That is most assuredly one of the most heavily used cliches in the history of the English language but a failure to understand it apparently causes Citi’s economics team to get it wrong when it comes to forecasting the depth and trajectory of recessions.
In a new note, the bank looks at what happens when mean reversion fails, pushing a struggling economy even further into the abyss. Here’s a list of some of the mean reverting forces that help economies to correct and pull themselves out of trouble:
“Both economic theory and practice establish that business cycles are self correcting. Of course, policies can help engineer a quicker recovery (and even altogether prevent a recession) but most economies and markets, under normal circumstances, eventually return toward mean growth. High unemployment puts pressure on wages which, in turn, reduce labor costs and eventually increase the demand for workers. Sustained low investment ultimately results in a low capital stock, which increases the return to capital, eventually driving up investment. Weak growth typically results in real exchange rate depreciations, which eventually increase net exports and aggregate demand. These are some of the mean-reverting forces that ensure that a market economy will normally go through a business cycle, but that it will seldom face an economic depression.”
But an overreliance on the assumption that these forces will everywhere and always lead economies out of the recessionary doldrums has apparently caused Citi to be “too optimistic” in their forecasts on EM growth - and that’s putting it nicely:
In an effort to figure out why their forecasts have consistently missed the mark as multiple EMs head toward severe corrections, Citi took a look at 55 recession episodes in emerging markets during the last few decades and discovered a funny thing: when things are going bad they tend to get worse, not better:
A first test of the nonlinearity hypothesis for recessions consists of estimating the probability of an additional decrease in output of, say, 2% or 4%, given the accumulated fall in output since the previous peak. Under the mean-reversion framework, this probability should decrease the bigger the cumulative fall is. Our estimates show that this is not the case. Once the cumulative decrease in output surpasses certain thresholds, the slope of the curves becomes positive. The Ushaped curve illustrates that the probability that output falls further bottoms out and eventually increases. As the output fall grows large, nonlinearities emerge, increasing the probability of another negative growth year.
As shown below in Figure 2, the probability activity falls an additional 2pp is decreasing for moderate declines in output, reaching a (local) low after an accumulated drop of around 4.5%. For instance, after activity has fallen 6%, the Ushaped probability curve suggests that an additional 2pp contraction has a 67% probability. In the case of the probability of an additional 4pp drop, the curve reaches a low at around 6%, increasing after that. In the case of “very deep” recessions (accumulated falls in output between 9 and 10%), both curves are upward sloping. This suggests that, eventually, after a certain threshold is exceeded, activity is likely to further contract quite meaningfully, i.e., the probability activity falls by an additional 4pp after a 10% depression-like contraction is no smaller than in the initial phase of a recession.
Now to someone without a PhD in economics this would have been obvious, but as anyone who's ever done any academic research knows, the "very serious" people spend quite a bit of their time discovering things that largely belong in the realm of common sense.
A slavish adherence to the notion of predictable business cycles has led professional economists astray on any number of occasions and indeed, the entire thesis behind the machinations central banks are currently going through rests on the notion that these cycles can be smoothed and manipulated. Far from being able to successfully tinker with them, it would appear economists don't understand them at all.
* * *
Below, find Citi's take on what the above means for Brazil, the poster child for EM malaise.
Take for instance the case of Brazil. When we use quarterly GDP data (available up to 3Q15), activity has shrank 5.8% from the peak. Thus, the country currently sits in the area where the blue line in Figure 2 has a positive slope. This means that the more output falls from this point (at the margin), the more likely it will contract by (at least) an additional 2pp. In other words, Brazil seems to have entered a stage where negative spillovers could offset mean-reverting forces. Given the preliminary Q4 data available, it seems that growth has remained negative. This could conceivably place Brazil beyond the trough of the light blue curve, indicating that even a 4% further contraction may be increasingly likely. In sum, this first exercise suggests that in Brazil, the accumulated fall in output may already be enough to trigger negative spillovers and nonlinearities.
PMI Plunges - The Last Time US Manufacturing Was This Weak, Bernanke Hinted At QE3
On the heels of weakness in the rest of the world's PMIs, US Manufacturing just printed 51.0 (missing expectations of 52.4) and tumbling to its lowest since October 2012... followed rapidly by Bernanke hinting at QE3. While Markit does 'blame the extreme weather', it notes however that "every indicator from the flash PMI survey, from output, order books and exports to employment, inventories and prices, is flashing a warning light about the health of the manufacturing economy."
“US factories are reporting the worst business conditions for over three years. Every indicator from the flash PMI survey, from output, order books and exports to employment, inventories and prices, is flashing a warning light about the health of the manufacturing economy.
“Output and order books are growing at one of their slowest rates since late-2012, with exports falling amid weakened global demand and the strong dollar. Hiring has weakened as a result. With backlogs of work slumping to the greatest extent since the height of the recession in 2009 and inventories rising for the third successive month, it’s likely that firms will come under increasing pressure to cut payroll numbers and production in coming months unless demand revives.
“Prices are meanwhile falling at the fastest rate since mid-2012 as firms compete to win or retain customers.
“The one caveat is that the survey was conducted in a month in which parts of the US suffered extreme weather. However, few survey respondents reported that the weather had a material impact on business over the month, instead often simply observing a general slowdown in trade and the economy.”
And with Services now tumbling also, what excuse will the permabulls have next...
Charts: Markit and Bloomberg
Has The German Manufacturing Juggernaut "Lost Its Mojo?"
Earlier today, we highlighted the noticeable weakness in European PMIs which largely missed expectations on - what else? - sluggish global demand and generally anemic economic growth.
Specifically, Germany’s PMI fell for the second month in a row in February, declining to 53.8 from 54.5 the previous month. Worryingly, the manufacturing PMI slumped 50.2, missing estimates by a wide margin and hitting its lowest level in 15 months.
Services looked ok, but as anyone who follows global macro knows, it’s all about manufacturing for the world’s fourth largest economy. The health of Germany’s manufacturing sector serves as a useful barometer not only for the health of the European economy for the pace of global growth and trade in general. Indeed, that’s one of the reasons why the Volkswagen emissions scandal was (and still is) so troubling. It has the potential to dent Germany’s manufacturing juggernaut.
In the wake of Monday’s data, Goldman is out asking if perhaps German manufacturing “has lost its mojo.”
“German real GDP grew a moderate 0.3%qoq in the fourth quarter of last year, and by 1.5% for the whole of 2015,” Goldman writes, adding that “part of the relative disappointment can be located in the manufacturing sector, which has shown a sub-par performance since 2011.”
What’s to blame, you ask? Why sluggish global growth of course:
The relative sluggishness of German manufacturing can be partly explained by slower global growth, which has resulted in weaker German export growth (Exhibit 2). In real terms, German exports have grown on average by only 3.5%pa over the past four years, compared with 8.8% in the four years prior to the financial crisis.
Using a model that explains German exports using global demand and Germany’s trade-weighted exchange rate, we find that German exports over the past two years have developed broadly as the model would have predicted. This suggest that it is indeed weaker global demand and not other, more fundamental changes in German manufacturing performance – such as a loss of international competitiveness – that lies behind weaker German exports.
Yes, "it is indeed" weaker global demand, a fact which underscores one of the key themes when it comes to assessing the state of the global economy. Depressed aggregate demand, anemic growth, and sluggish trade have become endemic. It's now a structural rather than a cyclical problem.
But everyone knows that by now (or at least they should). What puzzles Goldman is that manufacturing employment is on the rise and capacity utilization doesn't all that bad either.
So what gives? When in doubt, just say the numbers are wrong. "Together with the relative strength of the employment figures we see a possibility that the price-adjusted figures under-report the strength of the German manufacturing sector," Goldman posits.
Perhaps. But if the problem is subpar global growth, then analyzing the sub-components is futile. Either aggregate demand and trade pick up or the German economy sinks with everyone else. "Barring any sharp slowdown of the global economy, we would expect a continuation of the solid, though not spectacular, growth of the German economy," Goldman concludes.
About that whole "barring any sharp slowdown of the global economy" thing...
...note the red arrows...
TIPPING POINTS, STUDIES, THESIS, THEMES & SII
COVERAGE THIS WEEK PREVIOUSLY POSTED - (BELOW)
MOST CRITICAL TIPPING POINT ARTICLES THIS WEEK - Feb 21st, 2016 to Feb 27th, 2016
TIPPING POINTS - This Week - Normally a Tuesday Focus
RISK REVERSAL - WOULD BE MARKED BY: Slowing Momentum, Weakening Earnings, Falling Estimates
JAPAN - DEBT DEFLATION
EU BANKING CRISIS
MACRO News Items of Importance - This Week
GLOBAL MACRO REPORTS & ANALYSIS
US ECONOMIC REPORTS & ANALYSIS
CENTRAL BANKING MONETARY POLICIES, ACTIONS & ACTIVITIES
Market Analytics - WEDNESDAY STUDIES
STUDIES - MACRO pdf
TECHNICALS & MARKET ANALYTICS
COMMODITY CORNER - AGRI-COMPLEX
THESIS - Mondays Posts on Financial Repression & Posts on Thursday as Key Updates Occur
Dr. Marc Faber joins FRA Co-founder Gordon T. Long in an exciting discussion of monetary malpractice, negative interest rates, the influence of current geopolitical risk and much more. Dr Marc Faber was born in Zurich, Switzerland. He went to school in Geneva and Zurich and finished high school with the Matura. He studied Economics at the University of Zurich and, at the age of 24, obtained a PhD in Economics.
Between 1970 and 1978, Dr Faber worked for White Weld & Company Limited in New York, Zurich and Hong Kong. Since 1973, he has lived in Hong Kong. From 1978 to February 1990, he was the Managing Director of Drexel Burnham Lambert (HK) Ltd. In June 1990, he set up his own business, MARC FABER LIMITED which acts as an investment advisor and fund manager.
Dr Faber publishes a widely read monthly investment newsletter “The Gloom Boom & Doom Report” report which highlights unusual investment opportunities, and is the author of several books including “ TOMORROW’S GOLD – Asia’s Age of Discovery” which was first published in 2002 and highlights future investment opportunities around the world. “ TOMORROW’S GOLD ” was for several weeks on Amazon’s best seller list and is being translated into Japanese, Chinese, Korean, Thai and German. Dr. Faber is also a regular contributor to several leading financial publications around the world. A regular speaker at various investment seminars, Dr Faber is well known for his “contrarian” investment approach. He is also associated with a variety of funds and is a member of the Board of Directors of numerous companies.
JAPANESE NEGATIVE INTEREST RATES AND THEIR GLOBAL IMPLICATIONS
“It’s an experiment by few mad professors that occupy senior positions in central banks.”
Over the last 5000 years of recorded human history, interest rates have never been as low as they are now. The time value of money is the natural state. It is the markets way of pricing today’s money and the future’s money. The higher the uncertainty of future money is, the higher the rate of interest will be. What central banks are doing at the present is incomprehensible to me, unless it means an expropriation of money.
The central banks in their madness believe this will result in economic growth. But in reality it will force people to become insecure. For example if you received 6% on your money, and then rates become zero and in this case become negative which in other words you’re being penalized for your deposit. Does that rate make you save more or spend more? One thing I will never understand is despite us having democracies, somewhere, somehow, the system has given so much power to a bunch of well understood, unelected academics and most of them have never worked for the private sector for a day. The Fed, Bank of Japan, ECB are all likeminded people; they all believe money printing boosts economic activity and tight money is negative.
“They will bankrupt the world.”
We do not know how badly it will end, but an interesting thing to note is if you look at the 2008 financial crisis, which sector got the most bailout money? It was the banks and the fund managers. Then you look at the performance of their stocks, it is a disaster. Bailout money and money printing doesn’t help at all. In fact it has made matters worse for the average American. I side with Americans who support Bernie Sanders because he is expressing the views of ordinary people that the Wall Street guys and the banking lunatics have essentially cheated the people.
“In every instance where they have negative interest rates, the exact opposite of the objective occurs.”
This view of central banks to distort the free market and capitalist system is a view of the paternalist; some people that think they know better. They think they can steer the economy like how you would drive a car.
FED RAISING RATES
“As a working man it is hard to believe the world has handed so much power to a bunch of ignorant and arrogant people.”
Firstly Janet Yellen was the president of the San Francisco Federal Reserve which is in charge of California, Arizona, Nevada and another state. In her district we had the biggest real estate bubbles ever. Now she is the Fed chairman and slashed interest rates. We have had eight years of zero interest rates, and now she increases it by a quarter of a percent which is meaningless. She should have increased rates when there was a strong recovery in 2010 and 2011 but she waited. She waited right until the world is entering a very deep recession. She will go down and have a front portrait in a museum as a central bank failure.
IMPLICATIONS OF MONETARY MALPRACTICE
“There are reasons to believe that central banks will go bust.”
Systemically I think they have allowed the debt level to expand, particularly they have allowed government credit to expand as a percentage of the economy. You have to understand that when you try to supress individual risks in a system, eventually you end up with systemic risk. We will eventually have a huge crisis and investor will not know how to deal with it.
People like Bernie Sanders are not blaming the Fed, they are blaming Wall Street. In other words they are blaming rich people for the hardship or ordinary people. The Fed essentially threw money at Wall Street and naturally they kept it for themselves. Yes, there is a trickle-down effect which makes them give their waiter a slightly larger tip; it is insignificant.
ISSUES OF CURRENT GEOPOLITICAL RISK
“Everything the US touched in the Middle East and Central Asia, from Afghanistan to Iraq, Syria, Egypt and Lebanon, it all turned into a complete disaster.”
The Neocons had this brilliant idea to start making trouble in Ukraine, not understanding it is Russian territory and historically until the early 20th century Ukraine was part of Russia. Also not understanding that Crimea is of huge strategic importance to Russia, just like what California is to the US. Russia will never give up Crimea, I can promise you that. This is because it is a warm water port and they need it to have the access to the Mediterranean, without it they are at the mercy of America.
The Europeans are equally as incompetent. Angela Merkel just follows the US without understanding she is hurting the business interest of Germany. Russia and Germany were historically, culturally and politically very close. The interventions are very poorly thought out.
In the case of China, it is the second largest economy in the world with a population of 1.3 billion people. It is a highly advanced economy, especially in defense technology. A pivot to Asia by the US is seen by the Chinese as an aggression. It is a threat to the sovereignty and security of China which has created another set of geopolitical tensions.
FEAR OF A COLLAPSING PETRODOLLAR
Under Mr. Greenspan the central bank enjoyed a lot of prestige. He had done better than his predecessors; his only major mistake was deliberately creating the NASDAQ bubble.
“However, Bernanke and Yellen are complete chaos. I don’t actually believe that they make the decisions; they are told by someone what they should do.”
It is difficult to tell what people think but if you look into the Japanese negative interest rates, the intention was to weaken the Yen. Not that the weak currency helps anyone, but by slashing interest rates and having them below zero 10yr Japanese bond will cause you to lose money unless the Yen appreciates. The idea was to have negative interest rates cause the Yen weaken but it actually strengthened.
INVESTMENT OPPORTUNITIES IN ASIA
The area of Indochina is a boomtown. Not Thailand but Cambodia exports are rising at about 20%/annum. Vietnam has huge inflow of foreign direct investment, partly because the Taiwanese, Koreans and Japanese can invest in Vietnam and produce goods there.
There are a lot of investments coming from China and South East Asia. The US is afraid of China gaining too much influence in that part of the world so they waste money there by trying to displace the Chinese. The Chinese will go to Cambodian government and say they are going to make a road or a bridge and in 6 months it will be built. Whereas the US will send a team of useless characters to go check out the scenery then come back in 3 months to check out more scenery and 5 years later nothing will have been done. All the while in this time the Chinese will have built roads, bridges, tunnels and all kinds of infrastructure.
ADVICE FOR INVESTORS
“My advice is to have a diversified portfolio. You have to have some equities, some bonds, real estate and precious metals.”
In my view it will not end well. This era of artificially low and market distorting interest rate structure will end terribly. There is a popular notion now of ‘sell everything’ but this is a flawed idea. You sell everything and you have all this money now, what will you do? Deposit it in banks? What happens when the bank goes bankrupt? In practise it is very dangerous to have all your money with one bank.
Gordon T Long is not a registered advisor and does not give investment advice. His comments are an expression of opinion only and should not be construed in any manner whatsoever as recommendations to buy or sell a stock, option, future, bond, commodity or any other financial instrument at any time. Of course, he recommends that you consult with a qualified investment advisor, one licensed by appropriate regulatory agencies in your legal jurisdiction, before making any investment decisions, and barring that, we encourage you confirm the facts on your own before making important investment commitments.
THE CONTENT OF ALL MATERIALS: SLIDE PRESENTATION AND THEIR ACCOMPANYING RECORDED AUDIO DISCUSSIONS, VIDEO PRESENTATIONS, NARRATED SLIDE PRESENTATIONS AND WEBZINES (hereinafter "The Media") ARE INTENDED FOR EDUCATIONAL PURPOSES ONLY.
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