It’s now looking like the global economy has some positive momentum and could continue to surprise to the upside. But that doesn’t mean the world is now without risks. Although the news has been overwhelmingly positive in the last 4 months the economy still faces headwinds. The good news is there are signs of global economic strength. The bad news is the global economy continues to experience imbalances that threaten the sustainability of the recovery. With that said, let’s start with the bad news:
PCE – consumer spending has seen a sharp uptick in recent months, however, a long-term perspective shows that the US consumer remains weak. Personal consumption expenditures outside of food and energy are at all-time lows. This has resulted in a record output gap and creates the risk that growth in the coming years will remain far too low to help overcome the enormous lack of job’s growth. This is further confirmation of the disinflationary environment in which we exist and reveals unprecedented weakness in the US consumer:
Oil prices – A $15 rise in oil has the potential to shave 1% from US GDP. While the global economy continues to grow the energy shortage becomes an increasing problem. Goldman Sachs is projecting $105 oil in 2012, but rising inflation in China and an eternally easy Fed has the potential to create an environment similar to 2008 in which oil prices soar in the coming years and economic growth gets choked off once again revealing a very weak developed world consumer.
Sentiment – Sentiment has made a remarkable comeback in recent months. While confidence is a vital component of any sustained bull market it’s important that investors not get too euphoric. Such sentiment readings increase the risks of an unhealthy level of optimism. Near-term sentiment is wildly optimistic. While this is not confirmed by longer-term sentiment readings (such as my Wall of Worry) it’s important that any sustained bull market remain tempered by a heavy dose of skepticism. Current short-term readings are indicative of an unhealthy level of optimism:
Home prices – Home values are in the process of double dipping in the United States and appear vulnerable in several regions throughout the world. As the largest component of the US consumer’s balance sheet a housing double dip has the potential to put severe strains on the economy. While I don’t believe there is substantial downside to national home prices there is very real risk that rising rates, continued de-leveraging and supply problems continue to put negative pressure on prices. An overshoot to the downside cannot be entirely dismissed and the problems in Australia, the UK, Europe, Canada and China should be closely monitored.
China’s Inflation – There is, in my opinion, no greater risk to the global economy than the imbalances that are occurring in the Chinese economy. Global growth has become uncomfortably dependent on China. Unfortunately, their central bankers have been primarily educated with the same western world textbooks that helped contribute to many of the problems in the developed world. The major risk here is that China will fail to act in a proactive manner and risk a hard landing. With a tepid recovery in the developed world this would certainly cause a ripple effect around the world. Inflation in China is not currently at the levels we experienced in 2007/2008, but the Chinese would be wise to get a handle on the issue before it causes more pronounced problems (chart via Trading Economics):
And now for the good news:
Labor market – Recent trends in the labor market are pointing to jobs growth in 2011. We have seen sharp declines in jobless claims, increased job openings and an increase in corporate revenues. This single digit revenue growth should reduce the slack in the economy and help corporations leverage their operations up in order to capitalize on increased aggregate demand.
Corporate profits – Through global diversification and remarkable balance sheet management US corporations have barely lost a step during the great recession. Ultimately, this is the single most important bullish component of the current economic environment. Profits are at all-time highs and will give corporations flexibility in managing the uneven recovery. This has the potential to snowball as corporations spend, invest and ultimately contribute increasingly to the recovery :
Consumer credit – Although consumer debt levels remain extremely high and the balance sheet recession persists there are signs that consumers have slowed the pace of de-leveraging. While a re-leveraged US consumer is likely a long-term negative it will help contribute to near-term economic growth:
No austerity – My greatest concern throughout 2010 was that the US government would make the mistake of attempting to balance the budget. This was the classic Japan scenario or 1937 scenario where the government stopped spending and tipped the economy back into recession during a balance sheet recession. As I showed the other day in the sectoral balances analysis it’s impossible for the private sector and public sector to de-leverage at the same time without resulting in a shrinking economy. During a balance sheet recession this has the potential to cause substantial and sustained economic damage. The current budget deficit of $1.3T is a clear sign that the US government will continue to aid a weak private sector. With extremely low levels of inflation and no risk of insolvency this is absolutely a positive development for the US economy. We are not becoming Greece. The second great depression that so many have worried about (and that I said was never a real risk) can almost certainly be eliminated from commentary.
Expectations – As I have discussed every earnings season since early 2009 there has been and remains a disconnect between the strength of corporate earnings and Wall Street’s expectations. My expectation ratio measures the strength of corporate profits compared to a broad set of expectations. This dynamic, forward looking and intuitive indicator continues to show an environment that is unappreciated by Wall Street.
The icing on the cake for the bulls AND the bears is the Fed. This bonus chart shows the current Fed Funds Futures. As you can see the market is not expecting a rate increase in 2011. The Fed is at zero for the foreseeable future and that has the potential to be very bullish and both very bearish. In the near-term the Bernanke put is a sign that the Fed will remain very accommodative even if it involves talking up various markets in a misguided attempt to induce confidence in the markets. In the long-term, however, this is merely a continuation of the flawed policies of Alan Greenspan and is one more sign that the US economy remains dominated by misguided monetary policy and flawed economic strategies (chart via Global View):
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