Tuesday, December 21, 2010

One Scenario for Early 2011: Reality Intrudes

The global fantasy that euphoric stock markets reflect the real economy is about to be tested by its nemesis, reality.

Beneath the surface, all central banks and governments have pursued a single fantasy the past two years: that massive injections of borrowed capital to "extend and pretend" and inflate new asset bubbles will magically restart global "growth."

The policy is based on three simple ideas:

1. The financial and political power Elites are scared witless by the prospect that the entire financial/monetary status quo is irrevocabley unsustainable. They have no Plan B. So their only policy choice is to print/borrow unprecedented sums of credit/money and inject it into every failed institution to keep it afloat.

2. At some magical point, they hope that "growth" that isn't just government spending and credit creation will arise to replace their command-economy interventions. How the over-indebted and bankrupt will spark a new round of "growth" is left to magic: "animal spirits" and so on--the equivalent of putting on a funny hat and waving a dead chicken while chanting, "We are the Fed! Away, tides!"

3. This much-desired magical return of organic growth (i.e. not the "growth" created by governments borrowing and squandering 12% of their GDP every year) will be sparked by a new asset bubble: in China, the ongoing real estate bubble is the "answer," while in Europe, the U.S. and the developing world, a euphoric stock market is seen as the magical incantation.

Global markets have returned to their pre-global meltdown levels. Too bad the same can't be said of the real economies. Let's take a look at two data points:

Notice that prior to the Great Recession which began in late 2008, the private non-farm payroll in the U.S. totaled about 116,000,000.

Currently, the number of private non-farm jobs is about 107,000,000. That means there are 9 million fewer people getting paychecks.

According to the stock market, everything has returned to the heady days of wonderfulness before the Great Recession struck.

But of course the stock market doesn't reflect jobs, it reflects profits. And those soaring corporate profits are based on four premises:

1. The China story: China's searing growth and rising consumption of everything will fuel global growth essentially forever.

2. The declining U.S. dollar boosts the overseas profits of U.S. global corporations. In other words, you can still make more profit even as your revenues decline: since most major U.S. companies earn half or more of their profits overseas, a declining dollar boosts their profits. Borrow a couple billion at low rates to buy back some stock and presto, earnings per share are rising.

3. Productivity gains can flow directly to the bottom line because workers have zero leverage. Slash and burn that headcount, baby, work the survivors a bit more efficiently, and voila, no need to hire more bodies to handle the anemic growth in revenues.

4. Interest rates will remain absurdly low essentially forever. Mortgages will be cheap, corporate debt will be cheap and government borrowing will be cheap-- endless nearly free money will always be available.

Unfortunately for the the believers in magic, all four stories are unraveling.

The China Story was always based on a single premise: that China's central planners could magically weld together a command economy dominated by State companies, banks and bureaucrats and a vibrant capitalist model of private production, consumption and asset bubbles which would never pop.

The wheels are falling off that project: inflation is rampant-- China is now more expensive than the U.S., even though the average wages are 8 times higher in the U.S.--and the notion that the central government can prop up property values which are out of reach for 99% of the populace will be tested as the government is forced to raise rates, limit their explosive increases in money supply and constrain "hot money" seeking a quick "guaranteed" return.

The China Story was always based on cheap labor and rising consumption, both conditions which are changing. Restive labor is demanding higher wages, and consumption based on government stockpiling of commodities and building cities in the middle of nowhere are about to reverse course as money tightens.

The last time inflation took off in China (1989), the unrest quickly got out of control. Those who don't think it could happen again are relying on magic, not realism.

As the dollar rises, the "rising profits" of U.S. global companies reverse. Nobody seems to notice that this dynamic goes both ways. All those rosy projections of endlessly rising profits ignore the consequences of a rising dollar.

As for rising productivity: the easy gains have all been reaped over the past two years. It will be much harder to squeeze more profitablity out of current workers, especially as revenues decline.

About that endlessly cheap money in unlimited quantities:

That looks like rates are rising, and rather quickly. Oops. So much for the endlessly cheap money for mortgages, corporate debt and all the rest of the credit-based magic.

If we take the above into consideration, a scenario for early 2011 takes shape. This is only one scenario of many, and we'll just have to see what actually transpires.

As the wheels fall off and reality intrudes, the crown jewel of the central banks' interventionist policies, the stock market, may well encounter a bout of gravity. Since the central banks and governments have no other plan other than "borrow and spend" and "extend and pretend," they will move heaven and earth to reflate their golden child, the stock market, because its rise is their primary propaganda tool. Its demise would shred their claims to "success," so they will place the entire shadow machinery of intervention behind a last-gasp play at reflating stocks.

But reality will eventually intrude anyway. The tides don't really care if you're wearing a funny hat and waving a dead chicken, and that you're from the Federal Reserve. People are growing weary of the Fed's "we're the fourth banch of government, except with no controls or oversight, hahahaha" fiefdom, and as a result the Fed is about to encounter some political resistance to its feudal pretensions.

This scenario suggests a "head and shoulders" pattern might develop, where the current levels of resistance will form the head (top) and the previous peak in April 2010 will form the left shoulder.

It looks like 2011 will be an interesting year.

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