Ben Bernanke will save the world, but first we bleed

Posted by Ambrose Evans-Pritchard on 14 Dec 2007 at 12:48

The Bernanke ‘Put’ has expired.

Are Bernanke’s academic doctrines blurring his vision?

The Fed cuts a quarter point, and what happens? Wall Street’s ungrateful wretches knock 294 off the Dow 294 in an hour and half; the home builders index dives 10pc; Japanese bond surge; Euribor spreads rise to an all-time high of 99 basis points.

Have the markets begun to digest the awful possibility that central banks cannot cut rates fast enough to prevent a profits crunch because they are caught between the Scylla of the credit crunch and the Charybdis of inflation, a new deviant form of stagflation?

Nor is there any evidence or credible theory that interest rate cuts would help. For example, fed economists say that 1% rates didn’t do much – it was the fiscal impulse of 03 that added aggregate demand and turned the economy.

US headline CPI is stuck at around 3.5pc to 4pc, German CPI is 3pc (and wholesale inflation 5.7pc), China is 6.9pc, and Russia is skidding out of control at 10pc.

Note ‘out of control’. Mainstream theory says inflation will accelerate once it gets going.

As for the Fed, it now has to fret about the dollar – Banquo’s ghost at every FOMC meeting these days. A little beggar-thy-neighbour devaluation is welcome in Washington: a disorderly rout is another matter. No Fed chairman can sit idly by if half Asia and the Mid-East break their dollar pegs, threatening to end a century of US dollar primacy.

They are more worried about ‘imported inflation’ than ‘primacy’.

Yes, inflation is a snapshot of the past, not the future. It lags the cycle. After the dotcom bust, US prices kept rising for ten months. Alan Greenspan blithely ignored it as background noise, though regional Fed hawks put up a fight.

He had a deflationary global context, as he said publicly and in his book. That has changed, and now import prices are instead rising substantially.

Ben Bernanke has not yet acquired the Maestro’s licence to dispense with the Fed staff model when it suits him.

As above, different global context.

In any case, his academic doctrines may now be blurring his vision.

Not sure why they are, but all evidence is they are based on fixed exchange rate/gold standard theory.

So, in case you thought that every little sell-off on Wall Street was a God-given chance to load up further on equities, let me pass on a few words of caution from the High Priests of finance.

A deluge of pre-Christmas predictions have been flooding into my E-mail box, some accompanied by lavish City lunches. The broad chorus-by now well known – is that the US will hit a brick wall in 2008.

Yes, originally scheduled for 07. Not saying we won’t, but I am saying those forecasting it hae a poor record and suspect models.

Less understood is that Europe, Asia, and emerging markets will also flounder to varying degrees, knocking away yet another prop for US equities – held aloft until now by non-US global earnings.

Yes, that is a risk.

Morgan Stanley has just added a “mild recession” alert for Japan (Buckle Up) on top of its “manufacturing recession risk” for the eurozone. It’s US call (`Recession Coming’), it is no longer hedged about with many ifs or buts. Americans face a “perfect storm” and CAPEX is buckling. Demand will shrink by 1pc a quarter for nine months.

The bank has cut its target MSCI emerging market equities by 6pc next year. I suspect that this will be cut a lot further as the plot thickens, but you have to start somewhere.

They have been bearish all year.

Merrill Lynch has much the same overall view. “The US consumer is on the precipice of its first recessionary phase since 1991. The earnings recession has already arrived.”

Maybe, but no evidence yet. Employment remains sufficient for the consumer to muddle through, and exports are picking up the slack.

“Real estate deflations are unique and have never ended well for the consumer, the credit market, or the economy. Maybe it will be different this time, but we fail to see why.”

The subtraction to aggregate demand due to real estate is maybe a year behind us and rising exports have filled the gap.

And this from a Goldman Sachs note entitled “Quantifying the Stock Market Impact of a Possible Recession.”

“Our team believes that there is about a 40pc to 45pc chance that the US will enter recession over the next six months. If a recession does occur, it has the potential to feed on itself,” said bank’s global markets strategist Peter Berezin.

Goldman just upped their Q4 GDP foregast by 1.5%, and it’s now at 1.8%.

“We expect home prices to decline 7% in 2007 and a further 7% in 2008. But if the US does fall into a recession, home prices could decline by as much 30% nationwide, which would make it the worst housing bust since at least the Great Depression.

“If global growth slows next year as we expect, cyclical stocks that so far have held up quite well may feel more pressure. It seems unlikely that the elevated earnings estimates for next year can be sustained,” he said.

Lots of ‘if’ and ‘we expect’ language, but no actual ‘channels’ to that end. No one seems to have any. Best I can determine if exports hold up, we muddle through.

Now, stocks can do well in a soft-landing (which Goldman Sachs still expects, on balance), since falling interest rates offset lost earnings. But if this does tip over into outright contraction, History is not kind.

Stocks are likely to adjust PE’s to higher interest rates now that expectations are moving toward lower odds of rate cutting due to inflation.

The average fall in S&P 500 over the last 9 recessions is 13pc from peak to trough. These include 1969 (18pc), 1981 (23pc) and 2001 (52pc).

Still up 5% for the year. And it has been an OK leading indicator as well for quite a while.

As for the canard that stocks are currently cheap at a projected P/E ratio of 15.3, this is based on an illusion. US profit margins are currently inflated by 250 basis points above their ten-year average.

Inflated? Seems a byproduct of productivity and related efficiencies. No telling how long that continues. And products changes so fast there is no time for ‘competitive forces’ to drive down prices to marginal revenue with many products; so, margins remain high.

While Goldman Sachs does not use the term, this is obviously a profits bubble. Super-cheap credit in early 2007 – the lowest spreads ever seen – flattered earnings.

Not sure it’s related to ‘cheap credit’ as much as productivity.

I would add too that free global capital flows have allowed corporations to engage in labour arbitrage, playing off cheap Asian wages against the US and European wages. This game is surely played out. Chinese wages are shooting up.

Yes, as above, and this is the global context Bernanke faces – import prices rising rather than falling.

Voters in industrial democracies will not allow capitalists to continue take an ever larger share of the pie. Hence Sarkozy, Hillary Clinton, and the Labour victory in Australia.

Not sure both sides are pro profits. That’s where the campaign funding is coming from and most voters are shareholders or otherwise profit directly and indirectly from corporate profits. Wage earners are a shrinking constituency with diminishing political influence.

Once you strip out this profits anomaly, Goldman Sachs says the P/E ratio is currently 26. This compares with a post-war average of 18, and a pre-recession average of 17.

As above. PE’s are more likely to adjust down near term due to valuation issues – rising interest rates and perception of risk.

“It is clear that if the US enters a recession, there is significant scope for both earnings and stock prices to decline beyond what the market has already priced. The average lag between peak and nadir in stock prices is only 4 months. This implies a swift correction in equity prices.”

Sure, but that’s a big ‘if’.

The spill-over would be a 20pc fall in the DAX (Frankfurt) and the CAC (Paris), 19pc fall on London’s FTSE 250, 13pc on the IBEX (Madrid), and 10pc on the MIB (Milan).

Doesn’t sound catastrophic.

Be advised, this is not a Goldman Sachs prediction: it is merely a warning, should the economy tip over.

Yes, but without a direct reason for a recession, nor a definition of a recession, for that matter.

Now, whatever happens to US, British, French, Spanish, Italian, and Greek house prices, and whatever happens to the Shanghai stock bubble or to Latin American bonds, the Fed and fellow central banks can – and ultimately will – come to the rescue with full-throttle reflation.

Wrong, the fed doesn’t have that button. Lower interest rates maybe, if they dare to do that with the current inflation risks of the triple supply shock of crude, food, and the lower $US.

But as shown with Japan, low rates do not add aggregate demand as assumed.

Merrill says the Fed may cut rates to 2pc. (rates were 1pc in 2003 and 2004). Let me go a step further. It would not surprise me if debt deflation in the Anglo-Saxon countries proves so serious that we reach Japanese extremes – perhaps zero rates, with a dollop of ‘quantitative easing’ for good measure.

Right, and with the same consequences – those moves have nothing to do with aggregate demand.

The Club Med states may need the same, but they will not get it because they no longer control their monetary policy. So Heaven help them and their democracies.

True, the systemic risk is in the Eurozone. Not sure he knows why.

The central banks are not magicians, of course. We forget now that Keynes and his allies in the early 1930s knew that monetary policy ‘a l’outrance’ could be used to flood the system by buying bonds. They concluded that such a policy might backfire – possibly causing panic – since investors were not ready for revolutionary methods.

Keynes was right but was talking in the context of the gold standard of the time. Not directly applicable today without ‘adjustments’ to current floating fx regimes.

This at least has changed. The markets expect a bail-out, demand it, and believe religiously in its benign effects.

Ben Bernanke said in his 2002 ‘helicopter’ speech that there was practically no limit to what sorts of assets the Fed could buy in order to inject money.

No limits, but big differences to aggregate demand. Buying securities has no effect on demand, while buying real goods and services has an immediate effect, also as Keynes and others have pointed out many times.

The bank’s current mandate does not allow it to buy equities, but that could be changed easily enough.

Yes. Won’t support demand, but will support equity prices.

So yes, in the end, the Fed can always stop a deflationary spiral.

Yes, but more precisely, the tsy, as they can buy goods and services without nominal limit and support demand at any level they desire. The ‘risks’ are ‘inflation’ not solvency. (See ‘Soft Currency Economics‘.)

As Bernanke said to Milton Freidman on his 90th birthday, the Fed will not repeat the monetary crunch it allowed to happen 1930-32.

That was in the context of the gold standard of the day. Not applicable currently.

“Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”

Thanks to floating the $, it hasn’t happened since.

Bernanke is undoubtedly right. The Fed won’t do it again. But before the United States can embark on an economic course that radically transforms the nature of capitalism, speculative markets may have to take a beating – for appearances sake, at least.


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