (all seven now drive and pay for their gas) are very happy when the price of gas goes down.
- Grant Williams (you may know him as the author of Things That Make You Go Hmmm…) showed up for a surprise visit Thursday night. I threw a few more peppers into the chili I was making, and we shared a few bowls, talking all things macroeconomics and investing (and watching a little Dallas Cowboys football, to boot). I posed the question to him, “What could derail the US recovery?” His answer sounded like it came from my own playbook. If any two of the global trouble spots – China, Europe, Japan, and the emerging markets – have a crisis at the same time, we could easily see a global recession. It would be very convenient for the US if they could all manage to stage their corrections consecutively rather than simultaneously. Is that too much to ask?
- People ask me all the time what the trigger for the next equities bear market will be. My “stock” answer is that it typically takes a recession to generate a serious bear market correction. But Charles Gave (in a piece highlighted in this letter) recently asked whether in the current environment a bear market might be the trigger for a recession – the exact opposite of what we’ve experienced in the past few decades. Prior to World War II, however, a bear market was a common trigger for a recession.