Barry Norris of Argonaut Capital sent me a note on his latest thoughts this week. It came with an e-mail saying: "I suspect you'll disagree with about 90% of this." He was almost right. Barry is a big believer in a V-shaped recovery and I am absolutely not.
The case for the V is straightforward. The double-digit collapses in industrial production over the last year have meant that inventories have been "drawn down to an unprecedented degree", says Barry. So any normalisation of demand levels "caused by pent-up demand and easier credit" will be a "powerful positive stimulus" to production and quickly bring about a V-shaped recovery.
The idea that inventory restocking will lead to recovery does make some sense. At some point, businesses that want to stay in business have to restock and that suggests we may soon see the end to absolute falls in gross domestic product (GDP). Note that even Japanese factory output rose in June for the fourth month in a row.
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But I'm not sure that means a sharp rebound is sustainable. The argument that those who believe in the V don't accept is that this recession is, as James Ferguson of Pali keeps pointing out, not just a recession. It is a bank crisis. And these recover much more slowly than normal recessions taking "six to seven quarters until GDP returns to the previous peak, as opposed to three to four typically".
Why? Because the credit boom preceding them is usually characterised by consumption hitting a much higher percentage of GDP than is normal and by asset bubbles in the wake of which consumption tends to be very slow to recover (there isn't really any "pent-up demand").
At the same time, private sector credit growth tends to be slow in a bank crisis recovery. Banks don't lend as much and people don't borrow as much, however low rates go this inevitably holds back GDP growth.
The upshot? An end to recession doesn't mean much of a return to growth and it certainly won't mean a return to the debt-fuelled rates of growth we've long been used to. Without the consumer on board, cost cutting and restocking can only drive things so far. As my semi-retired hedge fund manager friend says: "One company's cost cutting is another company's lost sale."
There is a "new normal" on the way, says Ferguson, that doesn't rely on constantly rising leverage to drive economies and markets. It is therefore likely to be "a bit of a disappointment" to economic optimists.
Still, just because I don't believe in the V doesn't mean that I disagree with Barry on everything. I'm with him on the rising risks in the Chinese market (which I wrote about here a few weeks ago). As he puts it: "Economies where money supply is increasing at rates of more than 25% don't normally have happy endings." There are already enough signs of a speculative bubble in China to make us all very nervous indeed.
I'm also getting convinced by the case he makes for Europe, largely because he starts by pointing out that "there is no compelling secular growth narrative for Europe,"...which there isn't.
However, its stock markets are, arguably, cheap enough to buy even without one. European equities, overall, are still 50% off their peak and now around levels last seen in 1997. They also trade at a 45% discount to their long-run ex-bubble average price/earnings ratio of 20 times (today's price divided by the average of the last ten years' earnings).
Given that the recession is all but over, says Barry with valuations at multi decade lows this is surely "a once in a generation buying opportunity".
Another plus point for Europe is the way it has a bit of the Japan about it. Most equity investors hate it at any price, so it is priced for perpetual failure.
Finally, those after income might like to note that you get a higher dividend yield than you might think from a good many European shares the Argonaut European Income fund currently yields 5.5%.
Still, before you get the idea that I am turning all bullish, let me say that I'm not suggesting anyone buy much now. US investing guru Jeremy Grantham, who urged everyone to get back into the market in March (in a note aptly called "Reinvesting When Terrified"), is now suggesting that those who did "take some risk units off the table".
Like him and rather too many others for comfort I'm still expecting the global rally of the last few months to come to a sticky end as the market abandons its holiday high spirits and starts to accept the miserable truth about bank crisis recessions. That should happen relatively soon. When it does, European equities, like Japanese equities, should merit another look.
This article was first published in the Financial Times
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