The economic news of late has not been good. Last week the UK officially went into recession, followed this week by Spain. At home we continue to receive mixed signals. Last week’s durable goods report showed a significant pullback, followed by a GDP report worse than most expected, showing the economy grew at a slow 2.2 percent rate in the first quarter. We received a better-than-expected report from the Institute of Supply Management, which stated that manufacturing expanded in April. Interestingly, the expansion is the highest since March of 2011, right before the last attempt at recovery stalled. Based on all the other data, it seems likely to happen this time as well.
I wish I could come up with a better scenario, but when durable goods orders are down, meaning consumers are buying fewer manufactured goods, and manufacturing activity is higher, meaning more goods were manufactured, the signal for the future is, “slowdown ahead.” I know that I am beginning to sound like a broken record, but this is what a 2 percent growth economy looks like: fits and starts, and good news followed by bad, but little real growth.
In Europe things are much worse than most expected, although we never understood the optimism in the first place. It has become popular to blame the whole thing on the austerity measures taken by the troubled European governments. The problem with this theory is that it ignores both the actions that got Europe in this mess at the outset, and the current reality that the European nations are bankrupt. I really believe that much of the denial regarding Europe has to do with the fact that we are witnessing the collapse of social democracy, much like we witnessed the collapse of its more pure cousin, socialism, twenty years ago, and there are many to whom this realization is an anathema.
Unfortunately for those who want to blame austerity, when you have spent all the money you have as well as all the money people are willing to loan you, then you are bankrupt. Bankruptcy brings on a very austere reality. The long-term solution is to learn to live within one’s means, but in the short term, pain is unavoidable. Those who champion less austerity or even more stimulus are correct about reducing the immediate pain, but they only dig the hole deeper, leading to even more pain down the road. Borrowed money must be paid back.
I often think that John Maynard Keynes must turn over in his grave every time the proponents of never-ending spending use his name. The thing politicians don’t seem to understand about Keynes’ theory on the role of government in smoothing capitalism’s rough edges is that it was intended to be a two-edged sword. Yes Keynes believed governments should run deficits during economic downturns in order to stimulate the economy, but he paid for those deficits by running surpluses during the good times. His idea was to smooth the cycle, which in theory would not only reduce the pain of recessions but also reduce the reward of boom times. Keynes knew that there was no such thing as a free lunch.
Unfortunately, many politicians who claim to be following his theories do not seem to understand this basic principle. (Interestingly, one of the reasons economists believe Keynesian stimulus has never worked in reality as he thought it would is because the masses are smarter than he thought and intuitively know that borrowed money must be paid back.) If you ignore this reality long enough you become Greece or Spain or soon the whole of Europe. Those who call for less austerity are simply in denial about the seriousness of Europe’s situation.
The markets are just beginning to pay attention. The silver lining is that this scenario – recession in Europe and anemic growth elsewhere – is exactly what we thought would happen, and we believe our portfolios are well-positioned to ride out the impending storm. This storm, like all storms, will pass, and good times will return, but the storm must come. Blaming the medicine will not cure the disease, and holding back the storm will just make it bigger. Austerity is not fun, and will not be popular, but ultimately it is the only way out.
Chuck Osborne, CFA