Posts Tagged ‘John Mauldin’
Monday, July 2nd, 2012
Bull’s Eye Investing (Almost) Ten Years Later
By John Mauldin
June 30, 2012
Bull’s Eye Investing (Almost) Ten Years Later
Reliving the Past Nine Years
Are We There Yet?
High P/E, Low Returns
Tuscany, Italian Football, and Two German Losses
It’s been almost a decade since I co-authored with Ed Easterling of Crestmont Research some research in this letter that later became chapters five and six of Bull’s Eye Investing. Although the ten-year anniversary of the book is actually 2013, the current vulnerabilities in the markets encouraged us to revisit the material a bit early, to prepare you for what lies ahead. Reflecting back to yesteryear gives us the opportunity to assess the accuracy of our insights.
I am in Tuscany at the moment, watching the sun set over the Tuscan hills; so I will thank Ed for doing the heavy lifting in this letter while I get to relax, although there is so much going on and I am such a junkie that I am forced to get my current-events fix every day. I must say, the news certainly provides some very pure adrenaline rushes. But more on that at the end. For now we take the longer view of the stock market that I first wrote about at the end of the last century, and to which Ed added some real meat in early 2003.
But first, I am pleased to be able to announce the release of the rest of the videos of the 2012 Strategic Investment Conference, co-sponsored by my partner, Altegris, which we held last month. David Rosenberg (and many attendees!) said this was the best conference ever, featuring a world-class lineup of economic and financial leaders. Our very enthusiastic attendees created a roomful of energy that the speakers seemed to feed off of, and everyone brought their “A” game. It really was quite special. And now we have the videos.
Those of you who are members of my special program for accredited investors, called the Mauldin Circle, can access the conference videos by going to the “My Information” section at the bottom of your personal home page, when you log into www.altegris.com. I can’t think of a better way to sharpen your investment outlook than to partake of the insights of some of the best minds in the world, including Dr. Lacy Hunt, Niall Ferguson, David Rosenberg, Jeffrey Gundlach, Mohamed El-Erian … not to mention your humble analyst.
In order to view the videos, you must be a member of the Mauldin Circle. This program has replaced our Accredited Investor Newsletter Program. My partner Altegris and I have worked hard to enhance the program, which now includes access to webinars, conferences, special events, videos, accredited newsletters, and presentations featuring alternative-investment managers and other thought leaders and influencers.
The good news is that this program is completely free. The only restriction is that, because of securities regulations, you have to register and be vetted by one of my trusted partners, which in the United States is Altegris, before you can be added to the subscriber roster. This will be a quite painless process (I promise). Once you register, an Altegris representative will call you to provide access to the videos, presentations, and summaries from the speakers featured at our 2012 Strategic Investment Conference.
Click here to initiate your membership in our exclusive Mauldin Experience Program. After you have talked with the Altegris representative, you’ll be able to view the first set of five videos, featuring Dr. Lacy Hunt, Jeffrey Gundlach, Niall Ferguson, David Rosenberg, and Mohamed El-Erian, as well as the final set featuring Dr. Brock, our two all-star panels (one with Marc Faber), and yours truly. I think you will find the presentations particularly relevant this week. And now, let’s think about secular bear markets.
Bull’s Eye Investing (Almost) Ten Years Later
By John Mauldin and Ed Easterling
Our discussion of a coming secular bear market almost ten years ago was not hypothetical forecasting, but rather it was a discussion about the fundamental factors that drive stock market returns. Even though it is challenging to predict the market over months and quarters or even a few years, we believe the data shows that the stock market is quite predictable over some longer periods. Those periods are the secular stock market cycles of above-average bulls and below-average bears.
In the opening paragraphs of chapter five, in bold emphasis, we wrote:
We will make the case that it is more useful to analyze stocks during secular bear markets in terms of value than in terms of price… These cycles generally take a generation to work their way through the investor public, have significant magnitudes of becoming undervalued and overvalued, and have significant implications for the way that investors should approach each of these periods.
We emphasized that:
Further, we show that volatility and frequent large rallies are the norm and not the exception, thus giving the astute investor some terrific opportunities. Finally, we will make a connection between inflation, interest rates, and stocks that will give us further indications of the direction of the stock and bond market in the coming decade.
If the cycles of the past century continue to repeat, most of the first decade (or more) of this century will experience a secular bear market – an extended period of generally down or sideways and choppy stock market conditions….
These periods in the past have been the result of market valuation cycles represented by the P/E ratio. The valuation cycles have resulted from generally longer-term trends in inflation toward or away from price stability. The short-term, somewhat random, market gyrations are the result of then-current circumstances and market forces wrestling stock prices around a gravity line of the broader cyclical trend.
What did P/E do over the past decade and where is it today? What does it tell us about the future? What new insights can we glean by adding nine years of history to some of the charts and graphs in the original chapters? In addition to chart updates, there are quite a few new charts here from Crestmont Research. Well, there is a lot to review as we look back over the past decade, with an eye on the next decade.
Reliving the Past Nine Years
For a good overview of the past nine years and this secular bear market, here’s an update to Table 5.6 in Bull’s Eye Investing. When we wrote the chapters in 2003, the charts and graphs were current through year-end 2002. At the time, P/E was a lofty 26 –though it had come down significantly from bubble levels in the 40s. To reduce the distortions to P/E caused by the earnings cycle, earnings (E) were normalized using the approach popularized by Robert Shiller at Yale (which uses earnings over a ten-year period). The resulting P/E is often called the cyclically adjusted P/E, or P/E 10.
There are several points to emphasize in the chart above. This secular bear (so far!) has been relatively calm compared to historical secular bears. The typical bear has more negative years than positive years (only 42% positive), yet this cycle so far has had more positive years (58% positive). The gain and loss years have been more muted, with gains and losses averaging around two-thirds of normal levels.
Certainly this secular bear has not been calm as we have experienced it in real time, but the relative calmness compared to past cycles may be an indicator of what lies ahead before the bear retires.
Some investors certainly do think the current secular bear has been extreme. Here’s what it has brought us so far:
The pattern and process have not been very different from what we expected in 2003. As we wrote in Bull’s Eye Investing, “… volatility and frequent large rallies are the norm and not the exception” in secular bear markets. Here’s the previous secular bear (1966-1981) as an example. Yes, the 54% decline by 2009 was greater than the 45% in 1974, but the pattern of numerous short-term surges and falls had again repeated.
There is another approach to assessing volatility that was included in Bull’s Eye Investing. Table 5.1 revealed that the stock market is much more volatile than most people realize. Rather than use confusing and boring statistics, we took more of a layman’s approach. We highlighted that the market moves up or down more than 10% annually in almost 70% of the years. It moves more than 16% in either direction in half of all years. So what has happened so far in the present cycle?
Crestmont has updated that volatility analysis through 2011, and it now reveals new insights by breaking out separate details for bulls and bears. It is striking that overall volatility is relatively similar for secular bulls and bears. Note the frequency inside the 10% and 16% ranges. In both secular bulls and bears, nearly 30% and 50% of the years fall inside the respective ranges. The difference is that bulls predominantly have upside years, while bears have more downside years.
The results so far for this secular bear have been a bit different. First, there have been more inside years – another indication that the first part of this secular bear has been a bit tamer than usual. Second, notwithstanding the crisis plunge into 2009, the downside years have been under-represented. Why?
So far, this secular bear has not made much progress through the fundamental process that a secular bear must undergo. As we highlighted in Bull’s Eye Investing, “The valuation cycles have resulted from generally longer-term trends in inflation toward or away from price stability.” Other than an occasional flirt with deflation or inflation over the past decade, we’re stayed relatively close to price stability. There are certainly lots of pressures building for deflation and inflation, either of which would drive this secular bear to its den. But for now, the choppiness has us in a bit of a holding pattern. The stock market’s gyrations and underlying earnings growth over the past nine years have driven P/E from the mid-twenties to the low twenties, but the market has yet to experience the full process of valuation declines in the face of an adverse inflation rate trending into deflation or high inflation.
Are We There Yet?
Here are two new charts from Crestmont Research that explain how we got here and just how much farther we have to go. The charts reflect the normalized P/E ratio for the S&P 500 Index for all secular bull and secular bear cycles since 1900. The lines on the charts show the price/earnings ratio (P/E) over the life of each secular cycle.
First, note that secular bulls start when P/E is low and end when P/E is high. Similarly, secular bears start when P/E is high and end when P/E is low. In the charts, the low range is designated with green shading and the typical high range is shaded red.
Look at the secular bull of the 1980s and 1990s. It is as though that secular bull ran its course through the mid-1990s, then P/E more than doubled again. The already high P/E ascended to the bubblesphere.
Compare the two graphs. Every secular bear cycle prior to our current one followed a secular bull that ended with P/E in or near the red zone. That set the starting point for every subsequent secular bear. But this time, the super secular bull of the late 1990s ended nearly twice as high – it was a major bubble. The past twelve years saw the bubble popped and P/E restored to levels typically associated with a low inflation rate. It has taken more than a decade to wear away the effects of the late 1990s extremes.
The current valuation of the stock market is relatively high, but it is not overvalued, considering today’s conditions. Low inflation-rate conditions should be accompanied by relatively high P/Es. But if deflation or high inflation (or both) are likely upcoming, the market is very expensive. On the other hand, if the inflation rate happens to remain near price stability, then this secular bear could remain active a while longer – but how likely is that?
High P/E, Low Returns
In Bull’s Eye Investing we explained that high market valuations (P/E) necessarily drive low long-term returns. This occurs because periods that start with high P/Es often end with lower P/Es, eating away at returns. Further, high-P/E periods have low dividend yields. As a result, we could write with confidence nine years ago that subsequent returns would be well below average.
In all cases, throughout the years, the level of returns correlates very highly to the trend in the market’s P/E ratio. The P/E ratio is the measure of valuation as reflected by the relationship between the prices paid per share to the earnings per share (EPS). Higher returns are associated with periods during which the P/E ratio increased and lower or negative returns resulted from periods during which the P/E ratio declined.
This may be the single most important investment insight you will get from this book. When P/E ratios are rising, the saying that a “rising tide lifts all boats” has been historically true. When P/Es are dropping, stock market investing is tricky; index investing is an experiment in futility. As we will see in later chapters, in these secular bear market periods, successful stock market investing requires a far different (and sometimes opposite) set of skills and techniques than what is required in bull markets….
Given the current and recent level of P/Es, the prospects are not encouraging for general market gains (the emphasis is on general or index funds) over the next two decades. This dismal outlook is not from some congenital bear perspective; it corresponds to the series of factors driving the current secular bear market.
Although P/E has declined over the past nine years, from 26 to near 20 (using the Shiller method), stock market valuation remains relatively high. Almost everything in chapters five and six of Bull’s Eye Investing remains true today. The market has chopped around with fairly typical volatility. P/E is in the lower end of the red zone rather than above it. Most importantly, currently high valuations portend low returns from here.
How low? That depends upon the outlook for deflation or higher inflation.
Our crystal balls are showing us different things on that question, although our fundamental conclusions are the same. Ed sees moderate probabilities for either higher inflation or deflation. On his optimistic side, he even allows for the prospect of continued price stability for quite some time. John, however, sees flashing danger signs of upcoming deflationary pulses, to be followed later by higher inflation. He outlined his reasoning in Endgame.
So, together, we have several scenarios. We have some side bets as to who will be right; but more importantly for you, none of the outcomes deliver good overall equity market returns, because we are still at a relatively high P/E.
Next week we will return to a few more paragraphs from Bull’s Eye Investing, and then we will explore the implications of the entire analysis.
By the way, Ed has written a must-read book on the likely outcomes of the stock market over this decade. It enables the reader to see the impacts of key factors on their outlook. Probable Outcomes is packed with details and extensive full-color charts and graphs. Here’s a link to it at Amazon: www.amazon.com/Probable Outcomes.
And John has condensed Bull’s Eye Investing to a version for Wiley called The Little Book of Bull’s Eye Investing, in which he focuses on the basics of secular cycles and absolute-return investing. The book is just out, and you can get it at your local bookstore or at www.amazon.com/Little Book of Bull’s Eye Investing.
(For the record, Ed is the author of Probable Outcomes: Secular Stock Market Insights and the award-winning Unexpected Returns: Understanding Secular Stock Market Cycles. He is President of Crestmont Research, an investment management and research firm, and a Senior Fellow with the Alternative Investment Center at SMU’s Cox School of Business, where he previously served on the adjunct faculty and taught the course on alternative investments and hedge funds for MBA students. He publishes provocative research and graphical analyses on the financial markets at www.CrestmontResearch.com, one of my favorite websites.)
Tuscany, Italian Football, and Two German Losses
I am in Tuscany tonight, in a little town called Trequanda, staying in the same villa as on previous trips. It is an idyllic location, with each trip providing ever more delights upon which to feast my eyes and soul. This is the third year I have come back to Tuscany and the first time since I was a kid that I have been to the same spot even twice on vacations. This is truly a special place.
This year I have a number of friends coming to stay for a time, helping to create an ever-growing and always interesting collage of ideas and anecdotes. The conversations have been inspirational and thought-provoking. And perhaps it helps that the news has been so, well, entertaining and such food for discussion. More on the guests and our conversations next week, but for now I will close with couple of notes.
On Sunday night we wandered over to the next little village of some 400 souls, called Montisi. We had dinner in the town square, where we watched, with half the town, Italy play England in the Eurocup soccer quarterfinals. I watched the growing tension as the two teams played to a tie and then went into two overtime periods, which ended with the score still even.
This necessitated a “shoot-out,” which is a man-on-man match between one player trying to get the ball past the goalie. He is close enough that it requires both players to commit to a strategy before the action – at this high level of soccer there is no time to change once you commit. It is a total mind game, and one that requires skill and experience.
There were five alternating attempts, with the crowd cheering and groaning with each shift of the momentum tide. And then all of a sudden, with a block here and a miss there (including a marvelous soft “dink” shot by an Italian, totally catching the English goalie by surprise), Italy had drawn ahead. The level of emotion was profoundly moving to me. As an American, I can only relate it to the US-Russian Olympic hockey game in 1980, when a young, overmatched US team took down the Russian juggernaut.
And then Thursday night we watched Italy take on Germany in the semifinals. Germany was a 2-1 favorite, although one of my dinner guests offered 4-1 odds, which found a few takers. Given that I know so little about soccer and that betting against a 2-1 favorite on a one-time bet seemed a tad rash, I demurred but offered to hold the wagers.
I should have taken the plunge. Somehow, Italy stepped up and simply outplayed the Germans. And amusingly, as I was watching the game in Europe, the US markets were still trading; and this morning David Zervos sent me this note: “… as I was watching Italy vs Germany yesterday something very odd happened just as Balotelli scored his second goal. At that moment, when it became clear that the Germans were going to lose, the [S&P 500] shot up from 1308 to 1323. It then occurred to me, when Germany loses, spoos [the trader term for the S&P 500 index] win!”
And then Germany seemingly lost again today, as Italian Prime Minister Monti (and Spanish PM Rajoy) simply refused to allow any resolution at all to pass at the summit until Merkel agreed that the eurozone must jointly back Spanish banks without Spain having to guarantee the debt. And while there must have been relief in Madrid, there was also joy in Dublin, as the Irish are now in line for a similar deal, which will cost at least €64 billion. Of course, with Germany’s agreement, every taxpayer in Europe is now on the hook, and not just in Germany. But it was a necessary condition if a fiscal union is to be formed and the eurozone is somehow to be salvaged.
Perhaps Monti took courage from his football team, but he certainly got Merkel to back down. By my count, that is Merkel at 0-2 in recent contests. Interestingly, I was in Madrid on Saturday with good friend Alberto Dubois, who invited about ten of his friends to join us. Quite the group of very serious Spanish businesspeople in the room, mostly C-level and chairman types. After the usual questions and conversation about my views on the world, I turned the tables and started interviewing them.
I may write some more about what happened, but two items leapt out. They unanimously and emphatically agreed that Spain would do whatever it takes to remain in the eurozone. A breakup of the eurozone was simply not something they could contemplate. “It would be a total disaster for Spain,” said one, and everyone nodded.
“But what if Germany decided to leave on their own, as the price of staying was going to be too high?” I asked. Again, they were adamant that Germany would not leave and a fiscal union would be worked out. Perhaps this was a self-selected group of friends, but I was struck by the passion with which they argued that the euro would survive. They simply could not imagine a breakup.
I was not convinced they were right, but I left with a few things to ponder. And then today, Merkel backed down. And the markets leaped for joy on the news, even though the very thorny details have to be worked out. Germany loses, the market rises. How long can this trend last?
It is time to hit the send button. It is now quite late and as I wrap up I still feel the glow of six hours of fascinating conversation that postponed the completion of this missive. Oddly, I find I have been able to resist the powerful pull of the marvelous Italian wines that have been set on tables here and there this week, but the real temptation was cheap Italian Prosecco during the day. Go figure.
Have a great week. On Monday we will take in the famous Palio horse race in the square in Siena, along with some 250,000 people crowded into a very small place. Quite the tradition, going back to the mid-1600s. Fortunately, we have a balcony or two from which to watch. But enough. Have a great week! I certainly will.
Your wondering why I am not here for at least a month analyst,
Tags: Accredited Investors, Adrenaline Rushes, Attendees, Crestmont Research, Current Events, David Rosenberg, Ed Easterling, Financial Leaders, Heavy Lifting, Investment Conference, Italian Football, John Mauldin, Junkie, Losses, Nine Years, Stock Market, Tuscan Hills, Tuscany, Vulnerabilities, Yesteryear
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Tuesday, February 21st, 2012
Ben Graham’s Curse on Gold
by John Mauldin
February 20, 2012
This week we have a shorter Outside the Box, from my friend David Galland at Casey Research, with an interesting insight into why gold can be considered as a poor investment by some rather influential investors (like Warren Buffett) while others may see it as the core of a diversified portfolio. As usual when I use someone’s material for an OTB, I include a link at the end, if you want to look deeper. The rather large team at Casey Research specializes in gold, natural resources, and energy-related investments, for those with such an investing bent.
As a quick note, the feedback on this weekend’s letter on taxes has been substantial, and a great deal of it is quite good and worth thinking about. Many bring up real problems with the position I took in my letter, and I may surprise you by agreeing with some of them. My intention right now (barring something happening between now and Friday night) is to take some of the better statements and questions, and answer them. I am not married to any specific plan. I just want to solve the problem and am open to anything that is politically feasible and makes sense, as long as we solve the basic problem of the deficit. I think it will make for a very interesting letter. I do read your feedback, by the way. So if you wanted to respond and wondered if I might actually read it, the answer is yes I do, and this week will answer as many as I can.
And to answer a question I get a lot, I buy a little physical gold every month. I don’t even look at the price. The check is written the same day each month, for the same amount. I take delivery. I hope the price of gold goes down so I can get more gold per dollar. I also hope it ends up being worthless, as that will mean everything else has worked out just fine. But my gold is there just in case my crazy gold bug friends are right and we can’t actually trust the government to find a reasonable solution to our dilemma. And maybe because deep down I really don’t trust the (insert your favorite expletive). Just a little insurance, you understand.
So, until we connect this weekend, have a great week!
Your I am not a gold bug analyst,
John Mauldin, Editor
Outside the Box
Ben Graham’s Curse on Gold
By David Galland, Casey Research
It seems that the mainstream investment community only takes a break from ignoring gold to berate it: one of gold’s most outspoken critics, uber-investor Warren Buffett, did so recently in his latest shareholder letter. The indictments were familiar; gold is an inanimate object “incapable of producing anything,” so any investor holding it instead of stocks is acting out of irrational fear.
How can it be that Buffett, perhaps the most successful (and definitely the most well-known) investor of our time, believes that gold has no place in an intelligently allocated investment portfolio?
Perhaps it has something to do with his mentor, Benjamin Graham.
Graham, author of Security Analysis (1934) and The Intelligent Investor (1949), is correctly respected as one of history’s most knowledgeable investors. Over a career spanning 1915 to 1956, he refined his investment theories, in time becoming known as the father of value investing. Much of modern portfolio theory is based upon Graham’s work.
According to Graham, while no one can tell the future, there are periods when the valuations of stocks and bonds would deviate from fair value by becoming excessively over- or undervalued. To enhance returns and reduce risk, investors should alter their portfolio allocations accordingly. A quick look at a long-term chart supports Graham’s theory clearly shows periods when one asset class offered a better value than the other:
But what of the periods when both stocks and bonds stagnated or fell together? For much of the 1970s and again from 2001 through today, any portfolio allocated solely between stocks and bonds would have at best treaded water and at worst drowned in a sea of stagflation. To earn any real return, an investor would have needed to seek alternatives.
It’s clear from this next chart that gold was exactly that alternative, a powerful counter-trend investment for periods when both stocks and bonds were overvalued. Yet gold is conspicuously absent from Graham’s allocation model.
But this missing asset class is entirely understandable: for most of Graham’s adult life and the most important years of his career, ownership of more than a small amount of gold was outlawed. Banned for private ownership by FDR in 1933, it wasn’t re-legalized until late 1974. Graham passed away in 1976; he thus never lived through a period in which gold was unmistakably a better investment than either stocks or bonds.
All of which makes us wonder: if Graham had lived to witness the two great bull markets in precious metals during the last 40 years, would he have updated his allocation models to include gold?
We can never know.
We can know, however, that given Graham’s outsized influence on investment theory, there is little question that his lack of experience with gold, and therefore its absence from his observations, has had a profound effect on how most investment professionals view the yellow metal. This, in our opinion, goes a long way toward explaining the persistently low esteem in which gold is held by the mainstream investment community. And, as a consequence, its widespread failure to even be considered as an asset class.
A couple of takeaways: first, perhaps now you can stop wondering why your broker, the talking heads in the financial media, and Warren Buffett continue to misunderstand gold as a portfolio holding. More importantly, however, is that in order to have sustained, long-term investment success, one must accept that an intelligent portfolio allocation needs to include not two but three broad categories of investment – stocks, bonds and gold, with the amounts allocated to each guided by relative valuation.
[JFM here: I would suggest additional broad categories of investments depending on your personal situation. Alternative investments like commodity trading funds. Low leveraged income oriented real estate consistent with your ability to handle the ups and down of the rental/leasing market and shorter term carry costs. I for one am not psychology capable of dealing with renters, of whom I am one. I want service and you to pay for major maintenance, and the ability to move at the end of my lease. My choice, not dependent upon your cash needs. But I know of plenty of people who can do that and have amassed considerable portfolios over time. Perhaps your own small business that has the potential to grow. Investments outside of your country of residence. Etc.]
Investors who understand this tenet have an almost unfair advantage over other investors as it allows them to get positioned in gold ahead of the crowd and enjoy the bulk of the ride, while others sit on their hands.
So when you hear commentators ridiculing gold as a barbarous relic, lamenting that they cannot eat it or smugly asserting that it produces nothing, rest contently in knowing that they’re operating with a severe handicap in their own portfolio. Meanwhile, we’ll prosper, armed with the understanding that gold fulfills a very important and specific purpose in a portfolio, namely as real money that protects net worth during periods marked by excessive government debt and currency debasement such as we are currently experiencing.
Given the powerful influence of Ben Graham and his disciples, his curse on gold will not go quietly into the night. But it should.
David Galland is managing director of Casey Research, which provides independent investment analysis on a subscription basis to a global network of over 180,000 self-directed investors and money managers. Recognizing the emerging bull market in gold early on, in the late 1990s, Casey Research formed a metals and mining division that has grown into a leading provider of actionable gold and resource intelligence. For investors looking to become familiar with the asset category, Casey Research offers a monthly newsletter, BIG GOLD (try it risk-free for 90 days), focusing on undervalued opportunities in mid- to large-cap producers, as well as best practices in buying, holding and selling precious metals. Learn now why it’s more important than ever to invest in gold and gold-related equities.
Tags: Casey, Curse, Dil, Diversified Portfolio, Friday Night, Friend David, Galland, Gold Bug, Gold Dollar, Insight, Intention, Investments, John Mauldin, Natural Resources, Otb, physical gold, Poor Investment, Price Of Gold, Reasonable Solution, Warren Buffett
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Lacy Hunt: Face The Music, Road Back To Prosperity Is Through Shared Sacrifice, Not Government Stimulus
Friday, February 17th, 2012
John Mauldin posted an extraordinary interview by Kate Welling of Dr. Lacy Hunt, the chief economist of Hoisington Investment Management.
Dr. Lacy Hunt correctly identifies fractional reserve lending as the culprit behind the massive rise in debt. Hunt also explains why government spending cannot help, why Europe is in worse shape than the US, why a US recession is coming, and why Ben Bernanke is an exceptionally poor student of the great depression.
The entire PDF is a lengthy 29 pages, but well worth a read in entirety.
Here are some pertinent snips from “Face the Music“.
Face The Music
Road Back To Prosperity Is Through Shared Sacrifice, Says Lacy Hunt.
Kate: Happy New Year, Lacy. And thanks for sending all those charts to background me for our conversation. I have to say the first one stopped me — showing debt as a percentage of U.S.
Lacy: If you confine your analysis to post-war period, you only have one major debt-dominated cycle and that’s the one we’re currently in — and have been in for a number of years. But if you go back far enough, you have three more. You have the 1820s and 1830s. You have 1860s and 1870s and then you have 1920s and their aftermath. Sometimes it’s essential to take your analysis back as far as you possibly can.
Kate: Doesn’t your second chart, on the velocity of money [below], show how none other than Milton Friedman was misled into thinking that it was a constant because he only looked at post-war data?
Lacy: That’s correct and, in fact, I was misled along with him because I was also doing analysis based on the post-war data. Friedman’s period of estimation was basically from the 1950s to the 1980s. Well, if you look at the velocity of money in that time period, it’s not a constant, but it’s very stable around 1.675. So if you tracked money supply growth then, you were going to be able to get to GDP growth very well. Not on an individual quarterly basis, but even the individual quarterly variations were not that great. Until velocity broke out of that range after we deregulated the banking system. Now, velocity is breaking below the long-term average and it’s behaving exactly like Irving Fisher said, not like Friedman said, absolutely.
Kate: What a perfect example of the difference your frame of reference can make.
Lacy: Keynes and Friedman both felt that The Great Depression was due to an insufficiency of aggregate demand and so the way you contained a Great Depression was by your response to the insufficiency of aggregate demand. For Keynes, that was by having the federal government borrow more money and spend it when the private sector wouldn’t. And for Friedman, that was for the Federal Reserve to do more to stimulate the money supply so that the private sector would lend more money. Fisher, on the other hand, is saying something entirely different. He’s saying that the insufficiency of aggregate demand is a symptom of excessive indebtedness and what you have to do to contain a major debt depression event — such as the aftermath of 1873, the aftermath of 1929, the aftermath of 2008 — is you have to prevent it ahead of time. You have to prevent the buildup of debt.
Kate: And that your goose is cooked if you don’t you cut off the credit bubble before it overwhelms the economy?
Lacy: Yes, and Bernanke is thinking that the solution is in the response to the insufficiency of aggregate demand. That was Friedman’s thought. That was Keynes’ thought and most of the economics profession has traditionally thought the same way. They were looking at it through the wrong lens. Fisher advocated 100% money because he wanted the lending and depository functions of the banks separated so we couldn’t have another event like the 1920s.
Kate: You’re saying that Fisher argued against fractional reserve banking?
Tags: 1820s, 1920s, Ben Bernanke, Chief Economist, Culprit, Face The Music, GDP Growth, government spending, Great Depression, Happy New Year, Indi, Investment Management, John Mauldin, Massive Rise, Milton Friedman, Money Supply Growth, Music Road, Recession, Snips, Stimulus, Velocity Of Money, War Period
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Saturday, January 14th, 2012
The End of Europe?
by John Mauldin, Thoughts from the Frontline
Solving the Mayan Code
To Solve the Crisis You Must Solve Three Problems
Getting Simple About Europe
How Much Risk Do You Want in a Government Bond?
Do You Have a Spare €1.5 Trillion?
Singapore, Cape Town, and Thoughts on Hong Kong
One of the interesting things about being in Hong Kong is that I get to see the weekend edition of the Financial Times12 hours early. And the headlines were not all that pleasant. As I promised last week, we will cast our eyes to Europe and ponder what is in store for Europe for the year and the next five years. And what do we read on page 2? The “ECB raps revisions to draft a fiscal pact.” Seems they feel there are too many loopholes, which will make the document meaningless … somewhat like the treaty they have now. And we further learn that “Greek default threat grows as talks falter.” Seems there is a lack of agreement on how much of a haircut the investors ought to take, and the Greeks don’t want to guarantee any future debt, just in case they need to default some more in the future. But they do want the €15 billion they need to keep the debt machine running for a few more months.
And on page 1, in big type, we are surprised (but not very) by the headline, “France and Austria face debt blow.” Seems those sharp-eyed accountants over at S&P have decided to downgrade French debt from AAA. Which of course leads to another headline on page 2, suggesting “Firepower of bail-out fund cast into doubt.” The currency markets were shocked – shocked I tell you –that S&P would do such a thing and promptly took back the euro rally and cast the euro down to recent cycle lows. Who knew, other than the entire free world not watching reality TV, that S&P was planning to do such a thing? And we read elsewhere that the European Commission is dismayed that S&P would do something so clearly not right, at least according to the way they keep their own books.
Even here in amazing Hong Kong, with the growth of China driving a wave of prosperity, eyes are fixed on Europe. How will they deal with the crisis? We read that US exports to Europe were down 7% last quarter, and Europe has not yet really entered into recession, which is almost guaranteed this year. And if US exports are down, then so are Asian and Latin American exports. Global growth appears to be threatened.
Solving the Mayan Code
There are so many pieces of data to go through in order to augur Europe’s future –I want readers to know I have left no stone unturned! In fact, I went to some very old stones to get help with this week’s letter. I began to scrutinize the Mayan Code from ancient Central America, which so many feel predicts the end of the world on December 21 of this year, bringing my fresh eyes to an old mystery.
After much deliberation, I have come to this astounding insight: The Mayan academics who created the code were not in fact astronomers or even astrologers. No, it is clear they were another breed of even more dubious forecasters, called economists. Once you approach the glyphs with that understanding, it becomes clear they are not predicting the end of the world, merely the end of Europe. One symbol clearly shows the Greek flag dipping to the ground. Another depicts the Italian flag with its wheels coming off. Oh, and you don’t even want to know what they have prognosticated for the French. This is a family e-letter and I can’t squeeze such language past the censors. But now that I have provided the basic insight, I leave it to you, fellow scholars, to decipher the rest of code.
And we will spend our time together here this week trying to discern what it means, in fact, for Europe to come to the place in its journey where it must make extremely difficult and often painful choices. As I wrote last week, as I started this voyage of discovery with you, the choices the various countries in the developed world are now making will put us on a path that does not allow us to turn back without severe consequences. (If you missed last week’s letter, here it is.) We are left with debt that must be dealt with, with imbalances that must be balanced, and with deficits that must be brought under control. No matter what we choose, there will be pain for all of us. You cannot make debt go away without paying it back or defaulting, one way or the other, which means someone loses. And as we will see, paying it back can be very difficult, indeed, once it has grown this large.
To Solve the Crisis You Must Solve Three Problems
There are three main problems in Europe. The first is that most of the banks are massively insolvent, because they have 30 times their capital invested in the second problem, which is the sovereign debt of countries that are going to have trouble paying that debt. If the banks have to mark down the debt to what its real value is – or to what it will soon be – they will be bankrupt on a scale that makes 2008 look like a waltz in the park.
Countries simply cannot function in a manner that can be called normal without viable banking systems, which is why the authorities spend so much time worrying about them. If banks can’t make loans, then businesses must cut back, which means fewer jobs, products, and services, which quickly becomes an ugly spiral. Losses in the private sector mount up. This obliges the treasury secretary to get on one knee and beg some elected official who has no understanding of how business and economics work to save the world as he knows it.
But if countries must step in and save their banks, then they have to assume some of the losses. (I am assuming that this time shareholders get completely wiped out, as do most bondholders. Taxpayers – read voters –are actually paying attention this time. They are in no mood to bail out bankers.) But most of the countries in Europe with the worst banks simply do not have the money to invest. They already have too much debt. Where do they get the capital? (More on that later.)
For most of the past two years, European leaders have tried to deal with the problems as though they were short-term liquidity problems: “If we just find the money to buy some more Greek bonds, then Greece can figure out how to solve its problems and then pay us back. Given enough time, the problem can get solved.”
They have now arrived at the understanding that it this not a short-term problem. Rather, it’s a solvency problem of the various governments, which of course creates a solvency problem for their banks. They are now addressing the problem of solvency and providing capital until such time as certain countries can get their budgets under control and the bond market sees fit to provide the capital they need.
But they are completely ignoring the third and largest problem, and that is massive trade imbalances. Germany exports products to the peripheral European countries, which run trade deficits. As I have shown in several letters, a country cannot reduce private-sector leverage, reduce public-sector leverage and deficits (balance its budget), and run a trade deficit all at the same time. That is simple, unavoidable math, based on 400 years of accounting understanding. Ultimately, there must be a trade surplus if leverage and debt are to be reduced.
Greece runs a trade deficit of about 10% of GDP. Until they can stop that bleeding, they cannot get their government and private budgets under control. It is not simply a matter of cutting budgets or raising taxes. Indeed, their economy will continue to shrink, making it more difficult buy foreign goods without increasing their own production of goods and services. It is a vicious spiral. And that same spiral will spin up to take in all of Europe. Again, more on that later, as we consider what their choices are.
But for now, let’s start with my contention that if you do not solve all three problems you do not solve the real problem. Greece cannot “stand on its own” without a change in its cost of production relative to Northern Europe. Neither can Portugal, et al., unless Germany either changes how it exports and consumes more, or Germany is willing to fund Greek (and Portuguese and Italian and…) debt, so those countries can continue to run large deficits.
Let’s resort to something I have done in the past, and that is to create a simple model to help us understand the issues involved. As always, when we make simple assumptions we are ignoring the real complexities. I know things are vastly more complicated than the following simple analogies, but the underlying truths are basically the same.
Getting Simple About Europe
Let’s assume a country that has a gross domestic product (GDP) of $1,000. In the beginning it taxes its citizens about 25% of GDP and spends the money for the public’s benefit. But alas, it spends about 30% of GDP, so it must borrow the overage (about $50) from its citizens or from the citizens of other countries. Because the country starts out with relatively little debt, interest rates on this loan are low, because those who buy the debt can easily see that the the country can pay them back. If the debt of the country is only 5% of GDP ($50) and the interest rate is 4%, then the amount that must be paid as interest is only about $2 per year. Not a whole lot, about 0.2% of GDP.
But this goes on year after year. Sometimes the deficits get smaller and sometimes they get larger, depending on the economy; but government expenditures grow at the same rate as the country grows, and the debt keeps growing at an average of 5% of GDP per year. Now, if the country is growing at 3% a year, after 24 years the economy will have doubled to $2,000 GDP. That means the debt has grown (roughly) to a total of $1,800, which is now a debt-to-GDP ratio of 90%. Debt has grown faster than the country’s economy. Note that if the country had held its budget down to where it grew slower than GDP, thus reducing its need for debt, that ratio would be lower, even if the debt had grown. You can indeed grow your way out of a debt problem if the growth of government spending is less than the growth of the economy.
But what if the size of government grows to about 50% of GDP, rather than 25% or 30%, over the 24 years, as politicians decide to spend more money and voters decide they want more benefits? (Think France.) Then the private sector must pay about 50% of its production to the state – plus, the debt is now growing unwieldly. The private sector has less to invest in new businesses and tools, and the growth of the economy slows.
And then along comes a very nasty recession. The revenues of the government fall as the economy shrinks. If the economy shrinks by 3% and total taxes are 50%, then tax revenue falls to $970. But the government does not cut back; and indeed, because it must pay unemployment benefits and welfare (because unemployment rises in a recession), its expenses actually rise by 5%! So it now needs $1,050 to pay all its budgeted expenses. And it must now borrow $80 to pay everyone it has promised to pay, in addition to the $100 it was already borrowing every year to cover its deficit, or a total of $180 a year, which is 9% of GDP.
(Yes, I know that debt must change as a percentage over time and nothing is stagnant, but work with me here.)
Now debt-to-GDP is rising by about 5% a year. Not a large number in the grand scheme of things, and everyone knows that the recession will soon be over and the deficits will come down. Sovereign governments never default on their debts– our government leaders assure us of that. They can always raise taxes or cut spending, can’t they?
And things rock along just fine, and the bond market continues to buy the debt, until one day you look up and the debt is 120% of GDP. Then the bond market gets nervous and says that instead of 4% it wants 7%. Now the interest payments are over 8% of GDP and 16% of government spending, which means the government must either cut back on services or salaries or benefits, or raise taxes, or borrow more money. But cutting spending and raising taxes have consequences. They reduce GDP growth over the following 4-5 quarters as the economy adjusts.
What if that interest rate cost rose to 10%? Then the interest cost to the government would become 20% of its expenses and be rising faster than the country could grow, even in the best of times. And if they continued to borrow at 7% and the country did not grow, those interest expenses would rise at least 7% a year – as long as interest rates didn’t go up.
And what if the other countries who had been buying the government’s debt looked at the basic math and realized that, another step or two down the current path of government spending, there was no way they would be able to get their money back?
How Much Risk Do You Want in a Government Bond?
Now, government bond investors are a curious breed. They invest in government bonds because they actually think there is not supposed to be any risk. They want their money to be safe. If they wanted risk, there are lots of opportunities to invest with the potential for more reward.
The moment that government bond investors begin to think they might be at risk, they leave. And history suggests they tend to leave seemingly all at once. It is the Bang! moment. Someone fires the starting gun, and they all head for the exits. They start selling their bonds to speculators at discounts, which makes the effective interest rates in the market rise, sometimes by a lot. That means that if a country wants to borrow more money, it will have to pay the effective price in the market, or maybe as much as 15-20% IF – a big IF – it can even get someone to buy the bonds, which of course makes it even more difficult to pay their debt as interest costs rise.
Now, let’s add a twist. The other countries that have bought those bonds are not actually countries, but banks in other countries. And because the regulators of those banks knew it was impossible – inconceivable – that a sovereign country might default, they allowed their banks to buy 30 times as much sovereign debt as they had capital in their banks. They did not have to reserve against any losses, so these were “free” profits for the banks. You pay 2% on deposits or short term commercial paper and buy bonds paying at 4%. You make a 2% spread, which you then do 30 times. Now you are making 60% profits on your capital and deposits. It is a verynice business – as long as everyone pays the interest. And because it is such a good business, you just roll over the debt every time the bond comes due, because you want more easy profits.
Let’s say that banks bought up to 10% of their total government sovereign-debt holdings in our problem country. If the country gets into trouble and says, we will only pay 50% of our debt (we will discuss why below), then that means the banks lose 5% of their total assets. But they only have about 3% capital, because they were allowed to leverage. That means they are functionally bankrupt.
Without a functioning banking system, other countries now have to step in and take the losses (and perhaps wipe out the shareholders and owners of their banks). That would be bad for the other countries, as that much spare cash is not just lying around in government coffers. They are ALL borrowing money already and have their own deficits to worry about.
So everyone gets together and they tell the bankrupt country (because that is what it really is), we will lend you more money to keep you alive, but you must agree to balance your budget. And since that is the only way the problem country can get more money, they initially say, “Sure. We can do that. Just give us some money now so we can get it figured out and get everything under control.”
In the world of government, living within your means is called austerity. And it’s an uphill slog. Let’s say your deficit started out at 15% of GDP (somewhat like Greece’s). If you agree to cut that deficit by 4% a year for four years running, if everything stays the same, you could be back in balance. But the other counties would have to agree to lend you the difference between what you budgeted to spend and what you took in as tax revenues. Just to keep things going. Otherwise you’d have to default on your debt. If the countries simply have to guarantee the loans and not actually spend the money, it is a lot easier than having to find real money to save their banks, so they agree.
But the cuts you have to make are not as easy as everyone hoped. It seems that employees don’t like having their pay cut, and unions don’t want pensions cut, and retirees certainly expect the government to fulfill its promises; and don’t even get started on cutting healthcare, which is a God-given right.
So you raise taxes and cut spending by about 4% the first year. But a funny thing happens. That reduces the private economy by about 4%, so the base on which taxes are collected is reduced, which means less revenue is raised, which means that the deficit is much worse than projected. And then the following year you have to make another 4% in cuts, plus the last shortfall, just to make your plan and get to the agreed-upon deficit, in order to get more loan money. It becomes a very vicious circle.
Tags: Accountants, Cape Town, Currency Markets, ECB, European Commission, Firepower, Frontline, Government Bond, Greeks, Haircut, Interesting Things, John Mauldin, Loopholes, Lows, Next Five Years, Own Books, Pact, Reality Tv, Revisions, Trillion
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Tuesday, January 10th, 2012
John Mauldin’s Outside the Box report this morning highlights Gary Shilling’s take on 2012. Shilling believes the global economy will be dominated by an era of deleveraging and sees the following causes slowing down growth over the years ahead:
1. U.S. consumers will shift from a 25-year borrowing-and-spending binge to a saving spree. This will spread abroad as American consumers curtail the imports of the goods and services many foreign nations depend on for economic growth.
2. Financial deleveraging will reverse the trend that financed much global growth in recent years.
3. Increased government regulation and involvement in major economies will stifle innovation and reduce efficiency.
4. Low commodity prices will limit spending by commodity-producing lands.
5. Developed countries are moving toward fiscal restraint.
6. Rising protectionism will slow – even eliminate – global growth.
7. The housing market will be weak due to excess inventories and loss of investment appeal.
8. Deflation will curtail spending as buyers anticipate lower prices.
9. State and local governments will contract.
As far as his investment themes for 2012 are concerned, Shillings lists the “attractive” and “unattractive” items below.
- Treasury bonds
- Selected income-producing securities
- Small luxuries
- Consumer staples and foods
- The U.S. dollar, against the euro and commodity currencies
- Selected healthcare providers and medical office buildings
- Rental apartments
- Productivity enhancers
- North American energy producers, ex renewables
- Developed country stocks
- Homebuilders and related companies
- If you plan to sell your home, second home or investment houses any time soon, do so yesterday
- Selected big-ticket consumer discretionary equities
- Consumer lenders
- Junk securities
- Developing country bonds
- Developing country stocks
- Selected commodities
- Many old tech capital equipment producers
Tags: American Consumers, Commodity Prices, Consumer Lenders, Consumer Staples, Country Bonds, Developed Country, Energy Producers, Excess Inventories, Fiscal Restraint, Gary Shilling, Global Growth, Investment Appeal, Investment Houses, Investment Themes, John Mauldin, Medical Office Buildings, Productivity Enhancers, Rental Apartments, State And Local Governments, Treasury Bonds
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Sunday, January 8th, 2012
Have Winds Shifted to Provide Relief to Investors?
By Frank Holmes, CEO and Chief Investment Officer, U.S. Global Investors
Wind currents between the ocean and atmosphere affect climates around the world; likewise, government policy shifts and economic data have a similar ripple effect on markets.
During our Outlook 2012 webcast yesterday, our listeners heard a very passionate John Mauldin assess the debt situation in Europe, Japan and the U.S. and the need for immediate policy change. If you listened in, you may have wondered what economics and politics have to do with investments.
That’s a valid thought, as many investors hear predictions of which way the market will go or what stocks will outperform. As I often remind my readers, it’s not about political parties, it’s about the policies. And history says that government policy shifts can have a tremendous affect on the economy and the markets. While no one can predict the future, you can use probability in your favor.
For example, Chinese stocks have historically moved with money supply. In the webcast, Analyst Xian Liang showed the chart below plotting the year-over-year money supply in China against domestic B-shares (represented by the MSCI China Index) since the end of 2000.
The Chinese government is known for acting decisively in making policy changes to steer its economy in the right direction. In 2009, the growth in money supply was at an 11-year high of 30 percent after the government lowered the required reserve ratio (RRR) for major banks. Adjusting the reserve requirement is important inflation-fighting tool in China’s monetary policy. The lower the reserve requirement, the more money banks are able to lend out.
Throughout 2011, due to concerns about inflation, China had been raising the reserve requirement for banks and interest rates. This action reduced money supply to the low we see in the chart. This December, China shifted its stance as slow growth became a risk and inflation slowed. This action should increase money supply, and encourage markets, going forward.
China also recently announced an earlier-than-expected windfall profit tax cut for its oil companies. This special oil income levy raises the level at which a barrel of oil is taxed, going from $40 to $55. This $15 difference essentially translates to a substantial tax break for oil companies and extra money in their coffers.
Research firm Jefferies expected the tax adjustment, but thought that it would happen at the end of 2012. With this tax cut, it appears the government acknowledges the need for Chinese upstream oil companies to increase their cash flow so that they can increase domestic production, says Jefferies.
This tax cut was closely followed by analysts, and was seen as a “big positive” for China’s oil companies, specifically CNOOC, PetroChina and Sinopec, says Citigroup Global Markets. The market promptly responded positively, with each stock rising on the news.
Another economic measure that has a ripple effect on global markets is the Purchasing Managers’ Index (PMI), an indicator of manufacturing strength. We follow this index closely, as it is considered a leading indicator, meaning the markets react over the following three months after the PMI data is released.
As of December 31, the JP Morgan Global Manufacturing Purchasing Managers’ Index (PMI) crossed above the three-month moving average. Going back to the inception of the index in 1998, there have been 20 occurrences when the one-month number crosses above the three-month. When this has happened, it’s signaled higher prices for many commodities, especially oil, copper, and to less of a degree, materials and energy.
For copper, historically, 90 percent of the time, the price was positive over the next three months, with a median return of 10 percent over the following three months.
During the same three months, 85 percent of the time, West Texas Intermediate oil has also gone up. Its median three-month change has been an increase of 11 percent.
Materials and energy were also positively affected, with modest results: When the PMI crosses above the three-month average, 70 percent of the time, the S&P 500 Materials Index rose, with a median return of about 3 percent. The S&P 500 Energy Index had a median three-month return of about 5 percent, with an 80 percent chance of the three-month change being positive.
We believe the winds are shifting to bring needed relief to global investors. We’ve seen improving economic data from the U.S. lately, and this positive news from the world’s largest economy, along with an improving China—the world’s most populated country—offsets the negativity in Europe.
What’s the probability of the U.S. market heading higher in the year of a presidential election? Register today for our webcast next Tuesday to hear from Jeffrey Hirsch of the Stock Trader’s Almanac, the annual resource that countless money managers, traders and investors have come to rely on. We’ll discuss Jeffrey’s nearly 50 years of market research, along with the many other historical indicators such as the January Barometer and the Santa Claus Rally. Sign up now.
Tags: Chief Investment Officer, Chinese Government, Chinese Stocks, Climates, Debt Situation, Economic Data, Frank Holmes, Government Policy, John Mauldin, Monetary Policy, Money Banks, Money Supply, Msci China Index, Policy Shifts, Reserve Ratio, Ripple Effect, Rrr, U S Global Investors, Webcast Analyst, Wind Currents
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Tuesday, December 27th, 2011
Global markets have been tough in 2011 but I look forward to a strong 2012. To kick the year off, we’ve scheduled a special webcast with John Mauldin and our investment team to discuss our outlook for the coming year.
Mauldin is a wizard when it comes to markets and his annual outlook pieces are a perennial “must read” for global investors. His Thoughts from the Frontline e-newsletter is also distributed weekly to more than 1 million readers.
In this week’s edition, Mauldin shared his thoughts regarding the Keystone Pipeline that I thought you might find interesting. He begins with a short discussion from his book, Endgame, on the budget balance struggle that countries face when the private sector is deleveraging, and continues with a candid commentary on America’s dependence on energy and the impact of the proposed pipeline:
The desire of every country is to somehow grow its way out of the current mess. And indeed that is the time-honored way for a country to heal itself. But let’s look at yet another equation to show why that might not be possible this time. It is yet another case of people wanting to believe six impossible things before breakfast.
Let’s divide a country’s economy into three sections: private, government, and exports. If you play with the variables a little bit you find that you get the following equation. Keep in mind that this is an accounting identity, not a theory. If it is wrong, then five centuries of double-entry bookkeeping must also be wrong.
Domestic Private Sector Financial Balance + Governmental Fiscal Balance – the Current Account Balance (or Trade Deficit/Surplus) = 0
(By Domestic Private Sector Financial Balance we mean the net balance of businesses and consumers. Are they borrowing money or paying down debt? Government Fiscal Balance is the same: is the government borrowing or paying down debt? And the Current Account Balance is the trade deficit or surplus.)
The implications are simple. The three items have to add up to zero. That means you cannot have surpluses in both the private and government sectors and run a trade deficit. You have to have a trade surplus.
Thus the problem of Greece, with its massive trade deficit and huge fiscal deficit. They have no choices but default or depression.
The U.S. has two main sources of its trade deficit: energy and China, in roughly equal proportions. If we reduce our energy dependence, we can get the trade deficit below 2% of GDP.
The China problem is not simply one of reducing our trade deficit with China, as much of what China makes and sells to the U.S. is sourced in countries outside of China. While the final manufacture is perhaps in China, the bits and pieces come from other parts of Asia. The true cost of a product from China is less than 20% actual Chinese value added. An example is the Apple iPhone, which is assembled in China but whose most costly components come from elsewhere in Asia. Direct Chinese costs are less than 4%, but the entire amount is “attributed” to China in calculating the trade deficit.
The real problem is the demand in the U.S. for cheaper goods. If the U.S. were to pass a tariff on Chinese-manufactured goods, then production and buying would shift to other countries without the tariffs. Markets look for the lowest-price source. For a tariff to be truly effective, it would have to be on the product and not the source country. And the only way to do that is to start a trade war. That is typically not a good way to promote free markets and general prosperity. Think Smoot-Hawley in the 1930s.
On the other hand, the U.S. can do something about its energy dependence. We are blessed with abundant energy, if we simply exploit it in a responsible manner. And doing so would directly create hundreds of thousands of jobs, many of them quite high-paying, and many more hundreds of thousands of jobs servicing those employed and their companies.
Which brings us to the rather strange case of the Keystone XL Pipeline project. For non-U.S. readers, this is to be a 1,700-mile pipeline designed to connect Canada’s oil production in the province of Alberta with the U.S. Gulf Coast. The various government agencies of the current U.S. administration approved the project, after exhaustive environmental impact analyses. President Obama overruled his subordinates, postponing a decision until 2013, after the next election. Even though labor unions (normally thought of as Democratic and Obama allies) actively supported the project (as it means lots of jobs), various environmental lobbies were against it, and Obama apparently gave into them. (That is not just my opinion, but widely assumed, even by Democratic supporters.)
This issue has raised a few questions from international readers, wanting to know why so many people (the large majority of US voters, if polls are right) are seemingly willing to hurt the environment simply for the purpose of transporting oil. Wouldn’t a new pipeline create a whole new host of environmental dangers? What were we thinking?
As it turns out, a new pipeline is not all that radical. If you drive in the U.S., you cannot go ANYWHERE for any length to time without crossing dozens of pipelines that already exist, especially in the corridor where they want to build the Keystone XL pipeline.
Let’s look at two maps. The first is a map of natural gas pipelines in the U.S. To say it looks worse than your grandmother’s varicose veins is no exaggeration. It is hard to find a state that does not have a natural gas pipeline. Without them the U.S. would simply come to a grinding halt. (The source for this map is a governmental agency, the U.S. Energy Information Administration.)
The next map is just the major oil pipelines. If you were to add in all the small (8-inch or less) lines connecting minor oil fields, you could not distinguish between the lines in certain areas, as we will see in the third chart.
This next chart I throw in because it also shows the rather extensive pipeline system in Canada. This chart combines commodity pipelines of all kinds. The point is that we have the technology to build pipelines safely and in an environmentally reasonable way. When was the last time you heard of a serious pipeline disaster, or even a small one? Yes, the BP oil rig certainly comes to mind, but that was human error and not the fault of technology. Just as the large majority of airplane accidents are pilot error, you do everything you can to minimize the impact, and require safety procedures. But people screw up every now and then.
This is not to dismiss the problems and environmental concerns of drilling for petroleum products, or mining for various minerals. There needs to be strict controls on all such activities, with real penalties. You can see from the maps that my home state of Texas has a lot of pipelines and wells. The problems with pollution in the early development phase here in Texas were well-known. Now there is a very aggressive and popular regimen of control of drilling and transportation of oil and gas. We have to live next to the wells and pipelines. No one wants their water or land destroyed.
Now, let’s circle back to the Keystone Pipeline. We started this section with a reference to trade deficits. And this is Canadian oil, not U.S. oil. So it does not help our trade deficit directly, although a large portion of U.S. dollars that go to Canada come back to the U.S. Canada is far and away our largest trading partner and major energy supplier.
The problem is that the opposition is mainly of the “I don’t like any carbon-based energy” variety. Whether it is coal or oil or natural gas, it is not as “clean” as solar or wind.
The problem is that solar and wind simply cannot produce enough energy without huge government subsidies, at least with current technology (although that will change over time). In the meantime, if we want to balance our budget in the U.S. (and we must!), we are going to have to become energy independent as one part of the solution. In the short term (10-15-20 years), that means carbon-based energy. If we can produce our energy in the U.S., and we can, then why not create the jobs here rather than elsewhere, if jobs are our #1 political concern, as they seem to be, according to the polls? Further, in the short term, as Mexican production is falling rather fast, we are going to need that Canadian oil if prices are not going to rise.
(Note: in my book, I actually call for a slowly rising energy tax on gasoline usage, to be solely used for rebuilding our decaying infrastructure, so I am not against higher prices per se. I just want the reason for higher energy costs not to be shortages. But that’s another story for another day.)
In the “payroll tax cut” bill that will be passed in a few days here in the U.S., Congress will require the President to make a decision by the end of February on whether to allow the Keystone project. I hope they do pass it, and I hope he does decide to allow it.
But let’s not think that this one more pipeline is going to destroy the environment of the U.S. It might create competition for some U.S. producers, but if you can’t live with competition then you’re in the wrong country.
The U.S. is in a very deep hole. We need to stop digging and start figuring out a way to climb out. The world is sadly going to see what happens when Europe has to resolve its current crisis, one way or another, and what that will mean for world GDP growth. Then, I am afraid, Japan will be the next crisis in waiting.
The world can ill afford for the U.S. to be the third major economy to implode. The world is far too connected to shrug off such problems.
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Tags: Account Balance, Borrowing Money, Budget Balance, Candid Commentary, Current Account, Debt Government, Double Entry Bookkeeping, Endgame, Financial Balance, Fiscal Balance, Global Investors, Global Markets, Investment Team, John Mauldin, Keystone, Pipeline, Private Government, Private Sector, Six Impossible Things, Trade Deficit
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Monday, December 5th, 2011
Time to Bring Out the Howitzers
by John Mauldin
Employment Up But Not Enough
The World Slips into Recession
Central Bankers of the World, Unite!
New York, Hong Kong, Singapore, and Cape Town
And My Conference
It is now common to use the term bazooka when referring the actions of governments and central banks as they try to avert a credit crisis. And this week we saw a coordinated effort by central banks to use their bazookas to head off another 2008-style credit disaster. The market reacted as if the crisis is now over and we can get on to the next bull run. Yet, we will see that it wasn’t enough. Something more along the lines of a howitzer is needed (keeping with our WW2-era military arsenal theme). And of course I need to briefly comment on today’s employment numbers. There is enough to keep us occupied for more than a few pages, so let’s jump right in. (Note: this letter may print long, as there are a lot of charts.)
Employment Up But Not Enough
The headline number is that 120,000 new jobs were created in November, in line with estimates. That total is the sum of 140,000 jobs from the private sector coupled with the now usual loss of 20,000 jobs in the government sector. But when we look at the details, things are not as upbeat.
First, the good news: the US economy is continuing to grow. As I have said for quite some time, the US should not fall into a recession unless it is pushed by something from beyond our shores, which, sadly, I expect (details below). However, we are nowhere near the typical recovery pattern. By this time into a recovery we are usually making new highs on the employment front. As everyone knows, we are millions of jobs from that level.
And my friend Bill Dunkelberg, the Chief Economist of the National Federation of Independent Business, sends us these headlines today from his own survey:
· AVERAGE EMPLOYMENT PER FIRM ROSE
· HARD TO FILL JOB OPENINGS INCREASED, UNEMPLOYMENT DOWN
· PLANS TO CREATE NEW JOBS NEARLY DOUBLED
The net change in employment per firm wasn’t much different from zero, but it did have a plus sign in front of it for the first time in nearly half a year. On average, owners reported increasing employment an average of 0.12 workers per firm. Seasonally adjusted, 14 percent of the owners added an average of 3 workers per firm over the past few months, and 12 percent reduced employment an average of 2.9 workers per firm. The remaining 74 percent of owners made no net change in employment (47 percent hired or tried to hire and 35 percent reported few or no qualified applicants for positions, both figures up 4 points).
The percentage of owners cutting jobs has returned to “normal” levels (even in a great job market, over 300,000 file initial claims for unemployment, i.e., they are fired or laid off). And the percentage of owners adding workers (creating jobs) continued to trend up. Reports of new job creation should pick up a bit in the coming months.
(I spent last Sunday with Bill, and we outlined our new book on creating jobs and employment. Our goal is to finish it in record time and have it out next spring.)
120,000 jobs is not quite enough to keep up with the growth in the population. Along with positive revisions to previous months, we have now averaged about 114,000 a month for the last 6 months. But then why did the headline unemployment number fall to 8.6%? That is a very large drop for one month. The simple answer is that the number of people looking for a job fell by 315,000. And the number of people counted as not in the labor force (a different measure) swelled by 487,000 to a record 86.5 million.
Again, for new readers, you are not counted as unemployed if you have not looked for a job in the last four weeks. Let’s look at a chart from the St. Louis Fed database that shows the number of citizens not in the labor force. What we see is a rise from 77 million in 2007 to 86.5 million today. Part of that can be explained by population growth, but it would be less than half of the increase of almost 10 million people not considered to be in the labor force.
If we looked at a chart of those counted as being in the labor force, we would see that it is roughly where it was back in 2007, yet there has been working-age population growth of at least (my guess) 5 million. And the next chart shows the number of people that are actually employed, private or government, full- or part-time. What we see is that the number of people working is about where it was 8 years ago.
That is not a pretty chart. What all that means is that unemployment would be closer to 11-12% if we went back to the labor force of just a few years ago and adjusted for population.
Let me quickly note, too, that if we went back to the unemployment measurement basis of a few decades ago, the numbers would be closer to what I suggest above. Counting unemployment the way it is currently done allows whoever is in charge to publish numbers that look better than they are in reality on the street. I expect Republicans to point this out in the next election cycle, although if they get into office they will have to live with that analysis when it comes back to haunt them in four years. Because as the next chart shows (from my friend Lance Roberts of Streettalk Advisors in Houston), we need job growth of about 400,000 jobs a month to get back to the long-term trend by 2020. This shows the employment-to-population ratio, which has dropped by 6% since 2000, falling precipitously since the beginning of the recession. We have never had such strong employment growth, and are unlikely to get it as we reduce government spending, which we must do.
This shows above all else why the #1 issue for the coming elections will be jobs. The US economy is looking more and more European all the time in terms of unemployment numbers. If the course is not changed, it will make any real recovery back to what we think of us “normal” for the US highly problematic.
Let’s quickly look at a few other problems in this employment report. The work week was unchanged at 34.3 hours (and was down 0.2 hours in manufacturing). Aggregate hours were up just 0.1%. Average hourly earnings were off 0.1%, leaving the three-month average at -0.1%. For the year, hourly earnings were up just 1.8%. When the Great Recession began, they were rising at a 3.4% annual rate. Aggregate payrolls were up just 0.1% for the past month. The decline in unemployment was concentrated among the shorter durations, with almost all of it among those jobless for 14 weeks or less. Those unemployed for 99 weeks or more rose 143,000 to 2.0 million, very close to an all-time high. The mean duration of unemployment rose to 40.9 weeks, a record. (Hat tip The Liscio Report.)
This does not bode well for consumer spending. Any growth of late has come from a reduced savings rate, as income is barely keeping up with inflation; and if you look at the inflation we “feel” in healthcare, food, and energy, then the average consumer is losing ground. This also means any recovery is only one external shock away from slipping back into recession.
Finally, the “quality” of the new jobs is not what we would like. More and more people are taking lower-paying jobs. We saw 105,000 jobs in retail, temporary, and food services out of the total of 120,000. Many of these are seasonal and will fall off in the next quarter. (Let me hasten to add that I am not being derogatory of food-service jobs. They are important and are hard work. I have two kids who are employed in the food-service world, and most of my kids, and your humble analyst, have been employed in various food-service jobs at one time or another. Without those jobs some of my kids might be moving back home! So, the next time you’re out, leave a bigger tip than normal if it’s deserved. Your wait person is someone’s kid!)
The World Slips into Recession
How fragile is the recovery? The rest of the developed world is either in recession or soon will be.
This next chart is from friend Prieur du Plessis of Plexus Asset Management in South Africa. Notice that every major region is slipping into contraction except the US. (http://www.investmentpostcards.com/2011/12/02/global-manufacturing-pmi-saved-by-the-u-s/)
Now, let’s look at more details, provided by SISR (sadly, I lost the email of the person who provided this, so I can’t credit him). It shows that outside of the US and Canada, the rest of the developed world is watching their PMI (manufacturing production) numbers go into contraction. Of the emerging world, only India and South Africa are growing. Notice that the contraction in both Germany and France is getting worse month by month.
Source: Markit Economics, SISR
How long can the US resist a global slowdown? My answer would be, for longer than you might think, absent the potential shock coming from Europe. But the above data does set the stage for the rest of the letter.
Central Bankers of the World, Unite!
Now, a few quick observations. This was truly a global effort by the central banks of the world (the US, Europe, Japan, Switzerland, Canada, and China). But then, what else did you expect them to do? Their main tool is to provide liquidity, and that is what they promised. They lowered the cost of coming to the “window” and certainly lowered the “shame” factor in doing so. Going to the central bank could be seen as a sign of weakness and, at higher rates, banks might be reluctant to do so. At the new rate it is reasonably economical, and the central banks have signaled it is more than OK.
Second, this effort also included China, which cut its bank reserve requirements by 0.5%. David Kotok pointed out to me something unusual about this. Normally, China makes it moves with a number ending in “7,” like 27 or 47, as 7 is good luck. For those paying attention, this was China’s way of saying “We are part of the team,” rather than acting on their own, as they usually do. Now, it makes sense that if you include Canada in the “club” you should include China.
The stock markets of the world went into an ecstatic frenzy, capping off a very positive week. But I would remind my enthusiastic friends of a few things. Let’s look at what really happened. We just recovered from a very over-sold condition and are still down almost 7% from this summer.
And this has happened before. Let’s rewind the clock to October of 2008, deep in the credit crisis. This is a report from Jim Lehrer of PBS (emphasis mine):
“JIM LEHRER: World stock markets staged a comeback today. They did so as key governments moved to support troubled banks. On Wall Street, the Dow Jones industrial average scored its largest point gain ever, soaring 936 points to close above 9,387. The Nasdaq was up more than 194 points to close at 1,844. Overseas, stock indexes rose 8 percent in Britain, 11 percent in France and Germany. Markets across Asia also shot higher, including a gain of 10 percent in Hong Kong.
News of European efforts to end the banking and credit crisis helped ignite the rally. On Sunday, nations that use the euro agreed on coordinated steps. Today, Britain was first to act. It was followed by Germany, France, Spain, Portugal, Austria, and the Netherlands.”
The good news is that this week’s action may (and I emphasize may) help stave off a true bank credit crisis on the order of 2008. That is, if the central banks of the various European countries follow through (more on that below). The real problem was best summed up this week by Mervyn King, the governor of the Bank of England, speaking at the press conference to launch his Financial Stability Report.
“Many European governments are seeing the price of their bonds fall, undermining banks’ balance sheets. In response, banks, especially in the euro area, are selling assets and deleveraging. An erosion of confidence, lower asset prices and tighter credit conditions are further damaging the prospects for economic activity and will affect the ability of companies, households and governments to repay their debts. That, in turn, will weaken banks’ balance sheets further. This spiral is characteristic of a systemic crisis.
“Tackling the symptoms of the crisis without resolving the underlying causes, by measures such as providing liquidity to banks or sovereigns offers only short-term relief. Ultimately, governments will have to confront the underlying causes… The problems in the euro area are part of the wider imbalances in the world economy. The end result of such imbalances is a refusal by the private sector to continue financing deficits, as the ability of borrowers to repay is called into question.
“The crisis in the euro area is one of solvency and not liquidity. And the interconnectedness of major banks means that banking systems, and hence economies, around the world are all affected. Only the governments directly involved can find a way out of the crisis…” (Hat tip, Simon Hunt.)
Time to Bring Out the Howitzers
If the problem were one of liquidity, then this week’s action would be enough. But the problem is solvency. The majority of European banks are insolvent. They own too much debt of sovereign countries that are going to have to reduce their debts. There is a growing number of analysts who are realizing that even Italy may have to reduce its debt burden. I have highlighted the problems faced by Belgium. And how about Spain, and Portugal?
What this action does is give the ECB the dollars it will need to loan to the various national central banks, so they can loan to their insolvent banks. Will they bail them out, or nationalize them? The answer depends on the country and its voters. But absent recapitalizing their banks, there will be a credit crisis that will affect the whole world.
The amount of debt that will have to be written off and the loan portfolios reduced, as well as new capital raised, is daunting. As I have noted previously, the need is for around €3 trillion.
Writing off so much debt in the midst of a recession, coupled with austerity moves, will be massively deflationary for the eurozone. But Merkel and the German Bundesbankers have made it clear that they will not be part of any “printing press” action that is not coupled with serious commitments for balanced budgets. Even in the face of a recession.
Which makes it quite strange that the ECB has been tightening in terms of money supply the past year. Notice in the graph below that M1, M2 and M3 are all in negative territory. (Chart from the London Telegraph.)
The ECB under Trichet was apparently fighting inflation. He raised rates and let his inner Bundesbanker take control. Maybe with the rate cut and the new head of the ECB, Mario Draghi, we can see signs that the ECB may in fact act to ease. This is from my friend Dennis Gartman, writing this morning:
“Turning to the ECB, the new President, Mr. Draghi, has obviously taken on the most difficult of jobs and we’ve no choice but to admire him for the audacity necessary to take on a role such as his… especially at a time such as this. Yesterday, Mr. Draghi made a statement that we find tectonic-plating-shifting-like in nature when he said firstly that the ‘Downside risks to the economic outlook have increased.‘
“They have indeed, and we’ve no problem with what he said for that is indeed the truth. Then, however, the plates shifted when he said, noting that the ECB’s mandate, that price stability is to be maintained ‘in both directions.’ In other words, the ECB’s mandate forces the authorities to be concerned about deflationary risks as well as those inflationary.
“Did you hear the plates shifting? You should have for they have indeed shifted. Draghi’s warning was that the authorities are just as concerned about deflation as inflation and that monetary expansion is to be considered just as has monetary contraction.
“So we are now… or shall soon be… faced with a monetary and political union that is manifestly different than that which the original united nations had signed up for AND we have a central bank intent upon fighting deflation as strongly as it has fought inflation. These are the attributes of a regime intent upon weakening, not strengthening, its currency in order to strengthen the economy and to save the union… if at all possible.”
The coordinated central bank action will make dollars available to the ECB, which will in turn loan them to the national central banks, which presumably will loan them to their in-country banks, taking lower-quality collateral than the ECB (which under the rules they are allowed to do). Given the deflationary pressures that are the natural result of a recession and deleveraging/default, they can print a lot of money without igniting too much inflation. But I agree with Dennis; I just don’t see how they can do so without seeing the valuation of the euro fall rather smartly.
Merkel and Sarkozy have told us they will meet Monday and announce a plan on December 9, when the full eurozone meets. Forget bazookas, this needs the equivalent of a howitzer. They are seemingly intent upon rewriting the treaty, which is the only way that the Germans will go along with any major ECB action. But by my reckoning, a few hundred billion, or even a trillion, is not major action, at least not on the level of what will be needed.
The price for German acquiescence will be a loss of sovereignty and the ability to run deficits of any real size for any appreciable length of time for the countries of Europe. Will the peripheral countries go along? Heck, forget them; will Finland go along? This situation has been coming along since the foundation of the eurozone. The early founders acknowledged that a tighter fiscal union would eventually be necessary if the euro experiment were to survive. And eventually is now. As in this month. Time is running out if they want to forestall a credit crisis that would be worse than 2008.
The world is watching, as what happens in Europe will affect us all, in every part of the globe. It could easily tip the US into recession, and it will only be worse for the emerging markets. For Europe, the Endgame is now. We can only hope they come up with a plan that avoids disorderly defaults and a crisis far graver than 2008. They have no good choices, only difficult ones and disastrous ones. Let us hope they choose wisely.
(And for my fellow Americans, note that we will face the same consequences if we do not get our own house in order, and very soon. This is more than an academic observation.)
New York, Hong Kong, Singapore, and Cape Town
And My Conference
I am reading Niall Ferguson’s new book, Civilization. It is a great read. Quick note: If you enjoy Niall’s writing, you may also enjoy watching his TV series on 4oD: The Ascent of Money (same name as his early book). He presents six 1-hour episodes. Only 11 days left on the website, a good idea for this weekend!
Niall, along with Marc Faber, David Rosenberg, Mohamed El-Erian, Woody Brock, Lacy Hunt, David McWilliams, and your humble analyst, will all be at my conference (co-hosted with partners Altegris Investments) May 2-4 near San Diego. Does this not sound like the best line-up of any conference this year? Details will follow, but you won’t want to miss this one.
I am more or less home for the next six weeks, except for a quick trip back to New York later this month with Tiffani for a business meeting (good changes are coming, as always), and we will take some time to enjoy friends and the city lights.
Then I will go to Hong Kong and Singapore on January 10 for 12 days, coming back to finish a few things and then head off to Cape Town, South Africa in the middle of February (details later).
Tomorrow I go with Tiffani to take my granddaughter Lively to go see Yo Gabba Gabba “live.” This is a new kid’s show for very young toddlers that captures their attention like nothing I have ever seen. Below is a photo from last spring, when we were on a plane to somewhere (Lively is now a seasoned traveler!) and she was watching Yo Gabba Gabba on an iPad with her special baby earphones. Look how rapt she is. “Papa John” gets to sit in on this and even go back stage to meet with the cast. Wild horses could not drag me to endure this with your kid, but with my granddaughter? Try and keep me away! How we change with the advent of the next generation.
I am looking forward to the holidays. All the kids will be here, and we will go out to look at the lights, take in movies, and munch lots of great food! And it now looks like professional basketball will launch on Christmas Day, with the Mavericks playing the Miami Heat in a reprise of the NBA Finals last year. I do have rather good seats (front row behind the chairs), and my phone has been blowing up! The #1 most rabid Mavericks fan in the whole world, my daughter Abbi, has begged me to take her, and Dad can’t say no. (Are you listening, Mark?)
All Dad wants for Christmas is to meet his deadlines for the irrational amount of writing I have committed to do before I leave for Hong Kong. That and to have my kids around.
It is time to hit the send button so the translator in Hong Kong can get started. In theory, no more really late nights on Friday for me. But this letter has been more than long enough. Have a great week.
Your wondering how we Muddle Through analyst,
Tags: Bazookas, Bull Run, Central Banks, Chief Economist, Credit Crisis, Employment Numbers, Federation Of Independent Business, Friend Bill, Government Sector, Headline Number, Hong Kong Singapore, Howitzer, Howitzers, John Mauldin, Jump Right, Military Arsenal, National Federation Of Independent Business, New Highs, New Jobs, Typical Recovery
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Thursday, October 20th, 2011
Dr. Lacy Hunt and Van Hoisington of Hoisington Investment Management write a “Quarterly Review and Outlook” that is a must-read for me. This quarter they focus on US monetary policy, noting that “After peaking at 1.69 in the second quarter of 2010, M2 velocity declined for four consecutive quarters, and we estimate that a major contraction in velocity to 1.59 is likely for the third quarter.” (I mentioned the importance of the velocity of money in judging inflation vs. deflation prospects in this week’s e-letter, too.)
They say, “If our analysis of a new contraction in GDP is correct, the U.S. economy should be viewed as operating in the midst of a long-term slump, regardless of terminology.”
They borrow a riff from Harvard economic historian Niall Ferguson, who has asserted that the world is experiencing a “slight depression”; and mention that this conclusion has been backed up by Gluskin Sheff’s notable economist, David Rosenberg, who reminds us that “Depressions are basically long recessions lasting three to seven years.”
Hoisington Investment Management Company (www.hoisingtonmgt.com) is a registered investment advisor specializing in fixed-income portfolios for large institutional clients. Located in Austin, Texas, the firm has over $4 billion under management, composed of corporate and public funds, foundations, endowments, Taft-Hartley funds, and insurance companies.
Your kicking up my heels in the Big Apple analyst,
John Mauldin, Editor
Outside the Box
Quarterly Review and Outlook
Third Quarter 2011
Dr. Lacy Hunt and Van Hoisington
Hoisington Investment Management Company, 6836 Bee Caves Rd. B2 S100, Austin, TX 78746 (512) 327-7200 www.Hoisington.com
Negative economic growth will probably be registered in the U.S. during the fourth quarter of 2011, and in subsequent quarters in 2012. Though partially caused by monetary and fiscal actions and excessive indebtedness, this contraction has been further aggravated by three current cyclical developments: a) declining productivity, b) elevated inventory investment, and c) contracting real wage income.
In the last half of 2010, real GDP grew about 2.%. The consensus forecast for 2011 was for growth to accelerate to 3%-4% due to the massive easing of Fed policy (QE2), social security tax cuts, and other fiscal stimuli. Surprisingly, real GDP growth slowed to less than 1% in the first half of this year. When growth slows abruptly and it is markedly at variance to expectation, businesses find they have more employees than desired. Normally, firms are reluctant to resort to layoffs, but a failure to do so means unit labor costs rise swiftly as output per man hour (productivity) falls. This was exactly the experience in the first half of 2011. In the very broad, non-farm business sector, productivity did decrease at a .7% annual rate. Accordingly, unit labor costs surged at a 4.8% rate over the same time period, exceeding the rise in consumer prices.
Historically, a sustained and meaningful drop in productivity and a parallel rise in unit labor costs have been precursors to increased layoffs as businesses struggle to restore margins and profitability. Once these job losses commence, broad negative ramifications are felt throughout the economy (Chart 1).
b) inventory reversal
Inventory investment, the most volatile component of the economy, has contributed substantially to the recovery since 2009. From the second quarter of 2009 to the second quarter of this year, real inventory investment surged by $222 billion, accounting for 35% of the rise in real GDP over that period. Now inventory investment accounts for 1.18% of real GDP, which is .18% above the average since 1990. In July and August, production of consumer goods increased at a 3.2% annual rate versus the second quarter, while real retail sales contracted at a 1.4% rate; therefore, inventory investment moved to an even higher, likely undesired, level. Consequently, as firms move to rebalance inventories, the stage is set for a slowdown in production, requiring a further need to pare staffing levels.
c) real wages
Real average hourly earnings has fallen by 2.2% over the twelve months ending August 2011. Real disposable income (a broader measure of income) was lower in August than last December. Initially, consumers responded to this lack of income growth by cutting their saving rate back to the recession low of 4 .%, but now an evident slowdown in spending has occurred. Real spending expanded by only .7% in the second quarter, and remains sluggish in the third quarter. This lack of real income growth will contribute to the negative changes in GDP in coming quarters (Chart 2).
This reduction in real income can be traced, in part, to the misguided attempts to spur economic growth by the Federal Reserve via quantitative easing (QE2). The QE2 expansion in the Fed’s balance sheet backfired as the boost in stock prices (a positive for some consumers) was more than offset by the negative impact of food and fuel inflation on the average family budget. While rising equity values helped a few consumers, inflation in necessities such as food and fuel, decimated real incomes for the average family. Thus, the emergent cyclical weakness that lies ahead can be directly related to the unintended consequences of quantitative easing.
Although many measures of economic performance worsened during QE2, the Fed might argue that the recent M2 acceleration may eventually contribute to an improvement in economic growth as deposit growth fuels income expansion. In our opinion, such an optimistic assessment is not warranted.
In the past three months, M2 increased at a rapid annualized pace of more than 20%, and the annual increase in M2 is about 10%, well above the post 1900 average annual increase of 6.6%. This rise in M2, however, appears to reflect a massive balance sheet shift of assets, not a net creation of new assets. Theoretically, if funds are switched from non-M2 assets into M2 assets, M2 velocity would decline and bank loans plus commercial paper would be stable.
This is exactly what has been happening. After peaking at 1.69 in the second quarter of 2010, M2 velocity declined for four consecutive quarters, and we estimate that a major contraction in velocity to 1.59 is likely for the third quarter (Chart 3). Also supporting this idea of asset shifting, bank loans plus commercial paper in September totaled $7.845 trillion, down from $7.906 trillion in June 2010.
In an environment where short-term interest rates are close to zero, commercial paper has become an increasingly unattractive investment since the low interest rates do not cover the risk premium. As commercial paper has rolled off, issuers have been forced to meet funding requirements from bank loans. However, there are other balance sheet changes taking place along with the shift away from commercial paper. With the credit rating of major European banks sliding, companies operating globally may have moved euro-based deposits into dollar-based ones. Supporting this hypothesis, the dollar strengthened during this surge in M2. Economic stresses and uncertainty are responsible for the increased level of M2, not QE2. The real impact of QE2 was that inflation was boosted and real economic growth stunted.
Maturity Extension Program
The initial market reaction to the announcement of the Fed’s latest policy move, known as the Maturity Extension Program (MEP) or Operation Twist, was for commodities and stocks to fall, the dollar to strengthen, and bond yields to decline. Thus, the reaction was to reinforce trends already in place. These market reactions were the exact opposite of what occurred during QE2. Lower commodity prices and the firmer dollar will diminish inflation, thus serving to reverse the drop in real wages that millions of households suffered during QE2. This benefit will not be apparent immediately because the economy has to work through the negative consequences of falling real income and dropping productivity that occurred under QE2. Unfortunately, it is unclear whether Operation Twist will ultimately accrue any benefit to the economy because efforts to achieve very low interest rates could produce counterproductive or unintended consequences.
Banks and other financial intermediaries earn a profit by investing or lending at a rate that exceeds their cost. Due to the low interest rate structure and other considerations, this has become exceedingly difficult, if not impossible. Overnight interest rates are close to zero; thus, to earn a rate above 1% in the treasury market banks must invest at a maturity longer than five years. While this is a positive interest rate spread, all costs may not be covered as banks have to expense payroll, rent, taxes, elevated FDIC fees, and other overhead, and must have a risk or default premium when they lend to a private sector borrower. Therefore, profit erosion of banks and other intermediaries is likely with a lower interest rate structure.
Historical verification of this development is obvious in Japan where more and more of the bank balance sheets have been shifted to government securities rather than to private borrowers. In other words, normal bank lending functions are essentially shut down. This risk now confronts the U.S. with the zero short rate policy and with Operation Twist aimed at lowering yields in the intermediate and long end of the yield curve.
Though budgetary reductions have yet to materialize, fiscal policy via tax increases is also acting as a retardant to growth. The effective tax rate on households can be calculated each month by expressing the sum of federal, state and local taxes as a percent of personal income. From the middle of 2009 to last month, the effective tax rate has risen from 17.5% to 17.9%, a $247 billion tax increase (Chart 4). This rise mainly reflects increased taxation by state and local governments to cover their persistent deficits.
These increases more than offset the first quarter reduction in FICA taxes. Econometric research indicates the U.S. economy will not grow out of the ongoing slump if additional major tax increases are implemented.
In summary, the case for an impending recession rests not only on cyclical precursors evident in productivity, real wages, and inventory investment, but also on the dysfunctionality of monetary and fiscal policy.
The appearance of a renewed slump only a short twenty-one months after the end of the last recession is highly remarkable. Many statistics support the fact, however, that the U.S. is worse off today than it was prior to the onset of the previous recession. For instance: a) the economy has nearly 9. million fewer fulltime workers employed than at the peak in 2007 (Chart 5); b) real GDP is still below the level reached in Q4, 2007; c) industrial production is 6.7% less than its December 2007 reading; d) real retail sales is $13 billion below its 2007 peak, and e) real personal income (less government transfers) is more than $515 billion below the 2008 peak (Chart 6). The financial markets concur with this “things are worse off” idea. The S&P Index is over 20% lower, and bond yields have dropped more than 40% from their peak levels in 2007. Harvard economic historian Niall Ferguson recently noted that the world is experiencing a “slight depression”. This sentiment has also been cogently expressed by Gluskin Sheff’s astute economist, David Rosenberg, who notes that, “Depressions are basically long recessions lasting three to seven years.” If our analysis of a new contraction in GDP is correct, the U.S. economy should be viewed as operating in the midst of a long-term slump, regardless of terminology.
This economic malaise is a direct result of the accumulation of excessive levels of debt and subsequent reduction in the price level of underlying assets. This is a process that U.S. economist Irving Fisher discussed in his 1933 paper The Debt-Deflation Theory of Great Depressions. According to Fisher and confirmed subsequently by Reinhart and Rogoff and the McKenzie Global Institute, a long period of time is required to unwind previous borrowing excesses. These views were recently econometrically verified in a September 2011 publication by the Bank for International Settlements entitled The Real Effect of Debt. This article, authored by Stephen G. Cecchetti,
M. S. Mohanty and Febrizio Zampolli, stated, “Debt is a two edged sword. Used wisely and in moderation, it clearly improves welfare, but when it is used imprudently and in excess, the result can be disaster. For individual households and firms, over-borrowing leads to bankruptcy and financial ruin. For a country, too much debt impairs the government’s ability to deliver essential services to its citizens. High and rising debt is a source of justifiable concern.”
We have assembled, with support from Capital Economics in London, foreign debt to GDP ratios that are comparable to the U.S. debt to GDP ratio. The debt figures in these ratios include both private and government debt; thus, they are measures of aggregate indebtedness. These statistics indicate that the euro currency countries as a group, the United Kingdom, Japan and, interestingly Canada, are all more deeply indebted than the United States. This should not give the U.S. solace, nor detract from our severe problems. However, the greater debt in these areas may serve to provide backhanded support for the dollar. More critical is that all major countries are destined to experience slower growth because of excessive indebtedness.
The latest readings indicate that debt to GDP ratios are about: 450% for the Euro zone and the United Kingdom; 470% for Japan, and 410% for Canada. Thus, the Euro Zone, UK, Japan,and Canada ratios are 100%, 100%, 120%, and 60% higher, respectively, than the U.S. debt to GDP ratio of 350%.
We would like to be able to extend this analysis to China because of its rising importance on the global scene. While the Chinese don’t provide these statistics, a new book Red Capitalism: The Fragile Financial Foundation of China’s Extraordinary Rise by Carl E. Walter and Frasier J.T. Howie (John Wiley, 2011) sheds light on this issue. Carl Walter holds a Stanford Ph.D., is fluent in Mandarin, and resides in Beijing where he has lived for two decades. Walter and Howie acknowledge that China’s model has produced super growth, lustrous office towers, massive, grand new airports and other visible signs of wealth and success. Their disquieting theme is that beneath this glamorous veneer the growth model is flawed and fragile. Specifically, they argue that indiscernible, substantial risks are accumulating in the Chinese banking system–in other words, over-indebtedness.
The Bond Market
During the latter part of the 19th and the early 20th centuries the construction of the Trans-Continental railroad created an excessive accumulation of debt. The result was a period of low interest rates when the long treasury yield averaged less than 2.% for more than a decade. In a parallel case, the highly-indebted Japanese economy has seen its thirty year bond yield average about 2% or less since 1998.
In view of the United States extreme over-indebtedness, we believe that 2% is a an attainable level for the long treasury bond yield. In the previous historic cases yields tended to remain close to their record lows for an extended period of time, coinciding with a long period of deleveraging. Presently the U.S. is in its fifth year of deleveraging, and patient investors in the long end of the treasury market have been financially rewarded. We continue to hold long positions in thirty-year treasury debt, but remain increasingly wary of the potential for further adverse meddling by Federal Reserve authorities.
Van R. Hoisington
Lacy H. Hunt, Ph.D.
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Monday, July 25th, 2011
by John P. Hussman, Ph.D., Hussman Funds
In the day-to-day flood of news reports about debt problems of Greece, Ireland, Portugal, Italy, and even the U.S., it’s easy to get lost in a sea of opinions about the effects of a given bailout measure. The best tool to cut through this confusion is simple arithmetic.
As my friend John Mauldin wrote last week, “No country save Britain at the height of its empire has ever recovered from a debt-to-GDP ratio of over 150% without a default. None. And the reason is simple arithmetic. Even a nominal interest rate of 6% means that it takes 10% of your national income just to pay the interest. Not 10% of tax revenues, mind you; 10% of your total domestic production.”
For most countries in Europe, government revenues typically run between near 40% of GDP, while government spending presently runs several percent ahead of that. In Greece, government debt now represents about 150% of GDP at interest rates between about 10% for very short and very long-maturity debt, to about 25% annually on 2-year debt (reflecting a high expectation of default). The overall average yield on Greek debt is close to 15%. The problem is that 15% interest on 150% of GDP works out to 22.5% of GDP in interest costs if the debt actually has to be rolled-over without restructuring it. That would be more than half of the government revenues of Greece. The only way Greece can avoid default with that math is if investors quickly become willing to roll over the existing debt at an interest rate in the low single-digits.
While last week’s extension of further bailout provisions for Greece certainly gave the markets a rousing “risk on” day on Thursday, the main effect on Greek debt was to extend the expected date of certain default (estimated based on interest rate spreads and credit default swaps) from about 1.5 years away, where the expectation was on Wednesday, to closer to 2 years away, which is where the expectation was by Friday.
Unlike countries with an independent monetary policy, Greece can’t print its own currency, and can’t devalue its obligations on the foreign exchange markets. So it is stuck with impossible math, save for the willingness of other European countries – mainly France and Germany – to pay the tab. It’s still possible for Europe as a whole to summon the political will to do that, given that the GDP of Greece is only about 10% that of Germany. Still, Italy has a debt-to-GDP ratio of about 120%, and a GDP about two-thirds that of Germany, so the math becomes fairly daunting if contagion spreads past small countries such as Ireland and Portugal (which also have debt-to-GDP ratios near 100%).
As I’ve noted several times in recent months, bond market spreads imply very low near-term (3-6 month) probability of default in any Euro-area country. A sovereign default is much more likely to occur near the end of the next bear market, whenever it occurs, than at the start. As Ken Rogoff and Carmen Reinhart noted in their book This Time It’s Different , “Overt domestic default tends to occur only in times of severe macroeconomic distress.” The most likely window for a Greek (or other Euro-nation) default will be at a point when France and Germany are experiencing economic downturns sufficient to douse the political will to bail out their neighbors at a cost to their own citizens.
Here in the U.S., total Federal debt to GDP is also approaching 100%, but the debt held by the public (outside of that held by Social Security and the Federal Reserve) amounts to about 60% of GDP and rising, due to recent budget deficits of about 10% of GDP annually. This is presently manageable since so much of that debt is of short-maturity and is being financed at very low interest rates. And though U.S. Federal tax revenues have historically run near 19% of GDP (they’re presently only about 16% due to the sluggish economy), those depressed interest rates mean that debt service doesn’t consume a huge chunk of revenues just yet.
Still, it’s precisely that short average maturity that makes the debt problematic from a long-run perspective, because it can’t be inflated away easily. In the event of sustained inflation, the debt would have to be constantly refinanced at higher and higher yields. Contrary to the assertion that the U.S. can easily inflate its debts away, it is clear that sustained inflation would create enormous risks to our long-run fiscal condition by driving interest costs to an intolerable share of revenues. At that point, any shortfall in GDP growth or government revenues would result in a rapid spike in debt-to-GDP (as Greece and other peripheral European nations are experiencing now). Prior to embarking on an inflationary course, the first thing a government would want to do is dramatically lengthen the maturity of its debts.
For Greece, and increasingly for Portugal and Italy, our view continues to be “certain default, but not yet.” For the U.S., our view is that, barring significant restructuring of mortgage obligations, our debt problems are more likely to take the form of sluggish economic growth for an extended period of time. I continue to believe that the main window of inflation risk will begin in the back-half of this decade – not yet. Even so, we are already observing a sustained shift away from fiat currencies toward alternatives like gold (though there will certainly be fits and starts to that trend). Meanwhile, bond yields continue to offer very low yields-to-maturity, while credit spreads on corporate debt (even the riskiest types) have been squeezed as thin as they were in 2007. In stocks, on the basis of a wide variety of fundamentals, we expect the total return on the S&P 500 to average about 3.6% annually over the coming decade.
Tags: Bailout, Countries In Europe, Credit Default Swaps, Debt Problems, Europe Government, Friend John, GDP, Gdp Ratio, Government Debt, Government Revenues, government spending, Greece Government, High Expectation, Hussman Funds, Interest Costs, John Mauldin, News Reports, Nominal Interest Rate, Simple Arithmetic, Tax Revenues
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