For the last few months I have been casting around looking for bullish data points as counterfactuals to my more bearish long-term outlook. I have found some, but not enough. If you recall, early this year, I stated that we are in depression, making the case for the ongoing downturn as a depression with a small ‘d.’ Nevertheless, I was quite optimistic about the ability of policymakers to engineer a fake recovery predicated on stimulus and asset price reflation and I certainly saw this as bullish for financial shares if not the broader stock market. But, I saw these events as temporary salves for a deeper structural problem.

As a result, I have been on a quest to find data which disproves my original thesis – signs that the green shoots that everyone keeps talking about (and a term I had banned from my site) are part of a sustainable economic recovery. Unfortunately, I have concluded that they are not. This post will discuss why we are in a depression, not a recession and what this means about likely future economic and investing paths. I will try to pull together a number of threads from previous posts, add some context via Wikipedia links and draw in some good discussion via recent posts by Prieur du Plessis on balance sheet recessions and Marshall Auerback on the sector financial balances model of economics which completed the picture for me.

This post is very long and I have had to shorten it in order to pull all of the ideas into one post. Please do read the linked posts for background as I left out some of the detail in order to create this narrative.

Let’s start here then with the crux of the issue: debt.

Deep recession rooted in structural issues

Back in my very first post in March of 2008, I said that the U.S. was already in a recession, the only question being how deep and how long – a question I answered in the next post saying “we are definitely in recession. And according to Gary Shilling, this recession is going to be a big one. Worse than 2001, 1990-91 or the double dip recession of 1980-82.” This has certainly turned out to be true.  The issue was and still is overconsumption i.e. levels of consumption supported only by increase in debt levels and not by future earnings. This is the core of our problem – debt.

I see the debt problem as an outgrowth of pro-growth, anti-recession macroeconomic policy which developed as a reaction to the trauma of the lost decade in the U.S. and the U.K.. This was a period of low growth, high inflation and poor market returns, in which the U.K. became the sick man of Europe and labor strife brought that economy to its knees.  It is a period that saw the resignation of an American President and the humiliation of the Iran Hostage Crisis.

In essence, after the inflationary outcome that many saw as an outgrowth of the Samuelson-Keynesianism of the 1960s and 1970s, the Reagan-Thatcher era of the 1990s ushered in a more ‘free-market’ orientation in macroeconomic policy. The key issue was government intervention. Policy makers following Samuelson (more so than Keynes himself) have stressed the positive effect of government intervention, pointing to the Great Depression as animus, and the New Deal, and World War II as proof. Other economists (notably Milton Friedman, and later Robert Lucas) have stressed the primacy of markets, pointing to the end of Bretton Woods, the Nixon Shock and stagflation as counterfactuals. They point to the Great Moderation and secular bull market of 1982-2000 as proof. This is a divisive and extremely political issue, in which the two sides have been labelled Freshwater and Saltwater economists (see my post “Freshwater versus saltwater circa 1988”).

However, just as the policy of the 1950s to the 1970s was not really Keynesian (read Keynes’ General Theory as Richard Posner did and you will see why), the 1980s-2000 was not really an era of true ‘free markets.’ I call it deregulation as crony capitalism.  What this has meant in practice is that the well-connected, particularly in the financial services industry, have won out over the middle classes (a view I take up in “A populist interpretation of the latest boom-bust cycle”). In fact, hourly earnings peaked over 35 years ago in the United States when adjusting for inflation.

Remember, the 1970s was a difficult period in which the U.K. and the U.S. saw jobs vanish in key industrial sectors. To stop the rot and effectively mask the lack of income growth by average workers, a new engine of growth had to be found. Enter the financial sector. The financialization of the American and British economies began in the 1980s, greatly increasing the size and impact of the financial sector (see Kevin Phillips’ book “Bad Money”). The result was an enormous increase in debt, especially in the financial sector.

This debt problem was made manifest repeatedly during financial crises of the era. Not all of these crises were American – most were abroad and merely facilitated by an increase in credit, liquidity, and international capital movement. In March 2008, I wrote in my third post on the US economy in 2008:

From the very beginning, the excess liquidity created by the U.S. Federal Reserve created an excess supply of money, which repeatedly found its way through hot money flows to a mis-allocation of investment capital and an asset bubble somewhere in the global economy. In my opinion, the global economy continued to grow above trend through to the new millennium because these hot money flows created bubbles only in less central parts of the global economy (Mexico in 1994-95, Thailand and southeast Asia in 1997, Russia and Brazil in 1998, and Argentina, Uruguay, and Brazil in 2001-03). But, this growth was unsustainable as the global imbalances mounted.

Eventually, the debt burdens became too large and resulted in the housing meltdown and the concomitant collapse of the financial sector, a looming problem that our policymakers should have seen. This is why my blog is named Credit Writedowns. But, make no mistake, the housing and writedown problems are only symptoms. The real problem is the debt – specifically an overly indebted private sector (note the phrase ‘private sector’ as I will return to this topic).

This is a depression, not a recession

When debt is the real issue underlying an economic downturn, the result is a period of stagnation and short business cycles as we have seen in Japan over the last two decades.  This is what a modern-day depression looks like – a series of W’s where uneven economic growth is punctuated by fits of recession. A recession is merely a period of recalibration after businesses get ahead of themselves by overestimating consumption demand and are then forced to cut back by making staff redundant, paring back inventories and cutting capacity. Recessions can be overcome with the help of automatic stabilzers like unemployment insurance to cushion the blow. Depression is another event entirely. Back in February, I highlighted a blurb from David Rosenberg which summed up the differences between recession and depression quite well.

Depressions marked by balance sheet compression
Recessions are typically characterized by inventory cycles – 80% of the decline in GDP is typically due to the de-stocking in the manufacturing sector. Traditional policy stimulus almost always works to absorb the excess by stimulating domestic demand. Depressions often are marked by balance sheet compression and deleveraging: debt elimination, asset liquidation and rising savings rates. When the credit expansion reaches bubble proportions, the distance to the mean is longer and deeper. Unfortunately, as our former investment strategist Bob Farrell’s Rule #3 points out, excesses in one direction lead to excesses in the opposite direction.

The next day, I highlighted Ray Dalio’s version of this story because it takes a historical view and rightly emphasizes the debtor instead of the lender as the crux of the problem. Notice the part about printing money and devaluing the currency if the debt is in your own currency.

… economies go through a long-term debt cycle — a dynamic that is self-reinforcing, in which people finance their spending by borrowing and debts rise relative to incomes and, more accurately, debt-service payments rise relative to incomes. At cycle peaks, assets are bought on leverage at high-enough prices that the cash flows they produce aren’t adequate to service the debt. The incomes aren’t adequate to service the debt. Then begins the reversal process, and that becomes self-reinforcing, too. In the simplest sense, the country reaches the point when it needs a debt restructuring…

This has happened in Latin America regularly. Emerging countries default, and then restructure. It is an essential process to get them economically healthy.

We will go through a giant debt-restructuring, because we either have to bring debt-service payments down so they are low relative to incomes — the cash flows that are being produced to service them — or we are going to have to raise incomes by printing a lot of money.

It isn’t complicated. It is the same as all bankruptcies, but when it happens pervasively to a country, and the country has a lot of foreign debt denominated in its own currency, it is preferable to print money and devalue…

The Federal Reserve went out and bought or lent against a lot of the debt. That has had the effect of reducing the risk of that debt defaulting, so that is good in a sense. And because the risk of default has gone down, it has forced the interest rate on the debt to go down, and that is good, too.

However, the reason it hasn’t actually produced increased credit activity is because the debtors are still too indebted and not able to properly service the debt. Only when those debts are actually written down will we get to the point where we will have credit growth. There is a mortgage debt piece that will need to be restructured. There is a giant financial-sector piece — banks and investment banks and whatever is left of the financial sector — that will need to be restructured. There is a corporate piece that will need to be restructured, and then there is a commercial-real-estate piece that will need to be restructured.

Commence the fake recovery

So where are we, then?  We have left the fake recovery and are entering a new era of growth that could last as long as three or four years or could peter out very quickly in a double dip recession. By now, you have seen my post on the fake recovery, so I won’t cover that ground here.  However, I do want to highlight how I came to believe in the fake recovery and how asset prices have played into this period (the S&L crisis played out nearly the same way).  I see writedowns as core to the transmission mechanism of debt and credit problems to the real economy via reduced supply and demand for credit. Again, this is why my site is called Credit Writedowns.

In March, at the depths of the downturn I wrote:

The problem is the writedowns. You see, if you get $30 billion in capital from the government, but lose another $40 billion because of credit writedowns and loan losses, you aren’t going to be lending any money. To me, that says the downturn will only end when the massive writedowns end, not before.

The U.S. government has finally realized this and is now moving to stem the tide. Their efforts point in four directions:

1. Increase asset prices. If the assets on the balance sheets of banks are falling, then why not buy them at higher prices and stop the bloodletting? This is the purpose of the TALF, Obama’s mortgage relief program and the original purpose of the TARP.
2. Increase asset prices. If assets on the balance sheet are falling, why not eliminate the accounting rules that are making them fall? Get rid of marking-to-market. This is the purpose of the newly proposed FASB accounting rule change.
3. Increase asset prices. If asset prices on the balance sheet are falling, why not reduce interest rates so that the debt payments which are crushing debtors ability to finance those assets are reduced? This is why short-term interest rates are near zero.
4. Increase asset prices. If asset prices on the balance sheet are falling, why not create Public-Private partnerships to buy up those assets at prices which reflect their longer-term value? This is what Geithner’s Capital Assistance Program is designed to do.

So I lied, there is only one direction the government is headed: increase asset prices (or, at least keep them from falling). Read White House Economic Advisor Larry Summers’ recent prepared remarks to see what I mean. (Summers on How to Deal With a ‘Rarer Kind of Recession’ – WSJ)

I was more on target in my thinking here than I could have known. Within two weeks, the mark-to-market model was dead and mark-to-make believe had begun. It was then that I knew a recovery was likely to take hold. And it was going to be bullish for bank stocks and the broader market. What you should realize is that, despite the remaining problems in credit cards, commercial real estate or high yield loans, limiting credit growth, the changes instituted by government definitely have meant 1. that banks will earn a shed load of money and 2. that house price declines have stalled, underpinning the asset base of lenders. This necessarily means an end to massive writedowns, a firming of banks’ capital base, and a reduction in private sector deleveraging.

As an aside, I should mention that this dynamic called the asset-based economy, where economic well-being is dependent on asset prices, is far more pronounced in Anglo-Saxon countries like the U.S. and the U.K. (and Australia, Ireland, and Canada to a degree). While the free market ideal has gained sway globally, it is viewed with much more skepticism elsewhere. In Germany, for example, the term Anglo-Saxon is often bandied about as an epithet for political demagoguery to represent free market ideology. These cultural differences are something I explored in my post “Cultural attitudes on work, leisure and wealth in Europe and America.”

As for the recent asset-based economic reflation, be under no illusion that these measures ‘solve’ the problem. The toxic assets are still impaired and banks are still under-capitalized. But the increased asset value and the end of huge writedowns has underpinned the banks and led to a rise in the broader market in a feedback loop that has been far greater than I could have imagined at this stage in the economic cycle.

The double dip or the economic boom?

So what’s next?  A lot of the economic cycle is self-reinforcing (the change in inventories is one example). So it is not completely out of the question that we see a multi-year economic boom.  Higher asset prices, lower inventories, fewer writedowns all lead to higher lending capacity, higher cyclical output, more employment opportunities and greater business and consumer confidence. If employment turns up appreciably before these cyclical agents lose steam, you have the makings of a multi-year recovery. This is how every economic cycle develops. This one is no different in this regard.

However, longer-term things depend entirely on government because we are in a balance sheet recession. Ray Dalio and David Rosenberg make this case well in the previous quotes I supplied, but it was a recent post about Richard Koo from Prieur du Plessis which got me to write this post. His post, “Koo: Government fulfilling necessary function” reads as follows:

According to Koo, American consumers are suffering from a balance sheet problem and will not increase consumption until their personal finances are back in order. The banks are not lending mainly because nobody wants to borrow and, furthermore, the banks want to build their own balance sheets (raise cash) and get rid of toxic garbage…

Again, when asked what would happen if the government cuts back on its fiscal stimulus, Koo replies: “Until the private sector is finished repairing its balance sheets, if the government tries to cut its spending, we’re going to fall into the same trap Franklin Roosevelt fell into in 1937 (a crushing bear market) and Prime Minister Hashimoto fell into in 1997, exactly 70 years later.

“The economy will collapse again and the second collapse is usually far worse than the first. And the reason is that, after the first collapse, people tend to blame themselves. They say, ‘I shouldn’t have played the bubble. I shouldn’t have borrowed money to invest – to speculate on these things.’

This view of a second, more serious downturn mirrors the one I wrote of when I wrote about high structural unemployment last week. And, again, it is predicated on what government does.  I wrote last November that if government stops the support, recession is going to happen.

The U.S. economy cannot possibly work itself out of the greatest financial crisis in some 70-odd years in a mere 4 years and then expect to raise taxes on the middle class without a major recessionary relapse.

So, when you hear policy makers talking about reducing the deficit as soon as possible, what you should think is 1938 and continued depression.

Right now, if you listen to what President Obama is likely to do when we see more economic growth, you know that the government prop for the economy is going to be taken away. Koo again:

So the fact that Larry Summers was talking about ‘temporary’ fiscal stimulus had me very, very worried. That whole Larry Summers idea that one big injection of fiscal stimulus will get the US out of the recession, and everything will be fine thereafter, probably led to President Obama’s saying he’s going to cut his budget deficit in half in four years.”

Get ready because the second dip will occur. It will be nasty: unemployment will be higher and stocks will go lower than in 2009. I am convinced that it is politically unacceptable to have the government propping up the economy as Koo suggests it should. The question now is one of timing: when will the government stop propping up the economy? The more robust the recovery, the quicker the prop ends and the sooner we get a second leg down.

So to recap:

1. A depression was borne out of high levels of private sector debt, the unsustainability of which became apparent after a financial crisis.
2. The effects of this depression have been lessened by economic stimulus and government support.
3. Government intervention led to a reduction in asset price declines, which led to stock market increases, which led to asset price stabilization and more stock market increases and eventually to asset price increases. This has led to a false sense that green shoots are leading to a sustainable recovery.
4. In reality, the problems of high debt levels in the private sector and an undercapitalized financial system are still lurking, waiting for the government to withdraw its economic support to become realized
5. Because large scale government deficit spending is politically impossible, expect a second economic dip within three to four years at the latest.

Why is government spending necessary?

The government plays a crucial role here because of the huge private sector indebtedness.  In the U.S. and the U.K., the public sector is not nearly as indebted. So while, the private sector rebuilds its savings and reduces debt, the public sector must pick up the slack.  Why do I say must? It’s because of an accounting identity which comes from the financial sector balances model. Marshall Auerback says it best in a recent post:

We’ve said it before and we’ll say it again. As a matter of national accounting, the domestic private sector cannot increase savings unless and until foreign or government sectors increase deficits. Call this the tyranny of double entry bookkeeping: the government’s deficit equals by identity the non-government’s surplus.

So, if the US private sector is to rebuild its balance sheet by spending less than its income, the government will have to spend more than its tax revenue. The only other possibility is that the rest of the world stops saving on a massive scale — letting the US run a current account surplus. But that is highly implausible and socially undesirable, since it means we export our economic output, rather than consume it domestically. And if the government deficit does not grow fast enough to meet the saving needs of the private domestic sector, national income will decline, which, given the size of the private sector’s debt problem, will generate a huge debt deflation.

This is the foundation of modern monetary theory. Would that the IMF and the G20 understood these basic facts.

If the private sector is a net saver, the public sector must, I repeat must, run a deficit. That’s the law of double entry book-keeping. The only other way to prevent the government from running a deficit when the private sector is net saving is to run huge current account surpluses by exporting your way out of recession – what Germany and Japan tried in the 1990s and in this decade. But, of course, the G20 and the IMF are all talking about global re-balancing. This cult of zero imbalances is something Marshall first brought forward back in April. And it ignores the accounting identity inherent in the financial sector balances model. I highlighted this model in my post, “Minsky: Turning neoclassical economics on its head.” However, I must admit to having a preternatural disaffection for large deficits and big government which is what Koo and Minsky advise respectively – a recent cartoon shows why.  It is this knee-jerk aversion to what is viewed as fiscal profligacy which is at the core of the cult of zero imbalances.

So, what does this mean for the American and global economy?

1. The private sector (particularly households) is overly indebted. The level of debt households now carry cannot be supported by income at the present levels of consumption. The natural tendency, therefore, is toward more saving and less spending in the private sector (although asset price appreciation can attenuate this through the Wealth Effect).  That necessarily means the public sector must run a deficit or the import-export sector must run a surplus.
2. Most countries are in a state of economic weakness. That means consumption demand is constrained globally. There is no chance that the U.S. can export its way out of recession without a collapse in the value of the U.S. dollar. That leaves the government as the sole way to pick up the slack.
3. Since state and local governments are constrained by falling tax revenue (see WSJ article) and the inability to print money, only the Federal Government can run large deficits.
4. Deficit spending on this scale is politically unacceptable and will come to an end as soon as the economy shows any signs of life (say 2 to 3% growth for one year). Therefore, at the first sign of economic strength, the Federal Government will raise taxes and/or cut spending. The result will be a deep recession with higher unemployment and lower stock prices.
5. Meanwhile, all countries which issue the vast majority of debt in their own currency (U.S, Eurozone, U.K., Switzerland, Japan) will inflate. They will print as much money as they can reasonably get away with.  While the economy is in an upswing, this will create a false boom, predicated on asset price increases. This will be a huge bonus for hard assets like gold, platinum or silver.  However, when the prop of government spending is taken away, the global economy will relapse into recession.
6. As a result there will be a Scylla and Charybdis of inflationary and deflationary forces, which will force the hands of central bankers in adding and withdrawing liquidity. Add in the likely volatility in government spending and taxation and you have the makings of a depression shaped like a series of W’s consisting of short and uneven business cycles. The secular force is the D-process and the deleveraging, so I expect deflation to be the resulting secular trend more than inflation.
7. Needless to say, this kind of volatility will induce a wave of populist sentiment, leading to an unpredictable and violent geopolitical climate and the likelihood of more muscular forms of government.
8. From an investing standpoint, consider this a secular bear market for stocks then.  Play the rallies, but be cognizant that the secular trend for the time being is down. The Japanese example which we are now tracking is a best case scenario.

Not particularly uplifting, but hopefully well-documented. Your comments are very greatly appreciated.

Related posts:

• We are in depression
• Household debt as an indicator of secular bull and bear markets
• What is an economic depression?
• Some tidbits about stimulus, recovery, and the Great Depression
• What’s different about 2008?

It has been my thesis for some time that we are seeing a secular change in consumption patterns in the United States.  This will have grave implications for a world economy used to seeing the American consumer as an economic growth engine and consumer of first choice. Retail sales in the United States have fallen 10% since peaking in November 2007. Much of this decline represents a permanent fall in consumption by overly indebted American consumers.

Having finally had a chance to dissect the retail sales data from last week, I wanted to show you a few graphs which indicate how much consumption has fallen in the present downturn and what the implication is for the future global economy. But, first, I want to start with a broader discussion as to why the fall in US consumption is a longer-term change and not a cyclical one.

The Balance Sheet Recession

Numerous economies seem on the way to recovery: Germany and France, Singapore, and Hong Kong, to name a few, have all posted positive economic growth.  China looks likely to hit its 2009 growth target of 8%. But, the U.S., generally assumed to be a leader in recovery, is looking like a laggard.  Mind you, there are other laggards like Spain and Ireland too.  Why are these countries lagging?  The Balance Sheet Recession.

Nomura’s Chief Economist Richard Koo wrote a book last year called “The Holy Grail of Macroeconomics” which introduced the concept of a balance sheet recession, which explains economic behaviour in the United States during the Great Depression and Japan during its Lost Decade.  He explains the factor connecting those two episodes was a consistent desire of economic agents (in this case, businesses) to reduce debt even in the face of massive monetary accommodation.

When debt levels are enormous, as they are right now in the United States, an economic downturn becomes existential for a great many forcing people to reduce debt. Recession lowers asset prices (think houses and shares) while the debt used to buy those assets remains. Because the debt levels are so high, suddenly everyone is over-indebted. Many are technically insolvent, their assets now worth less than their debts.  And the three D’s come into play:  a downturn leads to debt deflation, deleveraging, and ultimately depression.  The D-Process is what truly separates depression from recession and why I have said we are living through a depression with a small ‘d’ right now.

Secular inflation will be non-existent

Therefore, the problem is a lack of demand for loans not a lack of supply. The Federal Reserve can print all the money it wants. But, if there is little demand for more indebtedness, it is not going to have the desired effect of permanently reflating the economy – although it can create bubbles.

The corollary of this is that inflation will be non-existent on a secular basis. For the increase in liquidity to feed into consumer price inflation, people have to actually buy more stuff.  And that’s not what happens in a balance sheet recession because people are concentrated on reducing debt and increasing savings.

Moreover, there is a huge glut of excess capacity globally now that we have had a major fall in consumption. Producers are waiting for demand to catch up with supply – not exactly the sort of situation that makes for inflation. I should point out that capacity is not fixed – it grows obsolete if unused. So, much of the investment in manufacturing capacity in China and property in America is going to have to be liquidated eventually.

But, the economy doesn’t move in a straight line. It courses through cycles. Just as we could be entering a cyclical recovery in the middle of a depression, it is altogether possible that the Federal Reserve can produce high cyclical levels of inflation despite the secular trend toward disinflation. A lot of this is likely to come through commodity prices or destruction of the currency.

For example, while the change in consumer prices has gone negative in the United States since the downturn began…

when one strips out food and energy, it has declined much less than even during the last deflation scare of 2001-2003, which caused Alan Greenspan to panic and reduce interest rates to 1%.

The discrepancy above is due wholly to changes in commodity prices.  So, if commodity prices re-assert themselves going forward, we could see a major uptick in inflation. Moreover, a fall in the value of the dollar could precipitate inflation as well.  And, finally, there is asset prices.  It is clear the Federal Reserve and the Obama Administration are targeting asset prices in order to reflate the economy. All of that stimulus can and will create cyclical inflationary forces which could be large. Nevertheless, the underlying level of demand is slack and that means secular inflation levels will remain subdued.  See my post “Central banks will face a Scylla and Charybdis flation challenge for years” for more on this concept.

This means the consumer will be under pressure

High debt and low inflation mean lower consumption growth.  It’s hard to spend more when you have a mountain of debt staring you in the face and its not getting reduced in real terms through inflation.

Look at the charts to the left.  They come from a story in Barron’s this weekend called They Shopped ‘Til They Dropped. They depict a tsunami of debt in the U.S. economy that has been building for four decades.  Even debt service levels have been inching inexorably higher since the 1980s. Clearly, the U.S. consumer is tapped out. And they are cutting consumption and reducing debt as a result.

So, for America, it is not business but consumers which are going to suffer a balance sheet recession.  In looking for evidence on Koo’s thesis, we need to look at consumption and retail sales.

Michael Shedlock recently reported on the horrible back to school sales numbers.  And Patty Edwards, a well-known Seattle-based retail analyst, was recently on Bloomberg radio with sobering anecdotal detail regarding the retail sector.  She sees no sign of an impending uptick in US retail sales and is very worried about the Christmas selling season. The audio of her conversation with Tom Keene is below (not available in the RSS feed).  It is very much in line with the balance sheet recession argument.

Shedlock’s post and Edwards’ view are very much in line with the retail sales numbers we saw late last week.  A lot of people had been looking for good retail sales numbers because they see recovery at hand.  But, the numbers disappointed, falling 0.1% from the previous month.

This puts retail sales 8.3% below year-ago levels and a full 10% below peak levels in November 2007. This is much more severe a decline than we witnessed in the shallow recession of 2001. When retail sales numbers hardly declined. In fact, on a nominal basis, they fell on a year-on-year basis only during September 2001 because of September 11th.

If one uses data both the present data series (1992 – present) and the previous data series (1967-2001), this downturn looks much more inline with the steep downturns of the 1970s and 1980s.

The key difference between then and now is the debt levels I showed you from the Barron’s article.  Let’s not forget low savings as well.

Macro Themes

One can only conclude that the asset-based economy of the last quarter century is over. It was based not just on a dubious productivity miracle but also on mountains of debt and over-consumption.  The new normal is debt reduction and savings.

What does this mean for the economy?  Here are a few macro themes:

1. Retailers are in a world of hurt, not just cyclically, but on a secular basis.  Listen to the Patty Edwards interview.  America has double the amount of retail space per capita that it did a generation ago. This is the definition of over-capacity. When a glut of supply meets a deficit of demand, you have the makings of a very bad outcome for the stocks in that sector. This is the same conclusion that the Barron’s article comes to.  The uptick in retail shares like JC Penney (JCP), Ann Taylor (ANN), and Macy’s (M) is all due to beating low earnings estimates. As a result, Abercrombie (ANF) has almost doubled. Nordstrom (JWN) is up 141% and Ann Taylor is up a massive 350%. Investors like George Soros are selling retail (Wal-Mart, Walgreen and Lowe’s).
2. Commercial Real Estate will feel the pain too. The Patty Edwards interview not only shows huge excess capacity in retail, but it shows that retailers are trying to re-negotiate contracts down.  They have Commercial REITS over a barrel because they can just threaten to close down outlets if they don’t get the contract price concessions they seek.  Back in January, I mentioned the fact that bankrupt anchor tenants like Circuit City  destroy the economics of malls for other tenants and create a domino effect.  So, if anchor retailers do not get the price concessions they want, they will shut down stores, creating a huge loss in income for all the other stores. Obviously, this will drive down the price of commercial real estate as there will be a huge glut of supply.
3. Export-oriented economies need to foster internal demand growth. Here I am talking about Germany, Japan, and China amongst the major economies.  The US consumer is out of gas and these countries are too dependent on exporting to US consumers. It is not clear who can replace her.  Certainly, the Chinese government and companies are doing their level best to foster domestic demand in China, even conspicuous consumption.  But, the Chinese are unlikely to replace Americans as the new global growth engine anytime soon.
4. The new normal is lower US and global growth. This all suggests that we are likely to see lower growth in the US and globally as a result – at least until the American consumer gets out of a hole or someone else picks up the slack.  That will likely mean we will see low-growth, short business cycles punctuated by fits of recession, all complicated by the three D’s (debt deflation, deflation, and depression).
5. One should fear a 1937-style relapse. If you recall, the Great Depression saw a major economic uptick in the years after 1932. No one would call this a boom (see the section called “recovery does not mean recovery” in my post “Economic recovery and the perverse math of GDP reporting.”) This was only a statistical recovery in the midst of a greater downturn. Eventually, stimulus was withdrawn and the economy tanked again. Richard Koo argues that Japan did not go into a 1929-style depression because it maintained much more stimulus than the US did in the Great Depression. If this stimulus is removed before the deleveraging and balance sheet repair is complete, you get a major relapse. So, beware of deficit hawks telling us that fiscal stimulus must end to eliminate deficits.  If anything, the government’s long-term deficit outlook should be eliminated via reigning in skyrocketing health care costs.
6. Banks will be in a permanent state of crisis. If we learn anything from Japan, it’s that time does not heal all wounds.  The Japanese tried to recapitalise their banking system by propping up zombie institutions.  That didn’t work.  It didn’t work in Japan in the 1990s and it didn’t work with Savings & Loans in the US in the 1980s. Why should we expect it is going to work now? But, team Obama has decided this is the way forward.  If and when an economic relapse occurs, the fragility of the banking system will be made manifest. Much of the so-called toxic assets is still on the balance sheet of American financial institutions. The same is true in countries like Germany, Spain and Ireland, to name a few. When another downturn hits, those assets will go bad and writedowns will drag down the weakest institutions.  This is the lesson of Japan.
7. Liquidate zombies while providing counter-cyclical stimulus. The banking example gives a hint to the correct policy response.  It is not a return to the bubble days of the asset-based economy.  It is not creating deficits as far as the eye can see while perpetuating overcapacity.  What policymakers need to do is allow bankrupt organizations to fail and reduce excess capacity, all the while providing enough stimulus to prevent worst-case outcomes.

When it comes to US consumers, weak spending growth will last for years. Ultimately, debt levels in the US economy must return to a sustainable level. This can happen over time, which would mean a decade-long low-growth, muddle-through economy – not a terrible outcome either for the economy or for asset prices.

Or it could happen overnight through default, bankruptcy, and liquidation – a Great Depression II scenario. The policy response in the US and elsewhere will make the difference. Right now, we are headed for a statistical recovery at best. If policymakers think we are off to the races and try to normalize policy, they will be making a heinous mistake.

Related posts:

• UK retail sales drop most in 22 years
• Data on past consumer deleveraging during recessions
• U.S. consumer spending down 1% in December
• Avoid consumer stocks
• Looking beyond the fake recovery

This is a translation of a Spanish-language article from Finanzas.

For UBS, there is no debate about the economy’s green shoots despite the improvement in employment and the slowest fall in consumption and industrial production. In a harsh report on Spain, the Swiss bank says that the worst is yet to come, and that unemployment will reach 20% of the population.

The institution ensures that the latest figures released “have shown a marked deterioration in the situation.” For the bank, the problem began with an unprecedented housing bubble, both in size and price, which now has spread to other sectors as demonstrated by the collapse of industrial production – which has fallen by nearly 30% and contributed more than the construction sector to the fall in Gross Domestic Product (GDP).

“We see very few reasons to be optimistic in the short term. The future will be much better, “say UBS analysts, none of them Spaniards, whose work has been supported by another study on the domestic banking sector. “The labour market will continue to deteriorate rapidly, with devastating effects on the rest of the economy!” they say. According to their calculations, unemployment will exceed 20% at the end of 2010.

In the view of the Swiss group, the construction sector has gone from employing 2.7 million workers in the second quarter of 2007 to 1.97 in March of this year. That is to say, 760,000 jobs have already disappeared, reducing its weight in the economy to 10%. In Europe, this figure is 7.5%, so building could lose another 500,000 jobs by the first quarter of next year.

The Swiss bank added that as a result of the aforementioned, the government fiscal situation has deteriorated, as it has subsidised work schemes to revive the economy. Moreover,  it has suffered lower revenues as well due to lower contributions to the Treasury. However, UBS believes that the Government has ample room to manoeuvre because the debt burden is still low and because the level of taxation is low compared to other European countries. However, they qualify this saying that the State has little capacity for new large stimulus packages due to the huge public sector deficit.

The price of houses

Regarding the real estate sector, UBS says that in late 2007, Spain was the country with the more overvalued house prices in Europe. It amounted to 55%, followed by Ireland, with about 30%. For the bank, the situation has not changed much since the prices of homes have only fallen by 6.5% from the peak.

The bank says that this market behaviour is logical because sellers do not want to dispose of assets if it is not at an attractive price. This attitude leads to a collapse in the number of transactions, which are ever increasing supply, which results in a longer fall of the house prices. According to their estimates, this fall will be at least 20%.

Source

UBS, contundente: “El desastre en España va a continuar” – Finanzas

Related posts:

• House price declines accelerate in Spain
• Spain: Bleak forecast puts unemployment at 22% in 2010
• Spain: who is responsible for the property bubble?
• Hypo Real Estate need for 10 billion also reveals huge problems in Spain
• Spain: “we need to go back to 2000 wages and prices and start again”

I love this guy. If you are looking for a guy who is super bearish on the U.S., then David Tice is your man.  He sees unemployment at 15%, stocks well down from present levels and a serious Depression with a Capital-D in the offing.  In short, he’s talking about a financial and economic catastrophe.  Obviously, I don’t see things quite as starkly based on my previous comments. Nevertheless, he is refreshing to watch. Very entertaining.

Below is a recent clip from 2 Jul 2009 that I caught of him spinning his doomsday tale on Bloomberg.  I liked it so much I decided to post several videos of him from earlier appearances on Bloomberg which are below the first video.  He makes a lot of sense if you watch them in chronological order from bottom to top.

Enjoy.

12 May 2009

17 Apr 2009

05 Feb 2009

25 Aug 2008

9 Jul 2008

16 Apr 2008

06 Feb 2008

20 Nov 2007

Related posts:

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• Getting bearish again
• A conversation about Prop. 8 with David Boies on Charlie Rose
• Stephen Roach is still bearish, no recovery until 2010
• Why I am bearish on the U.S. Dollar

A recent poll which ended on Wednesday as to when the economy will recover yielded the results below:

Clearly, you think this downturn has legs!

Please feel free to ping us with other important questions we should be asking readers.

Cheers.

Edward

Related posts:

• Poll: Is this a recession or a depression?
• When will the U.S. recover?
• Morgan Stanley: Recession will ‘end by mid-to-late summer’
• Jobless claims may signal the end is near
• The recession is over

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)

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• 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.
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Back in February I posted an article called “The bullish argument for the global economy” highlighting Goldman Sachs’ Chief Economist Jim O’Neill’s bullish view for the economy. O’Neill believed in February that a economic rebound was certainly possible due to fiscal and monetary stimulus. Paul Kasriel has made similar arguments.

While I do agree that fiscal and monetary stimulus have been great and may induce a cyclical rebound, I wanted to point out that he mentioned the Philly Fed Survey and the ISM surveys as potential leading indicators of recovery.

Both surveys are out and they have not been extremely robust.

Released on March 2nd, the ISM was marginally higher last month. But, with 50 as the border to recession, a PMI reading of 35.8 is deeply recessionary.

The Philadelphia Fed’s March Business Outlook Survey came out today and this is what it said (bolding mine):

The region’s manufacturing sector continued to contract this month, according to firms polled for the March Business Outlook Survey. Indexes for general activity, new orders, shipments, and employment remained significantly negative. Employment losses were substantial again this month, with over half of the surveyed firms reporting declines. Firms continued to report declines in input prices and prices for their own manufactured goods. Most of the indicators of future activity suggest that the region’s manufacturing executives expect declines to bottom out over the next six months, but the firms’ employment forecasts suggest continued weakness.

Indicators Reflect Further Contraction

The survey’s broadest measure of manufacturing conditions, the diffusion index of current activity, edged higher, from -41.3 in February to -35.0 this month. Last month’s reading was the lowest since October 1990. The index has been negative for 15 of the past 16 months, a period that corresponds to the current recession (see Chart). Continued weakness was evident in all of the broad indicators this month. The survey’s current new orders index declined nearly 10 points, to -40.7, its lowest reading since July 1980. The shipments index increased six points, but this follows a record low in February. The survey’s current inventory index declined precipitously this month, from -24.3 to -55.6, its lowest reading in the history of the survey.

Basically, the Philly Fed’s survey was big fat bust. No matter, the market is up nearly 160 points as I write this. So, is this a harbinger of good things to come or should I expect Jim O’Neill to change his tune?

Sources
February 2009 Manufacturing ISM Report On Business® - ISM
March 2009 Business Outlook Survey – Federal Reserve Bank of Philadelphia

Related posts:

• Philly Fed: Business outlook shows ‘notable improvement’
• Philly Fed survey points to manufacturing rebound
• ISM: U.S. manufacturing contracting slower
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The jobs picture is looking grim. Jobless claims for the week ending 14 Feb 2009 were 627,000, pushing the average to 619,000. Additionally, nearly 5 million people are staying on the unemployment roles, the highest figure ever. But, it should be a given that jobless claims have increased in this cycle — the U.S. population has increased. What do these figures really mean?

The number itself is largely meaningless except as a talking point for journalists comparing this recession to previous downturns. How many times have you heard the phrase: “this is the largest number since 1982?” Dozens of times, I bet. Unemployment is a lagging indicator and doesn’t tell us anything about whether the economy is going to rebound. What we need to divine from the number is how it predicts future employment, and therefore future spending and economic growth. That’s going to be important whether you are looking for a job investing money or are looking to strategize for your business.

Here’s my brief look into how one can do that (for a more in-depth analysis, see my October post “The Economy’s Four Horsemen“). When the economy starts to slow, it is usually starts with consumers pulling back somewhat, followed by business realizing they need to pull back in turn. This leads to job losses and a further pull back. The cycle of retrenchment eventually ends and consumers begin spending again. But, what you should notice is that consumers lead and companies follow. That means employment falls only after it is apparent that the economy is slowing, and employment continues to fall even after the economy starts to pick up. So, employment is a lagging indicator.

What is not a lagging indicator is the increase in unemployment. In business cycles I have studied, the 6-month or 12-month change in unemployment is a good gauge of the economy. Translation: if you can compare today to six months ago and the jobs picture looks worse (on a relative basis) than it did last month when you did the same exercise, that means the economy is deteriorating.

Now, there are any number of ways to represent this comparison. You can look at the 12-month change in the unemployment rate. You can use the look at the 12-month change in the number of unemployed, and so on. One of my best metrics is jobless claims. More precisiely, I look at the “12-month change in the 4-week average unadjusted number of initial unemployment claims.” That’s a mouthful, so let’s call this stat the “jobless claims change (JCC).”

What the JCC tells us is the rate of deterioration or improvement in the employment market, which very much more of a coincident or leading indicator than unemployment (see my post “Another Perfect Recession Indicator‘ for more). If the JCC increases a lot and is still increasing, that means the jobs picture is getting worse at a more rapid rate, which means that the economy is also deteriorating.

Below are two charts for jobless claims.

The above two charts indicate that the JCC reached a peak of 326,000 two weeks ago and has since fallen to 292,000. If this trend continues, it would indicate an improvement in the economy. However, two weeks, do not a trend make. Moreover, the continuing claims versions of the same charts show further deterioration i.e. an acceleration in the worsening of unemployment. And, all of these charts show a jobs picture on par with the deep recession of 1974.

So, the long and short of this is: the jury is still out on how quickly things are deteriorating. I fully expect an ugly unemployment number for February and double-digit unemployment before this is over. Because of inventory de-stocking, I also expect a poor GDP number for this quarter as well. But, let’s not get all doom & gloom here. The numbers are plateauing right now.  By the end of March, things could look very different.

Source
Unemployment Insurance Weekly Claims Report – U.S. Department of Labor

Related posts:

• Are US jobless claims telling us something?
• U.S. jobless claims foreshadow an ugly unemployment number
• U.S. jobless claims: Claims rise 62,000 to 589,000
• U.S. jobless claims: slight uptick to 588,000
• Jobless claims: 654,000 means flow is static, stock is up

Today’s Globe & Mail does an excellent job of presenting the three different potential outcomes for the global economy, one optimistic, one pessimistic and a third somewhere in between. Below are the key snippets of their article reflecting each of the three outcomes. However, I highly recommend reading the full article which is linked below.

The optimistic forecast – Mark Carney, Bank of Canada
Sure, 2009 will be a year of misery – for Canada, the U.S. and most of the world. But once we’re through the next few months, all the economies that plunged into a synchronized global recession rise again in unison like a flock of Canada geese.

The recovery starts where it all began – in the U.S. Mr. Carney expects the U.S. economy to shrink 1.7 per cent this year, rebounding nicely in 2010, growing 2.6 per cent.

And yet Mr. Carney’s GDP forecasts are a full percentage point more optimistic than most private sector forecasts. Morgan Stanley, for example, is calling for gross domestic product to shrink 2.7 per cent this year, and grow a modest 1.8 per cent in 2010.

All things considered, Canada gets off pretty lightly, the way Mr. Carney sees it. The economy shrinks 1.2 per cent in 2009, before roaring back to life in 2010.

Far from being the worst crisis since the Great Depression, Mr. Carney sees Canada bouncing back much faster than it did from previous recessions – in 1981-82 and 1990-92.

The middle of the road forecast – Mark Zandi, Economist.com
“The economy is expected to stabilize by year’s end,” Mr. Zandi says. “But this depends on a multitude of things going reasonably right, and on policy makers’ ability to implement their plans quickly.”

Fiscal stimulus will create or save as many as three million U.S. jobs and keep unemployment 1.5 percentage points lower than it otherwise would be.

“The plan is reasonably well structured,” Mr. Zandi says of the Obama administration’s stimulus plan.

The Treasury Department’s public-private scheme to purchase bad assets from financial institutions and “stress test” troubled institutions should help stabilize the financial system, Mr. Zandi adds.

Even then, the recovery will be long, hard and a lot more costly. There will be more job losses, further depressing consumer spending.

The banks will need a lot more capital to weather the recession. Millions more Americans will lose their homes to foreclosure…

“If we do get the stimulus, if we do get financial stability, I’m hopeful that by this time next year we’ll have a more stable economy and a more stable jobs market,” Mr. Zandi predicts.

The pessimistic forecast – Nouriel Roubini
“Even if the U.S. were to do everything right and fast enough, we would still have a severe … recession until early 2010, with a weak recovery of growth,” Prof. Roubini argues. “But if the U.S. does not do it right, this U.S. and global recession may turn into a nasty multiyear L-shaped, near-Depression like the one experienced by Japan.”

The way Prof. Roubini figures it, the recession is only half over. Unemployment will soar toward 10 per cent by mid-2010 from 7.6 per cent now, and stay punishingly high for some time. And for the next several months, expect 400,000 to 600,000 U.S. jobs to vanish every month.

U.S. real estate prices will fall another 20 per cent, on top of the 25 per cent decline we’ve already seen. Housing starts, after tumbling 75 per cent, will decline another 20 per cent. His reasoning is simple: All those layoffs, tighter credit conditions and lost stock market wealth have created a vicious cycle that puts more homeowners upside-down on their mortgages.

As a result, he argues, the number of U.S. underwater mortgages – households who owe more on their mortgages than their homes are worth – could more than double to 25 million from 12 million now. That would wipe out as much as $4-trillion worth of wealth, or roughly equal to what’s already been lost.

Following the money chain, bank losses will peak at $3.6-trillion, and we’re not even half-way there. U.S. stocks, already down nearly 50 per cent, could fall another 20 per cent. That virtually guarantees that one or more of the surviving big U.S. banks will fail, or be swallowed by a rival.

Prof. Roubini says the U.S. is headed for a 3.4 per cent drop in GDP this year, followed by just 1 per cent growth in 2010.

Source
Three Roads for the Global Economy – Globe & Mail

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• Bank of Canada blames Geithner for financial mess
• Nouriel Roubini: we are in recession
• Jim O’Neill on the Global Economy
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• World Economic Forum: Experts voice their views on the economy

The Chief Economist of Goldman Sachs, Jim O’Neill, sat down with the FT’s David Oakley and had a go on a number of topics from the financial crisis, investments in Emerging Markets, the future of the Bric (Brazil, Russia, India and China) economies, to the global economy.

Below are links to the three-part video series on the FT website. While he is more optimistic than I, I do think the videos are well worth watching.

Enjoy.

This first video is on the global economy. (Click on image below)

Click here for the second video on the Bric economies.

And click here for his view on investment in emerging markets.

Related posts:

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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

Related posts:

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• Barton Bigss on Charlie Rose
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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

I want to make a brief statement about analysis, prognostications and this global recession. When I began this site nine months ago, my focus was clearly on the downside scenario. 

The first four posts were entitled:

• The Economy Is Definitely In Recession
• Recession: How Long and How Deep?
• The US Economy 2008
• War in Iran: Is it inevitable?

You can’t pick a more dour set of post titles than that. Now, while I did believe policy makers were underestimating the threat of economic calamity, I must admit that I was optimistic about the potential outcomes. And I am still optimistic today that we can overcome the major hurdles we face. However, we must always prepare for the worst, even while we hope for the best. This is why I am still focused on the downside scenario — because I believe that complacency is still much too high regarding how quickly things could unravel.

In my third post on the US economy, I said the following about why I was worried about the present economic downturn (emphasis added):

The global economy, now supported in the main only by the overextended U.S. consumer, finds itself at stall speed, susceptible to any number of potential exogenous shocks. Ultimately, the economic malaise created by this confluence of events will take years to unwind. A positive outcome to this process is dependent wholly on liquidation of excess credit and consumption.

This process will be extremely painful in the short term, but will lead to a healthy economy long-term. Unfortunately, experience shows that these painful steps will only be taken as a last resort. Moreover, geopolitical events become volatile in a world of economic insecurity, leading to political upheaval and protectionism. Protectionism is a natural outgrowth of nationalist economic policy…

The “bad” scenario is playing out according to script because protectionism, trade wars, competitive devaluations, bailout packages, and export subsidies are all on suddenly on offer across the globe. All of these policies are designed to “protect” domestic producers and jobs. However, as they unfairly advantage domestic producers at the expense of consumers, they always invite a response from exporting nations. You can hear about it in China the U.S., Argentina, Brazil, Vietnam, Russia, Germany, India – the list is quite long.

But, I worry even more about political instability and social unrest. There are reports of burgeoning unrest in China. The Russians anticipate social unrest as the ruble loses value. And there are still more reports of strife between India and Pakistan. Below is a sample of articles in the news from just the past 12 hours:

• Guinea’s Ruling Military Junta Cancels All Mining Agreements
• Nigerian Military Says It Repelled an Attack on Pumping Station
• Baghdad Bomb Leaves at Least 18 Dead, Associated Press Reports
• Israeli Air Strikes Kill at Least 140 in Gaza Strip
• Bhutto’s Vision for Democratic Pakistan Crumbles
• Russia braced for unrest

We are living in a very unstable world already. The poor economy can only make matters worse. Is political upheaval and social unrest what we have to look forward to in 2009? Is this how the world MUST react to a severe recession? Again, my hope is this can be averted, but I have to point out the downside scenario here because it is very worrying. At a minimum, this is why I have gotten on board with the stimulus bandwagon despite my misgivings about government spending and the potential misallocation of resources.

So, as we head into 2009, I am hopeful that all of the ugly scenarios involving tariffs, competitive devaluations, export subsidies, riots, coup d’etats or the use of military force can be averted. My hope is that economic stimulus will be helpful in cushioning the downside scenarios and that we can start on an upward path by the end of 2009. While I hope I will continue to report events as they truly are.

In any event, because 2008 has been so dreadful, here’s to hoping for some upside in 2009.

Related articles
The Major Risks for 2009: Tariffs, Wars, Currency, etc. – Paul Kedrosky

Related posts:

• The Cold War redux
• World Economic Forum: Experts voice their views on the economy
• The bullish argument for the global economy
• Top ten economic wishes for 2009
• Is 2009 tracking a 1930 Great Depression scenario?

Has Paul Krugman been reading my stuff? He is certainly thinking like me regarding emerging market risk. He has a post today talking about Latvia as the new Argentina. He says:

I’ve been saying this for a couple of weeks, but Edward Hugh has the goods.

Hugh puts his finger, in particular, on one gaping hole in the logic of the opponents of devaluation. We can’t devalue, they say, because the Latvian private sector has a lot of debts in euros, and a devaluation would make it very hard for borrowers to service those debts. As Hugh points out, the proposed alternative — sharp wage cuts, and basically a major domestic deflation — will also make it hard to service those debts. In fact, I’d be a bit more specific than Hugh: other things equal, a nominal devaluation and a real depreciation achieved through deflation should have exactly the same effect on debt service (unless some of the debt is in lats rather than euros, in which case devaluation would do less damage.)

This looks like events repeating themselves, the first time as tragedy, the second time as another tragedy.

For those of you who have been reading my stuff regularly, I made a similar argument back in July in my post “Are the Baltics the new Argentina?“:

The Baltics are looking a lot like Argentina was before it collapsed at the beginning of the decade: fixed exchange rate, large current account deficit, significant foreign bank lending, overheating economy turning to bust.

This combination is a toxic mix that will certainly end in the disaster it did for Argentina. I have a vivid memory of being in Buenos Aires when workers were rioting in the streets, knocking over cars and setting them on fire. Foreign banks were littered with Graffiti, including the word “ratas,” scrawled across them. Many banks were shut down and closed and too many bank I could see had armed guards with submachine guns out front to protect them. I can’t say this same disastrous scenario awaits the Baltics, but things could get pretty dicey there in any event…

The Baltics have a lot of hot money invested in their economies as much of the lending growth came on the back of foreign financial investment. When distress hits, one should expect a giant sucking noise from foreigners repatriating funds. This will leave the Baltics subject to credit deflation just as the economy is entering recession.

When one adds the slow economy and the high inflation to a fixed exchange rate and high current account deficits it says: the Baltics do not have the appropriate fiscal and monetary policy for a fixed exchange rate.

One of two things must give: the exchange rate peg or the economy. In Argentina, it was both.

Make sure you read Edward Hugh’s analysis sourced below. It shows that the IMF has made a big mistake in NOT correcting the exchange rate disaster in Latvia.  As you can tell from my post in July, all of this was readily apparent months ago.  Don’t let anyone tell you otherwise.

With Hungary and the Ukraine also taking money from the IMF, the other Baltics in deep trouble and many more countries in peril, I fully expect Eastern Europe to be a problem. And for banks in Germany, Austria, Denmark and Sweden, loaded to the nines with loan exposure there, that spells massive credit writedowns and loan losses. Get ready.  It will happen.

Sources
Latvia is the new Argentina (slightly wonkish) – Paul Krugman
Why The IMF’s Decision To Agree A Lavian Bailout Programme Without Devaluation Is A Mistake – A Fistful of Euros

Related posts:

• Are the Baltics the new Argentina?
• Event risk in the Baltics is critically high
• Latvia – the insanity continues
• Estonia and Latvia: headed for the rails
• The Euro and Baltic currency overvaluation

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

The punderati has been especially kind to China. As the global recession takes hold, the conventional wisdom has moved from the largely debunked de-coupling of China to a story where China slows, but much less so than the west. But is that really how things will play out?

Marshall Auerback certainly thinks China faces some stiff headwinds, but he believes these are issues that can be overcome. Debt levels are extremely low and savings levels very high amongst the consuming masses there. Mark Mobius believes that the emerging markets generally are shortly due for an upswing. However, I would like to take a more pessimistic tack here.

You may recall that just yesterday I quoted from an Indian article which underlined the cratering of export demand for China. Let me add to those thoughts with the following analysis:

1. The Chinese are highly dependent on manufacturing exports to maintain growth. Most of their growth in the last two decades has come from export demand subsidized by a cheap currency and massive numbers of relatively low wage workers.
2. However, demand from the west is cratering because of the worst recession since the 1930s.  Because China’s export economy is geared to the west, this has had a devastating impact on export demand.
3. As a result, the Chinese will need to switch to a focus on domestic demand. Where is this demand going to come from? Granted they have no debt. However, people don’t just start buying stuff in the middle of the greatest downturn in 75 years. Chinese people see these and must know that caution is warranted.
4. Moreover, their residential property market has imploded as has the stock market. This too must work against the psychology of increased domestic spending as the wealth effects here are significant.
5. And the banking system was already fragile. My general thinking would be there are huge hidden losses at Chinese banks as a result. Therefore, lending capacity has to be restricted going forward. I would not be surprised if we saw a reduction in the money multiplier in China as well.
6. Ultimately, I would argue that the Chinese domestic consumer is not going to consume more.   In fact, they would need to consume a lot more given the GDP per capita of the average Chinese person in order to replace the lost demand from the West.  But, I believe they will consume less given the factors enumerated above.

I await more data from China. In the meantime, I remain skeptical but open to persuasion.

Sources
China’s industrial output growth stalls – Sydney Morning Herald
China ‘repeating US mistakes of 1930s’ – Sify.com, India
The Great Crash of China – Far Eastern Economic Review
China’s Output Growth to Drop Further, Minister Says – Bloomberg
China: Industrial Output – Bloomberg
China Industrial-Output Growth Is Weakest Since 1999 – Bloomberg

Related posts:

• China cutting overcapacity
• China can handle collapse of speculative inflows
• Marc Faber: China’s numbers are fake
• China wants all of Repsol’s Latin American oil assets
• The world’s biggest bank is Chinese

On a recent Bloomberg Radio with Tom Keene broadcast, Harvey Pitt and Arthur Levitt, two former SEC Chairman were guests. Levitt made the suggestion that hedge funds had once been given the choice of “regulation-light” or “regulation-heavy.” Now, in the wake of the Madoff scandal, “regulation-heavy” is all but assured. But, isn’t this just?

Listen to what Nobel-winning economist Paul Krugman makes of this:

How different, really, is Mr. Madoff’s tale from the story of the investment industry as a whole?

The financial services industry has claimed an ever-growing share of the nation’s income over the past generation, making the people who run the industry incredibly rich. Yet, at this point, it looks as if much of the industry has been destroying value, not creating it. And it’s not just a matter of money: the vast riches achieved by those who managed other people’s money have had a corrupting effect on our society as a whole.

Let’s start with those paychecks. Last year, the average salary of employees in “securities, commodity contracts, and investments” was more than four times the average salary in the rest of the economy. Earning a million dollars was nothing special, and even incomes of $20 million or more were fairly common. The incomes of the richest Americans have exploded over the past generation, even as wages of ordinary workers have stagnated; high pay on Wall Street was a major cause of that divergence.

But surely those financial superstars must have been earning their millions, right? No, not necessarily. The pay system on Wall Street lavishly rewards the appearance of profit, even if that appearance later turns out to have been an illusion.

Consider the hypothetical example of a money manager who leverages up his clients’ money with lots of debt, then invests the bulked-up total in high-yielding but risky assets, such as dubious mortgage-backed securities. For a while — say, as long as a housing bubble continues to inflate — he (it’s almost always a he) will make big profits and receive big bonuses. Then, when the bubble bursts and his investments turn into toxic waste, his investors will lose big — but he’ll keep those bonuses.

O.K., maybe my example wasn’t hypothetical after all.

So, how different is what Wall Street in general did from the Madoff affair? Well, Mr. Madoff allegedly skipped a few steps, simply stealing his clients’ money rather than collecting big fees while exposing investors to risks they didn’t understand. And while Mr. Madoff was apparently a self-conscious fraud, many people on Wall Street believed their own hype. Still, the end result was the same (except for the house arrest): the money managers got rich; the investors saw their money disappear.

What Mr. Krugman just described is what Kevin Phillips calls the “financialization” of America. The financial services industry is a behemoth unlike the military-industrial complex, which has taken on an ever larger share of U.S. jobs, U.S. GDP, and until recently what we thought was U.S. profits. However, witness the extreme levels of debt used to achieve these phantom profits in the chart below.

The fact is that two decades of deregulation has created a financial services monster, which is both an important lobbying group in Washington and of disproportionate size to the real economy. This allowed fund of fund hedge funds to pyramid fees on top of Madoff’s own fees without doing the necessary due diligence regarding the primary funds. No investor would ever have suspected a thing as they received their statements from the fund of funds and not from Madoff directly.

Moreover, the Madoff scandal reveals the laxity in SEC regulation as multiple warnings had been given about Madoff as far back as 1999. Pitt assured the listeners that Madoff could have happened even in a more regulated environment because this was not systemic regulatory failure but human regulatory failure.

Really? I would label this whole episode systemic regulatory capture. And it all leads back to the lack of regulation. This is a systemic problem that needs a systemic fix. Deregulation is the problem here, not the solution.

Source
If it’s broke, fix it – but how? – Willem Buiter’s Mavercon
The Madoff Economy – Paul Krugman, NY Times

Related posts:

• The FSA signals a need for regulation-heavy
• S.E.C. complicit in Madoff fraud, whistleblower says
• Video: Geithner calls for single agency to oversee systemic risks
• Guest post: Regulation in Defense of Capitalism
• A brief note on the fake reform agenda

The yield on all U.S. Treasurys securities are at historic lows. The 3-year T-bill and the 1-year T-bill have both actually sported negative yields — meaning investors are paying the U.S. Governemnt to borrow money from them. This is the first time this has ever happened and suggests that the zero bound may not be a problem. What gives?

The conventional wisdom in the marketplace is two-fold. First, many believe that investors are fleeing to the safe haven of U.S. treasury bonds and away from risky assets as the financial crisis has created extreme volatility in riskier asset classes. It is also believed that treasury prices are being supported by future deflation expectations. With the price of oil and commodities collapsing and consumer demand weak, inflation has dropped precipitouly in most countries around the world, including the United States.

I have a different view. Treasurys are in a bubble.

In the wake of popped stock, housing and commodity bubbles, some see a fourth bubble building — in Treasury bonds. Unlike those bubbles, this one doesn’t have to end disastrously.

Treasury yields, which move inversely to prices, are at historic lows. Friday, the yield on the 10-year note fell to 2.47%, the lowest in Federal Reserve records going back to 1962 and well below the average of the past decade of about 4.7%.

Treasurys have been rare good investments in this awful year, returning 10% through November, according to Merrill Lynch chief North American economist David Rosenberg, a longtime bond bull. But even he recently told clients that Treasurys were “clearly heading into a bubble phase” and suggested there might be greener pastures in other fixed-income investments, such as debt backed by government-sponsored entities.

Meanwhile, the U.S. government may post a trillion-dollar budget deficit in the fiscal year ending in September and has pounding fiscal headaches looming far beyond that. Some key buyers of its debt, foreign central banks, are launching their own expensive stimulus packages and would seemingly have better uses for their cash.

And while the U.S. government’s access to cheap money helps its efforts to stimulate the economy, it also may crowd out other borrowers. Municipalities and companies with good credit histories are paying exorbitant rates to borrow, arguably extending the pain of the credit crunch.

“We have a remarkable situation in which a 30-year loan to the U.S. government with a taxable instrument pays you 3% and a loan to the state of Ohio pays you 5% tax-free,” said David Kotok, president of money-management firm Cumberland Advisors in Vineland, N.J.

Eventually, investors will demand a higher yield for Treasurys. It could happen when risk appetite returns, or if the cash the Fed is pumping into the economy sparks inflation. Some worry a snapback could be as brutal as the popping of any bubble, sending interest rates soaring and short-circuiting any economic recovery.

Edward here. This is precisely the problem. No one knows what will happen if and when the economy recovers. It seems reasonable to expect that when things do turn around, investors’ risk appetite will increase. They will look at the paltry returns on treasury securities and flee for riskier assets en masse.

To my mind, it is not deflation and a flight to quality which created this bubble to begin with. It is easy money in the form of ultra low interest rates at the Federal Reserve. Time and again, the Fed’s easy money has created bubbles: in emerging markets, in stocks, in housing, in commodities. Now it is Treasurys. This bubble is only enhanced by the fact that many investors are fleeing to Treasurys not mindful of the quality of the assets. Because investors need liquid investments to sell during the market volatility created by the credit crisis, they are fleeing to the most liquid investment out there: Treasurys. This is not a flight to quality, it is a flight to liquidity.

But, let’s not forget the currency risk either. China is very exposed to the U.S., being the largest holder of Treasury securities. Will they want to hold these if the Dollar becomes a weak currency again? That would mean massive losses for the Chinese central bank.

But Treasurys have long defied bubble warnings, which cropped up as early as February, when the 10-year note yielded just below 4%. At the time, inflation was rising. Now it is falling. And the economy has turned much uglier, justifying lower yields.

Meanwhile the Fed, which begins a two-day policy meeting on Monday, has been swapping Treasurys for riskier assets. It can reverse that trade to keep yields from soaring and derailing the economy again.

“There’s a big actor out there called the Fed that has a huge balance sheet that used to be all in Treasurys and now isn’t,” said Council on Foreign Relations economist Brad Setser.

The Fed would have other allies in that effort — particularly China, which has an interest in keeping U.S. borrowing costs low, if only because it wants to protect American demand for its exports. Foreign central banks may have contributed to a Treasury bubble in the first place, but they also can keep its bursting from being messy.

It remains to be seen when this bubble will burst. But, burst it will — despite what this article from the Wall Street Journal says. And when it does so, it will be very messy, indeed.

Source
Treasurys Can Burst Bubble, Land Safely – WSJ

Related articles
One-month U.S. T-bill yield turns negative – Reuters
Treasury Bubble Talk Grows as U.S. Gets Free Money – Bloomberg
Treasurys bubble danger – FT Alphaville

Related posts:

• Treasuries are getting crushed
• Treasury yields go below zero
• Another take on the treasuries bubble
• Quote of the day: Stephen Roach
• Japan’s easy money policy was the trigger for the tech wreck

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

James Montier, a market guru usually known as a permabear has turned bullish of late.  In keeping with my bullish sentiments, I have posted his thoughts below according to Bloomberg News.

That said, I should always qualify my ‘bullishness.’  I still believe we are in a bear market and that equities will go lower on an inflation-adjusted basis.  Investing only in index funds is a bull market strategy to be avoided like the plague. However, there are many stocks trading for 3 and 4 times earnings like Valero Energy or Chevron that deserve a look – Montier obviously agrees.  This is shaping up to be a value investor’s dream.

Notice the huge number of deep value stocks in the energy sector at the bottom of this post.

Societe Generale SA strategist James Montier said he’s never been so bullish after the financial crisis dragged down prices for stocks, corporate bonds and inflation-protected government debt.

The Standard & Poor’s 500 Index is “distinctly cheap” because it trades for 15.4 times the 10-year moving average of its companies’ profits, compared with an average of 18 for the U.S. market since 1881, London-based Montier wrote in a research note today. Fifteen stocks in the U.S. index, from Chevron Corp. to Gap Inc., pass his test for “deep value,” while a tenth of shares in Europe and a fifth in Asia qualify.

“This is a value investor’s version of heaven,” wrote Montier, SocGen’s global equity strategist. “From a bottom-up perspective, the equity market is offering some excellent companies at truly bargain prices for those with the fortitude to shut their eyes, or at least switch off their screens and buy.”

Corporate bonds are pricing in the highest default rate since the Great Depression and some senior secured debt is trading for as little as 50 percent what investors would recover in a bankruptcy, Montier wrote. The drop in bonds may amount to “the investment opportunity of a lifetime,” he said.

Market Plunges

Equities tumbled this year, sending benchmark indexes in the U.S., Europe and Asia down more than 40 percent, as financial-company losses stemming from the U.S. housing-market collapse approached $1 trillion. Merrill Lynch & Co.’s U.S. Corporate Master Total Return Index of investment-grade corporate bonds declined 13 percent this year.

The Federal Reserve has reduced its benchmark interest rate to 1 percent from 5.25 percent in September 2007 and pledged to lend more than $7 trillion to revive the economy. Investors can get cheap insurance against the risk Fed lending spurs inflation by purchasing government bonds that pay interest on a principal amount that rises with the consumer price index, Montier wrote.

“Such instruments have seen their yields rise dramatically of late,” he said. “Mr. Market is offering you the opportunity to protect yourself from the ravages of inflation in an exceptionally cheap way.” Bond yields move inversely to prices.

Montier was a member of the top-ranked investment strategy team in Thomson Extel’s surveys the past three years.

“With all of these opportunities available I have never been more bullish!” he wrote. “Will I be early? Almost certainly yes, but if I can find assets with attractive returns and I have a long time horizon I would be mad to turn them down.”

S&P 500 stocks that Montier characterizes as “deep value
opportunities” based on profit and dividend yields, debt levels
and price relative to earnings:

Allegheny Technologies Inc.
Carnival Corp.
Chevron Corp.
ConocoPhillips
Cummins Inc.
Dow Chemical Co.
Gap Inc.
Illinois Tool Works Inc.
Ingersoll-Rand Co.
KLA-Tencor Corp.
Marathon Oil Corp.
Molex Inc.
Nucor Corp.
Tesoro Corp.
Valero Energy Corp.

Source
Montier Has ‘Never Been More Bullish’ on Stocks – Bloomberg

Related posts:

• Fridson Says Junk Debt Is ‘Extraordinary Opportunity’
• U.S. stocks at lowest level since 1997
• Fix the real economy first: lessons from James Montier
• Bullish
• Dividends are under pressure

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

Just a few moments ago I caught a very interesting post on Alice Cook’s site UK Bubble. The gist of the post was that things are falling apart in Ireland very quickly. Given what we saw with Iceland, I have to ask: is Ireland next?

I wouldn’t suppose that things are this fragile but we cannot dismiss out of hand talk of Ireland going the way of Iceland. Here is what Alice posted:

Someone left this intriguing comment on one of my posts yesterday:

Alice can you shed any light on what is going on in the Irish Republic?

Last week beef prices collapsed. This week I am unable to sell finished beasts at all.

Last week a police strike in Donegal was narrowly averted when the local authority agreed to stump up accrued overtime.

Bank of Ireland shares are trading for under 90 cents from a one time high of 18 Euro. It looks like the Government’s bluff is about to be called…

Rumour has it that the cashpoint system will stop within 3 days

Can you shed any light?

Is there anyone out there who can help?

Now, Ireland happens to be one of the worst affected bubble economies in Europe. They have seen a massive house price bubble along with huge leverage as their economy leapt forward over the last decade. However, this has all gone pear-shaped in the last year or so and Ireland has a recessionary economy with rising unemployment, collapsing house prices and severe knock-on effects in terms of commercial property. Immigrants, who once flocked to Ireland are no longer coming.

Meanwhile, Ireland was the first country to offer a blanket guarantee to it’s banks’ depositors. I welcomed this move as a necessary step to restore confidence. However, there are two problems associated with it.

1. As Willem Buiter has pointed out, this move was a “beggar thy neighbour” policy which initially sucked deposits out of British institutions. British savers flocked to government-protected Irish institutions in the UK which courted the British savers with higher interest rates — the government had effectively subsidized the banks. Eventually, Europe as a whole got onside, and sweeping deposit guarantees were offered all around.
2. The government must be able to credibly back up its guarantee. And this where Ireland looks a lot like Iceland. The country has an outsized financial sector which could not possibly be guaranteed by the Irish government. Moreover, Ireland is a member of the Eurozone — meaning it can’t print its own money. The UK, which borrows in Sterling can at least print money to finance any guarantees. The Irish are constrained — and, therefore, vulnerable.

It remains to be seen whether there is a sub-current of panic about the fragile Irish banking system that could lead it to Iceland’s fate. In fact, commentators like Wolfgang Munchau have argued that the single currency is a boon to the likes of Ireland because it prevents currency attacks like the one Iceland suffered, leading to its downfall.

However, a run on Irish banks is what would ultimately bring the Irish down. After all, it is the Government bank guarantee which creates the vulnerability. The Irish Government needs to make some contingency planning because an Icelandic fate is not out of the question. It need not worry about a currency run, but a bank run is still possible.

There are two ways to skin a cat.

Sources
Ireland – what is going on? – UK Bubble
Why the British may decide to love the euro – Wolfgang Munchau, FT
The Irish solution: unlawful, beggar-thy-neighbour and short sighted, but apart from that OK – Willem Buiter, FT Mavercon
Iceland, Switzerland, Denmark, Sweden, Jordan and countries with banks that are too big to bail out – Bronte Capital
The first casualty of the crisis: Iceland – VoxEU
Stunned Icelanders Struggle After Economy’s Fall – NYTimes.com

Related posts:

• Ireland guarantees bank deposits at six banks
• Irish government unveils plan to recapitalise banks
• Ireland nationalizes Anglo Irish bank
• Trouble in Ireland as Fitch cuts debt two notches to AA- and deficits soar
• Ireland: Next stop – IMF

Barack Obama promises to make some dramatic changes in U.S. foreign policy after eight years of a neo-conservative agenda. The question really is what would those changes be. Below, David Ignatius outlines a reasonable argument that Obama will follow a cautious and step-wise approach (hat tip Chris).

We won’t see an immediate end to the embargo on Cuba or detente with Hugo Chavez in Venezuela or even an end to the War in Iraq. What we will see is his picking the right players first, his listening to their counsel and then proceeding cautiously on his change agenda. He will use his image abroad to advantage while moving in a steady and cautious manner.

This is a far cry from the Clinton Administration’s philosophy. If you recall, they came into office wanting to change everything and were rebuked by the voting public in the mid-term elections of 1994. Obama desperately wants to avoid this fate. Hence, those of you chomping at the bit for immediate changes to the course America is now on may find his path a bit slow.

In July 2007, when the possibility that Barack Obama might win the presidency was still just a gleam in the candidate’s eye, he met with former national security adviser Zbigniew Brzezinski to ask for some advice. But he wasn’t after the usual campaign position papers or sound bites. Obama was already thinking in bigger terms.

What can a new president accomplish in foreign policy in his first 12 months in office that he can’t achieve later? Obama wanted to know. How should a new president reorganize his national security team so that the structure fits the problems of the 21st century? Brzezinski came away deeply impressed, and he became an informal Obama adviser.

With Tuesday’s victory, Obama and his advisers get to think about these global questions full time. Conversations over the past few days with several members of the president-elect’s inner circle yielded some basic outlines of the new administration’s approach to foreign policy:

· Obama wants to pick his foreign policy roster first, and then turn to substance. “There was a tendency to try to do both personnel and policy simultaneously in the past, and it stumbled,” said one key adviser. Among the big questions are whether to ask Bob Gates to stay on as defense secretary or, if not, whether to appoint a prominent Republican, such as Sen. Richard Lugar or Sen. Chuck Hagel, as secretary of state. Either way, Obama wants a bipartisan team.

· As he builds his team, Obama wants to spend time listening to experts who can advise him on policies. The former law professor is being characteristically deliberative. He doesn’t want to make up his mind until he’s heard from all sides. That consensus-seeking style is likely to be a trademark of his administration.

· For national security adviser, Obama is likely to pick a pragmatist. “He wants to find out what works — what advances U.S. national interests. . . . If secret diplomacy is required to achieve your objectives, he would certainly accept that,” says Gregory B. Craig, a Washington lawyer who’s on the shortlist for a top position.

· During the transition, Obama won’t meddle in the Bush administration’s decisions — and he won’t allow other governments to end-run Bush. “He’s not going to do anything that gives the idea they don’t have to negotiate with this administration,” says the adviser. This insistence on “one president at a time” is especially important in the deadlocked negotiations with Iraq over a new status-of-forces agreement. Several Obama aides caution that the Iraqis shouldn’t drag their feet and hope for a better deal.

· Obama wants to make an early push on the Israeli-Palestinian peace process, despite political turmoil in Israel. He has learned from watching Presidents Clinton and Bush that you can’t wait until the eleventh hour to be an active mediator. Similarly, he wants to work quickly to build strategic relationships with Russia and China, and to reassure both countries that the United States doesn’t threaten them.

· On Iran, Obama wants to open the door to a process of engagement and dialogue, even though his advisers aren’t confident it will succeed. They think Iran may not yet have found the language of “yes,” but that’s no reason not to explore areas of possible common interest.

· On Iraq and Afghanistan, Obama will listen carefully to advice from Gen. David Petraeus, the Centcom commander, and other military leaders before making decisions. Petraeus will make his recommendations on Afghanistan in January, and the early indications are that he will recommend a strategy of “surge first, then negotiate” — that is, building up security in Afghan cities with additional U.S. troops before beginning talks with Taliban “reconcilables” about how to settle the conflict. That approach would fit well with Obama’s view on Afghanistan, one key adviser said.

· Finally, Obama’s advisers are thinking about how to use his youth, charisma and African American heritage to transform America’s ailing image abroad. Already, there are discussions about his travel schedule — and whether he should travel first to Asia before he goes to Europe for NATO’s 60th-anniversary celebration in April. “How do we take advantage of the momentum coming out of this victory?” asks one top aide.

“I think he’s going to change course, but that he will be cautious,” says Brzezinski. For now, those are the two channel markers for Obama foreign policy — change and caution. After the Bush years, both are likely to be welcome abroad.

Source
All Deliberate Speed – David Ignatius, Washington Post, A21

Related posts:

• The Obama Doctrine
• Hillary’s saber-rattling
• Hillary’s Hawkishness
• I probably can’t vote for McCain
• Is Obama really “Change we can believe in?”

While yesterday was a very positive day in U.S. markets, with the Dow up over 300 points, the real action has been in Asia. The Nikkei bottomed at a 26-year low below 7200 on October 27th. Today, it stands at 9114.60. That is a gain of almost 27% in 5 days.

Gains have been noted across the board in markets across the globe, particularly in Asia and Europe. What does all of this mean?

To my mind it speaks to how oversold markets had become in October as we have just witnessed the mother of all relief rallies. A week before this rally, on Oct. 20th I wrote a post “Bullish,” that claimed we had seen a market bottom for the time being and that stocks were likely to trade up over the near term, particularly in beaten down sectors.

But, by no means should we believe that we are about to embark on an historic bull market. Back in June, I looked at economic growth and market gains as a proxy for bull and bear markets. This is what I said:

I have developed a long-term yardstick of market overvaluation and undervaluation. I have no short-hand for it yet so I’ll call it what it is: 10-yr. rolling average S&P 500 annualized returns vs. annualized nominal GDP growth. Now, that’s a mouthful. Let me explain what it’s supposed to show.

Basically, the stock market is a reflection of the inherent earnings capacity of the economy. As the economy grows, so do market earnings. As a result, one would expect the returns in the stock market to reflect the growth in the economy — at least over the long term i.e., 10 years. Unfortunately, that’s not how it works.

In the real world, stock markets become severely overvalued or extremely depressed depending on whether its a bear or a bull market. The reason is P/E ratios. During bull markets, they rise. In bear markets, they fall. And, as a result, the stock market simply does not reflect the underlying growth in the economy and earnings capacity of business — even over the long term.

That’s where my graph comes in. If the economy and the stock market grew at the same rate, one would see a relatively mild fluctuation in the comparison between the 10-year average returns in the market and in nominal GDP. Now, look at this chart.

That’s not what this chart shows at all. Comparing the S&P 500 index of the leading U.S. companies to the economy shows violent swings. In the last bull market, the differential was over 10%! That’s enormously overvalued. In the 1970s it was a differential of over -10%. That’s a severe undervaluation. Today, we have moved back into line — annualized returns on the S&P since 1998 are about the same as nominal GDP growth over that span.

My point here is not to pooh-pooh the recent stock market gains but rather to sound a note of caution that the future here is unclear. The graph above indicates that the S&P 500 may be about at fair value right now. However, markets do tend to move in cycles from over- to undervaluation and back again. This would suggest that we may have a number of years during which the stock market underperforms in the U.S. before we hit bottom.

Personally, I believe that we have seen a major relief rally. But, I do not believe that the bear market in stocks is over. I anticipate the market going much lower on an inflation-adjusted basis — either through large absolute declines or higher inflation or both.

Therefore, while I am bullish on some stocks and some sectors, I realize this market could turn on a dime — there is much more bad news out there to come in this business cycle. I remain cautious and I believe you should as well.

Your comments on how you see things developing are appreciated.

Related posts:

• Chart of the day: S&P vs. nominal GDP
• Rosenberg: Market rally is just multiple expansion
• Kass: Bearish on equities
• Chart of the day: medium-term returns
• Chart of the day: Dow Jones vs. Treasuries