My esteemed co-blogger Deep T made the comment that too little attention is being paid on MacroBusiness to creative solutions to the problems that are documented in great detail on MacroBusiness. I would go a step further. Economic analysis generally suffers from a deep flaw. Because it is a quasi-science (although in no respect truly scientific) is does not concentrate on what is new and unique. Science is not interested in the unique, only what is always the same. Having discovered what is always the case, then predictions can be made. Economics, in endeavouring to replicate that method, is not sensitive to what is new and what is changing.
Consequently it is a very poor tool for prediction. When economics looks forward it is usually to say that the system is out of balance, it must return to what it has always been (the current argument on MacroBusiness are a case in point: the housing market must return to the mean).
This is, if not nonsense, at best only a part of the story. Economic systems are human collective behaviour. That behaviour is always evolving. It throws up the new just as all human history has come up with something new. To try to predict it based on historical data is always to get it partly wrong. So I would go a bit further than Deep T. I would say it is time to start trying to anticipate the system, predict events, by not assuming that the system is static. In addition to conventional analyses (“we’ve seen this before, and we all know that this time it is not different, it will return to the mean”), we need to find what is new and step through what that uniqueness is likely to lead to.
To show what I mean, consider two reports, one about the Australian stock market and one about the US market.
The first is by Morningstar, and it shows how new the Australian resources boom has been for investors:
Since the start of the current GICS sectors in March 2000, the price index of the Materials sector (XMJ) has risen 321% compared to the S&P/ ASX200 index (XJO) advancing 46%. Of course, dividends need to be added to calculate total shareholder returns, but the relative capital appreciation of the indices is apparent when compared against the A$/US$ exchange rate. Returns are even stronger for a foreign investor, assuming the investment was un-hedged, with the Materials sector up 639% in US$ terms, while the S&P/ASX200 index is up 157%.
This is new in the Australian context. What are the implications of Australia’s capital markets being skewed so much towards one sector? Yes, we know that manufacturing and services are in trouble, but it means things like:
1. Many Australian non-resource companies will only focus on the domestic market because the high currency makes them uncompetitive internationally;
2. Exporters will be in trouble;
3. Globalisers, those that do not export but who look around for the cheapest hands and smartest minds, can thrive if they are smart enough.
4. There has to be a rise in the relative political power of mining companies and government, the recipients of the resources boom and that will have political, and then economic, implications.
The temptation, of course, is having seen the historical trend, to immediately invest in resources stocks. But is it the best play? Often big returns have priced in the future, meaning that even if the future transpires in the way predicted it is already anticipated in the price. Also, as prices rise the effect of further price rises become smaller. For example, the rise of the $A from US70 cents to $US1.10 is over 50%. A rise from $1.10 to $1.20 is less than 10%.
The second report is from Prudential on the American stock market:
It starts with what is different about this current cycle:
Compared with previous post-war recessions – all of which were triggered by imbalances in capital goods, business inventories, and world oil markets – the Great Recession can be best understood as a balance sheet recession. The primary characteristics of a balance sheet recession are as follows:
- A prolonged period of excessive household debt accumulation;
- An unsustainable rise in financial leverage within the banking system;
- Creation of extremely low quality debt owing to unsound underwriting standards, resulting in massive bank losses and writedowns;
- Overinflated real estate assets resulting from a bubble in the housing and commercial property markets.
The key point is that the necessary adjustments to correct these excesses in private sector balance sheets – deleveraging, absorption of massive credit losses and asset write-downs, rebuilding of net worth, and reliquification – can only occur over a protracted multi-year period. This is in sharp contrast with only several quarters of adjustment necessary to correct excesses and imbalances in business inventory accumulation and business investment in plant and equipment.
Creditless Recovery – While the severity of the recession can be attributed to the collapse in banking and credit markets, the defining feature of this economic recovery is the total absence of credit creation which normally accompanies a cyclical rebound in spending and output. Similar to Japan in the 1990s and the U.S. in the 1930s, the current business and financial environment can be best understood as a post-bubble credit collapse. Under such a scenario, flow of credit through the financial system comes to a sudden halt.
The report details a shift from consumers to businesses and management being in charge:
New Sector Leadership – GDP data since the end of the recession in mid-2009 suggests that our economy may be undergoing a major shift in leadership from consumers and housing to business investment, manufacturing, and exports. Compared with cumulative real GDP growth of less than 5% during the past seven quarters of recovery, business capital spending, exports, and manufacturing output have enjoyed cumulative increases of 25%, 20%, and 13%, respectively. Growth in consumer spending has been only 5%. These relative growth rates are likely to continue.
The report then details this shift in terms of profits and productivity:
Corporate Profits And GDP – The rebound in corporate earnings in the current cycle has exceeded that of all previous cycles by a wide margin (see chart). More noteworthy, however, is the unprecedented disparity between earnings and GDP: Through Q1 of this year, cumulative growth in profits has been an astounding 75%, which compares with cumulative growth in current dollar GDP of only 7%.
Management – The strong growth in profits in a slow growth economy can be attributed to the skill of business managers, in three key areas: (1) Massive restructuring of firms, accompanied by aggressive utilization of cost-effective IT applications; (2) Adoption of new business models to streamline operations and achieve enhancements in productivity, which have contributed directly to record profit margins; and (3) Repositioning within the global economy and penetration into rapid growth BRIC economies.
Productivity and Labor Costs – Productivity growth during the current economic cycle has been extraordinary. The combination of surging productivity and anemic growth in labor compensation has resulted in unprecedented declines in unit labor costs. Although productivity typically experiences a sharp rebound during the early years of an economic recovery, the current cycle has been exceptional.
Current Cycle – Average annual productivity growth of 4% (nonfarm business sector) during the past two years has far exceeded that of previous economic recoveries. Manufacturing sector productivity of 6% (annual rate) is even more impressive and partially explains the resurgence of the U.S. industrial sector. The result has been a collapse in unit labor costs of a cumulative 4.5% in the nonfarm business sector and more than 6% in manufacturing. Falling unit labor costs are highly favorable for both corporate profit margins and inflation.
Households and Firms Diverge – The current cycle has witnessed a massive divergence between business sector and household sector finances. The economic rewards associated with rising productivity have traditionally been distributed equally between workers and business firms; in the current cycle, virtually all of the benefits have accrued to businesses, as manifested in the sharp rise in returns on invested capital in our economy and surge in corporate earnings, while labor compensation has stagnated.
U.S. Living Standards – Not surprisingly, advances in U.S. living standards have slowed dramatically in recent years, the result of slumping net worth and profound weakness in personal income. Compared with a long-term average of 3.3%, growth in real disposable income (consumer purchasing power) has slowed to an annual rate of only 1.2% since the demise of Lehman, or close to zero on a per capita basis. Based upon current growth in per capita income, the number of years needed to double consumer purchasing power has increased significantly. The current trend in U.S. living standards is among the slowest since 1945.
In both these reports were are seeing things that are comparartively new. But what is new about this newness? What is happening outside the system to cause these things within the system to behave unusually?
The answer in both cases is the shift to the developing world. The end of Western hegemony in financial markets. Both Australia and America are creating wealth being suppliers to the industrialisation of emerging economies. Wealth creation from serving the domestic population on both cases is not working as it did before. The ate stage industrialisation of the West is in serious trouble; the housing and finance bubbles were really its death throes. The mid-stage industrialisation of the emerging world is not in trouble.
It has not been seen before and predictions based on what is likely to occur from such historical developments are far more likely to be on the money.