Update: 3 Apr 2009: I have been getting more positive about the possibility of a cyclical upturn before 2009 is over (what I like to call a fake recovery). Meanwhile, the punderati are seeing black when they should be seeing shades of grey. As a result, I wanted to re-post this December article as a reminder to all of you and to myself of the perils of becoming wedded to a certain ideological bias.

Also see the following article on the site Overcoming Bias.

Here’s the original post:

For a long time Byron Wien of Morgan Stanley used to have his “Ten Surprises for” whatever year we were about to enter. The predictions were sometimes head-scratchers and they were definitely ‘out there.’ Most of the time, these predictions ended up being wrong. Now, Saxobank has taken over from Morgan Stanley in this department. Their list is outlandish — and I’ll get to it in a moment. But, first, I want to say these predictions serve a very useful purpose.

It’s called thinking outside the box. All of us have a bias that reinforces a false belief in the certainty of what we believe to be true. It’s called the overconfidence effect. Basically, we construct a mental map in our minds of what is probable and what is improbable. Over time, these beliefs harden and become what is certain and what is certainly not. I got a true test of this in business school.

My professor asked us some off the wall question like how much does the earth weigh. After we wrestled with the question and wrote down our answers, he then asked us to put a 95% confidence interval around the answer. He said give me a range of numbers that you believe the earth’s weight is 95% certain to be in. We mulled this over and answered. Result? Our 95% confidence interval was wrong something like 40% of the time within the class. Why?

Basically, by asking us the first question: how much does the earth weigh and giving us a chance to think about it, our professor was secretly giving our little pea brains a chance to become overconfident. By the time he asked us the second question, we had become anchored to the first answer. Essentially, he asked us to think outside the box and the mix of our overconfidence and anchoring caused us to make catastrophically wrong answers.

That’s how humans work. And this was a 10-minute exercise. Just think if you spend your life looking at economic events and making predictions. The likelihood of your being anchored to a specific prediction is that much greater. Eventually, you become so overconfident about this prediction that you are willing to bet the farm on the outcome.

Enter Saxobank. They have just released a list of outrageous predictions like $25 oil and civil unrest in Iran. Now, even I had become anchored to $147 oil because I thought I was being aggressive in July when I predicted $100 oil (my secret whisper number was $70). So saying $25 a barrel is extreme to the max.

The point is we all need to make ourselves familiar with extreme outcomes. Otherwise, we risk becoming too certain about a range of possibilities that is much too narrow. And when the unexpected happens, we will be quite unprepared.

Here is Saxo’s list.

Source
[Outlook 2009] 10 outrageous claims from Saxobank – FT Alphaville
Outrageous predictions -Saxobank (pdf)

Related articles
Anchoring – Wikipedia
Overconfidence effect – Wikipedia

Originally posted on 18 Dec 2008 (1438 ET)

Related posts:

• Top ten predictions for the 2009 global economy
• Revisiting my predictions for 2008
• Another look at my 2008 predictions
• The market is moving. You should be too.
• Ten predictions for 2008

On February 6th, I started a poll asking whether the global economy was experiencing a recession or a depression.  In the interim, I have tried to stay neutral on the issue.

Now it is time to close out the poll.  Below you can add your vote.  I will release the final results tomorrow.

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• Readers of this blog expect the recession to last
• We are in depression
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With a name like “Credit Writedowns,” this site is obviously not preternaturally given to the wildly optimistic scenario. In fact, my operating assumption is to hope for the best, but plan for the worst and expect something in between. Indeed, in an economic downturn, one needs to be more fixated on planning for the worst than hoping for the best. Nevertheless, as with the last post on China, I want to present the ‘bullish’ scenario to paint a fuller picture of the potential outcomes for the global economy.

In that vein, I want to present an interview with Jim O’Neill, the Chief Economist of Goldman Sachs. Just yesterday morning, I watched O’Neill say on Bloomberg Television UK that he believed the worst is behind us. In his view, Q4 2008 may be the worst in the present downturn. His basic argument is compelling: policy stimulus has been massive all around the globe. This stimulus works with a lag, but will be felt in earnest in the second half of 2009. Therefore, we may have seen the worst of things already.

Now, I do think 2009 is going to be a complete write-off in the world’s major economies. But, I am sympathetic to his argument. For example, there is a realistic best-case scenario for positive growth in the United States starting already by Q3 or Q4 2009.

Because most economists are increasingly pessimistic and this forecast goes against the grain, I have located the O’Neill video and am posting a link below. O’Neill says we should look to the ISM Manufacturing Survey and the Philadelphia Fed Manufacturing Survey as leading indictors for an upside surprise. Irrespective of how you foresee developments in the global economy, you should take O’Neill’s view into your calculus.

Click on picture for video link

Jim O’Neill, chief economist at Goldman Sachs Group Inc., talks with Bloomberg’s Carol Massar about the outlook for recovery of global economies.

O’Neill, speaking from London, also discusses the response to the financial crisis. (Source: Bloomberg)

00:00 Crisis response by G-7, China; banks
03:32 Fourth-quarter 2008 was “worst” for world.
06:14 G-7 meeting; China, Brazil, Russia, India

Related videos
Jim O’Neill Says Contraction in Europe `Worse’ Than US – Bloomberg.com

Related posts:

• Jim O’Neill on the Global Economy
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• The bearish argument for the global economy
• Global instability must be contained in 2009
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The question on everyone’s mind in the emerging markets is who will blow up next. Arnab Das of Dresdner Kleinwort Benson takes a stab at answering that question. He targets the Baltics as the problem children and sees current account surplus nations in Asia as lest vulnerable. He also discusses his views on Russia.

Below is the video with him on CNBC giving forth his view.

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You probably know that I am gearing up for some serious writedowns in Eastern Europe because I see these countries as having external imbalances which will have to be corrected as the economy softens. In previous posts, I had mentioned that there was considerable exposure to Eastern Europe in Austria, Sweden, Denmark and Germany in particular. Austria is the worst of the lot. Today, I happened upon an article and a quote which puts the Austrian exposure into context.

Internationally, Smick said export-dependent developing countries, and the western banks that financed their growth, are particularly vulnerable.

“If too many of these emerging markets go down, the IMF (International Monetary Fund) lacks the necessary resources to mount rescue operations,” writes Smick, author of the 2008 book The World Is Curved: Hidden Dangers to the Global Economy.

“To put things in perspective, Austrian banks have emerging-market financial exposure exceeding $290 billion. Austria’s GDP is only $370 billion.”

Yves Smith tells me the word on the street is that Germany may be holding back on fiscal stimulus in anticipation of a need to bail the Austrians out when their banking system comes under fire. I have not heard these rumours, but, it does stand to reckon that some larger government entity is going to be left holding the bag here. The Austrians will not be able to get out of this alone.

Source
Economic ‘bubbles have only begun to burst’ – Vancouver Sun

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As the New Year unfolds, it is time for predictions. I have done my part, giving a full account of where I see things headed in 2009 in my post “Top ten predictions for the 2009 global economy” and where I want to see them headed in 2009 in my post “Top ten economic wishes for 2009.”  I have also mentioned Byron Wien in passing several times because he has done this soarrt of thing every year for the past 24 years, first at Morgan Stanley and now at Pequot Capital.  Well, his list for 2009 is now out and I want to show it to you – along with my usual commentary (in parenthesis) of course!

Enjoy.

WESTPORT, Conn. – (Business Wire) Byron R. Wien, Chief Investment Strategist of Pequot Capital Management, Inc., today issued his list of Ten Surprises for 2009. Mr. Wien has issued his economic, financial market and political surprises annually since 1986. The 2009 list follows:

1. The Standard and Poor’s 500 rises to 1200. In anticipation of a second-half recovery in the U.S. economy, the market improves from a base of investor despondency and hedge fund and mutual fund withdrawals. The mantra changes from “fortunes have been lost” to “fortunes can still be made.” Higher quality corporate bonds, leveraged loans and mortgages lead the way.

(I do NOT see the market rising here.  The consensus view is for a rise in equities as the recovery takes shape in the second half.  Even Richard Bernstein, the most cautious equity strategist on Wall Street, sees stocks up 7.9% in 2009.  The average on Wall Street says we’ll be up 17% with Barclays the only firm seeing another loss.  I am going for -10%.)

2. Gold rises to $1,200 per ounce. Heavy buying by Middle Eastern investors and a worldwide disenchantment with paper currencies drive the price of precious metals higher. In a time of uncertainty, investors want something they can count on as real.

(I am a gold bug of sorts.  But, first, it’s the deflation, then the inflation.  The question is when.  I say the global economy will be flat on its back all through 2009 so gold is not going anywhere.  Let’s put gold at $850 and wait for its rise in 2010).

3. The price of oil returns to $80 per barrel. Production disappointments and rising Asian demand create an unfavorable supply/demand balance. Other commodities also rise, some doubling from their 2008 lows. Natural gas goes to $9 per mcf.

(I have already said I see a fall to $25 – which is looking less likely now,oops – followed by a rise to$55 for oil. So, I will stick with that.  Natural Gas is trading at $6 per mcf, so $9 seems a fair bet here.)

4. Low Treasury interest rates coupled with huge borrowing by the Treasury send the dollar into a serious downward slide. Overseas investors become concerned that the currency printing presses will never stop. The yen goes to 75 and the euro to 1.65.

(Currencies are trouble.  But, Wien seems to be a bit of a dollar bear.  He and I see eye to eye.  Let’s call the yen peak at 80 and the Euro at 1.55. )

5. The ten-year U.S. Treasury yield climbs to 4%. Later in the year, as the economy shows signs of recovery, economists and investors shift their mood from concern about deflation to worries about inflation. A weak dollar, rapid growth in money supply and record-setting deficits (over $1 trillion) are behind the change.

(Here’s where Byron and I part ways.  I see the ten-year at 1.75% and the 30-year at 2%.  That’s an enormous upside move and a very risky call, which I would not necessarily bet on.  Basically, I am betting the bubble will extend itself to everyone’s surprise.  2010 is when the carnage will result.)

6. China’s growth exceeds 7% and its stock market revives. World leaders credit China’s authoritarian government for its thoughtful stimulus policies and effective execution during a challenging period. The Chinese consumer begins to spend more and save less and this shift is behind the unexpected strength in the economy.

(China is weaker than the consensus believes.  Over the long-term, I am very, very bullish on China, India and the emerging markets. But, downturns have a way of synchronizing markets.  I believe China will grow only 2% this year, as I have stated.)

7. Falling tax revenues from the financial sector cause New York State to threaten bankruptcy and other states and municipalities follow. The Federal government is forced to step in and provide substantial assistance. The New York Post screams “When will the bailouts stop?”

(I see California as the first to go bankrupt, and I have already said that I would look to Arizona, Nevada or Florida for the next weakest state.  Let me amend that by putting my money on Florida and New York.)

8. Housing starts reach bottom ahead of schedule in the fall, and house prices stabilize after dropping 15% from year-end 2008 levels. The Obama stimulus program proves effective and a slow growth recovery begins before year-end. Third and fourth quarter real gross domestic product numbers are positive.

(I agree.  House prices falls will also diminish in severity.  By June, I see year-over-year comparisons getting better. I believe we have already seen more than half of the declines. )

9. The savings rate in the United States fails to improve beyond 3%, as most economists expect. The concept of thrift seems to have vanished from American culture. Peak job insecurity and negative growth drive increased savings early in the year, but spending resumes as the economic growth turns positive in the second half, making Christmas 2009 the best ever.

(An interesting call here.  One could say that continued economic weakness would mean savings MUST remain low as budgets will be strained.  In the Great Depression, this is how events came to pass.  I had been looking for the savings rate to climb. But, Wien’s comments give me pause — not for the reasons he  mentions.  Let’s put the savings rate at 3% as well, suggesting an increase in savings, but not enough to revert back to the mean.)

10. Citing concerns about Iraq’s fragile democratically elected government and the danger of a Taliban-controlled Afghanistan, Barack Obama slows his plan for troop withdrawal in the former and meaningfully increases U.S. military presence in the latter. In a hawkish speech he states that the threat of terrorism forces the United States to maintain a strong military force in this strategic area.

(I think Obama is making a big mistake by betting on Afghanistan as the primary front in the war on terror.  I anticipate he will double down there as Wien suggests, but that he will not deviate from his plan to leave Iraq.)

Mr. Wien believes these surprises, which the consensus would assign only a one-in-three chance of happening, have at least a 50% probability of occurring at some point during the year. In previous years, more than half of the elements of the list have proven correct.

Whether Wien is correct – he claims to be about half right generally – is beside the point. His list is thought-provoking whether you agree or not.  It certainly gave me some interesting ideas.

Update: Below is a CNBC Video of Wien talking about his picks:

Source
Byron Wien Announces Ten Surprises for 2009 – Business Wire via Earth Times

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• Deutsche Bank: Loan losses will double in 2009
• Barton Bigss on Charlie Rose
• Think outside the box: ten outrageous predictions for 2009
• Stephen Roach sees a W-shaped recovery for China
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Happy New Year! As the new year begins, I find myself in a fairly optimistic frame of mind. I am thinking that perhaps we can wipe the slate clean and start anew this year.

In that vein, let me share with you what I think needs to be done in order to right a global economy that is suffering its worse recession since the 1930s. If we accomplish these ten steps, the global economy may well recover much sooner from recession than any of us expect. Feel free to add your own assessment in the comments section.

1. Fix the financial sector. I started writing on the Internet in large part because I felt a weak financial services sector was going to have a bad knock-on effect for the global economy.  (See my post “Why this blog is named Credit Writedowns” for more on that.)  The upshot is that my view is skewed toward a necessity to fix the financial services sector first. That means the sector must be right-sized and recapitalized to effectively fill its vital role going forward. To do this, we must end ad hoc solutions and take a more comprehensive approach. I am optimistic that we will see this policy approach in 2009. (One can read more on my ideas here in my September post, “The global economy has crashed: we need a comprehensive credit crisis plan“)
2. Return price discovery to global credit markets.  The credit crisis has reduced the liquidity of a number of  risky asset classes, making price discovery challenging.  Basically, no one is trading these depreciating but previously liquid securities. So it becomes difficult to know how much they are worth.  This undermines the entire credit market.  My hope is that government programs like the TARP (troubled asset relief program) in the U.S. can be used for their intended purposes — making those asset classes more liquid.  The mechanics of doing this without the government’s buying assets at inflated prices is going to be a key issue for governments in the G-7.
3. Help end the pain in housing.  House prices are going to keep going down in 2009.  I am not an advocate of propping them up artificially.  However, I do want the pain to end.  The easiest way to do that is for government to create incentives for lending institutions to accept loan losses.  I would imagine that governments will need to guarantee a capital for loan modification scheme in order to get this sorted.  By that, I mean that lending institutions will modify mortgage loans to a lower principal amount, incurring losses.  In return, the government will use taxpayer money to recapitalize those institutions only when the modifications occur. This would certainly have to be done in conjunction with a comprehensive banking solution that liquidates bankrupt institutions and strips out toxic assets in order to eliminate moral hazard. Again, the devil will be in the details, so should be a key policy issue for 2009.
4. Eliminate worst-case economic scenarios.  The problem with this recession and its debt deflation is that it leads to a downward spiral where good companies die and new companies don’t get formed.  This can only be avoided by preventing the downward spiral in the first place.  While I quibble with policy makers’ specific prescriptions, I realize they are on the case trying to prevent the worst-case scenarios.In my view, this can only be done by providing fiscal (and some monetary) stimulus where the private sector is unable to do so. My view here happens to be in contrast with more hawkish policy makers in the Eurozone, particularly in Germany, where fiscal and monetary stimulus have been weak. Time will tell which countries have followed the correct path.
5. Cushion the fall for workers.  A lot of workers will be displaced by this turbulence – so many in fact that I would expect civil unrest.  As a result, policy makers are definitely looking to use the social safety net as a way of cushioning the blow to workers.  But, I anticipate more will be done gloally by investing in public goods like education, infrastructure and health care that the private sector has underfunded.
6. Depreciate deficit country currencies.  The recession offers a perfect opportunity to correct some global imbalances that have been building for a while.  My principal concern here is overconsumption and underconsumption.  A number of countries have huge current account deficits due to overconsumption.  The U.S., the U.K., and many countries in Eastern Europe are prime examples. On the other hand, many Asian countries have relatively low domestic consumption demand. Here, China is the prime example.  A devaluation of the U.S. Dollar, the British Pound and Eastern European currencies relative to the Eurozone and China would correct this problem. A weak currency for debtors means high import prices and inflation. While this is an economic burden, it certainly helps avoid debt deflation and it definitely encourages savings and discourages overconsumption. In China, policy makers could look to spur domestic demand by opening the market to foreign competition and by favoring consumption through temporary tax policy changes.
7. Get the oil price back to $50-$55 a barrel.  It sounds masochistic to want an increase in oil prices.  However, oil at $35-$40 a barrel is not particularly good for the budgets of oil rich but potentially unstable countries like Russia, Venezuela, Nigeria, and Saudi Arabia.  In my view a slightly higher oil price is worth accepting if it eliminates potential problems in those nations.  Moreover, I would also argue that $35-$40 oil is extremely discouraging to investment in alternative energy and oil exploration and development.   That would means we would see another oil price shock when the economy recovers — the last thing we need.
8. Align pay incentives and compensation. This is a problem throughout the private sector in the G-7. However, in the financial services sector in particular, there has been an increasing misalignment of incentives and pay.   In days of old, investment banks were partnerships where senior executives had most of their wealth locked up in their companies for the long-term.  Today, senior executives are paid vast sums for recent market performance.  It is no coincidence that we have seen major market dislocations after the end of the partnership business model. Present compensation schemes reward risk and short-term profits at the expense of reliability and long-term profitability. This needs to be changed — if necessary by regulatory means.
9. Avoid protectionism.  We all have heard about the Smoot-Hawley Tariff Act of 1930.  It is legendary as a symbol of the every-man-for-himself mentality that economic turmoil and fear breeds.  There are many peddling the same visions today (See Pat Buchnan’s take: “George Bush, Protectionist“).  This is a recipe for tit-for-tat politics and a downward spiral as free trade becomes a casualty of recession.  My hope is that protectionism will NOT become a major factor in 2009.
10. Bring more countries into the global system.  Rather than stop free trade by turning to protectionism, the G-7 should take the lead in trying to bring former pariah states into the fold.  That means countries like Iran, Venezuela and Cuba.  How this is to be accomplished is a political question I don’t wish to examine.  Nevertheless, it stands to reason that more trade is better than less.  And were the U.S. to take the lead here, I am sure it would have a favorable impact n the bottom line of U.S.-based companies which could do business in those three countries.

So, that’s my wish list.  As the new year begins, I am hopeful that some of my wishes do actually come true.

Related posts:

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I caught a good article in today’s Guardian about the British Pound.  The question is: how weak will Sterling get?  My answer is below 1-to-1 with the Euro.  But before I tell you why, let me interject a blurb from the article.

The world’s foreign exchanges were today readying themselves for parity between sterling and the euro after further selling sent the pound to within touching distance of a one-for-one exchange rate against the European currency.

Fears of a severe UK recession in 2009, the weakness of the dollar prompted by the Israeli attacks on Gaza and thin post-Christmas trading all contributed to a 2% fall in the pound yesterday. At its lowest point this morning the pound was worth €1.0265, slightly up on the previous day’s low of €1.0198.

The euro has risen by almost a third against the pound in the course of 2008, with an 18% appreciation in December alone. Sterling’s trade-weighted index against a basket of currencies fell to 74.2% of its 2005 value, its lowest since the Bank of England first kept daily records in 1990.

Although the cheaper pound makes UK exports more competitive on world markets and encourages foreign visitors to Britain, it also means dearer imports and makes overseas travel more expensive.

Financial markets believe that UK interest rates – already at a record-equalling low of 2% – will be cut further in the new year as the Bank seeks to revive an economy that is on course to suffer its weakest year since the early 1980s.

Edward here. As much as I hate singing the same tune as everyone else, I have to agree with the tenor of the article.  The U.K. will suffer some horrific mortgage default levels in 2009.  I guarantee you that puts Mervyn King into a dovish frame of mind.  What’s more is the Europeans are not going to do the same.

“There’s a sense that UK rates will fall closer to zero, and that the Bank may be forced into some sort of quantitative easing, while there’s no sense of that in the eurozone,” said Daragh Maher, senior currency strategist at Calyon in London.

Well said.  I should also point out that going to zero gives one no incentive to use the repo market and it makes money fund yields after fees below zero.  This is what is hapenning in the United States and is one reason I see the Dollar lower.  The Europeans are not going to do the same.

But I am betting the BoE does.

Source
Sterling within a whisker of parity with the euro – Guardian

Related posts:

• The U.S. dollar plunges due to quantitative easing
• Morgan Stanley sees U.K. downturn worse than Great Depression
• Chart of the day: US Dollar
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In my most recent post, I gave a fairly comprehensive retrospective of the year that was.  Near the end of that post, I listed a number of posts I wrote in October and November which point to how I see 2009 shaping up.  Let me give you a more direct assessment here.  I will finish it off with my top ten predictions for 2009.

2008 was a disaster.  The subprime meltdown actually started in February 2007, giving policy makers plenty of time to act. However, inaction proved fatal as the subprime crisis metastasized into a global credit crisis that did not take full form until this past year.  In so doing, it revealed a number of inherent weaknesses in the global financial system which I believe will play out in 2009.

Banking weakness

The first problem to note is global banking fragility.  It bears noting that after the Japanese banking crisis, many prognosticators pointed to the weak capital structures at Japanese banks as a cause for the crisis.  I felt then and still do today that they had it backwards.  Poor lending practices made institutions in Japan that previously seemed well-capitalized into capital weaklings.  This will be very much the case globally in 2009.

In the U.S., Ireland and the U.K. in particular, there are significant loan losses that have yet to be taken.  This is part due to the fact that loans are carried at book value until the borrower cannot pay.  On the other hand, freely traded securities like Mortgage-backed securities must be written down immediately to reflect market values.   That has meant that institutions which have credit risk held in the form of marketable securities have taken the lion’s share of the pain.  I expect that to change in 2009.

Going forward, real economy problems i.e. default and bankruptcy will become an issue.  That means that those hidden loan losses will have to be taken.  You should note that I am definitely suggesting the following: had loans been traded in the same way that mortgage-backed securities were, we would have seen a tidal wave of losses here already.

Which countries and which asset classes are vulnerable?  From a country perspective, one could look first to the first bubble economies to pop as canaries in the coalmine: Ireland, Spain, the U.K. and the U.S.   I will not make any predictions about Spain, but I will say that I do expect to see horrific loan losses in the other three countries.

Asset Class Weakness

From an asset class perspective, here is my thinking:

• Residential Property – In the U.S., Alt-A payment resets approach and recession will start to hit through unemployment. Therefore, expect to see Alt-A loans go sour as their subprime brethren did before.  This class includes those exotic mortgage types like no-payment, option ARM, and negative amortization loans to prime borrowers.  As there are many Mortgage-backed securities  of the Alt-A variety, these loan losses will lead to writedowns at those same banks that have had massive writedowns already, further impairing their capital base.  The subprime crisis is less of an issue at this point.In the U.K. and Ireland, property prices will decline in 2009 and unemployment will rise. This double whammy will mean mortgage defaults will rise and loan losses will increase at those institutions most levered to the residential property markets.
• Commercial Property (CRE) – I was way too early on this asset class, expecting to see major losses in 2008.  But, CRE will be front and center in 2009.  Why?  It stands to reason that in recession, businesses are hit as consumption growth slows or goes negative.  This will depress demand for commercial property, driving down lease prices. Simultaneously, retailers will struggle and this will increase defaults.  That means much less income and huge loan losses for CRE REITs and commercial property-oriented financial institutions.  This will be true in the U.S., Ireland and the U.K. at a minimum.  However, although I am not making a forecast here, I am also hearing much the same across the Eurozone.
• Leveraged Loans and High Yield – These asset classes are sporting record yields because credit quality has deteriorated significantly across the board. For instance, at the tail end of the boom, there were many more low quality single B rated bonds. Leveraged loans are those loans given to finance higher risk, leveraged buyouts. High-Yield is simply a moniker used for lower quality bonds. It stands to reason that poorer asset quality loans and bonds will be hit first during a downturn.  That means leveraged loans and high yield will suffer before any other corporate bond and loan class.  This is going to be true in the U.S. and in Europe across the board.  (See Wikipedia’s entry for High yield debt).
• Credit Card and Auto Loans – Here is another class that will implode the balance sheets of major banks because of tradeable asset-backed securities (ABS).  We have already seen credit card chargeoffs increase significantly.  Even American Express, generally considered the highest card quality provider, has been experiencing increased loan losses.  Now, remember, there are boatloads of auto and credit card ABS bonds trading in the open market.  These securities will be severely impaired and writedowns will be enormous.  I predict some institutions will fail as a direct result of these writedowns.
• Eastern European loans – Countries like Ukraine, Hungary, Latvia, Estonia and Poland are going to see major downturns.  Unfortunately, this will mean currency weakness.  That has a major impact on debtors in those countries as they have borrowed in Euros (much like Icelanders had).  Combine the currency impact with recession and you have the makings of a debt crisis. The banks loaning Eastern European corporates and homeowners these funds are situated in countries like Austria, Germany, Denmark, and Sweden.  Therefore, expect to see significant writedowns at major European institutions as these loans sour.  Will this be Europe’s equivalent of the Latin American debt crisis of the 1980s. Yes.
• Other asset classes – We are talking about prime mortgages, ordinary bank loans, and corporate loans. These will suffer impairment because of the recession, but the problems here should be much less than in the asset classes I identified above.

Currency Weakness

It is extremely difficult to call currencies.  In 2009, it will be especially difficult because there are potential trouble spots everywhere.

However, on the whole, one should expect the British Pound and the U.S. Dollar to be weak currencies as their central banks are going to resort to quantitative easing in order to forestall depression.  The ECB is less likely to do so despite the problems in Ireland, Spain and Greece.  At its core, the ECB is an institution controlled by the Germans, French, and Belgo-Dutch.  These hard money types will be reluctant to resort to ZIRP (a zero interest rate policy) or quantitative easing.  So, I expect the Euro to be strong.

Why the Yen remains strong is beyond me because the Japanese are about to engage in quantitative easing and ZIRP.  They have experienced a very hard landing.  But, the carry trade is no longer as appealing because foreign interest rates are falling as other central banks cut rates. So the desire to unwind carry trades is supportive of the Yen.  I expect a strong Yen.

I’ll leave it at that for currencies, except to say that Latvia will be a test case for Eastern Europe as the IMF did not require a competitive currency devaluation there as part of a bailout package.  It remains to be seen how that will play out.  I reckon we will see economic pain followed by capitulation and devaluation.  Russia is doing the right thing in devaluing, although that reduces the standard of living (through high import prices) and invites civil unrest.  Let’s wait and see.

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Ten Predictions for 2009

So, now it is time for me to lay it on the line and make my ten predictions.  Here they are:

1. The Obama Administration will not be a significant change from the status quo economically.  As a result, they will drag their feet on offering a comprehensive banking solution, leading to another (fatal) banking crisis in 2009 from ABS losses.
2. The Obama Administration will satisfy cultural liberals by re-regulating the banking industry heavily and by massive spending on public works.  Liberals will be ecstatic about American jurisprudence: Obama will appoint at least two liberal Supreme Court justices to the bench as Ruth Bader Ginsburg and John Paul Stevens step down.
3. The Obama Administration will be faced with a state government bankruptcy. They will bail out the state and promise to do the same again, much to the liking of liberals and municipal bond holders.
4. Eastern Europe will face depression, much as Asia did in 1997.  The result will be civil unrest and a near collapse of the European banking system.
5. The Irish banking system will suffer a crisis of confidence as the Irish will come to be seen as the next Iceland: oversized banking sector, huge loan losses.  The European Union will bail out the entire Irish banking system.
6. Oil prices will sink to $25 a barrel before rising back to $55 by the end of the year.
7. China, damaged by a huge decline in export demand, will undergo a massive stimulus campaign.  It will not be enough.  GDP growth will drop to 2% and civil unrest will ensue.
8. Tariffs, export subsidies and currency devaluations will roil the desire for free trade.  Initially, countries will seek relief at the WTO (World Trade Organization) but later they will begin to act unilaterally.  The U.S. will be the first to unilaterally retaliate.
9. U.S. house price declines and subprime defaults will slow.  Prime and Alt-A defaults will increase.  Meanwhile, Irish and U.K. mortgage defaults will increase dramatically.
10. The U.S. will begin initiate detente with Venezuela, Cuba or Iran.  The moves will be heralded as a foreign policy coup on the lines of the Sino-American detente under Nixon.  Obama’s status abroad will be boosted.

So, there it is.  My ten predictions.  I think this set of ten is pretty bold, actually.  So I expect to be very wrong on many of them.  Hopefully, it gives you food for thought.  Please feel free to call me out on a especially good/bad prediction or opine on your own predictions in the comment section.

Related posts:

• Where is the global economy headed?
• The U.S. banking crisis: where are we?
• Europe is next
• Ten predictions for 2008
• JPMorgan Chase: Large exposure to real economy downturn

This is the time of year when everyone tends to look back and sum up the year in one way or another. I have been doing much of the same.

In keeping with that theme, I have taken a good look through my nearly 1400 posts to get a better sense of what I got right and what I got wrong and how knowing that can help me going forward. Call it an exercise in intellectual honesty. This exercise has given me a good understanding of where things went wrong in the past year and why.

It may also give me some thoughts as to where we need to go in 2009. Let me share a little of what I learned with you. This is a long but thoughtful post, so take a few minutes. It should be worth it.

On the whole my predictive powers were working pretty well this year. But, I made a few lousy calls and some controversial ones along the way. Below is my view of how the year went, on some of those calls and links to the relevant posts. At the end, I’ll wrap it up with a few thoughts about where that leaves my thinking for 2009.

Recession in 2008

I started the year (actually it was March when I began) blogging about recession. It was my belief at the time that we were already in a recession that would prove much deeper than widely acknowledged. I tagged this recession as having begun in December 2007 or January 2008. This has turned out to be right on the money. Relevant posts:

• The Economy Is Definitely In Recession (Mar 2008)
• Recession: How Long and How Deep? (Mar 2008)
• Last week’s GDP numbers (May 2008)

Easy Money as the problem, not the solution

My thinking at the time was that a recession,while deep, did not have to lead to deflation and depression if policy makers made the right calls. That meant following an Austrian prescription of appropriately high interest rates in conjunction with liquidity at penalty rates if needed and liquidating excess capacity where appropriate.

Until Lehman’s collapse, I stuck with the basic Austrian school belief: easy money is the problem and not the solution. I felt the Federal Reserve was a bubble blowing, easy money central bank that created the housing bubble because they did not have the regulatory wherewithal to stop the madness. I lay much of the blame for this malaise at the feet of the Federal Reserve. Relevant posts:

• Has anyone noticed the Dollar has gone into freefall? (Mar 2008)
• Is the Fed reckless? (Mar 2008)
• The US Economy 2008 (Mar 2008)

The Fed creates a commodities bubble and inflation

As the Spring progressed my worry was easy money. My logic was that an easy Fed was stoking a commodities bubble which, by seeping through into consumer price inflation, was going to cause a much harder landing when the bubble popped. My view was that inflation needed to be kept in check because it would set off demand destruction and create a hard landing that all but guaranteed deflation.

Ultimately, I believe this to be the correct interpretation of events but it is controversial because many see the Fed as having made the right calls in gearing up for deflation from the word go. You decide. Relevant posts:

• Liquidity trap of a different sort (Apr 2008)
• Oil price rise is accelerating May 2008
• The Fed is on the easy money trip (May 2008)
• George Soros warns UK on economy, oil and inflation May 2008
• What is Inflation? (Jun 2008)
• Peak oil: are we there yet? (Jun 2008)
• Bernanke is responsible for the market meltdown (June 2008)

Credit writedowns will be much worse than expected

Meanwhile the financial services sector was imploding. I was very concerned that policy makers were underestimating the severity of the writedown and loan loss problem about to come ashore. No one was chronicling the writedown problem comprehensively.

So I started the Credit Crisis Timeline on April 15th as a modest post called Global Bank write-offs and failures. Later that same day it later morphed into a post called Articles: Bank Writedowns & Failures before becoming the Credit Crisis Timeline in May.

As April hit us, I saw the credit crisis fanning out far beyond the U.S. and big bank exposure to subprime. This was NOT a subprime crisis and it was a global in nature. The U.S., U.K., Ireland, Spain and Denmark all suffered popped housing bubbles that weakened their banking system. Global banks like UBS were writing off tens of billions in exposure to mortgage backed securities. The U.S. regional banks were starting to look weak. So I started to write a lot about anticipated European bank writedowns and regional bank exposure.

My best call here was in predicting that many more writedowns to come and that the financial sector and its credit writedowns would be at the center of this downturn. My favorite call was on HBOS and its exposure to loan losses. My worst call was on Santander, which I thought was going to take down a lot of writedowns. I got that 100% wrong.

All in all, this was the most sickening time throughout this crisis in my view. The problems were mounting and the Bush Administration, The UK Government, The Federal Reserve, all of them, they were asleep at the wheel. Relevant posts:

• Finding a bottom (Apr 2008)
• RBS takes an enormous hit (Apr 2008)
• Where’s HBOS? (Apr 2008)
• Santander: US, Spanish and UK mortgage exposure (Apr 2008)
• HBOS to raise new capital (Apr 2008)
• The UK is ground zero in the credit crisis (May 2008)
• British Banks are underestimating losses (May 2008)
• Regionals are exposed to credit crisis (May 2008)
• Bradford & Bingley to issue profit warning (May 2008)

Oh no, debt deflation is the problem now

Then, in about June I made a controversial switch to a deflation-only perspective. Most everyone else was concerned about inflation at this point. Yes, I worried about the Fed’s easy money, but I figured the damage was done and now we were going to have to live with the consequences of easy money in the form of crushingly high food and oil prices. That meant a major, major recession. Meanwhile, it was very obvious that the banking sector was getting sicker by the minute Debt deflation became my main only concern starting about June. This was starting to look a lot like Japan.

This inflection period between having to worry about inflation to having to worry about deflation was perhaps the crucial moment for monetary authorities. You can see my angst in the post “What’s a central bank to do?” From where I sit, my seminal piece in all this was the post “The ECB is right and the Fed is wrong,” which I wrote on July 4th. Basically, I still felt that the inflation genie could be put back into the bottle before we suffered an extra-hard deflationary landing. The ECB was looking to do this, but the Federal Reserve was not. In my view, the Fed had been easy all along and it was this easy money that created the oil and food inflation monster.

In retrospect, it was probably too late by July. The extremely hard landing was baked in the cake. So, I was wrong here. I was still worrying about inflation as late as July 18th (post: Has the inflation damage already been done?). By July I should have realized deflation, or at least unwanted disinflation, had already begun. Relevant posts:

• De-leveraging (Jun 2008)
• De-leveraging redux (Jun 2008)
• Forget Inflation, debt deflation is the real threat (Jun 2008)
• The Japanese Problem is now ours (Jun 2008)
• Credit deflation and the Japanese problem (Jun 2008)
• Is the Fed going to raise rates? (Jun 2008)
• Deflation has already arrived (Jun 2008)
• BIS warns of worsening credit crisis and deflation (Jun 2008)
• Inflation or deflation? (Jun 2008)

Things fall apart

So that gets us to the IndyMac blowup. And we later get to the nationalization of Fannie Mae and Fredie Mac which I correctly predicted in April ( post: Question: How is Fannie Mae a AAA company?). Honestly, I didn’t see IndyMac coming. I knew that things had gone beyond subprime into Alt-A already but I was blindsided by IndyMac like most everyone else.

In retrospect, I see IndyMac as the unexpected event which changed psychology toward fear. No longer were Sovereign Wealth Funds ponying up billions into the financial services sinkhole. Investors started to flee the financials in droves and that spelt the end for Fannie and Freddie and later Lehman about whom chatter had already begun even befre IndyMac went bankrupt. Just my opinion.

Below are my warnings in April and May that buying financial services stocks was like catching a falling knife followed by investor revulsion in June and the blowups of IndyMac and the GSEs. I also said the true bloodletting would not begin until people stopped throwing money at the financials which were clearly headed down. One thing you might notice is that I was way too early on commercial real estate. Back in May, I was saying that Commercial Real Estate was the next leg down. It was not.

• Finding a bottom (Apr 2008)
• Carlyle: Expect protracted credit crisis (May 2008)
• What’s different about 2008? (May 2008)
• UBS warns on non-US property losses (May 2008)
• Regionals are exposed to credit crisis (May 2008)
• Regionals have CRE and Construction exposure (May 2008)
• Investors in Financials lose $10 billion (Jun 2008)
• Investors finally balk at giving banks more capital (Jun 2008)
• Financials: catching a falling knife (Jul 2008)
• IndyMac: Another Banking Bankruptcy (Jul 2008)
• Freddie and Fannie taken over by US government (Sep 2008)

The missed opportunity for a comprehensive solution

In jumping forward to Fannie’s bankruptcy, I am skipping July and August. I do that in part because I think the GSE bankruptcies were pretty much guaranteed post-Indy Mac. This was a lull where policy makers should have been looking for a comprehensive solution. We saw what happened in Japan and Scandinavia in the early 1990s. Why not use these as test cases? Instead what we saw were policy makers asleep at the wheel yet again. Did they not see the severity of the problem?

• Lessons from Japan’s Bank Crisis (Aug 2008)
• The Swedish banking crisis response – a model for the future? (Aug 2008)
• A cautionary tale: story from 1994 Japan (Aug 2008)
• Japan circa 1996 – forgotten already? (Jul 2008)

Commodities tailspin means hard landing

Meanwhile, I predicted commodity prices would collapse and we would have a brutal downturn. I never envisaged $35 oil. I thought $70 was reasonable and gave $100 as a bogey, but $35 is frightening. It speaks to the depth of deflationary forces.

Below are my posts on predictions about commodities, which would lead to deflation and recession.

• Oil to sink to $100 (Jul 2008)
• Have commodity prices peaked?
• Ten predictions for 2008 (Jul 2008)
• Refiners as a canary in the coalmine (Jul 2008)
• Commodity prices are dropping across the board (Jul 2008)
• The inflation – deflation debate redux (Aug 2008)
• What happened to peak oil? (Aug 2008)

The Lehman debacle: completely mishandled

I have been very critical of US economic policy makers and their handling of many aspects of the present financial crisis. But, the Lehman Brothers bankruptcy was the critical event in the whole daisy chain. It unleashed a tidal wave of panic and crushed the global financial system. Before Lehman Brothers went bankrupt, there was considerable wiggle room for the global economy. Yes, there would have been a sharp downturn, but recession is a necessary part of the business cycle. After, Lehman, it was game over.

I wrote this the day after Lehman’s bankruptcy and i think it is the most relevant post I wrote all year:

• Lehman’s bankruptcy: putting the cart before the horse?

Deflation is going to happen. Stimulus is needed

Before Lehman was allowed to go bankrupt, the right medicine would have been liquidating bankrupt institutions – financial and otherwise- before their zombie corpses pulled down good companies with them, whilst the central bank remained a ready lender of last resort in the event of market turbulence. That is the Austrian prescription.

But Lehman’s bankruptcy and the attendant market dislocations brought with them the absolute certainty of debt deflation, a downward deflationary spiral, and a deep recession. (For what it’s worse, I was blindsided by the depth f AIG’s fall, while I foresaw WaMu and Wachovia). After Lehman, Depression became more probable than not. This will be the worst economic event 95 of humans on the face of the earth will ever experience. Now suddenly, Keynes has become the man of the hour.

I have felt pretty conflicted by my about face. If you read any of my posts before Lehman Brothers’ bankruptcy, you’ll see that I take a hard Austrian line toward easy money and the solution to crisis. Granted, I have always had a sot spot for Galbraith, but I do not believe in fine tuning the economy, fiat money, or any of that.

In reading through my posts, I have tacked hard to the Keynesian side since about October. Why? In a word: Depression. Economic hardship of the magnitude we are about to face is the bedfellow to famine, war, disease, dictatorship, and economic nationalism. It is the breeding ground for fear and we have never experienced the type of hardship and fear that we are about to experience while in the possession of weapons of mass destruction. There are very bad scenarios to be avoided here. And there are no good choices. To ‘let them eat cake’ is not the way forward. I summed up my thoughts in four posts in mid-December.

• Confessions of an Austrian economist
• What does Mises say about trying to stimulate the economy out of recession
• Nouriel Roubini: Will massive stimulus ward off stag-deflation?
• A brief philosophical argument about the role of government, stimulus and recession

The Outlook for 2009 and beyond

So where does that leave us going into 2009? In my view it leaves us in a semi-depressionary state. There are many ills to overcome: commercial real estate, Alt-A mortgages, the unwinds of the banking sectors in the UK and Ireland, and the Eastern European debt crisis, a potential dollar crisis. Most of these things have yet to fully materialize but they are coming. Below are my predictions as made in posts in October and November following the market panic.

• The U.S. banking crisis: where are we?
• History shows US bank lending will be soft for years
• Europe is in for a rude awakening
• The Europeanisation of the Credit Crisis
• Where is the global economy headed?
• A shift to Eastern Europe and emerging markets too
• Dollar strength is an illusion
• Currency crisis is gathering storm
• Subprime good, prime bad
• The emerging markets crisis
• Iceland: a cautionary tale for small nations
• Is Ireland the next Iceland?
• Why I am bearish on the U.S. Dollar

Make no bones about it, we are in a very tough economic climate. It will get much worse before it get better.

The key, however, is the policy response. Are we going to stick our heads in he sand and act like these things will never happen or are we going to face the challenges head on? I say we forge ahead and take on the difficult decisions, work our way through this mess and make sure we reform the system so that it never happens again. It will be a long road to the kind of place we really want to be in – perhaps a decade – but we have done it many times before. All we need is the courage to do it again.

I am ever hopeful.

Related posts:

• Bank consolidation and getting positive about the credit crisis
• Danish banking crisis the worst in Europe
• Another look at my 2008 predictions
• Additions to Credit Crisis Timeline: 02 June 2008
• Structured Credit downgrades

Marshall Auerback here.  This will be short, but I felt compelled to post with my views on China.

There was clearly a bubble in exports in the past four years, with exports serving to cover capital inflow (overinvoicing must have been a big part of that).  So this is just part of the overall collapse of speculative capital flows, and not so much a decline in real effective demand.  China can handle this, the population is not constrained by either income or debt.

This is an aspect of China’s economy that most people don’t understand.  For the typical Chinese light-industrial firm, the optimal strategy for earning a profit is eventually to aim for exports, because export prices are multiples of those paid at home and therefore much more profitable.  The typical Chinese manufacturing, firm, then, produces and produces and produces, gaining practice, improving quality and demonstrating reliability – in the hope of eventually selling part of the production onto the export market.  For this, labour must be treated as a fixed cost. That is to say, that production must continue in spite of demand.  The strategy will be defeated if firms interrupt production and dismiss workers simply because the output they are producing cannot be immediately sold at the Wal-Mart price.

So with the output that is not exported, it is dumped domestically at whatever price it can command.  And the result is falling prices (deflation) for the Chinese consumer.  Relative to a fixed money wage, this implies a rising real wage in terms of staples for the average Chinese consumer, the result of which is a well-fed, well-clothed population and a near absence of significant human depravity in the cities.  That’s apparent to anybody who visits China.

So I don’t see any significant long term damage in China, even if it has a cyclical downdraft.  I realise this is not the fashionable view, but I think the alternative is based on a very superficial understanding of the country.

Your comments are welcome.

Related posts:

• China is set up for a big fall
• A few thoughts about China and their bluff on treasuries
• China cutting overcapacity
• Will Asia’s downturn be worse than America’s?
• Stephen Roach sees a W-shaped recovery for China

I am going to post a BBC article here that gives an anecdote about western Canada and how the boom in oil and commodities is causing economic problems there. Make of it what you will, but my bottom line is that Canada is neither immune from global pressures or from the commodities savaging.  This type of thing will com to an end.

Marshall Auerback has said to me that the Canadian economy is much less dependent on commodities than it once was. However, in my recent consulting experience there, it seemed very leveraged to commodities especially as regards employment, with many young people moving out west to take advantage of the high wages. One Canadian company executive told me last year that they were struggling to get entry level personnel because McDonald’s was paying $14 an hour in Alberta. I wonder if that’s the case today.

I meet Jaz at the Centre of Hope homeless drop-in centre in downtown Fort McMurray, Alberta, on a freezing cold morning.

She comes here during the day, but says she spends the nights in the woods and offers to show me where, for a fee. I explain that BBC policy forbids it, but she takes me anyway.

We stomp through the snow along the Athabasca River, past apartment blocks. She leads me through some thinly spaced trees to a campfire. A bit further on is the tent she uses to store food, and a second tent she sleeps in.

Jaz, 34, originally from the neighbouring province of Saskatchewan, is fairly media-savvy. With a smile, she describes being photographed for National Geographic magazine a few months ago. That was not her first media encounter.

Fort McMurray has attracted a lot of attention as the boomtown at the heart of Canada’s oil sands rush.

Established as a trading post in the late 19th Century, by the 1960s Fort McMurray had grown to a modest town of about 6,000.

With the commercial development of the oil sands industry in the late 1960s, the town grew to 32,000 in 1982.

Its current population is more than 65,000, with an extra 18,500 people in the so-called shadow population – oil workers who live in hotels or residential camps on the outskirts of town.

Population growth has averaged 9% a year for the past six years, and soared to 16% last year. Local police say they are working on the assumption that the population could reach 250,000 by 2030.

“We’re bursting at the seams. We’ve got this massive population growth, and we don’t have the infrastructure to accommodate it or service it,” says Fort McMurray’s mayor, Melissa Blake.

Working town

Ask any newcomer what brought them to this remote part of northern Canada, and the answer is always the same: money.

“People come here for the work, the whole town runs on the plants,” says John Keegan, an oil worker who arrived from Ireland almost 30 years ago.

The workers come mostly from other parts of Alberta, and from depressed parts of eastern Canada such as Newfoundland.

To attract and keep workers in a remote community where the jobs are often dull and repetitive, wages are high. Truck drivers can make C$175,000 ($146,000, £95,000) a year with overtime.

Teenagers working at a local fast food chain can make C$14 a hour – almost twice the minimum wage.

Housing costs are among the highest in Canada, with a small bungalow costing from C$550,000, about C$100,000 higher than in large urban centres such as Calgary or Edmonton.

Rent for a small apartment can range from C$1,800 for a one-bedroom flat.

“A lot of people do come here thinking the streets are paved with gold and that they’re going to walk into the big paying jobs,” says Mayor Blake.

“But the housing market is inaccessible to those that don’t have the highest income.”

The article goes on to recount from a very personal level how everything is expensive there and that things have become quite “stressful.” Alcoholism and cocaine are a problem. While this is merely an anecdote from one BBC reporter it describes an economy that is severely strained by events tied to commodities.

I think this type of thing is going to end soon. What effect this will have in Canada overall, in provinces like Quebec and Ontario, I don’t know.  Either way, if I were from Fort McMurray, I would not be happy with the picture the article paints of my town.

Source
Canada boomtown under pressure – BBC News

Related posts:

• Canada: Boom in progress
• Canada joins the list of housing busts
• Canada’s largest province on road to recession
• Canada is furious about U.S. protectonism
• Canadian housing crisis warning

Stephanie Pomboy is an economist who specializes in macroeconomic forecasting and their implications for investors and she has some very bad news for those looking for a quick recovery: it’s not going to happen. In Barron’s latest issue, Pomboy makes the case for an extended downturn (hat tip Scott) and that makes for a challenging investment climate. However, all is not lost, as Pomboy sees the potential for a rally in high yield assets and even equities.

Read the snippet from the Barron’s article below for more details.

AN INTERVIEW WITH STEPHANIE POMBOY: It will take consumers at least five years — and probably more — to recover from this crisis.

“LIKE THE BUBBLE IN FINANCIAL ASSETS, THE NEW REAL-ESTATE bubble has its own distinctly disturbing characteristics,” Stephanie Pomboy wrote in an April 2002 note titled “The Great Bubble Transfer.” The founder and president of MacroMavens was on to something, even if she was early, and she worried about the big buildup of consumer debt fueled by rising home prices. Pomboy, whose Manhattan firm analyzes macroeconomic themes and their investment implications, remains bearish, convinced that a long period of paltry U.S. economic growth is in store — akin to what happened in Japan in the 1990s. For more of her views and forecasts, read on.

Barron’s: How bad has the macro economy gotten?

Pomboy: It is certainly the toughest one any of us has lived through. My fear is that it’s actually just in the early stages and that it is going to get substantially worse on the economic side, although all the government measures that have taken place so far might help to insulate some of the damage on the financial side.

What about the short-term outlook?

Having been bearish, for me the real challenge is to identify the turn. One thing at work right now is what I call the cattle prod — essentially the Fed poking people to take risk. They are taxing cash by having negative real returns on cash. At the same time, yields on investment-grade and junk bonds are incredibly alluring. You can pick up 15 percentage points over cash buying junk bonds. Or you can pick up 8.5 percentage points on investment-grade paper. At some point, the cattle prod will get people moving, as it did in March of ‘03 when the market turned.

What else do you see happening in the near term?

With the government guaranteeing all manner of private-credit claims, many investors may decide to get long “socialism,” for lack of a better term. Or, as some euphemistically put it, this is partnering with the government. So in the short run, we could see a rally in risky assets and a selloff in Treasuries. But the economic deleveraging has barely begun, and that’s my longer-term thesis. It all revolves around the idea that U.S. consumers are actually going to do the unthinkable — they are going to save — and that we will be more like Japan than anyone believes is possible.

Hence, consumption declines.

Right. Wages have been silently crowded out by benefits as a share of total compensation, as companies look to offset rising health-care costs. The result is that the share of income that consumers can actually spend is at its lowest in the post-war period. It had not been a problem, because consumers would just borrow to fill that gap. But now, they don’t have appreciating assets against which to borrow. So while we could get a rally in risk assets — including high-yield debt — it’s likely to be a short-term rally within a context of a secular bear market.

Any other important longer-term trends you expect?

We are going to see a secular rotation from paper assets to hard assets like gold. The whole global competitive currency devaluation, including that of the dollar, plays right into that.

Do you see any asset classes besides junk bonds benefiting from a short-term rally?

There is a chance that equities participate in that rally as well, although I think investment-grade corporate credits look much more attractive than stocks. But when you think about pension funds that are trying to make 8% annual returns, they are not doing it by getting 1% on two-year Treasury notes. They can’t use the secret sauce of leverage anymore.

If I was going to hold my nose and buy anything, I probably would buy higher-quality corporate credits. If you want to get long socialism, one of the next segments of the market that will be given a guarantee will be municipal bonds. That’s because state and local governments are a huge share of total [gross domestic product] and employment, and we can’t afford to have them down for the count.

One thing that caught our eye in one of your recent notes was the steep decline of Treasury-buying by foreigners. What are the ramifications of that?

We are acting as though there are no consequences to basically running the money off the printing press and handing it to the Federal government to backstop financial markets or bail out homeowners or what not. There is no consequence to doing this, unless or until the rest of the world says to us, ‘We don’t like this game’ and ‘We don’t want to have all the dollar claims we are holding debased by [Fed Chairman Ben Bernanke] running his printing press.’

So if foreign investors stop buying Treasuries, or even significantly pare their buying, that means higher rates in the U.S.

That’s correct. But then [Bernanke] will start buying Treasuries to arrest the rise in interest rates. I’ve always had a very simplistic view about this: Either we are going to pay for our policy sins via higher interest rates or a weaker dollar. And for an economy that is as levered as the one in the U.S. is, the former choice is not an option. We can’t pay through higher interest rates; we barely got to 4.5%, 5% before the whole subprime crisis erupted. So a weaker dollar is the natural valve. But right now, we are enjoying some real competition in the ugly contest from the currencies of the European Union and the United Kingdom, and that will probably persist for a while because they are in pretty bad shape, and they are a little bit behind the curve relative to us.

Could you elaborate on that choice between higher rates or a weaker dollar?

If we rely on foreign creditors to lend us the money to sustain our lifestyles — and that’s what we do — we need to compensate them for that risk of lending to us. As the economy weakens and our credit quality should theoretically be deteriorating, the only way we can really attract that same capital is by offering a higher interest rate or making our assets cheaper to them, in this case by having our currency be weaker.

How would you assess the job Fed Chairman Bernanke and Treasury Secretary Henry Paulson have done in responding to the financial crisis?

My preferred solution would have been to do nothing. I think it’s the meddling of policy makers that got us into this situation in the first place, along with the asymmetric practice of capitalism where, as long as everyone is succeeding, it is wonderful thing — but the moment someone fails, we need to revert to socialism. That is really how we got to this place. And [former Federal Reserve Chairman Alan] Greenspan’s desire to constantly lubricate any pain by pumping money into the system really created this bubble. But since doing nothing was not a compelling option to [Bernanke and Paulson], I would have favored more aggressive action to arrest home-price deflation, which would have been tackling the disease. Instead, they’ve chosen to treat the symptoms. Having said all of that, Bernanke and Paulson are determined to mitigate the pain.

Ponmboy goes on to give some well-argued views on GDP growth, unemployment and interest rates. This is going to be an anemic growth environment similar to what has afflicted Japan. In the end, she sees this investment climate as particularly difficult and sees hard assets or emerging markets outperforming.

I have linked to the full article below, which is available to Barron’s subscribers.

Source
Forecast: A Long, Cold Winter – Barron’s

Related posts:

• Another take on the treasuries bubble
• Caroline Baum: Dollar Policy for Dummies
• Bernanke is responsible for the market meltdown
• After a 500 point loss, where next?
• Quote of the day: “The cash has to go somewhere”

This is the absurd thinking of economists. Australia has a 40% chance of recession next year. What does that even mean? If you asked me, I would say the chances of recession in Australia are 100%. You have a slowing property market, financial sector turmoil, a falling currency, plunging commodity prices and a global credit crunch. How do Australian economists figure Australia is going to be immune to this? Was this not the thinking in the U.S. just 4 or 5 months ago?

Australia’s economy will slow sharply in 2009 but is not expected to contract, before growth rebounds in the following year, a survey shows.

The survey of forecasts of the 14-member Australian Business Economists executive committee found business and dwelling investment would ebb next year, resulting in a median gross domestic product (GDP) growth rate of 1%.

That would be down from an estimated 2.3% in calendar 2008, and come ahead of an uptick to 2.2% in 2010.

“Despite the weaker prognosis in 2009, annual average GDP growth was not forecasted by any committee member to contract in 2009,” the ABE survey said.

Asked what chance the economy had of going into recession, members settled on a relatively high 40%.

It’s this type of forecasting that leaves most people underwhelmed by economists.

Source
Economists sees 40% chance of recession – Sydney Morning Herald

Related posts:

• Australia is set for a slowdown
• The Economy Is Definitely In Recession
• Australia: housing slowdown?
• Australia guarantees bank deposits for three years
• Recession ‘95% likely’ in Britain

Despite the plethora of data that has come out recently, one thing that has occasioned very little comment is the outlook for U.S. exports. Exports are generally not a big factor in the subset of companies involved in the ISM survey, but the plunge in export orders to 34.5 suggests that U.S. exports, hitherto a support in an otherwise collapsing economy, could be in big trouble as well.

U.S. November ISM Non-Manufacturing Index: Summary

	Nov.	Oct.	Sept.	Aug.	July	June	May	April	March	6-mo Avg
	2008	2008	2008	2008	2008	2008	2008	2008	2008
Composite Index	37.3	44.4	50.2	50.6	49.5	48.2	51.7	52	49.6	46.7
Export Orders*	34.5	50	50.5	44.5	47.5	52	54	48.5	55	46.5
Import Orders*	40	52	47.5	46	49	50.5	48	50	54.5	47.5

U.S. November ISM Non-Manufacturing Index: Summary, December 3, 2008, Bloomberg

Note that the export order index is falling faster than the import order index. The recent strength of the dollar is clearly having an impact. The combination of these two sub indices of the manufacturing ISM shows the substantial positive differential of exports over imports has disappeared. The same sub indices for the non-manufacturing ISM may be telling us once again that the whole trade improvement that was such a positive for the U.S. economy in recent quarters is about to disappear and may even reverse. This ominously echoes what happened in the wake of the Asian Financial Crisis in 1997/98, where a flight into the dollar from the Asian currencies triggered a huge deterioration in the U.S. current account and a further hollowing out of the country’s manufacturing base. With Detroit already on the verge of collapse, the decline of the Korean won from 900 to 1400 massively improves Korea’s competitiveness in the U.S. auto market. If dollar strength persists, then no bailout or no bailout, GM, Ford and Chrysler are toast.

Related posts:

• Dollar strength is an illusion
• Japanese defend dollar’s status while China tears it down
• U.S. Dollar: Cliff Diving
• The U.S. dollar plunges due to quantitative easing
• Why I am bearish on the U.S. Dollar

The U.S. Dollar has been holding up quite nicely during this credit crisis. In fact, it rallied significantly from deeply oversold levels against the Euro and British Pound (remember Dollar-Euro at 1.60 and Dollar-Pound at 2.10?). However, America has a number of structural problems which will inhibit further appreciation. Moreover, former buyers of U.S. Treasuries in the Middle East and Asia are going to have domestic economic worries of their own very shortly and will not be supporting U.S. assets. This means that the Dollar will be a weak currency in the not too distant future.

Let’s address the structural weaknesses of the United States. The first issue is savings. As the Anglo-Saxon countries of Australia, Canada, New Zealand, the U.K. and the U.S. prospered in the 1990s and earlier this decade, their savings rates dropped precipitously. In the U.S., we saw a drop from 7% at the beginning of the 1990s to near zero before the credit crunch hit in earnest.

As a result, the U.S. has run a massive current account deficit, borrowing money from abroad in order to maintain adequate levels of investment at home. In essence, Americans were selling off pieces of the country to finance their spending. This is akin to an addict selling furniture to fuel his habit. In 2005 and 2006, this deficit was as high as 7.5% of GDP.

In the meantime, all of this deficit spending was financed by debt. Debt to GDP levels have reached unprecedented levels: 341% Total U.S. Debt to GDP, 98% Household Debt to GDP, 133% Household Debt to Annual Disposable Personal Income, 115% Financial Sector Debt to GDP — all as of Q2 2008.

While debt levels could continue to rise during good times, the present financial crisis has caused massive credit writedowns at U.S. financial institutions, restricting their capital and ability to lend. Debt levels will contract.

Now, the U.S. could try to shift the burden of borrowing onto the federal government to cushion the downturn this deleveraging will cause. And it will do so in part as Federal Government deficits are expected to reach into the trillions in the coming years. However,the U.S. will be greatly constrained by events in the Middle East and China in particular — major U.S. creditors. Both China and Middle Eastern countries will have large domestic economic concerns with which to contend. I anticipate they will pull back on their purchases of U.S> assets, as a result.

In the Middle East, the economy boomed as oil rose from $10 a barrel to $147. However, oil has recently come crashing down to $50 a barrel. This is happening in the midst of an enormous property crash in places like Dubai (see source articles below). Most oil-exporting Middle Eastern nations have a experienced a population explosion of late and this puts enormous pressure on government to create jobs and economic growth. With oil prices and property prices falling, there will be a hard landing in these countries. They will not spend their money buying U.S. Treasuries or agency paper in such a predicament.

Then, you have China, America’s largest creditor. China is seeing its manufacturing sector implode and a very serious stock market and housing crash. The situation there is much worse than we are led to believe as the Chinese have recently lowered interest rates considerably, have started large domestic stimulus packages and have even tried to depreciate their currency. Again, one should anticipate a much lower appetite for U.S. assets going forward.

Where does that leave the U.S.? To my mind, it leaves the U.S. in a situation where inflation will be the preferred mechanism to reduce the real burden of its mountain-like debt load. This is dollar bearish. Moreover, even if the U.S. cannot or does not inflate, the structural problems I have already run down will inhibit growth over the medium-term in the U.S. This too is dollar bearish.

The U.S. Dollar is riding high right now in part due to weakness abroad. However, as recessionary events start to play out, it will become more evident that the U.S. is structurally weak and that is when the Dollar will lose favor.

Other Charts

Sources
Dubai: Has the bubble burst? – The Economist
Dubai shares hit despite promises – BBC News
Heavily in Debt, Dubai Calls in the Bankers – Deal Book
Could China be depreciating? – FT Alphaville
Economic nationalism and the USD – FT Alphaville
China factory output down sharply – BBC News
China’s $586bn boost for own economy may have done the whole world a favour – Independent Ireland
China tops U.S. govt foreign creditor list – Sydney Morning Herald
China Property Slump Threatens Global Economy as Growth Slows – Bloomberg
Flow of Funds Data – Federal Reserve Board

Related posts:

• Rosenberg: The U.S. dollar could be next
• Japanese defend dollar’s status while China tears it down
• China wants to get rid of the dollar
• Swiss Franc at Dollar parity?
• China is set up for a big fall

Yesterday morning, I heard Louise Yamada on Tom Keene’s show on Bloomberg Radio giving her assessment that stocks may break below 2002 lows. I mentioned this in yesterday’s news round-up. But, now I have the audio for you as well.

Yamada is a much followed technical analyst so her opinion has weight. Since at least this summer she has been warning investors to use caution especially with regard to financials.

While many think technical analysis is little more than hocus pocus, she has been very prescient in her analyses. Below is the audio from yesterday plus links to two prior posts on her.

Enjoy.

Nov. 18 (Bloomberg) — Louise Yamada, managing director of Louise Yamada Technical Research Advisors, talks with Bloomberg’s Tom Keene and Ken Prewitt about the outlook for the U.S. stock market.

Yamada also discusses the duration of economic slowdown and investment advice. (Source: Bloomberg)

00:00 Outlook for stocks, duration of slowdown
07:57 Investment timing; process of “bottoming”
11:55 Outlook for dollar; economy, rescue plan
15:00 Utilities; investment advice; volatility

Running time 23:03

Source
Yamada Sees Growing Chance Stocks May Break 2002 Lows: Audio – Bloomberg

Related posts:

• Louise Yamada: Sell stocks; Dow could be headed for 6000
• Louise Yamada: S&P has a 1175 price target
• Louise Yamada: Dow could hit 4,000
• Louise Yamada: financials going lower
• Major indices break through 1997 lows

I have been tied up with other activities all day today. But, I just had to send this post on Peter Schiff. My brother-in-law sent me this video a second ago of Schiff predicting doom and gloom on YouTube. And it’s actually kind of funny to look back and see what he was saying in 2006 and 2007 and how he was pilloried. His calls were uncannily right on the money.

It is definitely no fun going against the grain, though. Take a look.

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• Peter Schiff: “Government is a burden on the economy”
• Barron’s: an interview with Peter Schiff
• Wall Street Journal: Right Forecast by Schiff, Wrong Plan?
• New Writedown Risk: Alt-A
• Fitch: Prime RMBS loss estimates way too low

Last night an article by Niels Jensen of Absolute Return Partners caught my eye. In it, he made a very strong case for worrying about European bank exposure to emerging markets and its potential for creating systemic risk. I would like to share some highlights from this well-written piece and add a few thoughts of my own.

I have talked quite a bit about this problem in my blog in the past. Below are a few related articles. I am generally of the view that the crisis in the U.S. and Western Europe has been addressed sufficiently to provide a slow recovery. However, I am quite concerned of collateral damage from elsewhere bringing things to a head and precipitating a systemic problem. European bank lending to over-indebted emerging markets is tops on my list of worries.

Niels Jensen puts it quite well.

In the US, bank lending is already responding to Fed’s tactics. Total commercial and consumer bank lending has grown by an annualised rate of almost 50% in the last month and a half. Quite impressive in an economy which is supposedly in recession.

So far so good. The problem is, however, that the near meltdown has unleashed an asteroid storm of problems. Take Iceland. As most investors know by now, Iceland is in very serious trouble. According to at least one estimate, European banks stand to lose about $75 billion on Iceland – not exactly pocket change. And that is on a population the size of Coventry! Earlier this week, the Central Bank of Iceland raised the policy rate from 12% to 18%. Inflation is now running at about 16% and will undoubtedly peak at much higher levels. According to Danske Bank, expect it to hit 75% before things get better. That is ugly.

The canary in the coalmine

I have an increasingly uneasy feeling that Iceland is the canary in the coalmine. Hungary is struggling. So are Pakistan, Ukraine, Belarus, Romania and Argentina. Cristina Fernández de Kirchner, the President of Argentina, took everyone by surprise last week when she announced that the country’s private pension funds (about $26 billion) would be transferred into the state pension system. The official line is that she is aiming to protect the country’s pension funds from the global turmoil. Who is she kidding?

Now, the Federal Reserve Bank has decided to provide emergency loans to Mexico, Brazil, Singapore and South Korea. Not that long ago, it was Singapore (amongst others) which provided emergency funding to the ailing U.S. banking sector. If countries such as South Korea and Singapore require help from the outside, the state of affairs in other and less developed nations could be much worse than generally perceived.

This is the problem. There are any number of countries that are in jeopardy of imploding from a slowing economy, high debt and macro imbalances. The list extends from Asia to Eastern Europe to Latin America and beyond.

“So what?” you say. Well, not so fast. In a globalized economy, the interdependence of nations is a lot more than you might think. In fact, European banks have a lot of exposure to Emerging markets, having lent ridiculous sums over the past decade. Think of this as a 1980s Latin American debt problem writ-large.

European banks at risk
Worldwide cross-border lending now stands at $37 trillion with about $4.7 trillion going towards Eastern Europe, Latin America and emerging Asia. Cross-border lending by European and UK banks to emerging market countries accounts for 21% and 24% of respective GDPs compared to 4% for U.S. banks and 5% for Japanese banks (see chart 4). Europe has about $3.5 trillion of debt outstanding to emerging market countries whereas the U.S. has only about $500 billion on the line.

The country most exposed to emerging markets is Austria with total emerging market loans accounting for no less than 85% of the country’s GDP – most of it to Eastern Europe. Austrian banks have been aggressively pursuing opportunities in Eastern Europe for years. They have in fact been so aggressive that their total lending to the region (approximately $300 billion) exceeds the amount lent by Germany to Eastern Europe. Even more worryingly, Austrian banks are the largest holders of debt on Hungary and Ukraine – two of the most fragile economies on the old Soviet bloc. As an aside, when the global banking system collapsed in May 1931 in the midst of the Great Depression, it was a run on the Austrian banks which acted as a catalyst.

Italy is possibly in an even more dire condition. According to a recent article in The Daily Telegraph3, Italy’s public debt is now the third largest in the world, behind the U.S. and Japan. And, at 107% of GDP, it is almost twice the limit set by the Maastricht Treaty (so much for treaties!). Italy is also a big lender to Eastern Europe. Unicredit alone has about $130 billion of debt outstanding to Eastern European countries. Italy’s predicament is well recognised by fixed income investors. 10-year Italian government bonds now yield 1.08% more than their German sister bonds. The market is telling us that something rather unpleasant could happen to Italy. It is even possible that Italy could be forced to pull out of the euro, unless they can turn the ship around fairly quickly.

Meanwhile, UK banks are primarily exposed to emerging Asia and Latin America. Only Poland stands out in Eastern Europe as a major recipient of loans from UK banks and Poland is perhaps not up to its neck in problems the way Hungary and Ukraine are right now, but the situation is deteriorating there as well. Sweden is mostly exposed to the Baltic countries. The three Baltic countries owe a total of $123 billion, $83 billion of which originate from Sweden. Knowing that Latvian banks in particular have been rather innovative with the structure of their mortgage products (such as Yen based loans), would you sleep well if you were the credit officer of one of the major Swedish banks?

Spain is the Latin juggernaut

Spain is another worry. Contrary to popular belief, the U.S. is not the largest lender to Latin America – Spain is. Just under $1 trillion of cross-border debt is outstanding across Latin America. Only 17% of that comes from U.S. banks. Spanish banks, on the other hand, have more than 30% of the debt on their books. Let’s hope for Spain’s sake that Ms. Kirchner is telling the truth when she claims that the nationalisation of the private pension funds was done to protect them from the evils of this world. Somehow I doubt it.

The sharp rise in the value of the U.S. dollar and the Yen is not helping emerging market economies either. We do not know exactly what proportion of the $4.7 trillion of loans to emerging market countries are denominated in U.S. dollars and Yen respectively, but we suspect that it is a significant share. As long as the world is deleveraging, you should expect both currencies to continue to appreciate in value, as most carry trades have been based on either U.S. dollars or Yen. Meanwhile, some countries are putting up a brave fight (e.g. Hungary and Romania). However, as we learned in 1992, a wounded currency is like a bleeding torso in shark infested waters. You can rest assured that speculators will finish off the job. No central bank can win that battle.

One might argue that a devaluation of the Hungarian currency or a collapse of the Pakistani economy won’t really affect your portfolio, but that misses the point. It is the risk to an already wounded banking industry you have to worry about. And, as I have pointed out above, European banks are much more exposed to emerging market countries than their U.S. competitors.

And this is a big problem because European banks are undercapitalized. You might remember an article I wrote in June referencing a Citigroup study that said that European banks had a $400 billion capital shortfall. This shortfall has not disappeared. Arguably, it is much worse despite the many government bailouts in the intervening months because the losses have been much greater than anticipated.

If European banks were to suffer large losses in the emerging markets, we could have another panic on our hands, and this time no amount of government intervention would be able to forestall the inevitable bank runs and deleveraging. I recommend you read Niels’ piece. We need to sound the alarm on European banks because these institutions are in desperate need of more capital. If we wait until crisis hits to tackle this looming threat, it may be too late.

Source
When the Chickens Come Home to Roost – Niels Jensen

Related posts:

• A shift to Eastern Europe and emerging markets too
• Currency crisis is gathering storm
• Ten eastern European countries now looking to IMF for bailouts
• Quote of the day: Austrian banks
• Switzerland threatened with bankruptcy

In July, I made my ten predictions for the markets and global economy for the rest of the year. Some of my predictions were pretty pedestrians, and some were fairly bold. Let’s take a look and see how I’m doing.

Here’s what I originally said:

1. Oil prices will dip below $100 before year-end. Let’s face it $130-$140 oil is a real deterrent to energy consumption. After weeks of demand destruction, the price of oil is finally reflecting this fact. Moreover, with the global economy headed for recession, expect oil prices to fall sharply. This will be a great relief for consumers and a net help to GDP.
2. Inflation will fall globally. With oil prices coming down sharply, inflation will recede too. Therefore, I expect to see headline inflation in the US, the UK and the Eurozone in particular head down into the sub-4% area by year’s end, another happy turn for the economy.
3. The Fed will lower rates. With oil prices down, the Fed can give up its talk about being hawkish on inflation. We didn’t believe them anyway! When push came to shove the ECB acted and the Fed did not. With inflation sinking, the Fed can focus its policy response on the turmoil in the financial services sector.
4. A major financial institution will fail. The happy talk about the credit crisis being over is rubbish. It is now plainly obvious that writedowns have just begun in earnest. With a global recession looming, weaker financial institutions will go to the wall. A major bank will fail. My money is on a super-regional in the United States.
5. 2nd quarter GDP in the U.S. will come in above 1%. A pall of gloom has spread over North America, Europe, Japan, and ANZ. People are predicting the worst of all possible worlds for the US. However, this is not to be. The U.S. may be in serious trouble but it won’t be reflected in the Q2 GDP number to be released this week. Why? First, the GDP deflator will understate inflation. Real GDP may come in at 4-5%, suggesting a negative real number given the CPI is at 5.0%. But, the GDP deflator has not been keeping pace with the CPI. Moreover, the stimulus package has had its wanted effect in stimulating some consumer demand.
6. America will need another stimulus package. By September, it will become apparent that the U.S. economy is headed for recession. Politicians being politicians will need to forestall this with the election coming up in November. Therefore, they will vote to pass a second stimulus package. The great thing about the second package is that the year’ Federal deficit associated with it won’t be apparent until one year later.
7. The Eurozone will fall into recession. Europe looks weak. It seems ironic that a downturn that started in America will first be confirmed as recession in Europe, but the numbers point in that direction. Spain, Ireland, Germany, Denmark and Italy are all looking particularly weak. Denmark is already in recession. Ireland and Spain probably are. The whole Eurozone average will follow soon.
8. Britain will enter recession. The UK is looking as weak as Europe. And with a property bubble and high debt burdens, British shoppers are in no mood to keep on spending. The result will be recession the UK.
9. A major home builder will bust. The latest threat to house builders in the UK, Spain, the U.S. and Ireland is land prices. As a property bubble takes hold, home sales slow, followed by falling prices. However, one must ask, what is falling, the value of the physical structures or the land itself? With material costs not significantly lower, it is land prices that are falling. And house builders who have been buying up land in huge quantities in the U.S. and the UK in particular are exposed to this reality. I expect land price writedowns to step up in earnest producing a second major home builder bust after Martinsa Fadesa in Spain. Where will it be? My best guess is the U.S. or the UK.
10. Stock markets will fall. When the summer is over and people have returned to work again, preliminary readings on Q3 earnings will start to take shape. The will not be good. Warnings will increase in September and earnings will be bad in October, precipitating a global sell off in share prices. The financial services, retail, hospitality and discretionary consumer sectors will be hit hardest.

So, that is my list of ten predictions — not all bad, but certainly not all cheery. I would not describe this as a muddle -through prediction. I see a muted, but long recession gathering hold in the developed economies with financial services fragility being a determining factor in limiting the upside until the end of 2009 or 2010 at the earliest.

Let’s see how events unfold.

Let’s take them one-by-one and see what the trend should be going forward.

1. Oil Price: Here I was on the money. Despite believing in peak oil, I did feel that demand would collapse and prices along with it. Oil did fall to $100 and went much lower. Now it is trading at $88. I don’t see it dropping much more from here, but that all depends on how robust the economy is going forward. At a minimum, we’ll see a nice little inflation dividend from this.
2. Inflation: On the money, again. My call was pretty much a no-brainer given the first call I made. Inflation will continue to fall. BUT, with credit contracting the question now is about DEFLATION, rather than inflation. I expect inflation to crater from here and deflation to be a serious possibility.
3. Fed Funds Rates: The deed is done. Now, I do think the central banks are doing their best to keep this thing from going pear-shaped, but I am not a believer in liquidity from lower interest rates as the solution. Low interest rates are the problem. But, expect more of the same going forward.
4. Bank failures: Lots of them. That one was easy. — or at least so I thought. The question now is whether we will see more major bankruptcies. I am not worried about Itty Bitty Bank, but about RBS, UBS, Fifth Third and so on. I do think that a major U.S. regional will bust by the end of Q2 2009. But, with the central bankers on the case, maybe the worst is over. At least we can hope.
5. U.S. GDP: It was way over 1% in contrast to the two previous quarters — almost unbelievably so. But Q3 was a bust and it could be negative. The U.S. is clearly in recession and I expect the GDP numbers to reflect this for both Q3 and Q4.
6. Stimulus: I think we got it. The Bailout package had a lot of tax cuts and other incentives attached. I certainly see this as a stimulus package and I expect more of the same in the first quarter of 209. On the other hand, the Europeans are going to be constrained from getting crazy like the U.S. The UK, Ireland and Spain will want to do what the U.S. has done, but they are in a fiscal straight jacket and will not do so in the same measure.
7. Recession in Europe: Unfortunately, yes. Italy, France, Germany, Ireland, Spain, and the UK are not looking good. Denmark saw a reprieve last quarter, but mat fall back into recession. One reason the Euro is weak is that Europe is weak and will continue to weaken going forward.
8. Recession in Britain: Yes! That’s a foregone conclusion. The question now is how deep. I say it will be deep. But the BoE and Labour Government actions today should mitigate some of the worst of it. I am cautiously optimistic about the UK.
9. Home Builder Bust: Only one so far – WCI. Will others go bust? Maybe. The UK, Spain and the U.S. are place
   s to expect house builder problems.
10. Stock markets down: Way down! Global equity markets have gotten their clocks cleaned. It has been nasty and much worse than I expected. This has been a crash-like scenario that I did not foresee. Obviously, things unraveled rather quickly. At this juncture, all we can do is hope for the best. U.S. futures are predicting another massive selloff as I write this.

So as I see it, I am ten for ten now. Pretty good prognosticating. But, before I get giddy and start slapping myself on the back, I must admit that things are a bit more murky now. Once we see how the real economy reacts to the monetary and fiscal moves we have recently seen, we can determine how deep the global recession will be.

Look to Asia and BRIC (Brazil, Russia, India and China) to see what is going to happen next. If they have a hard landing – especially China, this will boomerang back toward the West and we will see another leg down in the Spring.

If they pull through, then we might see an economic bottom in the second half of 2009.

Related posts
Ten predictions for 2008
Revisiting my predictions for 2008

Related posts:

• Ten predictions for 2008
• Revisiting my predictions for 2008
• Europe is next
• Denmark: the latest victim of falling house prices
• Nouriel Roubini: we are in recession

This morning Chris Whalen made some comments on CNBC that hit the nail on the head regarding the U.S. banking crisis: there is a huge wave of old-fashioned loan losses coming down the pike. The writedowns we have seen to date are largely confined to tradeable securities that must be marked to market.

There are much bigger unrealized losses sitting on balance sheets right now. $700 billion will not be nearly enough to cover these losses. If the Federal government doesn’t step in and re-capitalize the U.S. banking system with more money, we are going to suffer a major deflationary spiral as these losses are realized. The WaMu-JPMorgan transaction is an example of a best-case scenario in recapitalizing the sector. However, the government will need to get involved now proactively as opposed to waiting until crisis hits again.

Where are these losses hiding?

• Residential Property (Alt-A, Payment Option, Negative Amortization Mortgages)
• Commercial Property (Commercial Real Estate and Construction Loans)
• Leveraged Loans and High Yield Bonds (from Private Equity LBOs)
• Credit Card Receivables and Asset Backed Securities
• Auto Loan Receivables and Securitized Auto Loan Bonds

While everyone is breathing a sigh of relief about the bailout package that Congress is about to pass, we need to keep our eye on the ball. There is still much work to be done. Do not be fooled into thinking that this will be the end of it.

Most people think $700 billion is a lot of money and are angry at having to fork over this sum. However, the scope of the problem in U.S. finance is much bigger than that. The bailout of the financial services sector has just begun and we need the government to admit this to the American people and get on the case.

Ultimately, if done correctly, bailouts will cause a net loss to U.S. taxpayers that could be much less than $700 billion despite large nominal outlays. If we wait until crisis again, the losses will be greater.

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Why is this blog named Credit Writedowns?
Bankrupt global financial institutions
Credit Crisis Timeline

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At the end of July, I wrote a post of my top ten predictions for the remainder of the year. A third of the way into things, my predictions are looking pretty good…so far. I said:

1. Oil prices will dip below $100 before year-end.
2. Inflation will fall globally.
3. The Fed will lower rates.
4. A major financial institution will fail.
5. 2nd quarter GDP in the U.S. will come in above 1%.
6. America will need another stimulus package.
7. The Eurozone will fall into recession.
8. Britain will enter recession.
9. A major home builder will bust.
10. Stock markets will fall.

I’m looking at 6 maybe 7 for 10 right now. Let’s look at each of these predictions in turn.

1. Oil prices have indeed dipped below $100 with Brent Crude just below that level. WTI is holding just below the $103 level. I can’t say I know where things are headed from here. We have already seen a massive decline. Let’s wait and see. But, put a check here.
2. Inflation will fall globally. That’ a guarantee given what happened with oil prices. But, will they fall by year’s end? We’ll see. No check.
3. The Fed will lower rates. Haven’t done so yet. Will they? They will definitely lower rates if things in financial services continue as they have. I anticipate that they will. But, no check.
4. A major financial institution will fail. Um, yeah: try Fannie and Freddie — otherwise known as the Nightmare on Wall Street. That’s pretty major. Frannie’s implosion was spectacular. However, I can’t say I anticipated it would happen so soon — If I’m honest I’d have to admit I thought it might be a 2009 event. I expected a financial firm to go bust, but I never said it was going to be Frannie first. Even so, this is a still big check for me. And, by the way, don’t count out another big failure.
5. 2nd quarter GDP in the U.S. will come in above 1%. As it turns out, it was way above 1%. In fact, I would say it was nearly unbelievably so at 3.3%. Regardless, I still get a check for calling this one, but I still question the accuracy of the data.
6. America will need another stimulus package.
7. The Eurozone will fall into recession. Apparently, this one is happening as we speak. The European Commission expects Germany, Spain and the UK all to enter recession this year. Ok well, it’s not really a check because no one said that Europe as a whole is in or will be in recession yet. But, I do anticipate that the downturn will be broad enoughto make this a check by year’s end. Let’s compromise and call it a half-check.
8. Britain will enter recession. According to the EC, this has already happened. Consumer spending in the UK is falling off a cliff right now and the housing sector looks worse than in the US. I anticipate that the UK will have a hard landing as severe as the early 1990s. This is easily a check
9. A major home builder will bust. WCI Communities declared bankruptcy a while ago. So check. But, what about the remaining big names? I can’t say I have a clue right now. Let’s see how Alt-A defaults go. My thinking is that if Alt-A and prime defaultsrise, home builders may suffer collateral damage and have some liquidity constraints. This could result in another major bankruptcy. I’m not holding my breath though. It may be a 2009 event. But, I do anticipate more major bankruptcies in 2009 in this sector.
10. Stock markets will fall. Right now, this is true. So I get a check, but just barely. The Dow is up 100 points meaning I am only 20 points away from being wrong. What will happen from here? It all depends on financials. If the financials continue their meltdown, I will be proven right.

So, that’s the story. I still have the outside chance of going ten for ten. For now, my predictions are looking right on the money.

Related posts
Ten predictions for 2008

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• Another look at my 2008 predictions
• Think outside the box: ten outrageous predictions for 2009
• Top ten predictions for the 2009 global economy
• My best and worst calls of 2008: a credit crisis retrospective

As you could probably tell — from all the stories I have been writing about the Baltics, Denmark, Sweden, you name it — I believe that Europe is the next leg down in the global housing bubble. As such, it will pay to focus as much attention on events outside the US, where the housing bubble began as it will to focus on the continuing U.S. problem.

Make no bones about it, with distress in Alt-A, Prime, Option Arm, and Negative Amortization mortgage products still rising, the U.S. has many more writedowns to come and some bankruptcies. Yet, it is Europe where the next leg down will be interesting.

In Britain, many of the larger financial firms have already suffered massive writedowns from U.S. exposure. They are in no position to take on more losses. Yet, this is what they must do as the UK price decline has gathered speed. Particularly vulnerable are Bradford & Bingley, HBOS, and RBS. Barclays and HSBC will have their share of losses too. However, Lloyds has weathered the storm much better than the other lot.

In Spain, Martinsa Fadesa marked the coming of age for the Spanish property bust. Spain is in or on the verge of recession. Yet, it is all quiet there. In fact, the two largest Spanish banks, BBVA and Banco Santander have performed wonderfully. I expect the situation to darken when the summer holiday recedes into the past.

In Denmark, recession has already hit. And prices are in decline. The result was that one prominent Danish bank went to the wall. Denmark is not on many people’s radar screen. So, this market will be a nice test case for what happens going forward in many European markets.

In Sweden, housing is hitting the skids as well, in part because housing there is overvalued. But, it is also because the Swedes went on a credit binge in the Baltics and those countries are slowing rapidly. We should expect major losses from Swedish banks going forward.

Ireland has been relatively quiet recently. But, prices there are still in free fall and its only a matter of time before we hear from Irish and British banking losses. Ireland shows the curious difference of a non-securitised market to the new securitised U.S. model in writedowns. While the U.S. has shown massive banking losses from Mortgage-Backed Securities, markets like Ireland have seen significant declines without any major writedown news. Either there are major losses hiding on the balance sheets of Ireland’s creditor banks or the U.S. has been overzealous in its writedown party. I’m sure you can guess I favor the former scenario.

As for the rest of Europe, there is significant weakness across the board. However, I should point out that Germany had its own housing bust and depression in the 1990s after a botched currency union. The lingering effects of that crisis have meant that Germany never really participated in the housing free-for-all earlier this decade.

How ever one looks at it, Europe is weak and this means more pain to come for European banks and another test of confidence in the credit markets. Stay tuned.

Related posts:

• Danish banking crisis the worst in Europe
• Denmark: the latest victim of falling house prices
• Ten predictions for 2008
• Another look at my 2008 predictions
• Denmark’s house prices fall

Not every financial services sector company is a basket case destined for bankruptcy. There are many well-run lower risk organizations in the bunch. Moreover, let’s not blame the banking model for individual companies’ woes. The Economist had a good article this weekend highlighting the fact that it is not the universal banking model which is to blame f0r large writedowns at the likes of UBS and Citigroup.

Yet, tempting as it is to believe that changing business models would solve UBS’s problems, or those of the wider industry, the evidence of the credit crisis suggests otherwise. No single model has emerged from the turmoil either wholly vindicated or entirely discredited. Credit Suisse shares a city square in Zurich and a business strategy with UBS, but has come through the past 12 months in much better shape and continues to attract money into its wealth-management division. Citigroup’s version of the universal-banking model is one where it walks into every punch going; Britain’s HSBC has been more successful in blunting the impact of its American misadventures through decent earnings in emerging markets. Of the Wall Street investment banks, Goldman Sachs has survived with its reputation enhanced. Bear Stearns did not survive at all. Pure retail banks can blow up too: Northern Rock, which was nationalised by the British government after a humiliating run on it, had a simple enough product line.-No size fits all, Economist, 14 Aug 2008

While it is not a sure bet that Credit Suisse, Goldman and HSBC will continue to outperform their peers, it should be obvious that there are extreme differences in the risk profiles of different financial institutions n the same line of business.

Enormous losses were not a given for financial services companies. Those organizations with the greatest losses are the ones who took the largest risk. Their risk play has not paid off and they are reaping the consequences. Losses in the financial services sector are a direct result of individual institutions succumbing to the pressure for sustained profits in a low-return environment and making large bets on riskier assets just when the housing bubble burst. Other companies in the same sectors avoided these risks.

This got me to thinking about relative value plays in the financials. In that vein, let me suggest some financial institution relative value plays:

1. Large U.S. Banks: Wells Fargo over Citigroup
2. Large U.S. Banks: U.S. Bancorp over JP Morgan Chase
3. Large U.S. Banks: Bank of New York Mellon over Bank of America
4. Large U.S. Regional Banks: SunTrust over Wachovia
5. Large U.S. Regional Banks: M&T Bank over Washington Mutual
6. Britain: Lloyds over HBOS
7. Switzerland: Credit Suisse over UBS
8. Canada: Scotiabank over CIBC
9. Germany: Commerzbank over Deutsche Bank
10. Investment Banking: Goldman Sachs over Merrill Lynch
11. Property and Casualty Insurance: Berkshire Hathaway over AIG

Why would you own the list of second names when you can own the first? Bottom-fishing is the only plausible reason I can come up with. But, in this credit crisis so far, bottom fishers have not done well. Expect more of the same going forward.

Related posts:

• Citigroup: the financial supermarket is dead
• Banks: are mergers in the offing?
• British banks are underestimating losses
• Global Bank write-offs and failures
• A brief note on upcoming bank earnings announcements

With 2008 now half over, it’s obvious that the global economy has lurched to the downside. While many have remained unrealistically optimistic about the workout of the present credit crisis, downside risks have been the determining factors in keeping things soft.
Where are we headed?

I’d like to answer that question with my top ten predictions for the second half

1. Oil prices will dip below $100 before year-end. Let’s face it $130-$140 oil is a real deterrent to energy consumption. After weeks of demand destruction, the price of oil is finally reflecting this fact. Moreover, with the global economy headed for recession, expect oil prices to fall sharply. This will be a great relief for consumers and a net help to GDP.
2. Inflation will fall globally. With oil prices coming down sharply, inflation will recede too. Therefore, I expect to see headline inflation in the US, the UK and the Eurozone in particular head down into the sub-4% area by year’s end, another happy turn for the economy.
3. The Fed will lower rates. With oil prices down, the Fed can give up its talk about being hawkish on inflation. We didn’t believe them anyway! When push came to shove the ECB acted and the Fed did not. With inflation sinking, the Fed can focus its policy response on the turmoil in the financial services sector.
4. A major financial institution will fail. The happy talk about the credit crisis being over is rubbish. It is now plainly obvious that writedowns have just begun in earnest. With a global recession looming, weaker financial institutions will go to the wall. A major bank will fail. My money is on a super-regional in the United States.
5. 2nd quarter GDP in the U.S. will come in above 1%. A pall of gloom has spread over North America, Europe, Japan, and ANZ. People are predicting the worst of all possible worlds for the US. However, this is not to be. The U.S. may be in serious trouble but it won’t be reflected in the Q2 GDP number to be released this week. Why? First, the GDP deflator will understate inflation. Real GDP may come in at 4-5%, suggesting a negative real number given the CPI is at 5.0%. But, the GDP deflator has not been keeping pace with the CPI. Moreover, the stimulus package has had its wanted effect in stimulating some consumer demand.
6. America will need another stimulus package. By September, it will become apparent that the U.S. economy is headed for recession. Politicians being politicians will need to forestall this with the election coming up in November. Therefore, they will vote to pass a second stimulus package. The great thing about the second package is that the year’ Federal deficit associated with it won’t be apparent until one year later.
7. The Eurozone will fall into recession. Europe looks weak. It seems ironic that a downturn that started in America will first be confirmed as recession in Europe, but the numbers point in that direction. Spain, Ireland, Germany, Denmark and Italy are all looking particularly weak. Denmark is already in recession. Ireland and Spain probably are. The whole Eurozone average will follow soon.
8. Britain will enter recession. The UK is looking as weak as Europe. And with a property bubble and high debt burdens, British shoppers are in no mood to keep on spending. The result will be recession the UK.
9. A major home builder will bust. The latest threat to house builders in the UK, Spain, the U.S. and Ireland is land prices. As a property bubble takes hold, home sales slow, followed by falling prices. However, one must ask, what is falling, the value of the physical structures or the land itself? With material costs not significantly lower, it is land prices that are falling. And house builders who have been buying up land in huge quantities in the U.S. and the UK in particular are exposed to this reality. I expect land price writedowns to step up in earnest producing a second major home builder bust after Martinsa Fadesa in Spain. Where will it be? My best guess is the U.S. or the UK.
10. Stock markets will fall. When the summer is over and people have returned to work again, preliminary readings on Q3 earnings will start to take shape. The will not be good. Warnings will increase in September and earnings will be bad in October, precipitating a global sell off in share prices. The financial services, retail, hospitality and discretionary consumer sectors will be hit hardest.

So, that is my list of ten predictions — not all bad, but certainly not all cheery. I would not describe this as a muddle -through prediction. I see a muted, but long recession gathering hold in the developed economies with financial services fragility being a determining factor in limiting the upside until the end of 2009 or 2010 at the earliest.

Let’s see how events unfold.

Related posts:

• Another look at my 2008 predictions
• Revisiting my predictions for 2008
• Oil to sink to $100
• Nouriel Roubini: we are in recession
• Oil down below $138