The long cycle

One of my friends has commented that he could not have imagined that he would witness such a long-lasting bull market in his lifetime, one that would not suffer a major correction. Obviously he had been referring to the United States when he had said this, where for the last six years, since the market bottom in spring 2009, the stock market has been, more or less, heading upwards. The same cannot be said of global markets, where, for example, Europe, as a result of its numerous bad economic policy decisions, saw a major collapse in 2011-2012; the emerging markets are just a shadow of their former selves; and the road taken by Japan has been more than a bit rocky. The correction-free upswing is therefore only partially true, and at any rate, it has a very important difference compared to earlier strengthening economic phases that could make it last a lot longer.

The 2008-2009 collapse was unique in that, unlike the other post-WWII “smooth” recessions that we have become accustomed to under capitalism, it was characterized by a credit-contractionary, balance sheet-adjusting recession that had been signaling the end of a credit cycle. During the recession, the players of the private sector tried to reduce their debt exposure, all other participants be damned. As a result, very strong deflationary-depressionary effects could be felt throughout the economy, which the central banks’ heretofore inconceivable policy decisions could not fully counter. So it was that a balance was reached wherein despite super low nominal interest rates, there was no serious risk of overheating; the economy slowly but surely stabilized / strengthened, with no inflationary pressure and very high company profits. This has been the basis of the stock market boom of the past several years. The question is how long can it last?

As economic growth has been slow to return, and employment figures have failed to dramatically improve as we have become accustomed to in a normal recovery, we may say that this is not a cyclical recession, but rather a once-in-a-generation credit market collapse. That is the reason why the recovery has taken so long to arrive, why the circumstances have failed to materialize whereby the central banks would step on the brakes. Moreover, the central bankers are extremely afraid of repeating the notorious “1937” mistake, when their economic policy-making predecessors tightened too soon, and inadvertently knocked the economy back into recession following the Great Depression. Thus it follows that all central banks will err on the side of caution.

The American economy (and several others) is in precarious balance. As long as interest rates remain relatively low, the economy will plod along, and even grow, since even a huge national debt can be serviced at these rates. But the time could come when interest rates suddenly go too high, and then completely unexpectedly, we could have a replay of 2008-09. We do not know what that “too high” rate is. It is probably well below those interest rate peaks of earlier cycles, perhaps between 3-5% for the US and a little lower for Europe. I am of the opinion that as long as central banks keep interest rates below this level, the emerging markets’ economic upswing will be sustainable. Since Europe is a long way away from raising rates (despite my conviction that, a year from now, the Bundesbank will be pounding the table warning of inflation), and since the Americans surely will not go above 2-2.5%, I do not see any great economic problems in the developed economies over the next two years – counter to the emerging economies, where the storm clouds are beginning to roll in, and whose problems could shock markets.

So, even as the developed world economies should remain stable, and their stock markets should manage to avoid the falls that characterized 2008, a sudden market correction could happen anytime.


Bill Gross tweets: “German 10-year bunds ‘the short of a lifetime’.”

I also think a sudden huge move could occur, which would then be the big story of the year. But it perturbs me that upon Gross’ announcement, we have seen a quick rise in yields. I have my doubts that this is the real move, however…