Rosenberg, 4/27: [My italics] Nobody would ever dispute that the U.S. economy has managed to see its government spend its way into some sort of statistical recovery — though it is more evident in the output and sales data than in the income data. Look at the largesse — a 0% policy rate, a $2.3 trillion Fed balance sheet loaded up with mortgages, a $1.4 trillion fiscal deficit loaded with bailouts and freebies and accounting changes that have allowed the banks to mark-to-model their way back towards earnings heaven. If the economy was not recovering without Uncle Sam’s generosity, then that would truly be a big story.
But Mr. Market at some point will have to confront the future. The time gap between recessions is shortening now — we went 10 years from 1990 to 2000, then 5 years from 2002 to 2007 and the next recession, following this pattern, is likely going to occur within the next 2-3 years. And, unlike the start of the last recession when the government had so many arrows in its quiver, there are none today to help lift the economy again.
Going into the 2007 downturn, the budget deficit was $160 billion. There was ample room for fiscal stimulus. The funds rate was 5.5% and could be cut 550bps — now it is at 0%. The Fed’s balance sheet could be allowed to triple without reviving inflation expectations — good luck the next time around.
Perhaps the downturn that really shakes the foundation (the equity culture, the view that we can spend more than we make to perpetuity, etc) is the next one because the policy response, by definition, will just not be there to turn things around. Not something to worry about today, but the day of reckoning is coming.
What we see in the crystal ball is not only the limited response the government will have on hand to deal with the next downturn, but that it will likely start with the economy never getting back to full employment. Recall that for the first time ever, the U.S. economy in 2007 slipped into recession without having first swung into excess demand terrain (when inflation pressures are burgeoning), which is why it didn't take long for deflation risks to come to the forefront. Imagine how intense the deflation pressures will be in the next go-around as the recession begins with a much higher unemployment rate, a much lower capacity utilization rate, and a more constrained government response.
We can understand that this is far beyond a market mindset that is fixated on next month’s nonfarm payroll release and the coming quarter’s earnings reports — but the primary trend, which is deflationary, is hardly going to be broken by current reflationary policies than was the case from 2002 to 2007 when credit growth and asset prices surged. It was a great five years for the beta trade, but it ended in tears. So will this whippy rally, even if not currently recognized by the majority of market pundits who will get you into safety as quickly heading into the next turndown as they so successfully did in late 2007...
Remember, in a deflationary environment, high-beta pro-cyclical trades will be the exception, not the rule. Income will be king, whether it spun out of paper or hard assets
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