The Atlanta Federal Reserve GDPnow model is quickly growing a reputation for the most accurate advance estimate for GDP. It is now tracking a negative growth rate for GDP over the first half of 2015.
The charts in the link above show the scale of the gap between consensus forecasts and the Atlanta Fed’s more accurate and timely measure. It exposes once again the dire record of mainstream forecasts.
“it’s worthwhile recalling that mainstream economists, the Federal Reserve, government agencies and the mainstream financial media all deny the economy is in recession until it falls off a cliff. Only after a recession can no longer be denied will the organs of propaganda concede that the economy is indeed mired in a recession. ” – Charles Hugh Smith.
However, while the statement above accurately reflects the dire forecasting record of most mainstream “economisseds”, it leaves out two important questions that arise from this observation.
Why do mainstream economists have such a poor track record? And where can investors find more useful information?
I hope I can provide some guidance on both these questions.
On the first question the chart above shows that the path of the financial economy and the real economy are very different. On the measure shown in the chart, the financial economy is now a multiple of 5 times larger in relation to the economy than it was a few decades ago.
Policy makers and Wall Street economists are highly intertwined with the rapid proliferation of debt and securities over the last 40 years. Both have a strong incentive to enable and then proclaim the success of the system they are in. If your economic model says you can boost the growth of this system then there is a clear incentive to do so.
However, what if your model is short-sighted or worse highly flawed? The long term evidence seems clear that the economic model policy makers are using is just plain wrong. The first two charts in the link below show that over the last 40 years there has been an exponential increase in debt levels, and a relentless decline in long term growth.
It is also relatively easy to understand why the models are deeply flawed. Steve Keen explains, for example, that the models take no account at all of the extraordinary level of debt in the economy.
Furthermore, there is now an additional problem. At what point does the finance sector itself become too big for the real economy? Does the tail then wag the dog to the point that the economy loses its natural pricing mechanism?
The Federal Reserve has clearly become highly sensitive to stock prices and their effect on the economy. They now claim market prices are part of policy, to the point that central banks have become highly active in all markets.
Corporations are also in the business of financial engineering. This is now reaching new heights never seen before as stock buybacks break into new record territory.
With financialization this big, normal market function can easily be overwhelmed in the short term by central bank or corporate financial engineering, and the usual relationships with underlying economic fundamentals can be temporarily suspended. So new and unpredictable forces are driving the markets as never before.
Putting this all together, markets have become increasingly erratic and confusing as well as increasingly disconnected and/or divergent.
The real economy is actually performing very poorly and policy makers have become hyperactive with flawed models and are compounding the problem.
Fortunately, there are still a few economists that throughout this transformation have been able to understand and predict market developments reasonably well. Richard Duncan has, I believe, accurately diagnosed the transformation in economics going back to 1968, and has an excellent framework and forecasting record. Most of his work is accessible only by subscription (I am a subscriber), but here is a publicly available interview out just this week, summarizing his approach.
Richard Duncan points out that financialization also has its own rules, and the most important drivers to understand are liquidity and credit growth. His insight into these relatively predictable factors enabled him to correctly forecast the current slowdown several months ago.
For the time being liquidity has remained supportive, which has helped to hold up the markets. However, going into the third quarter liquidity becomes much more challenging and for quite an extended period. Without further policy action this factor will soon turn negative for markets. Given the weakness of the economy already this could cause some significant volatility. Also far from raising rates the Fed is much more likely to end up introducing yet another round of QE.
Fed fund futures have already discounted very little risk of a rate rise this year, so Treasury bonds could be very oversold currently following the current correction. Equities may finally have a more significant setback at some stage over summer, but the Federal reserve may move very quickly to a new QE program to restore liquidity. The dollar should remain weak, so commodities could outperform equities over the next few months.