‘We are facing a secular economic breakdown’

David Levy
David Levy

Juergen Buettner

The good thing about an interview partner like David Levy is the clear and outspoken messages you get. The chairman of the Jerome Levy Forecasting Center, based in Mount Kisco, New York, does not shy away from assessments that differ significantly from the market consensus. That takes courage, but fortunately the U.S. economist is often correct.
However, his predictions are not always fulfilled. Thus, the prediction of a 65 percent probability for a U.S. recession in 2015 did not come true. But in 2016 the economy is finally ripe, Levy is sure.

Expressing his skepticism toward the emerging markets in an interview with The Cayman Islands Journal in January 2015, he already hit the bull’s-eye, especially since he also expected back then that China would soon be in big difficulties. When we asked him how he currently assesses the situation worldwide, Levy again did not mince words, which makes the answers worth reading.

Did the recent interest rate hike by the Fed come as a surprise to you, and what is your current interest rate scenario now?

We always acknowledged that a rate hike was possible, just not probable, and that any Fed rate increase would be slight and would be reversed before too long. We stand by that. By 2020, we expect people will call the 2010s “the Zero-Interest-Rate Decade” despite a quarter-point rise or two for a short time in 2016.

Economists on average forecast a growth rate of 2.5 percent for the U.S. economy in 2016. Why do you expect a recession?

If you want to know the direction of the economy, follow profits, and to anticipate profits, study the aggregate profits equation and the profit sources. U.S. profits fell by about 10 percent in 2015, and are still falling. The primary cause of this damage has been the weakening emerging market and resource-dominated economies. Global demand has weakened, undermining exports and fueling flight into the dollar, which has further undermined U.S. exports. As the global economy worsens, so will U.S. exports, global and U.S. equity markets, and U.S. domestic investment.

Do the very strong job data not speak against a recession in the foreseeable future?

Job growth is frequently strong before a recession hits. Employment growth at a rate near or above the October-December pace (in percentage terms) has occurred within six months of at least half of the past dozen U.S. recessions. Moreover, this time the U.S. economy will be hit by spiraling global problems rather than turning down on its own, so the dynamics of the change may be somewhat different than in past cycles.

Does this explain why you again deviate from the consensus and assume profits will continue to decline in the U.S.?

Consensus earnings estimates are biased guesses and often detached from reality. Good analysts can often make good forecasts for companies or industries when the macroeconomic conditions do not surprise them. However, when the economy turns abruptly up or down, their forecasts are likely to miss, and the consensus forecast will miss badly. However, by studying the activities and associated flows of funds that determine aggregate profits, which few analysts do, one can estimate what various economic scenarios would mean for profits. When we look at those flows today, it is difficult to come up with a reasonable scenario in which total corporate profits do not fall in 2016.

Why are you still so pessimistic about emerging markets?

Economic commentators generally do not recognize the financial consequences of runaway investment and the resulting overcapacity. The emerging market export boom of the 1990s and 2000s led to enormous rates of investment based on the idea that the emerging market economies would be able to rapidly increase global market share indefinitely. However, with the emerging markets approaching half of the world’s economy and the developed market economies stagnating, exports have been greatly disappointing and the result has been vast overcapacity.

There are two financial consequences. First, capital assets in the emerging markets aren’t earning the income their owners expected, and as this situation worsens so do credit conditions. Second, the EM investment boom was the greatest source of profits for these countries, and for the global economy as a whole in the last five years, and that investment is just beginning to correct. When investment drops, profitability falls, and the result is recession and possibly severe international financial and economic crisis.

Can China escape these problems?

Popular perception of financial stability is overly sensitive to the latest financial market behavior. The much-touted “rebalancing” of China’s economy is fraught with problems. China needs to hit the brakes on its reckless accumulation of overcapacity and the bad debt that financed it. That means that investment, officially 46 percent of GDP, must be slashed drastically. However, doing so would cause Chinese profits to collapse. Thus China faces a paradox, a situation not well understood in the economics discipline either in the West or the East.

How ugly can it get in China, and what exactly should be done to improve the situation?

China has far greater problems of debt and overcapacity than other emerging markets, although its government has some control over international capital flows and few legal constraints. The situation threatens – almost promises – to cause the politically unsettling Chinese recession and financial debacle that Beijing desperately wants to avoid.

Unfortunately, the problems are becoming increasingly knotty and cannot be solved simply by throwing more money at the problem. China remains dependent on vast investment, which is creating an increasingly appalling rate of excess capacity, and on a large trade surplus, which is increasingly difficult as the rest of the world economy weakens.

Unfortunately, there is no easy solution, and managing the problem would require a degree of economic sophistication and understanding that one would be hard pressed to find in Beijing or in the government of any other country I’m aware of.

What role does the oil price play in your economic forecasts?

Oil plays an enormous role in global trade, which redistributes profits among countries, and in global business investment, which generates profits around the world. Plunging prices benefit some countries’ profits – China, Japan, India, the euro area, for example – and crush other countries’ profits – Russia, Saudi Arabia, Venezuela – but do not alter global profits.

However, the vast global investment in oil capacity until recently was a great boost to the global profits expansion, and the continuing collapse of petroleum capital investment is sharply reducing global profits. U.S. corporate profits quickly benefited from lower oil imports, but the negative impact on U.S. profits from the oil investment collapse is by now just as big – and has further to go.

What factors will drive the dollar in 2016?

There are two main forces acting on the dollar in 2016. One is a flight to safety; the problems in the emerging markets are likely to become severe, and investors will flock to the relative stability of the U.S. economy and currency. The other is that U.S. short-term interest rates, which markets expect to rise modestly, will instead halt and ultimately reverse. The flight to safety is apt to prevail in 2016, but the changing interest rate picture will likely contribute to volatility along the way.

Will a stronger dollar benefit Europe?

Yes, the stronger dollar is certainly helping Europe, as is the lower oil price since Europe remains highly dependent on imported oil. Nevertheless, financial flows that determine profits tell the story the best – European profits are extremely dependent on exports and thus highly vulnerable to a downturn in the emerging markets. Also, unlike the United States, the euro area has made little progress reducing its private debt ratio. That makes the private sector especially vulnerable to cash flow shortfalls, and banks will face a tougher environment than in the ECB’s last stress test because of deflation. As for sovereign debt problems, expect the crisis to come roaring back.

And what would be the best policy response to fight a recession, or at least to limit the negative effects?

First we must note that policymakers will be facing not a typical recession but a secular economic breakdown caused by overcapacity, overvalued assets and excessive debt. This time emerging market economies will be the centers of the fiercest storms, whereas in 2007-2009 the center was in the developed market economies. The results this time will be a severe recession and financial crisis, although we do not expect it to be as bad in the United States and perhaps a few other developed markets. Given the challenges, policymakers must – if they can – allow or facilitate two government functions. First, government must serve as the lender of last resort (usually through the central bank) to prevent a failure of the banking system. Second, government must run fiscal deficits sufficient to limit the severity of the profits decline and thus limit the economic contraction and job losses. Both of these occurred in the United States in the last recession.

Unfortunately, most emerging market countries are heavily dependent on international hard currency denominated capital markets and therefore on foreign exchange stability, a prerequisite that often prevents pursuit of looser fiscal and monetary policy. In the absence of a vast international financial rescue effort by strong currency countries (the chances of which seem dubious), many emerging market debt instruments are likely to default and suffer extended financial and economic consequences. Meanwhile, the euro area will have grave difficulty supporting itself during the developing global crisis as long as there is no centralized, government borrowing. Otherwise, markets will continue to assess each euro area member country’s debt independently, leading to more of the destabilizing flight from those least favored that we have already witnessed in the cases of Greece and the other most vulnerable euro area economies.

How long will the misery last?

Debt levels and asset prices must decline until they are justifiable by incomes. This process will probably take at least several years and more than one business cycle. Two key policy tools in the United States, as they were in Japan, are an effective lender of last resort and a fiscal stabilizer. This means, first, government must serve as the lender of last resort (usually through the central bank) to prevent a failure of the banking system. Second, government must run fiscal deficits sufficient to limit the severity of the profits decline and thus limit the economic contraction and job losses.

However, unlike in Japan during most of the 1990s or in the euro area at present, banks must be compelled to work out or write off bad loans, and assets have to be liquidated. Unfortunately, the euro area presently lacks the political structure to fully address its balance sheet problems. Worse off still are most emerging market countries which, because of foreign debt denominated in dollars, euros or yen, lack the financial independence to use fiscal and monetary policies effectively to contain their economic depressions.

What is your advice for investors?

There are very few truly safe haven assets in the world. We recommend being overweight in U.S. Treasuries, especially long maturities, staying out of emerging market assets and currencies, and not fearing to hold cash. Gold is likely to decline a great deal further against the dollar in a deflationary global economy.

After all that doom and gloom, do you have some glimmer of hope for our readers?

We are very bullish about the long-term outlooks for the United States and Japan. Parts of the euro area, if it breaks apart, or all of it, if it can hold together under coming stresses, are also likely to exit the current balance sheet mess some years down the road and enjoy a great new investment boom. However, we worry about how long and difficult the adjustment period will be. Japan has been through a contained depression, rather than a great economic collapse, and the United States has been going through a contained depression since 2007. It remains to be seen how well the euro area will be able to contain the fallout from its own imbalances.