Stern Value Management's 2014 Economic Forecast

2014 Economic Forecast


There are three rules in economics that need to be explained before an economic forecast can be justified.  But before these rules are established, it is a pleasure to report that the extremely long economic malaise that began in 2007, and reached its peak with a deep recession in 2008 into 2009, appears to be over.

This leads us to the first rule.  It is so important that I would establish it as the most important observation that can be made when looking at macroeconomics, a study of how the economy as a whole functions in each of its major sectors.  The observation is: THE FASTER THE ECONOMY FALLS, THE FASTER IT RECOVERS.  The corollary is also true: A MILD RECESSION IS FOLLOWED BY AN EXTREMELY MILD RECOVERY.

The best examples can be found even during the 1930s depression, when economic activity literally collapsed, but there were a number of big recoveries that occurred but were snuffed out by bad government policy.

In 1957-58 a deep recession was followed by an extremely rapid recovery.  When Ronald Reagan became President in 1981, he and his central banker, Paul Volcker, engineered a deep recession to break the back of inflationary expectations.  President Reagan inherited long-term expected inflation of 12% a year and 30-year government bonds that were yielding over 15%.  However, Reagan and Volcker indeed were successful, but it took a deep and wide recession to accomplish that objective.  The recession lasted almost 20 months, with a huge decline that was broad-based.  In fact, in the industrial heartland of the U.S. the unemployment rate reached 16%, if one draws a line east and west from Detroit of 200 miles on each side and heads straight south to the Gulf of Mexico.  However, there too, the recovery was extremely rapid and the unemployment rate came down very sharply.

The mild recession of 1990-91 probably cost George H.W. Bush his reelection.  It was simply impossible to tell that the recession was over because the unemployment rate continued rising even as the economy was recovering from its decline.  The same happened in 2001 when an extremely mild recession began and ended within 8 months.  It was hard to tell that the recession had come, and even more difficult to tell that it had gone.

This brings us to the Great Recession of 2008-09, but unfortunately as an enormous exception to this rule.  In fact, the economy at the beginning of the recession was falling at an annual rate of 7%, but the recovery has been tepid.  The average annual growth rate since the bottom has only been about 2% a year, with some years significantly less, and 2013 at just about 1.9%.  Furthermore, $1.7 trillion in GDP has been lost permanently as a result of this tepid recovery.

How can one account for all of this, especially what has taken place in the last 4 years?  The answer is that government policies have actively attacked the free market system that has been the hallmark and source of economic growth in the U.S. for the past 225 years.

My teacher, the late Milton Friedman, often used to remark that the U.S. would still be an under-developed country had the activism of the social theorists dominated the U.S. in the 19th century.

Furthermore, contrary to popular opinion amongst Keynesian economists, government spending does not lead to the so-called Keynesian multiplier at all.  The distinguished Harvard economist, Robert Barro, estimates the Keynesian multiplier at only 0.8, which means that every dollar of government spending costs the U.S. economy 20ȼ in growth.  In addition, the Administration in Washington has been re-regulating the economy to such an extent that it has become almost impossible for businessmen to estimate the after-tax rates of return on investments to be made, especially when the returns are expected to be generated over the next 10 to 20 years.

Not only has the Keynesian theory been tested in the last 4 years and found wanting, but the same can also be said for Milton Friedman’s view, that rapid rates of growth in the money supply will accelerate economic growth in the short-run and then provide for a rebirth of significant inflation in the intermediate and long term.  By almost any measure, the money supply has grown at least 15 to 20 times faster than it should have in order to get the economy back on its feet.  In addition, by now inflation should be running at between 6 and 8% inflation a year, if not more.  Yet, 30-year government bonds are yielding only 3.75%, which implies a long-term inflationary expectation of less than 1.5% a year.

Prof. Barro has made another very important observation that normally economic agents should be aware of, but that the Administration in Washington should keep front and center whenever they think about macroeconomics: the extension of unemployment benefits during the Obama Administration from an initial period of 26 weeks to 99 weeks has encouraged the unemployed to take a wait-and-see attitude regarding taking available opportunities for employment.  Put another way, the government is essentially encouraging idleness.  Prof. Barro estimates that the unemployment rate today could be as much as 2 full percentage points less than the officially reported number of 6.7%, even though that number also is tainted by the fact that an enormous fraction of the employment force have voluntary dropped out.  In fact, the unemployment rate has dropped from around 8% a year ago to under 7% now, but with more than half of the decline accounted for by people who have simply left the workforce and are no longer counted as unemployed.  They were so discouraged in attempting to seek employment that they simply dropped out.  Thus, the actual numbers we see month-to-month do not give us a clear picture of what is really happening.

The second major rule in economics is that government spending must be financed somehow, either by increasing taxes, borrowing money, or printing money.  If the first two occur, these actions completely offset the stimulus from government spending.  Printing money only leads to inflation.  Yet none of this has happened.

The third rule has to do with whether people believe that competitive markets are the pre-requisite for stable and strong economic growth, or the alternative, that free markets when left to themselves are both destabilizing and lead to “unfair” outcomes.  In Washington we are told by members of the Administration that they believe in free markets, but that is usually followed with the word BUT.  Take the Great Recession, for example.  Those who believe in a larger role for government certainly do not want to be blamed for the Great Recession, and yet they are to blame.  They have tried to blame it on bankers who took extraordinary risks that worked out poorly for them and for the economy, also blaming it on the incentive contracts they had that led to a gambling mentality with other people’s money.

Of course, this is a ridiculous statement, first, because many of the bankers who were to blame for this, according to Washington, had huge payoffs for themselves if successful.  That is, the cost of what was alleged to be the precursor to the Great Recession would certainly have led the bankers to take much lower risks in order to protect the value of their shares and share options, as well as their cash bonus contracts.

No, it is my belief that the Great Recession had its birth all the way back in 1993 when President Bill Clinton activated a law already put on the books by President Carter in the 1970s called The Community Reinvestment Act.  This law encouraged banks to lend money to unqualified borrowers with the promise that the mortgage loans thus made would be purchased by Fannie Mae and Freddie Mac, two government agencies.  If markets work the way I believe they do, the outcome would be the bankruptcy of both Fannie Mae and Freddie Mac, and a gigantic loss in wealth in the U.S. due to real estate speculation, not by the banks, but by individuals who were encouraged to take out mortgage loans that they had not a prayer of repaying.  The banks were even told to lend money with no equity deposits.  Furthermore, in many states individuals who borrow money through a mortgage are not accountable for those loans, since they can give the key to the house back to the bank that loaned them the money, making the borrower scot free.  This makes no sense at all.  It will encourage risk-taking by unqualified borrowers beyond anyone’s imagination.

So, why am I optimistic about 2014?  The reason is that although the Administration tried to slow down and even stop foreclosures, such foreclosures would have cleared the market of excess supply very quickly, but the failure to let markets function, even though mistakes had been made, caused the process to be delayed for several years.  It is only now that the supply of housing is reacting properly to market forces. What is the evidence?  Normal housing starts run at about 1.4 million a year, but at the bottom of the recession, and for a few years thereafter, housing starts did not rise above 400,000 a year.  This means that the housing industry was in a 70% slump.  Imagine what anybody’s business would look like if revenues fell by 70%.  It is amazing that home builders did not go out of business one after another.  That is one of the miracles of the Great Recession.  Now housing starts are running at 1.1 million a year, meaning that we are still down by more than 20% — but, this is nowhere near 70%.  Furthermore, in parts of the country other than Las Vegas, Florida and California, there is actually a housing boom going on, and this is all to the good.  In addition, businesses cut back on capital expenditures for almost 5 years and thus now need to play catch up, so business investment in 2014 will be quite strong indeed.

The only question that remains is: what will the consumer do?  The answer is in the rate of growth in personal income, which for the last several years has been running at very poor levels, and only in the last 7 or 8 months rebounded significantly.  Unfortunately it was too late to show up in Christmas sales in retail establishments, although some of their sales are under-reported because so much of new sales are now taking place on the Internet.  After all, if you do not pay sales tax on the Internet, that is like having an 8% or so decline in the selling price of the products.

One more issue is the state of government spending.  The good news is that government spending has been cut back very sharply by the falling tax revenues across the country both at the federal and state levels.  This is all to the good, at least for the long-term prospects of the U.S. economy.  Unfortunately, when the economy begins to improve much more rapidly in the coming months, there will be the temptation by government leaders to rehire and grow government just as we made the mistake the last time around.

Now, for the numbers: Real GDP, adjusted for inflation, will grow at between 3.7% and 4.25% in 2014.  This also means that interest rates will rise, but not because of higher inflation.  Rising real interest rates is a good thing, because it is a sign that the rate of return on capital employed by businesses is rising, and it is an outstanding signal to the rest of the world that it is time for them to begin investing in the U.S.  I also believe that corporate profits will grow by between 12 and 15% in 2014.  Real interest rates will rise to at least 3%, so that long-term government bonds — 30-year bonds — will rise from 3.75% now, to over 5%.  The worry about inflation will be something that will concern us beginning in the second half of 2014.  I do not see how our country can avoid a resurgence in inflation given the explosion of the monetary aggregates.  If the banks that have been carrying gigantic excess reserves from this monetary explosion ever lend those reserves out, too much money will be chasing too few goods and the inflation rate could very well rise to between 6 and 7% a year, and government bonds could begin to yield as much as 10% or more.  For 2014, I am forecasting a Consumer Price Index (CPI) inflation number of 2.8%, and the Implicit Price Deflator — which measures inflation across the entire economy, not just at a consumer level — at 3%.  In short, we will see inflation begin to rise dramatically at the wholesale level rather than the retail level initially.  This would be a repeat of the mistakes of the 1970s, and a terrible legacy for President Obama.

I also believe that the value of the Euro will rise above $1.40, which will once again hurt the weak countries in the Euro Zone.  Greece would have been far better off dropping out so that their own currency would have fallen by about 50%.  This would have meant taking the medicine necessary immediately, potentially providing an impetus for a huge growth in tourism that would have had the economy operating in a very strong position.  Instead the country is entering the fifth year of negative economic growth of 7% or more.  It is a terrible situation.

The final comment is about the rest of the world.  The policies being followed in Argentina have caused capital flight.  Brazil, too, is experiencing its usual very high volatility of boom and bust.  Not a pleasant situation.  Colombia, Mexico, and Guatemala remain stable and strong.

Southeast Asia is going to experience a transformation as well.  There is no possible way that the growth in past years of 11% a year in China can continue.  The best China can hope for is something between 6 and 8% a year, no better than India.  However, the risks in China are much, much greater than people realize.  The British did some pretty awful things in India, but one of the good things they left behind was a judicial system that honors contracts and, especially, intellectual property rights.  I see India growing at between 7 and 9% a year for years to come, and that on a risk-adjusted basis they will be growing at at least twice the pace of China.  This means that the economies in Southeast Asia will have to make some serious adjustments.  Australia, too, will experience a tremendous slow down from their past experience in dealing with China, and this is already reflected in the huge decline of their currency to only 88ȼ from $1.09.

One more interesting thing about competitive markets, a belief in free markets in general, is that markets send out signals that are unambiguous, telling businessmen when and where to invest and what to avoid.  2014 will be a year of significant economic recovery, and we will all be pleased that at long last it has come.

Lastly, one should always explore the possibilities of what can go wrong.  It is only fair to let our friends know about the downside risk involved here.  We must keep in mind that the Great Recession ended in 2009, which means we are almost about to begin the fifth year of economic expansion.  This means that although the economic expansion has been extremely weak, still it is long in the tooth.  Economic expansions have not averaged longer than between 5 and 6 years in the U.S.  Some have been very long, such as the one when Ronald Reagan was President.  The expansion began in 1982 and lasted until the middle of 1991.  That one was certainly a length taking it to old age.  George W. Bush had the pleasure of the expansion beginning in 2001 and lasting until 2008, also extremely long by historical standards.  In short, it would not be unusual for a recession to begin not later than 2015.  Furthermore, the state of affairs in Asia could cause dislocations that would lead to a recession, albeit a short and shallow one, and although the European zone seems to be on the mend, its continued weakness could also represent a tipping point.  I place the odds of these negative possibilities at only about 1-in-4, so I am optimistic about 2014.

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