I want to make it perfectly clear that I am not predicting the direction of the economy when we say that economic risks are much higher than the consensus seems to believe at the moment. Our longer term view is that the economy will sputter along and be vulnerable to recession risk. That has not changed. So I was pretty curious when I read this headline this morning:
We are earnestly looking for reasons to make us think that the roller coaster ride to nowhere that global markets have ridden since April of 2010 might end, so I dug in to the article.
What is this global bellwether? Caterpillar. What does bellwether mean?
A bellwether is any entity in a given arena that serves to create or influence trends or to presage future happenings.
This gets me to one of my pet peeves about much market commentary. Claims are asserted as true or meaningful without ever investigating whether it has any validity. Stocks are cheap arguments are allowed without any evidence being provided that the method used works! Data that has no predictive value for the economy is assessed as if it does and sources that have no historical record of assessing the economic future accurately are treated as reliable indicators.
One source of economic forecasting that we should generally ignore when it comes to recessions are corporate projections. I often hear Jim Cramer and others say that to understand where the economy is heading the CEO’s and executives of our leading corporations are on the ground and in the know. I beg to disagree. Corporations are pretty good at forecasting their own earnings a quarter or two out as long as we do not have a recession. They are useless in forecasting recessions however, and thus economic and market risk. So what does Caterpillar say and let us see if maybe they are the exception.
First of all they had a great year, and they did. So, things must be great.
In general, prospects for economic growth have improved over the past quarter, and we expect the world economy to grow about 3.3 percent in 2012, a small improvement from about 2.8 percent in 2011. In response to economic concerns, some central banks began easing policies late in 2011. Underpinning our growth expectations for 2012, we expect this easing to continue and contribute to the improvement in growth.
Key points related to our economic outlook include:
- We expect improving world economic growth to increase demand for commodities. Our outlook assumes most commodity prices will increase slightly in 2012 and continue at levels that encourage investment. We expect that copper will average over $4 per pound, Central Appalachian coal about $75 per ton and West Texas Intermediate crude oil about $100 per barrel.
- In the developed economies, capital investment recovered much faster than did overall economies. This better performance occurred primarily because businesses had improved cash flow and better access to credit. In addition, businesses let capital stocks depreciate significantly during the financial crisis of 2008 and 2009. We anticipate business investment will continue to outperform other economic sectors in 2012.
- We expect the U.S. Federal Reserve will maintain the Federal Funds rate below 25 basis points throughout 2012 and will not reduce the size of its balance sheet. U.S. banks have record high capital ratios and considerable funds to lend. We expect bank lending in the United States, which increased during the second half of 2011, to continue to grow in 2012.
- Recent economic data suggests that U.S. economic growth improved in the fourth quarter of 2011, which we believe reflects the positive impact of Federal Reserve easing that was initiated in late 2010. The full impact has likely not materialized yet, and we expect economic growth will improve further in 2012. Our outlook assumes economic growth in the United States of at least 3 percent in 2012.
- We expect total U.S. construction spending, which, net of inflation, has declined since 2004, to finally begin to recover in 2012. We project a 1.5-percent increase in infrastructure-related construction and a 5-percent increase in nonresidential building construction. We are expecting housing starts of at least 700 thousand units in 2012, up from 607 thousand units in 2011.
- While U.S. economic activity is improving, the recovery has been slow by historic standards, and unemployment remains high. If economic growth does not accelerate, it may take several years for unemployment to reach pre-financial crisis levels. In our view, this would signal the potential for a prolonged period of continued growth in the United States.
- The Eurozone public debt crisis has been a lingering negative, but it is unlikely to trigger a worldwide recession. The Eurozone will likely have at least two quarters of weak, possibly negative growth, but should begin to improve in the second half of 2012. For 2012, our outlook assumes economic growth for the Eurozone near zero and growth of about half of a percentage point for Europe in total.
- Our expectation for improvement of European growth in the second half of 2012 rests on a continued easing by the European Central Bank (ECB). The ECB has recently lowered interest rates and could cut rates further in 2012.
- More importantly, the ECB increased its balance sheet more than 35 percent since July 2011 to improve banking system liquidity. Other European central banks have been taking similar actions.
- Business investment in both the Eurozone and the United Kingdom has grown faster than the overall economies and is a trend we expect will continue. Businesses have improved cash flow and need to upgrade capital stocks.
- We project the Japanese economy will grow 3.5 percent in 2012, recovering from a 2011 recession. Rebuilding from the tsunami and more expansionary central bank policies are expected to drive the recovery.
- We expect economic growth in Asia/Pacific will exceed 6.5 percent in 2012, about the same as in 2011. Growth should improve in Australia and Indonesia, the result of recent interest rate cuts.
- China took its first easing action in late 2011, and we expect that further easing is likely. We expect China’s economy will grow 8.5 percent in 2012, sufficient for growth in construction and increased commodity demand.
- Growth in Latin America is expected to slow from 4.3 percent in 2011 to about 4.0 percent in 2012. Our outlook assumes interest rates will be flat to lower in most countries. We expect that economic growth will be sufficient for construction spending and mining output to increase.
- Africa/Middle East will likely benefit from low interest rates and favorable commodity prices. We expect the regional economy will grow nearly 5.5 percent and that construction spending will continue to improve.
- We expect the CIS economies will grow more than 5 percent, and construction spending will increase more than 15 percent. Favorable factors include low interest rates, higher metals and energy prices, and increased production of oil, gas and metals.
As with any Economic Outlook we believe certain aspects are worth considering, and suggest you do so. However, does Caterpillar qualify as a bellwether? Should we give their opinion and economic outlook any credence as opposed to the poor record of economic forecasting from major corporations in general? Let’s test by looking at the last recession. That recession (if not its magnitude or exact characteristics) was the most obvious and telegraphed recession possible, yet most forecasts missed it. Did Caterpillar? Here is the January of 2008 version of today’s release. Unfortunately I haven’t located their outlook earlier which would be more relevant, but in reading this remember that the US was already in recession when this was written:
U.S. economic growth: We forecast the economy will grow 1 percent in 2008, slow enough that the National Bureau of Economic Research may eventually decide that a recession occurred. We expect construction will likely remain distressed in 2008. If the Fed continues to cut interest rates as we expect and the U.S. government takes action to stimulate economic growth, 2008 could be the bottom of this U.S. machinery cycle. U.S. housing: Housing starts should slow from 1.35 million in 2007 to 1.1 million in 2008. We expect continued downward pressure on the industry from a large inventory of unsold homes, tighter lending standards, increased home repossessions and lower home prices. U.S. nonresidential construction: New contracts awarded should decline more than 4 percent in 2008, continuing a weakness that developed in the last half of 2007. Negatives include tighter lending standards, reduced corporate cash flows, rising vacancy rates and a smaller increase in federal highway funding. U.S. coal: This sector showed some improvement in fourth quarter 2007, and further recovery should occur in 2008. We expect the recent rebound in coal prices and increased coal exports to drive the turnaround. European interest rates: Financial markets are unsettled in Europe, and we expect this will prompt the European Central Bank to hold interest rates at 4 percent for the rest of the year and the Bank of England to cut interest rates again to 5.25 percent. European economic growth: Our forecast is for 2.3 percent growth in 2008, down from 2.7 percent in 2007. Both nonresidential building and infrastructure construction should improve, however housing declined in 2007 and should do so again in 2008. Developing economies: The robust recoveries in these economies should last throughout 2008. Our forecasts are for 5.5 percent growth in Africa/Middle East, 7 percent in the CIS, 4.5 percent in Latin America and 7.5 percent in Asia/Pacific. Those growth rates are close to those of the past two years and should encourage further growth in construction. Metals mining: World demand for metals should increase, and inventories remain tight. We expect prices for most metals will remain attractive for new investment. Oil and Gas: The world's spare oil production capacity remains low, and oil prices should average higher in 2008. Higher prices should drive increased exploration, drilling, pipeline expenditures and tar sands development, which should benefit both machinery and engine sales. Electric Power: Rapid growth in oil producing and commodity exporting nations should drive generator set demand. Increased business investment in Europe should benefit demand for standby power. Marine: Demand should benefit from increased world trade and favorable freight rates. Shipyards are already contracting for 2009 and later berths.
Verdict? By January, after the recession had already begun Caterpillar sees at worst a shallow recession in the US and strong global growth and record profits for them. The specifics miss by a mile and they completely whiff on the global economy. I don’t mean to pick on Caterpillar either. This is a problem for economic forecasting in general, and we shouldn’t expect them to do any better than they do. Standard economic forecasting models are fine most of the time, but fail at modeling recessions. To add to these models factors that might help in recession forecasting makes them less useful in general. Here is the track record of mainstream economics:
Not exactly inspiring.
Which doesn’t mean that looking to the future is pointless. General economic regimes can be identified. Leading indicators can be assessed as long as you are rigorous in assessing whether they truly are leading indicators. Risks can be identified.
In general predictions of recession cannot be made with a great degree of confidence (2007-2009 being an exception in my mind) but identifying that a recession is more likely than usual can be done. True leading indicators (see John Hussman’s recent discussions) are flashing danger signals, even if not proof positive that a recession is imminent. That we are in a typical post financial crisis period when weak growth and elevated recession risk is present should have been the consensus since the recovery began. We may not know everything, but there is ample evidence of what we should have expected in general, even if most of Wall Street and economists ignored history for their typical models and assumptions.
All of that should have led to a reduction in risk taking by prudent investors once the rally in equity markets became stretched in terms of valuation heading into 2010. Certainty isn’t necessary to act prudently, just a reasonable idea of potential risks versus potential reward. Luckily, a broadly diversified portfolio has not fallen off a cliff yet if you missed the opportunity to reduce risk so far, but that is not a given if the global economy rolls over, China slows substantially or Europe starts to break apart.