It’s now looking like the global economy has some positive momentum and could continue to surprise to the upside.  But that doesn’t mean the world is now without risks.  Although the news has been overwhelmingly positive in the last 4 months the economy still faces headwinds. The good news is there are signs of global economic strength.  The bad news is the global economy continues to experience imbalances that threaten the sustainability of the recovery.  With that said, let’s start with the bad news:

PCE – consumer spending has seen a sharp uptick in recent months, however, a long-term perspective shows that the US consumer remains weak.  Personal consumption expenditures outside of food and energy are at all-time lows.  This has resulted in a record output gap and creates the risk that growth in the coming years will remain far too low to help overcome the enormous lack of job’s growth.   This is further confirmation of the disinflationary environment in which we exist and reveals unprecedented weakness in the US consumer:

Oil prices – A $15 rise in oil has the potential to shave 1% from US GDP.  While the global economy continues to grow the energy shortage becomes an increasing problem.  Goldman Sachs is projecting $105 oil in 2012, but rising inflation in China and an eternally easy Fed has the potential to create an environment similar to 2008 in which oil prices soar in the coming years and economic growth gets choked off once again revealing a very weak developed world consumer.

Sentiment – Sentiment has made a remarkable comeback in recent months.  While confidence is a vital component of any sustained bull market it’s important that investors not get too euphoric.  Such sentiment readings increase the risks of an unhealthy level of optimism.  Near-term sentiment is wildly optimistic.  While this is not confirmed by longer-term sentiment readings (such as my Wall of Worry) it’s important that any sustained bull market remain tempered by a heavy dose of skepticism.  Current short-term readings are indicative of an unhealthy level of optimism:

Home pricesHome values are in the process of double dipping in the United States and appear vulnerable in several regions throughout the world.  As the largest component of the US consumer’s balance sheet a housing double dip has the potential to put severe strains on the economy.  While I don’t believe there is substantial downside to national home prices there is very real risk that rising rates, continued de-leveraging and supply problems continue to put negative pressure on prices.  An overshoot to the downside cannot be entirely dismissed and the problems in Australia, the UK, Europe, Canada and China should be closely monitored.

China’s Inflation – There is, in my opinion, no greater risk to the global economy than the imbalances that are occurring in the Chinese economy.  Global growth has become uncomfortably dependent on China.  Unfortunately, their central bankers have been primarily educated with the same western world textbooks that helped contribute to many of the problems in the developed world.  The major risk here is that China will fail to act in a proactive manner and risk a hard landing.  With a tepid recovery in the developed world this would certainly cause a ripple effect around the world.  Inflation in China is not currently at the levels we experienced in 2007/2008, but the Chinese would be wise to get a handle on the issue before it causes more pronounced problems (chart via Trading Economics):

And now for the good news:

Labor market – Recent trends in the labor market are pointing to jobs growth in 2011.  We have seen sharp declines in jobless claims, increased job openings and an increase in corporate revenues.  This single digit revenue growth should reduce the slack in the economy and help corporations leverage their operations up in order to capitalize on increased aggregate demand.

Corporate profits - Through global diversification and remarkable balance sheet management US corporations have barely lost a step during the great recession.  Ultimately, this is the single most important bullish component of the current economic environment.  Profits are at all-time highs and will give corporations flexibility in managing the uneven recovery.  This has the potential to snowball as corporations spend, invest and ultimately contribute increasingly to the recovery :

Consumer credit – Although consumer debt levels remain extremely high and the balance sheet recession persists there are signs that consumers have slowed the pace of de-leveraging.  While a re-leveraged US consumer is likely a long-term negative it will help contribute to near-term economic growth:

No austerity – My greatest concern throughout 2010 was that the US government would make the mistake of attempting to balance the budget.  This was the classic Japan scenario or 1937 scenario where the government stopped spending and tipped the economy back into recession during a balance sheet recession.  As I showed the other day in the sectoral balances analysis it’s impossible for the private sector and public sector to de-leverage at the same time without resulting in a shrinking economy. During a balance sheet recession this has the potential to cause substantial and sustained economic damage.  The current budget deficit of $1.3T is a clear sign that the US government will continue to aid a weak private sector.   With extremely low levels of inflation and no risk of insolvency this is absolutely a positive development for the US economy. We are not becoming Greece.  The second great depression that so many have worried about (and that I said was never a real risk) can almost certainly be eliminated from commentary.

Expectations - As I have discussed every earnings season since early 2009 there has been and remains a disconnect between the strength of corporate earnings and Wall Street’s expectations.  My expectation ratio measures the strength of corporate profits compared to a broad set of expectations.  This dynamic, forward looking and intuitive indicator continues to show an environment that is unappreciated by Wall Street.

The icing on the cake for the bulls AND the bears is the Fed.  This bonus chart shows the current Fed Funds Futures.  As you can see the market is not expecting a rate increase in 2011.  The Fed is at zero for the foreseeable future and that has the potential to be very bullish and both very bearish.  In the near-term the Bernanke put is a sign that the Fed will remain very accommodative even if it involves talking up various markets in a misguided attempt to induce confidence in the markets.  In the long-term, however, this is merely a continuation of the flawed policies of Alan Greenspan and is one more sign that the US economy remains dominated by misguided monetary policy and flawed economic strategies (chart via Global View):


Got a comment or question about this post? Feel free to use the Ask Cullen section, leave a comment in the forum or send me a message on Twitter.

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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  • SS

    Great commentary as always. Thanks.

  • BFPowersJr

    Excellent article.

  • Bill

    via foia we have recieved footage of ben bernanke, literally in his helicoptor, rescuing a Bull on thin ice…


  • csodak

    Fix consumer demand and you fix the economy. Fix labor demand and you fix consumer demand. Fix exporting of jobs and you fix labor demand. Tax corporate profits at 100% while providing a tax credit for US corporations who hire American citizens as workers and you fix the exporting of jobs. Decrease taxes on consumption and increase taxes on savings and workers will spend earned income (earned income defined as income through labor, not capital gains)! Fix consumer demand and dormant US factories will light up. Tax imports. If the US consumer is the engine of global demand America can increase tarrifs, decrease imports, increase US production, labor demand, spending of earned income

    All this will result in a decrease of gov’t subsidies as transfer payments drop.

  • Paul

    The economic policies of this country are in place because they benefit the bankers. Period. Fix the bankers and stop helping companies offshore American jobs, the US economy will begin to reallign itself.

  • Paul

    Thanks TPC, for a great year. Many more.

  • Whiskey Tango Foxtrot

    You must be the Anti-Christ of Capitalism.

  • George H

    Excellent article. A few questions.

    1. How do you reconcile PCE and retail sales? As we see retail sales have approached pre-recession record. I believe even if stripping out food and energy, the figures are still very positive. Because of less revolving credit, consumers are drawing down their own savings. Are the economy and consumer confidence now in a sustained positive trend that spending will now drive everything forward? Have the U. S. consumers regained their confidence that, despite housing (and unemployment), they are now in an expanding mood instead of a permanent, long-term attitude change of de-leveraging as some had predicted? More obviously, can consumers sustain their spending without the housing sector?

    2. Some believe employment is a lagging indicator. The stabilization of the job market is a good sign. But if you look at this chart


    job loss can hardly find any precedent. Is this time the same or different?

    3. Many argue that the government must use deficit spending to counter the credit contraction. To say it negative, it is “borrow our way out of recession”. To say it positively, it is “growth can cure all disease”. I have no doubt “expanding” deficit spending will eventually have enough impact to counter any contraction. The question is if growth can become sustainable without government deficit spending.

    My fear is that the American people have made it clear that they do not want to reduce benefits at good times (not to say bad times). You lamented TBTF banks are still plenty, the Fed does not allow losers. Are all these Hercules effort an illusion and the ills will eventually come home to roost?

    There is no sign of hyper-inflation now and any time soon. But will it be the ultimate outcome (say in 5 years)?

  • Tom Hickey

    I am not sure that there is no risk of another great depression globally. While it is true that the real economy in the US is improving and it looks like the global economy will grow in 2011, too, the financial situation in the US and world is still precarious, with the global financial system heavily over-leveraged and a number of shocks yet to occur.

    For example, Chris Whalen (video) see a CA default in 2011 as well as several sovereign defaults in Europe, with Spain “the Florida of Europe.” He sees BoA as insolvent and thinks that it will be restructured in 2011. He also sees most housing sales a year from now involuntary sales, depressing the housing market into 2012.

    Whalen also sees the purpose of QE1 and QE2 as bank bailouts and doesn’t think that this will be sufficient to rescue the big banks, especially BoA, without their “doing the hard work” instead of continuing extend and pretend. He sees no real growth in the US without a healthy financial sector to provide the credit, which also requires healthy borrowers to take on debt. He also see the Fed actions driving up equity prices and thinks this will reverse should the Fed cease to keep interest rate/yields down, i.e., the Fed has driven equities higher than they would be otherwise.

    The stock market is the only bright spot (sort of). Falling equities along with falling housing prices would be a double whammy. I think that equities my be reaching a peak in this run, and it could be a political event, like a government shut down over the budget, or the forcing of US default due to refusal to raise the debt limit that could cause equities to tank.

    The political gridlock in the US is of particular concern economically. The government now appears impotent to act in the face of economic turmoil, and the chances of imposition of budgetary austerity are pretty high. The original stim is petering out and the tax cut bill stim is front loaded and its stim will end in 2011, with unemployment still extremely high. State and muni finances are to the fore in 2011, and the GOP agenda is to use this crisis to gut unions and knock down government wages, further contracting aggregate demand.

    Foreclosuregate is turning into a big thing, too, with state AG’s piling on. A worst case scenario would be a political decision to ratify fraud, which would undercut the basis of contract law in the US. But if that is not done, this is going to be a rat’s nest. There is no good solution here.

    China is rolling over according to Yu Yongding: China’s House of Cards. A hard landing is possible.

    Finally, if there would be another successful terrorist attack on the order of 9/11 or greater, all bets are off. Anything could happen then.

    So, while the probability of another global depression may not be high, it is not off the table in my view, “green shoots” notwithstanding. The global financial situation remains precarious, even thought the real economy is recovering. But the real economy was doing OK before the financial crisis, too. So how the real economy is doing doesn’t necessarily mean that the financial economy is doing well, too, in spite of the reported profits and bonuses. As Michael Hudson observes, these gains are fictional, and eventually someone has to pay when the house of cards unwinds — or we all pay for a decade or more with stagnation, while the mess unwinds slowly and painfully.

    So while we may not see depression, we will see stagflation as modest global growth drives up commodities but the debt overhang prevents real recovery and unemployment remains inordinately high over the period, while government services contract and social unrest rises.

    This is very sad, since it doesn’t have to be this way, and it is really in no one’s interest to have this way, except maybe a few very wealthy people who will feel relatively better off with so many others doing poorly, if that is what makes them happy.

  • LVG

    I can’t speak for the rest of the world, since a depression in China would certainly be very different from a depression in the USA, but it’s hard to imagine 25% unemployment and industrial production just collapsing as it did 80 years ago. People tend to forget that we’re a huge and mature economy now. I think we’re in a bad recession, but depression is just fear monger talk.

  • fin

    Could anyone comment on the dramatic improvement of corporation profit during the last ten years? It is better than any period in American history. why this period is so special and what is the mechanism? Do we expect that will be sustainable? Thanks

  • Tom Hickey

    I am not saying that there will be a repeat of GD1. There won’t be. As you say, conditions are different now. But that doesn’t mean that there won’t be another depression in the US or globally, too. It will just be different. It already is different.

    It can be argued that unemployment in the US is similar to unemployment in the 30’s although different, due to unemployment insurance and other government assistance that was not in place at the outset of GD1. U-3 is almost 10%, U-6 touching 17%, and large numbers are uncounted because they are not seeking work, hence are technically not “unemployed” even though they are out of work. Joh Williams at Shadow Government Statistics has unemployment at ~23% based on the previous way of computing the index.

    A big reason that industrial production in the US has not collapsed is it had already been exported. The US now is dominated by service and finance rather than industry. I think we have to look not only at the quantity of jobs but also the quality. A lot of jobs are now part-time and more people are underemployed for their knowledge and skills. The former middle class is shrinking before our eyes, and our children have less opportunity (unless they choose to emigrate to fast growing countries in the emerging world).

    While this may be better than the bread lines of the 30’s, it’s not a whole lot better in the eyes of millions of people.

  • Dumbpenis

    As long as millions of workers commute over long distance to jobs and back home, our economy will continue to reel and slip downhill! The commuting scenario with rush hour strangeholds will have to be made a terrible thing of the past real soon! Real estate schemes are working against mobilizing workers closer to their jobs.. Capitalism is not always all it is cracked up to be! We have to allow our government intervene into our insane ways of living… We do not exactly have freedom by the most noble means at all. We are slaves of Big Oil , Real Estate and Rush Limbaugh on satellite radio!!

  • Tom Hickey
  • Oroboros

    I’m sure it was hard to imagine 25% unemployment and industrial production collapsing 80 years ago, as well. The hugeness of the British empire did not prevent its contraction, nor did its maturity. While I am in no way postulating that a depression is imminent – truly I do not know – arguments of largeness or modernity (relative concepts in all cases) do not satisfactorily equate into our current situation being significantly “different this time” to prevent financial pain. History is replete with “mature” economies that fell. Would it be identical to the past, no. Could a downturn happen, nevertheless, yes.

  • Fernand

    “but it’s hard to imagine 25% unemployment and industrial production just collapsing as it did 80 years ago.”

    You should read the book “This Time is Different”. The title is ironic, since that phrase has been uttered for hundreds of years. The point is that it is never different.

    At the start of the Great Depression, there were many quotes of people looking back to the depressions of 1870 and 1837 and saying very similar things.

  • csodak

    this isn’t a game of capitalism..if it were, we would be in a depression. The game is rigged to support stock holders which is BULLLLLLLLCRAP.

  • okl

    some say looking in from the outside provides a better view…


  • KB

    Thank you for the good charts. The only thing – I do not see any bearish chart here….

  • stockguy

    This is excellent, excellent work. Great macro analysis of the current factors driving both our economy and the global one. The charts are very helpful in visualizing everything. I passed this article around to even my non-economic-enthusiast friends because its so good and I believe its so important for them to know where things stand. Keep up the great work!!!

  • Andrew P

    5 years is way too short a timeframe to be talking about “untimate outcomes”. You need to think in terms of decades to a century.

    Food for thought – Japan has been in a deflationary condition for 20 years. Why can’t we do the same?

  • Andrew P

    Actually, some things ARE different this time. Central bank interest rates are at 500 year lows. ZIRP like we have today is truly unprecedented, at least for major economic powers. Peak Oil is also unprecedented, and my favorite scenario for global economic disaster is a sudden drop in the supply of extracted oil. Oil supplies have been pretty constant from 2005 to present, but the markets have no way to handle a major drop in supply except by increasing the price – big time. Such an increase would drive overindebted developed countries to the wall.