John Mauldin's Outside the Box : Consumer Spending

Asia's Paradigm Shift

John Mauldin — Tue, 20 Jul 2010 03:04:00 GMT

This week we turn our eyes to Asia as my friend Louis Gave of GaveKal gives us a very thought-provoking piece on the problems of investing in Asia, with a focus on China. While there are real opportunities, Louis also sees some speed bumps. Those Asian ETFs may not be the winners a lot of people think for structural reasons.

I was to thank the team at GaveKal for letting me reproduce their research as typically it is only available to their clients who pay a rather hefty sum.

This has been a productive weekend book writing wise. I am down to finishing 2 chapters which are mostly written and two long flights to Vancouver in front of me. Then the hard part of re-writes but I can see the end of the race. Have a great week, and if you are in Vancouver be sure to say hello.

Your writing machine analyst,

John Mauldin, Editor
Outside the Box

Asia's Paradigm Shift

GaveKal Ad Hoc Comment
by Louis-Vincent Gave

For the past decade, having an overweight exposure to Asian equities in a global equity portfolio was, by and large, the easiest 'major trade'; if only because Asia was both a 'return to the mean' trade (with very undervalued stocks in the wake of the Asian Crisis and TMT bust) and a 'momentum' trade (with faster growth). A decade ago, having stock-picking skills did not matter much in Asia. What counted was having the courage, foresight, and cash, to pick up dominant blue chips like Samsung Electronics at KRW35,000 or DBS Bank at SG$5.

Fast forward to today and things have undeniably changed. By now, Asia has become the world's great hope for growth and this perception is, unsurprisingly, amply reflected in equity market valuations. Most Asian equity markets are now trading at significant premiums to Western markets, something which has never happened before, or at least not for very long...

This valuation premium may of course be warranted given Asia's stronger growth outlook. But this also means that Asian equities really need to deliver on investors' expectations, or face a new de-rating. Or to put things differently, Asian equity markets are clearly no longer a positive 'return to the mean' trade. They are now a full blown 'momentum' trade. And unfortunately, lately, equity market momentum has not been too hot. But is the recent negative momentum a reflection of global trends? Or an Asia specific problem? And if it is the latter, then what does it mean for investors who have telecast plans to overweight Asia in their portfolios?

1- Putting Asia's Premium in Context

In his recently published book, Capitalism 4.0, Anatole reviews the four key megatrends that have underpinned growth in the past decade. These are:

The emergence of 3 billion new consumers, producers, and savers. What set off this dynamic megatrend was the interaction between three historic events - the breakup of the Soviet bloc, the opening up of China, and the end of proxy wars between communism and capitalism in the developing world. The result was that almost the entire world's population found their lives guided for the first time by the invisible hand of market forces, instead of being ruled by the iron fists of communism and feudalism or the clumsy robotic grip of central planning.
Globalization transformed almost every economic activity in every country, as the principles of market competition, private enterprise, and free trade won universal acceptance after the breakdown of central planning and state ownership. In effect, the entire world economy started moving toward a NAFTA-style free trade area, if not quite a European-style single market. As this policy change interacted with the new technologies of zero-cost communications and cheap transport, the classical economic principles of specialization and comparative advantage began to operate with unprecedented effectiveness across the world. The result was an upsurge of productivity growth and wealth creation, especially in China and other previously backward Asian countries. This process of globalization transferred many manufacturing industries from the advanced economies to the developing world, vastly increasing the world's productive capacity. This transfer of industrial activity made the world economy more prosperous but also more stable, bringing us to the third megatrend.
The Great Moderation--a period of unprecedented stability in inflation, unemployment, and economic cycles--created 20 years of almost continuous growth throughout the world economy that lasted right up to the recession of 2008-09. As the world began to recover from the recurrent crises of the 1970s and learned to live with pure fiat money, governments and central banks gained previously unimagined freedom to manage their economies and stabilize both inflation and unemployment. Policymakers gradually reverted to the active demand management that had been abandoned. Moreover, globalization stabilized the world economy by suppressing inflation and shifting many volatile manufacturing industries from America and Europe to China and other emerging economies. This transfer of industry not only made advanced economies less susceptible to inventory and capital investment cycles, but also helped to stabilize emerging economies, most notably in Asia, by reducing their dependence on subsistence agriculture, the most volatile industry of all.
A Financial Revolution resulted from the adoption of a free-market philosophy, the buildup of savings in the rapidly growing Asian economies, and the stability created by globalization and successful demand management. With risks of bankruptcy and unemployment diminished in the stabilized economies of the 1990s, businesses and consumers felt that they could borrow more than ever before and banks were more willing to lend. Meanwhile, the demystification of money meant that debt ceased to be a moral or theological issue and became just another consumer product. Financial innovation also meant that savings previously locked up in property and other illiquid assets could be used as collateral to support consumer and business borrowing. This attractive new feature of property, summed up in the saying "my home is an ATM machine," led to an increase in the value of homes relative to other more traditional investments such as stocks and bonds. The result of this revolution was that ordinary homeowners and small businesses gained opportunities to smooth their spending over their entire lifetimes and to manage their finances in ways that had been available only to large multinational companies and wealthy family trusts. This financial revolution was responsible for the boom-bust cycle that exploded in the 2007-09 crisis, but the changes in traditional attitudes to debt, in property values, and in views about reasonable levels of borrowing may now have changed structurally?

Looking at Asia, the first two of these four megatrends--the emergence of three billion new capitalists, both producers and consumers, in Asia and the unification of the world economy into a single market--are hopefully still on track and have not been derailed by the Great Financial Crisis. Meanwhile, the 'Great Moderation', currently a discredited notion in the West, is still a visible reality in the East (if only because, as mentioned above, Asia is still weaning itself off an highly unpredictable agricultural cycle). Simultaneously the 'Financial Revolution' is still only now unfolding its many benefits on the Asian financial landscape (see What Will 2009 be Remembered For?). In short, Asia today looks nothing like most Western markets who are confronting two very serious problems.

2- The Western World's Two Distinct Problems

The first problem the OECD faces is that over the past decade the private sector has created a lot of assets (real estate in the US, Spain, UK, Ireland...) against which a considerable amount of debt has been collateralized by commercial banks. As the prices of these assets fall, a Fisher-like "debt deflation" looms.

The second problem is that, for structural reasons, a growing number of OECD countries are confronting a very challenging budgetary situation. As we reviewed in our latest Quarterly, the credit crunch, bank bailouts and recession only account for 9% of the increase in long-term public debt burdens in major advanced economies. The remaining 91% of the long-term fiscal pressure is due to the growth of public spending on pensions, health and long-term care. In other words, the credit crunch and recession did not create the present pressures on public borrowing and spending. They merely brought forward an age-related fiscal crisis that would have become inevitable once a majority of the baby boomers retired around 2020.

The solution to the first problem is simple monetary economics 101: central banks have to buy assets in the hope of preventing a collapse in asset prices. These purchases need not be accompanied by a rise in the budget deficit. Instead, they trigger a sharp rise in the local monetary base which is not inflationary as long as the prices of the underlying assets do not go up; and if credit creation in the private sector remains muted, they are unlikely to do so. The rise in the monetary base compensates the decline in bank lending and the decline in the velocity of money. Over time, the hope is that these assets stabilize and gradually move off the central bank's balance sheet. In the near term, the central bank's action also usually leads to a weaker currency which in turn allows for an 'exportled' growth rebound.

The solution to the second problem is, however, far more painful and there is little the central banks can concretely do to help. Instead, the onus is on governments to start cleaning up their balance sheets and income statements. This process may have started in the UK, and perhaps in Japan and certain European countries, though not without some backlash (witness the sudden stress that President Sarkozy finds himself under now that he is genuinely trying to tighten the government's belt). Meanwhile, in the US, there have been few concrete measures to encourage the market that the right steps are being taken (the healthcare debacle was clearly a missed opportunity) and the rhetoric has grown increasingly anti-business (bashing of banks, bashing of insurance companies, bashing of big oil...).

Confronting the above dilemma, the natural reaction of central banks should be to follow Bagehot's advice to 'lend freely and at a high price' otherwise, the risk is that nothing will be done to address the 'unfunded' problem. Worse yet, Western economies could fall into the trap of what Jacques Rueff called 'subsidizing expenditures that give no returns with money that does not exist', a path which invariably leads to inflation. Even more worryingly, such a path could conceivably lead to growing suspicion of the fiat monetary system, which, as Anatole reviews in Capitalism 4.0, has been the bedrock of the post Breton-Woods economic miracle.

Obviously, Asia has neither of the above two problems...which helps explain why most investors are today keener on increasing their risk in the East while decreasing their risk in the West. But of course this does not mean that Asia does not offer investors challenges.

3- The First Challenge: Stepping into the Unknown

A cliché among professional investors is that the four most expensive words in the English language are "This time it's different." But while it is dangerous to ignore the cyclical nature of financial markets, and of human behavior more generally, it is undeniable that the driving forces of economic and business activity--technologies, social structures and political institutions--can and do change. Thus, as we have argued many times before in various GaveKal papers, the four most expensive and foolish words in the English language are not 'This time it's different' but 'Everything's always the same.' At least, this much is obvious to anyone who has spent time in Asia in the past decade. And in the category of 'this time it's different', the fact that most Asian countries are now tightening monetary policy before the Fed, BoJ, ECB and BoE must count for something.

To some degree, this is good news as it shows a willingness on the part of Asian central bankers to tackle the continent's nascent inflationary problem. It also shows a certain degree of confidence that Asian central bankers always seemed to lack before. So, on a structural basis, it is encouraging. However, the hawkishness of Asia's central banks also means that while OECD yield curves are steep and likely to remain so for the foreseeable future, Asian yield curves are now flattening rapidly all across the board. In the charts below, the blue line is the yield curve in late 2007, the grey line is the yield curve a year ago and the red line is the yield curve today. One amazing development is how the US (and German) yield curves have, in the past year, continued to shift lower in spite of the economic recovery. In Asia, we are seeing exactly the opposite with yield curves flattening (Malaysia, Indonesia, China, Thailand, Australia...) or shifting higher (India), a divergence in trend which can only logically be explained by the differences in monetary policy. And, of course, this should logically have an impact on currency markets since steep yield curves often weaken currencies, while flat or inverted yield curves strengthen them (cash becomes harder to find hereby inviting companies and individuals to repatriate capital from abroad etc.).

In other words, the differences in monetary policies between the East and the West should ensure that Asian currencies remain well bid.

But it also means that most Asian indices face some new headwinds. Indeed, most Asian equity indices are typically comprised of 20-25% of exporting stocks (which should struggle as Asian currencies move higher) and 30-35% of Asian financials (for whom the flattening yield curves could prove a headwind). In other words, investors into Asia who decide to solely get exposure through benchmark ETFs are likely investing more than half of their money in what should prove to be 'dead money'. Asia's very different cyclical and policy outlook argues against investing in indices and instead for concentrating on the parts of the market that will benefit from the higher currencies and lower long term interest rates. This of course includes long-dated Asian government bonds (see Managing Money in a Solvency Crisis), high-dividend yield paying stocks (which tend to always outperform when yield curves flatten and/or invert), utility stocks (see Assets to Own in a Triple Merit Boom), local consumption stocks and all the 'stable growth' stocks, whether pharmaceuticals, consumer staples, software and tech stocks, etc.

Take China as an example where the local market peaked back in August 2009 and has since then given up more than a quarter of its value. Usually, in the midst of such a pullback, almost all stocks would be affected. But what is interesting is that in the past 12 months, stocks linked to local consumption, and which one would expect to hold up decently as yield curves flatten, have done precisely that. In a sign of unprecedented maturity for the Chinese market, most of the sectors listed above are actually trading at higher levels than they did when the Chinese market peaked in August 2009!

4- The Second Challenge: A Structural Shift?

We would be remiss if we brought up the outperformers in China's current bear market without highlighting the sectors that have brought the index down. And here, one finds mostly the sectors one would expect to see penalized by a flatter yield curve, whether financials, steel and cement (since there should be less construction), mining, oil & gas, real estate, etc. (see chart below)... But this underperformance raises the question of whether China's economy (and to some extent Asia's as China is increasingly the largest motor of Asian growth) is simply going through a cyclical adjustment? Or a structural shift?

For us, there is little doubt that it is the latter, for a number of reasons, including:

The fact that the momentum of exports to the developed world is unlikely to continue at the blistering pace of the past decade, whether because of higher base effects or weaker Western currencies and demand.
The fact that 'hard' infrastructure spending will lose steam, if only because a lot of the obvious infrastructure build-out (e.g., China's highways, high-speed rail lines, etc.) will soon be coming to completion.
But most importantly, because the era of cheap labor is now squarely behind us (see The End of Surplus Labor from a recent CEQ). This means that, unlike what we have witnessed in the past decade, any future spending on infrastructure, whether by the government or entrepreneurs, can no longer be funded by squeezing labor. In a Marxist world in which added value is split between workers, capital and governments, the workers are about to get a fairer shake... which is great news for consumption, but bad news for infrastructure spending.

And needless to say, when one buys an Asian ETF today, one buys an index that is heavily skewed towards a continuation of the infrastructure spending boom (i.e., steel stocks, coal mines, banks...), when what one wants to buy into is the unfolding Asian consumption boom (see our special report on Peak Sports, a Chinese sports shoe manufacturer and retailer for an interesting review of consumption trends in the Chinese heartland).

5- Higher Labor Costs Are A Genuine Paradigm Shift

Three years ago China's leading labor economist, Cai Fang of the Institute of Population and Labor Economics of the China Academy of Social Sciences (CASS), published a controversial book arguing that China's economy was about to hit a crucial turning point: the supply of "surplus labor" from the countryside was on the verge of drying up. Cai built on the development theory of British economist Arthur Lewis, who showed that early-stage industrial economies had two distinct sectors operating in parallel: a traditional agricultural sector with low productivity, and a modern capitalist sector with high productivity growth. In the early stage of industrialization, the impoverished traditional sector provides a large labor pool for the modern capitalist sector, which offers higher wages. This pool is at first effectively infinite, because the capitalist sector can continuously raise its demand for labor without raising real wages--or at any rate, raising wages well below the rate of productivity growth in the capitalist sector. But at some point--a moment dubbed the "Lewis turning point"--the pool of labor in the traditional sector becomes smaller than the demand for labor in the capitalist sector, and this changed supply-demand balance requires real wages to rise. In the first industrial revolution in the United Kingdom, real wages were static from the late 18th century until about 1840; after that they grew smartly. Japan hit its 'Lewis turning point' around 1960 and experienced very rapid wage growth thereafter. Cai's book asserted that China was about to hit the same turning point.

With the supply of young workers entering the labor force set to drop by onethird over the next dozen years, it now seems obvious that Cai was right and 2010 may well mark the year in which China hit its 'Lewis turning point'. This is a momentous change: for years, businesses have simply assumed that China has an unlimited supply of young people who can be had for modest wages and replaced at will. Over the next 15 years this will cease to be the case: businesses will have to pay more for entry level workers, and then work harder to retain them for longer, because they will not be so easy to replace.

The macroeconomic consequences of the Lewis turning point are large. Before the turning point, the capitalist economy grows mainly through an accumulation of factors - labor and capital. The efficiency with which those factors are used - in economists' jargon, "total factor productivity" or TFP--is secondary. After the turning point, sheer factor accumulation slows down, and efficiency or TFP gains must become the main driver of economic growth. In our view, this is now the most important question confronting Asian bulls such as ourselves: can Asia evolve from growth through accumulation of factors, to growth through productivity?

6- A Structural Rebalancing Towards Consumption

The answer to the above question would require another GaveKal book (and one that we may yet research and write should we find the time!) but regardless of the longer term trend, one thing now seems obvious: a certain amount of economic rebalancing will occur naturally, as households will grab a bigger share of national income, increasing their consumption power. This means that the central "imbalance" in China's economy, namely the excess of thrift, could soon start to abate and this should not be without consequences (for global interest rates? Global currencies? Regional growth? Etc...).

While it is important for a developing country to have a high national saving rate to finance large-scale investment in industry and infrastructure, it is true that China has taken this rule to an extreme: it saves and invests too much, and consumes too little of what it produces. In their intensive development eras, Japan, South Korea and Taiwan enjoyed peak national saving ratios of 35-38% of GDP. China maintained a similar saving rate in the 1990s and early 2000s, but after 2003 the saving rate soared, reaching 52% of GDP in 2009. This enabled China to finance investments totaling 47% of GDP, ten points higher than the peak ratios in earlier East Asian economies. And while we do believe that these absolute numbers are exaggerated, thanks to the chronic inability of the Chinese statistical system accurately to count consumption of services, the trend of rapidly rising national saving and investment, to levels that are almost certainly unsustainable, cannot be denied.

The question of why China saves so much has sparked much debate among economists. Some believe the rising saving rate reflects an increased tendency of households to save, because of an ever-more patchy social safety net, or for lifecycle reasons. Others (including ourselves) have argued that the main contributors to national savings have been ever more profitable companies and a parsimonious government. Usually, the debate boils down to an argument about how to interpret the "flow of funds" data in the national accounts, which track the sources of income in the whole economy. These data are of questionable quality, frequently revised, and hard to square with other economic statistics. Happily, recent careful work by two economists at Tsinghua University, Bai Chong'en and Qian Zhengjie, resolved many of these difficulties and made clear that virtually all of the increase in China's national saving since 2000 has been in the corporate and government sector. Bai and Qian reconciled national data with detailed provincial data, and found that the corporate saving rate rose from 16% of GDP in 1997 to 23% in 2004, after which it remained roughly constant. Government savings (much of which represents investments in infrastructure) exploded from 4% of GDP in 2002 to 12% in 2007. Household saving remained roughly constant at 15-17% of GDP during the whole 2000-07 period. And over that period, households tended to save a constant share of their income, a bit over one-quarter.

So household saving was roughly constant both as a share of GDP and of household income. But household consumption plummeted, from 46% of GDP in 2000 to 35% in 2008. If household saving was constant but the household consumption share of GDP fell, the only possible explanation is that household income's share of GDP also fell. And this is precisely what Bai and Qian found: by analyzing national and provincial data they estimate that the labor income share of GDP fell by 7 percentage points from 1997 to 2007.

Since the mid 1990s, Chinese wages have grown fast, but not as fast as GDP. As a result, household incomes - which are mainly a function of wages--grew slower than GDP. Consequently, household consumption's share of GDP also fell, even though households were not saving any more of their income. So if the government wants to boost the consumption share of the economy, it must try to boost the labor income share of GDP. In order to do so it must first understand why the labor income share fell so sharply in the first place.

Bai and Qian's answer to that question is straightforward. About two-thirds of the drop in the labor income share can be explained by the economy's structural shift from agriculture, where the labor income share is around 90%, to industry, where the labor income share is typically less than 50%; most of the remaining fall in the labor income share can be explained by a fall in the labor share within industry, mainly thanks to the restructuring of the state-owned enterprises sector in 1997- 2003, which resulted in the layoffs of many workers, large new capital investments, and the setting of wage rates more in line with productivity growth.

There can be almost no doubt that the sheer abundance of labor in the past two decades, which made it impossible for workers to bargain for a wage that matched the huge productivity growth being generated in industry, played a crucial supporting role to the processes described by Bai and Qian. But as labor becomes more scarce, wages will have to be bid up until they match or exceed the rate of productivity growth. This is what we are now witnessing all along China's coast (e.g.: Honda, Foxconn, etc...) Once wages grow faster than productivity, the labor income share of GDP will start to grow, and household consumption will begin to assume its rightful place as the main motor of the Chinese economy.

7- Conclusion

These are not easy times for Asian investors, what with global concerns weighing on markets (US double dip?, EMU solvency?, etc...), unprecedented cyclical adjustments (Asia now leading the tightening cycle), and a very important paradigm shift (the end of cheap labor in China). In the face of so many changes, one must remain nimble, and accept that being stubborn will not pay off. Instead, one has to remain very close to the market, identify where positive momentum is strongest--whether on earnings or share price performance--and question whether the momentum makes macro-sense before participating. Having said this, for us, a few key trends are already emerging. These include:

Asian currencies will remain well bid for the coming year and likely thereafter.
Long-dated Asian government bonds are increasingly the best hedge against equity risk for any portfolio. After all, if the twin 'fat-tail' threats to equity markets today are a) a double dip recession in the US and b) a solvency crisis in Europe, then long-dated Asian bonds can immunize the risk from either of these events... at least, this is what has happened in the past quarter!
Asian indices and ETFs are likely to suffer as the markets adjust to the new realities reviewed above; realities that are all too often under-represented in benchmarks. Investors deploying capital in Asia should do so with managers willing to stray massively from any benchmark.
Within the Asian equity markets, we would favor high-dividend yield paying stocks, utility stocks and stable growth stocks, especially those linked to the consumer.
Stocks linked to the infrastructure roll-out (steel, commodities, etc...) should be seen as a trade at best, or simply avoided, even if valuations now appear attractive. Such stocks were the main driver of the past decade's Asian boom. They will not be the leaders of the next decade.
As Francois-Xavier argued in a recent ad hoc comment (see The New Export Champions), going forward, Europe's machine tool and capital good exporters may not be the top performers in a portfolio of exporter stocks. Instead, investors should focus on the Western world's service exporters.

It Helps to be Rich

John Mauldin — Mon, 15 Mar 2010 19:00:00 GMT

Long time readers of Thoughts from the Frontline will be familiar with the name The Liscio Report. It is one of my "secret" sources of high quality analysis on a wide range of topics including taxes, employment and the underpinnings of the economic headlines that we read which can be so distorted. I say secret because they get nowhere near the attention their work deserves. Philippa Dunne & Doug Henwood, authors of The Liscio Report, do actual on the phone conversations with each of the various states on their tax collections, employment and so on. I find their primary research to be invaluable. Their real time proprietary research based on state withholding and sales tax receipts gives their clients a unique insight into the state of the US economy.

I have talked them into letting me send out their most recent letter, which I found very informative. While their work is not inexpensive ($7,500 annually), for hedge funds, banks, proprietary trading desks and those who need to know what is actually happening as opposed to whatever spin is being put out in the press, you should check them out at www.theliscioreport.com.

And before we jump into their report, I feel the need to comment on the revelations this last week about Lehman and what looks like can only be called fraud. How much more of this is going on? Regulators now have a road map to know what to look for. Auditors are now on notice that this lack of transparency and cooking the books at quarter's end must not be condoned.

And while we re on the topic of transparency, for God's sake, can't we get credit default swaps on an exchange before they blow us all up again? Please? Someone? Anyone? It's been two years. It's what brought Bear and Lehman down. Bluntly, the reason the banks oppose this is that the commissions for an OTC credit default swap are astronomical when compared to what will become a $10 commission on an exchange.

OK, I'll now stop my rant, and allow you to enjoy The Liscio Report. Have a great week.

John Mauldin, Editor
Outside the Box

Revenues stabilizing, though it helps to be rich

The Liscio Report

By Philippa Dunne & Doug Henwood

In February, 56% of the states in our survey met or exceeded their forecasted sales tax collections, up from 50% in January, and 13% reported positive collections over the year, down from 30% in January. Our intensity index, over-the-year rate of change weighted by state population, was –2.33%, about even with January's –2.28%, and the aggregated divergence from forecast held in the positive range at 0.26%, down a bit from January's 0.5%.

Both of the two last measures are showing real improvement: the over-the-year change, although still negative, is well off its record-setting lows (see below) and the divergence from forecast, with a few small exceptions, hasn't been positive since the fall of 2006.

For the various geographic regions, the good news is generally of a muted variety, and uneven no matter how you break them up. The best results came from states with large investment banking sectors--a few were both positive over the year and above forecast, one quite substantially so. The housing-bubble states without such sectors are slowly clawing back in the long, slow haul they anticipated, with one actually beating forecast by a hair.

The Midwestern manufacturing states continue to report mixed results. One reported the strongest year-over-year gains in the survey, and our contact there believes the relative stability of the major auto-makers is allowing "those who have jobs" to spend a bit more freely. Other states in the region did not do so well, but continue to report a stabilizing trend.

Greatest impatience was expressed by revenue officials around the country in smaller states with mixed economies. They expect to see revenues now moving into positive territory and another month of disappointing results is hard to take.

affluent tightwads

For the last two years, Gallup has been asking 1,000 Americans every day how much they've been spending at stores, restaurants, gas stations, and online. The average for upper-income households--those with incomes above $90,000--in February plunged to a new low of $98, down 13% from January. The numbers aren't seasonally adjusted, so the monthly changes have to be taken with a grain of salt, but the yearly change is a sharp –19%.

By contrast, spending by middle- and lower-income households has been more or less flat for a year. Both are way off their May 2008 peaks--down by almost half for both groups.

As Gallup's chief economist, Dennis Jacobe, pointed out in reporting these results on Wednesday, the retail economy badly needs freer spending by the well-off. That's where most of the discretionary juice is; households of more modest means just don't have the money to ramp up spending beyond the level of basics.

Jacobe attributes this tight-fistedness to "the new normal"--a general cautiousness born of economic uncertainty. Upper-income households are much less exposed to the vagaries of the job market than middle- and lower-income ones. For example, as a study by the Center for Labor Market Studies at Northeastern University reported in February, at the end of 2009, the average unemployment rate for the upper fifth of the income distribution was 2%; for the middle fifth, it was 6%; and for the bottom fifth, it was 19%.

the new normal

It's not just Gallup that's talking about a new regime of lower spending. In a new joint report, the consulting firms Kantar Retail and Price Waterhouse Coopers declare that "an enduring shift has taken place as a result of the Great Recession." Conspicuous consumption will give way to a more mindful sort of spending, and "rampant deal-seeking will be replaced by more purchases selectivity." Over the near future, people will apply the tools and consciousness they learned during the recession even as the economy recovers. Shoppers will put more effort into buying. Gone are the days of recreational browsing and impulse buying; shoppers will plan their purchases more, making lists and Googling for deals. There will be a stigma attached to wasteful spending--and purveyors of luxury goods will have to content themselves by selling to the actually rich alone, without any help from the aspirationally affluent. "Good enough" will take the place of the very best. The mix of goods may change. As Boomers approach retirement, they'll spend less and save more, ceding the cyclical lead to Gens X and Y--which means a bigger role for high-tech gadgetry. But overall spending is likely to remain muted.

Or so they say. The older among us, or the subset of those with still-intact memories, will recall that similar things were said in the early 1990s, when private labels and generic goods were all the rage. That trend faded as the job market recovered, the stock market bubble got going, and the former Chevy driver eventually just had to have an Escalade. Still, this sobriety is likely to be with us for some time--at least until the job market seriously recovers.

That said, spending on nonessentials has been recovering in recent months. Its growth rate is still lagging that of essentials, but the gap is closing. That's to be expected, but a return to 2006 certainly isn't.

By the way, as the graph below shows, the yearly change in sales tax collections in the SDI's universe correlates very nicely with movements in spending on nonessentials (r=0.87). This makes sense, since so many essentials are exempt from sales tax, but it's always gratifying when you can confirm good sense empirically.

Is this recovery secretly strong?

Every now and then you hear respectable analysts claiming that this recovery is stronger than anyone knows, or admits, or wants to contemplate. Rodney Dangerfield, who couldn't get no respect, is invoked in support of this claim.

We wish we could find something this encouraging in the data. To take the measure of the recovery, we've put together four cycle graphs, showing the behavior of some important indicators for the year before and after business cycle troughs. In all but one case (more on that one in a bit), values are indexed so that the trough month = 100. (We're assuming that the trough of the recent recession was in June 2009.) But instead of the usual recovery average, which blends together all upturns since the end of World War II (and which is how we've done this exercise most times in the past), we've done two averages--one representing the weak recoveries of 1991–1992 and 2001–2002, and the other, the strong recoveries of 1975–1976 and 1982–1983.

Graphed below are payroll employment and the unemployment rate. The recent trajectory of both measures is a lot closer to the "weak" line than the "strong." Employment is actually weaker than the "weak." In fact, if employment were hugging the "weak" line, there'd be over 600,000 more jobs in the economy than there were in February. If it were following the "strong" path, there'd be 3.2 million more jobs. Unemployment is close to the "weak" line; if it were following the "strong" path, the jobless rate would be a full point lower than it was in February.

Of course, the job market is only one part of the economic picture--though it's a very important part. What about the broad business cycle indexes? These have the virtue of giving a composite picture of all the economy's major aspects--and using them is a nice check on the temptation to cherry-pick data to prove the point you want to prove.

Two of those composite indexes are graphed below--the Conference Board's coincident index and the Chicago Fed's National Activity Index (CFNAI). The Conference Board index, after having fallen hard in the recession (like the employment indicators), is almost a dead-ringer for the "weak" line.

The CFNAI is the only one of these indicators that isn't indexed so that the trough month is set to 100. The reason for that is that the index itself is normalized over time so that its long-term average is 0, which is also the economy's long-term trend growth rate. Any value above 0 is over trend; any under 0, under trend. A value of 1 is a standard deviation above average. Values above .70 are thought to be where the economy is running far enough above trend that inflation is a worry. Historically, the CFNAI has proven to be a good real-time measure of the state of the business cycle.

Here too, we're much closer to "weak" than "strong"--and still below 0. Seven months into a strong recovery, the CNFAI has averaged 1.0--meaning that we're more than a standard deviation below a strong recovery's reading.

So, no, this is not a Rodney Dangerfield recovery. Maybe it will become one--but we doubt that the markets will be inclined to badmouth the strength of the thing in the coming months.

Philippa Dunne & Doug Henwood

Penury, self-imposed or inflicted, the new normal?

John Mauldin — Mon, 14 Sep 2009 15:04:00 GMT

One of my favorite sources of information is The Liscio Report by Philippa Dunne & Doug Henwood. Among other things, each month they survey all the states about tax revenues, expenses and then give us the results in a very pithy fashion. No one pays taxes unless they have to, and thus taxes tell us a lot about the current spending and income situation. Taxes are a far more reliable indicator then surveys, which most "data" is based on. They also look at various trends in a variety of topics. No surprise, this issue they talk about the numbers on retail sales, noting certain segments are up (essential spending) but sales for non-essential items are way down. This is very interesting to me. It is, as they point out, part of the journey to the new normal. They graciously allowed me to send this letter on to you as this week's Outside the Box. Those of you who might wish to learn more about theme can go to www.theliscioreport.com or drop them a note at online@theliscioreport.com.

John Mauldin
Editor, Outside the Box

Penury, self-imposed or inflicted, the new normal?

The Liscio Report on the Economy

In August, 30% of the states in our survey met or exceeded their forecasted sales tax collections. This is a big jump from July's 12%, and the best showing since August 2008's 50%. The percentage of states reporting growth over the year was just 1.43%, down from July's 1.59%, so basically flat and zero, and the intensity index (over the year percentage change weighted by state population) rose to -7.0% from July's -8.3%.

It is good news that actual collections are in line with forecasts for a larger percentage of our contacts, and in our universe narrowing the gap between actual collections and forecasts is the first step toward real improvement, no matter how weak those forecasts are.

We do want to underscore that forecasts have been revised down hard, and continue to be for extremely weak collections, in almost all cases negative over the year, and in some for double-digit declines.

Our sales tax survey began falling from its recent high of 81 in February 2006, edged back up to the low 70s in fall of 2007, and has fallen, albeit noisily, since. Sales receipts falling below prior-year levels has in the past been a sporadic and mostly calendar-driven event.

Currently many states have seen negative collections for over a year and, if we're lucky, the survey is now stabilizing in "unheard of territory." That's what led one contact to say: "Now, before we throw a party to celebrate the best monthly performance since November (-3.6%) - let's realize it still sucks and shows how much consumer retrenchment is still in place. Adjusting for calendar effects, we now have had 14 months of negative sales tax."

Tentatively encouraging news is that although there is no demographic or regional pattern, at least the survey did not come in with prior months' resounding thud: although the majority of our contacts are not seeing any real improvement, and supplying discouraging details, some contacts are reporting an improving situation, along with some stability in housing and their own confidence surveys. But concerns about heavy headwinds and what will happen now that Cash for Clunkers has clunked out remain in the forefront.

Just The Essentials

It's been a few months since we updated our graph of retail spending on essentials vs. more discretionary items. As of July, it looks like consumers are still concentrating on the essentials.

Graphed below are the yearly (nominal) changes in spending in food and beverage stores and drugstores compared to the changes in all other spending (less autos and gas). (Gas is also mostly an essential, but its price has been so volatile that it clouds the picture somewhat; still, the graphs would look little different had we included it as an essential.) For the year ending in July, spending on essentials, by this definition, was up 0.6%; spending on everything else was off 6.2%. That gap, 6.8%, is the widest since the new retail series began in 1992.

A gap this wide looks like a real structural shift in spending behavior, as austerity becomes the new normal. Though Americans have shaken off bouts of prudence before, like that of the early 1990s, with consumer credit constricted, household balance sheets ravaged, and labor income weak, it's probably going to take some time before anything resembling extravagance returns.

The Auto Bounce

That said, the federally subsidized bounce in auto sales in August was an extraordinary departure from recent trends (see graphs). It's not the biggest monthly leap ever -- sales rose 35% in October 2001 (thanks to the post-9/11 sales incentives), and 43% in January 1971 (following a strike against GM, which depressed sales late in 1970) -- but it's still impressive. Unit sales, which have been running almost 50% below trend for most of this year, rose to 82% of trend, the highest in nearly a year and a half.

As the graphs show, that bounce looks like earlier end-of-recession turns. The question is, of course, how much of this can be sustained without Washington's help. A $4,500 subvention isn't just gravy -- it's practically a meal in itself. Given how depressed sales have been -- though there was no serious decline in auto sales during the 2001 recession, the recent slump is without precedent in more than 40 years of monthly unit sales data -- there's room for a substantial bounce. But will incomes and the credit markets be there to fund one?

Credit Retrenchment

Speaking of consumer credit, July's decline, while not the worst ever, was about two standard deviations below the mean -- and the yearly decline is now the sharpest ever. (See graphs) The decline is being driven by revolving credit, meaning mainly credit cards. Partly offsetting that contraction, though, is continued strength in revolving home equity lines of credit (HELCs), whose yearly growth is surprisingly closer to its 2004 high than the 0 line.

And, as we keep pointing out, the longer-term picture suggests that deleveraging has only begun. Measured against after-tax income, consumer debt levels are drifting lower, but have a long way to go even to get back to late 1990s levels.

That's especially true if you add HELCs to the traditional forms of consumer credit. Recent declines in the consumer debt burden are considerably milder than we saw in previous recessions (and note that the declines typically continue for at least several months after the cyclical trough).

Benefit Squeeze

With health reform in the news, we thought it might be interesting to take a look at what's been happening in the realm of employee benefits. In a phrase, it looks like employers have been enacting some reform of their own, and they may be feeling no great urgency for systemic changes.

For the year ending in the second quarter of 2009, benefit costs for private employers are were up just 1.3%, the lowest since the BLS series begins in 1983. (See graph) That's a remarkable swing from 2004's rise of 7.4%. Benefit costs are now rising more slowly than direct pay, which has hardly ever happened in the last 25 years.

As the graph shows, the swing isn't entirely the result of a squeeze in health benefits; other benefits, like pensions, are also being squeezed. Health insurance costs for employers are rising just over 4% a year. But that's way down from the over-11% tempo of 2002.

As the graph shows, though, that decline isn't the result of any serious slowdown in medical inflation. No doubt there's a lot of shifting of costs onto employees going on, either in the form of dropped coverage or higher co-pays.

As we pointed out in our July 13 issue, a substantial portion of the rise in consumption over the last couple of decades has been driven by spending on medical care. With all this apparent cost-shifting from employers to employees going on, pressures on household budgets have been increasing -- another reason to wonder where any sustained consumption revival can come from.

Tuesday's Retail Numbers

We're expecting August headline retail sales to come in at a stronger than consensus +2.5%, +0.6% excluding autos -- and a much more tepid +0.2% excluding both autos and their fuel. States tax motor vehicle sales in different ways, but the majority of those that break out sales taxes on autos saw dramatic increases in July and in August, and we expect auto sales to make a larger contribution to the headline than July's +0.5%.

In July the ICSC anticipated that a somewhat late back-to-school season moved 0.5% in sales from July into August, and their August numbers suggest this shift took place. Retailers were reportedly surprised that August was as good as it was, and the markets may well be surprised by a stronger than anticipated retail report.

Whatever the noisy series tells us about August shopping, however, we anticipate it will take an unusually long time for American consumers to have the confidence (and means) to begin spending again over the longer term.

-- Philippa Dunne & Doug Henwood

Slow Long-Term Growth, And Government's Response

John Mauldin — Mon, 10 Aug 2009 20:50:00 GMT

This week I am really delighted to be able to give you a condensed version of Gary Shilling's latest INSIGHT newsletter for your Outside the Box. Each month I really look forward to getting Gary's latest thoughts on the economy and investing. Last year in his forecast issue he suggested 13 investment ideas, all of which were profitable by the end of the year. It is not unusual for Gary to give us over 75 charts and tables in his monthly letters along with his commentary, which makes his thinking unusually clear and accessible. Gary was among the first to point out the problems with the subprime market and predict the housing and credit crises. His web site is down being re-designed, but you can write for more information at insight@agaryshilling.com. If you want to subscribe (for $275), you can call 888-346-7444. Tell them that you read about it in Outside the Box and you will get not only his recent 2009 forecast issue with the year's investment themes, but an extra issue with his 2010 forecast (of course, that one will not come out until the end of the year. Gary is good but not that good!) I trust you are enjoying your week. And enjoy this week's Outside the Box....

John Mauldin, Editor
Outside the Box

Slow Long-Term Growth, And Government's Response

(excerpted from the August 2009 edition of A. Gary Shilling'sINSIGHT)

Beyond the current recession, the worst since the 1930s, lies years of slow growth, as we've discussed in pastInsights. The next economic recovery, which will probably start around mid-2010, will likely be so subdued that it may not feel like the recession has ended. And economic growth in the bulk of the next decade will probably be slow -- so slow that it will force the federal government to take continuing actions to prevent high and chronically rising unemployment.

Six Causes of Slow Long-Term Growth

As explored in detail in pastInsights, six forces will promote slow long-term growth in the U.S. and, indeed, on a global basis -- U.S. consumer retrenchment, financial sector deleveraging, weak commodity prices, increased government regulation and involvement in the economy, protectionism and deflation.

Consumer Retrenchment. First and foremost is the dramatic switch by American consumers from a 25-year borrowing and spending binge to a saving spree that should extend a decade or more. As we pointed out last month, in the 1980s and 1990s, U.S. consumers regarded their soaring stock portfolios as continually filling piggybanks that would fund their kids' education, early retirements and a few round-the-world cruises in between. So they slashed their saving rate and pushed up their borrowing to fund spending growth that consistently exceeded the rise in after-tax income. When stocks nosedived with the collapse in the dot com bubble in 2000-2002, leaping house prices seamlessly took over to finance oversized consumer spending growth.

But now stock and house prices -- the vast majority of most Americans' net worth -- are not only depressed but also unlikely to revive to their former glory days for many, many years. Furthermore, our earlier research found no other major consumer assets that could be borrowed against. So consumers are being forced to embark on the saving spree we have been predicting for some years.

For the next decade, we're forecasting an average one percentage point rise in the saving rate annually, raising it to 10% in 10 years. That still would not return the saving rate to the early 1980s level of 12% even though the demographics for saving have gone from the worst to the best in the interim. And even a decade of vigorous saving will probably not return household net worth even close to its former peaks or eliminate completely the three decades of ever-increasing household financial leverage.

Financial Deleveraging. Financial deleveraging will also reduce long-term economic growth. As we've discussed in many past Insights, the recession really started in early 2007 in the financial arena with the collapse of subprime residential mortgages. Then it spread to Wall Street in mid-2007 with the complete mistrust among financial institutions and their assets, too many of which were linked to troubled mortgages. A huge gap opened up back then between the 3-month LIBOR and Treasury bill yields, and that panicked Washington into opening the money floodgates. The Fed started its interest rate-cutting campaign that ultimately drove its federal funds rate target to the zero-to-0.25% range (Chart 1 ).

But the central bank soon found the banks were too scared to lend and creditworthy borrowers didn't want to borrow when Bear Stearns and Lehman collapsed and other large banks and Wall Street houses were on the brink. So the Fed embarked on quantitative easing that exploded its balance sheet. And Congress and the Administration joined in with the $700 billion TARP, the $787 billion fiscal bailout and many other programs, as witnessed by the exploding federal deficit.

The Bank for International Settlements recently said only limited progress has been made in clearing up the global financial system, and any economic recovery will be short-lived and followed by a long period of stagnation unless bank balance sheets are corrected.

Except for hotels, commercial real estate woes aren't so much the result of overbuilding, as is the case with residential. Rather, the problems are due to aggressive refinancing and pricing in earlier years as well as current slumping demand. As retailers close stores or fold completely, mall space becomes vacant. Warehouses are empty as consumer retrenchment curtails goods imported from Asia and elsewhere. Excess space and weak business and leisure travel is axing hotel room rates and occupancy. Layoffs result in sublease office space competing with landlords for tenants.

Furthermore, a great deal of real estate debt must be refinanced soon amidst falling occupancy, rents and sales prices as well as tight credit markets. Estimates are that $155 billion in securitizations are coming due by 2012 and two-thirds won't qualify for refinancing as prices drop 35% to 45% from their 2007 peaks. Meanwhile, $525 billion of commercial mortgages held by banks and thrifts will come due by 2012. About 50% won't qualify for refinancing since they exceed 90% of the underlying property value. Lenders prefer loans of no more than 65%.

Deleveraging of the financial sector will obviously have negative ramifications for the real economy it finances. We've already seen plenty of effects. Many small businesses that depend on outside financing are starving as banks tighten lending standards. In a sense, many derivatives were financial cobwebs spun among bank and other speculators, but they did finance much of the housing boom.

Commodity Crisis. The earlier collapse of the commodity bubble (Chart 2) will also subdue global economic growth in future years. Sure, commodity consumers benefit from lower prices by the same amount that producers lose. But the share of total spending on commodity imports by consumers, especially in developed lands, is tiny while they account for the bulk of exports for producers, many of them developing countries such as Middle East oil producers.

Furthermore, security losses last year devastated sovereign wealth funds, many of them in oil-rich countries as well as Asian exporters. A year ago, they were estimated to hold $3 trillion in assets on their way to $10 trillion. Now the estimate is $1.8 trillion and optimistically forecast to rise to only $5 to $6 trillion by 2012. Lower oil prices have a lot to do with the downward revisions. Singapore's huge Temasek Holdings fell more than $28 billion, or 22%, at the end of March from a year earlier.

More Government Regulation. So, U.S. consumer retrenchment, global financial deleveraging and weak commodity prices will keep worldwide economic growth subdued for many years. So, too, will vastly increased regulation here and abroad, the normal reaction to financial and economic crises, as noted in our earlier reports. When a lot of people lose a lot of money, there is a cosmic need for scapegoats and increased regulation. Sure, many embarrassed financial wizards have sworn off their wayward ways and will be cautious for years, probably the balance of their careers. But that won't stop witch hunts.

The Administration has proposed a substantial overhaul of financial regulation. It doesn't plan to combine regulators to eliminate overlaps and gaps, as originally discussed. Still, it would empower the Fed to monitor financial risks to avoid systemwide instability; create a Consumer Financial Protection Agency with control of mortgages, credit cards, savings accounts and annuities; push public companies to give shareholders say on pay; bring hedge funds under federal regulation; require firms to hold some of mortgage securitizations they create and sell; force derivatives to be traded on exchanges; beef up oversight of insurance; force industrial loan companies to obtain bank holding company charters; urge the SEC to stem runs on money market funds and to strengthen regulation of credit rating firms; create a mechanism for government to takeover large, failing financial institutions; and amends the Fed's lending powers to require the Treasury Secretary's approval.

The first Obama federal budget also points clearly to more government regulation and involvement in the economy, in health, education and the environment. Beyond the financial sector, the bailout of U.S. auto producers led to considerable government control of that industry, almost day-to-day management by Washington.

Rising Protectionism. Without question, protectionism will slow or even eliminate global economic growth as international trade slumps. As noted in earlier Insights, recessions spawn economic nationalism and protectionism, and the deeper the slump, the stronger are those tendencies. It's ever so easy to blame foreigners for domestic woes and take actions to protect the home turf while repelling the offshore invaders. The beneficial effects of free trade are considerable but diffuse while the loss of one's job to imports is very specific. And politicians find protectionism to be a convenient vote-getter since foreigners don't vote in domestic elections.

As noted earlier, initially this recession was in the financial arena -- the collapse in the residential mortgage market led by the Subprime Slime that started in early 2007, and the follow-on Wall Street woes that commenced in the middle of that year when two big Bear Stearns hedge funds imploded. So it's not surprising that protectionism began in the financial arena and took the form of competing to safeguard a country's financial institutions. But at least that competition was positive for financial systems and economies, even if expensive for taxpayers.

Now, however, protection has spread to its more classical import-export arena with the advent late last year of massive U.S. consumer retrenchment and globalization of the downturn. Both forces are severely depressing the goods and services sectors as U.S. consumer spending falls the most since the 1930s and unemployment here and abroad leaps.

Since the early 1980s, world trade has functioned in a smooth but unsustainable fashion. The rest of the world produced and America consumed. In many foreign lands, households were weak consumers and big savers, so production exceeded domestic consumption. Their production surpluses were exported, directly or indirectly, to the U.S. where consumers were saving less and less and spending more and more. With their growing trade surpluses, foreign nations had growing piles of dollars that they recycled into Treasurys and other American investments, helping to hold down interest rates and making it cheaper for spendthrift American consumers to borrow easily and cheaply to fund their leaping debts.

Now, with American consumers embarking on a saving spree, the U.S. will no longer be the buyer of first and last resort for the globe's excess goods and services. Furthermore, with slower global growth for years ahead, virtually every country will be promoting exports to spur domestic activity. When every country wants to export and none want to import, the pressure for protectionism leaps.

Deflation. Chronic deflation is the sixth reason we forecast slow economic growth in the next decade or so. Chronic deflation spawns self-fulfilling deflationary expectations. Today, who would have the guts to tell a friend he paid the full sticker price for a vehicle? Years of rebates have trained car buyers to expect continuing and even bigger rebates. So they wait to buy. That leads to excess inventories that require even larger price concessions. Buyer suspicions are confirmed so they wait longer, promoting more inventory buildup, more price cuts, etc. in a self-feeding cycle. A key effect, of course, is to retard spending and slow economic growth.

Long-time Insight readers know that we have been forecasting chronic deflation to start with the next major global recession. Well, that recession is here. We earlier forecast chronic good deflation of excess supply because of today's convergence of many significant productivity-soaked technologies such as semiconductors, computers, the Internet, telecom and biotech that should hype output and depress prices. As a result of rapid productivity growth, fewer and fewer man-hours are needed to produce goods and services. Big output growth also results from the globalization of production and the other deflationary forces we discussed in and since we wrote our two Deflation books a decade ago. With U.S. consumer retrenchment and a shrinking pool of global imports, export-dependent lands will be competing even more fiercely for the remaining markets.

In contrast to good deflation, bad deflation reigned in the 1930s as the Great Depression pushed demand well below supply. Japan also suffered bad deflation over the last two decades after the collapse of her 1980s housing and stock market bubbles. But in Japan, the lack of demand wasn't caused by a dearth of employment and income as in the U.S. in the 1930s, but because the government delayed cleaning up her financial institutions while consumers refused to spend their incomes.

We've consistently predicted the good deflation of excess supply, but we've also said clearly that the bad deflation of deficient demand could occur -- due to severe and widespread financial crises or due to global protectionism. Both are obvious threats, as explained earlier.

Few agree with our forecast of chronic deflation. They've never seen anything but inflation in their business careers or lifetimes, so they think that's the way God made the world. Few can remember much about the 1930s, the last time deflation reigned. Excessive monetary and fiscal stimuli are also key reasons why most observers forecast chronic and severe inflation in future years. They may concede that deflation is more likely in the balance of the recession (Chart 3) for the reasons we've cited in pastInsights. Past weakness in commodity prices is still working its way through the production and distribution system. Surplus inventories (Chart 4) -- the result of producers, wholesalers and retailers being caught unaware when consumers suddenly retrenched last fall -- are still being worked off and depressing prices in the process.

Wage cuts and mandatory furloughs for the first time since the 1930s, as well as layoffs are obviously deflationary as they depress purchasing power. In addition, the excess of supply overdemand has clear implications for deflation.

Nevertheless, the vast majority still maintain that inflation is inevitable in the long run. All the money being pumped out by the Fed and the Treasury deficits is sure to stimulate too much demand in relation to supply, they believe. But before money can promote excess demand, it's got to get into circulation, and scared lenders and creditworthy borrowers are unlikely to convert massive bank reserves into money until rapid economic growth resumes. And that, we believe, is unlikely for many years. Furthermore, if economic growth and loans mushroom, contrary to our forecast, major central bankers, with their congenital fear of inflation, will no doubt withdraw much of that liquidity.

Slow And Weak Recovery

We continue to forecast that the recession will extend into early 2010. Only by then is enough fiscal stimulus likely to be pumped out to stabilize consumer retrenchment. By then, most of the global financial woes should be at least stabilized. And by then, enough excess house inventories may be absorbed to end the downward pressure on prices.

Excess house inventories were built up in the 1996-2005 boom and still number about 1.5 million new and existing houses above normal working levels despite the collapse in housing starts and recent stabilization in sales. Excess inventories are the mortal enemy of prices in any goods-producing industry, especially housing. We continue to believe it will take at least until the end of next year before excess house inventories are reduced to levels that no longer depress prices. Meanwhile, prices -- already down 32% from their second quarter 2006 peak -- are likely to fall to reach a total 37% decline we've forecast for the last two years.

The decline in house prices is evaporating home equity. In the early 1980s, those with mortgages had almost 50% equity in their houses on average, after subtracting all mortgage borrowing from the market price of their homes (Chart 5). Due to increasing mortgage leverage and, more recently, collapsing house prices, that equity was only 20% in the first quarter and continuing to fall.

If house prices drop about 37% from their peak to their final bottom, that equity will be down to about the 15% range. At that point, over 25 million homeowners, or half those with mortgages, will be under water, compared to about 25% today.

After the recession ends as the economy stops falling, a weak recovery is likely to follow, one so tepid and with such high unemployment that you may not know it has arrived. The two normal forces that generate economic recoveries are missing this time. As usual, the Fed eased monetary policy once it saw that the economy was headed for recession.

But unlike the past, Fed action is not reviving housing (Chart 5), given the overhang of excess house inventories. And the normal pop in production when the liquidation of overall inventories ends (Chart 6 ) will be muted and overshadowed by the unusually large slashing of consumer spending. It's hard for businesses to cut inventories fast enough to keep up with dropping consumer demand.

2.0% GDP Growth

A chronic 1 percentage point annual rise in the consumer saving rate for the next decade or so will knock around 1 percentage point off real GDP growth after its effects work their way through the economy. That's a big contrast with 0.5 annual percentage point declines in the saving rate over the previous quarter century that added around 0.5 percentage points to growth. That total swing of 1.5 percentage points will reduce real GDP growth from 3.6% per year in the 1982-2000 salad days (Chart 7 ) to 2.1%.

So with the five other inhibitors to growth in coming years -- financial deleveraging, weak commodity prices that will retard spending by producing countries, more government regulation and involvement in the economy, rising protectionism and deflation -- our forecast of 2.0% real GDP growth is probably even optimistic.

With 2% to 3% deflation, nominal GDP might not gain at all. And with slower growth in the years ahead, economic expansions are likely to be shorter and less robust while recessions will probably be deeper and more frequent.

Consumer Spending Growth

We're also forecasting real consumer spending growth of 1.4% per year in the next decade. That, too, may be optimistic as consumers retrench and slash real debt which far outran real housing wealth even before it collapsed, outran real annual growth in real stock wealth before it nosedived, and bested real disposable income growth. Much of the explosion in debt was residential mortgage-related borrowing in the mid-1990s - mid-2000s housing bubble, fueled by low borrowing costs, weak lending standards, exotic mortgages and securitization, which distributed toxic mortgage loans to unsuspecting investors.

The deleveraging of consumers that we expect to continue for years is a reversal of the same longrun phenomenon of past decades that was measured in different ways -- the decline in the saving rate, the rise in debt and debt service rates and the rise in consumption's share of GDP, reflecting what consumers did with the money they didn't save and did borrow.

Consumption vs. GDP

With real consumer spending forecast to grow 1.4% annually over the next decade and real GDP 2.0%, real consumption's share of GDP falls from 71.0% last year to 66.5% in 2018 (Chart 7). That would bring it back to the level of the early 1980s when the consumer spending binge began (Chart 8 ). It may seem inconsistent that we're forecasting a rise in the household saving rate of 10 percentage points but a decline in real consumption's share of real GDP of only 4.5 percentage points from 71% to 66.5%. But note that the reverse occurred in the last 25 years -- the saving rate fell from 12% to zero, or 12 percentage points while consumption's share of real GDP rose from 67.5% to 71%.

These differences are in part because household saving is being measured as a percentage of disposable (after-tax) income, which is less than GDP, so the effects of the change in the saving rate on GDP are muted. In the earlier 1980s, real disposable income was about 78% of GDP. Furthermore, the rise in consumption's share of real GDP in the 1982-2000 boom years (Chart 8) was actually held back by the drop in the real DPI/real GDP ratio. That in turn was largely the result of employee compensation's share of national income falling while corporate profits' share leaped during those years.

In the years ahead, however, it's unlikely that DPI will decline as a share of GDP. As we discussed in earlier years when profits' share was at its zenith, a big decline in corporate earnings' piece if the pie was probably in the cards. In a democracy, we noted, neither capital nor labor can continually increase its share indefinitely while the other one's share chronically shrinks. We also suggested that the recession and financial mess we were forecasting, the worst since the Great Depression, would depress profits. We also opined that Obama Administration and Democratic-controlled Congress would be adverse to shareholders while smiling on their labor constituents.

Where's The Growth?

If consumer spending grows slower than GDP in the next decade, other GDP components must grow faster. Which ones? As shown in our forecast table (Chart 7), it's unlikely to be residential construction, which we see growing 1.0% per year in real terms compared with 5.2% in the 1982-2000 years. Housing should remain weak even after the huge excess inventory is worked off. Earlier, homeowners were convinced that house prices never declined -- and they hadn't on a nationwide basis since the 1930s.

But the recent collapse in house prices and the prospect that they will move with overall prices in the future -- which means chronic declines with chronic deflation -- are shattering the scales that blinded homeowners. So they're beginning to separate places to live from investments. That means they'll want smaller quarters, and the new houses that are built will be smaller and less expensive.

Capital Spending

Real spending on nonresidential structures grew only 0.6% per year in the 1982-2000 era as overexpansion in the earlier years curtailed spending later on. With slow economic growth in the years ahead, demand for warehouse, factory, office and hotel space is likely to be subdued. Ongoing consumer retrenchment will keep retail vacancies high and new building low. On balance, we project about the same growth rate for real nonresidential construction, 0.5% per year, in the next decade.

Equipment and software real spending advanced briskly in the 1982-2000 years, 8.2% annually as new technologies such as computers, semiconductors, the Internet, biotech and telecom absorbed tremendous amounts of spending. Furthermore, inflation and interest rates were declining (Chart 9 ) to the benefit of the corporate sector, and operating rates were generally high while profits growth was robust. Those new technologies will continue to attract heavy spending in the next decade, but their initial huge bursts of spending are probably over. Furthermore, although the interest costs to finance capital investment will probably remain low, especially with deflation, profits will probably remain under pressure in an era of slow revenue growth and deflation. And most important, capacity utilization rates are likely to remain low.

A statistical model that we've run many times over the years and just updated shows that year-over-year changes in corporate profits, interest costs and capacity utilization in the post-World War II era are all statistically significant in explaining year-over-year growth in both the equipment and software component of GDP and equipment and software plus nonresidential construction. But in either case, capacity utilization is much more important with coefficients almost three times as large as those for interest costs and even bigger relative to those for profits in both models (Charts 10 and 11).

We forecast annual real growth in equipment and software investment of 3.0% per year in the next decade, faster than the 2.0% we foresee for real GDP but much less than the 8.2% in the 1982-2000 golden years.

Imports and Exports

With weak consumer spending growth and overall muted economic advance, real imports are likely to rise only 2.8% annually in the next decade, much less than the 9.0% growth in 1982-2000 when U.S. consumer spending was booming and free trade ruled the world. This forecast is even lower than suggested by our 1.4% annual growth in real consumption. Historically, a 1% rise in consumer spending results in a 2.8% rise in imports, but rising protectionism is likely to dampen that relationship.

This weakness in U.S. imports will leave profound effects on the many foreign economies that have depended for growth on American consumers buying the excess goods and services for which they have no other ready markets. The net effect of subdued growth in U.S. imports will be sluggish economic growth abroad, perhaps even slower in other developed lands than in the U.S. That should limit the growth in U.S. exports to 3.0% per year compared with 7.4% in the 1982-2000 years (Chart 7). Still, government policies in Asia and elsewhere that promote consumer spending are likely to result in U.S. exports growing slightly faster than American imports, the reverse of earlier years. Severe protectionism, however, may stymie even these low growth forecasts for foreign trade.

State and Local Government Spending

Real state and local government spending, as recorded in the GDP accounts, rose slower than real GDP in the 1982-2000 years, 3.2% vs. 3.6%, and no doubt would in the years ahead -- except for federal government stimuli that's spent by municipalities, as discussed later. State governments are in terrible financial shape and likely to continue so in the years ahead. In the first four months of this year, state income taxes plunged 26%. In the economic climate we foresee, corporate, sales and individual income taxes will all remain depressed.

At the local level, collapsed real estate prices will hold down property tax collections in the years ahead while reductions in aid and revenue-sharing from state governments will persist. In a recent survey, 18 states reported cuts in local aid. California Gov. Schwarzenegger proposed that low-level crimes like auto theft and drug possession be considered only misdemeanors so those convicted would do time in county jails. That would reduce state prison expenses and save the state $1.1 billion in the next three years, but raise local government costs. Furthermore, California's latest budget stopgap will take, temporarily, $4 billion from local government funds.

We're forecasting 5.0% annual growth in state and local government spending in the next decade, but the majority of it will probably come from Washington, which will be forced to spend heavily to prevent high and chronically rising unemployment.

Rescued By Slow Productivity

Some suggest that slower economic growth will bring slower growth in production. That would reduce the upward pressure on unemployment since more people would be needed for work than with faster productivity growth. But there's no evidence that productivity growth necessarily slows with a chronically weak economy. In the depressed 1930s, productivity grew 2.39% annually, among the highest decades since 1900. In that decade, much of the new technologies of the 1920s -- electrification of homes and factories and mass-produced automobiles -- was being implemented, despite the Great Depression and its slow growth aftermath.

Similarly, the new tech burst of the last decade or so in computers, the Internet, biotech, telecom and semiconductors will no doubt promote rapid productivity growth in coming years.

Finally, the mindset of American business will probably promote robust productivity growth in future years. Throughout this decade, the emphasis has been on producing more with fewer people. Note (Chart 12) that even at the top of the expansion in 2007, job openings were fewer than in 2000 at the peak of the previous expansion, despite the growth in the economy in the meanwhile. And since 2007, job openings have collapsed.

Unemployment will also remain high since many of the people who have lost jobs were in construction and finance, two areas that will probably do little net hiring for many years. Normally, a 2 percentage point drop in real GDP causes a 1 percentage point rise in the unemployment rate. But June's 9.5% rate is 1.5 percentage points higher than this rule of thumb would predict, given the drop so far in real GDP.

Big Federal Spending

If we're right, then, on our forecast of slow economic growth in the next decade, unemployment will be high and chronically rising -- absent huge federal intervention. And that intervention is assured since no government -- left, right or center -- can withstand high and rising joblessness for long. And don't forget current as well as future increased federal immersion in the economy builds constituencies that fight fiercely to preserve their government goodies.

Some of this federal intervention will probably take the form of more federal employees and direct purchases of goods and services, which show up in the GDP breakdown (Chart 7). But most of it won't be recorded as the federal spending GDP component since it will be transferred to individuals as federal unemployment benefits, extra Social Security checks, etc. and to state and local governments to fund leaf-raking and other make-work projects.

Notice that in 2018, we project real federal spending to account for only 7.2% of real GDP, up from 5.9% in 2008. Of course, nobody but economists look at these measures of federal spending, but instead concentrate on the ratio of total federal budget spending to GDP. This ratio mixed apples and oranges since budget spending includes transfers that GDP does not, but it does measure federal involvement in the economy.

In 2008, federal spending equaled 21% of GDP, outdistancing the 17.7% from revenues. This gap is likely to widen even after the current extraordinary spending to combat the recession and financial mess is over. Anti-unemployment spending will jump to higher levels while federal revenues languish. How will the resulting large deficit be financed?

Savers To The Rescue

In the past, federal deficits were financed by foreigners as they recycled back to the U.S. the dollars gained from their trade surpluses, as noted earlier. The growing U.S. current account deficit measures the increasing gap between domestic saving and investment, or, in effect, and the need for foreigners to not only finance government deficits but also make up for declining U.S. consumer saving.

But now, the current account and trade deficits are shrinking as American consumers retrench and slash imports. Further declines will accrue in future years if exports grow faster than imports (Chart 7), so foreigners will have smaller American current account deficits to finance. At the same time, much more of federal deficits will probably be financed by rising U.S. consumer saving.

Household saving is basically what's left from wages, salaries, rent, interest, dividends and transfers like pension benefits after subtracting spending on durables like autos and appliances, non-durables such as food and clothing and services like recreation and medical services. That amount, divided by the after-tax income in the period in question, is saving rate. Saving can be used to either reduce debt or increase assets.

Debt Reduction

Although the stock bulls may salivate over the prospect that increased saving will mean more equity purchases, we believe that most of the money will go to debt repayment -- the flip side of a saving spree. The 6.9% saving rate in May, mentioned earlier, was a result of consumers saving their tax cuts and extra Social Security payments, and is unsustainable. Still, since after-tax income was about $11 trillion at annual rates in May, this saving rate produced annual rate saving of $769 billion. That money was basically used for debt reduction and since money is fungible, it ended up financing a major part of the mushrooming federal deficit. As consumer saving grows in future years, it will increasingly finance the federal deficit, indirectly.

Repaying debt will be attractive to many Americans in future years as they shun many investments after their huge losses in stocks throughout this decade and their shocking setbacks in real estate. A number will want to be less leveraged as slower economic growth makes employment less stable and unemployment more likely. Chastened lenders, pressed by regulators, will be pushing individuals to lower their leverage by repaying debt.

So will the deflation we foresee. Incomes may grow on average in real or inflation-adjusted terms, but shrink in current dollars. Still, debts are denominated in current dollars and therefore will grow in relation to current dollar incomes and the ability to service them. This will be the reverse of inflation, which reduced the value of debts in real terms and makes it easier to service them as incomes rise with inflation.

Future Insights

In futureInsights, we'll update our 2006 study that showed that over 50% of Americans depend in a meaningful way on government spending. The number will probably be much higher in the coming decade of likely slow growth and greater government involvement in the economy. We also plan to discuss our investment themes for an era of slow growth and deflation.

Meanwhile, don't expect the burst of federal government spending and immersion in the economy to disappear with economic recovery. It's likely to persist, not only because it spawns self-perpetuating constituencies, but also because the slow economic growth in the years ahead and threats of high and chronically rising unemployment will force continuing high levels of government involvement.

U.S. GDP Review -- Consumer, Where Art Thou?

John Mauldin — Tue, 04 Aug 2009 16:20:28 GMT

This week I am in the office for just one day, but I can rely on my friend Dave Rosenberg to give us solid insight on the latest GDP numbers for this week's Outside the Box. Dave slices and dices to show us what really happened. David was the former Chief Economist at the former Merrill Lynch (ah, Mother Merrill, we barely knew ye.) and is now Chief Economist at Gluskin Sheff + Associates Inc., which is one of Canada's pre-eminent wealth management firms. Founded in 1984, they manage $4.4 billion. David notes that the data gives us a mixed picture.

I am in Maine later this week. It is likely I will be on CNBC, as they will be shooting live from our fishing camp. Also, they plan to do a one hour special with a number of interviews. I will let you know when it airs. A quick note from me: The third quarter is likely to be positive, especially given the success of the "Cash for Clunkers" program which it looks like our Congress is going to pass another round of spending which taxpayers (our kids) will get to pay off, or more likely pay $50 million per years for decades in interest. Sigh. Essentially, we are moving up car sales today which would have been made later, except that if you can get someone else to make your down payment, why not make that purchase today? A very reasonable response on the part of the consumer.

A teaser from Dave's work below: "Consumer spending came in at -1.2% annualized, twice the decline expected by the consensus. This occurred in the face of gargantuan fiscal stimulus and leaves wondering how this critical 70% chunk of the economy is going to perform as the cash-flow boost from Uncle Sam's generosity recedes in the second half of the year. Imagine, government transfers to the household sector exploded at a 33% annual rate, while tax payments imploded at a 33% annual rate and the best we can do is a -1.2% annualized decline in consumer spending in real terms and flat in nominal terms? What do we do for an encore? In the absence of the fiscal largesse, it is quite conceivable that consumer spending would have shrunk at a 10% annual rate last quarter!"

Encore, indeed.

John Mauldin, Editor
Outside the Box

Lunch with Dave

by David A. Rosenberg

U.S. GDP Review -- Consumer, Where Art Thou?

While the headline real GDP number came in a tad better than expected, at -1.0% QoQ annualized rate, the back data were revised lower and show the recession to be deeper. First quarter of this year, for example, was revised to -6.4% from -5.5% previously. And, it may not be lost on anyone that the four consecutive quarters of economic contraction was unprecedented in the post-WWII era; ditto for the -3.9% year-on-year trend. In other words, while nobody is willing to go out on the limb and call this a depression (the same academics that brought you "The Great Moderation" during that last great albeit leveraged economic expansion are now labeling what we have endured over the past year-and-a-half as "The Great Recession"). This does go down as the worst economic performance both in terms of duration and intensity since "The Great Depression". While we are past the most pronounced part of the downturn, it may still be premature to call for the end of the recession merely because of the prospect of a positive third-quarter GDP result. After all, we saw GDP advance at a 1.5% annual rate in last year's second quarter, and if memory serves us correctly, the NBER did not subsequently declare the end of the recession. And even if the recession is ending, as we saw in 2002, that does not guarantee a durable rally in risk assets. Sustainability is the key, and it remains the wild card.

The details in today's report left something to be desired. Consumer spending came in at -1.2% annualized, twice the decline expected by the consensus. This occurred in the face of gargantuan fiscal stimulus and leaves wondering how this critical 70% chunk of the economy is going to perform as the cash-flow boost from Uncle Sam's generosity recedes in the second half of the year. Imagine, government transfers to the household sector exploded at a 33% annual rate, while tax payments imploded at a 33% annual rate and the best we can do is a -1.2% annualized decline in consumer spending in real terms and flat in nominal terms? What do we do for an encore? In the absence of the fiscal largesse, it is quite conceivable that consumer spending would have shrunk at a 10% annual rate last quarter! Nonresidential construction action sagged at an 8.9% annual rate and this was on top of a 44.0% detonation in the first quarter. Ditto for equipment & software 'capex' spending, also down at a 9.0% annual rate and this too followed a 36.0% collapse in the first quarter. Residential construction slumped sharply yet again, this time at a 29.0% annual rate. These are the guts of private sector spending and collectively, they contracted at a 3.3% annual rate -- the sixth decline in a row. So while there are many calls out there for the recession's end, it remains a forecast as opposed to a present-day reality.

As expected, inventories were sliced sharply -- by $141 billion at an annual rate, which alone subtracted 0.8 percentage point from headline GDP growth. But with consumer outlays slipping 1.2% and no signs of a 3Q recovery in sight, based on early back-to-school results looking rather tepid thus far and spending intentions in the confidence surveys rolling over, we wonder aloud just how much re-stocking we are going to see this quarter and even if we do, whether it will be a one-quarter wonder and set the stage for a fourth-quarter relapse. (Hopefully it has not been lost on anybody that the Chicago PMI inventory index in July hit its lowest level since June 1949. So maybe there is less to this inventory story than meets the eye.) Something tells us that an equity market trading north of a 760x multiple on reported earnings is not prepared for such a prospect.

While it is tempting to strip out the inventory withdrawal and look at the fact that outside of that, real GDP contracted at a mere 0.2% annual rate, misses the point. While inventories will undoubtedly add to current quarter growth, we doubt that we'll see another quarter of 13.3% growth in defense spending either. This added to GDP growth in 2Q by almost the same amount that inventories subtracted. Not only that, but the sharp improvement in the foreign trade sector, which added 1.4 percentage points to GDP growth in 2Q, is unlikely to be repeated either. The overwhelming consensus is that real GDP will be positive in3Q; but the key for how 4Q will shape up will rest in how real final domestic demand performs, which sagged at a 1.5% annual rate in 2Q, and -3.3% for private sector demand.

We remain in the deflation camp for the sole reason that the data compel us to. Wages and salaries contracted at a 5.0% annual rate in the second quarter and have deflated 4.3% on a year-over-year basis. This is the flip side of having the majority of companies beating their earnings estimates by aggressive cost-cutting -- a wage contraction of historical proportions that bites into aggregate demand and requires recurring doses of fiscal stimulus and other gimmicks (like "Cash for Clunkers") to establish a floor under the economy.

And, it is not just labour income that is still in deflation mode. Practically all forms of income are deflating from a year ago -- interest income is down 4.5%, dividend income is down 23.0% and proprietary income is down 8.0%. The only income that is really going up is the income from Uncle Sam, which is up more than 10.0% and we have reached a point where a record of nearly one-fifth of personal income is being accounted for by paychecks out of Washington. But it should be known that Uncle Sam himself does not create income -- he borrows cash from current bondholders and future taxpayers. Not the stuff that seems deserving of a 760x multiple.

Inflation was non-existent in the second quarter, with the GDP deflator flat and taking the YoY trend down to 1.5% from 1.9% in the first quarter. (We have seen out of the diffusion indices, such as the Chicago PMI, that pricing trends are in reverse.) This lack of pricing power along with sustained negative volume growth, dragged nominal GDP down at a 0.8% annual rate and -2.4% on a year-over-year basis, which is something we haven't seen since the fourth quarter of 1949. And, what should matter most for stocks and bonds is nominal GDP -- price multiplied by volume. Indeed, Charts 1 and 2 illustrate the case -- the rate of change in the S&P 500 (Chart 1) and the rate of change in bond yields (Chart 2) ultimately track the trend-line in nominal GDP growth.

Canadian Monthly GDP Weaker Than Expected

We also received Canadian GDP data today for May, which came in weaker than expected at -0.5% MoM (the consensus was expecting -0.3%) and we saw April revised to now show -0.2% instead of -0.1%. Therefore, despite all the bravado over the end of the Canadian recession, what we are seeing first hand is that any recovery is coming off a much deeper hole. It looks as though real GDP in Canada contracted at an annual rate of at least 3.0% in the second quarter -- triple the decline in the U.S.A.

Breakfast with Dave

John Mauldin — Mon, 27 Jul 2009 20:03:29 GMT

This week I offer something unusual for outside the Box, in that I agree on almost all points with my friend David Rosenberg, except he tells it so much better than your humble analyst. David was the former Chief Economist at the former Merrill Lynch (ah, Mother Merrill, we barely knew ye.) and is now Chief Economist at Gluskin Sheff + Associates Inc., which is one of Canada's pre-eminent wealth management firms. Founded in 1984, they manage $4.4 billion. (For those who wonder, David left NYS to return home to Toronto. Much shorter commute time.) David looks at the recent stock market run-up, why he likes corporate bonds better than stocks, what is lagging with the consumer and a lot more. It is a very pithy read.

Have a good week, I am off to a beach in a few days, but there will be an e-letter this Friday. You are in good hands.

Your looking forward to reading with drinks with little umbrellas analyst,

John Mauldin, Editor
Outside the Box

Breakfast with Dave

by David A. Rosenberg

MARKET THOUGHTS

The Dow is coming off its best weekly performance since March 2000, and if memory serves us correctly, that month was marking the beginning of the end of the great bull market at that time. While the bear market rally has been of 1930 proportions, from our lens, that is what it remains and what is lacking in this extremely flashy runup in equity prices are: (i) leadership, (ii) quality, and (iii) volume. There were some very useful statistics in Barron's (despite the fact that the headline in the ‘The Trader' column is Why the Rally Should Keep Rolling ... for Now):

The 50 smallest stocks have rebounded 17.2% from their nearby July 10th lows, outperforming the largest 50 stocks by 750 basis points.
The 50 most shorted stocks have rallied 17.6%, outperforming the 50 least shorted stocks by 880 basis points (over the same time frame).
The 50 stocks with the lowest analyst ratings have outperformed the 50 with the highest ratings by 380 basis points.
85% of the market has already broken above their 50-day moving averages, which in some sense highlights an overbought market, but the other three factoids still attest to a low-quality rally, which is best left for traders and speculators. As tempting as it is to jump in, history is replete with examples of these sorts of short-covering rallies ending very quickly and with no advance notice from analysts, strategists or economists for that matter.

Let's put aside the conventional wisdom that the stock market puts in its fundamental bottom 3-6 months ahead of the recession ending; it actually bottoms ahead of the economic recovery. That was the lesson of 2002 — recessions can end, but without a recovery there can be no sustainable bull market, though hopes can certainly bring on bouts of euphoric behaviour as we saw in the opening months of 2002 when the Nasdaq surged 45% and as we are seeing currently in the major averages. Japan is another great example. Its economy was out of recession 80% of the time in the 1990s and yet the lack of any sustainable recovery was largely behind its secular bear market. For a great reality check on the situation, have a read of Henry Kaufman's piece on page 37 of Barron's (A Long Road to Recovery). To wit:

"Some experts also expect the economy to get a boost from business inventory restocking. Maybe so, but most likely as a one-time event. Firms take on inventory if demand rises, if they expect higher prices and if they expect bottlenecks in the supply chain. But excess capacity is high, and there are no bottlenecks."

We also believe that the current edition of BusinessWeek is a must-read — there were lots of good stuff in there this weekend, some of it following in Mr. Kaufman's footsteps (page 14 — A Second Half Recovery Could be Fleeting). To wit:

"Will the upturn last? The question arises because the early stage of the recovery is going to be production-led, not demand-led ... to keep the production rebound — and the recovery — going into 2010, overall spending will have to pick up, and that's the big uncertainty given the headwinds facing consumers."

There is no doubt that inventories have been pared back over the past four quarters at a record rate, and that the ISM customer inventory index is running at extremely tight levels. That said, the NFIB inventory plan index remains very weak, so what we have contributing to GDP in the third quarter is a mathematical boost to the economy from a lower rate of destocking; much of this in the auto sector. To actually move towards a sustainable inventory cycle, businesses will have to see final sales revive. What businesses have done is essentially recognize that the secular credit expansion has moved into reverse and the process of deleveraging in the consumer and financial sectors is ongoing. So, what companies have done in their re-assessments is to re-align their output schedules, order books and staffing requirements in the context that there will be a whole lot less credit to support any given level of production in the future.

What is very likely going to be missing going forward is the consumer because while it is the "back end" of the economy that helps bring recessions to an end as inventory withdrawal subsides, it is the "front end" that causes the expansion to endure — in normal cycles, that is. Historically, consumers end up adding 3.5 percentage points to real GDP growth in the first year of an economic renewal. As the economic editorial in BusinessWeek puts it, "this time, that's most likely impossible."

Indeed, any student of the 2000-2003 cycle knows that in the year after that downturn, the consumer offered little help — contributing barely more than one percentage point to GDP growth, which was unprecedented and the cyclically sensitive spending segments exerted not one iota of positive contribution. The difference is that this 2007-2009 cycle was double the asset deflation and triple the job loss and coupled with a credit collapse, which means that it is going to take even longer for the consumer to come back this time around; the view that we have more stimulus this time around really misses the point. The government is merely substituting for the dramatic withdrawal in private sector spending and unless the Obama team manages to implement fiscal package after fiscal package, with the obvious distorting impact on the economy, the risk that the end of the recession only manages to bring on a prolonged period of stagnation is non-trivial and is not priced into the stock market at current valuation levels.

As we explain below, corporate bonds, while cyclical as well, are better suited for that sort of L-shaped economic environment.

Watch what the consumer does now that the fiscal stimulus is over for the time being. Year-to-date, total personal disposable income has risen at a 10.8% annual rate due to Uncle Sam's generosity; however, wages and salaries (60% of the income pie) have declined at a record 3.1% pace. We realize that there is a lot of hype surrounding the ‘cash for clunkers', which is a nice gimmick but only with transitory effects. Besides, just how many vehicles on the road today don't get at least 18 miles per gallon; this is the eligibility criteria — Jed Clampett's jalopy! — See Clunkers Rebate Drives Car Sales. The chatter is that we are going to see motor vehicle sales improve to 10 million units (annualized) in July. Whoopee. The program is going to keep sales near 25-year lows.

What is important to focus on here is the ‘new normal'. The ‘new normal' nearly a decade ago was that 0% financing would bring in 20 million in sales (and think of all the sales that were brought forward). Today's ‘new normal' is doing everything Washington can do to get to 10 million units. Has it dawned on them, or anyone else, that since 2000, the number of vehicles sold (net of replacement) rose nearly 30 million, doubling the 15 million increase in the number of licensed drivers? The over saturation of the auto market is unwinding, and this process will very likely take years.

While we are less enamored with the equity market as a whole, primarily the commodity-short U.S. averages, volatility does offer significant opportunities from a trading standpoint. For a perspective on this, have a look at Old-Fashioned Stock Picking Back in Style on page C2 of the WSJ. For the risk involved, we prefer to express our views in the corporate bond market. Unlike the stock market, which has de facto priced in a 40-50% earnings surge in 2010, there is no such hurdle or high-hope in the corporate bond market, which is still largely priced for a deep recession — a GDP contraction of 1-2% going forward and the unemployment rate heading towards 11-12%.

Insofar as the economy does not relapse to such an extent, there is a significant cushion embedded in the pricing of the corporate bond market this time, even after the impressive rally — from Armageddon levels, mind you — earlier this year. While the S&P 500 was certainly priced for bad news at the March lows, with an 11x P/E multiple and a 3½% dividend yield at the time, it can hardly be said that it was priced for nearly the disaster that Baa corporate bonds were when spreads were hovering near levels (over 600bps) not seen since the early 1930s. Have a look at Bonds Look to steal Stocks' Thunder on page C1 of today's WSJ. The article cites analysis showing that default rates could hit 14% and high-yield bonds, as an example, could still generate significant returns — and our former colleague, the legendary Marty Fridson, is quoted in the article as saying that returns could "reach the mid-teens over the next year" so long as the recession doesn't deepen (unlike equities, the downturn doesn't have to end — just not get any worse).

FINANCIALS LAGGING

Everyone we talk to believes that a new bull market began in March when the White House and the Fed gave the large banks blanket guarantees for their survival and Congress basically instructed FASB to switch back to ‘mark-to-model' accounting rules so the financials could show a profit. So the financials had their nice initial pop, but since May 6th, that is nearly three months now, they have basically done nothing. Not just done nothing, but have underperformed the market by 650 basis points. Financials do not have to necessarily lead the pack during a bear market rally, but no fundamental turning point has occurred with the financials lagging behind as they are currently. Food for thought.

Many pundits mistake a narrowing in credit spreads with some expectations that the economy is going to make a convincing shift into expansion mode. All spreads have done is go from pricing in a depression to pricing in a recession. Indeed, Baa spreads currently are still above the peaks of most prior recessionary phases. The credit crunch is far from over, even if we managed to emerge from the abyss last March. See CIT Beefs Up Tender; Chapter 11 Still Possible on page B3 of the weekend WSJ. And keep in mind that no regional bank is too big to fail, and they are failing — seven more seized by the FDIC last week, making it 64 for 2009 thus far.

As an aside, the sectors that will likely lead the market in the future will be the ones at the forefront of energy innovation (clean-tech). And that means companies that are working on contracts with DARPA (the research arm of the Defense Department) may be worth a look — DARPA was the pioneer behind the development of the Internet, the computer mouse, GPS and others — see Can The Military Find The Answer to Alternative Energy?

BUT NOT THE CONSUMER

What has led the last leg of this rally has been the most discretionary of the consumer space: casinos/gaming stocks are up 44% from the mid-July lows; the homebuilders are up 30%; the automakers are up 28%; advertisers are up 20%; home furnishings are up 18%; hotel/resorts and specialty retailing stocks are up 15%. It's only a matter of time before these gains unwind if the early surveys are correct that this may well go down as the weakest back-to-school shopping season on record. It is seriously tough to square the bounce-back in these sectors when you take a look at where consumers are pulling back the most — discretionary spending items. See Videogame Makers Can't Dodge Recession on page B1 of today's WSJ for just one example. The article below also serves as a commentary on how spending patterns are changing — penny-pinching and nickel-and-diming are both in vogue (see Organic Foods Get on Private-Label Wagon).

The consumer shift away from vacations towards ‘staycations' is forcing hotels to cut their room rates at a record pace — have a look at Starwood Offering Up To 50% Off Some Rooms on page 2B of the USA Today. In addition, the airlines are now raising their baggage fees to make up for the decline in passenger volumes (there is a take on this on page 1B of the USA Today). It seems as though as smoking is the only habit that is not dying, and the tobacco producers are actually raising their prices successfully (see Tobacco Lights Up on Premium blend on page C10 of today's WSJ).

A key test for the back-to-school season may be when the kids come back from camp, and we see the extent of any possible H1N1 virus. All we know is that there was no shortage of Purell being handed out on Visitor's Day in Muskoka yesterday. See When America Sneezes on page 8 of the weekend FT — this is still not front page news but the threat of a pandemic is gaining speed, according to the WHO. The Center for Disease Control estimates that without a successful vaccine, 40% of Americans will catch the virus within the next two years.

CONFIDENCE SAGS

The final results of the University of Michigan consumer sentiment survey for July came out on Friday, and a late-month pickup could not prevent confidence from slipping back to 66.0 from 70.8 in June. We like to look at the ‘buying conditions' segment, and it fell to a three-month low of 111 from 121 in June. Homebuying intentions faltered as well to 147 from 157; auto plans slid to 133 from 139. Income expectations also dropped to 113 from 120; and 50% now see the unemployment rate rising in coming months, up from 48% in June and 46% in July. Interestingly, opinions about government policy declined from 96 to 91, a five-month low for the White House and Congress.

THE NEW FRUGALITY IS FASHIONABLE

We have been writing about the need for the boomers to start putting more of their money into savings and less into discretionary spending for some time. And, BusinessWeek ran with an article that may sound as if it is has been said before (The Incredible Shrinking Boomer Economy on page 27), but there were some fascinating factoids in the piece (from a McKinsey study):

The rising savings rates in the boomer population will drain $400 billion out of consumer spending for the foreseeable future.
The boomer's were such an integral part of the spending culture that the group (79 million) accounted for 47% of national spending before the credit and real estate bubble burst, yet was responsible for just 7% of national savings.
The boomers were responsible for 78% of the spending growth in the economy from 1995 to 2005.
The peak year for spending in the boomer community was 54; whereas for the generation ahead of them (a thriftier bunch), the peak year was 47.
The share of boomers aged 54 to 63 who say they are "financially unprepared for retirement" comes to 69%.

We have said before (repeatedly) that one of the more interesting demographic trends this cycle is that the only segment of the population that is gaining employment is the 55+ age cohort. But this has created a gaping hole in job opportunities for the younger age categories, where jobless rates are either at or approaching the 20% threshold. What is also fascinating is the denial over this demographic reality because many college graduates are holding out for what they believe are going to be lucrative offers — see In Recession, Optimistic College Graduates Turn Down Jobs on page A10 of the Sunday NYT:

"Job recruiters may be bypassing university campuses in droves and the unemployment rate may be at its highest point in decades, but college career advisers are noticing that many recent graduates do not seem to comprehend the challenging economic world they have just entered". Indeed, as one example of where labour demand is heading, the article cites as an example a recent job fair at the University of Oregon, where just 55 corporate recruiters showed up compared to 90 a year ago.

WHAT'S HAPPENING WITH REVENUES?

According to S&P, only 61% of the companies have beaten their low-balled profit estimates. Yet as we saw in the first quarter, this is being accomplished via aggressive cost-cutting efforts. With 53% of the S&P 500 universe reporting, revenues are down about 10% YoY and the worst is yet to come because the retailers and homebuilders have yet to report. Even so, on an apples-to-apples comparison, sales were -16% YoY in 1Q and -14% in 4Q of last year, so the bulls (who have thus far been correct) would say that this is a classic ‘green shoot' second-derivative improvement in the data. The revenue declines have cut a wide swath, with 9 of the 10 sectors and 3 in 4 companies posting contractions.

For those believing the recession is over, let's just say that in the context of an economy that is not in recession, the odds of seeing a negative quarter for revenues is 1-in-13. And, just how bad is a -10% quarter for sales revenues? Well, it would tie the fourth worst performance of the past decade. To put it into perspective, when the 2001 recession ended, sales were running at -1.0% YoY — what we have now is worse by a factor of ten. And, when the last bull market was confirmed in the spring of 2003, sales had already swung well into positive territory on a YoY basis.

BIG WEEK AHEAD FOR THE BOND MARKET

The U.S. government is going to flood the market with newly minted Treasuries this week — $200 billion, which will make this the busiest week in 24 years. As of this month, the gross supply of Treasury security issuance has come to $1.25 trillion, up from $434 billion last year and $350 billion at this juncture of 2007. With the yield on the 10-year note still south of 4.0% this attests to the offset from intense deflationary pressures, though the deteriorating fiscal performance and outlook has generated a super-steep yield curve and for the time being established a higher floor for longer-dated yields.

This week, we will see records in the new issuance of 2s, 5s, 7s — a total of $109 billion, which compares to $104 billion at the June auction and $102bln in May. See page C1 of the WSJ for more.

UPDATE ON THE EMPLOYMENT SCENE

This got very little play, but the minimum wage was lifted on Friday to $7.25 an hour from $6.55 — a 10.6% increase. That may be great news for the 5 million workers that are affected, but it will likely trigger reduced job creation too as sectors like restaurants and hotels move to contain their aggregate labour bill.

We have said before that the unemployment rate is very likely to continue to rise for the next few years, not just quarters, and that it will take out the November-December 1982 post-WWII peak of 10.8%.

Why is that?

First, it should be noted that in the last cycle, the recession ended in November 2001 and yet the unemployment rate did not reach its peak until June 2003. Considering that the asset deflation and credit collapse this time around was so acute, why would anyone think that it will take less time to reach the peak in the current cycle?

Second, this cycle was most unusual in that 9 million full-time jobs were lost and of these, 3 million were pushed into part-time work. There are now a record 9 million people working part-time that would rather work full-time, which is about 5 million above the norm. On top of that, companies cut the hours worked by a record 2.3% to an all-time low of 33.0 hours this cycle, which is equivalent to another 3 million jobs being lost. So in sum, we have a total level of unemployment and underemployment that comes to 8 million and that is without precedent. So when it comes time to add to labour input again, what businesses are going to do is to raise the workweek and push the part-timers back to full-time work before embarking on a hiring spree. In the meantime, the usual 100,000-150,000 new entrants into the labour force every month will be looking for work with futility. Keep in mind that when we are talking about a total pool of existing labour totaling 8 million jobs, that is equivalent to over five year's supply during a normal business expansion.

Third, the hallmark of this recession was the permanent nature of the job losses that were incurred. Normally, and this includes that period of Ross Perot's "sucking sound" of post-NAFTA being siphoned to Mexico, we lose 2 million permanent jobs in a recession. This is classic Schumpeterian ‘creative destruction' as the recession expunges the old uncompetitive industries and paves the way for new more productive sectors — a recession is a painful but necessary transition to the net cycle as the torch is passed to new technologies.

But this time around we are really talking about the law of large numbers because the total increase in the number of people who lost their jobs permanently exceeded 5 million or twice what is ‘normal'. What happens to these people remains to be seen but thus far we see nothing in any ‘fiscal package; except for traditional goodies to induce consumption growth. The best fiscal policy of all, and the one that is still not being pursued since it doesn't offer a ‘quick fix', is retooling these unemployed individuals, many of them in their 20s and 30s, and providing them with new skills that will bolster long-term productivity growth. It is productivity that is the key variable in the nation's standard-of-living performance, and yet, this has somehow escaped the best and brightest economic minds in Washington — at least so far. If we can manage to improve education, and thereby income-per-capita, then a whole host of other problems get worked out too — such a affordable health care (and for a signpost of the problem Obama's plan is running into within his own party, see Blue-Dog Democrats Hold Health-Care Overhaul at Bay on the front page of today's WSJ (without the blue dogs, there are not enough votes on the floor to get the Obama health care plan through).

Another way of looking at the situation is that we are going to end up having some convergence between the popular definition of the unemployment rate and the more inclusive U6 measure — the former is 9.5% and the latter is 16.5% and this seven percentage point gap is without precedent. At the peak unemployment rate of the last cycle in mid-2003, the gap was four percentage points. As the unutilized labour pool starts to get absorbed again, the U6 is likely to come down and the U1 likely to go up, and if they converge at a four percentage point gap again, then look out — we'll be talking about an unemployment rate well north of 12% before the jobless recovery comes to an end.

NOT GIVING CREDIT, EVEN WHEN IT'S DUE

The front page of today's WSJ also runs with Loans Shrink as Fear Lingers. The largest 15 U.S. banks cut their loan book by 2.8% in Q2 — and more than half of the loan volumes came from mortgage refinancings and credit renewals among small businesses (to show how broadly based the credit shrinkage is, 13 of these banks shrank their balance sheet in the second quarter). New credit creation is practically nonexistent. Capital conservation remains the order of the day. This is one critical reason why it would likely be foolhardy to be expecting a normal inventory cycle to come our way merely because of an arithmetic addition to growth from lower de-stocking in the current quarter.

ANOTHER REASON TO BE BULLISH ON EMERGING ASIA

Government efforts are being stepped up to bolster the social safety net and help bring sky-high savings rates down as the U.S. consumer takes its savings rate up. This is good news for commodities since there is a much higher representation of ‘material' in the emerging market household consumption basket than is the case for the U.S. household who has become, at the margin, the buyer of services (recreation, medical, financial). See Asian Nations Revisit Safety Net in Effort to Bolster Spending on page A2 of the WSJ.

In our view, it is imperative that Asia finds a new source of growth beyond recurring public sector spending to offset the secular decline in export growth that will be associated with a retrenchment in demand growth in the developed world, primarily in the U.S.A. China currently is only the end-buyer of 22% of the rest of Asia's exports — it alone is not large enough to provide a complete offset. It likely pays to have a look at the editorial comment on this file on page 6 of today's FT — Too Early to Declare a V-Shaped Recovery.

The Financial Commentator on the Economy

John Mauldin — Mon, 04 May 2009 20:04:47 GMT

Late last week a letter from Jim Welsh crossed my desk. I started reading and found myself being pulled through his very thoughtful letter. I have not met Jim, but think this letter is worthy of an Outside the Box.

Jim Welsh of Welsh Money Management has been publishing his monthly investment letter, "The Financial Commentator", since 1985. His analysis focuses on Federal Reserve monetary policy, and how policy affects the economy and the financial markets.

The Financial Commentator on the Economy

Perspective – A way of regarding facts and judging their relative importance.

There are a number of data series that evaluate economic conditions using a diffusion index. A diffusion index will have a value above 50, when a plurality of respondents are positive, and below 50 when a majority are negative. If a diffusion index increases from 35 to 38, it represents a gain of 8.6%, while a rise to 46 from 45 is only a gain of 2.2%. It is natural to think of the larger percentage gain to be more noteworthy. However, the smaller gain is actually more significant, since it will only require a small further improvement, before actual economic growth is achieved. In recent weeks, many economists and market strategists have heralded the end of the recession and the arrival of spring, after spotting a few 'green shoots' of improvement. In most cases, the 'green shoot' was a modest up tick, from a multi-decade low! For instance, the Conference Board's Consumer Confidence Index edged up to 26.0 in March, from 25.3 in February, the lowest reading since records began in 1967.

In February, new home sales were up 4.7% to 337,000, and after that robust increase, were only down 75.7% from their July 2005 peak. In the last three years, housing starts have plunged from 1,823,000 to 358,000, or 80.4%. At the February sales rate, it will take 12.2 months to clear the inventory of new homes for sale, versus 5 months in a healthy market. In the past year, the median price of a new home has fallen from $251,000 to $200,900, a drop of 20%. After retail sales collapsed in the fourth quarter, the inventory-to-sales ratio soared from 1.25 to 1.45, or 16%. Companies were forced to cut production drastically in the first quarter, so bloated inventories could be whittled down. Although the ratio dipped to 1.43 in February, production levels will remain low, until the ratio falls further. The large decline in production will contribute to a fairly weak first quarter, and depress second quarter GDP too.

As noted last month, there is a good chance that GDP will post a positive print in the fourth quarter of this year, and maybe in the third quarter. Most of the 'gain' will be statistical nonsense, but that won't deter most economists from getting excited. In the last 2 years, the 80% plunge in housing starts has subtracted about .9% from GDP each quarter. If housing starts stabilize near February's level in coming months, the .9% hit to GDP will become 0%. If inventories are brought down by the fourth quarter and are in line with sales, the decline of 1% to 2% to GDP from production cuts in the first and second quarter could also improve to 0%. In the fourth quarter last year, personal consumption fell an extraordinary -2.99%, as consumers turned into Grinches.

But consumer spending improved in the first quarter, as government income transfers of $127 billion offset the decline in wages and salaries of $89 billion. In the second quarter, social security recipients will receive a onetime $250 payment in May. Tax refunds are up 11% from last year, and the decline in gasoline prices is also providing a boost to incomes. Consumers will use the extra disposable income to pay down debt, and increase savings and spending. All of these factors should help swing personal consumption to a positive for GDP in coming quarters.

In the second quarter of 2008, GDP grew 2.8%, which is a respectable number. Despite this growth, job losses continued each month, and a self sustaining economic expansion failed to take hold. The most important issue in the next 12 to 15 months is whether the rebound in the second half of 2009 and first half of 2010 will gain enough traction to launch a self sustaining economic recovery. There are many reasons why I remain skeptical.

In the first three months of 2009, more than 2 million jobs were lost, causing the unemployment rate to jump from 7.6% to 8.5%, the highest since November 1983. The unemployment rate increased in March in 46 states, with California, the world's eighth largest economy, hitting 11.2%, the highest since January 1941.

Underemployment, which combines the unemployed, with involuntary part time workers and discouraged workers, reached 15.6%. As noted in recent months, post World War II recessions have on average caused personal income to fall between 4% and 7%, and this one has further to go. Wages and salaries shrank at a 4% annual rate in the first quarter, and according to Deutsche Bank, payroll-tax withholding receipts collected by the Treasury Department are down 8.2% from a year ago. This suggests that personal income growth will remain weak in coming months, and shave more than $250 billion from total income and future demand. Changes in temporary jobs lead reversals in the overall labor market by 6 to 10 months. In 2007, a continuous decline in temporary jobs and hours worked led me to forecast a decline in jobs in 2008. When non-farm jobs fell in January 2008, most economists were shocked, and the stock market sold off sharply. In March, employers cut 71,700 temporary workers, so any real improvement in job growth is many months away.

Most economists are quick to note that unemployment is a lagging indicator, and they're right. But the magnitude of the job losses shouldn't be dismissed so glibly, given the impact they are having on the banking system. The American Bankers Association reported that 3.22% of consumer loans were delinquent at the end of 2008. That is the highest level since the ABA began tracking overall loan delinquency rates in the mid 1970's. And that was before 2 million jobs were lost in the first quarter.

An average of 5,945 bankruptcy petitions were filed each day in March, up 9% from February and 38% from a year ago. The soaring job losses since last September are certainly behind the increase in bankruptcies.

The surge in job losses are working their way up the income ladder, with an increasing number of middle income and upper middle income workers being affected. This is pushing many of those who previously were considered prime credit risks over the edge. Two-thirds of mortgages in the U.S. are held by the best credit risk, prime borrowers. According to the American Bankers Association, 5.06% of prime borrowers have missed at least one mortgage payment. Since prime borrowers are such a large group, this represents 1.8 million mortgages. Although the delinquency rate for sub prime mortgages is up to 21.9%, it only accounts for 1.2 million mortgages.

In the fourth quarter, a number of states mandated a freeze on foreclosures, and a number of banks, not wanting to be a modern day Mr. Potter during the holidays, voluntarily suspended foreclosures. According to RealtyTrac, foreclosure filings increased to 341,180 in March, up 17% from February, and up 46% from a year ago. After the foreclosure moratorium expired in California, notices of trustee sales, which precede foreclosure sales, climbed more than 80% to 33,178 in March from February. Moody's Economy.com estimates more than 2.1 million homes will be lost this year, up from 1.7 in 2008.

Existing home sales have declined 33.3% since peaking in September 2005. The median price has dropped 28.7%, after peaking in July 2006 at $230,900. In February, existing homes sales increased 4.4%, and the median home price advanced 2.4%. The ratio of monthly sales to the inventory of homes for sale was 9.5 months, versus 5 months in a healthy market. However, 45% of the sales in February were foreclosures, and that proportion will remain high in coming months. Since foreclosed sales represent forced selling, the persistently high level of foreclosures will continue to push home prices lower. As home prices fall another 5% to 10% or more, more home owners will realize that their mortgage exceeds the value of their home. An increasing number are simply choosing to walk away, since they have nothing to lose.

According to RealtyTrac, job losses result in a home foreclosure 10% to 15% of the time. If job losses narrow from the monthly average of 670,000 in the first quarter to 325,000, almost 3 million more jobs will be lost before year end. That will translate into another 300,000-450,000 foreclosures, and an unemployment rate of almost 11%. But what if that estimate of job losses is too optimistic?

New research by the Federal Reserve and Boston University of credit spreads of 900 non-financial companies from 1990-2008 predicted changes in the economy 'phenomenally' well. Based on their initial research on low to medium risk corporate bonds with more than 15 years to maturity, the researchers went back to 1973 and found the analysis still worked well. With the massive widening of corporate bond spreads last fall, the researcher's model predicts the economy will lose another 7.8 million jobs by the end of 2009, and industrial production will fall another 17%. In the spirit of optimism, let's assume this 'phenomenal' model is off by 35%, due to the extreme nature of this credit crisis. That still results in another 5.1 million lost jobs, and an 11% drop in industrial production. In that scenario, the unemployment rate climbs to near 12.5%, the underemployment rate breaches 20%, and another 500,000-750,000 foreclosures result.

The International Monetary Fund (IMF) now estimates the U.S., European, and Japanese financial sectors face losses of $4.1 trillion. Banks are confronting losses of $2.5 trillion, insurers $300 billion, and other financial institutions $1.3 trillion. To date, the banking sector has written down $1 trillion of expected losses. The IMF estimates that U.S. and European banks need to raise $875 billion in equity by next year to return to pre-crisis levels.

Over the last week a number of banks have reported first quarter earnings, which was a pleasant surprise. Citigroup said it made $1.6 billion. One of the ways Citigroup achieved this gain was booking a profit of $2.7 billion on the decline in Citi's own debt. Say what? Under accounting rules, Citi was allowed to book a one-time gain equivalent to the decline in its bonds because, in theory, it could buy back its debt cheaply and save $2.7 billion over time. Of course, Citi didn't actually do that. Even though more consumer loans went bad in the first quarter, Citi reduced its loan loss reserve from $3.4 billion in the fourth quarter to $2.1 billion in the first quarter, thereby picking up another $1.3 billion of 'earnings'. And the recent change in mark to market accounting enabled Citi to book an additional $413 million in 'profit' on impaired assets. Without theses one-time adjustments, Citi's $1.6 billion in first quarter profit becomes a $2.8 billion loss.

According to a Wall Street Journal analysis of Treasury Department data, the 19 banks that received tax payer funds made or refinanced 23% less in new loans in February versus last October. Why lend money when all you've got to do is make a few adjustments and make even more money.

Between 2000 and 2008, the major credit card companies increased the number of credit cards issued to small businesses from 5 million to 29 million. During that period, many small business owners increasingly relied on their cards to provide short term financing for their business. Spending on small business credit cards increased from $70.4 billion in 2000, to $296.3 billion, according to the Nilson Report. Over the last 15 months, business bankruptcy filings have risen faster than consumer bankruptcies, with the average charge-off rising to $11,000 from $7,000, according to Equifax, Inc. In response, the card issuers have been aggressively scaling back, and have reduced available credit lines by almost $500 billion. Just another example of how the availability of credit to the economy is evaporating, despite all the Fed's efforts.

Industrial production fell 1.5% in March, and is down 12.8% from a year ago. Capacity utilization fell to 69.3%, the lowest since records began in 1967. As I discussed in detail in January, excess capacity is a powerful dynamic. Companies are forced to reduce or eliminate budgeted investments in new equipment, compete for every dollar of revenue, even if it means accepting thinner profit margins, and reduce costs through job cuts. The amount of excess capacity that has been created by the depth of this economic contraction is unprecedented. What most inflation bugs and investors fail to understand is how long it will take to work off the current over hang of excess capacity. If the output gap grows from the current 7% to 10% next year, Goldman Sachs estimates it could be 2015 before all the excess capacity is used up, and that's if GDP grows 4.75% per year! Ironically, one of the reasons the economy is not likely to grow that fast is that business investment will be weaker than in prior business cycles. With so much excess capacity, businesses won't need to materially increase business investment for the next 2 or 3 years.

The economy needs to create 125,000 jobs each month, just to absorb the number of new entrants into the labor market. If job growth were to average 325,000 per month in coming years, it would still take four years to replace all the jobs lost in this recession. With so much excess labor capacity, wage growth will be weak for the next few years, which will make it harder for consumers to increase savings and spending. The combination of less credit availability, weaker business investment and consumer spending will be headwinds whenever the economy emerges from this recession.

The Untied States is mired in the deepest cyclical contraction since at least World War II, and arguably the depression. Falling home prices led us into this crisis, and home prices are still falling. The financial crisis in 2008 has become the economic crisis in 2009, as more than 2 million jobs were lost in just the first quarter, with another 3 to 5 million likely before year end. With the unemployment rate headed over 10%, and maybe up to 12% next year, the default rate on every type of consumer credit – (prime mortgages, Alt-A mortgages, Option Arm mortgages, sub-prime mortgages, home equity lines, credit cards, auto loans, student loans) – is headed much higher. Commercial real estate values are plunging, and corporate default rates are set to soar. Although every bank will 'pass' the government's stress test, some banks will fail the real world stress test, and need billions more in capital. Sooner or later, the Treasury Department will likely have to go hat in hand asking for more money from Congress for some of the banks. For the first time since World War II, the global economy will contract in 2009, so there aren't many places to hide. Although it is welcome to see a few 'green shoots', in this case, those green shoots are unlikely to yield a bountiful harvest in 2010.

In addition to the daunting cyclical problems challenging the economy, there are a number of significant secular issues I've discussed before that will make it even more difficult for a self sustaining recovery to develop in 2010. Between 1982 and 2007, the amount of Total debt grew from $1.60 to $3.53 for each $1.00 of GDP. This was made possible as the cost of money fell from 15% to 20% in 1982 to the generational lows of the last few years. As interest rates fell, consumers were able to take on more debt, without their monthly payments increasing very much.

Household debt has increased from $.44 in 1982 to $.98 for each dollar of GDP in 2007. However, there is no more relief coming from lower rates, so consumers are going to have to pay for their debt from income. From the mid 1990's until 2007, most consumers had the luxury of believing that their homes and 401Ks would provide most of what they would need for their retirement. The saving rate fell from over 8% 15 years ago to near 0% in 2007. The last 18 months has convinced them they need to increase their savings. The saving rate has rebounded to near 4% in the last six months, which is one reason why the economy has been so weak. As debt levels increased over the last 25 years, GDP was boosted as consumer's bought cars, bigger homes, second homes, went on nice vacations, and basically lived the good life. However, since 1966, each dollar of additional debt has given the economy less of a boost. In 1966, $1 dollar of debt boosted GDP by $.93. But by 2007, $1 dollar of debt lifted GDP by less than $.20.

The message from these facts is fairly clear. Debt levels are high, and any increase in interest rates will impose a bigger burden on the economy and quickly stunt growth. Consumer debt is already so high and interest rates are so low that it will be difficult for consumers to add debt. This means economic growth will be far weaker than the debt induced growth of the last 25 years. As consumers increase their savings, GDP will be lowered by .70% for each 1% consumers increase their saving, since consumer spending represents almost 70% of GDP. In addition, the banking system remains crippled. Lending standards are high and are not coming down with the economy remaining weak. The need for additional capital will lower future lending by several trillion dollars, as banks work to repair their balance sheets and lower their leverage ratios from 30 to the low teens. The securitization markets provide more credit than the banking system, but they remain on life support. Credit availability will remain constrained well into 2010, which represents a headwind than will mute some of the lift from fiscal stimulus.

The diminishing boost given to GDP from each additional $1.00 of debt since 1966 strongly suggests that adding more debt will not return the economy to prosperity. I am reminded of a movie from the 1950's, 'The High and the Mighty'. It starred John Wayne and Robert Stack and was about an airline flight from Honolulu to San Francisco. During the flight, one of the engines fails, but they are past the point of no return, so they must try to make it to San Francisco. Over the last 60 years, the United States has used a combination of fiscal stimulus and monetary policy to soften each recession and spur the subsequent recovery, with a fair amount of apparent success. From 1982 until 2007, the U.S. only experienced two shallow recessions that each lasted just 8 months. This stretch of 25 years may be the best 25 years in our economic history. But much of this prosperity was bought with debt, as the ratio of debt to GDP rose from $1.60 to $3.50 for each $1.00 of GDP. Sometime in the last 25 years, we passed the point of no return. Unfortunately, Hollywood won't get to write the script on how this ends.

E. James Welsh

Fighting Recklessness with Recklessness

John Mauldin — Mon, 06 Apr 2009 17:49:46 GMT

This week we visit some very thoughtful analysis by an old friend of Outside the Box, Dr. John Hussman of the Hussman Funds (http://www.hussmanfunds.com/index.html). Is the new PPIP program and related activities likely to help or hurt the situation? Will this help keep banks for bankruptcy or will it push the FDIC into insolvency requiring massive tax payer cash. This week's Outside the Box is brief, but poignant.

John Mauldin, Editor
Outside the Box

Fighting Recklessness with Recklessness

By John P. Hussman, Ph.D

Last week saw a continuation of the impenetrably misguided policy response to this financial crisis, which seeks to address the downturn by encouraging more of what got us into this mess in the first place. The U.S. Treasury's toxic assets plan, for instance, looks to "leverage" public funds (with the FDIC providing the "6-to-1 leverage") in order to defend the bondholders of mismanaged financials who took excessive leverage. At the same time, the Treasury plans to limit the "competitive bidding" to a few hand-picked "managers" who will be encouraged to overpay thanks to put options granted at public expense. This is a recipe for the insolvency of the FDIC and an attempt to bail out bank bondholders using funds that have not even been allocated by Congress. The whole plan is a bureaucratic abuse of the FDIC's balance sheet, which exists to protect ordinary depositors, not bank bondholders.

On Thursday, the stock market cheered a move by the Financial Accounting Standards Board (FASB) to relax FAS-157 (the "mark-to-market" accounting rule), allowing nearly insolvent financial companies to use more discretion in the models they use to assess fair value. Of course, the irresponsibly rosy assumptions built into these models have been a large contributor to this near-insolvency, because they virtually ignored foreclosure risks.

Notably, the one thing policy-makers have not done is to address foreclosure abatement in any serious way. The only way to get through this crisis without enormous collateral damage to ordinary Americans is by restructuring mortgage obligations (ideally using property appreciation rights), restructuring the debt obligations of distressed financial companies (ideally by requiring bondholders to swap a portion of their debt for equity), and abandoning the idea of using public funds to purchase un-restructurable mortgage debt ("toxic assets"). See On the Urgency of Restructuring Bank and Mortgage Debt, and of Abandoning Toxic Asset Purchases.

Look. You can play hot potato with the toxic assets all day long, and only outcome will be that the public will suffer the losses that would otherwise have been properly taken by the banks' own bondholders. You can tinker with the accounting rules all you want, and it won't make the banks solvent. It may improve "reported" earnings for a spell, but as investors who care about the stream of future cash flows that will actually be delivered to us over time, it is clear that modifying the accounting rules doesn't create value. It simply increases the likelihood that financial institutions will quietly go insolvent. I recognize that the accounting changes may reduce the immediate need for regulatory action, since banks will be able to pad their Tier 1 capital with false hope. But we have done nothing to abate foreclosures, and we are just about to begin a huge reset cycle for Alt-A's and option-ARMs. As the underlying mortgages go into foreclosure, it will ultimately become impossible to argue that the toxic assets would be worth much even in an "orderly transaction."

Meanwhile, in a bizarre convolution of reality reminiscent of Alice in Wonderland, the Financial Times reported last week: "US banks that have received government aid, including Citigroup, Goldman Sachs, Morgan Stanley and JPMorgan Chase, are considering buying toxic assets to be sold by rivals under the Treasury's $1,000bn plan to revive the financial system." And why not? They can put up a few percent of their own money, and swap each other's toxic assets financed by a bewildered public suddenly bearing more than 90% of the downside risk. The "investors" in this happy "public-private partnership" keep half the upside while ordinary Americans take the downside off of their hands. Some partnership.

With regard to the economy, there is quite a bit of optimism that the recent market advance represents a forward-looking call that the economy will recover in the second half of the year. Indeed, some analysts have noted that year-over-year consumer spending has only declined very slightly, hailing this as evidence that economic concerns are overblown. The difficulty is that consumer spending has never declined on a year-over-year basis, except in this downturn, so that slight decline is actually the worst showing for consumer spending in the available data. Likewise, capacity utilization has plunged to levels seen only in 1974 and 1982, both which were accompanied by far deeper valuation extremes than at present.

I recognize that given the depth of the recent decline, it seems as if stocks must be at once-in-a-lifetime valuations. Unfortunately, this is an artifact of the previous level of overvaluation. The depth of a bear market often has a loose relationship with the extent of the prior bull market (and particularly with the level of valuation of the prior bull), but there is very little relationship between the depth of a bear market and the subsequent bull.

If we assume that the long-term fundamentals of the economy have not been affected in any meaningful way by this economic downturn, then stocks are most likely priced to deliver long-term returns between 9-11% annually over the coming decade, with outlier possibilities of as much as 14% if the market ends the coming decade at historically overvalued levels, and as little as 4% if the market ends the coming decade at historically undervalued levels. Far from being once-in-a-lifetime values, prospective 10-year returns on the S&P 500 are not far from their historical norms here. Stocks are about fairly valued.

The only way that stocks could be considered extremely undervalued here is if we assume that the record profit margins of 2007 (based on record corporate leverage) are the norm, and will be quickly recovered. While we never rule out the potential for surprising strength or weakness in the markets or the economy, the assumption that profit margins will permanently recover to 2007 levels is equivalent to assuming that the past 18 months simply did not happen.

Still, given sufficient evidence of broad improvement in market action (which we take as a measure of risk tolerance and economic expectations), we wouldn't fight the combination of roughly fair values and a willingness of investors to bear risk. We've been carrying small "contingent" call option positions for a good portion of the recent advance. This helped to compensate for our low weightings in financials, homebuilders and other low-quality sectors that have enjoyed frantic short-covering. Still, with only about 1% of assets currently in those calls, our stance is still characterized as defensive here, as we are otherwise fully hedged. Again, we won't fight a broad improvement if it continues sufficiently, but if I were to make a guess, it would be that the potential downside in the S&P 500 from these levels could approach 30-40%. That is not a typo, and it is not a possibility that should be ruled out.

I have no idea how long investors will remain enthusiastic about trillion dollar band-aids and eroding the integrity of our accounting rules. I do know that at the end of the day, what matters is the long-term stream of deliverable cash flows that investors can actually expect to reach their hands. It's exactly that consideration that makes it clear that we will sink deeper into this crisis until we observe debt restructuring on a large scale. If we don't restructure the debt, the debt will fail, because for many borrowers, the cash flows aren't there, and it is not possible to service the debt on existing terms.

Long-Term Outlook: Slow Growth And Deflation

John Mauldin — Mon, 16 Mar 2009 22:07:22 GMT

This week I am really delighted to be able to give you a condensed version of Gary Shilling's latest INSIGHT newsletter for your Outside the Box. Each month I really look forward to getting Gary's latest thoughts on the economy and investing. Last year in his forecast issue he suggested 13 investment ideas, all of which were profitable by the end of the year. It is not unusual for Gary to give us over 75 charts and tables in his monthly letters along with his commentary, which makes his thinking unusually clear and accessible. Gary was among the first to point out the problems with the subprime market and predict the housing and credit crises. You can learn more about his letter at http://www.agaryshilling.com. If you want to subscribe (for $275), you can call 888-346-7444. Tell them that you read about it in Outside the Box and you will get not only his recent 2009 forecast issue with the year's investment themes, but an extra issue with his 2010 forecast (of course, that one will not come out for a year. Gary is good but not that good!) I trust you are enjoying your week. And enjoy this week's Outside the Box....

And if you have cable and get Fox Business News, I will be on Happy Hour tomorrow Tuesday the 17th at 5 pm Eastern. Have a great week.

John Mauldin, Editor
Outside the Box

Long-Term Outlook: Slow Growth And Deflation

(excerpted from the March 2009 edition of A. Gary Shilling's INSIGHT)

From 1982 until 2000, the U.S. economy enjoyed rapid growth with real GDP rising at a 3.6% average annual rate. Furthermore, this 18-year expansion, which cumulated to an 89% rise in inflation-adjusted economic activity, was interrupted by only one recession, the relatively mild 1990-1991 downturn, which depressed real GDP by only 1.3% from peak to trough.

Extended Expansion

From a fundamental standpoint, the growth spurt ended in 2000 as shown by basic measures of the economy's health. The stock market, that most fundamental measure of business fitness and sentiment, essentially reached its peak with the dot com blow-off in 2000 and has been trending down ever since (Chart 1). The same is true of employment, goods production and household net worth in relation to disposable (after-tax) income.

Nevertheless, the gigantic policy ease in Washington in response to the stock market collapse and 9/11 gave the illusion that all was well and that the growth trend had resumed. The Fed rapidly cut its target rate from 6.5% to 1% and held it there for 12 months to provide more-than ample monetary stimulus. Meanwhile, federal tax rebates and repeated tax cuts generated oceans of fiscal stimulus.

As a result, the speculative investment climate spawned by the dot com nonsense survived. It simply shifted from stocks to housing (Chart 2), commodities, foreign currencies, emerging market equities and debt, hedge funds and private equity. Investors still believed they deserved double-digit returns each and every year, and if stocks no longer did the job, other investment vehicles would. Thus persisted what we earlier dubbed the Great Disconnect between the real world of goods and services and the speculative world of financial assets.

Not Sustainable

Even before these final speculative binges, the forces driving the economy in its long expansion were unsustainable, as we've been stressing for years in Insight. These forces included the decline in the consumer saving rate and jump in consumer debt, the vast leveraging of the financial sector, increasingly freer trade and loose financial regulation, all of which are now being reversed.

In the 1980s and 1990s, American consumers were more than willing to cut their saving rate because they believed stock portfolios would continue to grow rapidly and take care of all their financial needs. Then, when stocks collapsed in 2000-2002, house appreciation (Chart 3) seamlessly took over to continue the push down the household saving rate from 12% in the early 1980s to zero. Americans saw their houses as continually-filling piggybanks because, they believed, home price appreciation would continue indefinitely. They tapped that equity freely with home equity loans and cash-out refinancing.

The flip side of saving less is borrowing more, as evidenced by the leap in all consumer debt and debt service, both in relation to disposable (after-tax) income and relative to assets. In relation to GDP, the cumulative outside financing of the household as well as the financial sector leaped for three decades, measuring the immense leveraging in these two areas. Not surprising, amidst this consumer borrowing and spending binge, consumer spending's share of GDP leaped from 62% in the early 1980s to 71% at its peak in the second quarter of 2008 (Chart 4).

The Tide Turns

Now, however, consumers have run out of borrowing power. As of the third quarter 2008, homeowners with mortgages had on average 25% equity in their abodes after all mortgage debt was removed and that number will probably drop to the 10%-15% range with the further decline in house prices we are forecasting (Chart 3). At that bottom, after a 37% peak-to-trough collapse, almost 25 million homeowners, or nearly half the 51 million with mortgages, will be under water, with their mortgages bigger than their house values. In total, the gap will be about $1 trillion.

The nosedive in stocks has also discouraged consumer spending as have mounting layoffs (Chart 5), maxed out credit cards and tighter lending standards and weak consumer confidence. Rising medical costs are also a drag on consumers as their co-pays and deductibles mount. For decades, credit card issuers and other lenders encouraged consumers to indulge in instant gratification. Buy now, pay later. But now, habits are changing. Debit cards are becoming popular since they deduct charges directly from the user's checking account and, therefore, don't increase indebtedness. Layaway plans are back in style after nearly disappearing.

Financially Unprepared

Between low saving levels in recent years and weak stock prices, few Americans are prepared financially for retirement. About 54% of 401(k) assets are invested in stocks, which fell 39% last year as measured by the S&P 500 index. And except for Treasurys, almost all other investments suffered huge losses in 2008. Around 50 million Americans have 401(k) plans, with $2.5 trillion in assets, and in the 12 months after the stock market peak in October 2007, over $1 trillion in stock value was wiped out in 401(k)s and other defined contribution plans. Another $1 trillion in IRAs was lost.

After 401(k)s were initiated in 1978, those containing stock assets appreciated in the long 1982-2000 bull market, which convinced many that they didn't need to save, as mentioned earlier. In 1983, 33% of working-age households were financially unprepared for retirement, but the number rose to 40% in 1998 as a result of lower saving and more borrowing, and to 44% in 2006 as the 2000-2002 bear market also depressed retirement funds. Obviously, with the subsequent collapse in house and stock prices, many more -- over 50% -- are unprepared. In 2007, in defined contribution accounts administered by Vanguard, the median account balance for 55-64 year-olds was just $60,740 and only 10% of participants contributed the maximum amount.

Economic Effects

As households increase their saving rate, their spending growth will slow, a distinct contrast from the decline of the saving rate from 12% in the early 1980s to zero recently. That decline, which averaged about a half-percentage point per year, meant that consumer spending grew an average of around a half-percentage point faster than disposable income annually. For the next decade, we're forecasting a one percentage point rise in the saving rate annually. That still would not return it to the early 1980s level of 12% even though the demographics for saving have gone from the worst to the best in the interim. Applying a 1.5 multiplier to account for the total destimulating effects as those dollars are saved, not spent, this means a reduction of about one percentage point in real GDP growth, from 3.6% per annum in the 1982-2000 years to 2.6%.

Although the stock bulls may salivate over the prospect that increased saving will mean more equity purchases, we believe that most of the money will go to debt repayment--the flip side of a saving spree. Note that if the saving rate rises one percentage point per year for 10 years, the cumulative increase in saving will total about $5.5 trillion. That will go a long way in offsetting federal deficits and debt.

So will the deflation that we'll explore later. Incomes may grow on average in real or inflation-adjusted terms, but shrink in current dollars. But debts are denominated in current dollars and therefore will grow in relation to incomes and the ability to service them. This will be the reverse of inflation, which reduced the value of debts in real terms and makes it easier to service them as incomes rise with inflation.

Foreign Effects

The effects, then, of a consumer switch from a 25-year borrowing-and-spending binge to a saving spree will be profound for the U.S. economy. Even more so for the foreign economies that have depended for growth on American consumers to buy the excess goods and services for which they have no other ready markets.

In 2007, U.S. consumers accounted for 18.2% of global GDP, and that share has jumped from 14.9% in 1980 and 16.8% in 1990. Furthermore, the shares of American consumer spending on durable and nondurable goods accounted for by imports from Central and South America and from the Pacific Rim have leaped since the early 1990s.

A clear result of the upward trend in consumers' share of GDP (Chart 4) and declining saving rate for a quarter-century has been the downtrend in the foreign trade and current account balances. We can't overemphasize the importance of the profligate U.S. consumer in fueling economic growth in the rest of the world, as we've discussed in many past Insights. We have also published our analysis of Asian exports. The intra-Asian trade was much bigger than the direct exports to the U.S., but when we accounted for the components produced in, say, Taiwan that were sent for subassembly to Thailand, then to Malaysia for final assembly with the finished product destined for the U.S., over half of Asian exports ended up in America.

Export-Dependent China

In late 2007, most forecasters disagreed with us and said China's economy would continue to grow at double-digit rates, and even support the U.S. economy if it softened. However, in "The Chinese Middle Class: 110 Million Is Not Enough" (Nov. 2007 Insight), we explained that China was not yet far enough along the road to industrialization to have a big enough middle class of free spenders to sustain economic growth if exports fell with U.S. consumer spending, as we were predicting.

As we noted in that report, in China, it takes $5,000 or more in per capita income to have meaningful discretionary spending. The 110 million who fit that category are a lot of people, but only 8% of China's population. In India, the middle and upper income classes are even smaller, 5%. In contrast, in the U.S. it takes $26,000 or more to have middle-class spending power, and 80% of Americans qualify. So we wrote in that report that all the cell phones and PCs being bought by Chinese was not the result of domestic economic strength, but merely the recycling of export revenues and direct foreign investment funds. And we went on to forecast that U.S. consumers would retrench, resulting in a nosedive in Chinese exports and a deep recessionary slump in China's growth.

Well, as they say, the rest is history. It now seems likely that China's earlier double-digit growth rates will slip to the 5%-6% range that would probably constitute a major recession, and probably lower. About 8% growth is needed to accommodate the vast numbers who continually flood from the countryside to the cities in search of work and better lives. Of those who went back to their villages to celebrate the recent lunar new year, 20 million didn't return because their factory jobs had vanished along with Chinese exports. Worker unrest us mounting and just as civil disturbances have ended many past Chinese dynasties, the Mao Dynasty's days may be numbered, as we've discussed in past Insights.

No Winners

With subdued U.S. consumer spending in the years ahead and the resulting weakness in American imports, economic growth abroad will be even weaker than in the U.S. Note that in previous U.S. recessions, the current account and trade balances tend to rise as imports weaken with economic activity, but exports fall less as economic growth abroad persists. That's been true of late, even though most would prefer strengthening balances from strong U.S. exports, not weaker imports. In any event, falling economies overseas are already weakening U.S. exports (Chart 6) and subdued global growth in the years ahead will probably limit the improvement in the U.S. current account and trade balances. Notice the close link between world industrial production and merchandise exports (Chart 7).

First And Last Resort

Now, with American consumers embarking on a saving spree, the U.S. will no longer be the buyer of first and last resort for the globe's excess goods and services. Furthermore, with slower global growth for years ahead, virtually every country will promote exports to spur domestic activity. Already, China has stopped allowing her yuan to rise in order to gain a bigger share of a declining pool of global exports.

Financial Deleveraging

There's no question that the financial sector is deleveraging, and its embarrassed leaders, pressured by regulators and everyone else, will no doubt continue this process for years to come. Securitization, off-balance sheet financing, derivatives and other financial vehicles that both stimulated and distorted economic activity are disappearing.

Big banks are reducing exposure to volatile proprietary trading and emphasizing safer asset management. Hence, Morgan Stanley's interest in buying Smith Barney, the brokerage unit of cash-hungry Citigroup. Furthermore, banks are cutting their financing of hedge funds by concentrating on the likely survivors in the ongoing shake-out and cutting off the rest. This will hasten the demise of many less-successful as well as smaller shops that are also at risk of investor withdrawals.

Banks are retrenching from lending to the point that corporate borrowers are turning to the bond market instead for funding. Despite government bailouts, writedowns continue to erode bank capital. Many still hold some of the leveraged loans they made to fund private equity leveraged buyouts back in the boom days. Lenders normally recover 80% on those loans when borrowers default since they rank high in the recovery pecking order. But recent bankruptcies indicate 25% recovery rates. Earlier, Japanese banks were flush with cash, but sharply lower earnings outlooks suggest they no longer will be able to provide capital to international markets.

As banks retreat to their core competencies, they're selling non-essential units. Faced with lasting fear spawned by huge losses and pressed by regulators, these institutions are retreating to basic banking 101. That's spread lending in which deposits are lent with a market-determined interest rate spread that covers costs plus a modest profit. Banks are also consolidating in response to gigantic losses and bleak outlooks. France's BNP Paribas bought the Belgium and Luxembourg assets of Fortis. Spain's Santander is acquiring full control of Sovereign Bancorp based in Wyomissing, Pa. Large consolidated financial institutions don't tend to be big risk-takers, and often lack the entrepreneurial spirit that promotes productivity and economic growth. Also, with fewer institutions, there are fewer counterparts to share risks, and that also dampens activity.

Eastern Europe

Overseas, Western banks largely financed the rapid economic growth in the former Iron Curtain countries in Europe after the Soviet Union collapsed in 1991. In addition, many companies in those lands financed their domestic businesses by borrowing Swiss francs, euros and other hard currencies at lower rates than in their own inflation-prone countries. Individuals entered the same carry trade to fund their home mortgages.

Now, however, lenders are retreating as they delever. Exports to Western Europe, another important source of growth, are falling. Eastern European borrowers need to repay $400 billion owed to Western banks this year, much of it denominated in foreign currencies. Eurozone banks have outstanding loans to Central and Eastern Europe totaling $1.3 trillion. EU leaders, led by German Chancellor Merkel, recently rejected a $240 billion bailout of Eastern Europe proposed by Hungary.

Like Asia 1997-1998

The dependence of Central and Eastern Europe on foreign financing is painfully similar to that is Asia in the 1990s that led to the 1997-1998 financial and economic collapse--except it probably will be worse this time since banks are delevering this time and weren't back then. Also, these European countries were more leveraged in 2008 than their Asian counterparts a decade ago. This can be seen in their foreign debts in relation to GDP (Chart 8) and in their current account deficit/GDP (Chart 9) as well as in their currency declines.

Asian lands reacted to the 1997-1998 crisis by cutting foreign borrowing and building foreign currency reserves. Ironically, however, they still didn't escape the current global recession and financial crisis. They're no longer as dependent on inflows of foreign capital, but this time are highly dependent on exports, which are plummeting as U.S. consumers retrench.

Commodity Crisis

The collapse of the commodity bubble will also subdue global economic growth in future years. Sure, commodity consumers benefit from lower prices as producers lose. But the share of total spending on commodity imports by consumers, especially developed lands, is tiny while they account for the bulk of exports for producers, notably developing countries.

Budget Signals

The new Obama federal budget points clearly to more government regulation and involvement in the economy. Going well beyond dealing with the deepening recession and financial crisis, the President wants $630 billion to move toward national health insurance. Businesses that emit carbon dioxide and other greenhouse gases would have to purchase permits. Another $20 billion would go for clean energy technology. The government would essentially take over student loans while eliminating private lenders, and make them entitlements with no annual limits on loan totals.

Obama also plans to increase taxes in higher-income households and capital gains and estate while redistributing money to lower-income people, even those who don't pay taxes. This reflects his populist views on the campaign trail, but with considerably more edge. The President's budget document states, "Prudent investments in education, clean energy, health care and infrastructure were sacrificed for huge tax cuts for the wealthy and well-connected. In the face of these trade-offs, Washington has ignored the squeeze on middle-class families that is making it harder for them to get ahead. There's nothing wrong with making money, but there is something wrong when we allow the playing field to be tilted so far in the favor of so few." The President's budget message also attacks "a legacy of misplaced priorities...and irresponsible policy choice in Washington."

Corporations, the energy industry, hedge funds and large farmers would also pay higher taxes while families with annual incomes under $200,000 and especially the working poor would get government checks.

The budget calls for more enforcement money for the FDA to step up drug safety rules, more for the EPA to crack down on industrial polluters, additional funds to protect endangered species and land and water conservation and to protect wildlife from climate change. More money is also requested to enforce fair housing laws and better disclosure of mortgage terms and to reverse "years of erosion in funding for labor law enforcement agencies." Employers that don't offer retirement plans will be forced to open IRAs for employees. There's also additional funds requested for enforcing workplace safety rules.

Stress Tests

Major banks are being stress-tested to determine their volatility under adverse conditions. To date, Fannie and Freddie are in conservatorship and controlled by the government. The remaining major investment banks, Goldman Sachs and Morgan Stanley are bank holding companies with Federal Reserve regulation. Is it a big surprise that Litton Loan Servicing, owned by Goldman, recently changed its strategy on mortgage modification to reduce borrowers' monthly payments to 31% of income from 38%, the industry standard?

Citigroup and BofA are, for all intents and purposes, wards of the state while the media and Washington spar over whether they will be formally owned by the government. Those two banks recently agreed to suspend mortgage foreclosures until the Treasury sets up its rescue program.

AIG is 85% owned by the Fed, which probably wishes it owned nothing of that bottomless money pit that has already absorbed $150 billion in government money. Recently, the government initiated its fourth plan to rescue AIG,which just reported a $62 billion loss in the fourth quarter. The firm is so troubled that Washington has completely backed away from its role as a stern lender that forced AIG to pay high interest rates on what it assumed would be short-term loans. Now the government is relaxing loan terms by wiping out interest in hopes of preserving some value for AIG. And it will be more involved as it splits AIG into two pieces and gets preferred shares in each entity.

Auto Bailout Payback

Beyond the financial sector, the ongoing bailout of U.S. auto producers is leading to more government intervention in that industry. As usual, he who pays the piper calls the tune. The government has already pumped $17.4 billion into GM and Chrysler, and they say they may need $21.6 billion more. GM also proposes a $4.5 billion credit insurance program for the auto parts makers. Furthermore, GMAC may need more than the $5 billion sunk into it by the Treasury last December.

Bonuses

Of all the signs of opulence carried over from the bubble years, corporate jets and big executive bonuses seem to bother Washington the most. BofA is selling three of its seven jets, a helicopter that was owned by Merrill Lynch and one of two of its New York corporate apartments. Obama wants firms that accept "extraordinary assistance" from the government to cap annual pay at $500,000, disclose pay to shareholders for a non-binding vote, claw back bonuses of corporate officials who provide misleading information, eliminate golden parachutes for those terminated and adopt board policies for luxuries such as entertainment and jets.

This reaction to big bonuses in firms that are taking huge writeoffs, losing big money and requiring massive government bailouts was predictable. From 2002 to 2008, the five largest Wall Street firms paid $190 billion in bonuses while earning $76 billion in profits. Last year, they had a combined net loss of $25 billion but paid bonuses of $26 billion.

The Trouble With More Regulation

Increased regulation may be the natural reaction to financial and economic woes, but it is fraught with problems. It's a reaction to crises and, therefore, comes too late to prevent them. And it often amounts to fighting the last war since the next set of problems will be outside the purview of these new regulations. That's almost guaranteed to be the case since fixed rules only invite all those well-paid bright guys and gals on Wall Street and elsewhere to figure ways around them.

Furthermore, government regulators have never, as far as we know, stopped big bubbles or caught big crooks. Consider the dot com and then the housing blowoffs, both of which occurred while the SEC, the Fed, other regulators, Congress, etc. sat on their hands. Think about Enron, WorldCom and Bernie Madoff, all of whom went on their merry ways until their self-induced collapses, completely free of regulatory interference.

Most importantly, government regulation and involvement in the economy is almost certain to prove inefficient. Risk-taking has been excessive, but government bureaucrats are likely to eliminate much of it, to the detriment of entrepreneurial activity, financial innovation and economic growth. Fannie, Freddie and government-controlled banks are now being directed by the government to modify mortgages to accommodate distressed homeowners. That may implement government policy, but leads to bad business decisions.

Confusion

Furthermore, if financial regulation changes massively, it probably will create confusion and uncertainty to the detriment of adequate financing, spending and investment. Some academics believe that the Great Depression was prolonged because the New Deal measures were so disruptive that banks and other financial firms as well as individual investors, consumers and businessmen were too scared to do anything. Recently, Tadao Noda, a Bank of Japan policy board member, said, "We are in a position where the central bank needs to interfere in financial markets, but if we do too much, the market functioning in turn may be hurt." In any event, major problems inexorably lead to greater government involvement. The Bush Administration was staunchly deregulatory in philosophy but forced to intervene in the financial crisis. The 20th century saw tremendous growth in government involvement in all aspects of the economy and financial markets as a result of three tremendous traumas--World Wars I and II and the Great Depression.

Protectionism

Recessions spawn economic nationalism, protectionism, and the deeper the slump, the stronger are those tendencies. It's ever so easy to blame foreigners for domestic woes and take actions to protect the home turf while repelling the invaders. The beneficial effects of free trade are considerable but diffuse while the loss of one's job to imports is very specific. And politicians find protectionism to be a convenient vote-getter since foreigners don't vote in domestic elections.

U.S. Leadership

Sadly, the U.S. appears to be among the leaders for protection of goods and services against foreign competition. The auto loan program last year under the Bush Administration largely excluded foreign transplants. Obama advocates a super-competitive economy, which requires highly productive workers. Yet the recent fiscal stimulus law restricted H-1B visas, granted to foreigners with advanced education and skills, for employees of firms that receive TARP (bank bailout) money.

Some in Congress worried that tax credits for renewable energy should be confined to American-produced equipment. And recall that during the presidential campaign, Obama called for renegotiating the North American Free Trade Agreement. Furthermore, the President's emphasis on health care, education and renewable energy turns attention inward, toward self-sufficiency and away from a global focus.

Outside the U.S., protectionism is being promoted by labor unrest. In England, workers at a French-owned oil refinery struck because Total awarded a construction contract to an Italian firm that planned to use its own staff from abroad rather than local workers. Rioters on the French Caribbean island of Guadeloupe protested high prices for food and other necessities for a month recently. High unemployment rates, especially among younger workers, have precipitated riots in Latvia, Lithuania, Greece, Russia and Bulgaria as well as France.

Competitive Devaluations

Good old-fashioned competitive devaluations to spur exports and retard imports, a mainstay of the 1930s, are making a comeback. Kazakhstan recently devalued, in part because of devaluations of her trading partners. As noted earlier, China stopped allowing her yuan to appreciate, in part because her labor costs are being undercut by countries like Vietnam and Bangladesh.

With the understanding that protectionism helped make the Great Depression "Great," country leaders still publicly espouse free trade and reject protectionism. And they express confidence that global organizations like the WTO, IMF and World Bank will forestall protectionism and economic nationalism, and they engage in endless meetings to promote free trade as well as global standards and cooperation for handling the deepening financial crisis. But almost nothing happens, as shown by the recent EU refusal to bail out Eastern Europe.

Stealth Protectionism

In any event, protectionism is returning by stealth. U.S. steelmakers plan to file anti-dumping suits against foreign producers, a strategy they have employed successfully for decades, and India recently proposed increased steel tariffs. In the first half of 2008, WTO antidumping investigations were up 30% from a year earlier. Bank bailouts have been aimed at protecting local institutions, as discussed earlier, and the Japanese government is buying stocks of Japan-based corporations to help company balance sheets, but also giving them a competitive advantage over the subsidiaries of foreign outfits.

Like America, France is aiding its own auto producers, not transplants, and has created a sovereign wealth fund to keep "national champions" out of foreign ownership. Since last November, Russia has introduced 28 import duty and export subsidies affecting steel, oil and other products as well as imposed special road tolls on trucks from the EU, Switzerland and Turkmenistan. Russia's tariff on imported cars recently rose 5 to 10 percentage points, curtailing shipments of used cars from Japan to the Russian Far East.

Meanwhile, Argentina has imposed new obstacles to imported shoes and auto parts. The EU again is giving export refunds to dairy farmers, to the detriment of New Zealand, slapped anti-dumping charges on Chinese nuts and bolts, and threatens duties on U.S. biodiesel imports in retaliation for America's export subsidies. Not to be outdone, the U.S. plans retaliatory tariffs on Italian water and French cheese in reaction to EU restrictions on U.S. chicken and beef imports in the hormones war.

Ecuador lifted tariffs across the board recently, with the levy on imported meat rising to 85.5% from 25%. Indonesia is using special import licenses to limit the inflow of clothing, shoes and electronics and also is curtailing toy imports by allowing them to enter through only a few of its ports. And there's the old standby, health and safety standards that Japan relies on consistently to keep out unwanted products.

Deflation

Long-time Insight readers know that we have been forecasting chronic deflation to start with the next major global recession. Well, that recession is here. As discussed in our Nov. 2008 Insight, deflation results when the overall supply of goods and services exceeds demand, and can result from supply leaping or from demand dropping. We've been forecasting chronic good deflation of excess supply because of today's convergence of many significant productivity-soaked technologies such as semiconductors, computers, the Internet, telecom and biotech that should hype output. Ditto for the globalization of production and the other deflationary forces we've been discussing since we wrote two books on deflation in the late 1990s, Deflation: Why it's coming, whether it's good or bad, and how it will affect your investments, business and personal affairs (1998) and Deflation: How to survive and thrive in the coming wave of deflation (1999). As a result of rapid productivity growth, fewer and fewer man-hours are needed to produce goods and services. Estimates are that 65% of jobs lost in manufacturing between 2000 and 2006 were due to productivity growth with only 35% due to outsourcing overseas.

Similar conditions held in the late 1800s when the American Industrial Revolution came into full flower after the Civil War. Value added in manufacturing leaped, and at the same time, real GNP grew 4.32% per year from 1869 to 1898, an unrivaled rate for a period that long, and consumption per consumer jumped 2.33% per year. Yet wholesale prices dropped 50% between 1870 and 1896, a 2.6% annual rate of decline. Good deflation also existed in the Roaring '20s when the driving new technologies were electrification of factories and homes and mass-produced automobiles.

The 1930s

In contrast, bad deflation reigned in the 1930s as the Great Depression pushed demand well below supply. As in the 1839-1843 depression, the money supply, prices, banks and real goods and services all nosedived. Employment dropped along with prices in the Great Depression and the unemployment rate rose to 25%. That depression was truly global.

We've consistently predicted the good deflation of excess supply, but in our two Deflation books and subsequent reports, we said clearly that the bad deflation of deficient demand could occur--due to severe and widespread financial crises or due to global protectionism. Both are clear threats, as explained earlier in this report.

Furthermore, with slower global economic growth in the years ahead due to the U.S. consumer saving spree, worldwide financial deleveragings, low commodity prices, increased government regulation and protectionism, excess global capacity will probably be a chronic problem. So deflation in the years ahead is likely to be a combination of good and bad.

Supply will be ample due to new tech, globalization and other factors we've explored over the years such as no big global wars (we hope), continual inflation worries by central bankers, continuing restructuring, and cost-cutting mass retailing. But demand will be weak, as discussed earlier. The chronic 1% to 2% deflation from excess supply that we forecast earlier still seems likely, but now we're adding 1% due to weak demand for a total of 2% to 3% annual declines in aggregate price indices for years to come.

2009 Seems Easy

For four reasons, the deflation that started several months ago (Chart 10) is quite likely to persist along with the recession, or at least until early 2010. First, the collapse in commodity prices continues and past declines are still working their way through the system. Crude oil prices have collapsed from $147 per barrel to around $40. Steel semi-finished billet prices were $1,200 a metric ton last summer but now is $350. Iron ore costs per metric ton dropped from $200 early last year to $80. It takes time for steel prices to work through to final consumer goods prices such as for washing machines.

Second, producers, importers, wholesalers and retailers were caught flat-footed by the sudden nosedive in consumer spending late last year and continue to unload surplus goods by slashing prices. All the giveaway bargains at Christmas still didn't entice enough consumers to open their wallets. Spring apparel, ordered before consumer retrenchment, is clearly in excess and being marked down before it's put on the racks. Retailers from Saks on down continue to chop prices. Branded food product manufacturers are willing to promote their wares alongside the private-label goods that supermarkets shoppers increasingly favor.

Wage Cuts

Third, wages are actually being cut for the first time since the 1930s. Previously, labor costs were controlled by layoffs, which still dominate. Benefits have also been trimmed in recent years by switching from defined contribution pensions to 401(k)s and increasing employee contributions to health care costs. Most workers are less sensitive to benefits than to salaries and wages, but the deepening recession and mounting layoffs (Chart 5) are making them more amenable to wage cuts.

So is the growing use of this approach. In a recent poll, 13% of companies plan layoffs in the next 12 months, but 4% expect to reduce salaries and 8% will cut workweeks.

So it just isn't the CEO who is taking the symbolic pay cut to deal with tough times. We argued in our Deflation books that cutting pay rather than staff is more humane, better for morale and better for keeping the organization together and ready for a business rebound. Now increasing numbers of employers agree with us.

A final reason to expect deflation in coming quarters in the U.S. is the surplus of aggregate supply over demand. Notice that the supply-demand gap is an excellent forerunner of inflation six months later. And deflation this year is spreading globally. Japan is once again flirting with falling prices, Thailand's CPI in January fell year over year for the first time in a decade. In Europe, inflation rates are rapidly approaching zero.

Prices In Recovery

The real test of deflation will come when the economy recovers--in early 2010 or later, we believe. Inflation rates normally fall in recessions, but then revive when the economy resumes growth. This time, inflation rates started low, so declines into negative territory are normal, especially given the severity of the recession and the collapse in energy and other commodity prices. If we're right, however, aggregate price indices like the CPI and PPI will continue to drop in economic recovery and verify the arrival of chronic deflation.

Few agree with us. They've never seen anything but inflation in their business careers or lifetimes, so they think that's the way God made the world. Few can remember much about the 1930s, the last time deflation reigned. Furthermore, we all tend to have inflation biases. When we pay higher prices, it's because of the inflation devil, but lower prices are a result of our smart shopping and bargaining skills. Furthermore, we don't calculate the quality-adjusted price declines that result from technological improvements. This is especially true since many of those items, like TVs, are bought so infrequently that we have no idea what we paid for the last one. But we sure remember the cost of gasoline on the last fill-up a week ago.

Too Much Money?

The main reason most expect inflation to resume, however, is because of all the money that's being pumped out by the Fed and other central banks as well as the Treasury to finance the mushrooming federal deficit. When the economy revives, they fear, all this liquidity will turn into inflationary excess demand.

At present, the Fed's generosity isn't getting outside the banks into loans that create money.

When cyclical economic recovery finally does arrive in 2010 or later, it will probably be sluggish and lenders will still likely be cautious, as discussed earlier. Furthermore, any meaningful increase in loans will probably continue to be more than offset by the continual destruction of liquidity as writedowns, chargeoffs, elimination of derivatives, etc. persists for years. Derivatives represent liquidity. You can't use them at the grocery store, but at least until recently, they were interchangeable from money in many uses.

In Sum

The deepening recession and spreading financial crisis is the beginning of the unwinding of about three decades of financial leverage and spending excesses. The process will probably take many years to complete as U.S. consumers mount a decade-long saving spree, the world's financial institutions delever, commodity prices remain weak, government regulation intensifies and protectionism threatens, if not dominates. Sluggish economic growth and deflation are the likely results.

A. Gary Shilling's INSIGHT - March 2009
Telephone: 973-467-0070

Weakness Unmatched in 35 Years

John Mauldin — Tue, 17 Feb 2009 02:24:19 GMT

One of the best gauges of an economy is tax collections. No one pays taxes unless they have to, so collections are a real-world, real-time analysis of the US economy. And the best source I know of for tracking taxes is The Liscio Report, by Philippa Dunne & Doug Henwood.

Tax collections are down. Philippa and Doug give us the actual numbers, which are not pretty. Bottom line? "What does this all mean? It suggests that the consumer retrenchment in this recession will be deep and long, and will probably continue into any recovery. The American consumer is no longer the world consumer of last resort, and that's an enormous change for both this country and the rest of the world to get used to."

You can learn more about the Liscio Report at www.theliscioreport.com. Enjoy your week.

John Mauldin, Editor Outside the Box

The Liscio Report On the Economy

Holiday blues: Weakness unmatched in 35 years

In January, 21% of the states in our survey met or exceeded their forecasted sales tax collections, up from 9% in December. Our index is based on states meeting their forecasts, not reporting strong or even positive over-the-year collections, so we need to point out that the entire improvement came from a large state doing slightly better than the stunning decline they had forecast. This decline was partially calendar related, but January 2008 was 7% below forecast, so they had a very low bar. In the words of our contact in that state: "Bad economy, good forecast." Had the revenue estimators in that state made a less dramatic forecast our survey would have slid to 6%, which we think is more in line with historical weakness reported for sales tax collections during the holiday season.

States reporting over-the-year growth fell to 3% from 15% in December. The average decline, weighted by state population fell from December's –6% to –10%. (More on this in a bit.) Forecasts were negative in all but two of the states that met their projected collections. The exceptions include a state that collects sales taxes on groceries and attributes their relative strength to the spike in food prices, and another that put through a rate increase, which accounts for all of the growth.

The energy-extraction states, which have held up the longest, are now weakening as well. To give you an idea of how powerful the surge in energy prices has been, our contact in one southern state told us that their Appalachian mine country is currently outperforming regions where manufacturing and research predominate.

Throughout the country, states are reporting historic weakness. One Midwestern state reported two months of double-digit declines, which just three months ago would have been "unthinkable." A small southern state reports that never before has an entire year fall below the prior year; they are currently down 5.7% for the year, and have to go back 35 years to find similar monthly weakness. Calling the holiday season one "large discretionary item," our contact in a large Midatlantic state reports that that item "imploded like never before" in his forty years of data. "Holiday receipts will make you say: OMG," he promised, even if you're too old to talk that way.

There is one piece of potentially encouraging news. A few contacts remarked that they do not expect the current rate of decline to continue into the spring as spending swings back toward day-to-day needs and away from the discretionary shopping of the holiday season. But, of course, there is no guarantee that consumer spirits will improve much with the job market in rapid decline, the markets in disarray, and our leaders struggling to come up with a viable plan to get the credit markets moving.

In addition to exceedingly weak sales receipts, our contacts are reporting record unemployment insurance payouts (in one state double what would formerly have been considered a "huge" month), plummeting corporate receipts, skyrocketing refunds, and evidence that withheld taxes may have been supported by employees opting out of retirement plan deductions, and even cashing out of 401K plans. (Hardship withdrawals trigger withheld taxes.)

Consumption: From Excess to Freefall

What's happened to consumption since the middle of 2008 is nothing short of stunning, both in speed and magnitude. Several examples will make this point.

Let's start with one of the mainstays of this report, sales taxes. Graphed below is the yearly change in state and local government (SLG) sales tax receipts adjusted for inflation from the national income accounts. (The price index is that for SLG purchases.)

The last entry on the graph is our projection, based on the results of our January survey -- a 10% nominal decline with a 2-point inflation adjustment, or a 12% estimated decline. (The estimate of 2% inflation is rough; it was about 3% in the fourth quarter, down from around 6% at midyear.) The actual result for the fourth quarter of 2008 was –6.3%, a little worse than the previous two quarters, which came in at –5.9%. That –6% neighborhood for late 2008 is the worst in the history of the series; its closest rival is the –5.1% hit during the sharp 1980 consumer recession, when Jimmy Carter got on TV and told people that it was their patriotic duty to stop using their credit cards -- which they actually did for a while, though not for long. This quarter should shape up to be a record-breaker.

OK, moving on to auto sales. Graphed below are monthly unit sales at a seasonally adjusted annual rate per 1,000 people. Adjusting for population really brings home the weakness. January's 9.5 million rate (for autos plus light trucks) is one of the lowest in history, but its earlier rivals were at times when the U.S. population was considerably lower than it is today.

January's rate translates into 31.1 units per 1,000 people, which is 3.5 standard deviations below the mean, and well below November 1970's 36.1, a dismal performance created not by economic weakness, but by a two-month strike at GM. It's also worse than the lowest levels of the 1973–75 and 1981–82 recessions (40.8 and 38.3 respectively). It comes after a 17-year period when there was basically no auto recession. But the contraction has hit suddenly and hard: sales were 50.3 per 1,000 in February 2008. The yearly drop-off is the worst since the numbers begin in 1968.

And now a macro measure: what Keynes called the marginal propensity to consume (MPC). The MPC is the share of after-tax income growth that is devoted to consumption. Between 1950 and 1990, the MPC was 89% (that is, the growth in consumption over those 40 years was equal to 89% of the growth in after-tax income). Americans started consuming more of their income growth in the 1990s, but really broke records in the 2000s.

Those points are illustrated by the graphs on below. The top graph shows the MPC computed over rolling one-year intervals. It's obviously very volatile, so we've added a trendline (as computed by a Hodrick–Prescott filter). In the 1980s, the HP trend broke above 100% for the first time, maxing out at 106% in 1986. It fell back to just below 100% as the decade turned, but began rising again in 1991. It stayed above 100% until mid-2006, and has now fallen very sharply to 75%. The actual MPC for the fourth quarter of 2008 was 2.4%, the lowest by far since 1950.

The graph on the bottom stretches the interval out to three years, to smooth out some of the volatility. That measure isn't at record lows, but its fall has been vertiginous: from 113% at the end of 2007 to 82% at the end of 2008. Measured in percentage terms, that's the sharpest fall over the last 58 years.

And the graph below shows the MPC by expansion, for the last 10 cycles. The MPC for the 2001–2007 expansion was 108%, a record by a comfortable margin. The #2 slot is occupied by the 1991–2001 expansion's 102%. Aside from the late 1950s expansion, nothing else came in above 100%.

What does this all mean? It suggests that the consumer retrenchment in this recession will be deep and long, and will probably continue into any recovery. The American consumer is no longer the world consumer of last resort, and that's an enormous change for both this country and the rest of the world to get used to.

Thursday's retail numbers

As we often point out, the retail sales series is extremely noisy, so noisy in fact that its month-to-month serial correlation is negative or non-existent. Stringing together the old and new series since 1967 gives you a serial correlation of –0.198 for the headline and –0.154 ex-auto; just looking at the new, post-1992 series, the coefficients are –0.151 and 0.032. This compares to the nonfarm payrolls correlation of +0.707.

This is by way of preface to saying that it's unusual to have several consecutive months of steep declines, as we have in recent months, but certainly not surprisingly in these unusual times (something to be thankful for in five or ten years, we hope).

Although our sales tax survey is abysmal, collections are lagged and we have seen some of that weakness in December's retail numbers. We suspect January sales fell -0.3% and –0.2% stripping out autos. The standard private surveys suggest that January wasn't as bad as December; the Goldman Sachs–ICSC weekly chain store numbers have stabilized (at low levels, suggesting necessities, not indulgences) in recent weeks. Our headline is far from consensus because we understand that weakness in unit auto sales was largely driven by fleet sales. The Census Bureau instructs retailers to include fleet sales in their responses, but since these sales usually bypass retail outfits they are probably more often missed than included.

--Philippa Dunne & Doug Henwood

The Great Experiment

John Mauldin — Tue, 20 Jan 2009 02:20:15 GMT

There is a reason I call this column Outside the Box. I try to get material that forces us to think outside our normal comfort zones and challenges our common assumptions. And this week's letter from Hoisington Investment Management Company does just that.

Let me give you two quotes to pique your interest: "Monetary policy works by creating the environment for a renewed borrowing and lending cycle. This cycle would require that the debt to GDP ratio, which is already at a record level, grow even higher. Would such an outcome really be that desirable when the controlling problem of the U.S. economy is too much improperly financed debt? If the Fed were able to engender an increase in the debt to GDP ratio, this might merely serve to postpone the reckoning of the current debt levels while laying the foundation for an even more vicious unwinding down the road."

And: "The only really viable option for federal stimulus is a permanent reduction in the marginal tax rates, as highlighted in the research of Christina Romer, incoming Chair of the Council of Economic Advisors. This would have the benefit of raising after tax rates of return, but the drawback in the short run of still having to be financed by an increased budget deficit. Over time, a massive reduction in marginal tax rates would be beneficial, but the operative word is time. Refunds, or transitory tax relief, will have no better results in stemming the recessionary tide in 2009 and 2010 than it did in the spring of 2008."

Van Hoisington and Dr. Lacy Hunt give us a seminar on the current bailout programs that is not the usual analysis we see in mainstream media. This week's letter requires you to think, but it will be worth the effort.

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. And now let's jump right in to the essay.

John Mauldin, Editor
Outside the Box

THE GREAT EXPERIMENT

Quarterly Review and Outlook -- Fourth Quarter 2008
Hoisington Investment Management Company

The late Nobel Laureate, Milton Friedman, noted in his 1963 book, Monetary History of the United States (coauthored with Anna Swartz), that the money stock decreased by a massive 31% in the Great Depression. The turnover of that money, called velocity, fell 21%. Nominal GDP equals money multiplied by velocity. Consequently, from 1929 to 1933 the breakdown of both measures resulted in a contraction in nominal GDP of approximately 50%. However, Friedman postulated that if the Fed had not let money shrink, velocity would have been steady and the Great Depression would have been averted, i.e., nominal GDP would not have collapsed. Our current Fed Chairman, Ben Bernanke, is an expert on the Great Depression, and he has, in fact, adopted Friedman's strategy to greatly expand the money supply. Whether this prescription for economic stability will work in a period of over indebtedness, such as now exists in the U.S., is most uncertain. Indeed, this could be called the "great experiment" since this economic theory has yet to be thoroughly tested in the real world.

Presently, major sectors of the U.S. economy are experiencing a debt deflation that is causing a massive destruction of wealth, thereby curtailing jobs, income and spending. Irving Fisher who, according to Friedman, was the most brilliant of all U.S. economists has noted that when the economy enters a period of "debt and price disturbances", those forces will eventually engulf the economy. Fisher developed that concept by examining the 1929-33 depressionary period, as well as the depressions of 1837 and 1873, as examples of when excessive debt and subsequent price declines controlled "all or nearly all" other economic variables. This theory of excessive debt and its pernicious and unrelenting deflationary impulse to the economy has been best chronicled by other notable economists: Charles P. Kindleberger (1910-2003), Hyman Minsky (1919-1996), Nikolai Kondratieff (1892-1938) and Joseph A. Schumpeter (1883-1950). Fisher contends that once extreme over indebtedness occurs, fiscal and monetary policy become impotent in spurring economic growth because money velocity will decline -- something that is currently happening. Individuals and businesses struggle to repay debt with harder dollars, and saving begins to rise as caution prevails.

The debt level of the U.S. has reached unprecedented proportions (Chart 1). More important than the level, however, is the fact that for the last few years the debt was improperly loaned and financed. In the words of the late economists Minsky and Kindelberger, this type of lending activity implies there is little likelihood of repayment of principal and interest. Stock prices have plunged, and with home prices plummeting, and commercial and industrial properties losing value, a deflation of assets has clearly begun while the underlying debt remains constant. Will this deflation overwhelm the best efforts of the Federal Reserve, invalidate Friedman's theory and prove Fisher correct? Most naturally feel and hope that the superiority of unbridled monetary and fiscal stimulus will overwhelm incipient price declines and stem the expanding cyclical downturn in economic growth. Our judgment is that the power of monetary policy revolves around the ability to initiate a new borrowing and lending cycle. This can only happen if lenders are willing to lend and borrowers are wanting and able to borrow. Presently, neither are so inclined (Chart 2). If price declines in assets continue, then Shakespeare's admonition of "neither a borrower nor a lender be" will become the economic mantra, meaning that a period of very low nominal growth will likely extend for a decade. Moreover, fiscal policy actions may not be helpful either and could produce unintended negative consequences. Conventional wisdom is that the current economic contraction is nothing more than a typical post war recession. In the ensuing paragraphs we intend to frame an argument that is contrary to this conventional wisdom.

Chart 1

Chart 2

CAN FED POLICY CONTROL ECONOMIC DESTINY?

To respond to the country's severe economic problems the Fed has invented many new vehicles for injecting liquidity into the economy, but few outward signs suggest that these actions are engendering a recovery. Total reserves in the latest twelve months increased a record 1,897%. In the latest three months the M2 money stock jumped at an 18.2% annual rate, one of the largest quarterly increases on record. Many feel this is tantamount to the Fed printing money. However, nominal GDP is not equal to the stock of money but, as noted above, it is equal to the stock of money multiplied by its turnover, or velocity.

Friedman and Bernanke both believe that if the money supply is increased sufficiently velocity will stabilize and Fed actions will at least be able to keep nominal GDP stable or growing slightly. Fisher, on the other hand, argues that if a generalized debt deflation takes hold, velocity will decline, just as it did during the Great Depression.

Our analysis suggests that the Fed will not achieve the desired results of stable velocity. Velocity is a function of financial innovation, rising during periods of new innovations and falling when these innovations are reversed or unchanging. Fisher also suggested that velocity rises when leverage increases and falls when leverage abates. So far the evidence at hand suggests that velocity is thwarting the efforts of the Fed. In the fourth quarter velocity plummeted, completely offsetting the increase in M2. Thus, nominal GDP declined at a very rapid rate.

Monetary policy works by creating the environment for a renewed borrowing and lending cycle. This cycle would require that the debt to GDP ratio, which is already at a record level, grow even higher. Would such an outcome really be that desirable when the controlling problem of the U.S. economy is too much improperly financed debt? If the Fed were able to engender an increase in the debt to GDP ratio, this might merely serve to postpone the reckoning of the current debt levels while laying the foundation for an even more vicious unwinding down the road.

ARE MASSIVE FISCAL DEFICITS A CURE?

The major debate in Washington surrounds the issue of how large the fiscal stimulus should be. In this case, as in many such debates, the question being raised is probably not the right one. In 2008, the consensus opinion was that a stimulus program based on tax rebates and one time transitory payments would be sufficient to halt the recession. Discussions were based on the need to make such payments timely and targeted. Hardly any discussions were held in either official or non-official circles as to whether such a program was desirable. Had there been such discussions, the funds might not have been so badly wasted. Numerous studies had shown that consumers have a very limited tendency to spend transitory income, and that prior efforts to stimulate the economy through tax rebates had failed. Nevertheless, the political process barreled through with a program with no reasonable expectation that it would work. Now the economy is even deeper in recession and the country has an additional $177 billion in debt on which the taxpayers will pay interest in perpetuity. About 17% of the rebates were spent, a tad less than during the rebate program of 2001. The minimal spending response was exactly in line with the consumption functions under Friedman's permanent income hypothesis, as well as the equivalent Modigliani's life cycle hypothesis. These pioneering works demonstrated conclusively that consumers have a far greater tendency to spend permanent rather than transitory income.

Fiscal stimulus will not work well, and may even be counterproductive, and this applies to both spending programs and to certain tax programs as well. One of the major problems on the expenditure side is that the government sector is smaller than the private sector. In the third quarter, real government spending, including the federal defense and non-defense sectors, as well as the state and local sectors, totaled $2.1 trillion, comprising 17.8% of real GDP (Chart 3).

Chart 3

If there is a desire to increase government spending, the federal government must either increase taxes on the far larger private sector, an option that would presumably be precluded under the present circumstances, or borrow funds in the financial markets that would have gone to the private sector. At this point we have to ask which sector has the better track record of growing the economic pie—private or government expenditures? The private sector has demonstrated the greater flexibility and creativity to expand the economic pie, increasing productivity and thereby improving living standards for all. The risk is that increased federal borrowing will stunt the private sector's ability to grow.

The only really viable option for federal stimulus is a permanent reduction in the marginal tax rates, as highlighted in the research of Christina Romer, incoming Chair of the Council of Economic Advisors. This would have the benefit of raising after tax rates of return, but the drawback in the short run of still having to be financed by an increased budget deficit. Over time, a massive reduction in marginal tax rates would be beneficial, but the operative word is time. Refunds, or transitory tax relief, will have no better results in stemming the recessionary tide in 2009 and 2010 than it did in the spring of 2008.

An important offset to the increased spending by the federal sector is a massive cutback in state and local expenditures. If transfer payments are excluded from federal expenditures, the spending of state and local governments totaled $1.9 trillion in the third quarter, much greater than the $1.1 trillion spent by the federal government. Further, state and local governments employed 19.8 million workers versus 2.8 million for the federal sector. J.P. Morgan estimates that state and local governments will have a $400 billion shortfall in funding this year, an economic drag since balanced budgets are required in all but one of the fifty states. Thus, spending will be curtailed or taxes will rise.

MAJOR HEADWINDS FOR CONSUMER SPENDING

Consumer spending is contracting at a near record pace despite: (a) a strenuous effort by the Fed to loosen monetary conditions; (b) a $170 billion fiscal stimulus package that occurred in the second quarter of 2008; (c) the enactment of a troubled asset recovery program totaling $750 billion, and (d) promises for a major additional fiscal stimulus in 2009. These monetary and fiscal actions were overwhelmed primarily by an unprecedented decline in household wealth (Chart 4). Moreover, the wealth loss is now being augmented by significant job losses and a shorter work week.

Chart 4

From the final quarter of 2006 through the third quarter of 2008, the real value of homes fell $3.5 trillion, while households' real holdings of stocks fell $2.1 trillion, resulting in a $5.6 trillion loss in total household wealth (Table 1). The wealth loss may exceed $10 trillion when the fourth quarter figures are tabulated. The Fed's econometric model indicates that a one dollar decline in real wealth will reduce total expenditures by 7.5 cents over three years. This means that the drag on consumer spending from declining wealth will be 3.4% per annum this year and for the next two years. By comparison, from 2000 to 2007 the annual increase in consumer spending was 2.9%. Additional losses in household income and wealth are likely in 2009.

Table 1

With consumers confronting such hostile wealth and income prospects, the saving rate is likely to rise sharply as it did after the Great Depression and, excluding the distortions created by World War II, continued to do for a half century. If the deflation now apparent in specific sectors of the economy spreads, the rise in the saving rate is likely to continue for a very long time. In the past, debt deflations have caused consumers to avoid at all cost the pattern of living beyond their means. Thus, the rising saving rate will constitute a major headwind for the U.S. economy.

GLOBAL IMPLICATIONS

As a percent of GDP, the trade deficit has fallen from 6% to 4.9% in nominal terms and 5.5% to 3% in real terms over the past two years. Real imports in constant dollars have declined by 3.5% in the latest four quarters, a dramatic reversal from the sharp increases of recent years. This drop in imports reflects the loss of consumer wealth and income, creating lower spending for imports, and this drag will persist for at least three more years. Therefore, further and even sharper declines in imports are likely. This will continue to transmit U.S. economic weakness to the rest of the world, while at the same time gradually and irregularly reducing the U.S. trade deficit.

Although the current account will narrow and fewer funds will recycle into the U.S., it is important to review the portfolios of foreign investors. Based on the latest available figures, the foreign sector held $9.1 trillion of long-term securities (Table 2). The Treasury department considers long term securities to be those with an original maturity of more than one year. As this table indicates, equities comprise 34% of foreign holdings, the highest for any category, followed by 30% in corporate bonds, 22% in Treasury securities and 14% in Federal Agency securities. The holdings of U.S. Treasury securities are primarily in the short end, with 70% held in 5 year or less maturities, 23% in 5 -10 year maturities, and just 7% in greater than 10 year securities. Thus, the shrinking U.S. capital account surplus is likely to have its greatest funding impact on the corporate bond and equity markets. The short-term Treasury market could be adversely affected, but the Fed is able to control the short-term rates.

Table 2

HISTORY OF DEBT BUBBLES AND LONG-TERM INTEREST RATES

In the world's three most recent debt deflations – the U.S. from the 1870s to the 1890s, the U.S. from the 1920s to 1940s, and Japan from the 1980s to the very present – the low in long term interest rates occurred about 15 years after the end of the debt mania (Chart 5). Even 20 years after the end of the debt boom, interest rates were not much above their yearly average lows. Using this history as a guide, it would not be surprising to experience a decade of low and declining interest rates

Chart 5

During 2008, long term Treasury bond yields fell from 4.5% to 2.7%, producing an extremely strong total return for such investments, as typified by the Wasatch-Hoisington Treasury Bond Fund (WHOSX), which returned 37.7%. Credit problems affected returns elsewhere in debt markets, limiting returns on the Barclays Capital U.S. Aggregate Bond Index (formerly the Lehman Index) to 5.2%. The decline in long Treasury yields reflected the intensification of recessionary forces as well as a collapse in inflationary expectations.

While the historical record indicates that the ultimate low in Treasury yields lies years away, the path to the ultimate low will be anything but smooth or linear as significant volatility continues. As the experience from U.S. and Japanese history indicates, many "false dawns" will occur, with investors assuming that the long-delayed cyclical recovery in economic activity is at hand. During these pleasant but relatively short interludes, stock prices will probably rise dramatically and bond yields will increase. If history is a guide, however, these episodes will further drain wealth and will be thwarted by the persistent forces of the debt deflation. With yields in the long Treasury market very low in nominal terms, the real return will be greater if deflation sets in. Moreover, in Japan from 1988 to the present, as well as in the U.S. from 1872 to 1892 and 1928 to 1948, the total return on Treasury bonds exceeded the total return on stocks. Such a condition cannot happen for the long run, but it did happen in these three instances spanning two decades. As a hedge against a recurrence of a prolonged debt deflation, some investors may want to consider even larger positions in high quality, long term Treasury securities.

Van R. Hoisington
Lacy H. Hunt, Ph.D.

A Daily Snapshot Of Market Moving Developments

John Mauldin — Mon, 22 Dec 2008 18:21:17 GMT

Have you done your Christmas shopping yet? Research shows that more of us are putting it off in expectations of better prices. In other words deflationary expectations! The prices I have seen while out shopping the past few weeks are simply amazing. I have to admit to have made a few purchases for some items that I was not planning to buy just yet because prices were off by 60% or more. A few days ago a friend came in sporting a new black cashmere sweater top with jeweled embroidery and quite fancy. She said she got it at Saks. But the real story is that when she walked into Saks looking for a present for her kids they handed her a coupon with a 30% off any one item from whatever price it was already marked down. That top? At one point it was almost $500. She bought it for $75. I have to confess that made me worry about retail sales and future unemployment. I like low prices, but I like profitable companies and employment. I went and talked to a Saks salesperson a few weeks ago who had been there 25 years and asked if they had ever discounted like that before Christmas and he said never. It was Saturday in New York and the place looked busy. I asked why? And he said, "The store is empty during the week." And I bought a few sweaters at 60% off. Tiffani just got some presents from J Crew at over 60% off. Before Christmas! How many readers have seen the same sales? And yet shopping is down?

As a side note, this year most of the kids and in-laws are all going to get a Visa gift cards so they can take advantage of what I think are going to be even better sales after Christmas. It is not that Dad put off his shopping to the last minute (which I did) but the kids are really looking forward to finding their special items on sale. I wonder how many more are doing that?

This week we look at David Rosenberg's latest missive. While listing a number of negative data points, the thing to watch for is all the deflationary news. I have been pounding the table for YEARS that deflation is going to be the problem, and there would be massive stimulus from the Fed to fight it. We are now coming to that inflection point. Rosenberg is one of my favorite main stream economists and the North American Economist for Merrill Lynch. I would say enjoy this week's Outside the Box, but it is not enjoyable reading, but you should read it anyway.

Have a Merry Christmas. And enjoy the after Christmas sales! All the best,

John Mauldin, Editor
Outside the Box

A Daily Snapshot Of Market Moving Developments

North America: Morning Market Memo
by David A. Rosenberg

Overseas Overnight Market action Outside of Japan, which rallied 1.6% on speculation that the BoJ would buy corporate debt to ease credit risk, equity markets across Asia were weaker across the board. The Hang Seng sank 3.3%, or -505 points, to 14,622. India's Sensex was off 1.7% while China's Shanghai Composite dropped 1.5%. The Korean Kospi, however, fell just 0.1%. In Europe, equity markets are trading lower and off about 0.8% in the aggregate. US equity futures, however, are pointing to a higher open across the major indices. Bonds are trading mixed across the globe, with yields down 2-4 bps in Europe but up a bp in the US. JGBs were down a bp to 1.2%. On the commodity front, we see that gold is rallying, up $6.50 an ounce to $844.75.

On the data front

This is a truly global recession. We learned overnight that Japanese exports collapsed 26.7% year-over-year in November; that's the biggest drop on record. Shipments to the US plunged at an unprecedented 34% year-over-year rate. Meanwhile, imports into Japan sank 14.4% year-over-year in a sign of weakening domestic demand. A similar story out of Thailand, where exports dropped 18.6% in what was the biggest drop in at least 16 years. In China, interest rates were cut for the fifth time in three months. The key one-year lending rate was cut 27 bps to 5.31%. The reserve requirement was cut 50 bps to 15.5% for big banks and 13.5% for smaller ones. Chinese policymakers are trying to head off social unrest. Take a look at page A8 of today's WSJ, "China Faces Unrest as Economy Falters." For a read of how another BRIC nation has hit a wall in the face of a deepening global recession, turn to page A10 of today's WSJ, "India's Textile Industry Unravels."

Across the pond, signs of deflation abound. Germany's import price index dropped 3.4% MoM in November on top of a 3.6% drop in October. This was well below the consensus estimate, which was looking for a 2.5% decline. In France, producer prices plunged 1.9% in November on top of a 0.9% decline in October, well below the consensus, which was looking for a 0.9% drop for the month. Meanwhile, European industrial orders dropped 4.7% MoM in October on top of a downwardly revised 5.4% decline in September. This took the year-over-year rate to -15.1%, which is the the worst on record. We also see that German consumer confidence remained essentially unchanged at 2.1 in January from 2.2 in December.

The next bailout: commercial real estate

Now that the auto-makers have secured a $17 billion bailout, the next group heading to Washington for government assistance is property developers. Take a look at the front page of today's Wall Street Journal, "Developers Ask US For Bailout as Massive Debt Looms." Developers are warning policymakers that office complexes, malls, hotels and other commercial real estate are headed into default and bankruptcy. According to Foresight Analytics, some $350 billion of commercial mortgages will be due for refinancing over the next three years. And, with credit virtually unavailable, borrowers will have give up the property to lenders.

Whiffs of deflation in pharmacies

Take a look at page B3 of today's WSJ, "Pharmacies Fight Tough Battle on Generic Prices." In response to a discount prescription drug program from Wal-Mart, retail pharmacies like CVS, Caremark, Walgreen's and Rite Aid have started to aggressively promote their discount drug programs.

Breaking News Today's events

It is quiet today with no economic data released. Tomorrow, we'll get the final take on third quarter GDP, which is expected to remain at -0.5% QoQ annualized. The U of M index of consumer sentiment is due as well and expected to drop to 58.7 in December from 59.1 in November. New home sales are expected to drop again to 415,000 units annualized in November from 433,000 in October. Existing home sales are up too and expected to drop to 4.93 million units annualized in November from 4.98 million units in October. On Wednesday, we'll get the personal income and outlays report. Personal income expected to come in flat in November while spending is expected to drop 0.7% MoM in November on top of a 1% decline in October. The core PCE price index is expected to drop to 2% YoY in November from 2.1%. Durable goods round out the week and are expected to drop 3% MoM in November after a 6.9% collapse in October. Ex-transportation orders look to drop 2% too after a 5.4% plunge in October.

Making it up as he goes along

The latest news out of the Obama economics camp is that the upcoming fiscal plan will create 3 million jobs instead of the 2.5 million pledged just a few weeks ago. It begs the questions: How does the government "create" jobs anyway? What jobs? Where will they come from? Doesn't the government really help create and nurture the backdrop for the private sector to generate employment and economic growth? See "Obama Expands Recovery Plans As Outlook Dims" on the front page of the Sunday NYT. Indeed, 3 million jobs sounds good and makes for front page headlines, but it would be useful to see a line-item list of where these bodies are going to come from and whether they have the skills to build new ports, medical infrastructure, mass public transit infrastructure and expanded electricity grid and "green" technologies.

Let's do the math

We have 1.2 million unemployed construction workers. We have 123,000 unemployed architects and engineers. We have 83,000 unemployed machinery workers. We have 145,000 unemployed transportation-related workers. So that brings us to barely more than 1.5 million of a labor pool the government can tap into for all the new building activity. But the bulk of the joblessness is in financials (up to half a million), retail/wholesale (1.2 million), leisure/hospitality (1.3 million) and health/education (1.2 million). And if investment bankers, shopkeepers, bell captains and medical chart technicians have anything in common it is that they don't have much experience in shovel-ready activities.

Urban renewal in Obama's fiscal package

As an aside, we published a report two weeks ago highlighting the need for urban renewal as part of Obama's fiscal package - and it looks like somebody in Washington shares our view. See "Top Democrat Seeks to Boost Mass Transit's Share of Funding" on page A4 of the weekend WSJ. This is a secular theme. Another place we can see Obama's infrastructure program touch is the nation's levees, where repairs have lagged. See the front page of today's USA Today for more, "Most Levee Repairs Lagging."

Deflation risks are intact

Households have lost over $7 trillion in terms of net worth in the year ending 3Q, and it looks like this wealth destruction will top $10 trillion when the 4Q Fed flowof-funds data come out (that already exceeds the entire $4 trillion loss during the tech wreck). For a great synopsis, see "A Deflation Maelstrom In the Making" on page 11 of BusinessWeek. Friday's WSJ (page B1 - "Retailers Drop Prices to Avert a Flop") was filled with stories of how merchants are discounting more now than they were on Black Friday. Macy's has cut the prices of its diamond earrings from $800 a pair to $249 and the GAP just sliced another 60% off its already discounted clothing prices (as Bloomberg News reported over the weekend) and we are supposed to be consumed about deflation fear. Really? As a sign of how consumers are delaying their purchases in anticipation of even lower prices, only 47% of shoppers have completed their holiday activity versus 53% a year ago. We regard this as evidence that deflation expectations are creeping in.

And one of the conditions for deflation is, of course, wage flexibility, and everywhere we look, we see an increasing number of companies cutting back on their wage bills. FedEx is just one example - slashing wages for 35,000 employees by 5% (that is 16% of the company's workforce), including a 20% base pay cut for its Chairman and CEO (plus no company contributions to 401k plans in 2009). We also see that Nortel, Eastman Chemical, Newell Rubbermaid, Agilent Technologies, Atlas World Group, and AK Steel Holding have all cut wages and salaries in the past few weeks. According to Watson Wyatt Worldwide, another 6% of companies also plan to cut wages and benefits and 23% intend to reduce the size of their staff in 2009. Also have a look at the front page of "In Need of Cash, More Companies Cut 401(k) Match" - again, the labor market is definitely deflating. Not only that, but these cuts to 401(k) contributions are going to accelerate the process towards rising personal savings rates in coming quarters and years - again, a highly deflationary development and we are not sure that there is an appropriate response to this given that the savings rate is already at rock bottom levels of around 2%.

Moreover, the national labor market has frozen to such an extent that labor mobility has contracted significantly - see "Data Show Drop in Americans On the Move" on page 27 of the FT. Also have a look at front page of today's New York Times, "More Companies Cut Labor Costs, Without Layoffs." Companies are implementing four-day workweeks, unpaid vacations, wage freezes and pension cuts but keeping their headcount. Finally, take a look at page 13 of today's Financial Times, "Christmas Shutdown in Silicon Valley." What is usually limited to traditional manufacturing industries like auto has now hit tech. Companies across Silicon Valley are shutting down until after the holidays to cut back on spending. In spite of the forced time-off, some workers will be required to use up part of their holiday entitlement or if they don't have vacation days, take unpaid leave.

Historians may title this era GDII

As we said, historians may look back on this era and title it GDII: After all, look at how people are behaving - one of the newest fashions is renting movies about the Great Depression, or that have a similar theme like the "Grapes of Wrath" and "It's a Wonderful Life". See "Reality Can be Escaping, Too" on the front page of the Sunday NYT's Week in Review section.

Consensus still loves equities and despises bonds

See Barron's for more on the 'groupthink' theme - every single strategist surveyed (outside of us) sees the 10-year note yield backing up next year from current levels (page M12). The consensus is 3% for the end of 2009. As for equities, the Roundtable (see page 23) is at 1,045 for the S&P 500 (which would be +15 from here). Nobody is lower than 975 (Rich B's prediction) so +10% is at the low end of the entire spectrum. Health care was cited as a 'favorite sector' by 10 of the 12 pundits, and at least one of utilities/staples/telecom showed up on the top list of two-thirds of the respondents. So the view seems to be that we are going to have a bounce next year, led by ... the defensives. Interesting.

We don't understand why so many are bearish on rates

What we truly don't understand is why it is that so many folks are bearish on interest rates when in fact we need a sustained period of very low yields to help blaze the trail for the next sustainable economic expansion: After all, isn't it good news that, because of Mr. Bond's strength and resolve, we now have the benchmark 30-year fixed-rate mortgage at the lowest level in at least 37 years (5.27%)? Mortgage rates are now down 7 weeks in a row (it does the beg the question, however, as to why it is that mortgage applications for new purchases slid at a 20% annual rate in November and are off in 9 of the past 10 months). And despite the best affordability ratios in 35 years, what did we hear from Lennar last week - that its order book collapsed 46% in the past year and backlogs are down 67%. Maybe the classic affordability ratios that use conventional mortgages don't tell the complete story - because nonconventional mortgage rates have lagged with jumbo loans still costing 6.9%.

Homebuilders pressuring Washington for a bailout

As the bailouts pile up, we thought that the best read of the weekend was from the Weekend WSJ - see page W1 ("Is the Medicine Worse than the Illness?"). And now we see that the homebuilders are pressuring Washington to provide first-time homebuyers with a $22,000 tax credit. It's as if there is now a pervasive belief that there is a bottomless pit of cash ready to be put to use to correct all the excesses of the past decade from financials, to autos to builders. It's amazing that we could have let so many tech companies go belly up in the last cycle but have gone this route of accelerating rescue packages this time around. At least in the last cycle, we were running balanced budgets as opposed to trillion-dollar deficits. What does concern us is the risk to civil liberties when bankruptcy judges can alter contracts, the government can force banks to accept public capital injections (Jamie Dimon said on CNBC he didn't want or need Paulson's help), the government by fiat can bring mortgage rates down as opposed to market forces, the government tells lenders how to price their credit card business (since when did a piece of plastic become a right instead of a luxury?).

The major risks for 2009

We continue to believe that trade protectionism, competitive devaluations and military conflicts are the major risks for investors for 2009 - this is, after all, the most broadly based global recession (according to the IMF, not just us) in the post-WWII era: Ecuador defaulted on its foreign debt. Since the G20 meeting in Washington in October, five of those countries - Russia, India, Indonesia, Brazil and Argentina - have announced their intentions to raise import tariffs or otherwise restrict trade. Russia has announced plans to raise tariffs on autos; India has already lifted duties on iron, steel and soy; Brazil and Argentina are putting together a case within Mercosur for boosting external tariffs. Vietnam just raised taxes on steel imports to 12% from 8%. The EU said it may reimpose duties of 79% on a paper-binder component in retaliation against China. French President Sarkozy has established a $7.5 bln fund to invest in domestic companies so as to avoid foreign takeovers. China has reinstated export rebates and now we see that US steel, textile and paper markets intend to file complaints against Chinese imports, and did anyone notice that this auto-bailout excludes foreign companies?

It's all about self-preservation. We think that for anyone who missed it, the article on the front page of Friday's NYT is a worthwhile read ("After 30 Years, Economic Perils on China's Path"). Russia also cannot be regarded as a stable data point either as it just posted its first monthly budget deficit in November and the sovereign debt was just downgraded by S&P for the first time in a decade (Friday's WSJ reports says "public panic is one of the Kremlin's greatest fears"; the NYT reports that "as Beijing worries about strikes and mass layoffs even in some of the its most prosperous areas, official tolerance of political dissent has seemingly narrowed".) Gold will be an important hedge against policy missteps

Gold, in our opinion, is going to be important hedge against such policy missteps in 2009; and not only gold, but security of supply and government procurement policies may end up putting a floor under the beleaguered commodity complex earlier than a lot of folks think. As the chart below attests, there is a pretty good link between government spending as a share of GDP and the CRB index, because governments don't buy clothing or jewelry but they do buy "material".

And as for gold, the chart looks good against a vast majority of currencies and has broken out against Sterling. See chart below.

As we said before, the new growth engine for the economy is government spending, which is already on the rise and set to take out the prior high of over 23%. After all, when you are in trouble, you go to family members for help first. Uncle Sam.....?

The Six Lessons from Last Week's Action

John Mauldin — Mon, 01 Dec 2008 22:19:58 GMT

This week we look at a short but excellent summary of the state of the current economic crisis. I always enjoy reading David Rosenberg, the North American economist of Merrill Lynch. He has a no-nonsense style that is refreshing from most mainstream economists. The reality is that things continue to deteriorate. Today's stock market action shows that we are not of the bear market woods just yet. Rosenberg gives us a few reasons why.

John Mauldin, Editor
Outside the Box

The Six Lessons from Last Week's Action

By David Rosenberg, North American Economist,
Merrill Lynch

1) Expect the worst recession in the post-WWII era

First, this is going to be the worst recession in the post-World War II era, in our view. The ECRI leading indicator hit a record low for the fifth week in a row – down to - 29.2 as of the November 21st week versus -28.2 the week before. This index, which leads real GDP by two quarters with a 70% historical correlation, is getting further and further away from the prior all-time low of -19.8 that defined the worst recession of the post-WWII era and saw a six-quarter consumer recession coincide with a 45% peak-to-trough decline in the stock market. Perhaps the fact that this bear market is proving to be even more severe is symptomatic of an economic downturn that will also prove to be deeper and more prolonged. After the flurry of data released just before Thanksgiving, we are now tracking close to a 4.5% QoQ annualized fall in real GDP in 4Q. This would be the largest pullback since the 1982 recession, and we see a similar contraction in the first quarter of 2009.

2) Capex is in a steep decline

Second, capex is in a very steep decline right now. Durable goods orders dropped 6.2% in October, the third decline in a row. Over that time frame, orders have plunged at a 39% annual rate, which is unprecedented. The retrenchment has spread to the tech sector, where order books were expanding at a 7% annualized rate over the three months to June. Currently, that same three-month trend has swung to a negative 13% annualized rate.

3) Consumer spending down sharply; savings rate is soaring

Third, consumer spending fell 1% in October, which was a near-record decline. This, in fact, was the fourth straight monthly decline, which is unprecedented. The savings rate is soaring; it leapt to 2.4% from 1.0% in September, in a sign of heightened risk aversion and cash preservation, and is a shift that we believe should be seen as secular, not merely cyclical.

This was a conclusion that came through loud and clear in the Conference Board's Consumer Confidence Index, principally in the spending intention components of the survey. Auto buying plans dropped for the third month in a row to a record low in October while home-buying plans fell to their lowest level since the 1982 recession. Consumer plans to buy a major appliance fell to a 14-year low as well – down for three months in a row. During this four-month period of unprecedented consumer retrenchment from July to October, spending on discretionary items collapsed at an average annual rate of 18%. Even spending on groceries has declined 6%, toiletries are off by 6% and utilities are down 3%. So, even some of the classic staples are being curtailed.

The only areas that have posted increases in spending over this unprecedented four-month decline in spending have been pharmaceuticals (+7%), telecom services (+3%), medical care services (+5%) and mass transit (+26%) – all other forms of transportation, from rail to bus to air fell at a 19% annual rate.

4) Obama planning a $700 billion fiscal package

Fourth, we learned this week that President-elect Obama's economics team is planning a fiscal package as big as $700 billion over the next two years. We are going to wait for the details to see how this is going to impact our base case macro forecast. Suffice it to say that the cornerstone of the stimulus this time around will likely be infrastructure, not tax rebates. The key for investors is where these outlays will be concentrated, which, in turn, means identifying the areas of the capital stock that have been the most underinvested in recent years. After sifting through the data, we believe that the prime candidates will be hospitals, waste management services and passenger transit.

5) Housing market is not close to bottoming out

Fifth, we learned that the housing market is nowhere close to bottoming out. New home sales dropped 5.3% in November to a 433k annualized rate – the worst since the 1982 recession. Even though sales are now down 69% from the July 2005 bubble peak of 1.39 million units, we believe builders have not been aggressive enough in curbing production because the most critical variable of all, the unsold inventory backlog, rose to 11.1 months' supply from 10.9 in September.

Need to see inventory backlog drop to 8 months' supply

The reality is that even though single-family starts have dropped to 26-year lows of 531,000, they are still running 23% above the prevailing level of new home sales. The worst the inventory-sales ratio ever got in the early 1990s real estate meltdown was 9.4 months' supply. We are currently 18% above that level and almost 40% higher than the 8 months' supply we would need to see before calling an end to the housing deflation phase.

Another 15-20% decline in home prices likely from here

As we saw last week, the Case-Shiller index fell 1.85% MoM or at a 20% annual rate. All 20 cities were down both sequentially and YoY. Home prices are now down a remarkable 22% from the 2007 peaks. With the unsold inventory sitting at the third highest level of the past three decades and mortgage approvals for new home purchases falling to their lowest level in nine years, we believe the laws of supply and demand point to a further 15-20% decline from here. So, of all the things that happened last week in the market, retailing stocks up 17%, the bank stocks up 26%, tech up 9%, the one development that probably has the greatest chance of being reversed is the 60% surge we saw in the homebuilding group.

6) Fed has switched December meeting to a two-day affair

Sixth, we learned that the Fed is going to make the December FOMC meeting a two-day affair instead of one (December 15-16). The market is already sniffing out a 50 basis point rate cut. However, now that the Fed has de facto embarked on the process of quantitative easing, perhaps the need for a two day meeting is to iron out a more aggressive plan to revive the credit markets and the economy. The only areas that have posted increases in spending over this unprecedented four-month decline in spending have been pharmaceuticals (+7%), telecom services (+3%), medical care services (+5%) and mass transit (+26%) – all other forms of transportation, from rail to bus to air fell at a 19% annual rate.

As Chairman Bernanke suggested in several speeches he gave back in 2002 and 2003, one of the deflation-fighting strategies would likely involve Fed action to nurture lower rates at the longer end of the yield curve. Perhaps this prospect is behind the rally in the 10-year note yield and long bond to cycle lows. This would fit in very well with our ongoing strategy of focusing on equity sectors that have income-generating characteristics like utilities, health care and telecom services; these sectors also screen very well in a negative nominal GDP growth environment.

Quarterly Review and Outlook - First Quarter 2008

John Mauldin — Tue, 22 Apr 2008 02:08:00 GMT

This week's Outside the Box is from my friends at Hoisington Management. While somewhat technical, they make the case that a slowdown in consumer spending is inevitable. This is worth taking some time and thinking about. Quoting: "This means that consumer spending increases should be approximately zero for the next three years. Further exacerbating the problem is the personal saving rate which declined from 5.2% in the decade of the 1990s to average 1.3% in the last seven years, and now stands at 0.3%. Should declining wealth, rising unemployment and poor economic conditions cause consumers to begin to save and lift the rate back to the 1.3% average of the past seven years, real consumer spending would experience a multi-year contraction."

If they are right, and the evidence of their research is compelling, then we are in for a much tougher time than the recent stock market rallies suggest. The stock market is not always a leading indicator. This week's letter suggests that businesses that depend on the US consumer for growth may be in trouble.

John Mauldin, Editor
Outside the Box

Quarterly Review and Outlook - First Quarter 2008

Semantics

Nominal GDP in the first quarter totaled an estimated $14.2 trillion, a 3% annual rate of increase from the final quarter of 2007, which also registered a 3% gain. This two quarter growth rate in nominal GDP is typically associated with recessionary periods (Chart 1). The various price deflators applied to this nominal gain will now determine whether real GDP will be negative or positive, possibly clarifying the debate of whether an actual recession is in place. For financial participants, however, this argument is moot since the U.S. economy, at best, has been in a growth recession since mid-2007.

Solomon Fabricant, the NYU professor and NBER committee member who first identified this particular characteristic of the business cycle, stated that a growth recession occurs when economic conditions are sufficiently poor that unemployment rises and industrial capacity falls. From the cyclical low in March 2007 to March 2008, the unemployment rate jumped from 4.4% to 5.1%. In February, the manufacturing capacity use rate was 78.7, down 1.4% from its peak in July. Both signify a deteriorating economy. Growth recessions, like full scale recessions, produce falling inflation, a margin squeeze on corporate profits, eroding stock prices, and declining interest rates. Thus, the difference is really one of semantics. The point for investors is not what type of recession we are experiencing, but rather how long the downturn will last. Our conclusion is that our present economic difficulties will persist for at least two years.

An Extended Slump

Going forward, the main problem for the U.S. economy is likely to be a protracted period of restrained consumer spending. In the expansion from 2002 to 2007, real Personal Consumer Expenditures (PCE), which comprised 71.5% of GDP at the end of last year, posted a 3.1% per annum increase, down from 3.5% and 4.2%, respectively, in the expansions of the 1990s and 1980s (Chart 2). The subdued gain in spending would have been even less had consumers lived within their means, as real personal income (2.5%) expanded less than the spending rate. With spending outpacing income, the personal saving rate dropped from 2.4% in 2002 to 0.4% in 2007.

A disparity of 0.7% per annum between the growth of income and spending might seem insignificant until you consider that income must also support all the other demands on consumers -- investment in housing and other real assets, financial investment, and gifts to charitable and other causes.

The main cause of the weaker trend in personal income in this decade was lackluster real wage and salary income that rose just 1.8%, or one-half the rate of gain in the expansion of the 1990s. This meager gain was caused by the sluggish .8% payroll employment growth rate that was the smallest of any expansion since World War II. With this key determinant of consumer spending restrained, consumers lived well beyond their means, only because their paper worth was boosted by surging home prices.

Consumption And The Wealth Effect

One of the most studied issues is the consumption function - the factors that determine the way in which consumers are motivated to spend. For example, in Macroeconomics by Andrew Abel of Wharton and Ben Bernanke (now of the Federal Reserve and formerly of Princeton University) have a lengthy section entitled "the effects of changes in income and wealth on consumption and saving". This analysis like many others of a similar nature conclude that both income, expected future income, wealth as well as other considerations are causally related to spending. Using econometric models, economists are able to assign different numeric weights to those elements in the consumption function. These studies indicate, as a general rule, that expected or permanent income is more important that current income and that income considerations are more important than wealth. However, something known as initial conditions (the current starting point in the business cycle) may serve to over-ride the general rule. We, for example, believe that there are notable difficulties facing the U.S. economy that were typically not present in the past.

Wages, salaries, interest, dividends and rent generate funds that are available for spending. When wealth rises, however, funds are not typically generated that, in turn, can be translated into spending. Thus, understanding the mechanism of how wealth translates into spending may involve additional steps.

Consumers could turn wealth into spending funds by selling appreciating assets. However, if all consumers decided to do this at roughly the same time, the prices of those assets would fall, reversing the rise in wealth that had seemingly occurred. Thus, the main mechanism that increased wealth leads to rising consumption is for consumers to borrow against those assets. This, therefore, avoids the necessity of selling the appreciating asset and avoiding or at least postponing the decline of the appreciating assets.

Our research suggests that the mechanism of choice from 2002 to 2007 to convert rising wealth into spendable funds was borrowing against what consumers and their lenders apparently believed to be was a permanent rise in housing wealth - i.e. something that we have come to know as equity cash take outs.

The Home Equity Connection

From 2002 to 2007, home equity extraction, as determined by Freddie Mac, averaged $51.5 billion per quarter, up from $5.8 billion in the 1990s expansion (Chart 3). If we convert these cash outs into real dollars (using the PCE deflator), we see that they represented 2.4% of real PCE from 2002 to 2007, compared with a miniscule .4% of PCE in the 1990s. Thus, for spending, the shortfall in jobs and income was substituted by the famous home ATM machine. However, the connection between equity withdrawal and wealth is a complex matter. A great deal of econometric research has demonstrated that for every dollar change in real wealth, real spending shifts by 7.5 cents over the ensuing three years. If the massive real wealth gains derived from both homes and the equity markets in the 2002 to 2007 period are adjusted by the $1 to 7.5 cent relationship, the real wealth gains amounted to 2.5% per annum, expressed as a percent of real PCE. For all practical purposes, this is equal to the 2.4% per annum rise in mortgage cash outs. Consumers borrowed against the value of their homes in virtual direct proportion to their wealth gains.

The problem going forward is that real wealth is now declining, with the bottom yet to be found. Assuming home prices fall only 30% from their peak (some estimate a 50% decline), while stock prices rise 10% from the first quarter level and inflation is 2% per annum, the real wealth loss is about $7 trillion (Chart 4). Using the $1 to 7.5 cent ratio, this will constitute a drag on real PCE of 1.8% per annum from 2008 to 2010. Considering that the 3.1% rate of increase was the last expansion's average, a 1.8% drag will be a 60% reduction in consumer spending growth over the next three years just from the cash out/wealth effect alone.

However, there are other constraints. During the postwar recessions, real personal income's average growth was only 1.9%, but it has risen only 1.1% over the past 12 months. If real personal income moves back up to 1.9%, in itself a highly optimistic assumption, it would, nevertheless, be completely offset by the negative wealth impact of 1.8% mentioned above. This means that consumer spending increases should be approximately zero for the next three years. Further exacerbating the problem is the personal saving rate which declined from 5.2% in the decade of the 1990s to average 1.3% in the last seven years, and now stands at 0.3%. Should declining wealth, rising unemployment and poor economic conditions cause consumers to begin to save and lift the rate back to the 1.3% average of the past seven years, real consumer spending would experience a multi-year contraction. It is not a stretch to predict an extended quasi-recessionary period.

Is Inflation Accelerating?

In the last twelve months, the CPI increased by 4.1%, well above the 2.8% average annual increase this decade. Do these readings mean that the inflationary spiral has started? Other factors that contribute to inflation fears are the acceleration in M2 growth to a 13% rate of increase in the past three months, $100 plus per barrel oil, elevated prices for food, a wide variety of other commodity prices, and a weak dollar. A related question is whether the higher CPI readings, combined with poor economic growth, will result in stagflation, a condition last witnessed nearly three decades ago. Four considerations suggest that these fears are not likely to be realized.

First, inflation is a lagging indicator. This is true of all major broad based inflation barometers -- the CPI, the core CPI, the more reliable core PCE deflator and the Employment Cost Index (ECI). Over the past five cyclical downturns, the year over year increases in these four series did not peak until the economy was in recession (Chart 5). In all these situations, major reductions in inflation occurred in the early stages of the ensuing recovery. This historical pattern is due to the fact that productivity surges rapidly in early stage expansion, causing unit labor costs to rise much more slowly than wage costs.

Second, in this particular episode all these inflation gauges have peaked well before the start of the growth recession in mid-2007. The year over year increases peaked as follows: 4.7% for the headline CPI in September 2005; 2.9% for the core CPI in September 2006; 2.5% for the core PCE in February 2007, and 4% for the ECI all the way back in the fourth quarter of 2003. The year over year change in the fourth quarter was a substantially lower 3%.

Third, the unprecedented deceleration in the increase in the ECI of one full percent during the past three years of economic expansion strongly documents the impact of globalization on the United States inflation rate. Even with the recent increases, the unemployment rate is still 1.2% lower than in June 2003. Despite this tighter job market, wage cost increases decelerated, a clear reflection that employers have global options, and wages are increasingly set in the global marketplace. This is strong confirmation that the upturn in headline inflation is transitory. Higher food and fuel costs have not fed into wages, a critical element since wage, salary and benefit costs comprise almost 70% of the cost of production in the United States. Persistent inflation episodes have all exhibited a price/wage spiral.

Fourth, in spite of the 13% rate of growth in M2 in the past three months, and the striking new creations in Federal Reserve lending and financial support activities, we actually judge the thrust of monetary polity to be somewhat restrictive, not expansionary. This is based on the consideration of both the stock of money (M) and its velocity (V). For example, the first quarter surge in M2 growth has been more than entirely neutralized by a dramatic decline in M2 velocity (Chart 6).

Moreover, velocity is likely to continue to decline. Velocity falls when financial innovations are not forthcoming and declines sharply when previous financial innovations are reversed. In the midst of the current massive credit crunch, this cycle's innovations in mortgage finance, collateralized debt obligations, and structured investment vehicles are all being reversed. In the first quarter, nominal GDP grew around a 3% annual rate, meaning that velocity dropped to 1.85 from 1.9 in the fourth quarter, remaining well above the post 1900 average of 1.67.

More striking, perhaps, has been the impact of velocity over the past seven quarters. M2 growth has accelerated to 6.8% versus 4.4% in the seven quarters ended in the second quarter of 2006 when velocity peaked. Based on M2 alone, the economy should have been accelerating, not falling into the current slump. However, in the past seven quarters V2 (the velocity of M2) declined 2.3% per annum, causing GDP growth to decelerate from 6.5% to 4.4% (Table 1). This declining velocity will mean the Federal Reserve's best efforts are likely to be thwarted, and nominal GDP will slow coincident with inflation and output.

Interest Rate Possibilities

Treasury yields have dropped to near record lows, but the historical record suggests the ultimate bottom in cyclical rates is considerably in the future. On average, thirty year Treasury bond yields are a lagging economic indicator. This is not surprising since inflation is a lagging indicator and inflation is the main long run determinant of bond yields. Since the end of World War II, the thirty year Treasury yields reached their cyclical lows, on average, 14.9 months after the end of the business cycle troughs (Table 2).

Thus, if this growth, or outright recession, ends in 2008, the low in bond yields will be some time in 2010. However, if we are in an extended growth recession that lasts into 2009 or 2010, as we suspect, and if rates are at record low levels, similar to the 1940s and 1950s, then the low in rates is likely to coincide with the end of the recessionary period.

Van R. Hoisington
Lacy H. Hunt, Ph.D.

Your doing my bit to keep up consumer spending analyst,

John Mauldin

Asleep at the wheel, or, How I learned to stop worrying and love the bomb

John Mauldin — Mon, 07 Apr 2008 19:52:47 GMT

For the last few months in my regular letter I have been pounding the table that corporate earnings are going to decline this year, which is always a negative atmosphere for stocks. Since today is the beginning of the earnings season for the first quarter...(read more)