Keynes’ theory of recovery – a lesson forgotton

John Maynard Keynes lived from the later 19th century until the 1940s. He saw a world that developed right before his eyes. He was a major economic voice during the period immediately after World War I and developed his General Theory of Employment, Interest and Money as he watched the economies of Europe fall into depression in the 1920s. Keynes’ theory was all about demand management (our economist friends will get us for that one). As Keynes saw the world, you could pretty much count on producers producing stuff in the hopes of getting rich. The issues surrounding the post-World War I world were all about demand rather than production. Simplistically, Keynes theorized that when private demand for stuff failed, public demand for stuff should step up and fill that gap. If we were producing too much steel, the government should buy steel so the steel mills will keep operating. If we were producing too much food, the government should buy the excess food to maintain prices. You probably see where this is going. Keynes described the world where we all now live with the government as a major economic actor.

Keynes spent a lot of chapters talking about how government should support aggregate demand. He writes about how to pay for it with massive deficits if necessary. He writes about the inflationary effects of these policies. He even writes about how when times are good, the government sector ought to lean against the wind and pay down some of its debts by increasing taxes, stopping payments for steel or crop support programs, cutting social spending, etc. to manage the excess demand at the top of economic cycles. It seems politicians then and now never bothered to read those chapters or at least never saw the need to implement them.

Fast forward to the 1970s when Keynes’ theories had been embraced by just about every government in the developed world (even Nixon said “we are all Keynesians now”) and exceeded by many of them that flirted with socialism (subject for another rant someday). Margaret Thatcher in Britain, Keynes’ home, tried to undo some of the worst of the damage from 50 years of Keynesianism including 25 years of socialist (Labour) policies. She succeeded to a certain degree. Ronald Reagan did some of the same things in the US, but the US never approached Britain’s level of public involvement in the economy. After this brief counter-trend move in fiscal policies, the developed world has pretty much gotten back on the Keynesian path.

This is one major factor that led to the PIIGS (Portugal, Italy, Ireland, Greece, and Spain). Government involvement in the economy, first to sustain demand, then to increase employment, then to support vital industries, then to develop new industries, all add up to a huge public share of the economy. Keynes must be rolling in his grave to think what these politicians have done to his demand management theories. Each of the PIIGS has flirted with socialism to one degree or another. So, maybe what we see isn’t really Keynes’ fault as much as it is the fault of socialist economic ideals. But, Keynes made it alright for governments in essentially capitalist economies to dabble in the economy more than they did before. This was a half-way house on the road to socialism.

We wonder today if maybe Keynesianism is dying. The solution for each of the PIIGS to fix the trouble they have created is to get the public sector out of some of the areas where they now operate, to cut welfare, to cut public payrolls, to cut public benefits. Maybe a dose of supply-side economics (which, if you think about it, makes sense as Keynes pushed demand-side economics) is what these countries need. Where is the Italian Maggie Thatcher? Where is the Spanish Ronald Reagan? Where is the Greek Art Laffer?

Crisis of the Week

The crisis we speak to this week isn’t really about last week, though we had crises enough last week, mostly retread crises and then the Israeli shoot-out in the Mediterranean Sea. The biggest crisis we face is one of perspective. For the last several weeks, the markets have been looking in the rear-view mirror and taking direction from where we have been, not where we’re going. Maybe that makes some sense since we’ve been going mostly backward over that time. But, looking backward only makes sense when you are trying to see where you have been, not where you are going. For that, we have to look forward.

Markets generally are forward-looking entities. The basic idea is to find trends that will persist so we can ride those trends to gains or to avoid losses. We haven’t been doing much of that recently. (And yes, this is another rant about ‘stock market’ people versus ‘market of stocks’ people.)

So what are the big trends? One big one is the reversal from economic contraction to expansion. That one is going on in most of the developed world to one degree or another. Here in the US, the signs are all around us. Production is up, consumption is up, incomes are up, employment has started to turn up. We are having a cyclical recovery, period. Japan is also seeing some modest signs that their moribund economy is starting to recover cyclically. The Japanese have a severe problem with secular decay in the strength of their economy. They are faced with a declining workforce. That is not good for their outlook over the next twenty or thirty years. But, it won’t limit their ability to start growing again in the next eighteen months.

Europe, which has been in the news a lot lately, has a similar problem to Japan with a population that isn’t growing and a workforce that will grow only grudgingly in the next twenty years. But, the argument that Europe can’t grow is specious. Europe will grow, some of the PIIGS economies won’t grow very much or at all due to the fiscal policy restraint they will endure as a quid pro quo for the financial aid they are receiving under the liquidity and stability pacts that are saving their economies from collapse. So, the northern tier of European nations aren’t doing all that badly. Germany is growing, albeit slowly. The Dutch, French, Belgians, Swedes, Austrians, Czechs and Swiss are doing okay. Those economies tend to be richer than the southern European ones and also are more export oriented. The southerners, Italy, Spain, Portugal, Greece aren’t in very good shape at all, though Italy is supposed to grow modestly this year. Eastern Europe (excluding Russia) is a hodge podge of trends but doesn’t matter to our discussion because they aren’t big actors on the global stage and don’t have huge debts they can’t rollover. The British Isles, are supposed to improve modestly on balance. Ireland, the northern PIIG, should see some economic improvement this year as they’ve been doing the austerity thing for over a year already.

So, that leaves the emerging world. Most of the emerging markets are doing fine. China is having to restrain its growth as the pace of growth has gotten scary over there and there are property bubbles emerging. Brazil is going very well with low inflation (for them) and stable growth after barely dipping last year. India is recovering from its own mini-recession last year and will see very good growth. Russia is a different story as they have a huge export sector trying to offset their domestic economy, which is a shambles. Most other emerging markets are getting better.

So, you don’t have to buy Greek bonds or stocks, Spanish stocks or bonds, Hungarian anything. You can buy assets in markets that are benefitting from improving economies. You can buy assets in the US, where things are getting better. You can buy assets in Asia, where things are getting better. You can by assets in Latin America, where things are getting better. You don’t have to buy assets in southern Europe. The prices of the assets in different parts of the globe will change to reflect the different outlooks. Prices will fall in places where the outlook isn’t rosy until those areas are bargains. Prices ought to rise in areas with a rosy outlook until those areas aren’t bargains any more. That’s the way these things work.

We suspect that once we tire of headlines about the PIIGS, we will look around and see some of these much better trends and decide to play those instead. That should be good for US stocks, French stocks, Japanese stocks, emerging market stocks, all sorts of credit markets and bad for Treasuries, gold and cash. But, strangely it won’t likely be all that bad for the purveyors of bad news. The same people who brought us the End-of-the-World Part 31 will still be out there looking for the End-of-the-World Part 32. And it will come soon enough. You’d think that we’d figure out that none of these disasters ever really mean the end of the world, but we still seem to want something to worry about.

Economic News

Existing home sales were great, compared to the last couple of years. But, they left a lot to be desired when compared to longer-term trends. The pace of 5.77 million homes in April was the best level we have seen since 2007, but is only about one-third the levels we experienced at the height of the real estate bubble, and half the pace we saw over a decade ago. And that is as the most recent version of the home-buyer incentives were about to expire at the end of April. The recent data on affordability seems to argue that most folks either don’t want to move, can’t afford to move, or can’t afford to dump their present house to buy a better one. We are somewhat more pessimistic on the affordability issue. Though monthly payments are helped by low mortgage rates and modestly lower prices, the average home still sells for over three times the average annual income across the country. There are pockets where affordability is still just awful and other areas where affordability is much better. Please, choose a spot where affordability is much better.

New home sales rose 14.8% as it seems a bunch of people rushed to get in under the deadline for the latest home-buyer incentives, which expired at the end of April. At 504,000 seasonally adjusted at an annual rate, this pace puts us back to about one-third of the pace seen back in 2004 and 2005. We aren’t likely to see this level again for quite some time as the incentives probably accelerated some demand into April that might have waited until June otherwise.

Case-Shiller home prices showed a drop in prices for their index of 20-cities. The drop of -0.5% comes after a couple more months of slack home prices. Last fall, you could see a trend of slight increases most months in most markets. That is no longer the case. Instead, there are a few markets that show halting progress in prices and others with stubborn declines. Again, choose wisely.

Consumer confidence, the Conference Board version, improved more than expected in May. The survey resulted in a reading of 63.3, much higher than the 57.7 reading in April and higher than expectations. Evidently those folks hadn’t heard that the Greek tragedy will undo most of the progress seen in the developed markets since at least World War II. This is no time for facetiousness. The consumer confidence is clearly responding to the jobs number from earlier this month and the spate of generally good economic news we’ve seen since. More of this and we might almost have a recovery.

Consumer sentiment, the other survey from the folks at Reuters and the University of Michigan, also rose in May. The new level of 73.6 versus 72.2 in April saw many parts of the survey improve.

Durable Goods orders rose a strong 2.9% in April. We also saw March’s orders revised to no change from the prior guess of a -0.6% decline. If we exclude transportation equipment (trains, planes and automobiles), orders actually fell about 1%. The volatile transportation segment fell in March, which caused the overall drop that month. It is very confusing, but the trend is still upwards in both the overall orders and ex-transportation.

Rather surprisingly, GDP for the first quarter was revised down. The prior guess of 3.2% was revised to 3.0% growth. Evidently, the pace of consumption wasn’t what it at first appeared, nor did we spend as much on business software. We are somewhat incredulous that the economy didn’t do better than that in the first quarter. We were in the camp of forecasters who thought a small upward revision was due. There will be one more revision to these numbers at the end of June, so maybe we’ll be found correct at that point. But, as we mention from time to time, these GDP numbers at this stage are still fraught with guesses. We now know quite a bit about what happened in January, also a lot about February, but our understanding of March is still a bit sketchy. There is room for us to discover more sales, more inventories or more investment by then.

Personal income rose in April. The gain was 0.4% and was ahead of expectations. At the same time, March data was revised upward to a 0.4% gain from 0.3%. The improvement in incomes means that the economic recovery is starting to have some deeper impact on most Americans. This may increase our belief that the recovery is on firmer ground and can be self-sustaining.

Consumer spending was essentially unchanged in April from March. The tepid pace of spending means that our savings rate rose in April after taking a tumble in the prior several months.

Weekly Stuff

Last month was absolutely awful, with most equity markets down roughly 8% or more. Foreign markets were hit especially hard. Developed markets were off 12% and emerging markets down 9%. Made the US seem a lot less negative when it is put this way.

US Stocks ended the week mixed, with small caps rising a bit while large caps were close to break-even. The Dow dropped, but everything else was at least profitable. This would be the time for another rant about how the Dow is just 30 stocks and that its price weighted so a drop in a couple of heavily weighted stocks can make it perform kind of strangely once in a while, but we don’t have the energy this morning.

Last Tuesday’s trading may ultimately be seen as a key reversal day. What’s that, you might ask? A key reversal day is one in which the index begins the day in one direction but reverses direction to end in the other direction. And not by just a little bit, by a lot. That is the one dimension of Tuesday’s action that didn’t get fulfilled. We went down as much as 300 points, and closed down only a handful. Had we had another 15 minutes to trade, we might have made it well into positive territory. But, with all the sentiment data pointing at an extreme of bearishness, all the internal technicals arguing that we were very oversold, it wouldn’t take a huge leap of faith for the market to go up just because it had gone down enough. As we mentioned in last week’s missive, all the long-term predictors of the market had improved in the month since the recovery highs in April, but the market was off 12%. That part didn’t make any sense. 

Foreign stocks had a nice bounce off their lows last week with developed markets rising the best part of 1% but the emerging markets up over 4%. It appears that the risk trade is back on from this data.

It wasn’t all that good for bonds last week. Treasury bonds backed-off from recent highs and took most high grade sectors with them. High yield bonds rose along with small and mid cap stocks.

Foreign bond markets had much the same reaction with sovereigns tending to drop a smidge. Emerging market bonds tended to do better.

Real estate securities had a pretty good week here in the US and struggled overseas. As often happens, whatever the trend in financial stocks gets played-out in real estate with a little extra vigorish.

Commodity markets were roiled by several cross currents. Energy markets had some big gains as crude rose 8%. Gold was back up as well, roughly 5%. Industrial metals were mixed as were agricultural commodities.

Au Revoir   

Memorial Day was begun as so many great holidays were after a war. In this case the US Civil War. The deaths in the Civil War affected nearly every household in the nation. So, a day to remember the dead of that war was an almost instant hit. Most early Memorial Days were somber affairs as befits a remembrance of the dead.

After World War I, the concept of Memorial Day expanded to all veterans who died in service to their country, not just those from the Civil War. Not only are the combat deaths remembered but all those who served in this nation’s wars. If you get a chance, take a second to thank those among us who have served their country in its time of need.

Have a great week.

Karl Schroeder, RFC, CSA

Investment Advisor Representative

Schroeder Financial Services, Inc.