The World is looking a lot like Japan

The complacency about the global economic recovery is gradually giving way to concern that the world economy may be able to relapse into another recession and even a depression. Infact the US and Western economies are looking a lot like Japan after its bubble burst in the early 1990s. Unless the policy makers think of solutions that may have to include default, this crisis will only be prolonged. Short-term quick-fix postponement of the solutions will only prolong the eventual pain and prolong the crisis. The World economy is in urgent need of long-term structural solutions but there is a clear lack of will power amonst the policy makers to undertake drastic reforms as they fear being branded 'anti-business'. Ironically, a 'pro-business' tag would mean a complete systematic siphoning off of public money to bailout speculators. I have reproduced some empirical data (shorne of any analytical inputs) in order to try and provide readers with a hope that they will be able to come to their own conclusions.

Problems in USA

A number of very important indicators are indicating troubling times ahead. The most important indications of problems ahead have once again come from the Bond markets and subsequently the commodity markets. The US Benchmark S&P 500 has lost nearly 16% from its 2010 high. The losses in the markets have largely been due to the fears that the deficit cutting may cause to the weak global economy that could dash all hopes for a recovery. It has been pointed out that globally governments have promised to cut nearly the equivalent of 2.5% of the world GDP. If the bond market is right, this could be a historical blunder.

All the important economic statistics released over the last two weeks are leading to concern replacing complacency as the dominant macro-economic theme. Concerns related to double-dip recession in the west or even an economic depression is coming to the forefront. Employment generation is still a distant dream in the USA. Unemployment claims actually increased to 472,000 as against the consensus estimate of 454,000 for the last week, while manufacturing in the USA slowed from 59.7 to 56.2, while the consensus was 58.9. Pending home sales collapsed by 30% (immediately after the expiry of US Government tax benefits, while the consensus expected it to fall by just 7.4%. The hope the private sector demand is turning out to be a mirage. The latest statistics from USA indicate that against the expected private sector job creation of 110,000 only 83,000 were created.

The yield on two-year US Treasuries has fallen to a record low of 0.61pc in a flight to safety, a level not seen during the depths of the Great Depression. Ten-year yields dropped below the psychologically sensitive level of 3pc to 2.96pc. Japan 10 year bond yields have reached a 7 year low of 1.06%, the same that they were when the government started its battle against deflation. Bond market sales by corporate dropped by 39% in the first six months of this year from last year’s level because of increased emphasis on safety rather than returns.

The US Housing 26 months of supply overhang – inventory of all kinds and the next big down move in the US housing sector has just begun. The housing sector cannot be helped due to the large debt overhang among the US and European households. In the USA, debt-fuelled demand during that last exponential surge in the credit cycle that took the household debt-to-GDP ratio from 100% in 2001, to the peak of 136% in 2008. That ratio has since come down, to 126%, but that suggests that the process of mean reversion will take more time. This ratio was closer to 30% at the end of the last secular credit collapse as we emerged from World War II.

Leading economic indicators are showing that the US economy would be lucky if it could expand by 1% in the second half of 2010, against the stock market discounting of 3% or more GDP. This would indicate that once the stock markets in the US start discounting low growth (which the bond market has already started discounting) then we could witness more panic in the equities markets which will boomerang throughout the world. The manufacturing gauge fell by more than forecast to 56.2 in June from 59.7 in May. A reading greater than 50 points to expansion. Other data showed contracts to buy existing homes fell 30 percent in May, and claims for jobless benefits unexpectedly rose last week. Car sales too were down sharply in June. They usually fall by about 3% from May to June each year, but this year they fell by an average of about 11%.

This has been aggravated by the banks unwilling to lend to small and medium enterprises which provide most of the jobs. Money supply has declined at an annualised pace of 5.5% in USA. In the first three months, Money supply fell by 9.6%

The JOC Commodity Index (which has a high degree of reliability) has crashed by nearly 45% this month after a 80% fall over the last two months. The only other time that the index collapsed with such speed was after the collapse of Lehman Brothers. The Baltic Dry continues to fall and it fallen by nearly 43% over the last one month, indicating that there is trouble for the commodity market over the next few months.

The US economy has officially lost 8.4 million jobs during the recession that began in December 2007. If we add those who are employed part-time, who want to work full-time but are unable to find work then the figure is nearly 18 million.

There are other equally important problems of mammoth size, both of which will pressurise employment and as a corollary consumption over the next few years. One is the problem of huge pension liabilities of the most of the US states, which varies but is estimated at a minimum of US$1 trillion to a higher estimate of US$5 trillion. Nearly all the US States’ have a gaping pension shortfall. The private Industry is no better. Therefore this will not only force people to cut down on spending by the nearly 78 million people who will retire over the next few years, but would force them to work longer, making it harder for the already unemployed to find work.

The second problem is that over burdened US States’ have just embarked upon a programme that would cut their work force by upto 20% in the next one year because they are running big budget deficits and are unable to find financing due to loss of tax revenues and the problems with jittery bond markets.

Thus it is clear that the US economy is about to slow down, quite substantially and this is increased concern about the tentative signs of stabilisation that came with the government support US and other parts of the world. The bond market on the other hand seems to be indicating that there is a very serious risk of a double dip recession in the west if not an outright depression. It is clear that the consensus estimate about US GDP growing at 3% during the second half of the year are extremely optimistic and the US should consider itself lucky if it is able to grow at 1% over the next six months.

Problems in Europe:

Europe continues to be beset with problems of phenomenal scale. Gradual deterioration of the world economy, especially European economies became more manifest over the past four weeks. Spain sold 3.5 billion euros ($4.3 billion) of five-year notes, with demand falling to 1.7 times the amount of securities offered, from 2.35 times at the previous auction on May 6. The notes were sold at an average yield of 3.657 percent, compared with 3.532 percent a May 6 auction.

The Spanish cajas or savings banks are clearly in trouble, relying on the ECB for 21pc of their funding. A number of banks in Europe may go insolvent (or already are insolvent, without ECB Help). 171 banks borrowed about Euros 131 billion. The markets are relieved the short-term because they expected Euros 200 billion borrowing, and hence the relief rally in the Euro.

Greek and Spanish spreads continue to be at record high. More worryingly, Italian spreads are slowly climbing that the bond market is has Italy’s problems in this shooting range. Bond markets spreads at least nearly double the level they were three months back indicating that the bond market is sceptical about the economic recovery.

A Spanish newspaper recently cited confidential sources that claimed that both Spain and Italy were likely to need a bail out.

Italy was the most recent county (after UK) which has announced another Euro 25 billion of austerity measures. These measures are likely to create further problems for the European Economy at the time of the most susceptibility.

Consumer prices continue their slide in Europe in a clear indication of deflationary pressures that stem from the lack of pricing power for nearly all the segments.

New Industrial order fell by nearly 5% from the previous months and were barely positive.

European Retail sales and consumer spending continued their downward decline.

French consumer confidence fell to a 8 month low.

Bank of England policy maker Alan Posen has warned that there is a high probability that Britain will slip bank into recession, due to a combination of Government austerity measures and importantly due to the unwillingness of the banks to lend money. Manufacturing in UK has declined consecutively for the past three months. Only 7.1% of the UK banks in a Bank of England survey were found to have increased their lending while a majority stated their intention to lend less. Problematically for UK the number of export order fell sharply from 56.7 to 50.7 in June. Home prices continued their fall in June.

Money supply (M3) in Europe continues to decline on a monthly basis, with the most recent being a 0.2% decline over the previous month.

Problems In China

There was a fond hope that China would rescue the world economy. Unfortunately, not only does China comprise just 6% of the world economy, but even that has started to slow down.

Chinese stocks continue to drop and they have dropped nearly nine percent this week, in response to a drop in their manufacturing index. The HSBC/Markit index of Chinese manufacturing has fallen from a high of 57.4 in January to 50.4 in June (50 is the terminal reading that differentiate a contraction from expansion)

China has decided to increase the minimum wages to its workers in response to the increased number of industrial strikes. The wage hikes differ in each provinces and they vary from 20% to 40%. While this is good over the long-term as it would increase the consumption ability of its populace, in the short-term it would make China’s exports less competitive as the rise in the cost of production would have to bear the impact of falling Euro thereby making their exports to Europe (which comprise about 27% of its total exports) more expensive.

The only sort of good news for the China bulls is that the nation has 28.8 trillion yuan of unfinished projects in place, amounting to 85 percent of gross domestic product. While that may be good news, the fact that the Chinese have recently increased minimum wages means that it will continue to have inflationary pressures over the short-term forcing the government to take up further measures to cool the economy.

Goldman Sachs has just cut its GDP growth estimate of China from 11.4 percent this year to 10.1%. Phew! This is the second time that we have realised that the investment banks can cut their estimates so quickly. The first time was in the aftermath of Lehman. Probably they have just completed their long liquidation.

China's car sales have slowed to about 10.9% for June, compared to the breakneck speed of the March, April and May. Little do most of the Western analysts realise that the structural nature of an Emerging market is such that while the growth can be extraordinary, so can the down move.

India Scenario:

India does not face similar problems to the west, but our policymakers and people need to be less complacent. India is not on the verge of tipping point into an abyss as of now. However, Indian econmy doesnot have the depth in its economy that would normally be expected of a country of its size and diversity. The dominant theme is that India will be insulated from the crisis. It is imperative to remember that in a globalised world, there can be region that can be insulation from a crisis, especially one of this magnitude. It is just a matter of time before it is affected. India needs to quickly overcome some of its deficiencies. While the economy will be stable this financial year, a prolonged crisis in the West, combined with a slowdown in exports will create new problems for India.

India’s recovery is largely because of its recovery of exports to China, trade and other concessions given by the government, which reacted proactively. Unfortunately that is where the good news stops. The government should not be overly complacent because its balance got better due to the petro price hike and the procceds from the sale of spectrum. The 1 lakh crores from sale of spectrum is a one off jackpot. The government is unlikely to gain such large amounts even if were to sell stakes in public sector assets as their success is completely dependent on the market conditions. Moreover, the huge quantity of supply of equity in the primary market will only dilute the potential for market conditions.

A more pressing concern is the problem of growing overseas borrowings by Indian companies. This growing indebtedness among the Indian companies, especially at a time of declining demand and margins means that we are bound to witness an increase in the pressure on the corporate balance sheets. It has been pointed out that nearly 44% of the borrowings in India are short-term in nature. That would make the country more prone to volatility and troubles if this debt mix doesnot change soon. This pressure will be aggravated due the government’s withdrawal of subsidies and an increase in taxes at the Central, State and Local level, due to the cash constraints facing the government.

The government has to remember that a prolonged crisis in the world economy would mean that they would be staring at problems by the end of next year the interregnum would be the period of declining exports (especially if China were to slow down dramatically), declining tax revenues (especially from service tax and other indirect taxes), while its expenditure would not decrease because they would have to spend more on the social schemes while the demands for concession increase.

What would investors need to do?

Investors may be well advised to be extremely cautious and preferably increase their cash holding. Any sharp declines in Gold should be used to increase their holdings as the crisis still has a number of chapters to play out. In times of uncertainty, Gold is the best investment.